Undergraduate study in Economics,

Management, Finance and the Social Sciences

Financial
management

L. Fung

AC3059
2023
Financial management
L. Fung
AC3059
2023

Undergraduate study in
Economics, Management,
Finance and the Social Sciences

This subject guide is for a 300 course offered as part of the University of London’s
undergraduate study in Economics, Management, Finance and the Social
Sciences. This is equivalent to Level 6 within the Framework for Higher Education
Qualifications in England, Wales and Northern Ireland (FHEQ).
For more information, see: london.ac.uk
The 2023 edition of this guide was prepared for the University of London:
L. Fung, Senior Lecturer, Department of Management, Birkbeck, University of London.
It is a revised edition of previous editions of the guide prepared by J. Dahya and R.E.V. Groves,
and draws on the work of those authors.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please communicate these through the discussion forum on the virtual learning environment.

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 Contents

Contents

Introduction............................................................................................................. 1
Aims and objectives........................................................................................................ 1
Employability outcomes.................................................................................................. 2
Syllabus.......................................................................................................................... 2
How to use the subject guide.......................................................................................... 5
Online study resources.................................................................................................... 6
Examination advice........................................................................................................ 7
Summary........................................................................................................................ 8
Abbreviations................................................................................................................. 8
Chapter 1: Financial management function and environment.............................. 11
Essential reading.......................................................................................................... 11
Further reading............................................................................................................. 11
Works cited.................................................................................................................. 11
Aims............................................................................................................................ 11
Learning outcomes....................................................................................................... 11
Two key concepts in financial management................................................................... 11
The nature and purpose of financial management......................................................... 13
Corporate objectives..................................................................................................... 16
Objectives for not-for-profit organisations..................................................................... 17
The agency problem..................................................................................................... 18
Financial management environment.............................................................................. 19
A reminder of your learning outcomes........................................................................... 20
Practice questions......................................................................................................... 20
Sample examination questions...................................................................................... 20
Chapter 2: Investment appraisals 1....................................................................... 21
Essential reading.......................................................................................................... 21
Further reading............................................................................................................. 21
Aims............................................................................................................................ 21
Learning outcomes....................................................................................................... 21
Overview...................................................................................................................... 21
Basic investment appraisal techniques.......................................................................... 21
Pros and cons of investment appraisal techniques......................................................... 25
Non-conventional cash flows........................................................................................ 26
How to value perpetuity and annuity............................................................................. 28
A reminder of your learning outcomes........................................................................... 28
Practice questions......................................................................................................... 28
Sample examination questions...................................................................................... 28
Chapter 3: Investment appraisals 2....................................................................... 31
Essential reading.......................................................................................................... 31
Further reading............................................................................................................. 31
Aims............................................................................................................................ 31
Learning outcomes....................................................................................................... 31
Advanced investment appraisals................................................................................... 31
A reminder of your learning outcomes........................................................................... 37
Practice questions......................................................................................................... 37
Sample examination questions...................................................................................... 37 i
AC3059 Financial management

Chapter 4: Investment appraisals 3....................................................................... 39

Essential reading.......................................................................................................... 39
Further reading............................................................................................................. 39
Works cited.................................................................................................................. 39
Aims............................................................................................................................ 39
Learning outcomes....................................................................................................... 39
Replacement decision................................................................................................... 39
Delaying projects.......................................................................................................... 41
Abandoning a project................................................................................................... 43
Sensitivity analysis........................................................................................................ 43
Practical consideration.................................................................................................. 44
A reminder of your learning outcomes........................................................................... 45
Practice questions......................................................................................................... 45
Sample examination questions...................................................................................... 45
Chapter 5: Risk and return.................................................................................... 47
Essential reading.......................................................................................................... 47
Further reading............................................................................................................. 47
Works cited.................................................................................................................. 47
Aims............................................................................................................................ 47
Learning outcomes....................................................................................................... 47
Overview...................................................................................................................... 47
Introduction of risk measurement.................................................................................. 47
Diversification of risk and Portfolio Theory..................................................................... 50
A reminder of your learning outcomes........................................................................... 52
Practice questions......................................................................................................... 52
Sample examination questions...................................................................................... 53
Chapter 6: Portfolio Theory and Capital Asset Pricing Model............................... 55
Essential reading.......................................................................................................... 55
Further reading............................................................................................................. 55
Aims............................................................................................................................ 55
Learning outcomes....................................................................................................... 55
Overview...................................................................................................................... 55
Applications of the Capital Market Line (CML)............................................................... 57
Derivation of Capital Asset Pricing Model (CAPM)......................................................... 59
A reminder of your learning outcomes........................................................................... 60
Practice questions......................................................................................................... 60
Sample examination questions...................................................................................... 60
Chapter 7: Practical consideration of Capital Asset Pricing Model and
Alternative Asset Pricing Models.......................................................................... 63
Essential reading.......................................................................................................... 63
Further reading............................................................................................................. 63
Works cited.................................................................................................................. 63
Aims............................................................................................................................ 63
Learning outcomes....................................................................................................... 63
Overview...................................................................................................................... 64
Alternative Asset Pricing Models................................................................................... 67
Practical consideration of CAPM................................................................................... 68
A reminder of your learning outcomes........................................................................... 68
Practice question.......................................................................................................... 68
Sample examination questions...................................................................................... 69

ii
 Contents

Chapter 8: Capital market efficiency..................................................................... 71

Essential reading.......................................................................................................... 71
Further reading............................................................................................................. 71
Aims............................................................................................................................ 71
Learning outcomes....................................................................................................... 71
Capital markets............................................................................................................ 71
Types of efficiency........................................................................................................ 72
Efficient Market Hypothesis (EMH)................................................................................ 72
A reminder of your learning outcomes........................................................................... 76
Practice questions......................................................................................................... 76
Sample examination questions...................................................................................... 77
Chapter 9: Sources of finance – Equity................................................................. 79
Essential reading.......................................................................................................... 79
Further reading............................................................................................................. 79
Work cited................................................................................................................... 79
Aims............................................................................................................................ 79
Learning outcomes....................................................................................................... 79
Introduction................................................................................................................. 79
Internal funds............................................................................................................... 79
External funds.............................................................................................................. 80
Floatation..................................................................................................................... 80
Share issues................................................................................................................. 81
Rights issues................................................................................................................ 83
Private issues................................................................................................................ 83
The role of stock markets.............................................................................................. 84
A reminder of your learning outcomes........................................................................... 84
Practice questions......................................................................................................... 85
Sample examination questions...................................................................................... 85
Chapter 10: Sources of finance – Debt.................................................................. 87
Essential reading.......................................................................................................... 87
Further reading............................................................................................................. 87
Aims............................................................................................................................ 87
Learning objectives....................................................................................................... 87
Introduction................................................................................................................. 87
Corporate bonds.......................................................................................................... 87
Debt finance................................................................................................................. 89
The issue of loan capital............................................................................................... 90
A reminder of your learning outcomes........................................................................... 93
Practice questions......................................................................................................... 93
Sample examination questions...................................................................................... 93
Chapter 11: Capital structure 1............................................................................. 95
Essential reading.......................................................................................................... 95
Further reading............................................................................................................. 95
Works cited.................................................................................................................. 95
Aims............................................................................................................................ 95
Learning outcomes....................................................................................................... 95
Introduction................................................................................................................. 95
Modigliani and Miller’s theory....................................................................................... 96
Modigliani and Miller’s argument with corporate taxes................................................. 98
Personal taxes.............................................................................................................. 99

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AC3059 Financial management

Other tax shield substitutes......................................................................................... 100

Financial distress........................................................................................................ 100
Trade-off Theory.......................................................................................................... 101
A reminder of your learning outcomes......................................................................... 102
Practice questions....................................................................................................... 102
Sample examination questions.................................................................................... 102
Chapter 12: Capital structure 2........................................................................... 103
Essential reading........................................................................................................ 103
Further reading........................................................................................................... 103
Works cited................................................................................................................ 103
Aims.......................................................................................................................... 103
Learning outcomes..................................................................................................... 103
Signalling effect.......................................................................................................... 103
Agency costs on debt and equity................................................................................. 105
Pecking Order Theory.................................................................................................. 107
Conclusion................................................................................................................. 107
A reminder of your learning outcomes......................................................................... 108
Practice questions....................................................................................................... 108
Sample examination questions.................................................................................... 108
Chapter 13: Dividend policy................................................................................ 109
Essential reading........................................................................................................ 109
Further reading........................................................................................................... 109
Works cited................................................................................................................ 109
Aims.......................................................................................................................... 109
Learning outcomes..................................................................................................... 109
Introduction............................................................................................................... 110
Types of dividend........................................................................................................ 110
Dividend controversy.................................................................................................. 111
Modigliani and Miller’s argument................................................................................ 111
Clientele effect........................................................................................................... 112
Information content of dividend and signalling effect.................................................. 113
Agency costs and dividend.......................................................................................... 114
Empirical evidence...................................................................................................... 115
Conclusion................................................................................................................. 116
A reminder of your learning outcomes......................................................................... 116
Practice questions....................................................................................................... 116
Sample examination questions.................................................................................... 116
Chapter 14: Cost of capital and capital investments.......................................... 119
Essential reading........................................................................................................ 119
Further reading........................................................................................................... 119
Aims.......................................................................................................................... 119
Learning outcomes..................................................................................................... 119
Introduction............................................................................................................... 119
Cost of capital and equity finance............................................................................... 119
Cost of capital and capital structure............................................................................ 120
A reminder of your learning outcomes......................................................................... 126
Practice questions....................................................................................................... 126
Sample examination question..................................................................................... 126

iv
 Contents

Chapter 15: Valuation of business....................................................................... 127

Essential reading........................................................................................................ 127
Further reading........................................................................................................... 127
Works cited................................................................................................................ 127
Aims.......................................................................................................................... 127
Learning outcomes..................................................................................................... 127
Introduction............................................................................................................... 127
Approaches to business valuation............................................................................... 127
Valuation of debt/bonds............................................................................................. 130
Valuation of equity..................................................................................................... 131
Conclusion................................................................................................................. 134
A reminder of your learning outcomes......................................................................... 135
Practice questions....................................................................................................... 135
Sample examination question..................................................................................... 135
Chapter 16: Mergers............................................................................................ 137
Essential reading........................................................................................................ 137
Further reading........................................................................................................... 137
Aims.......................................................................................................................... 137
Learning outcomes..................................................................................................... 137
Introduction............................................................................................................... 137
Motives for mergers.................................................................................................... 138
Conclusion................................................................................................................. 146
A reminder of your learning outcomes......................................................................... 146
Practice questions....................................................................................................... 146
Sample examination question..................................................................................... 146
Chapter 17: Financial planning and analysis....................................................... 149
Essential reading........................................................................................................ 149
Aims.......................................................................................................................... 149
Learning outcomes..................................................................................................... 149
Introduction............................................................................................................... 149
Financial analysis........................................................................................................ 149
Cash based ratios....................................................................................................... 151
Financial planning...................................................................................................... 156
Short-term versus long-term financing........................................................................ 159
A reminder of your learning outcomes......................................................................... 160
Practice questions....................................................................................................... 160
Chapter 18: Working capital management.......................................................... 163
Essential reading........................................................................................................ 163
Aims.......................................................................................................................... 163
Learning outcomes..................................................................................................... 163
Introduction............................................................................................................... 163
Working capital management..................................................................................... 163
Trade receivables management................................................................................... 164
Working capital and the problem of overtrading.......................................................... 170
A reminder of your learning outcomes......................................................................... 172
Practice questions....................................................................................................... 172
Sample examination questions.................................................................................... 172

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AC3059 Financial management

Chapter 19: Risk management – Concepts and instruments for risk hedging.... 173
Essential reading........................................................................................................ 173
Further reading........................................................................................................... 173
Works cited................................................................................................................ 173
Aims.......................................................................................................................... 173
Learning outcomes..................................................................................................... 173
Introduction............................................................................................................... 173
Reasons for managing risk.......................................................................................... 174
Instruments for hedging risk....................................................................................... 175
Put-call parity............................................................................................................. 176
Option pricing............................................................................................................ 177
Futures and forward contracts..................................................................................... 178
Conclusion................................................................................................................. 179
A reminder of your learning outcomes......................................................................... 179
Practice questions....................................................................................................... 179
Sample examination question..................................................................................... 179
Chapter 20: Risk management – Applications.................................................... 181
Essential reading........................................................................................................ 181
Further reading........................................................................................................... 181
Aims.......................................................................................................................... 181
Learning outcomes..................................................................................................... 181
Introduction............................................................................................................... 181
Risk management....................................................................................................... 181
Some simple uses of options....................................................................................... 183
Corporate uses of options........................................................................................... 184
Conclusion................................................................................................................. 184
A reminder of your learning outcomes......................................................................... 185
Practice questions....................................................................................................... 185
Sample examination questions.................................................................................... 185
Appendix 1: Sample examination paper............................................................. 187

vi
 Introduction

Introduction

AC3059 Financial management is a 300 course offered on the

degrees and diplomas in Economics, Management, Finance and the Social
Sciences (EMFSS) suite of programmes awarded by the University of
London.
Financial management is part of the decision-making, planning and
control subsystems of an enterprise. It incorporates the:
• treasury function, which includes the management of working capital
and the implications arising from exchange rate mechanisms due to
international competition
• evaluation, selection, management and control of new capital
investment opportunities
• raising and management of the long-term financing of an entity
• need to understand the scope and effects of the capital markets for a
company
• need to understand the strategic planning processes necessary to
manage the long and short-term financial activities of a firm.
The management of risk in the different aspects of the financial activities
undertaken is also addressed.
Studying this course should provide you with an overview of the problems
facing a financial manager in the commercial world. It will introduce
you to the concepts and theories of corporate finance that underlie the
techniques that are offered as aids for the understanding, evaluation and
resolution of financial managers’ problems.
This subject guide is written to supplement the Essential and Further
reading listed for this course, not to replace them. The aim of the course is
to provide an understanding and awareness of both the underlying concepts
and practical application of the basics of financial management. The subject
guide and the readings should also help to build in your mind the ability to
make critical judgements of the strengths and weaknesses of the theories,
just as it should be helping to build a critical appreciation of the uses and
limitations of the same theories and their possible applications.

Aims and objectives

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

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AC3059 Financial management

By the end of this course and having completed the Essential reading and
activities, you should be able to:
• describe how different financial markets function
• estimate the value of different financial instruments (including stocks
and bonds)
• make capital budgeting decisions in the world with and without tax,
under both certainty and uncertainty, and capital rationing
• apply the Capital Assets Pricing Model in project appraisals,
constructing portfolio with desired risk, and creating risk-free arbitrage
opportunity
• evaluate the pros and cons of using equity and debt for financing long-
term projects
• describe how leasing works for firms
• estimate cost of capitals
• determine the value creation from mergers and acquisitions
• apply working capital techniques in managing trade receivables,
inventory and trade payables
• determine how forwards, options and money market hedge can be
used to reduce uncertainty of foreign currency receipts and payments.

Employability outcomes
Below are the three most relevant skill outcomes for students undertaking
this course which can be conveyed to future prospective employers:
1. decision making
2. complex problem-solving
3. communication.

Syllabus
The subject guide examines the key theoretical and practical issues
relating to financial management. The topics to be covered in this subject
guide are organised into the following 20 chapters:
Chapter 1: Financial management function and environment
This chapter outlines the fundamental concepts in financial management
and deals with the problems of shareholders’ wealth maximisation and
agency conflicts.
Chapter 2: Investment appraisals 1
In this chapter we begin with a revision of investment appraisal
techniques. The main focus of this chapter is to examine the advantages
of using the discounted cash flow technique and its application in basic
investment scenarios.
Chapter 3: Investment appraisals 2
This chapter follows on from Chapter 2 to explore the application of
the discounted cash flow technique in more complex scenarios: capital
rationing, price changes and inflation and tax effect.
Chapter 4: Investment appraisals 3
This chapter illustrates the application of the discounted cash flow
technique in further complex scenarios: replacement decision, project
deferment and sensitivity analysis.
2
 Introduction

Chapter 5: Risk and return

We formally examine the concept and measurement of risk and return
in this chapter. We also look at the necessary conditions for risk
diversification, Portfolio Theory and the Two Fund Separation Theorem.
Asset Pricing Models are discussed and practical considerations in
estimating beta will be covered. Empirical evidence for and against the
Asset Pricing Models will also be illustrated.
Chapter 6: Portfolio Theory and Capital Assets Pricing Model
This chapter introduces more formally the Portfolio Theory and discusses
the derivation of the Capital Assets Pricing Model.
Chapter 7: Practical consideration of the Capital Assets
Pricing Model and Alternative Asset Pricing Model
Following on from Chapter 6 we examine the techniques for estimating
betas and their conceptual and practical considerations. We also introduce
an Alternative Pricing Model based on the Arbitrage Pricing Model.
Chapter 8: Capital market efficiency
This chapter discusses the concepts and implications of market efficiency
and the mechanism of equity and debt issuance.
Chapter 9: Sources of finance – Equity
In this chapter we focus on how companies raise funds from the stock
and bond markets, and discuss the advantages and disadvantages of this
financing method.
Chapter 10: Sources of finance – Debt
In this chapter we focus on how companies raise funds from the bond
markets, and discuss the advantages and disadvantages of this financing
method.
Chapter 11: Capital structure 1
This chapter introduces the arguments of Modigliani and Miller on capital
structure, and discuss the implication of the Trade-off Theory.
Chapter 12: Capital structure 2
This chapter critically reviews the existing leading theories of capital
structure. Specifically, signalling effect, agency cost of equity and debt
and the Pecking Order Theory will be examined. We will also evaluate the
practical considerations of capital structure decisions made by corporate
managers.
Chapter 13: Dividend policy
This chapter aims to explore how the amount of dividend paid by
corporations would affect their market values. The tax, signalling and
agency effects of dividend will be discussed.
Chapter 14: Cost of capital and capital investments
In this chapter we discuss how the cost of capital can be adjusted when
firms are financed with a mixture of debt and equity.
Chapter 15: Valuation of business
We introduce the valuation of equity, debt, convertibles and warrants in
this chapter.
Chapter 16: Mergers
This chapter focuses on the theory and motives of mergers and
acquisitions. The determination of merger value and the defensive tactics
against merger threats will also be covered. The empirical evidence of
using financial ratios to predict mergers and acquisitions will be discussed. 3
AC3059 Financial management

Chapter 17: Financial planning

This chapter focuses on the importance of careful financial planning
and examines and evaluates the approaches to and methods of financial
planning.
Chapter 18: Working capital management
The importance of managing working capital will be discussed in this
chapter.
Chapter 19: Risk management – concepts and instruments for
risk hedging
This chapter provides an introduction to risk management, including: the
concepts of risk management and the use of derivatives in hedging.
Chapter 20: Risk management – applications
This chapter discusses the techniques commonly used in risk hedging.

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

Reading

Essential reading
Brealey, R., S.C. Myers, F. Allen and A. Edmans Principles of corporate finance.
(New York: McGraw Hill, 2023) 14th edition [ISBN 9781264080946].
Hereafter referred to as BMAE, this textbook deals with most of the topics
covered in this subject guide.
Detailed reading references in this subject guide refer to the edition of the
set textbook listed above. New editions of this textbook may have been
published by the time you study this course. You can use a more recent
edition of this book or of any of the books listed below; use the detailed
chapter and section headings and the index to identify relevant readings.
Also check the VLE regularly for updated guidance on readings.

Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and
by thinking about how these principles apply in the real world. To help
you read extensively, you have free access to the VLE and the University of
London Online Library (see below).
Other useful texts for this course include:
Arnold, G. Corporate financial management. (London: Pearson, 2019)
sixth edition [ISBN 9781292140445]. Hereafter referred to as ARN, this
textbook also covers most of the topics in this subject guide. It is less
technical than BMAE.
Copeland, T.E., J.F. Weston and K.S. Shastri Financial theory and corporate
policy. (Harlow: Pearson-Addison Wesley, 2004) fourth edition
[ISBN 9780321127211]. This is a classic finance textbook pitched at an
advanced level. You may use this textbook for reference as it contains some
useful updates of empirical studies in the field of corporate finance.

4
 Introduction

Watson, D. and A. Head Corporate finance passnotes. (Harlow: Pearson

Education, 2010) first edition [ISBN 9780273725268]. This concise version
of a passnote neatly summarises the key concepts in financial management.
You might find it useful as a revision tool.
Apart from the above textbooks, this subject guide also refers to some of
the original articles from which the financial management theories are
developing. You should refer to the works cited in each chapter for the full
reference of these articles.

How to use the subject guide

This subject guide is meant to supplement but not to replace the main
textbook. You should use it as a guide to devise a plan for your own study
of this subject. Suggested here is one approach to using this subject guide.
Approach financial management in the same order as the chapters in
this subject guide. It is specifically designed to help you build up your
understanding of the subject.
4. For each chapter (apart from this Introduction) you should familiarise
yourself with the aim and outcomes before reading the materials.
5. Read the introductory section of each chapter to identify the areas you
need to focus on.
6. Carefully read the suggested chapters in BMAE, with the aim of
gaining an initial understanding of the topics.
7. Read the remainder of the chapter in the subject guide. You may then
approach the Further reading suggested in the subject guide and
BMAE.
8. The subject guide is designed to set the scope of your studies of this
topic as well as to attempt to reinforce the basic messages set out in
BMAE. Therefore you should pay careful attention to the examples
in both the texts and the subject guide to ensure you achieve that
basic understanding. By taking notes from BMAE, and then from
other books you should have obtained the necessary material for your
understanding, application and later revision.
9. Pay particular attention to the practice questions and the examples
given in the subject guide. The material covered in the examples and
in the Activities complements the textbook and is important in your
preparation for the examination.
10. Ensure you have achieved the listed learning outcomes.
11. Attempt the Sample examination questions at the end of each chapter
and the quizzes on the VLE.
12. Check you have mastered each topic before moving on to the next.
13. At the end of your preparations, attempt the questions in the Sample
examination paper at the end of the subject guide. Then compare your
answers with the suggested solutions, but do remember that they may
well include more information than the Examiner would expect in
an examination paper, since the guide is trying to cover all possible
angles in the answer, a luxury you do not usually have time for in an
examination.

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AC3059 Financial management

Online study resources

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

The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Course materials: Subject guides and other course materials
available for download. In some courses, the content of the subject
guide is transferred into the VLE and additional resources and
activities are integrated with the text.
• Readings: Direct links, wherever possible, to essential readings in the
Online Library, including journal articles and ebooks.
• Video content: Including introductions to courses and topics within
courses, interviews, lessons and debates.
• Screencasts: Videos of PowerPoint presentations, animated podcasts
and on-screen worked examples.
• External material: Links out to carefully selected third-party
resources.
• Self-test activities: Multiple-choice, numerical and algebraic
quizzes to check your understanding.
• Collaborative activities: Work with fellow students to build a body
of knowledge.
• Discussion forums: A space where you can share your thoughts
and questions with fellow students. Many forums will be supported by
a ‘course moderator’, a subject expert employed by LSE to facilitate the
discussion and clarify difficult topics.
• Past examination papers: We provide up to three years of past
examinations alongside Examiners’ commentaries that provide
guidance on how to approach the questions.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.

6
 Introduction

Making use of the Online Library

The Online Library (http://onlinelibrary.london.ac.uk) contains a huge
array of journal articles and other resources to help you read widely and
extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login.
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please use the online help pages (https://onlinelibrary.
london.ac.uk/resources/summon) or contact the Online Library team
using the ‘Chat with us’ function.
Unless otherwise stated, all websites in this subject guide were accessed in
May 2023. We cannot guarantee, however, that they will stay connected
and you may need to perform an internet search to find the relevant pages.

Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations
for relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination paper consists of eight questions of which you must
answer four questions. Each question carries equal marks and is divided
into several parts. The style of question varies but each question aims to
test the mixture of concepts, numerical techniques and application of each
topic. Since topics in financial management are often interlinked, it is
inevitable that some questions might examine overlapping topics.
Remember when sitting the examination to maximise the time spent
on each question and although, throughout, the subject guide will give
you advice on tackling your examinations, remember that the numerical
type questions on this paper take some time to read through and digest.
Therefore try to remember and practise the following approach. Always
read the requirement(s) of a question first before reading the body of the
question. This is appropriate whether you are making your selection of
questions to answer, or when you are reading the question in preparation
for your answer.
In the question selection process at the start of the examination, by
reading only the requirements, which are always placed at the end of a
question, you only read material relevant to your choice, you do not waste
time reading material you are not going to answer. Secondly, by reading
the requirements first, your mind is focused on the sort of information you
should be looking for in order to answer the question, therefore speeding
up the analysis and saving time.

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AC3059 Financial management

Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’
commentaries for the course which give advice on how each question
might best be answered.

Summary
Remember this introduction is only a complementary study tool to help you
use this subject guide. Its aim is to give you a clear understanding of what
is in the subject guide and how to study successfully. Systematically study
the next 20 chapters along with the listed texts for your desired success.
Good luck and enjoy the subject!

Abbreviations
AEV Annual equivalent value
AIM Alternative investment market
APM Arbitrage Pricing Model
ARN Arnold, 2019
ARR Accounting rate of return
BMAE Brealey, Myers, Allen and Edmans
CAPM Capital Asset Pricing Model
CFs Cash flows
CME Capital market efficiency
CML Capital market line
CPI Consumer price index
DFs Discount factors
DPP Discounted payback period
DPS Dividend per share
EMH Efficient Market Hypothesis
EPS Earnings per share
EVA Economic value added
IPO Initial public offer
IRR Internal rate of return
LSE London Stock Exchange
MM Modigliani and Miller
MVA Market value added
NCF Net cash flow
NPV Net present value
NYSE New York Stock Exchange
PE Price earnings ratio
PI Profitability index
PP Payback period
ROA Return on assets

8
 Introduction

ROC Return on capital

ROE Return on equity
S&P Standard and Poor’s
Std dev Standard deviation
WACC Weighted average cost of capital

9
AC3059 Financial management

Notes

10
 Chapter 1: Financial management function and environment

Chapter 1: Financial management

function and environment

Essential reading
BMAE, Chapters 1 and 2.

Further reading
ARN, Chapter 1.

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

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

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• outline the nature and purpose of financial management
• describe the general environment in which businesses operate
• explain the relationship between financial objectives and corporate 1
Risk is often measured
strategies as a dispersion of the
possible return outcomes
• assess the impact of stakeholders on corporate strategies
from the expected mean.
• discuss the time value for money concept and the risk and return In Chapter 3 of this
relationship. subject guide, we will
more formally define
the concept of risk in
Two key concepts in financial management financial management
and discuss the different
Before we look at what financial management is about, it is essential for us methods to quantify risk.
to understand two key concepts which lay the foundation of this subject.
2
Return refers to the
The two key concepts are:
financial reward gained
i. Risk and return. as a result of making
an investment. It is
ii. Time value of money. often defined as the
percentage of value gain
Risk and return plus period cash flow
Financial markets seem to reward investors of riskier investments1 with a received to the initial
investment value.
higher return.2 The following graph indicates this relationship.3
3
The graph has been
rescaled in log to fit the
page. You should note
the vast differences of
the cash returns from
each investment type.

11
AC3059 Financial management

Index
(Approximate values)

Small Cap. (5500)

S&P (1800)
1000

Corp. Bonds (55)

Long Bonds (39)

10 T Bill (14)

0.1 Year
1925 1997 end

Figure 1.1: The cash return from five different investments.

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

Activity 1.1
What are the main reasons for smaller companies having higher perceived risk? What are
the specific risks we are referring to?
See the VLE for discussion.

Time value of money4 4

BMAE, Chapter 2 deals
with the concept of time
Money (i.e. cash) has different values over time. Holders of money can value for money and
either spend a sum of money now or delay their consumption by investing covers in detail how to
the money in different investment opportunities until it is required. calculate present and
future values.
Suppose an investor can deposit a sum of money in a bank and earn an
annual interest of 5%. The value of money to this investor would then be
5% per annum. If the same investor can invest the same sum of money in
a financial asset which gives a return of 10% annually, then the value of

12
 Chapter 1: Financial management function and environment

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

1 is the t-period discount factor

where t
(1 + r )

The nature and purpose of financial management

Having discussed the two key concepts in financial management, we
can now turn our attention to the function of financial management.
In general, there are three main tasks that financial managers need to
undertake:
i. Investing decisions – this is how financial managers select the ‘right’
investments. This can be examined in two stages. First we look at how
financial managers invest in and manage short-term working capital
(this is covered in Chapter 18 of this subject guide) and then we examine
how financial managers may appraise long-term investment projects.
ii. Financing decisions – this involves the choice of particular sources of
funds which provide cash for investments. The key issues that financial
managers should address are how:
• these sources of funds can be raised (covered in Chapters 9 and 10)
• the value of the business may be affected through the combination
of different sources of funds (covered in Chapters 11 and 12)
• the sources of funds may affect the relationship between different
stakeholders (covered in Chapters 11 and 12).
iii. Dividend policy – this concerns the return to shareholders (covered in
Chapter 13).
So in theory and in practice, how are these decisions being considered by
financial managers?

Link between investing, financing and dividend decisions

In a perfect and complete capital market where there are no transaction
costs and information is widely available to everyone, it is argued that a
firm’s investing, financing and dividend decisions are not interlinked. This
is known as Fisher’s Separation Theorem (Fisher, 1930). This is illustrated
in the following diagram.
13
AC3059 Financial management

C1

a
C1, a

Individual 1

Y1

C*1 X

Individual 2

CF1
C1, b b
I1
C0
C0, a C*0 Y0 C0, b W0

Figure 1.2: Fisher’s Separation Theorem.

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

Investing decision
What should the firm do in terms of its investments? A firm will logically
rank and invest in investment projects in descending order of their
profitability (Ri for each i). A production opportunity frontier can be
obtained (such as the curve Y0Y1). A firm will invest up to the point where
the marginal investment i* yields a return that equals the return from
the capital market (i.e. interest rate r). The total investment outlays – the
amount represented by C*0Y0 – is the sum Ii for all i(i = 1 to i*). Once the
investment plan is fixed, the firm will have C*0 in period 0 remaining and
a cash return of C*1 in period 1.

14
 Chapter 1: Financial management function and environment

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

Financing decision
In the beginning, we assume that the firm has an initial cash flow of
Y0 and requires a total investment outlay of C*0Y0. If any part of Y0 is
not contributed by shareholders, the firm’s dividend in period 1 will
be reduced by the funds raised from borrowing (at a cost of r) and the
interest. However, shareholders can offset this shortfall of dividend in
period 1 by investing the fund not contributed in the firm to the capital
market and earn a return exactly equal to r.
The above argument illustrates the Fisher separation in which investing,
financing and dividend decisions are all unrelated. However, if the capital
market is imperfect in such a way that external funding is restricted, the
Fisher separation might not apply. The following scenarios highlight the
practical considerations that financial managers would need to take.

15
AC3059 Financial management

Investment Financing Dividends

A company would like to It will need to raise funds If the company fails to
undertake a large number in order to take up these raise sufficient funds from
of profitable investment projects. outside the company,
projects. it would need to cut
dividends in order to
increase internal funding.
Dividends Financing Investment
A company wants to A lower level of available If external financing is
pay a large dividend to internal cash flows might restricted through partially
shareholders force the company to seek financing the dividend,
extra funds via external the company might need
financing. to postpone some of the
investment projects.
Financing Investment Dividends
A company has been using Due to the high cost of The company’s ability to
a higher level of external financing, the number pay dividends in the future
funding. of attractive investment may be adversely affected.
projects might be reduced.

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

Corporate objectives
BMAE, Chapter 1, pp.8–11 discuss the goals of corporation. The general
assumption in financial management is that corporate managers will
try their best to maximise the value of the shareholders’ investment
in the corporation (i.e. shareholders’ wealth maximisation (SHWM)).
Maximisation of a company’s ordinary share price is often used as a
surrogate objective to that of maximisation of shareholder wealth.5 5
Profit maximisation
is not the same as
In order to achieve this objective, it is argued that corporate managers will shareholders’ wealth
maximise the value of all investments undertaken by the firm. This can be maximisation. See ARN,
illustrated in the following diagram: Chapter 1, pp.3–15 for
further discussion.
NPV 1

NPV 2

NPV A3 Corporate net present value SHWM

Share price
(sum of individual Projects’ NPVs)
(3) (4)
NPV 4 (2)

(1)
Figure 1.3: Shareholders’ wealth maximisation.
Source: BMAE.
6
http://welcome.
However, in practice, corporate objectives vary. For example, HP, a hp.com/country/uk/en/
US‑based computer corporation, has the following objectives listed on its companyinfo/corpobj.
website:6 html
16
 Chapter 1: Financial management function and environment

• customer loyalty
• profit
• growth
• market leadership
• leadership capability
• employee commitment
• global citizenship.
While profit maximisation, social responsibility and growth represent
important supporting objectives, the overriding objective of a company
must be that of shareholders’ wealth maximisation. The financial wealth of
a shareholder can be affected by a company’s financial manager’s action.
Arguably, when good investment, financing and dividend decisions are
made, a company’s market value will increase. The rest of this subject guide
will explore how financial managers’ decisions can increase a firm’s value.
While an organic growth in a business may improve its earnings per
share (EPS), an acquisitive growth may not. For example, Company
A has 100,000 shares outstanding. It has a total earning of $100,000
in the current year. It acquires Company B when it has a total earning
of $50,000. Company A pays $500,000 (which is also the fair value of
Company B) to acquire the outstanding shares in Company B. Assuming
that there is no synergy created in this acquisition, the EPS after the
acquisition of Company A and its group would be $100,000 + $50,000 /
100,000 shares = $1.50 (before acquisition, the EPS = $1). The market
value of Company A and its group remains unchanged. The apparent
improvement in EPS is only cosmetic.

Objectives for not-for-profit organisations

Organisations which exist for purposes other than shareholders’ wealth
maximisation would have very different missions and objectives. Read
UNICEF’s mission statement to find out more.
While an organisation such as UNICEF may not be able to sell goods or
provide services that would generate direct revenue, its survival still relies
heavily on financial management.
ACCA has provided a very concise guide on not-for-profit organisations.
Even though not-for-profit organisations may not have maximising profit
as their key objective, this does not mean that they do not need to carefully
plan how financial resources can be utilised economically, efficiently
and effectively, and to ensure that services they provide are distributed
equitably. This is commonly known as the ‘4 Es’ of value for money.
How do we ensure that the 4 Es can be achieved? How do we measure
the value for money from the services provided by not-for-profit
organisations?
ACCA outlines the following steps:
• Economy: obtaining the appropriate quantity and quality of
resources at the lowest cost possible; optimising the resources (inputs)
which an organisation has.
• Efficiency: maximising the output generated from units of resource
used; optimising the process by which inputs are turned into outputs.
• Efficiency: measuring this in terms of the cost of providing a service
per unit of resource used, per unit of output or per beneficiary served
(in the context of a service).
17
AC3059 Financial management

• Equity: providing and distributing services in an equitable manner.

Some key performance indicators (KPIs) for success that are commonly
used by not-for-profit organisations are:
Financial KPIs:
• revenue or turnover, including year-on-year changes
• number of donations and the average amount of donations
• fundraising return on investment = annual funds raised/annual
investments
• overheads measured in terms of percentage per revenue.
Campaigns delivery KPIs:
• number of people reached
• visitor to donor conversion rate
• new donors acquired
• number of donors/donations.

Activity 1.3
Although shareholders’ wealth maximisation seems to be the overriding objective,
corporate managers still face a number of constraints to implement multiple objectives
simultaneously.
Identify the types of constraint that corporate managers face when assessing long-term
financial plans.
See the VLE for discussion.

The agency problem

The agency problem occurs when financial managers make decisions
which are not consistent with the objectives of the company’s stakeholders.
It arises because:
1. There is a separation of ownership and control: agents (financial
managers) are given the power to manage and control the company by
the principals (stakeholders: shareholders, creditors and customers).
2. The goals of agents are different from those of the principals.7 7
For example,
agents may want to
3. Principals do not get full information about their company from the increase the size of
agent or the market (asymmetric information). the company (empire
building), strengthen
Activity 1.4 their managerial
power, secure their
What are the signs of an agency problem? What possible actions can be taken to mitigate jobs, improve their
such a problem? remuneration and
pursue other personal
See the VLE for discussion.
objectives. These
objectives may not
Corporate governance and regulations necessarily be enhancing
the value of the
Given the agency problem, a practical solution would be to identify a
company.
system by which companies are managed and controlled such that it
focuses on:
1. the responsibilities and obligations to executive and non-executive
directors
2. the relationship between firm’s owners, the board of directors and the
top tier of managers.

18
 Chapter 1: Financial management function and environment

This system, commonly known as corporate governance, is often shaped

in many different forms to respond to the different expectation from the
society and the forms of domestic stock exchanges. (See ARN, Chapter 1,
pp.16–18 for a typical code of corporate governance.)

Financial management environment

A complete system for a financial management environment consists of
four important components:

Financial managers
The role of financial managers is mainly to interact with the financial
world by performing the following three tasks:
1. raising finance by selling financial claims (equity or debt)
2. selecting investments by considering their risks and value added
3. determining the amounts to be returned to stakeholders.

Investors
Investors may be individuals or institutions who have surplus funds to
invest. Individual investors are generally small investors who commonly
provide funds to firms by purchasing their securities (equity shares or debt
securities). Institutional investors, on the other hand, have more funds
and seek to focus on providing loans and other securities issued by firms.
In Chapters 9 and 10, we explain how financial managers would interact
with investors in fund raising.

Financial markets
Financial markets facilitate the flow of funds among investors and
borrowers. There are two types of financial markets:
a. Capital markets facilitate trade of long-term debt and corporate
stock with a maturity period of more than one year, such as bonds,
stocks, etc. Individuals and institutions can act as either buyers
or sellers. In some cases, financial institutions may serves as
intermediaries for trade of both equity and debt securities. It is very
common for one financial institution to act as the institutional investor
while another financial institution serves as the intermediary for
execution of a particular trade transaction.
b. Money markets are the markets for debt securities with maturities
of one year or less. Securities traded in money market are treasury
bills, banker’s acceptances, certificates of deposits, commercial paper,
etc.
Both markets are characterised by regulations to ensure that the prices are
transparent, transaction fees are kept low and the system is maintained to
allow funds moving smoothly.
Recent developments in FinTech has also helped improving the efficiency
and effectiveness of financial markets. See the World Bank Report summary.

Financial instruments
Throughout this subject guide, you will be learning about various financial
instruments. Roughly speaking, there are two kinds:
(i) cash instruments – loans, bonds, stocks
(ii) derivative instruments – options, forward contacts, etc.

19
AC3059 Financial management

When you have worked your way through this subject guide, you should
be able to discuss how these four components interact with each other.

A reminder of your learning outcomes

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

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

Sample examination questions

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

20
 Chapter 2: Investment appraisals 1

Chapter 2: Investment appraisals 1

Essential reading
BMAE, Chapter 2 from p.55 to the end of the chapter, and Chapter 5, up to
p.135.

Further reading
ARN, Chapter 4.

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

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the commonly used investment appraisal techniques
• evaluate simple investment decision process.

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

Basic investment appraisal techniques

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

Accounting rate of return (ARR)

The method is also known as return on capital employed (ROCE)
or return on investment (ROI). It relates accounting profit to the capital
invested. One widely used definition is:
21
AC3059 Financial management

Average annual profit

ARR = × 100 %
Average investment outlays
Average investment takes into consideration any scrap value. It can be
expressed as follows:
Investment - Scrap value
Average Investment =
2
1
Some textbooks prefer
It measures the average net investment outlay of the project.1 Accounting
to calculate ARR by
profit is defined as before-tax operating cash flows after adjustment for referring to the average
depreciation. The decision rule is to accept investments with ARR higher level of investment.
than a predetermined target rate of return. Consequently, the
average investment will
Payback period (PP) be defined as (initial
investment + scrap
Payback period measures the shortest time to recover the initial investment value)/2.
outlay from the cash flows generated from the investment. A company will
accept an investment if the PP is less than or equal to a target period.

Discounted payback period (DPP)

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

Internal rate of return (IRR)

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

Net present value (NPV)

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

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

Before-tax operating
cash flows ($) Year
Project 0 1 2 3 4
A (25,000) 5,000 10,000 15,000 20,000
B (2,500) 2,000 1,500 250

22
 Chapter 2: Investment appraisals 1

Accounting rate of return

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

Project Initial Average Total Average ARR

investment investment profit after profit
depreciation

A 25,000 12,500 25,000 6,250 50%

B 2,500 2,000 1,250 417 33%

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

Cumulative cash flows

Project 0 1 2 3 4 PP
A (25,000) (20,000) (10,000) 5,000 25,000 2.67 Years
B (2,500) (500) 1,000 1,250 1.33 years

Discounted payback period

Year

Project A 0 1 2 3 4
Cash flows ($) (25,000) 5,000 10,000 15,000 20,000
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (25,000) 4.165 6,940 8,670 9,640
Cumulative cash flows (25,000) (20,835) (13,895) (5,225) 4415

Year
Project B 0 1 2 3 4
Cash flows ($) (2,500) 2,000 1,500 250
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (2,500) 1,666 1,041 144.5
Cumulative cash flows (2,500) (834) 207

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

23
AC3059 Financial management

Net present value

The NPV can be determined as:

Year

Project A 0 1 2 3 4
Cash flows ($) (25,000) 5,000 10,000 15,000 20,000
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (25,000) 4.165 6,940 8,670 9,640

NPV 4,415

Year
Project B 0 1 2 3 4
Cash flows ($) (2,500) 2,000 1,500 250
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (2,500) 1,666 1,041 144.5

NPV 351.5

Internal rate of return

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

Year

Project A 0 1 2 3 4
Cash flows ($) (25,000) 5,000 10,000 15,000 20,000
Discount factor (DF) (20%) 1 0.769 0.592 0.455 0.35
Present value (25,000) 3,845 5,920 6,825 7,000

NPV (1,410)

Year
Project B 0 1 2 3
Cash flows ($) (2,500) 2,000 1,500 250
Discount factor (DF) (20%) 1 0.741 0.549 0.407
Present value (2,500) 1,482 824 102

NPV (93)

We then substitute the relevant figures into the following equation:

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

24
 Chapter 2: Investment appraisals 1

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

Pros and cons of investment appraisal techniques

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

Projects NPV IRR PP ARR

A 4,415* 27.6% 2.67 years 50%*
B 351.5 31.9%* 1.33 years* 33%
* Indicates the project that will be chosen under the specific appraisal method.
Suppose the main objective is to maximise shareholders’ value. Financial
managers would prefer Project A as it provides a higher NPV, and hence
it gives the greatest increase to the shareholders’ value. However, if we
choose projects based on a higher value of IRR or PP, Project B will be
selected. But this project clearly does not produce the greatest value to the
company. So why are these techniques still being used in practice?
ARR
Advantages:
• It gives a value in percentage terms which is a familiar measure of
return.
• It is relatively easy to calculate compared to NPV or IRR.
• It considers the cash flows (but only after adjustment for depreciation
in profit) arising from the lifetime of the project (unlike PP).
• It can be used in selecting mutually exclusive projects.
Disadvantages:
• It is very much based on the accounting profits and hence technically it
does not deal with the actual cash flows arising from the project.
• It ignores the timing of the cash flows and hence it does not take into
consideration the time value of money.
• It is expressed in percentage terms and therefore it does not measure
the absolute value of the project. It does not indicate how much
wealth the project creates.
PP
Advantages:
• It is computationally straightforward.
• It considers the actual cash flows, not profits, arising from a project.
Disadvantages:
• It ignores cash flows beyond the PP and hence it does not provide a
full picture of a project.
• It does not consider the time value of money (even though the
discounted payback period takes care of that).
• The target payback period is somehow arbitrary.

25
AC3059 Financial management

IRR
Advantages:
• It uses all relevant cash flows, not accounting profits, arising from a
project.
• It takes into account the time value of money.
• The difference between the IRR and the cost of capital can be seen as a
margin of safety.
Disadvantages:
The main limitations of using IRR in investment appraisals are that it may
not give the correct decision in the following scenarios:
• when comparing mutually excusive projects
• when projects have non-conventional cash flows
• when the cost of capital varies over time
• It discounts all flows at the IRR rate not the cost of capital rate.

Mutually exclusive projects

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

Non-conventional cash flows

A typical investment project has an initial cash outflow followed by
positive cash flows in subsequent years. However, in some cases, a project
(such as oil drilling or mining) may have negative cash flows during its
lifetime. Mathematically, each time the cash flow stream of a project
changes sign, there is a possibility that multiple IRRs might arise.

Example 2.2
Suppose a project requires $100 as an initial investment. Its Year 1 and Year 2 cash flows
are $260 and –$165 respectively. Based on this project’s cash flows, it produces two
possible IRRs (10% or 50%):

DF PV DF PV
Year Cash flows 50% 10%
0 –100 1 –100 1 –100
1 260 0.667 173 0.909 236
2 –165 0.445 –73 0.826 –136
Net Present Value 0 0

Suppose the cost of capital for this project is 20%. According to the IRR rule, the project
should be accepted (as the cost of capital is less than the higher IRR of 50%). However,
it should also be rejected as the cost of capital is higher than the lower IRR of 10%. So
for a project with non-conventional cash flows, the IRR decision is sensitive to the cost
of capital. Therefore it is argued that IRR does not give an unambiguous decision when
dealing with non-conventional projects.
To further illustrate this problem, let’s look at the NPV profile of the project. This depicts
the relationship of the NPV of the project and its discount rate. In the above example, we
know that the NPV of the project is zero at both 10% and 50%.

26
 Chapter 2: Investment appraisals 1

Suppose the cost of capital is 5%, 25% or 70%. The NPV of the project will become –$2,
$2 and –$4 respectively. The following diagram shows the NPV profile of the project.
We can see that, due to the non-conventional cash flow pattern, the project’s NPV varies
at different discount rates. It only provides a positive NPV if the discount rate for the
project’s cash flows is between 10% and 50%.

0
NPVs 0% 10% 20% 30% 40% 50% 60% 70% 80%
-1

-2

-3

-4

-5
Discount rates

Figure 2.1: NPV profile.

However, if the project we have been examining has the ‘reversed’ cash flow pattern (i.e.
receiving $100 and $165 in year 0 and year 2 while paying $260 in year 1), we would
only accept it if the cost of capital is either lower than 10%
or higher than 50%. Why? This project with the reversed cash flow pattern has the same
IRRs (10% and 50%) as the original project. You can verify this result by discounting the
cash flows at 10% and 50% separately. However, the NPV profile of this project will be
as below.
Time-varying cost of capital
If the cost of capital changes over time, NPV can easily accommodate this. Suppose the
cost of capital is r for the tth year. The NPV of a project with different cost of capital over
its lifetime can be given in the following equation:
C1 C2 C3
NPV = −I0 + + + + ...
(1+ r1) (1+ r1)(1+ r2 ) (1+ r1)(1+ r2)(1+ r3 )
NPV assumes that cash flows can be reinvested at the cost of capital whereas IRR
assumes that cash flows can be reinvested at the IRR which is not a realistic assumption
in the real world.
The superiority of NPV:
• It takes into consideration all cash flows and time value of money.
• It can be applied to deal with mutually exclusive projects.
• It can deal with non-conventional cash flows.
• It has realistic assumptions about how the capital markets work in real life.

Activity 2.2
Attempt Question 10, BMAE Chapter 5.
See the VLE for solution.

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AC3059 Financial management

How to value perpetuity and annuity

There are two specific cases to discuss here.
Suppose a project generates a perpetual cash flow of CF at the end of each
year from now until infinity. Assume the cost of capital (the discount rate)
is r% per year. The present value (PV) of this project is:
CF CF CF
PV = + +...+
(1+ r) (1+ r)2 (1+ r)∞

Multiplying both sides by 1/(1+r), we get:

1 CF CF
PV = +...+
(1+ r) (1+ r)2 (1+ r)∞+1

Example 2.3
Suppose a project requires an initial investment outlay of $100,000. It generates $10,000
each year in perpetuity. The cost of capital is 8% per year. The NPV of this project is
$25,000 ($10,000/0.08 – $100,000).
Annuity is an asset that pays a fixed sum each year for a specified number of years.

Activity 2.3
Prove that an asset that generates $C each year for n years has a present value =
1/r – 1/[r(1 + r)]n.

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• describe the commonly used investment appraisal techniques
• evaluate simple investment decision process.

Practice questions
BMAE Chapter 5, questions 7, 12 and 13.

Sample examination questions

RC plc has been invited to supply sub-components for a period of four
years at a price of £20,000 per annum. The costing department has
produced the following data and estimates relating to the production of
these sub-components.
1. Material A is in stock and has an original cost of £16,000. It was
originally intended for use in a product line which has now been
discontinued. The materials can either be used for the production of
these sub-components (sufficient for the next four years), or disposed
of immediately which will incur transport and other costs of £1,400.
2. Material B will be required for the production, the current price of
which is £2,800.
3. Skilled workers will be required for the production of these
sub‑components. Currently there is a shortage of skilled workers.
RC plc can only obtain these workers by transferring them from an
existing job. This current job produces a total contribution of £8,000
per year and will terminate in one year’s time. The company expects

28
 Chapter 2: Investment appraisals 1

that the labour market will improve in a year’s time. By then there will
be no problem around recruiting skilled workers. The current wage for
these workers (who are contracted to work in RC plc until the end of
this year) is £13,000 per annum.
4. A machine which is currently lying idle will be used to manufacture
these sub-components. Details of the machine are:

Original cost 2 years ago £10,000

Estimated life 10 years
Current realisable value £4,000
Estimated realisable value in 4 years’ time £1,500
The machine is routinely depreciated on a straight line basis over
its useful life.
5. General overheads are to be allocated on the basis of 100% of skilled
workers’ cost.
6. The company’s cost of capital is 10% per annum.
7. Assume all cash flows relating to revenue and costs identified in (2)
and (3) arise at the end of the years to which they relate.
Required
a. Advise the management of RC plc whether this order should be
accepted. Provide detailed calculations.
b. If the company can rent a machine to produce these sub-components,
what is the maximum rental payment, payable at the beginning of each
year, that the company would be willing to make without diminishing
the original economic worth of the contract (as in part (a))?
c. Discuss other factors that the management should take into
consideration.

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AC3059 Financial management

Notes

30
 Chapter 3: Investment appraisals 2

Chapter 3: Investment appraisals 2

Essential reading
BMAE, Chapter 5 from p.135 to the end of the chapter and Chapter 6.

Further reading
ARN, Chapter 5.

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

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

Advanced investment appraisals

BMAE, Chapter 5, pp.135–38 deals with capital rationing and Chapter 6
deals with the remaining advanced topics. Before you proceed with the
following section, it would be advisable to skim through those sections in
the textbook.

Capital rationing
A company may have insufficient funds to undertake all positive NPV
projects. Due to the shortage of funds, this restriction is more commonly
known as capital rationing. There are two types of capital rationing.

Hard capital rationing

This is where the shortage of funds is imposed by external factors. This
might happen in three different ways:
1. Capital markets are depressed.
2. Investors are too risk adverse.
3. Transaction costs are too high.

Soft capital rationing

This may arise when financial managers impose internal restrictions on:
• issuing equity to avoid dilution of original shareholders’ value
• issuing debt to avoid fixed interest obligation and transaction cost
• investing activities in order to maintain a constant growth.

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AC3059 Financial management

In any case, ranking projects by absolute NPV in these situations may

not necessarily give the optimal strategy. Some combinations of smaller
projects may give a higher NPV.
For each type of capital rationing we can further sub-divide it into two
categories.

Single period capital rationing

If the shortage of funds is only restricted in the first year, the ranking of
projects can be done by using the profitability index. Profitability index
is defined as the present value of the future cash flows generated by a
project divided by its initial investment. It is also called the Present Value
Index (PVI) by some authors.
Present value of future cash flows
Profitability index, PI =
Initial investment

Example 3.1
Lion plc has the following projects:

Projects Initial Investment NPV ($)

($)
A 1,000,000 100,000
B 1,500,000 250,000
C 750,000 50,000
D 500,000 60,000
The company has only $2,500,000 available at year 0. There is no other investment
opportunity for the firm with any spare cash which is not invested in the above four
projects.
What would be the best way to allocate the $2,500,000 funding among these four
projects?
To answer this question, we first convert the NPV into PV (Initial investment + NPV) for
each project. We then calculate the PI using the above formula.

Projects Initial NPV ($) PV ($) PI Ranking

Investment
($)
A 1,000,000 100,000 1,100,000 1.10 3
B 1,500,000 250,000 1,750,000 1.17 1
C 750,000 50,000 800,000 1.07 4
D 500,000 60,000 560,000 1.12 2
In this case, the ranking of the project’s profitability is simple and straightforward. The
PI suggests that for every $1 invested in Project B, it produces a present value of $1.17.
When this is compared to Project A’s PI, it is obvious that for any $1 available, it is more
profitable to invest in Project B than in Project A.

When projects are infinitely divisible

The optimal plan is to invest all the available cash in the projects according to the ranking
of PI. In this case, we will invest in the whole of Project B and Project D (with a combined
total initial investment of $2,000,000) and in half of Project A with the remaining
$500,000. The maximum NPV of this investment plan is:
1
The optimal NPV = $250,000 + $60,000 + × $ 100 ,000
= $ 360 ,000 2

32
 Chapter 3: Investment appraisals 2

When projects are not infinitely divisible

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

WAPI = ∑ω i PIi + ω j
i=1

where ωi is the percentage of project i’s initial investment to the total cash available, PIi
is the profitability index of project i, and ωj is the percentage of unused cash to the total
cash available.

Weight Plan
Project A+B A+C A+C+D B+C B+D C+D
A 0.4 0.4 0.4 0 0 0
B 0.6 0 0 0.6 0.6 0
C 0 0.3 0.3 0.3 0 0.3
D 0 0 0.2 0 0.2 0.2
Unused 0 0.3 0.1 0.1 0.2 0.5
cash

WAPI 1.14 1.06 1.09 1.12 1.13 1.05

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

Multiple periods capital rationing

When a firm is facing multiple periods of capital rationing, it would not
be easy to resolve the optimal investment plan by using the profitability
index. In this case, linear programming technique might be useful.

Activity 3.1
Attempt BMAE Chapter 5, question 19.
See the VLE for solution.

Changing prices and inflation

The accuracy of NPV depends on the accuracy of the cash flow estimates.
In practice, prices change for the following reasons:
• inflationary effect
• demand and supply
• technological changes
• manufacturing learning effect
• stamp duties, value-added tax and other transaction costs.
The easiest way to deal with these external effects is to incorporate the
specific changes in the NPV calculation, i.e. the forecast for each period’s
flows will be based on each flow item adjusted by its specific inflation to
give the project actual net flow for each period.

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AC3059 Financial management

Example 3.2
Suppose Leopard plc has a project that produces 10,000 units of a digital diary per year
for the next four years. Each unit sells for $200. The unit production cost is $110. The
production requires a brand new machine at year 0. It costs $2,000,000 with a scrap
value of $20,000 at the end of year 4. The NPV of this project (assuming no inflation) is
determined as follows:

Year

0 1 2 3 4
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,100,000) (1,100,000) (1,100,000)
NCF before tax (2,000,000) 900,000 900,000 900,000 920,000
DF 1 0.909 0.826 0.751 0.683
PV (2,000,000) 818,100 743,400 675,900 682,360

NPV 865,760

Example 3.3
Suppose the production cost for each unit will rise by 10% per year from year 2 onward.
The revised NPV of this project can be determined by incorporating the price changes to
the production costs in Example 3.2.

Year

0 1 2 3 4
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,210,000) (1,331,000) (1,464,000)
NCF before tax (2,000,000) 900,000 790,000 669,000 555,900
DF (10%) 1 0.909 0.826 0.751 0.683
PV (2,000,000) 818,100 652,540 502,409 379,680

NPV 352,739

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

Taxation
When a firm is making a profitable investment, it is likely that it will be
liable for corporate tax. When evaluating a project, the tax effect must be
considered. There are two issues relating to the after-tax NPV of a project:

The amount of tax payable

Different countries have different tax rules. Generally, corporate tax
is payable as a percentage of the taxable profit determined by the tax
authority. In principle, most items that are charged to the Statement of
34
 Chapter 3: Investment appraisals 2

Comprehensive Income (more commonly known as a Profit and Loss

Account in the UK) are tax deductible. However, in some countries,
the accounting depreciation for capital expenditure is not a recognised
expense for tax purposes. If such a depreciation charge is not allowed,
the tax authority might give an allowance for capital expenditure. For the
purpose of this course, we assume that the taxable profit before capital
allowance is identical to the annual net cash flow. Capital allowance is
then determined as a percentage of the written down value of the capital
expenditure (i.e. initial investment).

Example 3.4
Suppose Leopard plc in Example 3.3 pays corporate tax at 45% on taxable profits after
capital allowances. We are told that the annual capital allowance is determined at 25%
of the written down value at the beginning of each year.
Any unrelieved written down value in the final year of the project is given out as capital
allowance in full in that year. The following table shows the calculations of the annual
capital allowance and tax payable.

Year

0 1 2 3 4
Taxable profit before 900,000 790,000 669,000 555,900
capital allowances
Written down values 2,000,000 1,500,000 1,125,000 843,750
(WDVs)
Capital allowances (500,000) (375,000) (281,250) (843,750)
(CAs)
Taxable profit after 400,000 415,000 6387,750 287,850
capital allowances
Tax (45%) (180,000) (186,750) (174,488) 129,533

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

The timing for tax payable

In Example 3.4, we determined how much tax Leopard had to pay.
However, we did not discuss the second issue of when tax should be paid.
Why is it important to determine the timing of tax payable? Recall the
concept of time value of money. Cash flows, whether positive or negative,
arising at different time periods would have an effect on a project’s NPV.
Regarding tax payables, the further away from today we settle the tax
liabilities, the less impact the tax will have on the project’s NPV. To see this
effect, let us consider the following two cases:
35
AC3059 Financial management

Case 1: Tax payable in the same year as the profit to which it is related
Year

0 1 2 3 4
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,210,000) (1,331,000) (1,464,000)
NCF before tax (2,000,000) 900,000 790,000 669,000 555,900
Tax (180,000) (186,750) (174,488) 129,533
NCF after tax (2,000,000) 720,000 603,250 494,513 685,433
DF 1 0.909 0.826 0.751 0.683
PV (2,000,000) 654,480 498,285 371,379 468,150

NPV (7,706)

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

Case 2: Tax payable one year in arrears

Year
0 1 2 3 4 5
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,210,000) (1,331,000) (1,464,100)
NCF before tax (2,000,000) 900,000 790,000 669,000 555,900
Tax (180,000) (186,750) (174,488) 129,533
NCF after tax (2,000,000) 900,000 610,000 482,250 381,413 129,533
DF 1 0.909 0.826 0.751 0.683 0.621
PV (2,000,000) 818,100 503,860 362,170 260,505 80,440
NPV
25,074

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

Activity 3.2
Attempt BMAE Chapter 5, question 21.
See the VLE for solution.
36
 Chapter 3: Investment appraisals 2

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• apply the discounted cash flow techniques in complex scenarios
• evaluate the investment decision process.

Practice questions
1. BMAE Chapter 5, questions 14, 15, 17 and 20.
2. BMAE Chapter 6, question 18.

Sample examination questions

1. Assume that you have been appointed as the finance director of
Dragon plc. The company is considering investing in the production
of an electronic security device, with an expected market life of five
years.
The previous finance director has undertaken an analysis of the
proposed project; the main features of his analysis are shown below.
He has recommended that the project should not be undertaken
because the estimated annual accounting rate of return is only 12.3%.
Proposed electronic security device project

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

(£’000) (£’000) (£’000) (£’000) (£’000) (£’000)
Investment in
depreciable fixed assets 4,500
Cumulative investment 300 400 500 600 700 700
in working capital
Sales 3,500 4,900 5,320 5,740 5,320
Materials 535 750 900 1,050 900
Labour 1,070 1,500 1,800 2,100 1,800
Overhead 50 100 100 100 100
Interest 576 576 576 576 576
Depreciation 900 900 900 900 900
3,131 3,826 4,276 4,276 4,276
Taxable profit 369 1,074 1,044 1,014 1,044
Taxation 129 376 365 355 365
Profit after tax 240 698 679 659 679
Total initial investment is £4,800,000. Average annual after-tax profit is
£591,000.
All the above cash flow and profit estimates have been prepared in terms
of present day costs and prices (i.e. no inflation), since the previous
finance director assumed that the sales price could be increased to
compensate for any increase in costs.
You have available the following additional information:
a. Selling prices, working capital requirements and overhead expenses
are expected to increase by 5% per year.
b. Material costs and labour costs are expected to increase by 10% per
year.
37
AC3059 Financial management

c. Capital allowances (tax depreciation) are allowable for taxation

purposes against profits at 25% per year on a reducing balance basis.
d. Taxation on profits is at a rate of 35%, payable one year in arrears.
e. The fixed assets have no expected salvage value at the end of five
years.
f. The company’s real after-tax weighted average cost of capital is
estimated to be 8% per year, and nominal after-tax weighted average
cost of capital to be 15% per year.
Assume that all receipts and payments arise at the end of the year to
which they relate, except those in year 0, which occur immediately.
Required:
a. Estimate the net present value of the proposed project. State clearly
any assumptions that you make.
b. Calculate by how much the discount rate would have to change to
result in a net present value of approximately zero.
c. Compare and contrast the NPV and IRR approaches to investment
appraisal.

38
 Chapter 4: Investment appraisals 3

Chapter 4: Investment appraisals 3

Essential reading
BMAE, Chapters 6 and 10.

Further reading
ARN, Chapters 5–6.

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

Aims
In this chapter we continue on from Chapter 3 looking at some other
applications of the discounted cash flow technique in investment
appraisals. In particular, we focus on the following scenarios:
• replacement decision
• timing of investment
• sensitivity analysis.

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

Replacement decision
When considering a scenario where we have to select mutually exclusive
projects with different life spans and where each project can be replicated
in exact cash flow patterns, the simple NPV rule might not necessarily give
the correct advice. To see why this might be the case, let us consider the
following example.

Example 4.1
Lion plc is considering two different machines in an operation. The following net
operating cash outflows for these two machines are given:

$ Year
Machines 0 1 2 3 4
A (100,000) (10,000) (10,000) (10,000) (10,000)
B (75,000) (15,000) (15,000) (15,000)

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

39
AC3059 Financial management

Example 4.2
Lion plc is considering two different machines in an operation. The following net
operating cash outflows for these two machines are given:

$ Year
Machines 0 1 2 3 4
A (100,000) (10,000) (10,000) (10,000) (10,000)
B (75,000) (15,000) (15,000) (15,000)

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

$ Year
Machine A 0 1 2 3 4
NCF (100,000) (10,000) (10,000) (10,000) (10,000)
DF 1 0.909 0.826 0.751 0.683
PV (100,000) (9,090) (8,260) (7,510) (6,830)
NPV (131,690)

$ Year
Machine B 0 1 2 3
NCF (75,000) (15,000) (15,000) (15,000)
DF 1 0.909 0.826 0.751
PV (75,000) (13,635) (12,390) (11,265)
NPV (112,290)
On the basis of the NPV calculations, it seems to cost the company less to run Machine B
($112,290 compared to $131,690). However, if the operation is a going concern and we
have to replace the machine once it has expired, how do we know if Machine B still gives
the best value to the company?
To answer this question, we need to find a way to compare the two machines’ cash flows
in a consistent manner. This can be done by converting a project’s NPV into its annual
equivalent value (AEV).
Suppose we can hire a machine, C, for $x each year for the next four years. It has the
same functionalities as Machine A and the hiring company is responsible for all the
running cost of Machine C. What would be the equivalent hiring cost we would be willing
to pay if both machines (A and C) have the same value to the company?
For these two machines to have the same value to the company, their total running costs
(measured at today’s value, i.e. present value) must be identical. Consequently this means:
x x x x
+ + + = 131,690
1.1 1.12 1.13 1.14
 1 1 1 1 
x + 2 + 3 + 4  = 131,690
 1. 1 1 . 1 1. 1 1 . 1 
x(A10%, 4 years ) = 131,690
131,690 131,690
x= = = 41,556
A10%, 4 years 3.169

Where A10%, 4 years is the annuity factor at 10% for 4 years

If we are indifferent between paying the annual hiring cost of $41,556 for Machine C and
paying the purchase cost and annual running costs for Machine A, then the hiring cost of

40
 Chapter 4: Investment appraisals 3

$41,556 must be the annual equivalent value of Machine A. From the above calculation,
we can define the annual equivalent value of a project as:
Project’s NPV
AEV =
Annuity for the duration of the project

We can now convert Machine B’s NPV into its AEV in the same way as the calculation
above:
112 , 290
Machine B´s AEV = = 45 ,169
2 .486

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

Delaying projects
In some cases it might be more advantageous for a company to delay the
commencement of a project. This might be a result of one of the following:
• There might be uncertainty about the outcomes of the project.
Delaying its commencement might allow the company to obtain vital
information to revise future cash flows which might give a higher NPV.
• There might be capital rationing in the current period and the
company needs to postpone the project due to shortage of funding.
In deciding whether a project should be postponed, we can treat the delay
of each project as separate and mutually exclusive. We can then evaluate
each option’s NPV accordingly.

Example 4.3
Rooster Ltd. is considering a new product, a roast chicken stand. It allows a chicken to
be roasted on all sides while maintaining its juiciness. The production requires a new
machine which has a purchase price of $100,000 with four years of economic life and
no residual value by the end of the fourth year. Each unit of the roast chicken stand is
expected to generate a net contribution of $5 (selling price minus variable costs). Market
research, which costs $25,000, indicates that future demand will be subject to the state
of the economy. If the economy is strong, the demand will be 10,000 units per year for
the next five years. However, if the economy is weak, the demand will fall to only 5,000
units per annum. There is an equal chance for each state of the economy to materialise.
It is also expected that once the state of the economy is set, it will stay that way for the
next four years.
Rooster has a choice to delay the production until the end of the year. If it does so, the
whole production cycle will be shortened to three years. The same machine will still
be required by the end of the year at the same expected purchase price. However, it
can be sold for $25,000 at the end of the production process (i.e. three years after the
commencement of production). But more importantly, delaying the commencement of

41
AC3059 Financial management

production will allow the company to know exactly which way the economy is going to
unfold for the next few years.
Advise the management on what action should be taken regarding this project.
Approach:
Introducing Probability Theory we can calculate the expected net present value, E(NPV),
for the project.
If Rooster Ltd. commences the production now:
Expected demand in the next 4 years = 50% × 5,000 units + 50% × 10,000 units =
7,500 units
Contribution per year = 7,500 units × $5 = $37,500

Year
No delay 0 1 2 3 4
Machine (100,000)
Contribution 37,500 37,500 37,500 37,500
E(NCF) (100,000) 37,500 37,500 37,500 37,500
DF 1 0.909 0.826 0.751 0.683
E(PV) (100,000) 34,088 30,975 28,163 25,613
E(NPV) 18,838
This is the expected NPV that the production could generate. However, the economy is
weak, Rooster can only sell 5,000 units per year. What, then, would be the outcome of
this state?
If Rooster is to face a weak economy for the next four years, the revised NPV will be as
follows:

Year
Weak state 0 1 2 3 4
Machine (100,000)
Contribution 25,000 25,000 25,000 25,000
NCF (100,000) 25,000 25,000 25,000 25,000
DF 1 0.909 0.826 0.751 0.683
PV (100,000) 22,725 20,650 18,775 17,075
NPV (20,775)
In other words, there is a 50% chance that Rooster will suffer a negative NPV of
$20,775. (If the good state had occurred at the outset then the NPV would have been
$58,450. (NB. 0.5 × $58,450 + 0.5 × ($20,775) = $18,838.) Should the company
delay the project and wait for the economic situation to materialise before committing
to production? If the company delays the production by a year, there are two possible
actions that the company will take by the end of the year. It could abandon production if
a weak economy materialises. It would not be advantageous to produce if the company
could only sell 5,000 units per year in a weak economy. You can check the NPV under this
option. However, if a strong economy materialises in year 1, the company will commence
production in that year with the following NPV:

42
 Chapter 4: Investment appraisals 3

Year
Delay 0 1 2 3 4
Machine (100,000) 25,000
Contribution 50,000 50,000 50,000
NCF 0 (100,000) 50,000 50,000 75,000
DF 1 0.909 0.826 0.751 0.683
PV 0 (90,900) 41,300 37,550 51,225
NPV 39,175
The expected NPV of delaying production would then be $19,587.5 (50% × 0 + 50% ×
$39,175). On the basis of the NPV consideration, it seems to be more advantageous for
the company to delay production by one year.
In this example, deferring the project allows the company to eliminate the possibility of
facing a loss in a weak economy. Even though the financial return to delay the project
seems low ($19,587.5 vs. $18,838), the risk elimination might be treated as more
valuable by a more risk-averse company.

Abandoning a project
A project that has the option to be abandoned before the end of the
investment period may also be financially valuable. For example, a project
requires $100,000 as an initial investment. The cash flow generated in
period 1 would depends on the state of the economy. If the economy is
good in period 1, the cash flow will be $21,000 in perpetuity, with the
chance being 50%; otherwise, a negative cash flow of $10,000 would be
generated forever. You have a cost of capital equal to 10%.
The expected NPV of this project = –$100,000 + 0.6 x $30,000/0.1 – 0.4 x
10,000/0.1 = $40,000
If you can abandon this project after period 1, what is the value of the
abandonment option?
In this case, the expected NPV of the project is equal to the expected cash
flow if the project continues beyond period 1 plus the expected cash flow
generated in period 1 with the economy in a bad state (the project will be
abandoned from period 2 onwards).
= –$100,000 + 0.6 x $30,000/0.1 – 0.4 x $10,000/1.1 = $76,364
The value of the abandonment = $76,364 – $40,000 = $36,364
This value represents the expected present value of the losses from
period 2 onwards that you can avoid with the abandonment =
(0.4 x $10,000/0.1)/1.1 = $36,364.

Sensitivity analysis1 1
See ARN, pp.180–85.

This method evaluates the impact of changes in a project’s variables on its

NPV. In a single variable situation, we can assess by how much a variable
needs to change before a project returns a loss. For example, referring to
the data in Example 2.4, we can ask:
1. By how much does the selling price need to drop before the project’s
NPV disappears?
2. By how much does the production cost per unit need to rise before the
project’s NPV disappears?
3. By how much does the discount rate need to rise before the project’s
NPV disappears? 43
AC3059 Financial management

To answer any of the above questions, we can use a trial-and-error

method. With the aid of a spreadsheet and changing the parameters
accordingly, we can see how the NPV will change. See the spreadsheet of
the demonstration on the VLE.
Alternatively, we can observe the relationship of the variable with the
overall NPV. Recall from Example 2.4 that each unit of the product sells
at $200 and the NPV of the project stands at $865,760. Let’s assume that
the selling price of each unit drops by $x. To make the NPV disappear, the
present value of the loss in revenue (or contribution) must be identical to
the NPV. We, therefore, can equate the PV of the loss in contribution to the
project’s original NPV as follows:
10,000x 10,000x 10,000x 10,000x
+ + + = 865,760
1.1 1.12 1.13 1.14
10,000x × A10%,4 = 865,760
10,000x × 3.169 = 865,760
x = 27.32
If the selling price drops by $27.32, the NPV will disappear. This gives
a safety net for the company as to how much it can afford to reduce the
selling price before incurring a loss. You can test each variable using the
approach outlined above and determine how sensitive the NPV is to each
of the variables considered. This is of benefit to management in both the
decision-making phase and the project management phase.

Practical consideration
Graham and Harvey (2001) surveyed 392 chief financial officers (CFOs)
in the USA. They asked each CFO to rank the importance of each appraisal
method in practice. Table 4.1 below shows the findings of their survey.
Watson and Head (2010) summarise the findings as follow:
• Discounted cash flow methods appear to be more popular than non-
DCF methods.
• Payback is used in large organisations in conjunction with other
investment appraisal methods.
• IRR is more popular than NPV in small companies but NPV is the most
popular investment appraisal method in large companies.
• ARR, the least popular investment appraisal method, continues to be
used with other methods.
• Companies tend not to use sophisticated methods to account for
project risk.
• Most companies allow for inflation when considering projects’ future
cash flows.
• Almost all companies use sensitivity analysis, an increasing minority
of companies use profitability analysis, very few companies use the
Capital Asset Pricing Model.

44
 Chapter 4: Investment appraisals 3

Appraisal technique Popularity, % always or

almost always
Internal rate of return 75.61
Net present value 74.93
Payback period 56.74
Sensitivity analysis 51.54
Discounted payback period 29.45
Accounting rate of return 20.29
Profitability index 11.87
Table 4.1: Popularity of evaluation techniques.
Source: Graham and Harvey (2001).

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• apply the discounted cash flow techniques in complex scenarios
• evaluate the investment decision process.

Practice questions
BMAE Chapter 6, questions 27, 28 and 33.

Sample examination questions

1. Rabbit Inc. is considering the production of Product X and Y.
Product X
It can only be produced on a new machine, which has an expected
cost of $200,000 and a four-year life span. The annual cash savings
are expected to be $50,000 in the first year, rising at 20% per annum
thereafter until the end of the production. The new machine will
attract a capital allowance of 25% on the written down value of the
machine in each year. The company can claim any unrelieved capital
allowance at the end of the production.
Product Y
Production of Product Y is expected to last for three years. Sales are
expected to be 1,000 units in the first year, 1,200 units in the second
year, and 800 units in the third year. Each unit can be sold for $20.
It can be produced on an existing machine which has been idle
for some time. This existing machine can be sold immediately for
$10,000. If the production does go ahead, a one-off modification
on the machine will be needed at a cost of $15,000 payable at the
beginning of the first year.
Each unit of Product Y requires 1 kg of material at $4 per kg and one
hour of skilled labour at $4 per hour. These costs are expected to rise
in line with inflation.
The company has a choice to defer the production of Product Y
until the beginning of the second year. If the company defers this
production, the first year sales contribution will be lost irrevocably.

45
AC3059 Financial management

The company also has an option to purchase a brand new machine for
the production of Product Y. It will cost the company $50,000 now or
$30,000 in one year’s time. This machine does not qualify for capital
allowance.
The company’s policy is to depreciate machines over their useful
economic life on a straight-line basis. No machine is expected to have
any value at the end of its life.
The inflation rate is expected to be 5% per annum. The company’s
after-tax cost of capital is 10% per annum. Corporate tax rate is 30%,
payable one year in arrears. Apart from the cash flows mentioned
above, the company can raise an additional fund of $190,000 only at
the beginning of year 1. There is no capital restriction in subsequent
years.
Required:
Advise Rabbit Inc. of the best investment plan in the above situation.

46
 Chapter 5: Risk and return

Chapter 5: Risk and return

Essential reading
BMAE, Chapter 7.

Further reading
ARN, Chapters 6 and 7.

Works cited
Markowitz, Harry M. ‘Portfolio selection’, Journal of Finance 7(1) 1952,
pp.77–91.

Aims
In this chapter we formally examine the concept and measurement of risk
and return for single asset and a portfolio with two assets. In particular,
we look at the necessary conditions for risk diversification.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the meaning of risk and return
• calculate the risk and return of a single security
• discuss the concept of risk reduction/diversification and how it relates
to portfolio management
• calculate the risk and return of a portfolio of securities.

Overview
In Chapter 1, we mentioned that one of the key concepts in financial
management is the relationship between risk and return. So how does this
concept link to the value creation and project appraisal? In Chapters 2–4,
we discussed the selection of suitable investment projects that would
create value for a firm and its shareholders. We assume that those projects’
cash flows are given with certainty. However, in reality, cash flows from
an investment project seldom materialise as expected. So how might the
variation of the realised cash flows affect an investment’s value?
To be able to answer these questions, we will first need to understand
what we mean by risk and how corporate managers can measure such risk.

Introduction of risk measurement

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

Risk = (R1 − R1)2 (5.1)

T −1 t=1

47
AC3059 Financial management

where Rt is the return of an investment at time t (1 to T) and R is the mean

return.

Example 5.1
Suppose we have an investment that has the following historic returns:

Year Return (%)

1 10
2 –2
3 0
4 5
5 7
What is the risk of this investment?

Solution to Example 5.1

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

Year Return Deviation = Squared deviation

(%) Return – Mean Return
1 10 6 36
2 –2 –6 36
3 0 –4 16
4 5 1 1
5 7 3 9
Sum 20 98
Average 4 24.5
Std dev 4.95
Based on the calculation above, we can say that this investment on average provides a
return of 4% per annum. However, none of the past five years’ returns meet the expected
return. In years 1, 4 and 5, the realised returns are higher than expected (upside risk).
Whereas in years 2 and 3, returns are lower than expected (downside risk). This kind
of deviation from the mean (expectation) constitutes the concept of risk in financial
management. As long as (i) the returns of an investment follow the normal distribution
and (ii) investors have no preference toward the upside and downside risks, standard
deviation will be a neat measurement of risk for this type of investment.
Activity 5.1
Attempt BMAE Chapter 7, question 9.
See the VLE for solution.

Implications of using standard deviation as a risk measure

Using standard deviation as a proxy for risk allows us to explore the
statistical property of a given investment. It enables us to estimate the
probability of obtaining a particular return. Take a look at the following
example.

48
 Chapter 5: Risk and return

Example 5.2
a. In Example 5.1, what is the probability that an investor will receive a return of 10%
from the investment?
b. What is the probability that an investor will not suffer a loss in the investment?

Solution to Example 5.2

a. The probability of an outcome from a normal distribution can be expressed as:
1 (x − μ)2

Prob(x) = e 2σ2 (5.2)

2σ2

where μ is the mean, σ is the standard deviation and x is the outcome of the function.
Given that in Example 5.1 that we have x = 10%, m = 4% and s = 4.95, we have:

1 (x − μ)2

Prob(x) = e 2σ2

2σ2
1 (10 − 4)2

= e 2 × 24.5

2 × 3.1416 × 24.5

= 0.038

b. The probability for an investor not suffering from a loss is equal to the probability
that the return is equal to or larger than 0%. Given that a normal distribution curve
is symmetrical at the mean value, we can easily see that the probability of returns
equal to and larger than 4% would be 50%. So what is the probability that a return
is between 0% and 4%?
To answer this, we first define the z-value as:
x µ
z=
σ
In this example, z = (0 – 4)/4.95 = 0.808.
Using the table ‘Area under the standardised normal distribution’,1 we can determine 1
This table can be found
the probability of return between 0% and 4% as 0.291. in ARN, Appendix 5.

Therefore the probability for an investor not suffering from a loss in this case would
be equal to 0.791 (0.5 + 0.291).
Activity 5.2
What would be the probability for an investor to earn a return of 8% in Example 5.1?
See the VLE for solution.

The use of Standard Deviation as a proxy for risk

Here we should point out that the following conditions apply when
investors can use standard deviation as a proxy for risk:
1. The returns of the investment are normally distributed.
2. Investors have equal preference to both the upside and down side
deviation of returns from the mean.
3. Investors are not holding well diversified portfolio. This point will be
further illustrated in Chapter 6.

49
AC3059 Financial management

Diversification of risk and Portfolio Theory

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

E Rp = ωi E Ri (5.3a)
i=1

and
N N

σP2 = ωi2 σ2i + ωi ωj σij (5.3b)

i=1 i≠j

where E(.) is the expectation function, ωi is the weight in investment i, σij

is the covariance of returns between investment i and j.

Two-asset portfolio
Let’s first examine how the risk of a portfolio with two securities can be
calculated.

Example 5.3
Suppose that you are considering an investment portfolio with two stocks, Rose Plc and
Thorn Plc. The returns of these two stocks for the last five years are in columns 1 and 2 of
the table below.

1 2 3 4 5 6 7
Year Rose, Rx Thorn, Ry Rx–E(Rx) [Rx – E(Rx)] 2
Ry–E(Ry) [Ry–E(Ry)] 2
[Rx–E(Rx)][Ry– E (Ry)]
1 4 2 0 0 –1 1 0
2 11 –2 7 49 –5 25 –35
3 13 6 9 81 3 9 27
4 –8 –1 –12 144 –4 16 48
5 0 10 –4 16 7 49 –28
Sum 20 15 290 100 12
Mean 4 3 Variance 72.5 Variance 25 Covariance = 3
Standard deviation 8.5 5
Coefficient of
0.07
correlation
Note that the variance and covariance are calculated using the following formulas:

[E R ]
2
T
– Rx
σx2 =
x (5.4a)
t=1
T–1

50
 Chapter 5: Risk and return

[E R ]
2
T
– Ry
σy2 =
y
(5.4b)
t=1
T–1

σxy =
T
[E R x
– Rx ][E R y
– Ry ] (5.4c)
t=1
T–1

To see the diversification effect, we first calculate the standard deviation of the two
companies and their covariance. Covariance measures the co-movement of the two
stocks. At first glance, Rose and Thorn are not moving in the same direction all the time,
suggesting that they are not perfectly correlated. To see the extent of their co-movement,
we compute the covariance and coefficient of correlation.
Next, we combine the two stocks with different weights in a portfolio. Using equations
5.3a and 5.3b we can compute the portfolio’s risk and expected return based on different
weights as follows:

Weight in Rose Weight in Thorn Portfolio’s risk Portfolio’s E(Rp)

1 0 8.5 4
0.9 0.1 7.7 3.9
0.8 0.2 7 3.8
0.7 0.3 6.2 3.7
0.6 0.4 5.6 3.6
0.5 0.5 5.1 3.5
0.4 0.6 4.7 3.4
0.3 0.7 4.5 3.3
0.2 0.8 4.5 3.2
0.1 0.9 4.6 3.1
0 1 5 3
The portfolio’s expected return is simply the weighted average of the two companies’
returns. The portfolio’s risk is determined by using the general formula and we can see that it
gradually decreases as the weight in the lower risk company (i.e. Thorn) increases. We should
also note that the portfolio’s risk falls below 5% when the weight in Thorn exceeds 0.5.
We could plot the portfolio’s risk against the expected return at different weights (see
2
An efficient portfolio
Figure 5.1). The solid line represents the efficient frontier which consists of all efficient
is one that maximises
portfolios that can be formed between Rose and Thorn.2 Investors can decide which expected return for a
composition they want to take. given risk.

4.5
Rose
4
3.5
3
Thorn
Return (%)

2.5
2
1.5
1
0.5
0
0 1 2 3 4 5 6 7 8 9
Risk (standard deviation)

Figure 5.1: Efficient frontier of portfolios formed by two assets.

51
AC3059 Financial management

Activity 5.3
Suppose we have two stocks, A and B with the following characteristics:

Return Risk
A 10 10
B 5 5
Sketch the efficient frontier of a portfolio which consists of stock A and B, assuming that
the coefficient of correlation equals:
a. 1
b. 0
c. –1
See the VLE for solution.

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• describe the meaning of risk and return
• calculate the risk and return of a single security
• discuss the concept of risk reduction/diversification and how it relates
to portfolio management
• calculate the risk and return of a portfolio of securities.

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

Year Inflation (%) S&P 500 Return (%) T-bill Return (%)
2006 3.3 23.1 5.2
2007 1.7 33.4 5.3
2008 1.6 28.6 4.9
2009 2.7 21.0 4.7
2010 3.4 –9.1 5.9
a. What was the real return on the S&P 500 in each year?
b. What was the average real return?
c. What was the risk premium in each year?
d. What was the average risk premium?
e. What was the standard deviation of the risk premium?
2. Is standard deviation an appropriate measure of risk for financial
investments or projects? Discuss.
3. A game of chance offers the following odds and payoffs. Each play of
the game costs £100, so the net profit per play is the payoff less £100:

Probability Payoff Net Profit

0.1 £500 £400
0.5 £100 0
0.4 £0 –£100

52
 Chapter 5: Risk and return

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

Sample examination questions

1. What are the necessary conditions for an efficient diversification of
risk?
a. What is the relationship between the number of available securities
and the gains from diversification?
b. Does this relationship have any implication for the small investor?
c. ‘In theory, an investor in risky securities is presumed to select
an investment portfolio which is on the efficient frontier and
touches one of his indifference curves at a tangent. But in
practice, neither the efficient frontier nor the indifference can be
estimated with high degree accuracy. Therefore, the Portfolio
Theory is redundant.’
Explain the terms in bold in the above statement. Critically assess
their validity.
2. You manage a large portfolio of Australian companies, composed of
mining and manufacturing stocks. The mining stocks have an expected
return of 5% and a standard deviation of 2.3%. The manufacturing
stocks have an expected return of 8% and a standard deviation of
4.2%. The correlation coefficient between the two assets is 0.24.
i. Determine the portfolio’s return and standard deviation giving
equal weight to the mining and manufacturing portfolios.
ii. What are the weights in the mining and manufacturing firm
portfolios that give the lowest variance of the combined portfolio?
iii. Would any risk-averse investors put all their investment in the
mining companies?

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Notes

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 Chapter 6: Portfolio Theory and Capital Asset Pricing Model

Chapter 6: Portfolio Theory and Capital

Asset Pricing Model

Essential reading
BMAE, Chapters 7 and 8.

Further reading
ARN, Chapters 6–8.

Aims
In this chapter we look at the necessary conditions for risk diversification,
the Portfolio Theory and the Two-fund Separation Theorem. In particular
we examine the derivation of the capital market line.
Asset Pricing Models are also discussed and practical considerations in
estimating beta will be covered. Empirical evidence for and against the
asset pricing models will be illustrated.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• calculate the risk and return of a portfolio of securities
• discuss the implications of the capital market line (CML).

Overview
In the previous chapter we discuss the possibility of risk being diversified
in a portfolio with two assets. In this chapter we look at the general form
of diversification in markets when certain assumptions are met. In addition
we discuss the implications of this diversification effect on asset pricing.

Multi-asset portfolio
The two asset analysis can be extended to a multi-asset scenario. Suppose
it is free to buy and sell assets to form a portfolio. An investor may want to
combine more assets in her portfolio if more risk can be diversified. To see
how this may work, let’s take a look of the analysis below.
Recall equations 5.3a and 5.3b
N

E Rp = ωi E Ri
i=1
N N

σ2P = ω2i σ2i + ωi ωj σij

i=1 i≠j

where σ2i is the return variance of stock i

and σij is the covariance between returns on stock i and j.
Suppose we put equal weight in each asset, the portfolio’s risk will be
reduced to

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AC3059 Financial management

N N

σp2 = 12 σi2 + 12 σij (6.1a)

N i=1
N i≠j

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

N N
(
σp2 = 12 σ2 + 1 – 12 σij ) (6.1b)

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

1 σ2 →0 and 1 – 1
N2 N2
( )σ →σ ij ij

That implies
σp2 = σij (6.1c)
The portfolio’s risk is therefore determined by the average covariance
among the stocks in the portfolio.

Implications
There are a few key implications from the above analysis worth noting.
i. As an investor combines more assets in a portfolio, the limiting
portfolio’s risk will gradually be reduced as both the first and second
term in equation 6.1a will slowly disappear. Consequently, the shape of
the efficient frontier will change and move more to the north-western
quadrant of the mean-variance space.
In Figure 6.2, each half-egg shell represents the possible weighted
combinations for two assets. The composite of all assets constitutes the
efficient frontier. The area underneath the efficient frontier consists of
feasible but not efficient portfolios.
Expected Return (%)

Standard deviation

Figure 6.1: Efficient frontier of portfolios formed by multiple assets.

ii. The portfolio’s risk will be minimised when a sufficiently large number
of assets are included in the portfolio.
iii. If there is no transaction cost involved in portfolio forming, then a
rational and sensible investor will combine all possible assets in her
portfolio. Ultimately, the portfolio is composed of and reflects the
entire market. The risk of such a portfolio must be the same as the risk
of the market. Using equation 6.1c, the market’s risk must be equal to
the average covariance of the assets in the market:
σmarket
2
= σij

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 Chapter 6: Portfolio Theory and Capital Asset Pricing Model

iv. If one can lend or borrow at some risk-free rate of interest, an investor,
who previously holds a risky portfolio on the efficient frontier, may
now combine the risk-free asset with the market portfolio.

Expected
Return (%) M ro
wi
ng
Bor

ing
nd
Le

rf

Standard Deviation

Figure 6.2: Efficient frontier and risk-free asset.

This is known as the Two-fund Separation Theorem. No matter what risk
attitude an investor has, he or she will always seek to form a portfolio
by combining the risk-free and a risky market portfolio on the efficient
frontier. Given the Two-fund Separation Theorem and the implications of
the Portfolio Theory, any efficient portfolio will lie on the capital market
line (CML), which has the following form:
E Rm – Rf
E Rp = Rf + σp (6.2)
σm

Activity 6.1
Equation 6.2 required that there is a single risk-free rate in the capital markets. In
practice, investors could seldom borrow and lend at the same risk-free rate. How would
this affect the capital market line?
See the VLE for discussion.

Applications of the Capital Market Line (CML)

The CML equation gives investors an idea of how much return should be
expected for any given portfolio risk.

Example 6.1
It is expected that the market has an average return of 10% and the risk-free asset has a
return of 5%. The standard deviation of returns on the market has been 7% in the past.
What is the expected return of a portfolio with a standard deviation of 10%?
Using equation 6.2, we have
E Rm – Rf
E Rp = Rf + σm σp

10 – 5
=5+ × 10
7
= 12.14

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AC3059 Financial management

Activity 6.2
Attempt BMAE Chapter 7, question 21.
See the VLE for solution.

In the above analysis, we address the issue of risk and return relating to a
portfolio. We now turn our attention to individual assets. At the beginning
of the chapter, we defined risk and return for a single investment. When
an investor holds a single investment (or asset), he or she faces the entire
variation of returns of that asset. Consequently, the standard deviation
will be a good proxy for risk to such an investor. However as we have seen
in the discussion of Portfolio Theory and diversification of risk, a sensible
investor should form portfolios with many assets in order to eliminate
‘risk’. The relationship between the number of assets and portfolio risk is
depicted in Figure 6.3.
Porolio’s
standard
deviaon

Unique risk reduces as

the number of securies
increases

Market risk (non-diversifiable)

0 Number of securies 15

Figure 6.3: Risk diversification and the number of securities.

Figure 6.3 depicts two types of risk: risk that can be diversified (specific
or unique risk) and risk that cannot be diversified (market or systematic
risk). Empirically, an investor who holds 15 or more stocks in a portfolio
would probably hedge most of the specific risk. Arguably the only risk in
the portfolio would be from the market (the undiversifiable risk).
If transaction costs are negligible, investors would combine all assets in
their portfolios. Ultimately, everyone will hold the same most diversified
portfolio (the market portfolio). If this is the case, then how would
investors price a new asset in the market?

Activity 6.3
Given Figure 6.3, what is the implication for small investors who have only a small
amount of capital to invest?
See the VLE for discussion.

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 Chapter 6: Portfolio Theory and Capital Asset Pricing Model

Derivation of Capital Asset Pricing Model (CAPM)

BMAE does not deal with the theoretical derivation for the Capital Asset
Pricing Model. Here you can find a simple numerical derivation.
Suppose an investor holds a portfolio which combines a% of an asset i and
(1-a)% of the market portfolio. The expected return and variance of the
portfolio p are
E Rpt = aE Rit + 1 – a E Rmt (6.3)

and

[
σ Rpt = a2 σi2+ 1 – a 2
σm2 + 2a 1 – a σim] ½
(6.4)
where is the variance of the return on the risky asset i; is the variance
of the return on the market portfolio; and σim is the covariance of returns
between asset i and the market portfolio. The marginal rate of substitution
(MRS) between the expected return and risk of the market portfolio is
defined as the ratio of the partial differentiation of its expected return over
the partial differentiation of its expected risk of the portfolio with respect
to a. In equilibrium, all marketable assets are included in the market
portfolio and there is no excess demand or supply for any individual asset.
This implies that
∂E Rpt / ∂a E Rit – E Rmt
= (6.5)
∂E σpt / ∂a a=0
σim – σm2 / σm

Also note that the MRS at the market portfolio on the efficient frontier
is the same as the slope of the capital market line (CML) at the point of
tangency to the efficient frontier. It can be shown that
E Rit – E Rmt E Rmt – Rft
MRS = = = Slope of the CML (6.6)
σim – σ 2
m
/ σm σm
Rearranging the equation 3.10, we have

[
E Rit = Rft + βi E Rmt − Rft ] (6.7)

σim
where βi = σm2 . Equation 6.7, also known as the equation of CAPM or
Security Market Line, shows that there is an exact linear relationship
between an asset’s return and its beta. This beta measures the risk of an
asset relative to the market. We can from now on call it the market risk of
an asset.
Return

Risk Free Efficient Portfolio

Return = R
f

BETA
1.0
Figure 6.4: The CAPM and the security market line.

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AC3059 Financial management

Activity 6.4
Attempt BMAE Chapter 8, question 12.
See the VLE for solution.

Application of CAPM
If the SML is indeed the true pricing equation, any stock i with return
deviating from the SML would be (due to market force) brought back to
equilibrium. For example, Stock A has an observed ‘expected’ return of
10% with a beta value of 0.8. The risk-free rate and the market return are
5% and 10% respectively. According to the SML, the expected return on
Stock A should be 9% (check this answer using the pricing equation of
6.7). This implies that the observed expected return is higher than the true
expected return from the SML. Rational investors would buy Stock A to
take advantage of its undervaluation. If the market is efficient,1 the price 1
Market efficiency is
of Stock A will rise under it reaches the equilibrium. covered in Chapter 8.

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
• calculate the risk and return of a portfolio of securities
• discuss the implications of the capital market line (CML)
• discuss the theoretical foundation of the Capital Asset Pricing Model
(CAPM).

Practice questions
Stock B has an observed ‘expected’ return of 10% with a beta value of 1.2.
The risk-free rate and the market return are 5% and 10% respectively.
Advise an investor to create a no risk arbitrage, assuming that the CAPM is
the correct pricing model.

Sample examination questions

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

Year Return on Rose Plc (%) Return on Thorn Plc (%)

–5 8 6
–4 20 7
–3 16 8
–2 4 –1
–1 12 10
Required:
a. Calculate the expected return and standard deviation to the
nearest percentage of both Rose and Thorn.
b. Calculate the coefficient of correlation between the return of Rose
and Thorn.
c. Suppose you combine 50% of Rose and 50% of Thorn in a portfolio.
Calculate the portfolio’s expected return and standard deviation.
d. Suppose that the risk-free rate is 6%. Explain, with the aid of a
graph, the composition of an optimal portfolio.
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 Chapter 6: Portfolio Theory and Capital Asset Pricing Model

1. James, who is a risk averse investor, is deciding how to divide his

money between two assets – peppers and corn – which have the
following characteristics:

Peppers Corn
Expected return 10 10
Standard deviation 5 5
2. If the returns on Peppers are independent of those on Corn, what will
be the composition of his optimal portfolio? Would the composition
of the portfolio be different if a risk-free investment is available to
James?
3. An investor has access to a set of N securities (where N is large). Each
of them has an annual return variance of 0.5 and the coefficient of
correlation between every pair of the N assets is 0.1.
The investor wants to build an equally weighted portfolio of a subset
of these N assets that has a return variance of 0.10 or smaller.
What is the lowest variance you would be able to obtain?
4. Suppose the risk-free rate is 5%. The expected return and the standard
deviation of return on the market are 15% and 205 respectively. A
stock has a return equal to 8% and a return standard deviation of
12%.
Create a no-risk arbitrage.

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AC3059 Financial management

Notes

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 Chapter 7: Practical consideration of Capital Asset Pricing Model and Alternative Asset Pricing Models

Chapter 7: Practical consideration

of Capital Asset Pricing Model and
Alternative Asset Pricing Models

Essential reading
BMAE, Chapters 7 and 8.

Further reading
ARN, Chapters 6–8.

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

Aims
In this chapter we discuss the techniques for estimating betas and the
practical considerations. Empirical evidence for and against the asset
pricing models will also be discussed.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• estimate the value of beta

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AC3059 Financial management

• discuss the empirical evidence of the Capital Asset Pricing Model

(CAPM) and its application in practice
• discuss the Alternative Pricing Models.

Overview
In the previous chapter we discussed how the Capital Asset Pricing Model
is derived. In this chapter we look at how the beta value can be estimated
in practice. In addition we discuss other practical and conceptual issues
relating to the estimation of beta. In the final part of the chapter we briefly
discuss some of the Alternative Asset Pricing Models.

Estimation of beta
In Chapter 6, Equation 6.7 depicts that there is a linear relationship
between risk and return on individual assets. The risk is measured in
terms of its risk relative to the market (beta) and return is what investors
and the market would expect to receive given this level of market risk.
Consequently knowing beta would allow us to estimate the expected
return on an asset or security.
How do we estimate the beta for a company? The following example
demonstrates a simple approach which can be used in practice.

Example 7.1
SpringTime plc is an all-equity financed company on the London Stock Exchange. For the
last five years, its stock returns and the returns on FTSE100 are as follows:

Year Returns on Returns on

SpringTime (%) FTSE100 (%)
1 10 8
2 6 1
3 -4 10
4 24 12
5 19 14
The risk-free rate is 5% per annum.
Using the above information, we can estimate beta and the expected return on
SpringTime. The approach is as follows:
1. Compute the mean return of SpringTime and FTSE100 (Column I and II).
2. Determine the deviation of each observation from its mean (Column III and IV).
3. Calculate the covariance of returns between SpringTime and FTSE100 by averaging
the sum of the products of each pair of deviations (Column V).
4. Calculate the variance of returns on FTSE100 (being the average of the sum of the
squared deviations of Column VI).
5. Estimate the beta.
6. Substitute beta into the CAPM equation.

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 Chapter 7: Practical consideration of Capital Asset Pricing Model and Alternative Asset Pricing Models

I II III IV V VI
SpringTime’s FTSE100’s
Year DEV, S DEV, M III × IV IV × IV
return return
% % % % % %
1 10 8 -1 -1 1 1
2 6 1 -5 -8 40 64
3 -4 10 -15 1 -15 1
4 24 12 13 3 39 9
5 19 14 8 5 40 25
Sum 55 45 105 100
Mean 11 9 Covariance 21
Variance 20
Beta is defined as the market risk of a company. This implies that we measure the
covariance of the return relative to the risk of the market. In other words, beta can be
calculated as follows:
Covariance σsm 21
Beta = = = = 1.05
Variance σm2 20
Substituting in the CAPM equation we have

[
E Rs = Rf + βs E Rm − Rf ]
= 5 + 1.05 × (9 – 5)
= 9.2

Activity 7.1
Attempt BMAE Chapter 8, question 9.
See the VLE for solution.

There are a few aspects of estimating beta worth noting here:

i. In the absence of any information about the expected return on the
market (i.e. the return on FTSE100 in the above example), the average
historic return will be the only sensible proxy for the expected return.
ii. In the above analysis, we have not adjusted for the small sample error.
If we do, the analysis will be as follows:

I II III IV V VI
SpringTime’s FTSE100’s
Year DEV, S DEV, M III × IV IV × IV
return return
% % % % % %
1 10 8 -1 -1 1 1
2 6 1 -5 -8 40 64
3 -4 10 -15 1 -15 1
4 24 12 13 3 39 9
5 19 14 8 5 40 25
Sum 55 45 105 100
Mean 11 9 Covariance 26.25
Variance 25

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AC3059 Financial management

You can see that the differences lie on the calculation of the
covariance and variance. We re-calculate the covariance and variance
using equations 3.4a – 3.4c. However, the beta remains unchanged
(26.25/25 = 1.05).
iii. The estimation of beta is sensitive to both the return intervals and
the sample periods. Daves, Ehrhardt and Kunkel (2000) have the
following conclusion:

‘Financial managers can estimate the cost of equity via the

CAPM approach. If the financial manager estimates the firm’s
beta... then the financial manager must select both the return
interval and the estimation period. Regarding return interval...
the financial manager should always select daily returns
because daily returns result in the smallest standard error
of beta or greatest precision of the beta estimate. However,
regarding estimation period, the financial manager faces a
dilemma. While a longer estimation period results in a tighter
standard error for the estimate of beta, a longer estimation
period also results in a higher likelihood that there will be a
significant change in the beta. Thus, the beta estimated over
longer estimation periods is more likely to be biased and of
little use to the financial manager.’

Conceptual issues with CAPM

• The CAPM implies relationships between ex ante (expected) risk
premia and betas that are not directly observable. However, in
most empirical work, we implicitly assume that the realised returns
on assets in a given time are drawn from the ex ante probability
distribution of returns on those assets under rational expectations.
• Empirical tests use time-series data to calculate mean excess rates of
return and betas; however, it is unlikely that risk premia and betas
of individual assets are stationary over time. This issue is addressed
by explicitly forming portfolios that are stationary over time or
conditioning risk premia and betas on information sets.
• Many assets are not marketable and tests of the CAPM are inevitably
based on proxies for the market portfolio. The test of the CAPM
becomes a test whether the proxy is mean-variance efficient (Roll,
1977).

Empirical evidence and evaluation

Both BMAE Chapter 8 (pp.233–37) and ARN Chapter 8 (pp.295–99)
discuss the empirical evidence of the CAPM. The key question one must
ask is whether the CAPM is indeed the true model for explaining the risk
and return of individual companies. The summary of empirical evidence
from the textbooks and the text given in this section both indicate that the
cross-sectional returns are not explained solely by the market risk factor,
beta. There appear to be other risk factors which explain the expected
returns of individual companies.
It is advised that you read and make notes from BMAE Chapter 8
(pp.223–27) and ARN Chapter 8 (pp.295–99) before proceeding with the
rest of this section.
An extensive body of empirical research has provided evidence
contradicting the prediction of the CAPM. This research documents that
deviations from the linear CAPM risk-return trade-off are related to,

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 Chapter 7: Practical consideration of Capital Asset Pricing Model and Alternative Asset Pricing Models

among other variables, firm size (defined as the natural logarithm of the
market value of a firm), earnings yield (defined as the earnings per share
of a firm over its share price value), leverage (measured as the ratio of
debt to equity) and the book-to-market ratio (defined as the net book
value of a firm over its market value). Ferson (1992) provides an extensive
summary of these empirical tests on the CAPM and its anomalies up to
1991. Other notable works include:
Banz (1981), Basu (1983), and Reinganum (1981) show that the firm size
and earnings yield can explain the cross-sectional returns in conjunction
with the market beta, suggesting that beta is not the only risk factor.
Fama and French (1992) show that by employing a new approach for
portfolio grouping, there is only a weak positive relation between average
monthly stock returns and market betas over the period from 1941 to
1990. This relation virtually disappears over a shorter period from 1963
to 1990. However, firm size and the book-to-market equity ratio have
considerable power. The findings in this paper cast serious doubt over the
validity of the CAPM as the true cross-sectional asset pricing model and
has stirred up a new wave of empirical attention on the CAPM.
However in any CAPM test, there are two issues that need to be resolved:
i. Is the data for measuring or testing the expected returns taken from a
complete set which has no bias? Kothari, Shanken and Sloan (1995)
argued that if portfolios are formed from a data set which contains
only the surviving firms, the CAPM test might not be conclusive.
ii. How can we be sure that the betas were correctly estimated in Fama
and French (1992) if significant estimation errors are found in the
estimated betas? If such estimation errors exist, then the tests on
the significance of the betas in cross-section regression would be
undermined (Kim, 1995).
Debate whether the CAPM is the true pricing model is still going on.
The following section outlines the Alternative Pricing Models.

Alternative Asset Pricing Models

BMAE Chapter 8 (pp.237–41) discusses the Alternative Pricing Models.
Read this section in the textbook before continuing with this section.
Multifactor models can be divided into three types: statistical,
macroeconomic and fundamental factor models. Statistical Factor Models
derive their pervasive factors from factor analysis of the panel data set of
security returns. Macroeconomic Factor Models use observable economic
time series, such as inflation and interest rates, as measures of the
pervasive shocks to security returns. Fundamental Factor Models use the
returns on portfolios associated with observed security attributes such as
dividends yield, the book-to-market ratio, and industry identifiers.
The basic model takes the following form:
E r – rf = b1 rfactor 1 – rf + b2 rfactor2 – rf +...
One of the most cited literatures on Macroeconomic Variable Model is
Chen, Roll and Ross (1986). They observe that asset prices are driven by
exogenous forces as daily experience seems to support the view that prices
react to unexpected news. If these forces are not diversifiable, the market
will compensate investors for bearing those risks. They find that, most
notably, the industrial production, changes in the risk premium, twists in
the yield curve, and somewhat more weakly, measures of unanticipated

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AC3059 Financial management

inflation and changes in expected inflation during periods when these

variables were highly volatile are significant. Contrary to previous belief,
they find that the market return is not priced despite its high content of
explanatory power.
Fama and French’s three factor model is a good example of a Fundamental
Factor Model. BMAE Chapter 8 (pp.239–41) explains how this model can
be estimated.

Activity 7.2
Attempt BMAE Chapter 8, question 16.
See the VLE for solution.

Practical consideration of CAPM

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

Estimation method for Popularity, % always or

cost of capital almost always
CAPM 73.49
Average historic return 39.41
CAPM with extra risk factors 34.29
Discounted Dividend Model 15.74
Investors’ expectation 13.93
Regulatory decisions 7.04
Table 7.1: Popularity of methods of calculating the cost of equity capital.
Source: Graham and Harvey (2001).

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
• estimate the value of beta
• discuss the empirical evidence of the Capital Asset Pricing Model
(CAPM) and its application in practice
• discuss the Alternative Pricing Models.

Practice question
Beta estimation
i. Select a quoted company of your choice.
ii. Obtain its historical share prices. (You may download the share prices
from www.finance.yahoo.com) Note that you can download both the
company and the market data from Yahoo Finance.
The Yahoo Finance site has share price history (you may download
daily, weekly or monthly share prices) and market indices.

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 Chapter 7: Practical consideration of Capital Asset Pricing Model and Alternative Asset Pricing Models

On www.finance.yahoo.com, type in the name of the company you

want to get a quote for.
You might be directed to a symbol look-up page. Click on the ‘A-Z
Stock List’. Search for the company’s name and its symbol.
Click ‘quote’ of the company on the list and you will be redirected to
the company’s financial statistics. Click ‘Historical prices’ on the left
margin and you will go to the page where you can download the share
prices.
Select the start date and end date and check the interval period (daily,
weekly or monthly).
You can also download the market index from the same website.
iii. Referring to the Excel data set on the VLE, estimate the beta value for
Marks and Spencer using the regression method.

Sample examination questions

1. Suppose that you have estimated the expected returns and betas of the
following five stocks using annual data available for the last 10 years:

Stock Market Size (£m) Beta Expected Return

(%)
A 360 0.6 8
B 23 0.8 10
C 250 1.2 11
D 10 1.3 12
E 500 1.4 12
The risk-free rate of interest and the expected return on the market
are 5% and 10% respectively. You are also told that the market size of
the companies in this market is normally distributed with a mean of
£400m and a standard deviation of £150m.
Required:
a. Explain carefully the extent to which these data are consistent with
the Capital Asset Pricing Model and whether there is any optimal
investment strategy.
b. What would you advise an investor who would like to hold a
portfolio with a beta equal to 1?
c. ‘The risk of a company depends upon much more than how well
the stock market is doing. Beta only captures the co-movement of a
company’s share price with the market; and hence fails to capture
various sources of risk.’
Critically assess the validity of the Capital Asset Pricing Model and
its use as a benchmark for project appraisals.
2. Consider two portfolios: A and B.
You regress the return of each portfolio against the market index,
and you find the following estimates (in percentage):
Ra=4+0.2 Rm+ea
Rb=1+0.8 Rm+eb
where
Ra and Rb are the return on Portfolios A and B, respectively.
Rm is the return on the market index, and
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AC3059 Financial management

ea and eb are the residuals in the regression model for Portfolios A and B,
respectively.
You estimate the risk-free rate as 5%, and the expected return and
variance of the market index are 12% and 25.2%, respectively.
(a) If ea and eb are uncorrelated, and they are also uncorrelated
with Rm, what are the covariances Cov(Ra, Rb), Cov(Ra, Rm), and
Cov(Rb, Rm)?
(b) Are the regression results consistent with the CAPM?
3. Suppose you have the following stocks. Assume the risk-free rate is 3%
and the market return is 8%.
Stock Beta Observed return (%)
A 0.5 5.5
B 0.7 6.5
C 0.8 7
D 1.2 8.5
E 1.4 10
(a) Construct a portfolio with beta = 0.75 using Stocks B and C.
(b) Create a no-risk arbitrage using the above stocks.

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 Chapter 8: Capital market efficiency

Chapter 8: Capital market efficiency

Essential reading
BMAE, Chapter 12.

Further reading
ARN, Chapter 14.

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

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

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

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You should learn the assumptions underpinning the definition of a perfect

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

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

Efficient Market Hypothesis (EMH)

There are three forms or levels of informational efficiency:
1. Weak form – prices reflect all past information.
This means that one cannot consistently earn better-than-expected
(abnormal) investment returns as a result of studying past patterns
of prices for particular securities. This implies that people who draw
charts of past share price movements, and try to detect patterns of
share price movements, would not gain as a result.
Share prices in a market which are consistent with the weak form
should behave like a ‘random walk’ (i.e. share prices do not follow any
particular pattern). Prices are moved only when relevant information
about the securities arrive in the market. Since the arrival of new
information does not normally follow any particular pattern, this has
the effect that share prices follow an apparently random walk.
BMAE shows the random pattern (random walk) of Microsoft’s share
prices in Figure 12.3.
The Random Walk Hypothesis suggests that there is no connection
between successive share price movements. Early empirical work
supports this view, meaning that capital markets are weak form
efficient.
2. Semi-strong form – prices reflect all publicly available information.
This means that no one can earn abnormal returns based on the study
of publicly available information about the enterprise. For example,
the publication of a company’s accounting reports would not be
expected to be advantageous.
3. Strong form – prices reflect all public and private information.
This means that no one can obtain abnormal return by trading private
information. Security prices would have already incorporated the
information content of any valuable private information about a
company.
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 Chapter 8: Capital market efficiency

It is important to understand that, if a market is efficient in the strong

form, it must also be efficient in the semi-strong form and the weak
form. Similarly, if a market is efficient in the semi-strong form, it must
also be efficient in the weak form.
These distinctions are useful. This is because evidence, which consists
of the results of a large number of research studies, tends to suggest
that the world’s capital markets are efficient in the weak and semi-
strong form, but not in the strong form. In other words, those who
have relevant information that is not generally known can expect to
earn better than average investment returns.
Note carefully what is meant by Efficient Market Hypothesis (EMH).
EMH does not require that the markets are perfect in the sense that
they are referred to by economists, nor does EMH require that any
investors have perfect knowledge of the future. EMH is concerned with
the extent to which the knowledge which does exist about a particular
security is fully taken account of in its market price. Thus the price
at which a security is traded today may, with the advantage of
information which may subsequently come to light, be above or below
the true worth of the security. EMH requires that the price at which
that security is traded today rationally reflects all of the information
which is available today.

Activity 8.1
Look at a local paper which quotes daily share prices. Select a company and plot the
closing share prices for the five days in one week with time on the x axis. Draw a line of
best fit through those five points. Then plot the next Monday’s closing price. By reading
the paper about Monday’s market activities try to explain why the plot for Monday’s
price is where it is, on, above or below the trend line you have drawn. Is your explanation
drawn from the weak, semi-strong or strong form?
See the VLE for discussion.

Foundation of market efficiency

To ensure that information can be reflected in security prices, the
following assumptions must be upheld:

Rationality
Investors are rational. They seek returns to compensate for their
investment risk and would avoid unnecessary risk wherever possible.
The stock market is rational in the sense that stock prices reflect their
fundamental values. If such rationality is in place, it is argued that
investors and the market will value securities based on their fundamentals.

Independent deviations from rationality

Efficient markets allow individuals to deviate from the principle of
rationality from time to time. As long as their irrational trading behaviour
is random, it is argued that the effects of their irrational actions will cancel
each other out without affecting the efficient price level.

Arbitrage
Arbitrage is possible to ensure securities that are out of price would be
aligned to their fundamental values. Even if most investors are irrational
in the same way, as long as some rational investors can arbitrage and

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eliminate the influence of the irrational traders’ actions, then prices can be
restored to their efficient level. However, if arbitrage is not possible, any
mispricing in securities would not be adjusted.

Activity 8.2
Identify and explain which forms of efficiency are adhered to and/or violated in each of
the following situations:
i. Stock returns tend to be lower in December than in January.
ii. Small capitalised stocks perform substantially better than the market while large
capitalised stocks perform significantly worse than the market in 2006.
iii. The London Stock Exchange has recently published a report on insider trading. It has
been found that there is no evidence for any insider trading.
iv. BAC plc has just announced a record profit but its share price falls by 10%.
v. Mrs Smith announced on national TV that she can predict stock returns better than
the Capital Asset Pricing Model.
See the VLE for discussion.

Tests of the Efficient Market Hypothesis

Chapter 13 of BMAE, pp.345–59 and Chapter 14 of Arnold, pp.570–96
cover a good deal of the testing of EMH. You should read the relevant
sections in the textbooks and familiarise yourself with the evidence for and
against market efficiency.
In general, we can summarise the testing on market efficiency in 3 areas:
i. Weak form testing
Researchers have conducted the greatest number of tests on the
weak form efficiency. Tests have looked for data patterns that might
have particular properties similar to different frequency distributions
– random-walk, sub-martingale,1 simple sequences of increases or 1
A sub-martingale
declines – all with the aim of being able to derive a trading rule which is a process in which
would enable the investor to out-perform the market using a simple the expected next
period’s value, based
buy and hold strategy. The tests have been performed on numerous
on the current period’s
different markets, over different time periods, etc. The results have not information, is greater
been uniform in outcome. The differences in results can be explained than or equal to the
by many features – developed country markets versus developing current period’s value.
country markets, monthly versus daily versus weekly prices, upward
versus downward price trends etc.
ii. Semi-strong form testing
The tests on the semi-strong form have also been numerous and again
produced results lacking in consistency. The tests using data from
developed country markets have tended to support the conclusion
that the market adjusts quickly (i.e. efficiently) to publicly available
information. Results from developing market studies have been much
fewer and have tended to suggest a lower degree of efficiency.
iii. Strong form testing
The strong form tests have been least successful in their proof of
the strong form of efficiency in the markets. Clearly there are still
circumstances that exist where investors under the strong form could,
and do, earn above average profits. This is in spite of legislation
in some countries in the markets outlawing particular operations
(e.g. insider trading).

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Anomalies, fads, insider trading and doubts concerning efficiency

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

Implications of EMH

Investors
If markets are adhering to the strong form efficiency, then no one can
obtain abnormal returns by using any private or public information.
Equity research is pointless and no bargains exist on the capital markets.
Investors are best advised to buy a portfolio of shares and to hold those
shares rather than look for opportunities to buy ‘cheap’ shares. This is
because securities reliably reflect all known information about a business,
so if shares look cheap it is illusory – all that will happen is that the
investor will waste time and money seeking out the ‘cheap’ shares, then
spend money on agents’ fees etc. to sell part of the existing portfolio and
replace it with the ‘cheap’ shares.
However, if the market is not adhering to the strong form efficiency, then
for the vast majority of people, public information cannot be used to earn
abnormal returns. Arguably only those investors who have superior private
information would gain. The perception of a fair game market could be
improved by more constraints and deterrents placed on insider dealers.
Similarly, if the markets are adhering to the semi-strong form efficiency,
fundamental analysis (which looks for the fundamental value of a share)
would not add value. Instead, investors need to press for a greater
volume of timely information to ensure that stock prices reflect full public
information about companies.
If the markets are adhering to the weak form efficiency, then technical
analysis (which seeks to predict share prices from studying their historic
movements) would be redundant as past stock price patterns would have
already been incorporated in the current stock prices.

Companies
Accounting misinformation will not fool investors generally. There is a
body of evidence which suggests that attempts by corporate managers to
make alterations to the accounting bases, to figures published in annual
accounts which have the effect of giving a changed view of the profit for
a period or the assets on the balance sheet, will not affect the market
price of the business’s shares; this is provided that the facts concerning
the alterations to the accounting bases are made public. However not
everything may be made public and in any case some manipulation
may be possible within the guidelines and thus not published. There
are numerous reasons why management wants financial information
presented in a particular way (e.g. income smoothing because of the link
with a management remuneration scheme).
The timing of issues of new shares by businesses is not an important
question. It seems that corporate managers are frequently concerned not
to issue shares at a point where share prices are historically low, since in

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order for the issue to be successful the new issue would have to be at a
low price; this is irrational if current share prices reflect all that is known
about the business. Only where the businesses’ managers have economic
information about the business that they have yet to release into the public
domain would delay be justified. Again, anecdotal evidence can show in
specific instances where businesses did lose out by having to issue at the
wrong time.
Possibly the shift in research findings reflects a genuine lessening of CME
over recent times, perhaps caused by an effective decline in the number of
individual investors active in the market.
Possibly it reflects the use of more sophisticated research techniques in
recent studies, which are leading to a truer view of things.

Activity 8.3
Review the implications of market efficiency on pp.335–45. Note the implications if the
market is not efficient.
See the VLE for discussion.

A reminder of your learning outcomes

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

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

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Sample examination questions

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

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AC3059 Financial management

Notes

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 Chapter 9: Sources of finance – Equity

Chapter 9: Sources of finance – Equity

Essential reading
BMAE, Chapters 13 and 14.

Further reading
ARN, Chapters 9–12.

Work cited
J. Jiang, M.H, Stanford and Y. Xie ‘Does it matter who pays for bond ratings?
Historical evidence’, Journal of Financial economics 2012; http://dx.doc.
org/10.1016/jfineco.2012.04.001.

Aims
In Chapters 9 and 10 of this guide we focus on the main reasons why firms
raise funds from capital markets and discuss the main methods of raising
equity and debt. We will also discuss the pros and cons of each method of
fundraising.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss how the equity markets operate, particularly with respect to
the provision of funds for companies
• outline the use of equity to generate funds for companies.

Introduction
In Chapter 2 to 4 we discussed why firms engage in financial investments.
In order to maximise the value of a firm, managers must come up with
sufficient cash flows to undertake all positive NPV projects. A firm may
rely on two sources of funds: internal and external.1 1
We will discuss more
thoroughly the theory

Internal funds of capital structure in

Chapter 6. In particular
The main source of internal funds comes from retained earnings. Firms the Pecking Order Theory
set aside resources by retaining part of their yearly earnings for future will be covered.

investment purposes. It is often argued that internal funds are much more
preferred to external funds because:
• retained earnings are seen as a ready source of cash or cash equivalent
• there is no issue or transaction cost involved with retained earnings
(as opposed to equity or debt issues – see below)
• there is no dilution of control with retained earnings
• there is no public scrutiny of why the funds are needed and how they
are to be used.

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AC3059 Financial management

External funds
External funds can be roughly divided into equity finance and debt
finance.
1. Equity finance
Equity finance can be raised by selling ordinary shares to existing
shareholders or new investors. These shares can be sold or bought
in stock exchanges around the world. Ordinary shareholders are
the ultimate bearers of risk in a company, as they are at the base of
the creditor hierarchy and stand to lose everything in the event of
liquidation. They therefore demand a higher return to compensate for
the risk they bear.
Ordinary shares have a nominal (or par) value which gives every
shareholder an equal voting right. An ordinary share is normally issued
at a price higher than the par value. The difference is called the share
premium. However, the issued price is not normally the same as the
market price of a share and the share price fluctuates on the basis of
how stock markets value the company.
2. Debt finance
Debt finance refers to the borrowings of a company to finance its
operations. (We will cover this in Chapter 10.)

Activity 9.1
On 4 May 2010, Essar Energy, an Indian oil and gas producer, issued ordinary shares at
£4.20 for a total of £5,470m on the main London Stock Exchange. Its share price as on
1 November was £2.97.
(Sources: www.essarenergy.com/ and www.newissuecentre.co.uk/2010issues.htm)
Why would a company such as Essar Energy issue ordinary shares on a stock exchange?
Why did the share price of Essar fall after the issue on 4 May 2010?
See the VLE for discussion.

Floatation
Many companies, such as Essar, would like to issue shares on stock
exchanges. The main reasons for companies to do so are to:
• raise funds for current and future investments, ease out liquidity
shortages and reduce debts
• gain easier access to equity and other sources of finance in the future
• use quoted shares in various ways, such as in a take-over bid.
However, flotation of shares in stock exchanges is not without
consequences. Some of the concerns are listed below:
• Meeting investors’ expectations – it is evident that once a company is
floated on a stock exchange, it will be more heavily scrutinised by the
public and especially existing investors. As share prices are supposed
to reflect the investors’ expectations about the company’s future
dividends, managers must try hard to ensure that this expectation is
met.
• Costs of flotation – the process of flotation is a very expensive exercise
for a company. It is often thought that most companies would at
some point in their life cycle have to consider flotation in the stock
markets. The attraction or benefits from a flotation must outweigh the
limitations.
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 Chapter 9: Sources of finance – Equity

• Increased financial transparency and stock exchange’s requirements

– the costs of flotation are not confined to the payments made to
sponsors, stockbrokers, underwriters and other professionals. Once
a company is listed on a stock exchange, the requirement for a high
degree of transparency and reporting requirements might threaten its
continued listing.2 2
Olympus was
threatened with delisting
Activity 9.2 from the Tokyo Stock
Exchange if it failed to
Read the following article from The Daily Telegraph, 4 November 2007: file a quarterly report by
www.telegraph.co.uk/finance/markets/2818853/Virgin-in-training-for-1bn-flotation-of- 14 December 2011. See
www.bbc.co.uk/news/
gyms-division.html
business-15669164
Discuss the pros and cons of flotation on the stock market. See the VLE for discussion.

Why do companies seek listing on more than one stock exchange?

Some companies may seek flotation on more than one stock exchange.
Some of the main reasons are listed below:
• Broaden the investor base – it allows companies to tap into a wider
base of investors with the hope that more funds can be raised in the
future.
• Domestic stock exchange is too small – it is argued that when
the domestic markets are too small, companies might seek listing
elsewhere.
• Reward to employees – employees of foreign-owned companies may
receive shares in their parent company as part of their remuneration.
If shares are quoted in the domestic market, it is argued that these
employees could be able to manage their share value better, appealing
more to them as a result.
• Better understanding in the foreign market (price stabilisation).
• Raising awareness of the company (Chinese and Russian companies
quoted on stock exchanges such as the Hong Kong Stock Exchange and
the London Stock Exchange).

Activity 9.3
Read the following article:
www.fundinguniverse.com/company-histories/DaimlerChrysler-AG-Company-History.html
In your opinion, why did Daimler-Benz (the luxurious car maker) seek listing on the
New York Stock Exchange?
See the VLE for discussion.

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

Initial public offer (IPO)

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

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AC3059 Financial management

Issuing process
Given the complexity of raising funds in the stock markets, it is often
considered to be essential that advisers should be appointed. These
advisers fall into the following categories:
• Sponsor
This is normally an investment banker, stockbroker or another
professional who possesses all the necessary expertise and is approved
by the local listing agents to act as an adviser to issuing firms. The
sponsor (commonly known as the issuing house) will first examine and
assess if going public is the appropriate corporate objective by taking
into consideration the composition of the board. The sponsor will also
advise on the issue price and the number of shares to be issued given
the market conditions and the method and timing of the equity issue.
• Underwriters
Since it is difficult to estimate the precise demand of the new shares,
an issuing company will normally appoint an underwriter (or a
syndicate of underwriters) to underwrite any unsubscribed shares. If
the price set by the sponsor is too high, the demand will be less than
supply and the issuing firm will be left with unwanted shares. This
implies that the firm will not be able to raise sufficient funds for its
use. To ensure that this is not going to happen, a firm will pay the
underwriters a sum of money (acting like an insurance premium). In
return, the underwriters will guarantee to buy back any unwanted
shares. The price of the unwanted shares that the underwriters will
buy back from the issuing firm will be lower than the original issue
price to the public.
• Other professionals
Accountants and lawyers provide reports about the issuing firm’s
financial position and advise on legal matters relating to the equity
issue.
In considering issuing shares to the public, a company might need to
take the following factors into account:
Price stability – a newly floated firm should ensure that its share
price is stable to give investors additional confidence. Therefore it
is important that after listing, the issuing firm has the continuing
obligation to release any price-sensitive information to the market as
soon as possible.
Timing – market timing for new share issues is crucial to determine
if the issue is going to be fully subscribed. The Industrial and
Commercial Bank of China (ICBC) simultaneously floated its shares
on both the Hong Kong Stock Exchange and the Shanghai Stock
Exchange. It was the world’s largest IPO at that time. Due to the
favourable market timing, the shares were heavily over-subscribed and
the share price ended up some 15% over the initial offer price by the
end of the first trading day.
Initial returns – investors are drawn to the prospect of receiving ‘good’
returns from their IPO shares. Companies which seek to float their
shares for the first time might need to consider underpricing their
shares to attract investors.3 3
See BMAE pp.410–12
and Figure 14.3.
Long-term performance – even though there are investors who often look
for ‘bargain’ or short-term profit from their investment, the majority of
them are looking for sustainable long-term returns on their investment. A

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new IPO firm would need to prove itself to be a worthwhile investment by

showing solid and good long-term performance.

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

P0 N 0 + PN N N
Pe =
N

Where:

P0 is the share price before the rights issue

N0 is the number of old shares
N is the total number of shares after the rights issue
PN is the issued price of the rights issue
NN is the number of new shares created from the rights issue

Example 9.1
TLC plc’s current share price is £10 each. There are 1m ordinary shares in issue. The
company considers a one for four rights issue at an issuing price of £8 per new share.
What is the theoretical share price after the rights issue?

P0 N 0 + PN N N
Pe =
N
1,000,000 250,000
= £10 × + £8 ×
1,250,000 1,250,000
= £9.60.
Rights can be sold to investors: the value of rights is the difference between the
theoretical ex-rights price and the rights issue price. If shareholders either buy the offered
shares or sell their rights, there is no effect on their wealth.
In the case when a shareholder accepts the rights and buys the share, her net worth is
£9.60 × 5 – £8 = £40 which is the same value before she subscribes to the new share
(i.e. £10 for each of the 4 shares she owns). If she sells the rights, she should have (under
the no arbitrage assumption) the same wealth. Consequently, the value of the rights must
be calculated as £10 × 4 – £9.60 × 4 = £1.60.
However, the actual ex-rights price will be different from the theoretical ex- rights price
due to market expectations about the economy, the company and dividends.

Private issues
For businesses that require additional finance but are unable to increase
their level of borrowing, venture capital (also known as private equity
finance) may be the answer. Sometimes it is more advantageous for a
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AC3059 Financial management

company to issue shares privately to potential shareholders. Some of the

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

The role of stock markets

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

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
• discuss how the equity markets operate, particularly with respect to
the provision of funds for companies
• outline the use of equity to generate funds for companies.

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 Chapter 9: Sources of finance – Equity

Practice questions
BMAE Chapter 14, questions 14, 23, 24 and 25.

Sample examination questions

1. Why do companies still seek flotation on a stock exchange?
2. Outline the reasons why companies seek floatation on more than one
stock exchange.
3. Why does shareholders’ wealth remain unchanged regardless of
whether they take up the shares in a rights issue? What factors are
there to motivate shareholders to take up the rights shares?

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AC3059 Financial management

Notes

86
 Chapter 10: Sources of finance – Debt

Chapter 10: Sources of finance – Debt

Essential reading
BMAE, Chapters 13 and 14.

Further reading
ARN, Chapter 21.

Aims
This chapter introduces the characteristics of corporate bonds/debt. We
will then discuss the advantages and disadvantages of debt financing.

Learning objectives
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss the characteristics of bonds/debt
• outline the use of debt to generate funds for companies.

Introduction
Bonds are long-term debt securities that are issued by government
agencies or corporations. In this chapter we will focus on corporate bonds.
An issuer of a bond is obliged to pay interest (annually or semi-annually).
This interest can be based on a fixed or floating rate.
Fixed rate bonds are linked to the bond rating, inflation and market
interest rate. They provide protection for investors against expected
inflation. Floating rate bonds are linked to the market interest rate (e.g.
3% over the three-month London Interbank Offered Rate (LIBOR)). They
provide protection for investors against unexpected inflation and allow
them a return consistently comparable with prevailing market interest
rates.

Corporate bonds
1. Covenants
Corporate bonds are often issued with an attachment of covenants
(which can be viewed as an agreement between the issuer and the
bond-holders). These covenants impose certain restrictions on the
corporation’s managerial flexibility such as:
• Further debt issuance – the issuing corporation might need to
obtain consensus from the bond holders before further corporate
bonds can be issued.
• Dividend level – there might be conditions whereby the issuing
corporation may not be able to pay dividends to its shareholders.
For example, when the corporation’s profit has fallen below a
particular level stipulated in the covenant, no further dividend to
ordinary shareholders would be permitted.

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• Disposal of assets – the bond might be ‘vested’ on certain assets.

Disposal of those assets could only be made with the consensus
from the bond-holders.
2. Redemption and maturity
Bonds are normally issued with a specific redemption date. They
are called redeemable bonds. Those bonds that do not have a
redemption date are known as irredeemable. Before a corporation
issues redeemable bonds, it must carefully consider the liquidity
requirement (i.e. the amount required to be raised), its future cash
flows pattern (whether the interests on these bonds can be serviced)
and its ability to redeem the bonds when they mature.
3. Charges
It is also quite common for bonds to have charges over the issuing
corporation’s assets. Those bonds that are vested on non-current assets
are called bonds with fixed charges (i.e. secured on non-current assets
(fixed assets) whereby these assets cannot be disposed of without
the consensus from the bond-holders). Contrary to fixed charges, a
bond can provide floating charges to its investors. In such a case, the
bond will be secured on current assets. In the event that the issuing
corporation fails to make the payment of interest, this floating charge
will be crystallised into a fixed charge.
4. Nominal value
The nominal value of a bond is its face value. It represents the
principle amount on which the interest is calculated.

Example 10.1
A bond is issued with an interest of 10% with a nominal value of £100,000. The annual
interest on this bond would be £100,000 × 10% = £10,000
How do corporations raise funds from a debt issue?
Debt can be sold on the open market to investment institutions or individual investors, or
they can be placed privately.
Raising finance through private placements
A corporation can sell bonds/debt through a private placement directly to individual
investors. Unlike a public offering of debt, there is no need for a detailed prospectus. A
private placement doesn’t need to involve brokers or underwriters and instead they can
usually be arranged through banks or specialist financial institutions.
Advantages of using private placements
There are several advantages to using private placements to raise finance for your
business. They:
• allow corporations to choose their own investors – this increases the chances of
having investors with similar objectives to them and provides business advice and
assistance, as well as funding
• allow corporations to remain a private company, rather than having to go public to
raise finance
• allow corporations to make a return on the investment over a longer time period as
private placement investors are typically more patient than other investors, such as
venture capitalists
• incur less cost (for example, professional fees) and time than public offers
• provide a faster turnaround on raising finance than the venture capital markets or
public offers.

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 Chapter 10: Sources of finance – Debt

Disadvantages of using private placements

There are also some disadvantages of using private placements to raise business finance.
For example,
a. The privately placed debt is not traded in public, thereby reducing the marketability of
the debt. It makes it harder for investors to transfer the debt.
b. As in private share placement, a limited number of potential investors may be
identified, thereby restricting the size of the placements. It might prove to be difficult
for a corporation to raise substantial amounts through private placement.
Raising funds through public offers
If bonds are sold on the public market, they can be traded – similar to shares. Some
corporate bonds are structured to be convertible, which means they can be exchanged for
shares at some point in the future.

Activity 10.1
With reference to the advantages and disadvantages of public offers of shares, discussed
in Chapter 9, consider the advantages and disadvantages of public offers of bonds.

Debt finance
Advantages of debt financing
The issue of loan capital (debt) can bring certain advantages to a business
and its shareholders. These advantages include:
• By employing loan capital to help finance the business, the returns to
equity shareholders will increase, providing the returns from the funds
invested exceed the cost of servicing the loan.
• Loan capital is normally perceived as being less risky by investors than
equity shares as loan interest is payable before share dividends and
security is normally provided by the business for the loan – this lower
level of risk results in lower expected returns by lender than equity
shareholders.
• In most countries, interest on loan capital is viewed as an allowable
business expense which can be offset against profits for taxation
purposes – this is not the case for dividend payments.
• The degree of sophistication and variety now available in bond or
quasi-bond securities has grown enormously in recent years through
the increasing competitiveness within financial markets. Examples of
these new types are junk bonds, deep discounted bonds, mezzanine
finance, interest-rate swaps and debt-equity swaps.

Disadvantages of debt financing

The use of loan capital to finance a business, however, also brings certain
disadvantages:
• The higher the level of borrowing, the higher the level of financial risk
associated with the business. The level of borrowing is also known as
the amount of gearing. Interest must be paid irrespective of the profit
level and capital must be repaid on maturity of the debt. Also in a
winding up, administration or receivership, an unsecured lender is
repaid before a shareholder. This higher level of risk is likely to mean
that equity shareholders will seek higher returns in compensation.
• The business may also be required to accept loan covenants as part
of the loan agreement (e.g. maintaining a certain level of liquidity,

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AC3059 Financial management

seeking permission from existing lenders before raising new loan

capital, etc.) which will restrict management’s freedom of action.
• Although interest rates are generally lower than equity returns, there
can be occasions when the returns on loan capital are higher than
those on equity capital.

The issue of loan capital

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

Activity 10.2
Apart from the conditions listed above, can you think of any other factors that a
corporation should consider before issuing any debt?

Risks
Some of the risks associated with investing in bonds can be broadly
defined as follows (as per Trading Bonds on the London Stock Exchange –
a guide to private investors, 2010):1 1
www.londonstockexchange.
com/traders-and-brokers/security-
Credit risk, also known as ‘default risk’ or ‘issuer risk’, is the risk types/retail-bonds/brochure.pdf
that the issuer may not be able to meet its obligations in terms of interest
payments or may not be able to repay the principal amount back to the
bondholder at maturity. Government bonds are deemed to be of very low
credit risk because they are backed by the central government which is
able to raise taxes or print money to meets its obligations. The default risk
of corporate bonds will vary depending on the credit quality of the issuer
(see below for credit rating).
Market risk is simply the risk that the price of the bond will fluctuate
away from the price at which the investor bought it (bond pricing is
covered in Chapter 15). These price fluctuations may simply relate to the
market forces of supply and demand and if the investor maintains his
holding, the variation in the value of his bond position will be a paper
profit or loss. If the investor is forced to sell his bond to raised funds
however, there is a real risk of capital loss.

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 Chapter 10: Sources of finance – Debt

Interest rate risk is a particular form of market risk comprising the

risk that the value of the bond may be adversely affected by the prevailing
direction of interest rates. If interest rates rise, the price of bond will
generally fall, since bond investors will demand a higher yield in keeping
with the higher rates available on deposits.
Issue-specific risk relates to special features that a particular bond
may have embedded within its structure. Some bonds, for example, have
a derivative element such as a ‘call’ which, if exercised, would allow the
issuer to repay the bond early. The risk is that the bond will be ‘called’
by the issuer and that this will be disadvantageous for the bondholders.
Investors should take care to read the prospectus documentation and make
themselves familiar with any particular.

Who are the credit rating agents?

The Big Three credit rating agencies are S&P, Moody’s, Fitch’s. Together
they cover close to 90% of all credit rating. See www.defaultrisk.com/
rating_agencies.htm for a full list of credit agents. Generally these credit
rating agencies examine the business models and future cash flows of the
potential bond issuing corporations to determine their credit quality. Given
the risk and return relationship, the credit rating would then suggest to
investors how much return they should expect from the bonds.

Why do firms pay to have their bonds rated?

A corporation would need to pay a fee to the credit agency for its bonds
to be rated. Why do firms pay to have their bonds rated? One argument is
that issuers are more willing to pay for these services than investors, since
the issuers needed certain ratings in order to sell their bonds to regulated
financial institutions, as suggested in a 2010 Organization for Economic
Cooperation and Development report (www.oecd.org/regreform/
sectors/46825342.pdf).
However, during the recent financial crisis, the major rating agencies were
criticised for not providing accurate ratings for subprime mortgage-backed
securities. Numerous commentators and policymakers argue that the
Issuer-pay Revenue Model drives the failure of rating agencies and that
rating agencies should switch to an Investor-pay Revenue Model. Jiang,
Stanford and Xie (2012) found that before 1974, S&P charged investors
while Moody’s charges issuers, and S&P’s ratings were lower than Moody’s.
Once S&P adopted issuer-pay, its ratings increased and no longer differ
from Moody’s. They also found that S&P only assigned higher ratings for
bonds that were subject to greater conflicts of interest, measured by higher
expected rating fees or lower credit quality. These findings suggest that the
Issuer-pay Model leads to higher ratings in general.

Finance for small and medium-sized businesses

In general, a small and medium-sized enterprise (SME) is usually larger
than self-employed businesses but is not big enough to be listed on any
stock exchange. An SME is also likely to be owned by a relatively small
number of shareholders. It is often believed that the owners of SMEs have
limited resources to finance future expansion. Therefore, they are more
likely to encounter some difficulties in raising finance. However, some
possible ways for SMEs to raise finance are discussed below.

The SME owner, family and friends

This is probably the most obvious source of potential finance. These
investors may be looking to help each other out and may accept a lower
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AC3059 Financial management

return than many other investors. One key limitation is that the finance
that can be raised from these type of investors would be limited.

The business angel

A business angel is a wealthy individual who is willing to invest in SMEs.
They often have business acumen which may be helpful to the SME.
However, these individuals are not common and are very often quite
particular about what they are prepared to invest in.

Trade credit
Like another company, SMEs can obtain credit from their suppliers.
However, riskier SMEs may find it difficult to stretch the credit period.

Factoring and invoice discounting

Factoring and invoice discounting involves selling a business’s unpaid
invoices to a larger company for cash advances at a fee. This helps to
improve the cash flow position for the SMEs. However, it is often a more
expensive way to finance a business in the short run than an overdraft.
However, as the SMEs grow, the amounts of receivables grow, and
therefore the amount that can be obtained from factoring would also
increase.
We discuss in detail both the credit term and factoring in Chapter 18.

Leasing
Leasing assets rather than buying them could avoid the need to raise funds
in the short run. However, other financial costs relating to leasing should
also be considered.
See the section on leasing in Chapter 17.

Bank finance
Banks may be willing to provide an overdraft facility to an SME. The
interest applied to the overdraft and the terms relating to it would depend
on the SME’s risk, profitability and liquidity position. Equally, banks may
also be happy to lend to SMEs in a medium to long term, provided that
these loans can be secured against major assets such as land and buildings.
However, raising medium-term finance to fund operations is often more
difficult for SMEs as banks are traditionally rather conservative. Many
SMEs may end up financing medium-term, and potentially longer-term
assets, with short-term finance such as an overdraft. The difference
between the maturity of the assets and liabilities within the business
may lead to the ‘maturity gap’. In this case, SMEs would be even more
vulnerable to interest rate fluctuations which may cause their businesses to
suffer unexpected financial losses.
Furthermore, banks will often require personal guarantees from the
owner-manager of the SME, which means the owner-manager has to risk
his personal wealth in order to fund the company.

The venture capitalist

In Chapter 9, we discussed the finance from venture capitalists. These
venture capitalists are often seeking high risk, high return investments.
SMEs which operate in regular business may find it hard to obtain funding
from venture capitalists.

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 Chapter 10: Sources of finance – Debt

Listing
An SME can also obtain a listing on a stock exchange if it satisfies the
listing requirement. Once it is listed, it would then be able to gain access
to the capital markets like other larger companies. However, listing on a
stock exchange may cause the SME to lose some form of independence;
it would be subject to tighter financial scrutiny so that many SMEs may
never hope to achieve this.

A reminder of your learning outcomes

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

Practice questions
BMAE, Chapter 14, questions 14, 23, 24 and 25.

Sample examination questions

1. Why are the costs of debt financing less than those of share issues?
2. Explain clearly why companies might issue bonds with different
maturities, coupon rates and face value?

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AC3059 Financial management

Notes

94
 Chapter 11: Capital structure 1

Chapter 11: Capital structure 1

Essential reading
BMAE, Chapters 16 and 17.

Further reading
ARN, Chapter 21.

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

Aims
We have discussed the reasons for companies to raise funds from external
sources in Chapters 9 and 10. In Chapters 11 and 12 we will look more
formally at how different sources of funds raised by companies may affect
their values.
In particular we will examine the various contrasting theories on capital
structure.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe and assess how Modigliani and Miller’s arguments on capital
structure with and without taxes might affect the way we look at
optimal capital structure
• discuss the implication of the Trade-off Theory

Introduction
We discussed in Chapters 9 and 10 how firms raise funds from equity and
debt. In this chapter and Chapter 12 we examine the Capital Structure
Theory and attempt to provide an answer to the following question: Can
a firm create additional value through the use of a financing policy which
does not change the nature of the assets held by the firm?
If the answer to the above question is ‘no’, then corporate managers should
only be focusing on maximising the firm’s value by undertaking all positive
Net Present Value (NPV) projects. This is the conclusion we arrived at
in Chapter 1. However, if the answer is ‘yes’, then the financing policy
becomes important and an optimal way of funding projects must be found.
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AC3059 Financial management

Modigliani and Miller’s theory

BMAE Chapter 16 pp.461–70 begins with an explanation of the irrelevance
of capital structure. The key points of Modigliani and Miller’s arguments
are summarised below:
Assumptions:
• Capital markets are frictionless with no transaction costs.
• Individuals and corporations can borrow and lend at the risk-free rate.
• All firms are in the same risk class and all cash flow streams are
perpetuities (i.e. no growth).
• There is no taxation in the world (no corporate tax nor personal
taxes).
• There is no cost on bankruptcy (i.e. debt is risk free).
• Corporate insiders and outsiders share the same set of information
(i.e. no signalling opportunities).
• Managers always maximise shareholders’ wealth (i.e. no agency costs).
This is a highly unrealistic and restrictive set of assumptions. But to
understand Modigliani and Miller’s (1958) argument, we will, for the time
being, be content with this setting. Under this setting where there are no
taxes and capital markets are functioning properly, Modigliani and Miller
(MM) argue that it makes no difference whether a firm or an individual
shareholder borrows. The market value of a company does not depend on
its capital structure.

Example 11.1

A B
$’000 $’000
Earnings 1,000 1,000
Interest (100)
Earnings available for dividends 1,000 900

Suppose Company A and B are identical in every respect except in their capital structure.
Company A is an all-equity financed firm whereas Company B is partly financed with
debt. Given that they are identical, both companies generate the same cash flows.
Suppose they pay out all earnings, after interest and tax, to shareholders as dividend.
Shareholders in Company A will receive $1,000,000 as dividends at the end of the period
while stakeholders of Company B who have claims on both the debt and equity would
have a combined cash return of $1,000,000 as well. Since the cash returns to both
stakeholders are the same, the value of their investments must be identical (to avoid
arbitrage in an efficient market); and hence we have MM’s proposition I (without tax):
The value of an unlevered firm is equal to the value of a levered firm:
Vu = VL (11.1)

Proposition I tells us that regardless of how a firm is financed, its value will always be
independent of the level of debt. The average return on assets will be identical across all
firms in the same risk class.

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 Chapter 11: Capital structure 1

To see why this is the case, let’s consider the following example.
However, as the percentage of debt (relative to equity) increases, a larger share of
earnings would be distributed to debt-holders as interest. Shareholders’ potential return
will thus be affected. This increases the shareholders’ financial risk. The required rate of
return by shareholders will need to increase to compensate for the higher financial risk.
However, the weighted average cost of capital (WACC) remains constant as the value of
the company remains unchanged.

R Re

Ro

Rd

D/E
Figure 11.1: Cost of capital and debt-equity ratio.
Since assets are financed by a mixture of debt and equity, the average return on assets
must be the same as the WACC.
D E
Ra = Rd + Re (11.2)
D+E D+E
where
Ra is the average return on assets
Rd and Re are the return on debt and equity respectively
D and E are the market value of debt and equity respectively
Rearranging this equation we have proposition 2 with tax
D
Re = Ra + (Ra – Rd ) (11.3)
E
Figure 11.1 indicates the relationship of proposition 2. As the debt to equity ratio
increases, shareholders require a higher return to compensate for the increased risk. This
can be seen as the straight part of the line of R. However, as the debt to equity ratio
becomes too high, debt-holders’ risk increases as well. At some point, shareholders can
walk away from their investments and they would not see the increased debt ratio as
an additional source to their risk. In this case, shareholders would actually drop their
required rate of return.

Example 11.2
A firm has £2 million of debt and 100,000 of outstanding shares at £30 each. If investors
can borrow at 8% and the shareholders require 15% return, what is the firm’s WACC?

Answer
The value of debt, D = £2 million.
The value of Equity, E = 100,000 shares × £30 per share = £3 million.
D E
Ra = Rd + Re
D+E D+E
2 3
= × 8% + ×15%
2+3 2+3
= 12.2% 97
AC3059 Financial management

Activity 11.1
Attempt BMAE Chapter 16, question 13.
See the VLE for solution.

Modigliani and Miller’s argument with corporate taxes

We now turn our attention to the world with taxes. Suppose that both
companies in Example 11.1 pay corporate taxes at 20% on their earnings
after interest.
Example 11.3

A B
$’000 $’000
Earnings 1,000 1,000
Interest (100)
Earnings before tax 1,000 900
Tax (200) (180)
Dividend 800 720
The after-tax cash return to a 100% shareholder in Company A is $800,000. The after-tax
cash return to an investor who owns all the debt and equity of Company B would be
$820,000 ($100,000 of interest + $720,000 of dividend). Given that the cash returns
are not identical, the value of these two companies must be different (in order to avoid
arbitrage in an efficient market).
By how much would the value of B be different from A?
In most countries, interest on debt is deducted before corporate tax is calculated. This
tax deductibility of debt interest provides an additional after- tax cash flow to the
stakeholders in B. The difference of the after-tax cash return between B and A is exactly
the same as the tax saving arising from the interest (i.e. interest × tax rate = $100,000
× 20% = $20,000). So over the lifetime of the debt, the amount of tax savings interest
would be:
∞
Interest × Tc
= TcD
i=1 (1+rd) i
This tax saving represents the value of a levered firm over an unlevered firm.
Consequently, the MM proposition 1 in the world with tax will become:

VL = Vu + TcD (11.4)

Where Tc is the corporate tax rate and D is the market value of debt.
Similar to the previous explanation, shareholders will demand a higher return to
compensate for the increased risk due to higher level of debt. However, the tax
deductibility of interest allows the company to save up taxes for shareholders. The
perceived risk, which increases as a result of higher levels of debt, would to some extent
be offset by the tax shield. Consequently the MM Proposition 2 will become:
D
Re = Ra + (Ra – Rd )(1 – Tc) (11.5)
E
What is the implication of the above argument?
According to the tax argument, a firm can maximise its value by using all debt financing.

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 Chapter 11: Capital structure 1

Activity 11.2
Discuss what the following companies should do with their debt policy:
1. Company A has a substantially high corporate tax rate.
2. Company B is a large, established company with a high taxable profit level.
3. Company C is a newly established company.
See the VLE for discussion.

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

= EBIT (1 – Tc )(1 – Te )+ RdD [(1 – T )– (1 – T )(1 – T )]

d c e
(11.6)

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

VL =
EBIT (1 – Tc)(1 – Te)
+
[ ]
RdD (1 – Td) – (1 – Tc ) (1 – Te )
(11.7)
R Rd (1 - Td)
U
e

= VU + 1 –
[ ( 1 – Tc)(1 – Te)
(1 – Td) ] D

It should be noted that the discount rate for the after-tax dividend income
to equity-holders is the required rate of return by the equity-holders
whereas the discount rate for the after-tax debt interest income should be
discounted by the effective required rate of return by debt-holders. We can
see from equation (11.7) that an incentive to issue debt is provided if:

[1–
( 1 – Tc)(1 – Te)
(1 – Td) ] > 0 more advantageous to issue debt

[ 1–
( 1 – Tc)(1 – Te)
(1 – Td) ] < 0 less advantageous to issue debt

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AC3059 Financial management

Activity 11.3
In many countries, the tax rate for both income from dividends and capital gain is
the same. How would that affect equation 11.7 and what advice would you give to
companies about their debt policy?
See the VLE for discussion.

Other tax shield substitutes

DeAngelo and Masulis (1980) argue that a company’s depreciation,
investment credits and oil depletion allowance may serve as another form
of tax shield substitute. The more of these other tax shield substitutes a
company has, the less it will be inclined to issue debt. Consequently, firms
will choose the level of debt which is negatively related to the level of
other tax shield substitutes. They also argue that there will be an optimum
trade-off between the marginal expected benefits of interest tax shield and
the marginal expected cost of bankruptcy.

Activity 11.4
What level of debt would you expect to find in the following companies (based on
DeAngelo and Masulis, 1980)?
1. A national utility company (such as a water company) which has a long-term plan for
substantial capital investment.
2. An oil exploration company which hires most of the equipment.
3. A pharmaceutical company which has committed itself to a high level of research and
development activities.
See the VLE for discussion.

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

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 Chapter 11: Capital structure 1

Activity 11.5
Attempt BMAE Chapter 17, question 10.
See the VLE for solution.

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

Market Value

Value of levered firm

Maximum value of
(with tax shields only)
firm

Cost of financial distress

PV of tax Value of levered firm

shields (with tax shields and
financial distress)

Value of
unlevered
firm

D/E rao
Opmal
debt rao

Figure 11.2: Trade-off Theory.

Figure 11.2 shows the Trade-off Theory. As the debt increases, the value
of a firm increases as the tax shield of debt interest kicks in. However,
as the level of debt increases, the potential cost of financial distress also
increases. Part of the tax shield benefit is cancelled out by the cost of
financial distress. The net increase in the firm’s value will be smaller
than the tax shield effect alone. The optimal capital structure is reached
when the marginal cost of financial distress equals the marginal tax shield
benefit, the firm should stop issuing more debt.

Activity 11.6
Using the trade-off theory, would you expect profitable companies to borrow more or
less?
See the VLE for solution.

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AC3059 Financial management

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• describe and assess how Modigliani and Miller’s arguments on capital
structure with and without taxes might affect the way we look at
optimal capital structure

Practice questions
BMAE Chapter 17, questions 14 and 15.

Sample examination questions

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

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 Chapter 12: Capital structure 2

Chapter 12: Capital structure 2

Essential reading
BMAE, Chapters 16 and 17.

Further reading
ARN, Chapter 21.

Works cited
Graham, J.R. and C.R. Harvey ‘The theory and practice of corporate finance:
evidence from the field’, Journal of Financial Economics 60, 2001,
pp.187–243.
Jensen, M.C. and W.H. Meckling ‘Theory of the firm: managerial behavior,
agency costs and ownership structure theory of the firm’, Journal of
Financial Economics 3, 1976, pp.305–60.

Aims
Following on from Chapter 11, this chapter presents further conceptual
and theoretical arguments for capital structure..

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• examine thoroughly concepts of signalling effect and agency costs of
both equity and debt in the Capital Structure Theory
• discuss the implications of the Pecking Order Theory.

Signalling effect
The trade-off theory appears to have provided a solution for corporate
managers to form the optimal capital structure. However, in reality,
suppose there are two types of firms in the market: good quality firms
characterised by high future cash flows, and poor quality firms with
low future cash flows. The true quality is not observable by the market.
Investors would not be able to distinguish the true quality between these
two types of firms. Consequently, they will all be valued at the same price.
The question is: How do managers of good quality firms signal their firms’
true quality to the market?
It is argued that a carefully selected debt policy might be able to signal the
true quality of a good firm. Let’s consider the following scenario:
A firm with a high level of debt implies that there is a higher probability of
bankruptcy. If this is a poor quality firm, it would not have sufficient profit
to absorb the potential tax shield from debt interest and it would have
insufficient funds to pay the debt interest and would thus be insolvent.
Therefore, only managers who are in charge of good quality firms would
be willing to adhere to a high level of debt. The market sees this as a
signal sent by the financial managers about the true quality of their firm.
Its share price would rise accordingly. However, in order to ensure that the
debt can be signalled effectively, the following conditions must be met:
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AC3059 Financial management

1. The market must adhere to the semi-strong but not strong form;
otherwise the firm’s value can be observed.
2. There is an incentive for the managers in a good quality firm to signal
the firm’s true value.
3. The penalty of using a misleading signal by managers in a poor firm is
more costly than the short-term gain.
So what incentive do we have for ‘good’ and ‘bad’ managers telling the
truth?
If the signal is linked with a manager’s compensation scheme, M, such
that:
M = (1+ r) γ0 V0 + γ1 V1 ≥ B (12.1a)
or
M = (1+ r) γ0 V0 + γ1 (V1 – C) if V1 < B (12.1b)

where
γ0, γ1 = positive weights

r = the one-period interest rate

V0, V1 = the current and future value of the firm
B = the face value of debt
C = a penalty paid if bankruptcy occurs, i.e. V < B.
A manager’s compensation is based on the realised value of the firm at
time 0 and 1. Suppose that B* is the maximum amount of debt that a poor
quality firm (type B) can carry. Managers from a good quality firm (type A)
will set a debt level higher than B* at time 0. The value of the firm at time
1 will be V1a, and the value of the firm at time 0, V0a is the discounted
value of V1a. Managers will receive the following positive compensation:
V1a
M = (1+ r) γ0 + γ1V1a (12.2)
1+ r
If managers of a poor quality firm try to raise the debt level above B*, the
value of the firm at time 0 will be the same as that of the good quality
firm, V. However, the value of the firm at time 1 when the market realises
that this is a poor quality firm will be V1b. If this value is less than B*,
managers of the poor quality firm will receive the following compensation:
M = (1+ r) γ0V0b + γ1 (V1b – C ) (12.3)
This compensation is negative if:
(1+ r) γ0V0b + γ1 (V1b – C )< 0 (12.4)

V1a
⇒ (1+ r) γ0 + γ1 (V1b – C )< 0
1+ r

⇒ γ0V1a + γ1V1b < γ1C

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

Activity 12.1
Discuss how in practice we can impose such penalty as in equation 12.4.

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 Chapter 12: Capital structure 2

Agency costs on debt and equity

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

Agency costs on debt

On the other hand, an increase in debt may also increase the agency costs
of debt. Debt-holders may insist on various types of protective covenants
and monitoring devices to ensure that their wealth is being protected.
Debt-holders may demand a higher return. These costs may increase as
a function of the level of debt. More importantly, managers may make
investment decisions which might be biased towards the equity-holders’
interest. When a firm is in financial trouble, both equity-holders and
debt-holders would like to recover their investments. Let’s consider the
following two scenarios:1 1
Refer to BMAE
Chapter 17 (pp.497–
1. Risk shifting 503) for the other
Suppose a firm, C, has $50m debt and $50m equity. Let’s assume that, possible sub-optimal
managerial actions in
due to some financial problems, the value of assets falls to $20m.
the event of financial
If debt-holders force the firm into liquidity, the best they can get is distress.
$20m.
Suppose the firm has an investment opportunity which requires $10m
as the initial investment outlay and generates $90m of PV with a 10%
chance and $0m with a 90% chance. Should financial managers of this
firm go for this investment?
First we should consider whether this is a positive NPV project or not.
The NPV of this project can be calculated as:
E(NPV) = $90m × 10% + $0m × 90% – $10m = ($1m)
It is clear to see that this is a sub-optimal project and under normal
circumstances, the firm should reject it. However, given that the firm
is in serious financial distress, financial managers who are supposed
to work for the best interest of their shareholders may attempt to
undertake this project using the existing cash resources from the firm.

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AC3059 Financial management

There are two possible outcomes from this investment decision:

• Worst case – the project does not pay off and the value of the firm
falls to $10m (being the original value less the investment outlay
which is not recovered from the investment). Shareholders will get
nothing in the event of liquidation.
• Best case – the project pays off with $90m PV, the value of the
firm rises to $100m (being the original value, $20m less the
investment outlay, $10m plus the pay-off from the project, $90m).
Shareholders will get $50m in the event of liquidation after paying
off the outstanding debt.
The expected pay-off to each stakeholder is as follows:

Worst Best Expected Do nothing Difference

$m $m $m $m $m
Debt-holders 10 50 14 20 (6)
Shareholders 0 50 5 0 5
Firm’s value 10 100 19 20 (1)

The expected pay-off is the probability weighted average of the

outcomes of the two cases. From the above table we can see that
shareholders gain at the expense of the debt-holders.
2. Underinvestment
Suppose Firm C in the above example is faced with a safe investment
which requires an initial investment outlay of $10m and generates a
fixed PV of $15m instead. Would managers undertake this project?
Let’s look at the expected pay-offs to the stakeholders in this case.

Do nothing Invest Difference

$m $m $m
Debt-holders 20 25 5
Shareholders 0 0 0
Firm’s value 20 25 5

Debt-holders, in this case, would hope that managers will undertake

this investment and their debt value will go up by $5m. However,
shareholders are not going to receive anything in any case. If
managers work for the best interest of their shareholders only, then it
is likely that debt-holders will lose out once again.
How do agency costs of debt arise?
In the above two scenarios, we can see that a firm with high level of
debt is likely to undertake sub-optimal investment decisions. These
actions will reduce the value of a firm. In order to avoid risk shifting
from equity-holders to debt-holders, debt-holders would need to impose
more restrictions on their loan agreements (covenants) and introduce
monitoring systems to ensure that their interests are protected. These
agency costs will reduce the tax shield benefits of higher debt levels.
Putting both agency cost of equity and debt together
As we increase the level of debt, the agency cost of equity will
decrease while the agency cost of debt rises. To minimise these costs,
one should set a debt level such that the aggregate agency costs are at
their lowest.
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 Chapter 12: Capital structure 2

Activity 12.2
Agency costs relate to both the direct and indirect monitoring costs on the agents’
behaviour and the indirect costs of sub-optimal agents’ action. How can we measure
these costs in practice?
See the VLE for discussion.

Pecking Order Theory

BMAE Chapter 17 (pp.505-09) discusses the pecking order of financing. In
short, the Pecking Order Theory is:
• Firms prefer internal finance.
Firms can build up an internal cash reserve to avoid external
financing. External financing involves issuing costs and indirect effects
on share values such as the agency costs on debts and equity discussed
on p.79. It is the preferred source of finance.
• Debt finance is better than equity finance.
The signalling effect on debt discussed on p.78 indicates that
managers in a good quality firm prefer to issue debt. Therefore it is
often argued that managers who issue equity must know that their
company’s shares are over-valued. If the market is efficient and
investors are rational, the equity issue must be viewed as a pessimistic
signal about the firm’s long-term value.

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

Debt policy factors Percentage of CFOs identifying factor

as important or very important
Financial flexibility 59.38
Credit rating 57.10
Earnings and cash flow volatility 48.08
Tax advantage of interest deductibility 44.85
Transactions costs and fees 33.52
Comparable firm debt levels 23.40
Bankruptcy/distress costs 21.35
Customer/supplier comfort 18.72
Debt restricted so project profits can be 12.57
captured fully by shareholders and not
paid to debt holders
Investor’s personal tax costs when they 4.79
receive interest income
Enough debt not to be a takeover target 4.75
Table 12.1: Factors affecting the decision to issue debt.
Source: Graham and Harvey (2001).

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AC3059 Financial management

In practice, however, managers seem to value financial flexibility more in

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

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• examine thoroughly concepts of signalling effect and agency costs of
both equity and debt in the Capital Structure Theory
• discuss the implications of the Pecking Order Theory.

Practice questions
BMAE Chapter 17, questions 14 and 15.

Sample examination questions

JDNV plc, a pharmaucetical company, has been quoted on the Stock
Exchange of Swayland for over 10 years. It is one of the leading spenders
in research and development activities of its country and has a significant
amount of capital investments. Despite its high profits in the past, the
company has only 10% of debt. As a result to the recent global financial
crisis, the national government of Swayland has decided to lower interest
rate by 2% and reduce the corporate tax rate by 5%.
The directors of JDNV plc forecast a significant downturn of the company’s
profit in the next few years.
Required
a. Explain clearly the Modigliani and Miller’s arguments on debt and
equity in the world with corporate tax.
b. Critically assess how costly bankruptcy (or financial distress) might
affect the equilibrium of a company’s capital structure.
c. With reference to the information given above regarding JDNV plc
and the economy of Swayland, advise the directors of JDNV what debt
policy the company should adapt.

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 Chapter 13: Dividend policy

Chapter 13: Dividend policy

Essential reading
BMAE, Chapter 15.

Further reading
ARN, Chapter 22.

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

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

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

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AC3059 Financial management

• describe and discuss alternative views on the effect of dividend policy

• explain the informational aspects of dividend payments
• explain the impact of tax on the dividend decision.

Introduction
In Chapter 15 of BMAE you will be exposed to the theory and practices
associated with corporate dividend policy. We will present opposing views
of the effects of dividend policy on the valuation of shares and discuss
the significance of the traditional view of dividends. This chapter also
addresses informational aspects of dividend payments and potential
clientele effects and how dividend payments are set in practice. The
general intention of this chapter is to provide an in-depth discussion on
the controversial question of how dividend policy affects firm value.
Dividend policy has been the source of some controversy over the years.
In this chapter we consider the nature of that controversy and the factors
that influence dividend policy in practice. We also consider alternatives to
dividend payments which a business might consider.

Types of dividend
Corporations can pay out cash to their shareholders roughly in three ways:
1. Cash dividend
Investors look for a return from their investment holding in
corporations. It is therefore natural for corporations to pay dividends
on a regular basis (yearly, half-yearly or quarterly) as a return to
their shareholders. Some corporations pay a high percentage of their
corporate earnings as dividend whereas some choose to keep the
dividend payout ratio low.1 1
See Securities Investors
Association (Singapore) for a
However in some cases, a corporation may choose to pay a one-off list of top paying companies:
special dividend. www.sias.org.sg/index.
2. Stock2 repurchase php?option=com_content&
view=article&id=248%3Adi
Another way for a corporation to pay out to shareholders would be vidend-payout-ratio-top-50-
through a stock repurchase. Figure 15.1 of BMAE shows the history companies&catid=20%3Apress-
of dividend and stock repurchases in the USA between 1985 and releases&Itemid=43&lang=en
2020. One emerging fact is that the absolute amount of stock being 2
The term ‘Stock’ is often
repurchased by corporations from their shareholders has increased used in the United States
significantly over that period. What is the main reason for that? to refer to shares issued by
companies.
There are four ways to repurchase shares from shareholders:3
i. open market 3
See BMAE pp.437-42.

ii. tender offer

iii. auction
iv. private negotiation.
3. Scrip dividend
Scrip dividend (or bonus shares) is an issue of shares (not for cash) to
existing shareholders.

Activity 13.1
Read BMAE p.437. Identify the main advantages and disadvantages of the four
methods of stock repurchase described above.
See the VLE for discussion.

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 Chapter 13: Dividend policy

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

Modigliani and Miller’s argument

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

Example 13.14 4
Adapted from BMAE,
Chapter 15.
Bear Inc. is currently traded at $10 each with 1,000,000 shares in issue. It has
$1,000,000 of cash and $9,000,000 of other assets (measured at their market value).
Suppose the firm has an investment opportunity which requires $1,000,000 of initial
investment outlay and can produce a net present value of $2,000,000. If Bear Inc. is to
undertake this investment, its value (in an efficient market) will go up to $12,000,000.
$’000
Original value ($10 × 1,000,000 shares) 10,000
Investment opportunity (NPV) 2,000
New value 12,000
New share price ($12,000,000/1,000,000) $12
Suppose Bear Inc. has now earmarked the $1,000,000 in the cash account for
investment. If existing shareholders would like to receive a dividend of $1 per share, what
should Bear Inc. do? To raise the amount necessary for the cash dividend, Bear Inc. would
need to issue $1,000,000 of shares. It should be noted that the cash raised from the
share issues is distributed out immediately as a cash dividend to shareholders. The value
of the firm would therefore remain at $12,000,000.
But what would happen to the share price after the share issue and cash dividend
payment?
Let x be the number of new shares issued and p be the new share price after the new
share issue and dividend payment. We have the following two conditions:

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AC3059 Financial management

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

Clientele effect
In reality, investors are often facing the following scenarios:
1. Buying and selling shares incur transaction costs (such as stamp duty,
brokerage fees etc).
2. Income from either the cash dividend or selling the shares is treated as
taxable income.
3. Investors have different income requirements and consumption
patterns.
Given these constraints, investors must consider their liquidity requirement
(subject to the consumption pattern) and their tax position before deciding
in which company they would like to invest.

Tax consideration
It is often argued that different investors are attracted to shares of
different businesses on the basis of their particular dividend policy.
Investors should consider their tax position before deciding which
company to invest in. We can easily hypothesise that those investors who
have a higher marginal tax rate on dividend income (than capital gain)
would prefer to invest in a firm which has a low dividend payout policy,
and those who have a lower tax rate on dividend income would prefer
to invest in a firm with a high dividend payout policy. Those who do not
have to pay any taxes or have the same marginal tax rate on both dividend
income and capital gain would naturally be indifferent to the different
dividend payout options.
So, given these three groups of investors, each type of firm (classified by
the level of dividend payout) caters to its own ‘clientele’ of investors. It can
be seen that any change in the dividend payout level by a firm may upset
its investors as they may be subject to higher tax. If they are, they will sell
their shares and re-invest in firms which cater for their tax consideration.
The firm which alters its dividend policy may therefore witness price

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 Chapter 13: Dividend policy

changes in its shares. What it means is that dividend policy might be

relevant in this tax clientele context.5 5
Also clientele effect
relates to investors’
Activity 13.2 preference for specific
payout patterns such
In most countries the tax rate on dividend income and capital gain is identical. Does it as fixed percentage
imply that the tax clientele effect is irrelevant? payout of profits, fixed
See the VLE for discussion. percentage growth in
annual dividend etc.

Liquidity requirement
Some investors – such as pensioners, institutional investors and insurance
companies – require regular dividends as a source of income to meet their
consumption and liquidity requirement. They would prefer companies to
pay dividends. If selling shares to generate cash flows incurs unnecessary
transaction cost, these tax-paying investors may prefer to hold dividend
paying shares. As a result, similar to the tax clientele effect, firms will
attract different clientele of investors. If a firm changes its dividend policy,
it might upset its investors and its share price will fall as a result when
investors rebalance their portfolios.

Activity 13.3
On 18 November 2003 Vodafone announced a £2.5bn share repurchase and an increase
of dividends by 20% to £1.5bn. Its share price went up by 6.4% on the day.
In Chapter 4 we discussed the Efficient Market Hypothesis. Share prices react to new
information in a semi-strong form efficient market. So what information arrived on
18 November 2003 that caused the share price of Vodafone to move up by 6.4%? What
does the share repurchase have to do with the share price? What information does the
increase in dividend convey to the market?
See the VLE for discussion.

Information content of dividend and signalling effect

Lintner (1956) interviewed a sample of managers from US corporations
and his research findings can be summarised into the following four
stylised facts:
1. Managers seem to have a long-term target dividend payout ratio.
2. This ratio is measured as a proportion of long-term earnings.
3. Managers focus more on dividend changes than on the absolute level
of dividend.
4. Managers are reluctant to make dividend changes that might have to
be reversed. Dividend changes follow shifts in long-term, sustainable
levels of earnings rather than short-run changes in earnings.
If Lintner’s stylised facts about how managers might formulate their
dividend payout are true, it means that an increase in dividend signals
managers’ confidence about their firm’s future. Share price will rise
accordingly like in the case of Vodafone.
Is dividend an effective signal? Suppose we have a market with two types
of firms – good quality firms are characterised with high future cash flows,
while poor quality firms are characterised with low future cash flows. For
dividends to act as an effective signal, we need to meet the following three
conditions:
1. Good quality firms are undervalued and their true values are not
unobservable. What this means is that good firms are not valued
correctly relative to the poor firms. The market fails to recognise the
mispricing. So how could we provide an incentive to managers to
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signal the true value of their firms?
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In this case, managers of a good quality firm would want to signal

the firm’s true value to the market provided that they will be suitably
rewarded by telling the truth about the firm’s value. Normally this is
done if their remuneration is linked to the value of the firm.
2. The market is consistent with the semi-strong form efficiency but
does not adhere to the strong form efficiency. Under this condition,
an increase in dividend sends good news about future cash flows and
earnings. Share prices will rise. On the other hand, a dividend cut
sends bad news as it indicates that managers are less confident about
the firm’s future than the market and a high dividend payout policy
will be costly to firms that do not have the cash flow to support it.
Share prices will fall accordingly.
3. A penalty will be imposed on managers of poor quality firms who
mishandle their firms.
This condition is necessary to stop managers of poor quality firms
from using high dividend payouts as a signal. Given that the market
cannot observe the true value of firms or distinguish the quality, an
increase in dividend by a manager of a poor firm might be mistaken
as a positive signal of the firm’s value. But we know that poor quality
firms do not have sufficient cash flow to sustain this high dividend
policy. Eventually the firm will collapse if it continues to pay out high
dividends. So in order to stop managers of poor firms lying about their
firm’s value, there must be a penalty system which discourages them
from lying to the market in the first place. This can be done as long
as the reward they get by temporarily increasing the firm’s value (as a
result of the increase in dividend) is outweighed by the penalty they
will have to pay when the true value of the poor firm is reviewed.

Activity 13.4
What are the main reasons why a firm’s true quality cannot be observed? Does it imply
that a higher degree of transparency of information is needed?
See the VLE for discussion.

Agency costs and dividend

When the ownership and control of a firm are separated, managers
who run the firm might behave opportunistically. This problem is
further intensified when there are conflicts between shareholders and
bondholders’ interest. For example, if a firm is facing financial difficulty,
managers might choose to pay out a large cash dividend to shareholders
instead of investing in positive NPV projects. This action will increase
shareholders’ value at the expense of debt-holders. In this case, paying out
a large dividend will actually suppress the share price.
To mitigate this problem, as one may recall in the section above, managers
in a poor quality firm would not increase dividend payouts as the penalty
of managing a bankrupt firm would be severe. Secondly, bondholders
would foresee that every firm has a chance of running into financial
difficulty. So before they lend, they would impose all kind of restrictions to
stop managers from paying out large dividends when the firm is suffering
financial distress.
Another possible conflict would be between managers and shareholders.
So far we assume that managers work for the best interest of their
shareholders. So what if they don’t? Managers might engage in sub-
optimal investment decision-making and use any spare cash (which is

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not invested) to pay for private uses (new office, company cars, etc.). As
the control over such a firm is lost as shareholders don’t participate in
day-to-day operations, the only thing shareholders can do, would be to
vote against the re-appointment of the managers or sell their shares as a
protest. However, these actions might come too late to recover the loss
that shareholders might have already suffered.
To mitigate this problem, one might opt to drain the company of cash
by requesting a high dividend payout. When management need cash
for future investments, they have to approach shareholders for capital
funding. Shareholders can exercise some control over their savings
by refusing to buy the firm’s new securities if they are suspicious of
managerial behaviour, but then there are the transaction costs to be paid
for raising the cash this way.

Empirical evidence
The importance of dividend decisions
Lintner (1956), Fama and Babiak (1968) and Fama (1974) concluded that
managers prefer a stable dividend policy and are reluctant to increase
dividends to a level which cannot be sustained.
Gordon (1959) finds positive correlation between a high payout ratio
(dividend per share/earnings per share) and high price to earnings
(market price/earnings per share) ratio among firms. He argues that
investors value companies more with high payout ratios. However, the two
ratios in his analysis contain the earnings per share as the denominator, so
when earnings move, both variables move.
If a company’s earnings are volatile (high risk), it tends to have lower PE.
This company is likely to have a low payout ratio to reduce exposure to
volatile earnings shifts.

Dividends and tax implications

Black and Scholes (1974) do not find any positive relationship between
high dividend yields and before-tax return. But Litzenberger and
Ramaswamy (1979) find a statistical relationship between dividend yields
and before-tax return. Elton and Gruber’s (1970) work shows evidence
that there is a relationship between high payout ratio and low marginal
rates of tax.

Determining dividend policy in practice

The early empirical evidence and casual observation seem to suggest
that managers consider the dividend decision to be very important and
that the maintenance of a stable dividend policy is preferred over time.
There seems to be a high degree of reluctance in firms to raise dividend
levels unless the directors of the firm are confident that the higher payout
ratio can be sustained over a long time period. Similarly, there is usually
reluctance for firms to cut dividends because of the (adverse) signals
which such an action may send out.
There is also evidence to suggest that managers of a firm consider the
firm’s level of earnings to be the most important influence on the dividend
decision. However, a more recent survey conducted by Brav, Graham,
Harvey and Michaely (2005) indicated that:

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...maintaining the dividend level is on par with investment

decisions, while repurchases are made out of the residual cash
flow after investment spending. Perceived stability of future
earnings still affects dividend policy as in Lintner (1956).
However, 50 years later, we find that the link between dividends
and earnings has weakened. Many managers now favour
repurchases because they are viewed as being more flexible
than dividends and can be used in an attempt to time the equity
market or to increase earnings per share. Executives believe that
institutions are indifferent between dividends and repurchases
and that payout policies have little impact on their investor
clientele. In general, management views provide little support
for agency, signalling and clientele hypotheses of payout policy.
Tax considerations play a secondary role.

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

A reminder of your learning outcomes

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

Practice questions
BMAE Chapter 15, question 29.

Sample examination questions

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

2007 2008 2009

Net income applicable $3,496,000,000 $4,834,000,000 $5,704,000,000
to common shares

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

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Notes

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 Chapter 14: Cost of capital and capital investments

Chapter 14: Cost of capital and capital

investments

Essential reading
BMAE, Chapter 18.

Further reading
ARN, Chapter 19.

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

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

Introduction
In Chapter 2 of this subject guide we discussed how managers select
projects based on projects’ NPVs. In this chapter we discuss how corporate
managers choose the discount rate for projects when they are financed
with debt and equity. BMAE’s Chapter 18 begins with a good summary of
how projects should be evaluated. You should read that before proceeding
with the rest of this chapter.

Cost of capital and equity finance

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

βe = ωj β j (14.1)
j=1

where ωj is the weight of project j in the company. Consequently, the

return on equity must be the weighted average of the returns on all
projects:
N

E (Re ) = ωj E( Rj )= E (Ra) (14.2)

j=1

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Example 14.1
Suppose ABC Ltd., a 100% equity financed company, has three projects, A, B and C. Their
betas and values are as follows:

Projects Betas Values (£’000) Weights

A 0.6 60 60/200 = 0.3
B 0.8 80 80/200 = 0.4
C 1.2 60 60/200 = 0.3

Suppose the risk-free rate is 5% per annum and the expected market return is 10%
per annum.
The weighted average beta of the three projects is (which is also the equity beta):
β = 0.3 × 0.6 + 0.4 × 0.8 + 0.3 × 1.2 = 0.86 = βe
The expected return on the average project is:

[ ] [ ]
E (Ra )= Rf + βa E (Rm) – Rf = 5 + 0.86 × 10 - 5 = 9.3 = E ( Re )

You should note that the expected return of the three projects can also be calculated
using the CAPM equation.

Projects Betas E(R)

A 0.6 5 + 0.6 × (10 – 5) = 8
B 0.8 5 + 0.8 × (10 – 5) = 9
C 1.2 5 + 1.2 × (10 – 5) = 11

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

There are other techniques to determine the cost of equity that we have
briefly looked at in previous chapters.
Using the CAPM, the expected equity return can be found by Risk-free
return + Beta of the firm x (expected return on the market – risk-free
return).
An all-equity financed firm’s dividend per share is expected to grow at
g%. Currently its share price is traded at P0. Let’s DPS1 be the next period
dividend per share. The Gordon’s Growth model implies that
P0 = E(DPS1)/(re – g)
Where re, the expected return on equity = E(DPS1)/P0 + g

Activity 14.1
Company A has just paid a dividend per share (DPS) of $1.50. It is expected that the DPS
will grow at 5% per year for the foreseeable future. The current share price is $20. What
is the cost of equity of Company A?
See the VLE for solution.

Cost of capital and capital structure

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

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E (Ra )= E E R + D
E+D
( e ) E+D (1 – tc)E (Re ) (14.3)

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

E ß + D
ßa =
E+D e E+D
(1 – tc) ßd (14.4)

Equation (14.3) is known as the weighted average cost of capital (WACC).

The no-tax equivalent to equations (14.3) and (14.4) are:

E (Ra )= E E R + E
E+D
( e ) E+D E (Rd) (14.5)

and
D
ße = ßa +( ßa – ßd ) (1 – tc ) (14.6)
E
Cost of debt calculations
In Chapter 10, we discuss the various forms of debt financing. In this
section, we look at the approach to estimate the cost of debt for the
following instruments: irredeemable debt, redeemable debt, convertible
debt, preference shares and bank debt.
Irredeemable debt is a debt that, once issued, will never be redeemed. The
holder of this instrument will receive coupon interest for life.
Suppose Bond A is an irredeemable bond with a coupon interest of 5% on
a face value of $100, currently priced at $90. The cost of capital for this
irredeemable bond can be found by solving the following equation:
Price of the bond $90 = discounted future coupon interest = $100 x 5%/
(1 + Rd) + $5/(1 + Rd)2 + ……
= $5/Rd => Rd = 5/90 = 5.56%
Suppose Bond B is a 5 year-bond with a coupon interest of 5% and a face
value of $100. Currently it is priced at $90. What is the cost of Bond B?
In this case, we equate the price to the expected discounted cash flows
from this bond. This gives
$90 = $5/(1 + r) + $5/(1 + r)2 + …… + $5/(1 + r)5 + $100/(1 + r)5
We can use the extrapolation method to determine the approximated r:
Years Cash flows Discount Present Discount Present
factor (5%) value factor (10%) value
1 5 0.952 4.76 0.909 4.545
2 5 0.907 4.535 0.826 4.13
3 5 0.864 4.32 0.751 3.755
4 5 0.823 4.115 0.683 3.415
5 105 0.784 82.32 0.621 65.205
100.05 81.05
Price 90 90
10.05 -8.95
The approximated r = 5% + (10% – 5%) x 10.05/[10.05 – (-8.95)]
= 7.64%

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A convertible bond is a bond that gives an option to the holder to convert

the bond into shares. The following terms show the different forms of the
conversion:
i. A 3-year convertible bond with a coupon interest of 10% and a face
value of $1,000 can be converted into 50 shares on the date when the
bond is matured.
ii. A 3-year convertible bond with a coupon interest of 10% and a face
value of $1,000 can be converted into 40 shares any time on or before
the date when the bond is matured.
iii. A 3-year convertible bond with a coupon interest of 10% and a face
value of $1,000 can be converted into shares at $20 each on the date
when the bond is matured.
iv. A 3-year convertible bond with a coupon interest of 10% and a face
value of $1,000 can be converted into shares at $25 each any time on
or before the date when the bond is matured.
The conversion ratio is defined as the number of shares that the
convertible bond can be converted into. In the above examples, if the
face value (the redemption value of the bond) is the amount that can be
converted into shares, then the conversion ratio would be:
i. 50
ii. 40
iii. $1,000/$20 = 50
iv. $1,000/$25 = 40
Conversion premium is defined as the amount by which the current
market value of the convertible bond exceeds the current market value of
the shares into which the bond will be converted (conversion value).
Suppose the convertible bond in (i) above is priced at $900. The current
share price is $15.
The conversion premium = $900 – $15 x 50 = $150
The conversion value will change as the underlying share price changes.
Similarly the conversion premium at any time before the conversion option
expires would also change.
The value of a convertible bond = value of a bond without the conversion
option + the conversion value at the expected time to convert.
How do we determine the cost of a convertible bond?
Suppose Company A has issued 3-year 8% convertible bonds. Currently
they are quoted at $85 per $100 nominal. The bonds can be converted in
three years’ time into 30 shares.
The share price is currently $3 and is expected to grow at a rate of 5% pa.
Let’s assume that the tax rate is at 30%.
Conversion value = $3 x (1.05)3 x 30 = $104.19
Since it is higher than the redemption amount, the holder of the
conversion bond would be expected to convert. The cost of this convertible
can then be estimated using the extrapolation method.

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Years Cash Discount Present Discount Present

flows factor (10%) value factor value
(20%)
1 8 0.909 7.272 0.833 6.664
2 8 0.826 6.608 0.694 5.552
3 112.19 0.751 84.255 0.578 64.846
98.135 77.062
Price 85 85
13.135 –7.938
The approximated cost of the convertible bond
= 10% + (20% – 10%) x 13.135/[13.135 – (–7.938)]
= 16.23%

Preference shares
Preference shares are treated in exactly the same way as ordinary bonds,
and hence the valuation and the cost of capital would be treated in the
same approach.

Example 14.2
Make-it-easy plc has 100,000 shares at the current market price of £10 each.
It also has £500,000 worth of debt. The expected return on equity is 12%. The debt is
estimated to be relatively risk free and has a return of 5%. Corporate tax rate is 40% per
annum.
Calculate the WACC.

Answer

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

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

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Example 14.3
Using the information from Example 14.2, suppose Make-it-easy plc decides to venture
into a risky operation. It requires £1,500,000 as an initial investment outlay. It is expected
to generate £200,000 per annum of perpetual net cash flows. This risky operation has an
estimated beta of 2. The company intends to raise the funds from existing equity-holders.
Assume that the market return is 10% per annum.
If Make-it-easy uses the WACC (9% as in Example 14.2) to evaluate this risky operation,
the net present value of the risky operation will be calculated as:
200,000
NPV = − 1,500,000 = 722,222
0.09
Make-it-easy will accept this venture as the NPC is higher than zero. However, the risk of
this venture is significantly higher than the company’s average project risk. Consequently,
a higher discount rate should be used to compensate for the increased risk. Using the
CAPM, the expected return on a project with a beta equal to 2 should be

E (Rrisky) = 5 + 2 × (10 − 5) = 15

Using this risk-adjusted rate, the risky operation’s NPV should be:
200,000
NPV = − 1,500,000 = −1,666,667
0.15

If WACC is inappropriately used to evaluate risky projects as in Example

14.3, a company risks making incorrect decisions about investment plans.
In general the problem with WACC in project appraisals can be highlighted
in the following diagram.
Return (%)

SML
Over investment

WACC

Rf Under investment

Risk
Figure 14.1: The problem of using WACC in project appraisals.
When WACC is used to appraise a project with a lower risk than the
company, the project’s NPV is likely to be understated. On the other hand,
the use of WACC on projects with higher risk than the company would
result in overstating the project’s NPV (such as the example of Make-it-
easy above).

Activity 14.2
Consider the three projects in Example 14.1. Identify whether their NPVs are over- or
under-estimated if the WACC is used as the discount rate.
See the VLE for solution.

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The effect of debt financing a project

BMAE (Section 18.4) introduces the concept of adjusted present value
(APV). It is defined as:
APV = Base – case NPV + sum of PV’s of financial side effect
See the example in BMAE, pp.537–38 for an illustration of the use of APV.

Capital structure and beta

We have seen that equation (14.6) captures the relationship between
a firm’s equity beta and its debt level. In practice, when market data is
limited, a firm’s equity can be estimated by using equity beta from other
companies. The following example illustrates this technique.

Example 14.4
The managers of Grand plc would like to estimate their firm’s equity beta. Grand has only
had a stock market quotation for two months. Managers fear that the lack of market data
for their firm may make it difficult to estimate the correct beta for Grand plc.
As a result they decide to use some existing firms’ data as it would be inappropriate
to attempt to estimate beta from Grand’s actual share price behaviour over such a
short period. Instead it is proposed to ascertain, and, where necessary, adjust the
observed equity betas of other companies operating in the same industry, and with the
same operating characteristics as Grand, as these should be based on similar levels of
systematic risk and be capable of providing an accurate estimate of Grand’s beta.
Two companies have been identified as firms having operations in the same industry as
Grand that utilise identical operating characteristics. However, only one company, Big
plc, operates exclusively in the same industry as Grand. The other two companies have
some dissimilar activities or opportunities in addition to operating characteristics that are
identical to those of Grand.
Details of the three companies are:
i. Big plc
It operates exclusively in the same industry as Grand plc. Its observed equity beta is
1.12. It is financed with 60% equity and 40% debt.
ii. Large plc
It has an observed equity beta of 1.11. It has two divisions. Division A represents
30% of Large plc and has an equity beta equal to 1.9. Division B shares very similar
operating characteristics with Grand plc. Large plc is financed entirely by equity.
iii. Grand plc is financed entirely by equity. It has a tax rate of 40%.
Assume that all debts are virtually risk free; determine three possible estimates of the
likely equity beta of Grand plc, based on the information provided for Big and Large.
Approach:
iv. Using the data from Big plc and equation (8.6), we first ‘de-gear’ Big plc’s beta:
D
ße = ßa +( ßa – ßd ) (1 – tc )
E
40
1.12 = ßa + (1 − 0.4) ß assume that the debt is risk free
60 a
ßa = 0.8
The de-geared beta of Big plc can be a proxy for Grand’s all equity beta.
v. Both Grand and Large are all equity financed. However, only Division B of Large
shares the same operating characteristics of Grand. So one may argue that the beta
for Division B would be a good proxy for Grand’s asset beta. Given that Large’s equity
beta would be a weighted average of the divisional betas, we have:

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ße = aßA + (1 – a) ßB

1.11 = 0.3 × 1.9 + 0.7 × ßa

ßB = 0.77

Grand’s equity beta can be proxied as 0.77.

Activity 14.3
Suppose that the risk-free rate and the expected return on the market in Example 14.4
are 5% and 10% respectively. Estimate the expected return of Grand plc.
See the VLE for solution.

A reminder of your learning outcomes

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

Practice questions
BMAE Chapter 18, questions 14 and 18.

Sample examination question

a. Arena Computers plc is a debt-free British IT firm. In the recent past,
its equity has had return variance of 64%. Over the same period, the
market has had an average return of 8% and a return variance of 25%.
The covariance between Arena’s returns and the market’s returns was
30%. Compute the beta for Arena’s stock. What does its level imply
for the relationship between Arena’s stock returns and those on the
market? (6 marks)
b. The risk-free rate is 5%. Compute the expected return on Arena’s
stock. (4 marks)
c. Arena is evaluating a project that would involve the installation of
a new inventory control system. The project would have an infinite
lifetime and is as risky as Arena’s existing assets. Arena’s management
estimates that, in the first year of its life, the project would produce
incremental cash-flows of £54,000 per year. This figure would increase
by 5% a year. The cost of the project is £1,250,000. Should Arena
invest in the new inventory control system? (5 marks)
d. How would your answer to part c. change if Arena’s capital structure
consisted of 30% of risk-free debt? (5 marks)

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 Chapter 15: Valuation of business

Chapter 15: Valuation of business

Essential reading
BMAE, Chapters 3, 4 and 18.

Further reading
ARN, Chapters 15–18 and 20.

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

Aims
In this chapter we focus on three main methods of valuing a business.
They are:
1. asset based
2. earnings based
3. cash flow based.

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

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

Approaches to business valuation

Asset-based valuation
The statement of financial position (balance sheet) of any company
provides a useful starting point for us to estimate a firm’s value. The
statement consists of all ‘recognisable and quantifiable’ assets and
liabilities that a business has.
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The first method is based on the historic cost approach. The valuation is
based on the balance sheet value of the net assets (i.e. total assets – total
liabilities). This would then give an idea of the value of the firm and
hence the value to the owners (i.e. shareholders). However, historic value
has very little use in decision making. There are intangible assets such
as goodwill, knowhow, brands and customer lists – none of which are
recognised as assets on the balance sheet. Therefore the net asset value
would not capture the intrinsic value of the business.
The second asset-based valuation method is net realisable values of the
assets less liabilities. This amount represents how much shareholders
should get if the assets are sold off and the liabilities settled. For a
successful business, its net realisable values of the assets are likely to be
higher than the total amount needed to settle all liabilities.
However, a successful business is likely to be in operational continuity.
To value a business based on its net realisable value does not seem to be
consistent with the going-concern concept. Net realisable value therefore
represents a ‘worst case’ scenario because, presumably, selling off the
tangible assets would always be available as an option. The selling
shareholders should therefore not accept less than the net realisable
amount – but should usually hope for more.
The third asset-based valuation applies the replacement values to each
individual operating asset of a business. This method provides a more
up-to-date valuation to those operating assets and values a business more
as a going concern. However, not all assets could easily be replaced with a
readily available market value. For example, a business may have included
a deferred development expenditure as an intangible on its balance. This
research and development project is highly specific to the developer, and it
is unlikely that other companies would benefit. In the absence of a ready
market for the finding, it would be difficult to estimate the replacement
value, limiting further its practicality in business valuation.

Activity 15.1
Examine the financial statements of Coca Cola. Determine a value for the company using
the asset-based valuation method. Why might the value you determine differ from the
stock market’s valuation (i.e. share price × number of shares in issue)?
See the VLE for discussion.

The statement of financial position only reports what accountants can

deem to be ‘recognisable’ and ‘quantifiable’. It is for this reason that
some of the valuable assets might not necessarily be accounted for in the
statement. For example, innovative knowledge may probably be one of
the most important assets for Apple Inc.; brand awareness is the most
important asset of Coca Cola; and British Airways’s world-wide established
contacts with airports, clients and authorities are their competitive
advantage. Knowledge, brand and customer relationships are valuable
to a company but might not be easily quantifiable. These resources are
often not reported on financial statements. As a result, the asset-based
method is unlikely to indicate the true value of a business. Nevertheless,
asset-based valuations are often used in practice as a basis for adaptation.
For example, a bidder might be looking for a value to start within a set of
takeover bid negotiations using the asset-based valuations.

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Earnings-based method
This method requires us to estimate the earning power of a company.
Typically we use the price-to-earning ratio (PER) as a surrogate. PER is
defined as:

Current market price of share pt

Historic PER = = (15.1)
Last year's earnings per share Et–1

The following table shows some UK retailers and their historic PER.

Retailers PER
Alliance Boots 23.6
Debenhams 11.6
DSG International 17.5
HMV 10.5
JJB Sports 24.0
Kingfisher 21.6
Marks and Spencer 21.0
Next 16.4
Table 15.1: UK retailers and their historic PER.
Source of information: Financial Times, 5 May 2007 (also Arnold, 2008).

How do we use PER in business valuation?

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

Example 15.1
The following data relates to Company A plc:

2007 2008 2009 2010

£ £ £ £
Price per share 6 8.4 11 9.18
Earnings per share 0.6 0.8 1.0 0.9
PER 10 10.5 11 10.2

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

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Discounted cash flow method

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

$ $
Investment 1 X Equity (shares) X
Investment 2 X Debt (borrowings) X
Investment 3 X
….
Total value of investments XX Total value of capital XX

If a company is made up of a number of investments, each investment’s

net present value can be computed using the discounted cash flow
technique we introduced in Chapter 2. The value of the company would
then be the sum of the NPV of all investments.
N

V= NPVi for all investments i (15.2)

i=1

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

Valuation of debt/bonds
A company which borrows would need to set out:
i. how long the borrowing is for
ii. the amount it borrows
iii. the interest it promises to pay during the life time of the borrowing.
A lender will receive a certain sum of cash flows over the life of thedebt
depending on the terms and structure of the above three aspects. The
value of such debt (borrowing) to the lender will therefore be the
discounted value of the cash flows that the lender can receive from the
borrowing firm. Consequently, the expected market value of redeemable
fixed interest debt will be found by discounting interest payments and
redemption value by the cost of debt:
T
I RV
D= + (15.3)
t=1
(1+Rd) t
(1+Rd)t
Where:
D = market value of the debt
T = number of years to maturity
Rd = rate of return (before tax) required by debt investors
RV = redemption value
I = interest paid.

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Example 15.2
What is the value of a 5 year 10% bond if the yield to maturity is 15% per annum?
Assume that the face value is $100.

Answer
The annual interest received by a bondholder is $100 × 10% (face value × coupon rate)
= $10. The yield to maturity is the required rate of return by the lender for a bond of this
kind. It is also the discount rate for the valuation purpose. Putting these together we
have:
10 10 10 10 10 100
D= + + + + +
1.15 1.15 1.15 1.15 1.15 1.155
2 3 4 5

= 10 × A5,15% + 100 × DF5,15%

= 10 × 3.352 + 100 × 0.497

= 83.22
Activity 15.2
What would be the value of the same debt in Example 15.2 if the yield to maturity were
now 5% per annum?
See the VLE for solution.

In the previous example, we considered a bond which needs to be repaid

by the issuing company within a fixed period of time. What if the bond is
irredeemable?
If a bond is irredeemable, the redemption value of the bond is equal to
zero. Consequently, the valuation formula will be reduced to:
∞
I I
D= + (15.4)
t=1
(1+Rd)t Rd

Where:
D = ex-interest market value
I = annual interest paid
Rd= rate of return required by debt investors.

Example 15.3
Consider the case of a 5% irredeemable bond of £100 par value where bond investors
require a yield of 10% per annum. The expected market value of the bond will be:
I £5
D= = = £50
Rd 0.1

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

Valuation of equity
We now turn our attention to the value of equity (shares). A shareholder
who owns a share in a company will receive cash flow in terms of the
resale value of the share and/or dividend paid by the company. Suppose
that at the end of the period, the price for a quoted share is P. Assume that

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shareholders receive dividends Div at the end of each time period t. Let the
discount rate (or the required rate of return) by the shareholders be r%.
The value of a share can then be computed as:

E (Div1) E (P1)
P0 = +
1+r 1+r

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

E (Div1) E (Div2) E (P2)

P0 = + +
1+r (1+r) 2
(1+r)2
By forward substitution, the share price can be rewritten as:

E (Div1) E (Div2) E (P2)

P0 = + +
(1+r) (1+r)2 (1+r)2
E (Div1) E (Div2) E (Div3) E (P3)
= + +
(1+r) (1+r)2 (1+r)3 (1+r)3
...
...
E (Div1)
∞

=
t=1 (1+r)1 (15.5)

This is the Discounted Dividend Model for the valuation of shares. To use
this model to estimate share prices in reality, we will need to estimate a
company’s future dividend and its cost of equity.
In Chapter 3 we discussed how one can use the Capital Asset Pricing
Model (CAPM) to estimate the required rate of return by equity-holders.
If this estimation process provides us with the correct discount rate, the
remainder of our work is to estimate the forecasted dividend.
Suppose we observe a company has been paying a constant dividend of
Div each year in the past. It is natural to assume that it is going to pay the
same constant dividend in the future. Given that the future dividend is
going to be constant, equation (15.5) will become:
Div
P0 = r (15.6)

Now suppose a company’s dividend has been growing by g% each year in

the past. If we believe that the same constant growth rate is going to be
persistent in the future, equation (9.5) will become:

(1+g) Div0
P0 = (15.7)
r–g
Equations (15.6) and (15.7) are known as the Constant Dividend Model
and Gordon’s Growth model.

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Activity 15.3
Sunlight plc paid the following dividends for the last 5 years: £1.30, 1.40, 1.55, 1.70 and
1.90. The company’s current cost of capital is 14% per annum.
Suppose dividend is expected to grow at the historic growth rate of the last 5 years for
the foreseeable future, what would be the estimated share price of Sunlight? If dividend
is only expected to grow at the historic rate for the next 3 years and thereafter stays
constant, what will be the revised share price?

Answer
We first calculate the historic growth rate of dividend. Given that Div (0) was £1.30 and
Div (4) was £1.90. We can depict this relationship as follows:

Div(4) = Div(0)× (1+g)4 ⇒ g = 10%1 1

For examination purposes,
you can assume that the
growth on dividend is not
Case 1 – when dividend is growing at 10% infinitely. Using the Constant Growth Model,
compounded. Consequently
the share price is: we have

(1+g) D0 (1+0.1) ×1.90 2.09 Div(4) = Div(0) × (1 + 4g)

P0 = = = = 52.25 � g = 11.5%
r–g 0.14 − 0.1 0.04

Case 2 – when dividend only grows at 10% for 3 years and thereafter stays constant, the
share price is:
Div1 Div2 Div3 P2
P0 = + + + (15.7a)
(1+r ) (1+r )2 (1+r )3 (1+r )3
Note that P3 is the terminal price at the end of year 3. Those who obtain a share at that
time would be entitled to dividend from year 4 to infinity. Therefore the terminal price is:
Div4 Div5 Div6
P3 = + + + ... (15.7b)
(1+r ) (1+r ) (1+r )3
2

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

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

1.1×1.90 1.12×1.90 1.13×1.90 1.13×1.90/0.14

P0 = + + + (15.7c)
(1.14) (1.14) 2
(1.14) 3
(1.14) 3
2.09 2.299 2.5289 2.5289/0.14
= + + +
(1.14) (1.14) 2 (1.14) 3 (1.14) 3
= 1.833 + 1.769 + 1.707 + 12.192
= 17.501

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

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• the time value of money is not included in the consideration

• the risk of the company is not being considered thoroughly.

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

How is value created?

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

How do we measure the value?

We can summarise how we measure value as follows:
1. In Chapter 2 we discussed how a firm’s value is based on the aggregate
of a firm’s projects’ NPVs.
2. The value of a firm can also be proxied as the sum of the value of the
financial instruments. We discuss this in Chapter 6 and this chapter.
3. A free cash flow approach which is discussed below.
Rappaport (1998) defines free cash flow (FCF) within the planning
period as:
FCF = sales – operating costs – tax
– incremental investment in fixed capital
– incremental investment in working capital
The corporate value is then defined as:
Corporate value = PV of free cash flow within the planning period +
PV of free cash flow after the planning period + the current value of
marketable securities and other non-operating investment.
A forecasted free cash flow is estimated and then discounted
accordingly to take into consideration the time value of money.

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

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A reminder of your learning outcomes

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

Practice questions
BMAE Chapter 3, questions 12, 34 and Chapter 4, questions 14, 15 and
16.
Additional question
A 6% six-year bond is priced at $753.32. A 10% six-year bond is priced at
$1,092.46. What is the six-year spot rate?

Sample examination question

Falcon Ltd. is a private company in the UK. Its balance sheet on
31 December 2011 shows the following information:
£’000
Share capital @ £1 par value 10,000
Share premium 5,000
Revaluation reserve 2,500
Retained profits 12,500
Shareholders’ funds 30,000
5% bonds, matured in 2019 20,000
Capital employed 50,000
Falcon paid the following dividends in the last 5 years:
£
2006 0.51
2007 0.60
2008 0.68
2009 0.77
2010 0.90
The risk-free rate is assumed to be 4% per annum and the expected
market’s return is set to be 10% for the foreseeable future.
Required:
a. What is the balance sheet value of Falcon Ltd.?
b. What is the market value of the bond in Falcon, assuming that the
market risk, beta, of the bond is 0.5.
c. Suppose a similar quoted company to Falcon Ltd. has an observed beta
of 1.1. Estimate the equity value of Falcon.
d. What is the value of Falcon based on (b) and (c) above?
e. Why is your answer to (a) different from (d)?
f. What reservations do you have in terms of the value you calculate in
(d)?

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Notes

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 Chapter 16: Mergers

Chapter 16: Mergers

Essential reading
BMAE, Chapter 32.

Further reading
ARN, Chapter 23.

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

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

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

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

Motives for mergers

BMAE Chapter 32 (pp.919–28) explains the main motives for mergers and
acquisitions. Some of these motives are explained here.

Economies of scale
You may have come across this term in your earlier studies. In short,
economies of scale can be found in the following areas:
• In production – a larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across more units.
• In finance – a large firm may be able to reduce its per unit
administrative cost when administrating finance issues.

Internalisation of transactions
This usually occurs when firms vertically integrate (vertical integration
backwards occurs by the acquisition of firms that supply raw materials and
vertical integration forwards occurs when firms are acquired nearer the
selling of the product). It is an important form of merger as it eliminates
transaction costs when firms have to deal with each other. One drawback
is that by merging two large firms, extra costs may result. For example,
suppliers may be less inclined to compete with one another, leading to
higher prices paid by the merged entity. Another problem is that firms may
be over-integrating. In this case, the benefits of reducing transaction costs
may be outweighed by the increase in costs of mergers.

Market power
During the boom of 1979–85, it was estimated that 3% of assets in the
UK changed hands as a result of vertical integration, while 57% were a
result of horizontal integration (horizontal integration occurs where firms
acquired are at the same stage of the production process, and the merger
leads to a greater share of a particular market). This is an attractive
feature for firms as it has been shown that a concentration in an industry
leads to a greater level of profit.

Entry into new markets/industries

A merger may allow the acquiring firm to enter into markets where the
acquired firm has the know-how. As the growth through a takeover is
quick, it can provide, almost instantly, the necessary size for a firm to
become an effective and formidable competitor.

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Elimination of misguided management

There is a substantial separation between the ownership and management
of large firms. Shareholders do not appoint or supervise the firm’s
management; they only elect directors who are agents responsible for the
choosing and monitoring of the top management of the firm.

Mergers as a use for surplus funds

If a firm is in a mature industry with few, if any, positive NPV projects
available, acquisition may be the best use of its funds.

Complementary resources
Merging may result in each firm filling in the ‘missing pieces’ of their firm
with pieces from the other firm. For example, an accounting firm merges
with a consultancy firm to provide an all-round one stop service to clients.
Similarly, a merger may take place when one firm’s loss can be used to
offset another firm’s profit for tax purposes within the group.

Dubious reasons for mergers

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

A B

EPS £1 £1
P/E 10 5
Share Price £10 £5
No. of shares 10m 1m
Market value £100m £5m
Earnings £10m £1m

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

Activity 16.1
Attempt BMAE Chapter 32 self-test question 32.1 (p.919) and question 3.
See the VLE for solution.

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

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Cash offer
• Acquired firm’s shareholders
In a cash offer, the shareholders of the acquired firm will receive a
certain sum of cash flow in selling their shares to the acquiring firm.
While they can calculate the actual return of the investment, the sale
of the shares will be deemed as a disposal which normally will attract
capital gain taxes. There is therefore a tax consideration that the
acquired firm’s shareholders would need to take into account when
accepting the offer price from the acquired firm.
• Acquiring firm and its shareholders
• If the firm is using idle cash, both free Cash Flow Theory and Pecking
Order Theory suggest that this will increase the value of the firm.
• If the firm can afford to purchase another firm with cash despite
the cash flow implication, it might suggest that the acquiring firm
might still have sufficient cash flows for other future investment.
Based on our discussion of the signalling effect on debt and
dividend, this might suggest that it is a good quality firm. Once
again its value might further be enhanced.
• Another advantage of using cash in acquiring another firm is that
there is no dilution effect to the existing shareholders’ holding in
the acquiring firm.

Share issues
• Issuing new shares to raise additional cash for acquisitions has very
similar advantages as in the cash offer above.
• However, according to the Pecking Order Theory, issuing shares might
lead the market to believe that the existing shares are overpriced. This
might have an adverse effect on the share value if the acquiring firm
issues new shares to raise funds for the acquisition.
• There can be difficulties for the market when trying to evaluate the
resultant combination if it perceives that the target company has part
or all of its operations in a different risk class or classes from that of
the acquiring company.

Debt issues
According to our discussion in the Trade-off Theory, as long as the firm’s
marginal tax shield benefit exceeds the marginal cost of financial distress,
the debt financing will increase the value of the firm. In a similar way, a
firm which issues debt to finance an acquisition might also increase its
value due to this financial effect.

Share exchange
In this mode of financing an acquisition, the acquiring firm issues new
shares to the shareholders of the acquired firm in exchange for the
control of the acquired firm’s net assets. In return, the shareholders of the
acquired firm will surrender their shares in the acquired firm. The relative
advantages and disadvantages of this method to the different stakeholders
can be summarised as below:
• Acquiring firm and its shareholders
• There is no immediate outflow of cash and therefore it reduces
the burden of raising additional finance. This is especially valuable
when the acquiring firm is facing a capital rationing problem.

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• However, the shareholders of the acquired firm will now be

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

Activity 16.2
Examine several recent mergers and identify the principal financing options in each case.

Impact of mergers1 1
See Arnold (2008),
pp.887–93.
There is a significant volume of academic and practitioner research on
mergers and their impact. In Arnold, the impact on different types of
stakeholder is discussed. Here is a brief summary:

Society
Society will benefit from mergers provided that the combined firms will
produce cheaper products as a result of economies of scale and improved
managerial efficiency. Empirical findings seem to suggest that at best
mergers are neutral to society.

Shareholders of acquired firms

In practice, a significant premium is often paid over the pre-bid price
of the acquired firm. The empirical evidence seems to overwhelmingly
suggest that shareholders of the acquired firm gain from mergers.

Shareholders of the acquiring firms

Empirical evidence seems to suggest that the majority of mergers result in
a poorer than expected return to the acquiring firms.
Why do mergers fail to generate value for acquiring shareholders?
Different mergers have their different reasons for possible failure.
However, there seems to be some common explanatory factors:
1. Misguided strategies
Companies engage in mergers in the hope of gaining larger market
shares. However, some of these mergers might be carried out at the
wrong time. For example, Daimler-Benz merged with Chrysler to
create a global car producer and found itself in a high-tech recession in
2001, and lost over 90% of its share value.
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2. Over-optimism
Acquiring managers often over-estimate the benefits of a merger and its
cost. This explains why acquiring firms seem to lose value in mergers.
3. Failure of integration management
Coopers & Lybrand (1993) surveyed the UK’s top 100 companies and
interviewed senior executives and found that the most commonly cited
reasons for merger failures are:
• Target management attitudes and cultural differences (85%).
• Little or no post-acquisition planning (80%).
• Lack of knowledge of industry or target (45%).
• Poor management and poor management practices in the acquired
company (45%).
• Little or no experience of acquisitions (30%).

Employees
In most merger cases, operating units of the merged firms are fused and
redundancy is inevitable. However, in some cases, mergers actually create
competitive strength in the combined firm and allow jobs to be saved or
created.

Directors
The directors of the acquiring firm will normally enjoy an increase in
status and power in the combined firm. Their salary and remuneration are
increased as a result.
On the other hand, the directors of the acquired firm will often be sacked as
they are regarded as the failed managers. However, these directors are often
given a good redundancy package and are often able to find jobs in other
companies.

Financial institutions
Financial institutions benefit from mergers greatly as they are usually paid
handsome fees for providing advice to both the acquired and acquiring
firms during merger talks.

Estimating economic gain

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

Gain = PVCombined − PVi

i=1

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

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• Cost reduction
• elimination of inefficient management
• economies of scale
• complementary resources.
A bidder is typically estimating the value of a target company using some
of the valuation methods we outlined in Chapter 9. The following example
illustrates how the cost and gain of a merger can be estimated.

Example 16.1
Wardour plc is a 100% equity financed company. It is considering acquiring
the net assets and full control of Frith plc. Currently Frith is expected to have a dividend
growth of 6% per annum. Under the management of Wardour plc, this growth rate is
expected to increase to 8% per annum without any additional investment.

Wardour Frith
Earnings per share 50p 15p
Dividend per share 30p 8p
No. of shares 40m 24m
Share price £9 £2

Wardour plc has the following three financing options:

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

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Net gain of acquisition to Wardour:

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

Activity 16.3
Suppose the realisation of the dividend growth is uncertain in Example 6.1, which
funding option would be ‘safer’ from the acquirer’s point of view?
See the VLE for solution.
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Conclusion
In this chapter we discussed the main reasons for companies merging with
each other. We also looked at how the gains of a merger can be estimated.
In short this is an area in which corporate managers need to make three
key decisions:
• Investment decision – does the target company provide benefits to the
merged firm? We can view it as an investment project which should be
appraised in line with Chapter 2 to 4.
• Financing decision – how should the acquisition be financed? Does it
add value to the merged firm with the different methods of financing?
This links with what we discussed in Chapters 9 to 11.
• Strategic decision – the success of a merger depends on how well the
merger plan can be executed. Coopers & Lybrand (1993) provide a list
of common factors for merger success:
• Detailed post-acquisition plans and speed of implementation. A
clear purpose for making the acquisition.
• Good cultural fit.
• High degree of management cooperation.
• In-depth knowledge of the acquired firm and its history.

A reminder of your learning outcomes

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

Practice questions
BMAE Chapter 32, questions 7, 19 and 20.

Sample examination question

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

Bei plc Jing Ltd.

Number of shares issued at £1 each 20,000,000 2,000,000
Market price per share £10 £12.5
Earnings after tax per share £0.875 £1.5
Beta 0.9 1.8

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

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Notes

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Chapter 17: Financial planning and analysis

Essential reading
BMAE Chapters 26, 29 and 30.

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

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

Introduction
This chapter covers two key areas in financial planning:
1. Financial analysis.
2. Financial planning.

Financial analysis
A company’s financial statements provide shareholders, bondholders,
bankers, suppliers, employees and management with information about
how well their interests are protected. Naturally, it is important for each of
these stakeholders to understand the performance of their company. You will
have already come across how we can use financial ratios to assess a firm’s
performance. BMAE Chapter 29 provides a very detailed explanation of how
these common financial ratios can be calculated and used in interpreting a
firm’s profitability, efficiency, liquidity, financial risk and leverage. We are not
going to repeat this material here. You should revise Chapter 28 thoroughly
before proceeding with the rest of this section. In particular, you should refer
to the summary of financial ratios on p.748.
A company’s set of accounts, its profit and loss account, cash flow statement
and balance sheet are only of limited value when read in isolation and
without analysis and evaluation. Therefore it is important to give meaning to
results portrayed by accounts via analysis and interpretation. The analysis of
financial information can perhaps be best broken down into two elements,
each with their own parts. These are the process and the context elements,
and each influences the other.
The process of analysis will be heavily influenced by its mode and its purpose.
The structure, depth and detail of work undertaken will be influenced
similarly. A very detailed review will start by strategically analysing the
company and then use the ratios to address strategic elements within each
area of enquiry. Most books delineate four areas: profitability, liquidity and
solvency, activity and efficiency, and financial structure.

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Each of these areas can be broken down further, for example in the case
of profitability it can cover trading profitability, the margin on sales, the
proportions of sales taken by the different types of costs, etc. Profitability
also includes the return on the investment made. As to what constitutes
investment depends on the reviewers’ perspective. Is it the return on
the long-term funds invested – capital employed – or is it the return on
the total assets used to generate the profit or the return to the ordinary
shareholders for their investment in the company? Each of the areas has its
own family of ratios, providing information for answers to the appropriate
strategic questions. Remember the process is generally to prepare a set of
ratios, analyse them, and use them for a review of the past performance
with the view of helping in the projections for the future. Also a
comparison with competitors or industry sector benchmarks can be useful.
The following table summarises the key ratios and their interpretation.

Ratios Definition Interpretation

Profitability
After-tax interest + net Measures the extra value added to
Economic value
income – cost of capital shareholders and bondholders after
added (EVA)
× capital1 accounting for the cost of capital. 1
An alternative
definition of EVA is
Measures the potential return to (profit after tax + before
Return on capital After-tax interest + net tax interest) – cost of
shareholders and bondholders on their
(ROC) income2/total capital capital × capital. The
investment in the company.
difference depends on
whether interest is tax
Measures the potential return to
Return on equity deductible.
Net income/equity shareholders on their investment in the
(ROE)
company. 2
It should be noted that
BMAE define net income
This measure focuses on how profit as the profit after
Return on assets After-tax interest + net
would be generated from the utilisation tax. Some UK authors
(ROA) income/total assets (such as Arnold, 2008)
of assets employed in the company.
define ROC as profit
Measures the difference between before interest and tax/
Market value Market value of equity – the market value of shareholders’ capital. Both the US
added (MVA) book value of equity investment and their cumulative and UK definitions are
acceptable.
investment in the company.
Measures how much gross profit a
Gross profit margin Gross profit/sales company can generate from every
£ of sales.

Measures how much operating profit

Operating profit
Operating profit/sales a company can generate from every
margin
£ of sales.
Efficiency
3
We can also define
Measures how well the company asset turnover as sales/
Asset turnover Sales/total assets3 generates revenues from its assets average level of total
employed in the year. assets for the year.
4
In most cases, the
Provides an estimate of how long year-end figures are
Inventory holding Average4 inventory/cost on average goods purchased from used for debtors (trade
period of sales × 365 days suppliers would be held in the receivables), creditors
(trade payables) and
company before they are sold.
closing stock (inventory)
instead.

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Ratios Definition Interpretation

This measure indicates on average

Debtors collection Average debtors/credit
how long it takes for a company to
period sales × 365 days
collect its debts from credit customers.

Measures on average how long it takes

Creditors payment Average creditors/credit
for a company to pay its debts to credit In the case when
period purchases5 × 365 days 5

suppliers. credit purchases are

not available from the
Liquidity financial statements, the
cost of sales figure can
Indicates how much a company be used instead.
Current assets/current
Current ratio can cover its obligations in the next
liabilities
12 months using its current assets.

This measure excludes the inventory

from the calculation. Effectively we
Current assets (less
are measuring how well a company
Quick ratio inventory)/current
can cover its liabilities in the next
liabilities
12 months using current assets other
than inventory.
Financial risk

Long-term debt/(long- Measures the reliance of a company’s

Gearing ratio
term debt + equity) finance on long-term debt.

Measures how much interest a

Earnings before interest
Interest cover company can cover from its operating
and tax/Interest payment
profit before interest.

Table 17.1: Key ratios and interpretations.

Cash based ratios

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

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Example 17.1
(This example is adapted from the 2008 subject guide)
The accounts for Chemistrand plc for the two financial years ended 31 December 2007
and 2008 are given below.
CHEMISTRAND PLC
Profit and loss account for years ended 31 December 2008 and 2007
2008 2007
£’000 £’000
Turnover 12,000 13,200

Variable cost of sales 5,700 6,660

Fixed production costs 1,320 1,200
Administration costs 1,020 1,080
Selling and distribution costs 1,320 1,290
Research and development costs 300 270

Interest 108 –
9,768 10,440

Net profit before tax 2,232 2,760

Taxation 642 960
Net profit after tax 1,590 1,800
Dividend paid (during years) 900 900
Profit retained 690 900

Balance sheets as at 31 December 2008 and 2007

2008 2007
£’000 £’000
Fixed assets
Leasehold property (note 1) 6,750 6,900
Plant and equipment (note 2)    1,620    1,080
8,370 7,980

Current assets
Stock 1,140 1,020
Debtors 1,320 1,140
Bank          –        60
2,460 2,220

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Less
Creditors due within one year
Tax creditors 600 540
Taxation 630 1,470
Bank       720       –
Net current assets        510      210
Net assets    8,880   8,190

Ordinary share capital

(£1 shares) – called up 6,000 6,000
Profit and loss account    2,880    2,190
   8,880    8,190

Note 1 Leasehold property (cost) 7,200 7,200

Accumulated depreciation       450       300
Balance    6,750    6,900

Note 2 Plant and Equipment (NBV) 1,080 1,140

Additions 720 60
Depreciation for year     (180)     (120)
Closing balance (NBV)    1,620    1,080

Note 3 No sales of assets took place during the year (NBV – Net Book Value)
Note 4 All dividends were paid during the financial year at the rate of £0.15 per share.

Cash flow statement for the year ended 31 December 2008

2008 2007
£’000 £’000
Cash flow from the operating activities 2,430 2,460
Returns on investments and servicing of finance
Interest paid (108) –
Taxation (1,482) (240)
Capital expenditure (720) (6,060)
120 (3,840)
Equity dividends paid (900) (900)
(780) (4,740)
Management of liquid resources – –
Financing
Share issue – 3,000
Increase/(Decrease) in cash in the period (780) (1,740)

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The following information from a credit rating agency for the industry is also available for
the two years 2008 and 2007.
2008 2007
LQ M UQ LQ M UQ
Return on net assets (%) 15.0 20.0 25.0 15.0 20.0 25.0
Net assets turnover (times) 1.0 1.5 1.7 1.1 1.5 1.7
Current ratio (times) 1.0 1.9 2.8 1.1 2.0 3.4
Acid test (times) 0.8 1.2 2.1 0.7 1.2 2.0
Collection period (days) 30 45 65 35 50 70
Total owing to total assets (%) 20 50 65 25 49 67
Long-term debt to capital employed (%) 5 15 40 5 15 35
Return on sales 11.5 13.3 14.7 11.0 13.3 14.7

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

Solution to Example 17.1

a. Profitability
2008 2007
Return on net assets 2,232 × 100 = 25.2% 33.7%
8,880
Return on sales 2,232 × 100 = 18.6% 20.9%
12,000
Net asset turnover 12,000 = 1.35× 1.61×
8,880
Return on equity 1,590 × 100 =17.9% 22.0%
8,880
Gross profit margin (12,000 – 7,020) × 100 = 41.5% 40.5%
12,000
Other ratios such as the various costs can be computed as percentages of turnover, or
annual growth rates of turnover, profit etc. Divisional and regional breakdowns of profit,
turnover and net assets can be evaluated similarly if it is useful to the task.

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Solvency and liquidity

Current ratio 2,460 = 1.26× 1.10×
1,950
Acid test (quick ratio) 1,320 = 0.68× 0.60×
1,950
Activity ratios
Debtors collection period 1,320 × 365 = 40.2 days 31.5 days
12,000
Stock holding period 1,140 × 365 = 59.3 days 47.4 days
7,020
Creditors payment period   600   × 365 = 31.2 days 25.1 days
7,020
Financing ratios
Long-term gearing     0     × 100 = 0% 0%
8,880
Total owing to Total Assets         1,950         × 100 = 18% 19.7%
(8,370 + 2,460)
Interest cover (2,232 + 108) = 21.7× n/a
        108
Dividend cover 1,590 = 1.77× 2.0×
  900
Earnings per share (EPS) 1,590   = £0.265 £0.30
6,000
Dividend per share    900    = £0.15 £0.15
6,000
Cash based ratios
Cash return on net assets 2,430 × 100 = 24.7% 30.0%
8,880
Cash interest cover 2,430 = 22.5× n/a
108
Cash dividend cover    840    = 0.93× 23.6×
   900
Internally funded investment 0% 21.8%

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

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

Activity 17.1
Attempt BMAE Chapter 29, question 15.
See the VLE for solution.

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

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4. The cash cycle is defined as:

Cash cycle = Average inventory holding period + average collection
period – average payment period.
5. Average inventory holding period is defined as:
(Closing inventory + opening inventory) /2
Average inventory holding period = × 365 days
Cost of Goods sold

It measures the average duration for a firm to hold its inventory before
selling.
6. Average collection period is defined as:
(Closing receivables + opening receivables) /2
Average collection period = × 365 days
credit sales

It measures the average duration for an average debtor to pay up.

7. Average payment period is defined as
(Closing payables + opening payables) /2
Average payment period = × 365 days
credit purchases

It measures the average duration for a firm to pay its debt to its trade
creditors.
8. A cash budget provides a forecast of cash inflows and outflows
based on the company’s estimates of the sales, collection of debts,
purchases (including inventory policy) and payments to suppliers. It
also incorporates other planned expenses such as capital expenditure,
administration and operating charges. Any forms of distribution
of profits, interest and taxes are also considered. A full example is
available in BMAE, Chapter 29 (pp.863–65).
9. The cash budget should provide an indication of how much cash
would be available to the business. Corporate managers should then
develop a short-term and long-term financing plan.
10. A short-term financing plan should identify how a company may utilise
surplus cash flows to reduce the burden of short-term working capital
and long-term finance. On the other hand, short-term cash flow deficit
should draw managers’ attention to the need for raising short-term
finance such as bank overdraft, short-term bank loans or extended
credit terms from suppliers.
11. A long-term financing plan focuses on three functions:
a. Contingency planning – would the company have sufficient finance
to cover an unexpected shortfall of cash in the long run? Would the
company be able to cope with unexpected changes in government’s
fiscal policies, tax rates and competitive environment?
b. Flexibility and options – would the company have sufficient
cash flows for future investments should it decide to expand its
current operations or extend its existing investments beyond their
intended investment periods? Would the company be able to repay
the long-term loans when they fall due?
c. Alignment – the long-term financing plan should be consistent
with the company’s long-term objectives and link strategic goals
together.

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Example 17.2
(This example is adapted from the 2008 subject guide)
Plantree plc prepares long-term financial plans. In order to achieve its long-term financial
objectives the planning team will be faced with decisions on investment policy, financing
policy and dividend policy.
Required:
a. Comment on the nature of these three types of decisions.
b. Comment on the interrelationship of these three types and how they will be affected
by the choice of the long-term financial objective(s) of the business.
c. Describe briefly some of the main examples of forecast information needed for each
type of decision.

Solution to Example 17.2

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

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3. a. Main forecast needs of investment decisions will include:

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

Activity 17.2
What are the main limitations for financial planning?
See the VLE for solution.

Short-term versus long-term financing

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

Bank borrowing
You should note the type of loans that the clearing banks and merchant
banks are prepared to make. When making a decision concerning a
business loan application, a bank will take a number of factors into
account. These include the:
• quality and integrity of the management of the business
• quality of the case made in support of the loan application
• period of the loan and the security being offered
• nature of the industry in which the business operates
• financial position and performance of the business.
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Specialist finance
There are numerous short and medium-term sources available which are
only provided with a specific end in view. For example, there are a number
of ways of getting money to support exports, or finance for specific
projects, or the more general hire purchase. General knowledge of their
existence is all that is required.

Leasing
Read BMAE, Chapter 26. When reading these sections you should note
carefully the distinction between an operating and a finance lease and
the reasons put forward to explain the growth of this form of financing
in recent years. In addition, you should study carefully the techniques of
lease evaluation.
In brief, a company that arranges to hire an asset under a finance lease
agreement is effectively borrowing from the lessor the equivalent of the
lower of the fair value of the asset and the present value of the lease
payments. Therefore the decision whether to lease or buy rests upon the
cash planning of the company.
Sale and lease back arrangements offer an opportunity for a business
with valuable property to raise new finance. You should compare the
advantages and disadvantages of this form of financing with that of a
mortgage.

Activity 17.3
Read BMAE Chapter 26 Section 26.4 (pp.750–52). Attempt self-test question 26.3.
See the VLE for solution.

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• describe the main focuses of financial planning
• evaluate the approaches to, and methods of, financial planning
• discuss techniques used to assist planning and management.

Practice questions
Lineflix Co has the following financial information at the start of January
2019 and 2020:
2019 2020
$ $
Inventory 312,550 356,890
Trade receivables 367,000 408,000
Trade payables 183,250 190,000
Cash at bank 25,480 (35,750)
The total sales for 2019 are $3,600,000 and are on credit. Monthly sales
are as follows:
$
November 2019 – Actual 270,000
December 2019 – Actual 300,000
January 2020 – forecast 350,000
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Lineflix Co has a gross profit margin of 30%. Although it offers 30 days

credit, only 60% of its customers pay in the month following purchase,
while the remaining customers take an additional month of credit.
Lineflix Co plans to pay 80% of trade payables in January 2020 and defer
paying the remaining 20% until the end of February 2020. All suppliers of
the company require payment within 30 days. Interest of $70,000 is due to
be paid in January 2020 on fixed rate bank debt. A new equipment which
costs $200,000 is expected to be paid for in January. The company has no
plans to raise long-term finance during January 2020.
Required:
a. Calculate the cash operating cycle (or working capital cycle) in days of
Lineflix Co at the start of January 2020 (using average inventory, trade
receivables and trade payables. (8 marks)
b. Calculate the overdraft expected at the end of January 20X7.
(6 marks)
c. The finance directors of Lineflix express concerns that the cash
operating cycle has been lengthened and the company has also seen a
significant overdraft built up during 2019. Suggest three measures that
Lineflix can take to manage its cash flows more effectively.

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Notes

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Chapter 18: Working capital management

Essential reading
BMAE, Chapter 31.

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

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain the importance of working capital management
• discuss techniques used to improve working capital.

Introduction
This chapter covers three key areas in working capital management:
1. Inventory management.
2. Trade receivables management.
3. Trade payables management.

Working capital management

Inventory management
A significant amount of a company’s resources is often tied up in inventory.
Previously, we mentioned the inventory holding period. The shorter the
time we keep our inventory, the faster we would be able to turn it into
cash flow. Therefore it is important to set an inventory level that would
enable the company to meet the demands of its products and free up
spare capital at the same time. Economic modelling has been developed to
identify the minimum level of inventory to enable a company to balance
out the risk of ‘stock-out’ and tied up working capital. BMAE Chapter 31
(pp.892–94), describes how such minimum inventory level may be
modelled. We briefly explain the rationale behind this model.
Suppose we have a constant demand of D units for a product in a year. We
order from our suppliers Q units each time when we run out of inventory.
Each order incurs a handling/delivery charge, C, and there is no lead time
between the ordering and the delivery of the goods. The average of stock
level is Q/2. Suppose we incur an annual cost of storage per unit, H.
Given the above information, the total ordering cost and the total holding
cost per annum are D/Q × C and Q/2 × H respectively. To minimise the
total cost, we have:

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D Q
TC = Q × C + 2 × H
DC H
∂TC = − 2 + =0
Q 2
DC H 2DC
⇒ 2 = ⇒ Q2 =
Q 2 H
⇒ Q = 2DCH

Example 18.1
Suppose the annual demand of a product is 10,000 units. The cost per order, C, is £300
and the annual unit storage cost is £5. The economic order quantity (EOQ) is therefore:
Q* = 2×10,000×300 = 1,096
5

Activity 18.1
Explain the terms ‘just-in-time’ and ‘build-to-order’ and identify the potential problems a
company may encounter if it introduces these concepts of inventory management in its
operations.
See the VLE for discussion.

Just-in-time management
In Example 18.1, suppose the company places an order each time the
inventory level falls to 100 units. The average level of inventory held will
therefore be 100 + EOQ/2 = 100 + 1,095/2 = 648 units. The holding
cost would therefore be increased by the buffer level (100 units) x the
holding cost per unit.
Just-in-time, or JIT, is an inventory management method in which
goods are received from suppliers only as they are needed.
The main objective of this method is to reduce inventory holding costs and
increase inventory turnover.
In the above case, if there is no lead time for suppliers to deliver goods, the
company can place an order when the inventory level drops to zero before
re-ordering. However, if suppliers normally take a week to deliver goods,
then the buffer level should be set to avoid any unnecessary stock out.
Assuming a 52-week year, the weekly demand would be 10,000 units/52
weeks = 192 units per week. The company may need to re-order each time
the inventory level falls to 192 units. This implies that the total holding
cost, as compared to the previous examples, would increase. JIT is meant
to find the balance between lead time, inventory level and holding cost.
Consequently, the company may need to source for new suppliers who can
deliver goods quicker, change the production process to enable smoother
operations, reduce potential stock out and minimise holding costs.

Trade receivables management

Allowing customers to pay for their purchases on credit requires some
serious management. Typically, there are five factors to consider:
1. Terms of sales – how long do we allow customers to pay their invoices?
Are we prepared to offer a discount for quick settlement?
2. Promise to pay – what sort of collateral do we require from the credit
customers?
3. Credit analysis – how do we assess the creditworthiness of the
customers?
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4. Credit decision – how much credit are we prepared to offer? Are we

willing to take risks to extend risk terms even though there might be a
chance of bad debt?
5. Collection policy – how do we ensure that all debts are collected? See
debt factoring below.
BMAE Chapter 31 (pp.894–900) covers these five points in detail. You
should read through those pages and understand the key points.
Let us consider two specific cases here:
(a) Extending credit terms
• This may increase sales, but trade receivables may be higher.
(b) Offering early settlement discounts
• This may shorten the receivables period, but the amount received
(after discounts) may be lower.

Example 18.2
(This example is adapted from the 2008 subject guide)
Pinewood Supplies Ltd. produces a pine bookcase which is sold to retailers throughout
Scotland. The accountant of Pinewood Supplies Ltd. has provided the following
information concerning the product:
£ £
Selling price 70
Variable costs 42
Fixed cost apportioned 6 48
Net profit 22

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

Option
1 2 3
Increase in average collection period (days) 15 30 45
Expected increase in sales (£,000) £120 £150 £325

The cost of capital to Pinewood Supplies is 12% per annum.

Required:
Explain, with supporting calculations, which credit policy option should be offered to
customers.

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Solution to Example 18.2

The profitability of each option can be determined by weighing the costs of the additional
investment in debtors against the benefits from the expected sales.
Contribution per unit
£
Selling price 70
Less Variable cost       42
Contribution per bookcase       28

Rate of contribution 28/70 = 40%

Option
1 2 3
Projected sales (£m)    1.52     1.55   1.725
Projected debtor period (days) (40 + 15)       55        70        85
Projected debtors
1.52m × 55/365 229,041
1.55m × 70/365 297,260
1.725m × 85/365 401,712

Less: Current debtors

1.4m × 40/365 153,425 153,425 153,425
Increase projected £75,616 £143,835 £248,287

Cost of additional investment in debtors

(12% × increase) (9,074) (17,260) (29,794)
Increase in contribution
(40% × sales increase) 48,000 60,000 130,000
Increase in profits £38,926 £42,740 £100,206

The calculations shown above indicate that extending the credit limit by 45 days provides
the most profitable option. The expected profit of £100,206 is considerably higher than the
other two options. The choice of option based on these figures is, therefore, unlikely to be very
sensitive to any inaccuracies in the underlying assumptions and estimates.
Example 18.3
Company A produces one type of product. It has a cost of capital = 10%. Its turnover is £1.4m
per year, and the average receivables period is 30 days. Each product is sold for £50, making a
contribution per unit of £20. Suppose that the company is proposing to offer an early settlement
discount of 1% to all its customers. We expect that all customers will take up this offer and the
average trade receivables period would be reduced by 5 days.
Should Company A offer this discount?
The cost of this early settlement discount = £1.4m x 1% = £14,000
The original year end trade receivables = £1.4 x 30 days / 365 days = £115,068
The expected year end receivables with the discount = £1.4m x 25 days / 365 days = £95,890
Saving from financing cost for trade receivables = (£115,068 – £95,890) x 10% = £1,918
Net effect = -£14,000 + £1,918 = -£12,082
Solution to Example 18.3
On this basis, it appears that it is not advantageous for Company A to offer this early
settlement discount.

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Debt factoring
Read BMAE Chapter 31 (p.900). When reading the relevant sections on
debt factoring note the services offered by a factor and the fee structure
employed. You must be clear about the distinction between debt factoring
and invoice discounting. Debt factoring is often a long-term arrangement
because of the administrative arrangements required to deal with the
transfer of the sales ledger accounting function. Invoice discounting, on
the other hand, may be a temporary arrangement.
Factoring can prove to be expensive and so it is important to identify the
relevant costs and benefits before entering into such an arrangement.
Study the worked example below.

Example 18.4
(This example is adapted from the 2008 subject guide)
Aztec Electronics Ltd. has an annual turnover of £25 million of which £0.2 million prove
to be bad debts. Credit controls within the business have been weak in recent years and
the average settlement period for its trade debtors is currently 70 days. All sales are on
credit and turnover has been stable in recent years. The business has been approached
by a debt factoring business, which has offered to provide an advance equivalent to 80%
of its debtors (based on an average settlement period of 30 days) at an annual interest
charge of 14%. The factor will take responsibility for the collection of credit sales and will
charge a fee of 2.5% of sales turnover for this service. The use of a factoring service is
expected to lead to cost savings in credit administration of £120,000 per annum and will
reduce bad debts by half. The settlement period for debtors will be reduced to an average
of 30 days which is in line with the industry norm. The business currently has an overdraft
of £6.2 million and pays interest at the annual rate of 15%.
Required:
Calculate the net annual cost or savings resulting from a decision to employ the services
of the factor.

Solution to Example 18.4

£’000 £’000
Existing investment in trade debtors {(70/365)£25m} 4,795
Expected future investment in trade debtors
2,055
{(30/365)£25m}
Reduction in investment 2,740
Factor costs
2.5% of sales turnover 625
Interest charge on advance {(£2,055,000 × 80%)14%} 230
855
Factor savings
Bad debt savings (£0.2m × 0.5) 100
Credit admin savings 120
Reduction in trade debtors (£2,740,000 × 15%) 411
Reduction in overdraft interest through advance
{(2,055,000 × 80%)15%} 247 878
Net annual savings 23
We can see that, in this case, the employment of a factor will lead to net savings for the
business.

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Trade payables management

Trade credit from suppliers is an extremely important source of finance for
small businesses in particular. It can be described as a spontaneous source
of finance as it results from normal business operations (i.e. increases in
sales lead, in turn, to increases in purchases on credit from suppliers).
Trade credit from suppliers can be a free source of finance to a business
providing the goodwill of the trade supplier is maintained and providing
discounts for prompt payment are taken. Failure to maintain supplier
goodwill, however, can lead to a reduced level of service in the future and
failure to take advantage of discounts can have a high implicit annual
interest cost.
Suppose trade suppliers offer a 2% discount for invoices paid within seven
days and, if payment is not made within seven days, the payment period
for invoices is 28 days (with no discount being allowed). The implicit
annual interest cost of a business paying at the end of 28 days rather than
at the end of seven days is:
2 365
× × 100% = 35.5%
100−2 28−7
We can see that the cost of foregoing discounts can be very high and,
therefore, other forms of short-term finance may prove to be cheaper.
When reading the relevant sections on trade credit you should note in
particular, the five factors which determine the length of the credit period
given to customers.

Activity 18.2
Attempt BMAE Chapter 31, question 21. See VLE for solution.

Trade receivables and trade payables in foreign currency

Managing receipts and payments in foreign currencies from customers and
to suppliers would require careful risk management consideration. We will
discuss the risk management techniques Chapter 19.

Cash management
Read BMAE Chapter 31 (pp.900–09). Cash has been described as the
‘lifeblood’ of a business. In order to survive, a business must retain an
uninterrupted capacity to pay its maturing obligations. The efficient
management of cash is, therefore, of critical importance to a business.
When reading the relevant chapter you should note the importance
of controlling the cash collection and payments cycle and the cash
transmission techniques available.
Typically, a company would establish a cash budget or forecast to identify
the sources of cash receipts and timing of cash payments. When a potential
overdraft is foreseen, measures must be taken to reduce such an overdraft.
Some possible steps that may be needed for better control of the overdraft
are as below:
1. Reduce the amount of goods to be purchased – a better and more
economical inventory control may lead to company’s saving on both
the order and holding costs of inventory. However, a reduction in the
quantity of goods purchased may result in the company losing a bulk
purchase discount from suppliers and potential stock out to meet the
demands.
2. Delay non-essential payments – this would enable a company to
avoid cash outflows at the wrong time. However, what constitutes
non-essential payments would depend on the company’s unique
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circumstances. For example, delaying capital expenditure for replacing

an obsolete machine may have a knock-on effect to the company’s
productivity. Potential revenue (cash inflows) may be lost as a result.
Similarly, delaying the payments of interest or tax may attract additional
penalty costs.
3. Encourage credit customers to pay promptly – as we have seen from the
examples for trade receivables management, this would potentially help
a company to improve its cash flows.
4. Negotiate a longer credit term from suppliers – this would spread the
payments over longer periods of time, easing the overdraft situation.
However, extensive credit terms from suppliers may be stipulated with
additional costs such as interest on outstanding amounts and a less
favourable purchase price.

Cash control
A company’s cash flows may fluctuate on a daily basis, depending on the
rate for cash receipts and the rate for cash utilisation. In such a situation, the
company would need to determine the minimum cash level to enable the
company to operate safely, while setting up a maximum cash level to avoid
piling up too much idle cash. Many economic models have been developed.
The model we will examine is the Miller-Orr model.
The Miller-Orr model of cash management is applicable if the following
conditions are met:
1. Both the cash inflows and cash outflows are time-changing and random.
On a daily basis, cash inflow may exceed or be lower than cash outflows.
2. The daily cash balance is normally distributed.
3. A company has opportunities to invest idle cash in marketable securities.
4. Transaction fees can be applied when marketable securities are bought
or sold.
5. A company wishes to maintain a minimum acceptable cash balance.

How does the Miller-Orr model work?

The model aims to ensure that the daily cash flows of a business would be
managed within a lower and upper limit. When cash falls below the lower
limit, the business would need to sell off marketable securities to replenish
its cash flow to a ‘target’ level. This is known as the return point. Similarly,
if the daily cash flow exceeds the upper limit, the business would need to
purchase marketable securities to restore the cash position to the return
point.

Formula used in the model:

Lower limit – this is set by a business itself. Management will determine what
the acceptable risk of cash flows gap is, how creditworthy is its business and
the expected needs in cash. In some cases the lower limit can be set to zero
if a business has sufficient investments in marketable securities or perfect
creditworthiness and can raise additional short-term debt at any time.
Return point = lower limit + 1/3 x Spread
Spread =
Where F = transaction costs
K = opportunity cost of holding cash
δ2 = the variance of the daily cash balance
Upper limit = Lower limit + Spread
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Example 18.5
ABC Ltd requires a safety cash balance of $60,000. The standard deviation (δ) of the
daily cash balance during the last year was $40,000, and the transaction cost was $50.
The company also has the opportunity to invest idle cash in marketable securities at an
annual interest rate of 9.125%.
Daily interest rate = 9.125% / 365 = 0.025%
Determine the return point and the upper limit.
Solution to Example 18.5
Spread = 3 x (3 x 50 x 40,0002 / 4 x 0.00025)1/3 = $62,145
Return point = lower limit + 1/3 x Spread = 60,000 + 1/3 x 62,145 = $80,715
Upper limit = Lower limit + Spread = 60,000 + 62,145 = $122,145
In this case, each time when the cash level falls below the lower limit ($40,000), this
company will sell marketable securities to generate cash flows to replenish the cash
balance to its return point ($80,715). If, however, the cash balance exceeds the upper
limit ($122,145), the company will buy marketable securities in the amount of $122,145
– $80,715 = $41,430.

Centralised treasury functions

The centralised treasury is the system of financial management used by
international companies with subsidiaries, in which funding activities,
investment and foreign exchange decisions are made not by local
treasurers but by one centrally located treasury team.
Read more about this in the article by Victoria Albovias ‘The Centralized
Treasury’, which captures the essence of the importance of such a system.

Working capital and the problem of overtrading

Overtrading will arise where the level of working capital and fixed
assets employed by a business is insufficient for its level of operations.
Overtrading often occurs when a new business expands its trading
operations quickly but is unable to find the necessary finance to invest
in fixed assets and working capital. The consequences of overtrading
are liquidity problems and difficulties in supplying customers (through
an inability to purchase the necessary stock). At the extreme, a business
may be forced to cease trading because it lacks the cash to meet maturing
obligations. Financial ratios may help detect the symptoms of overtrading.
The financial statements of a business which is overtrading may reveal
low liquidity ratios, high asset/sales ratios and a poor average creditors’
payment period.
Overtrading is a reflection of weak financial management. It may arise
through such factors as poor forecasting of profits and cash flows, failure
to control costs or a failure to attract finance at the appropriate times. To
deal with the problem of overtrading it is necessary to bring the level of
operational activity into line with the level of finance available (even if this
does lead to the rejection of profitable opportunities in the short-term).
Careful monitoring and control of fixed asset utilisation and working
capital is essential.

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Example 18.6
(This example is adapted from the 2008 subject guide)
Danton Ltd. began trading recently on 1 April 2008 with a balance at the bank of
£300,000. The business is both a wholesaler and retailer of carpets and floor coverings.
During the first month of trading the business will make payments for fixtures and fittings
of £15,000 and £8,000 for motor vehicles. In addition, the business will acquire an initial
stock on credit costing £24,000. The business has agreed with its bank an overdraft
facility of £20,000 to cover the first year of trading.
Danton Ltd has provided the following estimates:
1. The gross profit percentage on all goods sold will be 25%.
2. Sales during April are expected to be £10,000 and to increase at the rate of £4,000
per month until the end of July. From August onwards, sales are likely to remain at a
stable level of £24,000 per month.
3. The business is concerned that supplies will be difficult to obtain later in the year
and so, during the first six months of the year, it intends to increase the initial stock
level of £24,000 by purchasing an additional £2,000 worth of stock each month
in addition to the monthly purchases required to satisfy monthly sales. All stock
purchases, including the initial stock, will be on one month’s credit.
4. 60% of sales are expected to be on credit with the remainder being for cash. Credit
sales will be paid two months after the sale has been made.
5. Administration expenses are likely to be £1,000 per month and selling and
distribution expenses will be £700 per month. Included in the administration
expenses is a charge of £200 per month for depreciation and included in selling and
distribution expenses is a charge for £300 per month depreciation. Administration
expenses and selling and distribution expenses are payable in the month incurred.
6. The business intends to buy more fixtures and fittings in June for £8,000 cash.
7. The initial bank balance arose from the issue of 60,000 ordinary shares payable in
instalments. The second instalment of £0.50 per share is payable in September 2008.
Required:
a. Prepare a cash flow forecast for the six months ended 30 September 2008 showing
the cash balance at the end of each month.
b. State what problems the business is likely to face in the forthcoming six months and
how might these be dealt with?

Solution to Example 18.6

a. Cash flow forecast for the six months to 30 September 2008
Apr May June July Aug Sept
£’000 £’000 £’000 £’000 £’000 £’000
Receipts
Share issue   30.0
Credit sales 6.0 8.4 10.8   13.2
Cash sales 4.0 5.6 7.2 8.8   9.6    9.6
4.0 5.6 13.2 17.2 20.4 52.8

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Payments
Fixtures 15.0 8.0
Motor vehicles 8.0
Initial stock 24.0
Purchases 9.5 12.5 15.5 18.5 20.0
Admin expenses 0.8 0.8 0.8 0.8 0.8 0.8
Selling expenses 0.4 0.4 0.4 0.4 0.4 0.4
24.2 34.7 21.7 16.7 19.7 21.2
Cash surplus /(deficit) (20.2) (29.1) (8.5) 0.5 0.7 31.6
Opening balance 30.0 9.8 (19.3) (27.8) (27.3) (26.6)
Closing balance 9.8 (19.3) (27.8) (27.3) (26.6) 5.0

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

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential readings and
activities, you should be able to:
• explain the importance of working capital management
• discuss techniques used to improve capital.

Practice questions
BMAE Chapter 31, question 14.

Sample examination questions

1. Consider the advantages and disadvantages of funding all of a
company’s current assets from bank advances or other short-term
sources.
2. How might a firm go about determining its target cash balance?
Evaluate the model(s) you have recommended.
3. Consider the derivation and implementation of an optimal trade credit
policy. Discuss.
4. BMAE, Chapter 29, Questions 21–22.
5. BMAE, Chapter 30, Questions 24 and 38–41.
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 Chapter 19: Risk management – Concepts and instruments for risk hedging

Chapter 19: Risk management – Concepts

and instruments for risk hedging

Essential reading
BMAE Chapters 21, 22, 27 and 28.

Further reading
ARN, Chapters 24 and 25.

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

Aims
Companies undertake investments with various levels of risk. In Chapter
5 we discussed how risk could be diversified. In Chapters 19 and 20, we
examine the concepts of risk management in more details.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the reasons for companies managing risk
• identify the different risks that companies are exposed to
• acquire a working knowledge of how to price options, futures and
forward contracts.

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

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AC3059 Financial management

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

Reasons for managing risk

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

Years Nominal Inflation-adjusted

2000 $27.39 $35.76
2001 $23.00 $29.23
2002 $22.81 $28.50
2003 $27.69 $33.86
2004 $37.66 $44.81
2005 $50.04 $57.57
2006 $58.30 $65.03
2007 $64.20 $69.51
2008 $91.48 $95.25
2009 $53.48 $55.96
2010 $71.21 $73.44
Table 19.1: The annual average crude oil price from 2000 to 2010.
Note: Prices are adjusted for inflation to April 2011 prices using the Consumer
Price Index (CPI-U) as presented by the US Bureau of Labor Statistics. Figures are
price per barrel.
Source: http://inflationdata.com/inflation/inflation_rate/historical_oil_prices_
table.asp © 2010 Timothy McMahon.
• Agency costs may be mitigated by risk management.
A company’s profit may increase without the effort of internal
management. For example, oil prices have risen a lot in the first
decade of the twenty-first century (see Table 19.1). During the same
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 Chapter 19: Risk management – Concepts and instruments for risk hedging

period, airline companies’ profits plummeted, whereas oil companies

made record-breaking profits. The question is how much of the
increase (or decrease) in profit is due to the effort (or lack of effort) by
internal management? It is argued that risk management will reduce
the chance of speculative profit and therefore the effect of managerial
effort will be revealed more readily.

Activity 19.1
Large businesses spend millions of dollars annually on insurance. Why? Should they insure
against all risks or does insurance make more sense for some risks that others? Why
would some companies, such as BP, carry out self-insuring?
See the VLE for solution.

Instruments for hedging risk

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

Buyer Seller
Call option Right to buy Obliged to sell
Put option Right to sell Obliged to buy

An option is said to be in-the-money if it would lead to a profit for its

holder when it is exercised.
An option is said to be out-of-the-money if it would be unprofitable for
its holder when it is exercised.

Example 19.1
A typical option written on a stock can be traded on the Chicago Board Options
Exchange. It might have different exercise prices such as the options below:

Options Expiry Exercise price Call price Put price

1 May 2011 45 10.50 1.97
2 May 2011 50 6.75 3.15
3 May 2011 55 3.85 5.25

Pay-off of an option
The pay-off of an option depends on the cash position at the time when the option is
exercised. Suppose the price of the underlying asset on which the call option is written is
ST at any time T. Upon exercising the option, the buyer will get either 0 (if the asset price
is lower than the exercise price) or ST – X if the asset price is higher than the exercise
price. Consequently the pay-off of a call option is Max [0, ST – X]. The pay-off of a put
option, on the other hand, is Max [0, X – ST].
The value of an option at the expiry date can be expressed as a function of the stock price
and its exercise price 175
AC3059 Financial management

Example 19.2
Suppose today is 1 February 2011. Option 3 in Example 19.1 expires in three months’
time. It has an exercise price of $55. The pay-offs of a call and a put against the future
share price in three months’ time are:

Stock price $30 $40 $50 $60 $70 $80

Call 0 0 0 5 15 25
Put 25 15 5 0 0 0

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

20

0 Share price
55 75
Pay-off to a call holder
Figure 19.1: Pay-off to a call holder diagram.

Activity 19.2
Now try to draw the pay-off diagrams for Options 1 and 2 in Example 19.1.
See the VLE for solution.

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

T0 T1
Cash flows S1 < X S1 = X S1 > X
Write a call –C 0 0 S1 – X
Sell a put P – (X – S1) 0 0
Sell the stock S – S1 – S1 – S1
Net cash flows S+P–C –X –X

As long as the future share price moves away from the exercise price, this
strategy will ensure that an investment will earn a positive cash flow at T0
and repay X at T1. The cash flow at T0 is equivalent to a risk-free borrowing
of X/(1 + rf). Therefore we have the put-call parity:
X
S+P–C=
1 + rf
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 Chapter 19: Risk management – Concepts and instruments for risk hedging

Activity 19.3
Using the put-call parity, create a position of:
i. short-selling
ii. risk-free lending.
See the VLE for solution.

Option pricing
An option (call or put) gives the rights to the holders to buy or sell an
asset at a pre-determined price within a pre-determined period. It derives
its value from the underlying asset on which it is written.

Example 19.3
A call option with an exercise price of £100 is written on a share with a current price at
£100. The share price is expected to rise to either £105 or fall to £95 in three months’
time. The effective risk-free rate for the next three months is 3%.
Suppose one writes a call option on this share (i.e. buy a call option which gives us the
rights to buy the share at £100 in 3 months’ time). The cash flow implication is as follows:

T1
T0 S = £105 S = £95
S – X = £105 –
Buy a call –C Not exercise, £0
100 = £5

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

T1
T0 S = £105 S = £95
Buy half a share – £50 £52.5 £47.5
Borrow then repay +£47.5/1.03 – £47.5 – £47.5
– £50 + 47.5/1.03 £5 £0

Since the future cash flows of buying a call now and buying half a share and borrow
at the risk-free rate are identical, the initial cash positions must be identical, too (in an
efficient market where arbitrage opportunity is eliminated). The cost of the call value must
be:
C = 50 – 47.5/1.03 = 3.88
How do we know how many shares we need to buy and how much we need to borrow to
create a replicated portfolio for the call?
Assume that we can rewrite C as:
C = ∆S + B/ (1+rf) (19.1)

Spread of the possible pay-offs from the option 5–0 1

∆= = =
Spread of the possible share prices 105 – 95 2
B = The PV of the difference between the pay-offs from the option and the payoffs from
∆ of the share.

= ( 1
2 )
× 95 − 0 1.03 =
1
2 (
× 105 − 5 ) 1.03 = 47.5/1.03

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AC3059 Financial management

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

[
= N (d1 )× S ] − [N (d )× PV (X )]
2

where
[
log S/ PV (X ) ] σ t (19.2)
d1 = +
σ t 2
d2 = d1 – σ t

Activity 19.4
Attempt BMAE Chapter 22, question 13.
See the VLE for solution.

Futures and forward contracts

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

Options Forward Futures

Structure Standardised: on stock Custom-made, can Standardised: on stock
and bond indices, stock, be created on any and bond indices,
bonds, interest rate, items stock, bonds, interest
commodities and currency rate, commodities and
currency
Markets Traded on exchanges with Over-the-counter Traded on exchanges
transparent prices with transparent prices
Cash Require payment of an Not require an Not require an initial
flows initial premium (i.e. the initial premium premium
price of a call or a put)
Physical No delivery of the Delivery required Delivery required
delivery underlying asset required
but the pay-off is
transacted

Table 19.2: Differences between options, forward and futures contracts.

Pricing
You should refer to BMAE Chapter 27, pp.770–76. It should be noted that
the pricing formulae are different for a commodity and financial futures
contract.

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Activity 19.5
Attempt BMAE Chapter 27, question 15.
See the VLE for solution.

Conclusion
Risk management is a very advanced topic in financial management.
In this chapter we have only briefly discussed the concepts and reasons
for risk management. We examined the pricing of options, forwards
and futures contracts in risk management You should work through the
practice questions and familiarise yourself with the risk management
concept.

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
• describe the reasons for companies managing risk
• identify the different risks that companies are exposed to acquire
a working knowledge of how to price option, futures and forward
contracts.

Practice questions
BMAE Chapter 27, questions 9 and 27 and Chapter 28, questions 10
and 21.

Sample examination question

1. You observe that the UK FTSE 100 index is currently standing at 4210
and a three-month futures contract on the index is traded at 4,190.
The dividend yield on the index is 4.5% p.a. and the interest rate is 5%
per annum. Derive a formula for the theoretical futures contract price.
Explain how you might take advantage of the current situation. If the
interest rate is unexpectedly raised to 7.5%, explain clearly what might
happen to the FTSE100 index, the futures contract price on the index
and the relationship between the index and the futures.

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AC3059 Financial management

Notes

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 Chapter 20: Risk management – Applications

Chapter 20: Risk management –

Applications

Essential reading
BMAE, Chapters 20–22, 26 and 27.

Further reading
ARN, Chapters 24 and 25.

Aims
In this chapter, we examine the techniques of risk management.

Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• evaluate the techniques to reduce risk exposure.

Introduction
In Chapter 19, we discussed the concepts of risk management and
introduced the risk hedging instruments – derivatives. In this chapter we
explore the uses of these derivatives and other techniques in reducing risk
exposure.

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

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AC3059 Financial management

Example 20.1
A firm is going to borrow £950,000 in three months’ time for three months. The current
interest rate is 5% and is expected to rise in the future.
Current position
• The interest rate future is traded at £95 (100 – 5).
• Number of contracts sold to hedge the total borrowing = £950,000/95 = 10,000
contracts.
• A one tick price change = the value of the futures contract × one tick1 × number of
1
One tick is equivalent to 1
basis point; i.e. 0.01%
months covered by the contracts/12; i.e. £950,000 × 0.0001 × 3/12 = £23.75.
Future position
• Suppose the interest rate has risen to 7% in three months’ time. The futures price will
be 93 (100 – 7).
• Gain on futures = No. of ticks × the price change per tick = 200 × £23.75 = £4,750.
• Increase in borrowing cost = Amount of borrowing × increase in interest rate ×
number of months of the loan/12 = £950,000 × 0.02 × 3/12 = £4,750 Interest rate
hedge has exactly offset the higher borrowing cost. This is a perfect hedge.

Exchange risk
Internal management
Matching – Translation risk can be hedged if foreign currency based assets
and liabilities are matched. Transaction risk can be hedged if inflows and
outflows are in the same currency.
Netting – Companies can net off foreign currency transactions that
occur at the same time and in the same currency, and hedge only the net
exposure.
Invoicing in the domestic currency – One easy way to reduce exchange
rate risk is to avoid receipts and payments in foreign currency. An exporter
who purchases and pays for supplies in domestic currency may invoice
foreign customers in its own domestic currency.
External management
Forward/futures contracts.

Example 20.2
Suppose a UK exporter is expecting to receive a payment of $100,000 from a US
customer in three months’ time. The current (spot) exchange rate is £1 to $1.60. A
forward contract to sell $ in three months gives a rate of £1 to $1.65. The exporter
can engage in this forward contract and lock into an exchange rate of £1 to $1.65.
So in three months’ time, the exporter, upon receiving $100,000, would then sell it at
£1:$1.65. Effectively he will receive £60,606 in three months’ time.
Alternatively the exporter can hedge the exchange risk via the money markets. Knowing
that he will receive $100,000 in three months’ time, the exporter can borrow $X now at
a borrowing rate of r% for three months. When the loan is due, the exporter will repay
the loan plus interest (i.e. $X(1+r)) out of the proceeds from the US customer. If this
payment can be covered entirely by the $100,000 expected to be received from the US
customer in three months’ time, then we have a perfect hedge. The exporter can borrow
$X now and convert it into £ at the spot rate and the repayment of the loan and interest
will be covered by the future receipt.

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 Chapter 20: Risk management – Applications

Activity 20.1
How much should the exporter borrow now in Example 20.2?
See the VLE for solution.

In an efficient market when any arbitrage opportunity is eliminated, the

two hedging exercises should give identical outcomes.
Suppose the three month interest rate in $ is r % and the three month
interest rate in £ is R%. If we hedge via the money market, we must repay
$100,000 in three months. It means that we must borrow $100,000/
(1+r %) now. Convert this amount into £ at the spot exchange rate (i.e.
$100,000/(1+r %)/1.6) and deposit into a £ account for three months.
In three months we will get $100,000/(1+r %)/1.6 x (1+R%). This sum
must be identical to the cash flow the exporter will get in three months
from his forward contract position. Therefore we have:
100,000 100,000
× (1+ R) = 60,606 =
(1+ r) (1.6) 1.65
1+ r 1.65
=
1+ R 1.6

What it implies is that the ratio of the interest rate in $ to £ must be

identical to the ratio of the future to spot exchange rates.

Advantages and disadvantages of using futures to hedge risk

Advantages:
• Unlike options, futures contracts do not require payment of an initial
premium.
• Unlike forwards, futures are tradable and have transparent prices.
• Contracts are marked-to-market on a daily basis thereby reducing the
potential loss on default.
Disadvantages:
• There is a cash flow implication from the mark-to-market requirement.
The significant variation margin might cause a company to run out of
cash. See the case of Barings and Nick Leeson.2 2
www.riskglossary.
com/link/barings_
• It is difficult to construct a perfect hedge. In Example 20.1 we debacle.htm
construct a perfect interest rate hedge. However, if the borrowing
amount was £1,000,000, we would have needed to have sold
£1,000,000/95 = 10,626.3 contracts. Since futures contracts cannot
be traded in fractions, we would have to either sell 10,626 or 10,627
contracts. In either case, it would not be a perfect hedge.
Apart from interest rates and currency, options and futures can be created
on stock market indices, commodity prices and precious metals.

Some simple uses of options

• Suppose an investor has a portfolio of shares in the FTSE100 index.
He or she could cap the downside risk of this portfolio by writing a
put option. This strategy is called a ‘protective put’, which has the
following pay-off. When the FTSE index falls below the exercise price,
the investor could exercise the put option. The pay-off from the put
will cancel out the loss in value of the portfolio.

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AC3059 Financial management

• Suppose the FTSE100 index is going to be very volatile in the next

three months. An investor can write a call and a put on the index with
the same exercise price. He or she will gain from the pay-off of the call
or the put whichever direction the FTSE100 index may go.
Similarly, an investor who is already holding the FTSE100 as an investment
portfolio could reduce the market volatility by writing a call and a put.

Corporate uses of options

Apart from having options written on corporate shares and stock market
indices, options can often be found implicitly in corporate financial
instruments:
Share option schemes – Corporations give share options to their employees
to reward their services. Employees who receive such a share option have
the right to buy shares from their firms at a predetermined price. Unlike a
call option written on a share, this share option does require the issuing of
the new shares if it is exercised.
Warrants – This is an instrument very similar to a share option. A firm
can issue warrants to both private and public investors for an issue price.
Holders of warrants can exercise the right to buy shares from the firm if
they wish, within a set period of time. Physical shares must be created,
issued and delivered to the investors.
Convertible bonds – A convertible bond is an instrument which has two
financial components. It allows the holder to earn a fixed (or variable)
interest on the face value of the bond but also gives the right to the holder
to ‘convert’ it into shares. Effectively, it is a straight bond with a warrant
but without any outlay.
Rights issues – A rights issue is an issuance of shares to a firm’s existing
shareholders. It gives the right to the shareholders to buy shares from the
firm at a pre-set price based on the percentage of their shareholdings in
the firm.
Share underwriting (put option) – We have discussed underwriting in
Chapter 5. A firm who appoints an underwriter in a share issue has
effectively purchased a put option to sell shares (the unsubscribed shares
in a share issue) to the underwriters at the pre-determined price.
Real options – In Chapter 2 we discussed project appraisals. Most of the
examples we looked at are fixed-term projects. However, in real life, most
projects or investments can be extended if the company wishes. Therefore,
effectively, a project’s true NPV should be based on the NPV of the project
based on the fixed term estimates plus the value which can be derived
from extending its life. The value from the extension of life is effectively
the value of the option implicit in it.
Taking control of a company – Shareholders who invest in a firm which
has both debt and equity are effectively holding a call option over the
firm’s assets. If the asset value is below the face value of the debt, they
would not exercise the option and allow it to expire.

Conclusion
In this chapter we have only briefly discussed the various methods that a
firm may engage in to hedge risk against price movements. We examined
the use of options, forwards and futures contracts in risk management and
discussed their advantages and disadvantages. You should work through
the practice questions and familiarise yourself with the risk management
184
concept.
 Chapter 20: Risk management – Applications

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential reading and
activities, you should be able to:
• evaluate the techniques to reduce risk exposure.

Practice questions
BMAE Chapter 27, questions 9 and 27 and Chapter 28, questions 10
and 21.

Sample examination questions

1. Explain clearly the factors that affect the price of a European put
option.
2. Explain how you can use options in the following situations:
a. Suppose you don’t own a share, how would you create a share
position without buying a share?
b. Suppose you now own a share, how do you insure it against any
fluctuation in the share price?
c. Suppose you do not own a share. You expect the share price might
go up and down in the next period. How would you use options to
bet on this share’s volatility?
3. What is a financial futures contract? Explain the main use of it in risk
management. Give examples to illustrate your argument.
4. Company 2, a US firm, has a sterling receivable of £300,000 from a UK
supplier due 6 months from now. The 6-month forward exchange rate
is £1 = $1.25. Assume the forecasted spot rate in 6-months’ time is £1
= $1.20 or £1 = $1.28, with equal probability. The interest rate for
dollar deposit is neglectable.
(a) What is the expected dollar value to Company 2 if it chooses:
(i) not to hedge the sterling receivable?
(ii) to use a forward hedge?
(b) 6-months’ sterling put options and sterling call options are
available at a cost of $0.03 per £ with an exercise price of $1.235.
(i) How could Company 2 make use of an option hedge for its
sterling receivable?
(ii) What will be the expected value in dollars of the outcome of
the option hedge?
(c) If Company 2 is concerned only about downside risk, is it better to
choose the forward hedge or the option hedge? Explain.
(d) Suppose the spot rate is £1 = $1.26 now. What would be the
6-month interest rate for the sterling currency if there is no
arbitrage between the forward hedge and the money market
hedge?

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Notes

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 Appendix 1: Sample examination paper

Appendix 1: Sample examination paper

Important note: This Sample examination paper reflects the

examination and assessment arrangements for this course in
the academic year 2023–2024. The format and structure of the
examination may have changed since the publication of this subject
guide. You can find the most recent examination papers on the VLE
where all changes to the format of the examination are posted.

Time allowed: three hours

Candidates should answer FOUR of the following EIGHT questions. All
questions carry equal marks.
Workings should be submitted for all questions requiring calculations.
Any necessary assumptions introduced in answering a question are to be
stated. 8-column accounting paper is provided at the end of this question
paper. If used, it must be detached and fastened securely inside the answer
book.
A calculator may be used when answering questions on this paper and it
must comply in all respects with the specification given in the Regulations
The make and type of machine must be clearly stated on the front cover of
the answer book.

Question 1 (Answer both parts)

a. Outline the main factors that a company should consider if it wants to
offer its shares to the public for the first time (Initial Public Offer)?
b. Discuss the pros and cons of each of the following three methods in
valuing a company’s share.
i. Asset-based method
ii. Earning-based method
iii. Discounted dividend method (10 marks)

Question 2
Yamamoto Ltd. has the following three bonds outstanding on 31 December
2009:

Maturity (years) Coupon (%) Face value, £’000

Bond A 5 10 1,000
Bond B 20 12 3,000
Bond C 15 0 2,500

The company’s financial director believes that Yamamoto is a financially

sound company and it would have at least an Aa rating for its bonds.
Currently a one-year UK gilt has an expected return of 5% per annum.
Required:
a. Based on the information given above, calculate the value of each of
the three bonds. What further information would you require in order
to refine your valuation of these bonds? (15 marks)

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b. Explain clearly why companies such as Yamamoto Ltd. might issue

bonds with different maturities, coupon rates and face value?
(10 marks)
Total 25 marks

Question 3
Lion plc is a newly set up IT company. It has very few capital assets.
However, the directors are committed to spend a significant amount on
research and development activities every year. Currently the company
is operating at a loss. The profit forecast indicates that it will become
profitable in three years’ time. Profit will rise rapidly at a rate of 20% per
annum thereafter for a period of no more than 5 years. It is then expected
to have a more moderate growth of 5% per annum. The company has a
cost of capital of 10% and it is 100% equity financed.
Required:
Advise the management of Lion plc what capital structure policy it
should adopt for the next 3, 8 and 20 years. Your advice must include an
explanation of the appropriate financial theory on capital structure.
(25 marks)
Total 25 marks

Question 4 (Answer both parts)

a. Explain clearly the following terms:
i. Weak form efficiency.
ii. Semi-strong form efficiency.
iii. Strong form efficiency.
What are the implications for the market to be informationally efficient
to both the investors and companies?
(13 marks)
b. Identify and explain which forms of efficiency are adhered to and/or
violated in each of the following hypothetical situations:
i. Weekly returns appear to be weakly but positively correlated with
each other.
ii. The top 10 investment funds in the UK out-performed the UK
market by an average of 5% in 2009.
iii. A group of students from a famous Business School has created a
trading rule which appears to out-perform the UK market.
iv. Royal Petrol plc has just revealed that it has discovered a new
method to turn domestic waste into petrol. Its share price rises by
5%.
(12 marks)
Total 25 marks

Question 5
Apple Inc. is one of the most talked-about companies in recent years. From
its success in iPod to the latest iMac, the company has enjoyed a healthy
increase of earnings for the past years. However, the company has decided
to maintain its no dividend policy.

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 Appendix 1: Sample examination paper

Required:
Critically discuss the various financial theories on dividend policy. In your
answer, you should also discuss the implications of a no dividend policy,
such as the one adopted by Apple Inc., on the company and its investors.
(25 marks)
Total 25 marks

Question 6 (Answer all parts)

a. Explain clearly the factors that affect the price of a European call
option.
(8 marks)
b. Suppose Shadow plc, a construction company financed by both debt
and equity, is considering a project. If the project succeeds, the value of
the company in one year’s time will be £25 million. If the project fails,
the company’s value in one year’s time will only be worth £16 million.
The current value of Shadow plc is £20 million which takes into
consideration the prospect of the proposed new project. The company
has an outstanding zero-coupon bond which matures in one year’s
time with a face value of £19 million. The company pays no dividends
and a UK gilt that matures in a year has a yield of 7%.
Using the binomial (or two-state) Option-pricing Model, find the value
of the bond and equity of Shadow plc respectively.
(8 marks)
c. Explain how you can use options and futures to hedge risk. Give
examples to illustrate your argument.
(9 marks)
Total 25 marks

Question 7
West Central plc has been quoted on the London Stock Exchange for 10
years. A regression analysis using the last 10 years of data reveals the
observed equity beta of 1.20 for the company. The company has 60% of
equity and 40% debt. The current market value of West Central plc is £100
million.
The company is going to undertake a risky project which has an estimated
beta of 2.5. The project is expected to be financed entirely by equity. As
a result of this financing option and the undertaking of the project, the
company will have 70% of equity and 30% of debt measured at market
values. The risk-free rate is expected to be 5% per annum and the expected
return on the market is approximated to be 10% per annum. West Central
plc pays corporate tax at 40%. The company’s debt is thought to be risk-
free.
Required:
a. Calculate the company’s beta before the proposed project. (4 marks)
b. Calculate the company’s market value after the proposed project and
the funding option. (5 marks)
c. Calculate the net present value of the project. (2 marks)
d. Calculate the company’s beta after the project. (4 marks)

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

equity. What further information would you seek before you finalise
your advice? (10 marks)
Total 25 marks

Question 8 (Answer all parts)

a. What are the main motives for mergers and acquisitions? (8 marks)
b. As a finance director of Tudor plc, you are examining a proposal to
acquire Windsor plc. The following current data is available:
Tudor Windsor
Earnings per share 100p 30p
Dividend per share 60p 16p
No. of shares 20m 12m
Share price £18 £4
Assume that Windsor is expected to have a dividend growth rate of 6%
per annum, but that under the management of Tudor plc, the growth
rate would increase to 8% without any additional investment.
i. Calculate the gain from the acquisition. (6 marks)
ii. Calculate the net gain of the acquisition if Tudor plc pays £5 for
each of Windsor’s shares. (3 marks)
iii. What is the gain of the acquisition if one of Tudor’s shares is
exchanged for every three of Windsor’s shares? (6 marks)
iv. How would your answer to (ii) and (iii) alter if Tudor plc failed to
increase the growth rate of Windsor plc? (2 marks)
Total 25 marks

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 Example of 8-column accounting paper

Example of 8-column accounting paper

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AC3059 Financial management

Notes

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