FM Ans

TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT
Financial Management Function
Introduction to Financial Management
Objectives of a Company Risk Financial Intermediaries
The Balance Sheet and FM £ £
Investment Appraisal
Non-Current Assets x
…………………………………………………………………………………………………..
Current Assets x
Less: Current Liabilities (x) Working Capital

Management
Net Current Assets x
………………………………………………………………………………………………….
Less: Non-current Liabilities (Debt) (x)
Net Assets x
Long-Term Financing
Capital (Shares or Equity) x
©Johnson (BA (Hons) Accounting and Finance, AIA) Page 1

THE FINANCIAL MANAGEMENT FUNCTION
The management of all the processes associated with the efficient acquisition and deployment of
both short and long term financial resources.
There are three key decisions:
1. Investment – What to Invest in!
2. Finance – What funds to raise.
3. Dividends – The allocation of cash funds to shareholders.
Investment:
 Capital investment – Investment in non-current assets.

 Financial investment – Investment in shares, bonds etc.
 Working capital investment – Investment in current assets.
Finance:
The type of funding required and available to the business will depends on both the specific use
of the funds and the size and type of the organizations. Considerations will include:
1. The overall of funds required by the business.
2. Internal or external sources.
3. The balance of debt to equity (gearing).
4. The mix of long-term to short-term funds.
Dividends:
Factors that will influence the level of dividend will included:
1. Profitability
2. Growth
3. Taxation
4. Legal restriction
5. Liquidity
Dividend Policy:
Most organizations attempt to follow a consistent dividend policy. Examples included:
 Stable dividend
 Constant payout proportion
 Residual approach

OBJECTIVES OF A COMPANY
Primary Aim – Shareholders wealth maximization
The aims of financial management in a profit-making organization are to achieve the
maximization of wealth to the shareholder.
Secondary Aims:
 Maximize profit
Usually taken to be in the short-term (for a year), as opposed to wealth of shareholders,
which is long-term.
 Maximize sales revenue – Dangerous if profits and wealth are ignored.

 Satisficing – This means aiming for a satisfactory level of wealth.
Ownership and Control (Corporate Governance)

Shareholders own the company, but managers (directors) control it. This means that the manager
will often make decisions to maximize their own wealth rather than that of the shareholders.
A classic example would be whereby taking over a competitor, a manager gains a larger rate and
an increase in status. The shareholder of the buying company will not necessarily gain, in fact the
shareholders of the company being bought are more likely to benefit.
STAKEHOLDERS
A more balanced view of return may be to consider the company as having a number of different
‘stakeholders’ in addition to the shareholders. These may include:
1. Management
2. Employees
3. Community
4. Customers
5. Environment
6. Debt holders
7. Government
The analogy most often used is to consider the amount of ‘return’ generated by a company as a
pie and that the stakeholders must share this pie in some form of equitable manner.

PUBLIC SECTOR OBJECTIVES
The profit motive is not applicable in most public sector situations, instead we must measure the
services provided, in relation to the cost of providing those services. In recent years successive
governments have been concerned with measuring service provision. They have employed a
VFM (value for money) audit that aims to get ‘the best possible combination of services from
the least possible resources’. This is done by pursuing the three Es:
Effectiveness: Match the services provisions to the need.
Efficiency: Maximized the output of services for a given level of resource input.
Economy: Source the resource input at the lowest cost.
THE FINANCIAL ENVIRONMENT

Risk
Risk is the chance of loss because of the uncertainty of the future. The financial world operates
in an environment of uncertainty, which that all decisions are risky to some extent.
In relation to return there is normally some trade-off with risk. We would assume that investors
are rational and risk averse.
1. A rational investors selects the investment with the higher return assuming similar risk.
2. A risk-averse investors will select the investment with the lower risk given similar levels
of return.
This means that there must be some traded-off between risk and return; investors will require to
be compensated for additional risk with higher return. In other words, the higher the risk of a
course of action, the higher the returns need to be for an investor to follow that course of
action.
FINANCIAL INTERMADIARIES
(Role of the Banking Sector)
Financial intermediaries bring together investors or lenders with borrowers or users of funds.
They mirror the ‘real world’ by providing a relatively risk free lending environment and easily
accessible funds for borrowing.
Investors and savers FINANCIAL INTERMEDIARY Borrowers and Users

Roles of the Financial Intermediary:
1. Risk diversification – This means reducing the risk by spreading investment funds over a
wide variety of investment.
2. Aggregation – For example, banks take small amounts of deposits, aggregate them and
lend out large sums of money.
3. Maturity Transformation – For example, banks guarantee depositors their short-term
deposits while lending over long-term periods.
4. Hedging – Banks help sell financial tools to reduce risk, such as foreign exchange and
interest rate risk.
5. Making a market – Financial institutions help create new markets for new financial
instruments.
6. Advice – Financial institutions help provide advice to the private and business sector.
FINANCIAL MARKETS
You need to be aware of the differences between:

Primary and secondary markets, and money and capital markets.
Primary and Secondary Markets

Primary Market Secondary Market
The market in which the security or financial The market in which financial instruments that
instrument is created. have already been issued are traded.
Role: To raise finance for the issuing company Role: To provide a market for existing
securities hence increasing their marketability.
Money and Capital Markets

Money Markets Capital Markets
Markets concerned with short-term financial Markets concerned with long-term financial
instruments. instruments. It is concerned with the trading of
equity or shares and debt in the form of long-
term loans debentures.

TOPIC 2: WORKING CAPITAL MANAGEMENT
Working Capital Management:
 Working Capital Measures

 Debtor Management
 Creditor
 Stock Management
 Cash Management
Working capital can be defined as the excess of current assets over current liabilities. It can be
looked at as being the financial resources needed to undertake the daily activities of the firm.
Working Capital management involves ensuring that the firm has sufficient funds available at all
times to ensure that the firm runs efficiently.
Working Capital
Balancing act
Ensuring current assets are Maximizing the return on

sufficiently liquid to capital employed hence
minimize the risk of minimizing investment in
insolvency working capital

THE LEVEL OF WORKING CAPITAL
The level of working capital required is affected by the following factors:
1. The nature of the business, e.g. manufacturing companies need more inventory than
service companies.
2. Uncertainty in supplier deliveries. Uncertainty would mean that extra inventory need to
be carried in order to cover fluctuations.
3. The overall level of activity of the business. As output increases, trade receivable,
inventory, etc. all tend to increase.
4. The company’s credit policy. The tighter the company’s policy the lower the level of
trade receivable.
5. The length of the operating cycle. The longer it takes to convert material into finished
goods into cash the greater the investment in working capital.
Funding working capital – SHORT OR LONG TERM
Short-term sources of finance are generally cheaper than long-term ones. Trade payables do not
usually carry an interest cost. Short-term finance also tends to be more flexible. There is a danger
that the short-term funds may not be renewed or may be renewed on less favourable terms.
Traditional Approach
Traditionally current asset were seen as fluctuating, originally with a seasonal agricultural
pattern. Current assets would then be financed out of short-term credit, which could be paid off
when not required, whilst fixed assets would be financed by long term funds.
Total Assets (£)
Current assets
Short-term finance
…………………………......
Non-Current Assets Long-term finance
Time

Conservative Approach
This approach to the analysis is rather simplistic. In most businesses a proportion of the current
assets are fixed over time, thus being expressed as ‘permanent’. For example, certain base level
of inventory are always carried, cash balances never fall below a certain level, and a certain level
of ready credit is always extended. If growth is added to this situation a more realistic business
picture would be as follows:
Total Assets (£)
Fluctuating
Current assets
Short-term finance
Permanent
Current assets Long-term finance
Non-Current Assets
Time
Aggressive Approach
This is where short-term finance is used for all fluctuating current assets and most permanent
current assets too. This is likely to decrease interest costs and increase profitability but at the
expenses of an increase in the amount of higher-risk finance used by the company.
WORKING CAPITAL MEASRURES
There are two kinds of measures:
1. Operating cycle
2. Liquidity Ratios
OPERATING CYCLE
This is also known as the cash or trading cycle. The operating cycle is the length of time between
the company’s outlay on raw materials, wages and other expenditures and the inflow of cash
from the sale of goods. In a manufacturing business this is the average time that raw material
remain in inventory less the period of credit taken from suppliers plus the time taken for
producing the goods plus the time goods remain in finished inventory plus the time taken for
customers to pay for the goods.

ILUSTRATION
Operating Cycle = Inventory days + Trade Receivable days – Trade Payables days
Calculation of Days
Inventory Days = Raw Material Days + Work-in-Progress days + Finished Goods Days
𝐑𝐚𝐰 𝐌𝐚𝐭𝐞𝐫𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲
Raw Material Days = 𝒙 𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
𝐏𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬∗
𝐖𝐨𝐫𝐤−𝐢𝐧−𝐩𝐫𝐨𝐠𝐫𝐞𝐬𝐬
Work-in-Progress Days = 𝒙 𝟑𝟔𝟓 days
𝐩𝐫𝐨𝐝𝐮𝐜𝐭𝐢𝐨𝐧 𝐜𝐨𝐬𝐭∗
𝐅𝐢𝐧𝐢𝐬𝐡𝐞𝐝 𝐆𝐨𝐨𝐝𝐬 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

Finished Goods Days = 𝐱 𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬∗
*Or nearest approximation – depending on available data (Cost of Sales).

𝐓𝐫𝐚𝐝𝐞 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐁𝐚𝐥𝐚𝐧𝐜𝐞
Trade Receivable Days = 𝐱 𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
𝐂𝐫𝐞𝐝𝐢𝐭 𝐬𝐚𝐥𝐞𝐬
𝐓𝐫𝐚𝐝𝐞 𝐏𝐚𝐲𝐚𝐛𝐥𝐞 𝐁𝐚𝐥𝐚𝐧𝐜𝐞

Trade Payable Days = 𝐱 𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
𝐂𝐫𝐞𝐝𝐢𝐭 𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞𝐬∗
Note: If opening & Closing balance are given - Use average figures to calculate the days
(Opening + Closing)/2

Exercise 1:
Income Statement extract £
Turnover 350,000
Gross profit 100,000
Balance Sheet extract
Current Assets
Inventory - Raw material 25,000

WIP 15,000
Finished goods 105,000
Trade Receivables 35,000

140,000
Current Liabilities
Trade Payables 55,000
Required: Calculate the operating cycle
Note: 80% of costs of sales were purchases and WIP were only 70% completed.

Advantages of working capital:
• It helps the business concern in maintaining the goodwill.

• It can arrange loans from banks and others on easy and favorable terms.
• It enables a concern to face business crisis in emergencies such as depression.
• It creates an environment of security, confidence, and overall efficiency in a business.
• It helps in maintaining solvency of the business.
Disadvantages of working capital:
• Rate of return on investments also fall with the shortage of working capital.
• Excess working capital may result into overall inefficiency in organization.
• Excess working capital means idle funds which earn no profits.
• Inadequate working capital cannot pay its short term liabilities in time.
Implications
The operating cycle is a critical measure of the overall cash requirements for working capital.
This can be summed up from two perspectives:
1. Where level of activity (sales) is constant and the number of days of the operating cycle
increase the amount of funds required for working capital will increase approximate
proportion to the number of days.
2. Where the cycle remains constant but activity (sales) increase the funds required for
working capital will increase in approximate proportion to sales.
By monitoring the operating cycle the manager gains a macro view of the relative efficiency of
the working capital utilization. Further it may be a key target to reduce to improve the efficiency
of the business.

Short-Term Solvency, or Liquidity, Measures
As the name suggests, short-term solvency ratios as a group are intended to provide information
about a firm’s liquidity, and these ratios are sometimes called liquidity measure. The primary
concern is the firm’s ability to pay its bills over the short run without undue stress. Consequently,
these ratios focus on current assets and current liabilities.
For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. Because
financial managers are constantly working with banks and other short-term lenders, an
understanding of these ratios is essential.
One advantage of looking at current assets and liabilities is that their book values and market
values are likely to be similar. Often (through not always), these assets and liabilities just don’t
live long enough for the two to get out of step. On the other hand, like any type of near-cash,
current assets and liabilities can and do change fairly rapidly, so today’s amounts may not be a
reliable guide to the future.
This is a simple measure of how much of the total current assets are financed by current
liabilities. If, for example the measure is 2:1 this means that only a limited amount of the assets
are funded by the current liabilities.
Current Ratio
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
=
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
The Quick or Acid Test Ratio
Inventory is often the least liquid current asset. It’s also the one for which the book values are
least reliable as measures of market value, because the quality of the inventory isn’t considered.
Some of the inventory may later turn out to be damaged, obsolete, or lost.
More to the point, relatively large inventories are often a sign of short-term trouble. The firm
may have overestimated sales and overbought or overproduced as a result. In this case, the firm
may have a substantial portion of its liquidity tied up in slow-moving inventory.
To further evaluate liquidity, the quick or acid test ratio is computed just like the current ratio,
except inventory is omitted.

Quick Ratio or Acid Test Ratio
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

=
*Notice that using cash to buy inventory does not affect the current ratio, but it reduce the quick
ratio. Again, the idea is that inventory is relatively illiquid compared to cash.
A measure of how well current liabilities are covered by liquid assets. A measure of 1:1 means
that we are able to meet our existing liabilities if they all fall due at once.
These liquidity ratios are a guide to the risk of cash flow problems and insolvency. If a company
suddenly finds that it is unable to renew its short term liabilities (for instance if the bank
suspends its overdraft facilities) there will be a danger of insolvency unless the company is able
to turn enough of its current assets into cash quickly. A current ratio of 2:1 and a quick ratio of
1:1 are thought to indicate that a company is reasonable well protected against the danger of
insolvency- but ratios of less than these are not necessarily a bad thing.
*Note: The explanation in the above is for sake of understanding of the students, usually it is
depends on the company’s type of business they are doing.
Other Liquidity Ratios
We briefly mention three other measures of liquidity. A very short-Term payables might be
interested in the cash ratio:
Cash Ratio
𝐂𝐚𝐬𝐡
=
Net working capital is frequently viewed as the amount of short-term liquidity a firm has.
Net Working Capital
𝐍𝐞𝐭 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥

=
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬
Net Working Capital = Current Assets – Current Liabilities
*Note: A relatively low value might indicate relatively low levels of liquidity.

Interval Measure
Measure of how long a firm or business could keep running.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬
=
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐚𝐢𝐥𝐲 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧 𝐜𝐨𝐬𝐭𝐬
Average daily operation costs = Total cost for the year excluding depreciation and interest
Long-Term Solvency Measures
Long-term solvency ratios are intended to address the firm’s long-run ability to meet its
obligation, or, more generally, it’s financial leverage. These are sometimes called financial
leverage ratios or just leverage ratios. We consider three commonly used measures and some
variations.
Total Debt Ratio
The total debt ratio takes into account all debts of all maturities to all payables. It can be defined
in several ways, the easiest of which is:
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲

=
Gearing Ratios
The gearing ratio is the proportion of a company's debt to its equity. A high gearing ratio
represents a high proportion of debt to equity, and a low gearing ratio represents a low
proportion of debt to equity. The ratio indicates the financial risk to which a business is
subjected.
𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
=
𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲

Equity Multiplier Ratio
The equity multiplier is a financial leverage ratio that measures the amount of a firm's assets that
are financed by its shareholders by comparing total assets with total shareholder's equity. In other
words, the equity multiplier shows the percentage of assets that are financed or owed by the
shareholders. Conversely, this ratio also shows the level of debt financing is used to acquire
assets and maintain operations.
=
Long-Term Debt Ratio
A variation of the traditional debt-to-equity ratio, this value computes the proportion of a
company's long-term debt compared to its available capital. By using this ratio, investors can
identify the amount of leverage utilized by a specific company and compare it to others to help
analyze the company's risk exposure. Generally, companies that finance a greater portion of their
capital via debt are considered riskier than those with lower leverage ratios.
𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭
𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭 + 𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲
Times Interest Earned Ratio
A metric used to measure a company's ability to meet its debt obligations. It is calculated by
taking a company's profit before interest and taxes (PBIT) and dividing it by the total interest
payable on bonds and other contractual debt. It is usually quoted as a ratio and indicates how
many times a company can cover its interest charges on a pretax basis. Failing to meet these
obligation could force a company into bankruptcy.
𝐏𝐁𝐈𝐓
=
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭

Cash Coverage Ratio
The cash coverage ratio is useful for determining the amount of cash available to pay for a
borrower's interest expense, and is expressed as a ratio of the cash available to the amount of
interest to be paid. To show a sufficient ability to pay.
𝐏𝐁𝐈𝐓 + 𝐃𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 ∗
=
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
*Note: If there is no depreciation in the financial statement other Non-Cash Expenses can be
used for the computation of the cash coverage ratio.
Assets Management, or Turnover, Measures
We next turn our attention to the efficiency with which a firm uses its assets. The measures in
this section are sometimes called utilization ratios. What they are intended to describe is how
efficiently or intensively a firm uses its assets to generate sales.
Inventory Turnover or Inventory Days Ratio
A ratio showing how many times a company's inventory is sold and replaced over a period. The
days in the period can then be divided by the inventory turnover formula to calculate the days it
takes to sell the inventory on hand or "inventory turnover days."
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

= 𝐨𝐫 𝐱 𝟑𝟔𝟓 𝐝𝐚𝐲𝐬
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐬𝐚𝐥𝐞𝐬

Total Assets Turnover Ratio
The total asset turnover ratio is an efficiency ratio that measures a company's ability to generate
sales from its assets by comparing net sales with average total assets. In other words, this ratio
shows how efficiently a company can use its assets to generate sales.
The total asset turnover ratio calculates net sales as a percentage of assets to show how many
sales are generated from each dollar of company assets. For instance, a ratio of .5 means that
each dollar of assets generates 50 cents of sales.
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬
=
Fixed Assets Turnover Ratio
A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a company's
ability to generate net sales from fixed-asset investments - specifically property, plant and
equipment (PP&E) - net of depreciation. A higher fixed-asset turnover ratio shows that the
company has been more effective in using the investment in fixed assets to generate revenues.
This ratio is often used as a measure in manufacturing industries, where major purchases are
made for PP&E to help increase output. When companies make these large purchases, prudent
investors watch this ratio in following years to see how effective the investment in the fixed
assets was.
=
𝐅𝐢𝐱𝐞𝐝 𝐀𝐬𝐬𝐞𝐭𝐬

Net Working Capital Ratios
A measurement comparing the depletion of working capital to the generation of sales over given
a period. This provides some useful information as to how effectively a company is using its
working capital to generate sales.
A company uses working capital (current assets - current liabilities) to fund operations and
purchase inventory. These operations and inventory are then converted into sales revenue for the
company. The working capital turnover ratio is used to analyze the relationship between the
money used to fund operations and the sales generated from these operations. In a general sense,
the higher the working capital turnover, the better because it means that the company is
generating a lot of sales compared to the money it uses to fund the sales.
=
𝐍𝐞𝐭 𝐰𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
Profitability Measures
They are intended to measure how efficiently the firm uses its assets and how efficiently the firm
manages its operations. The focus in this group is on the bottom line, net income.
Operating Profit Margin
A ratio of profitability calculated as net income divided by revenues, or net profits divided by
sales. It measures how much out of every dollar of sales a company actually keeps in earnings.
Profit margin is very useful when comparing companies in similar industries. A higher profit
margin indicates a more profitable company that has better control over its costs compared to its
competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means
the company has a net income of $0.20 for each dollar of sales.
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭 𝐨𝐫 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭

= 𝐱 𝟏𝟎𝟎

Return on Assets
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to
how efficient management is at using its assets to generate earnings. Calculated by dividing a
company's annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this
is referred to as "return on investment".
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭 , 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐨𝐫 𝐏𝐁𝐈𝐓

= 𝒙 𝟏𝟎𝟎
Note: Some investors add interest expense back into net income when performing this
calculation because they'd like to use operating returns before cost of borrowing.
Return on Equity
The amount of net income returned as a percentage of shareholders equity. Return on equity
measures a corporation's profitability by revealing how much profit a company generates with
the money shareholders have invested.
𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 (𝐏𝐀𝐓)

= 𝐱 𝟏𝟎𝟎
Post tax
Return on Capital Employed
A financial ratio that measures a company's profitability and the efficiency with which its capital
is employed. Higher ROCE indicates more efficient use of capital. ROCE should be higher than
the company’s capital cost; otherwise it indicates that the company is not employing its capital
effectively and is not generating shareholder value.
𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭, 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐨𝐫 𝐏𝐁𝐈𝐓

= 𝒙 𝟏𝟎𝟎
𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝
Capital Employed = All the Long Term Debt + All the Equity

OVERTRADING
Overtrading is trading by an organization beyond the resources provided by its existing capital.
Overtrading tends to lead to liquidity problems as too much credit is extended to its customer, so
that ultimately there is not sufficient cash available to pay the debts as they raise.
Overtrading is caused by rapid growth.
Indicators:
 Rapid increase in turnover

 Increase in trade payables balances
 Decrease in cash/increase in overdraft
 Increasing operating cycle
 No matching in permanent capital (overtrading is sometimes called *under-capitalization)
*Excessive reliance on short term finance.
Remedies:
 Cut back trading

 Raise further permanent capital

MANAGING TRADE RECEIVABLES
Trade Receivable
Balancing act
Collecting sales receipts as Extending the credit period

quickly as possible to to customers to encourage
reduce the cost of additional sales.
financing the trade
receivables balance.
Credit Control
Assessing Customer’s Credit Risk
To minimize the risk of bad debts occurring, a company should investigate the creditworthiness
of all new customers (credit risk), and should review that of existing customers from time to
time, especially if they request that their credit limit should be raised. Information about a
customer’s credit rating can be obtained from a variety of sources. These include:
1. Bank References – These tends to be fairly standardized in the UK, and so are not perhaps
as helpful as they could be.
2. Trade References – Suppliers already giving credit to the customer can give useful
information about how good the customer is in paying bills on time.
3. Published information – The customer’s own annual accounts and reports will give some
idea of the general financial position of the company and its liquidity.

4. Credit Agencies – Agencies such as Dunn and Bradstreet publish general financial details of
many companies, together with a credit rating. They will also produce a special report on a
company if requested.
5. Company’s own Sales Record – For an existing customer, the sales ledgers will show how
prompt a payer the company is, although they cannot show how able the customer is to pay.
Agreeing Terms
Once it has been decided to offer credit to a customer, the company needs to set limits for both
the amount of credit offered and the time taken to repay.
Collecting Payment
An effective administration system for trade receivables must be established.
 Be strict with the credit limit

 Send invoices promptly
 Systematically review trade receivable eg aged trade receivables analysis.
 Chase slow payers
WAYS OF SPEEDING UP RECEIPTS
Discounts
Cash discounts are given to encourage early payment by customers. The cost of the discount is
balanced against the savings the company receives from a lower balances and a shorter average
collecting period. Discounts may also reduce the number of bad debts.
Advantages Disadvantages
1. Early payment reducing the trade 1. Difficulty in setting the appropriate terms.
receivable balance and hence the interest
charge. 2. Uncertainty as to when cash receipts will
be received complicating cash budgeting.
2. Potential to reduce the bad debts arising.
3. Unlikely to reduce bad debts in practice.
3. Offering a choice to customers of payment
terms. 4. In practice customer pay over normal terms
but still take the cash discount.

Factoring
This is the outsourcing of the credit control department to a third party. The debts of the
company are effectively sold to a factor (normally owned by a bank). The factor takes on the
responsibility to collect the debt for a free. The factor offers three services:
1. Debt collection and Administration – the factor takes over the whole of the company’s
sales ledger, issuing invoices and collecting debts.
2. Financing Provision – in addition to the above, the factor will advance up to 80% of the
value of a debt to the company; the remainder (minus interest) being paid when the debts are
collected. The factor becomes a source of finance.
3. Credit insurance – The factor may take the responsibility for bad debt, for this to be the case
the case the factor would dictate to whom the company was able to offer credit to. This is
called ‘without recourse’ factoring.
1. Saving in administration costs. 1. Likely to be more costly than an efficiently
run internal credit control department.
2. Reduction in the need for management
control. 2. Factoring has a bad reputation associated
with failing companies; using a factor may
3. Particularly useful for small and fast suggest your company has money worries.
growing businesses where the credit
control department may not be able to keep 3. Customers may not wish to deal with a
pace with volume growth. factor.
4. Once you start factoring it is difficult to

revert easily to an internal credit control.
5. The company may give up the opportunity

to decide to whom credit may be given.
Invoice Discounting
A service also provided by a factoring company. Selected invoices are used as security against
which the company may borrow funds. This is a temporary source of finance repayable when the
debt is cleared. The key advantage of invoice discounting is that it is a confidential service, the
customer need not know about it.
One use for invoice discounting is as a key financing tool for new businesses such as
management buyouts (MBOs). The creditworthiness of their customers is probably higher than
their own and utilized to borrow funds.
In some ways it is similar to the financing part of the factoring service without control of credit
passing to the factor.

FINANCIAL IMPLICATIONS
When looking at differing strategies to control cost associated with debtors the key is to identify
the interest cost. The outstanding debtor balance will need to be funded.
Cost of financing debtors
Key workings
Interest cost = Trade Receivable balance x Interest (Overdraft) rate

𝐓𝐫𝐚𝐝𝐞 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝐝𝐚𝐲𝐬
Trade Receivable balance = Sales x x Interest rate
𝟑𝟔𝟓
Exercise 2
Rani sayang Limited has sales of £20m for the previous year, debtors at the yearend were £4m,
and the cost of financing trade receivable is covered by an overdraft at the interest rate of 12%
pa.
Required:
a) Calculate the Trade Receivable days for Rani sayang.

b) Calculate the cost of financing Trade Receivables.
Exercise 3:
Rani sayang as above but cash discount of 2% is offered for payment of debts within 10 days.
Required:
Should the company introduce the discount given that 40% of the customers take up the
discount?
Exercise 4:
Rani sayang again but a factor has an offered a debt collection service which should shorten the
trade receivable collection period on average to 50 days. It charges 1.5% of turnover but should
reduce administration costs to the company by £150,000.
Required:
a) Should the company use the factoring facility?

b) In addition, the factor has offered a finance provision of 80% of the debt immediately. They
charge 14% but this is expected to save an additional £50,000 should saying take advantage
of this service?

Exercise 5
Love Francisca Limited produces a range of specialized components, supplying a wide range of
customers, all on credit terms. Twenty percent of turnover is sold to one firm. Having used
generous credit policies to encourage past growth, Love Francisca now has to finance a
substantial overdraft and is concerned about its liquidity. Love Francisca borrows from its bank
at 13% per annum interest. No further sales growth in volume or value terms is planned for the
next year.
In order to speed up collection from customers, Love Francisca is considering two alternative
policies.
Option one
Factoring on a non-recourse basis, the factor administering and collecting payment from Love’s
Francisca customers. This is expected to generate administrative savings of £200,000 per annum
and to lower the average trade receivable collection by 15days. The factor will make a service of
1% of Love’s Francisca turnover and also provide credit insurance facilities for an annual
premium of £80,000.
Option two
Offering discounts to customers who settle their accounts early. The amount of the discount will
depend on speed of payment as follows:
Payment within 10 days of dispatch of invoices 3%
Payment within 20 days of dispatch of invoices 1.5%
It is estimated that customers representing 20% and 30% of Love’s Francisca sales respectively
will take up these offers, the remainder continuing to take their present credit period.
Extracts from Love’s Francisca most accounts are given below:
(£000) (£000)
Sales (all on credit) 20,000
Cost of Sales (17,000)
Operating Profit 3,000
Current Assets
Inventory 2,500
Trade Receivable 4,500
Cash NIL
Required:
Calculate the relative costs and benefit in terms of annual profit before tax of each of the two
proposed methods of reducing trade receivables, and recommend the most financially
advantageous policy. Comment on your results.

Exercise 6
Cha kui plc is a medium-sized company producing a range of engineering products which it sells
to wholesale distributors. Recently, its sales have begun to rise rapidly following a general
recovery in the company as a whole. However, it is concerned about its liquidity position and is
contemplating ways of improving its cash flow. Cha kui’s accounts for the past two years are
summarized below.
Income Statement for the year ended 31 December
2013 2014
(£000) (£000)
Sales 12,000 16,000

Cost of sales (7,000) (9,150)
Operating profit 5,000 6,850
Interest (200) (250)
Profit before tax 4,800 6.600
Taxation (after capital allowances) (1,000) (1,600)
Profit after tax 3,800 5,000
Dividends (1,500) (2,000)
Retained profit 2,300 3,000
Balance Sheet As at 31 December 2013 2014

(£000) (£000) (£000) (£000)
Non-current Assets (Net) 9,000 12,000
Current Assets
Inventory 1,400 2,200
Trade Receivable 1,600 2,600
Cash 1,500 100
4,500 4,900
Current Liabilities
Overdraft - 200
Trade Payables 1,500 2,000
Other Payables 500 200
(2,000) (2,400)
10% Loan Stock (2,000) (2,000)
Net Assets 9,500 12,500
Capital and Reserves
Ordinary shares (50p) 3,000 3,000
Income statement account 6,500 9,500
9,500 12,500

In order to speed up collection from trade receivables, Cha kui is considering two alternative
policies. One option is to offer a 2 per cent discount to customers who settle within 10 days of
dispatch of invoices rather than the normal 30 days offered. It is estimated that 50 per cent of
customers would take advantage of this offer. Alternatively Cha kui can utilize the services of a
factor. The factor will operate on a service-only basis, administering and collecting payment
from Cha kui customers. This is expected to generate administrative savings of £100,000 per
annum and, it is hoped, will also shorten the trade receivable days to an average of 45. The factor
will make a service charge of 1.5 per cent of Cha kui turnover. Cha kui can borrow from its
bankers at an interest rate of 18 per cent annum.
Required:
a) Identify the reasons for the sharp decline in Cha kui’s liquidity and assess the extent to which
the company can be said to be exhibiting the problem of ‘overtrading’.
Illustrate your answer by references to key performance and liquidity ratios computed from
Cha kui’s accounts.
b) Determine the relative costs and benefits of the two methods of reducing trade receivables,
and recommended an appropriate policy.

MANAGING PAYABLES
Trade Payable
Balancing act
Delaying payment to Delaying too long may

suppliers, to obtain a ‘free’ cause difficulties for the
source of finance company
Trade credit is the simplest and most important source of short-term finance for many
companies. By delaying payment to trade payables companies face possible problems:
 Supplier may refuse to supply in future

 Supplier may only supply on a cash basis
 Loss of reputation
 Supplier may increase price in future
 Continues delays may be lead a supplier taking legal action against the company

Discounts
Trade payable is normally seen as a ‘free’ source of finance. Whilst this is normally true, it may
be that the supplier offers a discount for early payment. In this case delaying payment is no
longer free, since the cost will be the lost discount.
Exercise 7
One supplier has offered a discount to Appiah Ltd of 2% on an invoice for £ 7,500 if payment is
made within one month, rather than the three months normally taken to pay. If Macho’s
overdraft rate is 10% per annum, is it financially worthwhile for them to accept the discount and
pay early?
MANAGING INVENTORY
Stock is a major investment for many companies. In particular, manufacturing companies can
easily be carrying stock equivalent to between 50% and 100% of the turnover of the business.
Inventory
Balancing act
Reducing inventory to the Ensuring that sufficient

lowest possible level hence inventory is held to ensure
minimizing the level of that out of inventory do not
capital employed to be arise
funded

Material costs
Material costs are a major part of a company’s costs and need to be carefully controlled. There
are 4 types of costs associated with stock:
1. Ordering Costs
2. Holding Costs
3. Out of Inventory costs
4. Purchase Costs
Ordering costs
The clerical, administrative and accounting costs of placing an order. They are usually assumed
to be independent of the size of the order.
Holding costs
Holding costs include items such as:
1. The opportunity cost of the investment in stock

2. Incremental storage costs
3. Incremental material handling costs
4. Incremental insurance costs
5. Deterioration and obsolescence
6. Theft, vermin damage and evaporation
Inventory out costs
Inventory out costs include
1. Lost contribution through loss of sale;

2. Lost future contribution through loss of customer;
3. The cost of emergency orders of materials;
4. The cost of production stoppages.
In an efficient organization it is assumed that inventory out costs are not suffered. If we initially
assume that the purchase cost is a constant then we need only consider holding and ordering
costs.

Two effects of increasing the size of the
order quantity
HOLDING COSTS ORDERING COSTS

INCREASE DECREASE
….As the average inventory holding ….As the number of orders placed falls
increase
Economic order Quantity
When the reader quantity is chosen so that the total cost of holding and ordering is minimized, it
is known as the economic order quantity or EOQ.
As the size of the order increase, the average inventory held increase and holding costs will also
tend to increase. Similarly as the order size increases the number of orders needed decreases and
so the ordering costs fall. The EOQ determines the optimum combination.

Exercise 8
A Supi company requires 1,000 units of material x per month. The cost per order is £30
regardless of the size of the order. The holding costs are £2.88 per unit per annum. It is only
possible to buy the inventory in quantities of 400,500,600 or 700 units at one time.
Required:
What is the cheapest option?
The EOQ may also be determined using the formula:
2CoD
EOQ = √
Ch
Where:
Co = Cost per order

D = Annual demand
Ch = Cost of holding one unit for one year
Exercise 9
Use the formula to calculate the EOQ in exercise 8 above
Bulk Purchase Discounts
When it is possible to buy in bulk and thus obtain bulk purchase discounts, it is necessary to
consider the impact of those discounts upon the total cost associated with inventory and to
determine whether indeed the EOQ is still the cheapest option. It is only necessary to consider
the costs at the EOQ and at the quantities where the bulk purchase discounts are obtained.
Exercise 10
The material can normally be purchased for £10/unit, but if 1,000 units are bought at one time
they can be bought for £9,800. If 5,000 units are bought at one time, they can be bought for
£47.500
Required:
What reorder quantity would minimize the total cost?

JUST-IN-TIME INVENTORY MANAGEMENT
An alternative view of inventory management is the reduction or elimination of inventory, since

inventory is seen as waste. The supplier holds the Inventory until it is needed and delivers just in
time for production
Implications of JIT
 Total reliance on the supplier for both quality and reliability.
 Long term contracts with supplier to make it worth their while building the factory,
developing the systems to service their customer. Harsh penalty clauses for failure as the cost
to the customer of non-performance will be very high.
 Supplier factory ideally located very close to customer.
 Very close working relationship. Supplier’s workers will often spend time in the customer’s
factory and vice versa. In this way the response to problems/developments can be immediate.
 Factory design. To operate JIT then delivery trucks need ideally to gain access to each point
on the production line. Hence it is often hard to introduce JIT to an existing factory where
access to the production line is only possible for smaller fork-lift truck type vehicles.
 Better factory design can also reduce the work-in-progress inventory.
 Only produce for customer demand, hence no finished goods inventory.
 Emphasis on quality (because of the elimination of the inventory buffer).
 Operating JIT successfully can then open up further business opportunities.

Cash
Balancing act
Minimizing the holding of Being able to pay debts as

cash-an idle asset they fall due
Need for Cash
 Transactions motive – This is to manage the daily activities of the firm, such as the payment
of wages, expenses, etc.
 Precautionary motive – This is to keep money aside in case of any emergencies.
 Speculative motive – This is to keep money to take advantage of any opportunities to make
a quick gain.
Cash Management Models
1. The Miller-Orr Model

2. The Baumol Model
3. The Cash Budget

The Miller-Orr Model
Merton Miller and Daniel Orr developed a model for setting the target cash balance, which
incorporates uncertainty in the cash inflows and outflows.
The diagram shows how the model works over time. The model sets higher and lower
controls limits, H and L, respectively, and a target cash balance, Z. When the cash balance
reaches H, then H – Z pounds are transferred from cash to marketable securities that are the
firm buys H-Z pounds of securities. Similarly when the cash balance hits L, then Z – L
pounds are transferred from marketable securities to cash.
The lower limit, L is set by management depending upon how much risk of a cash shortfall the
firm is willing to accept, and this, in turn, depends both on access to borrowings and on the
consequences of a cash shortfall.
*The setting of the limits is beyond the scope of the syllabus.
The Baumol Model
William Baumol first noted that cash balances are in many respects similar to inventories, and
that the EOQ inventory model can be used to establish the target cash balance. Baumol’s model
assumes that the firm uses cash at a steady predictable rate and that the firm’s cash inflows also
occur at a steady predictable rate.

𝟐𝐂𝐨𝐃
Q =√
𝐂𝐡
Where:
Co = The brokerage cost (per transaction) of making a securities trade or borrowing.
D = The total amount of net new cash needed for transaction over the entire period, or the excess
cash available to invest in short term securities
Ch = Opportunity cost of holding cash (equals the rate of return generated by marketable
securities or the cost of borrowing in order to hold cash)
Assumptions:
1. All cash receipts are immediately invested in marketable securities.
2. Cash needed for business purposes is obtained through the periodic sales of marketable
securities.
Note: The EOQ model is ahead to determine the optimum safe of the marketable securities.
Exercise 11
A Suppiah muahx company generates £10,000 per month excess cash, which it intends to invest
in short term securities. The interest rate it can expect to earn on its investment is 5% per annum.
The transaction costs associated with each separate investment of funds is constant at £50.
Required:
a) What is the optimum amount of cash to be invested in each transaction?

b) How many transactions will arise each year?
c) What is the cost of making those transactions per annum?
d) What is the opportunity cost of holding cash, per annum?

TOPIC 3: SOURCES OF FINANCE
LONG TERM SOURCES OF

FINANCE
Equity Debt Other

(Shares) (Loans) Sources
SHARES
Ordinary Shares (Equity Finance)
 Owning a share confers part ownership of the business.
 Shareholders have full rights to participate in the business through voting in general
meetings.
 Shareholders are entitled to payment of dividends out of profit.
 Share capital is permanent financing, which is not expected to be paid back.
 Shareholders are entitled to repayment of capital in the event of liquidation, but only after all
other claims have been met.
 Ordinary shareholders bear the greatest risk; if there is no profit then dividend does not have
to be paid. Conversely, if the profits are high then high dividends can be paid.
 Shares are not tax efficient as dividends are post-tax as an appropriation of profit.
 Shares are marketable if listed.

Preference Shares (Non-equity)
 Pays a fixed dividend, ranking before (in preference to) ordinary shareholders.
 Hybrid form of finance ranking between Debt and Equity for payment.
 For gearing purposes, usually considered to be debt.
 Ranks after debt holders but before ordinary shareholders for repayment in the event of
liquidation.
 No obligation for company to pay dividend.
 May be cumulative (rights to dividend carried forward if insufficient profit in any year), or
non-cumulative.
 Dividends are paid out of post-tax profit, which means they are more expensive than debt for
the company.
 Not very popular, it is the worst of both worlds i.e.
- It is not tax efficient

- It offers no opportunity for capital gain (fixed return)
DEBT
Debt is something that has to be repaid. It is the loan of funds to a business without conferring
ownership rights. The usual methods of repayment are a combination of a regular interest
payment, with capital repayments either spread over a period or given as a lump sum at the end
of the borrowing.
Features
 Interest is paid out of pre-tax profits as an expenses of the business.

 Cheaper for the company than equity because it is cheaper to arrange and interest payments
usually lower than dividends (because less risky to investors).
 It carries a risk of default if interest and principal payments are not met, so the debt holders
can force the company into liquidation.
 No rights to share in the profits if the company is very successful.

SECURITY
Charges
The lender of funds will normally require some form of security against which the funds are
advanced. This means that in the event of default the lender will be able to take assets in
exchange of the amounts owing. There are two types of ‘charge’ or security that may be
offered/required.
1. Fixed charge – The debt is secured against a specific asset, normally land or buildings. This
form of security is preferred because in the event of liquidation it puts the lender at the ‘front
of the queue’ of creditors.
2. Floating charge – The debt ‘hovers’ over the general assets of the business and becomes
fixed on particular assets where the company defaults on its obligations. A floating charge
allows the managers of the company greater flexibility in their day-to-day operations since
assets may be traded without reference to the lenders.
Covenants
A further means of limiting the risk to the lender is to restrict the actions of the directors through
the means of covenants. These are specific requirements or limitations laid down as a condition
of taking on debt financing. They may include:
1. Dividends restrictions – limitations on the level of dividends a company is permitted to pay.

This is designed to prevent excessive dividend payments, which may seriously weaken the
company’s future cash flows and thereby place the lender at greater risk.
2. Financial ratios – specified levels, below which certain ratios may not fall, e.g. debt to net
assets ratio, current ratio.
3. Financial reports – regular accounts and financial reports to be provided to the lender to
monitor progress.
4. Issue of further debt – the amount and type of debt that can be issued may be restricted.
Subordinated loan stock (i.e. stock ranking below the existing unsecured loan stock) can
usually still be issued.

TYPES OF DEBTS
Bank Finance
For companies that are unlisted and for many listed companies the first port of call for borrowing
money would be the banks. These could be the high street banks or more likely for larger
companies the large number of merchant banks concentrating on ‘securitized lending’. The key
advantage of borrowing from banks is the confidential nature of the arrangement.
A term loan is a business loan with an original maturity of more than one year and a specified
schedule of principal and interest payments. It may or may not be secured. Terms and conditions
are negotiable dependent on term amount and the credit rating of the company wishing to make
the borrowing.
Bonds (Traded Investments)
As an alternative to borrowing funds from a bank the company, if listed on the stock exchange,
may issue debt to investors over the long-term. Typical features include:
1. The debt is denominated in units of £100, this is the value eventually redeemed on maturity.
It is often the value on issue (the cost to the investor) but the debt may be issued at a discount
(for less) or even at a premium.
2. Interest is paid (normally at a fixed rather than floating rate) on the nominal value of the loan.
For example, a 9% bond will pay annual interest of £9. This interest is sometimes known as
the ‘coupon’.
3. As with all debt, it is a less risky for investors than ordinary shares.
4. Market rates of bonds will fluctuate, depending on the prevailing interest rates.
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐏𝐚𝐢𝐝 𝐩𝐞𝐫 𝐚𝐧𝐧𝐮𝐦
Interest yield =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐦𝐚𝐫𝐤𝐞𝐭 𝐯𝐚𝐥𝐮𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐝𝐞𝐛𝐭
Exercise 1
What is the simple interest yield on the investment in Cute Francisca plc of a 15% bond if the
current market value of the bond is?
1. £150
2. £120
3. £90

TYPES OF BONDS
Debentures
Debt secured with a charge against assets (either fixed or floating)
Unsecured Loans
No security meaning the debt is more risky requiring a higher return. They normally require
covenants, to give some measure of safety to the debt holder.
Mezzanine Finance
 High risk finance issued when other sources are unavailable. A typical use is to fund a
management buyout.
 Also can be issued if there is a covenant restricting further loan issue. Ranks between ‘senior’
loans and equity for repayment.
 Very high interest rates because of the high risk.
Eurobonds
The issue of debt in a currency other than that of the country of issue. This form of finance is
only available to the largest international corporations.
Convertible Loan Stock

Normal bonds that also give the holder the right, but no obligation, to exchange the bonds at
some stage in the future into ordinary shares according to some prearranged formula, e.g. 40
shares for every bond held.
Advantages of Convertible bonds
 The benefit to the investor is the potential to share in profits if the company does very well.
 The benefit to the company is that original bond can be issued at a lower rate of interest.
 Another benefit to the company is that they are self-liquidating – that means the company
does not have to find the funds to redeem the debt.
Gilts
Gilts (or gilt edged securities) are bonds issued by the government. They are not a form of
finance for companies. Since they are considered to be (virtually) risk free, the interest rate will
be relatively low. Corporate bonds, which will be more risky will be issued at a higher rate of
interest.

OTHER SOURCES OF FINANCE
Sale and Leaseback
1. Selling good quality fixed assets such as high street buildings and leasing them back over
many (25+) years.
2. Funds are released without any loss of use of assets.
3. Any potential capital gain on assets is forgone.
4. A popular means of funding for retail organizations with substantial high street property e.g.
Tesco, Marks and Spencer.
Grants
1. Often related to technology, job creation or regional policy.

2. Of particular importance to small and medium sized businesses (i.e. unlisted)
3. Their key advantage is that they do not need to be paid back.
4. Remember the European dimension with grants also available through the European Union.
Retained Earnings
The single most important source of finance, most business use retained earnings as the basis of
their financing needs.
Leasing
If the finance is required for the acquisition of a fixed asset, the company may find it preferable
to lease the asset either through a finance lease (for the life of the asset), or an operating lease
(for short term/single use of the asset). The main benefits are:
1. The company does not have to raise the finance for acquisition of the asset
2. The lease rentals are tax deductible (see investment appraisal for more details)

TOPIC 4: EQUITY
Efficient market Raising equity

hypothesis (EMH) finance
Aspects of Equity
Dividend valuation Investor ratios

model (DVM)

METHODS OF RAISING EQUITY FINANCE
Equity finance for small and medium sized enterprises (SMEs) and unquoted companies include:
1. Owner finance
2. Retained earnings – Funds generated over time from profitable trading.
3. Friends and family
4. Venture capital
 It is high risk investment
 It involves a close working relationship between the venture capital company and
the company receiving the funds;
 It is neither a short-term nor a very long-term investment. The venture capital
company will be hoping to realize the equity shares it has acquired at a profit in 3-5
years either through floatation, or by takeover.
 The venture capitalist will have an exit strategy in place before investing in shares.
5. Business angel – (Rich individuals who start up the business) provide their own money
for fresh start up companies.
6. Private placing – The sale of a large block of shares to a new investor.
Stock Markets
Larger, established companies have the option of going for a stock market listing.
Purpose: to provide a wider market for funds, making raising finance easier.
Main consideration: Loss of control
The Alternative Investment Market (AIM)
- Purpose: to provide a market for the shares of companies that are too young or too small to
quality for, or benefit from, a full listing.
- Less demanding rules and regulation than those of the full market.
- The AIM has been very successful in encouraging companies to list, either as a stepping
stone to a full listing or to remain as an AIM member.

The Stock Exchange
Consideration:
1. Prestige – It is considered to be prestigious to be listed.

2. Growth – Allows for the raising of large sums of money, to finance growth.
3. Access – Allows access to new sources of funds that are unavailable to unlisted companies.
4. Visibility – The Company becomes more visible to the general public.
5. Accountability – The Company becomes more accountable to a wider range of stakeholder.
6. Responsibility – There is greater responsibility in running a listed company.
7. Regulation – There are more and regulations to be complied with.
Methods of obtaining a listing on the stock exchange
1. Fixed Price Offer for sale – Sale to the general public using a prospectus.
2. Offer for sale by tender – The public will be invited to tender for the shares and the company
will fix the successful price, called the strike price. All who tendered at, or above the strike
price will be successful, paying the strike price.
3. Placing – The sale of a large block of shares to a new investor.
4. Stock exchange introduction – A large unlisted company will seek to change its status to
listed company, without any issue of new shares.
Rights issues
A right issue is the right of existing shareholders to subscribe to new shares issues in proportion
to their existing holdings, thus enabling them to retain their existing share of voting rights. These
pre-emption rights can be waived with the agreement of shareholders at a properly convened
meeting.
Apart from the control factor, rights issues have certain other attractions:
1. They are far cheaper than a public share issue.

2. They may be made at the discretion of the directors without consent of the shareholders or
the Stock exchange.
3. They rarely fail. Rights issues are usually priced at below the current market price to give the
shareholders an incentive to take up his rights. The result of issuing these shares at an
effective discount is to reduce the market value of all the shares in issue.
Theoretical Ex-rights price (TERP)
The new share price after the issue is known as the theoretical ex-rights price and is calculated
by finding the weighted average of the old price and the rights price, weighted by the number of
shares.

Exercise 1
Chandran Baby plc, which has an issued capital of 2,000,000 shares, having a current market
value of £2.70 each, makes a right issue of one new share for every two existing shares at a price
of £2.10.
Required:
Calculate the theoretical ex-rights price.
Shareholders options
The shareholders options with a rights issue are to:
1. Take up his rights by buying the specified proportion at the price offered.
2. Renounce his rights and sell them in the market.
3. Renounce part of his rights and take up the remainder
4. Do nothing
The importance of issuing at a discount is that the ex-rights price will be less than the cum-rights
price (before the issue). This is simply because the ex-rights price is a weighted average of both
cum-rights and (the lower) issue price. This gives the ‘rights’ some value because shares are
purchased by the existing shareholders at a value lower than their eventual ex-rights value. The
difference is known as the value of a right.
Value of a right = Ex-rights price – Issue price
Exercise 2
For Bubble plc in exercise 1, what is the value of a right?
Exercise 3
Jackie Chandran the shareholders had 1,000 shares in sappiah plc before the rights offer.
Calculate the effect on the net wealth of Jackie Chandran of each of the following options:
a) Take up the shares

b) Sell the rights
c) Do nothing

OTHER EQUITY ISSUES
Capitalization Issue
A capitalization issue (or scrip issue or bonus issue), is a method of altering the share capital
without raising cash. It is done by changing the company’s reserves into shares capital and
allotting shares to existing shareholders pro rata.
The rate of a capitalization issue is normally expressed in terms of the number of new shares
issued for each existing share held, e.g. one for two (one new share for each two shares currently
held).
Main effect: reduces the share price, making them more marketable.
Scrip Dividends
This is where shareholders receive additional shares in place of a cash dividends. It is more like a
rights issue because shareholders are making a cash sacrifice if they accept the scrip shares.
Share split
Like a capitalization issue, a share split does not raise extra cash. A share split simply involves
the division of existing shares into smaller denominations, making the share capital more
marketable; e.g. a company whose shares have a nominal value of £1 shares into 10 shares of
10p each. The market value of each share then becomes £1.
The reverse procedure might be appropriate where the market value of a company’s share is very
low. This procedure is known as a consolidation of shares.
Warrants
A warrant confers the right but not the obligation for the holder to buy shares at a specified point
in the future for a specified (exercise) price. The warrant offers a potential capital gain where the
share price may rise above the exercise price.
The warrant has many uses including:
1) As additional consideration when issuing debt to make it more attractive.

2) As means of offering incentives to staff

THE DIVIDEND VALUATION MODEL
The dividend valuation model states that the current share price is determined by the future
dividends, discounted at the shareholders required rate of return.
𝐊 𝐞=𝐭𝐡𝐞 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐄𝐪𝐮𝐢𝐭𝐲

This is the rate of return that ordinary shareholders expect to receive on their investment.
𝐩𝐨=𝐭𝐡𝐞 𝐞𝐱 𝐝𝐢𝐯 𝐦𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐭𝐡𝐞 𝐬𝐡𝐚𝐫𝐞
The ex div market price means that new buyers will not receive a recently announced dividend.
The Price (Cum div) means with a dividend about to be paid.
Price (ex div) = price (cum div) minus dividend
If the dividend is the same every year (constant), then
𝐝
𝐏𝐨 =
𝐊𝐞
Where d = the constant dividend
Exercise 4
Shareholders in Sayang baby ltd expect a return on their investment of 8%. A dividend of 16p
per share has just been paid and there is expected to be no growth in dividends.
Required:
What is the share price in Sayang baby ltd?
The above formula can be arranged to find Ke:
𝐝
𝐊𝐞 =
𝐏𝐨
Exercise 5
The ordinary shares of Johnson cute are quoted at £4 per share cum div. A dividend of 30p is
about to be paid. These are expected to be no growth in dividends.
Required:
What is the cost of equity?

Growth
The dividend valuation model with constant growth
𝐝𝟏 𝐝𝟏
𝐏𝐨 = 𝐊𝐞 = + 𝐠
𝐊𝐞 − 𝐠 𝐏𝐨
Where: g = a constant rate of growth in dividends
d1 = dividend to be paid in one year’s time
Exercise 6
Muahx cutey ltd has just paid a dividend of 44p per share. Dividends are expected to grow at
10% per annum. Shareholders require a 15% return.
Required:
Calculate the current share price in Muahx cutey ltd.
Estimating Growth
1. The averaging method 2. Gordon’s growth model

𝐧 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 g = rb
g= √ − 𝟏 where r = return on reinvested funds
𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐧 𝐲𝐞𝐚𝐫 𝐚𝐠𝐨
b = proportion of funds retained
Exercise 7
Raj not macho ltd paid a dividend of 5p per share 8 years ago, and the current dividend is 9p.
The shareholders required rate of return 12%
Required:
a) Calculate the average annual growth rate for dividends
b) Calculate the share price
Exercise 8
The ordinary shares of Raj crazy ltd are quoted at £7.00 cum div. A dividend of 50p is just about
to be paid. The company has an annual accounting rate of return of 12% and each year pays out
30% of its profits after tax as dividends.
Required:
Estimate the cost of equity

Earnings per share (EPS)
𝐏𝐀𝐓 𝐥𝐞𝐬𝐬 𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝
EPS =
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐨𝐫𝐝𝐢𝐧𝐚𝐫𝐲 𝐬𝐡𝐚𝐫𝐞𝐬 𝐢𝐧 𝐢𝐬𝐬𝐮𝐞
Exercise 9
The Shi Yin Cicak Company earned profits after tax of £15m and has a preference dividend of
£3m. There are 24 million ordinary shares in circulation.
Required:
What is the EPS?
Note: If warrants or convertible debt are in issue the exercise or conversion could lead to a
dilution of the EPS.
Price Earnings Ratio (P/E Ratio)

The P/E ratio is a measure of future earnings growth; it compares the market value to the current
earnings.
Note: The PE ratio and the next 2 ratios may be calculated with information about one share or
the whole company. Both formulas have been given in each case.
PE Ratio One share Whole company
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞 𝐓𝐨𝐭𝐚𝐥 𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 (𝐌𝐕)

𝐄𝐏𝐒 𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱
Exercise 10
Two companies have the following details:
Murphy Henchoz
Share Price 300 pence 90 pence
EPS 10 pence 10 pence
Dividend per share 2 pence 6 pence
Number of shares 1 million 2 million
Required:
Which company retains higher confidence in the market?

Dividend Cover
The amount of profits attributable to shareholders that are actually paid out in the form of
dividend. The level of dividend cover depends on a number of factors:
1. The type of industry
2. The requirements of the specific shareholders
3. The investment opportunities available
4. Tax implications
5. Dividend policy
Dividend Cover One share Whole company
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱

𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 𝐓𝐨𝐭𝐚𝐥 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝𝐬
Exercise 11
Required:
What is the dividend cover for each company in exercise 10 above?
Dividend Payout Ratio
The dividend payout ratio is the amount of dividends paid to stockholders relative to the amount
of total net income of a company. The amount that is not paid out in dividends to stockholders is
held by the company for growth. The amount that is kept by the company is called retained
earnings.
Dividend Payout Ratio One share Whole company
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 𝐓𝐨𝐭𝐚𝐥 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐬

𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐨𝐟𝐢𝐭 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱
Exercise 12
Required:
What is the dividend payout ratio for each company in exercise 10?

Dividend Yield
The relationship of the dividend paid to the current market value. This is of importance when
deciding what type of investor we are trying to attract. If the yield is high this will appeal to the
investor who requires an income from the share. A lower yield suggests that more is being
reinvested back into the company, which should attract those investors who want capital gain.
Dividend Yield One share Whole company
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐏𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 𝐓𝐨𝐭𝐚𝐥 𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐬

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞 𝐓𝐨𝐭𝐚𝐥 𝐌𝐚𝐫𝐤𝐞𝐭 𝐕𝐚𝐥𝐮𝐞 (𝐌𝐕)
Exercise 12
Required:
Calculate the dividend yield for both companies in exercise 10, which company’s shares would
be favored by pensioners?
EFFICIENT MARKET HYPOTHESIS
The Weak Form
This is a theory reflect all past information. In the weak form, when new information becomes
available, it will take time before such information is reflected in the share price. All stock
markets will reflect this characteristic. Such a market isn’t considered to be efficient.
The Semi-Strong Form
Share prices reflect all publicly available information, which includes past period information. In
such a market, share price will change very quickly to any new information that becomes
available. Research shows that share prices in the US change within 6 minutes of the release of
quarterly earnings reports.
The Strong Form
Share prices are said to reflect ALL information, both private and publicly held information. This
assumes perfect information, where everyone knows everything! In such a market, insider
trading cannot exist, clearly, such a market is only a theoretical possibility, and it cannot really
exist.

TOPIC 5: CORPORATE DIVIDEND POLICY
In this topic, we learn how a company sets its dividend policy, and the importance of having a
dividend policy. A dividend policy is a statement by the firm on how it intends to pay dividends
to its shareholders. This allows shareholders and potential investors to decide on whether
investing in the firm is a worthwhile proposition.
The central theme of this topic is whether the dividend policy of a firm affects shareholders
wealth. There are two conflicting arguments with respect to this. One is the MM dividend
irrelevance theory, and the other is real world factors. We examine both these views as follows
Dividend Irrelevance Theory (MM)
The dividend irrelevancy argument starts from the premise that the future earnings and the level
of risk associated with that company will determine the value of the shares of a company
(shareholder wealth).The way in which the earnings of the company are applied between
dividend payments and retention is unimportant.
MM point out that shareholder can develop their own dividend/retention policies and need not be
dependent on the dividend /retention policy of the company.
If a shareholder wishes to receive their gains in the form of cash rather than through an increase
in share price, then they can create “home-made” dividends by selling a proportion of the shares,
which are held in the company.
If the shareholder received a cash dividend and would prefer the amount to be retained within the
company, they can re-invest the dividend received by acquiring more shares in the company.
Thus it would be illogical for shareholders to value shares in one company more highly than
another on the basis of the dividend policy, which it decides to adopt.
However like the MM theory on gearing their model is based on a number of unrealistic
assumptions.

UNREALISTIC ASSUMPTIONS
 There are no taxes.

 There are no transaction costs for example:
a) Investors face no breakage costs when buying or selling shares
b) Companies can issues shares without incurring issues costs
 All investors have perfect information is freely available
In the real world these assumptions do not hold true and therefore the conclusions of the
Dividend Irrelevance Hypothesis are incorrect.
REAL WORLD FACTORS
BROKERAGE FEES
If shareholders have a preference for some current income and are paid a low dividends or none
at all .They may have to sell some of their shares, which will reduce their wealth ,as they will
incur brokerage fees. If shareholder have a preference for capital gains and they were paid a
large dividend they would also incur brokerage fees when re-invest the dividends received
ISSUE COSTS ON NEW FUNDS
If a company has a positive NPV project to finance, it is usually cheaper to fund projects via
retained earnings as most forms of external finance involve incurring considerable issue costs.
When shares are issued in addition to the administration fees, they would be professional
adviser’s fees, underwriting costs and prospectus publishing costs. This can be 3% or more of the
fees raised.
THE TAX CLIENTELE EFFECT
An individual shareholder will usually have a firm preference of he/she wants his/her return to
be split between dividends and capital gains as both are subjects to different tax rules e.g. annual
exemption for capital gains .The preference will depend on the individual 's tax position.
Shareholders are attached to firms that follow dividend policies consistent with their tax planning
objectives (i.e. large dividend small capital growth ,small dividends large capital growth
).The clientele effect encourage s stability in dividend policy.

UNCERTAINTY/ (“BIRD IN THE HAND”).
In the real world shareholder do not have perfect information about the investments. This
uncertainty may lead shareholder to prefer a certain dividend now to uncertain future dividends.
Signaling effect: Directors are acting on “full” information
Research suggests that the dividend policy of the company gives a signal to shareholders about
the company performance. An unexpected change in dividends is regarded as a signal of how the
directors view the future prospects of the company i.e. for whatever reason means financial
problems.
Other Practical influences
 Corporate growth – the amount of funds required for positive NPV projects
 Future prospects – dividends are not increased unless it is believed that the increase can be
funded from a sustainable increases in cash flow
 The rate of inflation – Shareholder will not want their dividend income to fall in real terms
 Liquidity- resources may be tied up in assets other than cash
 Restrictive covenants – there may be restrictions on the levels of dividends in the articles of
association or in covenants on debts
 Policy of competitors – it may be difficult to reduce a dividend when competitors follow a
policy of higher distribution
Types of Policy
1) Constant % of PAT / Payout Ratio
In this a company pays out a certain proportion of its earnings each year. The advantage of this
policy is that a certain proportion of earnings are retained each year .The disadvantages are that
resulting dividends can be fairly volatile.
2) Residual approach
Is aimed at avoiding costs on new shares .The Company calculates how much cash is required to
fund imminent projects and then the balance is paid out as dividends .This results in a very
volatile stream.

3) Stable growth pattern
Directors seek to pay a dividend, which increases at a constant rate each year; in order to
encourage share price stability .This policy has been very popular in the past. The difficult is in
seeking to maintain the dividend during recessionary periods
SETTING A DIVIDEND IN PRACTICE – FACTORS TO CONSIDER
Shareholders preferences:
Signaling effect – (see above)
Clientele theory – Where a constant dividend policy is maintained this attracts a group of
shareholder, to whom the policy is suited in terms of tax, need for current income. A change in
the policy will result in shareholders selling their shares and driving the price down
SCRIP DIVIDENDS
 Shareholders offered extra shares in lieu of cash dividend

 In theory they have no impact upon shareholder wealth
 Offer advantages in preserving corporate liquidity
 Enhanced scrip sometimes offered as an alternative to cash dividend .(More shares than a
comparable cash dividend)
SHARE REPURCHASES
 Purchase and cancellation of shares by company

 Return of surplus cash to shareholder
 to reduce cost of capital by increasing gearing
 To increase EPS
 To avoid distorting dividend policy
 Arranged via open market operation, deal with institutional shareholders or offer to all
shareholders (special dividend )
 Capital gain tax on share repurchases ;income tax on special dividend

Important Ratios
𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
1. Dividend Yield – (%)
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐒𝐡𝐚𝐫𝐞 𝐏𝐫𝐢𝐜𝐞
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

2. Dividend Cover – (𝐱)
3. Dividend Growth - Measures the change in dividend from one period to the next

4. Dividend Payout Ratio – (%)
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞

TOPIC 6: INTRODUCTION TO CAPITAL INVESTMENT APPRAISAL
Investment Appraisal
Techniques
Basic Techniques Discounted Cash Flow

Techniques
 Net present value (NPV)

 Payback period
 Internal rate of return
 Accounting rate of
(IRR)
return (ARR)
 Annuities
 Perpetuities
INVESTMENT APPRAISAL
The use of decision making techniques to consider the costs and the benefits of an investments
over time. We are normally considering an investment in a fixed assets or a projects that involves
fixed assets. This decision may be considered the most important made by an organization
because of the long – term impact it will have on profitability. There are four appraisal methods:
1. Payback Period
2. Accounting rate of return (ARR)
3. Discounted cash flow – Net present value (NPV)
4. Discounted cash flow – Internal rate of return (IRR)

We shall use the following example to illustrate how the above methods are being calculated.
Exercise 1
Rani Katak Ltd has the opportunity to undertake investment with the following initial costs and
returns:
A B
(£ 000) (£ 000)
Initial investment (90) (20)
Cash flows Yr 1 40 10
Yr 2 30 8
Yr 3 20 6
Yr 4 20 4
Yr 5 20 4
Residual value Yr 5 4 2
Required:
a) Determine for each project separately, whether or not it should be accepted
b) Choose which project should be undertaken if they are mutually exclusive (only one can be
undertaken).

Payback period
The length of time it takes for cash flows from trading to pay back the initial investment
Exercise 1
A B
Initial Investment 90 20
($000)
Net cash flow ($) Periodic Cumulative Periodic Cumulative
Yr 1 40 10
Yr 2 30 8
Yr 3 20 6
Yr 4 20 4
Yr 5 20 4

Decision criteria
Only select projects that payback within the acceptable period (e.g. 3 years)
1.Simple to understand and calculate 1.It does not consider the time value of money
2.A simple measure of risk ,the longer the 2.There are no measure of return
payback the higher the risk
3.Ignores cash flows after the payback period
3.May be important to companies with limited
cash resources for budgeting purposes
4.Uses cash flows that are less open to

manipulation than profits
5.Emphasises cash flow in the early years
Accounting rate of return (ARR)
This measures has a close relationship to the performances measure Return on investment (ROI)
or ROCE. It is a measure of the impact of an investment on accounting profit .It may be
calculated many ways and is based upon profit (which already allows scope for manipulation)
.The common formula for examination is:
𝐄𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭
ARR = 𝐱 𝟏𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
Exercise 1 Continued
A B
Average Annual Profit
Total net cash flows

Less depreciation
Equals total profit
Divides number of years
Equals average profit

Average investment
Initial investment
Plus residual value
Divides 2
Equals average investments
ARR
Decision criteria
The ARR for an investment is to be compared to a target (often related to a company ROCE).If
the return is greater we will accept the investment
1.Widely used 1.It does not consider the time value of money
2. Simple to understand and calculate 2. It is based upon (subjective) accounting profit.
3. Can be calculated from available accounting 3. It is not an absolute measure of return.

data
4. It considers the whole of the investment and is

some measure of (accounting) return
COMPOUND INTEREST
With simple interest, the capital earns the same interest each period, whereas with the same
compound interest, the interest earned one period will earn interest in the next period.

Exercise 4
Calculate the total interest earned on $1000 invested for 3 years at 10% per annum under the
both simple and compound interest
Formula
The formula for compound interest is: F = P(1+r) n
Where: F =Future value after n periods

r =Rate of interest per period
n = Number of periods
Exercise 5
Calculate the value of $38,000 invested for 7 years at 5% per annum.
Discounting
𝐅
Rearranging the formula: F = P (1+r) n to P = = F = (1 + 𝐫)−𝐧
(𝟏+𝐫)𝐧
(1 + 𝐫)−𝐧 is called the discount factor and can be looked up in discount factor tables, by looking
for the appropriate percentage and number of periods.
Exercise 6
What should be invested Now to receive $ 10000 in 4 years’ time if r = 8 % per annum?
Exercise 7
What is the Present Value of $115000 receivable in 9 years’ time if r = 6% per annum?
Illustration of compounding and discounting
COMPOUNDING
Year 0 Year 1
DISCOUNTING

DISCOUNTED CASH FLOW
The discounted cash flow techniques are methods of investment appraisal, which take into
consideration the time value of money.
There are two discounted cash flow (DCF) techniques:
1. Net Present Value (NPV)

2. Internal Rate of Return (IRR)
Net Present Value
All future cash are discounted to the present value and then added to determine whether the
investment is profitable – that is the sum of discounted inflows is more than the discounted
outflows – or the Net Present Value is greater than zero.
If a project has a positive NPV then it should be accepted because the project is generating a
higher return that can be earned elsewhere. If a project has a negative NPV then the project
should be rejected. The capital should be invested elsewhere. The discount rate represents the
benefit that can be earned elsewhere, e. g. deposit in a bank. This rate is usually called the cost of
capital. It will always be given in the examination.
Decision Criteria
 If the NPV is positive, the investment should be undertaken – company (and hence
shareholder) wealth should increase by the amount of the NPV.
 If the NPV is negative, the investment should not be undertaken.
 If the projects are mutually exclusive, select the one with the Highest NPV

Exercise 8
a) Calculate the NPV for each investment in Exercise 1 and indicate for each investment,
whether or not it should be undertaken.
b) If the company can only undertake one investment, which should it choose?
Below is a reminder of Exercise 1:
Rani Katak Ltd has the opportunity to invest in investments with the following initial costs and
returns:
A B
($000) ($000)
Initial investment (90) (20)
Cash flows Yr 1 40 10
Yr 2 30 8
Yr 3 20 6
Yr 4 20 4
Yr 5 20 4
Residual value Yr 5 4 2
You are also told that the cost of capital is 10%
Internal rate of return (IRR)
If an investment has a positive NPV, it means it is earning more than the cost of capital. If the
NPV is negative, it is earning less than the cost of capital. This means that if the NPV is zero it
will be earning exactly the cost of capital.
Conversely, the percentage return on the investment must be rate of discount or cost of capital at
which the NPV equals to zero. This rate of return is called the internal rate of return (IRR) and is
our fourth method of investment appraisal.
The IRR may be calculated by a linear interpolation- either through graph or formula .That
means you must find two NPVs at different rates of interest and interpolate between them

The formula for the IRR is:
𝐍𝐏𝐕 𝐀
𝐚+( 𝐱 (𝐛 − 𝐚))
𝐍𝐏𝐕 𝐀 − 𝐍𝐏𝐕 𝐁
Where:
a = Cost of capital, (Positive NPV)
b = Cost of capital, (Negative NPV)
NPVA = Positive NPV
NPVB = Negative NPV
Decision criteria
If the IRR is greater than the cost of capital, accept the project
Exercise 9
a) For the project A, calculate the NPV at 20% discount rate then use this to estimate the IRR. If
the company’s cost of capital is now 15%, should investment A be undertaken?
b) The NPV of project B at 20% is £1696.Estimate the IRR and decide whether B should be
undertaken (cost of capital is 15%).
c) If A and B are mutually exclusive, which project should be undertaken?
Annuities
An annuities is a series of equal annual cash flows. The use of annuity tables allow a quicker
analysis of NPV in this circumstances
Exercise 10
A project costing £2,200 has returns expected to be £1,000 each years for 3 years and a discount
rate of 10%
Required:
a) Calculate the NPV using existing analysis

b) Calculate the NPV using annuity table
c) Estimate the IRR of the project

Exercise 11
Calculate the present value of an annuity of £1,000 per annum for five years starting:
a) 1 year from now

b) In 4 years’ time
c) Immediately
The cost of capital is 10% per annum
Perpetuities
A form of annuity that arises forever (in perpetuity).In this situation the calculation of the present
value of the future cash flows is very straightforward
𝐀𝐧𝐧𝐮𝐚𝐥 𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰
Present value of the perpetuity =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞
Exercise 12
A company expects to receive £1,000 each year in perpetuity .The current discount rate is 8%
Required:
a) What is the present value of the perpetuity using perpetuity formula?

b) What is the present value of the perpetuity using annuity NPV?

TOPIC 7: ADVANCED CAPITAL INVESTMENT APPRAISAL
Working capital
Relevant Cash Flows
Applications of discounted cash flow
Inflation Lease or Buy Decision
Risk
Taxation
Capital
Asset
Rationing
Replacement
Having learnt the basic fundamentals of investments appraisal, we will look at some advanced
issues .The first and most important thing is that in order to maximize the shareholder wealth, the
BEST appraisal method to use is NPV .All of the issues in this unit relate to advanced
applications of NPV .NPV is considered to be the best method of investment appraisal because:
 It recognizes the time value of money

 It uses pure cash flow, not accounting profits. Cash flows are a more objectives means of
assessing whether or not a project is viable
 It is an absolute measure of project returns, unlike the IRR measure which is a relative (%)
measure. Relative measures hide absolute values
 The measure shows the amount by which shareholders wealth will increase by, when a
project is accepted
Relevant Cash Flows

Investments decisions like all others decisions should be analyzed in terms of cash flow that can
be directly attributable to them.
Relevant cost: Future cash flow arising as a direct result of the decision

Sunk Costs
A sunk cost has already been incurred and therefore will not be relevant.
Opportunity cost
The benefit foregone by choosing one alternative in preference to the next best alternative. In
many decisions there is more than one simple “do nothing” alternative .In such circumstances the
benefit/cash of one course of action will be determined by other possible courses of actions
Opportunity cost are relevant and should be included.
Fixed cost
Should be treated as a whole, and only where relevant .This means using marginal, not
absorption costing: overhead absorbed using an overhead absorption rate is never relevant.
Depreciation
Depreciation is not a cash flow and so should never be included in a discounted cash flow
calculation .The only investment appraisal technique that will include depreciation is ARR.
Incremental Costs
Only the costs (and revenue) that change as a result of investment are relevant and need to be
included in the appraisal .If a cost or revenue will be incurred without the investment, in should
not be included in the appraisal.
Interest costs
Ignore all financing cash flow (e.g. interest charges, loan employments, dividends, etc.) and all
their tax effects (e.g. interest tax relief).This is because there are all implicitly taken into account
through the discounting process.
WORKING CAPITAL
Investment in new project often requires an additional investment in working capital that is the
differences between short-term assets and liabilities
The treatment of working capital is as follows:
1. It is treated as an investment at the start of the project, like any other investment. Any
additional working capital requirements are invested when required and only the change in
working capital is treated as a cash flow.
2. At the end of the projects the capital is released. This is treated as a cash inflow at the end of
the project, equal to the total investment in working capital.(unless told otherwise)

INFLATION
So far we have assumed that inflation does not exist (or affects all cash flow equally) this means
that the cost of capital has been the going rate of interest .This known as the money rate
If the money is invested it will earn interest but inflation will reduce the value of the return .By
deflating the future cash (money) we can find the real return – the return at today's prices
Inflation reduces the value of future cash
Exercise 1
£1,000 is invested in an account that pays 10% interest per annum .Inflation is currently 7% per
annum .Find the real return on the investment.
(𝟏+𝐦)
Formula: (𝟏 + 𝐫) =
(𝟏+𝒊)
and (1 + m) = (1 + r) (1 + i)
Where: r = real discount rate

m = money discount rate
i = inflation rate
Exercise 2
The real rate of interest is 8% and the rate of inflation is 5%

Required: What is the money rate of interest?
FINDING NPV WITH INFLATION
BE CONSISTENT!
Be real Be nominal (Money)

 Do not inflate the cash flow. Leave them  Inflate the cash flow to find the money values
expressed in real terms (today's prices) (using the inflation rate)
 Discount at the real rate  Discount at the money rate
Useful if given real cash flows and there is a Useful if different cash flow are subject to
single rate of inflation different rates of inflation – known as “specific
inflation”
The two methods give the same NPV, assuming the inflation rate is constant.

Exercise 3
Sarah Ltd is evaluating project X which requires an initial investment of £50,000.Expected net
cash flow are £20,000 per annum for 4 years at today's prices .However these are expected to rise
by 5.5% per annum because of inflation .The firm cost of capital is 15%.Find the NPV by :
i. Discounting money cash flows

ii. Discounting real cash flows
Exercise 4
(a) Explain how inflation affects the rate of return required on a investment projects, and the
distinction between the real and a nominal (or “money terms”) approach to the evaluation of
an investment of an investment project under inflation.
(b) Darling plc is contemplating investment in an additional production line to produce its range
of compacts discs. A market research study, undertaken by a well-known firm of consultants
has revealed scope to sell an additional output of 400,000 units per annum the study cost
£100,000 but the account has not yet been settled.
The price and cost structure of a typical disc (net of royalties) is as follows:
£ £
Price per unit 12

Costs per unit of output
Material cost per unit 1.5
Direct labour cost per unit 0.5
Variable overhead cost per unit 0.5
Fixed overhead cost per unit 1.5 4
Profit 8

The fixed overhead represents an apportionment of central administration and marketing costs.
These are expected to rise in total by £500,000 per annum as a result of undertaking this project
.the production line is expected to operate for 5 years and to require a total cash outlay of £11
million, including £0.5million of material stocks. The equipment will have a residual value of £2
million .Because the company is moving towards a JIT stock management policy, it is expected
that this project will involve steadily reducing working capital needs expected to decline at about
3 percent per annum by volume .The production line will be accommodate in a presently empty
building for which an offer of £2 million has recently been received from another company. If
the building is retained it is expected that property price inflation will increase its value to £3
million after 5 years.
While the precise rates of price and cost inflation are uncertain, economists in Darling’s
corporate planning department make the following forecasts for the average annual rates of
inflation relevant to the project
Retail Price Index 6 per cent per annum

Disc prices 5 per cent per annum
Material Prices 3 per cent per annum
Direct Labour Wages rates 7 per cent per annum
Variable overhead rates 7 per cent per annum
Other overhead costs 5 per cent per annum
Note: You may ignore taxes and capital allowances in this question
Required:
Given that Darling’s shareholder require a real return of 8.5 per cent for projects of this degree of
risk assess the financial viability of this proposal
(c) Briefly discuss how inflation may complicate the analysis of business financial decisions

TAXATION
We must also consider the impact that the tax will have on the return of an investment because
most companies will be liable for corporation tax on the additional profits generated There are
three aspects to taxation ,the good the bad and the ugly.
Tax and Investment Appraisal
GOOD UGLY BAD

Investment in fixed assets Tax payments are delayed .In Additional profit or net
attracts tax relief in the form some exam question this is dealt trading revenue leads to an
of capital or writing down with by delaying them by one increase in tax paid – a cash
allowances – These generate year outflow.
a cash saving – a cash inflow NOTE : READ THE EXAM
QUESTION CAREFULLY IS
THE TAX DELAYED
Writing down allowances

The tax allowance is based on the reducing balance method of depreciation at 25%.
Exercise 5
An assets is bought on the first day of the year for £10,000 and will be used for four years after
which it will be disposed of ( on the final day of year 4 ) for £2,500.Tax is payable at 30% one
year in arrear and capital allowances are available at 25% reducing balance
Required:
Calculate the writing down allowances and hence the tax savings for each year.

Year £ Tax saving Timing /year
1 Initial investment 10000

W.D.A
2 Book Value
W.D.A
3 Book Value
W.D.A
4 Book Value
Balancing Allowances/Charge
Residual Value
We are further told that net cash from trading is £4,000 per annum .The cost oof capital is 10%
Required:
Calculate the net present value NPV.
Format:
Year 0 1 2 3
Add an extra year (if tax is ugly)
These five 1) Net trading revenue The inflows and outflows from trading (e.g.
headings must be sales minus operating cash flows)
prepared for all 2) Tax payable The net trading revenue x tax rate (normally
taxation questions delayed by one year)
3) Investment
4) Residual value
5) Tax savings on W.D.A.s Calculated as a separated cash flow
Net cash flow
Discount factor
Present Value
NPV………

Exercise 6
You are the chief accountant of Dighton plc which manufactures a wide range of building of
plumbing fittings, it has recently taken over a smaller unquoted competitors Linton limited
.Dighton is currently checking through various documents at Linton’s head office, including a
number of investment appraisals. One of these, a recently rejected applications involving outlay
on equipment of £900,000 is produced below .It was rejected because it is failed to offer Linton
target return on investment of 25 per cent (average profit to initial investment outlay). Closer
inspection reveals several errors in the appraisals.
Evaluation of profitability of proposed project NT17 (all values in current year prices)
Item Year 0 Year 1 Year 2 Year 3 Year 4

£000 £000 £000 £000 £000
Sales 1400 1600 1800 1000

Materials (400) (450) (500) (250)
Direct lab our (400) (450) (500) (250)
Overheads (100) (100) (100) (100)
Interest (120) (120) (120) (120)
Depreciation (225) (225) (225) (225)
Profit before tax 155 255 355 55
Tax at 33% (51) (84) (117) (18)
Profit after tax 104 171 238 37
Outlay
Stock (100)
Equipment (900)
Market research (200)
(1200)
Average profit 138

Accounting Rate of return = = = 11.5%
Investemnt 1200

You discover the following further details:
1. Linton policy was to finance both working capital and fixed investment by a bank overdraft.
A 12 per cent interest rate applied at the time of evaluation
2. 25 per cent writing down allowances (WDA) on a reducing balance basis is offered for new
investment. Linton profit are sufficient to utilize fully this allowances throughout the project
3. Corporate tax is paid a year in arrears
4. Of the overhead charge ,about half reflects absorption of existing overhead costs
5. The market research was actually undertaken to investigate two proposal, the other projects
also having been rejected .The total bill for all this research has been already paid
6. Dighton itself requires a nominal return on new projects of 20 per cent after taxes is currently
ungeared and has no plans to use any debts finance in the future.
Required:
Write a report to the finance director in which you:
a) Identify the mistakes made in Linton evaluation.
b) Restate the investment appraisals in terms of the post -tax net present value to Dighton,
recommending whether the project should be undertaken or not.
ASSETS REPLACEMENT
Where there are competing replacements for a particular assets we must compare the possible
replacement strategies available. This type of question either looks at:
1. Comparing different competing assets or
2. The same assets replaced over differing time periods.
Key ideas / assumptions
1. Cash inflow in trading are not normally considered in this type of question .The assumptions
being that they will be similar regardless of the replacement decision.
2. The difficulty will arise from the differing lifecycle of each machine.
3. The operating efficiency of machine will be similar with differing machine or with machine
of differing ages.
4. The assets will be replaced in perpetuity or at least into the foreseeable future.

Exercise 7
A company is considering the replacement of an assets with one of the following two machine:
Machine
R S
£000s £000s
Investment cost (120) (60)

Life 3 years 2 years
Running costs (20) p.a. Yr 1.(40)
Yr 2.(35)
Residual value 10 nil
Required:
Determine which machine should be bought using a NPV analysis at a cost of capital of 10%.
Year CASH FLOW DISCOUNT PRESENT VALUE FACTOR
R S R S
£000s £000s £000s £000s
0 (120) (60) 1
1 (20) (40) 0.91
2 (20) (35) 0.83
3 (10) 0.75
PV of costs =
This cash flow is net of £20,000 outflow from maintenance and the inflow of £10,000 from the
residual value.
Machine S appears cheaper ,but it requires replacing on a more frequent basis, We are unable to
make an informed decision as to which is the most cost effective replacement strategy .To
compare like with like (over the same period of time) the method we use is the equivalent
annual cost EAC method.

Equivalent Annual Cost (EAC)
After calculating the NPV in the normal way we are then able to calculate some measure of
equal cost for each year by using the following calculation
𝐏𝐕 𝐨𝐟 𝐜𝐨𝐬𝐭𝐬
Equivalent Annual Cost =
𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐅𝐚𝐜𝐭𝐨𝐫
Machine R Machine S
(£000s) (£000s)
Present value of cost
Annuity factor
EAC
Decisions:
Capital Rationing
Shareholder wealth is maximized if a company undertakes all possible positive NPV projects.
Capital rationing is where there are insufficient funds to do so .There are 2 causes of this:
HARD CAPITAL RATIONING SOFT CAPITAL RATIONING

An absolute limit on the amount of finance An company may impose its own rationing on
available which imposed by the lending capital .This is contrary to the rational view.
institution. There are two reason : Reason for soft capital rationing:
1)Industry wide factors limiting funds eg a
recession ~limited management skills available
2)Company specific factors: ~desire to maximize return of a limited range of
~Lack of track record investments
~Poor track record ~limited of exposure to external finance
~Nonpayment of bills ~Encourage acceptance of only substantially
~Lack of assets security profitable business
~Poor management team

Multi – period capital rationing
A situation where there is a shortage of fund in more than one period .This makes the analysis
more complicated because we have multiple limitations and multiple output. In such a situation
we must employ a linear programming model to identify the profit maximizing mix of
investment .This is beyond the scope of this syllabus
Single period capital rationing
There is a shortage of fund in the present period that will not arise in following periods. Note that
the rationing in this situation is very similar to the limiting factor decision that we know from
decision making .In this situation we maximize the contribution per unit of limiting factor
Exercise 8
A company has £100,000 available for investment and has identified the following 5 investment
in which to invest. All investment must be started now (Yr 0):
Project Initial investment (Yr 0) NPV

£000s £000s
C 40 20
D 100 35
E 50 24
F 60 18
G 50 (10)
Required:
Which project should we invest in to maximize the return to the business?
Scenario 1: Divisibility
A proportion of a project may be undertaken and the returns (NPV) will be proportionate to the
amount of investment
Calculate the NPV per pound invested, also known as the 'Profitability Index'.
𝐍𝐏𝐕
Profitability Index =
𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

Project P.I Ranking
C
D
E
F
G
Funds available Projects undertaken NPV earned
Total NPV =
Scenario 2: Non -Divisibility
i.e. Projects may be taken as a whole or not at all .In this situation the profitability index cannot
be used .There is no technique or method available to make the decision beyond trial and error.
Scenario 3: Divisibility and mutual exclusivity
i.e. Where again we can take any part of a project and the return is proportionate to the
investment and the taking of one project precludes the taking of another.
Exercise 9
As per Exercise 8 but projects C and E are mutually exclusive
Required:
What is the optimal mix of projects?

RISK
When forecasting potential benefits there will always be an element of risk and uncertainty in the
figure to be achieved .This makes any NPV uncertain .We may consider the impact of risk on a
project using the following techniques:
PROBALITILY AND EXPECTED VALUES

Where there are a range of possible outcomes which can be identifies and a probability
distribution can be attached to those values .In this situation then we may use the expected value
(E (X)) – the average return.
E (X) = ∑ 𝐩𝐱
Where: p = the probability of an outcome

x = the value of an outcome
Exercise 10
Darkie plc are considering an investment of £460,000 in a fixed assets expected to generate
substantial cash inflow over the next 5 years .Unfortunately the annual cash flow from this
investment are uncertain ,but the following distribution has been established:
Annual cash flow Probability
£50,000 0.3
£100,000 0.5
£150,000 0.2
At the end of its 5 year life the assets is expected to be sold for £40,000.The cost of capital is
5%.Should the investment be undertaken?

PAYBACK PERIOD
Estimates of the cash flow several years ahead are quite likely to be inaccurate and unreliable. It
may be difficult to control capital projects over a long period of time. Risk may be limited by
selecting projects with short payback period, in addition to positive NPVs.
ADJUSTED DISCOUNT RATES
The discount rate we have assumed so far is the rate that reflects either the cost of borrowing
funds in the forms of a loan rate or it may reflect the underlying return of the business.(i.e. the
return required by the shareholder ), or a mix of both.
SENSITIVITY ANALYSIS
Sensitivity analysis typically involves posing what if question. For example, what if demand fell
by 10%, selling price was decreased by 5%, etc.
Alternatively we may wish to discover the maximum possible change in one of the parameters
before the projects is no longer viable.
This maximum possible change is often expressed as a percentage;
𝐍𝐏𝐕
Sensitivity margin =
𝐏𝐕 𝐨𝐟 𝐟𝐥𝐨𝐰 𝐮𝐧𝐝𝐞𝐫 𝐜𝐨𝐧𝐬𝐢𝐝𝐞𝐫𝐚𝐭𝐢𝐨𝐧
This would be calculated for each input individually. The key is to identify the relevant cash
flow.

Exercise 11
An investment of £40,000 is expected to give rise to annual contribution of £25,000 and annual
fixed cost of £10,000 for each of year 1 to 4 the discount rate is 10%
Required:
a) Should we accept or reject the investment based on NPV analysis?

b) Calculate the sensitivity of your calculation to the following
i. Initial investment
ii. Contribution
iii. Fixed costs
iv. Discount rate
c) The annual contribution of £25,000 is based on selling one product with a sales volume of
10,000 units ,selling price of £12.50 and variable costs £10.Calculate the sensitivity margin for :
i. The sales volume

ii. The selling price

Exercise 12
Burley plc a manufacturer of building products, mainly supplies the whole sale trade. It has
recently suffered failing demand due to economic recession and thus has spare capacity. It now
perceives an opportunity to produce designer ceramic tiles for the home improvement market. It
has already paid £0.5 million for development expenditure, market research and a feasibility
study.
The initial analysis reveals scope for selling 150,000 boxes per annum over a five – year period
at a price of £20 per box .Estimated operating costs largely based on experience are as follows.
Cost per box of tiles (at today's prices). £
Material cost 8
Direct labor 2
Variable overhead 1.5
Fixed overhead (allocated) 1.5
Distribution etc 2
Production can take place in existing facilities although initial re- design and set – up costs
would be £2 million after allowing for all relevant tax reliefs. Returns from the projects would be
taxed at 33%
Burley shareholders require a nominal return of 14 per cent per annum after tax which includes
allowances for generally expected inflation of 5.5 per cent per annum. It can be assumed that all
operating cash flow occur at year ends.
Required:
Assess the financial desirability of this venture in real terms, finding both the net present value
and the internal rate of return (to the nearest 1 per cent) offered by the project. Assume no tax
delay.
(b) Briefly explain the purpose of sensitivity analysis in relation to project appraisals, indicating
the drawbacks with this procedure.
(c) Determine the value of:
(I) price
(II) volume
Note: At which the projects NPV becomes zero.
Discuss your result, suggesting appropriate management action.

The Financing Decision
Once the decision has made to acquire an assets the decision can be made as to how to finance it.
The choices that will consider are:
 Lease
 Buy
The main consideration is the taxation position
Leasing
The assets is never 'owned' by the user company from the perspective of the taxman.
Implications
1. The finance company receives the writing down allowances as the owner of the assets.
2. The user receives no writing down allowances but is able to offset the full rental payment
against tax, this may have the effect of accelerating the tax allowances allowing them to be
taken in earlier years.
Buying
The assumptions is that buying requires the use of a bank loan (for the sake of comparability).
The user is the owner.
Implications
The user will receive writing down allowances on the assets and allowances against the interest
payable on the loan.
Cost of capital
We must use the Post Tax Cost of Borrowing as our discount rate .As all financing cash flows
are considered to be risk free, this rate is used for both leasing and buying.
Post Tax Cost of Borrowing = cost of borrowing x (1 - tax rate)

Exercise 13
Salomi Papan plc has already decided to accept a project and is now considering how to finance
it
For the four life of the projects the company can arrange a bank loan at an interest rate of 10%
after corporation tax relief .The loan is for £120,000 and would be taken out on 1st January 2014
the first day of the company's tax year .The residual value of the equipment is £10,000 at the end
of the fourth year.
An alternative would be to lease the assets over four years at a rental of £36,000 per annum Tax
is payable at 33% one year in arrears .Capital allowances are available at 25 % on the written
down value of the assets.
Required:
Should company lease or buy the equipment?
Solution:
Writing down allowances calculation:
Year £ Tax saving on WDAs Timing /year

1 Initial investment 120,000
W.D.A
2 Book Value
W.D.A
3 Book Value
W.D.A
4 Book Value
Balancing Allowances/Charge
Residual Value

Present Value Calculation for Buying
Year 0 1 2 3 4 5
Initial investment
Residual value
Tax savings
Net cash flows
Discount Factor@
10%
Present Value
NPV
Leasing
Present Value Calculation for leasing
Year Cash Flows Discount Factor @ Present Value

10%
Rentals
Tax Relief
Net Present Value
Conclusions:

Other Considerations
1. Who receives the residual value in the lease agreement? It is possible that the residual value
may be received wholly by the lessor or almost completely by the lessee.
2. There may be restrictions associated with the taking on of leased equipment the agreement
tends to be much more restrictive than bank loans.
3. Are there any additional benefits associated with lease agreement? Many lease agreement
will include within the payments some measure of maintenance or other support services.
Exercise 14
Assume that you have been appointed finance director of Sarah plc The Company is considering
investing in the production of an electronic security device with an expected market life of 5
years
The previous finance director has undertaken an analysis of the proposed project the main
features of his analysis are shown below
He has recommend 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 4500

assets
Cumulative investment in working 300 400 500 600 700 700
capital
Sales 3500 4900 5320 5740 5320
Materials 535 750 900 1050 900
Labour 1070 1500 1800 2100 1800
Overhead 50 100 100 100 100
Interest 576 576 576 576 576
Depreciation 900 900 900 900 900
3131 3826 4276 4726 4276
Taxable profit 369 1074 1044 1014 1044
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 of the above cash flow and profit estimates have been prepared in terms of present day cost
and price as the previous finance director assumed 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 requirement and overhead expenses are expected to
increase by 5% per year.
(b) Material cost and labor cost are expected to increase by 10% per year.
(c) Capital allowances (tax depreciation) are allowable for taxation purposes against profits
at 25% per year on a reducing balance basis.
(d) Taxation of profits is at rate of 35% payable one year in arrears.
(e) The fixed assets have no expected salvage value at the end of 5 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 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.

TOPIC 8: VALUATION OF SECURITIES
Introduction
The topic develop a general market model for the valuation of securities on the basis of the
discounted value of future cash flows. We will introduce the dividend valuation model and
investigate this model in detail .We will also apply the discounted cash flow technique for the
valuation of loan stock
The Dividend Valuation Model
The value of a share can be determine by discounting the future cash benefits arising from
holding it .These will be the dividend receivable, plus any eventual sale proceeds
The sales proceeds of a share represent a value which can itself be expressed as the present value
of dividends after the date of sale .Consequently the value of a share is really the present value of
the estimated dividends to be paid on the share to perpetuity.
This statement is referred to as the dividend valuation model
In order to make the model workable one of two assumptions usually made are :
1. Dividends will remain constant each year; or

2. Dividend will grow at a constant rate
Constant dividends
If a share is expected to pay constant dividend each year, we can use the simple perpetuity
formula:
Po = D/ r
Where: Po is the market price of the share ex div

D is the expected annual dividend per share in the future
r is the required rate of return on the share (the notation Ke can also be used as it stands
for Shareholder cost of capital).
Note: It is important to remember that in this model, the first dividend will be received at the
end of the year 1

Exercise 1
Mark plc is expected to pay a constant annual dividend of 40 p per share .IF the market expects a
return of 20% per annum for Mark plc shares at which price will the market value the shares?
Constant rate of growth in dividends
Using the growth formula, we have:
Po = D1/ r-g
Where D1 is the expected dividend to be paid in one year time and g is the expected constant
growth rate in dividends.
Exercise 2
Now assume that Mark plc dividend will grow at a constant rate of 4% per annum .What should
the value per ordinary share be?
Note:
Up to now all the formulas that we have looked at assume that the latest dividend has just been
paid which means that all the share value are ex div If you are given a situation where the next
dividend on a share is just about to be paid then we said that the share is cum div .Therefore the
only difference between cum div and ex div value of a share is the amount of the current
dividend.
Dealing with rapid initial growth
Of the two version of the dividend valuation model presented above the version incorporating
growth is generally more realistic simply because growth is likely to occur because of inflation
rather than in real terms .However it must be remembered that the growth factor used in the
model is in perpetuity. If a company is expanding rapidly and expected to continue this high rate
of growth for the next few years, you should not assume that this high rate of growth will be
sustained in the long term .it is more realistic to assume that the high rate of growth will be for
the first few years followed by a lower growth rate to perpetuity.

Exercise 3
Narvin plc has just paid a dividend of 15p per share. The market is in general agreement with
directors forecast of 30% growth in earnings and dividend for the next two years. Beyond this
point a reasonable estimate is 15 % growth in year 3 followed by 6% growth to perpetuity. The
market required return on investment of this risk level is 25% per annum .Estimate the share
value.
Estimating “g”
One of the major problems in applying the dividend valuation model is the determination of the
value of “g”. This cannot be known with certainly it can only be estimated using one of the
following ways:-
Using past period results
The year on year rate of growth could be examined oe we could take an average compound
growth rate over a longer period of time
Exercise 4
A company has paid a dividend of £1000 4 years ago the latest dividend paid now is £1500.
Determine the average annual growth rate of the dividends.
Past growth rates is only useful as one possible guide to the future, which could be very
different. This model is severely limited in estimating g.
Gordon Growth Model
This model determine g as follows:
g = br
b = the retention rate
r = the return on the reinvested funds (i.e. the ROCE)

Exercise 5
Cat plc is financed entirely by equity shares. Last year it earn a profit after corporation tax of £5
and paid a dividend of £2.Its net assets at the start of the year totaled £25m.What rate of growth
is estimated for future dividend if this profitability and retention policy are expected to continue?
However the model is unrealistic in practice .It is unlikely that a company will be able to find the
right number of projects which would produce a return justifying the continued use of a fixed
proportion of earning as in the above example.
Using other forecast
It is possible that other forecast can be used ,possibly from the forecast made by the directors of
the firm .again such forecast are likely to be highly subjective
The Valuation of Debt
The valuation principal is the same as for ordinary shares. The value of the loan stock is the
present value of the cash receipts to be generated by the loan stock, discounted at a rate which
allows for the risk of the investment. The discount rate will cover a risk free rate of return and a
premium to cover the risk of default by the company
Irredeemable loan stock (and irredeemable preference shares)
In practice irredeemable loan stock are virtually non-existent and therefore the study of the
pricing of this loan stock is only theoretical in nature. The formula to determine the value is:
Po = I / r
Where I = annual interest payment

r = the required yield expressed as an interest rate
You will notice that this formula is a simple perpetuity formula.

Exercise 6
An irredeemable debenture stock pays a nominal interest rate of 5%.The required yield on the
stock of this type is 12.5% per annum.
At what price will £100 nominal value of the stock sell for?
If market interest rates were to rise and the required yield on the loan stock rises to 14%.what
will happen to the stock price?
Redeemable loan stock
The same valuation principles apply except this time there is interest and redemption proceeds to
be discounted.
Exercise 7
Winnie plc has 10% loan stock in issue redeemable in 5 years’ time at par. The required yield on
the stock of this type is 8% per annum .At which price will the stock sell per £100 nominal?
Pricing of convertible loan stock and warrants
Convertible loan stock is loan stock which at the option of the holder may be converted into
ordinary shares in the company under specific condition. It will be worth converting if the value
of equity is higher than the value as straight debt.
Exercise 8
Luke plc has in issue 7% convertible loan stock .The conversion terms are 80 ordinary shares for
£100 of loan stock otherwise the loan stock will be redeemed at par. Today is the last day for
either redemption or conversion .above what share price is it worth converting to shares as
opposed to receiving redemption proceeds?

Warranty is options to buy shares in the company at a given price within a given period. They
can be traded on the market and are sometimes issued with loan stock as a sweetener. Some
important points to be considered about warrants are as follows:
 They do not pay any interest or dividends

 When it is issued as a sweetener the interest rate on the loan stock will be lower than a
comparable straight debt
 It will make a loan stock more attractive to a potential investor and may make an issue of
unsecured loan stock possible where adequate security is lacking
 They provide a means of generating additional equity funds in the future without any
immediate dilution in the earning per share (EPS)
If today is the last day for exercising a warrant, it will have a value equal to the difference
between the current market price of the share and the “exercise price” at which the holder of the
warrants can subscribe for the shares. Their minimum value is zero.
Tax and the cost of debt
An important aspects in evaluating the cost of finance is the effect of taxation .Loan interest is an
allowances expense for corporation tax purposes which effectively reduces the cost of loan
finance to the firm.
For irredeemable loan stock, the cost of debt to the company equal Kd (1-t) where Kd is the debt
holder required rate of return and t is the corporation tax rate .Now the cost of debt and the
required rate of return are no longer equal.
For redeemable debt, the tax position is a little more complex because there is only relief on the
interest payment element not the redemption premium. Thus the correct procedure is to reduce
only the interest payment by the corporation tax rate.
Exercise 9
An 8% debenture, redeemable in 5 years’ time at 105 is currently quoted at 95.42.What is the

required return of the debenture holders? If the corporation tax rate is 30%, what is the cost of
debt to the company?

TOPIC 9: PORTFOLIO THEORY
A portfolio is a collection of investment that make up an investors total holding. A portfolio can,
in theory, consist of any kind of investment, but for simplicity sake, it is usually assumed that it
consists entirely of quoted shares.
Portfolio theory (according to Harry Markowitz) is concerned with how risk involved with
investing in only one type of investment can be reduced through diversification. The theory of
risk reduction through diversification applies to both private investors as well as for companies.
Return can be defined as the financial gain that can be obtained by making an investment.
Risk is the possibility that actual returns will be different from expected returns. It is usually
measured as the variance of the outcomes, or the square-root of the variance i.e. the standard
deviation. The standard deviation gives a measure of dispersion of the probability distribution, in
that the higher the standard deviation, the greater the dispersion and hence the risk. When
comparing two investment, we can say that the one with the higher standard deviation has the
higher risk.
Factors in the choice of an investment:
 Security – investment should provide investors with an assurance that at least, their capital
value will be protected.
 Liquidity – this refers to how quickly an investment can be converted back to cash.
 Return – as defined earlier, the return is the financial gain an investor can obtain by making
a financial investment.
 Risk – this refers to the possibility that investor’s actual returns will be different from
expected returns.
 Brokerage fees – these are the fees involved when buying and selling securities
 Tax- how will the income from the securities be taxed?
Diversification as a means of reducing risk
Portfolio theory tells us that the risk and return from individual investments cannot be looked at
on its own, but the relationship between two investments can be of three types:
Positive correlation – where there is positive correlation between two investments, it means that
the return are expected to behave in a likewise manner. If you were to buy shares in two similar
construction companies, then both the shares will do badly in an economic slump.
Negative correlation – where if one investment performs well, the other will perform badly, and
vice-versa.

No correlation – the performance of one investment will be independent of the performance of
another i.e. we say that the returns are not correlated.
This relationship between different investments is measured by the coefficient of correlation.

This can range from a perfect positive correlation of +1 to a perfect negative correlation of -1. A
figure of 0 means no correlation. Risk can be significantly reduced in a diversification exercise
as long as a positive correlation is avoided.
Two asset portfolios
The logic of risk reduction through diversification can be explained by looking at a two asset
portfolio, where the risk of the portfolio can be calculated as follows:
𝛔𝐩 = √𝛔𝟐𝐚 𝐱 𝐚𝟐 + 𝛔𝟐𝐛 𝐱 𝐛𝟐 + 𝟐𝐱 𝐚 𝐱 𝐛 𝐩𝐚𝐛 𝛔𝐚 𝛔𝐛
Where: 𝛔𝐩 = is the standard deviation of two investment, a and b

𝛔𝐚 = is the standard deviation of investment a
𝛔𝐛 = is the standard deviation of investment b
𝐱 𝐚 = is the proportion of investment a in the portfolio
𝐱 𝐛 = is the proportion of investment b in the portfolio
𝐩𝐚𝐛 = is the correlation coefficient of returns from investment a and b
𝐂𝐨𝐯 𝐚,𝐛
Note: 𝐩𝐚𝐛 =
𝛔𝐚 𝛔𝐛
Exercise 1
A company is considering investment in one or both of two securities and you are given the
following information:
Market Condition Probability Return from Investments (%)

A B
Boom 0.2 10 6
Normal 0.5 14 15
Recession 0.3 20 11
Required: a) What is the expected return and risk of each investment?
b) What is the expected return and risk of a portfolio consisting of 50% investment A
and 50% investment B?

Exercise 2
A portfolio consists of two assets, A and B, whose expected returns are 16% and 20%
respectively and whose standard deviations are 8% and 12%. Asset A makes up 40% of the
portfolio and asset B makes up the remaining 60%.
Calculate the expected return and the standard deviation of the portfolio if the coefficient of
correlation between the assets are:
a) +1.0
b) +0.7
c) +0.3
d) -0.3
Systematic and Unsystematic Risk
The total risk of a portfolio (as measured by the standard deviation of returns) consists of two
types of risk, unsystematic risk and systematic risk. If we have a large enough portfolio it is
possible to eliminate the unsystematic risk, however the systematic risk will remain.
TOTAL RISK = standard deviation = 𝜎
Unsystematic / Specific risk Systematic / Market risk
Company specific factors General economic factors

can be eliminated cannot be eliminated
Unsystematic / Specific risk: refers to the impact on a company’s cash flow of largely random
events like industrial relations problem, equipment failure, R & D achievements, changes in the
senior management team etc. In a portfolio such random factors tend to cancel as the number of
investments in the portfolio increase.
Systematic / Market risk: General economic factors are those macro-economic factors that
affect the cash flows of all companies in the stock market in a consistent manner e.g. a country’s
rate of economic growth, corporate tax rates, unemployment levels and interest rates. Since these
factors cause returns to move in the same direction they cannot cancel out. Therefore systematic
(market) risk remains present in all portfolios.

What is the ideal number of investment in a portfolio?
Ideally the investor should be fully diversified i.e. invest in every company quoted in the stock
market. They should hold the “Market Portfolio”, in order to gain the maximum risk reduction
effect. However the wonderful news is that we can construct a well-diversified portfolio i.e. a
portfolio that will benefit from most of the risk reduction effects of diversification by just
investing in fifteen different sectors of the market.
The effect of increasing portfolio size with UK shares
The risk reduction is quite dramatic. We find that two thirds of an investment’s total risk can be
diversified away, whilst the remaining one third of systematic risk cannot be diversified away.
A well-diversified portfolio is very easy to obtain, all we have to do is, buy a portion of a larger
fund that is already well-diversified, like buying into a unit trust or a tracker fund.
Remember that real joy of diversification is the reduction of risk without any consequential
reduction in return. If we assume that investors are rational and risk averse, their portfolio
should be well-diversified i.e. only suffer the type of risk that they cannot diversify away
(systematic risk).
An investor who has well-diversified portfolio only requires compensation for the risk
suffered by their portfolio (systematic risk). Therefore we need to redefine our
understanding of the required return:
Required Return = Risk Free Return + Systematic Risk Premium

Investors who have well-diversified portfolio dominate the market. They only require a return for
systematic risk. Thus we can now appreciate the statement “that the market only gives a return
for systematic risk”.
The next question will be how do we measure an investment’s systematic risk? The answer to
this question will be given in the next session on the Capital Asset Pricing Model (CAPM).

Practice Questions
Question 1
You have already decided to invest £400,000 in Hotel Project, which is expected to show a
return of 26% and a standard deviation of 9%. The remainder of your wealth, £600,000, could be
invested in one of two indivisible projects, with details as follows:
Project Return Risk Correlation with Hotel Project

Honey 28% 15% 0.45
Baby 34% 13% 0.57
Using the principles of portfolio theory, decide which of the two projects A or B would be the
better investments.
Question 2
Cuci plc wishes to buy £1 million of shares in each of two companies from a choice of three
companies that it might wish to acquire at some future date. The companies are in different
industries. Historic five years data on the risk and returns of the three companies are shown
below:
Companies Average annual returns Standard deviation of returns

Mukabuku 11% 17%
Suka Cakap 20% 29%
Gila Makeup 14% 21%
Correlation coefficient between returns
Mukabuku & Suka Cakap 0.00
Cakap & Gila Makeup 0.40
Mukabuku & Gila Makeup 0.62
An adviser to Cuci plc has suggested that the decision about which shares to buy should be based
upon selecting the most efficient portfolio of two shares.
Required:
a) Estimate which of the possible portfolio is the most efficient
b) Discuss whether or not Cuci plc strategy should be to purchase the most efficient portfolio of
two shares.

Question 3
A division of Sexy plc has been allocated a fixed capital sum by the main board of directors for
its capital investment during the next year. The division’s management has identified three
capital investment projects, each potentially successful, each of a similar size, but has only been
allocated enough funds to undertake two projects. Projects are not divisible and cannot be
postponed until a later date.
The division’s management proposes to use portfolio theory to determine which two projects
should be undertaken, based upon an analysis of the projects risk and return. The success of the
projects will depend upon the growth rate of the company. Estimates of projects returns at
different levels of economic growth are shown below.
Economic Probability of Estimated return (%)

Growth occurrence
(annual average)
Project 1 Project 2 Project 3
Zero 0.2 2 5 6
2 per cent 0.3 8 9 10
4 per cent 0.3 16 12 11
6 per cent 0.2 25 15 11
a) To use the above information to evaluate and discuss which two projects the division is likely
to undertake. All relevant calculations must be shown.
b) What are the weaknesses of the evaluation techniques used in a) above, and what further
information might be useful in the evaluation of these projects?
c) Suggest why portfolio theory is not widely used in practice as a capital investment evaluation
technique.
d) Recommend, and briefly describe, an alternative investment evaluation techniques that might
be applied by the division.

TOPIC 10: THE CAPITAL ASSET PRICING MODEL (CAPM)
The Measurement of Systematic Risk
Systematic risk reflects market-wide factors such as the country’s rate of economic growth,
corporate tax rates, interest rates etc. Since these market-wide factors generally cause returns to
move in the same direction they cannot cancel out. Therefore, systematic risk remains present in
all portfolios. Some investments will be more sensitive to market factors than others and will
therefore have a higher systematic risk.
Remember that investors who hold well-diversified portfolios will find that the risk affecting the
portfolio is wholly systematic. Unsystematic risk has been diversified away. These investors may
want to measure the systematic risk of each individual investment within their portfolio, or of a
potential new investment to be added to the portfolio. A single investment affected by both
systematic and unsystematic risk of that investment would be owns a well-diversified portfolio
then only the systematic risk of that investment would be relevant. If a single investment
becomes part of a well-diversified portfolio the unsystematic risk can be ignored.
The systematic risk of an investment is measured by the covariance of an investment’s return

with the returns of the market. Once the systematic risk of an investment is calculated, it is then
divided by the market risk, to calculate a relative measure of systematic risk. This relative
measure of risk is called the “beta” and is usually represented by the symbol𝛃. If an investment
has twice as much systematic risk as the market, it would have a beta of two. There are two
different formulae for beta. The first is:
𝐂𝐨𝐯 (𝐞, 𝐦)
𝛃𝐞 =
𝛔𝐦𝟐
𝛃𝐞 = beta of an investment in shares/equity

𝐂𝐨𝐯 (𝐞, 𝐦) = covariance of returns on the shares with the returns on the market
𝛔𝐦𝟐 = variance of the returns on the market (i.e. the standard deviation squared)
The second formula is derived from the first:
𝐂𝐨𝐯 (𝐞, 𝐦) 𝐩𝐞𝐦 𝛔𝐞 𝛔𝐦 𝐩𝐞𝐦 𝛔𝐞

𝛃𝐞 = 𝟐
= 𝟐
=
𝛔𝐦 𝝈𝐦 𝛔𝐦
𝐩𝐞𝐦 𝛔𝐞
𝛃𝐞 =
𝛔𝐦
𝛃𝐞 = beta of an investment in shares/equity
𝛔𝐞 = total risk/standard deviation of the returns on the shares
𝛔𝐞 = total risk/standard deviation of the returns on the market
𝐩𝐞𝐦 = correlation coefficient between returns on shares and the market

Note: You must commit both formulae to memory, as they are not given on the exam. The
formula that you need to use in the exam will be determined by the information given in the
question. If you are given the covariance, use the first formula or if you are given the correlation
coefficient use the second formula.
Exercise 1
You are considering investing in Suppiah Hot plc. The covariance between the company’s
returns and the return on the market is 30%. The standard deviation of the returns on the market
is 5%.
Required:
Calculate the beta value
Exercise 2
You are considering investing in Chandran Sexy plc. The correlation coefficient between the
company’s returns on the market is 0.7. The standard deviation of the returns for the company
and the market are 8% and 5% respectively.
Required:
Calculate the beta value
Note: Investors make investment decisions about the future. Therefore, it is necessary to
calculate the future beta. Obviously, the future cannot be foreseen, as a result it is difficult to
obtain an estimate of the likely future co-movements of the returns on a share and the market.
However, in the real world the most popular method is to observe the historical relationship
between the returns and then assume that this covariance will continue into the future.

The CAPM Formula
The capital Asset Pricing Model (CAPM) provides the required return based on the perceived
level of systematic risk of an investment.
Required Return = Risk Free Return + Systematic Risk Premium
̅
𝐑 = 𝐑𝐅 + (𝐑 𝐌 - 𝐑 𝐅 )𝛃
̅
𝐑 = Required return on shares
𝐑𝐅 = Risk-free rate of return. Normally based on the return on treasury bills
𝐑𝐌 = Average return on the market. Normally based on the return on FTSE all-shares
index
(𝐑 𝐌 - 𝐑 𝐅 ) = Market risk premium. This is the reward that investors receive over and above the
risk free rate for investing in shares that have the same level of risk as the market
𝛃 = Beta of shares. This measure the systematic risk of the shares in a company relative
to the systematic risk on the market (market risk)
THE CALCULATION OF THE REQUIRED RETURN
The required return on a share will depend upon the systematic risk of the share. What is the
required return on the following shares if the return on the market is 11% and the risk free rate is
6%?
Exercise 3
The shares in Sasau plc have a beta value of 0.5. Answer: 6% + (11% - 6%) 0.5 = 8.5%
The shares in Jantan plc have a beta value of 1.0. Answer:
The shares in Cium plc have a beta value of 2.0. Answer:
Obviously, with hindsight there was no need to calculate the required return for Jantan plc as it
has a beta of one and therefore the same level of risk as the market and will require the same
level of return as the market i.e. the RM of 11%. The systematic risk-return relationship is
graphically demonstrated by the security market line.
The Required Rate of Return: The required rate of return is defined as the minimum rate of
return necessary to attract an investor to purchase an asset/shares. The definition is based on the
opportunity cost concept, in which an investment will only be made if the return offered by the
investment is at least the same as the return on the next best alternative that the investor has
forgone.

THE SECURITY MARKET LINE – (SML)
The CAPM model contends that the systematic risk-return relationship is positive (the higher the
risk the higher the return) and linear.
Returns
SML
Rm
Rf
Beta
1.0
If we engage our common sense, we would probably agree that the risk-return relationship
should be positive. However, it is hard to accept that in our complex and dynamic world that the
relationship will neatly conform to a linear pattern. Indeed, there have been doubts raised about
the accuracy of the CAPM.
The Security Market Line
The line that results when we plot returns and beta coefficients is obviously of some importance,
so it’s time we give it a name. This line, which we use to describe the relationship between
systematic risk and return in financial markets, is called the security market line (SML). After
NPV, the SML is arguably the most important concept in modern finance.
Shift in the Security Market Line
The Security Market Line (SML) is not static over time. Any shifts in the SML will result in a
change in the required rate of return. There are two forces that affect the slope and position of the
SML.
Changes in Inflationary Expectations changes in inflationary expectations affect the risk-free

rate (𝐑 𝐟 ), thus will result in a shift in the position of the SML. There are two basic components
that determine the risk-free rate: the real rate of interest (R*) and an inflation premium (IP).
𝐑 𝐟 = R* + IP

The inflation premium changes when the inflationary expectations change. Therefore events such
as a change in the government’s interest rate policy will result in a parallel shift in the SML in
response to the magnitude and direction of the change. Put another way, the position of SML
changes when inflationary expectations change. An increase in inflationary expectations will
raise the inflation premium, which in turn will increase the risk-free rate and shift the SML
upwards. Similarly a reduction in inflationary expectations will cause a downward shift in the
SML.
Changes in General Risk Aversion as discussed in the beginning of the chapter, rational
investors are risk-averse – any additional risk must be compensated with additional return. This
positive relationship between risk and return is depicted graphically by the SML. The slope of
the SML reflects the degree of general risk aversion of investors in the market: the steeper the
slope, the greater the degree of risk aversion. Examples of events that would change investors
risk aversion are such as a stock market crash, an economic crisis and political chaos. Any
changes in the general risk preference of investors will result in a shift in the slope of the SML.
The more risk averse the investors are, the steeper the slope of the SML, and vice versa.
The Meaning of Beta
The CAPM contends that shares co-move with the market. If the market moves by 1% and a
share has a beta of two, then the return on the share would move by 2%. The beta indicates the
sensitivity of the return on shares with the return on the market.
The beta value of 1.0 is the benchmark against which all share betas are measured.
 Beta > 1. Aggressive shares – These shares tend to go up faster than the market in a rising
(bull) market and fall more than the market in a declining (bear) market.
 Beta < 1. Defensive shares – These shares will generally experience smaller than average
gains in a rising market and smaller than average falls in a declining market.
 Beta = 1. Neutral shares – These shares are expected to follow the market.
Note: The beta value of a share is normally between 0 and 2.5. A risk free investment (a treasury
bill) has a 𝛽 = 0 (no risk). The most risky shares would have a beta value closer to 2.5.
Therefore, if you are in the exam and you calculate a beta of 10 you know that you have made a
mistake!

The Basic Application of CAPM in the Exam
1. Capital Investment decisions
The calculation of Ke in the WACC calculation to enable an NPV calculation
A shareholder required return on a project will depend on the project’s perceived level of
systematic risk. Different projects generally have different levels of systematic risk and therefore
shareholders have a different return for each project. A shareholders required return is the
minimum return the company must earn on the project in order to compensate the shareholder. It
therefore becomes the company’s cost of equity.
Exercise 4
Andrew Betina plc is evaluating a project, which has a beta value of 1.5. The return on the FTSE
all shares index is 15%. The return on treasury bills is 5%.
Required:
What is the cost of equity?
2. Stock Market Investment Decisions
Regarding Stock we read the financial section of our newspapers, it is commonplace to see
analyst advising us that it is a good time to buy, sell or hold certain shares. The CAPM is one
method that may employed by analyst to help them reach their conclusions. And then subtract
the required return from the expected return for each share i.e. they calculate the alpha value (or
abnormal return) for each share. They would then construct an Alpha Table to present their
findings.
Exercise 5
We are considering investing in F plc or G plc. Their details are as follows:
Beta values Expected returns

F plc 1.5 18%
G plc 1.1 18%
The market return is 15% and the risk free return 5%.
Required:
What investment advice would you give us?

Answer:
Alpha Table
Expected returns Required returns Alpha values
F plc 18%
G plc 18%
Sell shares in F plc as the expected return does not compensate the investors for its perceived
level of systematic risk, it has a negative alpha.
Buy shares in G plc as the expected return more than compensates the investors for its perceived
level of systematic risk, i.e. it has a positive alpha.
The preparation of an Alpha Table for a Portfolio

The Portfolio Beta is a weighted average.
The expected return of the portfolio is calculated as normal (a weighted average) and goes in the
first column in the alpha table. We then have to calculate the required return of the portfolio. To
do this we must first calculate the portfolio beta, which is the weighted average of the individual
betas. Then we can calculate the required return of the portfolio using the CAPM formula.
Exercise 6
The expected return of the portfolio A + B is 20%. The return on the market is 15% and the risk
free rate is 6%. 80% of your funds are invested in A plc and the balance is invested in B plc. The
beta of A is 1.6 and the beta of B is 1.1.
Required:
Prepare the alpha table for the portfolio (A + B).
β (A + B) =
R portfolio (A + B) =
Alpha Table
Expected return Required return Alpha value

Portfolio (A + B) 20%
The Alpha Value

If the CAPM is realistic model (that is, it correctly reflects the risk-return relationship) and the
stock market is efficient (at least weak and semi-strong) then the alpha values reflect a temporary
abnormal return. In an efficient market the expected and required returns are equal i.e. a zero
alpha. Investors are exactly compensated for the level of perceived systematic risk in an
investment i.e. shares are fairly priced. Arbitrage profit taking would ensure that any existing
alpha values would be on a journey towards zero.
Remember in exercise 4 that the shares in G plc had a positive alpha of 2%. This would
encourage investors to buy these shares. As a result of the increased demand the current share
price would increase (which if recall from the Portfolio Theory articles is the denominator in the
expected return calculation) thus the expected return would fall. The expected return would keep
falling until it reaches 16%, the level of the required return and the alpha becomes zero.
The opposite is true for shares with a negative alpha. This would encourage investors to sell
these shares. As a result of the increased supply, the current share price would decrease thus the
expected return would increase until it reaches the level of the required return and the alpha
value becomes zero.
It is worth noting that when the share price changes, the expected return changes and thus the
alpha value changes. Therefore, we can say that alpha values are as dynamic as the share
price.
Of course, alpha values may exist because CAPM does not perfectly capture the risk-return
relationship due to the various problems with the model.
Problems with CAPM
Investors hold well-diversified portfolio
CAPM assumes that all the company’s shareholders hold well-diversified portfolio and therefore
need only consider systematic risk. However, a considerable number of private investors within
the UK do not hold well-diversified portfolios.
One period model
CAPM is one period model, whilst most investment projects tend to be over a number of years.
Assumes the stock market is a perfect capital market
This is based on the following unrealistic assumptions:
1. No individuals dominates the market

2. All investors are rational and risk adverse
3. Investors have perfect information
4. All investors can borrow or lend at the risk free rate
5. No transaction costs

Estimation of future 𝜷 based on past 𝜷
A scatter diagram is prepared of the share’s historical risk premium plotted against the historical
market risk premium usually over the last five years. The slope of the resulting line of the best fit
will be the 𝜷 value. The difficulty of using historic data is that it assumes that historic
relationships will continue into the future. This is questionable, as betas tend to be unstable over
time.
Evidence
CAPM does not correctly express risk-return relationship in some circumstances. To cite a
number of these circumstances they are, for small companies, high and low beta companies, low
PE companies, and in certain days of the week or months of the year.
Data input problems
Richard Roll (1977) criticized CAPM has untestable, because the FTSE all-share index, is a poor
substitute for the true market i.e. all the risky investment worldwide. How can the risk and return
of the market be established as a whole? What is the appropriate risk-free rate?
However, despite the problems with CAPM, it provides a simple and reasonably accurate way of
expressing the risk-return relationship. Quite simply, CAPM is not perfect but is the best model
that we have at the moment.

Exercise 7
Gatal plc is considering investing in one of two short-term portfolios of four-short term financial
investments. The correlation between the returns of the individual investments is believed to be
negligible (zero/independent/no correlation).
Portfolio 1
Investment Amount invested Expected Total Risk Beta
£ million Return
A 10 20% 8 0.7
B 40 22% 10 1.2
C 30 24% 11 1.3
D 20 26% 9 1.4
Portfolio 2
Investment Amount invested Expected Total Risk Beta
£ million Return
A 20 18% 7 0.8
B 40 20% 9 1.1
C 20 22% 12 1.2
D 20 16% 13 1.4
The market return is estimated to be 15%, and the risk free rate 5%
Required:
a) Estimate the risk and return of the portfolios using the principles of both Portfolio Theory
and CAPM and decide which one should be selected.
b) How would you alter your calculations for the summary table if you were told “The
correlation between the returns of the individual investments is perfectly positively
correlated”?

TOPIC 11: THE COST OF CAPITAL
The cost of a particular source of a company’s capital is the rate of return which the company
must pay in order to satisfy the providers of these funds. In the case of loan capital, the
repayments will be agreed in the loan contract. In the case of equity capital (ordinary shares) the
rate of return is not fixed contract but is expected by the shareholders. If the company does not
pay this rate of return, shareholders react by selling their shares, in some cases to another
company which is interested in a takeover, and new equity capital becomes difficult to raise.
We consider the costs of individual sources of funds, before and after taxation and then show
how these costs can be combined into an overall cost of capital.
A company’s cost of capital is closely linked to its value. We examine the extent to which a
company can improve its value by choosing an optimal mix of funds. This question has produced
a detailed and lengthy on-going debate.
The cost of equity capital
The cost of equity capital represents the minimum expected return required by shareholders from
the investment of their funds by the company’s management. It is sometimes referred to as an
opportunity cost. If investors do not get this return, they will transfer some or all of their
investments elsewhere. Therefore, the yield on equity is the opportunity cost to shareholders of
not investing elsewhere.
Two possible ways of estimating the cost of equity capital of a firm are:
 The capital asset pricing model (CAPM)

 The dividend valuation model (DVM)
Using the CAPM
A company’s cost of equity, usually given by the symbol Ke, can be estimated using the CAPM
formula:
Ke = 𝐑 𝐅 + (𝐑 𝐌 - 𝐑 𝐅 )𝛃
The CAPM provides a very workable, and probably the best, method of estimating the
company’s cost of equity capital. The main advantage of the model compared with the DVM is
that it does make an attempt to estimate the required return, building it up from a pure rate of
interest and risk premium.

Using the DVM
The cost of a firm’s equity can be estimated using the dividend valuation model which assumes
that the market value of a share is equal to the expected future dividends received on that share
discounted at the shareholders required rate of return.
The model can be used to evaluate the cost of equity capital by rearranging the share valuation
formula.
Po = D/ r
Using the growth formula:
Po = D1/ r-g
For the cost of equity, we need to make r the subject of the formula and rename it Ke.
Ke from the constant dividend model:
𝐝
𝐊𝐞 =
𝐏𝐨
Ke from the constant growth in dividends model:
𝐝𝟏
𝐊𝐞 = + 𝐠
𝐏𝐨
If we are trying to estimate the Ke, the main practical problem is trying to estimate the future
growth rate. Whichever way you do it, the estimate is subject to a high degree of error.
In examining the cost of equity capital, it is best, therefore, to use both the CAPM and the DVM
and to compare the results, perhaps giving more weight to the CAPM but recognizing its
potential errors.
Exercise 1
Salomiya plc has just paid a dividend of 30p per share. The market price per share is £2.5. Future
dividends are expected to grow at 5% per annum. Estimate the cost to the company of using the
equity finance.

Cost of equity net issue costs
The above discussion has focused on the cost of continuing to use equity capital which is already
in issue. This includes the cost of using retained earnings, which could otherwise be returned to
shareholders as dividends.
When new equity capital is issued, the returns earned on the new funds should be the same as
those earnings on existing funds, provided that there is no change in the systematic risk involved
in the use to which the funds are put.
New issues are subject to issue costs, however, which are the lowest for the rights issues and
placing, and highest on offers for sale to the general public. The DVM can adjusted to allow for
issue costs, as follow:-
1. Using the constant dividends formula:
𝐝
𝐊𝐞 =
𝐏𝐨(𝟏 − 𝐟)
Where f is the issue costs, expressed as a proportion of issue proceeds.
2. Using the formula for constant growth in dividends
𝐝
𝐊𝐞 = + 𝐠
𝐏𝐨(𝟏 − 𝐟)
Exercise 2
Lucah plc has 20 million ordinary shares in issue quoted at £2.20 each. A dividend of 40p has
just been paid. Future dividends are expected to grow at 10% per annum. The company now
proposes to issue £2 million worth of shares, incurring £140,000 of issue costs. This money will
be invested in projects of the same systematic risk as existing operations. Estimate the costs of
new equity finance.

The cost of debt finance
The cost of debt is the figure which balances the cash received from investors with future
payments made for interest and redemption. Remember from a previous lecture that interest is
fully allowed for corporation tax unlike dividend payments.
We may distinguish irredeemable debt and debt redeemable at the current market price from the
debt redeemable at other than the current market price (or issue price if currently being issued).
Cost of irredeemable debt
Irredeemable debt is debt that will be issued by a company, which will not be redeemed. As such
the study of irredeemable debt is only of a theoretical nature. It doesn’t exist in practice.
𝐢
𝐊𝐝 = (𝐢𝐠𝐧𝐨𝐫𝐢𝐧𝐠 𝐭𝐚𝐱𝐚𝐭𝐢𝐨𝐧)
𝐏𝐨
𝐢(𝟏 − 𝐭)
𝐊𝐝 = (𝐚𝐟𝐭𝐞𝐫 𝐭𝐚𝐱𝐚𝐭𝐢𝐨𝐧)
𝐏𝐨
Exercise 3
Winnie plc has irredeemable loan stock in issue which pays 5% interest on nominal value. Its
current market price is £80 per £100 nominal. What is the cost of debt, both before and after
corporation tax relief assuming a rate of 33%?
Cost of debt which will be redeemed at the current market price
The cost is established by the same formula as for irredeemable stock. Remember that there is no
tax relief on the redemption proceeds.
Exercise 4
Luke plc has in issue loan stock (that is a rate on nominal value) of 7% per annum. It is currently
quoted at £110 per £100 nominal, and will be redeemed for £110 in 2 years’ time. What is the
cost both before and after tax relief assuming a rate of 33%?
Cost of debt which is redeemable at other than current market price
The cost of debt is the interest rate which links the NPV of future payments by the company with
its current market price.
Essentially, this means finding an IRR for the cash flows, which has to be done by trial and error.

Exercise 5
Tarchanai plc has in issue 9% debentures which are redeemable in 5 years at £96 per £100
nominal. The current market price is £92. Estimate the cost of debt capital before and after
corporation tax relief 33%.
The cost of debt capital in the above illustration represent the cost of continuing to use the
finance. It would represent the cost of raising additional fixed interest capital if we assume that
the cost of additional capital would be equal to the cost of that already issued. If a company has
not already issued any fixed interest capital, it may estimate the cost of doing so by making a
similar calculation for another company which is judged to be similar as regards risk.
Fixed rate bank loans
Most debt raised by companies is now in the form of bank loans rather than loan stock. If a fixed
rate of interest is paid, the cost of the loan to the company is simply this interest rate, adjusted for
tax relief:
Cost = interest rate (1-t)
Variable rate loans
In practice, most bank loans are at floating rates. Banks will peg the interest rate they charge to a
standard interest rate such as LIBOR. This rate will fluctuate daily. The bank will add a fixed
number of percentage points to LIBOR when charging the customer (for example, LIBOR + 2%)
With this type of finance, the cost of capital at any point of time is easily seen but it is difficult to
forecast the future cost to use in financing calculations. If a firm has a floating rate debt, then the
cost of an equivalent fixed interest debt should be substituted. Equivalent usually means fixed
interest debt with similar term to maturity in a firm of similar standing. This would be a better
rate to use rather than the current rate of interest because this takes into account the markets
forecast of future interest rates.
Weighted Average Cost of Capital (WACC)
When a firm uses different forms of finance, its overall cost of funds will be the weighted
average of the individual sources of funds used. The weights used in this calculation should be
the market values of the funds employed because these are the values used in computing the cost.
A simple example will illustrate this point:

Exercise 6
Cutemon plc has two types of funds: equity shares and 6% irredeemable debentures. The market
values of the funds are shown below:
Funds Market Value

£
Equity shares 10
6% irredeemable debentures 5
15
The debentures are quoted at £80
The company earns annual profits of £1.8 million before interest. After interest all the surplus is
distributed as dividends. Ignore corporation tax. The company expects to maintain stable profits
into the foreseeable future but to show no growth.
Required:
a) Calculate the cost of equity and the cost of debt.

b) Compute the WACC using market values as weights.
c) Compute the overall cost of capital by comparing total annual profits distributed to equity
and debt with the total market value of funds employed.
General formula for WACC
𝐄 𝐃
𝐖𝐀𝐂𝐂 = [ 𝐊𝐞 𝐱 ] + [ 𝐊𝐝 𝐱 (𝟏 − 𝐭) 𝐱 ]
𝐄+𝐃 𝐄+𝐃
Where: E = Market value of equity

D = Market value of debt
t = Corporation tax rate
Note: If the Cost of Capital is more than three than it is advisable to use table method to compute
the WACC answer rather than using the formula.

Exercise 7
Celaka plc has a capital structure in its balance sheet as follow:
£ Million
Ordinary shares (@ £1 par) 45
Retained earnings 90
10% loan 55
190
The share price of the company is 150p and it has just paid a net dividend of 15p. A growth rate
of 10% per annum has been achieved in dividends, but future growth is estimated to be 5%. The
loan is trading at par on the market and the corporation tax rate is 33%. Compute the WACC.
………………………………………………………………………………………………………
The WACC is used frequently in appraising capital projects. It is recommended for use on the
assumption that the WACC reflects a company’s long-term future capital structure and the
company continues to invest in projects which carry the same level of risk as existing operations.
Therefore, to apply the WACC, two assumptions must be made:
1. The business risk is constant – this means that the any new project that the firm undertakes
will be in the same line of business as the firms existing operations.
2. The financial risk is constant – this means that any new finance raised to undertake the
project will be in the same proportion as the firm’s existing gearing/capital structure level. It
assumes that the firms gearing level will remain unchanged when a new a project is
undertaken.
The arguments against using WACC are primarily based around the assumptions:
1. New investments undertaken by a company might have different business risk characteristics
from existing operations. As a consequence, the return required might go up or down because
business risk is perceived to be higher or lower. The CAPM is one method by which we can
derive a risk adjusted discount rate specific to each project. The existing cost of equity and
hence the existing WACC will only be of use if the new projects is of average systematic risk
for the firm.

2. The finance raised to undertake a new project might substantially change the company’s
capital structure and the perceived financial risk of investing in the company. Depending on
whether the project is financed by equity or debt capital, the perceived financial risk of the
entire company might change. This must be taken into account when appraising new
investments.
What of those cases where the conditions do not hold? For example, large capital projects
involving major issues of funds and a change in the risk profile of the business. It is possible to
make adjustments to the WACC to allow for these factors, but there are more effective ways of
tackling the problem which do not need the use of WACC.

Practice Questions
Question 1
a) Kent plc has issued 10 million ordinary shares of £1. Details of the company’s dividends per
share during the past four years are as follows:-
Year ended 31st December Dividend per share

2002 26p
2003 27p
2004 29p
2005 30p
The current (December 2005) market value of each ordinary share of Kent plc is £2.35 cum div.
The 2005 dividend of 30p per share is due to paid January 2006.
You are required to estimate the cost of capital for Kent plc ordinary share capital.
b) Ten years ago Freak plc issued £2.5 million 6% redeemable debentures at a price of £98 per
cent. The debentures are redeemable six years from now at a price of £102 per cent. They are
currently quoted at £59 per cent, ex interest.
You are required to estimate the cost of debt for Freak plc redeemable debentures, without
tax, and with a corporation tax rate of 30%.
c) The following figures are from the current balance sheet of Crazy plc:
£000
Issued ordinary share capital (@ £1 par) 8,000
Share premium 2,000
Reserves 6,000
Shareholders’ funds 16,000
12% Irredeemable debentures 4,000
Annual ordinary dividend of 20p per share has just been paid. In the past, ordinary dividends
have grown at a rate of 10% per annum and this rate of growth is expected to continue. Annual
interest has recently been paid on the debentures. The ordinary shares are currently quoted at
£2.75 and the debentures at £80 per cent. The corporation tax rate is 30%.
You are required to estimate the weighted average cost of capital for Crazy plc.

Question 2
Your company is considering the possible effects on its cost of capital if conversion of a
convertible debenture occurs. Stock market prices have recently been very volatile, and could
easily rise or fall by 10% or more during the next two months. The convertible is a £20m 8%
debenture with four years to maturity, which was originally issued at its par value of £100. The
debentures current market price is £110. Redemption in four years’ time would be at the par
value of £100. The company has other debt with a market value of £23m.
Your company could currently issue straight debt par of £100 with redemption yield of 9%.
The company’s current share price is 520p, the market value of shares is £180m, and financial
gearing 80% equity to 20% debt (by market values).
The systematic risk of the company’s equity is similar to that of the market, and is thought to be
unlikely to change in the near future.
The market return is 15%
The corporate tax rate is 30%
Required:
Assuming that no major changes in interest rates occur during the next two months, estimate the
impact on the company’s cost of capital if:
(i) The company’s share price in two months’ time is 470p, and no conversion takes
place.
(ii) The company’s share price in two months’ time is 570p, and conversion takes
place.
State clearly any other assumption that you make.
Comment on your findings.

Question 3
The finance director of Sarah plc is considering how to finance a major new expansion of
existing activities. The investment will cost £40m and is expected to last for five years.
The company’s current capital structure is:
£m
Medium-term floating rate loans 34
11% debentures redeemable July 2007 56
Issued ordinary shares (50p par value) 15
Reserves 82
Other information:
1) The company’s current share price ex-div is 478p, and the debenture price ex-interest is
£107.8. Each debenture is redeemable at its par value of £100.
2) Issue cost of externally financed equity are expected to be 6.5% of the total raised. Their
needs to be a minimum issue of £20m, otherwise issue costs increase substantially.
3) Issue costs of new debentures are estimated to be 3.5%.
4) The equity beta of Sarah plc is 1.15
5) The current dividend per share is 36.4p and dividends have grown by approximately 4%
per year for last three years.
6) The risk free rate is 3.5% per year and the market return is 11% per year.
7) The corporate tax rate is 30%
8) Sarah plc wishes to maintain its current capital structure.
Required:
a) Estimate the cost of capital of the new investment:

i) If internal sources of equity are used (retained earnings), and debt finance is
raised by a 7.5% floating rate bank loan with negligible issue costs;
ii) If internal sources of debt (new debentures issued at par of £100) and equity
are used. New equity may be assumed to be issued at the current market price.
Comment upon your findings and state clearly any assumptions that you make.
b) Discuss whether or not the techniques used in part (a) could be applied unlisted
companies.

TOPIC 12: CAPITAL STRUCTURE THEORY
Is it possible to increase shareholders wealth by changing the gearing ratio/level?
Capital Income Relative Risk Required

Repayment/security Interest/Dividends Levels Return
Debt Investors normally “Fixed” amount + Lower Kd – 10%
require security compulsory nature
Equity Could lose it all No guaranteed Higher Ke – 15%
payment
𝐅𝐮𝐭𝐮𝐫𝐞 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰𝐬

Market value of a company =
𝐖𝐀𝐂𝐂
(Perpetuity formula) Can we reduce the WACC by
Simplest form for teaching purposes changing the gearing ratio?
If you can reduce the WACC this results in a higher market value/net present value of the
company and therefore increases shareholders wealth.
100 100
Market value of a company = 667 = 𝟏, 𝟎𝟎𝟎
0.15 0.10
If it is possible to reduce the WACC by changing the gearing ratio, finance managers have
a duty to achieve this optimal gearing level / capital structure.
What mixture of debt (Kd) and equity (Ke) will give us the lowest WACC?
Debt is cheaper than equity (Kd < Ke):
a) Debt less risky than equity, therefore the return required by investors is lower.
b) Tax relief on interest payments.
The company gets tax relief on interest payments but not on dividends e.g. 10% (1 - 0.3) = 7.0%
(cost of debt – from the company’s viewpoint is after tax relief)

Therefore you may now think what the problem is, let’s simply:
1) Issue more debt and we will get a lower WACC.

2) But more debt also increases the WACC as:
Gearing Financial Risk Beta Equity Keg WACC
The geared company’s dividends is more volatile and therefore the financial risk is higher thus
the shareholders will demand a relatively higher return to compensate for the higher risk.
The theories of gearing ask the basic question:
Which has the greater effect on the WACC?
The reduction in WACC caused by the cheaper debt The Increase in WACC caused by
the increase in financial risk and
keg
Gearing Theories
1) M + M (No Tax) Cheaper Debt = Increase in Ke

2) M + M (With Tax) Cheaper Debt > Increase in Ke
3) Traditional Theory The WACC is U shaped – i.e. there is an optimum gearing
4) The pecking order No theorized process. Simply line of least resistance. First internally
generated funds, then debt and finally new issue of equity.

M and M – Without Tax
In 1958 Franco Modigliani and Merton Miller stated that a company’s level of gearing (capital
structure) has no effect on shareholder wealth.
Cost % £ Value of company
Keg
Keu WACC Vu Vg
Kd
Level of Gearing Level of Gearing
Summary effect of: Cheaper Debt = Increase in Ke
The cost of equity is directly linked to the level of gearing. The financial risk to
shareholders increases, therefore Keg increases as gearing increases.
Conclusion: The WACC and the total value of the firm are unaffected by gearing
levels.
M and M – With Tax
In 1963 M + M modified their model to reflect the fact, that the corporate tax system
gives tax relief on interest payments.
Keg Vg
Keu Vu
WACC
7% Kd
Level of Gearing Level of Gearing

Summary Effects of: Cheaper Debt > Increase in Ke
Conclusion: Gearing levels should be as high as possible. (99.9% - Debt)

Practical restrictions on gearing level
1) Bankruptcy risk
As gearing increases so does the possibility of bankruptcy. If shareholders become concerned,

this will reduce the share price and increase the WACC of the company.
As a company begins to “suffer” from high gearing some of the following problems may come
into play. If bankruptcy situation finally occur, the assets may be sold off quickly and cheaply. A
large proportion of management time is spent “firefighting” i.e. focusing on short-term cash flow
rather than long-term shareholder wealth.
Key staffs leave to avoid being tainted by a failed company. Uncertainties are placed in the
minds of customers and suppliers, which may result in lost sales and more expensive trading
terms. Shareholders refuse to invest new funds for +NPV projects, as they do not wish “to throw
good money after bad”.
2) Agency costs: restrictive conditions
In order to safeguard their investments debentures holders often impose restrictive condition in
the loan agreements that constrains management’s freedom of action.
E.g. restriction:
I. On the level of dividends

II. On the level of additional debt that can be raised
III. On management from disposing of any major fixed assets
IV. Without the debenture holders agreement
3) Tax exhaustion
After a certain level of gearing companies will discover that they have no tax liability left against
which to offset interest charges.
Kd (1-t) simply becomes Kd
4) Borrowing / debt capacity
High levels of gearing are unusual because companies run out of suitable assets to offer as
security against loans. Companies with assets, which have an active second-hand market, and
low levels of depreciation such as property companies, have a high borrowing capacity.

5) Difference risk tolerance levels between shareholders and directors
Business failure can have a far greater impact on directors than on a well-diversified investor. It
may be argued that directors have a natural tendency to be cautious about borrowing.
6) Restrictions in the articles of Association
7) The cost of borrowing increases as gearing increases
The Assumptions:
a) It ignores bankruptcy risks, agency costs and tax exhaustion costs.

b) Debt is risk free and irredeemable.
c) Personal taxation is ignored
d) Perfect capital markets – The 5 assumptions:
i) No individual dominates the market
ii) All investors are rational and risk adverse
iii) Investors have perfect information
iv) All investors can borrow or lend at the risk free rate
v) No transaction costs
The M + M (with tax) formula
As gearing increases:
The total market value of the company increases
Vg = Vu + Dt
g = geared
u = ungeared
Where Dt is the present value of the tax shield
The WACC decreases and tends towards Kd at extreme gearing levels
𝐃𝐭
WACC = Keu x [ ]
𝐄+𝐃
Note: When a firm is ungeared, the cost of equity and the WACC will be the same
The cost of equity (Ke) rises as the financial risk rises
𝐃 (𝟏−𝐭)
Keg = Keu + [ (𝐊𝐞𝐮 − 𝐊𝐝) 𝐱 ]
𝐄

The Traditional Theory
Keg
WACC
Keu Vu Vg
Kd
Optimal Level of Gearing Optimal Level of Gearing
The WACC will initially fall because of the benefit of the cheaper debt (after tax) is greater than
the increase in Ke.
Cheaper Debt > Increase in Ke
However the WACC will then rise when the bankruptcy costs cause shareholders to demand a
return (Ke) that outweighs the benefit of the cheaper debt.
Increase in Ke > Cheaper Debt
(and the eventual increase in the cost of debt)
Conclusion of the Traditional Theory
Shareholders wealth is affected by changing the level of gearing.
There is an optimal gearing ratio at which WACC is minimized and the total value of the
company is maximized.
Financial managers have a duty to achieve and maintain this ratio.
While we accept that the WACC is probably U shaped for firms generally, we cannot precisely
calculate a best gearing level.
The optimum level will differ from one firm to another and can only be found by trial and error.

The Pecking Order Theory
There is a pecking order for financing new projects, it as follows:
1) Internally generated funds

2) Debt
3) New issue of Equity
In this approach, there is no search for an optimal structure through a theorized process. Firms
simply use all their internally generated funds first then move down the pecking order to debt
and then finally to issuing new equity. Firms follow a line of least resistance that establishes the
capital structure.
The logic is as follows:
Internally Generated Funds – i.e. Retained Earnings
 Already have the funds.

 Does not have to spend any time persuading outside investors of the merits of the projects.
 No issue costs.
Debt
 The degree of questioning and publicity associated with debt is usually significantly less than
that associated with a share issue.
 Moderate issue costs.
New issue of Equity
 Perception by stock markets that is a possible sign problems. Myers and Majluf (1984)
provide a theoretical explanation of why an equity issue might be bad news – managers will
only issue shares when they believe the firm’s shares are over-priced.
 Benefit Stewart (1990) puts it differently: “Raising equity conveys doubt. Investors suspects
that management is attempting to shore up the firm’s financial resources for rough times
ahead by selling over-valued shares”.
 Extensive questioning and publicity associated with a share issue.
 Expensive issue costs.

A Stakeholder Theory
 This approach recognizes that non-financial stakeholders (customer, suppliers, employees,

society, and government) can have a major impact on a firm’s capital structure.
 Customers will prefer low gearing if products require future servicing or where specialized
training is involved.
 Firms may use high gearing to defend against union power (it is easier to use the “can’t
afford it” argument when the consequence of a pay rise will be failing to meet an interest
payment rather a dividend)
 Supplier may offer inferior terms and prices to high geared firms.
 If a firm is important in the economy government may be prepared “to bail it out, “if it
defaults on loans, therefore the company may take more gearing risk than normal.
ROE
This is a measure of return relating solely to the shareholders. It is calculated after taxation and
before dividends has been paid out. It gives an indication as to how well the company has
performed for its shareholders, the most important stakeholders. The impact of differing levels
of gearing will have an impact on the return.
It is useful to compare the ROE to the ROCE to measure the amount of the return underlying to
the business that pertains to the shareholders. Note however that they are not directly comparable
ROE being post-tax and ROCE, pre-tax.
ROCE
ROCE gives a measure of the underlying performance of the business finance. It gives an
indication of the health of the business in generating a return on its investments. Gearing has no
impact on the return and hence this is the most important measure of profitability to calculate.
The ratio is calculated before tax allowing return to be compared between companies under
differing tax regimes.
Note: Capital Employed represents the total funds invested in the business, it includes Equity
and Long-term Debt.
Formula:
𝐏𝐫𝐨𝐟𝐢 𝐀𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 (𝐏𝐀𝐓) 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 (𝐏𝐁𝐈𝐓)

𝐑𝐎𝐄 = 𝐱 𝟏𝟎𝟎 𝐑𝐎𝐂𝐄 = 𝐱 𝟏𝟎𝟎
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐟𝐮𝐧𝐝𝐬 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐝
(𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲)

Exercise 1
A company is considering a number of funding options for a new projects. The new projects may
be funded by £10m of equity or £10m debt. Below are the forecast financial statements given the
projects have been funded in each manner.
STATEMENT OF FINANCIAL POSITION EXTRACT
Original Revised balance sheet

Balance sheet Ungeared Geared
£m £m £m
Creditors
Debentures (10%) 0.0 0.0 10.0
Capital
Share Capital (50c) 3.5 11.0 3.5
Share Premium 1.5 4.0 1.5
Reserves 5.0 5.0 5.0
10.0 20.0 10.0
INCOME STATEMENT EXTRACT
£m
Turnover 100.0
Operating Profit 5.0
Corporation tax is charged at 30%
Required:
a) Calculate ROCE and ROE under each funding option

b) What is the impact on the company’s performance of financing by debt rather than
equity?
c) Investigate the impact on shareholders returns for both the ungeared and geared options if
Operating profit is:
i) £1m
ii) £10m

Effects on Earnings per Share (EPS) on different types of financing securities
Full disclosure of fully diluted EPS, in addition to EPS is required when the fully diluted EPS is
more than 5% away from the EPS. In FM, use is often made of potential shares issues at a future
date: such as;
1. Convertible loan stock

2. Convertible preference shares
3. Warrants
Exercise 2
On 1 April 20x3, the company issued by way of rights or otherwise £1,250,000 8% convertible
unsecured loan stock for cash at par. Each £100 nominal of the stock will be convertible in
20x6/20x9 into the number of ordinary shares set out below:
On 31 dec 20x6 124 Shares

Relevant information:
Issued share capital:
£500,000 10% cumulative preference shares of £1

£1,000,000 ordinary shares of 25p = 4,000,000 shares
Corporation tax is 45%
Trading result for the year ended 31 Dec 20x4 20x3

£ £
Profit before interest and tax 1,100,000 991,818
Interest on 8% convertible unsecured loan stock 100,000 75,000
Profit before tax 1,000,000 916,818
Corporation tax 450,000 412,568
Profit after tax 550,000 504,250
Required:
Calculate the basic EPS and fully diluted EPS for 20x4 and 20x3.

Exercise 3
Dummy plc is a confectionery manufacturing company that is keen to expand its current
operations.
The board is currently considering two proposals to raise the £300,000 required for the
expansion:
i) Issue £300,000 of debentures loan stock.

ii) Issue more equity shares via a rights issue.
The Finance Directors main concern is increasing the level of gearing within the firm. He asks
you to provide some information he can use at the forthcoming board meeting.
He provides you with the following data:

Currant Capital Structure:
£000
Ordinary share capital (£1 shares) 3000
Reserves 500
7% Preference shares (£1 shares) 1000
12% Secured irredeemable loan stock 1500
6000
The current market values are:

Ordinary share capital 170 pence
Preference shares 90 pence (ex-div)
12% Irredeemable loan stock £75 per £100 block
Additional information:
1. The last dividend paid to ordinary shareholders was 22 pence per share.
2. Records show that dividends to ordinary shareholders are growing at a constant rate of 3%
per annum.
3. The current rate of corporation tax is 35%.
Required:
a) Calculate the current weighted average cost of capital using the market values.
b) Calculate the current debt/debt + equity ratio and the revised ratio should proposal (i) be
taken.
c) If the rights issue route is followed and shareholders are offered one new share for every
3 currently held at what price must they be sold in order to raise the capital required for
the expansion and what would be the TERP?

TOPIC 13: BETAS AND GEARING
Modigliani and Miller developed their original theories before the CAPM was developed in 1964.
Using our knowledge of the CAPM we can now see that when M & M describe operating risk, we should
substitute ‘systematic risk of the firm’s operations’.
Financial risk (from borrowing) cannot be ‘diversified away’ and will therefore increase the systematic
risk of a share if the company is geared. In other words the beta factor of a share in a geared company will
be higher than the beta of that share if the company were ungeared.
By combining the formulae of M & M the formulae of M & M for the cost of equity and the CAPM
model formula we can arrive at the following formulae for the betas of geared and ungeared shares in
companies with the same level of systematic risk in their operations:
𝐃
Ignoring corporation tax: 𝛃𝐠 = 𝛃𝐮 [𝟏 + 𝐄
]
𝐃
Allowing for corporation tax: 𝛃𝐠 = 𝛃𝐮 [𝟏 + (𝟏 − 𝐭) 𝐄 ]
Where 𝛽𝑔 and 𝛽𝑢 are the betas in the geared and ungeared firms. D and E is the market value of debt and
equity, and t is the corporation tax rate.
These formulae can be seen to be the averaging formulae for the beta of equity and the beta of debt. The
beta of debt is zero because we assume, like M & M, that the debt in the company is risk-free. Take the
case when corporation tax is ignored.
According to M & M
𝐖𝐀𝐂𝐂 𝐠 = 𝐖𝐀𝐂𝐂 𝐮
Thus the overall β of the geared firm will also be equal to the 𝛽 of the ungeared firm, that is βu .
The overall β of the geared firm is the average of the beta of the ungeared equity, βg and the beta of debt
is zero. Thus:
𝐄 𝐃
𝛃𝐮 = [ 𝛃𝐠 𝐱 ] + [ 𝛃𝐝 𝐱 ]
𝐃+𝐄 𝐃+𝐄
Therefore, if debt has a beta of zero, then βd = 0
𝐄 𝐃
𝛃𝐮 = [ 𝛃𝐠 𝐱 ] + [𝟎 𝐱 ]
𝐃+𝐄 𝐃+𝐄
𝐄
- 𝛃𝐠 𝐱 = 𝛃𝐮
𝐃+𝐄
𝐃+𝐄
- 𝛃𝐠 = 𝛃𝐮 [ 𝐄
]
𝐃
- 𝛃𝐠 = 𝛃𝐮 [𝟏 + 𝐄 ]

Use of the geared beta formula to estimate the required return for a new project
In an earlier chapter, we suggested that the CAPM could be very useful for identifying a discount
rate suitable for project appraisal. We then said that in order to estimate the beta for a project, we
could look at the betas of companies in a similar line of business to the project .The problem that
we raised at that stage was that these companies would usually have debt in their capital
structure, which affected the beta. We are now in a position to solve that problem, using the
‘geared beta formula’.
Exercise 1:
Mark plc is a company that manufactures motor vehicle components. It is considering a new
project producing electronic components, which is known to be considering more risky than its
existing business.
The equity beta of Mark plc is 0.89 and the average equity beta of companies in electronic
components is 1.71.Mark plc is an –equity financed firm whereas the electronic components
companies are geared on average to a ratio of 30% debt: 70% equity. The risk –free rate of
interest is 8% and the return on the market, 15%.The corporation tax rate is 35%.
You are required to:
1. Degear the equity beta of electronic companies (i.e. find the ‘asset beta’).
2. Estimate the required rate of return which Mark should expect on its new venture, assuming it
remains all – equity financed.
3. Estimate the weighted average cost of capital of Mark‘s new electronics division if it
borrowed to a gearing level of 20% debt: 80% equity.
When debt is not risk – free
In practice, debt issued by companies is not risk –free. It has been estimated that a reasonable
figure for the beta of debt issued by large corporation is between 0.2 to 0.3.This affects the
‘geared 𝛽’ formula, which can be amended by using the weighted average approach.
The overall 𝛽 of a geared firm will be equal to the weighted average of the beta of geared equity,
𝛽g, and the beta of the debt 𝛽d. When we include corporation tax, the market value of debt is
multiplied by the factor (1-t) in the formula.
𝐄 𝐃(𝟏−𝐭)
Thus, u = [ 𝛃𝐠 ] + [ 𝛃𝐝 ]
𝐄+𝐃(𝟏−𝐭) 𝐄+𝐃(𝟏−𝐭)

Practice Questions on beta and gearing:-
Question 1
The management of Nelson plc wishes to estimate their firm’s equity beta Neslon has had a stock
market quotation for only two months and the financial manager feels that it would be
inappropriate to attempt to estimate beta from the actual share price behavior 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
Neslon, as these should be based on similar level of systematic risk and be capable of providing
an accurate estimate of Neslon’s beta .
Three companies have been identified as firms having operation in the same industry as Nelson
which utilize identical operating characteristics .However only one company, Oak plc operates
exclusive in the same industry as Neslon. The other two companies have some dissimilar
activities or opportunities in addition to operating characteristics which are identical to those of
Nelson.
Details of the three companies are:
1. Oak plc – Observed equity beta 1.12.Capital structure at market values is 60% equity, 40%
debt.
2. Beech plc – Observed equity beta 1.11.It is estimated that 30% of the current market value of
Beech is caused by risky growth opportunities which have an estimated beta of 1.9.The growth
opportunities are reflected in the observed beta. The current operating activities of Beech are
identical to those of Nelson. Beech is financed entirely by equity.
Pine plc – Observed equity beta 1.14.Pine has two division, East and West .East’s operating
characteristics are considered to be identical to those of nelson. The operating characteristics of
West are considered to be 50% more risky than those of East .In terms of financial valuation East
is estimated as being twice as valuable as west. Capital structure of Pine at market values is 75%
equity, 25% debt.
Nelson is financed entirely by equity. The tax rate is 40%.

Required:
a) Assuming that all debt is virtually risk-free, determine three estimate of the likely equity beta
of Nelson plc.The three estimates should be based, separately on the information provided for
Oak, Beech and Pine plc.
b) Explain why the estimated beta of beta of Nelson when eventually determined from observed
share price movements may differ from those derived from the approach employed in (a) above.
c) Specify the reasons why a company which has a high level of share price volatility and is
generally considered to be extremely risky can have a lower beta value, and therefore lower
financial risk, than an equally geared firm whose share price is much less volatile.

Question 2
Biggo plc runs a chain of food retailers. The company is considering opening a chain of
department stores. In order to estimate a suitable discount rate for this investment, some data is
obtained on a quoted company, Smallo plc which runs a successful department store business.
Data for Biggo and Smallo are shown below.
Biggo (£m) Smallo (£m)

Fixed assets 59.2 21.0
Working capital 38.4 12.4
97.6 33.4
Financed by
Bank loans 21.2 17.2
Ordinary shares 16.0 4.0
Reserves 60.4 12.2
97.6 33.4
Share price £3.2 £5.5

Beta of equity 0.82 1.47
The par value of ordinary shares is 25p for Biggo and £ 1 for Smallo.
Biggo plc can borrow at 0.5% above the Treasury bill rate, which is currently 5% per year.
Corporation tax is payable at 30%. The return on the market is estimated at 13 % per annum.
Biggo does not expect its financial gearing to change significantly if the company diversifies into
the new business. The beta of corporate debt can be taken as approximately 0.2.
Required:
Estimate a risk adjusted WACC, which Biggo can use in the appraisal of its proposed
diversification.

Question 3
The government has just announced that the corporation tax rate is being reduced from 33% per
year to 30% per year and the directors of Baris plc wish to know the likely effect of this change
on the company’s share price and cost of capital. The company’s current capital structure is as
follows.
£m
Ordinary shares (50p per value) 30
Share premium 48
Other reserves 62
Shareholders’ equity 140
10% irredeemable debentures 40
180
The company’s shares are trading at 320p ex-div, and the debentures at £ 125 ex-interest. Prior to
the tax change Baris’s beta equity was 1.2. The market return is 13% per year. The tax cut itself
is expected to increase the net present value of Baris’s operating cash flows by £ 15m. Assume
that the cost of debt and market price of debt do not change as a result of this tax change. Baris’s
debt may be assumed to be risk free.
Required:
a) Estimate the company’s current cost of capital

b) Using Modigliani and Miller’s theory of capital structure (with tax) estimate:
i) The expected share price after the tax change.
ii) The company’s expected cost of capital after the tax change.
c) Explain the reason for the difference between the old and the new cost of capital
d) Briefly discuss:
i) The main limitations of this analysis
ii) The importance in investment decision of accurate estimate of the cost of capital.

TOPIC 14: MERGERS AND ACQUISITIONS
Mergers and Acquisitions – The Term Explained
A merger is in essence the pooling of interest by two business entities, which results in common
ownership.
An acquisition normally involves a larger company (a predator) acquiring a smaller company (a

target). The predator effectively subsumes the target into its structure.
However it is quite normal for an acquisition to be referred to as a merger for the following PR
reasons (forget about ACR please).
 It portrays a better message to the customers of the target company.

 To appease the employees of the target company.
Organic Growth V Growth by Acquisition
ORGANIC GROWTH
Organic Growth is internally generated growth within the firm.
Advantages of Organic Growth and Disadvantages of Growth by Acquisition
Organic growth permits an organization to carefully plan its strategic growth in line with stated
objectives. It is less risky than growth by acquisition, which occurs at one go.
The cost is often much higher in an acquisition. As the bidding company usually has to pay a
significant acquisition premium to acquire the target company.
Post-acquisition integration problems. The integration process is often a difficult process due to
cultural differences between the two companies.
An acquisition places an immediate pressure on current management resources to learn to

manage the new business.

Disadvantages of Organic Growth and Advantages of Growth by Acquisition
If a company has chosen to enter a particular market, the quickest way is to purchase an
established company in the product or geographical market. The alternative is to grow
organically which may lead to oversupply and excessive competition.
To eliminate competition and increases market power in order to be able to exercise some
control over the price of the product. A company may be able to push up the price of the goods
sold because customers have few alternatives e.g. monopoly or by collusion with other
producers.
To acquire the target company’s staff highly trained staff. To apply their talent, knowledge and
techniques to the parent company’s existing and future products lines to give them a competitive
edge.
Acquisition enables a company to quickly take advantage of a market opportunity.
The Financial Aspects of Mergers and Acquisitions / Takeovers
The most common areas for the examiner to explore are the effect of a takeover on the share
price or the EPS of a company, and hence the wealth of shareholders.
AFFECT ON THE SHARE PRICE I.E. THE NET PRESENT VALUE OF A COMPANY.
Why merge? Synergy 2 + 2 = 5 creates wealth of 1
Synergy occurs when combined entity is worth more than the sum of the companies apart.
If A and B as individual companies present values are £120m and £100m respectively and the
value of 𝐏𝐕𝐀+𝐁 𝐏𝐎𝐒𝐓 𝐀𝐂𝐐 = 𝐏𝐕𝐀 + 𝐏𝐕𝐁 + 𝐒𝐧𝐞𝐫𝐠𝐲 the combined entity after merge costs
(underwrites fees, legal and accounting fees, stock exchange fees and etc.) is £270m, the synergy
from merger is:
£270m – (£120m + £100m) = £50m
WHAT IS THE MAXIMUM PRICE A SHOULD PAY FOR B (THE TARGET

COMPANY)?
𝐏𝐕𝐀+𝐁 − 𝐏𝐕𝐀 = 𝐓𝐡𝐞 𝐦𝐚𝐱𝐢𝐦𝐮𝐦 𝐩𝐫𝐢𝐜𝐞 = 𝐏𝐕𝐁 + 𝐒𝐧𝐞𝐫𝐠𝐲

270 – 120 = = 100 + 50
If A pays more than the £50m this is known as the “winners curse”.

WHICH SHAREHOLDERS WILL BENEFIT FROM THE SYNERGY?
This will demand on the price paid for B. However it is normal for the acquiring company to pay
a significant premium (i.e. an immediate payment for “part of” the synergy) to gain control,
this is called an acquisition or bid premium.
The average acquisition premium is about 30% - 50%. Therefore the shareholders of the target
company normally benefit from the merger e.g. say A paid £130m for B. Therefore the value
created by the merger has been split as follow £20m to A’s shareholders and £30m to B’s
shareholders.
Share for share exchanges and bootstrapping
Exercise 1
No of Shares Share Price EPS

Hi plc 10m £2.00 10p
Lo plc 10m £1.00 10p
Hi plc has made a bid for Lo plc. The offer is 1 share in Hi plc for every 2 shares in Lo plc.
Required: Please calculate the post-merger share price in the enlarged Hi plc.
Answer:
THE ADD COMPANIES METHOD:
Value of Equity
Hi
Lo
PV of the synergies
Values of enlarged Hi plc:
No of shares in the enlarged Hi plc
Share price of the enlarged Hi plc

BOOTSTRAPING – ONLY HI BUYS LO: THE TARGET COMPANY MUST HAVE A
LOWER P/E RATIO.
The bootstrapping argument is that the share price of the combined company =
Post acq EPS x Pre acq P/E ratio of the bidding company
It contends that the share price can rise (under certain conditions) despite there being no
synergies identified by the merger.
………………………………………………………………………………………………………
THE BASIC IDEA BEHIND BOOTSTRAPPING
Better Management Team
X20 X10
Hi Lo
Hi has a much superior management team than Lo and has a much brighter future. This fact is
denoted by their respective P/E ratios: investors are willing to pay 20 times the earnings to buy
shares in Hi. But investors in Lo are only willing to pay 10 times the earnings.

However when the management team of Hi takes over the activities of Lo, they will Lo’s
performance to their level i.e. from a P/E ratio of 10 to 20
---------- being lifted to Hi level

Hi Lo
Therefore all profits in the enlarged Hi (i.e. the original Hi profits and Lo profits) are now
multiplied by the factor of 20 i.e. pre-acquisition P/E ratio of the Hi – biding company.
The enlarged Hi
X20
SO COULD BOOTSTRAPPING HAPPEN TODAY?
It is unlikely, as the sophisticated lead investors will what to see a detailed breakdown of the
synergies. They will say: “show me the synergy” and then undertake a detailed analysis the risk
of the synergy.
Be careful as bootstrapping question has been very poorly answered in the past.

Calculation of an Acquisition Premium
Exercise 2
No of shares Share Price EPS

A plc 200m £4.04 40.4p
B plc 50m £2.00 13.33p
A plc has made a bid for B plc. The offer is 2 share in A plc for every 3 shares in B plc.
Required: Calculate the acquisition premium.
Answer:
P/E Ratio A plc = 10 B plc = 15
A plc is acquiring a company on a higher P/E ratio, therefore no bootstrapping opportunity.
The Add Companies Method.
Total value of the enlarged company
A plc 200m x £4.04 = £808m

B plc 50m x £2.00 = £100m
-----------
£908
No of shares in the enlarged company
A plc £200.00m
B plc 50m x 2/3 = £33.33m
------------
£233.33m
908
Post-merger share price: = £3.89
233.33

Calculation of the acquisition premium – VALUE PER ONE SHARE OF B PLC
A shareholders in B plc gets 2 shares in A plc (£3.89) for every 3 shares of B plc.
2 x 3.89 2.59 − 2.00

= £2.59 = 29.5%
3 2.00
The new share price of £3.89 is lower than current market price of A plc which is £4.04, which
reflects the fact that the premium payment to B plc shareholders has reduced the wealth of A
plc’s shareholders. Therefore before acquisition premium is paid, consideration should be given
to the synergistic effects of the acquisition.
Directors of the acquiring company have a duty to their shareholders not to reduce their wealth.
There is a potential conflict of interest directors and shareholders and thus a potential corporate
governance angle to merger and acquisition questions.
Exercise 3
No of shares Share Price EPS

A plc 200m £4.04 40.4p
B plc 50m £2.00 13.33p
A plc has made a bid for B plc. The offer is 2 shares in A plc for every 3 shares in B plc.
The present value of the synergies has been identified at £80m
Please calculate the acquisition premium.

Question 1
In a recent meeting of the board of directors of KFC plc the chairman proposed the acquisition of
Ayamas plc.
During his presentation the chairman stated that ‘As a result of this takeover we will diversify
our operations and our earnings per share will rise by 13%, bringing great benefits to our
shareholders’.
No bid has yet been made, and KFC currently owns only 2% of Ayamas. A bid would be based
on a share for share exchange, which would be one KFC share for every six Ayamas shares.
Financial data for the two companies include:
KFC Ayamas
£m £m
Turnover 56.0 42.0
Profit before tax 12.0 10.0
Profit available to ordinary shareholders 7.8 6.5
Dividends 3.2 3.4
Retained earnings 4.6 3.1
Issued ordinary shares 20m 15m
Market price per share 320 pence 45 pence
KFC and Ayamas share par value are 50 pence and 10 pence respectively.
A non-executive director has recently stated that he believes “the share price of KFC will rapidly
increases to £3.61 following the announcement of the bid.”
Required:
a) Explain whether you agree with the chairman’s and the non-executive director’s
assessment of the benefits of the proposed takeover. State clearly any assumptions that
you make.
b) Support your explanation with relevant calculations, including your assessment of the
likely post acquisition share price of KFC if the bid is successful.

TOPIC 15: FOREIGN CURRENCY AND RISK MANAGEMENT
Exchange Rates
An exchange rate is the rate at which one country’s currency is traded in relation to another
country’s currency. There will be two rates being quoted, by dealers for buying and selling the
currencies.
Exchange rates and the European Monetary Union (EMU)
Exchange rates between currencies in the EMU have been fixed in terms of the new European
single currency, the EURO, since its inception in 1999. The UK is not yet a member of the EMU.
The euro is a hard currency.
Spot rates and forward rates
The spot rate is the rate for delivery of the currency immediately. The forward rate is the rate
which applies to a transaction in the currency at a future time. The forward rate will be
determined based on the relative interest rate differences between the countries concerned. We
will look at this issue in the future.
The Foreign Exchange Markets (FX)
The FOREX markets are generally considered to be the largest financial markets in the world.
London is the largest FX market in the world, followed by New York. The demand for foreign
currency usually comes from importers and exporters of goods and services. Banks usually play
an active role in the FX markets.
Foreign Exchange Quotations and Rates
Foreign exchange quotations can be obtained on an immediate basis from FX dealers or from
banks. Major newspaper will quote the latest rates as done up to a point in time.
The rate can be quoted as either:
 Direct Quote – Which is the number of domestic currency units needed to buy one unit of
foreign currency (e.g. from a UK viewpoint, US$1 = £0.64)
 Indirect Quote – Which is the number of foreign currency units needed to buy one unit of
domestic currency (e.g. from a UK viewpoint, US$1.56 = £1)
Currencies can appreciate or depreciate relative to another currency. For example, if the $/£
exchange rate moves from US$1.56/£ to US$1.63£, the £ has strengthened/appreciated, or you
could say that US$ has weakened/depreciated.

Spot exchange rate
This is the rate quoted for immediate delivery of the currency. For example, the $/£ spot rate can
be quoted as follows:
1.4215 – 1.4225
 If buying $ from the bank the company would receive the offer rate of $1.4215 for every £1,
which is the smaller and least favorable of the two rates.
 If selling $ to the bank, the company would have to give to the bank $1.4225 for every £1 it
receives. This is again the least favorable of the two rates. The bank always wins!
The difference between the two rates is the banks profit, and it is also known as the spread.
Dealers at the banks make the market by quoting the bid and offer prices at which they are
prepared to buy and sell. The size of the spread between bid and offer rates varies depending on
the following:
 The stability of the market at the time

 Depth of the market, which refers to the volume of transactions in the market
Influences on exchange rates
The usual factors which influence the movement of exchange rates will be the demand and
supply of the currency. The demand and supply for the currency will in turn come from:
1. The rate of inflation, compared with inflation rate in other countries (Purchasing Power
Parity Theory – see below)
2. Interest rates, compare with interest rates in other countries
3. The balance of payments
4. Speculation
5. Sentiments of investors towards a particular currency
6. Government intervention on exchange rates
Purchasing Power Parity Theory (PPPT)
This theory predicts that the exchange value of a foreign currency depends on the relative
purchasing power of each currency in its own country and that spot exchange rates will vary over
time according to relative price changes. This is also sometimes referred to as the law of one
price. This theory can be used to predict future exchange rates. PPPT can be expressed in the
following equation:

𝟏 + 𝐢𝐟
𝐒𝐭= 𝐬𝐨 𝐱
𝟏 + 𝐢𝐮𝐤
Where: so is the current lower foreign currency spot exchange rate (at time 0)
St is the expected spot rate at time t
if is the expected inflation in the foreign country to time t (expressed as a decimal)
iuk is the expected inflation in the home country to time t (expressed as a decimal)
In the real world, exchange rates move towards PPPT only over the long-term. However, the
theory is sometimes used to predict future exchange rates in investment appraisal problems
where forecast of relative inflation rates are available
Exchange Rate Systems
There are a number of exchange rate policies which are open to governments. These are:
1. Fixed exchange rates – this is a situation where the government rigidly fixes its exchange
rate. The government will intervene in the FX markets to ensure the rate remains fixed.
2. Free floating exchange rates – these are directly opposite the rate suggested above, where
the rate is free to be determined by market forces.
3. A moveable peg system – this is a situation where the government allows the exchange rate
to fluctuate around a peg which it deems to be desirable.
4. Managed floating – where the currency is said to be freely floating, but in reality, the
government may intervene to ‘manage’ the currency. This is sometimes referred to as a
‘dirty’ float.
Foreign currency exposure risk
Exchange risk can be defined as the variability of a firm’s value that is due to uncertain exchange
rate changes. There are three types of exposure to currency risk:
1. Economic exposure risk – this can be defined as the effects of exchange rate movements on
the international competitiveness of a company. Economic exposure may be difficult to
avoid, although diversification of the supplier and customer base across different countries
may reduce this kind of exposure to risk.
2. Translation exposure risk – this refers to the possibility that the book value of shareholders’
funds may change as a result of a movement in exchange rates. It arises due to the need to
prepare periodic financial statements for a group with foreign subsidiaries. Translation
exposure is an accounting concept which may affect future cash flows, and therefore it must
be treated with caution.

3. Transaction exposure risk – is the risk of adverse exchange rate movements occurring in
the course of normal international trading transactions. A transaction can be purchase/sale of
goods or services, repayment of loan and interest or payment of dividend. Note that in
transaction exposure risk, we know the amount of foreign currency involved and the timing
in the future for repayment or receipt of the currency.
We will now look at the various ways in which FOREX risk can be hedged, focusing on
transaction exposure risk:-
Internal hedging techniques
Using domestic currency only
A company can insist that it will only deal with its local currency, either in making payments or
receiving payments. This policy may not really be applicable to a large MNC. It is a policy that
could only be applied by a small company undertaking import and export activities. Even then,
the bargaining position of the company may not allow it.
External hedging techniques
Forward Exchange contracts
A forward exchange contracts is an immediately binding contract between a bank and its
customer, for the purchase or sale of a specified quantity of a stated foreign currency, at a rate of
exchange fixed at the time the contract is made. The performance of the contract will be at a
future time, either at a specified date, or between two specified dates (i.e. an option forward
contract).
The rate quoted on a forward exchange contract is known as a forward rate. This rate is not the
bank predicting future rates, but it is in fact the spot rate adjusted for the interest differential
between the two countries.
Quoting of Forward Rates
Forward rates will be quoted as adjustments to the spot rate. It can be either at a premium or at a
discount to the spot rate. It is important to remember that premiums should be deducted from the
spot rate to find the forward rate and discounts should be added to the spot rate.

Interest rate parity (IRP)
By now it should be obvious to you that the difference spot rates and forward rates is the interest
rate differential. The principle of interest rate parity (not to be confused with PPPT) links the
foreign exchange markets and the international money markets. This principle can be stated as:
𝟏 + 𝐫$ 𝐟$/£
=
𝟏 + 𝐫£ 𝐒$/£
Where: r$ is the dollar ($) interest rate on a deposit for a certain time period
r£ is the pound (£) interest rate on a deposit for the same period of time
f$/£ is the forward exchange rate $/£ for the same time period
S$/£ is the spot exchange rate $/£
Option Forward Contracts
This is also known as a forward option contract, option date forward contract or forward option
dated contract. Such a contract offers the same arrangement as a forward contract except that
there is a choice of dates on which the user can exercise the contract. This is either on any date
up to a specified date or at any time between two future dates. In either case, the forward rate
that applies would be the forward rate, in the period in which the contract can be exercised, that
is the least favorable to the purchaser of the contract.
Money market hedge
With the money market hedged, the idea is either to buy or sell the foreign currency at the spot
rate today thereby fixing the exchange rate today and eliminating the exchange rate risk. The
following Question will help explain these techniques:-

Question 1:
It is now October, 2011. Sexy plc is a UK company which exports goods to the USA. Handsome
Inc, one of the customers, is due to pay US$2,140,000 in 6 months’ time in April, 2012. Sexy plc
is concerned that the $ may weaken relative to the £ before the $ is received.
Exchange rates:
Spot rates: $1.5766 - $1.5775/£
Forward rates:
6 month forward rate $1.5708 - $1.5739/£
9 month forward rate $1.5665 - $1.5709/£
UK: Deposits – 6.6865%

Borrowing – 7.2355%
US: Deposits – 5.533%
Borrowing – 5.875%
Required:
1. Evaluate which is the best method for sexy plc to hedge the currency risk on this transaction,
either a money market hedge or a forward contract.
2. In the past, Handsome Inc has not always paid on the due date and has sometimes paid up to
three months late. What £ would be received if Sexy plc used an option forward contract to
hedge this risk.

Question 2
Rooney Ltd sells shoes to Italy. A shipment has just been made to a major Italian customer, who
has been invoiced in Italian lire, payable in 3 months’ time. The amount due is 56m lire.
Rooney’s financial director has the following information about foreign exchange rates and
interest rates.
Exchange rates, lire/£:

Spot 2,320 – 2,322
3 month forward 15 – 23 dis
Interest rates
Sterling Deposit – 6%
Borrowing – 8%
Lire Deposit – 10%
Borrowing – 12%
Required:
1. What course of action would you recommend to the finance director for converting the lire
into £, so as to maximize £ receipts from the shipment?
2. How your advice would differ, if at all, were Rooney Ltd also due to make a payment of 30m
lire to an Italian supplier in three months’ time?
Question 3:
Repeat the above example, now assuming a payment of 56m lire in three months’ time.

Question 4:
Love (UK) Ltd trades with several countries. During the next six months exports and imports receipts and
payments are due as a result of business with companies in Australia, North Africa, Eastern Europe and
Italy. The transactions are in the currencies specified. It is now 31 Dec.
Payment date Exports Imports

Australia 31 Mar A$ 120,00 £40,000
Italy 31 Mar Lire 400m Lire 220m
North Africa 31 Mar Francs 565,000 -
Italy Between 31 Mar and 30 Lire 500m -
June
Eastern Europe 30 June Tinned meat -
Australia 30 June A$ 180,000 A$ 260,000
West Africa 30 June Coffee Tinned Meat
Italy 30 June - Lire 700m
The exports to Eastern Europe will be paid for by barter exchange of 100,000 tins of meat. Love has
arranged for this tinned meat to be exchange for 70 tons of coffee by its customer in West Africa where
tinned meat is in demand. The West African country’s currency is tied to the French Franc.
Exchange rates
A$/£ Lire/£ Franc/£
Spot 2.1400 – 2.1425 2,208 – 2,210 10.38 – 10.39
3 month forward 2 – 2.5 cents dis 3 – 6 lire dis 5 – 3 centimes pm
6 month forward 3.5 – 4.5 cents dis 5 – 8 lire dis 7 – 5 centimes pm
Commodities Future rate (£/tonne)

Coffee beans
March 791
June 860
Borrowing Lending
UK Bank 15% 10.5%
Australian Bank 16% 13%
Italian Bank Not available 16%
French Bank 9% 6%
Assume that interest rate will not change in the next six months.
Love proposes to invest net sterling proceeds from foreign trade in a UK bank. The company wishes to
hedge against all foreign exchange risk, and currently has no surplus cash. Taxation, transaction costs and
margin requirements on futures contracts may be ignored.
Required:
Using the forward market, money market or commodity futures market, as appropriate, estimates the
maximum size of cash surplus or the minimum size of cash that will result from Love’s foreign trade at
the end of six months.

Foreign currency derivatives
Foreign currency derivatives can be used to hedge foreign currency risk. Futures contracts,
option and swaps are types of derivative
Currency futures
Currency futures are standardized contracts for the sale or purchase at a set future data of a set
quantity of currency. Currency futures are not nearly as common as forward contracts and their
market is much smaller
A currency future is a standardized contract to buy or sell a specified quantity of foreign

currency.
A future market is an exchange traded market for the purchase or sale of a standard quantity of
an underlying item such as currencies, commodities or shares for settlement at a future date at an
agreed price.
The contract size is the fixed minimum quantity of commodity which can be bought or sold
using a futures contract. In general, dealing on future markets must be in a whole number of
contracts.
The contracts price is the price at which the futures contract can be bought or sold. For all
currencies futures the contract price is in US dollars. The contract price is the figure which is
traded on the futures exchange. It changes continuously and is the basis for computing gains or
losses.
The settlement date (or delivery date, or expiry date) is the date when trading on a particular
futures contract stops and all accounts are settled .On the international Monetary Market (IMM,
in Chicago),the settlement dates for all currency futures are at the end of March, June, September
and December.
A future’s price may be different from the spot price, and this difference is the basis
Basis = spot price – future price
One tick is the smallest measured movement in the contract price. For currency futures this is a
movement in the fourth decimal place.
Market trader will compute gains or losses on their futures position by reference to the number of
ticks by which the contract price has moved.

Exercise 5
A US company buys goods worth €720000 from a German company payable in 30 days. The US
company wants to hedge against the € strengthening against the dollar. Current spot is 0.9215 –
0.9221 € and the € future rate is 0.9245 €.The standard size of a 3 month € future contract is
€125000. In 30 days’ time the spot is 0.9345-0.9351€.Closing future price will be 0.9367.
Evaluate the hedge.
Exercise 6
Assume that it is now 30 June, KYT Inc. Is a company located in the USA that has contracted to
purchase goods from Japan in two months’ time on 1 September? The payment to be made in
yen and will total 140 million yen. The managing director of KYT Inc wishes to protect the
contract against adverse movement in foreign exchange rates and is considering the use of
currency futures. The following data are available.
Spot foreign exchange rate: Yen /$128.15
Yen currency futures contract on SIMEX (Singapore Monetary Exchange)

Contract size 12,500,000 yen, contract prices are in US$ per yen.
Contract prices
September = 0.007985
December = 0.008250
Assume that future contracts mature at the end of the month.
Required:
a) Illustrate how KYT might hedge its foreign exchange risk using currency futures.
b) Show what is the basis risk is involved in the proposed hedge.
c) Assuming that spot exchange rate is 120 yen/$ on 1 September and that basis risk decreases
steadily in a linear manner, calculate what is the result of the hedge is expected to be. Briefly
discuss why this result might not occur. Margin requirements and taxation may be ignored.

Advantage of futures to hedge risks
a) Transaction cost should be lower than other hedging methods.

b) Future are tradable and can be bought and sold on secondary market so there is pricing
transparency, on like forward contract where prices are set by financial institution.
c) The exact date of receipt or payment of the currency does not have to be known because
the futures contract does not have to be closed out until the actual cash receipt or payment
is made.
Disadvantage of futures
a) The contract can’t be tailored to the user exact requirement

b) Hedge inefficiencies are caused by having to deal in a whole number of contracts and by
basis risk ((the risk that the futures contract price may move by a different amount from the
price of the underlying currency or commodity)
c) Only a limited number of currencies are the subject of futures contracts (although the
number of currencies is growing, especially with the rapid development of Asian economies)
d) Unlike options (see below), they do not allow a company to take advantage of favourable
currency movements.
Currency options
Currency options protect against adverse exchange rate movements while allowing the
investor to take advantage of favourable exchange rate movement. They are particularly useful in
the situation where the cash flow is not certain to occur (e.g. when tendering for overseas
contracts).
A currency option is a right of an option holder to buy (call) or sell (put) foreign currency at a
specific exchange rate at a future date.
The exercise price for the option may be the same as the current spot rate or it may be more
favourable or less favourable to the option holder than the current spot rate.
Companies can choose whether to buy:
a) A tailor- made currency option from the bank, suited to the company’s specific needs. These
are over – the counter (OTC) or negotiated option, or
b) A standard option in certain currencies only from an option exchange such option are traded
or exchange traded option.
Buying a currency option involves paying a premium which is the most the buyer of the option
can lose

The purpose of currency options
The purpose of currency option is to reduce or eliminate exposure to currency risks and it is
particularly useful for companies in the following situations:
a) Where there is uncertainty about foreign currency receipts or payments either in timing or
amount. Should the foreign exchange transaction not materialize the option can be sold
on the market (if it has any value) or exercised if this would make a profit.
b) To support the tender for an overseas contracts, priced in a foreign currency
c) To allow the publication of price lists for its goods in a foreign currency
d) To protect the import or export of price – sensitive goods
In both situation (b) and (c), the company would not know whether it had won any export sales
or would have any foreign currency income at the time that it announces its selling prices. It
cannot make a forward exchange contract to sell foreign currency without becoming exposed in
the currency.
Drawbacks of currency options
 The cost depends on the expected volatility of the exchange rate.

 Option must be paid for as soon as they are bought
 Tailor- made option lack negotiability
 Traded option are not available in every currency.
Exercise 7
Lukey plc is expecting to receive 20 million Austrian Schillings (Sch) in one month’s time. The
current spot rate is Sch/£ 19.3383 – 19.3582.Compare the results of the following action:
a) The receipt is hedged using a forward contract at the rate 19.3048.

b) the receipt is hedged by buying an OTC options from the bank ,exercise price Sch/£19.30,
premium cost 12 pence per 100 Schillings
c) The receipt is not hedged
In each case, compute the results if in one month the exchange rate moves to :
a) 21.00
b) 17.60

Let out is a French company that trades frequently with the Germany and the USA. Transaction
to be completed within the next six months as follows:
Receipts Payments
3 months’ time $4.8 million $ 7.6 million
6 months’ time DM 4.5 million DM 2.8 million
Exchange rates in Paris
FF/DM FF/$
Spot 3.3260 – 3.3310 5.5640 – 5.5910
3 months forward 3.3105 – 3.3160 5.5880 – 5.6190
6 months forward 3.2978 – 3.3036 5.6020 – 5.6320
Current bank prime rate (per annum)
3 months 6 months
France 6% 6.25%
Germany 8% 8.30%
USA 4% 4.25%
Let out can borrow at prime plus 1% in France and prime plus 1.5% in Germany and can invest
at 1% below prime in France and Germany.
Franc market traded option prices (125,000 francs contracts size) in the USA
(The option relate to the purchase or sale of French francs)
Exercise price ($ FF) June Contracts September Contracts

Calls Puts Calls Puts
0.175 0.331 0.082 0.476 0.143

0.180 0.112 0.241 0.203 0.314
0.185 0.034 0.530 0.096 0.691
Option prime are in cents per franc and are payable up front. The option is American style.
Assume that it is now 1 June and that option contracts mature on the 15th of the month
Required:
Discuss with supporting calculation how Let out should hedge its foreign exchange risk during
the next six month. Include in you discussion comment about which currency option contracts
might be best for Let out. The company does not wish to take significant risk and wishes to
accumulate as high a cash flow as possible from its foreign trade transaction. Let out currently
has an overdraft of 5.5 million francs. Transaction costs may be ignored.
State clearly any assumption that you make

Currency Swaps
Currency swaps effectively involve the exchange of debt from one currency to another.
Currency swaps can provide a hedge against exchange rate movement for longer period than the
forward market and can be means of obtaining finance from new countries
A swap is a formal agreement whereby two organizations contractually agree to exchange
payment on different terms, e.g.: in different currencies or one at a fixed rate and the other at a
floating rate”
In a currency swap, the parties agree to swap equivalent amount of currency for a period .This
effectively involves the exchange of debt form one currency to another. Liability on the main
debt (the principal) is not transferred and the third parties are liable to counter party risk: if the
other party defaults on the agreement to pay the interest, the original borrower remains liable to
the lender.
Consider a UK company X with a subsidiary Y in France which owns vineyards. Assume a spot
rate of £1 = 1.6 Euros .Suppose the parent company X wishes to raise the loan of 1.6 million
Euros for the purpose of buying another French wine company. At the same time, the French
subsidiary Y wishes to raise £1 million to pay for new up - to – date capital equipment imported
from UK.The UK parent company X could borrow the £1 million sterling and the French
subsidiary Y could borrow the 1.6 million Euros each effectively borrowing on the other’s
behalf. They would then swap currencies.
Benefits of the current swap
a) Swaps are easy to arrange and are flexible since they can be arranged in any size and are
reversible.
b) Transaction costs are low, only amounting to legal fees, since there is no commission or
premium to be paid.
c) The parties can be obtain the currency they require without subjecting themselves to the
uncertainties of the foreign exchange markets
d) The company can gain access to debt finance in other country and currency where it is
little known and consequently has a poorer credit rating ,than in its how country .It can
therefore take advantage of lower interest rates than its could obtain if it arranged the
currencies loan itself.
e) Currency swap may be used to restructure the currency base of the company liabilities.
This may be important where the company trading overseas and receiving revenues in
foreign currencies, but its borrowings are denominated in the currency of its home
country. Currency swaps therefore provide a means of reducing exchange rate exposure.

f) At same time as exchanging currency, the company may also be able to convert fixed rate
debt to floating rate or vice versa. Thus it may obtain some of the benefits of an interest
rate swap in addition to achieving the other purpose of a currency swap.
g) A currency swap could be used to absorb excess liquidity in one currency which is not
needed immediately, to create funds in another where there is a need.
In practice most currency swap are conducted between banks and their customers. An agreement
may only be necessary if the swap were for longer than say one year.
Exercise 9
Suppose that A plc a UK construction company wins a contract to construct a bridge in

Argentina. The bridge will require an initial investment now and will be sold to the Argentinean
Government in one years’ time. The Government will pay in poses. Say the bridge will require
an initial investment of 100m pesos and it will be sold for 200m pesos in one year time. The
currency spot rate is 20pesos/£, and the government has offered a currency swap at 20 pesos/£.A
plc cannot borrow pesos directly and there is no forward market available. The estimated spot
rate in one year is 40 pesos/£ .The current UK borrowing rate is 10%.
Required :
Determine whether A plc should do nothing or hedge its exposure using a currency swap.

Exercise 10
Goldsmith mining plc wishes to hedge 1 year foreign exchange risk, which will arise on an
investment in Chile. The investment is for 800m escudos and is expected to yield an amount of
1000m escudos in 1 year time. Goldsmith cannot borrow escudos directly and is therefore
considering two possible hedging techniques:
(a) Entering into a forward contract for the full 1000m escudos receivable
(b) Entering into a currency swap for the 800m escudos initial investment, and then a
forward contract for the 200m escudos profit element.
The currency spot rate is 28 escudos to the pound and the bank has offered a currency swap at 22
escudos/pound with Goldsmith making a net interest payment to the bank of 1% in sterling
(assume at T1 )
Interest Rates Borrowing Lending

UK 15% 12%
Chile N/A 25%
A forward contract is available at a rate of 30 escudos per pound.
Required
Determine whether Goldsmith should hedge its exposure using a forward contract or a currency
swap.

TOPIC 16: INTEREST RATE RISK MANAGEMENT
Interest rate risk refers to a risk of an adverse movement in interest rates and thus a reduction in
the company net cash flow.
Three important considerations in this respect:-
(1) Maturity mix

The treasurer must avoid having too much debt becoming repayable within a short period
(2) Currency mix
Foreign currency debts create a risk of losses through adverse movement in foreign exchange
rates before the debts falls due for payment. Foreign currency management involves hedging
against foreign currency risk, for example by means of forward exchange contracts or having
debts in several currencies some of which will strengthen and some of which will weaken
over time
(3) The mix of fixed interest and floating rate debts
i) Too much fixed interest rate debts creates an unnecessary cost when market interest
rates fall. A company might find itself committed to high interest costs that it could
have been avoided
ii) Too much borrowing at a floating or variable rate of interest (such as bank overdrafts
and medium term bank lending) leads to high cost when interest rates go up.
Over the counter market Exchange traded instrument Purpose

FRA - Forward Rate Interest rate futures To lock the company in to a
Agreement target interest rate. To
hedge both adverse and
favourable movements
IRG – Interest Rate Interest rate option on futures To protect the company
Guarantee from adverse movement
and allow it takes
advantages of favourable
movements
Instruments bought on the Over the Counter Market OTC are purchased from the major bank
and are usually tailor made to suit the precise requirement of the company. The exchange
traded instruments are of a standard size thus ensuring that they are marketable. In the UK
the market where these instruments are bought and sold is the London International Financial
Futures and Option Exchange (LIFFE)

Forward Rate Agreement (FRA)
Objective is to fix the rate of interest payable (or receivable in the case of deposits) It
protects against downside risk, but does not allows the firm to take advantage of favourable
movement
Example
A 2 v 5 FRA at 6.00 – 5.70
This means an agreement to borrow or lend starts in two months’ time and ends in 5 months’
time (this means borrowing or lending for a period of 3 months ).The higher rate is for
borrowing and the lower rate is for lending
 The company is protected from a rise in interest rates but is not able to benefit from a
fall in interest rate-locked it-a FRA hedges the company against both an adverse
movement and a favourable movement.
 The FRA is a totally separate contractual agreement from the loan itself and could be
arranged with a completely different bank.
 Usually on amounts > £1m the daily turnover in FRAs now exceeds £4bn
 As an OTC instrument they can be a tailor made to the company precise requirement
 Enables you to hedge for a period of one month up to two years
Interest Rate Guarantees (IRG)
Interest rate guarantee like all option protect the company from adverse movement and allows it
take advantage of favourable
Decision rules:
If there is an adverse movement If there is a favourable movement
Exercise the option to protect Allow the option to lapse
IRGs are more expensive than the FRAs as one has to pay for the flexibility to be able to take
advantage of a favourable movement
If the company treasurer believes that interest rates will rise, will he use an FRA or an IRG? He
will use an FRA as it is the cheaper way hedge against the potential adverse movement
If the treasurer is unsure which way interest will move he may be willing to use the more
expensive IRG to be able to benefit from fall in interest rates?

Interest rate futures
The aim:
To lock the company into the current future interest rate (plus or minus the margin).To hedge
both adverse and favourable interest rate movement
Buy or sell future contracts?
Interest rate futures are effectively contracts to buy or sell the interest on a notional three
month deposit.
If you buy a futures contract you have a contract to deposits money – what you are buying is
the entitlement to interest receipts
If you buy a futures contract you have a contract to borrow money – what you are selling is
the promise to make interest payments
Deposits Loans
Buy futures Sell futures
This contracted depositing or borrowing starts on the date when futures contract expires i.e. a
December futures contract obliges us to deposits or borrow for three months starting at the end of
December.
However th depositing or borrowing is only notional because we close out the position by
reversing the original deal before the real depositing or borrowing starts i.e. before the expiry
date of the contract.
This means selling futures if you previously bought them or buying them if you previously sold
them to close out the position .The contract cancel out against each other i.e. we have contract to
borrow and deposits the same amounts of money.
The only cash flow that arises is the net interest paid or received i.e. the profit or loss on the
future contracts.
The future contracts arise is priced as (100-r) where r is the interest rate. This implies that the
future price and interest rates moves in an adverse manner.
The aim of the interest rate futures hedge is to obtain a profit in the futures position to offset any
loss on the spot/cash market. However, a futures hedge is rarely perfect due to the existence of
basis.

Basis:
The current interest rate (cash market rate) and the future interest rate (the futures prices) are
normally different. This difference is called the basis.
The basis risk:
Indeed between now and the date the rate is agreed the future rates do not normally move by
exactly the same amount as the cash market rates in which case a perfect hedge will not occur
and the future gain could be smaller or greater than the cash market loss. This risk of this
occurring is known as basis risk.
The futures hedge is imperfect due to:
1) Basis risk – the future rate (as defined by the future prices) moves approximately but not
precisely in line with the cash market rate.
2) If you are not dealing in whole contract and have to round-up to whole contracts
Interest rate futures contract are of standard sizes
The short sterling contract or the 3 month sterling contract traded on LIFFE is always the
standard size of £500,000.One feature of the futures market is that you can only deal in whole
contacts. Therefore you simply have to round to the nearest whole number.
Calculation of no. of contracts
𝐋𝐨𝐚𝐧 𝐨𝐫 𝐝𝐞𝐩𝐨𝐬𝐢𝐭 𝐚𝐦𝐨𝐮𝐧𝐭 𝐋𝐨𝐚𝐧 𝐨𝐞 𝐝𝐞𝐩𝐨𝐬𝐢𝐭𝐬 𝐩𝐞𝐫𝐢𝐨𝐝 𝐢𝐧 𝐦𝐨𝐧𝐭𝐡𝐬

×
𝐂𝐨𝐧𝐭𝐫𝐚𝐜𝐭 𝐬𝐢𝐳𝐞 𝟑 𝐦𝐨𝐧𝐭𝐡𝐬 − 𝐜𝐨𝐧𝐭𝐫𝐚𝐜𝐭 𝐝𝐮𝐫𝐚𝐭𝐢𝐨𝐧
Profit/loss on the futures contracts
A tick is a minimum price movement in the futures price. A tick is 0.01% (in decimal, it is
0.0001)
1% is equal to 100 ticks or basis points. The ticks can be used to calculate the profit or loss on a
future contract. The value of a tick on a short sterling £500,000 3 months futures contract is
£500,000 x 0.01% x 3/12 = £12.50
The profit will be = ticks/contracts x tick value x number of contracts

Exchange Traded Interest Rate Options
These are options to buy or sell futures. Therefore all the futures information is still valid:
1) The standard size of the contracts i.e. £500,000

2) The duration of the contracts i.e.3 months contracts
3) The appropriate tick value i.e. £12.50
4) Maturity dates end of March, June, September and December
Call or Put options?
A call option gives the holder the right to buy the futures contracts
A put option gives the holder the right to sell the futures contract
You always buy the option – buy the right to buy or buy the right to sell
Cash Market : Deposits Loan
Futures Market : Buy futures contracts Sell futures contracts
Options Market : Buy Calls Buy Puts

Practice Questions
Question 1
The monthly cash budget of HYK Communication plc shows that the company is likely to need
£18m in two months’ time for a period of four months. Financial markets have recently been
volatile due to uncertainties about the impact of the ‘millennium bug’. If severe computer
problem occur in January 2000 the finance director of HYK plc fears that the short term interest
rates could rise by as much as 150 basis points. If few problems occur then short term rates could
fall by 50 basis points. LIBOR is currently 6.5% and HYK plc can borrow at LIBOR + 0.75%
The finance director does not wish the pay more than 7.5% including option premium costs buts
excluding the effect of margin requirements and commissions:
LIFFE £500,000 3 months futures prices are as follows: (The value of one tick is £12.50)
December 93.40
March 93.10
June 93.75
LIFFE £500,000 3 months option prices (premiums in annual %)
Exercise Calls Puts

Price
December March June December March June
92.50 0.33 0.88 1.04 - - 0.08
93.00 0.16 0.52 0.76 - 0.20 0.34
93.50 0.10 0.24 0.42 0.18 0.60 1.93
94.00 - 0.05 0.18 0.36 1.35 1.92
Assume that it is now 1 December and that exchange traded futures and options contracts expire
at the end of the month. Margin requirements and default risk may be ignored
Required:
a) Discuss the results of undertaking EACH of an interest rate futures hedge and an interest
rate options hedge on LIFFE exchange, if LIBOR
i) Increases by 150 basis points AND
ii) Decreases by 50 basis points.
Discuss how successful the hedges would have been. State clearly any assumption that you
make

b) Discuss the relative advantages of using exchange traded interest rate options and over-
the – counter (OTC) interest options
c) Your finance director has received some quotation for over – the –counter (OTC) interest
rate options and wonders whether or not they are too expensive. Outline the main
determinants if interest rate option prices and comment upon whether or not the OTC
options are likely to be expensive

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TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT

Financial Management Function

Introduction to Financial Management

Objectives of a Company Risk Financial Intermediaries

The Balance Sheet and FM £ £

Less: Current Liabilities (x) Working Capital

Net Current Assets x

Less: Non-current Liabilities (Debt) (x)

Capital (Shares or Equity) x

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 1

 Capital investment – Investment in non-current assets.

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 2

 Maximize sales revenue – Dangerous if profits and wealth are ignored.

Ownership and Control (Corporate Governance)

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 3

THE FINANCIAL ENVIRONMENT

Investors and savers FINANCIAL INTERMEDIARY Borrowers and Users

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 4

You need to be aware of the differences between:

Primary and Secondary Markets

Money and Capital Markets

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 5

Working Capital Management:

 Working Capital Measures

Ensuring current assets are Maximizing the return on

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 6

The level of working capital required is affected by the following factors:

Funding working capital – SHORT OR LONG TERM

Total Assets (£)

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 7

Total Assets (£)

WORKING CAPITAL MEASRURES

There are two kinds of measures:

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 8

𝐅𝐢𝐧𝐢𝐬𝐡𝐞𝐝 𝐆𝐨𝐨𝐝𝐬 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

*Or nearest approximation – depending on available data (Cost of Sales).

𝐓𝐫𝐚𝐝𝐞 𝐏𝐚𝐲𝐚𝐛𝐥𝐞 𝐁𝐚𝐥𝐚𝐧𝐜𝐞

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 9

Income Statement extract £

Balance Sheet extract

Inventory - Raw material 25,000

Trade Receivables 35,000

Trade Payables 55,000

Required: Calculate the operating cycle

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 10

• It helps the business concern in maintaining the goodwill.

Disadvantages of working capital:

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 11

The Quick or Acid Test Ratio

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 12

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐚𝐬𝐬𝐞𝐭𝐬 − 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲

Other Liquidity Ratios

Net Working Capital

𝐍𝐞𝐭 𝐖𝐨𝐫𝐤𝐢𝐧𝐠 𝐂𝐚𝐩𝐢𝐭𝐚𝐥

©Johnson (BA (Hons) Accounting and Finance, AIA) Page 13

Measure of how long a firm or business could keep running.

Long-Term Solvency Measures

Total Debt Ratio

𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲