2024 Bcta Corporate Finance Module

BCTA CORPORATE FINANCE MODULE
Bridging Course to the Certificate in Theory of Accounting (BCTA)

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Corporate Finance (CPF 301)
Corporate Finance Module

1st Edition 2021
2nd Edition 2022
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4th Edition 2024
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to reproduce past examination questions. The
suggested solutions in the practice answer bank
www.caa.ac.zw [email protected] have been prepared by CAA Learning Media,
unless otherwise stated.
CAA Learning Media is an ICAZ Approved Learning Partner. This means we work closely with ICAZ to ensure
this Study Text contains the information you need to adequately prepare for your BCTA Examinations and
ultimately ZCTA and ICAZ ITC.
In this Study Text, which has been reviewed by the CAA examination team, we:
• Highlight the most important elements in the syllabus and the key skills you need.
• Signpost how each chapter links to the syllabus and the study guide.
• Provide lots of exam focus points demonstrating what is expected of you in the exam.
• Emphasise key points in regular fast forward summaries.
• Test your knowledge in quick quizzes.
• Examine your understanding in our practice questions.
• Video material accessible through MyCAA learning portal supports this module.
Property of CAA Learning Media © for 2024 Examinations

Introduction ............................................................................................................................................................. 3
Unit 1: Sources of Finance ....................................................................................................................................... 7
Unit 2: Time Value of Money ................................................................................................................................. 33
Unit 3: Lease vs Buy Decision ................................................................................................................................ 65
Unit 4: Theory of capital structure......................................................................................................................... 76
Unit 5: Cost of equity ............................................................................................................................................. 96
Introduction
Dear BCTA Student
Congratulations on successful enrolment for the BCTA program and wishing you all the best in
the examinations. The BCTA course offered by the Academy is specifically tailored to develop
technical skills and create a strong foundation to the professional education of chartered
accountants. This module has been written to help you in your preparation of your BCTA
Corporate Finance examinations. It is important for you to ensure that you grasp the principles
and the integration that is needed in the BCTA examination.
1. Study technique
NB: This is a model study technique. Different people will have different styles of studying and
hence must tweak this model to fit their personal styles.
i. Lectures
1.1. Pre-read the section that will be lectured in the week.
1.2. Watch the video lecture for the week’s topic.
1.3. Note down any points which you do not understand.
1.4. Attend the lecture and be attentive (take down notes).
ii. After Lecture

a. Revise the lecture including your lecture notes.
b. Attempt the lecture examples and note what you don't understand.
c. Attempt one of your tutorials to see if you understand the topic (note down anything you
don't understand or identify what you are always missing out).
iii. Doing Tutorials

a. Do tutorials prior to going for your tutorial.
b. Attempt the seen tutorials first and then the unseen i.e. do the tutorials where you have
the solution.
c. Do all tutorials blind i.e. do not look at solutions.

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d. Stick to the time allocated for the tutorial question i.e. 1.5 minutes per mark.
e. After the time limit continue writing with a different colour pen.
f. Mark your tutorial against the solution and identify:
i. Where you are losing marks after the time limit then you have a time
problem. Work on your time. ii. Where you are losing marks within the time
limit then you have concept problems. iii. Note down what you don't
understand and write down the principles regarding the issues you don't
understand.

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iv. Participate in the tutorial and ask questions on the issues you don't understand
down what you don't understand.
iv. Attempting Questions

a. Use about 10% of the allocated time to read the question and plan.
b. Read the given information for the first time.
c. Read the given information in detail for a second time and underline or
highlight the key points.
d. Read all the required questions briefly and see whether there are linkages
between the questions.
e. Also identify questions which are not linked and can be answered in isolation.
This helps identify easy marks.
f. Read the first required in detail:
i. Highlight the key points the question requires you to address (therefore do
not do what the question is not asking as this will lead to time wasting). ii.
Determine whether you have identified all the information to answer the
question.
iii. Attempt to answer the question.
Lecturing Team
Name Contact details

Elliot T. Wonenyika CA(Z) [email protected]
(04) 702532/5, +2638644121786
Innocent Sithole CA(Z) [email protected]
(04) 702532/5, +2638644121786
Nyasha Gonyora [email protected]
(04) 702532/5, +2638644121786
Once again, all the best and may God bless you as you engage on this journey.

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Phillippians 3:13 “Brothers, I do not consider that I have made it my own. But one thing I do:
forgetting what lies behind and straining forward to what lies ahead.”
2. Course Outline
1. SEMESTER ONE
Corporate Finance
1.1.1. Sources of finance
1.1.2. Time value of money 1.1.3.
Lease vs buy decision.
1.1.4. Theory of capital structure
1.1.5. Cost of equity
2. SEMESTER TWO
Investment Analysis
2.1.1. Corporate strategy
2.1.2. Risk and return 2.1.3.
Capital budgeting.
2.1.4. Valuations
Management Accounting and Decision Making
3.1.1. Introduction to cost and management accounting

3.1.2. Mathematical approaches
3.1.3. Cost accumulation systems
3.1.4. CVP analysis
3.1.5. Budgeting
3.1.6. Standard costing and variance analysis

Unit 1: Sources of Finance
1. Introduction
This study unit provides an overview of the various sources from where funds canbe
procured for starting and running a business. We shall discuss the advantages
and limitations of various sources and point out the factors that determine the choice of a suitable
source of business finance. It is important for any person who wants to start a business to know
about the different sources from where money can be raised. It is also important to know the
relative merits and demerits of different sources so that choice of an appropriate source can be
made.
2. Study unit objectives

Understand capital and money markets.
List and identify possible sources of funds.
Describe the role, characteristics, advantages and disadvantages of various sources of
financing.
Suggest which source of financing is most appropriate in a certain circumstance.
2.1 Learning Outcomes

Define the different types of financial markets.
Explain the role of the Zimbabwe Stock Exchange (ZSE) in raising finance.
Detail the listing criteria of the ZSE.
Detail the types of financial institutions.
Describe the role of private equity.

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Explain the types of financial instruments.

Describe the pricing of a rights issue.
Distinguish between equity and debt-related instruments.
Explain criteria by which to evaluate sources of finance.

Study Unit Content
Meaning, nature, and significance of business finance
Business is concerned with the production and distribution of goods and services for the
satisfaction of needs of society. For carrying out various activities, business requires money.
Finance, therefore, is called the life blood of any business. The requirements of funds by
business to carry out its various activities is called business finance. A business cannot function
unless adequate funds are made available to it. The initial capital contributed by the
entrepreneur is not always sufficient to take care of all financial requirements of the business.
A businessperson must look for different sources from where the need for funds can be met.
A clear assessment of the financial needs and the identification of various sources of finance,
therefore, is a significant aspect of running a business organisation. The need for funds arises
from the stage when an entrepreneur makes a decision to start a business.
The financial needs of a business can be categorised as follows:
(a) Fixed capital requirements:
To start a business, funds are required to purchase fixed assets like land and building, plant
and machinery, and furniture and fixtures. This is known as fixed capital requirements of the
enterprise. The funds required in fixed assets remain invested in the business for a long period
of time. Different business units need varying amount of fixed capital depending on various
factors such as the nature of business, etc. A trading concern for example, may require small
amount of fixed capital as compared to a manufacturing concern. Likewise, the
need for fixed capital investment would be greater for a large enterprise, as compared to that
of a small enterprise.
(b) Working capital requirements:
The financial requirements of an enterprise do not end with the procurement of fixed assets.
No matter how small or large a business is, it needs funds for its day-to-day operations. This
is known as working capital of an enterprise, which is used for holding current assets such as
stock of material, bills receivables and for meeting current expenses like salaries, wages, taxes,
and rent. The amount of working capital required varies from one business concern to another
depending on various factors. A business unit selling goods on credit, or having a slow sales
turnover, for example, would require more working capital as compared to a concern selling
its goods and services on cash basis or having a speedier turnover. The requirement for fixed
and working capital increases with the growth and expansion of business. At times additional
funds are required for upgrading the technology employed so that the cost of

production or operations can be reduced. Similarly, larger funds may be required for building
higher inventories for the festive season or to meet current debts or expand the business or
to shift to a new location. It is, therefore, important to evaluate the different sources from
where funds can be raised.
Classification of sources of funds
In case of proprietary and partnership concerns, the funds may be raised either from personal
sources or borrowings from banks, friends etc. In case of company form of organisation, the
different sources of business finance which are available may be categorised as given in Table
below:
As shown in the table, the sources of funds can be categorised using different basis, for
example, based on the period, source of generation and the ownership. A brief explanation
of these classifications and the sources is provided as follows:
Source : kvinsvalsura
Period Basis
Based on period, the different sources of funds can be categorised into

three parts. These are long-term sources, medium-term sources, and short-term sources. The
long-term sources fulfil the financial requirements of an enterprise for a
period exceeding 5 years and include sources such as shares and debentures, longterm
borrowings and loans from financial institutions. Such financing is generally required for the
acquisition of fixed assets such as equipment, plant, etc.
Where the funds are required for a period of more than one year but less than five years,
medium-term sources of finance are used. These sources include borrowings from
commercial banks, public deposits, lease financing and loans from financial institutions.
Shortterm funds are those which are required for a period not exceeding one year. Trade
credit, loans from commercial banks and commercial papers are some of the examples of the
sources that provide funds for short duration. Short-term financing is most common for
financing of current assets such as accounts receivable and inventories. Seasonal businesses
that must build inventories in anticipation of selling requirements often need short term
financing for the interim period between seasons. Wholesalers and manufacturers with a
major portion of their assets tied up in inventories or receivables also require large amount
of funds for a short period.
Ownership Basis
Based on ownership, the sources can be classified into ‘owner’s funds’ and ‘borrowed funds.
Owner’s funds mean funds that are provided by the owners of an enterprise, which maybe a
sole trader or partners or shareholders of a company. Apart from capital, it also includes profits
reinvested in the business. The owner’s capital remains invested in the business for a longer
duration and is not required to be refunded during the life period of the business.
Such capital forms the basis on which owners acquire their right of control of management.
Issue of equity shares and retained earnings are the two important sources from where
owner’s funds can be obtained. ‘Borrowed funds’ on the other hand, refer to the funds raised
through loans or borrowings. The sources for raising borrowed funds include loans from
commercial banks, loans from financial institutions, issue of debentures, public deposits, and
trade credit. Such sources provide funds for a specified period, on certain terms and
conditions and must be repaid after the expiry of that period. A fixed rate of interest is paid
by the borrowers on such funds. At times it puts a lot of burden on the business as payment
of interest is to be made even when the earnings are low or when loss is incurred. Generally,
borrowed funds are provided on the security of some fixed assets.
Source of Generation Basis
Another basis of categorising the sources of funds can be whether the funds are generated
from within the organisation or from external sources. Internal sources of funds are those that
are generated from within the business. A business, for example, can generate funds internally

by accelerating collection of receivables, disposing of surplus inventories, and ploughing back

its profit. The internal sources of funds can fulfill only limited needs of the business.
External sources of funds include those sources that lie outside an organisation, such as
suppliers, lenders, and investors. When large amount of money is required to be raised, it
is generally done using external sources. External funds may be costly as compared to those
raised through internal sources. In some cases, business is required to mortgage its assets as
security while obtaining funds from external sources. Issue of debentures, borrowing from
commercial banks and financial institutions and accepting public deposits are some of the
examples of external sources of funds commonly used by business organisations.
A business can raise funds from various sources. Each of the source has unique characteristics,
which must be properly understood so that the best available source of raising funds can be
identified. There is not a single best source of funds for all organisations. Depending on the
situation, purpose, cost and associated risk, a choice may be made about the source to be
used. For example, if a business wants to raise funds for meeting fixed capital requirements,
long term funds may be required which can be raised in the form of owned funds or borrowed
funds. Similarly, if the purpose is to meet the day-to-day requirements of business, the
shortterm sources may be tapped. A brief description of various sources, along with their
advantages and limitations is given below.
Trade Credit
Trade credit is the credit extended by one trader to another for the purchase of
goods and services. Trade credit facilitates the purchase of supplies without immediate
payment. Such credit appears in the records of the buyer of goods as ‘sundry creditors’ or
‘accounts payable’. Trade credit is commonly used by business organisations as a source of
short-term financing. It is granted to those customers who have reasonable amount of
financial standing and goodwill. The volume and period of credit extended depends
on factors such as reputation of the purchasing firm, financial position of the seller,
volume of purchases, past record of payment and degree of competition in the market.
Terms of trade credit may vary from one industry to another and from one person to another.
A firm may also offer different credit terms to different customers.
Merits
The important merits of trade credit are as follows:
(i) Trade credit is a convenient and continuous source of funds;
(ii) Trade credit may be readily available in case the credit worthiness of the customers
is known to the seller.
(i) Trade credit needs to promote the sales of an organisation;

(ii) If an organisation wants to increase its inventory level in order to meet expected
rise in the sales volume in the near future, it may use trade credit to, finance the
same;
(iii) It does not create any charge on the assets of the firm while providing funds.
Limitations
Trade credit as a source of funds has certain limitations, which are given as follows:
(i) Availability of easy and flexible trade credit facilities may induce a firm to
indulge in overtrading, which may add to the risks of thefirm;
(ii) Only limited amount of funds can be generated through trade credit. (iii) It is
generally a costly source of funds as compared to most other sources of raising
money.
Factoring
Factoring is a financial service under which the ‘factor’ renders various services which
includes:
(a) Discounting of bills (with or without recourse) and collection of the client’s debts.
Under this, the receivables on account of sale of goods or services are sold to the factor
at a certain discount. The factor becomes responsible for all credit control and debt
collection from the buyer and provides protection against any bad debt losses to the firm.
There are two methods of factoring — recourse and non-recourse. Under recourse
factoring, the client is not protected against the risk of bad debts. On the other hand, the
factor assumes the entire credit risk under non-recourse factoring i.e., full amount of
invoice is paid to the client in the event of the debt becoming bad.
(b) Providing information about credit worthiness of prospective client’s etc., Factors
hold large amounts of information about the trading histories of the firms. This can be
valuable to those who are using factoring services and can thereby avoid doing business
with customers having poor payment record. Factors may also offer relevant consultancy
services in the areas of finance, marketing, etc. The factor charges fees for the services
rendered.
Merits
The merits of factoring as a source of finance are as follows:
(i) Obtaining funds through factoring is cheaper than financing through other means
such as bank credit;
(ii) With cash flow accelerated by factoring, the client is able to meet his/her liabilities
promptly as and when these arise;

(iii) Factoring as a source of funds is flexible and ensures a definite pattern of cash
inflows from credit sales. It provides security for a debt that a firm might otherwise
be unable to obtain;
(iv) It does not create any charge on the assets of the firm; The client can concentrate
on other functional areas of business as the responsibility of credit control is
shouldered by the factor.
Limitations
The limitations of factoring as a source of finance are as follows: (i) This source is expensive
when the invoices are numerous and smaller in amount. (ii) The advance finance provided by
the factor firm is generally available at a higher interest cost than the usual rate of interest.
Ordinary (equity) shares
Ordinary shares are issued to the owners of a company. They have a nominal or 'face' value,
typically of $1 or 50 cents. The market value of a quoted company's shares bears no
relationship to their nominal value, except that when ordinary shares are issued for cash, the
issue price must be equal to or be more than the nominal value of the shares.
Deferred ordinary shares.
They are a form of ordinary shares, which are entitled to a dividend only after a certain date
or if profits rise above a certain amount. Voting rights might also differ from those attached
to other ordinary shares.
Ordinary shareholders put funds into their company:
a) by paying for a new issue of shares
b) through retained profits.
Simply retaining profits, instead of paying them out in the form of dividends, offers an
important, simple low-cost source of finance, although this method may not provide enough
funds, for example, if the firm is seeking to grow.
A new issue of shares might be made in a variety of different circumstances:
a) The company might want to raise more cash. If it issues ordinary shares for cash, should
the shares be issued pro rata to existing shareholders, so that control or ownership of the
company is not affected? If, for example, a company with 200,000 ordinary shares in issue
decides to issue 50,000 new shares to raise cash, should it offer the new shares to existing
shareholders, or should it sell them to new shareholders instead?
i) If a company sells the new shares to existing shareholders in proportion to their existing
shareholding in the company, we have a rights issue. In the example above, the 50,000 shares

would be issued as a one-in-four rights issue, by offering shareholders one new share for every
four shares they currently hold.
ii) If the number of new shares being issued is small compared to the number of shares
already in issue, it might be decided instead to sell them to new shareholders, since ownership
of the company would only be minimally affected.
b) The company might want to issue shares partly to raise cash, but more importantly
to float' its shares on a stick exchange.
c) The company might issue new shares to the shareholders of another company, in
order to take it over.

New shares issues
A company seeking to obtain additional equity funds may be:
a) an unquoted company wishing to obtain a Stock Exchange quotation.
b) an unquoted company wishing to issue new shares, but without obtaining a Stock Exchange
quotation.
c) a company which is already listed on the Stock Exchange wishing to issue additional new
shares.
The methods by which an unquoted company can obtain a quotation on the stock market are:
a) an offer for sale
b) a prospectus issue
c) a placing
d) an introduction.
Offers for sale:
An offer for sale is a means of selling the shares of a company to the public.
a) An unquoted company may issue shares, and then sell them on the Stock Exchange,
to raise cash for the company. All the shares in the company, not just the new ones, would
then become marketable.
b) Shareholders in an unquoted company may sell some of their existing shares to the
general public. When this occurs, the company is not raising any new funds, but just providing
a wider market for its existing shares (all of which would become marketable), and giving
existing shareholders the chance to cash in some or all of their investment in their company.
When companies 'go public' for the first time, a 'large' issue will probably take the form of an
offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can
be obtained more cheaply if the issuing house or other sponsoring firm approaches selected
institutional investors privately.
Rights issues
A rights issue provides a way of raising new share capital by means of an offer to existing
shareholders, inviting them to subscribe cash for new shares in proportion to their existing
holdings.

For example, a rights issue on a one-for-four basis at 280c per share would mean that a
company is inviting its existing shareholders to subscribe for one new share for every four
shares they hold, at a price of 280c per new share.
A company making a rights issue must set a price which is low enough to secure the
acceptance of shareholders, who are being asked to provide extra funds, but not too low, so
as to avoid excessive dilution of the earnings per share.
Preference shares
Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary
shareholders. As with ordinary shares a preference dividend can only be paid if sufficient
distributable profits are available, although with 'cumulative' preference shares the right to
an unpaid dividend is carried forward to later years. The arrears of dividend on cumulative
preference shares must be paid before any dividend is paid to the ordinary shareholders.
From the company's point of view, preference shares are advantageous in that:
· Dividends do not have to be paid in a year in which profits are poor, while this is not the case
with interest payments on long term debt (loans or debentures).
· Since they do not carry voting rights, preference shares avoid diluting the control of existing
shareholders while an issue of equity shares would not.
· Unless they are redeemable, issuing preference shares will lower the company's gearing.
Redeemable preference shares are normally treated as debt when gearing is calculated.
· The issue of preference shares does not restrict the company's borrowing power, at least in
the sense that preference share capital is not secured against assets in the business.
· The non-payment of dividend does not give the preference shareholders the right to appoint
a receiver, a right which is normally given to debenture holders.
However, dividend payments on preference shares are not tax deductible in the way that
interest payments on debt are. Furthermore, for preference shares to be attractive to
investors, the level of payment needs to be higher than for interest on debt to compensate
for the additional risks.
For the investor, preference shares are less attractive than loan stock because:
· they cannot be secured on the company's assets

· the dividend yields traditionally offered on preference dividends has been much too low to
provide an attractive investment compared with the interest yields on loan stock in view of
the additional risk involved.

Loan stock
Loan stock is long-term debt capital raised by a company for which interest is paid, usually half
yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the
company.
Loan stock has a nominal value, which is the debt owed by the company, and interest is paid
at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky
the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will
receive $10 interest each year. The rate quoted is the gross rate, before tax.
Debentures are a form of loan stock, legally defined as the written acknowledgement of a
debt incurred by a company, normally containing provisions about the payment of interest
and the eventual repayment of capital.
Debentures with a floating rate of interest
These are debentures for which the coupon rate of interest can be changed by the issuer, in
accordance with changes in market rates of interest. They may be attractive to both lenders
and borrowers when interest rates are volatile.
Security
Loan stock and debentures will often be secured. Security may take the form of either a fixed
charge or a floating charge.
a) Fixed charge; Security would be related to a specific asset or group of assets, typically
land and buildings. The company would be unable to dispose of the asset without providing
a substitute asset for security, or without the lender's consent.
b) Floating charge; With a floating charge on certain assets of the company (for
example, stocks and debtors), the lender's security in the event of a default payment is
whatever assets of the appropriate class the company then owns (provided that another
lender does not have a prior charge on the assets). The company would be able, however, to
dispose of its assets as it chose until a default took place. In the event of a default, the lender
would probably appoint a receiver to run the company rather than lay claim to a particular
asset.
The redemption of loan stock
Loan stock and debentures are usually redeemable. They are issued for a term of ten years or
more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become
redeemable (at par or possibly at a value above par).
Most redeemable stocks have an earliest and latest redemption date. For example, 18%
Debenture Stock 2007/09 is redeemable, at any time between the earliest specified date (in

2007) and the latest date (in 2009). The issuing company can choose the date. The decision
by a company when to redeem a debt will depend on:
a) how much cash is available to the company to repay the debt

b) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and
the current rate of interest is lower, say 10%, the company may try to raise a new loan at
10% to redeem the debt which costs 18%. On the other hand, if current interest rates are
20%, the company is unlikely to redeem the debt until the latest date possible, because
the debentures would be a cheap source of funds.
There is no guarantee that a company will be able to raise a new loan to pay off a maturing
debt, and one item to look for in a company's balance sheet is the redemption date of current
loans, to establish how much new finance is likely to be needed by the company, and when.
Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or
long leasehold property as security with an insurance company or mortgage broker and
receive cash on loan, usually repayable over a specified period. Most organisations owning
property which is unencumbered by any charge should be able to obtain a mortgage up to
two thirds of the value of the property.
As far as companies are concerned, debt capital is a potentially attractive source of finance
because interest charges reduce the profits chargeable to corporation tax.
Retained earnings.
For any company, the amount of earnings retained within the business has a direct impact on
the amount of dividends. Profit re-invested as retained earnings is profit that could have been
paid as a dividend. The major reasons for using retained earnings to finance new investments,
rather than to pay higher dividends and then raise new equity for the new investments, are
as follows:
a) The management of many companies believes that retained earnings are funds which do
not cost anything, although this is not true. However, it is true that the use of retained
earnings as a source of funds does not lead to a payment of cash.
b) The dividend policy of the company is in practice determined by the directors. From their
standpoint, retained earnings are an attractive source of finance because investment
projects can be undertaken without involving either the shareholders or any outsiders.
c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.
d) The use of retained earnings avoids the possibility of a change in control resulting from an
issue of new shares.

Another factor that may be of importance is the financial and taxation position of the
company's shareholders. If, for example, because of taxation considerations, they would
rather make a capital profit (which will only be taxed when shares are sold) than receive
current income, then finance through retained earnings would be preferred to other
methods.
A company must restrict its self-financing through retained profits because shareholders
should be paid a reasonable dividend, in line with realistic expectations, even if the directors
would rather keep the funds for re-investing. At the same time, a company that is looking for
extra funds will not be expected by investors (such as banks) to pay generous dividends, nor
over-generous salaries to owner-directors.
Bank lending
Borrowings from banks are an important source of finance to companies. Bank lending is still
mainly short term, although medium-term lending is quite common these days.
Short term lending may be in the form of:
a) an overdraft, which a company should keep within a limit set by the bank. Interest is
charged (at a variable rate) on the amount by which the company is overdrawn from day to
day;
b) a short-term loan, for up to three years.
Medium-term loans are loans for a period of from three to ten years. The rate of interest
charged on medium-term bank lending to large companies will be a set margin, with the size
of the margin depending on the credit standing and riskiness of the borrower. A loan may
have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will
be adjusted every three, six, nine or twelve months in line with recent movements in the Base
Lending Rate.
Lending to smaller companies will be at a margin above the bank's base rate and at either a
variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a
variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank
loans will sometimes be available, usually for the purchase of property, where the loan takes
the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft
facility, he will consider several factors, known commonly by the mnemonic PARTS.
- Purpose
- Amount

- Repayment
- Term
- Security
P The purpose of the loan. A loan request will be refused if the purpose of the loan is not
acceptable to the bank.
A The amount of the loan. The customer must state exactly how much he wants to borrow.
The banker must verify, as far as he is able to do so, that the amount required to make the
proposed investment has been estimated correctly.
R How will the loan be repaid? Will the customer be able to obtain sufficient income to make
the necessary repayments?
T What would be the duration of the loan? Traditionally, banks have offered short-term loans
and overdrafts, although medium-term loans are now quite common.
S Does the loan require security? If so, is the proposed security adequate?
Leasing
A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns
a capital asset but allows the lessee to use it. The lessee makes payments under the terms of
the lease to the lessor, for a specified period of time.
Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery,
cars and commercial vehicles, but might also be computers and office equipment. There are
two basic forms of lease: "operating leases" and "finance leases".
Operating leases
Operating leases are rental agreements between the lessor and the lessee whereby:
a) the lessor supplies the equipment to the lessee.
b) the lessor is responsible for servicing and maintaining the leased equipment.
c) the period of the lease is fairly short, less than the economic life of the asset, so that at the
end of the lease agreement, the lessor can either.
i) lease the equipment to someone else, and obtain a good rent for it, or ii) sell
the equipment secondhand.

Finance leases
Finance leases are lease agreements between the user of the leased asset (the lessee) and a
provider of finance (the lessor) for most, or all, of the asset's expected useful life.
Suppose that a company decides to obtain a company car and finance the acquisition by
means of a finance lease. A car dealer will supply the car. A finance house will agree to act as
lessor in a finance leasing arrangement, and so will purchase the car from the dealer and lease
it to the company. The company will take possession of the car from the car dealer, and make
regular payments (monthly, quarterly, six monthly or annually) to the finance house under the
terms of the lease.
Other important characteristics of a finance lease:
a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The
lessor is not involved in this at all.
b) The lease has a primary period, which covers all or most of the economic life of the
asset. At the end of the lease, the lessor would not be able to lease the asset to someone else,
as the asset would be worn out. The lessor must, therefore, ensure that the lease payments
during the primary period pay for the full cost of the asset as well as providing the lessor with
a suitable return on his investment.
c) It is usual at the end of the primary lease period to allow the lessee to continue to
lease the asset for an indefinite secondary period, in return for a very low nominal rent.
Alternatively, the lessee might be allowed to sell the asset on the lessor's behalf (since the
lessor is the owner) and to keep most of the sale proceeds, paying only a small percentage
(perhaps 10%) to the lessor.
Why might leasing be popular.
The attractions of leases to the supplier of the equipment, the lessee and the lessor are as
follows:
· The supplier of the equipment is paid in full at the beginning. The equipment is sold to the
lessor, and apart from obligations under guarantees or warranties, the supplier has no further
financial concern about the asset.
· The lessor invests finance by purchasing assets from suppliers and makes a return out of the
lease payments from the lessee. Provided that a lessor can find lessees willing to pay the
amounts he wants to make his return, the lessor can make good profits. He will also get capital
allowances on his purchase of the equipment.
· Leasing might be attractive to the lessee:

i) if the lessee does not have enough cash to pay for the asset, and would have difficulty
obtaining a bank loan to buy it, and so has to rent it in one way or another if he is to have the
use of it at all; or
ii) if finance leasing is cheaper than a bank loan. The cost of payments under a loan
might exceed the cost of a lease.
Operating leases have further advantages:
· The leased equipment does not need to be shown in the lessee's published balance sheet,
and so the lessee's balance sheet shows no increase in its gearing ratio.
· The equipment is leased for a shorter period than its expected useful life. In the case of high-
technology equipment, if the equipment becomes out-of-date before the end of its expected
life, the lessee does not have to keep on using it, and it is the lessor who must bear the risk of
having to sell obsolete equipment secondhand.
The lessee will be able to deduct the lease payments in computing his taxable profits.
Hire purchase
Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the
exception that ownership of the goods passes to the hire purchase customer on payment of
the final credit instalment, whereas a lessee never becomes the owner of the goods.
Hire purchase agreements usually involve a finance house.
i) The supplier sells the goods to the finance house. ii) The supplier delivers the goods to the
customer who will eventually purchase them. iii) The hire purchase arrangement exists
between the finance house and the customer.
The finance house will always insist that the hirer should pay a deposit towards the purchase
price. The size of the deposit will depend on the finance company's policy and its assessment
of the hirer. This is in contrast to a finance lease, where the lessee might not be required to
make any large initial payment.
An industrial or commercial business can use hire purchase as a source of finance. With
industrial hire purchase, a business customer obtains hire purchase finance from a finance
house in order to purchase the fixed asset. Goods bought by businesses on hire purchase
include company vehicles, plant and machinery, office equipment and farming machinery.
Government assistance
The government provides finance to companies in cash grants and other forms of direct
assistance, as part of its policy of helping to develop the national economy, especially in high

technology industries and in areas of high unemployment. For example, the Indigenous
Business Development Corporation of Zimbabwe (IBDC) was set up by the government to
assist small indigenous businesses in that country.
Venture capital
Venture capital is money put into an enterprise which may all be lost if the enterprise fails. A
businessman starting up a new business will invest venture capital of his own, but he will
probably need extra funding from a source other than his own pocket. However, the term
'venture capital' is more specifically associated with putting money, usually in return for an
equity stake, into a new business, a management buy-out or a major expansion scheme.
The institution that puts in the money recognises the gamble inherent in the funding. There
is a serious risk of losing the entire investment, and it might take a long time before any profits
and returns materialise. But there is also the prospect of very high profits and a substantial
return on the investment. A venture capitalist will require a high expected rate of return on
investments, to compensate for the high risk.
A venture capital organisation will not want to retain its investment in a business indefinitely,
and when it considers putting money into a business venture, it will also consider its "exit",
that is, how it will be able to pull out of the business eventually (after five to seven years, say)
and realise its profits. Examples of venture capital organisations are: Merchant Bank of Central
Africa Ltd and Anglo American Corporation Services Ltd.
When a company's directors look for help from a venture capital institution, they must
recognise that:
· the institution will want an equity stake in the company ·

it will need convincing that the company can be successful · it
may want to have a representative appointed to the company's board, to look after its
interests.
The directors of the company must then contact venture capital organisations, to try and find
one or more which would be willing to offer finance. A venture capital organisation will only
give funds to a company that it believes can succeed, and before it will make any definite offer,
it will want from the company management:
a) a business plan
b) details of how much finance is needed and how it will be used
c) the most recent trading figures of the company, a balance sheet, a cash flow forecast and
a profit forecast.

d) details of the management team, with evidence of a wide range of management skills e)
details of major shareholders
f) details of the company's current banking arrangements and any other sources of finance
g) any sales literature or publicity material that the company has issued.
A high percentage of requests for venture capital are rejected on an initial screening, and only
a small percentage of all requests survive both this screening and further investigation and
result in actual investments.
Franchising
Franchising is a method of expanding business on less capital than would otherwise be

needed. For suitable businesses, it is an alternative to raising extra capital for growth.
Franchisors include Budget Rent-a-Car, Wimpy, Nando's Chicken and Chicken Inn.
Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local
business, under the franchisor's trade name. The franchisor must bear certain costs (possibly
for architect's work, establishment costs, legal costs, marketing costs and the cost of other
support services) and will charge the franchisee an initial franchise fee to cover set- up costs,
relying on the subsequent regular payments by the franchisee for an operating profit. These
regular payments will usually be a percentage of the franchisee's turnover.
Although the franchisor will probably pay a large part of the initial investment cost of a
franchisee's outlet, the franchisee will be expected to contribute a share of the investment
himself. The franchisor may well help the franchisee to obtain loan capital to provide his- share
of the investment cost.
The advantages of franchises to the franchisor are as follows:
· The capital outlay needed to expand the business is reduced substantially. ·

The image of the business is improved because the franchisees will be motivated to achieve
good results and will have the authority to take whatever action they think fit to improve the
results.
The advantage of a franchise to a franchisee is that he obtains ownership of a business for an

agreed number of years (including stock and premises, although premises might be leased
from the franchisor) together with the backing of a large organisation's marketing effort and
experience. The franchisee is able to avoid some of the mistakes of many small businesses,
because the franchisor has already learned from its own past mistakes and developed a
scheme that works.

ZSE Listing Requirements

The application must be accompanied by a resolution of the directors of the applicant
authorising the application for the transfer of listing.
(a) a statement that: "It is understood that this application shall constitute a contract between
this company and the Zimbabwe Stock Exchange ("ZSE") and also between the
directors*/description of office equivalent to directors*, on a continuing basis, of the
company and the ZSE, and that in giving the General Undertaking referred to in paragraph
16.10 (s) of the Listings Requirements of the ZSE ("the Listings Requirements"), the
company and its directors*/description of office equivalent to directors* undertake to
comply with the Listings Requirements as they may exist from time to time."
(b) full name of the applicant;
(c) the addresses of the registered and transfer offices of the applicant in the Republic of
Zimbabwe;
(d) regarding the applicant's share capital: (i) the amount of the authorised share capital of
each class of share, and the nominal value and number of securities in each class; and
Zimbabwe Stock Exchange Listings Requirements Page 7 of 7 (ii) the number and amount
of the share capital issued and to be issued with respect to of share, and the number of
securities in each class for which a listing is applied for;
(e) the nominal amount and number of securities of each class: (i) offered to the public for
subscription, either by the applicant or otherwise ("the offer"), and the date the offer
opened; (ii) applied for in terms of the offer, and the date the offer closed (where this
information at the date of application); and (iii) issued and/or allotted, and the date of
issue and/or allotment (where this information is at the date of application) pursuant to
the offer; and
(f) the abbreviated name of the applicant. Such abbreviated name must not exceed 9
characters,inclusive of space .
Criteria
In addition to the requirements of paragraph 4.1 to 4.27, issuers wishing to apply for a listing
on ZEEM must comply (and after the listing has been granted, on a continuing basis) with the
following requirements:
(a) Applicants must appoint a Designated Advisor ( DA )and the terms of the
appointment must be in accordance with paragraph 20.13;
(b) The applicant must have share capital of at least US$250 000 (including reserves but
excluding minority interests, and revaluations of assets and intangible assets that are not

supported by a valuation by an independent professional expert acceptable to the ZSE

prepared within the last six months);
(c) The public shall hold a minimum of 26% of each class of equity securities and the
number of public shareholders (refer paragraph 20.7) shall be at least 150;
(d) The directors must have completed the Directors Induction Programme ("DIP") or
must make arrangements to the satisfaction of the ZSE to complete it;
(e) The applicant must appoint an executive Financial Director and the DA must be
satisfied (and submit confirmationin writing to the ZSE) that the Financial Director has the
appropriate expertise and experience to fulfil his/her role.
(f) The applicant must appoint a Compliance Officer and the DA must be satisfied (and
submit confirmationin writing to the ZSE) that the Compliance Officer has the appropriate
expertise and experience to fulfil his/her role. The Financial Director or the Company
Secretary may fulfil this role.
(g) The issuer must produce a profit forecast for the remainder of the financial year
during which it will list and one full financial year thereafter;
(h) The issuer's auditors or attorneys must hold in trust 50% of the shareholding of each
director and the DA ("the relevant securities") in such applicant from the date of listing, and
a certificate to that effect must be lodged with the ZSE by the issuer’s auditors or attorneys.
The relevant securities, whether new or existing, are to be held in trust until the publication
of the audited results for the periods referred to in paragraph 20.3 (f), after which 50% may
be released and the balance one year thereafter. The relevant securities may only be released
after notifying the ZSE; and
(i) At least 25% of the directors must be non-executive. Warning Statements 20.4 The
front cover of all documents (including announcements, circulars and annual reports) issued
or published by the issuer must contain an appropriate warning in bold relating to the risks of
investing in the issuer. This warning must include a statement that the ZSE does not guarantee
the viability or success of the issuer.
It must also include a statement relating to the importance of the DA and that if the issuer
fails to retain a DA, it faces suspension within the specified time and subsequent termination
without the prospect of an appropriate offer. Publication 20.5 Announcements must be
published on the ZSE Data Portal and the issuer's web site (where one exists). This is only a
minimum and the ZSE would encourage voluntary publication in the press. Corporate
Governance 20.6 All the provisions of the Listings Requirements relating to corporate
governance will be applicable with the exception of paragraphs 3.84 (c) and (d). Issuers must

however appoint an audit committee that must fulfil the role as set out in the Codes on
Corporate Governance acceptable to the ZSE. This committee must comprise the non-
executive directors and the DA as a minimum. The audit committee may not comprise of any
of the executive directors Public Shareholders 20.7 In addition to the provisions of paragraphs
4.25 and 4.26, any shareholding held beneficially, whether directly or indirectly by the DA will
not be regarded as being public. Issues for Cash 20.8
Issuers must comply with all the provisions of the Listings Requirements relating to general
issues of shares for cash with the following exceptions:
(a) the percentage in paragraph 5.52 (c) may not exceed 50%; and
(b) the approval as required in paragraph 5.52(e) is subject to achieving a 75% majority
of the votes cast in favour of such resolution by all equity securities holders present or
represented by proxy at the general meeting excluding the DA and the controlling
shareholders together with their associates. Pre-Listing Statements 20.9 Issuers must comply
with all the provisions of Section 6 of the Listings Requirements with the exception that the
percentage in paragraph 6.19(g) will be 50%. Financial Information 20.10 All the provisions of
section 8 are applicable with the exception that the period referred to in paragraph 8.4 is only
one year. Transactions
20.11 Issuers must comply with all the provisions of Section 9 of the Listings Requirements.
ZSE Trading Procedures
Trading Sessions
Trading on the Zimbabwe Stock Exchange (ZSE) is conducted in trading sessions. Trading
sessions shall be conducted in hours established by the ZSE and as set out in the trading
schedule detailed in the Zimbabwe Stock Exchange ATS Trading Procedures. The ZSE, with the
prior approval of the Securities Exchange Commission of Zimbabwe, may change the time of
the trading sessions after having published these changes in on its web site and in two
newspapers of wide circulation not later than four business days prior to these changes
becoming effective.
In addition the ZSE is to remind the market participants of such a change through e-mail alerts
originating from the Market Administrator.
Off-market transfers
(i) All trading in securities listed on ZSE must be conducted through the Zimbabwe
Stock Exchange Automated Trading System (ZSEATS).
(ii) Off-market transfers in listed securities are allowed to give effect to transfers or
transmissions effected by operation of law without consideration subject to the
approval of the respective issuers, and evidence of the payment of all taxes due in

the following exceptional cases, namely: (a) Successions / inheritances and (b)
Donations
(iii) For the purposes of this Rule 3A, “trading in securities” shall include making or
offering to make with any person or inducing or attempting to induce any person
to enter into or to offer to enter into –
(a) any agreement for or with a view to acquiring or disposing of securities, or
(b) any agreement the purpose or pretended purpose of which is to secure a profit to
any of the parties from the yield of securities or by reference to fluctuation in the price of
securities.
Supervision of Trading Sessions
Trading on the ZSE shall be supervised and monitored by the Manager of the Trading
Department or any other ZSE employee appointed by the ZSE.
Suspension of trading Were instructed by the SECZ, the ZSE shall suspend trading in any or
all securities at such time and for such period as shall be determined by the SECZ
Where in the opinion of the ZSE, circumstances exist or are about to occur that could result
in an unfair, disorderly and/or suspicious trading of securities, the ZSE may suspend
trading of any securities for one or more trading sessions or any part of a trading session.
The market shall be notified of all such actions before they take effect.
Securities of companies, which have been suspended from trading by the ZSE shall not be
traded during the period of suspension. All decisions to suspend or resume trading shall
be communicated to all securities dealing firms / stockbroking firms through the ZSEATS
messaging system, the ZSE Data Portal. The Central Securities Depository Company shall
also be informed of such decisions.
Schedule of Trading Procedures
Without prejudice to the requirements of these rules, the trading operations shall be carried
out in accordance with the Schedule of Trading Procedures laid down by the ZSE.
The Trading Procedures shall provide for:
(a) The trade matching mechanisms;
(b) The transmission and types of orders;
(c) Days and opening hours of the ZSE trading sessions;
(d) Types of transactions concluded on the ZSE;

(e) The types of Markets and Boards operated by the ZSE; and
(f) The surveillance mechanisms of the ZSE.
Trading of securities on ‘cum’ and ‘ex’ basis
For the purpose of trading, all securities will be traded and quoted ‘cum’ for a minimum of
ten business days before the last cum date. On the next business day after the last cum date,
the securities will be traded and quoted ‘ex’. Buyers of securities who transacted on an ‘ex’
basis shall have no rights to the entitlements declared by the company concerned. The record
date shall be the settlement date, as defined in the CSD Rules, of trades effected on the last
cum date, that is three (3) business days following the last cum date.
Unwinding of trades
In the case of a “Fund Settlement failure” or a “Securities Settlement failure” as defined in the
CSD Rules and Procedures, trades already concluded on the ZSE may be unwound pursuant
to the CSD Rules and Procedures.
In the event of a trade being unwound, the ZSE shall rectify the volume and the traded value
results pertaining to the day the trade was concluded on the ZSE. The ZSE shall publish the
fact that there has been a failed trade on the market, indicating the custodian concerned and
the reasons.
Official Price List and other market data information
The right to record and publish the prices related to Transactions on ZSE is the prerogative and
the sole property of the ZSE. The copyrights of the ZSE therein are reserved.
No person may make a commercial use of the publication of the prices and any other market
data information, in any form or manner whatsoever, unless prior written consent has been
given by the ZSE and on such terms and conditions for such use as the ZSE at its absolute
discretion shall impose.
The ZSE shall publish daily and periodic information on the prices, traded volumes, indices
and any other market data, necessary to ensure transparency and equity to investors.
The ZSE shall maintain a suitable communication system through which it will publish the
particulars for all listed securities, and the form in which and the precise time within which
the information is to be provided, as well as the means by which it is to be made available,
having regard to the nature, size and needs of the market concerned and of the investors
operating on that market.

Unit 2: Time Value of Money
1. Introduction
The concept of the time value of money is an integral concept in the study of
financial management. This is the focus of this unit which you have to study now before you
proceed to other topics. The discussion may appear to be very "technical", however, you are
advised to make an effort to grasp the concepts that are covered in this unit as they will come
up from time to time in our study of the other topics.
For example, you need the concepts covered in this unit in order to study Capital Budgeting,
Valuation of Shares, the Cost of Capital, and many other issues covered in corporate financial
management. Additionally, most of the concepts covered in this unit will come in handy in
your advanced studies of the subject.
2. Study unit objectives

Understand the role of time value of money in finance.
Understand the concept of compound interest.
Apply compounding and discounting to cash flow streams.
Apply the time value of money principles to practical problems like loan repayments.
Explain how to value estimated future cash flows.
2.1 Learning Outcomes

Use financial calculators to determine the:
Future Value of:
- a single sum
- an annuity Present Value of:
- a single sum - an annuity
- a perpetuity
- a growing perpetuity
- a cash flow growing at a constant rate.
- an uneven cash flow stream
Define and calculate an effective rate.
Distinguish between nominal and real interest rates.

Understand the role of interest rates.
Establish the factors that determine the term structure of interest rates
Study Unit Content

Time Value of Money
The notion that money has a time value is one of the most basic concepts in finance and
investment analysis. Making decisions today regarding future cash flows requires
understanding that the value of money does not remain the same throughout time.
A dollar today is worth less than a dollar sometime in the future for two reasons.
Reason No. 1: Cash flows occurring at different points in time have different values relative to
any one point in time.
One dollar one year from now is not as valuable as one dollar today. After all, you can invest
a dollar today and earn interest so that the value it grows to next year is greater than the one
dollar today. This means we have to consider the time value of money to quantify the relation
between cash flows at different points in time.
Reason No. 2: Cash flows are uncertain. Expected cash flows may not materialize.
Uncertainty stems from the nature of forecasts of the timing and/or the amount of cash flows.
We do not know for certain when, whether, or how much cash flows will be in the future. This
uncertainty regarding future cash flows must somehow be considered in assessing the value of
an investment.
Translating a current value into its equivalent future value is referred to as compounding.
Translating a future cash flow or value into its equivalent value in a prior period is referred to
as discounting. We are going to deal with the basic mathematical techniques used in
compounding and discounting.
An investment of money has different values on different dates. The adjustment in time value
is a function of the following factors: time, inflation rate, risk.
A lender will need compensation from a borrower for delaying payment and this
compensation will be determined by above three factors. This compensation is the interest
rate, which represents the opportunity cost of funds. Let us now discuss the following:
 Future Value
 Present Value
 Simple Interest
 Simple Discount
 Compound Interest
Simple Interest
Remark: Interest is the price paid for the use of borrowed money.
Interest is paid by the party who uses or borrows the money to the party who lends the
money. Interest is calculated as a fraction of the amount borrowed or saved (principal
amount) over a certain period of time. The fraction, also known as the interest rate, is usually
expressed as a percentage per year, but must be reduced to a decimal fraction for calculation
purposes. For example, if we have borrowed an amount from the bank at an interest rate of
12% per year, we can express the interest as:
12% of the amount borrowed.
or 12/100 of the amount borrowed or
0,12× the amount borrowed.
When and how interest is calculated result in different types of interest.
For example, simple interest is interest that is calculated on the principal amount that was
borrowed.

or saved at the end of the completed term.
As a student there is need to ask yourself where simple interest is calculated on (percentage
charged on the principal amount)
Remark: Simple interest is interest that is computed on the principal for the entire term of the
loan and is therefore due at the end of the term. It is given by
I = Prt
Where.
I-is the simple interest (in $) paid at the end of the term for the use of the money
P - is the principal or total amount borrowed (in $) which is subject to interest (P is also known
as the present value (PV) of the loan)
r- is the rate of interest, that is, the fraction of the principal that must be paid each period
(say, a year) for the use of the principal (also called the period interest rate)
t - is the time in years, for which the principal is borrowed
Interest is earned only on the original investment; no interest is earned on interest
Example 1
Suppose you have $10 000 to invest in a bank savings account at a simple interest of 20% per
annum. How much will you have at the end of the year?
It is key to understand what parameters are available as well as the missing ones

Suggested Solution
P = 10000, r = 0.2, t =1, therefore S =10000 (1+0.2(1)) =12000
Remark: The amount or sum accumulated of Future Value (S) (also known as the maturity
value, accrued principal) at the end of the term t, is given by
S = Principal value + Interest
S=P+I
S = P + Prt
S = P (1 + rt).
Remark: The date at the end of the term on which the debt is to be paid is known as the due
date or maturity date.
Example 2
Suppose you deposit $10 000 today in an account that pays simple interest of 20% per annum.
How much will you have at the end of 3 years?
As a student ask yourself what is required (Present value or Future Value)
Suggested Solution
P = 10000, t = 3, r =0.2 therefore S = 10000(1+(0.2(3)) = $16000
Once the parameters are identified it will be easier to compute the Future Value
Practice Questions
1. Calculate the simple interest and sum accumulated for $5 000 borrowed for 90days at
15% per annum.

Need to recall the formulas for simple interest as well as the future value
Suggested Solution
Simple Interest
I = Prt
I = 5000(0.15)90/365 =184.93 (assuming 365 days a year)
Sum Accumulated
S=P(1+rt)
S = 5000(1+0.15(90/365) = 5184.5
2. Calculate the sum accumulated at the end of 3 years, 4 months, and 17 days on a deposit
of$20 000 and an interest rate of 18.27% per year.
As a student ask yourself the meaning of sum accumulated
Sum accumulated at the end of 3 years
S=20000(1+0,1827(3)) =30962
Sum accumulated at the end of 4 months
S=20000(1+0.1827(4/12)) = 21379.8
Sum accumulated at the end of 17 days
S =20000(1+0,1827(17/365)) =2017
Only the time is changing which is resulting to the change in the sum accumulated
Present Values [discounting]
Sometimes we not only consider the basic formula I = Prt but also turn it inside out and upside
down, as it were, in order to obtain formula for each variable in terms of the others. Of
particular importance is the concept of present value P or PV, which is obtained from the basic
formula for the sum or future value S, namely

S = P (1 + rt)
Dividing by the factor (1 + rt) gives
𝑺𝑷=
𝟏 + 𝒓𝒕
How do we interpret this result? We do this as follows: P is the amount that must be borrowed
now to accrue to the sum S, after a term t, at interest rate r per year. As such it is known as
the present value of the sum S.
Remark: Discounting is a process of moving the future value of an obligation/investment back

to the present/today.
𝑆
For Simple Interest =𝑃=
(1+𝑟𝑡)
For Compound Interest=𝑃 = (1+𝑖)𝑛
Example
A promissory note with a future value of $12000, simple interest rate is 12% per annum is sold
3 months prior to its due date. What is the Present Value on the day it is sold?
Suggested Solution
P = (12000/ (1+0.12(3/12)) =11650.49
Remark: A promissory note is a written promise by a debtor (called the maker of the note) to
pay a creditor (called the payee) a stated sum of money (the so-called “maturity value”) on a
specific date (the due date), and stating a specific rate of interest. Such notes can be bought
and sold, that is, they are negotiable. Obviously with such transactions it is the present value
of the note that counts.
Timelines
A timeline is a useful way of representing interest rate calculations graphically. Time flow is
represented by a horizontal line. Inflows of money are indicated by an arrow from above
pointing to the line, while outflows are indicated by a downward pointing arrow below the
timeline.
For a simple interest rate calculation, the timeline is as follows:

P or PV
t- term
r =Interest
rate
FV or S= P(1 +rt)
At the beginning of the term, the principal P (or present value) is deposited (or borrowed) –
that is, it is entered onto the line. At the end of the term, the amount or sum accumulated, S
(or future value) is received (or paid back). Note that the sum accumulated includes the
interest received.
Remember that
FV or Sum accumulated (S) = Principal + Interest received that is
S = P + Prt
= P (1 + rt) or
equivalently
Future value = Present value + Interest received.
Negotiable Certificates of Deposit (NCDs).
The concept of simple interest is often applied to financial instruments found on the money
market (the short-term market). An important instrument on this market is the negotiable
certificate of deposit (NCD). NCDs arise when banks solicit large deposits from investors for a
fixed period of time during which the money cannot be withdrawn. The investor is then given
a certificate which is negotiable. This means that the investor can sale or negotiate the
certificate in the money market at any stage before the maturity date of the deposit.
The amount invested is the nominal, or face value of the instrument upon which interest is
calculated at the period of the deposit using simple interest. To find out how this interest is
calculated, let us look at the following example.
S=P+I
S = P (1+ rt)

Example 3
Suppose on 1 May 2012, you purchase an NCD with a maturity date of 31 July 2012, a face
value of $1 000 000 and an interest rate of 34.65% that is payable on maturity. How much will
you receive on the maturity date?
Suggested Solution
S= 1000000(1+0,3465(2/12)) = 1057740
Note that, when a security is issued for the first time, it is issued on the primary
market. Subsequently, it starts trading on the secondary market, on which it acquires a value
which may not necessarily be equal to the face value. NCDs are traded in the secondary
market on a yield basis, that is the price is determined on the basis of a yield. When calculating
the market value, or the consideration to be paid when the NCD is being negotiated, we need
to know the number of days remaining to maturity.
Counting days
The convention is that to determine the exact number of days between the two relevant term
dates, we include the day the money is deposited or lent and exclude the day the money is
repaid (or withdrawn). The reasoning behind this is the simple fact that if you deposit money
on the 12th of June and withdraw it on the 13th of June, there is only one day between the
two dates, not two. However, when a security is issued and held until maturity, we include
the day on which it was issued.
Let us look at the following example.
Example 5
Calculate the number of days between 25 May and 17 August.
You must remember that some months have 31 days while others have 30 days. You should be
able to get the number of days by a simple count of your fingers:
Month Days
May 7
June 30
July 31

August 16
Total 84 days
Now, let us look at the following examples.
Example 4
On 1 May 2012 you purchase an NCD with a maturity date of 31 July 2012, nominal value of
$1 000 000 and an interest rate of 34.65%. Subsequently, on that same day, the yield on
similar securities falls to 33%. You then decide to sell the NCD. How much should you expect?
You should ask yourself how many days are between the NCD purchase date and the
maturity date
Suggested Solution
Number of Days
May 31
June 30
July 30
Total 91 days
Amount expected = 1000000(1+(0.3465(91/365)) =1086300
The estimation of the number of days is critical
Simple Discount
Remark: If interest is calculated on the face (future) value of a term and paid at the beginning
of the investment term. You will receive interest in advance

Previously, we emphasised the interest that has to be paid at the end of the term for which
the loan (or investment) is made. On the due date, the principal borrowed plus the interest
earned is paid back.
In practice, there is no reason why the interest cannot be paid at the beginning rather than at
the end of the term. Indeed, this implies that the lender deducts the interest from the
principal in advance. At the end of the term, only the principal is then due. Loans handled in
this way are said to be discounted and the interest paid in advance is called the discount. The
amount then advanced by the lender is termed the discounted value. The discounted value is
simply the present value of the sum to be paid back and we could approach the calculations
using the present value technique as before.
Expressed in terms of the timeline of the previous section, this means that we are given S and
asked to calculate P.
P or PV
t- term
d= discount
rate
S=
The discount on the sum S is then simply the difference between the future and present values.
Thus, the discount (D) is given by
D = S − P.
The discount D is also given by
D = Sdt

(compare to the formula for simple interest I = Prt) where d= simple discount rate and the
discounted (or present) value of S is
P=S−D
= S − Sdt P=
S (1 − dt)
or
Present Value = Future Value − Future Value × discount rate × time.
PV = FV − FV × d × t
= FV (1 − dt)
(compare to the formula for the accumulated sum or future value for simple interest)
S = P (1 + rt).
Example 6
Suppose the government floats Treasury bills of face value $10 at a discount of 10%. Lisa wants
to subscribe and has the $10. The tenure of the TB is 1 year. How much does Lisa Pay now and
how much will she get at the end of 1 year.
Suggested Solution
PV =FV-FV*d*t
PV =10-(10*0.1*1) = 9
It is important to note that the face value is the same as the future value
Example 7
A treasury bill with a tenure of 90 days and a face value of $100 000 is issued at a discount of
18%. At what consideration is it being issued?
Suggested Solution
PV=100000-100000(0.18) (90/365) =95562

Money-market instruments that are traded on a discount basis are bankers’ acceptances
(referred to as BAs) and treasury bills. The value appearing on the acceptance or bill, the so-
called “face value”, is what the owner thereof will receive on the maturity date.
On the other hand, the price paid is the present value, which is calculated as described above
using the current rate as set by the market.
Equivalent Simple Interest Rate
It establishes a relationship between Simple Discount and Simple Interest. The calculation of
the discount rate assumes that the security is held to its full tenor. If an investor buys a
security, he may not necessarily hold it to its full tenor. The investor may opt to sell the security
before it matures. The yield will be the difference between what the investor gets when he
sells the security and what he paid for it. This is also called the equivalent simple interest rate.
When a note is discounted, the interest rate which is equivalent to the discount rate will be
greater than the actual discount rate. This difference arises from the fact that the Discount
Rate is calculated on the Face Value whereas Interest is calculated on the Present Value.
Cardinal Rules of Time Value
Remark: A particular investment has different values on different dates. This is linked through
the Future Value and Present Value by applying relevant interest rates whether simple or
compound.
For example, $1 000 today will not be the same as $1 000 in six-months’ time. In fact, if the
prevailing simple interest rate is 16% per annum, then, in six months, the $1 000 will have
accumulated to $1 080.
⇒ 1 000 × (1 + 0,16× 1/2) = 1 080
On the other hand, three months ago it was worth less – to be precise, it was worth $961,54.
PV = 1 000
1 + 0,16×3/4
= 961,54

Represented on a timeline, these statements yield the following picture:
916.5 $1 000
t=3/1 t=6/12
16%
no
1 1 080
This is summarised as below:
1. To move money forward (determining the Face Value)
a. Where simple interest is applicable you inflate the relevant sum by multiplying (1+rt)
b. Where compound interest is applicable you inflate by (1+i) n
2. When you want to move money backwards (determining the present value)
a. Where simple interest is applicable, we deflate by (1+rt)
b. Where compound interest is applicable you deflate the relevant sum by (1+i) n
The point is that the mathematics of finance deals with dated values of money. This fact is
fundamental to any financial transaction involving money due on different dates. In principle,
every sum of money specified should have an attached date.
Interest and date values
Payments and obligations of different dates
The value of a sum of money is determined by the date at which it is paid or received.
Example 8
If you owe $2000 to be paid in 10months time at an interest of 27%. How much would you pay?
Given that S=P (1+rt)
=20000 (1+0.27×10/12)
=$24500

Example 9
If you want $20000 today, how much should you have invested done 5months ago at the same
interest rate of 27%.
The above examples are represented in a timeline as following:
PV?t= 5/12 t=10/12
-5 0 10
months
20000 FV?
𝑆
Given that PV=
(1+𝑟𝑡)
PV= 20000
(1+0.27∗5/12)
PV=$17977, 53
Example 10
Suppose you owe $100000 to be paid 4months from now, $120000 to be paid 7months from
now. You then negotiate to pay all the amounts owed 10months from now. How much will
you eventually pay? (Use a simple interest rate of 22% for the evaluation purpose) Timeline
presentation is as follows.
T=6 months
T=3 months
r=22% PV=? 100 000 120 000
0 4 months 7 months 10 months
Future Value??

So, we need to calculate the values of the new obligation (t=6months for $100000 and
t=3months for $120000) at a time period 10months at a simple interest rate of 22%.
NB-For comparison purpose, all date values must be brought to the same date. Only cashflows
evaluated at the same date are comparable.
New Obligation
1) S ($100000for 6 months) =P(1+rt)
=100000(1+0.22×6/12)
=$111000
2) S ($120 000for 3 months) =P(1+rt)
=120000(1+0.22×3/12)
=$126600
⇒Therefore, Total obligation owing will be (Obligation 1 + Obligation 2)
= (111000+126600)
=$237600
Suppose you offered to pay $20000 now in part settlement of the debt, this amount cannot
simply be deducted from the amount ($237600). The $20000 must be extended (evaluated
for time value at an appropriate rate) for 10months for comparison purposes (inflating- finding
the future value). Then find the final amount needed to liquidate the resultant obligation.
Time value concept illustrated below in a timeline.
t=10 months
P=20 000 S?? @10 months
Given that S= P(1+rt); S@ 10 months= 20000(1+0.22×10/12)
S=$23667
To find final owing, at the final due date, the Total obligations should equal the Total payments.
Total Owing = Total Payments

Total Owing =Part Payment + Final Payment (say X to be determined)
⇒What he owes $237600 less what he paid $23667 (time value adjusted) gives what he has to
pay to level off the debt(X).
Their fore Final payment (X) =$237600-$23667
X=$213933
From time to time a debtor may wish to replace a set of financial obligations with a single
payment on a given date. In fact, this is one of the most important problems in financial
mathematics. It must be emphasised here that the sum of a set of dated values due on
different dates has no meaning. All dated values must first be transformed to values due on
the same date (normally the date on which the payment that we want to calculate is due).
The process is simply one of repeated application of the key rules of time value as the
following example illustrates:
Example 11
Lisa owes Tracy $5000 due in 3months and $2000 due in 6months. Lisa offers to pay $3000
immediately, if she can pay the balance in one year. Tracy agrees that they use simple interest
rate of 16% per annum. They also agreed that the $3000 paid now will also be subject to the
same rate of 16% for evaluation purposes. How much will Lisa pay at the end of the year?
Timeline
5000 t=9/12 r=0.16
2000 t=6/12 r=0.16
0 3 6 12 months
3000 t=12/12 r=0.16 ?
Finding values of Obligation at Final Due Date
a) S (5000@ 12 months) =P (1+rt) r= 0.16 t=9/12
=5000(1+0.16×9/12)
=$5600

b) S (2000@ 12 months) =P (1+rt) r=0.16 t=6/12
=2000(1+0.16×6/12)
=$2160
Total obligations= (a) + (b)
=$5600+$2160
=$7760
Finding the values of Payments
S (3000@12 months) =P (1+rt) given r=016 t= 1 year
= 3000(1+0.16×1)
=$3480
At the Final due date value, which is 12 months.
Total obligation=Total payments (i.e. part payments + final payment[X])
This way we find what Lisa owes Tracy at the end of 12 months
⇒ 7760 = 3480+X
⇒ X=7760-3480
⇒X=$4280
Lisa owes $4 280.
Compound Interest
Compound interest arises when, in a transaction over an extended period of time, interest
due at the end of a payment period is not paid but added to the principal. Thereafter, the
interest also earns interest, that is, it is compounded. The amount due at the end of the
transaction period is the compounded amount or accrued principal or future value, and the
difference between the compounded amount and the original principal is the compound
interest. Essentially, the basic idea is that interest is earned on interest previously earned.
Example 12
You deposit $1000 at 10% per annum into a savings account, how much will you have at the
end of 4 years if interest is compounded once per year.

Year/Period Beginning Interest factor Ending amount Interest
Amount
1 1000 0.1 1100 100
2 1100 0.1 1210 110
3 1210 0.1 1331 121
4 1331 0.1 1464,10 133,10
Compound 464,10
interest=
Compound Interest = Ending amount (1464.10)- Beginning amount (1000) = 464.10
As shown in the example, compound interest in fact is just the repeated application of simple
interest to an amount that is at each stage increased by the simple interest earned in the
previous period. It is, however, obvious that where the investment term involved stretches
over many periods, compound interest calculations along the above lines can become tedious.
To remedy this, we use a formula for calculating the amount generated for any number of
periods.
S (FV) =P (1+i) n
Where n, is number of periods and i, compound interest rate per period and P is Present value
It also follows when that when given the future value amount S, you can find the Present value,
P by the process of discounting as follows.
PV=S/ (1+i) n
Example 13
Find the present value of $170000 which should be received at the end of 8years when the
interest rate is 22.67% compounded once a year.

Solution
Timeline
PV?? t=8
0 8 years
170K
Given that 𝑃𝑉 = (1+𝑖)𝑛
PV=170000/ (1+0.2267)8
PV=$33154
Compounding More than Once a Year
Perhaps you have noticed that we have been careful to use the phrase “compounded
annually” in the above examples and exercises. This is because the compound interest earned
depends a lot on the intervals or periods over which it is compounded.
Financial institutions frequently advertise investment possibilities in which interest is

calculated at intervals of less than a year, such as semi-annually, quarterly, monthly, or even
on “daily balance”. What difference does this make? A few examples should help us answer
this question.
To find the Future Value when interest is paid more than once per year, we use the following
relationship:
𝑗𝑚 𝑚
S = P (1 + ) 𝑡𝑚
WhereS ≡ the accrued amount, also known as the future value.
P ≡ the initial principal, also known as the present value i≡jm/m,
the annual interest rate compounded m times per year.
n≡ t × m, = number of compounding periods t≡
the number of years of investment m≡ the
number of compounding periods per year
jm≡ the nominal interest rate per year

The above equation is same as: S=P (1+i) n
Where i= jm/m
n=tm
Example 14
Find the future value of $40 000 deposited into an account that earns 12.62% per annum for 6
years, compounded:
i. Once per year
ii. Semi-annually
iii. Quarterly iv.
Monthly
v. Daily
Solution
Once per year
S =40000(1+0.1262) ^6 =81611.83
Semi annually
S = 40000(1+0.1262/2) ^12 =83358.41
Quarterly
S=40000(1+0.1262/4) ^24=84299.85
Monthly
S=40000(1+0.1262/12) ^72 =84955.33
Daily (assuming 365 days in a year)
S=40000(1+0.1262/365) ^2190 =85280.74

The more compounding periods the higher the future value which is evidenced in the
above calculations
Nominal and Effective Annual Rates
Remark: In cases where interest is calculated more than once a year, the annual rate quoted is
the Nominal rate.
Effective Annual Rate [EAR]

Is the actual interest earned per year calculated and expressed as a percentage of the relevant
principal. This is the equivalent annual rate of interest – that is, the rate of interest actually
earned in one year if compounding is done on a yearly basis.
Given the following formula defined before. S=P
(1+i) n or that𝑆 = 𝑃 (1 + 𝑗𝑚) 𝑡𝑚

From the above example you should note that, in order to calculate the effective rate, we do
not require the actual principal involved. In fact, it is convenient to use P = 100, since the
interest calculated then immediately yields the effective rate as a percentage.
The EARs formulation is as follows:
𝑗𝑚 𝑚
𝐸𝐴𝑅 𝑜𝑟 𝑗𝑒𝑓𝑓 = [(1 + ) − 1]
𝑚
The Effect of increasing the number of Compounding times per annum
As we increase the number of times the interest is paid in a year implies that, effectively we
are increasing the interest rate or return earned on an investment. Notice that the Future
Value is increasing as we increase m, the number of compounding times p.a. The Future Value
increases at an increasing rate then tails off to a certain upper limiting value as m approaches
positive infinity (as well the interest rate increases at an increasing rate then tails off to a
limiting value as m approaches positive infinity). As m tends to positive infinity, the EAR turns
to an upper limit.
What is the significance of this behaviour of EAR?
It protects the creditor against the lender e.g. banks, in that the return on an investment
cannot be infinitesimally increased by increasing the rate at which interest is earned per
annum If such a limiting value did not exist, it would have meant that the future value of an
investment (or debt) could be made arbitrarily large by increasing the compounding
frequency. If it does exist, we know that there is an upper limit to the accrued value of an
investment or debt over a limited time period.
EAR EAR curve

Plot of EAR and m
Number of compounding times
Continuous Compounding
There is a limit regarding the effects of increasing m, on the accumulated Future Value or EAR.
The limit exists when m is so large that it approaches infinity is equal to letter e which is the
base of a natural logarithm which is equal to 2.1782
e=2.1782
𝑗𝑚 ) 𝑛 = 𝑒𝑗𝑚
𝑚 𝑚
We can write the effective interest rate (as a percentage) as:
Jeff= 100(ejm− 1).

This is the effective interest rate when the number of compounding periods tends to infinity.
Therefore, we will use the symbol J∞ to identify it, and now define.
J∞ = 100(ejm− 1).
EAR for continuous compounding [ j∞]
The case where interest is compounded an almost infinite number of times as continuous
compounding at a rate c, and to J∞ as the effective interest rate expressed as a percentage
for continuous compounding.
Thus
J∞ = 100(eC– 1)
NB. Thus, finally, with continuous compounding at rate c and for principal P, we can deduce
that:
The FV in one year is
S = Pec.
The FV in t years will then simply be
S = Pect
Derivation of usable Formulae involving continuous compounding
Suppose that we have a sum P that we invest for one year, on the one hand, at a nominal
annual rate of jm compounded m times per year and, on the other, at a continuous
compounding rate of c. In these two cases the sum accumulated in one year is then
respectively
S=Pec. 𝑆 = 𝑃 (1 + 𝑗𝑚) 𝑚
𝑚
The question is: What must the continuous rate c be for these two amounts to be equal? It
must be

ec= (1 + 𝑗𝑚) 𝑚
𝑚
since the principal is the same in both cases.
We can solve for c by taking the natural logarithm of both sides.
[stages left here]
This gives the following results
𝑗𝑚 c=
m ln(1 + )
𝑚
And
emc
jm = m −1
Remark: We use the above formulae to convert a continuous compounded interest rate to an
equivalent nominal interest rate that is compounded periodically, or vice versa. The two rates
obtained in this way are equivalent in the sense that they will yield the same amount of interest
or give rise to the same effective interest rate.
Equations of Value
From time to time, a debtor (the guy who owes money) may wish to replace his set of financial
obligations with another set. On such occasions, he must negotiate with his creditor (the guy
who is owed money) and agree upon a new due date, as well as on a new interest rate. This
is generally achieved by evaluating each obligation in terms of the new due date and equating
the sum of the old and the new obligations on the new date. The resultant equation of value
is then solved to obtain the new future value that must be paid on the new due date.
It is evident from these remarks that the time value of money concepts must play an
important role in any such considerations, even more so than they did in the simple interest

case, since the investment terms are generally longer in cases where compound interest is
relevant.
As we noted above that we would concern ourselves here with replacing one set of financial
obligation with another equivalent set. This sounds complicated but is really just a case of
applying the above rules for moving money back and forward, keeping a clear head and
remembering that, at all times, the only money that may be added together (or subtracted) is
that with a common date.
3. End of Study Unit Questions
Multiple Choice
1) The Short Holder bank pays 5.60%, compounded daily (based on 360 days), on a 9-
month certificate of deposit. If you deposit $20,000 you would expect to earn around
in interest.
A. $840
B. $858
C. $1,032
D. $1,121
2) In 2 years, you are to receive $10,000. If the interest rate were to suddenly decrease,
the present value of that future amount to you would .
A. Fall
B. Rise
C. remain unchanged
D. The correct answer cannot be determined without more information.
3) To increase a given future value, the discount rate should be adjusted .

A. Upward
B. Downward
C. first upward and then downward
D. None of the above answers are correct; you should use PVIF.
4) Interest paid (earned) on only the original principal borrowed (lent) is often referred to
as .

A. present value
B. simple interest
C. future value
D. compound interest
5) Interest paid (earned) on both the original principal borrowed (lent) and previous
interest earned is often referred to as .
A. present value
B. simple interest
C. future value
D. compound interest
6) Which of the following investment alternatives would provide the greatest ending
wealth for your investment?
A. 10% compounded daily (360 days)
B. 10.5% compounded annually.
C. 10.25% compounded quarterly.
D. There is not sufficient information to determine the best alternative from the above
information.
7) Which of the following statements is most correct?
A. The future value of an annuity due is greater than an otherwise identical ordinary
annuity.
B. A reduction in the discount rate will increase the future value of an otherwise identical
cash flow stream.
C. Continuous compounding will result in a higher present value relative to an otherwise
identical investment that is compounded monthly at the same nominal rate.
D. The FVIFA (i%, N periods) equals the sum of the PVIF (i%, n) for n=1 to N periods.
Suggested Solution
1. B
2. B
As the interest rate falls, this increases the value today. Thus, the PV of
$10,000 when rates fall from 8% to 6% will increase from $8,573 to $8,900 for example.
3. A
4. B
5. D
6. C

EAR = 10.5% which is less than (1 + .1025/4)4 - 1 = 10.65% of c).
7. A
This will actually decrease the future value although it would increase the
present value.
Structured Questions
Question 1
Suppose that you have earned a cash bonus for an outstanding performance at your job during
the last year.
Your pleased boss gives you 2 options to choose from:
Option A: Receive $10,000 bonus now
Option B: Receive $10,800 bonus after one year
Further information which you may consider in your decision:
- Inflation rate is 5% per annum.
-Interest rate on bank deposits is 12% per annum.
Which option would you choose? [25marks]
Suggested Solution
Although in absolute terms Option B offer the higher amount of bonus, Option A gives you
the choice of receiving bonus one year earlier than Option B. This can be beneficial for the
following reasons:
▪ To start with, you can buy more with $10,000 now than with $10,800 in one year's
time due to the 5% inflation.
▪ Secondly, if you receive the bonus now, you could invest the cash in a bank deposit and
earn a safe annual return of 12%. in contrast, you stand to lose this interest income if
you choose Option B.
▪ Thirdly, future is uncertain. In worst case scenario, the company you work for could
become bankrupt during the next year which would significantly reduce your chances

of receiving any bonus. The probability of this happening might be remote, but there
would be a slim chance none the less.
The above considerations must be incorporated into the decision analysis by factoring them
into a discount rate which will then be used to calculate the future values and present values
as illustrated below.
Discount Rates
As the interest rate on bank deposits is higher than the rate of inflation, we should set the
discount rate at 12% for our analysis because it represents the highest opportunity cost for
receiving the bonus in one year's time rather than today.
For this example, we may assume that the risk of not getting the bonus after one year (e.g.
due to the company becoming bankrupt) is minimal and is therefore ignored. If such a risk is
considered significant, we would have to increase the discount rate to reflect that risk.
Using the 12% discount rate, we could either calculate future value or present value of the 2
options to assess which option is better in financial terms. Both are included here for
completeness sake although they shall lead to the same conclusion.
Future Values
The future value of Option A will be the amount of bonus plus the interest income of 12%
which could be earned for one year.
Option A
Bonus $10,000
Interest Income$ 1,200 ($10,000 x 12%)
Future Value$11,200 after 1 year ($10,000 + $1,200)
Option B
Bonus $10,800
Interest Income - *
Future Value$10,800 after 1 year
* No interest income shall accrue on $10,800 as it shall be received after one year.
Based on the future values, Option A is preferable as it has the highest future value.

Present Values
The present value of Option B will be the amount required today that shall equal to $10,800
in one year's time after having accrued an interest income of 12%.
Option A
Bonus $10,000
Interest Income 1.0 *
Present Value $10,000 ($10,000 x 1.0)
*No need to discount as $10,000 is already stated in its present value terms.
Option B
Bonus $10,800
Interest Income0.8928 (1 ÷ [1 + 0.12] )
Present Value $9,642* ($10,800 x 0.8928)
*The present value of $9,642 represents the amount of cash that, if invested in a bank deposit
@ 12% p.a., shall equal to $10,800 in one year. This can be confirmed as follows:
$9,642 x 1.12 ≈ $10,800
Based on the present values, Option A is preferable as it has the highest present value.
Note
Both present and future value analysis lead to the same conclusion (i.e. Option A is preferable
over Option B). This is because both methods are a mirror image of the other.
You may wonder why the difference between the 2 future values (i.e. $400) and the 2 present
values ($358) is not the same. The difference is just a timing difference similar to that of other
cash flows (i.e. future value is calculated 1 year ahead of present value). The difference can

be reconciled by calculating either the future value of $358 (i.e. $358 x 1.12 ≈ $400) or the
present value of $400 (i.e. $400 x 0.8928 ≈ $358).

Unit 3: Lease vs Buy Decision
1. Introduction
A lease is a contract that provides a right to the use of assets,

legally owned by the lessor, in exchange for a specified rental paid
by the lessee. Leasing is a widespread form of medium-term and
long-term financing and the growth in lease financing has been
extraordinary. This chapter explores the use of a discounted cash
flow approach using the cost of debt as the relevant discount rate.
2. Study unit objective

At the end of the unit, students should be able to:
• Describe a direct lease, sale and lease-back and a leveraged lease

• Explain the advantages of leasing
• Evaluate the leasing decision and alternative sources of finance using discounted cash
flows
• Select and justify an appropriate discount rate, and

• calculate the net present cost of the various financing alternatives and the net
advantage of leasing
3. Prescribed study material

"Financial Management".9"Edition, Carlos Correia, Enrico Uliana & Michael Wormald
(2011), Juta – Chapter 15
4. Study unit content
4.1. Types of leases

Operating lease
An operating lease is an arrangement which provides an alternative means of obtaining the

use of an asset without purchasing. These leases are normally characterised by the term of
the lease being short in relation to the useful life of the asset being leased. Owing to the short-
term nature of the lease, the lessor frequently intends to either lease the asset again or sell it
at the termination of the lease. It would not be the intention of the lessee to acquire the use
of the asset on a permanent basis. The lessor would normally assume responsibility for the
maintenance and insurance of the asset. Frequently, operating lease agreements make
provision for cancellation and a required notice period would be stipulated. This cancellation
could be at the option of the lessee or lessor.
Finance lease
A financial lease has the following characteristics. The lease payments provide the lessor with
reimbursement for the cost of the leased asset, plus interest. Often the lease agreement
allows the lessee the option of buying the asset at the termination of the lease. Maintenance
and insurance of the asset are usually the responsibility of the lessee. Financial leases are
most commonly used to finance the acquisition of motor vehicles, equipment, and plant.
4.2. Methods used to acquire assets under leases
Direct lease
In a direct lease, the lessor acquires an asset from the manufacturer in order to lease it to the
lessee. A direct lease is the most straightforward of the financial leases, and also the type
most frequently encountered.

Sale and lease-back
A sale and lease-back form of lease can be employed in connection with existing or new assets.
A firm sells an asset under an agreement to lease it back from the buyer. In exchange for the
asset the selling firm obtains cash, and as the future lessee, the long-term right to the use of
the asset. On the other hand, the lessor pays out cash but obtains the legal right to the asset
and the right to lease instalments. At the end of the lease agreement there may be provision
for the lessee to repurchase the asset at a specified price.
Leveraged lease
With a leveraged lease, the lessor does not provide all the funds required to purchase the
asset that is to be leased. The balance of the funds would be obtained from other financial
institutions and the lease payments made by the lessee are then used to service these loans.
Any excess of the lease payment after the loan coverage is retained by the lessor.
4.3. Advantages of leasing
1. Changing technology - In some industries the rate of technological change is rapid, so

an advantage of leasing is that the term of a lease can be considerably shorter than
the life of the leased asset.
2. Tax advantages - Under certain conditions a lease can result in lower combined
taxation paid by the lessor and the lessee relative to the tax paid if the lessee were to
buy an asset.
3. Operating flexibility - Companies may be able to react more quickly to changes in
market conditions. For example, an airline may change routes more quickly and more
cost effectively if it is able to lease the right type of aircraft for certain routes.
4. Reduction in operating leverage - In some cases and for particular assets, a company
may be able to enter into an agreement that requires the company to pay an amount
per use rather than per period. This will result in changing a fixed cost to a variable
cost and lessors are able to charge a greater fee.

4.4. Evaluating the leasing decision
There has been considerable debate as to whether the decision to lease is an investment
decision or a financing decision. The two schools of thought are based on the premise that
the evaluation is ‘lease versus purchase’ or ‘lease versus borrow’ respectively, which is a
financing decision.
The attractiveness of a lease proposal should thus be evaluated in terms of the present
value of the differential cash flows relative to the borrow-and-buy alternative. It should be
noticed that, once again, we are about to evaluate cash flows using the present-value
technique to consider the time value of money. To conduct such an analysis, we need to
identify firstly an appropriate discount rate, and secondly the relevant cash flows for the
analysis.
4.4.1. Selecting the appropriate discount rate
With a leasing decision, management are examining a financing decision and so the
appropriate discount rate is the after-tax cost of debt. As the cash flows associated with
leasing would be much more certain than those associated with the investment decision,
a lower discount rate is appropriate.
A general rule emerges that, when analysing investment cash flows, the
weighted average cost of capital is used as a discount rate, and when
analysing financing cash flows, the after-tax cost of debt is the appropriate
discount rate.
The present cost of leasing
The cash outflows, which are the lease payments are shown as negative cash flows, with
the discount rate being the after-tax cost of debt. The cash flows are discounted using the
after-tax cost of debt to obtain the net present cost of leasing.

The present cost of borrowing and buying.
The first step in the determination of the present cost of borrowing is the calculation of
the equal annual repayments required on a loan. This can be done using a financial
calculator and a loan amortisation schedule can be prepared. Having calculated the loan
amortisation schedule, it is then necessary to discount the cash flows to obtain a present
cost associated with the loan payments.
4.4.2. The net advantage of leasing and NPV
The net advantage of leasing is the difference between the present value of the lease costs
and the present value of borrowing and purchasing. If the net advantage of leasing is
positive, we would lease the asset, while if it is negative, we would borrow and purchase.
Source: Financial Management by Correia and Flynn
4.5. Summary
− This decision comprises a choice between a lease option and the purchase option.
− The discounting rate used for such decisions is always the after-tax cost of debt
(cost of the normal loan). This is to ensure comparability.

− Only relevant cashflows must be taken into account (only those cashflows that
differ between the two options).
− Refer specifically to the following: amortisation schedule, assessed loss

treatment, relationship between the investment decision and the financing
decision. Also take note of the case of asset specific financing.
4.6. Exam technique
− Do a separate cash flow analysis for each option.
− Only include cash flows which are relevant to each option.
• Generally, income would be excluded, as it is the same regardless of

how the project is financed.
• Lease – lease payments will be relevant.
• Purchase via loan – the loan repayments will be relevant.

5. End of Unit Questions
Question
Volvo Ltd is a manufacturing company. They urgently need new machinery that would
dramatically decrease personnel members’ down time. The saving due to this ‘down time’
retrieved amounts to $324,000 a year. You are the newly appointed CFO and were asked to
make a presentation to the board concerning on whether to buy or lease the machinery. You
want to make a good impression and started gathering information straight away. The
cheapest price you could find on the machinery was $2,500,000. If Volvo buys the machinery,
the maintenance cost per year would amount to $60,000. During your search you found a
manufacturing company leasing out the same machine for $510,000 per year for 5 years. The
lease payments are payable in advance. If the machine is leased there is no need to pay for
the maintenance cost per year. The company’s after-tax cost of debt is 7%. The company also
depreciates their assets over 5 years.
Required
a. Calculate whether Volvo Ltd should buy or lease the machinery. Please show all
your calculations
b. Provide some of the good reasons for leasing
Suggested Solution
Lease Cash flows

NPC @ 7% ($2,091,100.69)
Buy Cash Flows
Year 0 Year 1 Year 2 Year 3 Year 4
Lease Payment -$510,000 -$510,000 -$510,000 -$510,000 -$510,000
Total Cash Flow -$510,000 -$510,000 -$510,000 -$510,000 -$510,000
NPC @ 7% ($2,566,366.21)
Net Advantage of Leasing (NAL)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cost of machine -$2,500,000
Maintenance Cost -$60,000 -$60,000 -$60,000 -$60,000 -$60,000
Total Cash Flow -$2,500,000 -$60,000 -$60,000 -$60,000 -$60,000 -$60,000
NAL = NPC (buy) - NPC (lease)
= $2,091,100.69 - $2,566,366.21
= ($475,265.52)
Conclusion
Volvo should lease the machine.

Required b:
• Taxes may be reduced.
• May reduce some uncertainty concerning the residual value.
• May have lower transaction costs (mainly operating leases)
• May require fewer restrictive covenants.
• May encumber fewer assets than secured borrowing.

Question 2
Carrera Ltd is a large and profitable company that processes canned fish. The management of
Carrera is keen to expand and is continuously searching for suitable investment opportunities.
In the past Carrera had always outsourced their canning processes at a cost of 50 cents per
tin. A new mini-canning plant was recently introduced to the market and the management of
Carrera is keen to determine whether it would be to their advantage to use their own canning
plant rather than outsourcing the canning processes. The canning plant will cost $200 000 and
will qualify for a tax write-off of 50%, 30% and 20% in years one to three respectively. It is
estimated that the plant’s useful life will be five years. It is further estimated that at the end
of five years the plant will have a residual value of $40 000. This residual value will not be
considered in determining depreciation. It is estimated that 300 000 cans will be prepared
annually. A compulsory maintenance contract will cost $1 000 while other expenses, including
depreciation, will amount to 40 cents per can.
In addition to the special introductory price of $200 000, the manufacturer also offers two
special introductory financing packages:
• A loan at 10% per annum which is payable in arrears in five equal annual installments.
• A lease with five annual lease installments of $43 000 which is payable annually in advance.
The lease installments include the maintenance contract.
If the machine is obtained with a lease, the lessee does not gain possession of the asset at the
end of the lease contract.
You may assume a company tax rate of 40%. Carrera’s cost of debt before taxation is 15% and
its weighted average cost of capital is 20%.
Required
Calculate the net present costs of both the lease contract and the alternative of 10% loan.

Suggested Solution
10% Loan
Cash Flow Analysis 0 1 2 3 4 5
Loan (52,760) (52,760) (52,760) (52,760) (52,760)
Proceed on disposal 40,000
Maintenance (1,000) (1,000) (1,000) (1,000) (1,000)
- (53,760) (53,760) (53,760) (53,760) (13,760)
NPC @ 9% = ($183,110.40)
Lease Contract
Cash Flow Analysis 0 1 2 3 4 5
Lease instalments (43,000) (43,000) (43,000) (43,000) (43,000)
(43,000) (43,000) (43,000) (43,000) (43,000)
NPC @ 9% = ($139,307.95)

Unit 4: Theory of capital structure
1. Introduction
Have you ever wondered what relationship is there between a firm’s

cost of capital, its value, and its capital structure? From your prior
studies, you should now be able to understand that the lower the
firm’s cost of capital, the higher the value of the firm. However, it is
no easy to determine whether differing capital structures can lead to
differing costs of capital. If this relationship holds, financial managers
should determine the capital structure which leads to the lowest cost
of capital and which consequently maximises the value of the firm.
Financial management is the catalyst between investment

opportunities on one hand and sources of finance on the other. This
is reflected in the Statement of Financial Position which shows assets
and the financing behind those assets (equity and liabilities). A
business may be viewed as a portfolio of all its assets.
The financing of these assets can be considered as a separate issue

which is the capital structure. Management must decide on the level
of debt, relative to equity, that it wants to maintain, and it can decide
on the types of debt and the types of equity that it plans to hold.
These decisions are influenced by the financial policy that the
management chooses and their ability to source the desired type of
financing they choose. Thus, in this chapter we are going to focus on
understanding factors behind a capital structure chosen by
management.
2. objective
The objectives of this Study Unit are to help students to:
• The objectives of the Study Unit are to help students to:
• Understand the relationship between capital structure and cost of capital.
• Understand the various theories on capital structure.
Thus, at the end of the study unit students should be able to:
• Explain how leverage increases the return and potential loss to shareholders.
• Describe how debt increases financial risk.
• Describe the pecking order approach to capital structure.
• Explain MM and why there is no optimal capital structure under certain assumptions.

Study unit
• Explain the conflicts between shareholders and bondholders’ interests.
• Explain how the conflict between management and shareholders will impact the
capital structure.
• Show the effect of inflation on the cost of debt.
• Explain the relationship between an optimal capital structure and the need for
flexibility.
• Evaluate the capital structure of a firm (quantitatively and qualitatively)
3. Prescribed study material

Financial Management ~ Carlos Correia, Chapter 14.
4. outline/Big picture
Whilst debt offers distinct tax advantages, high levels of debt bring about some financial crisis.
For instance, a company may face cashflow challenges which may hinder operations due to
interest and coupon payments on debt borrowed. A practical example was the downfall of
some banks and other entities that were highly geared that failed survive the perfect financial
storm that hit capital markets in 2008. Comparatively, corporate firms that generally had low
debt-equity ratios were able to survive the turmoil arising from the crisis. Low debt enabled
them to operate and sometimes borrow to survive a difficult operating environment. This
should raise eyebrows to investors as investing in highly geared firms may be risky. Low debt
offers firms the flexibility to survive financial storms and also enables firms to invest quickly if
opportunities arise.
Capital structure theory is based on the research of Modigliani and Miller (MM) who made
two important propositions.
 the value of a company is determined by the earning power and the riskiness of its
assets, not by how the assets are financed and,
 the cost of equity increases with financial leverage so that you cannot reduce your cost
of capital by taking on more debt.
MM made certain assumptions, principally about there being no tax and so this may change
our conclusions. Then there are agency issues in that the interests of shareholders and
bondholders may diverge particularly for highly levered firms. In this chapter, we will explore
all these issues.
5. content
Risk Profile
Financial managers should strive to maintain a balance in the risks to which the company is
exposed. There is a convention that an optimal strategy is to match long-term assets with
long-term finance, and short-term assets with short-term finance. This is known as maturity

Study unit
matching. While this may often be a very sensible way to arrange finance, the company may
choose to arrange it differently. This decision is a consequence of the policy that the company
adopts towards risk. It also depends on other risks to which it is exposed. The starting point
in evaluating the risk profile of a company is the evaluation of business risk and financial risk.
Business Risk
Business risk is the ‘what could go wrong’ in the operating activities of the company, which
can arise through its strategy, operations, legal and economic environment of the entity. For
example, an organisation such as a retail grocery chain has a low business risk because,
irrespective of the economic climate, it deals in basic necessities, thus a demand for its
products will always be present. Likewise, in boom periods the effect on basic products is not
as great as it would be on luxury goods. However, the building and construction industry is
the complete opposite as it suffers severely during periods of economic recession, but during
economic upswing it will tend to generate more revenues. To have a well-spread risk profile,
investors are thus encouraged to diversify their investments in different industries.
Financial Risk
Financial risk is the risk that arises from how the entity is financed (debt or equity) which is
commonly referred to as its capital structure. Debt and equity result in interest risk and capital
risk respectively. The interest risk is the risk of not being able to cover the fixed interest charge.
The capital risk is the risk that on liquidation, debt has a preferential claim against the assets.
Equity
Cash injections by shareholders or owners of an entity is referred to as equity. Unlike the debt
financiers who have a pre-determined interest at given intervals, equity providers are
rewarded through dividends and capital appreciation i.e. the growth in the value of the
shares. The risk to the company is low because, in the event of economic hardship, the
dividend need not be paid. On the other hand, when economic times are good, the
shareholders benefit greatly as the dividend is higher, or the capital growth is higher.
Debt
All borrowed funds that will need to be repaid are referred to as debt. These funds usually
have contractual interest commitments and capital repayments that will need to be paid at
pre-agreed intervals. Using our Zim tax principles (Section 15 of the Income tax Act) it can be
argued that interest is an amount that has been incurred in the production of taxable income.

thus can be deducted from gross income. However, by using debt, the organisation exposes
itself to financial risk and in the event of economic decline, interest payments and capital
repayments must still be made, and if the company has not generated sufficient income it
may be unable to meet these payments. Given that the exposure to debt increases risk, the
extent of the risk can be managed by the choice of the form in which the debt is placed.
 Long term or short term ~ Short-term debt is usually riskier because the commitments
have to be met rapidly, whereas in the case of long-term debt there is a longer period
in which to plan for repayment. Short-term debt has the advantage of allowing the
borrower greater flexibility to react to changing circumstances such as falling interest
rates.
 Secured or unsecured ~ Loan structures differ according to the amount being
borrowed, the borrower’s risk profile, duration of the loan and the general economic
landscape etc., which leads to some debt being secured or unsecured. It is also a
matter of policy as to whether the company is prepared to subject itself to the risk of
its assets being provided as security. Secured debt is associated with higher risk
because there is less flexibility on the part of the borrowing company.
If a company has a constant earnings pattern, it may be willing to assume greater financial risk
as they can plan for the payment terms unlike for a company subject to volatile trading
conditions, it would be unwise to take a position of high financial risk because, in the event of
an economic downturn, it could lead to financial distress.
Leverage (Gearing)
Using relatively more debt in the capital structure is known as leverage (or gearing). Leverage
is intended to increase the return on shareholders’ funds in exchange for greater financial risk.
Impact on Earnings
The use of debt rather than equity for financing will cause the firm to have a higher return on
equity as they should earn a higher return on assets than the interest rate on debt.
Shareholders will want to be rewarded for the additional risk that comes with debt financing.
Example 1: Favourable effect of leverage
Assume companies A and B are identical in all respects except in the way in which they are
financed. A is financed entirely by equity, while B is financed 60% by equity and 40% by debt,
bearing interest at 11% per year. Both companies have total capital structure of $1,000 and
EBIT of $400. Assume the tax rate is 28% .
Required
Calculate the ROA and ROE for both companies A and B.

Solution
The summarized statements of financial position and profit and loss statements for the
companies are:
Source: Correia
Both companies earn the same return on assets (NOPAT/Total assets) of 28.8%. The calculation
of the return on assets for Co B is indicated as follows:
Source: Correia
Otherwise, we can simply determine ROA = EBIT(1-t) /Assets = (400 x 0 .72)/1 000.
Through the use of debt, Company B has geared the ROA of 28,8% to a ROE of 42,7%
(253/600). The after-tax cost of the debt is 7,92%, and this has funded assets which are
generating an after-tax return of 28,8%. The net effect is that the shareholders have benefited
from the differential in the rates thus a reward for the increased risk they have taken .
Example 2: Unfavourable Effect of Leverage
Assume companies A and B are identical in all respects except in the way in which they are
financed. A is financed entirely by equity, while B is financed 60% by equity and 40% by debt,
bearing interest at 11% per year. Both companies have total capital structure of $1,000 and
EBIT of $42,5. Assume the tax rate is 28%.
Required

Calculate the ROA and ROE for both companies A and B.
Solution
The income statements for companies A and B are presented below:
Source: Correia
The return on assets for Co . B is determined as EBIT(1-t)/Assets = (42,5 x 0,72)/1 000 = 3,06%.
The return on equity is negative and is determined as –1,5/600 = –0,25% .
Optimal Capital Structure
The optimal capital structure is the debt-equity ratio that the company adopts so that its
weighted average cost of capital (WACC) is at the lowest point. There is considerable debate
as to whether an optimal capital structure is feasible and thus over the years a number of
theories have been developed to explain the relevance of capital structure. Modigliani and
Miller published a seminal paper which presented a rigorous analysis that capital structure is
irrelevant. However, the analysis is subject to certain assumptions which are:
 The individual can borrow on the same terms as the company can.
 There are no taxes.
 There are no transaction costs.
 There are no costs associated with the financial distress.  There are no agency costs.
6. The Modigliani–Miller Approach

Their main argument was that there is no optimal capital structure because, irrespective of
the level of gearing, a firm’s weighted-average cost of capital will not change. This occurs
because, as the company increases its debt (which is cheaper than equity), it is increasing its
risk.
The equity holders will require compensation for an increase in risk, and so the cost of equity
will rise and offset the relative benefit of the cheaper debt. One of the fundamental principles
in this argument is that it is the assets that determine the value of the business and not the
way in which those assets are financed. The firm’s investment in assets generates the profits,
not the way these assets were paid for. This makes sense as smart investments make money,
and this is one of the reasons there is so much emphasis on evaluating capital investments.

The measurement of this value is based on the net operating income (NOI), which we often
call earnings before interest and taxes (EBIT). The NOI is capitalized at the WACC which,
Modigliani and Miller contend, is a constant, as it is insensitive to changes in capital structure.
The value of a firm is consequently independent of its capital structure.
Modigliani and Miller establish this by showing that, if this were not the case, arbitrage would
take place and drive the prices of the shares to equilibrium. Let’s look at the illustration below:
Consider the case of two identical companies: Co. A (financed entirely by equity) and Co. B
(financed 40% by debt and 60% by equity). Assume the cost of equity is 20% and the cost of
debt 15%.
Source: Correia
Modigliani and Miller argue that if an investor holds 10% of the shares in company B can
increase the return from $6 ($60 x 10%) without necessarily increasing the risk. The investor
would sell the shares in B for $30 (10% of value of equity), borrow $20, and buy 10% of the
shares in company A for $45 (10% of value of equity). The new position from the investor’s
wallet would then be:
Source: Correia
The income is $6 in either event (whether he sells his shares in B or not), but the investor now
still has $5 left over to invest. Previously, shares were held in a company with a gearing of 40%
of total assets, but currently the investor has a personal gearing of 40% of total assets. Thus,
the risk is unchanged. Modigliani and Miller’s argument is that arbitrage will force the price
of B’s shares down and the price of A’s shares up until equilibrium is reached. The logical
deduction is that the cost of equity is moving in sympathy with the capital structure. It follows
that the WACC remains constant, irrespective of the quantity of debt financing, and is
therefore independent of capital structure.

7. Pecking Order and Signaling Theories
Pecking order theory assumes there is no target capital structure, rather finance will be raised
according to a preferred hierarchy. In general, this hierarchy suggests that financing
investments from retained earnings is the most preferred alternative. Additional funds will be
raised, in order of preference, from straight debt, to finally, the issue of new equity. This
hierarchy accommodates two attributes that managers value i.e flexibility and control.
Retained earnings preserve the existing control of the firm, because debt holders may impose
restrictive covenants and new equity dilutes existing control. As far as flexibility is concerned,
debt reduces flexibility in raising future finance.
Another factor would be Information asymmetry. As internal managers are more likely to have
better information about the firm than external investors, they would know if the firm’s
financial instruments are mispriced. Management would be reluctant to issue equity, which
is underpriced, consequently an equity issue may be interpreted as a signal that the equity is
overpriced.
The order in which funds would be issued is thus:
1 . Internally generated funds – retained earnings
2 . Debt
3 . Convertible debt and preference shares
4 . Equity
The pecking order theory states that management will always use the lowest-cost financing
alternative which is internally generated funds e.g retained earnings before making use of
external financing. If external financing is required, then a company will firstly prefer to use
debt as it is of lower cost than the issue of new equity. Companies will issue new equity only
when forced by circumstances or when the company is not able to raise any further loan
finance.
The use of equity financing acts as a signal to the market that management perceives the
share price to be over-valued. If the company has significant profit opportunities, then it will
endeavor not to issue shares and will try to rather use retained earnings or debt if this is not
possible. A company that is actively buying its own shares is signaling to the market that its
share price is understated. The issue of debt indicates that the company has excellent
prospects, and the equity holders wish to retain the benefits from any future investment
opportunities.
Companies will wish to avoid issuing new equity to finance investment opportunities that may
arise due to the negative signaling effects of such an issue. Therefore, a company will maintain
a lower-than-expected debt-equity ratio indicated by the pecking order theory so that it is
able to quickly take advantage of any investment opportunities without having to issue new
equity. The company will maintain spare borrowing capacity or surplus cash balances so that

it is able to quickly take advantage of investment opportunities. Further, the existence of spare
borrowing capacity means that the company is able to undertake investments without risking
making such information available to the capital markets.
Likewise, companies often maintain spare production capacity in order to immediately take
advantage of increased market demand.
8. Conflicts Between Management and Shareholders

Any potential conflict between management and the firm’s shareholders is heightened when
the firm has lots of free cash flow. Therefore, shareholders may take on more debt in order to
discipline management so that management avoids any waste and unnecessary capital
expenditure. The use of debt forces management to maximise returns and minimize the use
of capital.
Conflicts Between Shareholders and Bondholders
How does this conflict come into existence? As learnt in previous studies, in times of
liquidation, the bondholders will get preference on payouts and shareholders will receive
residual if any. What actions would shareholders tend to take when the entity is highly levered
or in financial distress?
Investing in High-Risk Projects
When a firm is close to failing, shareholders may be tempted to bet the firm on one last
investment. The firm is going to go down anyway, and the losers will tend to be the
bondholders.
Example 3
We will assume that XYZ Ltd has assets of $100 which is financed by loans of $60 and equity
of $40. The recession hits the company hard, and the value of the company’s assets falls to
$50. This means that there is no equity value, and the bonds have a value of $50. The
bondholders are still owed $60m but the value of their bonds have fallen to $50. Let’s assume
that the company is able to now undertake two projects with the following probabilities and
possible NPVs:

Source: Correia
Required
1. Which project will be accepted from the company’s point of view?

2. Which project will be accepted from the shareholders’ point of view?
3. Which project will be accepted from the bondholders’ point of view?
Solution
1. On the basis of NPV, the firm should select Project A as it has a higher expected NPV
and is less risky as there is a 50% chance to both outcomes.
2. The shareholders may wish to select Project B. Why?
• If project A is taken (Outcome 2) - The shareholders will recover a value of only
$10 (50 + 20 - 60) once the bondholders are paid.
• If project A is taken (Outcome 1) – This project will mean zero for the shareholders
as all the value will go to the bondholders (50 + 10 – 60).
• If project B is taken (Outcome 2) - The shareholders have a 25% chance of
recovering $40 (50 + 50 - 60) after the debt holders are paid. This means that 25%
of $40 ($50 – $10 payable to the bondholders) is better than 50% of $10 ($20 –
$10 payable to bondholders).
3. The bondholders would prefer the firm to take Project A because there is a 100%
chance that they will recover the loss of $10 whilst for Project B, there is only a 25%
that they will recover $10.
A capital structure that is highly levered which results in financial distress will mean higher
agency costs. Debt holders will be desperate to protect the value of their assets when
financial distress hits the firm as they understand the incentives that shareholders have.
When shareholders have nothing, they have nothing to lose and may take high risk bets
as they then own most of the upside and the bondholders own all the downside in other
words the profits go to the shareholders and the losses go to the bondholders.
9. Managing Shareholder and Bondholder Conflicts

Each time an entity secures a loan from financial institutions, there is always terms and
conditions that come with the financing. In instances where the company fails to comply or
shows signs of financial distress, the terms may have stipulated immediate repayment of the
loan or increase in interest rates, all in effort to protect the bondholders. The following are
some of the terms and conditions that can be imposed:
 A firm may need to comply with minimum working capital ratios, interest coverage
ratios, debt-equity ratios and maintain a certain value of shareholders’ equity
investment in the business .
 Limits may be imposed on the dividend payments to shareholders;

 The company may not issue additional debt without the permission of the current
bondholders;
 The firm is not allowed to dispose its major assets unless authorized by the current
bondholders;
 Any mergers or acquisitions may not be permitted unless authorized by the current
bondholders; and
 The firm is not permitted to offer guarantees or pledge its assets to other firms.
Covenants may also be used to limit a firm’s use of derivatives such as interest rate swaps,
forwards, futures and options unless such use reduces the risks to the debt holders . In fact,
banks may force firms to sell forward in order to fix future revenues.
10. The Impact of Inflation

When the impact of the interest tax shields on the cost of debt was considered, it was
assumed that there was no inflation. As tax shields are based on the nominal cost rather than
the real cost of debt, the real after-tax cost of debt decreases as inflation increases. This is
best explained through the use of an example.

Example 5: The Real Cost of Borrowing After Tax
Natural Herbs Pvt Ltd (NB) borrows $100m for one year from Hunzamari Microfinance (HM).
The current inflation rate is 10% and HM requires a real rate of return of 10% . Assume the
tax rate is 30% .
Required
1. Calculate the amount of capital that NB has to pay back at the end of the year.
2. Calculate the interest that NB has to pay at the end of the year.
3. What is the effective interest rate on the loan borrowed?
Solution
1. $100m x 1,10 (inflation) = $110m

2. $110m x 10% (real interest rate) = $11m
3. [121 / 100 ] – 1 = 21%
This relationship can be expressed in the following formula:
Source: Correia
Returning to example 5, we now need to consider the position after tax . For tax purposes the
company will be allowed to deduct the nominal interest of $21m, generating a tax shield of
$6,3m. However, the real interest amounts to only $11m, and so the real after-tax cost of
borrowing $110m is $4,7m. Therefore, the real after-tax cost of borrowing is only 4,27%. The
real after-tax cost of debt can be calculated using the following formula:
The real after-tax cost of debt can be calculated using the following formula:
Source: Correia
The significance of the above relationship is that the higher the rate of inflation, the lower the
real after-tax cost of debt. Inflation may therefore impact on the optimal capital structure by
encouraging a higher degree of financial leverage . However, inflation may also increase the
level of financial risk facing a company .

The Need for Flexibility
In as much there is a lot of theory around capital structure, it is imperative that the financial
manager does not view financing decisions with the rigidity. The financial manager should
approach this section with a degree of flexibility and an eye on market conditions and ability
to pay.
11. Strategic Considerations When Evaluating the Capital Structure Decision

There are a number of other strategic reasons which may not be quantified but are necessary
to consider when coming up with the capital structure of the entity. These are discussed below
and should be considered when evaluating a company’s capital structure:
Business Risk: If a company, by virtue of its operations, is subject to a high level of business
risk, then it will be less likely to use financial leverage. Lenders will also be less inclined to
grant credit to companies with high business risk. Therefore, in such an instance debt finance
will be limited; however, where business risk is assessed as low then a company will be more
likely to use debt finance.
Long-Run Viability: Large companies providing essential services, such as telecommunication

and electricity providers like Telone and ZETDC have a responsibility to provide continuous
service. These companies should refrain from using excessive debt finance in order to ensure
their long-run viability. If the cash flows are highly stable, then one may argue that this would
support a higher debt ratio. However, these companies are increasingly under pressure due
to changing business models.
Management Constraints (Agency Problem): If a company generates excess cash then

management may follow their own interests and squander the company’s money. This can be
avoided by limiting excess cash through paying dividends or repurchasing shares (decreasing
equity). Another alternative is to shift the capital structure to more debt as the interest
payment limits the amount of available cash.
Control: If certain shareholders barely have control and are not in a position to buy any more
shares, then excessive use of debt finance is likely. This is often particularly relevant for family-
controlled companies or holding companies who are not able to follow their rights in any
rights issue due to cash flow constraints.
Growth Rate: Faster growing companies generally rely more heavily on external capital.
Slower growth can be financed by retained earnings; however, rapid growth requires external
funds and often debt is used due to the advantages thereof e.g. debt is easier and less costly
to raise, does not have control implications and is cheaper than equity finance. However, if
high growth is matched with high business risk, then this will lead to the increased use of
equity finance as debt providers may offer ridiculous interest rates to compensate the high
risk.

Reserve borrowing capacity (financing flexibility): Maintaining a reserve borrowing capacity
preserves a company’s ability to issue debt on favorable terms and when needed e .g . when
interest rates are low, or a low-risk investment opportunity is available. In order to maintain
this borrowing capacity, companies generally use less debt than they would otherwise do.
Stakeholder theory: Stakeholders other than those who have provided finance, such as
customers, suppliers and employees, are less willing to transact with or work for a company
that has high levels of debt. When a company has ‘too much’ debt, stakeholders may rather
commit to doing business with or working for another company.
Nature of Assets: Companies with assets suitable to act as security for loans, such as property,
tend to use more debt as the security enables debt finance to be raised more easily and on
favourable terms. On the contrary, companies with minimal tangible assets, such as
pharmaceutical companies engaged in the research and development of new drugs, utilise
relatively little debt.
Market Conditions (Market Timing Theory): Conditions in equity and debt markets undergo
both long-run and short-run changes that can affect a company’s optimal capital structure.
When equity markets are rallying, or a company considers its shares overvalued then more
equity capital will be raised. During a credit crunch, as experienced in period following the
global financial crisis in 2008, low-rated companies in need of capital may be forced to issue
shares, regardless of their target capital structures. There may also be times when market
interest rates are favorable making debt finance more attractive.
Profitability: Companies with high rates of return on investment (and with limited growth
opportunities) tend to use less debt funding. High profits enable a company to finance its
operations with retained earnings.
Taxation: Interest is a deductible expense, but dividends are not deductible so the higher the
tax rate, the greater the advantage of using debt. However, if a company is in a tax loss position
then the advantage of using debt is deferred. The tax situation of a company therefore
influences its level of debt financing.
Capital Structure Analysis
Debt management ratios are an important category of ratios in the context of capital
structure. The following debt management or gearing (leverage) ratios are useful to calculate
and consider when analysing the capital structure or financial risk of an entity:
Comment
There could be numerous variations of these debt related ratios e.g. the debt
ratio could be ‘long-term debt’ divided by ‘net assets’ or debt could be
defined as ‘net debt’ which is debt less any cash reserves. Debt often will only
refer to interest bearing debt Light bulb
moment

Think about.
DFL is an indicator of financial risk – the greater the number, the higher the
interest charges and the greater the financial risk.

12. Summary
The choice of capital structure will depend on the financial risk the company is prepared to
take, which is influenced by the other risk factors affecting the company. These are primarily
the degree of operating, financial and business risk. The use of leverage will increase the
return on shareholders’ equity but, at the same time, it will also increase risk. There are
conflicting theories regarding an optimal capital structure.
Some scholars argue that WACC decreases with increased use of debt while others (the pure
M-M approach) contends that capital structure does not affect the WACC. The pecking order
theory suggests that management will raise funds from sources that retain flexibility and
control. Inflation will have an impact on the optimal capital structure as the real after-tax cost
of debt decreases with higher rates of inflation.
This is emphasized when a firm is in financial distress or is highly levered. Interest tax shields
can increase the value of debt and influence a firm’s capital structure decision. Whatever the
capital structure chosen; it should be regarded as a target. Short-term digressions to take
advantage of opportunities are all part of the financial management function.

13. End of Unit Questions Quiz

Comment
In a business, there are two principal sources of finance i.e. debt and equity.
Both these choices have their own effect on financial position of company in
form of tax advantages, procurement cost etc. From the comparison between
these two options of finance i.e. debt and equity, firm has to choose one to
achieve the targets. This is called Capital Structure Decisions.
In other words, Capital Structure is referred to as the ratio of different kinds of Light bulb
securities raised by a firm as long-term finance. moment
As per which approach the change in capital structure directly affects the
value of the firm as increase in debt reduces cost of capital and increase value
of firm.
Quiz Questions
1. As per which approach the change in capital structure directly affects the value of the firm
as increase in debt reduces cost of capital and increase value of firm.
A. Net operating income approach

B. Net income approach
C. Net asset approach

D. Return on net worth approach
2. Structure which relates to deployment of funds for long term assets is termed as
A. Financial structure
B. Capital structure.
C. Both 1 and 2
D. None of the above
3. A high EPS may not always maximize the stock price as EPS is not the sole indicator of the
price.
A. False
B. Partly true
C. 1
D. Partly false
4. A particular arrangement of various components of structure (debt and equity) which is

just in tune with both the long term and short term objectives of the firm is termed as
A. Reverse capital structure B. Financial leverage

C. Optimal capital structure
D. Vertical capital structure
5. Parties of Leveraged lease are
A. The lessor
B. The lessee
C. The lender
D. All of the above
6. Structure which relates to deployment of funds for the creation of both short- and long-
term assets is termed as
A. Financial structure
B. Capital structure.
C. Both 1 and 2
7. As per which approach the capital structure decision is not relevant and change in debt
will not affect the total value of firm.
A. Net income approach

B. Net operating income approach

C. Net asset approach

D. Return on net worth approach
8. The lease in which the lessor purchases the assets on loan from the lender and then give
it on lease to the lessee is known as
A. Leveraged lease.
B. Gross lease
C. Full-service lease
D. Gross industrial lease
9. The firm has to consider which of the following life cycle stages while deciding upon the
capital structure.
A. The pioneering stage

B. Expension stage
C. Stabilization stage
D. All of the above
10. In which structure the firm has zero debt component in the structure mix
A. Horizontal capital structure B. Vertical capital structure

C. Return on net worth.
Answers
1. B ~ As per net operating income approach the capital structure decision is not relevant
and change in debt will not affect the total value of firm.
2. B
3. C ~ There are other factors also which influence the stock price.
4. C
5. D ~ In leveraged lease, Lessor, Lesse and the lendor all are the parties. In this type of lease
lessor borrows some or most of the funds to finance the asset to be leased to a lessee.
6. A ~ Financial structure is the structure for both long and short term.
7. B ~ As per net operating income approach the capital structure decision is not relevant
and change in debt will not affect the total value of firm.

8. A ~ In leveraged lease, Lessor purchases the assets on loan from the lender and then give
it on lease to the lessee.
9. D
10. A

Unit 5: Cost of equity
Introduction
Managers are expected to grow or create wealth from the financial
recourses that are placed under their control. The financial manager
applies these resources, in accordance with the strategic objectives
of the business, by seeking investment opportunities which achieve a
return at least equal to that required by investors. When a business is
funded through equity only, then the cost of equity becomes the cost
of capital that managers use to evaluate investment opportunities. In
some cases, entities are financed by both equity and debt, which
means the required return to be used for appraising investments
should incorporate both the return on debt holders and on
shareholders i.e. weighted-average cost of capital.
In this chapter, we will firstly explain the importance of the weighted-
average cost of capital and explain the underlying principles. Then, we
will explain the pooling of funds concept and determine the cost of
ordinary equity using the available models.
Study unit objective
The objectives of this Study Unit are to help students to:
• Understand what constitutes costs of capital of an entity.
• Identify the various sources of long-term capital. • Determine the cost of various
sources of financing.
Thus, at the end of the study unit students should be able to:
• Describe the concept of the weighted average cost of capital (WACC)

• Calculate the cost of equity using the dividend growth model and the CAPM approach.
• Describe the practical issues of estimating the CAPM parameters.

Prescribed study material

Financial Management ~ Carlos Correia, Chapter 7.

Study unit content
The Weighted-Average Cost of Capital

The weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which
each category of capital is proportionately weighted. All sources of long-term capital,
including common preference shares, bonds, and any other long-term debt, are included in a
WACC calculation. The following are some compelling reasons for calculating a company’s cost
of capital:
The evaluation of capital projects
A correct calculation of WACC is important to enable a company to evaluate capital projects.

An acceptable project will be one that gives a positive NPV after cashflows are discounted at
the company’s WACC or a project that has an IRR that is higher than the company’s WACC.
The valuation of companies
A company’s WACC enables investors to undertake Discounted Cashflow valuations of

companies. A company’s cost of capital is used to discount a firm’s forecasted future operating
cash flows to determine their current value.
The determination of a company’s EVA or economic profit
Investors are making increasing use of Economic Value Added (EVA), or economic profit, to
evaluate the financial performance of companies and management is increasingly evaluated
on the basis of EVA. The calculation of EVA requires a company to determine the firm’s WACC
as EVA is determined as follows:
EVA = operating income – (WACC × Invested Capital)
Alternatively, Return on Invested Capital (RoIC) is often compared to the company’s WACC in
order to evaluate whether they are adding or destroying value.
The use of WACC to frame pricing decisions for industries subject to regulatory review

For companies and utilities operating in industries such as water, power and gas transmission,
which is subject to regulatory review, the determination of a company’s WACC is critical as it
is employed by the regulatory authorities to determine the company’s prices.
The determination of fair value for corporate reporting purposes
Companies may use WACC to determine the fair value of assets for corporate reporting
purposes. This is particularly relevant when there is an absence of a liquid, orderly market for
a company’s assets.
Principles in calculating cost of capital.
The following are some of the principles to follow in calculating a company’s cost of capital:
Use a weighted average of the costs of the different sources of finance.
We are interested in determining the required return that will provide a return to all the
providers of financing to the firm. If we use only the cost of a specific source of finance, then
this will lead to flawed investment decisions. Therefore, we need to determine the cost of
each instrument then weight it in accordance with its importance to the entity (target capital
structure).
Use marginal costs.
Use the interest cost of raising new debt and not the average cost of past debt issues and
loans. Do not use the average interest rate on bonds and loans reported in the company’s
financial statements. Use data that refers to the future in calculating the cost of equity and
the cost of debt, thus market related interest rate.
Include the effects of corporate tax
The discount rate should be stated after corporate tax since Section 15 of the Income Tax Act
regards interest expenses as an allowable deduction. Furthermore, when we discount future
cash flows, we discount cash flows after corporate tax and therefore to be consistent, we
should use a discount rate that is stated after corporate tax.

Use nominal rates.
Future cash flows are often stated in nominal terms and therefore we should use a nominal
rate as a discount rate. Real cash flows can be discounted at the real required return, but often
this creates further complications in relation to differential growth rates and determining the
value of depreciation deductions.
Use market values or a target capital structure.
To determine the weighted cost of each instrument, we use the desired target capital structure
to apportion the weights between debt and equity. However, in the event that the target
capital structure has not been made available we make use of market values. Ignore book
values to set the capital structure unless it reflects the future capital structure of the firm or
is close to market value.

The formula for WACC is as follows:
Source: Correia
If the company has issued preference shares this would be included as a separate component
in the above formula.
Component Costs of Capital

Although there are a number of itemized sources of finance, we will only focus on the long-
term or permanent sources of financing, being ordinary equity.
Cost of Shareholders’ Equity

The cost of funds contributed by shareholders is generally more difficult to ascertain. The cost
of equity is the rate of return required to at least maintain the value of the shares. There are
2 main ways in which to determine the cost of equity which we will discuss i.e. Gordon’s
Dividend Growth model and the Capital Pricing Method (CAPM
Example 1: Calculating the Component Cost of Equity
The following facts are known about Chimbadzo Ltd:
 Current market price: $7.68
 Expected EPS for the next year: $1.28
 Dividend payout ratio: 30%
 Expected growth rate: 11% p.a.
 Beta: 1.2
In addition, it is established that the expected return on the market (Rm) equals 14% and that
the risk-free rate (Rf) equals 8%. This means that the market risk premium is expected to be
6%. Chimbadzo has 500 shares in issue.

Required
Determine the cost of equity for Chimbadzo using:
i. The Dividend Growth Model
ii. The CAPM
Dividend growth method

The assumption of constant growth is made when using this model. In this method, we shall
use the formula below:
Ke = (D1 / Po ) + g
Where:
Ke is cost of equity
D1 is the dividend expected to be paid in the following

year
P0 is the current market price per share
G is the estimated constant growth rate
Solution (to example 1)
i. To apply this model, the expected dividend (D1) must be determined. As the expected EPS
is $1.28, and the dividend policy is known to be 30% of earnings, D1 is estimated as
follows: D1 = $1.28 × 0.30 = 38 cents
Applying the growth formula:
(0.38 / 7.68) + 11% = 15.95%

Capital Asset Pricing Model Method (CAPM)
The capital asset pricing model can be used to calculate a cost of equity and incorporates risk.
The CAPM is based on a comparison of the systematic risk of individual investments with the
risks of all shares in the market.
Using CAPM Ke = Rf + B(Rm – Rf)
Where Ke is Cost of Equity
Rf is risk free rate, usually estimated to be equal to government

bonds as the government has less risk of default
Rm return in the market
Rp is the risk premium or additional risk for investing in an entity

rather than the government i.e. the difference between market
return and the risk-free rate.
B is the systematic risk
Solution (to example 1)
ii. Applying the CAPM formula:
Ke = 0.08 + 1.20 (0.06)
Ke = 0.08 + 0.072
Ke = 15.2%
Systematic risk and unsystematic risk
• The risk involved in holding securities (shares) divides into risk specific to the company
(unsystematic) and risk due to variations in market activity (systematic).
• Unsystematic or business risk can be diversified away, while systematic or market risk
cannot. Investors may mix a diversified market portfolio with risk-free assets to achieve a
preferred mix of risk and return.

Implications of systematic and unsystematic risk on investments

(a) If an investor wants to avoid risk altogether, s/he must invest entirely in risk-free
securities.
(b) If an investor holds shares in just a few companies, there will be some unsystematic risk
as well as systematic risk in his portfolio, because he will not have spread his risk enough
to diversify away the unsystematic risk. To eliminate unsystematic risk, he must build up a
well-diversified portfolio of investments.
(c) If an investor holds a balanced portfolio of all the stocks and shares on the stock market,
he will incur systematic risk which is exactly equal to the average systematic risk in the
stock market as a whole.
Shares in individual companies will have different systematic risk characteristics to this
market average. Some shares will be less risky, and some will be riskier than the stock market
average. Similarly, some investments will be riskier, and some will be less risky than a
company's 'average' investments.
The capital asset pricing model is mainly concerned with how systematic risk is measured, and
how systematic risk affects required returns and share prices. Systematic risk is measured
using beta factors.
CAPM theory includes the following propositions:
(a) Investors in shares require a return in excess of the risk-free rate, to compensate them
for systematic risk.
(b) Investors should not require a premium for unsystematic risk, because this can be
diversified away by holding a wide portfolio of investments.
(c) Because systematic risk varies between companies, investors will require a higher return

from shares in those companies where the systematic risk is bigger
The same propositions can be applied to capital investments by companies
(a) Companies will want a return on a project to exceed the risk-free rate, to compensate
them for systematic risk.
(b) Unsystematic risk can be diversified away, and so a premium for unsystematic risk should
not be required.
(c) Companies should want a bigger return on projects where systematic risk is greater.
Problems with applying the CAPM in practice
(a) The need to determine the excess return 𝑹𝒎 − 𝑹𝒇. Expected, rather than historical,
returns should be used, although historical returns are often used in practice.
(b) The need to determine the risk-free rate. A risk-free investment might be a
government security. However, interest rates vary with the term of the lending.
(c) Errors in the statistical analysis used to calculate β values. Betas may also change
over time.
(d) The CAPM is also unable to forecast accurately returns for companies with low
price/earnings ratios and to take account of seasonal 'month-of-the-year' effects and 'day- of-
the-week' effects that appear to influence returns on shares.
Beta factor
(a) What does beta measure, and what do betas of 0.5, 1 and 1.5 mean?
(b) What factors determine the level of beta which a company may have?
(a) Beta measures the systematic risk of a risky investment such as a share in a
company. The total risk of the share can be sub-divided into two parts, known as systematic
(or market) risk and unsystematic (or unique) risk. The systematic risk depends on the
sensitivity of the return of the share to general economic and market factors such as periods

of boom and recession. The capital asset pricing model shows how the return which investors
expect from shares should depend only on systematic risk, not on unsystematic risk, which
can be eliminated by holding a well-diversified portfolio.
The average risk of stock market investments has a beta of 1. Thus, shares with betas of 0.5
or 1.5 would have half or 1½ times the average sensitivity to market variations respectively.
This is reflected by higher volatility of share prices for shares with a beta of 1.5 than for those
with a beta of 0.5. For example, a 10% increase in general stock market prices would be
expected to be reflected as a 5% increase for a share with a beta of 0.5 and a 15% increase
for a share with a beta of 1.5, with a similar effect for price reductions.
(b) The beta of a company will be the weighted average of the beta of its shares and the
beta of its debt. The beta of debt is very low, but not zero, because corporate debt bears
default risk, which in turn is dependent on the volatility of the company's cash flows.
Factors determining the beta of a company's equity shares include:
(i) Sensitivity of the company's cash flows to economic factors, as stated above. For
example, sales of new cars are more sensitive than sales of basic food stuffs and necessities.
(ii) The company's operating gearing. A high level of fixed costs in the company's cost
structure will cause high variations in operating profit compared with variations in sales. (iii)
The company's financial gearing. High borrowing and interest costs will cause high variations
in equity earnings compared with variations in operating profit, increasing the equity beta as
equity returns become more variable in relation to the market as a whole. This effect will be
countered by the low beta of debt when computing the weighted average beta of the whole
company.
Market risk and returns
Example

Shares in Beta & Theta Ltd have a beta (β) of 0.9. The expected returns to the market are
10% and the required return on a long-term government bond is 4%. What is the cost of
equity capital for Beta & Theta Ltd?
Solution: Ke = 9.4%
Beta values and the effect of gearing
The gearing of a company will affect the risk of its equity. If a company is geared and its
financial risk is therefore higher than the risk of an all-equity company, then the β value of
the geared company's equity will be higher than the β value of a similar ungeared company's
equity.
The CAPM is consistent with the propositions of Modigliani and Miller. MM argue that as
gearing rises, the cost of equity rises to compensate shareholders for the extra financial risk
of investing in a geared company. This financial risk is an aspect of systematic risk, and ought
to be reflected in a company's beta factor.
8.6.1. Geared betas and ungeared betas
The connection between MM theory and the CAPM means that it is possible to establish a
mathematical relationship between the β value of an ungeared company and the β value of a
similar, but geared, company. The β value of a geared company will be higher than the β value
of a company identical in every respect except that it is all-equity financed. This is because of
the extra financial risk. The mathematical relationship between the 'ungeared' (or asset) and
'geared' betas is as follows.
Try this formula
𝑉𝑒
𝛽𝛼 = 𝛽𝑒 × 𝑉
𝑒 + 𝑉𝑑(1 − 𝑡)

Where
𝛽𝛼 is the asset or ungeared beta
𝛽𝑒 is the equity or geared beta
𝑉𝑑 is the market value of the debt capital in the geared company. 𝑉𝑒

is the market value of the equity capital in the geared company.
t is the rate of corporate tax
8.6.2. Using the geared and ungeared beta formula to estimate a beta factor.
Another way of estimating a beta factor for a company's equity is to use data about the returns
of other quoted companies which have similar operating characteristics: that is, to use the
beta values of other companies' equity to estimate a beta value for the company under
consideration. The beta values estimated for the firm under consideration must be adjusted
to allow for differences in gearing from the firms whose equity beta values are known. The
formula for geared and ungeared beta values can be applied.
If a company plans to invest in a project which involves diversification into a new business, the
investment will involve a different level of systematic risk from that applying to the company's
existing business. A discount rate should be calculated which is specific to the project, and
which takes account of both the project's systematic risk and the company's gearing level. The
discount rate can be found using the CAPM.
Impact of financing on investment decisions and adjusted present values
Step 1: Get an estimate of the systematic risk characteristics of the project's operating cash
flows by obtaining published beta values for companies in the industry into which the
company is planning to diversify.
Step 2: Adjust these beta values to allow for the company's capital gearing level. This
adjustment is done in two stages.

(a) Convert the beta values of other companies in the industry to ungeared betas, using
above formula
(b) Having obtained an ungeared beta value βα, convert it back to a geared beta βe,
which reflects the company's own gearing ratio, using the formula:
𝛽𝑎(𝑉𝑒 + 𝑉𝑑(1 − 𝑡))

𝛽𝑒 =
𝑉𝑒
Step 3: Having estimated a project-specific geared beta, use the CAPM to estimate a project-
specific cost of equity.
Example
An investor is interested in acquiring Apple (Pvt) Ltd, a private company with net assets of
$240 million and debt capital of $160 million in its balance sheet.
Apple can be compared to a public company, Red Ltd, which operates in the same
industry.
and has similar business mix and business risk. The following information is available about
Market value of equity $450 million

Equity beta 1.60
Debt capital Risk free (debt capital beta = 0)
Price to book value of equity 1.50 times
Debt to equity ratio 1.25
The rate of taxation is assumed to be 25.75%. The risk-free rate of interest is 5%, and the
equity risk premium is 3%.
Required
Use this information to estimate a cost of equity of Apple (Pvt) Ltd.

Solution
Apple (Pvt) Ltd is a private company, and estimating a cost of equity has to be based on a
comparison with a similar public company, Red Ltd.
The asset beta formula uses market values for debt and equity. Although we have these
market values for Red Ltd, we do not have them for Apple (Pvt) Ltd. An assumption should
therefore be that book values are a reasonable approximation for market values, and book
values will be used in the calculations.
It is also assumed that debt in Apple (Pvt) Ltd is risk-free.
Taking data about Red Ltd and book values rather than market values, we can estimate an
asset beta for Red Ltd and then assume that the same asset beta applies to Apple (Pvt) Ltd.
Market value of Red Ltd = $450 million Price

to book value of equity = 1.5
$450 𝑚𝑖𝑙𝑙𝑖𝑜
Book value of equity = = $300 million
1.5
Debt:Equity ratio = 1.25 times

Book value of debt = $300 million × 1.25 = $450 million
300
𝛽𝛼 = 1.60 ×
300 + 450(1 − 0.2575)
𝛽𝛼 =1.60 × 0.4731 = 0.76
This asset beta can be used to estimate an equity beta for Apple (Pvt) Ltd:
0.76 = 𝛽𝑒 × 240+160(1−0.2575)
 𝛽𝑒 = 1.14
The CAPM can now be used to estimate a cost of equity in Apple (Pvt) Ltd:
𝐾𝑒 = 5% + 1.14(3%)
𝐾𝑒 = 8.42%
Weaknesses in the formula
The problems with using the geared and ungeared beta formula for calculating a firm's equity
beta from data about other firms are as follows.
(a) It is difficult to identify other firms with identical operating characteristics.
(b) Estimates of beta values from share price information are not wholly accurate. They are
based on statistical analysis of historical data, and as the previous example shows,
estimates using one firm's data will differ from estimates using another firm's data.
(c) There may be differences in beta values between firms caused by:
(i) Different cost structures (e.g., the ratio of fixed costs to variable costs)
(ii) Size differences between firms
(iii) Debt capital not being risk-free.

(d) If the firm for which an equity beta is being estimated has opportunities for growth that
are recognized by investors, and which will affect its equity beta, estimates of the equity
beta based on other firms' data will be inaccurate, because the opportunities for growth
will not be allowed for.
Perhaps the most significant simplifying assumption is that to link MM theory to the CAPM, it
must be assumed that the cost of debt is a risk-free rate of return. This could obviously be
unrealistic. Companies may default on interest payments or capital repayments on their loans.
It has been estimated that corporate debt has a beta value of 0.2 or 0.3.
The consequence of assuming that debt is risk-free is that the formulae tend to overstate the
financial risk in a geared company and to understate the business risk in geared and ungeared
companies by a compensating amount.
The Weighted-Average Cost of Capital – Some Practical Issues

The Risk-Free Rate – the yield on long term government securities is taken as this more closely
matches the term of the project being evaluated or the period in which the entity will operate
in. Furthermore, short-term rates are significantly more volatile and the yield on, say, 10-year
bonds, is more consistent with setting a long-term cost of equity.
The Market (Equity) Risk Premium - Investors expect to earn a return that rewards them for
taking on the higher risk involved in investing in equities as compared to bonds. The market
risk premium is the additional return that equity investors expect to earn over the risk-free
rate.
Adjustments to the cost of equity
Only systematic risk is rewarded in the CAPM framework. If shareholders are not fully
diversified, then the CAPM estimate of the cost of equity will understate the company’s true
cost of equity. Therefore, there is need to make separate adjustments to beta to include
factors that cannot be easily be quantified. Some of the factors are listed below:
 One key customer or supplier thus increasing risk of the entity

 Lack of track record thus increasing risk as potential suppliers, customers,
finance providers etc. will not have much trust in the entity
 Significant growth expectations thus lowering risk as growth entails more
wealth creation
Question
Tats is first year trainee of BigAchiever Petroleum (Pvt) Ltd (BP), a divisionalised company that
operates in different sectors of the economy. The bio-fuels division of BP is considering
investing in a project to develop and produce a fuel for cars made of reused cooking oil. Tats
has been asked to calculate the bio-fuel division’s WACC which is to be used for this project,
given the information below:
Extract of the Statement of financial position as at 28 February 2020
Ordinary share capital $20 000 000
The ordinary shares have a par value of $1 each and could currently be purchased at $5 each.
Government bonds are currently yielding a return of 7%. The market risk premium is 6%.
Shell Ltd is a listed company with operations similar to those of the bio-fuels division of BP.

The beta of Fuels-for-Ever is 1.2. The debt: equity ratio of Fuels-for-Ever is 66.6%, and that of
BP is 150%.
Tats recently found out that the company-level WACC of BP is 12% and got so excited thinking
that she found the discount rate!
Required
1. Calculate the cost of equity of BP.
2. Explain whether Tats should make any adjustments to the beta and what are the
implications of the adjustment?

Suggested solution
BP (Pvt) Ltd
1. Using information about the proxy (Shell Ltd), un-gear the beta
100
𝛽𝛼 = 1.2 ×
100 + 66.6(1 − 0.2575)
 𝛽𝛼 = 0.8029… (ungeared beta)
Re-gear the beta of BP

100
0.8029 … = 𝛽𝑒 ×
100 + 150(1 − 0.2575)
 𝛽𝛼 = 1.70

Adjust 𝛽𝛼 for the following:
𝛽𝛼 as per calculation 1.70
BP not a listed company (increases risk) +
Adjusted 𝛽𝛼 1.75
Using CAPM:
𝐾𝑒 = 7% + 1.75×6%
𝐾𝑒 = 17.5%
2. Tats should adjust the beta (increase the beta of BP) to incorporate the effect of
higher risk as compared to Shell.
This will increase the cost of equity, which will consequently increase the WACC.
Total

2024 Bcta Corporate Finance Module

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2024 Bcta Corporate Finance Module

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BCTA CORPORATE FINANCE MODULE

Bridging Course to the Certificate in Theory of Accounting (BCTA)

Corporate Finance Module

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Dear BCTA Student

ii. After Lecture

iii. Doing Tutorials

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iv. Attempting Questions

Name Contact details

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Management Accounting and Decision Making

3.1.1. Introduction to cost and management accounting

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Unit 1: Sources of Finance

2. Study unit objectives

2.1 Learning Outcomes

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Explain the types of financial instruments.

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Study Unit Content

Meaning, nature, and significance of business finance

The financial needs of a business can be categorised as follows:

(a) Fixed capital requirements:

(b) Working capital requirements:

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Classification of sources of funds

Based on period, the different sources of funds can be categorised into

Source of Generation Basis

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by accelerating collection of receivables, disposing of surplus inventories, and ploughing back

The important merits of trade credit are as follows:

(i) Trade credit is a convenient and continuous source of funds;

(i) Trade credit needs to promote the sales of an organisation;

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Ordinary (equity) shares

Deferred ordinary shares.

Ordinary shareholders put funds into their company:

a) by paying for a new issue of shares

b) through retained profits.

A new issue of shares might be made in a variety of different circumstances:

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New shares issues

A company seeking to obtain additional equity funds may be:

a) an unquoted company wishing to obtain a Stock Exchange quotation.

a) an offer for sale

Offers for sale:

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· they cannot be secured on the company's assets

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Debentures with a floating rate of interest

The redemption of loan stock

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a) how much cash is available to the company to repay the debt

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Short term lending may be in the form of:

b) a short-term loan, for up to three years.

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a) the lessor supplies the equipment to the lessee.

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Other important characteristics of a finance lease:

Why might leasing be popular.

· Leasing might be attractive to the lessee:

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Operating leases have further advantages:

Hire purchase agreements usually involve a finance house.

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· the institution will want an equity stake in the company ·

b) details of how much finance is needed and how it will be used

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details of major shareholders

Franchising is a method of expanding business on less capital than would otherwise be

The advantages of franchises to the franchisor are as follows: