1

ALL RIGHTS RESERVED

This book and material including write-up, tables, graphs, figures, etc., therein
are copyright material and are protected under Copyright Laws of Pakistan.
No part of this publication can be reproduced, stored in a retrieval system or
transmitted in any physical photocopying, recording or otherwise without prior
written permission or the ICMA’s Head Office.

Institute of Cost and Management Accountants of Pakistan

Email : education@[Link]
Website : [Link]
Phone : + 92-21-99243900
Fax : + 92-21-99243342

First Edition 2014

Contents developed by a consortium lead by KAPLAN.

Second Edition 2020

Contents updated by the ICMA Pakistan.

Third Edition 2024

Contents updated by the ICMA Pakistan.

Disclaimer
This document has been developed to serve as a comprehensive study and
reference guide to the faculty members, examiners and students. It is neither
intended to be exhaustive nor does it purport to be a legal document. In case
of any variance between what has been stated and that contained in the
relevant act, rules, regulations, policy statements etc., the latter shall prevail.
3

While utmost care has been taken in the preparation / updating of this
publication, it should not be relied upon as a substitute of legal advice.

Any deficiency found in the contents of study text can be reported to the
Education Department at education@[Link]
4

HOW TO USE THE MATERIAL

The main body of the text is divided into a number of chapters, each of which is organized
on the following pattern:

• Detailed learning outcomes. You should assimilate these before beginning detailed work
on the chapter, so that you can appreciate where your studies are leading.

• Step-by-step topic coverage. This is the heart of each chapter, containing detailed
explanatory text supported where appropriate by worked examples and exercises. You
should work carefully through this section, ensuring that you understand the material being
explained and can tackle the examples and exercises successfully. Remember that in
many cases knowledge is cumulative; if you fail to digest earlier material thoroughly; you
may struggle to understand later chapters.

• Examples. Most chapters are illustrated by more practical elements, such as relevant
practical examples together with comments and questions designed to stimulate
discussion.

• Self-Test question. The test of how well you have learned the material is your ability to
tackle standard questions. Make a serious attempt at producing your own answers, but at
this stage don’t be too concerned about attempting the questions in exam conditions. In
particular, it is more important to absorb the material thoroughly by completing a full
solution than to observe the time limits that would apply in the actual exam.

• Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to
think that this provides the same benefits as you would gain from a serious attempt of your
own. However, if you are struggling to get started on a question you should read the
introductory guidance provided at the beginning of the solution, and then make your own
attempt before referring back to the full solution.
5

STUDY SKILLS AND REVISION GUIDANCE

Planning
To begin with, formal planning is essential to get the best return from the time you spend
studying. Estimate how much time in total you are going to need for each subject you are
studying for the Strategic Level. Remember that you need to allow time for revision as well
as for initial study of the material. This book will provide you with proven study techniques.
Chapter by chapter it covers the building blocks of successful learning and examination
techniques. This is the ultimate guide to passing your ICMA Pakistan written by a team of
developers and shows you how to earn all the marks you deserve, and explains how to
avoid the most common pitfalls.

With your study material before you, decide which chapters you are going to study in each
week, and which weeks you will devote revision and final question practice.

Prepare a written schedule summarizing the above and stick to it.

It is essential to know your syllabus. As your studies progress you will become more
familiar with how long it takes to cover topics in sufficient depth. Your timetable may need
to be adapted to allocate enough time for the whole syllabus.

Tips for effective studying

(1) Aim to find a quiet and undisturbed location for your study, and plan as far as
possible to use the same period of time each day. Getting into a routine helps to
avoid wasting time. Make sure that you have all the materials you need before
you begin so as to minimize interruptions.

(2) Store all your materials in one place, so that you do not waste time searching for
items around your accommodation. If you have to pack everything away after
each study period, keep them in a box or even a suitcase, which will not be
disturbed until the next time.

(3) Limit distractions. To make the most effective use of your study periods you
should be able to apply total concentration, so turn off all entertainment
equipment, set your phones to message mode and put up your ‘do not disturb’
sign.
6

(4) Your timetable will tell you which topic to study. However, before dividing in and
becoming engrossed in the finer points, make sure you have an overall picture of
all the areas that need to be covered by the end of that session. After an hour,
allow yourself a short break and move away from your study text. With
experience. You will learn to assess the pace you need to work at.

Work carefully through a chapter, note imported points as you go. When you have covered a
suitable amount of material, vary the pattern by attempting a practice question. When you have
finished your attempt, make notes of any mistakes you make, or any areas that you failed to
cover or covered more briefly.
 7

CONTENT
S No. Chapters Page No.
1 Building Financial Sense 1
2 Equity Finance 28
3 Debt Finance 47
4 Risk and Return 62
5 Cost of Capital 73
6 Operating and Financial Leverage 91
7 Capital Structure Decisions 111
8 Capital Investment Decisions 134
9 Dividend Decisions 223
10 Business Valuation 246
11 Mergers and Acquisitions 284
12 Foreign Currency Risk Management 331
13 Working Capital Management 351
14 Financial Analysis 381
15 International Investment 406
8
9

Learning Objectives:

a) Identify and explain the primary goal of a firm and its significance in business decision-
making.

b) Understand and articulate the five foundational principles of finance, highlighting their
importance in guiding financial decisions and strategies.

c) Recognize and discuss the ethical considerations and the role of trust in financial
management and decision-making.

d) Describe the essential role of finance within a business, including its functions,
responsibilities, and impact on organizational success.

e) Differentiate among the various legal forms of business organization, such as sole
proprietorships, partnerships, corporations, and limited liability companies, and
understand their respective advantages and disadvantages.

f) Explain the evolution and factors leading to the rise of multinational corporations,
emphasizing the new role of finance in managing global operations and challenges.

g) Demonstrate an understanding of the mechanics of compounding, including calculating

future value and bringing the value of money back to the present using appropriate
formulas and calculations.

h) Explain the concept of annuities, including different types and their applications in
financial planning and investment.

i) Calculate the future or present value of a sum when compounding occurs at non-annual
periods, and interpret the results in the context of comparing interest rates across different
compounding frequencies.

j) Determine the present value of an uneven stream of payments, understand the concept of
perpetuities, and apply appropriate financial formulas and calculations to evaluate and
compare investment opportunities.
10

Principles of Finance:

Finance means the management of money and investments. In the corporate world, finance
involves activities like budgeting, investing, and managing assets to maximize shareholder
value. For instance, a CFO may oversee the company's financial strategy, deciding whether to
invest in new projects or distribute profits to shareholders as dividends. Additionally, finance
professionals analyze financial statements to assess the company's performance and make
recommendations for improvement.

Strategy:

A company typically uses multiple levels of strategies to achieve its goals and objectives. Here
are the different levels of strategies:

S# Strategy Example
1 Corporate Level Strategy: A company deciding to expand into new
Defines the company's overall mission, markets or divest from non-core
vision, and objectives. It outlines how the businesses.
company will allocate resources and
compete in the market.
2 Business Level Strategy: A company's product line or business unit
Focuses on how each business unit or deciding to differentiate itself through
division will compete in its respective quality or innovation.
market. It outlines the unit's mission,
goals, and competitive advantage.
3 Functional Level Strategy: The marketing department deciding to
Defines how each functional department focus on digital marketing to support the
(marketing, sales, finance, HR, etc.) will business unit's growth strategy.
support the business level strategy.

FINANCIAL STRATEGY:

Financial strategy in corporate business refers to the overarching plan designed to achieve the
company's financial objectives and optimize its financial resources. This involves decisions
regarding capital structure, investment opportunities, risk management, and financial
performance metrics. Three real-world examples include:

a) Capital Structure Optimization: Deciding on the mix of debt and equity financing to minimize
the cost of capital while balancing risk. For instance, a company may choose to issue bonds
to fund expansion projects rather than diluting ownership through issuing more equity.
11

b) Investment Allocation: Determining where to allocate financial resources to generate the

highest returns. For example, a technology company might invest in research and
development to innovate new products or acquire a competitor to expand market share.

c) Risk Management: Implementing strategies to mitigate financial risks such as interest rate
fluctuations, currency risks, or commodity price volatility. A manufacturing company may
hedge against fluctuations in the prices of raw materials by using derivatives or forward
contracts.

Objective of Organization:
The primary objective of a profit-seeking organization is to maximize shareholder wealth by
generating sustainable profits over the long term. This involves efficiently allocating resources to
generate revenue, controlling costs, and managing risks to ensure profitability and growth.
Maximizing shareholder wealth typically involves increasing the company's stock price through
dividends and capital appreciation, thereby providing a return on investment to shareholders.

Stakeholders:

STAKEHOLDERS AND THEIR OBJECTIVES:

S# Stakeholder Objective Example

1. Shareholders / Maximizing returns on Shareholders expect dividend
Investors investment. payments and capital appreciation.
They want the company to make
profitable investments and manage
risks effectively to increase the stock
price.
2. Management / Maximizing company Executives aim to enhance
Executives value while ensuring profitability, achieve growth targets,
operational efficiency. and increase market share. They
focus on strategic planning, cost
control, and operational excellence to
meet shareholder expectations.
3. Employees Job security, fair Employees seek competitive salaries,
compensation, and career benefits, and opportunities for
advancement professional development. They
expect a safe work environment and
fair treatment, which can enhance
morale and productivity.
4. Customers Value for money, quality Customers want high-quality
products/services, and products/services at competitive
satisfaction. prices. They expect excellent
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customer service, timely delivery, and

responsiveness to their needs.
Meeting customer expectations
fosters loyalty and repeat business.
5. Creditors Timely repayment of debt Creditors, such as banks and
and protection of invested bondholders, expect interest
capital. payments and repayment of principal
according to the agreed terms. They
assess the company's
creditworthiness and financial health
to mitigate credit risk.
6. Regulatory Compliance with laws and Regulatory agencies ensure that
Authorities regulations, protection of companies operate ethically,
stakeholders' interests. transparently, and within legal
boundaries. Compliance with financial
reporting standards, tax regulations,
and environmental laws is essential to
maintain credibility and avoid
penalties.

CONFLICTS AMONG STAKEHOLDERS AND POSSIBLE RESOLUTION:

S# Conflict Possible Resolution Measures

1. Shareholders vs. • Implement compensation structures tied to long-term
Management: performance metrics to align management's interests
Shareholders seek to with shareholders. Foster transparent communication
maximize returns, while and engagement with shareholders to build trust.
management may • Establish independent board oversight or shareholder
prioritize long-term advisory committees to provide oversight and
growth over short-term accountability, ensuring that management's decisions
profitability. align with shareholders' interests.

2. Shareholders vs. • Implement profit-sharing programs, employee stock

Employees: ownership plans (ESOPs), and fair compensation
Shareholders prioritize policies to align employees' interests with shareholder
maximizing profits, value. Prioritize employee well-being and development
potentially leading to to enhance engagement and productivity.
cost-cutting measures • Implement employee empowerment initiatives, such as
or layoffs that adversely employee involvement in decision-making processes
affect employees. and fostering a culture of inclusivity and collaboration, to
demonstrate management's commitment to employee
well-being and engagement.
13

3. Management vs. • Maintain open communication with creditors and adhere

Creditors: to debt covenants and repayment schedules to build
Management may trust and credibility. Balance growth objectives with
prioritize growth prudent risk management to mitigate default risk.
initiatives that increase • Provide creditors with additional collateral or security
risk but benefit interests to mitigate default risk and reassure creditors of
shareholders, potentially the company's commitment to fulfilling its financial
compromising creditors' obligations.
interests in repayment
and financial stability.
4. Management vs. • Invest in customer-centric initiatives, such as product
Customers: innovation, quality assurance, and responsive customer
Management may service, to enhance customer loyalty and satisfaction.
prioritize cost-cutting Seek feedback and adapt offerings to meet evolving
measures or customer needs.
product/service changes • Establish customer feedback mechanisms, such as
to enhance profitability, surveys, focus groups, and online forums, to solicit input
potentially and address customer concerns proactively,
compromising quality or demonstrating management's responsiveness and
customer satisfaction. commitment to customer satisfaction.

CONSTRAINTS ON FINANCIAL STRATEGY:

A Financial Manager faces several specific constraints while developing a financial strategy.
These constraints often stem from the need to balance competing priorities, manage risks, and
ensure regulatory compliance, among other factors. Here are some of the key constraints a FM
must navigate:

1. Regulatory and Legal Constraints

• Compliance: Ensuring the company complies with all relevant financial regulations.
• Taxation: Navigating complex tax laws to optimize tax liability while avoiding legal
pitfalls.
• Reporting: Adhering to strict reporting requirements and deadlines for financial
disclosures.

2. Market and Economic Conditions

• Economic Cycles: Developing strategies that can withstand economic downturns and
take advantage of growth periods.
• Interest Rates: Managing the impact of fluctuating interest rates on borrowing costs and
investment returns.
14

• Inflation: Protecting the company’s purchasing power and profitability against

inflationary pressures.

3. Capital Availability and Allocation

• Funding: Securing sufficient capital through equity, debt, or other financing options
while managing the cost of capital.
• Capital Allocation: Allocating capital efficiently among competing projects to maximize
returns and support strategic objectives.
• Leverage: Balancing the use of debt and equity to maintain an optimal capital structure
without over-leveraging.

4. Risk Management
• Credit Risk: Assessing and managing the risk of default by customers and
counterparties.
• Market Risk: Mitigating the impact of market volatility on the company’s financial
performance.
• Operational Risk: Implementing controls to prevent losses from operational failures,
fraud, and cyber threats.
• Strategic Risk: Navigating risks associated with strategic decisions, such as mergers
and acquisitions or entering new markets.

5. Liquidity Management
• Cash Flow: Ensuring the company has adequate cash flow to meet its short-term
obligations and operational needs.
• Working Capital: Efficiently managing working capital components such as inventory,
receivables, and payables to optimize liquidity.

6. Stakeholder Expectations
• Shareholders: Balancing the need to provide satisfactory returns to shareholders with
the long-term health of the company.
• Employees: Ensuring competitive compensation and benefits while managing overall
labor costs.
• Customers and Suppliers: Maintaining strong relationships with customers and
suppliers to ensure stable revenue streams and supply chains.

7. Technological Advancements
• Investment in Technology: Allocating resources to adopt new technologies that
improve financial processes, data analysis, and cybersecurity.
• Digital Transformation: Navigating the challenges of digital transformation while
ensuring the financial strategy supports technological advancements.

8. Global Operations
15

• Foreign Exchange Risk: Managing the financial impact of currency fluctuations on

international operations.
• Geopolitical Risk: Mitigating risks associated with political instability, trade policies, and
regulatory changes in different countries.
• Cultural Differences: Understanding and integrating diverse cultural practices and
market dynamics into the financial strategy.

9. Environmental, Social, and Governance (ESG)

• Sustainability: Incorporating sustainable practices into the financial strategy to meet
regulatory requirements and stakeholder expectations.
• Social Responsibility: Addressing social responsibility concerns, such as ethical
sourcing and fair labor practices.
• Governance: Ensuring robust corporate governance practices to enhance transparency
and accountability.

10. Short-term vs. Long-term Goals

• Balance: Balancing short-term financial performance with long-term strategic objectives.
• Investment Horizon: Selecting investments that align with the company’s growth plans
and risk tolerance over different time horizons.

11. Competition
• Competitive Positioning: Developing financial strategies that help the company
maintain or improve its competitive position.
• Innovation: Investing in innovation to stay ahead of competitors while managing the
associated financial risks.

These constraints require a FM to have a comprehensive understanding of the company’s

operations, industry dynamics, and broader economic factors. Effective financial strategies must
be adaptive, forward-thinking, and capable of navigating these complexities to support the
organization’s overall objectives.

ROLE AND FUNCTIONS OF FINANCE:

The role of finance in a business is analogues to the role of blood in a body. Every organization
has two important structures in place: (a) operating structure and (b) financial structure. These
two parts are depicted by the income statement: trading account shows operating performance
and lower part shows financial performance. Finance addresses three types of issues:

1. What long-term investments should the firm undertake? Capital Budgeting.

2. How should the firm raise money to fund these investments? Capital Structure Decisions.
3. How can the firm best manage its cash flows as they arise in its day-to-day operations?
Working Capital Management.
16

Every decision made should be evaluated as its impact on “Shareholders’ Wealth”. Therefore,
the objective is to “maximize shareholders’ wealth” i.e. the return they get by investing in the
company. The overall return of the shareholders consists of (a) dividend yield and (b) capital
gain yield i.e. increase in the share price.

FINANCIAL MANAGEMENT DECISIONS:

Every business, irrespective of the size and ownership structure, has to take certain financial
decisions. Corporate finance provides a set of principles that govern the businesses. Any
decision that affects finance of the business is a corporate finance decision. Corporate finance
decision also depends upon where the company is standing right now in its life cycle.
• A growth company has to be safer to finance its investments primarily from equity, since
most of its value lies in investments yet to be made. Moreover, it shouldn’t or very little
return to its shareholders.
• In contrast, a matured company has most of its value in assets already in place. It may not
have a lot of investment opportunities. Moreover, it could also afford to borrow a lot more
money.

Financial Management is concerned with the duties of the financial managers in the business
firms.
17

Objective of Financial Management:

Maximize the value of business i.e. stock price.

Assets Liabilities
Assets in Place: Debt:
Short- and long-term assets that Fixed claim on cash flows, little or
generate cash flows today. no role in management, fixed
maturity and tax deductibility.
Growth Assets: Equity:
Expected value that will be created Residual claims in cash flows,
by future investments. significant role in management,
perpetual life.

Maximizing the value of business implies maximize the value of both assets in place and growth
assets.

Investment Analysis & Decisions: (Operating Structure – upper part of P&L)

In today’s dynamic business world and global competitive scenario, manufacturing of any
product or rendering of any service is not a challenge; the challenge is “accepting the product by
18

the people” – this determines the success of the business. Therefore, market and demand
analysis is the heart of investment analysis.

Sources of Funds: (Financing Structure – lower part of P&L)

Financing mix requires careful analysis of the cost of the funds. At the start of the business,
pooling required finance is a big challenge. Even excellent investment / operating structure could
fail due to weak financial structure. If huge portion of the capital represents the external financing
i.e. debt, whatever is earned by the operating structure would be used in servicing the debt.

TIME VALUE OF MONEY – TOOL OF FINANCIAL DECISIONS

A rupee today (now or present) is not worth the same as a rupee tomorrow (later time or future)
due to the following reasons:

• Preference for current consumption over future consumption.

• Productivity of capital - a rupee today is better because it can be invested to earn more.
• Inflation – loss of purchasing power due to increase in prices.
19

TYPES OF PAYMENTS
Following are three types of payments:

1. FUTURE VALUE – SINGLE PAYMENT:

𝐹𝑉 = 𝑃𝑉 × (1 + 𝑖)𝑛

Example 01:
Find out the future value of Rs.10,000 after 7 years assuming interest rate of 12%.

Solution:
FV = 10,000 × (1 + 0.12)7
FV = 10,000 × 1.127
FV = 10,000 × 2.211
FV = 22,110

Interpretation:
It means, Rs.10,000 of today will grow at Rs.22,110 after 7 years at 10% compound interest.

Solution of problem 4-4 of course pack [p.163]

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COMPOUND
RATE YEARS
1 PV FACTOR FV
(i) (n)

A 200 5% 20 2.653 531

B 4,500 8% 7 1.714 7,712
C 10,000 9% 10 2.367 23,674
D 25,000 10% 12 3.138 78,461
E 37,000 11% 5 1.685 62,347
F 40,000 12% 9 2.773 110,923

2. PRESENT VALUE – SINGLE PAYMENT:

𝑃𝑉 = 𝐹𝑉 × (1 + 𝑖)−𝑛

Example 02:
Find out the present value of Rs.50,000 that will be received after 7 years assuming
interest rate of 12%.

Solution:
PV = 50,000 × (1 + 0.12)−7
PV = 50,000 × 1.12−7
PV = 50,000 × 0.452
PV = 22,600

Interpretation:
It means, Rs.50,000 that will be received after 7 years has a value of Rs.22,600 in today
terms assuming interest rate of 12%.
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Following table summarizes the calculations:

DISCOUNT
RATE YEARS
1 FV FACTOR PV
(i) (n)

A 7,000 12% 4 0.636 4,449

B 28,000 8% 20 0.215 6,007
C 10,000 14% 12 0.208 2,076
D 150,000 11% 6 0.535 80,196
E 45,000 20% 8 0.233 10,466

3. FUTURE VALUE – ANNUITY:

(1 + 𝑖)𝑛 − 1
𝐹𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 ×
𝑖

Example 03:
Find out future value of Rs.10,000 annual amount for 7 years assuming interest rate of
12%.
22

Solution:
(1 + 0.12)7 − 1
FVAnnuity = 10,000 ×
0.12
(1.12)7 − 1
FVAnnuity = 10,000 ×
0.12
2.211 − 1
FVAnnuity = 10,000 ×
0.12
1.211
FVAnnuity = 10,000 ×
0.12

FVAnnuity = 10,000 × 10.089

FVAnnuity = 100,890

Interpretation:
Rs,10,000 paid or received every year will have future value of 100,890 after 7 years at 12%
interest rate.

Following table summarizes the calculations.

ANNUITY
RATE YEARS
CASE ANNUITY FACTOR FV
(i) (n)

A 2,500 8% 10 14.487 36,216

B 500 12% 6 8.115 4,058
C 30,000 20% 5 7.442 223,248
D 11,500 9% 8 11.028 126,827
E 6,000 14% 30 356.787 2,140,721

4. PRESENT VALUE – ANNUITY

1 − (1 + 𝑖)−𝑛
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 ×
𝑖

Example 04:
Find out present value of Rs.50,000 annual amount for 7 years assuming interest rate of 14%.
23

Solution:
1 − (1 + 0.14)−7
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 15,000 ×
0.14
1 − (1.14)−7
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 15,000 ×
0.14
1 − 0.400
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 15,000 ×
0.14
0.600
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 15,000 ×
0.14
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 15,000 × 4.288
𝑃𝑉𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 64,325

Interpretation:
Rs,50,000 paid or received every year for 7 years will have value in terms of today of
64,325 at 14% interest rate.
24

Following table summarizes the calculations:

ANNUITY
RATE YEARS
CASE ANNUITY FACTOR PV
(i) (n)

A 12,000 7% 3 2.624 31,492

B 55,000 12% 15 6.811 374,598
C 700 20% 9 4.031 2,822
D 140,000 5% 7 5.786 810,092
E 22,500 10% 5 3.791 85,293

SUMMARY OF FORMULAS:

Single Payment Annuity

[A series of equal payments
with same intervals]
Present Value
Factor = (1 + i)−n 1 − (1 + i)−n
=
i
(Discounting
Factor)

Future Value
Factor = (1 + i)n (1 + i)n − 1
=
i
(Compounding
Factor)

TREASURY FUNCTIONS

Treasury Functions refer to the set of activities and responsibilities within an organization that
manage its financial assets, liabilities, and risks to ensure liquidity, optimize cash flows, and
support the company’s strategic financial goals. These functions are crucial for maintaining the
financial health and operational efficiency of the organization.

S# Function Objective Activities

1 Cash Ensure the company has enough • Monitoring cash balances
Management liquidity to meet its short-term • Forecasting cash flows
25

obligations and optimize cash • Managing receivables and

flow payables, and
• Optimizing the use of surplus
cash through investments.
2 Funding and Secure adequate funding for the • Managing relationships with
Capital Structure company’s operations and banks and financial
Management growth while maintaining an institutions,
optimal capital structure • Issuing debt and equity,
• Managing loans and credit
facilities, and
• Determining the right mix of
debt and equity.
3 Risk Optimize the returns on the • Evaluating investment
Management company’s surplus funds within opportunities,
an acceptable risk framework • Managing investment
and tolerance. portfolios, and
• Ensuring compliance with
investment policies and
regulations
4 Financial Provide insights and forecasts to • Budgeting,
Planning and support strategic decision- • Forecasting,
Analysis [FP&A] making and financial planning. • Variance analysis, and
• Financial modeling to support
strategic initiatives.
5. Treasury Ensure efficient and secure • Managing banking
Operations execution of treasury activities. relationships,
• Ensuring efficient transaction
processing, and
• Implementing treasury
management systems.

ROLES & RESPONSIBILITIES OF TREASURY DEPARTMENT:

1. Cash Management

• Monitor Cash Balances: Track daily cash positions to ensure sufficient liquidity.
• Forecast Cash Flows: Predict cash inflows and outflows to manage liquidity.
• Optimize Cash Usage: Invest surplus cash to maximize returns while maintaining
liquidity.
• Manage Receivables and Payables: Ensure timely collection of receivables and
payment of obligations.
26

2. Funding and Capital Structure Management

• Securing Funding: Arrange necessary financing through loans, bonds, or equity

issuance.
• Maintain Relationships: Develop and maintain relationships with banks and financial
institutions.
• Debt Management: Monitor and manage the company's debt levels and repayment
schedules.
• Capital Structure Optimization: Determine the ideal mix of debt and equity to minimize
cost of capital.

3. Risk Management

• Identify Financial Risks: Assess exposure to currency, interest rate, and liquidity risks.
• Hedging: Use financial instruments like forwards, futures, options, and swaps to mitigate
risks.
• Policy Development: Establish and enforce risk management policies and procedures.
• Monitor Market Conditions: Keep track of economic and market trends to anticipate
and manage risks.

4. Investment Management
• Evaluate Investment Opportunities: Assess potential investments for surplus funds.
• Portfolio Management: Manage the company's investment portfolio to achieve desired
returns within risk parameters.
• Compliance: Ensure all investments comply with regulatory requirements and company
policies.

5. Financial Planning and Analysis (FP&A)

• Budgeting and Forecasting: Prepare and manage budgets, financial forecasts, and
variance analyses.
• Financial Modeling: Create financial models to support strategic decision-making and
planning.
• Performance Analysis: Analyze financial performance and provide insights to senior
management.

6. Treasury Operations
• Transaction Processing: Ensure efficient and accurate execution of treasury
transactions.
• Bank Relationship Management: Handle day-to-day interactions with banks and
financial institutions.
27

• System Implementation: Implement and manage treasury management systems for

operational efficiency.

7. Regulatory Compliance and Reporting

• Compliance: Ensure all treasury activities comply with local and international regulations.
• Reporting: Prepare and submit required financial reports to regulatory bodies and senior
management.
• Audit Coordination: Work with internal and external auditors to ensure financial practices
meet standards and regulations.

8. Strategic Support
• Strategic Initiatives: Provide financial insights and support for mergers, acquisitions,
and other strategic initiatives.
• Corporate Finance: Assist in evaluating and executing corporate finance activities, such
as capital raising and restructuring.
• Financial Policy Development: Develop and implement financial policies aligned with
the company’s strategic objectives.
28
29

Learning Objectives:

a) Explain the functions and differences between primary and secondary markets, including
the processes and implications of Initial Public Offerings (IPOs), underwriting, tender
offers, and placing.

b) Comprehend the concept of rights issues and assess their impact on the wealth of
shareholders, including the ability to calculate the Theoretical Ex-Right Price (TERP).

c) Apply valuation techniques for common and preferred stocks using dividend discount
models and earning multiplier models.

d) Distinguish between scrip dividends, bonus issues, and share splits, and understand their
respective impacts on a company’s share structure and market perception.

e) Analyze factors influencing share prices and calculate investment returns based on
changes in market conditions and company performance.

f) Utilize the dividend discount model and the Capital Asset Pricing Model (CAPM) to
determine the required return on equity for investment decision-making.

g) Synthesize knowledge of various financial concepts and market mechanisms to make

informed investment and corporate finance decisions.
30

CAPITAL MARKETS:

The capital market is a financial market in which long-term debt (over one year) or equity-
backed securities are bought and sold. It is a key component of the financial system, providing
an avenue for raising funds for long-term investments. The capital market includes the stock
market and the bond market.

Distinct Characteristics of Capital Market

a) Long-term Securities: Capital markets deal with financial instruments that have a long
maturity period, typically over one year. This includes stocks, bonds, and other long-term
investments.
b) Variety of Instruments: Capital markets offer a wide range of financial instruments
including stocks, bonds, debentures, and derivatives, allowing investors to diversify their
portfolios.
c) Regulated Environment: Capital markets are heavily regulated by government bodies (like
the SEC in the United States) to ensure fair trading practices, protect investors, and
maintain market integrity.
d) Facilitation of Fund Mobilization: These markets enable the efficient transfer of funds
from savers to entities that need capital for productive use.
e) Price Determination: The prices of securities in the capital market are determined by
supply and demand dynamics, reflecting the collective information and expectations of
investors.

MONEY & CAPITAL MARKETS:

Feature Capital Market Money Market

Deals with short-term securities
Deals with long-term securities with
Definition with maturities of less than one
maturities over one year.
year.
Treasury bills, commercial paper,
Stocks, bonds, debentures, long-
Instruments certificates of deposit, repurchase
term loans, and derivatives.
agreements.
Corporations, governments,
Primary Banks, financial institutions,
institutional investors, individual
Participants corporations, governments.
investors.
Raising capital for long-term Managing liquidity, funding short-
Purpose investment, growth, and term needs, and ensuring financial
development. stability.
Higher risk and higher potential Lower risk and lower potential
Risk and
return due to long-term investment return due to short-term nature and
Return
horizon. stability.
31

Regulated primarily by central

More regulation by securities
Regulation and banks and financial regulatory
regulators (e.g., SEC in the U.S.)
Supervision bodies focusing on liquidity and
with strict disclosure requirements.
stability.
Generally less liquid than money Highly liquid; instruments are
Liquidity market instruments; secondary quickly and easily converted to
markets provide some liquidity. cash.
Primary market (new issues) and Predominantly over-the-counter
Market
secondary market (trading of (OTC) markets with direct
Segments
existing securities). transactions between parties.

INITIAL PUBLIC OFFERING [IPO]

An Initial Public Offering (IPO) is the process through which a private company offers its shares
to the public for the first time and becomes a publicly traded company on a stock exchange. In
Pakistan, this process is overseen by the Securities and Exchange Commission of Pakistan
(SECP) and the Pakistan Stock Exchange (PSX).

Procedures of an IPO:

1. Preparation Phase

a. Appointing Advisors:
• The company hires financial advisors, legal advisors, and underwriters to guide
through the IPO process.
• Financial advisors help in financial planning and valuation, legal advisors ensure
regulatory compliance, and underwriters assist in pricing and selling the shares.
b. Financial Audits and Due Diligence:
• Comprehensive financial audits are conducted to present accurate financial
statements.
• Due diligence involves a thorough examination of the company’s business,
operations, and financials to ensure transparency.
c. Restructuring:
• If necessary, the company may restructure its organization to meet regulatory
requirements and improve attractiveness to investors.
32

2. Regulatory Approval Phase

a. Drafting the Prospectus:

• The prospectus is a detailed document that provides potential investors with
essential information about the company, including financial performance, business
model, risks, and use of IPO proceeds.
b. Filing with SECP:
• The company submits the draft prospectus and other required documents to the
SECP for approval.
• SECP reviews the documents to ensure compliance with securities regulations and
transparency standards.
c. Approval and Public Announcement:
• Once approved by the SECP, the company announces its intention to go public and
publishes the prospectus for public review.

3. Marketing and Roadshows

a. Investor Education and Roadshows:
• The company, along with its advisors, conducts roadshows to market the IPO to
potential institutional and retail investors.
• Presentations and meetings are held to explain the company’s business model,
growth prospects, and financial health.
b. Book Building:
• The book-building process involves determining the demand for shares and setting a
price range. Investors bid for shares within this price range.
• Based on the bids received, the final offer price is determined.

4. Subscription and Allotment

a. Offering Shares to the Public:
• The company offers shares to the public at the determined offer price.
• Investors submit applications to purchase shares, which are collected during the
subscription period.
b. Allotment of Shares:
• Shares are allotted to applicants based on the subscription data. In case of
oversubscription, shares are allotted on a pro-rata basis or through a lottery system
for retail investors.
c. Listing on PSX:
• The company’s shares are officially listed on the Pakistan Stock Exchange, and
trading begins.

Example of an IPO in Pakistan

Consider ABC Ltd., a Pakistani company planning to go public. Here’s a simplified step-by-step
process:
33

1. Preparation:
o ABC Ltd. hires financial advisors, legal advisors, and underwriters.
o Conducts financial audits and due diligence.
o Drafts the prospectus with detailed information about the company.
2. Regulatory Approval:
o Submits the draft prospectus to the SECP.
o SECP reviews and approves the prospectus.
o ABC Ltd. announces its IPO and publishes the prospectus.
3. Marketing and Roadshows:
o Conducts roadshows to attract institutional and retail investors.
o Engages in the book-building process to determine the offer price.
4. Subscription and Allotment:
o Offers shares to the public at the determined price.
o Collects applications and allots shares based on demand.
o Lists shares on the PSX, allowing public trading to commence.

Benefits of an IPO

1. Access to Capital:
o Provides companies with access to capital for expansion, debt repayment, and
other business needs.
2. Increased Visibility and Credibility:
o Enhances the company's visibility and credibility in the market.
3. Liquidity for Shareholders:
o Offers existing shareholders a way to liquidate their investments.
4. Growth Opportunities:
o Enables the company to grow through acquisition and expansion using the capital
raised.

Challenges of an IPO

1. Regulatory Compliance:
o The process involves strict regulatory compliance and extensive disclosure
requirements.
2. Market Conditions:
o Market conditions and investor sentiment can significantly affect the success of an
IPO.
3. Cost:
o IPOs can be costly due to fees for advisors, underwriters, and compliance.
4. Ongoing Obligations:
o Public companies face ongoing disclosure and regulatory obligations, which can
be resource-intensive.
34

PRIVATE PLACEMENTS:

A private placement of equity involves the sale of securities to a relatively small number of
select investors as a way of raising capital. These investors can include institutional investors,
such as banks, mutual funds, insurance companies, and pension funds, or accredited individual
investors. Unlike public offerings, private placements do not require the securities to be
registered with regulatory authorities, such as the Securities and Exchange Commission of
Pakistan (SECP), making the process quicker and less costly.

Key Characteristics of Private Placements

1. Selective Investment:
o Securities are sold to a limited number of investors, often institutional or
accredited investors, rather than the general public.
2. Regulatory Exemption:
o Private placements are exempt from the rigorous registration and disclosure
requirements that apply to public offerings, which simplifies the process.
3. Confidentiality:
o Companies can keep their financial and operational details private, as the
disclosure requirements are minimal compared to public offerings.
4. Speed and Flexibility:
o The process is generally faster and more flexible, allowing companies to raise
funds more quickly and with fewer regulatory hurdles.
5. Negotiated Terms:
o Terms of the deal, including price, quantity, and investor rights, are typically
negotiated directly between the issuer and the investors.
6. Higher Investor Requirements:
o Investors usually need to meet certain financial criteria to participate, ensuring
they have the resources and sophistication to evaluate the investment.

Procedure of Private Placements of Equity

1. Planning and Preparation

a. Assessing Capital Needs:

• The company determines how much capital it needs to raise and for what purposes
(e.g., expansion, debt reduction, operational funding).
b. Identifying Potential Investors:
• The company identifies and approaches potential investors who are likely to be
interested in the private placement.
c. Preparing Offering Documents:
• Unlike a public offering, a detailed prospectus is not required. However, an offering
memorandum or private placement memorandum (PPM) is prepared. This document
35

includes information about the company's business, financial condition, and terms of
the offering.

2. Structuring the Deal

a. Negotiating Terms:
• Terms such as the price per share, number of shares, investor rights, and any
special conditions or protections are negotiated with potential investors.
b. Valuation:
• The company and its financial advisors determine a fair valuation for the equity being
offered, balancing the company's needs and investor expectations.

3. Executing the Placement

a. Legal and Regulatory Compliance:

• Although exempt from full registration, the company must still ensure compliance
with any relevant securities laws and regulations. Legal counsel is typically involved
to ensure all aspects of the deal meet regulatory standards.
b. Investor Agreements:
• Agreements are drawn up and signed by the company and the investors, outlining
the terms of the investment and any rights or obligations of the parties involved.
c. Fund Transfer:
• Investors transfer the agreed-upon funds to the company, and the company issues
the corresponding equity shares to the investors.

4. Post-Placement Management

a. Communication:
• The company maintains regular communication with its new investors, providing
updates on business performance and other relevant information.
b. Governance and Oversight:
• Depending on the terms of the private placement, investors may have certain rights,
such as seats on the board of directors or other governance roles.

Benefits of Private Placements

1. Speed:
o Faster process compared to public offerings due to fewer regulatory hurdles.
2. Confidentiality:
o Less public disclosure required, maintaining business confidentiality.
3. Flexibility:
o Terms can be tailored to meet the specific needs of the company and investors.
4. Cost-Effective:
36

o Lower costs associated with regulatory compliance and marketing compared to

public offerings.

Challenges of Private Placements

1. Limited Investor Pool:

o Smaller pool of potential investors compared to public offerings.
2. Potentially Higher Costs:
o Although lower than public offerings, legal and advisory fees can still be
significant.
3. Investor Control:
o Investors may demand significant control or influence over business decisions.
4. Dilution:
o Issuing new equity can dilute the ownership percentage of existing shareholders.

EQUITY & ITS FEATURES:

Equity capital is the funds raised by a company through the issuance of shares. This form of
capital is essential for companies as it provides the necessary funding for growth, expansion,
and other business activities. Here are the main features and aspects of equity capital:

Key Features of Equity Capital

1. Ownership
• Ownership Stake: Shareholders who invest in equity capital become part-owners of the
company. Their ownership stake is proportional to the number of shares they hold.
• Voting Rights: Equity shareholders typically have voting rights, allowing them to vote on
key company matters such as the election of the board of directors, mergers, and other
significant decisions.

2. Permanent Capital
• No Repayment Obligation: Unlike debt, equity capital does not have to be repaid. It
remains with the company as long as it operates, providing a stable source of funding.
• No Fixed Dividend Obligation: Dividends are paid out of profits at the discretion of the
company’s board of directors. There is no obligation to pay fixed dividends, unlike interest
on debt.

3. Risk and Return

• High Risk: Equity shareholders are the last to be paid in the event of liquidation, making
equity a riskier investment compared to debt.
• High Potential Return: Due to the higher risk, equity investors expect higher returns. This
return comes in the form of dividends and capital gains from stock price appreciation.
37

4. Dividends
• Profit-Dependent: Dividends are paid out of the company's profits. If the company does
not generate sufficient profits, dividends may not be paid.
• Variable Dividends: The amount and frequency of dividends can vary based on the
company's performance and policies.

5. Residual Claim
• Last in Line: In the event of liquidation, equity shareholders have a residual claim on the
company’s assets after all debts and obligations have been satisfied.

6. Marketability and Liquidity

• Trading on Stock Exchanges: Equity shares of publicly traded companies are listed on
stock exchanges, allowing shareholders to buy and sell shares relatively easily.
• Market Fluctuations: The value of equity shares can fluctuate based on market
conditions, company performance, and broader economic factors.

Types of Equity Capital

1. Common Shares
• Basic Equity Ownership: Common shares represent basic ownership in the company
with voting rights and the potential for dividends and capital gains.
• Voting Rights: Common shareholders typically have voting rights in proportion to their
shareholding.

2. Preferred Shares
• Priority in Dividends: Preferred shareholders have a higher claim on dividends
compared to common shareholders, often receiving fixed dividends.
• Limited Voting Rights: Preferred shares usually do not carry voting rights or have
limited voting rights.
• Priority in Liquidation: In the event of liquidation, preferred shareholders have a higher
claim on assets than common shareholders, but still after debt holders.

Advantages of Equity Capital

1. No Fixed Obligations
• No Interest Payments: Unlike debt, there are no mandatory interest payments, which
can help improve cash flow.
• Flexible Dividends: The company can choose when and how much dividend to pay
based on its profitability.
2. Strengthened Balance Sheet
• Increased Net Worth: Equity capital increases the net worth of the company, which can
improve creditworthiness and financial stability.
38

3. Growth Financing
• Funding Expansion: Equity capital provides funds for expansion, acquisitions, and
other growth opportunities without the burden of repayment.

Disadvantages of Equity Capital

1. Dilution of Control
• Reduced Ownership: Issuing new shares dilutes the ownership percentage of existing
shareholders, potentially reducing their control over the company.
• Conflict of Interests: Differences in objectives between new and existing shareholders
can lead to conflicts.
2. Cost of Equity
• Higher Cost: Equity capital is often more expensive than debt because investors expect
higher returns to compensate for higher risk.
• Dividends and Growth: High dividends or significant stock price appreciation can
increase the cost of equity over time.

RIGHT SHARE VS. BONUS SHARES:

Feature Right Shares Bonus Shares

Shares offered to existing
Additional shares issued to existing
shareholders at a discounted price,
Definition shareholders at no cost, distributed
allowing them to maintain their
from the company's reserves.
proportional ownership.

To reward shareholders and

To raise additional capital for the
Purpose increase the number of shares in
company.
circulation.

Shareholders need to pay for these No payment is required from

Payment
shares, typically at a price lower shareholders; shares are issued
Requirement
than the market price. free of cost.

Shareholders must exercise their

No dilution of ownership as shares
Impact on rights to maintain their ownership
are issued proportionately to all
Ownership percentage; if they don't, their
existing shareholders.
ownership is diluted.
39

Cash Flow Results in cash inflow to the No direct cash inflow or outflow;
Impact company. involves capitalization of reserves.

Increases share capital but no new

Effect on Increases share capital and raises
funds are raised; it's a reallocation
Share Capital funds for the company.
of reserves to share capital.

Shareholders have the option to No choice involved; shares are

Shareholder
subscribe to the right shares or sell automatically credited to
Choice
their rights. shareholders.

Typically offered at a discount,

May lead to a decrease in share
which might initially lower the
Market Price price per share proportionally, but
market price due to dilution, but the
Impact overall market capitalization remains
impact depends on market
the same.
perception.

Follows internal corporate approvals

Regulatory Requires a detailed prospectus and
and may need regulatory filing but is
Compliance regulatory approval.
generally simpler.

Recorded as an increase in share

Accounting Recorded by transferring amounts
capital and share premium account
Treatment from reserves to share capital.
(if any).

A company issues 1 right share for A company issues 1 bonus share for
Example every 5 shares held at a price lower every 5 shares held without any cost
than the current market price. to shareholders.

CASH DIVIDEND VS. STOCK DIVIDEND:

Feature Cash Dividend Stock Dividend

Payment made to shareholders in Distribution of additional shares to
Definition cash, distributed from the shareholders, issued from the
company’s earnings. company's reserves.
40

Form of
Cash Additional shares
Payment

Impact on Reduces the company’s cash

No immediate impact on cash flow
Cash Flow reserves

Impact on
Immediate cash increase for Increase in the number of shares
Shareholder
shareholders held; no immediate cash increase
Wealth

Tax Generally taxable as income for May be tax-free until shares are
Implications shareholders sold (depending on jurisdiction)

Share price typically drops by the Share price usually adjusts

Effect on
amount of the dividend after the ex- downward in proportion to the
Share Price
dividend date number of new shares issued

Company’s Reduces retained earnings and Transfers amount from retained

Financials cash on the balance sheet earnings to share capital

Frequency Typically paid quarterly or annually Typically declared less frequently

Investor Preferred by income-focused Preferred by investors focused on

Preference investors seeking regular cash flow growth and capital appreciation

Results in dilution of share value,

Dilution No dilution of ownership
but not ownership percentage

Administrative Requires cash handling and bank Involves issuing and distributing
Process transfers additional shares

Market Seen as a sign of financial strength Viewed as a signal of growth and

Perception and profitability confidence in future earnings

Increases investment in the

Flexibility for
Provides immediate liquidity company without providing
Shareholders
immediate liquidity
41

RIGHT ISSUE & ITS IMPACT ON SHAREHOLDERS’ WEALTH:

A right issue is a method by which a company raises additional capital by offering existing
shareholders the right to purchase additional shares at a discounted price. This process
ensures that shareholders can maintain their proportional ownership in the company.

Key Characteristics
• Proportional Allocation: Shareholders receive rights based on their existing holdings
(e.g., 1 new share for every 4 shares held).
• Discounted Price: Shares are offered at a price lower than the current market price.
• Time-bound Offer: The rights are typically valid for a specific period, after which they
expire.

Process
1. Announcement: The company announces the right issue, specifying the number of
shares, the ratio of new shares to existing shares, the issue price, and the subscription
period.
2. Rights Distribution: Shareholders receive rights, which can be exercised to buy new
shares at the discounted price.
3. Subscription: Shareholders can choose to exercise their rights, sell them in the market
(if transferable), or let them expire.
4. Issuance of New Shares: The company issues new shares to those who exercised
their rights.

Valuation of Rights:

Following steps are applied to calculate Value of Right.

Step 1: Calculate Theoretical Ex–Right Price

[𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠 × 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒] + [𝑅𝑖𝑔ℎ𝑡 𝑠ℎ𝑎𝑟𝑒𝑠 × 𝐸𝑥𝑒𝑟𝑐𝑖𝑠𝑒 𝑃𝑟𝑖𝑐𝑒]
𝑇𝐸𝑅𝑃 =
𝐸𝑥𝑖𝑠𝑡𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠 + 𝑅𝑖𝑔ℎ𝑡 𝑆ℎ𝑎𝑟𝑒𝑠

Step 2: Calculate Value of Right

Value of right = Ex-Right Price – Offer Price

Illustration: Right issue

Existing shares of A Ltd. = 100,000 shares

Current market price per share = Rs.40

Right Issue 1 share for every 5 shares hold

Offer price = Rs.30

42

Required:
(i) Calculate Ex-Right price.
(ii) Value of Right.
(iii) Assuming Aqib holds 100 shares, calculate his wealth if he
(a) Buy right shares.
(b) Sell right.
(c) Ignore right.

Solution:
(i) Theoretical ex-right price:
[100,000 × 40] + [20,000 × 30]
𝑇𝐸𝑅𝑃 = = 38.33
100,000 + 20,000

(ii) Value of right = 38.33 – 30 = 8.33

(iii) Impact on shareholder’s wealth

a. Buys the shares:

Wealth before the right = 100 x 40 = 4,000
Wealth after the right = 120 x 38.33 – (20 x 30) = 4,000.
[Impact: no change in wealth in case of exercise the right]

b. Sell the right:

Wealth before the right = 100 x 40 = 4,000
Wealth after the right = 100 x 38.33 + (20 x 8.33) = 4,000.
[Impact: no change in wealth in case of right is sold]

c. Ignores the right:

Wealth before the right = 100 x 40 = 4,000
Wealth after the right = 100 x 38.33 = 3,833.
[Impact: Wealth is reduced.]

Conclusion: Shareholders’ wealth remains the same whether right is exercises or sold;
however, wealth would reduce if the right is ignored.

COMMON STOCK VALUATION:

1. Dividend Discount Model:

43

Assumptions:
a. The expected rate of return by shareholders [ke] will always be higher than the growth rate
[g].
b. The company distributes dividend every year.
c. Dividend grows at a constant rate.
d. The company must retain a portion of its earnings for the purpose of growth.

Illustration [Constant Growth]:

On the basis of the following information:
Current dividend (Do) = Rs.2.50
Discount rate (ke) = 10.5%
Growth rate (g) = 2%

Required:
Calculate the present value of stock.

Solution:
2.50 × 1.02
𝑃0 = = 𝑃𝐾𝑅 30
0.105 − 0.02

Illustration [Multi-stage Growth]:

A Ltd stock’s dividend is expected to grow at 15% for the first three years and thereafter 6%
forever. The most recent dividend per share is Rs.12 per share and cost of equity is 16%.
Calculate intrinsic value per share.

Solution:
44

18.25 × 1.06
13.80 15.87 18.25
𝑃0 = + + + 0.16 − −3
0.06
1.16−1 1.16−2 1.16−3 1.16

13.80 15.87 18.25 193.46

𝑃0 = + + +
0.862 0.743 0.641 0.641

𝑃0 = 11.90 + 11.79 + 11.69 + 123.94 = 159.32 𝑃𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

2. Earnings Multiplier Model:

The Earnings Multiplier Model, also known as the Price-Earnings (P/E) Ratio Model, is a widely
used method for valuing shares. It helps investors determine the relative value of a company's
shares in comparison to its earnings. Here's a detailed explanation of how the model works:

The Earnings Multiplier Model values a company's stock by multiplying its earnings per share
(EPS) by an appropriate earnings multiple (or P/E ratio). The formula is:

Stock Price=Earnings Per Share (EPS)×Price-Earnings (P/E) Ratio

1. Earnings Per Share (EPS):

o EPS is calculated by dividing the company's net income by the number of
outstanding shares. It represents the company's profitability on a per-share basis.
2. Price-Earnings (P/E) Ratio:
o The P/E ratio is a valuation multiple that compares the company's current share
price to its per-share earnings.
o It indicates how much investors are willing to pay for each rupee of earnings.
o A high P/E ratio may suggest that investors expect high growth in the future,
while a low P/E ratio may indicate the opposite or potential undervaluation.

Determining the Appropriate P/E Ratio

Choosing the appropriate P/E ratio is crucial and depends on several factors:

1. Industry Averages:
o Compare with the average P/E ratios of similar companies in the same industry.
2. Growth Expectations:
o Higher expected growth rates can justify higher P/E ratios.
3. Risk and Stability:
o Companies with stable earnings and lower risk tend to have higher P/E ratios.
4. Market Conditions:
o Overall market sentiment and economic conditions can influence the P/E ratios.
45

Illustration:

Suppose a company has the following financials:

• Net Income: PKR 100 million

• Outstanding Shares: 20 million
• EPS: PKR 5 (PKR 100 million / 20 million shares)

If the appropriate P/E ratio for the industry is 15, the share price can be calculated as:

Stock Price=5×15=PKR 75

Advantages of the Earnings Multiplier Model

1. Simplicity:
o Easy to understand and calculate.
2. Comparative Analysis:
o Useful for comparing companies within the same industry.
3. Growth and Profitability Insight:
o Reflects investor expectations about growth and profitability.

Limitations

1. Earnings Manipulation:
o EPS can be affected by accounting practices, potentially distorting true
profitability.
2. Growth Assumptions:
o Relies on growth expectations which may not materialize.
3. Market Sentiment:
o P/E ratios can be influenced by market sentiment, leading to over- or under-
valuation.

PREFERRED STOCK:

Preferred stock, also known as preference shares, has several unique features that distinguish
it from common stock and debt instruments. Here are the key features:

1. Dividend Preference: Preferred shareholders have a higher claim on dividends compared

to common shareholders. Dividends on preferred stock are typically fixed and must be paid
out before any dividends are distributed to common shareholders.
46

2. Fixed Dividends: Preferred stocks usually pay a fixed dividend rate, which is often stated
as a percentage of the par value. This provides a more predictable income stream for
investors.

3. Cumulative Dividends: Many preferred stocks come with a cumulative dividend feature,
meaning that if a company misses a dividend payment, it must pay the missed dividends in
the future before any dividends can be paid to common shareholders.

4. Priority in Liquidation: In the event of a company's liquidation, preferred shareholders

have a higher claim on the company’s assets than common shareholders, but they are
subordinate to bondholders.
5. Convertibility: Some preferred stocks are convertible, allowing shareholders to convert
their preferred shares into a predetermined number of common shares, usually at any time
after a specified date.

6. Callable: Preferred shares can be callable, meaning the issuing company has the right to
repurchase the shares at a specified call price after a certain date.

7. Non-Voting: Preferred stockholders typically do not have voting rights in the company’s
annual meetings or other major corporate decisions, although some preferred shares may
have voting rights under special circumstances.

8. Perpetual or Fixed Maturity: Preferred stocks can be perpetual, having no fixed maturity
date, or they can have a fixed maturity date, at which point the company must repurchase
the shares at the par value.

9. Participating Preferred Stock: Some preferred stocks offer participating dividends, where
shareholders can receive additional dividends based on certain conditions, such as when
dividends on common stock exceed a specified amount.

10. Adjustable-Rate Preferred Stock: The dividend rate on some preferred stocks can be
adjustable, typically linked to a benchmark interest rate like LIBOR.

Preferred stock provides a blend of features found in both debt and equity instruments, offering
a fixed income-like stream with potential for equity-like upside, making it an attractive
investment for certain types of investors.

Valuation:

In case, preferred stock has fixed maturity, its valuation is done same as debt. However, for
perpetual preferred stock, value of preferred stock is:

Dividend Per Share

P0 =
Market Price Per Share
47
48

Learning Objectives:

a) Understand the characteristics and uses of medium-term financing options, and analyze
the advantages and disadvantages of medium-term finance in corporate funding
strategies.

b) Comprehend the different types of long-term debt instruments, and evaluate the impact of
long-term debt on a company’s financial structure and performance.

c) Explain the features and benefits of convertible securities, analyze the conditions under
which convertible securities are advantageous for both issuers and investors, and
understand the function and structure of warrants in financial markets.

d) Describe the various international debt financing options available to corporations,

evaluate the risks and benefits associated with international debt finance, and analyze the
pricing and valuation of deep discount bonds.

e) Calculate the value of perpetual bonds using appropriate valuation models, understand
the unique characteristics and valuation of zero-coupon bonds, and evaluate bonds with
specific maturity dates using present value techniques.

f) Explain the significance of KIBOR (Karachi Interbank Offered Rate) and LIBOR (London
Interbank Offered Rate) in the financial markets, and understand how these benchmark
rates are used in various financial instruments and contracts.

g) Identify different types of treasury securities and their features, and analyze the role of
treasury securities in government financing and investment portfolios.

h) Interpret the yield curve and understand its implications for interest rates and economic
outlook, and analyze how changes in the yield curve reflect investor sentiment and
economic conditions.

i) Understand the inverse relationship between bond prices and yields, analyze the factors
that influence bond prices and yields in the financial markets, and explain the features and
valuation of callable and putable bonds.
49

Debt, in financial terms, refers to funds borrowed by individuals, businesses, or governments

from lenders or creditors with the agreement to repay the principal amount along with interest
over a specified period. Here are the key features and characteristics of debt:

1. Principal Amount:
Debt involves borrowing a specific amount of money, known as the principal or the face
value of the debt. This amount is usually repaid in full at the end of the loan term.

2. Interest Payments:
Lenders charge interest as compensation for lending money. Interest rates can be fixed
(remain constant throughout the loan term) or variable (fluctuate based on market conditions
or a benchmark rate).

3. Maturity Date:
Debt instruments have a maturity date, which is the date by which the borrower must repay
the principal amount in full. It can range from short-term (less than a year) to long-term (up to
several decades).

4. Security or Collateral:
Some debts are secured by collateral, which is an asset pledged to the lender as security in
case the borrower defaults. Common examples include mortgages (secured by real estate)
and auto loans (secured by vehicles).

5. Creditworthiness:
Borrowers' ability to obtain debt and the interest rate they are charged depend on their
creditworthiness. This is assessed based on factors such as credit history, income stability,
and existing debt obligations.

6. Repayment Terms:
Debt repayment terms outline how and when payments are made. They include the frequency
of payments (e.g., monthly, quarterly), payment amounts (interest-only or principal and
interest), and any penalties for late payments.

7. Covenants:
Debt agreements often include covenants, which are terms and conditions that borrowers
must adhere to. These may restrict certain financial actions (like taking on additional debt or
paying dividends) to protect lenders' interests.

8. Types of Debt:
Debt can be classified into various types based on its characteristics:
• Secured Debt: Backed by collateral.
• Unsecured Debt: Not backed by collateral (e.g., credit cards, personal loans).
50

• Convertible Debt: Can be converted into equity under certain conditions.

• Subordinated Debt: Repaid after other debts in case of liquidation.
• Government Debt: Borrowings by governments through bonds or treasury bills.

9. Marketability:
Debt instruments are often traded in financial markets, providing liquidity to investors who
wish to buy or sell them before maturity. This marketability influences the perceived risk and
pricing of debt.

10. Tax Implications:

Interest payments on certain types of debt (like mortgages) may be tax-deductible, reducing
the overall cost of borrowing for individuals and businesses.

TYPES OF DEBT:

Aspect Short-Term Debt Medium-Term Debt Long-Term Debt

Generally has a
Typically due within one Typically has a maturity
Duration maturity ranging from
year exceeding five years
one to five years
Funds capital
Meets immediate Funds large-scale
expenditures,
operational needs like investments such as
Purpose expansions, equipment
payroll, inventory, or infrastructure projects,
purchases, and longer-
short-term projects real estate, etc.
term projects
Trade credit, bank Corporate bonds,
Types of overdrafts, commercial Term loans, bonds, mortgage loans,
Instruments paper, short-term loans, lease financing debentures, long-term
credit cards bank loans
Tends to be higher than Often lower than
Generally lower due to
Interest short-term debt due to shorter-term debt due to
shorter duration and
Rates longer duration and longer-term nature and
lower risk profile
associated risks lower perceived risk
Offers a balance Offers stability and
Provides short-term
between short-term predictability in
Flexibility flexibility and quick
flexibility and long-term financing needs over an
access to funds
stability extended period
Risks include liquidity Involves managing cash Involves managing
challenges if cash flows flow projections, interest long-term financial
Risk Profile
are inadequate for rate risks over a longer commitments and
repayment period interest rate fluctuations
51

Financing large
Financing equipment
Example Use Covering seasonal cash infrastructure projects,
purchases, business
Case flow fluctuations mergers and
expansions
acquisitions

CONVERTIBLE SECURITIES:

Convertible securities are financial instruments, typically bonds or preferred stocks, that can be
converted into a specified number of common shares of the issuing company at the option of
the holder. These securities offer investors the potential for capital appreciation through the
conversion feature while providing income in the form of regular interest or dividends. Here are
the key aspects of convertible securities:

1. Convertible Feature:
Convertible securities include convertible bonds and convertible preferred stocks. The
conversion feature allows the holder to convert the security into a predetermined number of
common shares of the issuing company at a specified conversion price and during a defined
conversion period.

2. Interest or Dividend Payments:

Similar to traditional bonds or preferred stocks, convertible securities pay regular interest or
dividends to investors. This provides income to investors even if they do not choose to
convert the security into common stock.

3. Conversion Ratio and Price:

The conversion ratio specifies the number of common shares that can be obtained by
converting one unit of the convertible security. The conversion price is the price at which the
conversion occurs and is typically set at a premium to the current market price of the
company's common stock at the time of issuance.

4. Investor's Choice:
The decision to convert the security into common stock lies with the investor. If the
company's common stock price increases above the conversion price, holders may choose
to convert to benefit from potential capital appreciation. If the stock price does not rise
sufficiently, holders may opt to retain the security for its income.

5. Risk and Return Profile:

Convertible securities offer a blend of features from both debt and equity investments. They
provide fixed income or preferred dividends with the potential for capital appreciation based
on the performance of the company's common stock.

6. Call Provisions:
52

Issuers often have the right to call back convertible securities at a predetermined price after a
specified call protection period. This feature allows issuers to manage their capital structure
and financing costs.

7. Market Demand:
Convertible securities appeal to investors seeking both income and potential equity upside.
They are particularly attractive in periods of low interest rates or when investors expect the
issuer's stock price to increase.

Considerations

Risk: Convertible securities carry issuer-specific risks, such as credit risk for bonds and
preference risk for preferred stocks. Additionally, the value of convertible securities is influenced
by changes in interest rates and the issuer's stock price.

Complexity: Evaluating convertible securities requires understanding the terms of conversion,

market conditions, and the financial health of the issuing company.
In summary, convertible securities offer a unique investment opportunity by combining features
of both debt and equity instruments. They provide income through interest or dividends while
offering potential capital appreciation through conversion into common stock, making them a
valuable tool for investors seeking diversified and flexible investment options.

WARRANTS:

Warrants refer to financial instruments that give the holder the right, but not the obligation, to buy
a specific number of shares of the issuer's common stock at a predetermined price (exercise
price) within a specified time frame. Warrants are often issued together with debt securities, such
as bonds, as a way for the issuer to enhance the attractiveness of the debt offering. Here’s how
warrants work and their relevance in debt finance:

1. Issuance with Debt Securities:

Warrants are typically attached to bonds or other debt instruments as sweeteners to attract
investors. They provide potential additional value beyond the fixed income component of the
debt.

2. Exercise Price:
Warrants have an exercise price (also known as strike price), which is the price at which the
warrant holder can purchase the underlying common stock. This price is set at a premium to
the current market price of the stock at the time of issuance.

3. Expiration Date:
53

Warrants have a specified expiration date, after which they expire worthless if not exercised.
The expiration period can range from months to several years, depending on the terms set by
the issuer.

4. Convertible Nature:
Warrants are similar to options in that they give the holder the right to convert them into
common stock. However, unlike convertible bonds where conversion is mandatory, warrant
conversion is at the discretion of the holder.

5. Value Proposition:
For investors, warrants represent an opportunity for potential capital appreciation if the
issuer's stock price exceeds the exercise price before the warrant expires. This potential
upside enhances the attractiveness of the underlying debt investment.

6. Impact on Debt Issuers:

From the issuer's perspective, warrants serve as a financing tool that can lower the effective
cost of debt capital. By attaching warrants to debt securities, issuers can attract investors
willing to accept lower interest rates in exchange for the potential equity upside provided by
the warrants.

7. Call Provisions and Redemption:

Issuers may include provisions allowing them to call and redeem warrants at a specified
price after a certain period. This provides flexibility in managing the capital structure and
financing costs.

INTERNATIONAL DEBT FINANCE:

International debt finance refers to the borrowing and lending of funds across national borders,
involving governments, corporations, financial institutions, and other entities. It plays a crucial
role in global finance by facilitating capital flows between countries and enabling economic
development, infrastructure projects, trade financing, and investment opportunities. Here are the
key aspects and characteristics of international debt finance:

1. Participants:

• Governments: Sovereign nations borrow funds from international markets to finance

budget deficits, infrastructure projects, or economic development initiatives.
• Corporations: Multinational corporations raise capital through international debt markets
to fund expansion, acquisitions, or working capital needs.
• Financial Institutions: Banks and financial intermediaries facilitate cross-border lending
and borrowing, often syndicating loans to spread risk.
54

2. Instruments:

• Bonds: Sovereign bonds issued by governments to raise funds in international markets.

These include government bonds denominated in foreign currencies (e.g., US dollars,
euros).
• Syndicated Loans: Large-scale loans provided by a group of lenders (syndicate) to
borrowers, often used for corporate financing or project finance.
• Eurobonds: Bonds issued in a currency different from the currency of the country where
they are issued, typically by multinational corporations.
• Development Finance: Loans provided by international financial institutions (IFIs) like the
World Bank or regional development banks for infrastructure and development projects in
emerging markets.

3. Currency and Exchange Rate Risks:

Borrowers and lenders face currency risk when debt is denominated in a currency different
from the borrower's home currency. Exchange rate fluctuations can impact debt servicing
costs and repayment obligations.

4. Interest Rates and Terms:

Interest rates on international debt instruments are influenced by global financial conditions,
sovereign credit ratings, and market perceptions of risk. Terms of international debt may
include grace periods, repayment schedules, and covenants designed to protect lenders'
interests and ensure repayment.

5. Credit Ratings and Risk Assessment:

• Borrowers' creditworthiness is assessed through credit ratings assigned by international

rating agencies. Sovereign debt ratings determine the interest rates at which governments
can borrow in international markets.
• Corporate borrowers' creditworthiness is evaluated based on financial performance,
industry outlook, and economic conditions in their home countries and globally.

6. Legal and Regulatory Framework:

International debt transactions are governed by legal frameworks that vary across
jurisdictions. Contracts and agreements specify rights and obligations of borrowers and
lenders, including dispute resolution mechanisms.

7. Impact on Global Economy:

International debt finance contributes to global economic growth by providing capital for
investments, infrastructure development, and economic stability in emerging markets. It
55

influences global financial markets, interest rates, and currency exchange rates, impacting
economies worldwide.

KIBOR & LIBOR:

KIBOR (Karachi Interbank Offered LIBOR (London Interbank Offered

Aspect
Rate) Rate)
Location Pakistan, specifically Karachi United Kingdom, primarily London
Calculation
Pakistan Banks' Association (PBA) ICE Benchmark Administration (IBA)
Authority
Benchmark rate for the Pakistani Benchmark rate for the global
Purpose
interbank lending market interbank lending market
Multiple currencies, including USD,
Currency Primarily Pakistani Rupee (PKR)
GBP, EUR, etc.
Benchmark Includes various tenures from Covers multiple tenures ranging from
Tenures overnight to one year overnight to 12 months
Published daily by the IBA
Published daily by the PBA
Daily Publication [Intercontinental (ICE) Benchmark
[Pakistan’s Bankers Association]
Administration]
Used locally within Pakistan's Used globally across international
Scope
financial system financial markets
Regulatory Regulated by the State Bank of Regulated by financial authorities in
Oversight Pakistan the UK

Pricing of financial products in Pricing of financial contracts globally,

Usage
Pakistan including loans and derivatives

Reflects local economic and Reflects global economic and

Market Influence
monetary conditions financial conditions
Recent Continues to evolve within Pakistan's Undergoing reform and transition to
Developments financial market alternative reference rates globally

TREASURY SECURITIES:

Treasury securities are issued by the Government of Pakistan through the State Bank of
Pakistan (SBP) to raise funds for government expenditures and manage public debt. These
securities are considered among the safest investment options in Pakistan because they are
backed by the creditworthiness of the government. Here’s an overview of the main types of
Treasury securities issued in Pakistan:

1. Pakistan Investment Bonds (PIBs):

PIBs are medium to long-term debt securities issued by the Government of Pakistan. They
have maturities ranging from 3 years to 20 years or more. PIBs pay semiannual interest
56

(coupon payments) based on a fixed or floating interest rate determined at the time of
issuance.

2. Pakistan Market Treasury Bills (MTBs):

MTBs are short-term debt securities with maturities typically ranging from 3 months to 1 year.
They are issued at a discount to face value and do not pay regular interest. Investors earn
interest by purchasing MTBs at a discount and receiving the full face value at maturity.

3. Pakistan Floating Rate Treasury Notes (FRTNs):

FRTNs are debt securities with variable interest rates that reset periodically based on market
interest rates. They provide flexibility to investors by adjusting interest payments according to
prevailing market conditions.

Characteristics:

• Credit Risk: Treasury securities issued by the Government of Pakistan are considered low-
risk because they are backed by the government's ability to levy taxes and manage its fiscal
affairs.

• Liquidity: These securities are actively traded in the secondary market, providing investors
with liquidity to buy or sell their investments before maturity.

• Marketability: Treasury securities serve as benchmarks for pricing other fixed-income

instruments in Pakistan’s financial markets.

• Tax Treatment: Interest income from Treasury securities in Pakistan is typically subject to
withholding tax, although specific tax treatments may vary based on the security type and
investor category.

Role in Government Finance

• Debt Management: Treasury securities play a crucial role in managing the government's
financing needs, funding infrastructure projects, and meeting budgetary requirements.

• Monetary Policy: The issuance and management of Treasury securities are important tools
for the State Bank of Pakistan in implementing monetary policy and managing interest rates.

CALLABLE AND PUTABLE BONDS:

Aspect Callable Bonds Puttable Bonds

Issuer has the right to redeem Bondholder has the right to sell
Issuer's Right
bonds early. bonds back early.
57

Callable after a specified call date Puttable after a specified put date
Timing
or call schedule. or put schedule.
Callable at a specified call price Puttable at a specified put price
Price
(often at a premium). (often at par value).
May include call protection period May include put protection period
Protection
for bondholders. for issuers.
Allows issuer flexibility in debt Provides bondholder with an exit
Purpose
management. option.
Provides an exit strategy in rising
Risk of early redemption, potentially
Risk for Holders rate scenarios or deteriorating
reducing income if rates decline.
credit quality.
Offers flexibility to issuers in Offers flexibility to bondholders to
Flexibility
managing debt obligations. manage investment risks.
Impact on bond prices influenced Influence on bond prices affected
Market Influence by interest rate movements and by interest rate movements and
issuer's financial condition. investor demand.
Used by bondholders to mitigate
Used by issuers to refinance debt
Use Case risk or capitalize on market
at lower rates or manage liquidity.
conditions.

BOND VALUATION:

Components of interest rate:

Price / Yield Relationship:

• When interest rates in the market rise, new bonds are issued with higher coupon rates, making
existing bonds with lower coupon rates less attractive. Therefore, the prices of existing bonds
fall to increase their yield to match new issues.
58

• Conversely, when market interest rates fall, existing bonds with higher coupon rates become
more attractive, causing their prices to rise and their yields to decrease to match the lower
rates on new issues.

CALCULATION OF INTRINSIC VALUE OF BOND:

Value of bond (intrinsic value) is the present value of all future cash flows during the term using
required rate of return.

Criteria:

Condition Result Decision

Value of Bond > Market Price Underpriced Purchase
Value of Bond < Market Price Overpriced Sell
Value of Bond = Market Price Fairly priced Indifferent

Deep Discount / Zero Coupon Bonds [ZCB]:

Deep discount bonds are a type of bond issued at a significant discount to their face (or par)
value. They do not pay regular coupon interest like traditional bonds but instead provide returns
through capital appreciation, as they are redeemed at their face value upon maturity.

Key Characteristics of Deep Discount Bonds:

1. Issued at a Discount:
Deep discount bonds are sold at a price significantly lower than their face value. The
discount can be substantial, often exceeding 20-30% of the face value.

2. Zero or Low Coupon:

These bonds typically do not pay periodic interest (coupon payments). Instead, the
bondholder's return is the difference between the purchase price and the face value
received at maturity.

3. Long Maturity Period:

Deep discount bonds generally have a long-term maturity, often ranging from 10 to 30 years
or more. The longer maturity allows for significant capital appreciation.

4. Capital Appreciation:
Investors in deep discount bonds primarily benefit from capital gains rather than periodic
interest income. The profit is realized when the bond matures, and the issuer repays the full
face-value.
59

5. Higher Interest Rate Sensitivity:

Due to the absence of regular coupon payments, the price of deep discount bonds is more
sensitive to changes in interest rates compared to regular coupon bonds. This sensitivity is
often measured by the bond's duration, which is higher for deep discount bonds.

6. Tax Treatment:
The tax treatment of deep discount bonds can vary. In many jurisdictions, the difference
between the purchase price and the face value (accrued interest) may be taxed as ordinary
income or capital gains, depending on specific tax laws.

7. Investor Profile:
These bonds are suitable for investors who do not need regular income but seek long-term
capital growth. They are often attractive to those with a higher risk tolerance due to their
sensitivity to interest rate fluctuations.

8. Credit Risk:
The issuer's creditworthiness is crucial for deep discount bonds. Since these bonds pay at
maturity, the investor is exposed to the risk of the issuer defaulting. Therefore, the credit
rating of the issuer is an important consideration.

Illustration:
Face value of bond Rs.7,500, term 7-year, yield on similar bonds 13%. Current market price is
Rs.3,450.

Required:
Should the bond be purchased?

Solution:
Since there is no coupon in the bond, the value of bond is the present value of principal
received after 7 years using discount rate on similar bonds.

= 7,500 × 1.13−7 = 3,188

Since the intrinsic value of bond [Rs.3,188] is less than the prevailing market price [Rs.3,450],
the security is overvalued in the market; therefore, it should not be purchased.

Plain Vanilla / Conventional Bonds:

Plain vanilla bonds, also known as conventional bonds, are the most basic and straightforward
type of bond. They have fixed features that make them easy to understand and are widely used
by both issuers and investors. Here are the key concepts and features:
60

1. Fixed Coupon Rate: The interest rate paid by the bond issuer to the bondholder is
expressed as a percentage of the bond’s face value. This rate is fixed and does not change
throughout the life of the bond, providing predictable income to investors.

2. Regular Coupon Payments: Periodic interest payments are made to bondholders, typically
semi-annually (every six months) or annually.

3. Face Value (Par Value): This is the amount of money a bondholder will receive from the
issuer when the bond matures. Plain vanilla bonds are usually issued with a face value of
$1,000.

4. Maturity Date: The date on which the bond’s principal amount (face value) is repaid to the
bondholder. This date is fixed and known in advance, providing a clear time frame for
investment.

5. Principal Repayment: The repayment of the bond’s face value to the bondholder at
maturity. The issuer is obligated to repay the full face value on the maturity date.

6. Yield to Maturity (YTM): The total return anticipated on a bond if it is held until it matures,
considering all coupon payments and the difference between the purchase price and the
face value. YTM provides a comprehensive measure of the bond’s potential return, factoring
in both interest income and any capital gain or loss.

7. Credit Quality: An assessment of the issuer’s ability to repay the bond’s principal and
interest, often expressed through credit ratings. Credit ratings provided by agencies like
Moody’s, Standard & Poor’s, and Fitch indicate the creditworthiness of the issuer and the
risk level of the bond.
8. Market Price: The current trading price of the bond in the secondary market. The market
price of a plain vanilla bond can fluctuate based on changes in interest rates, the issuer’s
credit quality, and overall market conditions.

9. Interest Rate Sensitivity: The degree to which a bond’s price is affected by changes in
market interest rates. Plain vanilla bonds are sensitive to interest rate changes; when
interest rates rise, bond prices typically fall, and vice versa.

10. Liquidity: The ease with which a bond can be bought or sold in the market without affecting
its price. Plain vanilla bonds generally have high liquidity, especially if they are issued by
well-known entities or governments.

Illustration:

Face value of bond Rs.1,000, term 5-year, annual coupon rate 12%, required rate of return 15%.

Required:
61

Calculate the intrinsic value of bond assuming the bond will be redeemed at 10% premium.

Solution:
Period Cash Flow Factor [15%] Present Value
1-5 120 3.352 402
5 1,100 0.497 547
Value 949

YIELD CURVE:

It is the relationship between yield rates and bond maturity; longer the maturity, higher the yield
rate.
62
63

Learning Objectives:

a) Understand the calculation and implications of expected return and risk for individual
assets and portfolios.

b) Learn to measure risk-adjusted return using the coefficient of variation.

c) Apply certainty equivalents in decision-making under uncertainty.

d) Analyze portfolio performance and risk management strategies, including the benefits of
diversification.

e) Grasp the significance of Beta in assessing systematic risk and its role in the Capital
Asset Pricing Model (CAPM).

f) Evaluate securities using the Characteristics Line (SML) and Capital Market Line (CML) to
understand pricing and expected returns.

g) Understand the Efficient Market Hypothesis (EMH) and its implications for market
efficiency and investment strategies.
64

RETURN OF SINGLE SECURITY:

Historical returns:
(𝑃1 −𝑃0 ) + 𝐷1
𝑟=
𝑃0

P0 = Current market price per share.

D1 = Expected dividend per share receivable by year end.
P1 = Expected market price per share by year end.
r = return on stock.

Expected return:
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑒𝑡𝑢𝑟𝑛 = ∑ 𝑋. 𝑃
X = individual returns on different states of natures.
P = probability.

RISK OF SINGLE SECURITY:

It is measured as the standard deviation of returns.

Series Probability Distribution

THE CONCEPT OF RELATIVE RISK:

The relative risk is measured through the notion of coefficient of variation that converts risk on
the basis of per unit of return.

𝑅𝑖𝑠𝑘
𝐶𝑉 =
𝑅𝑒𝑡𝑢𝑟𝑛

BETA:

Beta (β) quantifies the sensitivity of a stock's returns to the returns of the market. It is a measure
of systematic risk, which is the risk inherent to the entire market or market segment.

Interpretation:
65

β=1: The stock's price moves in line with the market. If the market goes up or down by 1%, the
stock is expected to also go up or down by 1%.

β>1: The stock is more volatile than the market. For example, a β\betaβ of 1.5 means that if the
market rises by 1%, the stock is expected to rise by 1.5%, and if the market falls by 1%, the
stock is expected to fall by 1.5%.

β<1: The stock is less volatile than the market. For example, a β\betaβ of 0.7 means that if the
market rises by 1%, the stock is expected to rise by 0.7%, and if the market falls by 1%, the
stock is expected to fall by 0.7%.

β=0: The stock's price movements are uncorrelated with the market.

Calculation:

Beta is calculated using the covariance of the stock's returns with the market's returns divided
by the variance of the market's returns.

Beta in Portfolio Management

1. Risk Assessment:

Beta helps investors understand the risk of individual stocks relative to the market. A
portfolio with a high average beta is more sensitive to market movements, implying higher
risk and potentially higher returns. Conversely, a portfolio with a low average beta is less
sensitive to market movements, implying lower risk and potentially lower returns.

2. Diversification:

By including stocks with varying betas, investors can diversify their portfolios to manage risk.
A mix of high-beta and low-beta stocks can balance the portfolio's overall risk profile.

3. Performance Prediction:

Beta is used in the CAPM to predict the expected return of a stock or portfolio.

4. Hedging:

Understanding beta can aid in hedging strategies. Investors can use stocks with negative
betas or derivatives to hedge against market downturns, reducing overall portfolio risk.
66

PORTFOLIO RETURN:

r P = (r A × w A ) + (r B × w B )
r = Return
P = Porfolio
w = Weight of stock in portfolio
A = 1st Stock
B = 2nd Stock

PORTFOLIO BETA:

βP = ( βA × w A ) + ( βB × w B )
β = Beta
P = Porfolio
w = Weight of stock in portfolio
A = 1st Stock
B = 2nd Stock

PORTFOLIO RISK:

σP = √(σA × wA )2 + (σB × wB )2 + 2(σA × wA )(σB × wB )ρAB

σ = Standard Deviation
w = Weight of stock in portfolio
P = Porfolio
A = 1st Stock
B = 2nd Stock
ρAB = Correlation coefficient between 1st and 2nd Stocks

Comprehensive Illustration:

Mr. Javed is planning to invest his retirement funds into the portfolio of two stocks. He has
gathered the information related to 3 high performing stocks:
Year Blue Red Yellow
2019 16% 5% 18%
2020 10% 15% 13%
2021 13% 8% 17%
2022 6% 14% 14%
2023 13% 17% 16%
67

He has got following portfolio options:

Portfolio Stock Mix Stock Mix

Option 1 Blue 0.40 Red 0.60
Option 2 Blue 0.30 Yellow 0.70
Option 3 Red 0.55 Yellow 0.45

Following are correlation information of each respective portfolio.

Portfolio Correlation
Blue & Red -0.59
Blue & Yellow 0.84
Red & Yellow -0.75

Required:
Based on portfolio risk and return relationship [CV], advise the best portfolio option to Mr.
Javed?

Solution:

Returns [%] Squared mean deviation

Year
Blue Red Yellow Blue Red Yellow
2019 16.00 5.00 18.00 19.36 46.24 5.76
2020 10.00 15.00 13.00 2.56 10.24 6.76
2021 13.00 8.00 17.00 1.96 14.44 1.96
2022 6.00 14.00 14.00 31.36 4.84 2.56
2023 13.00 17.00 16.00 1.96 27.04 0.16

Mean 11.60 11.80 15.60 11.44 20.56 3.44

SD 3.38 4.53 1.85

Return of portfolio options:

Option 1:
rP = (rBLUE × wBLUE ) + (rRED × wRED )
rP = (0.116 × 0.4) + (0.118 × 0.6) = 0.117 𝑜𝑟 11.7%
68

Option 2:
rP = (rBLUE × wBLUE ) + (rYELLOW × wYELLOW )
rP = (0.116 × 0.3) + (0.156 × 0.7) = 0.144 𝑜𝑟 14.4%

Option 3:
rP = (rRED × wRED ) + (rYELLOW × wYELLOW )
rP = (0.118 × 0.55) + (0.156 × 0.45) = 0.1351 𝑜𝑟 13.51%

Risk (SD) of portfolio options:

Option 1:

σP = √(σB × wB )2 + (σR × wR )2 + 2(σB × wB )(σR × wR )ρBR

σP = √(3.38 × 0.4)2 + (4.53 × 0.6)2 + 2(3.38 × 0.4)(4.53 × 0.6) × (−0.59)
σP = √1.82 + 7.39 − 4.33
σP = √4.88 = 2.21%

Option 2:

σP = √(3.38 × 0.3)2 + (1.85 × 0.7)2 + 2(3.38 × 0.3)(1.85 × 0.7) × 0.84

σP = √1.03 + 1.68 + 2.63
σP = √4.92
σP = 2.20%

Option 3:

σP = √(4.53 × 0.55)2 + (1.85 × 0.45)2 + 2(4.53 × 0.55)(1.85 × 0.45) × −0.75

σP = √6.21 + 0.69 − 3.11
σP = √3.79
σP = 1.95%

Portfolio Return Risk CV

B&R 11.7% 2.21% 0.18
69

B&Y 14.4% 2.22% 0.15

R&Y 13.51% 1.95% 0.14

Since the portfolio 3 [Red and Yellow] has lowest coefficient of variation, this is the best option.

SYSTEMATIC VS. UNSYSTEMATIC RISK:

Aspect Systematic Risk Unsystematic Risk

Risk inherent to the entire market or Risk specific to a particular
Definition market segment, affecting all company or industry, not affecting
investments. the entire market.
Specific risk, diversifiable risk,
Other Names Market risk, non-diversifiable risk.
idiosyncratic risk.
Economic recessions, interest rate Company management changes,
Examples changes, political instability, natural product recalls, industry-specific
disasters. regulations, strikes.
Affects all companies and industries Affects individual companies or
Impact Scope
across the market. specific industries.
Cannot be eliminated through Can be mitigated or eliminated
Diversification
diversification. through diversification.
Measured by metrics like beta Measured by analyzing company-
Measurement (β\betaβ) and standard deviation of specific or industry-specific factors,
returns relative to the market. not directly linked to beta.
Managed by diversifying
Investment Typically managed through asset
investments across different
Strategies allocation and hedging strategies.
companies and industries.
Captured in the Capital Asset Not directly considered in CAPM, as
Importance in
Pricing Model (CAPM) as beta it is assumed to be diversified away
CAPM
(β\betaβ). in a well-constructed portfolio.

DIVERSIFICATION:

Diversification is a risk management strategy that involves spreading investments across

various financial assets, sectors, industries, or other categories to reduce exposure to any
single asset or risk. In the context of stocks, diversification aims to minimize the impact of
unsystematic risk (specific to individual companies or industries) while maintaining potential
returns.
70

1. Risk Reduction:

Diversification reduces unsystematic risk by spreading investments across different

assets that are not perfectly correlated. While systematic risk (market risk) cannot be
eliminated, unsystematic risk can be minimized.

2. Correlation:

The effectiveness of diversification depends on the correlation between the assets in a

portfolio. Assets with low or negative correlation provide better diversification benefits as
they do not move in the same direction under similar market conditions.

3. Portfolio Composition:

A well-diversified portfolio includes stocks from different sectors, industries, geographical

regions, and asset classes. This ensures that poor performance in one area is offset by
better performance in another.

Benefits of Diversification

1. Reduced Volatility:

Diversified portfolios tend to exhibit lower volatility compared to individual stocks. This is
because the positive performance of some investments can offset the negative
performance of others.

2. Smoother Returns:

By spreading investments across various assets, diversification can lead to more stable
and predictable returns over time.

3. Risk Management:

Diversification helps manage risk by limiting the potential negative impact of a single
investment's poor performance on the overall portfolio.

How to Diversify a Stock Portfolio

1. Invest in Different Sectors and Industries:

Include stocks from various sectors (e.g., technology, healthcare, finance, consumer
goods) to avoid sector-specific risks.
71

2. Geographical Diversification:

Invest in companies from different countries and regions to mitigate the impact of region-
specific economic or political events.

3. Varying Market Capitalizations:

Include a mix of large-cap, mid-cap, and small-cap stocks. Large-cap stocks provide
stability, while mid-cap and small-cap stocks offer growth potential.

4. Include Other Asset Classes:

Complement stock investments with bonds, real estate, commodities, or other asset
classes to further reduce risk.

5. Use of Mutual Funds and ETFs:

Investing in mutual funds and exchange-traded funds (ETFs) can provide instant
diversification, as these funds typically hold a wide range of securities.

MARKET EFFECIENCY:

Market Efficiency is a concept in financial economics that describes how well market prices
reflect all available information. A market is considered efficient if asset prices fully incorporate all
relevant information at any point in time, meaning that prices adjust instantly and accurately to
new data. The Efficient Market Hypothesis (EMH), proposed by Eugene Fama in the 1970s,
categorizes market efficiency into three forms: weak, semi-strong, and strong.

1. Information Reflection:
o Market efficiency hinges on the idea that prices reflect all available information. If
markets are efficient, no investor can consistently achieve returns that exceed
average market returns on a risk-adjusted basis.
2. Price Adjustment:
o In an efficient market, prices adjust quickly and accurately to new information. This
means that it is difficult for investors to buy undervalued stocks or sell overvalued
ones because such opportunities are quickly eradicated by market participants.
3. Random Walk Theory:
o Market efficiency is closely related to the Random Walk Theory, which suggests
that stock price changes are random and unpredictable because they reflect all
known information.

Forms of Market Efficiency

72

1. Weak Form Efficiency

• Definition:
o Weak form efficiency asserts that current stock prices reflect all past trading
information such as historical prices and volumes.
• Implications:
o Investors cannot gain a competitive advantage using technical analysis, which
relies on past price patterns and trading volumes.
o Fundamental analysis, which examines a company's financial statements and
health, may still provide useful insights.
• Example:
o If weak form efficiency holds, analyzing past stock price trends and patterns would
not yield better-than-average returns.

2. Semi-Strong Form Efficiency

• Definition:
o Semi-strong form efficiency claims that stock prices reflect all publicly available
information, including historical data and new public announcements.
• Implications:
o Investors cannot benefit from trading on public information, such as earnings
reports, economic news, or company announcements, because stock prices
already incorporate this information.
o Both technical and fundamental analysis are ineffective in achieving consistent
excess returns.
• Example:
o If a company announces higher-than-expected earnings, the stock price will
quickly adjust to reflect this new information, leaving no opportunity for investors
to profit from it.

3. Strong Form Efficiency

• Definition:
o Strong form efficiency posits that stock prices fully reflect all information, both
public and private (insider information).
• Implications:
o No investor, including insiders with non-public information, can consistently
achieve higher returns than the market.
o Insider trading laws and regulations exist because markets are not perfectly
strong-form efficient in practice.
• Example:
o Even if a company's executives have inside information about a future merger,
they would not be able to profit from trading the company's stock if the market
were strong-form efficient.
73
74

Learning Objectives:

a) Define and explain the concept of cost of capital, its importance in financial decision-
making, and discuss the concept of optimum cost of capital and its relevance to a
company's capital structure.

b) Apply the Dividend Valuation Model (DVM) to determine the cost of equity without growth
and with growth, and utilize the Capital Asset Pricing Model (CAPM) to calculate the cost
of equity, understanding its components and assumptions.

c) Calculate the cost of various types of debt, including fixed-rate, floating-rate, redeemable,
irredeemable, and convertible debt, and explain the tax implications of interest payments
and how they affect the cost of debt.

d) Calculate the cost of redeemable, irredeemable, and convertible preference shares,

understanding the features of preference shares and their impact on the cost of capital.

e) Compute the Weighted Average Cost of Capital (WACC) using the costs of equity, debt,
and preference shares, and their respective proportions in the company's capital
structure, and explain the significance of WACC in investment appraisal and corporate
finance decisions.

f) Discuss the concepts of leverage, business risk, and financial risk, and their impact on a
project's cost of capital, and calculate the asset beta and equity beta to evaluate the risk
profile of a specific project.

g) Calculate the risk-adjusted WACC for a single business, incorporating project-specific

risks, and compute the risk-adjusted WACC for combined businesses, understanding the
complexities of integrating risk profiles from two different business units.
75

CONCEPT OF COST OF CAPITAL:

The Net Present Value (NPV) is a fundamental metric in capital budgeting used to evaluate the
profitability of a project. NPV is calculated by determining the difference between the present
value of cash inflows and the present value of cash outflows over the project's lifetime. A critical
component in calculating NPV is the discount rate, which reflects the risk and opportunity cost of
the invested capital. In many cases, the Weighted Average Cost of Capital (WACC) is used as
the discount rate.

Understanding WACC

The Weighted Average Cost of Capital (WACC) represents the average rate of return required by
all of the company's investors, including equity holders and debt holders. It serves as a benchmark
that the company must achieve to satisfy its investors.

COMPONENTS COSTS:

To calculate WACC, a company needs to estimate the cost of each source of finance separately
and then take a weighted average of these individual costs. The main components include
equity, preference share and debt.

COST OF EQUITY:
The cost of equity is the rate of return that ordinary shareholders expect to receive on their
investment. The two main methods of computing cost of equity [ke] are:

1. Dividend Discount Model:

The Dividend Valuation Model (DVM) asserts that the current share price is determined by
the present value of expected future dividends, discounted at the rate of return required by
investors.

Without growth:
This variation assumes that dividends are expected to remain constant over the periods:

𝐷
𝑘𝑒 =
𝑃0

D = Dividend per share.

P0 = Current market price [ex dividend] per share.
76

Ex-dividend vs. cum-dividend market price:

Ex-dividend market price refers to the price of a security that does not include the value of
the next dividend payment. It is typically lower than the cum-dividend market price, which
includes the upcoming dividend. Investors purchasing shares ex-dividend are not entitled
to the next dividend payment, while those buying cum-dividend shares are entitled to it.
This difference reflects the market's adjustment for the dividend payment, with ex-dividend
prices being adjusted downwards to account for the dividend's value.

For example, if a dividend of Rs.2 is due to be paid on a share which has a cum div value
of Rs.34.5, the ex div share price to be entered into the DVM formula is Rs.34.5 - Rs.2 =
Rs.32.5.

Example 1:
The ordinary shares of a company are quoted at Rs.20 per share ex div. A dividend of Rs.1.6
per share has just been paid and there is expected to be no growth in dividends.

Required:
What is the cost of equity?

Solution:
𝐷 1.6
𝑘𝑒 = = = 8.00%
𝑃0 20

Example 2:
The ordinary shares of Jibran Ltd are quoted at Rs.40 per share. A dividend of Rs.3 is about
to be paid. There is expected to be no growth in dividends.

Required:

What is the cost of equity?

Solution:
𝐷 3
𝑘𝑒 = = = 8.11%
𝑃0 40 − 3

Example 3:
The cost of equity capital is 12%. The current dividend for a share of a company is Rs.4. There
is expected to be no growth in the value of the dividend.

Required:
What is the value of the share (P0)?
77

Solution:
𝐷 4
𝑃0 = = = Rs. 33.33
𝑘𝑒 0.12

With growth:
The valuation of share with growth has the following formula:

𝐷1 or 𝐷0 × (1 + 𝑔)
𝑘𝑒 = +𝑔 𝑘𝑒 = +𝑔
𝑃0 𝑃0

Where:
D1 = Dividend per share.
P0 = Current market price [ex dividend] per share.
g = growth in dividends

Calculating growth rates:

Growth rate can be estimated using either of the following two methods:

Cumulative Annual Growth Rate Gordon Growth Rate

𝑔 = 𝑟𝑏
𝑛 𝑅𝑒𝑐𝑒𝑛𝑡 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑔= √ −1 r = return on invested capital
𝐸𝑎𝑟𝑙𝑖𝑒𝑠𝑡 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
b = retention ration
n = number of growth cycles or number
of years lag

Example 4:
Kashmir Ltd paid a dividend of Rs.3 per share four years ago, and the current dividend is
Rs.4.4. The current share price is Rs.100 ex div.

Required:
(a) Estimate the rate of growth in dividends.
(b) Calculate the cost of equity.

Solution:
4 4.4
𝑔=√ − 1 = 10.05%
3.0

4.4 × (1 + 0.1005)
𝑘𝑒 = + 0.1005 = 14.89%
100
78

Example 5:
The ordinary shares of a company are quoted at Rs.70 cum div. A dividend of Rs.5 is just
about to be paid. The company has an annual accounting rate of return of 12% and each year
pays out 70% of its profits after tax as dividends.

Required:
Estimate the cost of equity.

Solution:

𝑔 = 0.12 × (1 − 0.7) = 3.60%

5.0 × (1 + 0.036)
𝑘𝑒 = + 0.036 = 11.57%
70 − 5

Multiple growth rates:

Calculating the value of share with multiple dividend growth rates involves the following steps:
Step 1: Calculate the value of share in the year in which change in growth rate is expected.
Step 2: Calculate the dividend for each year before change in growth rate
Step 3: Calculate the present value of all amounts determined in step 1 and step 2

Example 5:
ABC Ltd paid a dividend of Rs.25 this year. Dividend is expected to grow at 3% for next three
years and at 2% afterwards.

Required:
Calculate current value per share if shareholders require annual return of 14%.

Solution:
Present value of dividend during initial phase.

Year G D Factor (14%) PV

1 3.00% 25.75 0.877 22.59
2 3.00% 26.52 0.769 20.41
3 3.00% 27.32 0.675 18.44
61.43

Price at the end of year 3.

27.32 × (1.02)
𝑃3 = = 232.20
0.14 − 0.02
79

Discounted value of Rs.232.20 is Rs.156.73 (232.20 x 0.675)

𝑃0 = 156.73 + 61.43 = 218.17

2. Capital Asset Pricing Model [CAPM]

The Capital Asset Pricing Model (CAPM) is a widely used financial model that helps investors
calculate the expected return on an investment based on its risk. Developed by William
Sharpe, John Lintner, and Jack Treynor in the 1960s, CAPM is a foundational tool in modern
finance and portfolio theory.

Assumptions of CAPM:

a) Efficient Markets:
CAPM assumes that markets are efficient, meaning that asset prices reflect all available
information and adjust instantly to new information.

b) Homogeneous Expectations:
Investors have the same expectations about risk, return, and correlations among assets.

c) Risk-free Rate:
A risk-free asset exists and is available to all investors at the same rate.

d) Investors are Rational:

Investors are rational and seek to maximize returns while minimizing risk.

Systematic Risk Unsystematic Risk

Systematic risk, also known as market risk Unsystematic risk, also known as specific
or undiversifiable risk, refers to the inherent risk, diversifiable risk, or idiosyncratic risk,
risk of an entire market or the overall refers to risks that are specific to a
economy. It affects the entire market and particular company, industry, or investment.
cannot be eliminated through diversification Unlike systematic risk, unsystematic risk
because it is beyond the control of can be reduced or eliminated through
individual investors or companies. diversification. By investing in a diversified
Systematic risk factors include economic portfolio of assets across different
recessions, changes in interest rates, industries and sectors, investors can
political instability, natural disasters, and mitigate unsystematic risk because the risk
global pandemics. These factors affect all factors affecting one investment may not
investments in the market, regardless of affect others in the portfolio. Example:
their specific characteristics or industry.
Example: a) Company-specific events: These
include management changes, product
a) Economic Recession: During a recalls, lawsuits, or supply chain
recession, consumer spending typically disruptions that affect only one
80

decreases, leading to lower corporate company or a few companies in a

profits and stock market declines. This particular industry.
affects all companies and industries, b) Industry-specific risks: Certain
regardless of their individual industries may face challenges that are
performance. unique to them, such as regulatory
b) Interest Rate Changes: When interest changes, technological advancements,
rates rise, borrowing becomes more or shifts in consumer preferences. For
expensive, affecting businesses' ability example, changes in government
to invest and consumers' ability to regulations may have a significant
borrow. This can lead to decreased impact on healthcare companies, while
economic activity and stock market technological disruptions may affect
volatility. traditional retail businesses.

Model:
𝑘𝑒 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )

Where:
𝑅𝑓 = 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
𝑅𝑚 = 𝑅𝑖𝑠𝑘 𝑜𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝛽 = 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 𝑜𝑓 𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑟𝑖𝑠𝑘

Explanation of components:

a) Risk free rate:

The theoretical return on an investment with no risk of financial loss, typically
represented by the yield on government bonds. Investors use the risk-free rate as a
baseline for comparing the returns of other investments.

b) Market risk premium:

The additional return investors expect to receive for taking on the risk of investing in the
market rather than a risk-free asset. It reflects the excess return of the market portfolio
over the risk-free rate and compensates investors for bearing market risk.

c) Beta:
A measure of an investment's volatility relative to the overall market. Beta indicates how
much an investment's returns are expected to move in response to changes in the
market. A beta of 1 implies that the investment moves in line with the market, while a
beta greater than 1 indicates higher volatility, and a beta less than 1 indicates lower
volatility.
81

Example 6:
Following is the data for three stocks:

A B C
Beta 1.50 0.70 1.00

Risk-free rate is 5% and expected return on the Market Portfolio is 12%.

Required:
Calculate the required return for each investment.

Solution:

A B C
Beta 1.50 0.70 1.00
Market Rate 5.00% 5.00% 5.00%
Risk Free Rate 12.00% 12.00% 12.00%
Required Return 15.50% 9.90% 12.00%

COST OF DEBT:

The cost of debt is the rate of return that debt providers require on the funds that they provide.

Cost of irredeemable debt:

Annual Interest (1 − tax rate)

kd =
Net Proceeds

Example 7:
The 10% irredeemable debentures of a company are quoted at Rs.130 ex int. Corporation tax is
payable at 30%.

Required:
What is the net of tax cost of debt?

Solution:
10 (1 − 0.3)
𝑘𝑑 = = 5.38%
130
82

Cost of redeemable debt:

The kd for redeemable debt is given by the IRR of the relevant cash flows. The relevant cash
flows would be (assuming that there is no one year delay in the tax saving):

Year Cash flow Rs

0 Market value of the loan (P0)
1 to n Annual net interest payments i (1 - t)
n Redemption value of loan RV

There are four steps to ensuring an accurate computation:

1) Identify the cash flows.

2) Estimate the IRR.
3) Calculate two NPVs (preferably one -ve and one +ve).
4) Calculate the IRR.

Example 8:
A company has 10% debentures quoted at Rs 95.00 ex interest redeemable at par in five years'
time. Corporation tax is paid at 31%.

Required:
What is the net of tax cost of debt?

Solution:
Using trial and error, we need to find two NPVs at two different rates: one negative and one
positive and put the values into the following IRR formula:

NPVLR
IRR = LR + × (HR − LR)
NPVLR −NPVHR

PV at 7% PV at 9%
Time CF
Factor PV Factor PV
0 (95.00) 1.000 (95) 1.000 (95)
1-5 6.90 4.100 28 3.890 27
5 100.00 0.713 71 0.650 65
4.59 (3.17)

4.59
IRR = 0.07 + × (0.09 − 0.07) = 8.18%
4.59 − (−3.17)
83

Cost of Convertible Debt:

Convertible debentures are like redeemable debts, but they offer the investor a choice of cash
or shares on the redemption date.

In practice, particularly if the value of the cash and shares option is very similar, some investors
will choose cash for liquidity reasons, whereas other investors may choose shares, hoping for
large dividend returns in the future.

In order to calculate the cost of convertible debt, we make a simplifying assumption that all
investors will make the same decision.

Example 9:

Consider a Rs 100 debenture which is redeemable at par in 5 years, or convertible into 10 shares
at that time. The current share price is Rs 8.60 and historically, dividends (and hence share prices)
have grown at 5% per annum.

To decide which option is likely to be chosen by investors, we compare:

• the value of the cash option, Rs.100; with

• the value of the conversion option, i.e. 10 × (Rs.8.60 × 1.055) =Rs.109.76

Hence, it is assumed that all investors will choose the conversion option, and the cost of the
convertible debt is calculated in a similar way to the cost of redeemable debt, i.e. it is the IRR of:

Year Cash flow Rs

0 Market value of the loan (P0)
1 to n Annual net interest payments i (1 - t)
n The higher of the cash and the conversion option C

COST OF PREFERENCE SHARES:

Preference shares usually pay a constant level of dividend, which is quoted as a percentage of
nominal value. Hence, the cost of preference shares (kp) can be calculated using a formula very
similar to the one covered earlier for ke in a no growth situation. The formula is:

𝐷
𝑘𝑝 =
𝑃0

D = is the constant dividend

P0 = the ex div market price of the share
kp = the cost of preference shares
84

WEIGHTED AVERAGE COST OF CAPITAL:

The weighted average cost of capital (WACC) is the average of cost of the company's finance
(equity, debentures, bank loans, and preference shares) weighted according to the proportion
each element bears to the total pool of funds.

A company's WACC can be regarded as its opportunity cost of capital/marginal cost of capital,
and this cost of capital can be used to evaluate the company's investment projects.

In the analysis so far carried out, each source of finance has been examined in isolation.
However, the practical business situation is that there is a continuous raising of funds from
various sources. These funds are used, partly in existing operations and partly to finance new
projects. There is not normally any separation between funds from different sources and their
application to specific projects.

In order to provide a measure for evaluating these projects, the cost of the pool of funds is
required. This is variously referred to as the combined or weighted average cost of capital
(WACC).

The general approach is to calculate the cost of each source of finance, then to weight these
according to their importance in the financing mix.

Procedure for calculating the WACC

The calculation involves a series of steps.

Step 1: Calculate weights for each source of capital.

Step 2: Estimate the cost of each source of capital.
Step 3: Multiply the proportion of the total of each source of capital by the cost of that source of
capital.
Step 4: Sum the results of step 3 to give the weighted average cost of capital.

Example 10:
Rahat Ltd has a capital structure as follows.

After Tax Capital Structure [Rs.m]

Component
Cost Book Market
Bank Loan 6.00% 5 5
Debenture loans 10.00% 8 5
Ordinary Shares 15.00% 18 30
85

Required:

Calculate Rahat’s WACC using market:

h) Book values as weights.
i) Market values as weights

Solution:
After Tax Capital Mix % WACC
Component
Cost Book Market Book Market Book Market
Bank Loan 6.00% 5.00 5.00 0.16 0.13 0.97% 0.75%
Debenture loans 10.00% 8.00 5.00 0.26 0.13 2.58% 1.25%
Ordinary Shares 15.00% 18.00 30.00 0.58 0.75 8.71% 11.25%
Total 31.00 40.00 1.00 1.00 12.26% 13.25%

When can WACC be used as a discount rate?

The WACC can be used as a discount rate in evaluating project appraisal under the following
situations:

(1) The capital structure is constant. If the capital structure changes the weightings in the WACC
will also change.
(2) The new investment does not carry a different risk profile to the existing company's
operations.
(3) The new investment is marginal to the company. If we are only looking at a small investment
then we would not expect any of ke, kd or the WACC to change materially. If the investment
is substantial it will necessarily change the values.
86

PROJECT SPECIFIC COST OF CAPITAL:

Calculating the project-specific cost of capital involves determining the appropriate discount rate
to evaluate the potential returns and risks of a particular project. This discount rate reflects the
project's risk profile rather than the overall company's average cost of capital. Here is the step-
by-step procedure to determine the project-specific cost of capital:

Step-by-Step Procedure:

1. Identify the Project’s Risk Profile:

o Assess the project's risk relative to the company’s average project.
o Determine whether the project has higher, lower, or similar risk compared to the
company’s typical projects.
2. Determine the Appropriate Discount Rate:
o If the project’s risk is similar to the company's overall risk, use the company's weighted
average cost of capital (WACC).
o If the project’s risk differs, adjust the discount rate accordingly.
3. Estimate the Risk-Free Rate:
o Identify the current rate on a risk-free investment, typically long-term government
bonds.
4. Calculate the Equity Risk Premium:
o Estimate the additional return required for investing in equities over risk-free
investments. This can be derived from historical market data.
5. Determine the Project's Beta:
o Project-Specific Beta: Calculate or estimate the beta of the project. Beta measures the
project’s sensitivity to market movements.
o Use comparable companies (comps) or industry data to estimate the project's beta if it
is not readily available.
6. Adjust for Financial Structure:
o If the project will be financed differently than the company's typical financing structure,
adjust the debt-to-equity ratio and calculate the project-specific cost of equity and debt.
o Calculate the project-specific cost of debt considering the specific financing terms and
tax implications.
7. Calculate the Project-Specific Cost of Equity:
o Use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity for the
project:
8. Calculate the Project-Specific WACC:
o Adjust the WACC formula to reflect the project-specific components
87

Example 10:

Garvey Co is planning to undertake a new project in a new business sector. Information for Garvey
Co and for Rocket Co, a listed company in the new business sector is as follows:

Garvey Co Rocket Co
Equity beta 1.25 1.86
Debt equity ratio 1:2 1:1

Garvey Co intends to finance the project to maintain its existing gearing ratio.

The tax rate is 30% and the return on the stock market has been 12% per annum in recent years.
Debt is assumed to be risk free and has a pre tax cost of 5% per annum.

Required:
Calculate a suitable cost of capital for the new project.

Solution:
Since the project is being undertaken in new business sector [Rocket Co], we need to use the
business risk of that company. Therefore, we need to un-gear the beta of Rocket Co using the
following formula:

1
𝛽𝐴𝑆𝑆𝐸𝑇 = 𝛽𝐸𝑄𝑈𝐼𝑇𝑌 × [ ]
𝐷
1 + ((1 − 𝑡) × 𝐸 )

1
𝛽𝐴𝑆𝑆𝐸𝑇 = 1.86 × [ ] = 1.094
1
1 + ((1 − 0.3) × 1)

The next step is to re-gear the asset beta of 1.094 as per capital structure of Garvey Co using the
following formula:

𝐷
𝛽𝐸𝑄𝑈𝐼𝑇𝑌 = 𝛽𝐴𝑆𝑆𝐸𝑇 × [1 + ((1 − 𝑡) × )]
𝐸

1
𝛽𝐸𝑄𝑈𝐼𝑇𝑌 = 1.094 × [1 + ((1 − 0.3) × )] = 1.477
2

The re-geared equity beta will be used in CAPM model to estimate the project specific risk:

𝑘𝑒 = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 )
88

𝑘𝑒 = 0.05 + 1.477(0.12 − 0.05) = 15.34%

We would now use WACC formula to calculate risk-adjusted WACC for the project:

𝑊𝐴𝐶𝐶 = [𝑘𝑑 × 𝑤𝑑 × (1 − 𝑡)] + [𝑘𝑒 × 𝑤𝑒 ]

1 2
𝑊𝐴𝐶𝐶 = [0.05 × × (1 − 0.3)] + [0.1534 × ] = 11.4%
3 3

We would use 11.4% as risk adjusted discount rate for the new project.

Test your understanding 2 – Wahab Ltd

Wahab Ltd is a company which specialises in elocution courses based in Preston and Oxford.
The recently appointed finance director, Mr Qasim, has asked for your assistance in obtaining a
cost of capital which Wahab Ltd can use in appraising its long-term investment opportunities. Mr
Qasim has provided you with the following information regarding the capital structure of the
company.

(1) 50,000 Rs 10 ordinary shares valued @ Rs 34.8. The annual dividend of Rs 180,000, which
represents 70% of the amount available for distribution, has just been paid. The company
expects to achieve a return of 26% on its retained profits.

(2) 10,000 9% preference shares of Rs 10 each valued at Rs 80,000 cum div.

(3) Rs.1 million 8% debentures which are redeemable in eight years' time at a premium of 5%.
Mr Qasim estimates that the debenture holders require a return of 11%. Corporation tax is at a
rate of 35%.

Required:

Calculate for Wahab Ltd its:

(a) cost of equity share capital;
(b) cost of preference share capital;
(c) market value of debentures;
(d) cost of debentures;
(e) weighted average cost of capital (WACC).

Solution:
89

a) Cost of Equity:

𝐷0 × (1 + 𝑔)
𝑘𝑒 = +𝑔
𝑃0

Growth rate
Return 26.00%
Retention 30.00%
G 7.80%

Dividend per share 3.60

3.60 × (1 + 7.8%)
𝑘𝑒 = + 7.8% = 18.95%
34.80

b) Cost of preference share:

0.90
𝑘𝑝 = = 12.68%
8 − 0.90

c) Market value of debentures:

Cash Factor
Year Flows [11%] PV
1-8 80,000 5.146 411,690
8 1,050,000 0.434 455,623
867,313
It is the present value of all cash flows.

Cost of debentures:

PV at 7% PV at 8%
Time CF
Factor PV Factor PV
0 (867,313) 1.000 (867,313) 1.000 (867,313)
1-8 52,000 5.971 310,508 5.747 298,825
8 1,050,000 0.582 611,110 0.540 567,282
54,304 (1,205)
90

54,304
IRR = 0.07 + × (0.08 − 0.07) = 7.98%
54,304 − (−1,205)

e) Weighted average cost of capital

Component Value Weight Cost WACC

Equity 1,740,000 64.75% 18.95% 12.27%
Preference Shares 80,000 2.98% 12.68% 0.38%
Debentures 867,313 32.27% 7.98% 2.58%
2,687,313 100.00% 15.22%
91
92

Learning Objectives:

1. Understand the concept of operating leverage and its impact on a company's cost structure,
profitability, and risk.

2. Calculate the degree of operating leverage (DOL) and analyze its implications for business
risk management.

3. Determine the operating breakeven point (BEP) and its significance in assessing the level
of sales needed to cover fixed costs.

4. Explain the concept of financial leverage and how it influences a company's capital structure
and financial risk.

5. Calculate the financial breakeven point (BEP) and evaluate its importance in assessing the
level of earnings needed to cover fixed financial costs.

6. Analyze the point of indifference between debt and equity financing options and its
implications for capital structure decisions.

7. Understand the degree of financial leverage (DFL) and total leverage (DTL) and their roles
in assessing the combined impact of operating and financial leverage on a company's risk
and return profile.
93

CONCEPT OF LEVERAGE:
Leverage in finance refers to the strategic use of borrowed funds (debt) to increase the potential
return on investment. It amplifies both gains and losses, magnifying the impact of financial
decisions. There are two main types of leverage:

a) Operating Leverage: Utilizing fixed costs, such as rent or equipment, to enhance

profitability. For example, a company that invests in expensive machinery to automate
production can increase output capacity without proportionately increasing variable costs. If
demand rises, the company enjoys higher profits, but if demand falls, fixed costs can lead to
significant losses.

b) Financial Leverage: Using debt financing to amplify returns on equity. For instance, a real
estate investor purchases a property using a combination of their own funds and a
mortgage. If the property appreciates, the investor's return on investment is higher due to
leverage. However, if the property value declines, the investor's losses are also magnified.

Degree of Operating Leverage:

Degree of Financial Leverage

94

Degree of Total Leverage

Using the above formulas, we can draw the following relationships:

BUSINESS RISK AND OPERATING LEVERAGE:

Business risk refers to the potential for a company to experience lower than expected profits or
even losses due to various factors affecting its operations. One critical aspect of business risk is
operating leverage, which relates to the proportion of fixed versus variable costs in a company's
cost structure. Here's how operating leverage impacts business risk:

Fixed costs:
Operating leverage measures the extent to which a company uses fixed costs in its operations.
Companies with high operating leverage have a large proportion of fixed costs relative to
variable costs. This means that a significant portion of the company's costs remain constant
regardless of the level of production or sales.

High Operating Leverage Low Operating Leverage

Indicates that a company has high fixed costs Indicates that a company has low fixed costs
and low variable costs. Examples of fixed and high variable costs. Examples of variable
costs include rent, salaries, and depreciation. costs include raw materials and direct labor
costs that fluctuate with production levels.

The level of operating leverage directly influences a company's business risk in the following
ways:

Profitability Sensitivity:

High Operating Leverage Low Operating Leverage

Companies with high operating leverage Companies with low operating leverage have
experience greater fluctuations in operating more stable operating income because their
income with changes in sales volume. This is variable costs fluctuate with sales. This
because fixed costs remain constant, so any provides a cushioning effect; if sales
decrease in sales can significantly impact decrease, variable costs decrease as well,
profitability. Conversely, an increase in sales
95

can lead to a disproportionate increase in which mitigates the impact on overall

profits, as fixed costs are spread over more profitability.
units.

Break-Even Point:

High Operating Leverage Low Operating Leverage

These companies have a higher break-even These companies have a lower break-even
point because they must cover more fixed point, making it easier to achieve profitability
costs before making a profit. This makes with lower sales levels. This reduces the risk
them more vulnerable to economic downturns during periods of low demand.
or market volatility.

Cost Structure Flexibility:

High Operating Leverage Low Operating Leverage

The inflexibility associated with high fixed Companies with higher variable costs can
costs means that companies cannot easily more easily adjust their cost base in
adjust their cost structures in response to response to changing market conditions,
market conditions. This rigidity can increase which can reduce business risk.
business risk during economic downturns.

Example 1:
Consider two companies, A and B, both in the manufacturing sector.

Company A has high operating leverage with significant investments in automated machinery
(high fixed costs) and low variable costs due to reduced labor requirements.
Company B relies more on manual labor (high variable costs) and has fewer fixed costs related
to machinery and automation.
In an economic downturn, Company A faces higher business risk because it must continue to
cover its high fixed costs despite potentially lower sales. This could lead to significant losses if
sales volumes decline substantially. On the other hand, Company B can reduce its variable
costs (e.g., by laying off workers or reducing production shifts) in line with lower sales, which
helps it maintain financial stability and reduces its business risk.

Operating leverage is a critical factor in understanding business risk. Companies with high
operating leverage are more sensitive to changes in sales volume, which can lead to greater
fluctuations in profitability and increased business risk. Conversely, companies with low
operating leverage have more stable earnings and lower business risk, as their costs are more
flexible and can adjust with changes in production levels. Therefore, understanding and
managing operating leverage is essential for businesses to mitigate risk and ensure
financial stability.
96

FINANCIAL RISK AND FINANCIAL LEVERAGE:

Financial risk refers to the possibility of a company experiencing financial distress or insolvency
due to its use of debt financing. Financial leverage, also known as gearing or leverage, is the
use of borrowed funds to finance the acquisition of assets.

Financial leverage involves using debt (borrowed capital) to increase the potential return on
equity. By using debt, a company can invest more in its operations without increasing its equity
capital. However, this also means that the company must meet its debt obligations, including
interest payments and principal repayments, regardless of its financial performance.

• High Financial Leverage indicates that a company has a high proportion of debt relative to
equity.
• Low Financial Leverage indicates that a company has a low proportion of debt relative to
equity.

The level of financial leverage directly influences a company's financial risk in the following
ways:

Obligations and Insolvency Risk:

High Financial Leverage Low Financial Leverage

Companies with high financial leverage have Companies with low financial leverage have
significant debt obligations. If the company’s fewer debt obligations, reducing the risk of
earnings are insufficient to cover these insolvency. This makes them more resilient
obligations, it may face financial distress or during periods of poor financial performance,
even bankruptcy. High debt levels increase as they have fewer mandatory payments to
the fixed financial burden, making the meet.
company more vulnerable to fluctuations in
revenue.

Interest Coverage Ratio:

High Financial Leverage Low Financial Leverage

These companies have higher interest These companies have lower interest
expenses. The interest coverage ratio, which expenses, resulting in a higher interest
measures the ability to pay interest from coverage ratio. This implies lower financial
operating earnings, tends to be lower. A lower risk, as they are more capable of meeting
ratio indicates higher financial risk, as the their interest obligations.
company may struggle to meet interest
payments during downturns.
97

Return on Equity (ROE):

High Financial Leverage Low Financial Leverage

Financial leverage can amplify ROE when the These companies have a more stable ROE,
company earns a higher return on its as their returns are less impacted by the cost
investments than the cost of debt. However, if of debt. While the potential for higher returns
the return on investments is lower than the is limited, the financial risk is also lower.
cost of debt, financial leverage can
significantly reduce ROE and increase
financial risk.

Example 2:
Consider two companies, C and D, both in the retail sector.

Company C has high financial leverage, with a significant amount of debt financing its
expansion. Company D has low financial leverage, relying primarily on equity financing for its
growth.

During a period of economic downturn, Company C faces higher financial risk because it must
continue to make substantial interest payments despite potentially lower revenues. If the
downturn is severe, Company C might struggle to meet its debt obligations, risking default or
bankruptcy.

In contrast, Company D has fewer mandatory debt payments, which allows it to navigate the
downturn with less financial strain. Its lower financial leverage means it has less financial risk,
even though it might also experience a decline in profitability.

Financial leverage significantly impacts financial risk. Companies with high financial leverage
can enhance their returns on equity when business conditions are favorable, but they also face
higher financial risk during downturns due to the fixed obligations of debt payments. Conversely,
companies with low financial leverage have more stable financial structures and lower financial
risk, as they have fewer debt obligations. Managing financial leverage is crucial for maintaining
financial stability and minimizing the risk of financial distress.

OPERATING BREAKEVEN POINT:

The operating breakeven point is the level of sales at which a company's operating income
(EBIT) equals zero, resulting in neither profit nor loss. It represents the minimum level of sales
needed to cover all operating expenses, both variable and fixed, without generating any profit.

𝐹𝑖𝑥𝑒𝑑 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 [𝑆𝑎𝑙𝑒𝑠] =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜
98

Fixed Costs:

These are expenses that do not change with changes in sales volume, such as rent, salaries,
and depreciation.

Contribution Margin Ratio:

The contribution margin ratio represents the proportion of each sales dollar that contributes to
covering fixed costs and generating operating income.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜 =
𝑆𝑎𝑙𝑒𝑠

Profitability Analysis: The operating breakeven point helps analyze the minimum level of
sales required to achieve profitability. It provides insights into the company's financial health and
its ability to cover operating expenses.

Risk Assessment: Companies with high operating breakeven points are more vulnerable to
fluctuations in sales volume. They may struggle to remain profitable during periods of low
demand or economic downturns.

Strategic Decision-Making: Understanding the operating breakeven point enables

management to make informed decisions regarding pricing strategies, cost control measures,
and sales targets. It guides resource allocation and helps optimize profitability.

Example 3
A manufacturing company in Pakistan produces and sells widgets. The company provided the
following information:

Fixed Costs: PKR 200,000 per month

Selling Price per Unit: PKR 500
Variable Cost per Unit: PKR 300

Required:
a) Calculate the operating breakeven point in units.
b) Calculate the breakeven point in terms of sales value in PKR.

Solution:

Contribution Margin per Unit = PKR500 − PKR300 = PKR200

99

Operating Breakeven Point (sales value) = 1,000 units × PKR500 per unit = PKR500,000

The company needs to sell 1,000 units of widgets each month to cover all fixed and variable
costs and reach the operating breakeven point. In terms of sales value, the company must
generate PKR 500,000 in sales each month to break even. Any sales beyond this point will
contribute to the company's operating income.

FINANCIAL BREAKEVEN POINT:

The financial breakeven point is the level of sales at which a company's net income becomes
zero, resulting in neither profit nor loss after accounting for all expenses, including interest and
taxes. Unlike the operating breakeven point, which focuses solely on covering operating
expenses, the financial breakeven point considers all expenses, including interest payments on
debt and taxes.

𝐹𝑖𝑥𝑒𝑑 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑜𝑠𝑡𝑠 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒

𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑃𝑜𝑖𝑛𝑡 [𝑆𝑎𝑙𝑒𝑠] =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜

Fixed Costs:

These are expenses that do not change with changes in sales volume, such as rent, salaries,
and depreciation.

Interest Expense:

This represents the interest payments on debt, including loans and bonds.

Contribution Margin Ratio:

The contribution margin ratio represents the proportion of each sales dollar that contributes to
covering fixed costs, interest expenses, and generating net income.

Example 4

A manufacturing company in Pakistan produces and sells capacitors. Following data is

provided:

Fixed Costs: PKR 150,000 per month

Selling Price per Unit: PKR 800
Variable Cost per Unit: PKR 500
100

Interest Expense: PKR 30,000 per month

Required:
Calculate the financial breakeven point, both in terms of units and sales value.

Solution:

Contribution Margin per Unit=PKR800−PKR500=PKR300

Financial Breakeven Point (sales value)=600 units × PKR800 per unit = PKR480,000

The company needs to sell 600 units of capacitors each month to cover all fixed costs, including
the interest expense, and reach the financial breakeven point. In terms of sales value, the
company must generate PKR 480,000 in sales each month to break even financially. Any sales
beyond this point will contribute to the company's net income.

Example 5

Alpha Ltd, Beta Ltd and Delta Ltd operating in the same industry. They are similar sized
company and selling same number of units but have different operating and financial structures.
Selling price for all companies are Rs.60 per unit and currently selling 7,000 units. Following
data are presented:

Alpha Ltd Beta Ltd Delta Ltd

Capital Structure:
Shares [Rs.10/- Par] 800,000 500,000 200,000
12% Bonds 200,000 500,000 800,000
Total 1,000,000 1,000,000 1,000,000

Cost Structure:
Variable Cost Per Unit 30 25 15
Total Fixed Cost 25,000 50,000 100,000

Required:
a) Prepare contribution format income statement at existing sales volume.
b) Calculate operating and financial break-even points of each company.
c) Calculate degrees of operating, financial and total leverage.
d) Calculate % change in net income using degree of total leverage if sales volume fluctuates
up and down by 20%.
e) Verify the calculations in part (c) by preparing revised income statements.
101

Solution:

a) Contribution Format Income Statement:

Alpha Ltd Beta Ltd Delta Ltd

Sales Revenue 420,000 420,000 420,000

Variable Cost (210,000) (175,000) (105,000)

Contribution Margin 210,000 245,000 315,000

Fixed Cost (25,000) (50,000) (100,000)

EBIT 185,000 195,000 215,000

Interest (24,000) (60,000) (96,000)

PBT 161,000 135,000 119,000

Income Tax [30%] (48,300) (40,500) (35,700)

Net Income 112,700 94,500 83,300

No. of Shares 80,000 50,000 20,000

EPS 1.41 1.89 4.17

Notice that the Delta company [highly levered] has high EPS.
102

b) Breakeven points

Alpha Ltd Beta Ltd Delta Ltd

Operating Break-Even Point:

Fixed Cost 25,000 50,000 100,000

CM Per Unit 30 35 45

Break Even Point [Units] 833 1,429 2,222

Financial Break-Even Point:

Fixed Cost 25,000 50,000 100,000

Interest Expense 24,000 60,000 96,000

Total Fixed commitments 49,000 110,000 196,000

CM Per Unit 30 35 45

Break Even Point [Units] 1,633 3,143 4,356

Delta company has to achieve more units in sales in order to break even due to high leverage.
Therefore, it has highest operating and financial risk despite currently it is operating in profit
region.
103

c) Degrees of operating, financial and total:

Alpha Ltd Beta Ltd Delta Ltd

Operating Leverage Degree:

CM 210,000 245,000 315,000

EBIT 185,000 195,000 215,000

DOL 1.14 1.26 1.47

Financial Leverage Degree:

EBIT 185,000 195,000 215,000

EBT 161,000 135,000 119,000

DFL 1.15 1.44 1.81

DTL = DOL x DFL 1.30 1.81 2.65

d) % change in net income:

Alpha Ltd Beta Ltd Delta Ltd

% Change in Sales 20% 20% 20%

DTL 1.30 1.81 2.65

% Change in NI 26.09% 36.30% 52.94%

It can be noted that higher the total leverage, higher the fluctuation in net income due to change
in sales volume.
104

e) Revised income statement with 20% increase volume

20% INCREASE IN SALES:

Alpha Ltd Beta Ltd Delta Ltd

Sales Revenue 504,000 504,000 504,000

Variable Cost (252,000) (210,000) (126,000)

Contribution Margin 252,000 294,000 378,000

Fixed Cost (25,000) (50,000) (100,000)

EBIT 227,000 244,000 278,000

Interest (24,000) (60,000) (96,000)

PBT 203,000 184,000 182,000

Income Tax [30%] (60,900) (55,200) (54,600)

Net Income 142,100 128,800 127,400

No. of Shares 80,000 50,000 20,000

EPS 1.78 2.58 6.37

Original EPS 1.41 1.89 4.17

% Increase 26.09% 36.30% 52.94%

The percentage increase is confirmed by the calculated done using degree of total leverage.

FINANCING OPTIONS:

When different financing options are available, selecting the best one involves evaluating
various criteria to determine the most suitable option for the company's specific needs and
circumstances. Here are the key criteria to consider:

1. Cost of Financing
• Interest Rates: Compare the interest rates for debt options.
• Cost of Equity: Estimate the expected return required by equity investors.
105

• Total Cost: Include all associated fees, charges, and potential costs over the term of the
financing.

2. Impact on Cash Flow

• Repayment Terms: Assess how repayment schedules affect cash flow.
• Flexibility: Look for options that offer flexible repayment terms to accommodate variations
in cash flow.

3. Impact on Financial Structure

• Debt-to-Equity Ratio: Evaluate how each option affects the company's leverage.
• Balance Sheet: Consider the impact on the company's financial statements and key
ratios.
• Covenants: Review any restrictive covenants associated with debt financing.

4. Risk Assessment
• Interest Rate Risk: Consider the risk of interest rates changing over time.
• Default Risk: Assess the risk of being unable to meet debt obligations.
• Dilution Risk: For equity, evaluate the impact on ownership and control.
• Market Risk: Consider the potential impact of market conditions on financing terms and
availability.

5. Control and Ownership

• Equity Financing: Assess the impact on existing shareholders' ownership and control.
• Debt Financing: Evaluate the level of control retained by existing owners.
• Hybrid Financing: Understand how convertible or mezzanine financing affects control
and decision-making.

6. Strategic Fit
• Alignment with Business Goals: Ensure the financing option supports the company’s
long-term strategic objectives.
• Growth and Expansion Plans: Choose an option that accommodates future growth
and expansion needs.
• Exit Strategy: Consider how the financing aligns with potential exit strategies for
investors or owners.

7. Tax Implications
• Interest Deductibility: Debt interest payments are typically tax-deductible, reducing the
effective cost of debt.
• Tax Benefits: Assess any tax benefits associated with different financing options.
• Net Impact: Calculate the net impact of taxes on the overall cost of financing.
106

8. Market Conditions
• Economic Environment: Consider the current economic climate and its impact on
financing availability and terms.
• Investor Sentiment: Gauge market and investor sentiment towards different types of
financing.
• Regulatory Environment: Understand the regulatory implications and compliance
requirements.

9. Availability and Accessibility

• Eligibility: Determine if the company meets the criteria for various financing options.
• Accessibility: Evaluate the ease and speed of obtaining the financing.
• Relationships: Leverage existing relationships with banks, investors, and financial
institutions.

10. Long-Term Considerations

• Sustainability: Assess the long-term sustainability of the financing option.
• Scalability: Ensure the financing can scale with the company’s growth.
• Future Financing Needs: Consider how the current financing decision affects future
financing options and needs.
107

Example 6

A company is considering three financing options to fund an expansion project: a bank loan,
issuing new equity, and a convertible bond.

Required:
Critically evaluate each option to help decide the optimum one.

S# Factor Bank Loan New Equity Convertible Bond

1 Cost of 6% interest rate. Expected return of 7% interest rate, with
Financing 10%. a conversion option.

2 Impact on Cash Fixed monthly No immediate cash Interest payments,

Flow repayments. flow impact but but potential for
dividends expected. conversion to equity.

3 Impact on Increases debt-to- Dilutes existing Initially increases

Financial equity ratio. ownership. debt, potential to
Structure convert to equity.

4 Risk Default risk if cash Dilution risk. Moderate interest

Assessment: flow issues arise. rate risk, conversion
mitigates some
default risk.

5 Control and No impact on Reduces control of Potential future

Ownership control. existing owners. dilution of control.

6 Strategic Fit Suitable for fixed- Best for long-term Offers flexibility and
term projects. growth without potential lower
repayment pressure. interest cost if
converted.
108

Example 7

Total funds required Rs.1,000,000

Options A: 100% equity of Rs.10/- each

Options B: 50% equity of Rs.10/- each and remaining debt at 15%.

Earnings before interest and taxes Rs.200,000. [ROI 20%]

Required:
a) Assuming applicable corporate tax rate of 40%, what is the better financing option based on
EPS / ROI and why?
b) Assume now, the EBIT now changes from 200,000 to 100,000, identify the better option.
c) Compare part “a” and part “b” and identify the reasons of differences.

Solution:

OPTION (A) 100% Equity 50% Equity

EBIT 200,000 200,000

Interest [15%] 0 (75,000)

Profit before Tax 200,000 125,000

Tax [40%] (80,000) (50,000)

Net Income 120,000 75,000

# of shares 100,000 50,000

EPS 1.20 1.50

In this case, 50% equity financing option is better which is providing higher EPS this is because
ROI [20%] is more than cost of debt [15%] and the remaining is accrued to shareholders.
109

OPTION (B) 100% Equity 50% Equity

EBIT 100,000 100,000

Interest [15%] 0 (75,000)

Profit before Tax 100,000 25,000

Tax [40%] (40,000) (10,000)

Net Income 60,000 15,000

# of shares 100,000 50,000

EPS 0.60 0.30

When EBIT falls to 100,000, ROI also falls from 20% to 10% which makes cost of debt higher
than ROI. This makes 100% equity financing option is better.

INDIFFERENCE POINT:

The indifference point in finance is where the cost of debt equals the cost of equity, resulting in
the same overall cost of capital for both financing options. It signifies the level at which a
company is indifferent between using debt or equity financing. Determining this point helps
companies make decisions about their financing mix, aiming to minimize the overall cost of
capital while balancing risk and return considerations. Beyond the indifference point, factors
such as risk, leverage, and financial flexibility play a more significant role in the decision-making
process. By understanding the indifference point, companies can optimize their financing mix to
achieve their financial goals while managing risk effectively.
110

Example 8

Calculate the level of earnings before interest and tax (EBIT) at which the EPS indifference
point between the following financing alternatives will occur. Assume the corporate tax rate is
35% and par value of equity share is Rs.10 in each case.

Financing Option A:
Equity share capital of Rs.600,000 and 12% debentures of Rs.400,000.

Financing Option B:
Equity share capital of Rs.400,000, 14% preference share capital of Rs.200,000 and 12%
debentures of Rs.400,000.

Solution:

Indifference point will be calculated by solving for x in the below equations:

(𝑥 − 48,000) × (1 − 0.35) [(𝑥 − 48,000) × (1 − 0.35)] − 28,000

=
60,000 40,000

0.65𝑥 − 31200 0.65𝑥 − 31200 − 28,000

=
1.5 1

0.65𝑥 − 31200 = 0.975𝑥 − 46800 − 42,000

−31200 + 46800 + 42,000 = 0.975𝑥 − 0.65𝑥
0.325𝑥 = 57,600
67,600
𝑥= = 177,231
0.325

Verification:
Indifference Point
Option 1 Option 2
EBIT 177,231 177,231
Interest (48,000) (48,000)
Profit before tax 129,231 129,231
Tax (45,231) (45,231)
Net Income 84,000 84,000
Preference dividends 0 (28,000)
Earnings attributable to equity shareholders 84,000 56,000
No of equity shares 60,000 40,000
EPS 1.40 1.40
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112

Learning objectives:

a) Understand and explain the concept of capital structure and identify the components that
contribute to an optimum capital structure.

b) Analyze how different capital structure decisions impact financial ratios such as debt-to-
equity, return on equity, and interest coverage ratios.

c) Evaluate the traditional theory of capital structure, including its assumptions and
implications for financial management.

d) Apply the Modigliani-Miller (MM) theory without taxes to assess the impact of capital
structure on a firm's valuation and cost of capital.

e) Incorporate the Modigliani-Miller (MM) theory with taxes to understand the benefits of debt
financing due to tax shields.

f) Compare and contrast the traditional theory of capital structure with the MM theories to
determine their practical applications and limitations.

g) Develop the ability to make informed capital structure decisions by integrating theoretical
knowledge with financial ratio analysis.
113

CAPITAL STRUCTURE:
Capital structure refers to the mix of debt and equity financing used by a company to fund its
operations and investments. It represents the composition of a company's financial resources,
including long-term debt, preferred equity, common equity, and retained earnings. The capital
structure decision is crucial as it determines the financial risk, cost of capital, and overall value of
the company.

Components of Capital Structure:

Debt: Funds raised by borrowing from creditors, such as banks, bondholders, or financial
institutions. Debt requires regular interest payments and repayment of principal.
Equity: Funds raised by issuing shares of stock to investors. Equity represents ownership in the
company and does not require repayment of principal but may entail dividend payments to
shareholders.

Illustration:
Consider a hypothetical company, ABC Inc., which is considering two financing options to raise
PKR 1 million for a new project:

Option 1 - Debt Financing:

ABC Inc. borrows PKR 1 million from a bank at an annual interest rate of 6%.
The company will have to make interest payments of PKR 60,000 per year (PKR 1 million * 6%).
Option 2 - Equity Financing:
ABC Inc. issues new shares of stock to investors, raising PKR 1 million in equity capital.
The company does not have to make interest payments but may need to pay dividends to
shareholders.

The capital structure decision involves determining the optimal mix of debt and equity financing
based on factors such as risk tolerance, cost of capital, and growth objectives. A company with a
higher proportion of debt in its capital structure may benefit from tax advantages but faces higher
financial risk due to interest payments and potential bankruptcy risk.
On the other hand, a company with a higher proportion of equity may have lower financial risk but
may face higher cost of capital and dilution of ownership. The goal is to find a capital structure
that maximizes shareholder value by balancing the benefits and costs of debt and equity
financing.
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OPTIMUM CAPITAL STRUCTURE:

The optimum capital structure refers to the ideal mix of debt, equity, and other financial
instruments that minimizes a company's cost of capital while maximizing its value. This balance is
crucial because it influences the company's financial stability, risk profile, and overall cost of
financing. The goal is to find a structure that provides the greatest return to shareholders while
maintaining an acceptable level of risk.
Following table summarizes debt and equity financing:

Aspect Debt Financing Equity Financing

Borrowing funds that need to be Raising capital by selling shares of

Definition
repaid with interest over time. the company.

Does not dilute ownership; lenders Dilutes ownership; shareholders

Ownership do not gain ownership in the gain a proportionate share of
company. ownership and control.

No obligation to repay investors;

Fixed repayment schedule with
Repayment dividends are paid at the company's
interest.
discretion.

Generally lower cost due to tax- Higher cost as shareholders expect

Cost
deductible interest payments. higher returns due to higher risk.

Increases financial risk and the

No risk of bankruptcy from equity
possibility of bankruptcy if the
Risk financing, but may dilute control and
company cannot meet interest
earnings per share.
payments.

Interest payments are tax-

Dividends are not tax-deductible;
Tax Implications deductible, reducing taxable
they are paid from after-tax profits.
income.
115

More flexibility as there are no fixed

Financial Less flexibility due to fixed
payments, only dividends when
Flexibility repayment obligations.
profits allow.

Generally has a neutral or positive

Impact on Credit High levels of debt can negatively
impact on credit rating since it does
Rating impact the company’s credit rating.
not involve repayment obligations.

New shareholders gain voting rights

Lenders have no control over
and influence over company
Control company decisions beyond the loan
decisions, potentially affecting
agreement.
control.

Can be easier for startups and

Often easier to obtain for
Access to growing companies that may not
established companies with good
Capital have sufficient credit history for
credit.
large loans.

Return Lenders expect fixed interest Shareholders expect higher returns

Expectations payments. through dividends and capital gains.

No collateral required, but may

Often requires collateral or security
Collateral involve issuing more shares,
for the loan.
diluting ownership.

Impact on Equity increases shareholders’

Debt increases liabilities and
Financial equity and does not impact debt
impacts leverage ratios.
Statements ratios.

Decision- Shareholders can vote on major

Lenders may impose covenants
Making decisions and influence company
and restrictions.
Influence policy.

The optimum capital structure is a dynamic target influenced by a variety of internal and external
factors. It requires careful consideration of the trade-offs between the benefits of debt, such as tax
shields, and the risks associated with financial distress. By achieving an optimal mix of debt and
equity, a company can enhance its value, lower its cost of capital, and maintain financial flexibility
to support growth and withstand economic fluctuations.
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EFFECT OF CAPITAL STRUCTURE ON RATIOS

When a business changes its capital structure, there will be an impact on ratio analysis (especially
the gearing ratio) and an impact on the business's WACC.

The impact of a change in capital structure on ratio analysis the gearing ratio

Two key measures of gearing:

Debt
Capital gearing = Debt + Equity x 100

OR

Debt
Equity
x 100

Note: Both of these measures are used in practice, but the first one is more commonly used.

Clearly if a business changes its capital structure by raising new finance as either debt or equity,
these gearing ratios will change.

Illustration 1 - Gearing ratio calculation

PPP is considering raising Rs 250 million new finance to fund the acquisition of QQQ.
QQQ is considered to have a value to PPP of Rs 270 million.
Extracts from PPP's statement of financial position show:

Rs m
Long term borrowings 950
Share capital (Rs 10 shares) 500

Retained reserves 400

The directors of PPP haven't yet decided whether debt or equity finance should be used to
fund the takeover. However, if equity is to be used, the new shares will be issued at a price of
Rs.26 per share. The current market share price is Rs.29 per share.
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Required:
Calculate the gearing ratio measured as (debt/(debt + equity)):
(a) before the acquisition of QQQ,
(b) after the acquisition, assuming that debt finance is used to fund the takeover,
(c) after the acquisition, assuming that equity finance is used to fund the takeover.
In all cases, present your calculations using both book values and market values.

Solution: Gearing based on book values

Pre-acquisition 950 / [950 + (500 + 400)] = 51.4%
Post-acquisition using debt (950+250) / [(950+250)+(500+400+20 (W1))] = 56.6%
Post-acquisition using equity 950 / [950 + (500 + 400 + 250 + 20 (W1) )] = 44.8%

(W1) Since QQQ is worth Rs.270m to PPP but the purchase price is Rs.250m, the value of
PPP's equity will increase by Rs.20m irrespective of how the purchase is financed.

Gearing based on market values (W2)

Pre-acquisition 950 / [950 + 1,450] = 39.6%
Post-acquisition using debt (950+250) / [(950+250) + (1,450+20)] = 44.9%
Post-acquisition using equity 950 / [950 + (1,450 + 250 + 20)] = 35.6%

(W2) Market value of existing shares = Rs 29 × 50m = Rs 1,450m

Note: The issue price of the new shares (Rs 26) is irrelevant when calculating the gearing
ratios. Of course the issue price does affect the number of shares issued and therefore other
ratios such as EPS (see further examples below), but gearing ratios are calculated based on
total values of equity and debt so the issue price is not relevant here.

Impact on other ratios

A change of capital structure may also impact other ratios (such as earnings per share,
earnings yield an interest cover) if the change in financing is associated with a new project
which increases profits.
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Illustration 2
Seed Co is considering investment of Rs 20m which is expected to have an NPV of Rs 8m,
and is expected to increase profit before interest and tax by Rs 4m per annum.

Extract from the most recent financial statements of Seed Co:

Statement of financial position extracts Rs m

Share capital (Rs 1 shares) 16
Reserves 48
Long term borrowings 56

Income statement extracts Rs m

Profit before interest and tax 15.0
Interest (4.0)

Profit before tax 11.0

Tax at 30% (3.3)
Profit after tax (earnings) 7.7

The current share price of Seed Co is Rs 2.70 per share.

The directors of Seed Co are considering two alternative ways of financing the new investment.

Borrow the Rs 20m at an interest rate 6% per annum,

Raise the funds using a 1 for 2 rights issue at Rs 2.50 per share.

Required:
(a) Prepare profit forecasts for Seed Co for next year under both financing options, assuming
that the new project goes ahead. Use the forecasts to calculate the impact of the project
and each financing option on Seed Co’s interest cover, earnings per share and earnings
yield ratios.
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(b) Based on the results of your calculations, discuss the likely reaction of the shareholders
and the lenders to each of the possible financing options.

Solution:

(a) Pre project ratios:

Interest cover = Rs 15m/Rs 4m = 3.75 times

Earnings per share (EPS) = Rs 7.7m / 16m = 48.1 cents per share

Earnings yield = EPS / Share price = Rs 0.481 / Rs 2.70 = 0.178, or 17.8%

Income statement Rs m – debt used Rs m – rights issue

forecasts
Profit before interest 19.0 19.0
and tax (Rs 15m + Rs 4m)
Interest (W1) (5.2) (4.2)
Profit before tax 13.8 15.0
Tax at 30% (4.1) (4.5)
Profit after tax (earnings) 9.7 10.5

(W1) Interest on the new debt is 6% of Rs 20m i.e. Rs 1.2m. Assume that interest on the
existing borrowings stays constant.

Share price workings:

Rights issue
If the rights issue goes ahead, the value of the shares after the rights issue will be the
theoretical ex-rights price (TERP), which was introduced in Chapter 4.
TERP = [(N x cum rights price) + issue price] / (N+1)
=[(2 x 2.70) + 2.50]/3 = Rs 2.63
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However, since the rights issue will be used to fund the new project with an NPV of Rs 8m, the
value of the project will also be reflected in the new share price, increasing the share price to
Rs 2.63 + [Rs 8m / (16m shares + 8m new shares)] = Rs 2.96

Debt finance
If debt finance is used to fund the new project, the share price should rise after the project has
been taken on, to reflect the NPV of the new project.
Expected share price = Rs 2.70 + (Rs 8m / 16m shares) = Rs 3.20

Post project ratios – using debt finance:

Interest cover = V19m / Rs 5.2m = 3.65 times

Earnings per share (EPS) = Rs 9.7m / 16m = 60.6 cents per share
Earnings yield = Rs 0.606 / Rs 3.20 = 0.189, or 18.9%

Post project ratios – using equity finance:

Interest cover = Rs 19m / Rs 4m = 4.75 times

Earnings per share (EPS) = Rs 10.5m / (16m + 8m) = 43.8 cents per share

Earnings yield = Rs 0.438 / Rs 2.96 = 0.148, or 14.8%

(b) Debt financing option

If debt is used to fund the new project, the shareholders are likely to see the change in EPS
and earnings yield as positive.
The EPS increase from 48.1 cents per share to 60.6 cents per share, and the earnings yield
increases form 17.8% to 18.9%. This indicates that Seed Co will potentially to able to pay out
a higher dividend to the shareholders in future.
On the other hand, the reduction in interest cover indicates that Seed Co will face a higher
level of risk if the debt financing option is used i.e. the chance of Seed Co being unable to meet
its interest obligations is higher. The higher risk to shareholders could lead to a fall in the share
price if considered to be significant.
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However, in practice it is unlikely that this issue will worry either the shareholders or the lenders
greatly, given that the movement in interest Cover is extremely small (3.75 to 3.65 times).
Overall, it is likely that both shareholders and lenders will be quite happy with the EPS, earnings
yield and interest cover ratios if the debt finance option is used (assuming that the expected
Rs 4m increase in profit and Rs 8m NPV are achieved).

Equity finance option

The lenders will be happy if the rights issue goes ahead, because there will be no additional
interest payable and yet profits will increase, so the interest cover ratio will rise significantly.
This means that the chances of Seed CO defaulting on its interest payments will be less if this
options goes ahead.
All first glances, it appears that the shareholders will not be happy with this option, given that
EPS reduces form 48.1 cents per share to 43.8 cents per share, and also given that earnings
yield falls from 17.8% to 14.8%.

However, in this situation, where a 1 for 2 rights issue has been used, a shareholder’s who
owned 2 shares before the rights issue will now own 3 shares (assuming he took up his rights).
The rights issue itself makes no difference to the shareholder’s return or wealth. However, the
positive NPV of the project undertaken causes the shareholder return and wealth to increase.
The increase in earnings attributable to each shareholder’s shareholding will be viewed
positively by shareholders, who might expect to see increased overall dividends in the future.

Once again, overall it is likely that both shareholders and lenders will be quite happy with the
EPS, earnings yield and interest cover ratios if this financing option is used (assuming that the
expected Rs 4m increase in profit and Rs 8m NPV are achieved).

THEORIES OF CAPITAL STRUCTURE:

When we consider the WACC formula, it is clear that if a company changes its capital structure
(gearing level), the WACC will change, since the ratio of debt to equity is a key variable in the
formula.

Also, since the value of a company is the present value of its cash flows discounted at the
WACC, as the WACC changes so does the value.

Several studies have focussed on this link between capital structure and company value. The
key question is:
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"What capital structure should the company aim for in order to maximise the company's
value?"

The main studies are:

• the traditional view;

• the Modigliani Miller view (or net operating income view), ignoring taxation;
• the Modigliani-Miller view, taking into account the tax relief on debt interest payments.

These studies are based on different assumptions and come to different conclusions.

In order to understand the different views, it is vital to understand the two opposing forces
which impact on the WACC as capital structure changes.

The two opposing factors which impact WACC

Impact on WACC of an increase in gearing

In general, the entity’s cost of debt finance is cheaper than its cost of equity finance, for two
reasons:
a) Interest is an obligation which has to be paid out each year, whereas dividends are paid
only if the company can afford them. This means that debt holders face less risk, so
accept lower returns.

b) Interest is a tax deductible expense, whereas dividends are paid out of post tax profits.
This further reduces the cost of debt for the company

Therefore, as the entity increases its gearing by raising more debt fiancé, the greater
proportion of (cheaper) debt in the capital structure exerts a downward force on the WACC.
123

Upward force on the WACC

As the gearing level increases, the extra interest payments to debt holders mean that the
likelihood of the entity being able to afford to pay dividends to shareholders reduces. This
increases the risk perception of the shareholders, so they demand higher return to compensate
for the increased risk.
This increase in the cost of equity exerts an upward force on the WACC.

Net effect
Clearly, the two factors identified have opposing impacts on the weighted average cost of
capital. The key questions are:

• Which of the two forces is stronger?

• What is the net effect of these two factors?

There is no simple answer to these questions. In fact, the different gearing theories propose
different answers to the questions, based on different assumptions.
However, an understanding of these two factors, and these key questions, is crucial to a sound
understanding of the capital structure theories covered in this Chapter.

Impact of capital structures on the equity investor

High gearing exists when an entity has a large proportion of prior charge capital in relation to
equity a low gearing exists when there is a small proportion of prior charge capital. High
gearing increases the financial risk of the equity investor but the reward can be in the form of
increased dividends when profits rise. If, however, profits falter, the equity investor can
expect to be the first to feel the effect of the first to feel the effect of the reduction in profits.
Low gearing or no gearing may not necessarily be in the equity investor’s best interests
because the entity might then be failing to exploit the benefits with borrowing can bring.
Provided that the return generated form borrowed funds is greater than the cost of those
funds, capital gearing could be increased. The extent to which it is prudent for an entity to
increase its capital gearing will depend upon many variables such as the type of industry
within which the entity operates, the cost of funds in the market, the availability of investment
opportunities and the extent to which the company can continue to benefit from the ‘tax
shield’.
The ordinary share price of highly geared entities will tend to be depressed in times of rising
interest rates.

Traditional View

According to the 'traditional' view of gearing and the cost of capital, as an organisation
introduces debt into its capital structure the weighted average cost of capital will fall because
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initially the benefit of cheap debt finance more than outweighs any increases in the cost of
equity required to compensate equity holders for higher financial risk.

As gearing continues to increase the equity holders will ask for increasingly higher returns. The
cost of equity therefore rises as gearing increases. Eventually this increase in the cost of equity
will start to outweigh the benefit of cheap debt finance, and the weighted average cost of capital
will rise. At extreme levels of gearing the cost of debt will also start to rise (as debt holders
become worried about the security of their loans) and this will also contribute to an increasing
weighted average cost of capital.

The diagram below demonstrates this position in which:

• ke is the cost of equity;

• kd is the cost of debt;
• ko is the overall or weighted average cost of capital.

Traditional view of gearing and the cost of capital

X = optimal level of gearing, where ko is at a minimum.

The traditional view therefore claims that there is an optimal capital structure where the
weighted average cost of capital is at a minimum. This is at point X in the above diagram.

At point X the overall return required by investors (debt and equity) is minimised.

It follows that at this point the combined market value of the firm's debt and equity securities
will also be maximised. (If investors are offered the same Rs return but the % return they
require has fallen, market pressures will make the value of the securities rise.)
125

MODIGLIANI AND MILLER'S VIEW

In 1958, the two American economists, Professors Modigliani and Miller, challenged the
traditional view of gearing and the cost of capital. Over a 20-year period they put forward a
number of propositions as to why the traditional view of gearing might be wrong. They began
by assuming that the effect of tax relief on debt interest could be ignored.

The Modigliani and Miller (M & M) first proposition was that companies which operate in the
same type of business and which have similar operating risks must have the same total value,
irrespective of their capital structures.

Their view is based on the belief that the value of a company depends upon the future operating
income generated by its assets. The way in which this income is split between returns to debt
holders and returns to equity should make no difference to the total value of the firm (equity
plus debt). Thus, the total value of the firm will not change with gearing. This means that its
weighted average cost of capital will not change with gearing, and will be the same at all levels
of gearing.

Modigliani and Miller view (no taxation)

126

If the weighted average cost of capital is to remain constant at all levels of gearing, it follows
that any benefit from the use of cheaper debt finance must be exactly offset by the increase
in the cost of equity. The essential point made by M & M is that, ignoring taxation, a firm
should be indifferent between all possible capital structures. This is at odds with the beliefs of
the traditionalists.

M & M support their case by demonstrating that market pressures will ensure that two
companies identical in every aspect apart from their gearing level will have the same overall
market value.

Modigliani and Miller with tax

In their original 'proposition 1' model M & M ignored taxation (tax relief on debt interest). In
1963 they amended their model to include corporation tax. This alteration changes the
implication of their analysis significantly.

Previously they argued that companies that differ only in their capital structure should have
the same total value of debt plus equity. This was because it was the size of a firm's operating
earnings stream that determines its value, not the way in which it was split between returns to
debt and equity holders. However, the corporation tax system carries a distortion under which
returns to debt holders (interest) are tax deductible for the firm, whereas returns to equity
holders are not. M & M, therefore, conclude that geared companies have an advantage over
ungeared companies, i.e. they pay less tax and will, therefore, have a greater market value
and a lower weighted average cost of capital.

Graph of M & M model with tax

127

As gearing increases, the WACC steadily decreases.

If the other implications of the M & M view are accepted, the introduction of taxation suggests
that the higher the level of taxation, the lower the combined cost of capital.

Modigliani and Miller (M & M) formulae

EBIT
Value of Firm =
ko

VG = VL

D
k e[L) = k e[UL) + [(k e[UL) − k d ) × ]
E

Interpreting the M & M graphs and formulae Without tax

Company value (Vg = Vu)

The graph showed a horizontal line for company value in the M & M without tax theory.
This is backed up by the formula, which shows that if T= 0, the values of an ungeared company
and an equivalent unguarded company are the same.

WACC (Kadj = Keu)

The graph also showed a horizontal line for WACC in the M & M without tax theory.
Again, the formula backs this up. If t = 0, the formula reduces to kadj = keu. This shows that the
WACC of the geared company is always the same as the WACC of an equivalent unguarded
company, irrespective of the level of gearing.

With tax
VL = VUL + Dt
128

Company value (Vg = Vu + TB)

The graph showed an upward sloping line for company value in the M & M with tax theory.
This is backed up by the formula, which shows that the higher the value of B (value fo debt),
the greater the value of the entire company should be.
As the company increases its gearing, the value of the entire company (debt plus equity)
increases.
Cost of equity (keg = keu + (Keu – kd) VD(1-t)/VE)

The cost of equity slopes upwards as gearing increases under M & M’s assumptions, because
shareholders face higher risk so demand higher returns.
We can form the formula that the Keg increases as the amount of debt (VD) increase relative to
the value of equity (VE).

Note that the inclusion of (--t) in the formula has the impact of reducing the slope of the line if
the tax rate increases. Most importantly, this means that the cost of equity in the M & M with
tax theory will always increase less steeply than in the without tax theory. This helps to explain
way the upward force on WACC is smaller in the with tax theory, and, and hence why the
downward force on the WACC caused by the (net of tax) cheap debt fiancé is the net stronger
force in the with tax theory.

WACC (Kadj = Keu (1-tL))

The formula shows that WACC will reduce as gearing (measured by L) increases. This is seen
on the graph as a downward sloping line.

Example 1 – M & M without tax

X Co is identical in all operating and risk characteristics to Y Co, except that X Co is all equity
financed and Y Co is financed by equity valued at Rs 2.1m and debt valued at Rs 0.9m based
on market values. X Co and Y Co. Operate in a country where no tax is

(i) A perfect capital market in which there are no information costs or transaction costs.

(ii) Investors are indifferent between personal and corporate gearing.

(iii) Investors and companies can borrow at the same rate of interest.

(iv) kd remains constant at all levels of gearing.

129

The traditional view can be criticised as there is no underlying analysis to support it. Nor is
there any evidence that the WACC is a U-shaped function in practice. This then leaves the
problem of how companies are to determine their capital structure in practice. Management
takes five factors into account in reaching a judgement on capital structure:

(i) The risks of bankruptcy

Direct costs

These are costs associated with a company being in liquidation:

– distress sale price of the assets;
– liquidators' fees.

Indirect costs

These are costs associated with a company being in severe financial

distress:
– loss of credit from suppliers;
– loss of customers;
– loss of key staff;
– lack of future finance.

(ii) The 'agency costs' (such as tight bank control) associated with gearing.

(iii) The company's ability to obtain interest tax relief by having sufficient off-

setting tax liability. (The problem of 'tax exhaustion'.)

(iv) Constraints imposed on the level or gearing, either by:

(1) Articles of Association; or

(2) loan agreement conditions.

(v) The company's ability to borrow money: the company's 'debt capacity'.
130

Real world approaches to the gearing question

Static trade-off theory
It is possible to revise M and M’s theory to incorporate bankruptcy risk and so to arrive at the
same conclusion as the traditional theory of gearing – i.e. that an optimal gearing level exists.

Given this, firms will strive to reach the optimum level by means of a trade-off.
Static trade-off theory argues that firms in a stable (static) position will adjust their current
level of gearing to achieve a target level:

Above target debt ratio the value of the firm is not optimal:
• Financial distress and agency costs exceed the benefits of debt.
• Firms decrease their debt levels.

Below the target debt ratio can still increase the value of the firm because:

• marginal value of the benefits of debt are still greater than the costs associated with the
use of debt
• firms increase their debt.
131

NB: Research suggests that this theory is not backed up by empirical evidence.

Pecking order theory

Pecking order theory tries to explain why firms do not behave the way the static trade-off
model would predict. It states that firms have a preferred hierarchy for financing decisions:

The implications for investment are that:

• the value of a project depends on how it is financed

• some projects will be undertaken only if funded internally or with relatively safe debt but
not if financed with risky debt or equity
• companies with less cash and higher gearing will be more prone to underinvest.

If a firm follows the pecking order:

• its gearing ratio results from a series of incremental decisions, not an attempt to reach a
target
– High cash flow ⇒ Gearing ratio decreases
– Low cash flow ⇒ Gearing ratio increases

• there may be good and bad times to issue equity depending on the degree of information
asymmetry.

A compromise approach
The different theories can be reconciled to encourage firms to make the correct financing
decisions:
(1) Select a long run target gearing ratio.
(2) Whilst far from target, decisions should be governed by static trade-off theory.
(3) When close to target, pecking order theory will dictate source of funds.

More on pecking order v static trade-off

132

Pecking order theory was developed to suggest a reason for this observed inconsistency in
practice between the static trade-off model and what companies actually appear to do.
Internally generated funds have the lowest issue costs, debt moderate issue costs and
equity the highest. Firms issue as much as they can from internally generated funds first
then move on to debt and finally equity.
Myers has suggested asymmetric information as an explanation for the heavy reliance on
retentions. This may be a situation where managers, because of their access to more
information about the firm, know that the value of the shares is greater than the current
market value based on the weak and semi-strong market information.
In the case of a new project, managers forecast maybe higher and more realistic than that
of the market. If new shares were issued in this situation there is a possibility that they
would be issued at too low a price, thus transferring wealth from existing shareholders to
new shareholders. In these circumstances there might be a natural preference for internally
generated funds over new issues. If additional funds are required over and above internally
generated funds, then debt would be the next alternative.
If management is against making equity issues when in possession of favorable inside
information, market participants might assume that management would be more likely to
favor new issues when they are in possession of unfavorable inside information. This leads
to the suggestion that new issues might be regarded as a signal of bad news!
Managers may therefore wish to rely primarily on internally generated funds supplemented
by borrowing, with issues of new equity as a last resort.
Myers and Majluf (1984) demonstrated that with asymmetric information, equity issues are
interpreted by the market as bad news, since managers are only motivated to make equity
issues when shares are overpriced. Bennett Stewart (1990) puts it differently: ‘Raising equity
conveys doubt. Investors suspect that management is attempting to shore up the firm’s
financial resources for rough times ahead by selling overvalued shares.’
Asquith and Mullins (1983) empirically observed that announcements of new equity issues
are greeted by sharp declines in stock prices. Thus, equity issues are comparatively rare
among large established companies.
Dealing with 'gearing drift'
Profitable companies will tend to find that their gearing level gradually reduces over time as
accumulated profits help to increase the value of equity. This is known as "gearing drift".
Gearing drift can cause a firm to move away from its optimal gearing position. The firm might
have to occasionally increase gearing (by issuing debt, or paying a large dividend or buying
back shares) to return to its optimal gearing position.
Signaling to investors
In a perfect capital market, investors fully understand the reasons why a firm chooses a
particular source of finance.
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However, in the real world it is important that the firm considers the signaling effect of
raising new finance. Generally, it is thought that raising new finance gives a positive signal
to the market: the firm is showing that it is confident that it has identified attractive new
projects and that it will be able to afford to service the new finance in the future.
Investors and analysts may well assess the impact of the new finance on a firm's statement
of profit or loss and balance sheet (statement of financial position) in order to help them
assess the likely success of the firm after the new finance has been raised.
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Learning Objectives:

a) Understand and explain the concept of capital investment and the importance of
investment appraisal in financial decision-making.

b) Apply non-discounted techniques such as accounting rate of return and payback period to
evaluate capital investments.

c) Utilize discounted techniques including NPV, IRR/MIRR, discounted payback period, and
profitability index to assess investment projects, incorporating adjustments for inflation
and taxation.

d) Analyze and compare the financial viability of assets with unequal lives using Equivalent
Annual Benefit (EAB) and Equivalent Annual Cost (EAC) methods.

e) Conduct sensitivity analysis and apply the concept of expected values to address risk and
uncertainty in capital investment appraisal.

f) Formulate strategies for capital rationing by calculating the optimum investment mix for
projects under both divisible and indivisible conditions, and understand the differences
between soft and hard capital rationing.

g) Understand and apply advanced investment appraisal techniques including the Adjusted
Present Value (APV) method, particularly in scenarios involving subsidized or cheap loans,
and introduce the basics of the Black-Scholes Model for real options.
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Overview of Chapter

INVESTMENT APPRAISAL

The investment decision was identified as one of the three key elements of financial
strategy.
An entity will only be able to provide appropriate returns to investors if it can identify
suitable projects which provide appropriate returns to the entity itself.

It is therefore critically important that the financial manager understands how to

appraise different investments and decide whether they are acceptable to the firm.
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An introduction to investment appraisal

In this Chapter, we discuss various methods of evaluating investment projects. These

methods are, in the main, concerned with quantitative aspects, but first you need to be
clear that methods of evaluation are by no means the only factors to be taken into
account in investment appraisal.

Consideration of stakeholders

Thus, we might define investment appraisal as being concerned with maximizing

shareholder wealth, but we must be careful to qualify this concept by making it subject
to constraints associated with issues of social responsibility, such as effective controls
over pollution.
So, shareholder’s wealth in this context needs to be linked with the wider view of
stakeholder theory, whereby many other interested parties apart from shareholders- for
example, suppliers, lenders, employees, managers, as we well as the general public –
need to be taken into account in assessing a project’s viability.

Incidentally, in the case of ‘not-for-profit’ entities, we should follow a similar path, but by
substituting maximizing benefits in place of shareholder’s wealth.

We must also be clear that maximizing wealth is not the same as maximizing profit
from a project by minimizing costs regardless of the wider implications of doing so
Shareholders will be served by action being taken to ensure that a project will meet an
economic want while maintaining a good and respected image of the entity, and indeed
projects which damage that image can negate the benefits of otherwise effective
marketing and promotional activities.

Investment appraisal data requirements

Clearly, then qualitative aspects of a proposal are very important, and this lead us on
to the data content needed to evaluate a project effectively.

Bear in mind that the cash inflows and outflows involved are simply the standard
means of translating into a common base of numbers all the underlying quantitative
and qualitative assumptions which are the real determinants of a project’s viability. The
management accountant needs to consider carefully the strengths and weaknesses of
these assumptions before finally converting them to cash flows:

The investment appraisal methods

It is useful to use a number of different methods for evaluating a project, especially for
a major project, as different methods may well throw valuable light on various and
different aspects of a project’s value, bearing in mind the strengths and limitations of
each method, as set out throughout this chapter.
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This Chapter covers the five main investment appraisal methods:

• payback period
• accounting rate of return (ARR)
• net present value (NPV)
• internal rate of return
• modified internal rate of return (MIRR).

In the next Chapter, we shall explore the use of the methods in various specific
circumstances.

Payback period

This method involves calculating the period of time likely to recoup the initial outlay on
a project, and then comparing this with the 'acceptable period'. If the payback period is
less than 'acceptable', and there are no other constraints, for example capital rationing,
the project will be accepted. i.e. How long it will take to recover initial investment?

Also alternative projects can be ranked according to the length of expected payback
period.

Limitations of payback period

(a) Ignores timing of cash flows within the payback period, the cash flows after the
payback period and therefore the total project return.
(b) Ignores the time value of money.
(c) Is unable to distinguish between projects with the same payback period.
(d) Tends to favour short-term (often smaller) projects over longer term projects.
(e) Takes account of the risk of the timing of cash flows but not the variability of those
cash flows.

Strengths of payback period

(a) Simple to calculate and understand - important when management resources

are limited. Also helpful in communicating information about minimum
requirements to managers responsible for submitting projects.
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(b) Can be used for first-stage screening in eliminating obviously inappropriate

projects prior to more detailed evaluation.
(c) Bias in favour of short-term projects which means that it tends to minimise
both financial and business risks.
(d) Can be used when there is a capital rationing situation to identify those
projects which generate additional cash for investment quickly.

Accounting Rate of Return (ARR)

Definition

This is a method of estimating the rate of return from an investment without discounting
or compounding. The investment inflows are totalled and the investment costs
subtracted to derive the profit.

The profit is divided by the number of years invested (to establish the average annual
profit), then by the investment cost (or average investment cost) to establish an annual
rate of return, e.g.

Average annual profit

————————— × 100
Project investment

where average investment = the average book value of the capital employed in the
project (i.e. the average of the initial investment and the residual value)

Note: in some cases, the initial investment will be used instead of average investment.

Explanation of ARR formula

Accounting rate of return (ARR) is calculated in basically the same way as ‘return on
investment’ as (Profit/ investment), but whether ‘profit’ is before or interest charges and
whether ‘investment’ is the initial outlay or is averaged over the life of the project is
unclear.
This lack of clarity seems strange.

The point of this technique is that it is bases on the same principles as the published
financial statements. Entities (and managers) are often evaluated by the ‘return on
investment’ or ‘return on capital employed’ ratio derived from the published income
statement and balance sheet. (The two ratios are identical, merely reflecting the two
sides of the balance sheet; ‘capital employed’ reflects the financing of the business,
‘investment’ reflects the use of that finance.) it is therefore logical that it should be
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calculated in a way which makes it comparable with these ratios. As the balance sheet
contains written-down asset values one would expect ARR to be calculates as
(Profit/Average written down investment).

This accords with common sense, because if profit is after depreciation, then one
would expect that depreciation to affect the value of the investment.

Limitations

(a) Figures are easily manipulated, e.g. by changing the method of depreciation or the
estimate of disposal value.
(b) Ignores the actual/incremental cash flows associated with the project, and the
effect of the timing of those cash flows on the real return.
(c) Double counting - depreciation is deducted from the profit figure in full, but the use
of the average assets figure means that part of this is also included in the denominator.
The effect is to depress the calculated return.

Strengths
(a) Expressed in terms familiar to managers - profit and capital employed.
(b) Easy to calculate the likely effect of the project on the reported statement of
comprehenisve income/ statement of financial position. Managers are frequently
rewarded in relation to performance against these variables.
(c) Business is judged by ROI by financial markets.

Example of payback period and ARR

Blake Co is considering investing in a project with a cost of Rs 100,000.

Cash inflows from the project are expected to be as follows:

Rs 000
Year 1 20
Year 2 30
Year 3 40
Year 4 40
Year 5 10

Straight-line depreciation will be charged on the capital expenditure, over the 5-year
life of the project.
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Required:

Calculate the payback period for the proposed investment, and the ARR (based on
the average investment).

Solution:

Payback period:

Year Cash Flows Cumulative

0 -100,000 -100,000
1 20,000 -80,000
2 30,000 -50,000
3 40,000 -10,000
4 40,000 30,000
5 10,000 40,000

Payback period = 3 + (10,000 / 40,000) = 3.25 years.

Accounting Rate of Return:

Year Cash Flows Depreciation Profit

1 20,000 -20,000 0
2 30,000 -20,000 10,000
3 40,000 -20,000 20,000
4 40,000 -20,000 20,000
5 10,000 -20,000 -10,000
Average Profit 8,000

ARR = Average Profit / Average Investment

ARR = 8,000 / 50,000 = 16%.

Average investment is initial investment i.e. Rs.100,000 and closing value which is 0
because all costs have been depreciated.

4 Discounted Cash Flow (DCF) Investment Appraisal Methods

Basic concepts for DCF methods

Compounding
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To calculate the value of an amount “X” in “n” years time in future, with an annual interest
rate of “r”, use the compounding formula:

X × (1+r)n

For example, an amount of Rs 10 in 2 years with an interest rate of 10% will be worth
Rs 10 × 1.102 = Rs 12.10

Discounting

Discounting is the opposite to compounding i.e. it allows us to calculate the equivalent

"present value" of a given future amount. The formula is below, but most of the time the
present value (PV) tables will be used.

1
PV = ——— = (1 + r)-n
(1 + r)n

where “r” is the discount rate for a single time period (normally a year) and “n” is the
number of time periods in the discount period (usually the number of years before the
cash flow occurs).

For example, an amount of Rs 100 receivable in 6 years with an interest rate of 10%
has a present value of Rs 100 × 1.10-6 = Rs 56.45.

Also, an amount of Rs 100 receivable in 3 months' time at a quoted annual interest

rate of 10%, or 2.5% paid every quarter (where 2.5% = 10% x 3/12), has a present
value of Rs 100/1.025 = Rs 97.56.

Present value of cumulative flows (Annuity)

The formula is below, but most of the time the cumulative present value tables will be
used.

1- (1 + r)-n
PV = ———
r

where “r” is the discount rate for a single time period (normally a year), and “n” is the
number of time periods of cash flows.

Notation: AF(1-n)(r%) =Annuity factor for “n” years at “r”%.

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Illustration 1 – Annuities

The present value of Rs 1,000 received next year and for the following 4 years if the
interest rate is 10% is:

AF1-5(10%) = 3.791

PV = 3.791 × Rs 1,000 = Rs 3,791

Examination twist: The deferred annuity. This is where the first cash flow takes place
not at time 1 but at a later date.
Consider a receipt of Rs 1,000 each year for five years starting at time 3. Interest rate
is 10%.
Since the receipt is for five years the five-year annuity factor is used. This gives the
present value 1 year prior to the first receipt i.e. time 2. This is then discounted back to
time 0.

3.791 × Rs 1,000 × 0.826 = Rs 3,131

Present value of a perpetuity

1
PV Factor = —
r

Hence, the present value of Rs 1,000 received every year from year 1 onwards if
interest rates are 10% is Rs 1,000 / 0.10 = Rs 10,000.

Present value of a growing perpetuity

1
PV Factor = —
r-g

Hence, the present value of a perpetuity which will be Rs 1,000 in 1 year and then will
grow at 3% per annum thereafter is Rs 1,000 / (0.10-0.03) = Rs 14,286 (assuming that
interest rates are 10%).
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Illustration 2 – Complex perpetuities and annuities

Calculate the present value of the following cash flows in each of the specified
circumstances:

Year Cash flow

1 1,000
2 1,500
3 1,600
4 1,800

(1) the Rs 1,800 will arise annually each year from year 4, for the next ten years (last
year - year 13).
(2) the Rs 1,800 will arise each year in perpetuity.

(3) the Rs 1,800 arises in perpetuity but grows at 2% per annum.

The cost of capital is 10%.

Answer

1 Year Cash flow DF PV

1 1,000 0.909 909

2 1,500 0.826 1,239
3 1,600 0.751 1,202
4-13 1,800 7.103 - 2.487 8,309
or
6.145 × 0.751
Total PV = Rs 11659

2 Year Cash flow DF PV

1 1,000 0.909 909
2 1,500 0.826 1,239
3 1,600 0.751 1,202
4- ∞ 1,800 1/0.10 - 2.487 13,523
or
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1/0.10 × 0.751

Total PV = Rs 16,873

3 Year Cash flow DF PV

1 1,000 0.909 909
2 1,500 0.826 1,239
3 1,600 0.751 1,202
4- ∞ 1,800 (1/(0.10-0.02)) × 0.751 16,898

Total PV = Rs 20,248

Net Present Value (NPV)

Definition

This is a method of determining whether the expected financial performance of a

proposed investment promises to be adequate when measured against a cost of
capital. All the estimated incremental cash flows relating to the project are discounted
to present value and then totalled.

A positive NPV indicates that expected return on a project more than compensates the
investor for the perceived level of (systematic) risk i.e. that the expected return is
greater than the required return.

Identification of a project’s relevant costs and benefits

A common difficulty experienced by students is how to choose which to exclude in the

investment appraisal calculations.
Some of the main points to look out for are:
• Accounting adjustments such as depreciation do not represent cash outflows,
as no physical movement of cash takes place. However, tax allowance does
represent inflows as they reduce the amount of tax actually to be paid in cash.
• Cash inflows should be after-tax.
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• Financing decisions can be analyzed separately from operational project

decisions, so financing charges should not be included as a cash flow in the
investment appraisal. This will be accounted for in discount rate.
• Any incidental effects of undertaking a project need to be included if they
represent cash movements.
• Working capital movements needs to be included (see examples later in this
Chapter), but bear in mind that there will usually be a release of working capital
(a terminal value) at the end of the project.
• Sunk costs, which have already been incurred, should be excluded as they do
not involve a new cash movement created by the project.
• Opportunity cost could be defined as ‘the value of a benefit sacrificed in favor of
an alternative course of action’. For example, if by undertaking a project, we use
some materials which would otherwise have been sold for Rs 1,000, the Rs 1,000
sale proceeds foregone would need to be recorded as a cost of new project.
• Residual values for any assets utilized in project should be included in the final
year of the appraisal period. The residual value will reflect the remaining useful
life in the asset or its disposal value. The residual value should be net being of
disposal costs.

In general terms, an item should be included in an NPV analysis if it represents a

future, incremental cash flow which will arise as a consequence of the project being
undertaken.

The meaning of NPV

A positive NPV indicates that expected return on a project more than compensates the
investor for the perceived level of (systematic) risk i.e. that the expected return is
greater than the required return.

The value of the NPV equals the gain (or loss) to shareholders if the project is
undertaken.

Recommended format

Year 0 1 2 3 4 5
Rs 000 Rs 000 Rs 000 Rs 000 Rs 000 000
Receipts X X X X
Payments:
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Wages (X) (X) (X) (X)

Materials (X) (X) (X) (X)
Variable/Fixed overheads (X) (X) (X) (X)
Administration/Distribution (X) (X) (X) (X)
expenses
__________________________
Taxable cash flows X X X X
Tax: Corporation tax (X) (X) (X) (X)
Capital allowances X X X X
Initial outlay (X)
Net Realisable Value X
Working capital (X) X

__________________________________________
Net cash flows (X) X X X X
(X)
Discount rate (e.g.10%) 1 0.909 0.826 0.751 0.683
0.621
Present value (X) X X X X
(X)

Net Present Value (NPV) Rs XXX

Strengths of the NPV method

(a) Any project with a positive NPV increases the wealth of the company. The
primary financial aim is to maximise the wealth of the ordinary shareholders,
and selection of projects on an NPV basis is consistent with this objective.
(b) Takes account of the time value of money and therefore the opportunity cost.
(c) Discount rate can be adjusted to take account of the different level of risk
inherent in different projects. Alternatively, the technique can be combined with
sensitivity analysis to quantify the risk of the project's results being different
from those expected.
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(d) Unlike the payback technique, it takes into account events throughout the
lifetime of the project.
(e) Superior to the internal rate of return (IRR) approach because it does not suffer
the problem of multiple rates of return due to irregularities in the pattern of cash
flows.
(f) Better than the accounting rate of return (ARR) method because it focuses on
cash flows rather than profits and avoids the understatement of returns.

Explanation of the incremental cash flow method

Reasons why the incremental cash flow basis is best for appraising capital projects:

(a) Cash flows are better than profits

(i) Cash can be spent - profits are only a guide to the cash that may be available.
(ii) Profit measurement is subjective, cash is real.
(iii) Cash is used to pay dividends.

(b) Incremental cash flows

Are those that result from accepting the project - they ignore those that would have
arisen anyway.

(c) Relevance of cash flows

(i) 'Sunk costs' ignored.

(ii) 'Opportunity costs' used as the value for cash flows.
(iii) Interest payments ignored.
(iv) Dividend payments ignored.
(v) Tax payments and receipts are valid cash flows.
(vi) Scrap proceeds are valid cash inflows.

The impact of taxation on the NPV analysis

There are three important tax effects to consider:

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(a) tax payments on operating profits;

(b) tax benefit from capital allowances;
(c) tax relief on interest payments on debt.

Tax relief on interest payments on debt is taken into account by adjusting the discount
rate.

Depreciation and tax depreciation allowance

Depreciation

The Financial Strategy syllabus is not specifically concerned with the accounting
treatment or methods of depreciation.

Depreciation is not cash and the key point to remember is that if a question requiring a
DCF calculation includes depreciation (or other non-cash items, including accruals and
prepayments), these items have to be added back to profits or losses to arrive at
operational cash flows.

Tax depreciation allowances

However, tax depreciation allowances do have an impact on the cash flows of a

business.

The important point is that tax depreciation allowances themselves are not cash, but
they affect the tax liability of an entity, which in turn affects tax payable or refundable.
Tax depreciation allowances do therefore have an effect on cash flow.

Tax depreciation allowances are sometimes given in the form of first year allowance
followed by allowances at a lower rate in subsequent years.

‘Capital allowances’ is the term used for tax depreciation allowances.

Assumptions

(a) Tax is normally assumed to be payable one year after the relevant cash flow.
(b) It is normally assumed that the company is generating sufficient taxable profits so
as to be able to absorb all allowances in full at the earliest opportunity.
(c) Capital allowances

Two alternative assumptions are possible:

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(i) the expenditure arises just before a company's year end. The first Allowances
can therefore be claimed immediately;
(ii) the expenditure arises at the beginning of a new accounting period. The first
allowance will therefore be claimed at time 1

Illustration 3

A company purchases a machine at the beginning of the year in order to undertake a

new investment project.

The machine costs Rs 30,000, it has a life of four years and a scrap value of Rs 5,000
in year 4.

Tax depreciation allowances can be claimed on the machine on a reducing balance

basis at 20% per annum. The tax rate is 30% and tax is payable in the same year as
profits are generated.

Required:

Calculate the annual tax depreciation allowances, and the associated tax relief.

Answer:

Tax Dep Tax Relief

Year WDV
[20%] [30%]
1 30,000 6,000 1,800
2 24,000 4,800 1,440
3 19,200 3,840 1,152
4 5,000 15,360 4,608

Example 1 – Taxation

A company purchases a machine at a cost of Rs 100,000.

It has a life of four years and a scrap value of Rs 20,000 in year 4.

Writing down allowances are claimable on the machine on a reducing balance basis at
25% per annum.

The machine will generate the following annual net income:

year 1 - Rs 30,000
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year 2 - Rs 40,000

year 3 - Rs 50,000

year 4 - Rs 40,000

The cost of capital is 12% net of corporation tax at 33%, payable in arrears.

Required:
Should the machine be acquired?

The impact of inflation on the NPV analysis

There are two acceptable approaches to incorporating inflation into an NPV

analysis:

(a) The "real" method

In this case cash flows are not inflated i.e. we consider future cash flows which will
be generated, but in today's prices. When discounting the cash flows, however, we
must use a discount rate which is adjusted for inflation. This is called a real discount
rate or a real cost of capital.

(b) The "money" method

In this case adjust future cash flows for the effect of inflation i.e. inflate the cash
flows, and then discount by using a money or nominal cost of capital.

We will consider how to discount using each approach. If you need to get from a
money cost of capital to a real cost of capital or vice versa then the relationship
between the two is as follows:

(1 + m) = (1 + r)(1 + i)

where m = money cost

r = real cost
i = inflation rate

Note: In an exam question, assume that both the discount rate and cash flows are
given in money / nominal terms unless told otherwise.
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Important note for exam point of view:

As you know in our normal practice most of the tax authorities allow a full year’s
capital allowance and a balancing allowance or balance charge in the year of disposal
and we claim a for a capital allowance if and only if we have depreciable asset on
closing date. Now suppose if you buy this asset on 31 December 2018 and 31
December is also the year end date of the business then we can claim first capital
allowance on 31 December 2018 and this will be the year (T0) for financial
management perspective and now we are eligible to claim tax savings accordingly.
If this business buys this asset on 1 January 2019 i.e. just one day after the year end
date then we can claim capital allowance on 31 December 2019 i.e. after a year we
are eligible to claim tax savings on this.

Although there is no difference between 31 December 2018 and 1 January 2019 from
Financial management point of view both dates will be considered as Y0 but it will
entirely change the timings of tax savings on the capital allowance.

So in Exam Question carefully read the date of purchase of the asset, if question is
silent then it means that asset is purchased on 1 January 2019.

Inflation terminology explained

A common source of confusion and misunderstanding in DCF calculations is the

treatment of inflation.

Money and real costs of capital

Typically, the discount rate is the money cost of capital (often referred to as the
nominal cost of capital), that is the rate payable on borrowed money ( the source of
funds may be a bank loan, bonds, equity or some combination of sources).
Such a rate includes an allowance for inflation, in the sense that the lender cannot
expect any more than the interest rate. (The lender may charge a 15% rate assuming
that inflation will be 8% and so a ‘real return’ of approximately 7% will be generated.)

Money and real cash flows

If a money cost of capital is employed, then the ash flows on which the analysis is
performed should also include any inflation which is expected. (An, if different rates of
inflation are expected on revenues and costs, then this should be reflected in the cash
flows.)

In practice, cash flows are often projected in so – called ‘real ’terms, that are excluding
inflation. Given the uncertain nature of estimated future cash flows this is not surprising
– inflating estimated future cash flows may introduce the potential for greater
confusion.
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And, since inflation might be expected to affect all entities equally, it can reasonably be
assumed that, if there are unexpected inflationary pressures, they will be compensated
by price adjustments.

There are therefore arguable reasons for the use of cash flows in ‘real’ terms in DCF
analysis. However, it therefore follows that the discount rate should also be in ‘real’
terms.

The interaction of tax and inflation in an NPV analysis

Finally, there is the problem of using the real rate when there are taxation implications
in an examination question.

If there are any taxation implications in an investment appraisal, it would not usually be
appropriate to leave the cash flows in terms of present day prices and discount those
cash flows at the real cost of capital.

This would understate the overall tax liability as tax depreciation allowances are based
on original, rather than replacement cost, and do not change in line with changing
prices. The cash flows will have to be adjusted by the appropriate estimate of price
change.

Illustration 4 - Inflation in an NPV calculation

Brooker has under review a project involving an outlay of Rs 55,000 and expected to
yield the following net cash flows in current terms:

Rs
Year 1 10,000
Year 2 20,000
Year 3 30,000
Year 4 5,000

The company’s money cost of capital is 20% and the expected rate of inflation is 5% per
annum.

Required:
Evaluate the project using both of the recognized approaches to dealing with inflation.

Solution:
The real method:
First, calculate the real rate of interest.

(1 + m) = (1+r)(1+i)
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1.20 = (1+(r) x 1.05

So r = 14.29% which should be used to discount the current terms cash flows:

Cash Discount factor PV

0 (55,000) 1 (55,000)
1 10,000 1/1.1429 8,750
2 20,000 1/1.14292 15,311
3 30,000 1/1.4293 20,095
4 5,000 1/1.4294 2,930
(7,914)

The money method:

Discount the inflated cash flows at 20%:

Cash Discount factor PV

0 (55,000) 1 (55,000)
1 10,500(10,000 x 1.05) 1/1.20 8,750
2 22,050 (20,000 x 1.052) 1/1.202 15,313
3 34,729 (30,000 x 1.053) 1/1.203 20,098
4 6,078 (5,000 x 1.054) 1/1.204 2,931
(7,908)

N.B. The small difference between the two methods is caused by rounding.

Example 2 – Inflation
Bahadur Ltd is considering investing in a machine which automatically dispenses
vodka when a person clicks his or her fingers. The machine costs Rs 100,000. It will
generate income of Rs 50,000 per annum for the next three years in current prices
when rented to modern trendy Moscow nightclubs. The selling price is expected to
increase in line with the rate of inflation at 10% per annum. The money cost of capital
is 20%.

Required:

What is the NPV at the real cost of capital?

What is the NPV at the money cost of capital?

Note:
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(1) If the rate of inflation affecting all the cash flows and the cost of capital is the same,
then the NPV in money terms will equal the NPV in real terms. In this case it does not
matter whether you discount in money or in real terms.
(2) In the exam you are much more likely to have to approach things in money rather
than real terms. If there are different rates of inflation quoted for different cash flows
e.g. for sales compared to cost of sales, then you will have to discount in money terms.
Likewise if capital allowances are given in a question then you will have to discount in
money terms. Basically, if in doubt assume that you have to discount in money terms.
(3) Assume that a discount rate is a money rate unless told otherwise.
(4) The only time when you are likely to have to discount in real terms is if you are given
annuities for a long period of time. e.g. 10 years. By discounting in real terms you can
use the cumulative annuity factors.

The working capital adjustment in an NPV analysis

In most industrial projects, investment is required, both in working capital and in fixed
capital, although the risk attached to working capital is less than that for fixed capital.
Values of land and buildings may appreciate and so present less risk, but money
invested in machinery is a sunk cost, which is unlikely to be recovered, except for
perhaps minimal scrap values.
In project appraisal, accurate estimates of working capital requirements are desirable,
not only for assessment of project profitability, but also to facilitate forecasting of
capital requirements.

Effectively it represents a cash flow that will automatically be refunded after the project
has ended.

Illustration 5 – Working capital

A project requires the following levels of cumulative working capital investment (the
working capital is required at the start of each year):

Year Year Year Year

1 2 3 4
500 600 700 800

NPV – cash flows – put only the incremental cash flows at the start of each year, then
release the total amount invested at the end of the project:
 156

Time Time Time Time Time

0 1 2 3 4
(500) (100) (100) (100) (800)

Example of NPV with taxation, inflation and working capital

PQ Co, a UK based motor components subsidiary of a conglomerate entity, has to

decide whether to invest in a new production line. The project involves an initial
investment in equipment costing Rs 600,000 and working capital costing Rs 180,000.

The Projected net cash flows for the products are Rs 200,000 per annum for 5 years
at current price levels. At the end of 5 years it is projected that the equipment will
have a terminal value of Rs 50,000, and that the elimination of working capital will
provide an inflow equal to its initial book value.

PQ Co’s post-tax cost of capital is 14% in nominal (money) terms and the inflation
rate is projected to be 5% per annum.

Taxation data is as follows:

i. The equipment will be subject to tax depreciation allowances of 25% per

annum on a reducing-balance basis, which can be claimed against taxable
profits as from the current year (year 0) which is shortly to end. A balancing
charge or allowance will arise on disposal.
ii. The rate of corporate tax is 35% payable 1 year in arrears.

Required:
Determine whether or not the NPV of the project will justify the investment.

Solution:

You should note that the figures required are in nominal (money) terms, but in this
case, while it is possible to convert net cash flows back from nominal to real terms, it
is not possible to ascertain a discount rate in real terms, from the data given,
because of the mixture of inflated and non-inflated cash flows in the projections. If
PQ Co’s planners wished the figures to be in real terms, then the company’s real
discount rate would have to be separately determined. Care would also be required
in adjusting the tax savings on tax depreciation allowances.

Tax
Workin
Invest Net Tax relief on Net cash DF Present
g
ment inflows 35% tax depn flow @14% Value
capital
Rs
Rs Rs Rs Rs Rs Rs Rs
0 (600,000) (180,000) (780,000) 1.000 (780,000)
1 210,000 52,500 262,500 0.877 230,213
2 220,500 (73,500) 39,375 186,375 0.769 143,322
 157

3 231,525 (77,175) 29,531 183,881 0.675 124,120

4 243,101 (81,034) 22,148 184,215 0.592 109,055
5 50,000 180,000 255,256 (85,085) 16,611 416,782 0.519 216,310
6 (89,340) 32,335 (57,005) 0.456 (25,994)

NPV 17,026

The NPV is positive and therefore the investment should be accepted.

The internal rate of return (IRR)

Definition

The IRR is the discount rate which gives a zero NPV.

In many cases this is the maximum discount rate at which a project would be
acceptable (because in most cases, the NPV is positive at all discount rates less than
the IRR).

Calculation
It can be estimated by working out the NPV at two different rates (L, the lower rate, and
H, the higher rate) and then using the following formula:

 NPVL 
L+  ( H − L)
 NPVL − NPH 

Limitations

• The IRR method assumes that earnings throughout the period of the investment are
reinvested at the IRR. If the cost of capital is different from the IRR (as in most cases)
this is an incorrect assumption which means that the IRR overestimates the project's
return.

• For a project having irregular cash flows there can be more than one IRR for that
project. This can make comparison of projects using IRR vey confusing. For
example, consider the following project:

Rs
Initial investment at t0 (50,000)
t1 cash inflow 127,500
t2 cash outflow (78,750)
158

This project has IRRs of 5% and 50% (i.e. NPV = 0 when discounted at either of
these rates).

• Ranking projects according to the size of their IRRs can give a different ranking from
the ranking using NPV. This is because IRR is a relative figure and NPV is an
absolute figure. For example, a project giving a Rs 1,000 return in 1 year from a Rs
900 investment immediately, has the same IRR as a project which gives a Rs 1m
return in 1 year from a Rs 900,000 investment. Clearly the larger project would have
a much bigger NPV.

More on the limitation of IRR

Decision rule

The decision rule for IRR is:

• Accept the project if its IRR is greater than the cost of capital;
• Reject if the IRR is less than the cost of capital.

If a decision has to be made about a single project with ‘conventional’ cash flows (i.e.
a single outlay followed by a series of inflows) IRR will lead to the same decision as
NPV.

However, in more complex circumstances IRR and NPV can lead to different
decisions.

Multiple IRRs

If project cash flows reverse during the life of the project – there may, for example, be
an initial outflow followed by several inflows before another major outflow (as plant
undergoes major refurbishment, for example)- there may be more than one IRR. A
graph of discount rate versus NPV might appear as follows:

NPV

IRR1 IRR2

Discount rate

Discount rate and NPV – more than one IRR

159

In such an example, the IRR decision rule (accept if cost of capital is less than
IRR) is misleading because the project should only be accepted if cost of capital
is between IRR1 and IRR2.

To explain the result, it is necessary to understand the reinvestment

assumptions implicit in the NPV and IRR calculations.

The reinvestment assumptions

All NPV calculations assume that incoming cost can be reinvested at the rate which is
used in the NPV calculation.

This means that the calculation of IRR1 assumes reinvestment at IRR1 while the
calculation of IRR2 assumes revetment at IRR2. Only at rates which is sufficient to
offset both the initial cash outflow and the eventual second cash outflow. This analysis
is perfectly sound and, arguable; the project is acceptable only if the cost of capital lies
between IRR1 and IRR2.

Unfortunately, however, it means that the IRR decision rule – accept if cost of capital
is less than IRR – can be applied only to projects having conventional cash flows.

The NPV approach avoids this problem quite simply. By using the cost of capital as
the discount rate in the NPV formula, a negative NPV is generated if cost of capital is
less than IRR1, a positive NPV is obtained if cost of capital is between IRR1 and IRR2,
and the NPV is negative again if cost of capital is greater than IRR2.

The possibility of multiple IRRs is cited as a disadvantage of the IRR technique.

However, the problem can be overcome. Multiple IRRs arise only when cash flows
reverse more than once. In these circumstances, it is only necessary to identity the
(possibly) several IRRs (some seconds (and draw the correct conclusions.

IRR and mutually exclusive projects

Another problem with IRR concerns the selection of a favored project form two or
more projects which are ‘mutually exclusive’ (i.e. if one is chosen the others are
automatically ruled out).

Suppose, instead of our project (A) being a simple accept/reject decision we have to
choose between it and another project (B) which can be compared with project A as
follows:

Project A Project B

Initial investment (Rs 000) 100.0 50.0

NPV (Rs 000) 6.5 5.0
IRR (%) 12.7 18.0
160

The IRR approach would favor project B (18.0% compared with 12.7%). However,
provided that funds are freely available, project A would maximize wealth because, if
chosen, it could generate Rs 6,500 NPV compared with project B’s Rs 5,000.

In essence, IRR can mislead because it may select a lower investment with higher
‘earning potential’, when it may be preferable to invest a greater sum which
generates a lower ‘return’ but (because of its scale) produces a greater sum in the
end.

Conclusion

While the IRR technique assumes that cash flows can be reinvested at the IRR, the
NPV technique assumes that cash flows can be reinvested at the cost of capital used
in the discounting process. This difference has two repercussions:

(1) Even if mutually exclusive projects have the same initial investment, NPV and
IRR can give conflicting results. IRR may prefer a project with high early cash
flows (assumed reinvestment at the IRR), while NPV may prefer a different
project – with higher flows later.
(2) If IRR is used to rank projects in a capital – rationing situation the ranking
may be different from that obtained using the profitability index because IRR
will favor early cash inflows (assuming investment at the IRR), while the
profitability index (being based on NPV) may produce a different ranking.
(Capital rationing is covered in more detail in the later Chapter ‘investment
appraisal further techniques.’)

It is usually assumed that NPV provides the best guidance because the cost of
capital reinvestment assumption is more conservative and likely to be more realistic.

Modified IRR (MIRR)

Definition and explanation of MIRR

Modified internal rate of return (MIRR) is that rate of return which, when the initial
outlay is compared with the terminal value of the project’s net cash flows reinvested at
the cost of capital, gives an NPV of zero.

The MIRR gives the percentage return from a project, on the assumption that any cash
inflows can be reinvested at the entity's cost of capital.

As a percentage return figure, it is arguably easier to understand than the absolute

figure given by an NPV analysis (in many other contexts the return from an investment
is given as a percentage, so the concept of a percentage return is well understood).
161

The process for calculating MIRR

• Cash inflows from the project are converted to a single cash inflow in the last year of
the project (a "terminal value" or TV) by assuming that the cash flows are reinvested
at the cost of capital.

• MIRR is calculated as the annual return which equates the present value of the
outflows to this TV.

• i.e. the MIRR is found by taking (TV / PV of cash outflows) (1/n) – 1 (Note: n is the
length of the project in years.)

Note: This calculation identifies the rate of interest that equates the terminal value
with the initial investment.

Illustration 6 – MIRR
Initial investment (5,000)
Cash flows at t1 2,000
at t2 (1,000)
at t3 3,500
at t4 3,800

Cost of capital 10%

NPV = 1,216
IRR ≈ 19%

Required:

Calculate the MIRR of this project.

Solution:

MIRR calculation

Inflow TV of inflows
1 2,000 (1.10)3 2,662
3 3,500 (1.10)1 3,850
4 3,800 1.0 3,800
———
10,312
162

Outflow DF PV of outflows
0 5,000 1 5,000
2 1,000 1/1.102 826
———
5,826

MIRR = (10,312 / 5,826) (1/4) – 1 = 0.1534 (15.34%)

This is a better measure of the financial return from the project than the IRR of
19% which was given.

Strengths of the MIRR approach

• MIRR is unique for each project and it assumes that reinvestment takes place at the
cost of capital, so it is a much more accurate measure of the return from a project
than IRR.

• MIRR represents the actual return generated by a project.

Discussion of investment appraisal methods

Discussion of techniques

In using discounting and other techniques of investment appraisal, you must always be
aware that financial analysis is only a part of the decision-making process and that
often social and other factors may also be of considerable importance.

However, accepting this point and the need for a rounded, pragmatic approach to
investment decisions, it is still essential that a management accountant should
thoroughly understand the application of the ‘tools of his trade’.

The arguments put forward here suggest that all the techniques of investment appraisal
need to be well understood if they are to be wisely used.

The arguments put forward here suggest that all the techniques of investment appraisal
need to be well understood if they are to be wisely used.

In summary:

(1) NPV is the principal theoretical recommendation and should be used if the cost of
capital is a realistic reinvestment assumption.
163

(2) IRR like NPV incorporates discounting principles and, for some managers, may be
more meaningful than the absolute NPV of the project. However, IRR needs to be
thoroughly understood because of possible difficulties concerning multiple IRRs
and its use if projects are mutually exclusive. MIRR is a recent innovation worthy
of consideration.
(3) Payback is must use in proactive and, aside from its obvious simplicity, it can also
be recommended if a risk-averse decision is needed (or if liquidity is a major
problem).
(4) ARR takes no account of the time value of money and could lead to an incorrect
decision if compared with the cost of capital. However, because of the extensive
use of the return on capital employed or return on capital employed or return on
investment ratio, in practice it could be foolish not be calculate it.

The analysis suggests that there may be a place for all techniques of investment
appraisal in the management account’s armory.

However, a thorough understanding of their strengths and limitations is important.

How is risk incorporated using the different methods?

The usual textbook advice is to take account of risk in the following ways:

(1) If payback is used, reduce the required payback period;

(2) If IRR is used, increase the required ‘cut – off rate;
(3) If NPV is used, increase the discount rate to take account the ‘risk’ associated
with the project. The capital asset pricing model can be used to provide a
means of assessing the premium which ought to be added to the ‘risk-free’
discount rate;
(4) Assign probabilities to ‘best’ most likely’ and ‘worst’ values for each variable and
calculate a range of possible outcomes together with their probabilities. (This
approach can be refined by establishing distributions for the input variables and
‘simulating’ the project many times in order to build up a distribution of possible
outcomes.)

The relatively straightforward methods of handing risk if payback or IRR are used are
cited as advantages of these techniques.
However, none of the techniques described above deals with the important point that
early cash flows are likely to be more certain than late ones. The discounting techniques
take account the time value of money but they assume that whatever cash flows are
projected are certain. Only the payback technique clearly favors early inflows much more
than later ones and this may partially account for its popularity.

The issue of risk in investment appraisal is dealt with more fully in the next Chapter.
164

Conclusion – Which investment appraisal method should be used?

To some extent, the decision as to which investment appraisal methods to use

depends on the circumstances.

For example, if the company has short term liquidity problems, the payback period may
well provide useful information. Alternatively, if a manager is being appraised based on
the ROCE generated, he may decide to use the ARR method as an important
investment appraisal method.

However, in most cases, the NPV method is considered to be the best investment
appraisal method, because it measures the absolute gain in shareholders' wealth if a
project is undertaken. This links to the primary financial objective of all companies – to
maximize the wealth of the shareholders.

The IRR is useful as a follow up to NPV when trying to assess the sensitivity of the
project to changes in input factors (see next Chapter for more details). However, if it is
difficult to interpret the IRR (perhaps because there is more than one IRR), the MIRR
gives a unique percentage measure of project return and should be used if trying to
explain the concept of return from a project to a non-financially minded audience.

Financial and strategic considerations in investment appraisal

The investment appraisal methods shown in this Chapter are, in the main, concerned
with financial aspects.

However, you need to be clear that financial methods of evaluation are by no means
the only factors to be taken into account in investment appraisal.

Maximizing shareholder wealth

We might define investment appraisal as being concerned with maximizing

shareholder wealth, but we must be careful to qualify this concept by making it subject
to constraints associated with issues of social responsibility, such as effective controls
over pollution.

Stakeholder considerations

Shareholders wealth in this context needs to be linked with the wider view of
stakeholder theory which was introduced in the earlier chapter on ‘Introduction to
Financial Strategy).
The key point here is many other interested parties apart from shareholders – for
example, suppliers, lenders, employees, managers, as well the general public – need
to be taken into account in assessing a project’s viability.
165

For example, a project with a large positive NPV would normally be considered to be
acceptable. However, if undertaking the project would lead to job losses within the
entity, or would increase pollution levels, the decision is not so clear cut.
In situations such as this, the competing needs of stakeholders would need to be
assessed and compared.

Although it may seem to go against the key “maximize shareholder wealth’ objective a
project with a positive NPV, it is worth considering that a project which fails to achieve
the objectives of the other stakeholders might ultimately undermine the entity’s position
and may lead to negative publicity which might adversely impact shareholder wealth in
the future.

Strategic considerations

The financial appraisal of a project must also be balanced against its strategic benefits
to the entity.

For example, if a project has been appraised which has a small positive (or negative)
NPV; usually the project would be rejected. However, if the project would help to
consolidate the entity’s competitive position, or give it the opportunity to expand into a
new, attractive market, the decision is not so clear cut.

In this case, management would have to try to balance the financial requirements of
the entity against the long-term strategic requirements.

If it is felt that undertaking a project now would improve the entity’s prospects and likely
shareholder wealth in the future, a project with a small positive (or negative) NPV might
sometimes be accepted.
Note: Real options theory (covered in the next Chapter) is one way of trying to
formalize the process, by assigning values to strategic factors so that they can be
incorporated more easily in the decision-making process.

Exam style questions

Test your understanding 1 – Bilawal Ltd
Assume that you have been appointed finance director of Bilawal Ltd. The
company is considering investing in the production of an electronic security
device, with an expected market life of five years.
The previous finance director has undertaken an analysis of the proposed project;
the main features of his analysis are shown below. He has recommended that the
project should not be undertaken because the estimated annual accounting rate
of return is only 12.3%.
Year Year Year Year Year Year
166

0 1 2 3 4 5
Rs 000 Rs 000 Rs000 Rs000 Rs000 Rs000
Investment in 4,500
depreciable
fixed assets
Cumulative 300 400 500 600 700
700
investment in
working capital
Sales 3,500 4,900 5,320 5,740 5,320
——– ——– ——– ——– ——
–
Materials 535 750 900 1,050 900
Labour 1,070 1,500 1,800 2,100 1,800
Overhead 50 100 100 100 100
Finance charges 576 576 576 576 576
Depreciation 900 900 900 900 900
—– ——– ——– —– ——
3,131 3,826 4,276 4,726
4,276
—– ——– ——– —– ——

Taxable profit 369 1,074 1,044 1,014

1,044
Taxation 129 376 365 355
365
——– ——– —– ——–
Profit after tax 240 698 679 659
679
Total initial investment is Rs 4,800,000.

Average annual after tax profit is Rs 591,000.

All of the above cash flow and profit estimates have been prepared in terms of present
day costs and prices as the previous finance director assumed that the sales price
167

could be increased to compensate for any increase in costs. You have available the
following additional information:

(a) Selling prices, working capital requirements and overhead expenses are expected
to increase by 5% per year.
(b) Material costs and labour costs are expected to increase by 10% per year.
(c) Capital allowances (tax depreciation) are allowable for taxation purposes against
profits at 25% per year on a reducing balance basis.
(d) Taxation of profits is at a rate of 35% payable one year in arrears.
(e) The fixed assets have no expected salvage value at the end of five years.
(f) The company's real after-tax discount rate (or weighted average cost of capital) is
estimated to be 8% per year, and nominal after-tax discount rate 15% per year. Assume
that all receipts and payments arise at the end of the year to which they relate except
those in year 0 which occur immediately.

Required:
(a) Estimate the net present value of the proposed project. State clearly any
assumptions that you make.
(b) Calculate by how much the discount rate would have to change to result in a net
present value of approximately zero.

Multiple choice questions (MCQs)

1. Which of the following is the limitation of IRR?

A. It ignores the time value of money

B. It does not consider the entire life of the project
C. It does not consider the size and amount of project
D. It considers profits and ignores cash flows

Test your understanding answers

Example 1 – Taxation

Assumptions:
168

(1) Asset is purchased on the first day of year 1.

(2) Tax is payable 1 year in arrears.

Working - Capital allowances

WDV Benefit
100,000
WDA Y1 (25,000) @ 33% 8,250 at T2
----———–
75,000
WDA Y2 (18,750) @ 33% 6,188 at
T3
----———–
56,250
WDA Y3 (14,063) @ 33% 4,641 at
T4
---———–
42,187
Proceeds (20,000)
—---——–
22,187
BA Y4 (22,187) @ 33% 7,322 at
T5
---———–
Nil

Net present value

0 1 2 3 4 5
Revenue
- 30,000 40,000 50,000 40,000 -
flows
Tax@ 33% (9,900) (13,200) (16,500) (13,200)
169

CA (Working) 8,250 6,188 4,641 7,322

Scrap 20,000
Capital (100,000)
———– ——– ——— ——— ———– —–
(100,000) 30,000 38,350 42,988 48,141
(5,878)
———– ——– ——— ——— ——– ——–

NPV at 12% = Rs 15,247.

Example 2 – Inflation

NPV in real terms

1.2 = (1 + r)(1 + 0.1)

r = 9.1%

AF 1-3 9.1% = (1 - (1.0901)-3) / 0.0901 = 2.5268

Time Flow DF @9.1% NPV

0 (100,000) 1.000
(100,000)
1-3 50,000 2.5268
126340

NPV 26,340

NPV in money terms

Time Flow DF @ 20% NPV

0 (100,000) 1.000
(100,000)
1 50,000 × 1.10 0.833 45,815
170

2 50,000 × 1.102 0.694 41,987

3 50,000 × 1.103 0.579 38,532
——
NPV 26,334
——

Note: Difference is due to rounding

Test your understanding 1 – Bilawal Ltd

Tutorial notes: As different items are inflating at different rates the only realistic
approach is to discount money cash flows at the nominal (money) discount rate. This is
particularly true as taxation is involved and the amount of tax payable will be based upon
a taxable profit figure that in turn is determined by items subject to various rates of
inflation.

The general procedure will be as follows:

· Determine the corporation tax liability.

· Determine other relevant cash flows (in money terms).
· Discount these cash flows to present value at the nominal WACC.

(a) Calculation of corporation tax liability

1 2 3 4 5
Rs 000 Rs 000 Rs 000 Rs 000 Rs
000
Sales (5% rise pa) 3,675 5,402 6,159 6,977 6,790
Materials (10% rise 588 907 1,198 1,537 1,449
pa)
Labour (10% rise pa) 1,177 1,815 2,396 3,075 2,899
Overheads (5% rise 52 110 116 122 128
pa)
171

Capital allowances 1,125 844 633 475 1,423

note
1,2
——– ——– ——– ——– ——
–
Taxable 733 1,726 1,816 1,768 891
Tax (35%) 256 604 636 619
312

Notes:
(1) Capital allowances
Opening balance Capital allowance
Rs 000 Rs 000
Year 1 4,500 1,125
Year 2 3,375 844
Year 3 2,531 633
Year 4 1,898 475
Year 5 1,423 1,423

This assumes that the first capital allowance is available in the first year and that the
balancing allowance is taken in year 5. Note that capital allowances are based upon
original cost of assets.

(2) Depreciation is replaced by the capital allowance

Interest is not deducted in calculating the tax liability. The tax deductibility of
interest will have been allowed for in the calculation of the weighted average
cost of capital.

Discount relevant cash flows to present value

Year Inflows 0 1 2 3 4 5 6
Sales - 3,675 5,402 6,159 6,977 6,970 -
Outflows
Materials - (588) (907) (1,198) (1,537) (1,449) -
 172

Labour - (1,177) (1,815) (2,396) (3,075) (2,899)

Overheads - (52) (110) (116) (122) (128) -(note
3)
Fixed assets (4,500)
Working (300) (120) (131) (144) (156) 851 -

Notes:
(1) Capital allowances
Opening balance Capital allowance
Rs 000 Rs 000
Year 1 4,500 1,125
Year 2 3,375 844
Year 3 2,531 633
Year 4 1,898 475
Year 5 1,423 1,423

This assumes that the first capital allowance is available in the first year and that the
balancing allowance is taken in year 5. Note that capital allowances are based upon
original cost of assets.

(2) Depreciation is replaced by the capital allowance

Interest is not deducted in calculating the tax liability. The tax deductibility of interest
will have been allowed for in the calculation of the weighted average cost of capital.

Discount relevant cash flows to present value

Year Inflows 0 1 2 3 4 5 6
Sales - 3,675 5,402 6,159 6,977 6,970
-
 173

Outflows
Materials - (588) (907) (1,198) (1,537) (1,449)
-
Labour - (1,177) (1,815) (2,396) (3,075) (2,899) -
Overheads - (52) (110) (116) (122) (128) - (note
3)
Fixed assets (4,500)
Working (300) (120) (131) (144) (156) 851 -

capital (note 4)
Taxation (256) (604) (636) (619) (312)

(note 5)
——— ——— ——— ——— ——— ——— ——
Net cash (4,800) 1,738 2,183 1,701 1,451 2,546 (312)
Flows ——— ——— ——— ——— ——— ——— ——
Discount 0.870 0.756 .658 0.572 0.497 0.432
factors at
15%
Present (4,800) 1,512 1,650 1,119 830 1,265
(135)
values

NPV = Rs 1,441,000 and on this basis the project should be

accepted.

(3) Once again interest is not included. The cost of interest is taken care of in the
discounting process. If we were to charge interest against cash flow and include
it in the discounting process we would be double counting. This is a very
common examination trap and should be avoided.
(4) We require the incremental investment in working capital each
year. Adjusting for inflation, this is:

Year 0
300
174

Year 1 (400 × 1.05) – 300 =

1
20
Year 2 (500 × 1.052) – (400 × 1.05) =
1
31
Year 3 (600 × 1.053) – (500 × 1.052) =
1
44
Year 4 (700 × 1.054) – (600 × 1.053) =
1
56
Year 5 Refund of working capital assumed(700 × 1.055) =
8
51
Net 0

(5) Tax payment lagged by one year

(b) Tutorial note: This is a roundabout way of asking what is the IRR of the project.
By normal trial and error procedures this may be determined as follows:

Year Cash flow 20% PV 27% PV

Rs000 discount Rs 000 discount Rs000
0 (4,800) (4,800)
(4,800)
1 1,738 0.833 1,448 0.787
1,368
2 2,183 0.694 1,515 0.620
1,353
175

3 1,701 0.579 985 0.488

830
4 1,451 0.482 699 0.384
557
5 2,546 0.402 1,023 0.303
771
6 (312) 0.335 (105) 0.238 (74)
____
____ 765
5 ______
_____

The discount rate would have to change from 15% to approximately 27% to produce a
net present value of zero. This is a change of approximately 80%.

Answers to MCQs:

1. C
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PART 2: FURTHER ISSUES

learning objectives

• Risk and uncertainty

• Capital rationing
• Sensitivity analysis and changes in variables
• Equivalent annual cost
• Real options
• Adjusted present value
• Investments and projects
• Feasibility study
• Project control
• Investment performance
• Post-completion audits
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1 Overview of chapter
Profitability
index (PI)

Total PV

AF for the
relevant period
Capital
rationing
Equivalent
Real Option annual
cost

Further
investment
appraisal
techniques Sensitivity
analysis

Adjusted The impact of

present value risk/uncertai
(APV) nty
Expected
values

Base case PV of Adjusted

NPV financing
discount
side effects Certainty
rates
equivalent
s

The previous Chapter introduced various investment appraisal techniques, most notably
the Net Present Value (NPV) method.

This Chapter introduces some further considerations, many of which incorporate the use
of NPV is different situations.
The main topics covered are:

Capital rationing

This considers how the investment decision is affected by a restriction in the amount of
capital available. The key consideration is which project to choose if we have a choice of
positive NPV projects available but insufficient finance to undertake them all.
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The impact of risk

All the investment appraisal techniques in the previous Chapter were based on
estimating future cash flows and / or profits. We need to also consider the potential for
inaccuracies in our estimates.

Sensitivity analysis is often performed to assess the likely impact on a project of certain
estimates being inaccurate.

We shall also see how to use probabilities and certainty equivalents to address potential
uncertainties in cash flows, and how to derive risk adjusted discount rates if a new
project is deemed to have a different risk from an entity's existing operations.

Equivalent annual costs

So far we have only considered one-off investment projects. If we need to appraise an

ongoing project where a machine needs to be replaced regularly, equivalent annual
costs (based on NPV analysis) are useful.

Real options theory

The NPV method takes no account of any flexible options associated with an investment
project. These 'real options' can make a project significantly more attractive.

Adjusted present value (APV)

In the earlier Chapter on 'Cost of Capital' we noted that a significant change in capital
structure means that the existing cost of capital is inappropriate to use as a discount rate
for project appraisal. The APV method is often proposed as an alternative investment
appraisal method in these circumstances.

Investment appraisal in specific contexts (e.g. IT investments, and

investment in design)

In the modern business environment, the traditional investment appraisal methods need
to be adapted when faced with projects such as IT investments where some of the
benefits may be difficult to quantify.

Capital Rationing

Introduction

This is a situation where the funds available for new projects are limited to an amount
which prevents acceptance of all new projects with a positive NPV.
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Capital rationing needs to be recognized as a constraint during the capital budgeting

cycle.

The methods below show how to decide between projects in different capital rationing
situations.

Definition of capital rationing

A restriction on any entity’s ability to invest capital funds, caused by an internal budget
ceiling being imposed on such expenditure by the management (soft capital rationing),
or by external limitations being applied to the entity, as when additional borrowed funds
cannot be obtained (hard capital rationing).

More details on the capital rationing problem

If capital is not rationed there is no problem; all projects which meet the cut-off criteria
are accepted.

When capital is rationed the ranking of projects becomes important. The various
methods of investment appraisal – payback, IRR, NPV, etc. often give conflicting
rankings of investment priorities.

Methods of determining how the investment decision should be made will depend on
the type of capital rationing.

Single-period capital rationing is a situation where capital is rationed at present (year 0),
but will be freely available in the future.

Multi-period capital rationing is a situation where capital is rationed over a number of

periods.

Capital budgeting and control

The capital budgeting cycle

A common feature of industrial activity is the need to commit funds by purchasing land,
buildings, machinery, etc. in anticipation of being able to earn, in the future, and income
greater than the funds committed. This indicates the need for an assessment of the size
of the outflows and inflows of funds the life of the investment, the degree of risk
attached (greater risk funds, the life of the investment, the degree of risk attached
(greater risk being justified perhaps by greater returns) and the cost of obtaining funds.
Basic stages in the capital budgeting cycle may be identified as follows:

(a) Needs for expenditure are forecast.

(b) Projects to meet those needs are distinguished.
(c) Alternatives are appraised.
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(d) Best alternatives are selected and approved.

(e) Expenditure is made and monitored.
(f) Deviations from estimates are examined as part of a post completion audit (PCA)

Types of capital project

Reasons for capital expenditure vary widely. Projects may be classified into the
following categories.

• Maintenance – replacement of worn-out or absolute assets, safety and security etc.

• Profitability – cost savings, quality improvement, productivity, relocation, etc.
• Expansion – new products, new outlets, research and development, etc.
• Indirect – office buildings, welfare facilities, etc.

A particular investment project, of course, could combine any number or all of the above
classifications.

Capital expenditure forecast

In preparing budgets, it is necessary to consider how much money can or must be
allocated to capital expenditure. Capital development schemes may be started because
a surplus of cash resources is revealed by the long-term plant, but usually management
decided on a capital development scheme and then seeks the means to finance it.
Initially, the budget will be an expression of management’s intonation to allocate funds
for certain board purposes. In the budget period, money will be required as follows:

• For previously authorized existing projects;

• For new projects, full details of which may not yet be available.

The forecasts will indicate whether sufficient funds are available, and perhaps
when additional funds will need to be obtained. It is advisable, therefore, for
managers to submit long-term capital expenditure forecasts, say for two to five
years ahead. Consequently, the possibility of obsolescence (and the direction of
the future development of the firm) must be borne in mind.

Capital expenditure committee

A capital expenditure committee may be formed, either as a subcommittee of the

budget committee or as a separate meeting of the entire budget committee. The
responsibilities of the capital expenditure committee are to:

• Co-ordinate capital expenditure policy:

• Appraise and authorize capital expenditure on specific projects;
• Review actual expenditure on capital projects against the budget.
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Capital expenditure decision

Capital expenditure requiring approval by the committee must be formulated by the
managers. The amount of detail should be stipulated by the committee and would
generally cover the following:
• Outline of the project, including the budget classification and how it is linked, if at all,
with other projects.
• Reason for the expenditure, if a new project and the departments affected. An
assessment of intangible benefits or disadvantages.
• The amount of capital expenditure required (fixed and working capital), including a
breakdown by budget periods, and an estimate of any internal work required.
• A complete statement of incremental costs and revenue arising from the project, and
the budget periods affected. An assessment of the effect of taxation ought to be
made.
• Estimated life of the project.
• Assessment of risks to which the project is sensitive – political, economic,
competitors, natural hazards, etc.
• Projects that are feasible alternatives, and comparative data.
• Effect of postponement or rejection of project.

Major projects would probably be subjected to a comprehensive financial evaluation, as

part of the committee’s consideration. Less important projects could be submitted,
accompanied by an economic justification.

Types of capital rationing

Hard rationing
This refers to an external constraint on the amount of capital available. It may
arise because of:

• problems raising bank loans due to tight lending criteria being applied
• problems raising equity or bond finance in a depressed stock market
• Prohibitively high costs of raising small amounts of finance.

Soft rationing
This is where the constraint is internally imposed. It may be because:

• Management is reluctant to issue share capital because it might dilute the earnings
per share, or lead to an unwanted change in the ownership structure of the business.
• Management don't want to raise additional debt finance because of concerns about
the level of gearing, or the potential problem of meeting higher interest payments.
• The capital expenditure budget may place a limit on the level of spending permitted
(perhaps for a subsidiary or a division).
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Single period capital rationing

(a) If projects are mutually exclusive, pick the project with the largest positive NPV.
(b) If projects are divisible, rank projects via the profitability index.

The profitability index is calculated as:

NPV of project/Capital investment

(c) If projects are indivisible, rank projects and combinations of projects via total NPV.
The optimal solution is found by using trial and error i .e identify the possible
combinations of investments and pick the one with the highest NPV.

Justification for the use of profitability index

The NPV technique is the academic recommendation and it is theoretically sound.

However, its use in practice implies that the decision – maker must judge a project by
an absolute number and while it is easy to give the ‘rule any project generating positive
NPV is acceptable a decision maker will be interested not only in the final NPV ‘payoff’
but also in the size of the initial investment and the length of time before the project
‘matures’.

Use of the NPV rule becomes problematic if capital is rationed, because not all projects
can then be accepted.

In this situation, it becomes necessary to rank projects according to their ‘earning

power’ placing the project which generates the maximum NPV per pound invested at
the top of the list.

Conventionally, the profitability index is calculated in order to rank projects.

More details on terminology

Mutually exclusive, divisible and indivisible projects

The key to a single period capital rationing problem is to identify first whether projects
are mutually exclusive, divisible or indivisible.

If projects are mutually exclusive, only one of the projects can be undertaken. In this
case the decision rule is clear cut choose the available project with the highest positive
NPV.
A divisible project is one where a fraction of the project can be undertaken and the
same fraction of total NPV generated.
For example, if an entity is considering buying 10 machines to undertake a
manufacturing project, it may be possible to only buy five of the machines and still
generate half of the NPV.
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An indivisible project is one which has to be done in total or not at all.

For example, a company buying a single machine to undertake a manufacturing project

will not be able to invest in a fraction of the project.

Implications for a capital rationing scenario

When faced with a limiting factor (capital in this case), management should follow the
decision rule of maximizing the return per unit of the limiting factor. This is called the
profitability index (PI).
Hence, if possible, projects should always be ranked using Pls.

However, whereas the PI approach works in a situation where projects are divisible, it is
not appropriate when projects are indivisible or mutually exclusive.
This is because:

• When projects are mutually exclusive, the decision should be to undertake the
project with the highest absolute return (i.e. NPV) rather than considering the
relative measure of PI.
• When projects are indivisible, there will often be some unused capital left over
when allocating finance to projects, because finance can only be allocated to full
projects. It may be that a better absolute return (NPV) can be generated by
investing in two projects with low Pls, rather than investing in the project with the
best PI and then having surplus funds left over which cannot be invested in any
other project

Example 1 – Capital rationing

Bahar Ltd has Rs 60,000 available to invest at time zero.

Data is available about the following four projects:

A B C D
Initial cost 30,000 20,000 40,000
10,000
PV of inflows 52,000 25,000 56,000
18,000

Required:

Determine the optimum investment plan if:

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(a) projects are divisible;

(b) projects are not divisible.

Assume that any surplus funds cannot be invested elsewhere.

Dealing with Risk and Uncertainty

Many projects are subject to risk or uncertainty and it is important that this can be
evaluated and incorporated into the evaluation process.

You can usually expect to see the term 'risk' used in examination questions in the
context of the possibility of an outcome that affects us in a negative manner, whereas
the term 'uncertainty' would refer to the possibility of both positive and negative
outcomes or inputs.

This follows common use of the term in practice.

For example, the possibility of a travel delay would normally be referred to as a 'risk'
and lack of certainty over the actual departure date as 'uncertainty', whereas the
possibility of a higher revenue than expected would be likely to be referred to as an
'opportunity' rather than as a 'risk'.

We set out below brief descriptions of procedures that can be used to help evaluate
projects which are subject to risk.

Sensitivity analysis

Definition of sensitivity analysis

A modeling and risk assessment procedure in which changes are made to significant
variables in order to determine the effect of these changes on the planned outcome.
Particular attention is thereafter paid to variables identified as being of special
significance.

When undertaking an NPV analysis of a project, the accuracy of the NPV depends on
the accuracy of the input factors in the calculation (e.g. estimates of cost of capital,
sales, expenses, tax rates).

After computing the NPV of a project, sensitivity analysis can be used:

• to identify which of the input variables of the project could have the most adverse
impact on the NPV of the project if they were to change.

• to assess the impact on the NPV of a certain change in a particular input factor.

• to consider by how much each input variable could change before the NPV of the
project became zero (and hence the project became unacceptable).
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Interpretation of sensitivity analysis results

A company has calculated the NPV of a project, and has subsequently identified the
following sensitivities:

Sales can fall by 10% or costs may rise by 20%, or the discount rate can increase by
1% before the NPV becomes zero.

In this case we would conclude that the project NPV is very sensitive to changes in
discount rate (small percentage sensitivity) but not very sensitive to changes in costs (if
costs were to change, unless they changed by more than 20% the NPV would still be
positive.

Limitations of sensitivity analysis

The major problem is that we normally consider the impact of only one variable at a
time. Management may be more interested in the risk of some key factors changing at
the same time. For example, if the selling price changes, there is likely to be an impact
on sales volume too. Sensitivity analysis can only deal with one of these variables
changing at a time.

Also, sensitivity analysis does not include any assessment of the probability of certain
variables changing.

It is therefore useful as an aid to decision making, rather than a decision rule in itself.

Two basic approaches to sensitivity analysis

(1) An analysis can be made of all the key input factors to ascertain by how
much each factor must change before the NPV reaches zero, the
indifference point.

(2) Alternatively, specific changes can be calculated, such as the sales

decreasing by 5%, in order to determine the effect on NPV.

Both approaches will be shown in the Illustration below.

Illustration 1 – Sensitivity

A project has an NPV of Rs 1m. The PV of material costs (included in the NPV
calculation) are Rs 5m.

Sensitivity = 1m / 5m = 0.2
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i.e. the material costs could rise by up to 20% and the project remains viable. A rise of
greater than 20% will produce a negative NPV and the project would not be worthwhile.

Alternatively, sensitivity analysis could be used to assess the impact of a given

percentage change in a variable.

To continue with the above example, if the material costs were to change by 10% (from
a PV of Rs 5m to Rs 5.5m – a change of Rs 0.5m) the NPV would reduce by Rs 0.5m
from Rs 1m to Rs 0.5m (a fall of 50%).

More detailed example of sensitivity analysis

AVI Co is evaluating a new investment project as follows:

Rs 000 T0 T1 T2 T3 T4
Sales 1,000 1,000 1,000 1,000

Costs 600 600 600 600

400 400 400 400
Tax (30%) (120) (120) (120) (120)
Net 280 280 280 280
CapEx (600)

Tax relief on 45 45 45 45
depreciation
(30% x 600/4)

Net cash flow (600) 325 325 325 325

DF @ 10% 1 0.909 0.826 0.751 0.683

NPV = Rs 430,000

Sensitivity to sales (i.e. by how much could sales fall before NPV becomes
zero)

=(NPV/PV of cash flows affected by the estimate of sales) x 100%

=[430 / (1,000 x (1 – 0.30) x 3.170)] x 100%

=19.4%

i.e. if sales were to fall by 19.4% (to Rs 806,000 per annum) then the NPV would be zero.

Sensitivity to tax rate

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=(NPV/PV of cash flows affected by the estimate of tax rate) x 100%

=[430 / ((46 - 120) x 3.170)] x 100%

=181%

i.e. if the tax rate were to rise by 181% (from 30% to 30 x 2.82 = 84.6%) then the NPV
would fall to zero.

Sensitivity to discount rate

This cannot be calculated in the same way. Instead the IRR of the project should be
calculated and the difference between the existing cost of capital and the IRR then
indicated the sensitivity to the discount rate. Here the IRR is approximately 40%.

Interpretation of sensitivity calculations

AVI Co would initially be inclined to accept the project due to its positive NPV.
However, before making a final decision, the sensitivities would be considered. Any
factors with small percentage sensitivities will have to be carefully assessed, because if
the estimates of these factors turn out to be incorrect, the result may be a negative
NPV.

In this example, the project NPV is not very sensitive to changes in the tax rate or the
discount rate. The likelihood of sales falling by 19.4% would need to be assessed
before making a final decision, but assuming that management decide that this is not a
major risk, the project would be undertaken.

Probabilities

If forecasts are uncertain and probabilities can be attached to the possible outcomes,
expected values (EV) can be calculated.

EV = (outcome 1 × probability 1) + (outcome 2 × probability 2) etc

Examples of probabilities

Simple example
GH Co is trying to estimate sales in the coming year.

It has been predicted that there is a 30% chance of sales being Rs 20,000, a 50% chance
of sales being Rs 30,000 and a 20% chance of sales being Rs 40,000.

Required:
Calculate the expected sales in the coming year.

Solution:
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Expected sales = (0.30 x 20,000) + (0.50 x 30,000) + (0.20 x 40,000) = Rs 29,000

More complex example (dependent probabilities)

Following on from the example above, assume that the sales in year 2 are dependent on
the level of sales achieved in the first year, as follows:

Sales in year 1 Probability sales in year 2

(as above) (as above)

Rs 20,000 30% Could be Rs 20,000 (probability 70%) or Rs

10,000 (probability 30%)
Rs 30,000 50% Will also be Rs 30,000
Rs 40,000 20% Could be Rs 40,000 (probability 60%) or Rs
50,000 (probability 40%)

Required:

Calculate the expected sales in year 2.

Solution:

Expected sales in year 2

= 0.30 x [(0.70 x 20,000) + (0.30 x 10,000)]
+0.50 x 30,000
+ 0.20 x [ (0.60 x 40,000) + (0.40 x 50,000)]

=Rs 28,900

Decision trees
In appraisal situations where uncertainty can apply to more than one variable, and
values of the variables can be interdependent, many different outcomes are possible.
The decision tree is a useful tool for reviewing a multiplicity of choices and outcomes.

Imagine the trunk of the tree as representing a project to be appraised, perhaps a new
product to be added to a range, then the first branches (of which there may be tow,
three or more) may represent alternative probabilities are assigned. Each revenue
volume branch then creates secondary branches to represent contributions, to which
again probabilities are assigned, and finally these branches create tertiary branches
with allied probabilities to represent fixed costs.

The probabilities of each branch sequence are then multiplied and the joint probabilities
thus obtained are applied in turn to each sequential set of values to give a series of pay-
offs or outcomes as shown below:
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Sales Contribution Fixed Costs Joint Pay-offs

(‘000 units) Rs Rs 000 probabilities Rs
7 400(0.4) 0.08 24,000
100 0.5 500 (0.6) 0.12 24,000
0.4 400 (0.4) 0.08
5 8,000
0.5 500 (0.6) 0.12 NIL
400 (0.4) 0.12
7 19,200
80 0.5 500 (0.6) 0.18
10,800
0.6 400 (0.4) 0.12
5 NIL
0.5 500 (0.6) 0.18 (18,000)
1.00 68,000

Decision tree

As can be seem form the diagram, we arrive at eight joint probabilities leading to eight
outcomes arising from 2 x 2 x 2 branches; representing 2 sales volumes x 2
contributions x 2 fixed cost values.

By relating the joint probabilities to the value figures, we obtain the eight pay-offs which
are added to give an overall predicted net contribution of Rs 68,000.

The pay-offs also show a range of net contributions from Rs 24,000 positive to Rs
18,000 negative, and by adding the joint probabilities there is a 58% chance of positive
outcome, 24% of a breakeven and 18% of a negative result.

Certainty equivalents

The cash flows of the project are calculated as per normal but then adjusted downwards
by a certainty equivalent factor. This in effect decreases the cash flow. The cash flows
are then discounted at a risk-free rate. In practice the major problem is that the use of
certainty equivalents is subjective.

Definition of certainty equivalents

An approach to dealing with risk in a capital budgeting context. It involves expressing
risky future cash flows in term of the certain cash flow which would be considered, by
the decision maker, as their equivalent, that is the decision maker would be indifferent
between the risky amount and the (lower) riskless amount considered to be its
equivalent.
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Illustration 2 – Certainty equivalents

Year Cash flow Certainty equivalent RF DF, 6%

PV
0 (1,000) 1 1 (1,000)
1 900 0.95 0.943 806
2 750 0.9 0.89 601

NPV = 407

More details on certainty equivalents

The certainty equivalents method adjusts for risk by incorporating the decision maker’s
risk attitude into the investment decision by converting the expected cash flows of the
project into equivalent riskless amounts.

The danger of using certainty equivalents lies in the high level of subjective judgment
required form the decision-maker, while it could also be arguing that risk-averse
management might be better off using a high cut-off rate.

Nevertheless, certainty equivalents do represent a useful tool in the investment appraisal

armory, especially in assessing cases where an apparently small change in a key
variable can interact with others to create significant falls in inflows, with a possible
cumulative effect over the life of the project.

Adjusted discount rate

Discount rate considerations

In all the examples considered so far in this section on risk, a constant discount rate has
been used, on the assumption that the cost of capital will remain the same over the life
of the project. As the factors which influence the cost of capital, such as interest rates
and inflation, can change considerably over a short period of time an organization may
wish to use different rates over the life of the project. Net present value and discounted
present rates over the life of the project. Net present value and discounted present value
allow this, but IRR and ARR present a uniform rate of return. Using NPV for example, a
different discount factor can be used for each year if so desired.

Perhaps, one of the major problems in using a discounted cash flow method is deciding
on the correct discount rate to use.
191

It is difficult enough in year 1 but deciding on the rate for, say, year 4 may be very
difficult because of changes in the economy, etc. If a very low rate is chosen almost all
projects will be accepted, whereas if a very high discount rate is chosen very few
projects will be accepted.

Looking back over the year, it would appear that the majority of managers have probably
used too high a discount rate and have, as a consequence, not invested in projects that
would have helped their organization to grow in relation to their competitors. There are
no prizes for being too conservative; it is just as much a failing as being too optimistic.

If there is any doubt over the correct discount rate to be used, sensitivity analysis can
help.

A premium to the normal discount rate may be added to evaluate projects that are
considered more risky.

Then, more marginal projects would be less likely to have a positive NPV.

More details on adjusted discount rates

A useful scheme is to have a risk category schedule providing different risk grading. For
example, a “normal” project could be discounted at the usual cost of capital, with more
riskier projects being discounted at perhaps 2% more than this.

The difficulty with risk-adjusted discount rates lies mainly in the need for skillful
management judgment as to the risk category, even though considerable product and
market research may have undertaken.

The capital asset pricing model (CAPM) is often used to calculate risk adjusted discount
rates, as shown in the earlier Chapter on “Capital Structure”.

Equivalent Annual Cost [Unequal project lives]

This is sometimes useful for comparing projects if they have different lives when the
assets of the project need replacing periodically, by new assets.

Definition

The Equivalent Annual Cost (EAC) is the equivalent annuity which has the same present
value as the project if paid for the same number of years as the project's life.

Formula
Total present value
EAC = ————————–
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Annuity factor for life of asset

Further details on the use of annual equivalent cost

When the present value (of a capital project) is expressed as an annual amount, this is
called annual equivalent cost and is used to compare projects having different life cycles.

Calculating equivalent annual costs is basically a method of discounting especially for

asset replacement decisions, but it also has value when comparing the sensitivity of
variables where projects have unequal lives.

Unequal lives

When two or more mutually exclusive investments with unequal lives are being
compared, consideration must be given to the time period over which a comparison of
the investments is to be made.

Before making a comparison between mutually exclusive projects with differing lives, and
explicit decision must be taken as to whether it is necessary to equalize the lives.

A choice should be made on the basis of NPV, whether equalization is required or not,
although the process of equalization may alter the ranking of the projects under
consideration.

Asset replacement cycles

The concept of equivalent annual costs can be used in determining the optimum
replacement cycle for an asset.

This decision involves how long to continue operating the existing asset before it is
replaced with an identical one. As the asset gets older, it may become less deficient, its
operating costs may increase and the resale value will reduce.

Illustration 3 – Equivalent annual cost

Assume that the NPV of cash outflows for asset replacement project A is Rs 64,300,
with discounting at 12% and an asset life of 4 years, while for project B, the NPV of
outflows is Rs 79,355, also after discounting at 12% but with an asset life of 6 years.

Annual equivalent costs are:

Project A: 64,300 / 3.037 (AF for 4 years at 12%) = 21,172

Project B: 79,355 / 4.111 (AF for 6 years at 12%) = 19,303

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So on an annualized basis, project B has the lower cost and would be preferred even
though on a non-annualized basis project A would have seemed more advantageous.

Note that the cash flows and discount rates must always be in real terms in order to deal
with inflation accurately.

Detailed example of the use of equivalent annual cost

Lita Co Operates a delivery vehicle, which cost Rs 20,000 and has a useful life of 3
years. Lita Co has a cost of capital of 5%. The details of the vehicle’s cash operating
costs for each year and the resale value at the end of each year are as follows.

Year 1 Year 2 Year 3

Rs Rs Rs
Cash operating costs 9,000 10,000 11,900
End of year resale value 14,000 11,500 8,400

Required:

Determine how frequently the vehicle should be replaced.

Solution

The first step is to calculate the present value of the total costs incurred if the vehicle is
kept for 1, 2 or 3 years, respectively.

Keep for 1 year

NPV = -20,000 + (5,000 x 0.952) = -15,240

Keep for 2 years

NPV = -20,000 – (9,000 x 0.952) + (1,000 x 0.907) = -27,661

Keep for 3 years

NPV = -20,000 – (9,000 x 0.952) - (10,500 x 0.907) – (3,500 x 0.864) = -14,116

These present value figures are not comparable because they relate to different time
periods.

To render them comparable they must be converted to average annual figures, or

equivalent annual costs, by dividing by the cumulative discount factors:

Keep for 1 year

EAC = 15,240 / 0.952 = 16,008

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Keep for 2 years

EAC = 27,661 / 1.859 = 14,880

Keep for 3 years

EAC = 41,116 / 2.723 = 15,100

The lowest equivalent annual cost occurs if the vehicle is kept for 2 years. Therefore, the
optimum replacement cycle is to replace the vehicle every 2 years.

Real Options

One criticism of the conventional NPV approach to investment appraisal is that

insufficient attention is given to the options aspect of making investment decisions. Any
project can be viewed as an opportunity which can either be taken immediately or
delayed. Traditional approaches to investment appraisal tend to treat investments either
as reversible or as an irreversible one-off decision which must be taken at a single point
in time, with the opportunity otherwise being lost. While this may typify some investment
decisions, it certainly does not apply to them all.

In many situations it may be possible to delay and gain further valuable information,
which could be influential in the viability or otherwise of the investment decision. In such
cases the opportunity to invest can be thought of as being very similar to a call option. It
gives a right, but not an obligation, to a stream of cash flows associated with the project
at some future date. When a company either decides to go ahead or completely rejects
an investment proposal it effectively brings this option to an end.

While the option is open it has a value, and recent research would suggest that the NPV
rule should be modified to take account of the value of this option. In effect this would
mean that, in order to proceed with a project, the value of the NPV would not only have
to be positive but must also be sufficient to cover the value of the option. When a
proposed capital investment project is being appraised, there are likely to be several
options inherent in the project:

• the option to make follow on investments if the project is a success;

• the option to abandon the project part way through its life, if it appears not to be a
success;
• the option to wait before investing;
• the strategic option-the project may open up new markets or follow-up products.
 195

Such options are called 'real options' because they are options on real physical assets, to
distinguish them from financial options which are options on financial assets.

Detailed explanation of real option

Introduction
Option – pricing theory is not part of the syllabus, but it is useful to consider the option-like
features found in investment decisions, when a projects is slipping behind forecast,
managers can take action in an attempt to achieve the original NPV target. In other words,
they can create options, or take action to mitigate losses or exploit new opportunities
presented by capital investments.

Terminology – calls and put options

Before discussing investment decisions as options on future cash flows, it may be useful
to identity the meaning of call and put option:

• A call option is an option to buy a specified asset at a specified exercise price on or

before a specified exercise date:
• A put option is an option to sell a specified asset at a specified exercise price on or
before a specified exercise date.
Application to investment appraisal

The NPV approach to investment appraisal makes two assumptions that may be
questioned:

(1) A project is reversible

(2) A project cannot be delayed.

The assumption that a project is reversible implies that if the project does not work out,
the original investment can be recovered and applied to a new project. This is flawed,
as in most significant projects the original investment will either be wholly or
partly irreversible.

In some instances, it may not be possible to delay an investment decision, but in the
majority of cases of delay is possible – although there may be costs associated with
delay. If a project is irreversible to some degree, the ability to delay the investment
decision in order to obtain new information is valuable. The additional costs associated
with delay should be assessed against the benefits associated with that new information.

Investment projects can be related to financial call options, in that the project provided
the right, but not the obligation, to purchase an asset (or commit to a series of cash
flows) in the future. When an irreversible investment decision is made, the call option
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becomes exercised. The opportunity to delay an investment and keep the option alive
has a value, which is not normally reflected in an NPV calculation.

The real options approach suggests that decisions that increase flexibility by creating
and preserving options should be pursued. Decisions that reduce flexibility by exercising
options and irreversibly committing resources should be valued at a lower figure than
conventional NPV would suggest.

categorization of real options

In the context of investment decision there are there options to be considered:

1) The abandonment option (financial put option).

2) Timing options (financial call option) – sometimes referred to as “wait and see
options:
3) Strategic investment options (financial call option) – sometimes referred to as “follow
– on options:

Different types of real options

The abandonment option

Major investment decisions involve heavy capital commitments and are largely
irreversible: once the initial capital expenditure is incurred, management cannot turn the
clock back and act differently.

Because the management is committing large sums of money in pursuit of higher, but
uncertain, payoffs, the ability to abandon, or ‘bail out’, should things look grim, can be
valuable.

Timing options (or "wait and see options")

Management may view an investment as a ‘now or never’ opportunity, arguing that in

highly competitive markets there is no scope for delay.

In effect, this amounts to viewing the decision as a call option which is about to expire. If
a positive NPV is expected, the option will be exercised, otherwise the option lapses and
no investment is made. However, delaying the decision by a year to gain valuable new
information is likely to be a more valuable option.

This helps us to understand why entities sometimes do not take up apparently wealth-
creating opportunities: the option to wait and gather new information is sufficiently
valuable to warrant such delay.

Strategic investment options (or "follow-on options")

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Certain investment decisions give rise to follow-on opportunities which are wealth-
creating.

For example, new technology investment, involving large-scale research and

development, is particularly difficult to evaluate, and many such projects would show
negative NPVs as the uncertainty involved would demand the use of high discount
rates. However, they offer the potential to access a large market in the future.

The negative NPV can be viewed as the option cost, or premium on the follow-on option.
The value of the option is the value of the flexibility associated with the project.

Simple real options example

Cardiff Components Co is considering building a new plant to produce components for

the nuclear before industry.

Proposal A is to build a custom-designed plant using the latest technology, but

applicable only to nuclear defense contracts.

A less profitable scheme, B, is to build a plant using standard machine tools, giving
greater flexibility in application.

The outcome of general election to be held one year hence has a major impact on the
decision. If the current government is returned to office, their commitment to nuclear
defense is likely to give rise to new orders, making proposal A the better choice. If,
however, the current opposition party is elected, its commitment to run down the nuclear
defense industry would make proposal B the better course of action.
Proposal B has, in effect, a put option attached to it, giving the flexibility to abandon the
proposed operation in favor of some other activity.

Illustration - 4 Real options

Initial scenario
A project, P, has expected cash flows as shown below:

Year 0 Year 1 Year 2 Year 3

Rs p Rs p Rs p Rs
(3,500) 1/3 3,000 1/3 3,000 1/3 3,000
1/3 2,000 1/3 2,000 1/3 2,000
1/3 1,000 1/3 1,000 1/3 1,000
Expected values 2,000 2,000 2,000

Note that p = probability of each outcome.

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The project’s NPV at a discount rate of 10%, based on the expected value of its cash
flows is:

Year Cash flow (Rs ) DF 10% PV (Rs )

0 (3,500) 1 (3,500)
1 2,000 0.909 1,818
2 2,000 0.826 1,653
3 2,000 0.751 1,503
1,474

More details regarding the project

The initial investment of Rs 3,500 in project P represents the purchases of a customized

machine, the price of which is known with certainty.

Because it is a customized machine its resale value is low’ it can only be sold for Rs
2,000 up to 1 year after purchase. Thereafter, its resale value will be zero.

The option to abandon the project immediately

Once the machine is bought, the expected value of abandoning the project immediately
would be Rs 2,000 (1 x Rs 2,000).

This must be compared with the expected value of continuing with the project, which is
Rs 4,974 (Rs 1,818 + Rs 1,653 + Rs 1,503).

In this case, the expected benefits of continuing with the project far outweigh the returns
form abandoning it immediately.

The option to abandon the project in 1 years’ time

Once the machine has been in operation for a year, the first year’s cash flows will be
known with certainty.

Assume that in this scenario, the year 1 outcome determines the years 2 and 3 outcomes
with certainty (i.e. if the outcome is Rs 1,000 in year 1, it will also be Rs 1,000 in year 2
and year 3, etc).

Note: If this were not to be case, a decision tree could be used to identity all the potential
combinations of outcomes.

Given that machine can be sold for Rs 2,000 at this point, the three possible outcomes if
the project is abandoned in 1 years’ time are:

Year Cash flow (Rs ) DF 10% PV (Rs )

New 0 2,000 1 2,000
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1 (1,000) 0.909 (909)

2 (1,000) 0.826 (826)
265

Year Cash flow (Rs ) DF 10% PV (Rs )

New 0 2,000 1 2,000
1 (2,000) 0.909 (1,818)
2 (2,000) 0.826 (1,652)
(1,470)

Year Cash flow (Rs ) DF 10% PV (Rs )

1 2,000 1 2,000
2 (3,000) 0.909 (2,727)
(3,000) 0.826 (2,478)
(3,205

Note that in each case it has been assumed that the project has been abandoned, and
therefore all the future cash flows have been foregone.

It can be seen that if the future cash flows are expected to be Rs 2,000 per annum or Rs
3,000 per annum, the project should not be abandoned in 1 years’ time. Since the value
of the future cash flows foregone would be higher than the disposal value of Rs 2,000.

However, if the future cash flows are expected to be Rs 1,000, the project should be
abandoned since the abandonment option has a positive NPV.

Assessing the value of the abandonment option

The fact that the project can be abandoned in 1 years’ time if cash flows turn out to be at
the low end of expectations (Rs 1,000 per annum) gives an additional value to the
overall project.

The value of this can be incorporated into the NPV of the project by recomputing the
NPV based on the cash flows if the abandonment takes place, as follows:

Year 0 Year 1 Year 2 Year 3

Rs p Rs p Rs p Rs
(3,500) 1/3 3,000 1/3 3,000 1/3 3,000
1/3 2,000 1/3 2,000 1/3 2,000
1/3 1,000 +2,000 1/3 NIL 1/3 NIL
Expected values 2,667 21,667 1,667
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The NPV of the project now becomes:

Year Cash flow (Rs ) DF 10% PV (Rs )

0 (3,500) 1 (3,500)
1 2,667 0.909 2,424
2 1,667 0.826 1,377
3 1,667 0.751 1,252
1,553

i .e. the option to abandon the project in 1 year’s time increases the NPV of the project by
Rs 79 (Rs 1,553 - Rs 1,474).

Valuing real options

Option valuation

Calculations on option pricing are not part of the syllabus, but it is worth noting that the
Black - Scholes option pricing model can be used to value real options if the following
five factors can be identified and entered into the model:

(1) Present value of the future cash flows from the investment:
(2) Initial outlay on the investment
(3) Time unit the investment opportunity disappears, that is the length of time than an
investment decision can be deferred without losing the opportunity to invest;
(4) Variability of project returns;
(5) Risk – free rate of interest.

In practice, however, the time to expiry and the variability of project returns may be
difficult to measure.

Pricing an option using values for these factors will arguably provide more information
about the value of a project than using NPV. However, quantifying these factors
objectively is not straightforward.

Adjusted Present Value (APV)

Introduction

The risk-adjusted WACC can be used as an NPV discount rate when capital structure is
being maintained, but project risk is different from that of the company. When capital
structure is not being maintained (i.e. the project will be financed in such a way as to
change the company's capital structure), then no form of NPV analysis, neither:

(i) NPV plus WACC; nor

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(ii) NPV plus risk-adjusted WACC

is suitable. Instead we have to use Adjusted Present Value (APV).

APV consists of two different decisions:

APV = Investment Decision + Financing Decision

(i.e. Value of a geared project = value of an all equity financed project + PV

of financing side-effects)

Three-stage approach

APV takes a three-stage approach:

· Stage One: the project is evaluated as if it is all equity financed.

· Stage Two: the project's 'finance package' is evaluated
· Stage Three: Stages One and Two are combined to produce the APV.

Stage One

Stage One is a standard NPV analysis of the project, except for the discount rate used.
In a normal NPV analysis either WACC or risk-adjusted WACC is used. In APV a special
discount rate is used: the base-case discount rate.

To find the base-case discount rate, we use the asset beta of a 'pure-play comparison'
company and input it into the CAPM. This gives the base-case discount rate for the
project: the return required for the project's business risk.

Procedure is to

· Find the ungeared beta value

· Put into CAPM to get keu to use as a base case discount rate
· Calculate the base case NPV

Stage Two

In Stage Two, the present value of the costs and benefits associated with the financing
package is calculated. Costs and benefits include:

· issue costs on debt and equity

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· tax relief on interest payments (the "tax shield")

· the value of a subsidy on debt

What rate should be used to discount these financing cash flows?

As all financing cash flows are low risk they are discounted at either the kd or the risk free
rate.

Details of financing costs and benefits

Issue costs

Equity issue costs are not tax deductible but debt issue costs tend to be. Sometimes the
amount raised has to cover the issue costs, in other cases, the issue costs will be in
addition - read the question carefully.

PV of tax relief on interest payments = PV of tax shield

This is a calculation of an annuity, or a deferred annuity if tax relief is first

received in year 2.

Annual tax relief = total loan x interest rate x tax rate

Subsidised / Cheap Loan

Like all loans, calculate the tax shield. In addition, you need to calculate
the opportunity benefit of the cheap loan as follows:

PV of interest saved X
Less PV of tax relief lost (X)
——
PV of the cheap loan X

Debt capacity

A project's debt capacity denotes its ability to act as security for a loan. It is the tax relief
available on such a loan, which gives debt capacity its value.

When calculating the present value of the tax shield (tax relief on interest) one should
base it on the project's theoretical debt capacity and not the actual amount of the debt
used.
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The company accrues a tax benefit from a project of each pound of debt finance that
project can support, even if the debt is used on some other project. Therefore we use
the theoretical debt capacity to match the tax benefit to the specific project.

This technique assumes that the theoretical debt capacity is fully utilised within the
company as a whole.

Stage Three

Having calculated the project's base-case present value and also the present value of
each 'subsidy' that the project receives and of each finance issue cost, these are then
combined to find an overall PV: the project's Adjusted Present Value or APV.

Example 2 : APV

DT Ltd is a quoted company. The directors have been evaluating a cost saving project
which will require Rs 1.9 million capital expenditure on new machinery. The directors
expect the capital investment to provide cost savings of Rs 300,000 per annum
indefinitely. Both of these figures are given net of any tax implications.

The company is at present all equity financed. The discount rate which it applies to
investment decisions of this nature is 16%. The directors believe the current capital
structure fails to take advantage of the tax benefits of debt and propose to finance the
new project with undated debt secured on the company's assets. The current rate of
interest required by the market on corporate debt of this risk and maturity is 9%, but
half of the loan will be subject to an interest rate of 3% under a Government subsidy
scheme. The costs of issue, which are not tax deductible, are expected to be 5% of the
gross proceeds of issue. The company intends to issue sufficient debt to cover the cost
of capital expenditure and the costs of issue.

The company's tax rate is 33%.

Required:

Using the information given for DT Ltd, calculate the APV of the investment.

Linking investment appraisal to customer requirements

Primary objective
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By this stage, you should be entirely happy with the assumed primary objective of
companies to maximise their shareholder wealth. Any investment decision should be
appraised with this objective in mind, as explained in the next section dealing with net
present value (NPV) analysis.

Link to customer requirements

However, it is worthwhile taking a step back from the mathematics and starting by
noting that an investment project will only be a success if it delivers value to its
customers, who are willing voluntarily to pay for the output of the investment project
and will thereby yield the cash inflows that are required. Satisfying customer
requirements is key to successful investment project management, from the initial
planning stage through to actual delivery.

Product / service design

Satisfying customer requirements is closely tied in with product/service design, for a

product should be specifically designed to include the features that customers actually
want and are willing to pay for.

For example, there is no point in a computer hardware manufacturer paying money to

paint a fancy logo on the hard drives that it produces. Customers simply want to pay for
a unit that they can install inside their computers and never look at again. They are not
willing to pay extra for units with fancy paintwork on the outside, so the outside of the
hard drives should be left unpainted.

Investment projects should be tested against this idea of delivering known value to
customers by bringing them the features that they require and are willing to pay for

Investments in IS / IT

A particular problem is experienced in appraising investment projects concerned with

Information Systems (IS) and Information Technology (IT). Businesses have always
used information systems, even before computers became widespread, as methods to
collect data about the company and its competitors, which is then made available to the
managers of the company to help them in their decision-making.

Recent developments in IT including the prevalence of cheap powerful computers and

database technology have allowed such systems to help managers:
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• at the strategic level, to plan for the achievement of the organisation’s overall
objectives
• at the operational level, to ensure that the processes currently carried out are
efficient and effective
• to control the business, by comparing actual performance with planned
performance, highlighting for attention any significant variances that arise.

While the cost of a computer or a software application is a known amount, the benefits
of IT are hard to tie down. As the economist Robert Solow has famously said: ‘In
business you can see computers everywhere but in the productivity statistics’.

Some senior managers simply believe that expenditure on IT is a ‘good thing’ and that
money must be spent as an ‘act of faith’, but the pressure on all budget areas in recent
years has led to blind faith no longer being an acceptable policy.

Top managers today insist on IT spending being justified in the same way as any other
proposed expenditure. The problem in applying conventional DCF analysis to IS/IT
projects is that, even if the up-front cost is known, the benefits will be both tangible and
intangible, and selecting a discount rate to reflect the risk of the project will also prove
difficult. Nevertheless, the exercise can still be carried out, even if it will only be possible
in approximate terms.

Control of investment projects

The capital budgeting cycle

A common feature of industrial activity is the need to commit funds by purchasing land,
buildings, machinery, etc, in anticipation of being able to earn, in the future, an income
greater than the funds committed. This indicates the need for an assessment of the size
of the outflows and inflows of funds, the life of the investment, the degree of risk
attached (greater risk being justified perhaps by greater returns) and the cost of
obtaining funds.

Basic stages in the capital budgeting cycle may be identified as follows:

(a) Needs for expenditure are forecast.

(b) Projects to meet those needs are distinguished.
(c) Alternatives are appraised.
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(d) Best alternatives are selected and approved.

(e) Expenditure is made and monitored.
(f) Deviations from estimates are examined as part of a post completion audit (PCA).

Post completion audit of capital projects

During the life of a project, an investigation should be undertaken to examine its

profitability and compare it with the plan. There are three reasons for undertaking these
post-mortems:

• To discourage managers from spending money on doubtful projects, because

they may be called to account at a later date.
• It may be possible over a period of years to discern a trend of reliability in the
estimates of various managers.
• A similar project may be undertaken in the future, and then the recently
completed project will provide a useful basis for estimation.

More on capital budgeting and controls

Types of capital project

Reasons for capital expenditure vary widely. Projects may be classified into the following
categories.

· Maintenance – replacement of worn-out or obsolete assets, safety and

security, etc.
· Profitability – cost savings, quality improvement, productivity, relocation, etc.
· Expansion – new products, new outlets, research and development, etc.
· Indirect – office buildings, welfare facilities, etc.

A particular investment project, of course, could combine any number or all of the above
classifications.

Capital expenditure forecast

In preparing budgets, it is necessary to consider how much money can or must be

allocated to capital expenditure. Capital development schemes may be started because
a surplus of cash resources is revealed by the long-term plan, but usually management
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decides on a capital development scheme and then seeks the means to finance it.
Initially, the budget will be an expression of management's intention to allocate funds for
certain broad purposes. In the budget period, money will be required as follows:

· for previously authorised existing projects;

· for new projects, full details of which may not yet be available.

The forecasts will indicate whether sufficient funds are available, and perhaps when
additional funds will need to be obtained. It is advisable, therefore, for managers to
submit long-term capital expenditure forecasts, say for two to five years ahead.
Consequently, the possibility of obsolescence (and the direction of the future
development of the firm) must be borne in mind.

Capital expenditure committee

A capital expenditure committee may be formed, either as a sub-committee of the budget

committee or as a separate meeting of the entire budget committee. The responsibilities
of the capital expenditure committee are to:

· co-ordinate capital expenditure policy;

· appraise and authorise capital expenditure on specific projects;
· review actual expenditure on capital projects against the budget.

Capital expenditure decision

It has frequently been reported that, in both the private and public sectors, investment
decisions are made rather casually and that this laxity is one of the major causes of lack
of growth within the economy. Of all the decisions taken by management, those
concerned with investment are the most crucial: once made, they may fix the future of
the company in terms of its technological role, cost structure and market effort required,
i.e. once the product has been selected and the plant built, the company is committed to
the specific cost structure which accompanies that particular type of plant and the
product made.

Authorisation of capital projects

The capital budget will not necessarily be based on a detailed analysis of required
projects. It is likely that managers will be asked to forecast their capital expenditure
requirements for inclusion in the budget but, even if such figures are included, it is still
necessary for detailed proposals to be submitted to the committee before the projects
may be started. Many projects will incur fairly small expenditure and, in order not to
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involve the committee in unnecessary detail, broad guidelines ought to be laid down
regarding the amounts of expenditure that may be committed by each level of
management. Top management must see that the types of expenditure to be treated as
capital are clearly defined, and that every subordinate or committee knows precisely the
limits to which they can approve capital expenditure.

Feasibility study

Feasibility study normally includes three main areas:

i) Market issues:

a) Potential market opportunities

b) Type of industry
c) Size of market
d) Projected market share

ii) Technical or organizational requirement

a) Management’s experience for the project under consideration

b) Organization’s access to sources of required resources
c) Technicalities involved in the investment projects
d) Organisational structure

iii) Financial overview

a) Estimated starting cost of the project

b) Estimated operating cost of the project
c) Estimated demand and revenues related to project
d) Project profit (loss) related to project
e) Possible sources of finance and cost of finance
f) Risk associated with project
g) Payback period and life of project
h) Taxation effect
i) Estimated residual value of project’s assets at the end of
project

Capital expenditure control

Strict control of large projects must be maintained and the accountant must submit
periodic reports to top management on progress and cost. A typical report would
include data such as the following:

· Budgeted cost of the project, date started and scheduled completion date.
· Cost and over- or under-expenditure to date.
· Estimated cost to completion, and estimated final over-or under-expenditure.
· Estimated completion date and details of penalties, if any.
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The capital expenditure committee will seek explanations for any overspending that may
have arisen. Where projects are incomplete and actual expenditure exceeds the
authorisation, additional authority must be sought to complete the project. In so
doing, the committee must consider the value of the project as it then stands and the
additional value that will be gained by completing it, compared with the additional
expenditure to completion.

Exam style questions

Test your understanding 1 – Borrowing Ltd

Whilst setting its long-term budget for the years ended 31 December 20X1 to 31
December 20X9, Borrowing Ltd has reviewed the costs attributable to each cost centre.
The firm is concerned with the cost forecasts for centre CS/23/CS, namely the circular
saw. The cost budget for the next five years is:

Year ended 31.12.X1 31.12.X2 31.12.X3 31.12.X4 31.12.X5

Rs Rs Rs Rs Rs
Depreciation 211 158 119 89 67
Supervision 500 600 720 864 1,037
salary
Power 15 15 20 20 25
Insurance 5 5 10 10 15
Consumable stores 130 150 180 220 270
Maintenance
- labour 800 1,000 1,200 1,500 1,900
- parts 550 830 1,090 1,500 1,790
Fixed
overheads
absorbed 200 250 300 350 450

The charge for insurance is in respect of a policy which specifically relates to the saw.
The supervisor only spends a portion of his time with the saw – when it is being used by
apprentices. The saw is currently (31 December 20X0) valued at Rs 750, although this
figure is expected to fall by Rs 250 each year.
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A new saw has come onto the market which is being offered at Rs 3,500. As a sales
promotion idea the firm selling the saw has promised that its first 100 customers may
purchase all future saws at the same price. The running costs of the new saw are
expected to be:

Year ended 31.12.X1 31.12.X2 31.12.X3 31.12.X4 31.12.X5

Rs Rs Rs Rs Rs
Labour 300 475 650 700 800
Parts 200 300 400 500 600
Other direct 500 600 700 800 900
costs
Fixed overheads
absorbed 300 350 400 450 500

The scrap value of the new saw is estimated as being Rs 2,000 at the end of its first
year's use, Rs 1,500 after two years, Rs 1,000 after three years, Rs 250 after four years
and from then on the asset would have negligible scrap value.

Required:

(a) Determine how often the new machine should be replaced.

(b) Determine when the old machine should be replaced.

Ignore taxation and assume that this type of machine will be used in perpetuity.

Borrowing Ltd has a required rate of return of 10%.

Test your understanding 2 – Sindh Ltd

Sindh Ltd has details of two machines which could fulfil the company's future production
plans. Only one of these machines will be purchased.

The 'standard' model costs Rs 50,000, and the 'de-luxe' Rs 88,000, payable immediately.
Both machines would require the input of Rs 10,000 working capital throughout their
working lives, and both machines have no expected scrap value at the end of their
expected working lives of four years for the standard machine and six years for the
de-luxe machine. The forecast pre-tax operating net cash flows associated with the two
machines are:
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Years hence
1 2 3 4 5

Rs Rs Rs Rs Rs
Standard 20,500 22,860 24,210 23,410 35,100
De-luxe 32,030 26,110 25,380 25,940 38,560

The de-luxe machine has only recently been introduced to the market and has not been
fully tested in operating conditions. Because of the higher risk involved, the appropriate
discount rate for the de-luxe machine is believed to be 14% per year, 2% higher than the
discount rate for the standard machine.

The company is proposing to finance the purchase of either machine with a term loan at
a fixed interest rate of 11% per year.

Taxation at 35% is payable on operating cash flows one year in arrears, and capital
allowances are available at 25% per year on a reducing balance basis.

Required:

(a) Calculate for both the standard and the de-luxe machine:
(i) payback period;
(ii) net present value.
Recommend, with reasons, which of the two machines Sindh Ltd should
purchase.
(Relevant calculations must be shown.)

(b) If Sindh Ltd were offered the opportunity to lease the standard model
machine over a four-year period at a rental of Rs 15,000 per year, not
including maintenance costs, evaluate whether the company should lease or
purchase the machine.

(c) Surveys have shown that the accounting rate of return and payback period
are widely used by companies in the capital investment decision process.
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Suggest reasons for the widespread use of these investment appraisal

techniques.

Multiple choice questions (MCQs)

1. Profitability index is calculated when:

A) Projects are divisible in capital rationing situation

B) Projects are not divisible in capital rationing situation
C) Asset replacement decision is taken
D) Buy or lease decision is taken

2. Adjusted present value (APV) is only used when:

A) Business risk is changed

B) Financial risk is changed
C) Both financial and business risks are changed
D) In all above situations

Test your understanding answers

Example 1 – Capital rationing

(a) Rs 000 A B C D
NPV 22 5 16
8
Initial cost 30 20 40 10
NPV/Rs invested 0.73 0.25 0.40
0.80
Rank 2 4 3 1

Bahar Ltd should invest the Rs 60,000 as follows:

(1) Do project D leaving Rs 50,000.

(2) Do project A leaving Rs 20,000.
(3) Do half of project C, using up the remaining funds.

(b) Bahar Ltd can afford to invest in the following multi-asset portfolios:
NPV
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A+B+D 35
B+C 21
C+D 24

By trial and error the optimal investment is A + B + D.

Example 2 : APV

APV = Base case NPV ± PV of financing side effects

Rs 300,000
Base case NPV = ————– – Rs 1,900,000 = (Rs 25,000)
0.16

The side effects of financing are:

Tax relief on debt interest

Debt issued = Rs 1.9m + issue costs (= 5% debt issued)

∴95% debt issued = Rs 1.9m
∴debt issued = Rs 1.9m/0.95 = Rs 2m

Tax relief on interest = [(Rs 1m × 9%) + (Rs 1m × 3%)] × 33% = Rs 39,600 pa

Rs 39,600
This has a PV of ————– = Rs 440,000
0.09

(Note: A discount rate appropriate to the level of risk of the flow is

used to find the PV.)

Value of subsidy

The subsidy saves 6% p.a. in interest (9% - 3%). The post tax value
of this subsidy in perpetuity is therefore:
1
6% × Rs 1m × (1-0.33) × —— = Rs 446,667
0.09

Issue costs

Issue costs = 5% of Rs 2m = Rs 100,000

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These arise at time 0, and thus have a PV of (Rs 100,000)

The adjusted present value is thus:

-Rs 25,000 + Rs 440,000 + Rs 446,667 - Rs 100,000 = Rs 761,667

Test your understanding 1 – Borrowing Ltd

(a) Running costs (new saw)

Labour, parts and other direct costs included.

PV factor PV
Cumulative
Rs Rs Rs
Year 1 1,000 0.909 909 909
Year 2 1,375 0.826 1,136 2,045
Year 3 1,750 0.751 1,314 3,359
Year 4 2,000 0.683 1,366 4,725
Year 5 2,300 0.621 1,428 6,153

Scrap value (new saw)

Year 1 2,000 0.909 1,818

Year 2 1,500 0.826 1,239
Year 3 1,000 0.751 751
Year 4 250 0.683 171
Year 5 Nil 0.621 −

One-year cycle

PV
Rs
Purchase cost(3,500)
Running costs - Year 1 (909)
215

Scrap value - Year 1 1,88

——
Total PV costRs(2,591)
——

Two-year cycle

Purchase cost (3,500)

Running costs - Years 1 and 2 (2,045)
Scrap value - Year 2 1,239
——
Total PV cost Rs(4,306)
——
Three-year cycle
Purchase cost (3,500)
Running costs - Years 1-3 (3,359)
Scrap value - Year 3 751
———
Total PV cost Rs(6,108)
———
PV
Rs

Four-year cycle
Purchase cost (3,500)
Running costs - Years 1-4 (4,725)
Scrap value - Year 4 171
———
Total PV cost Rs(8,054)
———
Five-year cycle
Purchase cost (3,500)
Running costs - Years 1-4 (4,725)
216

Scrap value - Year 4 171

———
Total PV cost Rs(8,054)
———

To calculate AE cost

Year Total PV cost Annuity factor AE cost

Rs Rs
1 2,591 0.909 = 2,850 pa
2 4,306 1.736 = 2,480 pa
3 6,108 2.487 = 2,456 pa *
4 8,054 3.170 = 2,541 pa
5 9,653 3.791 = 2,546 pa

(b) Non-identical replacement

Running costs (old saw)

Power, consumable stores, maintenance and insurance are included. Supervisor's salary
is ignored as it would be incurred anyway.

PV factor PV
cumulative
Rs Rs Rs
Year 1 1,500 0.909 1,364 1,364
Year 2 2,000 0.826 1,652] 3,016
Year 3 2,500 0.751 1,878 4,894
Year 4 3,250 0.683 2,220 7,114
Year 5 4,000 0.621 2,484 9,598
Replace now PV factor PV
Rs
Scrap value 750 1.00 750
AE cost - new machine
Year 1 − ∞ 2,456 (24,560)
217

———
0.10
———
Total PV cos Rs(23,810)
——

Replace in one year's time

Running costs Year 1 (1,500) 0.909 (1,364)

Scrap value Year 1 500 0.909 455
AE cost: new machine
Years 2 − ∞ 2,456 22,325)
——– × 0.909
0.10
——

Total PV cost Rs (23,234)

Replace in two year's time

Running costs Year 1–2 (3,016)

Scrap value Year 2 250 0.826 207
AE cost: new machine
Years 3 − ∞ 2,456 (20,287)
——– × 0.826
0.10
——
Total PV cost Rs (23,096)
——

Replace in three year's time

Running costs Year 1–3

(4,894)
Scrap value Year 3
AE cost: new machine
Years 3 − ∞ 2,456 (18,445)
——– × 0.751
0.10
———
Total PV cost Rs (23,339)
———
218

Replace in four year's time

Running costs Year 1–4

(7,114)
Scrap value Year –
AE cost: new machine
Years 5 − ∞ 2,456 (16,775)
——– × 0.683
0.10
——
Total PV cost (23,889)
——

Replace in five year's time

PV factor PV
Rs
Replace in five years' time
Running costs Year 1–5 (1,500) 0.909 (9,598)
Scrap value Year 5 500 0.909 –
AE cost: new machine
Years 6 − ∞ 2,456 (15,252)
——– × 0.621
0.10
——
Total PV cost Rs(24,850)
——

Test your understanding 2 – Sindh Ltd

(a) Calculation of tax liability

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Rs Rs Rs Rs Rs Rs
Standard

Operating cash 20,500 22,860 24,210 23,410

flows
Capital 12,500 9,375 7,031 21,094*
219

allowance
——— ——— ——— ———

8,000 13,485 17,179 2,316

Taxation (35%) 2,800 4,720 6,013 811

De-luxe

Operating cash 32,030 26,110 25,380 25,940 38,560 35,100

flows
Capital 22,000 16,500 12,375 9,281 6,961 20,883*
allowance
——— ——— ——— —— —— ———
10,030 9,610 13,005 16,659 31,599 14,217
Taxation (35%) 3,511 3,363 4,552 5,831 11,060 4,976

* Including balancing allowance

Forecast after-tax cash flows

Year Year Year Year Year Year

0 1 2 3 4 5
Rs Rs Rs Rs Rs Rs
Standard
Fixed (50,000)
assets
Working (10,000) 10,000**
capital
Operating 20,500 22,860 24,210 23,410
cash
flows
Taxation (2,800) (4,720) (6,013) (811)
——— ——— ——— ——— ——— —
(60,000) 20,500 20,060 19,490 27,397 (811)
Discount 0.893 0.797 0.712 0.636 0.567
factor
220

(12%)
Present (60,000) 18,307 15,988 13,877 17,424 (460)
Values

(i) Payback period is approximately three years.

(ii) Net present value is Rs 5,136
221

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year7

Rs Rs Rs Rs Rs Rs Rs Rs
De-luxe
Fixed (88,000)
assets
Working (10,000) 10,000***
capital
Operating 32,030 26,110 (25,380) 25,940 38,560 35,100
cash flows
Taxation (3,511) (3,363) (4,552) (5,831) (11,060) 4,976)
——— ——— ——— ——— ——— ——— ——
(98,000) 32,030 22,599 22,017 21,388 32,729 34,040 (4,976)
Discount 0.877 0.769 0.675 0.592 0.519 0.456 0.4
factor (14%)
Present (98,000) 28,090 17,379 14,861 12,662 16,986 15,522 (1,990)
Values

(i) Payback period is approximately four years.

(ii) Net present value is Rs 5,510.

** Assumes working capital is released immediately. In reality some time-lag will

exist.

Normally the project with the highest NPV would be selected. However, as the projects
have unequal lives, it can be argued that, although the de-luxe has a higher NPV, this is
only achieved by operating for two more years. If the machines are to fulfil a continuing
production requirement the time factor needs to be considered.

The annual equivalent cost approach is not appropriate as both machines have different
levels of risk. In this situation the most useful approach is to assume infinite
reinvestment in each machine and calculate their NPVs to infinity.

NPV of the investment ÷ Present value of an

annuity of appropriate years and discount rate
NPV ∞ = ————————————————————
Discount rate
222

Standard

5.136 ÷ 3.037*
NPV ∞ = ——————— = Rs 14,092
0.12
De-luxe
5.510 ÷ 3.889*
NPV ∞ = ——————— = Rs 10,120
0.14

* The present values of annuities are taken for four and six years as these are the
useful lives of the projects.

As the standard machine has the higher NPV , it is recommended that this machine
should be purchased.

An alternative approach to the problem of different lives might be to assume a

reinvestment rate for the shorter investment and to use this rate to equalise the lives of
the investments

Answers to MCQs:

1. A
2. B
223
224

Learning objectives:

1. Students will be able to compare and contrast traditional theories of dividend policy with the
Modigliani-Miller (MM) theory and the dividend irrelevancy theory, critically evaluating their
assumptions and implications on corporate financial decisions.

2. Students will identify and analyze the various internal and external factors affecting a firm's
dividend policy, including profitability, growth opportunities, liquidity, market conditions, and
shareholder preferences.

3. Students will understand the concept of dividend signaling, and assess how changes in
dividend policy can signal a company’s future prospects and financial health to investors
and the market.

4. Students will evaluate the importance of dividend stability in maintaining investor

confidence, and examine the strategies companies use to ensure consistent dividend
payments over time.

5. Students will differentiate between various dividend policies such as constant dividend
payout ratio (D/P), constant dividends per share (DPS), residual dividend policy, and zero
dividend policy, analyzing their advantages and disadvantages in different business
contexts.

6. Students will explain the concepts of stock dividends and stock splits, and assess their
impact on shareholder value, stock price, and company financials.

7. Students will evaluate the rationale behind share buybacks, understand their implications
on a company’s capital structure, earnings per share, and shareholder wealth, and compare
them with dividend payments as a method of returning value to shareholders.
225

Dividend decision

When deciding on the type of investment and level of finance needed, the financial
manager must have regard for the potential effects on the risk and level of dividends
payable to shareholders. If the shareholders are not happy with their return, they will be
reluctant to invest further, which in turn will affect the funding available for future
investment.

Links between the three key decisions

It is clear from the discussions above that the three areas are closely interrelated.

Investment decisions cannot be taken without consideration of where and how the
funds are to be raised to finance them. The type of finance available will, in turn,
depend to some extent on the nature of the project - its size, duration, risk, capital asset
backing, etc.

Dividends represent the payment of returns on the investment back to the

shareholdersthe level and risk of which will depend upon the project itself, and how it
was financed.

Fixed debt finance, for example, can be cheap (particularly where interest is tax
deductible) but requires a fixed payment to be made out of project earnings, which can
increase the risk of the shareholders' dividends.

Dividend Policy

One long-standing question in corporate finance is: Is shareholders' wealth affected by a

company's dividend policy?

Notice that the question is not asking whether dividends matter - of course they do (as
we know from the dividend valuation model) - what the question asks is whether the
chosen policy matters. Examples of such policies may include:

I. paying a constant annual dividend;

II. paying out a constant proportion of annual earnings;
III. increasing dividends in line with the annual rate of inflation, etc;
IV. paying out what's left after financing all future investment - the residual policy.

Four aspects to consider in relation to the payment of dividends are:

(1) Modigliani and Miller's (M & M) dividend irrelevancy argument.

(2) The clientele effect.

(3) The bird-in-the-hand argument.

(4) The signalling effect or information content of dividends.

226

FACTORS AFFECTING DIVIDEND POLICY:

Factor Aspect Explanation

Maintaining consistent A profitable company in a mature industry

dividends signals financial may prioritize returning profits to
Profitability
health and attracts income- shareholders, while a growing tech company
focused investors. might reinvest earnings into R&D.

A firm with high liquidity may distribute more

Ensuring sufficient liquidity
dividends to signal strong cash
to meet operational needs
Liquidity management, whereas a firm with liquidity
and investment opportunities
constraints may retain earnings to ensure
while also paying dividends.
operational stability.

Reinvesting earnings into

A biotech firm might forgo dividends to fund
new projects supports long-
Growth new drug development, aligning with its
term strategic objectives like
Opportunities strategy of achieving long-term growth
market expansion and
through innovation.
innovation.

A company with significant debt may reduce

Prioritizing debt servicing to or eliminate dividends to focus on debt
Debt Levels maintain credit ratings and repayment, signaling financial prudence and
financial stability. long-term sustainability to investors and
creditors.

Paying consistent dividends

Utility companies with stable earnings
Earnings appeals to risk-averse
streams often maintain high dividend
Stability investors seeking reliable
payouts to attract conservative investors.
income.

Adjusting dividend policies A consumer goods company might increase

based on economic and dividends in a strong economy to reward
Market
market conditions to balance shareholders and boost stock attractiveness,
Conditions
shareholder returns and while cutting dividends during a recession to
cash conservation. preserve cash.

Optimizing shareholder
If dividends are taxed at a higher rate than
Tax returns in a tax-efficient
capital gains, a company might opt for share
Considerations manner based on tax
buybacks over dividends.
policies.
227

Aligning dividend policies A mature company with a history of high

with investor expectations to dividends will continue this policy to retain
Investor
maintain shareholder income-focused investors, while a growth-
Expectations
satisfaction and attract a oriented firm might minimize dividends to
desired investor base. attract growth-seeking investors.

Ensuring compliance with

legal requirements and A bank might adjust its dividend policy to
Legal and
regulatory frameworks to comply with capital adequacy requirements,
Regulatory
maintain sufficient reserves balancing regulatory compliance with
Constraints
and adhere to financial shareholder returns.
regulations.

Adjusting dividend policies If peers in the industry offer high dividends, a

Competitive to remain competitive and company might follow suit to attract
Environment attractive to investors in the investors, even if it means adjusting its
industry. capital allocation strategy.

MM's Dividend Irrelevancy Theory

M & M's dividend irrelevancy theory says that the pattern of dividend payout should be
irrelevant. As long as companies continue to invest in positive NPV projects, the wealth of
the shareholders should increase whether or not the company makes a dividend payment
this year.

M & M's argument here is built up as follows:

(i) The return on a share is determined by the share's (systematic) risk.

(ii) The return itself is delivered to shareholders in two parts: one part is the
dividend paid and the other is the capital gain/loss in the share price.

(iii) The dividend decision that a company makes is a decision as to how the return is
delivered: how much of the annual earnings should be paid out as dividends and
how much of the annual earnings should be retained and re-invested within the
company - and so flow through to shareholders in the form of a capital gain on the
share price.

(iv) As the dividend decision does not affect the risk of the shares, it does not affect
their return. All the dividend decision therefore does is to determine how the return
is to be split up between dividends and capital gains.

(v) Do shareholders mind how their returns are split between dividends and
capital gains? The answer according to M & M is: no, they do not if we
assume:
228

(a) There are no taxes (really, there are no differences between the taxation
on dividends and on capital gains).

(b) Shares can be bought and sold free of any transaction costs (such as
stock-brokers' commission).

M & M argue that shareholders can 'manufacture' a dividend policy irrespective of the
company policy. For instance, if a person is holding shares for income but the company
withholds a dividend, the shareholder can sell some of the shares to replace the lost
income.

The assumptions that M & M make play a key role. Obviously, if dividends were taxed and
capital gains were tax free, shareholders would mind how their return was delivered - they
would strongly prefer it to be delivered in the form of capital gains rather than dividends.

Similarly, investors who were holding shares for the income they generated would mind
how their return was delivered if they had to incur transaction costs when realising their
capital gains so as to turn them into income - such investors would strongly prefer if the
return were delivered in the form of dividends, rather than capital gains.

However, given their assumptions hold good, M & M could claim that shareholders are
indifferent between dividends and capital gains and so the dividend decision / the dividend
policy that the company pursues is irrelevant.

Clientele effect

The Clientele Effect suggests different groups of investors (clienteles) are attracted to
different dividend policies based on their own preferences and tax situations. This theory
posits that a company’s dividend policy will attract a certain type of investor, and any
change in the dividend policy could lead to a shift in the investor base.

Investor Preferences:

Investors have different preferences for dividends based on their personal financial
situations, tax considerations, and investment goals. For instance, retirees or income-
focused investors might prefer companies that pay regular, high dividends because they
rely on this income for their living expenses. Conversely, investors in high tax brackets
might prefer companies that reinvest earnings rather than pay dividends to defer taxes
and benefit from capital gains, which are often taxed at a lower rate.

Tax Considerations:

Dividends are typically taxed as income, whereas capital gains are taxed only when the
asset is sold and often at a lower rate. Investors in high tax brackets may prefer low or
no dividend payouts to minimize immediate tax liability.

Tax-exempt investors (such as pension funds) or those in lower tax brackets might prefer
higher dividends since the tax impact is less significant for them.
229

Transaction Costs and Information Asymmetry:

Some investors might prefer dividends because they provide regular income without the
need to sell shares, thereby avoiding transaction costs.

Regular dividends can also signal company stability and profitability, reducing
information asymmetry for investors.

Stability in Dividend Policy:

Companies often strive to maintain stable dividend policies to cater to their existing
investor clientele.

Sudden changes in dividend policy can lead to dissatisfaction among current investors
and might force them to sell their shares, leading to price volatility.

Attracting Specific Investors:

By setting a particular dividend policy, a company can attract a specific type of investor.
For instance, high dividend payouts may attract income-focused investors, while low or no
dividends may attract growth-oriented investors.

Market Perception and Stock Prices:

If a company changes its dividend policy, it can lead to changes in the stock price as the
current clientele adjusts their portfolios. For example, reducing dividends might lead to
selling by income-focused investors, causing the stock price to drop, while increasing
dividends might attract these investors and boost the stock price.

The Clientele Effect highlights the importance of understanding investor preferences and
the potential impact of dividend policy changes on a company’s shareholder base.
Companies should carefully consider their dividend policies, aiming to attract and retain
the type of investors that align with their long-term strategy and goals. Understanding the
Clientele Effect can help companies maintain investor satisfaction and stability in their
stock prices.

The bird-in-the-hand argument

The "Bird-in-the-Hand" argument is a theory related to dividend policy that suggests

investors prefer dividends over potential future capital gains. This concept is based on the
proverb "A bird in the hand is worth two in the bush," implying that investors value the
certainty of dividends more than the uncertainty of future capital gains. This theory
contrasts with the Modigliani-Miller theorem, which posits that in a perfect market, dividend
policy is irrelevant to a company's valuation.

Preference for Certainty:

Investors view dividends as certain and tangible returns on their investment, whereas
capital gains are uncertain and depend on the future performance of the company.
230

Receiving regular dividends provides a sense of security and immediate income, reducing
the risk associated with waiting for potential price appreciation.

Reduction of Risk:

Dividends reduce the perceived risk of an investment. When investors receive dividends,
they realize some of their returns without relying solely on the company’s future growth
and market conditions.

The argument suggests that because dividends are perceived as less risky, investors
might require a lower rate of return on dividend-paying stocks, potentially increasing the
stock price.

Impact on Stock Valuation:

According to the Bird-in-the-Hand theory, companies that pay higher dividends may have
higher stock prices because investors are willing to pay a premium for the certainty of
receiving dividends.

Conversely, companies that retain earnings and reinvest them instead of paying dividends
might be valued lower by risk-averse investors.

Dividend Payout Ratio:

Companies might choose to adopt a higher dividend payout ratio to attract investors who
prefer the certainty of dividends.

A stable and consistent dividend policy can attract a loyal investor base that values
immediate returns.

Investor Attraction:

By offering higher dividends, companies can attract income-focused investors, such as

retirees or those seeking regular income.

This investor clientele might prioritize dividend stability over potential capital gains.

Market Perception:

A commitment to paying dividends can signal financial health and stability to the market.
It may imply that the company generates sufficient cash flow to support regular payouts.

This perception can enhance investor confidence and positively affect the company’s
stock price.

Contrasting Views – Modigliani-Miller Theorem:

The Bird-in-the-Hand argument contrasts with the Modigliani-Miller theorem, which

states that in a perfect market with no taxes, transaction costs, or information
asymmetry, dividend policy is irrelevant to a company's value.
231

According to Modigliani and Miller, investors can create their own dividend policy by
selling shares if they need cash, making the company’s dividend policy inconsequential.

The Bird-in-the-Hand argument suggests that investors prefer the certainty of dividends
over the potential for future capital gains, impacting their valuation of a company’s stock.
Companies may adopt higher dividend payout policies to attract and retain investors who
value immediate returns. Understanding this theory helps companies tailor their dividend
policies to meet investor preferences and potentially enhance their stock market
performance.

The signalling effect

The Signaling Effect refers to the idea that a company's dividend announcements convey
information to investors about the firm's future prospects and financial health. According
to this theory, managers use dividends as a tool to signal their confidence in the company's
future earnings and cash flow. Changes in dividend policy, such as initiating, increasing,
or cutting dividends, send important messages to the market.

It is widely believed that there are two very strong dividend signals:

(1) a reduction in the dividend per share signals that the company is in
financial difficulties;

(2) a failure to pay out any dividend at all signals that the company is very
close to receivership.

Thus a company must take great care not to reduce its dividend share (because, suppose,
it wishes to retain extra earnings to undertake a highly profitable investment), for fear that
the actions may be misinterpreted.

These ideas are very widely held in practice and this view is supported by Lintner who
discovered that dividend growth lagged two to three years behind earnings growth. This
evidence can be interpreted to mean that managers are reluctant to increase the dividend
per share until they are confident that they will be able to maintain that new level of
dividends in the future (and will not be subsequently obliged to reduce the dividend per
share).

Information Asymmetry:

There is often an information gap between a company's management and its investors.
Management has more and better information about the firm's current performance and
future prospects.

Dividend changes can bridge this information gap by signaling management’s view of the
company’s financial health and future profitability.
232

Positive Signals:

• Dividend Increases: When a company increases its dividend, it signals that

management is confident about the company's future cash flows and profitability.
This can lead to a positive reaction in the stock price.

• Initiating Dividends: When a company that previously did not pay dividends starts
paying them, it signals strong future earnings and financial stability, potentially
attracting more investors.

Negative Signals:

• Dividend Cuts: When a company reduces or eliminates its dividend, it may signal
financial trouble, declining future earnings, or cash flow problems. This often leads to
a negative reaction in the stock price.

• Maintaining Dividends in Tough Times: If a company maintains its dividend during

tough economic times, it may signal strength and resilience, positively influencing
investor perception.

Implications for Dividend Policy

Managerial Decisions:

Managers need to carefully consider the implications of dividend changes, as these

decisions send signals to the market that can significantly impact the company's stock
price.

Stable or increasing dividends are generally seen as positive signals, whereas cutting
dividends can raise concerns among investors about the company’s financial health.

Investor Reactions:

Investors closely monitor dividend announcements for signals about the company’s future
prospects. Positive signals can attract more investors and increase the stock price, while
negative signals can lead to selling pressure and a decline in stock price.

Strategic Dividend Policy:

Companies may adopt a conservative approach to dividend policy, paying dividends that
they are confident can be maintained or gradually increased over time.

By avoiding drastic changes in dividends, companies can maintain investor confidence

and avoid sending unintended negative signals

The Signaling Effect underscores the importance of dividend policy as a communication

tool between a company’s management and its investors. Dividend announcements can
significantly influence investor perceptions and stock prices by signaling management’s
233

confidence in the company’s future earnings and financial stability. Understanding the
signaling effect helps companies craft dividend policies that align with their strategic
goals and investor expectations, ultimately contributing to their market valuation and
investor relations.

This theory holds that investors read 'signals' into the company's dividend decision and
that these signals say as much about the company's future financial performance as they
say about its past financial performance. Thus management will not necessarily reduce
the dividend per share just because last year's performance was poor, if they believe
that next year's performance will be good.

If this theory is correct, and investors do indeed read signals into the dividend decision,
then the dividend decision becomes important: it becomes important for the company not
to give the wrong signal.

How to reconcile these differing views of dividend policy in the realworld

Given these contrasting views, how are managers to decide on the dividend policy that
they should pursue?

The answer is that, in the real world, like so much else in corporate finance, managers
have to make a judgement after taking many varying factors into account.

In this process they will consider:

(1) What dividends are our shareholders expecting (i.e. the clientele effect)?

(2) What dividend did we pay last time (i.e. we must not pay less than that
because of the signal that it might give)?

However they will also take into account a range of other factors, such as:

(3) Is it legal to pay out a dividend?

(4) Is the cash available to pay out a dividend?

(5) Do we have a minimum dividend cover ratio imposed on the company

as a loan condition?

(6) What is the tax impact of paying dividends?

(7) What investment opportunities does the company face?

(8) How difficult/expensive is it to raise external finance?

(9) What has been the rate of inflation (and so what dividend increase is needed to
maintain the purchasing power of last year's dividends)?

(10) What has been the capital gain/loss in the share price over the last

year?
234

DIVIDEND STABILITY:

The concept of "Dividend Stability" refers to a company's commitment to maintaining a consistent

dividend payout over time, regardless of short-term fluctuations in earnings or economic
conditions. This approach aims to provide investors with predictable and reliable income, fostering
investor confidence and potentially stabilizing the stock price.

Consistent Dividend Payments:

Companies with a stable dividend policy aim to pay a fixed or gradually increasing dividend over
time. This consistency helps attract and retain investors who rely on dividends for income, such
as retirees and income-focused investors.

Investor Confidence:

Stability in dividends signals to investors that the company is financially healthy and capable of
generating steady cash flows. This can enhance investor confidence and loyalty, leading to a
more stable shareholder base.

Smoothing Dividends:

Companies might smooth dividends by maintaining payouts even during periods of lower
earnings, using retained earnings from more profitable periods to cover shortfalls. This approach
helps avoid the negative market reactions associated with dividend cuts.

Long-term Planning:

A stable dividend policy requires careful long-term planning and prudent financial management.
Companies must ensure they have sufficient liquidity and reserves to support consistent dividend
payments.

Predictability for Investors:

Stable dividends provide a predictable income stream, making it easier for investors to plan their
finances. This predictability is particularly important for those who rely on dividends for regular
income.

Market Perception:

A stable dividend policy can positively influence market perception, portraying the company as
stable and reliable. This perception can result in a higher valuation and lower volatility in the
company’s stock price.

Attraction of Long-term Investors:

Stability in dividends can attract long-term, conservative investors who value steady income
over high, but volatile, returns. This can lead to a more stable and loyal investor base.
235

Challenges of Dividend Stability

Earnings Volatility:

Maintaining stable dividends can be challenging during periods of earnings volatility or economic
downturns. Companies must have sufficient financial reserves or access to credit to continue
paying dividends during tough times.

Opportunity Cost:

Allocating funds to dividends might limit the company’s ability to reinvest in growth opportunities,
pay down debt, or navigate financial challenges. Balancing dividend stability with the need for
reinvestment is crucial.

Pressure on Management:

The commitment to stable dividends can put pressure on management to maintain payouts even
when it might not be financially prudent, potentially leading to suboptimal financial decisions.

STOCK DIVIDENDS:

A stock dividend is a dividend payment made by a corporation to its shareholders in the form of
additional shares of stock rather than cash. This type of dividend increases the number of shares
held by each shareholder, but the total value of their holdings remains the same because the
increase in shares is proportional to their existing holdings.

Non-Cash Payment:

Instead of paying dividends in cash, the company distributes additional shares of its own stock
to shareholders. This helps the company preserve cash for other uses, such as reinvestment in
business operations or paying down debt.

Proportional Distribution:

Stock dividends are issued on a proportional basis. For example, a 10% stock dividend means
that for every 10 shares owned, shareholders receive an additional share. The ownership
proportion of each shareholder remains unchanged.

Increase in Outstanding Shares:

The issuance of stock dividends increases the total number of outstanding shares of the company.
This can lead to a decrease in the stock price per share, as the overall value of the company is
now spread over a larger number of shares.

Reasons for Issuing Stock Dividends

Preserving Cash:
236

Companies may choose to issue stock dividends to conserve cash for operational needs, debt
repayment, or investment opportunities, especially during times of cash flow constraints.

Signaling Growth:

Issuing stock dividends can signal to investors that the company expects strong future growth. It
indicates confidence in the company’s long-term prospects.

Attracting Investors:

Stock dividends can make the stock more attractive to certain types of investors, such as those
looking to reinvest dividends and compound their investment.

Improving Liquidity:

By increasing the number of shares outstanding, stock dividends can enhance the stock's liquidity,
making it easier for investors to buy and sell shares.

Impact on Shareholders

Dilution of Value:

While shareholders receive more shares, the overall value of their holdings does not change
because the stock price typically adjusts downward to reflect the increased number of shares.

For example, if a shareholder owns 100 shares of a company priced at $10 per share (total value
$1,000) and the company issues a 10% stock dividend, the shareholder will now own 110 shares.
If the stock price adjusts to $9.09, the total value remains approximately $1,000.

Tax Implications:

Stock dividends are generally not taxed until the shareholder sells the shares, at which point any
capital gains will be realized and subject to taxation. This can be advantageous for shareholders
in terms of deferring taxes compared to cash dividends, which are taxed as income when
received.

Strategic Considerations

Company Strategy:

Companies should consider their overall strategy and financial health when deciding to issue
stock dividends. They should ensure that the increase in outstanding shares aligns with their long-
term growth objectives and shareholder value creation.

Market Perception:

The market's reaction to stock dividends can vary. While some investors may view them
positively as a sign of confidence and growth, others may see them as a signal that the
company is not generating sufficient cash flow to pay cash dividends.
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Stock dividends offer an alternative way for companies to reward shareholders without depleting
cash reserves. By issuing additional shares, companies can signal growth, attract certain types
of investors, and improve stock liquidity. For shareholders, stock dividends provide an opportunity
to increase their holdings without immediate tax consequences, although they should be aware
of the potential for stock price dilution. Understanding the implications and strategic use of stock
dividends can help both companies and investors make informed decisions.

SHARE RE-PURCHASE

In past, share re-purchase had been illegal in Pakistan, but it is now possible and it represents
an alternative form of distribution to shareholders, other than the usual dividend payments.

If share re-purchase is restricted to amounts which could otherwise be used to pay dividends
then, in the absence of tax differences, share re-purchase gives corporate financial
management almost no additional opportunities compared with the payment of dividends.

Both options reduce equity and return funds to equity holders. The difference is that a dividend
is an equal cash return to all shareholders, whereas share re-purchase is a cash return of a
larger amount, but only to some shares. In this case, the only additional opportunity is that
share re-purchase for subsequent re-sale results in a temporary, rather than a permanent
dividend. However, even here its effect is similar to a conventional dividend payment followed
by a rights issue.

Benefits of share re-purchase

Having said this, the tax treatment of share re-purchase and the tax rates of shareholders may
well favour share re-purchase as a method of providing cash to a firm's equity holders. There
are also further benefits that share re-purchase can bring:

• Ability to alter leverage. Share re-purchase may assist in ensuring that any
desired increase in gearing can be carried out rapidly. However, providing the
desired adjustment requires share re-purchase of less than required earnings,
there is no greater opportunity available to financial management than already
exists with the payment of dividends.
• Reduction in the size of the company. Where circumstances indicate a reduction
in company size is desirable this can be achieved easily with share re-purchase.
Permanent reduction is facilitated by re-purchase and subsequent cancellation of
the shares.
• Financing problems may be eased. The ideal finance for a risky investment is
equity, but if the investment has a medium- or short-term life there may be a
reluctance to use equity, with a potentially infinite life, to fund such a project. The
possibility of a share re-purchase would make equity a variable life method of
finance.

The dangers of share re-purchase

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• Unrestricted re-purchase, without any liquidity requirements, could lead to the

privileged return of money to some shareholders at the potential expense of lenders,
creditors and remaining shareholders.
• A change in leverage is likely to alter the riskiness of debt with, again, a potential
wealth transfer between debt and equity capital.
•

Stock split

Split of Rs 10 ordinary shares into two shares of Rs 5 may result in great marketability.
Increase in market value (due to more marketability) will result in increase in
shareholder’s wealth.

Test your understanding 1 – Public v private sector

Public sector organisations do not have the requirement to produce 'profit' in the same
sense as the private sector. However, they are expected to work within budgets and
recognise aspects of financial management familiar to the private sector.

The following are four examples of differences between the public and private sector:

(1) A company that operates a chain of private hospitals uses a discount rate
of 16% to evaluate its investment decisions and generally expects an accounting
rate of return of 25%. A government-funded hospital trust is required to achieve a
return of only 6% on assets.

(2) Private sector companies are moving towards a more flexible approach to
budgeting. Organisations in the public sector are moving in the opposite direction
i.e. towards a more rigid approach to budgeting, enforced by the Treasury (up to
three years).

(3) Public sector pay is subject to government controls and has for many years failed
to keep pace with inflation. Market forces determine wages and salaries in the
private sector.

(4) Private sector companies can borrow in the market to finance their operations,
subject only to normal business cautions such as gearing ratios, investor
preferences and current economic conditions. The public sector is either not
allowed or severely discouraged from borrowing to fund operations.

Required:

Discuss the causes and consequences of THREE of the four scenarios outlined above,
using examples to illustrate your answer where appropriate.

7 Exam style questions

Test your understanding 2 – Stakeholders

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Quotation 1

The directors of all businesses must consider the wishes of all potential stakeholders for
whose support they are competing - not just owners but employees, suppliers, customers,
lenders, regulators and the community in which their business operates.

Quotation 2

'Stakeholder theory is incompatible with business and its objectives and should be firmly
resisted.'

Required:

Discuss the opposing arguments in the two quotations given above, and explain how these
views might be reconciled.

Test your understanding 3 – DEEWAN Ltd

DEEWAN Ltd is a large international company with widespread interests in advertising,

media and various consultancy activities associated with sales promotion and marketing.
In recent years the company's earnings and dividend payments, in real terms, have grown
on average by 15% and 12% per year respectively. The company is likely to have
substantial cash surpluses in the coming year, but a number of investment opportunities
are being considered for the subsequent two years. The senior managers of the company
are reviewing their likely funding requirements for the next two to three years and the
possible consequences for dividend policy.

At present the company has a debt : equity ratio of 1 : 5, measured in market value terms.
It does not want to increase this ratio at the present time but might need to borrow to pay
a maintained dividend in the future.

The senior managers of the company are discussing a range of issues concerning financial
strategy in general and dividend policy in particular.

Required:

Assume you are an independent financial advisor to the board of DEEWAN Ltd. Write a
report to the board which discusses the following issues:

i. The re-purchase of some of the company's shares in the coming year using the
forecast surplus cash, the aim being to reduce the amount of cash needed to pay
dividends in subsequent years. Other implications of share repurchase for the
company's financial strategy should also be considered.
ii. The advisability of borrowing money to pay dividends in years 2 and 3.
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iii. The likely effect on the company's cost of equity if the company decides on share
re-purchase and/or further borrowing.

Test your understanding answers

Test your understanding 1 – Public v private sector

(1) Rates of return

Capital is a scarce resource that firms must use efficiently. As a minimum, firms should
achieve a return that compensates for the opportunity costs incurred by investors and
which also allows for risk. The 16% discount rate applied to future cash flows presumably
is based on the risk-free rate plus a risk premium based upon the firm's Beta coefficient
and the risk premium on the market. The required return should be flexible, frequently
adjusted in line with changing market conditions i.e. interest rates and shareholder
requirements.

If the firm's objectives are logically structured, the accounting return of 25% mentioned
(but not defined) is consistent with achieving a DCF return of 16%. Firms often publish
their target ARRs but seldom disclose the discount rates they use.

Failure to achieve the target return is likely to lead to demands for changes in policies
and/or management. Because of this high degree of accountability in capital usage, funds
are more likely to be directed to optimal uses.

The 6% return on assets (again not defined) is a target imposed on the NHS hospital to
force efficient resources use. Returns are the charges imposed on budget-holding GPs
who refer patients for treatment, and an element of income from private treatment. The
6% criterion has applied for several years and is supposed to reflect the opportunity cost
imposed on society by diverting resources from the private to the public sector. It ignores
taxation and is a real return, i.e. inflation-adjusted. Failure to achieve this return does not
invite such severe consequences as in the private sector, nor is it used as a method of
capital allocation. Allocation of funds is by political process and rationing.

(2) Budgets

Budgeting has traditionally been applied in a directive top-down fashion - the Board and
its advisers determine the targets for the year and require lower management levels to
explain how it will meet the targets imposed. The bureaucratic top-down approach had
its merits in manufacturing organisations where the inter-linkages between departments
were linear, and objectives were understood and accepted. However, as advanced
economies become more service-orientated and knowledge-based, new managerial
control structures become more appropriate. Budgeting becomes increasingly devolved
to business units responsible for separate products and markets, and more attuned to
emerging opportunities. This reflects the demise of the middle manager as firms
become 'flatter' and more 'hollow'. So long as individual units meet their cash flow and
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return on assets objectives, they are allowed to become far more autonomous.
Empowerment or devolvement of responsibility for the annual budget frees senior
managers to concentrate on longer term strategic issues e.g. acquisitions and strategic
alliances. Some firms have even abandoned budgeting totally as a management tool,
trading loss of detailed control for greater flexibility and responsiveness to external
developments. Indeed, no or devolved budgeting is seen as a way of encouraging and
managing change, whereas the traditional top-down model often stifled change.

In the public sector, particularly in services, formal budgeting is very much in its infancy.
Senior managers have to produce a balanced budget, in line with resources granted out
of taxation income, and have little scope for raising extra capital apart from limited
borrowing powers and asset sales. Public sector budgeting still reflects a bureaucratic
style of management with rigid notions of external accountability. Budgeting is thus a
way of controlling change and tends to slow the ability of employees to respond to
developments in the external environment, in particular, to the changing needs of
service users.

(3) Pay

To compete effectively, managers need to command resources matched to the

requirements of the firm's strategy. If its present capabilities fall short of resource
requirements, it must pay the going market rates to buy in more resources,or train
existing staff accordingly, otherwise they will miss out on market opportunities.

Pay in the public sector is based on years-of-service-related scales with jump points
corresponding to promotion between grades. There is little or no payment by results
which stifles initiative and responsibility. The level of public sector pay is typically
unresponsive to market realities, insofar as job content comparisons are meaningful.
Indeed, they are frequently held down as an instrument of government policy. Capping
public sector pay is supposed to demonstrate responsibility to other employers and also
helps restrain public expenditure and the Borrowing Requirement - key tools in
controlling inflation. The result is widespread loss of morale, reduced job commitment
and resignation by people seeking better pay and conditions (but often with lower job
security) e.g. teachers and nurses. The resulting chronic de-skilling is particularly
prevalent in information technology and finance.

(4) Borrowing

Financial markets exist to match the needs of 'deficit units' (seekers of finance) with
'surplus units' (providers of finance). A variety of forms of raising finance is available,
each appropriate to the risk-return preferences of the investor. At any time, there exists a
clear 'risk-return trade-off' which summarises these opportunities, and thus specifies the
return required by purchasers of different financial securities or 'claims' over firms' cash
flow. The benchmark rate is the yield on government securities - beyond this, the higher
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the risk, the greater the required return. Firms can thus choose which form of finance is
most appropriate for their particular needs at any time. Private firms borrow when
conditions are not right to raise other forms of finance e.g. the stock market may have
been saturated with a spate of rights issues, or they want to lower their weighted
average cost of capital.

Whatever the reason, they know that interest must be paid as a prior charge against
profits before owners receive a dividend, and that failure to meet interest obligations
invites the risk of insolvency.

The public sector receives finance primarily from tax revenue. As the ability to raise
taxes between Budgets is limited, the government's fiscal stance can be de-railed by a
shortfall in economic growth that stunts tax revenues, necessitating borrowing to plug the
gap. The present Chancellor adheres to the 'Golden Rules' of public finance that
borrowing should only be undertaken for long-term capital projects, and the budget
should be roughly balanced over the economic cycle. He is further constrained by
wanting to meet the Euro membership criterion that total public sector debt should not
exceed 60% of GDP.

At the level of the individual public sector organisation, borrowing opportunities are
minimal, although the Private Finance Initiative has emerged to encourage partnerships
between public and private organisations. However, these take time to organise and
require close control to ensure accountability and avoid fraud. This means that, whereas
in the private sector a firm can usually obtain finance for a sound project, thus responding
to perceived market opportunities, in the public sector investment is typically constrained
by the ebb and flow of taxation revenue and planning and implementation delays.

Test your understanding 2 – Stakeholders

A sensible starting point is to list the various stakeholders and show how their interests
may conflict, before reconciling the two statements.

A firm is a collection of contributors, all of whom have a stake in its ongoing success and
survival. In a narrow sense, their respective interests are bound to conflict if pushed to the
limit.

Owners - want maximum dividends and share price.

Lenders - want maximum security for their investment.

Managers - want maximum pay and other forms of remuneration.

Other employees - want maximum pay for minimum effort plus optimal health and safety
standards.

• Customers - want maximum quality at minimum price plus maximum credit.

• Suppliers - want minimum settlement delay.
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• Government - wants maximum tax take.

• Society - wants maximum environmental safeguards, contributions to charity and local
community projects.

If pushed to the limit, most of these aims are likely to bankrupt the business. If
shareholders' aims are pursued neglecting all else, it requires screwing down wages and
conditions to minimal levels, racking up prices to take maximum advantage of short-term
opportunities, never paying suppliers until threatened with legal action, and so on.

Such behaviour is not just anti-social, it is anti-survival. It will attract critical attention from
the government and other bodies, resulting in penalties, fines and ongoing scrutiny which
will damage the firm's reputation and market position irretrievably.

The SWM aim is not a short-term profit maximising aim. It aims to create sustainable and
permanent value for owners. It is thoroughly consistent with treating customers and
employees well and building up an image as a respected contributor to society.

It is thus easy to reconcile the two statements - firms that treat their stakeholders badly
are unlikely to survive into the long term. To 'consider the wishes of all potential
stakeholders' does not require maximising everyone's particular interests but striking a
balance between them to the ultimate and ongoing benefit of all. This is simply good
business.

Test your understanding 3 – DEEWAN Ltd

Report

To: Board of Directors, DEEWAN Ltd

From: Independent financial advisor

Date: XX/XX/XX

Re: Dividend policy and other financing issues

You are currently considering the current and future position of the company as regards
dividend payments and financing over the next two to three years, in the light of your
current cash surplus and the investment opportunities available to you from next year. This
report addresses the following issues:

• the implications of share re purchase to reduce future dividend payments;

• borrowing funds to finance dividends;
• the possible effects on cost of equity if either or both of the above actions are taken.
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(i) Share re-purchase

You are likely to have substantial cash surpluses in the coming year. Your first decision is
to decide how much to distribute, bearing in mind both your investment financing
requirements in the future and the possible reactions of shareholders and other market
players. In the current climate, it is expected that 'spare' cash, in excess of that required
for specific profitable investment opportunities, should be returned to the shareholders to
do with as they wish.

You have some investment opportunities open to you in the near future. Whether or not
you have to retain some of the current surplus cash to fund these will depend upon the
extent to which you expect there to be spare funds generated in the next two or three
years.

Once the amount to be distributed (if any) has been decided upon, you then need to decide
whether to return it to all the shareholders as a dividend, or to some of them in the form of
a share re-purchase. The latter option will result in only a small number of shareholders -
likely to be the large institutional investors receiving cash, although their proportionate
holding, and therefore entitlementto future dividends, will be reduced. Other shareholders
will have to sell shares, incurring transaction costs, to 'manufacture' dividends should they
need them.

It should be noted that a share re-purchase is administratively more complex in that it

requires prior approval from a general meeting of shareholders (assuming the Articles of
Association provide that it can happen at all).

The two types of distribution will also affect share prices differently. When a dividend is
declared, the value of the shares falls from cum-div to ex-div, the shareholders having had
some of their capital investment realised as cash.

In theory, if the share re-purchase is made at current market price, a share re-purchase
should leave the individual share price unchanged - there has been a reduction in total
market value in proportion to the total number of shares in issue.

It should also be noted that a share re-purchase would result in a higher future EPS figure
than if a normal dividend had been paid. However this should not affect the market's
perception of the health of the company, as it is purely a result of the same earnings being
spread over a smaller number of shares.

Overall, it would appear that there is no particularly strong argument for a share
re-purchase in preference to a dividend payment to all shareholders. Whilst you may see
this as a means of reducing future dividend payments, it is likely that the remaining
shareholders, who would be holding a greater proportion of shares than previously,
would expect a higher dividend per share. If this expectation is not met, share prices may
be affected adversely.
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(ii) Borrowing to pay dividends

If it is decided to distribute an amount in the current year that cannot be maintained (with
planned growth) in future years out of operational cash flows, then additional funds will
need to be borrowed.

This will raise the company's gearing level above the current 1:5 debt:equity ratio, with
two consequences. First, the company will be funded by a greater proportion of cheap
finance, particularly as debt interest is tax deductible. Second, shareholders may perceive
a greater risk as being attached to their dividends, as more of the earnings are attributed
to fixed interest payments. It is a question of finding the optimum balance between these
two effects.

(iii) Effects on cost of equity

The probable effect of increasing the gearing level will be, as discussed in (ii) above, to
increase the required return by (cost of) equity.

Borrowing will directly affect the gearing level, by increasing the debt element.

The payment of a dividend or a share re-purchase will also increase the gearing level, by
lowering the value of the equity (as discussed in (i) above, a dividend results in a lower
share price with the number of shares being maintained; a share re-purchase results in
a maintained share price with a lower number of shares).

Thus both actions may result in a higher cost of equity.

Overall recommendations

It is advised that any surplus cash over and above the needs of all positive NPV
investments should be paid out in the form of a dividend. This 'residual' dividend policy
may lead to fluctuating dividends, however, and institutional investors generally prefer a
steady dividend pattern; you will need to keep a careful eye on your share price to ensure
it is not being adversely affected in the long term.

Should you need to borrow in the future, you should find this to your advantage, as your
current gearing level is quite low, and the benefits of cheaper debt should outweigh any
increase in cost of equity.
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Learning objectives:

a) Understand the reasons for performing valuations in various business

contexts and scenarios.

b) Explain different asset valuation bases and their applications in financial

analysis.

c) Comprehend earning valuation bases and how they are used to assess a
company's financial performance.

d) Analyze dividend valuation bases and their role in evaluating investment

returns.

e) Apply cash flow valuation methods to determine the value of a company or

asset.

f) Calculate Economic Value Added (EVA) and Market Value Added (MVA) to
measure a company's financial performance and value creation.

g) Understand the valuation of intangible assets using the Cost, Income, and
Market (CIV) approach.

h) Identify and address common valuation issues and challenges in financial

analysis.
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1 Overview of Chapter

2 Introduction to business valuation

Business valuation is the process of determining the economic value of a business
or company. This process involves assessing various aspects of the business,
including its financial performance, assets, liabilities, and market conditions, to
estimate its fair market value. Business valuation can be performed using different
methodologies, depending on the nature of the business, the purpose of the
valuation, and the available data.
Business valuation is not a precise, scientific process. The value of a business is
affected by:

• reported sales, profits and asset values

• forecast sales, profits and asset values
• type of industry
• level of competition
• range of products sold
• breadth of customer base
• perspective – the buyer and the seller will often have different expectations and
hence may value the business differently.

The valuation methods covered in this Chapter give suggested values of a business.
249

The final value is then agreed between buyer and seller after a process of
negotiation.

Situations requiring business valuation:

S# Factor Explanation
1 Buying or When purchasing or selling a business, both parties
Selling a need to agree on a fair price. A business valuation
Business provides an objective estimate of the business's
worth.
2 Mergers and In mergers and acquisitions, valuation helps
Acquisitions determine the appropriate exchange ratio of shares
or the cash value to be paid.
3 Raising Companies seeking to raise capital through equity
Capital financing need a valuation to negotiate terms with
investors.
4 Litigation: In legal disputes, such as shareholder disputes, divorce
settlements involving business assets, or bankruptcy
proceedings, a business valuation is necessary to
determine the value of the business involved.
5 Taxation Valuation is required for various tax purposes, including
estate planning, gift taxation, and determining capital
gains tax.
6 Financial For compliance with accounting standards, businesses
Reporting: need valuations for impairment testing, purchase price
allocation in business combinations, and fair value
measurement of certain assets and liabilities.
7 Exit Business owners planning their exit strategy (retirement
Planning: or transitioning ownership) need to understand the
value of their business to plan effectively.
8 Strategic Companies might conduct valuations to assess their
Planning: market position, evaluate the impact of strategic
decisions, or for performance measurement and
incentive plans.

Valuation of listed and unlisted companies

Listed companies
A listed company will have a stock market value (or market capitalization).
If small numbers of shares are being traded on the stock market, this share price will
be used by traders.

However, if one company is attempting to take over another acquiring the majority of
the shares, the market capitalization value will not necessarily give a suitable value
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for the transaction, since the shareholders will not have any incentive to sell their
shares at the current market price.
In order to encourage the shareholders in the target company to sell their shares, a
premium is normally offered on top of the current stock market share price.
In conclusion, when valuing a listed company, the current stock market share price
should be used as a starting point for the calculations rather than as a definitive final
figure.

Unlisted companies
An unlisted company has no stock market value, so the valuation process is more
complex. Also, there is likely to be less published information available which might
help a purchaser to assess the value of an unlisted company.
Therefore, when valuing an unlisted company, estimates often have to be made,
based on available information taken from similar listed companies (“proxy”
companies).
The valuation methods shown below often value unlisted companies using data
derived from proxy listed companies e.g. cost of equity, beta, dividend yield, P/E ratio
In practice, it can be difficult to find a similar listed company.
The final answer may have to be discounted by 25% to 35% to account for:

• Relative lack of marketability of unquoted shared – it is more difficult for investors

to sell their shares if the company is not listed

• Lower levels of scrutiny, therefore greater risk of poor quality financial

information.

• Higher risk of being a smaller, less well – regarded company with, possibly, a
more volatile earnings record.

3 The different valuation methods

There are three basic ways of valuing a business:
Net asset based valuation method
The business's assets form the basis for the valuation. Net asset based valuation
methods are difficult to apply to businesses with high levels of intangible assets, but
this Chapter covers methods of valuing intangible as well as tangible assets.

Earnings based valuation method

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The projected earnings for a business will give an indication of the value of that
business. For example, a business with high forecasted earnings will be attractive to
a potential purchaser, and hence will be valued highly. In this Chapter, we shall see
how earnings and dividends (which are dependent on earnings) can be used in
business valuation.

Discounted cash flow method

In theory, a business's value should be equal to the present value of its future cash
flows, discounted at an appropriate cost of capital. This Chapter explains how to
identify and forecast future cash flows, and how to choose an appropriate discount
rate.

Exam approach
Frequently, the compulsory case study (Section A) question in the examination will
give information on an entity and request the candidate to calculate a range of values
for that entity.
Part of the test is not only to be able to use the various methods to calculate values
but to understand the circumstances in which each is most appropriate.
For example asset-based valuations have very limited relevance for entities which
are going concerns especially if they have substantial intangible assets.
In each of the following sections, the various valuation methods are explained
together with the circumstances in which they might be most appropriate.

4 Net asset based valuation

In this method the company is viewed as being worth the sum of the value of its net
assets.
Remember to deduct borrowings when arriving at a net asset value if just the equity
is being acquired, but not if only the physical assets and related liabilities are being
purchased without acquiring any liability for the borrowings.
A net assets based valuation is most useful when a company is being broken up,
rather than purchased as a going concern. Since the method does not incorporate
the valuation of intangible assets, it usually gives a low valuation figure, which
helps the parties to set a minimum price in a takeover situation.
Asset valuations are therefore likely to be more useful for capital-intensive
businesses, than for service businesses, where many of the assets are intangible.

Alternative asset valuation bases

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The net asset valuation can be calculated in various ways:

Book value
This method suffers from being largely a function of depreciation policy, for
example, some assets may be written down prematurely and others carried at
values well above their real worth. Original costs may be of little use if assets are
very old, or if asset replacement has been irregular over time.
Thus, this method is of little use in practice.

Replacement value
This method calculates the cost of replacing the business's assets, which may be
relevant if the assets are going to be used on an ongoing basis.

Break-up value / Net realizable value

Individual assets are valued at the best price obtainable, which will depend partly on
the secondhand market and partly on the urgency of realizing the asset.
This method can be used to set a minimum selling price for the vendors, as they
could liquidate the business as an alternative to selling the shares.

The strengths and weaknesses of net asset based valuations

The main strengths of asset-based valuations are:

• the valuations are fairly readily available;

• they provide a minimum value of the entity.

The main weaknesses of asset-based valuations are:

• future profitability expectations are ignored;

• balance sheet valuations depend on accounting conventions, which may lead to
valuations that are very different from market valuations;
• it is difficult to allow for the value of intangible assets such as intellectual property
rights.

More detail on net asset based valuation

A net asset-based valuation method for a listed company will usually give a value
considerably lower than the market value of all the company’s shares (the market
capitalization value).
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So it should be obvious that shareholders/ the market does not value the company
on the basis of the balance sheet’s net asset figure.
Shareholders are not buying the company for its assets but for the income those
assets can produce.
This future income is generated from the use of the balance sheet assets together
with the non-balance sheet assets (intangible assets) like highly skilled workforce,
strong management team and completive positioning of the company’s products.
Thus assets in the crude sense of balance sheet values are only one dimension of a
company’s overall value (in a normal going concern situation).

Example 1
The summarized balance sheet (statement of financial position) of Owen at 31
December 20X7 is as follows:

Assets Rs 000
Non-current assets 23,600
Current assets 8,400
–––––
32,000
Equity and liabilities –––––
Capital and reserves
Rs 10 Ordinary shares 8,000
Retained earnings 11,200
–––––
19,200
Non current liabilities
6% Unsecured bond 8,000
Current liabilities 4,800
–––––
32,000
–––––
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Required:
Calculate the value of one ordinary share in Owen, using net assets based valuation
method.

Example 2
Fowler wants to make a bid for Owen (see details for Owen in the previous Example).
It has estimated that the replacement cost of Owen's noncurrent assets is Rs 40
million.

Required:
Calculate the value of a share in Owen from Fowler's perspective.

Example 3
Ray Ltd, a listed manufacturing company, is considering a takeover bid for Ribbon
Ltd, a smaller, unlisted company in the same industry.

Ribbon Ltd has been making losses in the last 2 years, so it is considered that an
asset based method should be used to value the business.

Extracts from Ribbon Ltd’s Statement of Financial Position

Assets Rs 000
Noncurrent assets (Note 1) 1,207
Current assets (Note 2) 564
–––––
1,771
Equity and liabilities –––––
Capital and reserves
Rs 10 Ordinary shares 100
Retained earnings 553
–––––
653
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Noncurrent liabilities
5% bonds 600
Current liabilities 518
–––––
1,771
–––––
Note 1: The noncurrent assets comprise specialized manufacturing equipment. To
replace the equipment would cost Rs 1.5m, but if Ribbon Ltd were to be closed down,
the assets would sell for no more than Rs 1m.
Note 2: Receivables contain an amount of Rs 120,000 from a large customer which
has just gone into liquidation. A contract for the same customer, included in work in
progress (inventory) at a value of Rs 30,000 will now have to be scrapped.

Required:
Calculate the expected valuation of Ribbon Ltd, from the perspective of Ray Ltd.
Explain and justify your figures.

5 Valuation of intellectual capital / intangible assets

Definition of intellectual capital

The term ‘intellectual capital’ has many complex connotations and is often used
synonymously with intellectual property, intellectual assets and knowledge assets.
Intellectual capital can be thought of as the total stock of capital or knowledge-based
equity that the entity possesses. As such, intellectual capital can be both the end
result of a knowledge transformation process or the knowledge itself that is
transformed into intellectual property or intellectual assets of the firm.
Intellectual capital includes:
Human resources – The collective skills, experience and knowledge of employees
Intellectual assets- knowledge which is defined and codified such as drawing,
compute program or collection of data
Intellectual property – Intellectual assets which can be legally protected such as
patents and copyrights.
Intellectual property is legally defined and assigns property rights to such things as
patents, trademarks and copyrights.
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These assets are the only form of intellectual capital that is regularly recognized for
accounting purposes.
However, accounting conventions based upon historical costs often understate their
value:

Valuation of intellectual capital / intangible assets

It is recognised that goodwill, brands and other intellectual capital (intangible assets)
often have a significant value. Indeed often intellectual capital is the main contributor
of value to an entity.
The net asset based methods covered above do not incorporate this value.
There are two ways of valuing the intangible assets of an entity:

(1) Simple estimate:

Value of intangibles =
Value of equity (either using a quoted market capitalization or using one of the
earnings based methods below i.e. DVM, P/E method, or PV of future cashflows)
minus
Value of the tangible assets (see Net Asset Valuation above)

(2) Calculated Intangible Value (CIV) method:

The CIV method examines the excess return earned by the entity over the return
expected on its tangible assets (this excess is called the Value Spread). The
discounted value of the post-tax Value Spread is the CIV of the entity, and then:

Total value of equity = Value of tangible assets + CIV

Example 4
Chapman Co has just reported a pre tax profit of Rs 24.29m, and the value of its
tangible assets in the balance sheet is Rs 128.66m.
The average return on assets for companies in the same industry is 10%.
The tax rate is 30% and Chapman Co's cost of capital is 16%.

Required:
Calculate the value of Chapman Co using the CIV approach.
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6 Earnings based valuation – the dividend valuation model

Dividend Valuation Model (DVM) Theory
The theory states that the value of the company / share is the present value of the
expected future dividends, discounted at the shareholders’ required rate of return.
This links to the NPV method covered earlier, where the discounted cash flows from
a project represented the gain in wealth to shareholders if the project were
undertaken wealth (share value) is linked to discounted future cash flows.

DVM formula

do do(1 + g)

Either: Po = —— Po = ————

ke ke – g

Assuming: a constant dividend or constant

growth

Note that:

g = forecast future growth rate in dividends, and:

Po = Value of company, when do = Total dividends
Po = Value per share, when do = Dividends per share

Also, note that the simple formula (when assuming a constant dividend) is just a
rearrangement of the standard dividend yield formula:

Dividend yield = (Dividend / Share price) × 100%

Example 5
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Target has just paid a dividend of Rs 250,000. It has 2 million shares in issue.
The current return to shareholders in the same industry as Target is 12%, although
it is expected that an additional risk premium of 2% will be applicable to Target, being
a smaller and unlisted company.

Required:
Calculate the expected valuation of Target, if
(a) dividends are expected to be constant
(b) dividends are expected to grow at 4% per annum

The strengths and weaknesses of dividend-based valuations

The strengths of dividend-based valuations are:

• value is based on the present value of the future dividend income stream, so the
method has a sound theoretical basis;
• they are useful for valuing minority shareholdings where the shareholder only
receives dividends from the entity (rather than a share of total assets or cash
flows – factors which form the basis of the other valuation methods).

The main weaknesses of using dividend models include:

• investors tend to have very different expectations from each other, so it is difficult
to estimate what dividends will be in the future (Modigliani and Miller’s theories
can hardly cope with the present-day wide difference in attitude between
institutional and individual investors);
• most investors look for a return based on two components: dividend and capital
appreciation leading to capital gain on sale of the shares the DVM approach only
looks at the dividend element;
• it is difficult to estimate a future growth rate;
• particularly for unlisted companies, it can be difficult to estimate the cost of equity
(note that in the exam, if you are not given the cost of equity, you should use
CAPM to derive it, or use proxy company information);
• dividend-based valuations are suitable for valuing small shareholdings rather
than for valuing a controlling interest.

Uneven growth rates

The dividend valuation model formula cannot be used directly when the annual
growth rate is expected to change.
In such cases, the entity’s lifespan should be segmented into the periods for which
the varying growth rates apply, and value each separately.
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Illustration 1
Target has just paid a dividend of Rs 250,000. It has 2 million shares in issue.
The current return to shareholders in the same industry as Target is 12%, although
it is expected that an additional risk premium of 2% will be applicable to Target, being
a smaller and unquoted company.

Required:
Calculate the expected valuation of Target, if dividends are expected to stay constant
for 3 years, then grow at 4% per annum thereafter.

Solution:
Separate the future dividend stream into two parts: first, the constant dividends for 3
years, then the growing perpetuity thereafter.

First 3 years
Present value of expected dividends = 250,000 x AF 1-3 (14%) = Rs 0.580m

Perpetuity from year 4:

Use the given DVM formula, then adjust for the fact that the dividend stream starts
in year 4, not year 1 as normal:

[(250,000x1.04) / 0.14–0.04)] x DF 3 (14%) = Rs 1.755m

Total value = 0.580m + 1.755m = Rs 2.335m

or 2.335 / 2 = Rs 1.17 per share.

7 Earnings based valuation – the P/E method

The P/E valuation method is a very simple method which values a business by
applying a suitable P/E ratio to the business's earnings (profit after tax).

P/E valuation method formula

Value of company = Total post-tax earnings× P/E ratio
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Value per share = EPS × P/E ratio

Using the P/E valuation formula

The P/E ratio method is the simplest valuation method. It relies on just two figures
(the post-tax earnings and the P/E ratio).

Post tax earnings

The current post – tax earnings, EPS, for a company can easily be found by looking
at the most recent published accounts. However, these published figures will be
historic, whereas the earnings figure needed for valuation purposes should be an
expected, future earnings figure.
It is perfectly acceptable to use the published earnings figure as a starting point, but
before performing the valuation, the historic earnings figure should be adjusted for
factors such as:

• One-off items which will not recur in the coming year (e.g. debt write offs in the
previous year);
• Directors salaries which might be adjusted after a takeover has been completed;
• Any savings (“synergies”) which might be made as part of a takeover.

P.E ratio
The P/E ratio for a listed company is a simple measure of the company’s share price
divided by its earnings per share.
The P/E indicates the market’s perception of the company’s current position and its
future prospects. For example, if the P/E ratio is high, this indicates that the company
has a relatively high share price compared to its current level of earnings, suggesting
that the share price reflects good growth prospects of the company
An unlisted company has no market share price, so has no readily available P/E
ratio. Therefore, when valuing an unlisted company, a proxy P/E from a similar listed
company is often used.

Proxy P/E ratios

An explained above, and unlisted company will not have a market – driven P/E ratio,
so an industry average P/E, or one for a similar company, will be used as a proxy.
However, proxy P/E ratios are also sometimes used when valuing a listed company
– of course if a listed entity’s own P/E ratio is applied to its own earnings figure, the
calculation will just give the existing share price.
261

In particular, proxy P/E ratios are used in the context of bootstrapping which is
covered in the next Chapter.

Example 6
Molier is an unquoted entity with a recently reported after-tax earnings of Rs
3,840,000. It has issued 1m ordinary shares. A similar listed entity has a P/E ratio of
9.

Required:
Calculate the value of one ordinary share in Molier using the P/E basis of valuation.

The strengths and weaknesses of earnings-based valuations

The main strengths of earnings-based valuations are:

• they are commonly used and are well understood;

• they are relevant for valuing a controlling interest in an entity.

The main weaknesses of earnings-based valuations are:

• they are based on accounting profits rather than cash flows;

• it is difficult to identify a suitable P/E ratio, particularly when valuing the shares
of an unlisted entity;
• it is difficult to establish the relevant level of sustainable earnings.

Example 7
Company X is considering a bid for Company Y.
X has earnings of Rs 3m per annum, and Y has earnings of Rs 1.5m per annum.
The P/E ratio of X is 12 and that of Y is 8.
If the takeover proceeds, it is expected that synergies of Rs 0.5m per annum will be
generated, and that the combined company will have a P/E ratio of 11.

Required:
Calculate the maximum price that X should pay for Y, and the minimum price that Y
should accept.

Earning yield method

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In some question, you may not be given the P/E ratio, but you may be given the
Earnings Yield instead.
The earnings yield is the reciprocal of the P/E ratio i.e. Earnings Yield = 1/(P/E ratio).
Hence,

Value of company = Total earnings / Earnings Yield

Value per share = EPS/ Earnings Yield
Understanding and interpretation of Earnings Yield

Some deeper analysis is desirable, for example earning the trend of share price over
a number of quarters in the light of any events such as profits warnings and
acquisitions (or rumors thereof), and the likely effect that they have had on earnings.
The stability of Earnings Yield is often as important as its growth, bearing in mind
that in a general way the market is absorbing new information to try to assess a
sustainable level of EPS on which to base growth for the future. Clearly, effective
growth is dependent on a stable base, and the trend of Earnings Yield over time is
to an extent a reflection of this factor.
A prospective acquirer would, of course, be concerned to assess the worth of a
prospective biddee on the basis of its becoming part of the acquiring entity, and the
valuation will especially need to take into account the expectation of the biddee’s
shareholders.
A further point relates to the acquirer’s intentions regarding the biddee. If, for
example the latter entity is to be partially demerged, that is certain parts disposed of
two other entities in which they would provide a better fit, and then the share price
valuation may will be greater than if the whole biddee entity was to be retained.
Nevertheless, any such break-up considerations will need to take into account all the
stakeholders, including employees, suppliers and customers of the biddee, as any
serious demonization will take away from the good will value of the acquisition and
quite possible damage that of the acquiring entity itself.

8 Discounted cash flow method

Overview of the method
Under the discounted cash flow (DCF) method, a value for the equity of the entity is
derived by estimating the future annual after-tax cash flows of the entity, and
discounting these cash flows at an appropriate cost of capital.
This is theoretically the best way of valuing a business, since the discounted value
of future cashflows represents the wealth of the shareholders (as seen in the earlier
Chapter 'Investment Appraisal basic techniques').
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The cost of capital used to discount the cash flows should reflect the systematic risk
of the cash flows.

Example 8
The expected after-tax cash flows of Thomas, an all equity financed company with 2
million shares in issue , will be as follows:

Year Rs
1 120,000
2 100,000
3 140,000
4 50,000
5 onwards 130,000

A suitable cost of capital for evaluating Thomas is 12%.

Required:
Calculate the value of Thomas's equity (in total and per share) using the DCF basis
of valuation.

More details on cash flows and cost of capital

Free cash flows
Ideally, free cash flows should be used in DCF valuations rather than post-tax post-
financing cash flows.
Free cash flows are similar to post-tax post-financing cash flows, except that they
include average sustainable levels of capital and working capital net cash flow
investments over the longer term rather than this year's figures.
Post-tax cash flows (after financing charges) are often used as an approximation for
free cash flows.
However, where sufficient information is provided in a question to enable free cash
flows to be calculated, free cash flows should be used in the DCF valuation instead
of post-tax
Post-financing cash flows.
264

The concept of “free cash flows”

The cash flow available for distribution to investors after the entity has made all the
investments in non-current assets and working capital necessary to sustain ongoing
operations is referred to as “free cash flow”.

Definition:
Free cash flow: Cash flow from operations after deducting interest, tax, preference
dividends and ongoing capital expenditure, but excluding capital expenditure
associated with strategic acquisitions and / or disposals and ordinary share
dividends.

Use of free cash flows

The value of the shareholder’s stake (equity) in an entity is then the sum of the future
free cash flows discounted at the cost of equity.
Note that if we assume that a company pays out all of its free cash flow as a dividend,
the DCF company valuation method (where free cash flows are discounted at cost
of equity) will give exactly the same result as the DVM valuation method introduced
earlier in the Chapter, where the free cash flows used in the DCF calculation are
assumed to grow at a constant rate and the same growth rate is used in the DVM
valuation.

The problem of block information

In a project appraisal, the cash flows generated from the project are easily
identifiable, but in a business valuation they are not necessarily.
This is because there are so many of them, and because the necessary
information does not usually exist in the public domain.
Therefore, for business valuation, we often have to estimate cash flows using the
readily-available accounting information.

Illustration 2 - Free cash flows

The recently published accounts of Carey show the following figures:
Operating profit (after deducting depreciation of Rs 3m) = Rs 32m interest paid = Rs
2m
Taxation = Rs 9m
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Capital expenditure = Rs 4m, which is assumed to represent a sustainable level of

investment non-current assets.

Required:
Calculate the free cash flow in the year.

Solution:
Free cash flow = 32m +3m -2m -9m -4m = Rs 20m

An appropriate cost of capital

The introductory paragraph above explained that "an appropriate cost of capital"
should be used for discounting. In some exam questions, you will be told directly
which cost of capital to use. However, in other cases you will be expected to either
calculate or select an appropriate cost of capital. It is then important to understand
the following relationships:

Use of cost of equity as a discount rate

The cost of equity can be used to discount the free cash flows ([Link]-tax cash
flows AFTER financing charges) in order to value the equity in a company directly.

Use of WACC as a discount rate

WACC can be used to discount post-tax cash flows BEFORE financing charges
when valuing a project or an entity (debt + equity value). To find the company's equity
value, the value of debt would need to be deducted.

In summary:
266

ENTITY VALUE EQUITY VALUE / SHAREHODLER

VALUE

• Use cost of equity to discount

• use WACC to discount post-tax free cash flows
cash flows BEFORE financing (or post – tax cash flows AFTER
charges
financing charges as an
approximation to free cash flows
where free cash flows are not
known)

DEBT VALUE

Use of proxy company information

The cost of capital used must reflect the risk of the entity's cashflows. If a cost of
capital is not given, or if is difficult to derive one (perhaps because the entity is
unlisted and therefore there is a lack of available information), a proxy cost of capital
from a similar listed company could be used instead.
When using a proxy cost of capital, care must be taken to ensure that it reflects the
entity's business risk and its capital structure. If necessary, a risk adjusted cost of
capital could be used, as covered in the earlier Chapter on 'Capital Structure'.

Illustration 3
Eamon Co is forecast to generate a constant stream of post-tax cashflows (after
interest charges) of Rs 10m per year.
The company is not listed, and no cost of equity has been calculated. However, a
similar listed entity, Frank Co, which operates in the same business sector has a cost
of equity of 10%.
Frank Co is all equity financed whereas Eamon Co has 20% debt and 80% equity by
market values. The tax rate is 30%, and the yield on Eamon's debt is 4%.

Required:
Calculate the value of Eamon Co, using the discounted cashflow method.
267

Solution:

The given post tax and post interest cashflows need to be discounted using an
appropriate cost of equity.
Although Frank Co operates in the same business sector, its gearing is different.
Hence, a risk adjusted cost of equity (suitable to Eamon Co's circumstances) would
be (using M + M's formula):

keg = keu + (keu – kd) (1 – t) VD / VE

= 10% + (10% – 4%) (1 – 0.30) 20/80

= 11.05%

Therefore, the value of Eamon Co's equity is Rs 10m / 0.1105 = Rs 90.5m

Example 9
Chassagne Co is considering making a bid for Butler Co, a rival company.

The following information should be used to value Butler Co.

Income statement for the most recent accounting period

Rs m
Revenue 285.1
Cost of sales (120.9)
–––––
Gross profit 164.2
Operating expenses (inc depreciation Rs 12.3m) (66.9)
–––––
Profit from operations 97.3
Finance costs (10.0)
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–––––
Profit before tax 87.3
Taxation (21.6)
–––––
Profit after tax 65.7

Other information

• selling prices are expected to rise at 3% p.a for the next 3 years and then stay
constant thereafter.

• sales volumes are expected to rise at 5% p.a for the next 3 years and then stay
constant thereafter.

• assume that cost of sales is a completely variable cost, and that other operating
expenses (including depreciation) are expected to stay constant.

• Butler Co invested Rs 15m in noncurrent assets and Rs 2m in working capital

last year. These annual amounts are expected to stay constant in future.

• Butler Co's financing costs are expected to stay constant each year in the future.
• the marginal rate of tax is 28%, payable in the year in which the liability arises.

• assume that book depreciation equals tax depreciation.

• Butler Co has 500 million shares in issue.

• the WACC of Butler Co is 9% and its cost of equity is 12%.

Required
Calculate the value of the equity in Butler Co (in total and per share) by forecasting
future free cash flows and discounting them to present value.

The strengths and weaknesses of cash-based valuations

The strengths of this method of valuation are:
269

• theoretically this is the best method of valuation;

• it can be used to place a maximum value on the entity;
• it considers the time value of money.

The weaknesses of this method are:

• it is difficult to forecast cash flows accurately;

• it is difficult to determine an appropriate discount rate;
• what time period should we evaluate in detail and then how do you value the
company's worth beyond this period? i.e. the realisable value at the end of the
planning period;
• the NPV method does not evaluate further options that may exist;
• It assumes that the discount rate and tax rates are constant through the period.

Summary of valuation methods – when should each be used?

This Chapter has covered the different valuation methods in turn, and has separately
identified the strengths and weaknesses of each of the methods.
To conclude, we should the circumstances in which each valuation method is most
useful.

Net asset-based methods

The net asset based valuation methods are most appropriate when valuing capital
intensive business with plenty of tangible assets.
Foe a service business, the net asset based approach is likely to significantly
undervalue the business, unless some effort is also made to value the intangible
assets of the business.
Note however that in times of uncertainty, the net asset based approach avoids the
need to forecast future earnings or cash flows, so it may be favored in these
circumstances.

Dividend valuation model (DVM)

The DVM is a suitable valuation method when valuing a minority shareholding in a
company, because if an investor purchases a minority stake, the dividends represent
the forecast income from the investment which will impact the valuation.
It the investor was to purchase a majority stake, it would be more relevant to consider
overall company cash flows or net asset values as a basis for the valuation.
270

P/E method and discounted cash flow method

Bothe these methods are based on forecasts of the future, and often use proxy
information form proxy companies. These factors may be difficult to identify in
practice.
Providing that free forecasts are accurate, these methods value the business based
on its future prospects, so automatically include a measure of the good will /
intangible assets associated with a business.
For service business, these methods are generally preferred to the net asset based
methods.

9 The Efficient Market Hypothesis (EMH)

Introduction to market efficiency

In theory, in a perfect market, the market value of a listed company should be a fair
reflection of all the information which is known about that company.
For example, a profitable company with good prospects should be worth more than
an underperforming company.
In the real world, it is often argued that the market is not perfect, so the value of a
listed company does not reflect all the information known about a company.
The extent to which market share prices are a fair reflection of a company's position
depends on the efficiency of the market.

The Efficient Market Hypothesis (EMH)

The efficiency of a financial market may be examined in various ways, the most
relevant here being in terms of information processing.
Information processing efficiency reflects the extent to which information regarding
the future prospects of a company is reflected in its current price.
Information processing efficiency is of great importance to financial management as
it means that the results of management decisions will be quickly and accurately
reflected in share prices. For example, if a firm undertakes an investment project that
will generate a large surplus, then in an efficient market it should see the value of its
equity rise. Accordingly there have been many tests of the so-called Efficient Market
Hypothesis (EMH) for the USA and the UK stock markets.
271

For the purposes of testing, the EMH is usually broken down into three categories,
as follows.
• the weak form;
• the semi-strong form (which is closest to the real world situation);
• the strong form (which is assumed by many of the theories in Financial
Strategy).

More Detail on the EMH

Weak form
When a stock market displays weak form efficiency, share prices reflect all known
publicly-available past information about companies and their shares. Share prices
reflect this historical information, such as published financial results and dividend
payments. If this hypothesis is correct, then it should be impossible to predict future
share price movements from historical patterns (which is what so-called ‘technical
analysis’ or ‘chartists’ attempt to do). For example, if a company’s share price had
increased steadily over the last few months to a current price of £2.50, this price will
already fully reflect the currently available information about the company.
The next change in share price could be either upwards or downwards, with equal
probability, depending on the nature of the next information made available to the
market.
Because of this randomness in share price movements, this is frequently referred to
as the random walk hypothesis. This means that the movements of share prices over
time approximate a random walk. It also follows that because the current share price
fully reflects past information about price changes it is the best estimate of share’s
value.
Semi-strong form
The semi-strong form hypothesis of market efficiency is that current share prices
reflect not only historical share price information and other historical information about
a company, but also respond immediately to other current publicly-available
information about the company.
For example, suppose that Alpha plc is a stock market company that announces its
latest profits and dividends figures. If the stock market is efficient in its semi-strong
form, the share price will react immediately to the news announcement and settle at a
new level that reflects the new information. If the stock market does not display semi-
strong form efficiency, it might be several days or weeks before the share price adjusts.
272

Thus a stock market specialist, who attempts use his expertise to use the publicly
available information to predict which shares will be worth buying, would have little
success in out-guessing the market.
The evidence also tends to confirm that the semi-strong form of efficiency does exist
in leading stock markets.
Strong form
The strong form hypothesis of market efficiency states that the current share price
reflects all the information relevant to the company, including information that has not
yet been made public! If the hypothesis is correct then the mere publication of the
information should have no impact on the share price, consequently it should not be
possible to make profits by dealing in response to inside information. It would be
impossible to make a profit by predicting future share price movements for reasons
not yet known to the market, because the market knows everything. It would be
impossible for individuals to make a profit from insider dealing. (Insider dealing is illegal
in both the UK and the US.) It is unlikely that the strong form exists.

Implications of the EMH for financial managers

If capital markets are efficient, the main implications for financial managers
are:

• The timing of issues of debt or equity is not critical, as the prices quoted in
the market are ‘fair’.
• The entity’s share price will reflect the net present value of its future cash
flows, so managers must only ensure that all investments are expected to
exceed the company’s cost of capital.

Multiple choice questions (MCQs)

1. Which of the following statement is correct:

A) EPS of risky company should be adjusted for valuation

B) Lower dividend of target company will result in lower value under earning
approach
C) Under net asset valuation method, company will be valued as book value of net
assets plus goodwill
D) DVM does not consider the earnings of company

2. If stock market is semi-strong efficient, when share price will change if company
takes a decision of investment in new project :

A) Share price will change when decision is taken

B) Share price will change at announcement of decision
C) Share price will change at actual results (profit or loss)
D) Share price will change at receipt of dividend
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10 Exam style questions

Note: Several of the exam style questions at the end of the next Chapter ('Financial
and Strategic Implications of Mergers and Acquisitions') also contain business
valuation calculations.

Test your understanding 1 – Predator Ltd

The board of directors of Predator Ltd is considering making an offer to purchase

Target Ltd, a private limited company in the same industry. If Target Ltd is purchased
it is proposed to continue operating the company as a going concern in the same line
of business.

Summarised details from the most recent financial statements of Predator and Target
are shown below:

Predator Ltd Target Ltd

SFP SFP

as at 31 March as at 31 March

Rs m Rs m Rs 000 Rs 000

Freehold property 33 460

Plant and equipment 58 1,310

Inventory 29 330

Receivables 24 290

Cash 3 20

less current liabilities (31) 25 (518) 122

—— —— —— ——–

116 1,892

—— ——–

Financed by:Ordinary shares 35 160

Reserves 43 964
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—— ——–

Shareholders funds 78 1,124

Medium term bank loans 38 768

—— ——–

116 1,892

—— ——–

Predator Ltd, Rs 10 ordinary shares, Target Ltd, Rs 5 ordinary shares.

Predator Ltd Target Ltd

Year PAT Dividend PAT

Dividend

Rs m Rs m Rs 000 Rs 000

T5 14.30 9.01 143

85.0

T4 15.56 9.80 162

93.5

T3 16.93 10.67 151

93.5

T2 18.42 11.60 175

102.8

T1 20.04 12.62 183

113.1

N.B. T5 is five years ago and T1 is the most recent year.

Target's shares are owned by a small number of private individuals. Its managing
director, who receives an annual salary of Rs 120,000, dominates the company. This is
275

Rs 40,000 more than the average salary received by managing directors of similar
companies. The managing director would be replaced if Predator purchases Target.

The freehold property has not been revalued for several years and is believed to have
a market value of Rs 800,000.

The statement of financial position value of plant and equipment is thought to reflect its
replacement cost fairly, but its value if sold is not likely to exceed Rs 800,000.
Approximately Rs 55,000 of inventory is obsolete and could only be sold as scrap for
Rs 5,000.

The ordinary shares of Predator are currently trading at Rs 86 ex-div. A suitable cost of
equity for Target has been estimated at 15%.

Both companies are subject to corporation tax at 33%.

Required:

Estimate the value of Target Ltd using the different methods of valuation and advise the
board of Predator as to how much it should offer for Target's shares.

Answers to MCQs:

1) D
2) B

Test your understanding answers

Example 1

Assuming the balance sheet values are realistic, the valuation is:

Rs 000
Noncurrent assets 23,600
Current assets 8,400
Less: 6% Unsecured bond (8,000)
Less: Current liabilities (4,800)
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–––––
19,200
–––––
So the value per share is Rs 19,200,000 / 800,000 = Rs 24

(Note that the net asset value of Rs 19,200,000 is equal to the value of the ordinary
share capital plus reserves.)

Example 2
Value per share = (Rs 19,200,000 + Rs 40,000,000 – Rs 23,600,000) / 800,000
= Rs 44.5

Example 3
Rs 000 Explanation / justification
Noncurrent assets 1,500 Ray Ltd is buying the business, so
would have to buy the machinery
from scratch if it decided on the
alternative of organic growth. The
realisable value will be a useful
minimum value from Ribbon Ltd’s
perspective, but it is not relevant to
Ray Ltd.

Current assets 414 The inventory and receivables

(564–120–30) relating to the bankrupt customer
will not be acquired by Ray Ltd.
They are therefore excluded from
the valuation.

Less: 5% bonds (600)

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Less: Current liabilities (518) In order for Ray Ltd to takeover

Ribbon Ltd, it needs to buy the
equity of the business. After the
takeover, Ray Ltd will be responsible
for meeting these liabilities,
so they should be included in
the valuation of Ribbon Ltd.
–––––
796
–––––

Value per share = Rs 796,000 / 10,000 = Rs 79.6

Example 4
Rs m
Current pre tax profit 24.29
Less: Industry ROA x Net assets 10% x 128.66m (12.87)
———–
Value Spread 11.42
———–
Post Tax Value Spread 11.42m x (1–0.30) 7.99
CIV (assuming constant perpetuity) 7.99m x 1/0.16 49.94

Therefore, the total value of Chapman Co is estimated to be 128.66m + 49.94m =

Rs 178.60m

Example 5

250,000
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(a) Po = ————
0.14

= Rs 1.786 million, or 1.786/2 = Rs 0.893 per share.

= Rs 2.6 million, or 2.6/2 = Rs 1.30 per share.

250,000 × 1.04
(b) Po = ——————
0.14 – 0.04

Example 6

EPS = 3,840,000 / 1,000,000 = Rs 3.84

Value = P/E × EPS = 9 × 3.84 = Rs 34.56

Example 7

The maximum that X should be prepared to pay for Y is the total increase in value
generated by taking over Y, i.e.

Value of combined = 11 × (3m +1.5m +0.5m) = Rs 55m

Less value of X = 12 × 3m = Rs 36m
Max. Price to pay = Rs 19m.

However, the shareholders of Y will value their company at 8 × 1.5m = Rs 12m since
they will not have enough information to enable them to value the expected
synergies.

The price paid by X to take over Y is then likely to fall somewhere between these two
valuations, depending upon the negotiating skills of the buyer and seller.
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Example 8

Year Rs DF (12%) PV
1 120,000 0.893 107,160
2 100,000 0.797 79,700
3 140,000 0.712 99,680
4 50,000 0.636 31,800
5 onwards 130,000 0.567 73,710
–––––
NPV 392,050
–––––

However, this ignores cash flows after year 5. Assuming the year 5 cash flow
continues to infinity, this has a present value of:

130,000 / 0.12 = Rs 1,083,333

This has a present value today of:

Rs 1,083,333 × 0.567 = Rs 614,250

This gives a total present value (value of equity) of:

614,250 + 392,050 = Rs 1,006,300

With 2 million shares, this is 1,006,300 / 2,000,000 = Rs 0.50 per share.

Example 9

Rs m Year 1 Year 2 Year 3 etc

Sales (×1.03×1.05) 308.3 333.5 360.6
Cost of sales (×1.05) (126.9) (133.3) (140.0)
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––––– ––––– –––––

Gross profit 181.4 200.2 220.6
Operating expenses (66.9) (66.9) (66.9)
Financing costs (10.0) (10.0) (10.0)
––––– ––––– –––––
Forecast profit before tax 104.5 123.3 143.7
Less Taxation (28%) (29.3) (34.5) (40.2)
Add back depreciation 12.3 12.3 12.3
Less Capital expenditure (15.0) (15.0) (15.0)
Less Working capital investment (2.0) (2.0) (2.0)
––––– ––––– –––––
Forecast free cash flows 70.5 84.1 98.8
––––– ––––– –––––
DF 12% 0.893 0.797 0.797/0.12
––––– ––––– –––––

Present value 63.0 67.0 656.2

So the net present value = Rs 786.2m

This is the total value of the equity in Butler Co.

With 500 million shares in issue, this corresponds to a value of

786.2 / 500 = Rs 1.57 per share.

Test your understanding 1 – Predator Ltd

The approaches to use for valuation are:

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(1) Net asset valuation

(2) Dividend valuation model

(3) P/E ratio / Earnings valuation.

(1) Net asset valuation

Target is being purchased as a going concern, so realisable values

are irrelevant.

Rs 000

Net assets per accounts (1,892 - 768) 1,124

Adjustments to freehold property (800 - 460) 340

Adjustment to inventory (50)

——
Valuation 1,414

——

Say Rs1.4m

(2) Dividend valuation model

The average rate of growth in Target's dividends over the last four years is 7.4% on
a compound basis.

The estimated value of Target using the dividend valuation model is therefore:

Rs 113,100 × 1.074

Valuation ———————— = Rs 1,598,281 Say Rs 1.6m

0.15 – 0.074

(3) P/E ratio/Earnings valuation

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A suitable P/E ratio for Target will be based on the P/E ratio of Predator as both
companies are in the same industry.

3.5m × Rs 86

P/E of Predator:—————— = 15.02

Rs 20.04

The adjustments: downwards

Target is a small private company. It has a poorer growth potential based on past
performance.

Predator Ltd Target Ltd

=8.8% = 6.36%

A suitable P/E ratio is therefore 15.02 x 80% = 12.02, say 12.

Target's maintainable earnings are:

Rs 183,000 + (Rs 40,000 x 67%) = Rs 209,800 after adjusting for the savings in the
director's remuneration.

The estimated value is therefore Rs 209,800 x 12 = Rs 2,517,600, sayRs 2.5m.

Advice to the board

On the basis of its tangible assets the value of Target is Rs 1.4m, which excludes
any value for intangibles.

The dividend valuation gives a value of around Rs 1.6m.

The earnings based valuation indicates a value of around Rs 2.5m, which is based
on the assumption that not only will the current earnings be maintained, but that
they will increase by the savings in the director's remuneration.
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On the basis of these valuations an offer of around Rs 2m would appear to be most

suitable. The directors should, however, be prepared to increase the offer to:

Maximum price:

It is worth noting that the maximum price Predator should be prepared to offer is:

The NPV of the combined group after the acquisition

X

The NPV of the acquiring company before the acquisition

(X)

Maximum price
X

If synergy occurs this could justify a higher price than shown by the valuation methods
illustrated.

The comment on the maximum price is particularly appropriate in this question as this
an example of horizontal integration where considerable synergies normally exist.
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Learning Objectives:

a) Understand the different types of mergers and integration strategies employed in corporate
restructuring.

b) Identify and explain the types of synergies that can be achieved through mergers and
acquisitions.

c) Explain the process and conduct involved in a takeover, including legal, financial, and
strategic considerations.

d) Evaluate various payment methods used in mergers and acquisitions, such as cash, stock,
and hybrid methods.

e) Apply valuation techniques specific to mergers and amalgamations to determine the fair
value and feasibility of transactions.

f) Analyze the regulatory frameworks and considerations governing acquisitions, including

antitrust laws and sector-specific regulations.

g) Assess the challenges and strategies involved in post-acquisition integration, including

cultural, operational, and strategic alignment.

h) Evaluate the impact of mergers and acquisitions on stakeholders, including shareholders,

employees, customers, and communities.

i) Understand the concept of bootstrapping and its application in financing mergers and
acquisitions.

j) Calculate and analyze the impact on combined earnings per share (EPS) after a merger,
considering the financial performance and synergy effects of the combined entity.
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1 Overview of Chapter

Terminology
The term ‘merger’ is usually used to describe the joining together of two or more
entities.
Strictly, if one entity acquires a majority shareholding in another, the second is said
to have been acquired (or ‘taken over’) by the first. If the two entities join together
to submerge their separate identities into a new entity, the process is described as
a merger.
In fact, the term ‘merger’ is often used even when an acquisition / takeover has
actually occurred, because of the cultural impact on the acquired entity – the word
merger makes the arrangement sound like a partnership between equals.

Types of merger / acquisition

Mergers and acquisitions can be to reflect the nature of the enlarged group:
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• Horizontal integration results when to entities in the same line of business

combine. For example, recent bank and building society mergers are good
example of this type of integration.

• Vertical integration result from acquisition of one entity by another which is at

different level in the ‘chain or supply’ – as an example, UK breweries have moved
heavily into the distribution of their product via public houses.

• A conglomerate results when two entities in unrelated business combine.

2 The reasons for growth by acquisition or merger

Specific reasons for merger / acquisition

The following reasons have been suggested as to why entities merge or acquire.

• Increased market share / power. In a market with limited product

differentiation, price may be the main competitive weapon. in such a example
reducing prices in the short term to eliminate competition before increasing
prices later.

• Economies of scale. These result when expansion of the scale of productive

capacity of an entity (or industry) causes total production costs to increase less
than proportionately with output. It is clear that a merger which resulted in
horizontal or vertical integration could be giving such economies since, at the
very least, duplication would be avoided. But how could a conglomerate merger
give economies? Possibly through central facilities such as offices, accounting
departments and computer departments being rationalized. (Indeed, both sets
of management are unlikely to be needed in their entirety.)

• Combing complementary needs. Many small entities have a unique product

but lack the engineering and sales organizations necessary to produce and
market it on a large scale. A natural course of action would be to merge with a
larger entity. Both entities gain something – the small entity gets “instant”
engineering and other benefits which a unique product can bring. Also if, as is
likely, the resources which each entity requires are complementary, the merger
may well produce further opportunities that neither would see in isolation.

• Improving efficiency. A classic takeover target would be an entity operating in

a potentially lucrative market but which, owing to poor management or inefficient
operations, does not fully exploit its opportunities. Of course, being taken over
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would not be the only way of improving such a poor performer, but such an
entity’s managers may be unwilling to give themselves the sack.

• A lack of profitable investment opportunities – surplus cash.

An entity may be generating a substantial volume of cash, but sees few
profitable investment opportunities. If it does not wish to simply pay out the
surplus cash as dividends (because of its long-term dividend policy, perhaps), it
could use it to acquire other entities. A reason for doing so is that entities with
excess cash are usually regarded as ideal targets for acquisition – a case of buy
or be bought.

• Tax relief. An entity may be unable to claim tax relief because it does not
generate sufficient profits. It may therefore wish to merge with another entity
which does generate such profits.

• Reduced competition. It is often one benefit or merger activity – provided that

it does not fall foul of the competition authorities.

• Asset – stripping. A predator acquires a target and sells the easily separable
assets, perhaps closing down or deposing of some of its operations.

The following reasons are of questionable validity:

• Diversification, to reduce risk. While acquiring an entity in a different line of

activity may diversify away risk for the entities involve, this is surely irrelevant to
the shareholders. They could have performed exactly the same diversification
simply by holding shares in both entities. The only real diversification produced
is in the risk attaching to the managers and employees’ jobs, and this is likely to
make them more complacent than before – to the detriment of shareholder’s
future returns.

• Share of the target entity are undervalued. This may well be the case,
although it would conflict with the efficient markets theory. However, the
shareholders of the entity planning the takeover would derive as much benefit
(at a lower administrative cost) from buying such undervalued shares
themselves. This also assumes that the acquirer entity’s management is better
at valuing shares than professional investors in the market place.

Synergy
Synergy may be defined as two or more entities coming together to produce a result
not independently obtainable.
For example, a merged entity will only need one marketing department, so there may
be savings generated compared to two separate entities.

Importance of synergy in mergers and acquisitions

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For a successful business combination we should be looking for a situation where:

MV of combined company (AB) > MV of A + MV of B

Note: MV means Market Value here.

If this situation occurs we have experienced synergy, where the whole is worth more
than the sum of the parts. This is often expressed as 2 + 2 = 5.

It is important to note that synergy is not automatic. In an efficient stock market A

and B will be correctly valued before the combination, and we need to ask how
synergy will be achieved, i.e. why any increase in value should occur.

Sources of synergy

There are several reasons why synergistic gains arise. These break down into the
following:

• operating economies, such as economies of scale and elimination of inefficiency,

• financial synergy, such as the reduced risk caused by diversification,
• other synergistic effects, such as market power.

Detailed examples of synergy

Synergy from operating economies

Economies of scale - Horizontal combinations (acquisitions of a company in a

similar line of business) are often claimed to reduce costs and therefore increase
profits due to economies of scale. These can occur in the production, marketing or
finance areas. Note that these gains are not automatic and diseconomies of scale
may also be experienced. These benefits are sometimes also claimed for
conglomerate combinations (acquisition of companies in unrelated areas of
business) in financial and marketing costs.

Economies of vertical integration - Some acquisitions involve buying out other

companies in the same production chain, e.g. a manufacturer buying out a raw
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material supplier or a retailer. This can increase profits by 'cutting out the middle
man'.

Complementary resources - It is sometimes argued that by combining the strengths

of two companies a synergistic result can be obtained. For example, combining a
company specialising in research and development with a company strong in the
marketing area could lead to gains.

Elimination of inefficiency - If the victim company is badly managed, its performance

and hence its value can be improved by the elimination of inefficiencies.
Improvements could be obtained particularly in the areas of production, marketing
and finance.

Financial synergy

Several financial arguments are proposed in this area.

Diversification - The argument goes that diversification normally reduces risk. If the
earnings of the merged companies simply stay the same (i.e. no operating economies
are obtained), there could still be an increase in value of the company due to the lower
risk.

Diversification and financing - If the future cash flow streams of the two companies
are not perfectly positively correlated then, by combining the two companies, the
variability of their operating cash flow may be reduced. A more stable cash flow is
more attractive to creditors and this could lead to cheaper financing.

The 'boot strap' or P/E game - It is sometimes argued that companies with high P/E
ratios are in a good position to acquire other companies as they can impose their high
P/E ratio on the victim firm and increase its value.

Other synergistic effects

Surplus managerial talent - Companies with highly skilled managers can make use
of this resource only if they have problems to solve. The acquisition of inefficient
companies is sometimes the only way of fully utilising skilled managers.
Surplus cash - Companies with large amounts of surplus cash may see the
acquisition of other companies as the only possible application for these funds. Of
course, increased dividends could cure the problem of surplus cash, but this may be
rejected for reasons of tax or dividend stability.
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Market power - Horizontal combinations may enable the firm to obtain a degree of
monopoly power that could increase its profitability. Removing competition from a
market in this way could attract the attentions of the competition authorities.
Speed - Acquisition may be far faster than organic growth in obtaining a presence in
a new and growing market.
By considering all the above sources of synergy, a company can work towards
increasing the post-merger value of the newly formed joint company.

Example 1
Williams Inc is the manufacturer of cosmetics, soaps and shower gels. It also
markets its products using its own highly successful sales and marketing
department. It is seen as an employer of choice and as such has a talented and loyal
workforce with a history of developing new and exciting products which have sold
well. It is now considering extending its range, however it has currently a buildup of
unfulfilled orders due to a lack of capacity.
GSL is a well-known herbal remedy for skin problems. GSL Co was founded by
three brothers in the 1950s and until the death of the remaining brother in 2007 has
performed well – however the new Chairman has limited experience and the
company has not performed well over recent years. GSL has a dedicated team of
herbalists who have developed products, which would find a ready market –
however, there is insufficient funds and expertise to correctly market these
products and market share is low.
Williams’ products and GSL’s products are made using similar production
technologies and their financial and administrative systems are similar and it is
hoped savings can be made here.

Required:
Identify any potential synergy gains that would emerge from a merger of Williams
and GSL.
Reasons why mergers and acquisitions fail
Not all mergers and acquisitions are successful.

Synergy will not automatically arise. Unless the management of the two entities can
work together effectively, there is a chance that any forecast benefits of the new
arrangement might not be realised.
In many cases, the forecast synergy is not achieved, or is not as large as expected.
It may be that the premium paid on acquisition by the acquirer was too high, so the
shareholder value of the acquirer actually reduced as a result of the acquisition.
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Detailed reasons why mergers / acquisition fail

The fit / lack of fit syndrome
There are may be a good fit of products or services, but a serious lack of fit in terms
of management’s styles or corporate structure.

Lack of industrial or commercial fit

Failure can result from a horizontal or vertical takeover where the acquired entity
turns out not to have the product range or industrial position that the acquirer
anticipated, Usually in the case where a customer or suppler is acquired, the acquirer
knows a lot about the acquired entity; even so, there may be aspects of the acquirer,
such that, even in these cases, a prospective acquisition should be planned very
carefully and not be based solely on experience gained form a direct relationship
with the acquired entity.

Lack of goal congruence

This may apply not only to the acquired entity but, more dangerously, to the acquire,
whereby disputes over the treatment of the acquired entity might will take away the
benefits of an otherwise excellent acquisition.

‘Cheap’ purchases
The ‘turn around’ costs of an acquisition purchased at what seems to be a bargain
price may well turn out to be high multiple of that price. In these situations, the
amount of resources in terms of cash and management time could well also damage
the acquirer’s core business. In preparing a bid, a would- be acquirer should always
take into account the likely total cost of an acquisition, including the input of its own
resources, before deciding on making an after or setting an offer price.

Paying too much

The fact that a high premium is paid for an acquisition does not necessarily mean
that it will fail. Failure would result only if the price paid is beyond that which the
acquirer considers acceptable to increase satisfactorily the long-term wealth of its
shareholders.

Failure to integrate effectively

An acquirer needs to have a workable and clear plan of the extent to which the
acquired company is to be integrated and the amount of auto me to be granted. At
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best, the plan should be negotiated with the acquired entity’s management and staff,
but it’s essential requirements should be fairly but filmy carried out. The plan must
address such problems as differences in management styles, incompatibilities in
data information systems, and continued opposition to the acquisition by some of the
acquired entity’s staff. Failure to plan can – and often does – lead to failure of an
acquisition, as it leads to drift and de-motivation, not
Only within the acquired entity but also within the acquirer itself.
Every aspect of a prospective acquisition, as it will affect he would be acquirer,
should be weighed up before embarking on a bid. Problems of integration have a
much better chance of being resolved before bidding action is taken than they do
after the event, when many more complications can ensue.
Even if a product fit is satisfactory, this would – be acquirer should be satisfied that
the aspects of its own operation affected by the bid will be properly adaptable to the
new activities. Running the rule carefully over one’s operations may yield vital
information as to areas which may need adaptation before a bid can be
contemplated, and provide vital clues to appropriate areas for search when a bid has
actually been launched. One factor of special importance is a clear assessment of
the flexibility of one’s information systems.

Inability to manage change

Several of the above points stress the need for an acquirer to plan effectively before
and after an acquisition if failure is to be avoided. But this in itself calls for the ability
to accept change – perhaps even radical change – from established routines and
practices. Indeed, many acquisitions fail mainly because the acquirer is unable – or
unwilling – reasonably to adjust its own activates to help ensure a smooth takeover.
One such situation is where the acquired company has a demonstrably better data
information system than the acquirer, which it might be greatly in the acquirer’s
interest to adopt.

3 Defenses against hostile takeover bids

Any listed company needs to be aware that a bid might be received at any time.
The directors of a company subject to a hostile takeover bid should act in the best
interests of their shareholders. However, in practice they will also consider the views
of other stakeholders (such as employees, and themselves).
If the board of directors of a target company decides to fight a bid that appears to be
financially attractive to their shareholders, then they should consider one of the
following defenses:

• Pre bid defenses’

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– Communicate effectively with shareholders

– Revalue noncurrent assets
– Poison pill
– Change the Articles of Association (super majority)

• Post bid defenses

– Appeal to their own shareholders
– Attack the bidder
– White Knight
– Counterbid ("Pacman")
– Refer the bid to the Competition authorities

Details of takeover defences

Pre – bid defences

Communicate effectively with shareholders

This includes having a public relations officer specializing in financial matters liaising
constantly with the entity’s stockbrokers, keeping analysts fully informed, and
speaking to journalists.
Revalue non-current assets
Noncurrent assets are revaluated to current values to ensure that shareholders are
aware of true asset value per share.

Poison pill strategy

Here a target company takes steps before a bid has been made to make it less
attractive to a potential bidder. The most common method is for existing shareholders
to be given rights to buy future bonds or preference shares. If a bid is making before
the date of exercise of the rights, then the rights will automatically be converted into
full ordinary shares.

Super majority
The Articles of Association are altered to require that a higher percentage (say 80%)
of shareholders have to vote for the takeover.
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Post – bid defences

Appeal to their own shareholders
For example, by declaring that the value placed on the target company’s shares is
too low in relation to the real value and earning power of the company’s assets, or
alternatively that the market price of the bidder’s shares is unjustifiably high and is
not sustainable.
A well-managed defensive campaign would include:
(i) Aggressive publicity on behalf of the company preferable before a bid is revived.
Investors may be told of any good research ideas within the company and of the
management potential or merely be made more aware of the company’s
achievements.

(ii) Direct communication with the shareholders in writing stressing the financial and
static reason for remaining independent.

Attack the bidder

Typically concentrating on the bidder’s management style, overall strategy, methods
of increasing earnings per share, dubious accounting policies and lack of capital
investment.

White Knight strategy

This is where the directors of the target company offer themselves to a friendlier
outside interest. This tactic should only be adopted in the last resort as it means that
the company will lose its independence. This tactic is acceptable provided that any
information given to a preferred bidder is also given to a hostile bidder. The
alternative company’s management will be considered to be sympathetic to the
target company’s management.

Counterbid (Pacman defence)

Where the bidding company is itself the subject of a takeover bid by the target
company.

Competition authorities
The target entity could seek government intervention by bringing in the Competition
authorities. For this to be effective it would have to be proved that the takeover was
against the public interest.
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4 The form of consideration for a takeover

Introduction

When one firm acquires another, two questions must be addressed regarding the
form of consideration for the takeover:
(1) What form of consideration should be offered? Cash offer, or share exchange, or
earn-out are the three main choices.
(2) If a cash offer is to be made, how should the cash be raised? The choice is
generally debt finance or a rights issue to generate the cash (if the entity does not
have enough cash already).

The key considerations regarding these two questions are outlined below.
Form of consideration
Cash
In a cash offer, the target company shareholders are offered a fixed cash sum per
share.
This method is likely to be suitable only for relatively small acquisitions, unless the
bidding entity has an accumulation of cash.

Advantages:
• When the bidder has sufficient cash the takeover can be achieved quickly and at
low cost.
• Target company shareholders have certainty about the bid's value i.e. there is
less risk compared to accepting shares in the bidding company.
• There is increased liquidity to target company shareholders, i.e. accepting cash
in a takeover, is a good way of realising an investment.
• The acceptable consideration is likely to be less than with a share exchange, as
there is less risk to target company shareholders. This reduces the overall cost
of the bid to the bidding company.

Disadvantages:
• With larger acquisitions the bidder must often borrow in the capital markets or
issue new shares in order to raise the cash. This may have an adverse effect on
gearing, and also cost of capital due to the increased financial risk.
• For Target Company shareholders, in some jurisdictions a taxable chargeable
gain will arise if shares are sold for cash, but the gain may not be immediately
chargeable to tax under a share exchange.
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• Target company shareholders may be unhappy with a cash offer, since they are
"bought out" and do not participate in the new group. Of course, this could be
seen as an advantage of a cash offer by the bidding company shareholders if
they want to keep full control of the bidding company.

Share exchange
In a share exchange, the bidding company issues some new shares and then
exchanges them with the target company shareholders. The target company
shareholders therefore end up with shares in the bidding company, and the target
company's shares all end up in the possession of the bidding company.
Large acquisitions almost always involve an exchange of shares, in whole or in part.

Advantages:
• The bidding company does not have to raise cash to make the payment.
• The bidding company can ‘boot strap’ earnings per share if it has a higher P/E
ratio than the acquired entity (terminology explained later in this Chapter).
• Shareholder capital is increased – and gearing similarly improved – as the
shareholders of the acquired company become shareholders in the post-
acquisition company.
• A share exchange can be used to finance very large acquisitions.

Disadvantages:
• The bidding company’s shareholders have to share future gains with the acquired
entity, and the current shareholders will have a lower proportionate control and
share in profits of the combined entity than before.
• Price risk – there is a risk that the market price of the bidding company's shares
will fall during the bidding process, which may result in the bid failing. For
example, if a 1 for 2 share exchange is offered based on the fact that the bidding
company's shares are worth
• Approximately double the value of the target company's shares, the bid might fail
if the value of the bidding company's shares falls before the acceptance date.

Earn-out
Definition of an earn-out arrangement: A procedure whereby owners/managers
selling an entity receive a portion of their consideration linked to the financial
performance of the business during a specified period after the sale. The
arrangement gives a measure of security to the new owners, who pass some of the
financial risk associated with the purchase of a new entity to the sellers.
The purchase consideration is sometimes structured so that there is an initial amount
paid at the time of acquisition, and the balance deferred.
Some of the deferred balances will usually only become payable if the target entity
achieves specified performance targets.
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Summary of key issues relating to forms of consideration

Considerations of different stakeholders
In order to evaluate which form of consideration is appropriate in a particular case, it
is important to assess the positions of both the target company’s shareholders, and
the bidding company and its shareholders.

Position of the target company’s shareholders

The target company’s shareholders may want to retain an interest in the business,
in which case a cash offer would not be welcomed. However, there is a greater
certainty of value with a cash offer (share prices fluctuate, so in a share exchange
the target company’s shareholders fluctuate, so in a share exchange the target
company’s shareholders cannot be completely sure whether they are receiving an
appropriate valuation for their shares).

Position of the bidding company and its shareholders

The bidding company will have to issue new shares if it is to undertake a share
exchange. This may require the consent of shareholders in a general meeting. The
shareholders may be concerned in share exchange that their control of the bidding
company will be diluted by the issue and exchange of shares.
Another key consideration is the impact of the takeover on the bidding company’s
financial statements. An issue of new shares could reduce the level of earnings per
share (a measure which is often used as a key performance measure by market
analysts). However, if a cash offer is made, the raising of the necessary cash could
have a significant impact on the gearing of the bidding company – see below for
details.

Methods of financing a cash offer

If the bidding company has a large cash surplus, it might be able to make a cash
offer without raising any new finance.
However, in most cases, this will not be the case, so various financing options will
have to be considered by the bidding company. The main two options are debt or a
rights issue.

Debt
The bidding company could borrow the required cash from the bank, or issue bonds
in the market.
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The advantage of using debt in this situation is the low cost of servicing the debt.
However, raising new debt finance will increase the bidding company's gearing. This
will increase the risk to the bidding company's shareholders, so might not be
acceptable to the shareholders.
The disadvantage to the target company’s shareholders is that debt might be
infrequently traded, and this will affect their ability to liquidate the investment should
they need to. Also, the lack of marketability might adversely affect the value of the
securities.

Rights issue
If the bidding company shareholders do not want to suffer the increased risk which
debt finance would bring, the alternative would be for the bidding company to offer a
rights issue to its existing shareholders. In this case, the company's gearing is not
affected, although its earnings per share will fall as new shares are issued.
From the shareholders' point of view, the problem with this financing option is that it
is the shareholders themselves who have to find the money to invest.

Evaluating a share for share exchange

One popular question is to comment on the likely acceptance of a share for share
offer. The procedure is as follows:

• Value the predator company as an independent entity and hence calculate the
value of a share in that company.
• Repeat the procedure for the victim company.

• Calculate the value of the combined company post integration. This is calculated
as:
Value of predator company as independent company X
Value of victim company as independent company X
Value of any synergy X
Total value of combined company X
—–

• Calculate the number of shares post integration:

Number of shares originally in the predator company X

Number of shares issued to victim company X
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——

Total shares post integration X

——

• Calculate the value of a share in the combined company, and use this to assess
the change in wealth of the shareholders after the takeover.

Illustration 1

Company A has 200m shares with a current market value of Rs 4 per share. Company
B has 90m shares with a current market value of Rs 2 per share.

A makes an offer of 3 new shares for every 5 currently held in B. A has worked out
that the present value of synergies will be Rs 40m.

Required:

Calculate the expected value of a share in the combined company.

Solution

MV of A = Rs 800m

MV of B = Rs 180m

PV of synergies = Rs 40m

TOTAL = Rs 1,020m

No. of new shares = 200m + (3/5) x 90m = 254m

New share price = 1,020m / 254m = Rs 4.02

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Shares MV Old wealth

Change

A 200m Rs 804m Rs 800m Rs

4m

B (3/5) x 90m = 54m Rs 216m Rs 180m Rs

36m

The wealth of the shareholders in company B will increase by Rs 36m as a on

sequence of the takeover. This is a (36/180) 20% increase in wealth.

Company B's shareholders should be advised to accept the 3 for 5 share for share
offer.

Example 2

Mavers Co and Power Co are listed on the Stock Exchange.

Relevant information is as follows:

Mavers Co Power Co
Share price today Rs 3.05 Rs 6.80
Shares in issue 48 million 13 million

Mavers Co wants to acquire 100% of the shares of Power Co.

The directors are considering offering 2 new Mavers Co shares for every 1 Power
Co share.

Required:
Evaluate whether the 2 for 1 share for share exchange will be likely to succeed.
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If necessary, recommend revised terms for the offer which would be likely to
succeed.

Bootstrapping and post acquisition values

In the previous examples, we were told specifically what the values of the separate
companies were before the takeover, and the synergy generated by the takeover
was also given.
Sometimes we might have to derive these figures, using the bootstrapping method
as in the following illustration.

Illustration 2

Post Tax Profit P/E ratio Pre-acquisition value

Company C Rs 10m 16 Rs 160m
Company D Rs 1m 8 Rs 8m

If Company C takes over Company D, the post-acquisition value of the combined

company can be estimated by applying Company C's P/E ratio to the combined post
tax profit.
This is known as bootstrapping, and it is based on the assumption that the market
will assume that the management of the larger company will be able to apply
common approach to both companies after the takeover, thus improving the
performance of the acquired company by using the methods that they have been
using on their own company before the takeover.
Value of (C+D) post acquisition = 16 x (Rs 10m + Rs 1m) = Rs 176m

Thus, the value of the synergy is this combined value, less the values of the individual
companies pre acquisition, i.e.

Rs 176m – Rs 160m – Rs 8m = Rs 8m

5 The Regulation of Takeovers

A: Competition (Merger Control) Regulations, 2007

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Mergers

Regulations define merger as:

(a) Two or more undertakings merge to form a new undertaking or

(b) One undertaking is absorbed by another; or
(d) Persons/undertakings acquire control of the whole or part of other
undertakings; or
(e) The result of an acquisition by one undertaking of the assets or shares, or a
substantial part of the assets or shares, of another undertaking
(f) A collaborative arrangement by which two or more undertaking devote their
resources to pursue a common objective.

Thresholds
Before consummation of the merger, concerned undertakings shall give notice
of its/their intention of merger, to the Competition Commission of Pakistan if;

(a) the value of gross assets of the undertaking, excluding value of

goodwill, is more than three hundred million rupees and/or the combined
value of the undertaking and the undertaking(s) the shares of which are
proposed to be acquired or the undertakings being merged, is more than one
billion rupees; or

(b) annual turnover of the undertaking in the preceding year is more than
five hundred million rupees and/or the combined turnover of the undertaking
and the undertaking(s) the shares of which are proposed to be acquired or the
undertakings being merged is more than one billion rupees; and

(c) the transaction relates to acquisition of shares or assets of the value of

one hundred million rupees or more; or

(d) in case of acquisition of shares by an undertaking, if an acquirer acquires voting

shares, which taken together with voting shares, if any ,held by the acquirer shall
entitle the acquirer to more than 10% voting shares;

(e) in the case of an asset management company carrying out asset

management services, its collective exposure for itself and in all of its collective
investment schemes in a single entity is more than 25% of total voting rights;
or

(f) the value of total assets under management of an Asset Management

Company is one billion rupees or more.
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B: Listed Companies (Substantial Acquisition of Voting Shares and

Take-overs) Ordinance, 2002.

Acquisition of more than ten per cent voting shares of a company

Any acquirer who acquires voting shares, which (taken together with voting
shares, if any, held by the acquirer) would entitle the acquirer to more than ten
per cent voting shares in a listed company, shall disclose the aggregate of his
shareholding in that company to the said company and to the stock exchange
on which the voting shares of the said company are listed.

Additional acquisition of voting shares

No person shall, directly or indirectly, acquire voting shares, which (taken
together with voting shares, if any, held by such person) would entitle such
person to more than twenty five per cent voting shares in a listed company or
control of a listed company, unless such person makes a public announcement
of offer to acquire voting shares or control of such company.

Consolidation of holdings
No acquirer, who has acquired more than twenty-five per cent but less than
fifty-one per cent of the voting shares or control of a listed company, shall
acquire additional voting shares or control unless such acquirer makes a
public announcement of offer to acquire voting shares or control. Provided
that such acquirer shall not be required to make a fresh public
announcement of offer within a period of twelve months from the date of the
previous announcement.

Procedure for making competitive bid

Any person, other than the acquirer who has made the first public
announcement, who is desirous of making a competitive bid, shall, within
twenty-one days of the public announcement of the first offer, make a public
announcement of his offer for acquisition of the same voting shares of the
target company at higher price.

Upon the public announcement of a competitive bid the acquirer, who has
made a public announcement of the earlier offer, shall have the option to make
another announcement:

(a) revising the public offer; or

(b) withdrawing the public offer with the prior approval of the SECP:

Provided that if no such announcement is made within ten days of the public
announcement of the competitive bid, the earlier offer on the original terms
shall continue to be valid and binding on the acquirer who has made the earlier
public offer, except that the date of closing of such public offer shall stand
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extended to the date of closure of public offer under the last subsisting
competitive bid.

6 The post-merger or post-acquisition integration process

Introduction to the post-merger or post-acquisition process
Mergers and acquisitions often fail to deliver the anticipated benefits as a result of
failing to effectively integrate the newly acquired entity into the parent.
Poor planning and a lack of information to guide the integration plans ahead of the
acquisition will lead to post-acquisition integration problems.

Druker’s Golden Rules

P. F. Druker (1981) identified five Golden Rules to apply to post-acquisition
integration.
(1) Ensure a ‘common core of unity’ is shared by the acquired entity and
acquirer. Shared technologies or markets are an essential element.
(2) The acquirer should not just think ‘What is in it for us?’, but also ‘What can
we offer them?
(3) The acquirer must treat the products, markets and customers of the acquired
entity with respect.
(4) Within 1 year, the acquirer should provide appropriately skilled top
management for the acquired company.
(5) Within 1 year, the acquirer should make several cross-entity promotions of
staff.

Post-acquisition value enhancing strategies

The following are key points to consider when determining strategy for the combined
entity:

• The integration strategy must be in place before the acquisition is finalized.

• Review each of the business units for potential cost cuttings/synergies or
potential asset disposals. It is possible there is outlets mover valuable to another
entity, but it is important they are in good shape before they are sold. However,
more than this is needed for a full effective enhancement program and a position
audit could be carried out.
• Consider the effect on the workforce and determine how many, if any
redundancies are likely and what the cost will be.
• Risk diversification may well lower the cost of capital and therefore increase the
value of the entity.
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• The entity’s cost of capital should be re-evaluated.

• Make a positive effort to communicate the post-acquisition intentions within the
entity to prevent de – motivation and avoid adverse post- acquisition effects on
staff morale.
• There may be economies of scale to identify and evaluate.
• Undertake a review of assets, or resource audit, and consider selling non-core
elements or redundant assets.
• There may well be need to pursue a more aggressive marking strategy.
• The risks of the acquisition need to be evaluated.
• There needs to be harmonization of corporate objectives.

Impact on ratios or performance measures

Following the completion of an acquisition the purchaser will need to examine
thoroughly the financial and management accounting records of each business unit
of the acquired entity.
Thus, the directors of the acquirer will be particularly interested in the financial
condition of those units which they might plan to dispose of.
From a strategic point of view these are likely to be of more use to another entity with
whom they would form a better fit. However, it is still essential that financially and
operationally they should be in as good shape as possible to ensure that a good
price can be obtained for them.

Illustration 3
Hall Co has just acquired a subsidiary called Wodgits as part of a larger acquisition.
Hall Co has no other subsidiaries in the same business sector as Wodgits, so
management are considering disposing of Wodgits.
A small listed company called Bigwodge, whose core business is similar to Wodgits,
has been identified, and by using all published and any other information reasonably
available, the following analysis has been prepared:

Wodgits Bigwodge
Return on Capital Employed (ROCE) 14.9% 25.0%
Asset turnover 1.3 times 1.8 times
Net profit margin 11.5% 13.9%
Current ratio 1.5 times 2.2 times
Inventory holding period 68 days 57 days
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Receivables collection period 54 days 43 days

Payables payment period 49 days 37 days

Note: All these ratios were introduced in the earlier Chapters on 'Performance
Measurement in Financial Strategy' and 'Short Term Finance – Working Capital
Management'.

Other key information:

• Bigwodge has a P/E ratio of 18.
• Wodgits made an operating profit of Rs 860,000 last year.
• Wodgits has total non current assets of Rs 4.87m, out of which land and buildings
comprise Rs 2.5m. Its net assets at book value are Rs 5.77m.
• The tax rate is 33%.

Required:
As the management accountant of Hall Co, prepare a report to the directors in which
you analyse the performance of Wodgits compared with Bigwodge, and recommend
a price which Hall Co ought to seek for the disposal of Wodgits.

Solution
Report to the directors of Hall Co
Return on capital employed (ROCE)
Wodgits’ inadequate ROCE seems to be mainly due to a low rate of asset turnover,
which we must carefully investigate.

We know that land and buildings account for Rs 2.5m of Wodgits’ fixed asset total of
Rs 4.87m and it is important to establish how much of this property value represents
redundant assets. As to plant and machinery, it may be that this is substantially new
or revalued, in which case the assets may be of good value and the faults may lie
mainly in under capacity working or production inefficiencies. Much more serious,
however, would be a situation where the plant is old and requiring heavy
maintenance, and would be hard put to cope with increased volume of throughput.

If the first of these plant scenarios is correct, then Wodgits may well fetch a
reasonable price, as a bidder, possibly Bigwodge themselves, would be obtaining
good assets to add to their own evidently successful performance in their sector. If
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the second scenario applies, then we might find it difficult to obtain net asset value
for the assets remaining after sale of the redundant properties.

Current ratio
Wodgits’ current ratio and inventory holding period are fairly good, but before we put
the unit up for sale, we would improve our prospects for a reasonable price by taking
early action in regard to both receivables and payables. Both are too high and we
should aim to tighten up credit control and also bring payables down to the more
acceptable level which Bigwodge's payable payment period indicates is appropriate
for the industry sector.

Conclusions
Assuming that we can find that, say, Rs 1.5m of land and buildings are redundant
and can be separately sold, and that the plant scenario is favourable or can be made
so, then it would not seem to be too difficult to make the remainder of Wodgits a
saleable proposition.
Thus if we can assume no debt interest, and taxation of 33%, then after-tax profits
could be Rs 576,000 (Rs 860,000 × 0.67), and as Bigwodge’s current P/E is 18, we
might achieve for Wodgits a P/E of 9 or 10 which suggests a price of between
Rs 5.2 and Rs 5.8m, which is comfortably above an asset value of Rs 4.3m (Rs 5.8m
– Rs 1.5m assets sold).

The impact of an acquisition on the acquirer’s post-acquisition share price

A very important aspect for an acquirer is the post-acquisition effect on its earnings
per share (EPS), and the impact on the share price and P/E ratio arising from the
market’s perceived views on the acquisition.
Once again, detailed analysis of the accounts and comparison to other companies
in similar business sectors can help to assess whether the likely impact will be
favorable.

Simple example of the impact on EPS

Assume that the new entity starts with a prospective EPS of 13.1 cents based on
combined profits of acquirer and acquired of Rs 8.4m, and 64m shares in issue, and
if these earnings could be maintained in year 1 (post-acquisition) they would appear
not to be diluted.
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However, if the acquirer is expected from its previous performances to attain 10%
per annum growth in normal (money) terms, then for year 1 EPS of 13.1 cents x 1.10
would be 14.4 cents, and arguably if this is not attained then dilution will seem to
have taken place.
A serious threat to an acquirer’s EPS is the ‘getting to know you’ costs and also the
‘reverse synergy’ effects of 2 + 2 = 3, which sadly seems to be the fate of numerous
acquisitions.
A major question is whether the present value of the combined earnings including
assumed longer – term profit improvements, really takes into account all the
downside costs of putting two different entities together, each with its own
management style.

7 Divestment
So far in this Chapter, we have considered entities joining together in mergers and
acquisitions. Now we turn our attention to the issue of divestment.
Definition
Divestment: Disposal of part of its activities by an entity.

Reasons for divestment

The reasons for divestment include:

The sum of the parts of the entity may be worth more than the whole
As identified earlier in this Chapter, businesses which combine will attempt to find
areas where resources can be combined to generate synergy. However, it may be
that a business with many disparate parts actually ends up suffering from the
opposite effect. For example, the company could be spending a lot of money trying
to integrate business units together where there are no apparent benefits.
In such situations, the divestment of part of the business should be considered.

Divesting unwanted or less profitable parts

If there is an underperforming business unit which fails to meet general company
performance targets, divestment should be considered.
However, management should always consider the effect of the divestment on the
other parts of the company. For example, if a division is sold off which previously
performed some work for other business units within the company, disposing of that
business unit will lead to the other parts of the business having to buy in goods and
services from third parties.
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To shift the strategic focus onto the core activities

A part of the business which operates in a different market sector from the rest of the
group may be considered for divestment. Increased focus on the company's core
activities should help to develop the expertise of management and staff, and the
strength of the company's brand.

A response to crisis
In a crisis, when cash is needed quickly, a part of the business might be divested if
an attractive offer is received.
The most common examples of divestments are sell offs (trade sales), spin offs and
management buyouts.

More on divestment – sell – offs and spin - offs

Sell-off (or trade sale)
A sell –off is the sale of part of an entity to a third party, usually in return for cash.
The most common reasons for a sell-off are:

• To divest of a less profitable business unit if an acceptable offer is received – this

could be through a management buyout – see below;
• To protect the rest of the business from takeover – a part of the business which
is attractive to a purchaser may be sold off to avoid the whole company being
taken over;
• To generate cash in a time of crisis.

A sell-off may disrupt the rest of the organization if key staff or products from within
the organization are part of the business unit sold off.

Spin-off (or demerger)

In a spin-off (or demerger) a new entity is created, where the shares of that new
entity are owned by the shareholders of the entity that made the transfer of assets
into the new entity. There are now two entities, each owning some of the assets of
the original single entity. The ownership has not changed, and in theory the value of
the two individual entities should be the same as the value of the original single entity.

Reasons for spin-offs

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Spin –offs may be justified as follows

• They allow investors to identify the true value of a business that was hidden
within a large conglomerate;

• They should lead to a clearer management structure;

• They reduce the risk of a takeover bid for the core entity.

8 Management buyouts
Definition
Definition of a management buyout (MBO): Purchase of a business from its
existing owners by members of the management team, generally in association with
a financing institution.

Overview of an MBO
In an MBO, the purchaser of the business is not another company (like in a selloff/
trade sale), but the existing management.
Usually the management provides some of the capital for the buyout, but the majority
is provided by other financiers such as venture capitalists and financial institutions.

MBOs - consideration for divesting company

Members of the buyout team may possess detailed and confidential knowledge of
other parts of the vendor’s business and the vendor will therefore require satisfactory
warranties over such aspects which it will not be able to control.
More seriously, key members of the MBO team may have skills vital to the vendor’s
operation, especially in regard to information services and networking.

A vendor may be reluctant to allow key players to end their contracts of service to
take part in an MBO, because losing vital operational skills can hardly be
compensated by forms of warranty.

MBOs consideration for the management team

MBOs are not dissimilar to other acquisitions and many of the factors to be
considered will be the same.
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• Do the current owners wish to sell? – The whole process will be much easier
(and cheaper) if the current owners wish to sell. However, some MBOs have
been concluded despite initial resistance from the current owners.

• Potential of the business – The management team engaged in the buyout will
be making the switch form a relatively safe salaried position to a risky ownership
position. They must, therefore, ensure that the victim business will be a long run
profit generator. This will involve analyzing the performance of the business and
drawing up a business plan (products, markets, required new investment,
sources of finance, etc.) for future operations. Research shows that MBOs are
less likely to fail than other types of new ventures, but server have collapsed, and
manages must appreciate the risks they are taking and attempt to reduce them
as far as possible.

• Loss of head office support – On becoming an independent firm many of the

services that are taken for granted in a large organization may be lost. The
importance of these services varies from one industry to another but provision
will have to be made for support in the areas of finance, computing, research and
development, etc. Although head office fees might be saved, after the buyout
these support services can involve considerable expense when purchased in the
outside market.

• Quality of the management team – The success of any MBO will be greatly
influenced by the quality of the management team. It is important to ensure that
all functional areas (marketing, sales production, finance) are represented and
that all managers are prepared to take the required risks. A united approach is
important in all negotiations and a clear responsibility structure should be
established within the team.

• The price – As in any takeover situation the price paid will be crucial in
determining the long term success of the acquisition. The usual valuation
techniques may be employed, often with more confidence as managers are likely
to have a clearer idea of the future prospects of the firm. Care must be taken to
ensure that all relevant aspects of the business are included in the package. For
example, trademarks and patents may be as important as the physical assets of
the firm. In a similar way, responsibilities for redundancy costs, etc. must be
clearly defined.

Terminology – leveraged buyout

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A leveraged buyout occurs when an investor, typically a private equity firm, acquires
a controlling interest in a company’s equity and where a significant percentage of the
purchase price is financed through leverage (borrowing).
Leveraged buyouts involve institutional investors and financial sponsors (like privet
equity firms) making large acquisitions without committing all the capital required for
the acquisition.
Financing the MBO
In an MBO, unlike a corporate-backed takeover, the acquiring group usuallylacks the
financial resources to fund the acquisition.
For small buyouts the price may be within the capabilities of the management team,
but it is unlikely that many managers could raise the large amounts involved in some
buyouts.
Several institutions specialise in providing funds for MBOs. These include the
following:
• venture capitalists;
• banks;
• private equity firms;
• other financial institutions.

Role of venture capitalist

Venture capitalists
Venture capitalists often provide their funds as a mix of equity and debt, in order to
give themselves security (the debt) while allowing them to participate if things go well
(the equity). Typically they will be prepared to advance funds for five to ten years,
and will expect annual returns on the funds of 25% or more.
The types of finance and the conditions attached vary between the institutions.
Points to be considered include the following.
The form of finance – Some institutions will provide equity funds. However, more
commonly loan fiancé will be advanced. Equity funds will dilute the management
team’s ownership but, on the other hand, high gearing could put substantiate strain
on the firm’s cash flow.
Exit strategy – The most important fact that nay investing institution will want to
know is how and when they will get their money back. The exit strategy is an
important part of the agreement to advance money in the first place. Exit strategies
are explained more fully later in this Chapter.

The involvement of the institution – Some institutions may require board

representation as a condition of providing funds.
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Ongoing support – The management team should also consider the institution’s
willingness to provide funds for later expansion plans. Some investors also officer
other services such as management consultancy to their clients.
Details on financing MBOs
Financiers tend to favor established businesses with reliable cash flows (to pay down
the debt) and a clear exit route.
They like definitive plans, but say they prefer them brief and to the point.
The emphasis should be on the competences of the team, and the market
opportunity to be exploited, with detailed financial numbers (focusing on cash flow)
put into an appendix. How services previously supplied by group departments, or
fellow subsidiaries, will be replaced is likely to be a key item.
Managers will be required to invest some of their own money and this will take the
form of shares with special features, for example a high proportion of any disposal
value.

Suggested financial structure

Capital structures are inevitably compelling, with several levels of risk/reward:

• Secured loans are usually obtained from a bank, with a first charge on the
assets taken over by the venture.

• The provider of senior debt will require a first ranking security over all the assets
involved in the MBO venture and, usually, over the capital of the MBO as
evidenced by shares in the new entity. Security will also involve undertakings
form the MBO team regarding the provision of financial information and the
setting of restrictions on the MBO’s capacity to raise other debt fiancé and do
dispose of assets.

• Junior debt is usually called mezzanine finance, which is an intermediate stage

between senior debt and equity finance can comprise a mixture of debt interest
and the ability to convert part of the debt into equity, perhaps by the conversion
of warrants. By this means the lender can in time have a share in the premium
resulting from eventual exit from the venture. The debt interest will carry a risk
premium, as it is subordinate to the senior debt and with less security: it may
even be unsecured.

• Venture capital is a form of equity provided mainly by institutional investors,

whose reward will usually be in some form of dividends, probably preferential,
combined with appreciation of their MBO equity holding which will build up a
capital gain for when the investment is realized.
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• The last link in the structural chain is the equity holding granted to the MBO
team itself which, if their activities are successful, will provide a substantial
capital gain when the venture is exited, either through flotation or by other means.
Meanwhile, the MBO management will draw salaries of fees for their services.

MBOs – consideration for the financers

Key points for investors – usually banks or other institutions – in deciding whether to
support an MBO are as follows:

• What is actually for sale, and why? It may be a division or subsidiary of an entity
which no longer first that entity’s strategy, or it may be separable assets such as
a factory or group of retail outlets.

• Whether the activities are profitable and enjoy a satisfactory cash flow. The
prospective retunes must justify the operational and financial risks involved.
Profits must be sustainable and cash flow adequate to sustain the level of
activities proposed.

• Whether the management is sufficiently strong. This point is particularly

significant if the MBO relates to loss – making activities, although sufficient
allowance must be made for the possibility that its existing owners may be
burdening it with excessive overheads. Financial competence and marketing
skills in the MBO’s sector are especially important.

• Whether the price is reasonable and a sufficient contribution is being made by

the managers. The managers should have some financial involvement and the
future prospects for the new entity should be demonstrable, especially in a ‘turn-
around’ situation.

These points are important as the main risks associated with MBOs. and hence the
reasons why they may fail are:

• The bid price offered by the MBO team might be too high;
• A lack of experience in key areas such as financial management;
• A loss of key staff who either perceive the buyout as too risky, or do not have
capital to invest;
• A lack of finance;
• Problems in convincing employees and follow colleagues of the need to change
working practices or to accept redundancy.

Investors, probably institutions, backing the MBO will initially hold majority of the
equity, with a relatively small minority of shares held by the managers.
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Although the backers must be prepared to hold their investment for the long term,
they and the managers will be looking to the entity growing successfully to the point
where it can be launched on the stock exchange. At this stage, a market value can
be obtained for the equity and, if desired, some portion of the investment can be
realized.

Where the backers desire a lower risk element in their investment, they can require
that some part of it will be in the form of redeemable convertible preference shares.
This can give them priority in obtaining income through a preference dividend and
preferential rights of repayment if the entity should fail. There is also the prospect of
redemption it the entity should fail. There is also the prospect of redemption if the
entity does not develop satisfactorily, or conversely, the convertible aspect will allow
backers eventually to increase their equity holding if the entity should prove
successful.

9 Exit strategies
Overview of exit strategies
The investors and financiers in an MBO will want to realise a profit from their
investment in the medium term.
Debt finance will normally have a specified repayment date, so the debt providers
will have a clear exit route (assuming the borrowing company has performed in line
with expectations and can afford to repay the debt as planned).

Exit strategies for equity holders

For the providers of equity, the exit route is not as easy to identify. The most common
exit route for an equity investor is the sale of the shares to another investor. This
could be through one of the following methods:

Trade sale
If the MBO company receives an offer for all its shares from another company, the
financiers will be able to realize their investment. However, in a trade sale, all the
shares are normally acquired by the bidding company, so the management would
have to sell their shares in their own company too. They may not be happy to do this,
because the appeal of an MBO to managers is that they will own their own company
rather than have to report to other shareholders.

IPO (Initial Public Offering)

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An IPO gives the financiers who want to sell their shares the chance to do so on the
stock market. If the managers want to keep hold of their shares, they will be able to
do so.
The problem with an IPO is that the company will have to satisfy certain stringent
criteria in order to join the stock exchange, and there will be significant costs
associated with the listing.
After an IPO, the shares will be freely traded, which should increase their
marketability and hence their value. On the other hand, the company becomes much
more susceptible to takeover when its shares are listed.

Independent sale to another shareholder

The managers could try to increase their shareholdings in the company by 'buying
out' the other financiers.

This would be expensive, but if the managers could afford it, it would prevent other
external shareholders buying the shares and having a say in the running of the
business.

Test your understanding 1 – ML Ltd

(a) One theoretical method of valuing a company's shares is to calculate the present
value of future dividends using a discount rate that reflects the risk of the business.
In respect of large, listed companies, current evidence suggests that this is far too
simplistic a view of how company values and share prices are determined.

Required:

Comment on the reasons why share prices may be substantially different from the level
suggested by theory. Include brief comments on the relevance of P/E ratios and net
asset values in share price determination.

(b) ML Ltd is an expanding clothes retailing company. It is all equity financed by ordinary
share capital of Rs 10 million in shares of Rs 5 nominal. The company's results to the
end of March 20X9 have just been announced. Pre-tax profits were Rs 4.6 million. The
chair's statement included a forecast that earnings might be expected to rise by 5% per
annum in the coming year and for the foreseeable future.

CO Ltd, a children's clothes group, has an issued ordinary share capital of Rs 33 million
in Rs 10 shares. Pre-tax profits for the year to 31 March 20X9 were Rs 5.2 million.
Because of a recent programme of reorganisation and rationalisation, no growth is
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forecast for the current year but subsequently constant growth in earnings of
approximately 6% per annum is predicted. CO Ltd has had an erratic growth and
earnings record in the past and has not always achieved its often ambitious forecasts.

ML Ltd has approached the shareholders of CO Ltd with a bid of two new shares in ML
Ltd for every three CO Ltd shares. There is a cash alternative of Rs 13.5 per share.

Following the announcement of the bid, the market price of ML Ltd shares fell while the
price of shares in CO Ltd rose. Statistics for ML Ltd, CO Ltd and two other listed
companies in the same industry immediately prior to the bid announcement are shown
below. All share prices are in Rs.

20X8 Company Dividend yield P/E

High Low

22.5 18.5 ML Ltd 3.4

15

14.5 11.5 CO Ltd 3.6

13

18.7 12.2 HR Ltd 6

12

23.0 15.9 SZ Ltd 2.4

17

Both ML Ltd and CO Ltd pay tax at 33%.

ML Ltd's cost of capital is 12% per annum and CO Ltd's is 11% per annum.

Required:

Assume you are a financial analyst with a major fund manager. You have funds invested
in both ML Ltd and CO Ltd.

– Assess whether the proposed share for share offer is likely to be beneficial to the
shareholders in ML Ltd and CO Ltd, and recommend an investment strategy
based on your calculations.

– Comment on other information that would be useful in your assessment of the

bid. Assume that the estimates of growth given above are achieved and that the
new company plans no further issues of equity.
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State any assumptions that you make.

Test your understanding 2 – KING Ltd

KING Ltd is a medium-sized food manufacturing company. It has recently sold a

subsidiary that traded in what the company considered to be non-core business. The
sale raised Rs 1.4 million in cash.

The company's long-term debt to equity ratio is relatively high compared with other
companies in the industry and the directors have ruled out further borrowing at the
present time. In fact, one of the directors thinks the cash raised from the sale of the
subsidiary should be used to repay some of the company's outstanding debt.

This is not a view shared by the other directors who are evaluating three small but
potentially profitable acquisition opportunities. The directors believe that the
shareholders of all three target companies would not be opposed to a bid at this time,
especially to a cash offer. However, to acquire all of them would require Rs 2.3 million.
The share price is standing at an all time high - a level considered unsustainable by the
directors based on the company's projected [Link] directors therefore intend to
limit their expenditure to the Rs 1.4 million cash raised by the sale of the subsidiary.

Expected after-tax cash flows

Company Year 1 Year 2 Year 3 Acquisition

price

Rs 000 Rs 000 Rs 000 Rs

000

AB Ltd (100) 750 1,100

(1,100)

CD Ltd 125 275 380 (550)

EF Ltd 200 325 450 (650)

Note: The cash flows are in real terms, i.e. they do not include inflation. KING Ltd's
shareholders currently require a real return of 12% on their investment in the
company. The company uses this rate to evaluate all its investment decisions,
including acquisitions.

Required:
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Assume you are a financial manager with KING Ltd. Write a report to the directors
evaluating the potential acquisitions. You should include the following information in
your report:

The expected net present value and profitability indexes of the three projects. Based
solely on these calculations comment on which company(ies) should be chosen for
acquisition and comment on the use of 12% as a discount rate in the circumstances
here;

Recommendation of uses for any cash that is left over after the acquisitions have been
made.

Comment on the directors' decisions:

(i) to invest rather than repay debt and

(ii) to limit their investment for the current year to cash purchases rather than raise
new capital in the form of debt or equity.

Comment on the advantages and disadvantages of growth by acquisition as

compared with growth by internal (or organic) investment.
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Test your understanding answers

Example 1
• Operating efficiencies – the unused capacity at GSL can be used to produce
Williams' products without adding to costs and capacity.
• Marketing synergies.
• If the cash flow streams of Williams and GSL are not perfectly positively
correlated then by acquiring GSL – Williams may reduce the variability of their
operating cash flow. This being more attractive to investors may lead to cheaper
financing.
• The ‘dedicated’ herbalists of GSL and the R+D staff of Williams may be a
complementary resource.
• Fixed operating and administrative costs savings.
• Consolidation of manufacturing capacity on fewer and larger sites.
• There may be bulk buying discounts
• Possibility of joint advertising and distribution.
• GSL is badly managed – thus the elimination of inefficiency could allow for
financial synergy.

Example 2
Calculations
Value of Mavers Co = Rs 3.05 × 48m shares = Rs 146.4m
Value of Power Co = Rs 6.80 × 13m shares = Rs 88.4m
Total value (assuming no synergistic gains) = 146.4 + 88.4 = Rs 234.8m
Number of shares post-integration = 48 million + (2 × 13 million) = 74 million
So the post-integration share price will be:
Rs 234.8m / 74 million = Rs 3.173

Shares MV Old wealth Change

Mavers 48m Rs 152.3m Rs 146.4m +Rs 5.9m

Power 2 x 13m = 26m Rs 82.5m Rs 88.4m –Rs 5.9m

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Advice
The Power Co shareholders will not accept a 2 for 1 share for share exchange since
it causes their wealth to reduce.

Recommendation
In order for the Power Co shareholders to be encouraged to accept the offer, it must
offer them a gain in wealth.
To make sure that Mavers Co is valuing Power Co at its current market value, the
value of the offer needs to be (Rs 6.80 x 13m shares) Rs 88.4m in total.
Given the current Mavers Co share price of Rs 3.05, this amounts to Rs 88.4m / Rs
3.05 = 28.98m shares in Mavers Co.
An exchange of 28.98m Mavers Co shares for the 13m Power Co shares represents
a ratio of 28.98m to13m or 2.23 to 1.
However, if the terms of the offer were to be exactly 2.23 Mavers Co shares for every
1 share in Power Co, there would be no incentive for the Power Co shareholders to
sell (financially, they’d be indifferent between keeping their existing shares and
exchanging them for Mavers Co shares).
In order to encourage Power Co’s shareholders to sell, a premium would have to be
offered.
Hence, an offer of (say) 2.5 Mavers Co shares for every 1 share in Power Co would
probably be needed to encourage the Power Co shareholders to sell.

Position of Mavers Co shareholders

In this situation, where no synergistic gains are included in the calculations, a gain
to Power Co's shareholders will result in a corresponding loss to the Mavers Co
shareholders. Clearly Mavers Co would not want to proceed with the takeover in
these circumstances.

Unless some synergies can be generated, to improve the wealth of the overall
company after the acquisition, there is no way of structuring the deal so that both
sets of shareholders will be satisfied.

Test your understanding 1 – ML Ltd

323

(a) Given the wording, you really need to explain why the dividend valuation
model may break down, as it is the 'theory' specifically mentioned in the
question. You probably have time only to mention a couple of drawbacks
with each approach.

A common way of valuing the ordinary shares in a company is discounting all future
dividends anticipated from holding the shares. Although having a ring of truth, it often
fails to give a price which corresponds to the current market price, due to its inherent
flaws:

– It requires constant dividend growth, which in turn implies a constant retention

ratio and return on re-invested funds. It is possible to cope with varying growth
rates but the calculation is awkward.

– It requires a continuous supply of investment opportunities through time to

justify retention.

– It can give nonsensical results e.g. zero current dividend generates zero value,
thus ignoring the value of the firm's assets and/or its earnings stream.

– It is only suitable for valuing minority stakes in a firm because it ignores the
opportunities for managers to restructure firms to improve earnings and cash
flow. The key to value is not the portion of profit paid out to shareholders but
the earning power of the business.

Price earnings (P/E) ratios

This is not a method of valuing shares of quoted firms - P/E ratios are the product of
valuation. When the market sets a value, the resulting share price divided by the last
reported earnings gives the P/E ratio. Generally, a high P/E ratio indicates that a
company is expected to grow its earnings rapidly in the future.

The P/E ratio can be used to cross-check against the value of other companies - if
their relative P/E ratios look out of line, it may suggest under- or overvaluation
somewhere. P/E ratios can also be used when valuing the shares of unquoted
companies, taking due care when interpreting the accounting data used.

Net Asset Value (NAV)

The NAV is the value per share of the firm's assets net of all liabilities i.e. the owners'
stake in the firm. It has some merit for unlisted companies whose shares are not
traded, but it is highly unreliable for many reasons:
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– Based on GAAP, statement of financial position values are primarily designed to

satisfy the directors' duty to account for past performance.

– It can be distorted by accounting practices e.g. different depreciation policies.

– Revaluation of assets is not mandatory (except in the property sector) so asset

values could seriously understate market values.

– It is only valid at one point in time, the reporting date.

– It (usually) ignores intangibles such as brands and market standing.

– It may exclude some liabilities - 'off-statement of financial position' debts like

operating lease obligations and warranty commitments.

– Stock values quickly outdate in some industries, and some debtors may be
doubtful.

The NAV provides merely a floor to equity value - usually, the market value is many
times the NAV because the market is valuing future earnings capacity. A discounted
cash flow approach is the most appropriate method of valuation
(b) The length of answer that you can offer will be limited. The bulk of your time will
be spent on computation. The solution presented here gives a step-by-step guide that
you would need to follow, rather than just a summary of the results.

Basic information

ML CO Combined

Profit after tax (PAT) for each firm is

ML: (0.67 × Rs 4.6m) Rs 3.082m Rs 3.484m Rs 6.566m

CO: (0.67 × Rs 5.2m)

Given respective P/E ratios,

market values are:

ML: (15 × Rs 3.082) Rs 46.23m Rs 45.29m Rs 91.52m

CO: (13 × Rs 3.484)

Given the number of shares, share

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price is:

ML: (Rs 46.23/2m) Rs 23.12 Rs 13.72

CO: (Rs 45.29/3.3m)

EPS:

ML: (Rs 3.082/2m) 1.541 1.056

CO: (Rs 3.484/3.3m)

Analysis

No. of shares post-bid: 2,000 + (2/3× 3,300) = 4,200

Expected market prices post-bid = Total market value/no of shares

= (Rs 91,520/4,200) = Rs 21.8

Value of bid at post-issue price = (2 =Rs 43.6

shares × Rs 21.8)

Cash value of bid per 3 shares =Rs 40.5

offered: (Rs 13.5 × 3)

Assessment

Assuming no changes in the level of market prices, and no re-rating of the sector, ML
share price would fall post-acquisition to Rs 21.8. At this price, the value of the 2-for-3
share offer should attract CO shareholders. They would be getting shares worth (2 ×
Rs 21.8) = Rs 43.6 in exchange for shares currently worth (3 × Rs 13.7) = Rs 41.1.

The share-for-share offer is also worth more than the cash alternative: Rs 43.6 vs Rs
40.5.
326

This is a 'reverse takeover', where the shareholders of the target end up holding a
majority stake in the expanded company - but who gains from this?

Former CO shareholders would hold (2,200/4,200) × Rs 91.52m = Rs 47.939m of the

value of the expanded firm, a gain of (Rs 47.939m - Rs 45.290m pre-bid value of CO)
= Rs 2.649m.

ML shareholders would lose Rs 2.649m, making the share-financed deal distinctly

unattractive to them.

Conversely, the cash offer would create wealth for ML shareholders i.e. they give Rs
40.5 for something worth Rs 41.1 pre-bid.

The advice to the fund manager is: 'accept the bid in respect of CO shares and sell
ML shares in the market if you can achieve a price above Rs 21.8'.

Other information required

The advice given hinges on the behaviour of ML's share price - it has already fallen
on the announcement, but by how much? It may already be too late if the market is
efficient, as it would already have digested the information contained in the
announcement

Also:

– What benefits are expected from the merger i.e. cost savings and synergies?
To make sense of the bid, ML must be setting the PV of these benefits above
Rs 2.649m to yield a positive NPV for the acquisition.

– How quickly are these benefits likely to show through? Any delay in exploiting
these lowers the NPV.

– It is feasible that the market might apply a higher P/E ratio to the expanded
company - maybe not as high as ML's but possibly at the market average,
currently 14.25, compared to the weighted average P/E ratio for ML/CO of 14.

– Is ML likely to sell part of CO's operations? And to whom? If ML has already

lined up a buyer, it must expect to turn a profit on the deal.

– Is the bid likely to be defended by the target's managers, fearful for their jobs? If
so, a higher bid might be expected.
327

– Is a White Knight likely to appear with a higher bid on more favourable terms?

– Are there competition implications likely to attract the interest of the authorities?

Test your understanding 2 – KING Ltd

Report

To: Board of Directors, KING Ltd

From: Financial manager

Date: XX/XX/XX

Re: Acquisition opportunities

In this report I have evaluated the three potential target companies the Board is
considering. I have also considered the further finance issues surrounding the use of
the cash raised from the recent sale of the subsidiary company, and the wider
question of whether growth by acquisition is preferable to organic growth.

Investment evaluation

Each investment has been evaluated on the basis of the NPV of the real cash flows
discounted at our real required rate of return of 12% (see Appendix). The results are
summarised as follows:

AB Ltd CD Ltd EF Ltd

Net present value (NPV) Rs 191,700 Rs 51,400 Rs

108,000

Initial investment Rs 1,100,000 Rs 550,000 Rs

650,000

Profitability index (PI) 17.4% 9.3% 16.6%

Purely on the basis of these computations, and bearing in mind that we only wish to
invest the Rs 1.4m realised from the subsidiary sale, the investment in AB Ltd is
preferable to the alternative of investing in both CD Ltd and EF Ltd. Having a positive
328

NPV indicates that this option is also preferable to returning the money to the
shareholders.

With regard to the use of the 12% required return as a discount rate for all three
companies, two points need to be made:

• the discount rate used to evaluate a project should reflect the specific level of
risk attached to its cash flows. The use of a blanket 12% rate assumes that all
three companies operate in the same risk class, which also includes KING
Ltd.
• 12% is a real required rate of return, and has been applied to real cash flows.
This evaluation may be invalidated if the cash flows are expected to inflate at
different rates, either from each other or from the general rate of inflation that
shareholders may build into their money (nominal) required return.

Use of surplus cash

The investment in AB Ltd will leave Rs 300,000 from the subsidiary sales proceeds.
This may be used to:

• invest elsewhere, either in a smaller company, or internally, in working capital

if this is justified by a possible increase in turnover;
• repay some of our borrowings;
• pay an increased dividend, if the company feels it cannot use it profitably either
this year, or in the near future.

Current finance policies

The Board has decided not to use the Rs 1.4m to repay debt, nor to supplement this
for investment by raising further equity or debt capital. This will mean that the
gearing level of the firm will remain largely constant (although the impact of the
investment is expected to marginally raise the market value of equity).

This implies that the Board feels that the company is currently operating at its
optimal gearing level, where the costs and risks of its finance are balanced to
produce the lowest overall cost and highest market value. Provided this is, in fact,
the case, this is a reasonable policy to follow, although it should be kept under
careful review as market conditions change.

The decision not to increase the level of investment in order to take advantage of all
three (and possibly more) investment opportunities is perhaps a little more
questionable. This can be done without significantly affecting the gearing level, by a
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mix of equity and debt, and will increase the wealth of KING shareholders. There
should be few problems raising new finance in these circumstances.

However, if the Board is convinced that the share price is unsustainable at its current
level, the expansion could be undertaken without further cash injection by making a
share-for-share offer to CD Ltd and EF Ltd.

External versus internal growth

In comparison with growth by internal (organic) investment - i.e. expanding existing

activities or setting up a new business from scratch - growth by acquisition has the
following advantages and disadvantages:

Advantages

• It may be cheaper, if the shares of the target company(ies) are currently

undervalued by the market for some reason, or the business is being
mismanaged.
• The growth is achieved at a faster rate.
• The expertise and skills needed can be bought with the company.
• Whilst the acquiring company is increasing (or acquiring) market share,
productive capacity of the market is maintained at the current level, avoiding
the increased competitive 'squeeze' that comes from expanding an existing
business in a limited market.

Disadvantages

• The indirect costs of acquisition are often underestimated - the integration of

the systems, management and culture of the new company can be a long,
costly and sometimes unsuccessful process.
• The benefits expected from the merger are often not realised due to estimates
being based upon inaccurate or incomplete information, or lack of
management understanding of a new industry or market. The knowledge and
experience base for organic expansion will generally be a lot firmer.
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Appendix

Time Cash flows 12% PV

Rs 000 df Rs 000

AB Ltd CD Ltd EF Ltd AB Ltd CD Ltd EF Ltd

0 (1,100) (550) (650) 1 (1,100) (550) (650)

1 (100) 125 200 0.893 (89.3) 111.6 178.6
2 750 275 325 0.797 597.8 219.2 259.0
3 1,100 380 450 0.712 783.2 270.6 320.4
NPV 191.7 51.4 108.0

PI 17.4% 9.3% 16.6%

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Learning Objectives:

a) Understand the fundamental concepts of foreign currency and domestic currency in

international trade and finance.

b) Explain FX exchange rates, bid/buying rates, and ask/offer/selling rates in both

direct and indirect quoting methods.

c) Evaluate risks associated with dealings in foreign currency and assess the
relationship between risk and reward.

d) Apply hedging strategies to manage foreign currency risk, including invoicing in

home currency, leading and lagging, netting/matching assets and liabilities, forward
rate agreements/contracts, money market hedging, currency options, currency
futures, and currency swaps.

e) Analyze the practical application of hedging techniques in real-world scenarios to

mitigate currency risk and enhance financial stability.

f) Assess the impact of currency market trends and exchange rate movements on
business decisions and financial performance in global markets.

g) Demonstrate proficiency in calculating and interpreting key metrics related to foreign

currency transactions and hedging instruments.
333

BASIC CONCEPTS:
Exchange rate:
A rate at which a currency can be exchanged with the other, for example $1 = PKR 230. It is the
price of one currency expressed in terms of another currency.

Direct Quote:
When a quote is given for one unit of foreign currency, it is called direct quote.

E.g., $1 = PKR 230.

Indirect Quote:
When a quote is given for one unit of local currency, it is called indirect quote.

E.g., PKR 1 = $ 1 / 230.

• In order to classify a quote as either direct or indirect, one of the currencies must be
the local currency.
• Inverse of direct quote is indirect quote; inverse of indirect quote is direct quote.

Spot and Forward Rate:

• Spot rate is the rate for immediate transaction.
• Forward rate is the rate agreed today for the transaction at any future point in time.

Two-way quote:
A two-way quote indicates two different exchange rates with respect to bank i.e. bid and ask rates.
• Bid rate = the rate at which bank will buy the currency.
• Ask rate = the rate at which bank will sell the currency.

The difference between the two is called “spread” or “margin”.

Under two way quote, inverse of bid rate of direct quote become ask rate of indirect quote
and vice versa.

Conversion of currencies:
334

1st Currency 2nd Currency

Buy [Payment] Low High
Sell [Receipt] High Low
Conversion by Divide Multiplication

Illustration 1:
We are provided with the exchange rate PKR / $ 283 – 285. [Rupee is 1st currency, $ is
2nd currency]
- How much will $ 500 cost in Rupees to buy? [500 x 285 = Rs.142,500]
- How much rupees will be received if $ 500 are sold? [500 x 283 = 141,500]
It is to note that Rs.1,000 is the profit for currency dealer.

Illustration 2:
Exchange rate $ / £ = 1.245 – 1.252

- What is the cost of buying $ 2,000? [2,000 / 1.245 = £ 1,606.43]

- What is the proceeds by selling $ 2,000? [2,000 / 1.252 = £ 1,597.44]
Dealer profit £ 8.98, difference between buying and selling.

- What is the cost of buying £ 600? [600 x 1.252 = $ 751.20]

- What is the proceeds by selling £ 600? [600 x 1.245 = $ 747.00]
Dealer profit $ 4.20, difference between buying and selling.

FOREIGN CURRENCY RISKS:

There are three types of currency risks: (a) transaction risk, (b) economic risk and (c) translation
risk. First two are cash flow risk as they affect cash flow risk; while translation risk are non-cash
flow risk.

1. TRANSACTION RISK – risk that exchange rate may change between initiation and
settlement of a transaction due to time interval.

Illustration – Transaction risk:

On Jan 01, 2023, a US firms enters into a contract to buy a piece of equipment from a UK
company for £ 45,000 when the spot rate $ / £ = 1.778. The payment is decided to be made on
31 Jan 2023.
335

Required:
Calculate the cost equipment under the following cases:

a) Spot transaction.
b) If exchange rate on 31 Jan 2023 is $ / £ = 1.834.
c) If exchange rate on 31 Jan 2023 is $ / £ = 1.692.

Solution:

a) If transaction is settled at spot, $80,010 will be required [£ 45,000 x 1.778].

b) If exchange rate on 31 Jan 2023 is $ / £ = 1.834, $82,530 will be required [£ 45,000 x 1.834].
c) If exchange rate on 31 Jan 2023 is $ / £ = 1.692, 76,140 will be required [£ 45,000 x
1.692].
It could be clearly noted that, the amount of foreign currency is same but the local currency
required to settle the payment in foreign currency changes with the change in exchange rate. This
is called transaction risk.

2. ECONOMIC RISK – The change in change rates affect the entity’s in two ways:
a) International competitiveness of a company is affected because [usually] prices are
quoted in the currency of customer and the variation in exchange rate alters the
competitiveness of the company even through prices in home currency remains constant.
b) Customer base is affected due changes the expected future cash flows of the entity as a
consequence of loss of customer base.

Illustration – Economic risk:

A Pakistani exporter wants sells its machines to US customer at cost plus 20% markup
basis. The cost to the company is Rs.25,000. The spot exchange rate is PKR / $ = 278.
The price of product is quoted in terms of US$.
Required:
Calculate the quoted price under the following cases:
a) Spot exchange rate.
b) PKR / $ = 281.
c) PKR / $ = 274.

Solution:
Exchange Rate Quoted Price
Cost in PKR Profit [20%] Price in PKR
[PKR / $] ($)
278 25,000 5,000 30,000 107.91
281 25,000 5,000 30,000 106.76
274 25,000 5,000 30,000 109.49
336

It is noted that quoted price changes in $ with the change in exchange rate even though
price in domestic currency remains unchanged.

TRANSLATION RISK (aka) BALANCE SHEET RISK – The risk of change in value of
foreign currency denominated financial statements [assets and liabilities] into local
currency especially in consolidated financial statements. It is a non-cash flow risk that
result in exchange gain / losses.

ADMINISTRATIVE TOOLS FOR RISK MANAGEMENT

1. Do nothing
This is the strategy employed by those businesses, which have very low volume of
foreign currency transactions, and their exposure to FC risk is very limited.
Alternatively, the loss in one transaction may be offset by the gain in the other.

2. Invoicing in home currency:

When a company sells goods or services to a foreign customer, instead of billing in
the customer's currency, the company invoices in its own domestic currency. By
adopting this approach, the company transfers the currency exchange risk to the
foreign customer. This means that any potential losses or gains due to exchange
rate fluctuations are borne by the customer, not the company.

Additionally, invoicing in home currency can simplify accounting and financial

reporting processes for the company. It reduces the complexity of dealing with
multiple currencies and eliminates the need for frequent currency conversions, which
can be time-consuming and costly.

However, this method may not be commercially viable if the local currency is not an
international currency.

3. Leading and lagging:

Both leading and lagging strategies aim to mitigate the potential negative impacts of
currency fluctuations on a company's financial performance.

a) Leading [Early settlement] involves adjusting the timing of payments and receipts to
match currency movements. For instance, if a company expects its domestic currency to
appreciate against a foreign currency, it might expedite payments in that foreign currency
to lock in current rates before they become less favorable.
337

b) Lagging [Delayed settlement] involves delaying payments or receipts to take

advantage of expected currency movements. If a company expects its domestic currency
to depreciate, it might delay converting foreign currency receipts into its domestic
currency, hoping to benefit from exchange rates that are more favorable in the future.

4. Matching receipts and payments:

It refers to aligning the timing and currency of incoming and outgoing cash flows. By
matching foreign currency receipts (income) with foreign currency payments (expenses) in
the same currency and timeframe, companies can reduce their exposure to currency
fluctuations. This strategy minimizes the need to convert currencies at unfavorable
exchange rates, thereby mitigating potential currency-related losses. There could be
challenges like timings and amount of receipts and payments may not match. In the
context of Pakistan, matching is not practical as the receipts in foreign currency are to be
surrendered to State Bank as per financial regulations.

5. Matching assets and liabilities [aka] Balance Sheet Hedging:

"Matching assets and liabilities" is a tool to manage translation risk that involves aligning the
currency denominations of a company's assets with its liabilities. By matching foreign currency
assets (e.g., investments, receivables) with foreign currency liabilities (e.g., loans, payables)
in the same currency and maturity, companies can reduce their exposure to currency
fluctuations. This approach helps to hedge against potential losses arising from adverse
currency movements by ensuring that gains or losses on assets are offset by corresponding
gains or losses on liabilities.

6. Diversification of international customer base:

"Diversification of international customer base" is a tool to manage economic risk that involves
expanding a company's customer base across multiple countries and currencies. By serving
customers in various regions, companies can naturally offset currency fluctuations. If one
currency depreciates, revenues from other stronger currencies may increase, balancing out
the impact of currency volatility. This strategy reduces reliance on a single currency and helps
mitigate potential losses from adverse currency movements.

7. Netting:
Netting is a tool primarily designed for multinational group of companies that operate in various
countries with an objective to reduce transaction cost, as for group perspective, gain in one
currency is exactly offset by the loss in other currency. However, occasionally, non-group
entities may also participate in the process which could contribute to currency risk
management.
338

FORWARD RATE AGREEMENT [FRA]

Calculation of forward rate:

The forward rate may also be calculated by the adjustment of premium or discount into the spot
rate. The addition or deduction would depend upon the type of quote given:

Quote Add Less

Direct Premium Discount
Indirect Discount Premium

Interest Rate Parity:

The forward rate should prevail in the forward market based on interest rate prevailing in the
countries.

(𝟏 + 𝐅𝐢𝐫𝐬𝐭 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞)

𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐑𝐚𝐭𝐞 = 𝐒𝐩𝐨𝐭 𝐑𝐚𝐭𝐞 ×
(𝟏 + 𝟐𝐧𝐝 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐑𝐚𝐭𝐞)

Illustration – Interest Rate Parity:

Spot rate USD 1 = PKR 285. Interest rate prevailing in US and Pakistan is 8% and 11%
respectively. Determine the one-year fair forward rate.

𝟐𝟖𝟓 × (𝟏. 𝟏𝟏)

= = 𝟐𝟗𝟐. 𝟗𝟏
𝟏 × (𝟏. 𝟎𝟖)
PKR is first currency.

Purchasing Power Parity [PPP]:

(𝟏 + 𝐅𝐢𝐫𝐬𝐭 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞)
𝐅𝐨𝐫𝐰𝐚𝐫𝐝 𝐑𝐚𝐭𝐞 = 𝐒𝐩𝐨𝐭 𝐑𝐚𝐭𝐞 ×
(𝟏 + 𝟐𝐧𝐝 𝐂𝐮𝐫𝐫𝐞𝐧𝐜𝐲 𝐈𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧 𝐑𝐚𝐭𝐞)

Illustration – Purchasing Power Parity:

Spot rate PKR / $ = 287.137, calculate one year forward rate assuming inflations rates in
US and Pakistan are 11% and 16% respectively.

𝟐𝟖𝟕. 𝟏𝟑𝟕 × (𝟏. 𝟏𝟔)

= = 𝟑𝟎𝟎. 𝟎𝟕𝟏
𝟏 × (𝟏. 𝟏𝟏)

FORWARD RATE AGREEMENT [FRA]:

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A Forward Foreign Exchange Contract is an agreement between two parties to exchange a

specified amount of one currency for another at a future date, at an exchange rate agreed upon
today.

Features of Forward Foreign Exchange Contracts:

a) Notional Amount: The notional amount represents the amount of currency to be exchanged
at the future date. This amount is agreed upon at the initiation of the contract.

b) Forward Exchange Rate: The exchange rate agreed upon today for the future exchange of
currencies. This rate is fixed and used to calculate the amount of currency to be exchanged
at maturity.

c) Maturity Date: The future date on which the exchange of currencies will occur, based on the
agreed-upon forward exchange rate.

d) Purpose: Forward foreign exchange contracts are used primarily for hedging against
currency risk. Businesses and investors use them to protect against adverse movements in
exchange rates that could affect the value of future transactions or investments
denominated in foreign currencies.

Settlement: Settlement of a forward foreign exchange contract involves the physical exchange
of currencies at the agreed-upon rate on the maturity date.

Example Scenario:

A company in the United States expects to receive €1 million in six months from a European
client. Concerned about potential depreciation of the euro against the US dollar, the company
enters into a forward foreign exchange contract with a bank at a forward exchange rate of 1.15
USD/EUR for the maturity date.

If, at the maturity date, the prevailing exchange rate is 1.10 USD/EUR, the company benefits
because it can exchange the euros received at the higher agreed-upon rate of 1.15 USD/EUR.
Conversely, if the exchange rate is higher than 1.15 USD/EUR, the company would still
exchange at the agreed rate, thus protecting against potential depreciation of the euro.

Forward foreign exchange contracts allow businesses and investors to hedge against currency
fluctuations by locking in exchange rates today for future transactions, thereby providing
certainty in international trade and finance.

Illustration - FRA:

Akif Ltd, a Pakistani based large industrial group, has the following exposure to foreign
currencies:
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a) Payment to UK based supplier is due in 6 months £ 25,600.

b) Receipts from US based client is due in 4 months $ 40,250.

The spot rates are as under:

PKR / $ 267.452 and PKR / £ 338.334

The expected inflation rates are:

Pakistan 18%, UK 11% and US 14%.

Required:
Illustrate the hedging transactions using FRA.

Solution:
Spot Rate Spot Rate
Forward
1st 2nd Days
Label Amount Rate
Currency Currency
PKR / $ 267.452 18% 14% 120 270.859
PKR / £ 338.334 18% 11% 180 349.558

The forward rates are locked for exposure in currencies.

MONEY MARKET HEDGE:

A money market hedge involves borrowing or lending in a foreign currency to offset the exchange
rate risk associated with future cash flows denominated in that currency. The objective is to lock
in a fixed exchange rate today, using short-term borrowing or lending, to ensure that the amount
received or paid in the future remains relatively stable in the company's home currency.

1. Identifying Exposure:
Companies identify transactions or cash flows denominated in foreign currencies that expose
them to exchange rate risk. This could include imports, exports, or foreign investments.

2. Borrowing or Lending in Foreign Currency:

To hedge against the risk, the company borrows or lends an equivalent amount of funds in
the foreign currency. This step is crucial as it determines the amount of foreign currency
available to meet future obligations.

3. Purpose of Borrowing or Lending:

• Borrowing: If a company expects to receive foreign currency in the future (e.g.,
from exports), it borrows that amount in the foreign currency now. The borrowed
funds are then used to finance operations or investments.
341

• Lending: If a company expects to pay foreign currency in the future (e.g., for
imports), it lends that amount in the foreign currency now. The lent funds are
invested in short-term money market instruments.

4. Locking in Exchange Rate:

By borrowing or lending in the foreign currency, the company effectively fixes the exchange
rate at which the future transaction will be settled. This reduces uncertainty and protects
against adverse exchange rate movements.

5. Settlement:
At the maturity of the hedge, the company settles its foreign currency borrowing or lending
obligations. The settlement amount is adjusted based on the prevailing exchange rate at
that time, but the overall exposure to exchange rate fluctuations is minimized.

6. Cost of Hedge:
The cost of implementing a money market hedge includes interest payments or earnings on
the borrowed or lent funds in the foreign currency. Companies compare this cost with
potential losses from adverse exchange rate movements to determine the effectiveness of
the hedge.

Example Scenario:
• Scenario: A US-based company expects to receive £1 million in six months from a UK
client. Concerned about potential depreciation of the British pound against the US dollar,
the company decides to implement a money market hedge.
• Implementation: The company borrows £1 million now in the UK money market and
converts it into US dollars. It then invests the US dollars in short-term instruments to earn
interest.
• Outcome: At the maturity of the hedge, the company will use the US dollars earned from
the investment to repay the pound-denominated loan. The amount received from the UK
client remains unaffected by exchange rate movements because the hedge has effectively
fixed the exchange rate.

Illustration: Money Market Hedge [for liability]

On 01 May, 2023, Jalil Traders, a Pakistani importer, has to pay $ 250,000 to a US exporter in
four months i.e. Aug 31, 2023.

Spot rate [01.05.23] PKR / $ = 267.563–268.124

Following are deposit and borrowing rates:

Borrowing Deposit
$ 7.22% 6.35%
PKR 8.56% 7.73%
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Required:
Construct a money market hedge.

Solution:

Since it is the case of liability [foreign currency need to be paid in future], we need to develop a
foreign currency deposit account. For this, we need to borrow in local currency in order to build
the foreign currency deposit account. Following are specific steps:

Step 1: Calculation of required $ to be purchased. This would be the present value at the
deposit $ rate.

$250,000
= = $244,818
4
1 + (6.35% × )
12

Step 2: Required amount of local currency to be borrowed to purchase the specified

foreign currency at the spot rate.

= $244,818 × 268.124 = PKR 65,641,586

Step 3: Purchase the foreign currency and deposit into investment account.

Step 4: Calculate total liability to be settled in PKR borrowed funds.

4
= PKR 65,641,586 × [1 + (8.56% × )] = PKR 67,514,560
12

Step 5: Calculate the effective exchange rate locked in the transaction.

PKR 67,514,560 𝑃𝐾𝑅

= = = 270.058
$250,000 $

Conclusion: At the end of 4 months, the deposited $244,818 will grow at the required $250,000
[principal plus interest. The same amount will be withdrawn from the deposit account and be paid
to settle the liability. Moreover, the borrowed amount of PKR 67,514,560 [principal plus interest]
will also be settled, resulting in effective exchange rate of 270.058.
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Illustration: Money Market Hedge [Asset liability]

On 01 April 2023, United Traders has sold goods to a Japanese client from which payment of ¥
425,000 is due on 30 June 2023 [3 months]. The company wants to hedge itself developing a
money market hedge arrangement with local banks. In this context, following information is
relevant.

Spot rate [01.04.23] PKR / ¥ = 1.772–1.867

Following are deposit and borrowing rates:

Borrowing Deposit
¥ 8.50% 7.75%
PKR 6.50% 5.25%

Required:
Construct a money market hedge.

Solution:

Since it is the case of asset [foreign currency will be received in future], we need to develop a
foreign currency liability account. For this, we need to borrow in foreign currency and sell on the
spot to realize local currency. The local currency will be deposited into money market account for
the stipulated time period. Following are specific steps

Step 1: Calculate the amount of ¥ to be borrowed.

¥425,000
= = ¥416,157
3
1 + (8.50% × )
12

Step 2: Sell the ¥ in Spot market and realize PKR.

¥416,157 × 1.772 = PKR 737,430

Step 3: Deposit the realized local currency into deposit account.

Step 4: After the three months, the borrowed ¥416,157 liability will be grown up to ¥425,000
which will be paid from the collection from foreign customer.

Step 5: The deposit investment in PKR 737,430 will grow at:

3
= PKR 737,430 × [1 + (5.25% × )] = PKR 747,109
12
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Step 6: The effective exchange rate will be

PKR 747,109 𝑃𝐾𝑅

= = = 1.758
¥425,000 ¥

FOREIGN CURRENCY OPTIONS:

Currency options are financial derivatives that give the holder (buyer) the right, but not the
obligation, to exchange a specified amount of one currency for another currency at a
predetermined exchange rate (strike price) on or before the expiration date of the option.

Currency options are a type of financial contract that provide flexibility and hedging capabilities
to parties involved in foreign exchange transactions. They allow participants to protect against
adverse currency movements while potentially benefiting from favorable movements.

1. Types of Currency Options:

o Call Option: A call option gives the holder the right to buy the specified amount of
one currency (the underlying currency) at the strike price in exchange for another
currency (the counter currency).

o Put Option: A put option gives the holder the right to sell the specified amount of
one currency (the underlying currency) at the strike price in exchange for another
currency (the counter currency).

2. Key Elements of Currency Options:

o Underlying Currency: The currency pair involved in the option contract, such as
USD/EUR or GBP/JPY.

o Strike Price: The predetermined exchange rate at which the currencies will be
exchanged if the option is exercised.

o Expiration Date: The date on which the option contract expires, after which the holder
no longer has the right to exercise the option.

o Premium: The price paid upfront by the option buyer to the option seller (writer) for
acquiring the right to exercise the option.

3. Features and Flexibility:

o No Obligation: Unlike forward contracts or futures contracts, currency options provide
the holder with the right, but not the obligation, to buy or sell currencies at the strike
price. The holder can choose to exercise the option if it is beneficial.
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o Limited Risk: The maximum loss for the option buyer is limited to the premium paid,
regardless of adverse exchange rate movements.

o Potential for Unlimited Gain: For call options, the potential profit is theoretically
unlimited as the underlying currency can appreciate significantly above the strike price.

o Customizable: Options contracts can be tailored to specific needs in terms of strike

price, expiration date, and the amount of currency involved.

4. Usage of Currency Options:

o Hedging: Businesses and investors use currency options to hedge against exchange
rate risk associated with international trade, investments, or operations.

o Speculation: Traders and investors may use options to speculate on future currency
movements without the need to take a direct position in the forex market.

o Risk Management: Options provide a structured approach to managing currency risk,

allowing participants to protect profits or limit losses in volatile currency markets.

5. Settlement of Currency Options:

o European Style: Options that can only be exercised at expiration.

o American Style: Options that can be exercised at any time up to and including
the expiration date.

o Upon exercise, the option holder can choose to buy (call option) or sell (put
option) the specified amount of currency at the agreed-upon strike price.

Example Scenario:
A US-based importer expects to pay €1 million to a European supplier in three months.
Concerned about potential appreciation of the euro against the US dollar, the importer
purchases a EUR/USD put option with a strike price of 1.10.
If the euro depreciates against the dollar, the importer exercises the put option, selling
euros at the agreed-upon strike price of 1.10, thereby protecting against currency
losses. If the euro appreciates, the importer lets the option expire and buys euros at the
prevailing spot rate.

Selecting the best exercise price:

The first step in drafting the foreign currency hedge is to select the best exercise price for
the available options. The criteria for the selection are appended below:

• Call option: where [Exercise price + Premium] is lowest.

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• Put option: where [Exercise price – Premium] is highest.

Hedging Strategy:
• Identifying which type of options to buy: call or put.
• Selecting the appropriate strike price.
• Selecting settlement date.
• Determining appropriate number of contracts.
• At the transaction date, decision to exercise or lapse is taken. In case option is lapsed, the
transaction is settled in the spot market.

Illustration: Foreign currency options

On 22nd September 2023, JH Traders imported goods from US supplier costing $76,500 payable
after 3 months i.e. [22nd December 2023]. The company not only wants to hedge against the
unfavorable exchange rate movements and but take the advantage of favorable exchange rate
fluctuations also. In this context, currency options are the best choice. Following related
information is available:

Spot PKR/$ [22.09.23]: 261.00–262.00

Spot PKR/$ [22.12.23]: 272.00–273.00

The option exchange offers currency options in the bundles of $15,000 with the following
exercise price and option premium structures:
Exercise Option Premium [Paisa / $]
Price CALL PUT
[PKR / $] 30-Sep 31-Dec 30-Sep 31-Dec
264.00 87.00 97.00 63.00 74.00
265.00 45.00 64.00 89.00 88.00
266.00 36.00 46.00 98.00 97.00

Required:
a) Construct the hedge and calculate its cost. [Answer: Premium Rs.72,750]
b) What would be the action at the settlement date? [Answer: Option is ITM]
c) Calculate the expected savings on the hedge. [Answer: Rs.602,250]

Solution:

a) The construction of hedge involves the following steps:

1. Type of option: Call [Foreign currency need to be purchased for payment]
2. Number of contracts: 5 i.e. 76500 / 15,000 [rounded].
347

3. Exercise date: Relevant option date is 31 December.

4. Exercise price:
[PKR / $] Call
Net Cost
EP 31-Dec
264.00 0.97 264.97 Lowest
265.00 0.64 265.64
266.00 0.46 266.46
5. The cost of option is as under:
PKR 72,750 = [5 × 15,000 × 0.97]

b) At the settlement date, the option is in the money because exercise price of Rs.264
is lower than prevailing buying price of 273, which denotes that it is better to
exercise the option.

c) Expected savings:
Cost of exercising the contract 19,800,000
Premium 72,750
Cost of remaining $1,500 at spot 409,500
Total cost of contract 20,282,250

Cost without contract at the spot 20,884,500

Expected savings 602,250

FOREIGN CURRENCY SWAPS:

Foreign currency swaps, often referred to simply as currency swaps, are agreements
between two parties to exchange principal amounts of different currencies for a specified
period of time. These swaps are used primarily to hedge against currency risk, manage cash
flows, and reduce financing costs in international transactions. Here’s a comprehensive
explanation of foreign currency swaps:

A foreign currency swap involves two parties exchanging principal amounts of different
currencies at the outset of the contract. The exchanged currencies are typically repaid at a later
date, based on predetermined exchange rates. The primary purpose of a currency swap is
to manage currency exposure and obtain cheaper financing in different jurisdictions.

Features and Mechanics:

1. Structure:
348

Two parties agree to exchange principal amounts of different currencies. For example,
Party A may agree to pay Party B in US dollars (USD), while Party B pays Party A in
euros (EUR).

2. Term and Payments:

o The swap has a specified term, ranging from a few months to several years,
during which periodic interest payments may be exchanged based on the agreed-
upon notional amounts.
o At the inception of the swap, the parties agree on the exchange rate for the
notional amounts and the schedule of payments.

3. Interest Rates:
Each party pays interest on the swapped currency amount at a predetermined rate
(fixed or floating). These rates are applied to the notional amounts, not the actual
principal exchanged.

4. Exchange of Principal:
At the beginning and end of the swap, the parties exchange the principal amounts
back at the same exchange rate agreed upon initially. This exchange of principal does
not involve any profit or loss for either party based on exchange rate movements
during the term of the swap.

5. Purpose and Benefits:

o Risk Management: Currency swaps allow parties to hedge against exchange
rate risk associated with international transactions, reducing uncertainty in cash
flows.
o Lower Financing Costs: By accessing lower interest rates in different markets,
parties can achieve cost-effective financing compared to borrowing directly in
foreign currencies or domestic markets.
o Access to Foreign Markets: Currency swaps provide access to foreign capital
markets where one party may not have a direct presence or favorable borrowing
terms.

6. Application:
o Corporate Use: Multinational corporations use currency swaps to manage
currency risk in international operations, especially for financing projects in
different countries.
o Financial Institutions: Banks and financial institutions use swaps to manage
their currency exposure and facilitate client transactions across borders.
349

o Governments and Central Banks: These entities use swaps to stabilize

exchange rates and manage foreign exchange reserves.

Example Scenario:
• Scenario: Company A, based in the United States, needs to finance a project in
Europe but prefers to borrow at lower interest rates available in the euro market.
Company B, based in Europe, needs to finance a project in the US and can benefit
from lower interest rates in the dollar market.
• Implementation: Company A and Company B enter into a currency swap where
Company A agrees to pay Company B interest and principal in euros, while
Company B agrees to pay Company A interest and principal in US dollars.
• Outcome: Both companies benefit from lower financing costs in their respective
markets while effectively managing their currency exposure through the swap
agreement.
In summary, foreign currency swaps are flexible financial instruments that allow parties
to exchange cash flows in different currencies to achieve strategic and financial
objectives. They provide an efficient means of hedging currency risk and accessing
favorable financing terms in international markets.

Illustration: Currency swaps

1. Sameer Ltd, Pakistani based company, wants to raise $ 1 million for its US based subsidiary.
The borrowing rates are as under: $ 12%, PKR 16%.

2. GTL Inc., US based company, wants to raise PKR 250m for its subsidiary in Pakistan. It can
borrow at the following rates: PKR 19%, $ 10%.

3. The spot rate PKR / $ = 250. Both companies require loan for 1 year.

Required:
a) Explain the procedure for currency swap.
b) Calculate the respective interest savings for both parties.

Solution:
(a)
Time Action Sameer Ltd GTL Inc.
Now Borrow from banks PKR 250m @ 12% $ 1m @ 10%
Exchange Pay PKR 250m to GTL Pay $1m to Sameer Ltd
principals Inc. and receives $ 1m and receives PKR 250m
End of Pay interest to PKR 30m [12%] to bank $ 0.1m [10%] to bank
year banks
[Maturity] Exchange interest Pays $0.1m to GTL Inc. Pays PKR 30m to Sameer
and receives PKR 30m. Ltd and receives $0.1
350

Swap back Pays $ 1m to GTL Inc. Pays PKR 250m to

principals and receives PKR 250m Sameer Ltd and received
$1m.
(b)
Interest Cost Sameer Ltd GTL Inc.
Without Swap: $1.2m [$1m @ 12%] PKR 47.50m [PKR 250 @
19%]
With Swap: $0.1m PKR 30m

Savings $0.2m PKR 17.5m

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352

learning Outcomes:

a) Differentiate between temporary and permanent working capital needs and explain their
impact on a company's liquidity and operations.
b) Evaluate the benefits and drawbacks of aggressive, conservative, and moderate working
capital financing strategies.
c) Apply appropriate working capital financing strategies to specific business scenarios,
balancing risk and profitability.
d) Analyze the effects of various working capital management strategies on a company’s
liquidity, profitability, and risk profile.
e) Formulate and defend strategic decisions in working capital management, integrating
theoretical knowledge with practical application.
353

1 Overview of Chapter

Working capital: The capital available for conducting the day-to-day operations of an
entity; Normally, the excess of current assets over current liabilities.

The key components of working capital are inventories, receivables, payables and cash.
Working capital management refers to the administration of a company's short-term assets
and liabilities to ensure its continued operation and to maximize its profitability and
liquidity. It involves managing the balance of current assets and current liabilities in a way
that optimizes the company's ability to meet its short-term obligations and operational
needs.

Key Components of Working Capital

354

1. Current Assets:
o Cash and Cash Equivalents: Highly liquid assets that can be quickly converted
into cash.
o Accounts Receivable: Money owed to the company by its customers for goods
or services delivered.
o Inventory: Raw materials, work-in-progress, and finished goods held by the
company for sale.
o Marketable Securities: Short-term investments that can be easily liquidated.
2. Current Liabilities:
o Accounts Payable: Money the company owes to its suppliers for goods and
services received.
o Short-Term Debt: Loans and other borrowings that are due within a year.
o Accrued Expenses: Expenses that have been incurred but not yet paid, such as
wages and taxes.

Objectives of Working Capital Management

• Ensure Liquidity: Maintain sufficient cash flow to meet short-term obligations

and operational needs.
• Optimize Profitability: Efficiently manage working capital to reduce costs and
improve the company's return on investment.
• Minimize Risk: Balance liquidity and profitability to minimize financial risk and
ensure the company can withstand financial shocks.

Allied Concepts in Working Capital Management

1. Cash Management:
o Efficiently managing the inflow and outflow of cash to ensure that the
company can meet its short-term obligations and avoid liquidity shortages.
2. Receivables Management:
o Policies and practices to manage credit sales and collections to ensure
timely receipt of payments, reduce the risk of bad debts, and optimize the
cash conversion cycle.
o Key Metrics: Days Sales Outstanding (DSO), Aging of Accounts Receivable.
3. Inventory Management:
o Controlling the levels of raw materials, work-in-progress, and finished goods to
balance the cost of holding inventory with the need to meet customer demand.
o Key Metrics: Inventory Turnover Ratio, Days Inventory Outstanding (DIO).
4. Payables Management:
o Managing the timing and amount of payments to suppliers to optimize cash flow
while maintaining good relationships with suppliers.
o Key Metrics: Days Payable Outstanding (DPO), Accounts Payable Turnover
Ratio.
5. Working Capital Cycle (Cash Conversion Cycle):
o The time it takes for a company to convert its investments in inventory and other
resources into cash flows from sales.
o Formula: Cash Conversion Cycle (CCC) = DIO + DSO - DPO.
o A shorter CCC indicates a more efficient working capital management.
6. Working Capital Financing:
355

o Strategies to finance the company's working capital needs, including short-term

loans, lines of credit, and trade credit.
o The choice of financing impacts the cost of capital and the company's financial
flexibility.

Importance of Working Capital Management

• Operational Efficiency: Effective working capital management ensures smooth day-to-

day operations by providing the necessary liquidity.
• Financial Stability: Proper management reduces the risk of insolvency and financial
distress.
• Profitability Enhancement: Optimizing the use of working capital can reduce costs and
increase profitability.
• Investor Confidence: Demonstrates prudent financial management, which can enhance
investor confidence and potentially improve access to capital.

Working capital management is a critical aspect of financial management that involves

optimizing the balance of current assets and current liabilities. By managing cash, receivables,
inventory, and payables effectively, companies can ensure liquidity, enhance profitability,
minimize risks, and maintain operational efficiency.

Working Capital Management as a Risk and Profitability Trade-Off

Working capital management involves balancing the need to maintain liquidity with the
goal of maximizing profitability. This balance creates a trade-off between risk and
profitability:

1. Liquidity:
o Maintaining high levels of current assets (like cash, receivables, and inventory)
ensures that a company can meet its short-term obligations and operate
smoothly. This reduces the risk of insolvency and financial distress.
o However, holding too much liquidity can be unproductive since these assets
typically generate lower returns compared to long-term investments or fixed
assets.

2. Profitability:
o Minimizing current assets can lead to higher profitability because excess cash
can be invested in higher-return projects, and reducing inventory can lower
holding costs.
o However, minimizing current assets increases the risk of liquidity shortages,
which can lead to missed opportunities, delayed payments, or inability to meet
short-term obligations.

Key Elements of the Trade-Off

1. Cash Management:
o High Cash Levels: Reduce liquidity risk but may lead to lower profitability
because cash typically earns low returns.
o Low Cash Levels: Increase the risk of not meeting short-term obligations but
free up funds for more profitable investments.
2. Accounts Receivable Management:
356

o Lenient Credit Terms: Increase sales and customer satisfaction but also
increase the risk of bad debts and tied-up capital.
o Strict Credit Terms: Improve cash flow and reduce bad debts but may result in
lower sales and customer dissatisfaction.
3. Inventory Management:
o High Inventory Levels: Ensure product availability and can reduce stockouts,
improving sales and customer satisfaction. However, they increase holding costs
and risk of obsolescence.
o Low Inventory Levels: Reduce holding costs and increase profitability but can
lead to stockouts, lost sales, and potentially dissatisfied customers.
4. Accounts Payable Management:
o Delayed Payments: Improve cash flow and provide more working capital for
other uses, but can damage supplier relationships and may lead to loss of
discounts or strained terms.
o Prompt Payments: Strengthen supplier relationships and may earn discounts,
but reduce the available working capital for other investments.

Strategies to Balance Risk and Profitability

1. Efficient Cash Flow Forecasting:
o Accurate forecasting helps maintain an optimal cash balance, ensuring liquidity
while minimizing idle cash.
2. Optimizing Credit Policies:
o Developing a balanced credit policy that maximizes sales while controlling the
risk of bad debts can help manage receivables effectively.
3. Inventory Optimization:
o Using inventory management techniques like Just-In-Time (JIT) can reduce
holding costs while ensuring product availability.
4. Negotiating with Suppliers:
o Negotiating favorable payment terms can help manage cash outflows better,
reducing the need for high cash balances.

Practical Example of the Trade-Off

Consider a manufacturing company:
• High Inventory Strategy:
o Risk: Higher holding costs, risk of obsolescence.
o Profitability: Ensures smooth production and meets customer demand
promptly, potentially increasing sales.
• Low Inventory Strategy:
o Risk: Stockouts, disrupted production, lost sales.
o Profitability: Lower holding costs and more funds available for other
investments.

The trade-off in working capital management between risk and profitability is a fundamental
aspect of financial strategy. Companies must find a balance that ensures sufficient liquidity to
meet short-term obligations while also maximizing the return on their investments. Effective
working capital management strategies help in maintaining this balance, optimizing both risk
management and profitability.

2 The management of working capital

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Liquidity and profitability

The efficient management of working capital is important from the points of view of both
liquidity and profitability.
Poor management of working capital means that funds are unnecessarily tied up in idle
assets, hence reducing liquidity, and also reducing the ability to invest in productive
assets such as plant and machinery, so affecting profitability.

Examples of the liquidity v profitability trade off

Working capital is the firms’ current assets, less its current liabilities, i.e. inventory,
receivables, cash and payables. The firm faces a trade off with regard to each of these
items, since too much or too little working capital can cause problems for the firm as
follows:

Advantage of large INVENTROY Advantage of low

inventories inventories

Few stock outs = good for Little cash tied up =good for
sales (profitability) preserving cash flow (liquidity)

Advantage of grating REVEIVABLES Advantage of grating little

several months of credit trade credit

Customers like credit = Little cash tied up = good for

good for sales (profitability) preserving cash flow (liquidity)

Advantage of high cash CASH Advantages of low cash

balances balances

Bills can be paid = good for More cash can be invested =

relations with creditors good for earning profits

Advantage of taking PAYABLES Advantage of adhering to

extended credit reasonable credit terms

Preserves own cash Suppliers are content = good

(liquidity) = cheap source relations and few disruptions
of finance
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Investment and financing decision

An entity’s working capital policy is a function of two decisions:

• The appropriate level of investment in, and mix of current assets to be decided upon,
for a set level of activity – this is the investment decision.
• The methods of financing this investment – the financing decision.

3 The working capital investment decision

All entities require working capital, but there is no standard fixed requirement.
The actual amount required will depend on many factors, such as :

• the industry within which the firm operates in some industries, customers expect long
payment periods (impacting receivables) whereas in other industries cash payments
are the norm (low receivables);
• the type of products sold – a business selling perishable products will have to keep a
lower level of inventory;
• whether products are manufactured or bought in – a manufacturing company will have
high levels of raw material and work in progress inventory as well as finished goods;
• the level of sales – if sales are high, it is likely that receivables will be high too;
• inventory management, receivables collection and payables payment policies – these
impact on the length of the operating cycle – explained in detail later in this Chapter;
• the efficiency with which working capital is managed.

For example, a retail company will usually have very low receivables (because most sales
are for cash) but high levels of inventories. In contrast, an IT support company will tend
to have high levels of receivables (long credit terms offered to attract customers) and high
levels of work in progress (inventories). Even comparing businesses in the same
business sector can reveal different levels of working capital caused by different working
capital management policies (aggressive, moderate and conservative policies are
covered below), and one firm being more efficient at collecting debts than another.
It is essential that an appropriate amount of working capital is budgeted for to meet
anticipated future needs.
In conditions of uncertainty, entities must hold some minimal level of cash and inventories
based on expected revenue, plus an additional safety buffer.
Aggressive, moderate and conservative approaches
With an aggressive working capital policy, a firm would hold minimal inventory. Such a
policy would minimise costs, but it could lower revenue because the firm may not be able
to respond rapidly to increases in demand.
Conversely, a conservative working capital policy would call for large inventory.
Generally, the expected return is lower under a conservative policy than under an
aggressive one, but the risks are greater under the aggressive policy.
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A moderate policy falls somewhere between the two extremes in terms of risk and returns.
More detail on aggressive, moderate and conservative policies
A company could pursue a more aggressive approach towards the management of
working capital or a more conservative (relaxed) approach.

Benefits of a more aggressive approach:

(1) Lower levels of current assets therefore lower financing costs.

(2) The lower financing costs should result in better profitability.

(3) Quicker cash turnover may allow more reinvestment and hence allow the
business to expand more quickly.

Benefits of a more conservative approach:

(1) Lower liquidity risk i.e. less risk of the company running out of cash or going into
liquidation.
(2) Greater ability to meet a sudden surge in sales demand.
(3) More relaxed credit policy for receivables may improve sales.

Note:
Generally the more conservative the approach, the lower the risk, but the higher the cost
in terms of money tied up in working capital.

4 The working capital financing decision

The traditional approach to working capital funding

Traditionally current assets were seen as fluctuating, originally with a

seasonal pattern. Current assets would then be financed out of short-term

credit, which could be paid off when not required, whilst fixed assets would
be financed by long-term funds (debt or equity).
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This analysis is rather simplistic. In most businesses a proportion of the

current assets are fixed over time, being thus expressed as 'permanent'.

For example, certain base levels of inventory are always carried, or a certain
level of trade credit is always extended. If growth were added to this
situation a more realistic business picture would be as follows

Working capital requirements with growth

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The modern approach to working capital funding

Given the permanent nature of a large proportion of current assets, it is generally
felt prudent to fund a proportion of net current assets with long-term finance.
Short-term financing is generally cheaper than long-term finance, since short-term
interest rates are generally lower than long-term rates. However, the price paid for
reduced cost is increased risk for the borrower, because of:

• Renewal problems – short-term finance may need to be continually

renegotiated as various facilities expire and renewal may not always be
guaranteed.

• Stability of interest rates – if the company is constantly having to renew its

funding arrangements it will be at the mercy of fluctuations in short-term interest
rates.

The term structure of interest rates

One of the primary considerations in evaluating the use of borrowings is the likely
movement in interest rates. This will affect the relative costs of long and short-term
borrowings, as well as increasing or decreasing the preference for fixed interest
attached. In practice, long-term rates will normally be higher than short-term rates,
owing to the additional risk borne by the lender. Hence an interest premium is
required to attract investors to longer – term securities.
This effect may be magnified or reversed by investor’s expectations of future rates,
and anticipated rate rise producing higher longer term rates. This difference
between long and short term rates is known as term structure. The term structure
of interest rates is shown by the yield curve (a graph of interest rates against time
to maturity).

The yield curve

The yield curve will normally be upward – sloping in order to compensate investors
for typing up their money for longer periods of time. In extreme cases, this may
justify an entity, using short dated borrowings which are replaced regularly –
although the level of transaction costs makes this unlikely.
Sometimes the yield curve will be downward, or inverse, with short term interest
rates higher than long-term rates. In the UK, the Bank of England Monetary Policy
Committee meets monthly to set interest rates. Their influence is directed primarily
towards short-term interest rates, as a means of managing inflation. If however,
interest rates are expected to fall in the future once the risk of inflation has been
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countered, long-term interest rates may be lower than short-term rates, and the
yield curve would therefore be downward sloping.

Factors that influence term structure

In general terms, an increasing term structure results from two factors:

• Increased terms, an increasing term structure results from two factors:

• Anticipated general interest – rate rises.

Aggressive, moderate and conservative financing policies

The financing of working capital depends upon how current and noncurrent asset
funding is divided between long-term and short-term sources of funding.
The choice is a matter for managerial judgement, and depends to an extent on the
cost v risk tradeoff described above.

Three possible policies exist, as follows:

An aggressive policy for financing working capital uses short-term financing to

fund all the fluctuating current assets as well as some of the permanent part of the
current assets. This policy carries the greatest risk of illiquidity, as well as the
greatest returns.
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A conservative policy is where all of the permanent assets – both noncurrent

assets and the permanent part of the current assets (i.e. the core level of investment
in inventory and receivables, etc.) – are financed by long-term funding, as well as
part of the fluctuating current assets. Short-term financing is used only for part of
the fluctuating current assets.

A moderate policy matches the short-term finance to the fluctuating current assets, and
the long-term finance to the permanent part of current assets plus noncurrent assets.

5 The Working Capital Cycle

Definition

The working capital cycle is the length of time between paying out cash for

purchases and receiving cash for the subsequent sale. It can be calculated
as follows:

Length of = Average inventry + Average recievables - Average payables

Cycle holding period collection period payment period

More explanation of the operating cycle

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The operating cycle is the length of time between the entity’s outlay on raw
materials, wages and other expenditures, and the inflow cash from the sale of the
goods.
In a manufacturing business this is the average time that raw materials remain in
stock less the period of credit taken from suppliers plus the time taken for producing
the goods plus the time the goods remain in finished inventory plus the time taken
by customers to pay for the goods. One some occasions this cycle is referred to as
the cash cycle, or the working capital cycle.
This is an important concept for the management of cash or working capital because
the longer the operating cycle, the more financial resource the entity needs.
Management needs to watch that this cycle does not become too long.
Allowances should be made for any significant changes in the level of stocks taking
place over the period. If, for example the entity is deliberately building up its level of
inventory, this lengthen the operating cycle.
Businesses will generally seek to shorten the operating cycle as much as possible
consistent with:

(a) providing good customer service;

(b) allowing reasonable credit period for sales; and

(c) paying suppliers within an acceptable time.

As seen above, the management of working capital requires management to find

an appropriate balance between profitability and liquidity.
A key consideration here is that shortening the operating cycle to improve liquidity
may have an adverse effect on the entity's profitability.

Shortening the operation cycle

If the operating cycle can be shortened, this should improve the entity’s liquidity.
In general terms, the volume of receivables balances could be cut by a quicker
collection of debt, finished goods could be turned over more rapidly, the level of raw
materials inventory could be reduced or the production period could be shortened.
More specifically, a number of steps could be taken to shorten the operating cycle,
as follows:

Reduce raw materials stockholding This may be done by reviewing slow-moving

lines and reorder levels. Inventory control models may be considered if not already
in use. More efficient links with suppliers could also help. Reducing inventory may
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involve loss of discounts for bulk purchases, loss of cost savings form price rises,
or could lead to production delays due to stock outs.

• Obtain more finance form suppliers by delaying payments this could result
in deterioration in commercial relationships or even loss of reliable sources of
supply. Discounts may be lost by this policy.
• Reduce work in progress by reducing production volume (with resultant loss
of business and the need to cut back on labor resources) or improving
production techniques and efficiency (with the human and practical problems of
achieving such change).
• Reduce finished goods inventory perhaps by reorganizing the production
schedule and distribution methods. This may affect the efficiency with which
customer demand can be satisfied and result ultimately in a reduction of
revenue.

• Reduce credit given to customers by involving and following up incentives.

The main disadvantages would be the potential loss of custom as a result of this
policy.

6 Working Capital Ratios

Operating cycle calculations

Receivables collection Average receivables or Average receivables × 365

period (in days) ————————— —————————
Average daily sales Total sales

Payables payment Average payables or Average payables × 365

period (in days) ——————————— ———————————
Average daily purchases Total purchases

Inventory holding period (days)

(a) Raw Average inventory of RM or Average inventory of RM

×365
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Materials ———————————— ———————————

—
(RM) Average daily purchases Total purchases

(b) Work in Average WIP or Average work in progress

×365
progress (WIP) ————————————— —————————
Average daily cost of production Total cost of production

(c) Finished Average inventory of FG or Average inventory of FG

×365
goods (FG) ——————————— ———————————
Average daily cost of sales Total cost of sales

Other working capital ratios

Current ratio Current assets

———————
Current liabilities

Quick ratio/Acid test Current assets – Inventory

———————————
Current liabilities

Inventory turnover Total cost of sales

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————————
inventory + WIP
Interpreting ratios

The Current ratio provides a broad measure of liquidity.

A high current ratio would suggest that the business would have little difficulty
meeting current liabilities form available assets. However, if a large proportion of
current assets are represented by inventory, this may not be the case as inventory
is less liquid than other current assts.
The quick ratio, or acid test, indicates the ability to pay suppliers in the short term.
The quick ratio recognizes that inventory may take some time to convert into cash
and so focuses on those current assets that are relatively liquid.
There are no general norms for these ratios and ‘ideal’ levels vary depending on the
type of business being examined.

Manufacturers will normally require much higher liquidity ratios, than retailers. When
analyzing these liquidity ratios, the absolute figure calculated for a particular year is
less important than the trend over time.

Illustration 1 – The operating cycle

The table below gives information extracted from the annual accounts of Dani for
the past 2 years.

Dani – Extracts from annual accounts

Year 1 Year 2
Rs Rs
Inventory: raw materials 108,000 145,800
Inventory: work in progress 75,600 97,200
Inventory: Finished goods 86,400 129,600
Purchases 518,400 702,000
Cost of goods sold 756,000 972,000
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Revenue 864,000 1,080,000

Receivables 172,800 259,200

Accounts payable 86,400 105,300

Required:

Calculate the length of the operating cycle for each of the 2 years.

Solution:

Note that, owing to the nature of the simplified information provided, end-of-year
values – rather than average values – have been used for inventories, receivables
and payables.

Year 1 Days Year 2 Days

RM holding period (108/518.4)×365 76 (145.8/702)×365 76

WIP (production) (75.6/756)×365 37 (97.2/972)×365 37
period
FG holding period (86.4/756)×365 42 (129.6/972)×365 49
Receivables
collection period (172.8/864)×365 73 (259.2/1,080)×365 88
Payables(86.4/518.4)×365 (61) (105.3/702)×365 (55)
payment period
–––– ––––
167 195
–––– ––––

Example 1
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Income statement extract Rs

Turnover 350,000

Cost of sales (250,000)

————

Gross profit 100,000

Statement of financial position extract Rs

Current assets

Inventory 105,000

Receivables 35,000

Current liabilities
Payables 55,000

Required:

Calculate the length of the working capital cycle.

7 Overtrading

Overtrading can be a problem for new, or fast-growing firms.

As sales increase, the levels of inventories and receivables also increase, and
the liquidity position of the firm deteriorates.

External finance is often needed to help the firm manage its liquidity position.
Careful working capital management, together with increased investment in
non-current assets to support the higher level of sales, can help to overcome the
problem of overtrading.

Symptoms of overtrading
The common symptoms of overtrading are:

• there is a fall in liquidity ratios;

• there is a rapid increase in revenue;
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• there is a sharp increase in the sales to noncurrent assets ratio;

• there is an increase in inventory in relation to revenue;
• there is an increase in receivables;
• there is an increase in the accounts payable period;
• there is an increase in short-term borrowing and a decline in cash balances;
• there is an increase in gearing;
• the profit margin decreases.

Preventing overtrading
Overtrading can results in the failure of an entity through liquidity problems.
To prevent overtrading, an entity will have to formulate an immediate response, and
then focus in the longer term on more efficient working capital management policies.
The longer term focus on efficient working capital management policies is covered
above.

Potential immediate responses to the overtrading problem

• Introduce new capital. An overdraft is often used as a short term solution,

since it is easy to negotiate with the bank, and very flexible. However,
overdrafts are repayable on demand, so are risky. Alternatively, the entity
could issue new share capital, or organize a long-term loan. The downside of
long term financing options is that the entity will have to continue paying
returns to investors for a long period after the immediate overtrading problem
has been addressed.

• Reduce distributions. This may not be a welcome suggestion, but not paying
dividends or taking less salary or fees it a partnership or sole trader any need
to be considered.

• Cost cutting. Reducing costs or finding efficiencies should increase cash flow
and reduce the impact of overtrading. This may include delaying capital
expenditure if possible.

• Factoring or invoice discounting. Factoring involves selling invoices to a

specialist finance entity who takes on the administration and cost of recovering
the invoice payments. With invoice discounting, a loan is raised form a finance
entity against the value of invoices, but the responsibility and cost of
recovering invoice payments is not passed to the invoice discounter.

• Lease or hire purchase assets. Both approaches can help smooth cash flows
to obtain noncurrent assets. Alternatively, a sale and leaseback agreement
involves selling an asset to generate cash immediately, and then leasing it
from the new owner for a period. The benefit is the immediate cash inflow, but
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the downside of a sale and leaseback is that the entity loses the potential
appreciation in value of the asset (usually property) in the future.

Multinational working capital management

The aims of a multinational entity in relation to ash management will be similar to
those for a purely domestic entity, which will be to:

• Ensure fast collection of cash;

• Take longer to pay out cash;
• Optimize cash flow within the entity;
• Generate the best return on cash surpluses.

Achieving these aims will be more difficult in a multinational entity due to the longer
distances involved, the number of parties involved, and the risk of governments
placing restrictions on the transfers of funds out of certain countries.
Grating credit is often an essential condition to undertake international business. In
addition to the normal risks of default, firm granting credit, exchange rate
fluctuations between the time of sale and the time the debt is collected provide an
additional risk.

Management of inventory is also similar to but more complex than for a purely
domestic enterprise. The baleen between minimizing inventory and being able to
meet customer demands is more difficult to judge. The movement in exchange rates
will also influence the timing of purchases, and the level of inventory held in a
particular currency.
Political risk is a further consideration; multinationals will need to allow for the
prospect of import for export quotas or tariffs being imposed, in certain countries,
the risk of expropriation of inventory will lead to minimal inventory holdings being
maintained. Some countries have property taxes on assets, including inventory,
where the tax payable is based on holdings on a particular date in the year, which
again will influence the strategy adopted for inventory management by a
multinational.

8 Short term financing options

The working capital financing decision (discussed above) considers the balance
between long-term and short-term finance.
Long-term financing options, such as equity, preference shares and bonds, were
covered in the previous Chapters.
Short-term financing options include:
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Bank overdraft
With an overdraft, an entity arranges to borrow, through its current account, a
fluctuating amount up to a pre-agreed amount. An overdraft is an extremely flexible
form of finance. However, an overdraft is repayable on demand; [Link] overdraft
facility is an uncommitted facility.

Term loan
A term loan is a bank loan which runs for a specified term, agreed with the bank
when the money is borrowed. Term loans can be short-term, or indeed medium-
term or long-term.
Under a term loan, a specified payment schedule has to be followed, to repay the
capital and interest over the term of the loan (or sometimes at the end of the term).
Term loans are quick and easy to set up, and give certainty to the borrower that the
money will be available for the whole of the term.

Money market borrowings

Large entities can also borrow on the money markets.
The term 'money market' can be confusing since the money market is not actually
a 'market' in the normal sense of the term, but a large number of one-to-one
borrowing/deposit agreements between two banks (or other large financial
institutions) or a bank and a company. The money market is dominated by the major
banks and other financial institutions, but large entities also borrow and lend on the
money market.
A money market line (an uncommitted borrowing facility) can be arranged with an
individual bank. A large entity can then borrow (or deposit) funds from that bank as
required up to the maximum total agreed borrowing level. Each borrowing is for a
fixed period of time, with interest payable on maturity.
These bank borrowings are referred to as 'money market borrowings'.
Terms on money market borrowings and deposits generally range from overnight
to 12 months.

Revolving credit facilities (RCFs)

A term loan generally specifies an agreed payment profile and the amounts repaid
cannot normally be re-borrowed. An RCF allows the borrower to draw down funds
in the form of short term borrowings over the life of the facility, up to the overall limit
agreed without further credit checks at the time of drawdown.
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An RCF has the important advantage over an overdraft and a money market line of
being a committed facility. That is, it cannot be withdrawn before the end of the term
of the facility. However, this comes at a cost in terms of fees payable for guaranteed
access to future borrowings.

Supplier credit
By taking credit from suppliers, organizations reduce the amount of other short-term
finance needed. Supplier credit can often be used on a very informal basis to deal
with a short-term cash flow problem.
However, taking too much credit from suppliers can be expensive (if prompt
payment discounts are foregone) and can adversely affect an entity's credit rating.
Bills of exchange
Bills of exchange enable suppliers to receive the benefit of payment well before the
customer actually pays, providing a useful source of receivables finance for entities
that are involved in selling goods on credit terms.
A bill of exchange is similar to a postdated cheque in that it is a written commitment
by the customer to pay a specified amount to the supplier of goods or services on
a future specified date. The supplier can hold the bill until the maturity date, or it can
be traded with a bank if the cash is needed earlier at a discount.
Acceptance credits
An acceptance credit is an authorisation given by a bank to a specified beneficiary
to draw drafts upon the bank up to a given amount.
Acceptance credits are available only to large companies with good credit ratings.
They may be called 'bank bills', and are often drawn down under an RCF
agreement. They provide a flexible source of short term bank funding.
Commercial paper (CP)
CP is an unsecured promissory note, promising to repay the principal on maturity
to the holder of the note. It is tradable paper.
Using CP enables a company to raise funds without using the banking system. CP
provides liquidity to the investor as it is a traded instrument and so can be sold on
before maturity.
Interest is not usually payable on short term CP instead it is issued at a discount
(i.e. a price that is lower than the principal value that is repayable on maturity) so
the maturity value is greater than the amount lent.

Supply chain financing

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This is sometimes used between retailers and their suppliers to satisfy both parties'
needs i.e. the supplier's desire to be paid quickly and the retailer's desire to extend
credit terms.
It works by the supplier selling its invoices to a bank at a rate dependent on the
credit rating of the retailer. The bank then pays the supplier when the supplier wants
to be paid, and the retailer pays the bank in line with normal credit terms.

Debt factoring
Factoring is defined as follows:
‘The sale of debts to a third party (the factor) at a discount, in return for prompt cash.
A factoring service may be with recourse, in which case the supplier takes the risk
of the debt not being paid or without recourse when the factor takes the risk.’

More detail on factoring and invoice discounting

Debt factoring
Specialist fiancé entities (usually subsidiaries of banks) offering factoring
arrangements will provide three main services:

• Provide finance by advancing, say 80% of invoice value immediately, the

remainder being settled when the client’s customer settles the debt (but net of
a charge for interest, for example 3% per annum above base rate).

• Take responsibility for the operation of the client’s sales ledger, including
assessment of creditworthiness and dealing with customers for an additional
service charge, typically 2% of turnover.

• They may, for an additional fee, offer non-recourse finance, that is guarantee
settlement even if they are not paid by the customer.

In order to do this economically, they have developed their expertise in credit control
in term of market intelligence (including credit scoring), information management
(sophisticated databases, processing and decision support systems) and the skills
required for dealing with customers especially those who are in no hurry to pay.

Invoice discounting
Alternatively, they may offer a confidential invoice discounting facility under which
they provide the finance as above, but do not get involved with the operation of the
sales ledger or hence become known to the customers.
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This has, to date, been more popular than the overt factoring arrangement. It is
cheaper, and avoids creating a barrier between the entity and its customers. It is
less attractive to the providers of finance, however, being in the nature of supplying
a commodity rather than adding value through expertise.

9 Exam style questions

Test your understanding 1 – Eden Ltd

Eden Ltd is a medium-sized company producing a range of engineering products

which it sells to wholesale distributors. Recently, its sales have begun to rise rapidly
following a general recovery in the economy as a whole. However, it is concerned
about its liquidity position and is contemplating ways of improving its cash flow.
Eden's accounts for the past two years are summarised below

Income statements for the year ended 31 December

20X2 20X3

Rs 000 Rs 000

Turnover 12,000 16,000

Cost of goods sold 7,000 9150

Operating profit 5,000 6,850

Interest 200 250

Profit before tax 4,800 6,600

Taxation (after capital allowances) 1,000 1600

Profit after tax 3,800 5,000

Dividends 1,500 2000

Retained profit 2,300 3000

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Statement of financial position as at 31 December

20X2 20X3

Rs 000 Rs 000 Rs 000 Rs 000

Non-current assets 9,000 12,000

Current Assets

Inventory 1,400 2,200

Receivables 1,600 2,600

Cash 1,500 100

4,500 4,900

Total Assets 13,500 16,900

Required:

Identify the reasons for the sharp decline in Eden's liquidity and assess

the extent to which the company can be said to be exhibiting the problem
of 'overtrading'.

Illustrate your answer by reference to key performance and liquidity

ratios.

Multiple choice question (MCQ):

1. Working capital cycle can be reduced by:

A) Allowing more credit to debtors

B) Paying creditors earlier
C) Obtaining short term loan
D) Applying Just in Time theory for inventory purchase
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Test your understanding answers

Example 1

Working capital cycle

Days

Inventory holding period 105,000

———— × 365 = 153

250,000

Receivables period 35,000

———– × 365 = 37
350,000

Less: Period of credit 55000

taken (payables days) ----------- x 365 = (80)

250,00

Total 110

Test your understanding 1 – Eden Ltd

Liquidity measures the amount of cash the company can expect to

realise in the short term. In this case, Eden's cash balance has fallen
from Rs 1.5 million in 20X2 to a net overdraft of Rs 0.1 million, a decline in
liquidity of Rs 1.6 million. This is in stark contrast to the apparently healthy
profit for the year, indicating that cash has been used to finance balance
sheet assets.
378

Indeed, analysis of the statement of financial position indicates that at least Rs 3

million has been ploughed into non-current assets. It is not possible to say

whether this investment has been in new technology, or perhaps some

kind of acquisition, but the result appears to be that turnover has
increased by 33 per cent.

At the same time, the company's working capital has been funded, to the

tune of Rs 0.8 million in inventory and Rs 1 million in receivables, probably at

the expense of trade payables which have lengthened by Rs 0.5 million.

More significantly, no long-term finance has been raised which appears

to be in conflict with the maxim that we should match the length of the
finance with the length of the project.

This may be a case of overtrading where a company undergoes a rapid

expansion without the support of long-term financing.

Growth here has been financed short term, at the expense of cash and

payables. As sales increase, so too do inventory and receivables,

leading to further liquidity problems.

We can now look at more specifics in the form of ratio analysis.

Current ratios
These have fallen from 2.3 to 2.0, but once we remove inventory to give

us the acid test ratio the fall is from 1.6 to 1.1, which may be significant if
Eden experiences bad debts and therefore severe short-term liquidity
constraints.

Working capital cycle

Inventory days have increased from 73 in 20X2 to 88 days in 20X3,

almost three months; this appears high but should be measured against
the industry average.
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Receivables days have lengthened from 49 days to 59 days, almost two

months, which will significantly pressure liquidity. Credit terms may have
to be reviewed and enforced.

Payables days have lengthened marginally from 78 to 80 days. Again

this must be compared to the terms offered and industry averages, but
any increase may result in a loss of goodwill from suppliers.

The net effect is that the working capital cycle has lengthened from 44

days to 67 days.

Return on capital employed

The ROCE (operating profit as a percentage of shareholders' funds and

long-term loans) has in fact risen from 43 per cent to 47 per cent. This
could be explained either by the net profit margin or by the asset
turnover.

The net profit margin has remained stable at 42 per cent versus 43 per

cent, which indicates first that the turnover increase is not due to price
reductions, and second that ROCE has improved due to asset turnover
by 1.04 versus 1.10. This has not lengthened too much in that the
increase in turnover appears to have been asset backed.

In summary although liquidity is certainly a problem, the expansion does

appear to be backed by fixed assets and therefore Eden may not

necessarily overtrade.

It would perhaps be advantageous to obtain long-term financing if

Eden is to maintain its growth.

380

Note: The following ratios have been used.

Current assets

Current ratio = ———————

Current liabilities

Current assets – Inventory

Acid ratio = ———————————–

Current Liabilities

Inventory

Inventry days = —————

Cost of sales

Receivables

Receive days = ——————

Sales

Payables

Payabless days = ————–

Sales

ROCE Operating profit

= ————————————————–—
Shareholders' funds + Long - term loans

Operating profit

Net profit = ———————

Sales

Sales

Asset tumover = ———————————–——————

Shareholders' funds + Long - term loans

If in doubt about using a ratio, always define the way you have calculate
381
382

Learning Objectives:

a) Students will understand the significance of performance analysis in evaluating an

organization's financial health and investment potential.

b) Students will be able to calculate and interpret profitability ratios, including Return
on Capital Employed (ROCE) and Return on Equity (ROE), and understand their
implications for business performance.

c) Students will learn to assess asset turnover and operating profit margin, gaining
insights into a company's efficiency and profitability.

d) Students will grasp the concept of financial gearing, including capital gearing and
finance charges cover, and evaluate its impact on a company's financial structure
and risk profile.

e) Students will acquire skills to calculate and analyze stock market ratios, such as
earnings per share (EPS), price-to-earnings (P/E) ratio, dividend cover, and
dividend yield, and understand their relevance for investors.

f) Students will explore Altman's Z score and its application in predicting bankruptcy,
understanding the limitations and enhancements provided by the ZETA® score.

g) Students will recognize the limitations of using published accounts for ratio analysis
and the importance of incorporating non-financial information and sustainability
reporting in evaluating an organization's overall performance.
383

1 Overview of Chapter

Performance analysis

Investors (both shareholders and lenders) will often appraise the performance of an
organisation, to assess whether the organisation represents a good investment. If it is
shown that the organisation's performance is declining, the shareholders may decide to
sell their shares, and the lenders might change their assessment of the organisation's
creditworthiness.

To appraise performance, it is necessary to first calculate ratios under the following

headings:
384

• profitability ratios,
• liquidity ratios (essentially the working capital ratios),
• gearing ratios,
• stock market ratios.

With the exception of the liquidity ratios covered already, the calculation of
these ratios is covered in this chapter.

Be aware that in the exam, it will also be important to comment on the ratios,
any trends, and any likely future developments.

2 Profitability Ratios

The aim of an organisation is to generate a return to the shareholders. In order to do this

the company must generate profits to cover the costs of financing itself. Financing over
the long-term will either be through debt instruments or equity. There are two measures
critical to any analysis of profitability:

(1) Return on Capital Employed (ROCE)

(2) Return on Equity (ROE)

Return on capital employed (ROCE)

A measure of the underlying performance of the business before finance. It gives an
indication of the health of the business in generating a return on its investments. Gearing
has no impact on the return and hence this is the most important measure of profitability
to calculate. The ratio is calculated before tax allowing return to be compared between
companies under differing tax regimes.

Operating profit
ROCE = ———————— × 100
Capital employed

Operating profit

A measure of return after cost of sales and expenses excluding financing and tax costs,
it is also usefully known as profit before finance charges and tax (PBFC&T).

Capital employed
The total funds invested in the business, it includes equity and long-term debt.
385

Return on equity (ROE)

A measure of return relating solely to the shareholders. It is calculated after taxation
and before dividends have been paid out. It gives an indication as to how well the
company has performed in relation to its shareholders, the most important
stakeholder. The impact of differing levels of gearing should have an impact on the
return.

Profit after tax

ROE = ——————— × 100
Equity

It is useful to compare the ROE to the ROCE to measure the amount of the return
underlying the business that pertains to the shareholder. Please note, however, that
they are not directly comparable, ROE being post-tax and
ROCE pre-tax.

Key working

Rs
PBIT X
Less finance charges (X)
——
PBT X
Less tax (X)
——
PAT X
Less dividends (X)
——
Retained earnings X
——
Example 1
A company is considering two funding options for a new project. The new project
may be funded by Rs 10m of equity or debt. Below are the financial statements
given the project has been funded in either manner.
386

Statement of financial position extract

Equity Debt
Rs m Rs m
Long term liabilities 0.0 10.0
Debentures (10%)
——– ——–
Capital
Share capital (Rs 10) 11.0 3.5
Share premium 4.0 1.5
Reserves 5.0 5.0
——– ——–
20.0 10.0
——– ——–
Income Statement extract

Rs m
Turnover 100.0
Gross profit 20.0
Less expenses (15.0)
(excluding finance charges)
——–
Operating profit 5.0
——–

Corporation tax is charged at 30%.

Required:

(a) Calculate all profitability ratios and compare the financial

performance of the company under either funding.
(b) What is the impact on the company's performance of financing by
debt rather than equity?
387

Asset turnover

We may look at how many times the turnover of the business exceeds the capital
employed of the business. This is normally an indicator of the type of business
the company is running.

Low turnover suggests that the business is capital intensive, involved in

manufacturing and perhaps concentrating on specialised products. High turnover
alternatively would suggest a retailer of standardised products.

Turnover
Asset turnover = ———————
Capital employed

Operating profit margin

How much does each individual unit of sale generate towards profit? The
arguments for this ratio are equal and opposite of those for asset turnover. In
addition, the profitability will be an indicator of the relative attractiveness of the
product range compared to the industry average. It may indicate which part of the
market the company is targeting.
PBIT
Operating profit margin = ———— × 100
Turnover
Example 2
Required:

Using the data from the previous example, calculate the sub-analysis of
the ROCE into:

(a) asset turnover

(b) operating profit margin.

3 Financial Gearing

Change in capital structure will affect financial gearing. Financial gearing is the mix
of debt to equity within a firm's permanent capital. There are two measures:

(1) Capital gearing - a statement of financial position measure.

(2) Finance charges cover ("interest cover") - an income statement measure.
388

Capital gearing - a measure of capital structure

There are two key measures of capital gearing:

Debt
Capital gearing = ——— × 100
Equity

Debt
—————– × 100
Debt + Equity

The calculation of capital gearing can be done in a number of different ways, the
examiner may have to specify what he wants. Whatever the measure it will
include debt and equity.
What do debt and equity contain?

Debt (also known as prior charge capital or PCC)

All permanent capital charging a fixed charge (interest) may be considered debt.
This includes debentures and loans naturally. It may include bank overdraft if
significant and considered part of the permanent financing.

Equity
All ordinary share capital and share premium together with reserves (they pertain
to the ordinary shareholders).

A note on preference shares:

Preference shares to be treated in the following way - if they are irredeemable,

treat as equity and, if redeemable, treat as debt.

Example 3
Statement of financial position for X Limited

Rs m
Non-current assets (total) 23.0
Current assets (total) 15.0
TOTAL ASSETS 38.0
Equity and Liabilities
389

Ordinary share capital 10.0

Ordinary share premium 4.0
Preference share capital (irredeemable) 1.5
Reserves 1.5
Non-current liabilities
Debenture 10% 8.0
Current liabilities
Trade creditors 8.0
Bank overdraft 5.0
TOTAL EQUITY & LIABILITIES 38.0

Required:

Calculate the capital gearing of the business.

Finance Charges cover (Interest cover)

This is an income statement measure that considers the ability of the business to
cover the finance charges and capital repayments as they fall due.

PBFC & T
Finance charges cover = —————––––
Finance Charges

Example 4

Y Limited Income Statement Extract

Rs m
Operating profit (PBIT) 10.0
Finance Charges (2.5)
——–
Profit before tax (PBT) 7.5
Tax @ 30% (2.25)
——–
Profit after tax (PAT) 5.25
——–
390

Required:

(a) Calculate the finance charges cover.

(b) Is this level of cover safe?

4 Stock Market Ratios

Investor ratios refer to both debt and equity.

Debt ratios

The single measure we need to understand is the simple coupon return, or yield i.e. the
interest paid by the debenture in relation to the current value of the debt. This does not
take into consideration the eventual redemption of the debenture which is considered at
a later date.

Finance charges paid pa

Simple finance charges (interest) yield = —————————–––
Current market value
Equity ratios

Before we can calculate any ratios we need to calculate a key measure of return, the
Earnings per share (EPS).

PAT less preference dividend

Headline EPS = –—————————–––——––
Number of ordinary shares in issue
391

Example 5

The United Company earned profits after tax of Rs 15m and has a preference dividend
of Rs 3m. There are 24 million shares in circulation.

Required:

What is the headline EPS?

There are three investor ratios that we must be able to calculate and understand:
(1) P/E ratio.
(2) Dividend cover.
(3) Dividend yield.

The key to being able to calculate these ratios is to identify that there are three values
that are used to calculate the above and to know the values needed, and you are more
than halfway there!

(1) Market value.

(2) EPS.
(3) DPS (dividend per share sometimes described as gross dividend).

P/E ratio

The P/E ratio is a measure of growth; it compares the market value (a measure of future
earnings) to the current earnings.

Current share price Total MV

P/E ratio = ————————— = ——————
Headline EPS Profit after tax

The higher the P/E ratio, the greater the market expectation of future earnings growth.
This may also be described as market potential.
Example 6
Two companies have the following details:

White
Black
392

Market value per share Rs 30 Rs

9
Headline EPS Re 1 Re
1

Required:

Which company does the market retain higher confidence in?

Dividend cover

This is the amount of profits attributable to shareholders that are actually paid out in the
form of dividend. The level of dividend cover depends on a number of factors:

• the type of industry

• the requirements of the specific shareholders
• the investment opportunities available
• tax implications
• dividend policy.

EPS PAT
Dividend cover = —— = ——————
DPS Total dividend
Example 7
Further to the previous example, we are told that White is paying 20 paisa per
share while Black is paying 60 paisa per share dividend.

Required:

What is the dividend cover for each company?

Dividend yield

This is the relationship of the dividend paid to the current market value. It is of importance
when deciding what type of investor we are trying to attract. If the yield is high this will
appeal to the investor who requires an income from the share. A lower yield suggests
that more is being reinvested back into the company which should attract those investors
who want capital gain.
393

DPS Total dividend

Dividend yield = ———————— = ——————
Current share price Total MV

Example 8
Continuing from the previous examples, calculate the dividend yield for
both White and Black.

Altman's Z score

Altman studied bankrupt manufacturing companies in the USA in 1968 and concluded
that the bankrupt firms shared common characteristics, which he incorporated in his Z
score model. The Z score used ratio analysis to highlight firms which were likely to fail. It
only incorporated 5 key ratios and was criticised for being too simplistic.

The original Z-score formula was as follows:

Z = 1.2T1 + 1.4T2 + 3.3T3 + 0.6T4 + 0.999T5.
T1 = Working Capital / Total Assets. Measures liquid assets in relation to the size of the
company.
T2 = Retained Earnings / Total Assets. Measures profitability that reflects the company's
age and earning power.
T3 = Earnings Before Interest and Taxes / Total Assets. Measures operating efficiency
apart from tax and leveraging factors. It recognizes operating earnings as being important
to long-term viability.
T4 = Market Value of Equity / Book Value of Total Liabilities. Adds market dimension that
can show up security price fluctuation as a possible red flag.
T5 = Sales/ Total Assets. Standard measure for total asset turnover (varies greatly from
industry to industry).
Altman found that the ratio profile for the bankrupt group fell at -0.25 avg, and for the non-
bankrupt group at +4.48 avg.

The development of the ZETA® score

In order to address the limitations of the Z score, Altman and others carried out further
research and developed the ZETA® score. This is a proprietary method and only
available to subscribers to the company which owns the model – therefore it is not
possible to give details of the formula here. The approach taken is similar to the Z score,
but the ZETA® score is based on seven variables, with the addition of an assessment of
the stability of the company’s earnings over a period of five to ten years, and the size of
the company based on its total assets.
394

5 The use of published accounts for ratio analysis

When external stakeholders, such as potential investors and lenders, try to assess the
performance of an entity, the most readily available source of information is the published
accounts of the entity.

In trying to interpret the ratios calculated from the published accounts figures, it is
important to understand the limitations of the published figures.

Limitations of published accounts figures for ratio analysis

• Published accounts are historic records, not forward looking. However, the

Operating and Financial Review (OFR), which companies are encouraged to

present as part of their published accounts, will contain the directors' view of the

company's prospects.
• The income statement is prepared using the accruals concept, so it is difficult to
relate the figures to the entity's cash position. However the inclusion of the cash
flow statement in the published accounts helps to give an impression of the cash
position.
• The published accounts have historically contained only financial information. In
recent years entities have been encouraged (under the Global Reporting
Initiative) to report on environmental and social issues, so users of the accounts
are able to see a fuller view of the entity's performance.
More on recent developments in financial reporting

Extending the scope of external reports

According to the IASB's Framework, the objective of financial statements is to 'provide

information about the financial position, performance and changes in financial position
of an entity that is useful to a wide range of users in making economic decisions'.

To help users make decisions, it may be helpful to provide information relating to the
future as well as the historic information that financial statements provide.

However, the inclusion of forecasts is unlikely to be acceptable to the management

team.

• What if forecasts aren't achieved?

395

• What if forecasts are deliberately pessimistic?

• Forecasts may provide too much information to competitors.
• Preparing forecast information may be costly.

There has also been increasing pressure for entities to provide more information in their
annual reports beyond just the financial statements since non-financial information can
also be important to users' decisions.

Entities have also begun to accept over recent years that they have responsibilities to
stakeholders other than just shareholders, for example:

• customers and suppliers

• local communities
• society as a whole and the environment.

Social accounting and environmental reporting

Entities have increased their reporting on matters such as:

• employment of disabled people

• ethnic groups
• gender diversity.

Entities have also become more accountable for their activities in relation to
environmental damage e.g. greenhouse gas emissions. This may impact on the entity
via tax charges/reliefs, additional costs and provisions.

Global Reporting Initiative

The Global Reporting Initiative (GRI), launched in 1997, issued a set of guidelines
regarding sustainability reporting i.e. the environmental, social and economic aspects of
performance. Applying these guidelines is voluntary.

The GRI suggests that entities report performance indicators so that users can monitor
their performance from economic, environmental and social perspectives. Examples of
such performance indicators may be:

Economic - the impact of the entity on local, national and global

economies
396

e.g. proportion of spending with local suppliers, proportion of local workforce employed
by entity, levels of taxes paid

Environmental

e.g. % of recycled material used in production, levels of gas emissions,

levels of organic ingredients used in products

Social

e.g. breakdown of workforce by ethnic background, policies in respect of working hours,

benefits provided to employees such as healthcare, gym membership.

Human resource accounting

There are suggestions that the human resources of an entity should be reflected as an
asset on the statement of financial position (formerly the statement of financial position).
Many companies are more service based and have low levels of traditional tangible
assets such as machinery and inventory. It can therefore be argued that under current
accounting rules, their statements of financial position do not appropriately reflect the
value of their assets and the business as a whole.

This in turn can distort interpretation of their results since a ratio such as
ROCE will be high due to the low level of capital employed on the
statement of financial position.

Also, by recording the asset on the statement of financial position management of an

entity are perhaps more likely to consider their value to the business and therefore take
more responsibility for looking after their well-being.

However, one of the main arguments against capitalising intellectual capital is that it
does not meet the definition of an asset. This is because the entity cannot "control"
human resources.

It will also be very difficult to reliably measure the value of intellectual capital. The
problems associated with this area may result in manipulation of financial statements
and also lack of comparability between the financial statements of different entities.

International financial reporting

As more and more companies operate globally, there has been an increasing need for
accounting practices to become more harmonised.
397

Advantages Disadvantages
• Increased efficiency and • Costs for non global companies
decreased costs for global • Changing attitudes and traditions
companies
• Increase comparability
• Increased competition in world
markets

6 Exam style question

Test your understanding 1 – STR

STR is a well-established marketing consultancy in a country with a low interest rate.

STR is a successful business which has experienced rapid growth in recent years.
There are 2 million Rs 10 ordinary shares in issue. These ordinary shares are quoted
on a recognised stock exchange and 40% are owned by the founders of the business.
Dividends were Rs 4 per share in 20x3 and grew by 5% per annum between 20x3 and
20x6. This pattern is expected to continue beyond 20x6. Dividends are paid in the year
in which they are declared.

Extracts from the financial statements for the past three years are as follows:

20x4 20x5 20x6

Rs million Rs million Rs million
Profit before tax 21.6 24.4 26.7
Tax expense 7.7 2.6 4.3
Net cash generated after deducting interest, 19.2 (7.1) 18.8
tax and net capital expenditure, but
excluding ordinary dividends
398

Additional information:

• The opening cash balance in 20x4 for cash and cash equivalents was Rs 6 million;
• The opening book value of equity in 20x4 was Rs 60 million;· Long term
borrowings remained at Rs 50 million throughout the years and the an nual gross
interest cost on the borrowings was Rs 1 million;
• There were a number of disposals of non-current assets in 20x4 and an exceptionally
high level of capital expenditure in 20x5.

The directors have noticed the build-up of cash and cash equivalents. They are
concerned that this might not be in the best interest of the shareholders and could have
an adverse effect on the share price. Various proposals have been made to reduce the
level of cash and cash
equivalents.

Required:

(a) Calculate the following financial information for STR for each of the
years 20x4 to 20x6:
– Closing cash balance;
– Closing book value of equity.
(3 marks)

(b) Analyse and discuss the financial performance of the entity from the viewpoint of both
the lenders and shareholders, referring to the information calculated in part (a) above and
making appropriate additional calculations. Up to 6 marks are available for calculations.
(10 marks)

(c)
(i) Discuss the comparative advantages and disadvantages of a
share repurchase versus a one-off dividend payment.
(7 marks)
(ii) Advise the directors of STR on alternative financial strategies
that they could consider that would reduce the level of surplus
cash.
(5 marks)
399

(Total for part (c) = 12 marks)

(Total: 25 marks)
Multiple choice question (MCQ):

1. High gearing results in:

A. Higher dividend cover

B. Lower interest cover
C. Higher interest cover
D. Lower P/E ratio

Test your understanding answers

Example 1

Equity finance Debt finance

(a) Return on capital employed = Rs 5m/Rs 20m × 100 = Rs 5m/Rs 20m × 100
= 25% = 25%
Working

Rs m Rs m
PB FC & T 5.0 5.0
Finance charges 0.0 (1.0)
—— ——
PBT 5.0 4.0
Tax (@30%) (1.5) (1.2)
—— ——
PAT 3.5 2.8
Return on equity = Rs 3.5m/Rs 20m = Rs 2.8m/Rs 10m × 100
× 100 = 17.5% = 28%

The financial performance of the two funding options is exactly the same for ROCE.
This should not be a surprise given that ROCE is an indication of performance before
financing, or underlying performance.
400

(b) When considering the ROE we see that the geared option achieves a higher return
than the equity option. This is because the debt
(10%) is costing less than the return on capital (25%). The excess return on that part
funded by debt passes to the shareholder enhancing their return.

The only differences between ROCE and ROE will be due to taxation and gearing.

Example 2

(a) Asset turnover = Rs 100m/Rs 20m =5.0 times

(b) Operating profit margin = Rs 5m/Rs 100m × 100 = 5%

Example 3

Capital gearing

Debt = Rs 5m + Rs 8m = Rs 13m
Equity = Rs 10m + Rs 4m + Rs 1.5m + Rs 1.5m = Rs 17m
Either = Rs 13m/Rs 17m × 100 = 76.5%
Or = Rs 13m/(Rs 13m + Rs 17m) × 100 = 43.3%

Example 4

(a) Finance charges cover = Rs 10m/Rs 2.5m = 4 times

(b) Whether the level of cover is safe depends on a number of factors, namely:
i. at what stage in the economic cycle are the company's results;
ii. the volatility of the pre tax profits;
iii. the amount of cash held by the business.

The measure attempts to equate the earning of profits with ability to pay interest as it falls
due. There will be some correlation between the two; however, it is very risky to equate
profits earned to cash flow.

A value of above 3.0 is normally considered safe.

Example 5
401

Rs 15m – Rs 3m
Headline EPS = —————— = 50 paisa per share
24m shares

Example 6

PE Ratio

Rs 30 ÷ 1 Rs 9 ÷ 1
= 30 times = 9 times

Example 7

Dividend cover

Re 1 ÷ 20 paisa Re 1 ÷ 60 paisa
= 5 times = 1.67 times
Example 8

Dividend yield

2p ÷ 300p 6p ÷ 90p
= 0.67% = 6.67%

Test your understanding 1 – STR

Key answer tips

In part (a) ensure that your workings are clearly set out. In part (b) it is vital that you
discuss any ratios calculated rather than simply presenting the examiner with a set of
numbers. Part (c) is bookwork and a good reminder that you need to be familiar with all
aspects of the syllabus.

(a) Cash balances

20x4 20x5 20x6
Rs m Rs m Rs m
Net cash flow before dividends 19.2 (7.1) 18.8
Dividends (W1) (8.4) (8.8) (9.3)
Net cash flow 10.8 (15.9) 9.5
402

Cash b/f 6 16.8 0.9

Cash c/f 16.8 0.9 10.4

Book value of equity

20x4 20x5 20x6

Rs m Rs m Rs m
Profit before interest and tax (bal) 22.6 25.4 27.7
Interest (1.0) (1.0) (1.0)

Profit before tax 21.6 24.4 26.7

Tax expense (7.7) (2.6) (4.3)
Profit after tax 13.9 21.8 22.4
Dividends (W1) (8.4) (8.8) (9.3)
Retained profit 5.5 13.0 13.1
Book value of equity b/f 60 65.5 78.5
Book value of equity c/f 65.5 78.5 91.6

(W1) Dividends

20x4: dividend = 2 million × Rs 4 × 1.05 = Rs 8.4 million

20x5: dividend = Rs 8.4 million × 1.05 = Rs 8.82 million

20x6: dividend = Rs 8.82 million × 1.05 = Rs 9.261 million

(b) Additional calculations

20x4 20x5 20x6
Interest cover 22.6% 25.4%
27.7%
Dividend cover 1.65% 2.48%
2.41%
Earnings per share (paisa) 69.5 109 112
403

Gearing = debt net of cash / (debt + equity)

20x4 20x5 20x6

Debt 50 50 50
Cash 16.8 0.9 10.4
Debt net of cash 33.2 49.1 39.6
Equity 65.5 78.5 91.6
Debt (net) + equity 98.7 127.6 131.2
Gearing 33.6% 38.5% 30.2%

Return on equity

20x4 20x5 20x6

Profit after tax 13.9 21.8 22.4
Equity 65.5 78.5 91.6
Return on equity 21.2% 27.8% 24.5%

Return on capital employed, using net debt + equity

20x4 20x5 20x6

Profit before interest and tax (bal) 22.6 25.4 27.7
Debt (net) + equity 98.7 127.6 131.2
Return on capital 22.9% 19.9% 21.1%

Comments

The financial performance from the shareholders’ point of view has

generally been encouraging:

– Both earnings per share and the book value of equity have been
increasing.
404

– Dividends have increased.

– Return on equity has consistently been above 20%.
– Financial gearing has fallen in 20x6 and dividend cover is now
over two, indicating lower risk attached to the dividends.

The only area of worry, however, is that return on equity fell from
20x5 to 20x6.

The financial performance from the lenders’ point of view has been
less convincing. On a positive note:

– Interest cover is very high and rising, suggesting a low default

risk.
– Gearing fell in 20x6, again suggesting less risk for lenders.

However,

– STR had poor cash flow in 20x5. Lenders may wish to see
more detailed analysis of cash flow to determine if any
underlying problems persist.

(i) The relative advantages of a share repurchase verses a one-off

dividend are as follows:
405

Share repurchase One-off dividend

· A repurchase may be more · A dividend may be more tax

tax efficient than a dividend advantageous for some
for some shareholders. shareholders.
· A reduction in the number of · All shareholders are treated
shares should boost EPS. fairly.
· Increased gearing as equity · The amount of cash paid is
is reduced. This is only an more certain - with a
advantage if STR is moved repurchase it will not be
closer to its optimal gearing known in advance how many
level. shareholders will choose to
· Does not create an sell.
expectation of higher future
dividends. On the contrary,
less cash will be needed for
future dividends due to fewer
shares.

(ii) Alternative strategies for reducing a cash surplus include the

following:
– increase the growth rate of dividends
– long-term equity investments – e.g. acquire other firms
and/or buy stakes in rivals, customers, etc
– reduce debt by repaying loans
– increase capital expenditure
– increase investment in research and development – e.g. to
enter new markets.

Answer to MCQ:

1) B
406
407

Learning Objectives:

a) Explain the fundamental concepts and principles of international investment.

b) Identify and evaluate the various risks associated with international investments,
including political, economic, and currency risks.

c) Calculate and interpret the Net Present Value (NPV) for international projects,
considering exchange rate fluctuations.

d) Define and explain the concepts of Purchasing Power Parity (PPP) and the
International Fisher Effect.

e) Analyze how PPP and the International Fisher Effect influence exchange rates and
international investment decisions.

f) Understand and apply the concept of Interest Rate Parity in international financial
contexts.

g) Evaluate how appreciation and depreciation of currencies impact international

investment strategies.
408

1 Overview of Chapter

As a starting point it is assumed that candidates bring through their knowledge of basic
investment appraisal, and in particular NPV analysis.

2 Basic Foreign Project Appraisal

The NPV analysis of an overseas project - (FDI) - requires some additional complexities
to those found with an NPV analysis of a domestic project.

(Please see table on next page)

409

Year 0 1 2 3 4 5
Rs.000 Rs.000 Rs.000 Rs.000 Rs.000 Rs.000

Receipts × × × ×
Payments:
Wages (×) (×) (×) (×)
Materials (×) (×) (×) (×)
Variable / (×) (×) (×) (×)
Fixed
overheads
Administrati (×) (×) (×) (×)
on
/Distribution
expenses
Taxable × × × ×
cash flow

Tax: (×) (×) (×) (×)

Corporate
tax
: Capital × × × ×
allowances
Initial outlay (×)
Net ×
receivable
value

Working (×) ×
capital

Net cash (×) × × × × ×

flow in Rs.
Exchange (×) × × × × ×
rate – IRP
of PPP
Net cash × × × × × ×
flows
Discount 1 0.909 0.826 0.751 0.683 0.621
rate (e.g.
10%)

Present (×) × × × × (×)

value

Net present ×××

value

3 Additional complexities in foreign NPV calculations

In particular, in exam questions, look out for complexities involving:
• tax;
• inter company cash flows (such as management or royalties charges);
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• remittance restrictions where the foreign government restricts the

amount of the project's cash flow that can be remitted back each year
to the parent;
• forecasting future spot rates.
Taxation
There are three possible tax scenarios for an exam question:

Home tax rate Foreign tax rate

(i) 33% < 40%
(ii) 33% = 33%
(iii) 33% > 25%

The question will always assume a double-tax treaty. Therefore a project's profits get
taxed at whatever is the highest rate between the two countries.

In scenarios (i) and (ii) there would be no further domestic tax to pay on the project's
foreign profits. But in scenario (iii) the project's profits would be taxed at 33% : 25%
in the foreign country and a further 8% tax payable in the home country.

Inter-company cash flows

Inter-company cash flows also impinge on the tax computations. In reality the whole
issue of whether or not an inter-company cash flow (such as royalty payments made
by an international project to the foreign parent) are or are not allowable for tax
purposes is a very politically sensitive issue.

In the exam assume such cash flows are allowable (and state it) unless the question
says otherwise.

The key point to remember is that, if an inter-company cash flow is allowable for tax
relief in the foreign country, there will be a corresponding tax liability in the home
country.
Transfer prices are particularly problematical. By manipulating the transfer prices
charged it may be possible to minimise the global taxation cost for the group. For
instance, suppose we have two companies within a group that are based in different
countries.
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Company A will report low income therefore limiting its tax charge where as company
B will be reporting high income as it pays less tax.

By manipulating the transfer price the overall tax charge can be lowered. The problem
is that the government of country A will not look favourably on this action.

Assume that the tax authorities will only allow 'arm's length' / open-market prices for
tax relief and will not allow an artificially high or low transfer price.

A second problem may also arise. Although the above may decrease the taxation,
the profits will end up in country B. If the currency of country B is weak relative to the
holding company, then loss from the depreciation of the currency may be more than
the tax saving.

Illustration 1

An example helps to illustrate many of these points. Take just the Year 2 cash flow of
a US project; assume tax is paid at 25% in the US and 33% in the Pakistan; assume
royalty payments of $10m; and assume a forecast spot rate of $1 = Rs 100.

Year 2
$m
Revenues 100
Costs (30)
Royalties (10)
Pre-tax profit 60
25% US tax 15
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Remit to 45
parent
Rs. m
x Rs Spot x 100
rate
Rs Cash flow 4,500
Royalties 1,000
($10m x
Rs.100)
Rs/$ =100
Pakistan Tax (8,10)*
33%
After tax 4,690
cash flows

Pakistan tax computation:

8% Pakistan tax on $ profits: $ 60m × 0.08 $ 4.8m

———
33%@ Pakista tax on royalties: $ 10m × 0.33 $ 3.3m
Total Pakista tax liability = $ 8.1m
x spot rate x 100

———
Pakistan tax payable = Rs810 m*
———

Remittance restrictions

Remittance restrictions are where the overseas government places a limit on the
funds that can be repatriated back to the holding company. By doing so this may
change the cash flows that are received by the holding company.

Suppose there are no tax complications. The project's after-foreing tax $ cash flow
is as follows ($m):
Year 0 1 2 3
(10) 3 4 6
In any one year, only 50% of cash flows generated can be remitted back to the
parent. The blocked funds can be released back to the parent in the year after the
end of the project.
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Cash flows to parent ($m):

Year 1 2 3 4
1.5 2 3 6.5

It is these cash flows that have to be put through the NPV calculation.

It is the parent company's cash flow that should now be converted into Rs terms and
discounted to NPV as we always need to evaluate the overseas investment from the
parent company's viewpoint (and that of their shareholders): what money does the
parent put in and what money is available for the parent company to take out?

Forecasting future spot rates

The exam question may provide you with estimated exchange rates over the life of
the project, but it is more likely you will have to estimate them using either:

• Purchasing Power Parity; or

• Interest Rate Parity.

The formulae are given in the exam as follows:

For purchasing power
1 +
inflation
(Currency
A)
Future spot rate = Spot rate (Currency A/CurrencyB) × ——————
1 +
inflation
(Currency
B)

For interest rate parity 1 + interest

(Currency A)
Future spot rate = Spot rate (Currency A/CurrencyB) × ——————
1 + interest
(Currency B)

Note: The phrase "spot rate Currency A/CurrencyB " means "the number of units of
“currency A” which are equivalent to 1 unit of “currency B".

Explanation of the Law of One Price

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Purchasing Power Parity (PPP) is sometimes known as the LAW OF ONE PRICE. The
theory states that the exchange rates will move to eliminate the difference in the
interest rates between two countries. For example:

The exchange rate will move so that £1,050 will equal $1,650 (i.e. $1.5714 = £1)

The same calculation can be undertaken by using the formula given in the
examination.

Using the previous information:

1 + inflation $
Future spot rate $/£ = Spot rate $/£ x —————–
1 + inflation £
1.10
1 year rate = 1.50 × ——— = $ 1.5714
1.05

Examination problem

In the examination you may be required to calculate many exchange rates for
several years into the future. For instance:

The current spot rate Rs/$ is 100 (that is Rs 100 = R$1). The anticipated rate of
inflation in the USA is 4% per annum whilst in the Pakistan it is expected to be 8%.
The exchange rates can be calculated as follows:

1.08
Year 1 Rs 100 × —— = Rs 103.85
1.04
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1.08
Year 2 Rs 103.85 × —— = Rs 107.84 etc.
1.04
Notice that the exchange rate at the end of one year becomes the basis of the next
year’s calculation.

Appreciating and depreciating currencies

As an alternative to IRP/PPP, you may be asked to calculate exchange rates given

currency appreciation / depreciation rates.

For example, the spot rate is Rs/$ 100 (that is Rs 100 = $1) and the Rs is depreciating
against the $ at 10% per annum. This means that, in future years, the $ can buy more
Rs. The exchange rate in 1 year's time will be Rs 100 x 1.1 = Rs 110 = $1 and in two
years' time it will be Rs 121 = $1.

Alternative approach to computations

An alternative method is available for calculating foreign project NPVs which could be
examined. This is carried out as follows:

Step 1 Estimate the project's relevant cash flows in the foreign currency.
Step 2 Assuming Interest Rate Parity (IRP) will apply, convert the domestic cost of
capital to the foreign equivalent.
Step 3 Use this adjusted cost of capital to discount the foreign cash flows to produce
an NPV in foreign currency.
Step 4 Convert the NPV into its domestic currency equivalent using the spot rate for
translation.

If IRP holds, this will give the same sterling NPV as the more conventional approach
explained earlier.

Example 1
A manufacturing company based in the Pakistan is evaluating aninvestment project
overseas – in UAE. It will cost an initial 5.0 million UAE Dirham (AED) and it is
expected to earn post-tax cash flows as follows:

Year 1 2 3 4
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Cash flow (AED 000) 1,500 1,900 2,500 2,700

The following information is available:

• Real interest rates in the two countries are the same. They are expected
to remain the same for the period of the project.
• The current spot rate is Rs/AED 25 (that is Rs 25 = 1AED).
• The risk-free rate of interest in UAE is 7% and in Pakistan 9%.
• The company requires a Rs return from this project of 16%.

Required:

Calculate the Rs net present value of the project using both the following methods:

(a) by discounting annual cash flows in Rs;

(b) by discounting annual cash flows in AED.

(12 marks)

Basis and basis risk

Basis

Basis: Future price of a foreign currency is never the same as the spot market rate.
For example Rs/$ future is @ $1 = Rs 97.2800 when current spot exchange rate is
$1 = Rs 97.2500. The difference of 0.0300 or 300 point is called “basis”

Basis risk

Basis risk is risk when future position is closed, the size of actual basis will be different
from the expectation of what the basis should be.

4 Political Risk (or Country Risk)

This is the risk, faced by an overseas investor, that the host country government may
take adverse action against the project, after the company has invested.
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Types of government interference

Type of Non- Discriminatory Discriminatory Wealth

political discriminatory interference sanctions deprivation
interference interference

Description Affects not only Designed to Designed to Designed to

direct give local eventually put put
investment producers foreign-owned foreign-own
but also joint an dvantage firms out of ed firms
ventures, over foreign- business immediately
licensees, etc. owned out of
ventures business

Examples · Minimum · Joint · Creeping · Expropriation

number of ventures only expropriation of assets
local nationals to
· Special · Claiming
be employed
taxes on compensation
· Temporary foreign firms for past actions
suspension
·Encouraging · Very high
of currency
boycotts taxes on
convertibility foreign-owned
· Invalidating
· Price fixing firms
patents
By government
· Minimum %
of local
components
to be used

Managing political risk

• Measure it.

• Avoid it.

• Prior negotiation (concession agreements and planned divestment).

• Structuring investment:
– local sourcing;
– location of facilities;
– control of distribution;
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– control of technology;
– financial measures;
– organisational measures.

More detail on political risk

Before undertaking a foreign direct investment, a company needs to try and assess
its exposure to political risk by:

• Using political risk ranking tables such as the Euromoney Magazine Tables.
• Evaluating the macro-economic situation of the country that might
heighten political risk exposure:
– balance of payments;
– IMF involvement;
– unemployment;
– per capital income;
– dependency on commodity prices;
– inflation;
– exchange rate policy;
– rate of economic growth;
– foreign debt.

• Evaluating the current government's popularity, stability and attitude to

foreign investment, together with the attitude of opposition parties.

• Looking at the historical stability of the political system and the size, power

and influence of the armed forces.

• Changing religious and cultural attitudes.

• Taking advice from:

– the company's bank, particularly if it has a 'representative office'
in the overseas country;
– British embassy in the overseas country;

– the company's trade association / local chamber of commerce;

– Department of Trade and Industry (DTI).
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Finally, how can political risks be taken into account in the investment appraisal
process?

• Exercise of managerial judgement.

• Use of sensitivity analysis.
• Use of a higher discount rate, to act as a risk premium.

5 Exam style questions

Test your understanding 1 – Ghani Ltd

Ghani Ltd is a Pakistan-based retailing company that operates in the USA and Pakistan.
The company is evaluating the potential for expansion into UAE.A detailed assessment
of the costs and likelyincremental revenues of opening stores in two major cities has been
carried out. The initial cost of the investment is AED 80 million. The nominal cash

flows, all positive and net of all taxes, are summarised below.

Year 1 Year 2 Year 3

Cash flow (AED million) 35.50 42.50 45.00
The company’s treasurer provides the following information:

• The expected inflation rate in AED is 4% each year and in the Pakistan 6% each
year.
• Real interest rates in the Pakistan and AED are the same. They are expected to
remain the same for the foreseeable future.
• The current spot rate is Rs/AED 25.
• The risk-free annual rate of interest in UAE is 6% and in the Pakistan 8%. These
nominal rates are not expected to change in the foreseeable future.
• The company’s post-tax weighted average cost of capital (WACC) is 15%, which
it uses to evaluate all investment [Link] expansion will bfinanced by a
combination of internal funds generated in the Pakistan and long-term fixed
interest rate debt raised in AED. The company plans to purchase in UAE the
majority of its goods for resale.
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Required:

(a) Calculate the Rs net present value of the project, using both the following
methods:
(i) by discounting annual cash flows in Rs
(ii) by discounting annual cash flows in AED, using an adjusted discount rate

and explain, briefly,0020the reasons why the two methods give almost identical
answers.
(9 marks)

(b) Assume that the company’s management is considering purchasing from

outside UAE a substantial proportion of its goods to be sold in the UAE stores.
Approximately 50% of total goods for resale might be purchased in the West
and a further 25% in the Pakistan. Discuss how a decision to change buying
patterns might Affect the evaluation and funding of the investment.

(8 marks)

(c) Assume that inflation in UAE turns out to be higher than forecast for the whole
period of evaluation, with corresponding impact on the other economic factors.
Inflation in Pakistan is slightly less than forecast. Discuss how the financial
returns on the investment might be affected, and advise on a funding strategy
that could minimise the impact of such inflationary effects.

(8 marks)

(Total: 25 marks)
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Multiple choice question (MCQ)

1) Purchasing power parity theory assumes that:

A. Exchange rate of currency with higher interest rate will strengthen

B. Exchange rate of currency with lower interest rate will strengthen
C. Exchange rate of currency with higher inflation rate will strengthen
D. Exchange rate of currency with lower inflation rate will strengthen

Calculate the adjusted discount rate using the interest rate parity formula.
Future spot rate Rs/AED = Spot rate Rs/AED × (1 + discount rate Rs) / (1 + discount
rate AED)

25.47 = 25 × 1.16 / (1 + discount rate AED)

29 / 25.47 = 1.1387

Discount rate = 13.87%

Test your understanding answers

Example 1

Method 1

Calculation of exchange rates

Using the interest rate parity theory:
Year 1 25 × 1.09/1.07 = 25.47
Year 2 25.47 × 1.09/1.07 = 25.94
Year 3 25.94 × 1.09/1.07 = 26.43
Year 4 26.43 × 1.09/1.07 = 26.92
Year 0 1 2 3 4
Cash flow (AED 000) (5,000) 1,500 1,900 2,500 2,700
Exchange rate 25 25.47 25.94 26.43

26.9
2
———– ———– ———– ———– ———
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Cash flow Rs (125,000) 38,205 49,286 66,075 72,684

PV factor 16% 1.000 0.862 0.743 0.641 0.552
———– ———– ———– ———– ———
PV (125,000) 32,933 36,620 42,354 40,122
———– ———– ———– ———– ——
NPV = Rs 27,029 k

Method 2

Calculate the adjusted discount rate using the interest rate parity formula.

Future spot rate Rs/AED = Spot rate Rs/AED × (1 + discount rate Rs) / (1 + discount

rate AED)

25.47 = 25 × 1.16 / (1 + discount rate AED)

29 / 25.47 = 1.1387

Discount rate = 13.87%

Year Cash flow PVF PV

AED 13.87%
0 (5,000) 1.000 (5,000)
1 1,500 0.878 1,317
2 1,900 0.771 1,465
3 2,500 0.678 1,695
4 2,700 0.594 1,604
———–
AED 1,081
———–

NPV = 1,081 x 25 = Rs 27,025 k

The difference between the two results is due to rounding.

Test your understanding 1 – Ghani Ltd

423

Key answer tips

For (a) there is a need to recognise the requirement to calculate exchange rates for
alternative (i) and apply the Rs discount rate to the Rs cash flows. For alternative (ii)
it should have been recognised that the cash flows in AED should be discounted at
an adjusted discount rate.

For (b) there is a need to recognise important considerations such as the effect of
transaction costs and taxes and also the effect of currency risks.

For (c) there is a need to recognise that the NPV of the investment will be higher
because the Rs is weakening against AED.

(a)
(i) Method 1: Converting cash flows to sterling and discounting at sterling
required rate of return

Spot rates

Current 25
In 1 year 25.48 25 × (1.06/1.04)
In 2 years 25.97
In 3 years 26.47
Year 0 1 2 3
Cash flow (AED m) (80) 35.5 42.5 45
Converted at spot rates (Rs m) (2,000) 904.54 1,103.73
1,191.15
Discounted at 15% 1 0.87 0.756
0.658
DCF (Rs m) (2,000) 786.94 834.42
783.77

NPV = Rs 405.13 m

(ii) Method 2: Discounting HKD at risk adjusted rate

Risk adjusted rate for AED cashflows can be found using the IRP formula:
424

Future spot rate in 1 year (Rs/AED) = Spot rate x (1+Pak interest) / (1+ UAE interest)

So,

25.48 (from above) = 25 × 1.15 / (1 + UAE rate)

Hence

(1+ UAE rate) = 1.15 × 25 / 25.48 = 1.1283

i.e. UAE rate = 12.83%

Alternative (short cut) calculation:

Risk premium is:

(1.15/1.08) – 1 = 6.48%

Required return on AED cash flow is therefore:

(1.06 × 1.0648) – 1 = 12.87%

Year 0 1 2 3
Cash flow (AED m) (80) 35.5 42.5 45
Discounted at 12.87% 1 0.886 0.785 0.695
DCF (80) 31.453 33.363 31.275

When converted at the spot rate of 25 this gives an NPV of Rs 402.3m.

Two basic assumptions allow these calculations:

– Interest rates are determined in the market. There is a relationship between foreign
exchange and money markets. A currency with a higher short term interest rate will
sell at a discount in the forward market, and the one with a lower interest rate will sell
at a premium.
–The expected difference in inflation rates between two countries equals, in
equilibrium, the expected movement in spot rates.

(b) In practice there are considerations such as:

425

• Sourcing goods from elsewhere increases exchange rate risks and there may be
a need to hedge future transactions.
• Relative prices in the various countries, adjusted for transport costs and taxes. The
‘West’ may contain many different countries and varied tax regimes.
• The imposition of legal restrictions on the purchase or movement of goods from
the West will need to be considered.
• The discount rate might need to be adjusted to accommodate the additional
risks and uncertainties of dealing in different currencies
• As the AED is forecast to appreciate against Rs, the benefits of buying in a
depreciating currency might be available (depending to some extent on any credit
period allowed/taken).
• Funding the expansion in AED might be disadvantageous – debt will be repaid in
appreciated currency.
(c) Inflation, interest rates and exchange rates are strongly connected. A rise in
inflation is likely to be associated with higher interest rates. In turn this will mean
that the AED will sell at a higher discount in the forward market (this assumes
that interest rate parity and purchasing power parity hold).

Hence if inflation is higher in UAE it is likely that the return on the investment in Rs
terms will be lower. This will however also depend on how the company is able to raise
its own prices, where goods are sourced, and the impact of inflation on different
elements of cost.

One issue to consider in relation to funding is the currency in which interest is paid. If
this is paid in AED in UAE then there is an advantage to this method of financing.

There is no indication of how the debt principal is to be repaid. Assuming it is paid at

the end of the period, then it will be paid in depreciated currency.

Answer to MCQ:

D
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