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BUSINESS FINANCE
OUbs002223
January 2014
OUbs002223 Business Finance
TableofContents
Unit 1
Agency Issue between shareholders and managers
Unit 2
Investment appraisal methods
Unit 3
Risks and Return
Unit 4
Asset Pricing Models, CAPM & APT
Unit 5
Capital Market Efficiency and Stock Market Anomalies
Unit 6
Cost of Capital, Shareholders wealth, Gearing & Leasing
Unit 7
The dividend decision
Unit 8
Corporate Restructuring
AimoftheModule
To provide learners with knowledge of the principles and practice of the financing
decisions of enterprises. Learners will learn about the decisions which firms make about
financing their investments in productive capital.
Teachingandlearningstrategy
The teaching and learning strategy is designed to develop in students an ability to
understand the mechanisms of financial markets and the issues pertaining to investment
decision in those markets. Students should be able to understand and apply the time value
concepts with regards to investment decision. They should also be able to evaluate the risks
and returns of financial instruments.
AssessmentStrategy
Unit(s)ofAssessment
Assignment
WrittenExamination
WeightingTowardsModuleMark(%)
30
70
GUIDELINESFORSELFSTUDY
This manual aims at fulfilling the preciously identified learning objectives. Despite the fact that
this manual is self-contained, you are expected to do some additional research in books and
academic articles to deepen your understanding of quantitative techniques and research
methodology.
Manual:
Open University of Mauritius OUbs002223: Business Finance
References
Brealey, R. and S. Myers Principles of Corporate Finance. (Boston, Mass.; London: McGrawHill, 2003) [ISBN 0071151451] Chapter 33.
Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading, Mass.;
Wokingham: Addison-Wesley, 1988) third edition [ISBN 0201106485] Chapters 15 and 16.
943-963.
Pandey I M, Financial Management, 9th Edition, Vikas Publishing House Pvt Ltd, 2009
OtherIndicativeReading
Students will need to thoroughly search the numerous journals that are most appropriate for their
chosen research topic.
Articles in reputable journals (Journal of Finance and Journal to
Corporate Finance among others) often deal with a topic in much more detailed than textbooks.
Moreover, because articles are generally peer reviewed, they are likely to have more credibility.
Videoresources:
https://www.coursera.org/;
https://www.futurelearn.com;
https://www.udacity.com/
HOWTOUSETHEMANUAL
Read the overview and learning objectives of each Unit. This will help you in
identifying the knowledge and skills that is required to successfully complete the
study of the Unit.
HOW TO STUDY
Plan your study time carefully
Read the Unit thoroughly. Prepare a list of questions that you may ask your tutor.
Note that the questions should be relevant to the Unit studied.
Be a critical thinker
Work your activities. It is important for you to attempt all activities as this will
give you an idea of concepts that you have not understood.
Re-work your corrected activities later.
You are expected to study regularly as there is no easy way to pass the examination.
UNIT 1 AGENCY PROBLEM BETWEEN SHAREHOLDERS AND MANAGERS
Unit Structure
1.0
Overview
1.1
Learning Objectives
1.2
Shareholder Wealth Maximization Principle
1.3
The Agency Relationship
1.4
Managers as Agents
1.5
Activities
1.6
Suggested Readings
1.0
OVERVIEW
Ownership and Control are most commonly separate as shareholders of a Company entrust the
day to day running of the organisation to managers, referred to as agents.In the pages that
follow, we shall explore the relationship between managers and shareholders and the possible
conflicts of interest.
1.1
LEARNING OBJECTIVES
By the end of this Unit, you should be able to:

1.
Demonstrate understanding of the basic notion of principal and agent;
2.
Demonstrate understanding of the possible conflict of interest;
1.2
Shareholder Wealth Maximization Principle
In general, the main aim of any firm is the maximization of shareholders wealth. Put in simple
terms, it implies making shareholders as rich as possible. The wealth of shareholders is
maximized when a given decision generates a net present value-which is the basically, the
difference between present value of the benefits of a project and present value of its costs. A
project that yields a positive net present value creates wealth for shareholderswhile onethat
generates a negative net present value reduces wealth of shareholders. It therefore follows that
only those projects which have positive net present value should be accepted.
1.3
The Agency Relationship
The relationship between stockholders and management is called an agency relationship. Such a
relationship exists whenever someone (the principal) hires another (the agent) to represent
his/her interests. In all such relationships, there is a possibility of a conflict of interest between
the principal and the agent. Such a conflict is called an agency problem .
Managers are usually appointed by the shareholders to run the firm in their best interests.
Whether the former holds true depends on two factors, the first being alignment of management
and shareholder goaland may often partly relate to the way managers are compensated. In reality,
there can often be goal divergence. The second factor pertains to control and the possibility of
the manager being replaced.
For instance, managers may be more interested in short term payback which favours their
promotional prospects rather than investing in projects with positive net present values which
optimizes shareholder wealth.
Furthermore, shareholders may wish todiversify their risk by investing in a number of firms
whilst the managers may be averse to investing in risky investments.It is also believed that
managers will generally be more inclined to maximize the amount of resources over which they
have control in a view to gain more corporate power. This can lead to an overemphasis on
corporate size or growth. Instances where managers are ready to overpay to buy another
company with the sole aim of growing the size of the business or to exhibit corporate power are
not uncommon.
All the above indicate that managers may be likely to overemphasize organizational survival to
protect job security.
Therefore the agency relationship between shareholders and managers has agency conflicts
which can have implications for corporate governance and business ethics.
1.4
How to Motivate Managers to Act in Shareholder's Best Interest
Managerial compensation
Direct intervention by stockholders
Threat of firing
Threat of takeovers
1. Managerial Compensation
It is a known fact that employees are motivated by rewards, tangible and intangible.
Since managers are mere agents of shareholders, the lattershould find means to induce them to
act in their best interests. By securing their commitment and make them feel that they are part of
the family in the organization, there will be a natural tendency that their goals get aligned with
those of the shareholders.
Incentives can be linked directly to better job prospects, promotion possibilities and more
attractive packages, be it higher salaries or perks such as company car. Thus, by upon successful
achievement of set shareholder goals, the managers can reap enormous rewards
Other forms of rewards can be performance bonuses and company shares.
Company shares can be distributed to managers either as:
Performance shares, where managers will receive a certain number shares based
on the company's performance.
o
Executive stock options, allowing managers to buy shares at a future date and
price. With this option, managers will join the line of shareholders and a greater possibility of
alignment with shareholder goals exist.
o
2. Direct Intervention by Stockholders

It can be argued here that control of the firm ultimately rests with stockholders. The latter elect
the board of directors, who, in turn, control management.
Another option can be by having the majority of the firms stock be owned by large institutional
investors, such as pensions and mutual funds. As such, these large institutional stockholders have
the ability to exert influence on managers and, hence, the firms operations.
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3. Threat of Firing
In case shareholders are still not satisfied with the performance of existing managers, they may
request to review the composition of current managers.
Shareholders even have the powerto re-elect a new board of directors that will accomplish the
task.
4. Threat of Takeovers
In extreme cases whereby stock price deteriorates because of managements inability to run the
company effectively, competitors or stockholders can take a controlling interest in the company
and bring in their own managers.
1.5 ACTIVITIES
Activity 1:
Managers always act in the best interests of shareholders. Discuss.
Activity 2:
Shareholder Wealth Maximization Principle-A utopia or reality? Discuss
1.6 SUGGESTED READINGS
Thomas E. Copeland, J. Fred Weston Financial Theory and Corporate Policy (3rd or Latest
Edition) by Addison Wesley
Brealey and Meyers, Principle of Corporate Finance, McGraw-Hill, 5th or Latest edition
UNIT 2
Investment Appraisal Techniques
Unit Structure
2.0
Overview
2.1
Learning Objectives
2.2
The Capital Budgeting & Investment AppraisalProcess
2.3
Identifying Cash flows
2.4
Discounting
2.5
Methods of Investment Appraisal
2.5.1
Payback Method &Discounted Payback Method
2.5.2
Net Present Value
2.5.3 Internal Rate of Return

2.5.4
Accounting Rate of Return
2.5.3
Activities
2.7
Suggested Readings
2.0
OVERVIEW
Financial managers and investors are faced with various investment opportunities.
However, the financial manager needs to ensure that the investment decisions are in line with the
objectives of the particular firm and depending on the firms strategy and budget constraints, the
manager may have to select the best alternative or rank them in order of preference, as well as
gauge the alternatives foregone. This is why a proper screening of investment proposals is very
important.
The process of evaluating long-term investment decision is known as Investment Appraisal. The
decision whether or not to select a project will usually depend on the stream of cash flows which
are generated over a given time period. Investment appraisal methods can be categorised into
discounted cash flows techniques based on time value of money and non-discounting techniques
ignoring the time value of money.
2.1
LEARNING OBJECTIVES

3.
Understand the different concepts and importance of investment decisions
4.
Calculate the NPV, IRR, payback and profitability Index.
5.
Analyse the results obtained in line with whether to invest in a particular project or not.
6.
Evaluate the pros and cons of each technique
2.2
THE CAPITAL BUDGETING &INVESTMENT APPRAISAL PROCESS
Further to Unit One, whereby you have learned that shareholders entrusting their money to
managers in a given Company and expect that their money is invested in the most optimal way.
To this effect, capital budgeting is the process of making long-term investment decisions that
support the shareholders wealth maximization principle.
To assess capital budgeting projects ,the followingare required:
2.3
Gauge the project's relevant cash flows
Decidewhether or not a project should be undertaken based on a particular decision rule.
IDENTIFYING THE PROJECTS CASH FLOWS
The following points should be taken into account when identifying relevant cash flows:
Accounting profits are irrelevant and only cash flows should be taken into account
Accounting profit takes into account not only cash sales but also credit sales. However, credit
sales are not cash flows as they have not yet been converted into cash. Therefore, you need to
disregard all non-cash flows for investment appraisal purposes.
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Incremental cash flows are the relevant cash flows
All sunk costs, committed future costs, non-incremental fixed costs and overheads should not be
taken into account In effect, only incremental cash flows (i.e those cash flows that will change
as a direct result of undertaking the project) are relevant.
All financing cash flows should be disregarded
The present value of the financing cash flows is represented by the project's initial outlay.
Interest and principal repayments over and above the initial capital outlay do not need to be taken
into consideration so as to avoid double counting.
Illustration:
A company desires to purchase a machine which costs Rs120, 000 and has a three year life. The
company decides to finance the purchase of this machine by taking a loan from the bank. The
bank charges an interest rate of 10% per annum with the principal being paid at the end of the
third year.
Cash flows:
Year
(12000)
(12000)
(12000)
Item
Machine
Interest
Principal
(120,000)
(120,000)
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However, the above is wrong since the present value of the loans cash flows is the machine
initial outlay. The interest and principal are financing cash flows and should be ignored.
In fact, the following calculation shows:
PV of loan cash flows:
12000 12000 12000 +120 ,000

+
+
1
2
1.1
1.1
1.13
Working capital adjustment needs to be taken into account
Changes in the level of working capital represent changes in cash flows. Basically, cash
outflows are represented by increases in the working capital requirement such as increase in
debtors or stocks. In fact, the increase in debtors represents an investment in working capital as
payment of sales is not made immediately. Also, increases in stock are due to lower stock
turnover. On the other hand, cash inflows are represented by decreases in the working capital
requirement. For instance, reduction in stocks may be due to greater stock turnover or reduction
in debtors may be to earlier payment by debtors
Take into account all opportunity costs from undertaking the project
The opportunity cost of any can be defined in terms of the next best alternative to that action,i.e
"What you would have done if you did not make the choice that you did". For, instance a firm
that uses a particular machinery for production purpose also has the choice to sell that
machinery. The opportunity cost of using the machinery is the value of its forgone alternative
use.
Taxation
In the appraisal of an investment project, focus is on the cash flows that will be generated by the
project and that which are available for shareholders. As such, we want to assess the after tax
cash flows of the project.
It is important to note that the taxation charge is levied on the taxable profits of the business and
not on the net cash flows.
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The investment appraisal process is a very important business decision as:

-
They influence the business growth in the future
They affect the risk of the firm
They involve the commitment of large amount of funds
The capital budgeting process involves three basic steps:

(i)
Generating long term investment proposals
(ii)
Reviewing, analysing and selecting proposals that have been granted
(iii)
Implementing and monitoring the proposals that have been selected.
Prior to selecting any investment proposal, it is important to take the following into
consideration:
(i)
If the projects are Mutually exclusive i.e,either one or the other can be selected
(ii)
If they are Independent Projects i.e, cash flows of one project are not affected
by accepting or rejecting other projects
(iii) Whether the company has Unlimited funds or is thereCapital Rationing- i.e, will
the company be able to finance any profitable projects or not.
(iv) Does the company need to either Accept a particular proposal and Rejectothers
or can it rank the alternatives based on available funds.
2.4 DISCOUNTING
To discount means to calculate the present value of a future cash flow.

Discounting into todays rupees helps us to compare a sum that will not be produced until later.
Technically speaking, to discount is to depreciate the future. It is to be more rigorous with
13
future cash flows than present cash flows, because future cash flows cannot be spent or
invested immediately.
First, take tomorrows cash flow and then apply to it a multiplier coefficient below 1, which is
called a discounting factor. The discounting factor is used to express a future value as a present
value, thus reflecting the depreciation brought on by time.
Consider an offer whereby someone will you Rs1,000 in 5 years. As you will not receive this sum
for another 5 years, you can apply a discounting factor to it, for example, 0.6. The present, or
todays value of this future sum is then 600. Having discounted the future value to a present value,
we can then compare it to other values. For example, it is preferable to receive 650 today than 1000
in 5 years, as the present value of 1000 5 years from now is 600, and that is below 650.
Discounting make is possible to compare sums received or paid out at different dates.
Discounting is based on the time value of money. After all, time is money. Any sum received
later is worth less than the same sum received today. Remember that investors discount they
demand a certain rate of return. If a stock pays you Rs110 in one year and you wish to see a
return of 10% on your investment, the most you would pay today for the security (i.e. the present
value) is 100.
Discounting is calculated with the required return of the investor. If the investment does not meet
or exceed the investors expectations, he will forego it and seek a better opportunity elsewhere.
2.5 METHODS OF INVESTMENT APPRAISAL
The investment appraisal techniques can be classified into two main categories, discounting and
non-discounting techniques.
Discounted Cash Flow Techniques: Takes into account the time value of money
Net present value
Internal Rate of Return.
Discounted payback
14
Non-Discounting Techniques : Ignores the time value of money
Payback period
Accounting rate of return
2.5.1 PAYBACK PERIOD

The payback method is one of the most popular and widely used methods of evaluating
investment proposals. The payback period is the amount of time required for the firm to recover
its initial investment. That is, the payback period can be calculated by dividing the cash outlay or
initial investment by the annual cash inflow.
= C0
C
Payback = Initial Investment

Annual Cash flow
llustration 1
Mr John decides to invest in 2 projects (Project A and Project B) with the following cash flows:
Project A ($)
Project B ($)
(1,200)
(1,200)
Year 1
500
200
400
200
300
700
100
900
Initial Investment
Payback Project A = 3 years

Payback Project B = 3.11 years{200+200 + 700+ (1200-1100)/900}
Based on above, the company will choose Project A since it will take less years as compared to
Project B.
15
The advantages of the payback period method include the following:

Easy to understand and simple to compute
When capital is scarce or in short supply, it could be argued that projects that returned
the expenditure rapidly are the best ones.
It is useful in certain situations (rapidly changing technology and improving investment
conditions)
It favours quick return, which in turn help company growth, minimizes risk and
maximizes liquidity
It uses cash flows, not accounting profits
The drawbacks of this method are:

Ignore the time value of money.
It does not assess the impact of cash inflows arising after the payback period, which
could greatly affect the projects profitability.
It is subjective no definitive investment signal
It ignores project profitability
The Discounted Payback Period method
The Discounted payback period method has been introduced to cater for the time value
disadvantage borne by the payback period. By discounting the future cash flows arising from the
project, the time value of money is taken into consideration. Consider the following example:
Year
Cash Flow
(250,000)
Discounted
Cash Flow
(at 7%)
(250,000)
80,000
Cumulative
Cash Flow
Payback Period
(250,000)
74,766
(175,234)
90,000
78,609
(96,625)
100,000
81,629
(14,996)
110,000
83,918
68,922
14,996/83,918
x 12 Months
= 3 years and 3 Months
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Hence, using the discounted payback period, as opposed to the normal payback period, the
payback period has increased from 2 years and 10 months to 3 years and 3 months. This new
method has taken into consideration the riskiness of the cash flows and has accounted for the risk
by applying the time value of money to it.
2.5.2 THE NET PRESENT VALUE (NPV)
When calculating the NPV of a project, follow the two steps hereunder:
1. Write down the net cash flows that the investment will generate over its life
2. Discount these cash flows at an interest rate that reflects the degree of risk inherent in the
project
The resulting sum of discounted cash flows equals the projects net present value. The NPV
Decision Rule says to invest in projects when the net present value is positive (greater than
zero):
NPV > 0
Invest
NPV < 0
Do Not Invest
The NPV Rule implies that firms should invest when the present value of future cash inflow
exceeds the initial cost of the project. The firms primary goal is to maximize shareholder
wealth. The discount rate r represents the highest rate of return (opportunity cost) that investors
could obtain in the marketplace in an investment with equal risk. When the NPV of cash flow
equals zero, the rate of return provided by the investment is exactly equal to investors required
return. Therefore, when a firm finds a project with a positive NPV, that project will offer a return
exceeding investors expectations
Consider the following example:
Greys Plc, a company engaged in the manufacture of deep-sea diving suits. The firm is
considering whether to invest in one of two automated machine processes, Machine A and
Machine B, in view of savings on operations. The following information is provided:
17
Greys Plc
Machine A
Machine B
(MUR)
(MUR)
150,000
185,000
Year 1
30,000
60,000
Year 2
40,000
61,000
Year 3
50,000
62,000
Year 4
60,000
63,000
Investment outlay (payable immediately)

Annual cost saving:
The rate of return that is expected on projects with similar risk is 6%.
Note: The annual cost savings imply that the company will receive these
cash flows and as such are relevant cash flows for the company
NPV of Machine A project
150,000 +
30,000 40,000 50,000 60,000

+
+
+
= 3,408.328
2
3
4
1.06
1.06
1.06
1.06
NPV of Machine B project
185,000 +
60,000 61,000 62,000 63,000

+
+
+
= 27,851.85
1.06
1.062 1.063 1.064
NPV shows how much more or less in money terms the project is earning in comparison with an
alternative project with similar risk levels. A positive NPV of 3,408.328indicates that the
shareholders' wealth will increase by this amount should they decide to go forward with the
project. Hence, this implies that the project has a higher return than the others of same risk
levels.
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Basically, if the same amount was invested on a similar risk level project, a return of 6% will be
obtained.
Advantages of NPV:
Takes into account the risk levels of the projects- Basically, the risk is reflected in the
discount rate as it is the return that is obtained on projects having similar risks.
Decision to reject or accept a project is a relative one not an absolute one- in fact, it is
relative to what the foregone alternative will earn.
Considers the time value of money concept
Take into consideration all cash flows arising
It is an absolute measure of return
Leads to maximization of shareholder wealth
Disadvantages of NPV
It is difficult to explain to managers. To understand the meaning of the NPV calculated

requires an understanding of discounting.
It requires the knowledge of the cost of capital
It is relatively complex
2.5.3 THE INTERNAL RATE OF RETURN (IRR)
If net present value (NPV) is inversely proportional to the discounting rate, then there must exist
a discounting rate that makes NPV equal to zero. The discounting rate that makes NPV equal to
zero is called the internal rate of return or IRR. The IRR is the actual rate of return of the
project.
The decision making rule is very simple: if an investments internal rate of return is higher than
the investors required return, he will make the investment. Otherwise, he will abandon the
investment.
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The IRR of Machine A project is calculated as follows:
150,000 +
30,000
(1+ IRR )
40,000
(1+ IRR ) 2
50,000
(1+ IRR )3
60,000
(1+ IRR ) 4
=0
A variety of computer software can be used to solve the above equation. Alternatively, linear
interpolation, a mathematical technique can be used to estimate the IRR
By linear interpolation, we apply the following formula to estimate IRR:
IRR= LDR +
HDR - LDR
NPVLDR
NPVLDR NPVHDR
Where:
HDR
Higher discount rate
LDR
Lower discount rate
NPVLDR
NPV corresponding to the LDR
NPVHDR
NPV corresponding to the HDR
IRRs and NPVs

The IRR only compares the project yield with that of the capital market. In other words, it
answers the question can the project produce a higher return than the capital market. However,
it does not give an indication to judge between alternative projects like the NPV i.e how much
more or less the project is earning relative to the risk equivalent capital investment alternative.
Another problem arising with the IRR is that this method gives rise to multiple IRRs when
uneven cash flows are considered. Out of these two investment appraisal techniques, NPV
always prevail over IRR.
Advantages of IRR
Considers the time value of money
Is a percentage and is readily understood

20
Uses cash flows and not profits
Consider the whole life of the project
Means a firm selecting projects where the IRR exceeds the cost of capital, should
increase shareholders wealth
Disadvantages
It is not a measure of absolute profitability
Interpolation only provides an estimate and an accurate estimate requires the use of
spreadsheet program
It is fairly complicated to calculate
Non-conventional cash flows may give rise to multiple IRRs which means the
interpolation method cannot be used.
2.5.4 THE ACCOUNTING RATE OF RETURN (ARR)

The ARR measure the projects profitability over the entire asset life. It compares the average
accounting profit of the project with the initial or average amount of capital invested. The ARR
can be calculated as follows:
ARR =
Average annual profit

100
Initial(or average) capital invested
We assume that straight line depreciation method is used in each case.

The average accounting profit and the ARR (based on initial capital invested) for Machine A can
be calculated as follows:
Machine Project A
Year 1
Rs
Year 2
Rs
Year 3
Rs
Year 4
Rs
Cash flow
80,000
90,000
100,000
110,000
(62,500)
(62,500)
(62,500)
(62,500)
17,500
27,500
37,500
47,500
Depreciation
Profit
21
The average profit over the years is: (17,500 + 27,500 + 37,500 + 47,500) / 4 = Rs 32,500
Hence, the accounting rate of return for Machine project A is given by:
(32,500/250,000) x 100 = 13%
The advantages of this method are:
easy to understand and simple to compute
It takes into account the importance of profitability.
The drawbacks of this method are that:
It ignore the time value of money
It makes use of accounting data instead of cash flow data
2.6 ACTIVITIES
Activity 1
ABC Company is considering investment in either project A or project B. The management
of the company has entrusted you the responsibility to determine the feasibility of the
project. Each project has an initial investment of Rs 300m and the Weighted Average Cost
of Capital (or discount rate or opportunity cost of capital) is 12%. Using both discounting
and non-discounting investment appraisal techniques, determine which project should be
selected.
Year
Expected Future Cash Flows

Project A
Project B
90M
75M
85M
70M
80M
65M
80M
65M
22
Activity 2
As a financial manager in Apple BLimited , you are considering whether to invest in
projects A or B. The expected cash flows for projects A& B over the next 4 years are given.
Each project has an initial investment of 150m and the Weighted Average Cost of Capital
is 13%.
Year
Expected Net Cash flows

Project A
Project B
68M
74M
63M
78M
61M
73M
60M
72M
Required:
Calculate for each project:
(i)
(ii)
(iii)
(iv)
Payback;
NPV;
IRR;
ARR
Activity 3
As financial analyst for Stone Ltd, you are asked to analyze the following investment
proposals. Each project has an initial investment of $10,000 and the WACC is 12 percent.
Year
Expected Net Cash Flows

Project X($) Project Y($)
(42,000)
(45,000)
14,000
28,000
14,000
12,000
14,000
10,000
14,000
10,000
14,000
10,000
1. Calculate the payback period, NPV and IRR for these two projects.
2. Which project(s) would you select if the projects are mutually exclusive? What if they
are independent?
23
Activity 4
Assess the following project given that each project has an initial investment of 200m and
the Weighted Average Cost of Capital is 22%.
Year
Expected Net Cash flows

Project A
Project B
85M
81M
82M
48M
80M
43M
80M
42M
80M
42M
Using the discounting and non-discounting, assess which projects you would select
assuming that project A and B are mutually exclusive.

Brealey and Meyers, Principle of Corporate Finance, McGraw-Hill, 5th or Latest edition
24
UNIT 3: RISK, RETURN AND DIVERSIFICATION

Unit Structure
3.0 Overview
3.1 Learning Objectives
3.2 Introduction
3.3 Measures of Risk and Return
3.4 Portfolio of Assets
3.5 The Concept of Minimum Variance Frontier
3.6 Activities
3.7 Suggested Readings
3.0 OVERVIEW
As an investor or financial manager or be it as a lay man, undertaking any project or investment
or decision involves an analysis of the risks and return trade-off.
In the sections that follow, you will have the opportunity to grasp understanding of the concepts
of risk and return and its computations for a single asset and for a portfolio made up of two assets.
3.1 LEARNING OBJECTIVES
By the end of this Unit, you should be able to do the following:
1.
Demonstrate understanding of the concepts of risk and return;
2.
Calculate expected return and standard deviation for individual assets.
3.
Compute expected returns and standard deviation for a portfolio of 2 assets.
4.
Determine the covariance and correlation between assets and an understanding of its effect
on a portfolio of assets.
5.
Appreciate the difference between systematic and unsystematic risk
6.
Show understanding of the minimum variance opportunity set and its implications
25
3.2 INTRODUCTION
It is believed that the riskier an investment, the higher the return. It therefore follows that the
main aim of an investor is to earn the highest return possible. However, in practice this depends
on the risk profile of the investor, i.e whether he is risk-lover or risk-averse or risk-neutral. In
general, investors are risk averse and seek compensation for the risk they take.
This possibly explains why the US Treasury Bills, which provide investors a lower return than
Microsoft have always been one of the most traded assets across the globe.
3.3 MEASURES OF RISK AND RETURN
A simplistic definition ofReturn is the percentage increase in value of an investment per amount
invested in the security initially.
Different return outcomes exist for a risky security and these return outcomes have different
probabilities. This information can be summarized in terms of a probability distribution. As a
result of this distribution, the expected return is the weighted average of all the returns, where the
weights are the probabilities.
Consider the following on stock A, a non-dividend payingstock.

Current Share Price
Probability, p (%)
(Rs)
Expected Share
Expected Return, R
Price in one year
(%)
(Rs)
100
25%
140
40%
50%
110
10%
25%
80
-20%
From its current market price of Rs100, the share can either move up or down since the future
outcome remains uncertain. Therefore, a probability of the expected future outcome (price) is
26
attached to it. Hence, the share has a 25% probability that it will increase to Rs140, a 50%
probability that it will move to Rs110 and a 25% probability that it will decrease to Rs80.
The expected return is calculated as follows:
Expected Return = (0.25*40% + 0.5*10% + -0.2*25%) = 10%
The risk of a given investment can be determined from the standard deviation, often referred to
as volatility, which is the square root of the variance, as per formulas below:
Applying the above formula to calculate the variance of the stock A:

Variance = 25%*(-0.2-0.1)2 + 50% * (0.1-0.1)2 + 25% * (0.4-0.1)2 = 0.045 = 4.5%
Standard deviation = Variance = 4.5% = 2.12%
The total risk of a stock comprises of two elements of risk: a diversifiable and a non-diversifiable
risk component.
Diversifiablerisk/Unsystematic Risk/ Unique Risk (or specific risk) Firmspecific/Idiosyncraticis the variability in return due to factors unique to the individual
firm. Examples include management team, workforce, equipment used. It is also known
as diversifiable risk as the unsystematic risks can be diversified away by holding a fully
diversified portfolio of assets. Harry Markowitz (1952) stipulated that investors are able
to do so by holding a portfolio of stocks that do not move exactly together. Same shall be
covered in more detail shortly.
27
Non-diversifiable risk/Market Risk/ Systematic Risk is the variability in return due to

market-wide or macroeconomic factors that affect all firms in the economy to a more or
less same extent. It is also known as non-diversifiable risk as it cannot be diversified
away. Hence, a risk premium is paid on market risk.
3.4 PORTFOLIO OF ASSETS
Assume 2 risky assets X and Y in a portfolio with weights W a% and W b% respectively.

The expected return of the portfolio Rpis:
E ( R p ) = W A E ( R A ) + W B E ( RB )
The total risk of the portfolio/stock is given by the sum of the unique and systematic risks and is
measured by the variance/standard deviation.
Portfolio variance will be:
=W
+ WB
2
+ 2W AW B Cov
AB
= WA A + WB B + 2WAWB A B1AB
2
The amount of firm-specific risk that can be diversified away depends on the covariance between
the pairs of stocks.Now, what is covariance?
Covariance is the expected product of the deviations of 2 returns from the mean. It is given by
the following formula.
Cov (Rx,Ry) = E[(Rx E[Rx]) (Ry E[Ry])]
It follows that if 2 stocks move together, their returns will tend to be above or below average at
the same time and the covariance will be positive and vice versa.As long as security returns are
not perfectly correlated, diversification benefits can be achieved.
28
A correlation of 0 (uncorrelated variable) implies absence of any linear (straight-line)

relationship between the variables. Increasing positive correlation indicates an increasingly
strong positive linear relationship (up to 1, which indicates a perfect linear relationship).
Increasing negative correlation indicates an increasingly strong negative (inverse) linear
relationship (down to -1, which indicates a perfect inverse linear relationship).
3.5 THE CONCEPT OF MINIMUM VARIANCE FRONTIER
The minimum variance frontier/ minimum variance opportunity set is defined as the set of
all portfolios of risky assets that yield the minimum variance for a given rate of expected return.
From the example above for portfolio of stocks X and Y, it was seen that when the weight
invested in each stock was 50%, the volatility reduced from 13.4% to 11.7%. Now, for these
same 2 assets, there can be a combination of weights that gives the investor a better return for
each unit of risk borne.
For the purpose of illustration, consider the following two stocks with their respective
characteristics:
Stock ABC:
Expected Return:26%
Volatility: 50%
Stock XZY:
Expected Return: 6%
Volatility: 25%
Correlation of 0.
If we invest 40% in A and 60% in B, the expected return of the portfolio is 14% and the
variance is given by:
Expected Return = 0.40*0.26 + 0.60*0.06
Variance= 0.42*0.52 + 0.62*0.252 + 2(0.4)(0.6)(0)(0.5)(0.25) = 0.0625
The volatility is 25%.
If the same procedure is repeated by varying the weights in the portfolio, we will obtain pairs
of expected return and volatility and the result is tabulated below.
29
Portfolio Weights
Alpha
Beta
Portfolio
Expected Return
(%)
100%
0%
26.0
50.0
80%
20%
22.0
40.3
60%
40%
18.0
31.6
40%
60%
14.0
25.0
20%
80%
10.0
22.3
0%
100%
6.0
25.0
Expected Returns
Portfolio
Volatility (%)
MinimumVarianceFrontier
(1,0)
(0.8,0.2)
(0.6,0.4)
(0.4,0.6)
(0.2,0.8)
(0,1)
Std.
Deviation
The part of the line below the 20% Alpha and 80% Beta weight consists of inefficient portfolios
the reason being that for the same volatility, a better portfolio closer to the (0.4,0.6) weight
allocation can be found to give investors higher returns for the same risk.
The portfolio lying on the efficient set and that is tangential to the line drawn from the risk free
asset (lying on the vertical axis with coordinates (0,1%) is called the efficient portfolio.
Given the 2 assets, this portfolio is the best among all other combinations from a risk-retun
perspective.
For different levels of correlation, the frontier will change as shown in the graph below.
30
For a given asset allocation, correlation has no impact on the expected return as the correlation is
not used in calculating the expected return of the portfolio. However, the volatility will change.
When assets are perfectly positively correlated (correlation of +1), the set of portfolios will be
along a straight line and there is no diversification benefit.
When the correlation is less than 1, volatility of the portfolio is reduced due to diversification
and the minimum variance frontier curve bends to the left. This reduction in volatility is greater
as the correlation decreases.
In case of uncorrelation between assets, i.e. correlation of -1, an optimal weight combination
would enable a return above the riskless rate (e.g. US T-Bill) at no risk as illustrated above.
In the previous sections, we have considered a portfolio consisting of risky assets only. However,
investors can also hold a combination of risky and risk-free assets. A risk-free asset is one which
pays a risk-free rate and has zero standard deviation.
The earlier figure can be combined to show the different possible portfolios consisting of a riskfree security and risky securities. The Capital Allocation Line (CAL) displays how capital can be
allocated between the risk-free and risky securities.
Assuming that the investors have three feasible combinations of risky portfolios (P, B and M) on
the efficient frontier, we draw three CALs from the risk-free rate to these three portfolios of risky
assets.
31
Return
Capital Market Line (CML)
Q
R
N
O
Capital Allocation Lines

(CALs)
P
L
Risk,
(Source: Financial Management by Pandey)
The CAL which is tangential to the efficient set of risky assets is the best. It shows the riskreturn trade off when the market is in equilibrium. The Capital Market Line (CML) shows this
efficient set of risk-free and risky securities in market equilibrium.
3.6 ACTIVITIES
Activity 1.
Calculate the risk and return for each assets of the two assets, A and B, under different economic
conditions as given below:
Economic climate
Recession
Stable
Growth
Probability
0.2
0.5
0.3
Return of asset A
11%
15%
20%
Return of asset B
7%
16%
12%
32
Activity 2
Consider the following probability distribution of fund returnsfor investment purposes:
Expected Return
Standard Deviation
ABC
30%
20%
XZY
13%
18%
Correlation coefficient between ABC & XYZ =0.6
Required:
Calculate the expected return and standard deviation of the following three portfolios:
Portfolio Proportions (%)

Portfolio
ABC
XYZ
45
55
60
40
100
Activity 3
The following information is given for two risky assets (an Equity Fund and a Debt Fund):
Securities
Expected Return
Standard Deviation
Equity Fund (E)
0.4
0.25
Debt Fund (D)
0.10
0.13
The correlation between the fund returns is -0.10.
33
a) Given that an individual decides to invest 55% of his wealth in Equity Fund and 45% in
Debt Fund, calculate the expected return and standard deviation of the individuals
portfolio.
b) What are the investment proportions in the minimum-variance portfolio of the two risky
funds?
c) Calculate the expected return and risk of the minimum variance portfolio?
Activity 4
The following information is given for three risky assets:
Securities
Expected Return
Standard Deviation
0.25
0.15
0.35
0.23
0.15
0.20
The correlation between X and Y is -0.10.

The correlation between X and Z is -0.33.
The correlation between Z and Y is +0.15.
Given that an individual decides to invest 25% in X, 20% in Y and the remaining in Z,
calculate the expected return and standard deviation of the individuals portfolio.
3.8 SUGGESTED READING
Brealey, Richard A.; Myers, Stewart C., Principles of Corporate Finance, Latest Edition
Pike, Richard; Neale, Bill, Corporate and Finance Investment Decisions and Strategies, Second
Edition
Bodie, Zvi; Kane, Alex; Marcus, Alan J., Investments, Eight Edition
34
UNIT 4: ASSET PRICING MODELS

Unit Structure
4.0 Overview
4.2 Introduction
4.3 The Capital Asset Pricing Model (CAPM)
4.4 The Arbitrage Pricing Theory
4.5 Other Models
4.6 Activities
4.0 OVERVIEW
Asset pricing models are a way of mapping from abstract states of the world into the prices of
financial assets like stocks and bonds. The prices are always conceived of as endogenous; that is,
the states of the world cause them, not the other way around, in an asset pricing model.
Several general types are discussed in the research literature. The CAPM is one, distinguished
from three that Fama (1991) identifies:
(a) the Sharpe-Lintner-Black class of models;
(b) the multifactor models like the Arbitrage Pricing Theory and
(c) the consumption based models.
35

After completion of this chapter, you are expected to:
Demonstrate understanding of the asset pricing models to find the required rate of return
of a security;
Be able to explain how, in large diversified portfolios, an individual asset's contribution

to the
risk of the portfolio is its covariance with the returns of the existing portfolio and that
individual variances are irrelevant.
Explain why, when a riskless asset is introduced, all investors will hold themarket
portfolio and the riskless asset in some proportion.
Understand why the return/risk tradeoff has to be the same for all assets in equilibrium.
Understand and use the Security Market Line or CAPM where appropriate.
. Appreciate the use of the CAPM in a capital budgeting exercise;
Identify the limitations of the CAPM and the alternative solutions;

Demonstrate understanding the APT and its relevance
4.2 INTRODUCTION
Portfolio theory has taught us how to determine the price of market risk if we combine a risk-free
asset with the market portfolio. The expected return on such a portfolio will be the risk-free
return plus a premium for the amount of systematic risk carried by the portfolio.
However, the investor may not be interested in investing in a portfolio of assets. He may only be
interested in investing in one asset. Therefore, the required rate of return which the investor
should expect if he invests in a particular asset i needs to be determined. This can be done by
extending portfolio theory to derive a framework for valuing risky assets, which is referred to as
the Capital Asset Pricing Model (CAPM). An alternative model for the valuation of risky
assets is the Arbitrage Pricing Model (APT). The following pages will provide a deeper insight
into the aforementioned models.
36
4.3 THE CAPITAL ASSET PRICING MODEL (CAPM)

The CAPM provides a framework to determine the required rate of return on an asset and
indicate the relationship between risk and return of the asset.
The required rate of return on the specific asset can be compared with the expected rate of return
on the asset to estimate if the asset has been fairly priced.
The Security Market Line illustrates the relationship between an assets risk and its required rate
of return.
4.3.1 The Security Market Line (SML)

The SML gives the required rate of return, E[ri], on an asset, which consists of the risk-freerate
and a risk premium. The premium is calculated by multiplying the expected excess returnof the
market portfolio, E[rM] rf, with the quantity of risk, which is measured by theassets beta:
i =i,M/2M
The risk-return relationship as

predicted by the CAPM can be shown graphically as follows.
From the graph above, the following can be depicted:
The linear relation between risk and return is the primary result of the CAPM.
If the model is correct, then all assets should have expected returns that can be found by
calculating and finding the corresponding E(r) on the security market line.
The SML graphs the risk premium of individual assets as a function of asset risk.
The relevant measure of risk for well-diversified investors is not the standard deviation
of an assets returns, but rather how it contributes to the risk of the portfolio as
measured by .
37
The required rate of return on an asset is given as a function of its beta. In practice, this relation
can be used as a benchmark to determine the fair expected return of a risky asset. Fairly priced
assets lie exactly on the SML. Underpriced assets lie exactly above the SML and the required
rate of return are higher than implied by the CAPM.
4.3.2 Distinction between CML and SML

The Capital Market Line (CML) shows the expected rates of return for ecient portfolios as a
function of the standard deviation of returns.
The Security Market Line (SML) depicts individual security risk premium as a function of
security risk. The individual security risk is measured by the securitys beta. Beta reflects the
contribution of the security to portfolio risk.
Under the CAPM framework, the risk of an individual asset is defined as the volatility of the
assets return with respect to the market portfolio. The risk of an individual risky asset is its
systematicrisk, which is the covariance between a single asset or portfolio and the market
portfolio itself. The market portfolio is defined as the portfolio of all risky assets, where the
weight on each asset is simply the market value of that asset divided by the market value of all
risky assets.
To analyse the contribution of a given assets contribution to the risk of a given portfolio, the
covariance between the asset and the the portfolio is divided by the overall variance of the
portfolio, given by m
2
The contribution of a specific asset to the risk of the market portfolio is measured by Beta, ,
which is actually a measure of its volatility in terms of market risk. The beta of the market as a
whole is 1.0. Market risk makes market returns volatile and the beta can simply be used as a
basis against which the risk of other investments can be measured.
For a specific Asset i, i =
Cov( Ri , Rm ) im
= 2
Var ( Rm )
m
38
It is worth noting here that:
Where >1, it implies that the shares have more systematic risk than the stock market
average
Where <1, it implies that the shares have less systematic risk than the stock market
average
Where = 0, it implies that the shares have no systematic risk.
Thus, the CAPM equation will be as follows:

E(Ri) = rf + (E(Rm) rf) *
im
m2
E(Ri) = rf + (E(Rm) rf) * Bi

Where
E(Ri)
E(Rm)
Bi
rf
=
=
=
=
expected return on asset i

expected return on the market portfolio
Beta of stock i
risk free rate
The CAPM equation shows that the expected return of a security or a portfolio equals the rate on
a risk-free security plus a risk premium. If this expected return does not meet or beat the required
return, then the investment should not be undertaken.
4.3.3 ASSUMPTIONS OF THE CAPM
The premises on which the CPAM Model is based are as follows:
1. Security markets are perfectly competitive.
a) Many small investors
b) Investors are price takers
2. Markets are frictionless
a) There are no taxes or transaction costs.
3. All investors have only one and the same holding period
4. Investments are limited to publicly traded assets with unlimited borrowing and lending at the
risk-free rate.
5. All investors are rational mean-variance optimizers
6. Perfect Information
a) All investors have access to the same information.
b) All investors analyze information in the same manner.
7. All investors have homogenous beliefs concerning the distribution of security returns.
39
4.3.4 LIMITATIONS OF THE CAPM
The model is based on a number of unrealistic assumptions;

It is difficult to test the validity of the model;
Betas do not remain stable over time;
There can be other factors in additional to systematic risk that might influence expected
return
4.3.5 USES OF THE CAPM

CAPM helps to:
(a)
Identify overvalued or undervalued assets;
(b)
Estimate a Risk-Adjusted Discount Rate
4.4 THE ARBITRAGE PRICING THEORY (APT)

The Arbitrage Pricing Theory (APT) was developed by Ross as an alternative approach to the
CAPM further to its limitations.
The APT is a multiple-index model, unlike the CAPM-which is a single index model. According
to the APT, there are many factors which influence asset returns and not just one, as per the
CAPM. From a conceptual point of view, this seems more plausible.
As per the APT, expected return is a function of several factors, each with their own beta,
measuring the sensitivity of an asset or portfolio to that particular factor.
E(R) =Rf+(1F1 + 2F2+ 3F3+. nFn)
The APT Pricing Equation is:
E(Ri) =1F1 + 2F2+ 3F3+. nFn
This equation specifies that the relation between the expectedreturn of a security and its factor
loadings (bs) is linear.
The or factor risk premia tells us how much extra return we can obtain for each extra unit of
risk our portfolio has.
From the equation, it can be seen that there is one for each factor in the economy, plus one
extra 0.( where that 0= rf)
40
4.4.1 MERITS OF THE APT MODEL
It is a multi-index model, i.e risk is multi-dimensional; there are many risk factors
influencing returns);
It does not require asset returns to follow a joint normal distribution;
There is no central role for the market portfolio;
The model can be tested.
4.4.2 LIMITATIONS OF THE APT MODEL
It does not convey what are the factors affecting returns;

The factors need to be determined by factor analysis or using an economic theory;
The factors are time-varying, i.e one set of factors found relevant at one point in time
may no longer be relevant five years down the lane;
The factors may also be country-specific or sector-specific or company-specific.
4.5 ACTIVITIES
Activity 1
Discuss the assumptions of the CAPM Model and usefulness of same.
Activity 2
What are the limitations of the CAPM and what alternative models can be used.
ZviBodie, Alan Marcus and Alex Kane Investments, 6th or Latest Edition by McGraw-Hill
Higher Ed.
Sharpe, Alexander and Bailey, Investments, Prentice-Hall, 6th or Latest Edition
41
UNIT 5
MARKET EFFICIENCY
Unit Structure
5.0 Overview
5.2The Efficient Market Hypothesis& the different Forms of Efficiency
5.3Testing Market Efficiency: Fundamental & Technical Analysis
5.3.1 Testing Weak Form Efficiency
5.3.2 Testing Semi-Strong Form Efficiency
5.3.3 Testing Strong Form Efficiency
5.4 Stock Market Anomalies
5.4.1 Size Effects
5.4.2 Day of the Week Effects
5.4.3 The January Effect
5.4.4 The Diwali Effect
5.4.5 The Ramadan Effect
5.4.6 The Chinese New Year Effect
5.5 Activities
5.0 OVERVIEW
Efficient Market Hypothesis was first heard of in the mid 60s. At that time, in general people
had only a vague notion of a well-functioning stock market and it was Samuelson in1965 who
stated that in a competitive market, price fluctuations are random. Fama (1970) made a
comprehensive overview of the relevant theoretical and empirical literature and was the first who
gave the name of Efficient Market, while also presenting empirical evidence. According to the
efficient market hypothesis, at any point in time stock prices fully reflect all available
information about individual stocks and about stock market as a whole. Following this stance,
excess return cannot be earned on the market since prices immediately adjust to any information
before any individual investor manages to make use of this information.
42
According to Efficient market hypothesis:

a) previous prices give no indication for future prices,
b) prices immediately and fully integrate all information.
In short, markets are assumed to be efficient where prices of financial assets are fair, thus making
it impossible to outperform or beat the market. In the pages that follow, we shall explore the
notion of market efficiency and whether it holds true in reality or is merely utopian.
5.1
LEARNING OBJECTIVES
By the end of this Unit, you should be able to do the following:

1.
Demonstrate understanding of the three forms of Markets Efficiency;
2.
Appreciate the usefulness of fundamental and technical analysis;
4.
Assess the validity of the market efficiency notion;
5.
Realise the implication of stock market anomalies on the market efficiency concept
5.2 MARKET EFFICIENCY AND ITS DIFFERENT FORMS

Efficiency can be viewed from two angles, namely operational efficiency and pricing efficiency.
Whilst operational efficiency relates to the infrastructural efficiency in terms of administrative
mechanism or institutional settings to improve trading, pricing efficiency relates to the extent to
which current share prices are fair on a specific day. Efficient Market hypothesis, commonly
denoted as EMH mostly relates to price efficiency. According to Fama (1970), an efficient
market is a market in which prices fully reflect all available information.
Following the above, since the shares at all times trade at their fair values, it is not possible for
investors to purchase undervalued shares or sell overvalued stocks and beat the market as current
share prices at all times include and reflect all significant information.
43
The efficient market hypothesis is generally stated in three forms as follows:
Weak Form Efficiency
In weak-form efficiency, security prices reflect all past information about price movements.
Excess return cannot be earned using investment strategies based on past prices or other
historical information. Share prices do not display any pattern, implying that prices follow a
random walk. In the weak form efficient market, current share prices represents the best,
unbiased, estimate of the value of the security.
Semi-Strong Form Efficiency
In a semi-strong form market, share prices reflect all public information such that no excess
return cannot be earned by relying solely on all publicly available information. Under semistrong-form efficiency, neither fundamental analysis nor technical analysis techniques will be
able to consistently produce surplus returns.
Strong Form Efficiency
Under strong-form efficiency, share prices reflect all information- both public and private, and
the market cannot be beaten. The prices incorporate private information and insider information,
such that it is impossible for insider trading to earn excess returns.
5.3 TESTING FOR MARKET EFFICIENCY

Even though EMH constitutes one of the vital tenants of current financial theory, it is highly
contentious and often dubious.If investors imbibe the notion of the Efficient Market Hypothesis,
then no profits can be reaped on the stock market. How can the success of Warren Buffet and the
existence of so many investment firms out there whose aims are to beat the market and reap
benefits for investors be explained then. On one hand, supporters of EMH claim that it will be
useless to undertake any forecasting exercise since the market will automatically update any
news on the market. On the other hand, there are otherswho believe that the market is inefficient
and abnormal returns can be reaped through either fundamental or technical analysis.
44
Fundamental Analysis
Fundamental analysis basically relates to the scrutiny of underlying factors affecting the welfare
of the economy, industry groups, and companies. Fundamental analysis comprises of
examination of financial data, management, business concept and competition at the companylevel. At the industry level, supply and demand forces for the products offered is usually
examined. At the national economy level, fundamental analysis uses economic data to assess the
present and future growth of the economy. Fundamental analysis is based on fundamental
information derived from company analysis, industry analysis, macro-economic analysis to
forecast the movement of security prices. In cases where the current stock prices do not tally
with the fair value, fundamental analysts believe that the stock is either over or under valued.
Since prices do not accurately reflect all available information, fundamental analysts aim at
exploiting the perceived price discrepancies until the market prices gravitate towards the fair
value eventually. Fundamental analysts believe that markets are weak-form efficient.
Technical Analysis
Technical analysis, also known as chartism, basically relates to forecasting of future financial
price movements by examining past price movements, using a variety of charts to depict any
existing trend or pattern.
5.3.1 TESTING WEAK FORM EFFICIENCY
Weak-form market efficiency is tested using past trading data. Most studies generally formulate
a trading rule based on past security prices which they then test to see whether its application can
earn risk-adjusted profits in excess of the market return. One commonly used trading strategy is
the filter rule which involves purchasing stocks following a price increase of at least x% and
selling stocks and going short after prices have fallen by at least y% from a subsequent high. The
investor stays in the short position until prices again increase again, after which the short position
is covered and the stock bought again. If the market is inefficient and stock prices exhibit
positive serial correlation, such a strategy could allow investors to reap abnormal profits.
Other tests of the weak form include trading rules, relatives strength as well as technical
analysis indicators. Most research on the subject support the validity of the hypothesis in that
technical analysis does not allow abnormal returns to be achieved.
45
5.3.2 TESTING SEMI-STRONG FORM EFFICIENCY

Event analysis or event study is the most common method employed to test semi-strong form
efficiency. The test is usually conducted by studying an event window of three or five days
around news announcements about certain stocks. If the news announcements convey new
information to the market or if they dispel any doubt on rumoursdoing the rounds prior to the
announcement, shares of the company which are affected by the news will show abnormal
returns. Also, by computing the abnormal returns on the stocks following news announcements,
the speed of price adjustment can be analysed and it can be evaluated whether information has
been leaked prior to announcements. For instance, if dividends have been announced on date d1
and abnormal gains have been made on d1, same should not recur the next day, i.e on d2. In case
there are statistically significant abnormal gains on dates other than d1, it implies that
information about the dividend could have been leaked prior to the announcement day or that the
market is not efficient asprices take more than one day to incorporate new information.
Most empirical research on the semi-strong form seem to suggest that the market is informational
efficient in the semi-strong form.
5.3.3 TESTING STRONG FORM EFFICIENCY
According to the efficient market hypothesis, based on technical, and fundamental analysis
above-average profits cannot be earned in the long run. The strong form efficiency is the most
difficult to verify, as it requires the use of non-public information. Strong form efficiency can be
tested by company insiders, who have access to information not accessible to investors to inspect
stock price movements after trade or looking for abnormal returns just before news
announcements.
5.4
STOCK MARKET ANOMALIES
Counter arguments to the Efficient Market Hypothesis claim that reliable patterns are present on
the market which can be exploited to make gains. Such patterns which have repeated themselves
over time are referred to as anomalies and include the following:
46
5.4.1 Size Effects

The size effect, also known the small firm effect claims that abnormal gains may be reaped
by holding stocks of low capitalisation companies.
Banz (1981) saw that the smallest stocks tend to outperform the largest stocks on the New York
Stock Exchange. Further toBanz(1981) study, there were other studies such as Dimson and
Marsh (1989) which provided evidence of a Size effect in different markets. In particular, it
was observed that small firms indeed seem to earn higher average return than larger firms.
The major explanations for the size effect are that differences in performance may be related to
superior risks and institutional neglect as very often, financial institutions tend to pay relatively
less attention to smaller companies due to their rather small investments.
5.4.2 Day of the Week Effects
Further to a number of research conducted, such as Fran Cross (1973), Gibbon & Hess (1981),
Fortune (1991) amongst others, it has been observed that the return of share prices are dependent
on the day of the week. It is particularly believed that companies and governments make public
good news on weekdays when market are open and the news can be readily absorbed. However,
bad news are announced mainly after the close of business on Friday as investors cannot react
until the Monday opening. As such, Gibbons and Hess (1981) assert that there may be possible
biases on Friday prices such that errors for low Monday returns could be offset by upward biases
in Friday. Essentially, prices will tend to fall on Mondays and rise on Fridays leading to a
Monday Effect. However, there are some emerging markets where research has proved that
returns have been higher in other days of the week. All the above are in sharp contradiction with
the EMH as prices should follow a random walk.
5.4.3 The January Effect
According to a number of studies, such as Rozeff and Kiney (1976); Keim (1983); Reinganum
(1983); Gulketin and Gulketin (1983); Ariel (1987) amongst others),it has been observed that
returns are abnormally higher in January relative to other months, which is referred to as the
January effect.
47
This may be so due to the following reasons:

(i) Minimisation of tax liability, also known as Tax-Loss Selling Hypothesis;
(ii) The belief that news released on specific dates or months influences the trading behaviour
of investors- referred to as Information release hypothesis;

(iii)Window-dressing, whereby managers sell loser stocks at the end of the year so that their
portfolios appear more decent at the end of the year to their clients
Seasonality effect which exists on stock market is contrary to the Efficient Market Hypothesis
proposed by Fama (1970). One of the reasons for presence of calendar effect is festivals
celebrated by the people of a nation which can have their impact of economic conditions of the
country. The following section highlights some of the most prominent festivals and their effect
on the stock market as per empirical research.
5.4.4 The Diwali Effect
For instance, in India, Diwali is one of the most celebrated festival andSrikanth et al. (2013) has
attempted to analyze the impact of Diwali festivals on the Indian stock market. However, the
study revealed that Diwali effect is not statistically significant on the stock market in India and
results of run tests conducted showed that average abnormal returns are random during the study
period.
5.4.5 The Ramadan Effect
Ramadan is another of the most celebrated religious traditions in the world. A study by Jedrzej et
al. (2011) investigates stock returns during Ramadan for 14 predominantly Muslim countries
over the years 19892007. The results show that stock returns during Ramadan are significantly
higher and less volatile than during the rest of the year. As per the research, since Ramadan
promotes feelings of solidarity and social identity among Muslims world-wide, Ramadan may
positively affect investor psychology, promoting optimistic beliefs that influence investment
decisions.
48
5.4.6 The Chinese New Year Effect

Research carried out byAbidin et al. (2012) with respect to the Chinese New Year Effect
demonstrate significant evidence supporting the Chinese New Year Effect. Significant positive
returns have been observed a few days before the Chinese New Year period in stock markets of
Hong Kong, Japan, Singapore, Malaysia, and Taiwan.
5.5
ACTIVITIES
Activity One
Efficient Market Hypothesis holds true at all times. Discuss
Activity Two
Discuss the 3 forms of market efficiency and how each form may be tested.
Activity Three
Fundamental Analysis is superior to Technical Analysis as the former is based on a rational
approach whereas the latter relies simply on charts. Discuss.

Higher Ed.
49
UNIT 6
COST OF CAPITAL,GEARING & SHAREHOLDERS WEALTH
Unit Structure
6.0
Overview
6.1
Learning Objectives
6.2
The Cost of Capital& its importance
6.3
The Concept of Opportunity Costof Capital
6.4
Components of Cost of Capital
6.5
How to determine the Cost of Capital;
6.6
The Weighted Average Cost of Capital;
6.7
Gearing, Cost of Capital and the shareholders' wealth
6.8
Activities
6.9
Suggested Readings
6.0
OVERVIEW
In the previous chapters, it was seen that 2 main inputs were required for evaluating investment
proposals using discounted cash flow techniques, which are:
(i)
(ii)
Identification of the projects relevant cash flows;

The Discount Rate
In all problems tackled earlier, the discount rate was already given. We shall now proceed with
the process of identifying and coming up with the discount rate.
6.1
LEARNING OBJECTIVES
Upon successful completion of this chapter, you are expected to:
demonstrate full understanding of the concept of Cost of Capital;

be able to determine the various components of the Cost of Capital;
appreciate the constitution of the Weighted Average Cost of Capital;
be able to determine the cost of capital
assess the effect of capital gearing on WACC, the value of the business and the
shareholders' wealth
the traditional view of this effect
the Modigliani and Miller view
the empirical evidence of the effects of gearing and CAPM
financial gearing and operating gearing

50
a conjectural conclusion on gearing trade-off theory
pecking order theory.
6.2
THE COST OF CAPITAL
The Cost of Capital, also referred to as the opportunity cost of capital is simply the discount
rate used for discounting a specific projects cash flows.
The projects cost of capital is the minimum required rate of return on the project, which is
directly related to the risk inherent in the cash flows. A companys cost of capital is the total or
averagerequired rate of return on the total investment proposals. Hence, a companys cost of
capital is not the same as a projects cost of capital. However, the companys cost of capital can
be used to discount those investment proposals which have similar risks to the average risk of the
company.
The most common method used for computing the risk-adjusted cost of capital of projects is the
Capital Asset Pricing Model (which was covered in the earlier chapters)
6.3 IMPORTANCE OF THE COST OF CAPITAL

The Cost of Capital is a useful benchmark for:
(i)
(ii)
(iii)
assessing the financial performance of top management;

evaluating investment decisions;
planning a companys debt policy
6.4 CONCEPT OF THE OPPORTUNITY COST OF CAPITAL

The opportunity cost of capital can be defined as the expected rate of return forgone on the next
best alternative investment opportunity of similar risk.
6.5 COMPONENT COST OF CAPITAL

Capital of a company is obtained from different sources and the cost of capital for each source of
capital is not the same due to the differences in risk and the contractual agreements between the
company and investors.
The cost of capital for each source of capital is referred to as the component or specific cost
of capital.
51
6.6 WEIGHTED AVERAGE COST OF CAPITAL

As stated above, different sources of capital have altering costs of capital.As a company obtains
capital from various sources, the cost of all sources of capital is combined together to give the
overall or average cost of capital. Now the question is how are these pooled together?
The component costs are added in accordance with the weight of each specific component
capital, which gives the average costs of capital. Therefore, the overall/ average cost of capital is
also denoted as the weighted average cost of capital.
6.7 HOW TO DETERMINE OPPORTUNITY COST OF CAPITAL & COMPONENT

COSTS OF CAPITAL
Required rate of returns for investors are determined by the market. The market price of
securities is a function of the return expected by investors on same. Equilibrium rates of return
for different securities are established by the forces of demand and supply in the market. The
opportunity cost of capital can be obtained as follows:
1
1
2
1
Where I = Capital supplied by investors in period 0, representing a net cash inflow to the
company;
C1= Expected returns by investors, representing cash outflows;
k = Required rate of return/ Cost of Capital
The component cost of a particular source of capital is usually equivalent to the rate of return
required by investors and can be found using the above equation. However, this needs to be
adjusted for tax in current practice.
Once the component costs are calculated, they are multiplied by the respective sources of capital
to obtain the WACC. The steps involved in the computation of a companys WACC are as
follows:
1. Calculate the cost of specific sources of funds;
2. Multiply the cost of each source by its proportion in the capital structure;
3. Add the weighted component costs to get the WACC.
52
6.8
GEARING &COST OF CAPITAL
As the primary financial objective is to maximise shareholder wealth, then companies should
seek to minimise their weighted average cost of capital (WACC). In practical terms, this can be
achieved by having some debt in the capital structure, since debt is relatively cheaper than
equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too
much gearing (the company suffers from bankruptcy costs, agency costs and tax exhaustion).
Companies should pursue sensible levels of gearing.
6.9
ACTIVITIES
Activity One
What do you understand by the term Cost of Capital of a Company? Explain its significance.
Activity Two
How can the cost of capital be determined in theory?
Higher Ed.
53
UNIT 7
THE DIVIDEND DECISION-THEORY AND EMPIRICAL EVIDENCE
Unit Structure
7.0
Overview
7.1
Learning Objectives
7.2
Types of Dividend
7.3
Issues involved in Dividend Policy
7.4
Dividend Theories
7.4.1 Dividend Irrelevancy Theory
7.4.2
The Bird-In-The-Hand Theory
7.4.3
7.4.4
Tax-Preference Theory
Dividend Signaling Theory
7.4.5
Clientele Effect
7.4.6 Dividend as a Residual
7.5
Activities
7.6
Suggested Readings
7.0
OVERVIEW
The main decisions a financial manager has to face are the Financing Decision, the Investment
Decision and the Investment decision. While the capital budgeting decision is concerned with
what long-term assets the firm should acquire, the financing decision is concerned with how
these assets should be financed. The dividend decision occurs when the firm begins to generate
profits. The main concern of managers lies in whether to distribute all or a proportion of earned
profits in the form of dividends to the shareholders, or should the profits be ploughed back into
the business altogether and trying to find the optimum dividend policy.
Dividend policy refers to the practice that management follows in making dividend payout
decisions or, in other words, the size and pattern of cash distributions over time to shareholders.
54
Dividend policy and its possible implications of firm value has always captured the attention of
finance scholars, who have tried to solve several issues pertaining to dividends and formulate
theories and models to explain corporate dividend behaviour. However, the dividend enigma has
not only been an enduring issue in finance, it also remains unresolved.
7.1
LEARNING OBJECTIVES
7.2
Appreciate the fact that the dividend question remains an important decision for financial
managers;
Demonstrate understanding of the various types of dividends available;
Explain the different theories of dividend policy and their implications
TYPES OF DIVIDENDS
Dividend refers to cash distributions of earnings.

The various types of dividends are as follows:
1. Cash dividends
These are the most common and are usually paid four times a year.
2. Stock dividends
Stock dividends are not deemed to be true dividends in that a distribution of stock does not affect
the value of the firm or the wealth of the shareholder. These dividends are paid out of Treasury
stock.
3. Stock split
Similar to a stock dividend. The NYSE requires share distributions of less than 25% to be treated
as stock dividends.
4. Share repurchases
The company repurchases the stock. Shareholders pay tax only on the capital gains portion.
Same effect as a regular dividend as cash leaves the corporation.
55
7.3
ISSUES INVOLVED IN DIVIDEND POLICY
Managers need to exercise a high degree of judgment when establishing a sound dividend pattern
since the latter to a large extent affects the financial structure, the flow of funds, liquidity, stock
prices and shareholders' satisfaction.
Some of the main factors to take into consideration when determining a sound dividend policy
are:
1.Cost of Capital
Prior to distribution of dividend, cost of capital needs to be taken into consideration. As a
decision making tool, the Board calculates the ratio of profits that the business expects to earn to
the profits that the shareholders can expect to earn outside. If the ratio is less than one, it is a
signal to distribute dividend and if it is more than one, the distribution of dividend will be
discontinued.
2. Realisation of Objectives
The dividend policy needs to be aligned with the main objectives of the firm and the shareholder
wealth maximization principle.
3. Shareholders' Group
The prevailing dividend policy of a firm affects the shareholders group. A company with low
pay-out and heavy reinvestment attracts shareholders interested in capital gains rather than in
current income whereas a firm having high dividend pay-out attracts those who are interested in
current income.
4. Release of Corporate earnings
Dividend distribution can be viewed as a means of distributing unused funds, whereby the
financial manager needs to decide whether to release corporate earnings or not, thereby affecting
the shareholders wealth by varying the dividend pay-out ratio.
7.4 DIVIDEND POLICIES

The three main theories of dividend policy are : high dividends increase share value theory (or
the so-called bird- in-the- hand argument), low dividends increase share value theory (the taxpreference argument), and the dividend irrelevance hypothesis. The dividend debate is not
limited to these three approaches. Several other theories of dividend policy include the
information content of dividends (signalling), the clientele effects, and the agency cost
hypotheses.
56
7.4.1 Dividend Irrelevancy Theory

Modigliani and Miller (usually referred to as M&M), the proponents of the dividend irrelevancy
theory ,advance that a firm's dividend policy has no effect on its market value or its cost of
capital. It is argued that dividend policy is a "passive residual" which is determined by a firm's
need for investment funds. Following this argument, it therefore does not matter how a firm
divides its earnings between dividend payments to shareholders and internal retentions and trying
to find the optimal dividend policy since an optimal dividend policy simply does not exist.
The assumptions on which M&M built their dividend irrelevancy are as follows
1. Capital markets are perfect whereby investors are rational, information is freely available,
there are no transaction costs, securities are divisible and no investor can influence the market
price of the share.
2. There are no taxes.
3. The firm has a fixed investment policy which will not change. Hence,if the retained earnings
are reinvested, there will not be any change in the risk of the firm.
4. Floatation cost does not exist.
7.4.2 The Bird-In-The-Hand Theory
The main premise of the bird-in-the-hand theory of dividend policy, which was put forward by
John Litner and Myron Gordon is that shareholders are risk-averse and prefer to receive dividend
payments rather than future capital gains. Since shareholders believe that dividend payments are
more certain that future capital gains, therefore a "bird in the hand is worth more than two in the
bush".
It is argued that because of the less risky nature dividends, shareholders and investors will
discount the firm's dividend stream at a lower rate of return, "r", thereby increasing the value of
the firm's shares.
According to the constant growth dividend valuation, commonly referred to as Gordon's
growthmodel, the value of an ordinary share, SV0 is given by:
SV0 = D1/(r-g)
57
Where g represents the constant dividend growth rate, r is the investor's required rate of return,
and D1 represents the next dividend payments. From the formula above, it is clear that the share
value is directly proportional to the value of the dividend payment and inversely proportional to
rate of return. Hence, the lower r is in relation to the value of the dividend payment D1, the
greater the share's value. According to Linter and Gordon, r, the return from the dividend, is less
risky than the future growth rate g from the investors perspective.
M&M debated against the aforementioned view, which they referred as thebird-in-the-hand
fallacy. M&M state that the required rate of return or cost or capital, r, is independent of
dividend policy and that a company's risk, which influences the investor's required rate of return,
r, is a function of its investment and financing decisions, and not its dividend policy. As stated in
the paragraphs above, investors are indifferent between dividends and capital gains, i.e between r
and g of the dividend valuation model.
7.4.3 Tax-Preference Theory
According to this theory, taxes are important considerations for investors and since capital gains
are taxed at a lower rate than dividends, investors may prefer capital gains to dividends.
7.4.4 Dividend Signaling Theory
The Dividend Signaling Theory" purports that a change in a firm's dividend hasan effect on its
share price, whereby an increase in dividend produces an increase in share price and vice-versa.
Now, the change in dividend payment is to be deemed to be a signal to shareholders and
investors about the future earnings prospects of the firm. Usually, an increase in dividend
payment is viewed as apositive signal since it conveys positive information about a firm's future
earning prospects thereby resulting in an increase in share price. The converse also holds true.
7.4.5 Clientele Effect
Different groups of investors, or clienteles, prefer different dividend policies. It is believed that a
companys past dividend policy largely determines its current clientele of investors.
58
7.4.6 Dividend as a Residual

Supporters of this school of thought believe that the dividend pay-out is a function of its
financing decision. The investment opportunities should be financed by retained earnings. It
basically consists of the following steps:
Find the retained earnings needed for the capital budget.

Pay out any leftover earnings (the residual) as dividends.
This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.
Thus internal accrual forms the first line of financing growth and investment. If any surplus
balance is left after meeting the financing needs, such amount may be distributed to the
shareholders in the form of dividends. Thus, dividend policy is in the nature of passive residual.
In case the firm has noinvestment opportunities during a particular time period, the dividend payout should be 100%.
A firm may smooth out the fluctuations in the payment of dividends over a period of time. The
firm can establish dividend payments at a level at which the cumulative distribution over a
period of time corresponds to cumulative residual funds over the same period. This policy
smoothens out the fluctuations of dividend pay-out due to fluctuations in investment
opportunities.
7.5 ACTIVITIES
Activity 1.
Discuss the theories of Dividend Policy and the possible implications on managers of a firm.
Activity 2.
What are the issues that can be faced when deciding on the dividend policy.
7.6SUGGESTED READINGS
Sharpe, Alexander and Bailey, Investments, Prentice-Hall, 1999, 6th edition
Brealey and Meyers, Principle of Corporate Finance, McGraw-Hill,1996, 5th or Latest

edition
59
UNIT 8
CORPORATE RESTRUCTURING-MERGERS AND ACQUISITIONS
Unit Structure
8.0 Overview
8.2Motived for Formation of Mergers & Acquisitions
8.3 Mergers
8.3.1Types of Mergers
8.4 Acquisitions
8.5Benefits & Limitations of Mergers and Acquisitions
8.6Activities
8.7Suggested Readings
8.0
OVERVIEW
Corporate Restructuring is said to occur when there are changes in ownership, business mix,
assets mix and alliances with a view to optimise shareholder value. Various ways in which this
can be achieved are as follows: Mergers and acquisitions, leveraged buy-outs, share buyback,
spin-offs, joint ventures and strategic alliances.
This unit explores the concepts underlying merger/takeover/acquisition activity and provides a
better picture of same.The basis of undertaking any such decision lies in the value creation
possibility. It is argued that mergers should be undertaken if they generate positive NPV and
where the value of the merged firm created from firms X and Y (VXY) exceeds the sum of premerger values of X and Y (i.e VX + VY). This can be achieved through the exploitation of scale
economies or elimination of inefficiencies. The pages that follow shall provide a deeper insight
into same.

Upon completion of this unit, you should be able to:
1. Appreciate the underlying dynamics of corporate restructuring ;
2. Differentiate between mergers and acquisitions;
3. Assess the benefits and limitations of mergers and acquisitions ;
4. Discuss the challenges faced to implement the corporate restructuring processes.
60
8.2 WHY M&A ARE FORMED

The motives for forming M& A can be analysed from two different standpoints, namely from the
seller side and the buyer side.
Sellers reasons for merging
The sale of the agency provides a good return onthe investment;
Inability of the current agents to make the company successful;
Growing age and wishing to transfer ownership and retire from the operations;
Demise of a principal and passage of ownership interest to wife/children/family who do not
want any active involvement in the agency.
Boredom, fatigue, frustration, leading to simply evade the ownership responsibility.
Buyers reasons for merging
Efficiency explanations
It is believed that if firm X is managed more efficiently than Firm Y, then it is likely that the
merger of X with Y, will increase the level of efficiency of Y to that of X, thereby bringing
private gains as well as social gains. The rationale is that the predator firm generally consists of
superior management having much experience in a particular line of business. Therefore, under
efficiency theories, the basic motive for companiesX and Y to merge is the value creation
rationale, that is, the expectation that once put together, the two firms would be worth more than
individually. The value of the combined firm, Vxy, exceeds the sum of the values of the
individual firms, Vx + Vy, brought together. This added value is termed synergy.
In cases where synergy is absent, other reasons for M&A believed to have potential synergistic
are:
Economies of scale
Larger firm size is usually associated with economies of scale-which are advantages that accrue
to the firm, in terms of lower average cost when the size of the firm increases. Economies come
from sharing central services such as office management.
61
Cost of external growth

Acquisition of another company can sometimes be cheaper than growing internally for big firms.
Moreover, the two merging firms may have complementary distinctions that each had been
unable to obtain until now due to barriers such as availability of finance. Hence, M&A can offer
a cheap as well as quick shortcut to growth and success.
Information Theories
When a potential merger is officially announced, the Information Signalling hypothesis involves
the revaluation of a firms shares as a response to the new information available. Basically,
information theories stipulate that a merger shall occur when firm X believes that the market
value of firm Y is much below its true worth and acquiring firm Y will be a gain. In short, it is
believed that an undervalued company is more susceptible to be taken over.
8.3MERGERS
Mergers refer to the pooling together of two or more companies to form one company.
The features of a true merger are as follows:
The parties aremore or less similar in size;

Management of the two entities is combined or unified after the combination.
The shareholders of the two combining businesses are still shareholders after the
combination.
8.3.1 TYPES OF MERGERS:

There are five most common types of business combinations known as mergers: conglomerate
merger, horizontal merger, market extension merger, vertical merger and product extension
merger. The term chosen to describe the merger depends on the economic function, purpose of
the business transaction and relationship between the merging companies.
Conglomerate
This type of merger is between firms that are engaged in unrelated business activities. This is
broken down further into pure and mixed conglomerate mergers. The former involves firms with
nothing in common, while the latter relates to companies looking for product extensions or
market extensions.
62
Horizontal Merger
Horizontal merger basically involves firms in the same industry. It often happens between
competitors offering the same good or service and is common in industries with fewer firms, as
there tends to be higher competition and the synergies and potential gains in market share are
much larger for merging firms in such industries.
Vertical Merger
This type of merger is between two firms operating at different levels within the same industry's
supply chain. The main aim of the vertical merger is to increase synergies created by merging
companies that would be more efficient operating as one. It is referred to as vertical in the sense
that the combination is a movement up or down the production ladder, which runs from
production to distribution. Therefore, vertical integration can be either:
Backward integration: this shows the movement of a firm, back down the supply chain. For
example, acquiring an existing supplier of raw materials.
Forward integration: is the reverse of backward integration. A company moves forward to the
next stage in the market, which can be, for instance, buying an existing customer.
Market Extension Mergers

A market extension merger is said to occur when two firms dealing in the same products but in
different markets merge together. The ultimate objective behind this type of merger is to provide
the merging companies with access to a larger market that also safeguards a larger client base.
Product Extension Mergers

Another type of merger is the product extension merger which occurs between two companies
dealing with related products and operating in the same market. This allows the merging
companies to group their products together and get access to a larger pool of customers, thereby
giving the possibility of earning higher profits.
8.4 ACQUISITIONS
Acquisitions or takeovers basically refer to the acquisition of the share capital of a company by
another in exchange of cash, ordinary shares, loan stock or some mixture of these. During this
process, the identity of the acquireegets absorbed into that of the acquirer.
Contrary to a merger, an acquisition generally involves a larger company (predator) acquiring a
smaller company (prey or target). The predator incorporates the target into its structure.
63
It is worth noting that in the terms mergers and acquisitions are commonly used interchangeably
and it is not uncommon for an acquisition or takeover to be referred to as a merger. This is
because:
Customers can have the wrong perception that an acquired company is weak and that
there can be considerable upheaval post the acquisition. On the other hand, a merger
portrays a better message to the customers.
Employees of the target company may be feeling insecure and so to ensure that the
predator company continues to get their commitment, it may be more appropriate to treat
the combination as a merger and graduallymake the employees integrate into the system
and culture of the new holding company.
8.5 BENEFITS AND LIMITATIONS OF MERGERS & ACQUISITIONS

The advantages of mergers and acquisitions include the following:
1.Economies of scale occur when a bigger firm with increased output can minimize average
costs. Lower average costs enable lower prices for consumer.
2.International Competition-mergers can help companies deal with the threat of multinationals
and compete on an international scale.
3.Mergerscan provide forlarger investment in R&D, which is due to more profits being made.
4.With greater efficiency, employees can be more productive and hence, redundancies can be
avoided.
5. Mergers may be valuable in a declining industry where businesses are struggling to stay
afloatand they can serve to protect an industry from closing.
6. In conglomerate mergers where two companies from different industries merge, there can be
diversification of activities as there is increased sharing of knowledge and know-how.
Costs of mergers and acquisitions

Some of the costs incurred are as follows:
1. Legal expenses
Mergers and acquisitions can be expensive due to the high legal expenses and the cost for the
acquisition of a new company may not be profitable in the short term
2. Short-term opportunity cost
M&A activity can be impaired by the short-term opportunity cost. This refers to the cost borne if
the same amount of investment could be placed elsewhere for a higher financial return. At times
64
this cost does not inhibit or dissuade the merger or acquisition because the anticipated long-term
financial benefits outweigh the short-term costs.
3. Cost of takeover
The costs involved in the takeover of the target company may be very high.
4. Potential devaluation of equity
5. Intangible costs
6. Consumer and shareholder drawbacks
In certain instances, mergers and acquisitions may be to the detriment of shareholders, as well as
consumers. This happens when the newly formed entity becomes a large oligopoly or monopoly.
Moreover, if due to reduced competition, higher pricing power emerges, consumers may be left
worse off financially. Some of the potential drawbacks to consumers with respectto mergers are:
Increase in cost to consumers
Decreased corporate performance and/or services
Potentially lowered industry innovation
Suppression of competing businesses
Decline in equity pricing and investment value
At times, if the new managers become too complacent with its market positioning, shareholders
may not stand to benefit. In other words, when a powerful and influential corporate entity is
produced from the merger/takeoveractivity, this lessens industry competition and the company
may be faced with non-competitive stimulus and lowered share prices.
8.6 ACTIVITIES
Activity 1.
Discuss the benefits and limitations of M & A.
Activity 2.
What are the various motives to merge?
65
8. 7 SUGGESTED READINGS
Bradley, M., A. Desai and E. Kim 'Synergistic Gains from Corporate Acquisitions and Their
Division Between the Stockholders of Target and Acquiring Firms', Journal of Financial
Economics (1988) 21: 3-40.
SupportingMaterials
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Fabozzi, F.J., Modigliani, F., Jones, F.J., and Ferri, M.J., Foundations of
FinancialMarketsandInstitutions.ThirdorLatestEdition
Thomas E. Copeland, J. Fred Weston Financial Theory and Corporate
Policy(3rdorLatestEdition)byAddisonWesley
ZviBodie,AlanMarcusandAlexKaneInvestments,6thorLatestEdition
byMcGrawHillHigherEd.
V. K Bhalla (Author) Investment management: Securities analysis and
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Bailey, Jeffery V, and Alexander, Gordon J, and Sharpe, William
FundamentalsofInvestments,3rded.,PrenticeHall,2000
Baye, Jansen. 1996. Money, Banking & Financial Markets, An Economics
Approach
Cheol,S.Eun.AndBruce,G.Resnick.InternationalFinancialManagement,
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DavidGoacher.1999.TheMonetaryandFinancialSystem,FourthEdition
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Tavella,D.A.,QuantitativeMethodsinDerivativesPricing.AnIntroduction
toComputationalFinance,WileyFinanceSeries,JohnWiley&Sons,2002.
Wilmott,P.,PaulWilmottonQuantitativeFinance,Vol1&2,JohnWiley&
Sons,Reprinted,2003.
RobertSteiner,1997,MasteringFinancialCalculations.ByPearsonEd.
Sharpe,AlexanderandBailey,Investments,PrenticeHall,1999,6thedition
BrealeyandMeyers,PrincipleofCorporateFinance,McGrawHill,1996,5th
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KeithPilbeamFinanceandFinancialMarkets:SecondEditionbyPalgrave
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Analysis,NewYork,JohnWiley&SonsInc.1991
Fabozzi Frank, J., Bond Markets, Analysis and Strategies, PrenticeHall,
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Fixed Income Analysis for the Chartered Financial Analyst Program by
FrankJ.Fabozzi(Paperback2005)
66

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OUbs002223 Business Finance

Agency Issue between shareholders and managers

Investment appraisal methods

Risks and Return

Asset Pricing Models, CAPM & APT

Capital Market Efficiency and Stock Market Anomalies

Cost of Capital, Shareholders wealth, Gearing & Leasing

The dividend decision

Articles in reputable journals (Journal of Finance and Journal to

UNIT 1 AGENCY PROBLEM BETWEEN SHAREHOLDERS AND MANAGERS

Shareholder Wealth Maximization Principle

The Agency Relationship

By the end of this Unit, you should be able to:

Demonstrate understanding of the basic notion of principal and agent;

Demonstrate understanding of the possible conflict of interest;

Shareholder Wealth Maximization Principle

The Agency Relationship

How to Motivate Managers to Act in Shareholder's Best Interest

2. Direct Intervention by Stockholders

1.6 SUGGESTED READINGS

Investment Appraisal Techniques

The Capital Budgeting & Investment AppraisalProcess

Identifying Cash flows

Methods of Investment Appraisal

Payback Method &Discounted Payback Method

Net Present Value

2.5.3 Internal Rate of Return

Accounting Rate of Return

By the end of this Unit, you should be able to:

Understand the different concepts and importance of investment decisions

Calculate the NPV, IRR, payback and profitability Index.

Evaluate the pros and cons of each technique

THE CAPITAL BUDGETING &INVESTMENT APPRAISAL PROCESS

Gauge the project's relevant cash flows

Decidewhether or not a project should be undertaken based on a particular decision rule.

IDENTIFYING THE PROJECTS CASH FLOWS

Incremental cash flows are the relevant cash flows

All financing cash flows should be disregarded

In fact, the following calculation shows:

PV of loan cash flows:

12000 12000 12000 +120 ,000

Working capital adjustment needs to be taken into account

The investment appraisal process is a very important business decision as:

They influence the business growth in the future

They affect the risk of the firm

They involve the commitment of large amount of funds

The capital budgeting process involves three basic steps:

Generating long term investment proposals

Reviewing, analysing and selecting proposals that have been granted

Implementing and monitoring the proposals that have been selected.

To discount means to calculate the present value of a future cash flow.

2.5 METHODS OF INVESTMENT APPRAISAL

Net present value

Internal Rate of Return.

Non-Discounting Techniques : Ignores the time value of money

Accounting rate of return

2.5.1 PAYBACK PERIOD

Payback = Initial Investment

Payback Project A = 3 years

The advantages of the payback period method include the following:

The drawbacks of this method are:

Investment outlay (payable immediately)