Mbacfint SB 24 2018 Study Book

FACULTY OF MANAGEMENT AND LAW
SCHOOL OF MANAGEMENT
E X E C U T I V E M B A
2017/18
AFE7031-A
Corporate
Finance
MODULE STUDY BOOK

Study Book: Corporate Finance
Copyright © University of Bradford 1999, 2002, 2003, 2004, 2006, 2008,

2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018
First published 1999 Thirteenth edition 2012

Second edition 2002 Fourteenth edition 2013
Third edition 2003 Fifteenth edition 2013
Fourth edition 2004 Sixteenth edition 2014
Fifth edition 2006 Seventeenth edition 2014
Sixth edition 2006 Eighteenth edition 2015
Seventh edition 2008 Nineteenth edition 2015
Eighth (CF) edition 2009 Twentieth edition 2016
Ninth edition 2009 Twenty-first edition 2016
Tenth revised edition 2010 Twenty-second edition 2017
Eleventh edition 2011 Twenty-third edition 2017
Twelfth edition 2012 Twenty-fourth edition 2018
MBACFINT–SB–24–2018 AFE7031-A
Bradford University School of Management

Director of Studies
Bradford: Craig Johnson
Dubai: Shahid Rasul
Programme Administration
Contact: gp.mbadladministration@bradford.ac.uk
Module Leader
Xiaoxia Ye: X.Ye4@bradford.ac.uk
Module Development Team

Jian Dollery, Jonathan Muir, Andrew Coutts, Patrick Barber, Bill Neale,
Christine Swales, Seán Finucane, Xiaoxia Ye
Bradford University School of Management

Emm Lane, Bradford, BD9 4JL
Tel: 01274 234374 Fax: 01274 232311
Website: www.bradford.ac.uk/management
This Study Book may not be sold, hired out or reproduced in part or in
whole in any form or by any means whatsoever without the publisher’s
prior consent in writing.
2 Bradford MBA
Contents
Introduction to the Module 7

Your module leader 7
Overview of Module and Module Descriptor 7
Assessment criteria 9
Support for your learning 11
Developing good academic practice 15
Module feedback from previous students 15
Unit 1: Introductory Issues and Concepts 17
Introduction 17
Objectives 18
Role of the financial manager 19
The financing decision 20
Concept of value 21
Value determinants 22
Risk–return trade-off 23
Accounting or strategy? 24
Key value drivers 25
Delivering value 26
Ownership and control 27
Business ethics and corporate social responsibility 28
Corporate governance 29
Summary 30
Additional learning resources 33
References 33
Unit 2: Company Valuation – Part 1 35
Introduction 35
Objectives 35
Valuation of quoted companies 36
Concepts of ‘efficiency’ 37
Implications of the EMH for financial management 43
Employing researchers 44
Summary 44
Bradford MBA 3
References 46
Unit 3: Company Valuation – Part 2 47
Introduction 48
Objectives 48
Valuing unquoted companies using alternative techniques 48
Net asset value (NAV) 49
Price: earnings multiples 51
Discounted cash flow (DCF) 53
Shareholder value analysis (SVA) 55
Summary 59
References 61
Unit 4: Investment Decisions 63
Introduction 63
Objectives 64
Investment decisions and appraisal methods 64
Investment appraisal techniques 65
‘Traditional’ or non-discounting methods 66
Discounting methods and discounted cash flow 67
Applications of project appraisal 71
Inflation 72
Allowing for taxation in DCF 75
Summary 78
References 80
Unit 5: Analysing Investment Risk 81
Introduction 81
Objectives 81
Risk and uncertainty in project appraisal 82
Sensitivity analysis 85
Expected NPVs and probabilities 91
Describing risk 92
Summary 96
References 98
Unit 6: Financing Decisions 99
Introduction 99
4 Bradford MBA
Contents
Objectives 100
Financial planning 100
Working capital management 107
Sources of long-term finance 110
Summary 116
References 118
Unit 7: Required Return on Investment 119
Introduction 119
Objectives 120
Cost of debt 120
Cost of equity (return required by shareholders) 121
Capital asset pricing model (CAPM) 124
Required rate of return when equity and debt are combined 127
Gearing and company value 128
Summary 131
References 135
Unit 8: Delivering Value 137
Introduction 137
Objectives 138
Total shareholder return (TSR) 138
Theories of dividend policy 140
Dividends as a residual or dividend irrelevance 140
Using external finance 142
Dividend relevance 144
Dividend policy: key determinants 147
Share buybacks 148
Summary 148
References 151
Unit 9: Revision 153
The main topics 153
Advice on assignment 155
Appendix A: Module Descriptor 157
Appendix B: Model Answers to Activities 161
Unit 1 161
Bradford MBA 5
Unit 2 166
Unit 3 169
Unit 4 171
Unit 5 173
Unit 6 175
Unit 7 179
Unit 8 185
6 Bradford MBA
Introduction to the Module
Your module leader

Dr Xiaoxia Ye
Xiaoxia Ye is a lecturer in Finance at Bradford University School of
Management. Xiaoxia did his PhD in finance at Wang Yanan Institute for
Studies in Economics (WISE), Xiamen University, China from 2007 to
2011. During his PhD study, Xiaoxia spent two years at Ross School of
Business, University of Michigan as a research scholar.
Xiaoxia has been working in various academic institutes in different

countries after obtaining his PhD degree. Prior to the position at University
of Bradford, Xiaoxia worked at Stockholm University and National
University of Singapore. Xiaoixa’s research is in asset pricing with a
special interest in credit risk and fixed income.
Overview of Module and

Module Descriptor
Welcome to this Corporate Finance module that builds directly on the
Business Accounting core module. You probably already appreciate that
topics in accounting usually have a fairly clearly defined answer. There
are techniques available to generate a solution, often in the form of an
accounting statement. However, while accounting, especially financial
accounting, tends to be historic in outlook (i.e. backward-looking), focusing
on reporting and analysing past behaviour and performance, the
perspective of finance is rather different. Finance focuses on
recommending appropriate financial policies designed to optimise the
interests of the owners of the firm. Because none of us can predict the
future, our policy recommendations are often uncertain. Some people find
this frustrating. Others see it as an opportunity to express flair and
imagination. Yet what is certain is that you need a firm foundation in
accounting to operate effectively in finance. Below is a checklist of
knowledge that you must have – if you do not think you are proficient in
these areas, the message is clear – go back and review your accounting
module materials!
From your introductory accounting module, you need to be familiar with:

 preparation of key financial statements: profit and loss account, balance
sheet, cash flow statement
Bradford MBA 7
 interpretation of accounts: ratio analysis

 elementary management accounting, especially cost classification and
break-even analysis
 cash budgeting
 discounted cash flow and other investment appraisal methods.
Module aims and objectives

The module will enable you to:
 consolidate and develop your knowledge of financial decision making
 understand the factors that impinge on the making and implementation
of financial decisions
 develop your ability to criticise corporate financial policy
 understand how capital markets operate, how companies are valued
and how markets shape the financial manager’s operating context.
More specifically, by the end of the module, you will be able to:
 identify the role of the financial manager in the modern corporation
 understand the determinants of company value
 appreciate how the stock market operates, both as a primary and a
secondary market
 understand how to value companies and appreciate the limitations of
valuation techniques
 evaluate the advantages and disadvantages of various investment
appraisal methods, and know when to apply them
 incorporate both inflation and tax complications into project appraisal
 distinguish between risk and uncertainty, and operate simple
procedures to allow for imperfect foresight
 advise on different financial strategies
 evaluate the advantages and disadvantages of different methods of
long-term finance
 advise on suitable financing methods for companies in different
situations
 identify the factors that determine the return required by shareholders
 assess the appropriate cut-off rate for a company using a mixture of
forms of finance
 determine the factors that affect delivery of value to shareholders.
8 Bradford MBA
Please see Appendix A for the module descriptor.
Assessment criteria
The assignment will contribute 100% of the module assessment. The
report should be typed or word-processed and should comprise no more
than 2,000 words, not including appendices. The assignment will be
assessed and you will be advised of your results.
Aim
The assignment is designed to test your understanding of corporate
finance and explores a number of areas within the module by applying
your learning to a real company. There is no perfect answer and therefore
you should state your assumptions clearly and make good use of
appendices. Remember, this is not a strategy or marketing assignment, so
focus on the finance!
Assignment tasks
Select a company listed on an internationally recognised and well-
established Stock Exchange (see below for choice of company):
Discuss how successful the company has been at delivering value to its
shareholders over the past 5 years.
 Complete an EVA analysis of your company for the last 5 years.
Clearly show your work rather than using final EVA numbers from
another source.
 Analyse the Total Shareholder Return (TSR) of the company for the
past 5 years, including any key events and compare with a similar
company or appropriate benchmark.
Undertake a current valuation of the equity in this company, using the

following methods:
 Net Asset Value.
 Comparable Ratios (e.g. P/E, P/B, EV/EBITDA). You will need to look at
both past results and comparable firms to analyse and justify an
appropriate valuation. Note that simply multiplying the current ratio by
the recent earnings (or book value or EBITDA) is not sufficient. An
audio recording discussing comparable ratios can be found in Canvas
under the appropriate Unit.
 Discounted Free Cash Flow. You will need to forecast each component
of free cash flow (e.g. Sales, costs, capex, etc.) for at least 5 years of
forecast cash flows and estimate a terminal value, and then discount
Bradford MBA 9
them back at the appropriate cost of capital which you estimate

yourself. Make sure to justify all of your assumptions. You can find
information to support your forecasts from sources including the MD&A
section of the company’s annual report (or its competitors), news
stories, industry trade publications and government or think tank studies
on the industry. Videos on how to estimate cost of capital and how to
forecast free cash flow can be found in Canvas under the appropriate
Unit.
Attempt to reconcile any differences in value that you obtain by using

these different methods and state (with reasons) what value you think is
correct for the company.
You must clearly explain all of your assumptions used in the valuations.
Choice of company
Choose a listed company on a major stock exchange (e.g. London, New

York, Tokyo, Mumbai) for which you can access the share price data over
the past 5 years. Do not choose financial firms since these are generally
much more complicated to work with. Large companies will provide
financial data on the websites, often under a section titled ‘investors’. You
will see throughout the module that BCE in Canada is used as an
example, so you may not choose this company.
Guidelines
The report should include:
 a key point summary of your conclusions
 graphical illustration, where appropriate
 a bibliography of sources of information used and references to texts or
other material drawn upon. You should follow Harvard referencing
guidelines which can be found on the Bradford University library
website.
 detailed tables, extracts or copies of financial information should be
placed in the appendices if they are necessary to understand your
report. You should only include appendices if you refer to them in the
body of the report. You do not need to include the entire financial
statements.
 You should not embed spreadsheets in the Word document as they will
not be seen by the marker. You should only copy those tables which
are important for the reader to understand your work.
Financial data available includes the FAME (Financial Analysis Made

Easy) database maintained in the Bradford University School of
10 Bradford MBA
Management library. You should request this information from the librarian
or go to the ‘How To’ resource selection and consult the ‘How To’ library
section for further information. Other special reports, for example,
Company Focus, are available from the Financial Times Share Service, or
brokers’ circulars issued from time to time by the broking arm of numerous
finance houses. Data can also be found online from the company
websites, yahoo.com, Bloomberg.com and other internet sources.
Submitting the assignment

All assignments will be submitted electronically on the module Canvas site
go to: Canvas > Dashboard > Module Tile > Assessment.
Click on the link ‘Click here to submit your assignment’.
You will then be taken to a submission page.
Select the File Upload Tab
Click Choose File and select the file you wish to submit from your device
or own file store.
A message will appear on the right of the screen confirming that you have
successfully submitted your work.
For further information on how to submit your assignments in Canvas, go

to: https://community.canvaslms.com/docs/DOC-9539-421241972.
Supplementary assessment
In the event that you are required to take supplementary assessment you
will be notified of this immediately after by the Examination Board. Prior to
the submission of any supplementary assessment you will have the
opportunity to have a one-to-one and/or group meeting (online or in
person) with the module tutor to discuss the supplementary assessment.
Support for your learning

General guidance on the support available for students from information
services can be found at: https://www.bradford.ac.uk/information-services/.
Bradford MBA 11
Approach to studying corporate finance

As an executive student you will be studying this module at a time and
place that fits around your work, social and family commitments; however,
it is strongly advised that you progress steadily through the module. In this
way, you will leave yourself plenty of time to prepare for the assessment.
By following this study regime you will leave yourself plenty of time to
prepare your assignment.
Remember two important points:
1. It is your responsibility to make a note of any difficulties and to resolve

them with your tutor. Your tutor is there to help you, but will not know
how to unless you tell him or her about your problems.
2. There is no substitute for extensive reading of the course materials and

the financial press.
You should try constantly to be aware in your regular business activity of

ways in which the concepts and techniques you are reading and working
on can be applied in practical ways. You should be taking opportunities to
read further in the subject, for example, in the regular financial press and
magazines, and following up topics of particular interest through the World
Wide Web. You should also reflect on the ways in which your own
organisation implements corporate finance. All these activities will broaden
your horizons, enabling you to appreciate the financial manager’s role in
the overall management picture.
Textbook
Throughout the module, you will need to refer to the module textbook:
Pike, R., Neale, B. and Linsley, P. (2015) Corporate Finance and

Investment: Decisions and Strategies. 8th edition. London: FT/Prentice-
Hall.
We are integrating the electronic version of the textbook into the course.
Not only is this more sustainable than sending heavy textbooks around the
world, it will make the textbook available on multiple devices, it will allow
you to highlight or annotate the text and create notes which you can share
with others. This will ensure that your experience of using the etextbook is
optimised beyond the basic advantages of easier portability, eco-
friendliness and speed of textbook delivery.
12 Bradford MBA
Accessing the etextbook

You can access the electronic version of the textbook through the Kortext
digital textbook platform. You will receive an email to your university email
address from Kortext at the start of teaching. The email will confirm your
username and password and these details will allow you to log in online at
https://app.kortext.com/login and to download your etextbook for offline
use on up to five devices.
Detailed download instructions are available from

https://www.kortext.com/support/ along with information, videos and FAQs
on the platform and supported devices.
If you haven’t received an email from Kortext by the 9 July, please contact
the admin team via gp.mbadladministration@bradford.ac.uk.
If you have any questions about accessing your Kortext account or need
help using the etextbook you can contact Kortext directly via
support@kortext.com.
Module Study Book

This Study Book is squarely based upon the core text by Pike, Neale and
Linsley (2015). You should read the appropriate chapters before you work
though the unit itself. You are also guided to the key passages in Pike et
al. (2015) in the Study Book. The Study Book introduces you to, and
outlines, the key concepts and techniques you will need to master in order
to succeed in this module. It provides you with a framework around which
to build your studies. You should develop your own study strategy.
Study Book activities and case studies

As you progress through the Study Book, you will be asked to complete a
series of short activities. Completion of these activities is essential if you
are to develop a good understanding of corporate finance. Prepare
answers to the activities and exercises in each unit. Don’t worry about
‘making a mess’ of a question. It is one of the most effective ways of
learning. You should attempt all of the activities as they arise. Remember
that it can give a false sense of security and confidence merely to review
the question as you read the answer. There is no substitute for having
made the first attempt on your own. Review activities at the end of the unit
will give you the opportunity of applying some of the ideas and concepts of
the unit in a business situation.
Model answers to all activities are provided in Appendix B.
Bradford MBA 13
Online tutorials on Canvas

During the module, you will be required to attend four live, online tutorials
conducted by a module tutor. These online tutorials will provide you with
an opportunity to engage in detailed, real-time discussions on key issues
and concepts with other students and academics. The subject and
materials for each live online tutorial are outlined in the Study Book. You
will be given details of the times and dates of these tutorial sessions once
the module has commenced.
If you have never used the Canvas online tutorial platform before, it is
essential that you familiarise yourself with the platform and test your
computer setup before you attend the first tutorial. For support and
information please go to:
https://community.canvaslms.com/docs/DOC-10503-4212627661.
Please note that the live tutorials will support you in your assignment
preparation.
Internet resources
Useful websites are listed below but you are advised to question the
information provided on these sites or with any other resources which you
use – is it ‘fact’ or someone’s opinion?
Useful websites include:
https://www.ft.com
https://www.advfn.com
https://www.bbc.co.uk/business
http://www.bloomberg.co.uk
https://www.stern.nyu.edu/~adamodar/
https://www.hemscott.com
Additional textbooks
If you wish to explore the subject area further, these textbooks are of use:
Berk, J. and DeMarzo, P. (2017) Corporate Finance. 4th edition. Pearson.
Brealey, R.A., Myers, S.C. and Marcus, A.J. (2015) Fundamentals of

Corporate Finance. 8th edition. McGraw-Hill.
Hillier, D., Ross, S., Westerfield, R., Jaffe, J. and Jordan, B. (2013)
Corporate Finance. European Edition of 2nd revised Edition. McGraw Hill.
14 Bradford MBA
Developing good academic practice

Harvard referencing style
Students will be required to provide references to the sources used to
produce work. This shows what students have read, supports the
arguments and acknowledges the work of others.
The referencing system used in this programme is called Harvard.

The reference consists of two parts:
1. A citation in the text. This appears next to the information you have
used. It consists of the family name of the author followed by the year of
publication. Each citation is matched to a reference.
2. The reference goes in a reference list at the end of your work. The list is
in alphabetical order. It contains the full details of all of the sources
referred to in the text.
For details on how to create your reference list, go to:

https://www.bradford.ac.uk/library/help/referencing/.
A note about referencing in the Study Book
This Study Book provides you with a model for citing literature and
presenting reference lists. Citations in the body of the units and in the
References section at the end of each unit, follow the University of
Bradford version of the Harvard referencing system. However, please note
that the references provided in the grey boxes at the start of each unit and
at intervals throughout use a different convention, with hyperlinks
embedded behind the title of the item (rather than given separately at the
end of the reference) and no access date included. This is simply to
increase the flow of text in the grey boxes.
Module feedback from previous students

At the end of the module you will receive an email with a link to a
questionnaire, requesting you to comment on the module. You are
expected to complete the questionnaire. The feedback you submit
regarding your learning experience will help the module development team
in their ongoing efforts to ensure the best possible learning experience for
all students.
Previous student feedback on the module includes:
Bradford MBA 15
“It has helped my understanding of CF especially on investment

decisions.”
“The study guide was clear and made learning simple.”
“It gave an overview of internationalisation.”
16 Bradford MBA
Unit 1:
Introductory Issues
and Concepts
Key reading:
1. Pike et al. (2015), Chapter 1 and Chapter 11, section 9
2. Humphrey, J.E., Lee, D. and Shen, Y. (2012) Does it cost to be

sustainable? Journal of Corporate Finance 18(3), 626–639 (Canvas >
Dashboard > Module Tile > Module Materials > Unit 1 > Activity 1.7)
Key video:
1. An Introduction to MBA Corporate Finance (Canvas > Dashboard >
Module Tile > Module Materials > Unit 1 > Activity 1.1)
2. The Role of the Financial Manager (Canvas > Dashboard > Module Tile
> Module Materials > Unit 1 > Activity 1.2)
Other:
1. Unit 1 multiple-choice questions (Canvas > Dashboard > Module Tile >
Formative Exercises > MCQs > Unit 1) – Activity 1.5
2. MyFinanceLab – Activity 1.6
3. Unit 1 live online tutorial (Canvas > Dashboard > Module Tile >
Collaborate) – Activity 1.8
Introduction
This module on corporate finance follows directly from your earlier study of
accounting. You will recall that in accounting there is generally a definable
solution, although we may sometimes argue about which accounting
policy, for example, depreciation, should be used. Balance sheets tend to
balance and cash flow figures tend to equal movements in cash and short-
term deposits. This often gives people a degree of comfort – while
perhaps difficult to find in some cases, there is solace in the notion that
there is a correct solution somewhere!
In corporate finance, this solace is absent. In accounting, the focus tends

to be on the past, and past behaviour is measurable, whereas the
Bradford MBA 17
opposite is true in finance. We emphasise the future. We look at financial

decisions in terms of their capacity to generate desirable future outcomes.
Yet none of us can foretell the future with certainty! What we can do is to
make reasoned assessments about future likelihoods, based on sensible
assumptions and reasoned arguments. Yet we are likely to be wrong! The
test of a financial decision is not how correct it was in predicting the future,
but in how intelligent an assessment was made in the first instance. Many
people find this approach frustrating; others find it exciting. Whichever
proves to be the case for you, you will not deny the key roles of insight,
initiative and flair play in financial analysis.
Every financial decision should have an objective. Finance centres on the

creation of value. The concept of value is thus critical to an understanding
of finance. But what is meant by the term ‘value’? To paraphrase the poet
and dramatist Oscar Wilde, we could define an economist as ‘Someone
who knows the price of everything and the value of nothing’. This suggests
that whereas prices are readily identifiable, value is somewhat more
esoteric and indefinable. This distinction is an interesting one. As applied
to companies, we can find their prices by looking in the financial press, but
often we suspect, and indeed, company chairmen tend to tell us, that
values are different from this. How can this be?
What is meant by value in finance? How is it measured and how can it be

created? What factors limit the ability of managers to create value? These
are the key issues in this introductory unit.
Objectives
By the end of this unit, you should be able to:
 explain the role of the financial manager in a modern corporation
 specify the relationship between net present value (NPV) and company
value
 identify the primary determinants of company value (value drivers)
 determine whether, and to what extent, a company has created value
for its owners
 understand the agency problem and the issue of corporate social
responsibility.
Activity 1.1 – watch and reflect
Watch: Unit 1 – An Introduction to DL MBA Corporate Finance (Canvas >

18 Bradford MBA
Unit 1: Introductory Issues and Concepts
Role of the financial manager

Read: Pike et al. (2015), Chapter 1: 5–7
In any organisation, managers face the problem of how to achieve the

organisational goals using the (usually) limited resources available to
them. All businesses are engaged in trying to deploy their resources to
optimal effect. In corporate finance, the key resource is cash. Thus
financial managers want to utilise cash to achieve maximum benefits for
the owners of the company. As we will find, this hinges on two key
decision areas.
 The investment decision – what assets should the company invest in?
 The financing decision – having decided what to invest in, how can
the company pay for it?
Any financial decision should be aimed at a coherent objective and judged

according to how well it meets that objective. Financial decisions should
be judged according to whether or not they create value (and how much).
Investment decisions are essentially a search for projects that are worth
more than they cost and thus create value. Remember you encountered
the concept of value in the Business Accounting module; in the unit on
capital investment appraisal and project evaluation, you saw that value
was portrayed as the net present value (NPV) of an investment project.
Investment decisions are all about finding investment projects with a
positive NPV. In the case of financial decisions, the same guideline
applies: using sources of finance that are worth more to the company than
they cost. In effect, this means trying to secure ‘cheaper’ financing.
In the case of investment decisions, finding value-creating opportunities is

relatively straightforward. If the firm devotes resources to R&D and
manages the process effectively, a stream of value-creating opportunities
ought to emerge whereby the firm can exploit temporary product market
imperfections – what the marketer calls ‘first-comer’s advantages’.
With financing decisions, this is more difficult. Financial markets are far
more efficient than product markets and, given increasing globalisation,
are becoming even more so. Providers of finance are increasingly able to
price in the true risks of lending so that the structure of interest rates
across the world financial markets very faithfully reflects the risks involved
in different types of loan (and other methods of finance). This is a
reflection of market efficiency. As we will see later, an efficient financial
market fully incorporates the risk and return characteristics of different
securities in their relative prices.
Bradford MBA 19
The financing decision

It may be helpful to visualise the financial manager as operating at the
interface of the firm’s operations (i.e. its investment projects), which drive
the demand for finance, and the financial markets which supply finance.
The financial manager’s task is to provide the right amounts of finance, at
the right cost at the right times, and to advise on the viability of different
courses of action.
Figure 1.1: The corporate finance function
Projects drive Financial markets

2 1
Financial
Demand 3 4 Supply
manager
for finance finance
In Figure 1.1, arrow 1 represents the flow of cash into the firm, arrow 2
represents the allocation of funds to projects, arrow 3 represents the
return flow of cash from successful projects, and arrow 4 represents the
return of cash to investors in the form of interest payments and dividends.
In most firms, the amount returned to the market (flow 4) is less than the
cash generated from operations in the short term, as firms wish to retain
financial resources for reinvestment.
Essentially, then, the finance function is one of cash flow management –

managing the flow of cash into, around and out of the firm – so as to
create value for the owners. Let us consider the concept of value more
carefully.
Watch: The Role of the Financial Manager (Canvas > Dashboard >
Module Tile > Module Materials > Unit 1).
This is a 1-minute video clip featuring Senior Vice President of Finance,

Gary Coughlan from Abbott Laboratories. During the clip Coughlan
discusses the role of the financial manager.
Note down your answer to the following question.
20 Bradford MBA
What are the main types of decision that a financial manager makes? Give
a relevant example.
Activity 1.2 – watch and reflect answer:
Concept of value
A successful financial decision is one that creates value, that is, it is worth
more than it costs. Consider the following example.
A company raises £1,000 from investors who require a return of 15%. The
return will be sufficient to compensate for their time value of money and
will presumably include a premium to allow for risk. The money is to be
invested in a short-term project with no residual value. It will have a single
cash flow after one year. For shareholders to be no worse off, the end-
year cash flow must be at least £1,000 (1.15) = £1,150 in order to meet
the required return. Now imagine the company expects a cash flow of
£1,300. The NPV of the investment is thus:
£1,300
NPV = – £1,000 + = – £1,000 + £1,130 = + £130
(1.15)
If a cash flow of £130 is promised, the company creates value. It takes

cash worth £1,000 and converts it into something (i.e. the project) worth
£1,130, an increase in value of £130, which is the NPV of the project.
This project, which has a positive NPV, does three things for the owners:
1. recovers the initial cash outlay of £1,000
Bradford MBA 21
2. meets the finance charge, the required return on capital

(15%  £1,000) £150
3. and, in addition, it generates a surplus of £150
Making a total of £1,300
The surplus after meeting the interest charge and recovering the initial
capital outlay, when discounted, is the NPV of the project:
£150
(1.15) = £130
Hence, the NPV of the project equals the increase in shareholder wealth
or value. A value-maximising company will attempt to develop and exploit
as many positive NPV projects as it can, in order to maximise the wealth of
its shareholders. In our example, the value of the project is £1,130 and the
value created is £130. Since a firm is a collection of projects, the value of
a company is simply the value of all its projects or the sum of all future
discounted cash flows. This is sometimes called its capitalisation.
Value determinants
Read: Pike et al. (2015), Chapter 1: 16–19 and Chapter 11: 288–291
Figure 1.2 expresses the determinants of company value, and thus is the
focus of this module. Essentially, these centre on, firstly, the investment
policy of the company, which determines the cash flows from which
dividends may be paid out to shareholders, and, secondly, the discount
rate at which these cash flows are discounted. The discount rate, or
required return, depends on the inherent risk of the company’s chosen
activity and also the financial policy it adopts. For example, does the
company use a mixture of equity and debt? This is often considered risky
because of the legal obligation to meet interest charges whatever
happens. And if it does use debt, what mixture of long-term debt and
short-term debt does it use? Short-term debt is often considered riskier
than long-term debt as it can be withdrawn at short notice. Although there
are advantages to debt financing, the additional financial risk imposed
does sometimes compel companies to offer a higher return as
compensation.
22 Bradford MBA
Figure 1.2: Value determinants
Risk–return trade-off
Our previous comments about risk and return lead to the consideration of
the risk–return trade-off. Any developed capital market will establish a
clear relationship between the rate of return required (or yield) on different
types of security and their risks. The yield on short-term government
debt, which is often considered risk-free, establishes the benchmark. Any
other securities have to offer an extra yield or risk premium, as
compensation for the risk they carry. The riskiest securities of all are
ordinary shares because there is no obligation for the company to pay a
dividend and, in the event of insolvency, the ordinary shareholder, being
the last to receive anything, will probably receive nothing. Conversely, the
risk to the company is low since failure to pay a return – the dividend – will
not result in legal action, as would be the case with corporate bonds. It is
useful to remember the two-sided nature of the risk of securities.
Identification of the risk–return frontier is important for the financial

manager as it defines the rate of return that investors require on different
Bradford MBA 23
types of security and therefore dictates the cost of capital, the denominator
in the valuation expression. Normally, investors are risk-averse – they
dislike risk but can be enticed to accept it, given suitable encouragement
by a higher than expected return.
Figure 1.3: The risk–return trade-off
Equities
Yield (%)
Preference
shares
Bonds
Treasury bills
Risk
Accounting or strategy?
Modern corporate finance centres on the concept of value and how it can
be created for the owners of the firm. In this respect, the focus has moved
away from that of traditional accounting. For the traditional accountant, a
company was a set of assets to be valued on ‘prudent’ accounting
principles of (usually) historic cost less depreciation. The modern financial
manager is far more aware of the importance of marketing and strategic
management, and aware that the development and pursuit of strategies
creates value for the owners. As a result, modern corporate finance
involves identifying the factors that create value – the value drivers – and
managing these appropriately.
24 Bradford MBA
Key value drivers

The concept of a value driver stems from the work of Michael Porter who
defined two generic forms of corporate strategy – exploiting a cost
advantage (applicable to ‘commodity’ products) and exploiting product
advantages (often applicable to products sold to the final consumer). The
relative importance of the various cost drivers is likely to vary according to
the type of strategy followed. However, for most businesses, the following
list would be relevant:
 period over which competitive advantage is expected to persist
 market share
 sales growth
 operating profit margin
 fixed investment programme
 working capital requirements
 cost of finance
 rate of tax and tax outflows.
Some of these factors may work in two directions. Taxation is essentially a

drag on value, but the company’s tax bill can be minimised by exploiting
certain tax breaks, for example, using debt finance and thus setting
interest against profit for tax purposes, and investing in capital equipment
thus generating tax-allowable depreciation allowances. The resulting tax
savings from exploiting these tax reliefs are called the tax shield.
The key value drivers are displayed in Figure 1.4, which shows the three
foci of strategy, and how they create value through the various value
drivers.
The concept of shareholder value permeates throughout this module and it

is therefore important that you absorb this philosophy.
Bradford MBA 25
Figure 1.4: Shareholder value analysis framework
Delivering value
Value creation is one issue – deciding how to deliver to shareholders is
another. Shareholders receive value in two forms, payment of dividends
and appreciation in share price. Taking the two elements together, we
have a concept known as total shareholder return (TSR). Most
companies, if they are successful, will deliver a mixture of returns. As you
will see, the precise balance between the two components can be an
important decision for the management of a company to make.
Should you wish to analyse an organisation then the following questions

are key considerations (with the answers contained in the organisation’s
annual report and accounts).
1. How, if at all, has the company structure changed over the past year?
For example, has it divested any activities or made any acquisitions?
2. How have sales in total changed? How have sales by activity changed?
3. What has happened to operating profit? Or to profit after tax? Or to

earnings per share?
4. What dividend has the company announced?
26 Bradford MBA
5. What ‘story’ do these financial highlights tell?
6. What explanation or justification is given by the top executives?
7. What can you glean about the company’s corporate and financial
strategy?
8. What is happening to share price?
Not all this information will be in the annual report and accounts. It is
important to interpret the answers in relation to what has happened in the
overall economy.
Ownership and control

The agency problem
In Anglo-Saxon countries, managers and directors are legally required to

faithfully pursue the interests of the owners of the company – the
shareholders. (In other countries there may be different requirements for
looking after the interests of other stakeholders in the firm.) In companies
where the original founders remain significant shareholders or where the
directors are major shareholders, this may well happen. However, where
ownership has been separated from control, which typically happens as
firms grow by share issue, and professional managers act for the owners,
this is difficult to enforce. In reality, due to this divorce of ownership and
control, managers have become freer to operate companies in ways that
are not necessarily in the best interests of shareholders. Owners can
closely monitor managerial behaviour through reports, etc., but this is
costly and may be resented. A better alternative is to make managers
identify more with shareholders and pay them according to criteria
consistent with the shareholders’ aims. Until recently, managerial bonuses
have been linked in with accounting measures such as growth in earnings
per share (EPS) and return on equity (ROE). However, these have been
proved easy to manipulate via creative accounting.
Short-term pressures
In the past, managers have typically been rewarded on the basis of year-
by-year performance. Coupled with focus on accounting measures of
performance, this has allegedly led to preference by managers for policies
that enhance short-term performance, possibly to the detriment of long-
term performance.
Bradford MBA 27
Activity 1.3 – stop and think
After reading the above two paragraphs on the agency problem and short-
term pressures note down the answers to the following question.
In what ways could short-term reported earnings be improved, but to the

detriment of long-term value?
Activity 1.3 – stop and think answer:
Solving the agency problem
Since most shareholders are impressed by, and actively seek, share price
appreciation, the solution seems to be to link managerial bonuses in with
share price performance via some form of long-term incentive plan
(LTIP). An example is a share option scheme. These are designed to
encourage managers to grow share price by allowing them to convert, or
exercise, share options. For example, imagine today’s share price is £1.
Managers may be incentivised by the offer of options to purchase shares
at, say, £1.50 in three years’ time. Any excess of market price above
£1.50 at the conversion date represents pure profit to the managers.
Clearly, such a scheme should not be made so demanding that it is
demotivating, nor should it be made too easy, unless the company wants
to bind the manager to the company.
Business ethics and corporate social

responsibility
Since the Enron scandal and other more recent scandals, business ethics
has become an important issue in today’s corporate practices. Defining
business ethics has been compared to ‘nailing jello to a wall’ (Lewis 1985).
28 Bradford MBA
There are many definitions available, but De Cremer et al. (2011) say that
‘most definitions focus on evaluating the moral acceptability of the actions
of management, organizational leaders and their employees’. More
specifically, it is related to a company’s attitude and conduct towards its
suppliers, customers, employees, shareholders and communities.
However, in modern corporate finance, maximising shareholder wealth is
the main objective of the firm. Is this objective consistent with corporate
social responsibility? Some argue that it is consistent where most
businesses are concerned, as shareholder wealth partially rests on the
reputation of the firm. However, there are always a few companies that
seek short-term gains from unethical activities by doing such things as
pursuing a project that may damage the climate or by employing child
labour. Although these firms may be able to increase their profits or
reduce costs in the short run, such unethical activities will damage both
their reputations and shareholder wealth in the long run. Therefore, it is
important for a corporation to be aware of its social responsibility and to
demonstrate its financial integrity and environmental awareness to the
public. Humphrey et al. (2012) (which you will read for Activity 1.7) found
that in their study of UK firms, there did not seem to be any stock market
penalty (or reward, unfortunately) for having socially responsible corporate
policies.
Corporate governance
These aspects bring us to the highly topical issue of corporate
governance. This is the way in which companies are managed at senior
levels. Since 2000, there have been numerous examples of spectacular
collapses of companies such as Enron, WorldCom and Lehman Brothers,
as well as more recent scandals like the LIBOR fixing scandal, currency
manipulation and money laundering accusations against global banking
giants. These companies had grown rapidly, acquiring other companies by
substantial issues of debt finance, which proved difficult to service when
the recession began. Sometimes corporate difficulties were laced with
fraud. In addition, ‘excessive’ payments to senior executives had been a
major concern, as high payments were often apparently unrelated to
performance. Many of these cases of ‘misgovernance’ seemed to be
associated with the activities of a single, dominant personality, who often
combined the roles of chief executive officer and company chairman. To
deal with these problems, guidelines of best practice in corporate
governance in the UK were issued by the Cadbury, Greenbury, Hampel
and Hicks committees, now consolidated in the UK Corporate Governance
Code (formerly known as the Combined Code), which is backed by the
London Stock Exchange. Directors have to state how the requirements of
the code have been applied. The CFA Institute has also developed a list of
best corporate governance practices for corporate directors and senior
executives. You will find links to these resources in the additional learning
resources at the end of this unit and an excellent paper by Shleifer and
Vishny (1999), which, while a little older, is an excellent literature survey
Bradford MBA 29
that lays out the fundamental theories and questions of corporate

governance.
Summary
This introductory unit has covered many ideas and concepts you will
encounter in corporate finance. As well as absorbing the significance of
these concepts, you should have realised the importance of keeping
abreast of developments in the financial world. Read the quality financial
press, for example, in the UK, Financial Times, Times, Guardian and
Independent. In the next unit, we examine more closely the question of
how to actually measure value, and consider the limitations of the methods
that we use.
Activity 1.4 – review activity
Read the case study below and then note down answers to the following
questions.
Question 1: In what ways would you expect the objectives of an

organisation like Cleevemoor/NEW to alter, following transfer from public
to private ownership?
Question 2: Using the data provided, assess the extent to which NEW
has met the interests of shareholders in its first six years as a privatised
enterprise.
Question 3: Comment on the view that the other groups of stakeholders

have borne the cost of meeting shareholders’ demands.
(This activity is loosely based on the situation in the UK water industry.

The former water authorities were privatised in 1989 amid allegations that
the government underpriced them to the advantage of the new
shareholders of the water companies. Following privatisation, many
directors awarded themselves substantial pay enhancements, often using
the arguments that they had to ‘catch up’ on pay levels elsewhere in the
private sector in order to retain good staff. This prompted widespread
allegations that the new companies were being run too overtly for the
benefit of managers – the ‘fat cats’ – and owners. The Cleevemoor case
study brings out some of these aspects.)
The Cleevemoor Water Authority was privatised in 2002, to become North

Eastern Water plc (NEW). Apart from political considerations, a major
motive for the privatisation was to allow access for NEW to private-sector
supplies of finance. During the 1990s, central government controls on
capital expenditure resulted in relatively low levels of investment, so that a
backlog of investment was required to enable the company to meet more
30 Bradford MBA
stringent water quality regulations. When privatised, it was valued by the

merchant bankers advising on the issue at £1 billion and was floated in the
form of one billion ordinary shares (par value 50p), sold fully-paid for £1
each. NEW’s capital structure also included £200m long-term debt
payable to central government. The shares reached a premium of 60% on
the first day of stock market trading.
Selected biannual data from NEW’s accounts are provided (see table
below) relating to three of the first six years of operating as a private-
sector concern. Also shown, for comparison, are the pro forma data as
included in the privatisation documents. The pro forma accounts are
notional accounts prepared to show the operating and financial
performance of the company in its last year under public ownership as if it
had applied private-sector accounting conventions. They also incorporate
a dividend payment based on the dividend policy declared in the
prospectus.
Activities of privatised utilities are scrutinised by a regulatory body that

restricts the extent to which prices can be increased. The demand for
water in the area served by NEW has risen at a steady 2% per annum,
largely reflecting demographic trends.
Key financial and operating data for year ending

December 31st (£m):
2002 2004 2006 2008
(pro forma) (actual) (actual) (actual)
Turnover 450 480 540 620
Operating profit 26 35 55 75
Taxation 5 6 8 10
Profit after tax 21 29 47 65
Dividends 7 10 15 20
Net assets 200 219 251 291
Capital 20 30 60 75
expenditure
Wage bill 100 98 90 86
Directors’ pay 0.8 2.0 2.3 3.0
Employees 12,000 11,800 10,500 10,000
(number)
P:E ratio – 7.0 8.0 7.5
(average)
Retail price index 100 102 105 108
Bradford MBA 31
Activity 1.5 – multiple-choice questions
The multiple-choice questions for this unit will enable you to test your
knowledge and understanding of the key concepts covered (Canvas >
Dashboard > Module Tile > Formative Exercises > MCQs > Unit 1).
Activity 1.6 – MyFinanceLab
Log on to: MyFinanceLab using the details provided by your faculty

member. You will find examples, quizzes and more resources to test and
enhance your knowledge of the material in this unit.
Activity 1.7 – concluding questions
Read: Humphrey, J.E., Lee, D. and Shen, Y. (2012) Does it cost to be

sustainable? Journal of Corporate Finance 18(3), 626–639 (Canvas >
Read: Pike et al. (2015), 10–14
Question 1: Why should maximising shareholders’ wealth be the overall

objective for a corporation?
Question 2: Is this objective consistent with corporate social

responsibility?
Activity 1.7 –concluding questions answers:
32 Bradford MBA
Activity 1.8 – live online tutorial
This initial online tutorial will provide you with an opportunity to meet your
module tutor and other students in the course, as well as get an overview
of the course and the final assessment. It is vital that you take part in this
exercise as it will enable successful participation in future online tutorials.
Your participation in all the tutorials will also support you in your
assignment preparation.
Live online tutorial: To access the tutorial, please go to: Canvas >
Dashboard > Module Tile > Online Tutorials > Activity 1.8 – live online
tutorial. For support and information about Canvas online tutorials, please
go to: https://community.canvaslms.com/docs/DOC-10503-4212627661.
Additional learning resources

Additional resources are available if you wish to learn more about the
issues covered in this unit (Canvas > Dashboard > Module Tile > Module
Materials > Unit 1 > Unit 1: Additional Learning Resources).
Financial Reporting Council’s Corporate Governance and Stewardship.

https://www.frc.org.uk/corporate/ukcgcode.cfm Accessed 1 June 2018.
Schacht, K., Allen, J. and Orsagh, M. (2009) The Corporate Governance

of Listed Companies: A Manual for Investors. 2nd edition. CFA Institute.
https://www.cfainstitute.org/learning/products/publications/ccb/Pages/ccb.v
2009.n12.1.aspx Accessed 1 June 2018.
Shleifer, A. and Vishny, R. (1999) A Survey of Corporate Governance.

Journal of Finance 52(2), 737–783.
References
De Cremer, D., van Dick, R., Tenbrunsel, A., Pilutla, M. and Murnighan,
J.K. (2011) Understanding Ethical Behaviour and Decision Making in
Management: A Behavioural Business Ethics Approach. British Journal of
Management 22, S1–S4.
Humphrey, J.E., Lee, D. and Shen, Y. (2012) Does it cost to be

sustainable? Journal of Corporate Finance 18(3), 626–639.
Lewis, P.V. (1985) Defining ‘Business Ethics’: Like Nailing Jello to a Wall.
Journal of Business Ethics 4(5), 377–383.
Bradford MBA 33
Unit 2:
Company Valuation –
Part 1
Key reading
1. Pike et al. (2015), Chapters 2 and 3
2. Doran, J.S., Peterson, D.R. and Wright, C. (2010) Confidence, opinions

of market efficiency, and investment behaviour of finance professors.
Journal of Financial Markets 13, 174–195 (Canvas > Dashboard >
Other:
1. The Efficient Market Hypothesis audio lecture (Canvas > Dashboard >
Introduction
The cornerstone of corporate finance decision-making is value creation for
the owners of the company – good decisions create value, poor decisions
destroy value. We, therefore, need a thorough understanding of how
companies are valued, in order to assess the likely impact of our financial
decisions on the wealth of shareholders. For example, how will a new
investment project affect value? What may happen to company value if we
announce an increase in dividends? In this unit, we will apply the principle
of capital market efficiency to value quoted companies.
Objectives
 understand why financial managers need to value companies
 distinguish between the three forms of market efficiency
Bradford MBA 35
 understand how the stock market values ordinary shares and why these
values change.
What applications of valuation analysis can you think of?
Valuation of quoted companies

Valuation is relatively straightforward if the company has a quotation on

the stock market. We can observe the market price of the shares daily and
if we are prepared to accept the validity of the current market price, then
we have the valuation!
The market price represents people’s best estimate of the likely future
profitability of the company, taking into account all available information,
and should strike a balance between those who are bullish (positive)
about the company and those who are bearish (negative). However,
market prices can only reflect the information made available, and some
firms are very careful in releasing information. Also, there are times when
rumour and speculation may predominate, distorting the ‘true picture’!
In corporate finance, we are frequently concerned here about the

accuracy of the stock market valuation or market efficiency. What is
meant by efficiency and how does an efficient market value a company?
This is the province of the efficient markets hypothesis (EMH).
36 Bradford MBA
Unit 2: Company Valuation – Part 1
Importance of market efficiency

Capital markets are important mechanisms in economic growth and
development. Almost all advanced economies have well-developed capital
markets.
Capital markets perform primary and secondary functions.

 The primary function is to balance the supply of, and demand for, new
funds, by bringing together organisations offering finance with those
seeking finance. This is the intermediation role of the market.
 The secondary function is to provide a clearing house (or second-hand
market) in which people can buy and sell existing securities according
to whether they want to expand or adjust their portfolios or realise their
assets.
To fulfil both these functions, the market must command trust – people
must have confidence that they will receive fair value when selling
securities and have to offer fair value when buying securities. If securities
are persistently mispriced by the market, an arbitrary redistribution of
income and wealth will result, benefiting those ‘in the know’ at the expense
of those duped into ill-informed participation. If capital markets fail in these
functions, the flow of finance to companies wishing to expand will dry up.
So how should an efficient market value a company? Before looking at this

question, it is useful to consider in more detail what is meant by market
efficiency. This means different things to different people.
Concepts of ‘efficiency’
Read: Pike et al. (2015), Chapter 2: 34–35, Chapter 3: 67–72
Efficiency can mean many things. The economist talks about allocative
efficiency – the extent to which resources are allocated to the most
productive uses, thus satisfying society’s needs to the maximum. The
engineer talks about operating or technical efficiency – the extent to
which a mechanism performs to maximum capability. The sociologist and
the political scientist talk about social efficiency – the extent to which a
mechanism conforms to accepted social and political mores and values.
The most important concept of efficiency for our purposes is pricing or
information efficiency. This refers to the extent to which available
information is built into the structure of share prices.
If information relevant for assessing a company’s future earnings

prospects (including both past information and relevant information
relating to future expected events) is widely and cheaply available, then
this will be impounded into share prices by an efficient market. As a result,
Bradford MBA 37
the market should allow all participants to compete on an equal basis in a

so-called fair game.
How an efficient market values a company
While opinions differ about the impact of rumour and speculation, there is
general agreement that what fundamentally determines the value of
shares in a company is the future stream of benefits, in the form of
dividends, which the company is expected to generate. Some people say
earnings are more important than dividends since, ultimately, dividends
can be only paid out of earnings. While this is true, it is equally valid to say
that future earnings represent potential future dividends; eventually, even
a company with a policy of high retention will unlock these in the form of
dividends. Here is a classic example: Microsoft, after years of phenomenal
growth, started to pay dividends in 2003. Ryanair, which was floated in
1997, paid its first dividend in 2010. Through these examples, we can see
that the share value in previous years can be driven by expectations, but
eventually comes to fruition, in that the company will eventually deliver
value to shareholders in cash form.
Valuation according to future dividends is incorporated in the dividend

valuation model, sometimes called the dividend discount model, which
simply states that the value of a share is given by the sum of all future
discounted dividends:
If D1 = dividend in year 1, etc.
ke = the rate of return required by ordinary shareholders
P0 = today’s share price
D1 D2 Dn
P0 = + 2 + ... +
(1+ke ) (1+ke ) (1+ke )n
D
if D is constant, and the series infinite, P0 =
ke
Why do share prices change?
Anything which changes expectations about the level of future dividends

and/or the required return will affect share price. Obviously, rumours and
speculation have a role, because announcements of new information to
the market are rarely complete – people inevitably ‘take a view’ on the
significance of new information and try to fill in the gaps.
38 Bradford MBA
It is now 2015. Tick the events in the following list which you think may
significantly affect the current share price of Laxog, a UK pharmaceuticals
group. Reflecting on the box’s you have ticked, in the space provided
below, outline why you think these events will affect Laxog’s share price.
1 Half-year results from the group expected at the end of 

December 2015
2 Takeover activity in the pharmaceuticals sector
3 Increase in the level of UK unemployment
4 Evidence about control of AIDS
5 News of an increase in R&D expenditure by the company
6 Size of the UK government’s borrowing requirement in May 2015
7 Life expectancy of people in the UK
8 Decision to join European Monetary Union in 2016
Activity 2.2 – stop and think answers:
Bradford MBA 39
Implications of market efficiency

If the stock market is information-efficient, no-one can consistently beat
the market by the presumed skills of their investment activity. The
expected value of buying shares is zero relative to the overall market.
Although you may win or lose, whichever turns out to be the case, chance
determines the future pattern of share prices. The logic of this is that
today’s price already includes all the available information relevant for
assessing the profitability of a company. This information has been
incorporated into share prices by the always-active security analysts
employed by stockbrokers and banks to research into companies, reacting
to new information as it hits the market, advising people to buy or sell as
appropriate. These people are attempting to identify cases of temporary
under- or over-valuation of securities in order to obtain an advantage. As
they attempt to do so, the information available to them will be impounded
into share prices.
As a consequence of their competition for business, the resulting share

prices will represent true or fair values, in the sense that all available
information is built into those prices. The prices can only change when
new information becomes available, and because new information, by
definition, is unpredictable, share prices can only change as a result of the
unpredictable. Consequently, the actual pattern of share price movements
over time is entirely random. If we look back over time, there will be no
definite pattern in the sequence of price changes – the time series will
follow a ‘random walk’. However, it will probably follow a rising trend, given
that share prices move with the economy in the long term, at least for
successful companies.
Levels of market efficiency

Share prices are affected by events that occur in the past, present and
future. The price is an attempt to value a business in the light of all known
information. An efficient market is one that keeps all interested parties fully
and equally well informed about issues that may affect share prices.
In the EMH, information can be classified as historic, current or forecast.

Only current or historic information is certain in its effect on price. The
more information that is available, the better the situation. Informed
decisions are more likely to be correct, although the use of inside
information to benefit investment decisions (insider dealing or insider
trading) is illegal in the UK.
Company information is available both within and without the organisation.

Those within the organisation will obviously be better informed about the
state of the business. They have access to sensitive information about
future investment projects, contracts under negotiation, forthcoming
40 Bradford MBA
managerial changes, etc. The additional knowledge will vary according to

a person’s level of responsibility and place in the organisational hierarchy.
Outsider investors fall into two categories: individual investors and

institutions. Of these two groups, the institutions are the better informed,
as they have greater access to senior management, and may be
represented on the board of directors.
Different amounts of financial information are available to different groups

of people. There is unequal access to the information, which may affect a
company’s share price. If you are one of the well-informed, this gives you
the opportunity to keep one step ahead of the market. Otherwise, you may
lose out. The share price reflects who knows what about the company.
You should note, however, that in the UK, share dealings by company
directors are tightly circumscribed; for example, they can only buy and sell
at specific times, and details of all such trades must be publicly disclosed.
There are three levels of efficiency of the stock market defined in terms of
who has access to what information and when. These levels of efficiency
are:
 weak form
 semi-strong form
 strong form.
Weak form
This applies when share prices reflect all historic data, that is, all the
information contained in the records of past share price movements.
Prices will only change when new information arrives, although possibly
not immediately and perfectly. Under weak-form efficiency, investors
cannot hope to beat the market by using an investment strategy based on
studying past share price movements. Many people believe, and act, to
the contrary. So-called chartists engage in technical analysis, the
detailed scrutiny of past movements to identify repetitive trends. Some of
them claim to have identified reliable dealing rules that allow them to ‘beat
the market’, but empirical tests of these rules have consistently revealed
that none is superior to a simple ‘buy and hold’ strategy. This supports the
view that markets are weak-form efficient.
In the space provided note down why a dealing rule like ‘Always buy in
early December’ should be doomed to failure. This rule is designed to
exploit the so-called ‘end of year effect’ claiming that share prices ‘always’
rise at the end of the year.
Bradford MBA 41
Semi-strong form
Share prices incorporate all published data relevant to the share price.
This will also include background data, such as changes in interest rates.
When new information arrives, the share price adjusts appropriately and
immediately. In reality, there is a short ‘window’ of a minute or so during
which market dealers can exploit the information before prices settle
down. (By the time you and I hear the news, it is too late!) Sometimes,
share prices will be unchanged by the publication of interim results, for
example, because those results have already been forecast and the
forecasts are widely known.
Share prices thus only respond to unexpected information, for example,

an unexpectedly high dividend increase by a company known to be doing
well. If you cannot consistently beat the market using only publicly
available information, the market is said to be semi-strong form efficient.
This is the view which is supported by most available research.
Strong form
Under strong-form efficiency, share prices incorporate all information,
including that which could only be obtained by careful internal scrutiny of
the company or inside information. In a strong-form efficient market,
prices will respond quickly even to unpublished information, that is, inside
information. This explains apparently erratic movements of share prices in
the absence of newly released information. If you cannot consistently beat
the market using all available information, including private inside
information, then the market is said to be strong-form efficient. Few
people believe that this is true of capital markets.
Figure 2.1 illustrates how each type of market – weak-form, semi-strong

and strong-form efficient – would react to favourable new information such
as a company announcing the award of a new export order.
42 Bradford MBA
Figure 2.1: Share price reaction to good news
Implications of the EMH for financial

management
If we accept that the current market price reflects all that is known about
the company, then poorly managed companies are likely to see their share
prices fall. Indeed, this is one of the mechanisms whereby ‘Anglo-Saxon’
capital markets work to remove poor management. Poor performance is
reflected in a low relative share price, thus signalling to an alternative
management group that the company is ready for takeover.
What other mechanism might operate to remove weak management?

Such mechanisms might include shareholder action and insolvency.
 Shareholder voting – this is difficult to mobilise due to the wide
dispersion of shareholders. The major institutional shareholders are
traditionally reluctant to vote out incumbent managers unless
performance is really poor. They prefer ‘behind the scenes’ pressure.
 Insolvency – this is costly and rarely benefits anyone apart from the
legal profession.
Bradford MBA 43
Announcements to the market have to be carefully presented, otherwise

the market tends to assume the worst! It is not uncommon for a poor set of
results (or a set ‘less good’ than expected) to trigger takeover speculation.
Research in Motion, maker of the popular Blackberry smartphone is a
good recent example. Even though it is still profitable and has lots of cash
flow, its recent decline has led to takeover talk. Some of the most
interesting applications of the EMH are in takeover activity.
It is noted that share prices of takeover targets invariably rise before the
formal announcement of a takeover bid. What does this suggest for the
EMH? On the face of it, this represents insider dealing, by people in the
know. It could represent speculation and rumour. If the company is known
to be weak, then it is a candidate for takeover and people begin to
speculate about how much the company may be worth in the hands of an
alternative owner.
Most bidders build up a ‘strategic stake’ (sometimes called a toehold) in a

takeover target prior to formal announcement. The present UK rules (The
Takeover Code) allow a holding of up to 3% without declaration of
beneficial ownership. The upward movement could simply be due to this
buying pressure. In reality, ‘abnormal’ buying also promotes speculation.
More information about The Takeover Code can be found in the additional
learning resources at the end of this unit.
Employing researchers
Finally, if the UK market is information-efficient, why do you think so many
people are employed to research into company prospects and to publish
research circulars?
Researchers might be employed for several reasons.

 They might be used as ‘loss-leaders’ to impress institutional investors
that are the main market players with the quality of their research and to
attract this investment business.
 Security dealers probably do not believe the EMH, nor is it in their
interest to do so.
Summary
In this section, we have looked at how the stock market values a company
and the importance of stock-market efficiency in setting ‘correct’ values.
Obviously, not all companies are quoted and those that are not have to be
valued using alternative means. Indeed, not everyone accepts the EMH
either – and such people also use alternative methods to value quoted
companies, especially in a takeover situation where a premium for control
is normally required. We will look at alternative methods in the next unit.
44 Bradford MBA
Activity 2.4 – listen and reflect
Listen to: The Efficient Market Hypothesis audio lecture (Canvas >
Company A has 2 million shares in issue and Company B has 5 million

shares. On day 1, the market value per share is £1 for A and £2 for B. On
day 2, the management of B decide, at a private meeting, to make a cash
takeover bid for A at a price of £1.50 per share. The takeover will produce
large operating savings with a present value of £1.6 million. On day 4,
Company B publicly announces an unconditional offer to purchase all
shares of A at a price of £1.50 per share with settlement on day 15.
Details of the large savings are not announced and are not public
knowledge. On day 10, B announces details of the savings that are
expected to follow from the takeover.
Question 1: Determine the share prices of A and B on day 2, day 4 and

day 10 if the market is semi-strong form efficient.
Question 2: Determine the share prices of A and B on day 2, day 4 and

day 10 if the market is strong-form efficient.
Question 3: Comment on any differences between your answers to

Questions 1 and 2. Which situation is most like real world markets?

Bradford MBA 45
Read: Doran, J.S., Peterson, D.R. and Wright, C. (2010) Confidence,

opinions of market efficiency, and investment behaviour of finance
professors. Journal of Financial Markets 13, 174–195 (Canvas >
Question 1: What does it mean to ‘beat the market’?
Question 2: If the stock market is efficient, does that mean can nobody
ever beat the market?
Activity 2.8 – concluding questions answers:

The Takeover Panel’s The Takeover Code.

http://www.thetakeoverpanel.org.uk/the-code Accessed 1 June 2018.
References
Doran, J.S., Peterson, D.R. and Wright, C. (2010) Confidence, opinions of
market efficiency, and investment behaviour of finance professors. Journal
of Financial Markets 13, 174–195.
46 Bradford MBA
Unit 3:
Company Valuation –
Part 2
Key reading
1. Pike et al. (2015), Chapter 11
2. Sharma, A.K. and Kumar, S. (2010) Economic Value Added (EVA) –

Literature Review and Relevant Issues. International Journal of
Economics and Finance 2(2), 200–220 (Canvas > Dashboard > Module
Tile > Module Materials > Unit 3 > Activity 3.9)
3. Reading for tutorial (Canvas > Dashboard > Module Tile > Online
Tutorials > Activity 3.11)
Key audio and video:

1. Valuation using price ratios (Canvas > Dashboard > Module Tile >
Module Materials > Unit 3 > Activity 3.3)
2. Forecasting for a DCF valuation (Canvas > Dashboard > Module Tile >
3. MVA and EVA (Canvas > Dashboard > Module Tile > Module Materials
> Unit 3 > Activity 3.6)
Other:
3. Unit 3 online tutorial (Canvas > Dashboard > Module Tile > Online
Bradford MBA 47
Introduction
In Unit 2, we discussed how to value quoted companies by applying the
principle of capital market efficiency. In this unit, we look at valuing
unquoted companies using alternative valuation techniques and
shareholder value analysis. These methods are also widely applicable to
publicly traded firms. As you will see, it builds firmly on the concepts
introduced in Unit 1, such as the relationship between risk and return and
the notion of value drivers. Again, you will see further application of
discounting approaches to value measurement. There are many valuation
techniques that are used in practice, but we only focus on the most well-
known and widely used of these. There is little doubt that cash flow-
oriented measures of value are becoming more and more prevalent as
guides to corporate financial managers and their advisers. Therefore, a
thorough understanding of the material in this unit and the relevant chapter
of Pike et al. (2015) will provide important insights into why people
increasingly view the primary motive of companies as the pursuit of value,
and how they perceive value.
Objectives
 value a company and its shares using:
– net assets value method
– price:earnings ratio method
– discounted cash flow method
 discuss the limitations of these three methods
 apply a shareholder-value based method of valuation
 discern the link between value drivers and shareholder value analysis.
Valuing unquoted companies using

alternative techniques
Read: Pike et al. (2015), Chapter 11: 271–272, 288 (section 11.8)
By definition, there is no market in the shares of unquoted companies,

although some off-market deals may be organised outside the main
market by market-makers on a matched bargain basis. Due to the lack of
an established market benchmark when valuing such companies, we often
have to rely on various valuation techniques. These tend to give different
answers reflecting the subjectivity of the valuation exercise. There is no
‘correct’ value; for example, in a takeover situation, the final price depends
on negotiation. The best you can do is to analyse the situation carefully
48 Bradford MBA
and make considered assumptions in order to arrive at a credible valuation

which you hope is acceptable!
Valuation techniques include:

 (net) asset value – this focuses on the company’s balance sheet
 price:earnings ratio – this focuses on accounting profits and thus on
the Profit and Loss Account.
 discounted cash flow – this relies on expected cash flows and the
time value of money concept.
Application
Now let us apply these methods to the following example. Shark is a
quoted company contemplating a takeover of an unquoted company,
Minnow. We have the following extracts from their respective accounts.
Shark Minnow
£m £m
Fixed assets (net) 12.2 3.5
Current assets 7.3 3.7
Current liabilities (2.2) (1.1)
10% long-term loan stock (3.5) (0.5)
Net assets 13.8 5.6
Ordinary share capital (par value £1) 10.0 5.00
Share premium – 0.2
Profit and loss account 3.8 0.4
Shareholders’ funds 13.8 5.6
Profit after tax attributable to
ordinary shareholders 2.4 1.5
Current market price/share £2.40 n/a
EPS 24p 30p
P:E ratio 10:1 n/a
Notes:
– No synergistic benefits (although this is unrealistic in a takeover
situation).
– Minnow’s depreciation charge = £0.2 million pa.
– Minnow’s profits include a (non-taxable) exceptional item of £0.3 million
relating to the profit on the sale of an asset.
Net asset value (NAV)

Bradford MBA 49
The total value of the company is the value of its assets. This is the
amount that a bidder would have to pay to acquire the company. However,
the valuation for a takeover hinges on valuing the equity stake – the net
value of the owner’s stake. The amount offered must be adequate to
persuade the owners to relinquish their control. In order to complete the
acquisition, the bidder will also have to make arrangements about the
liabilities of the company.
Refer to the figures and information given in the case of Shark and
Minnow above, and note down the answers to the following questions.
Question 1: What is the estimated total value of Minnow?
Question 2: How much must Shark offer to persuade the owners of

Minnow to part with their shares?
Problems with the NAV

The net asset value (NAV) is based on taking at their face value the
figures presented in the accounts, the so-called book values. What
problems are associated with using book values?
There are problems both on the asset and liability sides.
Assets
Fixed asset values are usually based on historic cost less depreciation.
Different depreciation methods result in different values of fixed assets.
50 Bradford MBA
Whatever depreciation method is used, book values are unlikely to

correspond to market values. Although companies do revalue their assets
periodically, this is a subjective exercise, often undertaken by the directors
themselves. If we incorporate valuations of fixed (and other) assets not
shown in the balance sheet, the NAV becomes the adjusted NAV. This
gives the value on a break-up basis, i.e., the value of the assets when
sold piecemeal, as opposed to their value as a combination in their
present state, the going concern value.
Values of stock may not be reliable, especially if the accounts were

prepared some time ago. (They could be up to a year old.) Companies
often ‘window-dress’ their accounts at year-end, and stock values in high
technology and fashion industries are often soon outdated.
Some accounts receivable may be uncollectable. Provision should have

been made for bad and doubtful debts but the bidder should be wary of
the extent of this allowance.
Liabilities
Some liabilities are ‘off-balance sheet’, such as guarantees to other

companies, for example, in a joint venture, warranty obligations and
operating lease commitments. Inspection of the notes to the accounts
should reveal these.
Some other provisions may be inadequate for the purpose intended. A

provision is a reduction in retained earnings to allow for some anticipated
contingency, such as replacement of assets or redundancy payments in
the event of closure of a factory.
Although these factors can be adjusted for, the fundamental problem with
the NAV method is that it views the company as a set of assets rather than
as an income-generating activity. It ignores the company’s earning power,
which is what really drives value. NAV is really only valid when a company
is making losses, or has a collection of assets that have a much greater
value when put to some alternative use, such as farming land converted to
a housing estate.
There are two main valuation approaches that focus on future income, the
price-earnings (P:E) ratio approach, which is based on accounting
profits, and discounted cash flow.
Price: earnings multiples

The essence of the approach is to apply the P:E ratio of a quoted
company to the earnings of the unquoted company that you wish to value.
Obviously, the surrogate should be as close a match to the unquoted
company as possible.
Bradford MBA 51
The P:E ratio indicates how the market rates a company’s prospects.
Specifically, it signals how the stock market values each £1 of company
earnings. For example, a company with earnings (after tax) per share of
20p and a share price of £2 has a P:E ratio of £2 ÷ 20p = 10, or 10:1.
Note that it is based on current earnings so that a high P:E indicates faith
in the potential of a company to grow its earnings. One way to look at this
is to say that a P:E ratio, because it is driven by market price, indicates not
how well a company has done in the past, but how well it is expected to
perform in the future. It is also important to note that a company with a
high P:E ratio is not necessarily ‘better’ than a company with a low P:E
ratio. The difference simply reflects the expectations for future earnings
growth. A company with a low P:E ratio may have slow, steady, consistent
earnings growth and be a good long-term investment.
Read the financial report of Minnow Company again and complete the
task.
Apply the P:E concept to the valuation of Minnow using Shark as a

benchmark.
Problems with the P:E multiples approach
There are several problems with this approach.

 The earnings figure can be distorted by accounting policies; for
example, Shark and Minnow may adopt different depreciation policies.
 The current earnings may be untypically high or low. It may be more
appropriate to take an average over the past few years. (Although do
we know how many to include?)
52 Bradford MBA
 We should consider likely growth in Minnow’s earnings, especially as

Shark would presumably exploit its assets more effectively. This
depends from whose perspective we perform the valuation!
 It is difficult in reality to find close substitutes, that is, companies which
produce the same product lines, serve the same markets and have
similar management capabilities. In short, companies have different
potentials for growth. This is what the P:E ratio is supposed to reflect.
 Shark and Minnow are not comparable in an important respect. Shark is
a large company and it has a stock market quotation. Investors are
usually prepared to pay a premium for size and especially,
marketability, that is, the ability to easily buy and sell their shareholding.
For this reason, it is usual to reduce the P:E ratio applied to the
unquoted company’s earnings. But by how much is a question of
judgement – and ultimately what the seller will accept. Applying a P:E
ratio of say 5, we arrive at a value for Minnow of [£1.2m  5 =] £6
million.
Watch: Valuation using price ratios (Canvas > Dashboard > Module Tile >
Module Materials > Unit 3 > Activity 3.3).
Discounted cash flow (DCF)

A DCF approach has the advantage of focusing on cash flows rather than
profits. Cash flows are less easily distorted by accounting manipulation.
Look again at the financial data for Minnow.
Question 1: Now attempt a discounted cash flow computation. Begin by

calculating the free cash flow.
Question 2: What other information do you need to perform a DCF

evaluation?
Bradford MBA 53
Problems with the DCF approach

Problems with DCF focus on specification of the key variables involved.
 Can the future investment be accurately projected? Most valuations of
this type project cash flows over only 5–10 years or so for this reason,
but build in a residual value to indicate the likely value of the company
at the end of the period. This is very largely guesswork, although errors
are moderated by the discounting process.
 How can we measure the discount rate? If valuing the equity stock, we
need to know what rate of return is required by shareholders. If we are
dealing with an acquisition, then the valuation is effectively an
investment appraisal and the return required by the bidders’
shareholders should be used. However, if the project operates in a
different line of business activity, adjustment should be made for the
risk differential.
 Over what time period should we assess value? This partly depends on
the size of company – small companies are more exposed to risk and
are more likely to have short lives. Market positioning factors are also
relevant. All companies have life cycles corresponding to their project
life cycles and the period over which they enjoy competitive
advantages.
 Should we accept the current earnings figure? There are two reasons
why we might want to adjust the earnings and hence the cash flow.
First, the current figure may be untypically high or low. Taking an
54 Bradford MBA
average over the past few years may overcome this problem. Second,
we may want to build in growth potential. This is easily done but the
appropriate rate to build in is problematic. One approach is to take the
forecast rate of growth of the industrial sector of which the company is a
member.
The table below sets out the result of our analysis.
Method Value of Value of Value of

equity debt company
NAV £5.6m £1.6m £7.2m
P:E ratio @ 10:1 £12.0m £1.6m £13.6m
@ 5:1 £6.0m £1.6m £7.6m
DCF £5.03m £1.6m £6.63m
Which valuation is correct? The word ‘correct’ is inappropriate! It depends

why we require a value. Obviously, the seller will apply a higher value than
the buyer and each party is likely to apply a different mix of assumptions
and perhaps rely on different methods. This really depends on the
negotiations. The ‘value’ is not established until the deal is finalised.
Remember, too, that all these methods can be applied to a quoted
company if we take exception to the market value, for example, if we are
not inclined to accept the EMH.
Watch: Forecasting for a DCF valuation (Canvas > Dashboard > Module
Shareholder value analysis (SVA)

In recent years, there has been greater appreciation of the need for
managers to meet the interests of shareholders. In general terms, this can
be achieved by achieving a rate of return which, at the very least, matches
their required return on investment, or the cost of equity. Remember that
shareholders incur an opportunity cost when subscribing capital for firms
to use and managers are then legally obliged to safeguard those funds
with all due diligence.
Sometimes, managers feel that ‘their’ companies are not ‘correctly’ valued
by the stock market – we saw a steady trickle of firms delisting from the
main UK market during 1998–2003, largely for this reason, although the
recovery in the stock markets since 2003 arrested this trend. Moreover,
Bradford MBA 55
share prices can swing quite violently in the short term. In consequence,
both managers and shareholders often feel the need for a more objective
and reliable measure of value than simply today’s market price. This
measure can be provided by the shareholder value approach, propounded
by Rappaport (1986) and drawing on the work of Michael Porter (1985).
You met the concept of a value driver in Unit 1 – here we make use of this
idea to analyse inherent shareholder value which provides a cross-check
on the market valuation of a company. We investigate Silsden plc using
this approach.
Application
The board of Silsden plc is concerned about its stock market value of
£40 million, especially since as board members, they hold 40% of the
ordinary shares. The board is aware of concepts such as SVA and has
assembled the following data:
Current sales £50 million
Operating profit margin* 15%
Estimated rate of sales growth 5% pa
Rate of corporation tax 30%
Book value of assets £60 million (fixed assets plus net

current assets)
Shareholders require a return of 14% pa
* After depreciation. Depreciation provisions roughly match ongoing

investment requirements and are fully tax-deductible.
Silsden presently pays out 30% of profit after tax as dividend and is
ungeared. The board estimates that Silsden can continue to enjoy its
traditional competitive advantage as a low-cost provider for a further six
years, at the end of which, it estimates that the book value of its assets will
be £75 million. What is the inherent or underlying value of this company?
Solution
To value Silsden, we can adopt a DCF approach, using the 14% required
return. There is no debt finance so all operating profits (less tax) are
attributable to shareholders. There appears to be no long-term investment
programme, and wear-and-tear is made good at a rate roughly
corresponding to tax-allowable depreciation provisions. This means that
free cash flows are equal to operating profits less tax. The firm enjoys a
56 Bradford MBA
temporary cost advantage for six years beyond which cash flows are
uncertain. Post-year 6 cash flows can be handled in a number of ways.
1. The year 6 cash flow figure can be assumed to flow indefinitely.
2. A view can be taken on the firm’s efforts to restore competitive

advantage and some growth assumption can then built in.
3. The safest assumption to make is that the expected year 6 book value
of assets will approximate the value of all future cash flows, that is, the
company has no further excess earnings capacity.
With this assumption, the value of Silsden is:
Present value of
cash flows + Residual value of
during years 1– 6 company at year 6
(competitive advantage
period)
Value created over competitive advantage period:
Operating profit = 15%  £50m = £7.50 million
Profit after tax = 0.7  £7.5m = £5.25 million
(These can be assumed to be cash flows given the assumption about

depreciation and capital expenditure.)
Year
£m 1 2 3 4 5 6
Cash flows 5.51 5.79 6.08 6.38 6.70 7.03
(net of tax)
PV @ 14% 4.83 4.46 4.10 3.78 3.48 3.20
Total = £23.85m
PV of residual value = £75m  PVIF14,6
= £75m  0.4556 = £34.17 million
Shareholder value = £23.85m + £34.17m = £58.02 million
Rather alarmingly, the calculated value is largely accounted for by the

residual value and the shareholder value exceeds the market value by
£40m, which itself is below the current book value of assets. This seems to
imply that the company would be worth more if it were broken up (although
this depends on whether the book value of assets matches the market
value). It seems likely that the market is valuing Silsden for its break-up
potential rather than as a going concern.
Bradford MBA 57
This raises the obvious question of why the market should place such a
low value on Silsden. We can consider some possible reasons for the
apparent market undervaluation of Silsden. (See if you can identify which
value driver is inherent in each point.)
 The market may apply a higher discount rate, for example, seeking a
higher reward for risk.
 The growth estimate may be regarded as optimistic.
 The flow of information provided to the market may be inadequate – for
example, are Silsden’s future investment plans known?
 Board control may be perceived as excessive – (presumably) family-
dominated enterprises rarely enjoy a good stock market rating. (Why
not?)
 The dividend policy may be thought ungenerous.
 There may be doubts about whether Silsden can recover competitive
advantage.
 The market may be unimpressed with Silsden’s cost advantage-based
strategy.
 Silsden’s gearing may be thought to be too low. At zero, there is no tax
shield.
Whatever the reason(s), there is plenty for the board to consider!
Related concepts to SVA
SVA provides the basis for two further value-related concepts that are
currently very popular.
Watch: MVA and EVA (Canvas > Dashboard > Module Tile > Module
Materials > Unit 3 > Activity 3.6)
This video explains the concepts EVA and MVA.

 Economic Value Added (EVA) – This is a measure of company
performance which looks at each year’s profit adjusted for the
shareholders’ required return. The logic follows the economist’s concept
of normal profit. The firm only makes a true or economic profit if it more
than covers the owners’ opportunity costs. The EVA is thus the true
addition to shareholder value in any one year.
 Market Value Added (MVA) – This long-term concept relates to how
the market perceives the company’s ability to create value in the future.
It is simply the excess of market value over the book value of the
58 Bradford MBA
company. Companies have values above their book values if they are
expected to add value by effective use of capital. Conversely,
companies that have a poor investment record or which hoard cash will
not be rated highly on this measure. The MVA is thus the future
expected stream of EVAs discounted at the shareholders’ required
return.
For more information on the estimation of EVA for evaluating whether or

not the company is increasing shareholder value, a document from ACCA
has been included in the additional learning resources section.
Summary
In this unit, we have presented a variety of perspectives on the valuation
of companies and on shareholder-oriented concepts of value. You should
now appreciate that accounting concepts are only a beginning in this tricky
but fascinating field. Try to observe cases in the financial press of
valuations, for example, in takeover situations, which seem hard to justify
and comprehend to the outsider. This will not be difficult!

enhance your knowledge of the material in this Unit.
Activity 3.9 – concluding question
Read: Sharma, A.K. and Kumar, S. (2010) Economic Value Added (EVA)
– Literature Review and Relevant Issues. International Journal of
Economics and Finance 2(2), 200–220 (Canvas > Dashboard > Module
Read the article and then answer the following question.
Does the empirical evidence support EVA?
Bradford MBA 59
Activity 3.9 –concluding question answer:
Read: the short case and answer the questions provided (Canvas >
Dashboard > Module Tile > Collaborate > Live Online Tutorial 2)
The scenario will form the basis of an online tutorial. Note down your
answers to the question provided and be ready to discuss your answer
during the online live tutorial. You will need to use a spreadsheet such as
Excel to solve the problem. (Your tutor will have posted details of the date
and time this tutorial will take place.)
Please note that the live tutorials will support you in preparing for the
assignment.

Additional materials are available if you wish to learn more about the
Porter, M.E. (1985) Competitive Advantage. New York: Free Press.
Rappaport, A. (1986) Creating Shareholder Value: The New Standard for

Business Performance. London: Macmillan.
Ryan, N. (2011) Economic value added versus profit-based measures of

performance – Part 1. ACCA Student Accountant Hub.
http://www.accaglobal.com/gb/en/student/exam-support-
60 Bradford MBA
resources/professional-exams-study-resources/p5/technical-
articles/economic-value-added-part1.html Accessed 1 June 2018.
References
Sharma, A.K. and Kumar, S. (2010) Economic Value Added (EVA) –
Literature Review and Relevant Issues. International Journal of Economics
and Finance 2(2), 200–220.
Bradford MBA 61
Unit 4:
Investment Decisions
Key reading
1. Pike et al. (2015), Chapters 4 and 5
2. Damodaran, A. (nd) 25 Questions on DCF Valuation (and my

opinionated answers) Damodaran Online: Stern School of Business at
New York University (Canvas > Dashboard > Module Tile > Module
Key video:
1. The NPV and IRR (Canvas > Dashboard > Module Tile > Module
2. Capital budgeting (Canvas > Dashboard > Module Tile > Module
Other:
Introduction
You are already experienced in investment appraisal. You met this topic in
the Business Accounting module, where you learned the importance of the
time value of money and the need to discount cash flows, and discovered
the difference between ‘crude’ methods of appraisal and the discounted
cash flow methods. In this unit, we extend your previous studies. However,
the field of investment appraisal is vast. Consequently, we must narrow
our focus to cover the key problem areas in this field. Initially, we look at
the structure and characteristics of the investment decision to emphasise
its importance for the firm, before reviewing the main methods of appraisal
used by firms. You encountered these – payback, accounting rate of
return (ARR), and the discounted cash flow (DCF) approaches – in your
earlier module. We then concentrate on the last group of methods to show
how practical problem aspects, such as taxation and inflation, can be
handled in project appraisal.
Bradford MBA 63
Objectives
 apply the commonly-used investment appraisal methods
 understand why net present value (NPV) is regarded as the best
method
 incorporate inflation into project appraisal
 allow for corporate taxation in project appraisal.
Investment decisions and appraisal

methods
An investment is any course of action that involves sacrifices now or in the

near future in anticipation of higher future benefits. This definition covers a
wide variety of expenditures ranging from plant, machinery and buildings
acquisition to advertising and promotion and training schemes. It need not
be confined to physical or tangible expenditures.
Give reasons why investment decisions are among the most (if not,
the most) important ones which a company makes.
64 Bradford MBA
Unit 4: Investment Decisions
Information required to evaluate investment

Investment decisions, like any others, have to be guided by an objective.
This is normally wealth creation for the owners of the enterprise.
Information is required regarding costs and benefits. There are a number
of guidelines to determine what data is relevant for evaluating new
investment and what is not. Generally, relevant costs and benefits are
those which result from undertaking the project – those which would not
be incurred or received if the project does not proceed. Usually, only cash
flow costs are relevant, such as the capital expenditure required to erect a
new factory, although opportunity costs may also be relevant. For
example, if repairing a machine rather than scrapping it involves selling it
later rather than sooner, the opportunity cost – the value of the foregone
alternative – is the resale value forsaken.
Irrelevant costs include sunk costs, for example, those already incurred or
those to which the firm is already contractually committed and therefore
inescapable, and apportioned fixed costs, which would be incurred
anyway. An example of the latter is the shared-out central administration
costs, which may be unaffected by the project, but, for accounting
purposes, are partly attributed to the project. This is not to say that fixed
administrative costs are irrelevant. The level of these may be affected by
the project, for example, there may be incremental overhead costs to
consider.
Investment appraisal techniques

Investment appraisal techniques are applied to projects of the following

types:
 choosing whether or not to do a project – the accept or reject decision
 choosing between alternatives – decisions about the best project.
Projects can range from those leading to higher revenues to those which
are cost-saving in nature. In all cases, the best project is the one which
results in greatest wealth creation.
There are a number of appraisal techniques. The commonest way of

classifying them is:
 those not involving discounting cash flows – traditional methods:
payback and the return on investment method (often called the
accounting or average rate of return method)
 discounted cash flow methods: net present value and internal rate of
return.
Bradford MBA 65
The attributes of a sound appraisal technique must include that it:

 ranks projects in meaningful order of value
 provides a clear ‘cut-off point’ beyond which no further investment is
worthwhile
 is consistent with, and helps to achieve, the company’s objectives.
Only the discounting methods satisfy these criteria.
‘Traditional’ or non-discounting methods

Payback
Payback involves calculating how quickly the cash flows generated by the
project recover the initial outlay. If this period of time is within or equal to a
stipulated time period, the project is accepted.
There are several reasons why payback is used.

 It is simple, and understandable by managers at all levels. It thus
provides an easy means of communication.
 It is biased in favour of quick-returning projects and thus provides a
safeguard against a) risk of market collapse and b) risk of financial
failure through illiquidity.
 For the above reason, it may be helpful where the company has
difficulty in raising external finance (capital rationing).
 It is useful for ‘screening’ projects and providing a rough assessment of
their validity before exposing them to more detailed scrutiny.
On the other hand, there are several problems with payback.

 It ignores the cash flows beyond the point of payback.
 It ignores the timing of cash flows – cash flows which occur years from
now are valued the same as cash flows which occur today. In other
words the time value of money is ignored.
 Risky cash flows are valued the same as riskless cash flows. This could
lead to accepting more risky projects.
 It can lead to rejecting worthwhile projects by ignoring the cost of
capital. For example, a company able to raise finance at 15%, but
imposing a four-year payback period would reject a five-year payback
project, even though the implied annual return is 20% (firms often apply
very short payback periods).
 It does not measure profitability.
66 Bradford MBA
Accounting or average rate of return (ARR) method

The most common way to express the ARR is to calculate the average
profit over the project lifetime, and then express this as a proportion of the
initial outlay (or the average amount invested). The project is acceptable if
the ARR thus calculated exceeds some specified target rate of return.
The advantages of the ARR method

 It is based on the ROI concept, familiar to most business people, and
uses ‘familiar’ terms like ‘profit’ and ‘capital’.
 Business people like to work in percentage terms (so they say).
 The impact of the project on the P&L and the balance sheet can be
projected.
 It is consistent with the way in which many managers are rewarded.
The disadvantages of the ARR

 It uses accounting profits rather than cash flows and thus is likely to
understate project profitability.
 Like payback, it ignores the timing of returns.
 It is vague – the terms ‘profit’ and ‘capital employed’ can be defined in
many ways (and manipulated by creative accounting).
 The target return is often arbitrarily selected, bearing little relationship to
the cost of capital. Typically, it is based on past performance, not on
what is reasonable to expect in the future.
Discounting methods and discounted

cash flow
Read: Pike et al. (2015), Chapter 4: 84–94 and 97–100
Discounted cash flow (DCF) methods all have the common advantage of
incorporating the rate of return required by the investors, which is based
on their time preference – their relative preference for money now as
compared to money in the future, the time value of money. A project is
only worthwhile if it generates a rate of return above the minimum rate of
return required by investors. Many companies ignore this simple truth, and
in the process, they destroy value for their owners. There are several
variants of the DCF approach. First, we look at the net present value
method.
Bradford MBA 67
Net present value (NPV)

How does the NPV operate? All future cash flows are discounted at the
required rate of return, and added together to yield the gross present value
(GPV) of the project. The NPV is then calculated by subtracting the initial
investment from the GPV. If the GPV exceeds the outlay required, the
NPV will be positive – and the project is then acceptable. In a choice
situation, the project with the highest NPV should normally be undertaken.
In general, the NPV is given by:
 ( 1+ r )
CFt
NPV  t
 I0
t 1
Special cases
 Annuities – For projects with constant annual cash flows, you can
value the cash flows using a single formula rather than valuing each
individual cash flow. You can find more information on valuing annuities
in the additional learning resources at the end of the unit.
 Perpetuities – A simple perpetuity is a constant cash flow project which
goes on forever. Its present value is simply:
 1 
annual cash flow   
 discount rate 
 A growing perpetuity – where the perpetuity grows at a constant rate,
g. Its present value is:
next year’s cash flow 
For example, if this year’s cash flow is £500, g is 5%, and investors
require a return of 15%, the present value of all the future cash flows is:
£500 (1+ g) £525

= = £5,250
15% – 5% 10%
Golden rules in calculating the NPV
1. No need to deduct interest payments from the cash flows. The

cash flows reflect the investment decision; the discount rate reflects the
financing decision. By discounting, you are testing to see whether the
project can tolerate a specified cost of finance. If the NPV is positive,
the return on the project exceeds the cost of finance. Reducing the cash
flows for interest would involve double-counting.
2. No need to reduce the cash flows for depreciation. Depreciation is

simply an accounting adjustment that is undertaken to spread the initial
68 Bradford MBA
(cash outflow) cost of acquiring the asset over its expected lifetime. By
setting the initial cash flow cost against the present value of the future
cash flows you are effectively ‘depreciating’ the project. If the NPV is
positive, the project recovers its initial expenditure and automatically
‘depreciates’ itself. Making a separate annual depreciation charge
results in double-counting for the initial outlay and poses the risk of
rejecting a worthwhile investment.
The profitability index (PI)

A variation on NPV is the PI, which is used when the company faces
capital rationing. It is defined as:
GPV
initial outlay = GPV per £ invested
You will accept the project if the PI > 1.0. Both the NPV and PI will give
the same answer to the accept/reject decision for a single project, but may
give different results when projects of differing sizes are being compared. .
The PI gives an indication of the efficiency or productivity of capital
invested in the project. It is biased in favour of productive projects, which
are desirable when capital resources are limited.
The annuity method

Another variation on the NPV, the annuity method converts the cash flows
into an equivalent annuity – the annuity that yields the same present
value. Then it recommends the project if the equivalent annuity exceeds
the annuity required to at least break-even. It is useful when projects have
different lifetimes and it is desired to compare them on an equivalent
basis.
Consider the following example:
Cost of finance = 10%
Initial outlay = £15,000
Project life = 2 years
Cash flow required to recover £15,000 over 2 years at 10%
£15,000 £15,000
= = = £8,645
annuity factor 1.735
Actual cash flows: £8,000 year 1, £10,000 year 2
Bradford MBA 69
Present value = £8,000 + £ 10,000 = £7,273 + £8,265

(1.1) (1 .21)
= £15,538
£15,538
This is equivalent to an annuity of = £8,956
1.735
As this exceeds the required annuity, the project is worthwhile.
Internal rate of return (IRR)
This is the rate of discount at which the NPV = 0. The decision rule is to
accept the project if the IRR > the required return. It will give the same
answer as the NPV method to the accept/reject decision.
Problems with the IRR method

 The IRR can yield more than one solution when there are multiple sign
changes in the cash flow profile. For example, consider the profile:
– + + –
 Here, there are two sign changes and possibly two positive solutions to
the IRR calculation. In this situation, it is better to use NPV.
 In the case of mutually exclusive projects of different sizes, the NPV
and IRR can give conflicting signals. For example, the two projects
below both have a one-year life.
Outlay Cash flow NPV @ 10% IRR

A £100 £125 +£14 25%
B £50 £65 +£9 30%
IRR says ‘do B’ and NPV says ‘do A’. Which should be undertaken? This
‘ranking problem’ arises because the IRR ignores the scale of the two
projects and thus the relative magnitude of the benefits. Scaling down
project B to just 1% of the original size would not affect its IRR but the
NPV would become minuscule. In these situations, decision makers are
recommended to use the NPV method as it signifies how much wealth is
created by the project (which is the object of the exercise).
Watch: The NPV and IRR (Canvas > Dashboard > Module Tile > Module
This video clip explains the use of NPV and IRR.
70 Bradford MBA
So far, we have discussed different appraisal methods. Now please note

down a summary of the strengths and weaknesses of each method.
Applications of project appraisal

In the previous section, we examined a variety of approaches to assessing

investment projects. However, our discussions were limited to simple
cases in order to help you to grasp the basic principle of different methods.
We now move on to more complicated cases, in particular, we examine
best practice in project appraisal in tackling two key problems:
 allowing for inflation
 allowing for taxation.
By working through this section, you will be able to take inflation and
taxation into account when assessing investment projects in practice.
Bradford MBA 71
Inflation
Why is inflation a problem? Under conditions of inflation, shareholders
require company management at least to maintain the real value of their
investment and to achieve an overall rate of return that fully compensates
for inflation. This means that the future purchasing power of project cash
flows must be no less than if there were stationary prices. For example,
consider a two-year project with cash flows of £100 in each year. With no
inflation, the purchasing power of each cash flow is £100 (although the
present values differ via the time value of money). With 10% compound
inflation, the purchasing power of the cash flows falls exponentially:
100 100
Year 1: purchasing power of 100 = = = 91
Year 1 Price index 110
100 100
Year 2: purchasing power of 100 = = = 83
Year 2 Price
index 121
In other words, future cash flows require deflation for two reasons: for the
time value of money in the normal way; and also for inflation. If
shareholders require a real, net of inflation, return (r) of 10% the real
present values (RPV) are:
Year 1: RPV = 100 = 83

(1.1)(1.1)
Year 2: RPV = 100 = 68

(1.1)2 (1.1)2
And the discount rate (required rate of return) adjusted for inflation at the
rate p:
= (1 + r) (1 + p) – 1
= (1.1) (1.1) – 1 = 21%
This is known as the money cost of capital and denoted as m – the cost
of finance expressed in terms that incorporate inflation. It can be
approximated by adding the two elements r and p together, m = r + p. This
is only a shortcut and may be misleading for high values of r and p.
Types of inflation
It is useful to distinguish between:

 general inflation, as measured by a price index such as the retail price
index (RPI)
 project-specific inflation.
72 Bradford MBA
Not all prices inflate at the same rate. The revenues from the project could
inflate by more than general inflation (which is beneficial) or the costs
could overshoot the general rate. Even when the rates of inflation are
equivalent, different items may adjust in price at different times. For
example, firms often produce price lists at the start of the year, and stay
with these figures, although their costs may inflate during the year. This is
unsynchronised inflation.
Question 1: If today’s bank base rate is 7.0% and the current rate of
inflation is 2.5%, what is the rate of return required by lenders in real
terms?
Question 2: How could inflation benefit an investment project?
Incorrect ways of dealing with inflation

It is often tempting to ignore inflation on the grounds that it is too difficult to
forecast and that, on balance, the effect will be neutral. This is dangerous
– projects can be devastated by imbalances in inflation rates. Alternatively
a project that looks unattractive when cash flows are expressed in today’s
prices could develop quite profitably if inflation works in its favour.
Sometimes, companies simply add the expected inflation rate to the

current cost of capital and then discount cash flows at the resulting higher
rate. This is shown in the table below where the accept/reject decision is
reversed.
If we increase the cost of capital by the expected rate of inflation:
Cost of capital = 15%, and p = 5%.
Bradford MBA 73
Outlay End Year 1 End Year 2 NPV

CFs at today’s prices –100 +65 +65 –
PV at 15% –100 +57 +49 +6
PV at 21%* –100 +54 +44 –2
* [(1.15) (1.05) – 1]
Clearly, as the NPV appears to be negative, the project should be

rejected.
Why this conclusion may be wrong!
What happens if the 15% cost of capital already incorporates an element

of expected inflation – the capital market’s anticipation of the future
inflation rate? If the discount rate is raised by the 5% expected inflation,
the firm may have thus allowed for inflation twice. In addition, it appears to
have failed to allow for any inflation of cash flows, especially at differential
rates.
Notice that the accept/reject decision is reversed. Is this acceptable? The

danger with this simple adjustment is that it may lead to rejecting
worthwhile projects.
Correct ways of dealing with inflation
There are two (equally valid) correct ways of tackling inflation in project
appraisal, both of which give the same answer:
1 discount money cash flows at the money cost of capital

i.e. including future inflation i.e. current capital market rate,
which incorporates expected inflation.
or
2 discount real cash flows at the real cost of capital

i.e. at constant prices i.e. net of inflation.
To illustrate these approaches, consider a simple example.

 In the absence of inflation, shareholders want a real return of 10%.
 A single cash flow of £1,500 is expected, as measured in today’s prices,
receivable at the end of one year. (This is the real terms cash flow.)
 General inflation is expected at 10%.
 The project’s cash flows can also be inflated at 10%.
 The initial outlay is £1,000.
74 Bradford MBA
Calculation
1 Money cash flow, incorporating inflation = £1,500 (1.1)
= £1,650
Money cost of capital m = (1 + 10%) (1+ 10%)– 1 = 21%
NPV = – £1,000 + £1,650 = + £364

(1.21)
2 NPV = – £1,000 + £1,500 = + £364

 (1.1)
Allowing

for taxation in DCF
Allowing for taxation is essential but can be tedious. It is necessary
because the measures of profitability and value that really matter to
shareholders depend on what remains after the tax authorities have taken
their part. It is tedious because of the intricacies of the tax regulations.
These vary from country to country, so your situation may well be different
from those we discuss here. You can find an example of recent tax and
investment issues in Alberta, Canada in the additional learning resources
at the end of the unit. A new government (after more than 40 years) has
said that it will overhaul the oil tax regime and companies are now
scrambling to determine how to deal with this in their investment
decisions. Fortunately, in the UK, the corporate tax system has recently
been overhauled and simplified as it affects investment appraisal.
Although these rules will vary by country, the following analysis will show
how you can incorporate different types of tax into DCF analysis.
You need to know these facts concerning UK tax.

 The rate of corporation tax (CT) is 20% in 2015–16.
 The timing of CT payments. Under the new regulations, companies will
pay quarterly ‘as you go’. This will presumably involve an element of
estimation. (However, we assume all tax payments are paid at the end
of the year of assessment).
 How to treat investment allowances. These are tax breaks designed
to offer tax-allowable depreciation to companies that undertake
investment. The main one at present is the 20% Writing-Down (or
Annual) Allowance (WDA). This enables a company to set 20% of the
written-down value (historic cost less tax-allowable depreciation)
against profit for tax purposes. This applies on a reducing balance
basis. It may also pose complications when an asset is sold (see
below).
Bradford MBA 75
Analysis
It is best to show the treatment of tax by a building-block approach. We
look at a simple project:
1. in the absence of tax
2. allowing for tax only
3. allowing for tax and the 20% WDA.
The project
Outlay = £8m Discount rate = 10%
Lifespan = 3 years Tax rate = 28%
Scrap value = 0 WDA of 25% pa
(reducing balance)
Output volume = 10,000 units pa
Product price = £1,000
Variable cost = £400 per unit
Incremental overheads = £1m pa
Solution
Pre-tax cash flows:
YEAR 0 1 2 3
Outlay (8m)
Revenues 10m 10m 10m
Variable costs (4m) (4m) (4m)
Fixed costs (1m) (1m) (1m)
Pre-tax cash flows (8m) 5m 5m 5m
NPV of pre-tax cash flows
= – 8m + 5m*PVIFA (10, 3) = – 8m + 5m (2.487) = 4.43m
The project appears worthwhile.
Now incorporate corporation tax @ 28% (with no delay–end-year

payments).
Cash flow profile:

YEAR 0 1 2 3
Pre-tax cash flows (8m) 5m 5m 5m
Tax @ 28%
Post-tax cash flows (1.4) (1.4) (1.4)
76 Bradford MBA
NPV of post-tax cash flows = +4.43m – 1.4m (2.487) = +4.43m – 3.48m =

+0.95m
This is because the incorporation of tax creates a 3-year annuity of (28% 

£5m) = £1.4m pa.
The project is still worth doing but its profitability is severely

impaired. Note that no tax adjustment to the initial outlay is made.
Introducing the WDA
This reduces the taxable profit by 20% of the net book value of the asset
on a declining balance basis and thus reduces the tax bill. It may help first
to set out the tax-allowable depreciation profile, for the outlay of £8m.
Year of project Tax-allowable Written-down value (WDV) WDV at end of year

depreciation (£) at start of year (£) (£)
1 25%  8m = 2m – 6m
2 25%  6m = 1.58m 6m 4.5m
3 (8m – 1.6m – 1.5m) = 4.5m 4.5m 0
We can make two comments here.

 The project ceases in year 3 and so the remaining WDV can be set
against tax so as to write it down to zero for tax purposes. This is called
a balancing allowance (BA). If the resale value was say £2m, the BA
would have been (£4.5m – £2m) = £2.5m.
 The project assumes that tax relief is taken from the first year of the
project.
In reality, the tax relief may be available earlier. If the company has
sufficient profits from other operations, it may claim the WDA in year 0 – in
the year immediately before the project begins. In tax matters, a day can
make quite a difference! For simplicity, we assume that the WDA
claimable is as per the table above, although it would be useful for you to
project the profit for the alternative case.
Now complete the table below. You may want to put this in to a
spreadsheet to make the calculations more straightforward.
Cash flow profile
Bradford MBA 77
YEAR 0 1 2 3
Pre-tax cash flow –8m +5m +5m +5m
WDA* (= reduction in taxable profit)
WDV of asset
Taxable income
Tax at 28%
Post-tax cash flows
PV at 10% = NPV at 10% =
Summary
In this unit, we have revised your understanding of the mechanics of
investment appraisal methods and extended the analysis to include
treatment of inflation and taxation. In the next unit, we will focus on
possible ways of handling imperfect information in investment decisions.
From now on, we assume that you have a thorough understanding of
investment appraisal methods!
Watch: Capital budgeting (Canvas > Dashboard > Module Tile > Module
Materials > Unit 4)
This short video will demonstrate how to perform the actual analysis
through some short examples of capital budgeting using Excel.

78 Bradford MBA
Read: Damodaran, A. (nd) 25 Questions on DCF Valuation (and my

opinionated answers) Damodaran Online: Stern School of Business at
New York University (Canvas > Dashboard > Module Tile > Module
Materials >
Unit 4)
Choose one question from three different sections (chosen from FCF
estimation, growth rate, terminal value, discount rate and value of equity)
and clearly explain how you would answer the question. How do you think
that this could be dealt with when valuing a public company (as you will
have to do for your assignment)?

Alanis Business Academy (2012) Episode 42: How to Calculate the

Present Value of an Annuity. YouTube, 7 October.
https://www.youtube.com/watch?v=9L6eQUM23Ng Accessed 1 June
2018.
Marriott, W.D. (2015) Rachel Notley’s royalty dilemma. Calgary Herald,

12 June. http://calgaryherald.com/opinion/columnists/marriott-rachel-
notleys-royalty-dilemma Accessed 1 June 2018.
Bradford MBA 79
References
Damodaran, A. (nd) 25 Questions on DCF Valuation (and my opinionated
answers). Damodaran Online: Stern School of Business at New York
University. http://pages.stern.nyu.edu/~adamodar/New_Home_
Page/valquestions/valquestions.htm Accessed 1 June 2018.
80 Bradford MBA
Unit 5:
Analysing Investment Risk
Key reading
1. Pike et al. (2015), Chapter 7
2. International Federation of Accountants (2013) Project and Investment

Appraisal for Sustainable Value Creation. ifac.org (Canvas > Dashboard
> Module Tile > Module Materials > Unit 5 > Activity 5.6)
Key video:
1. Sensitivity analysis (Canvas > Dashboard > Module Tile > Module
Other:
3. Unit 5 live online tutorial (Canvas > Dashboard > Module Tile > Online
Introduction
In the previous unit, our discussions of investment appraisals assumed
that all future cash flows were known for certain. In reality, this is rarely
true. In this unit, we will consider the problem of imperfect information and
examine some of the simpler (and commoner) methods of allowing for risk
and uncertainty.
Objectives
 understand the distinction between risk and uncertainty
 apply a sensitivity analysis
 use probabilities as an aid to investment appraisal.
Bradford MBA 81
Risk and uncertainty in project appraisal

As we know, future returns cannot usually be predicted with total

accuracy. It is therefore important to examine ways of modifying the
appraisal. Here, we concentrate on two methods of dealing with risk:
sensitivity analysis and the use of probabilities.
We address the following key issues.
 What is meant by project risk?

 What are the sources of risk?
 How can we measure risk?
 How can we control risk?
 How can we choose between alternative projects under risk?
We now examine the meaning of risk and uncertainty.
Risk and uncertainty

No projects are totally safe. Most have the capacity to inflict great damage
on the company if they go wrong. Many companies have been effectively
ruined by the big project (often a takeover) that went wrong. Often, the
capacity for disaster can be reduced by careful planning. However, much
of the problem stems from the sheer unpredictability of the future state of
the economic and political environment and hence the size of cash flows.
But we shouldn’t be too disheartened and talk ourselves out of doing
potential worthwhile projects. It is worth bearing in mind that risk is a two-
sided phenomenon – sometimes, things turn out better than expected!
Risk can be defined in general terms as ‘the likelihood that things will turn
out differently from what we expect’. This definition covers both ‘downside
risk’ and ‘upside potential’. A diagram may clarify this idea (Figure 5.1).
82 Bradford MBA
Unit 5: Analysing Investment Risk
Figure 5.1: Upside potential versus downside risk
Expectations too Higher than

pessimistic expected NPV
Calculated Expectations Outcome as

NPV fulfilled expected
Expectations too Lower than

optimistic expected NPV
However, you should note that there is a technical difference between risk
and uncertainty.
Risk Relates to repetitive phenomena where we have compiled

sufficient information about past outcomes to use the
relative frequencies of past occurrences as assessments
of the future probability of the same things happening
again.
Uncertainty Where the event in question is unique and there is

insufficient past evidence on either outcomes or their
frequencies to estimate probabilities.
Most investment projects, apart from routine replacements, tend to involve

uncertainty. Think about the information gaps involved in planning and
developing a new project. However, many people may feel comfortable in
‘guessing’ the relative likelihood of different levels of outcome. These
‘guesses’ have no objective basis – we call them subjective
probabilities. But they have a role if people are prepared to accept them
as rough-and-ready guides to decision-making in particular situations.
What people are doing is to effectively treat uncertainty as if it were risk;
thus the terms tend to be used interchangeably, and when people talk
about ‘risk’, they often mean ‘uncertainty’. (We will see these subjective
probabilities in action later.)
Figure 5.2 shows a listing of the various types of uncertainty impacting on

a project (taken from a Bradford PhD thesis – Simon Ho, 1988). You will
see that there are uncertainties impacting directly on the project itself that
are inherent in its operating characteristics; uncertainties feeding through
via the impact on the whole company; and uncertainties emanating from
the economic environment itself.
Bradford MBA 83
This chart shows what can go wrong. However, excessive scrutiny is

probably counterproductive as the decision maker may become so
depressed that he or she decides that doing nothing is safer. There comes
a time when you have to say ‘Forget the risks. Let’s do it anyway!’
Figure 5.2: Sources of risk and uncertainty
A Project uncertainty
Input/Supplier Output/Market Production Financial
Availability Demand Implementation Development
Quality Prices period costs
Price Market size Implementation Initial fixed costs
Market share complexity Variable costs
Market growth Output quantity Incremental
Competition Output quality fixed costs
Competitor Technical Financing costs
actions problems Revenues
Market familiarity Required rate of
return
Sources of
finance
Salvage value
Tax on project
profit
B Firm uncertainty
Strategy Strength Personnel
Corporate Resources Impact on staff morale,
strategy needed to gain absenteeism and turnover
Investment market share Strikes and stoppages
strategy Financial Wage demands, conditions of
Acquisition resources work
behaviour Earnings stability
Product/market Adequacy in
portfolio sales
Required rate of organisation
return Management skill
Technical ability
Financial
structure
Overall
competitive
advantages
84 Bradford MBA
C Environmental uncertainty
Macroeconomic Technological Govt/Regulatory Foreign
Economic Newness Consumer laws Political stability
conditions Reliability Competition laws Relations with
Business cycle Safety Government trade host country
Foreign Project life policy Nationalisation
exchange rate Rate of Employment laws policies
Inflation rate technological Tax policies Host country
Interest rate development Grants attitude towards
Availability of projects
Safety regulations
finance Expropriation
Environmental
Shift in regulations Currency
population convertibility
Special
pattern government Ownership
programmes restriction
Capital and
trade flow
restriction
Availability of
local
management
Socio-economic
factors affecting
the project
However, it does make sense to look at methods of trying to gauge the

impact of risk and, possibly, how to manage it. The commonest method is
sensitivity analysis.
Sensitivity analysis
This involves varying the key input values of a project appraisal to

determine how sensitive the NPV outcome is to specified variations in
them. If we also determine how far a variable can alter before wiping out
the project’s NPV, we can calculate the break-even value of key variables.
The value of this approach is that, having identified the critical factors, we
can arrange to focus resources in that area in order to try to engineer a
favourable outcome.
Bradford MBA 85
Consider the following project:
Year 0 1 2
Outlay (£1,000)
Revenue £1,000 £1,400
Operating costs _______ (£500) (£600)
Net cash flow (£1,000) £500 £800
12% DF ___1___ 0.893 0.797
PV (£1,000) £446 £638
NPV = –£1,000 + £1,084 = +£84
What are the five input variables in this NPV evaluation?
Clearly these are:

 outlay
 revenue
 operating costs
 discount rate
 project life.
On the basis of the above cash flows, the NPV is +£84. At what NPV does
doing the project become a matter of indifference to the company?
This occurs if the NPV = 0, where the project offers the same return as the
cost of finance. This is the point at which the project just breaks even. One
aim of sensitivity analysis is to find the break-even values of each variable.
Now let us look at each variable in turn, starting with outlay.
Outlay
By how much can the outlay increase before the project merely breaks
even? You should have realised that since the cost of the outlay is already
expressed in present value terms, any increase will directly reduce NPV.
£84
Therefore outlay can increase by  8.4%.
£1,000
Revenue
What happens to NPV if revenue falls by:
 5%
 10%?
86 Bradford MBA
(Sensitivity analysis usually looks at variables one at a time and you can
make a table with the results, so outlay now returns to the original £1,000.)
Solution
This is the completed table (all figures in £):

5% fall 10% fall
t0 t1 t2 t0 t1 t2
Outlay (1,000) (1,000)
Revenue 950 1330 900 1260
Costs _______ (500) (600) _______ (500) (600)
Net CF (1,000) 450 730 (1,000) 400 660
12% DF ___1___ 0.893 0.797 ___1___ 0.893 0.797
PV (1,000) 402 582 (1,000) 357 526
NPV = (16) NPV = (117)
Clearly a 5% fall in revenue is enough to remove the financial

attractiveness of this project.
Operating costs
What now happens if costs increase by 5%? Use the following table to set
out your answer.
5% increase
t0 t1 t2
Outlay
Revenue
Costs _______ _______ _______
Net CF
12% DF ___1___ 0.893 0.797
PV
NPV =
Discount rate
The sensitivity of this project to the discount rate is found by calculating
the IRR.
What is the IRR of the project?
Bradford MBA 87
Recall that, at a 12% discount rate, the NPV was +£84. Now discount at a
higher rate, say 20%.
NPV = –£1000 + £500 + £8002

(1.2) (1.2)
= –£1,000 + £417 + £556 = (£27)

 
The IRR is nearer to 20%. By interpolation,
IRR = 20% – (27/[27 + 84]  10%)
= 20% – 2.5% = 17.5%
The project is relatively insensitive to changes in the discount rate – the

cost of finance would have to rise by (17.5%-12%) , or 46%, before the
12%
NPV equals 0.
Project life span

At what life span will the NPV be zero?
Remember the NPV was + £84 for a 2-year life. For a 1-year life:
£500
NPV = – £1,000 +
1.2
= – £1,000 + £446 = (£554)


By interpolation, the break-even life is:
1 year + 554/[554 + 84]  1 year = 1.87 years
The project has to run for virtually 2 years to make it worthwhile.
Note that the procedure here is not ideal, mainly because we normally
assume end-year cash flows. Strictly, the answer is 2 years because after
1.87 years, only 1 year’s cash flow (year 1’s) will have been received. In
reality, of course, cash flows are usually received during the course of a
year.
In summary, we have found that the project:

 fails if initial outlay rises by more than 8.4%
 fails if revenues fall by more than 5%
 can just withstand a cost increase of 10%
88 Bradford MBA
 can tolerate a near 50% increase in the cost of finance

 has to run for the full 2 years to make it worthwhile.
Problems with sensitivity analysis
A sensitivity analysis examines the impact of specified variations in key

factors on the initially calculated NPV. The starting point for a sensitivity
analysis is the NPV using the ‘most likely’ value or ‘best estimate’ for each
key variable. Taking the resulting ‘base case’ NPV as a reference point,
the aim is to identify those factors that have the greatest impact on the
profitability of the project if their realised values deviate from expectations.
This intelligence signals to managers where they should arrange to focus
resources in order to secure favourable outcomes.
There are several problems with sensitivity analysis.

 It deals with changes in isolation, and tends to ignore interactions
between variables. For example, advertising may alter the volume of
output as well as influencing price, and price and volume are usually
related. It is possible with modern computing techniques to vary multiple
variables at the same time to generate a richer sensitivity analysis.
 It assumes that specified changes persist throughout the project
lifetime, for example, a postulated 10% change in volume is projected
for each year of operation. In reality, variations in key factors tend to
fluctuate randomly. Again it is possible to change factors through time if
the initial model is well defined.
 It may reveal as critical, factors over which managers have no control,
thus offering no guide to action. Nonetheless, it may still help to clarify
the risks to which the project is exposed.
 It does not provide a decision rule – it does not indicate the maximum
acceptable levels of sensitivity.
 It gives no indication of the likelihood of the variations under
consideration. Variations in a factor that are potentially devastating but
have a minimal chance of occurring provide little cause for concern.
Despite these weaknesses you should always perform sensitivity analysis

when you can – and certainly in your assignment for this module!
Watch: Sensitivity analysis (Canvas > Dashboard > Module Tile > Module
Materials > Unit 5 > Activity 5.2).
This short video provides an example of one simple way to perform

sensitivity analysis on the valuation performed in the video in Unit 4.
Bradford MBA 89
Task 1: Determine the break-even values of the key variables in the

following example of Bowman plc, and thus the highest percentage
adverse change tolerable for each variable.
Task 2: Draw a graph of NPV against maximum tolerable adverse

percentage change.
Task 3: Determine which variable is most critical in determining the

outcome of the project’s NPV.
(Hint: the cash flows are annuities.)
Bowman plc is contemplating an investment project in a sector totally

different from its current operations. It therefore has no basis for
undertaking a probability analysis, but is nevertheless concerned about
the riskiness of the proposal. Consequently, it decides to undertake a
sensitivity analysis.
The details of the project are:

Required outlay = £3m
Expected volume of output = 200,000 units pa
Expected selling price = £20/unit
Expected labour cost per unit = £8/unit
Expected material cost per unit = £6/unit
Cost of finance = 10%
Project lifetime = 4 years
1. The base case
NPV = – outlay + discounted cash flows
2. What are the maximum tolerable variations in key variables?
Capital outlay = how high can this be?
Volume = how low can this be?
Price = how low can this be?
90 Bradford MBA
Expected NPVs and probabilities

Another way of dealing with the uncertainty of future cash flows is to

assign subjective probabilities of occurrence to them. For example, a
project’s NPV may vary with the state of the market.
NPV Probability
Growth market £8,000 30%
Stable market £5,000 50%
Market in recession (£3,000) 20%
The expected NPV (ENPV) can be calculated by multiplying the NPV by

the probability and summing:
£ [(8,000  30%) + (5,000  50%) + (–3,000  20%)] = £4,300.
What is the significance of this figure of £4,300?
The ENPV is simply a weighted average; each possible outcome is

weighted by its probability of occurrence. In statistical theory, the ENPV
would be the average outcome over many repetitions. This poses a
conceptual problem because investment projects tend not to be repeated
many times over. However, the ENPV is a useful conceptual device for
guiding decisions.
Bradford MBA 91
Describing risk
The risk characteristics of an investment project are described by the
probability distribution of possible outcomes.
NPV Outcomes (Xi) Probability (Pi)

10 0.1
20 0.2
30 0.4
40 0.2
50 0.1
1.0
Two key characteristics are:
1. the expected value is a measure of central tendency:

N
∑
XiPi = ENPV
i =1
Verify that the ENPV is 30.
2. the standard deviation is a measure of dispersion. When dealing

with probabilities, its formula is:
N
∑ 2
[Pi (XI – ENPV) ]
i =1
2 2
Outcome (Xi) Pi (Xi – ENPV) (Xi – ENPV) Pi (Xi – ENPV)
10 0.1
20 0.2
30 0.4
40 0.2
50 0.1
If you work out the standard deviation, you should find that it is 120 =
10.95.
Interpretation
Happily, the distribution in the example is perfectly symmetrical or normal.

In a normal probability distribution, the expected value is also the most
likely value, i.e. 30. The normal distribution has some useful properties
92 Bradford MBA
including the ‘4-in-6’ rule (see Figure 5.3). In a normal distribution, 68% of
observations lie in the range ENPV ± 1 standard deviation.
Figure 5.3: The 4-in-6 rule
probability
x x x
19 ENPV = 30 41 NPV
This suggests that there is a 68% chance of an outcome between 19 and

41, a 16% chance of an outcome (downside risk) less than 19%, and a
16% chance of getting more than 41% (upside potential).
Please note that continuous normal distributions are usually only found in
textbooks! When dealing with uncertainty, people only pinpoint a limited
number of key outcomes and assign intuitive estimates of possibility to
them. Given the uncertainties, it is not surprising that decision makers tend
to focus more strongly on the downside potential or the likelihood of
outcomes less than the expected values, and the consequences for the
company.
Choosing between alternatives: risk aversion

Now let us think about the following example. How would you choose
between the following pairs of projects?
Choice A? ENPVx = 100 = 20

ENPVy = 100 = 40
Choice B? ENPVx = 100  = 20

ENPVz = 200  = 20
Choice C? ENPVx = 100 = 20

ENPVw = 200 = 60
Bradford MBA 93
Choice A is easy. For the same expected value, most people would opt for
the choice with the lowest risk, X. Choice B is also easy. For the same
risk, most people would go for the option with the highest ENPV, Z.
Choice C is more complex – W is potentially both more rewarding and
riskier. A risk averter is prepared to take on risk but only if suitably
compensated. The question is whether the extra 100 offered by W is worth
the extra risk (60 rather than 20). Would you be prepared to treble the risk
for double the return? Probably not.
Coefficient of variation
Our intuitive result in this activity is an application of the coefficient of

variation. This is given by:
Risk 20 60
= = 0.2 for X and = 0.3 for W
ENPV 100 200
This reflects the number of units of risk you have to bear per unit of
return. Risk averters
 would want tominimise risk per £ of return and would
therefore select the option with the lowest coefficient, which is X.
Decision trees
It can be useful to represent a risky decision in pictorial form. This is done

with a decision tree, which is an aid to understanding the risks of a
decision, especially where cash flows are receivable over a period of
years.
In the following example, the initial investment is £4m. There is a 50%

chance that the project will yield a cash flow of £5m at the end of year 1,
and a 50% chance of getting £1m. If the first year cash flow is £5m, there
is a 70% chance that year 2 will yield £5m again, but a 30% chance that it
will yield £1m. If the first year return is £1m, there is an 80% chance of
£1m again in year 2 and a 20% chance of –£1m. The company requires a
10% return.
The information can be shown as a ‘tree’ with two main branches and four
stems or routes through the tree. The chance of following each route
through the tree is called a joint probability. The complete tree with
calculation of the ENPV is shown in Figure 5.4.
94 Bradford MBA
Figure 5.4: A decision tree
Some limitations to the ENPV approach
No decision is made for you. If an ENPV is positive, there may still be a

chance that the project turns out badly (50% in the decision tree example).
Probabilities have to be assigned to the cash flows before they occur. This
inevitably is highly subjective.
When choosing between alternatives, we may need to look at the

relationship between risk and return. However, unless the probability
distribution is perfectly normal, the approach can be misleading. Consider
the following example:
State of the economy S1 S2 S3
Probability 0.33 0.33 0.33
Payoff A (ENPV) 8 10 12
Payoff B (ENPV) 20 25 30
Which project should be undertaken? The co-efficient of variation is

unable to separate options A and B, but inspection of the distributions
Bradford MBA 95
reveals that project B is always better than A, regardless of the state of

the economy. The difficulty here stems from the non-normal nature of the
distributions. Unless these are perfectly normal, the ENPV decision guide
can be unreliable.
1. Using expected values only (return maximisation)

ENPVA = 10
ENPVB = 25 } B is better than A
2. Standard deviations only (risk minimisation)
A=1.64
B = 4.08 } A is better than B
3. Coefficient of variation (risk aversion)
1.64
A = 0.16
10
4.08
B
25
= 0.16 } We can’t separate them!

Guarding against project risk

Up to this point, we have looked at ways of evaluating projects in order to
allow for risk. An alternative approach is to consider ways in which project
risk can be reduced by astute management, for example, by altering the
structure of the project and the timing of cash flows and inflows in order to
minimise the adverse impact of untoward contingencies. This is the area
of project management.
Summary
In this unit, we have focused on the issue of managing risk in the context
of investment decisions. In particular, the two methods, i.e. sensitivity
analysis and the use of probability, have been discussed. It is important to
realise that neither of these methods are perfect. They are simply ways of
trying to explore the risk characteristics of a project in order to understand
its dynamics more clearly. In the next unit, we begin to examine the other
key decision area of corporate finance, the financing decision, beginning
with an examination of the place of working capital management in
financial planning.
96 Bradford MBA

Read: International Federation of Accountants. (2013) Project and

Investment Appraisal for Sustainable Value Creation. ifac.org, 14 August
(Canvas > Dashboard > Module Tile > Module Materials > Unit 5)
Read the article and then answer the following question. Note that the
resources section at the end of this paper also has some excellent
resources for further study on this topic. (You will need to register with
IFAC to do so, but it is relatively straightforward and free.)
Imagine an investment or project which your firm (or another firm) might
want to undertake in the next year. What information do you need to apply
the methods presented in this paper to an NPV or valuation calculation?
What are the key strategic factors which will inform your decisions on
whether or not to proceed with the investment or project?
Bradford MBA 97
Read: Online Live Tutorial 3 Case (Canvas > Dashboard > Module Tile >
Online Tutorials > Activity 5.7)
Your tutor will email a copy of the material that you need to prepare for this
tutorial at least one week before the tutorial date.
Read the case and answer the questions provided. You will need to use a
spreadsheet such as Excel to solve the problem.

Amirkhalili, R. (1997) Risk and capital budgeting. AACE International

Transactions, 80–83.
References
International Federation of Accountants (2013) Project and Investment
Appraisal for Sustainable Value Creation.
https://www.ifac.org/publications-resources/project-and-investment-
appraisal-sustainable-value-creation-1 Accessed 1 June 2018.
98 Bradford MBA
Unit 6:
Financing Decisions
Key reading
1. Pike et al. (2015), Chapters 13 and 14 on risk and treasury
management and working capital and short-term asset management,
Chapter 16 on sources of long-term finance, and Chapters 18 and 19
on capital structure decisions.
2. Davidoff, S.M. (2011) Why IPOs Get Underpriced. New York Times,
27 May (Canvas > Dashboard > Module Tile > Module Materials >
Unit 6 > Activity 6.8)
Key video and audio:

1. Khan Academy (nd) Bonds vs. Stocks. khanacademy.org (Canvas >
2. Capital Structure (Canvas > Dashboard > Module Tile > Module
Other:
Introduction
You will remember that the two key decision areas of corporate finance –
and, hence, the fundamental drivers of value – are investment decisions
and financing decisions. These decisions involve deciding what to spend
and how to pay for it. Having looked at the first issue in the previous units,
the focus shifts in this unit to methods of raising finance. However, this is
not merely a checklist of advantages and disadvantages of different
financing methods – it is set in the context of financing strategy. To make
sensible financial decisions, companies must have coherent financial
strategies and clear financial policies to make these operational. We will
also clarify the relationship between long-term and short-term financing
and stress the role of efficient working capital management in pursuit of
shareholder value.
Bradford MBA 99
Objectives
 understand the principles of financial planning and different financing
strategies
 examine the case for short-term versus long-term financing
 investigate the role of working capital management in financial planning
 examine the case for debt versus equity financing
 advise on alternative ways of raising equity finance, including rights
issues.
Financial planning
Here we set the scene for analysing financial decision making by

pinpointing the key elements in financial planning and then focusing on the
role of working capital management. You will find that a lot of the
‘language’ of working capital management, for example, key ratio analysis,
is already familiar to you from the Business Accounting foundation
module.
Why financial planning?
Most companies exhibit growth at some stage of their development. Some

grow at a steady pace and others grow in fits and starts depending on how
closely their activities are ‘geared’ to (tied in with) the overall economy.
Growing firms face the need to finance higher levels of fixed assets and
working capital requirements. Fixed capital needs tend to be ‘lumpy’: firms
buy plant and equipment in discrete chunks; although replacement
investment to remedy wear and tear may have a smoother profile. Working
capital requirements tend to vary with seasonal factors, and with changes
in policy towards debtors and creditors. In Figure 6.1, total financing needs
(shown by the wavy line) are called the cumulative capital requirement
(CCR).
100 Bradford MBA

Unit 6: Financing Decisions
Figure 6.1: A firm’s cumulative capital requirement

P
A
Cumulative
capital
requirement
Time
Year 1 Year 2
Figure 6.1 shows possible long-term financing paths which a firm might
follow.
Path A Always above the CCR. The firm has a permanent cash surplus
– it is over-capitalised. This is a very conservative financing
policy.
Path B An intermediate strategy where the firm is in cash surplus for

the year and can lend (i.e. put money on deposit) but has to
borrow at other times.
Path C Always below the CCR. The firm is a permanent short-term

borrower. This is a highly aggressive policy, where the firm is
under-capitalised.
While helpful, this picture of financing needs and policies is rather limited
in what it shows. In particular:
 it says nothing about the composition of long-term liabilities, whether
they are in debt or equity form
 it says nothing about the relationship between fixed and current assets
and how they are financed.
Bradford MBA 101

Read the example below and note down answers to the questions that
follow.
The sales of Devon plc for the year 2012 were £100,000. Sales for 2013
are expected to rise by 20% to £120,000. You are to advise on the
additional financing required to support the higher level of sales. Its
summary balance sheet as at 31 December 2012 is:
£ £
Ordinary shares 22,000 Fixed assets (net) 32,000
Retained earnings 15,000 Stock 16,000
Debentures 10,000 Debtors 8,000
Trade creditors 11,000 Cash 2,000
58,000 58,000
Assume that except for ordinary shares, retained earnings, debentures

and fixed assets, the balance sheet items vary directly with sales.
Because of the fast growth policy, the company will need to spend about
£15,000 on new capital investment and on replacement capital
expenditures during 2013.
Devon plc earnings in 2012 before interest and tax were 15% of sales.
This was after deducting depreciation of £6,000. The depreciation charge
for 2013 is expected to remain the same. The interest rate on the
debentures is 10%. The corporate tax rate is 50%, and the company
distributes 40% of available earnings as dividends.
Question 1: Determine the increased net working capital required to meet

the higher sales level during 2013.
Question 2: Determine the company’s total additional financial

requirements for 2013.
Question 3: Estimate how much new external finance Devon plc is likely
to require during 2013.
102 Bradford MBA

The key issue

The key to successful financial planning is to meet the CCR by ensuring
that sufficient capital is available at the ‘right’ times and at the ‘right’ cost
while not having too much capital that is not profitably employed. In doing
this, there are two dangers to avoid.
Having too much capital (over-capitalisation) is wasteful and costly,

because it requires servicing, i.e. payment of interest or dividends when it
is not needed.
Having too little capital (under-capitalisation or over-trading) is the

problem faced by rapidly-growing companies unable or unwilling to raise
additional long-term capital and which push short-term financing, for
example, bank overdrafts and trade credit, to the limits of creditors’
tolerance. This may lead to inability to meet financial obligations and
insolvency. In the recent financial crisis even very strong companies were
unable to secure new financing in ways that they previously had, and
many struggled to survive.
Alternative financing strategies

1. The golden rule – the matching principle
It is generally considered prudent to follow the golden rule of finance: to

match the maturity of finance to the lifetime of the assets acquired with it.
This means that long-term assets are financed with long-term funds such
Bradford MBA 103

as equity or long-term debt, and short-term assets such as stock and

debtors are financed with short-term methods of finance like bank
overdraft and trade creditors.
However, although this is prudent, not all firms adhere to this principle. Let
us look at some exceptions.
2. Asset permanence
Some level of short-term assets will always appear in the accounts – in

this sense, they are permanent and may be financed by permanent
long-term funds. Assets permanence is shown in the CCR profile in
Figure 6.2 (which for simplicity removes the growth trend).
Figure 6.2: Asset permanence
Fluctuating current assets Short-term

Total financing
assets (£)
Permanent current assets
Total Permanent
permanent financing
assets
Fixed assets
1 2 3 4 5 6 Years
104 Bradford MBA

3. Minimise short-term financing (conservative)
If the firm regards short-term financing as dangerous, for example,

because it can easily be withdrawn, it may want to maximise reliance on
long-term finance. This is shown in Figure 6.3.
Figure 6.3: Conservative working capital policy
Total
Fluctuating current assets Short-term
financing
assets (£)
Total Permanent
permanent financing
assets
Fixed assets
1 2 3 4 5 6 Years
4. Minimise long-term financing (aggressive)
Firms which are concerned about the relatively greater cost of long-term
finance may decide to run the risks of heavy use of short-term methods
such as a bank overdraft. This is shown in Figure 6.4.
Bradford MBA 105

Figure 6.4: Aggressive working capital policy
Total Short-term
assets (£) financing
Fluctuating current assets
Total Permanent
permanent financing
assets
Fixed assets
1 2 3 4 5 6 Years
Short- versus long-term borrowing
An important issue in financial policy is the decision regarding relative

reliance on short- and long-term borrowing. A firm should consider the
following issues.
 Cost
Long-term debt is usually more expensive.
 Risk
Short-term debt is usually more risky due to:
1. risk of an overdraft being called in at short notice
2. risk of an overdraft not being renewed
3. risk of fluctuation in interest rates.
106 Bradford MBA

 Flexibility
Short-term debt is usually more flexible.
1. If working capital requirements fluctuate, it is better to avoid over-

commitment to long-term debt.
2. When interest rates are ‘high’ and expected to fall, it may be better to
borrow short and refinance long at lower rates in the future. (But how
well can you – or anyone – forecast interest rates?)
 Risk-aversion of managers
Risk-averse managers are likely to use a higher proportion of long-term
debt even though it reduces profitability.
Working capital management

You will have realised that an important ingredient in coherent financial

planning is effective working capital management.
These are the main components of current assets and current liabilities.
Current assets Current liabilities

Inventories/stocks Trade creditors
– Raw materials Taxation payable
– Work-in-progress Proposed dividends
– Finished goods Bank overdraft
Debtors/accounts receivable Other short-term loans
Prepayments Accrued expenses
Short-term investments
Cash/bank balances
Why is working capital so important?

Working capital is the lifeblood of the firm. It is required to finance the
production cycle. Remember the sequence: cash stock debtors.
Without adequate working capital, the firm cannot purchase sufficient
inputs to support production without borrowing, and is exposed to the
dangers of exceptional demands for cash.
Consider the example illustrated in Figure 6.5.
Bradford MBA 107

Figure 6.5: The working capital cycle
CASH
D A
Customers settle accounts Supplies purchased and
goods produced (£2,000)
DEBTORS STOCK
C B
Sale agreed and goods

invoiced and delivered Value = £2,000
(value = £5,000)
The firm begins with cash holdings of £1,000 but needs £2,000 to support
the production cycle. This takes a month, after which customers are found.
 Creditors will offer one month’s credit.
 Goods to the value of £5,000 are produced and sold to customers who
are given two months’ credit.
Measuring the cash conversion cycle
The cash conversion cycle is the length of time elapsing between paying
out cash and getting it back from customers. To measure it, we need to
compute the three key working capital ratios.
 Debtor days/Debtor collection period
Debtors
  Number of days in year
Sales
 Creditor days/Trade credit period
Trade Creditors
Purchases
 Stock period/Stock turnover
Stock
Cost of sales
108 Bradford MBA

We can use these to obtain the cash conversion cycle (or working
capital cycle)
= Debtor days + Stock period – Creditor days
You should note the following points.

 It is usually assumed that sales are all on credit, but this may not
always be true.
 Creditor days should be calculated from the figure for trade purchases,
although this is not always available. You may have to use cost of
sales.
 The stock period is calculated from cost of sales, given that stock is
usually valued at the lower of cost or net realisable value (NRV, not
known here).
 Ideally, average figures – average of start-year and end-year – should
be used for all calculations, but starting figures are not always available.
Consider these figures drawn from the accounts of XYZ Ltd:
Sales (all credit) £2,000

Trade purchases £800
Cost of sales £1,200
Operating profit £800
Debtors £500
Stock £400
Creditors £100
Bank overdraft £800
Question 1: What is length of the working capital cycle?
Question 2: If the company pays interest on its overdraft at 20%, what is

the profit benefit of increasing the speed of debtor collection by 40%?
Bradford MBA 109

Sources of long-term finance

Long-term finance is core finance – it is used (ideally) to finance

acquisition of long-term assets and stays in the balance sheet for the long
term. It thus represents a permanent obligation to pay interest (debt) or
dividends (equity), and in the case of debt, eventually to repay the
principal. Mistakes in raising long-term finance never go away for the
injudicious finance director! For example, too high a level of borrowing
imposes a permanent prior charge in the form of interest payments against
profits which has to be met year in, year out, good or bad. An example
which vividly illustrates this is the telecoms sector, where companies such
as Deutsche Telekom, BT Group and Orange have all refinanced due to
the pressures that the servicing of debt placed on these firms. However,
there are major benefits to borrowing. Here, we do not specifically
evaluate different methods of finance but rather we investigate the
situations when different sources may be appropriate for different types of
firm.
Watch: Khan Academy’s Bonds vs Stocks. khanacademy.org (Canvas >

Dashboard > Module Tile > Module Materials > Unit 6)
This video clip will reinforce your understanding of bonds and stocks.
110 Bradford MBA

Main types of long-term capital

For most firms, the choice among different financing firms is effectively
debt versus equity, although there are different sub-species of each.
Figure 6.6 below summarises some of these. Make sure you can
summarise their advantages and disadvantages, some of which are
brought out in the subsequent activities. There has been a large rise in
recent years of Islamic or Sharia finance based securities. This type of
finance is common in many countries including Malaysia and the GCC
(Gulf Cooperation Council), but has received growing attention in other
countries as well, particularly the UK. You can find more information about
this in the additional learning resources at the end of the unit. For more
information about Islamic finance visit www.islamicfiance.com
Figure 6.6: The main forms of long-term finance
Retentions/cash flow
(Internal equity)
A Equity
Rights issues
(External equity)
Bank overdrafts
B Debt
1 Non-market Debt
Term loans
Debentures (Secured loan stock)

Fixed and floating charges
2 Market Debt Unsecured loan stock
Convertibles, etc.
Retentions
Retentions, or retained earnings, may represent funds already to hand or,

more likely, already invested. True, it costs nothing in issue costs but it
does impose an opportunity cost on shareholders. Retentions represent
Bradford MBA 111

funds that could have been distributed as dividends to shareholders. By

not paying a dividend, the company is undertaking an obligation to achieve
a return on reinvested profits at least as great as shareholders could
otherwise achieve. Failure to do this destroys shareholder wealth.
Rights issue
A rights issue is an issue of new shares offered initially to existing

shareholders on a pro rata basis, based on their existing holdings. For
example, in a ‘1-for-4’ issue the company offers the right to buy one share
for every four already held. The shares are always offered at a discount,
partly to make them look attractive, but mainly to insure against a fall in
the market price during the offer period. A reduction in price to below the
offer price would result in no-one taking up the issue.
The discount has the effect of diluting the earnings of each existing share,
(although this is partly offset by the value of the greater cash holding by
the company). This effect is explained in the table below.
Before issue After issue

Share price = £4 Earnings diluted by extra shares
Makes 1-for-4 offer But
Offer price = £2 Company holds cash
Shareholder has 4 shares Shareholder holds 5 shares
£18
plus cash valued at = £3.60
5
Value = (£4  4) + £2 = £18 = Theoretical ex-rights price
Notice that a shareholder who fails toact loses (4  40p =) £1.60.

However, he or she can trade the right to buy new shares on the market.
The value of each right (i.e. to buy for £2 a share which will eventually be
worth £3.60) is thus (£3.60 – £2.00) = £1.60. This is called the nil paid
rights price. In principle, shareholders should be indifferent between
taking up the rights and selling them in the market. However, the picture is
clouded by the need to meet dealing fees, the inconvenience factor of
having to decide what to do and the unwanted disruption to the investor’s
portfolio. Against this, a company with a sound investment proposition and
with a good track record may see its ex-rights price rise well above the
theoretical ex-rights price (which assumes merely that the company will
achieve a return equal to the shareholders’ required return).
If rights issues are not necessarily good news, why do companies not
simply cut dividends when faced with a worthwhile investment
opportunity?
112 Bradford MBA

This is very rarely done! Dividend cuts, rightly or wrongly, are regarded as
the ultimate sign of financial incompetence. Shareholders have bought the
shares in expectation of a steadily rising stream of dividends over time. If
the dividends are cut, this betrays the concealed information that
management (which has far more information about the company than
investors in general) expect poor trading conditions in the future and are
concerned about conserving cash resources. Occasionally, firms can
persuade the market that a lower dividend is required to finance really
worthwhile projects, but it requires very good financial PR!
Generally, because the shares are so extensively held by financial

institutions that rely on the dividend stream to finance their own
obligations, for example, pensions and insurance claims, any disruption in
that income stream will be penalised heavily. The institutions coldly sell
out and transfer their money to shares in companies that offer higher,
more reliable dividends.
It is important to know the following terms. Although you may have learned
them either through the Business Accounting module or this module, you
need to make sure you can define them.
Explain the following terms:
1. gross dividend, dividend net
2. dividend yield
3. dividend cover, pay-out ratio
4. P:E ratio
5. cum dividend, ex-dividend
6. scrip dividend
7. scrip issue, bonus issue, stock split
8. rights issue, cum-rights, ex-rights.
Bradford MBA 113

Debt finance
A company which is unwilling to cut dividends or to make a rights issue
has only two alternatives if it wants to raise finance: it can sell assets, for
example, via a sale-and-leaseback, or it can borrow.
Borrowing has a major drawback – if the firm fails to make the annual
interest payment, the creditors can appoint a receiver to liquidate the
company in order to force the repayment of their capital. A heavily
indebted company is thus running the risk that in a bad trading year it may
be forced into insolvency. Bankruptcy and financial distress carry very
heavy costs! However, there are major benefits with borrowing that astute
financial managers can exploit.
 It is relatively cheap to raise. Unlike a rights issue, underwriting is not
normally required. A debenture issue can be syndicated among several
banks and other lenders who, by spreading their risk, can offer lower
interest rates.
 In a rights issue, there is the danger of loss of voting control if shares
are acquired by the underwriters. With debt, there are no voting rights.
Therefore, the only diminution in control is imposed by the incorporation
of restrictive covenants in the loan agreement, for example, restrictions
on liquidity, or on dividend policy, to safeguard the interests of creditors.
 Interest payments are tax-allowable generating a valuable tax shield
(although this is only of value to the tax-paying company).
 Gearing can have a large effect on shareholder earnings. This will be
discussed in the gearing and company value section in the next unit.
114 Bradford MBA

Borrowing and the gearing effect

Use of debt is excellent for shareholders in expanding economic
conditions – any increase in sales feeds through disproportionately in
favour of shareholder earnings but the reverse applies in adverse trading
conditions. Use of debt is good news in booms but can have dire
consequences in recessions. Heavily geared companies are prone to
insolvency in recessions, which explains why firms strive to reduce their
borrowings when trading conditions become poor. Another way of putting
this is to say that use of debt finance raises the break-even point – the
volume of output – or percentage of capacity utilisation required to enable
the firm to avoid losses.
Measuring gearing
Borrowing gears up the capital structure. It results in a higher proportion of
capital being in the form of debt which must be serviced regardless of
insolvency. This is one measure of financial gearing, in this case, capital
gearing. The commonest measure of capital gearing is:
Long - term debt

Net assets
This can be measured using book values – the figures in the accounts – or
at market values. Some people prefer the latter because it is more up to
date, although others prefer to use book values for reasons of prudence.
In times of financial distress, firms that need to sell assets to repay debts
are unlikely to achieve what they thought was market value. In addition,
until you try to sell, you don’t know the market value! Some people prefer
to include short-term borrowing on the basis that this too imposes
obligatory interest payments, and this seems sensible for companies that
make extensive use of overdrafts. Against this, it seems ‘fair’ to allow for
cash holdings, which offset the impact of short-term borrowing.
Increasingly common is the net debt measure of financial gearing:
Long-term debt + Short-term debt less Cash

Net assets
The capital gearing measure, being derived from the balance sheet,
purports to indicate the company’s ability to repay debts by selling assets
should the need arise. However, the ‘first line of defence’ where the strain
of borrowing is first revealed, is in the profit and loss account, or income
statement.
Income gearing refers to the company’s ability to meet interest charges

out of its operating profit, that is, profit before interest and tax (PBIT). Most
commonly, it is expressed as interest cover, or ‘times interest earned’:
Bradford MBA 115

PBIT
Interest charges
Thus, the greater the number of times the firm is able to make its interest
payments, the better from the safety perspective. Alternatively, income
gearing is expressed by inverting the expression for interest cover:
Interest charges
PBIT
This signifies the percentage of PBIT that is pre-empted as a prior interest

charge.
Operating gearing
The effects of gearing are rather more subtle in practice than we have
suggested above. Even firms with no borrowings are geared through their
methods of production and operation. These dictate the balance between
variable costs and the fixed costs which have to be met if the firm is to stay
in production in the long term. Whereas financial (capital) gearing refers to
the proportion of the firm’s capital structure accounted for by borrowing,
operating gearing refers to the proportion of the firm’s costs that are
fixed. A firm with high fixed costs will generally have a high
break-even point. As a result, it is usually argued that such firms should
not borrow excessively, if at all.
Summary
In this unit, we have discussed the ways in which a company can be
financed, with particular emphasis on both short-term and long-term
financing. Although we have emphasised the various types of financial
strategy which a firm may adopt, it is essential that you appreciate the
relationship between working capital management and company financing,
and that, to some degree at least, funds can be obtained from more
efficient management of debtors, stock and short-term creditors. Certainly,
any prospective provider of long-term finance will look carefully at this
aspect.
In the next unit, we examine the implications of the different methods of

finance for the rate of return required on investment. Specifically, we ask
whether and to what extent the method of financing a project affects the
required return from it and hence its acceptability. We find also that debt
financing has apparently magical properties in terms of its effect on the
value of the company!
116 Bradford MBA

Activity 6.5 – listen and reflect
Listen to: Capital Structure (Canvas > Dashboard > Module Tile > Module
Dashboard > Module Tile > Formative Exercises > Multiple-Choice
Questions > Unit 6).

Read: Davidoff, S.M. (2011) Why IPOs Get Underpriced. New York Times,
27 May (Canvas > Dashboard > Module Tile > Module Materials > Unit 6)
Question 1: What are some of the reasons that people give for believing
that IPOs are consistently underpriced?
Question 2: Given your response to Question 1, how would you explain

the performance of Facebook since its IPO? (Note that this will require
some extra research on your part.
Activity 6.8 – concluding questions answers:
Bradford MBA 117


Modigliani, F. and Miller, M. (1958) The cost of capital, corporation finance

and the theory of investment. American Economic Review 53(3), 433–443.
References
Davidoff, S.M. (2011) Why IPOs get Underpriced. New York Times,
27 May. https://dealbook.nytimes.com/2011/05/27/why-i-p-o-s-get-
underpriced/?mcubz=3 Accessed 1 June 2018.
Khan Academy (nd) Bonds vs Stocks.

https://www.khanacademy.org/economics-finance-domain/core-
finance/stock-and-bonds/venture-capital-and-capital-markets/v/bonds-vs-
stocks Accessed 1 June 2018.
118 Bradford MBA

Unit 7:
Required Return on
Investment
Key reading
1. Pike et al. (2015), Chapter 3 on valuing shares, Chapters 18 and 19,
and Chapter 9 on the Capital Asset Pricing Model.
2. Ghoul, S.E.I., Guedhami, O., Kwok, C.C.Y. and Mishra, D.R. (2011)
Does corporate social responsibility affect the cost of capital? Journal of
Banking and Finance 35, 2388–2406 (Canvas > Dashboard > Module
Key video:
1. Phillip (2008) Beta Calculation on Excel. YouTube, 2 March (Canvas >
2. Estimating WACC (Canvas > Dashboard > Module Tile > Module
Other:
3. Unit 7 live online tutorial (Canvas > Dashboard > Module Tile > Online
Introduction
A critical issue in corporate finance is the rate of return required on both
the company’s existing operations and also on new investment projects. If
the managers are unable to achieve a return at least as great as the
minimum required by the firm’s owners, then obviously there are some
serious problems! Either they need to restructure company operations to
achieve greater efficiency or they step aside to make way for a more
dynamic management team. Knowledge of this required return is needed
both for valuing the company as it stands and also for assessing the value
of any new operations, which should enhance the value of the corporate
Bradford MBA 119

whole. More specifically, the required return dictates the discount rate
applicable to cash flows anticipated from new investments.
However, most companies are financed partly by debt capital – lenders

also require a return to compensate for the costs they incur in making their
capital available. Thus all types of capital carry a cost which the firm must
cover. In this unit, we examine the costs of debt and equity capital, and the
concept of the weighted average cost of capital (WACC). Broadly
speaking, the WACC is the minimum rate of return required to satisfy all
providers of capital, including both the shareholders and the lenders.
Having addressed the issue of raising long-term finance, we now consider

the following questions.
 What are the costs of different types of finance?
 What rate of return should be earned on new investment projects?
 Does this depend on the type of finance used?
Objectives
 calculate the cost of debt finance, before and after corporate taxation
 use the dividend valuation model to assess the cost of equity
 estimate the cost of equity using the capital asset pricing model (CAPM)
 understand the case for shareholders forming a well-diversified portfolio
of shares, and the implications of this for the cost of equity
 show the impact of using debt finance on the required return
 grasp the impact of gearing up the capital structure on the value of the
whole company.
Cost of debt
As a very rough approximation, the interest rate payable on debt is its

cost. For example, if a firm issues a £10m debenture in £100 units with a
coupon rate of 8% repayable in full, i.e. at par value, in 20 years, the cost
of debt appears to be simply 8%. However, the market value of debt
capital varies inversely with changes in interest rates. For irredeemable
debt, the simplest case, the formula is:
coupon rate
Market value = Par value 
market rate
120 Bradford MBA

Unit 7: Required Return on Investment
Imagine the going rate set by the bond market for securities of this degree
of risk rises to 10%. This would make the debenture look bad value if it
were still traded at par, yielding just 8%, when newly issued securities
would be offering a yield of 10%. People would be unwilling to buy the old
debenture unless its price fell to equate its yield with the market rate. This
is roughly (note that these are very simplistic calculations – bond price
movements and yield calculations are beyond the scope of this course):
8%
£100  = £80
10%
8% x £100
At this price, its yield = = 10%
 £80
This is the market’s way of telling the company that it faces a cost of debt
which is really 10%. If it wanted to raise further debt capital, it would have

to offer the going interest rate of 10%. Strictly, the above formula only
works for irredeemable or very long-term bonds. The nearer the bond is to
maturity, i.e. the repayment date, the more its value is dictated by the final
lump sum payable rather than the annual interest.
Allowing for taxation

The previous calculation makes no allowance for the tax-deductibility of
debt interest. Interest can be set against profits for tax purposes
(assuming the company has sufficient or will soon have taxable capacity,
i.e. profits). If, for example, the company can borrow at 10% before tax,
the after-tax cost, with a 30% tax rate (T) is 10% (1 – 30%) = 7%.
Cost of equity (return required by

shareholders)
The return offered to shareholders should at least match what they could
achieve elsewhere for a similar amount of risk or what they have been
offered in the past. This is because they incur an opportunity cost in
leaving their money invested in the company, as it could be invested in
some other company.
One way of assessing this cost is to look at the achieved return on equity
(remember that equity is the same as net assets and shareholders’ funds)
and compare it with what is currently on offer in the industry concerned. It
is better to benchmark against the whole industry rather than against
individual firms in order to even out the effect of inter-firm differences in
products and markets, etc.
Bradford MBA 121

Last year, XYZ earned profit after tax (PAT) of £15m. Extracts from its
balance sheet are shown below.
£m
Fixed assets (net) 85
Net current assets 30
Long-term creditors (20)
Net assets 95
Issued share capital 20
Reserves 75
Shareholders’ funds 95
Question 1: What is XYZ’s return on equity (ROE)?
Question 2: How reliable is this as an indicator of the return required by

shareholders?
Using the dividend valuation model (DVM)
Many people prefer to use the DVM. The value of a share is given by the
sum of all discounted returns from holding it, i.e. all future dividends. If we
observe how the market values a company, we may infer the rate of return
that shareholders are seeking from it, that is, the rate of discount that is
122 Bradford MBA

implicitly being used by the market to discount future dividends (ke). The
DVM formula is:
P0 = share price = D0 ( 1+ g ) = D1
ke - g ke - g
where D0 = latest dividend

D1 = next year’s expected dividend
g = expected dividend growth rate
ke = rate of discount applied to future dividends (by implication
the cost of equity capital).
From this we can deduce:
ke = D1 + g
P0
Much of this information is known at any point in time.



We know today’s share price.
 We know the latest dividend.
 We can work out the dividend growth rate by looking at the last few
years’ dividends.
Suggest some problems in using the DVM to assess the cost of equity.
Bradford MBA 123

Capital asset pricing model (CAPM)

The CAPM provides a framework for:
1. determining the appropriate risk premiums for different investments –

both projects and securities
2. establishing the required rate of return for assets of different risk
3. assessing the market value of capital assets – hence, its name.
Types of risk
The critical concept of the CAPM is the distinction between two quite
different types of risk.
 Firm-specific risk is the variability in the returns from holding shares of
a company resulting from factors peculiar to that company, for example,
vagaries of the markets in which the firm sells its product, labour
problems and progress with R&D programmes. As these aspects are
specific to the individual firm, they can be diversified away by forming a
portfolio of securities from different industries. When some companies
in the portfolio do badly, the effects are counterbalanced by others that
are doing well. This source of risk is also called unsystematic or
diversifiable risk.
 Systematic or relevant risk relates to variability in returns stemming
from macro-factors, both political and economic, which impact on the
fortunes of all firms, such as interest and exchange rate changes. As
such factors impact on the stock market as a whole, they will be
reflected in movements of the market index (or market portfolio). The
impact of these factors cannot be diversified by portfolio formation
although the extent of the impact may vary between companies. This is
also called market risk.
As an investor builds in more and more securities into his or her portfolio,
the overall risk (for example, measured by the standard deviation of
returns) diminishes as specific risk is reduced. Market risk cannot be
removed (except by diversifying into the stock markets of other countries
or into other asset classes.) It is suggested that an investor needs 25 or so
securities – spread across a variety of industrial sectors – in order to
exploit the major part of the risk-reducing potential of diversification.
In relation to individual securities, the relevant risk is the market-related

risk. An efficient capital market does not reward people for bearing risk
that rational investors would eliminate by portfolio diversification. The
market risk of a single security is measured by its beta value, which
124 Bradford MBA

reflects the extent to which the return (including both dividend and capital
appreciation) on the security varies in response to, or in association with
variations in the overall market returns. Observations are made of
variations in both stock and market returns over a period of time and a
regression line is fitted to the resulting scatter of points. The slope of the
line best fitting that scatter is the beta, or beta coefficient.
Using your knowledge of regression analysis, determine the line of best fit
and hence the beta value from the following data.
Month Return on shares of XYZ Return on stock market

1 12% 10%
2 7.2% 6%
3 30% 24%
4 28.8% 20%
You should find that the regression line is a perfect fit with slope of 1.2!
What is the significance of this beta value?
A beta of 1.2 means that when the stock market offers a return of, say,
10%, this security on average can be expected to earn a return of 12%.
Hence, movements in the return on this stock generally outweigh
movements in the return on the market (in both directions). Such a stock is
said to be aggressive. A defensive stock has a beta of less than one. In
this example, because every observation lies on the line of best fit,
variations in the market return due to factors affecting all firms perfectly
explain variations in the return on the company in question. In other words,
all risk is attributable to systematic risk.
The London Business School publishes a quarterly Risk Measurement

Service (available in the Bradford University Library) which gives the beta
values of all companies in the UK FT-All share Index. These betas are
based on monthly observations over the preceding five years and thus
give 60 data points. They tend to be quite stable, period-to-period, as 57
observations are retained for each updating.
Watch: Phillip (2008) Beta Calculation on Excel. YouTube, 2 March

(Canvas > Dashboard > Module Tile > Module Materials > Unit 7 > Activity
7.3)
Bradford MBA 125

Why do betas tend to cluster around 1.0?

The overall market has a beta of 1.0 by definition (why?), and these large
companies make up a significant part of the market index itself. In
addition, these companies are usually well-diversified in themselves – they
tend to have eliminated a major part of their respective specific risks.
The key relationship: security market line (SML)

The CAPM postulates an important condition for the equilibrium in an
efficient capital market: all securities will plot along a linear relationship or
the security market line (ERj). This indicates how large a risk premium is
appropriate when assessing the rate of return that investors seek.
Generally the higher the beta, the indicator of systematic risk, the higher
the required return. The equation of the SML is:
ERj = Rf + j [ERm – Rf ]
Where ERj = return that investors require on security j
Rf = return on a risk-free asset, such as government stock
ERm = expected return on the overall market
j = beta coefficient for security j
The term in the square brackets [ERm – Rf] is called the market risk
premium – in other words how much extra return should be expected for
investing in a risky asset rather than the risk-free rate. In practice, this is
what we generally estimate (rather than the expected return on the
market). You can find more information on estimating this premium in the
additional learning resources at the end of this unit.
Key characteristics of CAPM
We can now summarise the key lessons of the CAPM.

 Only the systematic risk is relevant for assessing the rate of return
required by shareholders as efficient markets do not offer a reward for
bearing specific risk.
 The required return on a security depends on its relationship, as
indicated by the beta, with the return on the whole market. Securities
that are relatively immune from general macroeconomic factors have
low betas and thus relatively low required rates of return.
 To define the return which people require from an ordinary share, we
need to know:
126 Bradford MBA

(i) its beta value
(ii) the risk-free rate, usually taken to be the return on very short-dated
government stock such as Treasury bills (for the UK).
(iii) the expected excess return on the whole stock market over the risk-
free rate, called the equity premium. Generally, the historical
premium of around 5–7% is taken for this purpose, although the
investor may prefer to take a (subjective) view on the future course
of the market. Various studies have shown that this premium is
remarkably similar from country to country, and over time.
 The resulting rate is appropriate for evaluating cash flows from activities
whose risk parallels the existing (systematic) risk of the company. For
activities of differing degrees of risk, the beta of a comparable company
operating in the area of intended investment should be used.
Required rate of return when equity and

debt are combined
How gearing affects the required return

Consider the two cases below. These relate to two otherwise identical
companies.
Case 1 Company has zero gearing

Shareholders’ funds = £100m
(par value of shares = £1)
Shareholders require a return of 20%
Case 2 Shareholders’ funds = £75m

Long-term debt = £25m
(Gearing = 25%) if measured by (debt)/(debt + equity)
Interest rate on debt = 10% (after-tax)
Using these figures, we can see how use of debt affects the required
return on investment. In Case 1, with zero gearing, the company has to
achieve a return of 20% (or more) on new projects, as this is the return
being sought by shareholders.
In Case 2, assuming its shareholders also want a 20% return, the overall
required return becomes a weighted average of the component required
returns. Thus the cost of each type of finance is weighted according to its
contribution to the overall capital structure. Thus, so long as the firm
Bradford MBA 127

adheres to 25% gearing, the overall return, or weighted average cost of

capital (WACC):
= (cost of equity  % of equity) + (post-tax cost of debt  % of debt)
At a gearing of 25%, the weights are 75% equity and 25% debt and the
WACC is:
(20%  0.75) + (10%  0.25) = 17.5%.
This is the minimum rate of return required to keep all investors happy. A
WACC less than 20% means that a wider range of projects now becomes
available to the company and there is greater scope for creating value.
The lower discount rate applied to projects as part of the capital
investment appraisal process will give higher NPVs (in most cases) and
make some projects with a negative NPV at 20% positive at a rate of
17.5%.
Under what conditions is the WACC a valid investment cut-off rate? In

other words, what limitations does it have as a discount rate?
 The WACC implies that project financing involves no change in gearing.
 The WACC implies that the new project is in the same risk category as
the company’s other projects and is thus OK for minor projects in
existing areas.
 The WACC implies that the project is marginal so is a small addition to
existing activities with no spillover effects.
 So long as these conditions apply, the WACC can be used to appraise
new investments.
Watch: Estimating WACC (Canvas > Dashboard > Module Tile > Module
Materials > Unit 7)
Gearing and company value

Read: Pike et al. (2015), Chapter 18: 546–552, Chapter 19: 559–569 and
573–574
For a geared company, the lower WACC opens up a wider vista of

attractive wealth-creating opportunities. Another route to higher value is
the substitution of equity with debt via the currently highly popular
mechanism of a debt-financed share repurchase or buyback. We can
examine this by working through the next activity.
128 Bradford MBA

The following figures relate to the situation before the company

undertakes a share repurchase.
Debt = 0
Profit before tax = £20m
Shareholders’ funds = £100m
(par value = £1)
(Assume no corporate tax for simplicity)
Earnings per share = 20p
P:E ratio = 5
Share price = (5  20p) = £1
The buyback: The company borrows £25m debt in order to replace 25m
ordinary shares (interest rate = 10%). There are no other changes in either
operating or financial policy.
What is the effect on EPS and on the share price?
Bradford MBA 129

Optimal gearing ratio

There are limits to how far a company should push its gearing before the
risks of financial distress become too high. Until it reaches these limits,
careful use of debt finance can make shareholders better off as shown in
Figure 7.1. One task of the financial manager is to explore the frontiers of
permissible gearing until the critical gearing ratio, where value is
maximised, is discovered. Notice that, as drawn, the cost of equity is
constant over modest gearing ranges. It is questionable as to whether
equity holders will not respond at all to increases in gearing. Some
theorists argue that they will react immediately to any increase in gearing
by demanding a higher rate of return so as to neutralise the supposed
benefits of gearing. This is really an empirical issue. All we can conclude is
that debt can be advantageous so long as shareholders do not ‘scare
easily’, and if they do, there are still the tax advantages of debt to
consider. On balance, the WACC probably does fall over some range.
Figure 7.1: The ‘magic’ of gearing
Cost of
capital
Cost of equity
WACC
Cost of debt
*
Financial distress
The top section of Figure 7.1 paints quite a remarkable picture – it
suggests that a company can keep raising its value by gearing up the
capital structure! However, this situation must end as both lenders and
shareholders come to question the company’s ability to maintain ever-
130 Bradford MBA

increasing interest payments and the threat of insolvency will begin to

loom. As a company approaches and reaches the point of insolvency, it
will incur various costs in trying to avert the danger, or if the worst
happens, the costs of insolvency itself. These are called financial
distress costs. The word ‘cost’ here should be interpreted broadly to
include the costs of lost opportunities.
Can you list some of the direct and indirect costs a company may incur as
it approaches or reaches financial insolvency?
Summary
In this unit, we have covered a lot of ground. We have looked at the costs
of debt and equity respectively, and have shown how to combine them in
assessing the overall rate of return for a company financed by a mixture of
debt and equity – the WACC. This led on to our discussion of some
benefits of combining debt and equity, in particular, a lower cost of capital
and higher equity value. However, capital market imperfections associated
with financial distress and insolvency can offset the net benefits from
leverage due to taxes and agency costs.
Bradford MBA 131

Brealey Foods plc produces a range of processed foods for large

supermarket chains. The existing capital structure of the company is as
follows:
£m
£1 ordinary shares 60
Retained profit 40
Long-term loans 10% 50
150
The company has no plans to change its capital structure in the

foreseeable future. The ordinary shares are currently being traded on the
stock exchange at £3.20 per share and a dividend of 16 pence has
recently been paid. The dividend per share is expected to grow at a
compound rate of 4% per annum for the foreseeable future. The loan
capital issued by the company is irredeemable and has a current market
value of £92 per £100 nominal and interest due at year end has also
recently been paid.
The directors of the company are currently considering the acquisition of a

large fish-breeding farm. This would be a new venture for the company
and would require a large investment. The company uses discounted cash
flow techniques for screening new investment projects, however, the
directors are unable to agree on the appropriate discount rate to use in
their investment appraisal.
Director A believes that the cost of capital should be used and that the
appropriate figure, in this case, is the cost of long-term loan capital. He
argues that, as the funds employed for the venture will be raised from this
source, this represents the actual cost of funds used.
Director B also believes that the cost of capital should be used. However,
she argues that the weighted average cost of capital should be used as
this represents the overall cost of funds used by the company.
Director C believes that the risks associated with the venture are higher
than those of the existing business in which the company is engaged and,
as the proposed investment is large, a risk-adjusted discount rate should
be used. Brealey’s beta coefficient is 0.8.
Director D argues that the company has a target return on long-term

capital employed (ROCE) ratio of 15% and that the venture should only be
132 Bradford MBA

considered if this hurdle rate is achieved. The discount rate should,

therefore, be based on this hurdle rate.
In your calculations you should assume that the current rate of return on
government long-term bonds is 6% and the rate of corporation tax is 25%.
A leading security analyst expects the FTSE Index to yield an average
overall return of 12% in the foreseeable future.
Task 1: Calculate the discount rates which have been proposed by

Directors A, B and C.
Task 2: Comment on each of the four director’s arguments concerning the

appropriate discount rate to be used and state which of the discount rates,
if any, you would recommend.

Read: Ghoul, S.E.I., Guedhami, O., Kwok, C.C.Y. and Mishra, D.R. (2011)
Does corporate social responsibility affect the cost of capital? Journal of
Banking and Finance 35, 2388–2406 (Canvas > Dashboard > Module Tile
> Module Materials > Unit 7).
Task 1: Briefly outline different methods for calculating the cost of capital
for a firm.
Task 2: Compare and contrast the results of this article with the article that
you read in Unit 1.
Bradford MBA 133

Activity 7.10 –concluding questions answers:
Read: Online Live Tutorial 4 (Canvas > Dashboard > Module Tile > Online
Tutorials > Activity 7.12).
Read the case and answer the questions provided. You will need to use a
spreadsheet such as Excel to solve the problem.

Burton, J. (1998) Revisiting the Capital Asset Pricing Model.

https://web.stanford.edu/~wfsharpe/art/djam/djam.htm Accessed 1 June
2018.
Fernandez, P., Ortiz Pizarro, A., P. and Fernández Acín, I. (2016) Market
Risk Premium Used in 88 Countries in 2014: A Survey with 6,932. Social
Science Research Network. http://ssrn.com/abstract=2776636 Accessed 1
June 2018.
134 Bradford MBA

References
Ghoul, S.E.I., Guedhami, O., Kwok, C.C.Y. and Mishra, D.R. (2011) Does
corporate social responsibility affect the cost of capital? Journal of Banking
and Finance 35, 2388–2406.
Phillip (2008) Beta Calculation on Excel. [Video] YouTube, 2 March.

https://www.youtube.com/watch?v=7LiK-qbmPsw Accessed 1 June 2018.
Bradford MBA 135

Unit 8:
Delivering Value
Key reading:
1. Pike et al. (2015), Chapter 17. You will find that the dividend valuation
model covered in Chapter 3, Section 8 and the total shareholder return
in Chapter 9, Section 3 also apply here.
2. Mauboussin, M.J. (2012) Share Repurchase from All Angles. Legg

Mason Capital Management (Canvas > Dashboard > Module Tile >
Key video:
1. Wall St Training Self-Study (2008) WST: Share Repurchase Part 1.
YouTube, 8 July (Canvas > Dashboard > Module Tile > Module
Other:
Introduction
Throughout this module, we have emphasised that the focus of corporate
finance is on value creation. We have placed relatively little stress on the
issue of how to deliver this wealth to shareholders. When a company is
already profitable and has good future prospects, wealth has been
created but how should this wealth be delivered? It could be in the form of
annual dividends to shareholders or as further capital appreciation. At the
outset, you should be able to see a paradox here. If high dividends are
paid, the company may have insufficient capital to finance future growth –
although this implies some deficiency in the capital market’s ability to
supply finance for worthwhile projects. Conversely, too low a level of
dividend may starve investors of ready income and may even give the
impression that the company is highly risky. High retention and high
liquidity may signal that the company expects difficult trading conditions in
the future, and wants to build a financial cushion.
You will find that this issue of signalling dominates analysis of dividend
decisions. For example, if a company raises its dividend, it may convey the
Bradford MBA 137

information that it is confident that future earnings will be sufficiently

buoyant to at least maintain, and hopefully increase, this higher dividend.
Why is this? Simply, because no financial manager will ever want to cut a
dividend except under extremely adverse conditions. To cut a dividend is
regarded as the ultimate sign of financial incompetence on the part of
directors, as well as signalling desperate future prospects for the
company.
Hence, to avoid ever having to cut a dividend, the astute financial

manager will avoid increasing dividend levels to possibly unsustainable
levels. Even in extreme situations, managers will strive to pay dividends,
even dipping into reserves to do so by running down retained earnings.
This generally requires borrowing to mobilise the required cash.
Remember that dividends are paid out of profits – from both this year’s
and previous years’ profits – but with cash.
Running through this introduction is the notion that dividend decisions, like
any other financial decision, convey information. They are said to have
information content. Managers are generally reluctant to convey too
much ‘hard’ information for understandable commercial reasons, so the
market seizes on what information is available and interprets this
accordingly (and sometimes wrongly). This underscores the need for care
in releasing financial information.
Objectives
 describe how shareholders receive their overall returns
 evaluate the argument of dividend irrelevance
 argue the question of why companies pay dividends at all
 identify the key determinants of dividend policy.
Total shareholder return (TSR)

It is worth beginning this analysis by looking again at the notion of overall

shareholder return. TSR is comprised of the dividend paid over a particular
period (t) and the capital gain or loss in the share price. The TSR is
normally expressed as a percentage, and in symbols, it is:
TSRt = Dt  (SPt 1  SPt )

SPt
where SP = share price
138 Bradford MBA

Unit 8: Delivering Value
Dt = dividend paid in time t
For example: in 2009, XYZ plc paid a dividend of 10p per share and its
share price grew from £1.89 on 1 January to £2.07p on 31 December.
What was the TSR in 2009?
10p  (207p  189p)  100

TSR in 2009 
189p
28p
  100  14.8%
189p
Notice that this return is made up of two components.
D
(i) percentage dividend yield t = 10p =5.3%
SP 189p
t
SPt+1 – SPt 18p

(ii) percentage capital gain = =9.5%
SPt 189p
Over half of the return (as typically applies) is in the form of capital
appreciation.
Can you identify any limitations with this way of looking at shareholder
returns? For further information on this way of considering shareholder
returns go to p.208 in the textbook.
Bradford MBA 139

Theories of dividend policy

Read: Pike et al. (2015), Chapter 17: 487–508.
There are three principal theories of dividend policy.

 The residual school/dividend irrelevance. This says that a firm
should only pay a dividend once worthwhile investment opportunities
have been financed. Company value is driven by cash flows that result
from worthwhile investment not by dividends per se.
 Dividend relevance. Some people agree that the future dividends
expected to be paid out of the cash flows generated by investment
financed by retentions are inherently more risky than dividends paid
now. Investors are said to prefer early resolution of uncertainty and
thus value today’s dividend more highly than any future dividends.
 Pragmatists. Most people argue that it is too difficult to generalise
about a company’s dividend policy – it depends on the particular
circumstances of the company. We can identify the factors that should
be taken into account but not all may apply, or they may apply to
different firms in varying degrees.
We will look at these three positions in this order.
Dividends as a residual or dividend

irrelevance
This line of argument says that a firm should use retained earnings to
finance the pool of worthwhile investment and only pay a dividend if there
is an unspent residue of cash. In its most basic form, it implies that the firm
is not able to access external supplies of capital.
ABC plc has the following set of projects available to invest in. Its WACC is
20%. How much dividend should it pay? Retained earnings, held as cash,
are £90,000.
Project IRR Outlay required

A 32% £28,000
B 28% £12,000
C 24% £20,000
D 22% £10,000
E 21% £10,000
F 15% £10,000
140 Bradford MBA

Notice that ABC could finance all these projects internally, but F is
unattractive. So projects A–E would be recommended, requiring a total
outlay of £80,000, leaving £10,000 available for dividend payment. If the
IRR on project E was less than 20%, the dividend would be £20,000.
Notice that there may be problems in cases where projects are indivisible
like this.
Dividend cuts
Under this view, it may even be advisable to cut the dividend if worthwhile
projects are available. Consider the following case.
 A company will operate for three further years.
 Shareholders seek a 10% return.
 On present policies, its expected end-year cash flows are:
– £100 year 1
– £100 year 2
– £100 year 3
 All cash flows are usually paid as dividends.
 It now proposes a new venture which involves:
– retention of year 1 earnings
– investment in a one-year project with a single cash flow of £120
– reversion to 100% pay-out in year 2.
Question 1: What is the impact of accepting this project on the value of

the company?
Question 2: Respond to the argument that earnings retention would

penalise those shareholders dependent on a steady stream of income
from dividends.
Bradford MBA 141

Using external finance

The preceding discussion implies no external access to finance. If external
financing is allowed, a company can pay a dividend and still undertake as
much investment as it desires. We will now widen the analysis to allow for
equity financing via a rights issue. There are now two alternative methods
of financing investment:
 cut dividends and finance from retention
 pay the dividend and ‘claw back’ the required finance via a rights issue.
If we can show that shareholder wealth is unaffected and remains the

same under each financing option, then dividend policy really is irrelevant.
Consider the following case.

 An ungeared company has just made earnings, held as cash, of £100
and expects to earn the same level in future years from existing
activities.
 Its shareholders require a return of 10% per annum; normally it would
make a 100% pay-out.
 It has available a project requiring an outlay of £100 (this is equal to the
dividend which it would normally pay (100% of £100), and which is
expected to generate a perpetual cash flow of £20 per annum.
1. What is the value of the company now?
2. What is the NPV of the project?
3. What is shareholder wealth under each of the financing options
identified above?
Solution
Value of company before the dividend is paid
= Cash + PV of future cash flows

£100
= £100 + = £1,100
0.1
NPV of the project


£20
= – £100 + = +£100
0.1
(i.e. it is acceptable)

142 Bradford MBA

Shareholder wealth
(i) Using retentions
Shareholder wealth
= Dividend + PV of cash flows + PV of cash flows

for existing projects from new projects
£100 £20
= 0 + +
0.1 0.1
= 0 + £1,000 + £200 = £1,200


Wealth increases by the NPV of the project.
(ii) Using a rights issue
Shareholder wealth
= Dividend + PV of cash flows + PV of cash flows – Cost of

for existing projects from new projects undertaking
project
(= proceeds of
rights issue)
£100 £20
= £100 + + – £100
0.1 0.1
= £100 + £1,000 + £200 – £100

 
= £1,200
Since the wealth of shareholders is the same under each alternative, the
method of finance is irrelevant. Hence, whether the company pays a
dividend or not is immaterial.
Evaluation of the irrelevance argument

To many investors this is a surprising conclusion. Some models of
shareholder value, for example, the dividend valuation model, stress the
role of dividends, yet here we seem to be saying that dividends are
irrelevant! How can we reconcile these apparently conflicting positions?
Dividends are important – most people would prefer more dividends to

less, other things being equal. Yet dividends may impose a cost, for
example, if a worthwhile investment cannot be financed. What drives
company value is thus the investment decision and the resulting cash
flows (and their degree of risk) rather than the way that value is delivered.
Bradford MBA 143

Thus it is the actual pattern of the dividend flow that is important. In

other words, to quote one authority, ‘for a company acting in the best
interest of its shareholders, dividend policy is a mere detail’. Put another
way, if in Activity 8.2 we strip out the effect of the investment decision by
assuming zero NPV, we would find that the impact of the dividend cut was
totally neutral. Any effect on the company value thus only comes through
the impact of the investment decision.
Dividend relevance
The previous conclusion on dividend irrelevancy may sound perfectly
logical in theory (it is!) but what ‘practical’ objections would you make
about this notion?
You may have considered some of the following issues.
1. In reality, investors may be unwilling or unable to ‘home-make’

dividends by selling shares.
2. Shareholders may, in reality, prefer ‘near’ dividends to ‘distant’

dividends.
3. Rights issues are not always received favourably by investors.
4. Tax implications may drive investors towards a clear preference for or

against dividends.
5. If in the past, the company has used the dividend decision to convey
information, news of a dividend cut will not be greeted with equanimity.
For these reasons, dividends may be highly relevant! We will now deal
with these objections to dividend irrelevance.
Objections to dividend irrelevance

Why might investors object to having to ‘home-make’
dividends?
 They may incur dealing fees.
 Decisions to deal involve time and inconvenience.
 Significant share sales may lower share price. If a large percentage of
shareholders are income-dependent, their selling pressure may drive
share price down if the market demand for the company’s shares is less
than perfectly elastic.
 Having to sell shares to realise a capital gain may trigger a capital gains
tax liability.
144 Bradford MBA

Do you think investors may actually prefer ‘near’ dividends –

the so-called ‘early resolution of uncertainty’?
 This is a more complex issue. Retention of earnings, even if wisely
invested, postpones income. Hence, shareholders in a company which
pays lower dividends now to finance (albeit worthwhile) investment,
have to wait longer for the (hopefully) higher dividends to be paid out of
the higher future profits generated. Myron Gordon, who introduced the
dividend valuation model in 1959 (which is sometimes called the
Gordon growth model) argues that shareholders will resent having to
wait longer, especially due to the higher risk associated with more
distant dividends. He argues that people discount more distant
dividends more heavily to allow for risk. This implies investors believe
risk increases over time.
 However, this may not be the case – in many projects, for example,
R&D-intensive ones, the risk is ‘front-loaded’ and may even decline
over time. Moreover, even if risk does increase over time, this aspect
should already have been allowed for in the discount rate when
evaluating the cash flows from the project in the first instance. To
further discount the dividends paid out of those cash flows ‘to allow for
risk’ would be to double-count for risk. The higher risk is reflected in the
project cash flows not in the dividend payments. For this reason,
Gordon’s argument is usually dismissed as the bird-in-the-hand
fallacy. Admittedly, if the company has a poor record with reinvestment,
then it might be logical to look critically at more retention even when
higher future dividends are predicted by managers. But this is a reaction
to investment policy (or competence) rather than dividend policy.
We examined the mechanics of a rights issue in Unit 6. Why

may investors resent the announcement of a rights issue?
 A rights issue is always made at a discount to the market price resulting
in earnings dilution and a fall in share price. However, this should not
damage the shareholder if he or she takes up the rights or sells them in
the market. This ‘problem’ is purely psychological.
 The rights issue forces the investor to act, thus imposing the costs of
time and inconvenience.
 A rights issue can result in 3% or more of the money raised being lost
as advisers’ and underwriters’ fees and the company’s own
administrative costs.
 If the rights are sold, the investor incurs dealing fees.
 If the rights are taken up, the investor may end up holding rather more
of the company’s shares than he or she might have wished, thus
disrupting the balance of the portfolio.
 A rights issue needs careful timing if the bulk of the shares are not to be
left with the underwriters. Despite being paid to bear this risk,
Bradford MBA 145

underwriters bitterly resent having to perform, and few companies

recover their image and credibility after a ‘failed’ rights issue.
 A rights issue may alarm investors if the reasons for the issue are not
made very clear. The information content is important here. For
example, a rights issue with a deep discount may signal that the
company is really anxious to raise cash. If the company has a poor
track record with acquisitions, then the reaction to a rights issue, if it is
intended to finance further acquisitions, may be adverse.
How does the system of personal taxation affect investors’

relative preferences for dividends and capital gain via
retention?
 The precise answer depends on where you live! In the UK, it is
generally true to say that high-rate taxpayers prefer retentions and low-
or no-rate taxpayers prefer dividends. Both dividends and capital gains
are taxed as income although the relief and allowances generally favour
retentions. For 2015–2016, the UK is operating the following levels of
personal income taxation:
Taxable income Rate of tax
£0 – £31,785 20%
£31,786 – £150,000 40%
Over £150,000 45%
 For capital gains, the rate of tax depends on how long the asset is held
for. The rate of tax declines with the holding period; inflation-indexing is
applied to the period 2015–2016; and the first £11,100 of gain is exempt
from tax. With careful planning, capital gains tax can often be avoided
altogether – remember, you only pay it when you realise the gain,
whereas income tax on dividend payments is paid automatically by the
company distributing the dividend.
Personal taxation can vary significantly between countries. How do you

think the relative preference for dividends and capital gain is affected by
the tax system in your own country?
146 Bradford MBA

Dividend policy: key determinants
Watch: Wall St Training Self-Study (2008) WST: Share Repurchase Part

1. YouTube, 8 July (Canvas > Dashboard > Module Tile > Module
This 8-minute video clip will provide a brief discussion on dividend policies
adopted during the recent banking crisis.
If a company had full knowledge of its shareholders’ desires and tax

positions it would tailor its dividend policy as follows.
1. The time preference of the shareholding body and thus their relative
preferences for income now against future income as governed by
factors such as their age profile.
2. The relative tax efficiency of dividends and capital gains – for example,
a predominance of non-taxpayers might suggest orientation towards
relatively high pay-outs.
3. The perceived information content of dividend decisions. The company

would bear in mind that dividend cuts, although justifiable in terms of
accessing investment projects cause severe damage, and dividend
increases may encourage unrealistic expectations of even higher future
dividends.
The reality is rather difficult. Although the aim of tailoring dividend

decisions to the particular needs of shareholders may be laudable, it is
almost impossible to obtain sufficient information about their needs and
desires. Shareholders are simply too widely dispersed. Often, a company
will consult ‘key’ shareholders such as the institutional investors but this
raises the danger of dividend policy being driven by a small select band of
shareholders.
Bradford MBA 147

Instead, companies generally try to follow a stable dividend policy

involving either a relatively high or low pay-out, but with regular increases
in the dividend. In this way, the company attracts a clientele of
shareholders for whom its particular dividend policy is appropriate.
Shareholders then develop confident expectations about future dividends
and can plan their affairs accordingly. ‘What you see is what you get’
would sum up this approach. This does, of course, underline the need not
to abruptly change the dividend policy – people do not like shocks! This
would apply to sharp dividend increases as well as decreases. People are
not always able to deal with a sudden increase in liquid assets and a
dividend increase may impose tax penalties.
With such a policy, the dividend would be smoothed and the company
would pay regular and steady increases even though earnings per share
may fluctuate. This would leave the pay-out ratio to rise and fall with
variations in reported earnings.
Share buybacks
Increasingly, companies are finding that they are accumulating large

stockpiles of cash. Rather than worrying about dividend costs, the focus
changes – these companies are looking at ways of utilising these cash
surpluses, including higher dividends as one alternative. Many cash-rich
companies use a share buyback as a way of returning value to
shareholders by repurchasing shares off the stock market (and then
destroying them). This is not totally tax-efficient in some countries and may
not be legal in others but it has been practised in the UK since 1983
(following the 1981 Companies Act) when GEC became the first British
company to repurchase its own shares. At first glance, this seems an odd
tactic, as it appears to deliver important negative information – that the
firm has no worthwhile investment opportunities. Further information can
also be found in the additional learning resources.
Summary
In many ways, the ground covered in this unit represents the most
fascinating aspect of corporate finance – having created wealth, how
should a company deliver that wealth to its owners?
We looked at the notion of overall or total shareholder return (TSR) and

discussed the factors which determine whether a company should pay a
‘high’ or a ‘low’ dividend. In principle, dividend decisions are linked to the
investment decision as too high a dividend may preclude worthwhile
investment. However, this link is broken if the company has easy access
to external capital markets. In theory, dividends are irrelevant, but in
148 Bradford MBA

practice, there are several important influences on the dividend policy of a

company. The safest policy is to develop a clear dividend policy thus
attracting a clientele of investors for whom that policy is suitable, and then
adhere to that policy over time.
Phoenix plc, which manufactures building products, experienced a sharp

increase in operating profit (i.e. profits before interest and tax) from £25m
in 2009–10 to £40m in 2010–11, as the economy emerged from recession
and demand for new houses increased. The increase in profits has been
entirely due to volume expansion, with margins remaining static. It still has
substantial excess capacity and therefore no pressing need to invest,
apart from routine replacements.
Phoenix has followed a rather conservative financial policy, with restricted

dividend payouts and relatively low borrowing levels. It now faces the
issue of how to utilise an unexpectedly sizeable cash surplus. Directors
have made two main suggestions. One is to redeem the £10m secured
loan stock issued to finance a capacity increase several years previously,
the other is to increase the dividend payment by the same amount.
This is Phoenix’s present capital structure.
£m
Issued share capital (par value 25p) 70
Reserves 130
Creditors falling due after more than one year:
7% secured loan stock 2019 10
Further information
Phoenix has not used an overdraft during the two years.
Phoenix pays corporate tax at a rate of 33%.
The last dividend paid by Phoenix was 1.50 pence per share.
Sector averages currently stand as follows:
dividend cover 2.6 times

gearing (long-term debt/equity) 45%
interest cover 6.5 times
Bradford MBA 149

Question 1: Calculate the dividend payout ratios and dividend covers for
both 2009–10 and for the reporting year 2010–11, if the dividend is raised
as proposed.
Question 2: You have recently been hired to work as a financial strategist

for Phoenix, reporting to the finance director. Using the information
provided, write a report to your superior, which identifies and discusses
the issues to be addressed when assessing the relative merits of the two
proposals for utilising the cash surplus.
Dashboard > Module Tile > Formative Exercises > Multiple-Choice
Questions > Unit 8).

Read: Mauboussin, M.J. (2012) Share Repurchase from All Angles. Legg
Mason Capital Management (Canvas > Dashboard > Module Tile >
Why do firms engage in buybacks? Address this question from the point of
view of company executives, prospective shareholders, current
shareholders and the media.
Activity 8.8 – concluding question answer:
150 Bradford MBA


Allen, M., Oded, J. and Shaked, I. (2010) Not all buybacks are created
equal: the case of accelerated stock repurchases. Financial Analysts
Journal 66(6), 55–72.
Wall St Training Self-Study (2008) WST: Share Repurchase Part 1.

[Video] YouTube, 8 July. https://www.youtube.com/watch?
v=PCO9ByvH5Rw Accessed 1 June 2018.
References
Mauboussin, M.J. (2012) Share Repurchase from All Angles. Legg Mason
Capital Management. https://www.realclearmarkets.com/blog/
MauboussinOnStrategyShareRepurchaseFromAllAngles_MIPX014745.pdf
Accessed 1 June 2018.
Bradford MBA 151

Unit 9:
Revision
Key video:
1. A Conclusion to MBA Corporate Finance (Canvas > Dashboard >
Module Tile > Module Materials > Unit 9) – Activity 9.1
2. Unit 9 – Advice on the Assignment (Canvas > Dashboard > Module Tile
> Module Materials > Unit 9)
In this unit, we will briefly revise the main topics that you have covered in
the module.
Watch: A Conclusion to MBA Corporate Finance (Canvas > Dashboard >

Module Tile > Module Materials > Unit 9)
The video gives an overall picture of the module and the main areas that
have been covered.
The main topics

In Unit 1, we first looked at the role of the financial manager in a modern
corporation, in particular, we highlighted ‘creation of value’ as the centre of
the financial decision. Some important concepts such as value
determinants, key drivers and delivery value were introduced. It is crucial
for you to understand these concepts and to be able to apply them to
company valuation. Finally, the agency problem and corporate
governance were discussed.
In Units 2 and 3, we focused on the valuation of companies from different

points of view. We started with the concept of market efficiency and
broadly discussed how the stock market values a quoted company and the
importance of stock-market efficiency in setting ‘correct’ values. Then we
moved on to valuing unquoted companies using alternative valuation
techniques. The three well-known and widely used valuation methods of
net asset value, price:earnings ratio and discounted cash flow were
discussed in the context of company valuation. Furthermore, we presented
the concepts of shareholder value analysis, Economic Value Added and
Bradford MBA 153

Market Value Added, which provide a framework for linking management

decisions and strategies to value creation.
In Unit 4, we reviewed your understanding of the mechanics of investment

appraisal methods – payback, accounting rate of return (ARR), IRR, PI,
and NPV applying discounted cash flow (DCF) approaches. We then
concentrated on how practical problem aspects such as taxation and
inflation can be handled in project appraisal.
In Unit 5, we focused primarily on the problem of imperfect information and

concentrated on two methods of managing risk, i.e. sensitivity analysis
and the use of probability. It is important to realise that none of these
methods of risk analysis is perfect. They are simply ways of trying to
explore the risk characteristics of a project and to understand its dynamics
more clearly. If we know what can go wrong and the likelihood of this
happening, we are more able to take the evasive actions that we identified
under project management.
How to raise finance is another important issue in corporate finance. In

Unit 6, we examined the ways in which a company’s activities can be
financed, with particular emphasis on both short-term and long-term
financing. Although we emphasised the various types of financial strategy
that a firm may adopt, it is essential that you appreciate the relationship
between working capital management and company financing, and the
fact that, to some degree at least, funds can be obtained from more
efficient management of debtors, stock and short-term creditors. Certainly,
any prospective provider of long-term finance will look carefully at this
aspect.
In Unit 7, we discussed the critical issue of how to determine the rate of

return required on both the company’s existing operations and also on
new investment projects. We looked at the costs of debt and equity
respectively, and showed how to combine them in assessing the overall
rate of return for a company financed by a mixture of debt and equity – the
WACC. This led to our discussion of some benefits of combining debt and
equity, in particular, a lower cost of capital and higher equity value. The
reason for such benefits is because the use of debt finance generates a
tax shield, the value of which accrues to the owners of the company.
In Unit 8, we focused on how to deliver value to shareholders. We looked

at the notion of overall or total shareholder return (TSR) and this focused
on the factors that determine whether a company should pay a ‘high’ or a
‘low’, or even a reduced dividend. In principle, dividend decisions are
linked to the investment decision, as too high a dividend may preclude
worthwhile investment. However, this link is broken if the company has
easy access to external capital markets. In theory, dividends are
irrelevant, but in practice, there are several important influences on the
dividend policy of a company. The safest policy is to develop a clear
154 Bradford MBA

Unit 9: Revision
dividend policy, thus attracting a clientele of investors for whom that policy
is suitable, and then adhere to that policy over time.
Advice on assignment
Watch and listen: Advice on the Assignment (Canvas > Dashboard >
Module Tile > Module Materials > Unit 9)
There is a short video and a short audio recording with some advice on
how to complete the assignment successfully. Good luck!
Bradford MBA 155

Appendix A:
Module Descriptor
Module Title: Corporate Finance
Module Credit: 10
Module Code: AFE7031-A
Academic Year: 2017/18
Teaching Period: July intake Programmes
Module Occurrence: A
Module Level: FHEQ Level 7
Module Type: Standard module
Provider: School of Management
Related Department/Subject Area: Accounting, Finance and Economics
Principal Co-ordinator: Xiaoxia Ye
Additional Tutor(s):
Prerequisite(s): AFE7003-A Business Accounting
Corequisite(s): None
Module aims
To consolidate and develop students’ knowledge of financial decision-
making and to promote an understanding of how capital markets operate,
how companies are valued and how markets shape the financial
manager’s operating context.
Bradford MBA 157

Learning, teaching and assessment strategy

To gain a firm understanding of the subject area and the key issues (as
outlined in the syllabus) students will be required to access and engage
with a variety of online resources (selected readings, video and audio
resources) a designated set text and a module study book that sets out
guided reading, self-assessment exercises, case studies and links to
additional resources. This relates to module learning outcomes: 2a. In
addition students attend a series of tutorial sessions. These sessions allow
the students to reflect on their learning further applying key academic and
practitioner based models and frameworks thereby gaining a detailed
understanding. This relates to module learning outcomes: 1a, 2a, 2b, 2c.
Students have the opportunity to complete a series of online MCQ

exercises for each module unit studied. After completing the questions
students receive instant feedback on their performance. In addition to this
there is the option of completing two formative tasks. These tasks involve
answering a question(s) on a key issue/theory relating to the module.
Written feedback is provided by the module tutor. This relates to module
learning outcomes: 2a, 2b.
The individual assignment is designed to test students – this relates to

module learning outcomes: 1a, 2a, 2b, 3a, 3b. The assignment allows
students to gain an understanding of corporate finance and explores a
number of areas within the module by applying their learning to a real
company.
Module learning outcomes
1. Knowledge and understanding:
On successful completion of this module you will be able to:
a) Demonstrate a comprehensive understanding of the capital market’s

function, and the role of the financial manager of the modern
corporation.
2. Subject-specific skills:
a) Demonstrate an understanding of gearing and an appreciation of the

factors that impact upon it, calculating the cost of capital and valuation
of organisations.
b) Demonstrate the ability to value companies and to advise on different

methods of financing companies.
158 Bradford MBA

Appendix A: Module Descriptor
c) Assess the financial sustainability of the business.
3. Personal transferable skills:
a) Write professional research reports.
b) Critically evaluate academic and practitioner based

information/resources.
Outline syllabus
Overview of financial management: investment and financing decisions,

shareholder value analysis, strategic investment, sustainability. Valuation
of companies: quoted companies and the EMH. Unquoted companies:
using P/E ratios and net asset values and discounted cash flow
approaches. Financial strategy: short-term and long-term finance, working
capital management. Dividend policy. Do dividends matter? The
information content of dividends. Using debt finance; short-term and long-
term debt instruments. Measurement of gearing: impact on shareholder
value and the required rate of return. The return required by shareholders.
Dividend valuation model, return on investment.
Bradford MBA 159

Appendix B:
Model Answers to
Activities
Unit 1
Activity 1.2
The three decisions are:
a. the investment decision
b. the financing decision
c. the short-term capital management decision.
For example, consider the joint venture between Fiat and Chrysler, where
Fiat expanded into North America by using Chrysler manufacturing depots
and Chrysler does the same in Europe using Fiat manufacturing depots.
The investment decision relates to assessing the viability of the joint
venture. The financing decision relates to how best to fund the joint
venture, and the short-term capital management decision relates to the
best way to ensure that both firms have enough liquidity to manage the
expansion without running out of cash.
Activity 1.3
Closing down a loss-making operation rather than pumping in more

resources to turn it round will achieve this. (There may be closure costs,
but these can be presented as ‘exceptional’ and are normally tax-
allowable.) Cutting back on R&D, training and marketing budgets all help
the bottom line but obviously undermine long-term performance.
Bradford MBA 161

Activity 1.4
1. Organisational objectives
The main function of public enterprise is to serve the public interest. In the
case of a water undertaking, it would be responsible for ensuring a safe
and reliable supply of water to households at an affordable price, which
would also require close attention to control of operating and distribution
costs. Prior to privatisation, UK public enterprises were also expected to
achieve a target rate of return on capital which struck a balance between
the going rate in the private sector and the long-term perspective involved
in such operations. The authority would also have faced political
constraints on achieving its objectives in the form of pressure to keep
water charges down and also periodic restrictions on capital expenditure.
One problem faced by such enterprises was their inability to generate

sufficient funds necessary to finance the levels of investment required to
maintain water supplies of acceptable quality.
Once privatised, NEW would be required to generate returns for

shareholders allowing for risk, at least as great as comparable enterprises
of equivalent risk. Moreover, it would be expected to generate a stream of
steadily rising dividends to satisfy its institutional investors with their
relatively predictable stream of liabilities.
Any capital committed to fixed investment would have to achieve efficiency

in the use of resources and to achieve the level of returns required by the
stock market. In the UK, it is alleged that there is an over-concern with
short-term results, both to satisfy existing investors and to preserve the
stock market rating of the company. Although this may safeguard future
supplies of capital, it has militated against infrastructure projects and
activities such as R&D, which generate their greatest returns in the more
distant future.
2. Meeting shareholders’ interests

In financial theory, companies are supposed to maximise the wealth of
shareholders, as measured by the stock market value of the equity. In the
absence of perfect information, it is not possible to measure the
relationship between achieved shareholder wealth and the outright
maximum. However, good indicators of the benefits received by
shareholders are the returns they receive in the form of dividend payments
and share price appreciation.
 Dividends – The pro forma dividend was 7p and by 2008 the dividend
per share had grown by 186% to 20p, an average annual (compound)
growth of around 19%. The pro forma payout ratio was 33%, falling to
162 Bradford MBA

Appendix B: Model Answers to Activities
31% by 2008. This suggests dividend per share has grown by slightly
less than earnings per share (EPS). The pro forma EPS was 21p rising
by 210% to 65p, an average annual increase of about 21%. This
suggests the company broadly wishes to align dividend increases to
increases in EPS over time.
 Share price – Since the share price is not given for 2004 and 2008, we
need to estimate it using the data available. In this case, in 2004 the
EPS was 29p and the P:E ratio was 7, so the price per share was
7  29 = 203p per share. In 2008 the P:E ratio was 7.5 and the earnings
(profit after tax) was 65p per share, so the estimated value was
7.5  65 = 487.5p per share.
Next, we are told that on the first day of issue, the final price is 160p (up
from the £1 issue price). So the percentage increase is given by:
488/160 – 1 = 205%.
To determine an annualised rate (call it Ra), we have:
160  (1+ Ra)6 = 488
if we are looking at annual compounding over 6 years.
Solving this, we get that Ra = (488/160)1/6 = 20.4%
These figures suggest considerable increases in shareholders’ wealth,

and at a rate substantially above the increase in the RPI, however
information about returns in the market in general and those enjoyed by
shareholders of comparable companies are required to act as an
appropriate yardstick.
3. Impact on other stakeholders

i) Consumers
Although NEW’s ability to raise prices is ostensibly restrained by the

industry regulator, turnover has risen by 38% over the period, an annual
average of 5.5%. This is above the rate of inflation over this period
(about 1.3% pa) and also above the trend rate of increase in demand
(2% pa). This suggests relatively weak regulation, perhaps reflecting
the industry’s alleged need to earn profits in order to invest, or perhaps
that NEW has diversified into other, unregulated activities which can
sustain higher rates of product price inflation.
However, before accusing NEW of exploiting consumers, we would

have to examine whether it did lay down new investment, and also how
Bradford MBA 163

productive it had been, especially using indicators like purity and

reliability of water supply.
ii) Workforce
Numbers employed have fallen from 12,000 to 10,000 (17%). The

average remuneration has risen from £8,333 to £8,600.
Employee numbers in 2002 = 12,000
Employee numbers in 2008 = 10,000
Change in employee numbers = 10,000/12,000 – 1 = –16.7%.
Average remuneration = total wage bill / number of employees
Average remuneration in 2002 = 100,000,000/12,000 = £8,333
Average remuneration in 2008 = 86,000,000/10,000 = £8,600
Increase in average remuneration = 8600/8333 – 1 = 3.2%
This 3.2% is a nominal increase, so when the increase in inflation of

approximately 8% is considered, there is a significant decrease in real
wages. This suggests a worsening of the returns to the labour force,
although a shift in the skill mix away from skilled workers and/or a
change in conditions of employment away from full-time towards part-
time and contract working might explain the figures recorded. Certainly,
the efficiency of the labour force as measured by sales per employee
(up from £37,500 to £62,000 – an increase of 65%) has outstripped
movements in pay. However, apparently greater labour efficiency could
be due to product price inflation and/or the impact of new investment.
The directors seem to have benefited greatly. It is not stated whether

the number of directors has increased, but as a group, their
emoluments have trebled. Arguably, this might have been necessary to
bring hitherto depressed levels of public sector rewards into line with
remuneration elsewhere in the private sector in order to retain
competent executives. Conversely, the actual remuneration may be
understated as it does not appear to include non-salary items such as
share options, which would presumably be very valuable given the
share price appreciation that has occurred over this period.
iii) The macro-economy
There are numerous indicators whereby NEW’s contribution to the

achievement of macroeconomic policies can be assessed. Among
these are the following:
164 Bradford MBA

(a) Price stability
Via its pricing policy – NEW’s revenues have risen by 38% in nominal
terms and 30% in real terms. This questions the company’s degree of
responsibility in cooperating with the government’s anti-inflationary
policy.
Via its pay policy – There is evidence that NEW has held down rates of
pay, but if this has not been reflected in a restrained pricing policy, then
the benefits accrue to shareholders rather than to society at large.
Moreover, the rapid increase in directors’ emoluments is hardly anti-
inflationary, providing signals to the labour force which are likely to sour
industrial relations.
(b) Economic growth
Via its capital expenditure – Higher profitability has been implicitly

condoned by the regulator in order to allow NEW to generate funds for
new investment. This appears to have been achieved. Capital
expenditure has nearly quadrupled. As well as benefiting the industry
itself, this will have provided multiplier effects on the rest of the
economy to the extent that equipment has been domestically sourced.
Via efficiency improvements – It is not possible to calculate non-

financial indicators of efficiency, but there are clear signs of enhanced
financial performance. The sharp increase in sales per employee has
been noted. In addition, the return on capital as measured by operating
profit to long-term capital (net assets plus £200m long-term debt) has
moved steadily upwards as follows:
2002 2004 2006 2008
6.5% 8.4% 12.2% 15.3%
Tax payments – Although NEW’s average rate of taxation has fallen

from 19% in 2002 to 13% by 2008, this may be due to the impact of
capital expenditure, generating significant tax breaks.
Bradford MBA 165

Unit 2
Activity 2.1
You may have thought of some of the following:

 valuation of other companies for acquisition
 valuation of one’s own company, when deciding whether to accept a
takeover bid
 valuation of a company for flotation on the stock market – an initial
public offering (IPO)
 valuation of a company for privatisation
 valuation of a company for a trade sale or a management buy-out
 valuation of a small company for assessing estate taxes.
Activity 2.2
1. People’s expectations should already be in the share price, indeed, the

company may already have leaked out some indication of what the
results contain.
2. This should create expectations regarding the possibility of Laxog

becoming a takeover target. If this is not plausible, then the likelihood of
Laxog becoming a predator will be priced in. Given that at least half of
all takeovers fail to generate the promised benefits, the effect on share
price could be adverse.
3. Rising unemployment, and hence falling incomes, is bad for

pharmaceuticals as expenditure on cosmetics and proprietary drugs is
income-related.
4. Good for pharmaceuticals as sufferers spend more of their money on

curative drugs. A total cure may have the opposite effect!
5. Good for share price in an R&D-intensive industry, although the

company’s track record is important in this respect.
6. A decrease in the state borrowing will usually lead to lower interest

rates, but this information is already history. Expectations about the
future level of state borrowing are more relevant.
7. This is also information already known to the market, and besides, this
variable tends to change only gradually. Even when changes in life
166 Bradford MBA

expectancy are announced (increases being good for pharmaceuticals

and vice versa), any changes are only marginal.
8. This is probably already in the share price to some extent, but

confirmation of entry, thus removing uncertainty, will probably help the
share prices of all companies, especially those of large multinationals
whose shares are usually traded on several stock exchanges.
Activity 2.3
If these rules ever applied, investors would have soon realised the
potential, and would have bought in November rather in advance of the
expected price increase in December, thus creating a ‘November effect’,
and so on. Try the same argument on the old stock market advice ‘Sell in
May, and go away, and come back on St Leger Day’ (the date of a horse
race in the UK).
Many statistical tests have shown that all such dealing rules are usually
inferior, and never superior, to a simple ‘buy and hold’ strategy.
Activity 2.5
Day 1 Total value of each firm A: 2m  £1 = £2 million

B: 5m  £2 = £10 million
– B is making an offer of £3m for a company apparently worth only £2m.
– This will lower B’s value by £1m to £9m or £1.8 per share.
– The savings would raise B’s PV by £1.6m = 0.32/share

5m
(i.e. to £2.12/share)
1. If the market is semi-strong efficient, it will react only when the

information becomes public knowledge.
Value/Share
Day 2 No new information A £1 B £2
Day 4 Takeover bid announced. B appears

to be pay ‘over the odds’ A £1.50 B £1.8
Day 10 New information becomes available A £1.50 B £2.12
Bradford MBA 167

2. If the market is strong-form efficient, all information is reflected in the

share price even if the information is not publicly available. This means
that on day 2 when B’s management decide to offer £1.50 for A, the
share prices will then react to reflect the full impact on the bid on both
shares.
Day 2 Full impact of decision to bid and
make savings reflected in share A £1.50 B £2.12
price
Day 4 Takeover bid announced, market
al.ready aware of the information,
therefore no new information A £1.50 B £2.12
content
Day 10 Public announcement of savings –
no new information content A £1.50 B £2.12
3. In Question 1 with semi-strong market efficiency, the prices of the

companies only increase when the information becomes public. In
Question 2 with strong-form market efficiency the share prices change
immediately when the underlying information changes, even if it is not
public. Question 1 is more like the real market, though there may still be
short delays while the information spreads in the market.
168 Bradford MBA

Unit 3
Activity 3.1
1. This is simply the value of the total assets, i.e. £7.2 million. To obtain
ownership of the whole company’s assets, Shark would have to pay at
least this amount.
Net asset valuation (NAV) = Total assets less Total liabilities
= Fixed assets + Current assets – Current liabilities – Long-term debts
= £3.5m + £3.7m – £1.1m – £0.5m
= £5.6m
or value per share
£5.6m
= =£1.12
5m
2. In this example, the bidder would have to pay £5.6 million to the
owners, but to complete the deal, it would also have to either pay off the
liabilities of £1.6 million or assume responsibility for them. Obviously,
you cannot normally expect to buy assets worth a total of [£3.5m +
£3.7m] = £7.2 million for just £5.6 million.
Activity 3.2
Assuming Shark is in the same industry, we could use its P:E ratio to value
Minnow’s earnings. Minnow’s profit after tax is £1.5m, but £0.3m was due
to an exceptional item. Removing this one-off event, we have
‘maintainable earnings’ of [£1.5m – £0.3m =] £1.2 million. With a P:E ratio
of 10:1, the value of Minnow’s earnings, and hence its equity, is
[10  £1.2m =] £12 million.
Activity 3.4
1. To find cash flow, we have to add back non-cash items to profit after tax
(PAT), primarily depreciation:
PAT + Depreciation = £1.5m + £0.2m = £1.7 million
Bradford MBA 169

In reality, there will also be working capital adjustments to incorporate –

these are assumed to be off-setting. There is also the exceptional item,
the profit on the sale of the asset, again a non-cash item, as well as a
one-off.
This yields a sustainable cash flow of:
£1.7m – £0.3m = £1.4 million
There is yet another adjustment to make. To maintain this cash flow,

the company must replace worn-out capital equipment. But at what
rate? For simplicity, we may assume that the annual depreciation
provision is an accurate reflection of the replacement investment
undertaken. This yields a sustainable cash flow of:
£1.4m – £0.2m = £1.2 million
This is known as the free cash flow – cash flow free of all obligations
including ongoing replacement investment requirements. Thus it is free
for disposal by the directors by discretionary strategic investment and/or
dividend payments.
2. Basically two factors are required: a discount rate and a time period.
For illustration, we assume a 20% return required by shareholders and
a 10-year time span.
The valuation
Using these assumptions, the value of the equity is:
£1.2m  PVIFA (20,10)
The annuity factor is 4.1925, so the value is:
£1.2m  4.1925 = £5.03 million
Note that this assumes no residual value of the company at the end of
10 years. Obviously, other assumptions will yield different results.
170 Bradford MBA

Unit 4
Activity 4.1
Investment decisions are important because:

 they involve long-term commitment of capital
 they are often irreversible, except at great cost
 future benefits may be substantial but they are usually highly uncertain
 they define the future operating capability of the company
 they shape the company’s long-term strategic options.
Activity 4.3
 DCF methods remedy all the major drawbacks of the other methods.
 DCF methods are not totally problem-free.
 NPV is the best available method because of its clear signal regarding
wealth creation, but IRR remains popular with business people who
often prefer to work in percentage terms.
 In reality, firms often use a combination of methods; perhaps payback
to ‘screen’ projects, then NPV or IRR for a more rigorous appraisal.
 ARR is least popular as a primary appraisal method, although many
firms are still concerned about the effect of a project on accounting
measures of performance – the profit and loss account and the balance
sheet.
 All methods are heavily reliant on the quantity and quality of data input.
 Information is not cost-free. Sometimes, firms may economise on data
collection and rely on less rigorous methods.
 Finally, there is no evidence that use of allegedly ‘sophisticated’
evaluation methods like DCF is associated with superior company
performance. This suggests that quality of project identification,
development and operation is more important than the rigour of the
evaluation method.
Bradford MBA 171

Activity 4.4
1. The real rate of return is approximately 7.0%–2.5% = 4.5%. More

accurately, it is given by:
1 m = 1 + r = 1.07 = 1.044, whence (1 + r) – 1 = 0.044, (i.e) 4.4%.
1 p 1.025
Thus the return that rational lenders require net of inflation is about
 4.4%.
2. Inflation could benefit an investment project when:

 rate of revenue inflation exceeds rate of cost inflation
 revenue inflation occurs in advance of cost inflation
 both of the above apply.
Activity 4.5
Year 0 1 2 3
Pre-tax cash flow (1) (8m) +5m +5m +5m
WDA (2m) (1.5m) (4.5m)
(= reduction in taxable profit) (2)
WDV of asset (end year) (3) 6m 4.5m 0
Taxable income (4) = (1) – (2) 3m 3.5m 0.5m
Tax at 28% (5) (0.84m) (0.98m) (0.14m)
Post-tax cash flows (1) – (5) (8m) 4.16m 4.02m 4.86m
PV at 10% = (8m) 3.78m 3.32m 3.65m
NPV = – 8m + 10.76m = +2.76m
As you can see, the NPV of the project rises sharply compared to the ‘tax-
only’ case – by £0.95m. By implication, this is the present value of the tax
savings generated by the writing-down allowance. The total value tax
reliefs amount to £8m 28% = £2.24m, but of course, these are spread
out over time and thus have a lower present value. The quicker a
company can exploit tax reliefs, the better. A temporarily unprofitable
company would have to carry forward the tax relief thus reducing its
present value.
172 Bradford MBA

Unit 5
Activity 5.1
The completed table looks like this:
5% increase
t0 t1 t2
Outlay (1000)
Revenue 1000 1400
Costs (525) (630)
Net CF (1000) 475 770
12% DF ___1___ 0.893 0.797
PV (1,000) 425 614
NPV = + 39
The project is less sensitive to the same specified percentage (5%) cost
increase.
Activity 5.3
1. The basic NPV is:
– £3m + 200,000 [£20 – £8 – £6] 3.17)
= – £3m + £1.2m (3.17) = + £0.8m
2. Sample sensitivity calculation:
To find break-even volume where NPV = 0
0 = – £3m + V [£6]  3.17
V = £3m/[£6  3.17] = 157,728
This represents a volume reduction of about 21%: the maximum

tolerable fall in volume below the expected level is 21%.
 Repeat for material cost, labour cost, price, outlay, project life and
discount rate.
 You will find that the critical variable is price (see Figure 5.A1 below –
only price and volume are shown). The flatter the sensitivity profile,
the more sensitive the NPV is to changes in that variable. This
Bradford MBA 173

suggests that managers should attempt to follow policies designed to

support the price, for example, by advertising and promotions
expenditure.
Figure 5.A1: Bowman plc: sensitivity
% Volume
outcome
above
Price
expection
Base case
Best estimate 0
0.8m NPV
-6.3%
% -21%
outcome
below
expection
174 Bradford MBA

Unit 6
Activity 6.1
1. Current (2012) net working capital needs (£)
= (Stock + Debtors + Cash) – Trade creditors
= (16,000 + 8,000 + 2,000) – 11,000 = 15,000
2012: for a 20% increase, amount it requires = £18,000
2. Total additional financing (£)
= Capex + Working capital = 15,000 + 3,000 = £18,000
3. Additional external finance
= Total required financing – cash flow
To find cash flow, assume:

no accruals or prepayments
no tax delay
no change in dividend policy
Then: Cash flow = retained profits + depreciation
Note: Working capital changes, for example, increase in debtors,

which do generate cash outflows/inflows, are already allowed for in
the forecast above (Item 1).
Forecast P and L £
Sales (£100,000  20%) 120,000
COGS (85% of sales) (102,000)
Operating profit 18,000
Less:
Interest (10%  £10,000) (1,000)
Taxable profit 17,000
Corporate tax @ 50% (8,500)
PAT 8,500
Dividend (40%  PAT) (3,400)
Retained profit 5,100
Bradford MBA 175

Cash flow
Retained profit 5,100
Depreciation 6,000
11,100
Predicted shortfall 6,900
Total financing needs 18,000
Activity 6.2
1. Debtor collection period

500
=  365 = 91 days
2000
Trade credit period

 100
=  365 = (46 days)
800
Stock period
 400
=  365 = 122 days
1200
Operating cycle = (91 + 122 – 46) = 167 days


This is an exceptionally long operating cycle, possibly reflecting capital-
intensive production (maybe heavy engineering, ship or aircraft
building). Some labour-intensive activities such as house building also
have long operating cycles.
2. The interest charge is 20%  £800 = £160. Debtor days are now 91
days – if speeded up by 40%, they would become 55 days with average
debtor value of £300. Quicker collection could lead to a lower overdraft
by £200, enabling lower interest of 20%  £200 = £40. This raises profit
after interest:
from (£800 – £160) = £640 to (£800 – £120) = £680

40
an increase of = 6%.
640

176 Bradford MBA

Activity 6.4
1. A gross dividend is the amount of dividend per share in pence before

deduction of tax. In the UK, dividends are actually paid net-of-tax
assumed to be 10%. If a company pays a dividend net of say, 8.0p per
share, this is equivalent to a gross-of-tax payment of
8.0p/[1 – 10%] = 8.88p.
2. The dividend yield of a share is the rate of return that shareholders

currently earn on their shares (ignoring any capital gain). It is measured
by dividing the last annual dividend paid by current share price. It can
be expressed either in net-of-tax terms or, as is more usual, in gross
terms (hence yield gross) enabling comparison with the returns on
other securities, in particular, government stock.
3. The dividend cover indicates the number of times the company could
afford to pay out its net dividend from its post-tax profits. It thus purports
to measure the degree of security of the dividend payments, by
suggesting the extent to which profits can fall before endangering the
dividend.
The pay-out ratio is simply the inverse of the dividend cover and
shows the proportion of a company’s post-tax profits actually paid out
as dividends (net). In other words, it is the dividend per share divided by
the earnings per share:
DPS
EPS
where EPS is the profit after tax divided by the number of ordinary
shares issued.

4. The P:E ratio (price:earnings ratio) is the relationship between a
company’s current market value and its profit after tax: market price per
share divided by post-tax profit per share. It supposedly indicates the
number of years a company would take to earn back its share price,
assuming constant earnings. A relatively high P:E ratio indicates the
market’s confidence in the company’s earnings growth (or recovery)
potential.
5. When a share trades cum-dividend, the purchaser will receive the right
to receive the recently declared dividend. On a specified cut-off day,
shares will go ex-dividend, signifying that new purchasers will not
receive the dividend. Other things being equal, the share price will fall
by the amount of the dividend.
Bradford MBA 177

6. A scrip dividend is a payment to shareholders in the form of extra

shares rather than cash. Sometimes, it is given to all shareholders, in
addition to the cash dividend, while some companies allow
shareholders to choose between a scrip and a cash dividend, as you
saw earlier. From a shareholder’s perspective, it is a way of increasing
holding of a company’s shares without incurring dealing fees; while from
the company’s viewpoint, it preserves cash.
7. Scrip issues and bonus issues are synonyms for the issue of free
shares, for example, in a ‘one-for-ten’ scrip issue for every ten shares
held, shareholders may be given 1
an extra share. In principle, this should
drive down the share price by 11 , as the earnings are now spread over
more shares (earnings dilution). However, in practice, bonus issues
often carry an ‘information content’ as investors hope and expect that
companies will at least maintain the dividend per share. In effect, a scrip
dividend is often taken to signify a company’s own expectation that
earnings will increase sufficiently to enable payment of higher
dividends.
Stock split – When, as a result of past earnings retentions, a

company’s balance sheet reserves are high in relation to its issued
share capital, the share price will often be high in relation to the par
value of the shares. Some companies believe that a ‘heavyweight’
share price is a deterrent to active trading in the shares. As a result,
they may split their stock. For example, in a one-for-one split a
company distributes one new share for every one currently held. This
would halve its share price since the number of shares in issue would
double. Unlike bonus issues, in a stock split, the par value of the shares
is reduced accordingly.
8. A rights issue is an issue of new shares offered initially to existing

shareholders (see above). As with a scrip issue, a rights issue will lower
the market price due to earnings dilution, but in this case, cash changes
hands, to be invested by the company, or used to pay off debts. The
right to purchase the new shares can be transferred, so the existing
shares are said to trade cum-rights before the specified cut-off date,
after which new purchasers will not receive the right to purchase the
new shares, hence the description ex-rights.
178 Bradford MBA

Unit 7
Activity 7.1
PAT
1. The ROE is = 15  100 = 15.6%
Net assets 95
2. There are many problems with this measure.

 figure. This year’s results may be untypical of the
– It is a single year’s
trend over time.
– It may be quite different from the ROE of other firms in the industry
sector.
– However, comparisons over time and across companies are
hindered by changing accounting procedures by the firm in question
and by different accounting practices between companies,
respectively.
– The fundamental problem is that it is based on accounting rather
than market values. The book value of net assets is usually well
below the market value. Most rational investors look at current or
market values when judging company performance and assessing
the returns they require.
– Ideally, then, we might look at a series of returns over time based on
the market values of companies. Even so, there is no guarantee that
the past is a good guide to the future.
Activity 7.2
 It assumes that today’s share price is reliable and is set by an efficient
capital market.
 The value obtained depends on which day we do the calculation, given
that share prices fluctuate on a daily basis.
 It implies a constant rate of future dividend growth.
 It assumes that recent past dividend growth is a good indicator of future
growth.
 It only works for quoted companies (those with a market price).
 It only works when ke > g.
 It doesn’t work when the company pays no dividend (or a historically
low one, as in a recovery situation).
Bradford MBA 179

 One further problem with the DVM is that it yields an equity cost which
is only applicable at the level of the whole company. It is a blanket
figure of limited use for evaluating the cash flows generated by projects
with degrees of risk that differ from those of the whole company as a
whole. For evaluating most projects, we need to ‘tailor-make’ a discount
rate to reflect the risk of the project in question. For this, we use the
CAPM. This is the cornerstone of much of modern finance theory and
research.
Activity 7.5
PBIT = £20m
Interest = (10%  £25m) = (£2.5m)
Shareholders’ earnings = £17.5m
£17.5m
EPS = = 23.3p
75m
Share price = (5  23.3p) = £1.17
Value of equity = 75m  £1.17 = £88m
Value of debt = £25m
Value of whole company = £113m
Apparently, this piece of ‘financial engineering’ has created value of £13m

out of nothing! If we think about this, there has been no change in the
company’s operations – the only thing to have changed is the method of
financing and hence the sharing out of the firm’s operating income. How
then can its value change? This question should make us a little
suspicious of the claimed benefits of borrowing or at least, of the extent of
them.
Activity 7.6
Some possibilities are:

 forced sale of assets, both established winners and promising new
product developments
 termination of R&D programmes
 cut-backs in training programmes
180 Bradford MBA

 tighter working capital control – reduced stocks and shorter credit

periods: both may damage sales
 less attractive terms offered by suppliers
 cut-backs in capital expenditure programmes
 excessive emphasis on short-term projects in order to generate cash
 diversion of managerial energies into negotiations with creditors simply
‘to keep the ship afloat’
 costs and delays of receivership and liquidation if the worst does
happen.
Activity 7.7
Question 1: Calculation of discount rates
A: Cost of loan capital
Kd = 1
V
10(1  0.25)
=  100
 92
= 8.2%
B: Weighted average cost of capital (WACC)
Cost of equity
Ke = D1 + g
P0
= (1 6  1.0 4) + 4%
 320
= 9.2%
Bradford MBA 181

WACC
Cost % Target capital %

structure (weights)
Cost of equity 9.2 0.81 7.45
Cost of debentures 8.2 0.19 1.56
WACC 9.01
The market value of shares and loan capital was used in establishing the
weightings in the target capital structure:
Market value Weighting

Ordinary shares (£60m  £3.20) 192m 0.81
92 46m 0.19
Loan capital (£50m  )
100
Total £238m 1.00

C: Risk-adjusted discount rate
= risk-free rate + (risk premium)
= 6% + 0.8(12% – 6%)
= 10.8%
Question 2:
Cost of loan capital (Director A)
The cost of loan capital will be an inappropriate discount rate even though
finance for the project may be raised from this source. As the capital
structure of the company is expected to stay the same over time, this
means that some projects will be financed by loan capital and some will be
financed by equity capital. The particular choice between the two at any
particular point in time will be determined by various factors including,
perhaps, pure chance. On some occasions, it may be easier to raise
finance by loan capital and on other occasions, by equity. If the cost of the
specific source of finance was used as the relevant discount rate for a
project, it could lead to absurd decisions. For example, let us assume that
the company decided to invest in two projects A and B and that Project A
is financed by loan capital at a cost of 8.2% and Project B is financed by
equity at 9.2%. Let us further assume that the IRR for both projects is 9%.
If the specific cost of finance is used in each case, Project A would be
accepted and Project B would be rejected even though each project
produced exactly the same IRR.
182 Bradford MBA

Weighted average cost of capital (Director B)
The use of the weighted average cost of capital (WACC) as a discount

rate avoids the problems illustrated above. It provides an average cost of
capital and projects can either be accepted or rejected according to
whether or not they generate a return in excess of this average figure. The
WACC assumes that the various sources of finance enter a pool of funds
and lose their individual identity. It is out of this pool that the funds
required for a particular project are drawn (and it is back into this pool that
the funds generated by the investments are returned). It is therefore
considered inappropriate to identify a particular source of finance with a
particular investment project. Instead, the WACC of the ‘pool of funds’
should be used.
The WACC, however, may not always be appropriate as a discount rate. It

is most useful for marginal projects where the project is relatively small in
size when compared to the business as a whole. Where the risk of the
new project differs significantly from the risk associated with the existing
business, the use of WACC will be less valid.
Risk-adjusted discount rate (Director C)
This method calculates the discount rate by adding a risk premium to the
risk-free rate of return. The risk-free rate of return is usually taken from
long-term government bonds. The risk-adjusted discount rate reflects the
fact that shareholders will expect a higher rate of return from projects
where the risk is higher. However, problems arise when implementing this
method as determining the appropriate risk premium for a project may
prove difficult. The use of a risk-adjusted discount rate also assumes that
risk will increase over time, which may not always be the case.
Return on capital employed (ROCE) (Director D)
ROCE is a ratio widely used by managers in setting target profitability

returns. It may, therefore, appear to be logical to employ a discount rate
which reflects the target ROCE. However, the use of a target ROCE as a
hurdle rate for investment projects is likely to be inappropriate as it uses
the ratio for purposes for which it is not designed. The ROCE ratio is
rooted in accounting reports and relates accounting profits to the long-term
capital invested. For capital expenditure decisions, however, we are
concerned with cash flows rather than accounting profit. Moreover, this
discount rate is not related to the cost of funds employed by the business.
Where the ROCE is above the cost of capital, its use as a discount rate
may result in the rejection of profitable projects. Conversely, where the
ROCE is below the cost of capital it may result in the acceptance of
unprofitable projects.
Bradford MBA 183

The cost of loan capital and ROCE would be inappropriate choices as

discount rates in most, if not all, circumstances for the reasons mentioned
above. This leaves the choice between WACC and the risk-adjusted
discount rate. However, neither approach is perfect and each has
drawbacks. Nevertheless, if Director C is correct in stating that the new
project is in a different risk class than the existing business in which the
company is involved and the investment is significant in size, the risk-
adjusted rate may be appropriate, although it might be more appropriate to
use the beta coefficient of a company already operating in the particular
sector.
184 Bradford MBA

Unit 8
Activity 8.1
 The choice of time period is arbitrary – a different time period might
have painted a quite different picture.
 By annualising the TSR, it ignores the fluctuations in return in the
intervening years. Many investors value stability in returns, often being
prepared to accept a slightly lower return in exchange for a more
reliable one.
 The last point hints at the relative riskiness of the companies. Relatively
high returns might have been achieved by running relatively high risks.
 Just because a company has delivered value at a rapid pace in the
past, it does not follow that it can continue to do so, without expensive
and possibly ill-judged acquisitions.
It is tempting to assume that an increase in dividends is always likely to

increase share price. However, the academic world is divided on the
relationship between dividend payments and share price.
Activity 8.2
1. Before the project, the value of the company is:
£100 £100 £100

V0 = + + = £248
1.1 (1.1)2 (1.1)3
After accepting the project, the new company value is:
0 £100 + £120 £100

V1 = + + = £256
1.1 (1.1)2 (1.1)3
Company value increases because:
£120 £100
2

(1.1) (1.1)
£99 > £91


Acceptance of the project is beneficial because the cash generated by
the project in year 2 more than compensates (even when discounted)
for the reduced dividend in year 1. Quite simply, it is rational to retain
earnings for reinvestment because the return on the project concerned
exceeds the shareholders’ required return. Moreover, it would actually
Bradford MBA 185

penalise shareholders to pay them a dividend because it would exclude

them from participating in a worthwhile venture.
2. It is easy to rebut this argument. If the project is truly worthwhile and is

perceived as such by the financial markets, the share price will increase
as soon as the relevant information is released to the market (if it is
semi-strong efficient!). Those shareholders requiring income now can
sell off some portion of their shareholding at the higher price and use
the proceeds to finance their desired expenditures. Under this view,
people in older age brackets who have relatively short time horizons
and who prefer income now rather than in the future can ‘home-make’
dividends by selling shares in the market.
Activity 8.5
Question 1: Payout ratios/dividend cover
The last dividend was 1.50p per share, making a total payout of
£70m  4  1.50p = £4.2m. The profit after tax (£m) was:
Profit before interest and tax 25.00
Interest (0.70)
Taxable profit 24.30
Tax @ 33% (8.02)
Profit after tax 16.28
% Payout 4.20/16.28 = 26%
Dividend cover = 3.9 times
If the present cash balances are used to increase the dividend by £10m,
making a total dividend of £4.20m + £10m = £14.20m, the figures will
appear thus:
Profit before interest and tax 40.00
Interest (0.70)
Taxable profit 39.30
Tax @ 33% (12.97)
Profit after tax 26.33
% Payout 14.20/26.33 = 54%
Dividend cover = 1.9 times
This represents a substantial fall in dividend cover, from significantly

above the sector average to well below it. Such an apparent shift in
dividend policy is bound to provoke comment both from shareholders and
also from the market in general.
186 Bradford MBA

Question 2:
Report to: Finance Director

Subject: Utilisation of excess cash balances
From: Financial Strategist
Date: Anyday
I Introduction
Phoenix has built up significant cash balances over the past year as a
result of exceptional growth in sales and profits as the economy has
recovered from recession, sparking demand for the high quality
building products in which we specialise. There are several possible
uses for surplus cash balances such as investment in the short-term
money market and acquisition of other companies. However, my remit
is to consider only two such uses, firstly, an increase in dividends and
secondly, early repayment of the long-term loan stock, otherwise
repayable in 2019. This report will consider each of these in turn.
II Dividend increase
The factors which will need to be considered and investigated are as

follows.
(i) Preferences of our shareholders. Many shareholders will have

purchased Phoenix shares rather than those of competing
companies with higher payouts hoping for long-term capital growth
rather than dividend payments. In the past, we have served their
interests by restricting dividends and ploughing back profits into
the business. We will need to consider how they are likely to
respond to such a sharp shift in our distribution policy, albeit due
to lack of investment opportunities.
(ii) Shareholders’ tax position. A major determinant of shareholders’

preferences is their liability to tax. Some institutional shareholders
enjoy tax advantages from distribution, while some private
shareholders, perhaps the majority, prefer capital gains to
dividends because of the tax advantages attaching to the former.
This factor underlines the need to inspect our shareholder register
and to consult with major shareholders.
(iii) Actual and expected liquidity. Phoenix is highly liquid at present

and there are no plans to engage in significant capital
expenditures. However, it is prudent to examine our medium- to
long-term capital requirements to ascertain whether the monies
concerned are best left on deposit to avoid having to mount a
major capital raising exercise in the future. Equally, group cash
Bradford MBA 187

flow forecasts will need examining to identify any major demands

for cash of a non-capital nature, for example, closure costs, in the
foreseeable future.
(iv) Loan covenants. It is proposed to lower dividend cover

significantly. Our lawyers will have to inspect the terms of our long-
term loan outstanding to discover whether there are any
restrictions on dividend payouts.
(v) Stock market reaction. The proposal is to more than triple

dividend payments. Clearly, this represents a major departure
from past policy and raises several issues. Presumably, we will
present this payment as a special dividend of the kind paid by
certain UK utility companies in recent years in order to dampen
any expectations of similar increases in the future. This would best
be done by paying it at a different time to the regular dividend.
However, this begs the tactical question of the extent to which the
‘normal’ final dividend should be raised. If the normal dividend is
also raised significantly, this will signal directors’ confidence in our
ability to sustain future payments and thus exert pressure on the
company to meet these expectations. Given that our earnings are
cyclical and have recently been depressed, it is important that we
settle on a dividend payout policy which we feel confident of
maintaining through the various phases of the business cycle. The
stock market tends to be unforgiving of companies which cut
dividends.
III Repayment of the loan stock
(i) Conditions of the loan. Again, we must scrutinise the terms of

the loan to ascertain whether early payment is permitted at all and
whether it triggers any penalties.
(ii) The tax shield. If we repay the loan, we will lose the benefit of the
tax relief accorded to debt interest payments. Admittedly, the tax
saving is not substantial [33%  7%  £10m =] £0.23m, but it is
nevertheless worthwhile. Given our recent increase in profitability,
and assuming this can be sustained, there is a strong case for
increasing our gearing rather than reducing it, although this would
be contrary to our traditional policy. Our capital gearing is well
below, and our interest cover is well above, current industry
averages:
188 Bradford MBA

Phoenix Industry
Capital gearing £10m/£200m* = 5% 45%
(*ignoring retentions for the current year)
Interest cover £40m/£0.7m = 57 times 6.5 times
(iii) Interest rate expectations. If we need to borrow some time in the

future, we will lose if future interest rates exceed 7%, since we will
have effectively replaced 7% debt by higher cost debt. The
reverse argument also applies.
(iv) Reaction of the market. When companies with high gearing

levels and thus high levels of financial risk repay debt, there is
usually a favourable effect on share price. Given our low level of
gearing, it is doubtful that there would be any such benefit. Indeed,
the effect could be adverse, if the market perceives the debt
retirement as a signal of harder times ahead.
IV Recommendation
Subject to the conditions of the existing loan, if we believe that our

profitability will remain buoyant, there is a strong case for raising the
level of dividends and for increasing our level of financial gearing. The
risks seem low, although we will need to consult our major
shareholders in order to sound out their potential reactions.
Bradford MBA 189

Mbacfint SB 24 2018 Study Book

Загружено:

Сведения о документе

Оригинальное название

Авторское право

Доступные форматы

Поделиться этим документом

Поделиться или встроить документ

Параметры публикации

Этот документ был вам полезен?

Это неприемлемый материал?

Авторское право:

Доступные форматы

Mbacfint SB 24 2018 Study Book

Загружено:

Авторское право:

Доступные форматы

FACULTY OF MANAGEMENT AND LAW

MODULE STUDY BOOK

Copyright © University of Bradford 1999, 2002, 2003, 2004, 2006, 2008,

First published 1999 Thirteenth edition 2012

Bradford University School of Management

Module Development Team

Bradford University School of Management

Introduction to the Module 7

Your module leader

Xiaoxia has been working in various academic institutes in different

Overview of Module and

From your introductory accounting module, you need to be familiar with:

 interpretation of accounts: ratio analysis

Module aims and objectives

Please see Appendix A for the module descriptor.

Undertake a current valuation of the equity in this company, using the

them back at the appropriate cost of capital which you estimate

Attempt to reconcile any differences in value that you obtain by using

Choose a listed company on a major stock exchange (e.g. London, New

Financial data available includes the FAME (Financial Analysis Made

Submitting the assignment

Click on the link ‘Click here to submit your assignment’.

You will then be taken to a submission page.

Select the File Upload Tab

For further information on how to submit your assignments in Canvas, go

Support for your learning

Approach to studying corporate finance

Remember two important points:

1. It is your responsibility to make a note of any difficulties and to resolve

2. There is no substitute for extensive reading of the course materials and

You should try constantly to be aware in your regular business activity of

Pike, R., Neale, B. and Linsley, P. (2015) Corporate Finance and

Accessing the etextbook

Detailed download instructions are available from

Module Study Book

Study Book activities and case studies

Model answers to all activities are provided in Appendix B.

Online tutorials on Canvas

Useful websites include:

Berk, J. and DeMarzo, P. (2017) Corporate Finance. 4th edition. Pearson.

Brealey, R.A., Myers, S.C. and Marcus, A.J. (2015) Fundamentals of

Developing good academic practice

The referencing system used in this programme is called Harvard.

For details on how to create your reference list, go to:

A note about referencing in the Study Book

Module feedback from previous students

Previous student feedback on the module includes:

“It has helped my understanding of CF especially on investment

“The study guide was clear and made learning simple.”

“It gave an overview of internationalisation.”

2. Humphrey, J.E., Lee, D. and Shen, Y. (2012) Does it cost to be

2. MyFinanceLab – Activity 1.6

In corporate finance, this solace is absent. In accounting, the focus tends

opposite is true in finance. We emphasise the future. We look at financial

Every financial decision should have an objective. Finance centres on the

What is meant by value in finance? How is it measured and how can it be

Activity 1.1 – watch and reflect

Watch: Unit 1 – An Introduction to DL MBA Corporate Finance (Canvas >

Role of the financial manager

In any organisation, managers face the problem of how to achieve the

Any financial decision should be aimed at a coherent objective and judged

In the case of investment decisions, finding value-creating opportunities is

The financing decision