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CORPORATE FINANCE
QCF Level 6 Unit
Contents
4 Financial Markets 85
Introduction 86
Stock Markets 86
Other Sources of Finance 93
Other Financial Markets 96
Recent Changes in Capital Markets 97
Impact of the Markets on Market Decisions 97
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topics under consideration relate to your own work and to the situation at your own
workplace and others with which you are familiar. Using your own experience in this
way should help to develop your understanding by appreciating the practical
application and significance of what you read, and make your studies relevant to your
personal development at work. It should also provide you with examples which can be
used in your examination answers.
And finally …
We hope you enjoy your studies and find them useful not just for preparing for the
examination, but also in understanding the modern world of business and in developing in
your own job. We wish you every success in your studies and in the examination for this
unit.
Published by:
The Association of Business Executives
5th Floor, CI Tower
St Georges Square
New Malden
Surrey KT3 4TE
United Kingdom
All our rights reserved. No part of this publication may be reproduced, stored in a retrieval
system or transmitted, in any form or by any means, electronic, mechanical, photocopying,
recording or otherwise without the prior permission of the Association of Business Executives
(ABE).
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Learning Outcome 1
The learner will: Understand the role of the Corporate Finance Manager and its main links to
business objectives including mergers and acquisitions.
Assessment Criteria Indicative Content
The learner can:
1.1 Explain the role and business 1.1.1 The main types of corporate form.
objectives of the finance manager 1.1.2 The regulatory framework for companies.
and also the regulatory
1.1.3 The Corporate Governance requirements detailed
environment in which s/he
in the: Combined Code, Cadbury, Greenbury, Hampel,
operates.
Turnbull and Higgs Reports; the Financial Services and
Markets Act 2000; and the rules of the FSA.
1.1.4 The identification of key company stakeholders
and the management/shareholder relationship (agency
theory)
1.1.5 The primary objectives of companies both long-
and short-term for national, multi-national and public
sector organisations.
1.1.6 Shareholder Value Analysis.
1.2 Explain the City Code on 1.2.1 General principles, coverage and regulations of
takeovers and mergers and the the City Code.
other main regulatory constraints. 1.2.2 The regulations contained in the Companies Acts,
Competition Code and European Union.
1.3 Explain the main justifications 1.3.1 The strategies and justifications for growth via
for, and dangers of, mergers and mergers and acquisitions.
takeovers (financial and 1.3.2 The development of mega mergers.
otherwise).
1.3.3 The tactics for acquisitions and mergers and the
main defences used to resist unwelcome bids.
1.3.4 Measuring the success of mergers and
acquisitions.
1.3.5 Disinvestment.
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Learning Outcome 2
The learner will: Understand the main sources of debt and equity funding and the
significance of financial gearing.
Assessment Criteria Indicative Content
The learner can:
2.1 Outline the process for gaining 2.1.1 Placing and selective marketing.
a listing on the Official List or the 2.1.2 Offers for sale.
Alternative Investment Market and
2.1.3 Sale by tender.
explain the role of different
advisors in this process. 2.1.4 Rights issues.
2.1.5 Pricing shares for a flotation.
2.1.6 Issuing shares without raising capital.
2.2 Explain and evaluate the 2.2.1 Types of share capital.
sources of equity finance available 2.2.2 Share categories.
to an unquoted company and
2.2.3 Penny shares.
explain the differences between,
and the advantages and 2.2.4 Value.
disadvantages of: ordinary shares, 2.2.5 Authorised and issued capital.
preference shares, rights issues 2.2.6 Dividends.
and scrips. 2.2.7 Share repurchases.
2.2.8 Small business equity.
2.3 Identify and explain the main 2.3.1 Debentures and bonds.
sources of debt finance available 2.3.2 Loans.
to any size of business.
2.3.3 Overdrafts.
2.3.4 Mortgages.
2.3.5 Convertibles.
2.3.6 Warrants.
2.3.7 Leasing.
2.3.8 Hire purchase.
2.3.9 Medium-term notes.
2.3.10 Commercial paper.
2.3.11 Project finance.
2.3.12 Sale and leaseback.
2.3.13 Licensing.
2.3.14 Debt sources for small business.
2.4 Explain the significance, 2.4.1 Operating gearing
advantages and dangers of 2.4.2 Financial gearing.
different levels of financial gearing.
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Learning Outcome 3
The learner will: Be able to evaluate investment decisions using a variety of appraisal
techniques.
Assessment Criteria Indicative Content
The learner can:
3.1 Explain the principles, 3.1.1 Time value of money.
benefits and limitations of the 3.1.2 Accounting rate of return.
following
3.1.3 Payback.
different methods of investment
appraisal: accounting rate of 3.1.4 Discounted cash flow and net present value.
return, payback, net present value 3.1.5 Annuities.
(NPV), Profitability Indices, and 3.1.6 Multiple time periods.
the internal rate of return (IRR) 3.1.7 Perpetuities.
and be able to perform
calculations in order to assess 3.1.8 Impact of taxation and inflation
investment value. 3.1.9 Capital rationing
3.1.10 Sensitivity analysis
3.1.11 Simulation
3.1.12 Certainty equivalents
3.1.13 Lease versus buy.
3.2 Explain and calculate the 3.2.1 Risk premiums.
influence of risk in the investment 3.2.2 The Capital Asset Pricing Model (CAPM).
appraisal process.
3.2.3 Adjusted present value.
3.2.4 Using probabilities
Learning Outcome 4
The learner will: Understand and be able to calculate the main methods for valuing company
shares.
Assessment Criteria Indicative Content
The learner can:
4.1 Explain and calculate the 4.1.1 NAV method.
share value of a business based 4.1.2 PER method.
on: net asset value (NAV), price
4.1.3 Dividend valuation methods.
earnings (PER), free cash flow
and dividend valuation and 4.1.4 Discounted cash flow methods.
discuss the relative merits of each 4.1.5 Berliner method of free cash flow
method. 4.1.6 Use of CAPM.
4.2 Discuss the qualities of a 4.2.1 Non financial factors that affect share and
business that are likely to company valuation: reputation, knowledge, capabilities,
influence the share value. attitude, penetration, dynamism and leadership.
4.3 Explain and calculate the main 4.3.1 Liquidity.
accounting ratios that can be 4.3.2 Profitability.
applied to organisations.
4.3.3 Efficiency.
4.3.4 Debt/gearing.
4.3.5 Investors
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Learning Outcome 5
The learner will: Understand the factors that determine a company’s dividend policy.
Assessment Criteria Indicative Content
The learner can:
5.1 Explain and discuss the effects 5.1.1 Retention policy.
of dividends on shareholder wealth 5.1.2 Legal constraint.
and the main dividend policies that
5.1.3 Availability of internal funds.
companies may adopt including:
constant dividends, increasing 5.1.4 Profits.
dividends, zero dividends and 5.1.5 Effect on share prices.
fixed percentage dividends. 5.1.6 Signalling.
5.1.7 Shareholder expectations
5.1.8 Company law on dividends.
5.2 Explain and evaluate the main 5.2.1 Clientele effects.
dividend policy theories including: 5.2.2 Modigliani and Miller theory.
irrelevance (Modigliani and Miller)
5.2.3 Relevance theory.
and relevance theories.
5.2.4 Dividend growth model.
5.3 Explain the main alternatives 5.3.1 Bonuses.
to cash dividends. 5.3.2 Scrip dividends.
5.3.3 Stock splits.
5.3.4 Concessions.
Learning Outcome 6
The learner will: Understand the concept of, and know how to calculate, the cost of capital of
a business.
Assessment Criteria Indicative Content
The learner can:
6.1 Describe and calculate the 6.1.1 Ordinary shares.
cost of equity share capital. 6.1.2 Dividend yield.
6.1.3 Preference shares.
6.1.4 Retained earnings
6.1.5 CAPM.
6.2 Describe and calculate the 6.2.1 Irredeemable debt.
cost of debt capital. 6.2.2 Floating rate debt.
6.2.3 Convertibles.
6.2.4 Bank loans.
6.2.5 Overdrafts.
6.2.6 Tax effects.
6.3 Calculate the weighted 6.3.1 Methods.
average cost of capital and 6.3.2 Assumptions.
discuss its usefulness.
6.3.3 Required rate of return.
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Learning Outcome 7
The learner will: Understand the different elements of treasury and working capital and be
able to perform calculations from a given set of data to determine the effect
on an element of, or on the entire working capital of, a business.
Assessment Criteria Indicative Content
The learner can:
7.1 Explain the main areas of 7.1.1 Cash management.
treasury and working capital and 7.1.2 Stocks.
calculate the working capital cycle
7.1.3 Debtors and credit control.
and the cash conversion or
operating cycle. 7.1.4 Creditors.
7.1.5 Short-term investments.
7.1.6 Rate of turnover of working capital.
7.1.7 Key working capital ratios.
7.2 Calculate, from a given set of 7.2.1 Working capital decisions and policies..
figures, a working capital decision
on any of the areas of working
capital.
7.3 Explain overtrading and 7.3.1 Key symptoms of overtrading.
identify its symptoms. 7.3.2 Actions needed to address these symptoms.
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1. Understand the role of the 1.1 Explain the role and business objectives Chap 1
Corporate Finance of the finance manager and also the
Manager and its main links regulatory environment in which s/he
to business objectives operates
including mergers and 1.2 Explain the City Code on Takeovers and Chap 3
acquisitions Mergers and the other main regulatory
constraints
1.3 Explain the main justifications for, and Chap 3
dangers of, mergers and takeovers
(financial and otherwise)
2. Understand the main 2.1 Outline the process for gaining a listing Chaps 4 & 5
sources of debt and equity on the Official List or the Alternative
funding and the Investment Market and explain the role
significance of financial of different advisors in this process
gearing 2.2 Explain and evaluate the sources of Chap 5
equity finance available to an unquoted
company and explain the differences
between, and the advantages and
disadvantages of: ordinary shares,
preference shares, rights issues and
scrips
2.3 Identify and explain the main sources of Chap 5
debt finance available to any size of
business
2.4 Explain the significance, advantages Chap 8
and dangers of different levels of
financial gearing
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4. Understand and be able to 4.1 Explain and calculate the share value of Chap 2
calculate the main a business based on: net asset value
methods for valuing (NAV), price earnings (PER), free cash
company shares flow and dividend valuation and discuss
the relative merits of each method
4.2 Discuss the qualities of a business that Chap 2
are likely to influence the share value
4.2 Explain and calculate the main Chap 2
accounting ratios that can be applied to
organisations
5. Understand the factors 5.1 Explain and discuss the effects of Chap 9
that determine a dividends on shareholder wealth and
company’s dividend policy the main dividend policies that
companies may adopt including:
constant dividends, increasing
dividends, zero dividends and fixed
percentage dividends
5.2 Explain and evaluate the main dividend Chap 9
policy theories including: irrelevance
(Modigliani and Miller - MM) and
relevance theories
5.3 Explain the main alternatives to cash Chap 9
dividends
6. Understand the concept of, 6.1 Describe and calculate the cost of Chap 6
and know how to calculate, equity share capital
the cost of capital of a 6.2 Describe and calculate the cost of debt Chap 6
business capital
6.3 Calculate the weighted average cost of Chap 6
capital and discuss its usefulness
7. Understand the different 7.1 Explain the main areas of treasury and Chap 10
elements of treasury and working capital and calculate the
working capital and be working capital cycle and the cash
able to perform conversion or operating cycle
calculations from a given 7.2 Calculate, from a given set of figures, a Chap 10
set of data to determine working capital decision on
the effect on an element any of the areas of working capital
of, or on the entire working
7.3 Explain overtrading and identify its Chap 10
capital of, a business
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1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11
12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15
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Annuity Table
1 1 r
n
Present value of an annuity of 1, i.e.
r
where: r interest rate
n years
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·37 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·26 10·58 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·13 11·35 10·63 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·00 12·11 11·30 10·56 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·87 12·85 11·94 11·12 10·38 9·712 9·108 8·559 8·061 7·606 15
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·748 3·685 3·589 3·498 3·410 3·326 6
7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15
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FORMULAE
Cost of capital
Cost of irredeemable preference shares paying an annual dividend d in perpetuity, and
having a current market price p:
d
Kpref
p
Cost of irredeemable debt paying annual net interest i(1 – t) and having a current market
price p:
i 1 t
Kdebt
p
Cost of ordinary shares having a current ex-div, market price p, having paid a dividend d, with
dividend growth g% per annum:
d0 1 g
Kequity g
p
Cost of ordinary shares, using CAPM where Rf is the risk free rate and Rm is the return on
the market:
Kequity Rf (Rm – Rf)
Share valuation
Value of irredeemable preference shares paying an annual dividend d in perpetuity:
d
P0
Kpref
Value of irredeemable debt paying annual after tax interest i(1 – t):
i1 t
P0
Kdebt
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Chapter 1
The Context of Corporate Finance
Contents Page
Introduction 2
B. Financial Objectives 6
The Prime Objective 6
Valuation of Companies 7
Shareholder Value Analysis (SVA) 8
Long-term Versus Short-term Objectives 8
Objectives of Multi-National Companies 8
Objectives of Public Sector Organisations 8
C. Corporate Governance 10
Company Stakeholders 10
Management/Shareholder Relationship and Agency Theory 14
The Cadbury Report 15
The Greenbury Report 18
Hampel Committee Report 18
The Combined Code 19
The Turnbull Report 21
Financial Services and Markets Act, 2000 and the FSA 21
The Higgs and Smith Reports 22
Other Disclosure and Behaviour Compliance Provisions 24
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INTRODUCTION
Corporate finance covers a wide range of topics and functions within an organisation. The
three main areas we will look at in this manual relate to answers to the following questions:
Which investments should the firm undertake?
How, where, when and how much finance should be raised?
How should the firm's profits be used or distributed?
These questions are more commonly referred to as:
(a) The investment decision
(b) The financing decision
(c) The dividend decision.
In making such decisions, the firm must ensure that it achieves its objectives. Central to this
first chapter, then, is the issue of what the objectives of companies are.
The prime objective is often stated as the maximisation of shareholder wealth. This would
imply that companies must be run in the interests of shareholders. However, there are a
range of interests involved in the way in which companies are managed. We shall examine
these in the second main section of the chapter and consider, in particular, the importance of
the stakeholder concept and the tensions that arise from the different interests involved.
Finally, we turn to the scope of corporate financial management. We shall develop the
issues of financial decision-making referred to above and consider their implications for the
range of financial functions carried out in modern organisations and the roles required of the
finance manager.
The modern financial manager also needs to consider two different issues:
Risk. Some of the financial decisions made will incur little risk, for example, investing
in Government backed bonds, but other areas of investment, such as investing in
derivatives, will incur a lot of risk. There is a balance to be struck between the return
that can be expected and the risk involved with the particular investment concerned.
Strategy. There is an ever increasing need in the modern business world for senior
staff, including the financial manager, to play a key role in the strategic vision and
environment within which the business is operating. There needs to be input at all
three levels of strategic involvement – i.e. at a strategic level for broad issues, at a
business level in respect of how strategic vision can be turned into reality, and at an
operational level for how the broader plans can be turned into operational success.
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The Context of Corporate Finance 3
Types of Company
When a company is formed, the person or people forming it decide whether its members'
liability will be limited by shares. The memorandum of association (one of the documents by
which the company is formed) will state:
the amount of share capital the company will have; and
the division of the share capital into shares of a fixed amount.
The members must agree to take some, or all, of the shares when the company is registered.
The memorandum of association must show the names of the people who have agreed to
take shares and the number of shares each will take. These people are called the
subscribers.
A company is a separate legal entity, which means that it may take legal action against its
shareholders or vice versa. Limited liability companies have capital divided into shares. If a
shareholder has paid in full for his or her shares, then liability is limited to those shares. This
is the concept of limited liability.
The two main classes of limited company are public and private companies:
(a) Public companies
Company legislation defines a public company as one which:
Has an authorised share capital of at least £50,000;
Is trading a minimum of £50,000 issued share capital
Has a minimum membership of two (there is no maximum);
Has a name ending with "public limited company" or plc.
Not all public companies have shares which are traded on the Stock Exchange. Those
traded on the Stock Exchange are known as quoted or listed companies.
(a) Private companies
A private company can be formed by two or more persons. They are often smaller or
family owned businesses. A private company:
Can have an authorised share capital of less than £50,000, although there is no
maximum to any company's authorised share capital and no minimum share
capital for private limited companies.
Cannot offer its shares for sale to the general public.
You may know of private companies which have become public companies and have
started to trade on the Stock Exchange. An example was the clothing retailer Laura
Ashley which started life as a family owned private company.
The amount of share capital stated in the memorandum of association is the company's
"authorised" capital
A company can increase its authorised share capital by passing an ordinary resolution
(unless its articles of association require a special or extraordinary resolution). A copy
of the resolution – and notice of the increase on Form 123 – must reach Companies
House within 15 days of being passed.
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A company can decrease its authorised share capital by passing an ordinary resolution
to cancel shares which have not been taken or agreed to be taken by any person.
Notice of the cancellation, on Form 122, must reach Companies House within one
month.
Issued capital is the value of the shares issued to shareholders. This means the nominal
value of the shares rather than their actual worth. The amount of issued capital cannot
exceed the amount of the authorised capital.
A company need not issue all its capital at once, but a public limited company must have at
least £50,000 of allotted share capital. Of this, 25% of the nominal value of each share and
any premium must be paid up before it can get a trading certificate allowing it to commence
business and borrow.
A company may increase its issued capital by allotting more shares, but only up to the
maximum allowed by its authorised capital. Allotments must only be done under proper
authority.
A public company may offer shares to the general public. Share offers to the public are
made in a prospectus or are accompanied by listing particulars.
A private company is normally restricted to issuing shares to its members, to staff and
their families, and to debenture holders. However, by private arrangement, the
company may issue shares to anyone it chooses.
"Allotment" is the process by which people become members of a company. Subscribers to
a company's memorandum agree to take shares on incorporation and the shares are
regarded as "allotted" on incorporation.
Later, more people may be admitted as members of the company and be allotted shares.
However, the directors must not allot shares without the authority of the existing
shareholders. The authority will either be stated in the company's articles of association or
given to the directors by resolution passed at a general meeting of the company.
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The Context of Corporate Finance 5
Directors must be at least 16 years old, and all companies must have one natural
person as a director – i.e. they cannot have all corporate directors.
There will be improved rules for company names.
Companies will no longer be required to specify their objects on incorporation.
The articles will form the basis of the company's constitution.
(b) Applying to private companies:
There will be separate and simpler model Articles of Association for private
companies.
As part of the "think small first" agenda, there will be a separate, comprehensive
code of accounting and reporting requirements for small companies.
Private companies will not be required to have a company secretary.
Private companies will not need to hold an annual general meeting unless they
positively opt to do so.
It will be easier for companies to take decisions by written resolutions.
There will be simpler rules on share capital, removing provisions that are largely
irrelevant to the vast majority of private companies and their creditors.
(c) Benefits to shareholders:
There will be greater rights for nominee shareholders, including the right to
receive information electronically or in hard copy if they so wish
There will be more timely accountability to shareholders by requiring public
companies to hold their AGM within 6 months of the financial year-end.
The following changes came into force in April 2007:
Removal of the maximum age limit (which was 70) for directors of PLCs
Directors no longer need to provide details of their interests in shares or debentures of
the company or its group – the result being that Companies House no longer accepts
Form 325 (Location of Register of director's interests in shares) or Form 325a (Notice
for inspection of a register of directors interests in shares kept in a non-legible format)
There will no longer be a statutory annual report by the Secretary of State to Parliament
(the "Companies In" report), but BERR will continue to produce the information.
Directors are not required to disclose their interests in shares in the Directors report of
the Annual Accounts for reports signed on or after 6 April 2007.
Takeover forms have been replaced with forms that align with the clauses of the new
Act – 429(4) Notice of non-assenting shareholders will become Form 980(1); 429dec
Statutory Declaration relating to a Notice to non-assenting shares will become Form
980(dec); and 430A Notice to non-assenting shareholders will become Form 984.
In addition, UK company law must also incorporate European company law directives. For
example, the European Eighth Directive on company law required more direct control of
auditors and therefore the Companies Act 1989 introduced the concept of supervision of
auditors. There is an ever increasing amount of legislation being enacted by the EU and the
following examples illustrate the many different items currently being added to existing UK
legislation in place for limited companies :
Company Disclosures – 4th and 7th Company Law (Accounting) Directives
The Companies (Cross-Border Mergers) Regulations 2007
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B. FINANCIAL OBJECTIVES
The Prime Objective
The underlying assumption of the theory of finance states that:
"the main objective of the firm is the maximisation of shareholder wealth in
the long term".
In order to maximise shareholder wealth the management must maximise the value of the
firm, because the legal owners of the company are the shareholders, and all surplus value
after creditors and other liabilities have been met belongs to them. Thus the greater the
value of the firm after liabilities, the greater the wealth of the shareholders. The value of the
firm and shareholder wealth are represented by the market price of the company's shares,
which is the amount a shareholder could obtain for selling his part of the business as a going
concern.
It may seem to be a strange choice of major objective, but perhaps by thinking about some
other likely objectives you will appreciate why the maximisation of shareholder wealth is the
major objective of firms.
(a) The maximisation of company profits is often considered to be a major objective of
firms. Clearly it is important, but even when there are rising profits the value of shares
(and thus shareholder wealth) can fall. Can you think of how this might happen?
There are several ways in which it may occur; one is when a company raises additional
share capital in order to fund an investment to increase profits, but may cause earnings
per share to fall (there being more shareholders to share in the profits), thus resulting in
a fall in share price. Consider the following example.
A company currently has 200,000 shares in issue and has expected profits of £50,000,
thus EPS (earnings per share) are 25p. If the company issues a further 100,000 £1
shares to invest in a project which will give a 10% return on investment, then expected
profits will increase by £10,000. However, there are now 300,000 shares in issue, and
the EPS has fallen to 20p (£10,000 + £50,000/300,000 shares). The falling EPS
causes the share price to drop, and shareholder wealth is therefore also reduced.
(b) Another objective you might feel to be important is the maximisation of Statement of
Financial Position (balance sheet) or asset values. Whilst a company's Statement of
Financial Position is important to investors, you will discover from this course and your
accountancy studies that it does not necessarily reflect a true and up-to-date valuation
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of the company and its assets, and thus cannot be relied upon to determine the worth
of the company.
All of the objectives we have considered so far are financial objectives. In addition, a
company will have important non-financial objectives which might include:
Raising the skills of the workforce – perhaps through training and appraisal
Adhering to environmental legislation – for example, by reducing pollution emissions
The provision of a quality service to customers.
Increasing importance is now being placed on business survival. The modern market place
for most businesses is becoming truly world-wide and this when, added to government and
political influence and interference, presents much greater challenges than existed a few
decades ago. The modern business will need to adapt and change continually to ensure that
it survives, and continued growth is one of the keys to survival and one that all today's
businesses strive for.
Another area that is increasing in importance in the modern business world is social
responsibility. Some businesses have adopted social responsibility as a key objective to
work alongside their other main goals and objectives, and this is increasingly being seen in
explicit policies in both such traditional areas as good working conditions for staff, providing a
good all round product for customers and helping provide adequate and competent training
for staff and the local labour force, and also in more modern areas such as reducing
environmental pollution or stopping corrupt promotional practices.
Financial and non-financial objectives are both important to a company. They may
sometimes be in conflict, but often they are complementary. For example, training the
workforce will increase costs initially, but should result in increased production which will
generate additional profit for the company. There is also the recent example of many food
manufacturers spending time and resources on the issues of obesity in respect of their
products and, whilst it is very much in line with not having their profits adversely affected, it is
also an serious attempt to address their social responsibilities.
Valuation of Companies
In order to achieve the main objective of maximising shareholder wealth we have to
determine exactly how we value companies and their shares. Shareholder wealth obtained
from a company is measured by increases in the price of shares above the price the
shareholder paid for them (capital gains) and dividends received. You will see later that the
price of a share is strongly affected by expectations of future dividends (the higher the
expected dividends the higher the share price), and thus we can conclude that shareholder
wealth can be maximised by maximising a company's share price.
Management should therefore set itself financial targets directly related to maximising
shareholder wealth, but how can this be done?
The price of a company's shares reflects the future earnings of the company so, in
order to maximise shareholder wealth, the company must invest in those projects
which give the highest value over time.
Increasing earnings per share and dividends per share also increases the share price,
and firms should take decisions which allow a potential for maximisation of future
dividends and earnings.
By maximising profits – whilst we noted that maximising profits does not always
increase shareholder wealth, in general it does and firms should aim to achieve this
whilst considering the points raised above. Firms, however, should take care not to
take undue risks when attempting to maximise their profits.
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There are several differences which may exist between public bodies and commercial
organisations.
Many public organisations may have monopolies in either a service or geographical
area.
Although prices may be charged for some public services, they are rarely related to
profit-making objectives and sometimes fail to cover the full economic cost. In general,
the public sector does not use the price mechanism to test whether the public want the
services provided. Instead, the criteria applied tend to be based on the political
judgment of elected representatives under the constraints of the political mechanism of
elections, pressure groups and consultative processes.
The public sector exists to serve the community and, in the field of accounting, the
stewardship of funds is often the key objective (rather than the profit motive). However,
the responsibilities of the financial manager and the need to exercise good financial
public relations are as important as in commercial organisations. In order to replace
the profit motive as a yardstick performance measures have been developed in order
to ensure that the three "Es" of efficiency, economy and effectiveness are achieved,
and to protect public money. Thus, for example, in an attempt to improve the
performance of central and local government departments, the Government has
introduced a wide range of key performance indicators or targets.
Within these overall points about the public sector in general, we should also recognise a
number of particular aspects and developments relating to specific types of organisation.
(a) Nationalised Industries
In recent years the number of nationalised industries has been reduced due to the
privatisation programme of the Conservative Governments of 1979-1997. However,
there are still some large organisations remaining in this category, including the Post
Office (although this may soon be privatised). The objectives of such organisations are
generally social or service-led.
They are funded by borrowing from the capital markets and the Government. Whilst
the maximisation of profits is not their main objective they generally have to obtain set
financial targets, perhaps to maintain required subsidies at a set level or below. In
general nationalised industries in the UK have been expected to aim to achieve a set
rate of return (before interest and tax) on new investment programmes. The rate of
return is measured by current cost operating profit as a proportion of the net
replacement cost of assets employed. Nationalised industries also have other
performance measures, including cost reductions and efficiency gains which they have
to achieve.
(b) Government Departments
One major change in this area within the UK recently has been the formation of
executive agencies to carry out specific functions, such as the Contributions Agency.
They are expected to achieve a set level of service and are answerable to the
Government for their service levels but are managed independently on business-led
lines.
(c) Private Finance Initiative (PFI)
The Private Finance Initiative (PFI) is a small, but important part of the Government's
strategy for delivering high quality public services.
The Private Finance Initiative (PFI) was introduced in 1992 as a means of obtaining
private finance for public sector long-term capital projects, e.g. the building of prisons,
schools and hospitals. The current government is committed to developing this
approach across a wide range of public services. A new Commission on Public Private
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Partnerships was set up in Autumn 1999 (the Institute of Public Policy Research
Commission, IPPR) to examine questions about specific forms of partnership between
private sector firms and public sector organisations – for example, how can private
firms involved in partnerships be made accountable to the public, and how does this
accountability fit in with achieving the best value for money?
In assessing where PFI is appropriate, the Government's approach is based on its
commitment to efficiency, equity and accountability and on the objectives of public
sector reform. PFI is only used where it can meet these requirements and deliver clear
value for money without sacrificing the terms and conditions of staff.
Where these conditions are met, PFI delivers a number of important benefits. By
requiring the private sector to put its own capital at risk and to deliver clear levels of
service to the public over the long term, PFI helps to deliver high quality public services
and ensure that public assets are delivered on time and to budget.
(d) Not for Profit Organisations
The prime objectives of organisation such as charities are not concerned with profit-
making, but with the provision of services, e.g. to offer a service such as training guide
dogs for the blind, or to fund research into cancer treatments. They do, however,
operate within financial constraints and must work within the funds they obtain.
All not-for-profit organisations also strive, as do many commercial ones, to obtain the
three Es of economy, efficiency and effectiveness.
C. CORPORATE GOVERNANCE
Shareholders are the owners of a company and it is important to remember that the
maximisation of their wealth is the prime objective of companies in the private sector. This is
the underlying concept in the theoretical parts of this course. However, they are not the only
groups with an interest in the company and the interplay of factors in the governance of a
company is a key concept.
Company Stakeholders
Stakeholders are usually divided into two distinct categories:
Internal stakeholders such as managers and employees, and
External stakeholders such as shareholders, creditors and lenders.
In practice companies often have multiple objectives (both financial and non-financial)
involving various stakeholder groups, which prevent the maximisation of shareholder wealth.
The different stakeholder groups in an organisation were identified in 1975 by the Corporate
Report (ASC) which dealt with their objectives and specific requirements from accounting
information. Clearly, different users will look at the company in different ways, and the
objectives of organisations have to be designed to satisfy their varying needs, with the
objectives of one group often also applying to another group. The objectives of different
groups may conflict, and compromises will have to be made.
We consider the interests of some of the stakeholder groups below, but you should try to
think of other points yourself.
(a) Banks and other lenders
This group includes anyone who makes a loan or other financial accommodation
available to an organisation, examples being debenture-holders, finance companies,
building societies and venture capitalists.
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The main concern of this group is the safety of the investment; lenders expect to get
their money back within an agreed period and to make a profit. In order to maintain the
safety of the investment they want to ensure that the level of debt to equity does not
become too high, because increases in the level of debt increase the risk of insolvency
of the firm, with the firm being unable to pay the required interest payments. Short-
term lenders are especially concerned with the ability and willingness (known as
"corporate integrity") to repay the liability from cash generated by the business. Long-
term lenders may place a restrictive trust deed or set financial guidelines, e.g. a set
proportion of working capital, in order to ensure their investment remains safe.
(b) Business-contact group (includes debtors and creditors)
This group includes suppliers, competitors and all other business affected by an
organisation's activities. Their objectives include ensuring that the firm deals honestly,
does not misuse any monopoly powers and pays its bills promptly within the terms of
the trading agreement.
The group will be interested in developing long-term strategic relationships and the
continuity of trading opportunity with an organisation which is financially stable with
minimal administration. Customers of the organisation will be concerned with having a
supplier who is reliable, and who provides a constant supply of the product (when
required) of consistent quality with good, efficient service at a fair price. Customers
will also be concerned with the level of service they are receiving, the value for money,
and the safety of the goods they receive.
Competitors are also included in this group, and include those who may be interested
in acquiring the business as well as those who are rivals in trade. The group will
require as much information about the company and its finances as possible, although
the company will not wish them to have such information, and secrecy may conflict with
the needs of other groups.
(c) Public
The needs of the general public can take many forms, e.g. sections of the general
public may wish to see a restriction on contributions to political parties, charities or
social groups, or a restriction on the business activities carried out with, or in, a
particular country. Another example is where local residents are interested in the
amount of investment and degree of control that an entity has in their own community
and its ultimate effect on their local environment. When public money assists the
enterprise the public may wish to see the return in profitability, jobs and services.
(d) Government
The Government (and, indeed, the public) wish to ensure that the organisation adheres
to the law, pays the correct amount of taxes and other financial charges levied upon it
by government bodies, and provides the statistical and other information required in
order to ensure control over its (the Government's) own economic policy. The
Government will also be interested in ensuring that the organisation respects its social
and environmental commitments.
Moreover, the Government has a desire to regulate some of the privatised utilities to
prevent them abusing their monopoly powers. For this reason it has set up consumer
"watchdogs", e.g. Oftel, which regulates British Telecom, to oversee such companies.
The watchdogs may, amongst other things, limit price levels which can conflict with a
company's desire to maximise profits.
(e) Financial analysts and advisors
This group will comment upon the progress, or otherwise, of the entity. In order to do
so they will need the fullest possible information in whichever field their interest lies.
Their requirements may mirror those of any of the other user groups. They will,
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however, have the key objective of ensuring compliance with accounting standards to
provide for uniformity to the presentation of information and the easier comparison with
other organisations.
(f) Employees and management
Employees will be concerned with the remuneration they receive from the company,
their working conditions and security of employment. They may also be concerned
with other factors such as training and career development prospects within the firm;
benefits in kind such as company cars; company pension and redundancy provisions;
and the potential for future expansion of jobs for themselves and their friends and
families.
(g) Shareholders and investors
Shareholders and investors are obviously an important stakeholder group, being the
owners of the business. In order to meet the needs of shareholders management
must:
Maximise their wealth (shown by the growth in share price and the payment of
dividends).
Achieve a specific level of earnings, earnings per share and dividends per share.
Note that some shareholders prefer high dividends and some prefer capital gains
(see later chapter) but the needs of the majority should be met as far as possible.
Stick to a preset target for operating profitability represented by either a set return
on capital employed or a profit/sales ratio (also discussed later).
Expand the business when feasible – to be a worthwhile investment, growth,
level of risk, return on investment and profitability in relation to competitor
businesses and other investment opportunities will be expected to be at an
appropriate level.
Maintain the security (as far as is consistent with profit-making) of the
shareholder's investment. (The risk-return trade off is discussed in more detail in
a later chapter.) This includes considering the fact that shareholders have
different risk preferences and thus prefer different levels of gearing.
Satisfy the investor that the company has sufficient cash flow to accommodate its
plans and avoid future potentially fatal liquidity problems.
Give details of political, charitable or social donations in order to allow
shareholders to decide whether the convictions of the management are in line
with their own views.
This is not an exhaustive list of management objectives in respect of shareholder
interests and you may be able to think of several others. A company therefore has to
know who its major shareholders are and what their objectives for the company are,
and concentrate on achieving those objectives. Such knowledge would also help to
explain recent price movements when shareholdings change hands, and might help in
fighting off a takeover bid.
Companies may have only a few shareholders (e.g. a private family company) or they
may have many small shareholders (e.g. some of the privatised utilities). Advantages
of having a large number of shareholders include a reduced risk of one shareholder
obtaining a controlling interest; greater market activity in the firm's shares and thus the
likelihood of vast price movements caused by one shareholder selling his shares is
also reduced; and takeover bids are easier to frustrate. Against this, however, will be
increased administration costs covering statutory requirements of information to
shareholders, and it may be more difficult to meet all shareholders' conflicting
objectives.
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(iii) Suppliers (creditors) will want to know the liquidity of separate companies and
their ability to pay outstanding debts. Also how will outstanding debts be settled if
divisions are sold?
Japanese car-makers, such as Nissan and Honda, building new car plants in
other countries
The stakeholders will include:
(a) Shareholders;
(b) Employees and management;
(c) Government;
(d) Public.
Some of the key financial management issues will be:
(i) The public may be concerned that they have no control over foreign companies
setting up in their local areas, which may conflict with the aims of government in
encouraging investment by overseas companies.
(ii) The government may grant development finance and incentives to incoming
companies.
(iii) The shareholders of the Japanese companies will be concerned about the
security of their investment overseas.
(iv) Japanese management may be concerned about different pay and conditions if
they are sent to manage the overseas plants.
A public company offering to run the UK national lottery for free rather than for
profit
The stakeholders will include:
(a) The government;
(b) The public;
(c) Shareholders;
(d) Financial analysts.
Some of the key financial management issues will be:
(i) The government will be concerned about the company's objectives if profit is not
the obvious one.
(ii) Shareholders will want to know how this non-profit making venture will affect
dividends and the value of shares. After all, their main objective is maximisation
of shareholder wealth.
(iii) Financial analysts will study the possible effects on the company's value if it gains
the contract to run the lottery.
(iv) The public will want to know what percentage of takings will be donated to good
causes and how much will be retained by the company for administration and
investment in equipment.
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of the managers; a dynamic board of management can make a significant difference to the
performance of a business and the way the market views it.
An agency relationship exists where one person (an agent) acts on the behalf of another
(the principal). The management/shareholder relationship is an example of an agency
relationship. Goal congruence occurs when the objectives of the agents match those of the
principals. The agency problem is the conflict that arises from the separation of
management and ownership in many companies, leading to a lack of goal congruence. The
financial and other rewards of managers (agents) may not be linked to the shareholders'
(principals) financial return. In theory management should not be able to act contrary to the
wishes of shareholders because shareholders can dismiss the managers or sell their shares.
Unfortunately it is often not the case. Small shareholders frequently have little knowledge
about the running of the business and little power to alter its execution; and the large
institutional shareholders have often been passive and uninvolved.
However, a series of "corporate raids" in the late 1980s, when firms acquired and then asset
stripped managerially-focused companies believing them to be undervalued, has led to the
large institutional shareholders considering the actions of management more carefully.
A number of incentive schemes have been introduced in an attempt to encourage goal
congruence between management and shareholders. The most popular is the stock option
scheme. This allows senior management up to a certain number of the company's shares at
a fixed price at a specified time in the future. The management therefore have a financial
incentive to act in ways to maximise the share price, which benefits all shareholders.
However, such schemes are of doubtful benefit – management do not have to buy shares if
the price has fallen; and the schemes can lead to volatility in the share price which is counter
to the principle of a stable share price which many shareholders desire.
Another popular scheme involves profit-related incentives in which bonuses are based on
the annual growth in earnings per share, measured against a pre-set target such as
companies in the sector. However, you will appreciate that accounting figures can easily be
manipulated and can also be affected by external factors such as a change in tax rates.
Such measures therefore only give a partial (and perhaps misleading) picture of
managements' activities.
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The role and responsibilities of executive and non-executive directors as regards the
reporting of financial performance.
The heart of the Committee's recommendations was a Code of Best Practice, to be
adopted by the directors of all UK public companies, with all company directors to be guided
by it. Some allowances are made for the way in which it might be implemented in different
companies.
You will see later that the Cadbury Code of Best Practice has been incorporated into the
Combined Code. However, the recommendations of the Cadbury Committee are so
important in the development of corporate governance in the UK that we will look at them in
detail.
The Code of Best Practice
The major points are as follows:
(a) The Board
There should be a clearly accepted division of responsibility at the head of a company
ensuring a balance of power and authority. In cases where the Chief Executive is also
the Chairman there should be strong independent executives on the board with their
own appointed leader.
The calibre and number of non-executive directors should be such that their views
carry significant weight on the board.
Boards should meet regularly and have a formal schedule of matters reserved for their
decision to ensure that the direction and control of the company remain firmly in their
hands, including the monitoring of the executive management.
All directors should have access to the advice and services of the company secretary,
who is responsible to the board for ensuring that board procedures are followed and
that applicable rules and regulations are complied with. Any question of the removal of
the company secretary should be a matter for the board as a whole.
(b) Executive Directors
Directors' total emoluments and those of the Chairman and the highest-paid UK
director should be fully disclosed and split into their salary and performance-related
elements, with an explanation of the basis on which performance is measured.
Executive directors' pay should be subject to the recommendations of a remuneration
committee made up wholly or mainly (and preferably chaired) by non-executive
directors. Directors' service contracts should not, unless approved otherwise by
shareholders, exceed three years.
(c) Controls and Reporting
Boards must establish effective audit committees. The chairmen of audit and
remuneration committees should be responsible for answering questions at the AGM.
The board should ensure that an objective and professional relationship is maintained
with the auditors. The board must explain their responsibility for preparing the
accounts next to a statement by the auditors regarding their reporting responsibilities.
The Code requires that directors report on the effectiveness of the company's system
of internal control, and state that the business is a going concern, with supporting
assumptions or financial qualifications if necessary.
The board's duty is to present a balanced and understandable assessment of their
company's position. Statement of Financial Position information should be included
with the interim report, which should be reviewed by the external auditors but need not
be subject to a full audit.
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(d) Shareholders
Both boards and shareholders were encouraged by the Committee to consider how to
improve the effectiveness of general meetings.
(e) Auditing
The annual audit is described as "one of the cornerstones of corporate governance".
Several minor recommendations were made to ensure its effectiveness and objectivity:
Audit Effectiveness
Audit effectiveness should be increased by clarifying the respective
responsibilities of directors and auditors for preparing and commenting on
financial statements, and by developing audit practice in areas such as internal
control, going concern, fraud and other illegal acts.
Audit Objectivity
Both the board and auditors have a responsibility to ensure that the relationship
between them is professional and objective. Audit Committees
The Committee stated that the board should establish an audit committee of at
least three non-executive directors with written terms of reference which deal
clearly with their authority and duties.
(f) Non-executive or Outside Directors
Non-executive directors should bring an independent judgment to bear on issues of
strategy, performance and resources including key appointments and standards of
conduct.
The Committee recommended that a majority of non-executive directors should be
independent and free of any business or financial connection with the company (apart
from their fees and shareholdings). Fees should reflect the time which they commit to
the company, but they should receive no pension or share options as part of their
service. The Code also suggested that an agreed procedure should be in place for
non-executives to take independent professional advice at the company's expense.
The selection of non-executive directors should be by a formal process, for a specified
term, and their nomination should be a matter for the board as a whole. However, the
report does not discuss the action that should be taken in the event of a non-executive
director resigning or being released.
The independence of non-executives must be transparent. Fees should be such that
part-time rather than full-time involvement is encouraged and, since resignation is the
ultimate sanction of the non-executive director, the fees should not be so large that the
non-executive is dependent upon them.
In summary, the recommendations of the Cadbury Report, as encompassed by the Code of
Best Practice, were that listed companies should include in their accounts full and clear
disclosure of directors' total emoluments and those of the Chairman and the highest-paid
director. The disclosures should include pension contributions and stock options.
Performance-related elements, and the basis upon which performance is measured, should
be shown separately.
With effect from April 1993, the Stock Exchange stated that UK-incorporated listed
companies must state in their accounts for accounting periods ending after 30 June 1993,
whether they have complied with the Code throughout the accounting period in addition to
the other continuing obligations. Any failure to comply must be stated, along with reasons for
the non-compliance. The compliance statement must be reviewed by the auditors. Other UK
companies should adopt the Code at the earliest practicable date.
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In addition, from 1 January 1995 directors' statements should include the following:
(a) An acknowledgment that directors are responsible for the system of internal financial
control including the main procedures established and their effectiveness.
(b) An explanation that the system can only provide a reasonable level of control.
(c) Confirmation that the directors have reviewed the effectiveness of their present internal
financial control.
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(ii) The annual general meeting (AGM) should be used to communicate with
private investors and encourage their participation.
Accountability and Audit
(i) There should be a balanced, understandable assessment of the company's
position and prospects.
(ii) There should be a sound system of internal control to safeguard the
shareholders' investment and the company's assets.
(iii) There should be formal and transparent arrangements to apply the above
two principles and maintain relationships with the auditors.
The Combined Code requires an explanation in a listed company's annual report of
how these principles have been applied. A major impact of the Combined Code is that
a company must review the effectiveness of all controls, not just financial controls.
(b) Examples of Contents of Combined Code
Directors
(i) The Board must comprise at least one third non-executive directors.
(ii) There must be a senior independent director (not the Chairman) to whom
shareholders can raise their concerns.
(iii) A nomination committee is strongly recommended.
(iv) All directors should receive training when first appointed.
Directors' Remuneration
(i) A significant proportion of executive remuneration should be linked to
corporate and individual performance.
(ii) The remuneration report should be issued in the name of the board and not
just the remuneration committee.
Accountability and Audit
(i) Financial reporting provisions apply to all price-sensitive public reports and
reports to regulators.
(ii) The definition of "internal control" covers all controls, not just financial
controls.
(iii) The majority of the audit committee should be independent non-executive
directors.
(iv) The audit committee should review the scope, results, cost-effectiveness,
independence and objective of external audit.
(v) The company should review the need for internal audit.
(c) Matters to be Reported Publicly by Companies
How the company applies the principles
Whether or not the company complies with detailed provisions; any exceptions
must be explained
Justify combined posts of chairman and chief executive
Give the names of:
(i) The chairman, chief executive, senior independent director and other
independent directors
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In all but the smallest of organisations there should be provision for internal audit to
ensure that control systems are working and to help prevent and detect errors and
fraud.
The financial manager should ensure that all risks capable of being calculated are
covered by insurance, including cover in respect of accident, fire and consequential
loss and, if appropriate, credit insurance.
The business must comply with statutory requirements including those of central and
local government and the European Union, and for a listed company with those of the
Stock Exchange. Accounts must show a true and fair view of the position of the
business at the time they are drawn up. Moreover, they should be capable of being
interpreted in a way that gives the reader the correct impression. Problems arising
from reconstructions and amalgamations of companies also form a major part of the
role of the financial manager.
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modern business world it is very important that all managers are able to develop a
corporate role whereby they are willing and able to look at the entire business rather
than just their own particular functional area. One aspect of this is in respect of social
responsibility. This is increasingly important to the modern business and the finance
manager needs to incorporate its implications into all aspects of his/her role.
Communicator
Finance is a difficult subject for many people and one of the skills that is required by
the modern financial manager is to communicate these often complex issues to staff
within, and stakeholders outside, the business in an easy to understand manner.
Often smaller firms do not have a full-time financial manager, relying simply on regular visits
by a member of the firm's external audit staff. At least some businesses lack an awareness
of the degree of financial expertise required for their business to operate effectively. Even in
firms that do employ a financial manager, many limit his key responsibilities to the production
of accounting information and recording of financial data.
The finance director may also be responsible for general administration and/or information
technology, depending on the size of the organisation.
When considering financial functions in organisations remember that the financial manager
must, to some extent, be concerned with the way in which finance interacts with the other
activities in an organisation such as production and personnel. The financial manager must
ensure that the individual objectives of each function do not conflict with the overall corporate
objective of the business. For example, the marketing manager who seeks to increase sales
or market share must do so within budgetary constraints and profitably in the long term.
Budgeting is a useful way of coordinating all functional activities, and we discuss this in more
detail later in this chapter.
Planning
There are a number of different types of planning.
(a) Strategic Planning
Strategic planning is the process by which the objectives of an organisation are made
or changed. Examples of decisions involving strategic planning include deciding what
to produce and sell and where; whether to merge with another company; and what
overall profitability targets to set for the organisation.
Strategies are likely to exist at a number of levels in an organisation and strategic
planning must take this into account. Many management theorists have identified three
different levels of corporate strategy:
The corporate level, which is concerned with what type of business the
company should be in. The company may specialise in one product or operate in
diverse markets. Decisions would include considering whether to widen the
range of products or move into different geographical areas.
Competitive or business strategy, which focuses on how to compete in a
particular market; for example, a company may consider a strategy of
modernisation and rationalisation of its factories to help it compete in a fabric
manufacturing market.
Operational strategies, which look at how the different functions of the company
contribute to other levels of strategy; for example, in seeking to be competitive a
company will consider price and marketing of its products.
Strategic planning involves generation of options which are then evaluated and choices
made. Management will select the options they intend to pursue and use them to form
the basis of strategic plans.
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Forecasting
In order to develop plans with any degree of accuracy a company must forecast the variables
included in plans. Can you think what they might be?
The variables to be forecasted include:
Demand for, and sales revenue from, the company's products (analysing each product
separately)
Costs of raw materials
Wage and salary costs
Other expense costs
Competition in the product and supplier markets
Potential for new product or production methods development, including the results of
research and development
Interest rates and the cost of capital
Product and safety legislation
Availability of skilled workers
Rate of inflation
Economic growth rates
Changes in the political environment, including industry regulation
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Exchange rates
Taxation
Dividend policy
Assets and liabilities
Potential for new sales and marketing methods.
Plans should include contingencies for external factors which may occur (also known as
sensitivity analysis). Lenders will usually act with extra caution when the economy
emerges from recession, because of their potential exposure to the risks of second-round
failure (see later in this chapter). Modern computer modelling techniques can help with
forecasting. The computer model can be built to assess the effect of changes in all variables
and produce scenarios which match the change in the variables.
The actual outcomes of the above must be compared to the forecasts and the variations from
the predictions fed back into the planning process to help improve the accuracy of future
forecasts.
Budgeting
We have already seen how a business implements its long-term plans via tactical and
operational plans; often, they are expressed as budgets.
Budgets are quantitative and/or financial statements of the plans of an organisation which are
prepared and approved before the period to which they relate.
Budgets can be set for long periods of time covering several years, or for short periods
covering days or hours. Often the very short-term plans are expressed in quantitative rather
than financial terms and may deal with the production or service process. Similar to the
different levels of planning, the longer the period of time covered by a budget the less precise
the plans. The common length of time for most budgets, and the budgets you will probably
meet at work, are those of one year.
Budgets will be set for a wide variety of areas including all parts of sales and production. A
company, a group of companies, or other organisation will have a master budget. A master
budget includes an approved summary of production, sales and costs for the period, showing
the budgeted trading account, Statement of Comprehensive Income (profit and loss account),
cash flow statement and the Statement of Financial Position (balance sheet). In the area of
financial planning an organisation will have some, or all, of the following budgets:
Financial returns on investments
Cash flow planning
Profitability
Sources of finance
Capital structure
Working capital control
Arrangements for banking
Tax planning
Foreign currency management
Changes in asset structures
Funding planned takeovers
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Part of the budgeting and control process is the monitoring of actual results against those
forecast in the budgets and other plans. It is unlikely that the plans will be met precisely, and
management has to set a tolerance limit for deviations (or variances as they are known in
accountancy and finance). The tolerance limit will vary between organisations and between
different items of income and expenditure. Variances falling outside the limits must be
investigated to see whether there is a problem that needs correcting, an opportunity which
can be capitalised, the forecasts need revising in view of unforeseen circumstances, or
whether the variance happened purely by chance.
A major part of the process of analysing variances is that the results of the analysis will be
used with other new information to update plans and budgets for the future. Indeed, part of
strategic planning involves the continual updating of plans as new information becomes
available.
Cash Management
(a) Cash Flow Planning
In order to understand cash management you should be aware of the difference
between profits and cash flow. From your accountancy studies you will be aware that
profit is the amount by which income exceeds expenditure when both are matched on a
time basis. However, cash flow is the actual flow of cash in and out of the organisation
with no adjustments made for prepayments or accruals.
An organisation must ensure that it has sufficient liquid funds to pay its bills as they
become due. A business which has insufficient cash may be forced into liquidation by
its unpaid creditors, even if it is profitable. Management must therefore plan and
control cash flow to prevent liquidation. In the short term this is done by cash flow
budgeting, which can be daily, weekly, monthly or yearly, ensuring that the organisation
has sufficient cash inflows to meet its outflows as they become due. If a shortage is
expected, then the firm can arrange finance, perhaps by increasing its overdraft, to
overcome the problem. If there is a short-term surplus of funds then they should be
invested in short-term marketable securities. Fluctuations in cash can arise for a
variety of reasons, a major one being seasonal fluctuations in trade.
A significant part of strategic planning is the setting of long-term financial plans, setting
out the medium and long-term financial objectives. The plans can allow the business
to judge whether or not it will achieve its financial objectives, e.g. the repayment of
loans, what finance needs it may have in the long term and short term, and whether
there is any surplus cash which should be invested.
Strategic cash flow planning is basically long-term cash flow budgeting, except that
there are greater uncertainties about cash flows due mainly to the longer planning
horizon. The cash flows which result from planning must be consistent with the firm's
financing, investment and dividend policies. The firm will be able to respond to cash
flow shortages or surpluses in a planned way – raising or investing the required amount
of finance in the way most optimal for the company. This includes taking advantage of
changing interest rates and economic climates to the benefit of the company. Some
businesses will be at risk of failure due to insufficient financial resources to
accommodate their necessarily increased investment when the upturn in the economy
does arrive. Such failure is known as the "second-round" failure.
However, there may be unexpected changes in the business cash flow patterns, such
as a slump in trade, which can not be forecasted for, so an organisation must have
sufficient cash to cover such eventualities. Cash flow planning which considers the
ability of an organisation to overcome such cash flow deficits is called strategic fund
management.
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Strategic fund management may deal with such unexpected changes by cutting
dividend payments; improving working capital management by increasing creditors or
the overdraft level or by cutting debtors and stocks; or by selling assets which are not
required by the core activities of the organisation. (Those assets which are most
marketable, such as short-term marketable securities, would be sold before those
which would take longer to realise, such as land and unused machinery.)
Whilst a company should ensure that it has sufficient cash to cover unforeseen
circumstances, holding too much cash is inefficient because of the opportunity cost of
income foregone (either from placing short-term surpluses in marketable securities, or
from the investment in projects earning a rate of return higher than the return required
by the supplier of finance for longer-term surpluses). If the company cannot invest
long-term surplus money in projects which receive higher returns than placing the
money in a bank account, then they should return the money to the shareholders to
allow them to utilise the money in the way they consider optimal. This can be done
either by paying out higher dividends or by repurchasing the company's shares.
(b) Capital Structure and Cash Flow
The capital structure of an organisation is the way in which its assets are financed, i.e.
the levels, types and proportions of equity, debt capital, long- and short-term liabilities.
Obviously, when the business is growing it will require additional capital to fund its
increased assets.
The working capital of the business is made up of the more permanent current assets
plus the fluctuating current assets less current liabilities. Different levels, and types, of
long- and short-term sources of finance can be used to fund the fixed assets and the
working capital of the business. The method chosen will have an impact on the cash
flow of the organisation.
An aggressive approach to the financing of working capital is to finance all fluctuating
current assets and some more permanent ones from short-term sources. This may be
beneficial to the company if the short-term funds are cheaper than the equivalent long-
term ones, but increases the likelihood of liquidity and cash flow problems.
A conservative approach uses long-term financing to fund all permanent assets and
some fluctuating current assets. In fact it is only when current assets are large that
short-term financing is necessary – at other times there may be surplus cash to invest.
The company would probably invest this in marketable short-term securities, especially
if the amount is significant.
A balanced approach is to fund permanent assets from long-term sources and
fluctuating assets from short-term sources.
The method chosen will be a choice for senior management and will reflect their overall
policy and plans for the organisation. However, a business may be forced to adopt a
sub-optimal approach (from their viewpoint) due to restrictions in their ability to raise
the "correct" type of funds. As in all areas, the policy adopted by the firm should match
the expectations of the shareholders.
Moreover, the market's view of the company's prospects and abilities will determine the
level of debt investors will be willing to lend the company. The nature of the industry
that the company operates in will also affect the level of debt that the market will
consider prudent – the more volatile the sector, the lower the level of gearing which
would be advisable.
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environment has evolved, government has become more involved in the operation of
business – issuing laws, regulations, directives, voluntary policies and codes of practice
covering most areas of commercial life.
The area is rapidly changing, and we cannot possibly hope to cover every aspect affecting
companies, e.g. in areas such as health and safety; instead we will highlight some of the
more important pieces of legislation and government policy which directly impact in the area
of finance.
(a) The Companies Acts
The Acts of 1985, 1989 and 2006 contain various legal requirements for a company
operating its affairs in the UK including, in the field of accounting and finance:
requirements for depositing accounts; annual returns; registration of changes with the
Registrar of Companies; requirements for disclosure of information in the published
accounts; and procedures for the winding-up of a company. The legislation lays down
the minimum standards with which the company must comply.
There are also a number of further requirements established under the Acts and set
down by various different organisations such as:
Serious Fraud Office (SFO)
Financial Services Authority (FSA)
London Stock Exchange
(b) The European Union (EU)
The EU provides a huge area of government involvement in corporate laws. The
Council of Ministers can publish requirements that impose obligations upon all
companies in member countries, even overriding the laws in those member states.
However, the Community does provide the opportunity for additional markets and
greater availability of financial resources, including grant aid.
(c) Government Monetary Policy
Monetary policy is the manipulation by the Government of interest rates and/or the
supply of money in an attempt to influence the economy, and such economic variables
as growth, inflation and the balance of trade. However, in May 1997 the UK Labour
Government surrendered its setting of interest rates to the Bank of England, in line with
many other European countries. Nevertheless, the Bank of England will still
manipulate interest rates to achieve the desired levels of major economic variables,
including inflation, and this clearly, along with changes in the money supply, will have
an impact on the cost and availability of capital to an organisation. Moreover, as with
fiscal policy discussed below, monetary policy will also impact on other areas of a firm's
operation including the ability to export the firm's goods and the cost of imported raw
materials and components.
(d) Fiscal Policy
Fiscal policy is the alteration by the Government of the levels of taxation or the level of
government spending in order to affect economic variables such as unemployment and
inflation. It will obviously have an impact on the organisation – not just in the levels of
taxation which it pays and in the availability and level of grants, but also in the overall
level of demand in the economy and for the firm's products or services.
The current Government has taken significant steps to strengthen the framework for
fiscal policy since taking office. Fiscal policy is now directed firmly towards maintaining
sound public finances over the medium term, based on strict rules. Where possible,
fiscal policy supports monetary policy over the economic cycle and this approach,
together with the new monetary policy framework, provides the platform of stability
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necessary for achieving the Government's central economic goal of high and
sustainable levels of growth and employment.
Central to the fiscal framework are five principles of fiscal management:
transparency in the setting of fiscal policy objectives, the implementation of fiscal
policy and the publication of the public accounts
stability in the fiscal policy-making process and in the way fiscal policy impacts on
the economy
responsibility in the management of the public finances
fairness, including between generations
efficiency in the design and implementation of fiscal policy and in managing both
sides of the public sector balance sheet.
These principles were enshrined in the Finance Act 1998 and in the Code for Fiscal
Stability, approved in December 1998. The Code explains how these principles are to
be reflected in the formulation and implementation of fiscal policy. In addition, it
requires the Government to set out its fiscal policy objectives and the rules by which it
intends to operate fiscal policy over the life of the Parliament.
As set out in the 2007 Budget, the Government's fiscal policy objectives are:
over the medium term, to ensure sound public finances and that spending and
taxation impact fairly both within and between generations. In practice this
requires that:
(i) the Government meets its key taxation and spending priorities while
avoiding an unsustainable and damaging rise in the burden of public debt;
and
(ii) those generations who benefit from public spending also meet, as far as
possible, the costs of the services they consume; and
over the short term, supporting monetary policy, by:
(i) allowing the automatic stabilisers to play their role in dampening variations
in economic activity – for example, other things being equal, when the
economy is growing rapidly, there will be higher tax receipts and lower
social security payments – thus helping to moderate economic upturns and
stabilise the economy, and
(ii) where prudent and sensible, providing further support to monetary policy
through changes in the fiscal stance.
The Government has also specified two key fiscal rules that accord with the principles.
These are:
the golden rule – whereby, over the economic cycle, the Government will borrow
only to invest and not to fund current spending, and
the sustainable investment rule – whereby public sector net debt as a proportion
of GDP will be held over the economic cycle at a stable and prudent level.
These fiscal rules provide benchmarks against which the performance of fiscal policy
can be judged. The Government will meet the golden rule if, on average over a
complete economic cycle, the current budget is in balance or surplus. The Chancellor
has stated that, other things being equal, net debt will be maintained below 40% of
GDP over the current economic cycle, in accordance with the sustainable investment
rule.
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In setting fiscal policy, the Government takes a deliberately cautious approach. This
prudent approach is implemented, among other things, by basing public finance
projections on cautious assumptions for a number of key variables including the
economy's trend growth rate, levels of unemployment and oil and equity prices.
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Chapter 2
Company Performance and Valuation
Contents Page
Introduction 36
A. Ratio Analysis 36
Liquidity 36
Profitability 37
Debt and Gearing 39
Investor Ratios 40
Miscellaneous Items 42
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36 Company Performance and Valuation
INTRODUCTION
A company’s financial position will affect its plans, and its ability to carry out those plans, in
the key areas of financing, investment and dividend policy. Shareholders and other
interested parties will thus be interested in the profitability of the company, its ratio of debt to
equity, its liquidity and other measures of a company’s financial performance. Company
reports and financial statements can be used to assess the performance of companies by the
use of ratio analysis.
When considering ratios it is important that a number of years are looked at to obtain as
meaningful a picture as possible, and also to compare the organisation with others which are
similar in size and industry. The ratios chosen should be relevant to the organisation in
question, e.g. stock turnover would not be relevant to a service organisation with little or no
stock. The wider economic and environmental context the firm is operating in must also be
considered.
A. RATIO ANALYSIS
This should be a revision section for you, ratio analysis having been covered in your earlier
studies. The ratios we shall consider can be grouped into four main types:
Liquidity
Profitability
Debt and gearing
Investor.
We will now consider the main ratios under each heading.
Liquidity
A company may be profitable but not necessarily liquid and able to pay its obligations when
required – failure to do so may lead to the company being wound-up. The ratios and figures
under this heading indicate the extent to which a company can meet its current liabilities as
they become due. The common liquidity ratios are:
The current ratio, which is calculated as:
Current assets
Current liabilitie s
The acid test ratio, which is calculated as:
Current assets less stock
Current liabilitie s
These two ratios show the liquid resources available to pay the short-term liabilities, low
ratios indicating potential cash flow problems. The quick (acid test) ratio is often calculated
because of the length of time it may take to convert stock into cash, this ratio giving the truer
picture of the liquid assets of the organisation. The yardsticks which an organisation’s ratios
are traditionally compared to are 2:1 for the current ratio and 1:1 for the acid ratio. However,
the yardsticks should be viewed in relation to the organisation in question, and in relation to
other ratios – a company with high stock turnover can have a healthy liquidity position with an
acid ratio of less than 1.
When considering current and acid ratios remember that high results may indicate
overstocking, poor collection of debtors or that the company has excessive cash; in such
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Company Performance and Valuation 37
cases action should be taken to determine why there is a high ratio and steps taken (if
appropriate) to correct the situation.
The debtors’ payment period, which is calculated as:
Trade debtors
365
Credit sales
This shows the length of time taken by a company’s debtors to pay their bills. In
general companies give 30 days’ credit on invoices and this can be used as a
yardstick. The resultant ratio, however, must be viewed in the light of any seasonal
variations which may be present in the figures used to calculate the ratio. Industry
norms and the type of customers the firm has also need to be considered in
determining a yardstick to use (e.g. a high level of overseas customers may mean that
terms longer than 30 days may be given).
The stock turnover ratio, which is calculated as:
Average stock
365
Cost of sales
It shows the number of days that stocks are held; as with the debtors’ payment period
care must be taken to note any seasonal fluctuations contained in the figures used, for
which reason it is better to look at the trend in this figure. An increase may indicate a
slow down in sales or that the firm is overstocking.
Stock turnover debtor payment period give a good indication of the cash
conversion period.
The ratio can also be calculated to show the number of times average stock is turned
over in a year:
Cost of sales
Average stock
In addition, calculations by Beaver, Lev and others in the USA have shown that the
most significant single index of solvency is provided by establishing a trend line over a
period, from the ratio:
Cash flow
Total debt
Profitability
The primary (or most frequently used) ratio is return on capital employed (ROCE). This is
usually calculated as:
Profit on ordinary activities before interest and taxation
Capital employed
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38 Company Performance and Valuation
Profit/Assets employed
Assets/Sales Profit/Sales
Vehicles
However, as with many other ratios, there is no one agreed method of calculating it.
Problems in its calculation include the following:
(a) Should profit be pre-tax or post-tax? Shareholders will prefer post-tax because this is
the money available to pay dividends with; management will prefer pre-tax unless
they are responsible for minimising the company’s tax liability.
(b) Should non-recurring items, e.g. profit on the sale of an asset or arising from an
insurance claim, be included?
(c) Should non-trading profits, such as rents and investment income, be included?
(d) Should total assets or net assets (net assets = total assets minus current liabilities) be
used as the capital employed figure? Often a company has a permanent bank
overdraft (which is included in the current liabilities) and therefore should be considered
to be part of capital employed.
(e) Should intangible assets such as goodwill be included in the capital employed figure?
(f) How should assets be valued:
At cost?
At written-down book values?
At replacement values?
At current market values?
(Remember – the understatement of a company’s assets can produce an artificially
high ROCE.)
(g) Which Statement of Financial Position (balance sheet) date and profit figures are
relevant? Should the capital employed be that at the start or end of the year, or some
average figure?
The method chosen to calculate ROCE depends on the individual company. There is some
evidence that companies often choose the set of values which gives them the highest ROCE
but, whichever method is chosen, you must be consistent between years and companies to
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Company Performance and Valuation 39
allow comparability. Industry norms are also important, e.g. service industries tend to have
higher profit margins than manufacturing industries.
Other common profitability ratios are:
Gross trading profit : Sales
Net trading profit : Sales
(It is useful to compare trends in these two measures against each other to provide an
indication as to how well expenses are being controlled.)
Net profit : Equity capital
Net profit : Working capital
Sales : Capital employed (expressed as a number of times)
Fixed asset turnover rate, measured by Sales : Fixed assets (expressed as a number
of times) with a possible breakdown to asset class.
Current asset turnover rate, which is subdivided into the following:
(i) Sales : Total current assets
(ii) Sales : Debtors
(iii) Sales : Stocks held
In this calculation the figure of sales may be replaced by the cost of sales (if
known) since stocks at cost value remove the potentially distorting effects of
selling price changes in response to market conditions.
Note: The Du Pont Index is a variation on the primary ratio:
Profit Sales
Sales Capital employed
made up of the secondary ratios – the profit margin and asset turnover. Profit may be
calculated before interest and taxation or just as pre-tax profit. The first shows the level of
profit achieved on sales and the second shows how well assets are being used to generate
sales. Often there is a trade-off between profit margin and turnover – high profit levels may
lead to low sales and vice versa. Used in a series of ratios over a period of time this
provides more information than the basic ROCE ratio.
An obvious check on profitability is to look at the level of profit or loss shown in the accounts
and the change from previous years.
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40 Company Performance and Valuation
Example
Gearing ratio is frequently calculated using the formula:
Fixed interest + Fixed dividend capital
Gearing ratio
Ordinary share capital + Reserves
The following is an extract from the Statement of Financial Position of Denton Ltd as at
31 December 200X:
£000
Creditors: Amounts falling due after more than one year
8% debentures 10,000
Capital and Reserves:
Ordinary share capital (£1 ord shares) 30,000
10% Preference shares 15,000
Reserves 23,000
Investor Ratios
A major ratio in this class is that of earning per share (EPS) calculated as:
Net profit after tax, debenture interest, extraordinary items, minority interests and
preference dividends/No. of ordinary shares in issue and ranking for dividends. It is
measured in pence.
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Company Performance and Valuation 41
Investors wish to see growth in the EPS in order to fund investment and increases in
dividend payments. An inability to sustain a level of EPS could have a negative impact
on the level of a company’s dividend.
When looking at the trend of the EPS over time changes in capital structure, such as
the issuing of new shares or the conversion of convertible loan stock, need to be
considered. Similarly, when comparing different companies differences in their number
of issued shares should be considered. In the former case it would be useful to
calculate the fully diluted earnings per share which takes into account all capital
instruments ranking as equity shares now or in the future; for example, convertible loan
stock or share options. This also gives investors an indication of the effects of the
future exercise of share options, warrants and such like (including in the numerator the
savings in financing such instruments and the additional profits to be earned from
utilising the funds raised in the business).
Dividend cover shows how many times the declared dividend could be paid out of
distributable profits. For example, if a company’s profit after tax and debenture interest
was £40,000 and a dividend of £32,000 was declared, the dividend cover would be:
Profit after tax and debenture interest 40
times covered.
Declared dividend 32
If preference share dividends are payable these, too, form a prior deduction when
considering dividend cover on ordinary shares. The ratio shows the proportion of
distributable profits being paid out and indicates the risk that if earnings fall this level of
payout could not be maintained. A high cover may indicate that the firm is investing in
future growth.
Dividend cover can also be calculated using the EPS:
EPS
Dividend cover =
Dividend per ordinary share
The dividend yield of a company’s shares is important because it shows the return the
investor receives on the market value of shares (declared dividend is based on the
nominal (or par) value of shares). The shareholder can compare the yields between
different investments to help determine the value for money of his shares in the
company. Dividend yield is calculated as:
Gross dividend per share
100
Market value per share
Dividends paid to shareholders in the UK are net dividends (after tax); to determine the
gross dividend figure to use in the above calculation we have to adjust for taxation,
using the following formula:
Net dividend per share 100
Gross dividend
100 Low er rate of income tax (%)
Example
Thomas plc has just declared a net dividend of 10p per share. If the current share
price of Thomas is 135p, what is the dividend yield?
Net dividend per share 100
Gross dividend
100 Low er rate of income tax (%)
10 100
= 12.5p
100 20(%)
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Miscellaneous Items
The following ratios may also be of use to stakeholders when analysing reports:
Value added per employee
Sales per employee
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Company Performance and Valuation 43
Asset structure – this involves calculating the varying proportions in which the assets
are structured, for example:
Fixed assets 35%
Investments 5%
Net current assets 60%
100%
Alternatively the asset structure could show gross current assets, while gross current
liabilities are shown in the source of asset structure. The two could then be compared
to see to what extent outside interests “own” the company assets.
Proportions of shareholders’ interests, for example:
Preferential capital 10%
Ordinary capital 50%
Capital reserves 8%
General reserves 20%
Specific reserves 12%
100%
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Year 2 Year 1
£000 £000
Fixed assets (net) 6,401 2,519
Current assets
Stock 25,426 20,231
Debtors 21,856 20,264
Balance at bank 2,917 6,094
56,600 49,108
Year 2 Year 1
£000 £000
Sales 264,626 220,393
Trading profit 9,380 8,362
Interest payable 1,000 1,000
Taxation 4,380 3,642
Dividend 1,500 1,400
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(b) New Ideas plc requires £16 million for an investment project and is considering one of
the following:
(i) The issue to shareholders of £16 million 10% convertible (£1 for 1 share)
debentures at par.
(ii) A rights issue at 80p.
(iii) The sale in the market of £16 million 13% debentures at par.
You are required to:
(a) Calculate from the Statement of Financial Position and results:
(i) Two ratios particularly significant to creditors.
(ii) Two ratios particularly significant to management.
(iii) Two ratios particularly significant to shareholders.
(b) Comment briefly on the change between Year 1 and Year 2 in the ratios you have
calculated.
(c) Calculate the immediate effect of the three schemes on the gearing of the company.
(d) Calculate the effect of the three schemes on the earnings per share, on the assumption
that the Year 2 profits from the existing assets will be maintained and that the £16m net
investment will produce profits of £3.5m before tax and interest. The rate of tax can be
assumed at 50% (this is not the current rate but is used for ease of calculation).
Answer
Year 2 Year 1
(a) (i) Ratios significant to creditors
Current assets
Current ratio
Current liabilitie s
Year 2 50,199 : 21,404 2.35 : 1
Year 1 46,589 : 18,578 2.51 : 1
Current assets Stock
Liquidity ratio
Current liabilitie s
Year 2 24,773 : 21,404 1.16 : 1
Year 1 26,358 : 18,578 1.42 : 1
(ii) Ratios significant to management
Pre - tax profit
Activity ratio
Sales
Year 2 8,380 : 264,626 3.17%
Year 1 7,362 : 220,393 3.34%
Pre - tax profit
Profitability ratio
Net assets
Year 2 8,380 : 35,196 23.8%
Year 1 7,362 : 30,530 24.1%
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4,000
Earnings per share 40p
10,000
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economic and general environment making strict comparison extremely difficult. Similarly,
when making comparisons over time the impact of inflation must be considered because of
its impact on turnover, earnings, profit and asset values. However, the comparisons are
useful in helping to judge stewardship and the return on the investment relative to others
available.
If the accounts are different to those of the industry or segment to which they belong, further
investigation may be required by the financial manager or analyst.
Inter-firm variations could arise from Inter-firm variations could arise from
the ratio of: or various ratios the ratio of: or the ratio of:
relating
departmental
Gross profit Sales Sales
costs to sales
Sales Fixed assets Current assets
Firms can raise their gross profits either by achieving a higher volume of sales of items
earning high gross profits, or by adjusting prices within market constraints. The extent to
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Company Performance and Valuation 49
which either of them affects total gross profit will be indicated by the inter-firm comparison of
ratios showing:
(a) The composition of sales made;
(b) The gross profit achieved on different products.
Operatingprofit
ratio
Assets employed
Supporting
ratios
Operatingprofit Sales
Sales Assets employed
explanatory ratios
Productioncosts
Specific supporting ratios
Salesvalue of production
Once the ratios are compiled for the industry as a whole, they will be prepared for the
participating firm. The resultant ratios are then compared and any material deviations
investigated.
For example, if the primary ratio shows that the rate of return for the company is less than for
the industry as a whole, one or more of the subordinate ratios that make it up must be
affected. This type of comparison will indicate those work areas which are “up to standard”
as well as those which are either under, or over, performing. Senior management can then
focus its attention on the specific areas which have been identified.
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Advantages Disadvantages
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P/E Method
This is probably the most common and popular method to adopt when trying to value a
company share, as the historic price earnings ratio compares a businesses share price with
its latest profit figures and that is what is most likely to attract, or otherwise, new
shareholders and hence new capital investment.
This method calculates the value of a company’s shares by using the following formula:
Market value per share EPS P/E ratio
This method makes use of a company’s level of earnings to calculate its value; the EPS used
can either be an historical one, an average of past figures, or a prediction of a future figure.
The latter is the best but care must be taken when using forecasts, especially with the figures
used for growth in earnings. Similarly an appropriate P/E ratio should be used. The P/E
figure used depends upon:
(a) How secure the earnings of the company are – the more secure the earnings, the
higher the P/E ratio. Companies with high gearing levels tend to have lower P/E ratios
reflecting greater financial risk.
(b) Expectations of future profits – the higher the expected earnings, the higher the P/E
ratio. Adjustments may be made for past profit trends and the reliability of the
estimates. (Expectations of future profits can be calculated using the discounted cash
flow techniques which we shall discuss later in the course.)
(c) Companies which are unquoted generally have a P/E of between 50% and 60% of a
company which is quoted on the Stock Exchange and around approximately 70% of
shares quoted on the AIM, reflecting their reduced marketability and smaller size.
However, an unquoted company with earnings of £300,000 or more and growing at a
regular rate may have a higher P/E ratio because it may be able to be quoted on the
AIM.
(d) General financial and economic conditions.
(e) The industry or industries which the firm is in and the prospects of those sectors.
(f) Liquidity and asset backing, including the nature of assets – specialised assets with a
restricted resale market may reduce the P/E ratio.
(g) The make-up of the shareholders and the financial status of any major shareholders.
(h) Companies dependent on one or two key individuals and their skills may have their P/E
ratio lowered.
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Sometimes the P/E ratio of a company being acquired may be increased to reflect the
improvements the predator thinks they can introduce into the “victim” company, although
often such improvements are not realised.
Example
Sinbad plc is considering acquiring Flower Ltd. Sinbad plc’s shares have been quoted
recently at an average of £6.40 and the recently published EPS of the company is 40p.
Flower Ltd has 100,000 shares and a current EPS of 50p. Suggest an offer price for Flower
Ltd.
Answer
First we have to decide a reasonable P/E ratio. The P/E ratio for Sinbad plc is 640/40 16.
Assuming Flower Ltd is in the same industry its P/E ratio can be based on Sinbad plc’s P/E
ratio, adjusted for the fact that it is not quoted, its growth prospects, and riskiness of its
earnings. (If Flower Ltd is in a different industry then a typical P/E ratio for that industry could
be used as a basis for the calculations.)
Using Sinbad plc a P/E ratio for Flower Ltd can be estimated as, for example, 16 50% 8.
A value for the shares can then be calculated as 8 50p £4. This price would be the basis
for negotiations on the value of the company.
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(b) An adjustment may be required in a scheme of merger to the value of the companies’
shares to reflect differences in asset-backing – shares with higher net assets per share
figures could be expected to gain a higher price.
Unless otherwise told in an exam situation you should use the Statement of Financial
Position figures provided, adjusted for intangible assets, to calculate the share values.
However, you should list any concerns that you have along the above lines regarding the
figures given.
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54 Company Performance and Valuation
Example
Poh Ltd is expecting to pay a dividend of 20p this year, increasing at a rate of 5% per annum.
If its shareholders have a required return of 15%, calculate the current market price.
Answer
Using the formula:
d o (1+ g)
Po
(r g)
20(1 0.05)
210p
(0.15 0.05)
The dividend yield method is often used when valuing small shareholdings in unquoted
companies. The reasoning behind the model is that such shareholders, being unable to
influence a company’s earnings to any extent, will only be really interested in the dividends
they receive from holding their shares. This method assumes that a share price is equal to
the value of all the dividends it will attract during the time it is held, plus the amount received
when it is sold (the sale price will reflect future dividends expected at the point of sale).
Amounts of cash received in the future are worth less than cash received today, so we must
discount the future values to compensate and express them in terms of their equivalent value
today. The discount rate used is the cost of the capital provided (which is the yield the
investor expects to receive from his investment in the company). (We will cover this topic in
much greater detail later in the course.)
This discounting can be expressed as:
D1 D2 D3 P3
Po
(1 r ) (1 r ) 2
(1 r )3
(1 r )3
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Because the cash flows continue into the foreseeable future this will be the same as:
10p
at time t3
0.20
1
The present value of £1 a year forever at r% growth is .
r
10p 1 50p
Therefore the price today 3
3 28.94p (say 29p)
(0.20) (1.20) (1.20)
Note that growth will usually be expressed as a percentage.
Year Earnings
£000
1 85
2 88
3 92
4 96
5 96
Bear wishes to recover its investment within five years. If the after-tax cost of capital is
12.5%, what is the maximum price Bear should be prepared to pay?
Answer
The maximum price is the one where the discounted future earnings exactly equal the
purchase price paid.
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56 Company Performance and Valuation
Therefore the maximum purchase price would be £327,033. (Don’t worry if you do not
understand the discount factors at this stage; they will be fully explained later in the course.)
Note re CAPM
The Capital Asset Pricing Model is a further method of valuing shares. It is used especially
to determine the required yield on equity when the shares are being priced before a Stock
Market listing. We shall cover this topic in a later chapter, but we mention it here to remind
you to include it in your revision of this stage.
Worked Example
The following question is taken from the June 2006 examination paper.
The directors of Steel Ltd are considering putting in a bid to purchase a rival company Bronze
Ltd.
The most recent accounts of Bronze Ltd shows the following:
£’000 £’000
Sales 3,064,100
less: Cost of sales (924,100)
Gross Profit 2,140,000
less: Distribution expenses 225,000
Advertising expenses 308,000
Marketing expenses 568,000 (1,101,000)
Net Profit before tax 1,039,000
Corporation tax (311,700)
Net profit after tax 727,300
Dividend (127,300)
Retained profit 600,000
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Financed by
Capital
Ordinary shares (£1par) 1,500,000
Reserves
Profit and loss 285,000
Revaluation 26,700
1,811,700
Additional Information
1. A professional surveyor has recently established the following current realisable values
of the assets of Bronze Ltd
£
Land 650,000
Buildings 780,000
Fixtures 80,000
Motor Vehicles 260,000
Stocks 610,000
Trade debtors 100,000
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2. The estimated cash flows of Bronze Ltd (i.e. after tax, interest and replacement
investment) over the next ten years are estimated as follows:
£
2006 225,000
2007 275,000
2008 290,000
2009 360,000
2010 – 2015 380,000 p.a.
3. The directors would be seeking a return of 14% if they went ahead with the purchase.
4. A similar business to Bronze Ltd listed on the stock exchange has a Price Earnings
(P:E) ratio of 8:1
5. No strategic investment is envisaged over this period.
Required:
(a) Calculate the value of a share in Bronze Ltd using the following valuation methods:
(i) Net asset ratio
(ii) P:E ratio
(iii) Discounted (free) cash flow
(b) What are the main disadvantages of each method?
Answer
(a) (i) Net asset ratio:
£
Net asset value – per accounts 1,811,700
Adjustments:
Land 150,000
Buildings (120,000)
Fixtures (160,000)
Motor vehicles (60,000)
Stocks (30,000)
Trade debtors (10,000)
Adjusted net asset value £1,581,700
£1,581,700
Valuation per share is = £1.05 per share
1,500,000
(ii) P:E ratio:
Profit after tax = £727,300
P:E ratio = £727,300 x 8 = £5,818,400
£5,818,400
Valuation per share is = £3.88 per share
1,500,000
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61
Chapter 3
Acquisitions and Mergers
Contents Page
Introduction 63
A. Company Growth 63
Strategies for Growth 63
Economic Justification for Growth via Acquisition 65
The Development of "Mega-Mergers" 66
E. Disinvestment 80
Management Buy-Outs 80
Buy-Ins 82
Spin-Offs 83
Sell-Offs 83
(Continued over)
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Demergers 83
Going Private 83
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INTRODUCTION
In this chapter we will start to consider corporate structure and corporate growth. The first
part of the chapter investigates what happens when a company goes beyond being an
individual, single entity and, by means of acquisition or merger, becomes a multiple concern
or a group of companies.
When a firm is considering expanding whether internally (by expansion, integration or
diversification) or externally (via a merger or acquisition) it must ensure that growth is
economically justified, carefully planned and structured. Management must consider the
impact on the company, its (and if appropriate the target's) shareholders and employees, the
environment it operates in, and the Stock Market's views. In addition, the current regulatory
framework should be borne in mind and it is very important that the firm allows for a period of
transition for success to be achieved.
The converse of mergers and acquisitions is where a firm may decide to disinvest part of
itself, and this is the subject of the second part of the chapter.
Reasons for disinvestment include removing a part of the business which does not fit
correctly into a group's portfolio or its core business, selling an unprofitable subsidiary, or
selling a profitable subsidiary to finance expansion elsewhere. There may also be a desire
by the owners of a private concern to arrange their affairs to the best advantage to their heirs
in the light of favourable political or tax regimes. Disinvestment includes demergers,
management buy-outs, management buy-ins, spin-offs and sell-offs.
In common with the expansionary policies discussed in the first part of the chapter, it is
essential that such activity is carefully planned and monitored, and that the needs of the
various parties involved, including internal and external stakeholders (and especially the
shareholders), are considered.
We saw earlier in the course that there are several internal and external stakeholders in an
organisation, and the majority of them will be concerned with its stability and long-term
viability. In order to help them assess this several models of corporate failure have been
developed using financial and other ratios, often based on past empirical evidence. Although
these models can provide some useful guidance, as yet there is no one method that is
capable of predicting corporate failure in advance.
Acquisitions and mergers are a fairly frequent occurrence, and you should read the financial
press for details of any currently taking place – providing up-to-date examples is always
useful to your arguments.
A. COMPANY GROWTH
Strategies for Growth
The three main strategies a firm may adopt for growth are expansion, integration and
diversification.
(a) Expansion
This is the growth of existing, or development of new, markets or products, which can
be in response to changes in technology, customer taste or simply to exploit an
opportunity in the market.
(b) Integration
Integration, of which there are two forms – horizontal and vertical – is a form of
expansion.
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Horizontal integration is when a firm adds either new markets for its existing
products, or introduces new products to its current markets. It may be done so
the firm can benefit from economies of scale, although this may cause difficulties
for the firm if there are problems with the markets or the products.
Vertical integration is expansion of the firm along the supply chain and can be
either backward (supply of components or raw materials) or forward (being one
step closer to the end customer). It allows a firm to have greater control over the
industry including quality, quantity, price and share of the profits, although it
becomes more prone to falls in demand within the industry as a whole.
(c) Diversification
This policy is also a form of expansion – indeed, integration is sometimes referred to as
related diversification.
The diversification we are now going to consider is referred to as unrelated
diversification and comprises concentric and conglomerate diversification.
Concentric diversification is the development of products which are synergetic
with current products.
Conglomerate diversification is the development of products with no marketing,
technology or product synergy with the business's current products. The firm,
however, expects to obtain management synergies from the conglomeration.
There are several other potential advantages of conglomerate diversification. Can you
think what they might be?
Advantages include the following points:
The firm can move quickly into high profit areas by acquiring a firm in that market.
The resultant larger firm may have better access to funds.
A larger firm may have greater influence in the market and in the political
environment.
A spreading of risk may occur from operating in different markets.
Profitability may improve as a result of the diversification.
The new firm may be more flexible, and the acquisition of new firms may allow
withdrawal from existing markets.
There may be synergies to be obtained from the merger utilising a surplus in one
firm to satisfy a deficit in another (e.g. cash).
Unlike the takeover of a similar firm which may lead to a referral to the
Competition Commission, conglomerate (and concentric) diversification are
unlikely to be regulated by the state.
However, there are several problems associated with conglomerate diversification.
Profits in one part of the business may be used to help others making losses,
which may lead to the failure of the whole organisation.
Empirical evidence has shown that EPS (Earnings per share) are diluted when
companies with high P/E (Price Earnings) ratios are acquired and that risk may
be increased rather than reduced.
Empirical evidence has also shown that management synergies are often not
obtained in practice.
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(c) It has filed a prospectus for the issue of equity share capital at Companies House.
The Code is concerned with takeovers and mergers for all companies defined above and
includes partial offers and offers by a parent company wishing to acquire shares in its
subsidiary. Generally, the Code excludes offers for non-voting, non-equity capital.
You should note that, unlike legislation, the Code is not enforceable in law. However, those
who fail to conduct themselves in accordance with its rules may, by way of sanction, have the
facilities of the securities markets withdrawn from them.
The Code is made up of a number of general principles, which are essentially statements of
good commercial conduct, together with a set of Rules supported by substantial notes. The
Rules are not laid down in technical language, and they should therefore be interpreted by
their underlying spirit and purpose rather than appertaining to some specific legal framework.
General Principles
The six general principles are listed below:
1. All holders of the securities of an offeree company of the same class must be afforded
equivalent treatment; moreover, if a person acquires control of a company, the other
holders of securities must be protected.
2. The holders of the securities of an offeree company must have sufficient time and
information to enable them to reach a properly informed decision on the bid; where it
advises the holders of securities, the board of the offeree company must give its views
on the effects of implementation of the bid on employment, conditions of employment
and the locations of the company's places of business.
3. The board of an offeree company must act in the interests of the company as a whole
and must not deny the holders of securities the opportunity to decide on the merits of
the bid.
4. False markets must not be created in the securities of the offeree company, of the
offeror company or of any other company concerned by the bid in such a way that the
rise or fall of the prices of the securities becomes artificial and the normal functioning of
the markets is distorted.
5. An offeror must announce a bid only after ensuring that he/she can fulfil in full any cash
consideration, if such is offered, and after taking all reasonable measures to secure the
implementation of any other type of consideration.
6. An offeree company must not be hindered in the conduct of its affairs for longer than is
reasonable by a bid for its securities.
From time to time conflicts of interest may arise for the financial advisors involved. This may
apply where material confidential information is available to them or where the advisor is a
part of a multi-service organisation. Where the first situation arises, conflict may be removed
by the advisor declining to act; in the second circumstances, a careful segregation of the
business will be necessary to prevent conflict occurring within the rules – the latter is
sometimes referred to as "building a Chinese wall".
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70 Acquisitions and Mergers
Generally, unless a person (including those acting in concert with him) holds less than
30%, or rights over less than 30%, of the voting shares in a company, he may not
acquire a holding that would carry voting rights of more than 30%. Where a person
similarly holds between 30% and 50% of shares, or rights to shares, of the voting kind
within a company, he may not acquire more than a further 1% (2% before 3rd March
1993) of the voting rights in any 12-month period. Exempt from those described in this
paragraph are those who make an offer for the company.
When an offer is contemplated and the offeror (or person acting in concert) acquires
shares in the offeree in the three months prior to the offer, subsequent general offers
must not be on less favourable terms without the consent of the Panel. If, while the
offer is open, the offeror purchases shares at a higher price than the offer price, then
the offer price must be increased to be not less than the highest price paid for the
shares so acquired.
Immediate announcements may be required should the terms of the offer have to be
amended under various rules. Another rule requires immediate disclosure relating to
the number of shares acquired and the price paid, if practical, as soon as an acquisition
at a price higher than the offer price has been agreed.
Any dealings by the parties to a takeover or their associates must be disclosed daily by
12 noon on the business day following the transaction to the Stock Exchange, and it
will then be made available to the Panel and to the press. Additionally, disclosure
(excluding the financial press) will be required where purchases or sales of relevant
securities in the offeree or the offeror companies are made by associates for the
account of non-discretionary clients, themselves not being associated. Intermediaries
may be required to disclose the name(s) of their client(s).
(c) The Mandatory Offer and its Terms
Various Rules lay down the requirements and mechanics of a formal offer, providing
time limits in respect of acceptances, counter-offers, etc. The various options available
to both the offeror and the offeree are also laid down and reflect the percentage of
shareholders accepting or rejecting the offer. Whilst you do not have to remember
detailed prescriptions, you should remember that they exist and must be adhered to by
all parties concerned.
(d) Conduct During an Offer
The Rules lay down the requirements of a code relating to the conduct of the parties to
an offer while it is progressing. They are summarised below:
(i) All shareholders must have an equality of information.
(ii) Advertisements must be cleared by the Panel before their publication.
(iii) Details of all documents and announcements must be lodged with the Panel.
(iv) Generally, no actions are to be taken that would mislead shareholders or the
markets, including taking any action by the offeree that may frustrate the offer
prior to a bid being under way.
(v) Transfers by the offeree must be promptly registered.
(vi) Special care must be exercised with all documents, and the terms of the bid must
be covered carefully, including conflicting views, and so forth. Offer documents
should always be available and on display.
(vii) Specific rules govern the way profit forecasts are stated and assets valued.
(viii) The offer document should normally be posted within 28 days of the
announcement of a firm intention to make an offer. An offer must be open for at
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least 21 days after it is posted, and this period of time may be extended by further
notice.
(e) Substantial Acquisition of Shares
The Rules regulate the speed at which a person, or persons acting in concert (a
concert party), may increase shareholdings between 15% and 30% of the voting rights
of the company. They also invoke the accelerated disclosure of acquisitions of shares
or rights over shares relating to such holdings.
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Competition Commission
The Competition Commission (CC) is one of the independent public bodies which help
ensure healthy competition between companies in the UK for the benefit of companies,
customers and the economy.
The CC replaced the Monopolies and Mergers Commission in 1999, following the
Competition Act 1998. The Enterprise Act 2002 introduced a new regime for the assessment
of mergers and markets in the UK and under this, the CC's role is now clearly focused on
competition issues, replacing a wider public interest test under the previous regime. The
Enterprise Act also gave the CC remedial powers to direct companies to take certain actions
to improve competition, whereas under the previous regime, its role was simply to make
recommendations to Government.
Role and Work
It deals with issues in three broad areas:
In mergers – when larger companies will gain more than 25% market share and might
prove anti-competitive.
In markets – when it appears that competition might be distorted or restricted in a
particular market
In regulatory affairs – when the major regulated industries in the UK may not be
operating fairly.
Its investigations are thorough and open. If an investigation concludes that the situation
significantly damages or restricts competition in the UK, then it will work to determine and
implement appropriate remedies. For example, the CC can stop a merger from going ahead,
require a firm to sell off part of its business, or require it to behave in a way that safeguards
competition.
Its inquiries are always initiated following a concern referred to it by another authority, usually
the Office of Fair Trading. It also investigates issues referred by the sector regulators for
communications, gas and electricity, water, rail, airports, postal services, or by the Secretary
of State for Business, Enterprise and Regulatory Reform.
Membership and staff
The decision making body for each inquiry is a group of at least three independent experts,
drawn from a wider panel of around 50 appointed members. Members are supported by a
specialist staff team on each inquiry. Inquiry groups are usually led by the CC's Chairman or
one of the Deputy Chairmen.
Members are appointed to the CC for eight years, following open competition. They are
selected and appointed by the Government for their experience, ability and diversity of skills
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in competition economics, law, finance and industry. All except the Chairman work part-time
for the CC.
The CC's staff includes economists, business advisers, lawyers, administrators, accountants
and support staff (information services, finance, human resources). Two-thirds are direct
employees, with the remainder on temporary contract to help meet the CC's workload at any
particular time, or on loan from government departments.
European Union
A regulation introduced in 1990 gives the European Commission the power to block or
authorise mergers with a world-wide turnover of over 5 billion ecu (approximately £3.5
billion). Mergers with EU-wide turnover of 250 million ecu (approximately £175 million) need
to be agreed by the Commission. Reasons used to block mergers include incompatibility
with the European Common Market.
The European Union's 13th Company Law Directive dealing with takeover bids and
procedures will have statutory power in EU member states when it is adopted. This will be a
major change from the current UK approach of self-regulation.
You may find it interesting to note here that Britain has several more large industrial units
resulting from past mergers than the rest of Europe.
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74 Acquisitions and Mergers
jeopardise the takeover by reducing the value of the consideration offered to the
shareholders of the firm being taken over.
In order to defend against an unwelcome takeover bid, the directors have to plan and take
action as early as possible. They should keep a careful watch on dealings in the company's
shares to spot whether an individual (or group of individuals) is building up a significant
holding. They must also review the market price of their shares constantly in relation to their
earnings and asset values, in order to determine whether the company is undervalued by the
market and therefore prone to a takeover. In addition, directors should assess the
company's position within its industry as regards technology, size, etc., to see whether it is
uncompetitive and likely to attract a takeover bid by a major player in the industry. A further
tactic is to maintain contact with a range of stockbrokers, analysts and merchant bankers
who are the most likely to hear of hints and rumours of any takeover strategies at an early
stage.
The majority of mergers and bids are masterminded and engineered by the merchant
banking firms, and a defending company will almost invariably have to appoint its own
merchant bank to act in its defence.
The appointment of a merchant bank is just one of the substantial costs which may be
incurred in contesting a takeover bid – others include advertising, public relations and
underwriting costs. Similarly, the predator company will incur such costs. There is also the
possibility of capital gains or losses on the sale and repurchase of shares in the victim.
For a takeover bid to succeed enough shareholders must be willing to sell; this will happen
when they are attracted by the potential capital gain due to the high offer price, or when they
are unhappy with the current performance and its shares.
There are a number of different tactics used by companies to try and stop a bid, particularly a
hostile one. These include the following:
Developing their own management team to be creative and proactive, and ensuring its
potential is understood and appreciated by the shareholders
Keeping a very close eye on the businesses share register to spot individual
organisations building up a major shareholding in the company
Close co-operation of share buying between friendly companies
Attacking the logic and rationale of the bid
Improving the image and reputation of the business
Encouraging internal and external stakeholders to lobby on their behalf.
Considering share repurchase schemes as this reduces the number of shares available
for a rival to buy
Buying another business, thereby possibly making the business too large and
unattractive to predators!
Attacking the record of the bidder.
Convincing the shareholders that the shares are valued too low and they should
therefore not sell them, usually by circulating profit and dividend forecasts. They can
also suggest that forecasts may be at risk on a change of management, by the issue of
"defence documents" and press releases.
Revaluing the company's assets (using independent expert valuers) to increase the
asset-backing and encourage upward movement in the share price.
Launching a strong publicity campaign, aimed at highlighting present strengths and
potential, including promised improvements, e.g. in efficiency.
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Using additional shares either by issuing a block of shares to a friendly party, who will
act in the directors' interests making it almost impossible for the bidder to acquire 100%
control; or by issuing "A" shares, normally non-voting, so as to maintain shareholder
control but increasing the funds required by the predator to purchase the company.
Inviting a bid from another company (a white knight) which the directors believe would
be friendlier than the initial offeror. This is called a defensive merger.
Arranging a management buy-out.
If the companies are of a similar size, then the target company could make a counter-
bid for the predator.
Launching an advertising campaign against the predator, its accounts and methods of
operation.
Trying to have the bid referred to the Competition Commission.
The target company could introduce a "poison pill" preventing a build up of shares by
causing a change in structure and rights to be triggered by "abusive" takeover tactics.
It is important to remember that just as bids must follow the City Code on Takeovers and
Mergers, so must the actions taken by directors defending a company against a takeover
bid.
If a takeover of an unquoted company is resisted then the bid may simply fail. However, with
a quoted company some or all shareholders may wish to sell and there is more chance that
the takeover may succeed.
Consideration
Acquisitions will be financed by cash, shares, debentures or a mixture of the three. The
choice of payment will be determined by individual circumstances. When a merger takes
place, a share-for-share exchange occurs.
The factors to be considered when deciding the form that the consideration for acquiring a
firm will take are:
A potential capital gains tax liability may arise when shareholders dispose of their
shares for cash.
An increase in the number of shares may lead to a fall in the EPS and, perhaps, a
significant change in shareholder control.
Increases in borrowing limits or authorised share capital may have to be formally
approved by shareholders. Such increases will also have an effect on the gearing level
of the firm.
It may be cheaper to fund the takeover with debt rather than equity because interest is
allowable against tax.
The views of the shareholders in the target company should be considered; they may
wish to maintain an investment in the firm and thus prefer shares, and they will want to
ensure that they maintain their income levels – a fall in dividends will need to be
matched by a capital gain. Each shareholder will want to ensure that he receives at
least an equivalent return from his holding in the new company, assuming that there
are no other pressing external factors which make aspects other than return on
investment significant criteria for the shareholders.
As we discussed in the previous chapter there are several accepted methods of valuing a
company. Prices will generally reflect market forces and will tend to be higher when there
are several interested parties in competition. The package can be negotiated in such a way
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as may benefit both parties, perhaps by staggering the purchase over a period of time to aid
the purchasers' cash flow and to minimise capital gains tax liability.
The cost of the acquisition or merger will be the purchase price, plus any extra amounts to be
invested in, less the sale proceeds of any surplus assets in, the target company. When
considering the cost of the investment the projected returns and profits must be considered
alongside existing figures to ensure that the merger or acquisition is in the company's best
interests.
(a) Shares
A share (or paper) purchase involves the exchange of shares in the predator company
for the shares in the target company. The shareholders of both companies are now
shareholders in the predator company.
(b) Cash
A cash purchase simply involves the exchange of cash for the shares in the target
company. The predator should offset the expected earnings on the cash (if no takeover
were to take place) against the expected earnings from the acquired firm when
considering the purchase. The cash for the purchase can be raised from a Stock
Market issue of the predator company's shares or loan stock.
In assessing the sources of funding available, the financial manager should take into
account existing cash resources, and that a proportion of the capital can be generated
by:
Increasing working capital, e.g. by improving credit control. However, care
should be taken not to fund long-term assets with short-term finance.
Sale and leaseback of equipment or premises.
Staff share purchase schemes, or a rights issue to existing shareholders.
Disposal of surplus assets.
Borrowing, e.g. from the bank or by issuing debentures.
(c) Vendor Placing
This is a mixture of the above two approaches. Shares are exchanged in the target
company with those of the predator company – the predator shares are then "placed"
by the predator's stockbrokers with other buyers in order to raise the cash for the
target's shareholders.
You should remember that when shares are issued in the process of a takeover bid the
predator company's share capital will increase, and the effects on, for example,
earnings per share should be allowed for when considering the impact of the merger on
the company's performance.
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There will always be a certain level of risk in such an investment, but adequate research and
preparation should help to minimise such risk. Key features of the target company which will
improve the chances of success include:
A well-defined market niche
A balanced customer portfolio
A growth industry
Seasonal, fashion and economic cycle stability
A stable and motivated work force
High added value
Good technical know-how
A short production cycle
Located near the acquisitor's business
Matches the corporate strategic plan
Provides something the firm does not have for itself.
The early months will be critical in settling down the enlarged business and gradually
bringing about new working practices to improve the efficiency of the operation. It requires
commitment from all levels of the organisation. Mergers and acquisitions have often been
found to fail because senior management are more concerned with future expansion,
especially via further acquisitions, rather than with integrating the organisation's current units.
There is a particular problem if the cultures of the merging organisations are very different.
A further point for you to note is that mergers have often been criticised as being
implemented to reduce competition and thus to create a more comfortable environment for
further business development, rather than due to a desire for increased operating efficiency.
Company A Company B
Total earnings £300 £300
No. of shares 1,000 1,000
EPS 30p 30p
Share market price £4.50 £3.00
P/E ratio 15 10
Company A is seen by the market to be better managed, with better growth prospects, when
compared with Company B, and therefore its P/E ratio is higher. In the event of a takeover,
the position would be:
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New A plc
Employment
Staff will want to talk to the new owner and to be recognised for what they are able to
contribute. Talk will be important in order to maintain staff morale which may fall when the
sale is confirmed, especially if there is no more information forthcoming. The best staff will
be the first to go, because they will readily find jobs even in a depressed market.
Competitors may even tempt them away, with a resulting loss of goodwill. One method of
keeping key personnel is to require, as part of the purchase offer, that they sign service
contracts forbidding them to resign (and perhaps preventing them from selling their shares)
for a period of time (often three years). This will be in exchange for an attractive employment
contract.
In some cases new contracts of employment may be required for all staff to unify procedures
between the two firms.
Example
Strachan plc, a successful engineering company has made a bid for Atkinson plc, a large but
declining competitor. The following information is available for both companies which are
quoted on the Stock Exchange:
Atkinson Strachan
Share price £5 £3.10
No. of shares 10 m 25 m
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Both a cash and a share bid have been made. Strachan has offered Atkinson two shares in
Strachan plc for every share in Atkinson plc. Alternatively a cash offer of £6 per share has
been made. Strachan plc expects the takeover to generate savings of £5 m in present value
terms.
(a) Advise the shareholders of Atkinson plc on which offer to accept. Include financial and
other factors in your advice.
(b) How might Strachan plc expect to achieve the extra value of £5m? What uncertainties
might face Strachan plc in achieving this figure?
Framework Answer
We will consider briefly some points you could make in answering.
(a) Cash Offer:
Cash received 10 m £6
£60 m.
Share offer:
Shares in Strachan received 10 m 2
20 m shares.
At the current valuation of Strachan shares this would be worth 20 m £3.10 £62 m.
However, Strachan would now have 45 m shares in issue, which would be likely to
have an impact on earnings per share. In addition, the share price of the expanded
company will change as a result of the acquisition.
Advice to shareholders of Atkinson plc
The cash offer of £60 m is £10 m greater than the current value of the company's
shares, i.e. 10 m £5. We are not given any information about earnings per share of
each company or about future growth in earnings, other than the projected savings of
£5 m. The acquisition may result in a fall in earnings per share in Strachan plc. This in
turn may reduce the value of shares from £3.10 per share.
Cash proceeds are certain, the return on shares in Strachan plc is less certain.
However, receipt of cash means that shareholders of Atkinson plc face an immediate
tax liability on the capital gain. Strachan plc is already a successful company and it is
likely to have considered the acquisition of Atkinson plc very carefully. Strachan plc
must consider that it will be able to increase future earnings because of the acquisition.
With a competitor removed from the market, there is a real possibility of increased
turnover for Strachan plc.
On balance the acceptance of the cash offer would seem to pose less risk to
shareholders of Atkinson plc.
(b) Savings on acquisition may be achieved by:
Economies of scale, e.g. one head office with less staff than exists in the two
companies currently;
Additional expertise from staff of Atkinson plc, reducing training and development
costs;
Lack of competition should result in operating economies, e.g. the advertising
budget may be reduced;
Tax advantages may occur on acquisition.
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Now check your answer with the one given at the end of the chapter.
E. DISINVESTMENT
Some groups specialise in buying companies, either stripping their assets or "turning" the
business around, and then selling the companies, generally at a profit. Other groups may be
forced to sell off parts of themselves due to financial problems, changes in the markets or
alterations in their strategic plans.
It is not always easy to move out of a market – one reason may be a reluctance to admit to
failure. Management may feel they are safer continuing in the market and may want
(wrongly) to attempt to recover sunk costs. There may also be economic costs – it may be
easier to sell a going concern; there may be large redundancy costs; and the withdrawal of a
product may have a detrimental impact on the sales of the company's other products. In
certain countries government action may prevent withdrawal from a market.
Management Buy-Outs
A management buy-out (MBO) is the acquisition by the management of all or part of a
business from the owners. The owners can be the shareholders, an owner-proprietor or the
parent company, although it is generally the directors who make the disinvestment decision.
In general, MBOs have been of profitable subsidiaries which do not match the group's
strategic plans.
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Management buy-outs have become more common since the late 1980s, the number
increasing five fold in 10 years and the value increasing from less than £50 million to more
than £2,800 million. It has been due partly to incentives provided by the UK Government and
partly due to a belief that management functions better as part of an autonomous profit-
seeking unit.
(a) Advantages of MBOs
The potential benefits of an MBO include:
For the vendor an MBO provides an alternative to the closure of the business or
part of it, and prevents the sale to a third party who could be a competitor. The
management and employees are more likely to be cooperative to an MBO rather
than in a sale to a third party. Moreover, the sale of the going concern may well
achieve more money for the vendors.
For the management team the buy-out allows them to purchase an operation of
which they already have full operational knowledge. They must be certain,
however, that they can turn the business around to obtain a better return once
they are released from the constraints of the current ownership. An MBO will
also allow the management team to be owners rather than employees and, if the
business is threatened with closure, will prevent them losing their jobs.
For the financiers who may be invited to participate there is a reduced risk
compared to a new venture which has no track record to be evaluated.
(b) Disadvantages of MBOs
There are also potential problems with management buy-outs which include:
Technical managers, who are good at managing processes, may not have the
financial or legal knowledge required to conduct a management buy-out. They
will have to use expert advisors, who can be costly, for the tax and legal
complications that can arise from an MBO.
There are often redundancies following an MBO, used as a means of reducing
costs. In addition there may be problems convincing employees of the need to
adjust working practices and the company may lose key employees. There may
also be previous employment and pension rights to be maintained which may be
a drain on resources.
Individual managers will be required to be financially committed to the venture.
This may include borrowing from the bank, which may create problems in the
manager's personal financial affairs.
Problems may arise with regard to the continuity of relationships with suppliers
and customers.
It may be difficult to decide on a fair price to be paid for the business.
Management may resent the board representation required by suppliers of
finance.
Cash flow problems can arise, especially if fixed assets need replacing.
(c) Financing MBOs
The management's own financial resources which they are willing to invest will
generally be insufficient for the purchase of the business, and they will have to find
financial backers. In order to convince the backers of the viability of their idea the
management team should prepare a business plan. The business plan should
contain cash flow, sales and profit forecasts and planned efficiency savings. This will
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Buy-Ins
A management buy-in is similar to an MBO except that it is a team of outside managers who
mount a takeover bid to run the company.
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Spin-Offs
A spin-off is the creation of one or more new companies with shares being held by the
shareholders of the "old" company in the same proportion as before. The assets of the
business, having been separated, will be transferred to the new company which will usually
be under different management from the "old" company.
Sell-Offs
A sell-off is the sale of part of the company, generally for cash, to a third party. An extreme
form of sell-off is the liquidation of the entire company.
Demergers
A demerger is simply the opposite of a merger. A demerger can either be the selling of part
or parts of the business to a third party, or offering shareholders shares in the demerged
parts of the business in place of their current shares in the "merged" company. A famous
example of a demerger is the split of ICI plc.
There are both advantages and disadvantages of demergers, mainly arising from their
smaller size, e.g. if there were diseconomies of scale before the demerger these should be
reduced. Similarly any economies of scale would also be reduced. There may also be an
increased risk of takeover or, if the attractive parts of the company have been disinvested,
there may be a reduced takeover risk. Other advantages include an ability to concentrate on
fewer areas, thus hopefully improving efficiency and removing control problems, and an
increase in cash and earnings. Disadvantages include the reduction in the ability to raise
finance, lower turnover, status and profits.
The Stock Market's reaction to the demerger will depend on the reasons for it and the view
on the future profitability of the demerged components, but generally demergers are viewed
favourably. This may be because visibility of individual parts of the business is improved, and
there is a greater choice of shares for investors.
Going Private
A listed company may decide to go private. This occurs when a small group purchases all a
company's shares and the company is no longer quoted on the Stock Exchange – a well-
known example being the repurchase of shares in Virgin by Richard Branson.
The reasons for such a move may be to prevent takeover bids, reduce the costs of meeting
listing requirements and limit the agency problem. In addition, because the firm is not subject
to volatility in share prices, it can concentrate less on the short-term needs of the Stock
Market and more on its own medium- and long-term requirements.
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In this scheme Blue gains some earnings contributed by Yellow, and Yellow loses earnings to
Blue. The critical point to both sets of shareholders will be the rating placed on the shares of
Green by the market. Gains and losses in EPS will be mitigated by movements in the new
share prices.
As an alternative to the above, the shares in Green could be apportioned on the basis of
input of earnings without heeding the market price situation. This would penalise Blue in the
sense that the market appears to favour its development and growth potential more highly
than it does Yellow's. A straight proportional split would not acknowledge the apparent
difference in market rating.
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Chapter 4
Financial Markets
Contents Page
Introduction 86
A. Stock Markets 86
Why do we have Stock Markets? 86
The London Stock Exchange 87
Over-The-Counter 91
"Big Bang" 91
Market Participants 92
Some Other Common Market Terms 92
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INTRODUCTION
Financial managers have the responsibility of ensuring that sufficient short- and long-term
capital is available to organisations, at the time it is needed, and that surplus funds are
placed at suitably high rates of return. He/she will need to ensure that a suitable balance is
struck between obtaining a good rate of interest on funds held (the longer the term then
usually the higher the interest rate received) and when those funds are needed for internal
investment and business growth. It is not uncommon for the financial manager even to
invest "overnight" to get a small amount of investment before the funds are needed the
following day – maybe, for example, to pay staff salaries and wages!
To achieve this, the financial manager must therefore have a good all round working
knowledge of the financial markets that are available to the firm.
This chapter considers the financial markets, the institutions which operate upon them and
some of the terminology used. We shall pay particular attention to the markets for share
capital – highlighting the importance of the Stock Market and its players in company and
market decisions. (However, share capital itself, and alternatives to equity, are dealt with in
more detail later in the course, as are options and other financial instruments.)
A. STOCK MARKETS
There are several different stock markets in the world, of differing levels of sophistication.
Indeed, most major industrial countries have stock markets of some form. However, the
three major ones (or the "golden triangle") are those in London, New York and Tokyo. Here
we are mainly concerned with the London Stock Exchange.
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What reasons might a business have for seeking a stock market listing?
Access to a wider pool of resources. The number of potential investors in a business
grows much larger when it is opened up to a public arena, and this makes it much
easier to obtain funding for expansion, investment and growth and so on.
Improved marketability of shares as they are traded on the stock market and they can
be bought and sold relatively easily and in any quantities.
Capital can be transferred to other uses – raising capital through the stock market can
release internal funds for other purposes.
There is a perception in business that a quoted company is more secure and their
image is improved, allowing often easier relationships with customers and suppliers
and so on.
A listed company is in a better position to merge and acquire additional business
through the capital growth potential of a stock market listing.
Equity capital
The largest proportion of long term finance for a modern large business is usually provided
by shareholders and is called equity capital.
Ordinary share capital is usually the main source of new money provided from shareholders.
Shareholders are allowed to participate in the running of the business (usually through voting
in general meetings) and to receive dividends from profits. They carry the greatest risk in
terms of financial return and because of this the directors of a company will usually strive to
ensure that the shareholders (in recognition of this risk and support) get a good return on
their investment.
When a business is formed the original shareholders decide on the number of shares to be
issued – this is the authorised capital of the firm. This is the maximum amount of share
capital that the business can issue (unless shareholders vote to amend the limit).
At any one point in time, the business will have a certain amount of shares issued to the
market. This can never exceed the amount that is authorised in the legal documentation.
So, for example, a business might have an authorised ordinary share capital limit of, say,
£5,000,000, but only have say £3,000,000 issued on the stock market – allowing them at
some future stage to offer, for sale, up to another £2,000,000.
Shares have a stated par value, usually 25p, or 50p or more commonly £1. This nominal
amount has no bearing at all on the actual market price of the share or how much they can
be bought and sold for on the stock market. Whilst the par value has no real significance,
note needs to be taken of the fact that when looking at a Statement of Financial Position
(balance sheet) the share capital figure often appears out of place and insignificant.
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companies. Until a few years ago the second-tier was the Unlisted Securities Market
(USM), but this was phased out and replaced by the Alternative Investment Market (AIM).
(a) The Main Market
Any company wishing to be floated on the main market must comply with Stock
Exchange rules and regulations in addition to the legislation in this area.
Joining the Main Market involves two processes.
A company applies for its securities to be admitted to the Official List (a "listing")
through the UK Listing Authority (UKLA), a division of the Financial Services
Authority (FSA); and
the listing is dependent on those securities gaining admission to trading on the
Main Market through satisfying the Exchange's Admission and Disclosure
Standards.
The UKLA is responsible for drawing up and monitoring the FSA's Listing,
Transparency and Disclosure, and Prospectus Rules for Main Market companies.
The Exchange is a recognised investment exchange under UK law and has a duty to
ensure that dealings in securities admitted to its markets are conducted in a proper and
orderly manner. To ensure this, it requires listed companies to meet specific standards.
The listing rules are contained in the Stock Exchange's Admission of Securities to
Listing. The requirements seek to secure the confidence of investors in the conduct of
the market. This is done by:
Ensuring that applications for listing are of at least a minimum size. The size
rules relate to the market capitalisation and annual profit figures.
Requiring companies to have a successful track record of at least three years.
Ensuring that companies requesting listing at least appear to be financially stable.
Insisting that a sufficient number of shares of a tradable value (i.e. several shares
of a smaller value rather than fewer shares of a higher value are preferred), are
made available to the general investing public to allow a free market to exist in
the company's shares.
Requiring the directors of a company to make a company resolution to adopt the
terms and conditions of the Stock Exchange Listing Agreement. This includes the
provision of sufficient information (e.g. interim results) to form a reliable basis for
market evaluation.
Note that you may also see flotation on the Stock Exchange referred to as "going
public", or "getting a listing on the Stock Exchange".
From a company's viewpoint there are both advantages and disadvantages in obtaining
a full listing. Table 4.1 summarises the principal advantages and disadvantages of a
full listing to a company.
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Advantages Disadvantages
Going public and becoming a listed company is a major step for a business. It could
lead them to a greater amount of funds being available through the public capital
markets to help with development and business growth. However, there is a price for
this – for example:
There is a great deal of administrative and legal requirements that come with a
stock exchange listing and a very demanding (and ever increasing) list of rules,
regulations and constraints that all need to be met. The directors of a listed
company have a very large degree of responsibility to ensure that all these
various rules and regulations are met in full or they could be personally liable.
All companies that obtain a full listing must ensure that at least 25% of their share
capital is in public hands. This is to make sure that shares are available to be
traded on the "public market" and in this respect public means individuals that are
not associated with the company (for example, current directors or shareholders).
There will be great pressure to pay dividends to the shareholders as their reward
for providing equity funds for the company. In particular, institutional investors
(and particularly the ones who have a great deal of influence with companies) will
be looking for regular and good returns on their investments. Regular and
consistent dividend payments are often seen as a measure of how well the
business (and the senior management team) is performing.
The directors also need to be aware that in a listed company they lose some of
their privacy, particularly as details of their pay and "perks" will be reported as an
integral part of the annual accounts process.
There are a number of critical points that affect the timetable for an official listing and
these can take days, weeks or months depending on the work that needs to be done
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between expression of interest and actual listing day. The critical points could be
summarised as follows:
Issue of prospectus
Offer closure for share bids
Allocation and allotment of shares
Dealing begins.
The listing process itself involves a number of key specialist advisers as follows:
The sponsor, who may be a merchant bank, a stockbroker or other professional
adviser, is the key adviser to a business trying to gain a place on the official list.
The sponsor examines the company and its aims and objectives by taking into
account its structure, strategy, long term plans, aims and objectives and capital
needs.
Accountants, who are responsible for providing a detailed financial "health
check" on the company.
Legal advisers who are there to ensure that all the detailed legal requirements of
listing are met.
Brokers advise the business on share market conditions and the anticipated
demand, from the public, for shares in the business if full listing is obtained.
Registrars maintain the records of ownership of shares when they are bought
and sold.
Underwriters, who are usually issuing houses or merchant banks, generally act
in a syndicate by agreeing to purchase any securities not taken up at the issue
price (underwriting). The underwriters will charge a fee which will be payable
whether or not they are called upon to take up surplus securities. Whilst not used
in placings, they are often used in rights issues.
Merchant banks, who are sometimes employed to give financial advice, but may
also act in the role of issuing house or sponsor.
There are a number of different methods of issue which can be summarised as follows:
Offer for sale. When companies go public for the first time a large issue will
probably be by offer for sale and the offer price is advertised a short time in
advance so it is fixed without certain knowledge of the condition of the market at
the time applications are made.
Offers for sale by tender. A minimum price will be fixed and subscribers will be
invited to tender for shares at prices equal to or higher than this minimum price.
The shares will be allotted at the highest price at which they will all be taken up.
Offer for subscription is only partially underwritten. This method is
sometimes used by small companies who stop the offer if a stated minimum price
is not achieved.
A placing. This is an arrangement whereby the shares are not all offered to the
public and instead the sponsor arranges for most of the shares to be bought by a
small number of investors (usually institutional investors) such as pension funds
and insurance companies.
Reverse takeover. Sometimes a larger unquoted company makes a deal with a
smaller quoted company, which then takes over the larger company.
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Over-The-Counter
It is also possible to buy shares and other financial instruments in the "over-the-counter"
(OTC) markets. These are not regulated or supervised by the Stock Market so there is less
protection for the investor, although the costs of dealing on the OTC are less than those of
dealing on the main or secondary markets.
"Big Bang"
"Big Bang" occurred on 27 October 1986 and was considered necessary because of
restrictive practices on the London Stock Exchange, including fixed commission scales and
the limited number of firms permitted to participate in dealing.
The effects of "Big Bang" included the abolition of the fixed commission scales and the
opening of the Stock Exchange to a wider range of participants. The changes resulted in an
increase in competition due to large institutional investors being able to negotiate
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commission levels. There has also been a change in the constitution of the membership,
with foreign companies moving into the Stock Exchange (a well-known case being Merrill
Lynch) and some other overseas organisations acquiring hitherto private dealers, e.g.
Citicorp purchased Scrimgeours. In addition, there is now 24 hour trading in leading
international shares – starting in the Far East, moving to London and then to New York and
back to the Far East for the following day.
Market Participants
Prior to "Big Bang", there was a rigid distinction in the membership of the Stock Exchange
with brokers buying and selling financial instruments on behalf of clients for which they
charged fixed commissions, and jobbers acting on their own behalf in buying and selling
securities. Jobbers would trade with the brokers, but never actually came into contact with
the original investors. This was known as single capacity trading.
Single capacity trading has now been replaced by dual capacity trading as both activities
can now be conducted by a single firm. Firms can act as agents of the investor (previously
the responsibility of the broker) whilst also acting as principal in their own right in buying and
selling shares (previously the role of the jobber). Some firms only act as agency brokers,
working solely as agents on the behalf of clients in return for commission, and do not deal as
principals for themselves.
The new traders acting in a dual capacity are called market-makers. Market-makers must
be members of the Stock Exchange. They must register to deal in certain types of security,
and must agree to quote two-way prices (for buying and selling) in the shares they trade in.
"Chinese walls" are required to be set up in firms which deal as market-makers in order to
separate the broker and dealer functions. This is to prevent the investor (and the firm) from
unscrupulous market-makers making profits at their expense, and will also help provide some
protection for market-makers and firms against allegations of this type.
Only market-makers are permitted to use the Stock Exchange Automated Quotations
System (SEAQ) which is a computerised price display regularly updated by the market-
makers themselves. Dealers and investors may view the system on computer terminals via
dedicated networks.
Two other terms you may come across in this area are GEMMs and SEMBs. GEMMs are
Gilt-Edged Market-Makers and SEMBs are Stock Exchange Money Brokers. SEMBs
help to ensure liquidity in the share markets by dealing with the lending and borrowing of
money and stocks to those who are experiencing difficulty in fulfilling share-trading deals.
For larger institutional investors there is a growing alternative to this system of market-
makers known as crossing networks. Crossing networks, of which examples are Instinet
and Global Posit, electronically link buyers and sellers of shares and other financial
instruments. Another example of a crossing network is Tradepoint, which operates a screen-
based matching of orders for certain UK equities. Whilst the use of crossing networks is still
rare in the UK it is common practice in the US.
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uncovered bear (one who sells shares he does not have) can face unlimited losses if the
price rises quickly and he has to purchase shares to sell at a loss.
A bear-raid is when a number of dealers sell ostentatiously in an attempt to drive down the
market. In order to prevent this market-makers can mark up the prices near the end of the
account period – a so-called bear squeeze.
A bull may buy shares and intend to sell them at a profit before he receives them (he may
need the sale proceeds to pay for the shares); if this goes wrong and a loss is made he is
referred to as a stale bull.
A stag is someone who applies for shares at the start of a new issue of shares intending to
sell them straightaway. This is because new issues are usually priced low in order to ensure
that they are sold, and hence start trading at a substantially higher price. The difference
between the issue price and the initial trading price (the premium) is the stag's profit.
Banks
Banks are a major source of short-term (and recently medium-term) corporate financing.
Long-term loans from banks are in the form of mortgages. The banks will expect the
customer to provide a reasonable proportion of the required funding from its own resources
(e.g. from equity). Clearing banks like to lend against security (i.e. assets).
The rate of interest charged to larger companies on medium-term bank loans will be set at
LIBOR (London Inter-Bank Offer Rate) plus a margin which depends on the credit rating and
riskiness of the borrowing. For smaller companies the interest rate will be the bank's base
rate plus a margin, again depending on the riskiness and credit rating of the firm. The rate of
interest in both cases can be either fixed or variable. Often in the former cases it is adjusted
every quarter, half-yearly, three-quarterly, or yearly in line with changes in LIBOR.
Merchant Banks
These are banks dealing as investment banks, generally for corporate clients. They have a
range of activities, including:
Involvement in the business of the Stock Exchange for their clients, helping in the
issuing and underwriting of share issues and share registration.
The provision of venture capital and large scale medium-term loans to companies.
The taking of wholesale deposits in all currencies.
Dealing in foreign exchange and the bullion markets, and through subsidiaries in stocks
and shares.
The provision of advice during takeovers and mergers.
Granting acceptance credits.
The management of client investments and acting as trustees.
The provision of general investment and deposit advice to corporate clients.
Institutional Investors
These are institutions with large funds to invest in assets which provide sufficient returns and
security, including investments in company stocks and shares. The UK's main institutional
investors are:
(a) Unit Trusts
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Unit trusts were developed in order to allow small investors to hold a diversified
portfolio of investments. The portfolio is managed on behalf of investors by a unit trust
company which deducts management expenses from the income of the portfolio before
paying the investors their share of the income. Each investor holds a sub-unit or stake
in the portfolio. The sub-units are sellable, their price being determined by the
underlying value of the securities included within them.
(We shall examine portfolios in detail later in the course.)
(b) Investment Trusts
Investment trusts invest in a wide range of securities though they are generally
concerned with quoted and larger unquoted companies. They are interested in both
returns and securities, wishing to maintain a steady growth in income in order to pay
their shareholders' dividends.
(c) Venture Capital Organisations
Venture capital is the investment of money in a new or expanding business, or in a
management buy-out. It is generally done in exchange for an equity stake in the
business and a seat on the board.
There are several organisations offering venture capital, including venture capital funds
acting as agents for the venture capital industry, the clearing banks. Those which have
joined are regulated by the British Venture Capital Association. The biggest and oldest
venture capital provider is the 3i group (Investors in Industry plc).
Venture capital is a high risk, high return investment, which is generally short term,
being between five and seven years in duration. Often the venture capitalist will be
able to realise his investment (and hopefully profits) when the business is floated on
the AIM and the venture capitalist can sell his shares.
In order to qualify for venture capital a company must be able to show the venture
capitalist that it has the ability to succeed; that the product or service is viable and
meets a need in the market; that sufficient levels of the correct form of finance are
available; and there is, or will be, a good management team.
Venture Capital Trusts (VCTs) are investment trusts investing a significant proportion
of assets in unquoted companies to a maximum in a company of £1m, and per investor
of £100,000. There are general tax reliefs available to individuals aged 18 years or
over (but not to trustees, companies or others) who invest in VCTs as follows:
exemption from income tax on dividends from ordinary shares in VCTs ("dividend
relief"); and
"income tax relief" at the rate of 30% of the amount subscribed for shares issued
in the tax year 2006/07 and onwards (for subscriptions for shares issued in
previous tax years the rate is 40%). The shares must be new ordinary shares
and must not carry any preferential rights or rights of redemption at any time in
the period of five years (three years if the shares were issued before 6 April 2006)
beginning with their date of issue. This income tax relief at 30% is available to be
set against any income tax liability that is due, whether at the lower, basic or
higher rate.
The maximum amount of deferral relief is the amount subscribed for eligible shares in
VCTs that are issued in the year (up to a maximum of £100,000).
(d) Pension Funds
Pension funds hold large amounts of money which will provide retirement benefits for
their members. In most pension funds there is a surplus of incoming funds from
contributions over outgoings as pension payments. The surplus must be invested to
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achieve the best possible return whilst maintaining the security of funds. The pension
fund manager often spreads the investment between high yield securities, e.g. gilts,
and equity or property.
Pension funds may provide substantial finance for major investment schemes. For
example, funds from the Coal Industry Pension Scheme helped fund the new
"Galleries" in Wigan town centre. A new multi-million pound expansion of Milton
Keynes shopping centre is being funded by the Universities Superannuation Fund.
(e) Insurance Companies
These, along with pension funds, provide the most funds for investment in the UK.
They have similar investment policies, seeking secure returns and steady growth in
order to meet their commitments.
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Parallel Markets
These consist of the Foreign Exchange Market and the Eurocurrency Market, both of which
we shall consider later in the course. They also include:
The Local Authority Market
The Interbank Market
The Finance House Market
The Intercompany Market
The Certificate of Deposit (CD) Market.
Option Markets
Options are a form of dealing which can be used as an insurance against, or for speculation
on, a rise or fall in a particular share, and act as a way to limit the cost of taking a view on the
future performance of the share.
An option is the right to buy (a call option) or sell (a put option) shares at a future date
(generally three months forward) at a fixed price agreed now. There is also a double option
which gives the right to buy or sell and this is called a put and call option or a straddle.
Bargains are agreed at a striking price (the figure at which shares can be called or put at
the end of the option period), which is the current share price, plus interest to meet the carry-
over facilities during the option period. It is not necessary to wait until the end of the option
period before taking action, and it is possible to deal in those shares during the period. A fee
per share will be charged by the broker whether or not the option is exercised.
Options have a maximum life of nine months with expiry dates arranged on a three-month
cycle, so that a maximum of three extensions can be arranged on shares of any one
company. They are popular because they provide investors with price and time variety not
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possible with traditional call and put options and the opportunity to profit from price changes
which involve a smaller outlay than direct involvement in the securities themselves.
An extension of the options market is the Traded Options Market. This gives the holder of
the option the right to buy or sell the option itself before its expiry date.
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Chapter 5
Sources of Company Finance
Contents Page
Introduction 101
(Continued over)
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Bonds 121
Syndicated Loans 122
Mezzanine Finance 122
Medium Term Notes (MTNs) 123
Project Finance 123
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INTRODUCTION
In this chapter we will look at the main sources of finance available to companies.
We start by considering the primary source of funding for limited companies – equity finance
– including how it is raised. Whilst under UK company law all limited companies must have
equity, many also utilise additional types of finance. We go on, then, to examine the different
forms available, including those from international capital markets. This is an area in which
there are always new arrangements developing, and you will almost certainly learn of more
from your reading of the financial press as new ideas come to market.
A. SHARE CAPITAL
Shares are described as permanent capital because the funds supplied for their acquisition
are non-returnable (to the investor who provided them) in most circumstances other than in
the event of a liquidation. The ordinary shareholders collectively own the company, but stand
last in line for rewards on investment and in the event of liquidation, although they do have
ownership of the remaining funds either in a trading period or in the event of liquidation.
Ownership means that the ordinary shareholders bear the greatest risk. In return for their
acceptance of the risk they are equity shareholders, each share carrying a vote in the
management of the business, although as we saw in Chapter 1, managerial control may be
limited.
In the case of a limited company, the Articles of Association will include details of each class
of shares which comprise the capital structure of the company.
Value
We have already determined that the owners of the company are the shareholders – and to
show their ownership they have shares issued to them. Shares are issued in the UK at a
nominal, authorised or face value generally of £1, 50p, 25p, 10p or 5p.
Be careful not to confuse nominal value with market price, to which it bears no relationship.
The market price is the price that shares are sold for. (If the market value and the nominal
value are the same, the shares are said to be at par value.)
The only exception to this rule of no relationship is when the shares are first issued, and the
nominal value is the minimum at which the price would be set. Established companies
issuing new shares to the market, with existing shares that have a market value in excess of
the nominal value, may issue the new shares at a premium (i.e. at a value greater than their
nominal value).
(Not all countries have company shares with nominal value. It would be a useful exercise for
you to find out if countries which you deal with at work have shares with nominal values.)
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Retained Profits
You will recall from your earlier accounting studies that part of shareholder funds is retained
profit. Indeed the major source of new funding for companies in the UK is retained earnings.
Dividend Payable
Dividends are paid on ordinary shares as a percentage return on their nominal value. For
example, the holders of a £1 nominal ordinary share in a company which declares a dividend
of 20% will receive 20p per share regardless of the price paid for the share.
You will recall from an earlier chapter that the dividend yield relates the market price of a
share and the dividend received. If the dividend yield falls, then the share becomes less
attractive compared to other investments, demand for it will fall, and supply will increase as
investors wish to sell. Its market price will then reduce until the yield on its new market price
is in equilibrium with returns received elsewhere for similar levels of risk. Although this is a
highly simplified explanation, it does underpin the basic rationale behind the workings of the
stock markets.
We shall discuss the level of dividends paid by the company in greater detail later in the
course, but dividends are generally dependent on the results of the company. This benefits
the company, since ordinary shares have a fluctuating service cost which only increases (in
theory at least) during periods in which the company is successful.
Share Categories
Shares are categorised according to the company type and trading frequency:
(a) Alphas
These are the shares of the most prestigious companies which are generally heavily
traded and dealt in by a large number of market-makers. Prices are posted
immediately on SEAQ.
(b) Betas
These are also large company securities, but they are not as heavily traded as alphas.
They must have at least four market-makers dealing in them and prices quoted on
SEAQ are those at which firm deals can be made.
(c) Gamma
These securities are traded less frequently than betas and the prices quoted for them
are merely indicative.
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(d) Deltas
These are the least traded of all and no prices are actually shown, simply indications of
a dealer's interest.
Penny Shares
Penny shares are shares which have a very low value (often because the company is
experiencing difficulties) with the bid or offer spread of such shares exceeding 10% of their
market value. Investors buy such shares in the hope that the market has undervalued their
prospects and that they will make a substantial profit when the price recovers. In practice,
however, the market is rarely wrong and the price often falls further or the company goes into
liquidation. The low valuation of such shares reflects the high risk attached to them and the
efficiency with which the market operates.
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causing the company to issue more shares than necessary. A rise in share prices of
approximately 20% is usually aimed for.
Sale by Tender
This method is occasionally used for large first time issues but it is less common than offers
for sale because of uncertainties as to the amount of finance which will be raised and it may
give the impression that the issuing house is unable to set a price for the shares. An issue
by tender has become a more common method of share issue in recent years.
The issuing house (or the company) invites members of the public to subscribe by tender, i.e.
to state at what price they will take the security offered; sometimes there is a minimum price
below which tenders will not be accepted. Applications may be dealt with in a number of
ways and the most common methods are explained in paragraphs (1) to (4) in the following
example:
Example
ABC plc is to make an issue of £2m ordinary shares by tender. The minimum tender price
has been fixed at 50p. Applications were received as shown in the table below:
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£350. This method is the fairest so far for the small investor and generally means that
more applications are successful.
A further improvement results from a method whereby two prices are fixed.
Applications at prices between them are scaled down. Applications at lower prices are
rejected, and those above the higher price are accepted in full, up to a certain
maximum number, or scaled down slightly.
There are, of course, a number of variations to the above and issuing houses are continually
researching to make improvements. Although small investors tend to avoid tenders as they
have difficulty in deciding on a fair price, recent experiences suggest that the fixing price is
usually not much different from the ensuing market price, reflecting the influence of the
institutional investors.
The two main advantages for the company issuing shares are that:
(a) Paperwork is reduced as the number of applications is reduced.
(b) The fixing price in recent years has usually been higher than would be necessary in an
offer for sale. In an offer for sale, the price is kept low in order to ensure that the offer
is accepted, but in a tender the forces of supply and demand have improved the price.
Rights Issue
The term rights issue is applied to the system of issuing shares to existing shareholders,
usually at a discount from the market price, in order to raise further capital from existing
shareholders. (A discount makes rights issues impractical when current market price is at or
below nominal value.)
When offering shares in a rights issue, the company sends an explanatory letter to each
shareholder detailing the price, accompanied by a provisional allotment letter indicating the
number of shares to which the member is entitled to subscribe, e.g. a rights issue on a 1 to 5
basis at 120p per share means that for every 5 shares a shareholder holds he can purchase
an additional 1 at 120p. The offer must be on a "rights basis" in proportion to the member's
existing holding as a fraction of the holdings of all members eligible to receive the offer.
Forms of acceptance or renunciation accompany the offer, and should a member choose not
to accept he may renounce his "rights" in favour of someone else. In due course, if the
member accepts the offer, or exercises his rights, he will lodge his acceptance and cheque
with the company.
Should the member choose to renounce the offer he can sell the rights to his shares, a sale
being attractive because the price of the shares is below their current market value. The
rights of shareholders to buy the rights are known as pre-emptive rights.
If shareholders do not take up the rights or sell them, the company must, under Stock
Exchange rules, sell them for the shareholders who get the rights value. If small amounts
are involved the benefits can go to the company. In order to maintain his share of control the
shareholder must take up all his rights. The shares may be issued to outsiders or in different
proportions between members. Members may, if permitted under the company's Articles of
Association, be offered the shares which their peer group have rejected.
The key to a successful rights issue is to achieve a balance between the ratio of the
proposed new issue to those already in issue, and the price at which rights may be taken up,
considering that the rights issue will generally be at a discount.
Rights issues offer advantages to both the company and existing shareholders – for the
company there is less administration and no prospectus is required, both factors reducing
costs. The cost of underwriters, if used, will also be lower.
Shareholders obtain shares at a discount or can sell their rights allowing the purchaser a
chance to buy shares at a discount. The share price before dealing in the newly-issued
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shares will be "cum" rights, and thus the shares will trade at a higher price. Shareholder
control can be maintained provided the shareholder exercises his full rights.
Calculation of Issue Price
This is the amount that the company wishes to raise from the issue divided by the number of
new shares. It is important to issue a sufficient number of shares so that the issue price is
below current market price.
Alternatively, if the number of shares as well as the price is to be determined, the factors to
be considered include:
the ease of issue
the current market price – too large a discount is to be avoided, and a discount of
approximately 25% is usual; and
the number of shares currently in issue – too many new shares might dilute the EPS
too much.
Calculation of Price after Issue
(a) Ex-rights price
This is the theoretical price and is essentially a weighted average. If, for example, a
company is making a 1 for 3 rights issue, with each new share costing £2 and the
current market price being £3, then the ex-rights price will be:
Cum rights value of 3 shares ( £3) £9
New share £2
£11
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At lower earnings: if, say, the new shares are expected to yield 5% earnings:
Total earnings will be (£900,000 (1m £2 5%)) £1,000,000.
Monetary value of shares £10,000,000.
Value per share £10,000,000/4,000,000 £2.50 per share.
At higher earnings: if, say, the new shares are expected to yield 15% earnings:
Total earnings (£900,000 (1m £2 15%)) £1,200,000.
Monetary value of shares £12,000,000.
Value per share £12,000,000/4,000,000 £3.00 per share.
The break-even point (i.e. no dilution of earnings per share) is when the rights price
equals the current capital employed per share, assuming that current trends continue.
The actual impact on shareholder wealth will depend on the earnings generated
compared to the existing earning rates – if lower the market value will fall, if higher it
will rise and so forth.
Empirical evidence has found that the market price of shares tends to fall after a rights
issue due mainly to uncertainty as to the company and its prospects – the level
depends on the company and the rights issue.
Value of Rights
We noted earlier that shareholders can sell their rights. How do we determine what price
they would receive.
The value is the difference between the price of the rights shares and the ex-rights shares.
In the above example, the price of the rights shares was £2; if the value of ex-rights shares
was £2.75, then the value of the rights is £2.75 £2 or 75p. The new shareholder in effect
pays the ex-rights price purchasing the rights for 75p and the share for £2. The value of
rights attached to each existing share is the value of rights divided by the number of shares
required to issue. In the above example this would be 75p/3 shares or 25p per share.
Shareholders can take up part of their rights and sell the others.
Other Methods
(a) Subscription offers
An offer for subscription is an invitation to the public by, or on the behalf of, an issuer to
subscribe for securities not yet in issue or allotted.
(b) Prospectus issue
If reasonably substantial, the company might make an issue direct to the public with the
absolute minimum of assistance from the outside sources we discussed earlier. It is
rather unusual because of the complexity of the nature of the capital issue.
(c) Stock Exchange introduction
This is the introduction of the shares on the Stock Exchange so that a quotation (i.e. a
price) can be fixed, rather than the issue of shares. An introduction cannot be made
unless sufficient shares are available to establish a market and thus a price, and this
method tends to be restricted to larger firms.
(d) Role of underwriters
As we saw earlier, underwriters agree to purchase any securities not taken up at the
issue price and will charge a fixed fee for their service. Use of underwriters removes
the risk of a share issue being under-subscribed.
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However, the costs of underwriting are high and companies with marketable securities
may choose to use another method known as the bought deal. Here a major
investment bank will buy all the shares in the new issue at a slightly discounted price.
(e) Open offers
This is an offer to existing shareholders to subscribe for securities, whether or not pro
rata to their existing shareholdings. They are not allotted through the use of
renounceable documents.
An open offer is a concessionary method of listing, approval being sought in principle
early on. Once approval has been granted, the sponsor firm has to inform the market
ten business days prior to the "on-register" date. The announcement will state that the
proposals are subject to shareholder approval at general meeting.
(f) Vendor share scheme or placing
Where a vendor prefers cash to shares issued to finance an acquisition by a purchaser,
an issuing house can place the securities with clients for cash.
(g) Exchanges and conversions
This is the process used to replace one security with another, e.g. a vendor
consideration issue or paper issue used in a merger or takeover bid.
(h) Employee share schemes
Such schemes are often used as incentives, e.g. share option schemes which give
certain employees (usually directors) the chance to purchase shares in the company at
a price determined in advance, hopefully, for a financial benefit.
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C. SHARE REPURCHASES
Repurchases, or buy-ins, of shares may be made by companies out of their "distributable
profits", or out of the proceeds of a new issue of shares made especially for the purpose,
provided they are authorised to do so in the company's Articles of Association.
A company may not, however, purchase its own shares:
Where, as a result of the transaction, there would no longer be any member of the
company holding other than redeemable shares.
Unless they are fully paid up, and the terms of the purchase provide for payment on
repurchase.
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Now check your answer with the one given at the end of the chapter.
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It is also highly likely that the returns that investors will require from their equity investment
will exceed that required by the suppliers of debt capital. This is because there is less of a
risk involved for the suppliers of debt capital than there is for the suppliers of equity capital.
Further, in the event of a shortage of profits or the business going into liquidation, then the
debt capital would be paid before the remainder of profit (if there was any) would be paid as
dividends to shareholders.
Another major advantage to the business is that debt interest can be used to reduce taxable
profits (and hence tax liabilities) whereas dividends paid to shareholders cannot be used to
reduce a tax burden.
Legal implications
Whenever a business secures a loan there is usually a legal agreement between the lender
and the borrower that deals with the non-repayment by the borrower to the lender. Often the
debts and loans granted to a business will be secured loans – i.e. secured on named assets
of the company that stand to be lost if the business fails to repay the agreed debt to the
agreed schedule. In the event of a problem, most companies and lenders will do their best to
arrange a different repayment schedule that will meet the requirements of both parties – after
all, it is not in the interests of either party to be paying expensive legal fees to recover debts.
The important thing to bear in mind is that, with any debt, there will inevitably be a legal
obligation on both parties to keep to the agreed terms of the particular debt involved.
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The current levels of interest rates compared to the rate being paid on the
debentures.
Companies frequently find that interest rates are higher as the redemption date
approaches and will delay their redemption to the later date.
Debentures tend to be issued in times of low inflation and low interest rates. The
redemption will be financed either by cash reserves or by the raising of fresh debt or
equity capital. A company, and potential investors, will compare the finance a company
has available with the planned repayment of its debt shown by the repayment dates of
its loan stock and debentures.
Debentures may be issued at par, at a premium or at a discount. Debentures issued
at large discounts and redeemable at par or above are known as deep discount
bonds. They are generally issued at low rates of interest which can be attractive to
companies with cash flow problems. However, there is a high cost of redemption. The
investor may be attracted by the capital gain at maturity, but you should note that it is
taxed as income (less notional interest not paid).
(b) Security and debentures
Debentures are generally secured by a trust deed setting out the terms of the contract
between the company and the debenture-holders. The deed may include security
given in the form of:
(i) A specific or fixed charge over particular asset(s) in the form of a mortgage
debenture, restricting the alteration and disposal of the asset by the company.
(ii) A general or floating charge on assets, giving a general lien to the debenture-
holders, but not restricting the company in its utilisation of assets.
The trust deed may also contain provisions for a trustee (e.g. a bank) acting on the
behalf of debenture-holders to intercede if the terms of the trust deed or Articles of
Association in relation to the debentures were breached, e.g. failing to pay the correct
amount of interest, or exceeding prearranged borrowing limits. A receiver may be
appointed if the company is unable to honour its debts, although a reconstruction
scheme may be used to avert liquidation.
A well-established company may occasionally issue an unsecured or naked
debenture. Naked debentures generally have interest rates at least 1% higher than
secured debt in order to compensate investors for the additional risk they are bearing.
(c) Registration
Mortgages and debentures must be registered in the company's own register of
charges and with the Registrar of Companies to record their existence.
(d) Issue price and conditions for purchase
Debentures can be issued at a discount and a company may also enter the market and
buy up its own debentures without formality.
(e) Types of interest
The great majority of debentures are issued at fixed rates of interest. There are two
possible variations and these are:
(i) Floating rates
The issuer will be able to vary the interest paid. For the issuing company, floating
rates afford protection in periods of volatile interest rates since it will benefit when
rates fall. Investors benefit, since they should obtain a fair return whatever
happens to interest rates generally.
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The market value of the debentures depends on the coupon rate of interest
compared to general market rates. The value should remain stable since the
interest payable on the debentures will follow that of the market.
(ii) Zero coupon
These are debentures which are issued with no rate of interest attached.
Instead, they are issued at a discount. Thus there is an implied rate of interest in
the level of the discount. The advantage to the borrower is that there is no cash
outlay until redemption. For the lender, there may be tax advantages in not
receiving income in the short term.
(f) Return for investors
To determine whether a potential investor will receive a certain rate of return by
investing in a particular debenture, we need to calculate the NPV (net present value) of
all the cash flows involved. Whilst we will cover this topic in more depth later in your
course, it is worth spending a few minutes considering an example.
Example
An investor requires a return of 15% on his investments and is considering investing
£200 in 12% debentures redeemable in exactly three years' time. Their current price is
£80.
First calculate the amount of stock he can purchase:
£(200 100/80) £250.
The yield will be (£250 12%) £30 per year.
The calculate the return (assume interest is paid at the end of the year and personal
taxation is ignored).
As the NPV is positive, the investor will achieve more than his required return of 15%.
To find the market price given the cash flows and the anticipated market rates of
interest is simply a matter of excluding the purchase price from the calculation. In other
words, the NPV would be 233.70. This is, of course, the value of £250 worth of stock.
For £100 worth of stock, the calculation is: 233.70/2.50 £93.48.
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Mortgages
A mortgage is a form of secured loan placing the title deeds of freehold or long leasehold
property with a lender as security for a cash loan, usually up to two-thirds the value of the
property. The cash is generally repayable over a prearranged period, and interest (at either a
fixed or floating rate) is payable on the amount borrowed.
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There is no specific requirement for loans to be converted into shares on every occasion.
There may even be an option not to convert but simply to redeem the original investment.
You should understand and be able to calculate the following:
(a) Conversion Ratio
This is the number of ordinary shares that will be obtained from each unit of loan stock.
For example, if a company has 8% convertible loan stock standing at par and £10 of
loan stock can be converted into three £1 ordinary shares, then the conversion ratio is:
3 £10
0.30
£1
0.3 shares will be obtained for every £1 of loan stock converted.
(b) Conversion Price
This is the amount of stock necessary to obtain each ordinary share. In the example
above this would be:
£10
£3.33
3
£3.33 of stock is required for each share.
(c) Conversion Premium
This is the difference between the value of the stock and the conversion value of that
stock on the date of issue. Therefore, again using the figures above, £100 of stock
was worth £120 on issue and we know that £100 of stock can be converted into 30
shares. (We ascertained 0.30 shares can be obtained for every £1 of loan stock in (a)
above.) Supposing that on the day of issue, the market value of each share was £3,
then the conversion premium would be:
120 (30 3)
100 33.33%
(303)
The premium per share is calculated as:
Market value of convertible loan stock
Current price
No. of shares at conversion date
In our example we have:
(120 30) 3 4 3 £1 per share.
Looking at it another way, 30 shares, currently worth £90 (£3 per share) will be worth
£120 on their conversion (i.e. £4 per share).
From the point of view of the issuing company, the greater the amount of conversion
premium the better, because they will have to issue fewer shares for the amount of
original loan stock. For the investor, the level of conversion premium which is
acceptable will be weighed up against expectations for the company. If the investor
considers the premium reasonable, he will invest.
He may, for instance, expect that the value of each share will rise between the date of
purchase and the date of conversion. In our example, if the price has risen to £5, the
value of the conversion will then be (30 £5) £150 for an original investment of £120.
The conversion premium is often stated as a percentage of the conversion value.
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The attractiveness of convertible loan stock will depend on a combination of factors such
as:
The cost of the stock at the time of purchase.
The period of time to conversion.
Stockholders' future expectations for the company.
As a rule of thumb, convertible loan stock issued at par has a lower coupon rate than normal
stock, the lower returns effectively being the price the investor is prepared to pay for his
conversion rights.
The market value of the convertible stock cannot go lower than the market value of normal
stock of the same coupon rate. Should this occur, it will signify that the market does not
attach any value to the conversion rights.
The advantages of convertible loan stock to the respective parties are set out in Table 5.2.
Stock can be issued at a lower The market value of the stock cannot
coupon rate – useful in times of high fall below that for similar ordinary
interest rates. stock of the same coupon rate.
Interest on loan stock should be tax- Increases in share prices will cause
deductible unlike dividends on equity. the value of the conversion to rise
because this is the amount the
As it is a form of deferred equity,
investor will eventually receive.
there will be no cash outlay on
redemption. Stockholders will be paid before
shareholders in the event of a
Convertible loan stock may be
liquidation.
counted as equity for gearing
calculations, unlike ordinary loan
stock.
If share prices are depressed, it may
be easier to issue loan stock instead
of equity.
Warrants
Warrants are rights given to investors allowing them to buy new shares in a company at a
future date at a fixed, given price. This price is known as the exercise price, and the time at
which they can be used to obtain shares in is known as the exercise period.
Whilst warrants are generally issued alongside unsecured debt as a "bribe" to potential
investors, they are detachable from the debt and can be traded in any time up to the end of
the exercise period.
The value of the warrant is dependent on the market's view of the likely price of the shares it
can be traded for in the future. Its "theoretical value" is the difference between the current
share price of the company and the exercise price multiplied by the number of shares which
each warrant can be used to obtain. During the exercise period the value of the warrant will
not fall below this price; if this theoretical price is zero, then the value of the warrant will also
be zero (the holder would be better not exercising his rights and obtaining £0, than obtaining
something worth less than he paid for it).
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The price of warrants and their attached premiums depend on the length of time until the end
of the exercise period, the exercise price, the current share price and the future prospects of
the company.
Generally, if the company has good prospects then the warrants will be quoted at the warrant
conversion premium which is calculated by comparing the cost of purchasing a share using
the warrant, and the current share price. The premium will reduce the closer it is to the
exercise price because if there was a premium during the exercise period then it would be
cheaper to purchase the shares directly rather than via a warrant.
Example
Ella plc issued 50p warrants which entitle the holder to purchase one share at £1.75 at a
specified time in the future. If the current share price of Ella is £1.50 calculate the conversion
premium.
The conversion premium is:
£
Cost of the warrant 0.50
Exercise price 1.75
2.25
Current share price 1.50
Premium 0.75
The premium would be quoted as a percentage of the current share price – in Ella plc's case
50%.
There are several advantages to investors of purchasing warrants. Initially they have to
spend a smaller amount than if they were purchasing shares and, because of this lower
outlay, the potential loss is much less (the value of the warrant compared to the value of the
share). Conversely, because the initial outlay is less than for shares any increase in the
share price (and thus in the warrant's price) will result in a greater percentage increase in the
wealth of the warrant-holder than of the shareholder. For example, a 25p increase in the
value of Ella plc's shares (see above) would give shareholders an increase in their wealth of
25/150 or 16.67%, but warrant-holders would have an increase in wealth of 25/50 or 50%, –
this is known as the gearing effect of warrants. A final advantage for taxpayers is that
profits from warrants are classed as capital gains rather than income.
Companies often issue warrants to make debt issues more attractive, and even sometimes to
make them viable. In addition, they may be able to offer a lower rate of interest on the debt if
warrants are attached to the issue. Warrants are a potential future source of equity, which do
not require dividends immediately or cause a dilution of earnings per share or current
shareholder control.
Leasing
Leasing is a common method of financing the use of an asset – commonly equipment such
as office equipment and cars.
A leasing agreement is between two parties – a lessor and a lessee. A financier (the
lessor), generally finance house subsidiaries of banks, purchases the asset and provides it
for use by the company (the lessee). The lessor is considered to be the legal owner and can
claim capital allowances for the asset. The lessee makes payments to the lessor for the use
of the asset.
There are two forms of leases – finance leases and operating leases. In addition, you
need to be aware of the use of sale and leaseback methods.
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Hire Purchase
Hire purchase is in many respects a hybrid between lending and renting. The facility may be
simply defined as "hiring with the option to purchase". The HP payments consist partly of
capital and partly of interest payments. On payment of the final instalment ownership of the
asset passes to the customer. By concession the Inland Revenue will generally permit the
customer to claim and retain capital allowances provided that the option to purchase fee is
less than the market value at the end of the contract term.
The common procedure is for the finance house to buy the good from the supplier who
delivers it to the customer. The finance house and the customer set up a hire-purchase
agreement, which includes the payment of an initial deposit by the customer, the size of
which depends upon the finance company's policy and the credit worthiness of the customer.
The advantage for the customer is that the interest part of the payments are allowable
against tax, and capital allowances can be claimed on the asset.
Bonds
A bond is a loan to a company, government or a local authority. Generally, interest is paid to
the lender and the full amount of the loan is repaid at the end of the term, which is usually for
ten years or less. There are many other names for this type of investment – for example:
loan stock
fixed interest
debt securities
gilts (loans to the government), and
corporate bonds (loans to companies).
The main benefit of these investments is that the investor normally gets a regular stable
income. They are not generally designed to provide capital growth.
Bonds have a nominal value. This is the sum that will be returned to investors when the
bond matures at the end of its term. Most bonds have a nominal value of £100. However,
because bonds are traded on the bond market, the price paid for a bond may be more or less
than £100. There are several reasons why the price might vary from the nominal value,
including:
If a bond is issued with a fixed interest rate of, say, 8% and general interest rates then
fall well below 8%, then 8% will look like a good yield and the market price of the bond
will tend to rise – perhaps from £100 to £110 or £120.
The reverse is also true – if interest rates rise, the fixed rate of a particular bond might
become less attractive and its price could fall below its nominal value.
Ratings agencies might take the view that a particular company's bond no longer
qualifies for a high rating – perhaps because the company is not doing as well as it was
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when the bond was issued. If this happens, then the market price of the bond might
fall. On the other hand, the company's rating may be improved leading to a price rise.
The inflation rate might start to creep up and the interest rate on some bonds might
start to look less attractive compared with other investments.
Risk
Bonds are generally less risky than having a share in a company. One of the main risks is
that the company to which the money has been lent can no longer afford to pay the interest
due or may be unable to pay the money back at the end of the term (for example, if it is
bankrupt).
It is generally considered that these risks do not apply to gilts – a government is always
expected to pay in full, although there have been instances of certain countries being unable
to repay. Bonds issued by governments will usually pay a lower rate of interest as a result of
the perception that they are less risky.
Companies have different credit ratings and a company with a high credit rating is regarded
as a safer bet than a company with a lower credit rating. Thus, companies with a lower credit
rating will have to offer a higher rate of interest on their bonds than companies with the top
credit rating, simply to attract investors and to compensate for the higher risk.
Buying and selling
Bonds can be bought and sold in the market (like shares) and their price can vary from day
to day. A rise or fall in the market price of a bond does not affect what the investor would get
back if the bond is held until it matures. He/she will only get back the nominal value of the
bond, in addition, of course, to any coupon payment to which the owner is entitled during
ownership of the bond, irrespective of what was paid for it. If the holder paid less than the
nominal value then he/she will have made a capital gain when the bond matures; and a
capital loss if more was paid than the nominal value.
Bonds may be bought directly through a stockbroking firm, which incurs charges similar to
buying shares. Alternatively, bonds may be bought through a pooled investment.
Syndicated Loans
It is quite often the case that, where a business requires a very large loan, one single bank is
not willing to lend the whole amount – particularly if this is seen as exposing the bank to an
unacceptable level of risk with one client and one loan. In such cases, in order to spread the
risk involved, a number a banks may each contribute a proportion of the loan to the borrower,
with the bank that orginiates the loan being the lead manager and the one that is responsible
for the overall management of the syndicate and the loan. The managing bank will often
underwrite much of the loan whilst inviting other banks to underwrite the rest, so
guaranteeing to provide the funds if other banks do not participate.
Such syndicated loans generally offer lower returns than bonds, but on the grounds that they
are usually paid out (in the event of liquidation problems) before bond holders, then they are
less of a risk to the lender.
Mezzanine Finance
Mezzanine finance is a form of hybrid finance that offers a high return with a high risk. It is
somewhere between normal debt finance and normal equity finance and, because of its low
priority, it attracts a reasonably high rate of interest payment.
Mezzanine finance is often used in the funding of a management buyout (MBO) and is often
used when the limits of bank borrowing has been reached and the busines cannot or is not
willing to issue any more equity capital. It is a form of finance that allows the business to
move beyond what would normally be considered as a safe level of debt to equity ratio.
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Project Finance
Sometimes it is preferable to finance a major project through a stand alone investment with
its own source of funding. In a typical project-financed venture, a finance deal would be
created by a buiness that provides some equity capital for a separate legal identity to be
formed to build and operate the project – for example, the building of the Channel Tunnel or
a major sporting stadium (such as for the Olympics).
The amounts involved in this form of finance are usually large and complex in nature. It
usually takes the form of a loan provided through bonds or bank loans directly to the
separate entity, with the finance being secured through the assets of the particular project
rather than the parent company's assets.
For major new ventures, project finance offers a number of advantages, including:
Off Statement of Financial Position financing which is not recorded as debt in the
parent company
Where the project involves another country in which there might be a greater level of
political risk, this method of finance provides more "arms length" control
There is a transfer of risk to a separate legal identity
Management involved in the project may well be given an equity stake in the new
venture, which can provide incentives to the relevant management team to ensure that
the project succeeds.
E. SHORT-TERM FINANCE
The company will not always wish to raise long-term finance. In recent years, the capital
markets have recognised this need in the growing company, and there has been an
increased concentration on the short- or medium-term floating rate sector.
Securitisation
This is the practice whereby instead of lending money to customers, banks raise finance for
them by arranging and selling to customers their securities (e.g. commercial paper) often
allowing lower interest rates. Similarly companies can invest short-term securities in
commercial paper for better rates.
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Syndicated Credits
This is a facility whereby a borrower can borrow money when necessary up to the limit of the
facility – thus the company only has to borrow as and when required. The interest rates are
high compared to those offered elsewhere and are generally used by highly-geared
companies (who may find it difficult to find other sources of finance), and government-related
bodies (e.g. Eurotunnel). Another common use is in takeover bids. Syndicated credits are
most common in the US and are generally denominated in US dollars.
Banks
Bank lending to companies is predominantly short term, although it is also now a valuable
source of medium term finance.
(a) Bank loans
This is straightforward lending by a bank to a business whereby a fixed amount is lent
– for example, £40,000 – for a fixed period of time, say for four years. The bank will
charge interest on this, and the interest plus part of the capital (the amount borrowed)
will have to be paid back each month. As with all forms of loan, the bank will only lend
if the business is credit worthy, and it may require security. If security is required, this
means the loan is secured against an asset of the borrower – for example, an asset of
the business or, in the case of a sole trader, the borrower's house. If the loan is not
repaid, then the bank can take possession of the asset and sell the asset to get its
money back!
Loans are normally made for capital investment, so they are unlikely to be used to
solve short-term cash flow problems. However, if a loan is obtained, then this frees up
other capital held by the business which can then be used for other purposes.
The interest rate for small companies on medium-term loans may either be at a fixed
rate or at a margin above the bank's base rate. For larger companies, the interest rate
on medium-term loans may again be fixed for up to five years, but is usually at a
margin above the London Inter-Bank Offered Rate (LIBOR) adjusted every three, six,
nine or twelve months in line with LIBOR movements (the size of the margin being
determined by risk and the credit standing of the company).
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Not all term loans are drawn, in cash, at the commencement of the loan. Typically,
where a loan is to fund a longer term project such as a construction undertaking, it
would be common to draw the cash at different stages of the project. This has the
advantage for the borrower of not committing large sums of money against an asset
that has not yet been created.
The administrative procedures and the paperwork involved with term loans are often far
more than with a simple overdraft particularly as the lender (the bank) is entering into a
much longer agreement timescale. Typically, the bank will require a set of obligations
to be met by the borrower such as information flows to the bank and required levels of
gearing and liquidity ratios, and failure to deliver on these conditions would give the
bank the right, if needed, to terminate the contract.
(b) Overdrafts
These are, effectively, also a form of loan from a bank. A business becomes overdrawn
when it withdraws more money out of its account than there is in it and this leaves a
negative balance on the account. This is often a cheap way of borrowing money as
once an overdraft has been agreed with the bank the business can use as much as it
needs at any time, up to the agreed overdraft limit. However, the bank will of course
charge interest (on a daily basis) on the amount overdrawn, and will only allow an
overdraft if they believe the business is credit worthy – i.e. is very likely to pay the
money back. Interest rates on overdrafts are usually higher than with other forms of
finance, but it is a very flexible method of finance, particularly when a company has to
provide for seasonal variations in cash flow which will require facilities for short periods
of time only.
There is no penalty for repayment of an overdraft, unlike (usually) the early repayment
of a medium-term loan. The bank, though, can demand the repayment of an overdraft
at any time, and many businesses have been forced to cease trading because of the
withdrawal of overdraft facilities by their bank.
Even so, overdrafts are often the ideal solution for short term borrowing and are
extensively used to overcome short term cash flow problems, such as for funding
purchase of raw materials whilst waiting payment on goods produced. Many
businesses have a rolling (on going) overdraft agreement with their bank.
The advantages of an overdraft facility with the bank are that:
It provides flexibility – the borrower can't predict with any significant accuracy
what funds will be needed in the short term and the overdraft facility allows the
business to borrow up to stipulated limits an amount without unnecessary added
paperwork and bureaucracy.
It is a relatively cheap form of finance. The usual procedure from the lender
would be to add between two and five percentage points above the bank base
rate (or LIBOR). There may also be an arrangement fee in addition to the
overdraft rate (typically one or two percentage points).
Because interest is charged on the daily balance, a large cash surplus one day
can be used to reduce overdraft charges on further days.
The major drawback of an overdraft (as stated above) is that the bank can withdraw the
overdraft facility at short notice.
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Trade Credit
This source of finance really belongs under the heading of working capital management
since it refers to short term credit. By trade credit we mean that a creditor, such as a supplier
of raw materials, will allow a purchaser to buy goods now and pay for them later. Why have
we included lines of credit here as a source of finance? Well, if a business manages its
creditors carefully, it can use the credit they provide to finance other parts of the business.
Take a look at any company's Statement of Financial Position and see how much they have
under the heading of "Creditors falling due within one year". Let's imagine it is £50,000 for a
particular company. If that company is allowed an average of 30 days to pay its creditors,
then we can see that effectively it has a short term loan of £50,000 for 30 days and it can do
whatever it likes with that money, as long as it pays the creditor on time.
The advantages of trade credit is that it is a relatively convenient, cheap and informal way of
securing short term finance and is available to companies of all sizes.
Trade credit is often different for different firms in different types of business environment.
There are often quite big differences in the approach to this within different industries and
some industries have traditionally relied on a large amount of trade credit. Consider the
trade credit terms offered to, say, a retailer and a heavy goods manufacturer – little is usually
offered in the first case, but typically around three months in the latter case. The bargaining
strength of both parties will also have an impact on the case for trade credit and it has often
been the case that major retailers (with an ever increasing share of the market) have been
able to negotiate "one sided" and often unfair trade credit terms on much smaller suppliers.
The product type will also often have an impact – for example, where the product has a high
level of turnover compared to the level of stocks held, then it is likely to have a much smaller
level of trade credit than a product that has a longer shelf life between supply and sale.
Factoring
Factoring allows a company to raise finance based on the value of its outstanding invoices.
It also gives the business the opportunity to outsource its sales ledger operations and to use
more sophisticated credit rating systems.
The way it works is as follows:
Once a sale is made, the company invoices its customer and sends a copy of the
invoice to the factor (with most factoring arrangements requiring a company to factor all
its sales).
The factor then pays the company a set proportion of the invoice value within a pre-
arranged time – typically, most factors offer 80-85% of an invoice's value within 24
hours. (Thus, a major advantage of factoring is that the company receives the majority
of the cash from debtors within 24 hours rather than a week, three weeks or even
longer.)
The factor issues statements on the company's behalf and collects the payments.
However, the company remains responsible for reimbursing the factor for bad debts,
unless a "non-recourse" facility has been arranged. (Non-recourse means that if a
debtor doesn't pay, the factoring company will either suffer the loss or will have insured
themselves against the loss.)
The company will receive the balance of the invoice (less charges) once the factor
receives payment.
The factor provides regular reports on the status of the company's sales ledger.
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Factoring Charges/Fees
Finance charges should be comparable to an overdraft. Typical charges on the amount
financed range from 1% to 4% over base rate, with interest calculated on a daily basis.
Credit management and administration charges, including the maintenance of the sales
ledger, depend on turnover, the volume and number of invoices. Typical fees range from
0.50% to 3.0% of annual turnover – a company with 50 live customers, 1,000 invoices per
year and £1 million turnover might pay 1%.
Credit protection charges (for non-recourse factoring) largely depend on the degree of risk
the factor associates with the business. Typical charges range from 0.5% to 3% of annual
turnover.
Advantages
There are several advantages to factoring, including:
Cash flow is maximised as factoring enables a company to raise up to 80% or more on
outstanding invoices
Using a factor can reduce the time and money spent on debt collection since the factor
will usually run the sales ledger for the company
The factor's own credit control system can be used to help assess the creditworthiness
of new and existing customers
Factoring can be an efficient way to minimise the cost and risk of doing business
overseas.
Disadvantages
There are, however, disadvantages to factoring and, unless carefully implemented, factoring
can have a negative impact on the way a business operates. The most significant problems
are as follows:
The factor usually takes over the maintenance of the sales ledger, and customers may
prefer to deal with the company it is trading with rather than a factor
Factoring may impose constraints on the way business is conducted – for example, the
factor will apply credit limits to individual customers (though these should be no lower
than prudent credit control would suggest), and for non-recourse factoring, most factors
will want to pre-approve customers, which may cause delays
The client company might only want the finance arrangements and yet it might feel it is
paying for collection services they do not really need
Ending a factoring arrangement can be difficult where the only exit route is to
repurchase the sales ledger or to switch factors and that could cause a sudden shortfall
in working capital.
Invoice Discounting
Invoice discounting is similar to factoring in that the invoice discounter makes a proportion of
the invoice available to a company once it receives a copy of an invoice sent. However, the
client company collects its own debts, and this enables it to retain the control and
confidentiality of its own sales ledger operations. Once the client receives payment, it must
deposit the funds in a bank account controlled by the invoice discounter. The invoice
discounter will then pay the remainder of the invoice, less any charges.
The requirements are more stringent than for factoring and different invoice discounters will
impose different requirements.
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"'Confidential invoice discounting" ensures that customers do not know a company is using
invoice discounting as the client company sends out invoices and statements as usual.
However, the costs of this are greater since the discounter is carrying a greater degree of
risk. The requirements for "disclosed" (i.e. non-confidential) invoice discounting are generally
less demanding.
Bills of Exchange
These are a form of commercial credit instrument, or IOU, used in international trade. In
Britain, a bill of exchange is defined by the Bills of Exchange Act 1882 as an unconditional
order in writing addressed by one person to another, signed by the person giving it, requiring
the person to whom it is addressed to pay on demand or at a fixed or determinable future
time a certain sum in money to or to the order of a specified person, or to the bearer.
Eurocurrency
The Eurocurrency market is the borrowing and lending of Eurocurrency loans via banks
based outside the currency's country, e.g. a UK company could borrow Yen for trade with
Japan from a British bank (Euroyen). The loans are generally short term (three months),
often between banks.
The market generally offers high rates of interest, flexibility of maturities and a wide range of
investment qualities in comparison with other capital markets. The dealings for substantial
funds (generally in excess of $1m) are highly competitive. The unique feature is that the
transactions in each currency take place outside the country from which that currency
originates. The main function of the market is the financing of international trade, e.g. to fund
down payments of goods sold on export credit terms.
On the short-term, inter-bank Eurocurrency market, transactions may take place between
banks on an unsecured basis from overnight to five years' duration. Most transactions are
for six months or less and transactions of over £1m are common.
Eurobonds
The Eurobond market is an international capital market which has developed alongside the
Eurodollar market since the 1960s. Eurobonds are bonds sold outside the jurisdiction of the
country in which the currency is based – so, for example, the UK financial regulators have
little influence over the Eurobonds denominated in sterling even though the transactions are
in pounds. It deals in the lending of currencies for longer terms under bonds which are often
denominated in dollars.
The following advantages are claimed for the Euromarkets in various currencies:
Extremely large sums can be raised or deposited.
Money will often be cheaper than the domestic markets.
Controls tend to be less restrictive.
Some protection against exchange rate movements is offered, but here the user will
require a high level of skill in selecting his or her alternatives.
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Any period of surplus or shortage from one day to five years can be accommodated.
The markets offer a useful alternative to other sources of capital which the company
may not wish to use at the time.
US involvement in world trade makes a pool of dollars outside the home country most
useful when:
(i) It is impossible or undesirable to transfer funds from the home country.
(ii) Projected currency movements suggest that it is advantageous to rearrange
dollar commitments to parent companies, etc.
Eurobonds Available
There are three broad types of Eurobond which can be classified as follows:
Straight fixed rate bonds
The majority of Eurobonds with a fixed coupon can be described thus. Interest is
generally paid out once each year and is calculated using a 360-day year. Some older
issues do pay half-annually.
Whilst a 15-year term is typically the norm, maturity may range from three to 25 years.
Shorter maturity bonds (up to five years) are usually referred to as notes and issues
from the Netherlands are often within this period.
Equity related bonds
These may take two forms:
(a) Convertibles – whereby the bond holder has the right (but not the obligation) to
convert the bond into ordinary shares at a pre-determined price.
(b) Eurobonds with warrants – which are similar to convertible bonds in that
warrants are attached to the Eurobond enabling the holder to purchase ordinary
shares represented by the warrants at, or between, specified dates. The
exercise price will be set in a similar fashion to that of convertible Eurobonds.
Floating rate notes (FRNs)
These have a variable coupon reset on a regular basis, usually every three to six
months, in relation to a reference rate, such as LIBOR. The size of the reference rate
will reflect the perceived risk to the issuer.
Borrowing in the Euromarket
Borrowers in the Euromarket include:
Companies needing dollars for investment in the USA.
Unit trusts and investment trusts investing in foreign securities.
The United States banks, which find that it is expedient to take up loans through the
European market rather than to borrow in the USA.
Multinational companies wishing to invest in a particular country without wishing, or
being able, to transfer capital from their base country.
National governments and bodies associated with national and international agencies.
Euroequity
This is the issue of equity in a stock market outside the company's domestic stock market. A
lack of sufficiently active secondary markets limits Euroequity markets (as you can see by the
poor showing of the attempted issues by US and Japanese companies in European
markets). Hence they are not as popular as Eurobonds. This has led to the use of
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sweeteners in an attempt to sell Euroequity, including the issuing of bonds with warrants
attached.
Government Measures
There are two main government schemes providing funding support to small businesses.
(a) Enterprise Investment Scheme (EIS)
The Enterprise Investment Scheme is a government scheme that provides a range of
tax reliefs for investors who subscribe for qualifying shares in qualifying companies.
There are five current separate EIS tax reliefs:
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Business Angels
The Business Angels movement is an important, but still under-utilised source of money for
new and growing businesses.
Business Angels are high net worth individuals who invest on their own, or as part of a
syndicate, in high growth businesses. In addition to money, they often make their own skills,
experience and contacts available to the company, and their commitment is often very strong.
Business Angels invest across most industry sectors and stages of business development,
but especially in early and expansion stage businesses. Most prefer to invest in companies
within 100 miles of where they live or work. Investors in technology companies tend to be
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more prepared to travel longer distances. They rarely have a connection with the company
before they invest, but often have experience of its industry or sector.
The majority of Business Angels make investments for financial reasons. However, there may
also be other motives for investment – for example, taking an active part in the
entrepreneurial process, the enjoyment from being part of the success of a good investment,
or the sense of putting something back in.
A typical Business Angel makes one or two investments in a three-year period, although
some invest more frequently. The level of investment is usually between £10,000 and
£750,000. Where larger amounts are invested, this is often as part of a syndicate organised
through personal contacts or a Business Angel Network.
The methods used by Business Angels to decide which businesses to invest in vary greatly.
However, the following issues are all taken into consideration:
The expertise and track record of the founders and management
The businesses competitive edge or unique selling point
The characteristics and growth potential of the market
Compatibility between the management, business proposal and the business angel's
skills and investment preferences
The financial commitment of the entrepreneur
The company must also ensure that the Business Angel willing to invest in them is right for
their company. Before signing an agreement the business must ensure that:
The management team and the business angel are compatible and will be able to work
together; and
The Business Angel's skills match the company's needs.
Grants
Grants are available to all businesses, most of which carry a test relating to the number of
new jobs created from the project or development requiring assistance. The second test for
grant assistance will usually be that the project cannot proceed without financial assistance.
Grants are available from a range of institutions including governmental bodies and the
Prince's Youth Business Trust.
Banks
Whilst banks will usually be willing to lend a degree of support, without the ability to offer
some tangible security the business may have to seek finance from elsewhere.
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Capital Gains Rollover Relief will be given to people reinvesting up to £100,000 and, if
the shares are held for five years, no CGT will be payable on disposal.
Deferred Capital Gains Taxation on investment – subscribers for new ordinary VCT
shares who invest gains arising from the disposal of any asset will be able to defer the
tax chargeable, subject to certain timing restriction.
Exempt from Corporation Tax – on capital gains (such as an investment trust).
The 2000 Budget reduced from 5 years to 3 years (for shares issued on or after 6 April 2000)
the minimum period for which investments in VCT companies carrying on a qualifying trade
at the time of issue must be held if they are to qualify for income tax relief.
The 1999 budget tightened up the rules on VCTs to exclude schemes which are low risk,
often offering guarantees or being property backed.
Private Investors
In some cases, particularly with a very small business that is in the early stages of its
development, a number of private investors may be prepared to get involved with its
financing. These may be family members or friends who have a genuine interest in making
sure that the business succeeds.
Now check your answer with the one given at the end of the chapter.
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134 Sources of Company Finance
Dividend received:
60,000 × 45p 27,000 75,000 43.5p 32,625 60,000 43.5p 26,100
£5,220,000
* Theoretical ex-rights price would be shares £3.48.
1,500,000
48p
Thus, the value of one right = 12p
4
The total value of £5,220,000 derives from:
£
Value of shares on issue 4,320,000 (1,200,000 £3.60)
Value of rights issue 900,000 (300,000 £3)
5,220,000
1,200,000
The present net dividend yield is £ 45p 12.5p
4,320,000
1,500,000
The future net dividend yield is £ 43.5p 12.5p
5,220,000
From these calculations, the shareholder will be no better or worse off after the rights
issue and his or her action, therefore, can be determined on whether he or she wishes
to continue to be involved in the company to the same extent or to increase or
decrease his or her overall holding.
(b) The idea of a rights issue is to encourage existing shareholders to invest more funds in
a company so as not to dilute further the membership interest. To do so, a discount on
the market price is built into the price ruling on the market. To price the rights issue
above market price would mean it would be cheaper to go to the market to purchase
the shares, and the rights issue would fail.
(c) The total sum to be raised £900,000, made up as follows:
1,200,000
£3 £900,000 (300,000 new shares)
4
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Chapter 6
Cost of Finance
Contents Page
Introduction 139
(Continued over)
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Cost of Finance 139
INTRODUCTION
It is essential for a company to know the cost of the various types of funds included in its
capital structure in order to satisfy the terms of the providers of that capital – the investors. If
the investors are not satisfied with their returns they may remove their money from the firm.
The required rate of return to investors is how much the company has to pay to obtain its
finance – i.e. the cost of capital to the firm.
In addition, it is important for companies to know their cost of capital in order to ensure that
projects they invest in achieve the level of return required to satisfy those who provide funds
which finance the project.
We will consider initially the costs of the different types of capital individually, before looking
at the cost of the capital structure of the company as a whole.
It is important when you are revising this area to also consider the capital asset pricing model
(CAPM) that we will discuss in a later chapter.
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140 Cost of Finance
B. COST OF EQUITY
The requirements and expectations of shareholders must be considered when looking at the
cost of equity. The effect that changes in earnings and dividends may have on the share
price must also be considered.
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Cost of Finance 141
Example 2
Assume Pooh's past dividends have been:
Dividend per
Share
Year 1 0.26
Year 2 0.27
Year 3 0.28
Year 4 0.32
We can now find the average rate of growth by using the following formula:
Latest dividend
Growth rate (g) n 1
Earliest dividend
where: n number of years growth.
Applying this to the above figures, we get:
0.32
g 3 1 0.0717 or approximately 7%.
0.26
Note that here we are using the cube root because there are three years of growth. If we
had been given five years' data (from which we could project four years' growth) the fourth
root would have been used.
When the expected growth figure has been determined we can calculate the value of the
company's shares using the Dividend Growth Model or Gordon's Model of Dividend
Growth.
This model states:
De (1+ g)
P0 d0 (1 g) which is also written as Se
(r g) (Ke g)
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Taxation rates are assumed to be constant across all investors, and as such the
existence of higher rates of tax are ignored. The dividends used are the gross
dividends paid out from the company's point of view.
The costs of any share issue are ignored.
All investors receive the same, perfect level of information.
The cost of capital to the company remains unaltered by any new issue of shares.
All projects undertaken as a result of new share issues are of equal risk to that existing
in the company.
The dividends paid must be from after-tax profits – there must be sufficient funds to
pay the shareholders from profits after tax.
Share Issue Costs
Share issue costs can be incorporated in the formula, especially if they are considered to be
high. The formula then becomes:
De
Ke
(Se I)
where: Ke cost of equity
De current dividend payable
Se current share price (ex div)
I cost of issue per share.
Thus, for the example of Tigger above, if issue costs divided by the number of shares is 5p,
then the cost of equity becomes:
25
Ke 0.128 12.8%
200 5
If you are given issue costs you should, unless told otherwise, incorporate them in the
formula as shown above.
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Cost of Finance 143
Retained Earnings
Retained earnings will also have an effect because, when left in the business rather than
being distributed, they should achieve higher returns in the future to offset the lack of current
dividends. The shareholders' expectations of increasing future dividends rather than constant
payments may, however, persuade them to accept initial lower dividends.
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144 Cost of Finance
Irredeemable Debt
The formula for calculating the cost of irredeemable debt is:
I(1 t)
Kd
Sd
where: Kd cost of debt capital
I annual interest payment
Sd current market price of debt capital
t the rate of corporation tax applicable.
Taxation is considered because the interest can be offset against taxation, which will lower its
nominal rate, and thus its cost. The higher the rate of corporation tax payable by the
company, the lower will be the after-tax cost of debt capital. Thus the cost of debt capital is
much lower than the cost of preference shares with the same coupon rate and market value
as the debentures because of the availability of tax relief on the debt. Naturally this only
applies if the business has taxable profits from which to deduct its interest payments. When
the business has generated a taxable loss, the interest will increase that loss for carry
forward (to be offset against future taxable profits in later years), and the immediate benefit of
tax relief will be lost.
Example
Clown plc has £10,000 of 8% irredeemable debentures in issue which have a current market
price of £92 per £100 of nominal value. If the corporation tax rate is 33% what is the cost of
the debt capital?
The annual interest payment will be based on the nominal value, i.e. 8% of £10,000 or £800,
so using the above formula:
800(1 0.33)
Kd 0.0583 5.83%.
92/100 10,000
Redeemable Capital
In order to determine the cost of such capital to the date of redemption we must find the
internal rate of return (IRR). IRR is discussed in greater detail later, but basically involves
calculating all the necessary cash flows (generally the assumption will be made that all
payments and receipts are made at the end of the year) and determining at what cost of
capital the value of future cash flows are equal to zero. The IRR is calculated using discount
factors for the appropriate cost of capital and the following formula. Wherever possible the
ex-interest values should be used, so if the cum-interest value is quoted (i.e. if the interest is
due to be paid soon and thus is reflected in the market price of the debt) we should deduct
the interest payment from the market price. The longer the period to maturity, the lower will
be the overall cost of capital. This is to be expected because the real cost of redemption will
be lower in the future because of the effects of the time value of money. (Do not worry if this
appears complicated at this stage since we shall explain the IRR fully later in the course.)
Example
In this example, Clown's rate of corporation tax is assumed to be 33% throughout and
redemption is in 20x5. The following table sets out the workings on which the calculation is
based.
Note: df discount factor
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146 Cost of Finance
Cost of Convertibles
To determine the cost of convertibles we have to find the internal rate of return (IRR) of the
following equation:
K(1 t) K(1 t) K(1 t) K(1 t) V CR
P0 .... n n
(1 r) (1 r)2
(1 r)3
(1 r)n
(1 r)
where: P0 current market price of the convertible ex interest (i.e. after paying the current
year's interest)
K annual interest payment
t rate of corporation tax
r cost of capital
Vn market value of the shares at year n
CR conversion ratio.
It is also a useful exercise to calculate the cost of convertibles as though they were not
converted – if the cost is higher the holders will choose not to convert, because not
converting produces a higher return to the investor. The higher cost of capital should
therefore be the one used in the calculation of the company's cost of capital.
Example
Quality plc has 10% convertible debentures due for conversion in two years' time. They have
a current market value of £108 per cent. The conversion terms are 5 shares per £10 of
debentures. All the debenture-holders are expected to convert, and the shares are expected
to have a price of £4 at this time. What is the cost of capital?
For ease of calculation, we shall assume the rate of corporation tax is 50% and is payable in
the same year.
The market value of £108 per cent means that it is £108. Interest on convertibles is
offsettable against tax, and thus is shown as a saving in the following calculation:
Year 0 1 2
£ £ £
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Cost of Finance 147
Year 0 1 2
£ £ £
Thus the cost of capital is just over 40% – the precise level could be found using the
interpolation formula given above.
Again do not worry if the mechanics seem a little complicated since they will be covered in
greater detail later in the course.
Company X £ Company Y £
Year 1 Profits 200,000 Profits 200,000
less Dividend 160,000 less Dividend 20,000
Balance c/f 40,000 Balance c/f 180,000
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In Year 2, the capital needs of both companies are an additional £200,000. X obtains equity
of £160,000 and Y equity of £20,000. Assume dividends of 10% on new capital.
Company X £ Company Y £
Year 2 Profits (year 2) 200,000 Profits (year 2) 200,000
less Dividends: £ less Dividends: £
On existing capital 160,000 On existing capital 20,000
On new capital 16,000 176,000 On new capital 2,000 22,000
Balance c/f 24,000 Balance c/f 178,000
Suppose in Year 3 profits fell sharply to £100,000 for each company. The following would be
the result.
Company X £ Company Y £
Year 3 Profits 100,000 Profits 100,000
less Dividend (halved) 88,000 less Dividend (doubled) 44,000
Balance c/f 12,000 Balance c/f 56,000
What do these figures mean? That Y is more efficient than X? No, because profits each
year have been the same, the only difference being that Y obtains large amounts of "cost-
free" capital, whereas X is paying out most of its profits as it has to pay for its capital in the
form of a dividend.
Is Y able to weather the storm better than X? Yes, because it has a large balance, made
possible by its low pay-out ratio. It has been able to double dividends to shareholders
despite reduced profits in
Year 3.
Sooner or later the shareholders of Company Y will realise they are losing out, to the benefit
of the company itself.
From this two important principles emerge:
All capital has a cost.
Even retained profits should carry a cost (an implied or imputed cost).
Here the opportunity cost is concept related to the cost of retentions that we noted earlier.
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Cost of Finance 149
which is under consideration will produce a return that is positive in terms of the business as
a whole and not just in terms of an issue of capital made to finance it. Investments which
offer a return in excess of the WACC will increase the market value of the company's equity,
reflecting the increase in expected future earnings and dividends arising as a result of the
project.
Methodologies
There is no one accepted method of calculating a company's WACC – some use book values
in the proportions that they appear in the company's accounts and some use market values.
For unquoted companies book values may have to be used because of the problems we
discussed in earlier chapters of estimating market values for their securities. Book values
are generally easier to obtain than market values. However, many would argue that for
quoted companies market values are more realistic and, indeed, may be easier because only
one cost of equity is required – it being impossible to split the value of equity between the
shares and the retained earnings.
Example
(a) Using book values in the proportions that they appear in the company's accounts:
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150 Cost of Finance
You may also come across the following formula for use in calculating a company's WACC:
(E) (D)
WACC Keg Kd (1 t)
(E D) (E D)
where: Keg is the cost of equity
Kd the cost of debt
E the market value of the company's equity
D the market value of the company's debt
t the rate of corporation tax applicable to the company.
The model assumes that debt is irredeemable.
The model is simply another approach to calculating a company's cost of capital. It is often
considered easier by students, but you should use whichever method you feel the most
comfortable with. If you wish to calculate WACC using the above formula when the debt in
the company's structure is redeemable then you should calculate the cost of debt using the
methods above and replace Kd(1 t) in the formula with the answer.
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From this we can see that the market value of the shares will be improved by choosing to
raise the debt capital, on the assumption that the PBIT really does increase by £1.25m.
However, the financial manager should always remember that debt is a riskier route than
equity, because:
Debt payments cannot be deferred whereas dividends to shareholders can, should
trading estimates fail to materialise.
Use of debt capital could result in a lower price/earnings ratio than an equity issue.
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In our example the financial gearing ratio would increase and the interest cover will fall from
the present 2.94 to 2.4. (We shall consider gearing in detail later in the course.)
Interest cover should be calculated as the number of times the interest payable can be
divided into the PBIT figure. Unequivocally, the higher the number of times, the better the
result and the less risk will be attached to the decision.
A low figure, generally less than three times cover (when interest rates themselves are low),
indicates that the company should be cautious regarding further borrowings if these are likely
to be sensitive to adverse (upward) movements in interest rates, because the company's
ability to service the necessary payments may be in doubt.
Other Considerations
It is quite common for a company to lease a large part of its expenditure on capital items and
to use equity for its increased working capital needs although, due to the costs involved, a
quoted company will be unlikely to consider issuing less than £250,000 in new shares to be
worthwhile. Whilst the calculations demonstrated in this chapter will be simpler to apply to
quoted companies (because of the ease with which share prices can be determined) the
underlying principles will be appropriate to all businesses seeking to increase the capital
available for investment.
It is important when a business considers any particular source of finance to understand the
costs and relationships of that particular method of finance. Any method of debt finance will
require repayment and the business will need to ensure that profit and liquidity forecasts will
be high enough to meet any capital and interest payments as they become due. This will
require sound income and cash budgets to be compiled by the business on a regular and
moving basis.
Any payments of interest and capital will, therefore, result in less finance being available for
the shareholders and the business will need to ensure that there are readily available funds
for shareholders if they do not want the market to lose confidence in their business.
There are also tax reasons to be considered – for example, interest on debt capital can
currently be offset against Corporation Tax, but dividends to shareholders can not.
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For any business (particularly a large one), there is always a balance to be struck between
ensuring that there is a blend of different sources of finance within the firm, that it does its
best to ensure that it is not either too highly geared or too lowly geared and that there is
adequate available internal funds predicted to make interest and capital repayments to
lenders and dividend payments to their owners (i.e. the shareholders).
Not-For-Profit Organisations
Government departments do not have a market value, nor do they have business or financial
risk, and thus cannot calculate the cost of capital. To evaluate projects they use a targeted
"real rate of return" set by the Treasury as a cost of capital.
Non-profit making firms do not generally have market values, and will thus have to determine
a cost of capital to use to assess projects – many use the cost of any borrowing they have in
their Statements of Financial Position (balance sheets), but you will appreciate from this
chapter that it is not ideal.
Now check your answers with those given at the end of the chapter.
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Note that strictly speaking the return should be recalculated in line with the
market values if the information is available.
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Chapter 7
The Capital Asset Pricing Model
Contents Page
Introduction 156
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156 The Capital Asset Pricing Model
INTRODUCTION
CAPM was developed in the 1960s by Sharpe and Litner building on the work of Markowitz
and portfolio theory (which we are nor concerned with here). The model at its simplest brings
together aspects of share valuations, the cost of capital, and gearing, and thus has important
implications in financial management.
For our purposes, we can make the assumption that there are two basic functions associated
with the CAPM:
Attempting to establish the "correct" equilibrium market value of a company's shares.
Calculating the cost of a firm's equity (and thus the weighted average cost of capital),
as an alternative approach to the dividend valuation model which we considered in a
previous chapter.
The model can also be used by the financial manager in the assessment of risk and
expected return in relation to capital investment decisions.
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We can also see that individual investments will have their own levels of systematic or
market risk.
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The return on Company A's shares (Rs) and the return on the general market portfolio of
shares (Rm) may now be calculated as follows:
Capital gain (or loss) Dividend
Price at start of period
Therefore:
(130 110) 6.5
Rs 0.24
110
(510 490) 40.1
Rm 0.12
490
Statistical analysis of "historical" returns from Company A and from the "average" market may
suggest that a linear relationship exists. Thus, the linear relationship can be demonstrated
through collecting comparative figures from Company A and average market returns (say on
a month by month basis). The results can then be plotted on to a scatter diagram and a line
of best fit can then be drawn with linear regression (see Figure 7.1).
Figure 7.1: Relationship of returns between one company and the market
Return from
company A’s shares
(Rs)
This approach to analysis could bring out three important issues, namely:
The return from Company A (Rs) and the return from the market (Rm) will tend to rise or
fall together.
The return from Rs may be higher or lower than Rm because the systematic risk of an
individual security differs from that of the whole market. Company A is an illustration of
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an investment which provides generally higher returns than the market and is therefore
considered more risky than the average.
The graph may not always produce a line of good fit. This typically happens when
there is insufficient data to be plotted, and the data available is being affected by both
unsystematic and systematic risk.
Negative returns may also be possible, which may happen when share prices drop suddenly.
This will then amount to a capital gains loss, thereby equating to a negative return.
The measure of the relationship between the returns of the company and those of the market
can then be developed in the beta factor () for that company. The line of best fit, also known
as the capital market line or characteristic line, will dictate the beta factor – the steeper
the line, the greater will be the beta factor.
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Alpha Values
The alpha value of a share is used to measure the amount by which the return on that
investment is either above or below what is expected, given its level of systematic risk.
Example
A company's shares have a of 1.2, and an alpha of 2%. The market return is 10% and the
risk-free rate is 6%.
The expected return 6% 1.2(10 6)% 10.8%.
The current return is 10.8% 2% 12.8% expected alpha return.
You should note that alpha values are only temporary rates and can be () or (). They will
tend towards zero for shares over time and will for a diversified portfolio actually be zero if
the portfolio is taken as a whole.
Where alpha values are positive, they may attract investors, because of an implied abnormal
return, and the reaction will be a temporary increase in the share price.
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Calculation of Betas
Ass we saw earlier, the capital market line (CML) shows the rising rate of return associated
with increased risk (Figure 7.1). The slope of this line dictates the beta factor of a security,
and as such it can be calculated by measuring the gradient of the securities market line.
The gradient can be calculated using regression analysis. To calculate the gradient (and
thus the beta) you would use one of the following regression formulae:
(covariance s,m)
(1)
variance (m)
where: m return from the market
s returns from the security.
i.e. the covariance of returns on an individual security with the market as a whole
divided by the variance of the market returns
nxy xy
(2)
nx 2 (x)2
where: n number of pairs of data for x and y
σ sρsm
(3)
σm
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The cost of equity is the return shareholders expect to obtain from holding their shares (i.e. it
is the expected return from the investment) and can be calculated using the capital asset
pricing model:
Rs Rf (Rm Rf)
Government debt can be assumed (unless told otherwise) to be risk-free, and thus the return
on it is equivalent to the risk-free rate.
RJack 9 0.9(17 9) 16.2
Therefore the cost of equity for Jack plc is 16.2%.
CAPM Assumptions
We can list the various assumptions underlying the CAPM and assess the validity of each as
follows.
Investors are risk averse and require greater return for taking greater risks.
Empirical evidence supports this.
There are equal borrowing and lending rates
Generally borrowing rates are higher than lending rates. However, the CAPM can be
modified to incorporate this and the results remain the same.
There are no transaction costs
The existence of transaction costs means that investors may not undertake all required
transactions to make their portfolios efficient, thus the CML may be a band rather than
a line.
There are no market imperfections
Market imperfections do exist and may mean that unsystematic risk may be of some
importance.
Homogeneous expectations
Clearly not all investors have the same view on the prospects of securities. However,
when the assumption is relaxed the CAPM has been found to still maintain its
predictive abilities.
No taxation
The existence of taxation may mean that shareholders prefer capital gains or
dividends. However, when this assumption is relaxed the CAPM has still been found to
maintain its predictive abilities.
There is no inflation
Inflation clearly exists and may be seen as an additional risk. However, when
incorporated into the model, the model can still predict the required returns accurately.
It is difficult to test the CAPM because the model deals with expected returns and all
securities, and it is only possible to record actual results and those securities included in
market indexes. (Market indexes generally contain only a sample of the securities available
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to investors.) Empirical research suggests that although CAPM is not a perfect model of the
real world it does provide a reasonable model of risk/return trade off. For example, low beta
shares do provide lower expected returns than higher beta shares; however, low beta shares
often provide returns above, and high beta shares returns below, those which the model
would predict. The CAPM is used in practice as a decision-making tool in the choice of
portfolios in both the UK and the US.
Limitations of CAPM
The practical use of CAPM is limited by two major factors. These are:
the acceptability of the assumptions which are not really applicable to the "real world";
and
the problems of using the model, given that the assumptions are accepted. For
example, calculating by examining past returns is assumed as being valid for
decision making about the future and this is far from being acceptable.
The most critical of the assumptions is that individual investors are able efficiently to diversify
away unsystematic risk. The assumption of efficient diversification is itself dependent on
many other assumptions, including those of a perfect capital market, rationality of investors,
etc. Also, you should remember that CAPM is based on a one-year time period, and its
extension to multiple time periods requires the economic environment and returns on the
project relative to the market to remain reasonably stable. It must therefore be used with
care when evaluating projects over longer periods.
Further problems include those of estimating returns on projects and the market under
different economic conditions; the probabilities of these different conditions occurring; and
the determination of the risk-free rate. There are several government securities and their
return depends on their term to maturity.
There are many reasons why entrepreneurs may not diversify enough as required by CAPM.
One compelling reason is that managers simply do not want to diversify from a business that
they know well, and perceive considerable difficulties in moving outside of their experiences.
Similarly, managers may not wish to be actively restrained from "playing the markets",
whatever the arguments in favour of diversifying away risk. Moreover, there is considerable
effort and overhead involved in an individual investor attempting to manage a portfolio of
investments actively over any length of time. Managers also argue, quite correctly, that it is
for the shareholders to diversify their own risk and construct a portfolio to their own
preferences, rather than any individual company representing a fully balanced portfolio itself.
While these views appear "irrational" from a purist modeller's viewpoint, you can argue that
there is nothing rational in acting against your instincts and preferences.
Outside the very short term, the market imperfections of lack of divisibility of investments,
fixed charges, imperfect opportunities and poor information mean that the model has poor
predictive ability. Furthermore, each investment or project should have its own discount rate
according to its systematic risk as measured by its beta co-efficient. The discount rate in any
one year then depends on the risk-free rate of interest and the market risk premium in that
year. There are ways of forecasting such vagaries but such are the complexities of doing so
that it is beyond the scope of this discussion.
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Now check your answer with the one given at the end of the chapter.
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Chapter 8
Capital Structure
Contents Page
Introduction 168
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INTRODUCTION
Capital structure relates to the way in which a business is financed by a combination of long
term capital (ordinary shares, reserves, preference shares, debentures, long term bank
loans, convertible loan stock and so on) and short term liabilities (such as bank overdrafts,
short term bank loans and trade creditors).
A high level of debt creates a financial risk which could have an impact on the business from
a number of different perspectives, including both internal and external stakeholders. The
potential problems might typically include:
The company as a whole could be put in danger of liquidation if it creates high levels of
debt that cannot be repaid.
If a company goes into debt and is liquidated, then its creditors will suffer as they are
unlikely to be paid in full
Management and staff will suffer as, with high debt levels, the business is likely to have
to either streamline or close, leaving some or all workers and management redundant.
If the business has high debts, then the company might not make enough distributable
profits for the shareholders to receive any dividends and this in turn would lead to
market confidence suffering.
Customers, when faced with a business where consumer confidence is suffering, could
well seek out alternative organisations with which to do business.
Gearing is the proportion of debt within a company's capital structure, measured as
debt/equity generally at market values. We have seen in previous chapters that a high level
of gearing increases the financial risk of a firm and the required return of shareholders. A
high level of gearing may also affect the return required on debt. Thus, the level of gearing of
a firm could impact on the company's WACC, and obviously the optimal level of gearing is
where the company's cost of capital is minimised.
However, whether gearing does affect the cost of a company's capital is an area of
debate in finance – the two main schools of thought are the traditional view and the theories
of Modigliani and Miller (known commonly as MM).
Before going on to discuss them we shall consider gearing in some detail – looking at the
principal factors which influence the financial manager in choosing capital instruments to
maintain balance in the overall capital mix. We have also talked about some of the practical
ideas for day-to-day working.
Perhaps the most important point to emerge is that capital gearing is not a simple ratio
calculation with firmly defined ingredients, but more of a multi-dimensional problem. A series
of factors interact to establish a capital mix, and an appreciation of those factors is important
before beginning to attempt financial management in this area.
A. CAPITAL GEARING
The mix of the various types of capital employed within a business is referred to as the
capital gearing or leverage of the organisation. Financial gearing measures the
relationship between shareholders capital plus reserves and either prior-charge capital or
borrowings or both. Total fixed and current assets have to be financed. Some will be
financed by equity capital, i.e. the ordinary shares and the reserves belonging to the
shareholders, and some will (usually) be financed by debt capital, i.e. all fixed-interest-
bearing financial instruments.
There are two basic states to be distinguished – high and low gearing.
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High Gearing
When the proportion of debt compared with equity is high, the structure is said to be
high-geared. Typical examples may arise in heavy manufacturing firms where
investment in long life, high cost plant means that large sums have to be invested using
borrowed funds.
Low Gearing
When the proportion of debt capital to equity capital is low, the structure is said to be
low-geared. Service industries and supermarket chains generally have low gearing
ratios, because they do not have to invest heavily in plant and machinery.
Supermarkets are typically cash-based entities and will often receive payment from
customers who shop there before they have to settle with their suppliers. As a result,
their need to resort to external financing is minimal unless they embark on a major
store opening, or refurbishment, programme.
The gearing ratio of a business will, therefore, be largely determined by the nature of its
operations. It follows that particular industries will show common characteristics. Where a
prospective investor, or lender, is considering an investment, he or she will look at the typical
gearing ratio for that market sector to compare the efficiency of the business at managing its
financing needs, and will query significant variances which cannot obviously be obtained
from the published accounts.
Generally speaking, the accepted "norm" in the UK is to maintain a balance of debt capital to
total capital of 1:2, i.e. to finance half of the total assets with debt capital.
Gearing Ratios
Capital mix and capital problems can be analysed by a number of different gearing ratios, the
principal ones being:
Prior charge capital
(a)
Equity capital
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PQR plc
Statement of Financial Position at 31 December ....
Applying the different gearing ratios we get the following interpretations of capital mix.
Prior charge capital 500 500 500 1,500
(a) 100% 49.59%.
Equity 2,000 1,000 25 3,025
Note that prior charge capital is made up of:
£000
Debentures 500
Bank loans (of more than 1 year) 500
Preference shares 500
1,500
If short-term loans and overdrafts were included in prior charge capital, this figure
would become (1,500 175 50) 1,725 and the gearing ratio would rise to 57.02%.
Equity is taken as total capital and reserves excluding preference shares.
Prior charge capital 1,500
(b) 100% 33.15%.
Equity + Prior charge capital 3,025 1,500
Again, by including short-term borrowings, the gearing ratio would rise to:
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1,725
100% 36.32%.
3,025 1,725
Prior charge capital 1,500
(c) 100% 33.15%.
Total capital employed 4,525
It is not really appropriate to include short-term borrowing in this particular ratio
because it has already effectively been allowed for in the calculation of net assets.
Valuation Basis
Opinions are divided as to whether the relevant debt and equity contents should be valued in
terms of book values or market values. Many businesses may well revalue their investment
in bricks and mortar (real property) in view of a decline in market values.
By using market values of ordinary shares, a value will automatically be placed upon the
share capital and the shareholders' reserves, because the market is assumed to have taken
the value of reserves into account in determining the market price of the shares. Similarly,
the market value of debt capital will be taken to reflect more realistically the market opinion
and therefore the risk of that debt. A market-based approach is, of course, dynamic in the
sense that the gearing ratio will alter as soon as market values alter.
This is fine to an extent with quoted companies whose share prices can be readily
determined at any given point in time. Problems occur, however, with the private company,
partnerships and sole traders in view of the difficulty of attempting to arrive at a market
capitalisation. Supporters of the book value approach will, in attempting to take this into
account, argue that market values may not always reflect the real long-term position. For
instance, strike action in a particular industry may have an adverse impact on the securities
of a company in the short term which will, by virtue of the market-based approach, be
reflected in a temporary and unrepresentative gearing ratio.
It is of fundamental importance to see that all assets are correctly valued, and you should
note that book values may not always be realistic, as a result of changes in the property
market impacting on the valuation of land and buildings or customer fashions reducing (or
increasing) stock values, etc. A decision will also have to be made as to whether to include
intangibles such as goodwill, patents and brand names. Goodwill may have arisen through
paying more than the book value to acquire an asset, or group of assets, and it will generally
be deducted from the total asset values since it represents a historic figure which may no
longer apply.
Scientific Approaches
Beyond the simplistic target of financing only 50% of assets, more scientific approaches can
be applied. For example, long-term debt may be limited to a chosen percentage of equity
funds. This approach has the following problems:
The maximum may become the norm.
Unless maturity dates for debt finance are widely separated, the cash implications of
finding large sums for redemption may cause problems.
Short-term debt should be restricted to satisfying short-term needs. If a rollover of debt is
required, the financing of changing interest commitments, as well as the possibility of not
being able to arrange refinancing, can lead to difficulties.
Another more scientific approach is to consider the number of times a fixed interest payment
will be covered by annual earnings, which gives an indicator of financial risk. The main
problems here are:
(a) The determination of an optimum financial risk measure for a particular company.
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(b) Earnings may not always be representative of the cash available to meet interest
payments. Debtors cannot be used to finance debt until they have paid.
Because of (b) above, a rather more detailed approach is to base the level of corporate
indebtedness on the ability of the cash flow to support it. A potential debt provider is more
likely to be encouraged to supply funds where he or she can see that the cash flow to fund
the interest payments is planned to be available.
Whilst failing to reach an answer to the optimal gearing level question, the theorists have
highlighted a number of factors a firm should consider, including:
Its future taxable capacity
Risk and volatility of future earnings
Interest cover
Likely costs of financial distress
Availability of other sources of finance
Debt capacity (i.e. assets that can be secured, presence of covenants).
Or we could have:
Simple though the example is, it should clarify in your mind how the financial manager can
combine securities to arrive at the optimum capital structure for the company. As we can
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see, by using less risky, fixed-interest capital, it should be possible to reduce the demands on
equity amounts. In other words, the earnings expectation can be geared down.
The earnings of the capital, the company's policy in paying dividends or distributing retained
earnings, and the return required by the providers of capital will all influence the pattern of
finance that the business is able to raise. In turn the financial manager will take account of
present, and predicted, future interest rates in an assessment of the most suitable security to
be issued.
Year 1:
Earnings £1,500 £1,500
Debenture interest £720 £80
Available for dividend £780 £1,420
Dividend % 78% 15.8%
Year 2:
Earnings £720 £720
Debenture interest £720 £80
Available for dividend – £640
Dividend % NIL 7.1%
Debenture interest is, of course, a fixed charge, and the effect of having to service payment
when earnings fall is clearly demonstrated. Ordinary shareholders will only be entitled to
their dividend after this fixed charge has been met. In Year 1 the earnings are high and the
shareholders in the highly geared company obtain a higher return than those in the low
geared business. The reverse position is shown when earnings are low, and in our example
the shareholders in the highly geared company receive nothing.
The effect of the mixture of debt and equity effectively gears up the effect of fluctuating profits
and will generally influence the decision of an ordinary shareholder whether or not to invest.
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Demand Patterns
Progressing from the previous point, the demand for the products of a company, or the
nature of the industry as a whole, will impact on the amount of debt capital which can be
raised. We will consider this under three headings:
(a) Industry and individual demand
When industrial demand does not continue to grow for a protracted period, no matter
how well an individual company is performing within that industry, it will eventually
suffer the same problems as the industry as a whole. Careful thought should be given
to taking on additional debt capital by a buoyant firm in a declining industry, as the
eventual drop in orders may make the financing commitments through interest
payments difficult to maintain. This may not, of course, be the case where a firm in
these circumstances were to raise capital for a diversification project outside the
industry concerned.
(b) Sales stability
A steady sales record is generally considered to be a better pointer to future stability of
sales performance than a volatile record. A steady record will give confidence to
investors and should facilitate raising debt capital.
(c) Competition
Where a company trades in an industry that demands special skills (e.g. computers), or
where a large initial investment has to be made on entry to the market (e.g. steel
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processing), there will be less chance of new competition entering the market. The
established business in such markets should find it relatively easy to raise debt capital,
because the market will be confident in the firm's ability to service its debt payments, as
it is unlikely to be faced with new and aggressive competitors in the future.
Where market entry is easy and relatively cheap, the certainty that income will continue
for a business already established in that industry will be reduced. Investors will
typically be more cautious about providing debt capital because of the uncertainty that
it can be financed into the future.
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Cost of Ke
Capital (Cost of
Equity)
WACC
(Overall Cost
of Capital)
A
Kd
(Cost of
Debt)
A plc B plc
£ £
Net operating income 20,000 20,000
Interest on debt – 3,000
Earnings available to shareholders 20,000 17,000
Ke 15% 16.5%
Market value of equity (Earnings/ Ke) 133,333 103,030
Market value of debt – 60,000
Total value of firm 133,333 163,030
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MM argue that the difference in market values of two identical (except for financing mix) firms
will not remain because the arbitrage mechanism will bring the value of the firms into
equilibrium. The arbitrage process will occur via investors engaging in home-made
leverage, i.e. they will borrow and invest in A plc thus imitating B plc. Some examples will
show how this works.
Example
Charlie owns 10% of B plc. His investment of £10,303 (10% of the equity value) is made up
as follows:
£
10% of the value of the firm 16,303
less 10% proportionate share of debt 6,000
10,303
Clearly other investors would follow Charlie's lead and the forces of supply and demand
would increase the price of A plc shares and thus lower its cost of equity and vice versa for B
plc until their prices were in equilibrium and no arbitrage opportunities remained.
Shareholders therefore can obtain the benefits from gearing on their own account by
duplicating the capital structure of the firm and there is thus no benefit to be obtained to a
firm from simply changing its capital structure.
If a firm cannot change its value by changing its capital structure, then its weighted average
cost of capital (WACC) must remain constant because the value of any firm equals the NPV
of future earnings divided by its costs of capital.
This leads to one of MM's famous "propositions":
WACCg WACCug earnings before interest/WACC
where: g geared
ug ungeared
The value of the geared firm is thus equal to the value of the ungeared firm which is equal to
the earnings before interest/WACC.
MM then argued that as a company increases its level of gearing the cost of equity increases
due to increased financial risk (financial risk arises because there are more fixed charges to
pay before shareholders can obtain any returns), and the increase equals the savings made
from the lower cost of debt.
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Keug
Cost of Capital
Kd
Keg
Level of Gearing
Example
Scat plc and Millie plc are identical in every way except that Millie has 25% debt at the risk-
free rate of 9%, whereas Scat is all equity financed. Scat's cost of equity is 12%. Calculate
both companies' WACC.
Scat plc is all equity financed, and therefore its WACC Ke 12%.
For Millie:
Vd
Keg Keug (Keug Kd)
Veg
12% 1/3(12 9)
13%
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Cost of Capital Ke
WACC
Kd after tax
Level of Gearing
Example
Max plc has earnings before interest of £100,000. Its capital structure is made up of 10%
debt at a cost of 5%, and 90% equity. The cost of equity is 10%. Max plc operates in
Connahland which does not allow debt interest against taxation, but is considering doing so
under a new law. Calculate the change in Max plc's WACC and market value if the law is
passed. Corporation tax in Connahland is 25%.
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The weighted average cost of capital before the law would be:
WACC (Ke Proportion of equity) (Kd Proportion of debt)
10% 90% 5% 10%
9.5%
Therefore, the value of firm £100,000/9.5% £1,052,632
If the law was passed the WACC would be:
WACC (Ke Proportion of equity) (Kd (1 t) Proportion of debt)
10% 90% 5 (1 0.25)% 10%
9.375%
Therefore, the value of firm £100,000/9.375% £1,066,667
Thus the cost of capital would reduce by 0.125% and the value of the firm would increase by
£14,035.
Therefore, the cost of equity for a geared company given above becomes:
Vd
Keg Keug (Keug Kd)(1 t)
Veg
Dt
and WACCg WACCug(1 ).
D+E
where: D market value of debt capital in geared company
E market value of equity in a geared company
In the example of Scat and Millie above, consider what the situation would be if corporation
tax was 35%. Scat plc is all equity financed, and therefore its WACC Ke 12%
(unchanged from above).
However, for Millie:
Vd
Keg Keug (Keug Kd)(1 t)
Veg
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However, a firm may reach a point at which it has no taxes to offset debt interest against –
this is known as tax shield exhaustion. When such a point is reached there are no longer
any benefits to be gained by increasing the level of the firm's gearing.
The theory, like the previous one, has its limitations in that it again ignores bankruptcy and
agency costs. It also ignores personal taxation. (In 1977 Miller considered personal taxes
and concluded that there was no optimal debt level.)
Empirical testing of these theories is very difficult in practice and as such the optimal level of
gearing (if one exists) remains an unresolved issue. Strictly speaking, they are all
hypotheses rather than theories.
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E. OPERATIONAL GEARING
Financial gearing is a principle measure of financial risk.
Business risk refers to the risk of making only low profits, or even losses, due mainly to the
nature of the business in which the company is involved. One way of measuring business
risk is by calculating the company's operating (or operational) gearing.
The usual way of measuring a company's operational gearing is by using the following
formula:
Contributi on
Operating gearing =
Profit before interest and tax (PBIT)
where: contribution is sales less the variable cost of sales.
The significance of operational gearing is:
If the contribution is high but PBIT is low, then fixed costs must be high and only just
covered by contribution. This would mean that the business risk, as measured by the
operating gearing, is high.
If the contribution is not much bigger than PBIT, then fixed costs will be low and
reasonably easily covered. This would mean that the business risk, as measured by
operating gearing, will be low.
Consider the following example which examines the distinction between financial and
operational gearing (and is taken from the June 2003 Corporate Finance examination paper.)
Example
Blackpool Engineering Ltd produces and sells a computer modem. The company has been
in operation for four years and has an issued share capital of £200,000 (par value 25p per
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share). To date, the company has produced only one product. In the year ended 31
December 2000 it sold 20,000 units.
The statement of comprehensive income for the year to 31 December 2000 is as follows:
£000 £000
Sales 1,900
less: Variable expenses (700)
Fixed expenses (400) (1,100)
Earnings before interest and taxation 800
less: Interest payable on 10% debentures (200)
Earnings before taxation 600
less: Corporation tax (198)
Profit after taxation 402
Dividend (160)
Retained profit for the year 242
Recently, Blackpool has been experiencing labour problems and, as a result, has decided to
introduce a new highly automated production process in order to improve efficiency. The
new production process is estimated to increase fixed costs by £150,000 (including
depreciation), but will reduce variable costs by £15 per unit.
The new production process will be financed by the issue of £1,000,000 of debentures at an
interest rate of 12%. If the new production process is introduced immediately, the directors
believe that sales for the forthcoming year will not change. Stocks will remain at the current
level throughout the coming year.
Blackpool's shares currently sell at a P:E ratio of 13:1 and the current corporation tax rate is
35%.
Required:
(a) Explain the terms "operating gearing" and "financial gearing".
(b) Calculate the change in earnings per share and in share price if the company
introduced the new production process immediately. Explain any assumptions which
you make.
(c) Analyse the implications for share price if Blackpool makes a rights issue at an issue
price of £2.50 per share (ignore issue costs).
Answer
(a) Operating gearing may be defined as a measure of the impact of a change in sales
upon earnings before interest and tax (EBIT)
Financial gearing is measured by comparing a company's use of long term finance
relative to equity.
(b) Before the project:
PAT 402 402
EPS = = = = 50.3p
No of shares 200 x 4 800
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410
EPS = = 51.3p
800
Comments:
(i) As this is only a small change in expected EPS, the project might have to be
evaluated on other criteria.
(ii) The solution assumes no repayment of existing debt levels.
(iii) Assuming no change in P:E ratio, the share price will rise:
from (15 x 50.3) = £7.55
to (15 x 51.3) = £7.70
(c) Required funding = £1m
The rights price (deeply-discounted) = £2.50
£1m
Ignoring issue costs, need to sell = 400,000 new shares
£2.50
Hence, a "one-for-two" rights issue is required.
New number of shares = (800,000 + 400,000) = 1 .2m
Theoretical ex-rights share price:
Before issue:
2 shares@£7.55 15.10
Cash 2.50
£17.60
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Chapter 9
Corporate Dividend Policy
Contents Page
Introduction 186
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186 Corporate Dividend Policy
INTRODUCTION
We saw in earlier chapters that a firm’s dividend policy is one of the three key decisions it
must make. Corporate dividend policy is the decision between dividends and capital gains
(dividends may include scrip dividends, share splits and other perks).
There is a debate in this area as to whether the market value of a company’s shares (and
thus the value of the firm and shareholder wealth) is affected by its dividend policy. Before
looking at the theoretical arguments, though, we shall consider some of the practical
influences on a company’s choice of dividend policy, including the key decisions of
investment and financing policy..
Retention Policy
The company uses its funds in the pursuit of profit and, where that profit is sufficiently large, it
will pay a dividend to shareholders. The surplus then remaining is referred to as retentions
and will be available to finance growth and the replacement, as necessary, of the company’s
assets.
These retentions of profits which are ploughed back into the business are internally
generated capital.
Retentions of profit arise in two forms:
(a) As amounts set aside out of profits prior to determining the amount available for
dividends, i.e. provisions of profit.
(b) As the surplus remaining when the shareholders’ dividends have been paid, i.e.
retentions. Equally, we could argue that these funds have been invested by
shareholders through them foregoing dividends.
Naturally the board must consider the desirable levels of retentions in order to fund future
projects and growth. Retained earnings are the most important source of finance for UK
companies, providing most of all funding requirements over recent years.
The main reasons for this may be as follows:
Company managers often mistakenly believe that there is no cost involved when
retained earnings are used. As we shall see later there is, in fact, an opportunity cost
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derived from the idea that shareholders have consented to re-invest these earnings in
the company, but it is true to say that there is no cost involving the outlay of cash.
The dividend policy is determined by the directors, who see retained earnings as a
ready source of cash to invest in their favoured projects without the need, trouble or
expense involved in consulting or raising funds from shareholders and other outsiders.
By using retained earnings the directors avoid the expense of issue costs and, perhaps
more importantly, minimise the risks involved in losing control of the company following
an issue of shares or secured debentures.
These considerations are balanced by the shareholders’ need for at least a minimum return
of the profits and satisfaction of their investment expectations. Equally, though, a company in
search of funds will not be viewed favourably if it is over-generous with its dividends or pays
over-generous salaries to its owner-directors (if a limited company).
Legal constraints
Companies are bound by the Companies Act 1985 to pay dividends entirely out of
accumulated net realised profits, and this includes both profits earned in the current financial
year and those realised historically in previous financial periods.
Whilst the Act does not provide a satisfactory definition of what is meant by accumulated net
realised profits, the Consultative Committee of Accountancy Bodies (CCAB) has issued
guidance that specifies that dividends can be paid out of profit calculated using relevant
Accounting Standards after taking into account any accumulated losses.
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The effect of creating provisions for depreciation and other items is to reduce the profit
available to pay out dividends and/or make retentions. Because of this, amounts of cash are
held back in the business and are not paid as dividends. They become available for other
uses, e.g. fixed asset purchase.
It is important to note that usually, with provisions, a sum of money is not physically
separated from the rest in the bank account to substantiate the provision made. The cash
not now required for dividends, because provisions have been made, can be put to general
use. Some companies may in fact create a separate fund into which the cash backing for
their provisions is put. This requires cash to be paid out and an investment purchased. In
this case the creation of provisions does not comprise internally generated funds.
Where, however, the creation of provisions, their eventual spending and consequent
replacement is a more or less continuous process, then such provisions represent a
significant proportion of internally generated funds.
In practical terms it is recognised that at least some prudence is necessary, at least in times
of changing prices, to prevent the “real” value of the business being depleted. You can see
this in current cost accounting, where revaluation surpluses and deficits arising from changes
in the prices of fixed assets and stock etc. are taken to a non-distributable reserve. The idea
behind this is that if such amounts were distributed it would imply that the operating capability
of the business had been eroded.
You should not, however, think that the “current cost profit attributable to shareholders”,
apparent from current cost accounts, can prudently be distributed. Other matters must be
considered, such as cash availability, capital expenditure plans, changes in volume of
working capital, the effect on funding requirements of changes in production methods and
efficiency, liquidity, and new financing arrangements, as well as the effect of price changes
on the finance required.
Taxation liabilities. The level of estimated corporation tax liabilities needs to be
considered as part of the process for determining the level of available funds for
distribution as profits to shareholders.
Investment opportunities (or a significant percentage) are often funded from retained
profits and it is also important that the company ensures that a correct balance is struck
between leaving enough retained profits to fund much needed investment opportunities
and the payment of dividends to shareholders.
Liquidity issues. Since dividends are payments of cash out of the business the
directors need to ensure that the company, at all times, has sufficient liquid resources
to make dividend payments and to run their day to day transactions.
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From this approach a behaviour pattern can be determined for the process of fixing dividend
levels. The decision becomes strongly related to past behaviour:
What was last year’s dividend?
What are this year’s available profits?
Should the dividend be increased or decreased?
If so, by how much?
Can that position be sustained?
The effect of this cautious behaviour is to produce a time delay between increases in profits
and consequent increases (or decreases) in dividends.
This time delay is important for two reasons:
(a) As a company’s profits increase – and since the directors will tend to delay dividend
increases – retentions will increase. If a company’s profits decrease, retentions will be
decreased.
(b) Generally, when an increase in dividend rate is announced, it will be fair to assume that
the directors feel that the increased level will be capable of being sustained in the
future. Alternatively, dividend level will only be reduced if the directors feel that the
existing level cannot be maintained in the future.
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There have been many surveys and studies on this topic, involving different sized companies
and types of industry with different shareholding patterns, set against varying periods of
economic activity, rates of inflation, world situations and Stock Market confidence. Not
surprisingly, there are conflicting findings by the various authorities, not only because of the
factors indicated but primarily because such studies attempt to quantify, in mathematical
terms, the behaviour of a large and diverse group of human beings.
Shareholder Expectations
No matter what their preference for dividends as opposed to capital growth in the value of
their shares, all shareholders will hold some expectations about what the dividend should be.
Often this is based on prior dividends and a vague idea of an acceptable pay-out ratio, so
that as profits grow there is an expectation that dividends should keep in step.
Furthermore, it is generally accepted amongst shareholders that dividends should match
those declared last year or show an improvement. A stable dividend is taken (quite wrongly,
perhaps) as a sign of a stable company. This often forces directors to declare too large a
dividend when losses have been incurred in order to “save face” and prevent the share price
falling. Having to “pass” either a final or interim dividend became a subject of great concern
during the recession of the early 1990s.
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Public companies usually pay dividends twice a year: an interim dividend after the interim
results, and a final dividend, but only after the final results (and therefore this final dividend)
have been approved by the shareholders.
Remember, shareholders have the power to reduce the dividend payable, but not to increase
it. Company directors are therefore in a strong position and for all practical purposes
shareholders are often obliged to accept the proposed dividend.
Other Influences
(a) Personal taxation of shareholders
Different shareholders will suffer different rates of personal taxation on any dividend
income which they receive. Thus, if a dividend of 10p per share is declared, those
paying basic rate income tax at 20% will receive a net amount of 8p, whereas those
paying 40% will only receive 6p. Therefore, if the rate of capital gains tax is lower (after
the individual’s CGT annual exemption) than the shareholder’s marginal rate of
taxation, he will prefer a situation in which less is distributed as dividend but is instead
retained within the business to provide capital growth.
(b) Government policy: dividend restraint
From time to time the Government has operated a policy of dividend restraint as part of
a (prices and) incomes policy. No such constraints exist at present. Equally
governments could restrict the flow of funds to investors outside its borders or to certain
groups or individuals if they were so disposed.
(c) Profitability
As we have seen, the profitability of a company is a key factor in the amount which can
be paid out in dividends. If profits are volatile it is unwise to commit the firm to a high
pay-out.
(d) Inflation
In times of high inflation dividends based on historic cost profits can lead to distribution
of the company’s capital almost inadvertently, thereby reducing the operating capacity
of the business.
(e) Growth
Rapidly growing companies may prefer to re-invest the bulk of their earnings rather
than distribute them as dividends. This is often the case with newly-formed companies.
Alternatively some companies (perhaps those backed by venture capital) will be
obliged to offer higher dividends because of their relatively riskier investment.
(f) Other sources of finance
Unquoted companies in particular may find it difficult to access other sources of
finance. Retained earnings are important and dividends will therefore tend to be small.
(g) Control
By using internally generated funds ownership or control is not threatened and
directors are free to use such funds as they see fit rather than convince new investors
of the benefits of their schemes.
(h) Cash flow considerations
A company declares a dividend out of its Profits After Taxation. This is a dividend net of
any tax, and the full amount will have to be paid.
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Clientele Effect
There may not, however, be an optimal distribution/retention policy that the firm can adopt to
meet the needs of all shareholders, because of the different taxes (capital gains and income
tax) and tax rates borne by different investors. A company should choose and maintain one
policy which maximises one group of shareholders’ wealth. Shareholders will then migrate to
companies which operate a policy in line with their needs – this is known as the clientele
effect.
The changes in the treatment of tax credits in the 1997 Budget has had a major impact on
the preferred dividend policy of pension funds. Until then, pension funds were able to claim
back tax credits on dividends received. As a result of the Budget changes, dividend yield will
reduce in significance, as will the preference for dividends over capital gains by this particular
clientele. Ten years on from the 1997 budget, these changes to the tax treatment of
dividends have been shown to have had a major impact on pension fund valuations and one
of the main reasons for the stopping, in large numbers, of company “final salary” pension
schemes.
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194 Corporate Dividend Policy
Repayment of debt and any restrictions on dividend payments under loan agreements.
The liquidity of the company should be considered, together with the timing of cash
flows (the company must remain solvent and have enough cash to pay any dividends it
declares).
The level of inflation affects the level of dividend which can be paid – companies must
ensure they have sufficient capital to maintain their operating capability.
The company’s gearing level can have an effect on its dividend policy – any reduction
in retained earnings will increase its gearing ratio.
The company may have a large amount of cash which it may wish to return to its
shareholders, especially if its future cash flow predictions are strong. A large amount of
surplus cash was another reason for the 1996 National Power special dividend mentioned
above. This is a payment in excess of the usual amount that would normally be paid to
shareholders.
Share Repurchases
Repurchases, or buy-ins, of shares may be made by companies out of their “distributable
profits”, or out of the proceeds of a new issue of shares made especially for the purpose,
provided they are authorised to do so in the company’s Articles of Association.
A company may not, however, purchase its own shares:
(a) Where, as a result of the transaction, there would no longer be any member of the
company holding other than redeemable shares.
(b) Unless they are fully paid up, and the terms of the purchase provide for payment on
repurchase.
Purchases may be in the market or off-market. An off-market purchase is said to occur
when the shares are purchased not subject to the marketing arrangements of the Stock
Exchange, or other than on a recognised stock exchange. A buy-in of shares by a public
company will be subject to the rules of the Stock Exchange and to the provisions of company
law.
The change in the capital base will cause management to rethink its investment decisions,
gearing, interest cover, earnings, etc. This is particularly important as the financial
institutions focus their attention more towards income and gearing as an indicator of financial
risk.
It is important to be aware of the various advantages and disadvantages of share
repurchases. The advantages of share repurchases include the following:
It may allow a company to prevent a takeover bid. The control by the existing
shareholder group will be increased.
A quoted company may purchase its shares in order to withdraw from the Stock Market
(see below).
It can be a useful way of using surplus cash.
Repurchasing shares will reduce the number in circulation which should allow an
increase in earnings and dividends per share, and should lead to a higher share price.
It will increase future EPS as future profits will be earned by fewer shares.
Reducing the level of equity will increase the gearing level for a company with debt
which may be considered beneficial by the company.
If the business is in decline a share repurchase may give the firm’s equity a more
appropriate level.
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196 Corporate Dividend Policy
movements in reserves. This policy is quite rate in listed companies, though many
firms may work towards some notional target pay-out ratio.
(c) Residual value
A third, less common, dividend policy is to use retained earnings to fund all projects
which show a positive net present value (NPV) at the firm’s weighted average cost of
capital (WACC) and pay out any remaining funds as dividends.
This is possibly the most objective dividend policy for rational investors but the
concerns of “signalling” (see above) often overrule such a common sense approach.
Non-Dividend Transactions
You should not forget that there are alternatives to cash dividend payouts, as follows.
(a) Scrip issues
A scrip issue, also referred to as a capitalisation, or a bonus issue, involves the
conversion of reserves into capital, causing a fall in the reserves. Shareholders receive
additional shares in proportion to their holding. Unlike a rights issue no additional
funds are brought into the company – the shareholders do not “pay” for these shares.
There is then more equity in circulation with the result that the market value will
generally fall in the short term, thus making it more attractive to potential investors.
The reserves used are either from a credit balance in the statement of comprehensive
income, or from reserves specifically marked for the payment of shares, and authority
is required from the articles of association and the AGM.
(b) Scrip dividends
Scrip dividends are a conversion of profit reserves into issued share capital offered to
shareholders in lieu of a cash dividend. Enhanced scrip dividends are those where
the value of shares is greater than the cash dividend offered as an alternative. Such
dividends are of benefit to the company as they maintain cash within the business.
There may, however, be tax complications arising for individual investors.
(c) Stock split
A stock split is the splitting of existing shares into smaller shares, e.g. each ordinary
share of 50p is split into two of 25p, in order to improve marketability of the company’s
shares. It can also be used to send signals that the company is expecting significant
growth in EPS and dividends per share, and for this reason the resulting market price
of the split shares is higher than the simple split price would be. For example, if a
share with a market value of £10 was split into two shares their price would be higher
than £5. Reserves are not affected.
(d) Shareholder concessions
A number of companies offer discounts of one form or another to their shareholders.
These can be thought of as a dividend in kind and are a useful marketing tool or
publicity exercise – for example, hotel groups often give a concession to shareholders
on room rates
While these are often attractive to small shareholders (institutions rarely qualify, in any
case) they are often not a good reason for investment. The concession can be
removed at any time and often a significant holding must be maintained. To qualify for
concessions, shareholders usually have to hold a minimum number of shares.
An advantage, however, is that they are tax exempt!
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Chapter 10
Working Capital and Short-Term Asset Management
Contents Page
Introduction 199
B. Overtrading 207
(Continued over)
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Working Capital and Short-Term Asset Management 199
INTRODUCTION
Funds employed in an organisation can be split for planning purposes into long-term and
short-term funds. As we have seen in an earlier module, the financial manager will attempt
to match the funding available to the business to the life of the investment it is required for.
In this chapter we will consider the management of short-term funds applied to funding
current assets.
We shall start by looking at the definition of working capital, its constituent parts and
relationship to fixed capital, and some common ratios that can be applied as a management
tool. We then go on to consider the implications of cash management. Balance in cash flow
management is very important: too little cash resources highlights impending danger, but too
large a reserve of cash will mean that potential future earnings will be impaired.
The financial manager must predict the needs of the business and make suitable funding or
investment arrangements – planning the effective use of the financial resources, applying to
the working capital of a business. We shall discuss the specialist financial products that are
available to help to reduce the cash tied up in debtors, and look at ways in which the
company can decide on an optimum period of credit to be granted within the general
constraints of the markets in which it operates.
A. WORKING CAPITAL
Working capital is the total amount of cash tied up in current (i.e. short term) assets and
current (i.e. short term) liabilities, and is calculated by deducting the total amount of current
liabilities from the total amount of current assets. Thus, if A plc has current assets of £10m
and current liabilities of £6m then its working capital resources are £4m. Working capital is
sometimes expressed as the current ratio (see below) and current assets (less closing
stock) as the quick or acid test or liquidity ratio.
The finance needed to fund a firm's required level of working capital can be either short or
long term.
It is essential to ensure that a firm has sufficient working capital to allow it to operate
smoothly and have sufficient funds to pay its bills when they arise, including taking account of
the effects of inflation and projected future cash flows. However, an organisation should be
careful not to over-provide working capital and cause unnecessary cost, a phenomenon
known as overcapitalisation.
Overinvestment in working capital leading to excessive stocks, debtors and cash, coupled
with few creditors, is known as overcapitalisation. Such a situation will lead to lower return
on investment and the possibility of having to secure long term funding to pay for short term
assets which is not an ideal situation for a business to be in. Indicators of overcapitalisation
include long turnover periods, high liquidity ratios and a low sales/working capital ratio.
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200 Working Capital and Short-Term Asset Management
If the supplier of the raw materials required payment after 60 days, the company would need
to fund the cost of the goods sold for a period of 89 days, and of course wages and other
expenses would have to be paid during the period. Steps taken to speed up the rate of
working capital turnover, e.g. reducing stock levels, therefore means reducing the company's
investment in working capital.
To illustrate this point further, let's look at an example.
Example
A company sells £20m of goods throughout the 50 weeks of the working year. As the sales
are partly through retail outlets and partly through mail order, daily sales from Monday to
Friday can be considered to be equal. The firm banks its takings on Thursday of each week
and the incremental cost of banking is £50. The company's account is always overdrawn
and it pays interest on this overdraft of 15% pa (in this example to be applied daily on a
simple interest basis).
Management wish to know whether there will be a benefit to banking twice weekly on
Monday and Thursday. Investigate the possibility.
£20m over 50 weeks of the year gives a turnover of £400,000 per week and £80,000 per day
for a five-day week.
We will now assess the banking alternatives being considered:
Monday 80 3 240 0 0
Tuesday 80 2 160 2 160
Wednesday 80 1 80 1 80
Thursday 80 0 0 0 0
Friday 80 6 480 3 240
960 480
Banking only on Thursday has the same effect as having an overdraft of £960,000 for one
day each week. In terms of interest, the cost of this is:
£960,000 (15% 365) 50 £19,726.*
The annual interest cost of banking twice weekly is:
£480,000 (15% 365) 50 £9,863.*
(*For interest purposes, we are using a calendar year.)
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Monday 80 1 80
Tuesday 80 0 0
Wednesday 80 2 160
Thursday 80 1 80
Friday 80 0 0
320
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202 Working Capital and Short-Term Asset Management
(a) The current ratio (or working capital ratio) is measured as:
Current assets
, expressed as a ratio, e.g. 2:1
Current liabilitie s
Whilst there is a suggested target ratio of 2:1, the acceptability of the ratio calculated
will depend on the nature of the business, but current liabilities exceeding current
assets generally indicate that the business may have problems. In common with all
ratios it is important to monitor its trend in order to ascertain whether there are
potential problems developing. It is also useful to monitor the ratio by reference to that
of competitors to establish if it is higher than equivalent businesses.
(b) The quick asset ratio removes those items which cannot easily and quickly be
converted into cash at their full value (i.e. stock) and is calculated as:
Current assets Stock
Current liabilitie s
Again there is no ideal ratio; the acceptability of the one calculated depends on the
industry (although the target is 1:1). In addition, it is the trend over time that is
important. Again, it is also useful to compare this ratio with that of competitors to
establish if it is higher than equivalent businesses.
(c) The acid test ratio is the amount of cash which the firm has to service its current
liabilities and is measured as:
Cash + Deposits + Quoted investment s
Current liabilitie s
Again it is the trend that is of most importance and it is also useful to monitor the ratio
against that of competitors to establish if it is higher than equivalent businesses.
Companies with poor acid test ratios need to have standby overdraft facilities in order
to ensure that the short-term need to service payments of current liabilities can be met.
However, remember that too much cash will mean that the firm is under-utilising its
resources and that a better return could be available elsewhere.
The working capital cycle starts with the investment in raw materials which are then used in
the production process and, therefore, become partly finished goods. Eventually, finished
goods are produced which are then held in stock until sold. Some of these goods might be
sold for cash and the rest would be sold on credit with the customer paying days or weeks
later (depending on what arrangements the individual debtor had with the business and
indeed how long each debtor takes to pay). At each stage of the process, expenditure is
needed on labour and other operational requirements. Helping to ease the cash burden are
suppliers who supply credit to the business.
Money tied up at any stage in the working capital cycle has an opportunity cost.
Cash conversion cycle
The cash conversion cycle is a part of the working capital cycle and can be expressed as
follows:
"The cash conversion cycle is the length of time elapsing between parting with cash
and getting it back from customers".
How is the cash conversion cycle measured?
There is a need to complete three key working capital ratios:
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Working Capital and Short-Term Asset Management 203
Debtors
(a) x days (365) in year
Sales
plus
Stock
(b) x 365
Cost of sales
minus
Creditors
(c) x 365
Purchases
equals
Cash conversion cycle
Example
The following example has been taken from a question in the Corporate Finance paper for
June 2006.
Lancaster Model Aeroplanes Ltd has become increasingly concerned over its liquidity
position in recent months.
The most recent set of final accounts for the business show the following:
Statement of Comprehensive Income
for the period ended 31st December 2005
£ £
Sales 550,000
less: Cost of sales:
Opening stock 170,000
Purchases 465,000
635,000
Closing stock (165,000) (470,000)
Gross profit 80,000
Expenses (90,000)
Net loss (10,000)
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Fixed Assets
Premises 610,000 (300,000) 310,000
Fixtures and fittings 85,000 (40,000) 45,000
Motor vehicles 105,000 (35,000) 70,000
800,000 (375,000) 425,000
Current Assets
Stocks 152,000
Debtors 183,000
335,000
Current liabilities
Creditors 146,000
Bank overdraft 174,000
(320,000)
Working capital 15,000
440,000
Long term liabilities
Loans (160,000)
Net Assets 280,000
Financed by:
Capital 120,000
Retained profit 160,000
280,000
The debtors and creditors were maintained at a constant level throughout the year, and all
transactions were on a credit basis.
Required:
(a) Explain, using appropriate ratios, why the business is concerned with its liquidity
position.
(b) Explain the term "operating cash cycle" and state why this concept is important in the
financial management of a business?
(c) Calculate the operating cash cycle for Lancaster Model Aeroplanes Ltd based on the
information given (assume a 365 day year).
(d) State what steps might be taken to improve the operating cash cycle of the company.
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Working Capital and Short-Term Asset Management 205
Answer
(a) To help illustrate the worsening liquidity position of the company, it is useful firstly to
calculate a number of ratios involving solvency or liquidity:
Working capital ratio
Current assets : Current liabilities
= 335,000 : 320,000
= 1.05 : 1
Acid test ratio
Current assets ( less stock ) : current liabilities
= 183,000 : 320,000
= 0.57 : 1
Debtors days
Debtors
x 365
Sales
183,000
= x 365 = 121 days
550,000
Creditor days
Creditors
x 365
Purchases
146,000
= x 365 = 115 days
465,000
The current ratio shows that the current assets exceed the short term current liabilities.
However, the overall ratio of 1.05 :1 is low and if the current assets were to be
liquidated, they would only have to be sold off at a small discount on the cost to be
insufficient to meet the short term liabilities. The acid test ratio of 0.57 : 1 is also very
low and suggests that the company has insufficient liquid assets to meet its maturing
obligation.
The comparison of debtor days and creditor days is also worrying. Not only is the
business taking a long time to receive its debtor payments (121 days), it is paying its
creditors slightly quicker (115 days) and having to fund an average of 6 days of its
debtors figure, adding to its liquidity problems.
When interpreting these ratios, it needs to be borne in mind that they are based on
published figures at a point in time and are therefore only representative of that point in
time. They do, though, represent an indication of likely areas of concern and it would
be useful to monitor the trends of these ratios over time.
It would also be useful to prepare a cash flow forecast in order to gain a better
understanding of the estimated liquidity position of the business in the future.
The bank overdraft is the major form of short term finance and the continuing support
of the bank is likely to be of critical importance to the company.
(b) The operating cash cycle of a business represents the time period between the outlay
of cash on the purchase of stocks and the receipt of cash from trade debtors.
The operating cash cycle is important because the longer this period is, the greater the
financing requirements of the business and the greater the risks involved.
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(c) The operating cash cycle for Lancaster Model Aeroplanes Ltd is:
Average value of stocks
Average period stocks are held =
(to nearest whole day) Average daily cost of sales
(170,000 165,000)/2
=
(470,000/3 65)
= 130 days
Average debtors
Average settlement period for debtors =
(to nearest whole day) Average daily sales
183,000
=
(550,000/3 65)
= 121 days
Average level of creditors
Average settlement period for creditors =
(to nearest whole day) Average daily purchases
146,000
=
(465,000/3 65)
= 115 days
The operating cash cycle for Lancaster Model Aeroplanes Ltd is therefore:
130 days + 121 days – 115 days = 136 days
(d) The operating cash cycle of the business is quite long. It may be reduced by a
reduction in the stocks, extending further the average settlement period for creditors or
some combination of these measures. The stockholding period and average
settlement period for debtors also seems high and needs to be reduced, hopefully
without too much difficulty. The use of a factoring agency could be useful in this
respect. As the average settlement period of creditors is also high, it may be difficult to
extend this further without incurring problems for the company.
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B. OVERTRADING
An increase in a company's turnover is basically good, but it should be part of a planned
strategy with a permanent increase being supported by a matching permanent increase in
the working capital of the company. This will most commonly be achieved by retention of
profits and/or an injection of share capital. Inflation could increase the requirement more
than the funding injected.
Overtrading is a common phenomenon for growing companies, and occurs when a business
overextends itself by having insufficient capital to match increases in turnover. Increasing
turnover will result in higher stock and debtor levels which will need to be funded. Another
cause of overtrading is the repayment of a loan when the business has insufficient cash to
fund it. Whilst there will be some corresponding growth in creditors, sustaining growth on
trade credit alone is unlikely to be successful in the longer term.
In such a situation increasing the firm's overdraft and reducing the level of credit allowed to
debtors are other possible sources of finance. However, both will prove difficult in practice;
the latter especially may create problems preventing the required growth the firm desires.
Typical symptoms of overtrading would include the following:
A significant increase in turnover over the period
A decrease in gross profit and net profit ratios over the same period
A deterioration in stock turnover ratios
Increasing liquidity problems shown by the current asset and acid test ratios
Increasing reliance on short term finance such as an increase in bank overdraft and
creditors payment period
A rapid increase in the volume of current assets
Only a small increase in the owners capital
Some debt ratios alter significantly
And future action needed to address these issues could include the following:
Efforts to increase stock turnover, such as an advertising campaign or marketing
initiatives.
Reduction in expenses to improve net profit percentage
Seeking of alternative methods of finance to fund any expansion
Consider a reduction in the rate of raid expansion
Consider new capital from the owners of the business
Improve control systems, particularly cost control systems
Consider having to abandon any ambitious plans for the immediate future
Look at loan requirements – for example, has the business repaid a loan without
replacing it? This has the effect of reducing the long term capital of the business
Consider the use of credit and factoring agencies.
Overtrading is illustrated by the following example:
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Example
Year 1 Year 2
£ £ £ £
Fixed Assets 80,000 120,000
Current Assets
Stock 20,000 40,000
WIP 20,000 50,000
Debtors 50,000 80,000
Cash 5,000
95,000 170,000
Current Liabilities
Creditors 45,000 118,000
Bank 20,000 60,000
65,000 178,000
30,000 (8,000)
110,000 112,000
Financed By:
Share Capital 100,000 100,000
Profit & Loss Account 10,000 12,000
110,000 112,000
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(h) The positive current and quick asset ratios have disappeared, indicating a worsening in
the short-term financing position.
(i) The proprietors' stake for the two years is:
Year 1 Year 2
£ £
Total Assets 175,000 290,000
Financed By:
Capital 110,000 62.9% 112,000 38.6%
Creditors 45,000 25.7% 118,000 40.7%
Bank overdraft 20,000 11.4% 60,000 20.7%
175,000 290,000
There has been a dramatic decline in the proportion funded by the equity holders, and
should the bank limit be reached, no more trade credit be available and debtors be
unwilling to pay more quickly, then the firm could go out of business despite a full order
book and the potential to be successful.
Methods to relieve the situation could include:
Faster debt collection, although too much pressure may lose customers.
More efficient stock-holding.
Slower payment to creditors, but there are limits that will be acceptable.
Increased bank financing, although the bank will probably expect a capital injection
from outside the business as well.
Slowing down the rate of growth in turnover, allowing work in progress to be finished
and stock sold, thereby reducing the amount of working capital needed.
C. CASH MANAGEMENT
Every organisation must have adequate cash resources (including undrawn bank overdraft
facilities) available to it to meet its financial commitments of day-to-day trading (e.g. wages
and taxation). Cash is also required to meet contingencies, to take advantage of discounts
and other opportunities available, and to finance expansion. Firms should, though, avoid
holding too much cash with the resulting under-utilisation of resources.
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operates. If a shortage is expected then the firm can arrange finance, perhaps by increasing
its overdraft, to overcome the problem.
Other remedies that can be used to deal with short-term expected cash shortages are:
Accelerating cash inflows from debtors.
Postponing cash outflows by delaying payment to creditors; whilst this is considered to
be a cheap alternative (creditors rarely charge interest), such an alternative increases
the risk of insolvency of the firm.
Postponing capital expenditure (or negotiating extended payment terms with the
supplier).
Reversing past investment decisions, such as selling off non-essential assets.
Rescheduling loan repayments (with the lender's agreement).
Reducing the level of dividend to be paid.
Deferring (after discussion with the Inland Revenue) tax payments (but there will be an
interest cost to doing this).
Despite it being bad policy to finance long-term assets with short-term funding, where the
financial manager can determine from the cash budget that sufficient funds will become
available, it may be possible to operate such a funding policy without detriment to the firm.
In order to help cash management of groups, a facility called cash pooling may be
requested from the group's bank. This process of cash pooling allows the offsetting of
surplus and deficits held at the bank by the group's companies using a dummy account. The
net balance is the one on which interest is payable or chargeable, and the group can then
decide how to allocate this cost or income.
For those groups which have overseas subsidiaries involved in intra-group trading, then the
group may net off the transactions between its members on a multilateral basis. Whilst there
are some countries which limit or prohibit netting (e.g. Italy and France), the groups should
benefit from reduced transaction costs.
A further method of cash management that may be adopted by a multinational firm is to
centralise cash management, holding funds in one of the major financial centres such as
London or New York, with only the minimum level required for day-to-day purposes being
held by subsidiaries. The remittance of funds back to the parent can be done via the group's
bank, or telegraphic transfer, but there may be limitations imposed by overseas governments
on the level of remittances.
Margin of Safety
No forecast will ever be 100% accurate and the further into the future the projections are
made, the greater will be the margin of error. In cash budgeting the balance at the end of
each period represents a "margin of safety", whereby the company buys peace of mind at the
expense of profitable utilisation of cash. The size of the balance must be related to the
certainty or otherwise of the predicted inflows and outflows, and the availability of back-up
resources, such as overdraft facilities available. A cash-based business, such as a food
supermarket, will have more certainty of its cash inflows than a business selling principally on
extended trade terms. Where, therefore, cash inflow can be predicted with relative accuracy,
provision for a margin of safety can be smaller.
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Cash Ratios
Ratio analysis can help in cash management and serve as an indicator of the cash-holding
position. The main ratios are:
(a) Cash Holding – this ratio indicates the proportion of current assets which are held as
cash. Generally, the financial manager will want to keep this figure at the safe
minimum to be able to service immediate current outflows.
The ratio is measured as:
Cash
Current assets
The ratio may increase when a business is deliberately accumulating cash to meet
forthcoming needs, e.g. capital expenditure or repayment of debt capital.
(b) Cash Turnover – this ratio is used to determine how frequently cash is turned over
and is expressed as:
Sales during the period
Average cash balance
The ratio assumes that an average cash holding is used, typically calculated as:
Opening cash balance + Closing cash balance
2
However, note that cash flows will not be constant, especially if there is seasonal trade.
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For example, if sales for the year were £72,000 and the average cash holding was
£9,000 then using the above formula:
Sales during the period 72,000
8 times
Average cash balance 9,000
i.e. cash was turned over every 45.6 days.
A higher rate of cash turnover will generally be taken to imply the effective use of cash
– the more frequent the turnover, the lower the level of cash needed. High rates of
turnover, however, will appear as the result of maintaining too low a level of cash, and
as such these ratios should be viewed together, i.e. the maximum turnover rate
consistent with adequate holdings levels. Any proposed measures of improving cash
flow management must be carefully evaluated to ensure that the costs do not outweigh
the benefits.
Cash-based ratios will vary widely in different industries, e.g. turnover of cash in a food
supermarket will be rapid, but in a major engineering concern it may take months to turn over
once. Viewing one set of ratios for just one period will in itself disclose very little about the
management of the firm and its trading prospects, and calculated ratios should be compared
over time, and with industry norms.
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2FS
Q
i
where: Q total amount of cash needed to raise for the time period
F fixed cost of obtaining new funds (e.g. issue costs of shares)
S amount of cash to be used in the time period
i interest foregone (opportunity cost) of holding cash or near cash
equivalents (this is a variable cost of obtaining funds)
and the average total cost of holding an average level of cash incurred in a period is:
Qi FS
2 Q
Example
Sooty plc requires £6,000 cash per annum. Any cash raised will have an associated
fixed cost of £300 and an interest rate of 15%. The interest rate on short-term
securities is 10%. Advise Sooty as to the level of finance it should raise at any one
time.
The cost of holding cash for Sooty is the difference between the cost of the funds and
that earned on short-term securities, i.e. 15% 10% 5%.
Therefore, substituting into the above formula:
2 300 6,000
Q
0.05
£8,485
This level should be raised every £8,485/£6,000 1.4 years.
Whilst this model provides a good basis for cash management, especially for firms
which use cash at a steady rate, it ignores costs associated with having a cash deficit
(e.g. interest on an overdraft), and any costs which may increase with increases in the
amount of cash held. The model has been found in practice to be poor at predicting
the amounts of cash required in future periods, and of little help in those firms where
there are large and irregular inflows and outflows of cash.
(b) Miller-Orr Model
The Miller-Orr model, which was developed to produce a more useful model than the
Baumol model, sets upper and lower limits to the level of cash a firm should hold.
When these points are reached the firm either buys or sells short-term marketable
securities in order to reverse the trend of cash flows. In order to set these levels, the
variability of cash flows needs to be determined along with the costs of buying and
selling securities, and the interest rate.
The steps in using the model are:
(i) Determine the lower level of cash the firm is happy to have. This is generally set
at a minimum safety level, though in theory it could be zero.
(ii) Determine the variation in cash flows of the firm (perhaps over a three or six
month period).
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Working Capital and Short-Term Asset Management 215
D. MANAGEMENT OF STOCKS
Stock, or inventory as it is also known, comprises four main types:
Raw material
Work-in-progress
Finished goods
Miscellaneous items, e.g. tools, stationery, fuel, etc.
As with other working capital items, the problem for the financial manager is that of
maintaining balance. He or she must ensure that:
(a) There will be sufficient raw material stock available to satisfy production needs and
enough finished goods stock to meet customers' requirements.
(b) At the same time, the amount of capital employed in stocks is minimised.
(Stockholding has been called the graveyard of industry by financial commentators in
the past.)
Achieving balance can be particularly difficult in the distributive, wholesaling industries,
where customers expect a range of goods to be carried, but only place orders infrequently
when they need a non-routine item. The distributor is faced with the problem of finding a
balance between his ability (and reputation) for good service, and the need to restrict capital
tied up in slow moving lines.
Cost of Stockholding
Holding stock is generally an expensive cash utilisation of a firm's working capital resources.
Stock is basically money in another form, and some of the principal costs associated with
stockholding will include:
(a) Cost of stock, less any available discount (e.g. for bulk purchasing)
(b) Providing finance – since stock is money, there is the cost of financing it, which may
be taken as the weighted average cost of capital. There is also an opportunity cost of
capital to consider, as funds tied up in stocks cannot be used for other, more profitable
investments and so potential income will be forgone.
(c) Stock handling – included under this heading will be the costs of the stores
installation, which may include racks, bins, paperwork systems, insurance and
maintenance cost, security and so forth.
(d) Holding losses – these costs include evaporation, deterioration, obsolescence, theft,
damage in stores and in transit. There may well be, of course, holding gains,
particularly during times of inflation, but any gain will usually be offset by the usually
higher costs of funds in such periods.
(e) Procurement costs – the costs of obtaining stock. These include:
(i) Clerical and administrative costs of procurement, e.g. salaries, purchasing office,
telephones, letters, etc.
(ii) Transportation costs.
(iii) Related costs of tooling, production, scheduling, etc. associated with internal
order, where stocks are produced internally.
(f) Shortage or stock-out costs – the costs of being without stock for a period of time.
These include
(i) Loss of contribution through the lost sale caused by stock-out.
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Working Capital and Short-Term Asset Management 217
A items are those which are probably low volume usage but relatively high cost. In
terms of control they are usually treated on an individual basis. They may represent
20% in number and perhaps 80% of the value.
B items represent 30% of the items with, say, 15% of the value. In terms of control,
they will typically be monitored by the use of a reorder policy.
C items are the high volume, low priced items where close control is unimportant.
They can be controlled by bulk issue methods such as "two-bin" systems.
The Pareto rule can also be graphed by comparing the cumulative value of the items (which
could be in terms of cost, turnover, usage, etc.) against the cumulative number of items, as
shown in Figure 10.1.
Note that the proportions can change so that, for instance, the top 80% in value may be
represented by 30% of the items and so on.
Figure 10.1
Cumulative 100
value (%)
80
60
40
20
A B C
items items items
20 40 60 80 100
Cumulative no. of items (%)
We may conclude the subject of stock management by noting that this is another area where
the financial manager, in his or her broad overall management capacity, oversees what is, in
fact, a specialist activity. Stock control has grown into an autonomous subject with a
considerable background of mathematical modelling, both deterministic and probabilistic,
seeking to optimise suitable stockholding and holding cost minimisation, against the
background of production difficulties and product prices.
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Combined
Cost
Costs
(£)
Holding Costs
Ordering Costs
From this you can see that the larger the reorder quantity, the larger will be the stockholding
cost. However, as the number of orders during the year decreases, ordering costs will be
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reduced. Alternatively, the smaller the reorder quantity, the smaller the stockholding costs,
but the number of orders will increase, hence ordering costs will increase.
It can be proved that combined costs are minimised, i.e. the reorder quantity is most
economic, when:
2Cd
Q
h
Example
Annual demand for material is 300 units, the ordering cost is £2 per order, the units cost £20
each and it is estimated that the carrying costs will be 15% per annum. Determine the EOQ
and the numbers of orders to be placed per year.
Substituting into the EOQ formula:
C £2 per order
d 300 units
h £20 15% £3 per unit
2Cd 2 2 300
EOQ 20 units.
h 3
d 300
Therefore, 15.
Q 20
Therefore, place 15 orders per year for 20 units.
The EOQ model given above is for replenishment stock in one batch. Where replenishment
takes place gradually, e.g. where items are manufactured internally and placed into stock
when they are completed, the formula must be adjusted slightly as:
2Cd
EOQ
d
h(1 )
R
where: R is replenishment rate per annum
Firms using the EOQ method may decide, because of uncertainties as to demand or lead
time, to hold a "safety level" of stock to reduce the likelihood of a stock-out caused by
excessive demand or an extra long lead time. The cost of this safety stock would be its
quantity multiplied by the unit stockholding cost. The EOQ is still the quantity ordered.
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E. MANAGEMENT OF DEBTORS
Perhaps the management of debtors carries more importance than the management of
stocks. Such an hypothesis will be based on the fact that at least stocks, even when poorly
managed, remain on the premises and under the control of the company. Debtors represent
the capital of the company placed in the hands of others in the form of goods over which the
company has effectively lost all control.
The issue is, in common with all aspects of working capital, one of balance. With debtors,
the factors to be balanced are:
(a) Giving credit or discounts – which acts as an aid to sales and potential profitability –
and the period over which credit is, or has to be, extended.
(b) The cost of giving credit – effectively the company is lending out its precious working
capital resources at 0% interest, thus needing extra capital.
(c) The cost of being unable to use that capital for more profitable projects.
(d) The cost of eventual bad debts should they arise (administrative costs, collection costs,
etc.).
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(b) Setting a limit to the level of credit granted to individual customers and laying out terms
of trading clearly in writing.
(c) Implementing formal collection procedures for delinquent accounts.
(d) Negotiating cash discounts for the most valued accounts.
(e) Taking out credit insurance.
Credit Control
Credit control can be defined as:
"minimising the risks involved in handing over goods upon the strength of a
promise to pay in future".
The importance of the credit control department varies with the nature of the business in
which it functions. Some companies sell entirely for cash – this is generally the case with a
supermarket chain, for example. Companies who deal with small retail traders often have a
major problem in that granting and controlling credit will involve them in a large number of
accounts. This will be a time-consuming process in view of the numbers involved.
Other firms, making large industrial machines, may have few accounts and may even receive
progress (stage) payments from customers as certain stages of the project are completed.
Bearing in mind these variations, the financial manager should consider the volume of
business that will be sold on credit terms, the number of customers requiring credit and the
records to be maintained when organising the credit control department. Important
relationships will develop between credit control, and other departments, notably sales and
marketing who may resent "their" hard won customers being subjected to status checks. We
will now consider some of the most important aspects which affect credit control.
(a) The credit controller
This function may be combined with the sales ledger account department. This is a
convenient arrangement because credit limits and the actual amount permitted from
one period to another can be seen quite easily from the sales ledger records.
(b) Processing customers' orders
When a new customer is involved, it is essential to check his or her creditworthiness
and the following are useful methods:
Direct methods
(i) Information obtained by the sales person from reports and interviews.
(ii) The credit controller's own judgment, either from local knowledge, or from
studying published accounts (or both).
The accounts will help to identify the length of time taken to pay other
suppliers. A "rule of thumb" check which can be performed is:
Annual purchases of materials
Average purchases per day
365
then,
Trade creditors
Number of days purchases in creditors.
Average purchases per day
(iii) Valuation of the company's fixed assets.
(iv) Establishing a progressive and carefully managed system of credit, based
on the track record of the customer's ability and willingness to pay.
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Indirect methods
Methods available include:
(i) A report from the customer's bank.
(ii) References from people who have had dealings with the potential
customer.
(iii) The use of trade protection associations.
(iv) Consulting official records.
(v) Journals, newspapers and other publications.
(vi) Trade associations.
Generally, it is useful to have a number of opinions before granting credit, and whilst
direct methods can be efficient they are potentially time consuming. Experience will,
however, be needed to interpret the guarded wording in many third party reports. It is
often what they don't say, rather than what they do, that will lead the experienced
credit controller to a safe conclusion.
The merits and otherwise of indirect methods include:
Bank reports
These are often slow and must be made between two banks. The wording will
always be guarded and remember that the bank may not be aware of all of their
customer's other commitments.
Bank reports possibly have greatest value in foreign trade, where they should be
the best placed of all sources to assess the potential risks of the proposed
transaction.
Trade referees
Some buyers "nurse" specific accounts so that they can use them as referees
and may even give friends' names without disclosing the relationship. The best
use of trade references is as a gauge of potential volume.
Trade protection associations
Information is generally supplied only to members for their own use. Infolink is
one of the major players in this market, and it can provide a status report on any
form of business organisation, including sole traders and partnerships.
Commercial credit houses
These organisations are commercial firms who specialise in the collection of
credit information. Examples are Stubbs and Kemps, Seyde & Company and
Dun and Bradstreet. As with the trade protection associations, a status report
can be obtained for a reasonable fee. Some only report on incorporated entities,
however.
In addition to the reporting service, credit ratings are set for most businesses
above a certain size and published periodically in books available to members.
The rating systems use symbols, often letters, to indicate the likely credit limit that
could be set for specific companies.
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customer. As well as external reports, some of the factors that may be taken into account in
assessing a new credit limit may include:
The managerial efficiency and integrity of the business concerned.
Affording facilities as good as those available from competitors (providing the business
is not being offered because competitors have not been paid!).
The capital employed in the customer's business.
The nature of the business and the sector in which it operates.
Consideration may also be given to relaxing the credit period allowed to customers if this is
thought to be a profitable course of action. This may be of particular benefit when interest
rates are low (and therefore the cost of financing is similarly low) in order to rebuild trade
which has fallen off as a result of recession. However, care should be taken to ascertain the
degree of risk in such a course of action. To assess the viability of extending credit periods
given to customers, the company would undertake a calculation along the following lines:
Example
A company plans to extend its credit period from one to two months, with the intention of
increasing its sales by £½m on top of its current level of £1¼m. The current profit is around
5% and the increased sales would require increased working capital of £50,000 (excluding
the debtors). The required rate of return is 15%.
The company assumes that all customers take advantage of the new terms, and it calculates
that the increased level of debtors would be:
2 1
1,750,000 1,250,000 £187,500
12 12
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advantage of the discount. If the company requires a return of 15% on its investments,
would the offer of the discount be worthwhile?
It is possible to answer this question very simply by calculating the implied annual cost of the
discount and then comparing it to the rate that the firm could receive if it possessed the
money. Therefore, in the example, the cost would be:
Rate of discount (rd) 365
(100 rd) (Original credit period Period offeredfor discount)
2 365
16.5%.
98 (60 15 )
From this you can see that it would not be worthwhile, as the firm could only earn 15% on the
funds collected.
It is also possible to show the impact of a new policy in a different way:
2
Current level of debtors: 1.2m £200,000.
12
Level of debtors following new policy on discount:
15 1
30% of £1m 70% of £1m 12,329 58,333 £70,662.
365 12
Therefore the value of debtors is projected to fall by £(200,000 70,662) £129,338.
The value of the reduction in perpetuity is £129,338 15% £19,400.
The cost of the discount to the company is 2% £300,000 £6,000, which would appear to
make the offer of a discount worthwhile, but this does not take account of the effect of the fall
in profits as a result of the tighter credit control policy.
Thus, if the company would expect to obtain a profit margin of 7.5% on sales, then, in
addition to the £6,000 cost, it would lose (7.5% £200,000) £15,000 in profits, making a
total cost of £21,000. As the value is only £19,400 to the company, the discount is not
worthwhile.
Irrespective of discounts, reminders should be sent out periodically unless payment on
invoice is expected. One method of spreading the workload caused by sending out invoices
and statements is known as cycle billing, and this involves sending out bills weekly or daily.
This overcomes problems facing the credit control department when everything is processed,
for example, in the last few days of the month.
When payments are really overdue, it is essential to take action without delay. This may take
one or more of the following forms:
Sending further reminders
Asking a sales person to call to collect
Late reminders threatening legal action
A call from the credit controller or a debt collector
A solicitor's letter and, finally, legal action.
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Significant ratios will often be included, such as the ratio of debtors to creditors, the ratio of
credit sales to debtors, and the ratio of total sales to credit sales. A statement of outstanding
debtors illustrating the age of those debts will also be included, but may vary considerably
between different industries.
A typical statement of outstanding debtors is illustrated below.
Statement of Outstanding Debtors as at ............
Credit Insurance
The Export Credits Guarantee Department (ECGD) is the UK's official Export Credit Agency.
Its aim is to help UK exporters of capital equipment and project-related goods and services
win business and complete overseas contracts with confidence. The ECGD provides:
Insurance to UK exporters against non-payment by their overseas buyers
Guarantees for bank loans to facilitate the provision of finance to buyers of goods and
services from UK companies
Political risk insurance to UK investors in overseas markets.
The ECGD work closely with exporters, project sponsors, banks and buyers to put together
the right package for each contract. With almost 90 years experience in new and developing
markets across the world, their knowledge can help companies in unfamiliar environments.
Policies which may be taken out will either be:
(a) Whole turnover policies, which cover total sales for the year; or
(b) Specific account policies, which cover a specific account.
Selection of a policy will largely be determined by the nature of the business conducted by
the company and, if the company has a number of substantial accounts, a whole turnover
policy will almost certainly be preferred.
Each proposal will be taken on its merits and insurance cover is given on a sound proposition
where there is a satisfactory prospect that payment will be made.
The risks covered will include:
The insolvency of the buyer.
The prevention of, or delay in, the transfer of payment to the merchant in
circumstances outside the control of both the merchant and the buyer.
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War preventing the export of the goods or performance of contracts, or the delivery of
goods to the buyer's country (contracts and shipments).
War, revolution or civil disturbance in the buyer's country specifically.
The failure or refusal of a government buyer to fulfil the terms of the contract.
Trading Abroad
A knowledge of the procedures followed when intending to export goods is essential, and the
main factors are summarised below:
(a) Sell direct or through a merchant
It will be necessary to decide whether to sell direct or through a specialised export
merchant. Exporting is often a complicated process to which the manufacturer can
devote insufficient time. As a result, the company may be well advised to seek help
from a recommended export merchant who understands, and has established
contacts in, the chosen market.
(b) Winning customers
Help can be obtained from the DTI and through Business Link when an exporter is
deciding on where his best market is located. Banks, trade associations and overseas
agents can also fulfil a useful role, but care should be taken in choosing the latter since
he or she may already deal in competing products.
(c) Assessing the credit standing of buyers
An initial appraisal of the credit standing should be made and then a review carried out
at regular intervals.
(d) Complying with regulations
There are government restrictions in most countries, and in Britain an export licence
may be required for certain transactions. Other countries may have regulations
affecting factors such as:
Exchange controls.
Trade restrictions on imports.
Customs duties.
In Europe there are many Directives which lay down minimum requirements.
(e) Securing payment
Once the goods have been sold, the exporter may have to wait a considerable period
before he is paid by the overseas buyer. To be able to operate overseas it is quite
usual to obtain the backing of a bank or an accepting house.
The UK Trade & Investment division of the Department for Business, Innovation and Skills
co-ordinates all government interest in, and support services for, large overseas projects. It
collaborates closely with all appropriate government departments at home and with the
diplomatic service posts abroad. Where appropriate, the Division can bring the full weight of
government support to bear, including ministerial and diplomatic initiatives.
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F. CREDITOR MANAGEMENT
A firm needs to determine what policy to adopt in the management of its creditors. In doing
this it must consider the following factors:
The need to ensure continuing supplies as and when required, by maintaining good
relations with regular suppliers.
The level of credit required, and the ability to extend it when the firm has a cash flow
shortfall.
The advantages of having a high level of trade credit as a method of reducing the level
of working capital required.
The possibility of extending credit, but this provides the firm with a poor credit rating
and problems in obtaining additional credit.
Whether to accept or reject early payment discounts (this decision is made in the same
way as offering discounts to a firm's customers – the benefits of accepting the discount
(additional cost) must outweigh the costs (interest foregone) of paying the debt early).
This latter point illustrates the often forgotten cost of trade credit which is often assumed to
be free but there is a cost of any early payment discounts foregone. An additional intangible
cost may be the loss of supplier goodwill. In addition, recent legislation now allows suppliers
to charge interest on overdue accounts. This will further add to costs if payments to
suppliers are delayed.
The cost of early payment discounts foregone can be calculated as:
s 365
100 s t
where: s the size of the discount offered in percentage terms, and
t the reduction in payment period required in the payment period.
This gives the cost as a percentage which should then be compared to the interest rate that
the company would obtain for investing the cash for the same number of days as required to
obtain the reduction in payment period.
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on a certain future date, the price of the goods supplied, which is then accepted by the
purchaser (by signing and returning it to the seller). The purchaser is thus formally
acknowledging his debt to the seller. The seller can then use the bill of exchange as
security in order to obtain money from the seller's bank.
A bank may also agree to accept a bill from its customer in exchange for an agreement
that the customer will repay the bank. The cost for arranging this finance is the
discount (i.e. the full amount of the bill is not advanced). The more secure the bill (e.g.
from a bank as compared to a trader) the "finer" or lower the discount.
(b) Acceptance Credits
This is a facility offered by banks for large companies with a good reputation. The
company draws bills of exchange on the banks, generally for 60, 90 or 180 days,
denominated in whichever currency most matches the needs of the company. The bills
can be drawn on, as and when required, throughout the length of the agreement which
can be for up to five years, provided the credit limit is not exceeded. The bill is then
sold in the discount market and the proceeds passed to the company (less the bank's
commission). At maturity the company reimburses the bank the full value of the bill,
and the bank pays the holder of the bill.
A major advantage of accepting credits is that they can be sold at a lower discount than
trade bills. The cost of them is also fixed, allowing for easier budgeting and may be
lower in times of rising interest rates than that of an overdraft. The credit is also
guaranteed for the length of the agreement, unlike an overdraft.
Short-Term Investments
We have seen that firms may have a surplus of cash, either deliberately in order to meet
purchase costs in the near future or to take advantage of high interest rates, or because of
higher than expected profit levels or a lack of investment opportunities. These fluctuations in
cash can arise for a variety of reasons, a major one being seasonal fluctuations in trade.
Short-term surplus of funds should be invested in short-term marketable securities.
Treasurers will employ surplus funds to obtain the best possible returns with maximum
security, and in evaluating the alternatives a variety of factors must be taken into account
including:
Risk
Liquidity
Term
Cost
Return
Accessibility – deposits with banks, finance houses and local authorities are only
accessible when the term finishes – debt instruments and equities can, however, be
sold when cash is needed
Type and level of interest rate
Taxation
Complexity
Minimum/maximum criteria
Image/policy
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Have an assured cash flow. Generally, the factor will advance around 80% of the
value of the debt within two or three days of an approved debt being passed to
him or her.
Factoring is particularly useful to firms trading in markets that require a considerable
period of trade credit and to companies that are expanding rapidly, as it will leave other
lines of credit open for use elsewhere in the business.
Costs will vary with the perceived level of risk, the volume of business and the period
over which credit is granted. There will usually be a monthly facility fee payable by the
customer, whether or not funds are drawn from the facility.
(c) Block Discounting
This is also a facility available for companies trading in the home market. It emerged in
the 1960s and is used by companies who offer retail (white and brown) goods on
instalment credit (hire purchase or rental) and initially supported the massive growth in
television rental.
The facility is administered in a similar way to factoring, but the company will lodge its
instalment credit agreements with the block discounter, rather than its invoices. The
facility is usually undisclosed to the end-user customer and the company will collect
rentals and instalments due on behalf of the block discounter.
Because the block discounter has a right to the future cash flows arising under the
terms of approved agreements, he will generally agree to a higher gearing than a
clearing bank, and a financial gearing of 3:1 for a company selling goods extensively
on instalment credit may often be quite acceptable.
(d) Sales Aid Financing
As an alternative to offering their own trade credit, suppliers of capital equipment and
vehicles both to the home market and abroad may offer finance at the point of sale
through a third-party finance company. This is known as sales aid finance and is
especially prevalent in the UK retail motor trade where rates may be subsidised by the
manufacturer, the dealer or both, to attract business and private customers by easing
the burden of expenditure on a major capital item.
Whilst a simple loan document is the most common financial instrument used in the
personal sector, sophisticated financial packages are often negotiated for the business
user, these being based around either hire purchase or leasing, including operating
leasing in the guise of rental or contract hire.
The benefit to the supplier (and the manufacturer when they are not one and the same)
is that the finance company will generally settle at the time the goods are supplied and
there is no need to extend trade credit. Additionally, the payment is received in full,
generally without any recourse in respect of bad debts (other than those arising
through poor quality merchandise). Suppliers will often work in conjunction with the
finance company to present a "financial package" in such a way that less discount is
passed to the customer than would be the case with a cash sale. Commissions may
be generated from the sale of finance and related insurance products, which serve to
boost the profit generated by a credit-based sale.
Larger organisations are often able to persuade the finance company to operate on an
undisclosed basis. In these circumstances, all documentation will be designed in the
supplier's house style and will use the supplier's rather than the finance company's
logo.
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Required:
Daish is concerned about its management of working capital.
(a) Explain the changes in the cash operating cycle for this firm over the years
indicated.
(b) Do you think the firm is overtrading? Suggest possible future action based on
your analysis.
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2. Babb plc specialises in the manufacture of sportswear. Sales in the current year have
been £5.2 million. The terms of sale are 2% discount 14 days, net 28 days, although
those customers not taking the discount actually take longer than 28 days to pay on
average. The current level of debtors is £500,000, included in which are the one half of
Babb's customers who take advantage of the cash discount. 1% of credit sales
become bad debts. The net operating margin (excluding bad debts and discounts) for
Babb is 25% of sales.
The company is considering a change in its credit policy to 4% discount 14 days, net
28 days. It anticipates the following effects of this change:
Sales to increase by 10% pa
75% of customers to take advantage of the discount
The period of time before payment for customers not taking the discount to
increase by one week
Bad debts to fall to 0.5% of sales
Babb's cost of finance is 12%.
Required:
(a) Calculate the financial implications of this change in credit policy and give your
advice on the proposed change.
(b) Debtors and credit control are, of course, only one aspect of working capital
management. What policies may produce savings in other items of working
capital? Discuss some of the potential difficulties attached to the management of
working capital.
Now check your answers with those given at the end of the chapter.
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239
Chapter 11
Capital Investment Decision Making 1: Basic Appraisal
Techniques
Contents Page
Introduction 241
C. Payback 243
(Continued over)
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INTRODUCTION
At the beginning of this course we saw that one of three major decision areas undertaken in
an organisation is that of investment appraisal, and the financial manager has to employ
appraisal techniques in order to decide which projects to accept and which to reject. In this
and the following chapter, we will consider the financial models and techniques that are
commonly used in capital investment appraisal.
Capital investment decisions will largely shape the future of the business and its ability to
manage its future operations. They are, though, generally difficult and expensive to reverse
and must, therefore, be right first time. Appraisal of the implications of a decision is, then,
essential.
The criteria for the appraisal of projects may be based on legal requirements (e.g. to meet
health and safety legislation) or social and staff welfare needs (e.g. the provision of
canteens). However, in the majority of cases, it will be on economic grounds – the key being
that projects accepted meet preset financial criteria, generally a return greater than the cost
of the capital needed to finance it. In addition, they must also seek to maximise shareholder
wealth, by maximising long-term returns.
The methods of capital investment appraisal which we shall examine are as follows:
Return on Investment (ROI) or Accounting Rate of Return (ARR)
Payback
Net Present Value (NPV)
Internal Rate of Return (IRR)
Cost/Benefit Ratio
Adjusted Present Value (APV) (which we shall consider in the next chapter)
These methods do not all fulfil the criteria set above, but they are the most widely used in
practice. A useful exercise for you whilst working through the following sections is to assess
the validity of the different techniques, in view of the above criteria and of the primary
objective of corporate finance, that of shareholder wealth maximisation.
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242 Capital Investment Decision Making 1: Basic Appraisal Techniques
There is a risk that inflation will erode buying power during the period under
consideration. However, even if there is zero inflation, techniques which consider the
time value of money are still used in investment appraisal. (We shall consider methods
of dealing with inflation in the next chapter.)
Let us assume that you could deposit your £1 for 12 months at a 10% annual interest rate.
After one year interest of £1 10% 10p would be added to your £1 and your investment
would have grown to £1.10. We can therefore say that the future value of your £1 today, at
an interest rate of 10%, is £1.10.
Cash therefore has a time value and we express the values today (i.e. at the start of an
investment project) of future cash flows as the present value of the investment.
Year 1 2 3 4 5
Budgeted profits 600 600 500 500 300
less Depreciation (200) (200) (200) (200) (200)
400 400 300 300 100
Tax (say) 120 120 105 105 35
Net profit 280 280 195 195 65
We first need to establish the average profit arising from the investment and then compare
this with the investment:
280 + 280 + 195 + 195 + 65
Average profit £203.
5
We can then compare this with the original investment to give the rate of return:
Average profit 203 100
20.3%
Original investment 1,000 1
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Alternatively we can compare it with the average investment. This has traditionally been
calculated as the original investment divided by 2 – thus, here, it would be £1,000 2 £500.
Average profit 203 100
40.6%.
Average investment 500 1
This is not a very satisfactory way to make the calculation, because the figure of £500 has no
actual basis in reality. Furthermore, it produces a rate of return which does not represent the
facts of the case. The annual returns on the original investment in our example are as shown
below:
280
Year 1 28%
1,000
280
Year 2 28%
1,000
195
Year 3 19.5%
1,000
195
Year 4 19.5%
1,000
65
Year 5 6.5%, giving a total of 101.5%.
1,000
Dividing this result by 5 gives us (101.5% 5) 20.3%, i.e. half the figure of 40.6% which we
calculated by using the traditional formula for counting the investment involved.
Further problems arise because this method fails to recognise that a net profit of £65 in five
years' time is barely significant in today's terms, even when there is a low rate of inflation. In
other words, the method fails to recognise time value of money. This is a cornerstone of
discounted cash flow methods as we shall shortly see.
Another issue with this type of analysis is that profits are the results of receipts and outgoings
and they do not represent cash transactions and the cash flow arising is not taken into
account during the term of the investment.
Probably the greatest merit in this method of analysis is its simplicity, it being based in
conventional accounting terms and requiring only limited analytical skill to carry it out and to
interpret the conclusions that can be drawn from it.
C. PAYBACK
This method simply measures the time period taken until the profits generated from the
investment equal the initial cost of the investment. The aim is to calculate how much time will
elapse before the capital project "pays back" the original amount invested from the profits
generated by it. (Either cash receipts or accounting profits can be used – cash receipts
would be preferable for the reasons noted above.) The result is compared to a
predetermined company (or group, or division) target, an investment being accepted if the
result meets or is less than the target length of time. When comparing different projects the
one with the quicker payback period would be the one chosen.
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Project A Project B
Investment outflow Year 0 (600) (600)
Cash inflows Year 1 400 700
Year 2 200 400
Year 3 800 400
Total inflows 1,400 1,500
Payback for Project A is two years, assuming that the cash inflows occur at equal periods
and in equal amounts during each year. Payback in the case of Project B is just over ten
months.
Payback focuses on risk in considering the period during which the investment remains
outstanding. The sooner the investment is returned, the safer the project should be. You
should note, however, that the method takes no account of cash inflows after payback,
neither is there any attempt to consider reinvestment possibilities for incoming funds during
the period prior to payback.
Perhaps, therefore, we should view payback as more of a risk appraisal tool than a
performance measure.
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Example
A project has an initial cost of investment of £10,000 in a machine, and the following
expected cash inflows:
Year 1 £6,000
Year 2 £6,000
Year 3 £6,000
Year 4 £5,000
Year 5 £5,000
No scrap value is expected from the machine. The cost of capital is expected to be 10%
throughout the five years of the project. Should the project be accepted?
The way to make this decision is to turn these future cash flows into present values by either
the use of discount factor tables (see appendix), or the formula noted above. (Note that we
shall use both of these methods in this chapter.)
Present value of machine revenues:
In straight cash flow terms, the opportunity presented by the machine purchase is as follows:
£
Cash revenues resulting 28,000
less Cost of machine 10,000
Cash gain 18,000
This cash gain is received over a period of five years, which for the flows given is the same
as £11,436 now.
(Note that this method deals with liquidity, not profitability, and cash flows are used, not
accounting flows (e.g. capital outlay, not depreciation).
Calculating the discount factor to be used, without the use of discount tables, is a function of
both the company's cost of capital and the number of years over which the individual project
is expected to provide a return.
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If the cost of capital for the above example had been 6% rather than 10%, what would have
been the overall financial effect on the project proposals?
The figures would have been as follows:
The lower the discount factor used, then the less impact the inflation rate will have on the
final discounted figure – i.e. the higher the rate of inflation, then the more the value of money
will be affected in the future.
Note that the value of the machine is not £1,200, but is the present value of these cash flows
which, using discount factor tables, are calculated as:
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Example
An investment in Project R of £20,000 is expected to generate cash receipts of £6,000 at the
end of Year 1, £8,000 at the end of Year 2, and £10,000 at the end of Year 3. The business
is able to invest money at an annual rate of 10% (the opportunity cost).
From the cash flows below it is clear that Project R produces insufficient return on the
investment. Its net terminal value is £560, and that indicates that greater benefit will accrue
if the money is invested in a security (or with a deposit-taking institution) at the rate of 10%
pa which it is assumed is freely available.
* The compound factors reflect the fact that the receipts at the end of Year 1 are
available for investment for two years, and the receipts at the end of Year 2 for one
year, i.e. for Year 2 the formula is calculated as:
(1 i)n
where: i the interest rate per period; and
n the number of periods.
Therefore, (1 0.1)2 1.210.
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We discount the series of constant cash flows back to Year 1 using the (4 1) cumulative
discount factor, and then discount that amount back one year from Year 1 to the present
time.
As the project gives a positive net present value it should be accepted.
NPV Profile
For any project, a range of costs of capitals can be discounted and the results plotted against
the resulting NPVs. This is often called an NPV Profile Curve, and it is simply a
diagrammatic representation of the NPV possibilities. A profile curve is shown in Figure 11.1.
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NPV 150
(£000)
Project X
100
A
Project Y
50
B
0
5 10 15
Interest Rate (%)
–50
You will note that a study of the NPV profile reveals certain useful information, as follows:
(a) The net present value of a project at any selected cost of capital can be read directly
from the graph, e.g.
(i) Project X has an NPV of £90,000, if the cost of capital is 5% (point "A" on the
curve).
(ii) Project Y has an NPV of £20,000, if the cost of capital is 10% (point "B" on the
curve).
(b) Where two project curves are shown, any point of intersection marks the spot below
which one project is more profitable than the other, and above which the other project
is more profitable.
The project curves for X and Y intersect at 7%. Above this rate of interest Y is more
profitable, below it X is the more profitable project with a higher NPV.
(c) Where the curves cut the horizontal axis, the NPV of each project is nil (£0), the cost of
capital being equal to the project's yield; this is known as a project's internal rate of
return (see later). X has an internal rate of return of 9.5%, and Y has one of 14.25%.
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Perpetuities
When a project yields a sum for ever then its present value can be calculated as:
Cash flow
PV
i
because the cumulative present value of £1 in perpetuity (i.e. each year for ever) is £1/i.
NPV
IRR
0 Cost of Capital
A discount rate of 0% clearly has no effect. As the percentage rate increases, the NPV falls
until at a particular cost of capital, the NPV is equal to (or approximately equal to) zero, i.e.
NPV 0. This is the project's internal rate of return. The internal rate of return would then be
compared to the company's cost of capital; if it were higher it would be accepted, and if it
were lower it would be rejected, because it is not generating sufficient funds to satisfy the
needs of the suppliers of the company's finance. This method can also be used to compare
the cost of financing using alternative financial instruments.
Essentially each cash flow is appreciated to have an element of capital and interest within it.
Once the interest element is removed by discounting the instalments by the discount rate, the
payments, now comprising only the capital element, will equal the initial investment at the
IRR point.
The internal rate of return can be found by trial and error – in order to establish the precise
discount rate several attempts will usually be required using different discount rates until the
sum of the cash flows equals the initial investments. Further adjustments may well be
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needed where the cash flow payments required by the transactions are of an uneven nature.
A good starting place for such appraisals is two-thirds of the project's ROI.
An alternative approach is to plot an NPV profile using two or more discount rates and to
read the approximate internal rate of return from the graph. This is known as interpolation.
Example 1
An investment of £20,000 is expected to generate cash receipts of £6,000 at the end of Year
1, £8,000 at the end of Year 2, and £10,000 at the end of Year 3. The business can invest
money at an annual rate of 10% (its opportunity cost).
Our aim will be to find the discount rate which reduces all the cash flows to zero. In our
example the NPV is almost zero when we use an IRR (discount rate) of 9%, and from the
table below you will see that the return on Project R is just under 9%. As the required rate of
return is 10% (or more), the project would be rejected.
The table below shows the calculations at a discount rate of 9%. (The IRR will be
determined by trial and error.)
We should remember that a project with a higher IRR may not necessarily be better than a
project with a lower IRR. Let's just stop to think why.
The main reasons for this relate to the actual amount of money which is to be returned. A
30% return may sound excellent, but if the investment is only a few hundred pounds, it may
not be worth devoting the time necessary if a larger project with a lower IRR will generate
better cash returns.
It is also important to recognise that IRR assumes that surplus cash flows are to be invested
at the project's own "internal" rate. However, this may not be possible in many months' time
when market forces have changed, with the result that the returns actually available have
fallen.
It is also important that you are able (given a particular scenario) to calculate for yourself the
Internal Rate of Return.
Consider the following example:
Example 2
A business is considering a project that has an initial outlay of £11m (i.e. a capital outlay of
funds) and the discounted capital inflows of funds would be £12m. How would you calculate
the Internal Rate of Return (i.e. the discounted rate that would give a Net Present Value of
£0).
The first thing that you need to do is determine which two percentage figures the actual figure
would fall between and this can only be done by "trial and error". You also need to bear in
mind that capital money going out of the business (i.e. £11m) will be a negative figure and
capital money coming into the business (i.e. £12m), even if discounted, will be a positive
figure in this example.
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The overall return on the initial investment is 2, hardly a significant contribution on the face of
it. However, the cash flows actually satisfy an internal rate of return of 5%, 10% and 15% as
shown below!
This problem can arise when the cash flow is positive during one period and negative during
another. Every change of sign gives rise to an additional solution.
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then discounted at a predetermined rate (the rate required from the project), in order
subsequently to calculate the internal rate of the remaining cash flows.
This is a particularly important technique when conducting the evaluation of a project which
has surplus cash generated during only a part of its term.
G. COST/BENEFIT RATIO
This ratio, sometimes referred to as the Profitability Index (PI), is calculated by the formula:
PV of future inflow
(discounted at the cost of capital)
Present investment outflow
A project offering a PI of greater than 1.0 should be accepted. In the case of competing
projects, the highest over 1.0 will generally be preferred.
Thus, where capital rationing is important, the PI can be used to help to "rank" projects in
order of relative profitability.
H. COMPARISON OF METHODS
As with other areas of financial modelling, each method of investment appraisal has its
drawbacks, and most firms use three or four of the different methods.
Non-Discounted Methods
The ARR ignores both the timing of cash flows and the opportunity cost of capital, but it is
used in practice in approximately half of all companies.
The payback method ignores the time value of money, and total cash flows over a project's
life once the payback period has been reached. It is often used in practice, however, as a
screening device, being considered to provide a fair approximation to NPV if cash flows
follow a pattern. It is useful when firms have liquidity problems or are perhaps producing
novelty products which require a quick repayment of investment.
Discounted Methods
We noted above that it is generally preferable to use a method of investment appraisal that
discounts cash flows, the two main methods being IRR and NPV. Both these techniques are
acceptable in capital investment appraisal if an organisation can accept all projects which are
beneficial to the organisation.
However, when there is capital rationing, NPV is the better method, as IRR can mis-rank the
projects. This superiority can be proven using the incremental approach.
Example
Zak plc has only the space to implement either Project X or Project Y; both projects last one
year and have the following details:
NPV and IRR give different rankings. To find which is the better we need to use the
incremental cash flow approach.
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Firstly, let us accept Project X which is the preferred project using the IRR technique. If this
is the correct choice, then the incremental cash flows of Y X will not produce an IRR which
is acceptable (i.e. it will be lower than the cost of capital).
Consider the differences to cash flows if we move from Project Y to Project X:
IRR of 50% is acceptable – therefore using IRR as an appraisal tool we should accept X and
(Y X), but X (Y X) Y. Thus, Y should be chosen (as per NPV) and we have used IRR
to prove that NPV is the superior method.
NPV is also preferable because it is very useful for evaluating interrelated projects, and it
emphasises the size of return given. IRR also has the problem that it can give multiple IRRs.
The advantage of IRR over NPV is that IRR is better at highlighting the rate of return against
the cost of capital.
Despite the advantages of NPV over IRR, IRR is more popular in practice.
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Capital Allowances
If you buy plant and machinery (capital assets) such as cars, vans, tools, computers and
office equipment for use in your business, you can claim their cost as capital allowances to
be deducted from your profits. You can also claim capital allowances on some industrial or
agricultural buildings, or hotels, and on items like patents and scientific "know how". (Note
that only part of the allowance can be claimed if an asset is used partly for private, as
opposed to business, purposes.)
The basic principle is that you can claim 25% of the cost of an allowable item in the first year
(the "written down allowance" or WDA) and 25% of the remaining cost in each subsequent
year. However, in the accounting period of purchase, you may be able to claim a higher "first
year allowance" (FCA).
First year allowances
Small businesses can claim 50% of the cost of most plant and machinery purchased in
2006/07 and 2007/08 except cars (up from 40% for 2005/06 purchases). Businesses of any
size can claim 100% on some environmentally friendly equipment and this includes new cars
with CO2 emissions of 120g per kilometre or less bought before 31st March 2008. From 11th
April 2007, a business can claim a 100% Business Premises Renovation Allowance for
renovating vacant business premises in disadvantaged areas.
Changes to capital allowances
From April 2008, first year allowances for plant and machinery will be replaced by a £50,000
annual investment allowance and the writing down allowance will fall from 25% to 20%.
Allowances on industrial and agricultural buildings will be phased out, but tax credits for
research and development costs will be increased. Capital allowances for business cars are
also currently under review.
Working out allowances
The cost of each new item, after deducting the first year allowance, is added to a "pool" of
expenditure. Some items have to be kept in separate pools, but everything else goes into
one main pool.
Example
In May 2006, Phillips paid £1,500 for energy saving equipment on which he gets a 100% first
year allowance and £6,500 on office equipment to which a 50% allowance applies. He sold
his old equipment for £2,450. His pool value at the start of the period is £4,250.
Calculate his pool value after the above transactions and also the allowances due to be
reduced from his taxable profits.
Allowances Pool
£ £
Pool at start of period 4,250
Sales (2,450)
1,800
WDA £1,800 x 25% 450 (450)
1,350
Energy saving: £1,500 100% FYA 1,500 0
Other purchases: £6,500 50% FYA 3,250 3,250
To carry forward 5,200 4,600
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To apply capital allowances in practice we should assume, for example, that once an item of
plant and equipment has been purchased, then the corresponding tax allowance at the
current tax rate will effectively reduce the outlay for the item, because there will be less tax to
pay. The payment of tax and, hence, the cash benefit will usually be in the year following the
year in which the asset was acquired.
Now check your answer with the one given at the end of the chapter.
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Interest Rate
Period
1% 2% 3% 4% 5% 6% 7%
(Continued over)
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Interest Rate
Period
8% 9% 10% 12% 15% 18% 20%
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Interest Rate
Period
1% 2% 3% 4% 5% 6% 7%
(Continued over)
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Interest Rate
Period
8% 9% 10% 12% 15% 18% 20%
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Discount Rate
Period
1% 2% 3% 4% 5% 6% 7%
(Continued over)
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Discount Rate
Period
8% 9% 10% 12% 15% 18% 20%
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Discount Rate
Period
1% 2% 3% 4% 5% 6% 7%
(Continued over)
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Discount Rate
Period
8% 9% 10% 12% 15% 18% 20%
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Annuity Tables
Interest Rate
Year
1% 2% 3% 4% 5% 6% 7%
(Continued over)
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Interest Rate
Year
8% 9% 10% 12% 15% 18% 20%
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Chapter 12
Capital Investment Decision Making 2: Further
Considerations
Contents Page
Introduction 272
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INTRODUCTION
In this chapter we shall continue our look at investment appraisal by considering other factors
that impact on the decision, including inflation and uncertainty. We shall also consider a
further technique of investment appraisal – that of adjusted present value (APV) which builds
upon the work we have already covered on NPV and Modigliani and Miller.
You should note, though, that capital investment appraisal is not, however, a mechanistic
process where data is processed and an irrevocable "correct" answer emerges. The
methods are only as good as the data input to them. Despite the refinement of using risk,
inflation and other allowances, capital investment appraisal still requires the decision-maker –
the human being – to assimilate the available data and take a risk, using human senses
backed with management information.
Certainty Equivalents
Under this method the expected cash flows arising from a project are subjectively adjusted
by management to their equivalent riskless amounts. Different risk factors can be used for
each cash flow item and for each year – the greater the risk the smaller will be the certainty
equivalent value for cash inflows and the larger the certainty equivalent value for each
outflow. The risk factors are generally expressed as percentages, e.g. 80% of income, 20%
of costs.
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Simulation Models
An alternative to calculating an expected value when given probability estimates is to use a
simulation model to establish a probability distribution of the project's expected NPV.
Simulation models, such as the Monte Carlo Simulation, are operated on computers using
random numbers. The model of the cash flows is constructed and a range of random
numbers is assigned to each possible value for those variables which are uncertain. The
computer generates a series of random numbers and uses them to assign values to the
variables. The results can then be used (probably by the computer) to calculate the NPV for
each set of random numbers generated. The average, and range, of possible NPVs can be
determined and used in the decision as to whether to accept the project or not. From this we
can move to the distribution of the NPV or IRR and, in the decision-making situation we can
match the means and standard deviations of competing projects, matching expected
revenues (mean) against the risk of achieving the same (standard deviation).
Monte Carlo simulation is often used in general business for risk and decision analysis, to
help make decisions given uncertainties in market trends, fluctuations, and other uncertain
factors. In the science and engineering communities, MC simulation is often used for
uncertainty analysis, optimisation, and reliability-based design, and in manufacturing, MC
methods are used to help allocate tolerances in order to reduce cost. There are certainly
other fields that employ MC methods, and there are also times when MC is not practical
(particularly for extremely large problems where computer speed is still an issue). However,
MC continues to gain popularity and is often used as a benchmark for evaluating other
statistical methods.
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Sensitivity Analysis
This is a technique for determining the outcome of a decision if a key prediction turns out to
be wrong.
Basically, an investment project usually represents, as we have seen, an outflow of cash,
followed at later time intervals by an associated series of inflows. Allowing for risk aims to
quantify the likely effects of the results of the project not conforming to the pattern anticipated
when the project was assessed. Sensitivity analysis is an attempt to add to the number of
dimensions in an appraisal picture by indicating what the picture will look like if certain
dominant items in it are flexed away from their original quantification.
You will also appreciate that each of the pieces of data that collectively form an "investment"
will have a relative order of importance as to the resulting effect (of its being the one to go
wrong) on the overall project. Clearly, some aspects will be vitally important to the project;
others will be only marginally important. Some can go wildly astray; others deviate only a
fraction before the viability of the project is placed in jeopardy.
For example, a particular investment in, say, a drilling machine will not be greatly influenced if
it is found that more water-based coolant is required than was allowed for; but if the
expensive driving belts prove to require unexpectedly frequent renewal that would, obviously,
be more significant.
Here is risk in a new light, then – recognising that the component aspects of an investment
project can all have a probability of occurring as anticipated – and, further, that the various
aspects can have a separate and differing significance to the project.
Sensitivity analysis seeks to provide the decision-maker with more than just a "go/no go"
statement, and aims to bring in all the "maybes" and "ifs", i.e. each aspect of the investment
can be flexed slightly, and then a re-evaluation made, to see if the project is still acceptable
or not.
The decision-maker can be presented with an appraisal which says: "This project is OK as it
stands on paper; costs can be allowed to increase by x% or sales decline by y% before it
becomes an unacceptable project".
The sensitivity of a project to alterations in the original appraisal input data is analysed so
that the horizon of the decision-maker is widened, in order that they can see the proposed
project in its overall situation if things start to vary from those anticipated.
Other Approaches
A simple approach would be to have a "worst", "likely" and "best" estimate of each
projected cash flow. In this way a project could be appraised in each of the available
lights.
Linear programming (LP) could be used in a situation where a certain number of
constraints and variables exist. Some variables are known to be "slack" and LPs can
be produced with differing values input to these slacks.
It is a technique of operations research for solving certain kinds of problems involving
many variables where a best value or set of best values is to be found. It is most likely
to be feasible when the quantity to be optimised, sometimes called the objective
function, can be stated as a mathematical expression in terms of the various activities
within the system, and when this expression is simply proportional to the measure of
the activities – i.e. is linear – and when all the restrictions are also linear. It is different
from computer programming, although problems using linear programming techniques
may be programmed on a computer.
Option theory can be used in investment appraisal. When a project is undertaken it
often provides additional options – to abandon a project, to make follow-on investments
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and to wait before undertaking an investment – and such options may need to be
considered when undertaking investment appraisal. Such calculations are best
undertaken using a computer model.
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Taxation
Payments of tax, or reductions in taxation payments, are cash flows and should ideally be
considered in the DCF analysis.
A company will pay Corporation Tax on their profits usually in the year following that in
which the taxable profits are made. Capital Allowances (the tax equivalent of depreciation of
fixed assets) are available as an allowance that reduces taxable profit and the consequent
saving of a tax payment should be seen as a cost saving in the period in which they arise.
The area of capital allowances is complicated and changes constantly but let us make a
basic assumption, for example purposes, that a writing down allowance (WDA) is given at a
rate of 25% on the cost of plant and machinery on a reducing balance basis.
If an item of machinery cost a business, say, £60,000, then a capital allowance of £15,000
(based on a WDA of 25%) is available on which to reduce taxable profits. If the new piece of
machinery produced an estimated cost saving each year of £20,000 and the Corporation Tax
rate was, say, 30% and the after-tax cost of capital for the business was 6%, then the tax
implications for the DCF calculations would look as follows:
Year Equipment Savings Tax on Tax saved on Net cash Discount Present
savings capital flow factor Value of
allowances cash flows
£ £ £ £ £ £ £
0 (60,000) (60,000) 1.000 (60,000)
1 20,000 4,500* 24,500 0.943 23,104
2 20,000 (6,000) 3,375** 17,375 0.890 15,464
C. CAPITAL RATIONING
An organisation is said to be in a capital rationing situation when it has insufficient funds to
accept all projects with a positive NPV. A decision therefore must be made as to which
projects to choose. The technique used depends on whether capital rationing only exists for
the current period (single period capital rationing) or whether it will be limited for several
periods, and whether the projects being considered are divisible (can be undertaken in whole
or in parts) or non-divisible (can only be undertaken as a whole or not at all).
In a situation where there is single period capital rationing and divisible projects,
management should choose the projects which give the highest NPV per £1 of capital
invested (i.e. maximising the return from the limiting factor).
Example
The management of Rosie Ltd have found that for the following year the company has only
£100,000 available for investment. The company's cost of capital is 20%. They are currently
considering four independent and divisible projects, as set out in the following table.
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This combination of projects gives the maximum return to the company and should be
accepted by the management.
If the projects are not divisible then this method may not give the optimal decision because
there is likely to be unused capital. This unused capital could be invested and will earn
interest. The best method of solving such a problem is trial and error by comparing the NPV
available from the different possible combinations of projects, remembering to calculate any
interest that would be received on the unused capital.
For multi-period capital rationing the timing of cash flows from each project is important, but
again management are attempting to maximise NPV per unit of scarce resource – capital.
When there are divisible projects, linear programming can be used, and when there are non-
divisible projects integer programming would be used.
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funds would come from borrowing rather than from the general pool of retained earnings,
thus the decision could be seen as one of lease or borrow.
The methods used to consider hire purchase of an asset are the same as for considering
leasing an asset, but when looking at the non-financial aspects of the decision you should
remember that when the HP term is over the asset belongs to the firm.
The methods discussed below are based on finance leases – operating leases are simply a
form of renting and for them the only relevant cash flows are the lease payments and the tax
saved from offsetting these payments against tax. The traditional method of considering the
financial implications of whether or not to lease an asset is done in two stages; first a
decision is made as to whether or not to purchase the asset based on the operating cash
flows arriving from it using the NPV techniques (with the discount factor being the WACC or
other rate generally used by the organisation) that we have already discussed. If it is
decided to purchase the asset (i.e. the NPV is positive) then a decision is made as to how to
finance the asset (i.e. whether to lease it or fund it some other way). This latter decision is
made by discounting the differential cash flows which would arise from leasing at the
company's (after tax – if tax-payers) cost of borrowing.
When considering a lease or buy decision you must be careful to consider all the taxation
implications. The Finance Act 1991 states that depreciation is allowable as an expense
against taxation in the form of capital allowances, as is the interest element of the finance
charge. (Detailed knowledge of capital allowances and their subsequent tax implications are
outside of our present scope, but simple examples are shown both in the calculation above of
the implications of inflation and taxation on investment decisions, and the example which
follows.) If the purchase decision involves borrowing to buy, remember that debt interest is
allowable against tax; lease payments may also be allowable. Again, if you encounter this
type of problem in the examination, it is important to read the information provided very
carefully, and to state any assumptions you make; a generally accepted simplifying
assumption is that lease payments are all fully allowable against tax – something you may
assume unless told otherwise. The accounting rules and regulations for operating and
finance leases are changing with the introduction of the new International Accounting
Standards (IAS), but the basic differences between an operating lease and a finance lease
are as indicated.
You must also be careful to include all cash flows – including the sale of the asset (if bought),
any extension fees of the lease, any maintenance costs and so on. Whilst it is possible to
calculate the comparison in one table you are less likely to make mistakes if you calculate
the NPV of the two options separately, and then compare them.
Other factors that may need to be taken into account are:
The company's liquidity and cash flow position – it may not be in the position to
purchase an expensive asset outright.
The choice of lease or buy will have an effect on reported profits, and may affect the
market's view of the firm.
If the asset was to be purchased outright there would be an opportunity cost of what
other uses the funds could be put to.
Expenses of maintenance, insurance and so on may differ between leasing and
purchasing.
The costs of leasing may be far lower than a company's cost of capital, and as such there is
a danger in using the traditional approach that a project may be rejected before its financing
decision is considered when it would be worthwhile at the lower cost of capital.
In order to overcome this problem, some financial managers take the decision the other way
round – deciding which is the cheaper method of financing and then evaluating the project at
the cheaper cost.
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Capital Investment Decision Making 2: Further Considerations 279
A second and more preferable method of overcoming this problem is to evaluate the project
as though it is purchased, and then as though it is leased. The correct decision is the one
which provides the highest NPV. If neither NPV is positive the project should be rejected.
Example
A company is to make the decision whether to lease or buy a new Toyota Corolla car for use
in the business. The cost of the car is £14,000 and it has an estimated useful life of five
years. Due to the very high mileage the car is likely to do in this period, there is no estimated
residual value. Assume tax is payable at 31% on operating cash flows one year in arrears.
Capital allowances of 25% on a reducing balance basis are given on the car.
The company has the option to lease the car under a finance agreement for five years at an
annual cost of £3,200, payable at the year end. If the company were to purchase the car it
would need to borrow the full amount at 12% interest. Which is the most cost-effective
option?
We first need to calculate capital allowances if the car is purchased:
£
Year 1: 25% £14,000 3,500
Year 2: 25% £10,500 2,625
Year 3: 25% £7,875 1,969
Year 4: 25% £5,906 1,477
9,571
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280 Capital Investment Decision Making 2: Further Considerations
Purchase
The leasing option is therefore the cheaper one and should be adopted.
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Capital Investment Decision Making 2: Further Considerations 281
Using the industry average beta, rather than an individual company's beta, is a good
technique as this removes many of the problems with betas discussed earlier in the
course.
Unless told otherwise assume the debt is risk-free.
g ug [1 Vd(1 t)/Veg]
2.5 ug [1 3 (1 0.33)/4]
2.5 ug [1.5025]
ug 2.5/1.5025
ug 1.66
Using CAPM 10% (15% 10%) 1.66 18% base case discount rate.
(b) Estimate the base case NPV – this is done by discounting the project's cash flows at
the ungeared cost of equity.
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282 Capital Investment Decision Making 2: Further Considerations
Year 0 1 2 3 4
Outlay (75,000)
Cash flows 37,500 37,500 37,500
Tax (12,375) (12,375) (12,375)
WDA 6,188 4,641 13,992
After tax cash flows (75,000) 37,500 31,313 29,766 1,617
Discount factor (18%) 1 0.8475 0.7182 0.6086 0.5158
PV cash flow (75,000) 31,781 22,489 18,116 834
(d) Add the discounted side effects to the base case NPV to give the APV.
Adjusted present value:
£
Base-case present value (1,780)
Present value of tax shield 5,095
Arrangement fee (1,000)
PV of tax relief on arrangement fee 263
Adjusted present value 2,578
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Capital Investment Decision Making 2: Further Considerations 283
G. WORKED EXAMPLES
The following examples are typical of the types of problem you may expect to face in the
examination.
Example 1
A company has estimated the expected cash flows for four possible projects as follows:
Project Year
0 1 2 3 4 5
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284 Capital Investment Decision Making 2: Further Considerations
Required:
(a) Rank these projects in order of acceptability using:
(i) Payback;
(ii) Net present value at 20% cost of capital;
(iii) Internal rate of return.
(b) Explain which project should be accepted if the projects were mutually exclusive and
there was no capital rationing.
(c) Explain which project(s) should be accepted if the projects were independent and
indivisible, and the company had £1 million to invest.
(d) Explain which project(s) should be accepted if the projects were independent and
divisible, and the company had up to £1.1 million to invest.
(e) Explain briefly the relative advantages and disadvantages of the appraisal methods
used in (a) above.
The following discount factors are provided for use as necessary:
Answer
(a) (i) Payback method
Project 1
The £500,000 initial outlay is returned as follows:
(200,000 200,000 1
3 [300,000]) 2.3 years
Project 2
The £400,000 initial outlay is returned as follows:
(100,000 100,000 100,000 100,000) 4 years
Project 3
The £150,000 initial outlay is returned
(40,000 50,000 60,000) 3 years
Project 4
The £1,000,000 initial outlay is returned as follows:
(500,000 400,000 1
3 [300,000]) 2.3 years
So the ranking is:
1st equal – Project 1 and Project 4
3rd – Project 3
4th – Project 2
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Capital Investment Decision Making 2: Further Considerations 285
Project 1
Year Cash Flow Factor NPV
£000 £000
0 (500) 1.0000 (500.00)
1 200 0.8333 166.66
2 200 0.6944 138.88
3 300 0.5787 173.61
4 200 0.4823 96.46
5 200 0.4019 80.38
155.99
Project 2
Year Cash Flow Factor NPV
£000 £000
0 (400) 1.0000 (400.00)
1 100 0.8333 83.33
2 100 0.6944 69.44
3 100 0.5787 57.87
4 100 0.4823 48.23
5 500 0.4019 200.95
59.82
Project 3
Year Cash Flow Factor NPV
£000 £000
0 (150) 1.0000 (150.00)
1 40 0.8333 33.33
2 50 0.6944 34.72
3 60 0.5787 34.72
4 70 0.4823 33.76
5 100 0.4019 40.19
26.72
Project 4
Year Cash Flow Factor NPV
£000 £000
0 (1,000) 1.0000 (1,000.00)
1 500 0.8333 416.7
2 400 0.6944 277.8
3 300 0.5787 173.6
4 200 0.4823 96.5
5 100 0.4019 40.2
4.8
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286 Capital Investment Decision Making 2: Further Considerations
Project 1
Year Cash Flow Factor NPV
£000 £000
0 (500) 1.0000 (500.00)
1 200 0.7692 153.80
2 200 0.5917 118.30
3 300 0.4552 136.60
4 200 0.3501 70.00
5 200 0.2693 53.90
32.60
Project 2
Year Cash Flow Factor NPV
£000 £000
0 (400) 1.0000 (400.00)
1 100 0.7692 76.90
2 100 0.5917 59.20
3 100 0.4552 45.50
4 100 0.3501 35.00
5 500 0.2693 134.70
(48.70)
Project 4
Year Cash Flow Factor NPV
£000 £000
0 (1,000) 1.0000 (1,000.00)
1 500 0.7692 384.60
2 400 0.5917 236.70
3 300 0.4552 136.60
4 200 0.3501 70.00
5 100 0.2693 26.90
(145.20)
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Capital Investment Decision Making 2: Further Considerations 287
To determine the internal rate of return for each project we can apply the formula:
a
X (Y X)
a + b
where: X the lower rate of interest used
Y the higher rate of interest used
a the difference between the present values of the outflow and the
inflows at X%
b the difference between the present values of the outflow and the
inflows at Y%.
If one NPV is positive (i.e. a) and the other negative (i.e. b) the formula is:
a
X (Y X)
a b
So to take each project in turn:
Project 1:
155.99
IRR 20 (30 20) 28.3%
188.59
Project 2:
59.82
IRR 20 (30 20) 25.5%
108.52
Project 3:
26.72
IRR 20 (30 20) 27.1%
37.62
Project 4:
4.8
IRR 20 (30 20) 20.3%
150.0
This then ranks the projects in the order:
1st – Project 1
2nd – Project 3
3rd – Project 2
4th – Project 4
(b) With mutually exclusive projects and no capital rationing, the company should select
the one with the highest NPV, this being Project 1.
(c) In the situation of independent, indivisible projects where the company had £1 million to
invest, the best approach would be to maximise the NPV obtainable. In this case,
Projects 1 and 2 should be accepted.
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288 Capital Investment Decision Making 2: Further Considerations
(d) Looking at the situation of divisible, independent projects we would need to consider
the highest profitability index, being:
Project 1 2 3 4
P/V Inflow s 655.99 459.82 176.72 1004.8
Initial investment 500 400 150 1000
1.31 1.15 1.18 1.00
We would allocate our money to the most profitable first which would provide the
following portfolio:
Project 1 – investment of £500,000
Project 3 – investment of £150,000
Project 2 – investment of £400,000
£1,050,000
(e) Payback is useful in that it has the advantage of showing when the initial investment
has been repaid. However, it also has the disadvantages of:
(i) Ignoring income after the payback period; and
(ii) Ignoring interest.
Net present value provides the advantage of considering both cash flows and interest
over the project life but the disadvantage of ignoring risk.
Internal rate of return provides the advantage of an appraisal as a single percentage
figure and thereby indicates a project yielding the highest return on investment.
However, by the use of such a rate the cash flow effects can be hidden and the risk
aspects ignored.
Example 2
Hurdlevack Ltd relies on the payback method of project evaluation, requiring that investments
repay capital within three years. The board are currently considering the four following
projects.
Project A B C D
£ £ £ £
Sales 40,000 75,000 60,000 60,000
Direct costs 16,000 27,000 15,000 18,000
Depreciation 8,000 40,000 30,000 35,000
Interest 12,000 16,000 9,000 7,000
Initial investment 120,000 160,000 90,000 70,000
The engineering department has asked the board to evaluate these opportunities by means
of a discounted cash flow technique. The finance department has been unwilling to use a
discounted cash flow technique, because of difficulty in establishing an appropriate discount
rate. It therefore proposes to calculate each project's internal rate of return, and let the board
determine appropriate hurdle rates.
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Capital Investment Decision Making 2: Further Considerations 289
Required:
(a) Calculate each project's payback and state which of the opportunities is acceptable by
this criterion.
(b) Calculate each project's internal rate of return and using a hurdle rate (the minimum
rate of return acceptable to the company) of 15%, state which of the opportunities is
acceptable by this criterion.
(c) Suggest why the above two project appraisal methods do not give answers which are
consistent with each other for the accept/reject decision.
(d) Briefly outline some of the elements which should be considered when determining the
appropriate hurdle rate for an individual project.
Answer
(a) Direct costs, interest charges and flows from sales are used in the calculation of
payback periods, as follows.
Project A B C D
£ £ £ £
Sales 40,000 75,000 60,000 60,000
Direct costs (16,000) (27,000) (15,000) (18,000)
Interest (12,000) (16,000) (9,000) (7,000)
Net annual cash flow 12,000 32,000 36,000 35,000
As the payback is the time in which the cash flows repay the initial capital outlay, it can
be derived as follows.
Project A B C D
£ £ £ £
Capital outlay 120,000 160,000 90,000 70,000
Net annual cash flow 12,000 32,000 36,000 35,000
Payback period 10 years 5 years 2½ years 2 years
(b) When looking at the internal rate of return (IRR) of the projects, we look at cash flows
from sales and direct costs.
Project A B C D
£ £ £ £
Sales 40,000 75,000 60,000 60,000
Direct costs (16,000) (27,000) (15,000) (18,000)
Net annual cash flow 24,000 48,000 45,000 42,000
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290 Capital Investment Decision Making 2: Further Considerations
Project A B C D
£ £ £ £
Capital outlay 120,000 160,000 90,000 70,000
Net annual cash flow 24,000 48,000 45,000 42,000
Payback 5 years 3.33 years 2 years 1.67 years
From the annuity
tables, the IRR is
(approximately): 18% 8% 23% 13%
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Capital Investment Decision Making 2: Further Considerations 291
Machine A B
Initial cost £50,000 £90,000
Life – years 4 7
Salvage value at end of:
Year 4 – machine A £5,000
Year 7 – machine B £7,000
Annual running costs £10,000 £8,000
Both machines fulfil the same function and have equal capacities. The approximate
discount rate is 10%.
Required:
Determine which machine should be purchased. Specify any assumptions made.
To what amount would the initial cost of machine A be required to alter in order for the
two machines to be of equal financial attractiveness?
2. ABC Ltd, which is investigating the possible acquisition of XYZ Ltd, for diversification
purposes, has asked you to advise the firm on the basis of the following information:
XYZ Ltd
Summary Statement of Financial Position as at 30th September 2002
£000 £000
Ordinary shares 1,500 Land & buildings 900
Reserves 900 Plant (net of depreciation) 600
10% debentures 750 Investments 450
Creditors 300 Stock 600
Debtors 600
Cash 300
£3,450 £3,450
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292 Capital Investment Decision Making 2: Further Considerations
All of the investments and plant valued at £225,000 would not be needed by ABC
Ltd.
The investments have produced annual income of £45,000 per annum for the last
five years, and are expected to continue to do so.
ABC Ltd would repay the debentures at par, immediately after acquisition.
ABC Ltd requires a return on capital of 10%.
Required
You are required to calculate the maximum price which ABC Ltd should be prepared to
pay for XYZ Ltd on each of the following bases:
(a) Break-up value.
(b) Profitability.
(c) Discounted cash flow, assuming that the cash flows to be discounted are as
follows:
£000
2003 450
2004 600
2005 450
2006 onwards 570
Present value factors at 10%
Year 1 0.90909
Year 2 0.82645
Year 3 0.75131
Year 4 0.68301
(Note that it is normal in both practice and examinations to use discount figures to
only three decimal places – i.e. the above figures would normally be stated as:
Year 1 0.909
Year 2 0.826
Year 3 0.751
Year 4 0.683)
3. Stamford Ltd specialises in the production of plastic sports equipment. The company
has recently developed a new machine for automatically producing plastic cricket bats.
The machine cost £150,000 to develop and install, and production is to commence at
the beginning of next week. It is planned to depreciate the £150,000 cost evenly over
four years, after which time production of plastic cricket bats will cease. Production and
sales will amount to 30,000 bats each year. Annual revenues and operating costs, at
current prices, are estimated as follows.
Sales (£9.60 each) £288,000
Variable manufacturing costs £200,000
This morning, a salesman has called and described to the directors of Stamford Ltd a
new machine, ideally suited to the production of plastic cricket bats. This item of
equipment is distinctly superior to Stamford's own machine, reducing variable costs by
30% and producing an identical product. The cost of the machine, which is also
capable of producing 30,000 cricket bats per annum, is £190,000.
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Capital Investment Decision Making 2: Further Considerations 293
10 0.68 3.17
11 0.66 3.10
12 0.64 3.04
13 0.61 2.97
14 0.59 2.91
15 0.57 2.85
16 0.55 2.80
17 0.53 2.74
18 0.52 2.69
19 0.50 2.64
20 0.48 2.59
21 0.47 2.54
22 0.45 2.49
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294 Capital Investment Decision Making 2: Further Considerations
4. An opportunity has arisen for your company to acquire the specialised product stocks
of a bankrupt business for £50,000. The net proceeds from the sale of these stocks
will be influenced by a number of factors originating from outside the company but the
range of possibilities appears to be as follows.
The estimates for Year 2 are independent of those for Year 1. The company's required
rate of return is 20%.
Required:
(a) To calculate the expected net sales proceeds each year; and to state whether on
this basis the project would yield the required rate of return.
(b) To tabulate the possible combinations of sales value over the two years, with their
related probabilities, and from this data to calculate the overall percentage
probability of the rate of return being less than the required 20%.
(c) Without making any further calculations, to explain how you would arrive at the
standard deviation of net present value and the coefficient of variation for this
project, and the use that might be made of those statistics.
Now check your answers with those given at the end of the chapter.
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Capital Investment Decision Making 2: Further Considerations 295
A B
£ £
Initial cost 50,000 90,000
Running costs:
£10,000 3.170 (4 years at 10%) 31,700
£8,000 4.868 (7 years at 10%) 38,944
less Salvage value:
£5,000 0.683 (3,415)
£7,000 0.513 (3,591)
Present value of cost (a) 78,285 125,353
Annuity factor (b) 3.170 4.868
Equivalent annual cost (a b) £24,696 £25,750
This shows that machine A should be chosen, as it is the less expensive. At the end of
four years, then eight years, etc., new machines A would be purchased as
replacements.
To be equally financially attractive, it would be necessary for the initial cost of machine
A to rise until the equivalent annual cost of A was also £25,750. This would mean a
present value total of:
£
£25,750 3.170 81,628
less Present value now 78,285
£3,343 increase
So, it would be necessary for the initial cost of machine A to rise to £53,343 for the
machines to be equally attractive.
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296 Capital Investment Decision Making 2: Further Considerations
2. Maximum prices ABC Ltd would be prepared to pay for XYZ Ltd on the following bases.
(a) Break-up Value
This can be computed in two ways, bearing in mind that, even if the investment
and plant worth £225,000 are not needed by ABC Ltd, they do represent part of
the value of XYZ Ltd and any as yet unrealised profits in them constitute part of
the value. As the company is being acquired as a whole, any sale of assets
surplus to requirements and made subsequently would merely alter the values of
industrial assets, and it would not affect the overall break-up value.
The value is calculated as follows:
Either Or
Value at 30/11/2002 £000 £000
Land and buildings 900 900
Plant 600 375
Investments 675 –
Stock 750 750
Debtors 600 600
Cash 300 300
Sum due on sale of investments/assets or
cash proceeds realised – 900
3,825 3,825
less: Debentures 750 750
Creditors 300 300
Value of business to ordinary shareholder £2,775 £2,775
So, therefore, the break-up value is £2,775,000, which purely puts a value to the
assets as they stand and, to some extent, includes growth in the value of the
assets over the historical cost. Potential future profitability is not reflected in this
figure. To allow for this, a value of goodwill would need to be calculated in terms
of "n" years' purchase of average weekly profits less an allowance for the
projected interest on capital. The number represented by "n" would be that
typical to the particular industry or trade.
(b) Profitability
To obtain a maximum price on this basis, different assessments can be made.
Initially, it should be seen whether "profits" in the terms of the question relates to
profits after payment of debenture interest and including the interest received
from investments. An assumption is made that this is so.
Past profits are usually adjusted, in exercises such as this, in the light of
changing circumstances which will prevail when the purchasing company takes
over – with no investments and repaid debentures.
Two alternative methods can be used, with both unweighted and weighted profits.
The number of years' average profits to be taken into the market value needs to
be assessed.
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Capital Investment Decision Making 2: Further Considerations 297
£1,190,000
Average annual unweighted profit is £396,666
3
Method 2 (weighted)
£2,480,000
Average annual weighted profit is £413,333
6
So, on a P/E basis of 10, the price would be:
Method 1 – £3,966,666
Method 2 – £4,133,333 (maximum)
The higher values seen here reflect the vendor's ability to make a profit.
(c) Discounted Cash Flow
The cash flows represent the projected flows but excluding investment and
debenture interest. They compare, therefore, with the adjusted profits
assessments of value.
DCF looks at the value of the company as a discounted stream of future cash
flows available to the purchaser.
This gives the net present value, as follows:
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298 Capital Investment Decision Making 2: Further Considerations
Dividend
Valued at: 0.75131
Capitalisa tion rate
570,000
0.75131 4,282,500
0.1
1,243,100 4,282,500 £5,525,600
This treatment for £570,000 for 2006 onwards presents a value in perpetuity.
Therefore, to sum up:
Maximum value: £000
(a) Break-up value £2,775
(b) Profitability £4,133
(c) DCF £5,525
mi
3. (a) Real cost of capital
1+ i
0.21 0.10 0.11
= = 10%
1 + 0.10 1.1
Option 1, using the present machine, gives in real terms:
£
Sales 288,000
Variable costs of manufacture 200,000
Contribution 88,000
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Capital Investment Decision Making 2: Further Considerations 299
As regards the development and installation costs of £150,000 relating to the new
machine, this represents money spent. The sum does not come into the
calculations otherwise.
Another way of looking at this is to make the calculations in money terms with an
allowance for the 10% inflation.
Option 1
Option 2
(b) The present machine makes a contribution of £88,000 pa for four years –
£278,960 in all. The new and more efficient machine will increase the
contribution level to £148,000 pa. However, there is the high initial cost of
£190,000 less £12,000 sales receipts to be considered. This brings the PV of the
more efficient machine down to £291,160. The marginal superiority in results of
£12,200 needs to be carefully weighed against the risks of the project.
Will the market for plastic cricket bats continue to be buoyant?
Might the variable production costs increase?
Either possibility could easily eliminate any advantage, so it is probably better not
to invest in the new machinery.
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300 Capital Investment Decision Making 2: Further Considerations
The payback method is useful here, in the sense that, if we look at the return on
the outlay of £178,000, the contribution pa increases by £60,000. This means
that almost a full three years out of the project life of four years must elapse
before the company is satisfied in payback terms. We must remember also that
we have not considered interest, etc.
The project yields a return in excess of 20% and should, therefore, be accepted.
(b) The table of possible combinations of sales values and their related probabilities
are set out on the next page.
From this, the probability of the return being less than 20% is:
P(iii) P(vi) P(ix)
0.12 0.06 0.02
20%
© ABE
© ABE
Possible Discount NPV NPV NPV Probability Expected
Combinations Factor Cash Cash (Y1p x Y2p) Value
(r = 20%) Inflows Outflows (p x NPV)
£ £ £ £ £ P £
(i) Y1 24,000 0.83333 20,000
61,666 (50,000) 11,666 0.30 3,500
Y2 60,000 0.69444 41,666
(ii) Y1 24,000 0.83333 20,000
53,333 (50,000) 3,333 0.18 600
Y2 48,000 0.69444 33,333
(iii) Y1 24,000 0.83333 20,000
33,888 (50,000) (16,112) 0.12 (1,933)
Y2 20,000 0.69444 13,888
(iv) Y1 20,000 0.83333 16,667
58,333 (50,000) 8,333 0.15 1,250
Y2 60,000 0.69444 41,666
(v) Y1 20,000 0.83333 16,667
50,000 (50,000) 0 0.09 0
Y2 48,000 0.69444 33,333
(vi) Y1 20,000 0.83333 16,667
30,555 (50,000) (19,445) 0.06 (1,167)
Y2 20,000 0.69444 13,888
(vii) Y1 36,000 0.83333 30,000
71,666 (50,000) 21,666 0.05 1,083
Y2 60,000 0.69444 41,666
(viii) Y1 36,000 0.83333 30,000
63,333 (50,000) 13,333 0.03 400
Y2 48,000 0.69444 33,333
(ix) Y1 36,000 0.83333 30,000
43,888 (50,000) (6,112) 0.02 (122)
Y2 20,000 0.69444 13,888
1.00 3,611
Capital Investment Decision Making 2: Further Considerations
301
302 Capital Investment Decision Making 2: Further Considerations
p(x x)2
© ABE