Essentials of Corporate Financial Management 2nd

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Lecturers Guide
Corporate Financial
Management
Fourth edition
Glen Arnold
For further lecturer material
please visit:
www.pearsoned.co.uk/arnold
ISBN 978-0-273-71064-6
Pearson Education Limited 2008

Lecturers adopting the main text are permitted to download and copy this
guide as required.
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Pearson Education Limited

Edinburgh Gate
Harlow
Essex CM20 2JE
England
and Associated Companies around the world
Visit us on the World Wide Web at:
www.pearsoned.co.uk
First published under the Financial Times

Pitman Publishing imprint in 1998
Second edition published 2002
Third edition published 2005
Fourth edition published 2008
Financial Times Professional Limited 1998
Pearson Education Limited 2002, 2005, 2008
The right of Glen Arnold to be identified as author of this Work has been asserted by him in
accordance with the Copyright, Designs and Patents Act 1988.
ISBN-978-0-273-71064-6
All rights reserved. Permission is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the
Publishers, for educational purposes only. In all other cases, 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 either the prior written permission
of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the
Copyright Licensing Agency Ltd., Saffron House, 6-10 Kirby Street, London EC1N 8TS. This
book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of
binding or cover other than that in which it is published, without the prior consent of the
Publishers.
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CONTENTS
Preface
Location of answers to questions and problems
SUPPLEMENTARY MATERIAL FOR CHAPTERS
Chapter 1
The financial world
Chapter 2
Project appraisal: Net present value and internal rate of return
Chapter 3
Project appraisal: Cash flow and applications
Chapter 4
The decision-making process for investment appraisal
Chapter 5
Project appraisal: Capital rationing, taxation and inflation
Chapter 6
Risk and project appraisal
Chapter 7
Portfolio theory
Chapter 8
The capital asset pricing model and multi-factor models
Chapter 9
Stock markets
Chapter 10 Raising equity capital
Chapter 11 Long-term debt finance
Chapter 12 Short-term and medium-term finance
Chapter 13 Treasury and working capital management
Chapter 14 Stock market efficiency
Chapter 15 Value management
Chapter 16 Strategy and value
Chapter 17 Value-creation metrics
Chapter 18 Entire firm value measurement
Chapter 19 The cost of capital
Chapter 20 Valuing shares
Chapter 21 Capital structure
Chapter 22 Dividend policy
Chapter 23 Mergers
Chapter 24 Derivatives
Chapter 25 Managing exchange-rate risk
5
6
7
10
14
20
24
29
33
38
40
43
47
51
54
58
59
64
66
72
74
77
81
84
86
91
96
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Supporting resources
Visit www.pearsoned.co.uk/arnold to find valuable online resources
Companion Website for students
Learning objectives for each chapter
Multiple-choice questions with instant feedback to help test your learning
Weblinks to relevant, specific Internet resources to facilitate in-depth
independent research
A wide selection of FT articles, additional to those found in the book, to
provide real-world examples of financial decision making in practice
Interactive online flashcards that allow the reader to check definitions
against the key terms during revision
Searchable online glossary
For instructors
Complete, downloadable Instructors Manual including answers for all
question material in the book
A brand new set of over 800 PowerPoint slides that can be downloaded and
used as OHTs
Also: The regularly maintained Companion Website provides the following

features:
Search tool to help locate specific items of content
E-mail results and profile tools to send results of quizzes to instructors
Online help and support to assist with website usage and troubleshooting
For more information please contact your local Pearson Education sales
representative or visit www.pearsoned.co.uk/arnold
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PREFACE
This Guide is designed to assist lecturers and tutors using Corporate Financial Management
fourth edition.
Supplementary material for chapters
For each chapter:

The learning outcomes are outlined.
Key points and concepts are listed.
Solutions to selected numerical problems (those marked with an asterisk in the main book)
are provided. Note that there is often more than one possible correct solution to a problem.
Different answers, which nevertheless follow the logic of the argument presented in the text,
may be acceptable.
Overhead projector transparency masters
Also available on the website in PowerPoint for downloading are over 800 selected figures,
tables and key points reproduced in a form suitable for creating overhead projector transparency masters. These are arranged in the order in which they appear in Corporate Financial
Management. The learning objectives and summary points from the chapters are also included.
Glen Arnold
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LOCATION OF ANSWERS TO
QUESTIONS AND PROBLEMS
(No answers given to those in final column)
Chapter No Answered in
Appendix VII
Answered in
Lecturers Guide
Essay answer required

(see text)
All (see note
in Appendix VII)
1, 2, 4, 5, 6
3, 7
1, 2, 3, 6, 9, 11, 13, 15
4, 5, 7, 8, 10, 12, 14
1, 2, 4, 5
1, 2, 3, 5, 6, 9, 10
4, 7, 8
1, 4, 5, 6, 7, 8, 9, 10, 11
2, 3, 12
1, 2, 3, 7, 8, 9, 10, 11, 12,

13, 15
4, 5, 6, 14a, b, c
1, 3, 4, 5, 7, 8, 9, 10
6, 7, 8, 9
14d
2, 6, 11
111
10
12
17, 911, 1319
11
1, 2, 3, 4, 5, 6, 10, 11, 13, 16 7
8, 9, 12, 14, 15, 1720
12
1, 2, 4, 9, 10, 11
5, 12
3, 6, 7, 8, 13, 14, 15
13
1, 4, 5, 7, 9, 10
3a, 6, 8, 23, 25a
2, 3b, 11, 12, 1322, 24, 25b, 25c
14
15
8, 9
1, 317
7, 10
16
16
14
17
1, 5, 6, 7
18
1, 2
19
2, 3
20
3, 4, 5, 6, 7, 9
8, 10
1, 2
21
2, 3, 6a, 9
4, 5, 6b, 7, 8
22
4, 5, 8
23
1, 3, 4, 5
2, 7, 8, 9
24
1, 2, 3, 4, 5, 7, 10
6, 8, 9
11, 12, 13
25
1, 2, 7, 8a, 10, 11
4, 9
3, 4b, 5, 6, 8b
2, 3, 4, 4a
1, 2, 3, 4, 7
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SUPPLEMENTARY MATERIAL
FOR CHAPTERS
Chapter 1
THE FINANCIAL WORLD

LEARNING OUTCOMES
It is no good learning mathematical techniques and theory if you lack an overview of what finance is about.
At the end of this chapter the reader will have a balanced perspective on the purpose and value of the
finance function, at both the corporate and national level. More specifically, the reader should be able to:
describe alternative views on the purpose of the business and show the importance to any organisation
of clarity on this point;
describe the impact of the divorce of corporate ownership from day-to-day managerial control;
explain the role of the financial manager;
detail the value of financial intermediaries;
show an appreciation of the function of the major financial institutions and markets.
KEY POINTS AND CONCEPTS
Firms should clearly define the objective of the enterprise to provide a focus for decision making.
Sound financial management is necessary for the achievement of all stakeholder goals.
Some stakeholders will have their returns satisfied given just enough to make their contribution. One (or
more) group(s) will have their returns maximised given any surplus after all others have been satisfied.
The assumed objective of the firm for finance is to maximise shareholder wealth. Reasons:
practical, a single objective leads to clearer decisions;
the contractual theory;
survival in a competitive world;
it is better for society;
counters the tendency of managers to pursue goals for their own benefit;
they own the firm.
Maximising shareholder wealth is maximising purchasing power or maximising the flow of discounted cash flow to shareholders over a long time horizon.
Profit maximisation is not the same as shareholder wealth maximisation. Some factors a profit comparison does not allow for are:
future prospects;
risk;
accounting problems;
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Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

communication;
additional capital.
Corporate governance. Large corporations usually have a separation of ownership and control. This
may lead to managerialism where the agent (the managers) take decisions primarily with their interests
in mind rather than those of the principals (the shareholders). This is a principal-agent problem. Some
solutions:
link managerial rewards to shareholder wealth improvement;
sackings;
selling shares and the takeover threat;
corporate governance regulation;
improve information flow.
The efficiency of production and the well-being of consumers can be improved with the introduction
of money to a barter economy.
Financial institutions and markets encourage growth and progress by mobilising savings and encouraging investment.
Financial managers contribute to firms success primarily through investment and finance decisions.
Their knowledge of financial markets, investment appraisal methods, treasury and risk management
techniques are vital for company growth and stability.
Financial institutions encourage the flow of saving into investment by acting as brokers and asset transformers, thus alleviating the conflict of preferences between the primary investors (households) and the
ultimate borrowers (firms).
Asset transformation is the creation of an intermediate security with characteristics appealing to the
primary investor to attract funds, which are then made available to the ultimate borrower in a form
appropriate to them. Types of asset transformation:
risk transformation;
maturity transformation;
volume transformation.
Intermediaries are able to transform assets and encourage the flow of funds because of their economies
of scale vis--vis the individual investor:
efficiencies in gathering information;
risk spreading;
transaction costs.
The secondary markets in financial securities encourage investment by enabling investor liquidity (being
able to sell quickly and cheaply to another investor) while providing the firm with long-term funds.
The financial services sector has grown to be of great economic significance in the UK. Reasons:
high income elasticity;
international comparative advantage.
The financial sector has shown remarkable dynamism, innovation and adaptability over the last three
decades. Deregulation, new technology, globalisation and the rapid development of new financial products have characterised this sector.
Banking sector:
Retail banks high-volume and low-value business.
Wholesale banks low-volume and high-value business. Mostly fee based.
International banks mostly Eurocurrency transactions.
Building societies still primarily small deposits aggregated for mortgage lending.
Finance houses hire purchase, leasing, factoring.
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Long-term savings institutions:

Pension funds major investors in financial assets.
Insurance funds life assurance and endowment policies provide large investment funds.
The risk spreaders:

Unit trusts genuine trusts which are open-ended investment vehicles.
Investment trusts companies which invest in other companies financial securities, particularly shares.
Open-ended investment companies (OEICs) a hybrid between unit and investment trusts.
The risk takers:

Private equity funds invest in companies not quoted on a stock exchange.
Hedge funds wide variety of investment or speculative strategies outside regulators control.
The markets:
The money markets are short-term wholesale lending and/or borrowing markets.
The bond markets deal in long-term bond debt issued by corporations, governments, local authorities and so on, and usually have a secondary market.
The foreign exchange market one currency is exchanged for another.
The share market primary and secondary trading in companies shares takes place on the Official
List of the London Stock Exchange, techMARK and the Alternative Investment Market.
The derivatives market LIFFE (Euronext.liffe) dominates the exchange-traded derivatives market
in options and futures. However there is a flourishing over-the-counter market.
There are no numerical questions in this chapter; answers may be found from reading the text.
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Chapter 2
PROJECT APPRAISAL: NET PRESENT VALUE

AND INTERNAL RATE OF RETURN
LEARNING OUTCOMES
By the end of the chapter the student should be able to demonstrate an understanding of the fundamental
theoretical justifications for using discounted cash flow techniques in analysing major investment decisions, based on the concepts of the time value of money and the opportunity cost of capital. More specifically the student should be able to:
calculate net present value and internal rate of return;
show an appreciation of the relationship between net present value and internal rate of return;
describe and explain at least two potential problems that can arise with internal rate of return in specific circumstances;
demonstrate awareness of the propensity for management to favour a percentage measure of investment performance and be able to use the modified internal rate of return.
Time value of money has three component parts each requiring compensation for a delay in the receipt
of cash:
the pure time value, or impatience to consume,
inflation,
risk.
Opportunity cost of capital is the yield forgone on the best available investment alternative the risk
level of the alternative being the same as for the project under consideration.
Taking account of the time value of money and opportunity cost of capital in project appraisal leads to
discounted cash flow analysis (DCF).
Net present value (NPV) is the present value of the future cash flows after netting out the initial cash
flow. Present values are achieved by discounting at the opportunity cost of capital.
NPV = CF0 +
CF1
1+k
CF2
(1 +
k)2
+ ...
CFn
(1 + k)n
The net present value decision rules are:

NPV 0 accept
NPV 0 reject
Internal rate of return (IRR) is the discount rate which, when applied to the cash flows of a project,
results in a zero net present value. It is an r which results in the following formula being true:
CF0 +
CF1
1+r
CF2
(1 + r)2
+ ...
CFn
(1 + r)n
=0
The internal rate of return decision rule is:

IRR opportunity cost of capital accept
IRR opportunity cost of capital reject
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IRR is poor at handling situations of unconventional cash flows. Multiple solutions can be the result.
There are circumstances when IRR ranks one project higher than another, whereas NPV ranks the projects in the opposite order. This ranking problem becomes an important issue in situations of mutual
exclusivity.
The IRR decision rule is reversed for financing-type decisions.
NPV measures in absolute amounts of money. IRR is a percentage measure.
IRR assumes that intra-project cash flows can be invested at a rate of return equal to the IRR. This
biases the IRR calculation.
If a percentage measure is required, perhaps for communication within an organisation, then the
modified internal rate of return (MIRR) is to be preferred to the IRR.
ANSWERS TO SELECTED QUESTIONS

3 Confused plc
a Project C
IRRs at 12.1% and 286%. See Fig. 2.1.
NPV
12.1
286
Discount rate
Fig. 2.1
Project D
No solution using IRR. See Fig. 2.2.
+
NPV
Discount rate
Fig. 2.2
b This problem illustrates two disadvantages of the IRR method. In the case of project C multiple solutions are possible, given the non-conventional cash flow. In the case of project D there is no solution, no IRR where NPV = 0.
c NPV
Project C: +646
Project D: 200
Using NPV the accept/reject decision is straightforward. Project C is accepted and Project D is rejected.
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7 Seddet International
a Project A
At 20%:
5,266 + 2,500 2.1065 = 0, IRR = 20%
Project B
At 7%:
8,000 + 10,000 0.8163 = +163
At 8%:
8,000 + 10,000 0.7938 = 62
IRR = 7 +
163
163 + 62
(8 7) = 7.7%
Project C
At 22%:
2,100 + 200 0.8197 + 2,900 0.6719 = +12.45
At 23%:
2,100 + 200 0.8130 + 2,900 0.6610 = 20.5
IRR = 22 +
12.45
12.45 + 20.5
(23 22) = 22.4%
Project D
At 16%:
1,975 + 1,600 0.8621 + 800 0.7432 = 1
IRR is slightly under 16%.
The IRR exceeds the hurdle rate of 16% in the case of A and C. Therefore if all projects can be accepted these two should be undertaken.
b Ranking under IRR:
Project
Project
Project
Project
C
A
D
B
IRR
22.4%
20%
16%
7.7%
best project
c Project A
5,266 + 2,500 2.2459 = 349
Project B
8,000 + 10,000 0.6407 = 1,593
Project C
2,100 + 200 + 0.8621 + 2,900 0.7432 = 228
Project D
1,975 + 1,600 0.8621 + 800 0.7432 = 1
12
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Ranking
Project A
Project C
Project D
Project B
NPV
349 best project
228
1
1,593
Project A ranks higher than project C using NPV because it generates a larger surplus (value) over the
required rate of return. NPV measures in absolute amounts of money and because project A is twice
the size of project C it creates a greater NPV despite a lower IRR.
d This report should comment on the meaning of a positive or negative NPV expressed in everyday
language. It should mention the time value of money and opportunity cost of capital and explain
their meanings. Also the drawbacks of IRR should be discussed:
multiple solutions;
ranking problem link with the contrast of a percentage-based measure and an absolute moneybased measure;
additivity not possible;
the reinvestment assumption is flawed.
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Chapter 3
PROJECT APPRAISAL: CASH FLOW

AND APPLICATIONS
LEARNING OUTCOMES
By the end of this chapter the reader will be able to identify and apply relevant and incremental cash flows
in net present value calculations. The reader will also be able to recognise and deal with sunk costs, incidental costs and allocated overheads and be able to employ this knowledge to the following:
the replacement decision/the replacement cycle;
the calculation of annual equivalent annuities;
the make or buy decision;
optimal timing of investment;
fluctuating output situations.
Raw data have to be checked for accuracy, reliability, timeliness, expense of collection, etc.
Depreciation is not a cash flow and should be excluded.
Profit is a poor substitute for cash flow. For example, working capital adjustments may be needed to
modify the profit figures for NPV analysis.
Analyse on the basis of incremental cash flows. That is, the difference between the cash flows arising
if the project is implemented and the cash flows if the project is not implemented:
opportunity costs associated with, say, using an asset which has an alternative employment are relevant;
incidental effects, that is, cash flow effects throughout the organisation, should be considered along
with the obvious direct effects;
sunk costs costs which will not change regardless of the decision to proceed are clearly irrelevant;
allocated overhead is a non-incremental cost and is irrelevant;
interest should not be double counted by both including interest as a cash flow and including it as
an element in the discount rate.
The replacement decision is an example of the application of incremental cash flow analysis.
Annual equivalent annuities (AEA) can be employed to estimate the optimal replacement cycle for an
asset under certain restrictive assumptions. The lowest common multiple (LCM) method is sometimes
employed for short-lived assets.
Whether to repair the old machine or sell it and buy a new machine is a very common business
dilemma. Incremental cash flow analysis helps us to solve these types of problems. Other applications
include the timing of projects, the issue of fluctuating output and the make or buy decision.
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4 Mercia plc
a Proposal 1
Consultants fee sunk cost
Central overhead irrelevant
Depreciation irrelevant
Time (years)
000s
Earthmoving
Construction
Ticket sales
Operational costs
Council
Senior management
Opportunity cost
Cash flows
100
1,650
Discounted
Cash flows
1,650
150
1,400
200
+600
100
100
50
+600
100
50
+150
0
+450
150
(1.1)2
450/0.1
(1.1)2
NPV = + 2.193m
Proposal 2
Central overhead (70,000) irrelevant
Consultants fees (50,000) sunk cost
Time (years)
000s
100
5,000
4,000
400
100
5,000
4,000
400
100
Design & build

Revenue
Operating costs
Equipment
Executive
Opportunity cost
Sale of club
9,000
Cash flow
9,100
100
Discounted cash flow
9,100
100
1.1
100
+11,000
+500
+
500
(1.1)2
+11,500
+
11,500
(1.1)3
NPV = 137,566
Recommendation: accept proposal 1
IRR
Proposal 1: 20.2%
Proposal 2: 9.4%
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5 Mines International plc
a Survey sunk cost
Time (years)
m
Profit (loss)
Add depreciation
Capital equipment
Survey
0
0
4.75
2.1
0
4.75
0.30
3.9
2.0
4.7
2.0
4.7
2.0
2.9
2.0
1.5
0
0
0
2.0
2.0
2.0
2.25
0.25
2.25
2.25
0
2.25
1.75
+0.50
1.75
0
+1.75
0.125 0.125
0.125
0.10
0 0.025
0.10
0
0.10
Debtor adjustment:
Opening debtors
Closing debtors
Creditor adjustment
Opening creditors
Closing creditors
0
0.15
+0.15
Overheads
Hire cost
Cash reserves
Government refund
Cash flow
0.2
0.15
0.10
0.10 0.125
0.05 +0.025
0.2
0.2
0.1
0.2
1.0
5.125
0.2
+1.0
+0.2
5.75
5.75
6.20
4.05 6.575
6.9 8.075
1.85
6.20 + 4.05 + 6.575 +
6.9 + 8.075 + 1.85
1.12 (1.12)2 (1.12)3 (1.12)4 (1.12)5 (1.12)5.125
= 5.75 5.536 + 3.229 + 4.680 + 4.385 + 4.582 + 1.035 = 6.625m

The maximum which MI should bid in the auction is 6.625m. This additional cash outflow at time
zero would result in a return of 12% being obtained. (Some students may time the final debtor and
creditor payments at time 5.25 as time 6.)
b IRR = 29.4%.
c Points to be covered:
Time value of money.
Opportunity cost of money for a given risk class.
Sunk cost.
Treatment of depreciation.
Allocated overhead treatment.
Cash injections.
Hire cost opportunity cost.
Comparison of NPV with other project appraisal methods:

Advantages over IRR:
measures in absolute amounts of money;
ranking problem;
multiple solution problem.
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Advantages over payback:

time value of money allowed for;
all cash flows considered;
cash flows within pay back period considered properly.
Advantages over ARR:

firm theoretical base, time value of money;
defined decision criteria.
7 Reds plc
One-year cycle:
Time (years)
0
10,000
12,000
8,000
4,000
NPV = 10,000 4,000 0.9009 = 13,604

AEA =
13,604
0.9009
= 15,100
Two-year cycle:
Time (years)
0
10,000
12,000
13,000
6,500
6,500
NPV = 10,000 12,000 0.9009 6,500 0.8116 = 26,086

AEA =
26,086
1.7125
= 15,233
Three-year cycle:
Time (years)
0
10,000
12,000
13,000
14,000
3,500
10,500
NPV = 10,000 12,000 0.9009 13,000 0.8116 10,500 0.7312 = 39,039

AEA =
39,039
2.4437
= 15,975
Reds should replace the machinery on a one-year cycle.
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8 Immediate replacement:
Time (years)
0
+4,000
15,100
+4,000
15,100
0.11
133,273
Replacement after one year:

Time
2,000
2,000
3,000
15,100
0.9009
15,100/0.11
1.11
3,000
= 122,966
Replacement after two years:

Time
0
2,000
1,000
+1,500
15,100
2,000
1,000 0.9009 + 1,500 0.8116
15,100/0.11
(1.11)2
= 113,097
Recommendation: Commence replacement cycle after two years.
10 Curt plc
Incremental cash flows
Time (years)
Current cash flows

New plan
70,000
28,000
28,000
37,000
47,100
68,410
0.8621
0.7432
0.6407
0.5523
0.4761
0
70,000
100,000
80,000
48,000
110,000
82,000
121,000
84,000
133,100
86,000
146,410
88,000
10,000
70,000
28,000
28,000
37,000
47,100
68,410
=
=
=
=
=
=
70,000
24,139
20,810
23,706
26,013
32,570
8,960
The positive incremental NPV indicates that acceptance of the proposal to manufacture in-house
would add to shareholder wealth.
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Other factors: some possibilities
The relative bargaining strength of Curt and its supplier. Perhaps a search for another supplier would
be wise. Perhaps it would be possible to negotiate a multi-year price agreement.
Are there some other incidental effects Curt has not considered, e.g. factory space usage?
12 Netq plc
Output per year:
1,000 0.3333 2
1,000 0.3333 0.75 2
1,000 0.3333 0.5 2
= 667
500
333
1,500
Cost of annual output 1,500 4 = 6,000

PV = 6,000/0.13 = 46,154
Both machines replaced:
Annual costs 1,500 1.80 = 2,700
PV = 14,000 +
2,700
0.13
= 34,769
One machine is replaced:
Output:
first third of year
second third of year
last third of year
Old
New
333.3
166.7
0
500
333.3
333.3
333.3
1,000
Annual costs 500 4 + 1,000 1.8 = 3,800

PV = 7,000 +
3,800
= 36,231
0.13
The lowest cost option is to replace both machines.
14 Opti plc
Costs
One-year replacement:
PV = 20,000 6,000/1.1 = 14,545
AEA = 14,545/0.9091 = 16,000
Two-year replacement:
PV = 20,000 + 6,000/1.1 1,000/(1.1)2 = 24,629
AEA = 24,629/1.7355 = 14,191
Three-year replacement:
PV = 20,000 + 6,000/1.1 + 8,000/(1.1)2 + 4,000/(1.1)3 = 35,072
AEA = 35,072/2.4869 = 14,103
Four-year replacement:
PV = 20,000 + 6,000/1.1 + 8,000/(1.1)2 + 10,000/(1.1)3 + 10,000/(1.1)4 = 46,410
AEA = 46,410/3.1699 = 14,641
The optimal replacement cycle is 3 years.
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Chapter 4
THE DECISION-MAKING PROCESS

FOR INVESTMENT APPRAISAL
LEARNING OUTCOMES
The main outcome expected from this chapter is that the reader is aware of both traditional and discounted cash flow investment appraisal techniques and the extent of their use. The reader should also be
aware that these techniques are a small part of the overall capital-allocation planning process. The student is expected to gain knowledge of:
the empirical evidence on techniques used;
the calculation of payback, discounted payback and accounting rate of return (ARR);
the drawbacks and attractions of payback and ARR;
the balance to be struck between mathematical precision and imprecise reality;
the capital-allocation planning process.
Payback and ARR are widely used methods of project appraisal, but discounted cash flow methods are
the most popular.
Most large firms use more than one appraisal method.
Payback is the length of time for cumulated future cash inflows to equal an initial outflow. Projects are
accepted if this time is below an agreed cut-off point.
Payback has a few drawbacks:

no allowance for the time value of money;
cash flows after the cut-off are ignored;
arbitrary selection of cut-off date.
Discounted payback takes account of the time value of money.
Paybacks attractions:
it complements more sophisticated methods;
simple, and easy to use;
good for communication with non-specialists;
makes allowance for increased risk of more distant cash flows;
projects returning cash sooner are ranked higher. Thought to be useful when capital is in short supply;
often gives the same decision as the more sophisticated techniques.
Accounting rate of return is the ratio of accounting profit to investment, expressed as a percentage.
Accounting rate of return has a few drawbacks:

it can be calculated in a wide variety of ways;
profit is a poor substitute for cash flow;
no allowance for the time value of money;
arbitrary cut-off rate;
some perverse decisions can be made.
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Accounting rate of return attractions:

familiarity, ease of understanding and communication;
managers performances are often judged using ARR and therefore they wish to select projects on
the same basis.
Internal rate of return is used more than NPV:

psychological preference for a percentage;
can be calculated without cost of capital;
thought (wrongly) to give a better ranking.
Mathematical technique is only one element needed for successful project appraisal. Other factors to
be taken into account are:
strategy;
social context;
expense;
entrepreneurial spirit;
intangible benefits.
The investment process is more than appraisal. It has many stages:

generation of ideas;
development and classification;
screening;
appraisal;
report and authorisation;
implementation;
post-completion auditing.

3 Oakland plc
(1) a Payback
000s
Year
Cumulative inflows
1
2
3
4
5
50
170
520
600
1,400
Payback in year 5 and therefore not accepted under the boards decision criteria.
b Year
1
2
3
4
5
Cumulative
50 0.9091
120 0.8264
350 0.7513
80 0.6830
800 0.6209
45.455
99.168
262.96
54.64
496.72
45.455
144.623
407.583
462.223
958.943
Discounted payback: 5 years.
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c Accounting rate of return (one possibility):
000s
Year
Profit before depreciation 50

Depreciation
180
Profit/loss
130
120
180
60
350
180
170
80
180
100
800
180
620
Assets at start of each year:

Profit
Assets
900
720
540
360
180
130
900
60
720
170
540
100
360
620
180
14.4%
8.3% +31.5% 27.8% 344.4%
Average = 65%
d Internal rate of return: 11.8%
The project is acceptable under the IRR method as the IRR of 11.8% is greater than the required
rate of 10%.
e NPV: +58,943
NPV is positive; therefore this project is acceptable under the NPV method.
(2)
22
Merits
Demerits
Payback
1 Simple to use.
2 Easy to understand.
3 Easier for communications with
non-specialists.
4 May be used to filter out obviously poor
projects quickly.
5 In an uncertain world a quick return leaves
less exposure to unquantifiable risks.
6 If funds are limited, the sooner the money
is returned, the sooner other profitable
investments can be undertaken (for an
imperfect world scenario).
Payback
1 No allowance for the time value of money.
2 Receipts beyond the payback period are
ignored.
3 Arbitrary cut-off.
4 Initial outlay is not always unambiguously
identifiable.
Discounted payback
1 Time value of money within payback
allowed for.
2 Relatively simple to use and understand.
3, 4 and 5 are the same as 4, 5 and 6 for
payback.
Discounted payback
1 Receipts beyond the payback are ignored.
2 Arbitrary cut-off.
3 Initial outlay is not always unambiguously
identifiable.
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Merits
Demerits
Accounting rate of return

1 Easy to understand.
2 Easy to calculate accounting information
is usually available.
3 Management performance is often
evaluated by an ARR method, e.g. ROCE.
Thus, ARR may be preferred by the
management team for project appraisal.
Accounting rate of return

1 Not based on cash flow profit and asset
figures are often derived from subjective and
arbitrary decisions.
2 No allowance for time value of money.
3 Many variants of ARR no consistency.
4 Arbitrary cut-off point for accept/reject
decisions.
5 As a percentage measure it does not measure in
absolute terms.
Internal rate of return

1 Cash flow based.
2 Time value of money considered.
3 Consistency of method, rather than
many alternative methods, as with ARR.
4 Easier to communicate to the non-specialist
than NPV.
5 All cash flows considered.
Internal rate of return

1 Multiple/no solution.
2 Ranking problem.
3 Measures in percentage terms rather than
absolute amounts of money.
Net present value

1 Cash flow based.
2 Time value of money considered.
3 Consistency of method, rather than many
alternative methods, as with ARR.
4 Relates directly to shareholder wealth
enhancement.
5 Measures in absolute terms not percentages.
6 All cash flows considered.
Net present value

1 Less commonly understood than the other
methods.
2 More effort is needed to carry out the
calculations.
3 Relies on inputs being correct, e.g. an
appropriate discount rate is available.
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Chapter 5
PROJECT APPRAISAL: CAPITAL RATIONING,

TAXATION AND INFLATION
LEARNING OUTCOMES
By the end of this chapter the reader should be able to cope with investment appraisal in an environment
of capital rationing, taxation and inflation. More specifically, he/she should be able to:
explain why capital rationing exists and be able to use the profitability ratio in one-period rationing
situations;
show awareness of the influence of taxation on cash flows;
discount money cash flows with a money discount rate, and real cash flows with a real discount rate.
Soft capital rationing internal management-imposed limits on investment expenditure despite the
availability of positive NPV projects.
Hard capital rationing externally imposed limits on investment expenditure in the presence of positive NPV projects.
For divisible one-period capital rationing problems, focus on the returns per of outlay:
Profitability index =
Benefit-cost ratio =
Gross present value

Initial outlay
Net present value
Initial outlay
For indivisible one-period capital rationing problems, examine all the feasible alternative combinations.
Two rules for allowing for taxation in project appraisal:

include incremental tax effects of a project as a cash outflow;
get the timing right.
Taxable profits are not the same as accounting profits. For example, depreciation is not allowed for in
the taxable profit calculation, but writing-down allowances are permitted.
Specific inflation price changes of an individual good or service over a period of time.
General inflation the reduced purchasing power of money.
General inflation affects the rate of return required on projects:

real rate of return the return required in the absence of inflation;
money rate of return includes a return to compensate for inflation.
Fishers equation
(1 + money rate of return) = (1 + real rate of return) (1 + anticipated rate of inflation)
(1 + m) = (1 + h) (1 + i)
Inflation affects future cash flows:

money cash flows all future cash flows are expressed in the prices expected to rule when the cash
flow occurs;
real cash flows future cash flows are expressed in constant purchasing power.
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Adjusting for inflation in project appraisal:

Approach 1 Estimate the cash flows in money terms and use a money discount rate.
Approach 2 Estimate the cash flows in real terms and use a real discount rate.

4 Wishbone plc
a Project X
000s
Time 0
2,500
Time 1
Sales
Materials
Labour
Overheads
2,100
800
300
100
1.05
1.04
1.10
1.07
2,205
832
330
107
936
2,100
800
300
100
(1.05)2
(1.04)2
(1.1)2
(1.07)2
2,315
865
363
114
973
2,100
800
300
100
(1.05)3
(1.04)3
(1.1)3
(1.07)3
2,431
900
399
123
1,009
Time 2
Sales
Materials
Labour
Overheads
Time 3
Sales
Materials
Labour
Overheads
2,500 + 936 0.8547 + 973 0.7305 + 1,009 0.6244

NPV = 359K
Project Y
000s
Time 0
2,000
Time 1
Sales
Materials
Labour
Overheads
1,900
200
700
50
1.05
1.04
1.10
1.07
1,995
208
770
54
963
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Time 2
Sales
Materials
Labour
Overheads
1,900
200
700
50
(1.05)2
(1.04)2
(1.10)2
(1.07)2
2,095
216
847
57
975
1,900
200
700
50
(1.05)3
(1.04)3
(1.1)3
(1.07)3
2,199
225
932
61
981
Time 3
Sales
Materials
Labour
Overheads
NPV = 2,000 + 963 0.8547 + 975 0.7305 + 981 0.6244 = +148k

The superior project is Y as this generates more than the required return of 17%.
b h=
1 = 0.0833 or 8.33%
(1.17
1.08)
Project X
Year
000s
0
1
2
3
936 0.9259
973 0.8573
1,009 0.7938
Real cash flows

2,500
866
834
801
866/1.0833
834/(1.0833)2
801/(1.0833)3
Discounted real cash flows

2,500
800
711
630
NPV = 359
Project Y
Year
0
1
2
3
000s
963 0.9259
975 0.8573
981 0.7938
Real cash flows

2,000
892
836
779
892/1.0833
836/(1.0833)2
779/(1.0833)3
Discounted real cash flows

2,000
823
712
613
NPV = 148
7 Bedford Onions plc
26
Year
Annual WDA
Written-down value
0
1
2
3
4
0
12,500
9,375
7,031
5,273
50,000
37,500
28,125
21,094
15,821
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Tax payments
Profit
plus
depreciation
and overhead
less WDA
Incremental cash flow
Tax @ 30%
25,000
25,000
25,000
25,000
25,000
12,500
37,500
11,250
25,000
9,375
40,625
12,188
25,000
7,031
42,969
12,891
25,000
-11,094
38,906
11,672
100
50
12.891
37.109
10
15
100
50
11.672
63.328
000s
Time (year)
Machine
Working capital
Sales
Costs
Tax
50
15
65
100
50
11.25
38.75
100
50
12.188
37.812
NPV = 65 + 38.75 0.8772 + 37.812 0.7695 + 37.109 0.675 + 63.328 0.5921 = 60.633
8 Clipper plc
NPVs:
A Revenue
Fixed cost
Variable cost
20
5
8
7
10 + 7 2.4869 = +7,408
B Revenue
Fixed cost
Variable cost
30
10
12
8
30 + 8 3.7908 = +326
C Revenue
Fixed cost
Variable cost
18
6
7.2
4.8
15 + 4.8 3.1699 = +216
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D Revenue
Fixed cost
Variable cost
17
8
6.8
2.2
12 + 2.2 6.1446 = +1,518

E Revenue
Fixed cost
Variable cost
8
2
3.2
2.8
18 + 2.8 7.6061 = +3,297

Project
Investment
NPV
Benefit-cost ratio
Rank
A
B
C
D
E
10,000
30,000
15,000
12,000
18,000
7,408
326
216
1,518
3,297
0.7408
0.0109
0.0144
0.1265
0.1832
1
4
3
N/A
2
Project
Investment
NPV
A
E
10,000
18,000
12,000
7,408
3,297
172.8
40,000
10,877.8
_
qw of C
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Chapter 6
RISK AND PROJECT APPRAISAL

LEARNING OUTCOMES
The reader is expected to be able to present a more realistic and rounded view of a projects prospects by
incorporating risk in an appraisal. This enables more informed decision making. Specifically the reader
should be able to:
adjust for risk by varying the discount rate;
present a sensitivity graph and discuss break-even NPV;
undertake scenario analysis;
make use of probability analysis to describe the extent of risk facing a project and thus make more
enlightened choices;
discuss the limitations, explain the appropriate use and make an accurate interpretation of the results
of the four risk techniques described in this chapter.
Risk more than one possible outcome.
Objective probability likelihood of outcomes established mathematically or from historic data.
Subjective probability personal judgement of the likely range of outcomes along with the likelihood
of their occurrence.
Risk can be allowed for by raising or lowering the discount rate:

Advantages: easy to adopt and understand;
some theoretical support.
Drawbacks: susceptible to subjectivity in risk premium and risk class allocation.
Sensitivity analysis views a projects NPV under alternative assumed values of variables, changed one
at a time. It permits a broader picture to be presented, enables search resources to be more efficiently
directed and allows contingency plans to be made.
Drawbacks of sensitivity analysis:
does not assign probabilities and these may need to be added for a fuller picture;
each variable is changed in isolation.
Scenario analysis permits a number of factors to be changed simultaneously. Allows best- and worstcase scenarios.
Probability analysis allows for more precision in judging project viability.
Expected return the mean or average outcome is calculated by weighting each of the possible outcomes by the probability of occurrence and then summing the result:
i=n
= (x p )
x
i i
i=1
Standard deviation a measure of dispersion around the expected value:

x =
x2 or
i=n
)2 p }
{(xi x
i
i=1
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It is assumed that most people are risk averters who demonstrate diminishing marginal utility, preferring less risk to more risk.
Mean-variance rule:
Project X will be preferred to Project Y if at least one of the following conditions apply:
1 The expected return of X is at least equal to the expected return of Y, and the variance is less than
that of Y.
2 The expected return of X exceeds that of Y and the variance is equal to or less than that of Y.
If a normal, bell-shaped distribution of possible outcomes can be assumed, the probabilities of various
events, for example insolvency, can be calculated using the Z statistic.
Z =
Careful interpretation is needed when using a risk-free discount rather than a risk-adjusted discount
rate for probability analysis.
Problems with probability analysis:

undue faith can be placed in quantified results;
can be too complicated for general understanding and communication;
projects may be viewed in isolation rather than as part of the firms mixture of projects.
Sensitivity analysis and scenario analysis are the most popular methods of allowing for project risk.
The real options perspective takes account of future managerial flexibility whereas the traditional NPV
framework tends to assume away such flexibility. Real options give the right, but not the obligation, to
take action in the future.

2 Cashion International
a Most likely NPV:
Annual cash inflows:

Other cash flows
Investment
Recovery of WC:
50,000 2.4869
20,000 0.7513
124,345
90,000
15,026
74,974
49,371
Some data for sensitivity graph:

NPV
Sales price
Sales price
Labour
Labour
Materials
Materials
Discount rate
Discount rate
30
10%
10%
10%
10%
10%
10%
10%
10%
:
:
:
:
:
:
:
:
+99,109
367
+24,502
+74,240
+39,423
+59,319
+46,809
+52,009
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100
Sales price
Discount rate
50
NPV ( 000)
Materials
Labour
0
50
100
15
10
5
0
5
10
Percentage deviation of variable from expected level
15
Fig. 6.1 Sensitivity graph for Cashion International

b Break-even NPV
Sales price:
Labour costs:
Materials costs:
Discount rate:
1.80
119,852
59,852
37%
10%.
19.85%.
49.6%.
270%.
3 Worst-case scenario
Annual sales
90,000 1.90
Annual costs
Labour
Material
Other costs
171,000
110,000
44,000
13,000
(167,000)
4,000
Annual cash inflows 4,000 2.3612
9,445
Other cash flows:

Investment
Recovery of WC:
20,000 0.6931
Net present value
90,000
13,862
76,138
66,693
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Best-case scenario
Annual sales
Annual costs
Labour
Material
Other costs
110,000 2.15
95,000
39,000
9,000
236,500
(143,000)
93,500
Annual cash inflows 93,500 2.4868

Other cash flows
Investment
90,000
Recovery of WC:
20,000 0.7513
15,026
Net present value
232,516
74,974
157,542
12 Willow plc
a and b:
Time 0
Time 211
Time 1
0.3
0.3
0.4
1m
1.0m 0.2m
= 727,272
1.1
0.7
(1m 0.05m) 6.1446

= 5,306,700
1.1
(0.1m 0.05m) 6.1446
= 279,300
1.1
0.4
(0.7m 0.05m) 6.1446

= 3,630,900
1.1
0.6
(0.05m 0.05m) 6.1446

=0
1.1
0.7m 0.2m
= 454,545
1.1
0.3
0.2 0.2 = 0
NPV
Probability
NPV x pi
5,033,972
0.09
6,572
0.21
3,085,445
0.16
545,455
0.24
1,000,000
0.30
Expected NPV
453,058
1,380
493,671
130,909
300,000
517,200
(NPV NPV)2 pi
m
1.836
5.4756
1.055341
2.71017
6.9057
3.9077
1012
1010
1012
1011
1011
1012
Standard deviation = 1,976,785

c
1 0.5172
= 0.77
1.977
Probability of avoiding bankruptcy = 77.94%
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Chapter 7
PORTFOLIO THEORY
LEARNING OUTCOMES
This chapter should enable the student to understand, describe and explain in a formal way the interactions between investments and the risk-reducing properties of portfolios. This includes:
calculating two-asset portfolio expected returns and standard deviations;
estimating measures of the extent of interaction covariance and correlation coefficients;
being able to describe dominance, identify efficient portfolios and then apply utility theory to obtain
optimum portfolios;
recognise the properties of the multi-asset portfolio set and demonstrate the theory behind the capital
market line.
The one-year holding period return:

R=
D1 + P1 P0
P0
Use IRR-type calculations for multi-period returns.
With perfect negative correlation the risk on a portfolio can fall to zero if an appropriate allocation of
funds is made.
With perfect positive correlations between the returns on investments, both the expected returns and
the standard deviations of portfolios are weighted averages of the expected returns and standard deviations, respectively, of the constituent investments.
In cases of zero correlation between investments, risk can be reduced through diversification, but it will
not be eliminated.
The correlation coefficient ranges from 1 to +1. Perfect negative correlation has a correlation coefficient of 1. Perfect positive correlation has a correlation coefficient of +1.
The degree of risk reduction for a portfolio depends on:

a the extent of statistical interdependency between the returns on different investments; and
b the number of securities in the portfolio.
Portfolio expected returns are a weighted average of the expected returns on the constituent investments:
RP = aRA + (1 a)RB
Portfolio standard deviation is less than the weighted average of the standard deviation of the constituent investments (except for perfectly positively correlated investments):
P =
a2C2 + (1 a)2D2 + 2a(1 a) cov (RC, RD)
P =
a2C2 + (1 a)2D2 + 2a(1 a) RCDCD
Covariance means the extent to which the returns on two investments move together:
n
cov (RA, RB) = {(RA RA)(RB RB)pi}

i=1
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Covariance and the correlation coefficient are related. Covariance can take on any positive or negative
value. The correlation coefficient is confined to the range 1 to +1:
RAB =
cov (RA, RB)

A B
or cov (RA, RB) = RABAB
Efficient portfolios are on the efficient frontier. These are combinations of investments which maximise
the expected returns for a given standard deviation. Such portfolios dominate all other possible portfolios in an opportunity set or feasible set.
To find the proportion of the fund, a, to invest in investment C in a two-asset portfolio to achieve minimum variance or standard deviation:
a=
D2 cov (RC, RD)

C2 + D2 2 cov (RC, RD)
Indifference curves for risk and return:

are upward sloping;
do not intersect;
are preferred if they are closer to the north-west;
are part of an infinite set of curves;
have a slope which depends on the risk aversion of the individual concerned.
Optimal portfolios are available where the highest attainable indifference curve is tangential to the efficient frontier.
Most securities have correlation coefficients in the range of 0 to +1.
The feasible set for multi-asset portfolios is an area that resembles an umbrella.
Diversification within a home stock market can reduce risk to less than one-third of the risk on a typical single share. Most of this benefit is achieved with a portfolio of 10 securities.
International diversification can reduce risk even further than domestic diversification.
Problems with portfolio theory:

relies on past data to predict future risk and return;
involves complicated calculations;
indifference curve generation is difficult;
few investment managers use computer programs because of the nonsense results they frequently
produce.

4 a
Ri
%
30
15
2
34
pi
0.2
0.6
0.2
Expected return
Ri pi
6.0
9.0
0.4
15.4%
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Ri
%
b Ri
%
30
15
2
15.4
15.4
15.4
pi
(Ri Ri)2 pi
0.2
0.6
0.2
2
42.63
0.10
35.91
78.64
Standard deviation
5 a Rs
%
ps
Rs pi
5
0.2
15
0.6
20
0.2
Expected return
b Rs
%
Rs
%
5
15
20
14
14
14
8.87%
1.0
9.0
4.0
14.0%
pi
(Rs Rs )2 pi
0.2
0.6
0.2
2
16.2
0.6
7.2
24.0
Standard deviation
4.9%
6 a Covariance
Ri
%
Ri
%
Rs
%
Rs
%
pi
30
15
2
15.4
15.4
15.4
5
15
20
14
14
14
0.2
0.6
0.2
(Ri Ri ) (Rs Rs ) pi
26.28
0.24
16.08
42.60
Portfolio A
Expected return: 0.8 15.4 + 0.2 14 = 15.12%
Standard deviation:
0.82 78.64 + 0.22 24 + 2 0.8 0.2 42.6 = 6.1%
Portfolio B
Expected return: 0.5 15.4 + 0.5 14 = 14.7%
Standard deviation:
0.52 78.64 + 0.52 24 + 2 0.5 0.5 42.6 = 2.1%
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Portfolio C
Expected return: 0.25 15.4 + 0.75 14 = 14.35%
Standard deviation:
0.252 78.64 + 0.752 24 + 2 0.25 0.75 42.60 = 1.56%
b a=
24 (42.6)
78.64 + 24 2 42.6
= 35.46%
Lowest standard deviation is achievable with 35.46% of the fund devoted to ICMC and 64.54%
devoted to Splash.
Expected return: 0.3546 15.4 + 0.6454 14 = 14.5%
Standard deviation:
0.35462 78.64 + 0.64542 24 + 2 0.3546 0.6454 42.6 = 0.62%
ICMC
Expected return %
15.4
A
15.12
B
14.7
14.5
14.35
14
S
0.62
1.56 2.1
4.9
6.1
Standard deviation %
8.87
Fig. 7.1
14 a Horace Investments
Event (growth)
pi
R
%
R pi
Ecaroh 100%
Strong
Normal
Slow
Expected return
0.3
0.4
0.3
10
15
16
3
6
4.8
13.8
Acehar 100%
Strong
Normal
Slow
Expected return
0.3
0.4
0.3
50
25
0
R
%
(R R)2 pi
13.8
13.8
13.8
4.332
0.576
1.452
6.360
Standard deviation
2.5%
15
10
0
25
187.50
0.00
187.50
375.00
25
25
25
Standard deviation
36
19.36%
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Ecaroh 50%, Acehar 50%
Covariance:
Event
pi
RE
RE
RA
RA
(RE RE)(RA RA) pi
Strong
Normal
Slow
0.3
0.4
0.3
10
15
16
13.8
13.8
13.8
50
25
0
25
25
25
28.5
0
16.5
45.0
Expected return: 0.5 13.8 + 0.5 25 = 19.4%

Standard deviation:
0.52 6.36 + 0.52 375 + 2 0.5 0.5 45 = 8.5%
Ecaroh 90%, Acehar 10%
Expected return: 0.9 13.8 + 0.1 25 = 14.92%
Standard deviation:
0.92 6.36 + 0.12 375 + 2 0.9 0.1 45 = 0.9%
b
30
Indifference curve
25
Expected return
CFML_CH07v3.QXD
20
E and A (50%)
15
10
5
E
E and A 90%
10%
10 12 14 16
Standard deviation
18
20
22
24
Fig. 7.2
Efficient portfolios: A, A and E (50%)
Inefficient portfolios: E, possibly E and A (90%,10%) depending on the position of the risk-return line.
c Indifference curves
Shallow slope.
Curved.
Do not cross.
Slope to the NESW.
Optimal point at tangent to risk-return line.
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Chapter 8
THE CAPITAL ASSET PRICING MODEL

AND MULTI-FACTOR MODELS
LEARNING OUTCOMES
The ideas, frameworks and theories surrounding the relationship between the returns on a security and
its risk are pivotal to most of the issues discussed in this book. At times it may seem that this chapter is
marching you up to the top of the hill only to push you down again. But remember, sometimes what you
learn on a journey and what you see from new viewpoints are more important than the ultimate destination. By the end of this chapter the reader should be able to:
describe the fundamental features of the Capital Asset Pricing Model (CAPM);
show an awareness of the empirical evidence relating to the CAPM;
explain the key characteristics of multi-factor models, including the Arbitrage Pricing Theory (APT)
and the three-factor model;
express a reasoned and balanced judgement of the risk-return relationship in financial markets.
Risky securities, such as shares quoted on the London Stock Exchange, have produced a much higher
average annual return than relatively risk-free securities. However, the annual swings in returns are
much greater for shares than for Treasury bills. Risk and return are positively related.
Total risk consists of two elements:

systematic risk (or market risk, or non-diversifiable risk) risk factors common to all firms;
unsystematic risk (or specific risk, or diversifiable risk).
Unsystematic risk can be eliminated by diversification. An efficient market will not reward unsystematic risk.
Beta measures the covariance between the returns on a particular share with the returns on the market
as a whole.
The Security Market Line (SML) shows the relationship between risk as measured by beta and expected returns.
The equation for the capital asset pricing model is:

rj = rf + j (rm rf)
The slope of the characteristic line represents beta:

rj = + j rm + e
38
Some examples of the CAPMs application:

portfolio selection;
identifying mispriced shares;
measuring portfolio performance;
rate of return on firms projects.
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Technical problems with the CAPM:

measuring beta;
ex ante theory but ex post testing and analysis;
unobtainability of the market portfolio;
one-period model;
unrealistic assumptions.
Early research seemed to confirm the validity of beta as the measure of risk influencing returns. Later
work cast serious doubt on this. Some researchers say beta has no influence on returns.
Beta is not the only determinant of return.
Multi-factor models allow for a variety of influences on share returns.
Factor models refer to diversifiable risk as non-factor risk and non-diversifiable risk as factor risk.
Major problems with multi-factor models include:

the difficulty of finding the influencing factors:
once found, the influencing factors only explain past returns.
The Arbitrage Pricing Theory (APT) is one possible multi-factor model:

Expected returns = risk-free return + 1 = (r1 rf ) + 2(r2 rf ) + 3 (r3 rf ) + 4 (r4 rf ) + n (rn rf ) + e
Fama and French have developed a three-factor model:

Expected return = risk-free rate + 1 (rm rf ) + 2 (SMB) + 3 (HML)
Traditional commonsense-based measures of risk seem to have more explanatory power over returns
than beta or standard deviation.
Projects of differing risks should be appraised using different discount rates.
Refer to Appendix VII in Corporate Financial Management for answers to all numerical questions in this
chapter.
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Chapter 9
STOCK MARKETS
LEARNING OUTCOMES
An appreciation of the rationale and importance of a well-organised stock market in a sophisticated
financial system is a necessary precursor to understanding what is going on in the world around us. To
this end the reader will, having read this chapter, be able to:
describe the scale of stock market activity around the world and explain the reasons for the widespread
adoption of stock exchanges as one of the foci for a market-based economy;
explain the functions of stock exchanges and the importance of an efficiently operated stock exchange;
give an account of the stock markets available to UK firms and describe alternative share trading systems;
demonstrate a grasp of the regulatory framework for the UK financial system;
be able to understand many of the financial terms expressed in the broadsheet newspapers (particularly
the Financial Times);
outline the UK corporate taxation system.
Stock exchanges are markets where government and industry can raise long-term capital and investors
can buy and sell securities.
Two breakthroughs in the rise of capitalism:

thriving secondary markets for securities;
limited liability.
Over 100 countries now have stock markets. They have grown in significance due to:
disillusionment with planned economies combined with admiration for Western and the tiger economies;
recognition of the key role of stock markets in a liberal pro-market economic system.
The largest domestic stock markets are in the USA, Japan and the UK. The leading international equity
market is the London Stock Exchange.
The globalisation of equity markets has been driven by:

deregulation;
technology;
institutionalisation.
Companies list on more than one exchange for the following reasons:
to broaden the shareholder base and lower the cost of equity capital;
the domestic market is too small or the firms growth is otherwise constrained;
to reward employees;
investors in particular markets may understand the firm better;
to raise awareness of the company;
to discipline the firm and learn to improve performance;
to understand better the economic, social and industrial changes occurring in major product markets.
A well-run stock exchange:

allows a fair game to take place;
is regulated to avoid negligence, fraud and other abuses;
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allows transactions to take place cheaply;
has enough participants for efficient price setting and liquidity.
Benefits of a well-run stock exchange:

firms can find funds and grow;
society can allocate capital better;
shareholders can sell speedily and cheaply. They can value their financial assets and diversify;
increase in status and publicity for firms;
mergers can be facilitated by having a quotation. The market in managerial control is assisted;
corporate behaviour can be improved.
The London Stock Exchange regulates the trading of equities (domestic and international) and debt
instruments (e.g. gilts, corporate bonds and Eurobonds, etc.) and other financial instruments (e.g. warrants, depositary receipts and preference shares).
The primary market is where firms can raise finance by selling shares (or other securities) to investors.
The secondary market is where existing securities are sold by one investor to another.
Internal funds are generally the most important source of long-term capital for firms. Bank borrowing varies
greatly and new share or bond issues account for a minority of the funds needed for corporate growth.
LSEs Main Market is the most heavily regulated UK exchange.
The Alternative Investment Market (AIM) is the lightly regulated exchange designed for small, young
companies.
techMARK is the sector of the Official List focused on technology-led companies. The rules for listing
are different for techMARK companies than for other OL companies.
PLUS provides a share trading facility for companies, less costly than the LSE.
Stock exchanges undertake most or all of the following tasks to play their role in a modern society:
supervise trading;
authorise market participants (e.g. brokers, market makers);
assist price formation;
clear and settle transactions;
regulate the admission of companies to and companies on the exchange;
disseminate information.
A quote-driven share trading system is one in which market makers quote a bid and an offer price for
shares. An order-driven system is one in which investors buy and sell orders are matched without the
intermediation of market makers.
The ownership of quoted shares has shifted from dominance by individual shareholders in the 1960s
to dominance by institutions many of which are from overseas.
High-quality regulation generates confidence in the financial markets and encourages the flow of savings into investment.
The Financial Services Authority is at the centre of UK financial regulation.
Dividend yield:
Dividend per share
100
Share price
Price-earnings ratio (PER):
Share price
Earnings per share
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Dividend cover: Earnings per share

Gross dividend per share
Taxation impacts on financial decisions in at least three ways:

capital allowances;
selecting type of finance;
corporation tax.
Answers to questions can be found in the text of the chapter.
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Chapter 10
RAISING EQUITY CAPITAL

LEARNING OUTCOMES
By the end of this chapter the reader will have a firm grasp of the variety of methods of raising finance
by selling shares and understand a number of the technical issues involved. More specifically the reader
should be able to:
contrast equity finance with debt and preference shares;
explain the admission requirements and process for joining the Main Market of the London Stock
Exchange and for the AIM;
describe the nature and practicalities of rights issues, scrip issues, vendor placings, open offers and warrants;
give an account of the options open to an unquoted firm wishing to raise external equity finance;
explain why some firms become disillusioned with quotation, and present balanced arguments describing
the pros and cons of quotation.
Ordinary shareholders own the company. They have the rights of control, voting, receiving annual
reports, etc. They have no rights to income or capital but receive a residual after other claimants have
been satisfied. This residual can be very attractive.
Debt capital holders have no formal control but they do have a right to receive interest and capital.
Equity as a way of financing the firm:

Advantages
1 No obligation to pay dividends
shock absorber.
2 Capital does not have to be repaid
shock absorber.
Disadvantages
1 High cost:
a issue costs;
b required rate of return.
2 Loss of control.
3 Dividends not tax deductible.
Authorised share capital is the maximum amount permitted by shareholders to be issued.
Issued share capital is the amount issued expressed at par value.
Share premium The difference between the sale price and par value of shares.
Private companies Companies termed Ltd are the most common form of limited liability company.
Public limited companies (plcs) can offer their shares to a wider range of investors, but are required to
have 50,000 of share capital.
Preference shares offer a fixed rate of return, but without a guarantee. They are part of shareholders
funds but not part of the equity capital.
Advantages to the firm
1 Dividend optional.
2 Usually no influence over
management.
3 Extraordinary profits go to
ordinary shareholders.
4 Financial gearing considerations.
Disadvantages to the firm

1 High cost of capital relative to debt.
2 Dividends are not tax deductible.
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Types of preference share Cumulative, participative, redeemable, convertible.
Ordinary shares rank higher than deferred ordinary shares for dividends.
Golden shares have extraordinary special powers.
To float on LSEs main market of the London Stock Exchange the following are required:
a prospectus;
an acceptance of new responsibilities (e.g. dividend policy may be influenced by exchange investors;
directors freedom to buy and sell may be restricted);
25% of share capital in public hands;
that the company is suitable;
usually three years of accounts;
competent and broadly based management team;
appropriate timing for flotation;
a sponsor;
a corporate broker;
underwriters (usually);
accountants reports;
solicitors;
registrar.
Following flotation on the main market:

greater disclosure of information;
restrictions on director share dealings;
annual fees to LSE;
high standards of behaviour.
Methods of flotation:
offer for sale;
offer for sale by tender;
introduction;
offer for sale by subscription;
placing;
intermediaries offer;
reverse takeover.
Book-building Investors make bids for shares. Issuers decide price and allocation in light of bids.
Stages in a flotation:
pre-launch publicity;
decide technicalities, e.g. method, price, underwriting;
pathfinder prospectus;
launch of public offer prospectus and price;
close of offer;
allotment of shares;
announcement of price and first trading.
The Alternative Investment Market (AIM) differs from the Main Market in:
nominated advisers, not sponsors;
lower costs;
no minimum capitalisation, trading history or percentage of shares in public hands needed;
lower ongoing costs.
Costs of new issues:

administrative/transaction costs;
the equity cost of capital;
market pricing costs.
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Rights issues are an invitation to existing shareholders to purchase additional shares.
The theoretical ex-rights price is a weighted average of the price of the existing shares and the new shares.
The nil paid rights can be sold instead of buying new shares.
Value of a right on an old share:

Theoretical market value of share ex-rights subscription price
Number of old shares required to purchase one new share
Value of a right on a new share:

Theoretical market value of share ex-rights subscription price
The pre-emption right can be bypassed in the UK under strict conditions.
Placings New shares sold directly to a group of external investors. If there is a clawback provision, so that
existing shareholders can buy the shares at the same price instead, the issue is termed an open offer.
Acquisition for shares Shares are created and given in exchange for a business.
Vendor placing Shares are given in exchange for a business. The shares can be immediately sold by the
business vendors to institutional investors.
Scrip issues Each shareholder is given more shares in proportion to current holding. No new money
is raised.
Warrants The holder has the right to subscribe for a specified number of shares at a fixed price at some
time in the future. Warrants are sold by the company, which is committed to selling the shares if warrant holders insist.
Business angels Wealthy individuals investing 10,000 to 250,000 in shares and debt of small, young
companies with high growth prospects. Also offer knowledge and skills.
Private equity/venture capital (VC) Finance for high-growth-potential unquoted firms. Sums: 250,000
minimum, average 5m. Some of the investment categories of VC are:
seedcorn;
start-up;
other early-stage;
expansion (development);
management buyouts (MBO): existing team buy business from corporation;
management buy-in (MBI): external managers buy a stake in a business and take over management;
Public-to-private (PTP).
Rates of return demanded by VC range from 26% to 80% per annum depending on risk.
Exit (take-out) is the term used by venture capitalists to mean the availability of a method of selling
the holding. The most popular method is a trade sale to another organisation. Stock market flotation,
own-share repurchase and sale to an institution are other possibilities.
Venture capitalists often strike agreements with entrepreneurs to give the venture capitalists extraordinary powers if specific negative events occur, e.g. poor performance.
Venture Capital Trusts (VCTs) are special tax-efficient vehicles for investing in small unquoted firms
through a pooled investment.
Enterprise Investment Scheme (EIS) Tax benefits are available to investors in small unquoted firms
willing to hold the investment for five years.
Corporate venturing Large firms can sometimes be a source of equity finance for small firms. Incubators
provide finance and business services.
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Government agencies can be approached for equity finance.
Being quoted has significant disadvantages, ranging from consumption of senior management time to
lack of understanding between the City and directors and the stifling of creativity.

8 a Three old shares @ 3
One new share @ 2
9
2
11
&_
qq
& = 2.75
b 30m.
c Discuss pre-emption rights and ability to sell rights. If Patrick sold his rights, he would receive
75p 3,000 = 2,250.
d 2.75 2.00
= 25p
3
e See chapter.
f See chapter.
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Chapter 11
LONG-TERM DEBT FINANCE

LEARNING OUTCOMES
An understanding of the key characteristics of the main categories of debt finance is essential to anyone
considering the financing decisions of the firm. At the end of this chapter the reader will be able to:
explain the nature and the main types of bonds, their pricing and their valuation;
describe the main considerations for a firm when borrowing from banks;
give a considered view of the role of mezzanine and high-yield bond financing as well as convertible
bonds, sale and leaseback, securitisation and project finance;
demonstrate an understanding of the value of the international debt markets;
explain the term structure of interest rates and the reasons for its existence.
Debt finance has a number of advantages for the company:

it has a lower cost than equity finance:
a lower transaction costs;
b lower rate of return;
debt holders generally do not have votes;
interest is tax deductible.
Drawbacks of debt:
Committing to repayments and interest can be risky for a firm, ultimately the debt-holders can force
liquidation to retrieve payment;
the use of secured assets for borrowing may be an onerous constraint on managerial action;
covenants may further restrict managerial action.
A bond is a long-term contract in which the bondholders lend money to a company. A straight vanilla
bond pays regular interest plus the capital on the redemption date.
Debentures are generally more secure than loan stock (in the UK).
A trust deed has affirmative covenants outlining the nature of the bond contract and negative (restrictive) covenants imposing constraints on managerial action to reduce risk for the lenders.
A floating rate note (FRN) is a bond with an interest rate which varies as a benchmark interest rate
changes (e.g. LIBOR).
Attractive features of bank borrowing:

administrative and legal costs are low;
quick;
flexibility in troubled times;
available to small firms.
Factors for a firm to consider with bank borrowing:

Costs
fixed versus floating;
arrangement fees;
bargaining on the rate.
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Security
asymmetric information;
collateral;
covenants;
personal guarantees.
Repayment arrangements
Some possibilities:
grace periods;
mortgage style;
term loan.
A syndicated loan occurs where a number of banks (or other financial institutions) each contribute a
portion of a loan.
A credit rating depends on (a) the likelihood of payments of interest and/or capital not being paid (i.e.
default); and (b) the extent to which the lender is protected in the event of a default.
Mezzanine debt and high-yield bonds are forms of debt offering a high return with a high risk. They
have been particularly useful in the following:
management buyouts (MBOs), especially leveraged management buyouts (LBOs);
fast-growing companies;
leveraged recapitalisation.
Convertible bonds are issued as debt instruments but they also give the holder the right to exchange
the bonds at some time in the future into ordinary shares according to some prearranged formula.
They have the following advantages:
lower interest than on debentures;
interest is tax deductible;
self-liquidating;
few negative covenants;
shares might be temporarily underpriced;
cheap way to issue shares;
an available form of finance when straight debt and equity are not.
A bond is priced according to general market interest rates for risk class and maturity:
Irredeemable:
PD =
i
kD
Redeemable:
PD =
i1
1 + kD
i2
(1 +
kD)2
i3
(1 +
kD)3
+ ... +
Rn
(1 + kD)n
The interest yield on a bond is:

Gross interest (coupon)
Market price
100
The yield to maturity includes both annual coupon returns and capital gains or losses on maturity.
The Euromarkets are informal (unregulated) markets in money held outside the jurisdiction of the country
of origin of the currency.
A foreign bond is a bond denominated in the currency of the country where it is issued when the issuer
is a non-resident.
A Eurobond is a bond sold outside the jurisdiction of the country of the currency in which the bond is
denominated.
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A project finance loan is provided as a bank loan or bond finance to an entity set up separately from
the parent corporation to undertake a project. The returns to the lender are tied to the fortunes and
cash flows of the project.
Sale and leaseback Assets are sold to financial institutions or another company which releases cash.
Simultaneously, the original owner agrees to lease the assets back for a stated period under specified terms.
Securitisation Relatively small, homogeneous and liquid financial assets are pooled and repackaged into
liquid securities which are then sold on to other investors to generate cash for the original lender.
The term structure of interest rates describes the manner in which the same default risk class of debt
securities provides different annual rates of return depending on the length of time to maturity. There
are three hypotheses relating to the term structure of interest rates:
the expectations hypothesis;
the liquidity-preference hypothesis;
the market-segmentation hypothesis.

7 a Yield curve
Interest rate %
7.7
7.2
6.5
10
Time to maturity (years)
20
Fig. 11.1
b 2-year bond
6
106
+
= 99.09
1.065
(1.065)2
10-year bond
6 6.9591 + 100/(1.072)10 = 91.65
20-year bond
6 10.041 + 100/(1.077)20 = 82.93
c 2-year bond
6
106
+
= 95.57
1.085
(1.085)2
10-year bond
6 6.3615 + 100/(1.092)10 = 79.64
20-year bond
6 8.6908 + 100/(1.097)20 = 67.84
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d 2-year bond
6
106
+
= 102.8
1.045
(1.045)2
10-year bond
6 7.6473 + 100/(1.052)10 = 106.12
20-year bond
6 11.7546 + 100/(1.057)20 = 103.53
e The longest dated bond is the most volatile.
f The student should explain the liquidity preference theory. An excellent student will relate the evidence produced in a, b and c to illustrate the market risk of bonds of different maturities.
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Chapter 12
SHORT-TERM AND MEDIUM-TERM FINANCE

LEARNING OUTCOMES
This chapter is largely descriptive and so it would be an achievement merely to understand the nature of
each form of finance. However, we will go further and explore the appropriate use of these sources in
varying circumstances. Specifically the reader should be able to:
describe, compare and contrast the bank overdraft and the bank term loan;
show awareness of the central importance of trade credit and good debtor management and be able to
analyse the early settlement discount offer;
explain the different services offered by a factoring firm;
consider the relative merits of hire purchase and leasing;
describe bills of exchange and bank bills and their uses.
Overdraft A permit to overdraw on an account up to a stated limit.

Advantages:
flexibility;
cheap.
Drawbacks:
bank has right to withdraw facility quickly;
security is usually required.
bank usually considers the following before lending:

the projected cash flows;
creditworthiness;
the amount contributed by the borrower;
security.
Term loan A loan of a fixed amount for an agreed time and on specified terms, usually one to seven
years.
Trade credit Goods delivered by suppliers are not paid for immediately.
The early settlement discount means that taking a long time to pay is not cost free.
Advantages of trade credit:

convenient, informal and cheap;
available to companies of any size.
Factors determining the terms of trade credit:

tradition within the industry;
bargaining strength of the two parties;
product type;
credit standing of individual customers.
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Trade debtors are sales made on credit as yet unpaid. The management of debtors requires a trade-off
between increased sales and costs of financing, liquidity risk, default risk and administration costs.
Debtor management requires consideration of the following:

credit policy;
assessing credit risk;
agreeing terms;
collecting payment;
integration with other disciplines.
Factoring companies provide at least three services:

providing finance on the security of trade debts;
sales ledger administration;
credit insurance.
Invoice discounting is the obtaining of money on the security of specific book debts. Usually confidential and with recourse to the supplying firm. The supplying firm manages the sales ledger.
Hire purchase is an agreement to hire goods for a specified period, with an option or an automatic right
to purchase the goods at the end for a nominal or zero final payment.
The main advantages:
small initial outlay;
certainty;
available when other sources of finance are not;
fixed-rate finance;
tax relief available.
Leasing The legal owner of an asset gives another person or firm (the lessee) the possession of
that asset to use in return for specified rental payments. Note that ownership is never transferred to
the lessee.
An operating lease commits the lessee to only a short-term contract, less than the useful life of the asset.
A finance lease commits the lessee to a contract for the substantial part of the useful life of the asset.
Advantages of leasing:
small initial outlay;
certainty;
available when other finance sources are not;
fixed rate of finance;
tax relief (operating lease: rental payments are a tax-deductible expense, finance lease: capital
value can be written off over a number of years; interest is tax deductible. Capital allowance can
be used to reduce tax paid on the profit of a finance house, which then passes on the benefit to
the lessee);
avoid danger of obsolescence with operating lease.
Bills of exchange A trade bill is the acknowledgement of a debt to be paid by a customer at a specified time. The legal right to receive this debt can be sold prior to maturity, that is discounted, and thus
can provide a source of finance.
Acceptance credit A financial institution or other reputable organisation accepts the promise to pay a
specified sum in the future to a firm. The firm can sell this right, that is discount it, to receive cash from
another institution.
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5 a
20,000
1,222.22
= 16.36
16.36 is roughly equivalent to the 18-period annuity factor when the interest rate per month
is 1%:
(1 + 0.01)12 1 = 0.127 or 12.7%.
12 a Benefits:
50,000
30,000
Collection effort
Bad debts 0.003 10m
The overdraft due to debtors is currently:
10,000,000 90
= 2,465,753
365
If 60% of customers now pay on the 20th day, the overdraft will be reduced by:
(6,000,000 0.025 6,000,000) 70
365
= 1,121,918
Interest saved: 1,121,918 0.14 =

Total benefits 50,000 + 30,000 + 157,068 =
157,068
237,068
Costs:
6,000,000 0.025
150,000
The discount offered is less than the benefit; therefore accept the junior executives proposal.
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Chapter 13
TREASURY AND WORKING CAPITAL

MANAGEMENT
LEARNING OUTCOMES
This chapter covers a wide range of finance issues, from cheque clearance to optimum inventory models.
Matters such as the use of derivatives to reduce interest rate risk or foreign exchange risk have entire chapters devoted to them later in the book and so will be covered in a brief fashion here to give an overview.
By the end of this chapter the reader should be able to:
describe the main roles of a treasury department and the key concerns of managers when dealing with
working capital;
comment on the factors influencing the balance of the different types of debt in terms of maturity, currency and interest rates;
show awareness of the importance of the relationship between the firm and the financial community;
demonstrate how the treasurer might reduce risk for the firm, perhaps through the use of derivative
products;
understand the working capital cycle, the cash conversion cycle and an inventory model.
Working capital is net current assets or net current liabilities.
In deciding whether to borrow long or short a company might consider the following:
maturity structure of debt;
cost of issue or arrangement;
flexibility;
the uncertainty of getting future finance;
the term structure of interest rates.
Firms often strive to match the maturity structure of debt with the maturity structure of assets.
However, a more aggressive financing policy would finance permanent short-term assets with shortterm finance. A more conservative policy would finance all assets with long-term finance.
Firms need to consider the currency in which they borrow.
A balance needs to be struck between fixed and floating interest-rate debt.
Dont forget retained earnings as a financing option:
Advantages
Disadvantages
No dilution of existing shareholders returns or control
Limited by firms profits
No issue costs
Subject to uncertainty
Managers may not have to

explain use of funds (dubious
advantage for shareholders)
Regarded as free capital
Dividend payment reduced
Treasurers help decision making at a strategic level:

e.g. mergers, interest and exchange-rate changes, capital structure.
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Good relationships need to be developed with the financial community.

This requires effort often the treasurer makes a major contribution:
flow of information;
number of banks;
transaction banking versus relationship banking.
Some of the risks which can be reduced or avoided by a firm:

business risk;
insurable risk;
currency risk;
interest-rate risk.
The working capital cycle flows from raw materials, to work-in-progress, to finished goods stock, to
sales and collection of cash, with creditors used to reduce the cash burden.
The cash-conversion cycle is the length of time between the companys outlay on inputs and the receipt
of money from the sale of goods. It equals the stock-conversion period plus the debtor-conversion period minus the credit period granted by suppliers.
Working capital tension Too little working capital leads to loss of production, sales and goodwill. Too
much working capital leads to excessive costs of tying up funds, storage, handling and ordering costs.
Working capital policies:

relaxed large proportional increases in working capital as sales rise;
aggressive small proportional increases in working capital as sales rise.
Overtrading occurs when a business has insufficient finance for working capital to sustain its level of
trading.
The motives for holding cash:

transactional motive;
precautionary motive;
speculative motive.
Baumols cash management model:

Q* =
2CA
K
Some considerations for cash management:

create a policy framework;
plan cash flows, e.g. cash budgets;
control cash flows.
Inventory management requires a balance of the trade-off between the costs of high inventory (interest, storage, management, obsolescence, deterioration, insurance and protection costs) against ordering
costs and stock-out costs.
An economic order quantity in a world of certainty can be found by:

EOQ =
2AC
H
With uncertainty, buffer stocks may be needed.
In investing temporarily surplus cash the treasurer has to consider the trade-off between return and risk
(liquidity, default, event, valuation and inflation). Investment policy considerations:
defining the investable funds;
acceptable investments;
limits on holdings.
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3a Rounded plc
Month
m
Cash inflows
Sales (delivered and paid
for in same month)
0.433 0.500 0.533 0.500 0.667 0.733 0.767 0.667 0.667 0.600 0.633
1.00
Sales (cash received

from prior months sales)
one month
two months
Total inflows
0.433 0.500 0.533 0.500 0.667 0.733 0.767 0.667 0.667 0.600 0.633
0.433 0.500 0.533 0.500 0.667 0.733 0.767 0.667 0.667 0.600
0.433 0.933 1.466 1.533 1.700 1.900 2.167 2.167 2.101 1.934 1.90
2.233
Cash outflows
Stock
Labour
Shops
0.65
0.30
0.75
0.30
0.80
0.30
0.75
0.30
1.00
0.30
2.00
1.10
0.30
1.15
0.30
1.00
0.30
1.00
0.30
0.90
0.30
0.95
0.30
1.50
0.30
Total outflows
0.95
1.05
1.10
1.05
3.30
1.40
1.45
1.30
1.30
1.20
1.25
1.80
Balances
Opening cash balance
for month
Net cash surplus (deficit)
0.500 0.017 0.134 0.232 0.715 0.885 0.385 0.332 1.199 2.000 2.734 3.384
0.517 0.117 0.366 0.483 1.600 0.500 0.717 0.867 0.801 0.734 0.650 0.433
Closing cash balance
0.017 0.134 0.232 0.715 0.885 0.385 0.332 1.199 2.000 2.734 3.384 3.817
6 Some suggestions, assuming the firm is able to borrow/lend on the interbank market (creditworthiness,
etc.):
1.3.x1 and 2.3.x1, place surplus cash in overnight interbank market at 5.5%.
3.3.x1 and 4.3.x1, borrow on the interbank overnight market at 5.75%.
5.3.x1 to 11.3.x1, lend 10,000,000 on 7-day interbank market at 5.67%. Daily surpluses above this
figure could be lent on the overnight interbank market at 5.5%.
Risks:
Liquidity risk, e.g. 7-day lending may be risky because the firm may need cash earlier than anticipated.
Default risk highly unlikely that participants in the interbank market will default however, the
risk is not zero.
Event risk unlikely to be of significance here.
Valuation risk a tradable instrument is not bought or sold and therefore valuation risk is not a
problem.
Inflation risk over a short period this is not a great concern.
8
Q=
=
2CA
K
2 200 2,080,000
0.08
= 101,980
Silk plc should draw on these funds every two-and-a-half weeks.

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23 Rubel cash conversion cycle
Raw material stock period:
Days
Average value of raw material stock

Average usage of raw material per day
105
550/365
70
155
550/365
103
39
650/365
22
52.5
650/365
29
275
1,200/365
84
Less:
Average credit granted by suppliers:
Average level of creditors
Purchases on credit per day
33
Add:
Work-in-progress period:
Average value of WIP
Average cost of goods sold per day
Finished goods inventory period:
Average value of finished goods in stock
Average cost of goods sold per day
Debtor conversion period:
Average value of debtors
Average value of sales per day
102
25a Sheetly
Cash flow forecast
000s
May
June
July
Aug
Sept
Oct
Cash inflows
Sales (delivered and paid
for in same month)
330
345
270
240
390
360
Sales (cash received

from prior months sales)
one month
two months
120
0
440
80
460
330
360
345
320
270
520
240
Total inflows
450
865
1,060
945
980
1,120
820
100
800
110
810
90
200
660
90
600
110
950
100
50
40
50
50
50
60
150
50
45
50
50
50
60
1,010
1,010
1,210
995
810
1,160
500
560
1,060
145
1,205
150
1,355
50
1,405
170
1,235
40
1,060
1,205
1,355
1,405
1,235
1,275
Cash outflows
Purchases
Labour
Tax
Vehicles
Rent
Other
Total outflows
Balances
Opening cash balance
Net cash flow for month
Closing cash balance
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Chapter 14
STOCK MARKET EFFICIENCY

LEARNING OUTCOMES
discuss the meaning of the random walk hypothesis and provide a balanced judgement of the usefulness of past price movements to predict future share prices (weak-form efficiency);
provide an overview of the evidence for the stock markets ability to take account of all publicly available information including past price movements (semi-strong efficiency);
state whether stock markets appear to absorb all relevant (public or private) information (strong-form
efficiency);
outline some of the behavioural-based arguments leading to a belief in inefficiencies;
comment on the implications of the evidence for efficiency for investors and corporate management.
In an efficient market security prices rationally reflect available information. New information is (a)
rapidly and (b) rationally incorporated into share prices.
Types of efficiency:
operational efficiency;
allocational efficiency;
pricing efficiency.
The benefits of an efficient market are:

it encourages share buying;
it gives correct signals to company managers;
it helps to allocate resources.
Shares, other financial assets and commodities move with a random walk one days price change cannot
be predicted by looking at previous price changes. Security prices respond to news, which is random.
Weak-form efficiency Share prices fully reflect all information contained in past price movements.
Evidence: mostly in support but there are some important exceptions.
Semi-strong form efficiency Share prices fully reflect all the relevant, publicly available information.
Evidence: substantially in support but there are some anomalies.
Strong-form efficiency All relevant information, including that which is privately held, is reflected in
the share price. Evidence: stock markets are strong-form inefficient.
Insider dealing is trading on privileged information. It is profitable and illegal.
Behavioural finance studies offer insight into anomalous share pricing.
Implications of the EMH for investors:

for the vast majority of people public information cannot be used to earn abnormal returns;
investors need to press for a greater volume of timely information;
the perception of a fair game market could be improved by more constraints and deterrents placed
on insider dealers.
Implications of the EMH for companies:

focus on substance, not on short-term appearances;
the timing of security issues does not have to be fine-tuned;
large quantities of new shares can be sold without moving the price;
signals from price movements should be taken seriously.
No answers are given in this Lecturers Guide for this chapter.

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Chapter 15
VALUE MANAGEMENT
LEARNING OUTCOMES
This chapter demonstrates the rationale behind value-based management techniques. By the end of it the
reader should be able to:
explain the failure of accounts-based management (e.g. profits, balance sheet assets, earning per share
and accounting rate of return) to guide value-maximising decisions in many circumstances;
describe the four key drivers of value and the five actions to increasing value.
Value-based management is a managerial approach in which the primacy of purpose is long-run

shareholder-wealth maximisation. The objective of the firm, its systems, strategy, processes, analytical techniques, performance measurement and culture have as their guiding objective shareholderwealth maximisation.
Shareholder-wealth maximisation is the superior objective in most commercial organisations operating

in a competitive market for many reasons. For example:
managers not pursuing this objective may be thrown out (e.g. via a merger);
owners of the business have a right to demand this objective;
societys scarce resources can thereby be better allocated.
Non-shareholder wealth-maximising goals may go hand in hand with shareholder value, for example
market share targets, customer satisfaction and employee benefits. But sometimes the two are contradictory and then shareholder wealth becomes paramount.
Earnings (profit) based management is flawed:

profit figures are drawn up following numerous subjective allocations and calculations relying on
judgement rather than science;
profit figures are open to manipulation and distortion;
the investment required to produce earnings growth is not made explicit;
the time value of money is ignored;
the riskiness of earnings is ignored.
Bad growth is when the return on the marginal investment is less than the required rate of return, given
the finance providers opportunity cost of funds. This can occur even when earnings-based figures are
favourable.
Using accounting rates of return (ROCE, ROI, ROE etc.) is an attempt to solve some of the problems
associated with earnings or earnings per share metrics, especially with regard to the investment levels
used to generate the earnings figures. However balance sheet figures are often too crude to reflect capital employed. Using ARRs can also lead to short-termism.
That shareholders are interested solely in short-term earnings and EPS is a myth These figures are only
interesting to the extent that they cast light on the quality of stewardship over fund providers money
by management and therefore give an indication of long-term cash flows. Evidence:
most of the value of a share is determined by income to be received five or more years hence;
hundreds of quoted firms produce zero or negative profits with high market values.
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earnings changes are not correlated with share price changes; for example, earnings can fall due to
a rise in R&D spending and yet share prices may rise;
the window dressing of accounts (creative accounting) does not, in most cases, influence share prices.
Value is created when investment produces a rate of return greater than that required for the risk class
of investment.
Shareholder value is driven by four key elements:

1 Amount of capital invested.
2 Required rate of return.
3 Actual rate of return on capital.
4 Planning horizon (for performance spread persistence).
Performance spread
Actual rate of return on capital required return
rk
Corporate value
Present value of
cash flows within
planning horizon
Present value of
cash flows after
planning horizon
To expand or not to expand?
Grow
Shrink
Positive performance
spread
Value
creation
Value
opportunity
forgone
Negative performance
spread
Value
destruction
Value
creation
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The value action pentagon
1 Increase the return

on existing capital
5 Lower the
required rate
of return
VALUE
4 Extend
the planning
horizon
2 Raise
investment in
positive spread
units
3 Divest assets
from negative
spread units to
release capital
for more
productive
use

7 Company A
Year
1
2
3
4
5
6
7
Profit
(000s)
Debtor
increase
Inventory
increase
Cash flow
Discounted
cash flow
1,000
1,100
1,200
1,400
1,600
1,800
1,800
0
35
35
70
70
70
0
0
30
30
60
60
60
0
1,000
1,035
1,135
1,270
1,470
1,670
1,800
877
796
766
752
763
761
5,858
10,573
Profit
(000s)
Debtor
increase
Inventory
increase
Cash flow
Discounted
cash flow
1,000
1,080
1,160
1,350
1,500
1,700
1,700
0
4
4
9.5
7.5
10
0
0
8
8
19
15
20
0
1,000
1,068
1,148
1,321.5
1,477.5
1,670
1,700
877
822
775
782
767
761
5,532
10,316
Company B
Year
1
2
3
4
5
6
7
Company A creates most value.

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10 Busy plc
a
Polythene
Discounted cash flow within planning horizon:

880,000 3.4331
3,021,128
Discounted cash flow after planning horizon:

1,120,000/0.14
(1.14)5
Present value of future cash flows
4,154,949
7,176,077
Alternatively:
Investment + value within planning horizons + value after planning horizon
8,000,000 240,000 3.4331 + 0 =
Paper
7,176,056
2,640,000 5.0188
1,800,000/0.15
(1.15)10
Alternatively:
12,000,000 + 840,000 5.0188
13,249,632
2,966,216
16,215,848
16,215,792
Cotton
340,000 4.0386
320,000/0.16
(1.16)7
1,373,124
707,659
2,080,772
Alternatively:
2,000,000 + 20,000 4.0386
2,080,772
Total value of firm:

7,176,077 + 16,215,848 + 2,080,783 = 25,472,708
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Value creation (m)
b Value creation and SBU performance spreads

+
4.2
Paper
0.08
3
Polythene
Cotton
1
7
Performance spread:
percentage points
0.82
Fig. 15.1
Consult chapter.
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Chapter 16
STRATEGY AND VALUE

LEARNING OUTCOMES
By the end of this chapter the reader will be able to:
explain the extent of the ramifications of value-based management;
discuss the main elements to examine when evaluating alternative strategies for the business from a
value perspective; map business activities in term of industry attractiveness, competitive advantage
within the industry and life-cycle stage and make capital allocation choices;
describe a system for making strategic choices that requires both qualitative thinking and quantitative
analysis;
describe the four main tasks for the corporate centre (head office).
Switching to value-based management principles affects many aspects of the organisation. These include:
strategic business unit strategy and structure;
corporate strategy;
culture;
systems and processes;
incentives and performance measurement;
financial policies.
A strategic business unit (SBU) is a business unit within the overall corporate entity which is distinguishable from other business units because it serves a defined external market in which management
can conduct strategic planning in relation to products and markets.
Strategy means selecting which product or market areas to enter/exit and how to ensure a good competitive position in those markets or products.
SBU managers should be involved in strategy development because (a) they usually have great knowledge to contribute, and (b) they will have greater ownership of the subsequent chosen strategy.
A review of current SBU activities using value-creation profile charts may reveal particular product or
customer categories which destroy wealth.
Strategic analysis has three stages:

strategic assessment;
strategic choice;
strategic implementation.
Strategic assessment focuses on the three determinants of value creation:

industry attractiveness;
competitive resources;
life-cycle stage of value potential.
Competitive resource analysis can be conducted using the TRRACK system:

Tangible
Relationships
Reputation
Attitude
Capabilities
Knowledge.
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A companys SBU positions with regard to these three value-creation factors could be represented in a strategy planes diagram. The product and/or market segment within SBUs can also be shown on strategy planes.
To make good strategic choices a wide search for alternatives needs to be encouraged.
Sustainable competitive advantage is obtainable in two ways:

cost leadership;
differentiation.
In the evaluation of strategic options, both qualitative judgement and quantitative valuation are important. The short-listed options can be tested in sensitivity and scenario analysis as well as for financial
and skill-base feasibility.
Strategy implementation is making the chosen strategy work through the planned allocation of resources
and the reorganisation and motivation of people.
The corporate centre has four main roles in a value-based firm:
portfolio planning;
managing strategic value drivers shared by SBUs;
providing and inculcating the pervading philosophy and governing objective;
structuring the organisation so that rules and responsibilities are clearly defined, with clear accountability for value creation.
Targets, incentives and rewards should be based on metrics appropriate to the level of management
within the firm as shown in Exhibit 16.12.
Exhibit 16.12
Senior
management
SBU
management
Operational
functions
External value metrics:

TSR, WAI, MVA,
MBR
Discounted
cash flow,
SVA, EP, EVA
Operating value
drivers: e.g.
cost of output,
customer satisfaction
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Chapter 17
VALUE-CREATION METRICS
LEARNING OUTCOMES
describe, explain and use the following measures of value:

discounted cash flow
shareholder value analysis
economic profit;
provide a brief outline of economic value added and cash flow return on investment (CFROI).
Discounted cash flow is the bedrock method underlying value management metrics. It requires the calculation of future annual free cash flows attributable to both shareholders and debt holders, then discounting these cash flows at the weighted average cost of capital.
Corporate value (Enterprise value) equals present value of free cash flows from operations plus the
value of non-operating assets.
Shareholder value from operations equals present value of free cash flows from operations minus debt.
Total shareholder value equals shareholder value of free cash flows from operations plus the value of
non-operating assets.
Investment after the planning horizon does not increase value.
Shareholder value analysis simplifies discounted cash flow analysis by employing (Rappaports) seven
value drivers, the first five of which change in a consistent fashion from one year to the next.
Rappaports seven value drivers:

1
2
3
4
5
6
7
Sales growth rate.

Operating profit margin.
Tax rate.
Fixed capital investment.
Working capital investment.
The planning horizon.
The required rate of return.
At least four strategic options should be considered for an SBU or product and/or market segment:
base-case strategy;
liquidation;
trade sale or spin-off;
new operating strategy.
Merits of shareholder value analysis:

easy to understand and apply;
consistent with share valuation;
makes value drivers explicit;
able to benchmark.
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Problems with shareholder value analysis:

constant percentages unrealistic;
can lead to poor decisions if misused;
data often unavailable.
Economic profit (EP) is the amount earned after deducting all operating expenses and a charge for the
opportunity cost of the capital employed. A major advantage over shareholder value analysis is that it
uses accounting data.
The entity approach to EP

a The profit less capital charge method
Economic profit
(Entity approach)
Operating profit
before interest deduction
and after tax deduction
Capital charge
Economic profit
(Entity approach)
Operating profit
before interest deduction
and after tax deduction
Invested capital
WACC
b The performance spread method
Economic profit
(Entity approach)
Performance spread
Invested capital
Economic profit
(Entity approach)
Return on capital WACC
Invested capital
The equity approach to EP

Economic profit
(Equity approach)
Operating profit after

deduction of interest
and tax
Invested
equity
capital
Economic profit
(Equity approach)
Return on equity
Required return on equity
Invested
equity
capital
Required
return on
equity
Usefulness of economic profit:

Managers become aware of the value of the investment in an SBU, product line or entire business.
Can be used to evaluate strategic options.
Can be used to look back at past performance.
Economic profit per unit can be calculated.
Drawbacks of EP:
the balance sheet does not reflect invested capital;
open to manipulation and arbitrariness;
high economic profit and negative NPV can go together;
problem with allocating revenues, costs and capital to business units.
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Economic value added (EVA) is an attempt to overcome some of the accounting problems of standard EP.
EVA = Adjusted invested capital (Adjusted return on capital WACC)
or
EVA = Adjusted operating profit after tax (Adjusted invested capital WACC)

For possible action consult the section of Chapter 15 containing the value action pentagon.
2 Year
5+
Sales
28.25
31.92
36.07
40.76
40.76
Profit
2.825
3.192
3.607
4.076
4.076
Tax
0.876
0.990
1.118
1.264
1.264
IFCI
0.358
0.404
0.457
0.516
IWCI
0.260
0.294
0.332
0.375
Operating free cash flow
1.331
1.504
1.700
1.921
2.812
1.157
1.098
+ 10.718
1.137
Present value of cash flows
1.118
15.228m
Add Current value of marketable securities
5.000m
20.228m
3 B division
Year
7+
Sales
17.250
19.838
22.813
26.235
30.170
34.696
34.696
Profit
2.070
2.381
2.738
3.148
3.620
4.164
4.164
Tax
0.642
0.738
0.849
0.976
1.122
1.291
1.291
IFCI
0.293
0.336
0.387
0.445
0.512
0.588
IWCI
Cash flow
0.225
0.910
0.259
1.048
0.298
1.204
0.342
1.385
0.394
1.592
0.453
1.832
0.820
+ 0.827
Discounted
cash flows
0.798
0.806
0.813
14.248m
Current value of marketable securities

Market value of division A
5.000m
10.000m
29.248m
68
0.835
2.873
+
9.349
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Retention of both divisions
Year
6+
Sales
29.50
34.81
41.08
48.47
57.19
57.19
Profit
3.54
4.177
4.930
5.816
6.863
6.863
Tax
1.097
1.295
1.528
1.803
2.128
2.128
IFCI
0.675
0.797
0.941
1.109
1.308
IWCI
0.405
0.478
0.564
0.665
0.785
1.363
1.607
1.897
2.239
2.642
4.735
1.165
1.174
1.184
1.195
1.205
12.704
Cash flow
Discounted
cash flow
18.627m
Current value of marketable securities
5.000m
23.627m
Conclusion
The strategic option which will produce the most shareholder value is to sell division A and continue
with division B.
4 a Four-year planning horizon and 14% discount rate:
Year
5+
cash flows
1.331
1.504
1.700
1.921
2.812
Discounted cash flows (14%)
1.168
1.157
1.147
1.137
11.892
Operating free
PV of cash flows
Marketable securities
16.501m
5.000m
21.501m
Four-year planning horizon and 16% discount rate:

Year
5+
Discounted cash flows (16%) 1.147
1.118
1.089
1.061
9.707
PV of cash flows
14.122m
5.000m
19.122m
69
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Five-year planning horizon and 15% discount rate:
Year
6+
Sales
46.061
46.061
Profit
4.606
4.606
1.428
Tax
1.428
IFCI
0.583
IWCI
0.424
1.331
1.504
1.700
1.921
2.171
3.178
Discounted cash flow (15%)
1.157
1.137
1.118
1.098
1.079
10.534
PV of cash flows
16.123m
5.000m
21.123m
Six-year planning horizon and 15% discount rate:

Year
7+
46.061
52.049
52.049
5.205
5.205
Tax
1.614
1.614
IFCI
0.659
IWCI
0.479
Sales
Profit

Discounted cash flow (15%) 1.157
PV of cash flows
1.137
1.118
1.098
16.999m
5.000m
21.999m
Summary table
Required rate of return (m)
Planning horizon
4 years
70
14%
21.501
15%
16%
20.228
19.122
5 years
21.123
6 years
21.999
1.079
2.453
3.591
1.060
10.350
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Comment: Both factors examined have a significant effect on value created. Alongside these figures
management needs to consider the likelihood of either the discount rate or the planning horizon
changing, in order to judge the overall significance of the data generated.
The table does not contradict the conclusion from Question 3. The value generated by selling
division A and concentrating on division B at 29.248 is so much greater than the figures shown in
the table that it is highly unlikely that the planning horizon can be extended or the discount rate
reduced sufficiently to make the base case strategy the best alternative.
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Chapter 18
ENTIRE FIRM VALUE MEASUREMENT

LEARNING OUTCOMES
By the end of this chapter the reader will be able to explain the following value metrics, pointing out their
advantages and the problems in practical use:
total shareholder return;
wealth added index;
market value added;
excess return;
market to book ratio.
Total shareholder returns (TSR)

Single period:
dividend per share + (share price at end of period initial share price)
TSR =
initial share price
Multi-period:
Allow for intermediate dividends in an internal rate of return calculation.
Wealth added index (WAI)

WAI = Change in market capitalisation over a number of years
Less net additional money put into business by investors after
allowance for money returned to investors by dividends, etc.
Less required rate of return
Market value added (MVA)

MVA = market value invested capital
or, if the market value of debt (and preference shares) equals the book value of debt (and preference shares):
Equity MVA = Ordinary shares market value Capital supplied by ordinary shareholders
Excess return (ER)

Excess return
expressed in
present value terms
72
Actual wealth
expressed in
present value terms
Expected wealth
expressed in
present value terms
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Expected wealth is calculated as the value of the initial investment (plus any other monies placed in the
business by shareholders) in present value terms if it had achieved the required rate of return over the
time it has been invested in the business. Actual wealth is the present values of cash flows received by
shareholders, plus the current market value of the shares. Each cash flow received in past years needs
to be compounded up to the present:
Actual wealth
Present value of dividends

if the money received was
invested at the required
rate of return between
receipt and present time
Current market
value of shares
(market
capitalisation)
Market to book ratio (MBR)

market value
MBR =
capital invested
An alternative is the equity MBR:
market value of ordinary shares
MBR =
amount of capital invested by ordinary shareholders
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Chapter 19
THE COST OF CAPITAL

LEARNING OUTCOMES
calculate and explain the cost of debt capital, both before and after tax considerations;
describe the difficulties in estimating the equity cost of capital and explain the key elements that require
informed judgement;
calculate the weighted average cost of capital (WACC) for a company and explain the meaning of the
number produced;
describe the evidence concerning how UK companies actually calculate the WACC;
explain the outstanding difficulties in this area of finance.
The cost of capital is the rate of return that a company has to offer finance providers to induce them
to buy and hold a financial security.
The weighted average cost of capital (WACC) is calculated by weighting the cost of debt and equity in
proportion to their contribution to the total capital of the firm:
WACC = kEWE + kDATWD
The WACC can be lowered (or raised) by altering the proportion of debt in the capital structure:
Investors in shares require a return, kE, which provides for two elements:
a return equal to the risk-free rate; plus
a risk premium.
The most popular method for calculating the risk premium has two stages:
estimate the average risk premium for shares (rm rf); and:
adjust the average premium to suit the risk on a particular share.
The CAPM using a beta based on the relative co-movement of a share with the market has been used
for the second stage but other risk factors appear to be relevant.
An alternative method for calculating the required rate of return on equity is to use the Gordon growth
model:
d1
kE = + g
P
The cost of retained earnings is equal to the expected returns required by shareholders buying new
shares in a firm.
The cost of debt capital, kD, is the current market rate of return for a risk class of debt. The cost to the
firm is reduced to the extent that interest can be deducted from taxable profits:
kDAT = kDBT (1 T)
The cost of irredeemable constant dividend preference share capital is:

d1
kp =
Pp
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The weights in the WACC are based on market values, not balance sheet values.
For projects, etc. with similar risk to that of the existing set, use the WACC, which is based on the target debt to equity ratio. Do not use the cost of the latest capital raised.
For projects, SBUs, etc. of a different risk level from that of the firm, raise or lower the discount rate
in proportion to the risk.
Companies use a mixture of theoretically correct techniques with rules of thumb to calculate hurdle
rates of return.
Calculating a cost of capital relies a great deal on judgement rather than scientific precision. But there
is a theoretical framework to guide that judgement.
Difficulties remaining:
estimating the equity risk premium;

obtaining the risk free rate;
unreliability of the CAPMs beta.
Fundamental beta is based on factors thought to be related to systematic risk:
type of business;
operating gearing;
financial gearing.

1
Burgundy plc
a Cost of debt capital
105 =
10
1+r
10
(1 +
r)2
10
(1 +
r)3
110
(1 + r)4
Try 9%
10 2.5313
110 0.7084
25.313
77.924
103.237
Try 8%
10 2.5771
110 0.735
25.771
80.850
106.621
8%
106.621
105
8+
1.621
3.384
9%
103.237
(9 8) = 8.48%
kDAT = kDBT(1 T) = 8.48 (1 0.30) = 5.94%

b Cost of equity capital
kE = rf + (rm rf)
kE = 8 + 0.85 5.0 = 12.25%
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c WACC
WACC = kE WE + kDATWD
Weights:
Equity
Debt
4.00m
qpt
5m = 5.25m
Weight
4/9.25 = 0.43
5.25/9.25 = 0.57
9.25m
WACC = 12.25 0.43 + 5.94 0.57 = 8.65%
d Consult Chapter 19.
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Chapter 20
VALUING SHARES
LEARNING OUTCOMES
describe the principal determinants of share prices and be able to estimate share value using a variety
of approaches;
demonstrate awareness of the most important input factors and appreciate that they are difficult to
quantify;
use valuation models to estimate the value of shares when managerial control is achieved.
Knowledge of the influences on share value is needed by:

a managers seeking actions to increase that value;
b investors interested in allocating savings.
Share valuation requires a combination of two skills:

a analytical ability using mathematical models;
b good judgement.
The net asset value (NAV) approach to valuation focuses on balance sheet values. These may be adjusted to reflect current market or replacement values.
Advantage: objectivity.
Disadvantages: excludes many non-quantifiable assets;
less objective than is often supposed.
Asset values are given more attention in some situations:

firms in financial difficulty;
takeover bids;
when discounted income flow techniques are difficult to apply, for example in property investment
companies, investment trusts, resource-based firms.
Income flow valuation methods focus on the future flows attributable to the shareholder. The past is
only useful to the extent that it sheds light on the future.
The dividend valuation models (DVM) are based on the premise that the market value of ordinary shares
represents the sum of the expected future dividend flows to infinity, discounted to a present value.
A constant dividend valuation model:

d
P0 = 1
kE
The dividend growth model:

d1
P0 =
kE g
This assumes constant growth in future dividends to infinity.
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Problems with dividend valuation models:

highly sensitive to the assumptions;
the quality of input data is often poor;
g cannot be greater than kE, but then, on a long-term view, it would not be.
Factors determining the growth rate of dividends:

the quantity of resources retained and reinvested;
the rate of return earned on retained resources;
the rate of return earned on existing assets.
How to calculate g some pointers:

a Focus on the firm:
evaluate strategy;
evaluate the management;
extrapolate historic dividend growth;
financial statement evaluation and ratio analysis.
b Focus on the economy.
The historic price-earnings ratio (PER) compared with PERs of peer firms is a crude method of valuation (it is also very popular):
Historic PER =
Current market price of share

Last years earnings per share
Historic PERs may be high for two reasons:

the company is fast growing;
the company has been performing poorly, has low historic earnings, but is expected to improve.
The linking factor is the anticipation of high future growth in earnings. Risk is also reflected in differences between PERs.
The more complete PER model:

d /E
P0
= 1 1
E1
kE g
This is a prospective PER model because it focuses on next years dividend and earnings.
The discounted cash flow method:

t=n
P0 = (C/(1 + kE)t)
t=1
For constant cash flow growth:

P0 =
C1
kE g
The owner earnings model requires the discounting of the companys future owner earnings which are
standard expected earnings after tax plus non-cash charges less the amount of expenditure on plant,
machinery and working capital needed for the firm to maintain its long-term competitive position and
its unit volume and to make investment in all new value-creating projects.
Additional factors to consider when valuing unquoted shares:
78
lower quality and quantity of information;

more risk;
less marketable;
may involve golden hand-cuffs or earn-outs;
adjustment for over or under-paying of director-owners.
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Some companies are extraordinarily difficult to value; therefore proxies are used for projected cash
flow, such as:
telemedia valuations: multiply the number of lines, homes served or doors passed;
advertising agencies: annual billings;
fund managers: funds under control;
hotels: star ratings and bedrooms.
Control over a firm permits the possibility of changing the future cash flows. Therefore a share may be
more highly valued if control is achieved.
A target company could be valued on the basis of its discounted future cash flows, e.g.:
C1*
kE gc*
V=
Alternatively, the incremental flows expected to flow from the company under new management could
be discounted to estimate the bid premium (d1*, C1*, and g* are redefined to be incremental factors only):
P0 =
d1*
g*
kE
or V =
C1*
kE gc*
Real options or contingent claim values may add considerably to a shares value.

8 Lanes plc
a Value to Roberts
5
g=
1.4
1 = 0.0696 or 6.96%
1.0
C1
1.4(1.0696)
P0 =
=
= 24.792m
kE g 0.13 0.0696
b Value to Lanes
Value in present state
Value of annual savings
1 + 0.2 + 0.15
=
0.13
Distribution depot
24.792
10.385
1.800
36.977m
10 Dela plc
a Net asset value
Shareholders funds
Add additional fixed assets
Less overstated stocks
overstated debtors
Net asset value
m
130
50
180
30
30
120
b Drawbacks of NAV
In most firms, most of the time, the determinants of value are future income flows.
A firms assets are more than its balance sheet entries, e.g. brand values, competitive position.
Accounts are not designed to display up-to-date values (fixed assets are usually historic; many are
subjective estimates with potential for cynical manipulation).
c
Firms in financial difficulties.

Firms subject to a takeover bid.
Some firms are more appropriately valued by NAV (property investment firms, investment
trusts, natural resources companies).
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d kE = rf + (rm rf) = 6.5 + 1.2(5) = 12.5%
7
10
1 = 0.1041
5
g=
P0 =
e P0
E1
f
d0(1 + g)
10(1 + 0.1041)
=
= 528p
kE g
0.125 0.1041
d1/E1
kE g
96.50 +
10(1 + 0.1041)/20(1 + 0.1041)

0.125 0.1041
8
8
108
+
+
1+r
(1 + r)2 (1 + r)3
10
0.9687
1.47
9+
= 23.9
0.9687
= 9.4
0.9687 + 1.47
kDAT = 9.4(1 0.30) = 6.58

Equity 5.28 1,000m =
96.50
Debt
50
100
5,280.00m
48.25m
5,328.25m
WACC = kE WE + kDAT WD
= 0.125
5,280
48
+ 0.0658
5,328
5,328
= 0.124 or 12.4%
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Chapter 21
CAPITAL STRUCTURE
LEARNING OUTCOMES
The level of debt relative to ordinary share capital is, for most firms, of secondary consideration behind
strategic and operational decisions. However, if wealth can be increased by getting this decision right managers need to understand the key influences. By the end of the chapter the reader should be able to:
discuss the effect of gearing, and differentiate business and financial risk;
describe the underlying assumptions, rationale and conclusions of Modigliani and Millers models, in
worlds with and without tax;
explain the relevance of some important, but often non-quantifiable, influences on the optimal gearing
level question.
Financial gearing concerns the proportion of debt in the capital structure.
Operating gearing refers to the extent to which the firms total costs are fixed.
Capital gearing can be measured in a number of ways. For example:

1
Long-term debt
Shareholders funds
2
Long-term debt
Long-term debt + Shareholders funds
All borrowing
All borrowing + Shareholders funds
Long-term debt
Total market capitalisation
Income gearing is concerned with the proportion of the annual income stream which is devoted to the
prior claims of debt holders.
The effect of financial gearing is to magnify the degree of variation in a firms income for shareholders
returns.
Business risk is the variability of the firms operating income (before interest).
Financial risk is the additional variability in returns to shareholders due to debt in the financial structure.
In Modigliani and Millers perfect no-tax world three propositions hold true:
1 The total market value of any company is independent of its capital structure.
2 The expected rate of return on equity increases proportionately with the gearing ratio.
3 The cut-off rate of return for new projects is equal to the weighted average cost of capital which
is constant regardless of gearing.
In an MM world with tax the optimal gearing level is the highest possible.
The risk of financial distress is one factor which causes firms to moderate their gearing levels. Financial
distress is where obligations to creditors are not met, or are met with difficulty.
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The indirect costs of financial distress, such as deterioration in relationships with suppliers, customers
and employees, can be more significant than the direct costs, such as legal fees.
Financial distress risk is influenced by the following:

the sensitivity of the companys revenues to the general level of economic activity;
the proportion of fixed to variable costs;
the liquidity and marketability of the firms assets;
the cash-generative ability of the business.
Agency costs are the direct and indirect costs of ensuring that agents (e.g. managers) act in the best
interests of principals (e.g. shareholders, lenders), for example monitoring costs, restrictive covenants,
loss of managerial freedom of action and opportunities forgone.
Financial distress and agency costs eventually outweigh the lower cost of debt as gearing rises causing
the WACC to rise and the firms value to fall. (The trade-off theory)
Borrowing capacity is determined by the assets available as collateral this restricts borrowing.
There is often a managerial preference for a lower risk stance on gearing.
The pecking order of finance:

1 internally generated funds;
2 borrowings;
3 new issue of equity.
The reasons for the pecking order:
equity issue perceived as bad news by the markets;
line of least resistance;
transaction costs.
Market timing theory is founded on the observation that firms tend to issue shares when their share
price is high and repurchase shares when it is low. This leads to the idea of an absence of a movement
towards an optimal capital structure in the short or long term. However, the evidence suggests that in
the medium or long term firms do move towards a target optimal debt/equity ratio.
Financial slack means having cash (or near-cash) and/or spare debt capacity so that opportunities can
be exploited quickly (and trouble avoided) as they arise in an unpredictable world and to provide a
contingency reserve it tends to reduce borrowing levels.
Signalling An increased gearing level is taken as a positive sign by the financial markets because managers would only take the risk of financial distress if they were confident about future cash flows.
The source of finance chosen may be determined by the effect on the control of the organisation.
Tax exhaustion (profit insufficient to take advantage of debts tax shield benefit) may be a factor limiting debt levels.
Managers may be tempted to adopt the industry group gearing level.
It is suggested that high gearing motivates managers to perform if they have a stake in the business, or
if a smaller group of shareholders are given the incentive to monitor and control managers.
Reinvestment risk is diminished by high gearing.
It is argued that operating and strategic efficiency can be pushed further by high gearing.
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1 Vodafone plc
Capital gearing ratios:
Capital gearing (1) =
Long-term debt
17,798
=
= 26.4%
Shareholders funds 67,293
Long-term debt
17,798
= 20.9%
Long-term debt + shareholders funds
17,798 + 67,293
All borrowing
17,798 + 4,817
=
= 25.2%
All borrowing + shareholders funds
17,798 + 4,817 + 67,293
Long-term debt
Total market capitalisation
17,798
93,300
= 19.1%
Note: Some students may include other non-current liabilities this is acceptable.
Income gearing:
Interest charges
Profit before interest and taxation
Interest cover:
Profit before interest and taxation
Interest charges
1612
9200
9200
1612
= 17.5%
= 5.7%
Comments
Apparently relatively low gearing levels/low financial risk. (However, most of Vodafones assets are
goodwill arising from acquisitions.)
Very difficult to measure gearing with precision due to the alternative inputs and metrics.
Off-balance sheet finance could, if included, present a different picture.
Should be focused on market values rather than on balance sheet values.
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Chapter 22
DIVIDEND POLICY
LEARNING OUTCOMES
This area of finance has no neat over-arching theoretical model to provide a simple answer. However,
there are some important arguments which should inform the debate within firms. By the end of this chapter the reader should be able to:
explain the rationale and conclusion of the ideas of Modigliani and Millers dividend irrelevancy
hypothesis, as well as the concept of dividends as a residual;
describe the influence of particular dividend policies attracting different clients as shareholders, the
effect of taxation and the importance of dividends as a signalling device;
outline the hypothesis that dividends received now, or in the near future, have much more value than
those in the far future because of the resolution of uncertainty and the exceptionally high discount rate
applied to more distant dividends;
discuss the impact of agency theory on the dividend decision;
discuss the role of scrip dividends and share repurchase (buy back).
Dividend policy concerns the pattern of dividends over time and the extent to which they fluctuate from
year to year.
UK-quoted companies generally pay dividends every six months an interim and a final. They may
only be paid out of accumulated profits.
Modigliani and Miller proposed that, in a perfect world, the policy on dividends is irrelevant to shareholder wealth. Firms are able to finance investments from retained earnings or new share sales at the
same cost (with no transaction costs). Investors are able to manufacture homemade dividends by selling a portion of their shareholding.
In a world with no external finance, dividend policy should be residual.
In a world with some transaction costs associated with issuing dividends and obtaining investment
finance through the sale of new shares, dividend policy will be influenced by, but not exclusively determined by, the dividends as a residual approach to dividend policy.
The clientele effect is the concept that shareholders are attracted to firms that follow dividend policies
consistent with their objectives. The clientele effect encourages stability in dividend policy.
Taxation can influence the investors preference for the receipt of high dividends or capital gains from
their shares.
Dividends can act as conveyors of information. An unexpected change in dividends is regarded as a signal of how directors view the future prospects of the firm.
It has been argued (e.g. by Myron Gordon) that investors perceive more distant dividends as subject to
more risk; therefore they prefer a higher near-term dividend a bird in the hand. This resolution of
uncertainty argument has been attacked on the grounds that it implies an extra risk premium on the
rate used to discount cash flows.
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The owner control argument says that firms are encouraged to distribute a high proportion of earnings
so that investors can reduce the principalagent problem and achieve greater goal congruence. Managers
have to ask for investment funds; this subjects their plans to scrutiny.
A scrip dividend gives the shareholders an opportunity to receive additional shares in proportion to
their existing holding instead of the normal cash dividend.
A share repurchase is when the company buys a proportion of its own shares from investors.
A special dividend is similar to a normal dividend but is usually bigger and paid on a one-off basis.
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Chapter 23
MERGERS
LEARNING OUTCOMES
The study of mergers is a subject worthy of a textbook in its own right. This chapter provides an overview
of the subject and raises the most important issues. By the end of the chapter the reader should be able to:
describe the rich array of motives for a merger;
express the advantages and disadvantages of alternative methods of financing mergers;
describe the merger process and the main regulatory constraints;
comment on the question: Who benefits from mergers?;
discuss some of the reasons for merger failure and some of the practices promoting success.
Mergers are a form of investment and should, theoretically at least, be evaluated on essentially the same
criteria as other investment decisions, for example using NPV. However, there are complicating factors:
the benefits from mergers are difficult to quantify;
acquiring companies often do not know what they are buying.
A merger is the combining of two business entities under common ownership. It is difficult for many
practical purposes to draw a distinction between merger, acquisition and takeover.
A horizontal merger is when the two firms are engaged in similar lines of activity.
A vertical merger is when the two firms are at different stages of the production chain.
A conglomerate merger is when the two firms operate in unrelated business areas.
Merger activity has occurred in waves. Cash is the most common method of payment except at the
peaks of the cycle when shares are a more popular form of consideration.
Synergistic merger motives:

market power;
economies of scale;
internalisation of transactions;
entry to new markets and industries;
tax advantages;
risk diversification.
Bargain-buying merger motives:

elimination of inefficient and misguided management;
undervalued shares.
Managerial merger motives:

empire building;
status;
power;
remuneration;
hubris;
survival;
free cash flow.
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Third-party merger motives:

advisers;
at the insistence of customers or suppliers.
Value is created from a merger when the gain is greater than the transaction cost.
PVAB = PVA + PVB + gain
The gain may go to As shareholders, or Bs, or be shared between the two.
The winners curse is when the acquirer pays a price higher than the combined present value of the target and the potential gain.
Cash as a means of payment
For the acquirer

Advantages
Acquirers shareholders retain control of their firm.
Greater chance of early success.
Disadvantages
Cash flow strain.
For the target shareholders

Advantages
Certain value.
Able to spread investments.
Disadvantages
May produce capital gain tax liability.
Shares as a means of payment

For the acquirer
Advantages
No cash outflow.
The PER game can be played.
For the target shareholders

Advantages
Postponement of capital gains tax liability.
Target shareholders maintain an interest in the
combined entity.
Disadvantages
Dilution of existing shareholders control.
Greater risk of overpaying.
Unquoted acquirers may not be able to
do this.
Disadvantages
Uncertain value.
Not able to spread investment without
higher transaction costs.
The City Code on Takeovers and Mergers provides the main governing rules. It applies to quoted and
unlisted public companies. It is self-regulatory with some statutory back-up but powerful. Its objective is to ensure fair and equal treatment for all shareholders.
The Office of Fair Trading (OFT) and the Competition Commission investigate potential cases of competition constraints.
Pre-bid:
advisers appointed;
targets identified;
appraisal;
approach target;
negotiate.
A dawn raid is where a substantial stake is acquired with great rapidity.
Shareholdings of 3% or more must be notified to the company.
A stake of 30% usually triggers a bid.
Concert parties, where a group of shareholders act as one, but each remains below the 3% or 30%
trigger levels, are now treated as one large holding for the key trigger levels.
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The bid
notice to targets board;
offer document sent within 28 days;
target management responds to offer document;
offer open for 21 days, but can be frequently revised and thereby kept open for up to 60 days (or
longer if another bidder enters the fray).
Post-bid
When a bid becomes unconditional (usually at 50% acceptances), the acquirer is making a firm offer
and no better offer is to follow.
Target firms are not on average poor performers relative to others in their industry.
Society sometimes benefits from mergers but most studies suggest a loss, often through the exploitation
of monopoly power.
The shareholders of acquirers tend to receive returns lower than the market as a whole after the merger.
However, many acquirers do create value for shareholders.
Target shareholders, directors of acquirers and advisers gain significantly from mergers. For the directors of targets and other employees the evidence is mixed.
There are three stages of mergers. Most attention should be directed at the first and third, but this does
not seem to happen. These stages are:
preparation;
negotiation and transaction;
integration.
Non-quantifiable, soft, human elements often determine the success or otherwise of mergers.
Mergers fail for three principal reasons:

the strategy is misguided;
overoptimism;
failure of integration management.

1 Large plc
a Value gain = 110m 60m 30m 3m = 17m
Bid premium is greater at 20m and therefore the
merger does not create value for Large plc.
Large plc shareholders lose value:
Value after merger
Less value before merger
price paid
transaction costs
Loss of value
b 50m
45m
110m
60m
50m
3m
3m
= 111.11p
c If cash is paid:
107m 50m
30m
88
= 1.90
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3 a 2.5m
0.11
1m = 21.727m
b 1.727m
c Value of two-thirds of merged entity:
0.6667(100m + 50m + 21.727m) = 114.485m
Value created for Boxs shareholders:
114.484m 100m = 14.485m
4 High plc
a (1,000/5)3 = 600 shares in High.
Value of one share in High:
20m
22 = 4.40
100m
Value of holding after acceptance 4.40 600 =
Value of holding before 0.2 12 1,000 =
Wealth increase
b Bid premium
Value of offer 2.64 100m =
less previous value 2.4 100m =
2,640
2,400
240
264m
240m
24m
or 24p per share or 10%

c 40m 22
160m
= 5.50
d 40m (22 0.5 + 12 0.5)

160m
= 4.25
e Consult chapter.
5 a Value of a share in B prior to merger:
P =
5(1.05)
d0 (1 + g)
=
= 75p
kE g
0.12 0.05
Value of a share in B after merger:

P =
5(1.08)
= 135p
0.12 0.08
Total value creation:

135p 3m
Less transaction costs
Less value prior to merger 75p 3m

Value creation
4.05m
0.40m
3.65m
2.25m
1.40m
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b Bs shareholders:
3m (1.20 0.75)
As shareholders:
3m (1.35 1.20)
Value for A
1.35m
=
=
0.45m
0.40m
0.05m
c Value of combined company = 3.65m + 45m = 48.65m

Number of shares:
3m
5m + = 5.42857m
7
Value of each share:
48.65m/5.42857m = 8.962
Shareholders in A now have a holding of :
5m 8.962 = 44.809m
(a reduction of 0.1908m)
Shareholders in B now have a holding of:
0.42857m 8.962 = 3.8408m
(a rise of 1.5908m)
d Cash offer
Bs shareholders:
3m (1.20 0.75)
As shareholders:
3m (0.75 1.20)
Loss in value
1.35m
= 1.35m
= 0.40m
= 1.75m
Share offer
Value of combined company =
9 5m + 0.75 3m 0.4m = 46.85m
Total number of shares
= 5m +
Value per share
3m
7
= 5.42857m
46.85m
5.42857m
= 8.6303
Bs shareholders hold 0.42857m shares in A

with a value of 8.6303 0.42857m = 3.6987m.
This is 1.45m more than previously. Value gain = 1.45m.
As shareholders:
5m 8.6303
Previous value
Loss in value
90
43.15m
45.00m
1.85m
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Chapter 24
DERIVATIVES
LEARNING OUTCOMES
This chapter describes the main types of derivatives. Continued innovation means that the range of
instruments broadens every year but the new developments are generally variations or combinations
of the characteristics of derivatives discussed here. At the end of this chapter the reader should be
able to:
explain the nature of options and the distinction between different kinds of options, and demonstrate
their application in a wide variety of areas;
show the value of the forwards, futures, FRAs, swaps, caps and floors markets by demonstrating transactions which manage and transfer risk.
A derivative instrument is an asset whose performance is based on the behaviour of an underlying asset
(the underlying).
An option is a contract giving one party the right, but not the obligation, to buy (call option) or sell
(put option) a financial instrument, commodity or some other underlying asset, at a given price, at or
before a specified date.
The writer of a call option is obligated to sell the agreed quantity of the underlying some time in the
future at the insistence of the option purchaser (holder). A writer of a put is obligated to sell.
American-style options can be exercised at any time up to the expiry date whereas European-style
options can only be exercised on a predetermined future date.
An out-of-the-money option is one that has no intrinsic value.
An in-the-money option has intrinsic value.
Time value arises because of the potential for the market price of the underlying, over the time to expiry
of the option, to change in a way that creates intrinsic value.
Share options can be used for hedging or speculating on shares. Share index options can be used to
hedge and speculate on the market as a whole. Share index options are cash settled.
Corporate uses of derivatives include:

share options schemes;
warrants;
convertible bonds;
rights issues;
share underwriting;
commodity options;
taking control of a company;
protecting the company from foreign exchange losses;
real options.
A forward contract is an agreement between two parties to undertake an exchange at an agreed future
date at a price agreed now. Forwards are tailor-made, allowing flexibility.
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Futures are agreements between two parties to undertake a transaction at an agreed price on a specified future date. They are exchange-traded instruments with a clearing house acting as counterparty to
every transaction standardised as to:
quality of underlying;
quantity of underlying;
legal agreement details;
delivery dates;
trading times;
margins.
For futures, initial margin (0.1% to 15%) is required from each buyer or seller. Each day profit or losses
are established through marking to market, and variation margin is payable by the holder of the future
who loses.
The majority of futures contracts are closed (by undertaking an equal and opposite transaction) before
expiry and so cash losses or profits are made rather than settlement by delivery of the underlying. Some
futures are settled by cash only there is no physical delivery.
Short-term interest-rate futures can be used to hedge against rises and falls in interest rates at some
point in the future. The price for a 500,000 notional three-month contract is expressed as an index:
P = 100 i
As interest rates rise the value of the index falls.
Forward rate agreements (FRAs) are arrangements whereby one party compensates the other should
interest rates at some point in the future differ from an agreed rate.
An interest rate cap is a contract that gives the purchaser the right effectively to set a maximum interest rate payable through the entitlement to receive compensation from the cap seller should market
interest rates rise above an agreed level. The cap seller and the lender are not necessarily the same.
A floor entitles the purchaser to payments from the floor seller should interest rates fall below an
agreed level. A collar is a combination of a cap and a floor.
A swap is an exchange of cash payment obligations. An interest-rate swap is where interest obligations
are exchanged. In a currency swap the two sets of interest payments are in different currencies.
Some motives for swaps:

to reduce or eliminate exposure to rising interest rates;
to match interest-rate liabilities with assets;
to exploit market imperfections and achieve lower interest rates.
Hedgers enter into transactions to protect a business or assets against changes in some underlying.
Speculators accept high risk by taking a position in financial instruments and other assets with a view
to obtaining a profit on changes in value.
Arbitrageurs exploit price differences on the same or similar assets.
Over-the-counter (OTC) derivatives are tailor-made and available on a wide range of underlyings. They
allow perfect hedging. However they suffer from counterparty risk, low regulation and frequent inability to reverse a hedge.
Exchange-traded derivatives have lower credit (counterparty) risk, greater regulation, higher liquidity and
greater ability to reverse positions than OTC derivatives. However, standardisation can be restrictive.

6 a In October, sell 30,000,000/(5020 10) = 598 March future contracts @ 5035.
Then in March close the position by buying 598 March contracts.
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b FTSE 100 Index @ 4000:
Loss on shares
1020
30,000,000 = 6,095,618
5020
Gain on futures:
Able to buy @ 4000
598 10 4000
Able to sell @ 5035
598 10 5035
Gain on futures
23,920,000
30,109,300
6,189,300
Overall gain 6,189,300 6,095,618 = 93,682

FTSE 100 Index @ 6000:
Gain on shares
980
5020
30,000,000 = 5,856,574
Loss on futures:
Able to buy @ 6000
598 10 6000
Able to sell @ 5035
598 10 5035
Loss on futures
35,880,000
30,109,300
5,770,700
Overall gain 5,856,574 5,770,700 = 85,874

c Profit and loss diagram for futures strategy
Profit m
11.8
Share
portfoilio
6.19
5.9
Combination
0.1
3,000
4,000
5,020
6,000
Index level
7,000
5.77
6.1
Futures
12.07
Loss
Fig. 24.1
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Futures hedging total values
m
35.86
Share portfolio
30
Combination
23.90
6.19
0.1
4,000
5,020
5,035
6,000
Index level
Futures
5.77
Fig. 24.2
8 a FRA The treasurer agrees a 6 against 9 FRA whereby the counterparty will pay compensation to the
company should interest rates fall below 8%. These payments will exactly offset any loss of interest
below 8%. However, if interest rates rise above 8% the company will pay compensation to the counterparty such that the company effectively receives 8% return on deposited money. Certainty is
achieved.
Interest rate future
Three-month sterling interest future contracts (September contracts) are bought at 92.00. Each contract is for a nominal 500,000; therefore 40 contracts are bought to hedge the full 20m. If interest rates fall, the rise in the value of the future will offset the fall in the interest on deposited money.
b FRA
Interest rates at 7%
The loss on the underlying:
&e&
20,000,000 0.01 _
The counterparty pays compensation to equal this loss
Overall loss due to interest rate changes
= 50,000
=
50,000
0
Gain on the underlying:
&e&
20,000,000 0.01 _
=
The counterparty receives compensation to equal this gain
94
50,000
50,000
0
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Interest rate future
Loss on the underlying
Futures sold at 93.00 in September
100 ticks 12.50 40
50,000
50,000
0
Gain on the underlying
Futures position is closed by selling at 91.00 in September
Loss: 100 ticks 12.50 40
50,000
50,000
0
9 Black plc and White plc

a
Libor + 150 b.p.
Currently 9.5%
Black
White
Fixed interest 9%
Libor + 150 b.p.

Currently 8 + 1.5 = 9.5%
Fixed interest @ 9%
Bank A
Bank B
Fig. 24.5
b
Future variable interest rates may fall below 9% (i.e. Libor @ 7.5%). This will impose an opportunity cost of entering the swap arrangement.
Black must accept the possibility of counterparty default.
Transaction costs (e.g. legally binding contracts) may be considerable.
Black needs to consider its overall asset and liability profile.
c The cap seller compensates Black:

50,000,000 (0.11 0.095)
Black pays interest @ 11 + 1.5
50,000,000 0.125
=
=
=
750,000
12.5% to Bank A:
6,250,000
The compensation from the cap seller means that Black will not pay more than 5.5m (net)
d Consult main text, Chapter 24.
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Chapter 25
MANAGING EXCHANGE-RATE RISK

LEARNING OUTCOMES
explain the role and importance of the foreign exchange markets;
describe hedging techniques to reduce the risk associated with transactions entered into in another currency;
consider methods of dealing with the risk that assets, income and liabilities denominated in another
currency, when translated into home-currency terms, are distorted;
describe techniques for reducing the impact of foreign exchange changes on the competitive position of
the firm;
outline the theories designed to explain the reasons for currency changes.
An exchange rate is the price of one currency expressed in terms of another.
Exchange rates are quoted with a bid rate (the rate at which you can buy) and an offer rate (the rate
at which you can sell).
Forex shifts can affect:

income received from abroad;
amounts paid for imports;
the valuation of foreign assets and liabilities;
the long-term viability of foreign operations;
the acceptability of an overseas project.
The foreign exchange market grew dramatically over the last quarter of the twentieth century. Over
US$1,200bn is traded each day. Most of this trading is between banks rather than for underlying (for
example, import/export) reasons.
Spot market transactions take place which are to be settled quickly (usually one or two days later). In
the forward market a deal is arranged to exchange currencies at some future date at a price agreed now.
Transaction risk is the risk that transactions already entered into, or for which the firm is likely to have
a commitment, in a foreign currency will have a variable value.
Translation risk arises because financial data denominated in one currency then expressed in terms of
another are affected by exchange-rate movements.
Economic risk Forex movements cause a decline in economic value because of a loss of competitive
strength.
Transaction risk strategies:

invoice customer in home currency;
do nothing;
netting;
matching;
leading and lagging;
forward market hedge;
money market hedge;
96
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futures hedge;
currency option hedge.
One way of managing translation risk is to try to match foreign assets and liabilities.
The management of economic exposure requires the maintenance of flexibility with regard to manufacturing (for example, location of sources of supply), marketing (for example, advertising campaign,
pricing) and finance (currency).
The purchasing power parity (PPP) theory states that exchange rates will be in equilibrium when their
domestic purchasing powers at that rate are equivalent. In an inflationary environment the relationship
between two countries inflation rates and the spot exchange rates between two points in time is (with
the USA and the UK as examples):
1 + IUS
1 + IUK
US$/1
US$/0
The interest rate parity (IRP) theory holds true when the difference between spot and forward exchange
rates is equal to the differential between the interest rates available in the two currencies. Using the USA
and the UK currencies as examples:
1 + rUS
US$/F
=
1 + rUK
US$/S
The expectations theory states that the current forward exchange rate is an unbiased predictor of the
spot rate at that point in the future.
The Fundamental Equilibrium Exchange Rate (FEER) is the exchange rate that results in a sustainable
current account balance.
Flows of money for investment in financial assets across national borders can be an important influence
on forex rates.
The currency markets are generally efficient, but there is evidence suggesting pockets of inefficiency.

4 a (i) Forward market hedge
Agree to buy R150m of sterling three months forward
150
= 20m
7.5
If spot rate in three months is R7.00/ and the exchange was made at spot rate, then:
qtp
&&&
=
21.428m
Sterling income &
Income due to forward commitment
=
20.000m
Loss due to inability to exchange at spot
1.428m
If the spot rate in three months is R8.00/ and the exchange was made at spot rate, then:
qtp
&^&
Sterling income &
=
18.75m
Income due to forward commitment
=
20.00m
Gain due to forward contract
1.25m
(ii) Money market hedge
Borrow in Rand now an amount which, with accumulated interest, will become R150m in three
months. Exchange this sum at the current spot rate for sterling. In three months pay lender with sum
received from customer.
Amount borrowed now
150m
1 + 0.025
R146.3415m
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Exchanged at spot for sterling
146.341
7.46
19.6168m
(Note: Certainty about income from the export deal because sterling is received now.)
In three months:
Amount owed to lender 146.3415m 1.025
Repay lender with amount received from customer
=
=
R150m
R150m
If exchange rates move to R7.00/:

Loss due to lost opportunity to exchange at spot 21.428m 19.6168m
(less interest on sterling for three months)
= 1.8112m
If exchange rates move to R8.00/:

Gain due to money market hedge 19.6168m 18.75m
(plus interest on sterling for three months)
= 0.8668m
(iii) Option hedge

Buy Rand put sterling call option.
In three months consider whether to exercise this in the light of knowledge of spot rates.
If spot rate R7.00/:
qtp
&&&
Exchange R150m at spot &
(let the option lapse)
less cost of option (premium)
21.428m
0.400m
21.028m
If spot rate R8.00/:
.
Exercise option to exchange @ R7.5/ qtp
less cost of option (premium)
20.000m
0.400m
19.600m
This is better than having to exchange @ R8.00/ which would have produced merely 18.75m.
9 Lozenge plc
Numerical aspects only. (Students should also describe and explain instruments and methods used.
They should consider the advantages and disadvantages of each for more details of these consult the
chapter).
Forward market hedge
At the current time agree a forward contract whereby Lozenge plc will purchase 12 50,000 =
,
.
ppp = 110,599 to the counterparty
M$600,000 in three months. To do this it will need to provide ypp
in three months.
Then, if the Malaysian dollar rises against sterling in the intervening period, Lozenge will not have
to pay more than 110,599. Say the exchange rate moved to M$4.00/: an unhedged Lozenge would
.,
ppp
= 150,000. Hedging has saved the firm a sum of 150,000 110,599. On the other
pay ypp
hand, the firm cannot take advantage of a favourable forex move.
If the Malaysian dollar had weakened to M$7.00/ and the firm was able to exchange at the spot
rate, it would pay only ypp
,
ppp
&& && = 85,714. Thus, 110,599 85,714 = 24,885 forgone by entering
into the forward contract.
Option hedge
An option permits the firm to benefit from a favourable exchange rate while hedging against an
unfavourable movement. However, a premium has to be paid, which reduces net income.
Lozenge could purchase the right, but not the obligation, to sell sterling and buy Malaysian dollars
,
,
at a cost of ypp
ppp = 110,599 for a premium of

qt.
ppp
= 2,769.
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If the Malaysian dollar strengthens to M$4.00/, then Lozenge will exercise the right to purchase at
M$5.425/. This will save 150,000 110,599 2,769 = 36,632 compared with a no hedge policy.
If the Malaysian dollar weakens against sterling to M$7.00/, then Lozenge will abandon the option
and exchange at the spot rate.
Cost of imports:
600,000
+ 2,769 = 88,483.
7
This is cheaper than if a forward contract approach or money market approach were adopted, but
more expensive (due to the option premium) than if a no hedge approach were adopted.
Money market hedge
Exchange sterling now for Malaysian dollars, so that there will be M$600,000 with accumulated interest in three months:
600,000
= M$582,524
1.03
Sterling required =
582,524
5.4165
= 107,546
If the sterling is borrowed, then to be comparable with the alternative hedging approaches (which
involve the handing over of sterling in three months), we need to increase by three months interest:
107,546 (1.03) = 110,773
In three months:
Pay supplier with Malaysian dollars already purchased (including accumulated interest) M$600,000.
99

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First published under the Financial Times

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Also: The regularly maintained Companion Website provides the following

For each chapter:

Overhead projector transparency masters

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Essay answer required

1, 2, 3, 7, 8, 9, 10, 11, 12,

17, 911, 1319

1, 2, 3, 4, 5, 6, 10, 11, 13, 16 7

8, 9, 12, 14, 15, 1720

3a, 6, 8, 23, 25a

2, 3b, 11, 12, 1322, 24, 25b, 25c

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THE FINANCIAL WORLD

explain the role of the financial manager;

detail the value of financial intermediaries;

KEY POINTS AND CONCEPTS

Pearson Education Limited 2008

Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

Pearson Education Limited 2008

Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

Long-term savings institutions:

The risk spreaders:

The risk takers:

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PROJECT APPRAISAL: NET PRESENT VALUE

calculate net present value and internal rate of return;

KEY POINTS AND CONCEPTS

The net present value decision rules are:

The internal rate of return decision rule is:

Pearson Education Limited 2008

Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

The IRR decision rule is reversed for financing-type decisions.

NPV measures in absolute amounts of money. IRR is a percentage measure.

ANSWERS TO SELECTED QUESTIONS

Pearson Education Limited 2008

Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

(23 22) = 22.4%

Pearson Education Limited 2008

Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

additivity not possible;

the reinvestment assumption is flawed.

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PROJECT APPRAISAL: CASH FLOW

the replacement decision/the replacement cycle;

the calculation of annual equivalent annuities;

the make or buy decision;

optimal timing of investment;

fluctuating output situations.

KEY POINTS AND CONCEPTS

Depreciation is not a cash flow and should be excluded.

Pearson Education Limited 2008

Glen Arnold, Corporate Financial Management Lecturers Guide, 4th edition

ANSWERS TO SELECTED QUESTIONS

Design & build