1.

0 Introduction

Definitions

Risk− a condition in which several possible outcomes exist, the probabilities of which can be quantified
from historical data.
Uncertainty− the inability to predict possible outcomes due to a lack of historical data (i.e. information)
being available for quantification.

Key Points

Although the terms risk and uncertainty are often used interchangeably, only risk is measurable.
The major risk to the success of an investment project will be the variability of future cash flows. This
could be the variability of income streams or the variability of cost cash flows, or a combination of both.

In general, risky projects are those whose predicted possible future cash flows, and therefore the project returns, are more variable. The greater the variability, the greater the risk. The risk
associated with capital investments is increased because expenditure and benefit estimates might be for several years in the future: costs might escalate and long-term benefits can only be
estimated.
Note that uncertainty increases as a project’s life increases.

2.0 Introduction

Definition

Sensitivity analysis – the analysis of changes made to significant variables in order to determine their
effect on a planned course of action.
In project appraisal, sensitivity analysis is used to analyse the effect of changes in the value of an input variable (occasionally more than one input variable), assuming other inputs are kept constant.
The cash flows, probabilities or cost of capital are varied until the decision changes (i.e. NPV becomes zero). This will show the sensitivity of the decision to changes in those variables.
Therefore, the estimation of IRR is an example of sensitivity of the project’s NPV to changes in the cost of capital.
Sensitivity analysis can also be referred to as "what if?" analysis.

2.1 Method

Sensitivity analysis has TWO steps:

Step 1 Calculate the NPV of the project on the basis of best estimates.

For each element of the decision (cash flows, cost of capital), calculate the change necessary
Step 2 for the NPV to fall to zero.
The sensitivity can be expressed as a percentage change for an individual cash flow:
Sensitivity = × 100
The lower the percentage, the more sensitive the NPV is to that project variable, as the variable would need to change by a smaller amount to make the project non-viable.

Key Point

For a change in sales volume, the relevant cash flow is contribution. This may involve combining a
number of cash flows (i.e. revenue and variable costs).
Activity 1 Sensitivity Analysis

Williams has just set up a company, JPR Manufacturing Company, and estimates its cost of capital to be 15%. His first project involves investing $150,000 in equipment which has a life of 15 years
and a final scrap value of $15,000.
The equipment will be used to produce 15,000 deluxe pairs of rugby boots per year, generating a contribution of $2.75 per pair. He estimates that annual fixed costs will be $15,000 per year.
Required:
1. Determine, on the basis of the above figures, whether the project is worthwhile.
2. Calculate what percentage changes in the following factors would cause your decision in (a) to change:
i. Initial investment;
ii. Sales volume;
iii. Fixed costs;
iv. Scrap value;
v. Cost of capital.
Comment on each result.
*Please use the notes feature in the toolbar to help formulate your answer

2.2 Advantages of Sensitivity Analysis

• It gives an idea of how sensitive the project is to changes in any of the original estimates.
• It directs management attention to checking the quality of data for the most sensitive variables.
• It identifies the critical success factors for the project and directs project management.
• It can be easily adapted for use in spreadsheet packages.

2.3 Limitations of Sensitivity Analysis

• Although it can be adapted to deal with multi-variable changes, sensitivity analysis is normally used to examine what happens when one variable changes and others remain constant.
Variables are often interdependent, however.
• It assumes data for all other variables is accurate.
• Without a computer, it can be time-consuming.
• Probability of change in a variable is not considered.
• Sensitivity analysis does not provide a decision rule. Management must decide the level of sensitivity that is acceptable.
 • Definition

Simulation – a technique which allows more than one variable to change at the same time.
An example of simulation is the Monte Carlo simulation method. The output estimates not only a project’s outcomes but also their associated probabilities.

3.2 Stages in a Monte Carlo Simulation

1. Specify the major variables (e.g. revenue and costs).

2. Specify the relationship between the variables (e.g. revenue minus costs equals profit).
3. Attach probability distributions to each variable and assign random numbers to reflect the distribution (e.g. a 10% probability that costs are $1,000, a 50% probability that they are $10,000
and a 40% probability that they are $12,000).
4. Simulate the environment by generating random numbers for revenue and costs. For example, using random numbers from 00 to 99:
o assign 00 to 09 to $1,000 cost with 10% probability;
o assign 10 to 59 to $10,000 with 50% probability assigned to it, and so on.
5. Record the outcome of each simulation (e.g. the profit based on the revenue and costs levels randomly selected are recorded).
6. Repeat the simulation many times to obtain a probability distribution of the possible outcomes (e.g. the simulation will show the probabilities of various profit levels being achieved).
Exam advice

Calculations will not be required in the exam; an awareness of the stages will be sufficient.

3.3 Advantages of Simulation

• Monte Carlo simulation provides more information about the possible outcomes and their relative probabilities.
• This data can be used to calculate an expected NPV (and the standard deviation of the expected NPV).
Exam advice

Calculations of standard deviation (measures the spread of values around a mean value)
are not examinable.

3.4 Limitations

• Monte Carlo simulation is not a technique for making a decision, only for obtaining more information about the possible outcomes.
• It can be very time-consuming without a computer.
• It could prove expensive in designing and running the simulation, even on a computer.
• Simulations are only as good as the probabilities, assumptions and estimates used.

4.0 Introduction

A probability analysis of expected cash flows can be used to measure risk.

4.1 Expected Values

 Definition

Expected value – the quantitative result of weighting uncertain events by the probability of their
occurrence.
An expected value is calculated as follows:
Expected value = weighted arithmetic mean of possible outcomes= ∑xp(x)

Where x = value of an outcome

P(x) = the probability of outcome x

∑ = sum
Activity 2 Expected Values

The values in the table below show the NPV of three projects given three different states of the market.

State of market Contracting Static Expanding

Probability 0.4 0.3 0.3

Project 1 $100 $200 $1,000

Project 2 $0 $500 $600

Project 3 $180 $190 $200

Required:
Determine which is the best project, based on expected values.
*Please use the notes feature in the toolbar to help formulate your answer
Expected values can be discounted to calculate an estimated value of a NPV and to measure risk.

Example 1 Probability Analysis

An organisation is considering making a $40,000 investment in a project which is estimated will generate
cash inflows over the project’s two-year life as follows:
Year 1 Cash flow Probability
$20,000 0.4
$30,000 0.6
Year 2
If cash flow in there is a probability that cash flow in
year 1 is: of: year 2 will be:
$20,000 0.25 $10,000
 Example 1 Probability Analysis

0.75 $20,000
$30,000 0.30 $20,000
0.70 $25,000
The organisation’s cost of capital is 10%.
Required:
Calculate the EV of the project’s NPV and the probability that the NPV will be negative.
Solution
Calculate the PV of the cash inflows:
Year Cash flow Discount factor PV
$000 $000
1 20 0.909 18,180
1 30 0.909 27,270
2 10 0.826 8,260
2 20 0.826 16,520
2 25 0.826 20,650
Calculate the EV of the PVs of the cash inflows.
Year 1 Year 2 Total PV EV of PV
PV Probability PV Probability Joint probability
$000 $000 $000 $000
(a) (b) (c) (d) (b) × (d) = (e) (a) + (c) = (f) (e) × (f)
18,180 0.4 8,260 0.25 0.10 26,440 2,644
18,180 0.4 16,520 0.75 0.30 34,700 10,410
27,270 0.6 16,520 0.30 0.18 43,790 7,882
27,270 0.6 20,650 0.70 0.42 47,920 20,126
1.00 41,062
Less project cost 40,000
EV of the project’s NPV 1,062
The probability that the NPV will be negative (a measure of the risk) is the probability that the total PV of
cash inflows is less than $40,000. From the Total PV column, this corresponds to the joint probabilities
0.1 + 0.3 = 0.4. This might be considered an unacceptably high risk.

4.2 Advantages and Disadvantages

 Advantages Disadvantages

• The probabilities of the different possible outcomes

may be difficult to estimate.
• The average may not correspond to any of the
possible outcomes.
• Unless the same decision has to be made many
• Expected value reduces times, the average will not be achieved; therefore, it
the information to one is not a valid way of making a decision in "one-off"
value for each choice. situations.
• The idea of an average is • The average gives no indication of the spread of
readily understood possible results (i.e. it ignores risk).

5.1 Usefulness

Definition

Discounted payback – the period of time for the discounted returns from a project to recover the initial
investment. It is also referred to as the adjusted payback period
Discounted payback resolves one of the limitations of the standard payback method, which is that standard payback period ignores the time value of money. (The usefulness of unadjusted payback
as a measure of project risk is strictly limited as it gives equal weighting to cash flows irrespective of the year in which they are received.) In addition, it takes into consideration more of the project’s
cash flows because the amounts are discounted, and the payback period is therefore longer.
However, it does not overcome all the limitations of the payback method as it still ignores cash flows after the payback period.

Example 2 Limitation of Payback

Two alternative projects each require an initial investment of $1,000,000 and have the following forecast
operating cash flows ($000):

Project A Project B

Year 1 600 100

Year 2 200 300

Year 3 200 600

Year 4 205 205

Year 5 150 150

Each project has a payback period of three years, and based on this measure, would be ranked equally
in terms of liquidity and risk.
 Example 2 Limitation of Payback

However, Project A produces strong cash flows in early years which may be considered to carry a lower
level of uncertainty than more distant returns.
This standard payback limitation can be dealt with by using the discounted payback period (i.e. first
discount the project returns at a rate which reflects the level of operating risk, and recalculate the
payback period).

Activity 3 Discounted Payback Period

The company's WACC of 10% is believed to reflect the risk attached to both Project A and Project B in Example 2.
Required:
Calculate the discounted payback period of each project.
*Please use the notes feature in the toolbar to help formulate your answer
7.6.1 Methods
6.1 Methods

Methods of keeping project risk within acceptable levels include:

• Setting a maximum adjusted payback period in the initial screening process of potential projects.
• Using risk-adjusted discount rates for both NPV and adjusted payback. A higher discount rate should be applied to projects with higher risk, thereby reducing the influence of more distant
cash flows. In addition, investors prefer cash now to later and so require a higher return for longer time periods. Project-specific discount rates can be found using the capital asset pricing
model (see Chapter 12).
• Using conservative forecasts, such as reducing the forecast returns downwards to reflect the guaranteed minimum inflows from a project (certainty equivalents). Then discount these lower
cash flows at the risk-free interest rate (i.e. risk is removed from the cash flows rather than adjusted for in the discount rate).
• Selecting projects with a combination of an acceptable expected NPV and a relatively low standard deviation of NPV.
• Focusing attention on the critical success factors indicated by sensitivity analysis.
Exam advice

Calculations using reduced cash flows to reflect guaranteed minimum inflows are not required in the FM
exam.

Syllabus Coverage

This chapter covers the following Learning Outcomes.

D. Investment Appraisal
1. Investment appraisal techniques
1. Calculate discounted payback period and discuss its usefulness as an investment appraisal method.
3. Adjusting for risk and uncertainty in investment appraisal
1. Describe and discuss the difference between risk and uncertainty in relation to probabilities and increasing project life.
 2. Apply sensitivity analysis to investment projects and discuss the usefulness of sensitivity analysis in assisting investment decisions.
3. Apply probability analysis to investment projects and discuss the usefulness of probability analysis is assisting investment decisions.
4. Apply and discuss other techniques of adjusting risk and uncertainty in investment appraisal, including:
i. simulation
ii. adjusted payback
iii. risk-adjusted discount rates.
4. UMUNAT CO
5. Umunat Co is considering investing $50,000 in a new machine with an expected life of five years. The machine will have no scrap value at the end of five years. It is expected that
20,000 units will be sold each year at a selling price of $3.00 per unit. Variable production costs are expected to be $1.65 per unit, while incremental fixed costs, mainly the wages of a
maintenance engineer, are expected to be $10,000 per year. Umunat uses a discount rate of 12% for investment appraisal purposes and expects investment projects to recover their initial
investment within two years.
6.
7. Required:
Evaluate the sensitivity of the project’s net present value to a change in the following
(a) project variables:

(i) sales volume;

(ii) sales price;

(iii) variable cost;

and discuss the use of sensitivity analysis as a way of evaluating project risk. (10 marks)

Upon further investigation it is found that there is a significant chance that the expected sales
volume of 20,000 units per year will not be achieved. The sales manager of Umunat
suggests that sales volumes could depend on expected economic states that could be
(b) assigned the following probabilities:

Economic state Poor Normal Good

Probability 0.3 0.6 0.1

Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project. (5 marks)

(15 marks)
Your Answer:AXCDCDC

(a) Calculation of project NPV

Annual cash flow = ((20,000 × (3 − 1.65)) − 10,000 = $17,000 per year
Net present value = (17,000 × 3.605) − 50,000 = 61,285 − 50,000 = $11,285
 Alternatively: PV ($)
Sales revenue: 20,000 × 3.00 × 3.605 = 216,300
Variable costs: 20,000 × 1.65 × 3.605 = (118,965)
Contribution 97,335
Initial investment (50,000)
Fixed costs: 10,000 × 3.605 = (36,050)
Net present value: 11,285
Sensitivity of NPV to sales volume
Sales volume giving zero NPV = ((50,000/3.605) + 10,000)/1.35 = 17,681 units
This is a decrease of 2,319 units or 11.6%
Tutorial note: Alternatively, sales volume decrease = 11,285/97,335 = 11.6%
Sensitivity of NPV to sales price
Sales price for zero NPV = (((50,000/3.605) + 10,000)/20,000) + 1.65 = $2.843
This is a decrease of $0.157 or 5.2%
Tutorial note: Alternatively, sales price decrease = 11,285/216,300 = 5.2%
Sensitivity of NPV to variable cost
Variable cost must increase by $0.157 or 9.5% to $1.81 to make the NPV zero.
Alternatively, variable cost increase = 11,285/118,965 = 9.5%
Sensitivity analysis evaluates the effect on project net present value of changes in project variables. The objective is to determine the key or critical project variables, which are those where the
smallest change produces the biggest change in project NPV.

It is limited in that only one project variable at a time may be changed, whereas in reality several project variables may change simultaneously. For example, an increase in inflation could result in
increases in sales price, variable costs and fixed costs.
Sensitivity analysis is not a way of evaluating project risk, since although it may identify the key or critical variables, it cannot assess the likelihood of a change in these variables. In other words,
sensitivity analysis does not assign probabilities to project variables. Where sensitivity analysis is useful is in drawing the attention of management to project variables that need careful monitoring if
a particular investment project is to meet expectations. Sensitivity analysis can also highlight the need to check the assumptions underlying the key or critical variables.

(b) Expected NPV

Expected value of sales volume:
(17,500 × 0.3) + (20,000 × 0.6) + (22,500 × 0.1) = 19,500 units
Expected NPV = (((19,500 × 1.35) − 10,000) × 3.605) − 50,000 = $8,852
Since the expected net present value is positive, the project appears to be acceptable. From earlier analysis we know that the NPV is positive at 20,000 per year, and the NPV will therefore also be
positive at 22,500 units per year. The NPV of the worst case is:
(((17,500 × 1.35) − 10,000) × 3.605) − 50,000 = ($882)
The NPV of the best case is (((22,500 × 1.35) − 10,000) × 3.605) − 50,000 = $23,452
There is therefore a 30% chance that the project will produce a negative NPV, a fact not revealed by considering the expected net present value alone.
The expected net present value is not a value that is likely to occur in practice. It is perhaps more useful to know that there is a 30% chance that the project will produce a negative NPV (or a 70%
chance of a positive NPV), since this may represent an unacceptable level of risk as far as the managers of Umunat are concerned. It can therefore be argued that assigning probabilities to
expected economic states or sales volumes has produced useful information that can help the managers of Umunat to make better investment decisions. The difficulty with this approach is that
probability estimates of project variables or future economic states are likely to carry a high degree of uncertainty and subjectivity.

Visual Overview

Objective: To understand the issues relating to equity finance.

.1 Retained Earnings
 Key Point

The main internal source of finance is retained earnings (accumulated profits).

Internal finance can also be generated by increasing working capital management efficiency.

Note, however, that a company may have substantial retained earnings in its statement of financial position but no cash in the bank and will therefore not be in a position to finance investment. It is
therefore retained cash, rather than retained earnings, that is the source of finance.
Microsoft, for example, did not pay any dividends for many years. It reinvested all cash to produce growth of the company and its share price. Any shareholder that required a dividend could simply
sell some shares to take a capital gain and create a "home-made” dividend.
Retained cash as a source of finance has no issue costs, is flexible in terms of amounts used or repayment patterns and does not affect shareholdings. Shareholders may not appreciate the loss or
reduction of dividends.

1.2 Pecking Order Theory

1.2.1 Issue Costs

According to Pecking Order Theory, companies should follow an established pecking order to raise finance in the simplest and most efficient manner. The first justification for this theory is that
companies should want to minimise issue costs:
• The cheapest source of new finance is retained earnings, as it has no issue costs. This is a form of equity, since retained earnings would otherwise be distributable as a dividend to
shareholders.
• A bond issue or bank loan is the next cheapest source of new finance. These are forms of debt.
• The most expensive source of new finance is a fresh equity issue. For example, an initial public offering (IPO) on a regulated exchange typically incurs issue costs of between 2% and 8%
of the amount raised.
The second justification is that companies will want to minimise the time and expense involved in persuading outside investors of the merits of the project:
• If the company can use retained earnings, it does not have to spend any time persuading outside investors.
• Otherwise, the time and expense associated with issuing debt is usually significantly less than that associated with a share issue.

1.2.2 Asymmetrical Information

A further justification is the existence of asymmetrical information and the presumed information transfer (“signal”) that results from management actions. This recognises that management knows
more about the companies’ prospects than the outside investors/the markets. (Management knows all the detailed inside information, whilst the markets only have access to past and publicly
available information.)
Because of this asymmetry in information, management’s actions are closely scrutinised by the markets and often interpreted as the insiders’ view on the future prospects of the company. For
example, an unexpected increase in dividends is a sign of management’s increased confidence in the company’s future prospects which will typically increase the share price.
Management with favourable inside information would not want to issue shares because they would be undervalued. Conversely, outside investors assume that managers with unfavourable inside
information would want to issue shares as they would be overvalued. Therefore an issue of equity is interpreted as a “bad” sign; investors may start to sell their shares, causing the share price to
fall. The issue of equity is definitely a last resort.
The preference for internal finance is supported by research that found company directors often choose "the path of least resistance" when it comes to financing. Although this theory explains the
real-world preference for using internal finance, it does not imply that internal finance is always optimal. Rather, the theory argues that companies will choose the cheapest available source:
• New start-ups have no retained earnings and cannot yet borrow. They are therefore typically heavily equity financed, either by their owners or private equity.
 • As they grow, companies will seek debt in preference to new equity as it is cheaper, quicker and easier to issue, up to the limit of their debt capacity.
• Well established, stable companies can finance their expansion with retained earnings. They will become heavily equity financed (as retained earnings area component of equity) in the
absence of financial management”.

1.3 Working Capital Management

Creating accounting profits does not guarantee the availability of internal equity finance, as the company must also be converting the profits into positive cash flows. A company's ability to generate
internal finance therefore depends on its ability to generate operating cash flow in excess of interest and taxes.
Potential internal finance available = operating cash flow − interest − tax
As interest and tax are committed costs, the focus must be on maximising operating cash flows.
Operating cash flows are calculated as follows:

Earnings before interest and tax, depreciation and

amortisation (EBITDA) x

Rise/fall in inventory (x)/x

Rise/fall in receivables (x)/x

Rise/fall in payables x/(x)

Operating cash flow x

Improved working capital management can help to release more internal equity finance. Potential areas for improvement (which are covered in Chapters 13-16) include:
• Reducing the time taken to receive payments from customers (e.g. by offering discounts for quick payment or outsourcing debt collection to a factor).
• Reduction in the amount of inventory (e.g. through improved supply chain management or even moving to Just-in-Time (JIT) production).
• Taking increased credit from suppliers. However, care must be taken not to lose settlement discounts or compromise relationships with key suppliers.
• 8.2.0 Introduction
• 2.0 Introduction
•
• As well as, or instead of, using internal finance, a company may be able to issue new shares (or debt, which is covered in Chapter 9) to finance its investment projects (i.e.
using external finance).

2.1 Methods of Share Issue

2.1.1 Quoted Companies – New Shares

If a company is already listed, the following methods are available for issuing new shares:
 Method Explanation

Offer for
subscription A direct sale to the general public. This is generally the most expensive method of
(public issue) issuing new shares.

An indirect sale to the public accomplished by selling shares directly to an issuing

house (merchant/investment bank), which then sells them to the public. (The issuing
Offer for sale house guarantees to buy the shares.)

In a placing, the sponsor (normally a merchant bank) places the shares with its
clients (usually pension funds and insurance companies) rather than the shares
being offered to the general public. This is generally the least expensive method of
Placing issuing new shares.

An offer to allow existing shareholders to buy new shares in proportion to their

Rights issue existing holdings.

Offer for sale or

subscription by Like an auction, with the public being invited to bid for shares. Useful where setting
tender a price for the shares is difficult.

2.1.2 Options for Unquoted Companies

Options for unquoted companies include:
• To become quoted (i.e. raise new equity finance at the same time as becoming listed). This is known as an initial public offering (IPO). The method could be an offer for subscription or
sale, tender, or placing. It is an expensive process.
• To stay unquoted. Use a rights issue or private placing. However, there may be a limited source of funds from either existing owners or new private investors.
• To engage in what is known as "introduction".
o No shares (neither existing nor newly-created) are made available to the market, so no new finance is raised.
o Stock market grants a quotation, given that shares must already be widely held, so that a market can be seen to exist.
Useful to gain greater marketability of shares, a valuation for inheritance tax purposes or future easier access to additional capital.

Exam advice

The terms quoted, floated and listed all refer to the same thing (i.e. shares which are traded on a stock
exchange).

2.1.3 IPO Factors to Consider

Ordinary shareholders take more risk than any other type of investor in a company because:
• ordinary dividends are discretionary (i.e. the company has no legal obligation to pay an ordinary dividend); and
• ordinary shareholders rank last in the event of bankruptcy/liquidation.
Shareholders require high returns to compensate for this risk, and therefore issuing new shares is an expensive source of finance. However, sometimes a new share issue is the only available
source of finance.
There are several factors that the company should consider before doing an IPO:
 • Legal restrictions.
• Costs including:
o Underwriting costs (i.e. the fees that must be paid to an investment bank to underwrite/guarantee the share issue) which are typically 5% to 7% of the offering.
o Stock market listing fee (initial charge) for the new shares.
o Fees for the issuing house (investment bank), solicitors, auditors, PR.
o Cost of printing and distributing the prospectus (the document in which the shares are offered for sale).
o Advertising in national newspapers.
• Valuation: the setting of a price for the new shares to be issued.
• Stock exchange rules.
• Timing.

2.1.4 Official Listing Requirements

For a company to trade its shares on a stock exchange, it must be able to meet that exchange’s listing requirements and pay both the exchange’s entry and yearly listing fees.
Listing requirements vary by exchange but the requirements typically measure the size and market share of the security to be listed and the underlying financial viability of the issuing company.
Exchanges establish these standards as a means of maintaining their own reputation and visibility. For example, the UK Stock Exchange normally requires a three-year trading record, 25% of
shares to be in public hands and a minimum capitalisation of £700,000.
The costs of acquiring and maintaining an official listing mean that it is not really a possibility for small or medium-sized entities (SMEs). In the UK, for example, these companies may find the
London Stock Exchange's Alternative Investment Market (AIM) market more attractive as it has fewer regulations. Investors recognise that due to the more limited regulation, investing in AIM
companies carries additional

2.2 Other Types of Share Issue

2.2.1 Rights Issue

In a rights issue, the existing shareholders are offered more shares (usually at a discount to the current market price) in proportion to their existing holding.
UK company law guarantees shareholders pre-emptive rights (i.e. the right to purchase new shares before they can be offered to other investors). This is to protect shareholders from dilution of their
control.
The expected share price following the rights issue − the theoretical ex-rights price (TERP) of a share can be calculated. Although the formula is not published in the exam, it is simply the forecast
total market value of the company's equity after the rights issue divided into the number of shares that will be in issue after the rights issue.

TERP =
Points to note for the calculation of the TERP per share:
• Proceeds of the rights issue should be added net of any issue costs.
• If the project has already been announced, and if the market is operating at the semi-strong level of efficiency, the project's NPV will already be reflected in the existing share price and it
should not be included again in the formula above.
Activity 1 TERP

A company has 100,000 shares issued with a current market price of $2 each at the close of trading.
After trading closes for the day, the company announces that it will take on a project with a NPV of $25,000.
The project will be financed by a rights issue of one new share for every two existing shares. The rights price is $1 per new share.
Ignore issue costs and assume that the equity market operates at the semi-strong level of pricing efficiency.
Required:
Calculate the theoretical ex-rights price of the company's shares.
*Please use the notes feature in the toolbar to help formulate your answer
Activity 2 Mr X

Assume in Activity 1 above that Mr X owns 1,000 shares in the company. A shareholder's wealth depends on whether he exercises his rights.
Required:
Show Mr X's position if he:
(i) takes up his rights;
(ii) renounces and sells his rights;
(iii) does nothing.
Hint: Calculate his wealth before and after the rights issue for each scenario.
*Please use the notes feature in the toolbar to help formulate your answer

2.2.2 Bonus Issue

In a bonus issue, reserves (e.g. revaluation surplus or share premium accounts) are converted into share capital, which is distributed as new shares to existing shareholders in proportion to their
existing holdings).

Key Point

No finance is raised.
The purpose is to increase the marketability of the shares, as it increases the number of shares in existence and reduces their price. This creates a more active secondary market for the shares,
which will help future issues to raise cash (e.g. rights issues).
Bonus issues are also called "scrip issues" or a "capitalisation of reserves" and signal a company's strength to the market.

2.2.3 Stock Splits

Stock splits occur when ordinary shares are split in value (e.g. each $1 share is converted into two 50-cent shares). This reduces the market price per share, increasing their marketability.

3.0 Introduction

As introduced in in Chapter 1, the three key decision areas in financial management − investing, financing and dividend policy –are interrelated:
• An increase in dividends (the dividend decision), will reduce the level of retained cash available and increase the need for external finance (the financing decision) in order to fund capital
investment projects (the investment decision).
• An increase in capital expenditure (the investment decision) would also increase the need for finance (the financing decision) which may be sourced internally by reducing dividends (the
dividend decision).
Directors must therefore decide when to pay a dividend and when to retain earnings in the company.

3.1 Practical Influences

Practical factors have a significant influence on the company's dividend policy.

3.1.1 Legal Constraints

In most countries, a dividend can only be paid if there is a credit balance in the retained earnings account in the statement of financial position. No distributable reserves means no dividends.
• If a company has brought forward losses from previous years, the balance on retained earnings may be a debit ("negative"), even if a profit was made in the current year.
• This restriction on paying dividends for the foreseeable future could damage the company's ability to attract new equity investors to finance its growth. Therefore, some countries allow the
debit balance on retained earnings to be written-off against other reserves, which then allows the company to resume paying dividends.

3.1.2 Liquidity Requirements

Irrespective of any potentially detrimental effect on share price that a change in dividend policy might cause, companies have to maintain adequate liquidity. Dividend restrictions may be imposed to
stay solvent or meet statutory capital maintenance requirements.
Cash for dividend payments may also be unavailable because the company may wish to hold significant cash to meet both routine and any unexpected expenses, and also to be able to move
quickly into investment opportunities.

Example 1 Liquidity Requirements

As of June 2011, Apple Computers held an astonishing $76 billion of cash and cash equivalents. This
cash was held partly to be able to buy in advance large quantities of key components and ensure
continuous production, and partly as a "war chest" to finance the quick acquisition of other innovative
high-tech companies.

3.1.3 Shareholder Expectations

Most shares in quoted companies are held by powerful institutional investors (e.g. pension funds). Therefore, the directors of quoted companies have to carefully manage investor expectations
regarding the level of dividends.
• If a large dividend is paid in the current year, this may create expectations of the same, or even higher, in future. If these expectations are then not met, key investors may sell their
shareholdings.
• In smaller owner-managed companies, there is no such agency problem and the dividend decision is influenced more by the personal tax position of the owner-managers than sensitivity
over expectations.

3.1.4 Signalling
In quoted companies, where there is significant "divorce of ownership and control", investors do not have access to all information about the company's operations and prospects; they only have
what is publicly available. Therefore, public announcements of the level of proposed dividend are seen as key signals of company strength or weakness.
• A surprise cut in dividend may be interpreted as a signal of liquidity problems, even if the cut is actually to finance attractive projects.
• A surprise increase may be taken as a signal of company strength, although some investors may question why the directors have not found suitable strategies for reinvestment of surplus
cash.

3.1.5 Stability
Companies often strive for a stable level of dividends or a constant level of growth. This is done to avoid sharp movements in share price.
• Companies will therefore try to maintain the level of dividends in the face of fluctuating earnings.
• This is a very common approach for quoted companies.

3.1.6 Borrowing Covenants

A loan agreement may include a clause which limits dividend payments (e.g. to a specified proportion of earnings) to help ensure the loan is more secure. If less cash is paid as dividends, liquidity
might be better (though, of course, cash can still be consumed on the purchase of non-current assets).

3.2 Alternative Dividend Policies

3.2.1 Constant Dividend

A constant dividend policy avoids surprises and signals stability to shareholders, but shareholders might be dissatisfied if they receive relatively low dividends if earnings are rising. As the proportion
of retained earnings increases, shareholders might question whether the company can find enough suitable investment opportunities.

3.2.2 Constant Growth

Constant growth is predictable and favoured by shareholders but again the dividend growth rate might not match the earnings growth rate.

3.2.3 Constant Payout Ratio

A constant payout ratio means paying a dividend which represents a constant proportion of each year’s earnings. Although this approach sounds logical it creates uncertainty and is therefore rarely
adopted by quoted companies.

3.2.4 Residual Dividend Policy

Under the residual dividend policy, retained earnings are used to fund all positive NPV projects and any remaining earnings not needed to fund such projects are paid out as a dividend.
This clearly links to Pecking Order Theory (i.e. retained earnings are the cheapest source of new finance, so should be used to fund projects first).
A residual dividend policy is likely to lead to fluctuating dividends, so although it may excuse a cut in an otherwise stable dividend pattern, it is not common for quoted companies. When it is used, it
is likely to be accompanied by detailed information to support the decision, since this is effectively a form of new equity issue.

3.2.5 Zero Dividend Policy

A high growth company may find that, in early years, all surplus cash can be profitably reinvested back into the business − particularly if the company lacks access to external finance.
At some point, however, the company will find fewer positive NPV projects available and so should start paying dividends.

3.3 Dividend Theories

3.3.1 Clientele Theory

The company's historical dividend policy may have attracted particular investors to whom the policy is suited in terms of need for current income, tax implications, etc. Management should view
therefore shareholders as the company’s clientele.
• For example, a pension fund must base much of its investment portfolio on its need to produce income to pay to pensioners. It will therefore invest heavily in shares that pay regular,
relatively predictable dividends.
• Similarly, tax can affect investment decisions if capital gains and investment income are taxed differently.
• An abrupt change in dividend policy will disturb investors’ carefully constructed portfolios and investors will have to adjust their mix of shares incurring transaction costs. Although it may be
argued that an investor can “manufacture” dividends by selling some shares, this would also incur transaction costs and may attract different tax treatment.
• The company should therefore maintain a stable dividend policy or risk losing major investors such as financial intermediaries (e.g. insurance companies and pension funds).

3.3.2 “Bird-in-the-Hand” Theory

The “bird-in-the-hand” theory argues that shareholders prefer higher dividends (and therefore lower potential capital gains) because a cash dividend today is without risk, whereas future share price
growth is uncertain.
Although persuasive, this is incorrect. Market forces should mean that a share price is correctly set for the level of risk and returns. If more dividends are paid out as cash the investor has to decide
how to invest it. In another investment with higher returns and higher risk or lower returns and lower risks? According to the capital asset pricing model (see Chapter 12), diversified investors should
be happy with either because extra returns correctly compensate for extra risk.

3.3.3 Dividend Irrelevance Theory

Modigliani and Miller (finance theorists) argue that under certain conditions, shareholders are indifferent to dividend policy.
• If a company pays no dividend, the share price should rise due to reinvestment of earnings.
• Any shareholder who requires a dividend can sell part of their holding to create a capital gain (i.e. to manufacture a "home-made dividend").
Under this theory, the pattern of dividends is irrelevant to shareholder wealth. However, Modigliani and Miller made a series of assumptions which may not hold in practice:
• No distortions from the personal tax system (i.e. dividends and capital gains are taxed at the same rate in the hands of investors).
• No transactions costs (i.e. investors can sell shares to create a home-made dividend without incurring any trading costs).
• Perfect markets (i.e. if the company defers the payment of dividend, the current share price will fully reflect its value).
3.4 Alternatives to Cash Dividends

Like the payment of dividends, other distribution methods also require the company to have sufficient distributable reserves and sufficient liquidity to fund the distribution.

3.4.1 Share Buyback Programmes

• The buyback can be performed either by writing directly to all shareholders with an offer to buy shares at a fixed price (a tender offer) or by purchasing shares via the stock market at the
prevailing price.
• The shares are either cancelled (and a non-distributable reserve created) or held by the company as treasury shares for possible future reissue. If held by the company, the shares carry
no voting rights and receive no dividends.
• Distributable reserves must be reduced by the full value of the buyback.
• As there will be fewer shares in issue after the buyback, the share price should rise.
• Ratios such as earnings per share (EPS) and return on equity (ROE) should also improve.
• In many countries, a share buyback is treated as a capital gain in the hands of the investor rather than as income. This can have tax advantages if capital gains are taxed at a lower rate
than dividends.

3.4.2 Special Dividends

• If a quoted company announces a larger than expected dividend, this may raise market expectations that future dividends will also be higher.
• Therefore, to avoid creating expectations of an unsustainable level, a larger dividend may be announced as a "special" dividend − basically a bonus dividend.
• The directors are communicating to the markets that, from time to time, any exceptional cash surplus will be returned in this way, but that this should not be built into dividend per share
forecasts.
• Like a buyback, the company distributes cash. Also, all shareholders will receive cash (whereas, under a buyback, only those who sell receive cash).

3.4.3 Scrip Dividends

A scrip dividend is a choice between a cash dividend and shares in lieu of cash. Shareholders can choose to acquire new shares (if they do not need the cash dividend) without transactions costs.
The company conserves cash for reinvestment (the preferred source of finance under pecking order theory).

8.4.1 Characteristics
4.1 Characteristics

There is no official definition of a small and medium-sized entity (SME). McLaney (2000) identifies three characteristics:
1. the entity is likely to be unquoted;
2. ownership of the business is restricted to few individuals, typically a family group; and
3. it is not a micro business (i.e. a very small business that acts as a vehicle for self-employment of the owners).
SMEs contribute in a significant way to many economies in the world. Besides generating income (often in large proportions in relation to gross national product), they are frequently major
employers and the sector which is most identified with new ideas and entrepreneurial spirit. It is these latter factors that help sustain and support growth rates in many economies.

4.2 Difficulties in Raising Finance

SMEs are private companies with a limited number of shareholders and, unless those shareholders are wealthy, there is a limit to how much they can invest in the company.
SMEs therefore have to rely heavily on retained earnings for equity finance, but this source is limited, especially when profits are low. If they are restricted in the amount of equity they can raise, they
may have to rely on debt.

4.2.1 Perceptions of Risk and Uncertainty

SMEs are often viewed as unattractive investment opportunities due to the perception that they have high levels of risk and uncertainty attached to them.
• Larger businesses have a track record, especially in terms of a long-term relationship with their bankers. New businesses, typically SMEs, obviously do not have a track record.
• SMEs internal controls are often non-existent or very limited.
• Larger businesses conduct more of their activities in public than do SMEs. If information is public, there is less uncertainty. For example, a larger business might be quoted on a stock
exchange and therefore be subject to press scrutiny and stock exchange rules regarding the provision of certain of its activities (including publishing accounts that have been audited).
Many SMEs do not have to have audits, certainly do not publish their accounts to a wide audience and the press are not really interested in them. They therefore have fewer external
controls.
• The fact that potential investors in an SME have much less information about the business than its managers (i.e. asymmetry of information) contributes to their perception of high risk.
• Often SMEs have one dominant owner-manager whose decisions are rarely questioned.
• They tend to have limited assets to offer as security (see below).

4.2.2 Absence of Security

If an SME seeks a bank loan, the bank will look to see what security (collateral) is available for any loan provided. This is likely to involve an audit of the entity's assets.
• Collateral is important because it can reduce the level of risk a bank is exposed to in granting a loan to a new business.
• Many SMEs are based in the service sector where the main asset is likely to be human capital as opposed to physical assets. The directors may therefore be required to pledge personal
assets (e.g. their homes) to secure business loans.

4.2.3 Shares Lack Marketability

The equity issued by small companies is unquoted and difficult to buy and sell.
• Sales are usually on a matched bargain basis, which means that a shareholder wishing to sell has to wait until an investor wishes to buy.
• This lack of marketability means that small companies are likely to be very limited in their ability to offer new equity to anyone other than family and friends.

4.2.4 Tax Considerations

Individuals with cash to invest may be encouraged by the tax system to invest via large institutional investors rather than directly into small companies.
• In many countries, personal tax incentives are offered on contributions to pension funds.
 • These institutional investors themselves usually invest in larger companies (e.g. listed companies) in order to maintain what they see as an acceptable risk profile, and in order to ensure a
steady stream of income to meet ongoing liabilities. This reduces the potential flow of funds to small companies, although the government may try to mitigate this effect by also offering tax
advantages for investment in SMEs.

4.2.5 Funding Gap and Maturity Gap

Initial owner finance is nearly always the first source of finance for a SME, whether from the owner or from family connections. At this stage, many of the assets may be intangible, which makes
external financing difficult to obtain. The "funding gap" is the difference between the finance available to SMEs and the funding they could productively use.
Bank loans may become available at a later stage. However, with small businesses, longer-term loans are often easier to obtain than medium-term loans because the longer-term loans are easily
secured with mortgages against property. The fact that medium-term loans are hard to obtain is a well-known feature of SMEs, and many resort to financing medium-term assets with short-term
finance such as an overdraft. This is known as the maturity gap as there is a mismatch of the maturity of the assets and liabilities within the business, which is not ideal.
Due to the funding gap and the maturity gap, an SME may have to take an innovative approach not only to its business but also to its financing. Possible financing solutions are discussed below.

4.3 Financing Solutions

The level of funds available can be influenced by Government policies. For example:
• Tax policy such as higher taxes on dividends (meaning less income for investors) or concessions designed to encourage companies to invest (e.g. tax-allowable depreciation).
• Interest rate policy, for example low rates meaning borrowing becomes cheaper but the supply of funds falls as there is less incentive for investors to save.

4.3.1 Venture Capital

Venture capitalists are a potential source of financing for an SME. Venture capital is equity capital provided to small and growing businesses and is usually provided by a wealthy individual, by a
venture capital firm (e.g. the 3i Group) that manages a venture capital fund or by a high-risk, potentially high-return subsidiary of an organisation with significant cash to invest (e.g. a bank). Typically
$1 million minimum is involved for any one investment.
• Before investing, the providers look for:
o a product or products with strong potential (e.g. a new innovation);
o solid management; and
o potential for high returns.
• In order to invest, providers of funds would normally expect:
o typically, 25% to 49% of the equity;
o a business plan with medium-term cash flow and profit projections;
o board representation (to monitor their investment and give advice);
o a dividend policy which promotes growth (i.e. high reinvestment of earnings);
o an "exit route" for selling their investment (e.g. proposed time-scale for seeking a market quotation); and
o the provision of regular management accounting information.
Venture capital trusts (VCTs) also serve as a potential financing source.
• VCTs are listed investment trust companies which invest at least 70% of their funds in a spread of small unquoted trading companies.
• The UK government gives tax incentives to individual investors in VCTs.

4.3.2 Private Equity Funds

A private equity fund attempts to gain control over a company in order to put it through a restructuring programme before either selling to another fund or listing the company on the stock market.
• The difference between private equity and venture capital is that private equity funds usually seek total control of the target company, whereas venture capitalists provide growth finance in
return for partial control.
• Private equity funds do not only target SMEs, they also buy large quoted companies, take them off the stock market, restructure them, and then re-list on the stock market.
4.3.3 Business Angels
Business angels are private individuals (or small groups of individuals) who are prepared to invest equity (or perhaps debt) into small businesses with big potential.
• Angels are often entrepreneurs who made their own fortunes in the high-tech sector, were wise enough to sell before the "dot.com" bubble burst, and now invest in small business as a
hobby (although they do expect to make gains).
• Angels not only provide finance, they also provide advice, experience and business contacts. A typical business angel will hold a portfolio of investments and may, for example, add an
investment in an entity that makes health drinks to complement existing investments in fitness clubs.
• Angels receive many applications for finance, and will only be prepared to invest in a business with an innovative product and talented management.

4.3.4 Government Assistance

Governments are often keen to support SMEs in raising finance for profitable investments:
• to avoid lost investment opportunities and national wealth being lower than it could be;
• to support innovation (an area in which SMEs often excel); and
• to boost employment.
Forms of government assistance include:
•Providing grants and guaranteeing loans (see Chapter 9).
•Providing tax breaks or incentives to those willing to take the risk of investing in SMEs.
•Providing advice. For example, in Scotland, “Business Gateway” is a government-funded organisation which provides assistance to those setting up and running a business, including
advice on raising finance.
• Providing equity investment. Many countries have government-backed venture capital organisations that are willing to invest in the equity of SMEs. This is often done on a matching basis,
where the organisation will match any equity investment raised from other sources. For example, “Enterprise Capital Funds” in the UK and the “Small Business Investment Company”
programme in the US.
The UK Enterprise Investment Scheme (EIS) is an example of a scheme to help SMEs attract equity finance.
• The EIS is a scheme designed to encourage private investors to buy shares in unlisted trading companies.
• Tax relief, at an income tax rate of 30%, is available for investors.
• Maximum annual tax relief is £1 million (£2 million if at least £1 million is invested in knowledge-intensive companies).
• Shares must be held for at least three years (otherwise tax reliefs are withdrawn/ withheld).

4.3.5 Crowdfunding
Definitions

Crowdsourcing − using a large, evolving, relatively open group of people (usually assembled via the
internet) to provide goods, services or finance.
Crowdfunding – is crowdsourcing to fund a project. Under crowdfunding there is no financial
intermediary: each individual in the crowd has a direct relationship with the entity that is funded.
Crowdfunding may be appropriate for the early stages of "seed" finance for an SME.
The crowdfunding model is driven by:
• the project initiator who proposes the idea and/or project to be funded;
• individuals or groups who support the idea; and
• a moderating organisation (the "platform") that brings the parties together to launch the idea.
Crowdfunding lets people invest in projects or ideas that they believe in or are interested in, and so they might be willing to take relatively bigger risks and/or take relatively lower returns. In addition,
the “crowd” aspect means supporters will often encourage others to invest.
Crowdfunding can be particularly beneficial for SMEs as it allows them to reach out directly to investors who may be happy with the risks associated with providing funding for new innovations and
technologies that are so often associated with SME.
The main types of crowdfunding are:
1. Donation-based − any crowdfunding campaign in which there is no financial return to the investors or contributors (e.g. fundraising for disaster relief, charities, NPOs and medical bills). May also
be suitable to obtain support from a local community.
2. Reward-based− where entrepreneurs pre-sell a product or service to launch a business concept without incurring debt or issuing equity to outside investors. This is best for businesses that have
a product available and/or need funding before generating revenues.
3. Equity-based − where investors receive unlisted shares of a company, usually in its early stages, in exchange for the money provided. This is typically best for businesses that can grow and
scale quickly.
Example 2 Crowdfunding Platforms

Crowdfunding platforms for small businesses include:

Kickstarter: Rewards-based funding platform focuses on creative projects like art, music, film, etc.
Funding is “all or nothing” (i.e. funds pledged will only be received if the funding goal is reached within
the designated timeline). There are no fees if a campaign is unsuccessful.
Crowdfunder: A low-cost equity crowdfunding solution based on a subscription model.
Crowdfunding may also be debt-based (see peer-to-peer lending in Chapter 9).

8 Syllabus Coverage
Syllabus Coverage

This chapter covers the following Learning Outcomes.

E. Business Finance
1. Sources of, and raising, business finance
1. Identify and discuss the range of long-term sources of finance available to businesses, including:
i. equity finance
iv.venture capital.
1. Identify and discuss methods of raising equity finance, including:
i. rights issue
ii. placing
iii. public offer
iv. stock exchange listing.
1. Identify and discuss internal sources of finance, including:
i. retained earnings
ii. increasing working capital management efficiency
iii. the relationship between dividend policy and the financing decision
iv. the theoretical approaches to, and the practical influences on, the dividend decision, including legal constraints, liquidity, shareholder expectations and alternatives to cash dividends.
5. Finance for small and medium sized entities (SMEs)
1. Describe the financing needs of small businesses.
2. Describe the nature of the financing problem for small businesses in terms of the funding gap, the maturity gap and inadequate security.
3. Explain measures that may be taken to ease the financing problems of SMEs, including the responses of government departments and financial institutions.
 4. Identify and evaluate the financial impact of sources of finance for SMEs, including sources already referred to in syllabus section E1 and also:
i. Business angel financing
ii. Government assistance
iii. Crowdfunding
Summary and Quiz
• Retained earnings is the main internal source of finance.
• Internal finance can also be generated by increasing efficiency in working capital management.
• Company managers generally prefer to use internal finance rather than external finance. This preference is known as the pecking order theory.
• Issuing new shares in an IPO is an expensive source of finance.
• A company must meet several requirements before it can receive an official listing on the full London Stock Exchange. These requirements are costly, and effectively preclude small and
medium-sized entities (SMEs) from official listing.
• However, SMEs do find the London Stock Exchange's AIM more attractive because the listing requirements are less onerous.
• In a rights issue, the existing shareholders are offered more shares, at a discounted price, in proportion to their existing holding.
• The theoretical ex-rights price (TERP) of a share is the expected share price following the rights issue.
• A company's dividend policy will be affected by legal constraints, liquidity requirements, shareholder expectations, the likely signal given, and the desire for share price stability.
• Under a residual dividend policy, any remaining earnings, after funding all attractive projects, are paid out as dividends.
• The dividend irrelevance theory states that investors are indifferent as to whether a dividend is paid or not. This is because of the following:
o If a company pays no dividend, the share price should rise due to reinvestment of earnings.
o Any shareholder that requires a dividend can sell part of their holding to create a capital gain (i.e. to manufacture a home-made dividend).
• Alternatives to dividends include share buybacks, special dividends and scrip dividends.
• SMEs have difficulty raising finance because of business uncertainty, a lack of collateral, shares that are not marketable and tax incentives.
• Funding solutions for SMEs include venture capital, private equity, angel investors (business angels), crowdfunding and government schemes.

JJG CO
JJG Co is planning to raise $15m of new finance for a major expansion of its existing business and is considering a rights issue, a placing or an issue of loan notes. The corporate objectives of JJG,
as stated in its Annual Report, are to maximise the wealth of its shareholders and to achieve continuous growth in earnings per share. Recent financial information for JJG is as follows:
Revenue ($m) 28.0

Profit before interest and tax ($m) 9.8

Profit after tax ($m) 5.5

Dividends ($m) 2.2

Ordinary shares ($m) 5.5

Reserves ($m) 13.7

8% Loan notes ($m) 20

Share price ($) 8.64

The nominal value of the shares of JJG is $1.00 per share. The loan notes of JJG are redeemable after eight years and are currently trading at their nominal value of $100. The following values for
the business sector of JJG are available:
 Average interest coverage ratio 20 times

Average debt/equity ratio (market value basis) 50%

Required:
If the new finance is raised through a rights issue at $7.50 per share and the major
expansion of business has not yet begun, calculate and comment on the effect of the
(a) rights issue on:

(i) the share price of JJG Co;

(ii) the earnings per share of the company; and

(iii) the debt/equity ratio. (8 marks)

Discuss the merits of a rights issue or a placing as ways of raising the finance for the
(b) expansion. (4 marks)

Your Answer:QASDX

(a) Rights issue

Theoretical ex-rights per share
Current share price = $8.64 per share
Current number of shares = 5.5 million shares
Finance to be raised = $15m
Rights issue price = $7.50 per share
Number of shares issued = 15m/7.50 = 2 million shares
Theoretical ex-rights price per share = ((5.5m × 8.64) + (2m × 7.50))/7.5m = $8.34 per share
The share price would fall from $8.64 to $8.34 per share
However, there would be no effect on shareholder wealth
Effect on earnings per share
Current EPS = $1 per share
Revised EPS = 5.5m/7.5m = $0.73 per share
The EPS would fall from $1 per share to $0.73 per share
However, as mentioned earlier, there would be no effect on shareholder wealth
Effect on debt/equity ratio
Current debt/equity ratio = 20/47.5 = 42%
Revised market value of equity = 7.5m × 8.34 = $62.55m
Revised debt/equity ratio = 20/62.55 = 32%
The debt/equity ratio would fall from 42% to 32%, which is well below the sector average value and would signal a reduction in financial risk

(b) Merits of a rights issue or a placing

The current debt/equity ratio of JJG is 42% (20/47.5). Although this is less than the sector average value of 50%, it is more useful from a financial risk perspective to look at the extent to which
interest payments are covered by profits.
The interest on the existing loan note is $1.6m (8% of $20m), giving an interest coverage ratio of 6.1 times ($9.8m/$1.6m). The interest coverage ratio is not only below the sector average, it is also
low enough to be a cause for concern.
A placing, or any issue of new shares such as a rights issue or a public offer, would decrease financial gearing. If the expansion of business results in an increase in profit before interest and tax, the
interest coverage ratio will increase and financial risk will fall. Given the current financial position of JJG, a decrease in financial risk is certainly preferable to an increase.
A placing will dilute ownership and control, providing the new equity issue is taken up by new institutional shareholders, while a rights issue will not dilute ownership and control, providing existing
shareholders take up their rights.
Both financing choices are long-term sources of finance and so are appropriate for a long-term investment such as the proposed expansion of existing business.
Equity issues such as a placing and a rights issue do not require security.
1.1 Preference Shares

Definition

Preference shares – shares with a fixed rate of dividend which have a prior claim on profits available for
distribution.
Preference shares, which are also called "preferred shares", are legally equity. They are often treated as debt (e.g. under International Financial Reporting Standards) as they are similar in nature
to debt.
Some of the common features of preference shares include:
• The shares have a fixed percentage dividend payable before ordinary dividends. This preference share dividend is expressed as a percentage of the share's nominal value.
 • The dividend is only payable if there are sufficient distributable profits. If the shares are cumulative, however, the right to receive dividends which were not paid is carried forward (i.e.
cumulative preference dividends). Any arrears of dividend are then payable before ordinary dividends.
• As for ordinary dividends, preference dividends are not deductible for corporate tax purposes. The preference dividends are considered a distribution of profit rather than an expense.
• On liquidation of the company, preference shareholders rank before ordinary shareholders and after debt holders.
• A participating preference share is a type of preference share that gives the holder the right to receive an additional dividend (if certain conditions are met) in addition to a fixed percentage
of the share’s nominal value.
Advantages Disadvantages

• No voting rights; therefore no dilution of

control.
• Compared to the issue of debt:
o preferred dividends do
not have to be paid in any
specific year, especially if • Preferred dividends are not tax deductible
profits are poor; (unlike interest on debt which is a tax
o preferred shares are allowable expense). Preference shares
not secured on company are a relatively rare source of finance in
assets; and practice because of this.
o non-payment of • To attract investors to buy preferred
dividend does not give shares, the company needs to pay a
holders the right to appoint a higher return to compensate for the
liquidator. additional risk compared to debt.

1.2 Bonds (“Loan Notes”)

Definition

Bond – a negotiable security evidencing a debt governed by a contract which specifies, for example, the
coupon rate, repayment schedule, security (if any), principal value, seniority (if subordinate to other debt)
and other covenants.
The terms "debenture", "loan note" and "bond" all basically refer to the same thing (i.e. a written acknowledgement of a company's debt which can then be traded). Bonds may be secured by:
• a fixed charge over a specified asset (e.g. a specific building) which cannot therefore be sold unless the debt is repaid; or
• a floating charge over a class of asset which changes (e.g. inventory). On default, the floating charge “crystallises” as a fixed charge, and the asset class can no longer be traded until the
debt is repaid.
Bonds may be redeemable or irredeemable.
Holders of unsecured bonds have the same rights as unsecured trade creditors.
In the UK, bonds are usually issued with a face value (also known as a nominal value or par value) of £100. They can then be traded on the bond market and reach a market price. Therefore, if a
bond is "selling at a premium" of 15%, this means that a bond with a face value of £100 is currently selling for £115.
Interest is usually a fixed coupon expressed as a percentage of the bond's nominal value (e.g. an 8% loan note has a coupon of 8% and would pay interest of $8 against a nominal value of $100).
Variable (floating) interest rate loan notes automatically adjust their interest payment in line with an agreed market reference rate (e.g. Euro Short-Term Rate – “ESTER”).
1.3 Deep Discount Loan Notes

Definition

Deep discount loan notes – loan notes issued at a large discount to nominal value (i.e. issued well
below nominal value) and redeemable at nominal value on maturity.
Investors in deep discount loan notes receive a large capital gain on redemption, but are paid a low coupon during the term of the loan.
These loan notes offer a cash flow advantage to the borrower. This is especially useful for financing projects which produce weak cash flows in early years.

Example 1 Deep Discount Loan Notes

A five-year, $100, 3% loan note issued at $80 would generate the following cash inflows/(outflows) for
the issuing company:
t0 t1 t2 t3 t4 t5
Issue price 80
Interest (3) (3) (3) (3) (3)
Redemption (100)
The coupon rate is not the cost of debt where the market price differs from the redemption price. In this
example, the IRR of these cash flows, which is the cost of debt before tax, is 8%.

1.4 Zero-Coupon Loan Notes

Definition

Zero-coupon loan notes – loan notes issued at a discount to nominal value and which pay no
coupon.
Zero-coupon loan notes have the following advantages:
• The issuing company pays no interest and the only cash payout is at the loan note's maturity.
• Return to investors is wholly in the form of a capital gain (the difference between issue and redemption price).
1.5 Tax Relief on Debt Interest

Interest expense is tax deductible and therefore reduces corporation tax payments. The issue of debt is therefore preferable to the issue of shares, as dividends are not tax deductible.

Example 2 Debt Interest Tax Relief

Co A Co B
Profit before tax 100 100
Interest - (10)
 Example 2 Debt Interest Tax Relief

100 90
Corporation tax 30% (30) (27)
70 63

$7 difference
Effective cost of debt in Co B
Interest 10
Less: Tax relief (3)
7
Points to note:
• The after-tax cost of debt (i.e. to the company) = Pre-tax cost of debt × (1−tax rate).
• The pre-tax cost of debt to the company = Return required by the debtholders.
• The post-tax cost is said to be lower due the "tax shield" on the coupon payments.
2.1 Convertibles

Definition

Convertibles – loan notes or preference shares which can be converted into a pre-determined number
of ordinary shares.
Convertible loan notes and convertible preference shares:
• Pay a fixed coupon or dividend until converted.
• May be converted into ordinary shares:
o on, or by, a pre-determined date;
o at a pre-determined rate (the conversion ratio); and
o at the option of the holder.
• May have a conversion ratio which changes during the period of convertibility to stimulate early conversion.
(Numerical examples showing how convertibles work will be covered in Chapter 10.)
Convertibles have the following advantages:
• For investors, they are a relatively low-risk investment with the opportunity to make high returns on conversion to ordinary shares.
• For the issuer, they can offer a lower coupon/dividend rate than would have to be paid on a non-convertible (straight) loan notes/preference shares (because the conversion option has
value).
• For younger companies, investors may not want to risk investing in equity but may be prepared to invest in less risky loan notes. If the company does well, investors can opt to convert and
benefit from capital growth, or otherwise keep the safe loan notes.
Convertible loan notes require calculation of "fully diluted" earnings per share (EPS) to indicate what the EPS might be if debt is converted into equity (see Chapter 19).

2.2 Warrants
 Definition

Warrant – the investor's right, but not the obligation, to purchase new shares at a future date at a fixed
price. This fixed price is also called the exercise or subscription price.
Warrants:
• Are sometimes attached to loan notes, to make the loan notes more attractive.
• Are an option to buy shares.
• May be separated from the underlying debt so the holder of the warrants may sell them rather than keep them (i.e. they are traded independently).
Warrants offer several advantages for the issuing company:
• When initially attached to the loan note, the coupon rate on the loan note will be lower than for comparable straight debt. This is because the investor has the additional benefit of the
potential purchase of equity shares at an attractive price.
• They may make an issue of unsecured debt possible when the company's assets are inadequate to secure the debt.
• They are a way of issuing equity (albeit with a delay) without the usual negative signal associated with an equity issue.
3.1 Bank Loans

Companies agree borrowings from the bank at a fixed rate, for a specified period and with an agreed repayment schedule.

Advantage
• As the loan is for a fixed term, there is no risk of early recall (unlike overdrafts that are repayable on demand).

Disadvantages
• Inflexible.
• May require security.
• May require covenants, which are restrictions on the company (e.g. limits on dividend payments, limits on further borrowing), designed to protect the debt holder and could reduce the
interest rate on the debt.
3.2 Leasing

Instead of buying an asset outright, using retained earnings or borrowed funds, a company may lease an asset.
Under a lease contract, the lessee has the right to use an asset which is owned by the lessor, in exchange for a series of payments.

Advantages
• There are many willing providers (often associated with asset manufacturers and therefore offering attractive terms).
• Matches finance to the asset.
• Very flexible packages available, some of which include maintenance.

Disadvantage
• May be expensive.
3.3 Sale and Leaseback

Under a sale and leaseback, a company sells property to an institution, such as a pension fund, and then leases it. Funds raised from the sale generate short-term cash but there are disadvantages:
 • The company no longer owns the property and so cannot participate in any future increase in its value.
• The future borrowing capacity of the company will be reduced, as there will be fewer assets to provide security for a loan.
• Net effect is equivalent to secured borrowing. A right-of-use asset will be capitalised (potentially at a higher amount than the carrying amount of the leased asset) and a lease liability
recognised. Gearing (the proportion of debt finance to equity finance) will increase.
3.4 Mortgage Loans

A mortgage loan is a loan secured by property.

Advantages
• Given the security, the loan will have a lower rate of interest than other debt.
• Institutions will be willing to lend over a longer term.
• The company can still participate in the growth of the property's value.

Disadvantages
• There are likely to be restrictive covenants concerning the use of the property and its potential disposal.
• In the event of default on repayments, the bank may force the sale of the property to recover the loan.
4.1 Bank Overdraft

A bank overdraft is a borrowing facility associated with a current account. In jurisdictions where a bank overdraft is allowed, it is often the liquidity fallback of choice for small- and medium-sized
entities (SMEs).

Advantages Disadvantages

• Flexible. • Usually technically repayable on demand.

• Provides instant finance. • Expensive if used regularly.

4.2 Trade Credit

Businesses that offer trade credit invoice their customers with payment terms or 30, 60 or 90 days, for example. Customers can take advantage of trade credit by delaying/slowing payments to
existing suppliers or using more of the credit offered by suppliers.

Advantages Disadvantages

• Generally • May lose settlement (prompt payment) discounts.

cheap. • Temptation to delay payment beyond formal payment terms may
• Flexible. trigger penalties or lose supplier goodwill.

4.3 Bills of Exchange

 Definition

Bill of exchange – an acknowledgement of a debt to be paid on a stated date.

In international trade, an exporter typically requires a customer to accept a bill before releasing documents of title to the goods.
The exporter may then:
• hold the bill to maturity (and receive payment from the customer); or
• "discount" the bill with a bank to receive cash earlier. (If the customer then fails to pay, the bank has recourse to the exporter for payment.)
Bills of exchange are not widely used today – having been replaced with alternatives (e.g. bank wires and credit/debit card payments).

Example 3 Bill of Exchange

X sells $2 million worth of goods to Y. X writes out ("draws") a bill of exchange for $2 million payable in
two months which it sends to Y. Y signs the bill to acknowledge the debt and returns it to X.
X can either hold the bill for two months until Y pays the debt or sell it at a discount (e.g. at 98% of
nominal value). If Y then pays, the buyer of the bill receives the $2 million and makes a gain.

9.4.4 Commercial Paper

4.4 Commercial Paper

Definition

Commercial paper – short-term unsecured debt issued by high-quality companies. The paper can then
be traded by investors on the secondary market.
Commercial paper is appropriate for financing short-term liabilities.

Advantages Disadvantages

• Large sums can be raised

relatively cheaply. • Only available to large companies with
• No security is required. investment-grade credit ratings.

4.5 Short-term Bank Loans

A short-term cash injection can help companies in need of working capital. Short repayment terms are typically from 3 months to one year.

Advantages
• Available to most companies (assuming a well-functioning banking system).
• Typically unsecured (i.e. no need to provide collateral)
 • Short-term interest rates are usually lower than long-term interest rates, due to lower credit risk on short-term debt.

Disadvantages
• Arrangement fees may be high when expressed as an annual effective cost.
• Refinancing risk (rollover risk). Every time a short-term loan matures, the borrower faces the risk that it cannot be easily replaced or refinanced, or that interest rates have risen.
5.1 Debt Finance

Sources of debt finance available to SMEs include:

• Trade credit.
• Factoring and invoice discounting (whereby a company effectively raises finance against the security of its outstanding receivables – see Chapter 16). These forms of short-term financial
may be more expensive than a bank overdraft but the finance available grows as the SME grows (as it is based on the level of receivables).
• Leasing is useful for SME as it avoids the need to raise the capital cost of assets. For SMEs, leasing can be cheaper than borrowing because:
o Large leasing companies have bargaining power with suppliers, and so the reduced cost of assets can be partially passed on to lessees.
o Leasing companies can usually dispose of old assets more effectively than SMEs.
o The lease company can reclaim the asset if the lessee defaults on the lease payments, so the agreement has built in security.
o The finance cost to a large established leasing company is likely to be less than that for an SME.
• Bank finance, typically an overdraft or longer-term loans secured on major assets, is usually supported by business plans including cash flow forecasts and backed by personal guarantees
of the owner-manager of the SME.
Exam advice

These options are particularly suitable for small- and medium-sized entities (SMEs), which often have
difficulty finding debt finance. Such difficulties may be caused by asymmetry of information (as covered
in Chapter 8), such that banks fear making loans to entities which are not well-known and without
published credit ratings.

9.5.2 Government Sources

5.2 Government Sources

5.2.1 Grants and Subsidies

Depending on the location and nature of the SME, regional, national or even international grants may be available, either to help start-up the business or to contribute towards the cost of expansion.
Subsidies may take the form of government loans offered to SMEs at interest rates below commercial levels.

5.2.2 Government Loan Guarantee Schemes

The government may choose to act as guarantor for commercial loans to SMEs. For example, under the Enterprise Finance Guarantee scheme in the UK, the government will, for a small fee from
the SME, guarantee a large proportion of any loan advanced by a bank. Banks are therefore potentially more willing to lend, as most of their risk has been eliminated. The SME must, however, be
able to demonstrate to the lender that it should be able to repay the loan in full.

5.3 Business Angels

As described in Chapter 8, these are wealthy individuals who are prepared to invest money and time in small companies if they see high potential for growth.
If prepared to invest debt, they also may want the opportunity for equity participation in the future. Convertible debt or debt with warrants may therefore be appropriate.

9.5.4 Supply Chain Financing

5.4 Supply Chain Financing

Definition

Supply Chain Finance (SCF) – the use of financial instruments, practices and technologies to
optimise the management of the working capital and liquidity tied up in supply chain processes for
collaborating business partners.
SCF provides short-term credit that optimises working capital for both the buyer and the seller. It generally involves the use of a technology platform to automate transactions and track the invoice
approval and settlement processes from initiation to completion.
The growing popularity of SCF has been largely driven by the increasing globalisation and complexity of the supply chain, especially in industries such as car manufacturing and the retail sector.
SCF can be particularly beneficial to SMEs with a poor credit rating (or lacking a credit history) that supply goods or services to a large company with a good credit rating. It allows the SME to take
advantage of its customer's superior credit rating and receive immediate payment at a small discount to the sales invoice's face value. The customer may also benefit from its bank offering extended
payment terms on the invoice.
However, a disadvantage for SME suppliers is that larger trading partners may be in a position to abuse their power by demanding lower prices from them in exchange for arranging SCF.

Example 4 Supply Chain Financing

Aplus Co, a large company with a good credit rating, buys goods from Beplus Co, an SME, on 30 days
credit.
• Beplus Co issues a sales invoice to Aplus Co on standard terms (i.e. payment within 30
days).
• Aplus Co approves the invoice.
• Aplus Co is expected to pay the amount due to its financial institution, Bank C, in 30 days.
Bank C would then make immediate payment to Beplus Co.
• However, Beplus can request funds from Bank C at any time during the 30 days. In this case
Beplus will receive the amount due less a small discount which is Bank C’s fee for the
(minor) risk that the invoice will not be paid (by Aplus Co).
• If Aplus Co wants to delay payment to Bank C beyond 30 days it may ask for extended
credit (e.g. an additional 30 days' credit). Aplus Co will be charged bank interest at a rate
which reflects its credit rating.
• In the unlikely event that Aplus fails to pay Bank C, it is Bank C that suffers the bad debt.

9.5.5 Peer-to-Peer (P2P) Lending

5.5 Peer-to-Peer (P2P) Lending
 Definition

Peer-to-peer (P2P) lending – a method of debt financing that enables individuals to lend money to small
businesses without the use of an official financial institution as an intermediary.
P2P lending is also referred to as "debt-based crowdfunding".

Advantages
• Loans generate interest income for lenders, which can often exceed that which would be earned on a bank deposit account.
• Borrowers have access to finance when banks refuse credit or would charge very high interest rates.
• By effectively cutting out the middleman (i.e. the formal banking system), interest rates can be relatively attractive to both lenders and borrowers.
Example 5 P2P Lending

LendingClub is a debt-based crowdfunding platform that offers small business loans up to $300,000
with terms up to five years with relatively low interest rates starting at 5.99% per year.

Exam advice

If asked to recommend a suitable financing method, consider the following factors (in so far as the
information permits):
Availability. Finance may be limited if recent or forecast performance is poor and an SME will always
find it difficult to raise equity.
Cash flow. Debt requires a company to pay out cash in the form of interest and therefore the company’s
ability to generate cash will be relevant.
Control. Raising equity can lead to a change in control, debt will not.
Cost. Debt finance is cheaper than equity finance, so if the company can take on more debt, there could
be a cost advantage.
Ease and cost of issue. Raising equity is more difficult, takes more time and is more expensive than
raising debt.
Maturity. In general, the term of the finance should match the term of the need (matching principle). The
maturity dates of existing debt should also be considered, however.
Risk. Company directors must control the total risk (financial risk and business risk). If business risk is
rising, the company may seek to reduce financial risk and vice versa.
Security and covenants. Debt may require security (is this available?) or covenants (are these
acceptable?) such as to maintain a certain liquidity level.
Yield curve. If, for example, the yield curve is getting steeper (see Chapter 2), there is an expectation
that interest rates will rise. A fixed rate debt may therefore be appropriate if a company wises to take on
more debt.

9 Syllabus Coverage
Syllabus Coverage

This chapter covers the following Learning Outcomes.

E. Business Finance
1. Sources of, and raising, business finance
1. Identify and discuss the range of short-term sources of finance available to businesses, including:
i. overdraft
ii. short-term loan
iii. trade credit
iv. lease finance.
1. Identify and discuss the range of long-term sources of finance available to businesses, including:
ii.debt finance
ii.lease finance.
5. Finance for small- and medium-sized entities (SMEs)
1. Identify and evaluate the financial impact of sources of finance for SMEs, including sources already referred to in syllabus section E1 and also:
i. Business angel financing
ii. Government assistance
iii. Supply chain financing
iv. Peer-to-peer funding.

Summary and Quiz

• Although legally they are equity, preference shares are in substance debt, as they pay a fixed committed dividend in priority to any ordinary dividend. They also rank ahead of ordinary
shareholders on liquidation (although after "real" debt, such as bank loans and loan notes).
• Preference shareholders face lower risk than ordinary shareholders and require lower returns.
• Banks and holders of loan note, however, take even lower risks, as they rank ahead of preference shareholders on bankruptcy, and their debts may be secured by a fixed or floating
charge over assets. Providers of loans therefore require lower returns than other providers of finance.
• Loan notes can be secured or unsecured. The security can be specific assets (a fixed charge) or a class of assets (a floating charge). The assets are used as security and are sold to pay
the loan note if default occurs.
• Deep discount loan notes are loan notes issued at a large discount to nominal value (issued well below nominal value) and redeemable at par on maturity.
• The ultimate deep discount loan note is a zero-coupon loan note, which is issued at a discount to nominal value and pays no coupon.
• Convertibles are loan notes or preference shares which can be converted into ordinary shares.
• A warrant offers the investor the right, but not the obligation, to purchase new shares at a future date at a fixed price.
• Medium-term finance includes bank loans, leasing, sale and leaseback and bank loans.
• Short-term finance includes bank overdrafts, trade credit, bills of exchange, short-term bank loans and commercial paper. Commercial paper is short-term unsecured debt issued by high-
quality companies, which can then be traded by investors.
• SMEs may need to look at grants and subsidies, loan guarantees, business angels, supply chain financing and peer-to-peer lending when trying to raise debt finance.

ECHO CO
The following financial information relates to Echo Co:
Statement of profit or loss information for the last year
$m
Profit before interest and tax 12
Interest 3
Profit before tax 9
 Income tax expense 3
Profit for the period 6
Dividends 2
Retained profit for the period 4
Statement of financial position information as at the end of the last year
$m $m
Ordinary shares (nominal value $0.50) 5
Retained earnings 15
Total equity 20
8% loan notes, redeemable in three years’ time 30
Total equity and non-current liabilities 50
Average data on companies similar to Echo Co

Interest coverage ratio 8 times

Long-term debt/equity (book value basis) 80%

The board of Echo is considering two proposals that have been made by its finance director. Each proposal is independent of any other proposal.
Proposal A
The current dividend per share should be increased by 20% in order to make the company more attractive to equity investors.
Proposal B
A loan note issue should be made in order to raise $15m of new debt capital. Although there are no investment opportunities currently available, the cash raised would be invested on a short-term
basis until a suitable investment opportunity arose. The loan notes would pay interest at a rate of 10% per year and be redeemable in eight years’ time at nominal value.

Required:
(a) Analyse and discuss Proposal A. (4 marks)

(b) Evaluate and discuss Proposal B. (6 marks)

(10 marks)
Your Answer:AZXA

(a) Proposal A
Echo paid a total dividend of $2m or $0.20 per share according to the statement of profit or loss. An increase of 20% would make this $2.4m or $0.24 per share and would reduce dividend cover
from 3 times to 2.5 times. It is debatable whether this increase in the current dividend would make the company more attractive to equity investors, who use a variety of factors to inform their
investment decisions, not expected dividends alone. For example, they will consider the business and financial risk associated with a company when deciding on their required rate of return.
It is also unclear what objective the finance director had in mind when suggesting a dividend increase. The primary financial management objective is to maximise shareholder wealth and if Echo
has this objective, the dividend will already be set at an optimal level. From this perspective, a dividend increase should arise from increased maintainable profitability, not from a desire to “make the
company more attractive”. Increasing the dividend will not generate any additional capital for Echo, since existing shares are traded on the secondary market.
The proposal to increase the dividend should therefore be rejected, perhaps in favour of a dividend increase in line with current dividend policy.

(b) Proposal B
The proposal to raise $15m of additional debt finance does not appear to be a sensible one, given the current financial position of Echo. The company is very highly geared if financial gearing
measured on a book value basis is considered. The debt/equity ratio of 150% is almost twice the average of companies similar to Echo. This negative view of the financial risk of the company is
reinforced by the interest coverage ratio, which at only four times is half that of companies similar to Echo.
Raising additional debt would only worsen these indicators of financial risk. The debt/equity ratio would rise to 225% on a book value basis and the interest coverage ratio would fall to 2.7 times,
suggesting that Echo would experience difficulty in making interest payments.
The proposed use to which the newly-raised funds would be put merits further investigation. Additional finance should be raised when it is needed, rather than being held for speculative purposes.
Until a suitable investment opportunity comes along, Echo will be paying an opportunity cost on the new finance equal to the difference between the interest rate on the new debt (10%) and the
interest paid on short-term investments. This opportunity cost would decrease shareholder wealth. Even if an investment opportunity arises, it is very unlikely that the funds needed would be exactly
equal to $15m.
The interest charge in the statement of profit or loss is $3m while the interest payable on the 8% loan notes is $2.4m (30 × 0.08). It is reasonable to assume that $0.6m of interest is due to an
overdraft. Assuming a short-term interest rate lower than the 8% loan note rate − say 6% − implies an overdraft of approximately $10m (0.6/0.06), which is one-third of the amount of the long-term
debt. The debt/equity ratio calculated did not include this significant amount of short-term debt and therefore underestimates the financial risk of Echo.
The loan note issue would be repayable in eight years’ time, which is five years after the redemption date of the current loan note issue. The need to redeem the current $30m loan note issue
cannot be ignored in the financial planning of the company. The proposal to raise £15m of long-term debt finance should arise from a considered strategic review of the long-term and short-term
financing needs of Echo, which must also consider redemption or refinancing of the current loan note issue and, perhaps, reduction of the sizeable overdraft, which may be close to, or in excess of,
its agreed limit.
In light of the concerns and considerations discussed, the proposal to raise additional debt finance cannot be recommended.
Analysis
Current gearing (debt/equity ratio using book values) = 30/20 = 150%
Revised gearing (debt/equity ratio using book values) = (30 + 15)/20 = 225%
Current interest coverage ratio = 12/3 = 4 times
Additional interest following debt issue = 15m × 0.1 = $1.5m
Revised interest coverage ratio = 12/(3 + 1.5) = 2.7 times
CHAPTER 10: Visual Overview

Objective: To estimate the cost of equity and the cost of debt.

1.1 Creditor Hierarchy

The relative risk/return relationship of equity and debt is based on their relative priority for repayment on liquidation − the creditor hierarchy:
On liquidation, the company's assets are sold and the cash raised is paid out according to the priority of creditors:
• Secured loans and secured loan notes are repaid first. Some may be secured by "fixed charge" over a specific asset such as property, others by "floating charge" over classes of assets
such as working capital. Secured creditors would expect to receive most, if not all, of what they are owed in the event of liquidation.
• Trade creditors and unsecured debt are repaid next. When a company is forced into liquidation, by definition the value of its assets is likely to be below the value of its liabilities. In this
case, unsecured creditors may not receive everything they are owed.
• If there are any preference shares in issue, they would be repaid next should there be any cash remaining after paying all creditors.
• Ordinary shareholders rank last on liquidation and would be unlikely to receive anything.
In practice, other stakeholders may have claims on liquidation (e.g. employees, tax authorities and the liquidator). Exam questions would state where in the hierarchy these would rank, as it
depends on the laws of the particular country.

1.2 Risk, Required Return and Cost of Finance

Key Point

The risk faced by each class of investor drives the required return of that investor (there is a risk/return
pay off) and the required return drives the company's cost of each source of finance.

1.2.1 Secured Loans and Secured Loan Notes

Debt investors have legally binding contracts with the company for the payment of interest and repayment of principal. While the company is trading, interest must be paid in priority to dividends. If
the company goes into liquidation, secured creditors are repaid first. Therefore, secured debt can be considered a low-risk investment and investors in secured debt require relatively low returns,
creating relatively cheap finance for the company.
1.2.2 Unsecured Debt
This is also a legally binding contract and its interest must be paid prior to dividends. However, as there is no guarantee of full repayment on liquidation, the required return will be higher than on
secured debt and hence the cost will be higher.

1.2.3 Preference Shares

Although preference dividends are paid after interest on debt, they are a fixed percentage of the share's nominal value and paid before any ordinary dividends. On liquidation, preference shares
rank between creditors and ordinary shares, so the required return of preference shareholders (and hence the company's cost of preference capital) will be higher than on debt, but lower than on
ordinary shares.

1.2.4 Ordinary Shareholders

Equity shareholders have no guarantee of receiving dividends (ordinary dividends are discretionary, whereas preference dividends are committed) and rank last on liquidation. Therefore, ordinary
shareholders face high risk and expect high returns to compensate, leading to the company's cost of equity being relatively high.

1.3 Summary of Equity v Debt

Equity Debt

Rank on liquidation Last Higher

Servicing of finance Discretionary dividend Committed interest

Risk to investor High Lower

Return required High Lower

Cost to company High Lower

Cost of equity > cost of debt

Servicing tax allowable? No Yes

Post-tax cost of debt < pre-tax cost of debt

Speed of issue Slow Faster

Loan notes 1–2% Bank loan –

5–11% (IPO) arrangement fees
Issue costs

2.0 Introduction
This section explains the dividend valuation model that can be used to provide the market value of a share.
The model can be rearranged to estimate the return required by shareholders.
The next section, builds on the model to determine the cost of equity.

2.1 With Constant Dividends

The formula for share valuation can be derived as follows:

Ex-div market value at time Present value of the future dividends discounted at the shareholder’s
0 = required rate of return
Ex-div market value is the market value assuming that a dividend has just been paid (or just about to be paid).
Let:
P0 = Current ex-div market value
Dn = Dividend at time n
re = Shareholders' required rate of return
The model then becomes:

P0 =
If the dividend is assumed to be constant to infinity, this becomes the present value of a perpetuity, which simplifies to:

P0 =
This version of the model can be used to determine the theoretical value of a share which pays a constant dividend (e.g. a preference share or an ordinary share in a zero growth company).

Exam advice

The formula for the present value of a perpetuity is assumed knowledge; it is not provided in the exam
formula sheet.
This derivation of the DVM is not examinable but provided to emphasise that for this formula to “work”
the current market value P0 must be ex-div so the first dividend is receivable at time 1.
2.2 With Dividend Growth

If dividends are forecast to grow at a constant rate in perpetuity, where g = future annual growth rate:

P0 = =

Where D0= most recent dividend

D1 = dividend in one year

re = required return of equity investors

The formula is published in the exam as:

P0 =

2.3 Underlying Assumptions

Underlying assumptions of the DVM include:

• All investors have the same expectations and therefore the same required rate of return.
• Perfect capital market assumptions:
o rational investors;
o no taxes or transactions costs;
o large number of buyers and sellers of shares;
o no individual can affect the share price; and
o perfect information is freely available to all investors.
• Dividends are paid just once a year and one year apart.
• Dividends are either constant or are growing at a constant rate.
2.4 Advantages and Disadvantages of the DVM

2.4.1 Advantages
• It is easy to understand and can be applied to any share that offers a dividend.
• For minority shareholders who have no control over a company’s policies, dividends are the only available metric.
• The model is not subjective (e.g. there is no ambiguity in determining amounts of dividends whereas “earnings” or “profit” are open to interpretation).
• It is particularly suitable for “mature” companies paying regular dividends.
• It is based solely on dividends, taking no account of market conditions, making comparisons across companies of different sizes and industries easier.

2.4.2 Disadvantages
• It cannot be applied to shares that do not pay dividends and therefore cannot be used for smaller business and startups.
• It assumes shares have no issue costs.
 • It does not explicitly incorporate risk.
• It is overly simplistic, for example, g can only be an approximation because dividends do not grow at a constant rate in reality.
• It makes no allowance for non-dividend factors that influence the value of a share (e.g. brand loyalty and other internally generated intangible assets).
• It makes no allowance for the effect of taxation.
• It ignores capital gains tax on investors (although it could be argued that the change of ownership of a share does not affect the PV of a dividend stream).

2.5 Using the DVM

If the company is listed and the share price is known, the model can be rearranged and used to estimate the required return of shareholders, r e.
Example 1 Investors' Required Return

A share has a current ex-div market value of $0.80 and investors expect a dividend of $0.10 per share to
be paid each year, as has been the case for the past few years.
Using the DVM, the investors' required return can be determined:

P0 =

$0.80 =

re = = 12.5%
Investors will all require this return from the share, as the model assumes they all have the same
information about the risk of this share and they are all rational.
If investors think that the dividend is due to increase to $0.15 each year, the share is giving a higher than
12.5% return at a price of $0.80. Investors will therefore buy the share and the price will increase until,
according to the model, the value will be:

P0 = = $1.20
Alternatively, suppose that the investors' perception is that the dividend will remain at $0.10 per share but
that the risk of the share has increased and so requires a 15% return. If the share only gives a return of
12.5% (on $0.80 share price), investors will sell and the price will fall. The fair value of the share
according to the model will be:

P0 = = $0.67

3.1 Using the DVM

3.1.1 Constant Dividends

The basic DVM is:
P0 =
As seen in Example 1, this can be rearranged to find re:

re =
If re is the return required by the shareholders in order that the share value remain constant, it is also the return that the company must pay to its shareholders. Therefore, re also equates to the
company’s cost of equity, ke.
Therefore, the cost of equity for a company with a constant annual dividend can be estimated as the dividend divided into the ex-div share price (i.e. the dividend yield).
The ex-div market value is the market value of the share, assuming that the current dividend has just been paid.
A cum-div market value is one which includes the value of the dividend just about to be paid. If given a cum-div market value, this must be adjusted to an ex-div market value by deducting the
current dividend.
Activity 1 Cost of Equity

A company's shares have a market value of $2.20 each. The company is just about to pay a dividend of $0.20 per share, as it has every year for the last ten years.
Required:
Calculate the company's cost of equity.
*Please use the notes feature in the toolbar to help formulate your answer.

3.1.2 Dividend with Constant Growth

The model can also deal with a dividend that is growing at a constant annual rate, g.
The formula for valuing the share as seen earlier is:

P0 = =

Where D0 = most recent dividend

D1 = dividend in one year

Rearranged, this becomes:

re = +g

Where g = growth rate (assumed constant in perpetuity)

P0 = ex-div market value

Therefore, if shareholders’ required return is the same as the cost of equity, the cost of equity, k e = Dividend yield + estimated growth rate.
Example 2 Dividend with Constant Growth

D0 = $0.12
P0 (ex-div) = $1.75
g = 5%
Calculate the value of ke.
 Example 2 Dividend with Constant Growth

ke = + 0.05 = 12.2%
Activity 2 Dividend with Constant Growth

The dividend just about to be paid by a company is $0.24. The current market price of the share is $2.76 cum-div. The historical dividend growth rate, which is expected to continue in the future, is
5%.
Required:
Calculate the estimated cost of equity.
*Please use the notes feature in the toolbar to help formulate your answer.

10.3.2 The Growth Rate of Dividends

3.2 The Growth Rate of Dividends

The growth rate of dividends can be estimated using either of two methods:

3.2.1 From Past Dividends

This method analyses historical growth to predict future growth:
• If dividends have grown at 5% each year for the last 10 years, the predicted future growth is 5%.
• For an uneven but steady growth, take an average overall growth rate – the “geometric mean”.
• If there is a discontinuity in the growth rate, take the most recent evidence.
• For a new company with very high growth rates, take account of the fact that it is unlikely to produce such high growth in perpetuity.
• If there is no pattern (i.e. dividends up one year, down the next), this method should not be used.
Activity 3 Growth Using Extrapolation

A company has paid the following dividends over the last five years:
 Dividend per share
20X0 $1.00
20X1 $1.10
20X2 $1.25
20X3 $1.36
20X4 $1.45
The current (20X4) ex-div market value is $10.50 per share.
Required:
Estimate the growth rate and the cost of equity.
*Please use the notes feature in the toolbar to help formulate your answer.

3.2.2 Gordon's Growth Model

According to Gordon’s growth model, growth is achieved by retention and reinvestment of profits:
g = br

where b = proportion of profits retained ("retention ratio")

r = rate of return on those retained profits (the return on capital employed)

Take an average of r and b over the preceding years to estimate future growth:

re = =

b=
These figures can be obtained from the statement of financial position and statement of profit or loss.
Activity 4 Gordon Growth Model

A company has 300,000 ordinary shares in issue with an ex-div market value of $2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits of $100,000.
Net assets at the year end were valued at $1.06 million.
Required:
Estimate the cost of equity.
*Please use the notes feature in the toolbar to help formulate your answer.

Key Point

A company cannot alter its cost of equity by changing its dividends, which the equation for the DVM
might suggest. A cut in dividends or the growth rate would cause the market value of the shares to fall to
the level at which investors would obtain the return they require.
3.3 Cost of Equity and Project Appraisal

Example 3 Effect of a Project on Value of Equity

Axis Co, which is listed on a stock exchange, is all equity financed and has 1 million shares quoted at $2
each ex-div. It pays constant annual dividends of $0.30 per share.
It is considering adopting a project which will cost $500,000 and which is of the same risk as its existing
activities. The cost will be met by a rights issue. The project will produce inflows of $90,000 per year in
perpetuity. All inflows will be distributed as dividends.
Required:
Calculate the new value of the equity in Axis Co and the gain to the shareholders.
Ignore tax.

ke = = 15%

$000
Existing total dividend 300
Dividends from the project 90
New total dividend 390

Value of equity = = $2,600,000

Shareholders' gain = $(2,600,000 − 2,000,000) – $500,000 = $100,000

Project NPV = ($500,000) + = $100,000

Therefore, new value of equity
= Existing value + Equity outlay + NPV
= Existing value + PV of additional dividends

As shown by Example 3, the NPV of a project serves to increase the value of the company's shares (i.e. the NPV of a project shows the increase in shareholders' wealth).
This demonstrates that NPV is consistent with the assumed objective of maximising shareholder wealth: $1 of NPV is $1 increase in shareholders’ wealth.

3.4 Cost of Preference Shares

By definition, preference shares have a constant dividend:

ke =
where D = constant annual dividend
Preference dividends are normally quoted as a percentage (e.g. 10% preference shares). This means that the annual dividend will be 10% of the nominal value, not the market value.
Activity 5 Cost of Preference Shares

A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
Required:
Calculate the cost of the preference shares.
*Please use the notes feature in the toolbar to help formulate your answer.

4.1 Terminology

Definition

Loan note − a security instrument (so it is tradable) that acknowledges a company's debt.
Also called a bond or debenture, a loan note:
• Usually pays a fixed coupon.
• May be secured or unsecured.
• If quoted, it will trade on an exchange at a price determined by that market.
Definition

Coupon rate − the interest rate printed on the loan note certificate.
Therefore:

Annual interest = coupon rate × nominal value

Definition

Nominal value − the value that is stated on an issued security.

Nominal value is also known as par or face value.

Exam advice

In the exam the nominal value of one loan note is usually $100.
Market value (MV) is normally quoted as the MV of a block of $100 nominal value. For example, 10% loan notes quoted at $95 means that a $100 block is selling for $95 and annual interest is $10
per $100 block.
Market value (ex-int) is when interest has just been paid.
Market value (cum-int) includes the value of accrued interest which is just about to be paid.

4.2 Irredeemable Loan Notes

Irredeemable loan notes are a type of debt finance where the company will never repay the principal but will pay interest each year until infinity. They are also referred to as undated loan notes.
The market value of undated debt can be calculated using the same logic as the DVM:

Key Point

MV (ex-interest) = PV of future interest payments discounted at the debtholder's required rate of return.
For irredeemable loan notes the interest is a perpetuity.

P0 =
Where:
P0 = Ex-interest market price
I = Annual interest payment
kd = Bondholders' required return

The required return kd = = current yield (also called interest yield or running yield) is the firm's pre-tax cost of irredeemable bonds. If the company gets tax relief on the interest it pays, the cost
to the company will be reduced by the "tax shield" on debt.
Example 4 Tax Shield of Debt Interest

Consider two companies with the same earnings before interest and tax (EBIT). The first company has
some debt finance, the second has no debt.

$ $
EBIT 100 100
Debt interest (10)
Profits before tax 90 100
Tax @ 33% 29.70 33

$3.30 difference
Therefore:

$
Debt interest 10.00
Less: tax shield (3.30)
Effective cost of debt 6.70

Exam advice

An exam question will state whether to assume that tax liability is paid, and therefore tax relief is
received, in the year in which it arises (i.e. “instant”) or at the end of the following year.
If the debt is irredeemable:
Cost of debt to the company Return required by debt
=
(“post-tax” cost of debt) holders × (1 − Tc)
= kd × (1 − Tc)
Where Tc = corporate tax rate as a decimal
Key Point

kd is used to denote the pre-tax cost of debt.

Activity 6 Cost of Irredeemable Debt

12% undated loan notes with a nominal value of $100 are quoted at $92 cum-interest. The rate of corporation tax is 33%.
Required:
Calculate:
1. the return required by the debt investors; and
2. the cost to the company.
*Please use the notes feature in the toolbar to help formulate your answer.
10.4.3 Redeemable Loan Notes
4.3 Redeemable Loan Notes

Definition

Redeemable loan note – a loan note that can be redeemed by the issuer prior to its maturity date. Also
referred to as callable loan notes. Early redemption would usually be at a premium above the loan note's
nominal value.
The cash flows are not a perpetuity because the principal will be repaid. However, the following rule is derived from the DVM:

Key Point

The cost of any source of funds is the IRR of the cash flows associated with that source.
• Looking at the return from an investor's point of view, interest payments are gross.
• Looking at the cost to the company, interest payments are included net of corporation tax.
• Assume instant tax relief and that the final redemption payment does not have any tax effects.
• To find the cost of debt for a company, find the IRR of the following cash flows:
The cost of any source of funds is the IRR of the cash flows associated with that source.

Time $

0 Market value (ex-interest) x

1–n Post-tax interest (x)

n Redemption value (x)

The IRR is found as usual using linear interpolation.
 Exam advice

Usually NPV calculations present future cash flows as inflows. When future cash flows are presented
as outflows (as above), however, if the first NPV calculation is positive, NPV should be recalculated at
a lower discount rate to get closer to zero.
Activity 7 Cost of Redeemable Debt

A company has in issue $200,000 7% loan notes redeemable at a premium of 5% on 31 December 20X6. Interest is paid annually on 31 December. It is currently 1 January 20X3 and the loan notes
are trading at $98 ex-interest per $100 nominal value. Corporation tax is 33%.
Required:
Calculate the company's cost of debt.
*Please use the notes feature in the toolbar to help formulate your answer.

Required return of the redeemable debt holder = IRR of pre-tax cash flows from the bond = Gross redemption yeild
Gross redemption yield is also referred to as the yield to maturity (YTM).
10.4.4 Semi-annual Interest Payments
4.4 Semi-annual Interest Payments

In practice, interest is usually paid every six months rather than annually. This practical aspect can be built into calculations for the cost of debt as follows:
• If interest is paid every six months, the calculation of the IRR of the loan notes must be based on cash flows at six-month intervals.
• The IRR, or cost of debt, will then be a six-month cost of debt and must be adjusted to determine the annual cost of debt.
Effective annual cost = (1 + semi-annual cost)2 -1
Activity 8 Semi-Annual Interest

A company has in issue 6% loan notes, the interest on which is paid on 30 June and 31 December each year. The loan notes are redeemable at nominal value on 31 December 20X9. It is now 1
January 20X7 and the loan notes are quoted at $96 per $100 nominal value.
Required:
Calculate the effective annual cost of debt, kd. Ignore corporation tax.
*Please use the notes feature in the toolbar to help formulate your answer.

10.4.4 Semi-annual Interest Payments

4.4 Semi-annual Interest Payments

In practice, interest is usually paid every six months rather than annually. This practical aspect can be built into calculations for the cost of debt as follows:
• If interest is paid every six months, the calculation of the IRR of the loan notes must be based on cash flows at six-month intervals.
• The IRR, or cost of debt, will then be a six-month cost of debt and must be adjusted to determine the annual cost of debt.
 Effective annual cost = (1 + semi-annual cost)2 -1
Activity 8 Semi-Annual Interest

A company has in issue 6% loan notes, the interest on which is paid on 30 June and 31 December each year. The loan notes are redeemable at nominal value on 31 December 20X9. It is now 1
January 20X7 and the loan notes are quoted at $96 per $100 nominal value.
Required:
Calculate the effective annual cost of debt, kd. Ignore corporation tax.
*Please use the notes feature in the toolbar to help formulate your answer.
10.4.5 Convertible Loan Notes
4.5 Convertible Loan Notes

Convertible loan notes allow the investor to choose between redemption at some future date or conversion into a predetermined number of ordinary shares (see Chapter 9).
To find the post-tax cost of convertible debt, find the IRR of the after-tax cash flows:
Time $

0 Market value (ex-interest) x

1–n Post-tax interest (x)

n Higher of redemption value/forecast conversion value (x)

Activity 9 Convertible Loan Notes

A company has in issue some 8% convertible loan notes currently quoted at $85 ex-interest. The loan notes are redeemable at a 5% premium in five years' time or can be converted into 40 ordinary
shares at that date. The current ex-div market value of the shares is $2 per share and dividend growth is expected at 7% per year. Corporation tax is 33%.
Required:
Calculate the cost to the company of the convertible loan notes.
*Please use the notes feature in the toolbar to help formulate your answer.
Activity 10 Different Conversion/Redemption Dates

A company has 5% loan notes in issue which are redeemable at their nominal value of $100 per loan note in eight years' time. Alternatively, each loan note is convertible after seven years into 11
ordinary shares. The company's ordinary shares are currently trading at $6.50 per share and this is expected to increase by 6% per year. The current market value of the loan notes is $88.70 per
loan note. The corporate tax rate is 30%.
Required:
Calculate the cost to the company of the convertible loan notes.
*Please use the notes feature in the toolbar to help formulate your answer.

10.4.6 Bank Loans

4.6 Bank Loans

Unless the exam question states otherwise, the interest rate quoted on a bank loan can be assumed to be the pre-tax cost.
A profitable company should be able to claim a tax shield on bank loan interest, therefore the post-tax cost of bank loans = Quoted interest rate × (1 − corporation tax rate).
As bank loans are not traded, their book value must be used as a proxy for market value.

Syllabus Coverage

This chapter covers the following Learning Outcomes.

B. Financial Management Environment

2. The nature and role of financial markets and institutions
1. Explain the nature and features of different securities in relation to the risk/return trade-off.

E. Business Finance
2. Estimating the cost of capital
1. Estimate the cost of equity including:
1. application of the dividend growth model, its assumptions, advantages and disadvantages
2. Estimating the cost of debt:
1. irredeemable debt
2. redeemable debt
3. convertible debt
4. preference shares
5. bank debt.
3. Sources of finance and their relative costs
1. Describe the relative risk-return relationship and the relative costs of equity and debt.
2. Describe the creditor hierarchy and its connection with the relative costs of sources of finance.
Summary and Quiz
• On liquidation, the company's assets are sold and the cash raised is paid out according to the priority of creditors in which the ordinary shareholders rank last. Ordinary shareholders
therefore require the highest returns.
• If capital markets are perfect and the market price of a share is known, the dividend valuation model (DVM) can be rearranged to find the required return of investors, which is the
company's cost of equity.
• If dividends are growing, the growth rate can be determined by extrapolating past dividends or using Gordon’s growth model.
• For loan notes, annual interest = coupon rate × nominal value (usually $100 in the exam). Market value (ex-int) is when interest has just been paid. Market value (cum-int) includes the
value of accrued interest which is just about to be paid.

• For irredeemable loan notes, pre-tax kd =

• For redeemable loan notes and convertible loan notes, post-tax kd is the IRR of the post-tax cash flows associated with the source of funds.

Chapter 10 Quiz
 COST OF CAPITAL
(a) Calculate the current before-tax cost of the following loans:

i.A 10% irredeemable loan note issued at nominal value.

ii. A 10% irredeemable loan note trading at $85 per $100 nominal value.
iii. A 10% redeemable loan note trading at $74 per $100 nominal value, with three
years until redemption at nominal value.
iv. A 10% redeemable loan note trading at nominal value, with three years until
redemption at nominal value.
v. A 5% irredeemable $1 preference share trading at $0.65. (4 marks)

Assuming a corporate tax rate of 35%, calculate the current after-tax cost of the loans
(b) in (a) above. (3 marks)

(c) Given the following data about share prices, compute the cost of equity in each case:

i.Market price per share $1.50 ex-div. Dividend just paid $0.075, which is expected to remain
constant.
ii. Market price per share $1.65 cum-div. Dividend about to be paid $0.15, which is
expected to remain constant.
iii. Market price per share $1.20 ex-div. Dividend just paid $0.24, with expected
annual growth rate of 5%.
iv. Market capitalisation of equity $10m. Dividends just paid $1.5m, which are
expected to remain constant. (4 marks)

(d) Calculate the total market value of the following companies:

i.W Co has 50,000 $1 ordinary shares in issue, current dividends $0.10 per share expected to
remain constant; cost of equity 10%.
ii. X Co has 1,000 $1 ordinary shares in issue, total dividend $500, no growth
expected; cost of equity 15%.
iii. Y Co has one million ordinary shares, the dividend just paid was $0.10 per share
and it is expected to grow at 5% per year; cost of equity 15%.
iv. Z Co has 10,000 shares in issue, dividends for the next five years are expected to
be constant at $0.10 per share and then grow at 5% per year to perpetuity; cost of
equity 15%. (4 marks)

(15 marks)
Your Answer:ZXA

(a) Cost of debt (before-tax)

i. = = 10%
 ii. = 11.76%
iii. The IRR needs to found for the following cash flows:
t0 t1 t2 t3

$(74) $10 $10 $110

iv.By trial and error, NPV of the four cash flows at:
25% NPV = − $74 + 1.440 × $10 + 0.512 × $110 = − $3.28

20% NPV = − $74 + 1.528 × $10 + 0.579 × $110 = $4.97

Therefore, kd = 20% + × (25% − 20%) = 23%

v.As redeemable at current market price: = 10%

vi. Irredeemable: = 7.7%

(b) Cost of debt (after-tax)

i.10% (1 − 0.35) = 6.5%
ii. 11.76% (1 − 0.35) = 7.64%
iii. The IRR needs to be found for the following cash flows:
t0 t1 t2 t3

$(74) $6.5 $6.5 $106.5

iv.By trial and error:
15% NPV = − $74 + 1.626 × $6.5 + 0.658 × $106.5 = $6.646

20% NPV = − $74 + 1.528 × $6.5 + 0.579 × $106.5 = − $2.405

v.Therefore, after-tax cost of debt = 15% + × (20% − 15%) = 19%

vi.10% × (1 − 0.35) = 6.5%
vii. Is unchanged at 7.7% as there is no tax relief on preference share dividends.

(c) Cost of equity

i.ke = × 100 = 5%

ii. ke = × 100 = 10%

iii. ke = × 100 + 5 = 26%

iv. ke = × 100 = 15%

(d) Dividend valuation model

i.No growth, hence Po = = = $50,000

ii. No growth, hence Po = = $3,333

iii. Constant growth Po = = = $1.05m

iv.
Po = PV of future dividends
=
$0.10 × (10,000 × 3.352) + × 0.497 = $8,570

CHAPTER 11: Visual Overview

Objective: To understand weighted average cost of capital (WACC), including how it is estimated and the effect of gearing on it; the traditional view of capital structure; Modigliani and Miller's
models; and pecking order theory.
1.1 Calculation of WACC

Companies are usually financed by both debt and equity (i.e. they use some degree of financial/capital gearing). The WACC represents a company's average cost of long-term finance.
In the exam the formula given is:

WACC = ke + kd (1 − T)
where:
Ve = Total market value of equity
Vd = Total market value of debt
ke = Cost of equity “geared”
kd = Pre-tax cost of debt
T = Corporation tax rate

Exam advice

kd(1 − T) in the exam formula represents the post-tax cost of debt. However, this is only correct for
irredeemable loan notes.
For a redeemable loan note, the post-tax cost of debt must be calculated as the IRR of its post-tax cash
flows (as already covered in Chapter 10).
Market values of equity/debt (where available) are used to weight the individual costs of capital. However:
• If the company's shares are not listed on the stock market, the book value of equity will have to be used;
• Similarly for debt (i.e. if the company has issued loan notes);
• Use book values for bank loans.
Activity 1 WACC

A company has in issue:

45 million $1 ordinary shares
10% irredeemable loan notes with a book value of $55 million
The loan notes are trading at par.

Share price $1.50

Dividend $0.15 (just paid)

Dividend growth 5% p.a.

Corporation tax 33%

Required:
Estimate the WACC.
*Please use the notes feature in the toolbar to help formulate your answer.
Activity 2 WACC Using Book Values

Lifestyle Co is a family-owned company whose shares are not listed on the stock market. However, the family members have stated that they require an annual return of 12% to compensate for the
risk of their shareholdings.
The following is a summary of the most recent statement of financial position:

$m $m
Assets
Non-current assets 300
Current assets 211
Total assets 511
 $m $m
Equity and liabilities
Share capital 100
Retained earnings 121
Total equity 221
Non-current liabilities Long-term borrowings 200
Current liabilities
Trade payables 80
Accruals 10
Total current liabilities 90
Total liabilities 290
Total equity and liabilities 511
Additional information
Non-current assets include significant property acquired many years ago which has been recorded at historical cost.
The long-term borrowings consist of a bank loan at an annual interest rate of 8%. The company pays 25% tax on its profits.
Required:
1. Estimate Lifestyle Co's WACC.
2. Give FOUR reasons why it would be preferable to use market values rather than book values when estimating the WACC and suggest ONE improvement that Lifestyle could
make to its estimate.
*Please use the notes feature in the toolbar to help formulate your answer.

11.1.2 Implications for Project Financing

1.2 Implications for Project Financing

WACC is a potential discount rate for project appraisal using NPV.

So, a company's existing WACC can be used as the discount rate only if:
• The project exposes investors to the same level of business risk as they currently face; and
• The finance for the project does not alter the financial risk the company faces (i.e. it does not change its gearing).
If the above conditions do not apply (which is likely to be the case, as they are very restrictive), the project represents a change in risk and so investors will expect a different return and the cost of
capital will change. This is explored later in this chapter.

11.1.3 Limitations and Assumptions

1.3 Limitations and Assumptions

The calculation of the WACC depends on the accuracy of the inputs to the formula (k e, kd, Ve, Vd and T). The accuracy of each of these will depend on the models (and the limitations and
assumptions of those models) used to find them. For example:
• ke– Was this calculated using the DVM (Chapter 10) or CAPM (Chapter 12)? How was the growth rate found?
• kd− is this likely to be constant over the project life?
• Ve− if a market price is used, is the market efficient? If the company is unquoted, how has this been estimated?
• T − will this be constant over the life of the loan?

11.1.4 Marginal Cost of Capital

1.4 Marginal Cost of Capital

Marginal cost of capital (MCC) is the cost of raising the most recent dollar of finance. At first, it may seem reasonable to use MCC as the discount rate for project appraisal. But this can lead to
problems:
• Project finance may be drawn from the company's pool of funds and not from a specific source.
 • Even if a project is financed from a specific source it may not be appropriate to evaluate it using the MCC. For example, if a project is financed by debt the discount rate for NPV
should not be the cost of debt as this ignores the fact that the surplus cash flows belong to the equity investors and are exposed to business risk. Hence, the cost of debt understates the
risk of the project and would lead to an overstatement of the project's NPV.
Therefore, the WACC is a more appropriate discount rate than the MCC, as the WACC is an average of the cost of equity (which measures business risk) and the cost of debt.

2.1 Effect

The current WACC reflects the current risk profile of the company: both business risk and financial risk.
Definitions

Business risk – the variability in the operating earnings of the company associated with the industry in
which it operates. It is determined by general business and economic conditions.
Financial risk – the additional variability in returns as a result of introducing fixed-interest debt into the
capital structure. Interest on debt is a committed fixed cost which creates more volatile “bottom-line”
profits for shareholders.

Example 1 Level of Gearing

Two companies, U Co (ungeared) and G Co (geared) are involved in exactly the same type of business.
Between Years 1 and 2, their profits from operations are halved as follows:
U Co G Co
Year 1 Year 2 Year 1 Year 2
Profits from operations 2,000 1,000 2,000 1,000
Interest – – (400) (400)
Profit after interest 2,000 1,000 1,600 600
Tax at 20% (400) (200) (320) (120)
Available to equity shareholders 1,600 800 1,280 480
The amount available to equity shareholders in U Co also halves as profits halve. Their risk or
volatility/variability arises purely from the business operations (i.e. operating conditions are not as
favourable). However, in G Co, the amount available to equity shareholders decreases by 62.5%. Their
risk arises from two sources: business risk plus risk introduced by gearing.

The more highly geared a company is, the more fixed interest it has to pay regardless of profits, and hence the greater the risk that there will be little or nothing available to distribute as a dividend to
shareholders. High financial gearing means that a company is more vulnerable to poor trading conditions.
As a company gears up, shareholders therefore require a higher return, so two things happen as gearing increases:
The effect of increased gearing on the WACC depends on the relative sizes of these two opposing effects.
There are two main schools of thought about gearing and capital structure:
1. Traditional view (see s.3).
2. Modigliani and Miller's theories (see s.4).
A company’s capital structure is the mixture of equity and debt finance that is used to finance its assets. The decision on this mixture is called the financing decision.

Key Point

If the gearing ratio does not change, the WACC will not change. If capital structure is changed (i.e. it
varies the mixture of equity and debt finance), WACC will automatically change.

11.2.2 High Financial Gearing

2.2 High Financial Gearing

A company's level of financial gearing may be considered relatively high when its debt to equity ratio is significantly above the industry average and/or its interest coverage ratio (EBIT divided by
interest expense) is relatively low.
Potential problems of high levels of financial gearing include:
• High level of financial risk: The high levels of committed interest expense make earnings to equity investors more volatile, thereby pushing up the cost of equity.
• Financial distress costs: The company may lose customers due to concerns about its survival and may lose key staff if employees become concerned about job security.
• Increased credit risk: The ratings agencies may cut the company's credit rating, pushing up its cost of debt.
• Agency costs: Debt contracts would include increasingly restrictive covenants (e.g. limiting dividend payments or forcing the company to stay within low-risk projects). In this way the
directors become agents of debt holders rather than of the equity investors and shareholder returns are subsequently damaged.
11.2.3 Forecasting Cash Flows
2.3 Forecasting Cash Flows

To survive, all businesses must maintain an uninterrupted capacity to pay debts when they fall due. As debts are normally paid in the form of cash, the cash flows of a business should be a matter of
intense interest to its managers.
A forecast cash flow statement helps managers to monitor future movements in cash. It sets out the anticipated cash inflows and outflows arising over a particular forecast period and so can provide
an early warning of problems. For example, a forecast cash flow statement may help to identify future breaches of an overdraft limit which has been agreed with the bank and this may allow
managers time to review their plans.
Where the forecast cash flow statement indicates a cash surplus, managers have the opportunity to consider whether this surplus should be reinvested, used to make early redemptions of debt or
distributed to shareholders.
Activity 3 Cash Flow Forecast

Victor is a clothing wholesaler. At the beginning of June, it has a bank overdraft of $75,000. The overdraft limit agreed with the bank is $90,000 and management is keen to keep within this. The
overdraft has grown significantly over the past three months and, to avoid exceeding the limit, management is reviewing its plans for the next six months.
The following actual and forecast information for the period April to November is available:

Actual Forecast
April May June July August Sept Oct Nov
$000 $000 $000 $000 $000 $000 $000 $000
Sales 285 270 280 340 320 275 260 285
Purchases 188 164 175 204 183 188 167 194
Administration expenses 42 38 45 48 42 45 42 39
Selling expenses 36 74 45 43 47 42 46 48
Taxation payment 29
Mortgage repayment 70
Capital expenditure 38 59
Notes:
1. All sales are on credit. Customers paying within one month receive a 2% discount for prompt payment.
2. 80% of credit customers pay within one month and 20% of customers pay two months after the sale.
3. Suppliers allow one month's credit.
4. Management has negotiated an early repayment of a mortgage on freehold property. The outstanding capital sum is due to be repaid in August.
5. Administration expenses are paid when incurred and include a monthly depreciation charge of $12,000.
6. Selling expenses are payable one month after they are incurred.
Required:
1. Prepare a forecast cash flow statement for internal purposes for Victor for the six months ended 30 November which shows the cash balance at the end of each month.
2. Comment on the information provided by the forecast cash flow statement provided in (a) above and suggest how the directors might deal with any problems which are
revealed.
*Please use the notes feature in the toolbar to help formulate your answer.
3.1 Reasoning

The traditional view has no theoretical foundation; it is often described as the "intuitive approach". It is based on the trade-off caused by gearing (i.e. using more, relatively cheap, debt results in a
rising cost of equity). This model/view assumes the following:
• ke rises slowly at low levels of gearing and, therefore, the benefit of using lower-cost debt finance outweighs the cost of the rising ke.
• At higher levels of gearing, the increased financial risk outweighs this benefit and WACC rises.
• At very high levels of gearing, the cost of debt rises due to the risk of default on debt payments (i.e. credit risk). This is referred to as financial distress risk; it should not be confused
with financial risk, which occurs even at relatively safe levels of debt.
These relationships are shown in the graph below:
Where:
Vu = Value of ungeared company
Vg = Value of geared company = Value of equity + Value of debt

Example 2 Market Value of a Company

As seen in Chapter 8 the market value of a company = Future cash flows/shareholders’ required rate of
return (WACC).
So the lower the WACC, the higher the market value of the company. For example:
100 /0.15 = 667
100/0.10 = 1,000
When the WACC falls from 15% to 10%, the market value of the company increases from 667 to 1,000.
Therefore, if capital structure can be changed to lower the WACC, the market value of the company will
increase and so increase shareholder wealth.

11.3.2 Conclusions
3.2 Conclusions

As the graph shows, there is an optimal gearing level (an optimal capital structure) at which WACC is minimised and hence the NPV of all projects is maximised (i.e. the value of the company is
maximised).
• It is the duty of all finance managers to find the optimal capital structure that will result in the lowest WACC.
• However, there is no straightforward method of calculating ke or WACC, much less the optimal capital structure.
• The optimal capital structure can only be found by trial and error.
11.3.3 Implications for Project Financing and Appraisal
3.3 Implications for Project Financing and Appraisal

When considering projects and their financing, the company needs to determine whether it is optimally geared.
• If it is optimally geared: finance should be raised so as to maintain the existing gearing ratio.
• If sub-optimally geared: raise debt finance so as to increase the gearing ratio towards the optimal level.
• If supra-optimally geared: raise equity finance so as to reduce the gearing ratio back to the optimal level.
Once optimal gearing has been achieved:
1. Appraise the project at the existing WACC: If the NPV of the project is positive the project is worthwhile.
2. Appraise the additional finance: If marginal cost of the finance exceeds the WACC the finance is not appropriate and should be rejected.
4.1 Introduction

Modigliani and Miller (MM) constructed a mathematical model to provide a basis for company managers to make financing decisions.
• Mathematical models predict outcomes which would occur based on simplifying assumptions.
• Comparison of the model's conclusions to real-world observations then allows researchers to understand the effect of the simplifying assumptions. By relaxing these assumptions the
model can be moved towards real life.
MM's assumptions include:
• Investors are rational.
• Capital markets are perfect.
• There is no tax (either corporate or personal) in the initial MM theory. (But this assumption is relaxed in a later theory.)
• Investors are indifferent between personal and corporate borrowing.
• There is no financial distress risk (i.e. no risk of default even at very high debt levels).
• There is a single risk-free rate of borrowing (Rf).
• Corporate debt is irredeemable.

4.2 Theory Without Tax

4.2.1 Two Propositions

MM considered two companies, both the same size and with the same level of business risk:
1. One company, U, was ungeared.
2. One company, G, was geared.
Proposition 1: in the absence of corporation tax, the market values (V) and, hence, the WACC's of these two companies would be the same.
Vg = Vu
WACCg = WACCu
MM argued that the costs of capital would change as gearing changed in the following manner:
• ke would increase at a constant rate as gearing increased due to the perceived increased financial risk – Proposition 2.
• kd would remain constant (at Rf) whatever the level of gearing.
 • The rising ke exactly offsets the benefit of cheaper debt in order for the WACC to remain constant.

4.2.2 Graphically
• This can be shown as a graph:

4.2.3 Conclusions
Conclusions that can be drawn from the without tax theory:
• Only investment decisions affect the value of the company.
• The value of the company is independent of the financing decision.
Of course, this is not true in practice because the assumptions are too simplistic. There are obvious differences between the real world and the model.
MM did not claim that gearing does not matter in the real world. They said that gearing should not matter in a world in which their assumptions hold true. They then relaxed these assumptions to see
how the model's predictions would change.
The first assumption they relaxed was the no corporate tax assumption.

11.4.3 Theory With Tax

4.3 Theory With Tax

When MM took corporation tax into consideration, their conclusions regarding capital structure were altered. This is because of the tax relief available (the tax shield) on debt interest.

4.3.1 Proposition
In the theory with tax model:
• ke rises (as before) to reflect the increased uncertainty due to financial risk;
• kd is constant (as MM ignore the risks of financial distress).
MM recognised that operating profits are distributed three ways: to equity, debt and tax.
• MM argued that taking on more debt reduced the tax payments.
• So the after-tax cash available to debt and equity rises with debt.
• As the risk of the company has not changed (as the risk of financial distress is ignored), WACC must fall and the value must rise, as shown in the following graphs.

4.3.2 Graphically
• This can be shown as a graph:
4.3.3 Conclusions
MM’s theory with tax implies that there is an optimal gearing level and that this is to maximise debt in the capital structure to generate maximum value for the shareholders.
This is not true in practice (because companies’ capital structures are not geared as much as possible) because, for example:
• At high levels of gearing the risk of default on debt (bankruptcy) becomes significant. The cost of debt rises and the cost of equity increases by even more (as shareholders rank last in the
priority of claims in insolvency proceedings).
• Personal taxes exist and these may cause investors to prefer injecting equity rather than debt if dividends are taxed at lower rates than interest income.

5.1 Practical Factors

The following factors should be considered:
• The project's business risk. It is not wise to finance high-risk projects with debt, as payment of interest is a legally binding commitment.
• Existing level of financial gearing.
• Existing level of operational gearing, which is the proportion of fixed to variable operating costs. If this is high, the company may prefer to avoid more debt as this increases the level of
fixed costs even further.
• Quality of assets available for security on debt.
• Personal tax position of the shareholders and debtholders.
• Market sentiment (e.g. frozen debt markets following the 2007 US sub-prime meltdown).
• Tax exhaustion (i.e. not enough profit to fully utilise the interest tax shield).
A company may restrict its level of gearing from the point at which interest payments exceed profits (i.e. debt loses its tax advantage), as the cost of debt rises significantly (from kd(1 − T)
to kd).
• Issue costs.
• Agency costs. At high levels of financial gearing, the control of the company may move away from the shareholders towards the debt investors (e.g. restrictive debt covenants may restrict
dividends or limit operations to low-risk areas). Limiting operations to low-risk areas may reduce returns to shareholders.
• Costs of financial distress. At dangerous levels of financial gearing, the company may find that its costs of doing business start to rise (e.g. suppliers may ask for payment in advance, staff
turnover may rise, customers may lose faith in the warranties on the company's products).

5.2 Pecking Order Theory

As already discussed in Chapter 8, company managers usually prefer to use internal finance rather than external finance. This preference for internal finance is known as the pecking order
theory and is supported by research which found that company directors often choose "the path of least resistance" (i.e. the most convenient source) when it comes to financing a project.
Research has shown that the following hierarchy emerges:

5.2.1 Retained Earnings

Internal finance (i.e. reinvestment of profit) is preferred to raising external finance. There are several practical advantages of using internal finance:
• Management time is not consumed by paperwork;
• No issue costs;
• No change in the company's control structure;
• Privacy (e.g. no need to publish a prospectus); and/or
• External finance may not be available, particularly for SMEs due to asymmetry of information (a perceived high risk due to a lack of public information about the business).

5.2.2 Issue Debt

If internal finance is not sufficient (e.g. because existing shareholders require a significant dividend), external finance must be raised. Here the preference is for debt because:
• Debt is cheaper than equity;
• Interest is tax allowable, which results in a tax shield;
• Issue costs are lower on debt than equity; and/or
• Debt can be raised more quickly than equity.

5.2.3 Issue Equity

If debt cannot be raised (e.g. due to lack of assets for security), a share issue is inevitable. A new share issue ranks last in pecking order theory because:
• The cost of equity is high because equity investors are exposed to high risk (business and operating risk);
• Dividends do not give a tax shield;
• Issue costs are high; and/or
 • Share issues take much time and effort to organise.

Syllabus Coverage

This chapter covers the following Learning Outcomes.

E. Business Finance
2. Estimating the cost of capital
1. Estimating the overall cost of capital including:
1. distinguishing between average and marginal cost of capital.
2. calculating the weighted average cost of capital (WACC) using book value and market value weightings.
3. Sources of finance and their relative costs
1. Identify and discuss the problem of high levels of gearing.
2. Assess the impact of sources of finance on financial position and financial risk and shareholder wealth using appropriate measures including:
1. cash flow forecasting.
3. Impact of cost of capital on investments including:
1. the relationship between company value and cost of capital
2. the circumstances under which WACC can be used in investment appraisal.
4. Capital structure theories and practical considerations
1. Describe the traditional view of capital structure and its assumptions.
2. Describe the views of Miller and Modigliani on capital structure, both without and with corporate taxation, and their assumptions.
3. Identify a range of capital market imperfections and describe their impact on the views of Miller and Modigliani on capital structure.
4. Explain the relevance of pecking order theory to the selection of sources of finance.

Summary and Quiz

• WACC estimates the company's average cost of long-term finance.
• WACC is a potential discount rate to use for the calculation of the NPV of possible projects. However, the existing WACC should only be used if the project would not change the
company's business risk or level of gearing (i.e. financial risk).
• There are various and conflicting models of how financial gearing affects the WACC. The models include the following: traditional theory, Modigliani and Miller (MM) without tax and MM
with corporate tax. Each model has useful elements, even if the conclusions of such models lack practical relevance.
• Per the traditional theory, there is an optimal gearing level (an optimal capital structure) at which WACC is minimised and hence the NPV of all projects is maximised (i.e. the value of the
firm is maximised).
• MM without tax concludes: (1) there is no optimal capital structure and (2) a company's value is only affected by its investment decisions and is not affected by how it is financed.
• MM with tax concludes that a company should use as much debt financing as possible if it wants to maximise its overall market value.
• Under the pecking order theory, managers choose the path of least resistance (e.g. the most convenient source) of financing for a project.

Chapter 11 Quiz
RUPAB CO
Rupab Co is a manufacturing company that wishes to evaluate an investment in new production machinery. The machinery would enable the company to satisfy increasing demand for existing
products and the investment is not expected to lead to any change in the existing level of business risk of Rupab.
The machinery will cost $2.5m, payable at the start of the first year of operation, and is not expected to have any scrap value. Annual before-tax net cash flows of $680,000 per year would be
generated by the investment in each of the five years of its expected operating life. These net cash inflows are before taking account of expected inflation of 3% per year. Initial investment of
$240,000 in working capital would also be required, followed by incremental annual investment to maintain the purchasing power of working capital.
Rupab has in issue five million shares with a market value of $3.81 per share. The equity beta of the company is 1.2. The yield on short-term government debt is 4.5% per year and the equity risk
premium is approximately 5% per year.
The debt finance of Rupab consists of loan notes with a total nominal value of $2m. These loan notes pay annual interest before tax of 7%. The nominal value and market value of each loan note is
$100.
Rupab pays taxation one year in arrears at an annual rate of 25%. Tax-allowable depreciation on machinery is on a straight-line basis over the life of the asset.

Required:
(a) Calculate the after-tax weighted average cost of capital of Rupab Co. (6 marks)

Prepare a forecast of the annual after-tax cash flows of the investment in nominal
(b) terms, and calculate and comment on its net present value. (9 marks)

(15 marks)
Your Answer:AAZXXC

(a) Weighted average cost of capital

Cost of equity = 4.5 + (1.2 × 5) = 10.5%
Tutorial note: The loan note’s market value = nominal value. This implies that the coupon interest rate on the loan notes = the required return of loan noteholders = the company’s pre-tax cost of
debt.
After-tax cost of debt = 7 × (1 − 0.25) = 5.25%
Market value of equity = 5m × 3.81 = $19.05m
Market value of debt is equal to its nominal value of $2m
Sum of market values of equity and debt = 19.05 + 2 = $21.05m
WACC = (10.5 × 19.05/21.05) + (5.25 × 2/21.05) = 10.0%

(b) Cash flow forecast

Time 0 1 2 3 4 5 6
$000 $000 $000 $000 $000 $000 $000
Cash inflows 700.4 721.4 743.1 765.3 788.3
Tax on cash inflows 175.1 180.4 185.8 191.4 197.1
700.4 546.3 562.7 579.6 596.9 (197.1)
Tax saving on allowable
depreciation (W1) 125.0 125.0 125.0 125.0 125.0
After-tax cash flows 700.4 671.3 687.7 704.6 721.9 (72.1)
 Initial investment (2,500)
Working capital (W2) (240) (7.2) (7.4) (7.6) (7.9) 270.1
Net cash flows (2,740) 693.2 663.9 680.1 696.7 992.0 (72.1)
Discount factors 1.000 0.909 0.826 0.751 0.683 0.621 0.564
Present values (2,740) 630.1 548.4 510.8 475.9 616.0 (40.7)
NPV = $500
The investment is financially acceptable, since the net present value is positive. The investment might become financially unacceptable, however, if the assumptions underlying the forecast financial
data were reconsidered. For example, the sales forecast appears to assume constant annual demand, which is unlikely in reality.
WORKINGS
(1) Tax-allowable depreciation tax benefits
Annual allowance (straight-line basis) = $2.5m/5 = $500,000
Annual tax benefit = $500,000 × 0.25 = $125,000 per year
(2) Working capital investment
Time 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Working capital 240 247.2 254.6 262.2 270.1
Incremental investment (7.2) (7.4) (7.6) (7.9) 270.1
CLOSE CO
The statement of financial position of Close Co provides the following information:
$m $m
Non-current assets 595
Current assets 125
Total assets 720
Equity
Ordinary shares ($1 nominal) 80
Reserves 410
490
Non-current liabilities
6% bank loan 40
8% Loan notes ($100 nominal) 120
160
Current liabilities 70
Total equity and liabilities 720
Close Co has a cost of equity of 10% per year and a before-tax cost of debt of 7% per year. The 8% loan notes will be redeemed at nominal value in six years’ time. Close Co pays tax at 30% and
the ex-dividend market price of its shares is $8.50 per share.

Required:
Calculate the weighted average after-tax cost of capital of Close Co using market
(a) values where appropriate. (8 marks)

Discuss the circumstances under which the weighted average cost of capital (WACC)
can be used as a discount rate in investment appraisal. Briefly indicate alternative
(b) approaches that could be adopted when using the WACC is not appropriate. (7 marks)

(15 marks)
Your Answer:AZX

(a) Weighted average cost of capital

Total value of equity plus debt = 680m (W1) + 125.7m (W2) + 40m) = $845.7m
After-tax WACC = ((680m × 10%) + (125.7m × 4.9% (W3)) + (40 × 4.2% (W4)))/845.7 = 9.0 % per year
WORKINGS
1. Market value of equity
Close Co has 80 million shares in issue and each share is trading at $8.50 per share.
The market capitalisation is therefore 80 × 8.50 = $680m
 Cost of equity is given as 10% per year.
2. Market value of 8% loan notes
The market value of each loan note will be the present value of the expected future cash flows (coupon interest and principal) that arise from owning the loan note. Annual interest is
8% per year and the loan notes will be redeemed at their nominal value of $100 per loan note in six years’ time. The before-tax cost of debt is given as 7% per year and this is used as
a discount rate.
Tutorial note: The before-tax cost of debt can also be referred to as the gross redemption yield or yield to maturity (YTM).
$
PV of future interest (8 × 4.767) 38.14
PV of future principal payment (100 × 0.666) 66.60
Ex-interest loan note value 104.74
Total market value of loan notes = 120m × (104.74/100) = $125.7m
3. After-tax cost of debt of 8% loan notes
The before-tax cost of debt of the loan notes is given as 7% per year.
After-tax cost of debt of loan notes = 7 × (1 − 0.3) = 7 × 0.7 = 4.9% per year
Tutorial note: The after-tax cost of the 8% loan notes could have been calculated using linear interpolation (i.e. estimating the IRR of the market value, after-tax coupon payment and
redemption price). The result would be close to 4.9%.
4. 6% bank loan
The bank loan has no market value and so its book value of $40m is used in calculating the weighted average cost of capital.
The interest rate of the bank loan can be used as its before-tax cost of debt.
After-tax cost of debt of bank loan = 6 × (1 − 0.3) = 6 × 0.7 = 4.2% per year
(b) Circumstances when WACC can be used for investment appraisal
WACC is the average return required by current providers of finance. It therefore reflects the current risk of a company’s business operations (business risk) and way in which the company is
currently financed (financial risk). When the WACC is used as discount rate to appraise an investment project, an assumption is being made that the project’s business risk and financial risk are the
same as those currently faced by the investing company. If this is not the case, a marginal cost of capital or a project-specific discount rate must be used to assess the acceptability of an investment
project.
The business risk of an investment project will be the same as current business operations if the project is an extension of existing business operations, and if it is small in comparison with current
business operations. If this is the case, existing providers of finance will not change their current required rates of return. If these conditions are not met, a project-specific discount rate should be
calculated, for example by using the capital asset pricing model.
The financial risk of an investment project will be the same as the financial risk currently faced by a company if debt and equity are raised in the same proportions as currently used, thereby
preserving the existing capital structure. If this is the case, the current WACC can be used to appraise a new investment project. It may still be appropriate to use the current WACC as a discount
rate even when the incremental finance raised does not preserve the existing capital structure, providing that the existing capital structure is preserved on an average basis over time via subsequent
finance-raising decisions.
Where the capital structure is changed by finance raised for an investment project, it may be appropriate to use the marginal cost of capital rather than the WACC.

Summary and Quiz

• WACC estimates the company's average cost of long-term finance.
• WACC is a potential discount rate to use for the calculation of the NPV of possible projects. However, the existing WACC should only be used if the project would not change the
company's business risk or level of gearing (i.e. financial risk).
• There are various and conflicting models of how financial gearing affects the WACC. The models include the following: traditional theory, Modigliani and Miller (MM) without tax and MM
with corporate tax. Each model has useful elements, even if the conclusions of such models lack practical relevance.
 • Per the traditional theory, there is an optimal gearing level (an optimal capital structure) at which WACC is minimised and hence the NPV of all projects is maximised (i.e. the value of the
firm is maximised).
• MM without tax concludes: (1) there is no optimal capital structure and (2) a company's value is only affected by its investment decisions and is not affected by how it is financed.
• MM with tax concludes that a company should use as much debt financing as possible if it wants to maximise its overall market value.
• Under the pecking order theory, managers choose the path of least resistance (e.g. the most convenient source) of financing for a project.

CHAPTER 12: Visual Overview

Objective: To understand the Capital Asset Pricing Model and its uses in financial management.

1.1 Variability of Returns

If an investor has a portfolio of investments in shares of different companies, it might be supposed that the risk of the portfolio would be the average of the risks of the individual investments. In fact,
this is not the case; the risk of the portfolio is less than the average due to diversification.
Investment risk, the uncertainty or variability of returns on investments, can be split into two elements:
1. Unsystematic risk; and
2. Systematic risk.
Definitions

Unsystematic risk – the risk which is unique to each company's shares. (Also called "unique",
"diversifiable’’ or "industry-specific" risk.)
Systematic risk – the risk which affects the market as a whole rather than a specific company's shares.
(Also known as "market" risk or "undiversifiable’’ risk.)
Unsystematic risk is the element that can potentially be eliminated (“diversified away”) by investors building a diversified portfolio (i.e. positive and negative exposures cancel out). For example, if
the price of copper rises, prices of shares in copper mining companies will rise, but the price of shares in manufacturing companies that use copper will fall.
Systematic risk cannot be diversified away. This risk is associated with the financial system and still remains even in a well-diversified portfolio. For example, both copper mining and manufacturing
companies are exposed to increases in interest rates and the general state of the economy.
The sum of systematic risk and unsystematic risk is called total risk.
Therefore, a portfolio of shares has a total risk that is made up of these two types of risk. As more different shares are added to the portfolio, the unsystematic risk is diversified away and the amount
of total risk reduces to approach systematic risk.

This means that investors should only be rewarded for risks they cannot avoid − systematic risk.

12.1.2 Measurement of Systematic Risk

1.2 Measurement of Systematic Risk

A well-diversified portfolio of shares still has some degree of risk or variability (i.e. to macro-economic changes) because all shares are affected by market risk.
This systematic risk will affect the shares of all companies although some will be affected to a greater or lesser degree than others. For example:
 • A supermarket chain will have a relatively low risk because people will always buy food, regardless of the state of the economy.
• A tour operator will have a higher risk because, during a recession, demand for holidays will fall.
This sensitivity to systematic risk is measured by “an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole” called a beta value
or beta factor, or simply beta.

2.1 Measurement

Beta factors for quoted shares are measured using historical data and published in "beta books". They are determined by comparing changes in a share's returns to changes in the stock market
returns over many years (at least five years).
This can be illustrated by the "security characteristic line", which gives an indication of the share's sensitivity to market changes.
Beta is estimated from these observations by determining the gradient or slope of the "line of best fit" through the observed points. The steeper the slope the more volatile the share and the higher
the beta.

Where (Ri − Rf) = the excess return of the share over the risk-free return

(Rm − Rf) = the excess return of the stock market over the risk-free return

Rf = the return on a risk-free investment

The security characteristic line should, in the long run, pass through the point where the two axes meet.
In the short run, however, this may not always be the case and any short-term difference, or abnormal return, is known as the alpha factor.

2.2 Interpretation

A beta, therefore, simply describes a share's degree of sensitivity to changes in the market's returns, caused by systematic risk. For a typical share, beta lies between 0.2 and 1.6:
 Beta = 1 − Indicates a “neutral” share that is as sensitive as the market to systematic risk. Such shares should earn the market return.

Beta > 1 − Indicates an “aggressive” share that is more sensitive than the market. Therefore, if the market in general rises by 10%, the returns from this share are likely to be more than 10%.

Indicates a “defensive” share that is less sensitive than the market and is likely to rise and fall in value less than the market in general. For example, if a share has a beta of 0.5, the
Beta < 1 − expected will increase by only 5% if the return on the capital market increases by 10%.
The market return is the return on the market portfolio (i.e. a fully diversified portfolio with a representative sample of all traded shares).

3.0 Introduction

The CAPM is a method of calculating the return required on an investment, based on an assessment of its risk. It was developed from portfolio theory, which is based on the idea that an investor
who puts all of their funds into one investment risks everything on the performance of that individual investment. A wiser policy would be to spread the funds over several investments (establish a
portfolio) so that the unexpected losses from one investment may be offset to some extent by the unexpected gains from another. The rationale for establishing a portfolio is therefore the reduction
of risk.

12.3.1 Security Market Line

3.1 Security Market Line

The Security Market Line (SML) is a graph which plots the required return (E(ri)) from any investment according to its systematic risk, as measured by its beta, βi.

•The required return of an investment with β = 0 (i.e. no systematic risk) will be the risk-free return, Rf.
•The expected/required return of an investment with β = 1 will be the market return, E(rm).
•Therefore, the gradient (slope) of the line = (E(rm) − Rf)
Comparing forecast returns from an investment against the required return indicates whether an investment is undervalued or overvalued.
• Any share with a return above the SML (e.g. A on the graph) is forecast to earn higher returns than predicted by CAPM for its beta. It is, therefore, underpriced and will be sought after.
This will drive up its price and reduce its expected return, until it earns only the required return indicated by the SML. A is a "positive alpha" investment.
 • Any share with a return below the SML (e.g. B) would be sold as it appears to be temporarily overpriced. This will drive down the price and so increase the expected return, until it earns
the required return indicated by the SML. B is referred to as a "negative alpha" investment.
In the long run, market forces should ensure that all investments give the returns predicted by the SML.

3.2 Exam Formula

Key Point

CAPM assumes that investors hold fully diversified portfolios.

If a company’s shareholders hold well-diversified portfolios, they are concerned only with systematic risk. Therefore:
• The return these shareholders require is a reward for only the systematic risk of an investment.
• Since systematic risk is measured by a beta, the required return from an investment must be related to its beta.
CAPM is the equation of the SML that relates required returns to beta values as measures of systematic risk.
The CAPM formula as provided in the exam formulae sheet is:
E(ri) = Rf + βi(E(rm) − Rf)
Where:
E(ri) = expected/required return from an investment
Rf = risk-free return
E(rm) = expected return from the market portfolio
βi = beta of the investment
The market portfolio is a portfolio containing every share on the stock market.
(E(rm) − Rf) is known as the equity market premium, the equity risk premium, the market risk premium, or simply market premium (i.e. the extra return an investor expects for holding a diversified
portfolio of shares rather than a risk-free security).
Example 1 CAPM Formula

Consider the following information:

Risk-free rate of return = 4%
Equity risk premium = 5% (i.e. return on the market is 9%)
Beta value of shares of Ram Co = 1.2
Using CAPM:
E(ri) = Rf + βi (E(rm) − Rf) = 4 + (1.2 × 5) = 10%
Required return from an investment in Ram Co is 10%.

Example 2 Required Returns

Risk free rate = 5%

Market return = 14%
Calculate the required returns from investments whose beta values are:
 Example 2 Required Returns

(i) 1
(ii) 2
(iii) 0.5
Using CAPM:
(i) E(ri) = 5 + 1(14 − 5) = 14%
The return required from an investment with the same risk as the market, which is simply the market
return.
(ii) E(ri) = 5 + 2(14 − 5) = 23%
The return required from an investment with more risk than the market. A higher return than that given by
the market is therefore required.
(iii) E(ri) = 5 + 0.5(14 − 5) = 9.5%
The return required from an investment with less risk than the market. A lower return than that given by
the market is therefore required.

4.1 Well-Diversified Investors

If an investor already holds a well-diversified portfolio then that investor will be concerned only with systematic risk. The CAPM is therefore relevant.
The investor will be satisfied only if a potential investment gives a high enough return given its sensitivity to market risk as measured by its beta.
Activity 1 CAPM for Investors

An investment has a forecast return over the next year of 12%. The beta of the investment is estimated at 0.9. The risk-free rate is 5% and the market return is 15%.
Required:
Determine whether a well-diversified investor should buy this investment.
*Please use the notes feature in the toolbar to help formulate your answer.

12.4.2 Companies
4.2 Companies

Companies should not diversify their activities simply to reduce the risk of their shareholders. Shareholders can diversify their shareholdings much more easily than a company can diversify its
activities.
If shareholders are already well-diversified then the company should be concerned, on behalf of the shareholders, simply with the systematic risk of potential projects.
Therefore the aim of a company, with well-diversified shareholders, should be to determine the required return from its investment projects and then compare this to the forecast return.
If the project has the same risk as that of the existing activities of the company then the existing WACC can be used.
However if the project is of a different risk type to the existing activities then the existing WACC will not be appropriate. In these instances a tailor-made discount rate for that type of project must be
determined using the CAPM.

4.3 Geared and Ungeared Companies

4.3.1 Asset Beta

Suppose a company, A Co, is ungeared. As it has no debt it has no financial risk and so the only risk that it faces is business risk. The unsystematic business risk can be diversified away by
investors, so the investors face just systematic business risk. The beta factor for such a company is called the asset beta (because the company has assets, no debt) βa. As long as the business
operations − and therefore the business risk − do not change, the asset beta (also called the ungeared beta) remains constant.

4.3.2 Equity Beta

Suppose B Co is identical to A Co except that its capital structure includes debt. Gearing increases and financial risk is added to business risk. This will increase the effects of the systematic risk
investors in B Co face (see Chapter 10), and so the return they require will increase to compensate for the increasing risk. The beta factor for B Co’s shares, called the equity beta, increases as
gearing increases. The equity beta (also known as the geared beta) measures the sensitivity to market risks of the equity shareholders’ returns.
• In the all-equity financed company, A Co, (ungeared company) the asset beta and the equity beta are the same; βa = βe.
• In the geared company, B Co, however, the equity beta exceeds the asset beta; βe > βa.

12.4.4 Using the Equity Beta to Estimate the Cost of Equity

4.4 Using the Equity Beta to Estimate the Cost of Equity

As the equity beta, βe, measures the sensitivity to market risks of the equity shareholders' returns, it can be used in the CAPM as the required return for the equity shareholders.
The CAPM can therefore be used as an alternative to the Dividend Valuation Model (Chapter 10) for estimating the cost of equity of a company.
Activity 2 Cost of Equity Using CAPM

The equity beta of a company is estimated to be 1.2. The risk-free return is 7% and the return from the market is 15%.
Required:
Estimate the cost of equity of the company.
*Please use the notes feature in the toolbar to help formulate your answer.
12.5.1 Different Business Risks
5.1 Different Business Risks

When the business risk of a project differs from the existing business risk of the investing company, the return required on the project is different from the average return required on the investing
company's existing business operations. This means that it is not appropriate to use the investing company's existing cost of capital as the discount rate for the investment project. Instead, the
CAPM can be used to calculate a project-specific discount rate that reflects the business risk of the new project.
5.2 Ungearing Proxy Betas

The first step in using CAPM to calculate a project-specific discount rate is to obtain information on companies with business operations similar to those of the proposed project. These companies
are referred to as "proxy companies" and their published equity betas are referred to as "proxy betas". From a CAPM point of view, these proxy betas can be used to represent the business risk of
the proposed investment project.
However, an equity beta reflects not only the business risk of a company's operations, but also the company's financial risk. Therefore, it is necessary to remove the effect of the financial risk
(gearing) from the proxy equity beta to find the asset beta that reflects business risk alone. (Section 5.4 shows how this is done using the asset beta formula.)
When the equity betas of several proxy companies are ungeared, the resulting asset betas will usually have slightly different values (because no two companies will have exactly the same business
risk).
The effect of the slight differences in business operations and business risk that are reflected in the asset betas can be removed by averaging them. A simple arithmetic average is calculated by
summing the asset betas and dividing the total by the number of asset betas.

12.5.3 Regearing the Asset Beta

5.3 Regearing the Asset Beta

The average asset beta represents the business risk of the proposed project. However, before a project-specific discount rate can be calculated, the financial risk of the investing company must be
considered. In other words, having ungeared the proxy equity betas when calculating the asset betas, it is now necessary to “regear” the average asset beta to reflect the gearing and the financial
risk of the investing company.
The gearing and the tax rate of the investing company and the average proxy asset beta are inserted into the asset beta formula (see s.5.4) to calculate the regeared equity beta. The CAPM formula
can then be used to calculate a project-specific cost of equity.
The project-specific cost of equity can be used as the discount rate if the project is financed by equity (either retained earnings or new share issues). If a project is financed by a mixture of equity
and debt it would be necessary to calculate a project-specific WACC.

Exam advice

Calculation of a project-specific WACC will not be required in the exam.

12.5.4 Asset Beta Formula

5.4 Asset Beta Formula

The following formula (based on Modigliani and Miller's models) can be used to convert an equity beta to an asset beta (and vice versa):

βa = +
Where βa = asset beta
βe = equity beta
βd = beta of corporate debt
Ve = market value of equity
Vd = market value of debt
 T = company profit tax rate
Ve + Vd(1-T) = after-tax market value of company
Exam advice

If the exam question does not give a beta for debt, assume that debt is risk free (i.e. βd = 0).

Example 3 Asset Beta

The following information relates to RD Co:

Equity beta = 1.2
Debt beta = 0.1
Market value of shares = $6m
Market value of debt = $1.5m
Company profit tax rate = 25% per year
After-tax market value of company = Ve + Vd(1-T) = 6 + 1.5 × 0.75 = $7.125m
βa = [(6/7.125) × 1.2] + [(1.5 × 0.75)/7.125 × 0.1] = 1.024.

12.5.5 Summary of Steps

5.5 Summary of Steps

The steps in calculating a project-specific discount rate can now be summarised as follows:
1. Find suitable proxy companies.
2. Find the equity betas of the proxy companies, their gearing levels and tax rates.
3. Use the asset beta formula to ungear the proxy equity betas to obtain asset betas.
4. Calculate an average asset beta.
5. Use the asset beta formula to regear the asset beta to the investing company's capital structure.
6. Use the CAPM formula to calculate a project-specific cost of equity.
7. If the project will be financed by a mixture of equity and debt, a project-specific WACC would need to be calculated.
Exam advice

Step 7 calculations will not be required in the exam.

Activity 3 Degearing

A Co produces electronic components but is considering venturing into the manufacture of computers. A Co is ungeared with an equity beta of 0.8.
The average equity beta of computer manufacturers is 1.4 and the average gearing ratio is 1:4.
The risk-free return is 5%, the market return 12% and the rate of corporation tax 33%.
Required:
If A Co is to remain an equity-financed company, determine the discount rate it should use to appraise a computer manufacturing project.
*Please use the notes feature in the toolbar to help formulate your answer.
Activity 4 Regearing

Suppose that A Co in Activity 3 has a gearing ratio of 1:2. It still wishes to enter into the same computer manufacturing project.
Required:
Calculate the project-specific cost of equity which A Co should use for a computer manufacturing project.
*Please use the notes feature in the toolbar to help formulate your answer.
Activity 5 Several Proxies

Puggle Co is planning to invest in a new project that is significantly different from its existing business operations. Puggle Co financed 30% by debt and 70% by equity. It has identified three
companies with business operations similar to the proposed investment:
A Co has an equity beta of 0.81 and is financed 25% by debt and 75% by equity.
B Co has an equity beta of 0.98 and is financed 40% by debt and 60% by equity.
C Co has an equity beta of 1.16 and is financed 50% by debt and 50% by equity.
The risk-free rate of return is 4% per year and the equity risk premium is 6% per year. All companies pay tax at a rate of 30%.
Required:
Calculate a project-specific cost of equity for the proposed investment.
*Please use the notes feature in the toolbar to help formulate your answer.

12.6.1 Assumptions
6.1 Assumptions

The assumptions of the CAPM can be summarised as follows:

• Total risk can be split between systematic risk and unsystematic risk.
• Unsystematic risk can be completely diversified away.
• All of a company's shareholders hold well-diversified portfolios. This is fundamental to ignoring unsystematic risk. This is not an unreasonable assumption since it is
quite easy and inexpensive for investors to construct portfolios that “track” the stock market.
• A risk-free security exists which provides a minimum level of return required by investors. The assumption that investors can borrow and lend at the risk-free rate
(for which the yield on short-dated government debt is taken as a proxy) is not realistic as the risk associated with individual investors is much higher than that
associated with the government. Inability to borrow at the risk-free rate means that in practice the slope of the SML is shallower than in theory.
• A standardised holding period is assumed, to make the returns on different securities comparable (i.e. a return over six months cannot be compared with a return
over 12 months). A holding period of one year is usually assumed.
• A perfect capital market as for the dividend valuation model (see s.2.3 in Chapter 10), so all securities are valued correctly.
6.2 Advantages of CAPM
The advantages of the CAPM include the following:
• It considers only systematic risk (i.e. is relevant for listed companies whose institutional investors have diversified portfolios from which unsystematic risk has been eliminated).
• It generates a theoretically derived relationship between required return and systematic risk.
• CAPM has been subject to frequent empirical research and testing.
• It is generally seen as a much better method of calculating the cost of equity than the dividend growth model in that it explicitly takes into account a company's level of systematic risk
relative to the stock market as a whole.
• It is superior to using the existing WACC as the discount rate for a project with different business risk compared to existing operations.
Example 4 CAPM v WACC

Using CAPM will lead to better investment decisions than using the WACC in the two shaded areas,
which can be represented by projects A and B.

Using WACC, Project A has IRR < WACC, so will be rejected (where IRR is read off from the vertical
axis). This investment decision is incorrect. Using a CAPM-derived project-specific discount rate, Project
A offers a return greater than that needed to compensate for its level of systematic risk (because it is
above the SML line), so accepting it will increase the wealth of shareholders.
Similarly, using WACC, Project B has IRR > WACC, so would be accepted. This investment decision is
also incorrect. Using CAPM, Project B offers insufficient return for its level of systematic risk (because it
is below the SML line) so it should not be accepted.

6.3 Limitations of CAPM

The limitations of the CAPM include the following:

• It is a single period model − whereas company projects are often multi-period.
• It is a single index model − beta is the only variable to explain different required returns on different investments.
• Lack of data for the model − particularly in developing markets.
• CAPM tends to overstate the required return on very high-risk companies and understate the returns on very low-risk companies.
 • Assumptions may not hold in the real world.

Syllabus Coverage

This chapter covers the following Learning Outcomes.

E. Business Finance
2. Estimating the cost of capital
1. Estimate the cost of equity including:
1. explanation and discussion of systematic and unsystematic risk
2. relationship between portfolio theory and the capital asset pricing model (CAPM)
3. application of the CAPM, its assumptions, advantages and disadvantages.
3. Sources of finance and their relative costs
1. Impact of cost of capital on investments including:
1. the advantages of the CAPM over WACC in determining a project-specific cost of capital
2. the application of the CAPM in calculating a project-specific discount rate.

Summary and Quiz

• Unsystematic risk is the risk which is unique to each company's shares. It can be diversified away.
• Systematic risk is the risk which affects the market as a whole rather than a specific company's shares. It cannot be diversified away.
• A beta describes a share's degree of sensitivity to changes in the market's returns, caused by systematic risk.
• The CAPM is a method of calculating the return required on an investment, based on an assessment of its risk. It assumes that shareholders hold well-diversified portfolios and so are
concerned only with systematic risk.
• CAPM is also an alternative to the Dividend Valuation Model (DVM) for estimating a company's cost of equity.
• In an all-equity financed (i.e. ungeared) company, the asset beta (which measures business risk only) and the equity beta are the same; βa = βe.
• In a geared company, however, because the equity shareholders also face a degree of financial risk, the equity beta exceeds the asset beta; βe > βa.
• The asset beta is also known as the ungeared beta, while the equity beta is also known as the geared beta.
• The steps in calculating a project-specific discount rate are:
o Find suitable proxy companies.
o Find βe for the proxy companies, their gearing levels and tax rates.
o Use the asset beta formula to ungear the proxy βe to obtain βa.
o Calculate an average βa.
o Use the asset beta formula to regear βa to the investor's capital structure.
o Use the CAPM formula to calculate a project-specific cost of equity.
• CAPM is generally seen as a much better method of calculating the cost of equity than the dividend growth model in that it explicitly takes into account a company's level of systematic risk
relative to the stock market as a whole.
• It is also superior to using the existing WACC as the discount rate for a project with different business risk compared to existing operations.

BURSE CO
Burse Co wishes to calculate its weighted average cost of capital and the following information relates to the company at the current time:
 Number of ordinary shares 20 million

Book value of 7% convertible debt $29m

Book value of 8% bank loan $2m

Market price of ordinary shares $5.50 per share

Market value of convertible debt $107.11 per $100 loan note

Equity beta of Burse 1.2

Risk-free rate of return 4.7%

Equity risk premium 6.5%

Rate of taxation 30%

Burse expects share prices to rise in the future at an average rate of 6% per year. The convertible debt can be redeemed at nominal value in eight years’ time, or converted in six years’ time into 15
shares of Burse per $100 loan note.

Required:
Calculate the market value weighted average cost of capital of Burse Co. State clearly
(a) any assumptions that you make. (9 marks)

Discuss whether the dividend growth model or the capital asset pricing model offers
(b) the better estimate of the cost of equity of a company. (6 marks)

(15 marks)
AXQ

(a) Weighted average cost of capital (WACC)

Cost of equity
Cost of equity using capital asset pricing model = 4.7 + (1.2 × 6.5) = 12.5%
Tutorial note: The equity market risk premium of 6.5% given must not to be confused with the expected return on the equity market which would be 4.7% + 6.5% = 11.2%.
Cost of convertible debt
Annual after-tax interest payment = 7 × (1 − 0.3) = $4.90 per loan note
Forecast share price in six years’ time = 5.50 × 1.066 = $7.80
Forecast conversion value = 7.80 × 15 = $117.00 per loan note
Conversion appears likely, since the conversion value is greater than the redemption value. The future cash flows to be discounted are therefore six years of after-tax interest payments and the
conversion value received in year 6:
Time Cash flow $ 10% DF PV ($) 5% DF PV ($)
0 Market value (107.11) 1.000 (107.11) 1.000 (107.11)
1−6 Interest 4.9 4.355 21.34 5.076 24.87
6 Conversion 117.00 0.564 66.00 0.746 87.28
(19.77) 5.04
Using linear interpolation, after-tax cost of debt = 5 + [(5 × 5.04)/(5.04 + 19.77)] = 6.0%.
Tutorial note: A slightly different cost of debt would arise if different discount rates are used in the linear interpolation calculation.
We can confirm that conversion is likely and implied by the current market price of $107.11 by noting that the floor value of the convertible debt at an after-tax cost of debt of 6% is $93.13 (4.9 ×
6.210 + 100 × 0.627).
Cost of bank loan
After-tax interest rate = 8 × (1 − 0.3) = 5.6%
This can be used as the cost of debt for the bank loan.
An alternative would be to use the after-tax cost of debt of ordinary (e.g. not convertible) traded debt, but that is not available here.
Market values
Market value of equity = 20m × 5.50 = $110m
Market value of convertible debt = 29m × 107.11/100 = $31.06m
Book value of bank loan = $2m
Total market value = 110 + 31.06 + 2 = $143.06m
Tutorial note: As banks loans are not traded their book values is taken as a proxy for market value. WACC = [(12.5 × 110) + (6.0 × 31.06) + (5.6 × 2)]/143.06 = 11.0%
(b) Dividend growth model v CAPM
The dividend growth model has several difficulties attendant on its use as a way of estimating the cost of equity. For example, the model assumes that the future dividend growth rate is constant in
perpetuity, an assumption that is not supported by the way that dividends change in practice. Each dividend paid by a company is the result of a dividend decision by managers, who will consider,
but not be bound by, the dividends paid in previous periods. Estimating the future dividend growth rate is also very difficult. Historical dividend trends are usually analysed and on the somewhat risky
assumption that the future will repeat the past, the historic dividend growth rate is used as a substitute for the future dividend growth rate. The model also assumes that business risk, and hence
business operations and the cost of equity, are constant in future periods, but reality shows us that companies, their business operations and their economic environment are subject to constant
change. Perhaps the one certain thing about the future is its uncertainty.
It is sometimes said that the dividend growth model does not consider risk, but risk is implicit in the share price used by the model to calculate the cost of equity. A moment’s thought will indicate that
share prices fall as risk increases, indicating that increasing risk will lead to an increasing cost of equity. What is certainly true is that the dividend growth model does not consider risk explicitly in the
same way as the capital asset pricing model (CAPM). Here, all investors are assumed to hold diversified portfolios and as a result only seek compensation (return) for the systematic risk of an
investment. The CAPM represent the required rate of return (i.e. the cost of equity) as the sum of the risk-free rate of return and a risk premium reflecting the systematic risk of an individual
company relative to the systematic risk of the stock market as a whole. This risk premium is the product of the company’s equity beta and the equity risk premium. The CAPM therefore tells us what
the cost of equity should be, given an individual company’s level of systematic risk.
The individual components of the CAPM (the risk-free rate of return, the equity risk premium and the equity beta) are found by empirical research and so the CAPM gives rise to a much smaller
degree of uncertainty than that attached to the future dividend growth rate in the dividend growth model. For this reason, it is usually suggested that the CAPM offers a better estimate of the cost of
equity than the dividend growth model.
CHAPTER 13: Visual Overview

Objective: To appreciate the importance of working capital and its effective management.

13.1.1 Importance
1.1 Importance
 Definition

Working capital – the capital represented by net current assets which is available for day-to-day
operating activities. It normally includes inventories, trade receivables, cash and cash equivalents, less
trade payables.
The definition of working capital is fairly simple; it is the difference between an organisation's current assets and its current liabilities. Of more importance is its function, which is primarily to support
the day-to-day financial operations of an organisation, including the purchase of inventory, the payment of salaries, wages and other business expenses, and the financing of credit sales.
Many businesses which appear profitable are forced to cease trading due to an inability to meet short-term obligations when they fall due. To remain in business, an organisation must successfully
manage its working capital. Too often, however, this is overlooked.
Working capital comprises a number of different items and its management is difficult because these are often linked. This means altering one item may adversely affect other areas of the business.

Example 1 Working Capital's Linked Effects

A reduction in the level of inventory will reduce storage costs and reduce the risk of obsolescence. It will
also reduce the level of resources/amount of capital “tied up” in inventory.
However, such an action may damage customer relations if customers are made to wait for new
inventory to be delivered or, worse still, it may result in lost sales if customers go elsewhere.

Example 2 Working Capital Management

Extending the credit period might attract new customers and lead to an increase in revenue.
To finance this new credit facility, however, an organisation might require a bank overdraft. The cost of
the overdraft could exceed the profit arising from additional sales.

Management must ensure that a business has sufficient working capital. The consequences of too little will be cash flow problems highlighted by:
• Exceeding an agreed overdraft limit;
• Failing to pay suppliers (including employees) on time; and/or
• Inability to take advantage of discounts for prompt payment.
In the long run, a business with insufficient working capital will be unable to meet its current obligations and will be forced to cease trading even if it remains profitable on paper.
On the other hand, if an organisation ties up too much of its resources in working capital, it will earn a lower-than-expected rate of return on capital employed. Again, this is not a desirable situation.
Working capital management is crucial to the effective management of a business because:
•Current assets make up over half the assets of some companies; and
•Failure to control working capital, and therefore liquidity, is a major cause of business failure.
Two major questions must be considered:
1. How much to invest in working capital?
2. How to finance working capital?
Example 3 Need for Working Capital

A company has a healthy liquidity position (Stage 1). Business then doubles, without investing in more
non-current assets and without raising more equity capital. It is a reasonable assumption that if turnover
doubles, inventory, receivables and payables will also double (Stage 2).
 Example 3 Need for Working Capital

Stage 1 Stage 2
$000 $000 $000 $000
Non-current assets 1,000 1,000
Current assets
Inventory 50 ×2 100
Receivables 40 ×2 80
Cash 20 –
110 180
1,110 1,180
Equity 1,100 1,180
Current liabilities
Payables 10 ×2 20
Overdraft – Balancing figure 60
1,110 1,180
Cash will all be spent and so the company is then forced to rely on an overdraft (probably unexpected
and unplanned) to finance its net current assets. Relying permanently on overdraft finance is risky and
costly and the company would be advised to seek a more permanent and less costly form of funding.

1.2 Objectives of Working Capital Management

The two main objectives of working capital management are:

1. to ensure the organisation has sufficient liquid resources to continue in business; and
2. to increase its profitability.
There is, however, a trade-off between liquidity and profitability:
As shown by Examples 1 and 2 above, the objectives of liquidity and profitability can conflict. They are not necessarily always in conflict, however. Good warehouse management (to keep inventory
low, but not so low that sales are lost if inventory is not available, say) and good credit control (to keep receivables low, but not so low that sales are lost through excessive credit control, say) could
lead to higher liquidity and higher profitability.
For each company there will be an optimal level of working capital. However, this can only be found by trial and error, and in any case it is constantly changing.
Businesses must avoid the extremes:
• Overtrading –insufficient working capital to support the level of business activity. This also can be described as under-capitalisation and is characterised by an increasing proportion of
short-term to long-term finance;
• Over-capitalisation – an excessive level of working capital, leading to inefficiency.
As a guide, many textbooks suggest that to be safe an organisation requires a 2:1 ratio of current assets to current liabilities. That is, for every $1 of current liabilities $2 of current assets is required
to ensure that the organisation does not run into cash flow problems.
However, this is much too simplistic, and the required level of working capital will vary by industry. This is illustrated in Example 4, which shows a breakdown of the working capital for three UK
public limited companies operating in different sectors. The figures are taken from published annual reports and the given ratios calculated as follows:

Current ratio =

Quick (acid test) ratio = =

Example 4 Industry Comparison

Comparison of working capital by industry

Tesco Airtours MUFC
$m $m $000
Current assets
Inventory 584 17.0 3,565
Receivables 133 413.8 10,731
Short-terms investments 196 11.1 22,400
Cash at bank and in hand 29 364.2 23,244
 Example 4 Industry Comparison

942 806.1 59,940

Current liabilities 2,712 802.0 29,468
Working capital (1,770) 4.1 30,472
Profit before taxation 832 140.3 27,577
Current ratio 0.35 1.01 2.03
Acid test 0.13 0.98 1.91
Cash to current liabilities 0.01 0.45 0.79
Solution
Analysis
Each of these companies is profitable and is considered successful in its field. However, it is apparent
that only MUFC (Manchester United Football Club) meets the "suggested" current ratio of 2:1. Indeed,
Tesco appears to be in real trouble with only $0.35 of current assets and $0.13 of "quick" assets for
every $1 of current liabilities.
Worse still, considering the ratio of cash to current liabilities, Tesco has only 1 cent of cash coverage for
every $1 of current liabilities suggesting severe liquidity problems. Yet, Tesco is the largest supermarket
chain in the UK and, in the year of this extract, has an annual profit before taxation in excess of $800
million.
Airtours also falls well short of the suggested current ratio of 2:1, although its quick assets ratio of 1:1 is
satisfactory. These figures illustrate that the 2:1 ratio is inappropriate, and the amount of working capital
required by an organisation will vary depending on the nature of its business and the industry in which it
operates.
Tesco
Although Tesco's level of working capital appears low, this must be evaluated in the context of the nature
of its business. Each day, millions of customers will purchase their groceries from Tesco and they will
pay for their goods using cash before they leave the store.
Most items sold by Tesco have a shelf life of only a few days. As market leader, Tesco can rely on
regular deliveries of inventory from suppliers at fairly short notice. In addition, the use of forecasting
techniques will enable managers to make reasonably reliable predictions of daily sales levels. All of these
factors enable Tesco to operate with relatively low levels of inventory.
Because almost all sales are on a cash rather than credit basis, the level of receivables is also low. In
addition, the company is able to invest surplus cash balances in short-term investments (usually money
market accounts), hence maximising the return to its investors.
Considering current liabilities, Tesco will purchase most of its inventory on credit (resulting in a trade
payables balance of $826 million included in current liabilities). Indeed, most inventory will have been
sold and a profit realised before Tesco even pays its suppliers. Few organisations are in such a fortuitous
position. Other payables will include corporation tax and dividends, amounts which Tesco will know with
certainty when they are to be paid.
 Example 4 Industry Comparison

Due to the nature of its business, and in particular an abundance of cash sales, few receivables, low
levels of inventory and most purchases being for credit, cash flow is not likely to be a problem and,
hence, Tesco is able to operate with negative working capital.
Airtours
Customers will usually pay for their holidays well in advance of departure ensuring that cash flow is not a
problem while also minimising the incidence of bad debts. Unlike Tesco, Airtours' sales are seasonal with
most cash being received during the period of January to June. However, expenses will be incurred
throughout the year and careful planning is necessary to ensure that Airtours is able to meet its current
liabilities as they fall due.
Because it is a tour operator, inventory levels are relatively low. Receivables mostly comprise amounts
paid in advance for hotel accommodations and balances owing from customers for holidays. Payables
comprise amounts owing for accommodation and advance payments made by customers.
Like Tesco, Airtours can operate with a lower current ratio than the suggested 2:1. However, due to the
seasonal nature of its business, good budgeting and forecasting is essential to ensure that liabilities can
be met even during the quiet season.
Manchester United Football Club (MUFC)
There is little evidence of any working capital problems, with the company having a current ratio of 2:1. In
addition, the company has $0.79 of cash for every $1 of current liabilities. This is not surprising given the
nature of MUFC's business. During the period August to May, cash flow is not likely to be a problem
because almost every week over 50,000 fans will crowd into Old Trafford to watch their team play. Many
of these fans pay for their seats in advance, purchasing a season ticket before the season commences.
In addition, the club will receive cash from sponsors, television companies and the sale of merchandise.
However, as with Airtours, business is seasonal and careful planning is necessary to ensure that all
liabilities are met as they fall due.
A review of the club's working capital shows that inventory and receivables are relatively small, with the
majority of working capital comprising short-term investments and cash, reflecting the cash received from
season ticket sales.
Overall Conclusion
This analysis shows that the optimum level of working capital varies depending on the industry in which
an organisation operates and the nature of its transactions.

1.3 Current Assets Investment Policy

Even within the same industry sector, companies will have different policies regarding the level of investment in current assets, depending on management's attitude to risk.
• If management is highly risk-averse it will take a conservative approach to the level of investment in current assets. This is more appropriate if cash flows are erratic and unpredictable
and hence a margin of safety is needed. It is associated with:
o maintaining relatively high levels of inventory to ensure availability;
o offering generous credit terms to customers to encourage demand;
 o paying suppliers promptly to ensure goodwill/minimise stockouts; and
o holding high precautionary levels of cash.
Problems with such an approach include inventory obsolescence and a high financing cost for the high level of assets.
• If management has a higher tolerance for risk, it would adopt an aggressive approach and drive down the levels of inventory, receivables and holdings of surplus cash. It is more
appropriate if cash flows are very predictable. This policy would potentially be more profitable because of the lower level of investment in current assets. However, this would also be more
risky due to, for example:
o running out of inventory in periods of fluctuating demand;
o losing customers to competitors who offer more generous credit; or
o being less able to meet unexpected expenses.
• A moderate approach falls between the conservative and aggressive approaches.

13.2.1 Interest Rates

2.1 Interest Rates

Whatever level of current assets the business decides to hold, they must be matched by liabilities (i.e. current assets must be funded).
Management must decide whether to use short-term or long-term finance or, if a mix is used, in what proportions. A key factor is the relative cost of various sources of finance.
It is generally true that the cost of short-term finance is below the cost of long-term finance. This is due to the term structure of interest rates (see Chapter 2).

2.2 Sources of Finance

2.2.1 Short-term
• Usually expensive, but flexible (i.e. level of finance fluctuates to meet requirements).
• Variable interest rate exposes entity to rate rises.
Overdraft • Repayable on demand.

• Usually lower interest rate than long-term debt (unless yield curve is inverted − see Chapter 2).
Short-term loans • Renegotiation risk (i.e. bank may refuse to refinance on maturity).

• Appears cheap, but refusing settlement discounts can be expensive.

• Taking excessive credit may lead to lost goodwill with supplier and even penalties for late payment.
Accounts payable • Trade credit can disappear (i.e. if too much credit is taken from suppliers, they may lose patience and refuse to give credit in the future).
Although short-term funding may, in some cases, be relatively cheap there is a danger that it can quickly disappear. For example:
• The bank may ask for the overdraft to be repaid.
• Key suppliers may put a customer on a "stop list" and refuse further deliveries until all outstanding invoices are paid (and future deliveries may have to be paid for in advance).
Therefore, it may be wise to at least partly use long-term finance as, although generally more expensive, it reduces exposure to renegotiation risk.

2.2.2 Long-term
 • New share issues or, to avoid issue costs, retained profits.
Equity • No legal commitment to repay (i.e. no renegotiation risk).

• Loan note issues and/or long-term bank loans.

Debt • If interest rates are fixed, provides protection against rising rates (until maturity).

2.3 Permanent v Fluctuating Current Assets

Some proportion of "current" assets on the statement of financial position may in fact be more permanent in nature. Possible reasons include:
• Holding of "buffer stock" (i.e. a minimum level of inventory held throughout the year as protection against "stock-outs");
• Holding a minimum "precautionary" balance of cash to meet any unexpected payments;
• A minimum level of trade receivables over the business cycle. Over the year the total level of current assets will naturally fluctuate above the minimum permanent level − only this excess
is truly short-term in nature.

13.2.4 Strategies for Funding Current Assets

2.4 Strategies for Funding Current Assets

There is an argument that any permanent segment of current assets should be matched with long-term finance and the fluctuating segment of current assets be matched with short-term finance.
This is referred to as a "matching policy” to the financing of working capital (i.e. the maturity of the funds matches the maturity of the assets). A matching policy is consistent with management being
prepared to accept a moderate level of risk.
An "aggressive" financing strategy would be to use short-term finance not only for the fluctuating balance of current assets but also for some, if not all, of the permanent balance. This is potentially a
cheap financing strategy but indicates that management have a high, and potentially dangerous, tolerance for risk. Short-term finance can quickly evaporate, leaving the organization in financial
distress. Lessons should be learned from cases such as Northern Rock, a UK bank that exclusively relied on short-term interbank financing for its operations. In the financial crisis of 2008, Northern
Rock found its only source of finance was completely cut off, causing the bank to collapse.
A "conservative" financing strategy would be to use long-term finance not only for the permanent level of current assets but also for part, if not all, of the fluctuating balance. This may be relatively
expensive but is lower risk for the organisation and means that management does not have to think continually about rolling over finance. A conservative policy is therefore consistent with a highly
risk-averse attitude of management (e.g. in an owner-managed business).
Funding strategies are also affected by factors such as previous funding decisions and organisation size.