Instructors Manual-Corporate Finance and Investement [PDF]

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Instructor’s Manual Corporate Finance and Investment Decisions and Strategies Eighth edition

Richard Pike Bill Neale Philip Linsley For further instructor material please visit:

www.pearsoned.co.uk/pikeneale ISBN: 978-1-292-06411-6

© Pearson Education Limited 2015 Lecturers adopting the main text are permitted to download and photocopy the manual as required.

PEARSON EDUCATION LIMITED Edinburgh Gate Harlow CM20 2JE United Kingdom Tel: +44 (0)1279 623623 Web: www.pearson.com/uk

First published 2007 This edition published 2015 (electronic) © Pearson Education Limited 2015 (electronic) The rights of Richard Pike, Bill Neale and Philip Linsley to be identified as authors of this work have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. ISBN 978-1-292-06411-6 All rights reserved. This ePublication is protected by copyright. Permission is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, this ePublication must not be copied, reproduced, transferred, distributed, leased, licensed or publicly performed or used in any way except as specifically permitted in writing by the publishers (or, where applicable, a licence permitting restricted copying in the United Kingdom should be obtained from the Copyright Licensing Agency Ltd, Saffron House, 6-10 Kirby Street, London EC1N 8TS) as allowed under the terms and conditions under which it was purchased, or as strictly permitted by applicable copyright law. Any unauthorised distribution or use of this text may be a direct infringement of the author's and the publishers' rights and those responsible may be liable in law accordingly. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. Pearson Education is not responsible for the content of third-party internet sites. The Financial Times. With a worldwide network of highly respected journalists, The Financial Times provides global business news, insightful opinion and expert analysis of business, finance and politics. With over 500 journalists reporting from 50 countries worldwide, our in-depth coverage of international news is objectively reported and analysed from an independent, global perspective. To find out more, visit www.ft.com/pearsonoffer.

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Contents Chapters

Pages Preface

5

Part I

A framework for financial decisions

6

1.

An overview of financial management

7

2.

The financial environment

15

3.

Present values, and bond and share valuation

23

Investment decisions and strategies

26

4.

Investment appraisal methods

27

5.

Project appraisal – applications

36

6.

Investment strategy and process

49

Value, risk and the required return

50

7.

Analysing investment risk

51

8.

Relationships between investments: portfolio theory

61

9.

Setting the risk premium: the Capital Asset Pricing Model

64

10.

The required rate of return on investment

66

11.

Enterprise value and equity value

68

12.

Identifying and valuing options

72

Short-term financing and policies

74

13.

Risk and treasury management

75

14.

Working capital and short-term asset management

78

15.

Short- and medium-term finance

88

Strategic financial decisions

94

16.

Long-term finance

95

17.

Returning value to shareholders: the dividend decision

102

18.

Capital structure and the required return

108

19.

Does capital structure really matter?

116

20.

Acquisitions and restructuring

127

International financial management

137

21.

Managing currency risk

138

22.

Foreign investment decisions

143

23.

Key issues in modern finance: a review

Part II

Part III

Part IV

Part V

Part VI

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Preface This manual accompanies the eighth edition of Corporate Finance and Investment, and is designed to assist instructors in the use of the text on their courses. For each chapter of the text, the following three elements are provided. •

A note of the key learning objectives.

•

A summary of those chapter end exercise questions whose solutions are to be found in this manual.

•

Solutions to the exercises not given in Appendix B of the text. It should be remembered that there is often no single correct solution to a particular exercise; alternative solutions may be equally appropriate because the information given is not always complete, or because there is more than one possible approach to the problem.

Separately available on the web site are some additional questions with solutions thereto. There is also a selection of more complex case studies with relevant teaching notes. Richard Pike Bill Neale Philip Linsley

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PART I

A framework for financial decisions

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CHAPTER 1

An overview of financial management Learning objectives By the end of the first chapter, the reader should have gained a better appreciation of: •

What corporate finance and investment decisions involve.

•

How financial management has evolved.

•

The finance function and how it relates to its wider environment and to strategic planning.

•

The central role of cash in business.

•

The goal of shareholder wealth creation and how investors can encourage managers to adopt this goal.

Questions summary 2. Go4it plc explores the ideas behind the classical ‘maximisation of shareholder value’ approach to finance, and how success in this aim can best be measured. 3. These questions address the wider fields of ‘stakeholder’ and ‘agency’ theory. 4. This question asks students to evaluate benefits and problems of ESOPs in solving the ‘agency’ dilemma. 5. Zedo plc assesses various remuneration packages for senior management in relation to encouraging managers to pursue shareholder goals. 6. This question examines shareholder goals and social objectives. 7. The role and characteristics of the financial management function are examined. 8. In the Cleevemoor Water Authority, stakeholder goals and performance measures of a public utility are considered.

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Answers to questions 2. Go4it plc Maximising earnings per share will focus the company’s decision-making on profit after tax. This is an important element of shareholder value, but it ignores: •

Cash flow – depreciation policy will affect profits but not cash while capital investment affects cash but not profits.

•

Risk.

•

Cost of capital.

3. (a) Managers and owners may have different interests because ownership and management are separate in many firms. Shareholders have little direct influence on the day-to-day management. Managers are typically reckoned to be more risk averse than shareholders, who can diversify much of the risk by holding an investment portfolio. Examples of possible conflicts include: •

The level of perquisites that managers may look for.

•

The time horizon for decision outcomes – managers may not expect to stay with the firm for more than a few years.

•

Take-over situations – managers may be reluctant to support a bid if it means new management and redundancy.

(b) Corporate social responsibility refers to the way in which companies need to be aware of the needs of the wider community. Such responsibility includes: •

Employees – fair wages and a safe working environment.

•

Customers – providing a quality product at an appropriate price.

•

Public – safety and support to the local community.

•

Suppliers – prompt payment of bills.

•

Government – proper payment of taxes and compliance with regulations.

(c) ‘Value for Money’ (VFM), as its name infers, involves getting the best possible service at the least possible cost. With regard to public services, this would imply that the taxpayers’ requirements are being served by the most efficient use of resources. VFM has three aspects: •

Economy – acquiring the necessary inputs at the lowest cost.

•

Efficiency – gaining more output from given inputs.

•

Effectiveness – the extent to which a service meets its declared goals.

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4. Executive share option plans (ESOPs) have become popular in recent years, partly to aid goal congruence within companies. Goal congruence arises when goals of different groups coincide. The two main groups are the shareholders (principals) and the managers (agents). Other groups include the employees, the creditors, the government and the local community. ESOPs enable managers to buy a company’s shares at a fixed price over a specified period. The aim is to give managers a stake in the firm so that they will make decisions consistent with shareholder’s interests. However, share options typically form only a limited part of the remuneration package. If share prices fall, managers may decide not to take up the option. Once they have taken up the option, managers may feel that share price movements may have little to do with their efforts, but reflect the external market movements. ESOPs are viewed as a useful instrument for encouraging congruence between the shareholder and the manager, but which is by no means perfect. 5. Zedo plc (a) The management of Zedo plc, under the control of the board of directors, is probably a very different group of individuals, with different requirements and aspirations, from the company’s shareholders. For the majority of quoted companies, there is a clear separation of ownership and control. The owners (shareholders) must therefore seek to ensure that their agents (managers) act in their best interests. Shareholders seek to maximise their wealth by maximising the market value of their investment and by the dividends received. Managers, on the other hand, might seek to maximise their personal wealth or satisfaction through higher salaries, better ‘perks’ (company cars, better offices, etc.) and increased leisure time. They may have a different attitude to corporate risk, profitability and growth than shareholders, which would lead to the development of strategies and policies inconsistent with shareholders’ goals. One approach that shareholders frequently adopt is to introduce a remuneration scheme designed to motivate managers to take actions consistent with shareholders’ goals. Factors to be considered in devising a remuneration package: •

Linking management compensation to changes in shareholder wealth.

•

Reflecting manager’s contribution to increased wealth, i.e. rewarding efficiency rather than managerial luck.

•

Matching the time horizon for decisions of managers with that of shareholders. Many managers look towards maximising only short-term profits.

•

Encouraging the same risk attitude as for shareholders. This is not easy as shareholders, unlike managers, can reduce risk through holding investment portfolios.

•

Making the scheme easy to monitor and incapable of manipulation by the managers.

•

Operating a cost-effective scheme.

(b) Advantages and disadvantages of the three schemes. (i) A bonus based upon achieving a minimum pre-tax profit level. The danger with such a scheme is that it emphasises short-term profits at the expense of longer-term profitability. Investment decisions often have a negative profit impact in the short-term. This scheme may discourage vital investment decision-making. At the same time, it encourages the use of ‘creative accounting’ methods to manipulate year-end 9 © Pearson Education Limited 2015

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results, for example, companies may have sold properties and recorded the gains made as part of trading profit. Another trick is to issue new shares and invest the proceeds in the bank, and the interest accrued is shown as an increase in the year’s profits. (ii) A bonus based on turnover growth. While this has obvious merits for companies with strong growth goals, it emphasises growth at the expense of profitability and may not increase shareholders’ wealth. Investment decisions and acquisitions might be taken on the basis of turnover rather than wealth-creation. Prices may be reduced to increase sales at the expense of margins. (iii) A share-option scheme. These schemes are long-term compensation arrangements, which are dependent upon the company’s share performance. Managers can buy a given number of shares at a given price over a set period of time. Such share options only have value when the actual share price exceeds the option price. This offers managers, who take up the scheme, the incentive to take actions consistent with wealth-creation over a longer time period. While, in theory, the scheme is attractive, it is often difficult for managers to see a clear relationship between their efforts and share prices. For example, inefficient managers could be rewarded in times of a generally rising stock market, and vice versa. 6. The primary financial objective of companies and the potential conflict with environmental and social goals is discussed in Section 1.7. 7. Many of the techniques used in financial decision-making are based upon the assumption of shareholder wealth maximisation. This might be the main objective of shareholders, but it is unlikely to be the only objective. Environmental and social considerations are only two of a number of possible objectives of shareholders, some of which may conflict with wealth maximisation. Maximisation of shareholder wealth, to the exclusion of other objectives, is therefore, neither desirable nor possible in many companies. This does not negate its usefulness as a financial objective. A company might seek to maximise shareholder wealth after taking into account agreed environmental, social or other factors. Possibly, more serious concerns are the ‘agency’ conflicts that might exist within organisations. In large companies, in particular, shareholders own the company but control is exercised by management, especially the board of directors. Managers acting as ‘agents’ of the shareholders might in part take decisions, which maximise their own utility, for example, through high salaries, perks or job security, rather than maximise shareholder wealth. Decisions are sometimes argued to be ‘satisficing’ rather than maximising, with managers of all levels concerned with taking decisions that will satisfy the next higher level of authority, while at the same time fulfilling their own personal objectives. If shareholders wish managers to make decisions that are consistent with shareholders’ wealth maximisation, they will need to incur costs to monitor ‘managers actions’, and to introduce incentives for managers to seek wealth maximisation, for example, through the introduction of share-option schemes whereby managers also benefit from good market performance of a company’s shares. Shareholder wealth maximisation is a realistic objective for a profit-seeking organisation, but it is unlikely to be achieved because of imperfect information, the existence of additional objectives and the lack of goal congruence between shareholders and the company’s employees, especially its managers.

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(a) Quoted high-growth company: •

A large amount of time devoted to statutory and listing requirements, particularly if the company is growing by acquisition.

•

Strong focus on management and accounting, for example, evaluation of strategic opportunities including mergers and acquisitions.

•

Strong treasury skills to secure both the short- and long-term financing for the company.

•

Development of management information and accounting systems to meet the needs of the business.

(b) Quoted low-growth company: •

Focus on improvement of profit by means of cost control, and, therefore, the financial management must be able to select and implement appropriate budgetary and costcontrol systems and to provide management information in a concise and relevant form.

•

The department must be capable of dealing efficiently with the statutory and listing requirements.

•

If the slower rate of growth means that the company generates cash, the financial management will be concerned with the best ways in which to use the funds, for example, investment in new business opportunities or repayment to shareholders in the form of dividends or a buy-back of shares.

(c) Unquoted company aiming for a stock exchange listing: •

If the flotation is being made due to the need for access to a wider pool of funds to finance expansion, then many of the points made in part (a) would also be relevant.

•

The financial management must understand the listing requirements and be able to liaise with the banks and institutions advising on the flotation.

•

If the purpose of the flotation is to enable the owners to realise the value of their investment, then the financial managers must be able to persuade potential investors that the company will be as successful under a new ownership and control structure as it was, as a private company.

•

The managers must be good at communicating information about the company to the wider public, and must be able to present financial information in a clear and accessible format.

(d) Small family-owned business: •

The financial manager must be able to communicate effectively with a wide range of people, including the owners of the business, providers of finance, tax officers and shopfloor workers.

•

The role of the financial manager will depend on the position and nature of the company. For instance, is it growing or is it facing competitive pressure and liquidity problems? Different business situations will place different demands on the financial managers.

•

In a small company, the financial manager must be able to turn his hand to a much wider range of activities than in a large company. He must therefore be much more of a generalist and understand the details of a wide range of financial specialisms.

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(e) Non-profit-making organisation, for example, a charity: •

The main difference between a non-profit-making organisation and a commercial business is that resources are allocated not on the basis of cash-flow generation, but on the basis of value to those providing the funds. Thus, the financial manager will be more concerned with providing an appropriate way of measuring ‘value’ in the context of the aims of the organisation than with measuring cash flow.

•

Since funds are donated, there is likely to be a strong emphasis on cost control and the efficient use of allocated resources.

•

The financial manager will need to be involved in the fund-raising process. This is quite different from the way in which a commercial organisation raises funds in the form of equity and debt.

(f) Public sector, for example, a government department: •

In terms of expenditure, the work of the financial manager is likely to be similar to that in a non-profit-making organisation, the emphasis being on ‘value’ rather than cash flow. This is likely to demand an understanding of the techniques of cost–benefit analysis.

•

The financial manager will have little or no concern with the way in which the funds are raised since there is generally a separation in the public sector between sourcing of funds and expenditure.

•

Unlike the private organisation where some attempt will be made to look at the longer term, most of the budgeting in a government department is concerned with the one-year time span and is framed in revenue terms.

8. Cleevemoor Water Authority (a) The main function of public enterprise is to serve the public interest – in the case of a water undertaking, it would be responsible for ensuring a safe and reliable supply of water to households at an affordable price, which would also require close attention to the control of operating and distribution costs. Prior to privatisation, UK public enterprises were also expected to achieve a target rate of return on capital, which struck a balance between the going rate in the private sector and the long-term perspective involved in such operations. The authority would also have faced political constraints on achieving its objectives in the form of pressure to keep water charges down and also periodic restrictions on capital expenditure. One problem faced by such enterprises was their inability to generate sufficient funds necessary to finance the levels of investment required to maintain water supplies of acceptable quality. Once privatised, NW would be required to generate returns for shareholders, allowing for risk, at least, as great as comparable enterprises of equivalent risk. Moreover, it would be expected to generate a stream of steadily rising dividends to satisfy its institutional investors with their relatively predictable stream of liabilities. Any capital committed to fixed investment would have to achieve efficiency in the use of resources and to achieve the level of returns required by the stock market. In the United Kingdom, it is often alleged that there is an over-concern with short-term results, both to satisfy existing investors and to preserve the stock market rating of the company. Although this may safeguard future supplies of capital, it has militated against infrastructure projects

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and activities such as R&D, which may generate their greatest returns in the more distant future. (b) (i) Shareholders In financial theory, companies are supposed to maximise the wealth of shareholders, as measured by the stock market value of the equity. In the absence of perfect information, it is not possible to measure the relationship between achieved shareholder wealth and the outright maximum. However, good indicators of the benefits received by shareholders are the returns they receive in the form of dividend payments and share price appreciation. Dividends The pro forma dividend was 7p and by 2006 the dividend per share had grown by 186% to 20p, an average annual (compound) growth of around 19%. The pro forma payout ratio was 33%, falling to 31% by 2006. This suggests that dividend per share has grown by slightly less than earnings per share. The pro forma EPS was 21p rising by 210% to 65p, an average annual increase of about 21%. This suggests that the company broadly wishes to align dividend increases to increases in EPS over time. Share Price The flotation price was £1, rising to £1.60 on the first day of dealing. By 2002, the EPS had become 29p. Given a P:E ratio of 7, this implies a market price of 203p per share. By 2006, the EPS had risen to 65p, and with a P:E ratio of 7.5, this corresponds to a market price of 488p. Compared to the close of first day’s dealings, the growth rate was 205% (or just over 20% as an annual average), and over the period 2002–2006, growth occurred at the accelerated rate of 140% (an annual average of about 24%). Although information about returns in the market in general, and those enjoyed by shareholders of comparable companies are not available to act as a yardstick, these figures suggest considerable increases in shareholders’ wealth, and at a rate substantially above the increase in the RPI. (ii) Consumers Although NW’s ability to raise prices is ostensibly restrained by the industry regulator, turnover has risen by 38% over the period, an annual average of 5.5%. This is above the rate of inflation over this period (about 2% p.a.) and also above the trend rate of increase in demand (also 2% p.a.). This suggests relatively weak regulation, perhaps reflecting the industry’s alleged need to earn profits in order to invest, or perhaps that NW has diversified into other, unregulated activities, which can sustain higher rates of product price inflation. However, before accusing NW of exploiting the consumer, one would have to examine whether it did lay down new investment, and also how productive it had been, especially using indicators like purity and reliability of water supply. (iii) Workforce Numbers employed have fallen from 12,000 to 10,000 (i.e. by 17%). The average remuneration has risen from £8,333 to £8,600, corresponding to a mere 1% in nominal terms, but about 8% in real terms, after allowing for the 9% inflation in retail prices over this period. This suggests a worsening of the returns to the labour force, although a shift in the skill mix away from skilled workers and/or a change in conditions of 13 © Pearson Education Limited 2015

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employment away from full time towards part time and contract working might explain the figures recorded. Certainly, the efficiency of the labour force as measured by sales per employee (up from £37,500 to £62,000 – an increase of 65%) has outstripped movements in pay. However, apparently greater labour efficiency could be due to product price inflation and/or the impact of new investment. The directors, however, seem to have benefited greatly. It is not stated whether the number of directors has increased, but as a group, their emoluments have trebled. Arguably, this might have been necessary to bring hitherto depressed levels of public sector rewards in line with remuneration elsewhere in the private sector in order to retain competent executives. Conversely, the actual remuneration may be understated as it does not appear to include non-salary items such as share options, which would presumably be very valuable, given the share price appreciation that has occurred over this period. (iv) Macroeconomic objectives There are numerous indicators whereby NW’s contribution to the achievement of macroeconomic policies can be assessed. Among these are the following: 1. Price stability (i) Via its pricing policy. As noted, NW’s revenues have risen by 38% in nominal terms and 29% in real terms. This questions the company’s degree of responsibility in cooperating with the government’s anti-inflationary policy. (ii) Via its pay policy. There is evidence that NW has held down rates of pay, but if this has not been reflected in a restrained pricing policy, then, the benefits accrue to shareholders rather than to society at large. Moreover, the rapid increase in directors’ emoluments is hardly anti-inflationary, providing signals to the labour force, which are likely to sour industrial relations. 2. Economic growth (i) Via its capital expenditure. Higher profitability has been implicitly condoned by the regulator in order to allow NW to generate funds for new investment. This appears to have been achieved. Capital expenditure has nearly quadrupled. As well as benefiting the industry itself, this will have provided multiplier effects on the rest of the economy to the extent that equipment has been domestically sourced. (ii) Via efficiency improvements. It is not possible to calculate non-financial indicators of efficiency, but there are clear signs of enhanced financial performance. The sharp increase in sales per employee has been noted. In addition, the return on capital as measured by operating profit to long-term capital has moved steadily upwards as follows: 2000

2002

2004

2006

6.5%

8.4%

12.2%

15.3%

3. Tax payments. Although NW’s average rate of taxation has fallen from 19% in 2000 to 13% by 2006, this may be due to the impact of capital expenditure, generating significant tax breaks.

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CHAPTER 2

The financial environment Learning objectives By the end of this chapter, the reader should appreciate the nature of financial markets and the main players within them. A clear understanding is required of the following topics: •

The functions of financial markets.

•

The operation of the Stock Exchange.

•

The extent to which capital markets are efficient.

•

How taxation affects corporate finance.

Enhanced ability to read financial statements and the financial pages in a newspaper should also be achieved.

Questions summary 1. This question invites students to define and discuss the role of investment banks in providing corporate finance advice. 2. Parts (a) and (b) require discussion of the role and operation of capital markets, and especially the place and form of the Efficient Market Hypothesis (EMH) within these operations. Part (c) has a solution in the textbook. 3. Buntam plc/Zellus plc asks students to calculate some common ‘market’ indicators and comment on the issues to be considered and advice to obtain when investing in the stock market. 4. Beta plc examines the merits of a stock exchange listing. 5. Collingham plc considers the issues involved in gaining a stock market listing.

Answers to questions 1. (a) See Section 2.3 in Chapter 2 – the section on wholesale banks. 2. (a) See Section 2.2 in Chapter 2 (b) See Section 2.5 in Chapter 2

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3. Report to Clients: Buntam plc/Zellus plc Subject:

Traded investments

(a) ‘Traded investment’ refers to any investment asset, which is traded in the financial markets. Examples include government and company bonds, ordinary shares, preference shares, warrants and options or futures contracts. The range of such investments is therefore wide, and it is important to recognise that each type of investment has unique characteristics in terms of its cost, rate of return and risk. All of these factors must be taken into account when selecting an investment. The price of bonds and shares will vary, depending on economic conditions and the financial performance of the individual companies. Interest rates directly affect the price of gilt-edged stock and corporate bonds; an increase in interest rates reduces the price of bonds. This represents a capital risk to the investor, who cannot be certain of the price at which the bond can be sold. The return earned on bonds will generally be higher than that available through interest-bearing deposit accounts. Ordinary shares present a much riskier form of investment, particularly for private individuals, who may incur high charges from the purchase and sale of shares. The price of ordinary shares varies daily, depending on factors within the market in general, and also specific to the company. An investor may earn a return via dividends and/or capital gains. The amount of dividends receivable is dependent, among other things, upon the profits of the company, and hence is not predictable with certainty. Individual share prices are definitely not predictable with any level of certainty. Consequently, investment in ordinary shares is relatively risky, but may offer good returns, which historically have been shown on average to be higher than the returns on bonds. In conclusion, when comparing the different traded investments, it is essential that the composition of the investment portfolio matches both the liquidity and risk needs of each individual investor. (b) Financial intermediaries are important to the efficient functioning of the financial markets, as they play a crucial role in bringing the borrowers/companies and lenders/equity providers together. Financial intermediaries include pension funds, insurance companies, retail and merchant banks and unit trust companies. In relation to private investors, their functions include: (i) The provision of investment advice and information. (ii) Reduction of risk via aggregation of funds. (iii) Maturity transformation. Financial intermediaries play a role here in performing the function of maturity transformation. For example, a building society will lend out money for a period of 20–30 years, but their investors would still wish to be able to withdraw cash that they have in deposit accounts at random intervals. By taking advantage of the constant turnover of cash between borrowers and lenders, the building society can lend long term while holding short-term deposits. It is this process that is referred to as maturity transformation. Financial intermediaries can therefore be seen to be extremely useful to the private investor, as they may provide useful advice and make it easier for the individual to take advantage of the returns that can be earned in the financial markets (via, for example, personal pension funds), while, at the same time, leaving investors with a wide range of opportunities as a result of maturity transformation, aggregation and reduced risk.

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(c) (i) Gross dividend At the end of the financial year, companies will announce the profits or losses that they have earned, and a figure for net profit after tax. A company can choose to pay out profit in dividends or to reinvest it in the business. Dividends are paid out per share, and so the more shares that you own in a business, the more dividend income that you will receive. Using the example of Buntam plc, the figures indicate a gross dividend yield of 5%. This means that the dividend paid equals 5% of the share price, or 8p, in this case. The term ‘gross’ means that this is the dividend paid before tax. The equivalent calculation for Zellus plc means that the dividend yield of 3.33% is equivalent to a gross dividend payment of 9p. If an individual shareholder in Buntam plc pays tax at 10% on investment income, then he will collect a net dividend of 8.10p per share. The company pays this basic rate of tax to the government as an advance payment of its corporation tax liability, when it pays out its dividends, and so investors receive the dividend after deduction of the basic tax payable. The gross dividend figure is of relevance to an investor as it facilitates direct comparison of the dividend figure and dividend yield paid out by different companies, as well as comparison with interest yields on fixed-return investments. The tax liability is determined by the individual circumstances of each investor, and so its inclusion would serve only to confuse any comparative analysis. The dividend figure is also relevant to an investment decision because it is a way of earning income from investments, as opposed to capital gains, which can only be realised when the investment is sold. (ii) Earnings per share Earnings per share (EPS) is calculated as profit attributable to equity divided by the number of shares in issue and ranking for dividends. EPS thus represents what is available to be paid out as dividends. Clearly, therefore, if the number of shares in issue remains fixed, the EPS will rise as the net profit attributable to equity increases. The value or EPS can be calculated by dividing the share price by the P:E ratio. For Buntam, this means EPS equals 8p. In other words, the earnings per share is equal to the gross dividend payable. For Zellus, the EPS is equal to 18p (270/15), in comparison with a gross dividend of 9p. On first sight, therefore, it is tempting to view Zellus as a better investment because its EPS is higher. On the other hand, an investor has to pay 270p per share to get earnings of 18p, compared with 160p to get earnings of 8p. The EPS figure is of limited value on its own; it needs to be judged in conjunction with the share price, and hence the P:E ratio. (iii) Dividend cover Dividend cover measures the relationship between earnings per share and net dividends per share. The higher the level of dividends (for any given level of EPS), the lower will be the level of profit retained and reinvested within the business. This can have an effect on the balance of returns available to an equity investor. The returns from investing in shares may take the form of either income, i.e. dividends, which are paid twice yearly, or capital gain/loss which is earned/incurred when the shares are sold. Some investors may prefer one type of return to the other, often for tax reasons.

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Dividend cover is measured as follows: earnings per share, (net)/dividend per share (net). Using the example of Zellus plc, the net EPS is 18p. The gross dividend is 9p, and so if tax is payable at 10%, then the net dividend equals 8.1p. Using this formula, the dividend cover equals 18/8.1, which gives a dividend cover of 2.2. In other words, Zellus’ earnings are sufficient for the company to be able to pay out dividends at a rate 2.2 times their current level. By comparison, Buntam has an EPS of 8p and a net dividend per share of 7.2p, giving a dividend cover of just 1.1. Investors need to understand the relationship between dividend cover and investment returns. As a general rule, the greater the level of retention (and dividend cover), the greater is the likelihood that a share will yield capital gain rather than income. From the examples given above, it would thus appear for Buntam plc (paying out almost all its earnings as dividends), there is limited scope for capital growth in the share price. By contrast, Zellus has a relatively high dividend cover, and so the reinvestment of profits should generate capital gains. As with all investor ratios, dividend cover has to be interpreted with caution, and alongside a number of other measures. 4. Beta plc (a) The advantages of obtaining a listing on a stock exchange for a company and its shareholders are as follows: Cost of capital: The fact that listed shares are easily marketable means that listed shares are usually viewed as being less risky than unlisted shares. This may help lower the cost of capital for the company. Ready price: The fact that a ready price is available for listed shares should help avoid any uncertainties which occur when shares are being valued for certain purposes such as merger and take-over bids or for calculating liability for taxation. Efficient market price: Shares listed on a stock exchange are usually valued in an efficient manner. This means that the price of the shares reflects fully the available information concerning the company and its prospects. This should give potential investors greater confidence when trading in the company’s shares. Transferability of shares: Existing shareholders will be able to transfer shares more easily, as listed shares are more marketable than unlisted shares. This increase in the marketability of shares should also make it easier for the company to raise new share capital when required. Credit rating: A listed company may be seen as more creditworthy than an unlisted company. This may make it easier for the company to raise loans when required. High profile: When the company is listed, it will become more widely known and will be the subject of greater interest by the investment and business community. This may help the company in developing and exploiting market opportunities. The disadvantages of obtaining a stock exchange listing are as follows: Market expectations: A listed company may be under considerable pressure to meet market expectations. Failure to do so is likely to have an adverse effect on the share price. Sometimes, market expectations for profit in the short term may conflict with the longerterm strategies which the company wishes to pursue. 18 © Pearson Education Limited 2015

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Cost: The costs of floating a company on the stock exchange can be very high. These costs will usually include substantial legal and accountancy fees. Administration and disclosure requirements: A listed company must comply with various stock exchange rules and regulations and these may represent an administrative burden. The company must also meet additional financial disclosure requirements imposed by the stock exchange, for example, the London Stock Exchange requires that interim (half-yearly) accounts be published. Dilution of control: Existing shareholders will have their control over the company diluted as a result of widening ownership in the company’s shares. Risk of takeover: As shares in a listed company are easy to acquire, there is a greater risk that another company will acquire its shares with a view to a takeover. Public scrutiny: Listed companies are subject to a great deal of scrutiny from financial analysts, the financial press and investors. This may be a problem if Beta plc is engaged in activities which require sensitive handling or which may arouse criticism from certain quarters. (b) When attempting to place an issue price on shares in a company, which is to be floated on a stock exchange, the following factors should be taken into account: Risk: The level and type of risk associated with the business will be identified and assessed by investors. For certain types of business, associated risks may be identified and evaluated more easily than for others. Investors will take account of the risks and compare these with expected returns when evaluating the share price. Maintainable profits: The level of maintainable profits will be an important determinant of share price. The degree of confidence that investors have in the reliability of profit forecasts produced will also be important. Similar companies’ data: If there are companies operating in the same industry that are already listed on the stock exchange, it may be possible to obtain a guide price from the data available. The P:E ratio of similar companies can be multiplied by the earnings per share of the company to be floated in order to arrive at a market valuation. However, care must be taken in using the P:E ratio of other companies as they may not have the same risk and growth characteristics. Furthermore, the P:E ratio can be influenced by particular accounting policies being adopted by a company. Other investment ratios, such as the dividend yield and dividend cover of similar companies may also be used in developing a guide price. Investor interest: A company may wish to create a good impression among investors by having a fully subscribed issue of shares. This may be particularly important for a company that expects to make further issues in the foreseeable future. Thus, the shares to be issued may be offered at a discount on what is considered to be their true market value, in order to attract investor interest. Research suggests that small companies must usually offer a larger discount than large companies when issuing shares for the issue to be successful. An immediate premium will accrue to investors who subscribe to the issue for which a discount is offered. 5. Collingham plc (a) Seeking a quotation places many strains on a company; in particular, the need to provide more extensive information about its activities. However, the costs involved in doing this may seem worthwhile in order to pursue the following aims: 19 © Pearson Education Limited 2015

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(i) To obtain more capital to finance growth. Companies that apply for a market listing are often fast-growing firms, which have exhausted their usual supplies of capital. Typically, they rely on retained earnings and borrowing, often on a short-term basis. A quotation opens up access to a wider pool of investors. For example, large financial institutions are more willing to invest in quoted companies whose shares are considerably more marketable than those of unlisted enterprises. Companies with a listing are often perceived to be financially stronger and hence may enjoy better credit ratings, enabling them to borrow at more favourable interest rates. (ii) To allow owners to realise their assets. After several years of successful operation, many company founders own considerable wealth on paper. They may wish to realise some of their holdings to fund other business ventures or simply for personal reasons, even at the cost of relinquishing some measure of voting power. Most flotations allow existing shareholders to release some of their equity as well as raising new capital. (iii) To make the shares more marketable. Existing owners may not wish to sell out at present, or to the degree that a flotation may require. A quotation, effected usually by means of a Stock Exchange Introduction, is a device for establishing a market in the equity of a company, allowing owners to realise their wealth as and when they wish. (iv) To enable payment of managers by stock options. The offer of payment to senior managers partially in the form of stock options may provide powerful incentives to improve performance. (v) To facilitate growth by acquisition. Companies whose ordinary shares are traded on the stock market are more easily able to offer their own shares (or other traded securities, such as convertibles) in exchange for those of target companies whom they wish to acquire. (vi) To enhance the company’s image. A quotation gives an aura of financial respectability, which may encourage new business contracts. In addition, as long as the company performs well, it will receive free publicity when the financial press reports on their performance and discusses the results in future years. (b) The table below compares Collingham’s ratios against the industry averages: Industry

Collingham

Return on (long-term) capital employed

22%

10/33 = 30.3%

Return on equity

14%

6/28 = 21.4%

Net profit margin

7%

10/80 = 12.5%

Current ratio

1.8:1

23/2 = 1.15:1

Acid test

1.1:1

13/20 = 0.65:1

Gearing (total debt/equity)

18%

10/28 = 35.7%

Interest cover

5.2 times

10/3 = 3.33 times

Dividend cover

2.6 times

6/0.5 = 12 times

Collingham’s profitability, expressed in terms of both ROCE (Return on Capital Employed) and ROE (Return on Equity), compares favourably with the industry average. This may be inflated by the use of a historic cost base, insofar as assets have never been revalued. Although a revaluation might depress these ratios, the company appears attractive compared

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to its peers. The net profit margin of 12.5% is well above that of the overall industry, suggesting a cost advantage, either in production or in operating a flat administrative structure. Alternatively, it may operate in a market niche where it is still exploiting firstcomer advantages. In essence, it is this aspect which is likely to appeal to investors. Set against the apparently strong profitability is the poor level of liquidity. Both the current and the acid test ratios are well below the industry average, and suggest that the company should be demonstrating tighter working capital management. However, the stock turnover of (10/70 × 365) = 52 days and the debtor days of (10/80 × 365) = 46 days do not appear excessive, although industry averages are not given. It is possible that Collingham has recently been utilising liquid resources to finance fixed investment or to repay past borrowings. Present borrowings are split equally between short term and long term, although the level of gearing is well above the market average. The debenture that is due for repayment shortly will exert further strains on liquidity, unless it can be re-financed. Should interest rates increase in the near future, Collingham is exposed to the risk of having to lock-in higher interest rates on a subsequent long-term loan or pay (perhaps temporarily) a higher interest rate on overdraft. The high gearing is reflected also in low interest cover, markedly below the industry average. In view of high gearing and poor liquidity, it is not surprising that the pay-out ratio is below 10%, although Collingham’s managers would presumably prefer to link high retentions to the need to finance ongoing investment and growth rather than to protect liquidity. (c) It is common for companies in Collingham’s position to attempt to ‘strengthen’ or to ‘tidy up’ their balance sheets in order to make the company appear more attractive to investors. Very often, this amounts to ‘window dressing’, and if the company were already listed, it would have little effect in an information-efficient market. However, for unlisted companies, about whom little is generally known, such devices can improve the financial profile of the company and enhance the prospects of a successful flotation. (i) Some changes in the balance sheet that Collingham might consider prior to flotation are as follows: •

Revalue those fixed assets which now appear in the accounts at historic cost. The freehold land and premises are likely to be worth more at market values, although the effect of time on second-hand machinery values is more uncertain. If a surplus emerges, a revaluation reserve would be created, thus increasing the book value of shareholders’ funds, and hence the Net Asset Value per share. The disadvantage of this would be to lower the ROCE and the ROE, although these are already well above the industry averages. Asset revaluation would also reduce the gearing ratio.

•

Dispose of any surplus assets in order to reduce gearing and/or to increase liquidity which is presently low, both absolutely, and also in relation to the industry.

•

Examine other ways to improve the liquidity position, by reducing stocks, speeding up debtor collection or slowing payment to suppliers, although it already appears to be a slow payer with a trade credit period of (15/70 × 365) = 78 days.

•

Conduct a share split, because at the existing level of earnings per share, the shares promise to have a ‘heavyweight’ rating. Applying the industry P:E multiple of 13 to the current EPS of (£6m/£4m × 2) = 75p, yields a share price of (13 × 75p) = £9.75. While there is little evidence that a heavyweight rating is a deterrent to trading in already listed shares, it is likely that potential investors, certainly smallscale ones, will be deterred from subscribing to a highly priced new issue. A one-

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for-one share split whereby the par value is reduced to 25p per share and the number of shares issued correspondingly doubles, and would halve the share price, although other configurations are possible. •

It will have to enfranchise the non-voting ‘A’ shares, because, under present stock exchange regulations, these are not permitted for companies newly entering the market.

(ii) Following the flotation, Collingham would probably have to accept that a higher dividend payout is required to attract and retain the support of institutional investors. If it wishes to persist with a high level of internal financing, a compromise may be to make scrip issues of shares, especially if the share price remains on the ‘heavy’ side. Scrip issues are valued by the market because they usually portend higher earnings and dividends in the future. Finally, if the company has not already done so, it might consider progressively lowering the gearing ratio. It might begin this by using part of the proceeds of the flotation to redeem the debenture early. However, it must avoid the impression that it requires a flotation primarily to repay past borrowings as that might cast doubts on the company’s financial stability.

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CHAPTER 3

Present values, and bond and share valuation Learning objectives Having completed the chapter, students should have a sound grasp of the time-value of money and discounted cash flow concepts. In particular, students should understand the following: •

The time-value of money.

•

The financial arithmetic underlying compound interest and discounting.

•

Present value formulae for single amounts, annuities and perpetuities.

•

The valuation of bonds and shares.

Skills developed in discounted cash flow analysis, using both formulae and tables, will help enormously in subsequent chapters.

Questions summary 5. Construction of a yield curve and discussion of the relevance of yield curves to private investors. 6. Practice in calculating net present values at different rates showing how the preference between projects can change as discount rates alter. 7. A basic net present value question demonstrating how NPV falls as the discount rate increases. 9. Leyburn plc. This question involves the valuation of shares using the dividend valuation model where the company alters its dividend policy to invest in a series of new projects.

Answers to Questions 5. (a) The diagram the reader constructs has the following shape: It clearly shows that as the years to maturity increase, the yield earned on the gilt-edged investment falls. The shape of the curve drawn above is contrary to that which would be expected from liquidity preference theory. Theory suggests that investors require increasing levels of compensation as the time to maturity lengthens – the curve drawn above shows the exact opposite. The reason for the difference between the theoretical and the observed shape of the curve is found in market expectations. The market believes that over the long term,

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interest rates will fall, and the effect of market expectations is currently greater than the effects of liquidity preference. The slope of the yield curve shows not only how much an investor can expect as investment returns but also the cost of debt finance to the government. (b) The term ‘gilts’ refers to government issued bonds that are ‘gilt’-edged because the associated risk of default is negligible. For the private investor, gilts are an attractive form of investment because they offer fixed rates of return, they may be index-linked and the investment risks are low. Gilts have a nominal value of £100 but they may trade at prices above or below that value depending on the current level of interest rates. If the current interest rate exceeds the coupon rate payable on the gilt, then it will sell for a price below its nominal value, and vice versa. Yield curves are relevant to the private investor because they give an indication of interest rate expectations and trends. A downward-sloping yield curve, such as that shown above, indicates a long-term downward trend in interest rates. An investor in gilts can expect gilt prices to rise over the same time period. 6. NPV (£) Discount rate

A

B

Advice

0%

400

600

B

10%

197

213

B

20%

38

(63)

A

At the 10% discount rate, project B is marginally superior, but at 20%, only project A offers a positive NPV. The changes in ranking between projects arise because they have very different cash flow profiles. The correct approach is to decide upon the required rate of return and assess which project offers the higher NPV. 7. Brosnan plc Free cash flow after adding back depreciation, but deducting an equivalent amount for reinvestment is as stated, i.e. £5m p.a. (i) Assuming full distribution, and hence no growth: Value of equity = £5m/12% = £41.67m Share price = £41.67m/10m = £4.167 (£4.2). (ii) With 50% retentions, dividends = £2.5m Growth = (retention rate × return on investment) = (50% × 15%) = 7.5% Value of equity = [£2.5m(1 + 7.5%)]/(12% – 7.5%) = £2.69m/4.5% = £59.72, and thus £5.97, or £6 per share. (iii) With 50% retentions, dividends again = £2.5m Growth = (retention rate × return on investment) = (50% × 10%) = 5.0%

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Value of equity = [£2.5m(1 + 5%)]/(12% – 5%) = £2.625m/7% = ££37.5m and thus £3.75, per share. (iv) Assuming 50% retentions: Cash flows are: Year

Cash flows growing at 7.5%

PV at 12%

1.

2.5(1.075) = £2.69m

£2.40m

2.

2.69(1.075) = £2.89m

£2.30m

3.

2.89(1.075) = £3.11m

£2.21m

PV of years 1–3

= £6.91m

PV of years 4 – infinity inclusive:

[£3.11m(1.05)]/(12% – 5%) (1.12)3

= £33.20m

PV of equity

= £40.11m

i.e. £4 per share 9. Leyburn (a) Value of equity now =

D1 £4m(1 + 8%) = ke − g (14% − 8%)

=

£4.32m 0.06

= £72m Allowing for cash of £4m → = £4m = £76m

(b) This year’s earnings after tax = £10m (1−30%) Retention rate now Proposed retention rate

= = =

Growth rate

=

Value of equity

=

£7m 3/7 4/7 (57% × 20%) D (1 + g) Do + o (k e − g)

= =

43% 57%

=

11.4%

=

⎡ 3(1.114) ⎤ £1m + ⎢ ⎥ ⎣14% – 11.4% ⎦

=

⎡ £3.342 ⎤ £1m + ⎢ ⎥ ⎣ 0.026 ⎦

=

£1m + £128.5m

=

£129.5m

(Note: The reader might consider the feasibility of this result, i.e. the critical assumptions.)

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PART II

Investment decisions and strategies

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CHAPTER 4

Investment appraisal methods Learning objectives Having read the chapter, the reader should have a good grasp of the investment appraisal techniques that are commonly employed in business, and should have developed the skills in applying them to problems. Particular attention should be devoted to the following: •

The net present value approach and why it is consistent with shareholder goals.

•

The three discounted cash flow approaches – net present value, internal rate of return and profitability index.

•

The underlying strengths and limitations of the above methods.

•

How net present value and internal rate of return methods can be reconciled when they conflict.

•

Non-discounting methods.

•

Analysing investments when capital availability is an important constraint.

Questions summary 1. Yorkshire Autopoints is a basic NPV problem. 4. Mylo plc employs various appraisal methods to compare alternatives. 5. Mr Cowdrey analyses the relationship between NPV and IRR both computationally and graphically. 6. XYZ plc is a capital rationing problem involving the use of the profitability index. 7. Raiders Ltd. is a more advanced capital budgeting problem under capital rationing conditions, requiring a mathematical formulation of the problem.

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Answers to questions 1. Yorkshire Autopoints (a) Year 1 2 3 4 5 6 7

Cash flow 30,000 50,000 60,000 60,000 30,000 20,000 20,000 270,000 Less initial cost and setting-up expenses Net present value

Discount rate 30% 0.769 0.592 0.455 0.350 0.269 0.207 0.159

Present value 23,070 29,600 27,300 21,000 8,070 4,140 3,180 116,360 140,000 (23,640)

The car-washing project produces a negative net present value of £23,640 when discounted at the appropriate rate for the risks involved. It is not wealth-creating and should not be installed. (b) The most popular errors in this type of evaluation are: (i) To fail to discount cash flows. In money terms, the project will generate £130,000 (i.e. £270,000 – £140,000). (ii) To deduct depreciation as an expense. Depreciation is a non-cash item. (iii) To include fixed costs. Only relevant, incremental costs should be included. (iv) To discount cash flows at a rate other than that associated with the project’s degree of risk. 4. Mylo plc (a) (i) Net present value Project 1 – Incremental cash flows Year

Cash flows* Discount factor @ 10% Present value Net present value

*

0 £ (100,000) 1.0 (100,000) 9,500

1 £ 60,000 0.91 54,600

2 £ 30,000 0.83 24,900

3 £ 40,000 0.75 30,000

Calculated by adding the depreciation charge (i.e. capital outlay less residual value spread over three years) to the profit.

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Project 2 – Incremental cash flows Year

Cash flows Discount factor @ 10% Present value Net present value

0 £ (60,000) 1.0 (60,000) 7,040

1 £ 36,000 0.91 32,760

2 £ 16,000 0.83 13,280

3 £ 28,000 0.75 21,000

2 £ 30,000 0.72 21,600

3 £ 40,000 0.61 24,400

(ii) Internal rate of return Project 1 – Incremental cash flows Year

Cash flows Discount factor @ 18% Present value Net present value Net present value at 10% Net present value at 18% Difference

0 £ (100,000) 1.0 (100,000) 3,000

1 £ 60,000 0.85 51,000

9,500 (3,000) 12,500

By interpolation, the internal rate of return is 10% + (8% × (9,500/12,500)) = 16% Project 2 – Incremental cash flows Year

Cash flows Discount factor @ 18% Present value Net present value Net present value at 10% Net present value at 18% Difference

0 £ (60,000) 1.0 (60,000) 800

1 £ 36,000 0.85 30,600

2 £ 16,000 0.72 11,520

3 £ 28,000 0.61 17,080

7,040 (800) 7,840

By interpolation the internal rate of return is 10% + (8% × (7,040/7,840)) = 17%

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(iii) Profitability index

Profitability index = =

Project 1

= Project 2

Present value Initial investment 109,500 100,000 1.095

=

67,040 60,000

=

1.117

(iv) Payback period

Project 1

=

60,000 (Year 1) + 30,000 (Year 2) + 10,000 (Year 3)

Project 2

=

2.25 years

=

36,000 (Year 1) + 16,000 (Year 2) + 8,000 (Year 3)

=

2.29 years

(b) On the basis of the information given, Project 1 should be chosen in preference to Project 2 as it has a higher positive net present value. Given that the net present value of Project 1 is only slightly higher, it would be useful to undertake some assessment of the degree of risk associated with each project. (c) The net present value method is the most appropriate method for evaluating investment projects because:

(i) It takes account of all relevant information unlike the payback method, for example, which ignores cash flows beyond the payback period. (ii) It is directly related to the objective of wealth maximisation, which is the assumed goal of a business enterprise. (iii) It employs a discount rate based on the cost of capital. (iv) It takes account of the time value of money by discounting future receipts and payments.

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5. Mr Cowdrey

Workings Project A Discount rate

NPV

DISCOUNTED CASH FLOWS Year 0

Year 1

Year 2

Year 3

£

0%

−100

60

40

30

30

6%

−100 ×

60 ×

40 ×

30 ×

(£000s)

12%

18%

1.0

0.943

0.890

0.840

−100

56.58

35.60

25.20

−100 ×

60 ×

40 ×

30 ×

1.0

0.893

0.797

0.712

−100

53.58

31.88

21.36

−100 ×

60 ×

40 ×

30 ×

1.0

0.847

0.718

0.609

−100

50.82

28.72

18.27

Project B Discount rate

Year 1

Year 2

6.82

−2.19 NPV

DISCOUNTED CASH FLOWS Year 0

17.38

Year 3

£ 40

(£000s) 0%

−100

10

20

110

6%

−100 ×

10 ×

20 ×

110 ×

1.0

0.943

0.890

0.840

12%

18%

−100

9.43

17.80

92.4

−100 ×

10 ×

20 ×

110 ×

1.0

0.893

0.797

0.712

−100

8.93

15.94

78.32

−100 ×

10 ×

20 ×

110 ×

1.0

0.847

0.718

0.609

−100

8.47

14.36

66.99

(b) Internal rates of return (IRR) estimated from the graph in part (a):

PROJECT A PROJECT B

16.4% 13.2%

(c) On the basis of the figures calculated in the workings,

(i) NPV @ 6% (ii) NPV @ 12%

PROJECT A

PROJECT B

£000

£000

17.38

19.63

6.82

3.19

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3.19

−10.18

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Mr Cowdrey should consider accepting Project B if the discount rate is 6% or Project A if the discount rate is 12%. (d) The following additional information would assist Mr Cowdrey in his selection:

(i) An assessment of the degree of accuracy of the estimated cash flows. (ii) The risk category of each project. (iii) The cut-off rates, i.e. required rates of return relative to the risk category. (iv) The impact of taxation upon each project’s cash flows. (v) What happens if things go wrong? (vi) Non-financial factors, for example, social, political, practical, technological, etc. many of which are of a qualitative nature. (vii) Details of other projects/opportunity costs. (e) The relative merits of NPV and IRR as methods of investment:

It must be remembered at the outset that the financial data is just one component part of the capital investment decision-making process. It must also be remembered that methods such as NPV and IRR depend upon the estimation of cash flows and the selection of an appropriate discount rate. The NPV method discounts the cash flows at an appropriate rate and recommends acceptance/strong consideration of all projects that yield a positive NPV. With the IRR method, all projects whose IRRs exceed the required rate should be accepted as worthy of further consideration. Both methods give the same decision rule in simple accept/reject situations. In a simple accept/reject situation, knowledge of the project’s NPV is sufficient to ensure that the shareholder’s wealth will be maximised when the present value of the future stream of cash flows received by the shareholder is maximised. However, knowledge of a project’s IRR is not in itself sufficient for optimal investment decisions. The two methods may give different decision rules when selecting between two mutually exclusive investments. This difference stems from the different assumptions made regarding the reinvestment rates of intermediate cash flows. The NPV approach assumes that positive intermediate cash flows can be reinvested at a rate of interest equivalent to that used as the discount rate. The IRR method assumes that they can be reinvested and earn a return equal to the project’s IRR. Of the two, it appears that the NPV assumption is more realistic. The NPV method tends to be more flexible and can be adjusted to include multiple discount rates. From a ranking point of view, the NPV approach assumes that the discount rate reflects the opportunity cost of capital. The opportunity cost concept under the IRR method is less valid because of the IRR’s reinvestment assumption. However, it is argued that the theoretical difficulties of the IRR method are outweighed by its practical advantages, such as allowing management to adjust for risk, and that, being based on the rate of return concept the method is more easily understood and accepted. It also relieves the decision-makers from having to work out the firm’s cost of capital at the outset, which can be quite a complex task. The NPV method, on the other hand, requires the decision-makers to determine the discount rate to be used right from the word ‘go’.

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(a)

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6. XYZ plc (a) (i)

15% discount factors

Year 0

Year 1

Year 2

Year 3

Total

1.000 £000

0.870 £000

0.756 £000

0.658 £000

£000

P/I (NPV/Outlay)

Project A:

cashflow discounted

(350.0) (350.0)

104.5 90.9

133.1 100.6

266.2 175.2

16.7

1.05

Project B:

cashflow discounted

(105.0) (105.0)

49.5 43.1

54.5 41.2

59.9 39.4

18.7

1.18

Project C:

cashflow discounted

(35.0) (35.0)

(44.0) (38.3)

(30.2) (22.8)

166.4 109.5

13.4

1.38

(ii) With a limit of £400,000, the choice is restricted to A + C or B + C. B + C has the highest NPV with £32,100.

The fact that the company can invest for 10% per annum constant in the money market is not relevant to this particular decision, since this is below its cost of capital. (b) The higher the borrowings, the greater the volatility of returns to the shareholders. This inversely influences the value placed on prospective returns to the shareholder, thus partly offsetting the apparent benefit of the lower cost of borrowing. However, the fact that interest is tax-deductible usually reduces the offset. The decision to borrow depends on a number of factors:

•

Te volatility of prospective returns to the entity as a whole

•

Interest rate expectations, relative to the perceived cost of equity capital

•

The tax position of the company, notably any unused allowances.

7. Raiders Ltd (a)

Capital Rationing Ranking of Projects: Project NPV of cash flows Immediate outflow Therefore benefit/cost ratio (profitability index) Ranking

A £000 +157.0 −400

B £000 +150.0 −300

C £000 +73.5 −300

D £000 159.5

0.39

0.50

0.25

3

2

4

∞ 1

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Project D is ranked first because it has a positive NPV and it did not require an immediate outlay. The £500,000 will therefore be applied as follows: NPV

OUTLAY

£000

£000

Project D

159.5

–

Project B

150.0

300

Project A (50% × 157)

78.5 388.0

200 (max) 500

(b) Max: 157 A + 150 B + 73.5 C + 159.5 D

subject to: Year 0

400 A + 300 B + 300 C + DEP ≤ 500

Year 1

200 B + 300 D ≤ 300 + 50 A + 150 C + 1.07 DEP

A, B, C, D ≥ 0, ≤ 1 (c) The formulation of the above problem into a linear programme assumes infinite divisibility of the projects and the existence of linear relationships.

Thus, this means that insignificant limitations will exist in situations where the output has elements of indivisibility and scale economies and/or diseconomies. Another further area of problem relates to the quality of the data used. The linear programme can only be relied on to provide an optimal solution where the investment opportunities are fully and correctly specified, together with all the respective constraints, conditions and limitations. Another limitation is that the linear programme does not effectively take risk into account. Finally, it must be remembered that the DCF analysis is carried out on the assumption of a perfect capital market and that the discount rate used reflects the market rate of interest for the particular level of risk. However, in a situation where capital is being rationed, if the company is being denied funds by the market then there is a capital market imperfection and it will be difficult to determine an appropriate discount rate. (d) The view that capital is always available, but at a price, has over the years been the subject of frequent debate.

The MacMillan Committee, in 1931, identified ‘the MacMillan Gap’, a shortfall in the supply of funds to small- and medium-sized companies. However, the Bolton Committee which reported in 1971 was of the opinion that the capital market (including government sources of funds) was efficiently meeting demand. This view was supported by the Wilson Committee, in 1981. One of the real problems of this area is not so much a shortage of funds on the supply side but the existence of a ‘communication gap’. The providers of funds have not always been able to communicate their offerings to those who are in need of the finance. It is quite appropriate to use the mathematical capital rationing technique when capital has been rationed by management (i.e. soft capital rationing) – rather than by the market – as a control device.

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CHAPTER 5

Project appraisal – applications Learning objectives Having read the chapter, the reader should be well equipped to handle most capital investment decision problems found either on an examination paper or in business. Skills should be developed in the following areas: •

Identifying the relevant information in investment analysis.

•

Evaluating replacement and other investment decisions.

•

Handling inflation.

•

Assessing the effects of taxation on investment decisions.

•

Investment appraisal practices, strengths and limitations.

•

Identifying the appropriate discount rate.

Questions summary 3. This involves handling the IRR method when comparing mutually exclusive projects. 6. Argon Mining plc considers the appropriate investment appraisal method. 7. Consolidated Oilfields plc looks more difficult than it really is. It raises the issue of identifying incremental cash flows and the problems posed by inflation. 8. Deighton plc covers relevant cash flows, taxation and NPV. 9. Howden plc addresses inflation issues. Assignment

Engineering Products is a mini-case study in investment appraisal and its application. The main issues addressed are (i) distinguishing between relevant and non-relevant information; and (ii) dealing with taxation issues.

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Answers to questions 3. This question requires the student to calculate the IRRs and NPVs for both projects.

PROPOSAL L (Try 25% for IRR) £ £20,000 × 3.1699

63,398

less outlay

47,232

NPV

16,166

IRR (trial and error)

25%

PROPOSAL M (Try 22% for IRR) £ Year 0 Outlay 1

(47,232)

–

–

2 £10,000 × 0.8264

8,264

3 £20,000 × 0.7513

15,026

4 £65,350 × 0.6830

44,634

NPV

20,692

IRR

22%

The above analysis reveals that proposal M offers the higher net present value but the lower internal rate of return. To overcome this problem, two approaches are available: (i) Differential IRR approach This calculates the IRR on the incremental cash flows between the two options. If the IRR is above the discount rate, accept the option with the smaller IRR. Cash flows (£) 0

1

2

3

4

Proposal L

−47,232

20,000

20,000

20,000

20,000

Proposal M

−47,232

0

10,000

20,000

65,350

−20,000

−10,000

0

+45,350

M–L

0

This produces an IRR of approximately 17%. As this is greater than the 10% discount rate, select proposal M (with the lower IRR), thus, concurring with the net present value advice. (ii) Modified IRR Method (MIRR) This approach was introduced in Chapter 5. It involves calculating the terminal value at Year 4 using the cost of capital of 10% and determining the IRR which equates this figure with the initial cost.

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PROPOSAL L

Year 1 2 3 4

£ 20,000 × (1.1)3 20,000 × (1.1)2 20,000 × (1.1) 20,000 × 1.0

PVIF( x %,4yrs) =

Terminal value Yr 4 £ 26,620 24,200 22,000 20,000 92,820

47, 232 = 0.509 92,820

Using tables, x = 18% (approximately) PROPOSAL M

Year 1 2 3 4

£ – 10,000 × (1.1)2 20,000 × (1.1) 65,350 × 1.0

PVIF( x %,4yrs) =

Terminal value Yr 4 £ – 12,100 22,000 65,350 99,450

47, 232 = 0.475 99, 450

Using tables, x = 20%, approximately. The MIRR for proposal M is greater than that for proposal L thus giving a decision signal consistent with the net present value rule.

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6. Argon Mining plc (a) Incremental cash flows Years 0

1

2

3

4

5

£m

£m

£m

£m

£m

£m

9.4

9.8

8.5

6.3

(1.8)

(2.5)

(2.6)

(1.8)

(1.3)

(1.2)

(1.5)

(0.6)

consumables

(0.3)

(0.4)

(0.4)

(0.2)

Survey costs

(0.2)

Sales Wages and salaries Selling and distribution costs Materials and

Site repair

(0.4)

Head office expenses

(0.2)

(0.2)

(0.2)

(0.2)

Purchase of mine

(2.5)

Working capital

(0.5)

0.5

Equipment and vehicles

(12.5)

2.5

Discount factor @12% Present value NPV

(15.5)

5.6

5.5

3.8

6.5

(0.4)

1.00

0.89

0.80

0.71

0.64

0.57

(15.5)

4.98

4.40

2.70

4.16

(0.23)

£0.51m

(b) The project is expected to produce a positive NPV; thus its acceptance will enhance the wealth of shareholders of the company. However, the NPV is small in relation to the initial outlay required and a careful assessment of both the risks involved and the accuracy of the estimates should be undertaken before final acceptance. (c) The net present value method of investment appraisal was selected due to the following reasons:

(i) It is based on the concept of shareholder wealth maximisation which is assumed to be the primary objective of a business. (ii) It takes account of the time value of money. (iii) It takes account of all cash flows, which are relevant to a consideration of the project’s profitability. (iv) It uses a discount rate, which reflects the returns required by investors. (v) It provides clear decision rules.

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7. Consolidated Oilfields plc (a) Incremental cash flows Years 0

1

2

3

4

5

£000

£000

£000

£000

£000

£000

7,400

8,300

9,800

5,800

Sales Equipment

(5,200)

Working capital Licence fee

(300)

(5,200)

2,000

(650)

650

(300)

(300)

(300)

(300)

(300)

Wages

(550)

(580)

(620)

(520)

Materials

(340)

(360)

(410)

(370)

Overheads

(100)

(100)

(100)

(100)

Hire of tools

_____

_____

(150)

_____

_____

_____

Net cash flow

(5,200)

(6,150)

5,960

6,960

8,370

7,160

1.00

0.91

0.83

0.75

0.68

0.62

Discounted cash flows

(5,200)

(5,597)

4,947

5,220

5,692

4,439

NPV

+9,501

Discount factor

(b) The above analysis indicates that the Australian Oilfield project offers a positive net present value of £9,501,000. Acceptance of this project will increase shareholder wealth. (c) Problems posed by inflation:

(i) Inflation can affect revenues and various expenditures differently. For example, prices are subject to competitor actions and wages are subject to negotiation, etc. (ii) Some costs do not change: for example, capital allowances for tax purposes are based on the original cost, not the inflated cost of the project; rent may be fixed for a five-year period, etc. (iii) Inflation adds to the uncertainty surrounding project cash flows. (iv) Interest rates are likely to rise during a period of inflation, making it difficult to estimate the appropriate discount rate. Two possible approaches are available to deal with inflation in investment analysis: •

adjust future cash flows to take account of the inflation and discount them at the money rate of interest; or

•

convert the money cash flows into real terms and discount at the real rate of interest.

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8. Deighton plc

REPORT SUBMITTED TO: Finance Director, Deighton plc. FROM: An(n) Accountant. DATE: 12th of Never. SUBJECT: Investment Project NTI7 The above investment project was rejected by the former management of Linton Ltd, but it appears that the evaluation (attached) was flawed. This report identifies these flaws and reevaluates the proposal, which appears to be worthwhile. As the market opportunity is still open, I recommend acceptance of the project. (a) Mistakes made by Linton

1. The initial investment in working capital should be offset by a working capital release in the final year, assuming a constant level of stock-holding until the last year. 2. The interest cost, although a cash outflow in reality, should be subsumed in the overall cost of the capital. Linton’s evaluation confused the investment decision with the financing decision. If the project were evaluated by the new owners, the return of 20% required by Deighton’s shareholders would be the correct rate of discount. 3. At the end of four years, no scrap value is shown for either new equipment or the old machine. 4. Depreciation is not a cash outflow. By deducting the depreciation charge, Linton has double counted for the capital cost (and used the wrong outlay as a basis). 5. However, the annual depreciation allowances (WDA) do affect the tax outflow. These were ignored. 6. No tax delay is allowed. 7. The overhead charge is overstated. Only half of the amount charged appears to be incremental. 8. The market research cost, whatever it relates to, is irrelevant (i.e. it is sunk, unless a buyer could be found for the report). (b) In the following solution, the tax allowances in relation to the initial outlay on equipment are evaluated separately. Other approaches are acceptable.

(i) The tax-adjusted cost of the capital expenditure can be found by deducting the present value of the tax savings generated by exploiting the writing-down allowance from the initial outlay. It is assumed that the available allowances can be set off against profits immediately (i.e. beginning in the financial year in which the acquisition of the asset occurs). This yields five sets of WDAs as the project straddles five tax years.

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Years Item (£000)

0

1

2

3

4

5

Claimed at 25%

225

169

126

95

285

Written down value

675

506

380

285

0

74

56

42

31

94

0.833

0.694

0.579

0.482

0.402

62

39

24

15

38

Allowance

Tax saving @ 33% Discount factor @ 20% Present value

Present value of tax savings = 178, i.e. £178,000. The effective cost of the equipment is: Nominal outlay – present value of tax savings = [£900,000 – £178,000] = £722,000. (ii) The cash flow profile is: Years Item (£000)

0

1

2

3

4

5

Equipment/Scrap

(722)

0

Working capital

(100)

100

Sales

1,400

1,600

1,800

Materials

(400)

(450)

(500)

(250)

Direct labour

(400)

(450)

(500)

(250)

Overheads

(50)

(50)

(50)

(50)

550

650

750

450

100

–

(182)

(215)

(248)

(149)

550

468

535

202

(49)

0.833

0.694

0.579

0.482

0.402

458

325

310

97

(20)

Operating cash flow Tax @ 33% Net cash flow

(872)

Discount factor @ 20% Present value

(872)

NPV = + 298, i.e. £298,000. Recommendation Thus, the purchase of equipment is acceptable and should be undertaken, although an analysis of its risk is also recommended.

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9. Howden plc (a) Investors advance capital to companies expecting a reward for both the delay in waiting for their returns (time value of money) and also for the risks to which they expose their capital (risk premium). In addition, if prices in general are rising, shareholders require compensation for the erosion in the real value of their capital.

If, for example, in the absence of inflation, shareholders require a company to offer a return of 10%, the need to cover 5% price inflation will raise the overall required return to about 15%. If people in general expect a particular rate of inflation, the structure of interest rates in the capital market will adjust to incorporate these inflationary expectations. This is known as the ‘Fisher Effect’. More precisely, the relationship between the real required return (r) and the nominal rate (m) (the rate which includes an allowance for inflation), is given by: (1 + r)(1 + p) = (1 + m) where p is the expected rate of inflation. It is essential when evaluating an investment project under inflation that future expected price-level changes are treated in a consistent way. Companies may correctly allow for inflation in two ways, each of which computes the real value of an investment project: (i) Inflate the future expected cash flows at the expected rate of inflation (allowing for inflation rates specific to the project) and discount at m, the fully inflated rate – the ‘money terms’ approach. (ii) Strip out the inflation element from the market-determined rate and apply the resulting real rate of return r, to the stream of cash flows expressed in today’s or constant prices – the ‘real terms’ approach. (b) First, the relevant set-up cost needs identification. The offer of £2m for the building, if rejected, represents an opportunity cost, although this appears to be compensated by its predicted eventual resale value of £3m. The cost of the market research study has to be met irrespective of the decision to proceed with the project or not and thus is not incremental.

Second, incremental costs and revenues are identified. All other items are avoidable except the element of apportioned overhead, leaving the incremental overhead alone to include in the evaluation. Third, all items of incremental cash flow, including this additional overhead, must be adjusted for their respective rates of inflation. Because (with the exception of labour and variable overhead) the inflation rates differ, a disaggregated approach is required. The appropriate discount rate is given by: (1 + p)(1 + r) − 1 = m = (1.06)(1.085) − 1 = 15%

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Cash flow profile (£ m) Years Item Equipment Forgone sale of building Residual value of building Working capital* Revenue Materials Labour and variable overhead Fixed overhead Net cash flows Present value at 15%

0 (10.50)

1

2

3

4

5 2.00

(2.00)

5.04 (0.62)

5.29 (0.64)

5.56 (0.66)

5.83 (0.68)

3.00 0.50 6.13 (0.70)

(13)

(0.43) (0.53) 3.46

(0.46) (0.55) 3.64

(0.49) (0.58) 3.83

(0.52) (0.61) 4.02

(0.56) (0.64) 9.73

(13)

3.01

2.75

2.52

2.30

4.84

(0.50)

NPV = +£2.42m; therefore, the project appears to be acceptable. However, the financial viability of the project depends quite heavily on the estimate of the residual value of the building and equipment. *

Note: the working capital cash recovery towards the end of the project is equal to the initial investment in stocks because the rate of material cost inflation is cancelled out by the Justin-Time (JIT)-induced reduction in volume, leading to constant stock-holding in value terms throughout most of the project lifespan.

Case study: Engineering Products plc Issues addressed Roger Davis is faced with the type of problem that many a young manager may face: trying to justify a line of action when the financial analysis provided by the ‘experts’ suggests otherwise. The problem is essentially one of distinguishing between relevant and non-relevant information and analysing it in a proper fashion. Although a short case, it provides students with a practical exercise for capital budgeting analysis and raises several pedagogical issues for class discussion. For example: (i) How project risk can be assessed (ii) Whether investment and financing decisions should be separated (iii) The non-quantifiable benefits of advanced manufacturing technology (iv) The appropriate discount rate.

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Analysis The following pieces of information are not relevant to the DCF analysis: (i) Depreciation (non-cash) (ii) Apportioned fixed overheads (incurred regardless of the decision) (iii) Loss on disposal of existing plant (a non-cash item, although in practice profit impact cannot be ignored) (iv) Interest costs (regarded as part of the financing decision). All relevant incremental cash flows are then identified. As taxation can be a little complex, it is preferable to analyse the decision first on a no-tax basis. This is given in Exhibit 1. Attention should be drawn to the effects of the new decision on other parts of the business: (i) An existing machine is no longer required, giving rise to an immediate benefit (sale proceeds), a continuing benefit (cost savings) and an eventual benefit forgone (scrap value in Year 4) treated as a cash outflow. (ii) The marketing manager must incur additional advertising. (iii) Another product will lose customers (lost sales less variable costs). The proposal offers a payback period of 2.8 years – just within the 3-year requirement. However, the limitations of this method of analysis (ignores the time value of money and cash flows beyond the payback period) lead us to question whether a project of this size should be judged solely by such a simple technique. The project offers an IRR of 20%, before tax, and an NPV of £106K when discounted at the risk-free rate. In a situation such as this, where there is no clearly defined discount rate, we see the practical benefit of the IRR method. The question is whether 20% is good enough, and although no two individuals may agree upon the precise hurdle rate, they may well agree that a 20% IRR is sufficiently high to submit to the next level in the organisation for consideration and approval. Exhibit 2 presents the after-tax analysis. This involves calculating the taxable profits and capital allowances, assessing the tax payable (usually a year later), and adjusting the pre-tax cash flows accordingly. The impact of taxation is generally far less than it was in the early 1980s when allowances of 100% were given on industrial plant. In our case, the payback is unchanged, while the NPV and IRR have fallen somewhat. However, the discount rate of 10% has not been tax adjusted. Clearly, the actual hurdle/discount rate should be reduced for tax when cash flows are after-tax. When so adjusted, the NPV is very similar to the pretax NPV.

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Exhibit 1

CNC MILLING MACHINE APPRAISAL (£000)

Year

0

Purchase machine

1

2

3

4

(240)

Residual value

20

Sales

400

600

800

600

(260)

(300)

(360)

(240)

Labour

(80)

(120)

(120)

(80)

Other production (Note A)

(64)

(66)

(68)

(84)

18

18

18

18

Less costs: Materials

(40)

Sale of existing machine

20

Operating savings Scrap value forgone

(8)

Advertising

(40)

(8)

(8)

(8)

(8)

(15)

(15)

(15)

(15)

(300)

(9)

109

247

203

1.0

0.909

0.826

0.751

0.683

(300)

(8.2)

90.0

185.5

138.6

Less contribution on competing product Net cash flow Discount rate 10% PV Payback period:

2.8 years

NPV at 10%

£105.9

IRR:

Note A

20%

Year 1. 80,000 – 0.2 × 80,000 = £64,000 2. 90,000 – 0.2 × 120,000 = £66,000 3. 92,000 – 0.2 × 120,000 = £68,000 4. 100,000 –0.2 × 80,000 = £84,000

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Exhibit 2

TAXABLE PROFIT CALCULATION Year

1

2

3

4

Sales

400

600

800

600

Cost of sales

220

300

380

300

180

300

420

300

Labour

(80)

(120)

(120)

(80)

Other production

(64)

(66)

(68)

(84)

18

18

18

18

Advertising

(48)

(8)

(8)

(8)

Lost contribution

(15)

(15)

(15)

(15)

Operating profit

(9)

109

227

131

Sale of existing machine

20

Operating savings

Scrap value forgone

Taxable profits

(8)

11

109

227

123

Assume that the existing machine has a taxable written-down value of zero. Assume also that tax is paid a year after the cash flow to which it relates. CAPITAL ALLOWANCES £000 Investment Yr 1 WDA 25%

240 60 180

Yr 2 WDA 25%

45 135

Yr 3 WDA 25%

33.75 101.25

Yr 4 Sale proceeds

20.00

Balancing charge

81.25

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TAX PAYABLE Taxable

Capital

Taxable

Tax payable

Year

profits

allowances

amounts

at 30%

1

11

60

(49)

(15)

2

109

45

64

19

3

227

34

193

58

4

123

81

42

13

NPV CALCULATION Year

Net cash flow

Tax paid

Post-tax NCF

10%

PV

0

(300)

(300)

1.0

(300)

1

(9)

(9)

0.909

(8)

2

109

(15)

124

0.826

102

3

247

19

228

0.751

171

4

203

58

145

0.683

99

5

–

13

(13)

0.621

(8)

NPV

56K

48 © Pearson Education Limited 2015

CHAPTER 6

Investment strategy and process Learning objectives This chapter examines strategic issues in investment and the investment process: •

How strategy shapes investment decisions.

•

Evaluating new technology and environmental projects.

•

The investment decision and control process.

•

Post-audit reviews.

Question summary 4. Discussion on the appropriate capital investment process for a company.

Answers to questions 4. The capital investment process is discussed fully in the text. The main stages may be summarised as:

(i) Preliminary investigation (ii) Detailed evaluation (iii) Authorisation (iv) Implementation (v) Project monitoring (vi) Post-completion audit.

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PART III

Value, risk and the required return

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CHAPTER 7

Analysing investment risk Learning objectives For some readers, this and the subsequent two chapters on risk may be somewhat more difficult to grasp. The main learning objectives are to: •

To understand how uncertainty affects investment decisions.

•

To explore managers’ risk attitudes.

•

To appreciate the levels at which risk can be viewed.

•

To be able to measure the expected NPV and its variability.

•

To appreciate and apply the main risk-handling techniques in capital budgeting problems.

•

To understand the various forms of real options that can further enhance a project’s value.

Questions summary 5. Mikado plc requires the calculation of a break-even NPV and a sensitivity analysis in graphical form. 6. Devonia (Laboratories) Ltd provides more practice in basic project appraisal plus the calculation of the expected net present value. 7. Plato Pharmaceuticals Ltd involves sensitivity analysis surrounding key assumptions. 8. Tigwood Ltd is a more comprehensive question on risk analysis involving sensitivity analysis. 9. Zedland covers many of the issues included in earlier chapters (e.g. taxation and inflation). The second part centres on a discussion of Monte Carlo simulation in assessing investment risk.

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Answers to questions 5. Mikado plc (a) Annual sales 6,000 × (£60 − £36)

=

£144,000

Additional fixed costs

(£50,000)

Annual benefit

£94,000

Discount factor:

1 = 0.89 Yr 1 (1.125) n 0.79 Yr 2 0.70 Yr 3 0.63 Yr 4

Present value of annuity 4 yrs at 12.5%

3.01

NPV = (£94,000 × 3.01) − £180,000 = £102,940 (b) Break-even analysis

The present value of benefits can fall to £180,000. (The cost of the investment) to give zero NPV. That is, £180,000/3.01 = £59,800 cash receipts each year. A deterioration of (£94,000 − £59,800) = £34,200. Fixed costs can increase by £34,200 or 68.4%. Selling price: Break-even contribution = (£50,000 + £59,800) = £109,800. Selling price can fall by £34,200 or £5.70 a unit, a decline of 9.5%. Variable cost would increase by £5.70 a unit (15.8%). Volume can decrease by (£144,000 − £109,800)/£24 = 1,425 units or 23.7%.

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6. Devonia (Laboratories) Ltd (a)

Expected cash flows (£) Year 0

1

Sales revenue (see note) Labour (13,300 × £8) Ingredients (13,300 × £6)

2

3

4

266,000

266,000

266,000

266,000

(106,400)

(106,400)

(106,400)

(106,400)

(79,800)

(79,800)

(79,800)

(79,800)

Redundancy costs

(10,000)

Overheads

(15,000)

Sales of equipment

(85,000)

Sale of patent rights

(125,000)

(15,000)

(15,000) 35,000

(210,000)

64,800

64,800

64,800

89,800

1.00

0.89

0.80

0.71

0.64

(210,000)

57,672

51,840

46,008

57,472

Discount factor @ 12% Expected NPV

(15,000)

+2,992

Note : Expected annual sales

Sales revenue

=

(11,000 × 0.3) + (14,000 × 0.6) + (16,000 × 0.1)

=

13,300 units

=

13,300 × £20 = £266,000

(b) Devonia’s expected net present value is positive, which suggests that the new product should be produced as it will increase shareholder wealth. However, the expected NPV is fairly low and a relatively small downward adjustment to forecast sales demand or the forecast sales price could produce a negative figure. It should also be recognised that there is a 30% chance that the sales will be much lower, giving a negative NPV. Would the company be able to withstand this possible eventuality? The validity of the forecast figures should, therefore, be checked carefully before proceeding. In addition, any negative effects arising from the sale of the patent rights to a major competitor should be taken into account, if they exist. (c) The expected net present value approach gives a single figure outcome upon which decisions concerning acceptance or rejection of a project can be based. It is a convenient way of dealing with the problems of risk and uncertainty as it provides a clear usable result. However, this method does have certain drawbacks. It represents an average figure, which may not be capable of occurring. When employing averages, there is a risk that important information will be obscured. The expected value method assumes that it is possible to identify each possible outcome relating to a project and to assign appropriate levels of probability to each outcome. This may be difficult to do in practice. Given the information available, it is also advisable to calculate the standard deviation of the project’s NPV to gain a clearer measure of the uncertainty involved.

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7. Plato Pharmaceuticals Limited (a) Annual operating cash flows £000 Sales (150,000 × £5)

£000 750

Less Variable costs (150,000 × £3) Fixed costs

450 160

610 140

NPV

504

Annual cash flows (£140,000 × 3.60) Residual value of machinery and equipment (£100,000 × 0.57)

57 561

Less: initial outlay

520

NPV

41

(b) Sensitivity analysis (i) If the discount rate was 18%, the NPV of the project would be: £000 Annual cash flows (£140,000 × 3.13) Residual value of machinery and equipment (£100,000 × 0.44)

438.2 44.0 482.2

Less: initial outlay

(520.0)

NPV

(37.8)

By interpolation we can derive the IRR 12% + [41/(41 + 37.8) × 6%] = 15.1% (approximately)

This represents an increase of 26% on the cost of capital figure given in the question. (ii) The increase required for the initial outlay, to make the project no longer viable, will be equal to the NPV of the project (i.e. £41,000). This represents an increase of 7.9% on the initial outlay figure given in the question.

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(iii) Change in the net cash flows from operations necessary to make the project no longer viable: Let C be the annual operating cash flows.

(C × annuity factor for a five-year period) − NPV

=

0

(C × annuity factor for a five-year period)

=

NPV

C × 3.60

=

£41,000

C

=

£41,000/3.60

C

=

£11,389

which can be rearranged thus:

This represents a decrease of 8.1% on the estimated cash flows. (iv) Change in the residual value to make the project no longer viable:

Let R be the required residual value (R × discount factor at end of five years) – NPV of project

=

0

(R × discount factor at the end of five years)

=

NPV of project

R × 0.57

=

£41,000

R

=

£41,000/0.57

R

=

£71,930

which can be rearranged thus:

This represents a fall of 28.1% in the estimated residual value of the machinery and equipment. (c) Sensitivity analysis considers the key factors influencing an investment project to see by how much the estimated figures used must change before the investment ceases to be viable (i.e. produce an NPV of zero). It is a simple form of risk analysis, which helps managers to gain a ‘feel’ for the downside risk associated with a project. It helps them to identify which of the key factors are most sensitive to change and this information can be used as a basis for control.

Sensitivity analysis is a static form of analysis. It involves the examination of only one factor at a time while all others are held constant. More sophisticated forms of simulation would be required to cope with simultaneous changes in two or more factors. Sensitivity analysis does not give managers an indication of the probability of a change in a key factor arising. To make an informed decision, managers need to know both the degree to which a factor must change to affect the viability of the project and the likelihood of that change occurring. Sensitivity analysis does not provide managers with clear decision rules concerning whether to accept or reject a proposed project. Thus, no single figure outcome is provided, as with certain other methods of risk analysis. Managers must rely on judgement, and different managers may interpret the results of sensitivity analysis differently. (d) On the basis of the calculations in (a) above, the NPV of the project is positive. This indicates that the project should be accepted as it would result in an increase in shareholder wealth. The sensitivity analysis undertaken in (b) above reveals that the percentage change in the discount rate and residual value would have to be substantial before the project ceased 55 © Pearson Education Limited 2015

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to be viable. The percentage changes to the initial outlay and the annual operating cash flows, however, would have to be much smaller before the project ceased to be viable. Nevertheless, this does not suggest that the project should be rejected. Subject to additional information concerning the range of possible outcomes or the likelihood of changes occurring to the key factors, the project should go ahead. 8. Tigwood Ltd (a) Microbooks project analysis

Assumptions and workings •

Life of project: six years

•

Market research is a sunk cost

•

Cost of finance is accounted for in the discount rate

•

Variable costs per unit: Copyright: £3.95 × 20%

=

£0.79

Purchases: £1.50 × 40%

=

£0.60

Additional variable costs

=

£0.20 £1.59

•

Sales each year 1.5 million units

Outlay

Year 0

1–6

£000

£000

(1,500)

Sales (1.5m × £2)

3,000

Variable costs (1.5m × £1.59)

2,385

Taxable cash flow

615

Taxation (35%)

215

(1,500)

400

Discounting at 8%, the expected NPV is: (£1,500) + (£400 × 4.623) = £349.2 or £349,200 where 4.623 is the present value interest factor of an annuity (PVIFA) for 6 years at 8%. The project is wealth-creating. (b) A number of potential discount rates are listed, probably to seek to confuse the student! Because cash flows are expressed in real terms, without inflation adjustment, the real weighted average cost of capital of 8% is probably most relevant. (Cost of capital is discussed in a later chapter and so we will not expand on this issue here).

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(c) (i) In sensitivity analysis, all variables except the one under consideration are held constant, and an estimate is made of the value for the variable under consideration that produces a net present value of zero. Initial outlay: As the present value of net cash inflows is £1,849.2, the value of the initial outlay would have to be £1,849.2 to result in a zero NPV.

This represents a change of

349.2 × 100% = 23.28% 1500

Contribution: The zero NPV annual contribution can be estimated by solving the following equation for x (the zero contribution):

–1,500 + (0.65) 4.623x = 0 NB (0.65) is the after-tax cash flow that is dependent on the unknown contribution. Solving 3.005x = 1,500, x = £499.16, which is the zero NPV annual contribution. The present annual contribution is £615, so this represents a decline of:

115.84 × 100% = 18.83% 615 Life of agreement: The zero-NPV life has a present value of annuity factor at 8% of:

−1,500 + 400x = 0, x = 3.75 From the annuity table: PV annuity for four years is 3.312 PV annuity for five years is 3.993 Extrapolating, the zero-NPV life is

4 years +

3.75 − 3.312 × 1 year = 4.643 years 3.993 − 3.312

This is a reduction of 1.357 years or 22.61%. Discount rate: The zero-NPV rate is where the present value of a six-year annuity of 400 is zero.

Solving, −1,500 + 400x = 0, where x is the required rate x = 3.75

From the present value of annuity tables, 15% has a PV annuity factor of 3.784, and 16% has a factor of 3.685. Extrapolating, the zero-NPV rate is

15% +

3.784 − 3.75 × 1% = 15.34% 3.784 − 3.685

This represents a change of

7.34 = 91.75%. 8

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Sensitivity analysis suggests that the decision is most sensitive to a change in the annual contribution. The analysis does not, however, establish how sensitive the decision is to the sales price alone, or any of the elements of variable costs. (ii) Sensitivity analysis has several limitations:

(i) There is no measure of the probability of changes in any of the variables occurring. (ii) It treats variables as if they are independent and does not consider the interrelationships that might exist between variables. (iii) No decision rule is implied for managers. Managers do not know whether their decisions should be altered because of the level of sensitivity of a variable. (d) Further information might include:

(i) How accurate are the estimated cash flows? (ii) What is the effect of inflation on the cash flows? (iii) What is the risk of the project? (iv) Is the agreement likely to be renewed after six years? (v) If successful, can it be extended to more books? (vi) Is it possible to obtain patent protection on the microbooks? 9. Zedland postal service proposal (a) The question asks for a report. This is not provided here but the main points to be covered are:

(i) The government normally expects nationalised industries to earn an average after-tax return of 5% on average investment and break-even in net present value terms. (ii) This proposal achieves a 17.6% return on investment, but a negative NPV of $162,000. (iii) Consideration should be given to: •

pricing, depending on the price elasticity of demand (presumably it has a monopoly);

•

cost-reduction opportunities;

•

whether the risk is similar to that of the rest of the business. If not, the discount rate needs reconsideration;

•

is a five-year planning horizon appropriate?

Notes 1. Sales = daily sales × 260 days × rate. The result is then adjusted for inflation at 5% p.a. 2. Because, all cash expenses are subject to inflation at 5% p.a., it is convenient to calculate total expenses on the basis of current prices and then adjust the annual total for inflation.

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($000) Year Wages Premises

1

2

3

4

5

2,340

2,340

2,340

2,340

2,340

150

150

150

150

150

200

240

288

345

414

80

96

115

138

166

500

250

3,270

3,076

2,893

2,973

3,070

1.05

2

3

4

(1.05)5

3,614

3,918

Running costs: Vans $2,000 × 100 + 20% from Yr 2 Trucks Advertising Inflation adjustment Expenses

(1.05)

3,433

(1.05)

3,391

(1.05)

3,349

3. It is assumed that the whole postal service makes profits in excess of $500,000. All incremental income is therefore taxed at 40%. 4. Market research is a sunk cost. 5. The salaries of the five managers are payable regardless of this proposal. Incremental cash flows ($000) Year

1

2

3

4

5

(1)

2,048

2,867

3,010

3,160

3,318

Parcels

682

1,075

1,129

1,185

1,244

2,730

3,942

4,139

4,345

4,562

(3,433)

(3,391)

(3,349)

(3,614)

(3,918)

(703)

551

790

731

644

374

(127)

(223)

(200)

Sales: Letters

Expenses

(2)

Pre-tax cash flows (3)

Taxation

6

(165)

(703)

925

663

508

444

(165)

Discount factor @ 14%

0.877

0.769

0.675

0.592

0.519

0.456

Present values

(617)

711

448

301

230

(75)

PV of future cash flows Initial cost

998 (1,160)

NPV

(162)

Pre-tax cash flows

(703)

551

790

731

644

Depreciation

(232)

(232)

(232)

(232)

(232)

Taxable profit

(935)

319

558

499

412

374

(127)

(223)

(200)

(165)

(561)

192

335

299

247

Taxation Post-tax profit

i.e. ($162,000)

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Average annual profit =

(561) +192 + 335 + 299 + 247 = $102,000 5

Average investment = 1,160/2 = $580,000 Annual after-tax return on investment =

102, 000 = 17.6% 580,000

60 © Pearson Education Limited 2015

CHAPTER 8

Relationships between investments: portfolio theory Learning objectives A basic axiom of life is ‘do not put all your eggs into one basket’. The chapter is designed to explore the financial equivalent of this maxim. In particular, it aims to: •

To give the reader an understanding of the rationale behind the diversification decisions of both shareholders and companies.

•

To illustrate the mechanics of portfolio construction with a user-friendly approach to the key statistics, using numerical examples.

•

To explain why optimal portfolio selection is a matter of personal choice.

•

To examine the drawbacks of portfolio analysis as an approach to project appraisal.

A good grasp of the principles of portfolio analysis is an essential underpinning to understanding the Capital Asset Pricing Model, to be covered in Chapter 9.

Question summary 5. Gawain plc. This question requires the construction of a two-asset portfolio to achieve a targeted expected return, calculation of the correlation between the two assets and the effect of portfolio formation on company risk.

Answers to questions 5. Gawain plc (a) Project A

Expected return = (0.3 × 0.27) + (0.4 × 0.18) + (0.3 × 0.05) = 0.081 + 0.072 + 0.015 = 0.168, i.e. 16.8% Project B Expected return = (0.3 × 0.35) + (0.4 × 0.15) + (0.3 × 0.20) = 0.105 + 0.06 + 0.06 = 0.225, i.e. 22.5%

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To achieve an expected return of 20% Let α be % weighting in A (1 − α) = % weighting in B 0.20 = α ERA + (1 − α) ERB 0.20 = α (0.168) + (1 − α) (0.225) 0.20 = 0.168α + 0.225 − 0.225α Hence, −0.025 = −0.057α

α

=

0.025 = 0.44 0.057

Therefore, 44% of the portfolio should be invested in Project A and 56% in Project B. (b) Portfolio risk = α 2σ

2 A

+ (1 − α )2 σ

2 B

+ 2α (1 − α )σ AB

where σAB = rAB σA σB hence, rAB =

σ AB σ Aσ B

Standard deviations Weighted

Project A

Outcome

Deviation

Squared

squared

(%)

from ER

deviation

27

+10.2

104.04

0.3

31.21

18

+1.2

1.44

0.4

0.58

5

−11.8

139.24

0.3

41.77

Probability

deviation

= 73.56

Project B

σA

= 73.56

= 8.58

35

+12.5

156.25

0.3

46.88

15

−7.5

56.25

0.4

22.50

20

−2.5

6.25

0.3

1.88 = 71.26

σB

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= 8.44

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Covariance Product of

Weighted

RA

RB

(ERA − RA)

(ERB − RB)

deviations

Probability

27

35

+10.2

+12.5

127.5

0.3

+38.25

18

15

+1.2

−7.5

−9.0

0.4

−3.60

5

20

−11.8

−2.5

29.5

0.3

+8.85

=

+43.50

=

+0.60

Covariance Correlation coefficient

=

43.5 (8.58) (8.44)

product

The risk of the new project is thus:

σ p = (0.44) 2 (8.58) 2 + (0.56) 2 (8.44) 2 + 2(0.44)(0.56)(43.50) = (14.25) + (22.34) + (21.44) = 58.03 = 7.62 i.e. 7.62%

(c) Any new configuration of activities would involve a 50% weighting for existing operations and 50% for the new venture (whatever the combination of projects A and B). Given the standard deviation of existing operations of 10%, the new venture appears to lower the overall risk of Gawain. The extent of the risk reduction would depend on the correlation between the parent and the new venture. For illustration, if we assume that the relevant correlation coefficient is 80%, the risk of the expanded operation becomes:

δ p = (0.5) 2 (10) 2 + (0.5) 2 (7.62) 2 + 2(0.5)(0.5)(10)(7.62)(0.8) = 25 + 14.52 + 30.48 = 70 = 8.37 Obviously, the lower the correlation, the lower will be the risk of the expanded enterprise.

63 © Pearson Education Limited 2015

CHAPTER 9

Setting the risk premium: the Capital Asset Pricing Model Learning objectives The chapter deals with the rate of return required by shareholders in an all-equity financed company by extending the treatment of portfolio theory from Chapter 8 to the analysis of the Capital Asset Pricing Model (CAPM). Its specific aims are to: •

To explain what type of risk is relevant for valuing capital assets.

•

To explain what a ‘Beta coefficient’ is.

•

To determine the appropriate risk premium to incorporate into a discount rate, whether for investment in securities or in capital projects.

•

To examine the case for corporate diversification.

•

To examine some criticisms of the CAPM.

An understanding of the significance of Beta coefficient is particularly important in appreciating how financial managers should view risk.

Question summary 7. Z plc. This question requires an assessment of the advantages and disadvantages of a particular portfolio held by a company wishing to finance future investment.

Answers to questions 7. Z plc

Observations on the portfolio: •

Over 44% in UK equities, with a total of 62% in UK and US equities – a high proportion for a company that may need to liquidate its holdings in the short term.

•

The average Beta of the UK component is 1.5, possibly inflated by the AIM (Alternative Investment Market) shares. Suggests a high level of risk, i.e. exposure to a falling market.

•

The portfolio is an unbalanced mixture of equities and short-term marketable securities.

•

US stocks give rise to exchange-rate risk, although if the expansion is to take place in the United States, then this may provide a hedge (see below).

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•

The high average return in the past year is unlikely to be repeated in future years, or so the Efficient Market Hypothesis would argue. The conventional wisdom is that equities will show a higher return than government securities in the long term, but will be subject to wider fluctuations. This means there is a danger that, when investors wish to liquidate their holding, the prices could be at the bottom of the range. Hence, as one draws near the time when the funds are required for some specific purpose, the advice is to move into the less-volatile securities. However, with the expansion still up to two years away, it is perhaps too early to be in marketable securities such as the government debt and three-month bonds. Over the last 12 months, the return on the specific equities held by Z plc has been greater than that on their respective markets. On the surface, this was beneficial but those who believe that markets are efficient would suggest that this higher return must imply greater uncertainty, reinforcing the point made in the previous paragraph. If this is the case, was it deliberate policy on the part of the Z plc treasury? If the proposed expansion is in the United States or countries whose currencies move in line with the dollar, then the investment in US equities could be said to provide something of a hedge against the fall in the dollar/sterling rate. Otherwise, it could be said to have opened up an exchange-rate risk.

65 © Pearson Education Limited 2015

CHAPTER 10

The required rate of return on investment Learning objectives This chapter applies the models developed in earlier chapters to measuring the required rate of return on investment projects. After reading it, the reader should: •

Understand how the Dividend Growth Model can be used to set the hurdle rate.

•

Understand how the Capital Asset Pricing Model also can be used for this purpose.

•

Be able to apply the required rate of return to firm valuation.

•

Appreciate that different rates of return may be required at different levels of an organisation.

•

Be aware of the practical difficulties in specifying discount rates for particular activities.

•

Appreciate how taxation may influence discount rates.

Question summary 7. PFK plc. This question requires calculation of the risk–return characteristics of a proposed diversification project, and assessment of the impact of accepting it on the parent company’s risk profile.

Answers to questions 7. PFK plc (a) Expected IRR

=

(0.2 × −5%) + (0.3 × 8%) + (0.3 × 12%) + (0.2 × 30%)

=

(−1% + 2.4% + 3.6% + 6%)

=

11%

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Standard deviation:

Outcome

Prob

ER

Deviation

Squared deviation

Weighted by probability

−5

0.2

11

−16

256

51.2

8

0.3

11

−3

9

2.7

12

0.3

11

+1

1

0.3

30

0.2

11

+19

361

72.2

Variance =

126.4

St. dev. =

11.24%

(b) (i)

σ p = (0.75) 2 (20) 2 + (0.25)2 (11.24) 2 + 2(0.75)(0.25)(40) = 225 + 7.9 + 15 = 247.9 = 15.75 That is, total risk = 15.75%, reduced from 20% (ii) β j =

cov jm

σ

2 m

=

120 120 = = 0.83 122 144

(iii) New Beta = (¾ × existing Beta) + (¼ × Beta of project)

0.83 = (¾ × 1.05) + (¼ × Beta of project)

⎡ 0.83 − 0.7875 ⎤ Beta of project = ⎢ ⎥ = 0.17 0.25 ⎣ ⎦ (iv) ER = 5% + 0.17 [10% − 5%] = 5.85% (c) The new project lowers the total risk and the overall company Beta. This might please a highly risk-averse shareholder, but as investors are able to achieve their desired risk/return combinations by portfolio formation, some may resent the company’s interference with their preferences.

67 © Pearson Education Limited 2015

CHAPTER 11

Enterprise value and equity value Learning objectives The ultimate effectiveness of financial management is judged by its contribution to the value of the enterprise. The chapter aims: •

To provide an understanding of the main ways of valuing companies and shares, and of the limitations of these methods.

•

To stress that valuation is an imprecise art, requiring a blend of theoretical analysis and practical skills.

A sound grasp of the principles of valuation is essential for many other areas of financial management.

Questions summary 1. Amos Ltd. This question involves simple valuations of an unlisted company in a trade sale using various approaches. 2. Rundum plc. This question requires valuation of a take-over target, again using a variety of approaches. 4. Vadeema plc. This question involves valuation of a company operating in the pharmaceutical sector, where valuations are notoriously difficult.

Answers to questions 1. Amos Ltd (i) Book value = £670,000, or £1.34 a share since there are 500,000 shares issued. (ii) Current value:

£ Premises

780,000

Equipment

50,000

Investments

90,000

Debtors

108,000

Stock

85,000

Bank

25,000 1,138,000 68 © Pearson Education Limited 2015

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Less Creditors

(65,000)

Dividends

(85,000)

Loan

(85,000) 903,000

= £1.806 a share

2. Rundum plc (a) Net assets from the accounts are £6.6m, allowing for both short- and long-term debt. However, the debtors and stocks figures are suspect.

‘Realistic’ value of debtors = £3.0m − [l/3 × £3m × 50% chance of payment] = £2.5m ‘Realistic’ value of stocks = £1.5m − [½ × £1.5m] + £50,000 = £0.8m These adjustments reduce the NAV to £5.4m (b) A weighted average ‘surrogate’ P:E ratio for Carbo would be:

(50% × 8) + (50% × 12) = 10 (10:1) Earnings are £2.0m [1–33%] post tax = £1.34m (ignoring any stock or debtors write-off) However, if the existing MD was paid off, earnings after tax would increase by £60,000 (1–33%) = £40,200 Adjusted earnings would be [£1.34m + £0.0402m] = £1.3802m Applying a 10:1 P:E ratio, this yields a value of [10 × £1.3802m] = £13.802m Adjusting for the MD’s pay off, this reduces to £13.602m, say £13.6m. 4. Vadeema plc (a) (i) Net asset value

•

From the accounts, the basic NAV = £205m.

•

Adjustments:

NB – re-numbering

(1) Revaluation surplus (£65m − £50m)

=

£15m

(2) Patent

=

(£20m)

(3) Discount on outstanding work in progress (WIP) for which no contract has been signed, say (£40m) = (£40m) Net adjustments = (£45m) Adjusted NAV = (£205m − £45m) = £160m 69 © Pearson Education Limited 2015

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(ii) Price: Earnings ratio:

With no adjustments: Current sales

=

£300m

Operating profit margin (£300m × 25%)

=

£75m

(assuming depreciation all tax-allowable) Interest (20 × 12% + 40 × 10%)

=

(£10 m)

Tax @ 33%

=

(£21.45m)

Profit after tax

=

£43.55

Value of equity

=

P:E ratio × PAT

=

20 × £43.55

=

£871 m

(Using the current P:E for Vadeema, this is the current market capitalisation of the company) Adjustments: Sales volatility: •

Reduce sales to mid-range, i.e.

£250m

Patent expiry: •

Assume lose half of protected sales That is, 50% × 20% × £250m

=

(£25m)

Adjusted sales

=

£225m

Operating profit margin @ 25%

=

£56.25m

Interest (20 × 12% + 40 × 10%)

=

(£10 m)

Tax @ 33%

=

(£15.25m)

Profit after tax

=

£31m

Value of equity

=

P:E ratio × PAT

⎛ 22 + 14 ⎞ = Average ⎜ ⎟ = 18 × £31m ⎝ 2 ⎠

=

£558m

Use maintainable profits from above, i.e.

=

£56m

Add back depreciation (£5m + £25m)

=

£30m

Deduct taxation

=

(£15m)

Deduct replacement capex

=

(£5m)

Free cash flow before interest

=

£66m

(iii) Discounted cash flow:

Using the perpetuity formula (and assuming that the discount rate reflects the required return for all providers of capital, see Chapter 18):

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1 = £330m 20% Value of equity = EV − debt (overdraft + loan stock) = 330 − (20 + 40) = £270m Value of enterprise (EV) = £66m ×

For a more ‘realistic’ life span, say ten years: Value of enterprise

Value of equity = (£276.7m − £60m)

=

£66m × PVIFA20,10

=

£66m × 4.1925

=

£276.7m

=

£216.7m

(c) There is no such thing as a ‘correct’ valuation. The market can only take a view on the longterm prospects of a company in conjunction with the information provided by the directors. There are various reasons why Vadeema is difficult to value:

•

Volatile sales.

•

The uncertain impact of the patent expiry.

•

The development programme has an uncertain outcome, in terms of both the results obtained and also whether clients will take up options.

•

Pharmaceutical companies are notoriously cash-hungry when developing prospective ‘winners’.

•

The development programmes can be knocked off-balance by departure of key personnel – it takes time to build up an effective research capability.

•

Directors of these companies are often sparing in their release of information to the market for understandable commercial reasons.

•

Owing to insufficient expertise of their own, market professionals often fail to fully understand the significance of information when it is released.

For these reasons, valuation of a company like Vadeema is largely a guesswork, which helps explain why market values of such companies are so volatile.

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CHAPTER 12

Identifying and valuing options Learning objectives By the end of the chapter, the reader should possess a clear understanding of the following: •

The basic types of option and how they are employed.

•

The main factors determining option values.

•

How options can be used to reduce risk.

•

How option values can be estimated.

•

The various applications of option theory in investment and corporate finance.

•

Why conventional net present value analysis is not sufficient for appraising projects.

Questions summary 4. This question examines the factors underlying option pricing. 5. Marmaduke plc is an exercise in assessing the profit or loss on investing in an option. 11. Enigma Drugs plc is an exercise in identifying various types of option.

Answers to questions 4. Factors influencing the price of a traded option:

• Underlying share price. For a call option, the greater the share price, the greater the option value. Where the share price is below the exercise price of the call option, the option will have no intrinsic value, but will have a time value. • Time to expiry. For a call option, the longer the time to expiry, the greater the present value of the option because it gives greater opportunity for the share price to reach the exercise price. • Risk-free interest rate. The higher the interest rate, the lower the present value of the exercise price and the greater the value of a call option. • Volatility in underlying share price. Options on shares that are stable are worth less than on shares that are highly volatile. Volatility of a company’s share-option price is not necessarily a sign of financial weakness. It suggests that the market’s view on the above factors influencing the option price is unclear. 72 © Pearson Education Limited 2015

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5. Marmaduke plc Pence Current share price

135

Exercise price

120

Profit on exercise

15

Less premium Profit

(10) 5

(a, b) The profit on 100 shares is £15 on exercise, or £5 after deducting the premium. The option should therefore be exercised. (c) Had he invested £10 (i.e. 100 × 10p premium) for 6 months in a bank offering 10% p.a., the interest would be £10 @ 5% = 50p

The option therefore gives a tenfold greater return. 11. Enigma Drugs plc

This mini-case incorporates five options. Take another look at the case to identify the type of option, its length and exercise price. Recall that American options offer the holder the right to exercise at any time up to a certain date, while a European option is exercised on one particular date. The solution to this is given below. The order of the options follows those in the case. Enigma Drugs plc options

Option

Type

Length

Exercise price

Investment timing

American call

2 years

£50m investment outlay

Abandonment

American put

5 years

Resale value of ‘know-how’

Follow-on project

European call

4 years

£120m investment

Default on loans

European call

8 years

£40m face value of the loan

American call

4 years

360p

To the company:

To the loanstock holder: Convertible loan

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PART IV

Short-term financing and policies

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CHAPTER 13

Risk and treasury management Learning objectives The reader should, after reading the chapter, appreciate the following: •

The purpose and structure of the treasury function.

•

Treasury funding issues.

•

How to manage banking relationships.

•

Risk management, hedging and the use of derivatives.

Questions summary 1. The question debates the pros and cons for a company of centralising/decentralising the finance function. 2. A simple question asking the student to identify interest-rate risks and suggest two possible hedging instruments for their reduction. 3. ABC plc examines the responsibilities of a treasury department and the merits and drawbacks of establishing it as a profit centre.

Answers to questions 1. See Section 13.2 in the text. 2. See Section 13.6 in the text. 3. ABC plc (a) Treasury management is ‘the corporate handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows, and the complex strategies, policies and procedures of corporate finance’ Chartered Institute of Management Accountants (CIMA). The main responsibilities of such a department in a service-based multinational company are likely to include the following: Policy – It will make a significant contribution to the definition of corporate financial objectives, including strategies, policies and systems. Liquidity management – Ensuring that the company has the liquid funds it needs and that it invests any surplus funds. This will involve:

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•

Managing working capital and the transmission of funds within the group.

•

Maintaining banking relationships and arrangements for short-term borrowings and investments.

•

Money management.

Funding management – Funding policies and procedures, and the sources and types of funds to be used. Currency management –

(i) Exposure policies and procedures. (ii) Exchange dealing, including futures, options and derivative products. (iii) International monetary economics and exchange regulations. Corporate finance decisions such as the following: •

Dividend policy

•

Equity capital management

•

Mergers, acquisitions and divestments

•

Financial information for management

•

Project finance

•

Corporate taxation

•

Risk management and insurance

•

Pension fund investment management.

The benefits of a separate centralised treasury function are likely to include the following: (1) Centralisation of cash surpluses means that larger amounts are available for short-term investment, thus giving better investment opportunities. (2) Liquidity management can be improved by allowing bulk cash flows and therefore lower bank charges, and by avoiding the proliferation of small local surpluses and overdrafts. (3) Borrowings can be arranged in bulk at lower interest rates than for smaller amounts. (4) A specialist department can employ experts with knowledge and experience of corporate treasurership, derivative products and so on. (5) The centralised precautionary balance is likely to be lower than the sum of the local precautionary balances. (6) Foreign currency risk management is likely to be improved because it will be possible to match receipts and payments made in a given currency across all the subsidiaries.

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(b)

The benefits of operating a separate treasury department as a profit centre include the following: •

Some companies, particularly those with a high level of foreign exchange transactions, may be able to make significant profits from their treasury activities.

•

Recognition of the department as a profit centre may allow the company to introduce an element of performance-related pay, should it wish to do so.

The possible disadvantages of operating the treasury department as a profit centre include the following: •

Operating the department as a profit centre may encourage a more aggressive attitude to risk, which may be difficult to reconcile with the directors’ requirements. In addition, it means that a good system of controls must be in place to prevent speculation.

•

It is difficult to set prices to be charged for the treasury service to other departments. It may be difficult to put realistic prices on some services such as the arrangement of finance or general financial advice. If the charges are viewed as too high by the subsidiaries, they may be tempted to seek outside advice instead and thus the advantages of a centralised treasury function will be lost.

•

Even with a profit centre approach, it may be difficult to measure the success of a treasury department because successful treasury activities sometimes involve avoiding the incurring of costs. For example, a successful currency hedge during a period of strong currency movements may prevent the company from incurring a substantial loss.

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CHAPTER 14

Working capital and short-term asset management Learning objectives Having read the chapter, the reader should have a good appreciation of short-term asset management in corporate finance and of the basic control methods involved. Specific attention is paid to the following: •

Working capital policies.

•

The cash operating cycle and overtrading problems.

•

Managing trade credit.

•

Inventory management.

•

Cash management.

Questions summary 9. Torrance Ltd examines the financial implications of granting additional days’ credit to customers and claiming cash discounts from suppliers. 10. Keswick plc considers trade credit as a source of finance. 11. International Golf Ltd requires the preparation and analysis of a cash flow forecast. 12. Ripley plc/Bramham plc addresses financing policy and cash management policy.

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Answers to questions 9. Torrance Ltd (a) Assessment of credit policies Option 1

2

3

£

£

£

New debtors’ level £630,000 × 40/365

69,041

£645,000 × 50/365

88,356

£650,000 × 60/365

106,849

Current debtors £600,000 × 30/365 Increase in debtors Cost of capital @ 15%

49,315

49,315

49,315

19,726

39,041

57,534

(2,959)

(5,856)

(8,630)

Additional contribution 50% × £30,000

15,000

50% × £45,000

22,500

50% × £50,000

25,000

Increased profit

12,041

16,644

16,370

Note: Contribution percentage is the percentage of selling price less variable cost to the selling price, i.e.

(£36 − £18) × 100 = 50% £36 (b) Advantages of trade credit as source of finance:

•

Arises as part of the normal business process, that is, as customer orders increase so does the finance received from trade creditors for purchases to fulfil such orders.

•

A free source of finance provided the goodwill of suppliers is maintained.

Disadvantages of trade credit: •

Excessive time to repay may result in lost goodwill with suppliers and reluctance by creditors to continue to supply.

•

Generous cash discounts may be forgone.

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(c) Annual cost of cash discounts:

30 days:

2.5 365 × = 46.8% 97.5 (30 − 10)

45 days:

2.5 365 × = 26.7% 97.5 (45 − 10)

The cost to the firm if not taking the discount by paying within 10 days is high – 46.8% if paid within the terms of the invoice, or 26.7% if the company squeezes a further 15 days beyond the agreed credit terms. This compares with a cost of capital of only 15%. Unless the company can extend payment to above 70 days, the generous cash discount terms should be taken:

2.5 365 × = 15.6% 97.5 (70 − 10) Extending the credit period to over 70 days is likely to result in deterioration in customer– supplier relationship. 10. Keswick plc (a) (i) For many firms, trade creditors – suppliers of goods and services – represent the major component of current liabilities, the amounts owed by the company, which have to be repaid within the next accounting period. Together with current assets – cash, stock and debtors – current liabilities determine the firm’s net working capital position, that is, the net sum it invests in working capital.

Different suppliers will operate different credit periods, but the average trade credit period in days can be calculated as follows: Trade creditors/Credit purchases × 365 Sometimes, it is expressed in terms of total purchases and sometimes, in terms of overall cost of sales. The length of the trade credit period depends partly on competitive relationships among suppliers and partly on the firm’s own working capital policy. The trade credit period is an important element in a company’s cash conversion cycle – the length of time between a firm making payment for its purchases of materials and labour and receiving payment for its sales. The time period over which net current assets have to be financed depends not only on the policy towards suppliers but also on the debtor management and stock control policy. Cash conversion cycle = [Debtor days + stock period] – [trade credit period] (ii) In effect, because trade credit represents temporary borrowing from suppliers until invoices are paid, it becomes an important method of financing the firm’s investment in current assets. Firms may be tempted to view trade creditors as a cheap source of finance, especially as, in the United Kingdom at least, it is currently interest-free. Having a debtors’ collection period shorter than the trade collection period, may be taken as a sign of efficient working capital management. However, trade credit is not free.

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First, by delaying payment of accounts due, the company may be passing up valuable discounts, thus effectively increasing the cost of goods sold. Second, excessive delay in the settlement of invoices can undermine the existence of the business in a number of ways. Existing suppliers may be unwilling to extend more credit until existing accounts are settled, they begin to attach a lower priority to future orders placed, or they may raise prices in the future or simply not supply at all. In addition, if the firm acquires a reputation as a bad payer among the business community, its relationship with other suppliers may be soured. (b)

Working capital cycle: At present, the working capital cycle is: Debtor days:

£0.4m/£10m × 365

=

15 days

Stock days:

£0.7m/£8m × 365

=

32 days

Creditor days:

£1.5m/£8m × 365

=

(68 days)

=

(21 days)

Total

Clearly, Keswick is exceptionally efficient in its use of working capital. The proposed arrangement would shorten creditor days in relation to half the cost of sales to 15 days. The effect is to lower the average to: (1/2 × 68 days) + (1/2 × 15 days) = 41.5 days. Overall, this will increase cycle time to: [15 + 32 − 41.5 days] = 5.5 days. Interest cover: At present, interest cover (Earnings before interest and tax/Interest) is: £2m/£0.5m = 4.0 times, that is not unduly low. The advanced payment will raise interest costs but will generate savings via the discount. The discount applies to half the cost of sales, that is, 1/2 × £8m × 5% = £0.2m. The net advanced payment of (£4m − £0.2m) = £3.8m will have to be financed for an extra (68 − 15) days, generating interest costs of: [£3.8m × 12% × 53/365] = £66,214. The interest cover slightly declines to: [£2.0m + £0.2m]/[£0.50m + £0.066m] = 3.89 times. Profit after tax, ROE and EPS

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The ‘before’ and ‘after’ profit and loss accounts appear thus: £m

£m

No discount

With discount

Sales

10.000

10.000

Cost of sales

(8.000)

(7.800)

and tax

2.000

2.200

Interest

(0.500)

(0.566)

1.500

1.634

(0.495)

(0.539)

1.005

1.095

Discount

Earnings before interest

Taxable profit Tax @ 33% Profit after tax

ROE =

£1.005m = 50.3% £2m

£1.095m = 54.8% £2m

EPS =

£1.005m = 25.1p £1m × 4

£1.095m = 27.4p 4m

The proposal appears beneficial to Keswick in terms of the effect on profitability measures, that is, Earning Before Interest and Taxes (EBIT), Profit After Tax (PAT), EPS and ROE. Conversely, it does have a marginally harmful effect on its interest cover and lengthens its working capital cycle and turns it into a net demander of capital. This suggests an increase in its capital gearing. Before the adjustment, gearing at book values (overdraft/shareholders’ funds) was: £3m/£2m = 150%. Ignoring the beneficial effect on equity, the overdraft will increase by: [£3.8m × 53/365] = £0.55m. Gearing after the adjustment becomes: £3.55m/£2m = 178%. This looks rather perilous, considering the short-term nature of much of this debt and Keswick’s low liquidity. Perhaps Keswick should reconsider its policy regarding long-term borrowing, and whether prospective lenders would oblige is doubtful.

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11. International Golf Ltd (a) A cash flow forecast can be a useful tool for planning and decision-making, providing managers with an insight into the implications of possible decisions on the cash position of the business. Cash has been described as the ‘life-blood’ of a business and it is important that this asset is properly managed.

Cash flow forecasts help managers identify whether and, if so, when cash surpluses or deficits are likely to occur in the future. When a surplus is forecast, consideration must be given to possible ways in which the surplus can be re-invested. When cash deficits are forecast, it may be necessary to re-plan the timing of certain items in order to overcome the deficit. Alternatively, the business may seek ways of financing the deficit. By giving prior warning of a likely deficit, the financial manager will have time to consider the problems and to seek appropriate remedies. In addition, prospective lenders will often expect to be provided with a cash forecast before considering a loan to a business. (b) The costs associated with holding too much or too little cash are as follows: Borrowing costs. Insufficient cash may lead a business to borrow to continue operations. Interest payments on loans will be an explicit cost of having too little cash. Monetary losses. During a period of inflation, the holding of cash will result in a monetary loss being incurred. Cash held on deposit will be protected to the extent that inflation is taken into account in the rate of interest given. Loss of goodwill. A business may have to delay payments to suppliers if there is insufficient cash. This may result in a loss of goodwill and this, in turn, may affect future supplies. Opportunities forgone. Too little cash may mean that a business is unable to take advantage of profitable opportunities when they arise. Similarly, a shortage of cash may prevent a business from taking cash discounts for prompt payment to suppliers. Loss of income. Cash in hand, or cash held in a current account in the bank, will not yield the business any income. Other forms of asset held by the business, however, are likely to yield income. Therefore, there is often an opportunity cost associated with the decision to hold cash rather than some other form of asset. Although cash held on deposit will generate interest, this form of investment is likely to yield a lower return than other investment opportunities available to a business. Cessation of trade. A business must retain an uninterrupted ability to pay debts as and when they fall due. Failure to do so can, in the extreme, lead creditors to take legal action resulting in the winding up of the business.

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Cash flow forecast for the six months ending 31 May 1994 Dec

Jan

Feb

Mar

Apr

May

£000

£000

£000

£000

£000

£000

Cash sales

48

60

68

88

100

112

Credit sales

33

77

72

90

102

132

81

137

140

178

202

244

Purchases

140

156

180

195

160

150

Advertising

15

18

20

25

30

30

Rent

40

Receipts

Payments

Rates

40 30

Wages

16

16

18

18

20

20

Sundry expenses

12

16

16

18

18

18

Motor vans

24

Taxation

30 223

236

258

326

228

218

(142)

(99)

(118)

(148)

(26)

26

Balance b/f

(56)

(198)

(297)

(415)

(563)

(589)

Balance c/f

(198)

(297)

(415)

(563)

(589)

(563)

Cash flow

(d) The cash flow forecast reveals that the overdraft is going to get progressively worse over the first five months of the period. At the end of April, the overdraft required will reach a maximum of £589,000 for the period. Given the concern of the bank over the existing overdraft level, this position will almost certainly be unacceptable. In the following month, the cash flows become positive and the overdraft will begin to reduce. However, the overdraft at the end of the six-month period will still be at an unacceptably high level of £563,000.

The business does not appear to have a great deal of room to manoeuvre. It is told that purchases in the first three months are necessary to meet the demand from April onwards; however, it may be possible to delay purchase of some of these stocks until a little later to ease cash flows. Similarly, the purchase of the motor vans may be delayed until a later date. However, it may prove more difficult to delay payments relating to the other expenses. It may be possible to get credit customers to pay more promptly. However, this will depend on various factors such as the normal terms of trade operating within the industry and the market strength of the company. Although delaying payments and chasing credit customers may bring some success in reducing the forecast overdraft, such steps are unlikely to be sufficient. The size of the deficit suggests that the business is under-capitalised and should therefore consider some form of long-term finance to alleviate its problems. The business should also examine its level of profitability. If we assume that there will be no significant changes in stock levels over the period, the income for the period will be significantly lower than expenses. This will result in a net cash outflow from operations.

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12. Ripley plc/Bramham plc (a) Memo to: Ripley plc Main Board Members

From: An(n) Accountant Subject: Alternative Financial Strategies The present policy is termed a ‘matching’ financial policy. This policy, attempts to match the maturity of financial liabilities to the lifetime of the assets acquired with such finance. It involves financing long-term assets with long-term finance such as equity or loan stock and financing short-term assets with short-term finance such as trade credit or bank overdrafts. This avoids the potential waste of over-capitalisation where short-term assets are purchased with long-term finance, that is, the company having to service finance not continuously invested in income-earning assets. It also avoids the dangers of under-capitalisation, which entails exposure to finance being withdrawn when the company is not easily able to liquidate its assets. In practice, some short-term assets may be regarded as permanent and it may be thought sensible to finance these by long-term finance and the fluctuating remainder by short-term finance. The proposed policy is an ‘aggressive policy’, which involves far more reliance on shortterm finance, thus attempting to minimise long-term financing costs. This requires very careful manipulation of the relationship between creditors and debtors (maximising trade creditors and minimising debtors), and highly efficient stock control and cash management. While it may offer financial savings, it exposes the company to the risks of illiquidity and hence, possible failure to meet financial obligations. In addition, it involves greater exposure to interest-rate risk. The company should be mindful of the inverse relationship between the interest-rate changes and the value of its assets and liabilities. Before embarking on such an aggressive policy, the Board should consider the following factors: •

How good are we at forecasting cash inflows and outflows? How volatile is our net cash flow? Is there any seasonal pattern evident?

•

How efficiently do we manage our cash balances? Do we ever have excessive cash holdings which can be reduced by careful and active management?

•

Do we have suitable information systems to provide early warnings of illiquidity?

•

Do we have any holdings of marketable securities that can be liquidated if we run into unexpected liquidity problems?

•

How liquid are our fixed assets? Can any of these be converted into cash without unduly disrupting productive operations?

•

Do we have any unused long- or short-term credit lines? These may have to be utilised if we meet liquidity problems.

•

How will the stock market perceive our switch towards a more aggressive and less liquid financial policy?

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(b) To determine the net benefits of each policy, both cash costs and opportunity costs have to be considered.

First, consider the management costs over the course of the forthcoming year expected from each policy: Policy 1: Selling securities

This policy involves an opportunity cost in terms of the forgone returns from holding securities as well as cash transaction costs. This opportunity cost is partly offset by small interest earnings on the average cash balance held. Transaction costs: Optimal proceeds per sale: Q =

2 × £1.5m × £25 0.12

=

£25,000

No. of sales

=

£1.5m/£25,000

=

60

Transaction costs

=

60 × £25

=

£1,500

Average cash balance

=

£25,000/2

=

£12,500

Holding cost

=

£12,500 × 12%

=

£1,500

=

(£625)

Interest on short-term deposits: Average cash balance

= £12,500 × 5%

Total management costs

£2,375

Policy 2: Secured loan facility

Assuming an even run-down in cash balances: Interest charges = £1.5m × 14%

=

£210,000

=

(£67,500)

=

£5,000

Offsetting interest receipts: (= average balance × 9%) = £1.5m/2 × 9% Arrangement fee Total management costs

£147,500

Hence, the policy of periodic security sales appears greatly superior in cost terms by [£147,500 − £2,375] = £145,125. However, this simple comparison ignores the income likely to be received from the portfolio of securities under each policy. By taking the secured loan, the company preserves intact its expected returns of [12% × £1.5m = £180,000] from the portfolio. Conversely, making periodic sales from the portfolio during the year lowers the returns to: [average holding × 12%] = £1.5m/2 × 12% = £90,000. The net benefits from the two policies can be shown as: Security sales

Income from portfolio

£90,000

Net management costs

(£2,375)

Net income

£87,625

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Loan alternative

Income from portfolio

£180,000

Net management costs

(£147,500)

Net income

£32,500

Difference

£55,125

The policy of periodic security sales thus offers greater benefits. However, it is also necessary to consider the company’s net worth position at the end of the year ahead. By relying on security sales, the company would avoid the need to repay a loan at the end of the year, but, against this, will have no holdings of securities to fall back on. Moreover, the capital value of this portfolio is uncertain due to exposure to variation in the return from the portfolio. For example, if money market rates rose over the year, the capital value of the portfolio would probably fall, although the extent of the decrease in value would depend on the nearness to maturity of the securities. (c) Some limitations of the simple inventory model are as follows:

•

It assumes a steady run-down in cash holdings between successive security sales. In reality, the pattern of cash holdings is likely to be far more erratic, with exceptional demands for cash punctuated by periods of excessive liquidity. However, the period between sales is short enough and the transaction cost low enough to allow flexibility in cash management.

•

It allows for no buffer stock of cash. In reality, security sales are unlikely to be made when cash balances drop to zero, but rather when they fall to a level deemed to be the safe minimum.

•

It uses a ‘highly uncertain’ estimate of the return from the portfolio. Bramham should investigate the implications of assuming alternative (higher and lower) rates, and perhaps determine a ‘break-even rate’, at which the two policies are equally attractive. In this example, the actual rate would have to be well above 12% to achieve this result.

•

There may be economies in bulk-selling of securities, although exploiting these would increase the holding cost.

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CHAPTER 15

Short- and medium-term finance Learning objectives The aim of this chapter is to evaluate the advantages and disadvantages of the following means of short- and medium-term finance: •

Trade credit.

•

Bank finance.

•

Factoring and invoice discounting.

•

Bills of exchange and acceptance credits.

•

Hire purchase.

•

Leasing.

Particular attention is given to leasing in view of its importance as a method of financing the acquisition of a wide range of assets. In addition, the commonest ways of financing foreign trade are also described.

Questions summary 5. Haverah plc. This is an exercise to demonstrate the impact on financial ratios of new working capital management policies. 6. Raphael Ltd examines the cost and benefits of factoring. 8. Lee/Lor compares a borrow-to-buy against a lease decision.

Answers to questions 5. Haverah plc

Working capital cycle First, note that cost of sales = Sales − EBIT = (£45m − £5m) = £40m At present, the working capital cycle is: Debtor days: £2.50m/£45m × 365

=

20 days

Stock days: £1.00m/£40m × 365

=

9 days

Creditor days: £6.0m/£20m × 365

=

Total

(109) days (80) days

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Clearly, Haverah is exceptionally efficient in its use of working capital especially on stocks implying perhaps a J.I.T approach to purchases. The proposed arrangement would shorten creditor days in relation to 40% of its cost of sales to 25 days. The effect is to lower the average to: (0.4 × 25 days) + (0.6 × 109 days) = (10 + 65.40) = 75 days Overall, this will increase the cycle time to: [20 + 9 − 75 days], i.e. to (46) days, which still leaves Haverah as a net recipient of working capital. Interest cover At present, interest cover [Earnings before interest and tax/Interest] is: = (£5m/£2.0m) = 2.5 times, which may appear on the low side. The advanced payment will raise interest costs but will generate savings via the discount. The discount applies to 40% of cost of sales, i.e. (0.4 × £40m × 4%) =£0.64m. The net advanced payment of (0.4 × £20m × 96%) = £15.36m will have to be financed for an extra (109 − 25) = 84 days, generating interest costs of: (£15.36m × 10%) × (84/365) = £0.35m The interest cover slightly declines to: [£5.0m + £0.64m]/[£2.0m + £0.35m] = (£5.64m/£2.35m) = 2.4 times Profit after tax, ROE and EPS The ‘before’ and ‘after’ profit and loss accounts appear thus:

Sales Cost of sales Earnings before interest and tax Interest Taxable profit Tax @ 33% Profit after tax

£m

£m

No discount

With discount

45.00

45.00

(40.00)

(39.36)

5.00

5.64

(2.00)

(2.35)

3.00

3.29

(1.00)

(1.09)

2.00

2.20

ROE =

£2.00m = 50% £4m

£2.20m = 55% £4m

EPS =

£2.00m = 100.0p £1m × 2

£2.20m = 110.0p 2m

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The proposal appears, beneficial to Haverah in terms of the effect on profitability measures, i.e. EBIT, PAT, EPS and ROE. But it does have a marginally harmful effect on its interest cover and it lengthens its working capital cycle. This suggests an increase in its capital gearing. Gearing Before the adjustment, gearing at book values (overdraft/shareholders’ funds) was: £5m/£4m = 125% Ignoring the beneficial effect on equity, the overdraft will increase by: [£15.36m × 84/365] = £3.53m Gearing after the adjustment becomes £8.53m/£4m = 213% This looks pretty perilous, especially considering the short-term nature of much of this debt, and Haverah’s low liquidity. Perhaps Haverah should reconsider its policy regarding longterm borrowing, although whether prospective lenders would oblige is probably doubtful. 6. Raphael Ltd (a) Cost of existing credit policies

£ Cost of debtors (50/365 × £2.4m × 12%)

39,452

Bad debts (1.5% × £2.4m)

36,000 75,452

Factoring costs Factor charges (2% × £2.4m)

48,000

Factor finance charges [30/365 × (80% × £2.4m) × 11%]

17,359

Overdraft charges [30/365 × (20% × £2.4m) × 12%]

4,734 70,093

Less: Cost savings

18,000

Net cost of factor agreement

52,093

This shows that the net cost of the factoring agreement is much lower than the cost of the existing policies. (b) Factoring involves the administration of the credit sales of a business including the accounting, invoicing and debt collection procedures. A factor may be prepared to underwrite the outstanding debts of the business for an additional fee. In order to help finance the business, a factor will usually be prepared to advance up to 80% of the value of the trade debts outstanding at a reasonable rate of interest. Factoring arrangements can help

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to free-up management time, which may otherwise be spent chasing debtors and can help align the financing of the business with the level of sales generated. Invoice discounting involves the purchase of selected invoices from a business by a financial institution. The invoice discounter will normally be prepared to advance up to 75% of the face value of the invoices purchased and this advance will be recouped from the cash received from debtors. A business that uses the services of an invoice discounter may only sell a proportion of the total debtors outstanding and the arrangement is purely to help finance the business. Thus, the invoice discounter will not offer to administer the credit sales of the business as a factor is prepared to do. Factoring agreements are usually for a long period because of the time and cost involved in setting up the factoring arrangements. Invoice discounting, on the other hand, may be a oneoff arrangement. (c) The cost of forgoing discounts in order to obtain an extra 35 days’ credit (i.e. 50 − 15 days) is:

365/35 × 2.5/(100 − 2.5) = 26.7% In order to assess whether or not it is worthwhile for the company to take advantage of the discount offer, it would be necessary to compare the cost of forgoing the discounts with the opportunity cost of using the funds available for other purposes. Unless the funds available generate a return of at least 26.7%, it would be worthwhile to take advantage of the discounts offered. (d) The company must bear in mind the need to maintain the goodwill of its suppliers. At present, the company pays the owing amounts 10 days after the final due date for payment. This might be unacceptable to suppliers who may respond by giving lower priority to future orders, refusing back-up or technical services, charging interest on owing amounts or even refusing to supply goods in the future. A reputation for persistent late payment can also lead to problems when negotiating terms with new suppliers and is likely to have an adverse effect on the credit rating of the company.

The above will represent real costs to the company and must be taken into account when deciding on any change of policy directed towards suppliers.

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8. Lee/Lor leasing (i) As this is a borrow-to-buy versus a lease decision, we must first calculate the after-tax discount rate. This is:

Pre-tax cost (1 – tax rate) = (5.5% + 1.7%) (1 – 30%) = 7.2% × 0.7 = 5.04%, rounded to 5% Next, depreciation allowances and tax savings are calculated: Year $

0

Balance b/f

1

5,000

2

3

4

5

5,000

Depreciation at 25%

(1,250.00)

(937.50)

(703.13)

(527.34)

Balance c/f

3,750.00

2,812.50

2,109.37

1,582.03

Residual value

(2,000.00)

Balancing charge payable on

417.97

Tax saving of 10%

375.00

281.25

210.94

158.20

Balancing charge

(125.39)

(It is assumed that LEE has sufficient taxable capacity to absorb the depreciation allowance.) Evaluation of the purchase option now follows: Year $

0

Outlay/Residual value

1

2

3

4

(5,000)

Maintenance costs

5

6

2,000 (60)

(60)

(100)

Tax relief

18

18

18

30

30

Tax savings on outlay

375

281

211

158

(125)

Net cash flows Discount factor at 5% Present value

(60)

(100)

(5,000)

(60)

333

239

129

2,088

(95)

1.000

0.952

0.907

0.864

0.823

0.784

0.746

(5,000)

57

302

206

106

1,637

(71)

Present value of purchase option = ($2,763) The lease is much simpler. There is an annuity starting in year 0 (i.e. ‘one year in advance’) of the $850 rentals, followed by another annuity of delayed tax savings of $850(1 – 30%) = $255 over years 2–6.

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The relevant annuity factors are: Years 0–4: (1.000 + 3.546) = 4.546 Years 2–6: 4.329/(1.05) = 4.123 The calculation is thus: PV = [(850) ×4.546] + [255 × 4.123] = (3,864) + 1,051 = ($2,813) These figures suggest that the purchase option is cheaper, so that the break-even rental would be lower than $850. (ii) Setting R = highest acceptable lease rental, we need to solve for R in the expression PV of lease rental flows = PV of purchase cash flows

i.e. 4.456R – (4.123 × 0.3R) = 2,763 3.309R = 2,758 Whence R = (2,763/3.309) = $833 To break even, the pre-tax lease rental must be lowered to $833. .

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PART V

Strategic financial decisions

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CHAPTER 16

Long-term finance Learning objectives Reading this chapter should give the reader a sound grasp of the following: •

The key characteristics of the main forms of long-term finance.

•

The benefits and drawbacks of each capital form.

•

The factors that influence the choice between the various forms.

Questions summary 3. Shaw Holdings plc. A question designed to highlight the decision options facing investors in a company making a rights issue. 5. Lavipilon plc. This question examines the balance sheet impact of various forms of distribution to shareholders ranging from cash dividends to the issue of shares. 6. Netherby plc. Another case study set in the context of a make-or-buy decision but involving consideration of alternative financing options in order to raise the funds required for restructuring.

Answers to questions 3. Shaw Holdings plc (a) Theoretical ex-rights price: Number of

Value per share

Total value

shares (m)

(£)

(£m)

20

1.60

32.0

5

1.30

6.5

Value of company before rights issue Value of rights issue (20/4)

25

Theoretical ex-rights price = £38.5m/25 = £1.54 (b) Theoretical value of the rights = (£1.54 − £1.30) = £0.24

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(c) Evaluation of the options by owner of 2,000 shares:

(i) Selling the rights Value of the ex-rights holding

= 2,000 × £1.54

£3,080

Add: sales proceeds of the rights = 500 × £ 0.24

£120

Value of existing holding

£3,200

(ii) Taking up the rights Value of the ex-rights holding

= 2,500 (i.e. 2,000 + 500) × £1.54

£3,850

Less: cost of acquiring the rights = 500 × £1.30 Value of existing holding

£650 £3,200

(iii) Allowing the rights to lapse Value of the ex-rights holding = 2,000 × £1.54

£3,080

There is, in theory, no financial difference between selling or taking up the rights, but allowing the rights to lapse will reduce wealth for investors. (d) Rights issues are normally made at a discount because:

•

To encourage investors to take up the rights or to sell them to someone who will do so. The discount increases the likelihood that the company will raise the required funds from the issue. Some small investors often think (incorrectly) that they are getting a special inducement.

•

In a volatile stock market, it is always possible that share prices will fall below current prices during the rights offer period. No one is going to pay more than the current price, to take up shares in a rights issue. Companies must set a level below which they are confident the share price will not fall.

(e) We have already seen that the shareholder is not affected by rights issues unless the rights are allowed to lapse. The only concern for the company, therefore, is that the price set does not exceed the market share price.

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5. Lavipilon plc (a) The three proposals would produce the following balance sheets (all figures are in £m): Bonus

Scrip

Share

issue

dividend

split

135(b)

165(f)

135

Ordinary shares

35(c)

30(g)

25(j)

Share premium account

40(d)

45(h)

50(k)

Revenue reserves

60(e)

90(i)

60(e)

135

165

135

Net assets (a)

The letters in brackets refer to points listed below: (a) Net assets = fixed plus current assets less current liabilities less long-term debt. (b) Existing net assets of £115m plus profit of £50m less dividends £30m, yielding a net increase in assets of £20m, presumably in cash form. (c) 50m ordinary shares plus 20m bonus shares = 70m, valued at par 50p, book value = £35m. (d) The extra £10m ordinary shares at par, comes out of share premium in this answer. (Alternatively, it could come from revenue reserves.) (e) £20m retention added to existing £40m revenue reserve. (f) Existing net assets of £115m plus retained profit of £50m (no cash dividend paid). (g) 10m new shares added to the existing 50m. Valued at par of 50p, book value = £30m. (h) The extra £5m ordinary shares, comes out of share premium; alternatively, it could come from revenue reserve. (i) £50m retained profit added. (j) 50m ordinary shares at par 50p become 100m ordinary shares at 25p to generate the same total book value. (k) No reason why this should change. Lavipilon’s equity is worth (50m shares × £3) = £150m. In an efficient capital market, none of these adjustments in themselves should affect company value. In each case, additional shares are issued but no additional funds are raised. In effect, the same basic company is now split into smaller pieces, but more of them! However, each device will result in a different number of new shares. In each case, the resulting share price will be the equity value divided by the new number of shares. This can be seen most clearly if we assume that the new shares are not excluded from the dividend. Bonus issue

£150m/70m

=

£2.14 cum dividend

Scrip issue

£150m/60m

=

£2.50 cum dividend

Share split

£150m/100m

=

£1.50 cum dividend

However, in reality, it is usually the case that new shares do not qualify for dividends until the next declaration. In this case, the arithmetic (but not the principle) is different. For the

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bonus issue, the ex-dividend share price is £3 less 60p = £2.40. With the new shares in issue, share price falls to £2.40 × 25/35 = £1.71p. With the share split, the ex-dividend price of £2.40 is reduced as follows: £2.40 × 25/50 = £1.20. (b) In theory, none of these proposals will provide an extra return. However, if these devices provide new information to the market about the future earnings potential of the company, the predicted prices may not prevail. Often, the capital market will receive all three types of proposal favourably, especially if the company declares its intention of maintaining the same dividend per share. In the share split case, this is tantamount to doubling the dividend and is rather unlikely. In practice, empirical evidence shows that financial adjustments of this nature do portend a future dividend increase, although to a more modest degree. It should be noted that because companies do not like having to rescind a dividend increase, and try to smooth dividend payments over time, dividends are usually regarded by the market as a better guide to the director’s assessment of future profits than current earnings. (c) (i) From the company’s point of view, a scrip dividend preserves liquidity, which may be important at a time of cash shortage and/or high borrowing costs, although it may become committed to a higher level of cash outflows in the future if shareholders revert to a preference for cash. However, having issued more shares, the company’s reported financial gearing may be lowered, possibly enhancing borrowing capacity. In this respect, the scrip dividend resembles a rights issue.

For shareholders wishing to increase their holdings, the scrip is a cheap way into the company as it avoids dealing fees. The conversion price used to calculate the number of shares receivable is based on the average share price for several trading days after the ‘ex-dividend day’. Should the market price rise above the conversion price before the date at which shareholders have to declare their choice, there is the prospect of capital gain, although if the share price appreciation exceeds 15%, any such gain is taxable. A scrip dividend has no tax advantages for shareholders as it is treated as income for tax purposes. If the capital market is efficient, there is no depressing effect on share price of the scrip dividend through earnings dilution. This is because the scrip simply replaces a cash dividend that would have caused the share price to fall anyway due to the ‘ex-dividend’ effect. In other words, the shareholder wealth is unchanged. However, if the additional capital retained is invested wisely, then the share price may either be maintained or even rise, although this would depend on the proportion of shareholders who opt for the scrip. (ii) A share split will not generate additional funds, or even preserve liquidity. So why do companies do this?

A stock split will reduce unit share price and perhaps make the shares more marketable. This contradicts the EMH which asserts that all shares are always fairly priced, but it is often agreed that a ‘heavyweight’ share value is a deterrent to active trading, i.e. it makes the shares less liquid and hence less valued.

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6. Netherby plc (a) The costs of restructuring are set against profits in year zero, thus generating a tax saving after a one-year delay. The estimated cash flow profile is thus:

Cash flow profile (£m) Year Item

0

Closure costs

1

3

4

5

2

2

2

2

(0.66)

(0.66)

(0.66)

(0.66)

6

(5)

Tax saving

1.65

Cash flow increase

2

Tax

NPV (£m)

2

=

–5 + 1.65(PVIF15,1) + 2(PVIFA15,5) − 0.66(PVIFA15,5 PVIFA15,1)

=

–5 + 1.65(0.870) + 2(3.352) − 0.66(3.784 − 0.870)

=

–5 + 1.44 + 6.70 − 1.92 = +1.22, i.e. + £1.22m

Hence, the restructuring appears worthwhile. (b) A semi-strong efficient capital market is one where security prices reflect all publicly available information, including both the record of the past pattern of share price movements and all information released to the market about company earnings prospects. In such a market, security prices will rapidly adjust to the advent of new information relevant to the future income-earning capacity of the enterprise concerned, such as a change in its chief executive, or the signing of a new export order. As a result of the speed of the market’s reaction to this type of news, it is not possible to make excess gains by trading in the wake of its release. Only market participants lucky enough already to be holding the share in question will achieve super-normal returns.

In the case of Netherby, when it releases information about its change in market-servicing policy, the value of the company should rise by the value of the project, assuming that the market as a whole agrees with the assessment of its net benefits. Net present value of the project

=

£1.22m

Number of 50p nominal shares in issue

=

£5m × 2 = 10m

Increase in market price = £1.22m/10m

=

12.2p per share

(c) Arguments for and against making a rights issue include the following: For:

(i) A rights issue enables the company to maintain (or possibly, increase) its dividends, thus avoiding both upsetting the clientele of shareholders, and also giving negative signals to the market. (ii) It may be easy to accomplish on a bull market. (iii) A rights issue automatically lowers the company’s gearing ratio. (iv) The finance is guaranteed if the issue is fully underwritten. (v) It has a neutral impact on voting control, unless the underwriters are obliged to purchase significant blocks of shares. 99 © Pearson Education Limited 2015

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Against:

(i) Rights issues have to be made at a discount, which usually involves diluting the historic earnings per share of existing shareholders. However, when the possible uses of the proceeds of the issue are considered, the prospective EPS could rise by virtue of investment in a worthwhile project, or in the case of a company earning low or no profits, the interest earnings on uninvested capital alone might serve to raise the EPS. (ii) Underwriter’s fees and other administrative expenses of the issue may be costly, although some of these may be avoided by applying a sufficiently deep discount. (iii) The market is often sceptical about the reason for a rights issue, tending to assume that the company is desperate for cash. The deeper the discount involved, the greater the degree of scepticism. (iv) It is difficult to make a rights issue on a bear market, without leaving some of the shares with the underwriters. (v) A rights issue usually forces shareholders to act, either by subscribing directly or by selling the rights, although the company may undertake to reimburse shareholders not subscribing to the issue for the loss in value of their shares. (This is done by selling the rights on behalf of shareholders and paying over the sum realised, net of dealing costs.) (d) A rights issue normally has to be issued at a discount initially, to make the shares appear attractive, but more importantly, to safeguard against a fall in the market price prior to closure of the offer below the issue price. If this should happen, the issue would fail as investors wishing to increase their stakes in the company could do so more cheaply by buying on the open market. Because of the discount, a rights issue has the effect of diluting the existing earnings per share across a larger number of shares, although the depressing effect on share price is partly countered by the increased cash holdings of the company.

The two possible rights prices are now evaluated: (i) A price of £1 It is assumed that to raise £5m, the company must issue 5m new shares at the issue price of £1. In practice, it is possible that the number of new shares required might be lower than this, as the post-tax cost of the project is less than £5m due to the (delayed) tax savings generated. The company might elect to use short-term borrowing to bridge the delay in receiving these tax savings, thus obviating the need for the full £5m. Notwithstanding this argument, the terms of the issue must be ‘1-for-2’, i.e. for every two shares currently held, owners are offered the right to purchase one new share at the deeply discounted price of £1. The ex-rights price will be: [Market value of 2 shares before the issue + cash consideration]/3 = [(2 × £3) + £1]/3 = £7/3 = £2.33 (ii) Similarly, if the rights price is £2, the required number of new shares = £5m/£2 = 2.5m, and the terms will have to be ‘1-for-4’. The ex-rights price will be [(4 × £3) + £2]/5 = £14/5 = £2.80. Clearly, the smaller the discount to the market price, the higher the ex-rights price.

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(e) The cash flow benefit of the proposal, after tax at 33%

= (£2m × 0.67) = £1.34m This will coincide with the increase in profit as the existing plant is fully depreciated. The rights issue at £2 involves 2.5m new shares. The EPS was £15m/10m = £1.50 per share. After the rights issue, the prospective EPS will become [£15m + £1.34m]/12.5m = £1.31 per share With debt finance, there will be a financing cost, net of tax relief, of (12% × £5m) (1–33%) = £0.40m p.a. This reduces the net return from the project to (£1.34m − £0.40m) = £0.94m p.a. (In the first year, the cash flow cost will be the full pre-tax interest payment – thereafter, Netherby will receive annual cash flow benefits from the series of tax savings.) The EPS will be £15.94m/10m = £1.59 per share. Therefore, in terms of the effect on EPS, the debt-financing alternative is preferable, although it may increase financial risk. (f) A range of factors could be listed here. Among the major sources of risk are the following:

(i) Reliability of supply. This can be secured by inclusion of penalty clauses in the contract, although these will have to be enforceable. The intermediation of the European Bank for Reconstruction and Development may enhance this. (ii) The quality of the product. Again, a penalty clause may assist, although a more constructive approach might be to assign a UK-trained Total Quality Management expert to the Hungarian operation to oversee quality control. (iii) Market resistance to an imported product. This seems less of a risk, if retailers are genuinely impressed with the product, and especially as there are doubts over the quality of the existing product. (iv) Exchange rate variations. Netherby is exposed to the risk of sterling depreciating against the Hungarian currency, thus increasing the sterling cost of the product. There are various ways of hedging against foreign exchange risk, of which use of the forward market is probably the simplest. Alternatively, Netherby could try to match the risk by finding a Hungarian customer for its other goods. (v) Renewal of the contract. What is likely to happen after five years? To obtain a twoway protection, Netherby might write in the contract an option to renew after five years. If the product requires redesign, Netherby could offer to finance part of the costs in exchange for this option.

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CHAPTER 17

Returning value to shareholders: the dividend decision Learning objectives There is some dispute whether companies should pay dividends at all. Some observers even say it makes no difference whether a company pays dividends or not! After reading the chapter, the reader should be able to: •

Understand the competing views about the role of dividend policy.

•

Understand what factors a financial manager should consider when deciding to recommend a change in dividend payouts.

•

Understand what is meant by the ‘information content’ of dividends.

•

Know what alternatives to cash dividends may be used to deliver value to owners.

•

Appreciate the impact of taxation on dividend decisions.

•

Understand why changes in dividend payments usually lag behind changes in company earnings.

Questions summary 6. Laceby centres on the use of the DVM and the impact of variations in dividend and investment policy. It also requires consideration of the conditions under which a dividend cut could increase company value. 7. Pavlon plc requires a clear understanding of the relationship between dividend per share (DPS) and payout ratios, and the respective merits of attempting to stabilise DPS and the payout. Again, issues involving the company’s clientele are raised and again, it requires operation and criticism of the DVM. 8. Mondrian plc. This question requires evaluation of the respective views of three directors who make conflicting recommendations about the dividend policy of their firm.

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Answers to questions 6. Laceby (a) The return required by shareholders is

ERj = Rf + βj [ERm − Rf] = 11% + 0.83 [6%] = 11% + 5% = 16%

Expected value of cash flow = (0.2 × £0.5m) + (0.6 × £1.5m) + (0.2 × £4m) = (£0.1m + £0.9m + £0.8m) = £1.8m ⎡ £1.8m(1 − 33%) ⎤ NPV of project = − £2m + £1m + ⎢ ⎥⎦ 0.16 ⎣ = − £1m + £7.54m = £6.54m (b) (i) Existing value of Laceby (cum dividend)

⎡ £8m(1 − 33%) ⎤ =⎢ ⎥ + cash dividend of 50% × £8m(1 − 33%) 0.16 ⎣ ⎦ = £33.5m + £2.68m = £36.18m The ex-dividend price will fall by £2.68m to £33.5m. (The solution assumes that retentions are normally invested at the cost of capital, i.e. 16%.) (ii) In principle, the value of Laceby should increase by the NPV of the project, i.e. by £6.54m.

The cum dividend value = (£36.18m + £6.54m) = £42.72m If the project is undertaken, the dividend will be only: [‘normal’ dividend − £2m] = [£8m(1 − 33%) × 50%] − £2m = £0.68m Hence, the ex-dividend value = (£42.72m − £0.68m) = £42.04m (c) In practice, the expectation and receipt of the grant will tend to affect this calculation. The solution assumes that the grant is paid immediately. Any delay in approval and payment of the grant will lower the NPV of the project and thus lower the value of Laceby.

More fundamentally, the solution assumes that the market agrees with the company’s assessment of the value of the project and is not perturbed by any information content in the decision to lower the dividend. In reality, the market is likely to apply a ‘precautionary discount’ when managers announce details of a new project to counter what is often perceived as an optimistic bias among project sponsors. In addition, there may be a negative information content in the decision to retain. If the market considers that the real reason for the reduced dividend is concern about future earnings prospects, the price reaction could be negative, despite the apparent attractions of the project. Finally, if existing shareholders, due to their time preferences and tax positions, rely heavily on a stable flow of dividends, such interference in their income stream, causing them to borrow or sell shares, will have an adverse impact on the company value.

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7. Pavlon plc (a) Years prior to listing

No. of shares

Total dividend

Payout ratio

21.33m

£768,000

42.7%

4

21.33m

£1,024,000

42.7%

3

26.67m

£1,642,860

42.7%

2

26.67m

£1,750,000

42.7%

1

26.67m

£1,898,000

42.7%

Current

40m

The number of shares is found by working backwards from the present figure of 40m and adjusting by the two specified new issues (50% at listing and 25% three years previously). The total dividend paid is found by multiplying the dividend per share by the number of shares and the payout ratio then follows. The company’s declared objective is to maximise shareholder wealth. In principle, a variety of dividend policies is consistent with this aim depending on factors such as the tax position of the clientele and whether dividend policy has been used to convey information to the market. Pavlon has followed a remarkably consistent dividend policy, adhering to a constant payout ratio. At the time of listing, it would presumably have stated its dividend policy in its prospectus and unless specified otherwise, shareholders would have been justified in expecting continuation of this policy. A switch in dividend policy so soon after listing is certain to offend at least some portion of its clientele. However, whether the pursuit of a constant payout ratio is rational is debatable. As long as earnings are increasing, the company is able to continue to increase dividends, but should earnings fall, adherence to a constant payout implies lower dividend per share and possibly lower share price. It is more usual to follow a dividend policy incorporating a stable dividend per share, with ample dividend cover, to allow earnings fluctuations to be smoothed out. (b) The interim of 3.16p per share plus the proposed final of 2.34p makes a total payment of 5.50p per share, which represents a cut in dividend per share of 23% and involves a payout ratio of 40%. A large cut in DPS is associated with only a small cut in the payout ratio because, while issued share capital has risen by 50%, the profit after tax has increased relatively slowly (24%). The new shares were issued presumably to finance some new projects and perhaps some acquisitions. In either case, these investments do not yet appear to have had a substantial pay-off. Against this background, the proposed dividend cut could be construed as signalling concern over faltering new ventures.

If the majority of shares are owned by wealthy private individuals, the proposed dividend cut may be beneficial if it enables them to convert dividend income into capital gain. However, retention will only generate capital gain if the market expects the company to utilise the finance involved in a profitable fashion. If the majority of shares are owned by institutions, the proposed dividend cut may be undesirable. Many institutions rely on a steady stream of dividend income to meet their largely known liabilities, while some are exempt from income tax and therefore prefer dividend income to capital gains.

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There are, therefore, two issues here – whether the company’s recent financial performance is viewed as disappointing or not, and whether the shareholders actively prefer dividend income. (c) The Dividend Valuation Model states

share price =

D1 ke − g

This ‘works’ so long as ke is greater than g. However, for the next three years, dividend growth of 15% is expected. Therefore, the valuation calculation must be a multi-stage exercise, valuing the dividend stream over periods of fast and slow growth respectively, i.e. P0 = (PV of dividends over Years 1–3) + (PV of subsequent dividends)

=

D3 P3 D1 D2 + + + 2 3 (1.12) (1.12) (1.12) (1.12)3

where P3 = end of Year 3 share price and hence the PV of dividends from Year 4 and thereafter. P0 =

7.12p(1.15) 7.12p(1.15) 2 + (1.12) (1.12) 2

P3 7.12p(1.15)3 + (1.12)3 (1.12)3 [10.83p(1.08)](PVIF12,3 ) = 7.31p + 7.51p + 7.71p + [0.12 − 0.08] = 22.53p + 292.5p(0.7118) +

= 22.53p + 208.20p = 230.73p, i.e. £2.31 The present share price is:

market value £78m = = £1.95 number of shares 40m On this basis, Pavlon appears to be undervalued. (d) In addition to some mathematical weaknesses, such as inability to cope with zero dividend payers and cases where ke is less than g, the DVM suffers from several key weaknesses. It assumes infinite company life, and a constant rate of growth over specified periods. Constant growth, in turn, implies a constant retention rate and a constant rate of return on re-invested earnings. Moreover, dividend-paying capacity is not the only guide to a company’s value. Some companies may experience significant increases in asset value that exerts a more important influence on share price. However, this is really a signal that the assets concerned are more valuable in an alternative use. 8. Mondrian plc (a) The position taken by Director A reflects the traditional view of dividend policy, which assumes that investors would prefer dividends today rather than either dividends or capital gains at some future date. This is because investors prefer a certain sum of cash today to an uncertain return in the future. The implications of this view for dividend policy are that companies should attempt to pay out as much in the form of current dividends as is 105 © Pearson Education Limited 2015

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consistent with the long-term objectives of the company. It is argued that, because investors dislike uncertainty, they will apply a rising discount rate to future returns. Thus, if current dividends are lowered in order to ensure high investment for the future, the value of the company will fall as future dividends will be discounted at an increasing rate over time. However, many believe that such views are based on a misconception of the nature of risk. It can be argued that there is no reason why risk needs to necessarily increase over time. Risk arises from the nature of the activities undertaken by the company and investors will normally demand a higher return from companies that engage in high-risk ventures than companies that engage in low-risk ventures. The level of risk associated with the activities of a company will already be reflected in the discount rates applied to investment projects when assessing future returns. The view of Director B is supported by the work of Miller and Modigliani (MM). MM demonstrated that, given certain restrictive assumptions, dividend policy is irrelevant. They show that dividends do not change shareholder wealth but only its location. MM argue that the value of a company will be determined by the level of future earnings, and the degree of risk associated with the company. The way in which earnings are divided as between dividends and retentions is not important. The level of dividend will not influence share values providing the amounts retained are invested in similarly profitable projects. Any reduction in dividends will be compensated by an increase in capital gains. In the event that a shareholder requires cash, ‘home-made dividends’ may be created through selling a portion of the shares held. Thus, any differences in the consumption patterns of shareholders will be irrelevant. The arguments of MM concerning dividend irrelevance rest on a number of important assumptions, which include the absence of taxes and share transaction costs, and shareholders and managers having identical information concerning future investment opportunities. These assumptions do not hold in the real world and, as a result, the arguments put forward by MM are weakened. Differences in tax treatment between dividends and capital gains have led many investors to prefer capital gains as we discuss in some detail below. In addition, share transaction costs can be relatively high when small amounts are being dealt with. The view of Director C can be supported because of the different treatment, for taxation purposes, afforded to dividends and capital gains. In the United Kingdom, dividends are taxed at the taxpayer’s marginal rate of income tax, whereas, in the past, capital gains are taxed at a variable rate – 18% or 28%, depending on the investor’s income level. This difference in tax treatment leads many investors to prefer capital gains to dividends. Tax on capital gains only arises when the gain is realised which means that investors can defer payment of the tax, or perhaps even offset the capital gains in a year when a capital loss arises. In addition, a certain amount of capital gain arising in a particular year is exempt from taxation. However, there are practical problems associated with the view that dividends should not be paid. The creation of ‘home-made dividends’ as a substitute for a company dividend policy, as suggested above, may be difficult due to problems which include the share transaction costs referred to earlier, the indivisibility of shares leading to investors being unable to sell precisely the amount of shares required, and the lack of marketability of shares in unlisted companies.

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(b) A number of factors will influence the level of dividends that may be paid by a company. These include:

(i) Availability of profits Dividends are payable only out of profits which the law defines as being available for distribution, i.e. current profits plus retained earnings. (ii) Shareholder requirements The requirements of shareholders concerning the balance between dividends and capital gains should be considered. (iii) Market expectations The market may have expectations concerning the level of dividends payable that the company may wish to meet in order to retain the confidence of investors. (iv) Liquidity The cash available for dividend payments must be determined. Other commitments of the business (e.g. purchase of fixed assets) will influence the amount considered prudent to distribute to shareholders. (v) Market signals Dividends can be used by companies to signal to the market the directors’ views concerning the future. For example, a higher than expected dividend may be used to signal confidence in future earnings levels. (vi) Financing policy Some companies may decide to re-invest a high proportion of earnings, thereby leaving a relatively small amount available for dividends. This policy may be adopted for various reasons including the avoidance of dilution of control and share issue costs. (vii) Loan restrictions A company may be prevented from announcing a high dividend because of loan covenants. To protect lenders, a loan agreement may contain a clause restricting the level of dividend that can be paid to shareholders. (viii) Earnings pattern A company that has a volatile earnings pattern may decide to smooth the flow of dividends over time. This will involve retaining a proportion of profits during years when profits are high in order to be able to distribute dividends when profits are low or losses are being made. Thus, the future pattern of earnings volatility may influence current dividend policy.

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CHAPTER 18

Capital structure and the required return Learning objectives This chapter has the following aims: •

To explain some of the ways of measuring gearing.

•

To enable you to understand more fully the advantages of debt capital.

•

To explain the meaning of, and how to calculate, the Weighted Average Cost of Capital (WACC).

•

To help you to understand the likely limits on the use of debt, and the nature of ‘financial distress’ costs.

•

To help you understand the issues involved in financing foreign operations.

•

To enable you to understand the factors that a finance manager should consider when framing capital structure policy.

Questions summary 6. Zeus plc. This question involves calculation of the WACC from the data provided in the balance sheet. 7. RH plc. This question examines the impact of different ways of financing a new activity and the effects on the gearing measures and the WACC. 8. Celtor plc. This question involves explanation of the cost of capital concept, and discusses the main factors that determine a company’s cost of capital. The question also requires the calculation of the WACC. 9. Redley plc requires calculation of dividend cover and dividend yield for a company with sharply rising profits and requests advice about alternative ways of reducing an increasing cash surplus.

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Answers to questions 6. Zeus plc

Capital structure: Market value of equity Market value of the debenture

=

no. of shares × share price

=

2m × £1.36

=

£2.72m

=

£0.7m × 60%

=

£0.42m

=

£0.80m

Plus long-term loan

£3.94m Percentage

cost

Equity

69.0

19.1%

Debenture

10.7

13.3%

Long-term loan

20.3

17.0%

100.0

Cost of equity: dividend growth found from

ke

=

10.0 (1 + g)4

=

13.7

when g

=

8.2% (approx.)

=

13.7(1.082) + 0.082

D1 + g P0

Cost of debenture =

Coupon rate Market value

Cost of long-term loan WACC

£ 1.36 =

0.109 + 0.082

=

19.1%

=

8% × 100 60

=

13.3%*

=

16% + 1%

=

17%*

=

(19.1% × 69%) + (13.3% × 10.7%) + (17% × 20.3%)

=

(13.2% + 1.4% + 3.5%)

=

18.1%

∗Note that the incorporation of tax relief on interest payments would reduce this figure appreciably (so long as Zeus was able to utilise the tax relief available on debt interest).

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7. RH plc (a) (i) The current market capitalisation = (2m shares × £1.68) = £3.36m.

The present value of the cash flows from the investment project is (£0.3m [1 − 33%]/18%) = £1.12m (i.e. the NPV is (£1.12m − £1m) = £0.12m). Under all-equity financing, market capitalisation should rise by the full value of the project as it involves additional financing, i.e. to (£3.36m + £1.12m) = £4.48m. If the finance is raised via borrowing at 12% p.a., the net cash flow will be: (£0.3m − interest on £1m at 12%) [1 − 33%] = £0.12m p.a. At 18%, this has a PV of (£0.12m/0.18) = £0.67m. On the assumptions given, this would be the increase in the market capitalisation (i.e. the project is debt-financed). The new capitalisation is (£3.36m + £0.67m) = £4.03m. (ii) Assuming equity financing, gearing becomes (£1m/£4.48 + £1m) = 18.25%.

Assuming borrowed finance, gearing is £2m/(£4.03m + £2m) × 100 = 33.2%. (iii) Assuming equity finance, the WACC is:

(10% [1 − 33%] × £1m/5.48m) + (18% × £4.48m/£5.48m) = (6.7% × 0.18) + (18% × 0.82) = 16.0% Assuming borrowing, the WACC is: (10% [1 − 33%] × £1m/[£4.03m + £2m]) + (12% [1 − 33%] × £1m/6.03m) + (18% × £4.03m/£6.03m) = (6.7% × 0.165) + (8.0% × 0.165) + (18% × 0.67) = 14.5% (b) Report to: The Board of RH plc From:

Financial Manager

Subject:

Financing Alternatives

Date:

24th November 1998

Introduction

At our recent meeting, you had instructed me to examine alternative ways, and consequences, of raising an extra £1 million for working capital investment. Using the assumptions we discussed, and assuming that the aim of the exercise is to maximise Market Value-Added, i.e. the excess of market capitalisation over funds provided by shareholders, the borrowing alternative is superior. This offers an increase in the net value of equity of £0.67 million, compared with only using equity of £0.12 million. (See attached computations). Reservation

However, the equity enhancement may be moderated by the stock market’s possible adverse reaction to the increased level of capital gearing. As you know, increased gearing pre-empts a greater proportion of earnings before interest and tax for interest payments, thus increasing the volatility of the net after-tax earnings available to the shareholders. In an efficient financial market, rational investors will demand higher rewards for bearing greater risk, i.e. the cost of equity will increase, possibly negating or reversing the decrease in the WACC implied in my calculations. However, the increase in the discount rate applied to shareholder earnings that would be required to eliminate the potential increase in the market value of equity, would be implausibly substantial. 110 © Pearson Education Limited 2015

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Other issues

Debt may carry restrictions in the form of covenants. Long-term finance may be unnecessary to fund working capital. The ‘Golden Rule’ of finance argues that short-term assets should be financed by short-term means, for example, a bank overdraft facility that has greater flexibility so far as interest is only paid on any balance overdrawn. A revolving credit facility may be more suitable, as this is, in effect, a medium-term overdraft, and our requirement is for medium-term finance. Non-financial factors

Given that our need is for working capital, we should consider ways of shortening the operating cycle and thus reducing our investment in working capital. This involves close scrutiny of stock management and consideration of the extent to which, and how, we can speed up collections and slow down payments to suppliers. We would need to canvass the views of our major shareholders, especially concerning the acceptability of a rights issue, given that it could dilute control. The future prospects for the economy have an important bearing on our prospective level of sales, and hence ability to meet the interest payments out of the operating cash flows. Volatility in cash flows will also depend on our level of operating gearing. We might consider ways of eliminating some fixed operating costs, for example, by outsourcing some activities. If you require further details on any of these points, please contact me on my mobile. Signed: F. Manager, ACMA 8. Celtor plc (a) A company’s cost of capital is the discount rate which, when used to discount the future cash flows of the particular company, will not result in any change in the value of the business. The cost of capital is crucial in appraising investment opportunities, because it represents the minimum return required for investors. The net present value (NPV) of an investment project is calculated by discounting its future cash flows by the cost of capital of the company.

For a company wishing to maximise the wealth of its shareholders, only investment projects yielding a positive NPV should be accepted. If the cost of capital is calculated incorrectly, this may, in turn, lead to incorrect investment decisions. If the cost of capital is overstated, the resulting NPV of a project may be shown to be negative, whereas, if the correct cost of capital were applied to the cash flows, the NPV would be positive. Conversely, if the cost of capital is understated, the resulting NPV of a project may be positive, whereas, if the correct cost of capital were applied, the NPV may be negative. In this case, the investment should not be undertaken. (b) The main factors that determine the cost of capital of a company are as follows:

Business (or Activity) risk. These are risks associated with the nature of the business in which the company is engaged. The higher the level of these risks, the higher the level of return investors will require as compensation. Financial risk. Where a company takes on gearing, it risks inability to make interest payments and capital repayments when they fall due. Other things being equal, the higher the level of gearing, the greater the level of risk for shareholders. As a result, shareholders in highly geared companies are likely to demand higher returns than shareholders in lowgeared ones. 111 © Pearson Education Limited 2015

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Taxation. In the United Kingdom, interest payments in respect of loans attract relief from corporation tax. In calculating the weighted average cost of capital of a company, the aftertax cost rather than the pre-tax cost of interest payments is relevant. Thus, the cost of loan capital to the company will be determined, in part, by the relevant rate of corporation tax for the period. Inflation. During a period of inflation, the money rate of return required by investors is likely to increase in order for investors to protect their real rates of return from investment. Other investment opportunities. The required returns by investors in a particular company will be influenced by the returns offered in similar types of investment opportunities. Marketability of investment. Where shares are purchased in a public limited company that is listed on a recognised stock exchange, it is relatively easy for investors to dispose of their shareholdings when they so wish. However, shares of a private limited company are likely to be more difficult to sell. As a result, investors in private limited companies are likely to require a higher rate of return in compensation. All of the above factors help determine the cost of the individual elements of capital. These individual elements are then combined, using market values, to obtain the weighted average cost of capital. (c) Weighted average cost of capital (WACC)

Cost of equity:

ke =

D1 +g P0

(20p × 1.04) + 4% 390p = 9.3% =

Cost of loan capital (after tax) Interest(tax-adjusted) Value of debt 9(1 − 0.25) = × 100 80 = 8 .4 %

kd =

Weighted average cost of capital (WACC) Target capital Cost

Structures

%

(Weights)

%

Cost of equity

9.3%

100

58.8

Cost of debentures

8.4%

70

41.2

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WACC

=

(9.3% × 58.8%) + (8.4% × 41.2%)

=

5.5% + 3.5%

=

9%

9. Redley plc (a) Payout ratios/dividend cover:

Redley’s last dividend was 1.45p per share, making a total payout of £90m × 2 × 1.45p = £2.61 m. The profit after tax (£m) was: Profit before interest and tax

27.00

Interest

(2.70)

Taxable profit

24.30

Tax @ 33%

(8.02)

Profit after tax

16.28

Payout ratio £2.61m/£16.28

= 16%

Dividend cover

= 6.3 times

Share price

= EPS × P:E ratio = [£16.28/180m] × 17 = 9p × 17 = £1.54

Dividend yield

= DPS/Share price = 1.45p/£1.54 = 0.9%

(This represents [0.9%/1 − 20%] = 1.2% before 20% income tax.) If the present cash balances are used to increase the dividend by £10m, making a total dividend of (£2.61m + £10m) = £12.61m, the figures (in £m) will appear thus: Profit before interest and tax

42.00

Interest

(2.70)

Taxable profit

39.30

Tax @ 33%

(12.97)

Profit after tax

26.33

% Payout £12.61/£26.33

= 48%

Dividend cover

= 2.1 times

DPS

= £12.61m/180m = 7p

Dividend yield

= 7p/[(£26.33m/180m) × 17] = 7p/£2.48 = 2.8%

(or [2.8%/1 − 20%] = 3.5% before 20% income tax) This represents a substantial fall in dividend cover, from significantly above the sector average to well below it. Such an apparent shift in dividend policy is bound to provoke comment, both from shareholders and also from the market, in general.

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(b) Report to: Redley plc Finance Director Subject:

Utilisation of excess cash balances

From:

Financial Strategist

Date:

Everyday

1. Introduction We have built up significant cash balances over the past year because of exceptional growth in sales and profits, as the economy has recovered from recession, sparking demand for the high-quality building products in which we specialise. There are several possible uses for surplus cash balances, such as investment in the short-term money market and acquisition of other companies. However, my remit is to consider only two such uses: first, an increase in dividends; and second, early repayment of the long-term loan stock, which is repayable in 2004. This report will consider each of these in turn. 2. Dividend increase The factors that need to be considered and investigated are as follows: (i) The preferences of our shareholders. Many shareholders would have purchased Redley shares rather than those of competing companies with higher payouts hoping for long-term capital growth rather than dividend payments. In the past, we have served their interests by restricting dividends and ploughing back profits into the business. We will need to consider how they are likely to respond to such a sharp shift in our distribution policy, albeit because of lack of investment opportunities. (ii) Shareholders’ tax position. A major determinant of shareholders’ preferences is their liability to tax. Some institutional shareholders enjoy tax advantages from distribution, while some private shareholders, perhaps the majority, prefer capital gains to dividends because of the tax advantages attached to the former. This factor underlines the need to inspect our shareholder register and to consult with major shareholders. (iii) Actual and expected liquidity. We are highly liquid at present and have no plans to engage in significant capital expenditures. However, it is prudent to examine our medium- to long-term capital requirements to ascertain whether the cash balances concerned are best left on deposit so as to avoid having to mount a major capital-raising exercise in the future. By the same token, group cash flow forecasts will need to be examined to identify any major demands for cash of a non-capital nature, for example, closure costs, in the foreseeable future. (iv) Loan covenants. It is proposed to lower dividend cover significantly. Our lawyers will have to inspect the terms of our long-term loan outstanding to discover whether there are any restrictions on dividend payouts. (v) Stock-market reaction. The proposal is to pay more than triple dividend payments. Clearly, this represents a major departure from the past policy and raises several issues. Presumably, we will present this payment as a special dividend of the kind paid by certain UK utility companies in recent years to dampen any expectations of similar increases in the future. This would best be done by paying it at a time different to the regular dividend. However, this requires the tactical question of the extent to which the ‘normal’ final dividend should be raised. If the normal dividend is also raised significantly, this will signal directors’ confidence in our ability to sustain future payments and thus exert pressure on the company to meet these expectations. Given that our earnings are cyclical and have recently been depressed, it is important that we settle 114 © Pearson Education Limited 2015

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on a dividend payout policy, which we feel confident of maintaining through the various phases of the business cycle. The stock market tends to be unforgiving of companies which cut dividends. 3. Repayment of the loan stock (i) Conditions of the loan. We must scrutinise the terms of the loan to ascertain whether early payment is permitted and whether it triggers any penalties. (ii) The tax shield. If we repay the loan, we will lose the benefit of the tax relief accorded to debt interest payments. Admittedly, the tax saving is not substantial, i.e. [33% × 9% × £30m] = £0.9m, but it is nevertheless, worthwhile. Given our recent increase in profitability, and assuming that this can be sustained, there is a strong case for increasing gearing rather than reducing it, although this would be contrary to our traditional policy. Our capital gearing is well below, and our interest cover is well above, current industry averages:

Redley Capital gearing

Industry

£30m/£200m = 15%

48%

£42m/£2.7m = 15.6 times

5.9 times

(ignoring retentions for the current year) Interest cover

(iii) Interest rate expectations. If we need to borrow sometime in the future, we will lose, if future interest rates exceed 9%, since we will have effectively replaced 9% debt by higher-cost debt. The reverse argument also applies. (iv) Reaction of the market. When companies with high gearing levels and thus high levels of financial risk repay debt, there is usually a favourable effect on share price. Given our low level of gearing, it is doubtful that there would be any such benefit. Indeed, the effect could be adverse, if the market perceives the debt retirement as a signal of harder times ahead.

4. Recommendation Subject to the conditions of the existing loan, if we believe that our profitability will remain buoyant, there is a strong case for raising the level of dividends and for increasing our level of financial gearing. The risks seem low, although we will need to consult our major shareholders to sound out their potential reactions.

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CHAPTER 19

Does capital structure really matter? Learning objectives This chapter offers a more theoretically oriented analysis of capital structure decisions. After reading it, the reader should: •

Understand the theoretical underpinnings of ‘modern’ capital structure theory.

•

Appreciate the differences between the ‘traditional’ view of gearing and the Modigliani– Miller versions.

•

Appreciate how the CAPM is integrated into capital structure analysis.

•

Be able to identify the extent to which a Beta coefficient incorporates financial risk.

Questions summary 4. Kipling plc. This question requires discussion of the arguments as to whether it is possible to lower the WACC by gearing, and of the relative merits of financing by debt and by preference shares. 5. Berlan plc/Canalot plc. This is a two-part question. Berlan involves a straightforward calculation of the WACC, using the Dividend Value Management (DVM) to derive the cost of equity, and the Internal Rate of Return (IRR) method to find the cost of debt. Canalot is more complex, requiring application of the MM theory with tax to find the value of a geared company and its component securities, and then to deduce the WACC. 6. Stanley plc. This question requires calculation of share price, the value of equity and the value of a whole firm in an MM with-tax world under alternative financing options. 7. Electronics plc. This question uses the CAPM in a mixed capital structure context to find a company’s existing cost of equity, and the effect on this of retiring some of its debt. The impact of diversification into activities of different business areas is also examined. 8. Claxby requires consideration of the impact of corporate restructuring on Betas and required returns, and also the relative systematic and unsystematic risk components of the overall company. As in Chapter 9, the issue of whether corporate diversification is necessarily beneficial for shareholders is raised.

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Answers to questions 4. Kipling plc

At present, Kipling has the following capital structure: % Equity (£2.5m + £1m + £1.4m)

£4.9m

56.3

Preference shares

£1.2m

13.8

10% Debentures

£2.6m

29.9

£8.7m

100.0

Counting the preference shares as debt (i.e. fixed charge capital), the fixed charge capital is 43.7%. Alternatively, counting the preference shares as part of shareholders’ funds, the gearing ratio (long-term debt to total capital) is 29.9%. These are not especially high figures, but whether they would give cause for concern or not would depend on the nature of the industry, its operating gearing and the prospects for trading conditions, bearing in mind that capital structure per se is less significant than interest cover in signalling the changes of gearing. For example, if Kipling’s products are income-elastic and the economy is moving into recession, a reduction in profitability and the cash flow out of which interest payments are made may be imminent. (a) The traditional view of capital gearing suggests that, at modest levels of gearing, equity investors will not increase their required rates of return following the increase in risk from the introduction of additional gearing. As debt is less costly than equity capital, this means that increased gearing may reduce the Weighted Average Cost of Capital of the company. However, beyond a certain point, the level of risks involved will be more significant and the expected returns required by shareholders will rise. The point at which the WACC is at its lowest is considered to be the optimum level of gearing for the company. Here, the value of equity shares is maximised.

This view of gearing has been challenged by Modigliani and Miller (MM). In the purest form of their hypothesis, they argue that the WACC will be constant at all levels of gearing. They assert that the value of business will not be affected by the way in which it is financed. Hence, it is not possible to increase the value of a business by assuming additional gearing. MM argue that shareholders’ required rates of return will change immediately if there is a change in the level of gearing and, furthermore, will rise in proportion to increases in the level of gearing. Thus, any benefit from the introduction of low-cost loans will be immediately cancelled out by a corresponding increase in shareholders’ requirements. The MM position, although on the basis of rigorous logic, does rest on certain simplifying assumptions, such as the absence of bankruptcy costs and a constant cost of debt. (b) The main factors to consider when deciding between preference shares and debentures are as follows:

Payment of interest and dividends. It is of vital importance that a company honours its commitment to pay interest on debentures and makes capital repayments when due. Failure to do so can have grave consequences for the company. At the extreme, a company may have its assets seized by lenders or be forced to cease trading if it is unable to pay the amounts due. However, failure to pay a preference dividend will have less serious

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consequences. Preference shareholders have no right to receive a dividend if there are insufficient profits available for distribution. Rates of return. Preference shareholders will normally expect higher rates of return than debenture holders. This is because, from the investors’ viewpoint, there are higher risks associated with preference shares than debentures regarding both income received and capital repayments. Taxation. In the United Kingdom, debenture interest is an allowable expense, which can be offset against profits, whereas preference dividends are regarded as an appropriation of after-tax profits. This difference in tax treatment has meant that debentures are normally viewed as more attractive when raising non-equity finance. Redemption. Preference shares and debentures may be issued in a redeemable form. However, the conditions attached to redemption are significantly different. Redemption of preference shares requires either an issue of new shares or a transfer from distributable reserves (or some combination of these) to offset the reduction in share capital. However, redemption of debentures does not require replacement in the same way. Security. To make a debt issue attractive to investors, it is usual to offer some form of security to prospective lenders. However, preference shareholders are members of the company and cannot be offered such security. In the event of the company being wound up, lenders rank higher than preference shareholders in order of payment. Management restrictions. The issue of a debenture loan may carry with it various restrictive covenants, which inhibits management’s freedom of action. For example, there may be restrictions concerning issue of further loans and payment of dividends to shareholders. There may also be requirements concerning levels of liquidity to be maintained. These restrictions and requirements are designed to protect the interests of the lenders. For a debenture secured on assets of the company, management may also have to seek permission from debenture holders before disposing of the assets. Preference shareholders, however, cannot impose such restrictions on the actions of management. (c) Factors that may influence the level of debt financing by the company include:

Sales and profits. Companies that have stable or growing sales and profits are better placed to finance the fixed interest charges and capital repayments than companies that have volatile or declining sales and profits. Hence, higher profits make it feasible to sustain higher levels of gearing. Companies may, in practice, change their gearing according to changing economic conditions. Security. Companies wishing to raise debt finance usually have to offer some form of security. Lenders will normally require good-quality assets as security for any loan offered. If such assets are not available, or are already secured, it may not be possible for the company to raise debt finance. Kipling plc has already issued debentures and may have problems in finding security for additional debt. Borrowing restrictions. The company may have restrictions placed on it concerning the additional amount of debt finance it can raise. These restrictions may be contained in the company’s Articles of Association or in earlier loan agreements, or in policy decisions made by the owners. Kipling plc may, therefore, be restricted because of the previous issues of debentures. Cash availability. A company must ensure that it has the cash resources to make interest payments and capital repayments when due. Failure to do so can have serious consequences.

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Risk/returns. The higher the level of debt finance, the higher is the level of financial risk associated with the company. This higher level of risk is likely to lead to higher expected returns from prospective lenders. Beyond a certain level of debt finance, however, the costs may become too high. Kipling plc already has a significant level of gearing and this must be taken into account when assessing the feasibility of further borrowing. 5. Berlan plc/Canalot plc (a) Because Berlan has constant expected earnings and no retentions, the cost of equity can be estimated using the basic Dividend Valuation Model, that is:

ke =

Annual dividend D = Market value (ex-div) V

Earnings available for dividend payments are as follows: £000 EBIT

15,000

Interest = £23.697m × 16% =

(3,792) 11,208

Taxation at 35%

(3,923) 7,285

As the ex-dividend share price is 80p and the number of shares issued is 50m, the market value of the equity. = 80p × 50m = £40m. Hence, k e =

7, 285 = 18.2% 40, 000

The cost of debt, kd, can be found by discounting the stream of after-tax interest payments and the redemption payment, and equating the resulting sum to the market value. Thus (in £m):

105.5 =

16(1 − 35%) 16(1 − 35%) 16(1 − 35%) + 100 + + 1 + kd (1 + kd ) 2 (1 + kd )3

Discounting at 8%, NPV = 0.70 Discounting at 10%, NPV = (4.54) By interpolation, kd = 8% + = 8.3%

0.70 × 2% 0.70 + 4.54

The market value of Berlan’s debt is: £23.697m × (£105.5 per £100) = £25m Hence, the WACC is: 40 ⎞ ⎛ 25 ⎞ ⎛ = ⎜18.2% × ⎟ + ⎜ 8.3% × ⎟ 40 + 25 ⎠ ⎝ 40 + 25 ⎠ ⎝ = 11.2% + 3.2% = 14.4%

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(b) (i) Under MM’s revised proposition with tax, the market will value a geared company at the equivalent all-equity financed company value plus the tax shield, i.e.:

Vg = Vu + TB For Canalot, this is: Vg = £32.5m + (£5m × 35%) = £34.25m This is a premium of £1.75m over the corresponding all-equity value. (ii) For a geared company, the market value of equity, Vs, is found simply by subtracting the market value of debt from the total market value, that is:

Vs = Vg − VB = £34.25m − £5m = £29.25m Assuming that Canalot is meeting its cost of capital, the gross EBIT is:

100 ⎞ ⎛ ⎜ £32.5m × 18% × ⎟ = £9m 65 ⎠ ⎝ The earnings available for dividend are as follows: EBIT − Interest − Tax = [£9m − (£5m × 13%)] × (1 − 35%) = £5.428m The cost of equity is thus,

ke =

Earnings £5.428m = Market value of equity £29.25m

= 18.6% This result suggests that the introduction of financial risk has induced shareholders to raise their rate of return requirement by 0.6%. NB. Alternatively, the cost of equity can be found from the equation:

keg = keu + (keu − kd )

VB (1 − T ) Vs

(iii) The WACC is given by:

⎛ ⎞ 29.25 ⎞ ⎛ 5 ⎜18.6% × ⎟ + ⎜13%[1 − 35%] × ⎟ 29.25 + 5 ⎠ ⎝ 29.25 + 5 ⎠ ⎝ = 15.9% + 1.2% = 17.1% (c) Many managers and financial analysts appear to believe that there exists an optimum level of financial gearing at which the market value of the company is maximised and its overall cost of capital is minimised. The actual optimum is likely to vary according to differences in reliability of cash flow, business risk and marketability of fixed assets. These factors probably differ between industries because of differences in technology and inherent business risk, but there may exist, a definable optimum capital structure for particular industries. This suggests a U-shaped cost of capital profile in relation to the gearing ratio.

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Initially, as gearing increases, the stock market will acknowledge the beneficial effects on EPS but as gearing increases beyond a critical ratio, the required return by shareholders begins to rise, outweighing any further beneficial effects of using debt. If this optimum is definable, it follows that managers should move to this gearing ratio and adhere to it in any subsequent project financing. In practice, this presents difficulties insofar as market values continuously fluctuate, thus pulling the actual ratio, at any point in time, out of alignment with the optimum. Also, it is often not possible to finance specific projects in the optimum proportion. It is likely that managers have in mind an optimum longer-term gearing ratio as a target around which the actual ratio will oscillate. It follows that there is probably a range of capital structures that are considered equally acceptable by the market. However, if the company strays outside this range, it is likely to be punished by a downgrading of the share price in the market. Modigliani and Miller (MM) showed that under certain highly restrictive assumptions, including the absence of corporate profits tax, there was no optimum capital structure. With the introduction of corporate tax, it appeared that the cost of capital would continuously decline until there is just under 100% debt in the capital structure. However, the implication that the optimum capital structure should be comprised almost entirely of debt has been rejected for two broad reasons: (a) Lack of realism of assumptions. However logically the conclusions follow from the assumptions of the model, if the underpinnings of the theory are blatantly unrealistic, it is unlikely to win broad support from practising business people. For example, MM assumed that individuals could borrow at the same interest rate as companies, that borrowing costs did not vary with the level of borrowing, that information was freely available and that there were no transaction costs and no bankruptcy costs. (b) It ignores the costs associated with high levels of gearing, including those of financial distress. When the impact of these factors begins to outweigh the tax benefits of debt finance, there may appear an optimum level of gearing beyond which the cost of capital will increase. These factors are: (1) Bankruptcy costs. The direct costs associated with corporate failure that would not occur if the company thrives. As gearing (and interest payments) increases, the probability of bankruptcy also increases along with the associated costs. (2) Agency costs. Agency costs arise because of the constraints (e.g. restrictive covenants) that suppliers of finance (the principals) impose on managers (the agents) to protect the principals’ interests. At high levels of gearing, more onerous constraints are likely to be imposed. (3) Tax exhaustion. Debt finance is attractive because of the tax relief on interest payments. This tax relief is only available if a company has enough tax liability on its earnings to utilise the tax relief. The higher the gearing level, the more tax relief is available and the greater the chance of tax exhaustion where there is insufficient liability to utilise available relief. Use of non-debt corporate tax shields, especially capital allowances on investment, will also affect the likelihood of tax exhaustion. (4) Debt capacity. Since adequate security must be provided on many types of debt, a company’s financial gearing may be limited by its ability to offer acceptable security to lenders. When these factors are included, the resulting cost of capital profile appears remarkably like that of the traditional theory, which tends to support the view commonly held that there does 121 © Pearson Education Limited 2015

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exist an optimum gearing ratio. However, this ratio is likely to vary across industries and also alter over time along with changes in expectations about the future earnings of companies, which in turn influence notions of ‘safe’ levels of gearing. 6. Stanley plc (a) With new investment and equity (£m)

Current (£m)

With new investment and debt (£m)

79.500

85.2001

85.200

0

0

(4.560)3

79.500

85.200

80.640

(26.235)

(28.116)

(26.611)

50.000

2

50.000

107p

104p

108p

P:E ratio

9.0

9.5

8.5

Share price (pence)

963

988

918

Market value equity

481.500

540.011

459.000

Market value debt

0

0

38.000

Market value firm

481.500

540.011

497.000

EBIT Interest EBT Tax @ 33% Ord. shares of £1 each EPS

54.657

Notes (1) £79.500 + (£38.000 × 15%) (2) £50.000 + [£38.000/(960p × 85%)] (3) £38.000 @ 12% Apparently, using equity is preferable because of the expected adverse impact of gearing on the P:E ratio. (b) (i) MV of equity = MV of ungeared firm (Vug)

= (£85.2m × 1 − T)/0.14 = £407.7m (ii) MV of geared firm = Value of ungeared (Vug) firm + tax shield (TS) − financial distress cost (FD) Vug

=

(85.2 × 1 − T)/0.14

=

£407.743

TS

=

(£38m × 0.12 × 0.33)/0.12

=

£12.540

FD

=

£5m

=

(£5.000)

=

415.283

Note that, in the geared case, the value of the equity = [Value of firm − Value of debt] = [£415.3m − £38m] = £377.3m

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7. Electronics plc

Notice that there is no mention of taxation in this question, so we are dealing with a pure MM – no tax world. (a) Using the CAPM,

ke = 6% + 1.33 [13.5% − 6%] = 6% + 10% = 16% To find market value of the shares:

P0 =

D1 ke − g

g = retention ratio × return on re-invested earnings (ROE) = (b.R) = (1 − 60%) × 20% = 8% £2.0 = £25 16% − 8% Market value of equity = £ 25 × 1m = £25m To find market value of debt: Hence, P0 =

PV = (10% × £100) (PVIFA8.5) + £100 (PVIF8.5) = (£10 × 3.9927) + (£100 × 0.6806) = £39.93 + £68.06 = £108 per £100 of stock Value of debt = 1.08 × £20m = £21.6m Asset Beta (or Beta ungeared)?

=

βG 1+

VB VS

=

1.33 1.33 = £21.6m 1.864 1+ £25m

= 0.71 Overall cost of capital = 6% + 0.71 [7.5%] = 11.3% (NB. Using the standard formula for the WACC will only yield the same answer if the risk-free rate is used as the cost of debt.) (b) 50% of debt at current market value

= 0.5 × £21.6m = £10.8m As the activity Beta is unchanged, the new equity Beta is:

⎡

β = 0.71 ⎢1 + ⎣

VB ⎤ ⎡ £10.8m ⎤ ⎥ = 0.71 ⎢1 + ⎥ VS ⎦ ⎣ £25.0m ⎦

= 0.71 × [1.432] = 1.02 ke = 6% + 1.02[7.5%] = 13.65% In an MM world, the overall cost of capital is unchanged. 123 © Pearson Education Limited 2015

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(c) To find the asset Betas (βu):

A

βu =

1.5 = 1.00 1 + 12

B

βu =

1.8 = 0.90 1 + 11

C

βu =

1.2 = 1.20 1+ 0

Using market capitalisation weights, the weighted average Beta = (0.2 × βA) + (0.3 × βB) + (0.5 × βC) = (0.2 × 1.00) + (0.3 × 0.9) + (0.5 × 1.20) = 1.07 When the required return on new business is ER = 6% + 1.07 (7.5%) = 14.03% The diversification thus involves moving to a higher level of systematic risk. 8. Claxby (a) To find the asset Beta for Sloothby, the geared Beta for the industry sector must be ungeared, that is: ßu =

=

ßg 1+

VB (1 − T ) VS

1.12 1.12 = = 0.92 1 + [0.33(1 − 33%)] 1.22

This assumes that Sloothby’s risk is ‘typical’ of the industry as a whole. (b) Systematic risk = ßj δm = δj rjm

ß=

δ jrjm δm

For Claxby (c = Claxby, m = market):

ßc =

δ c rcm δm

0.6 =

40rcm 10

This yields a very low correlation coefficient of rcm = 0.15

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This, in turn, implies that the proportion of variation in the overall return explained by comovement with the market is also low. This is measured by the Coefficient of Determination, R2, i.e. R2 = (0.15)2 = 0.0225, i.e. 2.25% For Claxby, total variation, i.e. the variance, is 402 = 1,600 Hence of this variation only 2.25% [i.e. 36] is because of general market movements, the remainder [i.e. (1,600 − 36)] = 1,564 is because of specific risk factors. A variance of 36 corresponds to a standard deviation of √36 = 6 The same result is obtained by using the expression Systematic risk = ßc δm = (0.6)(10) = 6, i.e. 6% Similarly for Sloothby, Systematic risk = ßs δm = (0.92)(10) = 9.2, i.e. 9.2% This implies a variance of (9.2)2 = 84.64 Total variation is (25)2 = 625 Hence, for Sloothby, the proportion of total variation explained by market movements, i.e. the R2, is:

84.64 = 13.5% 625 As with Claxby, this implies a substantial unsystematic risk component, i.e. (625 − 84.64) = 540.36 (c) The Beta for the expanded company is found by weighting the component asset Betas accordingly:

ß = (0.92 ×

0.4 1.0 ) + (0.6 × ) = 0.69 1.4 1.4

(d) The required return for the firm as a whole is now

ERj = Rf + ßj[ERm Rf] = 11% + 0.69 [18% − 11%] = 11% + 4.8% = 15.8% (e) Claxby has diversified by acquiring a firm with lower total risk (25). As a result, the total risk of the new enterprise is likely to fall. Whether this is desirable for shareholders depends on the impact on systematic risk. As it happens, Claxby has very a low systematic risk while the proportion of Sloothby’s risk that is systematic is rather higher. As a result, the Beta for the whole company increases from 0.6 to 0.69, forcing a higher required return standard on the parent. If shareholders really wanted to alter the risk/return profile of their investment, they could have purchased shares of companies in the sector where Sloothby operates. Consequently, the diversification, especially if it involves transaction costs greater than Claxby’s shareholders, would incur in altering their personal portfolios, may well not be in the interests of investors.

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The main reason for the managers of a company to carry out this sort of diversification is because it may enhance earnings stability for the company as well as job security for the managers. Hence, managers will aim to reduce total risk and will not distinguish between systematic and unsystematic risks. In practice, however, it is easier to sell shares than to liquidate whole companies. Usually, there are substantial liquidation costs when a company fails. Diversification would therefore reduce such risk and the costs of portfolio disruption and readjustment. Further practical consideration might be given to other benefits of profit stability, such as a greater access to debt finance. On the other hand, if the diversification can bring about more efficient use of resources, then these should also be taken into account in the investment appraisal.

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CHAPTER 20

Acquisitions and restructuring Learning objectives A major aim of the chapter is to emphasise the strategic aspects of takeovers. Having read it, the reader should understand the following: •

Why firms select acquisitions rather than other strategic options.

•

How acquisitions can be financed.

•

How acquisitions should be integrated.

•

How the degree of success of a takeover can be evaluated.

•

How corporate restructuring can enhance shareholder value.

Questions summary 2. Gross plc and Klinsmann plc. This question focuses on the potential economies that an acquiror may exploit by more efficient operation of the acquired company. 3. Dangara plc. A relatively simple valuation exercise, which emphasises the strategic and contextual issues that influence takeover bidding and integration of the target. 4. Larkin Conglomerates plc. This question involves simple application of three takeover valuation methods and a discussion of the problems with each. It also requires discussion of the reasons for business divestment and considers the relevant strategic internal information concerning the target company. 5. Fama Industries plc. This question not only looks at valuation of a takeover target but also focuses on the impact of the takeover on the EPS, the share price of the bidder and on the sharing of the gains from the takeover among the two sets of shareholders. 6. Europium plc. This question requires evaluation of the terms to complete a takeover via share exchange, and focuses on issues of due diligence.

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Answers to questions 2. Gross plc and Klinsmann plc (a) Examination of the respective ratios suggests considerable scope for economies, if Gross can improve Klinsmann’s efficiency by bringing its ratios up to par with its own, resulting in savings and profits. Notice that most of the savings can be made from efficient use of the working capital. Ratios

Gross

Klinsmann

Operating profit margin

105 ×100 = 49% 216

41 ×100 = 37% 110

Average age of stock (on the basis of purchases) (days)

20 × 365 = 73 100

25 × 365 = 130 70

Debtor payment period (days)

40 × 365 = 68 216

24 × 365 = 80 110

Creditor payment period (days)

28 × 365 = (120) 100

12 × 365 = (63) 70

Operating cycle (cash conversion period) (days)

73 + 68 – 102 = 39

130 + 80 – 63 = 147

Current ratio (times)

68 = 2.4 28

50 = 2.5 20

Fixed asset turnover (times)

216 = 2.8 76

110 = 2.2 50

Total asset turnover (times)

216 = 1.5 76 + 68

110 = 1.1 50 + 50

ROI (Op. profit ÷ LT capital)

105 ×100 = 91% 116

41 ×100 = 51% 80

To illustrate the savings potential, consider investment in debtors. If the Klinsmann ratio can be lowered to the Gross ratio (from 80 down to 68, i.e. 12 days), the reduction in average stock investment will be:

12 × £ 25m = £ 3.75m 80 With an interest cost of 12%, this would generate higher pre-tax profits of [12% × £3.75m] = £0.45m. While this is only a small fraction of the bid premium [(£8.50 − £7.00) × 20m = £30m], the saving would persist into the future, and would be combined with similar economies elsewhere.

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(b) Some other important issues to consider are as follows:

•

Gross gearing (long-term debt ÷ equity) at market values is: £60m = 10%, compared to Klinsmann’s : £6 ×100 m £56m = 40% £7 × 20m

Assuming that these are both regarded as safe values, there may be scope for Gross to gear up its existing business, to reduce its overall cost of capital and exploit the tax shield. •

Although Klinsmann has a higher EPS than Gross:

£21 = 105p compared to 20m

£72m = 72p 100m

its P:E ratio is lower:

£7 = 6.7 compared to 105p

£6 = 8.3 72 p

Although Klinsmann is making a fair level of profits for its shareholders, the market assessment of its future earnings potential is inferior to that for Gross. •

Gross is taking over a competitor, which should enable a degree of rationalisation of the two businesses and a variety of synergies. Possibly most crucially, this is a horizontal merger, resulting in a reduced level of competition. At least for a time, Gross may be able to improve its margins.

3. Dangara plc (i) Net asset value (NAV)

Using a net asset value approach, the accounts suggest an NAV of £650m. However, there is a likely gain on disposal relating to the potential sale to Lucky Break. Including this would yield an adjusted NAV of (£650m + £100m) = £750m. However, the remaining assets could well be revalued upwards (see note c). Earnings-based Tefor’s PAT is £200m. With its own P:E ratio of 10, this suggests a market value of (10 × £200m) = £2,000m. However, if a rationale for acquisition is to sweat Tefor’s assets more vigorously, it might be appropriate to allow for this growth by applying Dangara’s P:E ratio, yielding a value of (14 × £200m) = £2,800m. DCF Ignoring working capital complications and tax delays, cash flow is broadly PAT plus depreciation. No data is given for depreciation, but since Tefor’s assets are mainly property-based, the depreciation provision is unlikely to be large, say 5% of fixed assets, i.e. £40m. Thus, estimated cash flow = (£200m + £40m) = £240m. However, there appears to be a need for

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refurbishment investment of £50m p.a. (assumed to be tax-allowable). Allowing for growth at Dangara’s rate (although this may take time to ‘kick in’), the PV of future cash flows is as follows:

£240m(1 + 7%) − £50m(1 − 33%)(PVIFA14% / 5 ) 14% − 7% = (£257m / 7%) − £50m(1 − 33%) × 3.4331

PV =

= £3,671m − £115m = £3, 556m Note that Tefor’s market value of equity is currently P:E × PAT = 10 × £200m = £2bn. A premium of 20% would suggest that a bid of £2.4bn might succeed. Clearly, a variety of answers are possible, depending on the assumptions made. (ii) Other issues Takeover premiums. The figure of 20% (note f) is only an average. A greater premium may be required if the present board and their supporters have a major stake, or if the institutional shareholders are sceptical about Dangara’s ability to utilise Tefor’s assets more efficiently. Ability to raise Tefor’s efficiency. A key motive for the acquisition seems to be to realise cost savings from Tefor. A programme of post-merger integration needs to be carefully planned well before the acquisition so that restructuring can begin immediately and efficiency gains exploited as soon as possible to raise the growth rate of earnings generated by Tefor’s assets. Attitude of the competition authorities. Prior to the bid, Dangara would be advised to consult the relevant authority for guidance as to whether, and which, assets might have to be divested so as to avoid creating a monopoly position in one or more of the market segments served by the expanded company. Although it seems that Dangara has already considered this aspect (note b), it should require utmost clarity on this issue. Equally, the sell-on value to Lucky Break needs to be subject to a firm undertaking. Political changes. A new government may soon be in power. Dangara will have to assess the likelihood of it introducing a more rigorous competition policy. Against this, it is possible that the stock market is dampened by political uncertainties, suggesting that Tefor may be temporarily under-valued at this time. Property values. Dangara would need expert advice as to the market value of Tefor’s assets, last revalued in 1992 towards the end of a recession period. It is possible that major revaluation gains might be revealed. Role of Tefor’s present Chairman. Dangara would have to assess the likelihood of the present Chairman being able to raise sufficient funding to take Tefor off the market. He and any team that he assembled would have to raise funding of at least the market value of £2bn (offset by the extent of his present holdings). This looks like a tall order. Also, should Dangara’s bid succeed the likelihood of being able to sell some assets back to him needs to be assessed. If at the moment he is a major shareholder, then he is likely to be highly liquid post acquisition.

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4. Larkin Conglomerates plc (a) (i) Net assets (liquidation) basis Net assets at realizable values No. of ordinary shares £160,000 = 60,000 = £2.67

Value per ordinary share (V0 ) =

The net asset figure is calculated as follows: £000

£000

Freehold premises

235

Motor vans

8

Fixtures and fittings

5

Stock

36

Debtors

22

Cash at bank

20 326

Less: Creditors due within one year Creditors due beyond one year

(66) (100)

(166) 160

(ii) To apply the dividend yield method, the net dividend needs to be grossed up.

(Net dividend per share* × 100 / 75) ×100 Gross dividend yield (6.67p × 100 / 75) = × 100 5 = £1.78

V0 =

*

Net dividend per share is calculated as follows: = 4.0k/60k = 6.67p

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(iii) Price:Earnings ratio

V= =

P : E ratio × profit after tax No. of ordinary shares £16, 400 ×12 60,000

= £3.28 (b) Net assets (liquidation) basis – values a share in a company using the realisable value of the net assets held. If a company plans to cease trading and dispose of its assets piecemeal, this method can provide a suitable form of share valuation. However, if a company intends to remain in business and continue trading, this method is likely to provide a valuation figure which is too conservative. The value of the business as a going concern is likely to be greater than the sum of the realisable values of individual items shown on the balance sheet. This may be because of such factors as unrecorded goodwill (arising from customer loyalty, brand names and so on) and the fact that the value of individual assets to the company when used in the business may exceed their realisable values.

Dividend yield – arrives at a share valuation using the dividend payments made. However, dividends normally represent only part of the earnings generated by a business. For valuation purposes, the total returns of the business should be taken into account. The method fails to take account of any growth in dividends that may occur over time. Application of this method requires the use of dividend yield data from a comparable company in the same industry, which is listed on the Stock Exchange. However, it may be very difficult to find a company, which closely matches the risk and growth characteristics of the one being valued. Moreover, the dividend policies pursued by the companies concerned may be quite different, especially since Hughes is a wholly owned subsidiary of Larkin. Price:Earnings ratio – uses a multiple of existing earnings to value company shares. P:E ratios reflect market sentiment concerning the value of a share. However, like the dividend yield method mentioned above, valuation requires the use of data from a similar listed business. Problems similar to those above can therefore arise. In addition, differences in accounting policies between companies may affect the way earnings are measured, which may further complicate matters. (c) A company may decide to divest part of its business for a number of reasons. These include:

Core business. The company may review its business operations and decide to concentrate on what it regards as its core business. Any business operations that are not regarded as core may be sold off following such a review. Poor performance. Some parts of the company’s business may not meet the required standards of performance. The company may not wish to invest time and resources trying to improve the level of performance or may feel that the standards originally set can no longer be achieved. As a result, the company may decide to dispose of low-performance operations. This may increase the overall profitability of the business. Takeover defence. A company may become the target of an unwelcome takeover bid because of interest expressed by another company in particular aspects of the company’s activities. The target company may decide to sell off the business activities of interest to the bidder to protect the rest of its operations from takeover.

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Raising finance. A company may decide to sell off part of its business in order to raise funds to use for purposes such as investing in other business operations or for dealing with cash flow problems within the company. (d) Other useful information may include:

Future obligations. Details of any onerous contracts to, which the company is committed, and any contingent liabilities, will need to be carefully considered. Quality of assets. The condition of the assets held by the company should be evaluated. For example, a prospective buyer will need to know if any fixed assets are nearing the end of their useful lives or need major improvements. Key personnel. A prospective buyer will need to know whether any change in ownership will affect the decision of key personnel to stay with the company and whether any renegotiation of their contracts has to be undertaken. Sales information. The market share of the company’s products, the range of its customer base and the state of its order book would be of great interest to a prospective buyer. Employees. The morale and motivation of employees, management/employee relations and the quality (e.g. training and experience) of employees is likely to be of vital importance. Forecast information. Financial forecasts prepared by the company and its advisers concerning the future performance may be extremely useful. Detailed costings. Information on the costs of operations may be useful to predict future savings arising from management decisions following the takeover. 5. Fama Industries plc (a) (i) The total value of the bid can be calculated as follows:

No. of shares of Beaver plc in issue

= 30m

Rate of exchange: 4 Fama for 5 Beaver No. of shares issued by Fama

= 30m × 4/5 = 24m

EPS of Fama

= £83m/100m = £0.83

Value of share in Fama = 16 × £0.83 = £13.28 Total value of bid

= £13.28 × 24m = £318.72m

(ii) EPS of Fama following a successful takeover is

Earnings of Fama before takeover

= £83m

Earnings of Beaver before takeover

= £25m

Cost savings because of takeover

= Total

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Shares in issue by Fama before takeover

= 100m

Shares issued for takeover consideration

= 24m Total

EPS after takeover

124 = £112/124m = £0.90p

(iii) Share price of Fama after takeover = EPS × P:E ratio:

= £0.90 × 16 = £14.40 (b) EPS of Beaver before takeover:

= £25m/30m = £0.83 Value per Beaver share

= EPS × P:E ratio = £0.83 × 12 = £9.96

After the takeover agreement, five shares in Beaver are exchanged for four shares in Fama The value of five shares in Beaver

= £9.96 × 5 = £49.80

Assuming the P:E ratio of Fama is maintained and the economies achieved, the value of four shares in the newly combined company is: = £14.40 × 4 = £57.60 These calculations suggest that a shareholder in Beaver would be better off by accepting the offer. However, there may be some doubt as to whether the existing P:E ratio of Fama can be maintained following the takeover. The market would need to be convinced that the takeover would result in a significant improvement in future earnings. The companies are in different industries and so the investors are likely to scrutinise the rationale for the takeover. The dividend per share of Beaver is currently 40p compared with 8p for Fama. Assuming no change in payouts, a shareholder with five shares in Beaver will receive 32p dividend (i.e. 4 × 8p) after the takeover instead of the current £2.00 (i.e. 5 × 40p) − a loss of £1.68. The prospect of a reduction in future dividends after the takeover may concern shareholders in Beaver who rely on receiving cash returns from the company. This may create problems in getting the share-for-share offer accepted. As the expected EPS post takeover exceeds the current returns, shareholders of Fama may be pleased to obtain Beaver shares for the offer price. However, if the current P:E ratio is not maintained, the share offer may seem too generous towards Beaver shareholders. For example, a reduction in the P:E ratio to 14 following the takeover would reduce the value of a share in Fama to £12.60 (i.e. 14 × £0.90), below the current share price.

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(c) A company may wish to acquire another company for several reasons apart from the pursuit of shareholder wealth maximisation. Two such reasons are as follows:

Diversification. A company may acquire another company operating in another industry to reduce risks. However, if investors can reduce investment risk by holding a diversified portfolio of shares, they do not need the company to diversify in order to achieve this. Moreover, it is usually cheaper for an investor to diversify than for a company to do so. Diversification to reduce risk offers no benefit for the shareholder if it provides nothing beyond what the investor can do for him/herself. Management objectives. The management of a company may decide to take over another to satisfy personal objectives. For example, it may feel that the increased size of the company following the takeover will lead to an increase in power, status and remuneration. Diversification may lead to managers feeling more secure, and may be used as a means of reducing risks for managers rather than for owners. 6. Europium plc (a) Europium plc’s

Promithium plc’s

£60m = £0.75 80m £24m EPS = = £0.80 30m

EPS =

Market value per share

= EPS × P:E ratio

Europium plc

= £0.75 × 16 = £12.00

Promithium plc

= £0.80 × 10 = £8.00

Rate of exchange: Market capitalisation of Promithium plc

= 30m × £10.00 [£8.00 + (25% × £8.00)] = £300m

No. of shares to be issued by Europium plc to acquire shares

=

£300m = 25m shares £12.00

Thus, 25m Europium plc shares will be issued for 30m Promithium plc shares. The required rate of exchange is therefore 5 Europium plc shares for 6 Promithium plc shares. (b) Reasons for offering above the current market value include the following:

Incentive to sell. Shareholders who continue to hold shares in the company at current market values are unlikely to accept an offer for the shares set at the current market value. Thus, a premium on the market value will normally be required simply to tempt shareholders to part with their shares. Inside knowledge. The managers of Europium plc may have access to information not generally available to the market and hence not taken into account in the current market value of the shares. Synergy. The managers may believe that, by combining the two businesses, substantial gains can be made. The potential gains from the merger may make it feasible to increase the bid price above the current market value of the shares.

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The ‘Knock-out Blow’. Where the bid is likely to be resisted or where Europium plc is in competition with other companies to acquire the business, the managers of Europium plc may increase the price offered to a figure so high that it can be neither matched nor refused. (c) Market value per share of combined group:

= Total market capitalisation

Total market capitalisation No. of shares issued

= Combined profit after tax × P:E ratio = £84m × 16 = £1,344m

No. of shares issued = 80m + 25m Market value per share

=

= 105m

£1, 344m = £12.80 105m

The P:E ratio would stay the same if the market failed to recognise the difference in growth potential between the two businesses. The P:E ratio may also stay the same if synergy between the two businesses and/or improvements in performance resulting from better management is expected. If these factors are not present, the P:E ratio will change and should reflect a weighted average of the P:E ratios of the separate businesses. (d) Europium plc might investigate the following:

Financial record. Past financial performance including comparison with industry performance. Information regarding forecast future performance. Operations. Nature of business operations including production, selling and distribution methods. Details of major suppliers and customers. Information regarding onerous contracts with suppliers or customers. Personnel. Information concerning directors and other senior managers including details of employment contracts. Number of employees, skills profile and history of employee relations over time. Details of pension schemes, profit-sharing arrangements and redundancy agreements. Marketing and sales. Details of the market including size of market, major competitors and market share. Market penetration of products over time and potential for future growth. Details of product range, new products being developed and R&D activities. Assets. Age, condition, location and market value of the assets. Efficiency and utilisation of assets. Details of legal title to assets and any financial claims against assets. Liabilities. Details of loans, debentures and leases. Details of future expenditure commitments and contingent liabilities, especially off-balance sheet. Owners. Details of shareholders and their rights. Likely reaction of major shareholders to takeover bid. Due diligence. Europium plc will send in its own team of independent accountants to carry out checks on the adequacy of accounting systems and controls and the reliability of the accounting information produced by Promithium plc to depict the financial performance and position of the business.

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PART VI

International financial management

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CHAPTER 21

Managing currency risk Learning objectives This chapter explains the nature of the special risks incurred by companies that engage in international operations: •

It explains the economic theory underlying the operation of international financial markets.

•

It examines the three forms of currency risk: translation risk, transaction risk and economic risk.

•

It explains how firms can manage these risks by adopting hedging techniques internal to the firm’s operations.

•

It explains how firms can use the financial markets to hedge these risks externally.

Questions summary 4. This question requires application of PPP. 7. This question examines the extent to which an investor can profit from covered interest arbitrage. 8. Europa plc. This question requires construction of hedges on the forward market and the money. 9. The Slade plc question is a simple comparison of money market hedging versus using the forward market over two separate time horizons. 10. Philadelphia. This question involves analysis of the appropriate option hedge that the corporate treasurer should purchase.

Answers to questions 4. (a) The exchange rate consistent with the two prices is £100 versus DKR 1,200, i.e. £1 versus 12 DKR. (b) The two bundles will rise in price as follows:

UK:

£100(1 + 5%) = £105

Denmark: DKR 1,200(1 + 3%) = DKR 1,236 138 © Pearson Education Limited 2015

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Assuming PPP holds, the future spot rate is expected to be as follows: (1,236/105) = DKR 11.77 versus £1, i.e. appreciation of the DKR by about 2%. The UK price level is expected to rise by (5%/4) = 1.25% over three months’ and in Denmark by (3%/4) = 0.75%. The exchange rate in the forward market consistent with these rates is 12 × (1.0075/1.0125) = DKR 11.94 versus £1. Hence, the DKR would be quoted at a premium of DKR 0.06, indicating that it was expected to strengthen against the GBP. 7. In calculating the agios, mid-points are used here for both interest rates and exchange rates:

£:$

Spot

$1.6575

Forward

$1.6375

New York interest rate

5.3/8%

=

5.375%

London interest rate

5.11/16%

=

5.6875%

(a) The interest agio:

⎡ i$ − i£ ⎤ ⎡ 5.375% − 5.6875% ⎤ ⎢ ⎥=⎢ ⎥ = −0.3% 1.056875 ⎦ ⎣ 1 + i£ ⎦ ⎣ The exchange agio:

⎡ F0 − S0 ⎤ ⎡1.6375 − 1.6575% ⎤ ⎢ ⎥=⎢ ⎥ = −1.2% 1.6575 ⎦ ⎣ S0 ⎦ ⎣ The discrepancy between the two agios does suggest the possibility of gains from arbitrage. (b) Covered interest arbitrage (using the rates available to the investor)

Now Convert £ into $

:

£100,000 × 1.6550

Invest at 5 1 4 % p.a.

:

$174,189 in one year

Sell forward

:

$174,189 1.6450

Net gain = (£105,890 − £100,000)

=

$165,500

=

£105,890

=

£5,890

OR

Invest in London at 5.625% Net gain

=

£105,625 in one year (£105,625 − £100,000)

=

£5,625

In principle, covered interest arbitrage would generate a guaranteed relative gain of (£5,890 − £5,625) £265 on paper, but this might well be eaten up by transaction costs.

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8. Europa plc (a) Forward market hedge: this simply involves arranging to sell the receivable $1.25m at the 3-month forward rate, which is as follows:

1.6480

–

1.6490

130 1.6350

Spot

124 –

Deduct forward premium

1.6366

Forward outright

Europa could only access the rate at the high end of the spread. Hence, amount payable to Europa by its bank in three months’ time is:

$1.25m = £763, 779 1.6366 (b) Money market hedge:

Amount of USD to borrow at 8% p.a. (i.e. 2.67% over 3 months)

=

Convert to £ at spot:

$1.25m 1.0267

=

$1,217,493

$1, 217, 493 1.6490

=

£738,322

=

£758,035

=

£5,744

Invest in UK at 8%: £738,322 (1.0267) (i.e. 2.67% over 3 months) (c) The forward hedge appears superior as it generates

higher net proceeds of (£763,779 − £758,035) 9. Slade plc

Outright exchange rates are:

£/$

Spot

1.4106–1.4140

3 months’ forward

1.4024–1.4063

6 months’ forward

1.3967–1.4006

(i) Hedging the 3-month transactions Forward market Sell $197,000 3 months' forward =

$197,000 = £140,084 1.4063

Net sterling payments in 3 months’ are £140,084 − £116,000 = £24,084 Money market Borrow $194,808 at 4.5% p.a. to repay $197,000 from receipts in 3 months’ time. Convert $194,808 Spot to £ at 1.4140 = £137,771

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Invest £137,771 for 3 months at 6% p.a. to receive £137,771 (1.015) = £139,838 Net sterling payments = £139,838 −£116,000 = £23,838 Hence, using the forward market is the better alternative. (ii) Looking ahead 6 months Any hedge should apply to the net payment of $447,000 − $154,000 = $293,000 (inflow) Forward market Buy $293,000 at 6 months forward at 1.3967 = £209,780 Money market Borrow £204,643 for 6 months at 7.5% p.a. (i.e. 3.75% over 6 months) Convert to $ at spot of 1.4106 = $288,670 Invest $288,670 for 6 months at 3.0% p.a. (i.e. 1.5% over 6 months) to yield the required total of $293,000 to make the payment. Total cost = (£204,643 + interest at 7.5%/2) = £212,317 The lowest net sterling payment is by using the forward market. 10. Philadelphia

Beliefs about future spot exchange rates are personal evaluations. If the treasurer decides to act upon his own hunch, this could dangerously expose the company to risk. Most companies have a system of controls in place that should prevent individuals from pursuing personal intuition. If the company is worried about exposure to currency risk, a portion of the risk that is not self-hedging should be hedged by using financial market techniques such as forward contracts, options or swaps. Acting on the treasurer’s forecast the company will need to sell sterling for dollars, i.e. buy put options on sterling. £1,625,000 will require 130 contracts. (a) $1.8950–$1.8970/£. The relevant future spot rate for selling £ for $ is $1.8950/£. If the future spot rate is $1.8950, the company would receive $3,079,375 using the spot market. The £ is expected to weaken relative to the dollar. September options are available at exercise prices of $1.90, $1.95, $2.00. At all of these prices, the option will be exercised.

At $1.90 Receipts are 1.625m × $1.9

=

$3,087,500

Less option cost of 1.625m × 0.42 cents

=

6,825

Net receipts

$3,080,675

At $1.95 Receipts 1.625m × $1.95

$3,168,750

Option cost 1.625m × 4.15 cents Net receipts

67,438 $3,101,312

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At $2.00 Receipts 1.625m × $2.00

$3,250,000

Option cost 1.625m × 9.40 cents

152,750 __________

Net receipts

$3,097,250

All three options result in higher expected dollar receipts than using the spot market in three months (excluding any further transaction costs). Selection of the $1.95 exercise price would give the highest expected receipts. (b) $2.0240–$2.0260/£. If the spot rate for buying dollars in three months’ time is $2.0240/£ then, if purchased, the options would not be exercised because using the spot rate in three months would give higher dollar receipts than any of the available option exercise prices. Therefore, the company would not purchase currency options.

This would leave the company exposed to foreign exchange risk, because the spot rate in three months’ time could be very different from the rate forecast by the treasurer.

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CHAPTER 22

Foreign investment decisions Learning objectives This chapter focuses on foreign investment decisions by Multinational Corporations (MNCs). It aims to: •

Study the advantages of MNCs.

•

Discuss different ways of entering foreign markets.

•

Consider the particular complexities of foreign direct investment (FDI).

•

Analyse the appraisal of foreign FDI.

•

Consider the impact of foreign exchange variations on foreign projects.

•

Analyse ways of insulating projects against foreign exchange risk.

•

Study political and country risk, and how to cope with it.

Questions summary 4. Kay plc. This is a capital investment appraisal of an overseas-located project that incorporates staged project receipts and UK taxation. 5. Brighteyes plc. This is another investment appraisal problem that looks at project value from three different perspectives – that of the foreign government, that of the firm’s overseas subsidiary and that of the parent company’s shareholders. 7. This question requires appraisal of the project both in sterling terms and in terms of the currency of the host country.

Answers to questions 4. Kay plc

Assumptions: Project inflation is assumed to occur at the national rate. PPP applies so that the project costs can be converted to sterling at the present rate of exchange, i.e. the increase in local construction costs is offset by appreciation of sterling. Construction costs are (10 million ponchos/4) = £2.5m half-yearly. At 20% (i.e. 10% for four half-yearly payments), the PV is as follows:

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(£2.5m × four-period discount factor @ 10%) = £2.5m × 3.169 = £7.92m Output of plant = 20,000 tonnes p.a., of which Kay will receive 40%, i.e. 8,000 tonnes p.a. At today’s prices, this is worth (8,000 × 500 Euros) Euros 4m. The value of output depends on the Euro versus sterling exchange rate, given that sterling will depreciate by 5% p.a. At the expected exchange rate (Euros versus £1), this is worth the following: Year 2

1.45

(no output)

Year 3

1.38

Value: £2.90m

Year 4

1.32

£3.04m

Year 5

1.25

£3.20m

Year 6

1.19

£3.36m

Year 7

1.13

£3.52m

Calculation of NPV (£m) Year 20%

Sterling cash flow

Tax

Post-tax cash flow

PV @ 20%

3

2.90

–

2.90

1.68

4

3.04

–

3.04

1.47

5

3.20

–

3.20

1.29

6

3.36

(0.76)

2.60

0.87

7

3.52

(1.06)

2.46

0.69

Total

6.00

NPV = (£7.92m) + £6.00m = (£1.92m), therefore it is not acceptable. Kay should not proceed on these terms. It needs a higher share of the output, or local incentives such as grants or concessionary finance. 5. Brighteyes plc

The table given below summarises the cash flows for the three decision-making levels. Net present values for each are shown in the second table. The project meets the Ministry’s requirement to achieve a 10% return, since the NPV at 10% is positive (L37.3m). It also achieves a satisfactory NPV at the project level after local financing costs. However, the project fails to offer an acceptable net present value for the parent company. The contrasting results stem from three factors: •

Deteriorating exchange rates

•

UK taxation and Lastonia withholding taxes

•

Spillover effects in terms of lost exports.

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Brighteyes plc: cash flow profiles Year

0

Basic project (Lm)

(40)

Plant working capital

(20)

Operating cash flows

1

2

3

4

5

10

22

22

22

22

Sale of plant

24

Sale of working capital

16

Country cash flow

(60)

10

22

22

22

62

Loan and interest

20

(2)

(2)

(2)

(2)

(22)

Project cash flow

(40)

8

20

20

20

40

(1.6)

(4)

(4)

(4)

(8)

Withholding tax Remitted to UK

(40)

6.4

16

16

16

32

Exchange rate

4

4

5

5

5

5

(10)

1.6

3.2

3.2

3.2

6.4

(0.2)

(0.3)

(0.3)

(0.3)

(0.3)

1.4

2.9

2.9

2.9

6.1

(0.5)

(0.5)

(0.5)

(0.5)

2.4

2.4

2.4

5.6

Sterling receipts UK tax (net) (30% − 20%) Post-tax cash flows

(10)

Lost exports Parent cash flow

(10)

1.4

The value of the project: discounted cash flows Year

(i) Country (£m)

PV @ 10%

(ii) Project (£m)

PV @ 15%

(iii) Parent (£m)

PV @15%

0

(60)

(60)

(40)

(40)

(10)

(10)

1

10

9.1

8

7.0

1.4

1.2

2

22

18.2

20

15.1

2.4

1.8

3

22

16.5

20

13.2

2.4

1.6

4

22

15.0

20

11.4

2.4

1.4

5

62

38.5

40

19.9

5.6

2.8

NPV

37.3

NPV

26.6

NPV

(1.2)

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7. If interest rates are expected to remain 2% higher per annum in the United Kingdom than in Eastasia (presumably due to higher UK inflation) then the £ sterling will be at a discount of that order in the forward markets, which is as follows:

EA$ per £1 sterling

Year 1

Year 2

Year 3

Year 4

1.9633

1.9273

1.8919

1.8572

(Note: For Year 1, the calculation is 2 × 1.07/1.09, etc.) If the institute requires a 16% per annum rate of return in £ sterling, then it would require 1.07 16% × per annum return in dollars, implying discount factors of: 1.09 Year 1

Year 2

Year 3

Year 4

£ sterling

0.8620

0.7432

0.6407

0.5523

EA$

0.8782

0.7712

0.6772

0.5948

The forecast cash flows can then be summarised as follows:

Undiscounted: Discounted:

Year 1

Year 2

Year 3

Year 4

$000

750

950

1,250

1,350

£000

382

493

661

727

$000

658

732

846

802

£000

329

366

423

401

Hence, (i) The discounted cash flows in £ sterling total £1.519m, against an investment of 2.5m ⎞ ⎛ £1.250m ⎜ EA$ ⎟ or an NPV of £269,000. 2 ⎠ ⎝ (ii) The discounted cash flows in EA$ sum to $3.038m, against an investment of $2.500m for an NPV of $538,000. At the spot rate of EA$2:£1, this equals

EA$538, 000 = £269, 000 . 2

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