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Business ManagementStudy Manuals

Advanced Diploma inBusiness Management

CORPORATE FINANCE

The Association of Business Executives

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The Association of Business Executives (ABE) and RRC Business Training

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Advanced Diploma in Business Management

CORPORATE FINANCE

Contents

Unit Title Page

1 The Context of Corporate Finance 1Introduction 2Basic Principles of Companies 3Financial Objectives 6Corporate Governance 10Corporate Financial Management 24

2 Company Performance, Valuation and Failure 35Introduction 37Ratio Analysis 37Using Ratio Analysis 44Introduction to Share Valuation 51Methods of Share and Company Valuation 52Non-financial Factors Affecting Share Valuation 61Predicting Company Failure 61Capital Reconstruction Schemes 64

3 Acquisitions and Mergers 67Introduction 69Company Growth 69The Regulation of Takeovers 73The Acquisition/Merger Process 78Measuring the Success and Failure of Mergers and Takeovers 82Disinvestment 86

4 Financial Markets 91Introduction 92Stock Markets 92Other Sources of Finance 99Other Financial Markets 102Recent Changes in Capital Markets 103Impact of the Markets on Market Decisions 103

5 Sources of Company Finance 105Introduction 107Share Capital 107Methods of Issuing Shares 110Share Repurchases 116Debt and Other Forms of Loan Capital 118Short-Term Finance 129International Capital Markets 134Finance and the Smaller Business 136

Unit Title Page

6 Cost of Finance 143Introduction 145Investors and the Cost of Capital 145Cost of Equity 146Cost of Debt Capital 149Cost of Internally Generated Funds 153Weighted Average Cost of Capital 154Assessment of Risk in the Debt Versus Equity Decision 157Cost of Capital for Other Organisations 159

7 Portfolio Theory and Market Efficiency 161Introduction 162Risk and Return 162The Impact of Diversification 164Portfolio Composition 168The Application of Portfolio Theory 175Market Efficiency 177

8 The Capital Asset Pricing Model 189Introduction 190Risk, Return and CAPM 190Calculation of Betas 196Validity of the CAPM 197Practical Applications of CAPM 199The Arbitrage Pricing Model 200

9 Capital Structure 203Introduction 204Capital Gearing 204Factors Determining Capital Structure 208Theory of Capital Structure 211Capital Gearing and the Effects on Equity Betas 217Operational Gearing 218

10 Corporate Dividend Policy 221Introduction 222Key Influences on Dividend Policy 222Theories of Dividend Policy 228Practical Aspects of Dividend Policy 229

11 Working Capital and Short-Term Asset Management 233Introduction 235Working Capital 235Overtrading 243Cash Management 245Management of Stocks 251Management of Debtors 256Creditor Management 263Short-Term Finance and Investment 263

Unit Title Page

12 Capital Investment Decision Making 1: Basic Appraisal Techniques 275Introduction 277Future Cash Flows and the Time Value of Money 277Return on Investment (Accounting Rate Of Return) 278Payback 279Discounted Cash Flow 280Net Present Value (NPV) 281Internal Rate of Return 288Cost/Benefit Ratio 291Comparison of Methods 291Impact of Taxation on Capital Investment Appraisal 292Appendix: Discounting Tables 296

13 Capital Investment Decision Making 2: Further Considerations 307Introduction 308Allowance for Risk and Uncertainty 308Impact of Inflation and Taxation on Investment Appraisal 311Capital Rationing 312Lease Versus Buy Decisions 313Adjusted Present Value (APV) 316Use of the Capital Asset Pricing Model 319Worked Examples 319

14 Managing Risk 339The Nature of Risk 341Principles of Hedging 343Interest Rates, Risk and Exposure 346Internal Techniques of Managing Interest Rate Exposure 350Futures Contracts 350Forward Rate Agreements (FRAs) 354Interest Rate Swaps 355Options 357

15 International Trade and Finance 371Introduction 373Theory and Practice of International Trade 373International Investment 380Finance and International Trade 383Exchange Rates 394Risk and International Trade/Finance 400Internal Methods of Managing Exchange Rate Risk and Exposure 402External Methods of Managing Exchange Rate Risk and Exposure 404

1

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Study Unit 1

The Context of Corporate Finance

Contents Page

Introduction 2

A. Basic Principles of Companies 3

Types of Company 3

Regulatory Framework for Companies 4

B. Financial Objectives 6

The Prime Objective 6

Valuation of Companies 7

Shareholder Value Analysis (SVA) 8

Long-term Versus Short-term Objectives 8

Objectives of Multi-National Companies 8

Objectives of Public Sector Organisations 8

C. Corporate Governance 10

Company Stakeholders 10

Management/Shareholder Relationship and Agency Theory 15

The Cadbury Report 16

The Greenbury Report 18

Hampel Committee Report 19

The Combined Code 19

The Turnbull Report 21

Financial Services and Markets Act, 2000 and the FSA 22

The Higgs and Smith Reports 22

Other Disclosure and Behaviour Compliance Provisions 24

D. Corporate Financial Management 24

Financial Decision Making 24

Financial Functions in Organisations 25

The Role of the Finance Manager 26

Planning 28

Forecasting 29

Budgeting 29

Cash Management 30

Economic and Government Influences 32

2 The Context of Corporate Finance

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INTRODUCTION

Corporate finance covers a wide range of topics and functions within an organisation. Thethree main areas we will look at in this course relate to answers to the following questions:

Which investments should the firm undertake?

How, where, when and how much finance should be raised?

How should the firm's profits be used or distributed?

These questions are more commonly referred to as:

(a) The investment decision

(b) The financing decision

(c) The dividend decision.

In making such decisions, the firm must ensure that it achieves its objectives. Central to thisfirst unit, then, is the issue of what the objectives of companies are. This is our first mainarea of study.

The prime objective is often stated as the maximisation of shareholder wealth. This wouldimply that companies must be run in the interests of shareholders. However, there are arange of interests involved in the way in which companies are managed. We shall examinethese in the second main section of the unit and consider, in particular, the importance of thestakeholder concept and the tensions that arise from the different interests involved.

Finally, we turn to the scope of corporate financial management. We shall develop theissues of financial decision-making referred to above and consider their implications for therange of financial functions carried out in modern organisations and the roles required of thefinance manager.

The modern financial manager also needs to consider two different issues:

Risk. Some of the financial decisions made will incur little risk, for example, investingin Government backed bonds, but other areas of investment, such as investing inderivatives, will incur a lot of risk. There is a balance to be struck between the returnthat can be expected and the risk involved with the particular investment concerned.

The strategic role of the modern financial manager. There is an ever increasing needin the modern business world for key staff, including the financial manager, to play akey role in the strategic vision and environment within which the business is operating.There needs to be input at all three levels of strategic involvement – ie at a strategiclevel for broad issues, at a business or competitor level in respect of how strategicvision can be turned into reality, and at an operational level for how the broader planscan be turned into operational success.

The Context of Corporate Finance 3

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A. BASIC PRINCIPLES OF COMPANIES

We shall start by reviewing two fundamental concepts relating to companies which underpinmuch of our studies.

Types of Company

When a company is formed, the person or people forming it decide whether its members'liability will be limited by shares. The memorandum of association (one of the documents bywhich the company is formed) will state:

the amount of share capital the company will have; and

the division of the share capital into shares of a fixed amount.

The members must agree to take some, or all, of the shares when the company is registered.The memorandum of association must show the names of the people who have agreed totake shares and the number of shares each will take. These people are called thesubscribers.

A company is a separate legal entity, which means that it may take legal action against itsshareholders or vice versa. Limited liability companies have capital divided into shares. If ashareholder has paid in full for his or her shares, then liability is limited to those shares. Thisis the concept of limited liability.

The two main classes of limited company are public and private companies:

(a) Public companies

Company legislation defines a public company as one which:

Has an authorised share capital of at least £50,000;

Is trading a minimum of £50,000 issued share capital

Has a minimum membership of two (there is no maximum);

Has a name ending with "public limited company" or plc.

Not all public companies have shares which are traded on the Stock Exchange. Thosetraded on the Stock Exchange are known as quoted or listed companies.

(a) Private companies

A private company can be formed by two or more persons. They are often smaller orfamily owned businesses. A private company:

Can have an authorised share capital of less than £50,000, although there is nomaximum to any company's authorised share capital and no minimum sharecapital for private limited companies.

Cannot offer its shares for sale to the general public.

You may know of private companies which have become public companies and havestarted to trade on the Stock Exchange. An example was the clothing retailer LauraAshley which started life as a family owned private company.

The amount of share capital stated in the memorandum of association is the company's"authorised" capital

A company can increase its authorised share capital by passing an ordinary resolution(unless its articles of association require a special or extraordinary resolution). A copyof the resolution – and notice of the increase on Form 123 – must reach CompaniesHouse within 15 days of being passed.


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A company can decrease its authorised share capital by passing an ordinary resolutionto cancel shares which have not been taken or agreed to be taken by any person.Notice of the cancellation, on Form 122, must reach Companies House within onemonth.

Issued capital is the value of the shares issued to shareholders. This means the nominalvalue of the shares rather than their actual worth. The amount of issued capital cannotexceed the amount of the authorised capital.

A company need not issue all its capital at once, but a public limited company must have atleast £50,000 of allotted share capital. Of this, 25% of the nominal value of each share andany premium must be paid up before it can can get a trading certificate allowing it tocommence business and borrow.

A company may increase its issued capital by allotting more shares, but only up to themaximum allowed by its authorised capital. Allotments must only be done under properauthority.

A public company may offer shares to the general public. Share offers to the public aremade in a prospectus or are accompanied by listing particulars.

A private company is normally restricted to issuing shares to its members, to staff andtheir families, and to debenture holders. However, by private arrangement, thecompany may issue shares to anyone it chooses.

"Allotment" is the process by which people become members of a company. Subscribers toa company's memorandum agree to take shares on incorporation and the shares areregarded as "allotted" on incorporation.

Later, more people may be admitted as members of the company and be allotted shares.However, the directors must not allot shares without the authority of the existingshareholders. The authority will either be stated in the company's articles of association orgiven to the directors by resolution passed at a general meeting of the company.

Regulatory Framework for Companies

The main legislation regulating companies is the Companies Act 1985 and the CompaniesAct 1989. The 1989 Act added to and amended the 1985 Act, but this is now beingsuperceded by the Companies Act 2006.

The 1985 and 1989 Acts have been changed in order to meet four key objectives:

To enhance shareholder engagement and a long term investment culture;

To ensure better regulation and a 'Think Small First' approach; lst

To make it easier to set up and run a company; and

To provide flexibility for the future.

Following the establishment of a Company Law Review Group in 1998 to consider in detailthe modernisation of company law, The subsequent report of this group formed the basis of aWhite Paper for consultation in March 2005 and eventually the new Companies Act waspassed in November 2006.

Some of the key effects resulting from the Act include the following.

(a) Applying to all companies:

A clear statement of directors' general duties clarifies the existing case law basedrules

Companies will be able to make greater use of electronic communications forcommunications with shareholders.


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Directors will automatically have the option of filing a service address on thepublic record (rather than their private home address).

Directors must be at least 16 years old, and all companies must have one naturalperson as a director – i.e. they cannot have all corporate directors.

There will be improved rules for company names.

Companies will no longer be required to specify their objects on incorporation.

The articles will form the basis of the company's constitution.

(a) Applying to private companies:

There will be separate and simpler model Articles of Association for privatecompanies.

As part of the "think small first" agenda, there will be a separate, comprehensivecode of accounting and reporting requirements for small companies.

Private companies will not be required to have a company secretary.

Private companies will not need to hold an annual general meeting unless theypositively opt to do so.

It will be easier for companies to take decisions by written resolutions.

There will be simpler rules on share capital, removing provisions that are largelyirrelevant to the vast majority of private companies and their creditors.

(c) Benefits to shareholders:

There will be greater rights for nominee shareholders, including the right toreceive information electronically or in hard copy if they so wish

There will be more timely accountability to shareholders by requiring publiccompanies to hold their AGM within 6 months of the financial year-end.

This 2006 Act is a piece of primary legislation under which number of provisions are currentlybeing set out in secondary legislation, mainly through regulations or orders made by statutoryinstrument. It will not be fully implemented until October 2009, although parts of it wereimplementated in April 2007, October 2007 and April 2008. (Full details can be found on theDepartment for Business, Enterprise and Regulatory Reform (BERR) and the CompaniesHouse websites.)

The following changes came into force in April 2007:

Removal of the maximum age limit (which was 70) for directors of PLCs

Directors no longer need to provide details of their interests in shares or debentures ofthe company or its group – the result being that Companies House no longer acceptsForm 325 (Location of Register of director's interests in shares) or Form 325a (Noticefor inspection of a register of directors interests in shares kept in a non-legible format)

There will no longer be a statutory annual report by the Secretary of State to Parliament(the "Companies In" report), but BERR will continue to produce the information.

Directors are not required to disclose their interests in shares in the Directors report ofthe Annual Accounts for reports signed on or after 6 April 2007.

Takeover forms have been replaced with forms that align with the clauses of the newAct – 429(4) Notice of non-assenting shareholders will become Form 980(1); 429decStatutory Declaration relating to a Notice to non-assenting shares will become Form980(dec); and 430A Notice to non-assenting shareholders will become Form 984.


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In addition, UK company law must also incorporate European company law directives. Forexample, the European Eighth Directive on company law required more direct control ofauditors and therefore the Companies Act 1989 introduced the concept of supervision ofauditors. There is an ever increasing amount of legislation being enacted by the EU and thefollowing examples illustrate the many different items currently being added to existing UKlegislation in place for limited companies :

Company Disclosures – 4thand 7th Company Law (Accounting) Directives

The Companies (Cross-Border Mergers) Regulations 2007

Implementation of Directive 2006/43/EC on Statutory Audits of Annual andConsolidated Accounts (8th Company Law Directive)

Shareholders' Rights Directive

Simplification of Capital Maintenance Rules – 2nd Company Law Directive.

Companies are also regulated in other ways:

The production of company financial statements must be prepared in accordance withUK accounting standards. These are issued by the Accounting Standards Board(ASB). Recent legal opinion has now established accounting standards as a source oflaw.

Another key area of regulation for the privatised utility companies are the consumerwatchdogs – for example, Oftel which regulates British Telecom.

Case law is also a very important aspect of company regulation. Try to think ofexamples from your legal studies.

B. FINANCIAL OBJECTIVES

The Prime Objective

The underlying assumption of the theory of finance states that:

"the main objective of the firm is the maximisation of shareholder wealth inthe long term".

In order to maximise shareholder wealth the management must maximise the value of thefirm, because the legal owners of the company are the shareholders, and all surplus valueafter creditors and other liabilities have been met belongs to them. Thus the greater thevalue of the firm after liabilities, the greater the wealth of the shareholders. The value of thefirm and shareholder wealth are represented by the market price of the company's shares,which is the amount a shareholder could obtain for selling his part of the business as a goingconcern.

It may seem to be a strange choice of major objective, but perhaps by thinking about someother likely objectives you will appreciate why the maximisation of shareholder wealth is themajor objective of firms.

(a) The maximisation of company profits is often considered to be a major objective offirms. Clearly it is important, but even when there are rising profits the value of shares(and thus shareholder wealth) can fall. Can you think of how this might happen?

There are several ways in which it may occur; one is when a company raises additionalshare capital in order to fund an investment to increase profits, but may cause earningsper share to fall (there being more shareholders to share in the profits), thus resulting ina fall in share price. Consider the following example.


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A company currently has 200,000 shares in issue and has expected profits of £50,000,thus EPS (earnings per share) are 25p. If the company issues a further 100,000 £1shares to invest in a project which will give a 10% return on investment, then expectedprofits will increase by £10,000. However, there are now 300,000 shares in issue, andthe EPS has fallen to 20p (£10,000 + £50,000/300,000 shares). The falling EPScauses the share price to drop, and shareholder wealth is therefore also reduced.

(b) Another objective you might feel to be important is the maximisation of balance sheetor asset values. Whilst a company's balance sheet is important to investors, you willdiscover from this course and your accountancy studies that balance sheets do notreflect a true and up-to-date valuation of the company and its assets, and thus cannotbe relied upon to determine the worth of the company.

All of the objectives we have considered so far are financial objectives. In addition, acompany will have important non-financial objectives which might include:

Raising the skills of the workforce – perhaps through training and appraisal

Adhering to environmental legislation – for example, by reducing pollution emissions

The provision of a quality service to customers.

Increasing importance is now being placed on business survival. The modern market placefor most businesses is becoming truly world-wide and this when, added to government andpolitical influence and interference, presents much greater challenges than existed a fewdecades ago. The modern business will need to adapt and change continually to ensure thatit survives, and continued growth is one of the keys to survival and one that all today'sbusinesses strive for.

Another area that is increasing in importance in the modern business world is socialresponsibility. Some businesses have adopted social responsibility as a key objective towork alongside their other main goals and objectives, and this is increasingly being seen inexplicit policies in both such traditional areas as good working conditions for staff, providing agood all round product for customers and helping provide adequate and competent trainingfor staff and the local labour force, and also in more modern areas such as reducingenvironmental pollution or stopping corrupt promotional practices.

Financial and non-financial objectives are both important to a company. They maysometimes be in conflict, but often they are complementary. For example, training theworkforce will increase costs initially, but should result in increased production which willgenerate additional profit for the company. There is also the recent example of many foodmanufacturers spending time and resources on the issues of obesity in respect of theirproducts and, whilst it is very much in line with not having their profits adversely affected, it isalso an serious attempt to address their social responsibilities.

Valuation of Companies

In order to achieve the main objective of maximising shareholder wealth we have todetermine exactly how we value companies and their shares. Shareholder wealth obtainedfrom a company is measured by increases in the price of shares above the price theshareholder paid for them (capital gains) and dividends received. You will see later that theprice of a share is strongly affected by expectations of future dividends (the higher theexpected dividends the higher the share price), and thus we can conclude that shareholderwealth can be maximised by maximising a company's share price.

Management should therefore set itself financial targets directly related to maximisingshareholder wealth, but how can this be done?

The price of a company's shares reflects the future earnings of the company so, inorder to maximise shareholder wealth, the company must invest in those projectswhich give the highest value over time.


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Increasing earnings per share and dividends per share also increases the share price,and firms should take decisions which allow a potential for maximisation of futuredividends and earnings.

By maximising profits – whilst we noted that maximising profits does not alwaysincrease shareholder wealth, in general it does and firms should aim to achieve thiswhilst considering the points raised above. Firms, however, should take care not totake undue risks when attempting to maximise their profits.

Shareholder Value Analysis (SVA)

SVA utilises the concept of NPV (net present value, which we shall discuss later) and arguesthat the value of an organisation is the net present value of its net future cash flowsdiscounted at its appropriate cost of capital.

SVA states that managers should concentrate on the value drivers, which are the factorswhich maximise shareholder value. They include:

Growth in sales

Profit margins

Investment in fixed assets

Investment in working capital

The cost of capital

The tax rate.

Management must identify the value drivers, cash flows and risks that result from investmentoptions and aim to maximise value in the long term. Whilst this approach is popular inseveral companies (well-known examples being Disney and Pepsi) it relies on subjectivejudgments of cash flows in the future, and so does not have universal appeal.

Long-term Versus Short-term Objectives

Unfortunately, the Stock Market is often more concerned with short-term increases in shareprices rather than the maximisation of long-term profits (short-termism) e.g. choosing theproject with the higher profits in the first year rather than over the life of projects. Oftencompanies have to trade off short-term gains (e.g. achieving an earnings figure for a financialyear) against acting in the best interests of the company in the long term (e.g. investing infuture training and development expenditure).

Objectives of Multi-National Companies

The objectives of multinational companies (MNC) are similar to those of other organisationsbut may be more complicated due to the number of differing views and requirements of thedifferent countries they are based in.

Objectives of Public Sector Organisations

Characteristics of organisations generally considered to be within the public sector includebeing non-profit making, with the Government accepting full, or a degree of, responsibility fortheir performance and exercising some measure of control over their activities. Broadly thepublic sector encompasses central government departments, local authorities, the HealthService, the police, and public bodies which receive their principal financing from central andlocal government (e.g. the Arts Council, the Fire Service, The Sports Council), plusnationalised industries (see below).

These bodies are statutory organisations created by Acts of Parliament. The appointment ofsome of the members of the organisation is a matter for the Executive. It may be that a


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minister has statutory powers to make appointments, such as in nationalised industries, oradministrative power, e.g. making appointments to advisory committees.

Public sector organisations will be funded either wholly or in part by money provided byParliament. Care must be taken, however, to distinguish between those organisationsfinanced by Parliament and those which simply receive grant-aid to assist them with aninvestment programme.

There are several differences which may exist between public bodies and commercialorganisations.

Many public organisations may have monopolies in either a service or geographicalarea.

Although prices may be charged for some public services, they are rarely related toprofit-making objectives and sometimes fail to cover the full economic cost. In general,the public sector does not use the price mechanism to test whether the public want theservices provided. Instead, the criteria applied tend to be based on the politicaljudgment of elected representatives under the constraints of the political mechanism ofelections, pressure groups and consultative processes.

The public sector exists to serve the community and, in the field of accounting, thestewardship of funds is often the key objective (rather than the profit motive). However,the responsibilities of the financial manager and the need to exercise good financialpublic relations are as important as in commercial organisations. In order to replacethe profit motive as a yardstick performance measures have been developed in orderto ensure that the three "Es" of efficiency, economy and effectiveness are achieved,and to protect public money. Thus, for example, in an attempt to improve theperformance of central and local government departments, the Government hasintroduced a wide range of key performance indicators (K.P.I.'s).

Within these overall points about the public sector in general, we should also recognise anumber of particular aspects and developments relating to specific types of organisation.

(a) Nationalised Industries

In recent years the number of nationalised industries has been reduced due to theprivatisation programme of the Conservative Governments of 1979-1997. However,there are still some large organisations remaining in this category, including the PostOffice (although this may soon be privatised). The objectives of such organisations aregenerally social or service-led.

They are funded by borrowing from the capital markets and the Government. Whilstthe maximisation of profits is not their main objective they generally have to obtain setfinancial targets, perhaps to maintain required subsidies at a set level or below. Ingeneral nationalised industries in the UK have been expected to aim to achieve a setrate of return (before interest and tax) on new investment programmes. The rate ofreturn is measured by current cost operating profit as a proportion of the netreplacement cost of assets employed. Nationalised industries also have otherperformance measures, including cost reductions and efficiency gains which they haveto achieve.

(b) Government Departments

One major change in this area within the UK recently has been the formation ofexecutive agencies to carry out specific functions, such as the Contributions Agency.They are expected to achieve a set level of service and are answerable to theGovernment for their service levels but are managed independently on business-ledlines.


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(c) Private Finance Initiative (PFI)

The Private Finance Initiative (PFI) is a small, but important part of the Government'sstrategy for delivering high quality public services.

The Private Finance Initiative (PFI) was introduced in 1992 as a means of obtainingprivate finance for public sector long-term capital projects, e.g. the building of prisons,schools and hospitals. The current government is committed to developing thisapproach across a wide range of public services. A new Commission on Public PrivatePartnerships was set up in Autumn 1999 (the Institute of Public Policy ResearchCommission, IPPR) to examine questions about specific forms of partnership betweenprivate sector firms and public sector organisations – for example, how can privatefirms involved in partnerships be made accountable to the public, and how does thisaccountability fit in with achieving the best value for money?

In assessing where PFI is appropriate, the Government's approach is based on itscommitment to efficiency, equity and accountability and on the objectives of publicsector reform. PFI is only used where it can meet these requirements and deliver clearvalue for money without sacrificing the terms and conditions of staff.

Where these conditions are met, PFI delivers a number of important benefits. Byrequiring the private sector to put its own capital at risk and to deliver clear levels ofservice to the public over the long term, PFI helps to deliver high quality public servicesand ensure that public assets are delivered on time and to budget.

(d) Not for Profit Organisations

The prime objectives of organisation such as charities are not concerned with profit-making, but with the provision of services, e.g. to offer a service such as training guidedogs for the blind, or to fund research into cancer treatments. They do, however,operate within financial constraints and must work within the funds they obtain.

All not-for-profit organisations also strive, as do many commercial ones, to obtain thethree Es of economy, efficiency and effectiveness.

C. CORPORATE GOVERNANCE

Shareholders are the owners of a company and it is important to remember that themaximisation of their wealth is the prime objective of companies in the private sector. This isthe underlying concept in the theoretical parts of this course. However, they are not the onlygroups with an interest in the company and the interplay of factors in the governance of acompany is a key concept.

Company Stakeholders

Stakeholders are usually divided into two distinct categories:

Internal stakeholders such as managers and employees, and

External stakeholders such as shareholders, creditors and lenders.

In practice companies often have multiple objectives (both financial and non-financial)involving various stakeholder groups, which prevent the maximisation of shareholder wealth.The different stakeholder groups in an organisation were identified in 1975 by the CorporateReport (ASC) which dealt with their objectives and specific requirements from accountinginformation. Clearly, different users will look at the company in different ways, and theobjectives of organisations have to be designed to satisfy their varying needs, with theobjectives of one group often also applying to another group. The objectives of differentgroups may conflict, and compromises will have to be made.


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We consider the interests of some of the stakeholder groups below, but you should try tothink of other points yourself.

(a) Banks and other lenders

This group includes anyone who makes a loan or other financial accommodationavailable to an organisation, examples being debenture-holders, finance companies,building societies and venture capitalists.

The main concern of this group is the safety of the investment; lenders expect to gettheir money back within an agreed period and to make a profit. In order to maintain thesafety of the investment they want to ensure that the level of debt to equity does notbecome too high, because increases in the level of debt increase the risk of insolvencyof the firm, with the firm being unable to pay the required interest payments. Short-term lenders are especially concerned with the ability and willingness (known as"corporate integrity") to repay the liability from cash generated by the business. Long-term lenders may place a restrictive trust deed or set financial guidelines, e.g. a setproportion of working capital, in order to ensure their investment remains safe.

(b) Business-contact group (includes debtors and creditors)

This group includes suppliers, competitors and all other business affected by anorganisation's activities. Their objectives include ensuring that the firm deals honestly,does not misuse any monopoly powers and pays its bills promptly within the terms ofthe trading agreement.

The group will be interested in developing long-term strategic relationships and thecontinuity of trading opportunity with an organisation which is financially stable withminimal administration. Customers of the organisation will be concerned with having asupplier who is reliable, and who provides a constant supply of the product (whenrequired) of consistent quality with good, efficient service at a fair price. Customerswill also be concerned with the level of service they are receiving, the value for money,and the safety of the goods they receive.

Competitors are also included in this group, and include those who may be interestedin acquiring the business as well as those who are rivals in trade. The group willrequire as much information about the company and its finances as possible, althoughthe company will not wish them to have such information, and secrecy may conflict withthe needs of other groups.

(c) Public

The needs of the general public can take many forms, e.g. sections of the generalpublic may wish to see a restriction on contributions to political parties, charities orsocial groups, or a restriction on the business activities carried out with, or in, aparticular country. Another example is where local residents are interested in theamount of investment and degree of control that an entity has in their own communityand its ultimate effect on their local environment. When public money assists theenterprise the public may wish to see the return in profitability, jobs and services.

(d) Government

The Government (and, indeed, the public) wish to ensure that the organisation adheresto the law, pays the correct amount of taxes and other financial charges levied upon itby government bodies, and provides the statistical and other information required inorder to ensure control over its (the Government's) own economic policy. TheGovernment will also be interested in ensuring that the organisation respects its socialand environmental commitments.

Moreover, the Government has a desire to regulate some of the privatised utilities toprevent them abusing their monopoly powers. For this reason it has set up consumer


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"watchdogs", e.g. Oftel, which regulates British Telecom, to oversee such companies.The watchdogs may, amongst other things, limit price levels which can conflict with acompany's desire to maximise profits.

(e) Financial analysts and advisors

This group will comment upon the progress, or otherwise, of the entity. In order to doso they will need the fullest possible information in whichever field their interest lies.Their requirements may mirror those of any of the other user groups. They will,however, have the key objective of ensuring compliance with accounting standards toprovide for uniformity to the presentation of information and the easier comparison withother organisations.

(f) Employees and management

Employees will be concerned with the remuneration they receive from the company,their working conditions and security of employment. They may also be concernedwith other factors such as training and career development prospects within the firm;benefits in kind such as company cars; company pension and redundancy provisions;and the potential for future expansion of jobs for themselves and their friends andfamilies.

(g) Shareholders and investors

Shareholders and investors are obviously an important stakeholder group, being theowners of the business. In order to meet the needs of shareholders managementmust:

Maximise their wealth (shown by the growth in share price and the payment ofdividends).

Achieve a specific level of earnings, earnings per share and dividends per share.Note that some shareholders prefer high dividends and some prefer capital gains(see later study unit) but the needs of the majority should be met as far aspossible.

Stick to a preset target for operating profitability represented by either a set returnon capital employed or a profit/sales ratio (also discussed later).

Expand the business when feasible – to be a worthwhile investment, growth,level of risk, return on investment and profitability in relation to competitorbusinesses and other investment opportunities will be expected to be at anappropriate level.

Maintain the security (as far as is consistent with profit-making) of theshareholder's investment. (The risk-return trade off is discussed in more detail ina later study unit.) This includes considering the fact that shareholders havedifferent risk preferences and thus prefer different levels of gearing.

Satisfy the investor that the company has sufficient cash flow to accommodate itsplans and avoid future potentially fatal liquidity problems.

Give details of political, charitable or social donations in order to allowshareholders to decide whether the convictions of the management are in linewith their own views.

This is not an exhaustive list of management objectives in respect of shareholderinterests and you may be able to think of several others. A company therefore has toknow who its major shareholders are and what their objectives for the company are,and concentrate on achieving those objectives. Such knowledge would also help toexplain recent price movements when shareholdings change hands, and might help infighting off a takeover bid.


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Companies may have only a few shareholders (e.g. a private family company) or theymay have many small shareholders (e.g. some of the privatised utilities). Advantagesof having a large number of shareholders include a reduced risk of one shareholderobtaining a controlling interest; greater market activity in the firm's shares and thus thelikelihood of vast price movements caused by one shareholder selling his shares isalso reduced; and takeover bids are easier to frustrate. Against this, however, will beincreased administration costs covering statutory requirements of information toshareholders, and it may be more difficult to meet all shareholders' conflictingobjectives.

Many decisions in financial management are taken in a framework of conflicting stakeholderviewpoints. For example, consider the stakeholders and the related financial managementissues involved in the following situations.

A private company converting into a public company

The stakeholders will include:

(a) Shareholders of existing private company;

(b) Shareholders of new public company;

(c) Employees and management.

Some of the key financial management issues will be:

(i) Who will gain a controlling interest in the new company?

(ii) Will the company be administered differently, perhaps as family ownershareholders no longer have day to day involvement in running the company?How will it affect terms and conditions of employees?

(iii) How will the conversion affect maximisation of shareholder wealth?

A highly geared company, such as Eurotunnel, attempting to restructure itscapital finance


(a) Debenture holders;

(b) Banks and other lenders;

(c) The government;

(d) Shareholders.


(i) Shareholders will be concerned about the effects of additional gearing on thecompany's ability to pay dividends, which may conflict with the government'sobjective of ensuring financial stability.

(ii) As this is a large public interest project (Eurotunnel) the government will want tosee financial stability to ensure that the company can complete the projectwithout financial collapse.

(iii) Debenture holders are concerned to ensure that the company will have sufficientcash flow to meet interest payments as they fall due.


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A large conglomerate "spinning off" its numerous divisions by selling them, orsetting them up as separate companies, e.g. Hanson


(a) Employees and management;

(b) Debtors and creditors;

(c) Shareholders.


(i) The security of jobs for employees and management in the new companies,which may conflict with the aim of shareholders to maximise wealth.

(ii) Customers (debtors) will be concerned about the quality of the product andwhether the new structure will affect this.

(iii) Suppliers (creditors) will want to know the liquidity of separate companies andtheir ability to pay outstanding debts. Also how will outstanding debts be settled ifdivisions are sold?

Japanese car-makers, such as Nissan and Honda, building new car plants inother countries


(a) Shareholders;

(b) Employees and management;

(c) Government;

(d) Public.


(i) The public may be concerned that they have no control over foreign companiessetting up in their local areas, which may conflict with the aims of government inencouraging investment by overseas companies.

(ii) The government may grant development finance and incentives to incomingcompanies.

(iii) The shareholders of the Japanese companies will be concerned about thesecurity of their investment overseas.

(iv) Japanese management may be concerned about different pay and conditions ifthey are sent to manage the overseas plants.

A public company offering to run the UK national lottery for free rather than forprofit


(a) The government;

(b) The public;

(c) Shareholders;

(d) Financial analysts.


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(i) The government will be concerned about the company's objectives if profit is notthe obvious one.

(ii) Shareholders will want to know how this non-profit making venture will affectdividends and the value of shares. After all, their main objective is maximisationof shareholder wealth.

(iii) Financial analysts will study the possible effects on the company's value if it gainsthe contract to run the lottery.

(iv) The public will want to know what percentage of takings will be donated to goodcauses and how much will be retained by the company for administration andinvestment in equipment.

Management/Shareholder Relationship and Agency Theory

The skill and experience of the senior management board (and to a lesser extent itssubordinate management) are important to shareholders as they are employed to managethe shareholders' investment on their behalf. There must be trust in the integrity and abilityof the managers; a dynamic board of management can make a significant difference to theperformance of a business and the way the market views it.

An agency relationship exists where one person (an agent) acts on the behalf of another(the principal). The management/shareholder relationship is an example of an agencyrelationship. Goal congruence occurs when the objectives of the agents match those of theprincipals. The agency problem is the conflict that arises from the separation ofmanagement and ownership in many companies, leading to a lack of goal congruence. Thefinancial and other rewards of managers (agents) may not be linked to the shareholders'(principals) financial return. In theory management should not be able to act contrary to thewishes of shareholders because shareholders can dismiss the managers or sell their shares.Unfortunately it is often not the case. Small shareholders frequently have little knowledgeabout the running of the business and little power to alter its execution; and the largeinstitutional shareholders have often been passive and uninvolved.

However, a series of "corporate raids" in the late 1980s, when firms acquired and then assetstripped managerially-focused companies believing them to be undervalued, has led to thelarge institutional shareholders considering the actions of management more carefully.

A number of incentive schemes have been introduced in an attempt to encourage goalcongruence between management and shareholders. The most popular is the stock optionscheme. This allows senior management up to a certain number of the company's shares ata fixed price at a specified time in the future. The management therefore have a financialincentive to act in ways to maximise the share price, which benefits all shareholders.However, such schemes are of doubtful benefit – management do not have to buy shares ifthe price has fallen; and the schemes can lead to volatility in the share price which is counterto the principle of a stable share price which many shareholders desire.

Another popular scheme involves profit-related incentives in which bonuses are based onthe annual growth in earnings per share, measured against a pre-set target such ascompanies in the sector. However, you will appreciate that accounting figures can easily bemanipulated and can also be affected by external factors such as a change in tax rates.Such measures therefore only give a partial (and perhaps misleading) picture ofmanagements' activities.


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The Cadbury Report

The Committee on the Financial Aspects of Corporate Governance (known as theCadbury Committee, after its Chairman) was set up in May 1991 by the Financial ReportingCouncil (FRC), the London Stock Exchange and the accounting profession, in response toincreasing public concern over the management of large companies and professionalinvestors' low levels of confidence in financial reporting and auditing. Concerns included lackof direction and control of organisations by the boards, a lack of true auditor independence,and an increase in litigation and damages awarded against companies. The aim of theCadbury Committee was "to bring forward proposals to promote good financial corporategovernance, without stifling entrepreneurial drive or impairing companies' competitiveness"."Corporate governance" was defined by the committee as "the system by which companiesare directed and controlled" and is the responsibility of the directors of the company. TheCommittee intends to consider the responsibilities of each group involved in the financialreporting process including:

The links between board, auditors and shareholders;

The role and responsibilities of audit and the auditors;

The need for audit committees, their functions and membership;

The type and frequency of information required by shareholders and other parties witha financial interest;

The role and responsibilities of executive and non-executive directors as regards thereporting of financial performance.

The heart of the Committee's recommendations was a Code of Best Practice, to beadopted by the directors of all UK public companies, with all company directors to be guidedby it. Some allowances are made for the way in which it might be implemented in differentcompanies.

You will see later that the Cadbury Code of Best Practice has been incorporated into theCombined Code. However, the recommendations of the Cadbury Committee are soimportant in the development of corporate governance in the UK that we will look at them indetail.

The Code of Best Practice

The major points are as follows:

(a) The Board

There should be a clearly accepted division of responsibility at the head of a companyensuring a balance of power and authority. In cases where the Chief Executive is alsothe Chairman there should be strong independent executives on the board with theirown appointed leader.

The calibre and number of non-executive directors should be such that their viewscarry significant weight on the board.

Boards should meet regularly and have a formal schedule of matters reserved for theirdecision to ensure that the direction and control of the company remain firmly in theirhands, including the monitoring of the executive management.

All directors should have access to the advice and services of the company secretary,who is responsible to the board for ensuring that board procedures are followed andthat applicable rules and regulations are complied with. Any question of the removal ofthe company secretary should be a matter for the board as a whole.


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(b) Executive Directors

Directors' total emoluments and those of the Chairman and the highest-paid UKdirector should be fully disclosed and split into their salary and performance-relatedelements, with an explanation of the basis on which performance is measured.

Executive directors' pay should be subject to the recommendations of a remunerationcommittee made up wholly or mainly (and preferably chaired) by non-executivedirectors. Directors' service contracts should not, unless approved otherwise byshareholders, exceed three years.

(c) Controls and Reporting

Boards must establish effective audit committees. The chairmen of audit andremuneration committees should be responsible for answering questions at the AGM.

The board should ensure that an objective and professional relationship is maintainedwith the auditors. The board must explain their responsibility for preparing theaccounts next to a statement by the auditors regarding their reporting responsibilities.

The Code requires that directors report on the effectiveness of the company's systemof internal control, and state that the business is a going concern, with supportingassumptions or financial qualifications if necessary.

The board's duty is to present a balanced and understandable assessment of theircompany's position. Balance sheet information should be included with the interimreport, which should be reviewed by the external auditors but need not be subject to afull audit.

(d) Shareholders

Both boards and shareholders were encouraged by the Committee to consider how toimprove the effectiveness of general meetings.

(e) Auditing

The annual audit is described as "one of the cornerstones of corporate governance".Several minor recommendations were made to ensure its effectiveness and objectivity:

Audit Effectiveness

Audit effectiveness should be increased by clarifying the respectiveresponsibilities of directors and auditors for preparing and commenting onfinancial statements, and by developing audit practice in areas such as internalcontrol, going concern, fraud and other illegal acts.

Audit Objectivity

Both the board and auditors have a responsibility to ensure that the relationshipbetween them is professional and objective. Audit Committees

The Committee stated that the board should establish an audit committee of atleast three non-executive directors with written terms of reference which dealclearly with their authority and duties.

(f) Non-executive or Outside Directors

Non-executive directors should bring an independent judgment to bear on issues ofstrategy, performance and resources including key appointments and standards ofconduct.

The Committee recommended that a majority of non-executive directors should beindependent and free of any business or financial connection with the company (apartfrom their fees and shareholdings). Fees should reflect the time which they commit tothe company, but they should receive no pension or share options as part of their


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service. The Code also suggested that an agreed procedure should be in place fornon-executives to take independent professional advice at the company's expense.The selection of non-executive directors should be by a formal process, for a specifiedterm, and their nomination should be a matter for the board as a whole. However, thereport does not discuss the action that should be taken in the event of a non-executivedirector resigning or being released.

The independence of non-executives must be transparent. Fees should be such thatpart-time rather than full-time involvement is encouraged and, since resignation is theultimate sanction of the non-executive director, the fees should not be so large that thenon-executive is dependent upon them.

In summary, the recommendations of the Cadbury Report, as encompassed by the Code ofBest Practice, were that listed companies should include in their accounts full and cleardisclosure of directors' total emoluments and those of the Chairman and the highest-paiddirector. The disclosures should include pension contributions and stock options.Performance-related elements, and the basis upon which performance is measured, shouldbe shown separately.

With effect from April 1993, the Stock Exchange stated that UK-incorporated listedcompanies must state in their accounts for accounting periods ending after 30 June 1993,whether they have complied with the Code throughout the accounting period in addition tothe other continuing obligations. Any failure to comply must be stated, along with reasons forthe non-compliance. The compliance statement must be reviewed by the auditors. Other UKcompanies should adopt the Code at the earliest practicable date.

In addition, from 1 January 1995 directors' statements should include the following:

(a) An acknowledgment that directors are responsible for the system of internal financialcontrol including the main procedures established and their effectiveness.

(b) An explanation that the system can only provide a reasonable level of control.

(c) Confirmation that the directors have reviewed the effectiveness of their present internalfinancial control.

The Greenbury Report

The Greenbury Report, published by the Greenbury Committee in July 1995, goes beyondthe Cadbury Code of Best Practice in establishing principles for determining directors' payand disclosures on pay to be given in the annual accounts and company reports.

The Greenbury Code recommends that a remuneration committee should be establishedcomprising solely non-executive directors – though the Chief Executive or Chairman may beasked for advice – and that this committee should determine executive directors'remuneration. The Code also recommends that directors should have service contractslimited to one year.

Other important recommendations are:

Public companies should publish an audited statement detailing compliance with theGreenbury Code under Stock Exchange rules.

The remuneration committee should report to shareholders via the annual report andaccounts. Full details should be included of directors' remuneration:

(i) Basic salary

(ii) Benefits in kind

(iii) Annual bonuses

(iv) Long-term incentive schemes.


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The majority of the Greenbury Code principles have been included in the Listing Rules of theStock Exchange.

Hampel Committee Report

Sir Ronald Hampel was given the task of continuing the work of Sir Adrian Cadbury oncorporate governance. The final report of the Hampel Committee was issued in February1998. Sir Ronald summed up the essence of his committee's report by saying that "Goodgovernance requires judgment, not prescription and for that reason I believe it is in business'own interest to conform, and that it will". The main features of this report relating tocorporate governance are:

Most non-executive directors should be independent and their independence should beidentified in the annual report.

Directors should receive appropriate training.

The roles of chairman and chief executive should be separate.

A senior non-executive director should be appointed to deal with shareholders'concerns. The name of the director should be identified in the annual report.

The practice of paying non-executive directors using company shares is notrecommended, although there is nothing against it in principle.

Directors should be on contracts of one year or less.

A remuneration committee of the board should be established, made up of independentnon-executive directors. The committee should make decisions on the pay packagesof executive directors and the framework of executive pay.

Companies should include in the annual report a narrative account of how they applybroad principles and should explain their policies. Any departure from best practiceshould be justified in the report.

The creation of an internal audit department is recommended.

Directors should review the effectiveness of the company's internal controls (not justfinancial controls) but need only report publicly on the system rather than itseffectiveness.

The Stock Exchange has a code of practice which incorporates the recommendations of theCadbury, Greenbury and Hampel reports (see later). The Stock Exchange will beresponsible for overseeing adherence to the code. The government has indicated that ifcompanies do not adopt best practice, it may take action to introduce legislation on corporategovernance. In particular, continuing large pay awards to directors and extensive shareoption schemes may prompt the government to take action.

The Combined Code

In June 1998 the London Stock Exchange published the Hampel Committee Principles ofGood Governance and the Code of Practice (the Combined Code). It replaces the Cadburyand Greenbury Codes but incorporates aspects of both of them.

(a) The Principles of Good Governance

Directors and the Board

(i) There should be an effective board to lead and control the company.

(ii) Running the board and running the business are separate tasks. Theremust be a clear division of responsibilities at the head of the company. Noone individual should have unfettered powers.


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(iii) There should be a balance of executive and non-executive directors(NEDs) including independent NEDs. No individual or group shoulddominate the board.

(iv) Timely and quality information should be provided to the board.

(v) There should be a formal and transparent procedure for boardappointments (usually a nomination committee of mainly NEDs).

(vi) Directors should be re-elected at least every three years.

Directors' Remuneration

(i) Remuneration should be sufficient to attract and retain the directors neededbut no more than necessary. Executive directors' remuneration should bepartly linked to corporate and individual performance.

(ii) There should be a formal and transparent procedure for developingremuneration policy and individual packages, i.e. a remuneration committeeof NEDs. Directors should not be involved in deciding their ownremuneration.

Relations with Shareholders

(i) The board should encourage dialogue on objectives with institutionalshareholders.

(ii) The annual general meeting (agm) should be used to communicate withprivate investors and encourage their participation.

Accountability and Audit

(i) There should be a balanced, understandable assessment of the company'sposition and prospects.

(ii) There should be a sound system of internal control to safeguard theshareholders' investment and the company's assets.

(iii) There should be formal and transparent arrangements to apply the abovetwo principles and maintain relationships with the auditors.

The Combined Code requires an explanation in a listed company's annual report ofhow these principles have been applied. A major impact of the Combined Code is thata company must review the effectiveness of all controls, not just financial controls.

(b) Examples of Contents of Combined Code

Directors

(i) The Board must comprise at least one third non-executive directors.

(ii) There must be a senior independent director (not the Chairman) to whomshareholders can raise their concerns.

(iii) A nomination committee is strongly recommended.

(iv) All directors should receive training when first appointed.

Directors' Remuneration

(i) A significant proportion of executive remuneration should be linked tocorporate and individual performance.

(ii) The remuneration report should be issued in the name of the board and notjust the remuneration committee.


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Accountability and Audit

(i) Financial reporting provisions apply to all price-sensitive public reports andreports to regulators.

(ii) The definition of "internal control" covers all controls, not just financialcontrols.

(iii) The majority of the audit committee should be independent non-executivedirectors.

(iv) The audit committee should review the scope, results, cost-effectiveness,independence and objective of external audit.

(v) The company should review the need for internal audit.

(c) Matters to be Reported Publicly by Companies

How the company applies the principles

Whether or not the company complies with detailed provisions; any exceptionsmust be explained

Justify combined posts of chairman and chief executive

Give the names of:

(i) The chairman, chief executive, senior independent director and otherindependent directors

(ii) The chairman and members of the nomination committee

(iii) Members of the remuneration committee

(iv) Members of the audit committee

(v) Biographies of directors submitted for election or re-election

Remuneration policy and details of the remuneration of each director

Explain the directors' responsibility for preparing the accounts

Whether the business is a going concern, together with the supportingassumptions or qualifications

State that directors have reviewed the effectiveness of internal controls

The Turnbull Report

Guidance for directors on the scope, extent and nature of the review of internal controls wasissued by the Institute of Chartered Accountants in England and Wales in late September1999 in the form of the Turnbull Report – "Internal Control: Guidance for Directors of ListedCompanies in the UK". This guidance has the support and endorsement of the StockExchange.

The Turnbull Report states that:

"A company's system of internal control has a key role in the management ofrisks that are significant to the fulfilment of its business objectives".

The company's system of internal control should:

Be embedded within its operations and not be treated as a separate exercise;

Be able to respond to changing risks within and outside the company; and

Enable each company to apply it in an appropriate manner related to its key risks.


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The Report makes it clear that the board of a company is ultimately responsible for its systemof internal control. It will normally delegate to management the task of establishing,operating and monitoring the system.

Financial Services and Markets Act, 2000 and the FSA

The Financial Services and Markets Act 2000 set out four statutory objectives, supported bya set of principles of good regulation which companies must have regard to whendischarging their functions. The objectives are:

market confidence – maintaining confidence in the financial system

public awareness – promoting public understanding of the financial system

consumer protection – securing the appropriate degree of protection for consumers,and

the reduction of financial crime – reducing the extent to which it is possible for abusiness to be used for a purpose connected with financial crime.

The Act also set up the Financial Services Authority (FSA), one of now a number of financialservice regulators. The FSA has set out its aims under three broad headings:

promoting efficient orderly and fair markets

helping retail consumers achieve a fair deal

improving companies' business capability and effectiveness.

These objectives condition the way in which the FSA acts:

providing political and public accountability – so its annual report contains anassessment of the extent to which it has met these objectives, and scrutiny of the FSAby Parliamentary Committees may focus on the extent to which this is being achieved

governing the way it carries out its general functions in respect of rule-making, givingadvice and guidance, and determining general policy and principles – so, for example,it is under a duty to show how the draft rules it publishes relate to these statutoryobjectives; and

assisting in providing legal accountability – so where it interprets the objectiveswrongly, or fails to consider them, it can be challenged in the courts by judicial review.

The Higgs and Smith Reports

At the turn of the century the world markets were affected by major collapses such asENRON and these had an adverse impact on the profile of corporate governence. In the UK,the Government established enquiries into two areas in which failures were were seen askey to these collapses:

the effectiveness on non-executive directors, reported on by the Higgs Report, and

the independence of audit committees, reported on by the Smith Report.

(a) The Higgs Report

The main recommendations were as follows:

(i) The chairman:

runs the board

sets its agenda

ensures effective communication with the shareholders


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ensures that the members of the board develop an understanding of theviews of the major investors

ensures that sufficient time is allowed to discuss complex or contentiousissues

takes the lead in ensuring induction training for new directors

takes the lead in identifying development needs for directors

ensures the performance of individuals and the board as a whole

encourages active involvement by all members of the board

should maintain a good working relationship with the chief executive.

(ii) As members of a unitary board, all members are required to:

Provide entrepreneurial leadership of the company within a framework ofprudent and effective controls

set the company's strategic aims

ensure that the necessary financial and human resources are in place tomeet its objectives

review the performance of management.

(iii) Non-executive directors should:

constructively challenge and help develop strategy

scrutinise the performance of management

satisfy themselves on the integrity of financial information

satisfy themselves that financial controls and the system of riskmanagement are robust and defensible

set the remuneration of the executive directors

have a prime role in appointing and removing executive directors

be independent of judgement and have an enquiring mind

be well informed about the company and the environment in which itoperates

by visiting sites and meeting middle and senior management ensure thathis/her knowledge of the company is kept up to date

uphold the highest standards of integrity and probity

question intelligently, debate constructively, challenge rigorously and decidedispassionately

promote the highest standards of corporate governance

declare any potential conflicts of interest and refrain from discussion onmatters where conflict of interest may arise

understand the views of major investors through the chairman and thesenior non-executive director.

(b) The Smith Report

This examined the role of audit committees and gave authoritative guidance on howaudit committes should be operated and run. The main recommendations were thatthe audit committee should:


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be a committee of the board

consist of at least two, and preferably at least three, members

consist of independent non-executive directors, of whom at least one membershould have recent and relevant financial experience (although this does notcomprise a departure from the principle of the unitary board)

have written terms of reference including:

– to monitor the integrity of the financial statements

– to review company's internal financial controls

– to monitor the effectiveness of internal audit

– to recommend appointment of external auditors

– to approve remuneration of external auditors

– to approve terms of engagement of external auditors

develop policy regarding use of external auditors for non-audit services

review whistle blowing policy and procedures

meet at least three times per year

meet at least annually with the internal and external auditors without thepresence of management

be provided with adequate resources

be able to take independent legal, accounting or other advice

be provided with appropriate training and additional remuneration as necessary.

Other Disclosure and Behaviour Compliance Provisions

There are requirements for disclosure of directors' remuneration in the annual financialstatements. These are the Company Accounts (Disclosure of Directors' Emoluments)Regulations 1997 and they apply to all listed and unlisted companies.

The various Companies Acts and European Union legislation require certain minimumstandards of behaviour from organisations, as does the Stock Exchange.

There is also an avenue for action to be taken against companies that do not adhere to therecognised standards, through being investigated and potentially prosecuted by the SeriousFraud Office (SFO).

D. CORPORATE FINANCIAL MANAGEMENT

In this final section, we shall consider the scope of financial management within the moderncompany.

Financial Decision Making

We noted earlier that corporate finance deals with three decisions which a firm mustundertake.

Which investments should the firm undertake? – the investment decision

How, where, when and how much finance should be raised? – the financing decision

How should the firm's profits be used or distributed? – the dividend decision.


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(a) The Investment Decision

The investment decision involves a firm in choosing which projects to invest ordisinvest in. It can include internal decisions concerned with current areas of the firm'sinvolvement, and external decisions concerned with expansion or contraction of thefirm by takeover, merger or disinvestment.

(b) The Financing Decision

An organisation is funded by a combination of debt (both long and short term) andequity (share capital). The financing decision involves deciding on the level of fundsrequired, which type or types of funds to raise, and the raising of funds. In deciding thelevel and type of funds to raise the firm has to know the cost and risk involved in eachparticular type of funds. The cost involved is the opportunity cost to the provider of thefunds; the risk involved in raising finance is the possibility of negative returns on theinvestment (risk is dealt with in more detail in a later study unit). In making thefinancing decision a trade-off is often made between keeping as low a level of funds aspossible to aid profitability (by limiting the costs of servicing those funds, i.e. interestpayments and administration of share registers) and ensuring the firm has sufficientfunds to remain solvent.

(c) The Dividend Decision

This is the trade-off between retaining profits in the business and distributing them toshareholders.

Whilst initially you will study the three decisions separately, always remember that in practicethey are interconnected and their interrelationship must not be ignored. Before readingfurther try to think of some likely interrelationships.

One common interrelationship is between investment decisions and the financingdecision. If a firm decides to invest in a major new project it may have to raise additionalfinance, having to make a choice with regard to the type and level of finance to acquire.Moreover, the cost of the funds will affect the viability of the project. Another commoninterrelationship is between the financing decision and the dividend decision – if a firmpays out a high percentage of its profits as dividends it may need to raise additional financeand – as we discussed earlier – it may not be in the shareholders' best interest. Clearlythese are only two examples and whenever a decision is made in one of the areas it willhave an impact on the other areas. We shall cover the interrelationships of the decisions ingreater detail later in the course.

Financial Functions in Organisations

The role of the finance function within an organisation is considerable and includes thefollowing aspects:

The determination of the volume of financial resources required.

The acquisition of the required financial resources, either internally through profitretention and dividend policy, or externally through share issues, debenture issues orloans.

The maintenance of an optimum mix of funding, bearing in mind the potential impact ofthe capital structure on the market value of the business.

The needs of the providers of finance have to be considered, including their requiredreturn on investment and the maximisation of the value of their shares. If the companyis floated on the Stock Market its rules and regulations must be adhered to. A financialmanager has a duty to value a business in a manner which shows its true worth, andhe should take into account the effect of price changes over time on the valuation ofthe business. The financial manager must take account of factors which determine


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share prices, particularly those over which he has control. The business should notonly be maximising the wealth of its shareholders, but it should also be seen to bedoing so, which requires some degree of financial public relations by the financialmanagers, in order to maintain a good financial image of the firm to outside sources ofinvestment.

Assessment and valuation of investment opportunities to ensure that the generatedresources are employed efficiently. This includes the investment of surplus cash inshort-term investments. In order to do the latter the financial manager must have athorough understanding of the workings of the "City" and investment markets generally.

The assessment of the optimum amount of assets provided, including the calculation offixed assets, current assets and liquid resources wanted by the business. Plans shouldcater for seasonal fluctuations as well as medium- to long-term strategic requirementsand plans of the organisation.

The finance manager should ensure that suitable control systems are employed for theauthorisation of expenditure on fixed assets, to ensure that stocks of raw materials,finished goods and work in progress are kept to a level which is the lowest possible tobe consistent with efficiency, and to ascertain that the cash available in the business isused as fully as possible throughout the year. The control function also coversinvestments, and the maintenance of a reasonable balance between credit taken andcredit given.

The control of liquidity, by ensuring sufficient working capital within the company takingaccount of the timing of future plans for growth and fixed asset purchases.

In all but the smallest of organisations there should be provision for internal audit toensure that control systems are working and to help prevent and detect errors andfraud.

The financial manager should ensure that all risks capable of being calculated arecovered by insurance, including cover in respect of accident, fire and consequentialloss and, if appropriate, credit insurance.

The business must comply with statutory requirements including those of central andlocal government and the European Union, and for a listed company with those of theStock Exchange. Accounts must show a true and fair view of the position of thebusiness at the time they are drawn up. Moreover, they should be capable of beinginterpreted in a way that gives the reader the correct impression. Problems arisingfrom reconstructions and amalgamations of companies also form a major part of therole of the financial manager.

The Role of the Finance Manager

The tendency to internalise corporate finance means that the financial manager of the majoror multinational company must become an expert in a wide variety of areas including theresponsibilities we described above. He must also remain up-to-date in a world-wide marketwhich is rapidly changing. It is a massive task and, to combat the resulting problems, largercompanies have typically created specialist functions, each reporting to the FinancialDirector. They are senior roles and their functional responsibilities are discussed below. Inthe biggest organisations, responsibilities would be further broken down and delegated.Smaller organisations may not require all the functions, and one person may takeresponsibility for more than one area of work. The job titles in any one organisation maydiffer from those listed below, but the functions remain the same.


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The different functions are:

The Controller

This role encompasses capital budgeting and investment appraisal, stock and creditcontrol, short-term investments and the internal and external audit functions.

The Accountant

The accountant will be responsible for the records of financial data and for producingmanagement reports and company accounts. The role is split into the disciplines ofmanagement and financial accounting covered elsewhere in your studies.

The Treasurer/Cashier

This involves budgeting for cash flows, procuring adequate liquid funds and thephysical security of cash resources. In a business which deals internationally thisfunction will also include foreign currency management.

Financial Strategist

This involves procuring and managing the correct volume and optimum mix of funds,whilst organising a suitable channel of communication with external bodies such asgovernment and investors and, as a member of general management, in meeting thedemands of fellow functional managers.

Corporate Planner and Strategist

The modern financial manager has a wider corporate role, involving sharingresponsibility for corporate goals and objectives, including the development of strategicand business plans.

In the past it was often the case that many managers would immerse themselves withintheir own particular discipline and financial managers were no exception. In themodern business world it is very important that all managers are able to develop acorporate role whereby they are willing and able to look at the entire business ratherthan just their own particular functional area. One aspect of this is in respect of socialresponsibility. This is increasingly important to the modern business and the financemanager needs to incorporate its implications into all aspects of his/her role.

Communicator

Finance is a difficult subject for many people and one of the skills that is required bythe modern financial manager is to communicate these often complex issues to staffwithin, and stakeholders outside, the business in an easy to understand manner.

Often smaller firms do not have a full-time financial manager, relying simply on regular visitsby a member of the firm's external audit staff. At least some businesses lack an awarenessof the degree of financial expertise required for their business to operate effectively. Even infirms that do employ a financial manager, many limit his key responsibilities to the productionof accounting information and recording of financial data.

The finance director may also be responsible for general administration and/or informationtechnology, depending on the size of the organisation.

When considering financial functions in organisations remember that the financial managermust, to some extent, be concerned with the way in which finance interacts with the otheractivities in an organisation such as production and personnel. The financial manager mustensure that the individual objectives of each function do not conflict with the overall corporateobjective of the business. For example, the marketing manager who seeks to increase salesor market share must do so within budgetary constraints and profitably in the long term.Budgeting is a useful way of coordinating all functional activities, and we discuss this in moredetail later in this study unit.


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Planning

There are a number of different types of planning.

(a) Strategic Planning

Strategic planning is the process by which the objectives of an organisation are madeor changed. Examples of decisions involving strategic planning include deciding whatto produce and sell and where; whether to merge with another company; and whatoverall profitability targets to set for the organisation.

Strategies are likely to exist at a number of levels in an organisation and strategicplanning must take this into account. Many management theorists have identified threedifferent levels of corporate strategy:

The corporate level, which is concerned with what type of business thecompany should be in. The company may specialise in one product or operate indiverse markets. Decisions would include considering whether to widen therange of products or move into different geographical areas.

Competitive or business strategy, which focuses on how to compete in aparticular market; for example, a company may consider a strategy ofmodernisation and rationalisation of its factories to help it compete in a fabricmanufacturing market.

Operational strategies, which look at how the different functions of the companycontribute to other levels of strategy; for example, in seeking to be competitive acompany will consider price and marketing of its products.

Strategic planning involves generation of options which are then evaluated and choicesmade. Management will select the options they intend to pursue and use them to formthe basis of strategic plans.

(b) Tactical Planning

Management or tactical planning deals with the achievement of strategic plans utilisingthe organisation's resources in the most effective and efficient manner. It involvessetting budgets and performance targets for departments, determining theorganisation's structure and developing and launching products and their marketingcampaigns.

(c) Operational Planning

Operational planning deals with the achievement of tactical plans by carrying outspecific tasks in the most effective and efficient manner.

The dividing lines between strategic and tactical planning, and tactical and operationalplanning are often unclear, and some decisions involve more than one type of planning. Thelevel at which the decision is taken is generally a guideline as to the type of planning beingundertaken, as is the frequency of the decisions. Operational decisions are often takenseveral times a day by lower-level management and supervisory staff; tactical decisions aregenerally taken at regular weekly, monthly or yearly intervals by middle and seniormanagement; whereas strategic planning is generally undertaken by senior managementand board members, and at infrequent and irregular intervals.

Knowing what is to be accomplished within a specific time-scale is a basic requirement of theplanning process, which is necessary to establish how the required results are to beachieved. The financial manager should provide a focal point for functional managersthroughout the process, emphasising the importance of financial matters in developing andimplementing plans. Especially important in the planning process are the source and timingof cash requirements. The shape of the balance sheet may also be an important issue forthe private company whose shareholders wish to realise a part of their investment by floating


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the company on the Stock Market at a later date. Similarly, a firm wishing to sell the entirebusiness may be very concerned about the size and value of its asset base.

Forecasting

In order to develop plans with any degree of accuracy a company must forecast the variablesincluded in plans. Can you think what they might be?

The variables to be forecasted include:

Demand for, and sales revenue from, the company's products (analysing each productseparately)

Costs of raw materials

Wage and salary costs

Other expense costs

Competition in the product and supplier markets

Potential for new product or production methods development, including the results ofresearch and development

Interest rates and the cost of capital

Product and safety legislation

Availability of skilled workers

Rate of inflation

Economic growth rates

Changes in the political environment, including industry regulation

Exchange rates

Taxation

Dividend policy

Assets and liabilities

Potential for new sales and marketing methods.

Plans should include contingencies for external factors which may occur (also known assensitivity analysis). Lenders will usually act with extra caution when the economyemerges from recession, because of their potential exposure to the risks of second-roundfailure (see later in this study unit). Modern computer modelling techniques can help withforecasting. The computer model can be built to assess the effect of changes in all variablesand produce scenarios which match the change in the variables.

The actual outcomes of the above must be compared to the forecasts and the variations fromthe predictions fed back into the planning process to help improve the accuracy of futureforecasts.

Budgeting

We have already seen how a business implements its long-term plans via tactical andoperational plans; often, they are expressed as budgets.

Budgets are quantitative and/or financial statements of the plans of an organisation which areprepared and approved before the period to which they relate.

Budgets can be set for long periods of time covering several years, or for short periodscovering days or hours. Often the very short-term plans are expressed in quantitative rather


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than financial terms and may deal with the production or service process. Similar to thedifferent levels of planning, the longer the period of time covered by a budget the less precisethe plans. The common length of time for most budgets, and the budgets you will probablymeet at work, are those of one year.

Budgets will be set for a wide variety of areas including all parts of sales and production. Acompany, a group of companies, or other organisation will have a master budget. A masterbudget includes an approved summary of production, sales and costs for the period, showingthe budgeted trading and profit and loss account, cash flow statement and the balance sheet.In the area of financial planning an organisation will have some, or all, of the followingbudgets:

Financial returns on investments

Cash flow planning

Profitability

Sources of finance

Capital structure

Working capital control

Arrangements for banking

Tax planning

Foreign currency management

Changes in asset structures

Funding planned takeovers

Part of the budgeting and control process is the monitoring of actual results against thoseforecast in the budgets and other plans. It is unlikely that the plans will be met precisely, andmanagement has to set a tolerance limit for deviations (or variances as they are known inaccountancy and finance). The tolerance limit will vary between organisations and betweendifferent items of income and expenditure. Variances falling outside the limits must beinvestigated to see whether there is a problem that needs correcting, an opportunity whichcan be capitalised, the forecasts need revising in view of unforeseen circumstances, orwhether the variance happened purely by chance.

A major part of the process of analysing variances is that the results of the analysis will beused with other new information to update plans and budgets for the future. Indeed, part ofstrategic planning involves the continual updating of plans as new information becomesavailable.

Cash Management

(a) Cash Flow Planning

In order to understand cash management you should be aware of the differencebetween profits and cash flow. From your accountancy studies you will be aware thatprofit is the amount by which income exceeds expenditure when both are matched on atime basis. However, cash flow is the actual flow of cash in and out of the organisationwith no adjustments made for prepayments or accruals.

An organisation must ensure that it has sufficient liquid funds to pay its bills as theybecome due. A business which has insufficient cash may be forced into liquidation byits unpaid creditors, even if it is profitable. Management must therefore plan andcontrol cash flow to prevent liquidation. In the short term this is done by cash flowbudgeting, which can be daily, weekly, monthly or yearly, ensuring that the organisationhas sufficient cash inflows to meet its outflows as they become due. If a shortage is


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expected, then the firm can arrange finance, perhaps by increasing its overdraft, toovercome the problem. If there is a short-term surplus of funds then they should beinvested in short-term marketable securities. Fluctuations in cash can arise for avariety of reasons, a major one being seasonal fluctuations in trade.

A significant part of strategic planning is the setting of long-term financial plans, settingout the medium and long-term financial objectives. The plans can allow the businessto judge whether or not it will achieve its financial objectives, e.g. the repayment ofloans, what finance needs it may have in the long term and short term, and whetherthere is any surplus cash which should be invested.

Strategic cash flow planning is basically long-term cash flow budgeting, except thatthere are greater uncertainties about cash flows due mainly to the longer planninghorizon. The cash flows which result from planning must be consistent with the firm'sfinancing, investment and dividend policies. The firm will be able to respond to cashflow shortages or surpluses in a planned way – raising or investing the required amountof finance in the way most optimal for the company. This includes taking advantage ofchanging interest rates and economic climates to the benefit of the company. Somebusinesses will be at risk of failure due to insufficient financial resources toaccommodate their necessarily increased investment when the upturn in the economydoes arrive. Such failure is known as the "second-round" failure.

However, there may be unexpected changes in the business cash flow patterns, suchas a slump in trade, which can not be forecasted for, so an organisation must havesufficient cash to cover such eventualities. Cash flow planning which considers theability of an organisation to overcome such cash flow deficits is called strategic fundmanagement.

Strategic fund management may deal with such unexpected changes by cuttingdividend payments; improving working capital management by increasing creditors orthe overdraft level or by cutting debtors and stocks; or by selling assets which are notrequired by the core activities of the organisation. (Those assets which are mostmarketable, such as short-term marketable securities, would be sold before thosewhich would take longer to realise, such as land and unused machinery.)

Whilst a company should ensure that it has sufficient cash to cover unforeseencircumstances, holding too much cash is inefficient because of the opportunity cost ofincome foregone (either from placing short-term surpluses in marketable securities, orfrom the investment in projects earning a rate of return higher than the return requiredby the supplier of finance for longer-term surpluses). If the company cannot investlong-term surplus money in projects which receive higher returns than placing themoney in a bank account, then they should return the money to the shareholders toallow them to utilise the money in the way they consider optimal. This can be doneeither by paying out higher dividends or by repurchasing the company's shares.

(b) Capital Structure and Cash Flow

The capital structure of an organisation is the way in which its assets are financed, i.e.the levels, types and proportions of equity, debt capital, long- and short-term liabilities.Obviously, when the business is growing it will require additional capital to fund itsincreased assets.

The working capital of the business is made up of the more permanent current assetsplus the fluctuating current assets less current liabilities. Different levels, and types, oflong- and short-term sources of finance can be used to fund the fixed assets and theworking capital of the business. The method chosen will have an impact on the cashflow of the organisation.

An aggressive approach to the financing of working capital is to finance all fluctuatingcurrent assets and some more permanent ones from short-term sources. This may be


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beneficial to the company if the short-term funds are cheaper than the equivalent long-term ones, but increases the likelihood of liquidity and cash flow problems.

A conservative approach uses long-term financing to fund all permanent assets andsome fluctuating current assets. In fact it is only when current assets are large thatshort-term financing is necessary – at other times there may be surplus cash to invest.The company would probably invest this in marketable short-term securities, especiallyif the amount is significant.

A balanced approach is to fund permanent assets from long-term sources andfluctuating assets from short-term sources.

The method chosen will be a choice for senior management and will reflect their overallpolicy and plans for the organisation. However, a business may be forced to adopt asub-optimal approach (from their viewpoint) due to restrictions in their ability to raisethe "correct" type of funds. As in all areas, the policy adopted by the firm should matchthe expectations of the shareholders (see Study Unit 1 if you wish to remind yourself ofthis topic).

Moreover, the market's view of the company's prospects and abilities will determine thelevel of debt investors will be willing to lend the company. The nature of the industrythat the company operates in will also affect the level of debt that the market willconsider prudent – the more volatile the sector, the lower the level of gearing whichwould be advisable.

Economic and Government Influences

The operations of an organisation are subject to a whole series of constraints imposed bycompetitors, customers, trade unions, the general public and statutory bodies. As the socialenvironment has evolved, government has become more involved in the operation ofbusiness – issuing laws, regulations, directives, voluntary policies and codes of practicecovering most areas of commercial life.

The area is rapidly changing, and we cannot possibly hope to cover every aspect affectingcompanies, e.g. in areas such as health and safety; instead we will highlight some of themore important pieces of legislation and government policy which directly impact in the areaof finance.

(a) The Companies Acts

The Acts of 1985, 1989 and 2006 contain various legal requirements for a companyoperating its affairs in the UK including, in the field of accounting and finance:requirements for depositing accounts; annual returns; registration of changes with theRegistrar of Companies; requirements for disclosure of information in the publishedaccounts; and procedures for the winding-up of a company. The legislation lays downthe minimum standards with which the company must comply.

There are also a number of further requirements established under the Acts and setdown by various different organisations such as:

Serious Fraud Office (S.F.O.)

Financial Services Authority (F.S.A.)

London Stock Exchange

(b) The European Union (EU)

The EU provides a huge area of government involvement in corporate laws. TheCouncil of Ministers can publish requirements that impose obligations upon allcompanies in member countries, even overriding the laws in those member states.


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However, the Community does provide the opportunity for additional markets andgreater availability of financial resources, including grant aid.

(c) Government Monetary Policy

Monetary policy is the manipulation by the Government of interest rates and/or thesupply of money in an attempt to influence the economy, and such economic variablesas growth, inflation and the balance of trade. However, in May 1997 the UK LabourGovernment surrendered its setting of interest rates to the Bank of England, in line withmany other European countries. Nevertheless, the Bank of England will stillmanipulate interest rates to achieve the desired levels of major economic variables,including inflation, and this clearly, along with changes in the money supply, will havean impact on the cost and availability of capital to an organisation. Moreover, as withfiscal policy discussed below, monetary policy will also impact on other areas of a firm'soperation including the ability to export the firm's goods and the cost of imported rawmaterials and components.

(d) Fiscal Policy

Fiscal policy is the alteration by the Government of the levels of taxation or the level ofgovernment spending in order to affect economic variables such as unemployment andinflation. It will obviously have an impact on the organisation – not just in the levels oftaxation which it pays and in the availability and level of grants, but also in the overalllevel of demand in the economy and for the firm's products or services.

The current Government has taken significant steps to strengthen the framework forfiscal policy since taking office. Fiscal policy is now directed firmly towards maintainingsound public finances over the medium term, based on strict rules. Where possible,fiscal policy supports monetary policy over the economic cycle and this approach,together with the new monetary policy framework, provides the platform of stabilitynecessary for achieving the Government's central economic goal of high andsustainable levels of growth and employment.

Central to the fiscal framework are five principles of fiscal management:

transparency in the setting of fiscal policy objectives, the implementation of fiscalpolicy and the publication of the public accounts

stability in the fiscal policy-making process and in the way fiscal policy impacts onthe economy

responsibility in the management of the public finances

fairness, including between generations

efficiency in the design and implementation of fiscal policy and in managing both sides of thepublic sector balance sheet.

These principles were enshrined in the Finance Act 1998 and in the Code for FiscalStability, approved in December 1998. The Code explains how these principles are tobe reflected in the formulation and implementation of fiscal policy. In addition, itrequires the Government to set out its fiscal policy objectives and the rules by which itintends to operate fiscal policy over the life of the Parliament.

As set out in the 2007 Budget, the Government's fiscal policy objectives are:

over the medium term, to ensure sound public finances and that spending andtaxation impact fairly both within and between generations. In practice thisrequires that:

(i) the Government meets its key taxation and spending priorities whileavoiding an unsustainable and damaging rise in the burden of public debt;and


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(ii) those generations who benefit from public spending also meet, as far aspossible, the costs of the services they consume; and

over the short term, supporting monetary policy, by:

(i) allowing the automatic stabilisers to play their role in dampening variationsin economic activity – for example, other things being equal, when theeconomy is growing rapidly, there will be higher tax receipts and lowersocial security payments – thus helping to moderate economic upturns andstabilise the economy, and

(ii) where prudent and sensible, providing further support to monetary policythrough changes in the fiscal stance.

The Government has also specified two key fiscal rules that accord with the principles.These are:

the golden rule – whereby, over the economic cycle, the Government will borrowonly to invest and not to fund current spending, and

the sustainable investment rule – whereby public sector net debt as a proportionof GDP will be held over the economic cycle at a stable and prudent level.

These fiscal rules provide benchmarks against which the performance of fiscal policycan be judged. The Government will meet the golden rule if, on average over acomplete economic cycle, the current budget is in balance or surplus. The Chancellorhas stated that, other things being equal, net debt will be maintained below 40% ofGDP over the current economic cycle, in accordance with the sustainable investmentrule.

In setting fiscal policy, the Government takes a deliberately cautious approach. Thisprudent approach is implemented, among other things, by basing public financeprojections on cautious assumptions for a number of key variables including theeconomy's trend growth rate, levels of unemployment and oil and equity prices.

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Study Unit 2

Company Performance, Valuation and Failure

Contents Page

Introduction 37

A. Ratio Analysis 37

Liquidity 37

Profitability 38

Debt and Gearing 40

Investor Ratios 41

Miscellaneous Items 43

B. Using Ratio Analysis 44

Analysing Company Performance 44

Problems with the Use of Ratios 48

The Centre for Inter-firm Comparison 49

C. Introduction to Share Valuation 51

D. Methods of Share and Company Valuation 52

P/E Method 52

Net Asset Method 53

Dividend (Valuation) Models 54

Discounted Future Profits 56

The Berliner Method or Free Cash Flow Method 57

Note re CAPM 57

Worked Example 57

E. Non-financial Factors Affecting Share Valuation 61

(Continued over)

36 Company Performance, Valuation and Failure

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F. Predicting Company Failure 61

Company Information Services 62

The Z Score 62

Other Models 63

Other Indicators 63

Problems with Prediction Models 64

G. Capital Reconstruction Schemes 64

Reasons for Capital Reconstruction 65

Principles of Capital Reconstruction 65

Company Performance, Valuation and Failure 37

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INTRODUCTION

A company’s financial position will affect its plans, and its ability to carry out those plans, inthe key areas of financing, investment and dividend policy. Shareholders and otherinterested parties will thus be interested in the profitability of the company, its ratio of debt toequity, its liquidity and other measures of a company’s financial performance. Companyreports and financial statements can be used to assess the performance of companies by theuse of ratio analysis.

When considering ratios it is important that a number of years are looked at to obtain asmeaningful a picture as possible, and also to compare the organisation with others which aresimilar in size and industry. The ratios chosen should be relevant to the organisation inquestion, e.g. stock turnover would not be relevant to a service organisation with little or nostock. The wider economic and environmental context the firm is operating in must also beconsidered.

A. RATIO ANALYSIS

This should be a revision section for you, ratio analysis having been covered in your earlierstudies. The ratios we shall consider can be grouped into four main types:

Liquidity

Profitability

Debt and gearing

Investor.

We will now consider the main ratios under each heading.

Liquidity

A company may be profitable but not necessarily liquid and able to pay its obligations whenrequired – failure to do so may lead to the company being wound-up. The ratios and figuresunder this heading indicate the extent to which a company can meet its current liabilities asthey become due. The common liquidity ratios are:

The current ratio, which is calculated as:

sliabilitieCurrent

assetsCurrent

The acid test ratio, which is calculated as:

sliabilitieCurrent

stocklessassetsCurrent

These two ratios show the liquid resources available to pay the short-term liabilities, lowratios indicating potential cash flow problems. The quick (acid test) ratio is often calculatedbecause of the length of time it may take to convert stock into cash, this ratio giving the truerpicture of the liquid assets of the organisation. The yardsticks which an organisation’s ratiosare traditionally compared to are 2:1 for the current ratio and 1:1 for the acid ratio. However,the yardsticks should be viewed in relation to the organisation in question, and in relation toother ratios – a company with high stock turnover can have a healthy liquidity position with anacid ratio of less than 1.

When considering current and acid ratios remember that high results may indicateoverstocking, poor collection of debtors or that the company has excessive cash; in such


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cases action should be taken to determine why there is a high ratio and steps taken (ifappropriate) to correct the situation.

The debtors’ payment period, which is calculated as:

365salesCredit

debtorsTrade

This shows the length of time taken by a company’s debtors to pay their bills. Ingeneral companies give 30 days’ credit on invoices and this can be used as ayardstick. The resultant ratio, however, must be viewed in the light of any seasonalvariations which may be present in the figures used to calculate the ratio. Industrynorms and the type of customers the firm has also need to be considered indetermining a yardstick to use (e.g. a high level of overseas customers may mean thatterms longer than 30 days may be given).

The stock turnover ratio, which is calculated as:

365salesofCost

stockAverage

It shows the number of days that stocks are held; as with the debtors’ payment periodcare must be taken to note any seasonal fluctuations contained in the figures used, forwhich reason it is better to look at the trend in this figure. An increase may indicate aslow down in sales or that the firm is overstocking.

Stock turnover debtor payment period give a good indication of the cashconversion period.

The ratio can also be calculated to show the number of times average stock is turnedover in a year:

stockAverage

salesofCost

In addition, calculations by Beaver, Lev and others in the USA have shown that themost significant single index of solvency is provided by establishing a trend line over aperiod, from the ratio:

debtTotal

flowCash

Profitability

The primary (or most frequently used) ratio is return on capital employed (ROCE). This isusually calculated as:

employedCapital

taxationandinterestbeforeactivitiesordinaryonProfit

oremployedAssets

taxationandinterestbeforeactivitiesordinaryonProfit

This provides a measure as to how the investment of capital in the company is beingrewarded. The result can be compared to the cost of capital and the returns availableelsewhere reflected in interest rates and other companies’ ROCE figures. You can see abreakdown of this ratio in Figure 2.1.


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Profit/Assets employed

Assets/Sales Profit/Sales

Currentassets/Sales

Fixedassets/Sales

Admin.costs/Sales

ProductionCosts/Sales

Selling &distributioncosts/Sales

Stock Land & buildings Labour

Debtors Plant & equipment Material

Cash Fixtures & fittings Expenses

Vehicles

Figure 2.1: Breakdown of ROCE

However, as with many other ratios, there is no one agreed method of calculating it.Problems in its calculation include the following:

(a) Should profit be pre-tax or post-tax? Shareholders will prefer post-tax because this isthe money available to pay dividends with; management will prefer pre-tax unlessthey are responsible for minimising the company’s tax liability.

(b) Should non-recurring items, e.g. profit on the sale of an asset or arising from aninsurance claim, be included?

(c) Should non-trading profits, such as rents and investment income, be included?

(d) Should total assets or net assets (net assets = total assets minus current liabilities) beused as the capital employed figure? Often a company has a permanent bankoverdraft (which is included in the current liabilities) and therefore should be consideredto be part of capital employed.

(e) Should intangible assets such as goodwill be included in the capital employed figure?

(f) How should assets be valued:

At cost?

At written-down book values?

At replacement values?

At current market values?

(Remember – the understatement of a company’s assets can produce an artificiallyhigh ROCE.)

(g) Which balance sheet date and profit figures are relevant? Should the capital employedbe that at the start or end of the year, or some average figure?

The method chosen to calculate ROCE depends on the individual company. There is someevidence that companies often choose the set of values which gives them the highest ROCEbut, whichever method is chosen, you must be consistent between years and companies toallow comparability. Industry norms are also important, e.g. service industries tend to havehigher profit margins than manufacturing industries.


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Other common profitability ratios are:

Gross trading profit : Sales

Net trading profit : Sales

(It is useful to compare trends in these two measures against each other to provide anindication as to how well expenses are being controlled.)

Net profit : Equity capital

Net profit : Working capital

Sales : Capital employed (expressed as a number of times)

Fixed asset turnover rate, measured by Sales : Fixed assets (expressed as a numberof times) with a possible breakdown to asset class.

Current asset turnover rate, which is subdivided into the following:

(i) Sales : Total current assets

(ii) Sales : Debtors

(iii) Sales : Stocks held

In this calculation the figure of sales may be replaced by the cost of sales (ifknown) since stocks at cost value remove the potentially distorting effects ofselling price changes in response to market conditions.

Note: The Du Pont Index is a variation on the primary ratio:

employedCapital

Sales

Sales

Profit

made up of the secondary ratios – the profit margin and asset turnover. Profit may becalculated before interest and taxation or just as pre-tax profit. The first shows the level ofprofit achieved on sales and the second shows how well assets are being used to generatesales. Often there is a trade-off between profit margin and turnover – high profit levels maylead to low sales and vice versa. Used in a series of ratios over a period of time thisprovides more information than the basic ROCE ratio.

An obvious check on profitability is to look at the level of profit or loss shown in the accountsand the change from previous years.

Debt and Gearing

The gearing ratio is expressed as Debt capital : Equity capital. Again there is no oneaccepted method of calculating this ratio – some analysts prefer to use long-term debtonly, whilst others prefer to use all debt (excluding provisions) in a company’s structure.(The latter is often called the debt ratio.) Similarly, there is no agreement as towhether balance sheet or market values should be used.

There is no absolute “correct” level of gearing, although an often quoted benchmark forthe debt ratio is 50%; the resultant figure again should be considered in line withprevious years and industry norms.

The significance of the gearing ratio is the extent to which profit fluctuations are borneby the equity holders. The higher the level of gearing the greater the impact onshareholder wealth of changes in profit levels (see later in course). Moreover, a highlevel of debt makes future borrowing more difficult.


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Example

Gearing ratio is frequently calculated using the formula:

Gearing ratio Reserves+capitalshareOrdinary

capitaldividendFixed+interestFixed

The following is an extract from the balance sheet of Denton Ltd as at 31 December200X:

£000

Creditors: Amounts falling due after more than one year

8% debentures 10,000

Capital and Reserves:

Ordinary share capital (£1 ord shares) 30,000

10% Preference shares 15,000

Reserves 23,000

The gearing ratio is:

0002300030

0001500010

,,

,,

0.47 : 1

Remember, however, that this is only one method of calculating the gearing ratio, andyou should always make this clear in using it.

Other ratios in this group include:

Equity interests : Net assets

Debentures : Net assets

These two ratios provide an indication of the cover of fixed assets to the particular type ofcapital investment. Moreover, by establishing a ratio of Fixed assets : Equity capital you cansee to what extent the shareholders “own” the fixed assets.

Debenture interest cover measures the “safety” of the interest payment – the higherthe cover the more dependable the payment is. It is calculated by dividing the Netprofit before tax and debenture interest by the Debenture interest payable. Forexample, if the profit before tax and interest was £15,000 and the debenture interestwas £3,000 then it would be 15/3 = 5 times covered.

The cash flow ratio, measured as:

)provisions(includingdebtTotal

statement)flowcashcompanythefrom(takenflowincashannualNet

This shows the ability of an organisation to meet its commitments, with changes in theratio showing changes in the cash position of the firm.

Investor Ratios

A major ratio in this class is that of earning per share (EPS) calculated as:

Net profit after tax, debenture interest, extraordinary items, minority interests andpreference dividends/No. of ordinary shares in issue and ranking for dividends. It ismeasured in pence.


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Investors wish to see growth in the EPS in order to fund investment and increases individend payments. An inability to sustain a level of EPS could have a negative impacton the level of a company’s dividend.

When looking at the trend of the EPS over time changes in capital structure, such asthe issuing of new shares or the conversion of convertible loan stock, need to beconsidered. Similarly, when comparing different companies differences in their numberof issued shares should be considered. In the former case it would be useful tocalculate the fully diluted earnings per share which takes into account all capitalinstruments ranking as equity shares now or in the future; for example, convertible loanstock or share options. This also gives investors an indication of the effects of thefuture exercise of share options, warrants and such like (including in the numerator thesavings in financing such instruments and the additional profits to be earned fromutilising the funds raised in the business).

Dividend cover shows how many times the declared dividend could be paid out ofdistributable profits. For example, if a company’s profit after tax and debenture interestwas £40,000 and a dividend of £32,000 was declared, the dividend cover would be:

dividendDeclared

interestdebentureandtaxafterProfit

32

40 times covered.

If preference share dividends are payable these, too, form a prior deduction whenconsidering dividend cover on ordinary shares. The ratio shows the proportion ofdistributable profits being paid out and indicates the risk that if earnings fall this level ofpayout could not be maintained. A high cover may indicate that the firm is investing infuture growth.

Dividend cover can also be calculated using the EPS:

Dividend cover =shareordinaryperDividend

EPS

The dividend yield of a company’s shares is important because it shows the return theinvestor receives on the market value of shares (declared dividend is based on thenominal (or par) value of shares). The shareholder can compare the yields betweendifferent investments to help determine the value for money of his shares in thecompany. Dividend yield is calculated as:

100sharepervalueMarket

shareperdividendGross

Dividends paid to shareholders in the UK are net dividends (after tax); to determine thegross dividend figure to use in the above calculation we have to adjust for taxation,using the following formula:

dividendGross(%)taxincomeofrateLower100

100shareperdividendNet

Example

Thomas plc has just declared a net dividend of 10p per share. If the current shareprice of Thomas is 135p, what is the dividend yield?

Gross dividend (%)taxincomeofrateLower100

100shareperdividendNet

20(%)100

10010

= 12.5p


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Dividend yield 100sharepervalueMarket

shareperdividendGross

100135

12.5 = 9.259

Interest yield is the equivalent of dividend yield for the return on the market price ofloan stock.

yieldInterest100stockloanofvalueMarket

tax)(beforeinterestGross

Be careful not to confuse interest yield with the coupon rate, which is the return on theface value of the debt.

The interest yield is generally higher than the dividend yield. This is becauseshareholders expect to receive capital gains on their shares. When capital gains anddividend yield are added together they should produce a higher return than interestyield, reflecting the greater risk of holding shares (risk is considered in detail in a laterstudy unit).

Earnings yield is the equivalent of dividend yield for the return on the market price ofearnings per share.

yieldEarnings100shareofvalueMarket

tax)(beforeearningsGross

The gross value of the EPS is used in order to allow comparability with dividend yield.

The price earnings (P/E) ratio compares the market price of a share to the earningper share and is expressed as:

tax)(aftershareperEarnings

priceMarket

Note that the net basis is used rather than the gross basis we encountered in earlierratios. For example, if ABC plc has 200,000 ordinary shares of £1 which are currentlyquoted in the market at £1.70, and its net earnings for the year were £45,000, the P/Eratio would be:

0,000)(45,000/20

1.707.56.

An investor purchasing the shares at £1.70 would, in other words, be paying 7.56 timesthe annual earnings on those shares. The level of a company’s P/E ratio is seen as areflection of the market’s views on the prospects of a company. A company with ahigher P/E ratio than another may have better growth prospects or more secureearnings. This is because the P/E ratio should remain constant over time, and anincreased EPS will result in an increased market price and thus an increased P/E ratio.However, the only real value of the P/E ratio is that it shows the relationship betweenearnings and market price for a company, which may be difficult to interpret whenmarket prices are fluctuating widely due to circumstances outside the control of thecompany, such as changes in interest and exchange rates.

Miscellaneous Items

The following ratios may also be of use to stakeholders when analysing reports:

Value added per employee

Sales per employee


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Asset structure – this involves calculating the varying proportions in which the assetsare structured, for example:

Fixed assets 35%

Investments 5%

Net current assets 60%

100%

Sources of asset structure, for example:

Ordinary capital and reserves 50%

Debt capital 45%

Net current liabilities 5%

100%

Alternatively the asset structure could show gross current assets, while gross currentliabilities are shown in the source of asset structure. The two could then be comparedto see to what extent outside interests “own” the company assets.

Proportions of shareholders’ interests, for example:

Preferential capital 10%

Ordinary capital 50%

Capital reserves 8%

General reserves 20%

Specific reserves 12%

100%

B. USING RATIO ANALYSIS

It would not be possible to list every single ratio capable of calculation. The important pointto note is that different groups will be interested in using different ratios to reflect theirparticular interest in the company. You must also remember that ratios should always beconsidered as part of a trend, and once calculated they require careful interpretation.Companies often give information on ratios in their five and ten year summaries, but the fullset of accounts is essential to allow a full comparison – they are generally only available forthe year of the accounts and the previous years.

There are two fundamental reasons why ratio trends are important:

To identify the trends within the business itself over the last few years – for example, toassess whether the business is doing better or worse, or what remedies or correctiveaction can be taken

To identify how the business is doing compared to similar businesses in the sameoperating and market environment.

It is also important to recognise that whilst much can be made of ratios and theirinterpretation, they are after all calculated at a particular point in time. In the past,organisations have been accused of manipulating their year end accounts to perhapsproduce a “healthier” looking picture.

Analysing Company Performance

We will now study the use of ratio analysis by considering a detailed example. It is importantto remember that you will generally be asked for an interpretation of the ratios identified,


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which means you must comment not only on individual ratios, but also on the compositeposition disclosed by your analysis, including changes in profit before and after tax andturnover. You must also remember, where possible, to look at a selection of ratios with atleast one from each of the four main groups we have discussed.

Example

The summarised accounts of New Ideas plc are as follows:

Balance Sheets as at 30 April

Year 2 Year 1

£000 £000

Fixed assets (net) 6,401 2,519

Current assets

Stock 25,426 20,231

Debtors 21,856 20,264

Balance at bank 2,917 6,094

56,600 49,108

Ordinary shares of 50p 5,000 5,000

Revenue reserves 14,763 12,263

Deferred taxation 5,433 3,267

10% Debenture loans 10,000 10,000

Creditors: Amounts falling due within one year

Trade creditors 18,762 16,431

Taxation 1,642 1,247

Dividends 1,000 900

56,600 49,108

Results for the year ended 30 April

Year 2 Year 1

£000 £000

Sales 264,626 220,393

Trading profit 9,380 8,362

Interest payable 1,000 1,000


Dividend 1,500 1,400

The following additional information is provided.

(a) The ordinary shares are quoted at £1.20.

(b) New Ideas plc requires £16 million for an investment project and is considering one ofthe following:

(i) The issue to shareholders of £16 million 10% convertible (£1 for 1 share)debentures at par.


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(ii) A rights issue at 80p.

(iii) The sale in the market of £16 million 13% debentures at par.

You are required to:

(a) Calculate from the balance sheet and results:

(i) Two ratios particularly significant to creditors.

(ii) Two ratios particularly significant to management.

(iii) Two ratios particularly significant to shareholders.

(b) Comment briefly on the change between Year 1 and Year 2 in the ratios you havecalculated.

(c) Calculate the immediate effect of the three schemes on the gearing of the company.

(d) Calculate the effect of the three schemes on the earnings per share, on the assumptionthat the Year 2 profits from the existing assets will be maintained and that the £16m netinvestment will produce profits of £3.5m before tax and interest. The rate of tax can beassumed at 50% (this is not the current rate but is used for ease of calculation).

Answer

Year 2 Year 1

(a) (i) Ratios significant to creditors

Current ratio sliabilitieCurrent

assetsCurrent

Year 2 50,199 : 21,404 2.35 : 1

Year 1 46,589 : 18,578 2.51 : 1

Liquidity ratio sliabilitieCurrent

StockassetsCurrent

Year 2 24,773 : 21,404 1.16 : 1

Year 1 26,358 : 18,578 1.42 : 1

(ii) Ratios significant to management

Activity ratio Sales

profittax-Pre

Year 2 8,380 : 264,626 3.17%

Year 1 7,362 : 220,393 3.34%

Profitability ratio assetsNet

profittax-Pre

Year 2 8,380 : 35,196 23.8%

Year 1 7,362 : 30,530 24.1%

(iii) Ratios significant to shareholders

Return on capital employed fundsrs'Shareholde

profittax-After

Year 2 4,000 : 19,763 20.2%

Year 1 3,720 : 17,263 21.6%


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Dividend cover ratio Dividend

interestdebentureandtaxafterProfit

Year 2 4,000 : 1,500 2.7 : 1

Year 1 3,720 : 1,400 2.7 : 1

Note that after-tax profit is used as this is preferred by shareholders.

(b) Comments on ratios

In spite of an increase in sales of 20% and an increase in pre-tax profits of 13.8%, theratios mentioned show a marginally unfavourable trend between Year 1 and Year 2.Among the unfavourable trends, the change in the liquidity ratio may cause concern tocreditors.

(c) Effect of fund-raising schemes on gearing

Gearing is:

reserves)+capital(shareEquity

sharesPreference+capitalLoan

This is currently:

50.6%.19,763

10,000

(i) Issue of £16m 10% convertible debentures changes the gearing to:

131.6%19,763

26,000

(ii) By implementing a rights issue of ordinary shares, the gearing is reduced to:

28.0%35,763

10,000

(iii) By issuing £16m 13% debentures, the gearing is the same as under (i) above.

It is considered that schemes (i) and (iii) represent a dangerously high level of gearing.

(d) Effect of fund-raising schemes on Earnings per Share

The current EPS is calculated as follows:

£000 £000

Trading profit 9,380

less: Interest payable 1,000


Net profit 4,000

Earnings per share 40p10,000

4,000


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(i) On issue of £16m 10% convertible debentures:

£000 £000

Net profit as before 4,000

add: Additional profit 3,500

less: Tax @ 50% 1,750 1,750

5,750

less: Debenture interest (10% on £16m) 1,600

Tax @ 50% 800 800

4,950

Earnings per share 49.5p10,000

4,950

(ii) On issue of 20 million ordinary shares (at 80p each = £16m):

£000 £000


add: Additional profit 3,500

less: Tax @ 50% 1,750 1,750

Net profit 5,750


5,750

(iii) On issue of £16m 13% debentures:

£000 £000


Additional profit (net) 1,750

5,750

less: Debenture interest (13% on £16m) 2,080

Tax @ 50% 1,040 1,040

4,710


4,710

Note that potential problems can also be detected from the company’s accounts by carefullyreading the reports that accompany the figures and the use of significant financial ratios. Weshall look at this in more detail in later in the course.

Ratios can also be used in inter-firm comparisons. Inter-firm comparisons involve thecontrasting of the results of a company with one or more other companies in order to helpassess their relative performances.

Problems with the Use of Ratios

The main difficulty with the use of ratios is the question: “Are we really comparing like withlike?”.

Even where the comparison is between two companies of roughly equal size and ambition,there will always be an element of doubt that the comparison has true validity because ofalternative accounting policies which can be adopted in areas such as depreciation and theuse of off-balance sheet items. One of the biggest problems in all forms of comparison is thedifferences which occur in the structure and culture of businesses, the economic and general


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environment making strict comparison extremely difficult. Similarly, when makingcomparisons over time the impact of inflation must be considered because of its impact onturnover, earnings, profit and asset values. However, the comparisons are useful in helpingto judge stewardship and the return on the investment relative to others available.

If the accounts are different to those of the industry or segment to which they belong, furtherinvestigation may be required by the financial manager or analyst.

The Centre for Inter-firm Comparison

Established by the Institute of Management and the British Productivity Council in 1959, theCentre has evolved the pyramid method of selecting ratios. Under this method the principalratios are listed at the top of the pyramid, starting with return on capital employed which isreferred to as the primary ratio. This is taken to be the key indicator of companyperformance and profitability. The ratio is then broken down into a number of subordinateratios as shown in Figures 2.2 and 2.3. (All ratios shown in the pyramid are compiled for theindustry as a whole.)

The overall profitability of the operations of the business, and theoverall success of its management, depend on the ratio:

employedassetsTotal

taxbeforeProfit

Differences between constituent parts of this ratio could arise from:

Differences in the ratio or Differences in the ratio

Sales

taxbeforeProfit

employedassetsTotal

Sales

Inter-firm variations could arise from Inter-firm variations could arise from

the ratio of: or the ratio of: or the ratio of:

Sales

profitGross

various ratiosrelating

departmentalcosts to sales

assetsFixed

Sales

assetsCurrent

Sales

Sales v Current assetsmay be affected bystock turnover ordebtor turnover

Figure 2.2: Pyramid Diagram of Ratios – Certain Distributive Trades(as devised by the Centre for Inter-firm Comparison)

Firms can raise their gross profits either by achieving a higher volume of sales of itemsearning high gross profits, or by adjusting prices within market constraints. The extent to


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which either of them affects total gross profit will be indicated by the inter-firm comparison ofratios showing:

(a) The composition of sales made;

(b) The gross profit achieved on different products.

employedAssets

profitOperating

Pri

mary

rati

o

Sales

profitOperating

employedAssets

Sales

Su

pp

ort

ing

rati

os

Sales

soldgoodsofcostsFactory

Sales

coststionAdministra

assetsFixed

Sales

assetsCurrent

Sales

Sales

costsondistributiandMarketingGen

era

lexp

lan

ato

ryra

tio

s

productionofvalueSales

costsProduction

stocksMaterial

costatSales

progressinWork

costatSales

costatstocksgoodsFinished

costatSales

Debtors

Sales

Sp

ecif

icsu

pp

ort

ing

rati

os


costsmaterialDirect


costslabourDirect


overheadsProduction

Figure 2.3: Pyramid Diagram of Ratios – Manufacturing Industries(as devised by the Centre for Inter-firm Comparison)

Once the ratios are compiled for the industry as a whole, they will be prepared for theparticipating firm. The resultant ratios are then compared and any material deviationsinvestigated.

For example, if the primary ratio shows that the rate of return for the company is less than forthe industry as a whole, one or more of the subordinate ratios that make it up must beaffected. This type of comparison will indicate those work areas which are “up to standard”as well as those which are either under, or over, performing. Senior management can thenfocus its attention on the specific areas which have been identified.


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Advantages and Disadvantages of Inter-firm Comparisons

Advantages Disadvantages

Participating firms can see theirefficiency in comparison with others.

It is often difficult to obtain uniformityof procedure, methods and definitions.

Correcting action to addressweaknesses can be made in goodtime.

Some companies hide or refuse torelease key data required in theprocess.

By using a specialist, confidentialagency, the fear that personalcompany data will pass to a competitoris removed.

The nature of a company’s operationsmay be too diverse for truecomparison.

Major customers’ and suppliers’accounts can be compared tomeasure their future stability and plansmade where serious weaknesses aredetected.

The process can be time-consumingand requires specialist skills.

C. INTRODUCTION TO SHARE VALUATION

Whilst for quoted companies share values can always be found from market prices on theStock Exchange, it may be necessary to calculate another valuation for a quoted company’sshares in the process of a takeover bid. (We shall consider this in more detail in the nextstudy unit.)

Unquoted companies do not have a market price for their shares, and may have to estimatethe value for them in the following situations:

The shares are to be sold.

The shares may have to be valued for taxation purposes.

Shares may be used as collateral for a loan.

The company may wish to be quoted on the Stock Market and wants to fix an issueprice.

The relative values of shares involved in a merger may need to be assessed in order todetermine the relative prices.

With mergers and takeover bids in the case of a quoted company, the minimum price whichcan be suggested will be the current market price of the shares. Often the final, negotiatedprice will be around 20% higher than this minimum in order to encourage the shareholders topart with their shares.


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D. METHODS OF SHARE AND COMPANY VALUATION

In this section we will look at company valuation in addition to share valuation. You will seethat a number of different methods can be used to value a company. Valuations using thesemethods can often differ significantly from the total of shareholders’ funds on a companybalance sheet.

The main methods that are required to be understood more comprehensively for this studymodule (and the ones that will be concentrated on) are as follows:

Price Earnings Ratio (P/E Ratio)

Net Asset Value (NAV)

Free Cash Flow and

Dividend Valuation Model (DVM)

P/E Method

This is probably the most common and popular method to adopt when trying to value acompany share, as the historic price earnings ratio compares a businesses share price withits latest profit figures and that is what is most likely to attract, or otherwise, newshareholders and hence new capital investment.

This method calculates the value of a company’s shares by using the following formula:

Market value per share EPS P/E ratio

This method makes use of a company’s level of earnings to calculate its value; the EPS usedcan either be an historical one, an average of past figures, or a prediction of a future figure.The latter is the best but care must be taken when using forecasts, especially with the figuresused for growth in earnings. Similarly an appropriate P/E ratio should be used. The P/Efigure used depends upon:

(a) How secure the earnings of the company are – the more secure the earnings, thehigher the P/E ratio. Companies with high gearing levels tend to have lower P/E ratiosreflecting greater financial risk.

(b) Expectations of future profits – the higher the expected earnings, the higher the P/Eratio. Adjustments may be made for past profit trends and the reliability of theestimates. (Expectations of future profits can be calculated using the discounted cashflow techniques which we shall discuss later in the course.)

(c) Companies which are unquoted generally have a P/E of between 50% and 60% of acompany which is quoted on the Stock Exchange and around approximately 70% ofshares quoted on the AIM, reflecting their reduced marketability and smaller size.However, an unquoted company with earnings of £300,000 or more and growing at aregular rate may have a higher P/E ratio because it may be able to be quoted on theAIM.

(d) General financial and economic conditions.

(e) The industry or industries which the firm is in and the prospects of those sectors.

(f) Liquidity and asset backing, including the nature of assets – specialised assets with arestricted resale market may reduce the P/E ratio.

(g) The make-up of the shareholders and the financial status of any major shareholders.

(h) Companies dependent on one or two key individuals and their skills may have their P/Eratio lowered.


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Sometimes the P/E ratio of a company being acquired may be increased to reflect theimprovements the predator thinks they can introduce into the “victim” company, althoughoften such improvements are not realised.

Example

Sinbad plc is considering acquiring Flower Ltd. Sinbad plc’s shares have been quotedrecently at an average of £6.40 and the recently published EPS of the company is 40p.Flower Ltd has 100,000 shares and a current EPS of 50p. Suggest an offer price for FlowerLtd.

Answer

First we have to decide a reasonable P/E ratio. The P/E ratio for Sinbad plc is 640/40 16.Assuming Flower Ltd is in the same industry its P/E ratio can be based on Sinbad plc’s P/Eratio, adjusted for the fact that it is not quoted, its growth prospects, and riskiness of itsearnings. (If Flower Ltd is in a different industry then a typical P/E ratio for that industry couldbe used as a basis for the calculations.)

Using Sinbad plc a P/E ratio for Flower Ltd can be estimated as, for example, 16 50% 8.A value for the shares can then be calculated as 8 50p £4. This price would be the basisfor negotiations on the value of the company.

Net Asset Method

With this method the company is viewed as being worth the total of its net assets and thismakes the balance sheet the critical part of the business that is needed for share valuationpurposes. If the share value is undertaken using this method, it is often necessary to updatethe balance sheet values, to ensure that the basis on which the valuation is done is asaccurate as possible.

The premise that the value of a class of a company’s shares is equal to the net tangibleassets of the company attributable to those shares is the basis of this method of calculatingshare values. Intangible assets are only included in the calculation if they have arecognisable market value, e.g. a copyright. To calculate the value of a share we simplydivide the value of the assets attributable to a class of shares by the number of shares in theclass.

Whilst this may seem to be an easy method in principle, in practice it can be quite difficult,the problems arising from arriving at a value for net assets. The problems include thefollowing:

Are the assets to be valued on a going concern or break-up basis?

Are any assets covered by prior charges?

How can the assets be valued – is a professional valuation required?

What are the costs of sale – redundancy, taxation charges on disposal?

Have all the liabilities been identified and correctly valued, including contingentliabilities?

If you are given the information to do so in an exam question on valuation, always calculatethe net assets per share. There are two reasons for this:

(a) The value shows the amount a shareholder could expect to receive if the companywent into liquidation. A potential shareholder could compare the asking price for theshares with the net assets per share value to calculate the maximum possible loss ifthe company fails to provide the promised dividends and earnings figures.


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(b) An adjustment may be required in a scheme of merger to the value of the companies’shares to reflect differences in asset-backing – shares with higher net assets per sharefigures could be expected to gain a higher price.

Unless otherwise told in an exam situation you should use the balance sheet figuresprovided, adjusted for intangible assets, to calculate the share values. However, you shouldlist any concerns that you have along the above lines regarding the figures given.

Dividend (Valuation) Models

These models are based on the assumption that the market value of ordinary sharesrepresents “the sum of the expected future dividend flows, to infinity, discounted to presentvalues”.

The model used under this method varies with the assumptions used. The simplest modelassumes that dividends will remain at a constant level in the future. The value of acompany’s shares can be calculated using the formula:

Market value %sharestheonyield)(orreturnExpected

penceinDividend

Example

Tinkeywinkey Ltd’s shareholders expect a dividend yield of 12% and have been told thatdividends per share for the foreseeable future will be 20p. Calculate the value ofTinkeywinkey’s shares if they have 100,000 in circulation.

Answer

Using the above formula to calculate the value of one share:

Value 166.67p.12%

20

returnExpected

penceinDividend

The value of all 100,000 shares value of one share number of shares in issue so thevalue of the company 166.67p 100,000 £166,670.

In other words, a shareholder in Tinkeywinkey who accepted a yield of 12% on an investmentof £1.67, would be prepared to pay £1.67 for a share which paid him a dividend of 20p, or12% on a nominal value of £1.

However, as we will see in a later study unit, shareholders prefer a constant growth in theirdividends. In order to reflect this in valuing the company using a dividend method we have topredict future growth in dividends – which generally reflects predicted changes in acompany’s earnings. When the expected growth figure has been determined we cancalculate the value of the company’s shares using the Dividend Growth Model or Gordon’sModel of Dividend Growth.

This model states:

Po g)r(

g)+(1do

where: Po the current ex dividend market price

do the current dividend

g the expected annual growth in dividends

r the shareholder’s expected return on the shares

The expression do(1 g) represents the expected dividend in the next year.


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Example

Poh Ltd is expecting to pay a dividend of 20p this year, increasing at a rate of 5% per annum.If its shareholders have a required return of 15%, calculate the current market price.

Answer

Using the formula:

Po g)r(

g)+(1do

0.05)(0.15

0.05)20(1

210p

The dividend yield method is often used when valuing small shareholdings in unquotedcompanies. The reasoning behind the model is that such shareholders, being unable toinfluence a company’s earnings to any extent, will only be really interested in the dividendsthey receive from holding their shares. This method assumes that a share price is equal tothe value of all the dividends it will attract during the time it is held, plus the amount receivedwhen it is sold (the sale price will reflect future dividends expected at the point of sale).

Amounts of cash received in the future are worth less than cash received today, so we mustdiscount the future values to compensate and express them in terms of their equivalent valuetoday. The discount rate used is the cost of the capital provided (which is the yield theinvestor expects to receive from his investment in the company). (We will cover this topic inmuch greater detail later in the course.)

This discounting can be expressed as:

Po 3

33

32

21

1111 )()()()( r

P

r

D

r

D

r

D

where D dividend (i.e. D1 is dividend in next year)

To calculate D1, D2, D3 , etc.:

D1 do (1 g)2

D2 do (1 g)3

D3 do (1 g)4

This model can be expanded to allow for potential growth in the dividend rate, and can besimplified to the dividend growth model shown above:

Po g)r(

g)+(1do

Example

Dipsey Ltd, whose shareholders require a return of 20%, expects to pay no dividends for thefollowing three years, but then expects to be able to pay a dividend of 10p per share for theforeseeable future. What is the value of its shares?

Answer

There is no return in the first three years so the price is:

0 0 0 4(1.20)

10p

5(1.20)

10p .......


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Because the cash flows continue into the foreseeable future this will be the same as:

0.20

p10at time t3

The present value of £1 a year forever at r% growth isr

1.

Therefore the price today (0.20)

p10

3(1.20)

1

(1.20)

50p3 28.94p (say 29p)

Note that growth will usually be expressed as a percentage.

Discounted Future Profits

This method is sometimes used when a company intends to purchase another’s assets andinvest in improvements in order to increase future profits. It is best illustrated using anexample.

Example

Bear plc is proposing to acquire Lion plc who is currently just breaking even. Bear feels thatthe investments it plans to make should lead to the following after-tax figures (ignoring anyprice paid) for Lion:

Year Earnings

£000

1 85

2 88

3 92

4 96

5 96

Bear wishes to recover its investment within five years. If the after-tax cost of capital is12.5%, what is the maximum price Bear should be prepared to pay?

Answer

The maximum price is the one where the discounted future earnings exactly equal thepurchase price paid.

Year Earnings Discount Factor Present Value

(Earnings × DiscountFactor)

£000 £

1 85 0.893 75,905

2 88 0.797 70,136

3 92 0.712 65,504

4 96 0.636 61,056

5 96 0.567 54,432

Present Value 327,033


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Therefore the maximum purchase price would be £327,033. (Don’t worry if you do notunderstand the discount factors at this stage; they will be fully explained later in the course.)

The Berliner Method or Free Cash Flow Method

This method is calculated by using the average of share prices obtained using the net assetsmethod and the earnings methods (see above).

This method is also known as the free cash flow approach. The method may be difficult toadopt in practice as it needs forecasts of working capital (see later in the course) andtaxation to ensure that estimates of future cash flows and their timings are accurate.

Note re CAPM

The Capital Asset Pricing Model is a further method of valuing shares. It is used especiallyto determine the required yield on equity when the shares are being priced before a StockMarket listing. We shall cover this topic in a later study unit, but we mention it here to remindyou to include it in your revision of this stage.

Worked Example

The following question is taken from the June 2006 examination paper.

The directors of Steel Ltd are considering putting in a bid to purchase a rival company BronzeLtd.

The most recent accounts of Bronze Ltd shows the following:

Profit and Loss Account for the year ended 31-12-05

£’000 £’000

Sales 3,064,100

less: Cost of sales (924,100)

Gross Profit 2,140,000

less: Distribution expenses 225,000

Advertising expenses 308,000

Marketing expenses 568,000 (1,101,000)

Net Profit before tax 1,039,000

Corporation tax (311,700)

Net profit after tax 727,300

Dividend (127,300)

Retained profit 600,000


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Balance Sheet as at 31-12-05

£’000 £’000 £’000

Fixed Assets Cost Depreciation NBV

Land 500,000 500,000

Buildings 1,200,000 (300,000) 900,000

Fixtures 280,000 (40,000) 240,000

Motor vehicles 370,000 (50,000) 320,000

2,350,000 (390,000) 1,960,000

Current Assets

Stock 640,000

Debtors (trade) 110,000

Prepayments 40,000 790,000

Current liabilities

Creditors (trade) (346,800)

Taxation (311,700)

Dividends (127,300)

Bank overdraft (38,500) (34,300)

Long term liabilities

8% Debentures (secured) (114,000)

Net Assets 1,811,700

Financed by

Capital

Ordinary shares (£1par) 1,500,000

Reserves

Profit and loss 285,000

Revaluation 26,700

1,811,700

Additional Information

1. A professional surveyor has recently established the following current realisable valuesof the assets of Bronze Ltd

£

Land 650,000

Buildings 780,000

Fixtures 80,000

Motor Vehicles 260,000

Stocks 610,000

Trade debtors 100,000


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2. The estimated cash flows of Bronze Ltd (ie after tax, interest and replacementinvestment) over the next ten years are estimated as follows:

£

2006 225,000

2007 275,000

2008 290,000

2009 360,000

2010 – 2015 380,000 p.a.

3. The directors would be seeking a return of 14% if they went ahead with the purchase.

4. A similar business to Bronze Ltd listed on the stock exchange has a Price Earnings(P:E) ratio of 8:1

5. No strategic investment is envisaged over this period.

Required:

(a) Calculate the value of a share in Bronze Ltd using the following valuation methods:

(i) Net asset ratio

(ii) P:E ratio

(iii) Discounted (free) cash flow

(b) What are the main disadvantages of each method?

Answer

(a) (i) Net asset ratio:

£

Net asset value – per accounts 1,811,700

Adjustments:

Land 150,000

Buildings (120,000)

Fixtures (160,000)

Motor vehicles (60,000)

Stocks (30,000)

Trade debtors (10,000)

Adjusted net asset value £1,581,700

Valuation per share is1,500,000

£1,581,700= £1.05 per share

(ii) P:E ratio:

Profit after tax = £727,300

P:E ratio = £727,300 x 8 = £5,818,400


£5,818,400= £3.88 per share


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(iii) Free cash flow:

Cash flow Present value

Year £ £

2006 225,000 197,325

2007 275,000 211,475

2008 290,000 195,750

2009 360,000 213,120

2010 – 2015 380,000 ^ 874,760

1,692,430

Assume Current assets = Current liabilities

Long term loan (debentures) (114,000)

1,578,430

^ combined aggregate annuity value, based on annuity table


£1,578,430= £1.05 per share

(b) Main Problems

(i) Net asset ratio

Fixed asset values are usually based on current historic cost less depreciation.Different depreciation methods result in different values of fixed assets and,whatever method of depreciation is used, the book values are unlikely tocorrespond to market values. Although companies do revalue their assetsperiodically, this is a subjective exercise, often undertaken by the directorsthemselves.

Values of stock may not be reliable, especially if the accounts were preparedsome time ago. Companies often “window dress” their accounts at year- end andstock values in some industries are often outdated.

Some accounts may be uncollectable. Provision should have been made for badand doubtful debts, but the bidder should be wary of the extent of this allowance.

(ii) Price Earnings

The earnings figure can be distorted by accounting policies.

The current earnings may be untypically high or low and it may be moreappropriate to take the average earnings over the last few years.

It is difficult in reality to find close substitutes – i.e. companies which produce thesame product lines, serve the same markets and have similar managementcapabilities.

Companies have different potential for growth.

(ii) DCF

Can the future investment be accurately predicted?

How can we measure the discount rate?

Over what time period should we assess value?


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E. NON-FINANCIAL FACTORS AFFECTING SHAREVALUATION

Despite all the influences of financial figures and projections on the value of a companyshare, there are a number of key non-financial factors that can have an effect on a companyshare price. The key ones are as follows:

Business reputation – Sometimes a business might have a key individual or individualswho have a flair for business and who tend to succeed in whatever business venturethey are invloved.

Knowledge – Some businesses are known as being market leaders and key innovatorsin research and development.

Capabilities of the management team might be well advanced and seen as a goodworking management team.

Company attitude might be such that the business is prepared to do whatever isreasonable to improve their products and services for their customers.

Market penetration – Some companies may have such a good product or such a goodmarketing capability that they are able to penetrate their markets aggressively toincrease their market share. For example, Tesco currently accounts for an everincreasing share of the supermarket trade in the UK and they are rapidly expandingtheir range of business ventures both in the UK and abroad and aggessively buying upsurplus land for future use or to stop rival expansion.

Dynamism – Some businesses might have an individual or individuals who are seen asdynamic and encourage customers.

Leadership qualities in some companies could be seen as excellent and thisencourages good customer confidence in the business.

F. PREDICTING COMPANY FAILURE

We have seen that ratio analysis is used to assess several factors of the firm’s performanceincluding the financial stability, the return received from investment and the efficiency andeffectiveness of management. We have also seen that inter-firm comparison can be a usefulway of identifying the strengths and weaknesses of different companies, and as a tool toincrease efficiency. It is also useful in predicting and identifying corporate failure.

A business that is highly dependent on one major customer or one major supplier, mustmonitor that company’s activities in order to detect any early warning signs of potentialcollapse which leave those who deal with it with potentially serious problems. A furtherreason for monitoring the progress of companies is when the managers of the firm areseeking a takeover opportunity, at which time they may be reviewing certain businesses tosee which could be the most suitable targets for acquisition.

The problem of corporate collapse is a serious one; empirical evidence shows that for everycompany which is in receivership there are three or four others with serious cash constraints.Many such businesses are at risk of second-round failure, which we discussed in theprevious unit.

Avoiding the pitfalls which the managers of such firms are likely to face will require, amongother things, careful control of debtor and creditor relationships. The quality of credit controlin the firm may, in these circumstances, mean the difference between survival and disaster,by ensuring that the firm always has sufficient funds to pay its obligations thus avoiding


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liquidation. Time spent in credit control should be regarded as equally important as timespent developing new business.

Company Information Services

Besides specialists in the field of inter-company comparison, there are several organisationsthat provide company information services. They include:

(a) Performance Analysis Services

Performance Analysis Services was formed to collect and collate results of some 800of Britain’s largest, listed, industrial companies. From data collected, the company hasdeveloped ways of predicting firms that appear to be most at risk of receivership.

(b) Dun and Bradstreet

Dun and Bradstreet are suppliers of financial information and related services and they,too, have developed an early warning system on possible company failures. Theservice is based on Stubbs Gazette, which is used as a key source of information,providing up-to-date information on compulsory winding-up orders, voluntaryliquidations, court judgments, mortgages and charges.

(c) Institute of Chartered Accountants in England and Wales (ICAEW)

ICAEW has produced an operational guideline on the continuity of business, whichidentified a number of factors which put continuity into question:

Loss of key management and staff

Significantly higher stock levels, without the apparent source of finance to pay forthem

Regular work stoppages and labour disputes

Dependence on a single product or project

Dependence on a single supplier, or a large customer

Outstanding legal proceedings

Political risks

Technical obsolescence

Loss of a major franchise or patent

History of poor performance within the industry.

Clearly it is the trend towards the regular occurrence of several factors which isimportant, not a single “one off” event in isolation. If there should be a build up, then itcould lead to a situation of “crisis management”, i.e. where managers are dealing withone serious problem after another rather than focusing on planning for the future needsof the business.

In extreme circumstances, managers may have no option but to slim down the entityresulting in lower, but more manageable, operating capacity. However, not everymanager will be willing to sacrifice the prestige of running a business of a certain size.Many problems stem from the failure of managers to react in time (if at all).

The Z Score

The analysis of financial ratios is generally concerned with the assessment of theeffectiveness and efficiency with which a company deploys its resources. This is in itself anattempt to measure the overall financial stability of the organisation – you will remember thatthis is a principal duty of the financial manager.


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An American, E.I. Altman, researched the use of ratio analysis in order to examine ratiocorrelation and business failure. In his research he looked simultaneously at several ratios toattempt to predict business failure. He used some 22 accounting and non-accounting ratioswhich he applied to a selection of failed and continuing US companies. From this initialanalysis, he determined that there were five key indicators of impending failure, and he usedthem to formulate the Z Score.

Using the Z score, Altman predicted that firms with a score below a certain level were muchmore likely to fail than those with higher scores, and he identified “middle ground” in whichthe outcome of the company’s future was uncertain.

Other Models

(a) Argenti

This model, also known as Argenti’s failure model, is based on the calculation of acompany’s scores in the areas of defects of the company, management mistakes andsymptoms of failure.

Company defects include a passive board, an autocratic Chief Executive and weakbudgetary control. Managerial mistakes include high levels of gearing and the failure ofa large (in relation to the company) project. Overtrading (the business expanding tooquickly for its level of cash funding and thus having insufficient liquid funds to paycreditors) is also noted as a major managerial mistake. Symptoms of decline includedeteriorating ratios, quality and staff morale and the use of window dressing. Each ofthese three areas has a danger mark.

Argenti based his model on past company data and, as with the other models, it isdifficult to assess its predictive ability.

(b) Taffler

Taffler has developed a model to predict business failure which is based on a series ofratios:

Sales/total assets

The current ratio

The reciprocal of the current ratio

Earnings before tax/current liabilities.

(c) Beaver

Empirical research conducted by Beaver found that the best prediction of corporatefailure is a low cash flow/borrowings ratio, and the poorest measure for forecastingfailure is the current ratio (current assets/current liabilities).

Other Indicators

One quick method of predicting company failure is the use of the liquidity ratios – proponentsof this method state that a current ratio of below 2 : 1 and an acid (quick) ratio of less than1 : 1 means that the firm is illiquid and liable to fail. However, as we discussed earlier, theseratios need to be viewed in the light of the nature of the business and the overall position ofthe firm. Moreover, empirical evidence (see Beaver above) has found that these ratios, andtrends in them, give little or no indication of eventual business failure. A worsening liquidityposition could, however, indicate that the firm is having problems and its financial andoperational performance should be carefully scrutinised.

Other accounting information which may provide indications of financial difficulties includeimportant post balance sheet events, large contingent liabilities and large increases inintangible assets.


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Non-accounting information contained in the annual report may also provide indications ofcompany problems, as may changes in the composition of the board if the more abledirectors have left. In addition, the Chairman’s Report, although generally optimistic (and notaudited), may discuss current and future unsolved problems.

External events such as legislation, political changes at home and abroad, competitors’actions, and changes in economic variations (e.g. interest and exchange rates) may alsogive forewarning of potential problems for a firm. In addition, newspapers and journals mayreport on the financial and other difficulties a firm is or may be experiencing.

Problems with Prediction Models

There are several problems with the use of the above models:

Many assumptions have to be made in interpreting information, including the methodsof accounting which have been used. Indeed, any limitations in the accounting dataused will also affect the models.

It is difficult to value the equity in a private company, which may make the use of themodels for private company analysis difficult and extremely subjective.

The information they use reflects the past and thus is out of date. The problem isexacerbated by the delay in the publication of company accounts.

Prediction models take little or no account of economic conditions occurring when theyare used, and the effect that economic variables may have on the figures used in theirmodels.

It is very difficult to define corporate failure because companies which would otherwisehave been liquidated can be “rescued” or taken over. Similarly, businesses may closefor reasons other than failure, e.g. a private company may cease to operate becausethe owner-manager wishes to retire.

Companies may manipulate the measures used in the models in order to preventpredictions of failure.

G. CAPITAL RECONSTRUCTION SCHEMES

It is not unusual for companies to be liquidated, the principal reasons for this being that:

The company does not have enough cash to pay its liabilities and its creditors apply tothe court for it to be wound up – this may happen even if the company is profitable.

A company may not be profitable enough to continue in business (or it may be acquiredby another company).

However, a company may be able to prevent liquidation if it can devise a capitalreconstruction scheme attracting new capital and/or persuade its creditors to “change” theirloan to the business into company securities, thus allowing the business to continue trading.The business must be able to show that its problems are only temporary and that the schemewill allow it to become profitable and/or improve its cash flow situation. Negotiating suchschemes is often difficult, but a failure to do so may lead to the business being liquidated.

We should distinguish between the term reconstruction, which is used to refer to majorchanges to capital as a prelude to a merger, and capital restructuring. Capitalrestructuring (or reorganisation) is the term usually used when there is only one companyconcerned and the rights of its members, and sometimes of its creditors, are varied by analteration of its capital structure but with the existing company continuing in business.


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Reasons for Capital Reconstruction

There are a number of reasons why a restructuring may be necessary:

The company may have become too highly geared and a solution may be to issueequity in place of debt capital.

The existing capital structure may have become over-complicated with perhaps toomany classes of shareholder with different rights to each class. They can beconsolidated into one or two classes, but care must be taken to ensure that the relativevoting strength remains in the same proportion.

Capital with prior rights may carry a high fixed dividend which then gives a misleadingimpression of the company, or preference shareholders may have control of thecompany. In such cases the structure should be reorganised into a more convenientnature.

The company may decide to replace preference shares with debentures in order toreduce the corporation tax on the company’s shares.

Principles of Capital Reconstruction

There are a number of points of principle in the design of a scheme of reconstruction.

(a) Firstly, if the company is having problems it is likely to require more finance which maycome from either existing shareholders or a bank, generally in the form of equityfinance, although some may be in the form of loan stock. This new equity may replaceexisting share capital, or may have a different nominal value to it. Those providingsuch finance will require profit and cash flow forecasts to show how the business canbe turned round and provide a good return for their additional money. In such cases itis wise to maintain the income position of a particular class under the scheme as far asit is possible. Often more income will be offered as an incentive to the holders of aparticular security to agree to the capital restructuring.

(b) In addition, a reconstruction scheme must treat all parties fairly, and not favour onegroup over others. The outcome of the scheme should be more beneficial to creditorsthan if the company went into liquidation, or they may press for the winding-up of thecompany. Often this is avoided by including in the scheme provision for paying off thecompany’s debts in full. The increased benefits to creditors (and investors) from thereconstruction scheme can be shown by comparing the liquidation value of the firmwith the estimated future results arising from the reconstruction scheme.

(c) The company must also take account of fixed charges (e.g. a mortgage on a factory)on assets of the business used as security for loans. These charges mean that thecreditor is “secured” and thus entitled to first claim in the process of liquidation (if thereare insufficient funds the creditor becomes unsecured for the balance of the loanunpaid). The charges mean that such creditors may have less incentive to keep thebusiness afloat. Second charges are when the lender has the prior claim on thesurplus from the sale of a secured asset after the prior claim has been met.

(d) In addition, the company may have to consider the existence of floating charges overthe assets (generally the current assets of the business which are continually turnedover during trading) that crystallise on liquidation thus providing the charge owner withprior call on the funds realised from these assets. Similarly to above, such creditorsmay have less incentive to keep a business afloat, unless it can be shown that it wouldbe financially beneficial to them to do so.

You may also find in practice that certain creditors can have a fixed charge on an asset,with a floating charge over a group of assets for the balance of their loan – this isknown as a fixed and floater.

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Study Unit 3

Acquisitions and Mergers

Contents Page

Introduction 69

A. Company Growth 69

Strategies for Growth 69

Economic Justification for Growth via Acquisition 71

The Development of "Mega-Mergers" 72

B. The Regulation of Takeovers 73

Extent of Coverage of the Code 73

General Principles 74

Rules of the Code 74

Companies Act 1985 77

Competition Commission 77

European Union 78

C. The Acquisition/Merger Process 78

Tactics for Acquisitions and Mergers 78

Defences Against an Unwelcome Takeover Bid 79

Consideration 80

D. Measuring the Success and Failure of Mergers and Takeovers 82

Company Performance 82

Shareholder Wealth and Power 82

Employment 83

Example 84

E. Disinvestment 86

Management Buy-Outs 86

Buy-Ins 88

Spin-Offs 88

Sell-Offs 88

(Continued over)

68 Acquisitions and Mergers

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Demergers 88

Going Private 88

Answer to Practice Question 90

Acquisitions and Mergers 69

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INTRODUCTION

In this study unit we will start to consider corporate structure and corporate growth. The firstpart of the unit investigates what happens when a company goes beyond being an individual,single entity and, by means of acquisition or merger, becomes a multiple concern or a groupof companies.

When a firm is considering expanding whether internally (by expansion, integration ordiversification) or externally (via a merger or acquisition) it must ensure that growth iseconomically justified, carefully planned and structured. Management must consider theimpact on the company, its (and if appropriate the target's) shareholders and employees, theenvironment it operates in, and the Stock Market's views. In addition, the current regulatoryframework should be borne in mind and it is very important that the firm allows for a period oftransition for success to be achieved.

The converse of mergers and acquisitions is where a firm may decide to disinvest part ofitself, and this is the subject of the second part of the unit.

Reasons for disinvestment include removing a part of the business which does not fitcorrectly into a group's portfolio or its core business, selling an unprofitable subsidiary, orselling a profitable subsidiary to finance expansion elsewhere. There may also be a desireby the owners of a private concern to arrange their affairs to the best advantage to their heirsin the light of favourable political or tax regimes. Disinvestment includes demergers,management buy-outs, management buy-ins, spin-offs and sell-offs.

In common with the expansionary policies discussed in the first part of the unit, it is essentialthat such activity is carefully planned and monitored, and that the needs of the variousparties involved, including internal and external stakeholders (and especially theshareholders), are considered.

We saw earlier in the course that there are several internal and external stakeholders in anorganisation, and the majority of them will be concerned with its stability and long-termviability. In order to help them assess this several models of corporate failure have beendeveloped using financial and other ratios, often based on past empirical evidence. Althoughthese models can provide some useful guidance, as yet there is no one method that iscapable of predicting corporate failure in advance.

Acquisitions and mergers are a fairly frequent occurrence, and you should read the financialpress for details of any currently taking place – providing up-to-date examples is alwaysuseful to your arguments.

A. COMPANY GROWTH

Strategies for Growth

The three main strategies a firm may adopt for growth are expansion, integration anddiversification.

(a) Expansion

This is the growth of existing, or development of new, markets or products, which canbe in response to changes in technology, customer taste or simply to exploit anopportunity in the market.

(b) Integration

Integration, of which there are two forms – horizontal and vertical – is a form ofexpansion.


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Horizontal integration is when a firm adds either new markets for its existingproducts, or introduces new products to its current markets. It may be done sothe firm can benefit from economies of scale, although this may cause difficultiesfor the firm if there are problems with the markets or the products.

Vertical integration is expansion of the firm along the supply chain and can beeither backward (supply of components or raw materials) or forward (being onestep closer to the end customer). It allows a firm to have greater control over theindustry including quality, quantity, price and share of the profits, although itbecomes more prone to falls in demand within the industry as a whole.

(c) Diversification

This policy is also a form of expansion – indeed, integration is sometimes referred to asrelated diversification.

The diversification we are now going to consider is referred to as unrelateddiversification and comprises concentric and conglomerate diversification.

Concentric diversification is the development of products which are synergeticwith current products.

Conglomerate diversification is the development of products with no marketing,technology or product synergy with the business's current products. The firm,however, expects to obtain management synergies from the conglomeration.

There are several other potential advantages of conglomerate diversification. Can youthink what they might be?

Advantages include the following points:

The firm can move quickly into high profit areas by acquiring a firm in that market.

The resultant larger firm may have better access to funds.

A larger firm may have greater influence in the market and in the politicalenvironment.

A spreading of risk may occur from operating in different markets.

Profitability may improve as a result of the diversification.

The new firm may be more flexible, and the acquisition of new firms may allowwithdrawal from existing markets.

There may be synergies to be obtained from the merger utilising a surplus in onefirm to satisfy a deficit in another (e.g. cash).

Unlike the takeover of a similar firm which may lead to a referral to theCompetition Commission, conglomerate (and concentric) diversification areunlikely to be regulated by the state.

However, there are several problems associated with conglomerate diversification.

Profits in one part of the business may be used to help others making losses,which may lead to the failure of the whole organisation.

Empirical evidence has shown that EPS (Earnings per share) are diluted whencompanies with high P/E (Price Earnings) ratios are acquired and that risk maybe increased rather than reduced.

Empirical evidence has also shown that management synergies are often notobtained in practice.


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Economic Justification for Growth via Acquisition

Internal growth is one method of growth and here there is a balance to be struck betweendistributing available profits to shareholders as dividends and retaining profits to fund internalgrowth.

An alternative method of growth is by acquiring or merging with another company (known asexternal growth):

The purchase of a controlling interest by one company in another is known as anacquisition or takeover – this is the acquisition by one company of the share capital ofanother company in exchange for cash, ordinary shares, loan stock or somecombination of these.

A merger or amalgamation is the combination of two separate companies into onesingle entity. It is a pooling of interests of two companies into a new business requiringan agreement by both sets of shareholders.

It is often difficult to determine in practice whether a takeover or merger has occurred,especially when there is a difference in size between the organisations. Whilst many suchjoinings are called mergers, and the two terms are often used interchangeably, in reality thereare very few true mergers, and those which are tend to occur in industries with histories ofpoor growth and returns.

Note that you should take care not to confuse acquisitions and mergers with joint ventures.In a joint venture the managers of two or more businesses decide to establish a newcompany under their common ownership and management for the purposes of exploiting anopportunity which neither of them has the resources to exploit individually. There were a fewjoint ventures occurring to celebrate the millennium!

There are several potential reasons for an acquisition or merger but it is important thereshould be a resulting synergy with, and that it helps in achieving the overall strategicobjectives of, the firm.

A firm must also consider the cost and value of the merger or acquisition and the relationshipbetween the two.

Common reasons for acquisitions and mergers are:

To reduce competition, although this may be prevented in the UK by the CompetitionCommission.

To purchase a new product range or move into a new market.

To obtain tax advantages..

To spread risk by diversification into new markets and/or products, which should lead tomore secure earnings.

To obtain assets that are undervalued or can be sold off ("asset stripping"), cash (if thevictim company is very liquid) and/or access to finance, expert staff, managementexpertise, technology, suppliers or production facilities. Whilst they might all beacquired internally they can be acquired a lot quicker by a takeover.

To achieve economies of scale in production, purchasing or marketing and other areasof the business.

To act as a defence against being acquired itself, either by purchasing the predatorcompany or by making itself bigger and thus harder to be taken over.

Growth can be achieved via a share exchange rather than having to acquire the cashthat an internal policy of growth would require. The policy may also be less expensivethan internal growth if a premium has to be paid to attract assets and staff.


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There are also major problems with acquisitions and mergers:

Economies of scale, especially in head office functions, often do not materialise, orindeed become diseconomies of scale. There can also be transportation problemswhen the acquired sites are geographically separate from existing sites.

There can be problems integrating the different work forces and there may be large-scale redundancies. Similarly problems in integrating new products, markets,customers, suppliers, management and systems can lead to management overload. Itis sometimes known as "indigestion".

There may be public relations problems with customers and the general publicboycotting the firm because they disagree with the takeover. Directors of the victimcompany may also do their best to impede the takeover.

There may be regulatory intervention.

The cost of the acquisition may be too high.

Shareholders of the target company may adopt defensive tactics to oppose the bid, andthere may be problems in unifying dividend, reporting and other policies affecting theshareholders of both companies.

In addition to the reasons for, and potential problems with, a mooted acquisition or mergerthe firm has to consider the views of its shareholders, the shareholders of the target companyand of the market. The company must also determine how it will pay for the company – will itbe with cash, share exchange, via loan stock or some combination? Unless it is purelyfinanced by cash the target company's shareholders will have an interest in the new mergedfirm.

Reasons why a company's shareholders and the market may not approve of a takeover ormerger include the following:

(a) There may be social or moral disapproval of the target company, e.g. it may producearms or deal with a country with an unpopular regime.

(b) The merger may result in a fall in the EPS or net asset backing per share.

(c) The merger may result in an increase in risk due to the nature of the target's industry orfinancial profile.

A company may not need shareholder approval, but a lack of shareholder and marketbacking can lead to a fall in the market price of the company's shares, which is not achievingthe company's primary objective of maximising shareholder wealth. Moreover, when atakeover is to be paid for by the issuing of a large number of new shares in the predatorcompany, shareholder approval at an AGM or EGM will be required by Stock Marketregulations.

The views of the target company's shareholders are considered below.

The Development of "Mega-Mergers"

You may be aware from your reading of the financial press that in recent years there havebeen several very large or "mega" mergers. The reasons for these mega mergers includethe following:

Globalisation and deregulation of financial markets makes it easier to arrange financefor such deals.

Buoyant equity markets allow share exchange schemes to be successful and cash tobe raised via rights issues.

Investors are demanding growth in earnings and a merger is often the cheapest andmost expedient way of doing this.


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The globalisation of operations and opportunities to achieve operating economies insome fields (e.g. oil).

Market trends (e.g. in the car industry) may mean that the small company can nolonger compete successfully – a merger may be a defence against being taken over.

Mergers may lead to economies of scale in overhead costs. For example, the mergerof Glaxo and Wellcome was undertaken with the aim (amongst others) of achievingeconomies of scale in research, development, testing and marketing of drugs.

B. THE REGULATION OF TAKEOVERS

The City Code, administered by the Takeover Panel, specifies the behaviour whichcompanies are expected to adopt during a takeover or merger. The Code is issued by thePanel on Takeovers and Mergers (the Panel), and whilst it does not deal with the price tobe offered in a merger or acquisition, both the Code and the Panel operate to see thatshareholders receive fair and equal treatment during this process.

The fundamental objectives of the Takeover Panel are to ensure fair and equal treatment forall shareholders and their main areas of concern are as follows:

Shareholders who may be treated differently – for example, because they belong to avery large business or they hold a large number of shares

Insider dealing

Actions that is not in the best interests of the shareholders

Lack of adequate and timely information released to shareholders

Artificial manipulation of the share price

Slowing down of the bid process.

The Panel on Takeovers and Mergers (POTAM) is the City watchdog whose job is to overseethe conduct of takeovers involving companies listed on the London Stock Exchange. ThePanel writes and enforces the City Code on Takeovers and Mergers which sets out inmeticulous detail the management and timing of takeover bids. The objective of the CityCode is to ensure that high standards of integrity and fairness are maintained, and thatshareholders in both the bidding and target company are treated equitably. The Panel is notconcerned with the financial or commercial advantages or disadvantages of a takeover, nor isit concerned with competition issues. The City Code does not have the force of law, but, asthe Code says "those who seek to take advantage of the facilities of the securities markets inthe United Kingdom should conduct themselves in matters relating to takeovers inaccordance with best business standards and, so, in accordance with the Code". It goes onto say that "those who do not so conduct themselves may find that, by way of sanction, thefacilities of those markets are withheld".

Extent of Coverage of the Code

The Code applies to offers for all listed and unlisted public companies as well as, whenappropriate, statutory and chartered companies considered by the Panel to be resident in theUK, the Channel Islands or the Isle of Man and it provides the main governing rules forcompanies engaged in merger activity. It also applies to an offer in respect of a privatecompany of the same residency, where at some time during the 10-year period prior to theannouncement of the offer:

(a) Its equity capital has been listed on the Stock Exchange;

(b) Dealings in its shares have been advertised in a newspaper on a regular basis for acontinuous period of at least six months; or


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(c) It has filed a prospectus for the issue of equity share capital at Companies House.

The Code is concerned with takeovers and mergers for all companies defined above andincludes partial offers and offers by a parent company wishing to acquire shares in itssubsidiary. Generally, the Code excludes offers for non-voting, non-equity capital.

You should note that, unlike legislation, the Code is not enforceable in law. However, thosewho fail to conduct themselves in accordance with its rules may, by way of sanction, have thefacilities of the securities markets withdrawn from them.

The Code is made up of a number of general principles, which are essentially statements ofgood commercial conduct, together with a set of Rules supported by substantial notes. TheRules are not laid down in technical language, and they should therefore be interpreted bytheir underlying spirit and purpose rather than appertaining to some specific legal framework.

General Principles

The six general principles are listed below:

1. All holders of the securities of an offeree company of the same class must be affordedequivalent treatment; moreover, if a person acquires control of a company, the otherholders of securities must be protected.

2. The holders of the securities of an offeree company must have sufficient time andinformation to enable them to reach a properly informed decision on the bid; where itadvises the holders of securities, the board of the offeree company must give its viewson the effects of implementation of the bid on employment, conditions of employmentand the locations of the company's places of business.

3. The board of an offeree company must act in the interests of the company as a wholeand must not deny the holders of securities the opportunity to decide on the merits ofthe bid.

4. False markets must not be created in the securities of the offeree company, of theofferor company or of any other company concerned by the bid in such a way that therise or fall of the prices of the securities becomes artificial and the normal functioning ofthe markets is distorted.

5. An offeror must announce a bid only after ensuring that he/she can fulfil in full any cashconsideration, if such is offered, and after taking all reasonable measures to secure theimplementation of any other type of consideration.

6. An offeree company must not be hindered in the conduct of its affairs for longer than isreasonable by a bid for its securities.

From time to time conflicts of interest may arise for the financial advisors involved. This mayapply where material confidential information is available to them or where the advisor is apart of a multi-service organisation. Where the first situation arises, conflict may be removedby the advisor declining to act; in the second circumstances, a careful segregation of thebusiness will be necessary to prevent conflict occurring within the rules – the latter issometimes referred to as "building a Chinese wall".

Rules of the Code

Numerous rules are contained in the Code that stretches to over 250 very detailed pages andthey are supported by detailed notes. Whilst you do not have to memorise individual Rules,you should have an understanding of their nature and the way they impact on the parties to atakeover. We will consider the Rules of the Code under the following headings:

The approach, announcements and independent advice

Dealings and restrictions on the acquisition of shares and rights over shares


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The mandatory offer and its terms

Conduct during an offer

Substantial acquisition of shares

(a) The Approach, Announcements and Independent Advice

The buying firm usually employs advisers to help make a takeover bid. (Indeed,identification of suitable takeover targets might be one of the first jobs of the variousadvisers.)

An offer should be proposed to the board in the first instance. The identity of theofferor or, in an approach with a view to an offer being made, the potential offeror mustbe disclosed at the outset. The board must be satisfied that the offeror has theresources to implement the offer.

An announcement should be made as soon as sufficient details have been decided.Any announcement of a firm intention to make an offer must contain:

(i) The terms of the offer;

(ii) The identity of the offeror and details of any existing shareholding;

(iii) The conditions to which the offer is subject;

(iv) Details of any arrangements which may be an inducement either to deal, or not todeal, in the shares.

Promptly after the start of the offer period, the board of the offeree company must senda copy of the announcement to its shareholders and to the Panel.

Any person stating that he does not intend to formulate an offer for a company willnormally be bound by the terms of that statement. All statements should be as clearand unambiguous as possible.

Another rule requires that the board of the offeree company must obtain competentindependent advice on any offer and the substance of that advice must becommunicated to the shareholders. This is especially important in cases such asmanagement buy-outs which we shall look at later in the unit. The Panel consider thatit is inappropriate for independent financial advice to be given by a person who is eitherin the same group as the financial advisor to the offeror or who has a substantialinterest in either the offeror or the offeree.

(b) Dealings and Restrictions on the Acquisition of Shares and Rights over Shares

Whilst some rules deal specifically with the criminal offence of insider dealing (the ECDirective on Insider Dealing was implemented through the Criminal Justice Act 1993),another rule restricts dealing in the securities of the offeree company by any personother than the offeror, where such a person has access to confidential, price-sensitiveinformation, from the time when there is reason to believe an offer is imminent to thetime of its determination (or lapse). Additionally, dealing will not be permitted in thesecurities of the offeror company where the offer is price-sensitive in respect of theofferor's securities.

A rule restricts the sale of securities in the offeree company by the offeror during theperiod of the offer, unless the Panel has given its approval and at least 24 hours' publicnotice has been given. After such consent and notice, the offeror may make no furtherpurchases.

A rule limits the opportunity for persons to contact private or small corporateshareholders with a view to seeking irrevocable commitments to accept (or to refrainfrom accepting) an offer, or a contemplated offer, without the prior approval of thePanel.


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Generally, unless a person (including those acting in concert with him) holds less than30%, or rights over less than 30%, of the voting shares in a company, he may notacquire a holding that would carry voting rights of more than 30%. Where a personsimilarly holds between 30% and 50% of shares, or rights to shares, of the voting kindwithin a company, he may not acquire more than a further 1% (2% before 3rd March1993) of the voting rights in any 12-month period. Exempt from those described in thisparagraph are those who make an offer for the company.

When an offer is contemplated and the offeror (or person acting in concert) acquiresshares in the offeree in the three months prior to the offer, subsequent general offersmust not be on less favourable terms without the consent of the Panel. If, while theoffer is open, the offeror purchases shares at a higher price than the offer price, thenthe offer price must be increased to be not less than the highest price paid for theshares so acquired.

Immediate announcements may be required should the terms of the offer have to beamended under various rules. Another rule requires immediate disclosure relating tothe number of shares acquired and the price paid, if practical, as soon as an acquisitionat a price higher than the offer price has been agreed.

Any dealings by the parties to a takeover or their associates must be disclosed daily by12 noon on the business day following the transaction to the Stock Exchange, and itwill then be made available to the Panel and to the press. Additionally, disclosure(excluding the financial press) will be required where purchases or sales of relevantsecurities in the offeree or the offeror companies are made by associates for theaccount of non-discretionary clients, themselves not being associated. Intermediariesmay be required to disclose the name(s) of their client(s).

(c) The Mandatory Offer and its Terms

Various Rules lay down the requirements and mechanics of a formal offer, providingtime limits in respect of acceptances, counter-offers, etc. The various options availableto both the offeror and the offeree are also laid down and reflect the percentage ofshareholders accepting or rejecting the offer. Whilst you do not have to rememberdetailed prescriptions, you should remember that they exist and must be adhered to byall parties concerned.

(d) Conduct During an Offer

The Rules lay down the requirements of a code relating to the conduct of the parties toan offer while it is progressing. They are summarised below:

(i) All shareholders must have an equality of information.

(ii) Advertisements must be cleared by the Panel before their publication.

(iii) Details of all documents and announcements must be lodged with the Panel.

(iv) Generally, no actions are to be taken that would mislead shareholders or themarkets, including taking any action by the offeree that may frustrate the offerprior to a bid being under way.

(v) Transfers by the offeree must be promptly registered.

(vi) Special care must be exercised with all documents, and the terms of the bid mustbe covered carefully, including conflicting views, and so forth. Offer documentsshould always be available and on display.

(vii) Specific rules govern the way profit forecasts are stated and assets valued.

(viii) The offer document should normally be posted within 28 days of theannouncement of a firm intention to make an offer. An offer must be open for at


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least 21 days after it is posted, and this period of time may be extended by furthernotice.

(e) Substantial Acquisition of Shares

The Rules regulate the speed at which a person, or persons acting in concert (aconcert party), may increase shareholdings between 15% and 30% of the voting rightsof the company. They also invoke the accelerated disclosure of acquisitions of sharesor rights over shares relating to such holdings.

Companies Act 1985

Section 151 prevents financial assistance being given by a company for the purchase of itsown shares. This is done in order to prevent the manipulation of share prices and ownershipin several scenarios including takeover and merger discussions.

Under Sections 428-430 a company holding more than 90% of the shares in anothercompany may compulsorily purchase the remainder on the same terms. The minorityshareholders can also insist that their shares are purchased on these terms.

You should also note that the legislation dealing with insider dealing may also be invokedwhen considering a merger or takeover bid – it being illegal to act on unpublished informationregarding such a bid (especially if with a view to financial gain).

Competition Commission

The Competition Commission (CC) is one of the independent public bodies which helpensure healthy competition between companies in the UK for the benefit of companies,customers and the economy.

The CC replaced the Monopolies and Mergers Commission in 1999, following theCompetition Act 1998. The Enterprise Act 2002 introduced a new regime for the assessmentof mergers and markets in the UK and under this, the CC's role is now clearly focused oncompetition issues, replacing a wider public interest test under the previous regime. TheEnterprise Act also gave the CC remedial powers to direct companies to take certain actionsto improve competition, whereas under the previous regime, its role was simply to makerecommendations to Government.

Role and Work

It deals with issues in three broad areas:

In mergers – when larger companies will gain more than 25% market share and mightprove anti-competitive.

In markets – when it appears that competition might be distorted or restricted in aparticular market

In regulatory affairs – when the major regulated industries in the UK may not beoperating fairly.

Its investigations are thorough and open. If an investigation concludes that the situationsignificantly damages or restricts competition in the UK, then it will work to determine andimplement appropriate remedies. For example, the CC can stop a merger from going ahead,require a firm to sell off part of its business, or require it to behave in a way that safeguardscompetition.

Its inquiries are always initiated following a concern referred to it by another authority, usuallythe Office of Fair Trading. It also investigates issues referred by the sector regulators forcommunications, gas and electricity, water, rail, airports, postal services, or by the Secretaryof State for Business, Enterprise and Regulatory Reform.


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Membership and staff

The decision making body for each inquiry is a group of at least three independent experts,drawn from a wider panel of around 50 appointed members. Members are supported by aspecialist staff team on each inquiry. Inquiry groups are usually led by the CC's Chairman orone of the Deputy Chairmen.

Members are appointed to the CC for eight years, following open competition. They areselected and appointed by the Government for their experience, ability and diversity of skillsin competition economics, law, finance and industry. All except the Chairman work part-timefor the CC.

The CC's staff includes economists, business advisers, lawyers, administrators, accountantsand support staff (information services, finance, human resources). Two-thirds are directemployees, with the remainder on temporary contract to help meet the CC's workload at anyparticular time, or on loan from government departments.

European Union

A regulation introduced in 1990 gives the European Commission the power to block orauthorise mergers with a world-wide turnover of over 5 billion ecu (approximately £3.5billion). Mergers with EU-wide turnover of 250 million ecu (approximately £175 million) needto be agreed by the Commission. Reasons used to block mergers include incompatibilitywith the European Common Market.

The European Union's 13th Company Law Directive dealing with takeover bids andprocedures will have statutory power in EU member states when it is adopted. This will be amajor change from the current UK approach of self-regulation.

You may find it interesting to note here that Britain has several more large industrial unitsresulting from past mergers than the rest of Europe.

C. THE ACQUISITION/MERGER PROCESS

This area is well known for its tactics both for acquisition and defence.

Tactics for Acquisitions and Mergers

A common acquisition tactic is for the predator company to purchase shares in the targetcompany in the market place quickly, to prevent the market interpreting its motives andincreasing the share price – known as a dawn raid. It is illegal for a "concert party"acquisition of shares to take place (i.e. a number of connected or unconnected partiespurchasing shares together).

When the predator has obtained 3% of the shares it must inform its target of its holding. TheLondon Stock Exchange publishes market-makers' holdings of 3% or more in UK-listedcompanies quoted either on the main Stock Market or the Alternative Investment Market(AIM).

When a company has acquired 30% it must make an offer to the remaining shareholders inthe target company (we will discuss this in the section on the City Code later in this studyunit). The company should then make an offer to the target's board (either directly or throughits merchant bank) in order to determine the board's view of the bid. The price discussedshould be below what the predator feels the company is worth but above its current shareprice. If the predator continues with the bid a formal offer document is then sent toshareholders with details of its offer price.


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Defences Against an Unwelcome Takeover Bid

The City Code requires directors to act in the best interests of the shareholders, employeesand creditors and there may be circumstances when they consider that it is in the bestinterests of the above to contest the bid. The directors can contest an offer because theyfeel that the terms offered are too low, that there is no advantage to the merger, or becauseemployees or founder members may be opposed to the bid. If the former is the case thepredator may offer a higher price. The relative prices of the companies' shares is a veryimportant issue during a takeover or merger bid which uses shares as part of theconsideration. A significant rise in the target's shares or a fall in those of the predator canjeopardise the takeover by reducing the value of the consideration offered to theshareholders of the firm being taken over.

In order to defend against an unwelcome takeover bid, the directors have to plan and takeaction as early as possible. They should keep a careful watch on dealings in the company'sshares to spot whether an individual (or group of individuals) is building up a significantholding. They must also review the market price of their shares constantly in relation to theirearnings and asset values, in order to determine whether the company is undervalued by themarket and therefore prone to a takeover. In addition, directors should assess thecompany's position within its industry as regards technology, size, etc., to see whether it isuncompetitive and likely to attract a takeover bid by a major player in the industry. A furthertactic is to maintain contact with a range of stockbrokers, analysts and merchant bankerswho are the most likely to hear of hints and rumours of any takeover strategies at an earlystage.

The majority of mergers and bids are masterminded and engineered by the merchantbanking firms, and a defending company will almost invariably have to appoint its ownmerchant bank to act in its defence.

The appointment of a merchant bank is just one of the substantial costs which may beincurred in contesting a takeover bid – others include advertising, public relations andunderwriting costs. Similarly, the predator company will incur such costs. There is also thepossibility of capital gains or losses on the sale and repurchase of shares in the victim.

For a takeover bid to succeed enough shareholders must be willing to sell; this will happenwhen they are attracted by the potential capital gain due to the high offer price, or when theyare unhappy with the current performance and its shares.

There are a number of different tactics used by companies to try and stop a bid, particularly ahostile one. These include the following:

Developing their own management team to be creative and proactive, and ensuring itspotential is understood and appreciated by the shareholders

Keeping a very close eye on the businesses share register to spot individualorganisations building up a major shareholding in the company

Close co-operation of share buying between friendly companies

Attacking the logic and rationale of the bid

Improving the image and reputation of the business

Encouraging internal and external stakeholders to lobby on their behalf.

Considering share repurchase schemes as this reduces the number of shares availablefor a rival to buy

Buying another business, thereby possibly making the business too large andunattractive to predators!

Attacking the record of the bidder.


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Convincing the shareholders that the shares are valued too low and they shouldtherefore not sell them, usually by circulating profit and dividend forecasts. They canalso suggest that forecasts may be at risk on a change of management, by the issue of"defence documents" and press releases.

Revaluing the company's assets (using independent expert valuers) to increase theasset-backing and encourage upward movement in the share price.

Launching a strong publicity campaign, aimed at highlighting present strengths andpotential, including promised improvements, e.g. in efficiency.

Using additional shares either by issuing a block of shares to a friendly party, who willact in the directors' interests making it almost impossible for the bidder to acquire 100%control; or by issuing "A" shares, normally non-voting, so as to maintain shareholdercontrol but increasing the funds required by the predator to purchase the company.

Inviting a bid from another company (a white knight) which the directors believe wouldbe friendlier than the initial offeror. This is called a defensive merger.

Arranging a management buy-out.

If the companies are of a similar size, then the target company could make a counter-bid for the predator.

Launching an advertising campaign against the predator, its accounts and methods ofoperation.

Trying to have the bid referred to the Competition Commission.

The target company could introduce a "poison pill" preventing a build up of shares bycausing a change in structure and rights to be triggered by "abusive" takeover tactics.

It is important to remember that just as bids must follow the City Code on Takeovers andMergers, so must the actions taken by directors defending a company against a takeoverbid.

If a takeover of an unquoted company is resisted then the bid may simply fail. However, witha quoted company some or all shareholders may wish to sell and there is more chance thatthe takeover may succeed.

Consideration

Acquisitions will be financed by cash, shares, debentures or a mixture of the three. Thechoice of payment will be determined by individual circumstances. When a merger takesplace, a share-for-share exchange occurs.

The factors to be considered when deciding the form that the consideration for acquiring afirm will take are:

A potential capital gains tax liability may arise when shareholders dispose of theirshares for cash.

An increase in the number of shares may lead to a fall in the EPS and, perhaps, asignificant change in shareholder control.

Increases in borrowing limits or authorised share capital may have to be formallyapproved by shareholders. Such increases will also have an effect on the gearing levelof the firm.

It may be cheaper to fund the takeover with debt rather than equity because interest isallowable against tax.

The views of the shareholders in the target company should be considered; they maywish to maintain an investment in the firm and thus prefer shares, and they will want to


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ensure that they maintain their income levels – a fall in dividends will need to bematched by a capital gain. Each shareholder will want to ensure that he receives atleast an equivalent return from his holding in the new company, assuming that thereare no other pressing external factors which make aspects other than return oninvestment significant criteria for the shareholders.

As we discussed in the previous study unit there are several accepted methods of valuing acompany. Prices will generally reflect market forces and will tend to be higher when thereare several interested parties in competition. The package can be negotiated in such a wayas may benefit both parties, perhaps by staggering the purchase over a period of time to aidthe purchasers' cash flow and to minimise capital gains tax liability.

The cost of the acquisition or merger will be the purchase price, plus any extra amounts to beinvested in, less the sale proceeds of any surplus assets in, the target company. Whenconsidering the cost of the investment the projected returns and profits must be consideredalongside existing figures to ensure that the merger or acquisition is in the company's bestinterests.

(a) Shares

A share (or paper) purchase involves the exchange of shares in the predator companyfor the shares in the target company. The shareholders of both companies are nowshareholders in the predator company.

(b) Cash

A cash purchase simply involves the exchange of cash for the shares in the targetcompany. The predator should offset the expected earnings on the cash (if no takeoverwere to take place) against the expected earnings from the acquired firm whenconsidering the purchase. The cash for the purchase can be raised from a StockMarket issue of the predator company's shares or loan stock.

In assessing the sources of funding available, the financial manager should take intoaccount existing cash resources, and that a proportion of the capital can be generatedby:

Increasing working capital, e.g. by improving credit control. However, careshould be taken not to fund long-term assets with short-term finance.

Sale and leaseback of equipment or premises.

Staff share purchase schemes, or a rights issue to existing shareholders.

Disposal of surplus assets.

Borrowing, e.g. from the bank or by issuing debentures.

(c) Vendor Placing

This is a mixture of the above two approaches. Shares are exchanged in the targetcompany with those of the predator company – the predator shares are then "placed"by the predator's stockbrokers with other buyers in order to raise the cash for thetarget's shareholders.

You should remember that when shares are issued in the process of a takeover bid thepredator company's share capital will increase, and the effects on, for example,earnings per share should be allowed for when considering the impact of the merger onthe company's performance.


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D. MEASURING THE SUCCESS AND FAILURE OFMERGERS AND TAKEOVERS

Company Performance

Following a merger or takeover there has sometimes been a fragmentation process, with thedecentralisation of individual companies and often the promotion of competition betweenthem. There have also been times when the advantages planned for the merger have failedto materialise, with economies arising from increased buying power being lost completely byincreased administration and duplication of effort.

There will always be a certain level of risk in such an investment, but adequate research andpreparation should help to minimise such risk. Key features of the target company which willimprove the chances of success include:

A well-defined market niche

A balanced customer portfolio

A growth industry

Seasonal, fashion and economic cycle stability

A stable and motivated work force

High added value

Good technical know-how

A short production cycle

Located near the acquisitor's business

Matches the corporate strategic plan

Provides something the firm does not have for itself.

The early months will be critical in settling down the enlarged business and graduallybringing about new working practices to improve the efficiency of the operation. It requirescommitment from all levels of the organisation. Mergers and acquisitions have often beenfound to fail because senior management are more concerned with future expansion,especially via further acquisitions, rather than with integrating the organisation's current units.There is a particular problem if the cultures of the merging organisations are very different.

A further point for you to note is that mergers have often been criticised as beingimplemented to reduce competition and thus to create a more comfortable environment forfurther business development, rather than due to a desire for increased operating efficiency.

Shareholder Wealth and Power

We saw above that a major concern of the predator's shareholders is changes in theirearnings per share. The change in EPS depends on the relative price earnings ratios of thetwo companies – in general, if the target has the higher P/E ratio then the EPS will fall, butmay rise if sufficient levels of synergy and profit growth are achieved. Often, in practice,companies who purchase shares with high P/E ratios do not achieve sufficient growth andexperience falls in their EPS. A fall may be acceptable if the shareholders wish to, and do,obtain an increase in net assets per share or a reduction in the risk of its earnings.


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In a takeover environment, it will be possible for companies to increase their earnings pershare simply as a result of the acquisition, for example:

Company A Company B

Total earnings £300 £300

No. of shares 1,000 1,000

EPS 30p 30p

Share market price £4.50 £3.00

P/E ratio 15 10

Company A is seen by the market to be better managed, with better growth prospects, whencompared with Company B, and therefore its P/E ratio is higher. In the event of a takeover,the position would be:

New A plc

Total earnings £600

No. of shares* 1,666

EPS 36p

* Company B's value on the market was (1,000 3) £3,000.

Company A would need to issue 3,000 4.50 666 (say) shares to acquire B.

The EPS of New A plc has increased because it was able to "save" 334 of its shares (1,000 666), because the market has set a higher value on its shares when compared to companyB.

We are left with the question: "What P/E ratio should we set for the new company?"

Generally the market will tend to place a higher P/E ratio on the amalgamated companiesthan would be expected from the result of an averaging. In the scenario above, we mightexpect a P/E ratio of around 12½.

If the P/E ratio were 14, representing a partial fall, the market price of the shares in New A plcwould be £5.04. A's original shareholders would have seen their shares increase in valuefrom £4.50 to £5.04, whilst B's (who owned 1,000 shares at £3.00) now own 666 shares at£5.04 £3,356.64. The somewhat illogical situation arises because of the expectations ofthe market that the assets of B will be managed similarly to those of A. This, of course, maynot always be the case.

The make up of shareholder control will change after a merger, and often changes after anacquisition, especially in the case of a reverse takeover (when a smaller company acquires amuch larger one and may require a more than doubling of its equity capital in order to fundthe purchase).

Employment

Staff will want to talk to the new owner and to be recognised for what they are able tocontribute. Talk will be important in order to maintain staff morale which may fall when thesale is confirmed, especially if there is no more information forthcoming. The best staff willbe the first to go, because they will readily find jobs even in a depressed market.Competitors may even tempt them away, with a resulting loss of goodwill. One method ofkeeping key personnel is to require, as part of the purchase offer, that they sign service


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contracts forbidding them to resign (and perhaps preventing them from selling their shares)for a period of time (often three years). This will be in exchange for an attractive employmentcontract.

In some cases new contracts of employment may be required for all staff to unify proceduresbetween the two firms.

Example

Strachan plc, a successful engineering company has made a bid for Atkinson plc, a large butdeclining competitor. The following information is available for both companies which arequoted on the Stock Exchange:

Atkinson Strachan

Share price £5 £3.10

No. of shares 10 m 25 m

Both a cash and a share bid have been made. Strachan has offered Atkinson two shares inStrachan plc for every share in Atkinson plc. Alternatively a cash offer of £6 per share hasbeen made. Strachan plc expects the takeover to generate savings of £5 m in present valueterms.

(a) Advise the shareholders of Atkinson plc on which offer to accept. Include financial andother factors in your advice.

(b) How might Strachan plc expect to achieve the extra value of £5m? What uncertaintiesmight face Strachan plc in achieving this figure?

Framework Answer

We will consider briefly some points you could make in answering.

(a) Cash Offer:

Cash received 10 m £6

£60 m.

Share offer:

Shares in Strachan received 10 m 2

20 m shares.

At the current valuation of Strachan shares this would be worth 20 m £3.10 £62 m.However, Strachan would now have 45 m shares in issue, which would be likely tohave an impact on earnings per share. In addition, the share price of the expandedcompany will change as a result of the acquisition.

Advice to shareholders of Atkinson plc

The cash offer of £60 m is £10 m greater than the current value of the company'sshares, i.e. 10 m £5. We are not given any information about earnings per share ofeach company or about future growth in earnings, other than the projected savings of£5 m. The acquisition may result in a fall in earnings per share in Strachan plc. This inturn may reduce the value of shares from £3.10 per share.

Cash proceeds are certain, the return on shares in Strachan plc is less certain.However, receipt of cash means that shareholders of Atkinson plc face an immediatetax liability on the capital gain. Strachan plc is already a successful company and it islikely to have considered the acquisition of Atkinson plc very carefully. Strachan plc


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must consider that it will be able to increase future earnings because of the acquisition.With a competitor removed from the market, there is a real possibility of increasedturnover for Strachan plc.

On balance the acceptance of the cash offer would seem to pose less risk toshareholders of Atkinson plc.

(b) Savings on acquisition may be achieved by:

Economies of scale, e.g. one head office with less staff than exists in the twocompanies currently;

Additional expertise from staff of Atkinson plc, reducing training and developmentcosts;

Lack of competition should result in operating economies, e.g. the advertisingbudget may be reduced;

Tax advantages may occur on acquisition.

Problems likely to be faced by Strachan plc include:

Economies of scale are often difficult to achieve in practice. Additionalexpenditure may be required, for example, to integrate the computer systems ofthe two companies.

Staff redundancies may be necessary, incurring redundancy costs.

Strachan plc may be keen to retain the skills of senior management of Atkinsonplc. Additional costs may be incurred in drawing up new management servicecontracts.

If the operational units of the two companies are geographically separate,additional transport costs will arise.

Practice Question

Blue plc and Yellow plc have entered into negotiations to merge and form Green plc. Detailsof the companies are as follows:

Blue plc Yellow plc

£1 ordinary share capital £500,000 £300,000

Estimated maintainable future earnings £200,000 £92,280

Agreed P/E ratio for amalgamation 15 13

Suggest a suitable scheme for a merger between the two companies.

Now check your answer with the one given at the end of the unit.


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E. DISINVESTMENT

Some groups specialise in buying companies, either stripping their assets or "turning" thebusiness around, and then selling the companies, generally at a profit. Other groups may beforced to sell off parts of themselves due to financial problems, changes in the markets oralterations in their strategic plans.

It is not always easy to move out of a market – one reason may be a reluctance to admit tofailure. Management may feel they are safer continuing in the market and may want(wrongly) to attempt to recover sunk costs. There may also be economic costs – it may beeasier to sell a going concern; there may be large redundancy costs; and the withdrawal of aproduct may have a detrimental impact on the sales of the company's other products. Incertain countries government action may prevent withdrawal from a market.

Management Buy-Outs

A management buy-out (MBO) is the acquisition by the management of all or part of abusiness from the owners. The owners can be the shareholders, an owner-proprietor or theparent company, although it is generally the directors who make the disinvestment decision.In general, MBOs have been of profitable subsidiaries which do not match the group'sstrategic plans.

Management buy-outs have become more common since the late 1980s, the numberincreasing five fold in 10 years and the value increasing from less than £50 million to morethan £2,800 million. It has been due partly to incentives provided by the UK Government andpartly due to a belief that management functions better as part of an autonomous profit-seeking unit.

(a) Advantages of MBOs

The potential benefits of an MBO include:

For the vendor an MBO provides an alternative to the closure of the business orpart of it, and prevents the sale to a third party who could be a competitor. Themanagement and employees are more likely to be cooperative to an MBO ratherthan in a sale to a third party. Moreover, the sale of the going concern may wellachieve more money for the vendors.

For the management team the buy-out allows them to purchase an operation ofwhich they already have full operational knowledge. They must be certain,however, that they can turn the business around to obtain a better return oncethey are released from the constraints of the current ownership. An MBO willalso allow the management team to be owners rather than employees and, if thebusiness is threatened with closure, will prevent them losing their jobs.

For the financiers who may be invited to participate there is a reduced riskcompared to a new venture which has no track record to be evaluated.

(b) Disadvantages of MBOs

There are also potential problems with management buy-outs which include:

Technical managers, who are good at managing processes, may not have thefinancial or legal knowledge required to conduct a management buy-out. Theywill have to use expert advisors, who can be costly, for the tax and legalcomplications that can arise from an MBO.

There are often redundancies following an MBO, used as a means of reducingcosts. In addition there may be problems convincing employees of the need toadjust working practices and the company may lose key employees. There may


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also be previous employment and pension rights to be maintained which may bea drain on resources.

Individual managers will be required to be financially committed to the venture.This may include borrowing from the bank, which may create problems in themanager's personal financial affairs.

Problems may arise with regard to the continuity of relationships with suppliersand customers.

It may be difficult to decide on a fair price to be paid for the business.

Management may resent the board representation required by suppliers offinance.

Cash flow problems can arise, especially if fixed assets need replacing.

(c) Financing MBOs

The management's own financial resources which they are willing to invest willgenerally be insufficient for the purchase of the business, and they will have to findfinancial backers. In order to convince the backers of the viability of their idea themanagement team should prepare a business plan. The business plan shouldcontain cash flow, sales and profit forecasts and planned efficiency savings. This willprobably be relatively straightforward – management should have access to a lot of thisinformation, especially if the vendor is happy with the sale.

Financial backers will include banks, accepting houses and venture capitalists, and ingeneral they view their investment as a long-term one. There will often be severalfinanciers providing venture capital for an MBO, and they may require an equity stakein the business because of the risk they are taking – indeed, often the managementhave only a minority of the shares in the business. Some backers may insist that someof their capital be in the form of redeemable convertible preference shares with votingrights should dividends become in arrears. This form of security allows them tocapitalise on the business if it is successful and to cover themselves if the businessfails. The purchasing company will usually be financed by bank and subordinated debt,together with the management's and financiers' equity. The resultant business willoften have a financial gearing level which is far higher than that accepted in generaltrading circumstances.

We noted above that the financiers' money is at risk in such an investment, and shouldbe assessed in relation to:

The expertise, motivation and ability of the management team (including the mixand range of management skills) and the amount the management are willing toinvest from their own funds.

The relationships with its suppliers and customers.

The projections contained in the business plan.

Is the projected return from their investment sufficient to offset the risk they aretaking?

Why is the business being sold, and what is being bought? Is additional capitalrequired to replace or improve the assets of the business?

What is the price and has it been set at the correct level?

The risks will be considered against projected returns before the financiers agree toback the buy-out.

More capital will often be wanted to finance growth. Raising it may be difficult becauseof the high existing debt/equity ratio. Financiers may commit to the provision of further


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capital at the start, but will apply stringent performance conditions before allowing afurther release of funding.

An alternative form of funding for expansion would be for the management to float thecompany, perhaps on the Alternative Investment Market. However, this, too, willrequire careful thought as such action will involve relinquishing at least some controlover the business, but it does allow financiers a means to realise their investment.

The long-term viability of a typical MBO in its initial form is a question of very careful riskassessment. It is the ability of the management to plan and develop the business whichdetermines its success. There have been a number of great successes in the past, e.g.National Freight. Empirical evidence has found a number of possible reasons, includingreduced overheads; higher levels of managerial motivation; quicker and more flexibledecision-making; more austere action on pricing and debt collection; and the MBO havingacquired the business for a good price.

Buy-Ins

A management buy-in is similar to an MBO except that it is a team of outside managers whomount a takeover bid to run the company.

Spin-Offs

A spin-off is the creation of one or more new companies with shares being held by theshareholders of the "old" company in the same proportion as before. The assets of thebusiness, having been separated, will be transferred to the new company which will usuallybe under different management from the "old" company.

Sell-Offs

A sell-off is the sale of part of the company, generally for cash, to a third party. An extremeform of sell-off is the liquidation of the entire company.

Demergers

A demerger is simply the opposite of a merger. A demerger can either be the selling of partor parts of the business to a third party, or offering shareholders shares in the demergedparts of the business in place of their current shares in the "merged" company. A famousexample of a demerger is the split of ICI plc.

There are both advantages and disadvantages of demergers, mainly arising from theirsmaller size, e.g. if there were diseconomies of scale before the demerger these should bereduced. Similarly any economies of scale would also be reduced. There may also be anincreased risk of takeover or, if the attractive parts of the company have been disinvested,there may be a reduced takeover risk. Other advantages include an ability to concentrate onfewer areas, thus hopefully improving efficiency and removing control problems, and anincrease in cash and earnings. Disadvantages include the reduction in the ability to raisefinance, lower turnover, status and profits.

The Stock Market's reaction to the demerger will depend on the reasons for it and the viewon the future profitability of the demerged components, but generally demergers are viewedfavourably. This may be because visibility of individual parts of the business is improved, andthere is a greater choice of shares for investors.

Going Private

A listed company may decide to go private. This occurs when a small group purchases all acompany's shares and the company is no longer quoted on the Stock Exchange – a well-known example being the repurchase of shares in Virgin by Richard Branson.


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The reasons for such a move may be to prevent takeover bids, reduce the costs of meetinglisting requirements and limit the agency problem. In addition, because the firm is not subjectto volatility in share prices, it can concentrate less on the short-term needs of the StockMarket and more on its own medium- and long-term requirements.


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ANSWER TO PRACTICE QUESTION

Value of shares for merger:

Blue plc Yellow plc

EPS 40p500

200 30.76p

300

92.28

EPS × P/E ratio 40p 15 30.76p 13

Market value £6.00 £4.00

If Green plc is to have ordinary share capital of £500,000 £300,000 (£800,000), theholdings of ordinary shares in the new company could be divided between the formercompanies' shareholders in the following proportions:

Blue: 500,000 £6 £3,000,000

Yellow: 300,000 £4 £1,200,000 (i.e. in the proportion of 3 : 1.2)

or:

Blue: 571,429 shares in Green (approx. 114 for 100)

Yellow: 228,571 shares in Green (approx. 76 for 100)

Total 800,000

This would mean that Green would have an EPS of:

shareper36.535p800,000

292,280

and that the proportions attributable to Blue and Yellow are:

Blue: 571,429 36.535p £208,772

Yellow: 228,571 36.535p £83,508

Total £292,280

In this scheme Blue gains some earnings contributed by Yellow, and Yellow loses earnings toBlue. The critical point to both sets of shareholders will be the rating placed on the shares ofGreen by the market. Gains and losses in EPS will be mitigated by movements in the newshare prices.

As an alternative to the above, the shares in Green could be apportioned on the basis ofinput of earnings without heeding the market price situation. This would penalise Blue in thesense that the market appears to favour its development and growth potential more highlythan it does Yellow's. A straight proportional split would not acknowledge the apparentdifference in market rating.

91

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Study Unit 4

Financial Markets

Contents Page

Introduction 92

A. Stock Markets 92

Why do we have Stock Markets? 92

The London Stock Exchange 93

Over-The-Counter 97

"Big Bang" 97

Market Participants 98

Some Other Common Market Terms 98

B. Other Sources of Finance 99

Banks 99

Merchant Banks 99

Institutional Investors 99

Government and European Union Assistance 101

C. Other Financial Markets 102

The London Money Market 102

Parallel Markets 102

Option Markets 102

D. Recent Changes in Capital Markets 103

E. Impact of the Markets on Market Decisions 103

92 Financial Markets

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INTRODUCTION

Financial managers have the responsibility of ensuring that sufficient short- and long-termcapital is available to organisations, at the time it is needed, and that surplus funds areplaced at suitably high rates of return. He/she will need to ensure that a suitable balance isstruck between obtaining a good rate of interest on funds held (the longer the term thenusually the higher the interest rate received) and when those funds are needed for internalinvestment and business growth. It is not uncommon for the financial manager even toinvest "overnight" to get a small amount of investment before the funds are needed thefollowing day – maybe, for example, to pay staff salaries and wages!

To achieve this, the financial manager must therefore have a good all round workingknowledge of the financial markets that are available to the firm.

This study unit considers the financial markets, the institutions which operate upon them andsome of the terminology used. We shall pay particular attention to the markets for sharecapital – highlighting the importance of the Stock Market and its players in company andmarket decisions. (However, share capital itself, and alternatives to equity, are dealt with inmore detail later in the course, as are options and other financial instruments.)

A. STOCK MARKETS

There are several different stock markets in the world, of differing levels of sophistication.Indeed, most major industrial countries have stock markets of some form. However, thethree major ones (or the "golden triangle") are those in London, New York and Tokyo. Herewe are mainly concerned with the London Stock Exchange.

Why do we have Stock Markets?

The main reasons for having stock markets are:

(a) To provide an efficient mechanism for the bringing together of organisations wishing toraise capital to invest in new projects and investors wishing to place capital in suchcompanies and institutions. A common way of doing so is for a company to issueshares.

There are a number of reasons why a company may want to issue more shares.Before reading further, think of as many different reasons as you can.

The reasons include:

The company may need to raise more cash to fund investment in profitableprojects.

The company may wish to be "floated" on a stock market. In the UK, when acompany is floated on the Stock Exchange there is a minimum proportion ofshares which must be made available to the general (investing) public unless theshares are already widely held. This also allows the owners of the company torealise some of their investment in the company by offering their shares for sale.

Shares may be issued to shareholders in another company in the process of atakeover bid. This is really only feasible when shares that are offered have anidentifiable market value and can be easily traded on a recognised stockexchange.

(b) To allow a ready "second-hand" market in stocks and shares allowing investors torealise their investment if they wish to, either for investing in other securities or forconsumption.

Financial Markets 93

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What reasons might a business have for seeking a stock market listing?

Access to a wider pool of resources. The number of potential investors in a businessgrows much larger when it is opened up to a public arena, and this makes it mucheasier to obtain funding for expansion, investment and growth and so on.

Improved marketability of shares as they are traded on the stock market and they canbe bought and sold relatively easily and in any quantities.

Capital can be transferred to other uses – raising capital through the stock market canrelease internal funds for other purposes.

There is a perception in business that a quoted company is more secure and theirimage is improved, allowing often easier relationships with customers and suppliersand so on.

A listed company is in a better position to merge and acquire additional businessthrough the capital growth potential of a stock market listing.

Equity capital

The largest proportion of long term finance for a modern large business is usually providedby shareholders and is called equity capital.

Ordinary share capital is usually the main source of new money provided from shareholders.Shareholders are allowed to participate in the running of the business (usually through votingin general meetings) and to receive dividends from profits. They carry the greatest risk interms of financial return and because of this the directors of a company will usually strive toensure that the shareholders (in recognition of this risk and support) get a good return ontheir investment.

When a business is formed the original shareholders decide on the number of shares to beissued – this is the authorised capital of the firm. This is the maximum amount of sharecapital that the business can issue (unless shareholders vote to amend the limit).

At any one point in time, the business will have a certain amount of shares issued to themarket. This can never exceed the amount that is authorised in the legal documentation.So, for example, a business might have an authorised ordinary share capital limit of, say,£5,000,000, but only have say £3,000,000 issued on the stock market – allowing them atsome future stage to offer, for sale, up to another £2,000,000.

Shares have a stated par value, usually 25p, or 50p or more commonly £1. This nominalamount has no bearing at all on the actual market price of the share or how much they canbe bought and sold for on the stock market. Whilst the par value has no real significance,note needs to be taken of the fact that when looking at a balance sheet the share capitalfigure often appears out of place and insignificant.

The London Stock Exchange

The London Stock Exchange functions both as a primary and a secondary market:

A primary market is one in which organisations can raise "new" funds by issuingshares or loan stock.

A secondary market is one for dealing in existing securities.

The primary market is known as the New Issue Market. The more important function,especially in terms of volume, of the Stock Exchange is the latter. In addition to acting asprimary and secondary markets for corporate shares and loan stock, the London StockExchange also functions as the market for dealing in gilts (government securities).

The London Stock Exchange administers and regulates the main market which deals withcompanies which are "fully listed" (see below) and the second-tier market for smaller


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companies. Until a few years ago the second-tier was the Unlisted Securities Market(USM), but this was phased out and replaced by the Alternative Investment Market (AIM).

(a) The Main Market

Any company wishing to be floated on the main market must comply with StockExchange rules and regulations in addition to the legislation in this area.

Joining the Main Market involves two processes.

A company applies for its securities to be admitted to the Official List (a "listing")through the UK Listing Authority (UKLA), a division of the Financial ServicesAuthority (FSA); and

the listing is dependent on those securities gaining admission to trading on theMain Market through satisfying the Exchange's Admission and DisclosureStandards.

The UKLA is responsible for drawing up and monitoring the FSA's Listing,Transparency and Disclosure, and Prospectus Rules for Main Market companies.

The Exchange is a recognised investment exchange under UK law and has a duty toensure that dealings in securities admitted to its markets are conducted in a proper andorderly manner. To ensure this, it requires listed companies to meet specific standards.

The listing rules are contained in the Stock Exchange's Admission of Securities toListing. The requirements seek to secure the confidence of investors in the conduct ofthe market. This is done by:

Ensuring that applications for listing are of at least a minimum size. The sizerules relate to the market capitalisation and annual profit figures.

Requiring companies to have a successful track record of at least three years.

Ensuring that companies requesting listing at least appear to be financially stable.

Insisting that a sufficient number of shares of a tradable value (i.e. several sharesof a smaller value rather than fewer shares of a higher value are preferred), aremade available to the general investing public to allow a free market to exist inthe company's shares.

Requiring the directors of a company to make a company resolution to adopt theterms and conditions of the Stock Exchange Listing Agreement. This includes theprovision of sufficient information (e.g. interim results) to form a reliable basis formarket evaluation.

Note that you may also see flotation on the Stock Exchange referred to as "goingpublic", or "getting a listing on the Stock Exchange".

From a company's viewpoint there are both advantages and disadvantages in obtaininga full listing. Table 4.1 summarises the principal advantages and disadvantages of afull listing to a company.


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Table 4.1: Advantages and disadvantages of full listing

Advantages Disadvantages

Once a listing is obtained, a companywill generally find borrowing fundseasier because its credit rating will beenhanced.

Additional long term funding can beraised by a new issue of securities.

Shares can be easily traded,facilitating expansion of the capitalbase.

Future acquisitions will generally beeasier because the company willhave the ability to issue equity as aconsideration for the transaction.

Share option schemes can bearranged potentially attracting thehighest calibre employees.

The profile of the business and itsmanagement team will be raisedconsiderably.

Publicity will not always be ofadvantage. An unquoted companywill be able to conceal its activitybecause of its lower profile in thecommunity at large.

The costs of entry to the StockExchange are high.

At least some control will be lostwhen shares are available to thegeneral public.

The requirements of the StockExchange are onerous andcompliance is enforceable.

The company can (potentially) bemore exposed to a hostile takeoverbid.

Going public and becoming a listed company is a major step for a business. It couldlead them to a greater amount of funds being available through the public capitalmarkets to help with development and business growth. However, there is a price forthis – for example:

There is a great deal of administrative and legal requirements that come with astock exchange listing and a very demanding (and ever increasing) list of rules,regulations and constraints that all need to be met. The directors of a listedcompany have a very large degree of responsibility to ensure that all thesevarious rules and regulations are met in full or they could be personally liable.

All companies that obtain a full listing must ensure that at least 25% of their sharecapital is in public hands. This is to make sure that shares are available to betraded on the "public market" and in this respect public means individuals that arenot associated with the company (for example, current directors or shareholders).

There will be great pressure to pay dividends to the shareholders as their rewardfor providing equity funds for the company. In particular, institutional investors(and particularly the ones who have a great deal of influence with companies) willbe looking for regular and good returns on their investments. Regular andconsistent dividend payments are often seen as a measure of how well thebusiness (and the senior management team) is performing.

The directors also need to be aware that in a listed company they lose some oftheir privacy, particularly as details of their pay and "perks" will be reported as anintegral part of the annual accounts process.

There are a number of critical points that affect the timetable for an official listing andthese can take days, weeks or months depending on the work that needs to be done


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between expression of interest and actual listing day. The critical points could besummarised as follows:

Issue of prospectus

Offer closure for share bids

Allocation and allotment of shares

Dealing begins.

The listing process itself involves a number of key specialist advisers as follows:

The sponsor, who may be a merchant bank, a stockbroker or other professionaladviser, is the key adviser to a business trying to gain a place on the official list.The sponsor examines the company and its aims and objectives by taking intoaccount its structure, strategy, long term plans, aims and objectives and capitalneeds.

Accountants, who are responsible for providing a detailed financial "healthcheck" on the company.

Legal advisers who are there to ensure that all the detailed legal requirements oflisting are met.

Brokers advise the business on share market conditions and the anticipateddemand, from the public, for shares in the business if full listing is obtained.

Registrars maintain the records of ownership of shares when they are boughtand sold.

Underwriters, who are usually issuing houses or merchant banks, generally actin a syndicate by agreeing to purchase any securities not taken up at the issueprice (underwriting). The underwriters will charge a fee which will be payablewhether or not they are called upon to take up surplus securities. Whilst not usedin placings, they are often used in rights issues.

Merchant banks, who are sometimes employed to give financial advice, but mayalso act in the role of issuing house or sponsor.

There are a number of different methods of issue which can be summarised as follows:

Offer for sale. When companies go public for the first time a large issue willprobably be by offer for sale and the offer price is advertised a short time inadvance so it is fixed without certain knowledge of the condition of the market atthe time applications are made.

Offers for sale by tender. A minimum price will be fixed and subscribers will beinvited to tender for shares at prices equal to or higher than this minimum price.The shares will be allotted at the highest price at which they will all be taken up.

Offer for subscription is only partially underwritten. This method issometimes used by small companies who stop the offer if a stated minimum priceis not achieved.

A placing. This is an arrangement whereby the shares are not all offered to thepublic and instead the sponsor arranges for most of the shares to be bought by asmall number of investors (usually institutional investors) such as pension fundsand insurance companies.

Reverse takeover. Sometimes a larger unquoted company makes a deal with asmaller quoted company, which then takes over the larger company.


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(b) Alternative Investment Market

The Unlisted Securities Market (USM) of the London Stock Exchange was a second-tier market for shares in companies not floated on the main market. For somecompanies the USM was seen as being a stepping stone to full listing – a majorpurpose in its development. The USM closed to new members at the end of 1994 andcompletely at the end of 1996.

To replace the USM, which was being gradually phased out, a new market – theAlternative Investment Market (AIM) – was launched by the London Stock Exchange inJune 1995. Like the USM it is a market for smaller growth companies that either do notwish to join, or fail to qualify for, the official list. It has, however, less stringent entryrequirements and regulations than the USM and as such should not be seen as a directreplacement for it.

The main difference between the process of obtaining full listing on The London StockExchange and the AIM is that the rules for AIM listings seek to keep cost ofmembership and of raising capital to a minimum. However, in common with all quotedcompanies, AIM companies are subject to the Exchange's Market Supervision andSurveillance Department and can be fined for breaches of AIM rules.Unlike the Official List, however, there are no requirements as to size, profitability, trackrecord, number of shareholders or ratio of shares in public hands for companieswishing to join the AIM. The only restriction on the type of security which can be tradedis that it must be fully transferable.The Inland Revenue treats AIM shares as unquoted, thus providing a number of reliefsfor investors, which helps to ease the process of raising finance at critical stages forfirms (e.g. start-ups). We shall deal with these reliefs in more detail later in the course.The AIM has established itself as a leading stock market for smaller growingcompanies, with listings from companies in 26 countries and ranged across 30 marketsectors and 90 sub-sectors. Fast-growing businesses with turnovers between £4million and £20 million are particularly keen to list on the market, with smaller computerand hi-tech companies feeling that an AIM listing gives them a higher City profile andaccess to a wider source of funds. There are two fully investable indices − the FTSEAIM UK50 and the FTSE AIM100 – and from 2006 the FTSE AIM All-ShareSupersector Indices provides sector indices.

Every AIM company is supported, advised and monitored by its own Nominated Adviser(Nomad). Firms that wish to act as Nomads must undergo stringent checks beforethey can be authorised to become a London Stock Exchange-approved Nomad for theAIM. These checks ensure the suitability both of Nomads and of the companies theyassist to operate as part of AIM, bringing investors increased certainty and security.

Over-The-Counter

It is also possible to buy shares and other financial instruments in the "over-the-counter"(OTC) markets. These are not regulated or supervised by the Stock Market so there is lessprotection for the investor, although the costs of dealing on the OTC are less than those ofdealing on the main or secondary markets.

"Big Bang"

"Big Bang" occurred on 27 October 1986 and was considered necessary because ofrestrictive practices on the London Stock Exchange, including fixed commission scales andthe limited number of firms permitted to participate in dealing.

The effects of "Big Bang" included the abolition of the fixed commission scales and theopening of the Stock Exchange to a wider range of participants. The changes resulted in anincrease in competition due to large institutional investors being able to negotiate


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commission levels. There has also been a change in the constitution of the membership,with foreign companies moving into the Stock Exchange (a well-known case being MerrillLynch) and some other overseas organisations acquiring hitherto private dealers, e.g.Citicorp purchased Scrimgeours. In addition, there is now 24 hour trading in leadinginternational shares – starting in the Far East, moving to London and then to New York andback to the Far East for the following day.

Market Participants

Prior to "Big Bang", there was a rigid distinction in the membership of the Stock Exchangewith brokers buying and selling financial instruments on behalf of clients for which theycharged fixed commissions, and jobbers acting on their own behalf in buying and sellingsecurities. Jobbers would trade with the brokers, but never actually came into contact withthe original investors. This was known as single capacity trading.Single capacity trading has now been replaced by dual capacity trading as both activitiescan now be conducted by a single firm. Firms can act as agents of the investor (previouslythe responsibility of the broker) whilst also acting as principal in their own right in buying andselling shares (previously the role of the jobber). Some firms only act as agency brokers,working solely as agents on the behalf of clients in return for commission, and do not deal asprincipals for themselves.The new traders acting in a dual capacity are called market-makers. Market-makers mustbe members of the Stock Exchange. They must register to deal in certain types of security,and must agree to quote two-way prices (for buying and selling) in the shares they trade in."Chinese walls" are required to be set up in firms which deal as market-makers in order toseparate the broker and dealer functions. This is to prevent the investor (and the firm) fromunscrupulous market-makers making profits at their expense, and will also help provide someprotection for market-makers and firms against allegations of this type.Only market-makers are permitted to use the Stock Exchange Automated QuotationsSystem (SEAQ) which is a computerised price display regularly updated by the market-makers themselves. Dealers and investors may view the system on computer terminals viadedicated networks.Two other terms you may come across in this area are GEMMs and SEMBs. GEMMs areGilt-Edged Market-Makers and SEMBs are Stock Exchange Money Brokers. SEMBshelp to ensure liquidity in the share markets by dealing with the lending and borrowing ofmoney and stocks to those who are experiencing difficulty in fulfilling share-trading deals.For larger institutional investors there is a growing alternative to this system of market-makers known as crossing networks. Crossing networks, of which examples are Instinetand Global Posit, electronically link buyers and sellers of shares and other financialinstruments. Another example of a crossing network is Tradepoint, which operates a screen-based matching of orders for certain UK equities. Whilst the use of crossing networks is stillrare in the UK it is common practice in the US.

Some Other Common Market Terms

The Stock Market, and its related activities, is full of unusual terms, e.g. the "Chinese walls"noted above. Below we mention a few of the more common terms, which you may haveheard of but be unsure as to their meanings. A useful exercise for you to undertake is to seeif you can relate the terms to your wider reading of the financial press.Bull markets are those with rising prices, and bear markets are ones whose prices fall.Similarly, optimistic people are bullish, expecting increases in share prices, whereasbearish people are more pessimistic about market prospects.If an investor goes long in a sector it means he is building up a holding of shares in thebullish hope of them increasing in value, whereas someone who goes short (generally abear) sells shares he does not own, again with the hope of making a profit. A short bear issomeone who takes a gamble that he may be able to purchase the shares cheaper (a bearcovering) before he has to deliver them (at a pre-arranged price) and thus make a profit. An


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uncovered bear (one who sells shares he does not have) can face unlimited losses if theprice rises quickly and he has to purchase shares to sell at a loss.A bear-raid is when a number of dealers sell ostentatiously in an attempt to drive down themarket. In order to prevent this market-makers can mark up the prices near the end of theaccount period – a so-called bear squeeze.A bull may buy shares and intend to sell them at a profit before he receives them (he mayneed the sale proceeds to pay for the shares); if this goes wrong and a loss is made he isreferred to as a stale bull.A stag is someone who applies for shares at the start of a new issue of shares intending tosell them straightaway. This is because new issues are usually priced low in order to ensurethat they are sold, and hence start trading at a substantially higher price. The differencebetween the issue price and the initial trading price (the premium) is the stag's profit.

B. OTHER SOURCES OF FINANCE

The markets discussed earlier are not the only sources of finance, and other sources include:

Banks

Banks are a major source of short-term (and recently medium-term) corporate financing.Long-term loans from banks are in the form of mortgages. The banks will expect thecustomer to provide a reasonable proportion of the required funding from its own resources(e.g. from equity). Clearing banks like to lend against security (i.e. assets).

The rate of interest charged to larger companies on medium-term bank loans will be set atLIBOR (London Inter-Bank Offer Rate) plus a margin which depends on the credit rating andriskiness of the borrowing. For smaller companies the interest rate will be the bank's baserate plus a margin, again depending on the riskiness and credit rating of the firm. The rate ofinterest in both cases can be either fixed or variable. Often in the former cases it is adjustedevery quarter, half-yearly, three-quarterly, or yearly in line with changes in LIBOR.

Merchant Banks

These are banks dealing as investment banks, generally for corporate clients. They have arange of activities, including:

Involvement in the business of the Stock Exchange for their clients, helping in theissuing and underwriting of share issues and share registration.

The provision of venture capital and large scale medium-term loans to companies.

The taking of wholesale deposits in all currencies.

Dealing in foreign exchange and the bullion markets, and through subsidiaries in stocksand shares.

The provision of advice during takeovers and mergers.

Granting acceptance credits.

The management of client investments and acting as trustees.

The provision of general investment and deposit advice to corporate clients.

Institutional Investors

These are institutions with large funds to invest in assets which provide sufficient returns andsecurity, including investments in company stocks and shares. The UK's main institutionalinvestors are:

(a) Unit Trusts


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Unit trusts were developed in order to allow small investors to hold a diversifiedportfolio of investments. The portfolio is managed on behalf of investors by a unit trustcompany which deducts management expenses from the income of the portfolio beforepaying the investors their share of the income. Each investor holds a sub-unit or stakein the portfolio. The sub-units are sellable, their price being determined by theunderlying value of the securities included within them.

(We shall examine portfolios in detail later in the course.)

(b) Investment Trusts

Investment trusts invest in a wide range of securities though they are generallyconcerned with quoted and larger unquoted companies. They are interested in bothreturns and securities, wishing to maintain a steady growth in income in order to paytheir shareholders' dividends.

(c) Venture Capital Organisations

Venture capital is the investment of money in a new or expanding business, or in amanagement buy-out. It is generally done in exchange for an equity stake in thebusiness and a seat on the board.

There are several organisations offering venture capital, including venture capital fundsacting as agents for the venture capital industry, the clearing banks. Those which havejoined are regulated by the British Venture Capital Association. The biggest and oldestventure capital provider is the 3i group (Investors in Industry plc).

Venture capital is a high risk, high return investment, which is generally short term,being between five and seven years in duration. Often the venture capitalist will beable to realise his investment (and hopefully profits) when the business is floated onthe AIM and the venture capitalist can sell his shares.

In order to qualify for venture capital a company must be able to show the venturecapitalist that it has the ability to succeed; that the product or service is viable andmeets a need in the market; that sufficient levels of the correct form of finance areavailable; and there is, or will be, a good management team.

Venture Capital Trusts (VCTs) are investment trusts investing a significant proportionof assets in unquoted companies to a maximum in a company of £1m, and per investorof £100,000. There are general tax reliefs available to individuals aged 18 years orover (but not to trustees, companies or others) who invest in VCTs as follows:

exemption from income tax on dividends from ordinary shares in VCTs ("dividendrelief"); and

"income tax relief" at the rate of 30% of the amount subscribed for shares issuedin the tax year 2006/07 and onwards (for subscriptions for shares issued inprevious tax years the rate is 40%). The shares must be new ordinary sharesand must not carry any preferential rights or rights of redemption at any time inthe period of five years (three years if the shares were issued before 6 April 2006)beginning with their date of issue. This income tax relief at 30% is available to beset against any income tax liability that is due, whether at the lower, basic orhigher rate.

The maximum amount of deferral relief is the amount subscribed for eligible shares inVCTs that are issued in the year (up to a maximum of £100,000).

(d) Pension Funds

Pension funds hold large amounts of money which will provide retirement benefits fortheir members. In most pension funds there is a surplus of incoming funds fromcontributions over outgoings as pension payments. The surplus must be invested to


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achieve the best possible return whilst maintaining the security of funds. The pensionfund manager often spreads the investment between high yield securities, e.g. gilts,and equity or property.

Pension funds may provide substantial finance for major investment schemes. Forexample, funds from the Coal Industry Pension Scheme helped fund the new"Galleries" in Wigan town centre. A new multi-million pound expansion of MiltonKeynes shopping centre is being funded by the Universities Superannuation Fund.

(e) Insurance Companies

These, along with pension funds, provide the most funds for investment in the UK.They have similar investment policies, seeking secure returns and steady growth inorder to meet their commitments.

Government and European Union Assistance

In common with the majority of governments, the UK Government provides financialassistance to companies, especially those operating in high technology industries or in areasof high unemployment.

Enterprise Initiative Scheme

This is a series of measures including local business advice centres, "Business Links",and grants provided by the Department of Trade and Industry (DTI).

Regional Enterprise Grants

These are available for companies in Development Areas employing fewer than 25staff, and are used to help finance investment in fixed assets or to aid innovativeprojects.

Regional Selective Assistance

This is considered by the local office of the DTI and is only available in areas definedgeographically for the purpose of the availability of financial assistance. The amount ofgrant will be the minimum required to commence the project. To be eligible the projectmust need assistance, be commercially viable, safeguard or create jobs and offer adistinct advantage to the region or country as a whole.

The EU funds the European Regional Development Fund (ERDF) which gives money tomember governments – the majority going to the poorest member nations. The UK receivedover £3.5 billion during the first 15 years of the ERDF's life.

Note that the sources of finance available to the company, especially from governmentalbodies, are an ever-changing area, and you should follow developments in the financialpress.


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C. OTHER FINANCIAL MARKETS

The London Money Market

The London money market covers a wide range of UK institutions.

The Bank of England

Merchant banks

Discount houses

Finance houses

Pension funds

Unit trusts

Parallel markets

Clearing banks

Other banks

Insurance companies

Investment companies

Building societies

The Stock Exchange.

Parallel Markets

These consist of the Foreign Exchange Market and the Eurocurrency Market, both of whichwe shall consider later in the course. They also include:

The Local Authority Market

The Interbank Market

The Finance House Market

The Intercompany Market

The Certificate of Deposit (CD) Market.

Option Markets

Options are a form of dealing which can be used as an insurance against, or for speculationon, a rise or fall in a particular share, and act as a way to limit the cost of taking a view on thefuture performance of the share.

An option is the right to buy (a call option) or sell (a put option) shares at a future date(generally three months forward) at a fixed price agreed now. There is also a double optionwhich gives the right to buy or sell and this is called a put and call option or a straddle.

Bargains are agreed at a striking price (the figure at which shares can be called or put atthe end of the option period), which is the current share price, plus interest to meet the carry-over facilities during the option period. It is not necessary to wait until the end of the optionperiod before taking action, and it is possible to deal in those shares during the period. A feeper share will be charged by the broker whether or not the option is exercised.

Options have a maximum life of nine months with expiry dates arranged on a three-monthcycle, so that a maximum of three extensions can be arranged on shares of any onecompany. They are popular because they provide investors with price and time variety not


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possible with traditional call and put options and the opportunity to profit from price changeswhich involve a smaller outlay than direct involvement in the securities themselves.

An extension of the options market is the Traded Options Market. This gives the holder ofthe option the right to buy or sell the option itself before its expiry date.

(We shall examine options in detail later in the course.)

D. RECENT CHANGES IN CAPITAL MARKETS

There have been vast changes in the capital markets over recent years including:

Increased competition with the impact of Big Bang, building societies becoming banks,and banks operating in non-domestic markets have, amongst other things, increasedthe levels of competition in the financial services industry.

Securitisation of debt, i.e. firms are increasingly issuing securities rather than borrowingfrom the banks.

The deregulation of the financial and other service markets.

The abolition of exchange controls allowing companies to use overseas markets toobtain funds.

Disintermediation – firms using securitisation to avoid using banks.

Globalisation – shares issued in one country are traded around the world.

The development of, and greater use of, risk management tools such as the use ofswaps and options which help in the borrowing of money and also reduce the financialrisk apparent in the balance sheet.

We shall consider these points in greater detail elsewhere in this course.

E. IMPACT OF THE MARKETS ON MARKET DECISIONS

The Stock Market and its players have a major impact on a company's, and on the market's,decisions. We will refer to them throughout this course, and you should take time to considerthe point when you have completed each study unit.

One example we can see from the last study unit is in the field of MBOs. Many firms areadopting the policy of focusing management and financial resources on core activities, and toa large extent it has been supported by the stock markets and institutional investors. Withdiversification often less attractive, opportunities for managers to buy-out their operationshave become more common.

Other examples from earlier study units include the existence of short-termism (see StudyUnit 1); the market's views on the relative strengths of two companies will affect the valuationplaced on them and the resulting terms of any acquisition or merger (Study Unit 2); and thethree financial management decisions discussed in Study Unit 1 will be affected by themarket and its workings.

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Study Unit 5

Sources of Company Finance

Contents Page

Introduction 107

A. Share Capital 107

Value 107

Authorised and Issued Capital 107

Types of Share Capital 108

Retained Profits 109

Dividend Payable 109

Newspaper Information on Shares 109

Share Categories 109

Penny Shares 110

B. Methods of Issuing Shares 110

Placing or Selective Marketings 110

Offers for Sale 110

Sale by Tender 111

Rights Issue 112

Other Methods 114

Pricing Shares for a Stock Market Quotation 115

Costs of Share Issues 115

Issuing New Shares Without Raising Capital 116

C. Share Repurchases 116

D. Debt and Other Forms of Loan Capital 118

Debt Capital 118

Debentures and Loan Stocks 119

Mortgages 122

Convertible Loan Stock 122

Warrants 124

Leasing 125

Hire Purchase 127

Licensing and Franchising 127

(Continued over)

106 Sources of Company Finance

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Bonds 127

Syndicated Loans 128

Mezzanine Finance 128

Medium Term Notes (MTNs) 129

Project Finance 129

E. Short-Term Finance 129

Securitisation 129

Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs) 129

Commercial Paper (CP) 130

Syndicated Credits 130

Banks 130

Trade Credit 132

Factoring 132

Invoice Discounting 133

Bills of Exchange 134

F. International Capital Markets 134

Eurocurrency 134

Eurobonds 134

Euroequity 135

Choice of Currency for Borrowing 136

Advantages of Raising Funds in International Markets 136

G. Finance and the Smaller Business 136

Government Measures 136

Business Angels 137

Grants 138

Banks 138

Venture Capital Providers 138

Finance Companies and Lessors 139

Private Investors 139

Answers to Practice Questions 140

Sources of Company Finance 107

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INTRODUCTION

In this study unit we will look at the main sources of finance available to companies.

We start by considering the primary source of funding for limited companies – equity finance– including how it is raised. Whilst under UK company law all limited companies must haveequity, many also utilise additional types of finance. We go on, then, to examine the differentforms available, including those from international capital markets. This is an area in whichthere are always new arrangements developing, and you will almost certainly learn of morefrom your reading of the financial press as new ideas come to market.

A. SHARE CAPITAL

Shares are described as permanent capital because the funds supplied for their acquisitionare non-returnable (to the investor who provided them) in most circumstances other than inthe event of a liquidation. The ordinary shareholders collectively own the company, but standlast in line for rewards on investment and in the event of liquidation, although they do haveownership of the remaining funds either in a trading period or in the event of liquidation.

Ownership means that the ordinary shareholders bear the greatest risk. In return for theiracceptance of the risk they are equity shareholders, each share carrying a vote in themanagement of the business, although as we saw in Study Unit 1, managerial control maybe limited.

In the case of a limited company, the Articles of Association will include details of each classof shares which comprise the capital structure of the company.

Value

We have already determined that the owners of the company are the shareholders – and toshow their ownership they have shares issued to them. Shares are issued in the UK at anominal, authorised or face value generally of £1, 50p, 25p, 10p or 5p.

Be careful not to confuse nominal value with market price, to which it bears no relationship.The market price is the price that shares are sold for. (If the market value and the nominalvalue are the same, the shares are said to be at par value.)

The only exception to this rule of no relationship is when the shares are first issued, and thenominal value is the minimum at which the price would be set. Established companiesissuing new shares to the market, with existing shares that have a market value in excess ofthe nominal value, may issue the new shares at a premium (i.e. at a value greater than theirnominal value).

(Not all countries have company shares with nominal value. It would be a useful exercise foryou to find out if countries which you deal with at work have shares with nominal values.)

Authorised and Issued Capital

The maximum amount of capital (detailed in the Memorandum of Association) that acompany may issue is known as the authorised capital. Do not confuse this with acompany's issued capital.

The issued capital is the nominal value of share capital allotted (also referred to as issued)to shareholders. The maximum amount of capital that can be issued is an amount equal tothe authorised share capital.


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Types of Share Capital

The rights and voting powers of shares, and the differentials between the different classes ofshares, are listed in the Articles of Association. The issue of different classes of ordinary(equity) shares is strongly discouraged by the Stock Market and only allowed in exceptionalcases. We will now look at some of the different types of share capital, but unless statedotherwise we will generally be considering ordinary share capital.

(a) Redeemable Shares

A limited company may, if authorised by its Articles, issue shares which are to beredeemed at the option of the shareholder, provided it has issued other shares beforethe redeemable ones. There are various rules relating to the redemption ofredeemable shares, varying between public and private companies, developed in orderto protect shareholders and the general investing public.

(b) Preference Shares

Unlike ordinary share capital, preference shares are entitled to a fixed percentagedividend, which is paid before any profits are distributed to ordinary shareholders.However, like ordinary share dividend it can only be paid if there are sufficientdistributable profits available. However, unpaid dividends on cumulative preferenceshares are carried forward and must be paid before any dividends can be paid toordinary shareholders.

Preference shareholders may be entitled to receive the nominal value of their shares inthe event of a company winding-up, before any distribution is made to ordinaryshareholders – in which case the rules underlying it will be stated in the company'sArticles of Association.

There are three further types of preference shares.

Participating preference shares may be entitled to some extra dividend, overand above their fixed dividend entitlement, but it may only be paid after theordinary shareholders have received an agreed amount in dividend.

Convertible preference shares are preference shares that can be convertedinto equity shares. A company may issue them to finance major acquisitionswithout increasing the company's gearing or diluting the EPS of the ordinaryshares. The shares potentially offer the investor a reasonable degree of safetywith the chance to make profits as a result of conversion to ordinary shares if thecompany prospers.

Redeemable preference shares may be issued provided the Articles permit thecompany to do so. The shares will be redeemable, either at some future date orwithin a range of dates, and at that time the shareholder will have his investmentreturned to him.

Preference shares constitute a small proportion of companies' finance, especially inrecent times – investors prefer loan stock where the returns and security are greaterand, from the companies' point of view, the dividend on preference shares, unlikeinterest on loan stock, is not allowable against corporation tax.

(c) Deferred Shares

These are the last in line for dividends and the proceeds of liquidation. In rarecircumstances, a founder's ordinary share may be authorised and held by thefounders of the company. Where it exists, it will rank behind all other shares fordividend.


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(d) Non-voting Shares

A company may issue non-voting shares which still carry the risk of equity shares butdo not allow the shareholder any say in the running of the company – for this reasonthey are not very popular except in takeover bids.

Retained Profits

You will recall from your earlier accounting studies that part of shareholder funds is retainedprofit. Indeed the major source of new funding for companies in the UK is retained earnings.

Dividend Payable

Dividends are paid on ordinary shares as a percentage return on their nominal value. Forexample, the holders of a £1 nominal ordinary share in a company which declares a dividendof 20% will receive 20p per share regardless of the price paid for the share.

You will recall from an earlier unit that the dividend yield relates the market price of a shareand the dividend received. If the dividend yield falls, then the share becomes less attractivecompared to other investments, demand for it will fall, and supply will increase as investorswish to sell. Its market price will then reduce until the yield on its new market price is inequilibrium with returns received elsewhere for similar levels of risk. Although this is a highlysimplified explanation, it does underpin the basic rationale behind the workings of the stockmarkets.

We shall discuss the level of dividends paid by the company in greater detail later in thecourse, but dividends are generally dependent on the results of the company. This benefitsthe company, since ordinary shares have a fluctuating service cost which only increases (intheory at least) during periods in which the company is successful.

Newspaper Information on Shares

Many of the broadsheet papers include a section showing security prices and relatedinformation including: the highest and lowest prices during the year; the closing price theprevious day; the change in price over the previous trading day; dividends net of tax;dividend cover; gross yield; and the P/E ratio. You should try to "read" such information on aregular basis and ensure that you understand the information contained in the differentcolumns.

Share Categories

Shares are categorised according to the company type and trading frequency:

(a) Alphas

These are the shares of the most prestigious companies which are generally heavilytraded and dealt in by a large number of market-makers. Prices are postedimmediately on SEAQ.

(b) Betas

These are also large company securities, but they are not as heavily traded as alphas.They must have at least four market-makers dealing in them and prices quoted onSEAQ are those at which firm deals can be made.

(c) Gamma

These securities are traded less frequently than betas and the prices quoted for themare merely indicative.


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(d) Deltas

These are the least traded of all and no prices are actually shown, simply indications ofa dealer's interest.

Penny Shares

Penny shares are shares which have a very low value (often because the company isexperiencing difficulties) with the bid or offer spread of such shares exceeding 10% of theirmarket value. Investors buy such shares in the hope that the market has undervalued theirprospects and that they will make a substantial profit when the price recovers. In practice,however, the market is rarely wrong and the price often falls further or the company goes intoliquidation. The low valuation of such shares reflects the high risk attached to them and theefficiency with which the market operates.

B. METHODS OF ISSUING SHARES

One way in which a firm can expand is to issue additional equity – usually on the main StockExchange or second-tier market, either by a quoted company issuing additional shares or byan unquoted company obtaining a quotation. An unquoted company may also wish to issueshares without being floated.

We discuss below various methods of issuing shares. The factors which help to determinethe best approach to adopt are the amount to be raised, the cost of raising it, and the state ofthe market and economic conditions generally.

Placing or Selective Marketings

This method is often used for a company wishing to be floated for the first time and to issue asmall issue, or by a quoted company wishing to raise additional finance. It involvessecurities' acquisition by a market-maker so that they can be purchased by a small numberof investors.

The method is widespread because it is relatively cheap, with the sponsoring firmapproaching selected institutional investors privately. However, it does limit the number ofshares available for trading on the market.

Offers for Sale

This method is popular with companies being floated for the first time and undertaking a largeissue, e.g. an unquoted company may sell some of its existing shares on the market. Anunquoted company can also issue new shares and market all (new and existing) shares.The selling of existing shares provides a wider market for finance (and shares) in a companyand allows shareholders a chance to sell their shares. A company will only receive additionalfunds if new shares are issued.

An unquoted company applying for quotation has to be sponsored by a Stock Exchangemember firm and an issuing firm. The responsibility of the former is to ensure that thecompany fulfils the requirements for listing; the issuing house has to ensure that the issue issuccessful both in price set and take up of shares.

In an offer for sale the issue price (which must be advertised a short time in advance) isusually given as based on a P/E ratio allowing for easy comparison by investors. The priceof shares is generally set at a discount to what could be obtained because of uncertaintiesregarding the market, and to prevent an undersubscription (when shares have to be boughtby the underwriters). Whilst the issuing house attempts to set the price so that share pricesrise briskly once trading commences, they should prevent the price being too low and


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causing the company to issue more shares than necessary. A rise in share prices ofapproximately 20% is usually aimed for.

Sale by Tender

This method is occasionally used for large first time issues but it is less common than offersfor sale because of uncertainties as to the amount of finance which will be raised and it maygive the impression that the issuing house is unable to set a price for the shares. An issueby tender has become a more common method of share issue in recent years.

The issuing house (or the company) invites members of the public to subscribe by tender, i.e.to state at what price they will take the security offered; sometimes there is a minimum pricebelow which tenders will not be accepted. Applications may be dealt with in a number ofways and the most common methods are explained in paragraphs (1) to (4) in the followingexample:

Example

ABC plc is to make an issue of £2m ordinary shares by tender. The minimum tender pricehas been fixed at 50p. Applications were received as shown in the table below:

Tender Price Number of SharesApplied For

CumulativeApplications

Value ofApplication

CumulativeValue

£ £ £

2.00 100,000 100,000 200,000 200,000

1.75 200,000 300,000 350,000 550,000

1.50 300,000 600,000 450,000 1,000,000

1.25 400,000 1,000,000 500,000 1,500,000

1.00 450,000 1,450,000 450,000 1,950,000

0.75 550,000 2,000,000 412,500 2,362,500

0.50 1,000,000 3,000,000 500,000 2,862,500

Different methods are:

Applications are accepted in full at the prices tendered, starting with those offering thehighest prices and working downwards until the new issue has been allotted in full.Therefore in the example above, the full issue is fully subscribed at a price of £0.75,which yields an overall value of £2,362,500 for the 2m shares. This method isunsuitable for most public issues as it tends to frighten away the private investor andthe issue is not spread amongst many applications.

Shares are allotted in full, starting with the applications offering the highest prices andworking downwards until all the issue has been fully allotted. However, here, the pricefixed is that of the lowest tender to be accepted and all applications pay at this price.In our example, the issue price is the point where the full 2m shares are allotted,namely at 0.75p. As everyone will pay this price, the issue will raise £0.75 2m £1,500,000. Whilst the approach is fair for the small shareholder, the issue is notusually spread amongst many applicants.

The applications accepted are scaled down so that each applicant only receives aproportion of the shares for which he asked. The issue price is again the lowestsuccessfully tendered. In our example and assuming that 2.5m shares are to beissued, five would be issued for every six applied for by each applicant – the issueprice being 50p. If therefore an investor had requested 600 shares and tendered at £1per share, he would have sent in a cheque with his application for £600. Under therules, he would be allowed 500 shares at 50p per share (£250) and receive a refund of


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£350. This method is the fairest so far for the small investor and generally means thatmore applications are successful.

A further improvement results from a method whereby two prices are fixed.Applications at prices between them are scaled down. Applications at lower prices arerejected, and those above the higher price are accepted in full, up to a certainmaximum number, or scaled down slightly.

There are, of course, a number of variations to the above and issuing houses are continuallyresearching to make improvements. Although small investors tend to avoid tenders as theyhave difficulty in deciding on a fair price, recent experiences suggest that the fixing price isusually not much different from the ensuing market price, reflecting the influence of theinstitutional investors.

The two main advantages for the company issuing shares are that:

(a) Paperwork is reduced as the number of applications is reduced.

(b) The fixing price in recent years has usually been higher than would be necessary in anoffer for sale. In an offer for sale, the price is kept low in order to ensure that the offeris accepted, but in a tender the forces of supply and demand have improved the price.

Rights Issue

The term rights issue is applied to the system of issuing shares to existing shareholders,usually at a discount from the market price, in order to raise further capital from existingshareholders. (A discount makes rights issues impractical when current market price is at orbelow nominal value.)

When offering shares in a rights issue, the company sends an explanatory letter to eachshareholder detailing the price, accompanied by a provisional allotment letter indicating thenumber of shares to which the member is entitled to subscribe, e.g. a rights issue on a 1 to 5basis at 120p per share means that for every 5 shares a shareholder holds he can purchasean additional 1 at 120p. The offer must be on a "rights basis" in proportion to the member'sexisting holding as a fraction of the holdings of all members eligible to receive the offer.Forms of acceptance or renunciation accompany the offer, and should a member choose notto accept he may renounce his "rights" in favour of someone else. In due course, if themember accepts the offer, or exercises his rights, he will lodge his acceptance and chequewith the company.

Should the member choose to renounce the offer he can sell the rights to his shares, a salebeing attractive because the price of the shares is below their current market value. Therights of shareholders to buy the rights are known as pre-emptive rights.

If shareholders do not take up the rights or sell them, the company must, under StockExchange rules, sell them for the shareholders who get the rights value. If small amountsare involved the benefits can go to the company. In order to maintain his share of control theshareholder must take up all his rights. The shares may be issued to outsiders or in differentproportions between members. Members may, if permitted under the company's Articles ofAssociation, be offered the shares which their peer group have rejected.

The key to a successful rights issue is to achieve a balance between the ratio of theproposed new issue to those already in issue, and the price at which rights may be taken up,considering that the rights issue will generally be at a discount.

Rights issues offer advantages to both the company and existing shareholders – for thecompany there is less administration and no prospectus is required, both factors reducingcosts. The cost of underwriters, if used, will also be lower.

Shareholders obtain shares at a discount or can sell their rights allowing the purchaser achance to buy shares at a discount. The share price before dealing in the newly-issued


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shares will be "cum" rights, and thus the shares will trade at a higher price. Shareholdercontrol can be maintained provided the shareholder exercises his full rights.

Calculation of Issue Price

This is the amount that the company wishes to raise from the issue divided by the number ofnew shares. It is important to issue a sufficient number of shares so that the issue price isbelow current market price.

Alternatively, if the number of shares as well as the price is to be determined, the factors tobe considered include:

the ease of issue

the current market price – too large a discount is to be avoided, and a discount ofapproximately 25% is usual; and

the number of shares currently in issue – too many new shares might dilute the EPStoo much.

Calculation of Price after Issue

(a) Ex-rights price

This is the theoretical price and is essentially a weighted average. If, for example, acompany is making a 1 for 3 rights issue, with each new share costing £2 and thecurrent market price being £3, then the ex-rights price will be:

Cum rights value of 3 shares ( £3) £9

New share £2

£11

Therefore the theoretical ex-rights price is 11/4 £2.75.

This could also be shown in terms of total value of the issue divided by the totalnumber of shares.

(b) Actual Price After Issue

The actual price after issue often differs from the theoretical price, which is due todifferences in expected earnings between the existing and the new shares.

Here the shares can be valued on a P/E basis. Using the figures in (a) above, we willfirst consider the situation where the earnings from the new shares are expected toyield the same return as the existing shares. We will then look at what happens ifexpected earnings are relatively higher or lower.

At current earnings:

Assume a P/E ratio of 10, which means that the earnings are currently 10% of themarket value (i.e. £3/10 30p) or if, for example, 3m shares are currently inissue, £900,000 in total.

If expected earnings from the new shares are at the same level, they will yield1m £2 10% £200,000. Total earnings will, therefore, be £1,100,000.

Monetary value of the shares ( P/E of 10) £11,000,000.

The share value is therefore 11,000,000/4,000,000 or £2.75, i.e. the same as thetheoretical ex-rights price.


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At lower earnings: if, say, the new shares are expected to yield 5% earnings:

Total earnings will be (£900,000 (1m £2 5%)) £1,000,000.

Monetary value of shares £10,000,000.

Value per share £10,000,000/4,000,000 £2.50 per share.

At higher earnings: if, say, the new shares are expected to yield 15% earnings:

Total earnings (£900,000 (1m £2 15%)) £1,200,000.

Monetary value of shares £12,000,000.

Value per share £12,000,000/4,000,000 £3.00 per share.

The break-even point (i.e. no dilution of earnings per share) is when the rights priceequals the current capital employed per share, assuming that current trends continue.The actual impact on shareholder wealth will depend on the earnings generatedcompared to the existing earning rates – if lower the market value will fall, if higher itwill rise and so forth.

Empirical evidence has found that the market price of shares tends to fall after a rightsissue due mainly to uncertainty as to the company and its prospects – the leveldepends on the company and the rights issue.

Value of Rights

We noted earlier that shareholders can sell their rights. How do we determine what pricethey would receive.

The value is the difference between the price of the rights shares and the ex-rights shares.In the above example, the price of the rights shares was £2; if the value of ex-rights shareswas £2.75, then the value of the rights is £2.75 £2 or 75p. The new shareholder in effectpays the ex-rights price purchasing the rights for 75p and the share for £2. The value ofrights attached to each existing share is the value of rights divided by the number of sharesrequired to issue. In the above example this would be 75p/3 shares or 25p per share.Shareholders can take up part of their rights and sell the others.

Other Methods

(a) Subscription offers

An offer for subscription is an invitation to the public by, or on the behalf of, an issuer tosubscribe for securities not yet in issue or allotted.

(b) Prospectus issue

If reasonably substantial, the company might make an issue direct to the public with theabsolute minimum of assistance from the outside sources we discussed earlier. It israther unusual because of the complexity of the nature of the capital issue.

(c) Stock Exchange introduction

This is the introduction of the shares on the Stock Exchange so that a quotation (i.e. aprice) can be fixed, rather than the issue of shares. An introduction cannot be madeunless sufficient shares are available to establish a market and thus a price, and thismethod tends to be restricted to larger firms.

(d) Role of underwriters

As we saw earlier, underwriters agree to purchase any securities not taken up at theissue price and will charge a fixed fee for their service. Use of underwriters removesthe risk of a share issue being under-subscribed.


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However, the costs of underwriting are high and companies with marketable securitiesmay choose to use another method known as the bought deal. Here a majorinvestment bank will buy all the shares in the new issue at a slightly discounted price.

(e) Open offers

This is an offer to existing shareholders to subscribe for securities, whether or not prorata to their existing shareholdings. They are not allotted through the use ofrenounceable documents.

An open offer is a concessionary method of listing, approval being sought in principleearly on. Once approval has been granted, the sponsor firm has to inform the marketten business days prior to the "on-register" date. The announcement will state that theproposals are subject to shareholder approval at general meeting.

(f) Vendor share scheme or placing

Where a vendor prefers cash to shares issued to finance an acquisition by a purchaser,an issuing house can place the securities with clients for cash.

(g) Exchanges and conversions

This is the process used to replace one security with another, e.g. a vendorconsideration issue or paper issue used in a merger or takeover bid.

(h) Employee share schemes

Such schemes are often used as incentives, e.g. share option schemes which givecertain employees (usually directors) the chance to purchase shares in the company ata price determined in advance, hopefully, for a financial benefit.

Pricing Shares for a Stock Market Quotation

We have seen that the setting of a price is the job for the sponsor, and we dealt with thevaluation of companies in Study Unit 3. However, factors a firm should take intoconsideration include:

The current and future market conditions and the firm's results.

P/Es of similar quoted companies.

Whether the quotation is to be on the main market or the AIM.

An initial premium on launch, followed by steady growth in the share price is desirable.

The amount of finance required.

Future dividends and earnings forecasts (the more shares the more dividends need tobe paid out).

Underwriting costs or deep discount required to avoid undersubscription of shares.

New issues are generally made when share price and expectations are high – investors aremore likely to buy shares, dilution of the EPS will be limited and the increases in thedividends required to be paid will occur.

Costs of Share Issues

Share issues (and debenture issues) can be expensive and depend on the method used.Costs involved in share issues include:

The Stock Exchange listing fee for the new securities.

Fees of advisors, including those of the issuing house.

Underwriting costs.


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The compulsory advertising in national newspapers.

Printing and distribution costs of details and prospectus.

Whilst some costs are variable, such as the commission payable to issuing houses, most arefixed and thus it is more economical to issue large amounts of shares, which discouragessmall firms.

Compliance with Stock Exchange rules (which vary according to the size of the issue) is alsoa cost to be borne by the company (the rules include the number of market-makers to useand how to issue the shares).

Issuing New Shares Without Raising Capital

There are also three methods by which new shares may be issued without bringingadditional funds into the company.

(a) Scrip issues

A scrip issue, also referred to as a capitalisation, or a bonus issue, involves theconversion of reserves into capital, causing a fall in the reserves. Shareholders receiveadditional shares in proportion to their holding. Unlike a rights issue no additionalfunds are brought into the company – the shareholders do not "pay" for the shares.This results in more equity in circulation with the result that the market value willgenerally fall in the short term, thus making it more attractive to potential investors.The reserves used are either from a credit balance in the profit and loss account orfrom reserves specifically marked for the payment of shares, and requires authorityfrom the Articles of Association and the AGM.

(b) Scrip dividends

Scrip dividends are a conversion of profit reserves into issued share capital offered toshareholders in lieu of a cash dividend. Enhanced scrip dividends are those wherethe value of shares is greater than the cash dividend offered as an alternative. Suchdividends are of benefit to the company as they maintain cash within the business andare not liable to advance corporation tax. There may, however, be tax complicationsarising for individual investors.

(c) Stock split

A stock split is the splitting of existing shares into smaller shares, e.g. each ordinaryshare of 50p is split into two of 25p, in order to improve the marketability of thecompany's shares. It can also be used to send signals that the company is expectingsignificant growth in EPS and dividends per share, and for this reason the resultingmarket price of the split shares is higher than the simple split price would be. Forexample, if a share with a market value of £10 was split into two shares their pricewould be higher than £5. Reserves are not affected.

C. SHARE REPURCHASES

Repurchases, or buy-ins, of shares may be made by companies out of their "distributableprofits", or out of the proceeds of a new issue of shares made especially for the purpose,provided they are authorised to do so in the company's Articles of Association.

A company may not, however, purchase its own shares:

Where, as a result of the transaction, there would no longer be any member of thecompany holding other than redeemable shares.

Unless they are fully paid up, and the terms of the purchase provide for payment onrepurchase.


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Purchases may be in the market or off-market. An off-market purchase is said to occurwhen the shares are purchased not subject to the marketing arrangements of the StockExchange, or other than on a recognised stock exchange. A buy-in of shares by a publiccompany will be subject to the rules of the Stock Exchange and to the provisions of companylaw.

The change in the capital base will cause management to rethink its investment decisions,gearing, interest cover, earnings, etc. This is particularly important as the financialinstitutions focus their attention more towards income and gearing as an indicator of financialrisk.

It is important to be aware of the various advantages and disadvantages of sharerepurchases. The advantages of share repurchases include the following:

It may allow a company to prevent a takeover bid. The control by the existingshareholder group will be increased.

A quoted company may purchase its shares in order to withdraw from the Stock Market(see below).

It can be a useful way of using surplus cash.

Repurchasing shares will reduce the number in circulation which should allow anincrease in earnings and dividends per share, and should lead to a higher share price.It will increase future EPS as future profits will be earned by fewer shares.

Reducing the level of equity will increase the gearing level for a company with debtwhich may be considered beneficial by the company.

If the business is in decline a share repurchase may give the firm's equity a moreappropriate level.

The disadvantages of share repurchases are that:

Repurchasing of shares may be viewed as a failure by the company to manage thefunds profitably for shareholders.

The company requires cash for the repurchase.

It may be difficult to fix a price which is beneficial to all involved.

It requires existing shareholder approval.

Capital gains tax may be payable by those shareholders from whom the shares arepurchased.

It increases gearing.

We mentioned above that a firm may decide to go private, which happens when a smallgroup purchases all a company's shares and the company is no longer quoted on the StockExchange – a well-known example was the repurchase of shares in Virgin by RichardBranson.

The reasons for such a move may be to prevent takeover bids, reduce the costs of meetinglisting requirements and to limit the agency problem. In addition, because the firm is notsubject to volatility in share prices it can concentrate less on the short-term demands of theStock Market and more on its own medium- and long-term requirements. Another key reasonfor a company wanting to buy its own shares stems from the desire of management toimprove earnings per share, a financial ratio in which investors are becoming increasinglyinterested. Such opportunities will be considered against financial performance, share priceand capital structure.


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Practice Question 1

TT is a public limited company with a paid up share capital of 1.2m £1 shares and no long-term debt. The dividend has been paid at a rate of 45 pence per share in each of the last twoyears and the market price per share has not varied significantly from its current market priceof £3.60.

The company now wishes to finance the expansion of its existing premises and the boardhas announced a rights issue of 1 new ordinary share at a price of £3.00 for every 4 sharescurrently held. The company forecasts that future dividends will be at a rate of 43.5 penceper share on the enlarged share capital and that its existing ratio of dividend cover can bemaintained.

You are required to comment on the theoretical and the practical validity of the followingthree reactions to the announcement from various shareholders.

(a) I hold 5% of the equity. Whether I take up or surrender my rights, I should be getting abargain at the offer price of £3.00.

(b) As I understand the position, I should not have been out of pocket in the long run if thecompany had priced the rights issue at £5.00 instead of £3.00. I think they should havedone that to raise a bit more money.

(c) The company could have fixed a lower price for the issue if the underwriters hadn'tbeen looking for a high amount of commission, 1¼% being the amount charged.


D. DEBT AND OTHER FORMS OF LOAN CAPITAL

Debt Capital

At many different stages of their development (including at the business start up stage)companies will need to borrow funds to expand and grow. These borrowed funds (fromwhatever source) will need to be paid back and the cost of debt is simply the amount that hasto be paid back (to the lender) for those funds that have been borrowed. This cost wouldtypically include interest and capital repayments at a rate determined by the particularcontract concerned, although in some cases there may be other elements involved in the re-payment – for example, shares in the company. Interest payments and capital repaymentswill be spread over an agreed timescale until the debt has been repaid or be liable at the endof an agreed period.

The cost of debt is generally cheaper than the cost of equity (ordinary shares). This is largelybecause there are high costs associated with raising equity finance, such as:

Arrangement fees

Bank, accountants' and solicitors' fees

Issuing house fees

Advertising and marketing fees

Stock Exchange fees

Underwriting fees.


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It is also highly likely that the returns that investors will require from their equity investmentwill exceed that required by the suppliers of debt capital. This is because there is less of arisk involved for the suppliers of debt capital than there is for the suppliers of equity capital.Further, in the event of a shortage of profits or the business going into liquidation, then thedebt capital would be paid before the remainder of profit (if there was any) would be paid asdividends to shareholders.

Another major advantage to the business is that debt interest can be used to reduce taxableprofits (and hence tax liabilities) whereas dividends paid to shareholders cannot be used toreduce a tax burden.

Legal implications

Whenever a business secures a loan there is usually a legal agreement between the lenderand the borrower that deals with the non-repayment by the borrower to the lender. Often thedebts and loans granted to a business will be secured loans – i.e. secured on named assetsof the company that stand to be lost if the business fails to repay the agreed debt to theagreed schedule. In the event of a problem, most companies and lenders will do their best toarrange a different repayment schedule that will meet the requirements of both parties – afterall, it is not in the interests of either party to be paying expensive legal fees to recover debts.The important thing to bear in mind is that, with any debt, there will inevitably be a legalobligation on both parties to keep to the agreed terms of the particular debt involved.

Debentures and Loan Stocks

Companies often raise long-term interest-paying debt, which is known as loan stock, and itsholders are long-term creditors of the company. Debt capital is attractive to companiesbecause the interest charges on it are allowable against corporation tax, and the status quoof shareholder control is also maintained. In addition, we will see later in the course that anincrease in the gearing ratio may be beneficial to shareholders by improving their EPS.

There are, however, limits to the amount a firm will borrow, including restrictions in theArticles of Association, debenture trust deeds (see below) and market attitudes. In addition,high interest rates may make high levels of borrowing impractical and there may beinsufficient security to cover new loans. We shall discuss the optimal amount of gearing acompany should have in detail in a later study unit.

Loan stock is often issued at its nominal value or face value (i.e. at par). The nominal valuerepresents the amount the company owes and the "coupon" (or interest rate) is based on thenominal value. The coupon rate set depends upon the company, its credit rating and themarket conditions when the debt is issued. The market value of the stock will, however,fluctuate with changes in interest rates and in the company's results and prospects.

(a) Features of debentures

A debenture is a multiple loan to the company in the sense that it is contributed byseveral people as opposed to just one individual. Debentures attract a fixed rate ofinterest, and debenture-holders are creditors, not members, of the company. Thereforetheir interest ranks for payment prior to shareholders' dividends, and must be paid evenif the company has made a loss.

Debentures may be either redeemable or permanent; a holder of permanentdebentures can obtain a return of his original investment by disposing of his holding toa third party, and companies may repurchase permanent debt.

Most debentures are redeemable. Typical issue periods are from 10 to 30 years, oftenwith two redemption dates – for example, 2008 or 2009 – with the choice of redemptiondate being the company's. This choice will depend on:

Whether the company has sufficient liquid funds to redeem the debentures, and


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The current levels of interest rates compared to the rate being paid on thedebentures.

Companies frequently find that interest rates are higher as the redemption dateapproaches and will delay their redemption to the later date.

Debentures tend to be issued in times of low inflation and low interest rates. Theredemption will be financed either by cash reserves or by the raising of fresh debt orequity capital. A company, and potential investors, will compare the finance a companyhas available with the planned repayment of its debt shown by the repayment dates ofits loan stock and debentures.

Debentures may be issued at par, at a premium or at a discount. Debentures issuedat large discounts and redeemable at par or above are known as deep discountbonds. They are generally issued at low rates of interest which can be attractive tocompanies with cash flow problems. However, there is a high cost of redemption. Theinvestor may be attracted by the capital gain at maturity, but you should note that it istaxed as income (less notional interest not paid).

(b) Security and debentures

Debentures are generally secured by a trust deed setting out the terms of the contractbetween the company and the debenture-holders. The deed may include securitygiven in the form of:

(i) A specific or fixed charge over particular asset(s) in the form of a mortgagedebenture, restricting the alteration and disposal of the asset by the company.

(ii) A general or floating charge on assets, giving a general lien to the debenture-holders, but not restricting the company in its utilisation of assets.

The trust deed may also contain provisions for a trustee (e.g. a bank) acting on thebehalf of debenture-holders to intercede if the terms of the trust deed or Articles ofAssociation in relation to the debentures were breached, e.g. failing to pay the correctamount of interest, or exceeding prearranged borrowing limits. A receiver may beappointed if the company is unable to honour its debts. However, as we saw in StudyUnit 5 a reconstruction scheme may be used to avert liquidation.

A well-established company may occasionally issue an unsecured or nakeddebenture. Naked debentures generally have interest rates at least 1% higher thansecured debt in order to compensate investors for the additional risk they are bearing.

(c) Registration

Mortgages and debentures must be registered in the company's own register ofcharges and with the Registrar of Companies to record their existence.

(d) Issue price and conditions for purchase

Debentures can be issued at a discount and a company may also enter the market andbuy up its own debentures without formality.

(e) Types of interest

The great majority of debentures are issued at fixed rates of interest. There are twopossible variations and these are:

(i) Floating rates

The issuer will be able to vary the interest paid. For the issuing company, floatingrates afford protection in periods of volatile interest rates since it will benefit whenrates fall. Investors benefit, since they should obtain a fair return whateverhappens to interest rates generally.


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The market value of the debentures depends on the coupon rate of interestcompared to general market rates. The value should remain stable since theinterest payable on the debentures will follow that of the market.

(ii) Zero coupon

These are debentures which are issued with no rate of interest attached.Instead, they are issued at a discount. Thus there is an implied rate of interest inthe level of the discount. The advantage to the borrower is that there is no cashoutlay until redemption. For the lender, there may be tax advantages in notreceiving income in the short term.

(f) Return for investors

To determine whether a potential investor will receive a certain rate of return byinvesting in a particular debenture, we need to calculate the NPV (net present value) ofall the cash flows involved. Whilst we will cover this topic in more depth later in yourcourse, it is worth spending a few minutes considering an example.

Example

An investor requires a return of 15% on his investments and is considering investing£200 in 12% debentures redeemable in exactly three years' time. Their current price is£80.

First calculate the amount of stock he can purchase:

£(200 100/80) £250.

The yield will be (£250 12%) £30 per year.

The calculate the return (assume interest is paid at the end of the year and personaltaxation is ignored).

Year Cash Flow Discount Factor 15% Present Value

0 Purchase 200 1.00 (200.00)

1 Interest 30 0.87 26.10

2 Interest 30 0.76 22.80

3 Interest 30 0.66 19.80

3 Redemption 250 0.66 165.00

NPV +33.70

As the NPV is positive, the investor will achieve more than his required return of 15%.

To find the market price given the cash flows and the anticipated market rates ofinterest is simply a matter of excluding the purchase price from the calculation. In otherwords, the NPV would be 233.70. This is, of course, the value of £250 worth of stock.For £100 worth of stock, the calculation is: 233.70/2.50 £93.48.


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If market interest rates were 20%, the value would be as follows:

Year Cash Flow Discount Factor 15% Present Value

1 30 0.83 24.90

2 30 0.69 20.70

3 Capital & interest 280 0.58 162.40

NPV 208.00

£100 worth of stock would be valued at 208/2.50 £83.20

Because market rates have increased, the price of debt capital has fallen, so there willbe a greater capital gain on redemption to make up for the interest shortfall whencompared with what is available in the market.

(g) Reverse yield gap

Generally, the investor will expect to be compensated for increased risk of loss by anenhanced return and vice versa. Consequently, ordinary shareholders expect a higherreturn than debenture-holders.

However, in times of inflation this may be an oversimplification. Investors may beprepared to bear the risk and, at the same time, accept modest returns in theanticipation of future capital growth which will maintain the value of their investment inmonetary terms.

When the return from equities exceeds that available from fixed interest stocks, there issaid to be a yield gap. When fixed interest returns are higher than those from equities,there is said to be a reverse yield gap.

Mortgages

A mortgage is a form of secured loan placing the title deeds of freehold or long leaseholdproperty with a lender as security for a cash loan, usually up to two-thirds the value of theproperty. The cash is generally repayable over a prearranged period, and interest (at either afixed or floating rate) is payable on the amount borrowed.

Convertible Loan Stock

Convertible loan stocks have proved to be a particularly attractive form of capital instrumentduring recent years. Usually this class of stock is sold as fixed interest loan stock initially, butthere will be an option to convert the loan into equity shares at a given price and during aspecified period. The terms of conversion often increase over time with increasedexpectations as to the share price and returns from the shares. The conversion value (thecurrent market value of a unit of stock converted into shares) will be below the loan stockvalue on issue but is expected to rise as conversion approaches.

From the investor's point of view, he will stand to gain a stake in the company, whilstmaintaining the status of a creditor and the security of fixed interest during the potentiallyrisky period when his funds are being used. At a later date and without extra outlay, he mayexpect the right to equity by which time it will be his hope that his money will have begunsuccessfully to contribute to the company's profits.

The company benefits by securing funds at fixed interest rates, supplemented by tax relief onits interest payments, at a time when it may not be able to support the burden of dividendpayments. As the intention is to convert into equities funds do not have to be repaid, andthere should be a realistic chance that the future increased dividend payments can be metfrom profits generated by successful utilisation of the invested moneys.


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There is no specific requirement for loans to be converted into shares on every occasion.There may even be an option not to convert but simply to redeem the original investment.

You should understand and be able to calculate the following:

(a) Conversion Ratio

This is the number of ordinary shares that will be obtained from each unit of loan stock.For example, if a company has 8% convertible loan stock standing at par and £10 ofloan stock can be converted into three £1 ordinary shares, then the conversion ratio is:

£1

£103 0.30

0.3 shares will be obtained for every £1 of loan stock converted.

(b) Conversion Price

This is the amount of stock necessary to obtain each ordinary share. In the exampleabove this would be:

3

£10 £3.33

£3.33 of stock is required for each share.

(c) Conversion Premium

This is the difference between the value of the stock and the conversion value of thatstock on the date of issue. Therefore, again using the figures above, £100 of stockwas worth £120 on issue and we know that £100 of stock can be converted into 30shares. (We ascertained 0.30 shares can be obtained for every £1 of loan stock in (a)above.) Supposing that on the day of issue, the market value of each share was £3,then the conversion premium would be:

3)(30

3)(30120

100 33.33%

The premium per share is calculated as:

dateconversionatsharesofNo.

stockloaneconvertiblofvalueMarket Current price

In our example we have:

(120 30) 3 4 3 £1 per share.

Looking at it another way, 30 shares, currently worth £90 (£3 per share) will be worth£120 on their conversion (i.e. £4 per share).

From the point of view of the issuing company, the greater the amount of conversionpremium the better, because they will have to issue fewer shares for the amount oforiginal loan stock. For the investor, the level of conversion premium which isacceptable will be weighed up against expectations for the company. If the investorconsiders the premium reasonable, he will invest.

He may, for instance, expect that the value of each share will rise between the date ofpurchase and the date of conversion. In our example, if the price has risen to £5, thevalue of the conversion will then be (30 £5) £150 for an original investment of £120.

The conversion premium is often stated as a percentage of the conversion value.


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The attractiveness of convertible loan stock will depend on a combination of factors suchas:

The cost of the stock at the time of purchase.

The period of time to conversion.

Stockholders' future expectations for the company.

As a rule of thumb, convertible loan stock issued at par has a lower coupon rate than normalstock, the lower returns effectively being the price the investor is prepared to pay for hisconversion rights.

The market value of the convertible stock cannot go lower than the market value of normalstock of the same coupon rate. Should this occur, it will signify that the market does notattach any value to the conversion rights.

The advantages of convertible loan stock to the respective parties are set out in Table 5.2.

Table 5.2: Advantages of convertible loan stock

The Issuing Company The Investor

Stock can be issued at a lowercoupon rate – useful in times of highinterest rates.

Interest on loan stock should be tax-deductible unlike dividends on equity.

As it is a form of deferred equity,there will be no cash outlay onredemption.

Convertible loan stock may becounted as equity for gearingcalculations, unlike ordinary loanstock.

If share prices are depressed, it maybe easier to issue loan stock insteadof equity.

The market value of the stock cannotfall below that for similar ordinarystock of the same coupon rate.

Increases in share prices will causethe value of the conversion to risebecause this is the amount theinvestor will eventually receive.

Stockholders will be paid beforeshareholders in the event of aliquidation.

Warrants

Warrants are rights given to investors allowing them to buy new shares in a company at afuture date at a fixed, given price. This price is known as the exercise price, and the time atwhich they can be used to obtain shares in is known as the exercise period.

Whilst warrants are generally issued alongside unsecured debt as a "bribe" to potentialinvestors, they are detachable from the debt and can be traded in any time up to the end ofthe exercise period.

The value of the warrant is dependent on the market's view of the likely price of the shares itcan be traded for in the future. Its "theoretical value" is the difference between the currentshare price of the company and the exercise price multiplied by the number of shares whicheach warrant can be used to obtain. During the exercise period the value of the warrant willnot fall below this price; if this theoretical price is zero, then the value of the warrant will alsobe zero (the holder would be better not exercising his rights and obtaining £0, than obtainingsomething worth less than he paid for it).


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The price of warrants and their attached premiums depend on the length of time until the endof the exercise period, the exercise price, the current share price and the future prospects ofthe company.

Generally, if the company has good prospects then the warrants will be quoted at the warrantconversion premium which is calculated by comparing the cost of purchasing a share usingthe warrant, and the current share price. The premium will reduce the closer it is to theexercise price because if there was a premium during the exercise period then it would becheaper to purchase the shares directly rather than via a warrant.

Example

Ella plc issued 50p warrants which entitle the holder to purchase one share at £1.75 at aspecified time in the future. If the current share price of Ella is £1.50 calculate the conversionpremium.

The conversion premium is:

£

Cost of the warrant 0.50

Exercise price 1.75

2.25

Current share price 1.50

Premium 0.75

The premium would be quoted as a percentage of the current share price – in Ella plc's case50%.

There are several advantages to investors of purchasing warrants. Initially they have tospend a smaller amount than if they were purchasing shares and, because of this loweroutlay, the potential loss is much less (the value of the warrant compared to the value of theshare). Conversely, because the initial outlay is less than for shares any increase in theshare price (and thus in the warrant's price) will result in a greater percentage increase in thewealth of the warrant-holder than of the shareholder. For example, a 25p increase in thevalue of Ella plc's shares (see above) would give shareholders an increase in their wealth of25/150 or 16.67%, but warrant-holders would have an increase in wealth of 25/50 or 50%, –this is known as the gearing effect of warrants. A final advantage for taxpayers is thatprofits from warrants are classed as capital gains rather than income.

Companies often issue warrants to make debt issues more attractive, and even sometimes tomake them viable. In addition, they may be able to offer a lower rate of interest on the debt ifwarrants are attached to the issue. Warrants are a potential future source of equity, which donot require dividends immediately or cause a dilution of earnings per share or currentshareholder control.

Leasing

Leasing is a common method of financing the use of an asset – commonly equipment suchas office equipment and cars.

A leasing agreement is between two parties – a lessor and a lessee. A financier (thelessor), generally finance house subsidiaries of banks, purchases the asset and provides itfor use by the company (the lessee). The lessor is considered to be the legal owner and canclaim capital allowances for the asset. The lessee makes payments to the lessor for the useof the asset.

There are two forms of leases – finance leases and operating leases. In addition, youneed to be aware of the use of sale and leaseback methods.


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(a) Finance leases

Finance leases are leases in which the lessor (the owner) will expect to recoup thewhole (or most) of his cost of performing the contract during the initial period of rental,referred to as the basic lease period (or primary term). At the end of the period theasset is generally either leased for a further period for a peppercorn rent, sold by thelessor, or sold by the lessee for the lessor for a large amount of the proceeds. Theservicing and maintenance of the asset is the lessee's responsibility. Finance leasesare reported on the face of the balance sheet.

(b) Operating leases

Operating leases are leases other than finance leases, and do not have to be reportedon the face of the balance sheet. Common examples of operating leases includeshort-term rental contracts for office equipment, and contract hire agreements for theprovision of vehicles. Operating leases do not cover the economic life of the asset, andat the end of one contract the equipment is leased to someone else. This is especiallyuseful for the lessee in the case of high-technology products which are quicklyobsolete, the risk being borne by the lessor. The servicing and maintenance of theasset is the lessor's responsibility.

As operating leases are not reported as balance sheet items, they will not be includedin gearing calculations. However, liability for payment of future rentals under the termsof contract will be reported as a note to the accounts, and will thus be considered whenthe company's accounts are analysed, e.g. by potential lenders.

Leases are popular with lessors, lessees and the suppliers of equipment. The latterlike them because they are paid fully for the asset at the start of the contract. Lessorsare able to make profits from leasing equipment, and obtain capital allowances on thepurchase. A lessee may find this option cheaper and easier than taking a bank loanout to purchase the asset. A lessee may also have insufficient cash to purchase theasset outright.

(c) Sale and leaseback

A financing arrangement, whereby a company will sell its building to an investmentcompany or other specialist in the field. The purchasing company (lessor) takes aninterest in the freehold land on which the property stands, and the selling companybecomes the lessee who then rents the building which it previously owned, generallyfor a minimum of 50 years. The rent is reviewed every few years.

The lessor will wish to obtain a good investment which could be rented to anothercompany if for some reason the original lessee no longer wishes, or is unable, to rentthe property. Thus they would prefer the building to be in good repair, non-specialisedand in an area which is, or is likely to be experiencing, rises in commercial propertyprices.

The main advantage from this method of financing is that the company can raise moremoney than would be the case if the property was used as security for a mortgage.

The main disadvantage is that fewer assets remain to support future borrowing, andthe effect of the removal of a significant asset from the balance sheet may cause anadverse reaction by financial commentators and the market in general.

Other disadvantages are that the company loses the flexibility to move and sell theproperty, the real cost can often be very high especially if rents are increasing rapidly,and the company loses future capital gains on the property.

Although this method is complex, you do not a detailed working knowledge – merely beaware of it as a financing arrangement, whereby the company is able to obtainadditional capital without recourse to further borrowing.


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Hire Purchase

Hire purchase is in many respects a hybrid between lending and renting. The facility may besimply defined as "hiring with the option to purchase". The HP payments consist partly ofcapital and partly of interest payments. On payment of the final instalment ownership of theasset passes to the customer. By concession the Inland Revenue will generally permit thecustomer to claim and retain capital allowances provided that the option to purchase fee isless than the market value at the end of the contract term.

The common procedure is for the finance house to buy the good from the supplier whodelivers it to the customer. The finance house and the customer set up a hire-purchaseagreement, which includes the payment of an initial deposit by the customer, the size ofwhich depends upon the finance company's policy and the credit worthiness of the customer.

The advantage for the customer is that the interest part of the payments are allowableagainst tax, and capital allowances can be claimed on the asset.

Licensing and Franchising

These allow for the acquisition of a product, service or business concept of anotherorganisation, without the purchase of the other entity as a whole. Examples of the former aremost forms of computer software, where the user pays a licensing fee for the right to use thesoftware, and examples of the latter are McDonalds and Kentucky Fried Chicken. Generallyfor a franchise an initial payment is required by the provider, and royalties will be due onsubsequent sales, in return for marketing the provider's goods and services in an exclusiveterritory. It is usual for the franchisee to have to acquire all goods and consumables from thefranchisor under the terms of the agreement.

Bonds

A bond is a loan to a company, government or a local authority. Generally, interest is paid tothe lender and the full amount of the loan is repaid at the end of the term, which is usually forten years or less. There are many other names for this type of investment – for example:

loan stock

fixed interest

debt securities

gilts (loans to the government), and

corporate bonds (loans to companies).

The main benefit of these investments is that the investor normally gets a regular stableincome. They are not generally designed to provide capital growth.

Bonds have a nominal value. This is the sum that will be returned to investors when thebond matures at the end of its term. Most bonds have a nominal value of £100. However,because bonds are traded on the bond market, the price paid for a bond may be more or lessthan £100. There are several reasons why the price might vary from the nominal value,including:

If a bond is issued with a fixed interest rate of, say, 8% and general interest rates thenfall well below 8%, then 8% will look like a good yield and the market price of the bondwill tend to rise – perhaps from £100 to £110 or £120.

The reverse is also true – if interest rates rise, the fixed rate of a particular bond mightbecome less attractive and its price could fall below its nominal value.

Ratings agencies might take the view that a particular company's bond no longerqualifies for a high rating – perhaps because the company is not doing as well as it was


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when the bond was issued. If this happens, then the market price of the bond mightfall. On the other hand, the company's rating may be improved leading to a price rise.

The inflation rate might start to creep up and the interest rate on some bonds mightstart to look less attractive compared with other investments.

Risk

Bonds are generally less risky than having a share in a company. One of the main risks isthat the company to which the money has been lent can no longer afford to pay the interestdue or may be unable to pay the money back at the end of the term (for example, if it isbankrupt).

It is generally considered that these risks do not apply to gilts – a government is alwaysexpected to pay in full, although there have been instances of certain countries being unableto repay. Bonds issued by governments will usually pay a lower rate of interest as a result ofthe perception that they are less risky.

Companies have different credit ratings and a company with a high credit rating is regardedas a safer bet than a company with a lower credit rating. Thus, companies with a lower creditrating will have to offer a higher rate of interest on their bonds than companies with the topcredit rating, simply to attract investors and to compensate for the higher risk.

Buying and selling

Bonds can be bought and sold in the market (like shares) and their price can vary from dayto day. A rise or fall in the market price of a bond does not affect what the investor would getback if the bond is held until it matures. He/she will only get back the nominal value of thebond, in addition, of course, to any coupon payment to which the owner is entitled duringownership of the bond, irrespective of what was paid for it. If the holder paid less than thenominal value then he/she will have made a capital gain when the bond matures; and acapital loss if more was paid than the nominal value.

Bonds may be bought directly through a stockbroking firm, which incurs charges similar tobuying shares. Alternatively, bonds may be bought through a pooled investment.

Syndicated Loans

It is quite often the case that, where a business requires a very large loan, one single bank isnot willing to lend the whole amount – particularly if this is seen as exposing the bank to anunacceptable level of risk with one client and one loan. In such cases, in order to spread therisk involved, a number a banks may each contribute a proportion of the loan to the borrower,with the bank that orginiates the loan being the lead manager and the one that is responsiblefor the overall management of the syndicate and the loan. The managing bank will oftenunderwrite much of the loan whilst inviting other banks to underwrite the rest, soguaranteeing to provide the funds if other banks do not participate.

Such syndicated loans generally offer lower returns than bonds, but on the grounds that theyare usually paid out (in the event of liquidation problems) before bond holders, then they areless of a risk to the lender.

Mezzanine Finance

Mezzanine finance is a form of hybrid finance that offers a high return with a high risk. It issomewhere between normal debt finance and normal equity finance and, because of its lowpriority, it attracts a reasonably high rate of interest payment.

Mezzanine finance is often used in the funding of a management buyout (MBO) and is oftenused when the limits of bank borrowing has been reached and the busines cannot or is notwilling to issue any more equity capital. It is a form of finance that allows the business tomove beyond what would normally be considered as a safe level of debt to equity ratio.


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Medium Term Notes (MTNs)

A medium term note is a promise to pay a certain amount on a named date. It is unsecureddebt and the maturity period can be anywhere from nine months to twenty years. Mediumterm notes are sold on the financial markets usually as part of a series under an MTNprogramme. The interest rates can be either fixed, floating or zero rate.

Project Finance

Sometimes it is preferable to finance a major project through a stand alone investment withits own source of funding. In a typical project-financed venture, a finance deal would becreated by a buiness that provides some equity capital for a separate legal identity to beformed to build and operate the project – for example, the building of the Channel Tunnel ora major sporting stadium (such as for the Olympics).

The amounts involved in this form of finance are usually large and complex in nature. Itusually takes the form of a loan provided through bonds or bank loans directly to theseparate entity, with the finance being secured through the assets of the particular projectrather than the parent company's assets.

For major new ventures, project finance offers a number of advantages, including:

Off balance sheet financing which is not recorded as debt in the parent company

Where the project involves another country in which there might be a greater level ofpolitical risk, this method of finance provides more "arms length" control

There is a transfer of risk to a separate legal identity

Management involved in the project may well be given an equity stake in the newventure, which can provide incentives to the relevant management team to ensure thatthe project succeeds.

E. SHORT-TERM FINANCE

The company will not always wish to raise long-term finance. In recent years, the capitalmarkets have recognised this need in the growing company, and there has been anincreased concentration on the short- or medium-term floating rate sector.

Securitisation

This is the practice whereby instead of lending money to customers, banks raise finance forthem by arranging and selling to customers their securities (e.g. commercial paper) oftenallowing lower interest rates. Similarly companies can invest short-term securities incommercial paper for better rates.

Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs)

A major development in capital provision is the arrival of the Note Issuance Facilities (NIFs)and Revolving Underwriting Facilities (RUFs). They are examples of Multiple OptionFacilities (MOFs) which are arranged by a company's bank, and involve a package ofmedium-term back-up facilities provided by a group of banks. The banks will underwrite thefacility to ensure that the borrower obtains the required funds, usually over a period of threeto ten years. The bank will also arrange a panel of banks tendering loans in a variety offorms and currencies to the company, and a panel to provide "standby" loans. The firm canthen, at competitive interest rates, have a series of short-term loans and in effect obtainmedium-term financing, or have standby loans for use as and when required.


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Commercial Paper (CP)

The company will usually be afforded a number of other mechanisms so that it can raiseshort-term funds, not just from underwriting banks. One example is where the companyissues six month dollar notes in the European Commercial Paper Market (ECP). Otherexamples of commercial paper include ECP in other currencies and SCP (SterlingCommercial Paper). These short-term securities issued in bearer form are a written promiseto pay (promissory note), within a fixed period of less than one year, the amount on the note.The rate of interest is the difference between its face price and the issue price which is at adiscount.

Medium-term notes (MTNs) are similar to commercial paper but have a stated rate of interestand are issued for between one and five years. The use of CPs and MTNs is limited in that aminimum size of company and issue restricts it to large companies, multinationals andcertain public sector bodies, and they are driven by the demand of investors (investor-driven). However, where they can be used they are very flexible, allowing the company toschedule borrowing to match its requirements and make the best use of interest ratefluctuations. The company does not have to be finely rated.

The company may also be able to call for advances of a multi-currency nature, perhaps indollars or sterling.

Syndicated Credits

This is a facility whereby a borrower can borrow money when necessary up to the limit of thefacility – thus the company only has to borrow as and when required. The interest rates arehigh compared to those offered elsewhere and are generally used by highly-gearedcompanies (who may find it difficult to find other sources of finance), and government-relatedbodies (e.g. Eurotunnel). Another common use is in takeover bids. Syndicated credits aremost common in the US and are generally denominated in US dollars.

Banks

Bank lending to companies is predominantly short term, although it is also now a valuablesource of medium term finance.

(a) Bank loans

This is straightforward lending by a bank to a business whereby a fixed amount is lent– for example, £40,000 – for a fixed period of time, say for four years. The bank willcharge interest on this, and the interest plus part of the capital (the amount borrowed)will have to be paid back each month. As with all forms of loan, the bank will only lendif the business is credit worthy, and it may require security. If security is required, thismeans the loan is secured against an asset of the borrower – forexample, an asset ofthe business or, in the case of a sole trader, the borrower's house. If the loan is notrepaid, then the bank can take possession of the asset and sell the asset to get itsmoney back!

Loans are normally made for capital investment, so they are unlikely to be used tosolve short-term cash flow problems. However, if a loan is obtained, then this frees upother capital held by the business which can then be used for other purposes.

The interest rate for small companies on medium-term loans may either be at a fixedrate or at a margin above the bank's base rate. For larger companies, the interest rateon medium-term loans may again be fixed for up to five years, but is usually at amargin above the London Inter-Bank Offered Rate (LIBOR) adjusted every three, six,nine or twelve months in line with LIBOR movements (the size of the margin beingdetermined by risk and the credit standing of the company).


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Not all term loans are drawn, in cash, at the commencement of the loan. Typically,where a loan is to fund a longer term project such as a construction undertaking, itwould be common to draw the cash at different stages of the project. This has theadvantage for the borrower of not committing large sums of money against an assetthat has not yet been created.

The administrative procedures and the paperwork involved with term loans are often farmore than with a simple overdraft particularly as the lender (the bank) is entering into amuch longer agreement timescale. Typically, the bank will require a set of obligationsto be met by the borrower such as information flows to the bank and required levels ofgearing and liquidity ratios, and failure to deliver on these conditions would give thebank the right, if needed, to terminate the contract.

(b) Overdrafts

These are, effectively, also a form of loan from a bank. A business becomes overdrawnwhen it withdraws more money out of its account than there is in it and this leaves anegative balance on the account. This is often a cheap way of borrowing money asonce an overdraft has been agreed with the bank the business can use as much as itneeds at any time, up to the agreed overdraft limit. However, the bank will of coursecharge interest (on a daily basis) on the amount overdrawn, and will only allow anoverdraft if they believe the business is credit worthy – i.e. is very likely to pay themoney back. Interest rates on overdrafts are usually higher than with other forms offinance, but it is a very flexible method of finance, particularly when a company has toprovide for seasonal variations in cash flow which will require facilities for short periodsof time only.

There is no penalty for repayment of an overdraft, unlike (usually) the early repaymentof a medium-term loan. The bank, though, can demand the repayment of an overdraftat any time, and many businesses have been forced to cease trading because of thewithdrawal of overdraft facilities by their bank.

Even so, overdrafts are often the ideal solution for short term borrowing and areextensively used to overcome short term cash flow problems, such as for fundingpurchase of raw materials whilst waiting payment on goods produced. Manybusinesses have a rolling (on going) overdraft agreement with their bank.

The advantages of an overdraft facility with the bank are that:

It provides flexibility – the borrower can't predict with any significant accuracywhat funds will be needed in the short term and the overdraft facility allows thebusiness to borrow up to stipulated limits an amount without unnecessary addedpaperwork and bureaucracy.

It is a relatively cheap form of finance. The usual procedure from the lenderwould be to add between two and five percentage points above the bank baserate (or LIBOR). There may also be an arrangement fee in addition to theoverdraft rate (typically one or two percentage points).

Because interest is charged on the daily balance, a large cash surplus one daycan be used to reduce overdraft charges on further days.

The major drawback of an overdraft (as stated above) is that the bank can withdraw theoverdraft facility at short notice.


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Trade Credit

This source of finance really belongs under the heading of working capital managementsince it refers to short term credit. By trade credit we mean that a creditor, such as a supplierof raw materials, will allow a purchaser to buy goods now and pay for them later. Why havewe included lines of credit here as a source of finance? Well, if a business manages itscreditors carefully, it can use the credit they provide to finance other parts of the business.

Take a look at any company's balance sheet and see how much they have under the headingof "Creditors falling due within one year". Let's imagine it is £50,000 for a particularcompany. If that company is allowed an average of 30 days to pay its creditors, then we cansee that effectively it has a short term loan of £50,000 for 30 days and it can do whatever itlikes with that money, as long as it pays the creditor on time.

The advantages of trade credit is that it is a relatively convenient, cheap and informal way ofsecuring short term finance and is available to companies of all sizes.

Trade credit is often different for different firms in different types of business environment.There are often quite big differences in the approach to this within different industries andsome industries have traditionally relied on a large amount of trade credit. Consider thetrade credit terms offered to, say, a retailer and a heavy goods manufacturer – little is usuallyoffered in the first case, but typically around three months in the latter case. The bargainingstrength of both parties will also have an impact on the case for trade credit and it has oftenbeen the case that major retailers (with an ever increasing share of the market) have beenable to negotiate "one sided" and often unfair trade credit terms on much smaller suppliers.The product type will also often have an impact – for example, where the product has a highlevel of turnover compared to the level of stocks held, then it is likely to have a much smallerlevel of trade credit than a product that has a longer shelf life between supply and sale.

Factoring

Factoring allows a company to raise finance based on the value of its outstanding invoices.It also gives the business the opportunity to outsource its sales ledger operations and to usemore sophisticated credit rating systems.

The way it works is as follows:

Once a sale is made, the company invoices its customer and sends a copy of theinvoice to the factor (with most factoring arrangements requiring a company to factor allits sales).

The factor then pays the company a set proportion of the invoice value within a pre-arranged time – typically, most factors offer 80-85% of an invoice's value within 24hours. (Thus, a major advantage of factoring is that the company receives the majorityof the cash from debtors within 24 hours rather than a week, three weeks or evenlonger.)

The factor issues statements on the company's behalf and collects the payments.However, the company remains responsible for reimbursing the factor for bad debts,unless a "non-recourse" facility has been arranged. (Non-recourse means that if adebtor doesn't pay, the factoring company will either suffer the loss or will have insuredthemselves against the loss.)

The company will receive the balance of the invoice (less charges) once the factorreceives payment.

The factor provides regular reports on the status of the company's sales ledger.


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Factoring Charges/Fees

Finance charges should be comparable to an overdraft. Typical charges on the amountfinanced range from 1% to 4% over base rate, with interest calculated on a daily basis.

Credit management and administration charges, including the maintenance of the salesledger, depend on turnover, the volume and number of invoices. Typical fees range from0.50% to 3.0% of annual turnover – a company with 50 live customers, 1,000 invoices peryear and £1 million turnover might pay 1%.

Credit protection charges (for non-recourse factoring) largely depend on the degree of riskthe factor associates with the business. Typical charges range from 0.5% to 3% of annualturnover.

Advantages

There are several advantages to factoring, including:

Cash flow is maximised as factoring enables a company to raise up to 80% or more onoutstanding invoices

Using a factor can reduce the time and money spent on debt collection since the factorwill usually run the sales ledger for the company

The factor's own credit control system can be used to help assess the creditworthinessof new and existing customers

Factoring can be an efficient way to minimise the cost and risk of doing businessoverseas.

Disadvantages

There are, however, disadvantages to factoring and, unless carefully implemented, factoringcan have a negative impact on the way a business operates. The most significant problemsare as follows:

The factor usually takes over the maintenance of the sales ledger, and customers mayprefer to deal with the company it is trading with rather than a factor

Factoring may impose constraints on the way business is conducted – for example, thefactor will apply credit limits to individual customers (though these should be no lowerthan prudent credit control would suggest), and for non-recourse factoring, most factorswill want to pre-approve customers, which may cause delays

The client company might only want the finance arrangements and yet it might feel it ispaying for collection services they do not really need

Ending a factoring arrangement can be difficult where the only exit route is torepurchase the sales ledger or to switch factors and that could cause a sudden shortfallin working capital.

Invoice Discounting

Invoice discounting is similar to factoring in that the invoice discounter makes a proportion ofthe invoice available to a company once it receives a copy of an invoice sent. However, theclient company collects its own debts, and this enables it to retain the control andconfidentiality of its own sales ledger operations. Once the client receives payment, it mustdeposit the funds in a bank account controlled by the invoice discounter. The invoicediscounter will then pay the remainder of the invoice, less any charges.

The requirements are more stringent than for factoring and different invoice discounters willimpose different requirements.


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"'Confidential invoice discounting" ensures that customers do not know a company is usinginvoice discounting as the client company sends out invoices and statements as usual.However, the costs of this are greater since the discounter is carrying a greater degree ofrisk. The requirements for "disclosed" (i.e. non-confidential) invoice discounting are generallyless demanding.

Bills of Exchange

These are a form of commercial credit instrument, or IOU, used in international trade. InBritain, a bill of exchange is defined by the Bills of Exchange Act 1882 as an unconditionalorder in writing addressed by one person to another, signed by the person giving it, requiringthe person to whom it is addressed to pay on demand or at a fixed or determinable futuretime a certain sum in money to or to the order of a specified person, or to the bearer.

F. INTERNATIONAL CAPITAL MARKETS

There is an increasing internationalisation of capital markets, especially for the largercompanies, e.g. when BT was floated it was on both the domestic and international markets.

Note that many of the terms discussed below have the prefix "euro" but it does not limit themto European currencies, the term being an historical one. The transactions are anyundertaken in a currency outside the country of origin of the particular currency concerned.

Eurocurrency

The Eurocurrency market is the borrowing and lending of Eurocurrency loans via banksbased outside the currency's country, e.g. a UK company could borrow Yen for trade withJapan from a British bank (Euroyen). The loans are generally short term (three months),often between banks.

The market generally offers high rates of interest, flexibility of maturities and a wide range ofinvestment qualities in comparison with other capital markets. The dealings for substantialfunds (generally in excess of $1m) are highly competitive. The unique feature is that thetransactions in each currency take place outside the country from which that currencyoriginates. The main function of the market is the financing of international trade, e.g. to funddown payments of goods sold on export credit terms.

On the short-term, inter-bank Eurocurrency market, transactions may take place betweenbanks on an unsecured basis from overnight to five years' duration. Most transactions arefor six months or less and transactions of over £1m are common.

Eurobonds

The Eurobond market is an international capital market which has developed alongside theEurodollar market since the 1960s. Eurobonds are bonds sold outside the jurisdiction of thecountry in which the currency is based – so, for example, the UK financial regulators havelittle influence over the Eurobonds denominated in sterling even though the transactions arein pounds. It deals in the lending of currencies for longer terms under bonds which are oftendenominated in dollars.

The following advantages are claimed for the Euromarkets in various currencies:

Extremely large sums can be raised or deposited.

Money will often be cheaper than the domestic markets.

Controls tend to be less restrictive.

Some protection against exchange rate movements is offered, but here the user willrequire a high level of skill in selecting his or her alternatives.


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Any period of surplus or shortage from one day to five years can be accommodated.

The markets offer a useful alternative to other sources of capital which the companymay not wish to use at the time.

US involvement in world trade makes a pool of dollars outside the home country mostuseful when:

(i) It is impossible or undesirable to transfer funds from the home country.

(ii) Projected currency movements suggest that it is advantageous to rearrangedollar commitments to parent companies, etc.

Eurobonds Available

There are three broad types of Eurobond which can be classified as follows:

Straight fixed rate bonds

The majority of Eurobonds with a fixed coupon can be described thus. Interest isgenerally paid out once each year and is calculated using a 360-day year. Some olderissues do pay half-annually.

Whilst a 15-year term is typically the norm, maturity may range from three to 25 years.Shorter maturity bonds (up to five years) are usually referred to as notes and issuesfrom the Netherlands are often within this period.

Equity related bonds

These may take two forms:

(a) Convertibles – whereby the bond holder has the right (but not the obligation) toconvert the bond into ordinary shares at a pre-determined price.

(b) Eurobonds with warrants – which are similar to convertible bonds in thatwarrants are attached to the Eurobond enabling the holder to purchase ordinaryshares represented by the warrants at, or between, specified dates. Theexercise price will be set in a similar fashion to that of convertible Eurobonds.

Floating rate notes (FRNs)

These have a variable coupon reset on a regular basis, usually every three to sixmonths, in relation to a reference rate, such as LIBOR. The size of the reference ratewill reflect the perceived risk to the issuer.

Borrowing in the Euromarket

Borrowers in the Euromarket include:

Companies needing dollars for investment in the USA.

Unit trusts and investment trusts investing in foreign securities.

The United States banks, which find that it is expedient to take up loans through theEuropean market rather than to borrow in the USA.

Multinational companies wishing to invest in a particular country without wishing, orbeing able, to transfer capital from their base country.

National governments and bodies associated with national and international agencies.

Euroequity

This is the issue of equity in a stock market outside the company's domestic stock market. Alack of sufficiently active secondary markets limits Euroequity markets (as you can see by thepoor showing of the attempted issues by US and Japanese companies in Europeanmarkets). Hence they are not as popular as Eurobonds. This has led to the use of


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sweeteners in an attempt to sell Euroequity, including the issuing of bonds with warrantsattached.

Choice of Currency for Borrowing

The factors affecting the choice of currency used for company borrowing include:

The ease and speed of raising finance, which is often easier outside the domesticmarkets.

The size of the debt – larger loans tend to be borrowed in the Euromarkets.

The cost of issues – small changes in interest rates can have a significant impact if theloan is large.

Whether the currency is required immediately (including coverage in preventingexchange exposure) and in the long run.

The security the company has available – Euroborrowings are generally unsecured.

Advantages of Raising Funds in International Markets

You will realise from the above that there are several advantages to the company in raisingfunds in international markets, including:

It is useful if the company's own capital market is too small, or too complex and/orregulated to raise the required finance quickly and easily.

It improves the liquidity and reputation of the company.

It may improve trade if the company trades in the country of the currency/capitalmarket.

It can help in preventing takeover bids.

G. FINANCE AND THE SMALLER BUSINESS

Small businesses generally rely on retained earnings, bank borrowings and (limited) issuingof shares to private shareholders. They are often criticised as being too dependent on short-term finance, but only because they often experience difficulty in raising finance due to aperceived higher risk of failure.

Several initiatives have been taken to try and solve the funding gap, a sample of which arediscussed below.

(Note that, whilst your examiner will not expect you to be able to demonstrate intimateknowledge of every source of assistance, those described below are given to give you someinsight into the variety of assistance available. This topic is continually changing and youshould supplement your studies by reading the financial press to ensure you are up-to-datewith the latest developments.)

Government Measures

There are two main government schems providing funding support to small businesses.

(a) Enterprise Investment Scheme (EIS)

The Enterprise Investment Scheme is a government scheme that provides a range oftax reliefs for investors who subscribe for qualifying shares in qualifying companies.There are five current separate EIS tax reliefs:


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Income tax relief

Provided an EIS qualifying investment is held for no less than three years fromthe date of issue, or three years from commencement of trade, if later, anindividual with no more than a 30% interest in the company can reduce theirincome tax liability by an amount equal to 20% of the amount invested. Theminimum subscription is £500 per company and the maximum per investor is£400,000 per annum. Where an individual subscribes for qualifying sharesbefore 6 October in a tax year, a claim may be made to carry back one half of theamount subscribed to the previous tax year, subject to a maximum of £50,000.

CGT deferral relief

Tax on gains realised on a different asset can be deferred indefinitely wheredisposal of that asset was less than 36 months before the EIS investment or lessthan 12 months after it. Deferral relief is unlimited – in other words, this relief isnot limited to investments of £400,000 per annum and can also be claimed byinvestors (individuals or trustees) whose interest in the company exceeds 30%.

CGT freedom

No capital gains tax is payable on disposal of shares after three years, or threeyears after commencement of trade, if later, provided the EIS initial income taxrelief was given and not withdrawn on those shares.

Loss relief

If EIS shares are disposed of at any time at a loss (after taking into accountincome tax relief), such loss can be set against the investor's capital gains orhis/her income in the year of disposal or the previous year. The net effect of thisis to limit the investment exposure to 48p in the £1 for a 40% tax payer if theshares become totally worthless.

Inheritance tax exemption

EIS Investments are generally exempt from inheritance tax after two years ofholding such investment.

EIS is appropriate for those investors who wish to include in their portfolio some highrisk companies.

(b) Small Firms Loans Guarantee Scheme (SMLGS)

The Small Firms Loan Guarantee Scheme provides a government guarantee for loansby approved lenders. Qualifying loans are those made to firms or individuals unable toobtain conventional finance because of a lack of track record or security. Theguarantee generally covers 70% of the outstanding loan, rising to 85% for establishedbusinesses trading for two years or more. Loans can be for amounts between £5,000and £100,000 (£250,000 for established businesses) and over a period of between twoto ten years.

Business Angels

The Business Angels movement is an important, but still under-utilised source of money fornew and growing businesses.

Business Angels are high net worth individuals who invest on their own, or as part of asyndicate, in high growth businesses. In addition to money, they often make their own skills,experience and contacts available to the company, and their commitment is often very strong.

Business Angels invest across most industry sectors and stages of business development,but especially in early and expansion stage businesses. Most prefer to invest in companieswithin 100 miles of where they live or work. Investors in technology companies tend to be


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more prepared to travel longer distances. They rarely have a connection with the companybefore they invest, but often have experience of its industry or sector.

The majority of Business Angels make investments for financial reasons. However, there mayalso be other motives for investment – for example, taking an active part in theentrepreneurial process, the enjoyment from being part of the success of a good investment,or the sense of putting something back in.

A typical Business Angel makes one or two investments in a three-year period, althoughsome invest more frequently. The level of investment is usually between £10,000 and£750,000. Where larger amounts are invested, this is often as part of a syndicate organisedthrough personal contacts or a Business Angel Network.

The methods used by Business Angels to decide which businesses to invest in vary greatly.However, the following issues are all taken into consideration:

The expertise and track record of the founders and management

The businesses competitive edge or unique selling point

The characteristics and growth potential of the market

Compatibility between the management, business proposal and the business angel'sskills and investment preferences

The financial commitment of the entrepreneur

The company must also ensure that the Business Angel willing to invest in them is right fortheir company. Before signing an agreement the business must ensure that:

The management team and the business angel are compatible and will be able to worktogether; and

The Business Angel's skills match the company's needs.

Grants

Grants are available to all businesses, most of which carry a test relating to the number ofnew jobs created from the project or development requiring assistance. The second test forgrant assistance will usually be that the project cannot proceed without financial assistance.Grants are available from a range of institutions including governmental bodies and thePrince's Youth Business Trust.

Banks

Whilst banks will usually be willing to lend a degree of support, without the ability to offersome tangible security the business may have to seek finance from elsewhere.

Venture Capital Providers

Venture Capital Trusts (VCTs) were devised in the 1993 budget as a way for new andunquoted companies to obtain money from investors. VCTs are essentially investment trustsand, like other investment trusts, their shares are often traded in the stock market.

Since these small and growing companies are a higher risk than investing in bigger, moremature businesses, VCT's offer more attractive tax breaks – everyone is permitted to investup to £100,000 in a VCT each year, and investors receive tax relief at 20% on the moneythey put in, and any dividends or capital gains are free of tax:

Relief on distributions – VCT dividends are free of income tax on investments of up to£100,000 each year

Relief on disposals – individuals are exempt from Capital Gains Tax on disposals ofordinary VCT shares on investments of up to £100,000 each year.


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Capital Gains Rollover Relief will be given to people reinvesting up to £100,000 and, ifthe shares are held for five years, no CGT will be payable on disposal.

Deferred Capital Gains Taxation on investment – subscribers for new ordinary VCTshares who invest gains arising from the disposal of any asset will be able to defer thetax chargeable, subject to certain timing restriction.

Exempt from Corporation Tax – on capital gains (such as an investment trust).

The 2000 Budget reduced from 5 years to 3 years (for shares issued on or after 6 April 2000)the minimum period for which investments in VCT companies carrying on a qualifying tradeat the time of issue must be held if they are to qualify for income tax relief.

The 1999 budget tightened up the rules on VCTs to exclude schemes which are low risk,often offering guarantees or being property backed.

Finance Companies and Lessors

Finance companies typically specialise in providing financial accommodation in respect offixed assets. Since they generally retain title to the assets throughout the term of thecontract they do not usually seek additional security. They may, however, seek directors'personal guarantees when the directors of a small business are also the principalshareholders.

Private Investors

In some cases, particularly with a very small business that is in the early stages of itsdevelopment, a number of private investors may be prepared to get involved with itsfinancing. These may be family members or friends who have a genuine interest in makingsure that the business succeeds.

Practice Question 2

Redbrick plc's 10% convertible loan stock is quoted at £138 per £100 nominal. The earliestdate for conversion is in three years time at the rate of 25 ordinary shares per £100 nominalloan stock. The current share price is £5.20.

(a) Calculate the conversion price;

(b) Calculate the conversion premium.



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ANSWERS TO PRACTICE QUESTIONS

Practice Question 1

(a) Investor who holds 60,000 ordinary shares (5% equity)

Present position If shareholder takes uprights

If shareholder sells rights

£ £ £

Value of investment:

60,000 O/S × £3.60 216,000 60,000 O/S £3.60 216,000 60,000 O/S £3.60 216,000

15,000 O/S £3.00 45,000 less 60,000 12p* (7,200)

216,000 261,000 208,800

Dividend received:

60,000 × 45p 27,000 75,000 43.5p 32,625 60,000 43.5p 26,100

% ROI (net): 12½% 12½% 12½%

* Theoretical ex-rights price would be0005001

0002205

,,

,,£shares £3.48.

Thus, the value of one right =4

48p 12p

The total value of £5,220,000 derives from:

£

Value of shares on issue 4,320,000 (1,200,000 £3.60)

Value of rights issue 900,000 (300,000 £3)

5,220,000

The present net dividend yield is0003204

0002001

,,

,,£ 45p 12.5p

The future net dividend yield is0002205

0005001

,,

,,£ 43.5p 12.5p

From these calculations, the shareholder will be no better or worse off after the rightsissue and his or her action, therefore, can be determined on whether he or she wishesto continue to be involved in the company to the same extent or to increase ordecrease his or her overall holding.

(b) The idea of a rights issue is to encourage existing shareholders to invest more funds ina company so as not to dilute further the membership interest. To do so, a discount onthe market price is built into the price ruling on the market. To price the rights issueabove market price would mean it would be cheaper to go to the market to purchasethe shares, and the rights issue would fail.

(c) The total sum to be raised £900,000, made up as follows:

4

1,200,000 £3 £900,000 (300,000 new shares)


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Therefore, the underwriting commission will be £900,000 1¼% £11,250.

It would have been possible to price the rights issue below that, at say £2.50, to raisethe same sum on a 3 for 10 issue at £2.50 as follows:

10

1,200,000 3 £2.50 £900,000 (360,000 new shares).

The underwriting commission will still be:

£900,000 1¼% £11,250

This will be payable whether the issue is fully subscribed or not.

An underwriter agrees to take up the remnants of an issue if it is not altogethersuccessful, which ensures that the company raises the sum required, i.e. the, albeitsmall, element of risk associated with the failure of the issue is insured against.

It would be argued that a slightly lower price could be offered if underwritingcommission were less or if the issue were not underwritten, but whether such aminimally lower price would influence the success of the issue enough to ignore therisk is unlikely. Underwriting commission is usually between 1¼% and 2%.

Practice Question 2

(a) The conversion price is the amount of stock required to obtain each ordinary share.

For Redbrick plc this is:

25

100£ £4

£4 of stock is necessary for each share.

(b) The conversion premium is:

25

138 5.20 5.52 5.20

£0.32 per share.

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Study Unit 6

Cost of Finance

Contents Page

Introduction 145

A. Investors and the Cost of Capital 145

The Required Rate of Return 145

The Effect of Risk 145

B. Cost of Equity 146

Dividend Yield (or Dividend Valuation) Method 146

Cost of Preference Shares 148

Retained Earnings 149

Capital Asset Pricing Model 149

C. Cost of Debt Capital 149

Irredeemable Debt 150

Redeemable Capital 150

Cost of Floating Rate Debt 152

Cost of Convertibles 152

Cost of Fixed Rate Bank Loans 153

Cost of Short-term Funds and Overdrafts 153

D. Cost of Internally Generated Funds 153

E. Weighted Average Cost of Capital 154

Methodologies 155

Assumptions When Using WACC 156

Arguments Against Using the WACC 156

F. Assessment of Risk in the Debt Versus Equity Decision 157

Effect on Market Value 157

Break-even Profit Before Interest and Tax 158

Other Considerations 158

(Continued over)

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G. Cost of Capital for Other Organisations 159

Unquoted Companies 159

Not-For-Profit Organisations 159


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INTRODUCTION

It is essential for a company to know the cost of the various types of funds included in itscapital structure in order to satisfy the terms of the providers of that capital – the investors. Ifthe investors are not satisfied with their returns they may remove their money from the firm.The required rate of return to investors is how much the company has to pay to obtain itsfinance – i.e. the cost of capital to the firm.

In addition, it is important for companies to know their cost of capital in order to ensure thatprojects they invest in achieve the level of return required to satisfy those who provide fundswhich finance the project.

We will consider initially the costs of the different types of capital individually, before lookingat the cost of the capital structure of the company as a whole.

It is important when you are revising this area to also consider the capital asset pricing model(CAPM) that we will discuss later in the course.

A. INVESTORS AND THE COST OF CAPITAL

It is important to remember that the cost of finance to the firm is the return required byinvestors in the firm.

The Required Rate of Return

The required return of investors will be determined by the opportunity cost foregone of theinvestors, and the risk they are required to bear. For example, if the return on a company'sordinary shares is 8% with no real prospect of capital growth in the short term, and a buildingsociety deposit will yield 10%, it is unlikely that the shares will be attractive to investors – theopportunity cost (the building society rate) is greater than the projected return, and the risk ofinvesting in a company is generally considered to be higher than that of depositing themoney in a building society account.

The Effect of Risk

Investing in companies involves risk – investors may lose some or all of their funds placed inthe company. The risk comprises two elements:

Business risk – due to a lack of certainty about the firm's prospects and projects, and

Financial risk – the higher the level of gearing the higher the risk of bankruptcy.

The return investors require depends on the level of risk – the higher the risk the higher theexpected return, because people expect to be compensated for bearing additional risk. This"risk premium" (made up of premiums for business and financial risks) will be required inaddition to the risk-free rate of return which is the basic return which would be required ifthere was no risk. (The risk-free rate is typically taken to be the return on governmentbonds.)

Thus the return required from investing in different companies will vary with the differinglevels of risk involved in the firms.

It is possible to assess the different risks involved by calculating both the operational gearing(as a measure of business risk) and the financial gearing (as a measure of financial risk).

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B. COST OF EQUITY

The requirements and expectations of shareholders must be considered when looking at thecost of equity. The effect that changes in earnings and dividends may have on the shareprice must also be considered.

Dividend Yield (or Dividend Valuation) Method

The main method of calculating the cost of equity is the dividend valuation or dividend yieldmodel. The precise form of model used varies with the assumptions used. The simplestmodel to use assumes that dividends will remain at a constant level in the future.

The value of a company's shares can be calculated using the formula we discussed earlier:

Market value sharestheonyield)(orreturnExpected

penceinpayabledividendCurrent

The formula can be rearranged for use in calculating the cost of equity as follows:

Expected return (or yield) on the shares valueMarket

penceinpayabledividendCurrent

The expected return (or yield) on the shares is the cost of equity, and the market value of theshares is the current ex div share price (i.e. the share price after the dividend has been paid).

This is often written as:

Ke Se

De

where: Ke cost of equity

De current dividend payable

Se current share price (ex div).

Example 1

Tigger plc's current dividend is 25p and the market value of each share is £2. What is thecost of Tigger's equity?

Using the above formula Ke Se

De:

Ke 200

25 0.125 12.5%

However, shareholders prefer a constant growth in their dividends. In order to reflect this inthe dividend valuation method, we have to predict future growth in dividends. Growthgenerally reflects predicted changes in a company's earnings, although it is difficult to decidethe level of growth that will be sustained in future years. The most usual approach is to takeseveral years' historical data and then attempt to extrapolate forward.

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Example 2

Assume Pooh's past dividends have been:

Dividend perShare

Year 1 0.26

Year 2 0.27

Year 3 0.28

Year 4 0.32

We can now find the average rate of growth by using the following formula:

Growth rate (g) n

dividendEarliest

dividendLatest 1

where: n number of years growth.

Applying this to the above figures, we get:

g 3

260

320

.

. 1 0.0717 or approximately 7%.

Note that here we are using the cube root because there are three years of growth. If wehad been given five years' data (from which we could project four years' growth) the fourthroot would have been used.

When the expected growth figure has been determined we can calculate the value of thecompany's shares using the Dividend Growth Model or Gordon's Model of DividendGrowth.

This model states:

Po dog)r(

g)(1

which is also written as Se g)(Ke

g)+(1De

where: Po or Se the current ex dividend market price

do or De the current dividend


r or Ke the shareholder's expected return on the shares

and can be rewritten as:

Ke Se

g)+(1De g

Note that growth, if given, is usually be expressed as a percentage.

Example 3

Using the example of Pooh above, and assuming its share price is £2.50, then:

Ke 2.50

)0.32(1.072 0.072 0.137 0.072 20.9%.

The dividend valuation and dividend growth model are based on the following assumptions:

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Taxation rates are assumed to be constant across all investors, and as such theexistence of higher rates of tax are ignored. The dividends used are the grossdividends paid out from the company's point of view.

The costs of any share issue are ignored.

All investors receive the same, perfect level of information.

The cost of capital to the company remains unaltered by any new issue of shares.

All projects undertaken as a result of new share issues are of equal risk to that existingin the company.

The dividends paid must be from after-tax profits – there must be sufficient funds topay the shareholders from profits after tax.

Share Issue Costs

Share issue costs can be incorporated in the formula, especially if they are considered to behigh. The formula then becomes:

Ke I)(Se

De

where: Ke cost of equity

De current dividend payable

Se current share price (ex div)

I cost of issue per share.

Thus, for the example of Tigger above, if issue costs divided by the number of shares is 5p,then the cost of equity becomes:

Ke 5200

25

0.128 12.8%

If you are given issue costs you should, unless told otherwise, incorporate them in theformula as shown above.

Cost of Preference Shares

The formula for calculating the cost of preference shares is:

Kp Sp

Dp

where: Kp cost of preference shares

Dp fixed dividend based on the nominal value of the shares

Sp market price of preference shares

Example

Anorak plc has 8% preference shares which have a nominal value of £1 and a market priceof 80p. What is the cost of preference shares?

Using the above formula, dividends are 8% of the nominal value of £1 and as such are 8p.Therefore:

Kp 80

8 10%.

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Retained Earnings

Retained earnings will also have an effect because, when left in the business rather thanbeing distributed, they should achieve higher returns in the future to offset the lack of currentdividends. The shareholders' expectations of increasing future dividends rather than constantpayments may, however, persuade them to accept initial lower dividends.

Capital Asset Pricing Model

The Capital Asset Pricing Model, which we shall discuss later in the course, can also be usedto value the cost of equity. You should revise this topic when you have worked through therelevant unit.

C. COST OF DEBT CAPITAL

Estimating the cost of fixed interest or fixed dividend capital (such as debenture interest) isrelatively easy because the interest rate is prescribed in the contract. The cost of debtcapital already issued is the rate of interest (the Internal Rate of Return) which equates thecurrent market price with the discounted future cash receipts from that particular investment.

Whilst it is possible to calculate the cost of any individual sources of capital, this is not thesame as the cost of capital as a whole, or the necessary discount rate to apply whenconsidering different investment proposals. It is more common in this scenario to considerthe financing of a business as a pool of resources rather than any particular way of funding aspecified investment opportunity and, under these circumstances, it is usual for the business,when considering the opportunity cost of the capital needed for an investment, to consider anaverage cost of capital to be used as the discount rate to be applied.

The weighted average costs of capital (WACC) is the average cost of the company's finance,weighted according to the relative size of each element compared with the total capital.

There are a number of other factors that might affect the costs of debt capital for a businessincluding:

The bargaining power of the business

The availability of government assistance – for example, the special governmentassistance (grants or reliefs) available in deprived areas

The conditions at any particular moment of the financial markets

The tax regime

Interest rates in the markets

The availability of internal sources of finance available

The record of debt repayment for the business concerned

The type of industry involved.

We saw earlier that debentures can be either redeemable or irredeemable. It is importantthat you know the type of debenture a firm has in issue when calculating its cost of capitalbecause, as we shall see, the approach used varies with the form of debentures beingconsidered.

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Irredeemable Debt

The formula for calculating the cost of irredeemable debt is:

Kd Sd

t)I(1

where: Kd cost of debt capital

I annual interest payment

Sd current market price of debt capital

t the rate of corporation tax applicable.

Taxation is considered because the interest can be offset against taxation, which will lower itsnominal rate, and thus its cost. The higher the rate of corporation tax payable by thecompany, the lower will be the after-tax cost of debt capital. Thus the cost of debt capital ismuch lower than the cost of preference shares with the same coupon rate and market valueas the debentures because of the availability of tax relief on the debt. Naturally this onlyapplies if the business has taxable profits from which to deduct its interest payments. Whenthe business has generated a taxable loss, the interest will increase that loss for carryforward (to be offset against future taxable profits in later years), and the immediate benefit oftax relief will be lost.

Example

Clown plc has £10,000 of 8% irredeemable debentures in issue which have a current marketprice of £92 per £100 of nominal value. If the corporation tax rate is 33% what is the cost ofthe debt capital?

The annual interest payment will be based on the nominal value, i.e. 8% of £10,000 or £800,so using the above formula:

Kd 10,00092/100

0.33)800(1

0.0583 5.83%.

Redeemable Capital

In order to determine the cost of such capital to the date of redemption we must find theinternal rate of return (IRR). IRR is discussed in greater detail later, but basically involvescalculating all the necessary cash flows (generally the assumption will be made that allpayments and receipts are made at the end of the year) and determining at what cost ofcapital the value of future cash flows are equal to zero. The IRR is calculated using discountfactors for the appropriate cost of capital and the following formula. Wherever possible theex-interest values should be used, so if the cum-interest value is quoted (i.e. if the interest isdue to be paid soon and thus is reflected in the market price of the debt) we should deductthe interest payment from the market price. The longer the period to maturity, the lower willbe the overall cost of capital. This is to be expected because the real cost of redemption willbe lower in the future because of the effects of the time value of money. (Do not worry if thisappears complicated at this stage since we shall explain the IRR fully later in the course.)

Example

In this example, Clown's rate of corporation tax is assumed to be 33% throughout andredemption is in 20x5. The following table sets out the workings on which the calculation isbased.

Note: df discount factor

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Year Amount df 6% df 12%

a b c b c d b d

Current market price 20x1 (94.0) 1.00 (94.00) 1.00 (94.00)

Interest 20x2 10.0 0.94 9.40 0.89 8.90

Tax saved 20x3 (3.3) 0.89 (2.94) 0.80 (2.64)

Interest 20x3 10.0 0.89 8.90 0.80 8.00

Tax saved 20x4 (3.3) 0.84 (2.77) 0.71 (2.34)

Interest 20x4 10.0 0.84 8.40 0.71 7.10

Redemption (1.1.x5) 20x4 100.0 0.84 84.00 0.71 71.00

Tax saved 20x5 (3.3) 0.79 (2.61) 0.64 (2.11)

8.38 (6.09)

The cost of capital is therefore:

6

)( 612

6.09)(8.38

8.38by interpolation

9.47% (that is the IRR)

If redemption occurs three years later in 20x7, the cost of capital changes as follows:

Year Amount df 6% df 12%

a b c b c d b d

Current market price 20x1 (94.0) 1.00 (94.00) 1.00 (94.00)

Interest 20x2 10.0 0.94 9.40 0.89 8.90

Tax saved 20x3 (3.3) 0.89 (2.94) 0.80 (2.64)

Interest 20x3 10.0 0.89 8.90 0.80 8.00

Tax saved 20x4 (3.3) 0.84 (2.77) 0.71 (2.34)

Interest 20x4 10.0 0.84 8.40 0.71 7.10

Tax saved 20x5 (3.3) 0.79 (2.61) 0.64 (2.11)Interest 20x5 10.0 0.79 7.90 0.64 6.4Tax saved 20x6 (3.3) 0.75 (2.47) 0.57 (1.88)Interest 20x6 10.0 0.75 7.50 0.57 5.7Redemption (1.1.x7) 20x6 100 0.75 75.00 0.57 57.0Tax saved 20x7 (3.3) 0.70 (2.31) 0.51 (1.68)

10.00 (11.55)

The cost of capital is:

6

)( 612

11.55)(10.00

10.00

8.78% (i.e. the IRR).

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Cost of Floating Rate Debt

If a company has floating rate debt in its capital structure, then an estimated fixed rate ofinterest should be used to calculate its cost of debt in a way similar to the above. The"equivalent" rate will be that of a similar company for a similar maturity.

Cost of Convertibles

To determine the cost of convertibles we have to find the internal rate of return (IRR) of thefollowing equation:

P0 r)(1

t)K(1

2r)(1

t)K(1

3r)(1

t)K(1

. . . .

nr)(1

t)K(1

nn

r)(1

CRV

where: P0 current market price of the convertible ex interest (i.e. after paying the currentyear's interest)

K annual interest payment

t rate of corporation tax

r cost of capital

Vn market value of the shares at year n

CR conversion ratio.

It is also a useful exercise to calculate the cost of convertibles as though they were notconverted – if the cost is higher the holders will choose not to convert, because notconverting produces a higher return to the investor. The higher cost of capital shouldtherefore be the one used in the calculation of the company's cost of capital.

Example

Quality plc has 10% convertible debentures due for conversion in two years' time. They havea current market value of £108 per cent. The conversion terms are 5 shares per £10 ofdebentures. All the debenture-holders are expected to convert, and the shares are expectedto have a price of £4 at this time. What is the cost of capital?

For ease of calculation, we shall assume the rate of corporation tax is 50% and is payable inthe same year.

The market value of £108 per cent means that it is £108. Interest on convertibles isoffsettable against tax, and thus is shown as a saving in the following calculation:

Year 0 1 2

£ £ £

Current market value of convertibles (108)

Interest 10 10

Tax relief (5) (5)

Value of shares on conversion:((5 100/10) £4) 200

Total yearly cash flow (108) 5 205

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Now apply an estimate of the cost of capital – say 40%:

Year 0 1 2

£ £ £

Total yearly cash flow (108) 5.000 205.000

Discount factor at 40% 1 0.714 0.510

Present value (108) 3.570 104.550

Net present value (108) 3.57 104.55 0.12

Thus the cost of capital is just over 40% – the precise level could be found using theinterpolation formula given above.

Again do not worry if the mechanics seem a little complicated since they will be covered ingreater detail later in the course.

Cost of Fixed Rate Bank Loans

The cost of this major source of finance is given by:

Cost Interest rate (1 t)

Cost of Short-term Funds and Overdrafts

The cost of short-term bank loans and overdrafts is the current interest rate being charged onthe capital lent.

D. COST OF INTERNALLY GENERATED FUNDS

Internally generated funds typically represent around 60% of all sources of capital availableto a business. The principal benefit of using internal funds is derived from the fact that thereare no formalities to their acquisition, but it will often be difficult to generate the optimumamount at exactly the time the business needs additional funding.

Whilst internally generated funds avoid the formal costs of issue, e.g. issuing house fees,they are not free of cost to the company.

Retained earnings (e.g. provisions, retentions) belong to the shareholders and, in order tojustify their retention, the company must be able to earn a return in excess of that which theshareholders could earn before tax had they been distributed to them. Thus there is anopportunity cost related to the cost of retentions. When the company is unable to meet thatrate, it has an obligation to distribute its retentions to its shareholders, allowing them to obtainbetter returns on their investments.

We can show an example, using a comparison between two companies:

Example

Company X pays out most of its earnings, whereas Company Y retains a high percentage.

Company X £ Company Y £

Year 1 Profits 200,000 Profits 200,000

less Dividend 160,000 less Dividend 20,000

Balance c/f 40,000 Balance c/f 180,000

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In Year 2, the capital needs of both companies are an additional £200,000. X obtains equityof £160,000 and Y equity of £20,000. Assume dividends of 10% on new capital.


Year 2 Profits (year 2) 200,000 Profits (year 2) 200,000

less Dividends: £ less Dividends: £On existing capital 160,000 On existing capital 20,000On new capital 16,000 176,000 On new capital 2,000 22,000


Suppose in Year 3 profits fell sharply to £100,000 for each company. The following would bethe result.


Year 3 Profits 100,000 Profits 100,000

less Dividend (halved) 88,000 less Dividend (doubled) 44,000


What do these figures mean? That Y is more efficient than X? No, because profits eachyear have been the same, the only difference being that Y obtains large amounts of "cost-free" capital, whereas X is paying out most of its profits as it has to pay for its capital in theform of a dividend.

Is Y able to weather the storm better than X? Yes, because it has a large balance, madepossible by its low pay-out ratio. It has been able to double dividends to shareholdersdespite reduced profits inYear 3.

Sooner or later the shareholders of Company Y will realise they are losing out, to the benefitof the company itself.

From this two important principles emerge:

All capital has a cost.

Even retained profits should carry a cost (an implied or imputed cost).

Here the opportunity cost is concept related to the cost of retentions that we noted earlier.

E. WEIGHTED AVERAGE COST OF CAPITAL

Companies tend to have a mixture of the different types of capital in their structure, and whenconsidering the cost of capital used to finance a project it is common to use the cost of themix of capital held by the company – the weighted average cost of capital (WACC).

The cost of capital that should be used in evaluating projects is the marginal cost of the fundsraised in order to finance the project, and WACC is considered to be the best estimate ofmarginal cost (the capital structure of a company changes slowly over time). Note, however,that it is only the most reliable if the company is assumed to continue investment in projectsof a normal level of business risk and funds are raised in similar proportions to its existingcapital structure.

The weighted average cost of capital is the average of costs of the different types of financein a company's structure weighted by the proportion of the different forms of capital employedwithin the business. The financial manager will therefore need to ensure that any project

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which is under consideration will produce a return that is positive in terms of the business asa whole and not just in terms of an issue of capital made to finance it. Investments whichoffer a return in excess of the WACC will increase the market value of the company's equity,reflecting the increase in expected future earnings and dividends arising as a result of theproject.

Methodologies

There is no one accepted method of calculating a company's WACC – some use book valuesin the proportions that they appear in the company's accounts and some use market values.For unquoted companies book values may have to be used because of the problems wediscussed in earlier study units of estimating market values for their securities. Book valuesare generally easier to obtain than market values. However, many would argue that forquoted companies market values are more realistic and, indeed, may be easier because onlyone cost of equity is required – it being impossible to split the value of equity between theshares and the retained earnings.

Example

(a) Using book values in the proportions that they appear in the company's accounts:

Weighting Cost Weighted Cost

Ordinary shares 60% 12% 7.2%

Debentures 40% 8% 3.2%

WACC 10.4%

(b) Using market values:

Number Price Market Value Cost WeightedMarket Value

Ordinary shares 6,000 2.50 15,000 12% 1,800

Debentures 4,000 1.50 6,000 8% 480

21,000 2,280

The WACC is then calculated as:

21,000

2,280 10.86%

Both methods produce the historic WACC and you should remember that raising fresh capitalcould well alter the weighting and therefore the cost of capital, the model assuming that newinvestments are financed by new funds. A change in the risk level of the company will alsoaffect the cost of a company's capital.

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You may also come across the following formula for use in calculating a company's WACC:

WACC Keg

D)(E

(E) Kd (1 t)

D)(E

(D)

where: Keg is the cost of equity

Kd the cost of debt

E the market value of the company's equity

D the market value of the company's debt

t the rate of corporation tax applicable to the company.

The model assumes that debt is irredeemable.

The model is simply another approach to calculating a company's cost of capital. It is oftenconsidered easier by students, but you should use whichever method you feel the mostcomfortable with. If you wish to calculate WACC using the above formula when the debt inthe company's structure is redeemable then you should calculate the cost of debt using themethods above and replace Kd(1 t) in the formula with the answer.

Assumptions When Using WACC

To use WACC in capital investment appraisal the following assumptions have to be made:

The cost of capital used in project evaluation is the marginal cost of funds raised inorder to finance the project.

New investments must be financed from new sources of funds, including new shareissues, new debentures or loans.

The weighted average cost of capital must reflect the long term future capital structureof the company.

Arguments Against Using the WACC

There are arguments against using WACC for investment appraisal based mainly on theassumptions underlying WACC.

Businesses may have floating rate debt whose cost changes frequently, and as wehave seen only an estimate is used to calculate the cost of this type of finance. Thusthe company's cost of capital will not be accurate and will need frequent updating.

The business risk of individual projects may be different to that of the company and willthus require a different premium included in the cost of capital.

The finance used for the project may alter the company's gearing and thus its financialrisk.

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F. ASSESSMENT OF RISK IN THE DEBT VERSUS EQUITYDECISION

Effect on Market Value

The direct cost of borrowing is represented by the interest charges and fees which areapplied by the lender. In common with debenture interest, such charges will generally bedeductible for tax purposes, and therefore the after-tax cost of borrowing will usually be lessthan the gross cost. Although the cost of borrowing will by and large appear cheaper thanequity, there is a risk to the company and the financial manager should take this into accountwhen comparing the costs of borrowing.

Example

A company has a current profit before interest and tax (PBIT) of £5m pa and current interestpayable of £1.7m. The company's issued share capital comprises £10m in ordinary sharesand the earnings per share (EPS) are 5p.

The firm wishes to invest £7.5m of new capital and it expects to increase its PBIT by £1.25mpa as a result. The alternatives under consideration by the directors are as follows:

(a) To issue 3.75 million shares at 200p, representing a discount on the current marketprice of 240p.

(b) To borrow £7.7 million on 10-year debentures at 12% annual interest.

Assume a corporation tax rate of 33% although note that current rates will vary from this rate.

One approach to decide on the better route would be to attempt to predict the effect on themarket value of the ordinary shares. The company would then elect for the opportunity whichgives the best return to shareholders (remember the dominant objective of financialmanagement).

The following table shows the effect on the earnings per share:

Current ProjectedEquity

ProjectedDebt

(£m) (£m) (£m)

PBIT 5.00 6.25 6.25

Interest payable (1.70) (1.70) (2.62)

Profit before tax 3.30 4.55 3.63

Tax at 33% (1.09) (1.50) (1.20)

Profit after tax 2.21 3.05 2.43

Issued ordinary shares 10m 13.75m 10m

Earnings per share 22.10p 22.18p 24.30p

From this we can see that the market value of the shares will be improved by choosing toraise the debt capital, on the assumption that the PBIT really does increase by £1.25m.

However, the financial manager should always remember that debt is a riskier route thanequity, because:

Debt payments cannot be deferred whereas dividends to shareholders can, shouldtrading estimates fail to materialise.

Use of debt capital could result in a lower price/earnings ratio than an equity issue.

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In our example the financial gearing ratio would increase and the interest cover will fall fromthe present 2.94 to 2.4. (We shall consider gearing in detail later in the course.)

Interest cover should be calculated as the number of times the interest payable can bedivided into the PBIT figure. Unequivocally, the higher the number of times, the better theresult and the less risk will be attached to the decision.

A low figure, generally less than three times cover (when interest rates themselves are low),indicates that the company should be cautious regarding further borrowings if these are likelyto be sensitive to adverse (upward) movements in interest rates, because the company'sability to service the necessary payments may be in doubt.

Break-even Profit Before Interest and Tax

The financial manager may choose to compute the break-even PBIT at which the earningsper share will be the same for the use of either equity or debt.

Using the same information as in the above example, this is done as follows:

EPS under debt 10

2.62)67%(y EPS under equity

13.75

1.70)67%(y

(67% is used to represent the position net of tax at 33%, and y represents the break-evenPBIT.)

13.75 (y 2.62) 10(y 1.70)

13.75y 36.02 10y 17

3.75 y 19.02

y 5

This shows us that the break-even PBIT in our example is £5m. Earnings per share will begreater using debt above this level, but below it equity should be favoured. In practice,more than one source of financing may be used, and it will be important for the financialmanager to consider the risks and rewards of the alternatives.

Other Considerations

It is quite common for a company to lease a large part of its expenditure on capital items andto use equity for its increased working capital needs although, due to the costs involved, aquoted company will be unlikely to consider issuing less than £250,000 in new shares to beworthwhile. Whilst the calculations demonstrated in this study unit will be simpler to apply toquoted companies (because of the ease with which share prices can be determined) theunderlying principles will be appropriate to all businesses seeking to increase the capitalavailable for investment.

It is important when a business considers any particular source of finance to understand thecosts and relationships of that particular method of finance. Any method of debt finance willrequire repayment and the business will need to ensure that profit and liquidity forecasts willbe high enough to meet any capital and interest payments as they become due. This willrequire sound income and cash budgets to be compiled by the business on a regular andmoving basis.

Any payments of interest and capital will, therefore, result in less finance being available forthe shareholders and the business will need to ensure that there are readily available fundsfor shareholders if they do not want the market to lose confidence in their business.

There are also tax reasons to be considered – for example, interest on debt capital cancurrently be offset against Corporation Tax, but dividends to shareholders can not.

Cost of Finance 159

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For any business (particularly a large one), there is always a balance to be struck betweenensuring that there is a blend of different sources of finance within the firm, that it does itsbest to ensure that it is not either too highly geared or too lowly geared and that there isadequate available internal funds predicted to make interest and capital repayments tolenders and dividend payments to their owners (i.e. the shareholders).

G. COST OF CAPITAL FOR OTHER ORGANISATIONS

Unquoted Companies

Unquoted companies do not have market values for their shares and thus calculating thecost of equity can be difficult. To estimate an approximate cost of capital the firm can eitheruse the cost of equity of a similar quoted company and adjust it for difference in gearing andbusiness risk, or it could add estimated premiums for its financial and business risk to therisk-free rate given by government bonds.

Not-For-Profit Organisations

Government departments do not have a market value, nor do they have business or financialrisk, and thus cannot calculate the cost of capital. To evaluate projects they use a targeted"real rate of return" set by the Treasury as a cost of capital.

Non-profit making firms do not generally have market values, and will thus have to determinea cost of capital to use to assess projects – many use the cost of any borrowing they have intheir balance sheets, but you will appreciate from this study unit that it is not ideal.

Practice Questions

1. A company has a share value of £1.27 (ex-div) and has recently paid a dividend of 8pper share. If dividend growth is expected to be approximately 3% per annum into theforeseeable future, calculate the cost of equity.

2. Calculate the WACC from the following information:

Balance Sheet Extract from CD plc

Capital Balance Sheet Value Market Value

Ordinary shares(20,000 – 50p ordinary) £10,000 £1.72 per share

8% Preference shares(£1 nominal value) £5,000 £0.98 per £1

Long-term liabilities10% debentures £7,500 £1.04 per £1

The cost of equity has been calculated at 9.5%.

Now check your answers with those given at the end of the unit.

160 Cost of Finance

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1. Ke Se

gDe )( 1 g

271

0301080

.

).(. 0.03

0.065 0.03

0.095 or 9.5%

2. (a) WACC at Balance Sheet Values

Value Weighting Return Weighted AverageReturn

Equity 10,000 0.45 0.095 0.0428

Preference Shares 5,000 0.22 0.08 0.0176

Debentures 7,500 0.33 0.10 0.0330

22,500 0.0934

WACC 9.34%

(b) WACC at Market Values

Value Weighting Return Weighted AverageReturn

Equity 34,400 0.73 0.095 0.069

Preference Shares 4,900 0.10 0.08 0.008

Debentures 7,800 0.17 0.10 0.017

47,100 0.094

WACC 9.40%

Note that strictly speaking the return should be recalculated in line with themarket values if the information is available.

161

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Study Unit 7

Portfolio Theory and Market Efficiency

Contents Page

Introduction 162

A. Risk and Return 162

Expected Return 162

Measuring Risk in a Portfolio 163

B. The Impact of Diversification 164

Correlation 164

Assessing Risk under Different Forms of Correlation 165

The Importance of Correlation 168

C. Portfolio Composition 168

Investment Indifference Curves 168

Efficiency Frontier 170

The Capital Market Line 171

Efficient and Inefficient Portfolios 173

Securities Market Line 175

D. The Application of Portfolio Theory 175

Planning Diversification 175

Selected versus Random Portfolios 176

Practical Difficulties 176

Limitations of Portfolio Theory 177

E. Market Efficiency 177

Fundamental Analysis Theory of Share Values 178

Technical Analysis 179

Random Walk Theory 182

Efficient Markets Hypothesis 182

Alternatives to the EMH 184


162 Portfolio Theory and Market Efficiency

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INTRODUCTION

Portfolio theory is a model which provides investors with an insight into the required rates ofreturn for a given level of risk.

A portfolio is the collection of investments or projects which an individual holds. A companywill generally also have a series of projects in its portfolio, and may make externalinvestments (in the financial sense) in some other investment market, when it has surplusfunds available. In order to do so effectively, and to understand investor behaviour in themanagement of his firm's own share price, the financial manager requires a good workingknowledge of the "City", its efficiency and of portfolio theory.

In order to simplify the model, finance theorists have assumed perfect capital markets and, inparticular, that there are no transaction costs, and that borrowing and lending rates are equal.Whilst they clearly do not exist in reality, the model still provides us with a basicunderstanding of the effect that levels of risk have on expected returns from investment.

In determining the composition of the portfolio the investor or company will consider thefollowing points:

The return received from the investment – obviously higher returns are more desirablethan low or negative returns; in general the better the growth prospects of the firm thebetter the expected returns.

Risk and security – investors will wish to minimise their risk of the level of returnsobtained and maintain at least their initial investment; often by diversifying (orspreading the risk).

The liquidity of the investments may be important if they are only to be held for a shortterm.

A. RISK AND RETURN

Different investors have different attitudes to risk – some are risk-seekers and others are risk-averse. Obviously an individual's attitude to risk will affect his/her choice of portfolio.However, risk aversion is extremely difficult to quantify in tangible terms with many factorsaffecting it including age, personal wealth, family circumstances, taxation, time restrictions onthe availability of investment capital and the requirements of trust deeds.

Traditional economic theory, upon which much of this course, and portfolio theory inparticular, is based assumes that individuals are "rational risk-avoiders" – i.e. they are riskaverse.

Expected Return

An investor will expect his individual investments and portfolio as a whole to yield a certainreturn. The expected return of a portfolio is the weighted average of the expected returns ofits constituent investments weighted by their proportion in the portfolio. This is bestexplained by an example.

Portfolio Theory and Market Efficiency 163

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Mr Trollope holds the following shares in his portfolio which have these expected returns:

Share Proportion Expected Return

% %

A 25 20

B 15 10

C 30 15

D 30 25

What is the expected return on his portfolio? It is the weighted average of returns:

Share Proportion Expected Return Prop. Expected Return

% %

A 25 20 0.25 20 5

B 15 10 0.15 10 1.5

C 30 15 0.30 15 4.5

D 30 25 0.30 25 7.5

Total expected return from portfolio 5 1.5 4.5 7.5 18.5%

Measuring Risk in a Portfolio

The return the investor will expect to receive from his portfolio is dependent principally on therisk of the portfolio. In the portfolio the greatest risk is that the investments will fail to achievethe required return. The risk can be measured as the standard deviation of expected returns.These expected returns are calculated using probabilities.

Let's consider an example of an investment with the following expected returns.

Probability Factor (P) Return (r) Expected Value

0.3 10% 3%

0.4 15% 6%

0.3 20% 6%

15%

Here the expected (the most likely) return ( r ) is 15% – it is the most likely estimate from theinformation available to us. However, it is only an average figure and there will be variationsaround this point. To calculate the likely variation we need to work out the variance and, fromthis, the standard deviation:

P Return (r) (r r ) P(r r )2

0.3 10% (5%) 7.5

0.4 15% 0% 0

0.3 20% 5% 7.5

Variance: 15


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The standard deviation is the square root of the variance ( 15 ), which is 3.87%. In other

words, we have found that our likely return could fluctuate by up to 3.87% in either direction.

(You need to be familiar with the concept of standard deviation from your earlier studies inQuantitative Methods.)

The higher the standard deviation the higher the risk. Since the standard deviation showsthe range of expected returns (in the above example these are 15% 3.87%), we can seethat the higher the risk, the higher the expected returns or expected losses.

In general, the higher the risk of the investment, the higher the expected return. Investorswill aim to avoid as much risk as possible whilst aiming for the highest return, and look tostrike a balance between the risk that they are prepared to take with the expected return forthat risk.

B. THE IMPACT OF DIVERSIFICATION

Investors and companies generally have more than one investment in order to minimise theirexposure to risk. A good example is the unit trust, which comprises a large number ofinvestments thereby spreading the risk incurred by the investor and generally reducing it.

Portfolio theory states that it is the relationship between the returns from the individualinvestments which is important, rather than the return on individual investments. Therelationship between the returns is known as correlation.

Correlation

This can take three forms.

(a) Positive Correlation

This concerns the situation which may arise when two or more investments in theportfolio are in connected industries. It is assumed that, if one investment is successfuland rises in value, then the other in a related industry will also do well. Similarly, if thefirst does badly, then the second will follow. For example, if there is a slump in theproperty market, the shares in a house-building concern will fall and be followed by adecline in the share price of related firms, such as those supplying building materials.

(b) Negative Correlation

This concerns the theory that, if one investment performs poorly, the other will do well.In the real world negative correlation is almost impossible to achieve. One examplecould be a steep rise in the price of oil. Initially this will usually benefit oil companies,whilst the rest of the market will be depressed. You may like to try to think of similarcircumstances.

(c) Nil Correlation

Here, the performance of an investment is unrelated to that of another. This situationwould typically arise when investments include an engineering firm and a clothingmanufacturer. Barring a total market collapse, both investments will be expected toperform entirely independently of each other.

From the above, we can see that, to reduce the risk, the finance manager in his or her role ofinvestor should choose investments which are perfectly negatively correlated, and where thiscannot be achieved, he or she should seek nil correlation as the next best alternative.


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Assessing Risk under Different Forms of Correlation

We shall consider this through an example.

Two investment opportunities have the following potential outcomes.

Investment 1:

Probability (P) Return (r)

Worst outcome 0.3 10%

Most likely outcome 0.4 15%

Best outcome 0.3 20%

Investment 2:

Probability (P) Return (r)

Worst outcome 0.3 9%

Most likely outcome 0.4 16%

Best outcome 0.3 21%

Where the investments are perfectly correlated, we can assume that if investment 1 yields20%, then investment 2 will yield 21%, and so on. If they are negatively correlated, theninvestment 1 will yield 20% whilst investment 2 will yield 9%, etc.

Having accepted the theory, we can move forward and calculate the return of a portfoliowhich is composed of exactly half of each type of the above securities under conditions ofpositive, negative and nil correlation.

(a) Positive Correlation

Where the two investments are positively correlated, the worst outcome will occur atthe same time for both.

Firstly, we work out the expected return of the portfolio by combining the expectedreturns of each investment. The expected return for investment 1 is 15% (from theexample considered previously). For investment 2 it is:

Probability Factor (P) Return (r) Expected Value

0.3 9% 2.7%

0.4 16% 6.4%

0.3 21% 6.3%

Expected return ( r ): 15.4%

The expected return on the portfolio is therefore:

(50% 15%) (50% 15.4%) 15.2%.


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Having determined the expected return from the investment, we can now go on tocalculate the likely variation in it. From the example above, we know that the standarddeviation for investment 1 is 3.87%. The standard deviation for investment 2 iscalculated as follows:

P Return (r) (r r ) P(r r )2

0.3 9% (6.4%) 12.29

0.4 16% 0.6% 0.14

0.3 21% 5.6% 9.41

Variance: 21.84

The standard deviation of investment 2 8421. 4.67%.

We can now consider the standard deviation of the portfolio under perfect correlation:

Returnon 1

(50%)

Returnon 2

(50%)

CombinedReturn

Probability ExpectedValue

(r r ) P(r r )2

Worstoutcome 5% 4.5% 9.5% 0.3 2.85 (5.7) 9.75

Most likelyoutcome 7.5% 8% 15.5% 0.4 6.20 0.3 0.04

Bestoutcome 10% 10.5% 20.5% 0.3 6.15 5.3 8.43

r 15.20 Variance: 18.22

Standard deviation 2218. 4.27%.

(b) Negative Correlation

If the two investments in our portfolio are negatively correlated, then the worst outcomefor investment 1 should coincide with the best outcome for investment 2 and viceversa. Our calculations will look like the following:

Returnon 1

(50%)

Returnon 2

(50%)

CombinedReturn

Probability ExpectedValue

(r r ) P(r r )2

Worstoutcome 5% 10.5% 15.5% 0.3 4.65 0.3 0.027

Most likelyoutcome 7.5% 8% 15.5% 0.4 6.20 0.3 0.036

Bestoutcome 10% 4.5% 14.5% 0.3 4.35 (0.7) 0.147

r 15.20 Variance: 0.210

Standard deviation 210. 0.46%.

The figures demonstrate the difference which occurs between perfect positive and perfectnegative correlation. With positive correlation, the standard deviation (the risk) is 4.27% onour return of 15.2%, whereas with negative correlation it is only 0.46%.


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There is also a formula which you may encounter that can also be used to calculate thestandard deviation of a portfolio which contains two investments:

S ))(σ)(c)(σ)(2(+σ)(+σ)( 21212

22

22

12

1

where: S the standard deviation of the portfolio

1 the weighting applying to the first investment

2 the weighting applying to the second investment

1 the standard deviation of the first investment

2 the standard deviation of the second investment

c the correlation coefficient between the investments

Using the two investments considered in the above example, we can use the formula tocalculate the standard deviation, and hence the risk, of the portfolio.

In a situation of perfect positive correlation, the correlation is expressed as 1 and theformula becomes:

S (4.67))(1)(3.87)2(0.5)(0.5+21.84(0.5)+15(0.5) 22

049465753 ...

2518.

S 4.27%.

Under conditions of perfect negative correlation, the correlation coefficient is 1 and theformula becomes:

S .67)1)(3.87)(4)(2(0.5)(0.5+21.84(0.5)+15(0.5) 22

049465753 ...

170.

S 0.41%.

The answers, as you can see, approximate very closely to the answers we calculatedpreviously. The negative calculation shows a slightly higher variation because of its relativesize, i.e. a standard deviation of less than half a percent.

Note that if no correlation existed at all, the correlation coefficient would be 0 and the secondhalf of the formula would, therefore, equal zero.

S 0465753 ..

219.

3.03%


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The Importance of Correlation

You may be wondering why the relationship between the returns from the individualinvestments is more important than the returns on individual investments.

When considering the risk from holding securities, we saw above that we look at thevariations in returns from individual securities and the correlation between the returns. If wecall the variance of an individual security v, and the correlation between returns fromsecurities c, we can see the factors affecting risk as the number of securities in the portfoliois increased:

Figure 10.1: Variance and correlation in a portfolio

Number ofSecurities

1 2 3 4 5 6 7 8 9 10

1 v c c c c c c c c c

2 c v c c c c c c c c

3 c c v c c c c c c c

4 c c c v c c c c c c

5 c c c c v c c c c c

6 c c c c c v c c c c

7 c c c c c c v c c c

8 c c c c c c c v c c

9 c c c c c c c c v c

10 c c c c c c c c c v

Thus, as the number of securities in the portfolio increases, the significance of individualvariances becomes less important, and it is the correlation between returns that is important.

C. PORTFOLIO COMPOSITION

When choosing his portfolio the investor will wish to maximise expected returns and minimiserisk. We can illustrate the relationship between the two using graphs and this can help usdetermine portfolio composition.

Investment Indifference Curves

The basis for this is the indifference curve. The indifference curve for an investor representsthe mixtures of risk and return which will be acceptable in terms of an investment. ConsiderFigure 7.2. At any point along the curve, the risk-return relationship is the same for theinvestor and he will be indifferent to whether the investment is at point A or point B.

(Indifference curves are curved because of the diminishing returns provided as the quantitiesof risk or return become disproportionate in the mixture towards the extremes of the curves.)


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Figure 7.2: An Investor's Indifference Curve

A will be preferable to D because it offers the same expected return for a lower risk and to Cbecause it offers a higher expected return for the same level of risk. A is said to dominate Cand D. Whether an investor will choose A or B depends on their attitude to risk – andremember that an investor may be risk averse or risk-seeking.

Traditional economic theory states that individuals will seek to maximise their utility. TheMarkowitz model of investment analysis seeks to measure the investor's utility function Uas:

U U( R )

where: R the investor's expected return from the shares; and

the standard deviation or risk of the investment.

We can be plot this as series of indifference curves for investors as shown in Figure 7.3.

Figure 7.3: An Investor's Indifference Curves

Thus shows the portfolios between which the investor will be indifferent. They all give equalutility – for example, A gives a lower return but has a lower risk than B.

The further the indifference curves go to the left the greater will be the value of utility to theinvestor, because these portfolios provide higher returns for the same level of risk, or lowerrisk for the same level of returns. Portfolios to the left of the curves are preferable becausethose below are mean variance inefficient and those on or above the utility curve are mean


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variance efficient. Mean variance efficient portfolios are those which give the maximumreturn for a given level of risk, or have the minimum risk for a given level of return. Meanvariance inefficient portfolios are those which are not efficient in the sense explained above.

Efficiency Frontier

We can develop the above analysis into a model of expected risk and return for all possibleinvestments.

If we plot the risk-return relationship for a number of investments, we get a scattergram asshown in Figure 7.4. The resultant plot does not follow a linear course, but is regarded ashaving an "umbrella" shape.

Figure 7.4: The Efficient Frontier

Those investments which maximise the expected return for a level of risk or minimise risk fora level of expected return can be seen to fall on the line AB – this is known as the efficientfrontier. A combination of investments falling on the line AB represent the most efficientportfolios. Before reading any further think why they give the most efficient portfolios.

The reason is that it is impossible to create a portfolio which gives a higher rate of return for agiven level of risk, or a lower level of risk for a given level of return. Remember – thetraditional economic theory on which it is based assumes that investors are risk averse.

We can now combine the indifference curve for a particular investor with this concept of theefficiency frontier. Consider Figure 7.5.


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Figure 7.5: The Optimum Portfolio

The optimum portfolio is the one where the efficiency frontier touches the individual'sindifference curve at a tangent, shown as portfolio M. Indifference curves above the efficientfrontier are not attainable there being no portfolios of securities offering both levels ofexpected return and risk.

The Capital Market Line

The return on government stocks is deemed to be risk-free (governments can always printmoney to meet their obligations). This is a point on the y axis (return) of the risk-return graphwhere risk is zero and is shown in Figure 7.6 as point Rf – the risk-free rate of return. If wedraw a line tangential from Rf to the efficient frontier we obtain the capital market line(CML).

Figure 7.6: The Capital Market Line

Any portfolio not on this line can be seen to be either mean variance inefficient (producinglower expected return or higher risk than those on the capital market line), or to be notobtainable (those above the line). Investors will be able to invest in a mixture of the marketportfolio and the risk-free investment. They can either invest in the risk-free investment withor without investing in the market, or borrow at the risk-free rate and invest in the marketportfolio, or invest solely in the market.


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You may be wondering what portfolio M consists of since it is the only portfolio investors wishto hold. All shares quoted must be held and therefore M must consist of all shares on theStock Market. In practice, no one shareholder will be able to hold every one, but a welldiversified portfolio of 15 to 20 shares has been found to mirror M.

An efficient portfolio would be one that offers a better combination of risk and return than thatoffered by the CML (although as we saw above it is unobtainable) and an inefficient one isone which offers a worse combination than that available on the CML.

Let's examine this in more detail. Consider the CML shown in Figure 7.7.

Figure 7.7: The Capital Market Line

We see the higher the risk the higher the expected return (this is in line with all the theory wehave discussed thus far). Using the equation for the gradient of a straight line (y mx c)we can give the gradient at any point on the CML.

Consider y m

fm

σ

RR

This shows the level of expected return required to compensate investors for the risk theyare bearing (including both business and financial risk).

The expected return over and above the risk-free rate is known as the risk premium. If youlook at the CML you can see that the statement "the greater the risk the greater the expectedreturn" does, indeed, hold, with riskier securities offering a higher level of risk premium.

We saw earlier that the expected rate of return comprises an element for the risk premiumand return required on the risk-free securities. The return required on portfolio P (and theequation of the CML) is:

Rp Rf

m

fm

σ

RRp

The risk premium

m

fm

σ

RRp can be rewritten as p

m

fm

σ

RR.

Capital Market Line

m

p

p mRisk ()

Expected

Return R

Rp

Rm

Rf


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The expressionm

p

σ

σis commonly known as the beta factor and, thus, the equation can be

written as:

Rp Rf (Rm Rf)

where: Rp the return required on a portfolio by an investor

the beta factor

Rm the return required for holding the market portfolio

Rf risk-free rate

The beta factor equation can also be used to determine the required return on an individualinvestment or security. Thus, the required return on a portfolio is determined by therelationship of its risk in relation to that of the market. This is because the greater thedifference in risk of the portfolio to that of the market (measured by their respectivevariances), the greater the difference in required returns.

The beta factor can be used to measure the extent to which the return on a portfolio orsecurity should exceed the risk free rate of return.

This point and the equation above is the basis of the capital asset pricing model which weshall discuss in the next study unit.

The capital asset pricing model can be used to calculate the market value of equity (seeStudy Unit 2) and the cost of equity (and thus the weighted average cost of capital) takingfinancial and business risk into consideration.

Efficient and Inefficient Portfolios

Consider the following information:

Expected return on market portfolio 16%

Risk-free rate of return 8%

Measure of risk on market portfolio 4%

If we plot these figures on a graph it would give us the CML as shown in Figure 7.8. Plottingthe CML simply involves locating the position on the graph which corresponds to the marketportfolio (M) – here, where the expected return is 16% and the risk is 4% – and joining it tothe point on the return axis corresponding to the risk-free rate (8%).


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Figure 7.8

Now consider a number of portfolios with different risk-return relationships. If we plot theseon the graph, we can establish whether they are efficient or inefficient.

Portfolio Expected Rate of Return Standard Deviation (Risk)

P 15% 5%

Q 15% 8%

R 17% 4%

S 23% 7.5%

These figures are shown plotted on Figure 7.9.

Figure 7.9

The efficiency of each of the portfolios is given by their relationship to the CML:

Capital Market Line (CML)

M16

Rf 8

4 Risk %

ExpectedReturn

%

2 4 Risk %

CMLS

MQP

16

Rf 8

12

ExpectedReturn

%R


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Portfolios P and Q are "inefficient" as they yield a lower risk/return combination than themarket portfolio.

Portfolio R is "super efficient" as it yields a higher risk/return combination.

Portfolio S is "efficient" because it lies on the CML and therefore yields a risk/returncombination equivalent to the market.

Securities Market Line

The Securities Market Line (SML) is the same as the CML, apart from the fact that beta co-efficients are substituted for levels of risk.

In the above example, therefore, a risk level of 4% (the market risk) is equivalent to a betaco-efficient () of 1.0. Similarly, a risk level of 2% would be equivalent to of 0.5 and so on.The difference between the two is that the CML measures total risk whilst the SML is relatedto market risk only.

The SML and beta co-efficients can be used in two ways.

If an investor knows the rate of return he or she requires, he or she can use a riskmeasurement service to identify the beta co-efficient of suitable shares, i.e. if he or sherequired a return of 12%, he or she would obtain shares with a beta co-efficient of 0.5(i.e. a risk level of 2%).

If the beta co-efficient of a share is known, it is possible to calculate the return it shouldprovide, i.e. a beta co-efficient of 1.0 in the above example should yield 16%, and soon.

D. THE APPLICATION OF PORTFOLIO THEORY

Portfolio theory is concerned with selecting and optimising a set of investments byconsidering the returns on those investments and the variability of such returns. A "portfolio"is usually a collection of shares but it could also comprise other investment opportunities.

Planning Diversification

Portfolio theory demonstrates that risk can be diversified away with a carefully selected typeand number of securities. However, if an investor such as a company is obliged to diversify(say by legislation or similar restrictions), portfolio theory can show that risk will actuallyincrease. Such investment over larger than optimum numbers of securities is called naïvediversification.

We saw above that portfolio theory can be applied to investments other than stocks andshares, including its use by companies choosing a selection of projects and businessventures to invest in. Companies will be able to reduce risk and stabilise profits by investingin businesses with a negative or weak positive correlation between them – for example, acompany which produces central heating systems would reduce its risk by a greater amountdiversifying into paints than by diversifying into winter coats.

The advantages of diversification are:

Reduced risk of corporate failure due to lower total company risk (and thus lowerpotential costs of redundancy).

More stable internal cash flows, which should help increase debt capacity, thusreducing the cost of capital and, in turn, increasing shareholder wealth.

Reduction in systematic risk may arise from investing in foreign markets generallyprotected by barriers to trade, thus increasing the risk/return combinations available toinvestors.


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A company may, however, over-diversify and may experience the following problems:

Conglomerates often have indifferent returns leaving them vulnerable to takeover. TheStock Market often values the P/E ratios of individual companies within the grouphigher than that of the conglomerate, thus providing an incentive for the buyer of thegroup to "unbundle" and sell off parts of the group.

There will be difficulties in becoming familiar with all the parts of the group and this lackof knowledge could lead to missed opportunities.

Companies may lack the skills and expertise to manage all the elements of the group,and indeed may lack the skills to manage a diversified group.

Empirical evidence has found that investors can diversify more efficiently thancompanies.

Companies considering diversification should assess the above points (tailored to theirparticular industry). However, in general, some diversification does help to protect againstshort-term profit fluctuations, but too much can create severe problems for the group.

Selected versus Random Portfolios

Recent years have seen a market growth in investment trusts, unit trusts, and pension andinsurance funds – all of which are, in effect, investors seeking a portfolio of investments.How, then, do these portfolio operators fare? How do they perform in relation to, say, arandomly-selected portfolio?

There have been numerous surveys along these lines. One survey concluded that, onaverage, unit trusts performed no better than randomly-selected portfolios in the industries inwhich the trusts had invested – i.e. the trust managers probably picked the right branch ofindustry to invest in, but not necessarily the right company in that industry.

There is no great condemnation of professional portfolio managers, however. They willnaturally tend to err on the prudent side and go for minimum risk, even though most of theirpromotional advertising stresses performance. What is never likely to be clarified is theextent to which portfolio managers use (or are even aware of) the formal portfolio selectiontechniques. Certainly, these large investors tend to have an effect on the shares theypurchase, for large-scale investments inevitably affect the market prices. The main theme ofthe findings seems to be that, during times of rising markets, unit trusts do worse thanrandom investments; in falling markets they do better.

Practical Difficulties

When considering the application of portfolio theory, all sorts of practical difficulties come tomind:

Can we really measure risk in statistical terms?

Is the standard deviation of future expected returns the only dimension involved?

How many investments shall we consider out of the thousands available on the world'sstock exchanges if the sheer volume of computation is not to be prohibitive?

What about the changing, dynamic nature of investment, taxation provisions and worldevents?

What of transaction costs in amending the portfolio, the marginal value of money to aninvestor, inflation, and so on?

Clearly, a great deal of work remains to be done on this topic. Markowitz refined his originalmodel to cut down the volume of computation. Other writers have built on his basic work,and this is undoubtedly one area in which future bodies of theory will emerge in a morerefined state than at present.


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Limitations of Portfolio Theory

Portfolio theory is:

(a) Concerned with a single time-period framework. It is not a dynamic model andtherefore can only be revised as the anticipated performance of securities alters or newones become available. In this respect, it has no predictive qualities.

(b) Concerned with guesswork to estimate the probabilities of different outcomes, whichmay be a particular problem when the model is being used to assess diversification bythe firm into new uncharted markets or products.

(c) Subject to investor attitudes which may be difficult to determine and reflect on whenmaking decisions, and investor perception or propensity for risk may well change overtime.

(d) Not the most convenient method for considering physical investment in fixed assets orthose generating irregular cash flows. A mix of "paper" and "physical" investments isbest handled by other techniques centred on risk-reward probability theory.

(e) Based on simplifying assumptions:

(i) That investors behave rationally and are risk-averse.

(ii) The agency problem is ignored – managers may be more risk-averse thanshareholders as they may be concerned about job security.

(iii) Legal and administrative constraints are also ignored.

(iv) Taxation, in particular, can give rise to very complex models – for this reason itseffects are often ignored.

(f) Not able to cope with investment policies, such as "selling short" and other leveragedevices.

(g) Assuming constant returns to scale and divisible projects, both of which may not occurin practice.

(h) Ignoring various other aspects of risk, e.g. the risk of bankruptcy.

The volume and type of information required can also be a disadvantage, although this isnow more widely available than used to be the case (at a cost). The quality of information,however, is still somewhat variable, and in any case, portfolios have to be updated andrevised regularly. (The principle "Garbage in; garbage out" applies here, too!) Each revisionwill carry administrative, transaction and switching costs.

A full understanding of the model requires detailed mathematical skills and is therefore indanger of being seen as too theoretical to be useful and so ignored if its principles are not putacross to sceptical managers in a convincing way.

E. MARKET EFFICIENCY

Individuals and companies invest in securities in order to receive income, the price reflectingthe expected returns; from shares this income comprises dividends and capital gains(increases in share prices), from loan stock income is received as interest, the redemptionvalue and perhaps capital gains (arising from an increase in the market value of the stock).

In order to maximise income from such securities, the optimal time for buying and sellingthem must be determined in order to maximise capital gains (or minimise capital losses).The general rule is to purchase cheap and sell dear. To determine the optimal points manyinvestors enlist the help of stockbrokers and investment advisors who predict share pricesand movements within them, basing their ideas on the following underlying theories.


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Fundamental Analysis Theory of Share Values

This theory uses the dividend yield valuation model we discussed in Study Unit 2 and arguesthat the price of a share is the present value of all future expected dividends and capitalgains received from the share. Thus provided all investors and their advisors have the sameinformation about a company and its prospects, and have identical required returns from thecompany's equity, the price of the shares can be predicted.

You will remember that the model used under this method varies with the assumptions used.The simplest model to use assumes that dividends will remain at a constant level in thefuture. The value of a company's shares can be calculated using the following formula:

Market value sharestheonyield)(orreturnExpected

penceinDividend

The market price given is the ex-dividend price – i.e. excluding any dividend that may bepayable.

Example 1

Susie Ltd's shareholders expect a dividend yield of 10% and have been told that dividendsper share for the foreseeable future will be 40p. Calculate the market value of Susie'sshares.

Using the above formula to calculate the value of one share:

Value 40p/10% 400p or £4

However, we have seen that shareholders prefer a constant growth in their dividends. Whenthe expected growth figure has been determined we can calculate the value of thecompany's shares using the Dividend Growth Model or Gordon's Model of DividendGrowth.

You will remember that this model states:

Po do)(

)(

gr

g1

where: Po the current ex dividend market price

do the current dividend


r the shareholder's expected return on the shares

(Dividends are generally paid as interim dividends part way through the year and as a finaldividend after the year end. However, unless told otherwise, assume that only one dividendis paid each year.)

Example 2

Bunny Ltd is expecting to pay a dividend of 50p this year, increasing at a rate of 5% perannum. If its shareholders have a required return of 25%, calculate the current market price.

Using the above formula:

Po 0.05)(0.25

0.05)50(1

262.5p

Note the following two points:

If you have a market price cum dividend (or cum div), this simply means that there is adividend due to be paid soon. In order to calculate the ex div price to use in theformula, deduct the dividend from the cum div price.


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You can also apply the same principle to the valuation of debt, using the formulae wediscussed in the last unit.

As with a lot of corporate finance there is only restricted empirical evidence testing thevalidity of fundamental analysis, partially because of uncontrollable variations in share pricescaused by day-to-day fluctuations in the economy, interest rates and investor expectationsand confidence. It is therefore difficult for an analyst to predict exactly a company's earningsand dividends and what the required returns of shareholders are. If the analyst can predictthese things, and in advance of others, then he will be able to advise his clients on whichshares to buy, sell and hold. Difficulties in predicting the uncontrollable variations using thefundamental theory have led to the development of a body of techniques known as technicalanalysis.

Technical Analysis

Technical analysis, or charting (chartism) as it is also known, assumes that successive pricechanges of shares are dependent, and that information about a company's future can bedetermined by studying past movements in its share price. It is felt by chartists that pastmovements will be repeated.

Models include the Dow Theory, which states that movements in the daily average of onestock herald similar movements in others. A. G. Ellinger developed similar theories to Dowwhich stated that share prices are determined by:

The yield on fixed interest securities (as interest rates rise, prices of fixed interestsecurities fall and exert similar pressure on ordinary shares).

Dividends on ordinary shares.

The confidence factor.

Ellinger stated that fundamental analysis is extremely important in deciding which shares tobuy; technical analysis charts (see below) should only be used to determine when, not what,to buy and sell.

In addition to these systems there is the classic chartist technique of using the statisticalmethod of moving averages. This technique is used to determine trends and moreimportantly, changes in trends in share prices and to remove the day-to-day fluctuations wediscussed above. A 20 day moving average will provide an indication of the underlying trend,whilst 60, 90 and 240 days will provide indications of longer-term movements. The trends inshare prices will be plotted and the following features highlighted as being of importance.

(a) Head and Shoulders

This is illustrated in Figure 7.10.

The rising price trend is reversed slightly before increasing to a higher level; there isthen a fall in share prices to around the level of the previous low before rising to aroundthe first high point before falling again. Any falls below the neckline are an indication tosell; future trends upwards would indicate the reverse. Sometimes this pattern is seenin reverse, and the chartist would supply the opposite advice.


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Figure 7.10: Head and Shoulders

(b) A Double Bottom

Here, the falling price trend reverses for a while, before falling to the minimum pointagain. Following this second fall the price begins to rise. Once the minimum point hasbeen reached for the second time, the chartist would use past experience to predictthat the price trend was now upwards.

Figure 7.11: Double Bottom

(c) A Double Top

Figure 7.12: Double Top


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Here, the rising price trend reverses for a while before rising again to the maximumpoint. Following this second rise the price begins to fall. Once the maximum point hasbeen reached for the second time, the chartist would use past experience to predictthat the price trend was now downwards.

(d) Resistance Level

Share prices can be seen to fluctuate around a rising or falling trend; once the trenddeparts from the line then the chartist would say that the previous trend has passed theresistance level.

Figure 7.13: Resistance Level

(e) The Hatch System

This theory, an example of a "filter" system, states that as a chart of share pricemovement is built up, the potential investor can not know when an exact peak or troughpoint has been reached. Thus he will try to sell or buy as near these turning points aspossible (within 10% is considered to be as good as possible).

Figure 7.14: The Hatch System

The investor should average a suitable index, e.g. the Financial Times Share Index, forevery month. When the index is rising he will hold on to a share until the average


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indicates a reading which is 10% below the highest recorded level in chronologicalsequence. At this point he should sell.

Conversely, when the average is falling, the investor should not enter the market untilthe average reading is 10% above the previously recorded low.

The biggest drawback of this system arises because activating signals may occur toooften with the result that transaction charges will be excessive in relation to therewards.

A major problem with all "systems" is the absence of a really comprehensive indicator of thestate of the market. Conventional indices include only a limited number of securities andcannot truly reflect the whole market.

In general terms the chartist models are all based around historic data from which attemptsare made to predict the future. Statistically most have been proved to be invalid and lackingtheoretical underpinnings, but it has not limited the market for new ideas and charts andchartists apparently flourish. This may be because of some very successful chartists whohave had more success than average. However, probably the principal benefit of the use ofcharts stems from their clarity and ease of comprehension to the lay person.

Random Walk Theory

In the 1950s Kendall working in the UK, and Roberts working in the USA, found thatsuccessive share price changes are practically independent over time, and that share pricesfollow a "random walk", reacting to new information regarding the company as it becomesavailable. Research into this "random walk" led to the formulation of the efficient markethypothesis (EMH).

The random walk theory relies on the stock markets being efficient and displaying perfectmarket characteristics. The principles underlying the theory are that:

The market price of a security represents the market's consensus as to the valuation ofthat security.

Public information is widely available to investors – about the economy, financialmarkets, the individual company, its results and prospects.

Market prices adjust readily and quickly to new situations, e.g. changes in interest ratesor decisions (good or bad) taken by the company.

No investor is large enough by himself to influence the market price of the share.

Transaction costs are low or zero.

There are negligible restrictions on investment.

Efficient Markets Hypothesis

Efficient markets are capital markets which have the following features:

No individual dominates the market;

Costs of buying and selling are at a level that does not discourage trading to anysignificant extent;

Share prices change quickly in response to all new information available to buyers andsellers.

To fully understand the EMH we will look first at three interrelated measures of efficiency –allocative, operational and information processing efficiency.

Allocative efficiency is the optimum allocation of funds within the financial markets,i.e. that which will maximise economic prosperity.


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Operational efficiency is the lowest level of transaction costs that are possible and ispresent when there is open and free competition within the market.

Information processing efficiency is the quick and accurate pricing of securities,preventing speculation pushing prices to unrealistic levels.

In finance a distinction is made between three potential levels of information processingefficiency – the weak form, the semi-strong form and the strong form.

The weak form

The information available to investors is historical information on past share prices andcompany results. Share prices change as and when this information becomesavailable.

The semi-strong form

The investor has access to all publicly available information about a company includingpress releases. Share prices react not only to released information, but also to theexpectation of changes in the company's fortunes. Investors will be able to see beyondcreative accounting or "window dressing" by companies in an attempt to overstateprofits.

The strong form

The share price reflects all available information, including inside information. Actingon insider information is illegal and so it is very difficult to get an accurate picture of itsuse.

There has been a large amount of empirical research on this theory in the UK and the USA,and the overwhelming evidence is that security markets are efficient in a semi-strong sense(and thus also in the weak sense) – i.e. that share prices follow a random walk, and react toall available information and the expectations of information, e.g. of a proposed merger. Aswith all theories there are times when it does not appear to hold, e.g. in the Stock Exchangecrash of October 1987 when 40% was removed from the value of shares with no underlyingexpectations of falls in the economy or company prospects. (However, the expected fall of1989 did not occur.)

You may be wondering how the 1987 crash can be explained. One theory proposed by Hillis that the EMH holds best when the market is stable but, during a bull phase (as in 1987) ora bear phase the market is driven by speculation and uncertainties. This irrationality can alsobe seen when there is an over-reaction in the short term to company and/or economicevents, over-emphasis placed on large companies, and the fact that price movements cansometimes be related to the time of day, week, month or year.

The EMH and the empirical evidence noted above indicating its validity have implications forcompanies, investors and analysts.

(a) The current market price is the best available indicator of a share's intrinsic value –therefore the fundamental analysts' search for undervalued shares using publiclyavailable information is a waste of time, and analysts should concentrate more onefficient diversification for clients.

(b) Individual investors should not worry about investment analysis but should insteadchoose a well diversified portfolio consistent with their risk preferences.

(c) NPV techniques should be used for evaluating projects because this is how the marketwill evaluate the company.

(d) The market value of the firm will only be as good an estimate of intrinsic value as thequality of public information available concerning the company permits.

(e) Creative accounting is seen by the market as a sign of weakness rather than strength.


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(f) The timing of new issues is deemed to be unimportant and there is no need tosubstantially discount them as they will be correctly priced by the market.

(g) Large premiums paid above the market price on takeover are difficult to justify.

The efficient market hypothesis does not imply perfect forecasting ability, but states that themarket makes a correct evaluation of uncertain future events. Nor does it imply that portfoliomanagers are incompetent, even though on average the experts do no better than thegeneral investor, or that share prices cannot represent fair value because they areconsistently moving up and down – indeed, it is the working of the EMH that is reflected influctuating share prices and which prevents investors/portfolio managers consistentlyoutperforming the market.

You may be wondering why, if the EMH shows that fundamental analysis does not produceexcess returns, so many people are employed doing fundamental analysis. Firstly, somepeople disbelieve the EMH and believe they can outperform the bull market during a bullphase. Secondly, some investors will be more successful than average while others will not(but due to chance rather than consistently outperforming the market using publicly availableinformation), and therefore investors regard "gambling" on the markets as a "fair game".There is also evidence that unit trusts, whilst doing no better in bull markets, do tend to dobetter in falling markets.

Finally, and ironically, it is the continual search for company information by fundamentalanalysts which ensures there is an efficient flow of information in the market which isessential for the EMH to hold.

Alternatives to the EMH

Over the past two decades there have been several financial scandals including the use of(illegal) insider information. This has led to some experts dismissing the EMH except in itsweakest form and deriving alternative theories of market behaviour.

(a) Speculative Bubble Theory

This theory states that the price of securities moves above their true value creating abull market because investors believe they will rise in future. However, eventually the"bubble" will burst when investors look at all previously available economic andcompany information and a crash will occur. Thus rises and falls in the market do notreflect economic conditions.

There is some empirical research supporting this, including evidence that investors arerisk-seeking in a bear market in an attempt to minimise their losses.

(b) Catastrophe Theory

This developed from the Speculative Bubble Theory and argues that capital marketshave the following characteristics:

They are dynamic.

They use "feedback" mechanisms with "critical" levels – when activity reachesparticular levels the equilibrium prices of the market no longer exist.

Prices in such markets are not based on economic forecasts, and small changesin the events affecting a company can lead to disproportionately large changes inits security's prices.

The latter point leads to large scale "chaos" or instability making predictions of pricesimpossible except in the short term. The chaos is made worse if there is a largenumber of speculators who amplify price movements in their attempts to maximise theirown profit. This, it is argued, is one reason for the phenomenon of short-termism wediscussed in Study Unit 1.


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(c) Coherent Market Hypothesis

Vaga (1991) developed the Catastrophe Theory and stated that the market may be inone of the four following states:

(1) Coherence

(2) Chaos

These two states are both based on prices being determined by crowd behaviour – theformer in a bull phase and the latter when the markets are more bearish.

(3) Unstable transition

(4) Random walk

These two states are underpinned by economic events, the former market being aninefficient market and the latter being an efficient market.

Vaga argues that the 1987 crash (see above) was an example of state (2).

Practice Questions

1. Show the effect of perfect positive and perfect negative correlation between thefollowing investments within a portfolio. (Assume a 40 : 60 ratio.)

Investment A Investment B

Return Probability Return Probability

Best outcome 5% 0.2 7% 0.2

Most likely outcome 15% 0.6 14% 0.6

Worst outcome 25% 0.2 21% 0.2

2. From the following data, draw the CML and show whether portfolios A and B areefficient or inefficient.

Expected return on the market portfolio 14%

Risk-free rate of return 5%

Measure of risk of market portfolio 6%

Portfolio ExpectedReturn

Standard Deviation

A 17% 7%

B 10% 4%



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1. Using the formula:

Investment A

Return Probability ExpectedValue

(r r ) P(r r )2

Best outcome 5% 0.2 1.00 (10) 20

Most likely outcome 15% 0.6 9.00 0 0

Worst outcome 25% 0.2 5.00 10 20

r 15.00 Variance: 40

Standard deviation 40 6.32

Investment B

Return Probability ExpectedValue

(r r ) P(r r )2

Best outcome 7% 0.2 1.40 (7) 9.8

Most likely outcome 14% 0.6 8.40 0 0.0

Worst outcome 21% 0.2 4.20 7 9.8

r 14.00 Variance: 19.6

Standard deviation 619. 4.43

(a) Under Perfect Positive Correlation

SD (4.43))(1)(6.32)2(0.4)(0.6+19.6(0.6)+4040 22).(

441306746 ...

926.

5.19%

(b) Under Perfect Negative Correlation

SD .43)1)(6.32)(4)(2(0.4)(0.6+19.6(0.6)+4040 22 ).(

441306746 ...

020.

0.14%


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2. The CML, market portfolio (M) and portfolios A and B are shown on the following graph.

Portfolio A is superefficient.

Portfolio B is inefficient.

2 864

10

Rf 5

16

14

Risk %

CMLA

M

B

ExpectedReturn

%

189

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Study Unit 8

The Capital Asset Pricing Model

Contents Page

Introduction 190

A. Risk, Return and CAPM 190

Systematic and Unsystematic Risk 190

Measuring Systematic Risk 191

Market Risk and Return 192

The Beta Factor and Market Risk 193

The Capital Asset Pricing Model Formula 195

Alpha Values 195

The CAPM and Share Prices 195

The CAPM and Gearing 196

B. Calculation of Betas 196

C. Validity of the CAPM 197

CAPM Assumptions 197

Limitations of CAPM 198

D. Practical Applications of CAPM 199

CAPM and Portfolio Management 199

CAPM and Capital Investment Decisions 200

E. The Arbitrage Pricing Model 200

Answers to Practice Question 202

190 The Capital Asset Pricing Model

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INTRODUCTION

In the last study unit we discussed portfolio theory and said that it underpins the CapitalAsset Pricing Model (CAPM). CAPM was developed in the 1960s by Sharpe and Litnerbuilding on the work of Markowitz and portfolio theory. The model at its simplest bringstogether aspects of share valuations, the cost of capital, and gearing, and thus has importantimplications in financial management.

For our purposes, we can make the assumption that there are two basic functions associatedwith the CAPM:

Attempting to establish the "correct" equilibrium market value of a company's shares.

Calculating the cost of a firm's equity (and thus the weighted average cost of capital),as an alternative approach to the dividend valuation model which we considered in aprevious unit.

The model also implies equilibrium between risk and the expected return for each securityand can be used by the financial manager in the assessment of risk in either individualcompany shares or a portfolio of securities.

A. RISK, RETURN AND CAPM

There is risk associated with investment in any security, and we said in the last study unit thatthe greater the risk, the greater the required return from the investment. However, one typeof stock which has a low risk, and which is assumed in portfolio theory to be risk-free, isTreasury bills (because, as we have already seen, the Government is unlikely to renege onits commitments to pay the returns agreed on the bills). The difference between a higherreturn and that achieved at the risk-free rate is known as the excess return, and it will differbetween securities depending on the market's perception of the relative risk of each.

The only way for an investor to avoid risk altogether is to invest solely in governmentsecurities, but in doing so the investor will trade off risk for a lower return than mightotherwise have been made.

Systematic and Unsystematic Risk

We showed in the last study unit that risk comprises financial and business risk. We alsosaw that investors tend to diversify their portfolios to reduce their risk whilst maintaining theirreturn. The risk which can be diversified away is known as unsystematic risk, and is uniqueto a particular company. It is independent of political and economic factors, and may arise,for example, as a result of bad labour relations causing strikes, the emergence of improvedcompetitor products or adverse press reports. It is diversified away because the factorscausing it are different for different companies and cancel each other out.

The risk related to the market, however, cannot be diversified away (if it could then the returnon the market would not be higher than the risk-free rate), and is known as systematic ormarket risk. Systematic risk is unavoidable risk. Systematic risk may also vary betweenprojects. Such risk may arise as a result of government legislation, from adverse trends inthe economy or from other external factors over which the company has no control.

The two types of risk are significant, because in building a portfolio of shares the investor willwant to minimise unsystematic risk.

We noted earlier that research has found that if a portfolio has between 15 and 20 sharesselected at random then the unsystematic risk in the portfolio should be eliminated.Increasing the size of the portfolio up to this level will certainly reduce the level ofunsystematic risk (see Figure 8.1).

The Capital Asset Pricing Model 191

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Figure 8.1: Systematic and systematic risk

Although by definition unavoidable, the degree of systematic risk will be a variable factorbetween different industries – shares in different companies will have systematic riskcharacteristics which are different from the market average because the market considerssome investments to be riskier than others (for example, food retailers are lower risk thanthose in the fashion industry). When an investor holds a portfolio which is balancedthroughout with all available stocks and shares, or a unit trust which mirrors the market, hewill incur systematic risk which is equal to the average systematic risk in the market as awhole.

We can also see that individual investments will have their own levels of systematic ormarket risk.

Measuring Systematic Risk

The CAPM is principally concerned with:

How systematic risk is measured.

How systematic risk affects the required returns and share price.

In order to measure systematic risk, we use the beta factor ().

The CAPM also includes some fundamental assumptions which we can summarise asfollows:

(a) Investors in shares (as opposed to risk-free investments, which are generallygovernment securities) require a return which is in excess of the risk-free rate as aform of compensation for taking the systematic risk of the investment.

(b) Investors should not require a premium for unsystematic risk as this may be diversifiedand removed from the portfolio (as discussed earlier).

(c) As the systematic risk is higher for some companies (as measured by their factor)the investor will expect a greater return and will continue to do so as the gets larger.

(d) Investors are rational and want to maximise their return.

(e) All information is feely available to investors and they are competent in interpretingthat information.

(f) Investors are able to borrow and lend at the risk free rate.


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(g) Capital markets are perfectly competitive with a large number of buyers and sellers,no monopolies, no taxes or transaction costs, and no entry or exit barriers to themarket.

The financial manager may, incidentally, adopt a similar approach to investment in one ormore new projects. When a company is considering an investment in a new project, therewill be a degree of risk involved. The greater the perception of risk in the venture, the greaterwill be the expected return (assuming, of course, that the directors are willing to sanction theinvestment in the first place).

Market Risk and Return

The CAPM was formulated principally to evaluate investments in stocks and shares ("themarket") as opposed to investment projects under consideration by companies. The model isbased on the comparison of systematic risk within individual investments and shares, withthat in the market as a whole (hence systematic risk also being described as market risk).Market risk, in its simplest form, is the average return of the market.

Market risk is, of course, something which is almost impossible to determine with any degreeof accuracy, as it is based on the total expected market return. As the components of themarket fluctuate consistently, so the systematic risk attached to shares will also change.Therefore CAPM must make one major and fundamental assumption – that there is a linearrelationship between the return obtained from one single investment and the market average.

Let's look at an example.

Our aim is to demonstrate at a basic level how the return from one investment compares withthe market:

Company A Whole Market

Price at start of period 110 490

Price at end of period 130 510

Dividend paid 6.5 40.1

The return on Company A's shares (Rs) and the return on the general market portfolio ofshares (Rm) may now be calculated as follows:

periodofstartatPrice

Dividendloss)(orgainCapital

Therefore:

Rs 110

6.5110)(130 0.24

Rm 490

40.1490)(510 0.12

Statistical analysis of "historical" returns from Company A and from the "average" market maysuggest that a linear relationship exists. Thus, the linear relationship can be demonstratedthrough collecting comparative figures from Company A and average market returns (say ona month by month basis). The results can then be plotted on to a scatter diagram and a lineof best fit can then be drawn with linear regression (see Figure 8.2).


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Figure 8.2: Relationship of returns between one company and the market

This approach to analysis could bring out three important issues, namely:

The return from Company A (Rs) and the return from the market (Rm) will tend to rise orfall together.

The return from Rs may be higher or lower than Rm because the systematic risk of anindividual security differs from that of the whole market. Company A is an illustration ofan investment which provides generally higher returns than the market and is thereforeconsidered more risky than the average.

The graph may not always produce a line of good fit. This typically happens whenthere is insufficient data to be plotted, and the data available is being affected by bothunsystematic and systematic risk.

Negative returns may also be possible, which may happen when share prices drop suddenly.This will then amount to a capital gains loss, thereby equating to a negative return.

Our example demonstrates the relationship between an individual company's systematic riskand that of the market fairly predictably. The measure of the relationship between the returnsof the company and those of the market can then be developed in the beta factor () for thatcompany. The line of best fit, also known as the characteristic line, will dictate the betafactor – the steeper the line, the greater will be the beta factor.

The Beta Factor and Market Risk

The beta factor is a measure of a share's volatility in terms of market risk.

We can identify three possibilities for that measurement:

Where > 1, the shares would be described as aggressive, i.e. they would outperformthe Stock Market whichever way the general trend in prices was moving.

Where 1, the shares would be described as neutral, i.e. they would follow thegeneral trend of the Stock Market.

Return fromcompany A’s shares

(Rs)

Return from whole market (Rm)

Line of best fit


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Where < 1, the shares would be described as defensive, i.e. they would be less riskythan the market generally.

As you will see, the market as a whole is assigned the value of "1". If a company's betafactor is 2, this would indicate that it would return twice as much as the market generally.Therefore, it would be expected that, if the market return (Rm) rose by 5%, then the return ina company (Rs) with a beta factor of 2 would rise by 10%. Variations in the company's return(Rs) outside this would be specifically due to the impact of its own unsystematic risk, which isunique to that company.

We should remember that another essential characteristic of the CAPM is that unsystematicrisk can be cancelled out by diversification of the portfolio. In a simple example, CompanyY's shares do worse than the average market returns and Company Z's do better (asoriginally predicted by the beta factor). The net effect will be self-cancelling and therefore theunsystematic risk has been removed from this hypothetical portfolio.

In such circumstances, the average return on the portfolio will be dependent upon:

Changes in the average market return, and

The beta factors of the shares which make up the portfolio.

We will now look at a further example to highlight these points.

Example

Suppose that:

(a) The return on government stock is 10%.

(b) The average market return is 15%.

(The difference of 5% is therefore the excess return as we described earlier.)

The difference between the risk-free return and the expected return on an individualinvestment can be measured as the excess return for the market as a whole, multiplied bythe beta factor of the investment.

Now suppose that we take the example of a company with a of 1.4, the risk-free return is9%, and the expected market return is 13%. The expected return on the company's shareswould exceed the expected market return by:

1.4(13 9)%, or 5.6%

(The total expected return would be 14.6% (9 5.6).)

If the market as a whole fell by an average of 3%, to 10%, then the total expected return onthe company would also fall as follows:

9% 1.4(10 9) 10.4%.

(The fall is represented by 1.4 3% 4.2%)


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The Capital Asset Pricing Model Formula

We can now move on to specify the formula for the CAPM.

The formula is based on the risk-free rate of return, the excess rate of return and the betafactor of the security in question. It is expressed as:

(Rs Rf) (Rm Rf)

or Rs Rf (Rm Rf)

where: Rs expected return from an individual investment

Rf the risk-free rate of return

Rm the market rate of return (the return on the all share index)

the beta factor of the investment.

Alpha Values

The alpha value of a share is used to measure the amount by which the return on thatinvestment is either above or below what is expected, given its level of systematic risk.

Example

A company's shares have a of 1.2, and an alpha of 2%. The market return is 10% and therisk-free rate is 6%.

The expected return 6% 1.2(10 6)% 10.8%.

The current return is 10.8% 2% 12.8% expected alpha return.

You should note that alpha values are only temporary rates and can be () or (). They willtend towards zero for shares over time and will for a diversified portfolio actually be zero ifthe portfolio is taken as a whole.

Where alpha values are positive, they may attract investors, because of an implied abnormalreturn, and the reaction will be a temporary increase in the share price.

The CAPM and Share Prices

The CAPM can also be used to predict share values as well as estimating returns frominvestments carrying different levels of risk. This is shown in the example below.

Company A and Company B pay an annual return of 34.04p per share and this is expected tocarry on indefinitely. The risk-free rate is 8% whilst the average market rate is 12%.Company A's 1.8 and Company B 0.8.

We will now calculate the expected return and predict the market value of each share, asfollows:

The expected return for A 8% 1.8(12% 8%) 15.2%.

The expected return for B 8% 0.8(12% 8%) 11.2%.

Using the dividend valuation model, the expected price of the share can be calculated:

Predicted share value in A 0.152

34.04 224p.

Predicted share value in B 0.112

34.04 304p.


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The CAPM and Gearing

Whilst we will look at gearing in detail in the next study unit, you will already be aware thatthe level of gearing in a company will affect the risk of its equity. Correspondingly, the factor will alter. The extra risk for which the investor is being compensated is systematic riskwhich should be reflected in the company's factor.

We will return to this concept later in your studies.

B. CALCULATION OF BETAS

In the last unit we explained that the slope of the capital market line (also known as thecharacteristic line) dictates the beta factor of a security, and as such it can be calculated bymeasuring the gradient of the securities market line.

The gradient can be calculated using regression analysis. To calculate the gradient (andthus the beta) you would use one of the following regression formulae:

(1) )variance(m

m)s,covariance(

where: m return from the market

s returns from the security.

i.e. the covariance of returns on an individual security with the market as a wholedivided by the variance of the market returns

(2) 22 x)(xn

yxxyn

where: n number of pairs of data for x and y

(3) m

sms

σ

ρσ

where: m the standard deviation of returns on the market

s the standard deviation of returns of the company's equity

sm the correlation coefficient between the total returns on the company'sequity and the total returns on the shares of the individual company.

Example

Returns on Jack plc's shares have a standard deviation of 12% – twice as high as that of themarket. It is estimated that the correlation coefficient of the market and Jack plc's returns is0.45. If the estimated market return is 17% and the return on government bonds is 9% –calculate:

(a) The beta of Jack plc's shares;

(b) The cost of equity for Jack plc.

Using the above formula (3), we can calculate Jack's beta – remember that Jack's standarddeviation is twice that of the market and therefore the market standard deviation is 12/2 6.

m

sms

σ

ρσ

6

45012 . 0.9

The beta of Jack plc's shares is therefore 0.9.


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The cost of equity is the return shareholders expect to obtain from holding their shares (i.e. itis the expected return from the investment) and can be calculated using the capital assetpricing model:

Rs Rf (Rm Rf)

Government debt can be assumed (unless told otherwise) to be risk-free, and thus the returnon it is equivalent to the risk-free rate.

RJack 9 0.9(17 9) 16.2

Therefore the cost of equity for Jack plc is 16.2%.

C. VALIDITY OF THE CAPM

You may feel that this is a very theoretical area, and many of the underlying assumptionstaken from economic theory are unrealistic. However, the lack of realism is unimportant if themodel can correctly predict the return on a security or portfolio for a given level of risk.

CAPM Assumptions

We can list the various assumptions underlying the CAPM and assess the validity of each asfollows.

Investors are risk averse and require greater return for taking greater risks.

Empirical evidence supports this.

There are equal borrowing and lending rates

Generally borrowing rates are higher than lending rates. However, the CAPM can bemodified to incorporate this and the results remain the same.

There are no transaction costs

The existence of transaction costs means that investors may not undertake all requiredtransactions to make their portfolios efficient, thus the CML may be a band rather thana line.

There are no market imperfections

Market imperfections do exist and may mean that unsystematic risk may be of someimportance.

Homogeneous expectations

Clearly not all investors have the same view on the prospects of securities. However,when the assumption is relaxed the CAPM has been found to still maintain itspredictive abilities.

No taxation

The existence of taxation may mean that shareholders prefer capital gains ordividends. However, when this assumption is relaxed the CAPM has still been found tomaintain its predictive abilities.

There is no inflation

Inflation clearly exists and may be seen as an additional risk. However, whenincorporated into the model, the model can still predict the required returns accurately.

It is difficult to test the CAPM because the model deals with expected returns and allsecurities, and it is only possible to record actual results and those securities included inmarket indexes. (Market indexes generally contain only a sample of the securities available


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to investors.) Empirical research suggests that although CAPM is not a perfect model of thereal world it does provide a reasonable model of risk/return trade off. For example, low betashares do provide lower expected returns than higher beta shares; however, low beta sharesoften provide returns above, and high beta shares returns below, those which the modelwould predict. The CAPM is used in practice as a decision-making tool in the choice ofportfolios in both the UK and the US.

Limitations of CAPM

The practical use of CAPM is limited by two major factors. These are:

the acceptability of the assumptions which are not really applicable to the "real world";and

the problems of using the model, given that the assumptions are accepted. Forexample, calculating by examining past returns is assumed as being valid fordecision making about the future and this is far from being acceptable.

The most critical of the assumptions is that individual investors are able efficiently to diversifyaway unsystematic risk. The assumption of efficient diversification is itself dependent onmany other assumptions, including those of a perfect capital market, rationality of investors,etc. Also, you should remember that CAPM is based on a one-year time period, and itsextension to multiple time periods requires the economic environment and returns on theproject relative to the market to remain reasonably stable. It must therefore be used withcare when evaluating projects over longer periods.

Further problems include those of estimating returns on projects and the market underdifferent economic conditions; the probabilities of these different conditions occurring; andthe determination of the risk-free rate. There are several government securities and theirreturn depends on their term to maturity.

There are many reasons why entrepreneurs may not diversify enough as required by CAPM.One compelling reason is that managers simply do not want to diversify from a business thatthey know well, and perceive considerable difficulties in moving outside of their experiences.Similarly, managers may not wish to be actively restrained from "playing the markets",whatever the arguments in favour of diversifying away risk. Moreover, there is considerableeffort and overhead involved in an individual investor attempting to manage a portfolio ofinvestments actively over any length of time. Managers also argue, quite correctly, that it isfor the shareholders to diversify their own risk and construct a portfolio to their ownpreferences, rather than any individual company representing a fully balanced portfolio itself.

While these views appear "irrational" from a purist modeller's viewpoint, you can argue thatthere is nothing rational in acting against your instincts and preferences.

Outside the very short term, the market imperfections of lack of divisibility of investments,fixed charges, imperfect opportunities and poor information mean that the model has poorpredictive ability. Furthermore, each investment or project should have its own discount rateaccording to its systematic risk as measured by its beta co-efficient. The discount rate in anyone year then depends on the risk-free rate of interest and the market risk premium in thatyear. There are ways of forecasting such vagaries but such are the complexities of doing sothat it is beyond the scope of this discussion.

There have been many critics of CAPM such as Rolls (1977) who criticised it as beinguntestable because the benchmark market indices employed, such as the FTSE All ShareIndex, are poor substitutes for the true market portfolio.


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D. PRACTICAL APPLICATIONS OF CAPM

CAPM and Portfolio Management

The capital asset pricing model has several practical uses, and beta factors of individualsecurities are published by a number of analysts (e.g. London Business School) forinvestment and other purposes. The capital asset pricing model can be used by investors inselecting their portfolios of shares, thus reflecting the individual's risk preference. A risk-takerwould select a portfolio with a beta greater than 1 (large gains/large losses) whereassomeone more cautious would select a beta equal to or less than 1. Portfolios of securitieshave beta factors which are the weighted average of the betas of the securities within theportfolio.

Example

Jessica wishes to know the expected return on her portfolio, when the risk-free rate is 7%and the return on the market is expected to be 20%. Her portfolio is made up as follows:

Security Percentage ofPortfolio

Beta Factor of Security

R plc 15 0.2

S plc 10 1.2

T plc 5 1.8

U plc 30 0.9

V plc 25 0.2

W plc 15 0.8

Firstly, let us calculate the portfolio's beta. This is simply the weighted average of theindividual betas:

Portfolio's beta (15% 0.2) (10% 1.2) (5% 1.8) (30% 0.9) (25% 0.2) (15% 0.8)

0.03 0.12 0.09 0.27 0.05 0.12 0.68

The expected return on the portfolio would be

Rp Rf (Rm Rf) so Rp 7 0.68(20 7) 15.84%

Whilst considering the above, a general rule for investors is to buy high beta shares in a bullmarket and sell them in a bear market (and replace them with shares having low betas in abear market).

As discussed above there are several problems with the CAPM which affect its use inportfolio management:

Whilst beta factors are fairly stable over time, errors in calculating them and genuinestatistical variations mean that companies should use industry betas rather thanindividual company betas in order to obtain reliable results. In addition, changingmarket demands (e.g. telephones are now considered more of a necessity than 30years ago) and changing cost structures in firms (firms tend to have a greaterproportion of fixed costs than in the past) means that a company's beta will not remainstable over time.

The risk-free rate is assumed to be equal to returns on government bonds – but thereare several government securities with different terms and interest rates.


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The model deals with expected returns but it is the historical excess return on themarket (Rm Rf) that is used.

The CAPM and portfolio theory are based on perfect, efficient markets with rationalinvestors who have diversified away all unsystematic risk. In reality, however, investorsmay not have well-diversified portfolios and will thus be concerned about their total risk.The model also ignores the costs of trading and insolvency – which do exist in the realworld and the investor must consider them.

CAPM and Capital Investment Decisions

If CAPM is accepted, it might be concluded that, when deciding whether to invest in aparticular project, management should be concerned with its systematic risk and not with itsoverall risk. If the factor can be estimated, then it is possible, using the formula givenearlier, to calculate the minimum required return on the project, based on the systematic riskof the project. The model can thus be used to compare projects of different risk classes,unlike the NPV method which does not consider risk in its choice of discount rate.

In using the model, management are determining a required rate of return based on marketand risk-free rates of returns, the returns on the project and its variation to the market; in sodoing they are assuming that shareholders wish them to evaluate such projects as thoughthey were stocks and shares in the market, and that shareholders are fully diversifiedthemselves and have no desire for the company to diversify on their behalf.

E. THE ARBITRAGE PRICING MODEL

The problems associated with the CAPM have led to the development of other models,including the Arbitrage Pricing Model (APM).

The CAPM is often criticised for its simplified relationship between risk and return. The APM,however, assumes that the return on security is based on a number of factors, each of whichis independent of the others; and that the expected rate of return on a security is a function ofthe risk premiums discussed below plus the risk-free rate. The model states that:

r E(rj) 1F1 2F2 3F3 4F4 ……….e

where: E(rj) the return expected from the security

1 the sensitivity to changes in factor 1

F1 the difference between the expected and actual values of factor 1







e a random term

In order to determine the factors to which returns on the securities are sensitive, and whichform the basis of risk factors, factor analysis is undertaken. Key factors identified include:

Changes in the expected level of industrial production

Unanticipated changes in the term structure of interest rates


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Unanticipated changes in inflation

Changes in the risk premium on bonds

If it is expected that a certain combination of securities will produce higher returns thanindicated by the model then arbitrage trading will occur with the aim of improving expectedreturns. When no arbitrage opportunities remain, the expected return on a security will be:

E(rj) rf 1(r1 rf) 2(r2 rf) 3(r3 rf) 4(r4 rf) ……….

where: rf the risk-free rate

r1 the expected return on a portfolio which has unit sensitivity to factor 1 and zerosensitivity to any other factor




The advantages of APM compared to CAPM are:

The need to determine the market portfolio is removed.

Systematic risk is broken into small components which need not be determined initially.

APM explains the pricing of securities in relation to each other, as opposed to CAPMwhich explains pricing in relation to the market as a whole.

The APM, however, does have disadvantages:

There is a need to identify those factors to which a security is sensitive.

The model is based on simplifying assumptions including portfolio theory, and perfectcompetition.

The APM, in common with CAPM, is a method of dealing with risk and return in uncertainconditions. Empirical evidence has cast doubt upon, but not disproved, either model;however, Hill (1995) states that CAPM is the model used in practice to determine theperformance of portfolios, mainly because the APM has not as yet been fully developed.

Practice Question

Calculate the return on a particular share with a beta factor of 0.7, given the following data:

Return on government securities: 6.5%

Market return: 9%

What would happen if market return:

(a) Increased to 12%?

(b) Fell to 5%?



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ANSWERS TO PRACTICE QUESTION

The return on the share 6.5 0.7(2.5) 8.25%

(a) The result of the increase in market return is that the return on the share rises asfollows:

6.5 0.7(5.5) 10.35%

(b) The result of the fall in market return is that the return on the share falls as follows:

6.5 0.7(1.5) 5.45%

203

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Study Unit 9

Capital Structure

Contents Page

Introduction 204

A. Capital Gearing 204

Gearing Ratios 205

Valuation Basis 207

Scientific Approaches 207

B. Factors Determining Capital Structure 208

Ability of Earnings to Support the Structure 208

Attitudes of Capital Suppliers 209

Patterns of Assets and Trading 210

Demand Patterns 210

Attitudes of Management and Proprietors 211

C. Theory of Capital Structure 211

Traditional View of Capital Structure 211

Modigliani and Miller 212

Impact of Taxation on the Cost of Capital and Capital Structure Decisions 215

D. Capital Gearing and the Effects on Equity Betas 217

E. Operational Gearing 218

204 Capital Structure

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INTRODUCTION

Capital structure relates to the way in which a business is financed by a combination of longterm capital (ordinary shares, reserves, preference shares, debentures, long term bankloans, convertible loan stock and so on) and short term liabilities (such as bank overdrafts,short term bank loans and trade creditors).

A high level of debt creates a financial risk which could have an impact on the business froma number of different perspectives, including both internal and external stakeholders. Thepotential problems might typically include:

The company as a whole could be put in danger of liquidation if it creates high levels ofdebt that cannot be repaid.

If a company goes into debt and is liquidated, then its creditors will suffer as they areunlikely to be paid in full

Management and staff will suffer as, with high debt levels, the business is likely to haveto either streamline or close, leaving some or all workers and management redundant.

If the business has high debts, then the company might not make enough distributableprofits for the shareholders to receive any dividends and this in turn would lead tomarket confidence suffering.

Customers, when faced with a business where consumer confidence is suffering, couldwell seek out alternative organisations with which to do business.

Gearing is the proportion of debt within a company's capital structure, measured asdebt/equity generally at market values. We have seen in previous study units that a highlevel of gearing increases the financial risk of a firm and the required return of shareholders.A high level of gearing may also affect the return required on debt. Thus, the level of gearingof a firm could impact on the company's WACC, and obviously the optimal level of gearing iswhere the company's cost of capital is minimised.

However, whether gearing does affect the cost of a company's capital is an area ofdebate in finance – the two main schools of thought are the traditional view and the theoriesof Modigliani and Miller (known commonly as MM).

Before going on to discuss them we shall consider gearing in some detail – looking at theprincipal factors which influence the financial manager in choosing capital instruments tomaintain balance in the overall capital mix. We have also talked about some of the practicalideas for day-to-day working.

Perhaps the most important point to emerge is that capital gearing is not a simple ratiocalculation with firmly defined ingredients, but more of a multi-dimensional problem. A seriesof factors interact to establish a capital mix, and an appreciation of those factors is importantbefore beginning to attempt financial management in this area.

A. CAPITAL GEARING

The mix of the various types of capital employed within a business is referred to as thecapital gearing or leverage of the organisation. Financial gearing measures therelationship between shareholders capital plus reserves and either prior-charge capital orborrowings or both. Total fixed and current assets have to be financed. Some will befinanced by equity capital, i.e. the ordinary shares and the reserves belonging to theshareholders, and some will (usually) be financed by debt capital, i.e. all fixed-interest-bearing financial instruments.

There are two basic states to be distinguished – high and low gearing.

Capital Structure 205

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High Gearing

When the proportion of debt compared with equity is high, the structure is said to behigh-geared. Typical examples may arise in heavy manufacturing firms whereinvestment in long life, high cost plant means that large sums have to be invested usingborrowed funds.

Low Gearing

When the proportion of debt capital to equity capital is low, the structure is said to below-geared. Service industries and supermarket chains generally have low gearingratios, because they do not have to invest heavily in plant and machinery.Supermarkets are typically cash-based entities and will often receive payment fromcustomers who shop there before they have to settle with their suppliers. As a result,their need to resort to external financing is minimal unless they embark on a majorstore opening, or refurbishment, programme.

The gearing ratio of a business will, therefore, be largely determined by the nature of itsoperations. It follows that particular industries will show common characteristics. Where aprospective investor, or lender, is considering an investment, he or she will look at the typicalgearing ratio for that market sector to compare the efficiency of the business at managing itsfinancing needs, and will query significant variances which cannot obviously be obtainedfrom the published accounts.

Generally speaking, the accepted "norm" in the UK is to maintain a balance of debt capital tototal capital of 1:2, i.e. to finance half of the total assets with debt capital.

Gearing Ratios

Capital mix and capital problems can be analysed by a number of different gearing ratios, theprincipal ones being:

(a)capitalEquity

capitalchargePrior

(b)capitalchargePrior+capitalEquity

capitalchargePrior

(c)employedcapitalTotal

capitalchargePrior

You should always make it clear which ratio(s) are being used and how any figures arearrived at.

Prior charge capital is anything appearing as a charge on the profit of the businessprior to taxation and dividend. The term includes debentures and long-term debt, andpossibly short-term debt.

Total capital employed, in its simplest form, will be the total assets less currentliabilities. However, you should note that certain items may or may not be included –examples are deferred tax and minority interests. You should always remember tostate how you have arrived at your assumptions.

The following is a short example to help to clarify these points.

Consider the following balance sheet.


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PQR plcBalance Sheet at 31 December ....

£000 £000 £000

Fixed assets 4,250

Current assets

Debtors 200

Stock 400

600

Creditors: amounts falling due within one year

Creditors 100

Bank loans 175

Overdrafts 50 325

Net current assets 275

Net assets 4,525

Creditors: amounts falling due after more than 1 year

Debentures 500

Bank loans 500 (1,000)

3,525

Capital and reserves

Ordinary shares 2,000

Profit and loss account 1,000

Preference shares 500

Share premium account 25

3,525

Applying the different gearing ratios we get the following interpretations of capital mix.

(a)Equity

capitalchargePrior

2500010002

500500500

,,

0253

5001

,

, 100% 49.59%.

Note that prior charge capital is made up of:

£000

Debentures 500

Bank loans (of more than 1 year) 500

Preference shares 500

1,500

If short-term loans and overdrafts were included in prior charge capital, this figurewould become (1,500 175 50) 1,725 and the gearing ratio would rise to 57.02%.Equity is taken as total capital and reserves excluding preference shares.

(b)capitalchargePrior+Equity

capitalchargePrior

50010253

5001

,,

,

100% 33.15%.

Again, by including short-term borrowings, the gearing ratio would rise to:


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72510253

7251

,,

,

100% 36.32%.

(c)employedcapitalTotal

capitalchargePrior

5254

5001

,

, 100% 33.15%.

It is not really appropriate to include short-term borrowing in this particular ratiobecause it has already effectively been allowed for in the calculation of net assets.

Valuation Basis

Opinions are divided as to whether the relevant debt and equity contents should be valued interms of book values or market values. Many businesses may well revalue their investmentin bricks and mortar (real property) in view of a decline in market values.

By using market values of ordinary shares, a value will automatically be placed upon theshare capital and the shareholders' reserves, because the market is assumed to have takenthe value of reserves into account in determining the market price of the shares. Similarly,the market value of debt capital will be taken to reflect more realistically the market opinionand therefore the risk of that debt. A market-based approach is, of course, dynamic in thesense that the gearing ratio will alter as soon as market values alter.

This is fine to an extent with quoted companies whose share prices can be readilydetermined at any given point in time. Problems occur, however, with the private company,partnerships and sole traders in view of the difficulty of attempting to arrive at a marketcapitalisation. Supporters of the book value approach will, in attempting to take this intoaccount, argue that market values may not always reflect the real long-term position. Forinstance, strike action in a particular industry may have an adverse impact on the securitiesof a company in the short term which will, by virtue of the market-based approach, bereflected in a temporary and unrepresentative gearing ratio.

It is of fundamental importance to see that all assets are correctly valued, and you shouldnote that book values may not always be realistic, as a result of changes in the propertymarket impacting on the valuation of land and buildings or customer fashions reducing (orincreasing) stock values, etc. A decision will also have to be made as to whether to includeintangibles such as goodwill, patents and brand names. Goodwill may have arisen throughpaying more than the book value to acquire an asset, or group of assets, and it will generallybe deducted from the total asset values since it represents a historic figure which may nolonger apply.

Scientific Approaches

Beyond the simplistic target of financing only 50% of assets, more scientific approaches canbe applied. For example, long-term debt may be limited to a chosen percentage of equityfunds. This approach has the following problems:

The maximum may become the norm.

Unless maturity dates for debt finance are widely separated, the cash implications offinding large sums for redemption may cause problems.

Short-term debt should be restricted to satisfying short-term needs. If a rollover of debt isrequired, the financing of changing interest commitments, as well as the possibility of notbeing able to arrange refinancing, can lead to difficulties.

Another more scientific approach is to consider the number of times a fixed interest paymentwill be covered by annual earnings, which gives an indicator of financial risk. The mainproblems here are:

(a) The determination of an optimum financial risk measure for a particular company.


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(b) Earnings may not always be representative of the cash available to meet interestpayments. Debtors cannot be used to finance debt until they have paid.

Because of (b) above, a rather more detailed approach is to base the level of corporateindebtedness on the ability of the cash flow to support it. A potential debt provider is morelikely to be encouraged to supply funds where he or she can see that the cash flow to fundthe interest payments is planned to be available.

Whilst failing to reach an answer to the optimal gearing level question, the theorists havehighlighted a number of factors a firm should consider, including:

Its future taxable capacity

Risk and volatility of future earnings

Interest cover

Likely costs of financial distress

Availability of other sources of finance

Debt capacity (i.e. assets that can be secured, presence of covenants).

B. FACTORS DETERMINING CAPITAL STRUCTURE

Ability of Earnings to Support the Structure

When the assets to be financed cost £100 and the earnings generated by them are £10, thensuch a level of earnings could only service the £100 if the return expected by the ordinaryshareholders for a class of risk of this type was 10%. Thus, all the earnings would have tobe paid out as dividends.

If the dividend required was, say, 12%, then an alternative structure would be necessary toovercome the problem that the earnings were only £10. Examples of two alternatives aregiven below (in both cases we will continue to use our £100 basis).

Capital Earnings Required£ £

Ordinary shares 50 Ordinary shares at 12% 6

Debentures 50 Debentures at 8% 4

Capital 100 Earnings 10

Or we could have:

Capital Earnings Required£ £

Ordinary shares 40 Ordinary shares at 12% 4.8

Preference shares 30 Preference shares at 7% 2.1

Debentures 30 Debentures at 8% 2.4

Capital 100 Earnings 9.3

Available for reserves 0.7

10.0

Simple though the example is, it should clarify in your mind how the financial manager cancombine securities to arrive at the optimum capital structure for the company. As we can


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see, by using less risky, fixed-interest capital, it should be possible to reduce the demands onequity amounts. In other words, the earnings expectation can be geared down.

The earnings of the capital, the company's policy in paying dividends or distributing retainedearnings, and the return required by the providers of capital will all influence the pattern offinance that the business is able to raise. In turn the financial manager will take account ofpresent, and predicted, future interest rates in an assessment of the most suitable security tobe issued.

Attitudes of Capital Suppliers

Potential suppliers of capital or equity will take account of other factors in addition to the rateof return offered by the company.

Providers of debt capital will consider the security offered and the ability of thebusiness to meet its interest payments (i.e. the interest cover). In the first of our twoexamples above, debenture interest is covered 2½ times by the earnings of 10%.Typically an unsecured lender would look for cover of between three and five times andwe can therefore assume that security would be required in this case.

Providers of equity capital must allow all other forms of capital to be serviced beforetheir dividend can be paid. They will look closely at the debt holder's stake as thevolume of debt will significantly affect ordinary dividends in times when earnings fall.

Let us consider the following, which assumes total payout and no retention. Taxation hasbeen ignored.

Highly GearedCompany

Lowly GearedCompany

Ordinary shares £1,000 £9,000

8% Debentures £9,000 £1,000

Capital £10,000 £10,000

Year 1:

Earnings £1,500 £1,500

Debenture interest £720 £80

Available for dividend £780 £1,420

Dividend % 78% 15.8%

Year 2:

Earnings £720 £720

Debenture interest £720 £80

Available for dividend – £640

Dividend % NIL 7.1%

Debenture interest is, of course, a fixed charge, and the effect of having to service paymentwhen earnings fall is clearly demonstrated. Ordinary shareholders will only be entitled totheir dividend after this fixed charge has been met. In Year 1 the earnings are high and theshareholders in the highly geared company obtain a higher return than those in the lowgeared business. The reverse position is shown when earnings are low, and in our examplethe shareholders in the highly geared company receive nothing.

The effect of the mixture of debt and equity effectively gears up the effect of fluctuating profitsand will generally influence the decision of an ordinary shareholder whether or not to invest.


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Where gearing is high, dividends can be expected to fluctuate in response to profitfluctuations and it will impact on the share prices in due course.

Hence profit maximisation does not always operate in the best interests of the shareholders'future wealth. An influx of debt capital may help to generate additional profit, but there will bea risk that it will disturb the financial gearing ratio, with the result that the market will thendemand a higher return in order to compensate for what it sees as increased risk. This mayresult in the share prices falling and the reduction of the shareholders' wealth in capital gainsterms, without a significant increase in future dividend to compensate for the fall.

Concepts of profit maximisation and shareholder wealth must be set against a relative timebackground. They should not be viewed as simple, absolute requirements. In planning themix of debt and equity capital, the financial manager must take account of the risk attitude ofexisting and potential investors.

Patterns of Assets and Trading

To some extent at least, the pattern of assets in most companies will dictate the gearing. Theuse of secured debt capital will, for instance, require some tangible assets on which thesecurity can be perfected. If the business has few tangible assets, it will have to raise itsfinance through alternative capital instruments.

A second consideration will be the nature of the principal trade of the firm. A stable, wellestablished business, such as a bakery, will generally have less difficulty raising debt capitalthan, for example, a company engaged in extensive research in aero-engine developmentand manufacture. This is because the market will consider the former, being well tried andtested, to be less risky.

Companies in, or about to enter, risk activities, such as developing new markets overseas,will be very likely to raise their financing requirements through risk capital (i.e. equity).Companies planning less risky activities, such as a large new building for their own use, willoften resort to the use of debt capital because of the ease and relative cheapness with whichit can be made available.

Demand Patterns

Progressing from the previous point, the demand for the products of a company, or thenature of the industry as a whole, will impact on the amount of debt capital which can beraised. We will consider this under three headings:

(a) Industry and individual demand

When industrial demand does not continue to grow for a protracted period, no matterhow well an individual company is performing within that industry, it will eventuallysuffer the same problems as the industry as a whole. Careful thought should be givento taking on additional debt capital by a buoyant firm in a declining industry, as theeventual drop in orders may make the financing commitments through interestpayments difficult to maintain. This may not, of course, be the case where a firm inthese circumstances were to raise capital for a diversification project outside theindustry concerned.

(b) Sales stability

A steady sales record is generally considered to be a better pointer to future stability ofsales performance than a volatile record. A steady record will give confidence toinvestors and should facilitate raising debt capital.

(c) Competition

Where a company trades in an industry that demands special skills (e.g. computers), orwhere a large initial investment has to be made on entry to the market (e.g. steel


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processing), there will be less chance of new competition entering the market. Theestablished business in such markets should find it relatively easy to raise debt capital,because the market will be confident in the firm's ability to service its debt payments, asit is unlikely to be faced with new and aggressive competitors in the future.

Where market entry is easy and relatively cheap, the certainty that income will continuefor a business already established in that industry will be reduced. Investors willtypically be more cautious about providing debt capital because of the uncertainty thatit can be financed into the future.

Attitudes of Management and Proprietors

Many people are instinctively conditioned to avoid borrowing external funds if it can beavoided. Even where borrowing is inevitable, they will try to minimise the extent of theircommitments. They have an attitude of "I've never owed anybody anything", a view whichperhaps influences their approach to capital gearing.

It is true that secured borrowing, such as a mortgage debenture secured on the company'spremises, may restrict the business in its free use of the building it occupies. Somemanagers would prefer to retain absolute control of their assets and only use equity. To themthe difference in the cost of debt and equity would be an opportunity cost of havingunencumbered use of their buildings. Whether the concept of control by suppliers of debtcapital is really valid is open to conjecture, as generally little control is ever exercised untilinterest payments are missed.

An alternative way in which some managers approach debt capital is to borrow the maximumamount available at present interest rates. This is only limited by financing ability, availablesecurity and risk. Such a policy may leave the business open to trouble if interest rates rise(if the rates are not fixed or capped), if costs rise, or if sales fall. The advantage is thatincreased debt financing may enable the business to make full use of its resources in aprofitable way. In addition to which, in conditions of rising inflation, the "real" cost of financingfixed-rate debt will decrease as payments will be made out of "future" pounds, the value ofwhich will have been eroded by inflation.

C. THEORY OF CAPITAL STRUCTURE

We noted earlier that the two main schools of thought are the traditional view and thetheories of Modigliani and Miller (MM). Both schools of thought are based on a number ofassumptions. To simplify the theories and to highlight their conclusions, we note theseassumptions at the outset (although some are later relaxed).

(a) There is no taxation.

(b) There are constant earnings, which are fully paid out as dividends.

(c) There is a widespread expectation of the prospects of the company.

(d) Business or operating risk is constant.

(e) There are no market imperfections such as transaction costs.

(f) Companies are immediately able to alter gearing, e.g. by redeeming or issuing debt.

Traditional View of Capital Structure

This view states that as the level of gearing increases, the cost of equity increases and thecost of debt initially remains constant, but once a certain level (not defined) of debt isreached, it starts to increase. The WACC initially falls due to the increasing levels of thecheaper debt, but then starts to increase to reflect the increasing cost of equity (and at higherlevels of gearing the increased cost of debt). We can show this graphically (Figure 9.1):


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Figure 9.1: Traditional View of Capital Structure

The minimum cost of capital is shown at point A.

Modigliani and Miller

To understand the work of MM we must first discuss arbitrage. Arbitrage is any transactionwhich makes an immediate, risk-free profit, and occurs in a situation when two identicalgoods or products (including shares) are sold in the same market but at different prices.Obviously such a situation would not last very long – traders would buy at the lower price andsell at the higher price (thus making a profit) until the forces of supply and demand force thelower and higher price, and thus the market, into equilibrium.

In their 1958 paper MM assumed that there are perfect capital markets (i.e. no taxes ortransaction costs, rational investors and so forth). They concluded that the value of the firmdepends on its assets and the operating income derived from them, and that there is nooptimal capital structure. Firms should thus concentrate on maximising the net present valueof investments.

The theory is based on the principle of arbitrage and can be illustrated by the followingexample.

A plc and B plc are identical except that B plc has £60,000 debt outstanding. The cost of thedebt is 5%. If the traditional theory is correct B plc will have the higher cost of equity to offsetthe risk of holding debt. The cost of equity (Ke) in A plc is 15% and in B plc is 16.5%

A plc B plc

£ £

Net operating income 20,000 20,000

Interest on debt – 3,000

Earnings available to shareholders 20,000 17,000

Ke 15% 16.5%

Market value of equity (Earnings/ Ke) 133,333 103,030

Market value of debt – 60,000

Total value of firm 133,333 163,030


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MM argue that the difference in market values of two identical (except for financing mix) firmswill not remain because the arbitrage mechanism will bring the value of the firms intoequilibrium. The arbitrage process will occur via investors engaging in home-madeleverage, i.e. they will borrow and invest in A plc thus imitating B plc. Some examples willshow how this works.

Example

Charlie owns 10% of B plc. His investment of £10,303 (10% of the equity value) is made upas follows:

£

10% of the value of the firm 16,303less 10% proportionate share of debt 6,000

10,303

Charlie's net return, therefore, is £1,700 (10% of £17,000).

Charlie's wealth could be improved if he:

(a) Sold his equity in B plc for £10,303.

(b) Borrowed £6,000 at 5% (which matches his proportionate share of debt in B plc, andbecause MM assume perfect capital markets individuals can borrow at the same rateas companies).

(c) Invested the £16,303 in A plc.

This would give Charlie a net return of:

£

Return on equity in A plc (Ke 15% £16,303) 2,445.45

less Interest on debt (5% £6,000) 300.00

Net return 2,145.45

Clearly other investors would follow Charlie's lead and the forces of supply and demandwould increase the price of A plc shares and thus lower its cost of equity and vice versa for Bplc until their prices were in equilibrium and no arbitrage opportunities remained.

Shareholders therefore can obtain the benefits from gearing on their own account byduplicating the capital structure of the firm and there is thus no benefit to be obtained to afirm from simply changing its capital structure.

If a firm cannot change its value by changing its capital structure, then its weighted averagecost of capital (WACC) must remain constant because the value of any firm equals the NPVof future earnings divided by its costs of capital.

This leads to one of MM's famous "propositions":

WACCg WACCug earnings before interest/WACC

where: g geared

ug ungeared

The value of the geared firm is thus equal to the value of the ungeared firm which is equal tothe earnings before interest/WACC.

MM then argued that as a company increases its level of gearing the cost of equity increasesdue to increased financial risk (financial risk arises because there are more fixed charges topay before shareholders can obtain any returns), and the increase equals the savings madefrom the lower cost of debt.


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MM's second proposition states that:

The savings from debtbeing cheaper than equity

The increase in cost of equitydue to increased risk

The increase in financial risk can be calculated as follows:

(Keug Kd)eg

d

V

V

where: Vd value of debt

Veg value of equity in the geared firm

Keug cost of equity in the ungeared firm

Kd the cost of debt

We showed above that the WACC of an ungeared and an identical geared firm are the sameand, therefore, the cost of equity in the geared firm must equal the cost of equity in theungeared firm plus a premium for the financial risk discussed above. Therefore:

Keg Keug (Keug Kd)eg

d

V

V

The model is shown in Figure 9.2:

Figure 9.2: MM Without Tax

Example

Scat plc and Millie plc are identical in every way except that Millie has 25% debt at the risk-free rate of 9%, whereas Scat is all equity financed. Scat's cost of equity is 12%. Calculateboth companies' WACC.

Scat plc is all equity financed, and therefore its WACC Ke 12%.

For Millie:

Keg Keug (Keug Kd)eg

d

V

V

12% 1/3(12 9)

13%

Kd

Keg

Level of Gearing

KeugCost of Capital


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WACCg 25% 9% (debt) 75% 13% (equity)

12%

Therefore, WACCg WACCug

There are several criticisms of MM's 1958 theory:

(a) Market imperfections do exist, e.g. there are transaction costs when buying/sellingshares.

(b) Personal borrowing cannot be substituted for corporate borrowing because mostindividuals do not have the capacity to borrow at the levels companies can, nor canthey obtain the same rates.

(c) Debt cannot be assumed to be risk-free because companies and individuals canbecome bankrupt.

(d) MM ignored bankruptcy, and as such their theory may not be valid at very high levels ofgearing where the risk of bankruptcy is greatest.

(e) The 1958 paper ignores taxation.

Impact of Taxation on the Cost of Capital and Capital Structure Decisions

In 1963 MM modified their work to include the effects of corporation taxes. In many countries(including the UK and the USA) debt interest is allowable against corporation taxes. Taxrelief on debt interest is therefore a gain for the shareholders. MM thus argued that the costof capital declines with gearing, and the firm's value increases by the present value of the taxrelief on debt interest.

This can be shown in a graph (Figure 9.3) and illustrated by an example.

Figure 9.3: MM With Tax

Example

Max plc has earnings before interest of £100,000. Its capital structure is made up of 10%debt at a cost of 5%, and 90% equity. The cost of equity is 10%. Max plc operates inConnahland which does not allow debt interest against taxation, but is considering doing sounder a new law. Calculate the change in Max plc's WACC and market value if the law ispassed. Corporation tax in Connahland is 25%.

Cost of Capital

Kd after tax

WACC

Level of Gearing

Ke


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The weighted average cost of capital before the law would be:

WACC (Ke Proportion of equity) (Kd Proportion of debt)

10% 90% 5% 10%

9.5%

Therefore, the value of firm £100,000/9.5% £1,052,632

If the law was passed the WACC would be:

WACC (Ke Proportion of equity) (Kd (1 t) Proportion of debt)

10% 90% 5 (1 0.25)% 10%

9.375%

Therefore, the value of firm £100,000/9.375% £1,066,667

Thus the cost of capital would reduce by 0.125% and the value of the firm would increase by£14,035.

Therefore, the cost of equity for a geared company given above becomes:

Keg Keug eg

d

V

V(Keug Kd)(1 t)

and WACCg WACCug(1 E+D

Dt).

where: D market value of debt capital in geared company

E market value of equity in a geared company

In the example of Scat and Millie above, consider what the situation would be if corporationtax was 35%. Scat plc is all equity financed, and therefore its WACC Ke 12%(unchanged from above).

However, for Millie:

Keg Keug eg

d

V

V(Keug Kd)(1 t)

12% 1/3(12 9)(1 0.35)

12.65%

and WACCg WACCug(1 E+D

Dt)

12(1 (1 0.35)/4

10.95%

or more traditionally to prove the formula:

WACCg 25% 9 (1 0.35)% (debt) 75% 12.65% (equity)

10.95%

WACCg WACCug and the conclusion could be drawn that a company should borrow asmuch as possible – the value of the geared firm will also be greater than the value of theungeared firm by the tax saving on debt.


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However, a firm may reach a point at which it has no taxes to offset debt interest against –this is known as tax shield exhaustion. When such a point is reached there are no longerany benefits to be gained by increasing the level of the firm's gearing.

The theory, like the previous one, has its limitations in that it again ignores bankruptcy andagency costs. It also ignores personal taxation. (In 1977 Miller considered personal taxesand concluded that there was no optimal debt level.)

Empirical testing of these theories is very difficult in practice and as such the optimal level ofgearing (if one exists) remains an unresolved issue. Strictly speaking, they are allhypotheses rather than theories.

D. CAPITAL GEARING AND THE EFFECTS ON EQUITYBETAS

The level of gearing has a significant impact on a firm's beta and has to be considered whenestimating the required rate of return for a new project.

A company's systematic risk, reflected in its beta, is made up of two main types – operatingrisk and financial risk. We saw above that a geared company has a higher financial risk,and thus a higher beta, than the equivalent ungeared company.

You do not need to be able calculate betas for geared companies, but you should understandhow the calculation is undertaken.

MM show, using their 1963 formula that:

g ug [1 Vd(1 t)/Veg]

Using this formula it is possible to calculate the operating beta (or equity beta) of a firm. Theoperating beta shows the risk of the firm's activities as opposed to its financing structure.

Example 1

Sam plc is an all-equity firm with a beta of 1.5. Sugar plc is identical in all respects exceptthat it has 50% debt in its structure. If the rate of corporation tax is 30% calculate the beta ofSugar.


Sugar 1.5[1 1(1 0.3)/1]

Sugar 2.55

It is important to consider differences in gearing when using one company's beta to estimateanother company's because, as noted above, increasing the level of gearing a firm hasincreases its beta. The equity beta of the first company must be found by "ungearing" itscompany beta, and then "re-gearing" it to match the second company's capital structure. Theprocedure is shown in the next example.

Example 2

Arnold Ltd is about to be floated on the Stock Exchange and wishes to estimate its beta. It isvery similar to Oliver plc which has a beta of 1.4, except that Oliver plc has 30% debt andArnold Ltd has 40% debt. Estimate the beta of Arnold using the above information. Assumethe tax rate is 33%.


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First we have to "ungear" Oliver:


1.4 ug [1 30 (1 0.33)/70]

1.4 ug 1.287

ug 1.4/1.287

ug 1.09

Now we re-gear this equity beta for Arnold Ltd's capital structure:


g 109 [1 40 (1 0.33)/60]

g 1.58

Note the higher beta for the higher geared firm, illustrating MM's formula.

Whilst this is a useful tool to know you must be aware of the limitations in using the formulato estimate betas for firms. The limitations include the general limitations of the CAPM thatwe discussed above and in the previous unit. In addition, different firms have different coststructures, opportunities for growth and are of different sizes; as such no one firm can beseen to be identical to another.

The model assumes that debt is risk-free. However, in reality corporate debt has a beta ofapproximately 0.25; it has the effect of overstating geared betas and understating ungearedbetas.

E. OPERATIONAL GEARING

Financial gearing is a principle measure of financial risk.

Business risk refers to the risk of making only low profits, or even losses, due mainly to thenature of the business in which the company is involved. One way of measuring businessrisk is by calculating the company's operating (or operational) gearing.

The usual way of measuring a company's operational gearing is by using the followingformula:

Operating gearing =(PBIT)taxandinterestbeforeProfit

onContributi

where: contribution is sales less the variable cost of sales.

The significance of operational gearing is:

If the contribution is high but PBIT is low, then fixed costs must be high and only justcovered by contribution. This would mean that the business risk, as measured by theoperating gearing, is high.

If the contribution is not much bigger than PBIT, then fixed costs will be low andreasonably easily covered. This would mean that the business risk, as measured byoperating gearing, will be low.

Consider the following example which examines the distinction between financial andoperational gearing (and is taken from the June 2003 Corporate Finance examination paper.)

Example

Blackpool Engineering Ltd produces and sells a computer modem. The company has beenin operation for four years and has an issued share capital of £200,000 (par value 25p per


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share). To date, the company has produced only one product. In the year ended 31December 2000 it sold 20,000 units.

The profit and loss account for the year to 31 December 2000 is as follows:

£000 £000

Sales 1,900

less: Variable expenses (700)

Fixed expenses (400) (1,100)

Earnings before interest and taxation 800

less: Interest payable on 10% debentures (200)

Earnings before taxation 600

less: Corporation tax (198)

Profit after taxation 402

Dividend (160)

Retained profit for the year 242

Recently, Blackpool has been experiencing labour problems and, as a result, has decided tointroduce a new highly automated production process in order to improve efficiency. Thenew production process is estimated to increase fixed costs by £150,000 (includingdepreciation), but will reduce variable costs by £15 per unit.

The new production process will be financed by the issue of £1,000,000 of debentures at aninterest rate of 12%. If the new production process is introduced immediately, the directorsbelieve that sales for the forthcoming year will not change. Stocks will remain at the currentlevel throughout the coming year.

Blackpool's shares currently sell at a P:E ratio of 13:1 and the current corporation tax rate is35%.

Required:

(a) Explain the terms "operating gearing" and "financial gearing".

(b) Calculate the change in earnings per share and in share price if the companyintroduced the new production process immediately. Explain any assumptions whichyou make.

(c) Analyse the implications for share price if Blackpool makes a rights issue at an issueprice of £2.50 per share (ignore issue costs).

Answer

(a) Operating gearing may be defined as a measure of the impact of a change in salesupon earnings before interest and tax (EBIT)

Financial gearing is measured by comparing a company's use of long term financerelative to equity.

(b) Before the project:

EPS =sharesofNo

PAT=

4x200

402=

800

402= 50.3p


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After the project:

£000

Sales 1,900

VC (400) [(700/20 – 15) x 20,000]

FC (550) [400 + 150]

EBIT 950

Interest (320) [200 + 12% x £lm]

Taxable profit 630

Tax@350/o (220)

PAT 410

EPS =800

410= 51.3p

Comments:

(i) As this is only a small change in expected EPS, the project might have to beevaluated on other criteria.

(ii) The solution assumes no repayment of existing debt levels.

(iii) Assuming no change in P:E ratio, the share price will rise:

from (15 x 50.3) = £7.55to (15 x 51.3) = £7.70

(c) Required funding = £1m

The rights price (deeply-discounted) = £2.50

Ignoring issue costs, need to sell£2.50

£1m= 400,000 new shares

Hence, a "one-for-two" rights issue is required.

New number of shares = (800,000 + 400,000) = 1 .2m

Theoretical ex-rights share price:

Before issue:

2 shares@£7.55 15.10

Cash 2.50

£17.60

After 1-for-2 rights issue:

3

6017.£= £5.87

On a forward-looking basis (including the benefits of the project):

Increase in PAT = £8,000 i.e.: 8/1200 = 0.7p per share.

Valuing this at a P:E ratio of 15:1, share price could increase by (15 x 0.7) = 10p

Ex rights price cum project = £5.87 + 0.10 = £5.97

221

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Study Unit 10

Corporate Dividend Policy

Contents Page

Introduction 222

A. Key Influences on Dividend Policy 222

Retention Policy 222

Legal constraints 223

Availability of Internal Funds 223

Profit Available for Distribution 223

Profits and Dividend Level 224

Effect on Share Prices 225

Concept of Signalling – Investor and Market Expectations 226

Shareholder Expectations 226

Company Law on Distributable Profits 226

Other Influences 227

B. Theories of Dividend Policy 228

Fundamental Theory of Share Values 228

Clientele Effect 228

Modigliani and Miller’s Dividend Irrelevance Theory 228

Dividend Relevancy Theory 229

C. Practical Aspects of Dividend Policy 229

Share Repurchases 230

Approaches to the Level of Dividend 231

Non-Dividend Transactions 232

222 Corporate Dividend Policy

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INTRODUCTION

We saw in earlier study units that a firm’s dividend policy is one of the three key decisions itmust make. Corporate dividend policy is the decision between dividends and capital gains(dividends may include scrip dividends, share splits and other perks).

There is a debate in this area as to whether the market value of a company’s shares (andthus the value of the firm and shareholder wealth) is affected by its dividend policy. Beforelooking at the theoretical arguments, though, we shall consider some of the practicalinfluences on a company’s choice of dividend policy, including the key decisions ofinvestment and financing policy..

A. KEY INFLUENCES ON DIVIDEND POLICY

The major source of internally generated capital is retained profits. Once profits have beenearned, the factor which most affects the amount of retentions is the corresponding amountdeclared and paid out as dividends. It is important to remember, though, that the payment ofa dividend to a shareholder is discretionary and this must be balanced against the economicargument that a shareholder is expecting a return on his or her investment. For this reasonwe shall consider retention policy and dividend policy together.

There are, basically, two opposing positions which could be adopted:

That a company should pay out all its earnings as dividends and go to the market foradditional capital as required. It is said that, in this way, the successful companies withthe higher rates of dividend will be best able to raise capital and to flourish, at theexpense of the less successful.

That a company should retain all its earnings and pay no dividends. Investors wouldmaximise their wealth in terms of capital gains, for the company would capitalise itsretentions and issue bonus shares for the shareholder to sell if he wished.

Retention Policy

The company uses its funds in the pursuit of profit and, where that profit is sufficiently large, itwill pay a dividend to shareholders. The surplus then remaining is referred to as retentionsand will be available to finance growth and the replacement, as necessary, of the company’sassets.

These retentions of profits which are ploughed back into the business are internallygenerated capital.

Retentions of profit arise in two forms:

(a) As amounts set aside out of profits prior to determining the amount available fordividends, i.e. provisions of profit.

(b) As the surplus remaining when the shareholders’ dividends have been paid, i.e.retentions. Equally, we could argue that these funds have been invested byshareholders through them foregoing dividends.

Naturally the board must consider the desirable levels of retentions in order to fund futureprojects and growth. Retained earnings are the most important source of finance for UKcompanies, providing most of all funding requirements over recent years.

The main reasons for this may be as follows:

Company managers often mistakenly believe that there is no cost involved whenretained earnings are used. As we shall see later there is, in fact, an opportunity cost

Corporate Dividend Policy 223

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derived from the idea that shareholders have consented to re-invest these earnings inthe company, but it is true to say that there is no cost involving the outlay of cash.

The dividend policy is determined by the directors, who see retained earnings as aready source of cash to invest in their favoured projects without the need, trouble orexpense involved in consulting or raising funds from shareholders and other outsiders.

By using retained earnings the directors avoid the expense of issue costs and, perhapsmore importantly, minimise the risks involved in losing control of the company followingan issue of shares or secured debentures.

These considerations are balanced by the shareholders’ need for at least a minimum returnof the profits and satisfaction of their investment expectations. Equally, though, a company insearch of funds will not be viewed favourably if it is over-generous with its dividends or paysover-generous salaries to its owner-directors (if a limited company).

Legal constraints

Companies are bound by the Companies Act 1985 to pay dividends entirely out ofaccumulated net realised profits, and this includes both profits earned in the current financialyear and those realised historically in previous financial periods.

Whilst the Act does not provide a satisfactory definition of what is meant by accumulated netrealised profits, the Consultative Committee of Accountancy Bodies (CCAB) has issuedguidance that specifies that dividends can be paid out of profit calculated using relevantAccounting Standards after taking into account any accumulated losses.

Availability of Internal Funds

The obvious advantage of internally generated funds is that they become available withoutthe formalities of issuing houses, brokers, offering of security and so on. They arecompletely free of formality but, obviously, the required volume of capital at the required timecannot be made available as easily as it can with external funds, i.e. profits arise as the resultof trading and not simply to ordered dates.

Profit Available for Distribution

There are a number of different considerations that need to be taken into account when acompany is considering the profit available for distribution.

The first consideration is in respect of provisions set aside out of profit.

Depreciation

The annual charge for depreciation in the profit and loss account does not arise due toan outflow of cash at the time the charge is made. The cash outflow associated withthe procurement of an asset (usually) occurs when the asset is first acquired. Theoutflow is treated as capital expenditure and recorded in the balance sheet. Thereafter,depreciation charges “filter” the capital expenditure from the balance sheet to the profitand loss account at periodic intervals.

Note, however, that the charge in the profit and loss account which actually representsa charging of calculating proportions of the original cost of the asset, reduced by anyanticipated scrap value, is not a cash flow-backed item, but a recording of portions ofan historic cost incurred on previous occasions.

Other Provisions

There are many items where this characteristic of non-cash flow backing occurs, e.g.provision for doubtful debts; provision for plant maintenance; provision for majorrepairs.


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The effect of creating provisions for depreciation and other items is to reduce the profitavailable to pay out dividends and/or make retentions. Because of this, amounts of cash areheld back in the business and are not paid as dividends. They become available for otheruses, e.g. fixed asset purchase.

It is important to note that usually, with provisions, a sum of money is not physicallyseparated from the rest in the bank account to substantiate the provision made. The cashnot now required for dividends, because provisions have been made, can be put to generaluse. Some companies may in fact create a separate fund into which the cash backing fortheir provisions is put. This requires cash to be paid out and an investment purchased. Inthis case the creation of provisions does not comprise internally generated funds.

Where, however, the creation of provisions, their eventual spending and consequentreplacement is a more or less continuous process, then such provisions represent asignificant proportion of internally generated funds.

In practical terms it is recognised that at least some prudence is necessary, at least in timesof changing prices, to prevent the “real” value of the business being depleted. You can seethis in current cost accounting, where revaluation surpluses and deficits arising from changesin the prices of fixed assets and stock etc. are taken to a non-distributable reserve. The ideabehind this is that if such amounts were distributed it would imply that the operating capabilityof the business had been eroded.

You should not, however, think that the “current cost profit attributable to shareholders”,apparent from current cost accounts, can prudently be distributed. Other matters must beconsidered, such as cash availability, capital expenditure plans, changes in volume ofworking capital, the effect on funding requirements of changes in production methods andefficiency, liquidity, and new financing arrangements, as well as the effect of price changeson the finance required.

Taxation liabilities. The level of estimated corporation tax liabilities needs to beconsidered as part of the process for determining the level of available funds fordistribution as profits to shareholders.

Investment opportunities (or a significant percentage) are often funded from retainedprofits and it is also important that the company ensures that a correct balance is struckbetween leaving enough retained profits to fund much needed investment opportunitiesand the payment of dividends to shareholders.

Liquidity issues. Since dividends are payments of cash out of the business thedirectors need to ensure that the company, at all times, has sufficient liquid resourcesto make dividend payments and to run their day to day transactions.

Profits and Dividend Level

Assuming that there are sufficient profits available, it is extremely difficult to determine whatinfluences a board of directors in declaring a particular level of dividends and hence making aparticular level of retentions.

You might think that dividends would be increased in line with increases in profits. However,there is a noticeable tendency in practice for there to be a time lag before dividends areincreased following an increase in profits. This is because companies like their dividend rateto be maintained and to increase steadily rather than fluctuate from year to year. Directorswill tend to wait until an increase (or decrease) in profits appears to be sustained beforebuilding it into the rate of dividend. This controlled, stable approach is felt to produceconfidence by investors in the financial management of the company.


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From this approach a behaviour pattern can be determined for the process of fixing dividendlevels. The decision becomes strongly related to past behaviour:

What was last year’s dividend?

What are this year’s available profits?

Should the dividend be increased or decreased?

If so, by how much?

Can that position be sustained?

The effect of this cautious behaviour is to produce a time delay between increases in profitsand consequent increases (or decreases) in dividends.

This time delay is important for two reasons:

(a) As a company’s profits increase – and since the directors will tend to delay dividendincreases – retentions will increase. If a company’s profits decrease, retentions will bedecreased.

(b) Generally, when an increase in dividend rate is announced, it will be fair to assume thatthe directors feel that the increased level will be capable of being sustained in thefuture. Alternatively, dividend level will only be reduced if the directors feel that theexisting level cannot be maintained in the future.

Effect on Share Prices

The impact on investors of the level of both dividends paid and earnings retained need to beconsidered.

(a) Dividends

The market price of a share is a single point indicator of all the expectations andinterpretations of the future investment suitability of the company by its shareholders.“Shareholders” will represent a complete cross-section of the financial institutions andthe investing public, all with their differing motives and requirements from theirshareholding. Thus, so many factors are built into the share price that it is impossibleto isolate any one factor with certainty. Generally, however, in line with reason (b)stated above, if a dividend rate is increased, the investors will assume that the newlevel is likely to be at least maintained and, since the yield from the shares hasincreased, and increase in market price will usually follow. In the long term, shareprices tend to follow the yield of the share.

Although not all shareholders will be holding shares for the dividends offered – they willbe primarily interested in capital gains – dividends are undoubtedly a tangible returnfrom the investment and are likely to have a marked effect upon share prices.

(b) Retentions

To make retentions is to defer the time when shareholders receive dividends. Bymaking retentions (“ploughing back” profits) the company is growing and will be able toearn larger profits, pay bigger dividends, grow still bigger and so on. So the promise isthat by retaining funds the company can invest them (in itself) and gain a better returnthan if they had paid the funds over to the shareholders for them to invest elsewhere(i.e. externally to the company).

There is thus an implied promise that dividends in the future will be increased. Thispromise may well be seen as more risky than tangible amounts of dividend at thepresent moment, and usually a less marked increase in share prices followsretention than follows increased dividends.


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There have been many surveys and studies on this topic, involving different sized companiesand types of industry with different shareholding patterns, set against varying periods ofeconomic activity, rates of inflation, world situations and Stock Market confidence. Notsurprisingly, there are conflicting findings by the various authorities, not only because of thefactors indicated but primarily because such studies attempt to quantify, in mathematicalterms, the behaviour of a large and diverse group of human beings.

Concept of Signalling – Investor and Market Expectations

This brings us to the concept of “signalling”. In reality investors do not have perfectinformation, particularly about the prospects of the company. The pattern of dividendpayments is therefore taken as a key to estimating future performance.

An increase in dividends is taken as a signal of increased management confidence and leadsinvestors to increase their estimates of future earnings thereby causing a rise in the shareprice. A dividend cut, on the other hand, is taken as a bad sign and the share price maydecline.

In practice, many factors are already discounted by the market in the prevailing share price,so movement only really occurs on the announcement of a dividend if the amount is differentto that which the market was expecting anyway. The dividend announced merely confirmsthe market’s expectations. This gives directors the opportunity to enhance expectations byan unexpectedly high dividend (which must be sustainable in future years) or of reducingexpectations by an unexpectedly low dividend.

Shareholder Expectations

No matter what their preference for dividends as opposed to capital growth in the value oftheir shares, all shareholders will hold some expectations about what the dividend should be.Often this is based on prior dividends and a vague idea of an acceptable pay-out ratio, sothat as profits grow there is an expectation that dividends should keep in step.

Furthermore, it is generally accepted amongst shareholders that dividends should matchthose declared last year or show an improvement. A stable dividend is taken (quite wrongly,perhaps) as a sign of a stable company. This often forces directors to declare too large adividend when losses have been incurred in order to “save face” and prevent the share pricefalling. Having to “pass” either a final or interim dividend became a subject of great concernduring the recession of the early 1990s.

Company Law on Distributable Profits

The Companies Acts lay down stringent rules which govern the power of a company todeclare a dividend. Under S.263 of the 1985 Act, for instance, it is restricted to themaximum of the aggregate of accumulated realised profits less accumulated realised losses.Thus, in this instance, it is the current net balance of distributable reserves which is theimportant figure.

In addition, public companies are also constrained by S.264 in that a dividend may only bepaid if net assets, after payment of the dividend, are equal to or greater than the total ofcalled-up share capital plus any non-distributable reserves. The latter includes:

Share premium account

Capital redemption reserve

Accumulated unrealised profits less accumulated unrealised losses not yet written off

Thus, the difference here is that unrealised profits and losses must also be taken intoconsideration, e.g. asset revaluations which have not yet yielded a profit or loss (dependingon whether the revaluation was up or down).


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Public companies usually pay dividends twice a year: an interim dividend after the interimresults, and a final dividend, but only after the final results (and therefore this final dividend)have been approved by the shareholders.

Remember, shareholders have the power to reduce the dividend payable, but not to increaseit. Company directors are therefore in a strong position and for all practical purposesshareholders are often obliged to accept the proposed dividend.

Other Influences

(a) Personal taxation of shareholders

Different shareholders will suffer different rates of personal taxation on any dividendincome which they receive. Thus, if a dividend of 10p per share is declared, thosepaying basic rate income tax at 20% will receive a net amount of 8p, whereas thosepaying 40% will only receive 6p. Therefore, if the rate of capital gains tax is lower (afterthe individual’s CGT annual exemption) than the shareholder’s marginal rate oftaxation, he will prefer a situation in which less is distributed as dividend but is insteadretained within the business to provide capital growth.

(b) Government policy: dividend restraint

From time to time the Government has operated a policy of dividend restraint as part ofa (prices and) incomes policy. No such constraints exist at present. Equallygovernments could restrict the flow of funds to investors outside its borders or to certaingroups or individuals if they were so disposed.

(c) Profitability

As we have seen, the profitability of a company is a key factor in the amount which canbe paid out in dividends. If profits are volatile it is unwise to commit the firm to a highpay-out.

(d) Inflation

In times of high inflation dividends based on historic cost profits can lead to distributionof the company’s capital almost inadvertently, thereby reducing the operating capacityof the business.

(e) Growth

Rapidly growing companies may prefer to re-invest the bulk of their earnings ratherthan distribute them as dividends. This is often the case with newly-formed companies.Alternatively some companies (perhaps those backed by venture capital) will beobliged to offer higher dividends because of their relatively riskier investment.

(f) Other sources of finance

Unquoted companies in particular may find it difficult to access other sources offinance. Retained earnings are important and dividends will therefore tend to be small.

(g) Control

By using internally generated funds ownership or control is not threatened anddirectors are free to use such funds as they see fit rather than convince new investorsof the benefits of their schemes.

(h) Cash flow considerations

A company declares a dividend out of its Profits After Taxation. This is a dividend net ofany tax, and the full amount will have to be paid.


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B. THEORIES OF DIVIDEND POLICY

There is a debate as to whether the market value of a company’s shares (and thus the valueof the firm) is affected by its dividend policy. This is reflected in the several theoriesregarding dividend policy, all of which have one common premise – that the aim of dividendpolicy should be to maximise shareholder wealth (which depends on both current dividendsand capital gains).

Fundamental Theory of Share Values

This model, also known as the traditional model, states that the level of dividends paid isimportant.

The fundamental theory of share values (which assumes that the market value of thecompany depends on the size and growth rate of dividends paid, and the rate of returnrequired by shareholders) values the company using the dividend growth model. Theimplications of this theory are that shareholders will want management to pursue adistribution/retention policy which will maximise the level of, and growth in, dividends.

Clientele Effect

There may not, however, be an optimal distribution/retention policy that the firm can adopt tomeet the needs of all shareholders, because of the different taxes (capital gains and incometax) and tax rates borne by different investors. A company should choose and maintain onepolicy which maximises one group of shareholders’ wealth. Shareholders will then migrate tocompanies which operate a policy in line with their needs – this is known as the clienteleeffect.

The changes in the treatment of tax credits in the 1997 Budget has had a major impact onthe preferred dividend policy of pension funds. Until then, pension funds were able to claimback tax credits on dividends received. As a result of the Budget changes, dividend yield willreduce in significance, as will the preference for dividends over capital gains by this particularclientele. Ten years on from the 1997 budget, these changes to the tax treatment ofdividends have been shown to have had a major impact on pension fund valuations and oneof the main reasons for the stopping, in large numbers, of company “final salary” pensionschemes.

Modigliani and Miller’s Dividend Irrelevance Theory

Modigliani and Miller’s dividend irrelevance theory argues that the value of a company isdetermined by the NPV of the investments undertaken by the company, and not by anydistribution policy.

MM showed that changes in the value of a firm’s shares are not dependent on the actualpattern of dividends paid (you do not need to know the workings of proof for this theory).They argue that if a company issues a dividend from retained earnings, and then needs toraise cash for an investment, the loss on shares of the additional finance is exactly equal tothe dividend paid, and a company should therefore be indifferent as to its dividend policy.Moreover, whilst accepting the existence of the clientele effect, MM state that the type ofclientele a firm has will have no effect on a firm’s value.

This argument assumes perfect capital markets and rational investors, and theseassumptions are the basis of the criticisms of MM’s model:

(a) It assumes that share issue costs are zero, and ignores the potential problems ofcapital rationing.


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(b) There is no taxation. In reality:

The timings of ACT payments discourage high dividend payouts by companies.

Taxpayers may have a slight preference for capital gains.

Some taxpayers will be indifferent between capital gains and dividends.

(c) Shareholders receive all relevant information about the company’s reinvestment plans.This ignores competition and different perceptions of risk.

Dividend Relevancy Theory

There are several arguments that support the idea that the level of dividend will have aneffect on the value of the firm – the dividend relevancy theory.

The effects that different tax rates have on investors’ preferences.

Market imperfections mean that a positive NPV project will not be automaticallyreflected in the firm’s share price, but its effects will be shown over time, whereas areported dividend has a much quicker impact on the share price.

Empirical evidence shows that investors prefer a constant dividend policy with eitherconstant dividends or dividends growing at a constant rate helping them plan theirfinances.

If capital rationing exists then it may be cheaper (because of issue costs and so forth)for the firm to retain its earnings and pay a lower level of dividend.

Uncertainty as to the future means that shareholders may prefer a certain dividend toan uncertain capital gain.

C. PRACTICAL ASPECTS OF DIVIDEND POLICY

In practice a company must consider several factors when determining its dividend policy.Note that it is the directors who determine dividend policy.

It has to match its dividend policy to its clientele, to prevent a mass buying and sellingof its shares.

If a company faces a takeover, management might declare an increased dividend as adefence. The market might perceive the increased dividend as a sign of improvedfuture profitability of the company and its share price will rise. This makes it moreexpensive for any potential takeover bid. In 1996 National Power paid a specialdividend of £1 per share. At the time the company was subject to a hostile takeover bidfrom a US electricity company.

High dividend payouts reduce the risk that shareholders may lose all their investment.

Dividends act as a signal to indicate the future prospects of the company – a suddencut in dividends indicates that the company is experiencing difficulties, and vice versafor an increase in dividends.

The market expects companies in general to follow industry practice.

The company should finance as much investment as possible using retained earnings,to avoid finance issue costs, and an issue of equity capital may have an impact on thestatus quo of shareholding control and may leave the company open to a takeover bid.

The necessity for companies to repatriate overseas profits.

The level of profits made and the legal position regarding the payment of dividends inits country (or countries) of operation.


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Repayment of debt and any restrictions on dividend payments under loan agreements.

The liquidity of the company should be considered, together with the timing of cashflows (the company must remain solvent and have enough cash to pay any dividends itdeclares).

The level of inflation affects the level of dividend which can be paid – companies mustensure they have sufficient capital to maintain their operating capability.

The company’s gearing level can have an effect on its dividend policy – any reductionin retained earnings will increase its gearing ratio.

The company may have a large amount of cash which it may wish to return to itsshareholders, especially if its future cash flow predictions are strong. A large amount ofsurplus cash was another reason for the 1996 National Power special dividend mentionedabove. This is a payment in excess of the usual amount that would normally be paid toshareholders.

Share Repurchases

Repurchases, or buy-ins, of shares may be made by companies out of their “distributableprofits”, or out of the proceeds of a new issue of shares made especially for the purpose,provided they are authorised to do so in the company’s Articles of Association.

A company may not, however, purchase its own shares:

(a) Where, as a result of the transaction, there would no longer be any member of thecompany holding other than redeemable shares.

(b) Unless they are fully paid up, and the terms of the purchase provide for payment onrepurchase.

Purchases may be in the market or off-market. An off-market purchase is said to occurwhen the shares are purchased not subject to the marketing arrangements of the StockExchange, or other than on a recognised stock exchange. A buy-in of shares by a publiccompany will be subject to the rules of the Stock Exchange and to the provisions of companylaw.

The change in the capital base will cause management to rethink its investment decisions,gearing, interest cover, earnings, etc. This is particularly important as the financialinstitutions focus their attention more towards income and gearing as an indicator of financialrisk.

It is important to be aware of the various advantages and disadvantages of sharerepurchases. The advantages of share repurchases include the following:

It may allow a company to prevent a takeover bid. The control by the existingshareholder group will be increased.

A quoted company may purchase its shares in order to withdraw from the Stock Market(see below).

It can be a useful way of using surplus cash.

Repurchasing shares will reduce the number in circulation which should allow anincrease in earnings and dividends per share, and should lead to a higher share price.It will increase future EPS as future profits will be earned by fewer shares.

Reducing the level of equity will increase the gearing level for a company with debtwhich may be considered beneficial by the company.

If the business is in decline a share repurchase may give the firm’s equity a moreappropriate level.


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The disadvantages of share repurchases are that:

Repurchasing of shares may be viewed as a failure by the company to manage thefunds profitably for shareholders.

The company requires cash for the repurchase.

It may be difficult to fix a price which is beneficial to all involved.

It requires existing shareholder approval.

Capital gains tax may be payable by those shareholders from whom the shares arepurchased.

It increases gearing.

What Percentage Dividend Payment to Make?

There are a number of different payment options that a company might consider in thepayment of dividends.

A company may pay a constant and fixed percentage of profits in dividend payments. Such aconstant payment percentage sends out a clear message to shareholders about theexpected level of performance and it is also relatively easy and clear to operate. One of themain problems with this approach, though, is that the company may reduce its ability to fundmuch needed investment and have to go to the financial markets when it would perhapshave preferred to use retained profits.

A company may decide to offer no, or zero, dividends at all. Given that most shareholderswould expect a return on their investment (and this would certainly include all the majorpension funds), then this approach is unlikely to be popular and in the long term would not bein the best interests of the company.

Some companies like, if possible, to pay an increasing dividend year on year. This is goodfor shareholders generally and should attract more shareholders (with some subsequentpossible effect on share price). It is possible, though, that if a company tries to do this yearon year, it is likely to have a negative impact at some stage on the company’s ability to fundmuch needed investment. It is also likely that if, for good reasons, the company needed toreduce the rate of dividend, this would have an adverse effect on the attitudes of bothshareholders and the market generally.

Approaches to the Level of Dividend

Three approaches may be identified.

(a) Dividend cover

This is the earnings per share divided by the net dividend per share. This indicates thenumber of times the same dividend could have been paid on the shares from thecurrent year’s earnings alone.

One dividend policy is to pay out a fixed dividend per share each and every year,which could be fixed in either real or money terms. This is the most common policy,with most companies going for stable, slightly rising dividends per share – the “ratchet”dividend policy.

(b) The pay-out ratio

Pay-out ratio is the relation of dividends paid to ordinary shareholders to the earningsavailable to be paid out to ordinary shareholders. As such, it includes previouscumulative earnings.

Another dividend policy is to maintain a constant pay-out ratio. Naturally the dividendwill fluctuate each year depending on the level of retained earnings and any


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movements in reserves. This policy is quite rate in listed companies, though manyfirms may work towards some notional target pay-out ratio.

(c) Residual value

A third, less common, dividend policy is to use retained earnings to fund all projectswhich show a positive net present value (NPV) at the firm’s weighted average cost ofcapital (WACC) and pay out any remaining funds as dividends.

This is possibly the most objective dividend policy for rational investors but theconcerns of “signalling” (see above) often overrule such a common sense approach.

Non-Dividend Transactions

You should not forget that there are alternatives to cash dividend payouts, as follows.

(a) Scrip issues

A scrip issue, also referred to as a capitalisation, or a bonus issue, involves theconversion of reserves into capital, causing a fall in the reserves. Shareholders receiveadditional shares in proportion to their holding. Unlike a rights issue no additionalfunds are brought into the company – the shareholders do not “pay” for these shares.There is then more equity in circulation with the result that the market value willgenerally fall in the short term, thus making it more attractive to potential investors.The reserves used are either from a credit balance in the profit and loss account, orfrom reserves specifically marked for the payment of shares, and authority is requiredfrom the articles of association and the AGM.

(b) Scrip dividends

Scrip dividends are a conversion of profit reserves into issued share capital offered toshareholders in lieu of a cash dividend. Enhanced scrip dividends are those wherethe value of shares is greater than the cash dividend offered as an alternative. Suchdividends are of benefit to the company as they maintain cash within the business.There may, however, be tax complications arising for individual investors.

(c) Stock split

A stock split is the splitting of existing shares into smaller shares, e.g. each ordinaryshare of 50p is split into two of 25p, in order to improve marketability of the company’sshares. It can also be used to send signals that the company is expecting significantgrowth in EPS and dividends per share, and for this reason the resulting market priceof the split shares is higher than the simple split price would be. For example, if ashare with a market value of £10 was split into two shares their price would be higherthan £5. Reserves are not affected.

(d) Shareholder concessions

A number of companies offer discounts of one form or another to their shareholders.These can be thought of as a dividend in kind and are a useful marketing tool orpublicity exercise – for example, hotel groups often give a concession to shareholderson room rates

While these are often attractive to small shareholders (institutions rarely qualify, in anycase) they are often not a good reason for investment. The concession can beremoved at any time and often a significant holding must be maintained. To qualify forconcessions, shareholders usually have to hold a minimum number of shares.

An advantage, however, is that they are tax exempt!

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Study Unit 11

Working Capital and Short-Term Asset Management

Contents Page

Introduction 235

A. Working Capital 235

Rate of Turnover of Working Capital 235

Ratios Associated with the Assessment of Working Capital 237

B. Overtrading 243

C. Cash Management 245

Cash Flow Planning 245

Margin of Safety 246

Cash Management Problems 247

Cash Ratios 247

Factors Affecting Cash Resources 248

Cash Management Models 248

D. Management of Stocks 251

Cost of Stockholding 251

Stock Turnover Ratios 252

The 80:20 Rule 252

Economic Order Quantity 253

Just-In-Time (JIT) Method of Procurement 255

E. Management of Debtors 256

Debtors' Turnover Ratio 256

Actions Available to the Company 256

Credit Control 257

Establishing Credit Limits and Terms 258

Debt Recovery and Management 259

Management Control Information 260

Credit Insurance 261

Trading Abroad 262

(Continued over)

234 Working Capital and Short-Term Asset Management

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F. Creditor Management 263

G. Short-Term Finance and Investment 263

Management of Short-Term Finance 263

Short-Term Investments 264

Specialist Sources Of Finance 265


Working Capital and Short-Term Asset Management 235

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INTRODUCTION

Funds employed in an organisation can be split for planning purposes into long-term andshort-term funds. As we have seen in an earlier module, the financial manager will attemptto match the funding available to the business to the life of the investment it is required for.In this study unit we will consider the management of short-term funds applied to fundingcurrent assets.

We shall start by looking at the definition of working capital, its constituent parts andrelationship to fixed capital, and some common ratios that can be applied as a managementtool. We then go on to consider the implications of cash management. Balance in cash flowmanagement is very important: too little cash resources highlights impending danger, but toolarge a reserve of cash will mean that potential future earnings will be impaired.

The financial manager must predict the needs of the business and make suitable funding orinvestment arrangements – planning the effective use of the financial resources, applying tothe working capital of a business. We shall discuss the specialist financial products that areavailable to help to reduce the cash tied up in debtors, and look at ways in which thecompany can decide on an optimum period of credit to be granted within the generalconstraints of the markets in which it operates.

A. WORKING CAPITAL

Working capital is the total amount of cash tied up in current (i.e. short term) assets andcurrent (i.e. short term) liabilities, and is calculated by deducting the total amount of currentliabilities from the total amount of current assets. Thus, if A plc has current assets of £10mand current liabilities of £6m then its working capital resources are £4m. Working capital issometimes expressed as the current ratio (see below) and current assets (less closingstock) as the quick or acid test or liquidity ratio.

The finance needed to fund a firm's required level of working capital can be either short orlong term.

It is essential to ensure that a firm has sufficient working capital to allow it to operatesmoothly and have sufficient funds to pay its bills when they arise, including taking account ofthe effects of inflation and projected future cash flows. However, an organisation should becareful not to over-provide working capital and cause unnecessary cost, a phenomenonknown as overcapitalisation.

Overinvestment in working capital leading to excessive stocks, debtors and cash, coupledwith few creditors, is known as overcapitalisation. Such a situation will lead to lower returnon investment and the possibility of having to secure long term funding to pay for short termassets which is not an ideal situation for a business to be in. Indicators of overcapitalisationinclude long turnover periods, high liquidity ratios and a low sales/working capital ratio.

Rate of Turnover of Working Capital

An organisation needs to control the rate of turnover of working capital constituents. Whilstreducing the rate of turnover reduces the level of working capital required, it may lead toovertrading (see later).

The rate of turnover of working capital can be determined by calculating the working capitalcycle (also called an operating cycle, trading cycle or cash cycle), which shows therelationship between investment in working capital and cash flow.


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The following is an example of a typical working capital cycle:

Raw materials in stock 20 days

Work-in-progress 21 days

Finished goods stock 38 days

Period between despatch and invoice to customer 10 days

Period from invoicing to customer payment 60 days

Total 149 days

If the supplier of the raw materials required payment after 60 days, the company would needto fund the cost of the goods sold for a period of 89 days, and of course wages and otherexpenses would have to be paid during the period. Steps taken to speed up the rate ofworking capital turnover, e.g. reducing stock levels, therefore means reducing the company'sinvestment in working capital.

To illustrate this point further, let's look at an example.

Example

A company sells £20m of goods throughout the 50 weeks of the working year. As the salesare partly through retail outlets and partly through mail order, daily sales from Monday toFriday can be considered to be equal. The firm banks its takings on Thursday of each weekand the incremental cost of banking is £50. The company's account is always overdrawnand it pays interest on this overdraft of 15% pa (in this example to be applied daily on asimple interest basis).

Management wish to know whether there will be a benefit to banking twice weekly onMonday and Thursday. Investigate the possibility.

£20m over 50 weeks of the year gives a turnover of £400,000 per week and £80,000 per dayfor a five-day week.

We will now assess the banking alternatives being considered:

Day Receipts Banking Thursday only Banking Monday & Thursday

£000sDays Interest

Charged"£ days"

£000sDays Interest

Charged"£ days"

£000s

Monday 80 3 240 0 0

Tuesday 80 2 160 2 160

Wednesday 80 1 80 1 80

Thursday 80 0 0 0 0

Friday 80 6 480 3 240

960 480

Banking only on Thursday has the same effect as having an overdraft of £960,000 for oneday each week. In terms of interest, the cost of this is:

£960,000 (15% 365) 50 £19,726.*

The annual interest cost of banking twice weekly is:

£480,000 (15% 365) 50 £9,863.*

(*For interest purposes, we are using a calendar year.)


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Annual incremental banking costs at £50 per time are:

Once weekly, 1 £50 50 £2,500

Twice weekly, (2 £2,500) £5,000.

The total cost of banking on Thursdays only is:

£19,726 £2,500 £22,226.

Banking on Mondays and Thursdays costs:

£9,863 £5,000 £14,863, a saving of £7,363 pa, assuming constancy of all factors.

There is one even better solution, still banking twice weekly. Can you decide what it is?

Day Receipts Banking Tuesday & Friday

£000sDays Interest

Charged"£ days"

£000s

Monday 80 1 80

Tuesday 80 0 0

Wednesday 80 2 160

Thursday 80 1 80

Friday 80 0 0

320

The calculation is as follows:

£320,000 (15% 365) 50 £6,575, and the total cost is:

£6,575 £5,000 £11,575.

An alternative way to compare the different banking methods would be to count the numberof days interest is charged. Interest is charged when the money is with the business and notin the bank. Paying takings in more quickly means a reduction in interest charged on theoverdraft (and less risk of loss or theft).

The summary of the days' interest is as follows:

Banking Thursday: 12 days

Banking Monday and Thursday: 6 days

Banking Tuesday and Friday: 4 days

If such an exercise was to be conducted over a period of several years then discounted cashflows (see later study unit) would be used.

Ratios Associated with the Assessment of Working Capital

In attempting to control working capital a financial manager will use some of the ratios wediscussed earlier in the course. However, unlike someone external to the company he willnot be restricted by balance sheet figures but will be able to monitor the ratios continually.

The main ratios that the financial manager will use in this area are the current ratio, quickratio and acid test ratio.


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(a) The current ratio (or working capital ratio) is measured as:

sliabilitieCurrent

assetsCurrent, expressed as a ratio, e.g. 2:1

Whilst there is a suggested target ratio of 2:1, the acceptability of the ratio calculatedwill depend on the nature of the business, but current liabilities exceeding currentassets generally indicate that the business may have problems. In common with allratios it is important to monitor its trend in order to ascertain whether there arepotential problems developing. It is also useful to monitor the ratio by reference to thatof competitors to establish if it is higher than equivalent businesses.

(b) The quick asset ratio removes those items which cannot easily and quickly beconverted into cash at their full value (i.e. stock) and is calculated as:

sliabilitieCurrent

StockassetsCurrent

Again there is no ideal ratio; the acceptability of the one calculated depends on theindustry (although the target is 1:1). In addition, it is the trend over time that isimportant. Again, it is also useful to compare this ratio with that of competitors toestablish if it is higher than equivalent businesses.

(c) The acid test ratio is the amount of cash which the firm has to service its currentliabilities and is measured as:

sliabilitieCurrent

sinvestmentQuoted+Deposits+Cash

Again it is the trend that is of most importance and it is also useful to monitor the ratioagainst that of competitors to establish if it is higher than equivalent businesses.

Companies with poor acid test ratios need to have standby overdraft facilities in orderto ensure that the short-term need to service payments of current liabilities can be met.However, remember that too much cash will mean that the firm is under-utilising itsresources and that a better return could be available elsewhere.

The working capital cycle starts with the investment in raw materials which are then used inthe production process and, therefore, become partly finished goods. Eventually, finishedgoods are produced which are then held in stock until sold. Some of these goods might besold for cash and the rest would be sold on credit with the customer paying days or weekslater (depending on what arrangements the individual debtor had with the business andindeed how long each debtor takes to pay). At each stage of the process, expenditure isneeded on labour and other operational requirements. Helping to ease the cash burden aresuppliers who supply credit to the business.

Money tied up at any stage in the working capital cycle has an opportunity cost.

Cash conversion cycle

The cash conversion cycle is a part of the working capital cycle and can be expressed asfollows:

"The cash conversion cycle is the length of time elapsing between parting with cashand getting it back from customers".

How is the cash conversion cycle measured?

There is a need to complete three key working capital ratios:


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(a)Sales

Debtorsx days (365) in year

plus

(b)salesofCost

Stockx 365

minus

(c)Purchases

Creditorsx 365

equals

Cash conversion cycle

Example

The following example has been taken from a question in the Corporate Finance paper forJune 2006.

Lancaster Model Aeroplanes Ltd has become increasingly concerned over its liquidityposition in recent months.

The most recent set of final accounts for the business show the following:

Profit and Loss Accountfor the period ended 31st December 2005

£ £

Sales 550,000

less: Cost of sales:

Opening stock 170,000

Purchases 465,000

635,000

Closing stock (165,000) (470,000)

Gross profit 80,000

Expenses (90,000)

Net loss (10,000)


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Balance Sheet as at 31st December 2005

Cost Cum. Dep'n NBV

£ £ £

Fixed Assets

Premises 610,000 (300,000) 310,000

Fixtures and fittings 85,000 (40,000) 45,000

Motor vehicles 105,000 (35,000) 70,000

800,000 (375,000) 425,000

Current Assets

Stocks 152,000

Debtors 183,000

335,000

Current liabilities

Creditors 146,000

Bank overdraft 174,000

(320,000)

Working capital 15,000

440,000

Long term liabilities

Loans (160,000)

Net Assets 280,000

Financed by:

Capital 120,000

Retained profit 160,000

280,000

The debtors and creditors were maintained at a constant level throughout the year, and alltransactions were on a credit basis.

Required:

(a) Explain, using appropriate ratios, why the business is concerned with its liquidityposition.

(b) Explain the term "operating cash cycle" and state why this concept is important in thefinancial management of a business?

(c) Calculate the operating cash cycle for Lancaster Model Aeroplanes Ltd based on theinformation given (assume a 365 day year).

(d) State what steps might be taken to improve the operating cash cycle of the company.


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Answer

(a) To help illustrate the worsening liquidity position of the company, it is useful firstly tocalculate a number of ratios involving solvency or liquidity:

Working capital ratio

Current assets : Current liabilities

= 335,000 : 320,000

= 1.05 : 1

Acid test ratio

Current assets ( less stock ) : current liabilities

= 183,000 : 320,000

= 0.57 : 1

Debtors days

Sales

Debtorsx 365

=550,000

183,000x 365 = 121 days

Creditor days

Purchases

Creditorsx 365

=465,000

146,000x 365 = 115 days

The current ratio shows that the current assets exceed the short term current liabilities.However, the overall ratio of 1.05 :1 is low and if the current assets were to beliquidated, they would only have to be sold off at a small discount on the cost to beinsufficient to meet the short term liabilities. The acid test ratio of 0.57 : 1 is also verylow and suggests that the company has insufficient liquid assets to meet its maturingobligation.

The comparison of debtor days and creditor days is also worrying. Not only is thebusiness taking a long time to receive its debtor payments (121 days), it is paying itscreditors slightly quicker (115 days) and having to fund an average of 6 days of itsdebtors figure, adding to its liquidity problems.

When interpreting these ratios, it needs to be borne in mind that they are based onpublished figures at a point in time and are therefore only representative of that point intime. They do, though, represent an indication of likely areas of concern and it wouldbe useful to monitor the trends of these ratios over time.

It would also be useful to prepare a cash flow forecast in order to gain a betterunderstanding of the estimated liquidity position of the business in the future.

The bank overdraft is the major form of short term finance and the continuing supportof the bank is likely to be of critical importance to the company.

(b) The operating cash cycle of a business represents the time period between the outlayof cash on the purchase of stocks and the receipt of cash from trade debtors.

The operating cash cycle is important because the longer this period is, the greater thefinancing requirements of the business and the greater the risks involved.


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(c) The operating cash cycle for Lancaster Model Aeroplanes Ltd is:

Average period stocks are held(to nearest whole day)

=salesofcostdailyAverage

stocksofvalueAverage

=65)(470,000/3

165,000)/2(170,000

= 130 days

Average settlement period for debtors(to nearest whole day)

=salesdailyAverage

debtorsAverage

=65)(550,000/3

000183,

= 121 days

Average settlement period for creditors(to nearest whole day)

=purchasesdailyAverage

creditorsoflevelAverage

=65)(465,000/3

000146,

= 115 days

The operating cash cycle for Lancaster Model Aeroplanes Ltd is therefore:

130 days + 121 days – 115 days = 136 days

(d) The operating cash cycle of the business is quite long. It may be reduced by areduction in the stocks, extending further the average settlement period for creditors orsome combination of these measures. The stockholding period and averagesettlement period for debtors also seems high and needs to be reduced, hopefullywithout too much difficulty. The use of a factoring agency could be useful in thisrespect. As the average settlement period of creditors is also high, it may be difficult toextend this further without incurring problems for the company.


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B. OVERTRADING

An increase in a company's turnover is basically good, but it should be part of a plannedstrategy with a permanent increase being supported by a matching permanent increase inthe working capital of the company. This will most commonly be achieved by retention ofprofits and/or an injection of share capital. Inflation could increase the requirement morethan the funding injected.

Overtrading is a common phenomenon for growing companies, and occurs when a businessoverextends itself by having insufficient capital to match increases in turnover. Increasingturnover will result in higher stock and debtor levels which will need to be funded. Anothercause of overtrading is the repayment of a loan when the business has insufficient cash tofund it. Whilst there will be some corresponding growth in creditors, sustaining growth ontrade credit alone is unlikely to be successful in the longer term.

In such a situation increasing the firm's overdraft and reducing the level of credit allowed todebtors are other possible sources of finance. However, both will prove difficult in practice;the latter especially may create problems preventing the required growth the firm desires.

Typical symptoms of overtrading would include the following:

A significant increase in turnover over the period

A decrease in gross profit and net profit ratios over the same period

A deterioration in stock turnover ratios

Increasing liquidity problems shown by the current asset and acid test ratios

Increasing reliance on short term finance such as an increase in bank overdraft andcreditors payment period

A rapid increase in the volume of current assets

Only a small increase in the owners capital

Some debt ratios alter significantly

And future action needed to address these issues could include the following:

Efforts to increase stock turnover, such as an advertising campaign or marketinginitiatives.

Reduction in expenses to improve net profit percentage

Seeking of alternative methods of finance to fund any expansion

Consider a reduction in the rate of raid expansion

Consider new capital from the owners of the business

Improve control systems, particularly cost control systems

Consider having to abandon any ambitious plans for the immediate future

Look at loan requirements – for example, has the business repaid a loan withoutreplacing it? This has the effect of reducing the long term capital of the business

Consider the use of credit and factoring agencies.

Overtrading is illustrated by the following example:


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Example

Year 1 Year 2

£ £ £ £

Fixed Assets 80,000 120,000

Current Assets

Stock 20,000 40,000

WIP 20,000 50,000

Debtors 50,000 80,000

Cash 5,000

95,000 170,000

Current Liabilities

Creditors 45,000 118,000

Bank 20,000 60,000

65,000 178,000

30,000 (8,000)

110,000 112,000

Financed By:

Share Capital 100,000 100,000

Profit & Loss Account 10,000 12,000

110,000 112,000

Sales £500,000 £1,000,000

Gross Profit £100,000 £100,000

Gross Profit % 20% 10%

Net Profit £30,000 £2,000

Net Profit % 6% 0.2%

The important points to note are:

(a) Turnover has doubled, but the gross profit percentage has halved. Discounts forquicker payment may have caused this, as could lower sale prices to win more orders.

(b) Net profit percentage shows a big decline. Increased wages and bonuses, or writingoff obsolete stock may have caused this.

(c) Stock and WIP have more than doubled. (Has obsolete stock been written off?)

(d) Although sales have risen by 100%, the increase in debtors is only 60%.

(e) Surplus cash from Year 1 has been used and bank borrowing has increasedsignificantly.

(f) Creditors have increased by 162% for a rise in turnover of 100%. Credit periods haveextended, and problems could arise if they have not been negotiated.

(g) Whilst fixed assets have increased, it may not be symptomatic of the increased trade.The expenditure may be part of a planned cycle, and indeed, if the machines are moreproductive they will benefit the increased business volumes. It is unwise to increasecapital expenditure from short-term finance such as trade credit and bank overdraft,however.


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(h) The positive current and quick asset ratios have disappeared, indicating a worsening inthe short-term financing position.

(i) The proprietors' stake for the two years is:

Year 1 Year 2

£ £

Total Assets 175,000 290,000

Financed By:

Capital 110,000 62.9% 112,000 38.6%

Creditors 45,000 25.7% 118,000 40.7%

Bank overdraft 20,000 11.4% 60,000 20.7%

175,000 290,000

There has been a dramatic decline in the proportion funded by the equity holders, andshould the bank limit be reached, no more trade credit be available and debtors beunwilling to pay more quickly, then the firm could go out of business despite a full orderbook and the potential to be successful.

Methods to relieve the situation could include:

Faster debt collection, although too much pressure may lose customers.

More efficient stock-holding.

Slower payment to creditors, but there are limits that will be acceptable.

Increased bank financing, although the bank will probably expect a capital injectionfrom outside the business as well.

Slowing down the rate of growth in turnover, allowing work in progress to be finishedand stock sold, thereby reducing the amount of working capital needed.

C. CASH MANAGEMENT

Every organisation must have adequate cash resources (including undrawn bank overdraftfacilities) available to it to meet its financial commitments of day-to-day trading (e.g. wagesand taxation). Cash is also required to meet contingencies, to take advantage of discountsand other opportunities available, and to finance expansion. Firms should, though, avoidholding too much cash with the resulting under-utilisation of resources.

Cash Flow Planning

In order to understand cash management you need to be aware of the difference betweenprofits and cash flow. From your accountancy studies you will be aware that profit is theamount by which income exceeds expenditure when both are matched on a time basis.Cash flow, however, is the actual flow of cash in and out of the organisation with noadjustments made for prepayments or accruals.

A business which has insufficient cash may be forced into liquidation by its unpaid creditorseven if it is profitable. A lack of cash can be seen by an increasingly late payment of bills.Management therefore needs to plan and control cash flow to prevent liquidation. In theshort term this is done by cash flow budgeting, which can be daily, weekly, monthly or yearly,ensuring that the organisation has sufficient cash inflows to meet its outflows as they becomedue. Such budgets should fit in with the overall budgetary scheme that the company


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operates. If a shortage is expected then the firm can arrange finance, perhaps by increasingits overdraft, to overcome the problem.

Other remedies that can be used to deal with short-term expected cash shortages are:

Accelerating cash inflows from debtors.

Postponing cash outflows by delaying payment to creditors; whilst this is considered tobe a cheap alternative (creditors rarely charge interest), such an alternative increasesthe risk of insolvency of the firm.

Postponing capital expenditure (or negotiating extended payment terms with thesupplier).

Reversing past investment decisions, such as selling off non-essential assets.

Rescheduling loan repayments (with the lender's agreement).

Reducing the level of dividend to be paid.

Deferring (after discussion with the Inland Revenue) tax payments (but there will be aninterest cost to doing this).

Despite it being bad policy to finance long-term assets with short-term funding, where thefinancial manager can determine from the cash budget that sufficient funds will becomeavailable, it may be possible to operate such a funding policy without detriment to the firm.

In order to help cash management of groups, a facility called cash pooling may berequested from the group's bank. This process of cash pooling allows the offsetting ofsurplus and deficits held at the bank by the group's companies using a dummy account. Thenet balance is the one on which interest is payable or chargeable, and the group can thendecide how to allocate this cost or income.

For those groups which have overseas subsidiaries involved in intra-group trading, then thegroup may net off the transactions between its members on a multilateral basis. Whilst thereare some countries which limit or prohibit netting (e.g. Italy and France), the groups shouldbenefit from reduced transaction costs.

A further method of cash management that may be adopted by a multinational firm is tocentralise cash management, holding funds in one of the major financial centres such asLondon or New York, with only the minimum level required for day-to-day purposes beingheld by subsidiaries. The remittance of funds back to the parent can be done via the group'sbank, or telegraphic transfer, but there may be limitations imposed by overseas governmentson the level of remittances.

Margin of Safety

No forecast will ever be 100% accurate and the further into the future the projections aremade, the greater will be the margin of error. In cash budgeting the balance at the end ofeach period represents a "margin of safety", whereby the company buys peace of mind at theexpense of profitable utilisation of cash. The size of the balance must be related to thecertainty or otherwise of the predicted inflows and outflows, and the availability of back-upresources, such as overdraft facilities available. A cash-based business, such as a foodsupermarket, will have more certainty of its cash inflows than a business selling principally onextended trade terms. Where, therefore, cash inflow can be predicted with relative accuracy,provision for a margin of safety can be smaller.


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Cash Management Problems

There are several reasons why a business may encounter problems with its cash flow,including:

Overtrading – which we discussed above.

Growth – a firm may need to finance new assets to replace old and obsolete ones.

Loss-making – if a business continually trades at a loss for a protracted period cashproblems will materialise.

Inflation – the replacement costs of stock will be at a higher price when there isinflation. However, competitive pressure may prevent a corresponding increase inselling price.

Payment delays – either due to the business's inefficiency or external delays.

Bad debts – a large customer going into liquidation can create severe problems with acompany's cash flow.

Large items of expenditure – fixed asset purchases or the redemption of loans candrain cash resources rapidly if insufficient plans have been made.

Seasonal trading – this can cause short-term difficulty, particularly if a retailer's stock,bought in especially for seasonal trading (e.g. Christmas), proves unpopular and doesnot sell.

A company experiencing problems with its cash flow should ensure that the invoicedepartment is informed immediately when goods are despatched, and that instructions forpayment are made clearly to customers.

Cash Ratios

Ratio analysis can help in cash management and serve as an indicator of the cash-holdingposition. The main ratios are:

(a) Cash Holding – this ratio indicates the proportion of current assets which are held ascash. Generally, the financial manager will want to keep this figure at the safeminimum to be able to service immediate current outflows.

The ratio is measured as:

assetsCurrent

Cash

The ratio may increase when a business is deliberately accumulating cash to meetforthcoming needs, e.g. capital expenditure or repayment of debt capital.

(b) Cash Turnover – this ratio is used to determine how frequently cash is turned overand is expressed as:

balancecashAverage

periodtheduringSales

The ratio assumes that an average cash holding is used, typically calculated as:

2

balancecashClosing+balancecashOpening

However, note that cash flows will not be constant, especially if there is seasonal trade.


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For example, if sales for the year were £72,000 and the average cash holding was£9,000 then using the above formula:

balancecashAverage

periodtheduringSales

0009

00072

,

, 8 times

i.e. cash was turned over every 45.6 days.

A higher rate of cash turnover will generally be taken to imply the effective use of cash– the more frequent the turnover, the lower the level of cash needed. High rates ofturnover, however, will appear as the result of maintaining too low a level of cash, andas such these ratios should be viewed together, i.e. the maximum turnover rateconsistent with adequate holdings levels. Any proposed measures of improving cashflow management must be carefully evaluated to ensure that the costs do not outweighthe benefits.

Cash-based ratios will vary widely in different industries, e.g. turnover of cash in a foodsupermarket will be rapid, but in a major engineering concern it may take months to turn overonce. Viewing one set of ratios for just one period will in itself disclose very little about themanagement of the firm and its trading prospects, and calculated ratios should be comparedover time, and with industry norms.

Factors Affecting Cash Resources

The amount of cash a firm is holding can be affected by a number of unforeseen events:

New competitors and/or new products may adversely affect demand for a company'sproducts.

Consumers may change their purchasing habits, e.g. people are becoming increasinglyaware of benefits derived from the use of environmentally friendly products.

Upward movements in interest rates will reduce the amount of cash available to firmsthat are in a net borrowing situation.

Businesses dependent on trading (both buying and selling) will be affected bymovements in foreign exchange rates.

Strikes or other disasters may halt production, or at least significantly reduce it, with aresultant fall in sales volume.

There is often a considerable amount of money tied up in the "float", i.e. in the process ofconverting the cheque sent by the debtor into cash in the receiver's bank. Delays during theprocess are those in receiving the cheque (transmission delay) and in the lodging andclearing of the cheque. The use of systems such as bank giro, BACS (Bankers' AutomatedClearing Services Ltd), standing orders, direct debits and CHAPS (Clearing HouseAutomated Payments System) help to reduce these delays. In addition a company couldcollect local cheques itself, and should certainly ensure that cheques are banked on the dayof receipt whenever possible.

Cash Management Models

A number of models have been developed to help companies manage their cash. Theserange from simple spreadsheet models to more complicated models such as the Miller-Orrmodel discussed later. The aim of these models is to trade-off the lost interest of holding idlecash balances against the problems of having insufficient cash, and thus help companiesdetermine the optimal minimum and maximum levels of cash holding. The models cangenerally be manipulated in order to allow the organisation to determine which factors needto be carefully managed in order to maintain optimal cash balances. Like all models theyhave their drawbacks and rely on good quality information being input to produce worthwhileresults.


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(a) Baumol's or the Inventory Model of Cash Management

This model states that the total cost for holding an average level of cash is minimisedwhen:

Q i

FS2

where: Q total amount of cash needed to raise for the time period

F fixed cost of obtaining new funds (e.g. issue costs of shares)

S amount of cash to be used in the time period

i interest foregone (opportunity cost) of holding cash or near cashequivalents (this is a variable cost of obtaining funds)

and the average total cost of holding an average level of cash incurred in a period is:

2

Qi

Q

FS

Example

Sooty plc requires £6,000 cash per annum. Any cash raised will have an associatedfixed cost of £300 and an interest rate of 15%. The interest rate on short-termsecurities is 10%. Advise Sooty as to the level of finance it should raise at any onetime.

The cost of holding cash for Sooty is the difference between the cost of the funds andthat earned on short-term securities, i.e. 15% 10% 5%.

Therefore, substituting into the above formula:

Q 050

00063002

.

,

£8,485

This level should be raised every £8,485/£6,000 1.4 years.

Whilst this model provides a good basis for cash management, especially for firmswhich use cash at a steady rate, it ignores costs associated with having a cash deficit(e.g. interest on an overdraft), and any costs which may increase with increases in theamount of cash held. The model has been found in practice to be poor at predictingthe amounts of cash required in future periods, and of little help in those firms wherethere are large and irregular inflows and outflows of cash.

(b) Miller-Orr Model

The Miller-Orr model, which was developed to produce a more useful model than theBaumol model, sets upper and lower limits to the level of cash a firm should hold.When these points are reached the firm either buys or sells short-term marketablesecurities in order to reverse the trend of cash flows. In order to set these levels, thevariability of cash flows needs to be determined along with the costs of buying andselling securities, and the interest rate.

The steps in using the model are:

(i) Determine the lower level of cash the firm is happy to have. This is generally setat a minimum safety level, though in theory it could be zero.

(ii) Determine the variation in cash flows of the firm (perhaps over a three or sixmonth period).


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(iii) Calculate the spread of transactions, using the following formula:

Spread 3 3

rateInterest

cost)nTransactioflowcashofVariance(0.75

(iv) Calculate the upper limit – this is the sum of the lower limit and the spread.

(v) However, in order to minimise the costs of holding cash, securities should be soldwhen a pre-calculated level (the return point) is reached. The return point is thesum of the lower limit and 3

1 of the spread.

We will look at an example to show application of the model. You will only be requiredto understand how calculations are undertaken in your examination.

Example

Pat Ltd faces an interest rate of 0.5% per day and its brokers charge £75 for eachtransaction in short-term securities. Their managing director has stated that theminimum cash balance that is acceptable is £2,000, and that the variance of cash flowson a daily basis is £16,000. What is the maximum level of cash the firm should hold,and at what point should it start to purchase or sell securities?

Following the above procedure:

(i) Determine the lower level of cash the firm is happy in having; this has been set at£2,000.

(ii) Determine the variation in cash flows of the firm – this has been found to be£16,000.

(iii) Calculate the spread of transactions:

Spread 3 3

rateInterest

cost)nTransactiocashflowofVariance(0.75

3 3

0.005

75)16,000(0.75

£1,694

(iv) Calculate the upper limit – this is the sum of the lower limit and the spread:

upper limit £2,000 £1,694 £3,694.

(v) However, in order to minimise the costs of holding cash, securities should be soldwhen a pre-calculated level (the return point) is reached. The return point is thesum of the lower limit and 3

1 of the spread £2,000 31 (1,694) £2,565.

Thus the firm is aiming for a cash holding of £2,565 (the return point). Therefore, if thebalance of cash reaches £3,694 the firm should buy £3,694 £2,565 £1,129 ofmarketable securities, and if it falls to £2,000 then £565 of securities should be sold.

The model is useful in that it considers the level of interest rates (the higher the ratesthe lower the spread, and thus the less cash that is needed to be held before the returnpoint and the upper limit is reached), and transaction costs (the higher the transactioncosts the greater the spread and thus the less transactions are needed). In addition,the variability of cash flows are considered – those which are more variable are alloweda greater degree of freedom. The major problem of the model is that it does not takeinto consideration the fact that several cash flows of the firm can be predictedaccurately (e.g. dividend payments), it having been developed to deal with uncertaintyin cash flow management.


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D. MANAGEMENT OF STOCKS

Stock, or inventory as it is also known, comprises four main types:

Raw material

Work-in-progress

Finished goods

Miscellaneous items, e.g. tools, stationery, fuel, etc.

As with other working capital items, the problem for the financial manager is that ofmaintaining balance. He or she must ensure that:

(a) There will be sufficient raw material stock available to satisfy production needs andenough finished goods stock to meet customers' requirements.

(b) At the same time, the amount of capital employed in stocks is minimised.(Stockholding has been called the graveyard of industry by financial commentators inthe past.)

Achieving balance can be particularly difficult in the distributive, wholesaling industries,where customers expect a range of goods to be carried, but only place orders infrequentlywhen they need a non-routine item. The distributor is faced with the problem of finding abalance between his ability (and reputation) for good service, and the need to restrict capitaltied up in slow moving lines.

Cost of Stockholding

Holding stock is generally an expensive cash utilisation of a firm's working capital resources.Stock is basically money in another form, and some of the principal costs associated withstockholding will include:

(a) Cost of stock, less any available discount (e.g. for bulk purchasing)

(b) Providing finance – since stock is money, there is the cost of financing it, which maybe taken as the weighted average cost of capital. There is also an opportunity cost ofcapital to consider, as funds tied up in stocks cannot be used for other, more profitableinvestments and so potential income will be forgone.

(c) Stock handling – included under this heading will be the costs of the storesinstallation, which may include racks, bins, paperwork systems, insurance andmaintenance cost, security and so forth.

(d) Holding losses – these costs include evaporation, deterioration, obsolescence, theft,damage in stores and in transit. There may well be, of course, holding gains,particularly during times of inflation, but any gain will usually be offset by the usuallyhigher costs of funds in such periods.

(e) Procurement costs – the costs of obtaining stock. These include:

(i) Clerical and administrative costs of procurement, e.g. salaries, purchasing office,telephones, letters, etc.

(ii) Transportation costs.

(iii) Related costs of tooling, production, scheduling, etc. associated with internalorder, where stocks are produced internally.

(f) Shortage or stock-out costs – the costs of being without stock for a period of time.These include

(i) Loss of contribution through the lost sale caused by stock-out.


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(ii) Loss of future custom to competitors.

(iii) Idle time caused by breaks in production.

(iv) Overtime, rescheduling and related costs, arising from the need to expedite a"rush" order.

(v) Lost production.

(vi) Higher prices.

There are practical problems in quantifying many of these items, since they willtypically be unknown until the effect of stock-out is known.

Stock Turnover Ratios

When turnover, or the throughput, of an item increases, the level of stockholding willgenerally be reduced. Management will therefore seek to verify the rate of stock turnover inorder to establish whether the position is satisfactory, or whether they will need to takeaction. Like all ratios, the real benefit comes from comparison over successive periods oftime against the overall plan for the business.

The ratio is expressed as:

periodtheinconsumedmaterialsofCost

periodindaysofNo.periodofendatngStockholdi No. of days stock in hand

For example, a company has a closing stock of £32,600 and an annual consumption of stockof £220,700. Applying the ratio:

700220

60032

,

, 365* 54 days.

(*This is for a full year.)

If we make some simplifying assumptions to the effect that stock is consumed evenlythroughout the year and the year end position is representative of the remainder of the year(i.e. there are no seasonal trends) we can say that the stock turned over every 54 days, i.e.6.8 times. The ratio may also use the average of opening and closing stock as a morerepresentative figure rather than just closing stock.

In some circumstances, similar calculations can be made expressing the relationshipbetween stock and sales, again arriving at turnover intervals in terms of days and times. Youshould bear in mind that a separate calculation may be required for each type of stock, alsobreaking down its constituent parts into raw materials, finished goods and work in progress.

The 80:20 Rule

This rule is known as Pareto's Law after the Italian economist whose career spanned thelate 19th and 20th centuries.

It is often found that a large percentage (the 80%) of stock is made up of only a small number(the 20%) of physical items. In these circumstances it is usual to adopt the procedure ofdual control. The smaller number of high value items is subjected to a detailed stock controlsystem. The larger number of low value items is made the subject of a more routineinventory system based on minimum and maximum reorder levels. The reasoning behindthis is that strict control of 80% of the value should be quite sufficient to maintain anappropriate rate of stock turnover and control stock availability.

Pareto analysis is sometimes called ABC Analysis (not to be confused with Activity BasedCosting). In this instance stock is broken down into three types depending on its value andusage:


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A items are those which are probably low volume usage but relatively high cost. Interms of control they are usually treated on an individual basis. They may represent20% in number and perhaps 80% of the value.

B items represent 30% of the items with, say, 15% of the value. In terms of control,they will typically be monitored by the use of a reorder policy.

C items are the high volume, low priced items where close control is unimportant.They can be controlled by bulk issue methods such as "two-bin" systems.

The Pareto rule can also be graphed by comparing the cumulative value of the items (whichcould be in terms of cost, turnover, usage, etc.) against the cumulative number of items, asshown in Figure 11.1.

Note that the proportions can change so that, for instance, the top 80% in value may berepresented by 30% of the items and so on.

Figure 11.1

We may conclude the subject of stock management by noting that this is another area wherethe financial manager, in his or her broad overall management capacity, oversees what is, infact, a specialist activity. Stock control has grown into an autonomous subject with aconsiderable background of mathematical modelling, both deterministic and probabilistic,seeking to optimise suitable stockholding and holding cost minimisation, against thebackground of production difficulties and product prices.

Economic Order Quantity

Economic Order Quantity (EOQ), a deterministic model, is defined by CIMA as:

"A quantity of materials to be ordered which takes into account the optimumcombination of:

Bulk discounts from high volume purchases

Usage rate

Stockholding costs

Storage capacity

Order delivery time

Cost of processing the order".


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There are several assumptions underlying this model:

(a) No bulk discounts.

(b) There is a known, constant stockholding cost.

(c) There is a known, constant ordering cost.

(d) The rates of demand are known.

(e) There is a constant, known price per unit.

(f) No lead time, i.e. replenishment is made instantaneously (the whole batch is deliveredat once).

Hence, the reorder quantity which minimises costs is the amount which minimises thecombination of:

Stockholding

Stock reordering.

The combined cost can be expressed algebraically as:

(2

Q h) (C

Q

d)

where: h cost of holding one unit of stock per annum (or other relevant period)

C cost of ordering a consignment from a supplier

d annual demand (or other period)

Q reorder quantity

Therefore Q 2 is the average stockholding per annum (or other time period).

This can be illustrated graphically as shown in Figure 11.2.

Figure 11.2

From this you can see that the larger the reorder quantity, the larger will be the stockholdingcost. However, as the number of orders during the year decreases, ordering costs will be


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reduced. Alternatively, the smaller the reorder quantity, the smaller the stockholding costs,but the number of orders will increase, hence ordering costs will increase.

It can be proved that combined costs are minimised, i.e. the reorder quantity is mosteconomic, when:

Q h

Cd2

Example

Annual demand for material is 300 units, the ordering cost is £2 per order, the units cost £20each and it is estimated that the carrying costs will be 15% per annum. Determine the EOQand the numbers of orders to be placed per year.

Substituting into the EOQ formula:

C £2 per order

d 300 units

h £20 15% £3 per unit

EOQ h

2Cd

3

30022 20 units.

Therefore,Q

d

20

300 15.

Therefore, place 15 orders per year for 20 units.

The EOQ model given above is for replenishment stock in one batch. Where replenishmenttakes place gradually, e.g. where items are manufactured internally and placed into stockwhen they are completed, the formula must be adjusted slightly as:

EOQ

)R

dh(1

2Cd

where: R is replenishment rate per annum

Firms using the EOQ method may decide, because of uncertainties as to demand or leadtime, to hold a "safety level" of stock to reduce the likelihood of a stock-out caused byexcessive demand or an extra long lead time. The cost of this safety stock would be itsquantity multiplied by the unit stockholding cost. The EOQ is still the quantity ordered.

Just-In-Time (JIT) Method of Procurement

The aim of this method is to minimise the costs of holding stock, and goods are obtainedfrom suppliers when required rather than holding stocks of materials and components. It isonly suitable where a stock-out would not be disastrous (e.g. a hospital must have sufficientstocks of drugs and other medical equipment to ensure that it can treat its patients).

In order to introduce JIT production flows need to be even and predictable, a criteria which isaided if the firm adopts a policy of Total Quality Management (TQM) removing waste andother bottlenecks. The aim of TQM is to have 100% quality with zero defects.

The advantages of JIT include:

A reduction in stockholding costs

Simplification of the accounting for raw materials


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Materials can be purchased at discounted prices

A reduction in production lead times

A reduction in scrap and work returned for correction

A reduction in labour costs per unit due to increased productivity

A healthier current ratio, and lower working capital requirements.

E. MANAGEMENT OF DEBTORS

Perhaps the management of debtors carries more importance than the management ofstocks. Such an hypothesis will be based on the fact that at least stocks, even when poorlymanaged, remain on the premises and under the control of the company. Debtors representthe capital of the company placed in the hands of others in the form of goods over which thecompany has effectively lost all control.

The issue is, in common with all aspects of working capital, one of balance. With debtors,the factors to be balanced are:

(a) Giving credit or discounts – which acts as an aid to sales and potential profitability –and the period over which credit is, or has to be, extended.

(b) The cost of giving credit – effectively the company is lending out its precious workingcapital resources at 0% interest, thus needing extra capital.

(c) The cost of being unable to use that capital for more profitable projects.

(d) The cost of eventual bad debts should they arise (administrative costs, collection costs,etc.).

Debtors' Turnover Ratio

Competent financial managers will need some "rule of thumb" calculations to monitor thedaily position relating to debtors and the debtors' turnover represents such a managementtool. It is expressed as:

yeartheduringmadeSales

yeartheofendtheatDebtors 365 No. of days' sales outstanding.*

(*Where the period is for less than one year, the figure of 365 will be adjusted accordingly.)

Therefore a company with debtors of £68,400 and sales during the year of £272,500 has:

500272

40068

,

, 365 92 days of sales outstanding and as yet unpaid by debtors.

As with stock turnover, if we assume that the balance sheet level of debtors is representativeof the entire year, and that sales arise evenly through the year with no seasonal trends totake into account, then we can say that debtors settle on average every 92 days.

Actions Available to the Company

The physical possession of the company's capital passes from its hands when the goods aretransferred. Broadly there are five areas of attention to which the company can pay heed inattempting to influence the level of indebtedness of its customers and the inherent risks thatthis brings. These are:

(a) Checking out the credit standing of the customer, and re-checking for any adversechanges periodically.


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(b) Setting a limit to the level of credit granted to individual customers and laying out termsof trading clearly in writing.

(c) Implementing formal collection procedures for delinquent accounts.

(d) Negotiating cash discounts for the most valued accounts.

(e) Taking out credit insurance.

Credit Control

Credit control can be defined as:

"minimising the risks involved in handing over goods upon the strength of apromise to pay in future".

The importance of the credit control department varies with the nature of the business inwhich it functions. Some companies sell entirely for cash – this is generally the case with asupermarket chain, for example. Companies who deal with small retail traders often have amajor problem in that granting and controlling credit will involve them in a large number ofaccounts. This will be a time-consuming process in view of the numbers involved.

Other firms, making large industrial machines, may have few accounts and may even receiveprogress (stage) payments from customers as certain stages of the project are completed.

Bearing in mind these variations, the financial manager should consider the volume ofbusiness that will be sold on credit terms, the number of customers requiring credit and therecords to be maintained when organising the credit control department. Importantrelationships will develop between credit control, and other departments, notably sales andmarketing who may resent "their" hard won customers being subjected to status checks. Wewill now consider some of the most important aspects which affect credit control.

(a) The credit controller

This function may be combined with the sales ledger account department. This is aconvenient arrangement because credit limits and the actual amount permitted fromone period to another can be seen quite easily from the sales ledger records.

(b) Processing customers' orders

When a new customer is involved, it is essential to check his or her creditworthinessand the following are useful methods:

Direct methods

(i) Information obtained by the sales person from reports and interviews.

(ii) The credit controller's own judgment, either from local knowledge, or fromstudying published accounts (or both).

The accounts will help to identify the length of time taken to pay othersuppliers. A "rule of thumb" check which can be performed is:

Average purchases per day 365

materialsofpurchasesAnnual

then,

dayperpurchasesAverage

creditorsTrade Number of days purchases in creditors.

(iii) Valuation of the company's fixed assets.

(iv) Establishing a progressive and carefully managed system of credit, basedon the track record of the customer's ability and willingness to pay.


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Indirect methods

Methods available include:

(i) A report from the customer's bank.

(ii) References from people who have had dealings with the potentialcustomer.

(iii) The use of trade protection associations.

(iv) Consulting official records.

(v) Journals, newspapers and other publications.

(vi) Trade associations.

Generally, it is useful to have a number of opinions before granting credit, and whilstdirect methods can be efficient they are potentially time consuming. Experience will,however, be needed to interpret the guarded wording in many third party reports. It isoften what they don't say, rather than what they do, that will lead the experiencedcredit controller to a safe conclusion.

The merits and otherwise of indirect methods include:

Bank reports

These are often slow and must be made between two banks. The wording willalways be guarded and remember that the bank may not be aware of all of theircustomer's other commitments.

Bank reports possibly have greatest value in foreign trade, where they should bethe best placed of all sources to assess the potential risks of the proposedtransaction.

Trade referees

Some buyers "nurse" specific accounts so that they can use them as refereesand may even give friends' names without disclosing the relationship. The bestuse of trade references is as a gauge of potential volume.

Trade protection associations

Information is generally supplied only to members for their own use. Infolink isone of the major players in this market, and it can provide a status report on anyform of business organisation, including sole traders and partnerships.

Commercial credit houses

These organisations are commercial firms who specialise in the collection ofcredit information. Examples are Stubbs and Kemps, Seyde & Company andDun and Bradstreet. As with the trade protection associations, a status reportcan be obtained for a reasonable fee. Some only report on incorporated entities,however.

In addition to the reporting service, credit ratings are set for most businessesabove a certain size and published periodically in books available to members.The rating systems use symbols, often letters, to indicate the likely credit limit thatcould be set for specific companies.

Establishing Credit Limits and Terms

Credit limits may be set in advance, in anticipation of a new account, but often no action willbe taken until the first order on credit terms has been received. At this stage a credit limitshould always be set and this will generally follow enquiries into the affairs of the new


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customer. As well as external reports, some of the factors that may be taken into account inassessing a new credit limit may include:

The managerial efficiency and integrity of the business concerned.

Affording facilities as good as those available from competitors (providing the businessis not being offered because competitors have not been paid!).

The capital employed in the customer's business.

The nature of the business and the sector in which it operates.

Consideration may also be given to relaxing the credit period allowed to customers if this isthought to be a profitable course of action. This may be of particular benefit when interestrates are low (and therefore the cost of financing is similarly low) in order to rebuild tradewhich has fallen off as a result of recession. However, care should be taken to ascertain thedegree of risk in such a course of action. To assess the viability of extending credit periodsgiven to customers, the company would undertake a calculation along the following lines:

Example

A company plans to extend its credit period from one to two months, with the intention ofincreasing its sales by £½m on top of its current level of £1¼m. The current profit is around5% and the increased sales would require increased working capital of £50,000 (excludingthe debtors). The required rate of return is 15%.

The company assumes that all customers take advantage of the new terms, and it calculatesthat the increased level of debtors would be:

£187,50012

11,250,000

12

21,750,000

so the total increase in working capital is £(50,000 187,500) £237,500.

The financing costs are £(237,500 15%) £35,625.

The increased profits from the new policy are:

£(500,000 5%) £25,000.

Therefore the new credit policy would not be worthwhile as £10,625 less would be made.

Debt Recovery and Management

An important function of credit control is to ensure that debts are collected as quickly aspossible. In order to induce the customer to pay promptly, it is a common feature for theterms of payment to include a discount of around 2½% for prompt settlement, say withinseven days.

Whether or not the discount can be justified depends upon the circumstances. If the discountreally does prompt settlement within a much shorter period it may be justified, but, even then,if the money is simply added to the existing credit balance on current account, it would bemuch better to wait for a more usual payment period of 28 days and then receive the full,undiscounted payment.

An example may serve to underline this point.

Example

A company with annual sales of £1.2m on credit allows two months for payment. It isconsidering the introduction of a scheme whereby a 2% discount is offered for the paymentof debts within 15 days from the date of invoicing, thereby reducing the period allowed to onemonth. The company would expect annual sales to fall to £1m with 30% of debtors taking


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advantage of the discount. If the company requires a return of 15% on its investments,would the offer of the discount be worthwhile?

It is possible to answer this question very simply by calculating the implied annual cost of thediscount and then comparing it to the rate that the firm could receive if it possessed themoney. Therefore, in the example, the cost would be:

rd)(100

(rd)discountofRate

discount)forofferedPeriodperiodcredit(Original

365

98

2

)( 1560

365

16.5%.

From this you can see that it would not be worthwhile, as the firm could only earn 15% on thefunds collected.

It is also possible to show the impact of a new policy in a different way:

Current level of debtors: 1.2m 12

2 £200,000.

Level of debtors following new policy on discount:

£1mof70

12

1£1mof30

365

15%% 12,329 58,333 £70,662.

Therefore the value of debtors is projected to fall by £(200,000 70,662) £129,338.

The value of the reduction in perpetuity is £129,338 15% £19,400.

The cost of the discount to the company is 2% £300,000 £6,000, which would appear tomake the offer of a discount worthwhile, but this does not take account of the effect of the fallin profits as a result of the tighter credit control policy.

Thus, if the company would expect to obtain a profit margin of 7.5% on sales, then, inaddition to the £6,000 cost, it would lose (7.5% £200,000) £15,000 in profits, making atotal cost of £21,000. As the value is only £19,400 to the company, the discount is notworthwhile.

Irrespective of discounts, reminders should be sent out periodically unless payment oninvoice is expected. One method of spreading the workload caused by sending out invoicesand statements is known as cycle billing, and this involves sending out bills weekly or daily.This overcomes problems facing the credit control department when everything is processed,for example, in the last few days of the month.

When payments are really overdue, it is essential to take action without delay. This may takeone or more of the following forms:

Sending further reminders

Asking a sales person to call to collect

Late reminders threatening legal action

A call from the credit controller or a debt collector

A solicitor's letter and, finally, legal action.

Management Control Information

Reports supplied internally to management will include details of any overdue accounts,potential bad debts emerging, volume of new business transacted on credit, previousproblems since reconciled, and any other specific difficulties affecting credit control.


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Significant ratios will often be included, such as the ratio of debtors to creditors, the ratio ofcredit sales to debtors, and the ratio of total sales to credit sales. A statement of outstandingdebtors illustrating the age of those debts will also be included, but may vary considerablybetween different industries.

A typical statement of outstanding debtors is illustrated below.

Statement of Outstanding Debtors as at ............

Overdue Accounts RemarksAccountName Over 1

MonthOver 2Months

Over 3Months

Over 4Months

Over 5Months

£ £ £ £ £

Atkins M 40 Cheque promised

Brown B 60 Court action pending

etc.

Total

Sales for year to date £................................

Sales for current period £................................

Current balances outstanding £................................

Credit Insurance

The Export Credits Guarantee Department (ECGD) is the UK's official Export Credit Agency.Its aim is to help UK exporters of capital equipment and project-related goods and serviceswin business and complete overseas contracts with confidence. The ECGD provides:

Insurance to UK exporters against non-payment by their overseas buyers

Guarantees for bank loans to facilitate the provision of finance to buyers of goods andservices from UK companies

Political risk insurance to UK investors in overseas markets.

The ECGD work closely with exporters, project sponsors, banks and buyers to put togetherthe right package for each contract. With almost 90 years experience in new and developingmarkets across the world, their knowledge can help companies in unfamiliar environments.

Policies which may be taken out will either be:

(a) Whole turnover policies, which cover total sales for the year; or

(b) Specific account policies, which cover a specific account.

Selection of a policy will largely be determined by the nature of the business conducted bythe company and, if the company has a number of substantial accounts, a whole turnoverpolicy will almost certainly be preferred.

Each proposal will be taken on its merits and insurance cover is given on a sound propositionwhere there is a satisfactory prospect that payment will be made.

The risks covered will include:

The insolvency of the buyer.

The prevention of, or delay in, the transfer of payment to the merchant incircumstances outside the control of both the merchant and the buyer.


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War preventing the export of the goods or performance of contracts, or the delivery ofgoods to the buyer's country (contracts and shipments).

War, revolution or civil disturbance in the buyer's country specifically.

The failure or refusal of a government buyer to fulfil the terms of the contract.

Trading Abroad

A knowledge of the procedures followed when intending to export goods is essential, and themain factors are summarised below:

(a) Sell direct or through a merchant

It will be necessary to decide whether to sell direct or through a specialised exportmerchant. Exporting is often a complicated process to which the manufacturer candevote insufficient time. As a result, the company may be well advised to seek helpfrom a recommended export merchant who understands, and has establishedcontacts in, the chosen market.

(b) Winning customers

Help can be obtained from the DTI and through Business Link when an exporter isdeciding on where his best market is located. Banks, trade associations and overseasagents can also fulfil a useful role, but care should be taken in choosing the latter sincehe or she may already deal in competing products.

(c) Assessing the credit standing of buyers

An initial appraisal of the credit standing should be made and then a review carried outat regular intervals.

(d) Complying with regulations

There are government restrictions in most countries, and in Britain an export licencemay be required for certain transactions. Other countries may have regulationsaffecting factors such as:

Exchange controls.

Trade restrictions on imports.

Customs duties.

In Europe there are many Directives which lay down minimum requirements.

(e) Securing payment

Once the goods have been sold, the exporter may have to wait a considerable periodbefore he is paid by the overseas buyer. To be able to operate overseas it is quiteusual to obtain the backing of a bank or an accepting house.

The UK Trade & Investment division of the BERR co-ordinates all government interest in,and support services for, large overseas projects. It collaborates closely with all appropriategovernment departments at home and with the diplomatic service posts abroad. Whereappropriate, the Division can bring the full weight of government support to bear, includingministerial and diplomatic initiatives.


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F. CREDITOR MANAGEMENT

A firm needs to determine what policy to adopt in the management of its creditors. In doingthis it must consider the following factors:

The need to ensure continuing supplies as and when required, by maintaining goodrelations with regular suppliers.

The level of credit required, and the ability to extend it when the firm has a cash flowshortfall.

The advantages of having a high level of trade credit as a method of reducing the levelof working capital required.

The possibility of extending credit, but this provides the firm with a poor credit ratingand problems in obtaining additional credit.

Whether to accept or reject early payment discounts (this decision is made in the sameway as offering discounts to a firm's customers – the benefits of accepting the discount(additional cost) must outweigh the costs (interest foregone) of paying the debt early).

This latter point illustrates the often forgotten cost of trade credit which is often assumed tobe free but there is a cost of any early payment discounts foregone. An additional intangiblecost may be the loss of supplier goodwill. In addition, recent legislation now allows suppliersto charge interest on overdue accounts. This will further add to costs if payments tosuppliers are delayed.

The cost of early payment discounts foregone can be calculated as:

t

365

s100

s

where: s the size of the discount offered in percentage terms, and

t the reduction in payment period required in the payment period.

This gives the cost as a percentage which should then be compared to the interest rate thatthe company would obtain for investing the cash for the same number of days as required toobtain the reduction in payment period.

G. SHORT-TERM FINANCE AND INVESTMENT

Management of Short-Term Finance

We have seen that short-term finance is a major source of working capital and that it can beobtained from a variety of sources, most of which we have already discussed earlier in thiscourse, i.e.

Bank overdrafts

The issuing of short-term debt instruments (for larger companies)

Taking trade credit from suppliers

There are two further methods available to firms that you need to know about and areexplained here. In addition, there are a number of specialist sources of finance, which wediscuss later in this section..

(a) Bills of Exchange

This method is a common source of finance for international trade. The settlement ofthe cost of a trading transaction may be by means of a bill of exchange (also calledtrade bills). This occurs when the seller draws a bill on the buyer asking them to pay,


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on a certain future date, the price of the goods supplied, which is then accepted by thepurchaser (by signing and returning it to the seller). The purchaser is thus formallyacknowledging his debt to the seller. The seller can then use the bill of exchange assecurity in order to obtain money from the seller's bank.

A bank may also agree to accept a bill from its customer in exchange for an agreementthat the customer will repay the bank. The cost for arranging this finance is thediscount (i.e. the full amount of the bill is not advanced). The more secure the bill (e.g.from a bank as compared to a trader) the "finer" or lower the discount.

(b) Acceptance Credits

This is a facility offered by banks for large companies with a good reputation. Thecompany draws bills of exchange on the banks, generally for 60, 90 or 180 days,denominated in whichever currency most matches the needs of the company. The billscan be drawn on, as and when required, throughout the length of the agreement whichcan be for up to five years, provided the credit limit is not exceeded. The bill is thensold in the discount market and the proceeds passed to the company (less the bank'scommission). At maturity the company reimburses the bank the full value of the bill,and the bank pays the holder of the bill.

A major advantage of accepting credits is that they can be sold at a lower discount thantrade bills. The cost of them is also fixed, allowing for easier budgeting and may belower in times of rising interest rates than that of an overdraft. The credit is alsoguaranteed for the length of the agreement, unlike an overdraft.

Short-Term Investments

We have seen that firms may have a surplus of cash, either deliberately in order to meetpurchase costs in the near future or to take advantage of high interest rates, or because ofhigher than expected profit levels or a lack of investment opportunities. These fluctuations incash can arise for a variety of reasons, a major one being seasonal fluctuations in trade.

Short-term surplus of funds should be invested in short-term marketable securities.Treasurers will employ surplus funds to obtain the best possible returns with maximumsecurity, and in evaluating the alternatives a variety of factors must be taken into accountincluding:

Risk

Liquidity

Term

Cost

Return

Accessibility – deposits with banks, finance houses and local authorities are onlyaccessible when the term finishes – debt instruments and equities can, however, besold when cash is needed

Type and level of interest rate

Taxation

Complexity

Minimum/maximum criteria

Image/policy


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Investment opportunities which are available include:

Money market deposits

Treasury bills

Equities

Commercial Paper

Bonds

Gilts

Certificates of Deposit

Bank and other financial institution deposits, the interest rate varying with theinstitution, the type of account and the amount deposited

Longer-term debt instruments

Eurocurrency deposits

Finance house deposits

Local authority deposits

Sterling Bankers' Acceptances (bank bills)

Local authority bills

Bills of exchange (trade bills)

Specialist Sources Of Finance

The exporter may obtain debtor financing through forfaiting. In the home market, factoring,invoice and block discounting are facilities to cater for the financing of credit afforded tocustomers. We will look at each of these in turn.

(a) Forfaiting

This is a specialist form of trade funding, geared to exports, which first emerged duringthe 1950s; it is currently growing in popularity as the range of markets in whichforfaiters are prepared to operate is expanding. Forfaiters usually operate from within aseparate department within a bank, and they provide non-recourse finance (essentiallyfunds which are only repayable if the exporter fails to perform under his contract) toexporters who seek to boost and secure foreign cash flow.

Forfaiters provide exporters with non-recourse finance by buying trade debts from theexporter at a discount. The debts are guaranteed (the forfaiter calls this avalised) byan acceptable bank but, despite this, the forfaiter will closely monitor country risk in allareas in which he or she is prepared to operate.

For example, a German exporter of machine tools may be offered a series ofpromissory notes maturing at, say, six-monthly intervals over a period of five years byhis Algerian customer. Unless the importer (customer) is of undoubted standing andthere is seen to be minimal country risk, the notes must be avalised (guaranteed) in aform acceptable to the forfaiter. On receiving the notes from the importer, the exportermay then sell them at a discount to a bank in his own, or in a third, country. At thispoint the exporter has no further obligations, other than those relating to quality andfitness of the products sold and the fulfilment of any contracted service obligations.


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Essential features of forfaiting

(i) The promissory note must carry a first-class name (of the highest creditstanding), or it must carry the guarantee (aval) of a first class bank.

(ii) The obligation of the importer (or guarantor) to pay must not depend on theexporter performing under the contract.

(iii) A standard commitment fee of around 1% per month will be payable to theforfaiter (this may vary with the perceived risk) and discount rates willreflect current money costs in the market and the length of the periodbefore the forfaiter receives payment.

Financial instruments used

The principal financial instruments used in a forfait financing are bills of exchangedrawn by the exporter on the importer, and promissory notes issued by theimporter in favour of the exporter. Promissory notes tend to be favoured byexporters because, as the endorser of a promissory note, the exporter can freehimself of any liability by means of a without recourse clause in theendorsement. With a bill of exchange, the exporter must obtain the agreement ofthe forfaiter not to take proceedings against him in the event of non-payment bythe importer.

Security for the forfaiter

Security will be aimed at reducing the forfaiter's risk, and also facilitatesrediscounting the instrument if necessary.

(i) Aval is an irrevocable and unconditional guarantee to pay on the due date.It is written directly on to the bill or note, rather than being contained withina separate document. The words "per aval" are written on the instrument,together with the banker's signature.

(ii) Guarantee is evidenced by a separate document which must not beconditional upon the performance of the exporter, i.e. it must be anunconditional obligation. It should also be transferable in order to permitrediscounting of the forfaited instrument.

(b) Factoring and Invoice Discounting

These facilities are specifically designed to meet the needs of the expanding businessoperating in the home market. As a business carries on trade and builds up itsdebtor/creditor relationships, value is passed in the form of goods not yet paid for. Afactor (factoring company) will advance money against the security of debts owed to abusiness. In this way, cash can be released more swiftly than waiting for the debtors topay within normal trade terms.

There are many variations of factoring, the factor's services frequently being tailored tothe customer's needs. The factor may take the entire sales ledger balances, or onlyspecific, larger debts arising from individual transactions. The factor may actually buythe debt(s) or he or she may merely collect on the customer's behalf, or the customermay collect on the factor's behalf.

Factoring grew as a way to facilitate trade credit and is now an important part ofcommercial life. Subject to the factor's approval, debts can be purchased free ofrecourse and therefore the company passing its debts to the factor will:

Not have to deal with bad debts.

Lose the administrative burden of the supervision of trade credit.


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Have an assured cash flow. Generally, the factor will advance around 80% of thevalue of the debt within two or three days of an approved debt being passed tohim or her.

Factoring is particularly useful to firms trading in markets that require a considerableperiod of trade credit and to companies that are expanding rapidly, as it will leave otherlines of credit open for use elsewhere in the business.

Costs will vary with the perceived level of risk, the volume of business and the periodover which credit is granted. There will usually be a monthly facility fee payable by thecustomer, whether or not funds are drawn from the facility.

(c) Block Discounting

This is also a facility available for companies trading in the home market. It emerged inthe 1960s and is used by companies who offer retail (white and brown) goods oninstalment credit (hire purchase or rental) and initially supported the massive growth intelevision rental.

The facility is administered in a similar way to factoring, but the company will lodge itsinstalment credit agreements with the block discounter, rather than its invoices. Thefacility is usually undisclosed to the end-user customer and the company will collectrentals and instalments due on behalf of the block discounter.

Because the block discounter has a right to the future cash flows arising under theterms of approved agreements, he will generally agree to a higher gearing than aclearing bank, and a financial gearing of 3:1 for a company selling goods extensivelyon instalment credit may often be quite acceptable.

(d) Sales Aid Financing

As an alternative to offering their own trade credit, suppliers of capital equipment andvehicles both to the home market and abroad may offer finance at the point of salethrough a third-party finance company. This is known as sales aid finance and isespecially prevalent in the UK retail motor trade where rates may be subsidised by themanufacturer, the dealer or both, to attract business and private customers by easingthe burden of expenditure on a major capital item.

Whilst a simple loan document is the most common financial instrument used in thepersonal sector, sophisticated financial packages are often negotiated for the businessuser, these being based around either hire purchase or leasing, including operatingleasing in the guise of rental or contract hire.

The benefit to the supplier (and the manufacturer when they are not one and the same)is that the finance company will generally settle at the time the goods are supplied andthere is no need to extend trade credit. Additionally, the payment is received in full,generally without any recourse in respect of bad debts (other than those arisingthrough poor quality merchandise). Suppliers will often work in conjunction with thefinance company to present a "financial package" in such a way that less discount ispassed to the customer than would be the case with a cash sale. Commissions maybe generated from the sale of finance and related insurance products, which serve toboost the profit generated by a credit-based sale.

Larger organisations are often able to persuade the finance company to operate on anundisclosed basis. In these circumstances, all documentation will be designed in thesupplier's house style and will use the supplier's rather than the finance company'slogo.


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Practice Questions

1. The final accounts for Daish, a small trading firm, are given as follows:

Income Statement

Nov 30, 2002 Nov 30, 2001 Nov 30, 2000

£000 £000 £000 £000 £000 £000

Sales 3,860 2,800 2,000

Opening Stock 200 100 100

Purchases 2,700 1,750 1,000

Closing Stock 400 200 100

Cost of Sales 2,500 1,650 1,000

Gross Profit 1,360 1,150 1,000

Operating and Financial Expenses 800 500 400

Net Profit 560 650 600

Balance Sheet

Nov 30, 2002 Nov 30, 2001 Nov 30, 2000

£000 £000 £000 £000 £000 £000

Fixed Assets 1,312 800 600

Current Assets:

Stock 400 200 100

Debtors 220 200 150

Cash 10 630 2 402 30 280

Current Liabilities:

Creditors 350 200 110

Bank Overdraft 380 730 150 350 50 160

Total Assets less Current Liabilities 1,212 852 720

Long Term Liabilities:

Bank Loan 250 250 225

Net Assets Capital 962 602 495

Required:

Daish is concerned about its management of working capital.

(a) Explain the changes in the cash operating cycle for this firm over the yearsindicated.

(b) Do you think the firm is overtrading? Suggest possible future action based onyour analysis.


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2. Babb plc specialises in the manufacture of sportswear. Sales in the current year havebeen £5.2 million. The terms of sale are 2% discount 14 days, net 28 days, althoughthose customers not taking the discount actually take longer than 28 days to pay onaverage. The current level of debtors is £500,000, included in which are the one half ofBabb's customers who take advantage of the cash discount. 1% of credit salesbecome bad debts. The net operating margin (excluding bad debts and discounts) forBabb is 25% of sales.

The company is considering a change in its credit policy to 4% discount 14 days, net28 days. It anticipates the following effects of this change:

Sales to increase by 10% pa

75% of customers to take advantage of the discount

The period of time before payment for customers not taking the discount toincrease by one week

Bad debts to fall to 0.5% of sales

Babb's cost of finance is 12%.

Required:

(a) Calculate the financial implications of this change in credit policy and give youradvice on the proposed change.

(b) Debtors and credit control are, of course, only one aspect of working capitalmanagement. What policies may produce savings in other items of workingcapital? Discuss some of the potential difficulties attached to the management ofworking capital.



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1. (a) The cash operating cycle is the period between the payment of cash to creditorsand the receipt of cash from debtors. We need to calculate appropriate ratios:

(i) Debtors' payment period sday365salesCredit

debtorsTrade :

Year ended Nov 30, 2002: 3658603

220

, 20.8 days

Year ended Nov 30, 2001: 3658002

200

, 26.1 days

Year ended Nov 30, 2000: 3650002

150

, 27.3 days

(ii) Creditors' payment period sday365Purchases

Creditors

Year ended Nov 30, 2002: 3657002

350

, 47.3 days

Year ended Nov 30, 2001: 3657501

200

, 41.7 days

Year ended Nov 30, 2000: 3650001

110

, 40.1 days

(iii) Stock turnover ratio sday365salesofCost

stockAverage

Year ended Nov 30, 2002: 3655002

2400200

,

)( 43.8 days

Year ended Nov 30, 2001: 3656501

2200100

,

)( 33.2 days

Year ended Nov 30, 2000: 3650001

2100100

,

)( 36.5 days

Cash operating cycle:

Y/e 30 Nov 2000

Average days before receipt of cash on sales 36.5 27.3 63.8 days

Average days before payment of creditors 40.1 days

Operating cycle 23.7 days

Y/e 30 Nov 2001





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Y/e 30 Nov 2002




Over the period, it appears that the company has continued to improve the cashoperating period from 23.7 days to 17.3 days. However, a closer look at theratios reveals some potential problems:

Although the company has improved its debt collection procedures and hasreduced the payment period from 27.3 days to 20.8 days, the stockturnover ratio in the year ended 30 November 2002 is longer, indicating thatit is taking longer to convert stock purchases into actual sales.

The creditors' payment period in the year ended 30 November 2002 islonger than previous years, indicating that the company is making more useof creditors as a source of short-term finance. This can be dangerous inthe long term as liquidity problems can arise.

(b) To consider whether the firm is overtrading we need to look at some ratios:

Year endedNov 30 2002



Turnover £3,860,000 £2,800,000 £2,000,000

Gross Profit Ratio:100

8603

3601

,

,100

8002

1501

,

,100

0002

0001

,

,

35.2% 41.1% 50.0%

Net Profit Ratio:100

8603

560

,100

8002

650

,100

0002

600

,

14.5% 23.2% 30%

Quick Asset Ratio:

730

230

350

202

160

180

0.3 : 1 0.6 : 1 1.1 : 1

Acid Test Ratio:

730

10

350

2

160

30

0.01 : 1 0.006 : 1 0.2 : 1

Current Ratio:

730

630

350

402

160

280

0.9 : 1 1.1 : 1 1.8 : 1

The company shows significant signs of overtrading:

An increase in turnover over the period.

A decrease in gross profit and net profit ratios over the same period.

A deterioration in stock turnover ratios.

Increasing liquidity problems shown by quick asset and acid test ratios.

Increasing reliance on short-term finance, e.g. increase in bank overdraftand creditors' payment period.


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Future action should include:

Efforts to increase stock turnover, e.g. advertising campaign

Reduction in expenses to improve net profit percentage

Seeking of alternative methods of finance to finance any expansion, e.g.bank loan

2. (a) The financial implications are:

(i) Increase in net operating profit

Current level of sales 25% £5.2m £1.3m

After change in policy 25% £5.72m £1.43m

(ii) Increase in discount allowed

Current level £5.2m 2% 50% £0.052m

After change in policy £5.72m 4% 75% £0.1716m

(iii) Savings on debtors

Assume average time taken to pay (customers not taking cash discount) y weeks

Current situation:

Make up of debtors (50% 52

£5.2m 2) (50%

52

£5.2m y) £0.5m

y 8 weeks

New situation (taking one week longer to pay):

Total debtors (75% 52

£5.72m 2) (25%

52

£5.72m 9) £412,500

Reduction in debtors £500,000 £412,500 £87,500

Savings 12% £87,500 £0.0105m

(iv) Reduction in bad debts

Current level 1% £5.2m £0.052m

After change in policy 0.5% £5.72m £0.0286m

Summary of changes: Saving Increased cost

£m £m

(i) Increase in net operating profit 0.13

(ii) Increase in discount allowed 0.1196

(iii) Savings due to reduced debtors 0.0105

(iv) Reduction in bad debts 0.0234

0.1639 0.1196

Overall benefit £0.0443m

This is a relatively small benefit given quite favourable assumptions have beenmade, e.g. a 10% rise in sales and a 50% reduction of bad debts. The cost of


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discount allowed is high and it is debatable whether the proposed change isactually viable.

(b) You could base your answer on the following points:

(i) Stock control – improvements using computerised systems andtechniques such as economic order quantity and just-in-time. Achievingfaster stock turnover can reduce costs of stockholding.

(ii) Cash control – use of cash flow forecasts can help identify likely surplusesand deficits of cash. Surpluses can be invested and short-term overdraftsarranged to cover deficits.

(iii) Creditors – it may be possible to delay payments to creditors but this canhave adverse effects on relationships with suppliers and the company couldincur interest payments on overdue accounts.

275

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Study Unit 12

Capital Investment Decision Making 1: Basic AppraisalTechniques

Contents Page

Introduction 277

A. Future Cash Flows and the Time Value of Money 277

B. Return on Investment (Accounting Rate Of Return) 278

C. Payback 279

D. Discounted Cash Flow 280

E. Net Present Value (NPV) 281

Future Value Over Time 283

Conventions Used in NPV Calculations 284

Net Terminal Values 284

Annuities or Uniform Series 285

Multiple Time Periods 286

NPV Profile 286

Perpetuities 288

F. Internal Rate of Return 288

Pitfalls with IRR 290

Dual Rate of Return Method 290

G. Cost/Benefit Ratio 291

H. Comparison of Methods 291

Non-Discounted Methods 291

Discounted Methods 291

(Continued over)

276 Capital Investment Decision Making 1: Basic Appraisal Techniques

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I. Impact of Taxation on Capital Investment Appraisal 292

Capital Allowances 293

Answer to Practice Question 295

Appendix: Discounting Tables 296

Single Payment Compounded Forward Factor 297

Uniform Series Compounded Forward Factor 298

Single Payment Present Worth Factor (Discount Tables) 300

Uniform Series Present Worth Factor (Cumulative Discount Tables) 302

Annuity Tables 304

Capital Investment Decision Making 1: Basic Appraisal Techniques 277

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INTRODUCTION

At the beginning of this course we saw that one of three major decision areas undertaken inan organisation is that of investment appraisal, and the financial manager has to employappraisal techniques in order to decide which projects to accept and which to reject. In thisand the following study unit, we will consider the financial models and techniques that arecommonly used in capital investment appraisal.

Capital investment decisions will largely shape the future of the business and its ability tomanage its future operations. They are, though, generally difficult and expensive to reverseand must, therefore, be right first time. Appraisal of the implications of a decision is, then,essential.

The criteria for the appraisal of projects may be based on legal requirements (e.g. to meethealth and safety legislation) or social and staff welfare needs (e.g. the provision ofcanteens). However, in the majority of cases, it will be on economic grounds – the key beingthat projects accepted meet preset financial criteria, generally a return greater than the costof the capital needed to finance it. In addition, they must also seek to maximise shareholderwealth, by maximising long-term returns.

The methods of capital investment appraisal which we shall examine are as follows:

Return on Investment (ROI) or Accounting Rate of Return (ARR)

Payback

Net Present Value (NPV)

Internal Rate of Return (IRR)

Cost/Benefit Ratio

Adjusted Present Value (APV) (which we shall consider in the next unit)

These methods do not all fulfil the criteria set above, but they are the most widely used inpractice. A useful exercise for you whilst working through the following sections is to assessthe validity of the different techniques, in view of the above criteria and of the primaryobjective of corporate finance, that of shareholder wealth maximisation.

A. FUTURE CASH FLOWS AND THE TIME VALUE OFMONEY

There are several different techniques used in organisations when making the investmentdecision. When evaluating an investment opportunity it is important that all cash flowsarising from that opportunity are considered, and that the timing of these different cash flowsis also taken into account.

You may wonder why the timing of cash flows is so important. This is because £1 receivedtoday is worth more than £1 received in 12 months' time, because of the subjective timepreference of investors, i.e. individuals prefer to consume income now rather than in thefuture.

There are other reasons sometimes mooted for the existence of the time value of money, butwhilst these have some credence they do not fully explain the situation. The commonreasons are that:

There is a risk involved in investing. Whilst there is uncertainty involved in capitalinvestment, techniques have been developed to deal with this within discounted cashflow (DCF) analysis (see later).


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There is a risk that inflation will erode buying power during the period underconsideration. However, even if there is zero inflation, techniques which consider thetime value of money are still used in investment appraisal. (We shall consider methodsof dealing with inflation in the next study unit.)

Let us assume that you could deposit your £1 for 12 months at a 10% annual interest rate.After one year interest of £1 10% 10p would be added to your £1 and your investmentwould have grown to £1.10. We can therefore say that the future value of your £1 today, atan interest rate of 10%, is £1.10.

Cash therefore has a time value and we express the values today (i.e. at the start of aninvestment project) of future cash flows as the present value of the investment.

B. RETURN ON INVESTMENT (ACCOUNTING RATE OFRETURN)

This approach expresses the profit after tax arising from an investment as a percentage ofthe total outlay on the investment. The profit is expressed after depreciation as it is arguedthat the original capital is being recovered. The result is compared to a predeterminedcompany (or group, or division) target, an investment being accepted if the result meets orexceeds the target.

When using ROI to compare projects which are mutually exclusive (i.e. the acceptance ofone prevents the adoption of the other) the project which gives the highest ARR is the onethat should be accepted (provided it meets or exceeds the target ARR).

Difficulties arise with this method when the duration of the investment (and hence theprofitability from it) extends for more than one year, as it then becomes necessary todetermine some representative profit and investment value for the duration of the project.This is usually achieved by a form of averaging, in view of the difficulty of estimating profitgeneration several years in the future.

We will now look at an example to clarify this.

An investment in a new machine costing £1,000 will generate the earnings shown below overthe five years of its projected useful life. Depreciation will be on a straight line basis to reflectthe estimated manner in which the value of the machine will decline over these years.

Year 1 2 3 4 5

Budgeted profits 600 600 500 500 300

less Depreciation (200) (200) (200) (200) (200)

400 400 300 300 100

Tax (say) 120 120 105 105 35

Net profit 280 280 195 195 65

We first need to establish the average profit arising from the investment and then comparethis with the investment:

Average profit 5

65+195+195+280+280 £203.

We can then compare this with the original investment to give the rate of return:

investmentOriginal

profitAverage

1

100

0001

203

, 20.3%


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Alternatively we can compare it with the average investment. This has traditionally beencalculated as the original investment divided by 2 – thus, here, it would be £1,000 2 £500.

investmentAverage

profitAverage

1

100

500

203 40.6%.

This is not a very satisfactory way to make the calculation, because the figure of £500 has noactual basis in reality. Furthermore, it produces a rate of return which does not represent thefacts of the case. The annual returns on the original investment in our example are as shownbelow:

Year 10001

280

, 28%

Year 20001

280

, 28%

Year 30001

195

, 19.5%

Year 40001

195

, 19.5%

Year 50001

65

, 6.5%, giving a total of 101.5%.

Dividing this result by 5 gives us (101.5% 5) 20.3%, i.e. half the figure of 40.6% which wecalculated by using the traditional formula for counting the investment involved.

Further problems arise because this method fails to recognise that a net profit of £65 in fiveyears' time is barely significant in today's terms, even when there is a low rate of inflation. Inother words, the method fails to recognise time value of money. This is a cornerstone ofdiscounted cash flow methods as we shall shortly see.

Another issue with this type of analysis is that profits are the results of receipts and outgoingsand they do not represent cash transactions and the cash flow arising is not taken intoaccount during the term of the investment.

Probably the greatest merit in this method of analysis is its simplicity, it being based inconventional accounting terms and requiring only limited analytical skill to carry it out and tointerpret the conclusions that can be drawn from it.

C. PAYBACK

This method simply measures the time period taken until the profits generated from theinvestment equal the initial cost of the investment. The aim is to calculate how much time willelapse before the capital project "pays back" the original amount invested from the profitsgenerated by it. (Either cash receipts or accounting profits can be used – cash receiptswould be preferable for the reasons noted above.) The result is compared to apredetermined company (or group, or division) target, an investment being accepted if theresult meets or is less than the target length of time. When comparing different projects theone with the quicker payback period would be the one chosen.


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Consider the following example.

Project A Project B

Investment outflow Year 0 (600) (600)

Cash inflows Year 1 400 700

Year 2 200 400

Year 3 800 400

Total inflows 1,400 1,500

Payback for Project A is two years, assuming that the cash inflows occur at equal periodsand in equal amounts during each year. Payback in the case of Project B is just over tenmonths.

Payback focuses on risk in considering the period during which the investment remainsoutstanding. The sooner the investment is returned, the safer the project should be. Youshould note, however, that the method takes no account of cash inflows after payback,neither is there any attempt to consider reinvestment possibilities for incoming funds duringthe period prior to payback.

Perhaps, therefore, we should view payback as more of a risk appraisal tool than aperformance measure.

D. DISCOUNTED CASH FLOW

Discounted cash flow (DCF) analysis (also known as present value analysis) is a techniqueused to determine the net value of a project in terms of today's money. It considers the timevalue of money, and the cost of capital to the organisation. By using a discounted cash flowmethod it is possible to convert all future cash flows to their present value and then to assessthem on a like-for-like basis. The net effect of all the cash inflows and outflows resulting froma project being discounted back to present values is known as a project's net present value(NPV).

In order to convert cash flows arising from a project into their present values, it is necessaryto establish the cash inflows and outflows arising from it, and what cost of capital should beused to evaluate such projects.

The cash flows, or sufficient information to determine them, will always be provided as giveninformation and they should be recorded, and the year in which they occur, in a logicalmanner (you will see in this and the next study unit how this is done).

The cost of capital used in evaluating such projects is generally the required rate of return ofthose investing in the firm – which we have seen to be its weighted average cost of capital(WACC). To calculate the cost of equity you should use either the dividend growth model orCAPM, depending on the information provided. The resulting WACC will be slightly different,although both methods have advantages and disadvantages because they are based ondifferent underlying assumptions. (Note that CAPM is generally used in the APV techniquediscussed in the next study unit.) However, we will discuss situations where an alternativerate should be used. Note that you may be presented with the cost of capital to be used, andyou should always consider the information provided when determining the figure to bechosen or calculated.

This required rate of return forms the basis of the discount factors which are used to convertcash flows to their present values.


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The formula used for deriving the discount factor is:

ni)+1

1

(

where: n represents the number of periods, and

i represents the cost of capital per period.

In practice discount factor tables are available to look up the relevant factor (see theappendix to this study unit). In order to use the discount factor tables you need to readacross the year, and down from the cost of capital you are considering to obtain the discountfactor. For example, with a cash flow arising 10 years in the future, for a company with a 5%cost of capital, the discount factor to use would be 0.614, giving a present value of the cashflow 0.614.

There are also several computer packages available for the purposes of investmentevaluation. Tables also exist for future cash flows.

In the assessment of the future cash flows generated by investment projects, the two mostcommonly used methods which use this discounted cash flow analysis are:

Net present value (NPV)

Internal rate of return (IRR)

The DCF methods concentrate on cash inflows and outflows associated with the project overits full life span, so you can see that they are superior to the other methods discussed so far.Another major advantage is that they consider the timing of cash flows associated with theproject.

E. NET PRESENT VALUE (NPV)

The concept of net present value (NPV) is of vital importance in the field of corporate finance,and we have already made several references to it in this course.

In order to determine the NPV of a project, we need to list all the cash flows related to theproject. The net cash flows are then discounted at the cost of capital using the formulashown above.

The decision rule in using the NPV technique is that if the NPV is positive the project shouldbe accepted, and if the NPV is negative then the project should be rejected. The reasoningbehind this is that when there is a positive NPV, the project offers you a return in excess ofyour cost of capital and acceptance of such a project will increase the wealth of the company.For a negative NPV project, the cost of capital is not covered and acceptance of such aproject will reduce the value of the firm. The primary objective of the firm is, of course, tomaximise shareholder wealth by maximising the value of the firm. The value of a companywill increase by the NPV of a project provided that its WACC remains unchanged. Theincrease in wealth will be reflected in the share price because of the efficient markethypothesis (EMH).

The use of the NPV technique is best seen by considering an example.


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Example

A project has an initial cost of investment of £10,000 in a machine, and the followingexpected cash inflows:

Year 1 £6,000

Year 2 £6,000

Year 3 £6,000

Year 4 £5,000

Year 5 £5,000

No scrap value is expected from the machine. The cost of capital is expected to be 10%throughout the five years of the project. Should the project be accepted?

The way to make this decision is to turn these future cash flows into present values by eitherthe use of discount factor tables (see appendix), or the formula noted above. (Note that weshall use both of these methods in this study unit.)

Present value of machine revenues:

Year Net Cash Flows Formula Disc. Factor NPV

£ £

0 10,000 - 1 10,000

1 6,000 1101

1

).( 0.909 5,454

2 6,000 2101

1

).( 0.826 4,956

3 6,000 3101

1

).( 0.751 4,506

4 5,000 4101

1

).( 0.683 3,415

5 5,000 5101

1

).( 0.621 3,105

+18,000 11,436

In straight cash flow terms, the opportunity presented by the machine purchase is as follows:

£

Cash revenues resulting 28,000

less Cost of machine 10,000

Cash gain 18,000

This cash gain is received over a period of five years, which for the flows given is the sameas £11,436 now.

(Note that this method deals with liquidity, not profitability, and cash flows are used, notaccounting flows (e.g. capital outlay, not depreciation).

Calculating the discount factor to be used, without the use of discount tables, is a function ofboth the company's cost of capital and the number of years over which the individual projectis expected to provide a return.


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If the cost of capital for the above example had been 6% rather than 10%, what would havebeen the overall financial effect on the project proposals?

The figures would have been as follows:

Year Net cash flows Disc. Factor NPV

£ £

0 -10,000 1.000 -10,000

1 +6,000 0.943 +5,658

2 +6,000 0.890 +5,340

3 +6,000 0.840 +5,040

4 +5,000 0.792 +3,960

5 +5,000 0.747 +3,735

Total +18,000 +13,733

The lower the discount factor used, then the less impact the inflation rate will have on thefinal discounted figure – i.e. the higher the rate of inflation, then the more the value of moneywill be affected in the future.

Future Value Over Time

Another way of regarding net present value is to say that, if the cost of capital is 10% over afive year period:

£11,000 in one year's time is the same as £10,000 now

£12,100 in two years' time is the same as £10,000 now

£13,310 in three years' time is the same as £10,000 now

£14,641 in four years' time is the same as £10,000 now

So the future value of £10,000 now (assuming a constant cost of capital of 10% throughoutthe period) is:

Year 1 £11,000

Year 2 £12,100

Year 3 £13,310

Year 4 £14,461

Example

Consider the following calculation. Suppose a company has a machine in mind which willproduce a stream of revenues as follows:

£

Year 1 400

Year 2 600

Year 3 200

1,200

Note that the value of the machine is not £1,200, but is the present value of these cash flowswhich, using discount factor tables, are calculated as:


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Cash Flow DF PV of Cash Flow

£ £

Year 1 400 0.9091 363.64

Year 2 600 0.8265 495.90

Year 3 200 0.7513 150.26

1,009.80

The value of the machine is therefore £1,009.80.

In the absence of cost of capital figures the project could be compared with the interest ratethat would be achieved by investing the initial outlay in investments of a similar level of risk.

Conventions Used in NPV Calculations

Presentation

The best method of answering such questions is to set out all your cash flows anddiscount factors in a table, putting each year's cash flows in the same column or row.Examples of correct presentation are provided throughout this course.

Signs

The normal method is to regard cash inflows as positive and cash outflows as negative.

Years

A simplifying assumption is made that all cash flows occur in discrete steps at the endof the year, but all initial outlays are regarded as occurring at the end of Year Zero, andthus are not discounted (and are given a discount factor of 1).

Time periods

Time periods always commence at the present, which is Year 0.

Relevant figures

The only relevant figures to put into an evaluation are those cash flows arising as aresult of accepting the project. Thus the concept of relevant cost, which you will havemet elsewhere in your studies, is the concept which should be applied in investmentappraisal. Sunk costs and apportioned overheads are, as such, ignored in DCFcalculations.

Items such as depreciation, which are accounting and not cash flows, are ignored (thevalue of fixed assets is already taken into account in the initial outlay required for theproject and in any scrap value from the assets at the end of or during the project).

Interest and repayment of loan principals are not included in the cash flows becausethis would be double counting, since the sums have already been included in the costof capital used.

Net Terminal Values

If the (opportunity) cost of capital in a business is 10% per annum, this will represent therequired rate of return from the project. This is sometimes referred to as the cut-off rate orthe criterion rate. Where the capital investment (as measured by the internal rate of return,or yield) is expected to generate less than this return, the viability of proceeding with theinvestment, based on the financial analysis, will be open to question since the return will beless than the cost of financing it.


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Example

An investment in Project R of £20,000 is expected to generate cash receipts of £6,000 at theend of Year 1, £8,000 at the end of Year 2, and £10,000 at the end of Year 3. The businessis able to invest money at an annual rate of 10% (the opportunity cost).

From the cash flows below it is clear that Project R produces insufficient return on theinvestment. Its net terminal value is £560, and that indicates that greater benefit will accrueif the money is invested in a security (or with a deposit-taking institution) at the rate of 10%pa which it is assumed is freely available.

End of: Cash Flow£

CompoundFactor *

Terminal Value£

Year 0 (20,000) 1.331 (26,620)

Year 1 6,000 1.210 7,260

Year 2 8,000 1.100 8,800

Year 3 10,000 1.000 10,000

Net Terminal Value (560)

* The compound factors reflect the fact that the receipts at the end of Year 1 areavailable for investment for two years, and the receipts at the end of Year 2 for oneyear, i.e. for Year 2 the formula is calculated as:

(1 i)n

where: i the interest rate per period; and

n the number of periods.

Therefore, (1 0.1)2 1.210.

Annuities or Uniform Series

In certain cases the level of cash flow will be uniform from year to year. In such cases thereis an easier method of calculating the net present value than using the discount factor tables.

The easier method is to use cumulative discount tables (provided in the appendix to thisstudy unit) which are simply the addition of discount factors over a number of years. To usethese tables you need to read down the correct cost of capital column, and across the row forthe number of years the cash flows remain constant, in order to obtain the cumulativediscount factor. You should, however, note that if the uniformity of cash flows does not startin Year 1, the discount figure you should use would be the difference between the discountfactor at the last year for the constant flows, less that for the year before the flowscommenced. The resulting present value is then discounted at the rate for the year beforethe constant cash flows started. An example should help to clarify this.

Example

A company is considering investing in a project which will cost £5,000, and will yield cashinflows of £2,000 in Year 1 and £3,000 for the following three years. There is no scrap valueat the end of the project. Should the investment be accepted if the company's cost of capitalis 10%?

First we need to set out the cash flows as before:


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Year Cash Outflow Cash Inflow Discount Factor Present Value

£ £ £

0 5,000 1 5,000

1 2,000 0.909 1,818

2 3,000

3 3,000 2.487 0.909 6,782

4 3,000

3,600

We discount the series of constant cash flows back to Year 1 using the (4 1) cumulativediscount factor, and then discount that amount back one year from Year 1 to the presenttime.

As the project gives a positive net present value it should be accepted.

Multiple Time Periods

These can be catered for by using the basic annual tables, as follows. Simply divide i by thenumber of times in the year that discounting occurs and multiply the years by the number ofperiods per year.

For example, find the PV of a uniform series of receipts of £500 discounted half-yearly for thetwo years, where i 8%.

i 8/2 4%

t 2 2 4 years £500 3.630 £1,815

You will not normally be requested to deal with other than annual cash flows.

NPV Profile

For any project, a range of costs of capitals can be discounted and the results plotted againstthe resulting NPVs. This is often called an NPV Profile Curve, and it is simply adiagrammatic representation of the NPV possibilities. A profile curve is shown in Figure 12.1.


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Figure 12.1: NPV Profile of Two Projects X and Y

You will note that a study of the NPV profile reveals certain useful information, as follows:

(a) The net present value of a project at any selected cost of capital can be read directlyfrom the graph, e.g.

(i) Project X has an NPV of £90,000, if the cost of capital is 10% (point "a" on thecurve).

(ii) Project Y has an NPV of just below £20,000, if the cost of capital is 17% (point "b"on the curve).

(b) Where two project curves are shown, any point of intersection marks the spot belowwhich one project is more profitable than the other, and above which the other projectis more profitable.

The project curves for X and Y intersect at 11.5%. Above this rate of interest Y is moreprofitable, below it X is the more profitable project with a higher NPV.

(c) Where the curves cut the horizontal axis, the NPV of each project is nil (£0), the cost ofcapital being equal to the project's yield; this is known as a project's internal rate ofreturn (see later). X has an internal rate of return of 15%, and Y has one of 19%.


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Perpetuities

When a project yields a sum for ever then its present value can be calculated as:

PV i

flowCash

because the cumulative present value of £1 in perpetuity (i.e. each year for ever) is £1/i.

F. INTERNAL RATE OF RETURN

We stated above that the internal rate of return of a project is that cost of capital whichmakes the net present value of a project to be equal to zero (the higher the cost of capital thelower the net present value of cash flows). It is this percentage rate of discount which wecompare with the company's cost of capital. If the cost of capital required to reduce thefuture cash flows to zero is greater than the company's cost of capital, then the project will beaccepted because it produces a positive return for the business.

You can see this in Figure 12.2, which represents the approach of taking a number of cashinflows and outflows and discounting them over a constant period of time at an increasingdiscount rate.

Figure 12.2

A discount rate of 0% clearly has no effect. As the percentage rate increases, the NPV fallsuntil at a particular cost of capital, the NPV is equal to (or approximately equal to) zero, i.e.NPV 0. This is the project's internal rate of return. The internal rate of return would then becompared to the company's cost of capital; if it were higher it would be accepted, and if itwere lower it would be rejected, because it is not generating sufficient funds to satisfy theneeds of the suppliers of the company's finance. This method can also be used to comparethe cost of financing using alternative financial instruments.

Essentially each cash flow is appreciated to have an element of capital and interest within it.Once the interest element is removed by discounting the instalments by the discount rate, thepayments, now comprising only the capital element, will equal the initial investment at theIRR point.

The internal rate of return can be found by trial and error – in order to establish the precisediscount rate several attempts will usually be required using different discount rates until thesum of the cash flows equals the initial investments. Further adjustments may well be


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needed where the cash flow payments required by the transactions are of an uneven nature.A good starting place for such appraisals is two-thirds of the project's ROI.

An alternative approach is to plot an NPV profile using two or more discount rates and toread the approximate internal rate of return from the graph. This is known as interpolation.

Example 1

An investment of £20,000 is expected to generate cash receipts of £6,000 at the end of Year1, £8,000 at the end of Year 2, and £10,000 at the end of Year 3. The business can investmoney at an annual rate of 10% (its opportunity cost).

Our aim will be to find the discount rate which reduces all the cash flows to zero. In ourexample the NPV is almost zero when we use an IRR (discount rate) of 9%, and from thetable below you will see that the return on Project R is just under 9%. As the required rate ofreturn is 10% (or more), the project would be rejected.

The table below shows the calculations at a discount rate of 9%. (The IRR will bedetermined by trial and error.)

End of Year Cash Flows Discount Factor Present Value

£ 9% £

0 (20,000) 1.000 (20,000)

1 6,000 0.917 5,502

2 8,000 0.842 6,736

3 10,000 0.772 7,720

NPV (42)

We should remember that a project with a higher IRR may not necessarily be better than aproject with a lower IRR. Let's just stop to think why.

The main reasons for this relate to the actual amount of money which is to be returned. A30% return may sound excellent, but if the investment is only a few hundred pounds, it maynot be worth devoting the time necessary if a larger project with a lower IRR will generatebetter cash returns.

It is also important to recognise that IRR assumes that surplus cash flows are to be investedat the project's own "internal" rate. However, this may not be possible in many months' timewhen market forces have changed, with the result that the returns actually available havefallen.

It is also important that you are able (given a particular scenario) to calculate for yourself theInternal Rate of Return.

Consider the following example:

Example 2

A business is considering a project that has an initial outlay of £11m (i.e. a capital outlay offunds) and the discounted capital inflows of funds would be £12m. How would you calculatethe Internal Rate of Return (i.e. the discounted rate that would give a Net Present Value of£0).

The first thing that you need to do is determine which two percentage figures the actual figurewould fall between and this can only be done by "trial and error". You also need to bear inmind that capital money going out of the business (i.e. £11m) will be a negative figure andcapital money coming into the business (i.e. £12m), even if discounted, will be a positivefigure in this example.


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Let us first consider, say, 10%. This would give us:

–11 +

).( 101

12= £0.881m

Now let us consider, say, 15%. This would give us:

–11 +

).( 1501

12= –£0.565m

So we now know that the actual rate that gives a NPV of £0 is between 10% and 15%

To calculate the actual IRR would be as follows:

10 +

0.5650.881

10)-(15x0.881= 13.046%

Pitfalls with IRR

Before attempting any detailed analysis, it is important to be aware of the potential pitfallswhich can arise when, for instance, the net cash flow changes during the investment periodfrom positive to negative, or vice versa. When this happens multiple internal rate solutionsare possible, and for the sake of clarity we shall give an example.

Example

An initial investment of £3,950 generates the following cash flows in the next three years:

£

Year 0 (3,950)

Year 1 13,102

Year 2 (14,500)

Year 3 5,350

2

The overall return on the initial investment is 2, hardly a significant contribution on the face ofit. However, the cash flows actually satisfy an internal rate of return of 5%, 10% and 15% asshown below!

Year Cash 5% 10% 15%

£ £ £ £

1 13,102 12,473 11,909 11,398

2 (14,500) (13,151) (11,977) (10,962)

3 5,350 4,622 4,018 3,520

3,952 3,944 3,950 3,956

This problem can arise when the cash flow is positive during one period and negative duringanother. Every change of sign gives rise to an additional solution.

Dual Rate of Return Method

It is possible to resolve this potential problem by using the Dual Rate of Return Method(sometimes known as the Extended Yield Method).

To do this, it is initially necessary to identify all periods in which the cumulative cash flowsproduce a cash surplus, when discounted at the internal rate of return. These cash flows are


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then discounted at a predetermined rate (the rate required from the project), in ordersubsequently to calculate the internal rate of the remaining cash flows.

This is a particularly important technique when conducting the evaluation of a project whichhas surplus cash generated during only a part of its term.

G. COST/BENEFIT RATIO

This ratio, sometimes referred to as the Profitability Index (PI), is calculated by the formula:

outflowinvestmentPresent

inflowfutureofPV(discounted at the cost of capital)

A project offering a PI of greater than 1.0 should be accepted. In the case of competingprojects, the highest over 1.0 will generally be preferred.

Thus, where capital rationing is important, the PI can be used to help to "rank" projects inorder of relative profitability.

H. COMPARISON OF METHODS

As with other areas of financial modelling, each method of investment appraisal has itsdrawbacks, and most firms use three or four of the different methods.

Non-Discounted Methods

The ARR ignores both the timing of cash flows and the opportunity cost of capital, but it isused in practice in approximately half of all companies.

The payback method ignores the time value of money, and total cash flows over a project'slife once the payback period has been reached. It is often used in practice, however, as ascreening device, being considered to provide a fair approximation to NPV if cash flowsfollow a pattern. It is useful when firms have liquidity problems or are perhaps producingnovelty products which require a quick repayment of investment.

Discounted Methods

We noted above that it is generally preferable to use a method of investment appraisal thatdiscounts cash flows, the two main methods being IRR and NPV. Both these techniques areacceptable in capital investment appraisal if an organisation can accept all projects which arebeneficial to the organisation.

However, when there is capital rationing, NPV is the better method, as IRR can mis-rank theprojects. This superiority can be proven using the incremental approach.

Example

Zak plc has only the space to implement either Project X or Project Y; both projects last oneyear and have the following details:

Cash FlowYr 0

Cash FlowYr 1

IRR NPV@ Cost of Capital 10%

Project X (10,000) 20,000 100% 8,182

Project Y (20,000) 35,000 75% 11,818

NPV and IRR give different rankings. To find which is the better we need to use theincremental cash flow approach.


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Firstly, let us accept Project X which is the preferred project using the IRR technique. If thisis the correct choice, then the incremental cash flows of Y X will not produce an IRR whichis acceptable (i.e. it will be lower than the cost of capital).

Consider the differences to cash flows if we move from Project Y to Project X:

Cash FlowYr 0

Cash FlowYr 1

IRR NPV@ Cost of Capital 10%

Change (10,000) 15,000 50% 3,636

IRR of 50% is acceptable – therefore using IRR as an appraisal tool we should accept X and(Y X), but X (Y X) Y. Thus, Y should be chosen (as per NPV) and we have used IRRto prove that NPV is the superior method.

NPV is also preferable because it is very useful for evaluating interrelated projects, and itemphasises the size of return given. IRR also has the problem that it can give multiple IRRs.

The advantage of IRR over NPV is that IRR is better at highlighting the rate of return againstthe cost of capital.

Despite the advantages of NPV over IRR, IRR is more popular in practice.

I. IMPACT OF TAXATION ON CAPITAL INVESTMENTAPPRAISAL

It is important to consider the effects of taxation on investment appraisal – not just as part ofa numerical question, but also because it can affect the outcome of the decision as towhether to invest.

Taxation should be taken into account in DCF analysis, since tax payments can seriouslyaffect the cash flows arising over the project's life, and you should always include additionalcolumns or rows in your DCF analysis to allow for taxation.

Capital investment appraisal is affected by taxation in four main ways:

(a) Annual profits are taxed – in practice nine months after the end of the accounting year– but you must read the question carefully to see what assumptions the examiner hasmade. The tax outflow may be included one year after the year in which the taxableincome arose, i.e. there will be a time lag of one year, making necessary a five-yeartable for a four-year investment scheme.

(b) Interest on debt is allowable against corporation tax, and this will affect the discountrate used.

(c) Tax losses must be included and they will normally be shown as a tax receipt, oradjustment, one year later.

(d) The existence of grants and capital allowances which help reduce the tax bill – thusmaking the project likely to be accepted. (If this arises in an examination question, youmust read the question very carefully for details of any such allowances – see below forfurther details.)

When appraising a capital investment scheme you not only need to take taxation intoaccount, but you must also consider the effect that a change in the tax rate or law (e.g. theremoval of a government grant) would have on a project. You must also consider thepossibility of any additional subsidies the firm may be able to claim, and their effect on thevalue of the project and, therefore, of the company.


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Capital Allowances

If you buy plant and machinery (capital assets) such as cars, vans, tools, computers andoffice equipment for use in your business, you can claim their cost as capital allowances tobe deducted from your profits. You can also claim capital allowances on some industrial oragricultural buildings, or hotels, and on items like patents and scientific "know how". (Notethat only part of the allowance can be claimed if an asset is used partly for private, asopposed to business, purposes.)

The basic principle is that you can claim 25% of the cost of an allowable item in the first year(the "written down allowance" or WDA) and 25% of the remaining cost in each subsequentyear. However, in the accounting period of purchase, you may be able to claim a higher "firstyear allowance" (FCA).

First year allowances

Small businesses can claim 50% of the cost of most plant and machinery purchased in2006/07 and 2007/08 except cars (up from 40% for 2005/06 purchases). Businesses of anysize can claim 100% on some environmentally friendly equipment and this includes new carswith CO2 emissions of 120g per kilometre or less bought before 31st March 2008. From 11th

April 2007, a business can claim a 100% Business Premises Renovation Allowance forrenovating vacant business premises in disadvantaged areas.

Changes to capital allowances

From April 2008, first year allowances for plant and machinery will be replaced by a £50,000annual investment allowance and the writing down allowance will fall from 25% to 20%.Allowances on industrial and agricultural buildings will be phased out, but tax credits forresearch and development costs will be increased. Capital allowances for business cars arealso currently under review.

Working out allowances

The cost of each new item, after deducting the first year allowance, is added to a "pool" ofexpenditure. Some items have to be kept in separate pools, but everything else goes intoone main pool.

Example

In May 2006, Phillips paid £1,500 for energy saving equipment on which he gets a 100% firstyear allowance and £6,500 on office equipment to which a 50% allowance applies. He soldhis old equipment for £2,450. His pool value at the start of the period is £4,250.

Calculate his pool value after the above transactions and also the allowances due to bereduced from his taxable profits.

Allowances Pool

£ £

Pool at start of period 4,250

Sales (2,450)

1,800

WDA £1,800 x 25% 450 (450)

1,350

Energy saving: £1,500 100% FYA 1,500 0

Other purchases: £6,500 50% FYA 3,250 3,250

To carry forward 5,200 4,600


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To apply capital allowances in practice we should assume, for example, that once an item ofplant and equipment has been purchased, then the corresponding tax allowance at thecurrent tax rate will effectively reduce the outlay for the item, because there will be less tax topay. The payment of tax and, hence, the cash benefit will usually be in the year following theyear in which the asset was acquired.

Practice Question

A project has an initial cost of investment of £25,000. It is expected to produce the followingcash inflows:

Year 1 £3,000

Year 2 £4,500

Year 3 £9,000

Year 4 £11,500

No scrap value is expected. The cost of capital is expected to be 9% over the four years.Should the project be accepted?



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ANSWER TO PRACTICE QUESTION

Present value of revenues:

Net Cash Flows£

Discount Factor NPV£

0 (25,000) 1 (25,000)

1 3,000 0.917 2,751

2 4,500 0.842 3,789

3 9,000 0.772 6,948

4 11,500 0.708 8,142

3,000 (3,370)

The project would not be accepted.

You need to note, though, that if the business had to undertake a new investment to replaceout of date technology, or for some other reason, then not accepting a project might not bean alternative. What would normally happen in these circumstances is that the businesswould consider a range of possible alternative investments and either accept the one thatgave the highest positive NPV or, if they were all negative, then the business would(normally) choose the investment that gave the lowest negative NPV.


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APPENDIX: DISCOUNTING TABLES

On the following pages you will find sets of discounting tables for:

£1 compounded annually

Uniform series (annuity) compounded annually

Present value of £1

Present value uniform series (annuity)

Present value of an annuity


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Annuity Tables

Present value of an annuity of 1, i.e.r

r)+(11 n

where: r interest rate and where n years

Interest Rates

(continued over)

307

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Study Unit 13

Capital Investment Decision Making 2: FurtherConsiderations

Contents Page

Introduction 308

A. Allowance for Risk and Uncertainty 308

Limiting the Payback Period 308

Inclusion of a Risk Premium in the Discount Rate 308

Certainty Equivalents 308

Attaching Probabilities to Cash Flows 309

Simulation Models 309

Sensitivity Analysis 310

Other Approaches 310

B. Impact of Inflation and Taxation on Investment Appraisal 311

Inflation 311

Taxation 312

C. Capital Rationing 312

D. Lease Versus Buy Decisions 313

E. Adjusted Present Value (APV) 316

Side Effects of Different Financing Methods 316

F. Use of the Capital Asset Pricing Model 319

G. Worked Examples 319


308 Capital Investment Decision Making 2: Further Considerations

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INTRODUCTION

In this study unit we shall continue our look at investment appraisal by considering otherfactors that impact on the decision, including inflation and uncertainty. We shall also considera further technique of investment appraisal – that of adjusted present value (APV) whichbuilds upon the work we have already covered on NPV and Modigliani and Miller.

You should note, though, that capital investment appraisal is not, however, a mechanisticprocess where data is processed and an irrevocable "correct" answer emerges. Themethods are only as good as the data input to them. Despite the refinement of using risk,inflation and other allowances, capital investment appraisal still requires the decision-maker –the human being – to assimilate the available data and take a risk, using human sensesbacked with management information.

A. ALLOWANCE FOR RISK AND UNCERTAINTY

All investments are subject to risk from unforeseen factors such as new legislation orchanges in fashion, which makes the original estimates of costs and sales, etc. no longervalid. There are several accepted methods for incorporating risk into a capital investmentappraisal and the more common ones are outlined below.

Note, though, that underlying all these approaches to allowing for risk is the problem that weare attempting to quantify in real numbers some aspect of the future which is largelysubjective to the person and firm carrying out the appraisal.

Limiting the Payback Period

One common method of dealing with risk and uncertainty is to limit the length of time aproject can pay back its investment. The justification used is that the further into the futureare the estimates of cash flows, the more inaccurate they are likely to be. Alternatives basedon this approach are to state that a project must also have a positive NPV in addition tomeeting its payback criterion, or that the discounted cash flows must pay back within acertain time period (i.e. the present values of cash flows occurring during the payback periodmust be positive).

Where there are constant cash inflows the payback of discounted cash flows can be found bydividing the initial outlay by the annual cash flow and seeing at what point in time theresulting figure is less than the cumulative discount factor.

Inclusion of a Risk Premium in the Discount Rate

The inclusion of a risk premium in the discount rate means that, if the normal discount rate tobe used were, say, 12%, then an additional amount – say 4% – might be allowed to cover forrisk, giving a 16% discount rate in total. Obviously the premium added is subjective and isthus correspondingly weak. Higher discount rates impact more significantly on the moredistant cash flows so that two projects – one short and one long in life-span – would betreated differently for risk by this method.

Certainty Equivalents

Under this method the expected cash flows arising from a project are subjectively adjustedby management to their equivalent riskless amounts. Different risk factors can be used foreach cash flow item and for each year – the greater the risk the smaller will be the certaintyequivalent value for cash inflows and the larger the certainty equivalent value for eachoutflow. The risk factors are generally expressed as percentages, e.g. 80% of income, 20%of costs.

Capital Investment Decision Making 2: Further Considerations 309

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Attaching Probabilities to Cash Flows

Another method of looking at each cash flow separately is to attach individual probabilities toeach cash inflow and outflow.

This method can also be used to calculate the worst possible outcome and its attachedprobability, or the probability that the NPV is negative or zero (i.e. it is a measure of risk).

For example:

Value Probability

£

130 0.2

138 0.6

145 0.2

We are stating probability values for the possible value of the outlay, so the "expected" valueis:

£ £

130 0.2 26

138 0.6 83

145 0.2 29

138

("Expected", here, is used in its statistical sense.)

Similarly, probabilities can be attached to the other inflows and outflows, to arrive at anexpected NPV. You should note that this procedure is rather more complicatedmathematically; this simple outline is given to indicate the formal methods of allowing for riskin DCF appraisals.

Simulation Models

An alternative to calculating an expected value when given probability estimates is to use asimulation model to establish a probability distribution of the project's expected NPV.

Simulation models, such as the Monte Carlo Simulation, are operated on computers usingrandom numbers. The model of the cash flows is constructed and a range of randomnumbers is assigned to each possible value for those variables which are uncertain. Thecomputer generates a series of random numbers and uses them to assign values to thevariables. The results can then be used (probably by the computer) to calculate the NPV foreach set of random numbers generated. The average, and range, of possible NPVs can bedetermined and used in the decision as to whether to accept the project or not. From this wecan move to the distribution of the NPV or IRR and, in the decision-making situation we canmatch the means and standard deviations of competing projects, matching expectedrevenues (mean) against the risk of achieving the same (standard deviation).

Monte Carlo simulation is often used in general business for risk and decision analysis, tohelp make decisions given uncertainties in market trends, fluctuations, and other uncertainfactors. In the science and engineering communities, MC simulation is often used foruncertainty analysis, optimisation, and reliability-based design, and in manufacturing, MCmethods are used to help allocate tolerances in order to reduce cost. There are certainlyother fields that employ MC methods, and there are also times when MC is not practical(particularly for extremely large problems where computer speed is still an issue). However,MC continues to gain popularity and is often used as a benchmark for evaluating otherstatistical methods.


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Sensitivity Analysis

This is a technique for determining the outcome of a decision if a key prediction turns out tobe wrong.

Basically, an investment project usually represents, as we have seen, an outflow of cash,followed at later time intervals by an associated series of inflows. Allowing for risk aims toquantify the likely effects of the results of the project not conforming to the pattern anticipatedwhen the project was assessed. Sensitivity analysis is an attempt to add to the number ofdimensions in an appraisal picture by indicating what the picture will look like if certaindominant items in it are flexed away from their original quantification.

You will also appreciate that each of the pieces of data that collectively form an "investment"will have a relative order of importance as to the resulting effect (of its being the one to gowrong) on the overall project. Clearly, some aspects will be vitally important to the project;others will be only marginally important. Some can go wildly astray; others deviate only afraction before the viability of the project is placed in jeopardy.

For example, a particular investment in, say, a drilling machine will not be greatly influenced ifit is found that more water-based coolant is required than was allowed for; but if theexpensive driving belts prove to require unexpectedly frequent renewal that would, obviously,be more significant.

Here is risk in a new light, then – recognising that the component aspects of an investmentproject can all have a probability of occurring as anticipated – and, further, that the variousaspects can have a separate and differing significance to the project.

Sensitivity analysis seeks to provide the decision-maker with more than just a "go/no go"statement, and aims to bring in all the "maybes" and "ifs", i.e. each aspect of the investmentcan be flexed slightly, and then a re-evaluation made, to see if the project is still acceptableor not.

The decision-maker can be presented with an appraisal which says: "This project is OK as itstands on paper; costs can be allowed to increase by x% or sales decline by y% before itbecomes an unacceptable project".

The sensitivity of a project to alterations in the original appraisal input data is analysed sothat the horizon of the decision-maker is widened, in order that they can see the proposedproject in its overall situation if things start to vary from those anticipated.

Other Approaches

A simple approach would be to have a "worst", "likely" and "best" estimate of eachprojected cash flow. In this way a project could be appraised in each of the availablelights.

Linear programming (LP) could be used in a situation where a certain number ofconstraints and variables exist. Some variables are known to be "slack" and LPs canbe produced with differing values input to these slacks.

It is a technique of operations research for solving certain kinds of problems involvingmany variables where a best value or set of best values is to be found. It is most likelyto be feasible when the quantity to be optimised, sometimes called the objectivefunction, can be stated as a mathematical expression in terms of the various activitieswithin the system, and when this expression is simply proportional to the measure ofthe activities – i.e. is linear – and when all the restrictions are also linear. It is differentfrom computer programming, although problems using linear programming techniquesmay be programmed on a computer.

Option theory can be used in investment appraisal. When a project is undertaken itoften provides additional options – to abandon a project, to make follow-on investments


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and to wait before undertaking an investment – and such options may need to beconsidered when undertaking investment appraisal. Such calculations are bestundertaken using a computer model. (Options and option theory are considered indetail in the a later unit.)

B. IMPACT OF INFLATION AND TAXATION ONINVESTMENT APPRAISAL

Inflation

The rate of inflation can have a major impact on a project and in particular the future cashflows of a project, and management must be made aware of any inflation assumptions madein NPV calculations. Remember that any projected inflation figures are only estimates (andthat there are a number of different ways of measuring it), and that the rate of inflation canvary between different years, and widely between different elements of cost, but to produceestimates for every element of cost for every year is not cost-effective.

The greater the rate of inflation the greater the minimum rate of return required by investors,in order to compensate for loss of income due to a declining value of money.

When considering the choice of the cost of capital to use in investment appraisal we need todiscuss the difference between the real and money (or nominal cost) of capital. The real costof capital is that in present value terms, whereas the nominal or money cost of capital is thatcash flow actually paid out. If you are asked in the examination about inflationary influenceson DCF calculations, the following formula will be useful to mention:

Real cost of capital i+1

1m

where: m the money cost of capital, and

i rate of inflation

When determining which discount factor to use you should note that the money rate ofinterest should be used when money cash flows are used, and real rates of interest if thecash flows are expressed in real terms. Thus, if you are required to adjust cash flows forinflation, you should use the money rate of interest, and if you are required to ignore inflation,or to treat all cash flows as real cash flows, then you should use the real cost of capital. It isessential to read the information provided carefully and state all assumptions – if inflation isnot mentioned then you should state "I am assuming that all cash flows are real cash flows,and the correct cost of capital to use is the real cost of capital".

Where the decision-maker is aware that inflation is going to occur they may wish to allow forit in their calculations. The correction may be either specific or general, as with adjustmentsfor risk.

Specifically, the cash flows for each year can be adjusted for the rate of inflationexpected to occur during that year, in an attempt to reduce all the data to a commonbase level.

Generally, an allowance can be made in the discount rate to cover the expected rateof inflation. Expectations about inflation are unlikely to be accurate and if they aresignificant to the outcome of the project we should use the risk and uncertaintytechniques discussed above.

Inflation can also have an impact on gearing and the resulting cost of capital. Inflation mayresult in a company increasing its selling price, which may have a major impact on demandfor a company's goods or services.


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Taxation

Payments of tax, or reductions in taxation payments, are cash flows and should ideally beconsidered in the DCF analysis.

A company will pay Corporation Tax on their profits usually in the year following that inwhich the taxable profits are made. Capital Allowances (the tax equivalent of depreciation offixed assets) are available as an allowance that reduces taxable profit and the consequentsaving of a tax payment should be seen as a cost saving in the period in which they arise.

The area of capital allowances is complicated and changes constantly but let us make abasic assumption, for example purposes, that a writing down allowance (WDA) is given at arate of 25% on the cost of plant and machinery on a reducing balance basis.

If an item of machinery cost a business, say, £60,000, then a capital allowance of £15,000(based on a WDA of 25%) is available on which to reduce taxable profits. If the new piece ofmachinery produced an estimated cost saving each year of £20,000 and the Corporation Taxrate was, say, 30% and the after-tax cost of capital for the business was 6%, then the taximplications for the DCF calculations would look as follows:

Year Equipment Savings Tax onsavings

Tax saved oncapital

allowances

Net cashflow

Discountfactor

PresentValue of

cash flows

£ £ £ £ £ £ £

0 (60,000) (60,000) 1.000 (60,000)

1 20,000 4,500* 24,500 0.943 23,104

2 20,000 (6,000) 3,375** 17,375 0.890 15,464

* £60,000 x 25% WDA x 30% C.Tax rate = £4,500

** (£60,000 – £15,000) x 25% WDA x 30% C.Tax rate = £3,375

The calculations above would carry on for the estimated useful length of life of the project.

C. CAPITAL RATIONING

An organisation is said to be in a capital rationing situation when it has insufficient funds toaccept all projects with a positive NPV. A decision therefore must be made as to whichprojects to choose. The technique used depends on whether capital rationing only exists forthe current period (single period capital rationing) or whether it will be limited for severalperiods, and whether the projects being considered are divisible (can be undertaken in wholeor in parts) or non-divisible (can only be undertaken as a whole or not at all).

In a situation where there is single period capital rationing and divisible projects,management should choose the projects which give the highest NPV per £1 of capitalinvested (i.e. maximising the return from the limiting factor).

Example

The management of Rosie Ltd have found that for the following year the company has only£100,000 available for investment. The company's cost of capital is 20%. They are currentlyconsidering four independent and divisible projects, as set out in the following table.


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Project Investment Required NPV at 20%

£ £

W 100,000 48,000

X 20,000 16,000

Y 30,000 18,000

Z 45,000 21,000

How should Rosie Ltd. proceed?

First we need to calculate the NPV per £1 of capital invested, i.e. the return achieved per unitof limiting factor, and rank the projects according to the results.

Project Investment Required NPV at 20% NPV/£1 Invested Ranking

£ £

W 100,000 48,000 0.48 3

X 20,000 16,000 0.80 1

Y 30,000 18,000 0.60 2

Z 45,000 21,000 0.47 4

The available £100,000 can now be allocated:

Project Investment NPV

£ £

X 20,000 16,000

Y 30,000 18,000

W (balance use 1/2) 50,000 24,000

100,000 58,000

This combination of projects gives the maximum return to the company and should beaccepted by the management.

If the projects are not divisible then this method may not give the optimal decision becausethere is likely to be unused capital. This unused capital could be invested and will earninterest. The best method of solving such a problem is trial and error by comparing the NPVavailable from the different possible combinations of projects, remembering to calculate anyinterest that would be received on the unused capital.

For multi-period capital rationing the timing of cash flows from each project is important, butagain management are attempting to maximise NPV per unit of scarce resource – capital.When there are divisible projects, linear programming can be used, and when there are non-divisible projects integer programming would be used.

D. LEASE VERSUS BUY DECISIONS

Because purchasing involves a large (in relative terms) capital outlay, which may involveborrowing, an organisation may consider leasing an asset rather than purchasing it outright.Purchase also leads to a commitment to particular assets which may succumb to newtechnology very quickly; leasing might provide an easier avenue to new technology, as andwhen it arrives. When considering whether or not to lease an asset it is assumed that the


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funds would come from borrowing rather than from the general pool of retained earnings,thus the decision could be seen as one of lease or borrow.

The methods used to consider hire purchase of an asset are the same as for consideringleasing an asset, but when looking at the non-financial aspects of the decision you shouldremember that when the HP term is over the asset belongs to the firm.

The methods discussed below are based on finance leases – operating leases are simply aform of renting and for them the only relevant cash flows are the lease payments and the taxsaved from offsetting these payments against tax. The traditional method of considering thefinancial implications of whether or not to lease an asset is done in two stages; first adecision is made as to whether or not to purchase the asset based on the operating cashflows arriving from it using the NPV techniques (with the discount factor being the WACC orother rate generally used by the organisation) that we have already discussed. If it isdecided to purchase the asset (i.e. the NPV is positive) then a decision is made as to how tofinance the asset (i.e. whether to lease it or fund it some other way). This latter decision ismade by discounting the differential cash flows which would arise from leasing at thecompany's (after tax – if tax-payers) cost of borrowing.

When considering a lease or buy decision you must be careful to consider all the taxationimplications. The Finance Act 1991 states that depreciation is allowable as an expenseagainst taxation in the form of capital allowances, as is the interest element of the financecharge. (Detailed knowledge of capital allowances and their subsequent tax implications areoutside of our present scope, but simple examples are shown both in the calculation above ofthe implications of inflation and taxation on investment decisions, and the example whichfollows.) If the purchase decision involves borrowing to buy, remember that debt interest isallowable against tax; lease payments may also be allowable. Again, if you encounter thistype of problem in the examination, it is important to read the information provided verycarefully, and to state any assumptions you make; a generally accepted simplifyingassumption is that lease payments are all fully allowable against tax – something you mayassume unless told otherwise. The accounting rules and regulations for operating andfinance leases are changing with the introduction of the new International AccountingStandards (IAS), but the basic differences between an operating lease and a finance leaseare as indicated.

You must also be careful to include all cash flows – including the sale of the asset (if bought),any extension fees of the lease, any maintenance costs and so on. Whilst it is possible tocalculate the comparison in one table you are less likely to make mistakes if you calculatethe NPV of the two options separately, and then compare them.

Other factors that may need to be taken into account are:

The company's liquidity and cash flow position – it may not be in the position topurchase an expensive asset outright.

The choice of lease or buy will have an effect on reported profits, and may affect themarket's view of the firm.

If the asset was to be purchased outright there would be an opportunity cost of whatother uses the funds could be put to.

Expenses of maintenance, insurance and so on may differ between leasing andpurchasing.

The costs of leasing may be far lower than a company's cost of capital, and as such there isa danger in using the traditional approach that a project may be rejected before its financingdecision is considered when it would be worthwhile at the lower cost of capital.

In order to overcome this problem, some financial managers take the decision the other wayround – deciding which is the cheaper method of financing and then evaluating the project atthe cheaper cost.


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A second and more preferable method of overcoming this problem is to evaluate the projectas though it is purchased, and then as though it is leased. The correct decision is the onewhich provides the highest NPV. If neither NPV is positive the project should be rejected.

Example

A company is to make the decision whether to lease or buy a new Toyota Corolla car for usein the business. The cost of the car is £14,000 and it has an estimated useful life of fiveyears. Due to the very high mileage the car is likely to do in this period, there is no estimatedresidual value. Assume tax is payable at 31% on operating cash flows one year in arrears.Capital allowances of 25% on a reducing balance basis are given on the car.

The company has the option to lease the car under a finance agreement for five years at anannual cost of £3,200, payable at the year end. If the company were to purchase the car itwould need to borrow the full amount at 12% interest. Which is the most cost-effectiveoption?

We first need to calculate capital allowances if the car is purchased:

£

Year 1: 25% £14,000 3,500

Year 2: 25% £10,500 2,625

Year 3: 25% £7,875 1,969

Year 4: 25% £5,906 1,477

9,571

Year 5: £14,000 £9,571 4,429

We now need to look at the cost of both options.

Leasing

Assume that lease payments are eligible for a full tax allowance. (Note that the discount rateof 12% must be adjusted for tax relief on borrowing costs, giving 12% (100% 31%) 8%.

Year Cash Flow Discount Factor NPV

£ 8% £

1 Lease cost (3,200) 0.926 (2,963)

2 Lease cost (3,200) 0.857 (2,742)

Tax saving on lease cost ( 31%) 992 0.857 850

3 Lease cost (3,200) 0.794 (2,541)


4 Lease cost (3,200) 0.735 (2,352)


5 Lease cost (3,200) 0.681 (2,179)


6 Tax saving on lease cost ( 31%) 992 0.630 625

(9,109)


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Purchase

Year Cash Flow Discount Factor NPV

£ 8% £

0 Cost of car (14,000) 1.000 (2,963)

2 Tax saved (capital allowances)31% £3,500 1,085 0.857 930

3 Tax saved 31% £2,625 814 0.794 646

4 Tax saved 31% £1,969 610 0.735 448

5 Tax saved 31% £1,477 458 0.681 312

6 Tax saved 31% £4,429 1,373 0.630 865

(10,799)

The leasing option is therefore the cheaper one and should be adopted.

E. ADJUSTED PRESENT VALUE (APV)

Side Effects of Different Financing Methods

Conventional methods of capital investment appraisal (e.g. NPV and IRR) discount therelevant future cash flows at the organisation's WACC. This is fine for simple, small projects,but it ignores changes in financing arrangements and differing levels of systematic risk thatmay arise from accepting a new project. These changes in financing arrangements oftenoccur because a new share or debt issue may be raised to pay for the capital project.

The interaction that may occur between the financing and investment decisions can be dealtwith in capital investment appraisal by adjusting the WACC using the CAPM (see earlier inthe course) or by using the adjusted present value technique which considers the abovepoints.

The steps in using an APV approach are:

(a) Find the ungeared cost of equity for the firm.

(b) Estimate the base case NPV – this is done by discounting the project's cash flows atthe ungeared cost of equity.

(c) Evaluate and discount the side effects of the project and its financing methods,examples of these being:

Tax

Financing

Issue costs

Subsidised loans

(d) Add the discounted side effects to the base case NPV to give the APV.

(e) If the APV is positive accept the project.

This process can be best illustrated by an example. Although it is useful for you tounderstand these workings you will not be expected to undertake similar calculationsconcerning APV in your examination.

Before looking at the example, let us briefly summarise the advantages and disadvantages ofthe APV method.


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The advantages are that:

It is easier to calculate than attempting to adjust the discount rate for all the sideeffects, and as such it is versatile and flexible.

It allows management to evaluate all the effects of the method of financing a project,and thus to see where the benefits of the investment are coming from. This may beespecially useful if the benefits are arising from, say, a government incentive whichmay be withdrawn quickly thus making the project unviable.

The disadvantages of the APV method are that:

It is dependent on the theories of MM (1963) (as considered in an earlier unit) for itsunderlying assumption and thus the problems with MM are also inherent with APV.

It can be difficult to identify all the costs associated with the method of financing andchoosing a correct interest rate to discount them with.

It can be long and complicated – as no doubt you may agree after studying theexample.

Example

Amigo is considering investing in a project which will cost £75,000. The cost of the projectwill attract writing down allowances at 25% on a reducing balance basis. The project willhave a net cash flow of £37,500 per annum for three years, after which time it will bescrapped for a minimal sum. To finance this project £15,000 will be taken from retainedearnings, and the remainder will be provided by Amigo's bank for a cost of £1,000. The rateof interest on the loan is to be 12%.

The industry average beta for projects of this type is 2.5, and its average gearing ratio is 3:4(debt: equity). The risk-free rate is 10%, and the market return is 15%. Assume corporationtax is 33%, paid a year in arrears. Assess the project's viability using an APV technique.

Note that it would be very difficult to assess this project with any reliability otherwise than byAPV.

The five steps in applying the APV technique are as follows:

(a) Find the ungeared cost of equity for the firm using the following formula:

g ug [1 eg

d

V

t)(1V ]

Using the industry average beta, rather than an individual company's beta, is a goodtechnique as this removes many of the problems with betas discussed earlier in thecourse.

Unless told otherwise assume the debt is risk-free.


2.5 ug [1 3 (1 0.33)/4]

2.5 ug [1.5025]

ug 2.5/1.5025

ug 1.66

Using CAPM 10% (15% 10%) 1.66 18% base case discount rate.

(b) Estimate the base case NPV – this is done by discounting the project's cash flows atthe ungeared cost of equity.


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Calculating the writing down allowances:

Timing Book Value WDA Tax Rate Tax Relief

Yr 2 75,000 0.25 18,750 0.33 6,188

Yr 3 56,250 0.25 14,063 0.33 4,641

Yr 4 42,187 (balancing allowance) 0.33 13,922

Base case present value:

Year 0 1 2 3 4

Outlay (75,000)

Cash flows 37,500 37,500 37,500

Tax (12,375) (12,375) (12,375)

WDA 6,188 4,641 13,992

After tax cash flows (75,000) 37,500 31,313 29,766 1,617

Discount factor (18%) 1 0.8475 0.7182 0.6086 0.5158

PV cash flow (75,000) 31,781 22,489 18,116 834

Base case present value (1,780) (note that this is negative).

(c) Evaluate and discount the side effects of the project and its financing methods.

(i) Present value of debt arrangement fee (£1,000) – assume paid in Year 0

Tax relief £1,000 0.33 £330

Claimed Yr 2 £330 0.7972 (applying 12% discount rate) £263

(ii) Present value of tax relief, discounted at the pre-tax cost of debt which reflectsthe low risk of the tax relief (note that the after-tax rate is not used because thiswould double-count the tax relief, and interest is assumed to be allowable againsttax unless stated otherwise):

Interest Annual tax relief on interest:

£60,000 0.12 £7,200 0.33 (tax relief) £2,376

Year 2: £2,376 0.7972 £1,894

Year 3: £2,376 0.7118 £1,691

Year 4: £2,376 0.6355 £1,510

PV of tax relief £5,095

(d) Add the discounted side effects to the base case NPV to give the APV.

Adjusted present value:£

Base-case present value (1,780)

Present value of tax shield 5,095

Arrangement fee (1,000)

PV of tax relief on arrangement fee 263

Adjusted present value 2,578

(e) As the APV is positive accept the project.


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F. USE OF THE CAPITAL ASSET PRICING MODEL

The principal input that the capital asset pricing approach can make into capital budgeting isin determining the discount rate. However, there are two important limitations:

The discount rate is determined as at a point in time, yet most projects run for severalyears; and

There are so many market imperfections that the rate may be influenced more by "realworld" distortions than determined by the model itself.

Furthermore, it is possible to have conflicting outcomes in appraising the same projectdepending on the source of the discount rate. If the rate is based on the weighted averagecost of capital (WACC) method, a project may be rejected because it gives insufficient return,say, whereas under CAPM it would be acceptable because such low return is offset by lowsystematic risk.

Rigid use of a cost of capital method will tend towards acceptance of higher risk and avoidingsufficiently profitable but lower risk projects. Such conflicts are rare, but can occur inpractice.

If CAPM is accepted, it might be concluded that, when deciding whether to invest in aparticular project, management should be concerned with its systematic risk and not with itsoverall risk. If the beta factor can be estimated, then it is possible, using the formula givenearlier, to calculate the minimum required return on the project, based on the systematic riskof the project. The model can thus be used to compare projects of different risk classes,unlike the NPV method which does not consider risk in its choice of discount rate.

In using the model, management are determining a required rate of return based on marketand risk free rates of returns, the returns on the project and its variation to the market; in sodoing they are assuming that shareholders wish them to evaluate such projects as thoughthey were stocks and shares in the market, and that shareholders are fully diversifiedthemselves and have no desire for the company to diversify on their behalf.

G. WORKED EXAMPLES

The following examples are typical of the types of problem you may expect to face in theexamination.

Example 1

A company has estimated the expected cash flows for four possible projects as follows:

YearProject0 1 2 3 4 5

1 (500) 200 200 300 200 200

2 (400) 100 100 100 100 500

3 (150) 40 50 60 70 100

4 (1,000) 500 400 300 200 100

Note that all figures are in £000s.


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Required:

(a) Rank these projects in order of acceptability using:

(i) Payback;

(ii) Net present value at 20% cost of capital;

(iii) Internal rate of return.

(b) Explain which project should be accepted if the projects were mutually exclusive andthere was no capital rationing.

(c) Explain which project(s) should be accepted if the projects were independent andindivisible, and the company had £1 million to invest.

(d) Explain which project(s) should be accepted if the projects were independent anddivisible, and the company had up to £1.1 million to invest.

(e) Explain briefly the relative advantages and disadvantages of the appraisal methodsused in (a) above.

The following discount factors are provided for use as necessary:

Year Net Present Value Value of an Annuity

20% 30% 20% 30%

1 0.8333 0.7692 0.833 0.769

2 0.6944 0.5917 1.528 1.361

3 0.5787 0.4552 2.106 1.816

4 0.4823 0.3501 2.589 2.166

5 0.4019 0.2693 2.991 2.436

Answer

(a) (i) Payback method

Project 1

The £500,000 initial outlay is returned as follows:

(200,000 200,000 31 [300,000]) 2.3 years

Project 2

The £400,000 initial outlay is returned as follows:

(100,000 100,000 100,000 100,000) 4 years

Project 3

The £150,000 initial outlay is returned

(40,000 50,000 60,000) 3 years

Project 4

The £1,000,000 initial outlay is returned as follows:

(500,000 400,000 31 [300,000]) 2.3 years

So the ranking is:

1st equal – Project 1 and Project 4

3rd – Project 3

4th – Project 2


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(ii) With NPV at 20%

Project 1Year Cash Flow Factor NPV

£000 £000

0 (500) 1.0000 (500.00)

1 200 0.8333 166.66

2 200 0.6944 138.88

3 300 0.5787 173.61

4 200 0.4823 96.46

5 200 0.4019 80.38

155.99


£000 £000

0 (400) 1.0000 (400.00)

1 100 0.8333 83.33

2 100 0.6944 69.44

3 100 0.5787 57.87

4 100 0.4823 48.23

5 500 0.4019 200.95

59.82


£000 £000

0 (150) 1.0000 (150.00)

1 40 0.8333 33.33

2 50 0.6944 34.72

3 60 0.5787 34.72

4 70 0.4823 33.76

5 100 0.4019 40.19

26.72


£000 £000

0 (1,000) 1.0000 (1,000.00)

1 500 0.8333 416.7

2 400 0.6944 277.8

3 300 0.5787 173.6

4 200 0.4823 96.5

5 100 0.4019 40.2

4.8

The ranking from Project 1 to 4 runs also from 1 to 4 in order.


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(iii) IRR method

NPV at 30%, when combined with the NPV at 20%, can be used to determine theIRR by use of a formula:


£000 £000

0 (500) 1.0000 (500.00)

1 200 0.7692 153.80

2 200 0.5917 118.30

3 300 0.4552 136.60

4 200 0.3501 70.00

5 200 0.2693 53.90

32.60


£000 £000

0 (400) 1.0000 (400.00)

1 100 0.7692 76.90

2 100 0.5917 59.20

3 100 0.4552 45.50

4 100 0.3501 35.00

5 500 0.2693 134.70

(48.70)

Project 3 Year Cash Flow Factor NPV

£000 £000

0 (150) 1.0000 (150.00)

1 40 0.7692 30.80

2 50 0.5917 29.60

3 60 0.4552 27.30

4 70 0.3501 24.50

5 100 0.2693 26.90

(10.90)


£000 £000

0 (1,000) 1.0000 (1,000.00)

1 500 0.7692 384.60

2 400 0.5917 236.70

3 300 0.4552 136.60

4 200 0.3501 70.00

5 100 0.2693 26.90

(145.20)


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To determine the internal rate of return for each project we can apply the formula:

X

X)(Y

b+a

a

where: X the lower rate of interest used

Y the higher rate of interest used

a the difference between the present values of the outflow and theinflows at X%

b the difference between the present values of the outflow and theinflows at Y%.

If one NPV is positive (i.e. a) and the other negative (i.e. b) the formula is:

X

X)(Y

ba

a

So to take each project in turn:

Project 1:

IRR 20

20)(30

188.59

155.99 28.3%

Project 2:

IRR 20

20)(30

108.52

59.82 25.5%

Project 3:

IRR 20

20)(30

37.62

26.72 27.1%

Project 4:

IRR 20

20)(30

150.0

4.8 20.3%

This then ranks the projects in the order:

1st – Project 1

2nd – Project 3

3rd – Project 2

4th – Project 4

(b) With mutually exclusive projects and no capital rationing, the company should selectthe one with the highest NPV, this being Project 1.

(c) In the situation of independent, indivisible projects where the company had £1 million toinvest, the best approach would be to maximise the NPV obtainable. In this case,Projects 1 and 2 should be accepted.


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(d) Looking at the situation of divisible, independent projects we would need to considerthe highest profitability index, being:

Project 1 2 3 4

investmentInitial

InflowsP/V

500

99655.

400

82459.

150

72176.

1000

81004.

1.31 1.15 1.18 1.00

We would allocate our money to the most profitable first which would provide thefollowing portfolio:

Project 1 – investment of £500,000



£1,050,000

(e) Payback is useful in that it has the advantage of showing when the initial investmenthas been repaid. However, it also has the disadvantages of:

(i) Ignoring income after the payback period; and

(ii) Ignoring interest.

Net present value provides the advantage of considering both cash flows and interestover the project life but the disadvantage of ignoring risk.

Internal rate of return provides the advantage of an appraisal as a single percentagefigure and thereby indicates a project yielding the highest return on investment.However, by the use of such a rate the cash flow effects can be hidden and the riskaspects ignored.

Example 2

Hurdlevack Ltd relies on the payback method of project evaluation, requiring that investmentsrepay capital within three years. The board are currently considering the four followingprojects.

Project A B C D

£ £ £ £

Sales 40,000 75,000 60,000 60,000

Direct costs 16,000 27,000 15,000 18,000

Depreciation 8,000 40,000 30,000 35,000

Interest 12,000 16,000 9,000 7,000

Initial investment 120,000 160,000 90,000 70,000

Project life 15 years 4 years 3 years 2 years

The engineering department has asked the board to evaluate these opportunities by meansof a discounted cash flow technique. The finance department has been unwilling to use adiscounted cash flow technique, because of difficulty in establishing an appropriate discountrate. It therefore proposes to calculate each project's internal rate of return, and let the boarddetermine appropriate hurdle rates.


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Required:

(a) Calculate each project's payback and state which of the opportunities is acceptable bythis criterion.

(b) Calculate each project's internal rate of return and using a hurdle rate (the minimumrate of return acceptable to the company) of 15%, state which of the opportunities isacceptable by this criterion.

(c) Suggest why the above two project appraisal methods do not give answers which areconsistent with each other for the accept/reject decision.

(d) Briefly outline some of the elements which should be considered when determining theappropriate hurdle rate for an individual project.

Answer

(a) Direct costs, interest charges and flows from sales are used in the calculation ofpayback periods, as follows.

Project A B C D

£ £ £ £

Sales 40,000 75,000 60,000 60,000

Direct costs (16,000) (27,000) (15,000) (18,000)

Interest (12,000) (16,000) (9,000) (7,000)

Net annual cash flow 12,000 32,000 36,000 35,000

As the payback is the time in which the cash flows repay the initial capital outlay, it canbe derived as follows.

Project A B C D

£ £ £ £

Capital outlay 120,000 160,000 90,000 70,000


Payback period 10 years 5 years 2½ years 2 years

Thus, C and D are acceptable.

(b) When looking at the internal rate of return (IRR) of the projects, we look at cash flowsfrom sales and direct costs.

Project A B C D

£ £ £ £

Sales 40,000 75,000 60,000 60,000

Direct costs (16,000) (27,000) (15,000) (18,000)



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Project A B C D

£ £ £ £

Capital outlay 120,000 160,000 90,000 70,000


Payback 5 years 3.33 years 2 years 1.67 years

From the annuitytables, the IRR is(approximately): 18% 8% 23% 13%

Thus A and C are acceptable.

(c) The cash flows of a project which arise after the payback period are not accounted forunder the payback appraisal method. Thus, where a project takes a relatively long timeto "come on stream", it will be rejected on payback terms, even if it has an acceptableIRR. As can be seen from the above, Project A is acceptable only under IRR. Paybackemphasises liquidity but, if cash flows cease quickly, as in Project D, the paybackcriteria may be met but an adequate return on capital is not seen.

Project B is rejected by both appraisal methods because of the small cash return.Project C is the opposite, having high cash returns, and it is acceptable under bothappraisal methods.

(d) The inherent risks associated with cash flows deriving from each project should beassessed in determining hurdle rates. As it is likely that investments will already beunder way, these should also be considered, as they might provide benefits associatedwith a new project – i.e. diversification of risks.

In a perfect capital market, flows from a projected project may not be positivelycorrelated with the earnings stream of the firm, and diversification may still not be wise.Where there are possibilities for private shareholder diversification, diversification inprivate and corporate terms may equate, and there would not be any benefit incorporate diversification. If this is so, then only the risk associated with the earningsstream from the project would not be diversified by portfolio investment.

Where the capital market is imperfect, it may be quite acceptable to diversify. Anumber of flows from various projects may alter the risk incurred by a firm very little, ifat all. In such cases, the firm's cost of capital may be used as a required rate of returnon investments. However, if the cash flows of a project will significantly affect the riskof a company on average, where these are taken with the existing earnings stream, it isnecessary to calculate the return on each available project combination linked with theexisting earnings stream. By doing this, the "right" mix of investments can beassessed, to compensate for any change in earnings with any change in associatedrisk.


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Practice Questions

1. A new polishing machine is required. The polishing machine forms a part of theproduction process, and most products manufactured require polishing at variousstages in their production. A polishing facility is expected to be required for as long asthe factory remains in operation, and no closure can be anticipated.

Details of the two machines under consideration are set out below.

Machine A B

Initial cost £50,000 £90,000

Life – years 4 7

Salvage value at end of:

Year 4 – machine A £5,000

Year 7 – machine B £7,000

Annual running costs £10,000 £8,000

Both machines fulfil the same function and have equal capacities. The approximatediscount rate is 10%.

Required:

Determine which machine should be purchased. Specify any assumptions made.

To what amount would the initial cost of machine A be required to alter in order for thetwo machines to be of equal financial attractiveness?

2. ABC Ltd, which is investigating the possible acquisition of XYZ Ltd, for diversificationpurposes, has asked you to advise the firm on the basis of the following information:

XYZ LtdSummary Balance Sheet as at 30th September 2002

£000 £000

Ordinary shares 1,500 Land & buildings 900

Reserves 900 Plant (net of depreciation) 600

10% debentures 750 Investments 450

Creditors 300 Stock 600

Debtors 600

Cash 300

£3,450 £3,450

Profits: 2000 – £350,000

2001 – £300,000

2002 – £450,000

You are also told the following:

It is estimated that the investments have a market value of £675,000, and that thestock could be sold for £750,000. The other assets have a value as stated in thebalance sheet.


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All of the investments and plant valued at £225,000 would not be needed by ABCLtd.

The investments have produced annual income of £45,000 per annum for the lastfive years, and are expected to continue to do so.

ABC Ltd would repay the debentures at par, immediately after acquisition.

ABC Ltd requires a return on capital of 10%.

Required

You are required to calculate the maximum price which ABC Ltd should be prepared topay for XYZ Ltd on each of the following bases:

(a) Break-up value.

(b) Profitability.

(c) Discounted cash flow, assuming that the cash flows to be discounted are asfollows:

£000

2003 450

2004 600

2005 450

2006 onwards 570

Present value factors at 10%

Year 1 0.90909

Year 2 0.82645

Year 3 0.75131

Year 4 0.68301

(Note that it is normal in both practice and examinations to use discount figures toonly three decimal places – i.e. the above figures would normally be stated as:

Year 1 0.909

Year 2 0.826

Year 3 0.751

Year 4 0.683)

3. Stamford Ltd specialises in the production of plastic sports equipment. The companyhas recently developed a new machine for automatically producing plastic cricket bats.The machine cost £150,000 to develop and install, and production is to commence atthe beginning of next week. It is planned to depreciate the £150,000 cost evenly overfour years, after which time production of plastic cricket bats will cease. Production andsales will amount to 30,000 bats each year. Annual revenues and operating costs, atcurrent prices, are estimated as follows.

Sales (£9.60 each) £288,000

Variable manufacturing costs £200,000

This morning, a salesman has called and described to the directors of Stamford Ltd anew machine, ideally suited to the production of plastic cricket bats. This item ofequipment is distinctly superior to Stamford's own machine, reducing variable costs by30% and producing an identical product. The cost of the machine, which is alsocapable of producing 30,000 cricket bats per annum, is £190,000.


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Assume the following:

Annual revenues and operating costs arise at the year-end.

The general rate of inflation is 10% per annum.

The company's money cost of capital is 21%.

The existing machine could be sold immediately for £12,000.

If purchased, the new machine could be installed immediately.

Either machine would possess a zero residual value at the end of four years.

Required:

(a) Calculation of the net present value of the two options open to the management,using the real cost of capital.

(b) Advice to the management as to which course should be followed, and anexplanation of the significance of your calculations under (a).

Note: Ignore taxation.

Table of Factors for n 4 Years

Interest Rate(per cent)

Present Valueof £1

Present Value of £1Received per Year

r (1 r)n

r

r)+11 n (

10 0.68 3.17

11 0.66 3.10

12 0.64 3.04

13 0.61 2.97

14 0.59 2.91

15 0.57 2.85

16 0.55 2.80

17 0.53 2.74

18 0.52 2.69

19 0.50 2.64

20 0.48 2.59

21 0.47 2.54

22 0.45 2.49


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4. An opportunity has arisen for your company to acquire the specialised product stocksof a bankrupt business for £50,000. The net proceeds from the sale of these stockswill be influenced by a number of factors originating from outside the company but therange of possibilities appears to be as follows.

Possible Amounts ofNet Sales Proceeds

Probability

£ %

Year 1 24,000 60

20,000 30

36,000 10

Year 2 60,000 50

48,000 30

20,000 20

The estimates for Year 2 are independent of those for Year 1. The company's requiredrate of return is 20%.

Required:

(a) To calculate the expected net sales proceeds each year; and to state whether onthis basis the project would yield the required rate of return.

(b) To tabulate the possible combinations of sales value over the two years, with theirrelated probabilities, and from this data to calculate the overall percentageprobability of the rate of return being less than the required 20%.

(c) Without making any further calculations, to explain how you would arrive at thestandard deviation of net present value and the coefficient of variation for thisproject, and the use that might be made of those statistics.



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1. The technique known as the equivalent annual cost technique may be used here, asthe service provided by the machines in question is to be required for the foreseeablefuture. The present value of operating each machine for its economic life is calculated,and then expressed as an annual equivalent. This latter figure is achieved by thefollowing calculation:

periodsametheforfactorAnnuity

lifeeconomicformachineoperatingofvaluePresent

Such a figure enables an easier comparison to be made of assets with differingeconomic lives, provided that at the end of its life an asset is replaced by a similar one.An assumption of unchanging technology and constant relative prices is necessary.

On this basis, the present value of the costs is as follows.

A B

£ £

Initial cost 50,000 90,000

Running costs:

£10,000 3.170 (4 years at 10%) 31,700

£8,000 4.868 (7 years at 10%) 38,944

less Salvage value:

£5,000 0.683 (3,415)

£7,000 0.513 (3,591)

Present value of cost (a) 78,285 125,353

Annuity factor (b) 3.170 4.868

Equivalent annual cost (a b) £24,696 £25,750

This shows that machine A should be chosen, as it is the less expensive. At the end offour years, then eight years, etc., new machines A would be purchased asreplacements.

To be equally financially attractive, it would be necessary for the initial cost of machineA to rise until the equivalent annual cost of A was also £25,750. This would mean apresent value total of:

£

£25,750 3.170 81,628

less Present value now 78,285

£3,343 increase

So, it would be necessary for the initial cost of machine A to rise to £53,343 for themachines to be equally attractive.


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2. Maximum prices ABC Ltd would be prepared to pay for XYZ Ltd on the following bases.

(a) Break-up Value

This can be computed in two ways, bearing in mind that, even if the investmentand plant worth £225,000 are not needed by ABC Ltd, they do represent part ofthe value of XYZ Ltd and any as yet unrealised profits in them constitute part ofthe value. As the company is being acquired as a whole, any sale of assetssurplus to requirements and made subsequently would merely alter the values ofindustrial assets, and it would not affect the overall break-up value.

The value is calculated as follows:

Either Or

Value at 30/11/2002 £000 £000

Land and buildings 900 900

Plant 600 375

Investments 675 –

Stock 750 750

Debtors 600 600

Cash 300 300

Sum due on sale of investments/assets orcash proceeds realised – 900

3,825 3,825

less: Debentures 750 750

Creditors 300 300

Value of business to ordinary shareholder £2,775 £2,775

So, therefore, the break-up value is £2,775,000, which purely puts a value to theassets as they stand and, to some extent, includes growth in the value of theassets over the historical cost. Potential future profitability is not reflected in thisfigure. To allow for this, a value of goodwill would need to be calculated in termsof "n" years' purchase of average weekly profits less an allowance for theprojected interest on capital. The number represented by "n" would be thattypical to the particular industry or trade.

(b) Profitability

To obtain a maximum price on this basis, different assessments can be made.

Initially, it should be seen whether "profits" in the terms of the question relates toprofits after payment of debenture interest and including the interest receivedfrom investments. An assumption is made that this is so.

Past profits are usually adjusted, in exercises such as this, in the light ofchanging circumstances which will prevail when the purchasing company takesover – with no investments and repaid debentures.

Two alternative methods can be used, with both unweighted and weighted profits.The number of years' average profits to be taken into the market value needs tobe assessed.


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As the company specifies a cost of capital, or capitalisation rate, of 10% a P/Eratio of 10 would be appropriate – i.e.

Market value rateationCrystallis

Earningsor Market value P/E ratio Earnings

The valuations at 30th November 2002 are as follows:

Method 1 (unweighted)

Annual Profits(given)

InvestmentInterest

DebentureInterest

AdjustedProfit

£000 £000 £000 £000

2000 350 (45) 75 380

2001 300 (45) 75 330

2002 450 (45) 75 480

£1,100 £(135) £225 £1,190

Average annual unweighted profit is3

0001901 ,,£ £396,666

Method 2 (weighted)

Adjusted Profit Weight Weighted AdjustedProfit

£000 £000

2000 380 1 380

2001 330 2 660

2002 480 3 1,440

£1,190 £2,480

Average annual weighted profit is6

0004802 ,,£ £413,333

So, on a P/E basis of 10, the price would be:

Method 1 – £3,966,666

Method 2 – £4,133,333 (maximum)

The higher values seen here reflect the vendor's ability to make a profit.

(c) Discounted Cash Flow

The cash flows represent the projected flows but excluding investment anddebenture interest. They compare, therefore, with the adjusted profitsassessments of value.

DCF looks at the value of the company as a discounted stream of future cashflows available to the purchaser.

This gives the net present value, as follows:


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Year Cash Flow DCF Present Value

£000 (10%) £000

2003 450 0.90909 409.1

2004 600 0.82645 495.9

2005 450 0.75131 338.1

1,243.1

2006 onwards 570

Valued at:ratetionCapitalisa

Dividend 0.75131

10

000570

.

, 0.75131 4,282,500

1,243,100 4,282,500 £5,525,600

This treatment for £570,000 for 2006 onwards presents a value in perpetuity.

Therefore, to sum up:

Maximum value: £000

(a) Break-up value £2,775

(b) Profitability £4,133

(c) DCF £5,525

3. (a) Real cost of capitali+1

im

%.

.

.

..10=

11

110=

100+1

100210

Option 1, using the present machine, gives in real terms:

£

Sales 288,000

Variable costs of manufacture 200,000

Contribution 88,000

£88,000 for 4 years gives a PV £88,000 3.17 £278,960

Option 2, using the new machine, gives:£

Sales 288,000

Variable costs of manufacture 140,000

Contribution 148,000

£148,000 for 4 years gives a PV £148,000 3.17 £469,160


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But costs arise on the changeover, as follows:

Cost of machine of greater efficiency £190,000

less Proceeds of sale of old machine 12,000 £178,000

Present value following allowance for net purchase cost £291,160

As regards the development and installation costs of £150,000 relating to the newmachine, this represents money spent. The sum does not come into thecalculations otherwise.

Another way of looking at this is to make the calculations in money terms with anallowance for the 10% inflation.

Option 1

Year Sales Variable Costs Contribution PV

£ £ £

21%Factor £

1 316,800 220,000 96,800 0.826 79,957

2 348,480 242,000 106,480 0.683 72,726

3 383,328 266,200 117,128 0.564 66,060

4 421,661 292,820 128,841 0.467 60,169

278,912

Option 2

Year Sales Variable Costs Contribution PV

£ £ £

21%Factor £

1 316,800 154,000 162,800 0.826 134,473

2 348,480 169,400 179,080 0.683 122,312

3 383,328 186,340 196,988 0.564 111,101

4 421,661 204,974 216,687 0.467 101,193

469,079

less Costs of changeover 178,000

291,079

The factors are calculated as (1.21)n.

(b) The present machine makes a contribution of £88,000 pa for four years –£278,960 in all. The new and more efficient machine will increase thecontribution level to £148,000 pa. However, there is the high initial cost of£190,000 less £12,000 sales receipts to be considered. This brings the PV of themore efficient machine down to £291,160. The marginal superiority in results of£12,200 needs to be carefully weighed against the risks of the project.

Will the market for plastic cricket bats continue to be buoyant?

Might the variable production costs increase?

Either possibility could easily eliminate any advantage, so it is probably better notto invest in the new machinery.


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The payback method is useful here, in the sense that, if we look at the return onthe outlay of £178,000, the contribution pa increases by £60,000. This meansthat almost a full three years out of the project life of four years must elapsebefore the company is satisfied in payback terms. We must remember also thatwe have not considered interest, etc.

4. (a) Expected net sales proceeds:

Possible Cash Flow Probability Expected Value

£ £

Year 1 24,000 0.6 14,400

20,000 0.3 6,000

36,000 0.1 3,600

24,000

Year 2 60,000 0.5 30,000

48,000 0.3 14,400

20,000 0.2 4,000

48,400

Cash Flow Discount Factor NPV

£ (r 20%) £

Y0 (50,000) 1.0 (50,000)

Y1 24,000 0.83333 20,000

Y2 48,400 0.69444 33,611

Net present value 3,611

The project yields a return in excess of 20% and should, therefore, be accepted.

(b) The table of possible combinations of sales values and their related probabilitiesare set out on the next page.

From this, the probability of the return being less than 20% is:

P(iii) P(vi) P(ix)

0.12 0.06 0.02

20%


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(c) (i) Standard Deviation

Standard deviation comes from the following formula:

2)xp(x

where: standard deviation

p probability of a particular outcome

x particular outcomes possible (i.e. NPVs)

x expected net present value (i.e. 3,611)

Standard deviation measures the dispersion around the mean value(expected net present value). Its significance is seen in its size relative tothe mean value. The greater the dispersion, the greater the risk of notachieving the expected outcome.

(ii) Coefficient of Variation

This can be calculated as follows:

Coefficient of variation x

It is useful in the comparison of the dispersion of two or more distributionsof projects of different sizes; the higher the coefficient, the more widelydispersed is the distribution.

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Study Unit 14

Managing Risk

Contents Page

A. The Nature of Risk 341

Types of Risk 341

Costs of Managing Risk 343

B. Principles of Hedging 343

Short and Long Positions 344

Closing out 344

Developing a Hedging Policy 345

Costs of Hedging 346

C. Interest Rates, Risk and Exposure 346

Interest Rate Structures 346

Impact of Interest Rate Changes 348

Managing Exposure to Interest Rate Risk 349

D. Internal Techniques of Managing Interest Rate Exposure 350

Matching 350

Smoothing 350

E. Futures Contracts 350

Characteristics 350

Hedging Interest Rate Exposure with Futures Contracts 352

F. Forward Rate Agreements (FRAs) 354

Characteristics 354

Hedging Interest Rate Exposure with FRAs 354

G. Interest Rate Swaps 355

Characteristics 355

Operation of Interest Rate Swaps 355

(Continued over)

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H. Options 357

Calls and Puts 358

Option Prices 362

Hedging and Trading Strategies using Options 364

Interest Rate Options 368

Application of Option Theory to Capital Investment Decision making 369

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A. THE NATURE OF RISK

Types of Risk

We have seen before that all business enterprises face a degree of risk. There are a numberof different types of risk that affect the work of the finance manager and these can besummarised as follows:

Business risk

Insurable risk

Interest rate risk

Currency risk

International trade and finance risk

The last two of these different types of risk are covered in the next (and last) study unit.

Running a business inevitably involves the taking of risks, but there are a number of waysand techniques in which a finance manager can help to reduce the amount of risk that thebusiness faces. However, risk reduction can often be costly and the finance manager willneed to balance that cost against the possible financial benefits gained (or losses incurred)as a result of taking action to reduce the risk.

Business risk

Business risk is that arising from the very nature of the business itself. We can divide thistype of risk into two groups.

That which is inherent in the conduct of business itself and cannot be reduced oreliminated without ceasing trading – effectively closing down the business or selling it.(The owner(s) accept this type of risk in making their investment and expect some formof financial return as compensation.) For example, sales may reduce because of atechnological breakthrough by a major competitor or there is a recession affectingoverall levels of demand. Also, again for example, any large (or small) delivery firm willinevitably be worried in the long term about the price of oil and government transportpolicy, and thus the costs involved in road haulage.

That which arises as a consequence of the financial transactions taking place in thenormal course of business. It is this element of risk exposure which the owner canseek to reduce or eliminate. For example, it is likely that a manufacturer of coffee willbe worried about the future price of coffee beans, and one possible solution to thisworry might be to establish a formal agreement with the coffee bean producers to takedelivery of coffee beans at a future date at a price agreed today. In technical terms,this would be called a "futures agreement" or a "forward agreement" (see below) for thesupply and price of coffee beans.

Essentially, we are concerned here with the possibility of incurring loss on certain types oftransaction – principally, through making investments or taking out loans, which gives rise tointerest rate risk, and through international trade which gives rise to exchange rate risk.

It is not possible to eliminate such risk completely, but it is possible to reduce it by way ofhedging. Hedging the risk involves taking action now to reduce the possibility of a futureloss, usually at the cost of foregoing any possibility of a gain. A simple example shouldexplain this.

A firm knows that it will need certain goods in six months' time. It is exposed to the risk thatthe price of these goods may rise in the meantime. This risk may be reduced by entering intoa "forward contract" to purchase the goods in six months' time at a price fixed now. However,

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if the price falls below the current price in the meantime, the firm will have lost the opportunityto make a gain.

The basis of hedging involves offsetting two transactions against each other:

a cash transaction – the receipt or payment of money arising from normal businesstransactions (such as international trade or the management of funds); and

taking a position on (buying or selling) a derivative instrument linked to the type ofcash transaction.

There are a considerable number of such financial derivatives and in this unit we shallexamine the principles of their operation and strategies for their use in relation to interest raterisk. (We shall consider the similar range of derivatives and strategies in relation toexchange rate risk in the next unit.)

The instruments we shall examine here are forwards and futures contracts, swaps andoptions. Options are somewhat different in that they offer the possibility of making gains aswell as hedging risk, and we shall consider them in some depth.

Insurable risk

Insurance is an inevitable part of modern life and this applies equally well to a business as itdoes to an individual. Insurance can be costly, but it is necessary (and sometimes it is alegal requirement) to insure the business against such situations as:

Damage to premises caused by fires or the weather, etc. (buildings cover)

Accidental damage to plant and machinery

Polluting the local environment (laying the firm open to claims for damages by affectedpersons or organisations)

Accidents causing injury to staff and visitors (health and safety insurance andoccupier's liability insurance – a legal obligation)

The sale of faulty goods and services

Faulty advice provided by professional staff (professional indemnity insurance).

This list is only an illustration of some of the different types of risk that a business mighttypically insure against. Whilst the cost of insurance is expensive, the business will need tobalance this costs against the possibility of the event occurring and, hence, the need to makea claim. For this, the financial manager will need to consider factors such as:

how to estimate the possibilities of events – for example, judging how likely it is that thefactory might burn down

a working knowledge of methods that might be used to reduce the risk

how to calculate if there is any possibility to pool risks.

It is not uncommon in the UK for major competitors and businesses with the same productionmethods to share expensive parts of machinery between them. For example, consider twosoft drinks manufacturers and a beer manufacturer. They are very likely to use the sameproduction processes with the same machinery to produce, bottle and package their goods.These machines are very expensive and it would not be uncommon for a major part to costaround £50,000 to replace if broken. The three manufacturers might, then, form anagreement between themselves to stock different parts that could be used by any of theparties to the agreement in the event of a breakdown.

Interest rate risk

Interest rate risk is a permanent feature for any business which has loans outstanding and itis true to say that interest rates cannot be predicted with any degree of certainty. Companies

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with a high degree of loan debt outstanding may be particularly vulnerable to the movementsof interest rates.

Finance managers need to establish a safe level of debt capital, and try to predict interestrates to work out whether their debt should be at a fixed rate or a variable rate, or acombination of both. Any individual with a mortgage on their property will fully understandthe financial implications of movements in interest rates.

Costs of Managing Risk

Managing risk is a balance between the costs of reducing the risks and "gambling" on therisk not happening. There are a number of different costs associated with the practicalmanagement of risk, including:

Staffing costs – staff will be needed within the business to work on risk strategies andthe implementation of risk reduction policies, and the costs associated with this willinclude not only salaries but premises and training costs

External consultancy fees – where advisors are needed for the more technical andcomplex areas of risk management, including dealing with the complex movements ofthe currency or derivatives markets

Costs of the "wrong" decision being made.

Note, too, that the underlying concept behind the Capital Asset Pricing Model (CAPM) is thatthe required return on an investment increases with the risk involved and a central theme ofCAPM is that systematic risk, as measured by beta, is the only factor affecting this for acompletely diversified investor. There is now, particularly amongst academics, somequestioning of this theory and, subsequently, this may cause additional costs being incurredunnecessarily.

B. PRINCIPLES OF HEDGING

As we noted above, hedging a risk involves taking action now to reduce the possibility of afuture loss, usually at the cost of foregoing any possibility of a gain. It is a process wherebythe exposure to potential loss caused by adverse movements in prices, interest rates andexchange rates may be limited.

A hedge against exposure to risk is invariably constructed by using a financial derivative.Again, as we noted above, there are a range of these instruments. They "derive" their valuefrom the price of underlying assets such as foreign currencies, commodities and fixed incomesecurities, etc. We can demonstrate the basic concept with an example using one suchinstrument – a futures contract – in relation to exchange rate exposure.

A UK firm is going to receive a $100,000 in one month's time as a result of some consultancywork carried out in the USA. It is exposed to the risk that an (unfavourable) movement in the£/$ exchange rate before the payment is made will reduce its value. However, it may hedgethis risk by using a futures contract. The futures contract will comprise a transaction to sell$100,000 in one month's time (the time of its receipt) at a £/$ exchange rate fixed today. Thepotential loss of value on the payment is, then, limited to the difference between the currentexchange rate and the agreed rate for the futures contract. This reduces the company'sexposure to any other adverse movements in the exchange rate, but also means that itcannot take advantage of a favourable movement in the rate.

Futures are one of the derivatives that allow a financial risk to be reduced, but do not(usually) allow any gain to come from favourable movements in the prices or rates underlyingthe instrument. Other such derivatives include forward contracts and swaps. However,these can be distinguished from option contracts which also allow a risk to be reduced, butdo allow gains to be made from favourable movements.

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Short and Long Positions

We have seen that the basis of hedging involves offsetting two transactions against eachother:

a cash transaction; and

buying or selling a derivative instrument linked to the type of cash transaction.

We can examine this relationship further.

When a firm holds cash or securities, it will want to maintain their current value. It is, though,exposed to the risk that its value will decrease due to adverse movements in prices orinterest or exchange rates. It will, therefore, sell a derivative of equivalent value at a pricefixed today (known as taking a short position on the derivative). This fixes the value of thecash or securities – possibly at a value less than the current value – but limits the exposureto any further losses. This position is known as a short hedge. It offsets a long position inrespect of the cash transaction with a short position in respect of the derivative.

Conversely, a firm expecting an inflow of cash or securities at some time in the future (forexample, through payments due or the purchase of an asset) will take out a long hedge toprotect the value of those future cash flows or the asset. This will involve buying a derivativeof equivalent value at a price fixed today – again fixing the value of the future cash/asset andlimiting any further loss due to adverse movements. The effect is to offset a short position inthe cash transaction with a long position on the derivative.

In both cases, the hedge works by ensuring that if the value of the asset/cash/securities fallsbelow the agreed price, any further loss is counterbalanced by a gain from the selling/buyingof the financial derivative.

Closing out

In the vast majority of cases, the hedge does not lead to delivery of the underlying asset inthe derivative – that is, neither the sale or the purchase of the underlying asset takes place.Rather, the contract is "closed out" by taking an opposite position in the derivatives market.Thus, a contract to buy can, in effect, be cancelled by one to sell, and vice versa. This isknown as "reversing the trade".

What this means is that a contract to buy a derivative at a particular price is matched byanother contract to sell the same derivative at a price which may or may not be the same asin the first contract. The two contracts can then be closed out. If the reverse trade is exactlyequal and opposite to the original, the financial position is neutral. This is, though, unlikely –in which case, there will be a gain or loss incurred, with a financial settlement being madebetween the parties involved.

Note that the transaction in the derivative is undertaken to hedge risk in respect of theunderlying cash transaction. There is, therefore, in most cases, no need to take delivery ofthe contract and actually buy or sell the underlying asset – particularly as this may involveconsiderable financial costs. Instead, any gain/loss incurred in the process of closing out thederivatives would be offset against any loss/gain in respect of the underlying position in thecash market.

Although forward and futures contracts are similar (see later), it is more common to close outa futures contract than a forward contract. This is because futures contracts are freelytradable and the holder of a contract to buy, say, a quantity of currency but who no longerwishes to hold that position can cancel it out by purchasing a contract to sell the sameamount on the same date. Indeed, it is estimated that only about 1% of futures contracts aresettled by actual delivery. You should contrast this with the forward market where thechances of reversing a position are costly and rare, and as a result approximately 90% ofsuch contracts are settled by actual delivery.

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An example will illustrate the process in detail.

DeanCo is a purchaser of natural gas and is due to take delivery of 5,000,000 litres inJanuary. In order to hedge against the possibility of gas prices increasing over the period upto January, the company takes a long position in a March futures contract. At the time, theprice of March futures contracts is $14.50 per 1,000 litres, with each contract being fordelivery of 1,000 litres. In January, the contract is closed out with both the spot price of gasand the March futures being $14.75 per 1,000 litres.

How effective is this strategy in hedging the risk?

The transactions involved are:

buying five March futures contracts (the long position in March futures) each at a priceof $14.50 1,000 (1,000 litres per contract);

selling five March futures contracts in January (to close out the original contracts) eachat a price of $14.75 1,000; and

buying the 5,000,000 litres of natural gas on the spot market at $14.75 per 1,000 litres.

The total gain on closing out the futures contracts is:

(14.75 14.50) 1,000 5 $1,250

The outlay for the 5,000,000 litres on the spot market is:

5,000 14.75 $73,750

The net cost to DeanCo is:

73,750 - 1,250 $72,500

This equates to a cost of $14.50 per 1,000 litres

The gain from closing out the futures contract offsets some or all of the likely increase in theprice of natural gas on the spot market over the period. The extent of this offset dependsupon the spot price of gas at the time that the futures contract was taken out, which in thiscase was not given. If the price of gas had fallen over the period, there would have been aloss on closing out, but this would again be offset by the lower spot price paid on delivery.

Irrespective of the spot price at the time of delivery, DeanCo is locked into a known pricefrom the beginning. The effect of the hedge is to guarantee that the company never has topay more than the $14.50 per 1,000 litres, although to achieve this guarantee, it has to forgothe opportunity to pay a lower price.

Developing a Hedging Policy

Hedging exposure to risk can be costly and carries certain risks in itself if the techniques andinstruments are inappropriately used. It needs, therefore, to be applied within a clearstrategic framework which reflects the organisation's objectives.

Whilst each company has to establish its own methods in accordance with the particularcircumstances in which it operates – for example, the nature of the markets traded in and itsattitude towards risk – there are a common set of issues which need to be addressed by allcompanies.

Establish and make explicit the exposure to risk – It is essential to know the extentof exposure to exchange and interest rate risk at all times. This can then form thebasis of decisions as to how to manage that risk.

Establish lines of responsibility and limits of authority – The way in whichexposure is reported, to whom and who acts on it are key issues. The lines ofresponsibility for action, and for reporting, must be clearly stated, understood by all

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concerned and monitored. Similarly, the limits on the volume and amount of derivativetransactions traded need to be made explicit, as do the types of instrument which it ispermitted to use. These must be supported by effective systems and procedures tomonitor and control activities – particularly to prevent unauthorised dealing, which wasone of the factors which undermined Barings Bank.

Determine how much, and the types of, exposure to hedge – It may not necessarilybe appropriate to adopt a "hedge everything" approach – this may be prohibitivelyexpensive in relation to the extent of the exposure. However, selective hedgingrequires ranking exposure and making decisions as to which risks to hedge, which isnot easy. Some general decisions could be made – for example, focusing on foreigncurrency receipts where the company is involved in considerable international trade, oron interest rate movements if the company is highly geared and is, therefore,vulnerable to interest rate risk.

Identify appropriate methods of hedging – This will involve matching different typesof derivative instrument to different types of risk and establishing guidelines for howlong to hedge exposure. Note that there are certain methods of hedging risk internally(as we shall consider later in the unit) and these are generally far less expensive thanusing external methods using derivatives. Only the net exposure, after offsettingliabilities and assets internally, should be the subject of external hedging.

Establish and maintain good banking relationships – It is important to develop andmaintain good relationships with one or two specialist banks or other financialinstitutions which have the expertise to arrange certain transactions. Even the biggestand best treasury departments cannot effect all their own transactions and need theassistance of intermediaries with the facility to set up such devices as currency orinterest rate swaps.

Costs of Hedging

On the face of it, the cost of hedging essentially comprises the premiums paid out on thederivatives transactions to the facilitating banks and/or exchanges.

However, there is always a risk associated with trading in derivatives, some of which are verycomplex and may be inappropriately applied, particularly if the controls noted above are noteffective. Thus, any losses incurred on the derivatives transactions not offset by gains in theunderlying cash transaction must be counted as costs.

In addition to these direct costs, there is a further significant cost in the overheads involved inthe hedging operation. These are tied up with the overheads of treasury management as awhole, and include not only the operations in respect of external hedging activities, but alsoin respect of the application of internal hedging techniques.

C. INTEREST RATES, RISK AND EXPOSURE

Interest rates are an important element of the economic environment and influence theforeign exchange value of a country's currency, as well as acting as a guide to the sort ofreturn shareholders might want and expect. Changes in market interest yields affect shareprices.

Interest Rate Structures

Every financial instrument has its own interest rate or range of rates. The marketsegmentation theory acknowledges that the demand for the great variety of financialproducts can be segmented into a number of different types, that different products aredesigned for different purposes and the interest charges are a fundamental part of the overall"package".

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The most common quoted rates include:

Base rate – the "bottom line" rate set by banks. Most lending to individuals, smallerand medium-sized enterprises is at a certain margin above base rate.

LIBOR – the London Inter-Bank Offer Rate at which banks lend to each other. Largeand multinational companies' lending is often tied into these more favourable LIBORrates.

Treasury bill rates – the rate at which the Bank of England sells Treasury bills to thediscount market and a good indicator of longer-term rates as these bills will not beredeemed for some years.

Gilts yield – again, rates attached to government securities and a good indicator oflonger-term rates.

Why are there so many rates?

The reasons include:

Risk – a higher risk must be compensated for by higher returns (i.e. higher interestcharges).

Need for profit – the "spread" between savings and lending-based products providesthe intermediaries' profit.

Duration of lending – interest rates may depend on the date to maturity of the product– for example, Treasury stock might be short, medium or long-dated. The yield on atype of security varies according to the term (length) of the borrowing period, andgenerally, long-term loans yield a higher return than short-term ones.

Size of loan – economies of scale and negotiating strength all have a part to play here.

International rates – domestic rates will be influenced by speculators' behaviour andthe movements of funds internationally.

(a) Risk and rates

Borrowers have different risks of default and this is reflected in the differences in theinterest rates they are expected to pay – for example, the government will pay a lowerrate of interest on its borrowing than a small, new company. The additional returnrequired will be equal to the fall in expected value of the investment taking intoconsideration the default risk. We can see this by considering an example.

Jim plc issues 10% loan stock which is redeemable, at par, after 12 months. There is,however, a 20% chance that Jim will default on payment and there will be no return forthe loan stockholders. If the interest rate on 12 month government stocks is 5%,calculate the yield on Jim's loan stock. Ignore taxation and market risk.

The expected value of the loan stock after 12 months:

(0.8 £110) (0.2 0) £88

Discounting at the rate on government stocks to reflect the additional return for theadditional risks to find the current market price:

051

88

.

£ £83.81

The yield is then:

8183

110

. 1 31.25%

The higher expected yield is required to compensate for the risk of default.

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(b) Nominal (or money) rates and real rates of interest

Nominal rates of interest are those expressed in money terms, whereas real ratesare those adjusted for the rate of inflation. The real rate is therefore a measure of theincrease in the real wealth of the investor or lender.

The real rate is calculated as:

inflationofRate1

interestofrateNominal1

1

If the nominal rate was 10% and inflation 5%, the real rate of interest would be:

051

101

.

. 1 4.76%

Real rates of interest are normally positive (i.e. the nominal rate exceeds the rate ofinflation). Investors can therefore be assured that their real wealth is increasing.

In times of high inflation, however, a negative real rate is possible, although nominalrates will rise, too, as investors want to see a real return on their investments.

(c) Interest rates and financial management

When interest rates are low it might be advisable to:

Borrow more, increasing the company's gearing at lower fixed rates

Borrow for longer terms

Pay back loans with higher rates or roll them over for loans of lower rates.

Alternatively, when interest rates are high it might be advisable to:

Substitute equity for debt finance and reduce the company's gearing by investingsurplus cash in short-term interest-bearing securities

Borrow short term rather than at even higher longer-term rates.

Impact of Interest Rate Changes

It is clear that changing interest rates will lead to variations in a firm's cashflows as receiptsand payments fluctuate with movements in those rates. This can cause problems in themanagement of working capital. Rising interest rates can cause the value of a firm with ahigh level of gearing to fall, and the increased debt repayments may mean it losingcompetitiveness and even facing bankruptcy. In addition, rising interest rates may prevent acompany extending its level of gearing.

Two other effects may be observed.

(a) Share prices

When interest rates change, the return expected by shareholders will also change. If ashareholder expects, say, a 10% return on their investment and the annual dividendper share was 15p then (ignoring any capital growth) the market value of a shareshould be:

10%

p15 £1.50

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If interest rates were to rise (to 12%, say) the shareholder would equally expect abigger return for his/her shares and the price would have to fall (assuming the dividendpay out was constant) as follows:

12%

p15 £1.25

You can surely calculate what the share value would be if interest rates were to fall(say to 8%).

(b) Capital gains and losses

A final point to note is that, because of movements in the capital value of aninvestment, an increase in interest rates will lead to market values dropping.

As an example, if you hold gilts with a "coupon rate" of 10% at a time when the marketis 10%, your market investment will be equal to the face value of the gilts, say £100.

If interest rates rise to 15%, their market value will drop:

£100 %

%

15

10 £66.67

If interest rates drop to 5%, their market value will rise:

£100 %

%

5

10 £200

Thus, a firm with any sizeable level of debt is exposed to problems arising from adversemovements in interest rates and needs to limit the risk associated with such exposure.

Managing Exposure to Interest Rate Risk

Most companies have some form of debt finance and as a consequence are exposed tointerest rate risk.

Interest rates on a loan may be either floating or fixed.

In the case of floating rates, payments will vary with the rate applied at the time andthe risk is that rates may rise, increasing the cost of the loan and, in turn, affectingprofits.

Fixed rates have the advantage that costs remain constant and they are,consequently, seen as less risky. However, there remains a risk in that spot rates mayfall below the fixed rate – in which case, a floating rate would be more advantageous.

Interest rate risk also applies to investments. Where companies have funds invested ininterest bearing securities, fluctuations in interest rates will give rise to variations in income.

Where companies have both assets and liabilities that are sensitive to interest rate changes,gap analysis is the means used to measure the extent of exposure to interest rate risk.Under this, assets and liabilities which are sensitive to interest rate changes and mature atthe same time are grouped together. The difference between the two represents the firm'sinterest rate exposure:

where interest sensitive assets are greater than liabilities, both with the same time tomaturity, the gap is positive and the firm will lose out if interest rates fall;

where interest sensitive liabilities are greater than assets, both with the same time tomaturity, the gap is negative and the firm will lose out if interest rates rise.

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The management of interest rate risk will involve hedging against adverse movements inorder to contain the extent of any exposure. As with managing exchange rate risk (which wedeal with in the next unit), this falls into two categories:

internal, or natural, techniques – those which are effected entirely by the financialorganisation and structure of the company itself; and

external, or transactional, techniques – those using the range of derivative instrumentswhich are effected by the use of third party services, such as banks and specialistexchanges.

Both types of technique provide effective means of covering exposure, depending on thecircumstances. We shall consider internal techniques first and then work through the variousexternal methods.

D. INTERNAL TECHNIQUES OF MANAGING INTERESTRATE EXPOSURE

There are two main internal means of reducing interest rate exposure.

Matching

The principle of internal matching to hedge interest rate exposure essentially involvesoffsetting assets with liabilities – for example, increases in borrowing costs can be offset byincreases in interest bearing deposits. For many firms, though, interest rate matching is notviable because the amounts received as income from interest bearing assets are rarelysufficient to offset more than a small proportion of their loan payments.

Smoothing

Smoothing refers to the maintenance of a balance between fixed rate and floating rateborrowing.

Floating rates enable a company to take advantage of any reduction in rates to reduce theirborrowing costs, whereas fixed rates aid cash planning. Both, though, have disadvantagesand it does not follow that one or other method should necessarily dominate. Having amixture of fixed and floating rate liabilities means that advantage may be taken of thebenefits of both. Thus, if interest rates rise, the increase in costs from the floating rateliabilities is to some extent offset by the relatively cheaper fixed rate payments.

E. FUTURES CONTRACTS

These contracts are fixed in terms of rate, delivery period and amount, and provide aninterest rate commitment for a future period that is agreed at the outset.

Before we move on to consider the use of futures in hedging interest rate exposure, we shalllook briefly at certain basic elements of the way in which they operate.

Characteristics

Futures contracts are "exchange traded" derivatives. That means that they are bought andsold on organised exchanges such as the London International Financial Futures Exchange(LIFFE). As such, there are certain rules affecting the way in which they are transacted, andsome specific terminology associated with them.

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(Note that option contracts are also exchange traded derivatives and exhibit many of thesame characteristics. Other types of derivatives – notably forward contracts – are not dealtwith on dedicated exchanges and therefore have somewhat different characteristics.)

(a) Margin accounts

All exchanges offering futures contracts require traders to lodge some form of depositas security against losses. This is the initial margin paid by the hedger to start amargin account.

At the end of each trading day, the daily gains or losses on the exchange for eachtrader are added to or subtracted from the margin account to arrive at a new balance.This process is known as marking to market, and the adjustment to the marginaccount is termed the variation margin. In most cases, despite the daily fluctuationsin the variation margin, the margin account is sufficient to offset the likely effect ofdefault. (The system proved its worth in the Barings case, where the SIMEX Exchangewas left largely intact and none of the counterparties to Barings' trade lost out.)

Note that, whilst all futures transactions have a buyer and a seller, because theexchange is regulating the trade and gains/losses are marked to the market throughthe variation margin, the obligation of futures traders is not to the party to their trade,but to the exchange itself (or, more precisely, to the clearing house holding the marginaccounts).

(b) Contract size

Futures contracts on a particular exchange are all of a standard size. For example, thestandard size for sterling interest rate futures contracts on LIFFE is £500,000. Thus, inorder to hedge an exposure of £2 million, it would be necessary to take out fourcontracts, each of which would be for £½ million.

(Similar standard sizes are also applied to currency futures contracts – for example, onthe IMM Chicago Exchange, sterling contracts are for £62,500 and those for yen are forYEN12.5m.)

(c) Basis points and tick values

The smallest recorded movements in futures prices are expressed in basis points –one basis point being 0.01% of the amount of the underlying asset (see below).However, it is more usual to express the price movement of futures contractsthemselves in ticks. The value of a tick will reflect the minimum gain or loss whichmay be recorded on a contract. This value varies from contract to contract dependingon the standard size of the contracts traded.

To illustrate this, let us consider currency futures for a moment. The price movementson the contract are movements in one currency against another, and one basis point is0.01% of the unit of currency – equating to a movement of 0.01 cent in the case ofdollars or 0.01 pence for pounds, etc. So, for example, the minimum price movementrecorded on a sterling contract on the Chicago exchange will be:

£62,500 0.0001$/£ $6.25

This minimum recorded movement in price represents the minimum gain or loss whichcan be made on the contract and is known as the tick value. Thus, the tick value of asterling futures contract on the Chicago Exchange is $6.25.

For interest rate futures, the price movements are movements in the interest ratesthemselves, and one basis point is a 0.01% change in interest rates. The tick value ofan interest rate futures contract needs to reflect the proportion of the year over whichthe contract runs (since interest rates are quoted per annum). Thus, the tick value of athree month sterling interest rates futures contract on the LIFFE will be given by the

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price movement consequent upon the movement of one basis point for three months ofa year:

Unit of contract basis point contract period tick value

£500,000 0.0001 12

3 £12.50

(c) Delivery dates of contracts

Exchange traded contracts – whether futures or options – all have pre-determinedmaturity dates on which delivery of the underlying asset occurs. For example, thecontracts quoted on the Chicago Exchange relate to delivery dates at the end of March,June, September and December. This pattern applies to both currency and interestrate futures contracts.

As we have seen, most futures contracts are not delivered, but are closed outbeforehand by the taking of an opposite position in the same derivative. Closing outclearly needs to be effected prior to the maturity date of the contract in order to cancelthe obligation to buy or sell the underlying asset. Thus, the purchase of a Decembersterling contract would be closed out with the sale of a December sterling contract,prior to December.

Where a futures contract is required for a period which falls between the specifieddates of available contracts, the trader will need to opt for the nearest delivery dates.For example, a company which wishes to hedge an interest rate exposure fromFebruary to May – a period which does not correspond with the available contracts –will need, in February, to take out a March futures contract and then roll the hedgeforward by simultaneously closing this out in March and taking out a June contract onthe same day. This will then be closed out in May with an equal and opposite trade.

In theory, there is nothing to stop a hedger rolling over the hedge indefinitely, althoughthis will incur transaction costs every time one is closed out and another opened.

(d) Prices of contracts

The prices of contracts are, as you would expect, a function of interest rates. They arecalculated by reference to an index of 100 less the rate of interest applicable to theunderlying instrument. Thus, an open (current) price of, say, a December contract of93.070, corresponds to an interest rate 6.93% (100 6.93).

Thus, if interest rates rise, the price of an interest rates future contract falls. Thisinverse relationship is central to hedging with interest rate futures.

Hedging Interest Rate Exposure with Futures Contracts

Any futures contract involves fixing the price today on a standard quantity of a financialinstrument (in this case, interest rate futures) to be purchased or sold at a fixed future date.As we know, futures contracts are rarely held to maturity and the underlying asset delivered,but are closed out by taking an opposite position. Hedging interest rate exposure usinginterest rate futures is based on the gain or loss on the closing out of the futures contractsequating with the loss or gain arising from a change of interest rates on the company'sliabilities.

To fully appreciate the way in which interest rate futures are used, we need to remindourselves that taking a short position on interest rate futures (i.e. selling them) hedges a risein interest rates. Borrowers, then, will take a short position in order to hedge against higherinterest rates, whilst lenders will take a long position in order to hedge against lower interestrates.

The following example illustrates the process of hedging using interest rate futures.

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A company is going to take out a £2.5m loan in two months time (December) for threemonths. The three month LIBOR rate is currently quoted on the London exchange at 7¼%and the company wishes to hedge against a rise in interest rates in two months time bylocking into an interest rate futures contract. Let us assume that the futures contract isquoted at 93.07 (as above). In December, it transpires that LIBOR rates had risen to 7½%and futures contracts were then quoted at 92.80.

To hedge against a rise in interest rates – which would result in a fall in futures prices –necessitates taking a short position (to sell) the three month December futures contracts atthe price currently quoted. In the solution which follows, the contract runs to expiration and acash settlement is received via the exchange's settlement price system. Cash settlement atexpiration is always based on the LIBOR rate on the last day of trading in those futures,which in this case is 92.80. All contracts are settled net – here, the difference between thequoted buying price of futures in December and the selling price of those contracts as quotedwhen they were entered into (in October).

(The same outcome would be achieved by closing out the original position through an equaland opposite trade – i.e. to buy December three month futures contracts – in December.Closing out is necessary when the period of the hedge does not coincide with the exchange'sdelivery settlement date. However, in this example, the two dates do coincide which allows achoice of methods used for settling the profit/loss on the futures contracts.)

The first step is to ascertain the number of futures contracts required to hedge the position.The contracts available on LIFFE are in denominations of £500,000. So, to hedge the sum of£2.5m, the company needs to enter into five contracts.

Entering into a contract in October to sell five three month December interest rate futuresfixes the price at 93.07. In December, the price has fallen to 92.80, resulting in a gain onexpiration as follows.

Gain Number of contracts movement in ticks tick value

As we explained above, the tick value on LIFFE sterling futures contracts is £12.50.

Gain 5 contracts (92.80 93.07) ticks £12.50

5 27 £12.5

£1,687.50

In December, the company will raise the £2.5m necessary by means of a loan at the nowcurrent three month LIBOR rate of 7½%. This results in an actual borrowing cost of £46,875(£2.5m 7.5% for ¼ of a year). We can compare this with the cost of interest at the Octoberrate (7¼%) and derive the increased cost of the loan as follows:

Cost of increase £2.5m (7.5 7.25%) 12

3months

£1,562.50

The efficiency of the hedge (the degree to which the hedge covers the exposure) is:

Efficiency 505621

506871

.,£

.,£ 100%

108%

The gain from the futures position has more than offset the cost of the ¼% increase ininterest rates. In fact, the success of the hedge results in an effective reduction of theinterest rate on the loan This is shown as the actual interest minus the gain on the futuresposition as an annual percentage of the principal:

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3

12

£2.5m

£1,687.50-£46,875 7.23%

The gain on the futures market has more than matched the loss in the cash market, and thecompany is only paying, effectively, 7.23% interest, even though interest rates rose over thetwo month period.

F. FORWARD RATE AGREEMENTS (FRAs)

These are forward contracts which provide for interest rates to be fixed in advance for aspecified period commencing at some agreed future date. They are the interest rateequivalent of forward currency or commodity contracts, although unlike these forms offorward contract, there is no intended delivery of a sum of principle.

Characteristics

Forward rate agreements are essentially an agreement between a bank and its customer tofix a future rate of interest to cover a specified amount of money to be lent or borrowed for aspecified period of time in the future. They relate only to the predetermined rate of intereston a sum of money and not to the actual sum of money borrowed or lent. (That will be aseparate transaction, conducted in the cash market in the usual way, to borrow/lend themoney at whatever interest rate is prevailing at the time.) All that happens in respect of theFRA is that either the bank is compensated by the client, or vice versa, if actual interest ratesvary from the pre-set interest rates agreed in the contract.

This means that, although there is an obligation to meet the terms of the interest ratecontract, there is no obligation to actually borrow or lend the money. Provided that thecompensating amount is settled between the two parties on the due date, that is where theobligation ends.

FRAs are not standard contracts as traded on the futures exchanges, but are tailored to meetindividual needs, though they tend to be only available for up to 12 months and on loans of£500,000 or more.

Hedging Interest Rate Exposure with FRAs

Where a hedge on future borrowings is required, the purchase of an FRA locks therepayments on the loan to a specified interest rate and protects against any further rise ininterest rates. On the other hand, selling an FRA provides a hedge on future lending bylocking future cash inflows from the loan to a specified interest rate and protects against anyfurther fall in interest rates. The rate at which the transaction is locked is a forward interestrate as quoted today, but taking effect at a specified date in the future.


Clock plc is going to take out a 90 day £10m loan in three months' time at an interest ratelinked to the three month LIBOR rate. As a hedge against an increase in interest rates overthe intervening period it also takes out an FRA, the interest rate for which is set at 8% pa.What would be the consequences if, on taking out the loan, the LIBOR rates had fallen to5%?

Since interest rates have decreased, Clock will have to pay the bank the interest ratedifferential on the sum of £10m. This is the amount by which the cost of the loan has fallenas a consequence of the fall in interest rates from 8% to 5%:

$10m (0.08 0.05) 365

90days £73,972

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In effect, the contract requires Clock to pay over this amount to the bank. However, thecontract has to be settled prior to the start of the loan period (when the interest rate on theloan is known) and not, as you might expect, when the loan matures. The total amount of thereduction in costs over the period of the loan will, then, have to be discounted to reflect itspresent value. The discount rate will be that applying to the interest rate on the loan:

365

900.051

1£73,972 £73,071

The payment to the bank in three months time is, therefore, £73,071.

Note that Clock plc has not gained financially from the fall in interest rates, but had theyincreased, the company would have been compensated by the bank for the interest ratedifferential. FRAs only give protection from adverse interest rate movements – it is notpossible to benefit from favourable movements. They do, however, effectively hedge theexposure.

G. INTEREST RATE SWAPS

An interest rate swap is an agreement between two parties under which each agrees to paythe other's interest for an agreed period.

Characteristics

The most common form of interest rate swaps involves the exchange of a fixed rate for afloating rate.

The interest rates are based on a "notional" underlying principal sum of money. Note,though, that it is not the principal which is swapped – merely the interest rate payments.(This is in contrast to currency swaps where both the principal and interest is swapped.)

Whatever the form of the exchange, each party remains responsible for servicing its owndebt and has to continue to make payments to its own lender at the agreed rate on the loan.Thus, a party agreeing to swap a fixed rate of interest for a floating rate would still beresponsible for making the fixed rate payments to the lender of its funds. The effect of theswap is a compensating payment between the parties to settle the net difference arising fromany differential rates on the interest payments.

Interest rate swaps work on the principle of comparative advantage (see below) and aremore common than their cousins, currency swaps.

Swaps are popular because they are easy and cheap to arrange (with only legal fees to pay),and are flexible as to the size and duration to which they are applied.

Operation of Interest Rate Swaps

The best way to explain the operation of interest rate swaps is through an example.

Hammer plc has a five year loan of £25m with a floating interest rate of LIBOR 0.5%. It isconcerned about fluctuating payments over the period of the loan and would like to convert toa fixed rate. Tongs plc also has a five year loan of £25m with a fixed rate of 7% and isseeking to reduce its repayments, preferably with a floating rate.

The rates for each party's present agreement and those quoted for the alternative type ofinterest payment (fixed or floating), are as follows.

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Company Fixed rate ofinterest

Floating rate ofinterest

Hammer Plc 6.5% LIBOR 0.5%

Tongs Plc 7% LIBOR 1.7%

How could a suitable arrangement be made whereby each party can take advantage of lowerinterest rates on each other's loan?

Each company has the choice of either opting for a floating or fixed rate agreement at therates quoted by the bank. Hammer has an interest rate advantage over that of Tongs, withits quoted rates for both fixed and floating rates of interest being lower than those available toTongs. The differential interest rate advantage for Hammer is as follows:

Fixed rate: 7% 6.5% 0.5%

Floating rate: (LIBOR 1.7%) (LIBOR 0.5%) 1.2%

Combining these two absolute advantages gives an "apparent" advantage of 0.7% (1.2% –0.5%). Because this apparent advantage exists, gains are possible via an interest rate swap.If this advantage did not exist, there would be no benefit to either party from a swaparrangement.

The strategy is for Hammer and Tongs to swap, in part or whole, their respective interestpayments, applying the most advantageous rates to the terms of the swap – those availableto Hammer. Under the swap agreement, Hammer will pay Tongs the fixed rate of 6.5% andTongs will pay Hammer the floating rate of LIBOR 0.5%. However, the swap paymentsneed to take account of the "apparent" advantage of 0.7% and this will be apportionedbetween the two parties on some agreed formula. Let us assume that this will be equallyapportioned (0.35% and 0.35%).

The effect on the interest cashflows of the two companies is shown in the following table.

Cashflow Hammer plc Tongs plc

Obligation to lender negative LIBOR 0.5% 7%

Swap receipts positive LIBOR 0.5% 6.15%(6.5% 0.35%)

Swap payments negative 6.15%(6.5% 0.35%)

LIBOR 0.5%

Net payment negative 6.15% LIBOR 1.35%(7% 6.15% LIBOR 0.5%)

The effect, then, is for Hammer to have secured a fixed interest rate 0.35% less than the rateit had been quoted (6.5%) and for Tongs to have secured a floating interest rate also 0.35%lower than the rate it had been quoted (LIBOR 1.7%). The terms of the swap will havesatisfied both parties in that they have acquired the type of rate desired (fixed or floating) andat a lower rate than originally quoted.

(Note that a different stream of cashflows would apply if the apparent advantage of 0.7% hadbeen apportioned differently to the 50:50 model illustrated.)

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Remember that each company remains responsible for the payments to their own respectivelenders under the terms of the original loans.

The whole process is illustrated in Figure 14.1.

Figure 14.1: Interest rate swap

H. OPTIONS

Option contracts provide the purchaser of the option with the right – but not the obligation –to buy or sell the underlying asset or instrument at a price established in the contract. Thisprice is referred to as the exercise or strike price. The purchaser of the option pays a non-refundable premium (the price of the option itself) to the seller of the option to establish thecontract.

There are a number of different types of option contract available on the various optionsexchanges around the world (the main ones being the LIFFE, New York, Philadelphia,Montreal and Chicago exchanges). These organised exchanges offer standard formatoptions in which the main elements of the contract are pre-determined:

size – each option contract relating to a particular volume of the asset/instrumentconcerned (for example, traded options in equities are in contract sizes of 1,000 units);

exercise price – as determined by the market; and

option period – with an expiry date usually of three months (or in multiples of threemonths).

There are two main types of standard format option contracts, as follows.

Traditional options – These are all three month contracts which must be held to theexpiry date, at which point the right to buy or sell the underlying asset/instrument mustbe exercised or allowed to lapse. There is no trading in these types of options.

Traded options – These types of options may be bought or sold through the exchangecontinuously throughout their life. Such options are usually offered with three-month,six-month or nine-month expiry dates, each with a different exercise price andpremium.

It is also possible to establish option contracts outside of the organised exchanges. Suchoptions are known as "over the counter" (OTC) options, and the individual elements – size,exercise price, expiry date – maybe negotiated and agreed between the buyer and seller.

Options tend to be more expensive than other derivatives since they offer the possibility ofmaking gains should the movement in the underlying asset be favourable (in contrast tofutures and forward contracts). Indeed, the attractiveness of options as part of a financial

Hammer plc Tongs plc

Bank Bank

Fixed rate @ 6.15%

Floating rate @LIBOR 0.5%

Floating rate @LIBOR 0.5%

Fixed rate @ 7%

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strategy derives from the range of pay-off profiles available, depending on whether the optionis to buy or sell the underlying asset/instrument and on whether the investor is the buyer orseller of the option (respectively, taking a long or short position on the option). The startingpoint for understanding the use of options, then, lies in identifying the outcomes associatedwith these characteristics.

Calls and Puts

There are two types of option contract:

a call option – which is an option to buy an asset/instrument; and

a put option – which is an option to sell an asset/instrument.

(The underlying asset/instrument may be bonds, shares, currency, agricultural products,interest rate futures, etc., but for now let us assume that it simply refers to equities. So, weshall consider options as relating to the right to buy or sell a share.)

(a) Call options

These will be purchased where it is anticipated that the price of an asset will rise. Thecall option buyer (said to be holding a long call) will only exercise the option (i.e. buythe asset) if the market price of the asset is above the exercise price.

We can examine the characteristics of these options for both long and short positionsby reference to a call option to buy shares in LTD at the exercise price of £25. We shallassume that the premium paid for the option (i.e. its price) is £1, which represents thevalue of the option at that instant in time.

Long call

For the buyer of a call option, there are two scenarios:

the share price falls below the exercise price of £25 – in which case the optionwill not be exercised, since the shares could be acquired on the market at the(lower) spot price, and the holder will, therefore, lose the price paid for the option(£1);

the share price rises above the exercise price of £25 – in which case the optionwill be exercised, the shares acquired and then resold at the (higher) spot price,with the result that the holder makes a profit equal to the spot price less theexercise price (and the premium).

We can show the pay-off profile for this position diagrammatically, as in Figure 14.2.

Figure 14.2: Pay-off profile for a long call

Note that the risk exposure is limited to the amount of the premium in the case of theasset price falling below the exercise price, whereas the potential return is theoreticallyinfinite.

Asset price

Pro

fit/lo

ss

Exercise price£25

Pay-off profile

0

2

3

1

3

2

1

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Short call

For the seller of a call, the position is the exact opposite of the buyer's position. He/sheis obliged to sell the asset at the exercise price, but will only have to do so where theoption is exercised by the buyer – i.e. if the market price of the asset is above theexercise price.

The potential profit is limited to the price of the option (here £1), but there is exposureto the risk of having to sell the shares at what might be a considerable loss.

Again, we can show the pay-off profile for this position diagrammatically (Figure 14.3).

Figure 14.3: Pay-off profile for a short call

(b) Put options

These will be purchased where it is anticipated that the price of an asset may fall. Thebuyer of a put option (a long put) will only exercise the option (i.e. sell the asset) if themarket price falls below the exercise price. This establishes a ceiling on any lossincurred if the option is not exercised, but allows profits to be taken if the price falls andthe option is exercised.

Again, we shall examine the characteristics of these options for both long and shortpositions by reference to a put option to buy shares in LTD at the exercise price of £25.The premium is £1.

Long put

For the put option buyer, there are two scenarios:

the share price rises above the exercise price of £25 – in which case the optionwill not be exercised and the buyer loses the price of the option (£1);

the share price falls below the exercise price of £25 – in which case the optionwill be exercised, since the shares can be sold at the exercise price and thenbought back at the (lower) spot price, with the result that the holder makes aprofit equal to the exercise price less the spot price (and the premium).

Note that, even if the buyer of the put option does not already own the shares at theexpiry date, he/she can still profitably exercise the option by acquiring them on theopen market and then selling them at the (higher) exercise price. The profit is thesame.

We show the pay-off profile for this position in Figure 14.4.

Pro

fit/lo

ss

Asset price

Exercise price£25

Pay-off profile

0

2

3

1

3

2

1

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Figure 14.4: Pay-off profile for a long put

Note that the risk exposure is limited to the amount of the premium in the case of theasset price rising above the exercise price, whereas the potential return is thedifference between the exercise price and the (lower) asset price.

Short put

For the seller of a put the position is, again, the exact opposite of the buyer's position.He/she is obliged to buy the asset at the exercise price, but will only have to do sowhere the option is exercised – i.e. if the market price of the asset is below the exerciseprice.

Again, profit is limited to the price of the option (the £1 premium), whereas the riskexposure if the asset price falls is considerable.

The pay-off profile for this position is shown in Figure 14.5.

Figure 14.5: Pay-off profile for a short put

As can be seen from the above, the seller of an option carries a considerable downside risk.The premium charged is, therefore, a reflection of this risk – and we shall look at the pricingof options in the next section. However, it must be said that the "odds" are in favour of theseller – otherwise the option would not be sold in the first place.

For the buyers of options, we can see that they offer a ceiling on potential losses fromfluctuating asset prices equivalent to the price paid for the option, whilst at the same timeenabling a profit to be taken from a favourable change in those prices.

(c) Put-call relationships

The essence of developing strategies in the use of options lies in the relationshipbetween the pay-offs associated with short and long positions on puts and calls.

Consider the taking of a long position on a call (purchasing a call option) together witha short put (selling a put option) on the same underlying asset, both with the same

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strike price. We can show the pay-offs associated with this position as follows. (Notethat in this and the diagrams which follow, we have ignored the effect on the pay-offprofile of paying the premium for the option.)

Figure 14.6: Pay-off profiles for a long call/short put

This position results, no matter what the price of the underlying asset, in that assetbeing acquired for "X" – the strike price. Can you work out why?

There are two possible scenarios at the expiry date:

the price of the asset has risen above the strike price – in which case the shortput will not be exercised (i.e. the right to sell will not be exercised), but the longcall will be exercised (i.e. the right to buy will be exercised) and the assetacquired at the strike price; or

the price of the asset has fallen below the strike price – in which case the longcall would not be exercised, but the short put will be and the seller of the put willhave to acquire the asset at the strike price.

An alternative strategy which equates with the above position would be to purchase theunderlying asset itself at the outset (taking a long position on the asset). If this wasdone using borrowed funds at a risk free rate equivalent to the present value of thestrike price at the expiry date (which would be "X"), then at the expiry date, the loan "X"will be repaid and the asset acquired for that price.

Thus, these two strategies have the same result – acquisition of the asset at "X", theexercise price.

We can express this in terms of an equation as follows:

PC

r1

XS

t

where S spot price of the underlying asset

X exercise price

r risk free rate of interest

t time for the option to run (before expiry date)

C value of the call option (the premium)

P value of the put option (the premium)

This equation is known as the put-call parity.

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Using this equation allows us to define different combinations of short and longpositions on puts, calls and/or the asset itself which result in parity, in order to hedgeagainst changes in the price of the asset. For example, a call option can be createdsynthetically by taking a long position on both the asset itself and a put option. This isconfirmed by transposing the terms of the put-call parity equation above, as follows:

tr1

XPSC

We can similarly express the value of a put option as:

tr1

XSCP

Option Prices

The price of an option contract is the premium paid on its formation or the market price atwhich the option may be traded.

There are two elements to the price of an option:

the intrinsic value – which is the gain to be made from exercising the optionimmediately; and

the time value – which reflects the length of time that the option has left to run beforeexpiry.

(a) Intrinsic value

The intrinsic value is the difference between the price of the underlying asset (at anytime) and the exercise price. The following diagram illustrates this in relation to a longcall.

Figure 14.7: Intrinsic value of a long call

When the spot price of the asset is at "A", the intrinsic value of the call option is A X.In such a position, the option is said to be "in the money" – meaning that the exerciseprice is above the current price of the underlying asset. (For a long put, the contractwould be "in the money" where the exercise price is below the spot price.)

If the spot price is at "B", the contract is said to be "out of the money", meaning thatthe exercise price is below that of the asset (for a long call) or above that of the asset(for a long put).

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Where the exercise price and the spot price are equal, the contract is said to be "at themoney".

The minimum intrinsic value of an option is zero. Why should this be expected?

If the contract is out of the money, the option will not be exercised. In the case of a calloption, if the price of the underlying asset is below the exercise price, it would be moreadvantageous for the holder to purchase the asset in the market at the lower spot priceand, thus, the option would be allowed to lapse. The opposite holds true for a putoption in that, if the price of the underlying asset was above the exercise price, againthe option would be allowed to lapse.

The maximum intrinsic value of a put option is limited by its exercise price. Why shouldthis be expected?

A put option will only be exercised when the price of the asset is below the exerciseprice. The intrinsic value of the option will, therefore, rise as the asset price fallstowards zero. At its maximum, with the asset price at zero, the gain from exercising theoption will be equivalent to the exercise price itself.

(b) Time value

The value of an option at any particular time is not just a function of its intrinsic value –this can, of course, change over the period prior to its maturity. There is, therefore, avalue associated with the length of time that the option has left to run before expiry –and the longer this period, the greater the likelihood that a gain may occur on thecontract. It follows, therefore, that an option which is not due to expire immediately,would possess an element of value associated with time, irrespective of whether it wasin the money, out of the money or at the money.

The time value represents, therefore, the difference between the intrinsic value of theoption and its market value.

For example, consider the following prices for call options on XYZ shares as shownbelow for two different exercise prices and three maturity dates. XYZ's shares arecurrently trading at 231p.

Expiry dateExerciseprice

January April July

230p 16.5p 35p 39.5p

250p 8p 26.5p 32p

The intrinsic value of the 230p option is:

231p (asset price) 230p (exercise price) 1p

The time value associated with the January expiry 230p option is, therefore:

16.5p (option price) – 1p (intrinsic value) 15.5p

You can see that the time values of those options with later expiry dates areconsiderably higher.

What are the intrinsic and time values of the 250p call options?

The call options with the higher exercise price are currently out of the money. Theirintrinsic value, therefore, is zero. The prices of the options, then, reflect just the timevalues associated with them – i.e. 8p for the January expiry date, etc.

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Note that the time value tends towards zero as the option nears maturity, leaving theprice of the option equating with its intrinsic value.

There are two factors affecting time values.

Potential for change in the price of the underlying asset

Clearly, the likelihood of the asset price changing and making the option contractin the money will influence the time value. This is, to some extent, a function ofthe length of time before the option expires (as seen above), but is alsoinfluenced by the volatility of the price of the underlying asset itself.

The more volatile the price, the more likely it is that it will put the option in themoney – either by rising above the exercise price (for a long call/short put) orfalling below it (for a short call/long put). Volatility of the underlying asset is inpart a function of the general buoyancy, or otherwise, of the market itself.

Note that the greater the likelihood of market volatility making an option in themoney for the buyer, the greater the need for the seller of the option to raise thepremium in order to cover the additional risk.

Variability of interest rates

This is a less obvious influence on option prices than the volatility of the assetprice. It derives from the alternative strategy of acquiring the asset itself withborrowed funds.

Buying a call option contract is, in effect, putting a deposit on the deferredpurchase of the underlying asset. The balance of the cost of the asset (theexercise price) will be paid in the future, at the expiry date, by which time itspresent value will be lower. The higher the level of interest rates, and/or thelonger the period before expiry, the lower the present value would be. This(effective) lowering of the exercise price adds value to the option premium and,thus, its time value.

Conversely, a lowering of interest rates, and/or a shorter time period beforeexpiry, will increase the present value of the exercise price. This would add valueto holding a put option and increase its time value.

Hedging and Trading Strategies using Options

So far, we have considered the general nature of options and identified a number of theircharacteristics. We now move on to look at strategies for hedging and/or trading, based onthese underlying principles. Initially, the focus will be on equities, but we shall move on toexplore options involving futures in respect of hedging interest rate exposure.

Note that, whilst options relate to an asset – allowing the holder of the option to take aposition on, potentially, buying or selling that asset in the future at a fixed price – the point ofentering into an option contract is not, in the vast majority of cases, actually to acquire or sellthe asset. Rather, the intention is to establish a position (in relation to the seller of the option)whereby profits may be taken if the movement of the asset price is favourable – i.e. risingabove the exercise price in the case of a call or falling below it in the case of a put. At theexpiry date, therefore, a view could be taken as to whether the option is to be exercised and,if so, the seller would simply pay the buyer the profit due on the transaction, without any needfor the asset itself to change hands. (Note, from the examination of the positions of buyersand sellers above, that any profit due to the buyer comes directly from the seller of theoption.)

Alternatively, the contract may be closed out before maturity in the same way as previouslydiscussed in respect of futures contracts. In this case, sellers and buyers adopt a position inrespect one option which is directly contrary to their position on another option. This

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effectively cancels out their rights/obligations under both positions and the two options canbe closed out, with any profit or loss on the transactions being taken. Remember that theobjective in taking positions with options is not necessarily to acquire or dispose of theunderlying asset in question, but to hedge against fluctuations in prices or to generate profitsfrom them. Adopting positions which lead to closing out may be the best way of cuttingexposure to risk and/or taking profits.

(a) Strategies involving an option and share combined

In the first strategies we consider, we shall look at two combinations involving an optionand the holding of the underlying asset itself:

a covered call – whereby a long position on the share is combined with a shortposition on a call option; and

a covered put – whereby a long position on the share is combined with a longposition on a put option.

Covered call

This is one of the most fundamental investment strategies, involving a portfolio of along asset (purchase of the share itself) with a short call (selling of a call option) on thesame asset.

The principle behind the strategy is that, if the price of the asset were to fall and causea loss on the holding of the asset itself, this would be compensated by the inflow offunds from the premium received on the option. Of course, the loss on the asset maynot exactly be offset by the premium, but it can, nevertheless, be contained to a largeextent.

Consider the position in respect of a share purchased at 200p and a short call on thesame share with a premium of 20p and an exercise price of 200p. We show the pay-offprofile for the strategy diagrammatically in Figure 14.8.

(Note that the pay-off profiles for the long asset and the short call are shown by thedotted lines and that for the strategy as a whole by the heavy, unbroken line.)

Figure 14.8: Pay-off profile for covered call

Note that, if the asset price rises, the option will be exercised and the profit is limited tothe premium on the call. If the asset price falls, the option will not be exercised and theinvestor is left with the loss on the asset itself, offset by the premium on the call option– the potential net loss here is 180p (200p - 20p) if the share price continues on adownward spiral to zero.

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In order to protect against this downside risk, it would be necessary to adopt a slightlydifferent hedging strategy.

Covered put

This portfolio combines a long asset (purchase of the share) with a long put(purchasing a put option) on the same asset. The principle here is that the putprovides a floor price beyond which no further loss can occur.

We can illustrate this with a similar example to that above. Again the share ispurchased at 200p and this time is combined with a long put on the same share with anoption premium of 20p and an exercise price of 200p. The pay off profile is shown inFigure 14.9.

Figure 14.9: Pay-off profile for covered put

If the price of the asset falls, the investor can exercise the put and sell the asset at theexercise price of 200p, limiting the loss to the amount of the premium. Thus, thedownside risk is minimised whilst any potential gain from a rising asset price can betaken.

(b) Strategies using a combination of options

The previous strategies of holding an asset together with a short call or long put arehedging strategies – they are designed to offset losses on the underlying asset itself.However, investors can seek to generate profits from the options themselves.

The simplest trading strategies would involve holding a single option on an underlyingasset, anticipating a rise/fall in the asset price – a long call/put.

More sophisticated trading strategies involve combinations of options, known as aspreads, straddles and strangles.

Spreads

These involve taking simultaneous long and short positions using different options –either calls or puts – on the same underlying asset.

The following example illustrates this in respect of a "call spread" comprising a long calland a short call on the same share with the following premium and exercise prices:

Long call – premium (paid): 40p; exercise price: 160p

Short call – premium (rec'd): 20p; exercise price: 220p

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Figure 14.10: Pay-off profile for call spread

The three scenarios which can result are:

if the asset price falls below 160p, neither of the calls will be exercised and theinvestor is left with a net loss of 20p on the premiums;

if the asset price is between 160p and 220p, the long call will be exercised andthe asset acquired at the exercise price of 160p – constituting a gain of up to 60p(if the asset was at 220p) less the net loss of 20p on the premiums;

if the asset price rises above 220p, both calls will be exercised, with the resultthat the asset will be acquired at 160p and then sold at 220p – constituting,again, a gain of 60p less the net loss of 20p on the premiums.

Thus, it can be seen that the strategy reduces the downside risk if the share price falls,although it places a ceiling on the maximum profit which can be generated if the shareprice rises.

Straddles and strangles

These are further examples of the ways in which different options can be combined toproduce a portfolio matched to the investor's own risk profile. In both cases, theyinvolve the simultaneous holding of long or short positions on both a call and a putoption with the same expiry date on the same underlying asset. The strategies differ inthat the exercise prices for the put and call options are the same for a straddle, but varyin the case of a strangle.

Consider the following illustration of a long straddle with an exercise price of £5, thepremiums being 20p for the call and 30p for the put.

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Figure 14.11: Pay-off profile for long straddle

The three possible scenarios are:

if the price falls below £5, the call will not be exercised but the put will be,allowing the share to be acquired at the lower market price and then sold at theexercise price – the net profit being

(exercise price market price) cost of the premiums (50p);

if the price remains at £5, neither of the options will be exercised, resulting in anet loss of 50p (the combined cost of the premiums);

if the price rises above £5, the put would not be exercised but the call will be,allowing the share to be acquired at the exercise price and then sold on at themarket price – the net profit being

(market price exercise price) 50p

This strategy allows profits to be taken if the asset price (share) rises or falls either sideof the exercise price by an amount equal to the combined cost of the premiums (50p).It is, therefore, a suitable strategy where the investor considers that market volatility islikely to rise (either as a whole or in respect of the particular asset).

Interest Rate Options

Option contracts may be used to hedge against fluctuating interest rates in a similar way tochanging equity prices. They enable investors to set a floor or ceiling on interest rates at alater date, and yet still benefit by taking profits from the sale of the option prior to maturity.

An interest rate option gives the holder the right, but not the obligation, to fix a rate of intereston a notional loan or deposit of an agreed amount for a fixed term on a specific forward date.

Interest rate options may be standard exchange traded options – as, for example, those onLIFFE –or may be tailor-made away on the "over the counter" (OTC) market. Amongst theoptions available on LIFFE are options on interest rate futures such as three month sterlingfutures, three month eurodollar futures, three month Euro LIBOR futures and long gilt futures.Interest rate options on futures are now the norm on LIFFE because of their convenience,liquidity and flexibility. They are priced in a similar way to futures contracts.

The most common type of interest rate options offered on the OTC market are interest ratecaps, floors and collars. The principal underlying each of these is based on the setting ofinterest rate limits which, if reached, trigger the exercise of the option, thus protecting theholder from any further adverse interest rate movements.

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In the case of a cap, the buyer receives compensation from the seller of the option ifinterest rates go above the capped rate.

In the case of a floor, a lower limit to interest rates is set and an investor whopurchases a floor will be compensated by the seller if interest rates fall below thepredetermined limit.

An interest rate collar consists of taking a position in an interest rate cap at the sametime as taking a position in an interest rate floor. Where a hedge is required to protectagainst an increase in interest rates on borrowings, an interest rate cap is purchasedalong with selling an interest rate floor. The premium received from selling the floor isused to offset the premium paid on the cap, helping to reduce the overall cost of thehedge. The collar ensures, in this case, a minimum borrowing floor and a maximumborrowing rate. This is achieved by buying puts and selling calls.

Note that, as we have said before, interest rate futures lock in a particular interest rate and,as a result, the company is protected against adverse movements, but it cannot takeadvantage of any favourable movement. Interest rate options, on the other hand, enable theparticipator not only to protect against adverse movements of interest rates, but also tobenefit from any favourable change in those rates.

Options are also available on interest rate futures and there are advantages to trading inoption contracts on futures as opposed to the futures themselves. With a futures contract,both parties are required to deliver on the contract or must reverse the trade by closing out.With an options contract, the purchaser can let the option lapse if required and forgo thepremium. This can, however, be expensive since the premiums can be high, especially ifthere is a great deal of volatility in the market.

Application of Option Theory to Capital Investment Decision making

The theory underlying the operation of options is not only relevant to hedging andspeculating, but is also relevant to the wider context of business. It lends itself to decisionmaking in general, and capital investment decisions in particular.

There are many well established methodologies available to support business decisionmaking – for example, capital investment decisions are invariably based on some form ofdiscounted cash flow (DCF) analysis. However, many of these traditional methods do notprovide the flexibility needed by management to adapt and revise decisions in response tochanges in market conditions or technological developments. A knowledge andunderstanding of option theory and its application to decision making can provide aframework for this.

Companies are continually faced with decisions about the allocation of resources tocompeting opportunities. Decisions as to whether to invest now, invest at a future date,divest or do nothing underpin a series of other management decisions. Because each ofthese choices creates a different set of pay-offs, they can be thought of in terms of options,and option theory may provide a useful analytical tool.

In the context of capital investment decisions, there are a range of possible examples wherethis may apply.

The option to make follow-on investments if the immediate investment projectsucceeds

The fact that an organisation has undertaken the initial project will place it in anadvantageous position for future investments and opportunities. This decision may beviewed as a call option on the assets which constitute the follow-on investment.

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The option to abandon a project

If it is seen that, once a project has been started, the returns are significantly less thanwas anticipated, then there may be a real possibility that the project should beabandoned. This decision may be viewed as a put option on the assets employed todate and which may be subsequently relieved or sold.

The option to wait and see before investing

The option of delaying an investment might well be disadvantageous in that it mayallow a competitor to take advantage of the opportunity. However, it may also bebeneficial – waiting could allow time for new technologies and new operating skills tobe exploited. The decision in these types of cases could be viewed as a call option oninvestment in the asset.

What is apparent, then, is that the price of the option is, in effect, valuing "flexibility" in thedecision making process.

Discounted cash flow techniques are widely used to evaluate investment decisions, and theyare entirely appropriate for evaluating the associated financial outcomes (in respect ofmortgages and loans, etc.). However, the flow of outcomes from many such decisions is lessthan straightforward. In these cases, a greater degree of flexibility in approach is requiredand they lend themselves to a more proactive role in influencing the outcome.

For example, investors in the equity of a company are generally passive, depending on thedegree of control they have over the firm. In effect, they are merely confined to monitoringthe progress and performance of the business and exercising choice after the event. On theother hand, managers play a far more active role in influencing the final outcome. Theyhave, so to speak, a range of options which, if exercised, could influence – and, crucially,allow advantage to be taken – of new opportunities. In this case, a DCF analysis, althoughvalid as a tool in its own right, does not have the flexibility to handle many of the uncertaintiesfaced by the decision maker.

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Study Unit 15

International Trade and Finance

Contents Page

Introduction 373

A. Theory and Practice of International Trade 373

Absolute and Comparative Advantage 373

Development of International Trade and Operations 376

Foreign Direct Investment 377

MNCs and World Trade 378

B. International Investment 380

The Investment Decision 380

International Investment Appraisal 381

Repatriation of Profits 382

Finance 383

C. Finance and International Trade 383

Terms and Methods of Payment 383

Finance for Exporters 384

Government and Quasi-Government Aid 390

Finance for Importers 391

Countertrade 392

D. Exchange Rates 394

Exchange Rate Concepts 394

Exchange Rate Systems 396

Influences on Exchange Rates 397

E. Risk and International Trade/Finance 400

Political or Country Risk 400

Foreign Exchange or Currency Risk 400

(Continued over)

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F. Internal Methods of Managing Exchange Rate Risk and Exposure 402

Currency invoicing 402

Netting 402

Matching 402

Leads and Lags 403

G. External Methods of Managing Exchange Rate Risk and Exposure 404

Forward contracts 404

Currency swaps 405

Currency Futures 406

Currency Options 408

Money Market Hedge 409

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INTRODUCTION

The first part of this last study unit in your course considers international trade, focusing onthe development of trading operations and the implications for such businesses in activitiessuch as foreign investment and financing overseas projects.

We then move on to the major area of managing exchange rate risk. Firstly, here, we shalllook at the workings of the foreign exchange market, examining the more practical aspects ofthe subject such as the different exchange rate systems and the influences on exchangerates. We then concentrate on the techniques and policies adopted by an organisation tominimise its exposure to risk.

A. THEORY AND PRACTICE OF INTERNATIONAL TRADE

International trade arises because of differences in the demand for and the supply of goodsbetween countries.

Some countries may be unable to produce certain goods they require, or to produce them insufficient quantities or in a cost-effective manner – for example, the USA is a net importer ofoil. Conversely, on the supply side production of certain commodities, or the presence ofcertain commodities and resources, is unevenly distributed throughout the world – forexample, oil in the Middle East. Such commodities/resources are often restricted to an area,and are relatively immobile between one country and another (especially natural resourcesand labour), but may be sold to those with a demand for the resource concerned. Countriesthus tend to specialise in those areas in which they enjoy the greatest comparativeadvantage.

Absolute and Comparative Advantage

It is easy to see why foreign trade is advantageous when a country can not, perhaps forreasons of climate or natural resources, produce particular goods which it desires but canpurchase them from another country which can provide them. For example, the UK has nodiamond reserves but has oil, whilst South Africa has no oil but has diamonds – thus bothnations can benefit by exchanging one for the other. However, even countries such asFrance and Germany, which have many similar natural resources, still benefit from trading.This can be explained by the theory of absolute advantage.

(a) Absolute advantage

A country which is able to produce a good using less labour and capital than anothercountry is said to have absolute advantage in the production of that good. Thus, wemight consider that Germany has the absolute advantage over France in theproduction of high-performance cars (such as Porsche and Mercedes), but France hasthe absolute advantage in the production of inexpensive cars (such as Citroen). Thismeans that due to the concentration of skilled labour and production facilities it is moreefficient in terms of the usage of resources (minimising the capital and labour required)to produce Porsches and Mercedes in Germany and Citroens in France, and toimport/export cars to meet the needs of the populations of the two nations. Such trade,by utilising the more efficient production methods, means that more goods will beproduced from the fixed level of natural resources.

(b) Comparative advantage

In certain trading relationships (e.g. the USA and India) it can be shown that one of thecountries has the absolute advantage in the production of all goods (the USA has ahigher output per unit of labour and per unit of capital than India). However,specialisation of production and trade between countries can still be advantageous to


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both countries if each has a comparative cost advantage in the production of a good,and concentrates on the production of that good. Remember that when economistsrefer to comparative costs they are considering opportunity costs and not absolutecosts – i.e. the production of other goods foregone by producing X rather than Y willdiffer between countries.

The concept of comparative cost advantage and how it may be applied to internationaltrade can be explained through a very simple model based on two products (X and Y)each produced by two countries (A and B). Table 15.1 shows the production in tonnesper day of each of the products, achieved by packages of 10 factor (of production) unitsproducing each product in each country – i.e. there are 40 factor units employedaltogether:

Table 15.1: Comparative advantage – initial production (tonnes)

Production per Day of 10 Factor Units

Country A Country B Total

Product X 20 10 30

Product Y 30 20 50

Country A is more efficient in the production of both X and Y. It has an absolute costadvantage for both products. However, suppose one factor unit (assuming each unit ineach package is equally efficient) is moved in A from producing X to Y, then this wouldresult in the loss of 2X and a gain of 3Y. In other words:

in Country A, the cost of a gain of 1Y achieved by factor movement is 32 X; but

in Country B the same gain of 1Y achieved in the same way costs ½X.

Measured in terms of X, therefore, Y costs more in Country A than in Country B.

If we consider the results of other possible movements in the two countries we canproduce the following analysis:

Country A

Movement of one factor unit from X to Y loses 2X and gains 3Y, so to gain 1Ycosts 3

2 X.

Movement of one factor unit from Y to X loses 3Y and gains 2X, so to gain 1Xcosts 2

3 (or 1½) Y.

Country B

Movement of one factor unit from X to Y loses 1X and gains 2Y, so to gain 1Ycosts ½X.

Movement of one factor unit from Y to X loses 2Y and gains 1X, so to gain 1Xcosts 2Y.

So in Country A, 1Y costs 23 X and 1X costs 1½Y, whereas in Country B, 1Y costs ½X

and 1X costs 2Y. Thus:

X is cheaper in A measured by its opportunity cost in Y; and

Y is cheaper in B measured by its opportunity cost in X.

We can thus say that A has a comparative cost advantage in X and B has acomparative cost advantage in Y. When we take our measurements in opportunity


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cost, we see that although B has an absolute cost disadvantage in both products, ithas a comparative cost advantage in one.

Let us try moving some factors in A from producing Y to producing X, where the countryhas a comparative cost advantage. Suppose we move 5 factor units, i.e. half theavailable package. This increases production of X by half to 30 tonnes per day, whilst itreduces the production of Y by half to 15 tonnes per day. We have gained in X but lostin Y. Suppose we make up this loss of Y by transferring factors in B, say transfer 8factor units from X to Y. Production of X will fall by 8/10ths and of Y will rise by 8/10ths.We can now produce Table 15.2 showing the position after the movement of factorunits.

Table 15.2: Comparative advantage – adjusted production (tonnes)

Production per Day of 10 Factor Units

Country A Country B Total

Product X 30 2 32

Product Y 15 36 51

Comparing Table 15.1 with Table 15.2, we see that production of X has risen from 30 to32 tonnes per day, whilst production of Y has risen from 50 to 51 tonnes per day as aresult of switching 5 factor units from Y to X in Country A and 8 factor units in CountryB. If both X and Y are freely traded between the two countries then both gain as aresult of the specialisation and trade. If the opportunity cost ratio for two goods werethe same in two different countries then there would be no benefit from trade.

The belief that comparative cost leads to a growth in total production and trade and a moreefficient use of scarce resources in the world has long been an argument in favour of freetrade; the argument is that countries should specialise in those goods for which they have acomparative advantage and that all goods should be freely traded on an international scale.However, we need to be aware of the assumptions on which the assumed benefits arebased:

The factor units are transferable from one activity to the other.

All factor units are equally efficient and there is no loss of efficiency after transfer – thenewly transferred units produce just as much as those already operating in the activity.

There is no unemployment either before or after the transfer, i.e. all units of oneproduct have an opportunity cost in terms of the other.

There is no transfer of resources from one country to the other. Clearly, the greatestgains would be achieved by transferring all factors from Country B to Country A wherethey could all produce more. If the comparative advantage is caused by superiormanagement, then gains could be achieved by transferring management ability from Ato B.

We have to recognise that, in the modern world:

There is specialised production and factor immobility within countries. Factors cannotalways be transferred from one activity to another, e.g. shipyard welders do not alwaysmake good computer programmers.

There is unemployment and the opportunity cost of employing factors with noalternative employment is nil.


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Multinational companies can and do transfer factors from one country to another – theycan change the absolute cost of production by transfer of capital and managerial skill,and this is becoming more and more prevalent in today's modern world.

There is no free trade, even without political controls, because modern internationalmarkets are becoming oligopolistic on a world scale.

High transportation costs can reduce or even cancel out the advantages of internationaltrade and specialisation.

There are some areas of the world that are expanding very rapidly (particularly Chinaand India) and these are having a major impact on world trade and the economics ofworld trade.

As a result of these changes we have to be very cautious in applying the concept ofcomparative cost advantage to modern international trade, although there are examples of itapplying in practice and countries specialising in the production of certain goods.

Development of International Trade and Operations

The most common form of international trade remains exporting, either directly into a foreignmarket or indirectly using agents and distributors based in that market. There are, though,limitations on export opportunities – there may be restrictions such as tariffs and quotasimposed on exporting by the recipient country, and also, on occasions, from the homegovernment itself (as, for example, on arms sales to certain countries). There may also bepolitical reasons why one country, whatever the economic benefits, would not trade withanother country. In addition, the logistics of exporting certain products, such as bulkymachinery, may mean that it is more economical to produce the goods closer to the markets.

Developments whereby companies get increasingly involved with the foreign market include:

Management contracts, whereby a company sells its management expertise to anoverseas company in exchange for a level of fees, often in conjunction with a licensingagreement, involve minimum investment.

Licensing, which may be used when penetration of the overseas markets needs to befairly rapid, where the political risk is high, and when the company does not wish toinvest large amounts of money. It may also be used when it is difficult to invest directlyin a country or the remittance of funds to the parent is difficult. There are, however,disadvantages to licensing – quality may suffer, profits may not be very high and thereis the risk of producing a competitor both in the overseas market and (via export) inother markets.

We saw in earlier study units that there has been an increasing globalisation of capitalmarkets, allowing organisations to raise and trade capital relatively easily in overseascountries. This globalisation has allowed a significant increase in foreign direct investment(FDI). These opportunities for FDI have allowed a significant growth in the development ofmultinational companies.

There is no standard definition of a multinational company (MNC), but a working definition is:

"an enterprise which owns or controls subsidiaries, service or productionfacilities, in countries outside of that in which it is based".

The basic form of MNCs is a parent or holding company and several (wholly or partly) ownedsubsidiaries and sub-subsidiaries.

You should note that it is control and/or ownership that is important in determining whethera company is an MNC – a company which merely imports/exports goods and/or services isnot a multinational company. Where only a few countries are involved in the firm'soperations, the company is generally referred to as an international company, but when its


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operations span the globe it is typically referred to as a multinational company. The countriesin which the subsidiary or facilities are based are known as host countries.

MNCs are growing in number and size, with increases in output nearing 20% per annum.Whilst there are some medium-sized MNCs, there are also some very large companies (e.g.Ford) which have GNPs larger than several countries. Multinational companies include theWestern world's largest companies; their operations span the globe and they generate thebulk of international trade.

Foreign Direct Investment

There are several reasons why a company may grow via FDI and become a multinational,and often in making the decision financial considerations are outweighed by strategicreasons. The common reasons quoted for FDI are listed below, but you should note thatthere is often more than one reason why a firm may decide to invest overseas.

The provision of raw materials (e.g. oil, minerals) – many MNCs base part of theiroperations in the location of their raw materials, for cost or logistic reasons, or in orderto comply with the political and legislative wishes of the host government.

The provision of cheap and productive sources of labour is a reason given for manyMNCs locating in the Far East and Mexico.

Location in the market for the company's goods, e.g. several Japanese car firms havelocated in Europe in order to supply the EU markets.

Location in centres of knowledge, e.g. several Japanese and European companieshave purchased firms in the US in order to gain access to technological knowledge inthe field of electronics. An example of a firm investing in Britain for this reason are theplans of Microsoft to establish facilities in Cambridge.

To permit diversification opportunities not available in the country's domestic markets.

To allow growth if there are limited opportunities for the firm "at home"; such growth cantake the form of diversification, or horizontal or vertical integration.

For companies based in countries with unstable or unpredictable political regimes FDImay be a way of ensuring safety from interference in, or expropriation of, theirbusiness. Such fears led to FDI in Australia and North America by Hong Kong-basedfirms prior to its repatriation by the People's Republic of China.

The criteria by which investment opportunities are selected will vary between companies.MNCs often prefer to invest in their own domestic market, and they will only go abroad if theycan secure a higher rate on capital by doing so.

Sometimes the MNC will undertake a foreign investment that is uneconomic, the mainreasons for this being:

To ensure an outlet for some other aspect of its worldwide operations (e.g. an oilcompany may construct a refinery as an outlet for its own crude oil production).

To safeguard its existing interest (e.g. by producing a new but uneconomic car, in orderto keep a brand name alive for the sake of a larger, successful model).

Studies indicate that many MNCs do not have a master plan for international investment butreview each individual project on its merits. In many cases it is generally the viability of theproject, rather than the finance available for investment, that is the key to the investmentdecision.

Trade Policy and the European Union

The UK, as part of its membership of the European Community, has agreed to join with otherMember States in a customs union with common arrangements for imports from and exports


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to third counties. These common arrangements are decided, discussed, agreed andadministered through the Community's "Common Commercial Policy" (CCP).

The CCP establishes uniform principles between all Member States governing EU TradePolicy including changes in tariff rates, the conclusion of tariff and trade agreements withnon-member countries, uniformity in trade liberalisation measures, export policy andinstruments to protect trade such as anti-dumping measures and subsidies. For example, bymaintaining the Common External Tariff, any product entering the Community will be subjectto the same tariff rate whether it enters through a port in Italy, in Portugal or in the UK.

Where issues which affect the Community's CCP are being discussed in international fora, allMember States co-ordinate on policy in order to present a cohesive Community externalpolicy. Thus, in the multilateral World Trade Organisation negotiations, the Commissionspeaks on behalf of the Community and its Member States.

Community trade policy is decided in the Article 133 Committee. This Committee, namedafter the relevant article of the EC Treaty, is comprised of representatives from each MemberState and chaired by whichever Member State holds the EU Presidency. It meets on aweekly basis to discuss the full range of trade policy issues affecting the Community, fromthe strategic issues surrounding the launch of rounds of trade negotiations at the WTO tospecific difficulties with the export of individual products, and considers the trade aspects ofwider Community policies in order to ensure consistency of policy. Specialist meetings of theArticle 133 Committee also take place separately to consider such complex issues as tradein services and textiles in greater depth than is usually possible.

Officials representing their Member States at the Article 133 Committee – at whatever level,generalist or specialist – are accountable to their domestic Ministers for their actions.

MNCs and World Trade

Traditional economic theory insists that international trade arises from bargaining betweenindependent traders in different countries with a buyer in one doing business with the seller inanother. The arrival of the MNC distorts this theory as an ever larger proportion ofinternational trade results from decisions taken at the nerve centres of these large industrialempires.

This is of increasing concern to governments for a number of reasons, including:

Governments fear for their national interest which may be sacrificed for that of anothercountry.

Governments will be anxious about their own share of an expanding company'sinvestment programme.

Governments will be anxious when there is a cutback in the investment in, and thebusiness in, their own country.

MNCs are continually anxious to secure a high and ever-increasing level of new industrialinvestment. Countries and governments want to be on the receiving end of the MNCs'investment, and compete for the large investment funds which MNCs can move around theworld.

As a general rule, the subsidiaries of an MNC will be expected to earn a profit for their parentorganisation and their financial policies and planning will be based on the objectives andinterests of their parent. In theory each subsidiary should be capable of financing itself,whilst continuing to make a profit for the parent company. Of course this may not always bepossible. New operations in a foreign country may mean that the company may not generatea satisfactory return in the early years. In such circumstances the parent may have tosupport the company by the provision of cash or guarantees.


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Countries which receive foreign investments have to accept that foreign subsidiaries ofMNCs will become net exporters of cash in the longer term. One of the main benefits to thehost country, beyond the creation of jobs, arises from the payment of taxes and customsduties. Generally, too, the level of industrial investment will be increased, and the balance ofpayments of the host country will be improved as the MNC starts to export to other parts ofthe world.

Benefits are not always one way. Decisions to transfer reserves out of the host country maynot be in its best interests and there are many examples where limits are placed on theimport of capital and the sending home of high proportions of their foreign earnings. Inaddition, host countries may establish trade policy instruments which aim to safeguard thenational interest – such as anti-dumping measures and other environmental policies.

These actions can serve to distort competition and restrict trade at both the national andinternational level, when applied contrary to competitive principles, and there is a carefulbalance to be struck between abuse of the host country's interests and the ability ofcompanies to develop their international trading realistically.

Note, though, that the actions of MNCs themselves can place restraints on competition.Practices such as orderly marketing, managed trade, export cartels, mergers to attaincommanding market positions and displacement strategies can lead to serious tradingbarriers, in themselves serving to undermine the value of international trading agreementsand concessions. This can generate political pressure to react to such competitivedistortions by national trade policy measures which also serve to undermine internationalagreements.

World Trade Organisation (WTO) Overview

In 1995, the WTO was established to succeed the General Agreement on Tariffs and Trade(GATT). The GATT was formed in 1948 as a "provisional" instrument, initially intended topave the way for an International Trade Organisation (ITO). However, the Havana Charter,which would have established the ITO, was never ratified and the GATT remained the onlymultilateral instrument governing international trade.

An informal organisation was built around the GATT to discuss trade-related issues andnegotiate further liberalisation. Taking place in "rounds", these negotiations at firstconcentrated on lowering tariffs before moving on to additional issues such as subsidies,anti-dumping and non-tariff measures.

The eighth trade round – the Uruguay Round – ran from 1986-94 and was the mostextensive of all, covering trade in goods, services and intellectual property, and establishingthe WTO as a permanent organisation.

The WTO is the only global international organisation dealing with the rules of trade betweennations. At its heart are the WTO agreements, negotiated and signed by the bulk of theworld's trading nations and ratified in their parliaments. The goal is to help producers ofgoods and services, exporters and importers conduct their business. The key principle isnon-discrimination, ensuring that products from different countries are treated the same way.As well as acting as a forum for trade negotiations, the WTO also provides an arbitrationservice for countries embroiled in trade disputes.

The WTO is a member-driven organisation which works on a consensus basis, ensuring thatall members have an equal voice. At the end of 2005, the WTO had 149 member countries,with others waiting to join. The UK is a member of the WTO in its own right, although for allpractical purposes it works through its membership of the European Union, as required bythe Common Commercial Policy (as described above).

As an international organisation, the WTO has a sound legal basis with all members beingaccountable, having ratified the WTO Agreements. These agreements are contracts,


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guaranteeing member countries important trade rights. They also bind governments to keeptheir trade policies within agreed limits to everybody's benefit.

Doha Development Agenda

The current round of negotiations, the Doha Development Agenda (DDA) began in 2001.This includes negotiations on agriculture, non agricultural market access, trade andenvironment, trade facilitation, services and special and differential treatment for developingcountries addressing, for example, the difficulties they face in implementing WTOagreements.

B. INTERNATIONAL INVESTMENT

There are different forms of overseas investment available to an MNC – the choice made willdepend on the reasons for the FDI (to extract the maximum possible profits from thesubsidiary and as quickly as possible, or to develop a lasting presence in the country to themutual benefit of all parties) and the options available in the country (there may berestrictions on the type of investment allowed and the level and type of funds permitted to berepatriated by the parent company imposed by the political regime in a country). The level ofrisk (see later) will also have a major impact on the company's decision.

The most common forms of investment abroad are:

(a) The takeover of, or merger with, a firm already established in the target country. Thisoption has the same advantages and disadvantages as a "domestic" takeover –established markets, production and distribution facilities, but often poor performance,financial status and management.

(b) Joint ventures with an overseas partner local to the area where investment is to takeplace, either for a fixed period for co-operation on a defined number of projects, or acontinuing long-term joint-equity venture. Joint ventures are common in the MiddleEast and Japan where legislation prevents or makes difficult 100% foreign ownership offirms. It is also becoming increasingly popular in areas with high research anddevelopment costs, e.g. the aerospace and car industries.

(c) Firms may start up overseas subsidiaries or branches from scratch; again this routereflects the same advantages and disadvantages as domestic start-ups with theadditional problems/opportunities that may occur as a result of differences between thetwo countries concerned.

The parent company will aim to achieve a cash return from overseas subsidiaries.There are several ways of achieving this:

By dividends from subsidiaries

By the parent company selling goods and services to the subsidiary

Making a loan to a subsidiary at a high interest rate

Levying charges on the subsidiary for management services provided by theparent company

The Investment Decision

Points to be considered by a company prior to establishing new operations in an overseasterritory include the following:

Will the investment be temporary or permanent? For example, a temporaryinvestment, such as a mine, will be worked out within a finite period of time. In suchcases a loan will generally be the best method of finance, whereas for permanentinvestment equity will usually be the best approach.


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Is it best to operate as a branch or should a separate local company be created? Theanswer to this question will depend on local considerations, including the tax laws ofthe country concerned, as well as strategic policy regarding decentralisation of controlof subsidiaries.

How difficult will the repatriation of funds be in the future?

Where borrowing is envisaged, should funds be borrowed locally, provided through theparent or raised through the Euromarkets, and what exchange risk (see later) will beinvolved?

What is the cheapest and safest way of providing capital?

Would it be politically wise to have a local participation in the chosen country?

The decision to locate, or relocate, part of an MNC's operations in a foreign country willfollow detailed research and often complex negotiations. Of the issues which will primarilyconcern the management team, the following will be of particular significance:

The political, economic and currency stability of the country.

The availability and cost of suitably qualified labour and management, and theindustrial relations record of the country.

Support, assistance (and interference) of, and by, the government of the country.

Communication facilities.

Controls on the movement of products and currencies.

The ability to acquire an established firm or whether a "green field" operation can bedeveloped.

The fiscal and international policy of the country.

The level of competition already established in the region.

The stability of the market for raw materials.

Inflation and local taxes.

Entities trading internationally face particular difficulties based on different currency unitswhich can cause potential problems in translating one unit of currency into another. Theyalso have the problem of different laws, taxes, business practices and cultures which may beincompatible with existing operating methods.

International Investment Appraisal

Investment appraisal in an MNC uses NPV, IRR or (occasionally) APV techniques, which wediscussed earlier. However, different factors may have to be considered to reflect thediffering nature of the investment:

An increase in (unsystematic) risk caused by currency and political risk (see later) maylead to the firm increasing the discount rate used to evaluate projects; or the firm mayuse the discount rate determined by its overall systematic risk level (if it is assumed tobe unchanged by the potential investment) and adjust the cash flows for the expectedpolitical and currency risk. In practice the discount rate is adjusted for political risk –because all cash flows would be affected by adverse political circumstances, whereascurrency risk may have some beneficial, and some detrimental, effects on cash flowsand as such is accounted for by adjusting cash flows.

The different rates of inflation between the host country and that of the parent need tobe considered.


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The different methods of repatriating cash flows (e.g. royalty fees, dividends) must bebrought into consideration.

The project must be shown to be beneficial both in the host country and its currencyand in terms of funds remitted to its parent in order to fully justify it, both from the pointof view of the parent company and in comparison with other (potential) projects in thehost country.

There may be financial incentives offered to the firm to encourage investment in aparticular country.

Differences in accounting practices and tax systems in the host country may have asignificant impact on the investment appraisal.

The problems of managing different exchange rates and rapid movements in exchangerates.

Taking into account the above points, an exercise to consider investment in an overseasproject is the same as for a domestic one, with the added complication that cash flows haveto be converted from the host currency to the domestic one.

Repatriation of Profits

The aim of investment in overseas subsidiaries is to increase group profits for the MNC. Incommon with all groups, those companies with inter-divisional trade need to determine thelevel at which to set transfer prices for goods and services provided by one group memberfor another. The basis on which the transfer price is set – cost (either marginal or full),market price or some negotiated level – will affect the profit share of the group, and shouldbe determined in order to maximise group profits by maximising the motivation ofsubsidiaries and circumventing any repatriation controls imposed by the host government.

Transfer prices of goods and services provided by group members for each other are onlyone way of obtaining cash returns from an overseas subsidiary; others include:

Royalties charged to the subsidiary for making goods, or providing services, for whichthe parent holds the patent.

Management charges levied in respect of services provided by "head office".

The subsidiary may borrow from its parent, and thus pay interest charges to it.

Dividends which can be paid to the parent on the equity provided by it.

The choice of method, and level received from each (often by manipulating the variousfactors, e.g. the rate of interest for parental loans), will be determined by the requirements ofthe parent and the subsidiary, any exchange controls present, and the perceived risk of theinvestment.

This manipulation can make the interpretation of the accounts of MNCs and their subsidiariesextremely difficult. This problem is exaggerated by the differing accounting policies used indifferent countries; the differing choices made as to which exchange rates (actual (and atwhat date) or predicted) to use in setting forecasts and translating accounts into the parentcompany's currency; and the different economic and political circumstances a subsidiary maybe operating in.

Internal evaluation (i.e. by the companies themselves) tends to be most effective if based onbudgets with operational management held responsible for those factors which they cancontrol, including exchange rate variances which they should have been able to predictreasonably accurately. A common method of control in MNCs is to show a comparisonagainst budgets in the parent company's domestic currency to allow comparison betweengroup members, but showing exchange rate variances separately.


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Finance

MNCs will often obtain their funds from the international markets, although working capitalneeds of individual subsidiaries may be raised locally. Because of the scale of operationsthere is rarely any difficulty in raising funds, but there may be some local limitation to theamount of borrowings which the host country is prepared to allow.

Eurobonds and Eurodollars which we discussed earlier in the course both have relevance tothe international operations of a typical MNC. The borrower must be of high credit standingand must need large sums of money, as both markets are for the international gathering ofcapital resources, and are not aimed at the smaller organisation.

MNCs often use international sources of funds, e.g. Eurobonds or overseas capital markets,to finance both themselves and their subsidiaries. A common method of financing anoverseas subsidiary is to finance its fixed assets with a long-term loan in the host country'scurrency, which permits the repayment of the loan using the profits generated in that country.This is known as the matching of assets and liabilities, and is a method used to reduceexchange rate risk (see later).

In deciding the financial structure of an overseas subsidiary, the parent needs to consider thelevel of gearing the subsidiary should have and from what source; how much equity shouldbe placed by the parent in the subsidiary and how much from outside (and from whatsources); and the level of reserves and working capital the subsidiary should aim for. Thesechoices will be determined by political and legal restrictions in the parent's country and thehost country and the expected level of permanence of the investment (for a longer-terminvestment long-term sources of funds such as equity would be used in preference to short-term funds such as trade credit – which would be used for a short-term investment).

Moreover the firm, in common with all organisations, needs to consider the cost of capitalwhich we discussed in depth earlier in the course. Whilst the factors affecting a domesticfirm when deciding on its capital structure also need to be considered by an MNC, thedecision is made somewhat harder by the greater choice of capital available frominternational capital markets, taxation and other legal restrictions in the various countries inwhich the MNC operates.

C. FINANCE AND INTERNATIONAL TRADE

Working capital finance requirements for overseas trade are likely to be greater than forsolely domestic trade because of transport time, administrative delays and perhaps longercredit terms (90 days from shipment or 60 days from receipt).

Before considering financing methods themselves, it will be useful to briefly review the termsunder which international trade transactions conducted.

Terms and Methods of Payment

The most common form of settlement for the cost of a trading transaction is by means of abill of exchange (also called trade bills). This occurs when the seller draws a bill on thebuyer asking them to pay, on a certain future date, the price of the goods supplied, which isthen accepted by the purchaser (by signing and returning it to the seller). The purchaser isthus formally acknowledging his debt to the seller. The seller can then use the bill ofexchange as security in order to obtain money from the seller's bank.

A bank may also agree to accept a bill from its customer in exchange for an agreement thatthe customer will repay the bank. The cost for arranging this finance is the discount (i.e. thefull amount of the bill is not advanced). The more secure the bill (e.g. from a bank ascompared to a trader) the "finer" or lower the discount.


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Note that a bill of exchange is a method of facilitating payment and could therefore be usedin several of the terms of payment we consider below. A bill of exchange may also be termeda draft.

There are a number of different ways in which payment for transactions may be effected.

(a) Open account

The exporter ships the goods and any documents of title direct to the importer.Payment is made by the importer in accordance with invoice terms, the exporterbearing the risk of non-payment.

(b) Documentary collection

The exporter ships the goods and sends the documents of title through the bankingsystem. There is a collection order which instructs the overseas bank regardingrelease of documents to the buyer. The exporter can instruct that the documents areeither released against payment or against acceptance.

Open account trading status reports should be taken on the buyer, and insurance canalso be taken out, if required.

(c) Documentary letters of credit

A documentary credit is a guarantee by the buyer's bank (the issuing bank) that bills ofexchange drawn by the exporter will be honoured, provided the credit terms have beenfulfilled.

If the credit is irrevocable, it can only be modified or cancelled with the agreement of allparties.

Confirmed credits are ones which contain the additional guarantee of a bank in theexporter's country to honour them, should the issuing bank default.

Documentary credits have an additional security over documentary collections. Banksdeal in documents not in goods and, as the seller must comply with the instructionsissued by the buyer's bank, the seller will check those instructions before shipping thegoods and, if he can comply with the instructions, he will get his money. Failure tocomply with the instructions as detailed will mean that the seller's bank must refer tothe buyer's bank and get permission to effect payment.

(d) Advance payment terms

The most advantageous method of payment from an exporter's point of view is toreceive cash for his goods before shipment. This method affords the greatestprotection and allows the exporter to avoid tying up his own funds. Although lesscommon than in the past, cash payment upon presentation of documents is stillwidespread.

Cash terms are used where there is political instability in the importing country orwhere the buyer's credit is doubtful. In addition, where goods are made to order,prepayment is usually demanded, both to finance production and to reduce marketingrisks.

Finance for Exporters

Delays in receipt of payment for goods sold overseas can seriously affect a company's cashflow, eventually reducing profitability. Banks and other organisations have thereforedeveloped a wide range of finance facilities to assist exporters in financing their internationalbusiness. Export credit can be split into two categories.


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Supplier credit – where the exporter sells goods to an overseas buyer on credit terms(for example, 30 days) and then obtains finance from a bank to cover the period of timebetween shipping the goods and receiving payment.

Buyer credit – where the bank provides finance directly to the overseas buyer and theexporter receives payment upon shipment of the goods.

Payments made by banks in respect of various export finance schemes are paid either:

With recourse – where the bank has the right to claim reimbursement for sumsadvanced to the exporter, in the event that the buyer does not pay.

Without recourse – where the exporter is not liable to repay finance received from abank, if the buyer defaults.

If the exporter is cash-rich, he may be able to finance export sales from his existing bankbalances. However, outlay can be considerable and, if credit terms are allowed to the buyer,the cost of raw materials, manufacturing and shipping will not be recouped in the form of thebuyer's payment for some time, and additional funding may be required. The following arethe normal method of obtaining such funding.

(a) Bank overdraft

Probably the easiest way of financing export sales is by use of an overdraft facilityagreed with the exporter's bankers, though exporting companies are unlikely to use thismethod to finance all their exports, since other forms of finance which are specificallydesigned for export credit are available at lower cost.

(b) Advance against bills

This is short-term, with-recourse, finance obtained by an exporter who draws a bill ofexchange, under the terms of the export contract, on the overseas buyer. The exporterpresents the bill of exchange to the bank, which advances an agreed percentage of theface amount of the bill to the exporter and undertakes to present it to the buyer forcollection. The bank charges a fee for this service, together with interest at a variablerate for the period of the advance.

(c) Negotiation of bills

This means that the bank buys the bill from the customer. The customer receives theface amount of the bill immediately. The bank sends the bill of exchange and therelated shipping documents to the buyer's bankers for collection and reimburses itselfupon receipt of the proceeds, at the same time recovering its collection charges andinterest for the period involved.

A negotiation facility must be specifically agreed with the exporter's bankers, and fundsmade under this facility are on a with-recourse basis. Recourse is available to thebanker upon dishonour of the bill, the charges and interest for this being fixed at thetime of negotiation.

(d) Discount of a bill

Banks are prepared to discount bills of exchange which can be either:

Drawn by an exporter on a buyer and accepted by that buyer; or

Drawn by an exporter on a bank, under a letter of credit, and bearing a bankacceptance.

Bills are discounted with recourse to the customer and the discounting bank pays theface value of the bill less the discount charge which depends partly on the length oftime the bill has to run to maturity and partly on the rate of discount which is usual forthat type of bill. Finer rates are available for bills bearing a bank acceptance than forthose accepted by an unknown or doubtful buyer.


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(e) Acceptance credit facility

This is a facility offered by banks for large companies with a good reputation. Thecompany draws bills of exchange on the banks, generally for 60, 90 or 180 days,denominated in whichever currency most matches the needs of the company. The billscan be drawn on, as and when required, throughout the length of the agreement, whichcan be up to five years, provided the credit limit is not exceeded. The bill is then sold inthe discount market and the proceeds passed to the company (less the bank'scommission). At maturity, the company reimburses the bank the full value of the bill,and the bank pays the holder of the bill.

A major advantage of acceptance credits is that they can be sold at a lower discountthan trade bills. The cost is also fixed, allowing for easier budgeting and may be lowerin times of rising interest rates than that of an overdraft. The credit is also guaranteedfor the length of the agreement, which is not the case with an overdraft.

Where goods are involved, the bank generally has control over the documents and thegoods.

Be careful not to confuse acceptance credits with documentary acceptance credits.

(f) Documentary acceptance credit

When an exporter presents documents under a confirmed irrevocable letter of credit tothe confirming bank, he can obtain immediate finance, provided the documentscomply with the terms of the letter of credit. The confirming bank will accept a term billof exchange which can be discounted by the confirming bank, or the exporter canregain possession of the accepted bill and discount it with any bank for cash. Discountfees are paid by the exporter unless, under the terms of the letter of credit, theapplicant/overseas buyer is responsible for such costs.

(g) Merchant bank finance

A merchant bank can provide most of the facilities already mentioned but, in addition, itmay offer an accepting house acceptance facility. The exporter again hands over thedocuments as collateral security and draws a second bill on the accepting house for upto, say, 75% of the collection value and with a tenure slightly longer than the export bill,to allow receipt of proceeds before the accommodation bill matures. The merchantbank accepts the accommodation bill and discounts it in the market. For protectionagainst risks, the merchant bank would expect not only to have control of the bill andthe documents it is handling for collection, but also additional safeguards such asinsurance cover.

(h) Factoring

Factoring is a without recourse form of finance and the factor will only enter into anagreement with an exporter after satisfactory reports have been obtained as to theexporter's standing, the reliability of the overseas buyer, and trading conditions in theforeign country.

There can be many advantages for the exporter in employing a factor to deal with debtcollection:

Credit risk is eliminated under the non-recourse agreement and there are,therefore, no losses through bad debt.

There is no need for credit and political risk insurance, nor any need to take outforward exchange cover.

Immediate financing is available on approved invoices, if required.

There is a reduced staffing requirement, since accounting, debt collection and thesales ledger are handled by the factor.


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It gives the exporter the opportunity of trading on "open account" terms, but withthe security of also using more traditional instruments, such as letters of creditand bills of exchange.

Experienced credit managers are on hand, whose knowledge of language, locallaws and trading customs are invaluable. A factor with established contacts isable to assess foreign buyer's creditworthiness more easily and thoroughly thanthe exporter can from his own sources. There is, then, no need for any othersource of status reports and credit information.

However, the disadvantages of factoring must also be considered:

Costs – these vary, depending upon the extent of the service required by theexporter, but may include administration of the exporter's exports sales ledger,credit protection and financing.

A factor is selective in choosing clients and debts.

A factor may set an overall turnover limit for the exporter.

A factor may set a limit on the amount owing at any one time by any one buyer.

Terms may be limited to 120 days.

Factors lend or provide finance against debts which are already approved on thestrength of the creditworthiness of the overseas buyer. The exporter's own bankersmay be prepared to effect an introduction to a factoring subsidiary of the bank. Anexporter considering employing the services of a factor should always consult hisbankers, since factoring can affect the value of a lending banker's security.

(i) Export house finance

Export houses can be grouped into:

Export merchants

These buy goods in their own right from suppliers and export them to their ownbuyers abroad for cash – usually within seven days. A merchant can thereforeeliminate credit risk for the exporter, and transform the deal into the equivalent ofa domestic cash sale.

Export agent

An export agent acts as agent for the exporter, and the contract relationshipbetween the buyer and seller is maintained. The exporter receives payment fromthe export agent upon shipment of the goods, and the overseas buyer is alloweda period of credit by the agent, which is provided from the agent's own resources.

Confirming house

A confirming house acts as agent for the overseas buyer, places an order with theexporter, and accepts a usance bill from the buyer which can be discounted at afine trade bill rate. The buyer therefore receives a period of short-term credit, andthe exporter need not be concerned with credit risk , since this is the equivalent ofa domestic sale.

Export finance house

This will provide non-recourse finance to the exporter under the terms of theexport contract and agree credit terms to the buyer. Like the factoring company,it will deal with obtaining a credit assessment of the buyer and will relieve theexporter of the need for credit/risk insurance but it can arrange such, if required,or accept an assignment of a policy, as the banks do.


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(j) Instalment finance

Some finance houses can arrange hire-purchase finance, covering a wide range ofconsumer and capital goods, through a network or credit union of associates in bothbuyers' and sellers' countries.

The exporter will gain satisfaction from the arrangement (which is without recourse tohimself), as he receives immediate payment, while the buyer receives deferred termsunder a hire-purchase agreement. It is a relatively costly plan, and it may not workwhere there are exchange control restrictions or other monetary regulations.

(k) Leasing

An exporter sells the equipment to a leasing company, which then leases it to anoverseas hirer. The exporter receives payment without recourse from the leasingcompany – usually after the equipment has been shipped and installed at the hirer'spremises.

There are two main types of lease seen in the international context:

Cross-border leases, which are made directly from the leasing institution (oftensubsidiaries of major banks) in the exporter's country to the overseas buyer.

Local leasing facilities, which may be available, perhaps, through overseasbranches or international leasing associations.

Both types of arrangement may be eligible for insurance cover. Where contracts arearranged between the leasing company and the foreign buyer, the insurance will beundertaken by the lessor. Here the exporter will have no risk, having sold the goodsdirect to the leasing company. In those cases where the exporter arranges his ownleasing deals direct with the foreign buyer, he will himself be able to obtain cover.

(l) Forfaiting

Forfaiting is a means of providing exporting companies with trade finance on a withoutrecourse basis, while their overseas buyer acquires a period of credit of up to sevenyears.

When forfaiting an exporter is giving up the right to claim payment for goods deliveredto an overseas buyer. These rights are surrendered to the forfaiter (normally a bank,finance house or discount house) in return for cash payment at an agreed rate ofdiscount.

Any type of trade debt can be forfaited and these debts can be in any form but they areusually either:

A bill of exchange accepted by the buyer, or

A promissory note issued by the buyer.

The forfaiter will calculate the discount rate, taking into account:

The currency used

The buyer's credit rating

The credit-risk factor for the buyer's country

The discount rate is calculated as a margin above prevailing eurocurrency market ratesfor the period of credit and it varies in line with those rates, since this is the mainsource of funds which forfaiters tap to provide finance to exporters. Trade paper isdiscounted in any fully convertible currency, although US dollars, Swiss francs andEuros are usual, since these are the main eurocurrency market currencies.


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A forfaiter will not finance a trade debt without the guarantee of a known internationalbank, although finance will be considered in respect of bills of exchange accepted, orpromissory notes issued, by a first-class buyer, such as a government agency or amajor multinational company.

There are two main forms in which the debt instrument may be secured:

The "Aval"

This is an irrevocable and unconditional guarantee to pay on the due date. Thewords "pour aval", together with the bank's signature, are written directly onto thebill or the promissory note and thus the bank becomes the debtor as far as theforfaiter is concerned.

The aval is not legally recognised in some countries, including England.However, this does not appear to have caused practical difficulties and, in fact,most forfaiters, including those in the UK, prefer the aval to a separate letter ofguarantee.

A Guarantee

This is a separate document whereby the guarantor undertakes to pay bills ofexchange or promissory notes on their due dates. The guarantee must not, ofcourse, refer to the underlying commercial transaction, since the forfaiter, havingbought the debt instrument without recourse, will not wish to find payment iswithheld because of a dispute between exporter and importer as to the goods orservices supplied.

The aval or the guarantee is the forfaiter's security which effectively eliminates anycommercial risk.

The forfaiter may hold the bill or note until the maturity date, which is known asprimary forfaiting, or sell it to another institution in what is known as the secondaryforfaiting market.

A separate guarantee is generally less favoured than an aval, since it involves morework for the forfaiter and its transferability can cause problems.

Advantages of forfaiting for the exporter include:

Forfaiting offers 100% finance on a without recourse basis and at a fixed rate,thereby enabling the exporter to build finance costs into the contract price.Finance is off-balance sheet, thus preserving existing bank credit facilities.

In addition to removing interest risk, forfaiting also eliminates exchange, credit,political and transfer risks.

Forfaiting is flexible, there being no distinction between types of goods andservices and no constraints on origin.

Forfaiting finance can be arranged very quickly, and documentation is brief andrelatively simple.

Forfaiting transactions are rarely published, and this aspect of confidentiality isoften attractive to exporters.

The ability to offer forfaiting in a tender may be necessary in order to remaincompetitive.

Disadvantages of forfaiting for the exporter include:

Despite the greater degree of competition among financial institutions forforfaiting business, which has brought interest margins down, forfaiting tends tobe relatively expensive.


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Forfaiting is generally limited to the major currencies, and forfaiters will not acceptcountries where too great a risk is perceived. Similarly, the forfaiting institutionswill only accept the aval of a limited number of banks considered suitable.

The exporter normally has a responsibility to ensure that the debt instruments arevalidly prepared and guaranteed.

Government and Quasi-Government Aid

Governments will often encourage MNCs to establish operations in their country, therebycreating wealth and increasing employment. This is often achieved through grants,subsidies, favourable loans and guarantees. Whether assistance is given to a businessapplying for such help will depend upon whether its proposals qualify.

Many different institutions are involved in providing aid to companies wishing to break intoexport markets, in addition to the provision of finance. The following institutions provideadvice and help for this purpose.

Chambers of Commerce

The International Chamber of Commerce produces publications aimed at aidinginternational trade, and also provides certificates of origin and carnets which enablegoods to be temporarily imported without payment or import duty.

Department for Business, Enterprise and Regulatory Reform (BERR)

This is the main government department concerned with overseas trade, havingreplaced the Department for Trade and Industry in 2007. It oversees export licensing,regional groups, and British Trade International whose role is to foster businesscompetitiveness by helping UK firms secure overseas sales and investments, and byattracting high quality foreign direct investment. Other services include the exportintelligence, information and marketing research services and the Information Serviceon Tariffs, Regulations and Licences, all with the aim of providing information andadvice to exporters.

Financial assistance is also available from the BERR in helping trade associations orother representative bodies to assist UK companies to present their products to aspecified overseas audience, e.g. at fairs and seminars.

Export Credit Guarantee Department

The ECGD works closely with exporters, project sponsors, banks and buyers to helpUK exporters compete effectively in overseas markets by arranging finance facilitiesand credit insurance for contracts where the private sector may be unable to help

Export Credit Agencies (ECAs) are usually Government-sponsored agencies that usetaxpayers' money to help their countries' companies to export goods or services or towin overseas contracts. Their support is typically provided in the form of guaranteesand insurance and, in some cases, direct loans. The purpose of ECAs is to supporttheir domestic companies in export markets by offering a degree of protection frompolitical and commercial risks.

The Department for International Development (DFID)

The DFID is the part of the UK Government that manages Britain's aid to poorcountries and works to get rid of extreme poverty. It is headed by a Cabinet minister,one of the senior ministers in the Government. and this reflects how important theGovernment sees reducing poverty around the world.

What, though, is "development"?

When we talk about international development we are referring to efforts, by developedand developing countries, to bring people out of poverty and so reduce how much their


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country relies on overseas aid. Many different things can contribute to developmentwhich reduces poverty, such as settling conflicts, increasing trade, securing more andbetter aid, and improving health and education.

More than a billion people – one in five of the world's population – live in extremepoverty. This means they live on less than 65p a day. Other indicators include that 10million children die before their fifth birthday, most of them from preventable diseases,and more than 113 million children do not go to school.

In a world of growing wealth, such levels of human suffering and wasted potential arenot only morally wrong, they are also against our own interests. We are becomingmuch closer to people in faraway countries as we trade more and more with peoplearound the world. Further, many of the problems which affect us, such as war andconflict, international crime, refugees, the trade in illegal drugs and the spread ofdiseases like HIV and AIDS, are caused or made worse by poverty in developingcountries. Thus, getting rid of poverty will make for a better world for everybody.

Finance for Importers

The importer must also have adequate finance available to enable him to purchase goodseither for immediate resale or for processing prior to resale. Banks and other financialinstitutions have developed various products to make sterling and foreign currency financingavailable to importers.

These are similar in nature to the methods available to exporters and include the following.

Bank overdraft

In most cases an importer would not be able to finance all his purchases from anoverdraft facility, since this is an expensive source of finance. Overdraft facilities maybe secured or unsecured, depending on the financial standing of the importer.

Bank loan

Bank loans are available to companies in both sterling and foreign currency. Someform of security, however, would be called for by the bank.

Importers may take advantage of favourable interest rates by borrowing in foreigncurrency, especially if they are able to make repayment of the loan from receivablesdenominated in the same currency. Eurocurrency loans are available for large nationalor international projects.

Term documentary letter of credit

The importer can ask his bank to open a documentary letter of credit in favour of theseller, under which drafts are drawn, payable not at sight but at usance, i.e. 30, 60, 90,120 or 180 days after sight. The exporter can readily discount such bills and get spotcash because of the standing of the accepting bank. The importer, however, does nothave to provide cash until the maturity of the bill. As an alternative, where adocumentary letter of credit is not considered appropriate, the importer's bank maysimply add his "pour aval" endorsement to the bill. This guarantees to the drawer thatthe bill will be paid at maturity.

Produce loan or merchandise advance

A produce loan is made by a bank to an importer to enable him to pay for goods whichhe has contracted to buy. The goods are the security for the loan, which is repaid fromthe proceeds of sale.

Produce loans are granted for short periods only – long enough for the importer to beable to resell the goods and repay the loan with the proceeds – usually between sevendays and three months.


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Acceptance credits

As we considered earlier in the unit.

Export credit

Export credit agencies have been established in several countries, to encourage theexport of goods and services. The exporter can obtain credit facilities from theseagencies at fixed and preferential interest rates, which enables credit finance to bemade available to importers in other countries.

Rates of interest and lengths of credit terms are agreed by members of theOrganisation for Economic Cooperation and Development (OECD) and these terms,which are offered by most national credit agencies, are reviewed on a regular basis.

Confirming houses

The importer can receive short-term credit from the confirming house, to which he mustpay a commission for the service provided.

In addition to direct financial assistance, banks also provide a range of further services. Theprincipal service is effecting payment:

Where open account or payment in advance terms are used, banks will effect paymentby means of money transfers, telegraphic transfers, the SWIFT system, or by draft.

Opening of documentary letters of credit, including back-to-back and transferableletters of credit.

Selling foreign currency to the importer to settle his purchases, both on the spot and onforward currency markets.

In addition, they will also obtain status reports on prospective suppliers, provide advice andpractical assistance in complying with exchange control requirements, import licences,documentation, etc., secure travel facilities for importers seeking to make contacts overseasand assist in finding suppliers via the bank's correspondent networks, and arrangingintroductions.

Countertrade

Countertrade can be defined as a trading transaction whereby export sales are dependent onthe exporter receiving imports, in one form or another, from the buyer. Countertradedeveloped rapidly during the 1980s as the international debt crisis worsened and manycountries did not have the funds or credit facilities to pay for imports in the normal way.Countertrade has also been used to protect or stimulate the output of domestic industries. Itis thought that 30% of world trade is arranged through some form of countertrade agreement,being common in developing countries; centrally-planned economies (as part of their politicaland economic policies); in those lacking foreign currency; and in buyers' markets. It is lesscommon between industrial countries, though it is used in high technology areas such asaviation and defence.

Types of countertrade transactions are:

Counter purchase

This is the most common form of countertrade. As a condition of obtaining a salesorder, the exporter agrees to purchase goods and services from the buyer's country.Two parallel, but separate, contracts are arranged, and the value of the counterpurchase varies from 10% to 100% of the export order.

The counter-purchase goods will often be unrelated to those exported – and indeed thecounter-purchase agreement may be between parties not involved in the original


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transaction (although normally there will be recourse to the exporter if the counter-purchase obligations are not fulfilled).

Barter

This is a direct exchange of goods for goods, and only one contract is involved. Suchdeals are rare, although they are still sought by several African and Latin Americancountries, or for large contracts involving oil.

Buyback

Here, exporters of capital equipment agree to be repaid from the future output of theequipment supplied; such deals tend to be for large amounts and for long periods.They are sometimes referred to as "compensation" deals.

Switch trading

Because of imbalances in trading agreements, one country may accumulate largesurpluses owed by another country, e.g. Brazil may have a large surplus with Poland.These surpluses could be used by, for example, UK exports to Brazil being financed bythe sale of Polish goods to the UK. Such "switch" or "swap" deals can be very complexand specialist intermediary organisations are often involved in arranging suchtransactions.

Offset

This type of countertrade is most commonly used in connection with high technologyproducts, and involves an agreement by an exporter of such products to use materialsand components produced in the importing country in his final product. Alternatively, anoffset agreement may incorporate a requirement that bidders establish local productioncapacity.

Evidence accounts

In some countries there is a requirement for goods imported to be matched by anequivalent amount of goods exported from that country, and where such trade is of acontinuing nature it may be impractical to balance the business on an item-by-itembasis. In these cases, a record of the balance of this trade may be kept by means ofevidence accounts, such accounts being kept in balance on a year-by-year basis.

Countertrade is expensive, administratively difficult and often collapses – thus smaller andmedium-sized companies tend to avoid it. One party may receive goods it is unable to tradein, or receive them at too high a price; or there may be too many parties involved to ensurethe contract goes ahead.

The costs of countertrade include:

Insurance costs.

Advice fees, e.g. from banks, specialist consultants or third-party trading houses orbrokers who may take up obligations of countertrade.

The discount needed to dispose of goods can be up to 50% of low quality goods; this isknown as disagio.

Countertrade transactions are fraught with danger, and the number of successfultransactions form a relatively small percentage of those negotiated. However, the ability ofan exporter to quote countertrade terms, even if the particular exporting transaction does noteventually result in countertrade, may mean the difference between success and failure intendering for business. It can therefore be an important marketing tool.


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Among the many dangers associated with countertrade are:

Inability to dispose of large quantities of unmarketable goods taken as part of acountertrade deal.

Loss of profits on the main exports because the costs of countertrade have not beenfully considered.

Cancellation of export orders because of the failure of other parties to meetcountertrade obligations.

There are a number of specialists who can assist in countertrade, such as traders, brokersand banks.

D. EXCHANGE RATES

An exchange rate is the rate at which a unit of one currency can be exchanged for another –for any currency there is an exchange rate for each currency it can be traded with.

Exchange Rate Concepts

There are three concepts involved in the way in which exchange rates are expressed whichmust be understood at the outset.

(a) Buying and selling prices

Two prices are always quoted for any currency – a buying and a selling price. Thus, aUK bank would quote its exchange rates as follows:

Value of £ against other currencies

US Dollar 1.9695 – 1.9718

Euro 1.2716 – 1.2734

Japanese Yen 207.840 – 208.10

(Note that these rates vary on a daily basis and the figures given here are forillustration only.)

The lower of the two rates is the price at which the bank will buy sterling (for example,sell dollars in return for sterling) and the higher figure is the rate the bank will buy theexchange currency (for example, sell pounds for dollars). The wider the spreadbetween these two quotes the larger the profit margin.

Note that the terms "bid" and "offer" rates are often used as an alternative to buy andsell rates, but here we shall stick to the latter terminology throughout.

(b) Spot and forward rates

This is an important distinction.

The spot rate is the current rate of exchange for a unit of currency for immediatetransactions and quotations for which no previous arrangements have beenmade, delivery to the buyer being made two days later.

The forward rate refers to a rate of exchange fixed today for delivery at a defineddate in the future – for example, one month forward and three months forwardbeing for one month and three months in the future respectively.


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Thus, for example, a German company which is contracted to receive $1 million inthree month's time could either:

wait for three months and then sell the dollars for Euros at the (then) spot rate; or

enter into a contract now to sell the dollars for Euros in three months' time at thethree month forward rate.

Whilst the company may expect that the spot rate in three months' time may be higherthan the current forward rate, there is an element of risk. By waiting and seeing whatthe spot rate is on the day of receipt of the dollars, the company stands to possibly gainor lose on the exchange at the prevailing spot rate in relation to the forward rate. Onthe other hand, the company can buy certainty about the exchange rate by selling thedollars forward at the (possibly) lower forward rate.

It is important to note that forward rates are not statements of what spot rates will be atthe future date implied by the forward rate, (e.g. three months in the future for a threemonth forward rate), but are merely indications of the direction in which spot priceswill move. Depending on the risk assessment, the forward rate can be expected to behigher or lower than the expected future spot rate. This is because a forward pricecomprises the spot price on the date of the contract plus (or minus) the interestdifferential reflecting the expected relative changes in interest rates. Thus, forexample, if the forward rate of Euros against sterling is expected to fall it is becauseinterest rates in Germany are expected to be higher than those in the UK. (Weconsider the impact of interest rates on exchange rates in more detail below.)

(c) Discount and premium

These refer to the strength of the forward rate in respect of the current spot rate. Theyidentify whether the market considers the currency to be, respectively, weaker orstronger in the future, in relation to the exchange currency.

A currency with a forward discount implies that it is becoming weaker in relation to theexchange currency and will buy less of that exchange currency in the future. A forwardpremium would have the opposite effect.

The rates for one and three, or more, months in advance are often quoted in terms ofthe discount or premium applying. For example:

Value of £ against other currencies (spot and forward rates)

Spot Rates 1 Month Forward 3 Months Forward

US Dollar 1.9695 – 1.9718 0.97 – 0.95 c pm 2.63 – 2.60 c pm

Euros 1.2716 – 1.2734 1.5 – 1.25 pf pm 3.75 – 3.625 pf pm

Japanese Yen 207.840 – 208.10 1.25 – 1.375 y dis 3.375 – 3.5 y dis

Thus, if the quoted spot rate for sterling against the US dollar is £1 $1.9695 and thethree month forward rate is £1 $1.9432, the pound will buy less dollars in threemonth's time compared to today. It is, therefore, at a discount relative to the dollar – orthe dollar is at a premium relative to the pound. The size of the premium is thedifference between the two rates – $0.0263 or 2.63 cents.


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The discount or premium may also be expressed as a percentage annualised figureaccording to the following formula (in respect of the three month forward rate):

100%3

12

rateSpot

rateSpot-rateForward

%100496951

9695194321

.

..

-5.34%

Thus, the dollar is said to be at an annualised premium of 5.34% against the pound.

The rule for calculating rates is:

add a discount, deduct a premium.

This rule is important and you should remember it. It is essential to get the additionsand subtractions correct.

Remember, too, that premiums and discounts are quoted in fractions of a currency.The Euro is therefore quoted in cents, as is the dollar, and so on.

Exchange Rate Systems

An exchange rate is simply the price of one currency denominated in terms of another. Assuch, it is subject to very much the same processes as those which determine the price ofany other good or service – the laws of supply and demand – and these will result in therebeing an equilibrium position.

We shall look at the supply and demand influences below, but first we should make anessential distinction between two different types of exchange rate system.

(a) Fixed exchange rates

This is where governments which are members of the international monetary systemuse their official reserves (which comprise foreign currency and gold) to maintain afixed exchange rate. By adding to, or using, their official reserves the governmentensures that the demand for, and the supply of, their currency are balanced (thusmaintaining its price).

The exchange rate of each member currency is generally set against a standard –which could be gold, a major currency (e.g. the US $) or a basket of currencies. It isalso possible for each currency in the system to be set against each other.

Fixed exchange rate systems encourage international trade by removing uncertainty.However, they restrict member states' independence in setting domestic economicpolicies by requiring them to take appropriate action to maintain their exchange rate.

(b) Floating exchange rate systems

In such systems, exchange rates are left to, and are determined by, market forces,there being no use of the official reserves in maintaining the exchange rate level.

Floating exchange rate systems may be either free floating or, more commonly,managed floating.

Wide fluctuations of exchange rate values can occur under floating exchange ratesystems creating problems of uncertainty for international trade. However, it is likelythat the underlying economic conditions creating these fluctuations would have createdsevere problems for the working of a fixed exchange rate system – even creatinginstability.


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Influences on Exchange Rates

The demand for and supply of a currency, and hence its equilibrium price (or the exchangerate) is determined by number of factors, including:

Income and expenditure in a country on both domestic goods (which would otherwisehave been exported) and imports.

Differential interest rates between countries.

Differential inflation rates between countries.

The balance of payments position between the countries concerned.

Government economic policy, particularly in regard to influencing exchange rate levels.

Speculators and the general view as to the economic prospects of a country.

The relationship between currency exchange rates, inflation and interest rates has occupiedthe attention of economists over a number of years. The differential interest rates, inflationrates, and the spot and forward exchange rates between two countries are allinterconnected, and all impact on each other. In the absence of restrictions on internationalcapital movements, this relationship can best be summed up in the form of a series ofequilibrium models.

(a) Inflation rates and exchange rates

In a perfectly competitive market, and assuming the absence of transport andtransaction costs, the price of goods in one country should be the same, after adjustingfor exchange rates, in another country. This is referred to as the law of one price.

The support for this rests with the fact that arbitrage can take place – if goods arecheaper in one country, then they can be purchased there and re-sold in anothercountry at a higher price. This process would continue until, under the laws of supplyand demand, the price of the goods in the first country would rise (through increasingdemand) and/or the price of the goods in the second country would fall (throughincreasing supply). In due course, therefore, an equilibrium price will be established.

If prices are in equilibrium, but then change as a result of differential rates of inflationbetween two countries, we can expect the exchange rate to move in order tocompensate for the gain/loss in the purchasing power of the exchange currency. So, ifinflation in the US is 5% and in the UK it is 3%, then the exchange rate of the poundagainst the dollar would adjust to maintain the equilibrium in prices.

As a general rule, we can conclude that the purchase price for a commodity in countryA must be equal to the purchase price for the same commodity in country B, adjustedfor the exchange rate difference. That is, if inflation in one country relative to the othercauses the price to rise, then there will be a proportional change in the exchange rate.

This gives rise to the theory of Purchasing Power Parity. This is based on the law ofone price and states that the expected changes in the spot rate of exchange are linkedto the inflation differentials between the respective two countries over the same period.Thus, the change in exchange rates over a time period is approximately equal to thedifference in inflation between the two countries over the same period. A higher rate ofinflation in one country will lead to a depreciation of its currency in terms of the othercurrency – ensuring that the real cost of purchasing the same good in differentcountries should be the same.


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This is expressed in the following formula:

o

ot

S

SS

d

df

i+1

ii

where: So the current spot rate

St the spot rate at time t

if the expected rate of inflation in the foreign country to time t

id the expected domestic rate of inflation to time t


Let us assume that there is currently purchasing power parity between USA andFrance with an exchange rate of 1€ to 1.5$. Let us also assume that, at the end of theyear, US inflation is expected to be 5%, and French inflation is expected to be 10%.Advise the French firm you are working for what the expected spot rate will be at theend of the year.

You are assumed to be working for a French firm so the domestic currency is the €.Substituting into the above formula:

1.5

1.5S t (1 € to 1.5$) 0.10+1

0.10050 .(inflation rates expressed as a decimal)

St 1.5 1.5 10.1

)05.0( 1.4318

We can check these calculations by comparing the prices at the end of the year.

A good now costing 10€ will cost 10 1.5 15$. At the end of the year the same goodwill cost:

10€ (French inflation rate of 10%) 1.10 11€

15$ (US inflation rate of 5%) 1.05 15.75$

The price of the goods in US is 15.75$/1.4318 11€.

This method is often used to calculate exchange rates for use in investment appraisalif there are reasonable estimates of relative inflation rates available to the company.However, in reality purchasing power parity only holds over the long term, marketimperfections impeding its effects in the short term.

Just as relative inflation rates help to determine exchange rates, alterations (by acountry's government or other factors discussed below) in a country's exchange ratecan also have an impact on its inflation rate.

A devaluation of a currency would lead to an increase in the price of imports and areduction in the price of exports. For several countries, including the UK for whichimports are price inelastic and exports are price elastic, this would lead to an increasein exports but have little impact on the level of imports. Thus, inflation would risecaused by dearer imports – the greater the proportion of goods and services consumedthat are imported the greater the rise in inflation. An increase in the cost of goods andservices will lead to higher wage claims which firms benefiting from increased exportswould agree to. These higher wages would increase the level of inflation. Whilst thebalance of trade may improve because of the increased export levels, any increasesare likely to be offset by a net disinvestment of capital from the depreciating currencythe overall impact being a further depreciation of the currency.


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(b) Interest rates and exchange rates

We can observe the same processes at work in relation to interest rate differentialsbetween countries as in inflation rate differentials.

We can see that, where there is a differential in the interest between two countries,investors wish to place their funds where the rates of interest are highest, so a countrywith higher interest rates will experience an influx of funds. This influx of funds will leadto an increased demand for the currency and thus increase its price (exchange rate).At a later date, when the investment matures, the funds will be converted back into theoriginal currency of exchange and repatriated. This selling of the base currency willthen cause its rate of exchange to fall relative to the exchange currency.

Just as purchasing power parity denotes the relationship of inflation rates to exchangerates, Interest Rate Parity (IPP) does the same for interest rates. This states that theexpected changes in the spot rate of exchange (i.e. the difference between the spotand forward rates) are linked to the differential between interest rates in the twocountries over the same period. Any gain from an increase in interest rates in onecountry relative to another will, then, be cancelled out by an adjustment in theexchange rate. The forward rate is then said to be at IPP.

The theory can be stated as:

b

a

i+1

i+1

ratespot

rateforward

where i interest rate, and a and b are the two countries under consideration.

Thus, if the 90-day interest rate in the US is 5.25% and in the UK for the same period is6.75%, and the current spot rate is £1:$1.9695, the 90-day forward rate may becalculated by substituting in the above formula:

06750+1

05250+1

.

.

1.9695

rateforward

The forward rate $1.9418

(c) Relationship between interest rates and inflation (the Fisher Effect)

The relationship between expected levels of inflation and interest rates is described asthe Fisher Effect after the economist who first documented it.

This states that the difference in nominal rates of interest between two countries willreflect the expected difference in inflation rates. In equilibrium, the real rate of returnon capital is the same in both countries – that is, the rate of return, adjusted forinflation, in one country will equate with the rate of return, adjusted for inflation, in theother.

Interest rates can be money rates (i.e. the actual amount of cash paid) or real rates (i.e.money rates adjusted to remove the effects of inflation). In general the higher theexpected rate of inflation the higher the rate of interest – to allow investors to obtain ahigh enough return after the effects of inflation have been considered, and as a tool ofgovernment to help reduce the rate of inflation.

The Fisher equation states that:

1 + the money or nominal rate of interest (1 + the real rate of inflation) (1 + the expected rate of inflation)

The Fisher Effect is developed in the International Fisher Effect which states that theratio of nominal interest rates between two countries is equal to the ratio of theirinflation rates, and those currencies with higher nominal interest rates will depreciate in


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relation to those with lower nominal interest rates. The belief behind this theory is thathigher rates of interest are required to offset the effects of currency depreciation, andgiven free world-wide capital markets adjustments to spot exchange rates will meanthat real rates of interest will be equal in different countries.

The International Fisher Effect can be expressed as:

d

f

r+1

r+1

d

f

i+1

i+1

where rd is the domestic money rate of interest and rf is the foreign money rate ofinterest.

E. RISK AND INTERNATIONAL TRADE/FINANCE

In addition to normal business and financial risk, companies face extra risks connected withtrading and investing overseas. These risks can be separated into political risk and foreignexchange risk.

Political or Country Risk

Political risk (also known as country risk) includes the problems of managing subsidiariesgeographically separated and based in areas with different cultures and traditions, andpolitical or economic measures taken by the host government affecting the activities of thesubsidiary.

Whilst a host country will wish to encourage the growth of industry and commerce within itsborders, and offer incentives to attract overseas investment (such as grants), it may also besuspicious of outside investment and the possibility of exploitation of itself and its population.The host government may restrict the foreign companies' activities to prevent exploitation orfor other political and financial reasons. Such restrictions may range from import quotas andtariffs limiting the amount of goods the firm can either physically or financially viably import, toappropriation of the company's assets with or without paying compensation. Other measuresinclude restrictions on the purchasing of companies, especially in sensitive areas such asdefence and the utilities – such restrictions could be an outright ban, an insistence on jointventures or a required minimum level of local shareholders. In order to prevent the"dumping" of goods banned elsewhere (e.g. for safety reasons) a host government maylegislate as to minimum levels of quality and safety required for all goods produced orimported by foreign companies.

Host governments, particularly in developing and underdeveloped countries, may beconcerned about maintaining foreign currency reserves and preventing a devaluation of theirnational currency. In order to do this they may impose exchange controls. This is generallydone by restricting the supply of foreign currencies – thus limiting the levels of imports andpreventing the repatriation of profits by MNCs by restricting payments abroad to certaintransactions. This latter method often causes MNCs to have funds tied up unproductively inoverseas countries.

Foreign Exchange or Currency Risk

Exchange rate risk applies in any situation where companies are involved in internationaltrade. It arises from the potential for exchange rates to move adversely and, thereby, toaffect the value of transactions or assets denominated in a foreign currency.

There are three main types of exchange rate risk to which those dealing overseas (importers,exporters, those with overseas subsidiaries or parents, and those investing in overseasmarkets) may be exposed.


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(a) Transaction exposure

This occurs when trade is denominated in foreign currency terms and there is a timedelay between contracting to make the transaction and its monetary settlement. Therisk is that movements in the exchange rate, during the intervening period, will increasethe amount paid for the goods/services purchased or decrease the value received forgoods/services supplied.

(b) Translation exposure

This arises where balance sheet assets and liabilities are denominated in differentcurrencies. The risk is that adverse changes in exchange rates will affect their value onconversion into the base currency.

Any gains or losses in the book values of monetary assets and liabilities during theprocess of consolidation are recorded in the profit and loss account. Since only bookvalues are affected and these do not represent actual cashflows, there is a tendency todisregard the importance of translation exposure. This is, though, a false assumptionsince losses occurring through translation will be reflected in the value of the firm,affecting the share price and hence, shareholders' wealth and perceptions amonginvestors of the firm's financial health.

(c) Economic exposure

This refers to changes in the present value of a company's future operating cashflows,discounted at the appropriate discount rate, as a result of exchange rate movements.

To some extent, this is the same as transaction exposure, and the latter can be seen asa sub-set of economic exposure (which is its long term counterpart). However,economic exposure has more wide ranging effects. For example, it applies to therepatriation of funds from a wholly-owned foreign subsidiary where the local currencyfalls in value in relation to the domestic currency of the holding company. It can alsoaffect the international competitiveness of a firm – for example, a UK companypurchasing commodities from Germany and reselling them in China would be affectedby either a depreciation (loss of purchasing power) of sterling against the Euro and/oran appreciation of Yuan.

It can also affect companies who are not involved in international trade at all. Changesin exchange rates can impact on the relative competitiveness of companies trading inthe domestic market vis-à-vis overseas companies when imports become cheaper.Thus, reduced operating cashflows may be a consequence of a strengtheningdomestic currency – a situation which has affected UK companies in the late 1990s.

The management of exchange rate risk will involve hedging against adverse movements inorder to contain the extent of any exposure. At the operating level, the focus of attention isprimarily on managing the exposure caused by transaction and economic risk, bothessentially being underpinned by cashflows. The techniques which we shall examine in thefollowing sections, then, relate essentially to these aspects of exposure, with the greateremphasis on transaction exposure

As with managing interest rate risk, these techniques fall into two categories:

internal, or natural, techniques – those which are effected entirely by the financialorganisation and structure of the company itself; and

external, or transactional, techniques – those using the range of derivative instrumentswhich are effected by the use of third party services, such as banks and specialistexchanges.

Although both types of technique provide effective means of covering the exposure, certainexternal techniques offer the possibility of taking advantage of favourable movements inexchange rates to generate profits.


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F. INTERNAL METHODS OF MANAGING EXCHANGERATE RISK AND EXPOSURE

There are four main internal means of reducing exchange rate exposure. These are basedon methods of processing transactions and payments, and of offsetting assets and liabilitiesin different currencies.

Currency invoicing

The first approach is simply to invoice foreign customers in the currency of the seller.

Invoicing for goods supplied, and paying for goods received, in a company's domesticcurrency removes the exchange rate risk for that company – but only one party to anexchange between foreign companies can have this facility, and the other bears the risk ofexchange rate fluctuations. However, the advantages of removing exchange rate risk needto be weighed against those of invoicing in the foreign currency. These include marketingadvantages such as the ease for the customer of dealing in his own currency and thepossibility of purchasing at a discount if the foreign currency is depreciating relative to thedomestic currency. In fact, often the only way to win a contract overseas is to deal in thecurrency of that market.

One way to prevent one or both parties being subject to exchange rate risk is for the firmsinvolved to set a level of exchange rate to use for a transaction regardless of what the actualexchange rate is on the day the money is transferred.

Netting

This is an internal settlement system used by multinational companies with overseassubsidiaries. It involves offsetting (netting out) the outstanding foreign exchange positions ofsubsidiaries against each other through a central point – the group treasury.

Suppose there are two overseas subsidiaries in different countries. Subsidiary A expects toreceive a payment in one month's time for the sale of goods to the value of $2m, whilesubsidiary B has to make a payment of $3m in one month's time to a supplier. The centraltreasury can offset the two exposures and set up an external hedge for the net risk of $1m.This negates the need for two separate hedges to be carried out – the first to cover the $3magainst a rise in exchange rates against the dollar and second to cover the $2m against a fallin exchange rates against the dollar. The single hedge is more efficient and cost-effective.

Matching

This is the process of matching receipts in a particular currency with payments in the samecurrency. This prevents the need to buy or sell the foreign currency and thus reducesexchange rate risk to the surplus or deficit the firm has of the foreign currency. It is a cheapmethod of reducing or eliminating exchange rate risk provided that the receipts precede thepayments, and the time difference between the two is not too long.

For example, where a company is selling to the US and has outstanding receiptsdenominated in $, it could purchase raw materials in the same currency. The one transactionwill offset the other and minimise the exchange exposure that requires external hedging. Ittherefore does not matter whether the $ strengthens or weakens against the domesticcurrency.

Alternatively, a firm could match, say, dollar currency receipts from the export of goods to theUS with a dollar loan. The receipts will be used to pay off the loan. This again secures thematching of an asset with a liability.

This process can be made easier either by having a bank account in the foreign country or aforeign currency account in a firm's own country, and putting in all receipts and taking from it


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all payments in the overseas currency. The exchange rate risk on the surplus or deficit canbe avoided by utilising one of the other methods of risk management.

Matching may also be used to reduce translation exposure – offsetting an investment inassets in one currency with a corresponding liability in the same currency. For example, theacquisition of an asset denominated in Yen could be achieved by borrowing funds in Yen. Asthe exchange rate against the Yen varies, the effect it has on the translated value of the assetand liability will increase and decrease in concert. The amount of the reduction in exposurewill depend on the extent to which the expected economic life of the asset corresponds withwhen the loan matures.

Leads and Lags

This final method of hedging internally involves varying payment dates to take advantage ofthe exchange rate – for example, paying either before or after the due date, depending onexchange rate movements. The effectiveness of this is dependent on how well exchangerate movements can be anticipated. A company will only pay in advance if it expects thedomestic currency to weaken, but if it misreads the movement and the exchange ratestrengthens, advance payment may prove expensive.

Leads are advance payments for imports to avoid the risk of having to pay more localcurrency if the supplier's currency increases in value.

Lags involve slowing down the exchange of foreign receipts by exporters whoanticipate a rise in the value of the foreign currency received. When this occurs, theywill then benefit by an exchange rate in their favour.

The table below shows the scope for leading and lagging by financial managers of importersor exporters:

UK Exporter UK ImporterExpectation offoreign currency Receiving foreign currency Paying foreign currency

Devaluation Leads Lags

Revaluation Lags Leads

Foreign Importer Foreign ExporterExpectation ofsterling Paying in sterling Receiving sterling

Revaluation Leads Lags

Devaluation Lags Leads

A UK exporter would accelerate (lead) his receipts in the event of an anticipateddevaluation, but he would delay (lag) his foreign receipts if a revaluation was expected,and so forth. In leading, he will need to borrow or otherwise raise the cash which will involvea cost of capital, whilst lagging will attract interest as there will be surplus for investment.


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G. EXTERNAL METHODS OF MANAGING EXCHANGERATE RISK AND EXPOSURE

Here we shall consider the methods of using derivatives – forwards, futures and optionscontracts – as considered in the last unit in relation to interest rate exposure, as well ascurrency swaps and money market hedges.

Forward contracts

Forward foreign exchange contracts are a binding agreement between two parties toexchange an agreed amount of currency on a future date at an agreed fixed exchange rate.The exchange rate is fixed at the date the contract is entered into.

Forward contracts are binding and must be executed by both parties. As we saw in theprevious unit, they are not exchange regulated and one problem of this is that one of theparties might default. However, they do not – like futures contracts – come in standard sizesand have fixed delivery dates. Rather, they are over the counter (OTC) instruments – inwhich the contract can be tailor made to suit the needs of the parties and delivery dates canrange from a few days to upwards of several years.

In most cases, forward contracts have a fixed settlement date. This is appropriate where thecash transaction being hedged will take place on the same day that the forward contract issettled. However, there is no guarantee that the two days will tally – for example, a customermay be late paying – in which case the fixed settlement date is less than optimal. Analternative, to provide flexibility, is an "option date forward contract". This offers a choiceof dates on which the user can exercise the contract, although there is a higher premiumpayable on the contract for such an additional benefit.

The purpose of a forward exchange rate contract is to purchase currency at a future date at aprice fixed today. As such, it provides a complete hedge against adverse exchange ratemovements in the intervening period. Consider the following example.

A UK company needs to pay A$1m to a Australian company in three months' time. Thecurrent spot and forward exchange rates for sterling are as follows:

A$/£

Spot 2.060 – 2.065

3 months forward 4 – 3 cents pm

What would be the cost in sterling to the UK company if it enters into a forward contract topurchase the A$1m needed?

Note the way in which the rates are quoted. The spot rate spread shows the sell and buyprices – the banks will sell A$s for sterling at the rate of A$2.060/£, and buy A$s in return forsterling at the rate of A$2.065/£. The forward rate is quoted in terms of the premium ("pm")in cents which the Australian dollar is to sterling in the future. If the currency is at a premium,it is strengthening and the A$ will buy more pounds forward than it will spot or, conversely,the pound will buy less A$ forward than it will spot. (If the quoted forward rate had been, say,"3 cents dis" this would indicate a weakening of the currency.)

To calculate the cost of the forward contract, we need to convert the forward rate premiuminto an exchange rate. Because it is a premium, we need to subtract the amount from thespot to give the following sell/buy forward rates:

(2.060 – 0.04) – (2.065 – 0.03) 2.020 – 2.035 A$/£


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The cost of buying A$1m forward, therefore, is:

0202

0000001

.

,,$A 495,050

Whilst we have said that forward contracts are binding, they can be closed out by enteringinto an opposite contract to sell the currency – either at the spot rate or through a differentforward rate. Partial close-outs can also be arranged where, for example, the full amount ofthe forward contract is not required. However, these arrangements are costly and, hence,rare.

Currency swaps

In general, a swap relates to an exchange of cashflows between two parties – as we saw inrelation to interest rate swaps in the previous unit. Thus, currency swaps relate to anexchange of cashflows in different currencies between two parties. They are agreements toexchange both a principal sum and the interest payments on it in different currencies for astated period. Each party transfers the principal and then pays interest to the other on theprincipal received.

Swaps are arranged, through banks, to suit the needs of the parties involved.

The two key issues in setting up a currency swap are:

the exchange rate to be used; and

whether the exchange of principal is to take place at both commencement and maturity,or only on maturity.

The following example illustrates the general principles.

A German company is seeking to invest £20m in the UK and has been quoted an interestrate of 8% on sterling in London, whereas the equivalent loan in Euros is quoted at 7% fixedinterest in Frankfurt. At the same time, a UK company wants to invest an equivalent amountin its German subsidiary and has been quoted an interest rate of 7.5% to raise a loandenominated in Euros on the Frankfurt Exchange. It could, however, raise the £20m insterling in London at 5% fixed interest.

In the absence of a swap, each company would have to accept the quoted terms for its loandenominated in the foreign currency. This would result in both companies paying a higherrate than would apply if the loan was raised in their domestic currency. A swap agreementwould involve each company taking out the loan in its own domestic currency and thenexchanging the principals. Each company would pay the interest on the principal received –i.e. the other company's loan – and at the end of the loan period, the principals would beswapped back.

The exchange rate to be applied is clearly crucial. If we assume that this is agreed as €1.25 £1, the swap would be conducted as follows.

The UK company borrows £20m in England at an interest rate of 5% pa. It then swapsthe principal of £20m for €25m (at the agreed exchange rate) with the Germancompany. The German company pays the interest payments on the £20m loan (at 5%interest) to the UK company, which then pays the bank. At the end of the loan period,the principal of €25m is swapped back for the £20m with the German company.

The German company borrows €25m in Frankfurt at an interest rate of 7% pa. It thenswaps this principal with the UK company which pays the interest payments on the loan(at 7% interest) to the German company, which then pays its bank. At the end of theloan period, the principal of £20m is swapped back for the €25m with the UK company.

The process is illustrated in Figure 15.1.


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Figure 15.1: Currency swap

Currency Futures

A currency futures contract is an agreement to purchase or sell a standard quantity of foreigncurrency at a pre-determined date. As we saw previously, futures have standard quantitiesand delivery dates set by the exchange on which the contracts are traded. As we have alsoseen, the vast majority of these contracts are not delivered, but are closed out.

The process of hedging exchange rate risk through the futures market is the same as weexamined in relation to interest rate exposure in the previous unit. Thus, a UK companyexporting to the USA and invoicing in US dollars, would need to hedge against a rise in theexchange rate (sterling strengthening relative to the dollar) in the period before payment isreceived.

If we assume that payment is due in two months' time, the exporter will need to sell dollarsthen in exchange for sterling. The strategy would be, therefore, to take out a three monthsterling futures contract and close it out in two months' time – i.e. buy sterling futures now,hold them for two months and then sell them to cancel out the obligation to deliver theunderlying currency. Any profit on the contract (the difference between the buying and sellingprices) will offset any loss on the dollars received from an exchange rate rise over the period.

We can illustrate the process in more detail by reference to the actions of a speculator who isanticipating a rise in the value of the $ against the pound. He will, therefore, take a positionto sell sterling futures in anticipation that the future cost (in dollars) of buying the poundsnecessary to meet the contract obligation will be less than the proceeds of the sale under thecontract.

If the current spot rate is $1.900/£ and December sterling futures are trading at $1.875/£,what will be the gain or loss on five sterling futures contracts if the spot rate in December is$1.800/£? (The standard size of sterling futures is £62,500.)

Sale of five December contracts (each of which is for £62,500) at the agreed rate of$1.875/£ results in proceeds of:

5 £62,500 $1.875 $585,937.50

London bank Frankfurt bank

UK Company German Company

£20m

£20m

€25m

€25

5%interest

5% interest

7%interest

7% interest

UK company now has€25m available forinvestment at 7%

interest

German company nowhas £20m available for

investment at 5%interest


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Purchase of the equivalent amount in sterling in December at the spot rate of $1.8/£results in an outlay of:

5 £62,500 $1.8 $562,500

The gain on the transaction is $23,437.50 or, converting this into pounds at theDecember spot rate, £13,020.

The advantage for the speculator of using the futures contract compared to the alternative ofbuying sterling at the current spot rate is that he only needs to put down a small deposit (themargin account) as opposed to an "up front" investment of $593,750 (£312,500 x $1.9).

Hedging using futures and forwards contracts

We can also consider the difference between a hedge using forward contracts and a hedgeusing futures contracts.

In December, a UK exporter invoices its US customer for $407,500 payable on 1 February.The exporter needs to hedge against a change in exchange rates whereby sterling becomesstronger relative to the dollar and he receives less pounds than now upon exchange of thedollars received in February. To hedge this exchange rate exposure, the company could takeout either a forward contract or a futures contract. Which would be more appropriate giventhe following rates?

In December:

Spot rate $1.9575 – 1.9595/£

February forward rate $1.9550 – 1.9575/£

March sterling futures contracts $1.9600/£(Contract size is £62,500)

Those applying on 1 February:

Spot rate $1.9670 – 1.9690/£

March sterling futures contracts $1.9655

Using a forward contract would require the exporter to commit to the sale of the dollarreceivables (i.e. $407,500) at the February forward price of $1.9575/£, resulting in proceedsof:

95751

500407

.

,$ £208,173

The futures contract hedge would require the exporter to take a long position in sterlingfutures – i.e. a commitment to buy sterling at the rate of $1.9600/£ – with the intention ofclosing out the contract on 1 February, prior to the receipt of the dollars. If sterling doesstrengthen against the dollar, this position will result in a gain. However, if the exchange ratefalls, then the exporter will lose on the futures contract, but gain in the cash market.

The number of sterling futures contracts necessary to cover the exposure is:

96001

500407

.

,$

50062

1

,£ 3.33 (i.e. 4 contracts will be needed)

The gain/loss on the futures transaction is calculated as follows:

Buy four March contracts in December at $1.9600/£:

4 x £62,500 $1.9600 $490,000

Sell four March futures contracts in February at $1.9655

4 x £62,500 $1.9655 $491,375


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Gain through closing out:

$491,375 – $490,000 $1,375

Converting this into sterling at the February spot rate gives a gain of:

96901

3751

.

,$ £698

The total proceeds from the futures hedge is calculated by adding this gain to the proceedsof the exchange of the dollars received on 1 February at the then current spot rate of1.9690$/£:

96901

500407

.

,$ £206,957 £698 £207,655

This is marginally worse than the hedge using the forward contract.

Currency Options

A currency option gives the holder the right, but not the obligation, to buy (in the case of acall option) or sell (a put option) a specified amount of currency at an agreed exchange rate(the exercise price) at a specific future date.

The principles of currency options are the same as those discussed in the previous unit inrespect of other types of option. Thus, using the options market to hedge exchange rateexposure sets a limit on the loss that can be made in the case of adverse movements inexchange rates, but also allows the holder to take advantage of favourable movements.

The following example illustrates their use.

At the beginning of July, a UK company purchased goods to the value of $300,000 from itsUS supplier on three months' credit, payable at the end of September. The spot exchangerate is currently $1.95/£, and for the purposes of the example, we shall assume that it falls to$1.88/£ by the end of September, coinciding with the expiry of the option.

Because the company needs to pay for the goods in dollars, it needs a strategy whichenables it to sell pounds and buy dollars. The two choices are a long put or a short call. Theshort call, though, can only provide protection against exchange rate losses up to the cost ofthe premium, so the favoured strategy would be a long put. (Check with the previous unit toensure that you understand the various pay-off profiles for these different types of option.)

The relevant sterling options offered on the Philadelphia exchange (the major market forcurrency options) are at the following prices:

Strike price September puts

1.93 2.32

1.94 2.65

1.95 3.22

Contracts expire on a monthly basis and are for denominations of exactly half of those forfutures contracts. Thus, the standard contract sizes for sterling options are £31,250.

In this case, the company decides to buy a September put option with a strike price of$1.93/£. It could have opted for a different strike price, but this would have incurred higherpremiums (albeit for a higher degree of protection).


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The strategy works in the following way:

The company needs to raise $300,000 which, at the exercise price of $1.93/£, equatesto £155,440. To cover this amount, it will need to purchase five standard contracts.The premium paid will be:

$3,6255£31,250x100

322

.

In sterling, at the current exchange rate, that is:

£1,859951

6253

.

,

Because the spot exchange rate has declined during the period (the dollar havingstrengthened), it is advantageous to exercise the put option – i.e. less pounds will needto be exchanged at the exercise price than at the spot price to buy the required amountof dollars.

Total proceeds from exercising all five option contracts:

5 £31,250 $1.93 $301,562 (covering the liability)

The net sterling cost of the transaction will be:

£156,250 + £1,859 £158,109

If the option was not exercised, then the liability in dollars would need to be realised byselling sterling on the spot market. The cost involved here would be:

£159,574881

000300

.

,$

Thus, using a long put results in a saving of:

£159,574 – £158,109 £1,465

Money Market Hedge

The money market can be used to hedge against exchange rate fluctuations by borrowing anamount in foreign currency equal to the value of, say, invoiced exported goods, exchanging itfor the domestic currency at the spot rate, and then using the receipts from the customer torepay the loan.

Effectively, this method uses the matching principle we saw earlier in respect of internalhedging, but applies it to the creation of an asset/liability in the money market, to match theliability/asset which needs to be hedged.

Thus, a UK exporter due a sum of dollars in three months' time may eliminate the exchangerate exposure by borrowing the sum of dollars at the outset – creating a matching liability. Itcan then exchange the dollars for sterling at the current spot rate, fixing the exchange rate onthe transaction. The sterling can then be invested for the three months. If the moneymarkets and the foreign exchange markets are in equilibrium, we can expect that interestrate parity holds and the interest earned on the sterling investment will offset any change inthe exchange rate. The dollars received can be used to pay off the loan, plus interestaccrued, in three months' time. This should, then, provide the same result as a forwardcurrency hedge.

Companies which regularly operate this form of hedging usually hold different accounts withtheir banks for the major currencies in which they trade. In this way, money can be depositedeasily, and interest earned when there are surplus funds, and borrowing (overdraft) facilitiesare readily available when necessary.


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A UK company is due $500,000 in three months' time from a customer in the USA. Theinterest rate is 6% pa and the spot exchange rate is $1.93/£.

The company stands to lose value in sterling on the asset (the $½m) if the dollar weakensagainst the pound. To hedge this in the money market involves creating a matching dollarliability – a loan equivalent to $½m in three months' time – exchanging this for sterling(thereby fixing the exchange rate on the transaction) and investing the proceeds for threemonths, and then using the receipt of the $500,000 to pay off the loan, plus interest accrued.The process is as follows.

We first need to calculate the amount of dollars to be borrowed now, so that it will grow,with interest, over the three months to $½m. We shall call this amount "Q". Theinterest rate applied over the three month period is 1.5% (one quarter of the annualrate of 6%), so the sum borrowed will be:

Q 1.015 $500,000

0151

000500

.

,$

$492,611

The UK company, therefore, only needs to borrow $492,611 now in order to create aliability of $½m in three months' time.

Now we convert this sum into sterling at today's spot rate, thereby fixing the exchangerate and eliminating the exposure:

931

611492

.

,$ £255,238

This sum is now available to the company in sterling and can be put on deposit in themoney market for three months, earning interest of 6% pa (or 1.5% over the period):

£255,238 1.015 £259,066

This return, assuming interest rate parity holds, will equate with a sterling forwardmarket hedge on the $½m.

In three months' time, the receipt of the $½m from the US company will be used torepay the bank for the $492,611 loan, plus the interest accrued (which should equate to$½m).

This is a highly simplified example, but it does, nevertheless, illustrate the process. We canshow it diagrammatically as in Figure 15.2.


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Figure 15.2: Money market hedge

Liability(Bank loan)

Asset(Debtor) $500,000

$500,000

£259,066

Three months’ time

$492,611 Bank

(invest)£255,238@ 1.5%

UScustomer

UKCompany

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