Institute of Distance Learning, KNUST

Template
For
Course Material

A 3-credit course outlay

2009
Updated

i
KWAME NKRUMAH UNIVERSITY OF SCIENCE AND
TECHNOLOGY, KUMASI

INSTITUTE OF DISTANCE LEARNING

(BSC. BUSINESS ADMINISTRATION, THIRD YEAR)

[ACF 366: FINANCIAL MANAGEMENT]

[Credit: 3]

KWASI POKU

ii
Publisher’s Information

© IDL, 2012

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Kumasi, Ghana

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Publisher’s notes to the Learners:

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Course Writer

KWASI POKU
Lecturer, KNUST School of Business
Department of Accounting and Finance.

v
Acknowledgement
I would like to thank the Almighty God for his guidance and also those who contributed to the
development of this material.

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Course Introduction
This course is basically the continuation of ACF 361, Business Finance.
Business Finance is therefore a mandatory requirement for this course.
Corporate Finance is concerned with the financing and investment decisions
made by the management of companies in pursuit of corporate goals. As a
subject, corporate finance has a theoretical base which has evolved over many
years and which continues to evolve. It has a practical side too, concerned with
how companies actually make financing and investment decisions.

The fundamental problem that faces financial managers is how to secure the
greatest possible return in exchange for accepting the smallest amount of risk.
This necessarily requires that financial managers have available to them (and
are able to use) a range of appropriate tools and techniques. These will help
them value the decision options open to them and assess the risk of those
options. The value of an option depends on the extent to which it contributes
towards the achievement of corporate goals. In corporate finance, the
fundamental goal is usually taken to be to increase the wealth of shareholders.

The aim of this text is to provide an introduction to the core concepts and key
topic areas of corporate finance in an approachable, “user-friendly” style. This
material covers the core concepts and key topic areas without burdening the
reader with unnecessary detail or too heavy a dose of theory.

COURSE OBJECTIVES

The objectives of this course include the following:

1. To introduce students to the basic concepts in corporate finance such as

the principal agent relationship and financial management decisions.

2. To help students to be able to calculate the cost of the various sources of

capital employed by companies such as ordinary shares and preference
shares as well as bonds.

3. To help students to be able to calculate the cost of equity using the

capital asset pricing model.

4. To introduce students to the capital structure debate and help them to

appreciate the differing views on capital structure and their implications
for the financial manager.

5. To introduce students to the dividend policy debate and help them to

appreciate the differing views on dividend policy and their implications
for financial the financial manager.

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 6. To help students to gain an understanding of the different types of
mergers and takeovers, the justifications for mergers and takeovers and
the strategies and tactics employed in the takeover process by bidding
and target companies.

COURSE OUTLINE

 Unit 1: OVERVIEW OF CORPORATE FINANCE

 Unit 2: COST OF CAPITAL

 Unit 3: CAPITAL ASSET PRICING MODEL

 Unit 4: CAPITAL STRUCTURE DEBATE

 Unit 5: DEVELOPING A DIVIDEND POLICY

 Unit 6: MERGERS AND TAKEOVERS

GRADING

Continuous assessment: 30%

End of semester examination: 70%

READING LIST / RECOMMENDED TEXTBOOKS

1. Aboagye, A.Q.Q. (2010). Business Finance II. Centre for Distance

Education, University of Ghana, Legon.
2. Arnold, G. (2008). Corporate Financial Management. 4 th edition.
Financial Times/Prentice Hall. Pearson Education Limited, UK.

3. Atrill, P. (2003). Financial Management for Non-Specialists. Pearson

Education Limited, Essex, UK.

4. Atrill, P and McLaney, E. (2011). Accounting and Finance for Non

Specialists. Pearson Education Limited.
5. Brealey, R.A, Myers, S.C and Allen, F (2006). Corporate Finance. 8 th
Edition. McGraw Hill.
6. Watson, D. and Head, A. (2010). Corporate Finance: Principles and
Practice. 5th Edition. Financial Times/Prentice Hall/Pearson Education
Limited, UK.

viii
Table Of Contents

Publisher Information.................................................................................................i
Course Writer.............................................................................................................v
Acknowledgement....................................................................................................vi
Course Introduction.................................................................................................vii
Table Of Contents.....................................................................................................ix
List Of Tables............................................................................................................xi
List Of Figures..........................................................................................................xi
List Of Appendices...................................................................................................xii

Unit 1.........................................................................................................................1
OVERVIEW OF CORPORATE FINANCE..................................................................1
SESSION 1-1: FLOW OF FUNDS...................................................................2
SESSION 2-1: FINANCIAL MANAGEMENT ROLE..........................................3
2-1.1 Analyse and Plan..............................................................................4
2-1.2 Acquisition of funds..........................................................................4
2-1.3 Allocation of funds............................................................................4
SESSION 3-1 : THE FINANCIAL DECISION AND FORMS OF
BUSINESS……………...
ENTERPRISES……………………………………………………………………………
…5 3-1.1 Sole
proprietorship……………………………………………………………………..5
3-1.2
Partnership……………………………………………………………………………...6
3-1.3 Limited liability
company……………………………………………………………...6
3-1.4 Finance in the organizational
structure………………………………………………...7

SESSION 4-1: GOAL OF THE

FIRM…………………………………………………………8 4-1.1
Profit maximization…………………………………………………………………….8
4-1.2 Agency
problem………………………………………………………………………11
4-1.3 Efficient market
hypothesis………………………………………………………….. 13

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 SESSION 5-2: THE FINANCIAL
SYSTEM………………………………………………...17 5-1.1
Importance of financial markets………………………………………………………
17 5-1.2 Financial intermediation
role………………………………………………………... 17
5-1.3 Allocation of
resources………………………………………………………………..18

Unit 2.......................................................................................................................21
COST OF CAPITAL..................................................................................................21
SESSION 1-2: OVERVIEW OF COST OF CAPITAL.......................................22
SESSION 2-2: EQUITY FINANCE................................................................23
2-2.1 Odinary shares...............................................................................23
2-2.2 Preference shares...........................................................................26
SESSION 3.2: DEBT
FINANCE...............................................................................................28

3-2.1 Loan capital....................................................................................28

3-2.2 Bonds.....................................................29
SESSION 4-2: WEIGHTED AVERAGE COST OF
CAPITAL...............................................30 4-2.1
Limitations of
WACC..............................................................................................31
4-2.2 Worked
examples.....................................................................................................31

Unit 3.......................................................................................................................39
CAPITAL ASSET PRICING MODEL.............................................................................39
SESSION 1-3: CAPITAL ASSET PRICING MODE..........................................40
1-3.1 Assumptions..................................................................................40
1-3.2 Calcualting CAPM...........................................................................43
1-3.3 Limitatios of CAPM.........................................................................44

Unit 4.......................................................................................................................46
CAPITAL STRUCTURE DEBATE...............................................................................46
SESSION 1-4: THE CAPITAL STRUCTURE DEBATE....................................47
SESSION 2-4: THE SCHOOLS OF THOUGHT..............................................47
2-4.1Traditional view...............................................................................47
2-4.2 The modernist view.........................................................................50
2-4.3 MM and the introduction of tax.......................................................53

Unit 5.......................................................................................................................57
DEVELOPING A DIVIDEND POLICY.....................................................................57

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 SESSION 1-5: THE PAYMENT OF DIVIDENDS............................................58
SESSION 2-5: DIVIDEND POLICY IN PRACTICE.........................................59
2-5.1 Dividend policy and shareholder wealth..........................................60
SESSION 3-5: TWO SCHOOLS OF THOUGHT.............................................62
3-5.1 Traditional view.............................................................................62
3-5.2 Modernist view...............................................................................62
3-5.3 MM assumptions............................................................................63
SESSION 4-5: THE IMPORTANCE OF DIVIDENDS......................................65
4-5.1 The clientele effect..........................................................................65
4-5.2 Information signalling.....................................................................66
4-5.3 Reducing agency cost.....................................................................67
SESSION 5-5: FACTORS DETERMINING THE LEVEL OF DIVIDENDS........69
5-5.1 The dividend policy of another business..........................................71

Unit 6.......................................................................................................................74
MERGERS AND TAKEOVERS................................................................................74
SESSION 1-6: MERGERS AND TAKEOVERS...............................................75
1-6.1 Types of mergers and takeovers......................................................76
1-6.2 Why recent increase in merger activities.........................................76
SESSION 2-6: THE RATIONAL FOR MERGERS...........................................77
SESSION 3-6: FORMS OF PURCHASE CONSIDERATION
3-6.1 Cash
3-6.2 Shares
3-6.3 Loan capital
SESSION 4-6: ASSESSING VULNERABILTY OF TAKEOVER
4-6.1 Resisting a takeover bid
4-6.2 Who benefits
4-6.3 Defensive measures for a takeover
SESSION 5-6: DIVESTMENT AND DEMERGERS

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List Of Figures
Figure 1; Flow of funds within a
firm.............................................................................................3

Figure 2; Finance in the organizational structure of the

firm..........................................................7

Figure 3; The role of financial

intermediaries...............................................................................18

Figure 4; The relationship between risk and

returns.....................................................................41

Figure 5; The relationship between the expected level of return and the level of
risk measured

by
beta ..................................................................................................................
.......................42

Figure 6; The traditional view of the relationship between levels of borrowing

and expected

returns..............................................................................................................
..............................48

Figure 7; Relationship between the level of borrowing, cost of capital and

business value

the traditional
view...................................................................................................................
....49

Figure 8; The MM view of the relationship between levels of borrowing and

expected returns..50

Figure 9; The relationship between the level of borrowing, cost of capital and
business

value, the MM
view...................................................................................................................
....51

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Figure 10; The MM view of the relationship between levels of borrowing and
expected

Returns ( including tax

effect) .....................................................................................................54

Figure 11; The relationship between the level of borrowing, cost of capital and
business

value, the MM view (including tax

effect) ...................................................................................55

xiii
 Unit 1
AN OVERVIEW OF CORPORATE
FINANCE

Introduction
This course focuses on the management of the financial resources of a
business firm. When we talk of ‘financial management’ in a business setting or
‘corporate finance’ we mean the efficient management of the flow of funds
within a business enterprise. The key aspects of the definition are “efficient”
and “flow of funds”. We will first consider the flow of funds aspect.

Learning Objectives
After reading this unit you should be able to:

1. Describe the financial management role and how

financial management decisions are made in the
various forms of business enterprises.
2. Explain the goal of a firm.
3. Briefly describe the financial system in Ghana.

Unit content
Session 1-1: FLOW OF FUNDS

Session 2-1: FINANCIAL MANAGEMENT ROLE

2-1.1 Analyse and plan
2-1.2 Acquisition of resources
2-1.3 Allocation of resources

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Session 3-1 FINANCIAL MANAGEMENT DECISIONS AND FORMS OF
BUSINESS ENTERPRISE

3-1.1 Sole proprietorship

3-1.2 Partnership
3-1.3 Corporation
3-1.4 Finance in the organisational structure of
the firm

Session 4-1 GOAL OF THE FIRM

4-1.1 Profit maximization
4-1.2 Agency problem
4-1.3 Efficient market hypothesis

Session 5-1 THE FINANCIAL SYSTEM

5-1.1 Importance of financial markets
5-1.2 Financial intermediation
5-1.3 Allocation of resources

SESSION 1-1: FLOW OF FUNDS

Firms receive funds from various sources and allocate them within the firm.

Inflow; include cash flows from;

1. Investors in company’s shares.

2. Creditors who lend money.
3. Earnings.

Outflows; if the financial officer of a large corporation has excess cash, he will
in all probability be looking for the best way of using the excess cash. Among
the possibilities you might consider;

1. Invest in new project or expand /upgrade

2. Invest in financial assets (e.g. treasury bills)
3. Repay debt
4. Pay a dividend

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The list includes many of the topics of corporate finance. Outflows represent
the use of funds for;

1. Acquisition of fixed assets.

2. Working capital (stock, debtors accounts receivable, short- term
investments)
3. Dividend, loan repayments and interest

From a balance sheet perspective, corporate finance is about managing the

‘sources’ (primarily liabilities and shareholders’ equity) and the ‘uses’ (the asset
side of the balance sheet)

firm's financial
capital market
operations manager

debtors shareholders
stocks and creditors
fixed assets

GOVERNMENT

 Self Assessment 1-1

1. What are the sources of a firm’s cash inflow

COMPOUNDING AND DISCOUNTING

When a principal amount is left in a bank account and interest also
withdrawn, the sum of money is said to compound since the
customer would earn interest on interest. Thus, the interest on the
principal amount is accumulated over a period of time.

3
The future value depends on the rate of interest paid, the initial
sum invested and the number of years the sum is invested for:
FV = PV(1 + r)^n
Where:
FV = future value
PV = sum deposited now or present value
r = interest rate
n = number of years until the cash flow occurs

For example, GHs50 deposited for five years at an annual interest

rate of 6 per cent will have a future value of:
FV = GHs50 × (1.06)^5 = GHs66.91

In Corporate Finance, by discounting, we can take account of the

time value of money. Discounting is the opposite of compounding.
While compounding takes us forward from the current value of an
investment to its future value, discounting takes us backward from
the future value of a cash flow to its present value.

Reversing the compounding illustrated above, the present value can

be found from the future value by using the following formula:

PV = FV/(1+r)^n
where:
PV = present value
FV = future value
r = discount rate

4
n = number of years until the cash flow occurs

SESSION 2-1: FINANCIAL MANAGEMENT ROLE

The financial manager has three principal tasks. These are called the three A’s
of financial management. These tasks are:

1. Analyze and plan the company’s performance.

2. Acquire the funds the company needs.
3. Allocate funds to acquire the most profitable assets.

2-1.1 Analyze and Plan

It is important for management to know where the company is now and where
it wants to be in the future. The financial manager gives management and
investors an assessment of the company’s current position and the financial
consequences of alternative courses of action. This involves analytical work
that leads to the preparation of;

 Income statement
 Balance sheet
 Pro-forma financial statements
 Capital budgeting

2-1.2 Acquisition of funds

This is also called the ‘Financing decision’. Acquiring funds involves a complex
question: what are the appropriate proportions of debt and shareholders’ equity
in the capital structure of the firm? This is called the optimal capital structure.
The financial manager needs to know the principal securities that may be used
(shares, debt, preference shares) and the condition under which any particular
mix of financing instrument is optimal.

5
2-1.3 Allocation of funds
Allocation of acquired funds requires that the financial manager make
investment decisions. This includes:

1. Capital budgeting- investment in long- term assets such as building and

equipment.
2. Working capital management (management of short term assets- stocks,
debtors, cash and short term securities).

THE ROLE OF THE FINANCIAL MANAGER

The financial manager is responsible for the management of corporate funds

and spearheading financial decision making. They take responsibility in
raising funds, investment and reinvestment.

6
7
 Self Assessment 2-1

1. What are the three basic tasks of a financial manager?

 Answer tips
1. The three A’s of financial management.

8
SESSION 3-1 THE FINANCIAL DECISION AND FORMS OF
BUSINESS ENTERPRISE

The financial management function is performed in all business organisations,

regardless of the form of organization or size. However the scope of the
financial management function changes significantly from one form of business
organization to another. In addition, the sources of financing available to a
business enterprise are a function of the type of corporate organization.

There are three main forms of business organization;

1. Sole proprietorship
2. Partnership
3. Limited liability company

The three forms of business organization differ in way that affect the
performance of the finance function. The factors the differ among the forms of
business organization are;

1. How the firm is taxed

2. The degree of control that owners may have on the decisions of the firm
3. The liability of the owners
4. The ease with which ownership interests may be transferred.
5. The ability to raise additional funds
6. The longevity of the business

3-1.1 Sole proprietorship

A business that is organized as a sole proprietorship has a single owner who

usually provides all the capital from personal resources. Banks, friends and
relatives are the primary sources available to the sole proprietor for raising
borrowed funds. A sole proprietor is personally liable for all the debts of the
business. This means that the proprietor’s personal property can be seized by
creditors in settlement of an unpaid debt. For tax purposes, all income of the

9
business is treated as the proprietor’s income and taxed at tax rates applicable
to personal income. For most sole proprietorships, the life of the business ends
with the life of the proprietor although assets of the business may pass on to
the heirs of the proprietor.

3-1.2 Partnership

A partnership is an agreement between two or more persons to operate a

business. The partners are jointly and severally responsible for the debts of the
partnership. Thus, each partner is personally and individually liable for the
debts of the business even if those debts were contracted by other partners.

A partnership is not taxed as a business. Instead, the income of the business is

allocated to the partners and each partner’s share of the income is taxed as if it
were from a sole proprietorship. In general, a partnership interest cannot be
sold without the consent of the other partners.

3-1.3 Limited Liability Company

A limited liability company is an independent legal entity. It can enter into

contracts and carry out business under its own name independently of the
owners of the business. Ownership interest is called equity which is
represented by shares. The owners may die but the company continues to live.
A limited liability company is a taxable entity and pays tax on its taxable
income at the corporate tax rate. Dividends are taxed in the hands of
shareholders as their personal income. Thus, the limited liability is subject to
‘double taxation’. Shareholders pay tax first at the corporate level and then pay
a personal tax on dividends paid to them by the company.

Many limited liability companies are ‘private’ or ‘closely held’ in the sense that
they do not issue shares to the public. Companies that can legally issue shares
to the public are called ‘public companies’. Thus companies whose shares are
traded on the Ghana Stock Exchange are public companies. Other public
companies such as Barclays bank are not traded on the Ghana Stock

10
Exchange but sell their shares ‘over the counter’ through dealers such as
National Trust Holding Company.

One of the advantages of the limited liability company is that it can raise
capital by borrowing and issuing additional shares. Unlike the sole proprietor
and partnership, the shareholders of a limited company are personally liable
for the debts of the company to the amount of their investment in the firm.
Hence, the term “limited”. If for example, Joe Bloggs is a shareholder in a
limited liability company which defaults on a loan and Joe Bloggs’ investment
is 1 million, as represented by his proportional share of the shareholder’s
equity of the firm, then the maximum he can lose to creditors is 1 million,
regardless of how much the firm owes.

As a firm grows and needs to access capital markets to raise funds, the
advantages of the limited liability company begin to dominate. Because of the
ease of transferring ownership through the sale of shares and the flexibility in
dividing the shares, the limited liability company is the ideal business entity in
terms of raising new capital. In contrast, the unlimited liabilities of both the
sole proprietorship and partnership are deterrents to raising equity capital.

3-1.4 Finance in the organisational structure of the firm

How is the firm organized to carry out the finance function? As financial
markets develop, the functions of the financial manager change. The Chief
Financial Officer (usually with the title of Director of Finance) is likely to
emerge as a team player in creating value for shareholders. The figure below is
an organizational chart depicting the finance function in a typical publicly
traded company.

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 CORPORATE FINANCE IN A CORPORATE ORGANISATION

BOARD OF DIRECTORS

MANAGING DIRECTOR

DIRECTOR OF FINANCE

TREASURER

CONTROLLER

 Cash management Management

Accounting
 Credit management Financial
Accounting
 Securities and Insurance Tax Accounting
 Bank relations Financial Planning
 Shareholder and Bondholder relation

The development of the financial markets usually induces a distinction

between role of a “controller” and “treasurer” within the corporate finance
function. An officer usually called the “Treasurer” who is different from the
Controller increasingly manages the function of interaction with financial
markets. The Controller, on the other hand, becomes increasingly specialized
in management, financial and tax accounting and also oversees the financial
planning of the company.

 Self Assessment 3-1

12
 1. Briefly describe the three main forms of business organizations and
how the type of business organization affects financial management
decisions.

 Answer tips

1. Answer to self assessment question can be found in sessions 3-1.1 to 3-

1.3.

SESSION 4-1 GOAL OF THE FIRM

We have talked about “flow of funds”. How about efficiency? This requires a
statement of the criteria for efficiency. A financial decision is efficient if it is
consistent with the goals of a firm. We will start by identifying the appropriate
goal of the firm. This will help us to better understand the role and significance
of financial decision making within the firm.

We will design the goal of the firm to be the maximization of shareholders

wealth. The wealth of a shareholder is the market value as quoted on the
Ghana Stock Exchange. The specification of this goal is based on the fact that
the market value of shares is affected by all financial decisions. To justify the
statement of the firm’s objective as maximization of shareholder’s wealth, we
will compare this objective to another popular statement of the objective of the
firm, the maximization of profit or Earning per Share (EPS)

4-1.1 Profit maximization

Profit maximization is an efficiency concept. It stresses the idea that resources

should be used efficiently by generating the most output with the least
resources. Thus, in theory, a firm that produces 1,000 units of output per unit
of input is more profitable than a firm that produces only 500 units of output
with one input unit. In business terms, if we can increase sales and hold
expenses down, we maximize profits.

13
The profit maximization objective however creates an unrealistic picture of the
real world. In particular, it leaves out the following key factors:

1. Uncertainty of returns
2. The timing of returns
3. The role of dividends

Uncertainty of Returns

The role of uncertainty is best illustrated with an example. Suppose that we are
considering two mutually exclusive investment opportunities. (This means that
we can only choose one of the two). Suppose that Project G involves building a
factory to produce a soft drink called “Power Cola” in Ghana. The second
project is project S, which involves building a plant in Somalia to produce the
same product. As a beverage, the product is expected to have a relatively stable
demand in a normal environment. However Somalia is not normal because for
almost 10 years, it had not had a government. The political chaos is reflected in
the fact that the country is run by clan-based factions, each one jealously
regarding a small enclave. A.U.S. peacekeeping force was withdrawn because of
violence. The possibilities for profit from the two projects are presented in the
table below. Regardless of what happens, we make profit of ₵150 million when
we produce Power Cola in Ghana. Thus there is no variability associated with
the profitability of a plant located in Ghana. Now consider Somalia. Power Cola
might catch on and do very well. However, it could also fail because of social
and political instability, which might destroy the business. If we look at
expected outcome, which is the most likely scenario, it is equal in both in
Ghana and Somalia. But the Somalia project is actually a more risky project. If
things go well, we make a profit of ₵300 million. However we could also make
zero profits. By ignoring uncertainty, profit maximization will consider the two
profit opportunities equally desirable. However, individuals are generally said
to be risk averse. This means that given two prospects with equal profitability,

14
they would always prefer the less risky alternative. This is reflected in the
saying that “a safe dollar is worth more than a risky dollar”.

FORECASTS OF PROFITS
PROFITS
PROJECT G PROJECT S

POWER COLA IN POWER COLA IN

GHANA SOMALIA

OPTIMISTIC ₵150m ₵300m

PREDICTION

EXPECTED ₵150m ₵150m

OUTCOME

PESSIMISTIC ₵150m 0
PREDICTION

Timing of returns

“A cedi today is worth more than a cedi tomorrow”. However, profit

maximization ignores the timing of profits. Suppose that we ignore risk for the
moment and consider only the timing of the profits from two projects A and B.
both projects involve the set up of a plant to manufacture Power Cola in the
same location- Ghana. The table indicates that project A yields a profit of 10m
in the first year but has zero profits in the second year. Project B on the other
hand makes zero profits in the first year but makes 10m profit in the second
year. Which project is more desirable? Note that total profit is the same but the
timing is different

It is clear that Project A is the better of the two. Suppose at the end of the first
year the interest rate on treasury bills is 20%. Then after one year the 10
million received from TB is worth:

15
₵10 million × (1.20) =₵12 million

After two years, the profits are worth:

₵12 million × (1.20) =₵14.4 million

At the end of two years, the profits of A, after considering the returns from
investing early profits is ₵4.4 million more than the profits of B. Thus we want
cash flows sooner rather than later.

YEAR PROFITS

A B

1 ₵10m 0

2 0 ₵10m

Dividends

The profit maximization objective assumes that dividends are irrelevant. A

focus on profit does not allow for the effect of dividend policy on share price. To
maximize profits, a firm need not pay dividends since all earnings could be
ploughed back into new investments. However, if dividends affect the market of
shares, then such a policy would not maximize the market value of the firm.

The maximization of shareholder wealth involves a modification of the profit

maximization motive to reflect the complexities of the real world. It captures
the effects of all managerial decisions

Shareholders react to poor investment decisions by selling their shares causing

market value to fall. They also react to good decisions by buying more shares
causing prices to rise. Thus the market price of shares reflects the value of the

16
firm as seen by owners. It reflects uncertainty, timing dividend and any other
factors that are of interest to shareholders.

4-1.2 Agency problem

The goal of maximizing shareholders wealth is a valid goal even though its
attainment may be difficult. This is because managers of companies may not
always act in the best interest of shareholders. Ownership of modern limited
company is commonly widely diffused. Shareholders who may number in
millions usually delegate managerial control of the corporation to a
professional management team. Managers who usually do not have major
share ownership positions conduct day to day operations. Therefore, large
corporations are characterized by separation of ownership and control. In legal
terms, the shareholders are the principals while ‘management’ is the agent. An
agent is someone who is given authority to act on behalf of another referred to
as the principal. In a corporate setting, the shareholders are the principals
because they actually own the firm. The Board of Directors, Managing Director,
corporate executives and all others with decision making power are agents of
shareholders. In finance, the risk that management may not act in the interest
of shareholders is called the principal-agent or agency problem.

As agents, managers are expected to act in the interest of shareholders and

Board of Directors monitor managers on behalf of shareholders. In practice,
however, wide dispersion of ownership makes it difficult for shareholders to
exercise control through Board of Directors.

Managers may have goals that differ from those of shareholders. Some
managers acquire perks such as expensive offices, numerous assistants, etc.
managers may also avoid projects that have risk associated with them even if
they are good projects with huge potential returns and a small chance of
failure. This is because if the project does not work out well, the agents of the
shareholders may lose their jobs.

17
The individual shareholder does not have enough of a stake to justify time and
money needed to monitor management. In theory the shareholders pick the
board of directors and the board of directors in turn picks the management.
Unfortunately, in reality, the system frequently works the other way around.
Management selects the board of director nominees and distributes the ballots.
In effect, shareholders are offered a slate of nominees selected by management.
The end result is that management actually selects the directors, who then
may have more allegiance to management than to shareholders.

When managers subordinate the objective of maximizing shareholder wealth to

other objectives, they create additional monitoring expenditures such as;

1. Auditing systems to limit management behaviors

2. Changes in organizational systems to limit ability of managers to
engage in undesirable practices, e.g. shuffling of positions.

The costs associated with managerial behaviour that is against the interest of
shareholders are called agency costs. Evidence from capital markets around
the world indicates that high agency costs are ultimately reflected in lower
share prices. The interest of managers and shareholders can be aligned by
establishing management stock options, bonuses and prerequisites that are
directly tied to how closely decisions coincide with the interests of
shareholders. The agency problem will persist and interfere with the objective
of maximizing shareholder wealth unless the incentive structure is set up that
aligns the interests of both managers and shareholders. In short, what is good
for shareholders must also be good for managers.

18
19
4-1.3 Efficient market hypothesis

Decisions that maximize shareholders wealth are decisions that are reflected in
an increase in share price. Good financial decisions are reflected in share price
whenever markets are efficient. In an efficient capital market, information is
quickly and accurately reflected in security prices so that share prices reflect
expected earnings and risks of the firm. An efficient market is characterized by
a large number of profit-driven investors who act independently. In addition,
new information arrives in the market place in a random manner. Given this
setting, investors adjust to new information immediately and buy and sell the
security until they feel that the price correctly reflects the new information.

Thus, as new information about the firm, the industry and economy is
received, share prices should change to reflect the impact of the new
information. Examples of the items of information that will affect share prices
in an economy are;

 The government announces new tax measures

 A company announces a new product
 A company releases annual report
 A company announces higher dividends

Studies in advance capital markets have shown that capital markets in such
countries are generally efficient so that new information is rapidly reflected in
the shares within minutes.

20
For a number of reasons, corporate financial managers have a significant
interest in whether markets are efficient. If the goal of a financial manager is to
maximize share prices, then companies can only be sure that new share issues
can be sold for their true worth only if all information is reflected in security
prices. Also, if prices of shares do not change as new information about a firm
is revealed, the financial manager is unable to assess his decisions of the value
of the company’s shares and the attainment of the objective of maximizing
shareholders wealth is frustrated.

The factors that affect efficiency of markets are numerous and include rules
and regulations, trading arrangements, the technology of information
dissemination and the competitiveness of the brokerage or issue house
industry. Rules and regulations such as the prohibition of insider trading are
designed to improve market efficiency. Thus it is illegal for any person to
benefit financially through the possession of private information obtained
through official association.

What are the implications of efficient markets? Efficiency means that the price
is right, i.e. all available information is captured in the stock price. We can
therefore apply the rule of shareholder wealth maximization by focusing on the
decision that increases the share price, if everything were held constant.
Overtime, good decisions will result in higher stock prices, and bad ones, lower
stock prices.

Using the maximization of shareholder wealth criterion requires us to

understand what determines share prices. There are several external factors
such as government regulation and general business conditions which affect
share price. While financial managers cannot do much to affect the external
environment, they can through their managerial decisions have a significant
impact on the factors that determines share price.

21
External factors and managerial decisions determine the firm’s cash flow. The
share price of a company is the result of interaction of three basic forces that
operate on the cash flows of a firm.

1. Size: the size of the cash flows that shareholders expect to receive from
owning shares.
2. Risk: the risk of the cash flows as perceived by the shareholders.
3. Timing: shareholders expectation of when they will receive the cash.

 Expected cash flows

The components of cash flows to an investor are;

1. Cash dividends
2. Proceeds from the sale of shares (capital appreciation)

It is the cash flows that determine the rate of return on investment. Suppose
you hold a share for one year. The rate of return is;

RATE OF RETURN = SELLING PRICE – BUYING PRICE +DIVIDENDS

BUYING PRICE

That is, shareholders’ annual return is the capital appreciation (selling price –
buying price) plus dividend.

Example: At the end of December 1997, Guinness Ghana Limited shares closed
at ₵650 per share. During 1998, the company paid dividends of ₵39.94 per
share. The share price at the end of 1998 was ₵800. If you bought Guinness
shares in December 1997 and sold in December 1998, your one year return is
calculated as follows;

Rate of return = 800 – 650 + 39.94 × 100

650 = 29.22%

22
Higher expected cash flows lead to increase in today’s share price. As expected
cash flows rise and fall, the share price rises and falls in the same direction. By
making financing and investment decisions that increase shareholders
expected cash flows, the actions of managers increase share price.

 Risk of cash flows

Risk is the uncertainty that shareholder perceive surrounding future cash

flows, cash dividends and the future selling price of their shares. From the
equation on the rate of return, we can describe risk as the uncertainty
surrounding the expected return. The greater the potential for unexpected
changes from expected return, the greater the risk. Most investors are risk
averse that is do not risk. An increase in risk holding other factors constant
causes a decline in share price. Therefore, by minimizing risk perceived by
shareholders and maximizing their expected cash flows, managers increase
share price. Unfortunately, larger expected cash flows and greater cash flow
often go up hand in hand, leaving managers with the delicate balancing act of
identifying the appropriate combination of risk and cash flows.

 Timing of cash flows

The third major influence on share price is the timing of cash flows t
shareholders. Shareholders prefer to receive cash earlier than later because
cash in hand is worth more than cash in the future. There are a number of
reasons for this;

1. The future is fraught with uncertainty

2. The price of goods and services continue to rise because of inflation
3. A cedi received today can be reinvested to earn a return.

 Self Assessment 4-1

23
 1. What goal might be pursued by managers of company instead of
maximizing shareholder’s value?
2. What is an efficient market?
3. Briefly describe the agency problem.

 Answer tips

1. Answer to self assessment question 1 can be found in session 4-1

2. Answer to self assessment 2 can be found in session 4-1.3
3. Answer to self assessment question 3 can be found in session 4-1.2

Session 5-1 THE FINANCIAL SYSTEM

The financial environment Ghana changed dramatically in the 1980s.
Beginning with the structural adjustment programme of the early 1980s and
accelerating rapidly, we have seen a deregulation of the financial service
industry in Ghana. Removal of interest rate controls and sector allocation of
lending has increased competition among banks and other suppliers of capital.
At the same time, we are experiencing for the first time, an environment
characterized by considerable volatility interest rates. The confluence of these
events has resulted in a continual change in the environment in which a firm
operates. The financial manager must adapt if his or her company is to
maximize shareholder wealth.

5-1.1 Importance of financial markets

24
Financial markets are institutions and procedures that a company uses to
raise funds for investment. Financial markets serve the following purposes;

1. The market brings together savers and users of funds.

2. It helps managers to understand how investors view the company’s
investment decisions.
3. It helps managers to know what returns investors want.

5-1.2 Financial Intermediation

At any point in time in the economy, there are some individuals and
institutions who have surplus cash while other individuals and institutions
have a shortage of cash. Financial market provide an efficient means of
transferring cash from cash surplus individuals to cash deficit individuals and
institutions. In the absence of financial markets, an individual or business who
has excess cash would have to conduct a search on his own to find an
individual or business which has a cash deficit and arrange to loan the surplus
cash to the deficit organization. Because of the difficulty of such direct
transaction, institutions exist to acquire cash surpluses and lend them to
individuals and institution that face a deficit. Because such institutions act as
a link between surplus and deficit units they are collectively called financial
intermediaries. Such financial intermediaries include commercial banks,
merchant banks, insurance companies, pension trusts and discount houses.

The role financial intermediaries in channelling funds from cash surplus to

cash deficit organisations are shown in the figure below;

The role of financial intermediaries

25
 SURPLUS UNIT FINANCIAL DEFICIT UNITS
1. Individuals INTERMEDIARIES Individuals
2. Businesses banks , insurance Businesses
3. Governments companies, Discount Government
houses, pension trusts Foreigners
4. ForeignerS

Surpl
us units may consist of individuals, businesses, governments and foreigners
who have surplus cash balances. The financial institutions perform the task of
pooling surplus cash balances and transferring them to deficit units. While all
units could have surpluses and deficits, historically, governments tend to be
deficit units and borrow large amounts of money to finance their expenditures.
Foreigners tend to surplus units relative to the needs of Ghana. This is
reflected in the large amounts of external borrowing that are needed to satisfy
the funding needs of businesses and the Ghana government.

5-1.3 Allocation of resources

When financial markets exist, investible funds will tend to flow to the most
profitable investments. This occurs because the most profitable investments
would tend to pay the highest returns to investors. The society as a whole
benefits because inefficiencies and waste are removed if resources are invested
in the most profitable company.

 Self Assessment 5-1

1. What is the role of financial intermediaries in Ghana?

26
 Answer tips
1. Answer can be found in 5-1.2

Learning Track Activities

 Unit Summary
1. The financial manager has three principal tasks and these are called the
three A’s of financial management.

2. The preferred goal of the firm is to maximize of shareholders wealth.

3. Players in the financial market serve as intermediaries by channelling funds

from surplus units and deficit units.

 Key terms/ New Words in Unit

1. financial management;
2. agency problem;
3. market efficiency;
4. financial intermediation;

27
  Discussion Question: Why is shareholder value
 maximization preferred to profit maximization?

Unit Assignments 1
Apart from profit maximization, what other goals may be pursued
by managers?

Unit 2
COST OF CAPITAL

Introduction

28
When appraising investment opportunities, the cost of capital has an important
role to play. We saw in Business finance that the cost of capital is used as the
appropriate discount rate for NPV calculations. In this chapter we examine the
way in which the cost of capital may be computed. Following this examination,
we would also compute the weighted average cost of capital for businesses
using multiple sources of capital.

Learning Objectives
After reading this unit you should be able to:

1. Calculate the cost of capital for a business and explain

its relevance to investment decision making.
2. Calculate the weighted average cost of capital for a
business and explain its limitations.

Unit content
Session 1-2: Overview of cost of capital
Session 2-2: Equity finance
2-2.1Ordinary shares
2-2.2Preference shares
Session 3-2 Debt finance
3-2.1 Loan capital
3-2.2 Bonds
Session 4-2 Weighted average cost
of capital 4-2.1 Limitations of
WACC 4-2.2
Worked examples

SESSION 1-2: OVERVIEW OF COST OF CAPITAL

As investment projects are normally financed from long term capital, the
discount rate that should be applied to new investment projects should reflect
the expected returns required by the providers of these various forms of

29
capital. From the viewpoint of the business, these expected returns by
investors will represent the cost of capital that it employs. This cost is an
opportunity cost since it represents the returns that investors would expect to
earn from investments with a similar level of risk.

The calculation of the cost of capital figure is an important part of investment

appraisal and should be undertaken with care.

If a business calculates its cost of capital incorrectly, it will apply the wrong
discount rate to investment projects. If the cost of capital figure is understated,
this may result in the acceptance of projects that will reduce shareholder
wealth. This can arise when the understated cost of capital produces a positive
NPV whereas the correct cost of capital produces a negative NPV. Applying the
NPV decision rule of accepting projects with positive NPV would in this case
result in acceptance of unprofitable projects. If, on the hand, the cost of capital
figure is overstated, this may result in the rejection of profitable projects. This
can arise when the overstated cost of capital produces a negative NPV whereas
the correct cost of capital produces a positive NPV.

In Business finance, we saw that the main forms of external long term capital
for businesses include;

 Ordinary shares
 Preference shares
 Loan capital

In addition, an important form of internal long term capital is;

 Retained profit

In the sections that follow, we examine the ways in which the cost of each
element of long term capital may be deduced. We shall see there is a very
strong link between the cost of a particular element of capital and its value;
both are determined by the level of return. As a result, our discussions

30
concerning the cost of capital will also embrace the issue of value. For reasons
that will soon become clear, we will also consider how each element of capital
is valued and then go on to deduce its cost the business.

 Self Assessment 1-2

1. Explain what is meant by the term ‘cost of capital’.

2. What are the possible implications for investment decision making if a

business fails to calculate its cost of capital correctly?

 Answer tips
1. Answer can be found in session 1-2
2. Answer can be found in session 1-2..

SESSION 2-2 EQUITY FINANCE

2-2.1 Ordinary Shares

There are two major approaches to determining the cost of ordinary shares to a
business; the dividend based approach and the risk/return based approach
(The Capital Asset Pricing Model- CAP M). We consider each approach below.

Dividend Based Approach

Investors hold assets in expectation of receiving future benefits. In broad

terms, the value of an asset can be defined in terms of the stream of future
benefits that arise from holding the asset. When considering ordinary shares,
we can say the value of an ordinary share can be defined in terms of the future
dividends that investors receive by holding the share. To be more precise, the
value of an ordinary share will be the present value of the future dividends

31
from the particular share. In mathematical terms, the value of an ordinary
share (P0) can be expressed as follows;

D1 D2 D3 Dn
Po = 1 + 2 + 3 +… n
(1+ K o ) (1+ K o ) (1+ K o ) (1+ K o )

Where;

Po = the current market value of the share.

D = the expected future dividend in years 1 to n.

n = the number of years which the business expects to issue dividends.

Ko= the cost of ordinary shares to the business, that is the required return by
investors.

The valuation model above can be used to determine the cost of ordinary
shares to the business (Ko). Assuming we know the value of an ordinary share
will be the discount rate that, when applied to stream of expected future
dividends, will produce a present value that is equal to the current market
value of the share. Thus, the required rate of return for ordinary share
investors is similar to the internal rate of return (IRR) that is used in evaluating
investment projects.

There may be problems with predicting the future dividend stream from an
ordinary share and as a result, there is a need for some simplifying
assumption. Often, one of two simplifying assumptions concerning the pattern
of future dividends will be employed.

1. The first assumption is that dividends will remain constant over time.
Where dividends are expected to remain constant for an infinite period,
the fairly complicated equation to deduce the current market value of a
share stated above can be reduced to;

Do
Po =
Ko

32
This equation can be rearranged to provide an equation for deducting the cost
of ordinary shares to the business. Hence;

Do
Ko =
Po

Example; Kow Investment Plc has ordinary shares in issue that have a current
market value of GH₵2.20. The annual dividend to be paid by the business in
future years is expected to be 40p. What is the cost of the ordinary shares to
the business?

Do
Solution; Ko=
Po

0.40
Ko=
2.20

= 0.182 or 18.2%

2. The second simplifying assumption that can be employed is that

dividends will grow at a constant rate over time. Where dividends are
expected to have a constant growth rate, the equation to deduce the
current market value of a share shown above can be reduced to;

D1 Do (1+ g)
Po = or Po =
K o−g K o−g

Where g is the expected annual growth rate and D1 = Do (1+g).

This equation can also be rearranged to provide an equation for deducing the
cost of ordinary share capital. Hence;

D1 Do (1+ g)
Ko = +g or +g
Po Po

Determining the future growth rate (g) in dividends is often a problem in

practice. One approach is to use the average past rate of growth in dividend.

33
Example; Avalon Plc has ordinary shares in issue that have a current market
price of GH₵1.50. The dividend expected for next year is 20p per share and
future dividend s are expected to grow at a constant rate of 3% per year. What
is the cost of the ordinary share to the business?

D1
Solution; Ko = +g
P o−g

0.20
Ko = + 0.03
1.50

= 0.163 or 16.3%

The Risk/Return Based Approach (The Capital Asset Pricing Model- CAP
M)

An alternative approach to deducing the returns required by ordinary

shareholders is to use the Capital Asset Pricing Model (CAPM). The formula
for CAPM is stated as

K o = KRF + b (Km – KRF)

Where;

Ko = the required returns for investors for a particular share

KRF = the risk free rate on government securities

b = beta of the particular share

(Km – KRF) = the expected market average risk premium for the next period.

This section will have a detailed discussion in the next chapter.

Example:

34
Lansbury plc has recently obtained a measure of its beta from a business
information agency. The beta obtained is 1.2. The expected returns to the
market for the next period is 10 per cent and the risk-free rate on government
securities is 3 per cent. What is the cost of ordinary shares to the business?

Solution:

Ko = KRF + b(Km – KRF)

Ko = 3% + 1.2(10%-3%)

= 11.4%

2-2.2 Preference Shares

Let us again begin by a consideration of the value of this element of capital

before moving on to consider its cost. Preference shares may be either
redeemable or irredeemable. They are similar to loan capital in so far as the
holders receive an agreed rate of return each year. However, preference shares
differ from loan capital in that the annual dividends paid to preference
shareholders do not represent a tax-deductible expense for the business.
Where the rate of dividend on the preference shares is fixed, the equation used
to derive the value of irredeemable preference shares is again similar to the
equation used to derive the value of ordinary shares where the dividends
remain constant over time. The equation for irredeemable preference shares is:

Dp
Pp =
Kp

Where

Pp,= the current market price of the preference shares

Kp = the cost of preference share to the business

Dp = the annual dividend payments

35
This equation can be rearranged to provide an equation for deducing the cost of
irredeemable preference share. Hence;

Dp
Kp =
Pp

 Self Assessment 2-2

1. Identify and explain the two approaches used in calculating the cost
ordinary shares.
2. State the two simplifying assumptions for the determination of cost of
ordinary shares.

 Answer tips
1. Answer can be found in 2-2.1
2. Answer can be found in 2-2.1

SESSION 3-2 DEBT FINANCE

3-2.1 Loan capital

We shall begin this section concerning loan capital as we did the section
relating ordinary shares. That is we shall consider the value of this element
first and then go on to a consideration of its cost. Loan capital may be
irredeemable, that is the business is not expected to repay the principal sum
and so the interest will be paid indefinitely. Where the rate of interest on the
loan is fixed, the equation used to derive the value of irredeemable loan capital
is similar to that of ordinary shares where the dividends remain constant over
time. The equation for the value of irredeemable loan capital is;

I
Pd =
Kd

Where

36
Pd = the current market value of the loan capital

Kd = the cost of loan capital to the business

I = the annual rate of interest rate on the loan capital

This equation can be rearranged to provide an equation for deducing the cost of
loan capital, hence
I
Kd =
Pd

Interest payments on loan capital are an allowable expense for taxation

purposes and so the net cash flows incurred in servicing the loan capital will
be the rate of interest payable less the tax charged. For investment appraisal
purposes, we take the after tax net cash flow resulting from the project and so
when calculating the appropriate discount rate, we should be consistent and
use the after tax rate for the cost of capital. The after tax loan capital is
calculated as follows:

I (1−CT )
Kd =
Pd

Where CT is the rate of corporation tax payable

Example:

Tan and Company plc has irredeemable loan capital outstanding on which it
pays an annual rate of interest of 10 per cent. The current market value of the
loan capital is GH₵88 per GH₵100 nominal value and the corporation tax rate
is 20 per cent. What is the cost of the loan capital to the business?

Using the above formula, the cost of loan capital will be:

I (1−CT )
Kd =
Pd

10(1−0.20)
Kd =
88
= 9.1%

37
3-2.2 Bonds

There are two types of bonds; irredeemable and redeemable bonds.

The cost of irredeemable bonds is calculated in a similar way to that of

irredeemable loan capital. Since the interest payment made on irredeemable
bonds are subjected to tax deductions, it will have both a before and after tax
cost of debt. The before tax cost of irredeemable bonds (K ib) can be calculated
as follows;

I
Kib =
P

where

I = interest payment on irredeemable bonds

P = current market price if irredeemable bonds.

The after tax cost of irredeemable bonds is then easily obtained as;

I (1−CT )
Kib =
P
The cost of redeemable bonds can be calculated using the bond yield
approximation model developed by Hawawini and Vora (1982).

I +[( P−NPD)¿¿ n]
Krb = ¿
P+0.6 ( NPD−P)

Where;

I = annual interest payment

P = face value

NPD = net proceeds from disposal (market price of bond)

n = number of years to redemption

38
The cost of redeemable bonds after tax will be; Krbt = Krb (1 – t)

 Self Assessment 3-2

1. What are irredeemable loans?

 Answer tips
1. Answer can be found in session 3-2.1

SESSION 4-2 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

It is argued that managers of a business have a target capital structure in

mind when making financing decisions. Although the relative proportions of
equity and loans may vary over the short-term, these proportion, it is claimed,
remain fairly stable when viewed over the medium to longer-term.

The existence of stable capital structure has important implications for the
evaluation of investment projects. It has already been argued that the required
rates of return from investor should provide the basis for determining an
appropriate discount rate for investment projects.

If we accept that a business will maintain a fairly stable capital structure,

(that is combines both equity and debt finance) over the period of the project,
then the average cost of capital can provide an appropriate discount rate. The
cost of each source of finance must be identified. Once the costs of a
company’s individual sources of finance have been found, the overall weighted
average cost of capital (WACC) can be calculated. The weighted average cost of
capital can be calculated by taking the cost of the individual elements and then
weighting each element in proportion to their relative importance as a source of
finance in the capital structure of the business.

39
The WACC calculation for a company financed solely by debt and equity
finance is represented by;

Ke×E K d (1−CT )× D
WACC = +
(E+ D) ( E+ D)

Where;

Ke =cost of equity

E = value of equity

Kd(1-CT) = cost of debt after tax

D = market value of debt

This equation will expand in proportion to the number of different sources of

finance used by a company. For a company using ordinary share, preference
shares and both redeemable and irredeemable bonds, the equation will
become;

Ke × E K ps × P K ib (1−CT ) Di K rb (1−C T ) Dr
WACC = + + +
(E+ P+ D i+ D r) (E+ P+ D i+ D r) ( E+ P+ D i+ D r) ( E+ P+ D i+ D r)

Where P, Di and Dr are the market values of preference shares, irredeemable

bonds and redeemable bonds respectively
Current market price
Market value = Nominal value ×
Block (If any)

NB; that shares and bonds are sometimes issued in blocks of hundred. In
situations where they are not, the market value will be obtained by multiplying
their nominal values with the current market prices.

4-2.1 Limitations of WACC

1. Calculating the cost of a particular source of finance is not always

straightforward. For example certain securities may not be traded
regularly and therefore do not have a market price (e.g. ordinary
shares of private companies).

40
 2. It is usually difficult to determine which source of finance to include
in the calculation of WACC and which should not.
3. Difficulties in finding the market values of securities also have an
impact on the WACC.
4. WACC is not fixed because as the market values of securities change,
so will a company’s average cost of capital.

4-2.2 Worked examples

Example 1:

Danton plc has 10 million ordinary shares in issue with a current market value
of GH₵2.00 per share. The expected dividend for next year is 16p per share
and this is expected to grow each year at a constant rate of 4 per cent. The
business also has GH₵20 million of irredeemable loan capital in issue with a
nominal rate of interest o f 10 per cent and which is quoted at GH ₵80 per
GH₵100 nominal value. Assume a rate of corporation tax of 20 per cent and
that the current capital structure reflects the target capital structure of the
company. What is the weighted average cost of capital of the company?

The first step is to calculate the cost of the individual elements of capital. The
cost of ordinary shares in Danton plc will be calculated as follows:

D1
Ko = +g
Po

0.16
= + 0.04
2

= 12%

Note: that although we have used the dividend valuation model to calculate the
cost of ordinary shares in this case, the CAPM model could have been used if
relevant information had been available.

41
The cost of loan capital will be calculated as follows;

I (1−t)
Kd =
Pd

10(1−0.2)
=
80

= 10%

The second step is to find the current market values of each element or source
of capital;

Current market price

Market value = nominal value ×
Block (If any)

Market value of equity = 10m × GH₵2 = GH₵20m

80
Market value of loan capital = GH₵20m ×
100

= GH₵16m

Having calculated the cost of the individual elements, we can now calculate the
WACC of these elements;

K e×E K d (1−CT )× D
WACC = +
( E+ D) ( E+ D)

E +D = 20m +16m = GH₵36m

12× 20 10× 16
WACC = +
36 36

42
 = 6.67 + 4.44

= 11.11%

Example 2;

Billy Boat Plc is calculating its current weighted average cost of capital. You
have the following information;

Financial position as at 31 December;

GH₵
Non-current assets 33 344

Current assets 15 345

Current liabilities (9 679)

5% bond (redeemable in 6 years) (4 650)
9% irredeemable bonds (8 500)
Bank loans (3 260)
22 600
Ordinary share (GH₵ 1 par value) 6 400
8% preference share (GH₵ 1 par value) 9 000
Reserves 7 200
22 600

1. The current dividend, shortly to be paid, is 23p per share. Dividends in

the future are expected to grow at a rate of 5% per year.
2. Corporate tax currently stands at 30%.
3. The interest rate on bank loans currently stands at 7%.
4. Stock market prices as at 31 December ( all ex-dividend and ex-interest);

Ordinary shares GH ₵ 4.17

Preference shares 89p
5% bonds GH₵96 per GH₵100 bond
9% irredeemable bonds GH₵108 per GH₵100 bond

SOLUTION

43
Step 1; calculate the cost of the individual sources of finance

a. Cost of equity: using the dividend valuation model

Do (1+ g)
Ke= +g
Po
23×(1+ 0.05)
= + 0.05
417
= 10.8%

b. Cost of reference shares;

Dp
Kps =
Pp
0.08
=
0.89
= 9%

c. Cost of redeemable bonds (after tax): using the Hawawini-Vora bond

yield approximation model;
I +[( P−NPD)¿¿ n]
Krb = ¿
P+0.6 ( NPD−P)

5+[(100−96)/6]
=
100+0.6(96−100)

= 5.8%
Then Krb(after tax) = Krb (1 – t)
= 5.8 (1 – 0.3)
= 4.1%
d. Cost of bank loans after tax;
Kbl(after tax) = 7×(1-0.3)
3260

= 1.50%

e. Cost of irredeemable bonds (after tax;

9 ×(1−0.3)
Kib(after tax) =
108

44
 = 5.8%

Step 2; calculate the market values of the individual sources of finance;

Source of finance Book value (GH₵) Market value (GH₵)

Equity 6 400 + 7 200 = 13 600 6 400 × 4.17= 26 688

Preference shares 9 000 9 000 × 0.89 = 8 010
96
Redeemable bonds 4 650 4 650 × = 4 464
100
108
Irredeemable bonds 8 500 8 500 × = 9 180
100
Bank loans 3 260 3
260
Total 39 010 51 602

Step 3; calculate the WACC

Ke × E K ps × P K ib (1−CT ) Di K rb (1−C T ) Dr
WACC = + + +
(E+ P+ D i+ D r) (E+ P+ D i+ D r) ( E+ P+ D i+ D r) ( E+ P+ D i+ D r)

E + P + Dib +Drb + Dd = 26 688 + 8 010 + 4 464 + 9 180 + 3 260 = GH₵51 602

10.8× 26 688 9 ×8 010 4.1 × 4 464 1.50× 3 260 5.8× 9 180
= + + + +
51602 51602 51602 51602 51602

WACC = 8.45%

 Self Assessment 4-2

1. State two limitations of WACC

 Answer tips

1. Answer can be found in session 4-2.1

45
 Learning Track Activities

 Unit Summary
1. We have seen how the cost capital for individual elements of long
term capital can be calculated.

2. We have also seen how these individual costs can be combined to

derive a weighted average cost of capital (WACC) for investment
decisions.

 Key terms/ New Words in Unit

1. Cost of capital

2. Weighted Average Cost of Capital (WACC)

3. Capital Asset Pricing Model (CAPM)

 Review Question: Explain what is meant by the term cost

 of capital and state why it is important for a business to
calculate its cost of capital correctly.

  Discussion Question: Discuss the possible reasons why

the cost of ordinary share capital might differ between two
 businesses.

46
 Unit Assignments 2
1. Discuss the two main approaches that can be used to deduce
the cost of ordinary shares to s firm.

Unit 3
CAPITAL ASSET PRICING MODEL

Introduction
In the previous chapter, we briefly discussed how the value of ordinary shares
could be calculated using the Risk/Return Based Approach. In this chapter, we
will do a detailed study of the Capital Asset Pricing Model (CAPM). The fact
that the capital asset pricing model, a development based on Markowitz’s
portfolio theory, owes its conception to William Sharpe, a PhD student
unofficially supervised by Markowitz, is perhaps no great surprise. Sharpe
developed this method of share valuation in his seminal 1964 paper in which
he attempted to construct a market equilibrium theory of asset prices under
conditions of risk.

47
 Learning Objectives
After reading this unit you should be able to:

1. Critically explain the capital asset pricing model and

the assumptions upon which it is based.
2. Calculate the required rate of return of a security
using the capital asset pricing model.
3. Explain the limitations of the capital asset pricing
model.

Unit content

Session 1-3: CAPITAL ASSET PRICING MODEL

1-3.1 Assumptions
1-3.2 Calculating CAPM
1-3.3 Limitations of CAPM

SESSION 1-3: CAPITAL ASSET PRICING MODEL

The capital asset pricing model is a method of establishing the cost of share
capital that identifies two forms of risk; diversifiable and non-diversifiable risk.

1-3.1 ASSUMPTIONS
As with most academic models, the CAPM is based on a simplified world using
the following assumptions;

1. Investors are rational and want to maximize their utility.

2. There are no information costs and that all information is freely available
to investors.
3. Investors are able to borrow and lend at a risk free rate.
4. Investors hold a diversified portfolio eliminating diversifiable risk.

48
 5. Capital markets are perfectly competitive

You may recall that, when discussing the attitude of investors towards risk, the
following points were made;

1. Investors that are risk averse will seek additional returns to

compensate for the risk associated with a particular investment.
These additional returns are referred to as the risk premium.
2. The higher the level of risk, the higher the risk premium.
3. The risk premium is an amount required by investors that is over and
above the returns from investing in a risk free investments.
4. The total returns required from a particular investment will therefore
be made up to a risk free rate plus any risk premium.

Although the above ideas were made in respect of investment projects

undertaken by businesses, they are equally valid considering investments in
securities. The CAPM model is based on the above ideas and so the required
rate of return to investors in securities is viewed as being made up of a risk free
rate plus a risk premium. This means that to calculate for the required rate of
return on securities, we have to derive the risk free rate of return and the risk
premium.

The relationship between risk and return

Returns (%)

Risk premium

Risk- free

rate

49
 Risk

The above figure shows how the risk premium rises with the level of risk and so
the total required returns will rise as the level of risk increases.

Calculating the risk free rate of return does not pose a major problem as the
return from government securities can be used as an approximation. A more
difficult problem, however is calculating the risk premium for a particular
share. The CAPM model does this by adopting a three stage process, which is
as follows:

1. Measure the risk premium for the ordinary share market as a

whole. This figure will be the difference between the returns from
ordinary share market and the returns from an investment in risk
free investments.
2. Measure the returns from a particular share in relation to returns
from the ordinary share market as whole.
3. Apply the relative measure of returns to the ordinary share market
risk premium (calculated in stage 1) to derive the risk premium for
the particular share.

The second and third stages require further explanation.

You may recall that total risk is made up two elements; diversifiable and non
diversifiable risk. Diversifiable risk is that part of the risk that is specific to the
project and which can be eliminated by spreading available funds between
investment projects.

Non diversifiable risk is that part of total risk that is common to all projects
and which, therefore cannot be diversified away. This element of risk arises
from general market conditions. This portfolio approach to risk can also be
used investors. The total risk associated with holding shares is also made up of
diversifiable and non diversifiable risk. By holding a portfolio of shares, an

50
investor can eliminate diversifiable risk and this would leave only non-
diversifiable risk.

We know that risk-averse investors will only be prepared to take on increased

risk if there is the prospect of increased returns. However, as diversifiable risk
can eliminate through holding a diversified portfolio, there is no reason why
investors should receive additional returns for taking on this form of risk. It is,
therefore, only the non-diversifiable risk element of total risk for which
investors should expect additional returns. The non-diversifiable risk element
for a particular share can be measured using beta. This is a measure of the
non-diversifiable risk of the share in relation to the market as a whole or it is
the degree to which a share fluctuates with movement in the market as a
whole. In other words, the beta of a security measures the sensitivity of the
returns on the security to changes in systematic factors. For example if a
security has a beta of 0.8 and the market return increases by 10%, the
securities return will increase by 8%. If the market return decreases by 10%,
the return on the security will decrease by 10%

Relationship between the expected level of return and the level of risk as
measured by beta

Expected SML

return (%) Slope of the line (Rm –Rf)

Rm

Rf

0 0.5 1.0 1.5 2.0 2.5

Beta

51
The figure shows the relationship between the level of return and the level of risk
as measured by beta. The risk/return characteristics of an investment will lie at
some point on the continuous line (which is referred to the security market line-
SML). Where there is no risk, the return required from investors will be the risk-
free rate. As the level of risk increases, investors will demand an increasingly
large risk premium to compensate. The market as a whole will have a beta of 1.

A risky share is one that experiences greater fluctuation than those of the
market as a whole and therefore has a high beta value. It follows that the
expected returns for such a share should be greater than the average returns
of the market.

1-3.2 Calculating CAPM

Using the above ideas, the required rate of return for investors for a particular
share can be calculated as follows:

R i = Rf + b (Rm – Rf)

Where;

Ri = the required returns for investors for securities

RF = the risk free rate on government securities

b = beta coefficient of the particular security

Rm = the return of the market

(Rm – Rf) = the expected market average risk premium for the next period

This equation reveals that the required return for a particular share is made up
of two elements: the risk-free return plus a risk premium. We can see the risk
premium is equal to the expected premium for the market as a whole
multiplied by the beta of the particular share. This adjustment to the market

52
risk is undertaken to derive the relative risk associated with the particular
share.

Example:

Lansbury plc has recently obtained a measure of its beta from a business
information agency. The beta obtained is 1.2. the expected returns to the
market for the next period is 10 per cent and the risk-free rate on government
securities is 3 per cent. What is the cost of ordinary shares to the business?

Solution:

Ri = Rf + b (Rm – Rf)

Ri = 3% + 1.2(10%-3%)

= 11.4%

1-3.3 Limitations of CAPM

1. The general assumptions of CAPM are not applicable to the real world
and hence may undermine the applicability of the model
2. The CAPM assumes that transactions take place over a single period
of time, which is usually taken to be more than one year

 Self Assessment 1-3

1. What is a risk premium?

2. Briefly describe what a beta is.

3. Distinguish between diversifiable and non-diversifiable risks.

53
 Answer tips
1. Answers can be found in session 1-3.1

Learning Track Activities

 Unit Summary
1. Sharpe’s capital asset pricing model is a development of Markowitz’s
portfolio theory. The model identifies a linear relationship between the
return of individual securities and their systematic risk as measured by
their beta factor.

2. The relationship between risk and returns plays an important role in

corporate finance. The risk of an investment can be divided into
systematic and unsystematic risk.

3. While the assumptions on which the model is based are not realistic,
the model does provide a useful aid to understanding the relationship
between systematic risk and the required rate of return of securities.

 Key terms/ New Words in Unit

1. Beta

2. Systematic risk

54
 3. Unsystematic risk

4. Risk premium

 Review Question: Explain what is measured by beta.

  Discussion Question: Explain whether you consider the

 assumptions upon which the capital asset pricing model is

based to be unrealistic.

Unit 4
CAPITAL STRUTURE DEBATE

Introduction
In the earlier chapters, we looked at how a company can determine its average
cost capital by calculating the costs of the various sources of finance it uses
and weighing them according to their relative importance. The market value of
a company clearly depends on its weighted average cost of capital. The lower a
company’s WACC, the higher the net present value of its future cash flows and
therefore the higher its market values. In this chapter we are considering
whether financing decisions can have an effect on investment decisions and
thereby affect the value of the company.

Learning Objectives
After reading this unit you should be able to:

1. Evaluate different capital structure options available

to a business.

55
 2. Identify and discuss the main issues in the capital
structure debate

Unit content

Session 1-4: THE CAPITAL STRUCTURE DEBATE

Session 2-4: THE SCHOOLS OF THOUGHT
2-4.1Traditional view
2-4.2Modernist view
2-4.3 Modernists with the introduction of tax

SESSION 1-4: THE CAPITAL STRUCTURE DEBATE

It may come as a surprise to discover that there is some debate in the finance
literature over whether the capital structure decision really is important. There
is some controversy over whether the ‘mix’ of long-term funds employed can
have an effect on the overall cost of capital of a business. If a particular mix of
funds can produce a lower cost of capital, then the way in which the business
is financed is important as it can affect its value. ( in broad terms, the value of
a business can be defined as the net present value of its future cash flows. By
lowering the cost of capital, which is used as the discount rate, the value of the
business will be increased).

SESSION 2-4: THE SCHOOLS OF THOUGHT

The issue to whether it really matters how the business is finance has been the
subject of intense debate between two schools of thought: the traditional school
and the modernist school.

2-4.1 The Traditional View:

The traditionalists point out that the cost of loan capital is chapter that the
most of ordinary (equity) share capital. This difference in the relative of the cost
of finance suggests that by increasing the level of borrowing (or gearing), the
overall cost of capital of the business can be reduced.

56
However, there are drawbacks to taking on additional borrowing. As the level of
borrowing increases, ordinary shareholders will require higher levels of return
on their investments to compensate for the higher levels of financial risk that
they will have to bear. Existing lenders will also require higher levels of return.

The traditionalists argue, however, that at fairly low levels of borrowing, the
benefits of raising finance through the use of loan capital will outweigh any
costs that arise. This is because ordinary shareholders and lenders will not
view low levels of borrowing as having a significant effect on the level of risk
that they have to bear and so will not require a higher level of return in
compensation. As the level of borrowing increases, however, things will start to
change. Ordinary shareholders and existing lenders will become increasingly
concerned with the higher interest charges that must be met and the risks this
will pose to their own claims on the income and assets of the business. As a
result, they will seek compensation for this higher level of risk in the form of
higher expected returns.

The situation just described is set out in the figure below. We can see that,
where there are small increases in borrowing, ordinary shareholders and
existing lenders do not require greatly increased returns. However, at
significantly higher levels of borrowing, the risks involved take on greater
importance for investors and this reflected in the sharp rise in the returns
required from each group. Note that the overall cost of capital (which is a
weighted average of the cost of ordinary shares and loan capital) declines when
small increases in the level of borrowing occur. However, at significantly
increased levels of borrowing, the increase in required returns from equity
shareholders and lenders will result in a sharp rise in the overall cost of
capital.

57
The traditional view of the relationship between levels of borrowing and
expected returns

Cost of capital Cost of ordinary share

capital

------------------------------------------------------------

Overall cost of capital

Cost of loan

---------------------------------------------------
Optimal level of borrowing

(that is point at which overall cost of capital

is minimized) Level of borrowing

The figure assumes that at low level of borrowing, ordinary shareholders will not
require a higher level of return to compensate for the higher risk incurred. As
loan finance is cheaper than ordinary share finance, this will lead to a fall in the
overall cost of capital. However, this situation will change as the level of
borrowing increases. At some point, the increased returns required by ordinary
shareholders will begin to outweigh the benefits of cheap loan and so the overall
cost of capital will start to rise. The implication is therefore, that there is an
optimum level of gearing for a business.

An important implication of the above analysis is that managers of the

business should try to establish that mix of loan/equity finance that will

58
minimize the overall cost of capital. At this point, the business will be said to
achieve an optimal capital structure. By minimizing the overall cost of capital
in this way, the value of the business will be maximized. This relationship
between the level of borrowing, the cost of capital and business value is
illustrated in the figure below.

Relationship between the level of borrowing, cost of capital and business

value; the traditional view

cost of value of

capital the business

level of borrowing level of borrowing

The first graph plots the cost of capital against the level of borrowing. We saw
earlier that the traditionalist view suggests that in the instance, the cost of
capital will fall as the level of borrowing increases. However, at higher levels of
borrowing, the overall cost of capital will begin to increase. The second graph
plots the level of borrowing against the value of the business. This is the inverse
of the first graph. As the cost of capital decreases, the value of the business
increases and vice versa.

We can see that the graph of the value of the business displays an inverse
pattern to the graph of the overall cost of capital. (This is because a lower cost
of capital will result in a higher net present value for the future cash flows of
the business). This relationship, of course, suggests that the financing decision
is critically important. Failure to identify and achieve the right financing ‘mix’
could have serious adverse consequences for shareholder wealth.

59
2-4.2 The modernist view:
Modigliani and Miller (M&M), who represent the modernist school, challenged
the traditional view by arguing that the required returns to shareholders and to
lenders would not follow the pattern as set out above. They argued that
shareholders in a business with financial gearing will expect a return that is
equal to the returns expected from investing in a similar ungeared business
plus a premium, which rises in direct proportion to the level of gearing. Thus,
the increase in returns required for ordinary shareholders as compensation for
increased financial risk will rise in constant proportion to the increase in the
level of borrowing over the whole range of borrowing. This pattern contrasts
with the traditional view, of course, which displays an uneven change in the
required rate of return over the range of borrowing.

The M&M analysis also assumes that the returns required from borrowers
would remain constant as the level of borrowing increases. This latter point
may appear strange at first sight. However, if lenders have good security for the
loans made to the business, they are unlikely to feel at risk from additional
borrowing and will not, therefore, seek additional returns. This is providing, of
course, that the business does not exceed it s borrowing capacity.

The M&M position is set out in the figure below.

The MM view of the relationship between levels of borrowing and expected

returns

Cost of capital Cost of ordinary share capital

--------------------------------------------------Overall cost of
capital

Cost of loan capital

60
 Level of borrowing

The MM view assumes that the cost of capital will remain constant at different
levels of gearing. This is because the benefits of cheap loan capital will be
exactly offset by the increased returns required by ordinary shareholders. Thus,
there is no optimal level of gearing.

As you can see, the overall cost of capital remains constant at varying levels of
borrowing. This is because the benefit obtained from raising finance through
borrowing, which is cheaper than share capital, is exactly offset by the increase
in required returns from ordinary shareholders.

An important implication of the M&M view is that the financing decision is not
really important. The figure above shows that, as the overall cost of capital
remains constant, a business does not have optimal capital structure is not
better or worse than any other and so managers should not spend time on
evaluating different forms of financing ‘mixes’ for the business. Instead, they
should concentrate their efforts on evaluating and managing the investments of
the business.

Relationship between the level of borrowing, cost of capital and business

value; the MM view

Cost of Value of

capital the business

Level of borrowing Level of borrowing

The first graph shows that according to MM, the cost of capital will remain
constant at different levels of borrowing. The second graph shows the implication

61
of this for the value of the business. As the cost of capital is constant, the NPV of
future cash flows from the business will not be affected by the level of borrowing.
Hence, the value of the business will remain constant.

Although the views of Modigliani and Miller were first published in the late
1950s, they are often described as modernists because they base their position
on economic theory (unlike the traditional school). They argue that the value of
business is determined by the future income from its investments, and the risk
associated with those investments and not by the way in which this income is
divided between the different providers of finance. In other words, it is not
possible to increase the value of a business (that is, lower the overall cost of
capital) simply by borrowing as the traditionalists suggest. M&M point out that
borrowing is not something that only businesses are able to undertake.
Borrowing can also be undertaken by individual investors. As business
borrowing can be replicated by individual investors, there is no reason why it
should create additional value for the investor.

The M&M analysis, while extremely rigorous and logical, is based on a number
of restrictive assumptions. These include the following:

 Perfect Capital Markets

This assumption means that there is no share transaction cost s and that
investors and companies can borrow unlimited amounts at the same rates of
interest. Although these assumptions may be unrealistic, they may not have a
significant effect on the arguments made. Where the prospect of ‘arbitrage’
gains (that is, selling shares in an overvalued business and buying shares in
an undervalued business) are substantial, share transaction costs are unlikely
to be an important issue as the potential benefits will outweigh the costs. It is
only at the margin that share transaction costs will take on significance.

Similarly, the assumption that investors can borrow unlimited amounts at

same rate of interest may only take on significance at the margin. The UK stock

62
market is dominated by large investment institutions such as pension funds,
unit trusts and insurance companies that hold a very large proportion of all
shares issued by listed companies. These institutions may well be able to
borrow very large amounts at similar rates to those offered to a business.

 No Bankruptcy Costs

This assumption means that, if a business were liquidated, no legal and

administrative fees would be incurred and the business assets could be sold at
a price that would enable shareholders to receive cash equal to the market
value of the shareholding prior to the liquidation. This assumption will not hold
true in the real world where bankruptcy costs can be very high.

However, it is only at high levels of gearing that bankruptcy costs are likely to
be a real issue. Borrowing leads to commitment to pay interest and to repay
capital: the higher the level of borrowing, the higher the level of commitment
and the higher the risk that this commitment will not be met. In the case of a
low-geared, or moderately-geared, business it may be possible to take on
additional borrowing, if necessary, to meet commitments whereas a high-
geared business may have no further debt capacity.

 Risk

It is assumed that businesses exist that have identical operating risks but
which have different levels of borrowing. Although this is unlikely to be true, it
does not affect the validity of M&M’s arguments.

 No taxation

A world without corporate or personal income taxes is clearly an unrealistic

assumption. However, the real issue is whether or not his undermines the
validity of M&M’s arguments. We will, therefore, consider the effect of
introducing taxes on the M&M position.

63
2-4.3 M&M and the Introduction of taxation
M&M were subject to considerable criticisms for not dealing with the problem
of taxation in their analysis. This led them to revise their position so as to
include taxation. They acknowledged in their revised analysis that the tax relief
from interest payments on loans provides a real benefit to ordinary
shareholders. The more the level of borrowing increases, the more tax relief the
business receives and so the smaller the tax liability of the business will
become.

You will recall that the original M&M position was that the benefits of cheap
loan capital will be exactly offset by increases in the required rate of return by
ordinary share investors. Tax relief on loan interest should, therefore represent
an additional benefit to shareholders. As the amount of tax relief increases with
the amount of borrowing, the overall cost of capital (after tax) will be lowered as
the level of borrowing increases. The implication of this revised position is that
there is an optimum level of gearing and it is at 100 percent gearing. In the
figure below, we can see the M&M position after taxation has been introduced.

The MM view of the relationship between levels of borrowing and expected

returns (including tax effect)

Cost of capital Cost of ordinary share capital

Overall cost of capital

Cost of loan capital

Level of borrowing

The figure shows the revised MM view. As the level of borrowing increases, the
greater the tax benefits to ordinary shareholders. These tax benefits will increase
with the level of borrowing and so the overall cost of capital after tax will be

64
lowered as the level of borrowing increases. This means that there is an optimum
level of gearing and it is at the 100% level of gearing.

Thus, the M&M position moves closer to the traditional position in so far as it
recognizes that there is a relationship between the value of the business and
the way in which it is financed. It also recognizes that there is an optimum
level of gearing.

The relationship between (i) the level of borrowing and the cost of capital and
(ii) the level of borrowing and business value, after taking into account the tax
effects, is set out in the figure below.

In the real world, however, few businesses follow the policy just
described. When borrowing reaches very high levels, lenders are likely to feel
that their security is threatened and ordinary share investors will feel that
bankruptcy risks have increased. Thus, both groups are likely to seek higher
returns, which will, in turn, increase the overall cost of capital. (A business
would have to attract risk-seeking investors in order to prevent a rise in its cost
of capital.)

Relationship between the level of borrowing, cost of capital and business

value; the MM view (including tax effects)

Cost of Value of

capital the business

Level of borrowing Level of borrowing

65
The first graph displays the MM view (including tax) of the relationship between
the cost of capital and the level of borrowing. We can see that as the level of
borrowing increases, the overall cost of capital decreases. The second shows the
relationship between the value of the business and the level of borrowing and so,
as the level of borrowing increases, the value of the business increases.

The debate concerning capital structure still rumbles on. Although the
arguments of the traditional school have been undermined by the inexorable
logic of M&M, it does seem that, in practice, businesses tend to settle for
moderate rather than high levels of gearing. Nevertheless, it could be argued
that, from an ordinary share investor’s viewpoint, the business should
continue to borrow until the risks of incurring bankruptcy costs outweigh the
benefits from higher gearing.

Learning Track Activities

 Unit Summary
1. The optimal capital structure debate addresses the question of
whether a company can maximize its cost of capital by adopting a
particular combination of debt and equity.
2. The traditional approach to the optimal capital structure question
argued that an optimal capital structure did exist for companies.
3. MM argued that a company’s market value depends on its
performance and commercial risks; market value and average cost of
capital are therefore independent of capital structure.

66
4. MM later modified their earlier model to take into accounts corporate
tax and argued that companies should gear up in order to take
advantage of the tax shield of debt.

 Key terms/ New Words in Unit

1. Optimal capital structure;

 Review Question: Briefly explain the traditional view of

 capital structure

  Discussion Question: What are the main implications for

the financial manager who accepts the arguments of;

 The traditional approach

 The MM approach
 The MM and the introduction of tax.

Unit Assignments 4
Critically discuss whether you consider that companies, integrating
a sensible level of gearing into their capital structure, can minimize
their weighted average cost of capital.

67
 Unit 5
DEVELOPING A DIVIDEND POLICY
Introduction
The issue of dividend policy has aroused much controversy over the years. At
the centre of the controversy is whether the pattern of dividends adopted by a
business has any effect on shareholders wealth. In this chapter, we examine
the arguments that have been raised. Although the importance of dividend
policy to shareholders remains a moot point, there is evidence to suggest that
managers perceive the dividend decision to be important. In this chapter, we
consider the attitudes of managers towards dividends and we examine the
factors that are likely to influence dividend policy in practice. We also consider
the alternatives to cash dividend that might be used.

Learning Objectives
After reading this unit you should be able to:

1. Describe the nature of dividends and the way in

which they are paid
2. Explain why dividends should have effects no
shareholder wealth in a world of perfect and efficient

68
 market.
3. Discuss the factors that influence dividend policy in
practice.
4. Discuss the alternatives to cash dividends that may
be used.

Unit content
Session 1-5: THE PAYMENT OF DIVIDENDS

Session 2-5: DIVIDEND POLICY IN PRACTICE

2-5.1 Dividend Policy And Shareholder Wealth

Session 3-5; TWO SCHOOLS OF THOUGHT

3-5.1 Traditional View
3-5.2 Modernist View
3-5.3 The MM Assumptions

Session 4-5; THE IMPORTANCE OF DIVIDENDS

4-5.1 The clientele effect
4-5.2 Information signalling effect
4-5.3 The need to reduce
agency cost

Session 5-5; FACTORS DETERMINING THE LEVEL OF DIVIDENDS

5-5.1; The Dividend Policy Of Other Businesses

SESSION 1-5: THE PAYMENT OF DIVIDENDS

It is probably a good idea to begin our examination of dividend and dividend
policy by describing briefly what dividends are and how they are paid.
Dividends represent a return by a business to its shareholders. This return is
normally paid in cash, although it would be possible for it to be paid with
assets other than cash. In your previous studies, you may have discovered that

69
there are legal limits on the amount that can be distributed in the form of
dividend payment to shareholders.

Question; why does the law impose a limit on the amount of cash that
can be distributed as dividends?

If there were no legal limits, it would be possible for shareholders to withdraw

their investment from the business and so leave the lenders and creditors in an
exposed financial position. The law tries to protect lenders and creditors by
preventing excessive withdrawal of shareholders capital. One way in which this
can be done is through placing restrictions on dividend payments.

The law states that dividends can only be paid to shareholders of private
limited companies out of realized profits. In essence, the maximum amount
available for distribution will be the accumulated trading profits (less any
losses) plus any profits on the disposal of fixed assets. Any surpluses arising
from the revaluation of fixed assets will represent an unrealized profit that
cannot be distributed. However, shareholders of public companies can be paid
out of the net accumulated profits whether the profits are realized or
unrealized.

It should be noted that businesses rarely distribute the maximum amount

available for distribution. Indeed, the dividend paid is normally much lower
than the trading profits for the year in which the dividend is declared. In other
words, the trading profits usually cover the dividend payment by a comfortable
margin.

Dividends can also take the form of bonus shares. Instead of receiving cash,
the shareholders may receive additional shares in the business.

Dividends are often paid twice yearly by large listed businesses. The first
dividend is paid after the interim (half yearly result) results have been
announced. It represents a sort of ‘payment on account’. The second and final
dividend is paid after the year end. The final dividend will be paid after the

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annual financial reports have been published, and after the shareholders have
agreed, at the annual general meeting, to the dividend payment proposed by
directors.

As the shares are bought and sold continuously by investors, it is important to

establish which investors have the right to receive the dividends declared. To
do this a record date is set by the business. Investors whose names appear in
the share register on the record dare will receive dividends payable, they are
also quoted ‘cum dividend’. However, on a specified day before the record
date, the quoted share prices will exclude the accrued dividend and so will
become ‘ex dividend’. Assuming no other factors affect the share price, the ‘ex
dividend’ price should be lower than the ‘cum dividend’ price by the amount of
dividend payable. This is because a new shareholder would not qualify for the
dividend and so the share price can be expected to fall by the amount of the
dividend.

SECTION 2-5 DIVIDEND POLICIES IN PRACTICE

It was mentioned above that businesses rarely distribute all of the profits
available to shareholders in the form of dividend. Usually the dividends paid
are lower than the profits available for the purpose. The extent to the profit
generated during a particular period, and available for distribution, cover
the dividend payment can be expressed in the dividend cover ratio. The
ratio is calculated as follows;

Earnings for t h e year available for dividends

Dividend cover = × 100
Dividends announced for t h e year

The higher this ratio, the lower the risk that dividends to shareholders will be
affected by adverse trading conditions. The inverse of this ratio is known as the
dividend payout ratio. The lower this ratio, the lower the risk that dividends
will be affected by adverse trading conditions.

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Many businesses express their dividend policy in terms of either a target
dividend cover ratio or a target dividend payout ratio. The factors that
determine the particular target level of dividend cover or dividend payout
adopted by a business are considered later in the chapter.

2-5.1 DIVIDEND POLICY AND SHAREHOLDER WEALTH

Much of interest surrounding dividend policy has been concerned with the
relationship between dividend policy and shareholders wealth. Put simply, the
key question to be answered is; can the pattern of dividend adopted by a
influence shareholders wealth? (Note that it is the pattern of dividends rather
than the dividends themselves which is the issue. Shareholders must receive
cash at some point in order for their shares to have any value). While the
question may be stated simply, the answer is less simple. After more than three
decades of research and debate we have yet to solve this puzzle.

The notion that dividend policy is important may seem, on the face of it, to be
obvious. We have considered various dividend valuation models, which suggest
that dividends are important in determining share price. On such model, you
may recall, was the dividend growth which is as follows;

D1
Po =
K o−g

Where;

D1 = expected dividend next year

g = a constant rate of growth
K0 = the expected return on the share

Looking at this model, it may appear that by simply increasing the dividend
(D1) there will be an automatic increase in share price (P 0). If the relationship
between dividends and share price was as just described, then, clearly,

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dividend policy would be important. However, the relationship between these
two variables is not likely to be straightforward as this.

QUESTION; Why might an increase in the dividend (D 1) not lead to an

increase in share price (P0)? (Hint ; think about the other variables in the
equation)

An increase in dividend payment will only result in an increase in share price if

there is no consequential effect on the dividend growth rate. It is likely however
that an increase in dividend will result in a fall in the growth rate, as there will
be less cash to invest to invest in the business. Thus, the beneficial effect on
share price arising from an increase in next year’s dividend may be cancelled out
by a decrease in future year’s dividends.

 Self Assessment 2-5.1

1. Can the pattern of dividend adopted by a influence shareholders

wealth?

 Answer tips
1. Answer could be found in 2-5.1

SESSION 3-5 TWO SCHOOLS OF THOUGHT

The dividend policy issue, like the capital structure issue, has two main
schools of thought.

3-5.1TRADITIONAL VIEW

The early finance literature accepted the view that dividend policy was
important for shareholders. It was argued that a shareholder would prefer to

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receive £1 today rather than to reinvest in the business, even though this
might yield future dividends. The reasoning for this was that future dividends
or capital gains are less certain and so will be valued less highly. The saying ‘a
bird in hand is worth two in the bush’ is often used to describe this argument.
Thus if a business decides to replace an immediate and certain cash dividend
with uncertain future dividends, shareholders will discount the future
dividends at a higher rate in order to take account of this greater uncertainty.
Referring back to the dividend growth model, the traditional view suggest that
K0 will rise if there is an increase in D 1, as dividends received later will not be
valued so highly.

If this line of reasoning is correct, the effect of applying a higher discount rate
to future dividends will mean that the share value of the business that adopt a
high retention policy will be adversely affected. The implication for corporate
managers is therefore quite clear. They should adopt as generous distribution
policy as possible, given the investment and financing policies of the business
as this will represent the optimal dividend policy for the business. In view of
the fact that the level of payout will affect shareholder wealth, dividend
payment decision will be an important policy decision for managers.

3-5.2 MODERNIST VIEW

Modigliani and Miller (MM) have challenged this view of dividend policy. They
argue that, given perfect and efficient markets, the pattern of dividend payment
adopted by a business will have no effect on shareholders wealth. Where such
markets exist, the wealth of shareholders will be affected solely by the
investment projects that the business undertakes. To maximize shareholders
wealth, therefore, the business should take on all investment projects that
have a positive NPV. The way in which the returns from these investment
projects are divided between dividends and retention is important. Thus, a
decision to pay a lower dividend will simply be compensated for by an increase
in share price.

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MM point out that it is possible for an individual investor to ‘adjust’ the
dividend policy of a business to conform to his or her particular requirements.
If a business does not pay a dividend, the shareholder can create ‘homemade’
dividends by selling a portion of the shares held. If, on the other hand, a
business provides a dividend that the shareholder does not wish to receive, the
amount can be reinvested in additional shares in the business. In view of this
fact, there is no reason for an investor to value the shares of one business more
highly than another simply because it adopts a particular dividend policy.

The implications of the MM position for corporate managers are quite different
from the implications of the traditional position described earlier. The MM view
suggests that there is no such thing as an optimal dividend policy, and that
one policy is as good as another (that is, the dividend decision is irrelevant to
shareholder wealth). Thus managers should not spend time considering the
most appropriate policy to adopt, but should, instead, devote their energies to
finding and managing profitable investment opportunities.

QUESTION; There is one situation where even MM would accept ‘a bird in

hand is worth two in the bush’ (that is, that immediate dividends are
preferable). Can you think what it is? (Hint; Think of the way in which
shareholder wealth is increased)

Shareholder wealth is increased by the business accepting projects that have a

positive NPV. If the business starts to accept projects with a negative NPV, this
would decrease shareholders wealth. In such circumstance, a rational
shareholder would prefer to receive a dividend rather than to allow the business
to reinvest the profits of the business.

3-5.3THE MM ASSUMPTIONS

The logic of the MM argument has proved to be unassailable and it is now

widely accepted that, in a world of perfect and efficient capital markets,
dividend policy should have no effect on shareholder wealth. The burning issue

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however is whether or not the MM analysis can be applied to the real world of
imperfect markets. There are three key assumptions on which the MM analysis
rests and which have been the subjects of much debate. These assumptions
are in essence that we live in a frictionless world where there are;

1. No share issue costs.

2. No share transaction costs.
3. No taxation

The first assumption means that money paid out in dividends can be replaced
by the business through a new share issue without incurring additional costs.
Thus, a business need not be deterred from paying a dividend simply because
it needs cash to invest in a profitable project, as the amount can be costlessly
replaced. In the real world, however, share issue costs can be significant.

The second assumption means that investors can make ‘homemade’ dividends
or reinvest in the business at no extra cost. In other words, there are no
barriers to investors pursuing their own dividend and investment strategies.
Once again, in the real world, costs will be incurred when shares are
purchased or sold by investors. The creation of ‘homemade’ dividends as a
substitute for business dividend policy may pose other practical problems for
the shareholder, such as the indivisibility of shares, resulting in shareholders
being unable to sell the exact amount of shares required, and the difficulty of
selling shares in unlisted companies. These problems, it is argued, can lead to
investors becoming reliant on the dividend policy of the business as a means of
receiving cash income. It can also lead them to have a preference for one
business rather than another, due to the dividend policies adopted.

The third assumption concerning taxation is unrealistic and, in practice, tax

may be an important issue for investors. It is often argued that, in the United
Kingdom, the taxation rules can have a significant influence on investor
preferences. It may be more tax efficient for an investor to receive benefits in
the form of capital gains rather than dividends because, below a certain

76
threshold, capital gains arising during a particular financial year are not
taxable, whereas all dividends are taxable.

QUESTION; In a world where taxation is an important issue for investors,

how will the particular dividend policy adopted by a business affects its
share price?

If, as a result of the tax system, investors prefer capital gains rather than
dividends, a business with a high dividend payout ratio would be valued less
than a similar business with a low payout ratio.

Although the difference the tax treatment of dividend income and capital gains
still exist, changes in taxation policy have narrowed these differences in recent
years. One important policy change has been the creation of tax shelters which
allows investors to receive capital gains and dividend income free of taxation.

The three assumptions discussed undoubtedly weaken the MM analysis when

applied to the real world. However, this does not necessarily mean that their
analysis is destroyed. Indeed, the research evidence tends to support their
position. One direct way to assess the validity of MM’s arguments in the real
world is to see whether there is a positive relationship between the dividends
paid by businesses and their share price. If such a relationship exists then
MM’s argument would lose their force. The majority of studies however, have
failed to find any significant correlation between dividends and share prices.

SESSION 4-5; THE IMPORTANCE OF DIVIDENDS

Whether we accept the MM analysis, there is little doubt that in practice, the
pattern of dividends is seen by investors and corporate managers as being
important. It seems that there are three possible reasons to explain this
phenomenon. These are;

1. The clientele effect

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 2. The information signaling effect
3. The need to reduce agency costs.

Each of these reasons is considered below.

4-5.1 The Clientele Effect

It was mentioned earlier that transaction costs may result in investors

becoming reliant on the dividend policies of businesses. It was also argued that
the tax position of investors can exert an influence on whether dividends or
capital gains are preferred. These factors may in practice mean that dividend
policy will exert an important influence on investor behavior. Investors may
seek out businesses whose dividend policies match closely their particular
needs. Thus businesses with particular dividend policies will attract particular
types of investors. This phenomenon is referred to as the clientele effect.

The essence of a clientele effect has important implication for managers. First,
dividend policy should be clearly set out and consistently applied. Investors
attracted to a particular business of its dividend policy will not welcome
unexpected changes. Second, managers need not concern themselves with
trying to accommodate all the different needs of shareholders. The particular
distribution policy adopted by the business will tend to attract a certain type of
investor depending on his or her cash needs and taxation position.

However, investors should be wary of making share investment decisions based

primarily on dividend policy. Minimizing cost may not be an easy process for
investors. Those, for example requiring a regular cash income and who seeks
out business with high dividend payout ratios, may find that any savings in
transaction costs are cancelled out by incurring other forms of cost.

QUESTION; what kind of costs may be borne by investors who invest in

high dividend payout companies, do you think?

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Being committed to a high dividend payout may prevent a business from
investing in profitable projects that would have increased shareholder wealth.
Hence, there could be a loss of future benefits for the investor. If however, a
business decides to raise finance to replace the amount distributed in dividends,
the cost of raising the required finance will be borne by existing shareholders.

Investors must therefore look beyond the dividend policy of a business in order
to make a sensible investment decision.

4-5.2 Information Signalling

In an imperfect world, managers of a business will have greater access to

information regarding the profits and performance of the business than
investors. This information asymmetry as it is called between managers and
investors allows dividends to be used by managers as a means of passing on
information concerning the business to investors. Thus, new information
relating to future prospects may be signalled by managers to shareholders
through changes in dividend policy. If for example, managers are confident
about the business’s future prospects, there may be information signalling to
this effect through an increase in dividends.

Sending a positive signal to the market by increasing dividends is an expensive

way to send a message. It may also seem wasteful (particularly where investors
do not wish to receive higher dividends for tax reasons). However, it may be the
only feasible way of ensuring that investors take seriously the good news that
managers wish to convey.

Various studies have been carried out to establish the information content of
dividends. Some of these studies have looked at the share price reaction to
unexpected changes in dividends. If signalling exists, an unexpected dividend
announcement should result in a significant share price reaction. The results
from these studies provides convincing evidence that signalling does exist, that
is, a dividend increase positive signal) results in an increase in share price and

79
vice versa. One interesting feature of the evidence is that the market reaction to
dividend reductions is much greater than the market reaction to dividend
increases. It appears that investors regard reduction much more seriously.

4-5.3 Reducing Agency Costs

In recent years, agency theory has become increasingly influential in the

financial management literature. Agency theory views business as a coalition of
different interest groups (managers, shareholders, lenders and so on) in which
each group is seeking to maximize its own welfare. According to this theory,
one group connected with the business may engage in behavior that results in
costs being borne by another group. However, the latter group may try to
restrain the action of the former group, through contractual or other
arrangements, so as to minimize these costs. Two examples of where a conflict
of interest arises between groups, and the impact on dividend policy are
considered below.

The first example concerns a conflict of interest between shareholders and

managers. If the managers (who are agents of the shareholders) decide to
invest in lavish offices, expensive cars and other ‘perks’, they will be pursuing
their own interests at a cost to the shareholders. One way in which
shareholders can avoid incurring these agency costs is to reduce the cash
available for managers to spend. Thus, shareholders may make it clear that
they expect surplus cash to be distributed to them in the form of dividends.
Managers may support such a policy to demonstrate their commitment to the
shareholders’ interests. The managers may recognize that agency costs prevent
them from receiving full recognition for their achievements and helping to
reduce these costs could be in their best interests.

The second example concerns a conflict between shareholders and lenders.

Shareholders may seek to reduce their stake in the business by withdrawing
cash in the form of dividends. This may be done to reduce their exposure to the
risks associated with the business. However, this is likely to be to the

80
detriment of lenders, who will become more exposed to these risks. The lenders
may, therefore try to prevent this kind of behavior by restricting the level of
dividend to be paid to shareholders.

QUESTION; How can lenders go about restricting shareholders’ rights to

dividends?

Lenders can insist that loan covenants, which restrict the level of dividend
payable, be included in the loan agreement.

Agency cost will be more of an issue where there is a clear separation between
the shareholders and the managers of the business. This may explain in part,
why private limited companies tend to have lower dividend levels than public
limited companies, where the separation between ownership and control is
greater.

 Self Assessment 4-5

1. Briefly discuss the importance of dividend payment

 Answer tips
1. Answer could be found in 4-5

SESSION 5-5; FACTORS DETERMINING THE LEVEL OF

DIVIDENDS

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We have now seen that there are three possible reasons why investors and
managers regard dividends as being important. In addition there are various
practical issues that have a bearing on the level of dividends paid by a
business. These include the following.

 Investment and financing opportunities

Businesses that have good investment opportunities may try to retain a

greater proportion of their profits. This may occur where there are problems
in raising external finance, thus making it necessary to rely on profit
retention in order to finance the investments. There is some evidence to
show that businesses that are growing quickly tend to select a policy of
either low dividends or no dividends, but at a more mature stage of the
business cycle, increase the level of dividend distribution.

It can be argued that, where there are problems in raising external sources
of finance and investors are indifferent about dividends, it would make
sense for managers to regard dividends as simply a residual. That is, the
managers should only make dividend distribution where the expected
return from investment opportunity is below the required for investors. The
implication of this policy is that dividends could fluctuate each year
according to the investment opportunity available: the greater the
investment needs of the business, the less that is available for distribution
and vice versa. Where, however a business is able to finance easily and
cheaply from sources, there is less need to rely on retained profits, which
can be distributed in the form of dividends. In practice, larger, well
established businesses will usually have better access to cheap sources of
external finance than newer smaller businesses and so, other things being
equal, they will have higher dividend payout ratios.

 Legal requirements

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Company law restricts the amount that a business can distribute in the
form of dividends. We saw earlier that the law states that dividends can only
be paid to shareholders out of realized profits. In essence, the maximum
amount available for distribution will be the accumulated trading profit (less
any losses) plus any profits on disposal of assets

 Loan covenants

There may be covenants included in loan a contract that restricts the level
of dividends available for distribution to shareholders during the loan
period. Such covenants are designed to protect the lenders’ investment in
the business.

 Profit stability

Businesses that have a stable pattern of profits over time are in a better
position to pay higher dividend payouts than businesses that have a volatile
pattern of profits. This is because businesses that have a stable pattern of
profits are able to plan with greater certainty and are less likely to feel a
need to retain profits for unexpected events.

 Control

A high profit retention/low dividend policy can help avoid the need to issue
new share, and so control exercised by existing shareholders will not be
diluted.

 Threat of takeover

A further aspect of control concerns the relationship between dividend

payments and the threat of takeover. It has been suggested, for example
that a high retention/low dividend distribution policy can increase the
vulnerability of a business to takeover. Dividend policy may, however help
avert the threat of takeover. Issuing a large dividend may signal to the

83
market the managers confidence in the future prospects of the business.
This should in turn increase the value of the shares and so make a takeover
more costly for the predator company. However, the market may not
necessarily interpret a large dividend in this way. Investors may regard a
large dividend as a desperate attempt by the directors to gain their support
and so discount the dividend received.

 Market expectations

Investors may have developed certain expectations concerning the level of

dividend to be paid. These expectations may be formed as a result of earlier
statements made by the managers of the business. If these expectations are
not met, there may be a loss of investors’ confidence in the business.

 Inside information

The managers of a business may have inside information concerning the

future prospects of a business that cannot be published but which indicates
that the shares are currently undervalued by investors. In such a situation,
it may be sensible to rely on internal shareholder funds (that is retained
profit) rather than issuing more shares. Although this may lead to lower
dividends, it could enhance the wealth of existing shareholders.

5-5.1 THE DIVIDEND POLICY OF OTHER BUSINESSES

The dividend policy adopted by a business may be considered in relation to

other comparable businesses. Indeed it has been suggested by that
investors make comparisons between businesses and that a significant
deviation in dividend policy from the sector will attract criticisms. The
implication seems to be that managers should shape the dividend policy of
their business according to what other comparable businesses are doing.
This however, may be neither practical nor desirable.

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To begin with, there is the problem of identifying comparable businesses. In
practice, there may be real differences between businesses concerning risk
characteristics, rate of growth and accounting policies adopted. There may
also be real differences between businesses concerning the influences
mentioned above such as investment opportunities, loan covenants, and so
on. Even if comparable businesses could be found, the use of such
businesses as a benchmark assumes that they adopt dividend policies that
are optimal, which may not be the case. These problems suggest that
dividend policy is best determined according to the particular requirements
of the business. If the policy adopted differs from the norm, the managers
should be able to provide reasons to investors.

 Self Assessment 5-5

1. What are the factors affecting dividend payment?

2. Can the dividend policy of another business affect the dividend policy
of your business? If yes, in what way?

 Answer tips
1. Answers could be found in 5-5

Learning Track Activities

 Unit Summary
1. A company’s dividend decision has important implications for both its
investment and its financing decision.

85
2. We have seen that there are opposing views concerning whether or not
the pattern of dividends has an influence on shareholders wealth.

3. We have also explored various reasons why dividends may be

important to shareholders in an imperfect world.

 Key terms/ New Words in Unit

1. Dividend

2. Dividend cover ratio

3. Clientele effect

4. Information asymmetry

5. Information signalling

 Review Question: Identify and discuss the factors that

 may influence the dividend policies of businesses.

  Discussion Question: The dividend policy of businesses

has been the subject of much debate in the financial
management literature. Discuss the view that dividends can
increase the wealth of shareholders.

Unit Assignments 5
Describe how agency theory may help explain the dividend policy of
businesses.

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 Unit 6
MERGERS AND TAKEOVERS

Introduction
In this chapter, we consider various aspects of mergers and takeovers. We
examined the reasons for mergers and takeovers and consider ways in which
they can be financed. We look at the evidence concerning who are likely to be
the winners and losers in a takeover and whether it is possible to identify
businesses that are vulnerable to takeover.

87
 Learning Objectives
After reading this unit you should be able to:

1. Identify and discuss the main reasons for

mergers and takeovers.
2. Discuss the advantages and disadvantages of
each of the main forms of purchase
considerations used in a takeover.
3. Identify those who are likely to benefit from
takeover activity and discuss which businesses
are vulnerable to takeover
4. Outline the tactics that may be used to defend
against a hostile bid.

Unit content
Session1-6: Mergers and Takeovers
1-6.1 Types of mergers and takeover
1-6.2 Why Recent Increase In Merger Activities

Session 2-6: THE RATIONAL FOR MERGERS

Session 3-6; FORMS OF PURCHASE CONSIDERATION

3-6.1Cash
3-6.2Shares
3-6.32Loan capital

Session 4-6; ASSESSING VULNERABILITY TO TAKEOVER

4-6.1 Resisting a takeover bid
4-6.2 Who benefits
4-6.3 Defensive Measures For A
Takeover Bid

Session 5-6; DIVESTMENT AND DEMERGERS

88
SESSION 1-6 MERGERS AND TAKEOVERS

When two or possibly more businesses combine, it can take the form of either a
merger or takeover. The term merger is normally used to describe a situation
where there are two businesses of roughly the equal size and there is
agreement between the two management and shareholder groups on the
desirability of combining them. A merger is usually effected by creating an
entirely new business from the assets of the two existing businesses, with both
shareholder groups receiving an ownership stake in the new business.

The term takeover is normally used to describe a situation where a larger

business acquires control of a smaller business. When a takeover occurs, the
shareholders of the target business may cease to have any further interest in
the business and the resources of the business may come under entirely new
ownership. (The particular form of consideration used to acquire the shares in
the target business will determine whether the shareholders continue to have a
financial interest in the business). Although the vast majority of takeovers are
not contested, there are occasions when the management of the target
business will fight on to retain its separate identity.

In practice, however, many business combinations do not fit into these neat
categories and it may be difficult to decide whether a merger or a takeover has
occurred. The distinction between the two forms of combination is only really
important in the context of financial reporting, as different forms of accounting
exist for each type of combination. It is worth noting that the merger method of
accounting can often provide a much better picture of financial health than the
acquisition method of accounting for the combined business. In the past there
has been some misuse of mergers accounting methods, and so now strict
conditions must be met before a business combination can adopt the merger
accounting method. In this chapter, no real distinction will be made between
the terms merger and takeover and we will use the term interchangeably.

89
1-6.1 Types of mergers and takeover

Mergers and takeovers can be classified according to the relationship between

the businesses being merged.

 Horizontal merger occurs when two businesses in the same industry

and at the same point in the production /distribution process decide to
combine.
 Vertical merger occurs when two businesses in the same industry, but
at different points in the same production/distribution process, decide
to combine.
 Conglomerate merger occurs when two businesses in a unrelated
industries decide to combine.

QUESTION; Can you think of an example for each type of merger?

1-6.2 Why Recent Increase In Merger Activities

In recent years, there has been a dramatic increase in the frequency and scale
of merger and takeover activity. Various factors have been cited to explain this
phenomenon, including

 The globalization of markets leading to the need for larger business

entities
 Improvement in communication, transportation and technology
enabling the better management of dispersed operations
 Deregulation of industries such as gas, electricity, water and
telecommunications leading to greater competition
 Restructuring of industries in the face of increased competition and
changes in demand
 Rising share prices and relatively low interest rates that has made the
financing of mergers easier.

90
These factors have combined to provide the environment within which mergers
and takeover activities can thrive.

 Self Assessment 1-6

1 .Identify and explain the various types of mergers.

2. What do think you is the cause of the recent increase in merger

activities.

 Answer tips
1. Answer can be found in 1-6.1

2. Answer can be found in 1-6.2

SESSION 2-6: THE RATIONALE FOR MERGERS

In economic terms, a merger will only be worthwhile if combining the two

businesses will lead to gains that would not arise if the two businesses stayed
apart. We saw in the previous chapter that the value of a business can be
defined in terms of the present value of its future cash flows. Thus if a merger
is to make economic sense, the present value of the combined business should
be equal to the present value of future cash flows of both the bidding and
target business plus any gain from the merger. The reasons for mergers are
explained below:

 Benefits of scale

A merger or takeover will result in a larger business being created that may
enable certain benefits of scale to be achieved. For example, a larger business
may be able to negotiate lower prices with suppliers in exchange for larger
orders. A merger or takeover may also provide potential for savings, as some
operating costs may be duplicated (for example administrative cost, research

91
and development costs and so on). These types of benefits are more likely to be
gained from horizontal and vertical mergers than from conglomerate mergers. It
is more difficult to achieve economies where the businesses are unrelated. The
benefits described, however, must be weighed against the increased costs of
organizing and controlling a larger business.

QUESTION; Is it necessary for a business to merge with, or take over

another business in order to reap the benefits of combination? Can these
benefits be obtained y any other means?

A business may be able to obtain lower prices from suppliers, reduced research
and development costs, and so on, by joining a consortium of business or by
entering into joint ventures with other businesses. This form of cooperation can
result in benefits of scale and yet avoid the costs of a merger.

 Eliminating competition

A business may combine with or take over another business in order to

eliminate competition and to increase the market share of its goods. This, in
turn can lead to increased profits.

QUESTION; What kind of merger will achieve this objective? What are
the potential problems of this kind of merger from the consumer point of
view?

A horizontal merger will normally be required to increase market share. The

potential problems of such mergers are that consumers will have less choice
following the merger and that the market power of the merged business will lead
to an increase in consumer prices. For these reasons, governments often try to
ensure the interests of the consumer are protected when mergers resulting in a
significant market share are proposed.

 Underutilized resources

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A business may have poor management team that fails to exploit its full
potential. In this situation, there is an opportunity for a stronger management
team to be installed that would exploit more fully the resources of the
business. This argument is linked to what is sometimes referred to as the
market for corporate control. The term is used to describe the idea that mergers
and takeovers are motivated by teams of managers that compete for the right to
control business resources. The ‘market for corporate’ control ensures that
weak management teams will not survive and that, sooner or later, they will be
succeeded by stronger management teams. The threat of takeover however may
motivate managers to improve their performance. This suggests of course that
mergers and takeovers are good for the economy as they help to ensure that
resources are fully utilized and that shareholder wealth maximization remains
the top priority for managers.

 Complementary resources

Two businesses may have complementary resources that, when combined will
allow profits to be made which are higher than if the businesses operate as
single entities. By combining two businesses, the relative strengths of each
business will be brought together and this may lead to additional profits being
generated. It may be possible of course for each business to overcome its
particular deficiency and continue as a separate entity. Even so, it may still
make sense to combine.

 Surplus funds

A business may operate within an industry offering few investment

opportunities. In such a situation, the management may find that it has
surplus cash that is not earning a reasonable return. The solution to this
problem may be to invest in a new industry where there is no shortage of
profitable investment opportunities. By acquiring an existing business within

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the new industry, the necessary specialist managerial and technical ‘know how’
will be quickly acquired. This reason for mergers does not result in gains
arising for shareholders. However, mergers and takeovers may be motivated by
reasons that are difficult to justify in these terms. The following reasons for
combining fall within this category:

 Diversification

A business may decide to invest in another industry in order to reduce the level
of risk. You may recall in the previous chapters that we discussed the benefits
of diversification in dealing with the problem of risk. At first sight such a policy
may seem appealing. However, we must ask ourselves whether diversification
by management will provide any benefit to shareholders that the shareholders
themselves cannot provide more cheaply. It is often easier and cheaper for a
shareholder to deal with the problem of risk by holding a diversified portfolio of
shares than for a business to acquire another. It is quite likely that the latter
approach will be expensive, as a premium may have to be paid to acquire the
shares and external investment advisers and consultants may have to be
employed at a substantial cost.

QUESTION; Who do you think might benefit from diversification?

Diversification may well benefit the manager of the predator business. Managers
cannot diversify their investment of time and effort in the business easily. By
managing a more diversified business, the risks of unemployment and loss of
income for managers are reduced.

There may be circumstances however where shareholders are in similar position to

managers. For example owner-managers may find it difficult to diversify their time and

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wealth because they are committed to the business. In these particular circumstances,
there is a strong case for diversifying the business.

 Management interest and goals

Linked to the above points concerning the benefits of mergers to managers is

the argument that some mergers may be undertaken to fulfil the personal goals
or interests of managers.

Thus, managers may acquire another business simply to reduce the risk that
they face. Managers may also acquire another business to increase the amount
of resources that they control. The size of the business will often influence the
status, income and power that managers enjoy.

Although the support of shareholders will often be necessary for mangers to

acquire a new business, the shareholders are likely to rely heavily on
information that is supplied to them by their managers when making a
decision. If the managers are determined to pursue their own goals, the
shareholders may not receive all the information they require to make the
correct decision.

 Self Assessment 2-6

1. Identify and explain the rational for mergers

 Answer tips
1. Answer can be found in session 2.6

Session 3-6; FORMS OF PURCHASE CONSIDERATION

When a business wishes to purchase the shares of another, it can offer

payment in different ways. These are cash, shares in the bidding business and

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loan capital. Some combination of these methods may of course also be used.
Below we consider the advantages of each form of payment consideration from
the point of view of both the bidding business’s shareholders and the target
business’s shareholders.

3-6.1 Cash

Payment by cash means the amount of the purchase consideration will be both
certain and clearly understood by the target business’s shareholders. This may
improve the chance of a successful bid. It will also mean that shareholder
control of the bidding business will not be diluted as no additional shares will
be issued.

Raising the necessary cash, however can create problems for the bidding
business, particularly when the target business is large. It may only be
possible to raise the amount required by a loan or share issue or by selling off
assets, which the bidding business’s shareholders may not like. On occasions,
it may be possible to spread the cash payments over a period. However,
deferred payments are likely to weaken the attraction of the bid to the target
business’s shareholders.

The receipt of cash will allow the target business’s shareholders to adjust their
share portfolios without incurring transaction costs on disposal. However,
transaction costs will be incurred when new shares or loan capital are acquired
to replace the shares sold. Moreover, the receipt of cash may result in a liability
to capital gains tax (which arises on gains from the disposal of certain assets,
including shares).

3-6.2 Shares

The issue of shares in the bidding business as purchase consideration will

avoid any strain on its cash position. However, some dilution of existing
shareholder control will occur and there may also be a risk of dilution in
earnings per share. (Dilution will occur if the additional earnings from the

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merger divided by the number of new shares issued is lower than the existing
earning per share). The directors must ensure that the authorized share capital
of the business is sufficient to make new share issue and more importantly,
that the market value of the business’s shares does not fall during the course
of the takeover. A substantial fall in share price will reduce the value of the bid
and could undermine the chances of acceptance. The cost of this form of
financing must also be taken into account.

The target business’s shareholders may find a share-for-share exchange very

attractive. As they currently hold shares, they may wish to continue with this
form of investment rather than receive cash or other forms of security. A share-
for-share exchange does not result in a liability for capital gain tax because no
disposal is deemed to have occurred when this type of transaction take place.
The target shareholders will also have a continuing ownership link with the
original business, although it will now be part of a larger business. However,
the precise value of the offer may be difficult to calculate due to movements in
the share prices of the businesses.

3-6.3 Loan capital

Like the issue of shares, this is simply an exchange of paper and so it avoids
any strain on the cash resources of the bidding business. It has however
certain advantages over shares insofar that the issue of loan capital involves no
dilution of shareholder control and the service costs will be lower. A
disadvantage of a loan capita-for-share exchange is that it will increase the
gearing of the bidding business and, therefore the level of financial risk. The
directors of the bidding business must ensure that the issue of loan capital is
within its borrowing limits.

Loan capital may be acceptable to shareholders in the target business if they

have doubts over the future performance of the combined business. Loan
capital provides investors with both a fixed level of return and security for their

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investment. When a takeover bid is being made, convertible loan capital may be
offered as purchase consideration.

QUESTION; What is the attraction of this form of loan capital from the
point of view of the target business’s shareholders?

The issue of convertible loan capital would give target business shareholders a
useful hedge against uncertainty. This type of loan capital will provide relative
security in the early years with an option to convert to ordinary shares at a later
date. Investors will of course only exercise this option if things go well for the
combined business.

There may be various factors influencing the form of consideration used by

bidding businesses. Market conditions may be a critical factor. Research
evidence suggests that ordinary shares are more likely to be used following a
period of strong stock market performance. Recent high returns are seen as
making shares more attractive to investors. Accounting policies are also cited
as an important influence on the choice of bid consideration. There is also
evidence that businesses with good growth opportunities are more likely to use
ordinary shares when financing acquisitions. It seems that growth businesses
prefer to use ordinary shares as this form of financing is less constraining than
the issue of loan capital or the payment of cash.

Session 4-6; ASSESSING VULNERABILITY TO TAKEOVER

When a business is taken over, all those connected with the business are likely
to be affected. Shareholders, managers, employees, suppliers and others all
have a stake in the business and may stand to lose or gain by a change in
ownership. Predicting the likelihood of takeover should therefore be of interest
to these various stakeholder groups. Financial ratios can be used to predict the
likelihood of a takeover. In recent years, various studies have been carried out
to identify the particular characteristics that make a business vulnerable to

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takeover and predict the prospects of such an event. There studies have used
both univariate and multivariate analysis.

In the USA, a study by Palepu compared the financial characteristics of 163

acquired businesses during the period 1971-9 and group of 256 businesses
that were not acquired during the same period. The study found that the
acquired businesses exhibited the following characteristics;

 Lower average shares return over the four year period to takeover.
 Higher ‘growth-resource mismatch’.

The second characteristic mentioned requires some explanation. It means that

a business with either high growth and low resource or low growth and high
resources are more likely to be taken over as they will represent ‘good deals’.
Average sales growth, average liquidity and average gearing were used to
determine whether a growth a growth-resource mismatch had arisen. Thus,
where a business has either;

 Low average sales growth/high average liquidity/low average gearing or

 High average sales growth/low average liquidity/high average gearing,

a growth-resource mismatch will arise.

The study by Palepu also found that target businesses were generally smaller
than those that were not acquired and that they tended not to be in an
industry where acquisitions occurred in the previous year.

In the UK, Barnes developed a multivariate model to predict vulnerability to

takeover. The study matched 92 businesses that were taken over during the
period 1986-7 with 92 businesses that were not taken over and which were of
similar size and industry type. The actual ratios in relation to the industry
average were used as measures of vulnerability in the study. The study found
that the following five ratios could be used to classify businesses as either
acquired or not acquired with a level of accuracy of slightly more than 68%;

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  Acid test ratio
 Current ratio
 Return on shareholder funds
 Net profit before tax and
 Net profit after tax

It is interesting to note that the five key ratios include two liquidity ratios and
two profitability ratios. The weights given to each are not available as this is a
proprietary model.

4-6.1 Resisting a takeover bid

There are various reasons why a business may decide to defend against a
takeover bid. The managers may believe that it is in the best interest of
shareholders for the business to remain an independent entity as their wealth
would be adversely affected by a takeover. The managers may however, believe
it is in their best interest, rather than the shareholders, to resist a takeover.
They may feel their jobs were in jeopardy if a takeover occurred.

Studies have found that those businesses that successfully fended off hostile
bid have;

 Lower profitability, that is lower ROCE, ROSF AND profit margin

 Higher liquidity and
 Higher dividend payout

Although the findings of these studies are interesting, more research needs to
be carried out before a clear picture can emerge. In the long run, the most
successful way of defending against a hostile takeover bid is for managers to
demonstrate their ability to maximize shareholder wealth.

Defending against a takeover bid, however, need not imply that managers and
shareholders are committed to maintaining the business as an independent
entity. It may simply be a tactic to increase the premium bid, thereby, to

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increase shareholder wealth. Some studies have focused on this reason for
defending against a takeover bid. It seems that the particular type of defensive
tactics employed can have an influence on shareholder wealth. We shall
consider some of the defensive tactics that can be used later in the chapter.

4-6.2 Who benefits

At the time of a takeover, various economic benefits may be claimed in support

of two businesses combining. However, it is worth asking whether or not there
are benefits to be gained from this form of activity and, if so, which groups are
most likely to benefit?

Various studies have shown that shareholders in the target business are
usually the main beneficiaries. They are likely to receive substantial benefits
from a takeover through a premium on the share price.

QUESTION; Why might a bidding business be prepared to pay a premium

above the market value for the shares of a business?

Various reasons have been put forward to explain the phenomenon. They include
the following;

 The managers of the bidding business have access to information that is

not available to the market, which is therefore not reflected in the share
price.
 The managers of the business may simply misjudge value of the target
business
 The managers may feel that there will be significant gains arising from
combining the two businesses that are worth paying for. In theory, the
maximum price a buyer will be prepared to pay will be equivalent to the
present value of the business plus any gains from the merger.

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  ‘Management hubris’. Where there is more than one bidder or where the
takeover is being resisted, the managers of a bidding business may fail to
act rationally and may raise the bid price above an economically justifiable
level. This may be done in order to salvage management pride as they
may feel humiliated by defeat.

Share prices in the target business will usually reflect the bid premium for as
long as the bid is in progress. However, where a takeover bid is unsuccessful
and the bid withdrawn, the share price of the target business will usually
return to its pre-offer level.

Evidence concerning the effect of a takeover on the bidding business

shareholders provides more glooming news. Although early studies provided
some evidence that there was either a small increase or no increase in the
wealth of these shareholders, more recent studies suggest that, over the long
run, takeovers produce a significant decrease in shareholders wealth. Some
studies also suggest that conglomerate takeovers provide the worst form of
performance as indicated by both lower profitability and higher subsequent
see-offs of the acquired business.

QUESTION; Why might the bidding business’s shareholders lose wealth

as a result of a takeover of a target business? Can you think of two
reasons why this may be so?

Various reasons have been suggested. These include:

 Overpayment; The bidding business may pay too much to acquire the
target business. We saw earlier that large premiums are often paid to
acquire another business and this may result in a transfer of wealth from
the bidding business shareholders to the target business shareholders.
 Integration problems; Following a successful bid, it may be difficult to
integrate the target business’s operations. There may be problems
relating to organizational structure, key personnel, management style,

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 management rivalries, and so on, which work against successful
integration. These problems are most likely to arise in horizontal mergers
where an attempt is made to fuse the systems and operations of the two
separate entities into a seamless whole. There are likely to be fewer
problems where a conglomerate merger is undertaken and where there is
no real attempt to adopt common systems or operation.
 Management neglect; There is a risk that following the takeover,
managers may relax and expect the combined business to operate
smoothly. If the takeover has been bitterly contested, the temptation for
management to ease back after struggle may be very strong.
 Hidden problems; Sometimes, problems relating to the target business
are unearthed following the takeover. This is more likely to arise where a
thorough investigation is not carried out prior to the takeover.

In discussing who will be winners and losers in a merger or takeover, the

senior managers of the bidding business and the target business should also
be considered. Both groups of managers are important stakeholders in their
respective businesses and both groups have an important role to play in
takeover negotiations.

QUESTION; In relation to the senior managers of the bidding business

and the target business, who do you think will be the winners and
losers?

The managers of the bidding business are likely to be winners as they will
manage a larger business following the takeover that will usually result in
greater status, income and security. The position of senior managers in the
acquired business is less certain. In some cases, they may be retained and
may even become directors of the combined business. In other cases, however,
the managers of may lose their jobs (although compensations for loss of office
may be paid.

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 Finally, we should recognize that takeovers can be rewarding for the external
investment advisers and lawyers employed by the businesses involved.

4-6.3 Defensive Measures for a Takeover Bid

In some cases, a takeover bid will not be welcomed by the directors of the
target business. Various defensive measures may be used to reduce the risk
of takeover. Some of these measures must be put in place before receiving a
hostile bid whereas others can be deployed when the bid has been made.
Such measures include.

 Conversion to private company status; The directors of the target

business may recommend that the business converts to private limited
company status. This ‘pre-offer’ defense should make it more difficult
for a bidder to acquire the shares of the target business.
 Employee share option schemes; By encouraging employees to
acquire shares in the business, the proportion of shareholders that are
likely to resist takeover bids will be increased. This is a further
example of a pre-offer defense.
 Circularizing shareholders; When an offer has been received, the
directors of the target business will normally circularize shareholders.
In the circular, the directors might argue that it is either not in the
interest of the shareholders to accept the offer, or that the share price
offered is too low. In support of such arguments, the directors may
disclose hitherto confidential information such as profit forecasts,
future dividend payments, asset valuation, details of new contracts,
and so on.
 Making the business unattractive; The directors may take steps to
make the business unattractive to the bidder. In the colorful language
of mergers, this may involve taking a poison pill through the sale of
prized assets of the business (the crown jewels). Other tactics include
agreements to pay large sums to directors for loss of office resulting

104
 from a takeover (golden parachutes) and the purchase of certain
assets that the bidding business does not want.
 Pac-man defense; This involves the target business launching a
counterbid for the predator business. However, this tactic is difficult to
carry out where the target business is much smaller than the predator
business.
 White knight; A target business may avoid a takeover by an
unwelcome bidder by seeking out another business (a white knight)
with which to combine. This tactic will normally be used only as a
resort, however, as it will result in the loss of independence. There is
also a risk that the white knight will be less gallant after the merger
than was hoped.
 White squire: this is a variation of the white knight tactic mentioned
above. In this case, another business that is regarded as supportive
will purchase a block of shares in the target business that is big
enough to prevent any real prospect of a takeover but will not provide a
controlling interest. The white squire will usually be given some
incentive to ‘ride to the rescue’ of the target business. This might take
the form of a seat on the board or a discount on the price of the shares
purchased.

The management of the bidding business will also employ tactics to

overcome any resistance to the bid by the management or shareholders of
the target business. Thus the bidding business may circularize the
shareholders of the target business with information that counters any
claims made against the commercial logic of the bid or offer price. The
bidding business may decide to increase the offer price for the shares in
the target business in order to overcome resistance. In some cases, the
original offer price may be pitched at a fairly low level as a negotiation
ploy. The offer price will then be increased at a later date, thereby allowing

105
 the target business’s managers and shareholders to feel that they have
won some sort of victory.

 Self Assessment 4-6

1. Briefly describe four defences that could be used by a company after

its board has received a takeover bid.

 Answer tips
1. Answer could be found in 4-6.3

SESSION 5-6; DIVESTMENT AND DEMERGERS

In recent years, we have seen a number of businesses divesting

themselves of particular business operations rather than acquiring them.
The divestment or sell-off of business operations may be undertaken for
various reasons. Sometimes, it will arise in response to particular
problems experienced by the business. An example of this is where a
business is short of cash or too highly geared and management decides to
improve the liquidity or gearing by realizing certain assets. A further
example is where a business is vulnerable to a takeover and decides to
take pre-emptive action by selling its ‘crown jewels’.

On some occasions, the decision to divest may be taken because the

business has reviewed its strategic plans and has decided that certain
operations of the business are no longer compatible with its objectives. In
recent years, for example many businesses have decided to focus on what
they regard as their core activities rather than be diversified. As a result,
‘non-core’ operations are sold off. In some cases, the managers decide to
sell off part of the business to enable a more profitable use of resources.

106
 This may arise when the performance of the particular business
operations has been disappointing.

When a sell-off is undertaken, the managers of the particular business

operations may bid to become the new owners. If their bid is successful,
the purchase arrangement is referred to as a management buy-out.
Management buy-outs are often financed by venture capital organisations
that may acquire a shareholding in the business.

In some cases, a group of managers from outside the business may make
a successful bid to become the new owners of the business operations.
When this occurs, it is referred to as a management buy in. Once again,
venture capital organizations will often help to finance this purchase
arrangement.

Rather than selling off business operations to a third party, they may be
transferred to a new business. In this case, the ownership of the business
operations will not be changed as the shareholders will be given shares in
the newly created business. The distribution of shares in the new
business is usually made in proportion to shareholdings in the existing
business. This kind of restructuring is referred to as a demerger or spin-
off.

 Self Assessment 5-6

1. Differentiate between management buy-out and management buy-in

 Answer tips
1. Answer can be found in session 5-6 paragraphs 3 and 4.

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 Learning Track Activities

 Unit Summary
1. We have explored the various aspects of mergers and takeovers, and
also examined the reasons for takeovers and saw that not all those put
forward can be justified in economic terms.

2. We also identified the various forms of purchase considerations that

might be used in a takeover and considered their advantages and
disadvantages.

3. We discussed who might benefit from a takeover and concluded that it

is often the bidding business’s shareholders who will gain the most

 Key terms/ New Words in Unit

1. Merger

2. Takeover

3. Demerger

4. White squire

 Review Question: Distinguish between a merger and a

 takeover. What is the significance of this distinction?

  Discussion Question: When a business wishes to

acquire another business, it may make a bid in the form of
cash, a share-for-share exchange or a loan capital-for share
exchange. Discuss the advantages and disadvantages of each
form of purchase consideration from the viewpoint of;

108
 i. the bidding business’s shareholders
ii. the target business’s shareholders.

Course Summary
ACF 361, Business Finance formed the foundation for ACF 362, Corporate
Finance.

In Unit 1, we introduced the three A’s of financial management, what Financial

management entails, how the type of Business Organisation affects financial
management decisions and an overview of the Financial system in Ghana.

109
In Unit 2, we focussed on how the cost of the various sources of capital
employed by a Business can be calculated. We discussed how to calculate the
cost of ordinary shares, preference shares, debt or loan capital as well as
redeemable and irredeemable bonds. Finally, we discussed the weighted
average cost of capital.

In Unit 3, we discussed how the capital asset pricing model (CAP-M) is used to
determine the cost of equity. We explained how risk is estimated under the
CAP-M by using beta values and how the risk free rate is also estimated.

In Unit 4, we discussed the debate on capital structure decisions. The two

schools of thought on capital structure, that is, traditional school and
modernists schools and their implications for financial management have been
explained.

In Unit 5, we discussed the different views on dividend policy and their

implications for the contemporary manager.

Finally, in Unit 6 we discussed Mergers and Acquisitions, the different types of

mergers and acquisitions, the rationale for mergers and the defensive measures
that companies can employ to resist a takeover bid.

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