Financial Management

Professional Level
Course Notes
For exams in 2016

1 Chapter 1: Tax implications

 ISBN 9781472792969
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2
CONTENTS
Course Study Study
Note Manual Manual
Page Chapter Page

Introduction

1. Investment decisions 5 1, 2 1
Objectives 7 1 3
Investment Appraisal 10 2 17
Specific Investment Appraisal Scenarios 28 2 34

2. Risk and decision making 57 3 101

Investment Appraisal and Risk 59 3 103
Capital Asset Pricing Model 70 3 115

3. Managing financial risk 81 9 383

Addressing Risk 83 9 385
Interest Rate Risk 94 9 399

4. Currency risks 119 10 433

Exchange Rates 121 10 435
Currency Hedging 131 10 446

5. Financing decisions 153 4, 8 149

Capital Markets 155 4 151
Forecasting 167 8 335

6. Cost of capital 191 5 191

Cost of Equity 193 5 193
Cost of Debt 203 5 201
WACC 210 5 206

7. Capital structure 223 6, 7 249

The Effect of Gearing 225 6 251
Returns to Shareholders 238 7 291

8. Business valuation and restructuring 251 8 317

Business Valuation 253 8 317
Restructuring 266 8 330

Appendix 275

Contents 3
 MODULE AIM
To enable candidates to recommend relevant options for financing a business, recognise
and manage financial risks and make appropriate investment decisions.
On completion of this module, candidates will be able to:
 Identify capital requirements of businesses, assess financing options and
recommend relevant methods of financing
 Identify the financial risks facing a business and the principal methods of managing
those risks
 Apply appropriate investment appraisal techniques taking into account other
factors affecting investment decisions

SYLLABUS OVERVIEW
Weighting
(%)
Financing options 35
Managing financial risk 30
Investment decisions and valuation 35
100

EXAM FORMAT
Your exam will consist of one part consisting of long form written test questions worth
100 marks.
The exam may consist of three or four questions.
Time available 2.5 hours.

4 Introduction
 1
INVESTMENT DECISIONS

Learning Objectives
 To explain the general objectives of financial management
 To explain the roles played by different stakeholders in the financial strategy
selected by a business
 To explain the decision making process
 To select and justify investment appraisal techniques
 To choose appropriate values for use in investment appraisal
 To take account of tax and inflation
 To recommend and justify a course of action based on the results of investment
appraisal
 To consider relevant non-financial factors, including the limitations of the
techniques

Exam Requirement
In the exam, you may be required to discuss the likely objectives of various stakeholders
and comment upon how conflicting objectives might be reconciled.
You may be asked to set out the relevant cash flows of a decision, including tax and
inflation effects, decide whether or not to make an investment, and to discuss the
financial and non-financial issues surrounding it.

Math Tables 5
 TOPIC OVERVIEW

6 Topic 1: Investment decisions

OBJECTIVES
WHAT IS FINANCIAL STRATEGY?
For a profit making company, maximisation of shareholder wealth is assumed to be
the financial objective.
Investment
decisions

Financing Dividend
decisions decisions

Investment decisions (in projects or takeovers) need to be analysed to ensure they

are beneficial to the investor.
Financing decisions mainly focus on how much debt a firm should use, and aim to
minimise the cost of capital.
Dividend decisions concern whether or not a firm should pay a dividend and, if one is
to be paid, how much that dividend should be.
An important aspect of all three decisions is the issue of how risky or uncertain each
decision might actually be to an entity as well as the uncertainties raised by how these
decisions interact with each other.

STAKEHOLDERS

Objectives, stakeholders and conflicts

STAKEHOLDERS
Requirement
Many decisions in financial management are taken in a framework of conflicting
stakeholder viewpoints. Identify the stakeholders and some of the financial management
issues involved in the following situations:
a) A private company converting into a public company.
b) A highly geared company, such as Eurotunnel, attempting to restructure its capital.
c) A large conglomerate 'spinning off' its numerous divisions by selling them, or
setting them up as separate companies (eg, Hanson).
d) Japanese car-makers, such as Nissan and Honda, building new car plants in other
countries.

Topic 1: Investment decisions 7

 SOLUTION

Agency theory and managerial objectives

One of the most important of these potential conflicts is between shareholders
(principals) and directors (agents). Shareholders employ directors to run the entity on
their behalf, which can lead to conflicts. Eg, remuneration decisions or not
recommending the best option for shareholders because it would lead to the board’s
dismissal.

Ethical considerations
Directors/managers (and shareholders) are often faced with ethical considerations in
setting objectives and making financial decisions, for example:
 Increasing profits by using foreign child labour
 Polluting the environment or using non-renewable energy because it is cheaper
 Exploiting superior (inside) information
A firm's value can depend very much on its reputation. Some businesses explicitly
state their ethical principles in order to distinguish themselves, eg, Body Shop
(animal testing), Co-op (fair trade).

8 Topic 1: Investment decisions

SUMMARY

Topic 1: Investment decisions 9

 INVESTMENT APPRAISAL
INVESTMENT APPRAISAL TECHNIQUES
Summary of techniques
Payback The time taken for cash inflows from a project to equal the cash outflows.

The decision rule: accept if payback < target

Accounting rate of Average annual profit from investment
return ARR = ×100
Initial investment
Average annual profit from investment
or ×100
Average investment
Initial outlay  Scrap value
where average investment =
2
Note: profit is after depreciation

The decision rule: accept if ARR > target

Net present value The maximum an investor would pay for a given set of cash flows (at
his/her cost of capital) compared to the actual amount he/she is being
asked to pay.
The difference, the NPV, represents the change in wealth of the
investor as a result of investing in the project.

The decision rule: accept if NPV is +ve (usually)

Internal rate of A cost of capital at which the NPV of a project is £0.
return IRR is usually found via interpolation using two discount rates.
NPVa
IRR = a + (b–a)
NPVa – NPVb
Where a is the lower discount rate giving NPVa
b is the higher discount rate giving NPVb

The decision rule: accept if IRR % > cost of capital (usually)

10 Topic 1: Investment decisions

 REVISION OF BASIC TECHNIQUES
A company is considering expanding its business. The expansion will cost £350,000
initially for the premises and a further £150,000 to refurbish the premises with new
equipment. Cash flow projections from the project show the following cash flows over
the next six years.
Year Net cash flows
£
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the same period and, after
the sixth year, it is expected that the new business could be sold for £350,000.
Requirements
Calculate
a) The payback period for the project
b) The ARR (using the average investment method)
c) The NPV of the project. Assume the relevant cost of capital is 12%
d) The IRR of the project

SOLUTION

Topic 1: Investment decisions 11

 RELEVANT CASH FLOWS

The relevant cash flows are future, incremental, cash flows arising from the decision
being made.

The figures put into the NPV working must be relevant to the decision being
considered.
 Cash flows only – eg depreciation should be ignored
 Future amounts – questions might refer to costs which have already been
incurred
 Directly relevant – ignore costs that are allocated (eg overheads) and which
would be incurred with or without the project
 Finance related cash flows – normally excluded from project appraisal exercises
because the discounting process takes account of the cost of capital
 Opportunity costs – include costs incurred or revenues lost from diverting
existing resources from their existing use eg lost contribution

The opportunity cost of a resource may be defined as the cash flow forgone if a unit
of the resource is used on the project instead of in the best alternative way.

12 Topic 1: Investment decisions

The relevant cost of materials can be found using the following diagram:

Not in stock In stock

In constant use No other use Scarce

Have to buy If use, must If use, no need If use, cannot

replace to replace replace

Relevant cost is…

Current Current Current resale Opportunity

replacement replacement value / scrap cost
cost cost value lost

RELEVANT COST OF MATERIAL

A new contract requires the use of 50 tonnes of metal ZX 81. This metal is used regularly
on all the firm's projects. At the moment there are in inventory 100 tonnes of ZX 81,
which were bought for £200 per tonne. The current purchase price is £210 per tonne,
and the metal could be disposed of for net scrap proceeds of £150 per tonne.
Requirement
With what cost should the new contract be charged for the ZX 81?

SOLUTION

Topic 1: Investment decisions 13

 The relevant cost of labour and variable overheads can be found using the
following diagram:

Current workforce

Spare capacity Full capacity

Workforce No workforce
available for hire available

Relevant cost is…

Nil labour cost plus Current rate of Opportunity cost

variable overhead only pay plus extra
(if any) variable overhead
incurred

RELEVANT COST OF LABOUR

A mining operation uses skilled labour costing £8 per hour, which generates a
contribution of £6 per hour, after deducting these labour costs.
A new project is now being considered which requires 5,000 hours of skilled labour.
There is a shortage of the required labour. Any used on the new project must be
transferred from normal working.
Requirement
What is the relevant cost of using the skilled labour on the project?

SOLUTION

14 Topic 1: Investment decisions

 RELEVANT COSTS
A research project, which to date has cost the company £150,000, is under review.
If the project is allowed to proceed it will be completed in approximately one year, when
the results are to be sold to a government agency for £300,000.
Shown below are the additional expenses which the managing director estimates will be
necessary to complete the work:
Materials. This material has just been purchased at a cost of £60,000. It is toxic; if not
used in this project, it must be disposed of at a cost of £5,000.
Labour. Skilled labour is hard to recruit. The workers concerned were transferred to the
project from a production department, and at a recent meeting the production manager
claimed that if these people were returned to him they could generate sales of £150,000
in the next year. The prime cost of these sales would be £100,000, including £40,000 for
the labour cost itself. The overhead absorbed into this production would amount to
£20,000.
Research staff. It has already been decided that, when work on this project ceases, the
research department will be closed. Research wages for the year are £60,000, and
redundancy and severance pay has been estimated at £15,000 now, or £35,000 in one
year's time.
Equipment. The project utilises a special microscope which cost £18,000 three years
ago. It has a residual value of £3,000 in another two years and a current disposal value
of £8,000. If used in the project it is estimated that the disposal value in one year's time
will be £6,000.
Share of general building services. The project is charged with £35,000 per annum
to cover general building expenses. Immediately the project is discontinued, the space
occupied could be sub-let for an annual rental of £7,000.
Requirement
Advise the managing director as to whether the project should be allowed to proceed,
explaining the reasons for the treatment of each item.
(Note: Ignore the time value of money.)

SOLUTION

Topic 1: Investment decisions 15

 Deprival value

DEPRIVAL VALUE
A company has a printing press which needs to be used on a new contract.
The press could be sold for £1,000 or made use of to service the needs of existing
customers for business which has a value (in present value terms) of £1,500.
Requirements
a) What is the opportunity cost of using the machine on a new contract?
b) If the printing press could be replaced at a cost of either:
i) £800
ii) £1,800
What would the relevant cost be?

SOLUTION

16 Topic 1: Investment decisions

This can be summarised as follows:

Deprival value

= lower of

Replacement cost and Recoverable amount

ie the cost of replacing = higher of

the asset with one of a
similar age and Value in use/ Net realisable
condition and
Economic value

ie the present value ie the asset's worth if

of the cash generated it were to be sold,
from using the asset net of selling costs

QUOTATION FOR A CONTRACT

RFT, an engineering company, has been asked to provide a quotation for a contract to
build a new engine. The potential customer is not a current customer of RFT, but the
directors of RFT are keen to try and win the contract as they believe that this may lead
to more contracts in the future. As a result they intend pricing the contract using relevant
costs.
The following information has been obtained from a two-hour meeting that the
Production Director of RFT had with the potential customer. The Production Director is
paid an annual salary equivalent to £1,200 per 8-hour day.
110 square metres of material A will be required. This is a material that is regularly used
by RFT and there are 200 square metres currently in inventory. These were bought at a
cost of £12 per square metre. They have a resale value of £10.50 per square metre and
their current replacement cost is £12.50 per square metre.
30 litres of material B will be required. This material will have to be purchased for the
contract because it is not otherwise used by RFT. The minimum order quantity from the
supplier is 40 litres at a cost of £9 per litre. RFT does not expect to have any use for any
of this material that remains after this contract is completed.
60 components will be required. These will be purchased from HY. The purchase price is
£50 per component.
A total of 235 direct labour hours will be required. The current wage rate for the
appropriate grade of direct labour is £11 per hour. Currently RFT has 75 direct labour
hours of spare capacity at this grade that is being paid under a guaranteed wage
agreement. The additional hours would need to be obtained by either (i) overtime at a
total cost of £14 per hour; or (ii) recruiting temporary staff at a cost of £12 per hour.
However, if temporary staff are used they will not be as experienced as RFT’s existing
workers and will require 10 hours supervision by an existing supervisor who would be
paid overtime at a cost of £18 per hour for this work.
25 machine hours will be required. The machine to be used is already leased for a
weekly leasing cost of £600. It has a capacity of 40 hours per week. The machine has
sufficient available capacity for the contract to be completed. The variable running cost
of the machine is £7 per hour.

Topic 1: Investment decisions 17

 The company absorbs its fixed overhead costs using an absorption rate of £20 per direct
labour hour.
Requirement
Calculate the relevant cost of building the new engine and explain the reasons for the
treatment of each item.

SOLUTION

18 Topic 1: Investment decisions

WORKING CAPITAL
Projects need funds to finance the level of working capital required. The relevant cash
flows are the incremental cash flows from one year’s requirement to the next. At the
end of the project, the full amount will be released. There is no tax effect.

WORKING CAPITAL
Gorgon plc expects the following sales from a new project over its three-year life:
£
t1 150,000
t2 175,000
t3 200,000
Working capital equal to 10% of annual sales is required and it needs to be in place at
the start of each year.
Requirement
Calculate the working capital cash flows.

SOLUTION

TAXATION

Effects
Taxation has two effects in investment appraisal, both giving rise to relevant cash flows:
 Tax payments (benefits) on operating profit (losses)
 Tax benefit from capital allowances on capital expenditure

Topic 1: Investment decisions 19

 Capital allowances (CAs)
This is Her Majesty's Revenue and Customs’ (HMRC’s) version of depreciation.
Unless otherwise stated:
 Calculate capital allowances (CAs) at 18% on a reducing balance basis.
 There is no CA in the year of sale; a balancing allowance/charge is calculated
instead.

Other assumptions
 Although large companies make tax payments in four equal instalments during the
accounting year, for examination purposes the whole tax payment is
assumed to be made at the end of the year to which it relates.
 For examination purposes corporation tax is assumed to be paid at 21%.
 The tax rate can be assumed to be constant over the life of the project (unlikely
in practice).
 It should be assumed that working capital flows have no tax effects.

CAPITAL ALLOWANCES
Happy plc bought a machine for £10,000 on 31 December 20X1, its accounting year end.
The asset generated cash flows of £7,000 pa. It sold the asset on 31 December 20X3 for
£2,000.
20X1 20X2 20X3

Acquired Disposed
The company pays tax at 21%. Capital allowances are available at 18% on a reducing
balance basis.
Requirements
a) Calculate the net cash flows for the project.
b) Recalculate the tax relief on the capital allowances if the asset is now purchased
on 1 January 20X2.

20 Topic 1: Investment decisions

 SOLUTION

TAXATION
A company has 31 December as its accounting year end. On 1 January 20X5 a new
machine costing £2,000,000 is purchased. The company expects to sell the machine on
31 December 20X6 for £300,000.
The rate of corporation tax for the company is 21%. Writing down allowances are
obtained at 18% on the reducing balance basis, and a balancing allowance is available
on disposal of the asset. The company makes sufficient profits to obtain relief for capital
allowances as soon as they arise.
If the company's cost of capital is 15% per annum, what is the present value of the
capital allowances at 1 January 20X5?

Topic 1: Investment decisions 21

 SOLUTION

INFLATION

Real and money (or nominal) rates

The rates of interest that would be required in the absence of inflation in the economy
are referred to as the real rates of interest.
Money rates, real rates and general inflation (CPI) are linked by the following:

(1 + m) = (1 + r)  (1 + i) This is often referred to as the Fisher Equation

where m = money (nominal) rate

r = real (effective) rate
i = general inflation rate

Discounting
Money method ('money @ money')
 Adjust the individual cash flows, eg sales/revenue, materials, labour using their
specific inflation rates to convert to money cash flows, ie the flows which will
actually occur.
 Discount these money flows using the money rate, ie the rate of interest which
will actually occur.

22 Topic 1: Investment decisions

This is the simplest technique. Use wherever possible unless a question directs
otherwise.
Real method ('real @ real')
 Remove the effects of general inflation from money cash flows to generate real
cash flows
 Discount using real rate
Although this achieves the same NPV as the money method, it is often very long winded
and would only be useful in a question where the real flows and interest rate were
already given. It should not be used in situations where the scrap value of an asset is
given at the end of the project life, as we are unable to determine the pre-inflation or
real value with any confidence.

Practical considerations
 General inflation may not be constant
 Longer term estimates become more prone to error

INFLATION
Project Invest £10,000 at t0 in new plant and equipment
Returns £5,000 pa in current terms for three years, inflating at 7% pa
Money rate of interest is 10%
Requirement
Calculate the project's NPV using the money method and the real method.

SOLUTION

Topic 1: Investment decisions 23

 NPV Proforma
The following proforma summarises the topics dealt with so far and provides a layout for
NPV calculations useful in 95%+ of situations:
t0 t1 t2 t3
£ £ £ £
Operating cash flows
Adjust for inflation X X X
Sales/revenue
Include only relevant cash flows costs (X) (X) (X)
Net X X X
Tax (X) (X) (X)
Asset
Purchase (X)
Scrap X
Tax on WDAs X X X X
Working capital (X) (X) (X) X
Net flows (X) X X X
* Discount factor 1 X X X
PV of cash flows (X) X X X
PV = NPV
* Use discount factors for the after-tax cost of capital. The formula (1+r) -n can be
used to calculate discount factors for ‘n’ periods if rate ‘r’ is not on the discount
table.

NET PRESENT VALUE

Shaw Security Systems plc, a company financed by a mixture of equity and debt capital,
manufactures devices which seek to deter the theft of motor vehicles. The company's
development department has recently produced a new type of anti-theft device. This
device, which will be known as an Apollo, will be fitted to private motor vehicles. The
Apollo emits an electronic signal which can be picked up by an electronic sensor fitted to
police cars, enabling the police to locate stolen cars and, possibly, apprehend the thief.
Development costs totalled £500,000. These were all incurred in 20X5.
A decision now needs to be taken as to whether to go ahead with producing and
marketing Apollos. This is to be based on the expected net present value of the relevant
cash flows, discounted at the company's estimate of the 20X5 weighted average cost of
capital of 8% (after tax). The company's management believes that a three year
planning horizon is appropriate for this decision, so it will be assumed that sales will not
continue beyond 20X8.
Following discussions with a number of police forces, the company has reached
agreement that, if it decides to go ahead with the project, one of the Midland forces will
trial the Apollo system, and the sensors will be fitted to its police cars.
The cost of providing and fitting the sensors to the police cars would be borne by the
company, which would retain ownership. The police force would bear the cost of
maintenance. The sensors would be manufactured and fitted by a sub-contractor, who
has offered to do this work by the end of 20X5 for a total cost of £1 million, payable
immediately on completion of the work. This cost would attract the normal capital
allowances for plant and equipment at 18% reducing balance. If the company were to

24 Topic 1: Investment decisions

make the investment, it would elect for the sensors to be treated as a short-life asset. At
the end of three years the sensors would be scrapped.
The first sales of Apollos would be expected to be made during the year ending 31
December 20X6. There is uncertainty as to the level of sales which could be expected, so
a market survey has been undertaken at a cost of £100,000.
The survey suggests that, at the company's target ex-works price of £200 per Apollo,
there would be a 60% chance of selling 10,000 Apollos and a 40% chance of selling
12,000 during 20X6.
If the 20X6 sales were to be at the lower level, 20X7 sales would be either 8,000 Apollos
(30% chance) or 10,000 (70% chance). If 20X6 sales were to be at the higher level,
20X7 sales would be estimated at 12,000 Apollos (50% chance) or 15,000 (50%
chance).
20X8 sales would be expected to be 50% of whatever level of sales were to occur in
20X7.
Sales of Apollos would be expected to have an adverse effect on sales of the Mercury, a
less sophisticated device produced by the company, to the extent that for every two
Apollos sold one less Mercury would be sold. This effect would be expected to continue
throughout the three years.
Materials and components would be bought in at a cost of £70 per Apollo. Manufacture
of each Apollo would require three hours of labour. This labour would come from staff
released by the lost Mercury production. To the extent that this would provide
insufficient hours, staff would work overtime, paid at a premium of 50% over the basic
pay of £6 an hour.
The Mercury has the following cost structure.
£ per unit
Selling price (ex-works) 100
Materials 20
Labour (4 hours) 24
Fixed overheads (on a labour hour basis) 33
The management team currently employed by the company would be able to manage
the Apollo project except that, should the project go ahead, four managers, who had
accepted voluntary redundancy from the company, would be asked to stay until the end
of 20X8. These managers were due to leave the company on 31 December 20X5 and to
receive lump sums of £30,000 each at that time. They were also due to receive an
annual fee of £8,000 each for consultancy work, which the company would require of
them from time to time. If they were to agree to stay on, they would receive an annual
salary of £20,000 each, to include the consultancy fee. They would also receive lump
sums of £35,000 each on 31 December 20X8. It is envisaged that the managers would
be able to fit any consultancy requirements round their work managing the Apollo
project. These payments would all be borne by the company and would qualify for full
tax relief.
Apollo production and sales would not be expected to give rise to any additional
operating costs beyond those mentioned above.
Working capital to support both Apollo and Mercury production and sales would be
expected to run at a rate of 15% of the ex-works sales value. The working capital would
need to be in place by the beginning of each year concerned. There would be no tax
effects from changes in the level of working capital.

Topic 1: Investment decisions 25

 The company's accounting year end is 31 December. Sales should be assumed to occur
on the last day of the relevant year. The company's corporation tax rate is expected to
be 21% throughout the planning period. Tax cash flows occur at the end of the
accounting period to which they relate.
Requirement
Prepare a schedule which derives the annual expected net cash flows from the Apollo
project, and use it to assess the project on the basis of its expected net present value.

Ignore inflation.
Work to the nearest £1,000.

SOLUTION

26 Topic 1: Investment decisions

SUMMARY

Topic 1: Investment decisions 27

 SPECIFIC INVESTMENT APPRAISAL
SCENARIOS

REPLACEMENT ANALYSIS

Asset replacement
The requirement is to decide how often a new asset should be replaced. Where decisions
are repeatable, NPVs cannot easily be compared.
When cash flows do not inflate, the quickest way to determine the optimal replacement
cycle is to calculate the equivalent annual cost (EAC).

NPV of one cycle of replacemen t

EAC =
AF for this cycle length

EAC calculates an annuity. This annuity is an equivalent of money payable each year of
the asset's life.

REPLACEMENT CYCLE
A company requires a new machine on a regular basis. The following information is
available.
The new machine costs £30,000.

Year Running costs Resale value at end of year

1 £3,000
2 £4,000 £7,000
3 £5,000 £4,000
The company's cost of capital is 15%.
Requirement
Identify the optimal replacement cycle of the new asset. Ignore taxation and inflation.

SOLUTION

28 Topic 1: Investment decisions

Lowest common multiple approach
When cash flows inflate, EAC cannot be used as an annuity cannot exist. To calculate the
optimal replacement cycle now, the lowest common multiple is needed.
Assume that the costs in the previous example are expressed in current prices and
inflation is expected to be 5% per annum for running costs and 7% per annum for
machine prices.
The lowest common multiple is 2 years  3 years = 6 years
Replace every 2 years (3 cycles)
0 1 2 3 4 5 6
Machine
purchase
30,000 x 1.07n (30,000) (34,347) (39,324)
Running costs
3,000 x 1.05n (3,150) (3,473) (3,829)
4,000 x 1.05n (4,410) (4,862) (5,360)
Resale
7,000 x 1.07n 8,014 9,175 10,505
Net cash flow (30,000) (3,150) (30,743) (3,473) (35,011) (3,829) 5,145
DF 15% 1 0.870 0.756 0.658 0.572 0.497 0.432
PV (30,000) (2,741) (23,242) (2,285) (20,026) (1,903) 2,223
NPV £(77,974)

This would then be compared with the option to replace every 3 years and the cheapest
option chosen.

REPLACEMENT ANALYSIS
Cern has an annual cost of capital of 10%. One of its most successful products is
Hadtone, a mortar colouring agent. Hadtone is made using a single processing machine
which mixes the raw ingredients and dispenses the completed product into five-litre
cartons.
A five-litre carton of Hadtone sells for £12.00 and estimated maximum annual demand at
this price is 300,000 cartons. At this level of demand, Cern can justify the operation of
only one processing machine, which Cern currently replaces every three years, although
the processing machine has a productive life of four years.
In the first year of its life the processing machine has a productive capacity in line with
the maximum annual demand for the product, but each year thereafter this productive

Topic 1: Investment decisions 29

 capacity falls at a rate of 15,000 units pa. Annual maintenance costs in the first year of
operating the processing machine are estimated at £12,000. Thereafter, the directors
expect the annual maintenance costs to increase by £2,000 pa regardless of the actual
number of five-litre cartons produced. Cern incurs variable costs, excluding depreciation
and maintenance costs, of £8.00 in producing each five-litre carton. Cern provides for
depreciation on all its non-current assets using the straight-line method.
If Cern were to dispose of the processing machine after one year, the directors estimate
sale proceeds of £320,000, but these would fall by £120,000 pa in each of the following
two years. Once the machine has reached the end of its four-year productive life its
residual value will be £10,000.
Following a recent increase in the cost of a processing machine to £480,000, Cern’s
directors are reconsidering their current replacement policy with a view to maximising
the present value of the company’s cash-flows. It can be assumed that all revenues and
costs are received or paid in cash at the end of the year to which they relate, with the
exception of the initial price of the processing machine which is paid in full at the time of
purchase.
Requirement
Assuming that the processing machine is used to maximum capacity, and showing all
your supporting calculations, advise Cern’s directors how often they should replace the
processing machine.
Note: Ignore inflation and taxation.

SOLUTION

30 Topic 1: Investment decisions

CAPITAL RATIONING

Capital rationing is the situation where insufficient funds exist to undertake all positive
NPV projects, so a choice must be made between projects.

Two types of rationing

 Hard rationing – external limits exist on funds available (eg caps on borrowing,
covenants)
 Soft rationing – internal constraints are imposed (eg budgets or policy amounts)

Single period rationing (divisible projects)

Projects are ranked by NPV per £ capital outlay in the rationed period ('profitability
index'). Divisible projects can be fully or partially completed (eg a housing development
can be scaled back to fit the land available, or a musical tour can be curtailed to
accommodate changes in venue).
The most profitable project by this measure is then completed first, with any spare funds
used for the next most profitable and so on until all capital is allocated.

CAPITAL RATIONING (1)

A business has £50,000 available at t0 for investment.
Four divisible projects are available:
Project NPV Funds required at t0
£ £
A 100,000 (50,000)
B (50,000) (10,000)
C 84,000 (10,000)
D 45,000 (15,000)
Requirement
Which project(s) should be undertaken?

SOLUTION

Topic 1: Investment decisions 31

 Indivisible projects
In some circumstances, a project must either be completed in full or not at all – you
would not consider building an ocean liner with its bows intact but no stern.
In such cases, there is no definitive rule so trial and error is used to determine the most
profitable combination of projects.

Mutually exclusive projects

Some project combinations might not be possible due to certain projects being mutually
exclusive – it is not possible to undertake them both simultaneously – again trial and
error alongside the techniques included here is used to select the best combination.

Project synergy
So far projects have been considered independently. It may be the case that by
undertaking certain combinations of projects, some synergy (extra NPV) is created, eg
from cost savings.

CAPITAL RATIONING (2)

A company has identified a number of independent investment projects, each of which
lasts two years. It is estimated that the cash flows and net present values of the projects
are as follows:
Time NPV
t0 t1 t2
£ £ £ £
Project H (500) +250 +260 (49)
Project I (2,000) +1,500 +1,500 +603
Project J +500 +650 (1,250) +58
Project K +350 (750) +375 (22)
Project L (1,000) +600 +1,200 +537
Cash flows in t1 and t2 occur at the end of each year, and t0 is the immediate
inflow/outflow. Inflows from one project can be used to finance outflows for another
project in the same period.
Requirement
If the cash available for investment projects at t0 is limited to £2,850 and projects are
indivisible, what is the maximum net present value that could be generated from
projects?

SOLUTION

32 Topic 1: Investment decisions

 CAPITAL RATIONING (3)
WIDGET is a listed group which operates a number of manufacturing facilities. It has
£700 million funds available for capital investment in new product lines in the current
year. Most products have a very limited life cycle. Four possible projects have been
identified, each of which can be started without delay.
Initial calculations for these projects are shown below:
Project Initial Net annual Project PV of cash NPV
investment cash term flows (£ million)
(£ million) inflows (years) arising after
after the the initial
initial investment
investment (£ million)
(£ million)
A 100 151.2 1 135 35
B 150 82.3 4 250 100
C 300 242.6 2 410 110
D 350 124.0 6 510 160
Notes:
1. The projects are independent, non-divisible and each project can only be
undertaken once.
2. Apart from the initial investment, annual cash flows are assumed to arise at the
end of the year.
3. A discount rate of 12% has been used throughout.
4. Ignore taxation.
Requirement
(a) (i) Prioritise the projects according to each of the following measures:
• Net present value (NPV)
• Profitability index (PI)
• Payback (undiscounted)
(ii) Explain the strengths and weaknesses of each of the prioritisation methods
used in (a)(i) above as the basis for making investment decisions in the
context of capital rationing for non-divisible projects.
(b) (i) Advise what combination of projects maximises shareholder wealth within a
maximum total initial investment of £700 million.
(ii) Explain how the optimal combination of projects would need to be
reassessed under EACH of the following circumstances:
• 'Soft’ rather than ‘hard’ single period capital rationing applies.
• The same level of capital rationing and range of projects is expected in
the following year.

Topic 1: Investment decisions 33

 SOLUTION

34 Topic 1: Investment decisions

PROJECT GENERATION, DECISION MAKING AND CONTROL

Analyse the current position of the business by examining the

external (eg competitors) and internal (eg human resources)
environment. Normally summarised by SWOT analysis (strengths,
weaknesses, opportunities, threats)

Determine mission and objectives

(assumed to be wealth maximisation)

Identify and select strategies (eg

new products, new markets)

Implement and control

SHAREHOLDER VALUE ANALYSIS

Shareholder value analysis (SVA) is the process of analysing the activities of a

business to identify how they will result in increasing shareholder wealth.

The main purpose of SVA is to highlight seven key drivers of value, enabling managers
to set targets for achieving value enhancing strategies:

1. Sales growth rate An entity will always look to increase sales volumes as
extra sales mean greater contribution and profit, leading
to increased shareholder wealth.
2. Operating profit Value can be enhanced by removing non value-adding
margin activities, thus saving unnecessary costs and increasing
operating profits.
3. Corporation tax rate This is a marginal area of impact on wealth creation, as
directors frequently do not have much impact on this.
4. Investment in non- Shareholder value is about finding the right balance
current assets between investment to maintain operating ability and
wealth creation but avoiding unnecessary expenditure on
capacity. Directors’ remuneration is frequently linked to
such a measure by means of ratios such as ROI or ROCE.
5. Investment in Value is created by increasing operating activity and
working capital hence profits without extending the operating cycle. This
is usually achieved by adopting lean principles such as
just in time (JIT) and effective credit control to encourage
early payment.

Topic 1: Investment decisions 35

 6. Cost of capital Value is by definition enhanced if cheaper long term
finance is sourced, due to the reduction in the cost of
capital.
7. Life of projected cash Clearly, the longer the life of a cash generating activity,
flows the more opportunity to deliver value it has, making it
more important to shareholders.

REAL OPTIONS
The true worth of a project is not always easy to quantify precisely as there may be a
number of more intangible issues that could affect the investment but whose value is
less easy to quantify, usually due to some uncertainty.
Such uncertainty can be referred to as a real option and may have some value in the
final ‘accept or reject’ decision:

Project worth = Traditional NPV + value of any real options

Follow on options
A firm is considering investing in a project to manufacture microcomputers. The initial
NPV is negative. However, the experience gained from this first investment offers the
right to use that technology in the future and hence the option to make future profits.
Research and development is a good example of such an option.
Abandonment options
A firm is considering investing in two projects, both having the same expected NPV. The
first uses a highly specialised machine with little resale value or alternative use. The
second involves expenditure mainly on highly marketable land and buildings.
Management will probably opt for the latter as it offers value by having a ‘back-up’ plan
(such as selling the land and buildings) in case things don’t go well with the initial
project.
Timing options
A firm has the development rights over a piece of land. The rights can be exercised any
time over the next five years. Clearly, having such flexibility is valuable: consider having
the right to buy property in the UK at any time between 2006 and 2010 – the fall in the
housing market seen in 2008 would have meant that purchases made in 2007 would
have been substantially over-priced by comparison with the 2008 market. This is
sometimes called ‘wait and see’.
Growth options
New technology, deregulation etc present uncertain growth opportunities for firms –
investing could produce substantial losses. Options to delay, complete only part of a
project or even to follow on can all be valuable.
Flexibility options
A power station could be constructed to generate electricity using only gas as the input
fuel. Whilst this might be the cheapest option it lacks flexibility in the face of volatile gas
prices and a ‘dual fuel’ option might be cheaper in the long run than the demolition of
the gas power station and having to build nuclear instead. This is sometimes referred to
as ‘future proofing’.

36 Topic 1: Investment decisions

 REAL OPTIONS
RST is a privately owned specialist equipment supply and support company based in
Sydney, Australia with a strong local customer base. The company is considering setting
up an operation in Perth, Australia, a five hour plane journey from Sydney. It would be
the first time that RST has operated outside Sydney. Perth is currently experiencing rapid
growth due to the development of the mining industry which has created new
opportunities for supplying specialist equipment.
The new operation in Perth would supply specialised mining equipment to the local mines
and also provide maintenance support. RST would lease office space in Perth for a five
year period and hire new local sales people and technicians. A significant proportion of
the lease premium will need to be paid on the first day of the lease period. In all, it is
anticipated that the new operation will require an initial investment of AUD 25 million.
If successful, this new operation would increase the size of RST significantly and also
provide an opportunity for establishing a permanent operation in Perth. However, it
involves a considerable amount of risk and uncertainty, largely because of the new
location. In addition, the new operation will be targeted at the mining industry which is a
new type of industry sector for RST. As a result, the business risk of this new operation
in Perth will be different from that of the current operations in Sydney.
Net present value (NPV) calculations have been undertaken and the results are given
below:
Out-turn scenario Probability of occurrence NPV (AUD million)
Best case 30% 54
Average case 50% 30
Worst case 20% -48
This gives an overall expected NPV of AUD 21.6 million.
Requirement
Explain what 'real options' are and give some specific examples of real options relevant
to this scenario.

SOLUTION

Topic 1: Investment decisions 37

 INVESTING OVERSEAS
Overseas investment carries additional risks:
Political risk
Political risk is caused through Government action, which can render assets worthless or
alter the ability to expatriate cash. This could include introducing quotas, changes in
taxation or confiscation of assets.
Product and cultural risks
Trading with a foreign country creates risks relating to customs, tastes, laws and
language.
Existing products or services may be unacceptable in certain markets (e.g. the sale of
alcohol in countries with religious restrictions) or have to be altered to be more
acceptable to the target market.
Trading and credit risks
Trading overseas adds risks due to the distances involved and the time invested. This
increases:
a) Physical risk – goods lost or stolen in transit
b) Credit risk – payment default by customers
c) Liquidity risk – inability to finance an increased working capital cycle

38 Topic 1: Investment decisions

SUMMARY

Topic 1: Investment decisions 39

 ACTIVITY ANSWERS

STAKEHOLDERS
a) A private company converting into a public company
When a private company converts into a public company, some of the existing
shareholders/managers will sell their shares to outside investors. In addition, new
shares may be issued. The dilution of ownership might cause loss of control by
the existing management.
Existing shareholders/managers will want to sell some of their shareholding at
as high a price as possible. This may motivate them to overstate their company's
prospects. Those shareholders/managers who wish to retire from the business may
be in conflict with those who wish to stay in control – the latter may oppose the
conversion into a public company.
New outside shareholders may hold minority stakes in the company and will
receive their rewards as dividends only. This may put them in conflict with the
existing shareholders/managers who receive rewards as salaries as well as
dividends. On conversion to a public company there should be clear policies on
dividends and directors' remuneration.
Employees, including managers who are not shareholders
Part of the reason for the success of the company will be the efforts made by
employees. They may feel that they should benefit when the company goes public.
One way of organising this is to create employee share options or other bonus
schemes.
b) A highly geared company attempting to restructure its capital
The major conflict here is between shareholders and lenders. If a company is
very highly geared, the shareholders may be tempted to take very high risks. If the
gamble fails, they have limited liability and can only lose the value of their shares.
If they are lucky, they may make returns many times the value of their shares. The
problem is that the shareholders are effectively gambling with money provided by
lenders, but those lenders will get no extra return to compensate for the risk.
Removal of risk
In restructuring the company, something must be done either to shift risk away
from the lenders or to reward the lenders for taking a risk.
Risk can be shifted away from lenders by taking security on previously
unsecured loans or by writing restrictive covenants into loan agreements (eg
the company agrees to set a ceiling to dividend pay-outs until gearing is reduced,
or to confine its business to agreed activities).
Lenders can be compensated for taking risks by either negotiating increased
interest rates or by the issue of 'sweeteners' with the loans, such as share warrants
or the issue of convertible loan stock.
Other stakeholders
Other stakeholders who will be interested in the arrangements include trade
creditors (who will be interested that loan creditors do not improve their position
at the expense of themselves) and managers, who are likely to be more risk

40 Topic 1: Investment decisions

 averse than shareholders if their livelihood depends on the company's continuing
existence.
c) A large conglomerate spinning off its divisions
Large conglomerates may sometimes have a market capitalisation which is less
than the total realisable value of the subsidiaries. This is referred to as
'conglomerate discount'. It arises because more synergy could be found by the
combination of the group's businesses with competitors than by running a
diversified group where there is no obvious benefit from remaining together.
Shareholders will see the chance of immediate gains in share price if subsidiaries
are sold.
Subsidiary company directors and employees may either gain opportunities
(eg if their company becomes independent) or suffer the threat of job loss (eg if
their company is sold to a competitor).
d) Japanese car makers building new car plants in other countries
The shareholders and management of the Japanese company will be able
to gain from the combination of advanced technology with a cheaper workforce.
Local employees and managers engaged by the Japanese companywill
gain enhanced skills and better work prospects.
The government of the local country, representing the tax payers
The reduction in unemployment will ease the taxpayers' burden and increase
the government's popularity (provided that subsidies offered by the government do
not outweigh the benefits!)
Shareholders, managers and employees of local car-making firms will be
in conflict with the other stakeholders above as existing manufacturers lose
market share.
Employees of car plants based in Japan are likely to lose work if car-making
is relocated to lower wage areas. They will need to compete on the basis of
higher efficiency.

REVISION OF BASIC TECHNIQUES

a)
Time Cumulative cash flow
£
0 (500,000)
1 (430,000)
2 (360,000)
3 (280,000)
4 (180,000)
5 (80,000)
6 40,000  Payback = 5.67 years (5 +
[80/120])

Topic 1: Investment decisions 41

 b) Profit calculation:
£
Total cash flows from operations 540,000
Total depreciation (150,000)
Total profits 390,000
Average profits ( 6) = £65,000 p.a.
Average investment calculation
500, 000 + 350, 000
= £425,000
2
65
ARR = = 15.3%
425
-n
c) NPV @ 12% (using the formula [1+r] to work out each discount factor: r = rate
and n = years)
Time Discount Factor PV
£'000 £'000
0 (500) 1.000 (500.00)
1 70 0.893 62.51
2 70 0.797 55.79
3 80 0.712 56.96
4 100 0.636 63.60
5 100 0.567 56.70
6 (350 + 120) 470 0.507 238.29
NPV 33,850.00
d) NPV at 15% p.a.
Time Discount Factor PV
£'000 £'000
0 (500) 1.000 (500.00)
1 70 0.870 60.90
2 70 0.756 52.92
3 80 0.658 52.64
4 100 0.572 57.20
5 100 0.497 49.70
6 470 0.432 203.04

at 15% NPV = (23,600)

at 12% NPV = 33,850
33,850
IRR = 12 + (15 – 12)
33,850  23,600
= 13.8%

42 Topic 1: Investment decisions

 RELEVANT COST OF MATERIAL
The use of the material in inventory for the new contract means that more ZX 81 must
be bought for normal workings. The cost to the organisation is therefore the money
spent on purchase, no matter whether existing inventory or new inventory is used on the
contract.
Assuming that the additional purchases are made in the near future, the relevant cost to
the organisation is current purchase price, ie 50 tonnes  £210 = £10,500.

RELEVANT COST OF LABOUR

What is lost if the labour is transferred from normal working?
£
Contribution per hour lost from normal working 6
Labour cost per hour which is not saved 8
Cash lost per hour as a result of the labour transfer 14
The contract should be charged with 5,000  £14 £70,000

RELEVANT COSTS
Costs and revenues of proceeding with the project.
£
1. Costs to date of £150,000 are sunk costs, therefore ignore.
2. Materials – purchase price of £60,000 is also sunk.
There is an opportunity benefit of the disposal costs saved. 5,000
3. Labour cost – the direct cost of £40,000 will be incurred
regardless of whether the project is undertaken or not – and so is
not relevant.
Opportunity cost of lost contribution = 150,000 – (100,000 – (90,000)
40,000)
The absorption of overheads is irrelevant – it is merely
an apportionment of existing costs which do not change.
4. Research staff costs
Wages for the year (60,000)
Increase in redundancy pay (35,000 – 15,000) (20,000)
5. Equipment
Deprival value if used in the project = disposal value (8,000)
Disposal proceeds in one year 6,000
(All book values and depreciation figures are irrelevant)
6. General building services
Apportioned costs – irrelevant
Opportunity costs of rental forgone (7,000)
(174,000)
Sales value of project 300,000
Increased contribution from project 126,000
Advice. Proceed with the project.

Topic 1: Investment decisions 43

 DEPRIVAL VALUE
a) The existing customers create more value than selling the machine, so the
machine would not be sold.
Hence the opportunity cost is the value in use of £1,500
Note: if the value in use ever dropped below the net realisable value (NRV), then
the asset would not be worth keeping.
b) i) If the new contract will make use of a currently owned machine then in
principle the cost of using it will be the replacement cost. If the value in use
is £1,500, and the replacement cost is £800, then the machine will be
replaced. The equipment cost of the new contract would therefore be £800.
ii) If, however, the replacement cost is £1,800 then it is not worth replacing.
Thus the relevant cost of equipment for the new contract will be the
opportunity cost or benefit forgone – ie the £1,500.
In each case therefore the relevant cost is the cash flow effect of the decision to use the
existing resource – either the replacement cost or the benefit in the next best case, ie
the deprival value.

QUOTATION FOR A CONTRACT

The relevant cost of building the new engine is the net incremental cash outflow that will
be incurred if the contract is undertaken. Any price in excess of this relevant cost will
provide marginal benefit for the company.
Cost item Note £
Production Director’s time 1 Nil
Material A 2 1,375
Material B 3 360
Components from HY 4 3,000
Direct labour 5 2,100
Machine costs 6 175
Fixed overheads 7 Nil
Total relevant cost 7,010
Notes
1. Production Director’s time
The cost of the Production Director’s time is not relevant for two reasons. The
Director is paid a fixed annual salary, and no additional cash expenditure is
incurred. The Director’s time has already been used, and costs incurred in the past
cannot be relevant costs, even if they had resulted in extra cash spending.
Relevant cost = £Nil
2. Material A
If 110 square metres are used from existing inventory, this will lead to additional
purchases being required, because the material is in regular use. Therefore, the
relevant cost is the current replacement cost.
Relevant cost = 110 square metres  £12.50 = £1,375

44 Topic 1: Investment decisions

3. Material B
Although only 30 litres of material B are required, the minimum order quantity is
40 litres. The surplus quantity would have no other use and so would presumably
be disposed of (a zero cost of disposal or sales proceeds is assumed.)
Relevant cost = 40 litres  £9 = £360
4. Components
The purchase cost is a relevant cost.
Relevant cost = 60 components  £50 = £3,000
5. Direct labour
235 direct labour hours are required. The first 75 hours of direct labour can be
obtained at no extra cost, because there is spare capacity for this amount of time,
and the employees will be paid anyway under the guaranteed wage agreement.
Only 160 hours will have to be paid for. These hours can be obtained by getting
employees to work overtime, and the incremental cost would be 160 hours  £14
= £2,240. Alternatively temporary staff could be used with supervision and the
incremental cost would be (160 hours  £12) + (10 hours  £18) = £2,100. The
supervisor’s time is an incremental cost because it would be overtime work.
Using temporary staff would cost less, and it is assumed that the cheaper option
will be selected.
Relevant cost = £2,100
6. Machine costs
The lease cost is a committed cost that will be incurred anyway – it is not a
relevant cost. The relevant cost is the incremental cost of using the machine.
Relevant cost = 25 hours  £7 = £175
7. Fixed overheads
Absorbed fixed overheads are not an incremental cost. It is assumed that there will
be no incremental fixed costs as a consequence of performing the contract.
Relevant cost = £Nil

WORKING CAPITAL
First, calculate the absolute amounts of working capital needed at the start of each year
and then find the cash flows.
t0 t1 t2 t3
£ £ £ £
Working capital at start 15,000 17,500 20,000 Nil
Cash flow (15,000) (2,500) (2,500) 20,000
Only the incremental flow is relevant, so for example at t1 an additional £2,500 is
required over and above the £15,000 already in place.
At the end of the project all working capital is assumed to be recovered, ie an inflow of
£20,000 at t3.

Topic 1: Investment decisions 45

 CAPITAL ALLOWANCES
a)
£ Tax saved @ 21%
31 Dec 20X1 10,000
WDA @ 18% (1,800) 378
31 Dec 20X2 8,200
WDA @ 20% (1,476) 310 In 20X3 asset sold. As
31 Dec 20X3 6,724 proceeds (in this case) are
less than WDV a balancing
Proceeds (2,000)
allowance is given.
Balancing allowance 4,724 992
NPV calculation
31 Dec 20X1 31 Dec 20X2 31 Dec 20X3
£ £ £
Net inflows 7,000 7,000
Tax (1,470) (1,470)
Asset purchase (10,000)
Scrap 2,000
Tax saved on WDAs 378 310 992
Net cash flow for discounting (9,622) 5,840 8,522
b)
£ Tax saved @ 21%
1 Jan 20X1 10,000
31 Dec 20X2 WDA @ 18% (1,800) 378
31 Dec 20X3 8,200
Proceeds (2000)
Balancing allowance 6,200 1,302

TAXATION
The investment is made on 1 January 20X5, so CAs can first be set off against profits for
the accounting period ended 31 December 20X5. The tax cash saving will therefore be
at 31 December 20X5, ie time 1.
Time Date Tax saved Payment time
£ £
0 1 January 20X5 2,000,000
1 31 December 20X5
WDA @ 18% (360,000) at 21% = 75,600 1
1,640,000
2 31 December 20X6
Sale proceeds (300,000)
BA 1,340,000 at 21% = 281,400 2
Present value = (£75,600  0.870) + (£281,400  0.756) = £278,510

46 Topic 1: Investment decisions

 INFLATION
Money method
t0 t1 t2 t3
£ £ £ £
Invest (10,000)
Returns inflated at 7% 5,350 5,725 6,125
Net CF (10,000) 5,350 5,725 6,125
DF @ 10% 1 0.909 0.826 0.751
PV (10,000) 4,863 4,729 4,600
NPV = £4,192
Real method
Real cash flow = £5,000 annuity for 3 years
Real discount rate:
(1 + m) = (1 + r) × (1 + i)
(1 + 0.1) = (1 + r) × (1 + 0.07)
1 + r = 1.1/1.07
= 1.028
r = 2.8%
1 1 
Annuity factor = 1  
r  (1  r)n 
= 1/0.028 × (1 – (1/1.0283))
= 2.8395
NPV = -10,000 + (5,000 × 2.8395)
= £4197.50

Topic 1: Investment decisions 47

 NPV
Investment appraisal schedule – Apollo project
t0 t1 t2 t3
Item £'000 £'000 £'000 £'000
Sales revenue (W1) 2,160 2,208 1,104
Materials and components (W2) (756) (773) (386)
Incremental labour costs (incl (97) (99) (50)
overtime) (W3)
Management salaries (W4) (48) (48) (48)
Lost contribution (W5) (432) (442) (221)
Redundancy costs (W6) 120 (140)
Taxable cash flows 120 827 846 259
Tax (21%) (25) (174) (178) (54)
Production costs (1,000)
Working capital requirements (W7) (243) (5) 124 124
Tax saved on WDAs (W8) 38 31 25 116
Relevant cash flows (1,110) 679 817 445
DCF (8%) 1 0.926 0.857 0.794
Present values (1,110) 629 700 353
NPV of project = £572,000
WORKINGS
1. Expected sales – units at £200
20X6 (0.6 × 10,000) + (0.4 × 12,000) = 10,800 units
20X7 Expected sales (units)

1,440
8,000
0.3

10,000 10,000
0.7
0.6 4,200

2,400
12,000 12,000
0.4
0.5

15,000
0.5 3,000
11,040

20X8 11,040 × 50% 5,520 units

2. Materials and components
£'000
t1 10,800  £70 756
t2 11,040  £70 773
t3 5,520  £70 386

48 Topic 1: Investment decisions

3. Incremental labour costs and overtime
Labour hours Labour hours Overtime hours
required by released by required by
Apollo Mercury Apollo
20X6 (10,800  3) 32,400 (5,400  4) 21,600 10,800
20X7 (11,040  3) 33,120 (5,520  4) 22,080 11,040
20X8 (5,520  3) 16,560 (2,760  4) 11,040 5,520
Therefore, incremental labour costs
£'000
20X6 10,800  £9* 97
20X7 11,040  £9 99
20X8 5,520  £9 50
*(£6 × 150%)
4. Management salaries
£(20,000 – 8,000*) = £12,000 × 4 = £48,000 pa
* Consultancy fees saved/avoided as result of project.
5. Lost contribution from lost Mercury sales
Gross * £'000
Sales lost
CPU
20X6 5,400 × £80 = (432)
20X7 5,520 × £80 = (442)
20X8 2,760 × £80 = (221)
* Direct labour costs treated as a 'fixed' cost, since they will be paid whether
or not Apollo is produced. Therefore, effect on cash flow of lost Mercury sale
is (100 – 20) = £80 per unit.
6. Redundancy costs
t0 £120,000 saved at t0 if Apollo is produced
t3 £140,000 incurred at t3 if Apollo is produced.
7. Working capital requirements
Sales (£'000) t0 t1 t2 t3
New – 2,160 2,208 1,104
Old – 540 552 276
– 1,620 1,656 828
15% 243 248.4 124.2 –
 Cash flow effects of changes in working capital requirements are:
t0 t1 t2 t3
(243) (5.4) 124.2 124.2

Topic 1: Investment decisions 49

 8. Tax saved on WDAs
(21%)
Time Item Tax saved Timing
£000 £000
t0 Production costs 1,000
t0** WDA† (180) 38* t0
820
t1 WDA (148) 31* t1
672
t2 WDA (121) 25* t2
551
t3 Sale proceeds Nil
t3 Balancing allowance 551 116* t3
† WDA of 18% assumed.
* Figures to nearest £1,000 as required by question.
** Payment of £1m occurs at end of accounting period (ie 20X5); therefore
first WDA occurs at t0.

REPLACEMENT CYCLE

Replace every two Replace every three

years years
Cash PV at Cash PV at
Year flow 15% flow 15%
£ £ £ £
0 (30,000) (30,000) (30,000) (30,000)
1 (3,000) (2,610) (3,000) (2,610)
2 3,000 2,268 (4,000) (3,024)
3 (1,000) (658)
(30,342) (36,292)

Years between Equivalent annual cost

replacements £
2 £30,342/1.626 = 18,661
3 £36,292/2.283 = 15,897
The new machine should be replaced every three years, as a three-year replacement
cycle gives the lowest EAC.

50 Topic 1: Investment decisions

 REPLACEMENT ANALYSIS
Maximum annual production/sales (units) 300,000 285,000 270,000 255,000
Annual contribution @ £4 per unit 1.20m 1.14m 1.08m 1.02m

One-year replacement cycle:

Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 320,000
Maintenance costs (12,000)
Contribution 1,200,000
Net cash flow (480,000) 1,508,000

NPV = (480,000) + (1,508,000  0.909) = £890,772

EAC = 890,772/0.909 = £979,947
Two-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 200,000
Maintenance costs (12,000) (14,000)
Contribution 1,200,000 1,140,000
Net cash flow (480,000) 1,188,000 1,326,000

NPV = (480,000) + (1,188,000  0.909) + (1,326,000  0.826) = £1,695,168

EAC = 1,695,168/1.736 = £976,479
Three-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 80,000
Maintenance costs (12,000) (14,000) (16,000)
Contribution 1,200,000 1,140,000 1,080,000
Net cash flow (480,000) 1,188,000 1,126,000 1,144,000

NPV = (480,000) + (1,188,000  0.909) + (1,126,000  0.826) + (1,144,000  0.751) =

£2,389,112
EAC = 2,389,112/2.487 = £960,640

Topic 1: Investment decisions 51

 Four-year replacement cycle:
Year 0 Year 1 Year 2 Year 3 Year 4
Purchase price (480,000)
Scrap value 10,000
Maintenance costs (12,000) (14,000) (16,000) (18,000)
Contribution 1,200,000 1,140,000 1,080,000 1,020,000
Net cash flow (480,000) 1,188,000 1,126,000 1,064,000 1,012,000

NPV (480,000) + (1,188,000  0.909) + (1,126,000  0.826) + (1,064,000  0.751) +

(1,012,000  0.683) = £3,020,228
EAC = 3,020,228/3.170 = £952,753
Therefore, the directors should change their existing policy of replacing the processing
machine every three years to replacing it every year, as that gives the greatest annual
equivalent net revenue.

CAPITAL RATIONING (1)

Project NPV ÷ outlay Rank
A 100,000 ÷ 50,000 = 2 3
C 84,000 ÷10,000 = 8.4 1
D 45,000 ÷15,000 = 3 2
Project B is rejected because of its negative NPV.
Plan: NPV Funds
Accept C 84,000 10,000
Accept D 45,000 15,000
25,000
Accept ½ A 50,000 25,000
179,000 50,000 available
The solution assumes it is possible to accept half of project A, ie projects are perfectly
divisible so that half the outlay gives half the NPV, etc.

CAPITAL RATIONING (2)

For individual projects the maximum NPV must be found basically by trial and error, as
follows:
Project H is clearly not viable, since it has a negative NPV and requires investment at t0.
It is not worthwhile considering project K unless its capital generated at t0 is required,
since it has a negative NPV.
There is sufficient capital to undertake the remaining three projects without project K
and so this must be optimal.
NPV = 603 + 58 + 537
= £1,198

52 Topic 1: Investment decisions

 CAPITAL RATIONING (3)
(a) (i)
PV of Annual
cash flows cash
after initial PI = flows
Project Investment investment NPV NPV/outlay Term Payback
£m £m £m £m (Years) (Years)
A (100) 135 35 0.35 151.2 1 0.7
B (150) 250 100 0.67 82.3 4 1.8
C (300) 410 110 0.37 242.6 2 1.2
D (350) 510 160 0.46 124.0 6 2.8

Payback calculations
Project A 100/151.2 = 0.7
Project B 150/82.3 = 1.8
Project C 300/242.6 = 1.2
Project D 350/124 = 2.8

Ranking of projects
Project NPV PI Payback
A 4 4 1
B 3 1 3
C 2 3 2
D 1 2 4
(ii) The NPV method gives an absolute figure which shows the increase in
shareholders’ funds as a result of the investment in a particular project. If
capital is unlimited then this is the measure that should determine the
projects to be invested in. If capital is limited then it is also necessary to
consider the amount of limited capital required by the project.
The profitability index is a measure that can be used when capital
rationing is in place. It is most useful where projects are divisible, but is less
useful, as in this case, where projects are indivisible. It can be of some
help to rank non-divisible projects and can help to identify the optimum
combination of projects.
The payback method takes into account the timing of the cash flows.
Project A is therefore prioritised as it returns the initial investment within the
first year. This can be useful in a multi-period scenario as it will indicate that
funds could be reinvested in a different project in the following year. This
may be an advantage where projects planned for the following period will
deliver greater shareholder wealth than those in the current period.
However, if capital rationing is only in place for the current period, then this
is less useful. Payback helps to identify riskier projects as the uncertainty
of future cash flows increases with time and therefore a project with a lower
payback period will be less risky.

Topic 1: Investment decisions 53

 All of these methods have drawbacks. Capital rationing decisions are often
more complicated than identifying the ranking by such methods.
No one method is likely to provide the best solution to a capital rationing
scenario on its own. Each method provides useful information which can help
the decision making process.
(b) (i) Project combinations
Combination Investment NPV
£m £m
ABC 550 245
ABD 600 295
CD 650 270
The best combination is from projects A, B and D. This only uses £600m of
the available funds.
(ii) Soft capital rationing occurs when the capital restriction is internally
imposed by the company, usually for budgeting purposes. The capital limits
are targets and there is the potential to adjust them according to particular
circumstances.
Hard capital rationing is externally imposed, for example due to restrictive
debt covenants, and the limits cannot be adjusted.
If WIDGET applies soft capital rationing, it may seek to increase the limit on
capital to £800 million as this would mean that projects B, C and D could be
undertaken. They would generate an NPV of £370 million which is £75
million higher than the current optimum combination of £295 million. This is
an increase of 25%, with an increase in capital of 14% (100m/700m).
If the limit could be increased further, it would be beneficial to the
shareholder to undertake all of the available projects, as they all have a
positive net present value.
Capital rationing in the following year
The optimal combination depends on whether capital is rationed in the
following year. If this is the case, project A becomes more attractive as the
payback period is less than one year and so this capital is available to be
reinvested in the next year.
Assuming that the limit of £700 million applies again in the next year, this
will then greatly enhance the funds available for investment at that time.

54 Topic 1: Investment decisions

 REAL OPTIONS
A real option is an alternative or choice that becomes possible as a result of taking a
business investment opportunity.
Option to abandon
If in the early stages of a project there is the possibility of abandoning the project for a
low cost, then this option has a value which should be considered at the decision making
stage. This may include disposal value or a get out clause. Therefore the value of this
option should be included in the NPV appraisal.
The option to abandon a project can be valuable where there is uncertainty over the
outcome of the project. In this case there are three possible outcomes and one has a
negative NPV. If there is a way of determining if RST will suffer the worst case scenario
early on in the project, then it may be better to abandon the project and reduce losses.
Option to follow-on
Once a project is undertaken, it might lead to opportunities for further projects. Where
these opportunities exist, there should be a value attached to them and this should be
included in the original decision making. Follow-on projects may exist for a project that
has a negative NPV itself, but by including the follow-on projects a positive NPV is
generated and therefore the initial project is worthwhile.
For RST, the Perth-based project may provide new contacts at companies which may
lead on to additional work in the same area, in other parts of Australia or even abroad.
Timing option
This option would allow RST to wait and see how the market develops before starting the
project. This may be useful as there is significant uncertainty about the outcome of the
project. The option to wait could be used to see if the worst case scenario occurs and so
is potentially of significant value to RST as it could prevent the acceptance of a project
with a negative NPV.
However, if a competitor decides to take advantage of the opportunity while RST is
waiting then the opportunity may be completely lost to RST and the option to wait would
be of little value.

Topic 1: Investment decisions 55

56 Topic 1: Investment decisions
 2
RISK AND DECISION
MAKING

Learning Objectives
 To understand the shortcomings of investment appraisal techniques and how these
are addressed practically
 To take account of uncertain outcomes by making use of expected values
 To appreciate the benefits of diversification and the resultant analysis of risk which
is possible
 To be able to price systematic risk using the CAPM in determining a required rate
of return

Exam Requirement
In the exam you may be asked to take into account uncertainty either by commenting upon
the reasonableness of the estimates made, or by adjusting the required rate of return to
reflect risk

Math Tables 57
 TOPIC OVERVIEW

58 Topic 2: Risk and decision making

INVESTMENT APPRAISAL AND RISK
INTRODUCTION TO RISK AND UNCERTAINTY

Upside risk is the possibility Downside risk is the

that things may go better possibility that things will
than expected go worse than expected.

What is the shareholder’s preferred position regarding risk, uncertainty and return?

Risk
Decisions are usually said to be subject to risk when there may be several possible
outcomes and these outcomes and their probabilities (ie the likelihood of each
possible outcome actually occurring) are both known and can be quantified.

Uncertainty
Future outcomes cannot be predicted with much confidence from any available
data. It is particularly the case that probabilities of various outcomes will be unknown.
Decisions are usually said to be subject to uncertainty if possible outcomes are
known but probabilities are unknown.
For example, most business decisions carry a degree of uncertainty.
Although there is a clear distinction between these two problems, in practice the words
'risk' and 'uncertainty' are used interchangeably.

Methods of dealing with decision making under risk and uncertainty

Risk is best handled by using probability distributions, expected values,
simulation, portfolio theory, the capital asset pricing model and risk-adjusted
discount rates.
Techniques for handling uncertainty are generally more crude but practically just as
useful. These include the following:
a) Setting a minimum payback period for projects
b) Increasing the discount rate subjectively in order to submit the project to a
higher 'hurdle' rate in investment appraisal
c) Making prudent estimates of outcomes to assess the worst possible situation
d) Assessing both the best and the worst possible situations to obtain a range of
outcomes
e) Using sensitivity analysis to measure the 'margin of safety' on input data (see
next section)

Topic 2: Risk and decision making 59

 SENSITIVITY ANALYSIS

Introduction
Investment involves expenditure now in return for a stream of future returns which are
inherently uncertain. Investment appraisal assesses this uncertainty by deciding whether
the uncertain cost of the investment exceeds its uncertain benefits.

Basic principle

NPV of project
Sensitivity =
PV of cash flows subject to uncertainty

Sensitivity analysis is a formalised approach to incorporating alternative forecasts

in the project evaluation. The technique is to take each uncertain forecast one by one,
and calculate the change necessary for the NPV to fall to zero, ie this is essentially
breakeven analysis in NPV terms.

SENSITIVITY ANALYSIS
The following information applies to a new project:
Initial cost £125,000
Selling price £100/unit
Variable costs £30/unit
Fixed costs £100,000 pa
Sales volume 2,000 units pa
Life 5 years
Discount rate 10%
Requirement
Calculate the project's NPV and show how sensitive the result is to the various input
factors.

SOLUTION

60 Topic 2: Risk and decision making

Topic 2: Risk and decision making 61
 NON-RECURRING CASH FLOWS
A company is about to embark on a two year project. Estimates of relevant inflows and
outflows in current terms are as follows:
Year 1 Year 2
£ £
Sales 50,000 50,000
Costs 30,000 32,000
The following inflation rates are applicable to the flows:
Sales 6% pa
Costs 4% pa
Tax is payable at 21% on net flows.
The net cost of the project at t0, after allowing for capital allowance tax effects, is £20,000.
The money cost of capital is 10% pa.
Requirements
a) Calculate the NPV of the project.
b) Assess the sensitivity of the investment decision to changes in sales revenue.

SOLUTION

62 Topic 2: Risk and decision making

Strengths and weaknesses of sensitivity analysis
Strengths
 Presented to management in a form which facilitates subjective judgement.
 Identifies those areas which are critical to the success of the project and which
need to be carefully monitored.
 No complicated theory to understand, it is relatively straightforward.
Weaknesses
 Only one factor at a time can be analysed.
 It assumes that changes to variables can be made independently.
 It only identifies how far a variable needs to change, it does not look at the
probability of such a change.
 It provides information on the basis of which decisions can be made, it does not
point directly to the correct decision.

SENSITIVITY ANALYSIS PRACTICE

A company is evaluating a three year project which has the following pre-tax operating
cash flows:
Year 1 Year 2 Year 3
£'000 £'000 £'000
Sales 4,200 4,900 5,300
Costs 2,850 3,100 4,150
The project requires an investment of £2m at the start of Year 1 and has no residual
value.
Tax is payable at 21% on net flows. There is no tax depreciation available on the
investment.
Requirements
a) Calculate the NPV of the project at the company’s required rate of return of 7%.
b) Calculate the sensitivity of the NPV to the changes in:
(i) the selling price
(ii) the cost of capital

SOLUTION

Topic 2: Risk and decision making 63

 SIMULATION

Simulation is a technique which allows the effect of more than one variable changing at
the same time to be assessed.

Monte Carlo simulation

This is a simulation technique based on the use of random numbers and probability
statistics to investigate problems.
Many companies use Monte Carlo simulation as an important tool for decision-making.
For example, both General Motors and Procter and Gamble use simulation to estimate
both the average return and the riskiness of new products.
Monte Carlo Simulation
A Restaurant setting up in business
Assume that you are setting up a restaurant and need to produce some likely profit forecasts
for the purpose of securing start-up finance from the bank.
To do this, you will need to establish a number of parameters, such as:
 The number of customers served (referred to as ‘covers’ in the trade)
 Spend per cover on food and drink
 Price to be charged per cover on food and drink
 Cost of staff, including kitchens
 Opening and closing times
 Required capital to fund the restaurant
Each is then fed into a software package that generates a number of different alternatives for
each and calculates the likely profits for the business. These alternatives can then be plotted
on a graph to give a spread of the potential profits that the restaurant could earn.

Results of any simulation exercise

Imagine that a firm is choosing between two projects and, using simulation, it has generated the
distribution of the NPVs for each project. The results might look like this:

64 Topic 2: Risk and decision making

Distribution of simulated NPVs for two projects
Project A has the lower average NPV but also is less risky (its outcomes are less
widely dispersed about the mean – it therefore has a smaller standard deviation).
Project B has the higher average NPV but also is more risky (higher standard
deviation of outcomes).
All simulation will do is to give the firm the above results. It will not tell the firm which is
the better project. That depends on attitude to risk.

Advantages and limitations of simulation

Advantages
 It gives more information about the possible outcomes and their relative
probabilities.
 It is useful for problems which cannot be solved analytically.
Limitations
 It is not a technique for making a decision, only for obtaining more information
about the possible outcomes.
 It can prove expensive in designing and running the simulation on a computer for
complex projects.
 Monte Carlo techniques require assumptions to be made about probability
distributions and the relationships between variables that may turn out to be
inaccurate.

EXPECTED VALUES AND ATTITUDE TO RISK

Expected values
The simplest way to work with a spread of possible outcomes is to use expected
values or averages.

The expected value is an average (arithmetic mean) of possible outcomes, weighted

by the probability of each outcome occurring.

Topic 2: Risk and decision making 65

 EXPECTED PAYOFF
State of market Diminishing Static Expanding
Probability 0.4 0.3 0.3
Project 1 100 200 1,000
Project 2 0 500 600
Project 3 180 190 200
Payoffs represent the net present value of projects in £m under each market state.
Requirement
Based on expected values, which is the best project?

SOLUTION

UNCERTAIN SALES
Harry is trying to evaluate a two year project using NPV. There is uncertainty as to the
level of sales (in units) in each of the two years:

Year 1 Year 2
Sales Probability Sales Probability
(units) (units)
10,000 0.3 8,000 0.2
10,000 0.8
(if year 1 sales are
10,000)
15,000 0.7 20,000 0.6
10,000 0.4
(if year 1 sales are
15,000)

Requirement
On what expected level of sales in years 1 and 2 should Harry base his NPV calculation?

66 Topic 2: Risk and decision making

 SOLUTION

UNCERTAIN CONTRIBUTION
Imagine in the previous example that the project outlay is £230,000 and each unit sold
has a contribution of £10.
Requirement
If Harry's cost of capital is 10%, what is the project's expected NPV?

SOLUTION

Topic 2: Risk and decision making 67

 Advantages and limitations of expected values
Advantages
 The information is reduced to a single number for each choice.
 The idea of an average is readily understood.
Limitations
 The probabilities of the different possible outcomes may be difficult to estimate. It
is possible to use:
– Objective probabilities based on past experience of similar projects; or
– Subjective probabilities, eg from the results of market research, where the
project is very different.
 The average may not correspond to any of the possible outcomes.
 Unless the same decision has to be made many times, the average will not be
achieved; it is therefore not a valid way of making a decision in 'one-off' situations
unless the firm has a number of independent projects and there is a portfolio
effect.
 The average gives no indication of the spread of possible results, ie it ignores risk.

Attitude to risk
A risk averse investor is one who requires a higher average return in order to take on
a higher level of risk. A project which has a positive expected NPV, but which
nevertheless carries a fair chance of forcing the company into liquidation if things go
wrong, would probably be rejected.
A risk seeker is interested in the best outcomes no matter how small a chance that they
might occur.
A common approach taken is to increase the required rate of return on risky
projects.

68 Topic 2: Risk and decision making

SUMMARY

Topic 2: Risk and decision making 69

 CAPITAL ASSET PRICING MODEL
THE PORTFOLIO EFFECT
Investors seldom hold securities in isolation. They usually attempt to reduce their risks by
'not putting all their eggs into one basket' and therefore hold portfolios of securities.
A portfolio is simply a combination of investments.
Assume two companies, A and B, whose fortunes are inversely correlated (ie when A
does well B does badly and vice versa). This is an example of diversification.

Individual returns
If both investments are held, the resulting portfolio will show the same average return but a
greatly reduced risk, because the 'ups' of A cancel with the 'downs' of B and vice versa.

The portfolio effect

SYSTEMATIC AND UNSYSTEMATIC RISK

As seen above, portfolios enable risk to be reduced. Evidence shows that the total risk of
a security can be split into the proportion that may be diversified away, and the
proportion that will remain after diversification. This remaining risk is the relevant risk
for appraising investments.

70 Topic 2: Risk and decision making

 Unsystematic, unique or specific risk: The risk that can be eliminated by
diversification.

Unsystematic risk is related to factors that affect the returns of individual investments
in unique ways (eg the risk that a particular firm's labour force might go on strike or its
equipment might fail). Evidence shows that increasing the number of securities in a
portfolio reduces the risk. A diversified portfolio of 15–20 securities will eliminate
the vast majority of unsystematic risk.
Once the unsystematic risk is diversified away, investors need only concern themselves
with (and will only earn returns for taking) systematic risk.

Systematic or market risk: The risk that cannot be eliminated by diversification.

Changes in macroeconomic variables such as recession, interest rates, exchange

rates, taxation, inflation, etc affect all companies to a greater or lesser extent and
cannot be avoided by diversification. For example, food retailing is less susceptible to
economic factors than the construction industry.

Portfolio size and risk reduction

CAPM FORMULA

Measuring systematic risk

The capital asset pricing model (CAPM) is used to measure the systematic risk of
investments and the required returns.
Systematic risk is measured as an index, beta (). The beta of a security measures the
sensitivity of the returns on the security to changes in systematic factors.
As with any index some base points need to be established and then other observations
will be calibrated around these points.
The risk-free security – this carries no risk and therefore no systematic risk. The risk
free security hence has a beta of zero.
The market portfolio – this is a portfolio of all risky investments. This represents the
ultimate in diversification and therefore contains only systematic risk. CAPM sets beta to
1.00 for the market portfolio and this will represent the average systematic risk for
the market.
Securities with a beta greater than 1.00 means that these investments are more
affected by changes in macroeconomic variables than the average market investment.

Topic 2: Risk and decision making 71

 CAPM equation
The capital asset pricing model gives a formula for calculating expected return.

rj = rf +j (rm – rf)

where rj = required rate of return on investment j
rf = risk-free rate of interest
rm = return on the market portfolio
j = index of systematic risk for security j

This formula is provided in the examination. Note that when applied to shares, rj is
the same as the cost of equity capital ke. Very basic calculations are required and you are
expected to be able to explain how the equation works and any shortcomings.

Aggressive and defensive shares

Beta is a measure of the responsiveness of the expected share return to changes in the
return of the market. Shares with high betas are termed aggressive, and those with
betas less than one are termed defensive.
As far as stock market investment tactics are concerned, an investor should buy high
beta shares if the market is expected to rise (a 'bull' market) because they can be
expected to rise faster than the market. If the market is expected to fall (a 'bear'
market) low beta shares are more attractive.
The only problem with this strategy is the need to forecast general market movements in
advance, otherwise the investor might end up holding an aggressive share in a falling
(bear) market.

Application of the CAPM to project appraisal

CAPM is used in the setting of minimum required returns (ie risk-adjusted discount
rates) for new capital investment projects.
The great advantage of using the CAPM for project appraisal is that it clearly shows that
the discount rate should be related to the project's risk. The cost of capital is merely a
return which investors require on their money, and this will go up if risk increases.

WEAKNESSES IN CAPM
 The company's shareholders may not be diversified. Particularly in smaller
companies they may have invested most of their assets in this one company.
 Even in the case of larger companies the shareholders are not the only
participants in the firm. Directors and employees are exposed to both the
systematic and specific risks of the business so may try to diversify.
 CAPM depends on a perfect capital market.
 The need to determine the excess return (Rm – Rf). Expected, rather than
historical, returns should be used, although historical returns are often used in
practice.
 The need to determine the risk-free rate. A risk-free investment might be a
government security. However, interest rates vary with the term of the lending.

72 Topic 2: Risk and decision making

 Errors in the statistical analysis used to calculate  values. Betas may also
change over time.
 The CAPM is also unable to forecast accurately returns for companies with
low price/earnings ratios and to take account of seasonal 'month-of-the-year'
effects and 'day-of-the-week' effects that appear to influence returns on shares.

CAPM
Requirements
a) Explain why certain levels of risk cannot be avoided even in a well diversified
portfolio.
b) The equity shares of Front plc have a beta value of 0.9. The risk-free rate of return
is 5% and the market risk premium is 4%. What is the required rate of return on
the shares of Front plc?

SOLUTION

Topic 2: Risk and decision making 73

 ALTERNATIVES TO CAPM

Alpha value
The alpha value can be seen as a measure of how wrong the CAPM is.
 Reflects only temporary, abnormal returns, if CAPM is a realistic model.
 Can be positive or negative.
 Over time, will tend towards zero for any individual share, and for a well-diversified
portfolio taken as a whole will be 0.
 May exist due to the inaccuracies and limitations of the CAPM.
If the alpha value is positive, investors who don't hold shares will be tempted to buy
them (to take advantage of the abnormal return), and investors who do hold shares will
want to hold on to them so share prices will rise. If the alpha value is negative,
investors won't want to buy them, and current holders will want to sell them, so share
prices will fall.
For example, ABC plc's shares have a beta value of 1.2 and an alpha value of +2%. The
market return is 10% and the risk-free rate of return is 6%.
The required return is 6% + (10%  6%) 1.2 = 10.8%
The current return = expected return  alpha value = 10.8% + 2% = 12.8%

Arbitrage Pricing Model (APM)

The arbitrage pricing model (APM) assumes that the return on each security is based on
a number of independent factors.
Factor analysis is used to ascertain the factors to which security returns are sensitive.
Four key factors identified by researchers have been:
 Unanticipated inflation
 Changes in the expected level of industrial production
 Changes in the risk premium on bonds (debentures)
 Unanticipated changes in the term structure of interest rates
The Arbitrage Pricing Theory (APT) works in a similar way to the CAPM in that it
assumes that investors are fully diversified, so only systematic risks influence the returns.
The general APT model for the return of a security has been formulated as follows.
E(ri) = rf + (E(rA) – rf)A + (E(rB) – rf)B + .......... +(E(rm) – rf)m + .......
Where (E(rA) – rf)A is the risk premium on factor A.
(E(rB) – rf)B is the risk premium on factor B and so on

Fama-French three-factor model

The arbitrage pricing model (APM) does not say what the factors are.
Fama and French suggested three factors:
 The return on the market portfolio less the risk-free rate of interest.
 The size factor measured as the difference in return between a portfolio of the
smallest stocks and a portfolio of the largest stocks. The average small stock is
thought to be riskier than the average large stock.

74 Topic 2: Risk and decision making

 The value factor – a share with a high balance sheet (book) value per share
when compared to the market share price will have a higher return than a share
with a low book value compared to the market price.

Bond-yield-plus premium approach

Since equities are riskier than bonds, the difference between the two returns is a reward
the investor requires in order to invest in the riskier asset. If the equity market premium
was constant, then the required rate of return for equity could simply be calculated by
looking at the bond yields and then adding the fixed premium.

Fundamental beta
Where a company’s cash flows are subject to greater risk, then the required return
should be higher. A fundamental beta is calculated by making a subjective
adjustment up or down based on expected future cash flows.
Greater risk is caused by three different factors:
 The nature of the business operations
 The level of operating gearing
 The level of financial gearing

Topic 2: Risk and decision making 75

 SUMMARY

76 Topic 2: Risk and decision making

ACTIVITY ANSWERS

SENSITIVITY ANALYSIS
NPV = – 125,000 + [(100 – 30) 2,000 – 100,000]  3.791
= £26,640
Sensitivity to
1. Selling price
125,000 = [(P – 30) 2,000 – 100,000]  3.791 Alternatively
32,973 = 2,000P – 60,000 – 100,000 £26,640
P = 96.49 2,000  £100  3.791
ie fall of 3.51% before NPV is zero.
2. Variable costs
125,000 = [(100 – V) 2,000 – 100,000]  3.791 Alternatively
32,973 = 200,000 – 2,000V – 100,000 £26,640
V = 33.51 2,000  £30  3.791
ie increase of 11.7% before NPV is zero.
3. Volume
125,000 = [(100 – 30) q – 100,000]  3.791 Alternatively
32,973 = 70q – 100,000 £26,640
q = 1,900 2,000  (£100 – 30)  3.791
ie fall of 5% before NPV is zero.
4. Initial cost Alternatively
£(125,000 + 26,640) = £151,640 £26,640
ie increase of 21% before NPV is zero. £125,000
5. Fixed costs
125,000 = [(100 – 30) 2,000 – F]  3.791 Alternatively
32,973 = 140,000 – F £26,640
F = 107,027 £100,000  3.791
ie an increase of 7% before NPV is zero.
6. Life
125,000 = 40,000  AFn @ 10%
3.125 = AFn @ 10%
AF for 4 years at 10% is 3.17
ie life can fall to approximately 4 years before NPV is zero.
7. Discount rate
3.125 = AF for 5 years @ x %
From tables AF for 5 years @ 15% is 3.352, so x is more than 15%
Try 20%
NPV = (125,000) + 40,000  2.991 = (5,360)

Topic 2: Risk and decision making 77

 26,640
IRR = 10% + (20% – 10%) = 18% (ie an increase of 80% before
26,640 5,360
NPV is zero.)

NON-RECURRING CASH FLOWS

a) NPV
t0 t1 t2
£ £ £
Sales – current values inflated @ 6% 53,000 56,180
Costs – current values inflated @ 4% (31,200) (34,611)
21,800 21,569
Tax @ 21% (4,578) (4,529)
Investment (20,000)
(20,000) 17,222 17,040
DF @ 10% 1 0.909 0.826
PV (20,000) 15,655 14,075
NPV = £9,730
b) Sensitivity
Let R = revenue at t1 and t2 in current terms.
£ Time DF PV
Investment (20,000) t0 1 (20,000)
After tax revenue 0.79  1.06R t1 0.909 0.761R
After tax revenue 0.79  1.062R t2 0.826 0.733R
After tax costs 0.79  (31,200) t1 0.909 (22,405)
After tax costs 0.79  (34,611) t2 0.826 (22,585)
1.494R – 64,990
If 1.494R – 64,990 = 0, then R = £43,501
This is £6,499 less than the £50,000 estimated. £6,499 is 13.0% of £50,000, so
revenue can fall by 13.0% before the NPV becomes zero.
Alternatively
PV of revenue
t1 t2
£ £
Revenue 53,000 56,180
Tax effect (11,130) (11,798)
41,870 44,382
DF @ 10% 0.909 0.826
PV 38,060 36,660
NPV £9,730
Sensitivity = × 100% = × 100% = 13.0%
PV of CFs affected £74,720

78 Topic 2: Risk and decision making

 SENSITIVITY ANALYSIS PRACTICE
(a) Net present value
t0 t1 t2 t3
£000 £000 £000
Sales 4,200 4,900 5,300
Costs (2,850) (3,100) (4,150)
Pre-tax cash flow 1,350 1,800 1,150
Tax @ 21% (284) (378) (242)
Investment (2,000)
Net cash flow (2,000) 1,066 1,422 908
DF @ 7% 1 1/1.07 = 1/1.072 = 1/1.073 =
0.935 0.873 0.816
PV (2,000) 997 1,241 741
NPV = £979,000
(b) Sensitivity
(i) Selling price
PV of sales:
t1 t2 t3
£000 £000 £000
Sales 4,200 4,900 5,300
Tax @ 21% (882) (1,029) (1,113)
Net cash flow 3,318 3,871 4,187
DF @ 7% 0.935 0.873 0.816
PV 3,102 3,379 3,417
Total PV of sales = £9,898,000
Sensitivity = £979,000/£9,898,000 × 100% = 9.9%
(ii) Cost of capital
Try 20%
t0 t1 t2 t3
£000 £000 £000
Net cash flow (2,000) 1066 1,422 908
DF @ 20% 1 0.833 0.694 0.579
PV (2,000) 888 987 526
NPV @ 20% = £401,000
979,000
IRR = 7% + (20% – 7%) = 29% (ie an increase of
979,000  401,000
314% before NPV is zero.)

Topic 2: Risk and decision making 79

 EXPECTED PAYOFF
Project 1 Expected value = (£100  0.4) + (£200  0.3) + (£1,000  0.3) = £400m
Project 2 Expected value = (0  0.4) + (£500  0.3) + (£600  0.3) = £330m
Project 3 Expected value = (£180  0.4) + (£190  0.3) + (£200  0.3) = £189m
Therefore, based on expected values, Project 1 should be adopted

UNCERTAIN SALES
Year 1 Expected sales = (10,000  0.3) + (15,000  0.7)
= 13,500
Year 2 Expected sales = (0.3 (8,000  0.2 + 10,000  0.8)) + (0.7 (20,000  0.6 +
10,000  0.4))
= 14,080

UNCERTAIN CONTRIBUTION
13,500 £10 14,080  £10
NPV = – £230,000 + + = £9,090
1.1 1.1 2
Alternatively (using discount tables):
NPV = – £230,000 + (13,500  £10  0.909) + (14,080  £10  0.826) = £9,016
(difference due to rounding).

CAPM
a) Risk can be divided into systematic risk and unsystematic risk.
Systematic risk refers to the extent to which a company’s cash flows are affected
by factors not specific to the company. It is determined by the sensitivity of cash
flows to the general level of economic activity and by its operating gearing (the
proportion of a company’s fixed costs relative to its total costs).
Unsystematic risk refers to the extent to which a company’s cash flows are
affected by company specific factors, such as the quality of its managers, the level
of its advertising, the effectiveness of its R & D and the skill of its labour.
By careful choice of a range of investments in a portfolio, unsystematic risk can be
diversified away. Systematic risk cannot be diversified away as it is experienced by
all companies.
The risk of a well diversified portfolio will be similar to the systematic risk of the
market as a whole.
b) Return = rf +j (rm – rf)
Market risk premium = rm – rf
Return = 5 + (0.9 × 4)
= 8.6%

80 Topic 2: Risk and decision making

 3
MANAGING FINANCIAL
RISK

Learning Objectives
 To identify and describe the key financial risks facing a business
 To show and explain how financial instruments can be used to manage those risks
 To describe the characteristics of financial instruments used for hedging

Exam Requirement
In the exam you are likely to be asked to explain how derivatives provide a hedge
against risks, and you may have to illustrate this with non-complex calculations.

Math Tables 81
 TOPIC OVERVIEW

Managing financial risk

Addressing risk Interest rate risk

What is interest rate

Forward contracts
risk?

Forward rate
Futures
agreements

Options Interest rate futures

Interest rate options

Interest rate swaps

82 Topic 3: Managing financial risk

ADDRESSING RISK
Some of the risks faced by a business derive from price changes eg interest rates,
exchange rates and for commodities.
The purpose of hedging is to remove or reduce price risk. A range of hedging devices
exists to address risks.

Derivative: a financial security whose value is derived from the value and
characteristics of an underlying security. Option contracts, futures and swaps are all
types of derivative.

FORWARD CONTRACTS

A forward contract is a binding agreement to exchange a set amount of goods at

a set future date at a price agreed today.

Forward contracts allow businesses to set the price of a commodity well in advance.
They are particularly suitable in commodity markets such as gold, oil and agriculture
where prices can be highly volatile.
Forward contracts are tailor made between two parties and are binding contracts.

FORWARD CONTRACT
On 1 January the spot price of cocoa beans is £2,000 per ton. You will need to buy a ton
of cocoa beans on 28 February to fulfil a customer order and are concerned about the
price going up. You have therefore contracted with a seller of cocoa beans to buy a ton
at £2,100 on 28 February.
Requirement
Calculate the outcome for you and the seller if the spot price per ton of cocoa beans on
28 February is:
a) £2,200
b) £1,800
What will happen if your customer withdraws their order?

SOLUTION

Topic 3: Managing financial risk 83

 FUTURES

Introduction to futures

Future: is a standardised contract to buy or sell a specific amount of a

commodity, currency or financial instrument at a particular price on a stipulated
future date.

A futures contract represents a commitment to an additional transaction in the

future that limits the risk of existing commitments.
Unlike a forward, a future is traded on an organised exchange and is therefore
standardised in terms of products, contract sizes and delivery dates.

COMMODITY FUTURES
On 1 January the spot price of cocoa beans is £2,000 per ton. You will need to buy a ton
of cocoa beans to fulfil a customer order, which will be placed at some point during
March, and are concerned about the price going up.
There is an active market in cocoa futures and you buy a three-month contract for
one ton at £2,100. It expires on 31 March, so you are committed to buying one ton on
that date at the futures price of £2,100.
However, you do not plan to take delivery of these cocoa beans, you plan to close your
position by selling a contract for one ton when your customer places their order.
Your customer places their order on 10 March.
Requirement
Calculate your outcome if both the spot price and the March futures price per ton of
cocoa beans on 10 March is:
a) £2,200
b) £1,800

SOLUTION

84 Topic 3: Managing financial risk

Index futures
These can be used to protect against falls in the value of a portfolio of shares, thus are
of real importance to companies with significant investments, such as pension funds.

USING INDEX FUTURES TO SET UP A PORTFOLIO HEDGE

The investment manager of Moonstar Pensions Fund is concerned that share prices
will fall over the next month and wishes to hedge against this using FTSE stock index
futures. The fund's pension portfolio comprises investments which have a market value
of £5 million on 1 June 20X3.
On 1 June 20X3 the following prices are observed:
The prevailing value (ie spot value) of the FTSE 100 index is 5,000
The quote for September FTSE 100 index futures is 4,980
The face value of a FTSE 100 index contract is £10 per index point.
Using the futures price of the FTSE 100 index, this gives a contract value of 4,980 × £10
= £49,800
Requirement
Demonstrate what hedge should be undertaken to protect the portfolio against falls in
share prices.

SOLUTION

HOW INDEX FUTURES PROVIDE A HEDGE IF THE MARKET

FALLS

On 30 June 20X3, the market value of the shares in the portfolio was £4.8 million.
The FTSE 100 index and the futures index both stood at 4,800 on that date.
Requirement
Calculate the outcome of the hedge that Moonstar has undertaken.

Topic 3: Managing financial risk 85

 SOLUTION

THE IMPACT OF HEDGING IF THE MARKET RISES

On 30 June 20X3, the market value of the shares in the portfolio was £5.1 million.
The FTSE 100 index and the futures index both stood at 5,100 on that date.
Requirement
Explain what happens as a consequence of the hedge.

SOLUTION

86 Topic 3: Managing financial risk

The main elements of futures transactions
 Impact of a futures Downward risk is eliminated, the disadvantage is that any
hedge upside is also removed.
 The initial margin The amount held ‘on account’ at the exchange, usually to
cover any major losses that the trader may incur (similar
to a deposit).
 Basis risk Changes in spot price of underlying asset are not perfectly
correlated with changes in futures prices.
 Hedge efficiency Refers to the extent of risk neutralisation that the hedge
delivers - this is usually affected by using whole contracts
instead of exact amounts to hedge with and the element
of basis risk present in the hedge.
= gain on futures/loss on portfolio × 100%

INDEX FUTURES PRACTICE

A company has a portfolio of large company UK shares which is worth £6.3 million on 1
February 20X0 and the spot value of the FTSE100 index on that date is 4,200.
The board wishes to explore the implications of hedging the company against a potential
fall in share prices in the next month using FTSE100 stock index futures. At 1 February
20X0 the quote on Euronext. Liffe for FTSE100 stock index futures in one month is 4,130
and the face value of a FTSE100 index contract is £10 per index point.
Requirement
Calculate the outcome of this hedge if in one month’s time the portfolio’s value falls to
£6.15 million and the FTSE100 index and the FTSE100 stock index futures contract both
fall to 4,100. Calculate the hedge efficiency.

SOLUTION

Topic 3: Managing financial risk 87

 OPTIONS

The nature of an option

 An option is similar to a future or forward, except that the holder of the option can
choose whether or not to go through with the transaction and buy or sell the
asset.
 A call option, means an investor is entitled to buy the shares at the exercise
price within the specified period.
 A put option means an investor has the right to sell the shares at the exercise
price within the specified period.
 An option reduces or eliminates downside risk while allowing the user to benefit
from favourable price movements.
 The cost of an option to a purchaser is known as the option premium.
 Options may be traded on an exchange or agreed between two parties ('over-
the-counter' or 'OTC').

OPTIONS
On 1 January the spot price of cocoa beans is £2,000 per ton. You will need to buy a ton
of cocoa beans on 28 February to fulfil a customer order. You are concerned about the
price going up, but think there is also a reasonable chance that prices will fall, and you
do not want to miss out on the potential gain.
You therefore take out a call option (an option to buy) at £2,100 for one ton of cocoa
beans on 28 February. The seller (or 'writer') of the option will charge you a fee, or
premium of £70 for this.
Requirement
Calculate the outcome for you if the spot price per ton of cocoa beans on 28 February is:
a) £2,200
b) £1,800

SOLUTION

88 Topic 3: Managing financial risk

Traded options
Traded options are standardised and are bought and sold on secondary markets such
as NYSE Euronext.

PRICES OF TRADED OPTIONS

Prices (premiums) of traded share options are quoted in tables, such as the following for
options on shares in Reuters.
Reuters – underlying security price 679 (7 May)
Calls Puts
Exercise
Jul Oct Jan Jul Oct Jan
price
650 52 67 84 14½ 24 31½
700 25 41 58 37½ 44½ 55
Requirement
Explain what the table tells us

SOLUTION

Intrinsic value
The intrinsic value of an option is computed by assuming that its expiry date is
today.
'In the money' options would be exercised and have an intrinsic value equal to the
difference between the exercise price and the current share price.
'Out of the money' options would not be exercised and would therefore have zero
intrinsic value.

Topic 3: Managing financial risk 89

 Intrinsic Values
Intrinsic values as at 7 May – Reuters share options
(underlying share price = 679)
Calls Puts
Exercise Jul Oct Jan Jul Oct Jan
price

650 29 29 29 0 0 0

700 0 0 0 21 21 21

Time premiums
The time value can be computed for each option as the difference between the option's
actual value and its intrinsic value.
Three factors that will affect the time value of an option:
 The time period to expiry of the option – the longer the time to expiry, the more
the time value of the option will be.
 The volatility of the underlying security price – the more volatile, the greater the
chance of the option being ‘in the money’, which increases the time value of the
option.
 The general level of interest rates – the time value of an option reflects the
present value of the exercise price.

Time values
Time values as at 7 May – Reuters share options
(underlying share price = 679)

Calls Puts
Exercise Jul Oct Jan Jul Oct Jan
price

650 23 38 55 14½ 24 31½

700 25 41 58 16½ 23½ 34

Note that the time value of all options increases with the time period to expiry.

90 Topic 3: Managing financial risk

Index options
Traded options are available on the FTSE 100 share index.

INDEX OPTIONS
The investment manager of Moonstar Pensions Fund is concerned that share prices will
fall over the next month and wishes to hedge against this using June FTSE stock index
options.
The fund's pension portfolio comprises investments, which have a value of £4 million on
1 June 20X3. The spot value of the FTSE 100 index is 4,000.
On 1 June 20X3 the following options are available.

FTSE 100 INDEX OPTION (*4000) £10 per full index point
3,900 3,950 4,000 4,050 4,100
C P C P C P C P C P
June 135 30 100 44 70 66 45 95 30 130
July 210 90 180 110 150 130 120 155 100 185
August 270 130 240 150 215 175 185 195 160 220
*Underlying index value.

Requirement
Demonstrate what happens if either of the following two situations arises on 30 June:
a) The portfolio value falls to £3.8 million, and the FTSE index drops to 3,800.
b) The portfolio value rises to £4.1 million and the FTSE index rises to 4,100.

SOLUTION

Topic 3: Managing financial risk 91

 INDEX OPTIONS PRACTICE
A company has a portfolio of large company UK shares which is worth £6.3 million on 1
February 20X0 and the spot value of the FTSE100 index on that date is 4,200. The
board wishes to explore the implications of hedging the company against a potential fall
in share prices in the next month. Accordingly, it is considering the use of traded
FTSE100 index options. The following information from Euronext. Liffe has been
gathered:

FTSE 100 INDEX OPTION (£10 per full index point)

Exercise
4,100 4,150 4,200 4,250 4,300
Price
C P C P C P C P C P
March 137 31 101 46 72 67 46 97 32 131
April 211 92 181 111 151 132 122 156 101 187
May 272 131 241 152 217 176 186 197 162 221

Assume that the board decides to use options to protect the current value of the portfolio
in one month’s time.
Requirements
Explain, with supporting workings, what will happen in one month’s time if:
a) The portfolio’s value rises to £6.375 million and the FTSE100 index rises to 4,250
b) The portfolio’s value falls to £6.15 million and the FTSE100 index falls to 4,100

SOLUTION

92 Topic 3: Managing financial risk

SUMMARY

Topic 3: Managing financial risk 93

 INTEREST RATE RISK
WHAT IS INTEREST RATE RISK?

Introduction
Corporate treasurers will be responsible for managing the company's cash and
borrowings in order to repay debts as they fall due and to minimise the risks surrounding
interest payments and receipts.
Where the magnitude of the risk is immaterial in comparison with the company's
overall cash flows, one option is to do nothing and to accept the effects of any
movement in interest rates which occur.

Risks from interest rate movements

Fixed rate versus Depends on whether rates are falling or rising
floating rate debt
Term of loan Might need to be repaid early

Term loan or overdraft Can be expensive due to short term nature of debt
facility
Deposit at floating rates Sensitive to falling rates

Pooling of assets and liabilities

Some of the interest rate risks to which a firm is exposed may cancel each other out,
where there are both assets and liabilities which both have exposure to interest rate
changes. If interest rates rise, more interest will be payable on loans and other
liabilities, but this will be compensated for by higher interest received on assets such as
money market deposits.

FORWARD RATE AGREEMENTS (FRAS)

 Forward Rate Agreements allow borrowers or lenders to fix their future rate of
interest.
 A borrower will buy a FRA while an investor will sell a FRA, these are separate
from the underlying loan or deposit.
 5.75-5.70 means that you can fix a borrowing rate at 5.75% and a deposit rate at
5.70%.
 A '3–6' forward rate agreement is one that starts in three months and lasts for
three months ie ends six months from now.

94 Topic 3: Managing financial risk

 FORWARD RATE AGREEMENT
It is 30 June. Lynn plc will need a £10 million six month fixed rate loan from 1 October.
Lynn wants to hedge using a FRA. The relevant FRA rate on 30 June is 6%.
Requirement
a) State what FRA is required.
b) Explain the result of the FRA and the effective loan rate if the six month FRA
benchmark rate has moved to:
i) 5%
ii) 9%

SOLUTION

Limitations of FRAs
 They are usually only available on loans of at least £500,000.
 They are also likely to be difficult to obtain for periods of over one year. This
problem can be overcome by using a swap.
 They remove any upside potential ie they give a fixed rate of interest.
Advantages of FRAs
 For the period of the FRA at least, they protect the borrower/investor from
adverse market interest rate movements.
 FRAs can be tailored to the amount and duration required, whereas some other
hedges, eg futures, are standardised.

Interest rate guarantee (IRG)

 An interest rate guarantee is an over the counter option which hedges the
interest rate for a single period of up to one year.
 Can be purchased from major banks, with specific values, periods of maturity,
denominated currencies and rates of agreed interest.
 The cost of the option is the 'premium'.
 Offer more flexibility than FRAs, although they are more expensive.

Topic 3: Managing financial risk 95

 FORWARD RATE AGREEMENT PRACTICE
In three months’ time a company will be drawing down a three-month £2.5 million loan
facility which is granted each year by its bank to see the firm through its peak borrowing
period. The following information is available:
1) The quotation for a ‘3-6’ forward rate agreement is currently 2.60 – 1.35.
2) The spot rate of interest today is 2.40% pa.
Requirement
Explain how the company could use a forward rate agreement to resolve the uncertainty
surrounding its future borrowing costs and show the effect if, in three months’ time, the
spot rate of interest is 3% pa.

SOLUTION

INTEREST RATE FUTURES

Futures contracts
 Borrowers will wish to hedge against an interest rate rise by selling futures
now and buying futures on the day that the interest rate is fixed (ie when the
hedge is closed out).
 Savers will wish to hedge against the possibility of falling interest rates by buying
futures now and selling futures on the date that the actual saving starts.
 Short-term interest rate futures contracts (STIRs) normally represent interest
receivable or payable on notional lending or borrowing for a three-month
period beginning on a standard future date.
 3-month sterling interest rate futures have a standard contract size of £500,000.

Pricing futures contracts

The pricing of an interest rate futures contract is determined by the interest rate (r) and
is calculated as (100 – r).

96 Topic 3: Managing financial risk

 STANDARDISED INTEREST RATE FUTURES
Requirement
If an investor buys one 3-month sterling £500,000 March contract for 93.00 what have
they done?
What would happen if interest rates dropped by 2%?

SOLUTION

Maturity mismatch
Maturity mismatch occurs if the actual period of lending or borrowing does not match
the notional period of the futures contract (three months).
Amount of actual loan or deposit Length of loan
Number of futures contracts = 
Futures contract size 3 months
Remember it is the length of the loan that determines how many futures contracts are
needed.

MATURITY MIS-MATCH
On 5 June, a corporate treasurer decides to hedge a short-term loan of £17 million which
will be required for two months from 4 October to 3 December. Three-month sterling
futures, December contract, are trading at 98.15. The contract size is £500,000.
Requirement
How many contracts are required?

SOLUTION

Topic 3: Managing financial risk 97

 INTEREST RATE HEDGE USING FUTURES
It is 1 January, and a company has identified that it will need to borrow £10 million on
31st March for six months.
The spot rate on 1 January is 8% and March 3 month interest rate futures with a
contract size of £500,000 are trading at 91.
Requirement
Demonstrate how futures can be used to hedge against interest rate rises. Assume that
at 31st March the spot rate of interest is 11% and the March interest rate futures price
has fallen to 89.

SOLUTION
a) Set up the hedge

b) Outcome in futures market

c) Outcome in spot market

98 Topic 3: Managing financial risk

 INTEREST RATE HEDGE USING FUTURES PRACTICE
In three months’ time a company will be drawing down a three-month £2.5 million loan
facility which is granted each year by its bank to see the firm through its peak borrowing
period.
The spot rate of interest today is 2.40% pa and the relevant three-month sterling
interest rate futures contract (standard contract size £500,000) is currently trading at
97.20.
Requirement
Explain how the company could use sterling interest rate futures to hedge its exposure to
interest rate risk and show the effect if, in three months’ time, the spot rate of interest is
3% and the price of the interest rate futures contract has fallen to 97.

SOLUTION

Topic 3: Managing financial risk 99

 INTEREST RATE OPTIONS

Traded interest rate options

 Exchange-traded interest rate options are available as options on interest rate
futures.
 A borrower will purchase an option to sell futures (a put option) and only
exercises the option if interest rates have risen causing a fall in the price of the
futures contract.
 A saver will purchase an option to buy futures (a call option) and only exercises the
option if interest rates have fallen causing a rise in the price of the futures contract.

TRADED OPTIONS
Panda Ltd wishes to borrow £4 million fixed rate in June for nine months and wishes to
protect itself against rates rising above 6.75%. It is 11 May and the spot rate is currently
6%. The data is as follows:
SHORT STERLING OPTIONS (STIR)
£500,000
Strike price Calls Puts
June Sept Dec June Sept Dec
93.25 0.16 0.19 0.21 0.14 0.92 1.62
93.50 0.05 0.06 0.07 0.28 1.15 1.85
93.75 0.01 0.02 0.03 0.49 1.39 2.10
Panda negotiates the loan with the bank on 12 June (when the £4m loan rate is fixed for
the full nine months) and closes out the hedge.
Requirement
Calculate the outcome of the hedge and the effective loan rate if prices on 12 June are
as follows:
Closing prices
Case 1 Case 2
Spot price 7.4% 5.1%
Futures price 92.31 94.75

SOLUTION

100 Topic 3: Managing financial risk

 TRADED OPTIONS PRACTICE
A company has identified the need to invest £2.5 million in the spot market for a six
month period from 1 March 20X0. The current spot interest rate is 5.5% pa and the
board wants to protect the company from interest rates falling below 5% pa and is
considering the use of traded interest rate options on 3 month sterling futures. These
have a contract size of £500,000 and current prices (option premiums are in annual %
terms) are:
Calls Puts
Strike price March June Sept. March June Sept.
94.50 0.18 0.20 0.23 0.15 0.94 1.63
94.75 0.06 0.08 0.09 0.30 1.16 1.87
95.00 0.03 0.04 0.05 0.51 1.40 2.12
Requirement
Calculate the outcome of the hedge if interest rates on 1 March 20X0 are 4.5% pa and
the futures price is 95.80.

Topic 3: Managing financial risk 101

 SOLUTION

102 Topic 3: Managing financial risk

INTEREST RATE SWAPS

Swap procedures
 An interest rate swap is a contractual arrangement for two organisations to
exchange future interest rate payments, eg on different loan terms.
 For a swap to be effective, the size of the loan must be notionally equal for both
parties.
 Interest rate swaps act as a means of switching from paying one type of interest
(eg fixed) to another (eg floating), much more cheaply than renegotiating
existing debt.
 They are transactions that exploit different interest rates in different markets
for borrowing, reducing interest costs for either fixed or floating debt.
 The gain arises due to the principle of comparative advantage.

INTEREST RATE SWAPS

Sparrow plc wishes to borrow fixed but, because of its credit rating, the best rate it can
obtain is 11% pa. It can borrow variable at LIBOR +2%. Nightingale plc can borrow fixed
at 9% or variable at LIBOR +1%. Nightingale plc is happy to borrow variable.
Assume both wish to borrow £10m.
Requirement
Illustrate how a swap would benefit both parties, assuming the following:
1) Sparrow plc borrows £10m variable at LIBOR +2%
2) Nightingale plc borrows £10m fixed at 9%

SOLUTION

Topic 3: Managing financial risk 103

 PRACTISE CREATING A SWAP
Goodcredit plc has been given a high credit rating. It can borrow at a fixed rate of 11%,
or at a variable interest rate equal to LIBOR, which also happens to be 11% at the
moment. It would like to borrow at a variable rate. Secondtier plc is a company with a
lower credit rating, which can borrow at a fixed rate of 12.5% or at a variable rate of
LIBOR plus 0.5%. It would like to borrow at a fixed rate.
Requirement
Demonstrate the savings available from entering into a swap and suggest the terms of
the swap.

SOLUTION

104 Topic 3: Managing financial risk

Advantages and disadvantages of swaps
Advantages
 They enable a switch from floating rate to fixed rate interest, or vice versa,
for use as a hedge against interest rate risk.
 The arrangement costs are often significantly less than terminating an
existing loan and taking out a new one.
 They can be used to make interest rate savings, either out of the counterparty
or out of the loan markets, by using the principle of comparative advantage.
 They are available for longer periods than short-term methods of hedging risk
(FRAs, futures and options).
 They are flexible, since they can be arranged for tailor made amounts and
periods, and reversible.
Disadvantages
 There is a risk that the counterparty to the swap will default before completion
of the agreement, this risk is lessened by using a reputable intermediary.
 The risk of unfavourable market movements of interest or exchange rates
after the company enters a swap.
 The risk that swap activity may lead to the financial statements of the party
involved being misleading.

Topic 3: Managing financial risk 105

 SUMMARY

106 Topic 3: Managing financial risk

ACTIVITY ANSWERS

FORWARD CONTRACT
At a price of £2,200, you will be £100 better off than buying in the spot market.
At a price of £1,800, you will be £300 worse off than buying in the spot market.
If your customer withdraws their order, you will still need to go through with the forward
contract, buy the cocoa beans and then either retain them or sell them at whatever the
spot market price is.

COMMODITY FUTURES
a) £2,200
You BOUGHT the futures contract on 1 January at £2,100
You SOLD the same contract on 10 March at £2,200
You have therefore made a GAIN on the contract of £100, which the exchange will
credit to you.
You buy the cocoa beans on the spot market at £2,200
The NET COST of your cocoa beans is therefore £2,100
b) £1,800
You BOUGHT the futures contract on 1 January at £2,100
You SOLD the same contract on 10 March at £1,800
You have therefore made a LOSS on the contract of £300, which you will pay to
the exchange
You buy the cocoa beans on the spot market at £1,800
The NET COST of your cocoa beans is therefore £2,100
Assuming there is no divergence between the spot price and futures price, and
that you can match your exposure with whole contracts, you have effectively
guaranteed the price you will pay as being £2,100.

Topic 3: Managing financial risk 107

 USING INDEX FUTURES TO SET UP A PORTFOLIO HEDGE
Calculate number of contracts
We should sell futures to protect our portfolio.
Market value of portfolio
Number of contracts =
Value of one contract
£5,000,000
=
£49,800
= 100.4 rounded to 100 contracts

HOW INDEX FUTURES PROVIDE A HEDGE IF THE MARKET

FALLS

Step 1
Position in spot market
Loss on portfolio = £4.8 million – £5 million
= £0.2 million

Step 2
Calculate gain or loss on futures
Buy futures at lower price than we sold them for (closing out)
Gain on futures = (4,980 – 4,800)  £10  100 contracts
= £180,000

Step 3
Calculate net position
Net position = 180,000 gain on futures – 200,000 loss on portfolio
= (20,000) loss overall
Note: the hedge is less than 100% efficient because of basis (ie the 1 June FTSE index
value and the futures price are different) and the rounding of the number of contracts.

108 Topic 3: Managing financial risk

 THE IMPACT OF HEDGING IF THE MARKET RISES

Step 1
Position in spot market
Gain on portfolio = £5.1 million – £5 million = £0.1 million

Step 2
Calculate gain or loss on futures
Initially sold futures for 4,980
Now buy futures for 5,100
Loss on closing out futures (120)  £10  100 contracts = £120,000

Step 3
Calculate net position
Net position £100,000 gain on portfolio
(120,000) loss on futures
£(20,000) loss overall

INDEX FUTURES PRACTICE

Number of contracts required = 6,300,000/(4,130 × 10) = 153 contracts
Need to sell futures to protect the portfolio:
Sell @ 4,130
Buy @ 4,100
Gain 30 × £10 × 153 contracts = £45,900
Loss in portfolio value = £150,000
Net loss = £104,100
£45,900 of the £150,000 loss is protected therefore the hedge is 45,900/150,000 = 31%
efficient.

OPTIONS
a) If the spot price is £2,200, You will exercise your option to buy at £2,100 as this
gives you a better price than the spot market.
Including your premium of £70, the total cost to you is £2,170, leaving you £30
better off than simply buying in the spot market.
b) If the spot price is £1,800, You will let the option lapse and buy your cocoa beans
in the spot market at £1,800.
However, you will still need to pay the premium of £70.

Topic 3: Managing financial risk 109

 PRICES OF TRADED OPTIONS
Prices of traded share options are quoted in tables, such as the following for options on
shares in Reuters.
Reuters – underlying security price 679 (7 May) 1)
Calls 2) Puts 3)
Exercise
Jul Oct Jan Jul Oct Jan
price
4) 650 52 67 84 14½ 24 31½
700 25 41 58 5) 37½ 44½ 55
This table shows the following.
1) Reuters shares are trading at 679 pence on 7 May.
2) Call or buy options are available with expiry dates at the end of July, October and
January.
3) Put or sell options are also available with expiry dates at the end of July, October
and January.
4) Two possible exercise prices exist, one below the current share price (650p) and
one above the current share price (700p).
5) The figures in the table show the price (premium) per share of each option
contract in pence.
a) A call option is in the money if the exercise price is below the underlying
security price. All the 650 call options are in the money, and all the 700 call
options are out of the money.
b) A put option is in the money if the exercise price is above the underlying
security price. All the 700 put options are in the money, and all of the 650
put options are out of the money.
If the Reuters share price were to rise to 700p, all the 700 options would be at the
money.
For all traded options there will be at least one exercise price above the current share
price and another below it. If the Reuters share price were to rise above 700p (for at
least three days) a new series of options with exercise price 750p would be created.

110 Topic 3: Managing financial risk

 INDEX OPTIONS

Step 1
Set up the hedge
 What sort?
The concern is that the value of the portfolio held by the fund will fall, so an option
to sell is required. Thus a June put option with an exercise price of 4,000 is
purchased. (ie the 4,000 exercise price is closer to maintain the existing value of
the portfolio)
 How many?
The portfolio value is £4 million
The spot value of the FTSE is 4,000
The value of one contract is 4,000  £10 = £40,000
The number of option contracts required to cover a portfolio of £4 million is
therefore £4 million/£40,000 = 100 contracts

Step 2
What does it cost?
The premium payable for 100 June puts at 4,000 is 66 points per contract.
66 points  £10 per point  100 contracts = £66,000

Step 3
Outcomes
Index falls to 3,800 Index rises to 4,100
Exercise option? Yes No
Gain on option (4,000 – 3,800)  £10 = –
2,000
 100 contracts = £200,000
Change in portfolio value (£200,000) £100,000
Cost of the premium (£66,000) (£66,000)
Overall position (£66,000) £34,000

Topic 3: Managing financial risk 111

 INDEX OPTIONS PRACTICE
What contract? Put, March, 4,200
How many contracts? 6,300,000/4,200 × 10 = 150
Cost of premium = 150 contracts × £10 × 67 points = £100,500
(a) FTSE rises to 4,250
Do not exercise
Increase in portfolio value = £6,375,000 - £6,300,000 = £75,000
Net loss = 75,000 – 100,500 = (£25,500)
There is still a loss in portfolio value due to the cost of the premium but the
company benefits from the upside.
(b) FTSE falls to 4,100
Exercise option to sell at 4,200
Gain on option = (4,200 – 4,100) × £10 × 150 contracts = £150,000
Fall in portfolio value = £6,300,000 - £6,150,000 = £150,000
Net loss = (£100,500) (the cost of the premium)

FORWARD RATE AGREEMENT

a) The Forward Rate Agreement to be bought by the borrower is '3-9' (or 3v9)
b) i) At 5% because interest rates have fallen, Lynn plc will pay the bank:
£
FRA payment £10 million  (5% – 6%)  6/12 (50,000)
Payment on underlying loan 5%  £10 million  6/12 (250,000)
Net payment on loan (300,000)
Effective interest rate on loan 6%
ii) At 9% because interest rates have risen, the bank will pay Lynn plc
£
FRA receipt £10 million  (9% – 6%)  6/12 150,000
Payment on underlying loan at market rate 9%  £10 million  (450,000)
6
/12
Net payment on loan (300,000)
Effective interest rate on loan 6%

112 Topic 3: Managing financial risk

 FORWARD RATE AGREEMENT PRACTICE
As a borrower the company should buy a 3-6 FRA and can thereby fix a borrowing rate
of 2.60%.
At 3% because interest rates have risen, the bank will pay the company:
£
3
FRA payment £2.5 million  (3% – 2.6%)  /12 2,500
Payment on underlying loan 3%  £2.5 million  3/12 (18,750)
Net payment on loan (16,250)
Effective interest rate on loan 16,250/2,500,000  12/3 2.6%

STANDARDISED INTEREST RATE FUTURES

The features of this futures contract can be broken down as follows:
3-month March contract This notional investment will pay interest for three months
only, from March
Sterling The currency in which interest will be paid, and in which
the notional investment is being made
£500,000 The standard contract size. An investment of less than this
is not possible, and more than this will be only possible in
multiples of £500,000
Buying a contract They are worried that interest rates will fall. If so, the
futures price will rise so buy futures now and sell at a
profit
93.00 The price of a future =100 – r
Therefore a price of 93 implies a rate of 7%
These are 3-month contracts, so the 7% refers to the
annual rate of interest on a 3-month deposit
(Price = 100 – r)
93 = 100 – 7%
If interest rates dropped by 2% to 5% the price would rise.
Price = 100 – 5 = 95
The investor could then close out his position by selling a March contract
Buy at (93.00)
Sell at 95.00
Gain 2.00%
The interest rate used to determine the price of a future is an annual rate, whereas the
contract is for three months.
In the example, the 2% refers to the change in the annual rate for 3-month deposits. As
these are 3-month contracts, the gain on one contract is
2%  3/12  £500,000 = £2,500

Topic 3: Managing financial risk 113

 MATURITY MIS-MATCH
£ 17 million  2 months
Number of futures contracts =
£0.5 million  3 months
= 22.67 contracts, rounded to 23

INTEREST RATE HEDGE USING FUTURES

The following steps should be taken.
a) Setup
i) What contract: 3-month contract
ii) What type? sell (as rates expected to rise)
iii) How many contracts?:
Exposure Loan period 10m 6
 =  = 40 contracts
Contract size Length of contract 0.5m 3
b) Futures outcome
At opening rate: 91 sell
At closing rate: (89) buy
Gain: 2%
Futures outcome: 2%  £0.5m  3/12  40 contracts = £100,000
c) Net outcome
£
Payment in spot market £10m  11%  6/12 (550,000)
Receipt in futures market 100,000
Net payments (450,000)
Effective interest rate = 450,000/10,000,000 × 12/6 = 9%

INTEREST RATE HEDGE USING FUTURES PRACTICE

The company will need to sell three-month £ interest rate futures contracts
Number of contracts = 2,500,000/500,000 × 3/3 = 5
Outcome in futures market:
Sell at 97.20 and buy at 97.00 for a gain of 0.20%
0.20% × 500,000 × 3/12 × 5 = £1,250
Payment in the spot market = 2,500,000 × 3% × 3/12 = (£18,750)
Net payment = (£18,750) – (£1,250) = (£17,500)
Effective interest rate = 17,500/2,500,000 × 12/3 =2.80%

114 Topic 3: Managing financial risk

 TRADED OPTIONS
The following method should be used.

Step 1
Setup
a) Which contract? June
b) What type? As paying interest need a put option (the right to sell a future)
c) Strike price 93.25 (100 – 6.75) Cap needed at 6.75%
d) How many? £4m/£0.5m  9/3 = 24 contracts
e) Premium At 93.25 (6.75%) June Puts = 0.14%
Contracts  premium  contract size  contract duration = 24  0.14%  £500,000 
3/12 = £4,200
Note: As these are 3-month contracts, the premium – which is quoted as an annual rate
– needs to be adjusted to reflect this.

Step 2
Closing prices
Case 1 Case 2
Spot price 7.4% 5.1%
Futures price 92.31 94.75

Step 3
Outcome
Case 1 Case 2
a) Options market outcome
Strike price right to sell (Put) at 93.25 93.25
Closing price buy at (92.31) (94.75)
Exercise? Yes No
If exercised, gain on future 0.94% –
Outcome of options position 0.94%  £500,000  –
3/12  24
= £28,200

b) Net position £ £
Borrow spot £4m  9/12  7.4% or 5.1% (222,000) (153,000)
Option 28,200 –
Option premium (4,200) (4,200)
Net outcome (198,000) 157,200)
198,000 12 157,200 12
c) Effective interest rate   6.6%   5.24%
4,000,000 9 4,000,000 9

Topic 3: Managing financial risk 115

 TRADED OPTIONS PRACTICE
The company would need to buy March call option contracts as follows.
£2,500,000 × 6 / 3
Number of contracts = = 10
£500,000
Cost of premium = 0.03% × £500,000 × 10 contracts × 3/12 = £375
Interest rates @ 4.5%, will exercise option
Buy @ (95.00)
Sell @ 95.80
Gain 0.8% × £500,000 × 10 contracts × 3/12 = £10,000
Actual transaction: £2,500,000 × 4.5% × 6/12 = £56,250
Net receipt = 56,250 + 10,000 – 375 = £65,875
Effective interest rate = 65,876/2,500,000 × 12/6 = 5.27%

INTEREST RATE SWAPS

Sparrow pays 2% more for fixed debt, but only 1% more for variable debt. There is
therefore a 1% possible gain from a swap, that we will split evenly between the two
participants.
Sparrow N Nightingale
Borrow (LIBOR + 2%) (9%)
Swap floating LIBOR + ½% (LIBOR + ½%)
Swap fixed (9%) 9%
Net interest cost (10½%) (LIBOR + ½%)

PRACTISE CREATING A SWAP

A swap allows both parties to end up paying interest at a lower rate via a swap than is
obtainable from a bank. Where does this gain come from? To answer this question, set
out a table of the rates at which both companies could borrow from the bank.

Goodcredit Secondtier Difference

Can borrow at fixed rate 11% 12.5% 1.5%
Can borrow at floating rate LIBOR LIBOR + 0.5% 0.5%
Difference between differences 1.0%
Goodcredit has a better credit rating than Secondtier in both types of loan market, but
its advantage is comparatively higher in the fixed interest market. The 1%
differential between Goodcredit's advantage in the two types of loan may represent a
market imperfection or there may be a good reason for it. Whatever the reason, it
represents a potential gain which can be made out of a swap arrangement.

116 Topic 3: Managing financial risk

 Goodcredit Secondtier Sum total
Company wants Variable Fixed
Would pay (no swap) (LIBOR) (12.5%) (LIBOR + 12.5%)
Could pay (11%) (LIBOR + 0.5%) (LIBOR + 11.5%)
Potential gain 1%
Assume that the potential gain of 1% is split equally between Goodcredit and Secondtier,
0.5% each. Then Goodcredit will be targeting a floating rate loan of LIBOR less 0.5%
(0.5% less than that at which it can borrow from the bank). Similarly, Secondtier will be
targeting a fixed interest loan of 12.5% – 0.5% = 12%. These are precisely the rates
which are obtained by the swap arrangement illustrated below.

Goodcredit Secondtier Sum total

Split evenly 0.5% 0.5% 1%
Expected outcome (LIBOR – 0.5%) (12%) (LIBOR + 11.5%)
The rate that each company expects to pay after the swap is thus 0.5% less than it would
pay without a swap.
eg Goodcredit would pay LIBOR, so will pay LIBOR – 0.5%
Secondtier would pay 12.5% fixed so will pay 12% fixed

Swap terms Goodcredit Secondtier Sum total

Could pay (11%) (LIBOR + 0.5%) (LIBOR + 11.5%)
Swap floating (LIBOR + 0.5%) LIBOR + 0.5%
Swap fixed 12% (12%)
Net paid (LIBOR – 0.5%) (12%) (LIBOR + 11.5%)
Would pay (LIBOR) (12.5%) (LIBOR + 12.5%)
Gain 0.5% 0.5% 1%
To construct a simple swap:
Let Goodcredit pay all of Secondtier's interest
ie LIBOR + 0.5% paid to Secondtier, as shown above
Secondtier must then reciprocate by paying fixed interest to Goodcredit. However,
Secondtier will only pay 12% as calculated and shown above, in order to be 0.5% better
off under the swap.
The overall effect of this is to leave each party 0.5% better off.
The results of the swap are that Goodcredit ends up paying variable rate interest, but
at a lower cost than it could get from a bank, and Secondtier ends up paying fixed rate
interest, also at a lower cost than it could get from investors or a bank.
Note that for the swap to give a gain to both parties:
a) Each company must borrow in the loan market in which it has comparative
advantage. Goodcredit has the greatest advantage when it borrows fixed interest.
Secondtier has the least disadvantage when it borrows floating rate.
b) The parties must actually want interest of the opposite type to that in which they
have comparative advantage. Goodcredit wants floating and Secondtier wants
fixed.
Once the target interest rate for each company has been established, there is an infinite
number of swap arrangements which will produce the same net result. The example
illustrated above is only one of them.

Topic 3: Managing financial risk 117

118 Topic 3: Managing financial risk
 4
CURRENCY RISKS

Learning Objectives
 To explain the key risks deriving from foreign exchange movements
 To explain how financial investment can be used to hedge against foreign
exchange risk
 To demonstrate how hedges work using non-complex calculations
 To identify appropriate methods of managing the risks of overseas trade

Exam Requirement
In the exam you may be asked to explain and illustrate how hedges work in a
straightforward scenario. Knowledge of how to construct a hedge and how to choose
between different hedges may be tested.

Math Tables 119

 TOPIC OVERVIEW

120 Topic 4: Currency risks

EXCHANGE RATES
QUOTING EXCHANGE RATES
 An exchange rate is the rate at which one country's currency can be traded in
exchange for another country's currency.
 The spot rate is the exchange rate currently offered on a particular currency
quoted for immediate delivery of the currency.
 Foreign exchange dealers make their profit from the difference between a buying
rate (bid price) and a selling rate (offer price).
 A direct quote is the amount of domestic currency is required to buy one unit of
foreign currency.
 An indirect quote is the amount of foreign currency is needed to buy one unit of
domestic currency, direct rates are reciprocals of the indirect rates.

EXCHANGE RATES
Requirement
Calculate how much sterling exporters would receive or how much sterling importers
would pay, ignoring the bank's commission, in each of the following situations, if they
were to exchange the overseas currency and sterling at the spot rate.
a) A UK exporter receives a payment from a Danish customer of 150,000 kroners.
b) A UK importer buys goods from a Japanese supplier and pays 1 million yen.
Spot rates are as follows.
Bank sells Bank buys
(offer) (bid)
Danish Kr/£ 9.4340 – 9.5380
Japan ¥/£ 203.650 – 205.781

SOLUTION

Topic 4: Currency risks 121

 RISK AND FOREIGN EXCHANGE

Currency risk

Transaction risk: this is the risk of adverse exchange rate movements occurring in the
course of normal international trading transactions.
This arises when the prices of imports or exports are fixed in foreign currency terms and
there is movement in the exchange rate between the date when the price is agreed and
the date when the cash is paid or received in settlement.
Translation risk: this is the risk that the organisation will make exchange losses when
the accounting results of its foreign branches or subsidiaries are translated into the
home currency.
Translation losses can result, for example, from restating the book value of a foreign
subsidiary's assets at the exchange rate at the balance sheet date.
Economic risk: this refers to the effect of exchange rate movements on the
international competitiveness of a company.
For example, a UK company might use raw materials which are priced in US dollars, but
export its products mainly within the EU. Both a depreciation of sterling against the
dollar or an appreciation of sterling against other EU currencies will erode the
competitiveness of the company. Economic exposure can be difficult to avoid, although
diversification of the supplier and customer base across different countries will
reduce this kind of exposure to risk.

Managing transaction exposure

CHANGES IN EXCHANGE RATES

Bulldog Ltd, a UK company, buys goods from Redland which cost 100,000 Reds (the local
currency). The goods are re-sold in the UK for £32,000. At the time of the import
purchase the exchange rate for Reds against sterling is 3.5650 – 3.5800.
Requirement
What is the expected profit on the re-sale?

SOLUTION

122 Topic 4: Currency risks

 TRANSACTION RISK
Requirement
Calculate the actual profit earned by Bulldog Ltd if the spot rate at the time when the
currency is received has moved to:
a) 3.0800 – 3.0950
b) 4.0650 – 4.0800
Ignore bank commission charges.

SOLUTION

Should we hedge?
While the idea of reduced risk may sound appealing, it is of course possible to do
nothing ie leave the business open to changes in the foreign exchange rate. There are a
number of factors to consider before getting involved in hedging activities:
 Costs
 Exposure
 Attitude to risk
 Portfolio effect
 Insolvency risk and cost of capital

Direct risk reduction

Transaction risk can be controlled without using capital markets in the following ways:
 Invoicing in the company’s home currency
 Matching receipts and payments (netting-off)
 Matching assets and liabilities
 Leading and lagging

External hedging
Transaction risk can be controlled using established currency or capital markets.
 Forward contracts
 Money market hedges
 Futures market
 Options market

Topic 4: Currency risks 123

 RISK AND FOREIGN EXCHANGE

Requirements
a) A UK company has despatched a shipment of goods to Sweden. The sale will be
invoiced in Swedish Kroner and payment is to be made in three months' time.
If the Pound sterling were to weaken substantially against the Swedish Kroner,
what would be the foreign exchange gain or loss effects upon the UK exporter and
the Swedish importer?
b) Mogs plc has recently purchased goods from Cantona, a French company. Mogs plc
was invoiced in £ sterling and payment for the goods was made after thirty days.
During this period, the £ sterling strengthened against the euro. Neither party to
the transaction hedged against exchange rate risk.
What was the effect (gain/loss/no effect) of the change in exchange rates for Mogs
plc and for Cantona?

SOLUTION

FORWARDS

Forward exchange contracts

A forward exchange contract is:
 An immediately firm and binding contract, eg between a bank and its
customer.
 For the purchase or sale of a specified quantity of a stated foreign currency.
 At a rate of exchange fixed at the time the contract is made.
 For performance (delivery of the currency and payment for it) at a future time
which is agreed when making the contract. (This future time will be either a
specified date, or any time between two specified dates.)

124 Topic 4: Currency risks

 FORWARD EXCHANGE CONTRACT
A UK exporter sells goods to a US customer for $5m on three months' credit.
Requirement
Assuming the forward exchange rate is: $/£1.6777, determine the £ receipt that can be
guaranteed using a forward contract.

SOLUTION

Fulfilling a forward contract

An importer might find that:
 His supplier fails to deliver the goods as specified
 The supplier sends fewer goods than expected and so the importer has less to
pay for
 The supplier is late with the delivery
An exporter might find the same types of situation, but in reverse.
The bank will make the customer fulfil the contract, meaning that the customer is
exposed to currency transaction risk even though it attempted to manage such risks by
hedging. These arrangements are known as closing out a forward exchange contract.

Option forward exchange contracts

Option forward contracts are forward exchange contracts where the customer has the
option to call for performance of the contract:
 At any date from the contract being made, up to a specified date in the future,
or
 At any date between two dates both in the future
Performance must take place at some time: it cannot be avoided altogether.
Option forward contracts are normally used to cover whole months straddling the likely
payment date, where the customer is not sure of the exact date on which he will want to
buy or sell currency. (The purpose of an option forward contract is to avoid having to
renew a forward exchange contract and extend it by a few days, because extending a
forward contract can be expensive.)

Topic 4: Currency risks 125

 How are forward exchange rates set?
A forward rate might be higher or lower than the spot rate.
 Forward rate for the overseas currency is weaker than spot, quoted at discount.
 Forward rate for the overseas currency is stronger than spot, quoted at
premium.
A discount is therefore added to the spot rate, and a premium is subtracted from
the spot rate. (The mnemonic ADDIS may help you to remember that we ADD
Discounts and so subtract premiums.)
The longer the duration of a forward contract, the larger will be the quoted premium or
discount.

ADJUSTING FOR A PREMIUM OR DISCOUNT

1 January: Spot rate US $ $1.9500 – 1.9610
One month forward discount: 0.20c – 0.22c
Three month forward premium: 0.22c – 0.18c
Requirement
What are the forward rates quoted for one and three month contracts respectively?

SOLUTION

Use of interest rate parity to forecast future exchange rates

Interest rate parity theory states that the difference between the spot and forward rate
can be predicted by the difference in interest rates between the two countries.
If an investor places money in a currency with a high interest rate, they will be no better
off after conversion back into their domestic currency using a forward contract than if
they had left the money invested at the domestic interest rate.
The relationship between the spot and forward rates is shown algebraically as follows:

126 Topic 4: Currency risks

 1 i f
Spot rate  = Forward rate
1  i uk
where if is the overseas interest rate
iuk is the domestic interest rate

and where the spot and forward rates are quoted as indirect quotes (ie overseas rate /
domestic rate).

INTEREST RATE PARITY

A UK company is expecting to receive $1 million in one year's time. The spot rate is
$1.95/£. The company could borrow in dollars at 6% or in sterling at 5%.
Requirement
Predict what the exchange rate is likely to be in one year.

SOLUTION

Purchasing power parity (PPP)

Purchasing power parity: the theory that in the long term exchange rates between
currencies will tend to reflect the relative purchasing power of each country.

This theory is based on the idea that a basket of goods in one country will – after the
effect of the exchange rate – cost the same no matter where it is traded. It is sometimes
called the law of one price.

Topic 4: Currency risks 127

 Purchasing power parity
Consider a collection of goods that sell for £1,000 in the UK.
If the exchange rate is $1.80/£, what are the implications of the same goods selling for
$2,000 in the US?
In principle, if the same goods cost $2,000 in the US, instead of (£1,000 @ $1.80) =
$1,800, then consumers would buy from the UK (requiring £) and not in the US
(therefore selling $).
These forces of supply and demand would ultimately cause the exchange rate to alter
with dollars weakening to $2.00/£, at which point the prices are effectively the same.

The impact of different inflation rates will cause prices to change at different speeds. So
even if parity has been achieved (as above) a disequilibrium will be created. Purchasing
power parity predicts that the disequilibrium will be removed by exchange rates
changing.

PURCHASING POWER PARITY

Requirement
Taking the situation above, ie where an equilibrium rate of $2/£ exists, show what would
happen if:
 Expected inflation in the UK is 3%
 Expected inflation in the US is 4%

SOLUTION

128 Topic 4: Currency risks

 FORWARDS
Requirements
a) Simpleton sells goods to a US customer for $200,000, receivable in two months'
time. Exchange rates are given below.
Spot $1.7620 – 1.7680
Two months forward 0.40 – 0.35 cents pm
If Simpleton enters into a forward contract to sell $200,000 in two months' time,
what will he receive?
b) Arold plc is expecting to pay $500,000 in four months' time to a US customer. To
hedge against currency risk, the company enters into a forward exchange contract
with a bank to buy $500,000 in four months' time.
Exchange rates are:
$/£ spot 1.9015 – 1.9055
4-months forward $0.0030 – 0.0025 premium
What sterling amount will be paid by Arold plc in four months' time (to the nearest
£)?
c) The US dollar/sterling spot rate is $1.52 = £1
One year US interest rates = 8%
One year UK interest rates = 14%
What should the one year forward exchange rate between the dollar and sterling
be?

SOLUTION

Topic 4: Currency risks 129

 SUMMARY

130 Topic 4: Currency risks

CURRENCY HEDGING
HEDGING USING THE MONEY MARKETS
Because of the close relationship between forward exchange rates and the interest rates
in the two currencies, it is possible to 'manufacture' a forward rate by using the spot
exchange rate and money market lending or borrowing. This technique is known as a
money market hedge or synthetic forward.

Setting up a money market hedge for a foreign currency payment

Step 1 Borrow the appropriate amount in the home currency now

Step 2 Convert the money borrowed to the currency of payment
Step 3 Put the money on deposit in the foreign currency to accrue interest
Step 4 Settle the liability using the deposit plus interest

MONEY MARKET HEDGE (1)

A UK company owes a Danish company Kr 3,500,000 in three months' time. The spot
exchange rate is Kr/£ 7.5509 – 7.5548. The company can borrow in Sterling for three months
at 8.60% per annum and can deposit Danish kroner for three months at 10% per annum.
Requirement
What is the cost in pounds with a money market hedge and what effective forward rate
would this represent?

SOLUTION

Setting up a money market hedge for a foreign currency receipt

Step 1 Borrow an appropriate amount in the foreign currency today

Step 2 Convert it immediately to home currency

Step 3 Place it on deposit in the home currency

Step 4 When the customer's cash is received, the company repays the foreign
currency loan and takes the cash from the home currency deposit account

Topic 4: Currency risks 131

 MONEY MARKET HEDGE (2)
A UK company is owed SFr 2,500,000 to be paid in three months' time by a Swiss
company. The spot exchange rate is SFr/£ 2.2498 – 2.2510. The company can deposit in
Sterling for three months at 8.00% per annum and can borrow Swiss Francs for three
months at 7.00% per annum.
Requirement
What is the receipt in pounds with a money market hedge and what effective forward
rate would this represent?

SOLUTION

Choosing the hedging method

When a company expects to receive or pay a sum of foreign currency in the next few
months, it can choose between using the forward exchange market and the money
market to hedge against the foreign exchange risk. Other methods may also be possible,
such as making lead payments. The cheapest method available is the one that ought to
be chosen.

CHOOSING THE CHEAPEST METHOD

Trumpton plc has bought goods from a US supplier, and must pay $4,000,000 in three
months' time. The company's finance director wishes to hedge against the foreign
exchange risk, and the three methods which the company usually considers are:
 Using forward exchange contracts
 Using money market borrowing or lending
 Making lead payments
The following annual interest rates and exchange rates are currently available.
US dollar Sterling
Deposit rate Borrowing Deposit rate Borrowing rate
rate
% % % %
1 month 7 10.25 10.75 14.00
3 months 7 10.75 11.00 14.25
$/£ exchange rate ($ = £1)
Spot 1.8625 – 1.8635
1 month forward 0.60c – 0.58c pm
3 months forward 1.80c – 1.75c pm

132 Topic 4: Currency risks

Requirement
Which is the cheapest method for Trumpton plc?

SOLUTION
Forward Contract

Money Market hedge

Lead payment

CURRENCY FUTURES

Introduction
 They are standardised contracts to buy or sell a fixed amount of currency at a fixed
rate on a fixed future date either:
– To buy a futures contract = agreeing to receive the contract currency
– To sell a futures contract = agreeing to supply the contract currency
 Transactions must be for a whole number of contracts

Topic 4: Currency risks 133

 CURRENCY FUTURES (1)
A US exporter is expected to receive £250,000 in December.
It is currently August.
 The spot rate now is: $1.85/£
 The quote for December futures is: $1.85/£.
The US exporter uses futures to hedge its currency risk. Contract size is £62,500.
In December, the company receives £250,000
 The spot rate in December moved to $1.90
 The futures rate in December was also $1.90
Requirement
Show the outcome of a futures hedge.

SOLUTION

CURRENCY FUTURES (2)

On 31 May a UK company owes an American supplier $950,000 payable on 31 August.
31 May prices:
Futures: £/$ contracts (£62,500, expiring at the end of the relevant month)
June $/£1.4316
September $/£1.4214
Spot $/£1.4290 – $1.4370
Assume that on 31 August the spot rate is $/£1.3328 – 1.3408 and the closing futures
price is $/£1.3339.
Requirement
Show the outcome of a futures hedge.

134 Topic 4: Currency risks

 SOLUTION

Advantages and disadvantages of currency futures

Advantages Disadvantages

Transaction date flexibility, because the Contracts cannot be tailored to exact

future does not have to be closed out until requirements
the stated settlement date
Exchange regulated market so Limited number of currencies traded
counterparty risk is reduced
Ease of buying and selling of contracts The need to use a broker (fees)
through a highly liquid market
The need to deposit and maintain a margin
account

CURRENCY FUTURES PRACTICE

Tyldesley Inc is a US company which has recently entered into negotiations to buy
Remedia plc, a company jointly owned by a group of local authorities in the UK. A price
of £20 million has been agreed, and the deal will be finalised in six months’ time.
In light of these developments, the company accountant at Tyldesley is proposing to
hedge the company’s foreign exchange exposure by using futures contracts. The relevant
£ futures contracts are currently priced at $1.6436/£. The £ futures contract size is
£62,500. The current spot rate is $1.6520/£.
Requirement
Calculate the cost of the purchase if futures contracts are used and if in six months’ time
the following scenarios occurred:
1) A spot rate of $1.6630/£ and a £ futures price of $1.6610/£
2) A spot rate of $1.6420/£ and a £ futures price of $1.6400/£

Topic 4: Currency risks 135

 SOLUTION

CURRENCY OPTIONS

Introduction
 Currency options give customers the right but not the obligation to buy
('call') or sell ('put') a fixed amount of currency at a fixed rate on a fixed date.
 As with other types of option, buying a currency option involves paying a
premium, which is the most the buyer of the option can lose.
 Currency options protect against adverse movements in the exchange rate while
allowing the investor to take advantage of favourable exchange rate movements if
it suits them.

Over-the-counter currency options

An OTC option is tailored to the customer’s specifications regarding the specific dates,
currencies and total amounts involved.

OVER-THE-COUNTER CURRENCY OPTIONS

Sugar plc is expecting to receive 20 million South African rands (R) in one month's time.
The current spot rate is R/£ 19.3383 – 19.3582.
Requirement
Compare the results of the following actions:
a) The receipt is hedged using a forward contract at the rate 19.3048.
b) The receipt is hedged by buying an over-the-counter (OTC) option from the bank,
exercise price R/£ 19.30, premium cost of £24,000.
c) The receipt is not hedged.
In each case compute the results if, in one month, the exchange rate moves to:
i) R 21.00/£
ii) R 17.60/£

136 Topic 4: Currency risks

 SOLUTION

Exchange traded currency options

Traded currency options are available on the Philadelphia Stock Exchange with prices for
£/$ options set out in tables.

TRADED CURRENCY OPTIONS

Prices (premiums) on 1 June for Sterling traded currency options on the Philadelphia
Stock Exchange are shown in the following table.
Sterling £31,250 contracts (cents per £)
Exercise price Calls Puts
$/£ September December September December
1.5000 5.55 7.95 0.42 1.95
1.5500 2.75 3.85 4.15 6.30
1.6000 0.25 1.00 9.40 11.20
Prices are quoted in cents per £.

Topic 4: Currency risks 137

 On 1 June, the current spot exchange rate is $1.5404 – $1.5425 and September futures
are quoted at $1.54 with a standard contract size of £62,500.
Stark Inc, a US company, is due to receive £3.75 million from a customer in four months'
time at the end of September. The treasurer decides to hedge this receipt using either
September £ traded options or September futures.
Requirement
Compare the results of using an option to hedge with a futures contract.
Illustrate the results with an option exercise price of $1.55 if by the end of September
the spot exchange rate moves to (i) $1.4800; (ii) $1.5700.
Assume that at the end of September the quote for September futures is the same as the
spot exchange rate.

SOLUTION

138 Topic 4: Currency risks

Advantages and disadvantages of currency options
Options remove downside risk but leave upside potential.
The major drawbacks are:
 The cost is about 5% of the total amount of foreign exchange covered, although
the exact amount depends on the expected volatility of the exchange rate and the
particular option chosen.
 Options must be paid for as soon as they are bought.
 Tailor-made options lack negotiability.
 Traded options are not available in every currency.

CURRENCY HEDGING
Rutini Ltd is a small manufacturing company which has recently completed a major
contract in Europe, as a result of which it will receive €5 million in three months' time. Its
directors are worried that the euro will weaken relative to sterling, and hence affect the
company's cash flow. Four possible approaches have been suggested to deal with the
foreign currency exposure.
1) Do nothing now and convert the €5 million at the spot rate prevailing in three
months' time
2) Use the forward market to sell €5 million for £s at today's three-month forward
rate
3) Buy today a three-month €5 million over the counter put option at a strike price
equal to the three-month forward rate. The option will cost £125,000, which will be
paid from the company's surplus cash currently in a bank deposit account
4) Use the money market to cover the position
The following relevant information has been collected.
i) The spot rate is €/£1.5575 – 1.5625
ii) The three-month forward premium is €0.0047 – 0.0015
iii) The current bank interest rates per annum are
Eurozone UK
Borrowing rate 3.2% 4.0%
Three-month deposit rate 2.8% 3.6%
Requirement
Calculate the effects of each of the four approaches, assuming that the spot rate
prevailing in three months' time is €/£1.50 and €/£1.70.

Topic 4: Currency risks 139

 SOLUTION

140 Topic 4: Currency risks

SUMMARY

Topic 4: Currency risks 141

 ACTIVITY ANSWERS

EXCHANGE RATES
a) The bank is being asked to buy the Danish kroners and will give the exporter:
150,000
= £15,726.57 in exchange
9.5380
b) The bank is being asked to sell the yen to the importer and will charge for the
currency:
1,000,000
= £4,910.39
203.650

CHANGES IN EXCHANGE RATES

Bulldog must buy Reds to pay the supplier, and so the bank is selling Reds. The expected
profit is as follows.
£
Revenue from re-sale of goods 32,000.00
Less cost of 100,000 Reds in sterling ( 3.5650) (28,050.49)
Expected profit 3,949.51

TRANSACTION RISK
a) If the actual spot rate for Bulldog to buy and the bank to sell the Reds is 3.0800,
the result is as follows.
£
Revenue from re-sale 32,000.00
Less cost (100,000  3.0800) (32,467.53)
Loss (467.53)
b) If the actual spot rate for Bulldog to buy and the bank to sell the Reds is 4.0650,
the result is as follows.
£
Revenue from re-sale 32,000.00
Less cost (100,000  4.0650) (24,600.25)
Profit 7,399.75
This variation in the final sterling cost of the goods (and thus the profit) illustrates
the concept of transaction risk.

142 Topic 4: Currency risks

 RISK AND FOREIGN EXCHANGE

a) Since the sale is to be invoiced in the Swedish currency, the Swedish importer will
suffer no gain or loss. However, if the pound weakens, the UK exporter will be able
to exchange the Kroner for a greater number of pounds, and will therefore make a
gain.
b) Mogs plc is invoiced in £ sterling and so exchange rate movements will have no
effect.
Cantona invoiced the sale in £ sterling. As the £ sterling strengthened (ie more
euros to £) against the euro, the amount received, when converted to euros, will
be higher. Hence a gain will be experienced.

FORWARD EXCHANGE CONTRACT

$5,000,000
= £2,980,270
1.6777
The impact of the forward contract is to remove both upside potential and downside
risk. It gives a fixed exchange rate.

ADJUSTING FOR A PREMIUM OR DISCOUNT

The forward adjustments here are given in cents and need to be converted to dollars.
For example: One month forward discount 0.20c – 0.22c
Equates to $0.0020 – $0.0022
Spot rate $1.9500 – $1.9610
One month forward 1.9520 – 1.9632
Obtained by adding the discount to the spot
Three month forward 1.9478 – 1.9592
Obtained by deducting the premium from the spot

INTEREST RATE PARITY

Using interest rate parity, dollar is the numerator and sterling is the denominator. So the
expected future exchange rate dollar/sterling is given by:
1.06
$1.95/£  = $1.9686/£
1.05
This prediction is subject to great inaccuracy, but note that the company could 'lock into'
this exchange rate, working a money market hedge by borrowing today in dollars at 6%,
converting the cash to sterling spot and putting them on deposit at 5%. When the dollars
are received from the customer, the dollar loan is repaid.

Topic 4: Currency risks 143

 PURCHASING POWER PARITY

A disequilibrium is created in one year which is then removed by the exchange rate
altering.
The new equilibrium exchange rate would be $2,080/£1,030 =$2.0194/£
Note: This is the application of the same relationship as set out above:
1  if
Spot rate  = Forward rate
1  i uk

1.04
$2/£  = $2.0194
1.03

FORWARDS
a) Forward rate = $(1.7680 – 0.0035)
= $1.7645
$200,000
Receipt =
1.7645
= £113,347
b) Forward rate $(1.9015 – 0.0030) = $1.8985
£ sterling conversion = $500,000/$1.8985
= £263,366
c) $1.4400 to £1
$1.52  1.08/1.14 = $1.4400

MONEY MARKET HEDGE (1)

The interest rates for three months are 2.15% to borrow in pounds and 2.5% to deposit
in kroners. The company needs to deposit enough kroners now so that the total including
interest will be Kr3,500,000 in three months' time. This means depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.

144 Topic 4: Currency risks

These kroners will cost £452,215 (spot rate 7.5509). The company must borrow this
amount and, with three months' interest of 2.15%, will have to repay:
£452,215  (1 + 0.0215) = £461,938.
Thus, in three months, the Danish creditor will be paid out of the Danish bank account
and the company will be paying £461,938 to satisfy this debt. The effective forward rate
which the company has 'manufactured' is 3,500,000/461,938 = 7.5768. This effective
forward rate shows the kroner at a discount to the pound because the kroner interest
rate is higher than the sterling rate.

MONEY MARKET HEDGE (2)

The interest rates for three months are 2.00% to deposit in pounds and 1.75% to borrow
in Swiss francs. The company needs to borrow SFr2,500,000/1.0175 = SFr 2,457,003
today. These Swiss francs will be converted to £ at 2,457,003/2.2510 = £1,091,516. The
company must deposit this amount and, with three months interest of 2.00%, will have
earned £1,091,516  (1 + 0.02) = £1,113,346
Thus, in three months, the loan will be paid out of the proceeds from the debtor and the
company will receive £1,113,346. The effective forward rate which the company has
'manufactured' is 2,500,000/1,113,346 = 2.2455. This effective forward rate shows the
Swiss franc at a premium to the pound because the Swiss franc interest rate is lower
than the sterling rate.

Topic 4: Currency risks 145

 CHOOSING THE CHEAPEST METHOD
The three choices must be compared on a similar basis, which means working out the
cost of each to Trumpton either now or in three months' time. In the following
paragraphs, the cost to Trumpton now will be determined.
Choice 1: the forward exchange market
Trumpton must buy dollars in order to pay the US supplier. The exchange rate in a
forward exchange contract to buy $4,000,000 in three months time (bank sells) is:
$
Spot rate 1.8625
Less three months premium 0.0180
Forward rate 1.8445
The cost of the $4,000,000 to Trumpton in three months' time will be:
$4,000,000
= £2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that by
deferring payment for three months, the company is:
 Saving having to borrow money now at 14.25% a year to make the payment now,
or
 Avoiding the loss of interest on cash on deposit, earning 11% a year
The choice between (a) and (b) depends on whether Trumpton plc needs to borrow to
make any current payment (a) or is cash rich (b). Here, assumption (a) is selected, but
(b) might in fact apply.
At an annual interest rate of 14.25% the rate for three months is 14.25/4 = 3.5625%.
The 'present cost' of £2,168,609.38 in three months' time is:
£2,168,609.38
= £2,094,010.26
1.035625
Choice 2: the money markets
Using the money markets involves
a) Borrowing in the foreign currency, if the company will eventually receive the
currency.
b) Lending in the foreign currency, if the company will eventually pay the
currency. Here, Trumpton will pay $4,000,000 and so it would lend US dollars.
It would lend enough US dollars for three months, so that the principal repaid in three
months time plus interest will amount to the payment due of $4,000,000.
a) Since the US dollar deposit rate is 7%, the rate for three months is approximately
7/4 = 1.75%.
b) To earn $4,000,000 in three months' time at 1.75% interest, Trumpton would have
to lend now:
$4,000,000
= $3,931,203.93
1.0175

146 Topic 4: Currency risks

These dollars would have to be purchased now at the spot rate of (bank sells) $1.8625.
The cost would be:
$3,931,203.93
= £2,110,713.52
1.8625
By lending US dollars for three months, Trumpton is matching eventual receipts and
payments in US dollars, and so has hedged against foreign exchange risk.
Choice 3: lead payments
Lead payments should be considered when the currency of payment is expected to
strengthen over time, and is quoted forward at a premium on the foreign exchange
market. Here, the cost of a lead payment (paying $4,000,000 now) would be $4,000,000
÷ 1.8625 = £2,147,651.01.
Summary
£
Forward exchange contract 2,094,010.26 (cheapest)
Currency lending 2,110,713.52
Lead payment 2,147,651.01

CURRENCY FUTURES (1)

Number of contracts = £250,000 ÷ £62,500 = 4 contracts
Exporter needs to sell futures (sell £s to get $s)
Outcome in futures market:
$
Sell at 1.85
Buy back at (1.90)
Loss per £ (0.05)
$0.05  (£62,500  4 contracts) = $12,500 loss
The £250,000 received by the US exporter is then sold in December at the prevailing
spot rate - £250,000 @ $1.90 = $475,000
Notice that sterling strengthened in the spot rate over the period, causing an increase in
the value of the sterling as follows:
$
Value of £250,000 – in August @ 1.85 462,500
Value of £250,000 – in December @ 1.90 475,000
Increase in value 12,500
Summary
$
Increase in value of sterling remittance: 12,500
Loss due to futures position (12,500)
Thus the futures hedges remove risk – both upside potential (as above) and downside
risk.

Topic 4: Currency risks 147

 CURRENCY FUTURES (2)
The contract must last at least as long as the underlying exposure, so use September
contracts.
Need to sell £. Futures contract is in £, therefore SELL futures.
How many contracts?
$950,000 / 1.4214 (Sept futures price) = £668,355.
£668,355 / £62,500 = 10.69 contracts, say 11 contracts
Outcome in futures market:
 Opening: Sell at 1.4214 Sell at high price
 Closing: Buy back at 1.3339 Buy at low price
Movement 0.0875 Profit
$0.0875  (£62,500  11 contracts) = $60,156.25 profit
Note that all contracts are priced in US$, so any gain or loss will be in US$
Net outcome:
Pay ($950,000)
Receive $60,156
Net cost ($889,844) @ $1.3328 = (£667,650)

Note that in this scenario the dollar has strengthened, which has increased the cost of
the payment in sterling. However, the gain on the futures transaction has offset the
resulting loss.

CURRENCY FUTURES PRACTICE

Need to buy £s therefore buy £ futures contracts.
Number of contracts = £20,000,000/62,500 = 320 contracts
Scenario 1:
Buy 320 contracts @ (1.6436)
In 6 months sell 320 contracts @ 1.6610
Gain per £ 0.0174
Total gain (320  62,500  0.0174) $348,000
Purchase of £20m in 6 months $33,260,000 (20m  1.6630)
Net cost $32,912,000
Scenario 2:
Buy 320 contracts @ (1.6436)
In 6 months sell 320 contracts @ 1.6400
Loss per £ 0.0036
Total loss (320  62,500  0.0036) ($72,000)
Purchase of £20m in 6 months $32,840,000 (20m  1.6420)
Net cost $32,912,000

148 Topic 4: Currency risks

 OVER-THE-COUNTER CURRENCY OPTIONS
The target receipt at today's spot rate is 20,000,000/19.3582 = £1,033,154.
a) The receipt using a forward contract is fixed with certainty at 20,000,000/19.3048
= £1,036,012. This applies to both exchange rate scenarios.
b) The cost of the option is £24,000. This must be paid at the start of the contract.
The results under the two scenarios are as follows.
Scenario (i) (ii)
Amount received at exchange R 20 million @ R21.0/£ = @ 17.60 = £1,136,364
rate £952,381
Amount received at exercise R 20 million @ R19.30/£ = @ 19.30 = £1,036,269
price £1,036,269
Does the company exercise the YES NO
option?

(i) (ii)
£ £
Pounds received 1,036,269 1,136,364
Less option premium (24,000) (24,000)
Net receipt 1,012,269 1,112,364
c) The results of not hedging under the two scenarios are as follows.
Scenario (a) (b)
Exchange rate 21.00 17.60
Pounds received £952,381 £1,136,364
Summary. The option gives a result between that of the forward contract and no
hedge.
 If the South African rand weakens to 21.00, the best result would have been
obtained using the forward market (£1,036,012).
 If it strengthens to 17.60, the best course of action would have been to take no
hedge (£1,136,364).
 In both cases the option gives the second best result, being £24,000 below the
best because of its premium cost.

TRADED CURRENCY OPTIONS

The target receipt is 3,750,000  1.5404* = $5,776,500.
*The American company gets the lower number of dollars for selling sterling.
A receipt of £3.75 million will require £3,750,000/£31,250 = 120 option contracts.
Using options, the treasurer will purchase 120 September put options (ie needs to sell £
as the underlying option is in £ s). The premium cost will vary with the exercise price as
follows.

Topic 4: Currency risks 149

 Exercise price Cost £
1.5000 120  0.42/100  31,250 = $15,750
1.5500 120  4.15/100  31,250 = $155,625
1.6000 120  9.40/100  31,250 = $352,500
Assuming an exercise price of 1.55 is chosen, the cost of the premium on 1 June is
$155,625.
Impact of options
Scenario (i) (ii)
Prevailing exchange rate ($/£) in September 1.48 1.57
Have right to sell sterling for 1.55 1.55
Intrinsic value of option ($ per £) 0.07 Zero
Exercise? Yes No

Value of options: $0.07 × £31,250 = $2,187.50 per contract

No. of contracts 120
Gain on option $262,500

Value of sterling receipt at prevailing exchange rate $5,550,000 $5,887,500

(£3.75m)
Gain on option $262,500
Less premium $(155,625) $(155,625)
$5,656,875 $5,731,875
Impact of futures
£3.75 million
The company will want to sell = 60 contracts.
£62,500
The hedge position will be to sell the September futures at $1.54 on 1 June, and then
close out at the end of September.
Scenario (i) (ii)
Closing futures price (1.48) (1.57)
Sold futures at 1.54 1.54
Gain/(loss) on future $0.06/£ $(0.03)/£

 £62,500  £62,500
 60 contracts  60 contracts
Overall futures position = $225,000 $(112,500)
Value of sterling receipt at prevailing
exchange rate (£3.75m) $5,550,000 $5,887,500
$5,775,000 $5,775,000
The effect of the future is to give a fixed exchange rate. This is slightly different from the
target receipt because of basis risk.
Summary
The future gives a fixed exchange rate whereas the option removes the downside risk
leaving the upside potential. Unfortunately, the option premium is so expensive that the
receipt under the future is more attractive. This does depend of course, on which option
is chosen and what the closing exchange rate turns out to be.

150 Topic 4: Currency risks

 CURRENCY HEDGING

a) Convert at spot in three months' time

1) If exchange rate is €/£1.50
€5m/1.50 = £3,333,333
2) If exchange rate is €/£1.70
€5m/1.70 = £2,941,176
b) Use the forward market
3-month forward sell rate = 1.5625 − 0.0015
= €1.561
€5m/1.561 = £3,203,075
c) Buy a €5m put option
1. Exchange rate in three months: €/£1.50
In this case the company will not exercise the option but will convert at spot.
€5m/1.50 = £3,333,333
2. Exchange rate in three months: €/£1.70
In this case the company will exercise the option and convert at the strike
price of €1.561.
€5m/1.561 = £3,203,075
In both cases the company will have paid £125,000 for the option. If it is
assumed that this is currently invested at the three-month sterling deposit
rate of 3.6% pa, this will effectively cost (when interest is taken into
account):
125,000  1.009 = £126,125
d) Money market hedge
€5m
Borrow = = €4,960,317
0.032
1
4
Convert at spot = €4,960,317 ÷ 1.5625
= £3,174,603
Invest for 3 months = £3,174,603  (1 + 0.009)
= £3,203,174
Summary
Cash receipts in three months' time (in £)
Spot rate in three months
€/£1.50 €/£1.70
i) Conversion at spot 3,333,333 2,941,176
ii) Using the forward market 3,203,075 3,203,075
iii) Buying a €5m put option
After premium cost 3,207,208 3,076,950
iv) Money market hedge 3,203,174 3,203,174

Topic 4: Currency risks 151

152 Topic 4: Currency risks
 5
FINANCING DECISIONS

Learning Objectives
 Assess the suitability of different financing options for a given business
 Explain the characteristics of different types of finance
 Explain the role of different types of finance
 Identify a company's liquidity position by producing forecasts
 Analyse a company's financing requirements using appropriate evaluation
techniques

Exam Requirement
Exam questions will not only require the candidate to be aware of practical sources of
finance but also to be able to assess their suitability to given situations.
Candidates may have to identify and evaluate different financing options and give a
recommendation.

Math Tables 153

 TOPIC OVERVIEW

154 Topic 5: Financing decisions

CAPITAL MARKETS
CAPITAL MARKETS, RISK AND RETURN

Capital markets
There are many ways in which firms can access funds, including:
National stock markets In the UK this includes the London Stock Exchange ('the
Stock Exchange') and the Alternative Investment Market
(AIM) acting as secondary markets for securities, and as a
primary source of new funds, eg via new share issues.
The banking system Split between the retail market which services
individuals/small businesses and the wholesale market,
which services large companies.
Bond (debt) markets Mostly used by large companies seeking substantial
finance.
Leasing A very important source of capital finance for a whole
variety of companies.
Debt factoring Normally used by smaller organisations to help finance
their working capital requirements.
Governmentand Promotes development of industry in underdeveloped
European Union grants areas or in overseas markets.
International markets Typically available to larger companies, these markets
allow funds to be raised in different currencies, typically in
very large amounts.

Issued capital

Equity represents the ordinary shares in the business. Equity shareholders are the
owners of the business and through their voting rights exercise ultimate control.
Preference shares form part of the risk-bearing ownership of the business but, since
they are entitled to their dividends before ordinary shareholders, they carry less risk. As
their return is usually a fixed maximum dividend, they are similar in many ways to debt.
Loan stocks and debentures are typically fixed interest rate borrowings with a set
repayment date. Most are secured on specific assets or assets in general such that
lenders are protected (in repayment terms) above unsecured creditors in a liquidation.

Risk and return

In structuring its capital finances, a company must have regard to the risk-return
trade-off desired by potential investors.
Debt holders face lower risk than shareholders. They receive interest before
shareholders receive any dividends, and in the event of company failure, the debt
holders will rank higher than the equity holders. They will receive a lower rate of return
on their capital for this lower level of risk.

Topic 5: Financing decisions 155

 The shareholders' position is more risky – they will suffer the downside of any loss.
Correspondingly, they will expect a higher rate of return. Thus any profits will go to
the shareholders, not the debt holders.
Preference shares will usually have a risk somewhere between debt and ordinary
shares.

SOURCES OF EQUITY FINANCE

There are broadly three methods of raising equity:

Method Real world use

Retentions, ie retaining By far and away the most important source of equity
profits, rather than paying
them out as dividends
Rights issues, ie an issue The next most important source
of new shares to existing
shareholders
New issues to the public, The least important source of new equity
ie an issue of new shares to
new shareholders

Retained earnings
The profits earned by a business can be either:
 Paid out to shareholders in the form of dividends
 Reinvested in the business

Dividend payout ratio = Dividend/Earnings after tax and preference dividends

Retained earnings are a very easy and important source of finance, particularly for
young growing businesses where there may be a continual need for funds but where
it is impractical to keep raising them using rights/new issues (and debt).
Retained earnings have an opportunity cost as shareholders will still expect a return on
the funds re-invested in the business, ie they will expect the funds to be invested in
projects which increase their wealth.

Rights issues

A rights issue is an issue of new shares for cash to existing shareholders in proportion
to their existing holdings.

 Legally a rights issue must be made before a new issue to the public
 The issue price is less than the prevailing market price to encourage take-up
 Existing shareholders can take up the rights or sell them
 No change in control if fully taken up by existing shareholders

156 Topic 5: Financing decisions

Theoretical ex-rights price
The ex-rights price is the price at which the shares will settle after the rights issue has
been made.

Ex-rights price
market val ue of shares pre -rights issue  rights proceeds  project NPV
=
number of shares ex -rights

PV of new total dividends

=
number of shares ex -rights

If an examination question does not give the NPV of the project in which the funds are
invested, assume it is nil.

THEORETICAL EX-RIGHTS PRICE

A company has 100,000 shares with a current market price of £2 each.
It announces an increase in share capital to be achieved by a rights issue of one new
share for every two existing shares. The rights price is £1 per new share, thus raising
£50,000 for investment in the new project.
Requirements
a) Work out the theoretical ex-rights price.
b) Calculate the value of the right to subscribe for each new share.

SOLUTION

Topic 5: Financing decisions 157

 Impact of a rights issue on shareholder wealth
Does it make any difference to the wealth of an existing shareholder, whether they sell
the rights, exercise the rights or simply do nothing?

IMPACT OF A RIGHTS ISSUE ON SHAREHOLDER WEALTH

A company has 100,000 shares with a current market price of £2 each. It announces an
increase in share capital to be achieved by a rights issue of one new share for every two
existing shares. The rights price is £1 per new share, thus raising £50,000 in order to
take on a project with an expected NPV of £25,000.
Requirements
a) What is the value of the company after the new project and the new issue?
b) What is the ex-rights price per share and the value of the right?
c) Assume a shareholder owns 1,000 shares. What is the effect on the shareholder's
wealth if he:
i) takes up his rights
ii) sells his rights
iii) does nothing

SOLUTION

158 Topic 5: Financing decisions

New issues
These may take the form of:
 Placings
 Offers for sale
 Offers for subscription
This is an expensive method appropriate for large issues. They are expensive because
they are underwritten and advertised.

Underwritingis the process whereby, in exchange for a fixed fee, usually 1–2% of the
total finance to be raised, an institution or group of institutions will undertake to
purchase any securities not subscribed for by the public.

Shareholder investor ratios

Dividend per share

Dividend yield = ×100
Market price per share
Profits distributable to ordinary shareholders
Earnings per share =
Number of ordinary shares issued
Market price per share
Price-earnings ratio =
EPS

The value of the P/E ratio reflects the market’s appraisal of the share’s future prospects –
the more highly regarded a company, the higher will be its share price and its P/E ratio.
Total shareholder return = dividend yield + capital gain

EQUITY FINANCE
An uncle of yours, who has a comparatively small holding of shares in Nash Telecom, has
sent you a newspaper report that contains the following commentary.
'Nash Telecom raised a record €9 billion after the banks underwrote a rights issue
intended to resolve concerns about the €40 billion debt mountain. Shareholders will be
able to buy 16 new Nash Telecom shares at €15.5 each for every 20 existing Nash
Telecom shares held.
Nash Telecom's share price fell 1.5% to €20. Shares will start trading on an ex-rights
basis today with a theoretical ex-rights price of €18.'
Requirements
a) Explain the terms 'rights issue', 'ex-rights' and 'underwriting'.
b) Explain how the 'theoretical ex-rights price of €18' is calculated and why the actual
price might be different.
c) Explain to your uncle, who owns 200 shares, the effect on his wealth of:
i) Subscribing, or
ii) Not subscribing for the rights issue.

Topic 5: Financing decisions 159

 d) Explain to your uncle two other ways in which Nash Telecom might raise money in
order to reduce its debt mountain, setting out the differing impacts on the
shareholders and debt holders involved.

SOLUTION

160 Topic 5: Financing decisions

SOURCES OF DEBT FINANCE

Loan stock

Loan stock: debt capital in the form of securities issued by companies, the government
and local authorities. These are also referred to as bonds or debentures.

Coupon (interest)  The annual interest is the coupon rate x the nominal value
rate of the stock (£100)
 Can be fixed rate
 The coupon can sometimes be set at zero
Redemption value  A £100,000 loan can be repaid at par (with £100,000) or
at a premium (say, £105,000) or discount (say £95,000)
to the par value
Redemption date  Loan stocks are normally medium- to long-term. Some
bonds are undated (perpetual or irredeemable)

Convertible loans

Convertible loans are fixed return securities – either secured or unsecured – which
may be converted, at the option of the holder, into ordinary shares in the same
company. Prior to conversion the holders have creditor status, although their rights may
be subordinated to those of trade payables.

Advantages
 Obtaining finance at a lower rate of interest than on ordinary debentures (provided
that prospects for the company are good)
 Encouraging possible investors with the prospect of a future share in profits
 Avoiding redemption problems if the debt is converted into equity
 Being able to issue equity cheaply (if converted)

Loan stock with warrants

These are loan stocks which cannot themselves be converted into equity but give
the holder the right to subscribe at fixed future dates for ordinary shares at a
predetermined price. The subscription rights are known as warrants.

Loan documentation
Debt holders will typically face less risk than equity holders, for which they expect a
lower return.
How do they ensure that their position is low risk?
 Check the legality of borrowing
 Check the financial condition of the company
 Require a guarantee
 Impose covenants

Topic 5: Financing decisions 161

 Debt ratios

debt debt
Gearing = or
equity debt  equity
EBIT
Interest cover =
Interest

SOURCES OF FINANCE
Easterways plc is a listed company involved in the tourist trade. The company wishes to
make an offer for a smaller rival business, Tinytours Ltd. Since it is believed that the
Tinytours Ltd shareholders would only accept cash, a relatively large amount of cash will
have to be raised. A share issue seems a realistic possibility for achieving this. The
directors are undecided between making a public issue or a rights issue of shares. They
are also unsure about the price at which shares should be issued.
One of the directors has suggested that a convertible loan stock issue might be worth
considering. The directors are adamant that a conventional loan is out of the question.
Requirement
Prepare a report for the directors explaining the major factors that relate to their
decision, including the points about which the directors are uncertain.

SOLUTION

162 Topic 5: Financing decisions

INTERNATIONAL MONEY MARKETS
Larger companies are able to seek funds in international financial markets called
Euromarkets. ‘Euro’ refers to any currency traded outside its natural domestic market.
Forms of finance available include Eurocurrency and Eurobonds.
The factors which are relevant to choosing between borrowing on the euromarkets or
through the domestic system are as follows:
 It is often easier for a large multinational to raise very large sums quickly on
the euromarkets than in a domestic financial market.
 Euromarket loans generally require no security, while borrowing on domestic
markets is quite likely to involve fixed or floating charges on assets as security.
 The cost of borrowing on euromarkets is often slightly less than for the same
currency in home markets.
 Issue costs are generally relatively low.
 Euromarkets are attractive to investors as interest is paid gross.

ETHICS

ICAEW ethical guidance for accountants undertaking corporate

finance work
The fundamental principles are:
 Integrity
 Objectivity
 Professional competence and due care
 Confidentiality
 Professional behaviour
Categories of activity covered by the guidance are as follows:
 General corporate finance advice
 Acting as adviser in relation to takeovers and mergers
 Underwriting and marketing or placing securities on behalf of a client
 Acting as sponsor or nominated adviser under the Listing Rules and the AIM Rules
respectively

CAPITAL MARKET EFFICIENCY

Introduction
The Stock Exchange and AIM provide access not only to new funds but also act as a
market for dealing in 'second-hand' securities such as shares.
Prices on the market are fair if the market is efficient, ie the price reflects all known
information about the business and its prospects.

Topic 5: Financing decisions 163

 Efficient market hypothesis
If a stock market is efficient, share prices should vary in a rational way and will reflect
the amount of relevant information that is available.
The efficient market hypothesis (EMH) identifies three forms of efficiency – weak,
semi-strong and strong.

Levels of efficiency Explanation

Weak form efficiency Share price reflects information about past price
movements
Share prices follow a random walk
Future price movements cannot be predicted from past
price movements
Semi-strong form Share prices incorporate all publicly available
efficiency information
The market cannot be beaten by examining publicly
available information – it will already be incorporated
in share prices.
The market can only be beaten if an investor has inside
information.
Strong form efficiency Share prices reflect all information, published or not.
No investor could beat the market by having superior
information as it does not exist.

The stock exchanges of all developed nations are regarded as at least semi-strong
efficient for the shares traded actively on those markets.
The implications of a semi-strong efficient market are:
 Market prices are fair and cost of equity, debt etc calculations will produce a 'fair'
result.
 Manipulating accounting policies, eg depreciation to boost reported earnings, will
not improve the share price (cash flows unchanged).
 It should not be necessary to make new share issues at a substantial discount to
the existing market price as long as the return offered is commensurate with the
risk undertaken by the investor.
 Share prices are a better guide to performance than published financial
statements.
 Managers can time new share issues in relation to share price by using inside
information (ie release good news, share price rises, issue new shares) but this
relates to the future not past information.

Behavioural finance
Behavioural finance offers an alternative view of financial market activity to the efficient
market hypothesis. It suggests that irrational investor behaviour may significantly
affect share price movements.
Investors attempt to be rational, but have limitations in their memory, emotion and
cognitive function which lead them to repeat mistakes.

164 Topic 5: Financing decisions

 CAPITAL MARKET EFFICIENCY
Requirements
Critically comment on each of the following three statements, clearly explaining any
technical terms contained within them or used by you.
a) In view of the fact that the market is efficient in the semi-strong form, financial
information released by companies is of no value to investors, because the
information is already included in share prices before it is released.
b) If an investor holds shares in about 20 different companies all of the risk is
eliminated and the portfolio will give a return equal to the risk-free rate.
c) A graph of the daily price of a share looks similar to that which would be obtained
by plotting a series of cumulative random numbers. This shows clearly that share
prices move randomly at the whim of investors, indicating that the market is not
price efficient.

SOLUTION

Topic 5: Financing decisions 165

 SUMMARY

166 Topic 5: Financing decisions

FORECASTING
FORECAST FINANCIAL STATEMENTS

Changes in business variables

Businesses need to be aware of likely changes in economic and business variables and
forecast:
 How the predicted changes will affect demand, costs etc
 How the business will respond to changes in variables

FINANCIAL STATEMENT FORECASTING

Loumar plc started trading four years ago in 20X3 and manufactures components for the
computer games industry. You have the following information.
a) Revenue and cost of sales are expected to increase by 10% in each of the financial
years ending
31 December 20X7, 20X8 and 20X9. Operating expenses are expected to increase
by 5% each year.
b) The company expects to continue to be liable for tax at the marginal rate of 21%.
Tax is paid in the same year it is charged.
c) The ratios of receivables to sales and trade payables to cost of sales will remain
the same for the next three years.
d) Non-current assets comprise land and buildings, for which no depreciation is
provided. Other assets used by the company, such as machinery and vehicles, are
hired on operating leases.
e) The company plans for dividends to grow at 25% in each of the financial years
20X7, 20X8 and 20X9.
f) The company plans to purchase new machinery to the value of £500,000 during
20X7, to be depreciated straight line over ten years. The company charges a full
year's depreciation in the first year of purchase of its assets. Tax allowable
depreciation at 18% reducing balance is available on this expenditure.
g) Inventory was purchased for £35,000 at the beginning of 20X7. The value of
inventory after this purchase is expected to remain at £361,000 for the foreseeable
future.
h) No decision has been made on the type of finance to be used for the expansion
programme. The company's directors believe that they can raise new debt if
necessary.

Topic 5: Financing decisions 167

 A summary of the financial statements for the year to 31 December 20X6 is set out
below.
LOUMAR PLC
SUMMARISED INCOME STATEMENT
FOR THE YEAR TO 31 DECEMBER 20X6 £'000
Revenue 1,560
Cost of sales 950
Gross profit 610
Operating expenses 325
Interest 30
Tax 54
Net profit 201
Dividends declared 85
SUMMARISED BALANCE SHEET AT 31 DECEMBER 20X6
£'000
Non-current assets (net book value) 750
Current assets
Inventories 326
Receivables 192
Cash and bank 90
Total assets 1,358
Financing
Ordinary share capital (ordinary shares of £1) 500
Retained profits to 31 December 20X5 222
Retentions for the year to 31 December 20X6 116
10% loan note redeemable 20Z0 300
1,138
Current liabilities
Trade payables 135
Other payables (dividends) 85
Total equity and liabilities 1,358
Requirements
Using the information given:
a) Prepare forecast income statements for the years 20X7, 20X8 and 20X9.
b) Prepare cash flow forecasts for the years 20X7, 20X8 and 20X9, and estimate the
amount of funds which will need to be raised by the company to finance its
expansion.

Notes
1. You should ignore interest or returns on surplus funds invested during the three-
year period of review.
2. Assume all cash flows occur at the start or end of each year and ignore the time
value of money.

168 Topic 5: Financing decisions

SOLUTION

Topic 5: Financing decisions 169

 FINANCING DECISION
In order to explore whether a potential source of finance is viable or attractive, a forecast
cash flow, balance sheet or income statement is required.

FINANCING DECISIONS
MAX PLC
Max plc is a printing and publishing business. The business has traded very successfully
for many years, largely on the basis of a life style magazine which has sold well due to
the recent fashion for such publications. The increase in the number of similar offerings
from competitors however has resulted in a need to re-invigorate the product range.
A plan to launch new magazine titles by the directors is expected to increase revenue by
10% per annum for the foreseeable future. In order to finance the expansion, the
directors are considering either a rights issue or new debt finance.
The overheads of the business should be unaffected by the expansion in sales.
Other relevant information is as follows.
 The level of competitive rivalry between the suppliers to this industry is very
pronounced, and as a result an increase in direct costs of only 8% per annum is
expected
 The working capital will be controlled in the same fashion as before, with no
changes anticipated to the terms of trade. Thus the amount of credit taken (in
proportion to revenue) and the credit given (in proportion to direct costs) will be
unchanged. The increase in the business will require increased inventory of £5
million
 Depreciation on non-current assets existing at 30 December 20X0 is forecast to be
£5.7m p.a. and it is forecast that £10 million of new non-current assets will be
needed. This, together with the new inventory, will be acquired in the year to 30
December 20X1. Depreciation on these new assets will be 18% on a reducing
balance basis starting in the year of purchase
 The company pays tax at 21% per annum in the year in which the liability arises,
and capital allowances are available at the same rate as depreciation
 Dividends are payable the year after they are declared. The company intends to
maintain the existing payout ratio
Summary financial statements
Income statement year to 30 December 20X0
£'000
Revenue 81,000
Direct costs (45,600)
Depreciation (5,700)
Indirect costs (12,000)
Interest payable ( 1,500)
Profit before tax 16,200
Tax on profit at 21% ( 3,402)
Profit after tax 12,798
Dividends declared 7,679

170 Topic 5: Financing decisions

Balance sheet at 30 December 20X0
£'000 £'000
Non-current assets (NBV) 70,200
Current assets
Inventory 10,500
Receivables 14,700
Cash at bank 3,150
28,350
98,550
Capital and reserves
Ordinary shares (£1 nominal value) 15,000
Reserves 47,971
62,971
Non-current liabilities
10% debentures 20X5 15,000
Current liabilities
Payables 12,900
Dividends payable 7,679
20,579
98,550
The proposed financing methods are:
1) A 1 for 5 rights issue at £5 per share
2) A £15 million term loan at 8% interest
Requirements
For the two financing alternatives being considered by the directors of Max plc, prepare
forecast
a) Income statements for the year to 30 December 20X1
b) Balance sheet at 30 December 20X1
Note: Ignore transaction costs on the issuing of new capital and returns on surplus cash
invested short term.
c) Write a report to the directors that evaluates the proposed methods of financing
for Max plc.

SOLUTION

Topic 5: Financing decisions 171

172 Topic 5: Financing decisions
 FORECASTING
Worsley plc is a supplier of specialist engineering components to the UK defence and
airline industries. In spite of the impact of the global recession, demand for the
company’s products has held up well in recent times and is expected to pick up further in
the next two years.
As part of a recent strategic review, the directors have made the following projections for
the years ending 31 March 20X1 and 31 March 20X2:
1) An anticipated increase in annual revenues of 8% pa in each of the years.
2) An anticipated increase in operating costs (excluding depreciation) of 4% pa in
each of the years.
3) The directors are assuming that for the next two years tax will continue to be paid
at a rate of 21% and be payable in the year in which the liability arises.
4) The ratio of trade receivables to revenue will remain the same in each of the next
two years as will the ratio of trade payables to operating costs (excluding
depreciation).
5) An anticipated increase in inventory levels of 10% in the year ending 31 March
20X1, but remaining stable thereafter.
6) The non-current assets in the company’s balance sheet are Worsley’s headquarters
and main factory complex, both of which are freehold premises. The company’s
accounting policy is that these assets are not depreciated. Capital allowances on
these assets are negligible and can be ignored.
7) The directors foresee no change in the company’s annual dividend growth rate of
6% pa. Annual dividends are declared at the year end and paid in full during the
following financial year.
8) To cope with the anticipated increase in business levels, Worsley will shortly be
purchasing new machinery at a cost of £8 million. All existing machinery is rented
and its rental costs are included in operating costs. The company is not intending
to seek any equity or long-term debt financing in respect of this machinery
purchase, as it intends to accommodate the purchase within existing overdraft
facilities available to the company. The new machinery will be depreciated on a
straight-line basis over 8 years (assuming a residual value of £1 million) with a full
year’s depreciation to be charged in the year the machinery is purchased. Capital
allowances on a reducing balance basis at a rate of 18% pa will be available on the
new machinery from the year of acquisition.
9) As a result of this machinery purchase, there will be an anticipated increase in
finance costs of 50% in the year ending 31 March 20X1, but remaining stable in
the following year.

Topic 5: Financing decisions 173

 Extracts from the company’s most recent financial statements are provided below:
Income Statement for the year ended 31 March 20X0
£’000

Revenue 60,240
Operating costs (49,500)
Operating profit 10,740
Finance costs (800)
Profit before tax 9,940
Tax (2,087)
Profit after tax 7,853
Balance Sheet as at 31 March 20X0
ASSETS £’000 £’000
Non-current assets 28,850
Current assets
Inventories 9,020
Trade receivables 9,036
Cash and cash equivalents 396
18,452
47,302

EQUITY AND LIABILITIES

Equity
Ordinary share capital 16,700
Retained earnings 12,482
29,182

Non-current liabilities
6% Debentures 20X8 8,000

Current liabilities
Trade payables 7,336
Dividends 2,784
10,120
47,302

Requirement
Prepare forecast financial statements (comprising income statement, balance sheet and
cash flow statement) for each of the years ending 31 March 20X1 and 31 March 20X2.
Note: All calculations should be undertaken to the nearest £’000.

174 Topic 5: Financing decisions

SOLUTION

Topic 5: Financing decisions 175

176 Topic 5: Financing decisions
SUMMARY

Topic 5: Financing decisions 177

 ACTIVITY ANSWERS

THEORETICAL EX-RIGHTS PRICE

a)
Each shareholder Company as a whole
Value of existing
2 at £2 = £4 100,000 at £2 = £200,000
shares
Value of capital
injected
by rights issue 1 at £1 = £1 50,000 at £1 = £50,000
3 shares £5 150,000 £250,000

Theoretical ex-rights price = £5/3 shares = £1.662/3 per share

(this works out to be the same as £250,000 / 150,000 shares)
b) Value of the right to subscribe for each new share
= ex rights price – subscription price
= £1.66 2/3 – £1
= 66 2/3p
Value of a right per existing share = 66 2/3p / 2 = 33 1/3p

IMPACT OF A RIGHTS ISSUE ON SHAREHOLDER WEALTH

£
a) Value of the company now is 100,000  £2 200,000
Increase in value due to new shares being sold 50,000
Impact of new project being taken on = NPV 25,000
Value of company after issue and project 275,000

MV of shares * pre-rights issue + rights proceeds + project NPV

b) Ex-rights price =
number of shares ex-rights

(100,000×£2) + (50,000×£1) + £25,000

=
100,000 +50,000
= £1.831/3
Value of the right = £1.831/3 − £1.00 = £0.831/3
* If the market price of the existing shares had been given post the
announcement of the project, then the project NPV of £25,000 would already
be included in the MV of the old shares (see market efficiency).

178 Topic 5: Financing decisions

c) i) Takes up rights
£
Step 1: Wealth prior to rights issue 1,000  £2 2,000
Step 2: Wealth post rights issue 1,500  £1.831/3 2,750
Less Rights cost 500  £1 (500)
2,250
 £250 better off
ii) Sells rights
Step 1: Wealth prior to rights issue 1,000  £2 2,000
Step 2: Wealth post rights issue
Shares 1,000  £1.831/3 1,8331/3
Sale of rights 500  £0.831/3 4162/3
2,250
 £250 better off
iii) Does nothing
Step 1: Wealth prior to rights issue 1,000  £2 2,000
Step 2: Wealth post rights issue 1,000  £1.831/3 1,8331/3
 Loss of £1662/3

EQUITY FINANCE
(a) Rights issues
A rights issue is an issue of new shares for cash to existing shareholders in
proportion to their existing holdings.
The ex-rights price is the price at which the shares will theoretically settle after the
rights issue has been made.
Underwriting is the process whereby, in exchange for a fee, an institution or group
of institutions will undertake to purchase at the issue price any securities not
subscribed for by the public.
(b) Theoretical ex-rights price
€
Current holding 20 shares at €20 each 400
Rights issue 16 shares at €15.5 each 248
Total new holding 36 shares worth 648
So theoretical ex-rights price = €18 (€648 ÷ 36) as stated in the newspaper.
However, it is possible that the actual price may be higher or lower than the
theoretical figure, depending on market expectations about the prospects for the
business.
(c) Effect on wealth
You should consider a number of factors in deciding whether to take up the rights
issue.
 Whether you wish to continue in the company for the long term (as its
recent performance has been poor and it has run up a debt mountain).

Topic 5: Financing decisions 179

  Whether you want to maintain your holding at the same proportionate level.
(If you give up your rights, you will effectively have half the proportionate
holding).
 Whether you have the money to subscribe for the rights issue.
 The market price for selling the rights.
In theory, this is the financial effect on your uncle of him subscribing or not
subscribing for the rights issue.
€ €
Uncle's current holding (say 200 shares) is worth (200  €20) 4,000
i) If uncle takes up the rights
New holding is worth ((200 + 160)  €18) 6,480
Less Cost of new shares (160  €15.5) (2,480)
Net effect 4,000
ii) If uncle sells the rights
Holding is now worth (200  €18) 3,600
Plus Sale of rights (160  (€18 – €15.5)) 400
Net effect 4,000
iii) If uncle does nothing
Holding is now worth (200  €18) 3,600
Thus in situations (i) and (ii) above uncle 'breaks even', ie his wealth remains the
same (€4,000). If he chooses to do nothing (situation (iii)), however, he will lose €
400 (€4,000 – €3,600).
However, in practice the company might well sell the rights on your uncle's behalf
and reimburse him with the difference (€400).
(d) Reducing debts
Nash Telecom seems to have considered debt-based options. Other possibilities
might include the following.
 Make a public issue of shares – this would dilute the control of existing
shareholders. This would also be expensive. However, existing lenders would
be encouraged, as gearing will be declining.
 Negotiate the conversion of (substantial) loans into equity – this dilutes
existing shareholders' interests and eliminates right of lenders to repayment.
 Seek to be taken over by a large company with limited debts, ie to produce a
combined company with a reasonable debt to equity relationship – this
reduces risks for existing shareholders and for employees.
 Seek a venture capitalist investment – this dilutes the existing shareholders'
interests; and there is continuing uncertainty about long-term ownership for
both employees and shareholders.
 Divestment, ie sell off assets and raise cash to reduce debt. This subsequent
lack of assets might well affect the company's performance, and a sale and
leaseback arrangement might be preferred.
 Seek Government finance to re-structure the company and/or to support
specific operations – this increases the Government's stake in the future of
the business.

180 Topic 5: Financing decisions

 SOURCES OF FINANCE
REPORT
To The Board of Easterways plc
From Mark Green, Financial consultant
Date 12 September 20X2
Subject Financing the Tinytours Ltd takeover
Terms of reference
To advise the board on various approaches to raising equity finance for the takeover of
Tinytours Ltd.
For the purposes of this report it is assumed that neither retained earnings nor a
conventional loan is a possible means of raising the necessary cash.
A public issue of equity
This amounts to the company selling shares, normally through an intermediary, to the
general investing public. This is a relatively rare event except when a newly-listed
business is seeking a wider ownership for its shares. Once listed, companies tend not to
use public issues. This is for several reasons.
 Public issues are expensive. The issue costs (legal, administrative etc) can be very
costly; 10% or more of the value of the funds raised, though there are economies
of scale so that large issues are proportionately cheaper.
 Setting the issue price is difficult and important. Even if the price is set at what is
believed to be a realistic level, there is still the possibility that there will be
insufficient demand to ensure the sale of all the shares. This is particularly the case
when markets are volatile. When not all the shares are sold, the company is in
danger of falling short of its target level of funds. Underwriting is an option to
ensure that all shares are sold which will enable the firm to reach its target. The
main problem with underwriting is that it is very expensive and the fees are
payable even if the underwriters do not have to buy any outstanding shares.
 Control of the company could pass from the existing shareholders.
Since existing shareholders have the right to be offered shares first, those shareholders
can, in effect, block a public issue in favour of a rights issue.
Rights issues
A rights issue is one to the existing shareholders where each shareholder is given the
'right' to take up a number of new shares which represents a proportion of the existing
holding. Shareholders who do not wish to take up their rights can usually sell the right to
another investor who will be able to take up the rights instead. For an established listed
company, rights issues are much more popular for the following reasons.
 Rights issues are relatively cheap to make, perhaps less than half as expensive as
a public issue.
 The issue price is relatively unimportant. Since all existing shareholders benefit
from the cheap price in proportion to their shareholding, there is no
disproportionate gain. The company needs to make the rights price significantly
cheaper than the market price. This puts pressure on shareholders to take up the
shares or to sell them to an investor who will. Thus rights issue tend not to fail, ie
the shares tend to be issued and the required cash raised.
 Control tends to stay with the existing shareholders.

Topic 5: Financing decisions 181

 It seems as if a rights issue would provide a cheaper and more practical way for the
company to raise the funds for the Tinytours takeover than would a public issue.
Convertible loan stock issue
Convertibles are a mixture of loan and equity financing. They are issued as loan stocks
with the right to convert them into equity shares of the same company at some pre-
determined rate and date.
From the investors' point of view they are relatively safe, in that there is a close-to
guaranteed interest payment periodically and a right to convert to equity if it is beneficial
to do so.
From the company's viewpoint they are attractive because:
 They are cheap to issue; loan stock is generally cheap to issue, so it becomes, if all
goes well, a cheap way of issuing equity.
 Loan finance is relatively cheap to service because of the tax-deductibility of
interest charges.
 They are self-liquidating; provided the holders convert, the loan liquidates itself
through an equity issue, which saves the company the problem of raising the cash
to replace the expiring loan stock
Disadvantages of any type of loan financing include:
 The likely need to provide security for the loan.
 The possibility that lenders will impose covenants, for example restricting the level
of dividends and/or insisting on a minimum liquidity ratio.
Raising finance, unless it is from a mixture of debt and equity, will affect the level of
gearing, with probable implications for the risk/return profile and the cost of capital.

CAPITAL MARKET EFFICIENCY

a) A stock market is described as efficient when the price of a particular security is
adjusted instantly by the market to take account of new information. There are
three grades of efficiency currently used, although a market could be between
them.
The weak form of the efficient market hypothesis states that the only information
which is fully reflected in the share price is the trends which can be deduced from
previous share prices.
The semi-strong form states that the market price of a security already reflects all
public information about the company.
The strong form includes private information as well.
It is generally held that the UK Stock Exchange is approximately semi-strong, ie
the market price of a security will reflect all public information which is relevant. As
new information becomes available that price will change. Financial information, as
one example, will give the market more information to judge whether the security
is under or overpriced, resulting in trading which will adjust its price. Thus
information is useful to investors as it is likely to affect the market price when it
becomes public.

182 Topic 5: Financing decisions

 The second part of the quote in the question implies strong form efficiency and is
contrary to semi-strong efficiency where information is of value to investors – it is
impounded in share prices when released.
b) It is possible for an investor to pick carefully about 20 investments in different
sections of the stock market and by doing so maintain a well-diversified portfolio.
It is important however, that the investments are carefully chosen from different
sectors, rather than simply 20 different shares.
A well-diversified portfolio means a collection of shares which, together, roughly
resemble, in their returns and risks, the whole stock market. Risk means the
possible fluctuations in return on an investment around the average. By putting
together a portfolio, or collection of investments, with returns which do not move
in the same way, it is possible to reduce the risk below that of a single investment.
In a well-diversified portfolio the risk in the portfolio is reduced. The remaining risk
is called the market or systematic risk. It is therefore not true to say all the risk is
eliminated as only the unsystematic risk (ie that part of the fluctuations in possible
returns on a security not due to changes in the system) will be eliminated in the
portfolio.
As there is still some risk, it is also incorrect to say that the portfolio will give a
return equal to the risk-free rate (the return expected from an investment with no
risk, such as short-term government gilts); the return, will be substantially higher
than the risk-free rate to compensate for the risk of investing in the stock market.
c) The concept of price efficiency and the efficient market hypothesis have been
explained in (a).
It would be true to say that in general the daily price movements of a share look
random in relation to each other and that no relationship can be deduced. This
does not, however, mean that share prices are random in relation to the
information released to the market, and a clear connection can be deduced
between the information released and the direction and size of the change in the
share price.
If the stock market is semi-strong efficient, the share price movements will still
appear random but will react in a predictable manner to any new information
becoming public. Information released is random, so movements which reflect that
information will appear to be random.
An investor holding information which is not yet public, or guessing at it, would
therefore be able to predict a future share price movement when that information
becomes public.
Behavioural finance theories suggest that irrational investor behaviour may
significantly affect share price movements.

Topic 5: Financing decisions 183

 FINANCIAL STATEMENT FORECASTING
a) LOUMAR PLC INCOME STATEMENTS
Scenario Actual Forecast
reference 20X6 20X7 20X8 20X9
£'000 £'000 £'000 £'000
Revenue (increase 10% pa) (a) 1,560 1,716 1,888 2,076
Cost of sales (increase 10% pa) (a) (950) (1,045) (1,150) (1,264)
Gross profit 610 671 738 812
Operating expenses
(increase 5% pa) (a) (325) (341) (358) (376)
Depreciation (10% pa  (f) (50) (50) (50)
£500,000)
Profit from operations 285 280 330 386
Interest (assumed constant) (30) (30) (30) (30)
Profit before tax 255 250 300 356
Taxation (see working) (54) (44) (58) (72)
Net profit 201 206 242 284
Dividend (25% growth pa) (e) (85) (106) (133) (166)
Retained profit 116 100 109 118
Reserves b/f 222 338 438 547
Reserves c/f 338 438 547 665

Actual Forecast
20X6 20X7 20X8 20X9
£'000 £'000 £'000 £'000
Share capital 500 500 500 500
Year end reserves 338 438 547 665
Year end shareholders' funds 838 938 1,047 1,165
WORKING: Tax payable
Actual Forecast
20X6 20X7 20X8 20X9
£'000 £'000 £'000 £'000
Profit before tax 255 250 300 356
Add back depreciation (f) 50 50 50
Less tax allowance (18% red./bal) (f) (90) (74) (61)
Taxable profit 255 210 276 345
Tax at 21% (b) 54 44 58 72

184 Topic 5: Financing decisions

b) Cash flow forecasts
Cash receipts and payments
20X7 20X8 20X9
Receipts £'000 £'000 £'000
Cash from sales
(revenue + opening receivables – closing 1,697 1,867 2,052
receivables)
Payments
For purchases (cost of sales + opening
payables – closing payables) 1,032 1,135 1,247
Operating expenses 341 358 376
Additional inventory purchase 35
Machinery 500
Interest (current year) 30 30 30
Tax (current year) 44 58 72
Dividends (previous year) 85 106 133
2,067 1,687 1,858
Net cash flow (370) 180 194
Cash/(deficit) b/f 90 (280) (100)
Cash/(deficit) c/f (280) (100) 94

Topic 5: Financing decisions 185

 FINANCING DECISIONS
a) YEAR ENDED 30 DECEMBER 20X1
INCOME STATEMENT
Rights issue Loan
£'000 £'000
Revenue 81,000  1.1 89,100
Direct costs (49,248)
Depreciation 5,700 + (18%  10,000) (7,500)
Indirect costs (12,000)
Operating profit (same for each method) 20,352 20,352
Interest payable (Unchanged for RI)(1,500 + £15m  8%) (1,500) (2,700)
Profit before tax 18,852 17,652
Tax at 21% (3,959) (3,707)
Profit after tax 14,893 13,945
Dividend (60% of profit after tax (8,936) (8,367)
Retained profit 5,957 5,578
b) SUMMARY BALANCE SHEET
Rights issue Loan
£'000 £'000
Non-current assets 72,700 72,700
70,200 + 10,000 – 7,500 depreciation
Inventory 10,500 + 5,000 15,500 15,500
Receivables 14,700  1.1 16,170 16,170
Cash (balancing figure) 17,426 16,478
121,796 120,848
Capital and reserves
Share capital 15,000 + 3,000 18,000 15,000
Reserves b/fwd 47,971 47,971
Retained profit 5,957 5,578
Share premium on new issue 12,000 0
Debentures 15,000 + 15,000 15,000 30,000
Payables 12,900  1.08 13,932 13,932
Dividend payable 8,936 8,367
121,796 120,848
Note: The cash position has been identified as the balancing figure above.
c) To: The directors of Max plc
From: Consultants
This report evaluates the proposed methods of financing for the new magazine
launch.

186 Topic 5: Financing decisions

Appendix
Rights issue Loan
EPS 14,893/18,000 = £0.83 13,945/15,000 = £0.93
Gearing 15,000/98,928 = 15.2% 30,000/98,549 = 30.4%
Interest cover 20,352/1,500 = 13.6 20,352/2,700 = 7.5

Equity finance
A share issue may alter the disposition of power in the ownership of the
company, reducing the influence of the original shareholders.
Because it is risk-bearing capital, and dividend payouts are not tax deductible,
equity finance is expensive compared with the direct cost of debt. It also has
very high issue costs because of the legal requirements that must be observed.
As can be seen in the EPS calculations, a share issue will often cause a fall in EPS,
especially in the early years of a new investment.
However, the advantage is that gearing is reduced, which improves the stability
of equity earnings, reducing shareholders' financial risk and lowering the return
that they demand from their investment.
Debt finance
Debt finance will not cause any dilution of shareholding and, because interest
payments are more predictable than dividends and are an allowable expense for
tax purposes, debt has a cheaper direct cost than equity finance.
The additional profit generated from the investment will therefore enhance
expected EPS.
However the increase in gearing and interest payments will cause shareholders'
returns to drop markedly if profits do not materialise, increasing their financial risk
and causing an increased cost of equity capital.
Gearing that is too high may also increase bankruptcy risk, with its attendant
costs.
Other sources of finance
We might also consider acquisition of the new assets by hire purchase or
lease finance, sale and leaseback of existing property, or raising finance from our
working capital, for example by factoring our debts or invoice discounting, or by
negotiating purchase finance for inventory.

Topic 5: Financing decisions 187

 FORECASTING
Forecast Income Statements for the years ending 31 March
31 March 20X1 31 March 20X2
£'000 £'000
Revenue 65,059 70,264
Operating costs (excluding depreciation) 51,480 53,539
Depreciation 875 875
Operating profit 12,704 15,850
Finance costs 1,200 1,200
Profit before tax 11,504 14,650
Tax (W1) 2,297 3,012
Profit after tax 9,207 11,638
Dividends 2,951 3,128
Retained profit 6,256 8,510
WORKINGS
1 Tax
Profit before tax 11,504 14,650
Add back depreciation 875 875
Less capital allowances (1,440) (1,181)
Taxable profits 10,939 14,344
Tax @ 21% 2,297 3,012
Forecast Balance Sheets as at 31 March
31 March 20X1 31 March 20X2
ASSETS £'000 £'000
Non-current assets 35,975 35,100
Inventories 9,922 9,922
Receivables 9,759 10,540
Cash (balancing figure) – 7,449
TOTAL ASSETS 55,656 63,011

EQUITY AND LIABILITIES

Ordinary share capital 16,700 16,700
Retained earnings 18,738 27,248
Debentures 8,000 8,000
Payables 7,629 7,935
Bank overdraft (balancing figure) 1,638 –
Dividends 2,951 3,128
TOTAL EQUITY AND LIABILITIES 55,656 63,011

188 Topic 5: Financing decisions

Forecast Cash Flow Statements for the years ending March
31 March 20X1 31 March 20X2
£'000 £'000
Profit before tax 11,504 14,650
Depreciation 875 875
Increase in inventories (902) –
Increase in receivables (723) (781)
Increase in payables 293 306
Purchase of non-current assets (8,000) –
Tax paid (2,297) (3,012)
Dividends paid (2,784) (2,951)
Net cash flow (2,034) 9,087
Cash balance brought forward 396 (1,605)

Cash balance carried forward (1,638) 7,449

Topic 5: Financing decisions 189

190 Topic 5: Financing decisions
 6
COST OF CAPITAL

Learning Objectives
 To calculate the cost of equity capital using the dividend valuation model
 To estimate growth rates based on historic dividends and on retention rates
 To estimate the cost of equity using the CAPM
 To estimate the costs of preference and debt capital
 To adjust the cost of debt to reflect the effects of taxation and redemption
 To combine various costs of capital into a weighted average, having regard to what
the appropriate weightings are
 To determine when it is correct to use a weighted average cost of capital

Exam Requirement
In the examination, you may be required to calculate a cost of capital – be it equity,
preference shares, debt or an overall weighted average. The basis of the calculation may
form a discussion, either on its own or combined with an exploration of business or
financial risk.

Math Tables 191

 TOPIC OVERVIEW

192 Topic 6: Cost of capital

COST OF EQUITY
INTRODUCTION

Calculating returns
The cost of each source of long-term finance can be equated with the return which the
providers of finance expect on their investment.

Market value of investment = Cash flows from investment discounted at investors'

required rate of return

Determinants of the cost of finance

The two major determinants of a company's cost of finance are:
 The risk-free rate of return or a rate of return that reflects the time value of
money
 The reward for the risk taken by investors in advancing funds to the firm

THE DIVIDEND VALUATION MODEL (GORDON GROWTH MODEL)

The current share price is totally determined by the anticipated dividends,
discounted at the investor's required rate of return (the cost of equity).

The pattern of future dividends

The most convenient assumptions are that dividends either remain constant, or
grow at some fixed annual rate, g. Working from the method of valuing a perpetuity;
Dividends remain constant:
D0 D0
P0 = or ke =
ke P0

Dividends grow at constant rate, g:

D 0 (1  g)
ke = +g
P0
where: P0 = ex-dividend market value of equity
D0 = dividend paid at time 0
ke = equity investors' required rate of return

In this model it is assumed that dividends are paid at annual intervals.

Note that one result of this model is that if dividends grow at a rate 'g' per annum then
so does the share price.
There are obvious flaws in such simple models of anticipated dividend behaviour. In
particular, note the following points:
 Growth (g) must be less than ke.
 In practice companies are likely to experience periods of varying growth rates.

Topic 6: Cost of capital 193

 DIVIDEND VALUATION MODEL (GORDON GROWTH
MODEL)

A company's shares are quoted at £2.50 ex-div. The dividend just paid was 50p. No
growth in dividends is expected and dividends are forecast to continue indefinitely.
Requirements
a) What rate of return, ke, do the investors anticipate?
b) Using the data above, but with an anticipated annual growth rate in dividends of
10%, what is ke?

SOLUTION

Cum-div and ex-div share prices

Dividends are paid periodically on shares. During the period prior to the payment of
dividends, the price rises in anticipation of the payment. At this stage the price is cum-
div.

COST OF EQUITY 1
The market value of a company's shares is £2.20. It is about to pay a dividend of 20p,
which is expected to remain constant in future.
Requirement
What is the cost of equity?

SOLUTION

194 Topic 6: Cost of capital

 COST OF EQUITY 2
A company currently pays a dividend of 12p which is expected to grow at 5% per
annum. The ex-dividend share price is £1.75.
Requirement
What is its cost of equity?

SOLUTION

Estimating growth rates

Historical pattern (extrapolation)

EVALUATING FUTURE GROWTH BASED ON HISTORIC

GROWTH
Assume the following data has been assembled concerning the net dividend per share
paid in the last five years:
Year Dividend per share
p
20X1 1.00
20X2 1.10
20X3 1.20
20X4 1.34
20X5 1.48
Requirement
What is growth g?

SOLUTION

Topic 6: Cost of capital 195

 ESTIMATING GROWTH RATES AND COST OF EQUITY
A company has paid the following dividends over the last five years:
Pence/share
20X0 100
20X1 110
20X2 125
20X3 136
20X4 145
Requirement
Estimate the growth rate and the cost of equity if the current ex-div market value is
£10.50/share.

SOLUTION

Impact of bonus issues

Bonus (or scrip or capitalisation) issues raise no new money for a company. Shareholders
are given more shares in proportion to their existing holdings. The total value of all the
company's shares does not change but the value per share drops in proportion to the
additional shares. The fall in price (supposedly) makes the shares more attractive to
buy/sell.
Care needs to be taken in estimating dividend growth rates when a bonus issue has
taken place.

BONUS ISSUE
The following information relates to a company quoted on the London Stock Exchange.
Balance sheet as at 31 December 20X4
£m
Paid up share capital 36
Share premium 29
Revaluation reserve 24
Retained earnings 89
Shareholder funds 178

196 Topic 6: Cost of capital

Five year summary
20X0 20X1 20X2 20X3 20X4
Profit after tax (£m) 12.6 14.2 18.6 27.2 31.2
Dividends (£m) 4.2 5.0 6.6 9.4 10.8
Shares qualifying for dividends (m) 24 24 48 60 90
In October 20X2 the company made a 1 for 1 scrip (bonus) issue. Other share
adjustments arose from rights issues. The share price on 31 December 20X4 is £1.50.
Requirement
Using the constant growth rate model and years 20X0 and 20X4, what is the cost of
equity capital?

SOLUTION

Earnings retention model

This growth estimate is based on the idea that retained profits are the only source of
funds.
Growth therefore comes about by retaining and reinvesting profits on which a return
is earned. The relationship between these variables is shown by:

g = rb
where:
g = growth in future dividends
r = the current accounting rate of return
b = the proportion of profits retained

Topic 6: Cost of capital 197

 USE OF EARNINGS RETENTION MODEL
Consider the following summarised financial statements for XZ plc:
BALANCE SHEET AS AT 31 DECEMBER 20X1
£m £m
Assets 200 Ordinary shares 100
Reserves 100
200 200
Profit after tax for the year ended 31 December 20X2 £20m
Dividends (a 40% payout) £8m
BALANCE SHEET AS AT 31 DECEMBER 20X2
£m £m
Assets 212 Ordinary shares 100
Reserves £(100 + (20 – 8)) 112
212 212
Requirement
If the company's accounting rate of return and earnings retention rate remain the same,
what will be the growth in dividends in the next year?

SOLUTION

APPLYING THE EARNINGS RETENTION MODEL

A company has 300,000 ordinary shares in issue with an ex-div market value of £1.35
per share. A dividend of £50,000 has just been paid out of post-tax profits of £75,000.
Net assets at the year end were valued at £1.06m.
Requirement
Estimate the cost of equity.

198 Topic 6: Cost of capital

 SOLUTION

Problems with the Earnings retention model

Note that the accounting rate of return is calculated with reference to opening balance
sheet values.
The major problems with this model are:
 Its reliance on accounting profits
 The assumption that r and b will be constant
 Inflation can substantially distort the accounting rate of return if assets are valued
on an historical cost basis
 The model also assumes all new finance comes from equity – it therefore
ignores the use of debt in a company’s capital structure

Shortcomings of the dividend valuation model (DVM)

There are a few problems with the underlying assumptions and with the data used.
In addition to the assumption that growth (g) must be less than the cost of equity (ke):
 Underlying assumptions
– Shares have value because of the dividends – not always true
– Dividends either do not grow, or grow at a constant rate – again, not always
true or realistic
– Estimates of future dividends based on historic data – this is always going to
be a problem
 Data used
– The share price is used in the DVM but is subject to volatility
– The growth in future dividends – more likely to mirror future growth than
past dividends

Topic 6: Cost of capital 199

 CAPM AND THE COST OF EQUITY

Recap of concept
The Capital Asset Pricing Model (CAPM) provides a relationship between risk and return:

ke = rf + j (rm – rf)
where: j = the beta which measures a share's (systematic) risk
rm = the return on the market
rf = the risk free rate of interest

CAPM can be used as an alternative to the dividend valuation model for deriving the cost
of equity.

CAPM
Bloggins plc is an all equity company with a j = 1.10
The risk free rate is 4% pa and the return on the market is estimated at 11% pa
Requirement
Calculate Bloggins' cost of equity.

SOLUTION

COST OF PREFERENCE SHARES

Preference shares usually have a constant dividend. So, using the perpetuity valuation
formula:

D
kp =
P0

where: D = constant annual dividend

P0 = ex-div market value

Preference dividends are normally quoted as a percentage. Thus 10% £1 preference

shares will provide an annual dividend of 10% of the £1 nominal value (not of the
market value).

200 Topic 6: Cost of capital

 COST OF PREFERENCE SHARES
A company has 100,000 12% preference shares in issue, nominal value £1.
The current ex-div market value is £1.15/share.
Requirement
What is the cost of the preference shares?

SOLUTION

Topic 6: Cost of capital 201

 SUMMARY

202 Topic 6: Cost of capital

COST OF DEBT
IRREDEEMABLE DEBT
The underlying principle of the DVM above was that the value of the investment equalled
the present value of the cash flows received.
The same principle is used to identify the cost of debt capital. If securities are
irredeemable, the company does not intend to repay the principal but to pay interest
for ever.

kd= Interest/P0
where: P0 = Price of the bond ex interest
Interest = Interest paid on the bond
kd = Required return of debt holder (= cost of debt if no tax)

IRREDEEMABLE DEBT
Irredeemable debt is quoted at £40% and the coupon (nominal) interest rate is 5%.
Requirement
What is the return on the security?

SOLUTION

REDEEMABLE DEBT
Where there is a difference between the current market price and the redemption price,
there are two elements to the cost of that security:
 Interest payments, ie an income return
 A capital gain or loss represented by the difference between the current market
price and the redemption price
Internal rate of return is used to calculate the cost of debt (gross redemption yield).

NPVa
IRR = a + (b  a)
NPVa  NPVb

Topic 6: Cost of capital 203

 Time
0 (Market value)
1–n Interest
n Redemption value

REDEEMABLE DEBT
Requirement
If a company's debenture stock is quoted at £65.75%, coupon interest is 9% pa just
paid, and redemption is in ten years' time at par, what is the cost of the debt?

SOLUTION

EFFECT OF TAXATION
An important aspect in evaluating the cost of finance is the effect of tax. Loan interest is
an allowable expense for corporation tax, effectively reducing the cost of loan finance to
the company.
Net of tax cost of debt, kd = Pre-tax cost of debt (1 – T)
For irredeemable loan stocks:

Interest (1  T)
kd =
P0

EFFECT OF TAXATION
12% irredeemable debentures with a nominal value of £100 are quoted at £92 cum
interest. The rate of corporation tax is 21%.
Requirement
Find the net of tax cost to the company.

204 Topic 6: Cost of capital

 SOLUTION

TAXATION AND PREMIUM ON REDEMPTION

A company has 10% debentures in issue quoted at £98 ex interest. The debentures will
be redeemed in five years at a premium of 5% compared to the nominal value.
Corporation tax rate = 21%
Requirement
What is the cost to the company if interest is paid annually?

SOLUTION

Topic 6: Cost of capital 205

 COST OF DEBT
Requirements
a) A company’s capital structure includes 50m 8% irredeemable debentures valued at
£85%. Corporation tax is 21%.
Calculate the post-tax cost of debt to the company.
b) A company has in issue £20 million 7% debentures redeemable at par in eight
years' time. Interest is paid annually and qualifies for immediate tax relief at 21%.
The debentures are currently quoted at £93 ex interest.
Estimate the post-tax cost of debt capital.

SOLUTION

206 Topic 6: Cost of capital

CONVERTIBLE DEBENTURES/LOAN STOCK
Convertible debentures/loan stock allow the investor to choose between taking cash on
redemption or converting the debentures into a pre-determined number of shares.

Step 1 Calculate the value of the conversion option using available data

Step 2 Compare the conversion option with the cash option. Assume all investors
will choose the option with the higher value

Step 3 Calculate the IRR of the flows as for redeemable debentures

CONVERTIBLE LOAN STOCK

A company has in issue 8% convertible loan stock currently quoted at £85 ex interest.
The loan stock is redeemable at a 5% premium in five years' time, or can be converted
into 40 ordinary shares at that date.
The current MV ex div of shares is £2 per share with a dividend growth of 7%.
Requirement
What is the cost to the company of the loan stock?
Corporation tax = 21%.

SOLUTION

Topic 6: Cost of capital 207

 CONVERTIBLE LOAN STOCK PRACTICE
A company has in issue 6% convertible loan stock currently quoted at £95 ex interest.
The loan stock is redeemable at par in five years' time, or can be converted into 50
ordinary shares at that date.
The current MV ex div of shares is £1.50 per share with a dividend growth of 8%.
Requirement
What is the cost to the company of the loan stock?
Corporation tax = 21%.

SOLUTION

208 Topic 6: Cost of capital

SUMMARY

Topic 6: Cost of capital 209

 WACC
The concept of a weighted average cost of capital

Funds from Funds from

equity sources other sources
Pool of
funds

Used to finance various investment projects

In order to provide a measure for evaluating projects, the cost of the pool of funds is
required.

PROCEDURE FOR CALCULATING WACC

Calculate the cost of each source of finance, then weight these according to their
importance in the financing mix using market values.
Note that when using market values, reserves (such as share premium and retained
earnings) are ignored.
The company's weighted average cost of capital, k, is defined as follows:

(MVe  k e )  (MVd  k d )
k =
MVe  MVd
where: MVe = Total market value of issued shares (market capitalisation)
MVd = Total market value of debt

FINDING THE WACC

A company is financed by 10 million £1 ordinary shares and £8,000,000 8% redeemable
bonds having market values of £1.60 ex div and £90% ex interest respectively. A
dividend of 30p has just been paid and future dividends are expected to grow by 5%.
The bonds are redeemable at par in five years’ time.
Corporation tax = 21%.
Requirement
What is the WACC?

210 Topic 6: Cost of capital

 SOLUTION

FINDING THE WACC PRACTICE

Assume it is 31 December 20X1. You work as a finance manager for Caldene Financial
plc (Caldene), a publicly quoted company that operates in the UK professional education
market. Caldene is currently financed by a mixture of debt and equity. You have been
asked to calculate an after-tax weighted average cost of capital (WACC) for use in
assessing the viability of a major investment in a new training business in India.
The company’s balance sheet at 31 December 20X1 showed the following long-term
sources of finance:
£m
60 million ordinary shares of 25p each 15
Reserves 25
5% irredeemable preference shares of £100 each 25
9% redeemable loan stock (nominal value) 20
On 31 December 20X1, the ordinary shares are quoted at 242p cum-dividend, with a
dividend of 10.4p per share due to be paid early in 20X2. Over recent years, dividends
have increased in line with the company’s target dividend growth rate of 4% pa.

Topic 6: Cost of capital 211

 The current market price of the 5% irredeemable preference shares is £103.50 (ex-
dividend).
The 9% redeemable loan stock is redeemable at par on 31 December 20X8. Its current
market price is £117 per £100 nominal (ex-interest). Interest on debt is payable annually
on 31 December.
Caldene’s directors would like you to assume that the rate of corporation tax will be 21%
for the foreseeable future.
Requirement
Calculate Caldene’s after-tax WACC at 31 December 20X1.

SOLUTION

212 Topic 6: Cost of capital

WHEN TO USE THE WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital can only be used for project appraisal if:
 The historical proportions of debt and equity are not to be changed (financial
risk)
 The business (operating) risk of the firm is not to be changed
 The finance is not project specific

Other problems with the weighted average cost of capital

 Which sources of finance to include
 Loans without market values
 Cost of capital for small companies

Topic 6: Cost of capital 213

 SUMMARY

214 Topic 6: Cost of capital

ACTIVITY ANSWERS

DIVIDEND VALUATION MODEL (GORDON GROWTH

MODEL)

D 0 0.5
a) ke = = = 0.2 or 20%
P0 2.5

D 0 (1  g) 0.5  1.1
b) ke = +g= + 0.1 = 0.32 or 32%
P0 2.5

COST OF EQUITY 1
MV (cum div) = £2.20
MV (ex div) = £2.00
D0 20
ke =   100% = 10%
P0 200

COST OF EQUITY 2
0.12(1.05)
ke = + 0.05 = 12.2%
1.75

EVALUATING FUTURE GROWTH BASED ON HISTORIC

GROWTH

An approximate average period growth rate can be taken by averaging the growth rates
of the individual years:
Period
1.1 – 1
20X1 – 20X2 = 0.100
1.0
1.2 – 1
20X2 – 20X3 = 0.091
1.1
1.34 – 1
20X3 – 20X4 = 0.117
1.2
1.48 – 1
20X4 – 20X5 = 0.104
1.34
0.412 ÷ 4 = 0.103 or 10.3%

Topic 6: Cost of capital 215

 A more direct compound growth calculation would be:
1.0  (1 + g)4 = 1.48

1.48
(1 + g) = 4
1.0

g = 1.103 – 1 = 0.103 = 10.3%

ESTIMATING GROWTH RATES AND COST OF EQUITY

Data is available for the four years to 20X4, so:
100(1 + g)4 = 145
145
(1 + g)4 =
100

145
1+g= 4 = 1.097
100

Thus compound growth, g = 9.7%

D 0 (1  g) 145 (1.097)
The cost of equity is ke = +g= + 0.097 = 24.8%
P0 1,050

BONUS ISSUE

g =  10.8   4.2 
4     1 = 0.0822
 90   48 

10.8  1.0822
ke = + 0.0822 = 16.88%
90  1.50

USE OF EARNINGS RETENTION MODEL

£20m
The 20X2 profit after tax as a percentage of opening capital employed = = 10%.
£200m
Applying this to the end-20X2 capital employed (10%  £212m), gives a profit for 20X3
estimated at £21.20m.
Therefore, the dividends for 20X3 will be 40%  £21.20m = £8.48m, representing a
growth of 6% on the previous year's divissdends.
Normally, this is more directly calculated by the following equation:
g = r(accounting rate of return) × b(earnings retention rate) = 10% × 60% = 6%

216 Topic 6: Cost of capital

 APPLYING THE EARNINGS RETENTION MODEL
Growth rate: g = r  b where:
£25,000
b = % profit retained = = 33%
£75,000
profit after tax
r = return on investment =
opening net assets
£75,000
=  100% = 7.2%
£1,060,000  £25,000
g = 0.33  0.072 = 0.024 = 2.4%

D 0 (1  g) £50,000 (1.024)
ke = + g, the cost of equity is + 0.024 = 15.0%
P0 300,000  £1.35

CAPM
ke = 4% + 1.1 (11% – 4%) so this gives us ke = 11.7%

COST OF PREFERENCE SHARES

12% preference shares: dividend is 12%  nominal value
D £0.12
kp = =  100% = 10.4%
P0 £1.15

IRREDEEMABLE DEBT
The term '£40%' means that £100 nominal value can be purchased for £40
The nominal or coupon rate of 5% means investors will receive £5 pa for each £100
nominal value of debt security purchased.
£5
The return on this investment = = 0.125 or 12.5%
£40

Topic 6: Cost of capital 217

 REDEEMABLE DEBT
Cash flows 15% PV 20% PV
£ factor £ factor £
t0 (65.75) 1 (65.75) 1 (65.75)
t1 – t10 9.00 5.019 45.17 4.192 37.73
t10 100.00 0.247 24.70 0.162 16.20
4.12 (11.82)
Since this is positive,
increase to 20%
4.12
Cost of debt via interpolation = 15% +  (20 – 15)% = 16%
4.12  11.82

EFFECT OF TAXATION
The cost to the company is calculated by reference to the ex-interest market price, so:
Interest (1  T) £12(1  0.21)
kd = = = 11.85%
Po £92  £12

TAXATION AND PREMIUM ON REDEMPTION

DF PV DF PV
£ @ 5% £ @ 10% £
t0 (98) 1 (98.00) 1 (98.00)
t1 – t5 10 4.329 43.29 3.791 37.91
t5 105 0.784 82.32 0.621 65.21
27.61 5.12
27.61
IRR = 5 + (10 – 5) = 11.14%
27.61 -5.12
Post-tax cost of debt = 11.14 × (1 – 0.21) = 8.8%

COST OF DEBT
Interest (I  T)
a) Cost of debt = P0

8  0.79
= 85

= 0.0744, ie 7.44%

218 Topic 6: Cost of capital

b) DF PV DF PV
£ @ 5% £ @ 10% £
t0 (93) 1 (93) 1 (93)
t1 – t8 7 6.463 45.24 5.335 37.35
t8 100 0.677 67.7 0.467 46.7
19.94 (8.95)
IRR = 5 + ((19.94/19.94 + 8.95) × (10 – 5)) = 8.45%
Post-tax cost of debt = 8.45 × (1 – 0.21) = 6.7%

CONVERTIBLE LOAN STOCK

Firstly we need to decide whether or not the loan stock will be converted in five years.
To do this we compare the expected value of 40 shares in five years’ time with the cash
alternative.
We assume that the MV of shares will grow at the same rate as the dividends.
MV/share in five years = 2(1.07)5 = £2.81
Therefore MV of 40 shares = £112.40
Cash alternative = £105
Therefore all loan stockholders will choose the share conversion.
To find the cost to the company, calculate the IRR of the cash flows.
DF @ 5% PV DF @ 10% PV
£ £ £
T0 (85) 1 (85.00) 1 (85.00)
T1-5 8 4.329 34.63 3.791 30.33
T5 112.4 0.784 88.12 0.621 69.80
37.75 15.13
37.75
IRR = 5 + × (10 – 5) = 13.34%
37.75 - 15.13
Therefore the post-tax cost to the company = 13.34 × (1 – 0.21) = 10.54%.

CONVERTIBLE LOAN STOCK PRACTICE

MV/share in five years = 1.5 × (1.08)5 = £2.20
Therefore MV of 50 shares = £110
Cash alternative is £100, so all loan stockholders will choose the share conversion.
DF @ 5% PV DF @ 10% PV
£ £ £
T0 (95) 1 (95.00) 1 (95.00)
T1-5 6 4.329 25.97 3.791 22.75
T5 110 0.784 86.24 0.621 68.31
17.21 (3.94)

Topic 6: Cost of capital 219

 IRR = 5 + ((17.21/17.21 + 3.94) × (10 – 5)) = 9.07%
Therefore the post-tax cost to the company = 9.07 × (1 – 0.21) = 7.2%.

FINDING THE WACC

D o 1  g 30(1.05)
Ke = g  0.05
Po 160

= 24.69%
Ve = 10m  1.6 = £16m
Kd : Internal Rate of Return
Time DF PV DF PV
£ @ 10% £ @ 5% £
0 (90) 1 (90) 1 (90)
1-5 8 3.791 30.33 4.329 34.63
5 100 0.621 62.10 0.784 78.40
2.43 23.03
 23.03 
IRR = 5%     5% 10.6%
 23.03  2.43 

Post-tax cost to the company = 10.6 × (1 – 0.21) = 8.37%.

Vd = 8,000,000  90% = £7,200,000
16 7.2
WACC =  24.69%  8.37%  19.63%
16  7.2 16  7.2

FINDING THE WACC PRACTICE

Ordinary shares
Ke = D0 (1 + g) / P0 + g
Ke = 0.104(1 + 0.04)/(2.42 – 0.104) + 0.04
Ke = 8.7%
MVe = £2.316 × 60m = £138.96m
5% irredeemable preference shares
Kp = D / P0
Kp = 5 / 103.5  100
Kp = 4.8%
MVp = £103.50  25m ÷ 100 = £25.875m

220 Topic 6: Cost of capital

9% redeemable loan stock
5% df PV 10% PV
df
T0 Ex-interest market (117.00) 1 (117.00) 1 (117.00)
price
T1-7 Interest (pre-tax) 9.00 5.786 52.07 4.868 43.81
T7 Repayment of capital 100.00 0.711 71.1 0.513 51.3
6.17 (21.89)
Kd (pre-tax) = 5 + {6.17/(6.17 + 21.89)  5} = 6.1%
Kd (post-tax) = 6.1 × (1 – 0.21) = 4.8%
MVd = £117 × 20m ÷ 100 = £23.4m
WACC
(MVe  Ke) + (MVp  Kp) + (MVd  Kd) / MVe + MVp + MVd
((138.96 × 8.7) + (25.875 × 4.8) + (23.4 × 4.8)) / 188.235
WACC = 7.7%

Topic 6: Cost of capital 221

222 Topic 6: Cost of capital
 7
CAPITAL STRUCTURE

Learning Objectives
 To explain and illustrate what is meant by financial risk
 To explain the traditional view of gearing
 To explain the M & M view of gearing
 To outline the key aspects of capital structure
 To explain why in theory the source of equity finance is irrelevant in determining
shareholder wealth
 To explain the practical limitations of the theory on raising equity
 To explain the theoretical and practical issues surrounding the dividend decision

Exam Requirement
Exam questions on this topic are likely to require an explanation of the underlying theory
of capital structure and then a description of any shortcomings of the theory and the
practical issues surrounding gearing.
You may be asked to evaluate the implications of different dividend policies in the exam.
You may also be expected to explore the implications of raising equity finance from a
variety of sources.

Math Tables 223

 TOPIC OVERVIEW

224 Topic 7: Capital structure

THE EFFECT OF GEARING
GEARING

Business and financial risk

Business risk is the variability in earnings before interest and tax associated with the
industrial sector in which a firm operates. This is sometimes referred to as operational
risk.
It is determined by general business and economic conditions.

Well-diversified shareholders will only be interested in risk that cannot be diversified

away, ie the systematic element of business risk ('systematic business risk').

Financial risk is the additional variability in returns as a result of having fixed interest
debt in the capital structure. Equity holders take this risk in particular, but debt holders
also suffer financial risk at high gearing levels.

Operating and financial gearing

Operating gearing (or leverage) is the extent to which a firm's operating costs are
fixed, as opposed to variable, measured by establishing the ratio of total contribution
to earnings before interest and tax (EBIT). Firms with high operating gearing, eg
steel plants, oil refineries, have high break-even points and EBIT which are very sensitive
to changes in sales. Operating gearing is linked to business risk.
Financial gearing is the extent to which debt is used in the capital structure. This can
be measured in two ways:
 Capital terms (normally by market values):
debt debt
or
equity debt  equity
(either of these expressions is acceptable)
 Income terms using interest cover:
EBIT
Interest

DEMONSTRATION OF GEARING
A company has £40m of debt on which it pays 5% interest. The company's expected
results are as follows:
£m £m
Sales 10
Variable costs 2
Fixed costs 5
7
EBIT 3

Topic 7: Capital structure 225

 Requirement
Ignoring tax, show the effect of the fixed costs and the interest cost on the volatility of
the earnings, and the interest cover if sales:
a) Decrease by 10%
b) Increase by 10%

SOLUTION

What happens if gearing increases?

As a company gears up financially two things happen:
k e MVE  k d MVD
WACC =
MVE  MVD

 ke increases due to the  The proportion of debt relative to

increased financial risk equity in the capital structure
increases
 All else equal, this pushes up
the value of WACC  Since kd< ke this pushes down
the value of WACC, all else equal

The effect of increased gearing on the WACC depends on the relative sizes of these two
opposing effects.

Traditional view of gearing

The traditional view is that as an organisation introduces debt into its capital structure,
the weighted average cost of capital will fall, because initially the benefit of cheap
debt finance more than outweighs any increases in the cost of equity required to
compensate equity holders for higher financial risk.
As gearing continues to increase, the equity holders will become more concerned due
to their possible dividend shrinking in favour of increasing interest payments, and the
general concerns that increasing levels of debt tend to bring. They will ask for
progressively higher returns and eventually this increase will start to outweigh the
benefit of cheap debt finance, and the weighted average cost of capital will rise.

226 Topic 7: Capital structure

At extreme levels of gearing the cost of debt will also start to rise (as debt holders
become worried about the security of their loans and ask for higher returns to
compensate accordingly) and this will also contribute to an increasing weighted average
cost of capital.
Conclusions
 There is an optimal level of gearing at which the value of the firm is maximised.
This occurs at the point where the WACC is minimised (shown below).
 There is no precise method of calculating ke or WACC, or indeed the optimal
capital structure. The latter needs to be found by trial and error: changing the
gearing and seeing how the market responds.
 The value of the business equals post tax earnings discounted to perpetuity
@ WACC.
 If the lowest WACC is maintained, projects will have the highest NPV (at the lowest
discount rate) and shareholder wealth is maximised.
keu = Cost of equity in
Cost of ungeared firm
capital (reflects business
% risk only)
keg = Cost of equity in
k geared firm
keu
(reflects business
and financial risk)
kd kd Cost of debt
=

k = WACC
0 optimum Gearing
Market
value
£ The traditional view of gearing

MVE + MVD

0 Gearing

MODIGLIANI AND MILLER (M&M) 1958 & 1963

In 1958 and 1963 M & M published papers on capital structure which were at odds with
the traditional approach.

M & M 1958
M & M showed in 1958 that with no corporation tax there is no advantage for firms to
issue debt (gear up).

Topic 7 : Capital structure 227

 CAPITAL STRUCTURE (IGNORING EFFECT OF TAX)
A company generates EBIT (earnings before interest and tax) of £100m. It currently has
no debt in the capital structure. It is considering the use of debt, and is exploring raising
£800 million or £1,800 million. Interest is payable at 5%.
Requirement
Ignoring taxation and assuming all earnings after interest are paid out as dividends, find
out which is the most attractive capital structure.

SOLUTION

M & M showed in 1958 that:

Vg = Vu
| |
| |
| |
value of debt value of equity
+ value of equity in equivalent
in geared firm ungeared firm
The implication is that the WACC is constant no matter what the gearing level.
 There is no optimal level of gearing.
 The benefits of cheap debt finance are exactly offset by the increased returns
required by shareholders for the extra financial risk – the cost of equity rises in
direct proportion to the increased gearing.

228 Topic 7 : Capital structure

M & M 1963
M & M showed in 1963 that, in the presence of corporation tax, it is advantageous for
firms to issue debt (gear up).

CAPITAL STRUCTURE WITH EFFECT OF TAXATION

The same situation as in the capital structure example above, but this time corporation
tax is payable at 21%.
£m £m £m
EBIT 100 100 100
Interest – (40) (90)
100 60 10
Requirement
Which capital structure is most attractive in terms of total amount paid to investors,
taking into account the tax payable?

SOLUTION

Vg = Vu + DT

value of debt value of equity tax shield on debt where

+ value of equity in equivalent T is the corporation tax
in geared firm ungeared firm rate and D is the market
value of the geared
firm's debt
Cost of K eg
capital
%

K eu M&M 1963 position

Kd

Gearing

Topic 7 : Capital structure 229

  The effect of interest being allowable against tax means that geared companies
pay less tax.
 The implication is that the WACC falls as the gearing level rises.
 Geared companies will have more cash to pay out to investors, and therefore are
worth more.
 This suggests that the optimal level of gearing is nearly 100% debt.

Limitations in the real world

Whilst M & M’s theory is widely recognised, it has restrictions when applied in the real
world.

Perfect capital markets

M & M assume that capital markets are perfect:
 A firm will always be able to raise funds for worthwhile projects.
 There are no transaction costs.
 It ignores the increasing danger that very high levels of gearing can lead to
financial distress costs and agency problems (bankruptcy risk).

Bankruptcy risk
As firms take on higher levels of gearing, the chances of default on debt repayments,
and hence liquidation (bankruptcy), increase.
Investors in both debt and equity will ask for higher rates of return from highly-
geared companies and thus drive down the prices for their securities.
Indirect financial distress costs can be suffered by companies with high levels of
gearing. Eg loss of sales, higher costs from suppliers, sale of inventory at below market
price.
Directors may be unwilling to gear the company up to a high level (agency problem).

Loan covenants
Most loan agreements contain restrictive covenants for protection of the lender.
Complying with such covenants places a restriction on the actions of managers and
imposes a potential additional cost of borrowing. For example, restrictions on issuing
new debt, dividends, merger activity.
Contravention of these agreements will usually result in the loan becoming immediately
repayable.

Tax exhaustion
A further disincentive to high gearing is that the firm must be in a taxpaying position to
obtain the tax shield on debt. At a certain level of gearing companies will discover
that they have no taxable income left against which to offset interest charges, or that
they no longer receive any capital allowances.

Practical aspects
In addition to the above points, the following practical aspects apply equally to the
traditional and M & M theories:

230 Topic 7 : Capital structure

In addition the following should be borne in mind:
 Signalling
Raising debt could be taken as a sign of confidence by investor.
 Clientele effect
Particular shareholders (a 'clientele') may have an opinion on gearing levels - this
needs to be considered before action is taken to either increase or decrease such
levels.

ADJUSTED PRESENT VALUE

Changing capital structure

Where capital structure changes significantly, the existing WACC is no longer appropriate
because financial risk has now changed.
Projects financed with new debt can be evaluated using the adjusted present value
technique.
Modigliani and Miller’s theory on gearing suggests that the impact of debt finance is
purely to save tax, this can be quantified and added to the present value of a project.

Topic 7 : Capital structure 231

 Adjusted present value

1. Calculate a base case value of a project using keu (cost of equity for an ungeared
company), this gives the value of the project as if it were ungeared
2. Establish the present value of the tax shield arising as a result of the debt
capacity generated by the project.

Adding these two together gives an Adjusted Present Value (APV). A positive value for
the APV indicates an increase in shareholder wealth, and so the project should go ahead.

APV
Toes Ltd, currently all equity financed, is considering a project which will involve
investing £240 million now and will generate annual net cash flows of £40 million for
each of the next 10 years. The project will use buildings and equipment which, when
used as security, will enable Toes Ltd to borrow £187.5 million at a rate of 8%. The costs
of issuing the debt are £1 million. The debt will last as long as the project: 10 years.
Corporation tax rate is 21%.
If the project were to be funded entirely by equity, the cost of capital would be 12%.
Requirement
Establish whether Toes should go ahead with the project, by completing the table below.

SOLUTION
Project base case?

Value of tax shield:

Interest charge

Tax relief per annum

Present value at pre-tax cost of debt

APV?

232 Topic 7 : Capital structure

 APV PRACTICE
Adams, Parlour & Vieira plc is a leading hotel group interested in expanding its activities.
It is planning a new flagship hotel which will require an additional capital injection.
The potential cash inflows from this investment would be £5m indefinitely from an initial
investment of £50m, £25m of which would come from new irredeemable debt finance –
the balance from internal funds.
The company wishes to use the adjusted present value technique to determine the
financial viability of the above.
Relevant information
i) The company's existing WACC is 10.5%
ii) The ungeared cost of capital for this sector is 11.06%
iii) Taxation is currently at the rate of 21%
iv) The loan to fund the investment will attract an interest rate of 8%
Requirement
Calculate the Base Case NPV, the present value of the tax shield and therefore the
adjusted present value of the proposed investment.

SOLUTION

Problems with the APV approach

The technique is based upon the assumptions of M & M with tax. That means that issues
such as agency costs and financial distress may affect the attractiveness of debt finance
which are not reflected in this technique.

Topic 7 : Capital structure 233

 GEARING AND THE CAPM
The relationship between the required return on a share and the level of gearing is as
shown in the graph.

The reason the required return goes up is because as a company borrows more, the risk
that the shareholders face will increase.
It follows that a geared company’s shares will have a higher beta.
The assets of a business contain only systematic business risk which is measured by a
(asset beta). In an ungeared firm this must be the same as e (there is no financial
risk). But, as gearing increases the e increases, such that e > a.
One way of relating e, a and the level of gearing (assuming risk free debt) is:

e = a ( 1 + D(1  T) )
E

where D and E are the market values of debt and equity respectively, and T is the
corporation tax rate. (Formula is provided in exam)
This can be used to calculate a risk-adjusted discount rate based on the systematic
risk of a project.

RISK ADJUSTED DISCOUNT RATE

Hubba plc, an all equity financed food manufacturer, is about to embark on a major
diversification into the consumer electronics industry. Its current equity beta is 1.2, while
the average equity beta of electronics firms is 1.6. Gearing in the electronics industry
averages 30% debt, 70% equity by market values. Debt is considered risk free.
rm = 25% rf = 10% T = 21%
Requirement
Estimate a suitable discount rate for the project if it were financed:
a) Entirely by equity
b) By 40% debt, 60% equity (by market values)

234 Topic 7 : Capital structure

SOLUTION

Topic 7 : Capital structure 235

 EQUITY BETA
An extract from the balance sheet of Jug plc is as follows.
£
Ordinary shares of £1 each 3,000,000
Reserves 11,000,000
Total equity 14,000,000
The current market value of the shares is £8.
The company also has in issue £16 million of debt, which you can assume to be risk-free,
which is currently valued at par.
The equity beta of Jug is 1.20.
The company proposes to issue new shares to raise £4 million in order to pay off some
of its debt. The tax rate is 21%.
Requirement
Assuming there are no transaction costs with issuing the new shares or redeeming £4
million of debt, what should the equity beta of the company be after the capital
restructuring?

SOLUTION

236 Topic 7 : Capital structure

SUMMARY

Topic 7 : Capital structure 237

 RETURNS TO SHAREHOLDERS
SOURCES OF EQUITY FINANCE

M & M irrelevance
Modigliani and Miller’s views are regarded as the classic position. All sources of equity
finance have the same cost, and therefore that the particular source of equity finance is
irrelevant.
The cost of equity finance represents the returns required on equity funds invested. If
this level of return is not obtained, share prices will fall until the implied return on equity
equals the shareholders' required rate of return. This argument applies to all sources of
equity.
D
ke = 0
P0
If returns to investors ie dividends fall, then the value of the share price will fall. This
results in the required rate of return (ke ) being maintained at the required level.
In practical terms, the share price set for a new issue determines how the wealth is
shared between new and existing shareholders, but not the amount of the wealth, which
is unaffected.

Pricing of new issues

One of the most difficult problems in making a new issue to the public is setting the price
correctly. If it is too high, the issue will not be fully taken up and will be left with the
underwriters. This will reflect badly on the company and on the issuing house.
The solution may be to under-price the new issue. However, this works to the
detriment of the existing shareholders.
A rights issue completely bypasses the price problem. Since the shares are offered to
existing shareholders, it does not matter if the price is well below the traded price.
Indeed, it would be normal for this to be so. Although there would be a gain on the new
shares, by the nature of a rights issue this would go to the existing shareholders.

Pecking order
New equity issues, including rights issues, are expensive and time consuming – a very
important practical point that results in retained profits being a much more frequent
source of equity finance.
It has been suggested that because of issue costs firms try to access equity finance in a
particular sequence, ie they follow a 'pecking order':
 Retained earnings are usually the cheapest source of finance as they involve no
issue costs. However, if they are used too extensively the result can be a
substantial cut in dividends, which will upset shareholders, depress the share price
and drive up the cost of equity.
 Rights issues and placings are the next cheapest form of equity finance due to
the relatively low issue costs.
 New issues to the public tend to be the most expensive source of equity finance.

238 Topic 7 : Capital structure

DIVIDEND POLICY

M & M irrelevance
Modigliani and Miller proposed that in theory the pattern of dividends over time is
irrelevant in determining shareholder wealth.
If the source of equity finance is irrelevant (retentions or new issues) then dividend
policy must also be irrelevant. This means that paying or not paying a dividend does
not matter, provided a firm takes on all available positive NPV projects such that
shareholders' wealth is maximised.
Only after a firm has invested in all positive NPV projects should a dividend be paid if
there are funds remaining, ie retentions should be used for project finance with dividends
as a residual.

Traditional theory
It could be argued that the use of retained earnings involves sacrificing current income
(dividends) in order to increase wealth through a higher share value, ie a capital gain.
Traditionalists would argue that £1 of dividend income received now is more certain than
£1 of capital gain (the so called 'bird in the hand' approach).
Greater value would be put on a firm paying a dividend (and issuing shares to finance
new investments) than one using retentions (ie cutting dividends).

Signalling
In reality investors do not have perfect information concerning the future prospects of
the company. It is therefore argued that the pattern of dividend payments is a key
consideration on the part of investors when estimating future performance.
This argument implies that dividend policy is relevant. Firms should attempt to adopt a
stable (and rising) dividend payout to maintain investors' confidence.

Clientele
Investors may be attracted to firms by their dividend policies.
High payouts may attract those who prefer current income.
Low payouts attract those with high marginal income tax rates or those seeking capital
gains, eg pension funds.
Many shareholders will prefer companies which pay regular cash dividends and will
therefore value their shares more highly.
Modigliani and Miller challenged this argument and claimed that investors requiring cash
can generate 'home-made dividends' by selling shares. This argument ignores
transaction costs.

Cash availability
If cash is unavailable to pay a dividend either the planned investment should be cut back
or money borrowed if it is felt that payment of a dividend is necessary to avoid adverse
signalling effects.

Topic 7 : Capital structure 239

 Agency issues
Managers/directors do not necessarily act in the best interests of shareholders.
Shareholders can keep some control over their money by insisting on high payout ratios.
If managers/directors want new funds for investment, they are forced to issue shares (by
rights issue or to the public) and justify why the investment is sound. Obviously,
managers/directors would prefer to use retentions in this instance.
The agency cost is represented by the cost of the new share issue.

SHARE BUY-BACKS AND SCRIP DIVIDENDS

Share repurchases
 As an alternative to dividend payments a company can use the cash to repurchase
issued shares.
 The repurchase may be achieved by buying shares in the stock market, or inviting
shareholders to tender their shares, or by arrangement with particular
shareholders.
 This reduces equity and increases gearing.
 Enables a company to use surplus cash without disturbing the normal dividend
policy.
 An alternative to buying back shares would be to pay a 'special dividend' making it
clear that it was a one-off above normal sustainable levels.

Scrip dividends
 An issue of new shares to existing shareholders in lieu of cash dividends.
 Company avoids liquidity problems.
 Shareholder swaps income for capital gain and may be better off (depends on their
income and capital gains tax position).

240 Topic 7 : Capital structure

 FINANCING DECISION
Quigley Industries plc is a listed manufacturer whose principal product is 'Qboard'.
Qboard is widely used in the building trade, particularly in residential properties. The
company has several manufacturing plants in the UK. Qboard manufacture is a highly
capital intensive activity. The company's other products, which account for only a small
part of revenue are also supplied to the building trade.
Recently demand for Qboard has been very buoyant and the directors have decided to
open a new manufacturing plant in Staffordshire to supply the local market and save on
transport costs. A net present value assessment of the projected plant shows a
substantial positive outcome. The cost of establishing this plant will be significant for the
company, representing about 15% of its current stock market value.
The company is financed by a combination of equity and loan stock. Since the company's
funds are all tied up in operations, establishing the new plant will require that the
company raises additional finance. The directors generally have open minds on the
source or sources of finance.
You are the company's finance director and have had some conversations with your
colleagues, when the following points were made.
Director A
'This is not a good time to be issuing equity. I have a small share portfolio of my own
and I plot the monthly prices of each share on graphs. I have done this for some years
now and I can tell you that the patterns clearly show that we are heading for a major
downturn in share prices. If we went for equity finance, by the time that we could get it
organised the bear market would be with us and we would need to issue a large number
of shares to raise the necessary cash.'
Director B
'We must pay attention to financial gearing. If we get that wrong, the stock market will
probably savage our share price. By the way, are we going to make the financing
decision without outside advice and are we going to handle the practicalities? If not, who
is going to do it for us?'
Director C
'People only seem interested in equities these days; the evidence all shows that average
returns are higher than you get from lending. We'll struggle to raise loan finance.'
Director D
'Everyone seems to be talking about external finance, but I'm not so sure that it's
necessary. We make good profits and have done for some time; can't we use some of
the retained earnings for this?'
Requirement
Draft notes for the directors, addressing the whole question of the financing decision, as
well as picking up the points raised by the directors. The notes should use language that
you expect the directors to understand and should explain any technical terms.

Topic 7 : Capital structure 241

 SOLUTION

242 Topic 7 : Capital structure

SUMMARY

Topic 7 : Capital structure 243

 ACTIVITY ANSWERS

DEMONSTRATION OF GEARING
The following shows an abbreviated statement for a financially geared firm before and
after a 10% decrease in sales and a 10% increase in sales.

Sales before Decreased sales Increased sales

Before Comment After Comment After

£m £m £m £m £m £m
Sales 10 – 10% 9.0 + 10% 11.0
Variable costs 2 – 10% 1.8 + 10% 2.2
Fixed costs 5 no change 5.0 no change 5.0
(7) (6.8) (7.2)
2 2
EBIT 3 – 26 /3 % 2.2 + 26 /3 % 3.8
Interest (£40m @ 5%) (2) no change (2.0) no change (2.0)
Earnings before tax 1 – 80% 0.2 + 80% 1.8
Interest cover 3  2 = 1.5 2.2  2 = 1.1 3.8  2 = 1.9
Conclusion. Returns are enhanced when sales increase but the position is reversed
when sales fall. Financial gearing affects the volatility of equity earnings and, therefore,
requires a premium to be reflected in the cost of equity.
This can be seen in the 26 2/3% change in EBIT and the 80% change in earnings before
tax created by only a 10% change in sales.

CAPITAL STRUCTURE (IGNORING EFFECT OF TAX)

The total returns to all investors needs to be calculated.
No debt £800m £1,800m
(status quo) debt debt
£m £m £m
EBIT 100 100 100
Interest (£800m @ 5%) – (40)
(£1,800m @ 5%) (90)
Dividends 100 60 10
Dividends + Interest 100 100 100
The total distributions to providers of finance are the same, no matter what the level of
gearing.
Thus these firms should be worth the same in total, as they generate the same total
distributions for investors with the same business risk.

244 Topic 7 : Capital structure

 CAPITAL STRUCTURE WITH EFFECT OF TAXATION
No debt £800m debt £1,800m debt
£m £m £m
Profit before tax 100 60 10
Tax @ 21% (21) (12.6) (2.1)
Dividends 79 47.4 7.9
Dividends + Interest to providers of 79 87.4 97.9
finance
Cost to company
Dividends 79 47.4 7.9
Interest  (1 – 0.21) 0 31.6 71.1
79 79.0 79.0
The extra distributions arise because of the corporation tax savings on debt interest. For
example, paying £40m interest saves £40m × 21% = £8.4m tax (which is the difference
between the tax bills of £21m and £12.6m in the first and second columns). This gives
rise to the extra £8.4m distributed (£83.2m – £72m).
The more highly geared a firm, the greater should be its total distributions.
Therefore the firm should become more valuable as gearing increases.

APV
Base case NPV
Time £m DF@12% PV £m
0 (240) 1.00 (240)
1–10 40 5.65 226
(14)
PV of tax shield
Interest pa = £187.5m × 0.08 = £15m
Time £m DF @ 8% PV £m
1–10 15  0.21 = 3.15 6.710 21.1
Adjust for issue costs of £1m.
APV = £(14)m + £21.1m + £(1m) = £6.1m
 project worthwhile overall (in fact project itself is no good, but financial benefit creates
positive NPV).

Topic 7 : Capital structure 245

 APV PRACTICE
Base case NPV
keu = 11.06%
Base case NPV = –£50m + (£5m × 1/0.1106) = –£4.79m
PV of the tax shield
Interest paid per annum = £25m × 8% = £2m
Tax relief per annum = £2m × 21% = £0.42m
Present value of the tax relief (discounted @ cost of debt) = £0.42m × 1/0.08 = £5.25m
APV = –£4.79m + £5.25m = £0.46m

RISK ADJUSTED DISCOUNT RATE

a) Find the systematic risk of the electronics industry – measured by a.
 30(1 – 0.21) 
1.6 = a 1+ 
 70 

a = 1.20
ke = 10% + 1.20 (25% – 10%)
= 28%
(= WACC as no debt)
b) a = 1.20. Adjust to reflect new gearing.
 40(1 - 0.21) 
ie e = 1.20 × 1+ 
 60 

= 1.832
ke = 10% + (1.832 × (25% – 10%))
= 37.48%
kd = 10 × (1 – 0.21) = 7.9%
WACC = (37.48% × 0.6) + (7.9% × 0.4)
= 25.65%

246 Topic 7 : Capital structure

 EQUITY BETA
Market value of the company's equity = £8 × 3m = £24 million
Ungear the current equity beta:

e = a (1 + D(1  T) )
E
1.2 = a × (1 + (16 × (1 - 0.21)/24))
a = 1.2 × 24/(24 + 16 (1 – 0.21)) = 0.79
By raising £4 million in equity to pay off debt, it has to be assumed that the company's
equity shares will be worth £28 million and the debt capital £12 million.
At this new gearing level, the equity beta (e) will be:

e = a ( 1 + D(1  T) ) = 0.79 × (1 + (12 (1 – 0.21)/28)) = 1.057

E

FINANCING DECISION

Financing and other issues relating to a major investment

Gearing
Quigley Industries plc (QI) is operating in a classic cyclical industry, with high capital
intensity and, almost certainly, high operating gearing. Operating profits are susceptible
to great fluctuations in the face of fluctuations in revenue. History shows this trade to be
subject to such fluctuations.
Financial gearing must therefore be approached with caution. Identifying the optimal
level of gearing seems very difficult to achieve. It can only be a matter of judgement, but
forming that judgement must take account of QI's current level of gearing and of levels
of gearing in the industry, particularly with market leaders and with companies having
high operating gearing, such as QI.
In theory (Modigliani and Miller) gearing makes no difference to the wealth of the
shareholders: cheap loan finance has a positive effect that is precisely cancelled out by
the higher returns required by shareholders in the face of higher risk. If we take account
of the tax deductibility of loan interest, gearing in theory favours shareholders since, in
effect, there is a transfer of wealth from the tax authorities to shareholders.
At higher levels of gearing the risk of the company being unable to meet its debt
commitments of interest and capital repayment, particularly during a period of low
revenue/operating profitability, could force the company to liquidate, to the detriment of
shareholders' wealth (Director B's comment). Gearing policy tends, therefore, to be seen
as striking a balance between the benefits of tax relief and the potential costs of
'bankruptcy'.
Other factors that could come into play
Agency
Directors may be unwilling to gear the company up to a level optimum to the
shareholders. This is because gearing imposes a set of disciplines on the directors, ie of
having to meet interest payments and arranging continuing finance when the loan is due
for redemption.

Topic 7 : Capital structure 247

 Signalling
It is believed by some that a company making a loan issue implies confidence in the
future, and this could have a favourable effect on the share price.
Clientele effect
It is believed that particular shareholders are attracted to the shares of a particular
company, because of the level of gearing. Altering the level of gearing could have a
detrimental effect on the share price as investors move away from the company to a
'preferred habitat'. Uncertainty about the company's intentions could also have a
detrimental effect.
A large positive NPV project, such as the new plant, will affect gearing, since it will add
value to the equity of the company.
Equity
This is an obvious source of finance, subject to the gearing level. The most obvious
source of equity is a rights issue to existing shareholders. This has the advantage of
being relatively cheap to issue and does not face the company with much of a problem
regarding the issue price. There is normally a right that existing shareholders are offered
new shares before a public issue can be made. Usually the shareholders would need to
vote away their 'pre-emption' rights, before the company could go for a public issue.
A public issue is much more expensive than a rights issue to achieve, because there are
legally-required, expensive procedures to be met. Public issues tend to be more likely to
fail. Setting prices for public issues tends to be difficult to judge.
Equity is rather more expensive to QI than loan finance: investors expect higher returns
than they do for loans, but their returns are distinctly more risky. (Director C's
comment). Equities seem popular at present.
Loan finance
Whether a loan stock issue to the public or a term loan from a financial institution, loan
finance is relatively cheap to raise relative to equity. Lenders typically expect good
security, and freehold land tends to offer the best security. So the ability of QI is likely to
be linked to the extent that it has unused “debt capacity” in its assets.
Lenders typically expect lower returns than equity holders, but they have contractual
rights to interest and redemption payments on the due dates. This exposes the company
to risk and to discipline.
Provided that the company has sufficient taxable profits, loan interest is tax deductible
and this makes it still cheaper for the company.
Retained earnings
This is an important source of new finance to UK companies. It would not be suitable in
this case, since all of the company's available funds are already committed. There is the
option of waiting, perhaps a few years, until retained earnings build up before making
the investment, but commercially this may not be a real option.
The revenue reserves are not cash, but part of the owners' claim. Therefore they are not
available as investment funds (Director D's comment).
Retaining profit has implications for dividend policy and, possibly, for shareholder wealth.
Market efficiency
The evidence is clear, that in sophisticated stock markets charted price patterns do not
repeat themselves, except by chance. Weak form efficiency is present in such markets.

248 Topic 7 : Capital structure

It is illogical to feel that a time of low share prices is a bad time to issue new shares.
Market efficiency theory (and evidence) suggests that whatever the share price is at any
point represents the best unbiased estimate of its worth based on available evidence
(Director A's comment).
Other sources
 Leasing the plant  Working capital efficiencies
 Sales and leaseback  Possibility of grants from public funds
Advice
It is possible that QI has sufficient 'in-house' expertise to enable it to avoid the need for
professional advice. Raising the level of finance that we are probably considering here is
not an everyday event for a commercial company, so it is probably better to seek advice
from experts.
Merchant banks typically are able to offer advice and may well be able to put the
company in touch with potential investors, assuming that the rights-issue route is not
taken.
The larger firms of chartered accountants, almost certainly QI's auditors, have close links
to corporate finance advisors.
The advice will not typically be cheap (Director B's comment).

Topic 7 : Capital structure 249

250 Topic 7 : Capital structure
 8
BUSINESS VALUATION AND
RESTRUCTURING

Learning Objectives
 Calculate values for businesses and shares
 Explain the different types of financial restructuring that are relevant at various
stages of a business life-cycle
 Set out the main components of a business plan

Exam Requirement
In the exam, candidates may be required to carry out a valuation of a business using
different methods, perhaps for the purpose of stock exchange listing. Candidates may
have to draft a straightforward business plan for a given situation.

Math Tables 251

 TOPIC OVERVIEW

252 Topic 8: Business valuation and restructuring

BUSINESS VALUATION
ORGANIC GROWTH V ACQUISITION
 Organic growth involves the retention of profits and/or the raising of new
finance (equity and/or debt) to fund internally-generated projects, eg new
product development.
 In an acquisition, the bidder company acquires the target company either in its
entirety or by buying sufficient shares in the target to exercise control.
 Reasons for an acquisition include synergy, risk reduction, reduced competition.

Organic growth Acquisition

The costs are spread over time Faster approach to growth

The rate of change within the firm is likely Overcomes barriers to entry in new
to be slower and therefore avoids the markets
disruption and behavioural problems that
can be associated with acquisition
It may be more risky than acquiring an Bidding company shareholders often lose
established business out as a result of paying too much, high
costs or overestimated synergies

VALUATION METHODS
In making a bid for another company, the buyer will need to create a range of values
within which the buyer is prepared to negotiate.
Companies listing on the stock exchange will also need to be valued.

Asset-based approaches

Historic cost (book value)

 Balance sheet value of equity (but meaningless because historic cost ≠ market
value)

Net realisable value

 NRV of assets less liabilities (showing minimum acceptable value to owners
determined to sell)
 Problems can occur with estimating NRV of certain specialised assets with no ready
market, redundancy costs, liquidator’s costs and tax etc
 Ignores goodwill

Replacement cost
 Cost of setting up business from scratch
 Problems can occur with estimating replacement costs
 Ignores goodwill

Topic 8: Business valuation and restructuring 253

 Assets are more certain than income, income is generated only if assets are well
managed, which is by no means certain.
An asset-based approach is useful for asset strippers.
Service businesses often have very few tangible assets so asset-based methods would
place very little value on business. Most value in a successful service industry would
reside in its goodwill.

Income-based approach
 The value of the business is calculated as the present value of the future cash
flows.
 It requires an estimate of the future and a discount rate.
 It is more appropriate for valuing service businesses than assets.
The maximum price a bidder should pay for a target is:

Market value of combined businesses less market value of bidder before bid is
made.

CONSTANT ANNUAL CASH FLOWS

A plc generates constant annual cash flows of £15m. The appropriate discount rate for
these flows is 20% pa. It plans to make a bid for the entire share capital of B plc. If B plc
were acquired the combined businesses would generate constant annual cash flows of
£20m and the appropriate discount rate would be 16% pa.
Requirement
What is the maximum price A plc should pay for all of B plc's shares?

SOLUTION

254 Topic 8: Business valuation and restructuring

 PV OF FUTURE CASH FLOWS
Arrow plc is considering purchasing the entire share capital of Target plc.
Arrow operates on a five year planning horizon and believes that Target will be able to
generate operating cash flows (after deducting funds for necessary reinvestment) of £1
million per annum before interest payments.
The following information is also relevant but has not been included in the above
estimates.
1. Target’s head office premises can be disposed of and its staff can be relocated in
Arrow’s head office. This will have no effect on the operating cash flows of either
business but will generate an immediate net revenue of £2 million.
2. Synergistic benefits of £200,000 per annum should be generated by the
acquisition.
3. Target has loan stock with a current market value of £1.5 million in issue. It has
no other debt.
4. Arrow estimates that in five years’ time it could, if necessary, dispose of Target for
an amount equal to five times its annual cash flow.
Arrow believes that a WACC of 20% per annum reflects the risk of the cash flows
associated with the acquisition.
Requirement
Calculate the maximum price to be paid for Target plc. Ignore taxation.

SOLUTION

Topic 8: Business valuation and restructuring 255

 Price-Earnings ratio valuation

The Price-Earnings (P/E) ratio is the share price divided by the earnings per share
for a company.

The P/E ratio shows how much an investor is prepared to pay for a company’s shares,
given its current earnings per share.

Value = P/E  Earnings

The higher the P/E ratio relative to other companies, the more confident the market is
that future earnings will increase.
A disadvantage of this method is the uncertainty surrounding the accuracy of the
earnings figure (accounting policies, one-off transactions).
To value unquoted companies:
 Find a P/E for a similar quoted company (same industry, size, gearing, risk, etc)
 Adjust downwards for non-marketability of unquoted shares

P/E VALUATION
You are given the following information regarding Accrington Ltd, an unquoted company.
Issued ordinary share capital is 400,000 25p shares.
Extract from Income Statement for the year ended 31 July 20X4
£ £
Profit before taxation 260,000
Less: Corporation Tax (72,800)
Profit after taxation 187,200
Less: Preference dividend 20,000
Ordinary dividend 36,000
(56,000)
Retained profits for year 131,200
The P/E ratio applicable to a similar type of business is 12.5.
Requirement
Value 200,000 shares in Accrington Ltd on a P/E basis.

SOLUTION

256 Topic 8: Business valuation and restructuring

 MAXIMUM PRICE (2)
Price plc wishes to acquire the entire share capital of Maine plc. Details of current
earnings and P/E ratios are as follows:
Earnings P/E
£m
Price plc 50 20
Maine plc 20 15
It is believed that as a result of synergies the combined earnings would be £75m and the
market would apply a P/E of 18 to the combination.
Requirements
a) What is the maximum amount Price plc should pay for Maine plc?
b) What price are Maine plc's shareholders likely to accept?

SOLUTION

Dividend yield method

The dividend yield gives a measure of how much an investor expects to gain in exchange
for buying a share, ignoring any capital gains

Dividend per share

Dividend yield = × 100
Market price of share

To value unquoted companies:

 Find a dividend yield for a similar quoted company
 Divide the most recent dividend per share for the company that is being valued by
the dividend yield
 Adjust downwards for non-marketability of unquoted shares

Topic 8: Business valuation and restructuring 257

 Dividend valuation method
Dividend valuation is useful for non-controlling interests (that is, a few shares).
The present value of future dividends is calculated:

d0 (1  g)
Value 
(k e  g)

Where d0 is the dividend at time 0

g is the growth rate
ke is the cost of equity

Problems include:
 Estimating future dividends and growth
 Estimating ke (risk)
 The model is often used for valuing shares in non-quoted companies and then an
arbitrary downwards adjustment made to reflect the lack of marketability (as with
the P/E ratio approach)
 It is not very useful for valuing controlling interests

DIVIDEND VALUATION
Claygrow Ltd is a company which manufactures flower pots. The following data are
available.
Current dividend 25p per share
Required return on equities in this risk class 20%
Requirement
Value one share in Claygrow Ltd under the following circumstances:
i) No growth in dividends
ii) Constant dividend growth of 5% per annum
iii) Constant dividends for five years and then growth of 5% per annum to perpetuity
iv) Constant dividends for five years and then sale of the share for £2.00.

SOLUTION

258 Topic 8: Business valuation and restructuring

Shareholder value analysis (SVA)
Future free cash flows are forecast using the seven value drivers and discounted at
the current WACC to obtain a present value.
The market value of debt should be deducted from the present value to get the value of
equity.

SVA
Mark plc expects to have a competitive advantage over its competitors for the next three
years. It has the following estimates for its value drivers for this period and beyond.
Competitive advantage period Beyond
Year 1 2 3 4+
Sales growth % 7 4 2 0
Operating profit margin % 10 12 12 12
Tax rate % 21 21 21 21
Incremental non-current asset
investment 5 3 2 0
(as a % of sales increase)
Incremental working capital 2 2 2 0
investment
(as a % of sales increase)
Other information is as follows:
 Current year sales are £380m
 The current WACC is 10%
 Depreciation for the first period will be £7m, increasing by £0.5m each year in the
competitive advantage period
 Replacement non-current asset expenditure is assumed to be equal to depreciation
 Short-term investments are held with a value of £2.5m
 Debt held by Mark plc has a nominal value of £120m and has a market value of
£95 per £100
Calculate the value of equity using the SVA method

Topic 8: Business valuation and restructuring 259

 SOLUTION

260 Topic 8: Business valuation and restructuring

 BUSINESS VALUATION
The directors of Lafayette Ltd, a medium-sized private company, have been approached
by a large public company which is interested in purchasing their business. The directors
of Lafayette Ltd have indicated that they would like to receive cash for their shares, and
this is acceptable to the prospective purchaser. They have been asked by the public
company to state the price at which they would be willing to sell. You have been asked
to advise Lafayette Ltd.
Extracts from the last set of published financial statements for Lafayette Ltd for 20X2 are
given below.
Income statement
£
Profit before interest and tax 5,556,962
Interest 1,000,000
4,556,962
Taxation (21%) 956,962
Profits after tax 3,600,000
Dividends paid – preference 200,000
ordinary 1,000,000
Profits retained 2,400,000
Balance sheet as at 31 December 20X2
Non-current assets £'000 £'000
Goodwill 5,000
Freehold property 10,000
Plant and equipment 20,000
Investments 5,000
40,000
Current assets
Inventory 3,000
Receivables 6,000
Cash 1,000
10,000
Less Payables: amounts due within 1
year
Payables 6,000
6,000
Less Payables: amounts due after 1
year
Loan stock 10,000
34,000
Ordinary share capital (£1 par) 20,000
5% preference shares 4,000
Retained earnings 10,000
34,000

Topic 8: Business valuation and restructuring 261

 For the year ending 31 December 20X0, the profits before interest and tax were £10
million and in the year ending 31 December 20X1 they were £8 million. The owners of
the preference shares have found a financial institution who will buy at a price of £0.40
per preference share. They are willing to sell at this price.
You are asked to take the following factors into account in calculating a value per share.
1) The prospective purchaser has agreed to purchase the debentures at a price of
£75 per £100 stock.
2) It has been ascertained that the current rental value of the freehold property is
£1.5 million per annum, and that this could be sold to a financial institution on the
basis of offering an 8% return to the freeholder.
3) The investments owned by Lafayette have a current market value of £7.5 million.
4) There is an amount of £1 million shown in the 20X2 receivables figure which is
now thought to be irrecoverable.
Two companies in the same business as Lafayette Ltd are quoted on the stock market.
However, both are slightly bigger in size than Lafayette. The most recent financial data
relating to the companies is given below.
Par value Market P/E Net dividend Times Yield
per share price ratio per share covered %
of shares
X £1.00 £3.50 11.3 £0.12 2.6 4.9
Y £0.50 £1.25 8.2 £0.04 3.8 4.1
Requirement
The directors of Lafayette Ltd are naturally interested in obtaining the highest price
possible for their shares. You are asked, based on the following valuation methods
i) The net asset value
ii) The price/earnings ratio
iii) The dividend yield
to determine the highest possible asking price for the shares that can be justified on the
basis of the available information and comment on the alternative prices you have
arrived at.

SOLUTION

262 Topic 8: Business valuation and restructuring

Topic 8: Business valuation and restructuring 263
 METHODS OF PAYMENT

Buyer Seller

Cash For:  More attractive to seller  Certain amount received

Against:  Liquidity issues  Possible immediate tax

issues
Share for For:  Preserves liquidity  No immediate tax issues
share  Sellers can undertake not to
exchange sell the shares for a period to
ensure their continued
cooperation with the buyer
Against:  Increased dilution  Uncertain amount
received
 Dealing costs to sell
shares
Loan For:  Avoid dilution  More assured return
stock- than on shares
for-share
exchange
Against:  Gearing problems  May prefer equity

264 Topic 8: Business valuation and restructuring

SUMMARY

Topic 8: Business valuation and restructuring 265

 RESTRUCTURING
DIVESTMENT
Divestment involves the disposal of parts of a business eg selling off a subsidiary.
Reasons for this include:
 Lack of fit within the existing group of companies – either unprofitable or
incompatible.
 The subsidiary is too small and does not warrant the management time devoted
to it.
 A belief that the individual parts of the business can be worth more than the whole
when shares are selling at less than their potential value – the so-called
conglomerate discount.
 It is trading poorly but selling the subsidiary as a going concern may be a
cheaper alternative than putting it into liquidation, particularly when redundancy
and winding-up costs are considered.
 The parent company may need to improve its liquidity position.

MANAGEMENT BUY-OUTS (MBOS)

 The part of the business being sold (eg a subsidiary) is bought by its existing
management from the parent company
 May be viewed more positively by employees than a sell-off
 Large amounts of debt are often used in the financing package which has often
led to MBOs failing eg junk bonds, mezzanine finance

MBO
Can plc is divesting one of its subsidiaries and the managers of the subsidiary have
offered an attractive price of £20m subject to confirming a finance package with a
venture capital provider (VC) and a bank.
The finance package is as follows.
£m
Equity from managers 2
Equity from VC 1
Mezzanine finance from VC 7
Senior debt from bank 10
20
Requirement
What are the objectives facing the various parties and how might they manage their
specific risk?

266 Topic 8: Business valuation and restructuring

 SOLUTION

Sellers

Managers

Venture Capitalists

Banks

OTHER ARRANGEMENTS
Spin-offs or demerger Shareholders are given shares in a new legal entity
pro rata to their shareholding in the original parent
Repurchase of own shares Can be used to enhance the share price, reduce
gearing and provide a way for shareholders in
unquoted companies to sell their shares
Liquidation (or winding-up) Initiated by creditors or shareholders

Outsourcing Enables the business to concentrate on core

activities, while buying in specialist goods and
services from experts

WRITING A BUSINESS PLAN

Introduction
A written business plan is a result of a process of planning, and sets out:
 The direction of an organisation
 Strategies chosen
 The background to the decisions made
 Their practical implications and outcomes

Topic 8: Business valuation and restructuring 267

 Format of the business plan

Front sheet: Title page, foreword or disclaimer

Contents page
1) Executive summary
2) History and background
3) Mission statement and objectives
4) Products or services
5) Market information
6) Resources employed, management and operations
7) Financial information, risks and returns
8) Summary action plan containing milestones
9) Appendices – past accounts, CVs, market research, brochures, technical data
etc.

268 Topic 8: Business valuation and restructuring

SUMMARY

Topic 8: Business valuation and restructuring 269

 ACTIVITY ANSWERS

CONSTANT ANNUAL CASH FLOWS

£m
Value of A and B combined £20m 125
0.16
Value of A on its own £15m (75)
0.20
Maximum price for B's shares 50

PV OF FUTURE CASH FLOWS

Year 0 1 2 3 4 5
£m £m £m £m £m £m
Operating 1.000 1.000 1.000 1.000 1.000
cash flow
Sale of head
office 2.000
Synergistic
benefits 0.200 0.200 0.200 0.200 0.200
Disposal 5.000
Net cash 2.000 1.200 1.200 1.200 1.200 6.200
flow
PVF at 20% 1.000 0.833 0.694 0.579 0.482 0.402
Present 2.000 1.000 0.833 0.695 0.578 2.492
value
Present value £7.598m
Less value of loan stock (£1.500m)
Maximum value of Target £6.098m

Notes
1. The estimated disposal value of Target is included to compensate for Arrow’s short
planning horizon. It is assumed that the estimated disposal value is an
approximation of the present value of cash flows from year 6 onwards.
2. The present value of the cash inflows is £7.598m. This is generated by a company
funded by equity and debt. Therefore, the market value of loan stock has to be
deducted from the total value of the business to arrive at an equity value.

270 Topic 8: Business valuation and restructuring

 P/E VALUATION
Valuation of 200,000 shares = 200,000  P/E ratio  EPS
£187,200 – 20,000
= 200,000  12.5 
400,000
= £1,045,000
This amount would then, typically, be reduced by 1/2 to 1/3 to reflect the difficulty in
selling these shares.

MAXIMUM PRICE (2)

£m
a) Combined value = £75m  18 = 1,350
Price plc on its own = £50m  20 = (1,000)
Maximum amount 350
b) Current value of Maine plc = £20m  15 = 300
This is likely to be the minimum price. Anything between £300m and £350m splits the
additional £50m (1,350m – 1,000m – 300m) between both sets of shareholders.

DIVIDEND VALUATION
£0.25
i) Constant dividend P0 = = £1.25
0.2
ii) Constant growth in dividend P0 = £0.25 x 1.05 = £1.75
(0.2 - 0.05)

iii) Present value of five years’ dividend of £0.25 pa = £0.25 x 2.991 = £0.748
plus
Present value of growing dividend from year 6 onwards
£0.25 x 1.05  1 = £0.703
(0.2 - 0.05) 1.2 5
£1.451
iv) Present value of five years’ dividend of £0.25 pa = £0.25 x 2.991 £0.748
Present value of £2.00 in five years’ time = £2.00 x 1
£0.804
1.2 5
£1.552

Topic 8: Business valuation and restructuring 271

 SVA
Competitive advantage period Beyond
Year 1 2 3 4+
£m £m £m £m
Sales (W) 406.6 422.9 431.3 431.3
Operating profit 40.7 50.7 51.8 51.8
Tax (8.5) (10.6) (10.9) (10.9)
Depreciation 7.0 7.5 8.0 8.0
Operating cash flow 39.2 47.6 48.9 48.9
Replacement non-current asset expenditure (7.0) (7.5) (8.0) (8.0)
Incremental non-current asset expenditure (W) (1.3) (0.5) (0.2) 0.0
Incremental working capital investment (W) (0.5) (0.3) (0.2) 0.0
Free cash flow 30.4 39.3 40.5 40.9
Discount factor 0.909 0.826 0.751 0.751 ×
1/0.1
Present value 27.6 32.5 30.4 307.2
Total present value = £397.7m
Value of short-term investments = £2.5m
Market-value of debt = 120m × 95/100 = £114m
Value of equity = £397.7m + £2.5m – £114m = £286.2m
WORKING
Year 0 1 2 3 4+
£m £m £m £m £m
Sales (increasing at given rates) 380.0 406.6 422.9 431.3 431.3
Sales increase 26.6 16.3 8.4 0
Incremental non-current asset 1.3 0.5 0.2 0
expenditure
Incremental working capital 0.5 0.3 0.2 0
investment

272 Topic 8: Business valuation and restructuring

 BUSINESS VALUATION

i) Asset basis
Revalued assets: £'000 £'000
Goodwill 5,000
Property (1.5m/0.08) 18,750
Plant 20,000
Investments 7,500
Receivables 5,000
Inventories 3,000
Cash 1,000
60,250
Less Debenture payment 7,500
Payables 6,000
Assets of preference shareholders 4,000
(17,500)
42,750
Number of equity shares 20m
Price per share (£42.75m / 20m) 2.14
ii) P/E ratio
Earnings per share (20X2)
Earnings after tax and pref divs
=
Number of shares
£3.4m
= = £0.17
20m
Average P/E ratio for X and Y = 9.75
£
Suggested price = £0.17 × 9.75 = 1.66
Less reduction for non-marketability (25% say) 0.42
1.24
iii) Dividend yield
Dividend 20X2 ÷ Number of shares = £1m ÷ 20m = £0.05
Average gross dividend yield for X and Y = 4.5%
£
Suggested price = £0.05 ÷ 0.045 1.11
Less reduction for non-marketability (25%, say) 0.28
0.83
Comment
There is clearly a big difference between the value per share arrived at on an asset basis
and one based on earnings. The highest price is £2.14 but the purchaser may not be
willing to accept this. It is based on the market value of the freehold property which
presumably is needed by Lafayette in order to continue in business. It also includes a
valuation for goodwill, an intangible asset. If the goodwill valuation is excluded, which
might well be justified as the profits from Lafayette are falling and the property is kept at
its balance sheet value, the asset basis shows the following valuation.

Topic 8: Business valuation and restructuring 273

 £'000
Property 10,000
Plant 20,000
Investments 7,500
Current assets 9,000
46,500
Debentures, payables, preference shareholders, as before 17,500
29,000
This is £1.45 per share, which is reasonably close to the prices arrived at by the P/E ratio
and dividend yield methods before the reduction for non-marketability. A price of £1.50
or £1.60 would appear to be a reasonable price, but in the negotiations Lafayette should
start by asking for a higher figure, nearer to the £2 per share based on asset values
under one set of assumptions, namely break-up value.

MBO
Seller: They will want to ensure that the amount offered from the managers is
backed up by a reliable financial package. Work by their financial
advisers and lawyers will help to ensure that the finance is in place.
There may be other, lower bidders. Whilst those alternative offers may
be lower, the finance may be more easily available if the bidder is a
large organisation with liquid assets.
Managers: The attractions of an MBO are:
 Independence
 Financial reward
 Motivation
The risks however are:
 Lack of support from within the business and also from suppliers and
customers.
 Lack of skills within the business if key employees leave
 Financial risk. If business profits fall even by a little, it might become
impossible to service the large amount of debt.
VC: The objective will be to make a very high financial return. This is
typically achieved by selling the business within three to five years, by
flotation or otherwise. The VC will not be assured that the value of their
shares will be as high as they want. Their downside risk is typically
managed by:
 Having board representation
 Investing a mixture of debt and equity
 Including convertible terms in the debt, such that debt converts into
a higher equity share in the event that the company on subsequent
sale is worth less than originally envisioned.
Bank: The bank will manage their risk by investing in senior debt, ie debt
which ranks higher than other debt in terms of interest, security and
repayment. The bank might also want personal guarantees from the
buyout team.

274 Topic 8: Business valuation and restructuring

APPENDIX

Formulae sheet
Formulae you may require:
a) Discounting an annuity

1 1 
The annuity factor: AF1 n = 1  
r  (1  r)n 

Where AF = annuity factor

n = number of payments
r = discount rate as a decimal

D0 (1 + g)
b) Gordon growth (dividend valuation) model: ke = +g
P0

Where ke = cost of equity

D0 = current dividend per ordinary share
g = the annual dividend growth rate
P0 = the current ex-div price per ordinary share

c) Capital asset pricing model: rj = rf + ßj (rm – rf)

Where rj = the expected return from security j
rf = the risk free rate
ßj = the beta of security j
rm = the expected return on the market portfolio

d) e = a ( 1 + D(1  T) )
E
Where e = beta of equity in a geared firm
a = ungeared (asset) beta
D = market value of debt
E = market value of equity
T = corporation tax rate

Note: Candidates may use other versions of these formulae but should then define the
symbols they use.

Appendix 275
 Discount tables
Interest Number of Present value of Present value of
rate years £1 receivable at £1 receivable at
p.a. n the end of n years the end of each of
n years
1% 1 0.990 0.990
2 0.980 1.970
3 0.971 2.941
4 0.961 3.902
5 0.951 4.853
6 0.942 5.795
7 0.933 6.728
8 0.923 7.652
9 0.914 8.566
10 0.905 9.471
5% 1 0.952 0.952
2 0.907 1.859
3 0.864 2.723
4 0.823 3.546
5 0.784 4.329
6 0.746 5.076
7 0.711 5.786
8 0.677 6.463
9 0.645 7.108
10 0.614 7.722
10% 1 0.909 0.909
2 0.826 1.736
3 0.751 2.487
4 0.683 3.170
5 0.621 3.791
6 0.564 4.355
7 0.513 4.868
8 0.467 5.335
9 0.424 5.759
10 0.386 6.145
15% 1 0.870 0.870
2 0.756 1.626
3 0.658 2.283
4 0.572 2.855
5 0.497 3.352
6 0.432 3.784
7 0.376 4.160
8 0.327 4.487
9 0.284 4.772
10 0.247 5.019
20% 1 0.833 0.833
2 0.694 1.528
3 0.579 2.106
4 0.482 2.589
5 0.402 2.991
6 0.335 3.326
7 0.279 3.605
8 0.233 3.837
9 0.194 4.031
10 0.162 4.192

276 Appendix
Appendix 277
278 Appendix
Appendix 279
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280 Appendix