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How to use your CIMA Learning System xi. Study technique .. With your study material before you, decide which chapters &...
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CIMA’S Official Learning System
Strategic Level
Management Accounting – Financial Strategy John Ogilvie
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CIMA Publishing is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA First edition 2006 Copyright © 2006 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (44) (0) 1865 843830; fax (44) (0) 1865 853333; e-mail:
[email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining Permissions to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein.
British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13: 978 0 7506 8044 8 ISBN-10: 0 7506 8044 X For information on all CIMA publications visit our website at www.cimapublishing.com Typeset by Integra Software Services Pvt. Ltd, Pondicherry, India www.integra-india.com Printed and bound in Great Britain 06 07 08 09 10 10 9 8 7 6 5 4 3 2 1
Working together to grow libraries in developing countries www.elsevier.com | www.bookaid.org | www.sabre.org
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Contents
The CIMA Learning System Acknowledgements How to use your CIMA Learning System Study technique Management Accounting – Financial Strategy Syllabus
1 Formulation of Financial Strategy 1.1 Introduction 1.2 Objectives of profit-making entities 1.2.1 Financial objectives 1.2.2 Non-financial objectives 1.2.3 Agency theory 1.2.4 Shareholder value analysis 1.3 Objectives of not-for-profit entities 1.3.1 The three ‘E’s 1.4 Public and private – similarities and differences 1.5 Assessing attainment of financial objectives 1.5.1 Financial performance indicators 1.5.2 Non-financial performance indicators 1.6 The three key decisions of financial management 1.6.1 Investment decisions 1.6.2 Financing decisions 1.6.3 Dividend decisions 1.7 Policies for distribution of earnings 1.7.1 Practical dividend policies 1.7.2 Theory of dividend irrelevance 1.7.3 Scrip dividends 1.7.4 Share repurchases 1.8 The impact of internal and external constraints on financial strategy 1.8.1 Internal constraints 1.8.2 External constraints 1.9 Developing financial strategy in the context of regulatory requirements 1.9.1 Corporate governance and the Cadbury Report 1.9.2 The Greenbury Report 1.9.3 The Hampel Report 1.9.4 Regulatory bodies 1.9.5 The regulation of takeovers and the Competition Commission
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xi xi xi xiii xiv 1 1 2 3 3 4 5 7 8 8 9 9 10 11 11 12 12 13 14 15 17 18 18 18 19 19 19 20 21 21 23
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1.10 Major economic influences 1.10.1 Interest rates 1.10.2 Term structure of interest rates 1.10.3 Inflation 1.10.4 Exchange rates 1.11 Modelling and forecasting cash flows and financial statements 1.11.1 Forecasting cash flows 1.11.2 Forecasting financial statements 1.11.3 Sensitivity analysis 1.12 Current and emerging issues in financial reporting 1.12.1 IFRS 1 first time adoption of IFRS 1.12.2 IFRS 2 Share-based payment 1.12.3 Reporting environmental issues 1.12.4 Reporting of social issues 1.12.5 Inclusion of forecasts in the annual report 1.12.6 Reporting of human capital 1.13 Summary Readings Revision Questions Solutions to Revision Questions
2 Financial Management 2.1 Introduction 2.2 The finance function 2.2.1 Financial control 2.2.2 Evaluating key success factors in the management of the finance function 2.2.3 Relationships with stakeholders 2.2.4 Outsourcing and shared service centres 2.3 The treasury function 2.3.1 The role of the treasury function 2.3.2 Cost centre or profit centre 2.4 Financial markets 2.4.1 Money market 2.4.2 Capital or securities market 2.4.3 The foreign exchange market 2.4.4 Derivatives markets 2.5 Share price volatility 2.5.1 Technical analysis or chartism 2.5.2 Fundamental analysis 2.5.3 Random Walk Theory 2.6 The efficient market hypothesis 2.6.1 Weak form 2.6.2 Semi-strong form 2.6.3 Strong form 2.6.4 Implications of EMH for financial managers
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Readings Revision Questions Solutions to Revision Questions
3 Sources of Long-term Finance 3.1 Introduction 3.2 Shareholders’ funds 3.2.1 Ordinary shares 3.2.2 Preference shares 3.2.3 Reserves 3.3 Raising share capital – the stock market 3.3.1 New issues 3.3.2 Rights issues 3.3.3 Bonus issues 3.3.4 Share splits 3.4 Debt finance 3.4.1 Bonds 3.4.2 Debt yields 3.4.3 Convertible bonds 3.4.4 Warrants 3.5 Medium-term financing 3.5.1 Term loans 3.5.2 Mezzanine finance 3.5.3 The lender’s assessment of creditworthiness 3.5.4 Leasing 3.5.5 Lease-or-buy decisions 3.5.6 Factoring
71 71 71 72 72 72 73 73 74 74 75 75 77 78 79 80 80 80 81 83 85 87 93 93 93 93 94 95 95 96 97 102 103 103 103 104 106 107 108 108 108 109 109 112 116
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2.7 Investor ratios 2.7.1 Market price per share 2.7.2 Earnings per share 2.7.3 The price/earnings ratio 2.7.4 Earnings yield 2.7.5 Dividend-payout rate 2.7.6 Dividend yield 2.7.7 Dividend cover 2.7.8 Book value per share 2.8 Working capital management strategies 2.8.1 The investment decision 2.8.2 The financing decision 2.8.3 Liquidity ratios 2.8.4 The operating cycle 2.9 Overtrading 2.9.1 Symptoms of overtrading 2.9.2 Preventing overtrading 2.10 Multinational working capital management 2.11 Summary
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3.6 Financing of small profit-making entities 3.6.1 Venture capital 3.6.2 Business ‘angels’ 3.6.3 Government assistance 3.7 Summary Readings Revision Questions Solutions to Revision Questions
4 Capital Structure and Cost of Capital 4.1 Introduction 4.2 Measuring gearing 4.2.1 Capital gearing 4.2.2 Classification of debt and equity 4.2.3 Interest cover 4.2.4 Leverage 4.3 Cost of capital 4.3.1 Cost of equity 4.3.2 Cost of debt 4.3.3 Cost of preference shares 4.4 Weighted average cost of capital 4.4.1 Assumptions in the use of WACC 4.5 Marginal cost of capital 4.6 The traditional theory of gearing 4.7 Modigliani and Miller’s theories of gearing 4.7.1 Limitations of MM theory 4.8 Cost of capital and adjusted cost of capital 4.8.1 Adjusted present value 4.8.2 Adjusted cost of capital – Modigliani and Miller 4.9 Risk and reward 4.10 Portfolio theory 4.10.1 Systematic risk and unsystematic risk 4.11 The capital asset pricing model 4.11.1 Measuring beta values 4.11.2 The security market line 4.12 Using the CAPM as an investment tool 4.13 MM, CAPM and geared betas 4.13.1 Ungearing beta 4.13.2 Geared equity beta 4.14 Use of CAPM in investment appraisal 4.14.1 Limitations of CAPM 4.15 Arbitrage pricing model 4.16 Summary Readings Revision Questions Solutions to Revision Questions 2006.1
118 119 120 120 121 123 127 133 143 143 144 144 145 149 150 150 151 155 157 157 159 160 161 162 167 167 167 169 170 172 175 176 177 178 180 181 181 183 185 185 185 186 189 195 201
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5.1 Introduction 5.2 Asset-based valuations 5.2.1 Choice of valuation base 5.2.2 The strengths and weaknesses of asset-based valuations 5.3 Earnings-based valuations 5.3.1 P/E ratio valuation 5.3.2 Earnings yield valuation 5.4 Dividend-based valuations 5.4.1 Dividend yield 5.4.2 Dividend growth model 5.4.3 Problems of dividend-based valuations 5.4.4 Capital asset pricing model 5.5 Cash-based valuations 5.5.1 Discounted cash flow (DCF) 5.5.2 The strengths and weaknesses of DCF 5.5.3 Shareholder value analysis 5.6 Business valuations and efficient markets 5.7 Intellectual capital 5.7.1 Forms of intellectual capital 5.7.2 The components of intellectual capital 5.7.3 Valuing intellectual capital 5.7.4 Comparative indicators 5.8 The impact of changing capital structure 5.9 Recognition of the interests of different stakeholder groups in company valuations 5.9.1 Liquidation 5.9.2 Re-financing 5.9.3 Mergers and acquisitions 5.10 Summary References Readings Revision Questions Solutions to Revision Questions
6 Mergers, Acquisitions and Buyouts 6.1 Introduction 6.2 Terminology and types of merger 6.2.1 Terminology 6.2.2 Types of merger 6.3 The reasons for merger or acquisition 6.4 Defences against takeover 6.4.1 Before the bid 6.4.2 After the bid 6.5 Methods of payment for an acquisition 6.5.1 Cash 6.5.2 Share exchange
211 211 212 212 213 213 213 214 214 215 215 215 216 216 216 217 217 217 218 218 220 224 226 228 228 229 229 229 229 230 231 239 243 251 251 251 251 252 252 253 253 254 254 254 255 2006.1
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5 Business Valuations
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6.6
6.7
6.8
6.9 6.10
6.5.3 Other types of finance 6.5.4 Earn-out arrangements The post-merger or post-acquisition integration process 6.6.1 Druker’s Golden Rules 6.6.2 Post-acquisition value enhancement strategies 6.6.3 Impact on ratios or performance measures 6.6.4 Acquirer’s post-acquisition share price 6.6.5 Example: Impact on stakeholders 6.6.6 Reasons why mergers and acquisitions fail Exit strategies 6.7.1 Sell-off 6.7.2 Spin off Management buyouts 6.8.1 Financing MBOs 6.8.2 Evaluation by investors and financiers Reconstruction 6.9.1 Effect on the share price of a listed company Summary Readings Revision Questions Solutions to Revision Questions
7 Investment Appraisal Techniques 7.1 Introduction 7.2 Accounting rate of return 7.3 Payback 7.3.1 Discounted payback 7.4 Discounting techniques 7.4.1 Net present value 7.4.2 Internal rate of return 7.4.3 Modified internal rate of return 7.4.4 Discussion of techniques 7.5 Capital rationing 7.5.1 Single-period capital rationing 7.5.2 Single-period rationing with mutually exclusive projects 7.5.3 Single-period rationing with indivisible projects 7.6 Annual equivalent cost 7.6.1 Asset replacement cycles 7.7 Summary Revision Questions Solutions to Revision Questions
8 Advanced Investment Appraisal Techniques 8.1 Introduction 8.2 Taxation 8.2.1 Depreciation and tax depreciation allowances 2006.1
256 256 256 256 257 257 259 259 265 266 266 267 267 267 268 269 270 270 271 275 283 293 293 294 296 297 297 297 298 301 302 303 304 305 306 306 308 309 311 315 323 323 323 324
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8.7
8.8
8.9 8.10 8.11
8.12
8.13
Inflation Working capital Identification of a project’s relevant costs and benefits Linking investments with customer requirements and product/service design 8.6.1 Reasons for developing new products or services Linking investment in IS/IT with strategic, operational and control needs 8.7.1 Benefits of a formal strategy 8.7.2 IS, IT and IM strategy 8.7.3 Content of information systems strategy 8.7.4 Cost-benefit analysis 8.7.5 Evaluating system performance Adjusting for risk 8.8.1 Sensitivity analysis 8.8.2 Decision trees 8.8.3 Certainty equivalents 8.8.4 The discount rate 8.8.5 Adjusted discount rate 8.8.6 Capital asset pricing model Evaluating and reporting investment opportunities Adjusted present value Assessing investments as options on future cash flows 8.11.1 The abandonment option 8.11.2 Timing options 8.11.3 Strategic investment options 8.11.4 Valuing options Project implementation and control 8.12.1 The investment cycle 8.12.2 Post-completion auditing 8.12.3 Benefits of post-completion auditing 8.12.4 Organisation of PCA 8.12.5 Role of post-appraisal in project abandonment Summary Readings Revision Questions Solutions to Revision Questions
9 Financing and Appraisal of Overseas Operations 9.1 9.2 9.3 9.4
Introduction Financing overseas operations – a global strategy The effect of restrictions on remittances The Euromarkets 9.4.1 Eurocurrency markets 9.4.2 Eurobonds 9.5 The effect of taxation 9.5.1 Double taxation relief
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9.6 International capital budgeting 9.6.1 Interest-rate parity (IRP) 9.7 APV method 9.8 Summary Revision Questions Solutions to Revision Questions
Preparing for the Examination Revision technique Planning Getting down to work Tips for the final revision phase Format of the examination Structure of the paper Types of question Allocation of time Weighting of subjects
Case-study Questions Solutions to Case-study Questions Scenario Questions Solutions to Scenario Questions
381 384 385 387 389 393 399 401 401 402 402 402 402 403 403 404 407 441 509 553
November 2005 Examinations
655
Index
693
May 2006 Examinations
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The CIMA Learning System
Acknowledgements Every effort has been made to contact the holders of copyright material, but if any here have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the first opportunity.
How to use your CIMA Learning System This Management Accounting – Financial Strategy Learning System has been devised as a resource for students attempting to pass their CIMA exams, and provides: ● ● ● ●
A detailed explanation of all syllabus areas; extensive ‘practical’ materials, including readings from relevant journals; generous question practice, together with full solutions an exam preparation section, complete with exam standard questions and solutions
This Learning System has been designed with the needs of home-study and distancelearning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to undertake extensive question practice. However, the Learning System is also ideal for fully taught courses. The main body of the text is divided into a number of chapters, each of which is organised on the following pattern: ●
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Detailed learning outcomes. expected after your studies of the chapter are complete. You should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading. Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters. Readings and activities. Some chapters are illustrated by more practical elements, such as relevant journal articles or other readings, together with comments and questions designed to stimulate discussion. xi
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Question practice. The test of how well you have learned the material is your ability to tackle exam-standard questions. Make a serious attempt at producing your own answers, but at this stage do not be too concerned about attempting the questions in exam conditions. In particular, it is more important to absorb the material thoroughly by completing a full solution than to observe the time limits that would apply in the actual exam. Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to think that this provides the same benefits as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, and then make your own attempt before referring back to the full solution.
Having worked through the chapters you are ready to begin your final preparations for the examination. The final section of this CIMA Learning System provides you with the guidance you need. It includes the following features: ● ●
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A brief guide to revision technique. A note on the format of the examination. You should know what to expect when you tackle the real exam, and in particular the number of questions to attempt, which questions are compulsory and which optional, and so on. Guidance on how to tackle the examination itself. A table mapping revision questions to the syllabus learning outcomes allowing you to quickly identify questions by subject area. Revision questions. These are of exam standard and should be tackled in exam conditions, especially as regards the time allocation. Solutions to the revision questions. As before, these indicate the length and the quality of solution that would be expected of a well-prepared candidate.
If you work conscientiously through this CIMA Learning System according to the guidelines above you will be giving yourself an excellent chance of exam success. Good luck with your studies!
Guide to the Icons used within this Text Key term or definition Equation to learn Exam tip to topic likely to appear in the exam Exercise Question Solution Comment or Note 2006.1
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Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section, we briefly outline some tips for effective study during the earlier stages of your approach to the exam. Later in the text we mention some techniques that you will find useful at the revision stage.
Planning To begin with, formal planning is essential to get the best return from the time you spend studying. Estimate how much time in total you are going to need for each subject that you face. Remember that you need to allow time for revision as well as for initial study of the material. The amount of notional study time for any subject is the minimum estimated time that students will need to achieve the specified learning outcomes set out earlier in this chapter. This time includes all appropriate learning activities, for example, face-to-face tuition, private study, directed home study, learning in the workplace, revision time, etc. You may find it helpful to read Better exam results by Sam Malone, CIMA Publishing, ISBN: 075066357X. This book will provide you with proven study techniques. Chapter by chapter it covers the building blocks of successful learning and examination techniques. The notional study time for Strategic level Financial Strategy is 200 hours. Note that the standard amount of notional learning hours attributed to one full-time academic year of approximately 30 weeks is 1,200 hours. By way of example, the notional study time might be made up as follows: Hours Face-to-face study: up to Personal study: up to ‘Other’ study – e.g. learning in the workplace, revision, etc.: up to
60 100 1140 200
Note that all study and learning-time recommendations should be used only as a guideline and are intended as minimum amounts. The amount of time recommended for face-to-face tuition, personal study and/or additional learning will vary according to the type of course undertaken, prior learning of the student, and the pace at which different students learn. Now split your total time requirement over the weeks between now and the assessment. This will give you an idea of how much time you need to devote to study each week. Remember to allow for holidays or other periods during which you will not be able to study (e.g. because of seasonal workloads). With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and final question practice. Prepare a written schedule summarising the above – and stick to it! The amount of space allocated to a topic in the study material is not a very good guide as to how long it will take you. For example, ‘Formulation of Financial Strategy’ has a weight of 45 per cent in the syllabus and this is the best guide as to how long you should spend on it. It only occupies 15 per cent of the main body of the text by volume. 2006.1
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It is essential to know your syllabus. As your course progresses you will become more familiar with how long it takes to cover topics in sufficient depth. Your timetable may need to be adapted to allocate enough time for the whole syllabus.
Tips for effective studying 1. Aim to find a quiet and undisturbed location for your study, and plan as far as possible to use the same period of time each day. Getting into a routine helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to minimise interruptions. 2. Store all your materials in one place, so that you do not waste time searching for items around the house. If you have to pack everything away after each study period, keep them in a box, or even a suitcase, which will not be disturbed until the next time. 3. Limit distractions. To make the most effective use of your study periods you should be able to apply total concentration, so turn off the TV, set your phones to message mode, and put up your ‘do not disturb’ sign. 4. Your timetable will tell you which topic to study. However, before diving in and becoming engrossed in the finer points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your books. With experience, you will learn to assess the pace you need to work at. You should also allow enough time to read relevant articles from newspapers and journals, which will supplement your knowledge and demonstrate a wider perspective. 5. Work carefully through a chapter, making notes as you go. When you have covered a suitable amount of material, vary the pattern by attempting a practice question. Preparing an answer plan is a good habit to get into, while you are both studying and revising, and also in the examination room. It helps to impose a structure on your solutions, and avoids rambling. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered only skimpily. 6. Make notes as you study, and discover the techniques that work best for you. Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’, or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. 7. Organise your paperwork. There are now numerous paper storage systems available to ensure that all your notes, calculations and articles can be effectively filed and easily retrieved later.
Management Accounting – Financial Strategy Syllabus First examined in May 2005
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Syllabus outline The syllabus comprises: Topic A Formulation of Financial Strategy B Financial Management C Business Valuations and Acquisitions D Investment Decisions and Project Control
Study Weighting 20% 30% 25% 25%
Learning aims Students should be able to: ● ● ●
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understand and apply contemporary thinking on strategic financial management, understand and utilise appropriate tools for strategic financial management, evaluate strategic financial management options in light of the needs of management and the policy of the enterprise, characterise and describe the enterprise’s financial strategy and use that characterisation to develop optimal financial strategy for all stages of the life-cycle, and assess and evaluate proposed strategies.
Assessment strategy There is a written examination paper of three hours, with the following sections. Section A – 50 marks A maximum of four compulsory questions, totalling 50 marks, all relating to a single scenario. Section B – 50 marks Two questions, from a choice of four, each worth 25 marks. Short scenarios will be given, to which some or all questions relate.
Learning outcomes and syllabus content A – Formulation of financial strategy – 20% Learning outcomes On completion of their studies students should be able to: (i) identify an organisation’s objectives in financial terms and evaluate their attainment; (ii) discuss the interrelationships between decisions concerning investment, financing and dividends; (iii) identify and analyse the impact of internal and external constraints on financial strategy (e.g. funding, regulatory bodies, investor relations, strategy, and economic factors); (iv) evaluate current performance, taking account of potential variations in economic and business factors; (v) recommend alternative financial strategies for an organisation. Syllabus content ● The financial and non-financial objectives of different organisations (e.g. value for money, maximising shareholder wealth, providing a surplus). 2006.1
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The three key decisions of financial management (by which we mean investment, financing, dividend) and their links. Benefits of matching characteristics of investment and financing, for example, in crossborder investment. Identifying the financial objectives of an organisation and the economic forces affecting its financial plans, for example, interest, inflation and exchange rates. Assessing attainment of financial objectives. Developing financial strategy in the context of regulatory requirements (e.g. price and service controls exercised by industry regulators) and international operations. Modelling and forecasting cash flows and financial statements based on expected values for economic variables (e.g. interest rates) and business variables (e.g. volume and margins) over a number of years. Analysis of sensitivity to changes in expected values in the above models and forecasts. Identifying financing requirements ( both in respect of domestic and international operations) and the impacts of different types of finance on the above models and forecasts. Assessing the implications for shareholder value of alternative financial strategies, including dividend policy. Note: Modigliani and Miller’s theory of dividend irrelevancy will be tested in broad terms. The mathematical proof of the model will not be required, but some understanding of the graphical method is expected. Current and emerging issues in financial reporting (e.g. proposals to amend or introduce new accounting standards) and in other forms of external reporting (e.g. environmental accounting).
B – Financial management – 30% Learning outcomes On completion of their studies students should be able to: (i) identify and describe optimal strategies for the management of working capital and satisfaction of longer term financing requirements; (ii) identify and evaluate key success factors in the management of the finance function and its relationship with other parts of the organisation and, where necessary, with external parties; (iii) discuss the role and management of the treasury function. Syllabus content ● Working capital management strategies. (Note: No detailed testing of cash and stock management models will be set since these are covered at the Managerial level.) ● Types and features of domestic and international long-term finance: share capital (ordinary and preference shares, warrants), long-term debt (bank borrowing and forms of securitised debt, e.g. convertibles) and finance leases, and methods of issuing securities. ● The lender’s assessment of creditworthiness. ● The lease or buy decision (with both operating and finance leases). ● The operation of stock exchanges (e.g. how share prices are determined, what causes share prices to rise or fall, and the efficient market hypothesis). (Note: No detailed knowledge of any specific country’s stock exchange will be tested.) ● The capital asset pricing model (CAPM): calculation of the cost of equity using the dividend growth model (knowledge of methods of calculating and estimating dividend 2006.1
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C – Business valuations and acquisitions – 25% Learning outcomes On completion of their studies students should be able to: (i) calculate values of organisations of different types, for example, service, capital intensive; (ii) identify and calculate the value of intangible assets (including intellectual property); (iii) identify and evaluate the financial and strategic implications of proposals for mergers, acquisitions, demergers and divestments; (iv) compare and recommend alternative forms of consideration for, and terms of, acquisitions; (v) calculate post-merger or post-acquisition value of companies; (vi) identify and evaluate post-merger or post-acquisition value enhancement strategies; (vii) discuss and illustrate the impact of regulation on business combinations; (viii) evaluate exit strategies. Syllabus content ● Valuation bases for assets (e.g. historic cost, replacement cost and realisable value), earnings (e.g. price/earnings multiples and earnings yield) and cash flows (e.g. discounted cash flow, dividend yield and the dividend growth model). ● The strengths and weaknesses of each valuation method and when each is most suitable. ● Recognition of the interests of different stakeholder groups in mergers, acquisitions and company valuations. ● Application of the efficient market hypothesis to business valuations. ● Selection of an appropriate cost of capital for use in valuations. ● The impact of changing capital structure on the market value of a company. (Note: An understanding of Modigliani and Miller’s theory of gearing, with and without taxes, will be expected, but proof of their theory will not be examined.) ● Forms of intellectual property and methods of valuation. 2006.1
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growth will be expected), the ability to gear and ungear betas and comparison to the arbitrage pricing model. The ideas of diversifiable risk (unsystematic risk) and systematic risk. (Note: use of the two-asset portfolio formula will not be tested.) The cost of redeemable and irredeemable debt, including the tax shield on debt (numerical questions on the cost of convertible debt will not be tested). The weighted average cost of capital (WACC): calculation, interpretation and uses. Criteria for selecting sources of finance, including finance for international investments. The effect of financing decisions on balance sheet structure and on ratios of interest to investors and other financiers (gearing, earnings per share, price–earnings ratio, dividend yield, dividend cover gearing, interest cover). Management of the finance function and relationships with professional advisors (accounting, tax and legal), auditors and financial stakeholders (investors and financiers). The role of the treasury function in terms of setting corporate objectives, liquidity management, funding management, currency management. The advantages and disadvantages of establishing treasury departments as profit centres or cost centres, and their control.
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The reasons for merger or acquisitions (e.g. synergistic benefits). Forms of consideration and terms for acquisitions (e.g. cash, shares, convertibles and earn-out arrangements), and their financial effects. The post-merger or post-acquisition integration process (e.g. management transfer and merger of systems). The implications of regulation for business combinations. (Note: Detailed knowledge of the City Code and EU competition rules will not be tested.) The function/role of management buy-outs, venture capitalists. Types of exit strategy and their implications.
D – Investment decisions and project control – 25% Learning outcomes On completion of their studies students should be able to: (i) analyse relevant costs, benefits and risks of an investment project; (ii) evaluate investment projects (domestic and international) taking account of potential variations in business and economic factors; (iii) recommend methods of funding investments, taking account of basic tax considerations; (iv) evaluate procedures for the implementation and control of investment projects; (v) recommend investment decisions when capital is rationed. Syllabus content ● Identification of a project’s relevant costs (e.g. infrastructure, marketing and human resource development needs), benefits (including incremental effects on other activities as well as direct cash flows) and risks (i.e. financial and non-financial). ● Linking investments with customer requirements and product/service design. ● Linking investment in IS/IT with strategic, operational and control needs (particularly where risks and benefits are difficult to quantify). ● Calculation of a project’s net present value and internal rate of return, including techniques for dealing with cash flows denominated in a foreign currency and use of the weighted average cost of capital. ● The modified internal rate of return based on a project’s ‘terminal value’ (reflecting an assumed reinvestment rate). ● The effects of taxation (including foreign direct and withholding taxes), potential changes in economic factors (inflation, interest and exchange rates) and potential restrictions on remittances on these calculations. ● Recognising risk using the certainty equivalent method (when given a risk free rate and certainty equivalent values). ● Adjusted present value. (Note: The two-step method may be tested for debt introduced permanently and debt in place for the duration of the project.) ● Capital investment real options (i.e. to make follow-on investment, abandon or wait). ● Project implementation and control in the conceptual stage, the development stage, the construction stage and initial manufacturing/operating stage. ● Post completion audit of investment projects. ● Single period for capital rationing for divisible and non-divisible projects. (Note: Multiperiod rationing will not be tested)
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Valuation models (i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d kpref (ii) Ordinary (equity) share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d ke (iii) Ordinary (equity) share, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value: P0
d1 ke g
or
P0
d0[1 g] ke g
(iv) Irredeemable (undated) bonds, paying annual after-tax interest, i[1 t], in perpetuity, where P0 is the ex-interest value: P0
i[1 t] kd net
or, without tax: P0 i kd (v) Total value of the geared firm, Vg (based on MM): Vg Vu TBc (vi) Future value of S, of a sum X, invested for n periods, compounded at r % interest: S X[1 r ] n (vii) Present value of 1.00 payable or receivable in n years, discounted at r % per annum: PV
1 [1 r ]n
(viii) Present value of an annuity of 1.00 per annum, receivable or payable for n years, commencing in one year, discounted at r % per annum:
1 PV 1r 1 [1 r ]n
(ix) Present value of 1.00 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r % per annum: PV 1r (x) Present value of 1.00 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r % per annum: 1 PV r g 2006.1
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Formulae
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Cost of capital (i) Cost of irredeemable preference capital, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0: kpref d P0 (ii) Cost of irredeemable, paying annual net interest, i[1 t], and having a current exinterest price P0: i[1 t] P0
Kd net
(iii) Cost of ordinary (equity) share capital, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0: ke d P0 (iv) Cost of ordinary ( equity) share capital, having a current ex-div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g % per annum: ke
d1 g P0
d0[1 g] g P0
ke
or
(v) Cost of ordinary (equity) share capital, using the CAPM: ke Rf [Rm Rf ]ß (vi) Cost of ordinary (equity) share capital in a geared firm (no tax): keg k0 [k0 kd]
VD VE
(vii) Cost of ordinary (equity) share capital in a geared firm (with tax): keg keu [keu kd]
VD[1 t] VE
(viii) Weighted average cost of capital, k0: k0 keg
V V V k V V V E
E
D
d
D
E
D
(ix) Adjusted cost of capital (MM formula) kadj keu[1 tL]
or
r* r[1 T *L]
In the following formulae, ßu is used for an ungeared ß and ßg is used for a geared ß: (x) ßu from ßg , taking ßd as zero (no tax): ßu ßg
V V V E
E
D
(xi) ßu from ßg, taking ßd as zero (with tax): ßu ßg 2006.1
V
E
VE VD[1 t]
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Exchange rate in 12 months’ time C$/Euro 1 annual discount rate C$ Spot rate C$/Euro 1 annual discount rate Euro
Other formulae (i) Interest rate parity (international Fisher effect): Forward rate US$ £ Spot US$ £ 1 nominal US interest rate 1 nominal UK interest rate (ii) Purchasing power parity (law of one price):
Forward rate US$ £ Spot US$ £ 1 US inflation rate 1 UK inflation rate (iii) Link between nominal (money) and real interest rates:
[1 nominal (money) rate] [1 real interest rate][1 inflation rate] (iv) Equivalent annual cost: Equivalent annual cost
PV of costs over n years n year annuity factor
(v) Theoretical ex-rights price: TERP
1 [(N cum rights price) Issue price] N1
(vi) Value of a right: Value of a right or
Rights on price issue price N1
Theoretical ex-rights price issue price N
where N number of rights required to buy one share.
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(xii) Adjusted discount rate to use in international capital budgeting using interest rate parity:
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LEARNING OUTCOMES After completing this chapter you should be able to:
identify an organisation’s objectives in financial terms and evaluate their attainment;
discuss the interrelationships between decisions concerning investment, financing and dividends;
identify and analyse the impact of internal and external constraints on financial strategy;
evaluate current performance, taking account of potential variations in economic and business factors;
recommend alternative financial strategies for an organisation;
discuss and illustrate the impact of regulation on business combinations.
1.1 Introduction In this chapter we identify the financial and non-financial objectives of different entities; the three key decisions of financial management and their links; economic forces affecting financial plans; regulatory requirements; modelling and forecasting of cash flows and financial statements; dividend policy, and current and emergency issues in financial reporting. Strategy: A course of action, including the specification of resources required, to achieve a specific objective. (CIMA Official Terminology, 2005) Financial strategy is the aspect of strategy which falls within the scope of financial management, which will include decisions on investment, financing and dividends. Strategic financial management: The identification of the possible strategies capable of maximising an entity’s net present value, the allocation of scarce capital resources among the competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives. (CIMA Official Terminology, 2005) 1
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1.2 Objectives of profit-making entities The definitions above both indicate that strategy depends on objectives. For a profitmaking entity the main strategic objective is to optimise the wealth of the proprietors, which means achieving the maximum profit possible consistent with balancing the needs of the various stakeholders in the entity, including shareholders, fund lenders, customers, suppliers, employees and government (in terms of taxation and legal constraints on operations). The health of the entity also depends on a proper balance being achieved between long-term projects and short-term opportunities, a major constraint against the latter being that they must not be taken where there is a significant risk that they will damage long-term viability. If all these factors can be effectively balanced the result should be the achievement of the overriding strategic financial management objective of maximising shareholder value.
1.2.1
Financial objectives
For a profit-making entity the main strategic objective is to optimise the wealth of the proprietors. In other words, the objective is assumed to be to maximise shareholder wealth. In practice, this may be interpreted as achieving the maximum profit possible consistent with balancing the needs of the various stakeholders in the entity.
Stakeholders Stakeholders: Those persons and entities that have an interest in the strategy of an entity. Stakeholders normally include shareholders, customers, staff and the local community. (CIMA Official Terminology, 2005) The various stakeholder groups may have different interests in the activities of an organisation: ● ● ● ● ●
●
Shareholders – maximisation of wealth from their investment. Fund lenders – receipt of interest and capital repayments by the due date. Customers – a continuous trading relationship with suppliers. Suppliers – to ensure that they are paid in full by the due date. Employees – to maximise rewards paid to them in salaries and benefits, and continuity of employment. Government – may have the broad objectives of sustained economic growth and maintaining levels of employment.
Economists, and many accountants, believe that cash flow is the main criterion to judge an entity’s performance. Cash is a fact, whereas profit can be manipulated by accounting policies. Entities have in fact gone out of business because of a lack of funds, even though they were profitable. In reality, shareholder wealth is based on the present value of future cash flows. Managers in practice may have broader objectives – perhaps undertaking any financing, investment, or dividend decision that will achieve satisfactory returns rather than those that 2006.1
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may optimise returns. Alternatively, objectives may be more related to achievement of a level of: revenue, earnings per share, dividend per share, or survival. Shareholder wealth may be measured by the return that shareholders receive from their investment, represented partly by the dividend received each year and partly by the capital gain from the increase in the value of the shares over that period.
FORMULATION OF FINANCIAL STRATEGY
1.2.2 Non-financial objectives A profit-making entity may also have a number of important non-financial objectives, which may be related to: ● ● ● ●
customer satisfaction; welfare of employees; welfare of management; the environment.
For example, in its annual report for 2004, J. Sainsbury plc, stated the following objectives which recognised in some detail the interests of other stakeholders. Our objective is to meet our customers’ needs effectively and thereby provide shareholders with good, sustainable financial returns. We aim to ensure all colleagues have opportunities to develop their abilities and are well rewarded for their contribution to the success of their business. Our policy is to work with all of our supplies fairly, recognising the mutual benefit of satisfying customers’ needs. We also aim to fulfil our responsibilities to the communities and environments in which we operate. Contrast this with the all-embracing objective of International Power plc in its annual report for 2002: Our objective is to enhance shareholder values through the viable growth of our business in a socially responsible manner.
The general thrust of this objective features in various sections of the company’s annual report but it is not quantified and it might be useful to consider how its achievement might be measured. In both the examples given above, the lack of quantification of the objectives would make it difficult for shareholders to challenge their achievement in an Annual General Meeting.
1.2.3 Agency theory A possible conflict can arise when ownership is separated from the day-to-day management of an entity. In larger entities, the ordinary shares are likely to be diversely held, and so the actions of shareholders are likely to be restricted in practical terms. The responsibility of running the entity will be with the board of directors, who may only own a small percentage of the shares in issue. The managers of an entity are essentially agents for the shareholders, being tasked with running the entity in the shareholders’ best interests. The shareholders, however, have little opportunity to assess whether the managers are acting in the shareholders’ best interests. Agency theory: Hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationships between principals 2006.1
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(such as shareholders) and agents (such as company managers and accountants). A conflict may exist between the actions undertaken by agents in furtherance of their own self-interest, and those required to promote the interests of the principals. (CIMA Official Terminology, 2005)
Investor relations Where ownership is separated from the day-to-day management of an entity, managers may be motivated to behave in ways that are not optimal to the shareholders of the organisation: ●
●
●
Shareholders can spread their risk by investing in a number of companies. Managers have personal and financial capital invested in the company and so may be averse to investing in a risky investment. Shareholder wealth will be maximised by investing in projects with positive net present values. Managers may be more interested in short-term payback than net present value as the investment criterion, in order to help further their own promotion prospects. Managers of entities that are subject to a takeover bid often put up a defence to repel the predator. While arguing this action is in the shareholders best interests, shareholders of acquired entities often receive large gains in the value of their shares. The managers of the acquired entity often lose their jobs or status.
Goal congruence Goal congruence: In a control system, the state which leads the individuals or groups to take actions which are in their self-interest and also in the best interest of the entity. (CIMA Official Terminology, 2005) It is evident that an important element within profit-making entities is the extent to which all members of the management team and their staff work together to achieve the strategic objectives of that entity. An aspect of agency theory aims to demonstrate that while various kinds of contract exist, formal and informal (such as job descriptions, departmental responsibilities and office and factory rules), these can only be effective in helping to make an entity successful if there is general acceptance of them in practice, and a concerted effort by all concerned to strive in the same direction, that is, to achieve genuine goal congruence.
1.2.4 Shareholder value analysis Traditionally, managers of limited liability entities have used financial measures such as profit margin and return on assets to assess progress, and have used discounted cash-flow measures to assess the viability of projects or investments. Shareholder value analysis (SVA) is used to bring these three measurement systems into line, and starts from the view that the main objective of the directors of a profit-making entity is to maximise the wealth of the shareholders. Coca-Cola, Monsanto, Unilever and Tate and Lyle have all used SVA to measure financial performance. 2006.1
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An assumption of SVA is that the value of an entity is the net present value of future cash flows, discounted at an appropriate cost of capital. Financing and investment decisions should be evaluated on their ability to maximise value for the shareholders. The inference is that the decision made will be reflected in the share price. Seven key value drivers have been identified that have the greatest impact on share price:
FORMULATION OF FINANCIAL STRATEGY
● ● ● ● ● ● ●
revenue growth rate (per cent); profit margin (per cent); cash tax rate (per cent); working capital/revenue (per cent); capital expenditure/revenue (per cent); cost of capital (per cent); value growth duration period (years).
The ‘value growth duration period’ represents the future period for which the entity has a foreseeable competitive advantage. SVA is used to indicate the amount of economic value created in a period. It does so by measuring and managing cash flows of the entity that take account of risk and the true value of money. The cash flows used in SVA are the net profits after tax, plus non-cash items, less any investments in working capital and non-current assets. These are known as the ‘free’ cash flows. Free cash flow: Cash flow from operations after deducting interest, tax, preference dividends and ongoing capital expenditure, but excluding capital expenditure associated with strategic acquisitions and/or disposals and ordinary dividends. (CIMA Official Terminology, 2005) A major difficulty is calculating those future cash flows. This problem can be partly resolved by breaking the value of the entity into two constituent parts, such that the value of the entity equals the present value of free cash flows during the normal planning horizon, plus a residual value. The residual value represents the present value of free cash flows after the normal planning horizon. Nevertheless, it is still difficult to establish a reliable estimate for the residual value. You will find a comprehensive article on shareholder value analysis in the Readings section of this chapter.
1.3 Objectives of not-for-profit entities As a general rule, books on financial management, and modern corporate finance theories, are written in the context of the profit-seeking segment of the private sector. Note that the very survival of such entities depends on their being able to identify and satisfy needs and to offer the prospect of an adequate financial return. Those which can hold out such a prospect are able to attract the funds necessary to grow their businesses, while those which cannot must inevitably shrink. Financial management involves not only heeding that discipline but also translating it into a criterion for the allocation of resources within the entity. In this context, the expression ‘an adequate return’ describes a situation in which the value of outputs (to customers or, in more upmarket situations, ‘clients’) exceeds the value of inputs of all kinds: not just bought-in goods and services and labour, but also capital. 2006.1
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It would be easy to overlook the fact that these profit-seeking entities (even if we include privately owned entities as well as publicly quoted ones) represent only a minority of economic activity. The majority comprises a wide variety of entities which are usually referred to as ‘not for profit’. In the private sector, you might think of: ●
● ● ● ●
trades unions, trade associations, employers’ organisations and federations thereof (such as the Confederation of British Industry); professional bodies, such as the Chartered Institute of Management Accountants; housing associations, friendly societies, clubs and cooperatives; charities; religious organisations, such as the Church of England.
It is enlightening to ask which of the business imperatives do not apply to such organisations. Can they operate without identifying and satisfying needs? To operate, can they do without adequate investment in resources, and hence the need to attract funds? Is it conceivable that they could do so if the value of their outputs is perceived as being less than the value of inputs? The answers to all these questions must be in the negative. In a way, the expression ‘not-for-profit’ is somewhat misleading: if profit is the legitimate reward for the commitment of funds, why should any entity which requires long-term funding not seek a profit (albeit under a different name, for example, surplus of income over expenditure, and with an intention that it be ploughed back)? So it is with the public sector, of which central government is the most prominent example. Activities in this sector should not be insulated from the application of financial disciplines. Would it make sense, for example, for: ● ●
a public sector college to use a different criterion from CIMA Mastercourses? a public sector hospital to use a different criterion from a private hospital?
If the rate of return sought by enterprises in the public sector were to be lower than that sought in the private sector, then the result would inevitably be that the public sector would grow (financed by taxation or borrowing) while the private sector would shrink. In short, the criterion used in resource allocation should be the same across all sectors: the value of outputs should exceed the value of inputs. At this point, however, the distinguishing feature of the ‘not-for-profit’ entities begins to emerge. It is that their customers are not synonymous with their clients. Accountancy institutes use funds supplied by their members to develop their specialism for the benefit of employers and the public. Charities and religious entities use the cash from donors to alleviate suffering or promote a belief. The government takes money from those in employment to give it to those out of work, or from the healthy to give to the sick. All of these redistributions are noble in themselves, but they lack the direct link between consumption and price. It is a well-known economic ‘law’ that as the price of a service at the point of delivery tends towards zero, so demand for it tends towards infinity. Consequently, entities whose income comes from a source other than paying customers are frequently plagued by an excess of demand over supply. There are variations on the customer/client theme, as follows: ●
Some entities have elaborate transfer pricing arrangements, which could allow internal customers to relate cost to value, by reference to: – benchmarks derived from prices prevailing in the market economy. – the prices quoted by quasi-competitive units within the organisation.
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In some cases, the clients (e.g. the passengers travelling on some railway routes in Britain) will contribute towards the cost but the taxpayer meets the balance in the form of a subsidy. In other cases, the primary function is a regulatory one, and fees are charged to those being regulated.
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To various degrees, however, managers in such entities see their role in terms of rationing their limited resources. Specifically, many are uncomfortable with the concept of value, and retreat into choosing between costs. Resources are assumed to be finite, and the task is seen as trading-off within one time-frame, for example the current fiscal year. On a small scale, for example, a church council’s decisions could include choosing between a toilet for the disabled or paying for a missionary to go to a far-off land. On a large scale, governments make a political assessment of what it can raise in taxation and borrowings, and this becomes the total that it can ‘afford’ to spend. Choices have to be made and confrontation (in this case between spending ministries: Health/Education/Defence, etc.) is inevitable. Lower down the scale, departments use the term virement (significantly, a term which is unknown in the private sector) to refer to the need to get permission to offset an overspend on one account against an underspend in another.
1.3.1 The three ‘E’s The public sector is usually credited with having drawn attention to the distinctions between: ●
●
●
economy, which is generally thought of in terms of doing things as cheaply as possible, and is therefore associated with the operational level of control; efficiency, which is generally thought of in terms of productivity (the ratio of output to input) and is therefore associated with the tactical level of control; effectiveness, which is generally thought of in terms of doing the right things, and is therefore associated with the strategic level of control.
The first two are much in evidence in public-sector management-control systems. A public sector college will measure the number of students, the number of courses, the ratio of lecturers to students, and so on. It will also seek its customers’ assessments of the standard of, for example, its lecturing and catering, and compare them with preset targets. In the language of strategic financial management, these are answers to the question ‘How well did we do what we chose to do?’. You should also be aware, by now, of the dangers of concentrating on what can be measured. Note, for example, that it is possible to measure crime detection, but it is not possible to measure crime prevention; it is possible to measure the extent to which the sick are cured, but not the extent to which sickness is prevented. People can be rewarded on the basis of measurables, but it should come as no surprise if they then skimp on the immeasurables: you get what you measure. Measuring performance is but a part of monitoring progress: assessing potential and changes therein are at least as important. Disturbingly, the third (and, arguably, the most important) ‘E’ – effectiveness – is the least in evidence. Where the word ‘strategy’ is used, it usually means a 3-year budget. Zero variances (and hence zero feedback) are expected. Health-service purchasers tend to talk, for example, of ‘delivering’ a strategy as though it were a result – a destination rather than the route thereto. This stems, perhaps, from the top-down style which we have seen is still the 2006.1
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norm: top management decides what is to be done, middle management has some choice as to how it is done, the vast majority are seen as responsible for doing it. In other words, the emphasis is on tactics, in the form of leadership from behind: ‘Carry on doing what you have been doing but do it cheaper/faster/more accurately, etc.’ Partly, this is cultural, reflecting an antipathy towards uncertainty, risk and surprises. When publicsector investments go awry (e.g. investments in information technology not producing the expected benefits) they tend to be reported in terms of wasting public money. The same outcome in the private sector might be seen as the risk inevitably associated with pushing out the boundaries.
1.4 Public and private – similarities and differences Financial management is, on the whole, equally applicable to the not-for-profit sector generally and the public sector in particular. It is worth stressing perhaps, that – in common with the private sector – it is never possible to say whether or not value has been maximised. We do not know what we do not know: specifically, we do not know what opportunities have been missed. This is not a problem for those familiar with devolved authority, as it is the only approach compatible with empowerment: you cannot tell an explorer what to find, or identify what he/she has not found! Some bridge is usually required, from the known to the unknown, for example, to relate the value of a unit to the costs of its tangible assets, and to consider what ‘intangibles’ explain the difference. This will often act as a very good attention-directing tool, but recognise it as holding up a mirror: in reality, value is not a function of cost. The health sector provides other examples. Investments in medical equipment represent decisions to trade in purchasing power now in the expectation of benefits later. These benefits may take the form of increased throughput (and hence reduced waiting lists) or the meeting of needs which would otherwise go unsatisfied. These benefits are not measurable, because it is not possible to measure something which has not yet happened; they are judgmental. But this does not mean that they are not quantifiable and hence capable of evaluation. The main obstacle is usually an unwillingness on the part of those in authority (e.g. politicians) to express value judgements, perhaps because they fear such judgements ‘being taken down and used in evidence against them’. For the avoidance of doubt, it is worth stressing that values are equally subjective in the private sector. No one pretends that they can measure the effectiveness of a proposed investment in advertising: they forecast the improvement after assessing the likely reactions of competitors, direct customers and ultimate consumers. The management accountant fulfils a vital role in being able to synthesise these judgements together with others (e.g. the volume–cost relationship and the cost of capital) to identify the optimum level of investment they imply. The forecast outcome is logged, so as to provide a benchmark by which to monitor progress. Of course, there are differing degrees of difficulty – discomfort, even – in making value judgements in the public sector. Currently and foreseeably, the health sector is providing many examples. Thanks to results of research in pharmaceuticals, for example, previously incurable illnesses are being dealt with, and people are living longer. Demand for drugs, etc., is correlated with age, so demand continues to increase. With a progressively smaller proportion of the population in employment, the financial pressures are substantial. How does 2006.1
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one make an informed choice as to the transfer of funds between the well and the unwell? What value does one put on curing an illness, or saving a life? These are societal matters, the discomfort being one of the reasons they are placed firmly in the public sector, rather than being left to the ‘survival of the fittest’ philosophy associated with the competitive struggle for existence that we call the market economy. In the UK, this is being addressed by reforms characterised by the creation of the internal market. The main feature is the separation of purchasers (representing a particular geographical area) from the providers (hospitals and other healthcare facilities). The providers are competing among themselves for the purchasers’ funds, the idea being that those offering the best value for money will gain an increasing share of the available funds. In the early days, at least, various ‘rules of the game’ have been laid down, most notably (from a strategic financial management point of view) in the area of pricing. Given that the health service is still one large (but hybrid) business, formula-based transfer pricing is to be expected. The rules are very simple: price must equal cost, and cost must equal total cost, including a target return on capital employed. Those who framed the rules seem to have been thinking in terms of there being one objectively verifiable cost of an activity (which is valid only when looking backwards) but prices have to be established in advance. The demand for sophisticated yet pragmatic costing systems will, consequently, be high for some considerable time to come, as providers seek costs which signal good value for money for the business they seek to attract, and poor value for those they wish to repel.
FORMULATION OF FINANCIAL STRATEGY
1.5 Assessing attainment of financial objectives Traditionally, managers have focused on financial measures of performance and progress. Increasingly, entities in both the private and public sectors are using non-financial indicators to assess success across a range of criteria, which need to be chosen to help an entity meet its objectives. We discuss a number of common financial and non-financial indicators below.
1.5.1 Financial performance indicators ●
●
Cash generation. Poor liquidity is a greater threat to the survival of an entity than is poor profitability. Unless the entity is prepared to fund growth with high levels of borrowings, cash generation is vital to ensure investment in future profitable ventures. In the private sector the alternative to cash via retained earnings is borrowing. In the public sector this choice has not been available in the past, and all growth has been funded by government. However, in the face of government-imposed cash limits, local authorities and other public-sector entities are beginning to raise debt on the capital markets, and are therefore beginning to be faced with the same choices as profit-making entities. Value added. This is primarily a measure of performance. It is usually defined as revenues less the cost of purchased materials and services. It represents the value added to an entity’s products by its own efforts. A problem here is comparability with other industries – or even with other entities in the same industry. It is less common in the public sector, although the situation is changing and many public-sector entities – for example, those in the health service – are now publishing information on their own value added. 2006.1
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Profitability. Profitability may be defined as the rate at which profits are generated. It is often expressed as profit per unit of input (e.g. investment). However, profitability limits an entity’s focus to one output measure – profit. It overlooks quality, and this limitation must be kept in mind when using profitability as a measure of success. Profitability as a measure of decision-making has been criticised because: – it fails to provide a systematic explanation as to why one business sector has more favourable prospects than another; – it does not provide enough insight into the dynamics and balance of an entity’s individual business units, and the balance between them; – it is remote from the actions that create value, and cannot therefore be managed directly in any but the smallest entities; – the input to the measure may vary substantially between entities. Nevertheless, it is a well-known and accepted measure which, once the input has been defined, is readily understood. Provided the input is consistent across entities and time periods, it also provides a useful comparative measure. Although the concept of profit in its true sense is absent from most of the public sector, profitability may be used to relate inputs to outputs if a different measure of output is used – for example: surplus after all costs, to capital investment. Return on assets (RoA). This is an accounting measure, calculated by dividing annual profits by the average net book value of assets. It is therefore subject to the distortions inevitable when profit, rather than cash flows, is used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation policy, inventory revaluations, write-off of intangibles such as goodwill, etc. A further defect is that RoA ignores the time value of money, although this may be of minor concern when inflation is very low. RoA may not adequately reflect how efficiently assets were utilised: in a commercial context, taking account of profits but not the assets used in their making, for whatever reason, would overstate an entity’s performance. In the public sector, the concept of profit is absent, but it is still not unrealistic to expect entities to use donated assets with maximum efficiency. If depreciation on such assets were to be charged against income, this would depress the amount of surplus income over expenditure. Other points which may affect interpretation of RoA in the public sector are: – difficulty in determining value; – there may be no resale value; – are for use by community at large; – charge for depreciation may have the effect of ‘double taxation’ on the taxpayer.
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Non-financial performance indicators
Market share. A performance indicator that could conceivably be included in the list of financial measures, market share is often seen as an objective for an entity in its own right. However, it must be judged in the context of other measures such as profitability and shareholder value. Market share, unlike many other measures, can take quality into account – it must be assumed that if customers do not get the quality they want or expect then the entity will lose market share. Gaining market share must be seen as a long-term goal of entities to ensure outlets for their products and services, and to minimise competition. However, market share can be acquired only within limits if a monopoly situation is to be avoided.
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1.6 The three key decisions of financial management The practical applications of financial management can be grouped into three main areas of decisions – investment decisions, financing decisions and dividend decisions – which reflect the responibilities of acquiring financial resources and managing those resources.
1.6.1 Investment decisions Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects, which can range from acquisition of plant to the acquisition of another entity. Investing in non-current assets usually carries the need for supporting investment in working capital, for example, inventories and receivables, less 2006.1
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It is a measure that is becoming increasingly relevant to the public sector – for example universities and the health service. Health providers must now ‘sell’ their services to trusts established to ‘buy’ from them. Those providers which are seen to fail their customers will lose market share as the trusts will buy from elsewhere (within certain limits). Customer satisfaction. This can be linked to market share. If customers are not satisfied they will take their business elsewhere and the entity will lose market share and go into liquidation. Measuring customer satisfaction is difficult to do formally, as the inputs and outputs are not readily defined or measurable. Surveys and questionnaires may be used but these methods have known flaws, mainly as a result of respondent bias. It can of course be measured indirectly by the level of sales and increase in market share. Competitive position. The performance of an entity must be compared with that of its competitors to establish a strategic perspective. A number of models and frameworks have been suggested by organisational theorists as to how competitive position may be determined and improved. A manager needing to make decisions must know by whom, by how much, and why he is gaining ground or being beaten by competitors. Conventional measures, such as accounting data, are useful but no one measure is sufficient. Instead, an array of measures is needed to establish competitive position. The most difficult problem to overcome in using competitive position as a success factor is in collecting and acquiring data from competitors. The public sector is increasingly in competition with other providers of a similar service both in the private and public sectors. For example, hospitals now have to compete for the funds of health trusts. Their advantage is that it is easier to gain access to data from such competitors than it is in the private sector. Risk exposure. Risk can be measured according to finance theory. Some risks – for example, exchange-rate risk and interest-rate risk – can be managed by the use of hedging mechanisms. Shareholders and entities can therefore choose how much risk they wish to be exposed to for a given level of return. However, risk can take many forms, and the theory does not deal with risk exposure to matters such as recruitment of senior personnel or competitor activity. Public-sector entities tend to be risk-averse because of the political repercussions of failure and the fact that taxpayers, unlike shareholders, do not have the option to invest their money in less (or more) risky ventures.
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payables, an aspect often not properly taken into account by management. Investment to enhance internal growth is often called ‘internal investment’ as compared with acquisitions, which represent ‘external investment’. The other side of the investment coin is disinvestment, which means the preparedness to withdraw from unsuccessful projects, and the disposal of parts of an entity which no longer fit with the parent entity’s strategy. Such decisions usually involve one very special element – the right timing for the action to be taken. Disinvestment decisions can also be involved in reconstructions, where an entity has to alter its capital structure, possibly to survive as a result of heavy losses.
1.6.2 Financing decisions Financing decisions relate to acquiring the optimum finance to meet financial objectives and seeing that non-current assets and working capital are effectively managed. The financial manager must possess a good knowledge of the sources of available funds and their respective costs, and should ensure that the entity has a sound capital structure, that is, a proper balance between equity capital and borrowings. Such managers also need to have a very clear understanding of the difference between profit and cash flow, bearing in mind that profit is of little avail unless the entity is adequately supported by cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation of risk: excessive borrowing carries high risk for an entity’s equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading, where an entity is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures – such as hedging – which are available. Hedge: Transaction to reduce or eliminate an exposure to risk. (CIMA Official Terminology, 2005)
The opportunity cost of finance In making financial decisions, the manager must always be aware of the opportunity cost aspect involved. Thus, if an entity wishes to raise money by means of an issue of ordinary shares, the terms must be made attractive enough to make it worth while for the investor to forego the opportunity cost of investing in the next-best investment project. Also if an entity wishes to maintain or improve its share price, it must pay satisfactory dividends and show good long-term growth prospects, otherwise it will lose out because its investors will find it more satisfactory to sell out and not forego the opportunity cost of alternative equities. In setting a price for anything – whether it be for an entity’s product or services, or the rate of interest to be paid for borrowings or to receive on loans, or the cost of equity capital – it is important to be fully aware of what the market requires and what the market will bear.
1.6.3 Dividend decisions Dividend decisions relate to the determination of how much and how frequently cash can be paid out of the profits of an entity as income for its proprietors. The owner of any profit-making entity looks for reward for his or her investment in two ways: the growth of the capital invested and the cash paid out as income. For a sole trader this income would be termed drawings and for a limited liability entity the term is dividends. 2006.1
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1.7 Policies for distribution of earnings Dividend policy is one of an entity’s financing decisions. How should an entity divide its earnings between payments to shareholders and retention for future investments if the aim is to increase the market value of the entity? Using internally generated funds is often thought to be a ‘free’ form of finance. This is of course not the case, and it is important to remember that these funds do have a cost, that is, an opportunity cost, normally taken as the cost of equity. In deciding an entity’s dividend policy the following factors should be considered: ●
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Liquidity. In order to pay dividends, an entity will require access to cash. Even very profitable entities might sometimes have difficulty paying dividends if resources are tied up in other forms of asset, especially if bank overdraft facilities are not available. Repayment of borrowings. Dividend payout may be made difficult if borrowings are scheduled for repayment and this is not financed by a further issue of funds. Restrictive covenants. The Articles of Association may contain agreed restrictions on dividends. In addition, some forms of borrowing may have restrictive covenants limiting the amount of dividend payments or the rate of growth which applies to them. Rate of expansion. The funds may be needed to avoid overtrading. Stability of profits. Other things being equal, an entity with stable profits is more likely to be able to pay out a higher percentage of earnings than an entity with fluctuating profits. Control. The use of internally generated funds to finance new projects preserves the entity’s ownership and control. This can be advantageous in entity’s where the present disposition of shareholdings is of importance. Policy of competitors. Dividend policies of competitors may influence corporate dividend policy. It may be difficult, for example, to reduce a dividend for the sake of further investment, when competitors follow a policy of higher distributions. Signalling effect. This is the information content of dividends. Dividends are seen as signals from the entity to the financial markets and shareholders. Investors perceive dividend announcements as signals of future prospects for the entity. This aspect of dividend policy is assuming increasing importance, and there have been numerous instances reported in the press where entities have paid an increased dividend when financial prudence suggests that they should be paying no dividend at all. 2006.1
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The dividend decision thus has two elements: the amount to be paid out and the amount to be retained to support the growth of the entity, the latter being also a financing decision; the level and regular growth of dividends represent a significant factor in determining a profitmaking entity’s market value, that is, the value placed on its shares by the stock market. The three types of decision are interrelated, the first two pertaining to any kind of entity, while the third relates only to profit-making entities. Thus it can be seen that financial management is of vital importance at every level of business activity, from the sole trader to the largest multinational corporation. It is instructive to think this point through by taking the case of the sole trader. He (she) has to invest capital in a shop, fittings and equipment and in the purchase of inventory and sustaining receivables (working capital); he has to have sources of capital to finance his investment such as his own capital and bank borrowings; and he has to make dividend decisions to determine how much can be reasonably withdrawn from the business to ensure that it will remain sufficiently liquid and, if desired, capable of growth.
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Having taken into account the above factors, entities will formulate standard dividend policies, three of which are discussed below.
1.7.1 Practical dividend policies Constant payout ratio There are important links between dividends and profits. In company law, for instance, the prohibition of paying dividends other than out of profits is seen as an important protection for creditors (including lenders, who may well specify a maximum proportion of profits which can be declared as dividends while their loans remain in force). This is reinforced by the accounting concept which defines profit as what you could afford to distribute, and still be as well off as you were. Such links encourage an approach to dividend policy, based on historic trends with some boards of directors publishing an objective to maintain a certain dividend cover, that is, to declare dividends which represent a constant percentage of profits after tax. In a stable state, one would expect some symmetry in the figures, for example, an entity whose profits after tax represented a 10 per cent per annum return might choose to plough half back into the business, and look forward to a 5 per cent per annum growth in its profits (and earnings per share) and hence dividends. This forms the basis of the idea that the value of a profit-making entity is a multiple of its past profits. The reality, however, is not one of a stable state. One very specific shock to the system has been the instability of the unit of measure (money). Should dividends be related to the profits calculated under the historical cost convention, or after making an adjustment to exclude the inflationary element? Ought they to be influenced by translation gains and losses? Bear in mind that ‘well-offness’ is measured by reference to the cost of unconsumed tangible assets. No allowance is made for the intangible assets (such as quality, reputation and pace of innovation) which are so crucial to survival in a rapidly changing environment. Intriguingly, what the accountant calls an asset, for example, an old-fashioned piece of plant, can actually be a strategic liability. Stable policy – signalling Some boards of directors think not in terms of maintaining dividend cover, but in terms of maintaining a trend in the absolute level of payout. Their starting point for deciding this year’s dividend is what was paid last year, what rate of increase it represented on the previous year, and whether they feel that this rate can be repeated, taking into account considerations of liquidity. Rightly or wrongly, the dividend decision is seen as a powerful signal to the market of the directors’ confidence in the future of the entity, and this does appear to be supported by evidence that unexpected dividend cuts have been followed by a reduction in share prices. The danger, of course, is that this can become a game, in which directors seek to give the signal they think will have the most favourable effect on the share price. Some even argue that the aim must not be to surprise the market, which leads to the suggestion that the dividend should be what the analysts are predicting. In pure economic terms, entities should pay zero dividends when they have sufficient positive net present value projects to utilise all their after tax profits and pay out 100 per cent of after tax profits when they have no such investment possibilities. Whatever the theoretical rationale, boards would not normally countenance such potentially huge variation in dividends payouts that such a policy would imply. 2006.1
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Residual dividend policy The residual approach to dividends argues that if an entity has opportunities to invest for a return in excess of the cost of capital, it should retain funds within the entity. If, on the other hand, it has funds in excess of its identifiable viable investment opportunities, it should return them to its shareholders for investment elsewhere. This would mean much more volatile levels of dividend, of course, but that was what equity capital was originally meant to be about.
1.7.2 Theory of dividend irrelevance To appreciate the theory advanced by Modigliani and Miller (MM) in 1961 regarding dividend policy and the hypothesis of dividend irrelevance, we need to understand MM’s fundamental principle of valuation: ‘that the price of each share must be such that the rate of return (dividends plus capital gains per dollar invested) on every share will be the same throughout the market over any given interval of time.’ This principle is supported by three basic assumptions: 1. In ‘perfect’ capital markets no buyer, seller or issuer of securities is large enough for their transactions to significantly affect the current ruling price. Information regarding the ruling price is available to all without cost, and no brokerage fees, transfer taxes or other transaction costs are incurred in the trading of securities. In addition, no tax differentials exist either between dividends or retentions of profit or between dividends and capital gains. 2. All investors will behave ‘rationally’ in that they will prefer more wealth to less, and they are indifferent as to whether any given increment of their wealth is in the form of cash payments (dividends) or an increase in the market value of their holdings (capital gains). 3. ‘Perfect certainty’ carries the implication of complete assurance on the part of every investor as to the future investment programme and future profits of every company. With this assurance there is, among other things, no need to distinguish between equity and bonds as sources of funds for this analysis, which is itself based on an analytical framework set up to examine the effects of differences in dividend policy on the current price of shares in an ideal economy, characterised by the three assumptions of perfect capital markets, rational behaviour and perfect certainty. 2006.1
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In the UK, the practice of maintaining a particular rate (sometimes real, sometimes nominal) of growth of dividends has been very popular, and seemed to work well as long as things were stable, cyclical or at least predictable. As the rate of change has speeded up, however, its limitations have become more obvious and more serious. In particular, the unexpectedly severe downturn in the UK in the early 1990s presented boards with a dilemma: given sharply reduced profits, what should be preserved – dividend growth or dividend cover? Some fund managers made it clear that they preferred dividends to retentions. Some boards responded, to the point of declaring dividends in excess of their profits after tax. One chairman talked about the need to ‘reward shareholders for their loyalty’. As a general rule, however, financial journalists took the opposite view, based on their perception of dividends as just another outlay, like wages or advertising or plant and machinery. Entities in financial difficulties, they argued, should cut dividends and increase investment. Such comments give the impression that their authors mistakenly see financial management as being about trade-offs within one time-frame (i.e. the short term). The reality is that it is about trade-offs between different time-frame.
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Important aspects of this theory arising from the above assumptions, or developed from them, include the following: ●
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In a tax-free world, shareholders will not differentiate between dividends or capital gains, the value of an entity and therefore the price of its shares being based only on the earnings capacity of its assets and investments, that is, on the worth of the projects in which the entity has invested its funds. The so-called ‘clientele effect’ shows that an entity with a particular pattern and stability of dividend profile will attract shareholders having a similar preference for that type of profile. Thus, since shareholders’ expectations are being met, the price of shares will be unaffected by changes in dividend policy. If retentions are insufficient to allow an entity to take up all its worthwhile investments, the shortfall caused by a dividend can be offset by obtaining further funds from other external sources. MM argue that although there will be a loss in value of existing shares as a result of using external finance instead of retentions, such loss will be exactly offset by the amount of the dividend paid; as a result an entity should be indifferent as to whether it pays a dividend and obtains external funding or retains more of its profits. Thus, the effect of dividends on share price is exactly compensated for by other sources of financing. MM recognise that dividends can in some way affect share prices, but suggest that the positive effects of dividend increases on such prices relate not to the dividend itself but to the ‘informational content’ of dividends in regard to future earnings. This information leads to shareholders pushing up the share price on the basis of their expectations as to future earnings. From these arguments it seems reasonable to assume that if an entity does not have sufficient worthwhile projects to use up retentions, it should distribute these surplus funds to its shareholders, who will then be able to invest in other entities which do have satisfactory investments to which these extra funds can be applied.
Within the considerable limitations of the assumptions made, which are discussed below, MM do present some interesting, if contentious, arguments as to why dividends are irrelevant to the value of any particular entity. Has MM’s theory any practical relevance today? Arguably we can answer positively in that: ●
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it sets out a number of issues which provide useful background in developing an approach to dividend policy, for example, concerning ‘informational content’ of dividends; since legalisation of share buy-backs in the UK, a number of entities have shown interest in, and a number have acted upon, the concept of returning surplus funds to shareholders, signifying that this may prove to be the better way of ensuring their more profitable use.
In a perfect world, which in the interests of clarity MM explicitly assumed, their theory would seem unexceptional. In the real world, however, we need to recognise some imperfections: ●
Use of the accounting model for purposes beyond its design specification. As mentioned above, retention of profits is likely to result in the entity reporting earnings per share growth. Paying dividends and raising capital would not. If that earnings per share figure is seen as a measure of performance, or is used for determining rewards, this could have considerable significance.
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Transaction costs. It costs money to pay a dividend, and it costs money to raise capital. To eliminate one transaction by reducing the size of the other would clearly avoid wasteful administration costs. Taxation is never neutral, and the declaration of a dividend can affect the attribution of value as between shareholders and the tax-gatherers. Whether entities need be concerned about the tax ultimately borne by their shareholders – in respect of dividends and/or the buying and selling of shares – is a moot point. Some are adopting policies which appeal to a particular clientele, that is, category of investor; others are passively watching the steady decline of the individual shareholder, and the growth of the taxexempt fund. The inefficiency of the market. A dividend is certain, being tangible cash-in-hand and discretionary income, whereas the market price is subject to all sorts of extraneous influences and therefore more uncertain. Note, accordingly, how increasing the dividend is a predictable response to a threat of a takeover, the presumption being that it will have the effect of increasing the share price. Supporters of the efficient market hypothesis would like to think that prices equate with the net present value of projected cash flows and are therefore fair as between buyers and sellers, but it would be perverse to argue that directors have a responsibility for the bargains struck between consenting shareholders, that is, for ensuring that reality fits the hypothesis! It would be more rational to argue that they should concentrate on creating wealth, and recognise that the question of its distribution as between stakeholders is far from being within their control.
1.7.3 Scrip dividends Entities sometimes offer shareholders a choice between a cash dividend and additional shares worth the same, or approximately the same amount. The dividend paid in shares is referred to as a scrip dividend and is often offered when the directors feel they must pay a dividend but would prefer to retain cash funds within the entity. The presumption is that the retained funds will be invested in projects which can reasonably be expected to earn an adequate return. As with bonus or scrip issues directors rarely highlight the fact that once the reserves are capitalised in this way, they become undistributable. To see how scrip dividends work, imagine an entity with 100 million shares in issue, the directors of which decided to declare a dividend of 12p per share. In the ‘normal’ course of events this would mean a cash outflow of £12 million to the shareholders. Assuming, for the sake of illustration, that the entity’s shares had been trading at around 360p ex div., the board might offer an alternative of one new share for every 30 held. There would be rules as to fractional entitlements, of course, but in simple terms someone who held, say, 3,000 shares could receive a dividend of £360, or 100 shares’ worth – at the contemporary share price – £360. From the point of view of the individual shareholder: ●
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if he (or she) had been thinking of buying some more shares, and felt that the price was unlikely to fall below 360p in the near future, he would welcome the opportunity of obtaining some without having to pay the usual commissions, etc.; if he had no wish to increase his holding, he could simply take the dividend as originally declared; if he had no firm views, he could take part dividend and part shares. 2006.1
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1.7.4 Share repurchases The decline in scrip dividend offers in recent years has coincided with an increase in the number of entities returning capital to investors through share repurchase schemes, or in some cases by making a special dividend payment. The repurchase of an entity’s shares may be carried out for a number of reasons: ● ● ● ● ●
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return of surplus cash to investors; to reduce the entity’s cost of capital; to enhance earnings per share in the hope of also increasing market price per share; to prevent, or reduce the likelihood of, unwelcome takeover bids; to adjust the gearing of the entity to a higher level, closer to the entity’s optimal capital structure; to reduce the amount of cash needed to pay future dividends.
The ability of UK entities to repurchase shares was introduced in the Companies Act 1981. The process requires approval of the shareholders, and any shares repurchased must be cancelled. There are also further rules imposed by the Stock Exchange and the Takeover Code, which control the use of share repurchases. The majority of recent share repurchases, and special dividends, have been as a result of entities having surplus cash in excess of their operational requirements. Shares may be repurchased by: ● ● ●
purchase on the open market; individual arrangement with institutional investors; a tender offer to all shareholders.
An individual arrangement with institutional investors tends to be the most popular approach as it is the quickest, most efficient means of returning surplus cash. Often therefore, only a small group of shareholders will participate in a share repurchase, whereas all shareholders will participate in a special dividend. A further consideration in the return of surplus cash concerns the possible tax implications for investors. A share repurchase may lead to a capital gains tax liability for participating investors, while a special dividend would normally attract an income tax liability. A share repurchase may suggest a failure of management to identify projects that will generate returns above the entity’s cost of capital. Returning capital to shareholders gives the shareholders the opportunity to generate higher returns for themselves by investing elsewhere. It can also be difficult to determine a price for the share repurchase that is fair to all parties.
1.8 The impact of internal and external constraints on financial strategy 1.8.1 Internal constraints Two of the main internal constraints on financial strategy are funding and gearing. Traditionalists claim that capital structure can be planned and managed to maximise the value of the firm. Modigliani and Miller claim that the value of an ungeared entity cannot be more than the value of a geared entity except for the present value of the tax shield and the costs of financial distress. These issues are dealt with in Chapter 4. 2006.1
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1.8.2 External constraints Major external constraints include: ● ● ● ●
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Government regulation (this is discussed in Section 1.9). Regulatory bodies (Regulation is discussed in Sections 1.9.4 and 1.9.5). Major economic influences (these are discussed in Section 1.10). Accounting concepts: Detailed knowledge of accounting procedures will not be examined in this volume. However, discussion may be required on current and emerging issues in financial reporting (relevant topics are discussed in Section 1.12). Sources of finance and their cost when determining capital structure policy (these are discussed in Chapters 3 and 4).
1.9 Developing financial strategy in the context of regulatory requirements The financial manager must have a proper understanding of those aspects of legislation which impact upon entities. Such legislation will include the Companies Acts, health and safety regulations, laws relating to consumer protection and consumer rights, laws relating to contract and agency, employment law and laws relating to protection of the environment. You should be aware of the meaning of tax havens, which are used by large entities – usually multinational corporations – to defer payment of tax on funds earned prior to them being remitted to the parent entity’s host country or used for investment purposes. Such havens will be expected to impose only low rates of tax on income earned by resident subsidiaries or low withholding taxes on dividends remitted, to have satisfactory financial services able to provide adequate support facilities and to possess political and currency stability. Understanding the implications of regulation on takeover and merger activities is required although you will not need detailed knowledge of the City Code on takeovers and mergers.
1.9.1 Corporate governance and the Cadbury Report Statutory control of corporate governance has been with us for a long time, and has increased over time, but has generally lagged behind the demonstrable need for it. It is impossible to legislate against crime, for example, fraud, but there is a case for spelling out the ‘rules of the game’. The theory which underpins current UK legislation is based on the idea that a board of directors represents the interests of the shareholders, but in practice it is often dominated by executive managers. The trends towards share options and pay schemes related to high profits have opened up a risk that courses of action which are good for the directors can 2006.1
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The main argument in favour of gearing, that is, introducing borrowings into the capital structure is that the interest payments attract tax relief. The argument against borrowing is that it introduces financial risk into the company. Financial managers have to formulate a policy that balances the effect of these opposing features, such as the state of the economy, government economic policy, and sources of finance and their cost cannot be ignored when determining capital structure policy.
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have an adverse effect on the long-term health of the enterprise. Among the issues of particular concern at the moment are: ●
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creative accounting designed to circumvent limits on directors’ powers as defined in Articles of Association (e.g. the inclusion of brands on the balance sheet, avoiding the need for prior approval of acquisitions); the inability of shareholders to stop directors investing in uneconomic projects (often funded by rights issues, the arithmetic of the process meaning that the best they can do is sell their rights in the market); the question of where the loyalties of auditors lie. The practice of valuing intangibles and then auditing them has now been outlawed by the Institute of Chartered Accountants, but many auditors are helping to devise schemes of off balance sheet finance, so as to avoid limitations on directors in listing agreements and banking covenants – suggesting they are servants of the management rather than shareholders, bankers and creditors.
The philosophical question is whether legislation and regulation should spell out the broad principles and trust directors and auditors to follow its spirit, or provide a detailed set of rules which should be followed to the letter. What we have at present is claimed to be the former, but there are many who say it is not working satisfactorily. The central recommendation of the Cadbury Committee’s Report in 1991 was that the boards of all listed entities should comply with the ‘Code of Best Practice’ set out in its report, and this is to be underpinned by a Stock Exchange listing requirement for a ‘statement of compliance’. Objectively verifiable items should be reviewed by the auditors. Among the items covered in the code are: ● ● ● ● ●
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regularity and comprehensiveness of board meetings; separation of powers at the top of the entity; availability of advice to all directors; inclusion of ‘independent’ non-executive directors; limit of 3 years for executive directors’ contracts (unless overridden by general meeting), disclosure of total emoluments, and control via a remuneration committee; appointment of an audit committee; report on the effectiveness of internal controls; assertion of ‘going concern’ status, with supporting assumptions as necessary.
Detailed knowledge of corporate governance issues is not required for the Financial Strategy syllabus. Students are expected to have a general understanding of the key principles. Overseas candidates will be able to comment on regulation in their own country as an alternative to the UK examples given in this Learning System.
1.9.2 The Greenbury Report There have been further developments since the Cadbury Report. The main recommendations of the Greenbury Committee’s Report have become requirements for Stock Exchange listing: ●
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The remuneration committee should consist entirely of non-executive directors with no personal interest other than as shareholders in the matter to be decided. An annual report should be provided for shareholders, approved by the shareholders at the annual general meeting. Full details of the directors’ remuneration should be disclosed.
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bonuses should partly comprise shares or options; directors’ contracts should be for terms of one year or less, in order to avoid large pay-offs.
1.9.3 The Hampel Report The Hampel Committee was set up to develop issues raised in the Cadbury and Greenbury Reports. The report, issued in 1998, proposed combining the best practices, principles and codes of all three reports into a single code. The Stock Exchange subsequently issued a combined code on corporate governance, and amended the listing rules to make compliance with the code obligatory for listed entities. Among the key recommendations of the Hampel Report are: ● ●
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The primary duty of the directors is to enhance the shareholders’ investment. Non-executive directors should comprise at least one-third of the membership of the board. The roles of chairman and chief executive should generally be separate. All directors should submit themselves for re-election at least once every 3 years. A remuneration committee should be established, composed of independent, nonexecutive directors. A business presentation is recommended at the annual general meeting, with a questionand-answer session. A resolution should be proposed at the annual general meeting relating to the annual report and accounts. An audit committee should be established, composed of at least three non-executive directors, at least two of these being independent. Directors should report on internal control. The accounts should contain a statement describing how corporate governance principles are applied.
1.9.4 Regulatory bodies Where a market is not competitive, or is in the early stages of becoming so, there is a need for regulators whose role is to try to balance the interests of the various stakeholders. Customers need to be protected by limiting the extent to which entities can use a monopoly position to create excessively high added value for the benefit of shareholders, employees, and, through taxation, the state. Even so, the regulator still needs to ensure that prices will provide sufficient margins to allow for necessary investment. Similar situations can exist in countries at an early stage of competition development. Here the state will often control the rate of development by licensing ‘private’ entities, while delegating to regulators a number of powers relating to business operations. Important issues for regulation are the prevention of ‘cross-subsidy’, that is, the transferring or offloading of portions of overhead costs from lower- to higher-margin products, the limitation of non-price barriers affecting the entry of new competitors, and assuring reasonable quality of product in relation to price. Non-price barriers could include trade restrictions, or restricted access to supplies or distribution channels. Regulators and their relationship to the regulated is a tricky area. Regulators rarely have statutory rights to enforce decisions and can usually only advise government. Their 2006.1
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A number of non-mandatory recommendations were also made, which included:
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responsibilities may also only extend to the regulated portion of an entity’s business; if the company has interests in a deregulated area the regulator has to take steps to ensure the correct allocation of costs. In the UK, examples of institutions covered by this section of the syllabus are the regulators of privatised industries. Examples include Oftel (telecommunications), Ofgas (gas) and Ofwat (water), plus organisations such as the Competition Commission (which is not strictly a regulator, rather a watchdog). Understanding the purpose of these organisations, and the influence they may have on government and company decisions, is necessary. Detailed knowledge of the procedures of the various organisations will not be expected in your examination.
In an international environment, financial managers need to know about issues in other countries. However, examination questions will usually allow overseas candidates to comment on institutions in their own country as an alternative to the UK examples which may be given in the question.
Exercise 1.1 Explain the objectives and main activities of a regulatory authority.
Solution The starting point for establishing a regulatory regime is a clear set of government objectives. The regulatory rules should then be designed so that they both meet government objectives and can readily be understood by both regulator and the regulated industry. These objectives may be classified under three headings: ● ● ●
the protection of customers from monopoly power; the promotion of social and macroeconomic objectives; the promotion of competition.
Where participants in a regulated market are judged to possess significant market power, and where there is no other protection for customers, methods for protecting customers in a specific sector by controls on prices and on quality of service will need to be considered. A particular focus here will be on price or tariff controls. Social objectives cover a variety of possible government objectives, including the availability and affordability of services in particular areas and to particular groups such as the disabled or customers in rural areas. It is often difficult to achieve these objectives (which may be specific) from wider government macroeconomic objectives. These can include policy on employment, pricing (and inflation) and investment, and may be particularly important in developing countries. The first step in designing effective regulations to promote competition is to identify where potential barriers to entry might exist, and their relative importance. Once the market segments in which there is scope for competition have been identified, steps will be needed to assist its development. 2006.1
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Prohibiting cross-subsidy. To enforce this it will be necessary to require the entity to make available to the regulator separate accounts for separate businesses. Removal of the right to compete in defined activities. An alternative to requiring separation or prohibiting cross-subsidy is to prohibit the regulated entity from competing in the activity in which competition is to be promoted. Creation of a regulation prohibiting discrimination. The established entity can prevent the loss of its most valuable customers to a new competitor by offering special terms of service. A rule to prevent this may therefore be appropriate. Regulation may be enforced by a number of means: legislation, licences, industry codes of practice, government department versus independent regulator.
The need for these, and the effectiveness of current controls, will depend very much on the technical characteristics of the particular service offered.
1.9.5 The regulation of takeovers and the Competition Commission The syllabus does not require detailed knowledge of the regulation of takeovers or the operations of the UK Competition Commission. However, some understanding of the implications of regulation is useful, as often entities use a reference to the competition authorities as a defence against takeover. UK takeovers are regulated in three ways, two of them formal and the third informal. UK mergers are considered by the competition authorities under the Enterprise Act 2002. Any UK mergers which do not fall under the EC Merger Regulation (ECMR), and which meet the jurisdictional tests in the Enterprise Act 2002, fall to the UK authorities: Office of Fair Trading (OFT), Competition Commission (CC) and, in the case of public interest considerations and, for the time being, mergers between water and sewerage entities, the Secretary of State for Trade and Industry (SoS). The public interest considerations relate to national security and media mergers. The latter covers newspapers, broadcasting and crossmedia mergers. Generally, mergers can only be considered by the UK competition authorities if the turnover in the UK of the entity being taken over exceeds £70m or the merger creates or increases a 25 per cent share in a market for goods or services in the UK or a substantial part of it. There is no general requirement to notify mergers to the UK competition authorities. The OFT investigates all mergers in the first instance and, with the exception of public interest cases, decides whether or not they should be referred to the CC for further investigation. The test is whether the OFT believes a merger has resulted or may be expected to result in a substantial lessening of competition. At this stage there are three ways in which a merger may be treated: ● ● ●
it may be referred to the CC for further investigation; it may be cleared; or undertakings may be sought in lieu of a reference to the CC.
Where a merger is referred to the CC, they are required to determine whether it has resulted or may be expected to result in a substantial lessening of competition and to take
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Other regulatory options may also be considered, including:
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the action it considers reasonable and practicable to address any adverse effects of the merger that they have identified. All CC reports are published. Entities can also obtain confidential guidance or informal advice from the OFT on whether or not a potential merger would be likely to be referred. For public interest cases, the SoS will decide whether to clear a merger, refer it to the CC, or seek undertakings in lieu of a reference following receipt of advice from the OFT and, in the case of media mergers, from OFCOM. The SoS will also decide whether to make an adverse public interest finding following receipt of the CC’s report. In making these decisions, the SoS must accept the views of OFT and CC as to jurisdiction and whether there is an anti-competitive outcome. For a merger situation raising defined public interest issues, but which falls below the turnover and share of supply tests, the SoS may issue a special intervention notice allowing the competition authorities to consider those issues. As with other public interest cases, the SoS will make any decision on reference to the CC and on an adverse public interest finding. The public interest considerations relating to media mergers came into force on 29 December 2003 when they were inserted into the Enterprise Act by the Communications Act 2003. A special regime exists for mergers between water and sewerage entities. These are currently considered under the Water Industry Act 1991, with changes to be made through the Enterprise Act and the Water Act. A key change will be that the OFT and the CC will replace the SoS as relevant authorities in water mergers. Those mergers completed, notified to the OFT by means of the statutory merger notice, or referred to the CC before 20 June 2003, are considered under the Fair Trading Act as follows: ● ●
●
final decisions on mergers taken by the SoS rather than the OFT and the CC; mergers considered against a broader public interest test rather than the new test of whether they result in a substantial lessening of competition; a worldwide assets-based criteria for determining whether a merger is subject to merger control procedures rather than a UK-based revenue test.
Section 58 of the Fair Trading Act 1973 requires proprietors of newspapers circulating in the UK to obtain the Secretary of State’s (Department of Trade & Industry) prior written consent to acquire a controlling interest in another newspaper or newspaper assets if the total revenues (i.e. paid-for circulation) of all the newspapers concerned (the proprietor’s existing titles plus those to be acquired) is 500,000 or more copies per day of publication. The second mode of regulation is under the competition policy of the European Union, set out in Articles 81 (formerly Article 85) and 82 (formerly 86) of the Treaty of Rome. Article 82 prohibits the abuse of a dominant entity position insofar as it may affect trade between member states. The ECMR provides that a merger that creates a dominant position, as a result of which competition would be significantly impeded, shall be declared incompatible with the common market. The Regulation applies to all mergers with a ‘Community Dimension’, defined in terms of turnover levels. The ECMR was designed to provide ‘one-stop’ merger control to avoid the risk of mergers being investigated under two or more jurisdictions. National authorities may not normally apply their own competition laws to mergers falling within the ECMR. The third control on takeovers is operated by the Takeover Panel, formed in 1968 to counter the perceived inadequacy of the statutory mechanisms for regulating the conduct 2006.1
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1.10 Major economic influences In this section we review some of the major economic forces affecting an organisation’s financial plans, such as interest rates, inflation and exchange rates.
1.10.1 Interest rates A rate of interest is the price of money which is lent/borrowed. It is expressed as a percentage of the sum, calculated on an annual basis. For example, if someone buys a government bond, and thus lends money to the government, they will receive interest. In this case it is calculated on the purchase price. Thus there is an inverse relationship between the price of government bonds and the rate of interest. Let us assume that a £100 bond pays £10 annually to the holder as interest. If someone bought the bond and held it until maturity, after (say) a year they are effectively receiving 10 per cent interest. However, if the £100 nominal value bond is bought for less than its face value at, say, £97, the purchaser is really receiving 10.31 per cent, that is, £10 on an outlay of £97. Furthermore, if the government needs to sell more bonds in order to finance its publicsector borrowing requirement, the price might fall to £95. However, this effectively means that a higher rate of interest is paid by the borrower (and received by the buyer). It is 10.52 per cent, that is (£10 £95). Generally, the longer the time period of a loan, the higher the rate of interest given/charged because of the greater risk and uncertainty involved. However, because some borrowers are safer than others, two loans for the same length of time might carry different interest rates. For example, normally a bank loan to a low-risk, blue-chip entity listed on a stock exchange would receive a lower rate of interest than a loan to a high-risk sole trader. A central rate of interest It is clear that there is no such thing as the rate of interest because there are many rates of interest, which reflect varying risk. However, there is usually a central rate around which the others vary and to which governments have paid great attention. In the UK this has usually 2006.1
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of both parties in the takeover process. The Panel consists of representatives from City and other leading business institutions, such as the CBI, the Stock Exchange and the ICAEW accounting body, thus representing the main associations whose members are involved in takeovers, whether as advisers, shareholders or regulators. The Panel promulgates and administers the Takeover Code, a set or rules with no force of law, but which reflects what those most closely involved with takeovers regard as best practice. It does, however, have some sanctions to enforce its authority, such as public reprimands, which damage the reputation of violators of the Code, perhaps leading to the collapse of the bid and, for financial advisers, to long-term loss of business. The Panel’s ultimate sanction is to request its members to withdraw the facilities of the City from offenders, although this is extremely rare. Source: Department of Trade and Industry. (www.dti.gov.uk/cp/ukmergerguide.htm)
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been the rate at which the Bank of England would lend to the money market, based on Treasury bill rates. In the post-war period until 1971 this key central rate was called bank rate and was fixed by the Bank of England. It was replaced by minimum lending rate which was set at _12 per cent above the weekly Treasury bill lender rate, so that it reflected market conditions. However, in 1981 this rate was abolished and so there is no ‘official rate’.
1.10.2 Term structure of interest rates One of the primary considerations in evaluating the use of borrowings is the likely movement in interest rates. This will affect the relative costs of long- and short-term borrowings, as well as increasing or decreasing the preference for fixed interest rates. In practice, long-term rates will normally be higher than short-term rates, owing to the additional risk borne by the lender. Hence an interest premium is required to attract investors to longerterm securities. This effect may be magnified or reversed by investors’ expectations of future rates, an anticipated rate rise producing higher longer-term rates. This difference between long- and short-term rates is known as term structure. The term structure of interest rates is shown by the yield curve. Figure 1.1 shows an upward-sloping, or normal, yield curve showing long-term rates to be higher than those available in the short term. The yield curve will normally be upward-sloping in order to compensate investors for tying up their money for longer periods of time. In extreme cases, this may justify an entity, using short-dated borrowings which is replaced regularly – although the level of transaction costs makes this unlikely. Sometimes the yield curve will be downward, or inverse, with short-term interest rates higher than long-term rates, as shown in Figure 1.2. In the UK, the Bank of England Monetary Policy Committee meets monthly to set interest rates. Their influence is directed primarily towards short-term interest rates, as a means of managing inflation in the economy. Short-term interest rates might be increased to combat inflation. If, however, interest rates are expected to fall in the future once the risk of inflation has been countered, long-term interest rates may be lower than short-term rates, and the yield curve would therefore be downward sloping.
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Figure 1.2
Inverse yield curve
Factors that influence term structure In general terms, an increasing term structure results from two factors: ● ●
27
increased risk of longer dated borrowings; anticipated general interest-rate rises.
More detailed analysis is required, however. Below are listed formal theories as to why interest rates increase with time. Expectations theory This states that the forward interest rate is due solely to expectations of interest-rate movements. If an individual wishes to borrow for two years, two obvious possibilities present themselves: (a) borrow for 2 years at an agreed rate; (b) borrow for 1 year and refinance for the second year (i.e. pay off the first loan by taking out a second). In option (a), the interest paid on the loan will be based on the current interest rate and the forward rate for one year. In option (b), the individual will consider the current interest rate and the expected interest rate for year two. Thus, the choice between the options hinges on whether the forward rate for year two is higher or lower than the expected rate. From the lender’s point of view, if the expected rate was higher they would only lend short, preferring to renegotiate at the end of 1 year and take advantage of the anticipated rate rise. A similar argument could be made if the expected rate was lower than the forward rate. Thus, for long- and short-dated borrowings to coexist, expected future rates and forward rates must be equal. Thus, the term structure of interest rates arises purely from investor expectations. Liquidity preference theory The problem with the expectations theory is that it ignores risk. If the expected rate for year two is the same as the forward rate, then an individual needing to borrow for 2 years would choose a 2-year loan since this eliminates the uncertainty of the actual interest rate to be paid in year two. Thus, borrowers will aim to borrow for the period for which they need funds. If lenders wish to lend for only 2006.1
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one year there will be a shortage of long funds and an excess of short funds. This will lead to a premium on forward rates – that is, lenders will get a bonus for lending for two years and borrowers will have to pay extra if they insist on a 2-year loan. In this case the term structure of interest rates would again be upward-sloping but now this would be because of the liquidity preference of lenders and borrowers. Market segmentation It has been argued that demand for capital funds in practice can be segmented, particularly on a time basis. Thus, for example, entities tend to finance inventories with short-term funds and equipment with long-term funds. This leads to different factors affecting long- and short-term rates and a lack of a clear trend in the yield curve, characterised by irregularities such as humps and dips. Real interest rates The real interest rate puts interest rates in the context of inflation. When the rate of interest is higher than the rate of inflation, there is a positive real rate. This means that borrowers are losing in real terms but savers are gaining. Conversely, when the rate of inflation is higher than the rate of interest, the real rate of interest will be negative. In such a case borrowers gain and savers lose. The relationship between real and nominal rates of interest is given by the formula originally considered by Fisher: (1 nominal rate) (1 real rate) (1 inflation rate) If the nominal rate of interest is 7 per cent and the rate of inflation is 2 per cent, the real rate of interest is calculated as: 1 + real rate = 1 + nominal rate = 1.07 = 1.049 1 + inflation rate 1.02 Thus, the real rate is 4.9 per cent. The effects of interest rate changes Changes in interest rates affect the economy in many ways. The following consequences are the main effects of an increase in interest rates: ●
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Spending falls – expenditure by consumers, both individual and business, will be reduced. This occurs because the higher interest rates raise the cost of credit and deter spending. If we take incomes as fairly stable in the short term, higher interest payments on credit cards/mortgages, etc., leave less income for spending on consumer goods and services. This fall in spending means less aggregate demand in the economy and thus unemployment results. Asset values fall – the market value of financial assets will drop, because of the inverse relationship (between bonds and the rate of interest) explained earlier. This, in turn, will reduce many people’s wealth. It is likely that they will react to maintain the value of their total wealth and so may save, thereby further reducing expenditure in the economy. This phenomenon seems to fit the UK recession of the early 1990s when the house-price slump deepened the economic gloom. For many consumers today a house, rather than bonds, is their main asset. Foreign funds are attracted into the country – a rise in interest rates will encourage overseas financial speculators to deposit money in the country’s banking institutions because the
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1.10.3 Inflation Inflation is defined simply as ‘rising prices’ and shows the cost of living in general terms. The effects of inflation If the rate of inflation is low, then the effects may be beneficial to an economy. Businessmen are encouraged by fairly stable prices and the prospect of higher profits. However, there is some argument about whether getting inflation below 3 per cent to, say, zero, is worth the economic pain (of, say, higher unemployment). There is agreement, though, that inflation above 5 per cent is harmful – worse still if it is accelerating. The main arguments are that such inflation: ●
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distorts consumer behaviour – people may bring forward purchases because they fear higher prices later. This can cause hoarding and so destabilise markets, creating unnecessary shortages. redistributes income – people on fixed incomes or those lacking bargaining power will become relatively worse off, as their purchasing power falls. This is unfair. affects wage bargainers – trades unionists on behalf of labour may submit higher claims at times of high inflation, particularly if previously they had underestimated the future rise in prices. If employers accept such claims this may precipitate a wage–price spiral which exacerbates the inflation problem. undermines business confidence – wide fluctuations in the inflation rate make it difficult for entrepreneurs to predict the economic future and accurately calculate prices and investment returns. This uncertainty handicaps planning and production. weakens the country’s competitive position – if inflation in a country exceeds that in a competitor country, then it makes exports less attractive (assuming unchanged exchange rates) and imports more competitive. This could mean fewer sales of that country’s goods at home and abroad and thus a bigger trade deficit. For example, the decline of Britain’s manufacturing industry can be partly attributed to the growth of cheap imports when they were experiencing high inflation in the period 1978–83. redistributes wealth – if the rate of interest is below the rate of inflation, then borrowers are gaining at the expense of lenders. The real value of savings is being eroded. This wealth is being redistributed from savers to borrowers and from payables to receivables. As the government is the largest borrower, via the national debt, it gains most during inflationary times. 2006.1
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●
rate of return has increased relative to that in other countries. Such funds could be made available as loans to firms in that country by the banking sector. The exchange rate rises – the inflow of foreign funds raises demand for the domestic currency and so pushes up the exchange rate. This has the benefit of lowering import prices and thereby bearing down on domestic inflation. However, it makes exports more expensive and possibly harder to sell. The longer-term effect on the balance of payments could be beneficial or harmful depending on the elasticity of demand and supply for traded goods. Inflation falls – higher interest rates affect the rate of inflation in three ways. First, less demand in the economy may encourage producers to lower prices in order to sell. This could be achieved by squeezing profit margins and/or wage levels. Second, new borrowing is deferred by the high interest rates and so demand will fall. Third, the higher exchange rate will raise export prices and thereby threaten sales which in turn pressurises producers to cut costs, particularly wages. If workers are laid off then again total demand is reduced and inflation is likely to fall.
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1.10.4 Exchange rates The exchange rate of a currency is a price. It is the external value of a currency expressed in another currency, for example £1 $1.60. A more complex measure expresses the value in terms of a weighted average of exchange rates as an index number. These are currencies of a nation’s main trading partners in manufactured goods and are collected in a representative basket. This is known as the effective exchange rate and shows the relative importance of the country as a competitor in export markets. A fall in the index shows a depreciation of a currency relative to the total basket of currencies on which the index is based. However, it is possible that that currency may be appreciating against some currencies in the basket whilst depreciating against others. A fall in the index simply shows that there is an overall depreciation, whereas a rise in the index would show an overall appreciation. The exchange of currencies is vital for trade in goods and services. British firms selling abroad will require foreign buyers to exchange their currency into sterling to facilitate payment. Similarly, British importers will need to pay out in foreign currencies. Also, when funds are transferred between people in different countries, foreign exchange is required. Today, the sale and purchase of currencies for trading purposes is dwarfed by the lending and borrowing of funds. The internal and external values of a currency are different. The former refers to the purchasing power of a currency at home. Inflation lowers the internal value. The external value is not affected by domestic inflation directly, but it changes with variations in other nations’ exchange rates. These variations reflected the demand for and supply of currencies on foreign exchange markets. In turn these tend to reflect trade performance. The foreign exchange market This market enables entities, fund managers, banks and others to buy and sell foreign currencies. Capital flows arising from trade, investment, loans and speculative dealing create a large demand for foreign currency, particularly sterling, US dollars and Euros. Typical deals are in Euros, and £300 billion is traded daily in London, the world’s largest foreign exchange centre. London benefits from its geographical location, favourable time intervals (with USA and the Far East in particular) and the variety of business generated there – insurance, commodities, banking, Eurobonds, etc. Foreign exchange trading may be spot or forward. Spot transactions are undertaken almost immediately and settled within two days. However, forward buying involves a future delivery date from three months onward. Banks and brokers, on behalf of their clients, operate in the forward market to protect the anticipated flows of foreign currency from exchange rate volatility. The forward price of a currency is normally higher (at a premium) or lower (at a discount) than the spot rate. Such premiums (or discounts) reflect interest rate differentials between currencies and expectations of currency depreciations and appreciations. As the foreign exchange market has grown, so other instruments such as futures and options have been developed to protect foreign exchange commitments. Currency futures involve the trading of forward transactions other than for currencies themselves, while currency options enable buyers (at a premium paid to the writer of the option, usually a bank) to guarantee a buying (or selling) price for a currency at a future specified date. 2006.1
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1.11.1 Forecasting cash flows Cash flow forecasts are vital to the management of cash. They show, over periods varying between a single day, a week, a month, a year or even longer, the expected inflows and outflows of cash through the company. They help to show cash surpluses and cash shortages. Management can therefore use cash budgets to plan ahead to meet those eventualities; arranging borrowing when a deficit is forecast, or buying short-term investments during times of excess cash. Remember that there will be differences between the cash flow forecast for a period and the forecast income statement for that period. This is because the cash budget is concerned with cash payments and cash receipts, while the income statement is concerned with income earned and expenses consumed in a period. Areas where the two statements may show different amounts include: ●
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the cash budget will record budgeted cash receipts from customers, while the income statement will show forecast revenue for the period; the cash budget will record budgeted cash payments to suppliers, while the income statement will show forecast cost of sales, which will reflect opening inventory, plus purchases, less closing inventory; the cash budget shows the budgeted cash payments for expenses such as wages, electricity and rates. The income statement will record the expenditure expected to be consumed in the period, reflecting any accounts or prepayments; the cash budget will reflect the cost of purchasing a non-current asset at the expected date of purchase and the proceeds at the date of sale. The income statement will record a depreciation charge for the consumption of the asset and a profit or loss on disposal.
1.11.2 Forecasting financial statements In an examination you may be required to model annual cash-flow forecasts and other financial statements using expected changes in values, based on data for a base year. The example below demonstrates such an approach.
Example 1.A Lavinia Products plc manufactures toys and other goods for children. It has been trading for 3 years. The shares in the company are owned by five people, all of them employed full time in the business. The entity is doing well and now needs additional capital to expand operations. Assume that you are a consultant working for Lavinia Products plc. You have been assigned to the entity to advise on its objectives and financial situation. As well as being provided with financial statements for the year to 31 December 2006, the entity’s accountant gives you the following information: 1. Revenue and costs of sales are expected to increase by 10 per cent in each of the financial years ending 31 December 2007, 2008 and 2009. Operating expenses are expected to increase by 5 per cent each year. 2. The company expects to continue to be liable for tax at the marginal rate of 33 per cent. Assume tax is paid or refunded twelve months after the year end. 3. The ratios of receivables to revenues and payables to cost of sales will remain the same for the next three years. 4. The non-current assets are land and buildings which are not depreciated in the entity’s books. Capital allowances on the buildings may be ignored. All other assets used by the entity (machinery, cars, etc.) are rented. 2006.1
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1.11 Modelling and forecasting cash flows and financial statements
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STUDY MATERIAL P9 5. Dividends will grow at 25 per cent in each of the financial years 2007, 2008 and 2009, as per the entity’s objectives. 6. The entity intends to purchase new machinery to the value of £500,000 during 2007 although an investment appraisal exercise has not been carried out. It will be depreciated straight line over 10 years. The entity charges a full year’s depreciation in the first year of purchase of its assets. Capital allowances are available at 25 per cent reducing balance on this expenditure. 7. Additional inventory was purchased for £35,000 at the beginning of 2007. The value of inventory after this purchase is likely to remain at £361,000 for the foreseeable future. 8. No decision has been made on the type of finance to be used for the expansion programme. However, the entity’s directors think they can raise new medium-term secured debt if necessary. 9. The average P/E ratio of listed entities in the same industry as Lavinia Products plc is 15. The entity’s objectives include the following: ● ● ●
to earn a pre-tax return on the closing book value of shareholders’ funds of 35 per cent per year; to increase dividends per share by 25 per cent per year; to obtain a quotation on a recognised stock exchange within the next 3 years.
A summary of the financial statements for the year to 31 December 2006 is shown below. LAVINIA PRODUCTS PLC Summarised income statement for the year to 31 December 2006 Revenue Cost of sales Gross profit Operating expenses Interest Tax liability Net profit
£000 (1,560 1,(950) (1,610 1,(325) 1,0(30) 1,0(84) 1,0171
Dividends declared
1,5068
Summarised balance sheet at 31 December 2006 Non-current assets (net book value) Current assets: Inventory Receivables Cash and bank
£000 £750 326 192 1,350 1,318 £000
Capital and reserves Ordinary share capital (ordinary shares of £1) Retained profits to 31 December 2005 Retentions for the year to 31 December 2006 Total financing Non-current liabilities 10% debenture redeemable 2020 Current liabilities Accounts payable Other payables (including tax and dividends)
500 128 103 731 300 135 1,0 152 1,318
Requirements Using the information in the case: (a) prepare forecast income statements for the years 2007, 2008 and 2009, and calculate whether the entity is likely to meet its stated financial objective (return on shareholders’ funds) for these 3 years; (b) prepare cash-flow forecasts for the years 2007, 2008 and 2009, and estimate the amount of funds which will need to be raised by the entity to finance its expansion.
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Solution (a) Income statements for the year to 31 December
Revenue Cost of sales Gross profit Operating expenses Depreciation Interest on debt Profit before tax Tax Profit after interest and tax
.2006 .£000 1,560 (,(950) (1610 (.(325)
(2007 ((£000 (1,716 (1,045) 00671 00(341) 00;(50) (1,,(30) 00250 (1,, (58) (1,192
(1,(30) (1255 (1,(84) 1,171
(2008 ( £000 (1,888 (1,150) 00738 0((358) (1,,(50) (1 ,(30) 00300 (1, (85) (1,215)
(2009 ( £000 (2,076 (1,264) 00812 0( (376) (1,,(50) (1 ,(30) 00356 (1,(111) (1,245)
Notes: 1. Revenue and direct costs are increased by 10 per cent and operating expenses by 5 per cent per annum from 2006 onwards. 2. Tax is calculated as: Profit before tax Add depreciation Capital allowances Taxable profit Tax at 33%
£000 255 125) ,255
£000 250 50 (125) ,175.
£000 300 50 (((94) ,256)
£000 356 50 ( (70) )336)
,284
,158.
.285.
)111)
Other relevant information 2006 Dividends Dividends payable (£000) DPS (%) Percentage increase Percentage payout Earnings Profit retained (£000) EPS (pence) Percentage increase Value of equity (£000) 500,000 shares at PE of 15
68 13.6 49 103 34.2
2007
2008
2009
85 17.0 25 44
106 21.2 25 49
133 26.6 25 54
107 38.4 12.4
109 43.1 12.1
112 49.0 13.8
2,565
2,880
3,232
3,675
£000
£000
£000
£000
Shareholders’ funds Ordinary share capital Retained earnings
500 2,231
500 2,338
500 2,447
500 2,559
Shareholders’ funds
2,731
2,838
3,947
1,059
Profit before tax ROSF (%) ROCE (%)
255 34.9 31.0
250 29.8 27.0
300 31.7 29.0
356 33.6 31.0
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Notes: 1. You should ignore interest or returns on surplus funds invested during the 3-year period of review. 2. This is not an investment appraisal exercise; you may ignore the timing of cash flows within each year and you should not discount the cash flows. 3. Ignore inflation.
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2007 £000
2008 £000
2009 £000
Inflows Cash from sales
1,697
1,867
2,053
Outflows Payments for purchases Operating expenses Working capital Machinery Tax payments Dividends paid Interest Total outflows
1,031 341 35 500 84 68 1,030 2,089
1,135 358
1,248 377
58 85 1,130 1,666
85 106 1,230 1,846
Net cash flow Opening balance Cumulative cash balance
(392) (3350 ---(342)
201 (((342) ---(141)
207 (((141) ---(166
The entity will need to raise a minimum of £342,000 plus interest payments – which at 12 per cent would be £41,000 in the first year. A total of approximately £400,000 will therefore need to be raised. Calculation of cash from sales and payments for purchases Assuming, as per the question, that the ratio of receivables to revenue and payables to cost of sales remains the same (12.3 and 14.2 per cent respectively) the calculations are as follows:
Revenue Opening receivables Less closing receivables (12.3% of revenue) Cash received Purchases Opening payables Less closing payables (14.2% of CoS)
2007 £000 1,716 192 3(211) 1,697
2008 £000 1,888 211 3(232) 1,867
2009 £000 2,076 232 3(255) 2,053
1,045 135 3(149) 1,031
1,150 149 3(164) 1,867
1,264 164 3(180) 2,053
An IAS 7 format is also acceptable. 2007 £000 290 (30) (((68)
2008 £000 374 (30) (((85)
2009 £000 428 (30) (106)
Net cash inflow
192
259
(292
Tax paid Investing activities: fixed assets Net cash outflow Net cash flow before financing
(84) (500) (584) (392)
(58) ((((–((((( (((58) 201)
(85) ((((–(((( (((85) 207)
Net cash inflow from operating activities Interest paid Dividends paid
Net cash inflow from operating activities for 2007 Gross profit (before depreciation) Less operating expenses Increase in receivables Increase in payables Increase in inventory
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Sensitivity analysis tests the effect of varying the projected value of important variables. When forecasting cash-flows and financial statements, it is essential that uncertainties in estimates of costs and benefits are taken into account by, at the very least, undertaking a sensitivity analysis. Significant variables may include: ● ● ● ●
revenue volumes levels of productivity costs of materials labour costs.
Sensitivity tests should be well designed; it is not sufficient to show the implications of an arbitrary variation around a particular cost or benefit. Some indication of the likely range of variation is needed.
1.12 Current and emerging issues in financial reporting Since it was established the Inernational Accounting Standards Board (IASB) has been very active, resulting in new accounting standards being issued. The technical agenda that the Board announced in 2001 included the following: Four key high-priority projects ● Accounting for share-based payments ● Business combinations ● Performance reporting ● Accounting for insurance contracts Applying international accounting standards ● New guidance on first-time application of International Financial Reporting Standards (IFRS) ● Disclosure and presentation of financial institutions’ activities Improvements projects ● Amendments to IAS 39 Financial Instruments: Recognition and Measurement ● Improvements (e.g. eliminating inconsistencies and reducing elements of choice). The four high-priority projects are all controversial to some degree. However, the IASB has issued standards in respect of three of these projects. Performance reporting has been, and continues to be, a major problem in both practical and conceptual terms for reasons which include the following: ● ● ●
●
●
Problems of definition of gains, revenue, income, losses. Tension between economic and accounting definitions of income. Decision-usefulness and fair-value accounting: dealing with the consequences in the income statement. Complexity of income statements which cover operational and financial gains and losses, and recognised but not realised gains and losses on operational and financial assets and liabilities. Establishing a bottom line. 2006.1
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1.11.3 Sensitivity analysis
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1.12.1 IFRS 1 first time adoption of IFRS This standard applies to all entities adopting IFRSs as the basis of their reporting. The objective of the IFRS is: ●
to ensure that an entity’s first IFRS financial statements, and its interim financial reports for part of the period covered by those financial statements, contain high quality information that: (a) is transparent for users and comparable over all periods presented; (b) provides a suitable starting point for accounting under International Financial Reporting Standards; and (c) can be generated at a cost that does not exceed the benefits to users.
1.12.2 IFRS 2 Share-based payment Share-based payment is an issue that has concerned standard-setters around the world for at least a decade. It was debated at length during the 1990s in the USA where the problem is particularly pressing due to the large number of entity executives who are paid in the form of shares or share options. The Financial Accounting Standards Board in the US was only partially successful in addressing the problem; a standard was issued but compliance was voluntary. In 2000, the G41 group of standard setters issued a discussion paper whose proposals would require entities to account fully for the costs of share-based payment. The IASB announced during 2001 that it would be undertaking a project to produce a standard on the subject. In February 2004 it issued IFRS 2 Share-based payment. What is the issue? Share option schemes are frequently used as a means of rewarding employees. They may also be used as a means of buying-in goods or services from parties outside the entity. Such schemes can become very complicated, especially if the options are dependent in some way on entity or employee performance. In some cases, share schemes of various types are used as a means of replacing substantial parts of remuneration in the form of regular salary, or indeed as a complete substitute for remuneration. In the case of risky business start-ups (particularly in high-tech industries) employees may agree to work for little or nothing, being rewarded instead either by shares in the entity at start-up (at which point the shares are likely to be worth little or nothing) or by options to purchase shares at a minimal price at some future date. Employees in such cases voluntarily take on a risk, in the hope of material reward in future. The advantage to the start-up entity is obvious: it obtains the advantages of highly skilled labour without having to pay for it. If the business fails, the value of the stock or options will never materialise and the employees bear the opportunity cost of their services which, in the event, have been supplied for no return. If the business prospers the shares gain in value, the options are exercised, and, in some cases, the employees gain huge rewards for the risk they have run. A simple example, set in the context of an established business, will illustrate the issue.
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Entity A, a listed entity, rewards its senior employees from time to time by granting share options. On 1 January 20X3 it grants each member of a group of senior employees an option on 10,000 shares, at an exercise price of the market value of the shares on 1 January 20X3 ($3.50), the option to be exercised no earlier than 1 January 20X6. Three years later, on 1 January 20X6 the market value of one share is $4.50. Senior employee B decides to exercise the option. He pays A $35,000 (10,000 shares @ $3.50) and receives 10,000 shares in exchange. Employee B has thus gained a benefit with a current value at 1 January 20X6 of $10,000 (current value of shares $4.50 10,000 $45,000 less the $35.000 just paid). Whether or not B chooses to realise his gain immediately by selling the shares at $4.50 each is entirely up to him; hence-forth, for as long as he owns the shares, he bears all of the risks and rewards of ownership, just like any other equity shareholder in a listed entity. Accounting for this transaction appears straightforward: $10,000 to be credited to share capital, being the nominal value of shares issued; $25,000 to share premium account; a debit of $35,000 to cash for the amount received from the employee. However, beyond these simple entries there is the question of the $10,000 benefit to the employee, which can be viewed as representing delayed remuneration for his services over the 3-year period. Applying the accruals concept, remuneration should be matched against the revenue which the services of the employee have helped to create. So, in this case, should there not be an additional debit of $10,000 to the income statement over the 3 years in order to reflect the cost of these services? The arguments for and against its inclusion are as follows. For The $10,000 represents remuneration and so should be properly reflected as an expense; the means by which the remuneration is paid is irrelevant. ● If the entity does not fully reflect remuneration for services to employees the performance statement will be incomplete, and users will neither be able to properly assess the stewardship of management nor to make fully informed economic decisions. ● If costs of employment are fully reflected in some entities (because they are paid via regular salaries) and not in others (because rewards are wholly or partly in shares or share options) then the performance statements between entities will not be comparable. (Remember: comparability is one of the four key qualitative characteristics of financial statements identified by the IASC in its Framework). ●
Against ● The $10,000 does not represent an outflow of economic benefits from the entity. The gain arises because of the entity’s share price performance, and is receivable by the employee independently of any action by the entity. ● The $10,000 does not represent an expense within the terms employed by the conceptual framework. Losses (which include expenses) ‘are decreases in ownership interest not resulting from distributions to owners’. The $10,000 is not a decrease in ownership interest. ● If $10,000 is debited to the entity’s performance statement, what should happen to the related credit? It is doubtful whether it fulfils the characteristics of either a liability or ownership interest. Up till now there has been limited guidance on accounting for share-based payment. There is a standard in the US but, because of adverse responses from interested parties, its adoption for share-based payments is voluntary.
IFRS 2’s response to the problem The IFRS should be applied to all share-based payment transactions, and it identifies three principal types: 1. Equity-settled share-based payment transactions. This category would include the transaction in Example 1B above. 2. Cash-settled share-based payment transactions. This is where the provider of services or goods (i.e. in most cases the employee) is rewarded in cash, but the cash value is based upon the price of the entity’s shares or other equity instruments. 3. Transactions where one of the parties involved can choose whether the provider of services or goods is rewarded in cash (value based on equity prices) or in shares. The underlying assumption of the IFRS is that the issue of share options and grants of shares to employees and others creates a financial instrument which must be accounted for.
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Example 1.B
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Recognition. Where payment for goods and services is in the form of shares or share options the transaction should be recognised in the financial statements. There should be a charge to profit and loss account when the goods or services are consumed. Where the payment is equity-settled (type 1 above) the corresponding credit should be to equity. Where the payment is cash-settled (type 2 above) the corresponding credit should be to liabilities. Measurement. The transaction should be measured at the fair value of the shares or options issued. Measurement can be direct, that is, at the fair value of the goods or services received, or indirect, that is, by reference to the fair value of the equity instruments granted. In this latter case, fair value should be measured at the date of grant.
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1.12.3
Reporting environmental issues
Protecting the environment is a key issue affecting everyone. Pressures are placed on businesses to ensure that the environment suffers minimum damage as a result of their products, processes or services. Businesses are using recyclable materials, monitoring pollution levels and taking other environmentally sound measures to comply with customer demand for ‘green’ products. Indeed, as writers suggest, the work of the accountant is changing so as to encompass environmental issues. This will include: ●
● ● ● ●
Dealing with environmental taxes. France, for example, charges businesses for air and water pollution and reinvests those taxes in pollution control. Investment appraisal will have to take environmental factors into account. Costing new pollution controls. Reporting on the feasibility of replacing materials for environmental purposes. Estimating the impact of ‘green’ consumer preference.
This general trend is extending to the annual financial report; entities are reporting information about their actions with regard to maintaining the environment. Such disclosures include: ● ● ●
level of toxic waste, energy usage and noise; policies regarding environmental care; comment on actions the entity has taken, for example in choice of raw materials or product policies.
The annual report is traditionally a vehicle for financial information about the entity. However, the users of the annual report represent a wide audience which extends beyond the shareholders and investors. Entities therefore view the annual report as a public relations document and report much voluntary information regarding their products, policies and so on and this now includes information about their actions towards preserving the environment. Indeed some entities are almost obliged to report on environmental issues. Generally, the trend in environmental reporting by entities has been slow and on an ad hoc basis. Some entities make an entity policy statement only, others may make an entity policy statement and a statement of what action has been taken to implement the policy, not 2006.1
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●
●
●
●
Not all entities currently report environmental information; some entities may report environmental issues one year and none at all in another year. As disclosures are of a voluntary nature there is a danger that the information may be incomplete and therefore unreliable. The importance of disclosure of information varies according to particular industries. Chemical, oil, steel and other high-polluting industries are seen as being more responsible for reporting on environmental issues. The use of environmental issues appears to be more of a public relations exercise rather than an obligation.
However, adequate disclosure is of limited reliability unless it is adequately audited. There is at present no obligation to carry out an environmental audit. If such audits are carried out they are confidential, are not carried out to agreed standards, and the audit reports do not have to be published.
1.12.4
Reporting of social issues
The present nature of environmental reporting is a product of lobby groups, government and international pressures on entities and individuals to be aware of, and take care of, the environment. 2006.1
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necessarily quantified. Finally, some entities may report physically audited measurements, such as water pollution, emissions or depletion of non-renewable resources, plus reporting on indirect effects such as the environmental impact of suppliers and the impact resulting from the disposal of a product, and consideration of stakeholders from an environmental point of view. A powerful force in the demand for environmental information from entities arises from the ethical investment movement and the Green Alliance. Furthermore, the green movement headed by groups such as Greenpeace and Friends of the Earth is making the public aware of environmental issues and forcing entities to care. The situation is inconsistent. International bodies such as the United Nations, as well as the UK’s Confederation of British Industries, have addressed the main issues. However their proposals have been complex and impractical for implementation by industry and standard-setting bodies. Environmental issues are major concerns, and regulations issued by governments and international bodies are helping to ensure that environmental care is increasing. At present there are no mandatory requirements to publish results of environmental audits but some environmental bodies require that entities publish a summary of figures on pollution emissions, waste production, consumption of raw materials, energy and water, noise and a presentation of the entity’s environmental policy. EC proposals set standards for environmental issues, such as emission levels for pollution. It is also seeking a requirement for publication of these levels and targets. As environmental regulations increase and demands from the public, consumers and investors become more onerous, entities will suffer the cost of these actions. Contingent liabilities relating to the results of environmental audits, other clean-up measures, environmental disasters and other litigation due to noise or waste policies need to be disclosed in the financial statements. The current situation is not wholly satisfactory and there is much ground to cover:
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However, this is not a new concept. Accounting theorists have always questioned the role of financial reports. Currently, they communicate financial information resulting from historic transactions entered into by the company. This relates primarily to the exchange of goods and services and excludes movements in human capital, the effects on the social environment and details of future financial position and performance. The theory of socio-economic accounting is the process of ordering, measuring and disclosing the impact of exchanges between a firm and its social environment. This involves looking at social resources and the exchanges between an entity and society. Society is seen as a number of subsystems with which the company will interact. Interaction with the economic system is currently reported in the financial reports. Social accounting seems to extend the reporting function beyond this system to include: ●
●
●
The physical environment. The entity will utilise physical resources such as coal, gas and agricultural products but the social cost of this use is currently not reported. The meteorological and biological environment. In its use of energy and the production of goods the entity will cause changes in the surrounding atmosphere and natural environment. The sociological environment. The way in which an entity attracts human resources, and uses those resources, will affect local society.
The activities of an entity may lead to an increase in social resources. For example, the provision of employment in an area may result in a social benefit. On the other hand, if the activities of an entity lead to the depletion of social resources this is termed a social cost. Social costs include: ● ● ● ●
pollution: air, water, noise; depletion and destruction of animal resources; soil erosion and deforestation; unemployment and idle resources.
Social reporting would include a social income statement, recording social costs and benefits to different areas of society, and a social balance sheet disclosing staff assets, organisational assets, the use of public goods, financial and physical assets. One of the most important papers to be produced on the subject was The Corporate Report (UK), published in 1975. It reviewed the objectives and role of the financial statements as the IASB has done in its Framework. The Corporate Report went further in advocating the publication of supplementary reports to meet the needs of other users. These were: ●
●
●
●
Statement of corporate objectives. The statement could take many forms but would include all stakeholders’ objectives The employment report, intended to give information on the number and details of employees, wage rates, the type of work and training. Statement of future prospects. The Corporate Report acknowledged that it was difficult to report on issues in this area. Yet it would provide vital information to all users. Value-added reports, showing the development of resources throughout the organisation and the interdependency of all parties (employees, government, capital providers, not just
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ABC Group: value-added statement for the year ended 31 December 20X1 $ Revenue X Less: bought-in materials and services (X) Value added 0X0 Applied to Employees Wages, pensions and other benefits X Government Corporation tax X Providers of capital Interest on loans X Dividends X Retained by the company for future growth and capital expenditure Depreciation X Retained earnings ‘X‘ Total allocated funds ‘X‘
The provision of such information would be costly. There would be a need for independent review or audit, further adding to the cost. The incorporation of this additional information in the annual report would become truly widespread only if encapsulated in regulation.
1.12.5 Inclusion of forecasts in the annual report Why not require entities to include forecasts in their annual report? There has been discussion within the accounting profession on the issue of including forecast information in the annual report. A suggestion is that the primary statements should include an additional column for forecast budgets. This information is available within the management information system. However, the implications for entities including this information are profound. If the entity included an optimistic forecast and those forecasts were not met then the market’s perceptions would be that management was incompetent, with resultant effects on the entity’s share price. If, on the other hand, the forecast was too pessimistic then again this would have adverse effects on the entity’s share price and would result in undervaluation of the entity. Furthermore, if the entity outperformed the forecast, perceptions may be that this was due to luck rather than management efforts. Some authors have stated, however, that these potential effects would force budgets to be realistic. Annual reports would include management’s analysis of the forecasts and so produce a new type of reporting. It would also force management to consider the effects of decisions. The analysis of the financial report and information for decision-making would be more relevant from a user’s point of view. Those who do not wish to include forecasts cite commercial reasons. Forecasts would have to include commercial plans and so provide valuable information to competitors. However, if this was a mandatory obligation, competitors would of course have to provide that information as well. Provision of additional information would be costly. Costs include not only the financial costs of obtaining the information but also costs to the firm from action taken on the information by investors, customers and suppliers. 2006.1
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profit for shareholders). A typical value-added statement shows the split of turnover between the interested parties:
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1.12.6
Reporting of human capital
The difference between the market value of an entity and shareholders’ funds in the balance sheet can be due to factors such as staff with good management skills, the existence of certain technical skills within the company and know-how. These human resource factors are not quantified in the financial statements at present but are, all the same, recognised by the markets involving an entity. An asset is defined by the IASB Framework as ‘… a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise’. Certainly the skills and talents of employees and management will contribute to the generation of future benefits to the entity. The problem arises as to how to value the human resource factors. The wages and salaries paid to management and employees for their skills are expensed in the year. However, if the view was taken that human resources were an ‘asset’ of the business, the costs would be capitalised in the balance sheet and depreciated or charged to the income statement in line with the income they generate. Valuation of the ‘asset’ would be in line with other methods used in the balance sheet: historical cost, replacement cost, economic value. The historical cost method would involve capitalising all costs associated with recruiting, selecting, employing, training and developing an employee and then amortising these costs over the expected useful life of the asset. Problems arise with this method. The value of the asset’s ability to generate benefits to the firm does not necessarily correspond to the historical cost and amortisation. Furthermore, different entities will incur differing costs for training and development, for example, therefore hampering comparisons. The replacement cost method estimates the cost of replacing the existing human resources, that is, what costs would be incurred to bring new staff to the level of competence of existing staff. Again, however, this value does not equate with the value of future benefits the asset will generate. Also, as with other physical assets there may not be an equivalent replacement for a given human asset. Finally, estimating the replacement costs would be very subjective. An economic value for a human asset could be obtained using an adjusted discounted future wages method. Discounted future wages are adjusted by an efficiency factor to measure the effectiveness of human capital of an entity. There are many other non-monetary methods of valuing human resources of an entity and these would involve much subjectivity.
1.13 Summary This chapter has aimed to provide an overview of financial strategy. We discuss the main groups into which financial management decisions can be classified: investment, financing and dividends. We explain how financial strategy is applicable to, and equally important in, organisations which do not seek distributable profits, emphasising that the key factor is the assessment of the value of the output of an entity and especially the excess of that value over the cost of inputs, whether it be in the private or the public sector. Dividend payments have been shown to be irrelevant to shareholder wealth in perfect capital markets. When market imperfections – such as taxes, transaction costs and imperfect 2006.1
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information – are considered, the situation is less clear. Entities tend to adopt stable and consistent dividend policies, in order to attract a clientele of investors whose personal taxation position suits that particular policy. Unexpected fluctuations in the dividend payment tend to be avoided because of the informational content of the dividend which is being signalled to the market. We discuss the impact of economic and regulatory constraints on financial strategy. We have illustrated in detail an approach to modelling and forecasting cash flows and financial statements and identified some current and emerging issues in financial reporting.
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1
Readings
The article by Paul Nichols compares the concepts of cash-flow return on investment, economic value added and cash value added. He revisits the ‘profit is an opinion; cash is a fact’ argument of a couple of decades ago, and concludes that management will have to relearn how to manage the fact of cash, and that the ability to manage and manipulate profit is no longer sufficient. The second article considers the trend towards corporate social responsibility reporting. The third article discusses the trend for companies to purchase their own shares.
Unlocking shareholder value Paul Nichols, Management Accounting, October 1998. Reproduced with permission. I get paid to make the owners of the company increasingly wealthy with each passing day. Everything else is just fluff. Former Coca-Cola CEO, Roberto Giozueta Our traditional mindset has always somehow perceived business as buying cheap and selling dear. The new approach defines a business as the organisation that adds value and creates wealth. Peter Drucker, Harvard Business Review, February 1995
Since the start of limited liability entities, corporate accountants have been measuring the success of their organisations by using traditional measurements – profit margin, return on assets, return on equity etc. At the same time, when judging the viability of individual projects or investments, they have used discounted cash flow measurements – NPV, IRR etc. And while they were adopting this dual approach the investor was using yet a third set of measurements – EPS, P/E etc. It was surely only a matter of time before something happened to bring the three different measurement systems into line: for both management and investors to judge the success of an entity by the same criteria that they judged investments. That catalyst was the publication in 1986 of Alfred Rappaport’s Creating Shareholder Value. This book started a major change in the way both management and shareholders view performance. At the same time it was the starting point for an acceleration in the activity of consultants, each developing their own version of the best way of judging performance in this new world. All the consultants follow a similar thought process: 1. Profit has become to some extent a discredited measure – to quote Price Waterhouse’s Profit is an opinion; cash is a fact. Arguably, decades ago there was little difference between cash flow and profit. However, as the world has become more complex and accounting 45
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rules and practices have had to match this complexity, so a gulf has developed between the two. Inevitably (?) this has led to many accounting entries being made on the basis of management judgement. Acquisitions, goodwill adjustments, pension funding, depreciation policies, deferred-tax accounting etc. have taken us down the judgement route. No longer is profit judged by the auditor to be correct. It is now only true and fair. 2. If profit cannot be trusted then cash, the fact rather than the opinion, needs to be measured. Rappaport argued (and all the consultants agree) that there are five drivers of cash: ● turnover growth rate; ● operating profit margin; ● the percentage of incremental revenue spent on fixed capital net of depreciation; ● the similar percentage for working capital; ● the percentage tax rate – paid rather than the accounted charge. These drivers need to be measured over the future period for which the company has perceived competitive advantage – what Rappaport calls ‘the value growth potential period’. 3. The traditional cost of capital reflected in the profit and loss account – interest – is inadequate. When assessing the validity of a project or an investment an entity will use a composite capital cost rate that contains not just the cost of loan interest but also some proxy for the cost of shareholders’ funds. The same concept of a composite rate is needed in the evaluation of the total enterprise. Normally an entity will use the traditional weighted average cost of capital, which takes both the cost of debt and of equity and weights them according to the book, or projected book, gearing. 4. What needs to be measured is how well the company is performing to the benefit of its owners, the shareholders. There is a view strongly held by many that entities are only there to generate value for their shareholders. The shareholder knows after the event how much he has made by measures such as total shareholder return (the increase in the value of his portfolio assuming reinvestment of all dividends). What is needed is a tool to help management deliver it. Although all consultancies follow these four basic logical steps they all have their own individual models, which can broadly be grouped under three main types. Cash-flow return on investment (CFROI)
There are many variants of this approach, which is perhaps the most popular in the UK, but all follow the original Rappaport thinking. Future cash flows are compared with the weighted average cost of capital either as an absolute sum of money surplus or future cash flows are stated as an internal rate of return (IRR) which in turn is compared with the WACC. Each consultancy will have its own version of how the result is to be computed. Each will have its own way of handling inflation, of valuing assets and of portraying the final result. It is general practice to make a distinction between replacement capital and growth capital, treating the former as negative cash flow like normal expenses and only the latter as genuine investment. Some will want to evaluate past performance on the basis of actual data and some will want to forecast future CFROI on the basis of projected results. Essentially, it seeks to value company performance using similar techniques to those traditionally used in evaluating individual items of investment. Consistent with the use of CFROI is the use of the Q ratio, originally a macro-economic measure in which the market value of an entity (plus debt) is compared with the inflationadjusted value of its assets. The Q ratio indicates whether an entity’s managers have generated value for their shareholders with the assets they control. 2006.1
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Developed by consultants Stern Stewart, this methodology has received considerable publicity and has a growing acceptance among entities, particularly in the USA. The Stern Stewart method is to start with profit rather than cash flow. In recognition of the potential distortions caused by traditional accounting methodologies, however, they make changes to the reported profit from a shopping list of some 160 different adjustments. The guiding principles of EVA adjustments are: ●
●
Investment decisions taken by the company should result in assets regardless of how they are treated in the accounts. Thus some training expense, perhaps some marketing expense, will be capitalised. Most notably, goodwill expense that has been written off will normally be reinstated as an asset. Assets once created cannot be eliminated by accounting action. For example, where an entity has capitalised goodwill and subsequently, for perfectly prudent accounting reasons, decides to write down the value of the goodwill, the write-down (in the USA called asset impairment) is written back in the EVA calculation. It is therefore perfectly possible to report an after-tax loss and yet still report a positive EVA.
Despite the complexity of these adjustments, the basic concept of EVA is not difficult to understand. Consider Figure 1. By all traditional measures company B is the better company: it is double the size, has a higher after-tax profit margin and a higher return on capital employed. Yet when the cost of equity is deducted it has a negative Economic Value Added compared with the positive result in company A. Essentially (apart from the accounting adjustments), the only difference between the traditional P&L and the EVA result is the cost of equity. As such, it is not a difficult concept to grasp and a growing number of entities are quoting an annual EVA value in their annual report. Stern Stewart supplements EVA with MVA (market value added) which reflects the spread between the capital invested in an entity and the market value of a business.
Revenue Operating profit Tax* Capital Debt/equity ratio Interest rate Cost of equity Operating profit after tax Cost of interest: 10% 3 300 10% 3 100 Traditional profit after tax Cost of equity: 15% 3 300 25% 3 900
Company A 400 200 100 600 50/50 10% 15% 100
Economic value added ROCE (70 600) (190 1000) PROFIT %
Company B 800 400 200 1000 10/90 10% 25% 200
30 70
10 190
45 225 25
35
12% 17.5%
19% 23.75%
* Includes tax effect of interest (EVA and Economic Value Added are registered trademarks of Stern Stewart & Co.)
Figure 1 2006.1
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Economic value added (EVA)™
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Operating cash flow OCFD Cash value added CVA Index
Year 1 180 273 (123) 0.66
Year 2 270 287 (17) 0.94
Year 3 350 301 19 1.16
Year 4 390 316 74 1.23
Year 5 430 332 98 1.34
Average discounted CVA Index 1.03
Figure 2
Cash value added (CVA)™
This concept, developed by Swedish consultants FWC AB, takes cash flow as the starting point, making a similar distinction as with CFROI between strategic investments and book assets. To calculate CVA, first calculate what FWC call the operating cash-flow demand (OCFD). This represents the annual cash-flow amounts, growing by the assumed rate of inflation that will yield an IRR equal to the WACC on the original investment. Thus in Figure 2, the OCFD line shows the annual amounts, growing at an assumed inflation rate of 5 per cent which give a NPV of zero over the five-year period with a discount rate (WACC) of 15 per cent and an original investment of 1,000. Annual cash flows in some years are insufficient to meet this requirement, the extent being measured by the CVA index. Over the full five years the average index (the PV of the operating cash flow divided by the PV of the OCFD) being greater than 1, the business is generating value. So what?
Does this amount to more than merely the latest way in which consultancies can make money? Perhaps only time will tell, but there are a number of pointers that suggest that something radical has changed in the way entities will be managed: ●
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An increasing number of stockbrokers and analysts are using the new methodologies to assist in forming the opinions they give their clients as to which shares to buy. To the extent that an entity convinces the analysts that it will add value so the analyst will recommend it and so the share price will rise. A self-fulfilling prophecy. With wider share ownership and the sophistication of markets, shareholders are demanding a healthy return. No longer is it sufficient for an entity continually to deliver decent profits. Now the shareholder understands measures like Total Shareholder Return and wants to invest in entities that deliver it. Management now understand that they are employed ultimately by the shareholders and to keep their jobs they must deliver shareholder value. These new models help them to manage their entities in ways that will do so. No longer is the management and manipulation of profit, the opinion, sufficient. Management must re-learn the skills of managing the fact, cash. Controlling the cash drivers that Rappaport defined presents a new way of managing a business. What else could be more important?
Green signals ‘go’ Danka Starovic, Financial Management, October 2002. Reproduced with permission.
Sustainable development has crept up the corporate agenda in the past few years. An issue that was still a marginal concern when the Body Shop became a public company in 1985, it 2006.1
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now claims a place in boardrooms around the country. This surge of interest is less connected to mounting evidence of manmade environmental and social disasters than to intense pressure from protesters. The firms that were targeted in anti-capitalist riots and media campaigns in the past few years are often the ones putting corporate social responsibility (CSR) on the map – Shell after publicity about Nigeria and Brent Spar, Monsanto after GM crops, Nike after the NoLogo campaign and the Seattle riots. They are recognising that the activists cannot be ignored. Managing reputational risk has become a serious corporate governance concern. This is hardly surprising considering that brands can be an entity’s most significant intangible asset. In addition, the internet has made it much easier for people to disseminate information and voice their dissatisfaction. Many firms’ first line of defence is to produce a CSR report. Voluntary reporting guidelines are emerging all the time, as are independent social and environmental auditing standards. This is a positive development. The more we know about what entities are doing, the more we can make informed investment choices. But, if such reporting fails to translate into a mechanism for improving performance, it cannot reduce an entity’s environmental impact or promote social equity. Indeed, there is a danger that, in a rush to appear good, the purpose of reporting is being forgotten. In June, British American Tobacco issued its first social report. Although it was designed to meet standard AA1000 and was audited by an independent verifier, it failed to convince BAT’s key stakeholders (many of whom had refused to participate in its production). The company was accused of hypocrisy. BAT’s arguments that no industry is wholly good or bad, and that risky businesses are in particular need of this type of report, may be valid – up to a point. The problem is that no amount of stakeholder engagement will make cigarettes safe. An attempt to build trust by increased disclosure inevitably seems misplaced. Real sustainability involves structural changes, either to your value chains or to your entire business model. This may seem drastic, but we have to tackle the paradox that, while capitalism has created more wealth than any previous economic system, it has done so at a price. Environmental rating agency Trucost recently said that no UK company would be profitable if the cost of its impact on the environment was reflected in its bottom line. It is debatable whether any of the most respected entities of the past 100 years have ever made an environmentally sustainable profit. If BAT is at one end of the scale, the Co-operative Bank is at the other. Last year, it refused £2.5 million of business on ethical grounds. Around 98 percent of the bank’s electricity comes from renewable sources, its water consumption has been cut by 9.1 per cent and it saves £3.5 million a year primarily from reduced paper usage. It also reports that its ethical stance has contributed £20 million to its pre-tax profits of £107.5 million. In the Co-operative Bank’s case, sustainability is about adjusting what it does, not simply making it transparent. Reporting should be the visible part of the structure. It should be supported by a robust internal architecture for measuring performance and a decision-making capability that reflects a wider range of concerns. Of course, more firms should still be encouraged to produce audited CSR reports. Entities such as the Co-operative Bank show the benefits to be gained from stakeholder engagement. If nothing else, it helps firms to stay ahead of the regulators. Compliance may still be the biggest driver for sustainable development. Those who trust that industry interest will prevail over government intervention should remember not only the mandatory Operating and Financial Review (part of the Company
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Law Review), but a spate of EU legislation such as the end-of-life vehicle and end-of-life electronic and electric equipment directives. This autumn Linda Perham MP is reintroducing to the Commons the corporate responsibility bill, which seeks to put social reporting on a par with mandatory financial reporting. It may not go through, but it has been signed by more than 200 MPs and reflects a change of mood on this issue. It is unrealistic to expect entities to drop profit-making operations to save the planet. We should focus instead on findings such as those of the Business in the Environment survey that FTSE-100 firms are gaining competitive advantage by being ahead of the law in this area. Change should be incremental, not accompanied by a big regulatory stick. Enforced regulation will at best produce grudging compliance. For markets to operate with sustainable development principles firmly embedded as a basis for decision-making, this is not enough. There has to be a programme of education that should engender a gradual shift in views. Firms whose reputations were damaged by protesters should be at the forefront. It is far better to be judged on controlled performance indicators, developed in consultation with stakeholders, than to be considered guilty because of rumours.
Share buybacks Michael Goddard, Financial Management, October 2005. There are good reasons for a firm to buy its own stocks, so why does it sometimes go so horribly wrong? Michael Goddard looks at the debts behind the headlines.
For several years now, share buybacks have been extremely popular. Companies that have done this recently include BP, Barclays Bank and Alexon. But are they really good for the firms and shareholders concerned? There are several reasons for their popularity, including the fact that if a company had surplus cash in the past there was always a problem about what to do with it. Some directors have used the extra funds to build empires by embarking on ill-considered takeovers with disastrous results. Surplus cash can also make managers complacent. For example, they may allow debtor and stock levels to rise without justification, or may fail to sort out lossmaking divisions promptly. A share buyback can provide the solution by returning the money to shareholders who can use it to take other investment opportunities. The Companies Act 1981 allowed limited-liability companies incorporated in Great Britain to purchase their own shares for the first time. Share buybacks have been aided by the subsequent abolition of advance corporation tax. Another factor driving firms to buy back stock, according to The Economist, may be the short-term aims of powerful institutional investors, particularly in the US. Anthony Bolton of investment management firm Fidelity International has been quoted as saying: “We also like the use of share buybacks. If a company is going to make an acquisition, for example, our view is that it should test this option against the alternative of buying back its own shares.” The buyback trend has probably been compounded by the end of the nineties’ investment boom. Where companies once reinvested cash flows for expansion projects, they now tend to pay for share buybacks, dividends and other forms of capital distribution. This implies that the private sector cannot supply growth and capital appreciation. Companies are facing almost impossible pressure to show that they are investing their capital wisely. “Just give it back to us” is the growing refrain of investors. 2006.1
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• Earnings per share. • The share price. • The value of executive stock options. The object of increasing earnings per share works best when interest rates are low and the company’s share price is also low. In some instances, the interest earned on the surplus cash used for the share buyback can be lower than the cost of the dividend on the shares purchased. A buyback in itself won’t necessarily increase a company’s share price. It’s more likely to if it’s part of a package – for example, if it’s connected with selling off an underperforming subsidiary. The fundamentals of the business have to be sound, too. The move can make financial sense when a company has a cash surplus over and above its day-to-day needs, a good cash flow and little or no debt, and if it’s not planning to spend substantial amounts on expansion through capital expenditure or acquisitions in the near future. In theory, the best time to put a share buyback into operation is after a stock market crash, when the shares of many companies can be purchased for less than net asset value. But, even if a company has surplus cash in the bank, its directors will normally have other things on their minds during a crash – survival, for example. Another time when directors are likely to be tempted to effect a buyback is when the company’s shares are out of favour with the market and are going cheap as a result. A company that decides to buy back its shares and announces this, along with plans to enhance future trading, could purchase the stock at below net asset value, so increasing the net asset value and earnings per share, as well as the share price. There has, however, been a disturbing trend whereby companies borrow to fund share buybacks. One reason given for this is that it can reduce the cost of financing the business, since the interest paid is deductible for corporation tax, while dividends are non-deductible. But this works only if the interest paid (less corporation tax) on the loan is lower than the dividend paid on those shares. It also does not take into account the possibility that the company will hit hard times and be forced to reduce or even cancel its dividend, while still paying interest on its borrowings. Other problems can occur if the company has raised money to fund the share buyback by issuing loan stock. There is always the chance that this loan stock may have to be repaid, perhaps many years later, during a recession when its bank balance is insufficient for the purpose. If so, the company may struggle to raise money at a difficult time. In addition, a severe economic downturn may cause the value of a company’s assets to fall, so reducing the security for its borrowings. Despite these potential pitfalls, directors who have stock options must be tempted to vote for a share buyback even when it is funded by borrowings. An increase in earnings per share, a higher share price and executive stock options all have merit, but not if the buyback risks putting the company into danger many years ahead. When considering a share buyback, the overriding principle for the board of directors must be the long-term interests of the shareholders. So how successful are buybacks? The Financial Times reports that at BP’s annual general meeting, Rich Silk, a private shareholder, raised a serious point when he said: “I’m disturbed to see more buybacks than dividends. I’ve studied the effects of buying back shares and it doesn’t seem to work.” 2006.1
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The main reasons for a company to buy back its own shares are that it will increase the following:
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Tony Jackson, writing in The Sunday Telegraph, comments that Rentokil Initial’s balance sheet, at first glance, is in tatters: it has a net debt of £1.1bn and shareholders’ funds of minus £600m. This is the legacy of Sir Clive Thompson, who built up the business but was ousted in May 2004. Having grown spectacularly in the nineties, Rentokil hit problems in 1999–2000. Thompson’s response was to mount a hugely ambitious share buyback programme that cost £1.9bn over five years (it was halted as soon as he left). Rentokil was almost wholly ungeared at the outset and buybacks were bizarrely popular at the time. The fewer shares in issue, the higher the earnings per share. In those bullish days, it was unquestionable that the share price would rise accordingly. In fact, as financial theorists have pointed out for decades, the rise in earnings per share is cancelled out by higher gearing. More debt means more risk and a correspondingly lower rating for the shares, as Rentokil discovered. In 2000 alone, Thompson paid £1.3bn for shares at an average price of 167.5p, which is higher than the price at the time of writing. Share buybacks are as popular as ever and, where they are financed by surplus cash, they are generally a good thing both for the company and its shareholders. But, where buybacks are financed by borrowings the effect is questionable at best. History tells us that it’s not a good idea to substitute debt for share capital. The concept of equity share capital has stood the test of time. A company must be adequately capitalised both for growth and to withstand financial storms. FM Michael Goddard is the former finance director of Concord Express Transport. Since his retirement, he has become a journalist specialising in financial matters.
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Question 1 The objective of a health authority (a public-sector entity) is stated in its most recent annual report as: To serve the people of the region by providing high-quality healthcare within expected waiting times.
The ‘mission statement’ of a large plc in a manufacturing industry is shown in its annual report as: ‘In everything the company does, it is committed to creating wealth, always with integrity, for its shareholders, employees, customers and suppliers and the community in which it operates.’
Requirements (a) Discuss the main differences between the public and private sectors which have to be addressed when determining corporate objectives, or missions. (8 marks) (b) (i) Describe three performance measures which could be used to assess whether or not the health authority is meeting its current objective. (6 marks) (ii) Explain the difficulties which public-sector entities face in using such measures to influence decision-making. (6 marks) Note: Candidates may draw on their knowledge and experience of the public sector in their own country when answering this question. (Total marks 20)
Question 2 Assume that you are a financial analyst attending a shareholders’ meeting at PDQ plc on behalf of your employers, a large pension fund. Your entity is one of the few institutional investors in PDQ plc, which is a medium-sized listed entity. The majority of the shareholders are small, private investors. At the shareholders’ meeting you overhear a group of shareholders discussing the entity’s dividend policy. Some of the comments you hear are as follows: ●
●
‘I think the entity should increase its dividend payout to the maximum it can afford without having to borrow. That way our returns are less risky.’ ‘I don’t agree. I think the entity should reduce the dividend and retain even more of its earnings for future investment.’ 53
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‘I would prefer no cash dividend at all and receive annual bonus shares. The value of my shareholding would then immediately increase.’ ‘I read somewhere that dividend policy has no effect at all on the value of the entity’s shares.’
Requirements (a) Discuss the validity or otherwise of the shareholders’ comments. (15 marks) (b) The expectations and requirements of institutional investors in respect of an entity’s dividend policy may be different in a number of respects from those of private, individual shareholders. Explain these differences and comment on the problems PDQ plc might face in trying to reconcile the requirements of the two groups of shareholders. (10 marks) (Total marks 25)
Question 3 When determining the financial objectives of an entity, it is necessary to take three types of policy decision into account – investment policy, financing policy and dividend policy. Requirements (a) Discuss the nature of these three types of policy decision, commenting on how they are interrelated and how they might affect the value of the entity (i.e. the present value of projected cash flows.) (10 Marks) (b) Describe the different function of treasury and financial control departments of an entity and comment on the relative contributions of these two departments to policy determination and the achievement of financial objectives. (10 marks) (Total marks 20)
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Solution 1 (a) Among the differences between the public and private sectors of the economy, as far as objectives and missions are concerned, are the following: ● Those of the public-sector entities are likely to have been spelled out in a statute or vesting document. As such, managers would have difficulty in adapting them as conditions change. On the other hand, the directors of a private-sector entity are able to determine its objectives and mission themselves, and to change them as conditions dictate. ● The value of the output of a private-sector entity is determined by paying customers, and can be incorporated in its objectives, missions and decision criteria. One of the main arguments for retaining an endeavour in the public sector is that it cannot be left to the market to determine its income. Unfortunately, however, top managers in the public sector are generally reticent about quantifying the value of such endeavours. ● In the private sector, failure to meet the aspirations of the various stakeholders (e.g. as listed in the plc mission statement) brings penalties, and may trigger the demise of the enterprise. In the public sector, disbelief can be suspended for long periods, with the result that some stakeholders’ aspirations are ignored. Objectives often boil down simply to the aim to achieve the results spelled out in a plan imposed from above. ● The public sector is constrained by tactical controls in the shape of short-term cash limits. This often ushers in rationing, which amounts to a conflict between stakeholders. Private-sector entities can look far enough ahead to see how the interests can be harmonised – though not all avail themselves of this facility! ● Private-sector entities are acutely aware of the need to earn a satisfactory return on investment (typically around 15 per cent per annum in terms of operational cash flows in the UK). The public sector is only slowly moving away from the concept of capital being free at the point of delivery (a recipe for demand in excess of supply) and has not yet embraced the idea that it is a commodity which is freely available at a price. (b) (i) Unfortunately, ‘high-quality healthcare’ and ‘within expected waiting times’ are rather vague. It would be useful to quantify them in some way. Assuming that is done, among the measurements which might be useful are: ● waiting time for accident/emergency admissions, or arrival of ambulance, compared with expectation (or failing that, a regional or national average); ● length of waiting lists for important elective surgery, again compared with expectation (or failing that, a regional or national average); ● patients’ view as to quality of service, against declared aim. 55
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(ii) Some of the difficulties of the public sector are just beneath the surface of the question. Health authorities are responsible for the purchasing of healthcare from providers (typically NHS trusts). However, they are constrained by rigid budgets allocated by the NHS Executive. lf an authority fails to live up to objectives along the lines of those quoted, or to achieve expected results, it could simply be because it does not have the funds. Letting waiting lists lengthen is the easiest way to keep within an inadequate budget. That is not a reason for not measuring performance of course, but it does affect the interpretation of the measurements. Some performance measurements in the public sector can run counter to what constituents want and, in many cases, to common sense. Judging police forces on the basis of costs per crime recorded, for example, discourages crime prevention. If surgeons were influenced by the measurement of how quickly they discharge their patients, they would not meet the patients’ aspirations. The more important things in life cannot be measured, because they have not happened – e.g. crimes and illnesses which have been prevented, or opportunities created. The way forward is to be honest about constraints, e.g. to phrase the health authority’s objective in terms of obtaining the maximum value in healthcare terms for a given budget.
Solution 2 (a) The fact that different shareholders have different views as to what the entity should do is hardly surprising, but some of the remarks could be based on misunderstandings. Dealing with each in turn: ● The idea that the entity should increase its pay-out to the amount it can afford has considerable merit in corporate governance terms in the sense that, to the extent that it acquired funds for expansion, it would have to make the case to its shareholders’ general meeting. We do not know what the entity’s borrowings are, so we do not know what impact there would be of establishing zero borrowings as the criterion. The shareholder should be dissuaded from thinking, however, that the net result such a policy would be to reduce the risk associated with the returns to shareholders. The uncertainty associated with returns achieved by the entity depends on the projects in which it chooses to invest, and the individual shareholder is also subject to the risk that, when he comes to sell the shares, the price will be at a cyclical low. ● To the extent that funds are retained in the business, rather than paid as a dividend, the important question is whether the investments are viable, that is, enhance the net present value of the equity. From an individual shareholder’s point of view, there is a secondary question as to whether this enhancement will be reflected in the share price at the time he comes to sell his holding. ● Paying no dividend at all is an extreme case of the situation described in the previous paragraph. The viability of the investments the retentions would fund is what affects the value of the business (as an entity and therefore, indirectly, to its shareholders). There is no necessity to capitalise the retentions in the form of a bonus issue – indeed, the effect of doing so is to make them undistributable for ever more, thereby weakening shareholder power vis-à-vis the directors. ● The net cash flow attributable to shareholders is a function of the investment and borrowing decisions made by the board of the company concerned. In other 2006.1
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How the entity deals with these possible conflicts depends on a number of factors: ●
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whether it is happy with the mix of individual and institutional shareholders it has at present, or whether it wished to attract more institutions; market image – if it is to satisfy institutions it may need to raise dividends even when it cannot afford to (as noted above) or when it does not wish to; its belief in the importance of dividend policy. 2006.1
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words, the difference between distributions (e.g. dividends) and financing (e.g. rights issues) is predetermined. Directors can ‘mix and match’ these two components as they see fit, and there is a spectrum of possibilities, from paying high dividends and having frequent rights issues, to retaining a high proportion of profits and occasionally buying back some of their shares. There may well be some tax benefits – for some shareholders at least – in adopting a particular policy. This will be identified by a treasury function which has the aim of maximising the proportion of entity value which is attributable to the equity. Whether this value is reflected in the share price at any particular point in time is, of course, a different question again. If the speakers accept these comments, they might well ask what dividend policy does make economic sense. The answer is to see the dividend as being a return to shareholders of those funds which cannot be invested for a return in excess of the cost of capital. This would make dividends as volatile as the rest of the environment, but is consistent with a rational investment policy (i.e. projects are supported if they show positive net present value) and recognises that the share price is part of a zero-sum game: for every buyer there is a seller. Over and above those considerations, it should be recognised that there are a number of factors, given current regulations and practices, which prompt many people to see short-run share prices as important in themselves. If enough people believe that share prices are a function of current dividends then they will be, and this will influence directors’ decisions – especially if they have some share options about to mature. Setting out to maximise the short-term share price will rarely maximise the long-term financial health of the entity. (b) One theory of dividend policy is that an entity attracts particular types of shareholder because of its policies, including its dividend policy. This is known as the ‘clientele’ effect. This effect might influence the attitudes of the two types of shareholder mentioned in the question. Other considerations are as follows: ● Financial institutions are largely non-taxpaying because they can reclaim the advance corporation tax that they pay on dividends. This means that they will be mostly unconcerned about dividends or capital gains as far as taxation is concerned. However, there are two main considerations: cash flow and transaction costs. ● It is likely that institutions would press for a higher payout, as they did in 1991–92, when entities were reporting lower profits. ● Small private investors are less easy to categorise. If they are wealthy they may prefer capital gains because they are tax-efficient (even when tax rates are the same there is an annual tax-free allowance, and capital gains tax is not paid until it is assessed. Dividends are taxed at source). If they are not particularly wealthy they may prefer a high, stable dividend which guarantees them a regular income. In fairness, these individuals are most likely to prefer investment in gilt-edged securities, high-quality corporate debt, or National Savings.
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Solution 3 Aim of question. This question dealt with the determination of financial objectives and the role of treasurer and financial controller. The question aimed to test candidates’ abilities to examine, evaluate and assess the policy decisions and organisation structure of an entity. Tips/guidance/common errors ● Most candidates made a satisfactory to good effort at Part (a). ● Not many candidates managed to discuss the interrelationships of the three policies and how they affected the value of the entity. ● Many candidates spent far too long discussing dividend policy to the detriment of the answer as a whole. ● Answers to Part (b) of the question were varied. ● Most candidates recognised the major functions of the two departments but these were often provided as a list with no discussion of the relative contributions to the achievement of financial objectives. This question examines the following syllabus area: (i) The finance function. ● ●
●
The three key decisions of financial management: The role of the treasury function; The benefits and shortcomings of establishing treasury departments as profit centres and cost centres; The financial objectives of different organisations.
(a) Investment decisions involve the analysis and appraisal of capital expenditure projects, acquisitions, mergers and disinvestments, together with the related committal of funds; also decisions relating to working capital and trade investments, with the aim of maintaining satisfactory returns for the entity. Financial controllers will assess the likely cash flows of the various alternatives and identify the one with the maximum net present value. Financing decisions relate to obtaining suitable and adequate funds with which to operate the entity, and to the desired level of gearing represented by the most appropriate combination of short-, medium- and long-term debt, together with equity, including internally generated funds. If capital needs to be raised the entity will seek that mix of sources that minimises the weighted average cost of capital. Dividend decisions are based in part on making payments to shareholders that will currently satisfy their desired long-term rate of return and thereby help to maintain the entity’s share price. They are also based in part on retaining sufficient profits to sustain and advance the level of operations to secure shareholders’ aspirations for the future. The key decision is whether shareholders would be better off having money now or allowing it to be reinvested in the entity to produce a higher level of cash flow in future. The three kinds of decision are subsets of comprehensive financial management and are linked by the twin foundations thereof: cash flow and the cost of capital. Financial management is about heeding the discipline of the market economy (that only enterprises that can offer the prospect of an adequate return will be able to raise the money required to fund their growth) and translating it into a criterion for the deployment of funds (to business opportunities that offer the prospect of an adequate return, that is, 2006.1
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in excess of the cost of capital). On this (dynamic) basis, dividends reflect the amount of cash not required for investment or reducing borrowings. (b) In summary, a treasurer handles the acquisition and custody of funds, whereas the controller has responsibility for accounting, reporting and control. The CIMA Official Terminology describes treasury management as the function concerned with the provision and use of finance. The main functions of such a department include: – establishment of corporate financial objectives; – managing the entity’s liquid assets – cash, marketable securities, etc.; – managing the entity’s funding – determination of policies, identifying sources and types of funds; – corporate finance and related issues, such as taxation, pension fund investment, etc. (although these functions are sometimes performed by the controller); – (in a multinational) dealing with currency management – dealing in foreign currencies, hedging currency risks, etc. The financial control function is concerned mainly with the recording and reporting of financial information such as: – preparation of budgets and budgetary control; – preparation of periodic financial statements such as monthly accounts and annual accounts; – management and administration of activities such as payroll and internal audit (which in some cases may be a separate department responsible directly to the finance director). From the above it appears that treasury has the main responsibility for setting corporate objectives and policy, and financial control has the responsibility for implementing policy and ensuring the achievement of corporate objectives. This distinction is probably far too simplistic: in reality, both departments will make contributions to both determination and achievement of objectives. There is a circular relationship, in that treasurers quantify the cost of capital, which controllers use as the criterion for the deployment of funds; and controllers quantify projected cash flows, which in turn trigger treasurers’ decisions to employ capital. In smaller entities the functions of treasury and financial control may be combined, and even in larger entities the two roles often include related activities – for example, management of cash. Although the controller has the main reporting responsibilities, the treasurer will typically report on cash flows and cash management. In some cases, ownership of responsibility for certain activities is not clear-cut. For example, credit control, taxation, insurance and pensions are sometimes handled by the treasury department, sometimes by the controller’s department.
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2
Financial Management
LEARNING OUTCOMES After completing this chapter you should be able to:
identify and evaluate optimal strategies for the management of working capital;
identify and evaluate key success factors in the management of the finance function and its relationship with stakeholders
discuss the role and management of the treasury function.
2.1 Introduction Financial management is defined in CIMA’s Official Terminology as follows: ‘The management of all the processes associated with the efficient acquisition and deployment of both short- and long-term financial resources’. We begin this chapter with a discussion of the finance function, which in larger entities is likely to be split into financial control and treasury. This is followed by a discussion of the efficiency of capital markets. We consider key success factors by which stock market analysts measure performance and conclude with an evaluation of the strategies for the management of working capital.
2.2 The finance function In a large entity the finance function may be split between treasury and financial control, with both functions reporting to the chief financial officer. The financial control function will be concerned primarily with the allocation and effective use of resources, and will have responsibility for investment decisions. The treasury function is usually responsible for obtaining finance and managing relations with the financial stakeholders of the entity who will include shareholders, fund lenders, and taxation authorities. 61
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The relationship between financial control and treasury is often blurred, but two examples of the relationship may be: 1. The treasurer is best able to assess the cost of capital and quantify the entity’s aversion to risk, while the financial controller relates these factors to group strategy. 2. The financial controller identifies the entity’s currency risks, while the treasurer advises on the best means to hedge the risk.
2.2.1
Financial control
The main activities of the financial controller, or chief accountant, include: • • • • •
preparation of financial reports to all internal and external stakeholders preparation and control of budgets management of pricing policies preparation of investment appraisals management of working capital. The roles of the financial controller may be described as:
• Scorekeeper – processing transactions and maintaining accounting records at low cost and delivering efficient month-end reporting processes. • Communicator – explaining the business story to internal and external stakeholders. • Caretaker – ensuring effective operation of governance and control. For entities listed in USA, this will include ensuring compliance with the Sarbanes-Oxley Act. This requires the annual report of an entity to include an internal control report that contains an assessment of the effectiveness of the internal control structure and procedures for financial reporting. • Business partner – providing the business with insight and advice on competitive issues, developing strategy and plans, and operating as business advisor.
2.2.2 Evaluating key success factors in the management of the finance function There are many methods of measuring the success of the finance function; two are identified here. Balanced scorecard This is an approach that emphasises the need to provide information that addresses all relevant areas of performance in an objective and unbiased fashion. The Balanced Scorecard was developed by Prof. Robert S. Kaplan and Dr David P Norton at the Harvard Business School. It was designed to improve performance measurement systems by providing alternatives to managing performance exclusively through financial measures. The Balanced Scorecard sets out a framework for measuring an entity’s mission and strategy in terms of four key perspectives: • Customer satisfaction – Success is measured by the strength of relationships between the finance function and other stakeholders, and the customers assessment of the quality of service provided. 2006.1
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Benchmarking The relative performance of the finance function could be measured by benchmarking against finance functions in other entities. Alternately, in a large entity, the finance functions in subsidiary entities could be benchmarked against each other.
2.2.3 Relationships with stakeholders Business complexity is increasing, driven by a range of factors including greater governance and regulation, and the intensifying competition brought about by globalisation and emerging technologies. More is now expected of the finance function. Boards of directors are looking to finance directors to: • • • •
add value by contributing to business strategy; manage financial risk; reduce costs and work more efficiently; ensure effective compliance with more exacting governance regulations.
Managers want more timely and relevant input to improve the quality of their decisions. They also want better methods of planning, managing and monitoring performance. Investors want to see that the entity has delivered the results projected and made good use of resources. As a result, financial management now often involves much more than handling every transaction as quickly as possible or ensuring the financial accounts are accurately represented. The finance function may also provide a wide range of support services and become an integral part of the entity’s decision-making processes.
2.2.4
Outsourcing and shared service centres
In response to the pressures discussed in section 2.2.3 many finance directors are restructuring their operations and enhancing their capability to take on a wider remit. Process change enables cost to be driven out through standardisation, while further financial benefit may be derived by outsourcing transactional activities associated with finance and accounting. An alternative to outsourcing is to move support functions such as human resources, finance and procurement into shared service centres in order to enhance services and cut costs.
2.3 The treasury function The establishment of a specialist treasury function within the finance department can be traced back to the late 1960s. Developments in technology, the breakdown of exchange controls, increasing volatility in interest rates and exchange rates, combined with the increasing 2006.1
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• Enhancement of internal processes – This considers what processes must be carried out to achieve the financial and customer objectives. • Financial – Indicators of success might include the frequency of forecasts and average preparation times for key elements of the business planning processes. • Learning and growth – This considers the ability of the entity to adapt to change, and the development of the finance function staff ’s competences.
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globalisation of business have all contributed to greater opportunities and risks for entities. To survive in today’s complex financial environment, entities need to be able to actively manage both their ability to undertake these opportunities, and their exposure to risks. A separate treasury function is more likely to develop the appropriate skills, and it should also be easier to achieve economies of scale; for instance, in achieving lower borrowing rates, or netting-off balances. In larger entities, treasury will usually be centralised at head office, providing a service to all the various units of the entity and thereby achieving economies of scale, for example, by obtaining better borrowing rates, whereas financial control is frequently delegated to individual units, where it can more closely impact on customers and suppliers and relate more specifically to the competition that those units have to face. As a result, treasury and financial control may often tend to be separated by location as well as by responsibilities.
2.3.1
The role of the treasury function
The key responsibilities of the treasury function are: ●
●
●
●
Banking. The treasurer will be responsible for managing relationships with the banks. In this book we view this function as an integral part of the three other functions identified below, and it is considered within the chapters covering those specific functions. Liquidity management. This will involve working capital and money management. The treasurer will need to ensure that the entity has the liquid funds it needs, and invests surplus funds. Funding management. Funding management is concerned with identifying suitable sources of funds, which requires knowledge of the sources available, the cost of those sources, whether any security is required, and management of interest rate risks. Currency management. The treasurer would be responsible for providing the entity with forecasts of exchange rate movements, which in turn will determine the procedures adopted to manage exchange rate risks. Dealing in the foreign exchange markets and day-to-day management of foreign exchange risks becomes a key function for the treasurer.
The treasurer’s responsibilities can also be categorised according to the three levels of management: ●
●
●
strategic, for example, matters concerning the capital structure of the entity and distribution/retention policies, the actual raising of capital, including share issues, the assessment of the likely return from each source and the appropriate proportions of funds from each source, the decision as to the level of dividends, and consideration of alternative forms of finance; tactical, for example, the management of cash/investments and decisions as to the hedging of currency or interest rate risk; operational, for example, the transmission of cash, placing of ‘surplus’ cash and other dealings with banks.
Treasurers require specialist skills to be able to handle effectively an ever growing range of capital instruments, for example convertible preference shares issued in the name of an offshore subsidiary, and to determine the most suitable way to protect their entity from foreign exchange risk, which demands a good knowledge of forward 2006.1
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2.3.2
Cost centre or profit centre
An area for debate is whether the treasury activities should be accounted for simply as a cost centre, or as a business in its own right, seeking to make a profit out of its activities – for example, by charging other business units in the entity for its services (and giving those business units the choice of whether they use it or a bank). The main advantages of operating treasury as a profit centre rather than as a cost centre are as follows: ●
●
Individual business units of the entity can be charged a market rate for the service provided, thereby making their operating costs more realistic. The treasurer is motivated to provide services as effectively and economically as possible to ensure that a profit is made at the market rate, for example, in managing hedging activities for a subsidiary, thereby benefiting the entity as a whole. The main disadvantages are as follows:
●
●
●
The profit concept is a temptation to speculate, for example, by swapping funds from currencies expected to depreciate into ones expected to appreciate. Management time is unduly spent in arguments with business units over charges for services, even though market rates may have been impartially checked (say by internal audit department). Additional administrative costs may be excessive.
The decision as to whether to operate treasury as a profit centre may well depend on the particular ‘style’ of the entity and the extent of centralisation or decentralisation of its activities.
Example: Treasury management at J Sainsbury The annual report of J Sainsbury for 2004 states: Treasury policies are reviewed and approved by the Board. The Chief Executive and Finance Director have joint delegated authority from the Board to approve finance transactions up to £300m and responsibility for monitoring treasury activity and performance. The group’s central treasury function operates as a cost centre with responsibility for funding, interest rate and currency risk management and cash management. Group policy permits the use of derivative instruments but only for reducing exposures arising from underlying business activity and not for speculative purposes.
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markets and an ability to select the most appropriate methods of hedging and foreign exchange cover. They also need a knowledge of taxation in all areas in which the entity operates and, deriving from that, the ability to advise effectively on policies such as transfer pricing in permissible ways to minimise overall tax liability, and to be able to liaise competently with the entity’s taxation department. The capacity to make large gains or losses is enormous: a treasurer can wipe out, in a few hours, all the profit made from making and selling things over several months. It is important, therefore, that authority and responsibility associated with the treasury function are carefully defined and monitored. This becomes even more important as the range of derivatives increases. Senior managers need to be aware of which risks are being carried, which laid off, and, where appropriate, taken on. Changes in the value of derivatives can have a major impact on reported profit, and need expert management.
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2.4
Financial markets
Financial assets and claims on financial assets are traded in financial markets. Nowadays there may be no physical marketplace, transactions taking place by telecommunications. The major financial centres throughout the world will, typically, have three (or possibly four) financial markets. These are as follows.
2.4.1
Money market
The money market is the market for trading in relatively short-dated funds, usually for less than one year. These markets are dominated by the major banks and other financial institutions. Large companies will also borrow and lend on the money market. The term ‘money market’ encompasses the markets for trading in: ● ●
●
●
●
●
●
Short-term inter-bank loans. Terms may range from overnight to 12 months or more. Short-term inter-company loans. Large companies are able to lend and borrow directly with banks on the inter-bank market. Short-term local authority debt instruments. Local authorities have a requirement for short-term cash, with terms ranging from overnight to twelve months or more. Interest would be payable on these instruments. Bills of exchange. Bills of exchange enable suppliers to receive the benefit of payment will before the customer actually pays. Certificates of deposit. Certificates of deposit (CDs) are issued by banks at a fixed interest rate for a fixed term, usually up to 90 days. CDs are tradeable. Commercial paper. Large profit-making entities may issue unsecured short-term loan notes, referred to as commercial paper. These loan notes will generally mature within nine months, typically between a week and three months. The notes can be traded at any time before their maturity date. Eurocurrency. Banks lend and borrow in foreign currencies.
2.4.2
Capital or securities market
Capital or securities markets trade in longer-dated securities (usually over twelve months) such as shares and loan stocks. Examples of capital markets would be the Stock Exchange, the bond market and the Eurobond market. Capital markets have two main functions: 1. They provide a primary market for raising new capital for business, usually in the form of equity (shares) to new shareholders or existing shareholders (via rights issues). 2. They also allow trading in existing securities – the secondary market. This is an important function as it provides investors with a means of selling their investments should they wish to. In the UK, the London Stock Exchange is the principal trading market for long-dated securities. It controls and regulates two markets: 1. the Official List or Main Market, which deals in the securities of larger, more established companies; 2006.1
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The London Stock Exchange is also the market for government securities (gilts). Flotation Flotation is the process of making shares available to investors by obtaining a quotation on the Stock Exchange.
Exercise 2.1 Before reading the solution see if you can list the main advantages and disadvantages of flotation for an entity.
Solution There are a number of advantages and disadvantages of a flotation on the Stock Exchange.
Advantages of flotation ●
● ●
● ●
Once listed, the market will provide a more accurate valuation of the entity than had been previously possible. Realisation of paper profits. Raise profile of entity, which may have an impact on sales, credibility with suppliers and long-term providers of finance. Raise capital for future investment. Makes employee share schemes more accessible.
Disadvantages of flotation ● ●
● ● ●
Costly for a small entity (flotation, underwriting costs, etc.). Investors perceive small companies to be riskier and therefore may require higher returns if they are to be attracted at all. Making enough shares available to allow a market. Reporting requirements are more onerous. Stock Exchange rules for obtaining a quotation on the full market are quite stringent.
A private entity seeking a stock market quotation may obtain a listing on the Alternative Investment Market initially, with the intention of progressing to the Official List at a later date.
2.4.3 The foreign exchange market The foreign exchange market is a market for trading in currencies. Deals here may be for immediate delivery (spot deals) or for future delivery (forward deals). 2006.1
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2. the Alternative Investment Market (AIM), which deals in the securities of smaller, less wellestablished companies. The compliance rules and costs of this market are less onerous than for the Official List.
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2.4.4 Derivatives markets An example of a fourth type of market is the London International Financial Futures and Options Exchange (LIFFE) where derivatives are traded. Derivatives is a generic term for a range of traded financial instruments that have developed from securities, commodity and currency trading. Examples of derivatives are options and swaps. These can be used as hedging devices, to reduce risks, or simply for speculation.
2.5
Share price volatility
An example of the volatility of today’s business environment, of particular interest to financial managers, is that displayed by the prices at which the shares of publicly quoted entities change hands. The return from such an investment is the reward required by investors and equates to the dividend plus the capital gain. The required reward will reflect the level of risk undertaken by the investor. In terms of this return on investment, the dividend is dwarfed by the potential for capital gains (or losses). In recent years, for example, the dividend yield on UK shares has been around 4 per cent per annum, but it has not been unusual for the price of a share in a particular entity to rise or fall by 50 per cent in a year. Anyone able to predict such movements would become very wealthy indeed! There are people who claim to be able to do so, their techniques ranging from interpretation of zodiac horoscopes though to more sophisticated computer based techniques.
2.5.1
Technical analysis or chartism
Technical analysts or chartists believe future prices can be charted and a pattern identified that can be used to predict future prices. Technical analysis: The analysis of past movements in the prices of financial instruments, currencies, commodities etc, with a view to, by applying analytical techniques, predicting future price movements. (Official Terminology, 2005).
2.5.2 Fundamental analysis The fundamental theory of share valuation states that the value of a share will be equal to the discounted present value of the future expected dividends from the share, discounted at the shareholders’ cost of capital. Fundamental analysis: Analysis of external and internal influences upon the operations of an entity with a view to assisting in investment decisions. Information accessed might include fiscal/monetary policy, financial statements, industry trends, competitor analysis etc. (Official Terminology, 2005) Fundamental analysts will assess whether a share is undervalued or overvalued and recommend buying or selling accordingly. 2006.1
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Despite the considerable efforts made in this area, however, it is significant that the majority of funds underperform the index of the equity market as a whole. This has led many practitioners (e.g. pension fund trustees) to choose passive management, i.e. buying and holding a selection of shares representative of the market as a whole. There has also been a significant increase in the number of ‘tracker’ funds in recent years. These are funds that provide a return in line with the stock market as a whole. They do this by investing in all the entities in the stock market, or investing in a representative sample of those entities. On the available evidence, it is not surprising that theorists have developed the idea that the progress of a particular share price is a ‘random walk’, rendering the achievement of consistently superior returns an impossibility. In other words, tomorrow’s share price is independent of today’s share price.
2.6
The efficient market hypothesis
The purpose of a stock market is to bring together those people who have funds to invest with those who need funds to undertake investments. Entities seeking to raise equity are asking investors for a permanent investment as equity shares have no redemption date. Investors may not be encouraged to invest on these terms unless they can be convinced that they will be able to realise their investment at a fair price at any time in the future. For this to happen, stock markets must price shares efficiently. Efficient pricing means incorporating into the share price all information that could possibly affect it. In an efficient market investors can buy and sell shares at a fair price and entities can raise funds at a cost that reflects the risk of the investments they are seeking to undertake. A considerable body of finance theory has been built on the hypothesis that, in an efficient market, prices fully and instantaneously reflect all available information. The efficient market hypothesis (EMH) is therefore concerned with information and pricing efficiency. Three levels or forms of efficiency have been defined: these are dependent on the amount of information available to the participants in the market.
2.6.1
Weak form
The EMH in its weak form says that the current share price reflects all the information that could be gleaned from a study of past share prices. If this holds, then no investor can earn above-average returns by developing trading rules based on historical price or return information. This form of the hypothesis can be related to the activities of chartists using technical analysis. The EMH in its weak form questions the value of technical analysis, as share prices will move randomly if the market shows weak form efficiency. The weak form of the efficient market hypothesis has been tested by subjecting series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether trading rules enable above-average returns to be earned. These tests attempt to determine if it is possible to earn above-average returns by following standardised trading rules. 2006.1
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2.5.3 Random Walk Theory
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2.6.2
Semi-strong form
The semi-strong form of the EMH says that the current share price will not only reflect all historical information, but will also reflect all other published information. If this holds, then no investor can be expected to earn above-average returns from trading rules based on any publicly available information. This form of the hypothesis can be related to fundamental analysis. Fundamental analysis attempts to identify over- or undervalued entities through studying publicly available information. The EMH in the semi-strong form suggests that any publicly available information will already be captured in the current share price. Studies have shown that it is not possible to benefit from always buying shares when good news is published. This is explained by the fact that the speed at which the market reacts to public information is so rapid that individual investors cannot adopt a policy that will consistently result in exceptional profits from a quick reaction to good news.
2.6.3 Strong form The strong form of the EMH says that the current share price incorporates all information, including non-published information. This would include insider information and views held by the directors of the entity. If this holds, then no investor can earn aboveaverage returns using any information whether publicly available or not. It is difficult to test this proposition as with ‘insider information’ it should be possible to gain some advantage. A member of staff involved in a takeover bid could predict the likely movement in the share price of the entities concerned. It would then be possible to buy or sell shares in the entities before the details of the takeover bid were published. As ‘insider trading’ is illegal in many countries, it is difficult to test this form of the EMH.
2.6.4 Implications of EMH for financial managers If capital markets are efficient, the main implications for financial managers are: ● ● ●
the timing of issues of debt or equity is not critical, as the prices quoted in the market are ‘fair’; an entity cannot mislead the markets by adopting ‘creative accounting’ techniques; the entity’s share price will reflect the net present value of its future cash flows, so managers must only ensure that all investments are expected to exceed the company’s cost of capital. A summary of the hypothesis is as follows:
● ●
●
the weak form of efficiency is where share prices reflect all historical information; the semi-strong form of efficiency is where share prices reflect all publicly available information; the strong form of efficiency is where share prices reflect all information (public and internal) and is the perfect information environment.
The more efficient the market is, the less the opportunity to make a speculative profit. If the market displays strong-form efficiency, it becomes impossible to consistently outperform the market. Research has suggested that the UK capital markets are efficient in the semi-strong form. Abnormal gains may be made from what is called insider dealing, where an investor obtains internal information about the entity and purchases or sells shares based on that information. Insider dealing is an offence in the UK in order to protect the stability of the capital markets. 2006.1
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2.7 Investor ratios Investors will wish to assess the performance of the shares they have invested in: over time, against competing entities in the same sector, and against the market as a whole. There are a number of ratios which will be of specific interest to investors. The use of the market price of equity is an important component of this type of analysis.
2.7.1 Market price per share The market price (MPS) used throughout Management Accounting: Financial Strategy is the ex-dividend market price. Ex-dividend means that in buying a share today, the investor will not participate in the forthcoming dividend payment. Sometimes in an examination, the market price may be quoted cum-dividend which means with dividend rights attached. Here the investor will participate in the forthcoming dividend if purchasing the share today. Arguably the investor will be willing to pay a higher price for the share, knowing that a dividend payment is forthcoming in the near future. The relationship between the cum-dividend price and the ex-dividend price is then: MPS (ex-dividend) MPS (cum-dividend) forthcoming dividend per share
2.7.2 Earnings per share Earnings per share (EPS) is an entity’s net profit attributable to ordinary shareholders divided by the number of ordinary shares in issue. A simple example of an EPS calculation is shown below. Example 2.A Earnings before interest and tax Interest on debt Earnings after debt interest Tax payable Earnings after tax available for distribution
£m 525 075 450 125 325
Number of shares in issue 175 million EPS
£325m 186 pence per share 175m
An important point to remember is that EPS is a historical figure and can be manipulated by changes in accounting policies, mergers or acquisitions, etc. The City and company executives 2006.1
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In some countries (e.g. Japan), however, insider dealing is not illegal and is considered to be a useful contributor to an informationally efficient market. Although there are some dissidents, the majority of observers would appear to be satisfied that the random pattern of share price movements is consistent with the semi-strong form, that is, that shares reflect all published information. Given that insider dealing is illegal, they say, that is good enough: the market can be presumed to be efficient.
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occasionally appear obsessed about EPS as a performance measure, an obsession which many think is quite disproportionate to its true value. It is future earnings which should concern investors, a figure far more difficult to estimate.
2.7.3 The price/earnings ratio A common benchmark when analysing different entities is the use of the price/ earnings (P/E) ratio, which expresses in a single figure the relationship between the market price of an entity’s shares and the earnings per share. It is calculated as: Market price per share (MPS) Earnings per share (EPS) Using the figures from the EPS example above, and assuming that the entity’s current share price is 2,250p, the P/E ratio would be 2,250/186, or approximately 12. The P/E ratio is often referred to as the market capitalisation rate. This simply means that the market value of the entity’s equity can be calculated by multiplying last year’s earnings per share by the P/E ratio (to give the share price), then multiplying by the number of shares in issue.
2.7.4 Earnings yield The P/E ratio is the reciprocal (in maths, a number or quantity divided into 1) of the earnings yield. Again, using the EPS example above, the gross earnings yield is 8.3 per cent (186/2,250 100), or 0.083. The P/E is therefore the reciprocal of this, that is, 1/0.083, or approximately 12. The market price will incorporate expectations of all buyers and sellers of the entity’s shares, and so this is an indication of the future earning power of the entity. Earnings yield EPS MPS
2.7.5 Dividend-payout rate The cash effects of payment of dividends is measured by the dividend-payout rate. Payout rate
Dividend per share (DPS) Earnings per share (EPS)
Assuming the cash dividend is 20p per ordinary share out of EPS of 40p, then the dividend-payout rate is 20/40 0.5 or 50 per cent. The relationship between the above investors’ ratios is usually that an entity with a high P/E ratio has a low dividend payout ratio as the high growth entity needs to retain more resources in the entity. A more stable entity would have a relatively low P/E ratio and higher dividend-payout ratio. When analysing financial statements from an investor’s point of view it is important to identify the objectives of the investor. Does the investor require high capital growth and high risk, or a lower-risk, fixed dividend payment and low capital growth? 2006.1
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Dividend yield will indicate the return on capital investment, relative to market price. Dividend yield
Dividend per share (DPS) Market price per share (MPS)
Assuming a dividend of 25p per ordinary share and a market price of 250p per share, then dividend yield is 25/250 0.1 or 10 per cent. Buying the share today for 250p should give the investor a return of 10 per cent for the year, based on the dividend income. Remember that the dividend represents only part of the overall return from a share. The other part of the return is the capital gain from an increase in the value of the share. The capital gain from a share may well be far more significant than the dividend.
2.7.7 Dividend cover Dividend cover measures the ability of the entity to maintain the existing level of dividend and is used in conjunction with the dividend yield. Dividend cover
Earnings per share (EPS) Dividend per share (DPS)
Assuming EPS of 50p and net dividend of 20p, then dividend cover is 50/20 2.5 times. The higher the dividend cover the more likely it is that the dividend yield can be maintained. Dividend cover also gives an indication of the level of profits being retained by the entity for reinvestment by considering how many times this year’s dividend is covered by this year’s earnings. Example 2.B Lilydale plc has 5,000,000 ordinary shares in issue. Its results for the year end are as follows:
Profit before taxation Taxation Profit after taxation Ordinary dividend – proposed Retained profit
£ 750,000 150,000 600,000 150,000 450,000
The market price per share is currently 83p cum-dividend. The tax credit on dividends is currently 10 per cent.
Requirements Calculate the following ratios: (i) (ii) (iii) (iv)
price/earnings; dividend payout; dividend yield; and dividend cover. 2006.1
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2.7.6 Dividend yield
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Solution Earnings per share
Dividend per share
600,000 Profit after tax 12p 5,000,000 Number of shares Ordinary dividend Number of shares
MPS (ex-div) MPS (cum-div) less DPS
83p 83p 80p
(i) Price earnings
MPS 80 6.7 EPS 12
(ii) Dividend payout
DPS 3 25% EPS 12
(iii) Dividend yield
DPS 3 3.75% EPS 80
(iv) Dividend cover
EPS 12 4. DPS 3
2.7.8
150,000 3p 5,000,000
Book value per share
From a capital point of view the balance sheet may be used in computing ratios for the investor. The book value per share indicates the asset backing of the investment Shareholders’ funds Number of equity shares in issue at the balance sheet date Assume shareholders’ funds of £2.5 million and number of equity shares in issue to be 5 million, then the asset book value per ordinary share is 2.5/5.0 £0.5, or 50p per share. Note that shareholders’ funds for this calculation must be those attributable to equity, that is, the ordinary shareholders. However, this must be interpreted with care: 1. The valuation of the balance sheet may be based on historical cost values. Other valuations of assets may be more informative. 2. The ratio may be irrelevant in service-based entities where the major asset is the quality of staff and other intangibles which may not be included in the balance sheet. The book value per share may be compared to the market value per share to determine the market’s evaluation of the entity.
2.8 Working capital management strategies In CIMA’s Official Terminology, working capital is defined as: Working capital: The capital available for conducting the day-to-day operations of an entity; normally, the excess of current assets over current liabilities. In accounting terms, this is a static balance sheet concept, referring to the excess – at a particular moment in time – of permanent capital plus long-term liabilities over the fixed 2006.1
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●
●
the appropriate level of investment in, and mix of current assets to be decided upon, for a set level of activity – this is the investment decision; the methods of financing this investment – the financing decision.
2.8.1 The investment decision All entities, to one degree or another, require working capital. The actual amount required will depend on many factors, such as the age of the entity, the type of business activity, credit policy, and even the time of year. There is no standard fixed requirement. It is essential that an appropriate amount of working capital is budgeted for to meet anticipated future needs. Failure to budget correctly could result in the business being unable to meet its liabilities as they fall due. If an entity finds itself in such a situation, it is said to be technically insolvent. In conditions of uncertainty entities must hold some minimal level of cash and inventories based on expected revenue, plus an additional safety buffer. With an aggressive working capital policy, a firm would hold minimal inventory. Such a policy would minimise costs, but it could lower revenue because the firm may not be able to respond rapidly to increases in demand. Conversely, a conservative working capital policy would call for large inventory. Generally, the expected return is lower under a conservative policy than under an aggressive one, but the risks are greater under the aggressive policy. A moderate policy falls somewhere between the two extremes in terms of risk and returns.
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assets of the business. As such, it depends on accounting rules, such as what is capital and what is revenue, what constitutes a retained profit, the cut-off between long term and short term (12 months from the balance sheet date for published accounts), and when revenue should be recognised. If working capital, thus defined, exceeds net current operating assets (inventory plus receivables less payables) the entity has a cash surplus (usually represented by bank deposits and investments); otherwise it has a deficit (usually represented by a bank loan and/or overdraft). On this basis, therefore, the control of working capital can be subdivided into areas dealing with inventory, receivables, payables and cash. An entity must be able to generate sufficient cash to be able to meet its immediate obligations and therefore continue trading. Unprofitable entities can survive for quite some time if they have access to sufficient liquid resources, but even the most profitable entity will quickly go under if it does not have adequate liquid resources. Working capital is therefore essential to the entity’s long-term success and development, and the greater the degree to which the current assets cover the current liabilities, the more solvent the entity. The efficient management of working capital is important from the points of view of both liquidity and profitability. Poor management of working capital means that funds are unnecessarily tied up in idle assets, hence reducing liquidity, and also reducing the ability to invest in productive assets such as plant and machinery, so affecting profitability. An entity’s working capital policy is a function of two decisions:
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With an aggressive financing policy, the entity finances part of its permanent asset base with short-term debt. This policy generally provides the highest expected return (because shortterm debt costs are typically less than long-term costs) but it is very risky. Under a conservative financing policy, the entity would have permanent financing (long-term debt plus equity) which exceeds its permanent base of assets. The conservative policy is the least risky but also results in the lowest expected return. The maturity matching policy falls between the two extremes. There is a basic difference between cash and inventories on the one hand, and receivables on the other. In the case of cash and inventories, higher levels means a safety buffer, hence a more conservative position. There is no such thing as a ‘safety buffer of receivables’, and a higher level of receivables in relation to revenue would generally mean that the entity was extending credit on more liberal terms. If we characterise aggressive as being risky, then lowering inventories and cash would be aggressive but raising receivables would also be aggressive. The financing of working capital depends upon how current- and non-current asset funding is divided between long-term and short-term sources of funding. Three possible policies exist, and these are shown in Figures 2.1–2.3. A conservative policy is where all of the permanent assets – both non-current assets and the permanent part of the current assets (i.e. the core level of investment in inventory and receivables, etc.) – are financed by long-term funding, as well as part of the fluctuating current assets. Short-term financing is used only for part of the fluctuating current assets.
Figure 2.1
Figure 2.2 2006.1
Conservative financing policy
Aggressive financing policy
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Figure 2.3
Moderate financing policy
An aggressive policy for financing working capital uses short-term financing to fund all the fluctuating current assets as well as some of the permanent part of the current assets. This policy carries the greatest risk of illiquidity, as well as the greatest returns. A moderate policy matches the short-term finance to the fluctuating current assets, and the long-term finance to the permanent part of current assets plus non-current assets.
2.8.3
Liquidity ratios
Liquidity refers to the amount of cash in hand or readily obtainable to meet payment obligations. Liquidity ratios indicate the ability to meet liabilities from available assets and are calculated from balance sheet information. The most commonly used are the current ratio and the quick ratio. The current ratio
The current ratio is the ratio of current assets divided by current liabilities: Current ratio current assets current liabilities The current ratio provides a broad measure of liquidity. A high current ratio would suggest that the business would have little difficulty meeting current liabilities from available assets. However, if a large proportion of current assets is represented by inventory, this may not be the case as inventory is less liquid than other current assets. The quick ratio
The quick ratio, or acid test, indicates the ability to pay suppliers in the short term. The quick ratio recognises that stock may take some time to convert into cash and so focuses on those current assets that are relatively liquid. Quick ratio
current assets inventory current liabilities
There are no general norms for these ratios and ‘ideal’ levels vary depending on the type of business being examined. Manufacturers will normally require much higher liquidity ratios, than retailers. When analysing these liquidity ratios, the absolute figure calculated for a particular year is less important. 2006.1
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2.8.4
The operating cycle
The operating cycle is the length of time between the entity’s outlay on raw materials, wages and other expenditures, and the inflow of cash from the sale of the goods. In a manufacturing business this is the average time that raw materials remain in stock less the period of credit taken from suppliers plus the time taken for producing the goods plus the time the goods remain in finished inventory plus the time taken by customers to pay for the goods. On some occasions this cycle is referred to as the cash cycle. This is an important concept for the management of cash or working capital because the longer the operating cycle, the more financial resource the entity needs. Management needs to watch that this cycle does not become too long. The operating cycle can be calculated approximately as shown in the calculation below. Allowances should be made for any significant changes in the level of stocks taking place over the period. If, for example, the entity is deliberately building up its level of inventory, this will lengthen the operating cycle. Calculation of the operating cycle
Raw materials
Days
Number of days raw materials inventory
average value of raw material stock purchase of raw materials per day
x
Less: Period of credit granted by suppliers
Period of production
Number of days of finished goods stock
Period of credit taken by customers
average trade payables purchase of raw materials per day average value of work in progress average cost of goods sold per day average value of stock of finished goods average cost of goods sold per day average trade receivables average value of sales per day
Total operating cycle
(x)
x
x
x x
Exercise 2.2 The table below gives information extracted from the annual accounts of Davis plc for the past two years. You are required to calculate the length of the operating cycle for each of the two years. Davis plc – Extracts from annual accounts
Inventory: Raw materials Work in progress Finished goods Purchases Cost of goods sold Revenue Receivables Accounts payable 2006.1
Year 1 £ 108,000 75,600 86,400 518,400 756,000 864,000 172,800 86,400
Year 2 £ 145,800 97,200 129,600 702,000 972,000 1,080,000 259,200 105,300
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Year 1 % Raw materials stockholding (raw materials stock purchases) Less: Finance from suppliers (accounts payable purchases) Production time (work in progress cost of sales) Finished goods stockholding (finished goods stock cost of sales) Credit given to customers (receivables revenue)
Days
Year 2 %
Days
20.83 365
76
20.77
76
16.67 365
61 15
15.00
55 21
10.00 365
37
10.00
37
11.43 365
42
13.33
49
20.00 365 073 167
24.00
088 195
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Solution
79
Note that, owing to the nature of the simplified information provided, end-of-year values – rather than average values – have been used for inventories, receivables and payables. The percentages calculated are multiplied by 365 to give figures expressed in numbers of days. A number of steps could be taken to shorten the operating cycle: • Reduce raw materials stockholding This may be done by reviewing slow-moving lines and reorder levels. Inventory control models may be considered if not already in use. More efficient links with suppliers could also help. Reducing inventory may involve loss of discounts for bulk purchases, loss of cost savings from price rises, or could lead to production delays due to stockouts. • Obtain more finance from suppliers by delaying payments This could result in a deterioration in commercial relationships or even loss of reliable sources of supply. Discounts may be lost by this policy. • Reduce work in progress by reducing production volume (with resultant loss of business and the need to cut back on labour resources) or improving production techniques and efficiency (with the human and practical problems of achieving such change). • Reduce finished goods inventory perhaps by reorganising the production schedule and distribution methods. This may affect the efficiency with which customer demand can be satisfied and result ultimately in a reduction of revenue. • Reduce credit given to customers by involving and following up outstanding amounts more quickly, or possibly offering discount incentives. The main disadvantages would be the potential loss of custom as a result of this policy. The volume of receivable balances could be cut by a quicker collection of debt; finished goods could be turned over more rapidly; the level of raw materials inventory could be reduced or the production period could be shortened. The operating cycle is only the time span between production costs and cash returns; it says nothing in itself about the amount of working capital that will be needed over this period. In fact, less will be required at the beginning than at the end.
2.9 Overtrading Overtrading is defined in CIMA’s Official Terminology as follows: ‘The condition of an entity’s which enters into commitments in excess of its available short-term resources. This can arise even if an entity is trading profitably and 2006.1
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is typically caused by financing strains imposed by a lengthy operating cycle or production cycle.’ Overtrading refers to the situation of operating an entity with insufficient long-term capital resources to support the current volume of business. Although there are many potential causes of overtrading, over-expansion is one of the main causes, hence the alternative term ‘under-capitalisation’. A rapidly expanding business will require additional levels of inventory and receivables to support the expansion. If the increases in working capital requirements are permanent, they should be financed from additional long-term capital. If, however, the expansion is financed from a bank overdraft and a shorter operating cycle, the business could easily run into serious liquidity problems. Increases in output are often obtained by more intensive utilisation of existing noncurrent assets, and growth tends to be financed by more intensive use of working capital. Overtrading companies are often unable or unwilling to raise long-term capital and thus tend to rely more heavily on short-term sources such as accounts payable and bank overdrafts.
2.9.1
Symptoms of overtrading
The common symptoms of overtrading are: • • • • • • • • •
there is a fall in liquidity ratios; there is a rapid increase in revenue; there is a sharp increase in the sales to non-current assets ratio; there is an increase in inventory in relation to revenue; there is an increase in receivables; there is an increase in the accounts payable period; there is an increase in short-term borrowing and a decline in cash balances; there is an increase in gearning; the profit margin decreases.
2.9.2
Preventing overtrading
Overtrading can result in the failure of an entity through liquidity problems. A possible solution is to reduce the level of revenue. This will mean either turning profitable business away, or increasing selling prices, which may decrease demand and increase profits. Alternatively, tight control could be introduced to ensure that the inventory levels are reduced and outstanding debts collected to improve the liquidity position of the firm. Another possibility is to increase the capital by introducing more capital through increased investment by the owners. Long-term loans could also be a solution to the problem.
2.10 Multinational working capital management The aims of a multinational entity in relation to cash management will be similar to those for a purely domestic entity, which will be to: ● ●
ensure fast collection of cash; take larger to pay out cash;
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●
optimise cash flow within the entity; generate the best return on cash surpluses.
Achieving these aims will be more difficult in a multinational entity due to the longer distances involved, the number of parties involved, and the risk of governments placing restrictions on the transfers of funds out of certain countries. Granting credit is often an essential condition to undertake international business. In addition to the normal risks of default firm granting credit, exchange rate fluctuations between the time of sale and the time the debt is collected provide an additional risk. Management of inventory is also similar to but more complex than for a purely domestic enterprise. The balance between minimising inventory and being able to meet customer demands is more difficult to judge. The movement is exchange rates will also influence the timing of purchases, and the level of inventory held in a particular currency. Political risk is a further consideration; multinationals will need to allow for the prospect of import or export quotas or tariffs being imposed. In certain countries, the risk of expropriation of inventory will lead to minimal inventory holdings being maintained. Some countries have property taxes on assets, including inventory, where the tax payable is based on holdings on a particular date in the year, which again will influence the strategy adopted for inventory management by a multinational.
2.11 Summary This chapter has described the two principal rules within the financial management function, that is, treasury and financial control, pointing out their relationships and respective duties. Financial markets and their efficiency have been examined. An efficient capital market is one in which share prices move rationally, and reflect all information that could affect the price. Conservative and aggressive financing and investment strategies for working capital have been evaluated.
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2
Readings
The article below discusses the volatility in the UK and US stock markets during the first quarter of 2000. In doing so, it raises questions about the validity of fundamental analysis and the efficient market hypothesis.
Volatility unvanquished Phillip Coggan, Financial Times, 8/9 April 2000. © Financial Times. Reproduced by permission.
Remember those 1960s and 1970s sci-fi films where giant computers - the kind that filled a whole room – plotted to take over the world? Maybe it is time for some sequels. This week investors suffered Turbulent Tuesday, when the tech stocks on the UK Nasdaq market briefly fell nearly 14 per cent, before recovering. Then there was Washed-Out Wednesday when a computer problem at the London Stock Exchange meant that trading could not even start until the middle of the afternoon. Perhaps we have had a glimpse of the computers’ master plan. Cause so much stress among the human population that we all die out – and leave them to take control. It is certainly as plausible an explanation as any other. Tough to argue the case for an efficient market made up of rational investors when the same stocks trade in a 14 per cent range within a matter of hours. Can earnings expectations have altered so much so quickly? It is also hard to believe in a ‘new era’ of highly productive technology when the stock exchange in one of the world’s leading financial centres can crash for several hours. So what has really been going on? Our old friends fear and greed have certainly played their part. Investors have been buying stocks in some companies, not because they have rationally analysed the fundamentals, but because they have been going up. Some in the US have been buying on margin, i.e. borrowed money. The good news for investors is that this kind of buying can drive share prices up to unimagined heights. Fundamental analysis simply does not work. Investors do not care about the price they pay for shares because they expect someone else to pay a higher price in a month’s, or a week’s time. Witness the more than doubling in the Techmark 100 index in four short months. What had changed about the fundamentals of technology stocks in that period? Not much. The big change was in investors’ perceptions. 83
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The bad news, alas, is that when the spell fades, there can be nothing to support the shares. It can be rather like those Road Runner cartoons where Wile E Coyote runs happily over the edge of the cliff – until he suddenly looks down. Take poor old Lastminute.com. When everybody thought they were going to make their fortunes from the shares, the spread-betting firms were quoting prices of over 500p. Once the shares started trading, the magic dissipated; the price dipped below 200p this week. Nothing has changed about the business in the meantime. All this does not necessarily signal that the overall market is in for a bloodbath. There are plenty of investors who believe in ‘buying on the dips’. They have absorbed the age-old lesson that equities outperform over the long term. Thus, market dips are not a cause for panic but a buying opportunity. That has been a pretty good general rule but it is worth remembering that there have been occasions – Wall Street during 1929–32 or the UK in 1972–74, for example – when investors needed immense patience for it to come right. Investors who bought into the Tokyo stock market in 1989 are still waiting. For the moment, the old economy gets the benefit whenever the new economy suffers and vice versa, leaving indices like the FTSE 100 stuck in a trading range. Credit Suisse First Boston points out that the nine, largely new economy, stocks that joined the Footsie on March 6 have underperformed the market by an average of 32 per cent, while the old economy groups that were dumped out of the index have outperformed by 23 per cent. Investors may also have been getting more selective, looking for the new economy stocks with established brands or strong niches, and discarding those that never looked like making a profit. They have also started to realise there are plenty of old-economy businesses that will not suffer from the internet (and there are even some that will benefit). This is a pretty healthy development but it seems unlikely that stock markets have seen the last of the kind of volatility that dominated events this week. Interest rates are still likely to rise in the US, Europe and the UK (although the Bank of England left them on hold on Thursday). New economy stocks (technology, media and telecoms) still, as a group, trade on very fancy price–earnings ratios, which suggests that there may be a lot of scope for disappointments at the individual company level. The UK market will also lose shortly the support from the ‘ISA effect’ – the end of tax year cash flows into individual savings accounts that tend to keep the market buoyant in March and April. As if the first quarter has not been exciting enough, investors could be in for a testing summer. Perhaps the computers are running amok after all.
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2
Question 1 (a) Explain the weak form of the efficient market hypothesis (EMH). (4 marks) (b) Outline and appraise the empirical research undertaken to test the validity of the weak form of EMH. (4 marks) (c) If the capital markets are efficient, this has implications for corporate finance. Discuss the implications for the financial manager of a large profit-making entity that is trying to maximise the wealth of its shareholders. (12 marks) (Total marks 20)
Question 2 ABC plc is a UK-based service entity with a number of wholly owned subsidiaries and interests in associated entities throughout the world. In response to the rapid growth of the entity, the managing director has ordered a review of the entity’s organisation structure, particularly the finance function. The managing director holds the opinion that a separate treasury department should be established. At present, treasury functions are the responsibility of the chief accountant. Requirements (a) Describe the main responsibilities of a treasury department in an entity such as ABC plc and explain the benefits that might accrue from the establishment of a separate treasury function. (12 marks) (b) Describe the advantages and disadvantages that might arise if the entity established a separate treasury department as a profit centre rather than as a cost centre. (8 marks) (Total marks 20)
Question 3 UR is a privately owned machine tool manufacturing entity based in the Rupublic of Ireland. For the past five years, it has operated an aggressive policy in respect of the management of its working capital. The following information concerns the entity’s forecast end-of-year financial outcomes if it continues with this type of policy. 85
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Receivables Inventory Cash at bank Total current assets Non-current assets Trade creditors
€000 5,200 2,150 14,350 7,700 14,500 4,500
Revenue Operating costs Operating profit
17,500 14,000 13,500
Earnings
2,625
There are 2.5 million shares in issue. The entity has been experiencing a series of problems because of the type of working capital management policy it has been following and is considering an alternative approach to working capital management. The percentage figures shown below are changes to the above forecast. These changes are anticipated to occur if a more conservative policy is adopted. Receivables Inventory Cash (figures in €000) Non-current assets Curent liabilities Forecast revenue Operating profit and earnings
40% 20% Increase to €1,000 No change 30% 5% 5%
Requirement Evaluate the two working capital management policies described above and recommend a proposed course of action. Include in your evaluation a discussion of the problems that might have arisen as a result of operating aggressive working capital management policies and the key elements to consider and actions to take before making a decision to change. You should calculate appropriate and relevant ratios or performance measures to support your arguments. [The calculations will earn up to 8 marks.] (25 marks)
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2
Solution 1 This question examines the following syllabus area: ●
The efficient market hypothesis (EMH).
(a) The weak form of EMH states that the current share price reflects all the information contained in the record of past prices. Studies have shown that share prices usually display the features of a random walk and this means that future prices do not follow past trends. This has implications for people who chart the prices of shares in fundamental analysis. Even the weak form of the EMH would make ‘charting’ a waste of time. (b) The weak form of the efficient market hypothesis has been tested by subjecting a series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether following trading rules enables above-average returns to be earned. (c) It is generally acknowledged that the prime objective of a company is to maximise the wealth of shareholders. Can financing decisions contribute to the increase in wealth of the shareholders? If the capital markets are perfect, then financing decisions will not create value. If the capital markets are efficient, on the other hand, it is possible that shareholders’ wealth could be increased by the ‘right’ decisions being made by financial managers, though it is unlikely that the benefits will be generated consistently. So managers can make investment decisions that generate positive NPVs and create value through the disequilibriums that often exist in the real markets. However, the nature of the capital markets, especially the evidence of efficiency, means that it is less likely to occur in the area of finance. If capital markets are efficient, the main implications for corporate finance are as follows: ●
● ●
It is not possible to generate a surplus by timing an issue of new securities at the ‘best’ time. A company can sell as many securities as it wishes without affecting the price. A company cannot mislead the markets by adopting ‘creative accounting’ techniques.
Efficient market theory has provided valuable insights into the functioning of the markets for financial assets. It appears to be sensible for corporate financial managers to 87
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assume that the financial markets are highly efficient and it is, therefore, important that this is taken into consideration when they develop strategic plans to create value for shareholders.
Solution 2 This question examines the following syllabus areas: ● ●
●
The role of the treasury function; The benefits and shortcomings of establishing treasury departments as profit centres or cost centres; The control of treasury departments when established as cost centres or profit centres.
Tips ●
●
A significant minority of candidates were ignorant of the treasurer’s role and confused the job’s functions with those of the financial manager/controller. Another weakness was to confuse separation with decentralisation. The question did not require a discussion of decentralisation, or devolvement to overseas subsidiaries, although candidates were given credit for making good points.
(a) CIMA Official Terminology describes the treasury function as the function concerned with the provision and use of finance. It includes provision of capital, short-term borrowing, foreign currency management, banking, collections and money-market investment. The main functions of such a department include: 1. Establishment of corporate financial objectives. 2. Managing the firm’s liquid assets: cash, marketable securities, etc. 3. Management of the company’s funding: determination of policies (e.g. on transfer pricing), identifying sources and types of funds. 4. Corporate finance and related issues such as taxation, pension fund investment, etc. 5. In a multinational such as ABC, it will also deal with currency management: dealing in foreign currencies, hedging currency risks, etc. 6. Cash management in a multinational such as ABC can involve centralised cash management and multilateral netting of foreign currency transactions between subsidiaries and associated companies. Treasury is usually a centralised function in that the relationships mentioned above are usually concentrated in head office, that is, the parent company of a group. Financial control, meanwhile, is increasingly being devolved to individual business units, so as to be close to the customer, alert to competition, etc. Where this is the situation, a separation of treasury from control is inevitable. The skills required are also different, for example, given the liberalisation of financial markets and foreign exchanges, treasurers need to be aware of the expanding range of hybrid capital instruments (e.g. convertible preference shares issued in the name of a subsidiary registered in the Dutch Antilles) and financial instruments (forward markets and the various ‘derivatives’) and to be able to select from these the ones that are appropriate to the company’s needs in the prevailing circumstances. A separate treasury function is more likely to develop the appropriate skills: it is impossible for anyone to be expert in these matters and have time to be proactively involved in the management of individual businesses. It will also 2006.1
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Solution 3 Preliminary calculations Appropriate choice could include EPS, return on net assets and the current and/or quick ratio. Other calculations could include debtors/creditors days, stock days/turnover and the operating cycle. 2006.1
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be easier to achieve economies of scale (e.g. better borrowing rates and the netting-off of balances). (b) As indicated in the answer to part (a), the case for a separation of treasury – not only from accounting but also from financial control – is a strong one. The question remains, however, as to how its performance/progress should be measured/assessed. Some people would argue for a ‘profit centre’ approach. This usually means that the treasury charges individual business units a market rate for the service it provides. If it writes currency options, for example, it charges the business unit a premium in line with that charged by the banks. It then has the task of managing that option (by buying and selling in the forward market, or by using derivatives) for a cost that leaves it with a profit. The main argument for this is that the treasurer is then motivated to do what is best for the company as a whole, that is, to minimise the cost of the operation. Spot checks are obviously required (e.g. by internal audit) to ensure that charges are indeed at market rates, since there is an imbalance in the amount of information available to the two parties (weighted in favour of the treasurers). There are obviously some administrative costs involved, but the main drawback in practice has been that some treasurers have interpreted the profit concept as encouraging them to speculate. If it can make a profit writing options, why not write them for other companies? If it understands the foreign currency markets, why not speculate – for example, swap funds from currencies expected to depreciate into ones expected to appreciate? Often spectacular gains can be made, but the record shows that spectacular losses are at least as likely. A sound internal control system is a necessity in any treasury function, but especially so when speculation is encouraged. Consequently there are many who advocate a ‘cost centre’ approach. This usually means that the costs of running the department are collected (and, no doubt, compared with budget) but that the substance of the transactions that they manage is reflected in the business unit’s books: for example, the ‘profit’ made on writing options is credited to the business for which it was written. Alternatively, the profits/losses are allowed to lie where they fall: for example, the business unit carries the profit or loss on an overseas sale (according to the spot rate when the cash is received) and the treasury carries the offsetting currency loss/gain respectively (the difference between the forward rate obtained and the eventual spot rate). This approach collects the total cost/benefit of hedging. It discourages speculation but may, by the same token, discourage initiative. Confrontation can occur when the business unit bears a loss, caused – as it sees it – by the treasury. The debate as to which method is appropriate mirrors that in various other aspects of business enterprise. Perhaps the most important observation is that the accounting model – whether it focuses on costs or profits - is insufficiently dynamic/long-termist to provide a platform for strategic control. What is required is a distinctive financial management approach.
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Policy Receivables Inventory Cash Current assets Non-current assets Current liabilities Forecast revenue Forecast profit Forecast earnings Current assets less current liabilities Net assets Earnings per share (€) Return on net assets (%) Current ratio Quick ratio Debtors days Creditors days Stock days Operating cycle Operating profit margin ROCE
Aggressive €000 5,200 2,150 2,350
€000
Conservative €000 3,120 2,580 1,000
€000
7,700 14,500 (4,500) 17,500 3,500 2,625
6,700 14,500 (3,150) 16,625 3,675 2,756
3,200 17,700
3,550 18,050
1.05 19.8 1.71 1.23 108.5 117.3 56.1 47.3 20.0 13
1.10 20.40 2.13 1.31 68.5 88.8 72.7 52.4 22.11 15
Evaluation of the alternative policies Investment in working capital is, typically, in stocks, debtors and cash or marketable securities (highly liquid, short-term assets). In conditions of uncertainty firms must hold some minimal level of cash and stock based on expected sales, plus additional safety stocks. With an aggressive working capital policy, a firm would hold minimal safety stocks. Such a policy would minimise costs, but it could lower sales because the firm could not respond rapidly to increases in demand. Conversely, a more conservative working capital policy would call for large safety stocks. There is a basic difference between cash and stock, on the one hand, and receivables on the other. In the case of cash and stock, higher levels mean higher safety stock, hence a more conservative position. There is no such thing as a ‘safety stock of receivables’, and a higher level of receivables in relations to sales would generally mean that the firm was extending credit on more liberal terms. Possible explanations for UR’s problems/difficulties of changing policy The problems UR has been experiencing are likely to be one or more of the following: ● ● ● ●
increase in bad debts because of more liberal credit policies; increased overdraft charges because the company may have unexpected cash shortfalls; stock outs because of low stock levels and, possibly, inadequate, JIT-type systems; refusal of supplies or even legal action because of late payments to creditors.
The main difficulty likely to be experienced by a change in policy is the loss of custom. This issue is discussed further below. The key elements to consider/actions to take before making a decision The implications for change could be wide-ranging and the likely effect on customer relations and sales are key considerations. The main elements to review and evaluate before a decision is taken are summarised below: 2006.1
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Industry-related characteristics, for example if competitors offer 90 days credit. It is difficult to require a shorter payment period unless you offer a much superior product or service or other unque factor. UR’s debtors’ days are at present 108.5, which seems generous and was probably the result of a campaign to increase sales under the ‘aggressive’ policy regime. This ratio would fall to 68.5 days under the proposed policy. Industry figures are not given so it is not possible to make any valid comparisons. The current ratio, even under an aggressive policy, seems high for modern working capital management. This would rise to 2.13 under the proposed policy, which might imply under-utilised current assets. Cash lying idle in a bank account is not a good use of money and again the need is to investigate cash management systems before deciding it is simply the cash balances that are too low. A detailed cash flow budget should be prepared. The use of cash management models should be considered if the company is likely to now be always in cash surplus. A review of stock control polices should be carried out to assess whether the problems are faulty systems rather than too low stock levels. The type of product or service sold. The operating cycle for UR is expected to be 47.3 days based on the information available and the existing policies are maintained. This figure would rise to 52.4 if the proposed policy were adopted. Again, industry figures are needed but transport and distribution does not have a long cycle and these figures may not be untypical. Volume of sales: organisations such as supermarkets have very high volume sales but, typically, low margin. The operating profit margin for UR is currently only 20 per cent seems low for a company such as this. This would rise to 22.1 per cent under the proposed policy, but this is fairly marginal. Level of centralisation of working capital management: the more centralised the tighter the control (usually) that allows a more aggressive approach. UR is a relatively small company and it is likely their WCM will be centralised. This would favour an aggressive policy so before a decision is taken the real reason for the problems should be reviewed and evaluated. The efficiency of the credit control department in an organisation. If the company has a long period between invoice production and despatch, it needs to recognise this in the credit period allowed. This is unknown from the information in the question, but the 108.5 debtor’s days suggest this could be investigated.
Recommendation The figures calculated in support of the evaluation suggest that profits, EPS and return on net assets will increase if UR adopts the proposed policy. The current ratio rises from 1.71 to 2.13 (quick ratio from 1.23 to 1.31). This is not a dramatic change and, given modern debt collection, ordering and banking practices and the installation of a new computer system, a ratio of 1.71 might be considered comfortable enough. However, before a decision is taken, UR should consider the effect on its customers, suppliers and staff. The company should review the various components of working capital and the procedures as well as policies for their management. The calculations so far do not provide an overwhelming case for a change in policy. The current ratio is already generous and the likely increases in profits, earnings and return on net assets are relatively small. It is possible that the same benefits could be obtained by better management of the existing policies rather than risking customer relations and loss of custom.
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3
LEARNING OUTCOME After completing this chapter you should be able to:
Identify and calculate optimal strategies for the satisfaction of longer-term financing requirements.
3.1 Introduction The topics covered in this chapter are as follows: ● ● ● ● ● ●
Types of share capital. Equity issues; new and rights issues. Long-term debt finance. Methods of issuing securities. Operating and finance leases. The difference between the coupon on debt and the yield to maturity.
3.2 Shareholders’ funds 3.2.1 Ordinary shares An equity interest in an entity can be said to represent a share of the entity’s assets and a share of any profits earned on those assets after other claims have been met. The equity shareholders are the owners of the entity – they purchase shares (commonly called ordinary shares), the money is used by the entity to buy assets, the assets are used to earn profits, and the assets and profits belong to the ordinary shareholders. Equity shares entail no agreement on the entity’s part to return to the shareholders the amount of their investment. Ordinary shares are sometimes referred to as the risk capital of an entity; it is the ordinary shareholders who take most of the risk in business. Nominal value Ordinary shares may be issued with a nominal value of, say, 10 pence each. These shares will continue to be referred to as 10 pence shares, even though the price at which they are bought and sold on the stock market may differ substantially from this. 93
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Dividends are usually paid in pence per share and are not based on nominal values, which is usually the case with fixed-interest securities. There is no express relationship between the nominal value and the market value of a share. However, company law in the UK prevents shares from being issued below their nominal value. This means that a company whose share price has fallen below the nominal value would not be able to raise additional funds by way of a share issue. Book value Book values apply to both assets and liabilities. The book value of an asset is the net result of the accounting procedures and adjustments to which the balance has been subjected, for example, depreciation charges. However, it is not necessarily any guide to the market, or realisable-value of the asset. In Financial Strategy we are likely to be more concerned with the differences between book and market values of shareholders’ equity. The book value of equity is the sum of the ordinary share capital shown in the balance sheet plus the value of shareholders’ reserves (share premium account, revaluation reserve, retained earnings, etc.). This value may be quite different from the market value of equity. This is mainly because the book value: (a) reflects accounting procedures and adjustments; and (b) is a historical figure. Market values reflect investors’ expectations about future earnings. Market value This is the value of an asset based on the amount it is believed it would command if sold. Some assets, such as securities, are traded regularly on an organised market and their value is relatively simple to establish. However, the market value of, for example, specialised plant and machinery may be more difficult to establish. The market value of shares is simply the share price multiplied by the number of shares in issue. The share price reflects investors’ expectations of future earnings; the book value reflects the accounting value of past earnings. An error sometimes made by students is to calculate the market value of equity by correctly multiplying the share price by the number of shares in issue, then adding the accounting value of reserves. The market value of equity, the market capitalisation, is calculated by multiplying the market price of an ordinary share by the number of shares in issue; the value of the reserves is already included in the market price of the shares and should not be double counted.
3.2.2 Preference shares Preference shares entitle their holder to a fixed rate of dividend from the entity each year. This dividend ranks for payment before other equity returns and so the ordinary shareholders receive no dividend until the preference shareholders have been paid their fixed percentage. Preference shares carry part ownership of the entity and allow due participation in the profits of the entity. In fact, their dividend is an appropriation of profits and so if a bad year means no profits, it also means no dividend for the preference shareholders. This point constitutes the essential distinction between preference shares and bonds. Bond holders are not part owners of the entity; their interest claims have to be met whether 2006.1
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3.2.3 Reserves Reserves include share premiums, revaluation reserves and retained earnings. Regardless of how the reserve was created, it is included as part of the equity of the entity. Retained earnings are the most important source of finance for most businesses. In part this is because retaining earnings avoids issue costs associated with other sources of finance. It often thought that retained earnings are a free source of finance, but this is not the case. There is an opportunity cost reflecting the dividend forgone as a result of retaining profits instead of paying them out as a dividend. It is important to appreciate that reserves are a historical source of funds, and so are unlikely to be represented by an equal amount of cash on the balance sheet.
3.3 Raising share capital – the stock market The activities of a stock market are mainly concerned with the secondary market, that is, enabling investors to buy and sell shares in particular entities, without the entities themselves being directly affected. This is a vital role in the sense that without the prospect of being able to sell shares when they wished, investors would be far less willing to buy them in the first place. Investors may buy and sell shares, hoping to make a capital gain as the share price rises. The capital gain will be realised when the share is sold to another investor at a price higher than that originally paid. Shares may be traded in one of two markets, according to the size and status of the company concerned. The largest entities will be traded on the Stock Exchange. The financial and other criteria necessary for a entity to receive a full Stock Exchange quotation (or listing) are stringent. Entities that do not satisfy these criteria may be traded through the Alternative Investment Market (AIM), where entry conditions are significantly easier. Although AIM entities face similar regulations to fully listed entities, the entry procedures and ongoing obligations are much less onerous. In particular, there are no criteria concerning the capitalisation of the entity or its trading history. Investors may speculate by buying shares in a particular entity or sector of the market, believing that the value of those shares will rise shortly. Such a speculator is known as a ‘bull’. Conversely, a ‘bear’ speculator is one who sells shares in the belief that their value is about to fall. If the entity were to fail altogether, the shares would be worthless, but the shareholder would not normally be required to use his or her own money to pay off the company’s debts. Liability is said to be limited to the original investment. Creditors of the entity need to be aware of this when trading or lending to the entity, hence the need to include plc or Ltd in the company name. 2006.1
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the entity has made a profit or not. Interest payments are not an appropriation of profits. It is for this reason that the tax treatment of each of the two forms of fixed percentage capital is different. Bond interest, as a charge, is a tax-deductible expense and, like any other form of tax-allowable expenditure, it reduces the entity’s tax bill. Preference dividends, as an appropriation of profits, are not tax-deductible. Tax is payable on the profits figure before the preference dividends are deducted. Consequently, an entity earning profits and committed to paying out, say, 8 per cent on capital raised, would prefer to be paying it on bonds (for which the interest charge is net of tax) than on Preference shares for which the entity would have to stand the gross cost.
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Entities may become publicly quoted merely by making shares available by way of an ‘introduction’, that is, existing shareholders being willing to sell some at a price. Otherwise, additional funds may be raised (i.e. for the entity as well as existing shareholders) by means of new issues.
3.3.1 New issues Shares that come into circulation for the first time are called new issues. This section will briefly outline the ways in which this happens. Offer for sale These offers may be of completely new shares or they may derive from the transfer to the public of shares already held privately. An issuing house, normally a merchant bank, acquires the shares and then offers them to the public at a fixed price. The offers are usually made in the form of a prospectus detailed in the Financial Times and other newspapers, sometimes in an abbreviated form. Buying new issues through the prospectus in the newspaper avoids dealing charges. An example of an invitation to bid for shares is included below. Other examples of such issues include: ● ●
government privatisations; and privately held shares transferred to the public.
It is easier for prospective purchasers to form a judgement about such companies where there is some track record, rather than with offers for a completely new company such as Eurotunnel. Some investors apply for new issues in the hope of selling immediately and reaping a quick profit. For this to succeed the number of shares purchased must be sufficiently high to cover selling charges. For oversubscribed issues, the allocation may be scaled down and the applicant may receive only a small number of shares. The strategy of selling immediately is called stagging (and investors who do it are called stags). There have been some notable successes for stags, particularly in some of the privatisation issues, but there have also been cases where the initial dealing price has been substantially below the offer price. The most notable example of the latter was the offer for sale of BP shares in 1987. Offer for sale by tender This method of issue is similar to that above, the only difference being that the shares are not issued at a fixed price. Subscribers must tender for the shares at, or above, a minimum fixed price. The shares are allotted at the highest price at which they will all be taken up. This is known as the strike price. Prospectus issue In a prospectus issue, or public issue, an entity offers its shares direct to the general public. An issuing house may act as an agent, but this type of issue will not be underwritten. This makes this type of issue risky, and also very rare. Placing In this type of issue the shares are not offered to the public, but the issuing house will arrange for the shares to be issued to its institutional clients. This method has become the 2006.1
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Introduction Here, no new shares are issued, and the entity is not seeking to raise any new finance. The entity may already be quoted on another stock exchange, or else the ownership of the shares is already widespread and the owners are now seeking a quotation for their shares. The entity becomes publicly quoted as a result of existing owners being willing to sell some of their holdings to generate a free market.
3.3.2 Rights issues In a rights issue, the entity sets out to raise additional funds from its existing shareholders. It does this by giving them the opportunity to purchase additional shares. These shares are normally offered at a price lower than the current share price quoted, otherwise shareholders will not be prepared to buy, since they could have purchased more shares at the existing price anyway. The entity cannot offer an unlimited supply at this lower price, otherwise the market price would fall to this value. Accordingly the offer they make to the existing shareholders is limited. For example, they may offer one new share for every four held. A rights issue may be defined as: Raising of new capital by giving existing shareholders the right to subscribe to new shares in proportion to their current holdings. These shares are usually issued at a discount to market price. (CIMA, Official Terminology, 2005) Selection of an issue price In theory, there is no upper limit to an issue price but in practice it would never be set higher than the prevailing market price (MPS) of the shares, otherwise shareholders will not be prepared to buy as they could have purchased more shares at the existing market price anyway. Indeed, the issue price is normally set at a discount on MPS. This discount is usually in the region of 20 per cent. In theory, there is no lower limit to an issue price but in practice it can never be lower than the nominal value of the shares. Subject to these practical limitations, any price may be selected within these values. However, as the issue price selected is reduced, the quantity of shares that has to be issued to raise a required sum will be increased. Underwriting Underwriting avoids the possibility that the company will not sell all of the shares it is issuing, and so receive less funds than it expects. Underwriters are normally financial institutions such as insurance companies and pension funds. In return for a fee, they agree to buy any shares that are not subscribed for in the issue. Underwriters receive their fee whether or not they are required to take up any unsubscribed shares. The underwriting costs could potentially be avoided through a deep-discounted rights issue. In such an issue, the issue price is set at a large discount to the current market price so reducing the possibility of shareholders not taking up their rights. 2006.1
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most popular method of issue in the UK, being cheaper and quicker to arrange than most other methods.
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Selection of an issue quantity It is normal for the issue price to be selected first and then the quantity of shares to be issued becomes a passive decision. The effect of the additional shares on earnings per share, dividend per share and dividend cover should be considered. The selected additional issue quantity will then be related to the existing share quantity for the issue terms to be calculated. The proportion is normally stated in its simplest form, for example, 1 for 4, meaning that shareholders may subscribe to purchase one new share for every four they currently hold. Terms of an issue Once the issue price and share quantity have been selected by the company, the terms of the rights issue can then be announced. For example, Lauchlan plc has 2 million £1 ordinary shares in issue with a current MPS of £5. It decides to raise £2 million by means of a rights issue at £4 per share. Since 500,000 additional shares will now have to be issued, the terms of the rights issue may be summarised as ‘1 for 4 at £4’. The theoretical ex-rights price (TERP) Assuming this rights issue is taken up by the existing shareholders, the market price of the shares will readjust to a value above that of the rights issue but below the original market price. Using the data above for Lauchlan plc, the following TERP calculation results: p 1 ‘new’ share at 400p 400 04 ‘old’ shares at 500p 2,000 05 2,400 TERP 480p
This calculation may be expressed by way of a formula as: Pp No P N n n N N Pp Pre-issue price Pn New-issue price No Number of ‘old’ shares Nn Number of new shares N Total number of shares TERP
TERP
2,000,000 500,000 500p2,500,000 400p2,500,000
400p 80p TERP 480p Value of a right The value of a right is the theoretical gain a shareholder can make from taking up their rights. The value of a right will be the difference between the theoretical ex-rights 2006.1
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TERP 480p Issue price 400p Value of the right 80p per ‘new’ share (80 4) 20p per ‘old’ share. If a shareholder decides not to take up the rights to a rights issue, the rights may be sold to another investor. Theoretically the investor could sell the right to subscribe for one new share for 80p. Shareholder options A shareholder receiving notification of a rights issue from an entity has a number of options available. Consider the position of a shareholder in Lauchlan plc owning 1,200 shares and, then, being offered 300 shares at £4 each. Option 1 – Do nothing. In this situation, the market value of the investment could be expected to fall by £240 from £6,000 to £5,760 (1,200 @ £4.80). The company would normally reserve the right to sell any ‘unaccepted’ shares for the best price available in the market. After having deducted any expenses and, of course, £4 per share, the balance would be sent to the shareholder. This cash balance could fully or partially compensate the shareholder for the reduction in market value. The shareholder’s percentage share of the entity will reduce. Option 2 – Sell the rights. In this situation, the shareholder decides to sell the right to buy the shares at £4 each to another investor. A rational investor would not be expected to pay more than 80p per share (TERP £4) for such a right. The existing shareholder might receive £240 (300 @ 80p) less any dealing costs incurred. The shareholder’s percentage share of the entity will be reduced. Option 3 – Fully subscribe. In this situation, the shareholder will have to increase the value of the shareholding by paying the entity £1,200 for the 300 new shares. The shareholder will then own 1,500 shares which, using TERP, will be valued at £7,200. The shareholder’s percentage share of the entity will be maintained. Option 4 – Sell some to buy some. In this situation, the shareholder may be unable or unwilling to invest more funds in the entity. Since the rights can normally be sold in the market, the shareholder could sell sufficient of the rights to purchase the balance. In the Lauchlan plc example, each block of 5 rights sold at 80p raises sufficient cash to purchase one new share at £4. The shareholder could sell 250 @ 80p to raise £200 which would be sufficient to purchase 50 @ £4. The value of the investment will be maintained at £6,000 but the shareholder’s percentage share of the entity will be reduced. Yield-adjusted ex-rights price The calculations of theoretical ex-rights price above assume that the additional funds raised will generate a return at the same rate as existing funds. If an entity expects (and the market agrees) that the new funds will earn a different return than is currently being earned on the existing capital then a ‘yield-adjusted’ TERP should be calculated. 2006.1
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price and the issue price of the shares. In the example above, the value of a right is calculated as:
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Yield-adjusted TERP
Pp No P N Y n n n N N Yo
Pp Pre-issue price Pn New-issue price Yo Yield on ‘old’ capital Yn Yield on ‘new’ capital No Qty of ‘old’ shares Nn Qty of ‘new’ shares N Total quantity of shares Using the figures for Lauchlan plc and assuming: ● ●
the rate of return (yield) on the new funds 15% the rate of return on the existing funds 12%
The yield-adjusted ex-rights price becomes: Yield-adjusted TERP
2,000,000 500,000 500p2,500,000 400p2,500,000 1512
400 80p 15 12 400p 100p 500p Alternatively, this may be calculated as:
p 1 ‘new’ share at 400p 15/12.5 500 04 ‘old’ shares at 500p 2,000 05 2,500 TERP 500p
Notice that if the new funds are expected to earn a return above the rate generated by existing funds, there will be less dilution of the market price than suggested by the original TERP calculation.
Exercise 3.1 Rosenior plc makes a 2-for-3 rights issue at an issue price of £2. The cum rights price is £4. You are required to calculate the theoretical ex rights price (TERP).
Solution TERP
£4 5 3 £2 5 2
£2.40 £0.80 TERP £3.20 2006.1
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Molson plc has a paid-up ordinary share capital of £2,000,000 represented by 4 million shares of 50p each. Earnings after tax in the most recent year were £750,000 of which £250,000 was distributed as dividend. The current price/earnings ratio of these shares, as reported in the financial press, is 8. The entity is planning a major investment that will cost £2,025,000 and is expected to produce additional after-tax earnings over the foreseeable future at the rate of 15 per cent on the amount invested. The necessary finance is to be raised by a rights issue to the existing shareholders at a price 25 per cent below the current market price of the entity’s shares. (a) You are required to calculate: (i) the current market price of the shares already in issue; (ii) the price at which the rights issue will be made; (iii) the number of new shares that will be issued; (iv) the price at which the shares of the entity should theoretically be quoted on completion of the rights issue (i.e. the ‘ex-rights price’), ignoring incidental costs and assuming that the market accepts the entity’s forecast of incremental earnings. (8 marks) (b) It has been said that, provided the required amount of money is raised and that the market is made aware of the earning power of the new investment, the financial position of existing shareholders should be the same whether or not they decide to subscribe for the rights they are offered. You are required to illustrate and comment on this statement. (7 marks) (Total 15marks)
Solution (a)
(i) Current market price of shares already in issue: Earnings per share
£750,000 4,000,000
18.75p Market price per share Earnings per share 8
P/E ratio
Market price per share 8 18.75p £1.50 (ii) Price at which rights issue will be made: £1.50 75% £1.125 (iii) Number of new shares that will be issued: £2,025,000 1.8 million £1.125 2006.1
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Exercise 3.2
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(iv) Ex-rights price is 1,800,000 15% £1.125 £1.50 4,000,000 5,800,000 5,800,000 12.5%* £1.034 £0.419 £1.453 *The price/earnings ratio is given as 8. This would imply an earnings yield of (1 8) 12.5%. This is assumed to be the yield or rate of return on existing funds. (b) This statement can be illustrated as follows: For every 20 shares held the rights issue means another nine shares. At least in theory, the selling price of the right to purchase one share will be £1.453 less £1.125, that is, £0.328. A shareholder with 20 shares taking up the rights: Market value of 29 shares at £1.453 each Less: Cost of taking up rights of nine new shares at £1.125 each
£ 42.137 10.125 32.012
A shareholder with 20 shares selling the rights: Market value of 20 shares after rights issue at £1.453 each Add: Sale of nine rights at £0.328 each
£ 29.060 32.952 32.012
The above, however, assumes no transaction costs. Furthermore, the market may read a particular message into the rights issue that would affect the above calculations.
3.3.3 Bonus issues These are shares issued without payment to holders of existing ordinary shares. They are issued because the price of the existing shares has become unwieldy. Bonus issues are at the initiative of the entity directors, with the subsequent approval of the shareholders. Obviously, these additional shares are normally accepted by the shareholders, but they are not getting something for nothing even though they are called bonus shares. This is because if all other things are unchanged, the value of the entity remains unaltered. Accordingly if, before the bonus issue, there were 1 million shares each valued at 220 pence, then if there was a one for one bonus issue resulting in the number of shares increasing to 2 million the price of the shares would fall to 110 pence. Thus, the shareholders would have twice as many shares each with half the value. In many cases, bonus issues are made in different ratios to one new share to each existing share but the same principle remains that the value of the holding is unchanged. Consequently, selling the shares from the bonus issue reduces the value of
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3.3.4
Share splits
Another way of addressing an unwieldy share price is to split the ordinary shares into a larger number with a lower nominal value.
3.4 Debt finance 3.4.1 Bonds The term ‘bonds’ is a general term used to describe a variety of forms of long-term debt an entity may issue. These include debentures, loan stock, loan notes, zero coupon bonds and convertible bonds. A debenture is a document issued by a company containing an acknowledgement of indebtedness. It need not give, although it usually does, a charge on the assets of the company. Secured or unsecured Bonds can be secured or unsecured. It is usual, however, to use the expression ‘debenture’ when referring to the more secure form of issue and the term ‘loan stock’ for less secure issues. When the loan is secured this is by means of a trust deed. The deed usually charges, in favour of the trustees, the whole or part of the property of the company. The advantages of a trust deed are that a prior charge cannot be obtained on the property without the consent of the debenture holders, the events on which the principal is to be repaid are specified and power is given for the trustees to appoint a receiver and in certain events to carry on the business and enforce contracts. The bonds can be secured by a charge upon the whole or a specific part of a company’s assets, or they can be secured by a floating charge upon the assets of the company. In this latter case the company is not precluded from selling its assets. The latter case is known as a general lien, whereas the bond issued on the security of a specific asset is a mortgage debenture or mortgage bond. With a floating charge, when the company makes a default in observing the terms of the bond, a receiver may be appointed and the charge becomes fixed, with the power to deal in the assets passing into the hands of the receiver. Such restrictions are referred to as ‘covenants’. Deep-discounted bonds Deep-discounted bonds are debt instruments that are issued at a price well below their nominal value. At the eventual redemption date they will be redeemed at their nominal (par) value. For example, a company might raise £5,000,000 by issuing deep-discounted bonds in 2004 at a price of £60 per £100 nominal that will be redeemed at par in 2015. The deep discounting means that the interest rate on the bond will be much lower than current market rates. This will give a cash-flow benefit to the issuing company as interest payments will be low throughout the life of the bond. Investors will be prepared to sacrifice interest for the
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the individual’s holding. Usually bonus issues are of ordinary shares but the issue can be in the form of preference shares.
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capital gain on redemption they can lock into. This may be appealing to investors who would prefer capital gains to income. Zero-coupon bonds The lower the issue price of a bond in relation to its nominal value, the greater the potential for a capital gain on redemption. The interest rate can therefore be reduced until we reach a stage where no interest is paid on the bond at all during its life. This is referred to as a zero-coupon bond. With a zero-coupon bond, all of the investor’s return is wrapped up in a capital gain on redemption.
3.4.2 Debt yields The rate of return, or yield, on bonds is measured in two different ways. Interest yield Interest yield is also referred to as running yield or flat yield and is calculated by dividing the gross interest by the current market value of the bond as follows: Interest yield
gross interest 100% market value
Example 3.A A 6 per cent debenture with a current market value of £90 per £100 nominal would have an interest yield of: 6 100% 6.7% gross or pre-tax 90
Yield to maturity (redemption yield) The yield to maturity (or redemption) is the effective yield on a redeemable bond, taking into account any gain or loss due to the fact that it was purchased at a price different from the redemption value.
Exercise 3.3 You are asked to put a price on a bond with a coupon rate of 8 per cent. It will repay its face value of £100 at the end of 15 years. Other similar bonds have a yield to maturity (YTM) of 12 per cent.
Solution The price of the bond is: £8 (annuity factor for t 15, r 12) £100 (discount factor for t 15, r 12) (£8 6.811) (£100 0.1827) £72.76. 2006.1
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t 15; r 10, so £8 7.606 £100 0.239 ≈ £84.75 t 15; r 14, so £8 6.142 £100 0.140 ≈ £63.14 Then, by interpolation, bearing in mind that r 10 is closer to £78.40 than is r 14, so that the required rate must be nearer 10, then:
Redemption yield 10% 84.75 78.40 4% 84.75 63.14 10% 1.17% 11% Coupon rate A connected issue that is often misunderstood is the relationship of face value to market value and coupon rate (on debt) to rate of return. When a bond or any fixed-interest debt is issued, it carries a ‘coupon’ rate. This is the interest rate that is payable on the face, or nominal, value of the debt. Unlike shares, which are rarely issued at their nominal value, debt is frequently issued at par, usually £100 payable for £100 nominal of the bond. At the time of issue the interest rate will be fixed according to interest rates available in the market at that time for bonds of similar maturity. The credit rating of the entity will also have an impact on the rate of interest demanded by the market.
Example 3.B An entity issues bonds at par (the face or nominal value) with a coupon rate of 12 per cent. This means that for every £100 of debt the buyer will receive £12 per annum in gross interest. Assume that interest is payable annually (it is usually paid bi-annually but this would require more tricky calculations). Mr A bought £1,000 of this debt on 1 January 2005. He will receive £120 in interest every year as long as he owns the bond. This might be until it matures or it might be when he sells it in the market. If the opportunity cost to investors of bonds of similar risk and maturity is 12 per cent, then the coupon rate and the rate of return are the same. However, assume that inflation increases at a much higher rate than expected by the market when the bond was issued. In January 2007, the opportunity cost to investors of similar bonds has risen to 15 per cent. Mr A continues to receive £120 on his £1,000 nominal value, but no new buyer would now pay £1,000 to get a return of 12 per cent – they now want 15 per cent. The price of the bond therefore falls to the level where the return on the debt is 15 per cent. This is £80 per £100 nominal of the bond. Mr B buys £1,000 nominal of the bond in January 2007. He will receive £120 per year in interest, just like Mr A, but as Mr B paid only £800, his return is 15 per cent (120/800 100). The coupon rate stays at 12 per cent, the nominal value at £1,000, but the rate of return is 15 per cent and the market value £800.
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What we are doing here is adding the NPV of 15 years of interest payments to the present value of the sum receivable on redemption. We can turn this example round to calculate the YTM. If the price of the bond is known to be £78.40, what is the yield to redemption? This is basically an internal rate of return calculation and the answer is approximately 11 per cent. The calculation is as follows. Assume two discount rates as for an IRR interpolation, between which the required percentage is likely to fall. Let us say, in this case, 10 per cent and 14 per cent. Then the equations are:
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3.4.3 Convertible bonds Convertible bonds are hybrids between equity and debt finance. They offer investors a fixed return but also give the investor the right to convert into the underlying ordinary shares of the entity at fixed terms. There are various types of convertible bond: convertible debentures, convertible loan stock, and convertible preference shares. All carry the right to convert into the underlying ordinary shares, and represent less risk to the investor than ordinary shares because they have greater priority for repayment should the entity be liquidated. The most secure is the convertible debenture which is secured upon the tangible assets of the entity. One advantage that is often quoted for convertible debt is that it is cheaper than ordinary debt finance since the conversion option allows the bond to be issued with a lower coupon rate than would otherwise be the case. Although it is true that the coupon on a convertible bond is lower, this does not mean that the overall cost is lower, since one must also consider the expected cost of the conversion option. The lower coupon rate of a convertible bond may, however, be advantageous from a liquidity point of view. This form of finance may suit a project where the cash inflows are expected to be low in the early years. Prior to conversion, the bond will represent debt finance and will therefore increase the level of gearing of an entity. Convertible bonds are seen as a way of issuing deferred equity. This may be particularly advantageous if existing shareholders want to minimise any loss of control since the number of shares issued via a convertible bond (assuming conversion takes place) will be smaller than if straight equity were issued. A useful aspect of convertible bond is that, assuming the entity’s share price rises sufficiently to force conversion, the debt is self-liquidating. Since it is replaced by equity, conversion will reduce the level of gearing and thereby enable the entity to issue further debt finance. While convertible bonds remain as debt, the interest is tax-deductible. This gives rise to the tax advantage that also accompanies other forms of debt finance. However, since the coupon rate on this bond is lower than that associated with normal debt, the tax advantage is consequently reduced also. As the convertible bond carries the right of conversion into the underlying ordinary shares, its price will be directly linked to that of the equity for as long as the conversion option exists. As the ordinary shares increase in price, so will the convertible bond and vice versa.
Conversion value and conversion premium The relationship between the price of the ordinary share and the convertible bond is usually expressed in one of two ways as illustrated below.
Exercise 3.4 Oldham plc has in issue a convertible bond with a coupon rate of 10 per cent. Each £100 nominal bond is convertible into 20 ordinary shares. The market price of the convertible bond is £108, while the current ordinary share price is 480p. Calculate (i) the conversion premium and (ii) the conversion value. 2006.1
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The conversion terms are: £100 bond 20 ordinary shares. This is known as the conversion ratio. The conversion terms could also be expressed as: £5 bond one ordinary share. (i) The conversion premium measures how much more expensive it is to buy the convertible bond than the underlying ordinary share. The cost of buying £5 bond is: £5 108 £5.40 100 compared with the cost of buying one ordinary share, £4.80. The conversion premium is therefore: 5.40 4.80 12.5% 4.80 In this case, it is more expensive to purchase the bond and convert, than to purchase one ordinary share directly. (ii) The conversion value is calculated as the market value of ordinary shares that is equivalent to one unit of the convertible bond. Conversion value conversion ratio MPS (ordinary shares) 20 £4.80 £96 Note that from this calculation of conversion value, the conversion premium may also be stated as: £108 £96 12.5%. £96
3.4.4 Warrants Warrants are options to buy shares in the entity at a given price within a given period. They can be traded on the market and are sometimes issued with bonds as a ‘sweetener’. Share warrants issued in conjunction with a bond will put the holder in an overall position that is very similar to that of a convertible bond holder. Thus, it follows that the holder has both debt and equity interest in the issuing firm. However, it may be argued that investors will find warrants more attractive than a convertible bond since they can sell warrants separately, whereas the conversion option is an integral part of convertible bonds. The warrant, like the conversion option, will enable the coupon rate to be reduced on the debt. The amount of this reduction will depend upon the value of the warrant. Unlike a convertible bond, the debt issued with warrants will run to maturity, thus maintaining the tax deduction. The warrants, if exercised, will also result in new capital being raised; this may be useful if expansion of the project originally undertaken is being contemplated. However, the timing of the exercising of warrants is determined by investors and may not result in extra capital when needed by the entity. 2006.1
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Solution
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Bonds issued with warrants are not self-liquidating and therefore additional finance will be needed for redemption. The use of both convertible bonds and warrants represents an attempt to make debt capital more attractive to investors; they also have characteristics that may make them useful to an entity as part of its financing.
3.5 Medium-term financing The distinction between short-, medium- and long-term finance is not well defined but, as a guide, short-term is up to 1 year, medium-term is from 1 to 5 years, and long-term is from 5 years upwards. The major sources of medium-term financing in recent years have been either term loans or leasing. Most medium-term finance is used by small entities, as a result of the problems they face in raising capital.
3.5.1 Term loans Term loans are offered by the high street banks and their popularity has increased for a number of reasons, not least their accessibility, which is of importance to smaller entities. A term loan is for a fixed amount with a fixed repayment schedule. Usually, the interest rate applied is slightly less than for a bank overdraft. The lender will require security to cover the amount borrowed and an arrangement fee is payable dependent on the amount borrowed. Term loans also have the following qualities: ●
●
●
They are negotiated easily and quickly. This is particularly important when a cashflow problem has not been identified until recently and a quick but significant fix is needed. Banks may offer flexible repayments. High street banks will often devise new lending methods to suit their customers; for example, no capital repayments for, say, two years, thus avoiding unnecessary overborrowing to fund capital repayment. Variable interest rates. This may be important given the uncertainty that exists with interest rates.
3.5.2 Mezzanine finance Mezzanine finance is a term that has come to prominence in management buy-out (MBO) situations. Also known as intermediate or subordinated debt, mezzanine finance refers to unsecured loans that rank after secured or senior debt but ahead of equity in the event of liquidation. Banks will be prepared to lend only up to certain gearing limits, and many MBOs will require additional finance to bridge the gap between the amount banks are willing to lend and the level of equity funding available. Mezzanine finance can fill this gap. Greater risk brings with it higher interest, and the interest rate on mezzanine loans will tend to be above interest rates on bank loans, with yields typically 4–5% above the London Interbank Offered Rate (LIBOR). Mezzanine also sometimes involves additional compensation for the provider of finance in the form of warrants or options that entitle the holder to subscribe to a future equity stake in the entity. 2006.1
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3.5.3 The lender’s assessment of creditworthiness When a company is seeking to raise loan finance, the lender will carry out an assessment of the company. The factors that the lender will consider before extending finance will include: ● ● ● ● ● ● ●
the purpose of the loan; the amount of the loan; the duration of the loan; if there are assets available to offer as security for the loan; the credit rating of the borrower; how the borrower is proposing to repay the loan; the level of borrowings currently outstanding.
3.5.4 Leasing A business may buy equipment outright, or on hire purchase or lease it. Lease: Agreement whereby the lessor conveys to the lessee, in return for a payment or series of payments, the right to use an asset for an agreed period of time. (Official Terminology, 2005) There are two kinds of lease, the finance lease and the operating lease. Finance lease: Lease agreement that transfers substantially all the risks and rewards incidental to ownership of an asset from the lessor to the lessee. (Official Terminology, 2005) Operating lease: Lease agreement other than a finance lease. (Official Terminology, 2005) The justification for leasing relies heavily on two distortions in the capital market: taxation and accounting. The UK tax system, because it is based on a version of accounting profits rather than cash flows, has an adverse effect on investment. If for any reason the entity is not paying mainstream tax (including local authorities and other ‘not-for-profit’ organisations, for example), it will not be able to utilise the capital allowances – making the net present value even more negative. Leasing enables another entity with tax capacity to buy the asset, claim the capital allowances and pass on at least part of the benefit to the user in the form of a lower financing charge than would otherwise be the case. On a smaller scale, where the lessee’s effective tax rate is lower than the lessor’s (e.g. UK small-company rate of 19 per cent versus standard rate of 30 per cent) a benefit can be created and shared. The restrictions that are placed on directors’ freedom of manoeuvre – in articles of association, banking covenants and Stock Exchange agreements – are expressed in terms of accounting numbers. Total borrowings, for example, are usually limited to a defined percentage of the net worth (equity capital) of the enterprise. Where these limits have been 2006.1
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Providers of mezzanine will base their investment decisions on the ability of the entity to generate cash. With high levels of gearing, cash generation is important in order to meet the interest commitments on debt. Mezzanine finance would usually be raised through a private placing or direct borrowing from a bank or other lender.
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reached, or are forecast to be reached, and the company cannot or does not wish to increase its permanent capital, there is obviously something to be said for an arrangement that enables it to have the use of an asset that does not have to appear in its accounts. Who bears the risk? The dividing line between finance and operating leases is determined by the proportion of the value of the asset that is in the contract – above 90 per cent is a finance lease and below it is an operating lease. This has spawned a large number of deals that are technically just below 90 per cent, or involve third parties that cloud the issue. The accounting standard setters are anxious to minimise the number of arrangements that are classified as operating leases, arguing for an ‘economic substance over legal form’ rule, that is, to bring such assets and a corresponding borrowing on to the balance sheet. If successful, many of the currently popular arrangements will cease to be attractive. Lease finance is sold as being: ●
● ● ●
● ●
●
stable – in the sense that, once negotiated, it will remain in place and not be subject to cancellation like an overdraft facility; the risk associated with the residual value of the asset can be transferred to the lessor; fixed price or suitably hedged; smooth, in terms of its effect on cash flow (as compared with outright purchase); cheap – thanks to greater security for the lender, that is, the legal ownership of the asset (though some assets depreciate very quickly, or would be difficult to reuse); tailored to individual needs and flexible, for example, inclusive of a facility to upgrade; ‘off balance sheet’, thereby protecting key ratios such as gearing that either directly or indirectly, via credit rating, may determine the cost of other forms of finance; inclusive of some services, for example, buying and selling, registration and other administration, maintenance and disaster recovery.
There are some drawbacks, of course, including the possibility that some government grants might be missed. The economic effect of leasing stems from the fact that it is the owner (who is not necessarily the user) of the asset who is entitled to the capital allowances. They may be worth more, say, to a bank that has high profits and low capital expenditure, than to a manufacturer with a big capital expenditure programme relative to its taxable profits. The practice was very popular, for example, in the days of high inflation, price control, and 100 per cent first-year capital allowances. In some situations, therefore, the interest built into the leasing arrangement, being in effect after tax, can be lower than that which would be incurred by the user had he/she borrowed money in the usual way (e.g. if the company is not making a taxable profit, and is not able to use the tax allowance). Finance leases Finance leases are essentially term loans. These have to be shown in the lessee’s accounts as assets and liabilities and the depreciation and financing charged against profits. The term of the lease normally extends over the full useful life of the asset. The lessor therefore receives lease payments that will fully cover the cost of the asset. The agreement will usually not be cancellable and will not provide for any maintenance of the asset. The leasing entity is not normally involved in dealing with the assets themselves, being a bank or 2006.1
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Sale and leaseback Entities can use what is known as a sale and leaseback arrangement in order to convert certain assets that the company owns into funds yet still continue to use the assets. For example, if a building is sold to an insurance entity or some other financial intermediary and then leased back from the purchaser, the entity has secured an immediate cash inflow. The only cash outflow is the rental payments that it now has to make. These rental payments are allowed as a tax-deductible expense. However, the entity may be subject to capital gains tax, which will arise if the sale price is in excess of the written-down value as agreed by the tax authorities. It must be remembered, however, that the leased asset no longer belongs to the entity; the lease may one day come to an end and then alternative assets will have to be obtained. This financing possibility is particularly applicable to assets that appreciate in value, such as land, buildings or some other forms of property. It is particularly appropriate to entities owning the properties freehold, and to institutions such as insurance entities or pension funds that are interested in holding long-term secure assets. The property is leased back at a negotiated annual rental, although with long leasebacks there will need to be a provision for the revision of the rental at certain intervals of time. Clearly the sale and leaseback releases funds that can be used for some other investment. In the 1980s and 1990s a number of takeovers were financed by this means. Assets were sold and leased back; the cash obtained from the sale was used to finance the purchase of another entity. If the acquired entity had substantial property, this could then be sold to an insurance entity and leased back. Operating leases Operating leases are treated very much like contract hire. They do not appear on the lessee’s balance sheet and the fee for the hire is charged directly against profits. These agreements will usually not last for the full life of an asset. They are offered by entity who manufacture or deal in the particular product, often incorporating maintenance and other services. The lease can be cancelled and the equipment returned. Operating leases are common for office and business equipment, for example, typewriters, photocopiers, computers and motor vehicles. The lessor will not recover his/her full investment on any one lease but will hope to lease a particular asset several times over its life. Operating leases are particularly useful for industries where there is a rapid change in technology that makes it necessary to have the latest equipment, for example, computers. Hire purchase Hire purchase is similar to leasing, except that the legal title to the asset passes to the hire purchase customer on payment of the final instalment payment. In a lease agreement ownership of the asset does not transfer to the lease. 2006.1
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finance entity. The asset is selected by the firm that will use it, who negotiates price, delivery, etc. The leasing entity simply buys the asset and arranges a lease contract with the lessee. At the end of the lease period there will usually be an agreement where the sale proceeds from the asset are shared between the lessor and lessee, or if the lessee desires it can carry on using the asset for payment of a nominal amount each year, called a peppercorn rent.
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Exercise 3.5 Johnson plc is to use a lease agreement to acquire machinery on 31 May 2005. The lease term is 5 years and lease rentals of £10,000 each year are payable annually in advance. You are required to calculate the present value of the lease rental payments at 31 May 2005 using an annual discount rate of 10%.
Solution As the lease rentals are equal amounts each year, the solution may be found using annuity factors. The annuity factor for 4 years at 10% is 3.17. The annuity factor for four years is relevant as rentals are payable in advance. To this must be added the discount factor for the first rental payable at year 0. We then multiply the resulting figure (1.0 3.17) by the constant annual rental payment of £10,000. (1.0 3.17) £10,000 £41,700.
3.5.5
Lease-or-buy decisions
The decision to lease or buy an asset is a financing decision that will be made only once the decision to invest in the asset has been taken. The decision to invest in the asset would be determined by discounting the operational costs and benefits from using the asset at the cost of capital normally used by the enterprise to evaluate projects, typically its weighted average cost of capital. Investing in the asset would be justified if a positive NPV is obtained. The financing decision is then concerned with identifying the least-cost financing option. In evaluating the financing decision, it is usually assumed that the entity would have to borrow funds in order to purchase the asset. Example 3.C Pleasure-boat operators Woodfield and Hills Ltd are considering investing in a new boat for their fleet. The entity can either borrow the necessary funds from its bank at 9 per cent and purchase the boat, or enter into a finance lease involving five annual year-end payments of £24,000. The new boat costs £100,000 and would attract capital allowances at 25 per cent on a reducing balance over its 5-year life for its owners. Corporation tax is 33 per cent, payable in the year of the relevant profits. You are required to calculate which of the two options, borrowing or leasing, is financially more advantageous for Woodfield and Hills Ltd.
Solution (i) Borrow and purchase The first stage is to calculate the capital allowances attracted by the purchase of the boat. The first capital allowance is assumed to be claimed at the end of year 1. Year
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£100,000 25% (£100,000 £25,000) 25% (£75,000 £18,750) 25% (£56,250 £14,063) 25%
5
Bal. (£100,000 £68,360)
Allowance £ 25,000 18,750 14,063 310,547 68,360 331,640 100,000
Tax shield (33%) £ 8,250 6,188 4,641 3,481 10,441
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Year 0 1 2 3 4 5
Investment £ (100,000)
Tax shield £ 8,250 6,188 4,641 3,481 10,441
Discount factor @ 6% 1.000 0.943 0.890 0.840 0.792 0.747
Present value £ (100,000) 7,780 5,507 3,898 2,757 1 7,799) .(72,259)
Note that the interest charges from borrowing are reflected in the discount rate used.
(ii) Finance lease Under current UK legislation depreciation on leased assets is treated as a tax-deductible expense, as is the interest element of the finance lease payments. However, for examination purposes we shall assume that it is the full finance lease payment that is allowable for tax. The after-tax cash flows associated with this financing option should again be discounted at the after-tax cost of borrowing on the basis that the minimum return necessary to accept the lease contract will be the after-tax return obtainable on a similar loan.
Year 1 2 3 4 5
Lease payment £ (24,000) (24,000) (24,000) (24,000) (24,000)
Tax shield 33% £ 7,920 7,920 7,920 7,920 7,920
Net cash £ (16,080) (16,080) (16,080) (16,080) (16,080)
Discount factor @ 6% 0.943 0.890 0.840 0.792 0.747
Present value £ (15,163) (14,311) (13,507) (12,735) (12,012) (67,728)
In this example, the finance lease is financially the most advantageous method of financing the investment in the boat.
Selecting the discount rate An issue in this kind of evaluation, in examination questions at least, is the discount rate to use: the cost of capital to the entity (which has presumably been used to evaluate the decision to acquire the plant) or the cost of the next best alternative means of finance (e.g. an overdraft). The discount rate that should be used in all investment decisions is the opportunity cost. If we argue that leasing is a direct substitute for borrowing, the opportunity cost of leasing is the cost of borrowing. There can be a complication when, say, £100-worth of leasing is not replacing £100-worth of borrowing. It could be that the debt capacity of the kind of equipment being leased is different from that of the existing assets of the company. The leased equipment could then either increase or decrease the gearing possibilities of the lessee. If £100 of lease liability is a substitute for less than £100 of debt, then a cost of capital other than the borrowing rate will have to be used. Repayment of borrowings Under the borrow and purchase option in the above example, no consideration was given as to how or when the borrowings were to be repaid. This is common in examination questions on this area, and simplifies the arithmetic required to calculate the present value of this financing option. 2006.1
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The after-tax cash flows associated with this financing option should be discounted at the after-tax cost of borrowing, which is 9% (1 0.33) 6%.
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Example 3.D Let us now consider the workings required if the borrowings of £100,000 were to be repaid to the bank in equal annual year-end instalments comprising principal and interest at 9 per cent per annum.
Solution The first stage is to identify the amount of the equal annual instalments required to service the bank loan. Dividing the amount of the loan by the annuity factor for 5 years at 9 per cent: £100,000 £25,707 3.890 Each instalment then needs to be split down between the repayment of principal and interest on an actuarial basis.
Year 1 2 3 4 5
Balance b/f £ 100,000 83,293 65,082 45,232 23,596
Interest @ 9% £ 9,000 7,496 5,857 4,071 2,111*
Annual instalment £ (25,707) (25,707) (25,707) (25,707) (25,707)
Balance c/f £ 83,293 65,082 45,232 23,596
*Rounding difference
When discounting the cash flows associated with the borrow and purchase option at the after-tax cost of borrowing, it should be remembered that the annual instalment includes the interest payments on the loan and so the tax shield relating to the interest must be included as a cash flow.
Year 1 2 3 4 5
Annual instalment £ (25,707) (25,707) (25,707) (25,707) (25,707)
Tax shield on interest £ 2,970 2,474 1,933 1,343 697
Tax shield on capital allowances £ 8,250 6,188 4,641 3,481 10,441
Net cash flow £ (14,487) (17,045) (19,133) (20,883) (14,569)
Discount factor @6% 0.943 0.890 0.840 0.792 0.747
PV £ (13,661) (15,170) (16,072) (16,539) (10,883) (72,325)
Allowing for rounding differences, the present value obtained should be identical to our original answer for the borrow and purchase option in the previous section. Lessee and lessor In the example above we had only to consider the position of the lessee and whether they should lease or buy. We should also look at the arrangement from the perspective of the lessor. If the lessor and lessee can both claim the same capital allowances, both have the same cost of capital. If the leasing entity does not add on a profit percentage, or if the cost of capital to the lessee plus the add-on percentage is the same as the cost of capital to the lessor, then the lessee will be indifferent whether he/she leases or buys. Leasing can be attractive to a lessee when faced with cash flows different from those of the lessor. The lessor will receive capital allowances if purchasing the asset, and will receive the lease payments as income. 2006.1
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Using the information from the Woodfield and Hills Ltd example above, evaluate the finance lease from the point of view of the lessor, assuming the lessor’s required rate of return is 15 per cent after tax.
Solution Year 0 1 2 3 4 5
Investment £ (100,000)
Tax shield £
Lease £
Tax £
8,250 6,188 4,641 3,481 10,441
24,000 24,000 24,000 24,000 24,000
(7,920) (7,920) (7,920) (7,920) (7,920)
Net cash flow £ (100,000) 24,330 22,268 20,721 19,561 26,521
15% DF 1.000 0.870 0.756 0.658 0.572 0.497
PV £ (100,000) 21,167 16,835 13,634 11,189 (1)13,181) (23,994)
Perhaps not surprisingly, the leasing entity could not justify repayments of £24,000, as this leads to a negative NPV. The lessor will have to increase the lease rentals.
Exercise 3.6 Cheesley plc is considering whether to buy or lease an asset which has a 10-year economic life with a zero residual value. It can be purchased for £80,000 payable immediately. Alternatively, it can be leased for 10 lease rentals of £12,000 per annum payable annually in advance. How should the entity finance this asset? The required rate of return is 10% per annum. Ignore taxation.
Solution Buy £80,000 Lease (Annuity factor @ 10% for 9 years 1) £12,900 (5.759 1) £12,000 £81,108 The entity should buy the asset.
Exercise 3.7 Ritchie plc is considering whether to buy or lease an asset which has a 5-year economic life. It can be purchased for £81,000 payable immediately, and will have a residual value of £40,000 after 5 years. Alternatively, it can be leased for five lease rentals of £14,000 per annum payable annually in arrears, and the asset will be handed back to the lessor at the end of this 5-year contract. How should the entity finance the asset? The required rate of return is 10% per annum. Ignore taxation. 2006.1
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Example 3.E
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Solution Buy £81,000
£40,000 (1.1)5
£56,163 Lease (Annuity factor @ 10% for 5 years) £14, 000 3.791 £14,000 £53,074 The entity should lease the asset.
3.5.6
Factoring
In CIMA’s Official Terminology, 2005, factoring is defined as follows: ‘The sale of debts to a third party (the factor) at a discount, in return for prompt cash. A factoring service may be with recourse, in which case the supplier takes the risk of the debt not being paid, or without recourse when the factor takes the risk.’ Specialist finance entities (usually subsidiaries of banks) offering factoring arrangements will provide three main services: • provide finance by advancing, say, 80 per cent of invoice value immediately, the remainder being settled when the client’s customer settles the debt (but net of a charge for interest, typically 3 per cent per annum above base rate); • take responsibility for the operation of the client’s sales ledger, including assessment of creditworthiness and dealing with customers for an additional service charge, typically 2 per cent of turnover; • they may, for an additional fee, offer non-recourse finance, i.e. guarantee settlement even if they are not paid by the customer. In order to do this economically, they have developed their expertise in credit control in term of market intelligence (including credit scoring), information management (sophisticated databases, processing and decision support systems) and the skills required for dealing with customers especially those who are in no hurry to pay! Alternatively, they may offer a confidential invoice discounting facility under which they provide the finance as above, but do not get involved with the operation of the sales ledger or hence become known to the customers. This has, to date, been more popular than the overt factoring arrangement. It is cheaper, of course, and avoids creating a barrier between the entity and its customers. It is less attractive to the providers of finance, however, being in the nature of supplying a commodity rather than adding value through expertise. Though, as mentioned, these financiers are usually subsidiaries of banks, they like to distinguish their approach from that of their parents. They argue that the mainstream banks, when deciding on the extent to which they are prepared to lend, have traditionally looked to an entity’s past profits and tangible assets. This explains why they are reluctant to lend just when the entity needs it, i.e. ahead of a growth phase. A sales-based package is a logical, flexible alternative. Having siphoned off the debtors in this way, the returns from an 2006.1
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• the specialist information providers, covering credit assessments, increasingly available electronically. This means that the sales function can have access, thereby reducing the potential for friction, e.g. taking an order only to find that ‘finance’ reject it on the grounds of credit risk; • credit insurance, dominated in the UK by Trade Indemnity. Clients typically pay around 1 per cent of sales, depending on the industry into which they are selling and on their perceived credit control skills. It should be seen as complementary to, rather than a substitute for, in-house vigilance; • debt collectors, often members of the legal profession, who take over responsibility for dealing with unpaid bills – sometimes on commission, otherwise for a fee. These various services are mutually supportive and there have been signs of convergence, i.e. of providers who offer a menu from which businesses can pick. Examination questions often ask you to consider whether it is beneficial for an entity to use factoring or to raise the finance by an alternative method, e.g. bank overdraft.
Exercise 3.8 (a) You are required to summarise the services that may be obtained from various forms of agreement for the factoring of trade debts and from invoice discounting. (5 marks) (b) B plc has been set up for the purpose of importing commodities that will be sold to a small number of reliable customers. Revenue is forecast at £300,000 per month. The average credit period for this type of business is 21⁄2 months. The entity is considering factoring its accounts receivable under a full factoring agreement without recourse. Under the agreement the factor will charge a fee of 21⁄2 per cent on total invoicing. He will give an advance of 85 per cent of invoiced amounts at an interest rate of 13 per cent per annum. The agreement should enable B plc to avoid spending £95,000 on administration costs. You are required: (i) to calculate the annual net cost of factoring; and (ii) to discuss the financial benefits of such an agreement, having regard to current interest (10 marks) rate on bank overdrafts of 121⁄2 per cent. (Total marks 15)
Solution (a) Factoring and invoice discounting are methods of raising finance from customers. In factoring the debts are sold, while invoice discounting is the assignment of debts as security for a loan. 2006.1
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entity are going to be more uncertain, making it difficult to raise more traditional forms of finance except at high interest rates. It is also worth noting that factoring is associated in many people’s minds with financial difficulties (‘the banks don’t refer their best prospects to their factoring subsidiaries’) or at best with small entities, which may have an impact on the image of the entity in the eyes of its suppliers. Apart from the factors and invoice discounters, it is worth noting some other players in the receivables industry:
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The main services associated with companies offering this finance are: • Provision of finance of between 80 per cent and 85 per cent of approved debts from the moment the goods or services are invoiced. • Sales ledger service covering credit-checking, invoicing and collection. In effect, the sales ledger function or part thereof is subcontracted. • Bad-debt insurance to cover the firm in the event of default on an invoice or invoices. • Confidentiality to prevent the arrangement being apparent to customers and others. (b) (i)
Annual revenue: £300,000 12 Annual net cost of factoring Fee: 2.5% of £3,600,000 Annual interest* (85% 2.5/12 3.6m 13%) Total annual cost Less: administration costs Net cost
£3,600,000 £ 90,000 82,875 172,875 195,000 177,875
* Assuming the agreement is based on existing invoices and does not phase in.
(ii) The borrowing of £637,500 (2.5⁄12 3.6m 85%) from the bank would cost £79,687.50. Therefore factoring offers a saving of around £2,000 as well as providing certain advantages: • Flexibility. As revenues increase with the corresponding demand for finance, so finance from this source increases. • Security. It allows the entity to pledge other assets as security for the finance. • Last resort. It may be the most cost-effective lender to a entity that has no assets to offer as security. • Responsibility. Relieves management of the responsibility for the sales ledger and can probably perform credit-checking better than the entity. Management must balance the disruption from cutting back its administrative costs with the financial and other advantages of factoring. Before reaching a decision, management should consider the possibility that the financial advantages may change and that re-establishing a sales ledger function may be costly.
3.6 Financing of small profit-making entities Individual entities come into being, they grow, they shrink, they cease to exist. Positive encouragement of small businesses is advocated in many quarters, as the natural offset to the decline of the very large entities. Indeed, either voluntarily, or as a result of the attention of predators, some large entities have been subject to ‘unbundling’ or ‘demerging’. Small entities tend to be privately owned, of course, and part of the problem is that owners are anxious not to cede control to (or share equity rewards with) outsiders. This can have the effect of restricting the rate of growth to that which can be funded by retentions, but judicious subcontracting and the use of leasing, hire purchase, factoring, licensing, etc., can mitigate this. Owners of small entities are especially critical of the High Street banks, particularly now that authority previously devolved to local managers has been centralised, and there has been a shift away from customers to products. Consequently, as one consultant remarked: ‘When you ask your local bank manager for a loan, don’t be surprised if he says he has to refer it to head office, but meanwhile tries to sell you some life assurance.’ 2006.1
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the costs of monitoring such loans are high or even prohibitive, in which case the risk is greater, that is, the investment has more of the characteristics of equity than lending; the banks themselves are involved in a competitive struggle for existence and have gone through difficult times, incurring substantial bad debts during recessions and in the emergence from recessions, exacerbated by a fall in the values of properties used as security; (consequently?) the regulators attach a higher risk weighting to corporate loans when assessing capital adequacy, with the result that banks are predisposed towards property and government loans; some of those other services are being provided by ‘niche’ players who are able to specialise and therefore offer better terms than the full-range banks. As regards this situation, the following trends are worth noting.
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The banking industry is itself in transition, with strategies based on consolidation and focus clearing the way for a stronger role to be played – possibly involving greater use of long-term loans. Some banks are even prepared to consider equity stakes, so as to share in the successes as well as the failures. Schemes involving more specific securitisation of assets are being developed. Perhaps the most significant trend for financial managers is that some banks are calling for more information to justify the original facility, and to monitor its use. The key information is likely to take the form of a cash-flow forecast. If this prompts them to place less emphasis on accounting statements, they will be more amenable at the time the small company needs their help – ahead of an expansion that has an adverse effect on the short-term profit/asset profile of the entity.
3.6.1
Venture capital
Venture capital is the name given to equity finance provided to young, unquoted profitmaking entities to help them to expand. The traditional structure of a venture capital fund has been a 10-year partnership (of investors such as pension funds) but, in recent years, there have been moves to create more flexible forms, for example rolling 1-year funds, a guarantee to return funds on request or, potentially, funds with unlimited life. There has also been a move towards a market in portfolios, with a view to offloading unsatisfactory performers, seeking economies of scale, etc. The managers are rewarded by means of an annual fee (typically 2 per cent of the funds invested, but tending to taper off as funds get bigger) and part of the capital gain when the investments are realised. Though extremely significant in the 1980s, venture capital has been in decline in recent years, for a number of reasons. ●
Investors have been disappointed with the results achieved so far and are reluctant to commit further funds. The level of management fees has caused concern. The valuation 2006.1
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Lending to small entities used to be seen as an attractive part of any bank’s portfolio. The rate of interest was good and the client was likely to need other services on which the banks could make money. From time to time, however, attention is drawn to the difficulties small entities have in obtaining the finance to support their growth strategies, at anything less than penal rates of interest (several percentage points higher than that at which large businesses can borrow) and the additional charges they face (e.g. manager’s time attending a lunch hosted by the client!). Among the explanations given for this situation are that:
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of funds is not easy, which militates against reliable measurement of performance, assessment of potential and hence monitoring of the progress. Investee companies have been concerned at the short-termism displayed by the venture capitalists in terms of requiring early reported profits – at the time of writing, with base rates well down into single figures, funds are telling prospective investees that they are looking for constant compound internal rates of return in excess of 30 per cent per annum (in the jargon of the industry, plums have to pay for lemons) and an early exit (by way of flotation, a trade sale or re-financing on a more permanent basis).
The two problems interact, of course, with the moment of exit being the only time when a comprehensive measure of performance is possible. The funds tend to seek a definitive long-range plan and rely on accounting numbers. Indeed, most funds are run by accountants and financiers (rather than experienced industrialists) and tend, therefore, to be risk averse. This may explain their apparent lack of interest in start-up finance schemes, which are relatively more time-consuming, higher risk and take longer to produce results. Rather, they have tended to concentrate on later-stage development and changes of ownership: management buyouts, buy-ins and the hybrid ‘bimbos’ (involving both existing and new managers). Some tend to favour particular geographical areas, while others specialise in particular industries. Styles vary from hands on (most common where funds concentrate on particular industries or markets) through close monitoring to hands off. Equity funds provide a basis for the company to raise further bank finance. Dividends can be delayed until the company is making profits.
3.6.2 Business ‘angels’ To judge from deals reported, venture capital funds are rarely interested in investing less than £250,000 on the grounds that monitoring progress is uneconomic. Below this level, companies may think in terms of business ‘angels’ (a term borrowed from show business), that is, private individuals (e.g. big-company directors/managers who have retired with ‘golden handshakes’), usually with time and expertise available as well as cash and hence looking for a local, hands-on involvement. They may come together in syndicates, led by an ‘archangel’. This practice is very big in the US, where it is estimated to be three times as large a source of funds as the formal venture capital industry. There, lawyers and accountants tend to act as brokers. In the UK it is a growing source, and the government say they are keen to arrange introductions, via Training and Enterprise Councils and similar organisations as well as to foster cooperation between small and large organisations. Angels are more likely to be persuaded by outward-looking and forward-looking considerations, like strategic vision, intuition, flexibility and the identification of sources of competitive advantage, as well as the skills required to develop appropriate tactics and to manage operations. They would also look for the appropriate information systems, covering forecasting, decision support and monitoring.
3.6.3 Government assistance Governments will often have a number of schemes, aimed at providing assistance to: • small- and medium-sized profit-making entities; • entities wanting to expand or relocate in particular regions; 2006.1
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You do not need to have knowledge of any specific scheme, but relevant discussion of methods of government assistance in your own country will earn credit in the examination.
3.7 Summary Reliance on equity capital as the main form of corporate finance is a distinguishing feature of the UK and US economies. The value of an entity to its equity shareholders is a function of projected cash flows to them (dividends minus rights issues). Equity capital is, however, not the only form of finance for an entity, and you should be aware, not only of the different forms of debt but, by reference to other chapters, of the impact on a company’s cost of capital of combining debt and equity. Small entities, for example, private entities, often claim that it is difficult for them to raise capital at anything other than penal rates. This may reflect perceptions of risk, especially as regards the probability of repayment. The venture capital industry has not been as active as perhaps it should have been in financing small entities, which might be why we have seen the creation of business ‘angels’ and buy-in teams.
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• promote innovation and technology; • projects that will create new jobs or protect existing ones.
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Readings
The article below draws on BT’s experiences of raising funds from a rights issue in 2001 to explain the finer points of the technique.
Know your rights Ben Ukaegbu, Financial Management, February 2002
The rights issue has become an increasingly rare beast on both sides of the Atlantic over the past few years, but BT’s recent campaign to raise £5.9 billion shows that this alternative method of drumming up capital is not quite extinct. So what exactly is a rights issue? It’s when a company gives existing shareholders the right to buy a new issue of ordinary shares at a discount price. The number of shares an individual shareholder is offered is determined by the proportion of their holding relative to the total number of shares in the company. The shareholders have four possible courses of action. The first is to exercise their rights. Here they simply buy the new shares at the offered price and retain them, thus maintaining their percentage holding. Another option is to renounce their rights and sell these on the open market. This will mean that the shareholder will hold a lower percentage of the company’s equity and the total value of this will be reduced (assuming that the actual market price after the issue is close to the theoretical ex-rights price). The third line a shareholder can take is to renounce part of their rights and exercise the remainder. For example, they may sell enough of their rights to enable them to buy some of the shares from the proceeds of the sale. Lastly, they can choose to do nothing. In this instance they might be protected from the consequences of their inaction, because unexercised rights can be sold on their behalf by the company. But if the amount involved is small these shares can be sold for the benefit of the company. The shareholder (or the company) will then receive the difference between the issue price and the market price after the issue. The share price of a company usually falls when it announces a rights issue. The size of the drop depends on the discount and the market’s reaction to the issue. The price is likely to fall because there will be more shares on offer and the new ones are being sold cheaply. It’s also likely that there’ll be a general marking down by ‘market makers’ in the expectation that a significant number of shareholders will sell their rights because they don’t have enough funds to buy all the new stock on offer to them. But there are occasions when the share price rises following a rights offer – there may be a strong demand for shares if the company is growing fast or investors think it’s a particularly exciting investment prospect. 123
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On 10 May 2001 BT’s board announced a rights issue on the basis of three new shares for every 10 existing shares held at the close of business on the previous day. The new shares were priced at 300 pence, against the closing middle market price of 568.5 pence, representing a 47 per cent discount. In theory, such a pricing strategy ensures that the rights issue is taken up. But in practice it presents a number of difficult questions for financial managers and investors alike. For managers contemplating a rights issue, the following issues are crucial: the number of shares to offer, the cost of the capital to be raised and the market’s reaction. The shareholders must also consider the value of these rights, what action(s) to take and the impact of the issue on the company’s future earnings. The financial manager must be satisfied that there will be enough new funds to achieve the objective for which the capital is being raised – in BT’s case, to hit its debt-reduction target of £10 billion. Another factor is the size of the capital outlay relative to the shareholders’ existing stake. Shareholders are more likely to subscribe to an issue amounting to, say, a 30 per cent addition to the shares they hold than they are to a 60 per cent addition. At BT, it was three new shares for every 10 already held – i.e., a 30 per cent addition. The financial manager must also consider whether the earning potential of the extra funds, when capitalised with the appropriate cost-of-capital rate, would increase the market value of the company. The minimal offer price must at least be equal to the nominal value of the company’s shares. This prevents the company from breaking the Companies Act rule on the issue of shares at a discount. Investors are also interested in determining the theoretical value of the shares after a rights issue. Using this value they can estimate the investment status of shares without rights attached (ex-rights). Therefore, the value of the shares ex-rights will influence their decision to sell rights, to retain their present position or to add to their holding. From a financial manager’s viewpoint, this information and the resulting decisions are hugely important, because they can spell success or failure for a rights issue.
The ex factor The formula for calculating the theoretical ex-rights share price is
Pp(No) Pn(Nn) N
where Pp pre-issue price No number of shares already held Pn rights issue price Nn number of new shares offered N total number of shares In BT’s cases Pp 568.5 No 10 Pn 300 Nn 3 N 13 So BT’s theoretical ex-rights price was
568.5(10) 300(3) 506.5 13
In the case of BT, the theoretical ex-rights price was 506.5 pence per share (see panel for calculation). Consider the position of someone who held 10,000 BT shares when the rights offer was made. These each had a market value of 568.5 pence, so the shareholder owned 2006.1
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shares with a total value of £56,850. If they exercise their rights, they will be able to buy 3,000 new shares. The price of the new share is 300 pence, so their new investment will be £9,000, making a total holding of £65,850. Based on the theoretical ex-rights price, the value of their 13,000 shares is now £65,850 (13,000 506.5 pence) – i.e., exactly what they have invested in the company. Alternatively, if the shareholder sells their 3,000 ‘rights’, which have a value that is simply the difference between the theoretical ex-rights price and the issue price of the new shares, they would have 3,000 (506.5 300) £6,200. They would now have their original shares plus £6,200. But their 10,000 shares now have a market price of 10,000 506.5 £50,650. This amount plus the £6,200 is the same as the original investment of £56,850 that they had in the company. From a purely arithmetical standpoint, the shareholder neither gains nor loses from the sale of additional shares through rights issue. It can be shown that if the market correctly estimates the earnings from investing in the new funds, and if the ex-rights share price is based on a correct estimate of future earnings, the price at which the new rights shares are offered needn’t bother the shareholders. They will be at least as wealthy after the issue as before. This apparently satisfies the cost-of-capital constraints – that new issues should not leave shareholders worse off than they were before the rights issue, whether they exercise their rights or sell them. But there may be occasions when the actual value of a right may differ from its theoretical value. This may happen as a result of transaction costs, speculation or the sale of rights over the subscription period. If the price of a right is significantly higher than its theoretical value, investors will sell their rights and buy shares in the market. This action will force down the market price of the right and push up the theoretical value. Conversely, if the price of the right is significantly lower than its theoretical value, speculators will buy the right, exercise their option to buy shares and then sell them in the market. This would put a downward pressure on the theoretical value of the right and an upward pressure on its market price. The cost of capital depends upon the proportion of the new issue taken up by the existing shareholders. When the issue is successful, the cost of the rights funds may be viewed as similar to the cost of equity funds. But, if the shares are undervalued at the ex-rights prices and the existing shareholders do not take up all their rights, the cost of rights funds will be higher than the cost of new equity. The reason the cost of capital behaves in sympathy with the success (or failure) of the rights issue is that the company is likely to compensate the existing shareholders for the ‘unjustified’ dilution of their holdings. This implies that when profits are made the company will be giving a higher return than necessary to the shareholders who bought more shares through the rights issue. Rights issues are typically arranged using standby underwriting. Here the underwriter commits to taking up the unsubscribed part of the issue. The underwriter usually gets a standby fee and additional amounts based on the shares taken up. Standby underwriting protects the issuer against undersubscription, which can occur if investors ignore their rights or if bad news causes the market price of the share to fall below the subscription price. In practice, only a small percentage of shareholders fail to exercise their rights. It was therefore not surprising that BT decided not to go to the expense of underwriting its issue. If a rights issue takes place and shares are offered at a discount on the full market price, the shareholders may seem to have received something of a bonus. But the share price in the year of the rights issue is not the same as the share price the year before. Therefore the worth of a share in 2001 is equal to the sum of the share in 2000 and the bonus element of the rights issue. To get comparable figures over time, FRS 14 states that it’s necessary to adjust the number of shares in issue before the rights issue to reflect the inherent bonus
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element, and that ‘notes to the financial statements should state that such adjustments have been made’. The change is necessary, because after the rights issue each new share is not claiming quite as much of the earnings as each old share. So, after the rights issue, the figures for earnings per share produced by the company will be based on the new type of share. Hence previous EPS figures should be scaled downwards for comparative purposes. There is also a problem in the year in which the rights issue is made. A different number of shares will have been issued at the end of the year to that at the start. FRS 14 recommends that the weighted-average share capital for the period should be calculated. This is the average number of shares ranking for dividends during the year, weighted on a time basis. The rights issue is an alternative way for a plc to raise capital. It is less costly than a public offer, yet it is not a popular route. Financial managers should not see such discounted offers as a ‘giveaway’. The shareholder who acts neither wins nor loses. The shareholder who sells their rights on the market is theoretically compensated for the fall in the value of their shares. But the shareholder who fails either to exercise or to sell their rights would lose out. Consequently, a rights issue represents not a handout to shareholders but an imposed obligation. In order to protect themselves from loss, they have to act.
Discussion questions 1. Discuss whether a rights issue will only be attractive to an entity if the stock market is rising. 2. Look through the financial pages of a newspaper for details of an entity that has announced a rights issue. Find out the terms of the rights issue. Calculate the theoretical ex-rights price. Track the share price from the announcement of the issue through to the ex-rights date, and see if the ex-rights price turns out to be the same as your TERP calculation. Outline solution 1. In theory a rights issue can be made under any market conditions. Practically, the key issue is the purpose of the rights issue, and the market’s interpretation of that purpose. In a falling market the entity’s share price will fall, which means that the company will need to issue more shares than if the market was rising. This may lead to higher dividend payments in the future if the directors feel obliged to maintain dividends per share. The amount subscribed by each shareholder will be the same whatever the issue price or state of the market. Shareholders will also have the opportunity to maintain their percentage shareholding whatever the market conditions.
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Revision Questions
Question 1 (a) List and explain the major functions performed by the capital markets. (5 marks) (b) Discuss the reasons why rights issues are often used to increase the equity of both small and relatively large entities. (5 marks) (c) Explain the different forms of borrowing that are available and suggest which form would be most appropriate for use by an entity that wishes to expand. (10 marks) (Total marks 20)
Question 2 Assume you are a newly recruited junior consultant with Q, Y & R, a large international of accountants and financial consultants. A number of its clients are currently examining the methods available for financing or refinancing their businesses. You have been asked to review two of Q, Y & R’s clients. Only brief details are available at present. These are given below. Client number 1: ABC Ltd ABC Ltd is a software house in the south of England. The entity was established 4 years ago by five telecommunications specialists who had been made redundant. The initial investment was £250,000 in equity and a bank loan of £250,000, repayable over ten years at a fixed rate of interest of 12 per cent. The original five shareholders are still the only shareholders. The entity was formed to develop and market a range of specialist software for the telecommunications industry. At present, the company’s main customers are in the United Kingdom and part of Western Europe. Extracts from the entity’s financial statements for last year and forecast for the current year are as follows: Income account (extracts) for years
1993 Actual £000 2,350 485 440
Revenue Profit after tax Dividends payable (net of ACT)
127
1994 Forecast £000 3,250 763 563
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Non-current assets ( NBV) Current assets Current liabilities Total net assets Financed by: Issued share capital (ordinary £1 shares) Reserves Long-term loan (10-year bank loan) Total financing
1993 Actual £000 250 1,093 1(778) 1,565
1994 Forecast £000 350 1,472 (1,082) 1, 740)
250 165 150 565
250 365 125 740
Notes: 1. The non-current assets are primarily vehicles, furniture and fittings and computers. The entity’s premises are rented. The net book value is after charging depreciation of £100,000 and £150,000 in 1993 and 1994 respectively. 2. The tax charge for 1993 was £220,000 and the forecast for 1994 is £375,000. 3. Inflation, as it affects this entity’s business, has been negligible over the 3-year period.
ABC Ltd is now considering expanding its product range and moving into new international markets. These markets are highly competitive but expected to be very profitable in the long term. The entity estimates it will need £2 million to establish local operations and support facilities in three main centres outside Western Europe. If financing can be obtained and the expansion proceeds, revenue and profits could treble by 1997. The shares of listed entities trading in ABC Ltd’s industry are currently capitalised at P/E ratios between 16 and 20. Client number 2: DEF plc DEF plc is a clothes retailing entity that has been established for over 50 years. It has shops mainly in small towns in the UK, selling to low-income families. The entity has been listed on the Stock Exchange since 1962. Summary financial statistics for 1993 and forecasts for 1994 are as follows: Income account (extracts) for years Revenue Profit after tax Dividends payable Balance sheet (extracts) at end of year Non-current assets (NBV) Current assets Current liabilities Total net assets Financed by: Issued share capital (ordinary 25p shares) Reserves Long-term debt 9% (redeemable in 2002) Total financing Share price (pence, average)
1993Actual £ million 1,250 113 60
1994 Forecast £ million 1,450 118 72
1993 Actual £ million 925 153 (195) . 883.
1994 Forecast £ million 915 229 (215) . 929.
100 573 210 883
100 619 210 929
314
n/a
The entity has recently launched a profit-improvement programme. A number of costcutting measures have been implemented and the product range has been revised; a number of older products have been discontinued and new ones introduced. Overall, the entity is moving into a higher-priced section of the market and believes it can now open new shops in 2006.1
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equity; debt with warrants; mortgage debt; leasing; convertible debt; preference shares.
You are required to: (a) describe, very briefly, three of the methods of finance listed above; (6 marks) (b) prepare, for discussion with the senior consultant, a set of briefing notes for each of your clients. These should contain reasoned arguments for an appropriate method, or methods, of financing, taking into account the circumstances of each entity. Make whatever assumptions you think necessary, but state them clearly in your notes. (24 marks) (Total marks 30)
Question 3 (a) CP plc is an entity operating primarily in the distribution industry. It has been trading for fifteen years and has shown steady growth in turnover and profits for most of those years, although a failed attempt at diversification into retailing 4 years ago caused profits to fall by 30 per cent for 1 year. The figures for the latest year for which audited accounts are available are: Revenue Profit before tax:
£35.2 million £13.7 million
The entity has been financed to date by ten individual shareholders, three of whom are senior managers in the entity, and by bank loans. Shares have changed hands occasionally over the past 15 years, but the present shareholders are predominantly those who invested in the entity when it was formed. Some of the shareholders are now keen to realise some of the profits their shareholdings have earned over the years. At the last annual general meeting, it was proposed that the entity should consider a full listing on the Stock Exchange. You are required to: (a) (i) discuss the advantages and disadvantages of a flotation on the Stock Exchange in the circumstances described above; (ii) explain and compare the following methods by which the entity’s shares could be brought to the market: ● private placing; ● offer for sale at fixed price; ● offer for sale by tender. (8 marks) 2006.1
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towns where it has had no presence and where it will come into direct competition with the major retailing stores. It estimates it will require £250 million to undertake this expansion. The current share price is 245 pence. Debt of similar risk and maturity to that in DEF plc’s balance sheet is currently trading in the market at £125 per £100 nominal. The methods of finance being considered by the two entities include, but are not limited to, the following:
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(b) Describe the services that are likely to be provided by the following financial institutions in connection with a public offering of shares: ● merchant banks; ● stockbrokers; ● institutional investors. (8 marks) (Total marks 16)
Question 4 Z plc is a long-established entity with interests mainly in retailing and property development. Its current market capitalisation is £750m. The company trades almost exclusively in the UK, but it is planning to expand overseas either by acquisition or joint venture within the next 2 years. The entity has built up a portfolio of investments in UK equities and corporate and government debt. The aim of developing this investment portfolio is to provide a source of funds for its overseas expansion programme. Summary information on the portfolio is given below. Type of security UK equities US equities UK corporate bonds Long-term government bonds 3-month Treasury bonds
Value £m 23.2 9.4 5.3 11.4 3.2
Average % return over last 12 months 15.0 13.5 8.2 7.4 6.0
Approximately 25 per cent of the UK equities are in small entities’ shares, some of them trading on the Alternative Investment Market. The average return on all UK equities over the past 12 months has been 12 per cent. On US equities it has been 12.5 per cent. Ignore taxation throughout this question. Requirements (a) Discuss the advantages and disadvantages of holding such a portfolio of investments in the circumstances of Z plc. (10 marks) (b) One of Z plc’s corporate debt investments is £50,000 nominal in a convertible bond 1997–99, currently selling at £106.50 per £100 of stock. The coupon rate is 6 per cent. If not converted, it is repayable on 31 December 1999 at par. Interest is payable annually and has just been paid for 1997. Bonds of similar risk without a conversion feature are currently selling to return 7 per cent. The 1997 date for conversion is 31 December 1997 at a conversion ratio of 20 shares per £100 of stock. The ratio applicable for conversion in 1998 is 18 shares per £100 of stock. The market price of the ordinary shares is 540 pence. At the time the bonds were purchased by Z plc in 1996, the equity share price was 480 pence. Assume that interest rates have remained unchanged since the bonds were purchased. You are required to: (i) explain what is meant by the terms conversion premium and conversion discount; (ii) advise the company’s treasurer about the factors to consider before deciding whether to convert the bond in 1997 or 1998. Include all relevant calculations in your advice. (10 marks) (Total marks 20) 2006.1
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The directors of Denetter plc wish to make an equity issue to finance an £8 million expansion scheme, which has an expected net present value of £1.1 million, and to re-finance an existing £5 million 15 per cent term loan that is due to mature in five years’ time. There is a £350,000 penalty charge for early redemption of this loan. Denetter has obtained approval from its shareholders to suspend their preemptive rights and for the entity to make a £15 million placement of shares which will be at the price of 185 pence per share. Issue costs are estimated to be 4 per cent of gross proceeds. Any surplus funds from the issue will be invested in commercial paper, which is currently yielding 9 per cent per year. Denetter’s current capital structure is summarised below: Ordinary shares (25 pence per share) Share premium Revenue reserves 15% term loan 11% debenture 1998–2001
£000 8,000 11,200 23,100 42,300 5,000 59,000 56,300
The entity’s current share price is 190 pence, and debenture price £102. Denetter can raise debenture or medium-term bank finance at 10 per cent per year. The stock market may be assumed to be semi-strong form efficient and no information about the proposed uses of funds from the issue has been made available to the public. Taxation may be ignored. Requirements (a) Discuss the factors that Denetter’s directors should have considered before deciding which form of financing to use. (5 marks) (b) Explain what is meant by pre-emptive rights, and discuss their advantages and disadvantages. (6 marks) (c) Estimate Denetter’s expected share price once full details of the placement, and the uses to which the finance is to be put, are announced. (11 marks) (d) Suggest reasons why the share price might not move to the price that you estimated in (c) above. (3 marks) (Total marks 25)
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Question 5
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3
Solution 1 This question examines the following syllabus areas: ● ●
Types and features of domestic and international long-term finance; Criteria for selecting sources of finance
(a) The capital markets provide the means by which entities and people who are trying to obtain funds can be linked to lenders and investors. The capital markets provide a means by which a corporate financial manager has access to a range of different alternative sources of funds. The capital markets can be divided into two main categories, namely the primary and secondary markets. Primary markets provide new capital by making it possible for new shares to be issued to new or existing shareholders or, alternatively, by bringing borrowers and lenders together so that loans can be negotiated. The secondary markets provide the investors with the means to either increase or decrease the number of shares they own. Similarly, it is possible to either increase or decrease the amount that is borrowed or lent depending on the liquidity requirements of each party. The facility for trading in shares and other financial instruments has implications for the whole economy and includes the following: ● Savings and investment are promoted as the financial requirements of both savers and lenders can be brought together and funding provided for new or existing projects. ● Banks, pension funds and other institutional investors act as financial intermediaries by gathering funds from savers and channelling the funds to users of the funds through loans, leasing arrangements and other forms of financing. These functions are extremely important within the economy and it is essential that a developed country has facilities of this nature to enable the economy to prosper. (b) A rights issue is an invitation to existing shareholders to purchase additional shares in the entity. If the existing shareholders buy the same proportion of the rights issue that they currently hold, the entity acquires additional funds and the current owners of the company retain their proportion of the total entity. This has implications for 133
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their voting rights. The problem of existing shareholders who are not able to take up their allocation of shares, is resolved by making it possible for the rights to be sold to a third party. There are a number of reasons for their use and these include: ● It is possible for an entity to raise equity funding relatively quickly. It is usual for rights issues to succeed as they are often issued at a price 10 per cent below the market price. However, as only existing shareholders are involved, this does not create problems. ● It is much cheaper to obtain additional equity without having to make a new issue, which is often very expensive. ● The administrative procedure is much less complicated in respect of the existing shareholders and the Stock Exchange regulations. (c) There are a number of different forms of debt that can be used to provide funding for entities that are planning to expand. These include: ● Debentures are usually sold in units of £100 via the stock market. This means that investors can sell their debentures if they require their funds before the date on which the debentures are scheduled to be redeemed. Debenture issues are often secured by means of a floating charge against all present and future assets. This does not represent a major problem to the management of the entity as they can act within the contractual obligations that are usually specified in the documentation prepared at the time of the debenture issue. ● Debentures will be issued as an alternative to equity and the funds will usually be used to finance growth or a major new project. It is likely that debenture issues will be monitored more closely by external bodies than the other forms of borrowing, which are really a matter between the lender and the borrower. ● Unsecured bonds will usually pay a higher rate of interest than secured loans and debentures. The higher rate of interest is to compensate the lenders for the added risks. In the event of a collapse of the organisation, the unsecured loans will only be paid out when the secured loans have been paid. It is possible that restrictive covenants may be imposed by the lender and these may restrict the amount of dividends paid or further debt raised while the loan is outstanding. It is also possible that it will be required to achieve specified financial ratios and to provide regular financial statements to the lender. ● Convertible unsecured bonds can be converted into equity at the request of the holder. If the entity is successful, the lender can obtain shares at the time and price specified in the loan agreement. This facility means that the rate of interest is usually lower and so provides the entity with a lower cost of borrowing. Lenders can become involved with entities that are perceived to be a high risk as, if they succeed, they can convert the loan to equity. However, if the entity is not particularly successful, the lender will be repaid the amount borrowed and the interest on the loan. This is an attractive proposition for entities that expect to flourish but this view is not generally accepted by the financial markets. In general terms, the most suitable debt for an entity will depend on the debt capacity of the entity and the risk profile of the project that is being funded by the loan.
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Aim of the question The purpose of this question is to test whether students fully understand some common financing options available to entities and to explain, with reasons, the best method of financing investment opportunities of different entities in given circumstances. This question examines the following syllabus area: ● ●
Types and features of domestic and international long-term finance; Criteria for selecting sources of finance.
Tips ● The key points to recognise about ABC Ltd are that the entity is highly profitable, with profit margins around 30 per cent expected to rise to 35 per cent in 1994 with an expected current ratio for 1994 of 1.4. ● It is in a high-technology business that is competitive and risky. ● There are few non-current assets, so secured debt is unavailable unless the directors provide personal guarantees. ● The most obvious method of financing would be a flotation of the entity on the stock market. ● A venture capital entity could be a possibility although this would almost certainly involve a large dilution of equity. ● A joint venture with entities in each of the countries being exported to is also a possibility. ● DEF is suffering a decline in profitability based on the 2 years’ figures provided. ● Dividends have been increased by more than the increase in earnings. ● The P/E ratio is now 8.3 compared with 11.2 in 1993, suggesting the market is not convinced of DEF’s ability to reposition itself. (a) (i) Equity. The normal form of equity is ‘ordinary shares’. These are permanent capital (unless the directors are empowered, and choose, to arrange for the company to buy them back) and are rewarded by a dividend (out of profits struck after all other legitimate claims, including interest and tax, have been met). They bear the residual uncertainty, therefore, as regards the financial success of the entity. (ii) Mortgage debt. This relates to a loan to the entity, secured by a charge over particular (usually tangible) assets. Interest is payable (and chargeable against tax) on either a fixed or variable basis, and the lender is given certain rights, for example, to take ownership of the assets mortgaged should the borrower default. (iii) Convertible debt. This starts life as debt, that is, entitled to a predetermined return in the form of interest, but (on terms and within time frames specified) can be exchanged for shares in the entity. (iv) Debt with warrants. This is, and may remain, debt but is accompanied by a document that enables the holder to buy other securities (e.g. shares) at a specified time in the future, at a specified price. These documents (the ‘warrants’) can be traded separately from the original debt.
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Solution 2
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(v) Leasing. This means that particular assets (typically plant and machinery) used by an entity are not actually owned by that entity. A separate entity (usually a subsidiary of a bank) owns the assets and charges the user a predetermined fee, for example, on a monthly or annual basis, for an agreed length of time. The agreement may include a provision for the user to buy the assets at the end of the specified period. (vi) Preference shares. These give all the rights of membership to the entity, but the entitlement to a reward is predetermined, for example, 8 per cent per annum of the nominal value, provided that the entity has a positive balance on its reserves. They may also have a right to further participation once ordinary shareholders have had a certain dividend, and usually have preference in a winding-up. (b) ABC Ltd The profit before tax was £705,000 in 1993, and is forecast to be £1,138,000 in 1994. Interest at 12 per cent amounts to £21,000 and £18,000, respectively, implying operating profits of £726,000 and £1,156,000. Net assets are forecast to increase from £565,000 at the beginning of 1994 to £740,000 at the end. Add back dividends and taxes payable £660,000 and £938,000. Therefore, operating assets increase from £1,225,000 to £1,678,000, that is, £453,000. Operational cash generation in 1994 is therefore expected to be £1,156,000 minus £453,000, that is, £703,000, applied as follows: £ Distributions: Interest Tax Dividends Financing: reduced borrowings Operational cash generation
£
18,000 220,000 440,000 678,000 725,000 703,000
In short, it is forecasting a return on assets of over 90 per cent in conditions commensurate with a 12 per cent cost of borrowing. The new venture looks even more profitable than the existing entity, given that profits are expected to treble, whereas operating assets are expected to increase by only 125 per cent. The payback will therefore be extremely rapid, which militates against long-term debt. Assuming the objective of the shareholders is to maximise the value of their investment, the shareholders should be advised to: ● restrict their dividends as much as possible, so as to retain funds and control; ● look into the possibility of borrowing money as individuals in order to subscribe for additional equity capital; ● minimise capital requirements, for example, by leasing (or buying on hire purchase) physical assets and/or factoring book debts; ● identify friendly investors, for example, employees, customers, suppliers or potential competitors, who would be prepared to invest limited amounts (i.e. in aggregate, a minority) in the company, or in some form of joint venture; ● seek to borrow money in the entity’s name, with a fairly early payback envisaged; ● as a last resort, contact providers of venture capital. They would find this business attractive, but would want equity, would price it so as to achieve their target return (currently in excess of 30 per cent per annum) and might insist on having representation on the board. 2006.1
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●
●
Assuming they have the authority under their articles, the directors might consider debt. Currently borrowings amount to £210m, that is, less than 22 per cent of operating assets. Increasing borrowings to £460m and assets to £1,179m would leave the ratio at less than 40 per cent, which does not seem unreasonable. It would, of course, increase the amount of cash pre-empted for interest by around £20m assuming, say, 8 per cent per annum net interest. Alternatively, they might think about a rights issue. Its current market capitalisation is 2.45£400m, that is, £980m, so we are talking about, approximately, a 25 per cent increase. The most likely approach (again, assuming the authority has been obtained) would be a rights issue, for example, 1-for-3 at around 210p. Recent experience suggests that analysts will concentrate on the arithmetic of the issue and not question the use to which the money will be put. Some boards of directors (especially in a situation like this, where the share price has fallen) choose to have the issue underwritten, that is, they can be sure of raising the capital for the expansion, even if shareholders do not support it.
Alternatively, a hybrid issue might be considered, for example, initially debt, but with a predetermined conversion into equity. The decision would be made on the basis of projected cash flows and the margin of error (e.g. the greater the margin of error, the more appropriate the equity route).
Solution 3 Aim of the question The question tests an understanding of the factors to be considered by an entity when deciding on the appropriateness of a stock market listing, in given circumstances. It also requires explanations of various methods by which a listing might be achieved and comparison of the advantages and disadvantages of each, in the circumstances of the entity in the question. Part (c) of the question requires an understanding of the functions of financial institutions and the services they might perform in connection with a public offering of shares. This question examines the following syllabus areas: ● ●
Types and features of domestic and international long-term finance; Criteria for selecting sources of finance. 2006.1
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DEF plc It is difficult to advise the directors of DEF plc as to the form in which they wish to raise £250 million, because we are not told what they are projecting in the way of a return thereon, or the margin of error in such a projection. The current-year forecast shows a return on (closing) equity of £118m/£719m, that is, 16.4 per cent. Assuming tax of 33 per cent, this suggests a return before tax of £176m/£777m, that is, 22.65 per cent. Adding in £19m/£210m for borrowings, we can see that the overall return on assets is expected to be £195m/£987m, or just under 20 per cent. If, in the absence of any prospectus, we assume that the additional £250m will achieve a similar return, the additional operating profit would be close to £50m. This should not prove difficult to finance, provided that the directors can communicate the prospect to the appropriate market. Two possibilities might be considered:
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Tips ● A very common error made by candidates when answering this question was to assume that this entity was already quoted. This was presumably because it is a plc. Plc means public limited company, not public listed company; a plc does not have to be listed. ● There was a widespread belief that flotation would bring in new management. Where from was not clear. Shareholders in general are apathetic in the management of the companies in which they invest and rarely have a direct influence on activities and operations. ● Very few candidates managed to successfully compare methods of flotation and in particular to relate them to the circumstances of the question. ● Part (b) of the question was less well answered than might have been expected, with many candidates providing lists of identical services for all three types of institutions. (a) (i) The principal advantage of floating CP plc on the Stock Exchange, from the point of view of the current shareholders, is that they will be able to convert ‘paper wealth’ into real cash. This would not have been impossible before, especially as the entity is already designated a plc, but the availability of a wider market will make it that much easier. Beyond that, it might be argued that the advantages are: ● that it is useful to have an external, and hence objective, valuation of the business; ● that expansion, by way of an acquisition financed by a share issue, will be easier; ● that it will be easier to provide employees with tax-effective incentives, e.g. share options (but see sixth disadvantage below). The disadvantages include: ● a liability to taxation on any gains, albeit reduced by indexation and the annual allowance; ● a clear (and usually higher!) liability to such taxes as inheritance tax; ● a reduction in future dividend income and potential for capital gain; ● the cost of the flotation; ● an increase in administration costs, for example, managing the share register, preparation of more glossy accounts, dealing with the Stock Exchange, analysts, journalists, etc.; ● a danger of conflicting objectives, owing to the arrival of stakeholders with shorter time-scales, for example, a focus on share price, not previously relevant; ● a danger that the volatility of past profits would adversely affect market sentiment, thereby reducing the value that could be obtained (in which case, it might be better to wait until that big profit drop falls out of the figures that need to be published). Effects that could come under either heading include a separation of ownership from control. (ii) The choice as to the method by which the flotation might be brought about will be influenced by the extent to which it is intended to raise additional capital (e.g. to finance an acquisition, other forms of expansion, or simply reduce borrowings), as opposed to providing an exit route for existing shareholders. In a ‘placing’ the issuer arranges for a relatively small number of buyers (usually institutional investors) to take the shares. This is usually a cheaper route, suited to the smaller issue, but does not normally lead to a very active market. An ‘offer for sale’ involves an issue of new shares perhaps accompanied by a certain proportion of existing shares being made available. This is the preferred approach for the larger issue and where the creation of a substantial market is desired.
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Solution 4 Aim of the question The scenario in this question concerned an entity that is building up an investment portfolio with a view to developing funds for expansion, including overseas acquisitions. The question tests treasurership skills and ability to evaluate action on one particular type of security – a convertible bond. Tips ● Answers provided for part (a) were generally at least satisfactory. Additional points were as follows. ● More than 44 per cent of the portfolio is in UK equities; 62 per cent is in UK and US equities. This is a high proportion for an entity that may need liquidity to expand, particularly if expansion is to be achieved by acquisition for cash. ● Shares traded on the AIM are generally high-risk investments, and may also be fairly illiquid – that is, there may not be a ready buyer for the shares at the time Z plc wants to sell.
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This can be done on either: 1. a fixed-price basis, that is, the entity determines the price, and recognises that demand will be more or less than the amount it wishes to issue; or 2. a tender basis, which amounts to a sealed bid auction in which prospective purchasers bid different prices, and a price is struck at which the required amount can be allocated. Some privatisations have been able to mix the two by distinguishing between institutional and private shareholders. (b) The various parties mentioned could help as follows: Merchant banks. These will normally play the lead role, once the decision has been made to go ahead. They will advise on: ● the appointment of other specialists (e.g. lawyers); ● the content of articles of association, etc., against the requirements of the Stock Exchange; ● the form of any new capital to be made available (equity, preference, loan, hybrid?); ● the number of shares to be issued, and the price; ● arrangements for underwriting; and ● promotion. Stockbrokers. These are likely to provide advice as to which of the various methods of obtaining a listing is best in the circumstances, and may provide preliminary advice (i.e. before the merchant bankers get involved) on some of the items mentioned above. For small issues, they may identify substantial investors. Institutional investors. Very little direct involvement, but they might agree to buy a certain number of shares (especially in a placing), and might also participate as underwriters in an offer for sale. Some issuers conduct roadshows to explain the company and seek feedback from this class of investor as to their attractiveness as an investment.
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●
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US stocks give rise to possible exchange risks in the short term. However, if expansion is planned in the US, then holding these stocks as medium-term investments may be more acceptable. There has been a high average return over the past twelve months.What are the expectations for the future? Attitude to risk is specific to an entity. Is Z plc (i.e. its shareholders) happy to accept higher risk for higher returns? Answers to part (b) of the question were generally very poor. Few candidates understood the meaning of conversion premium and conversion discount and virtually none could provide the correct calculations (or even any calculations for part (b)(ii)). Convertible bonds are bonds that, at the option of the holder, may be converted into ordinary shares in the entity under specific conditions. A conversion premium measures how much more expensive it would be to buy the convertible bonds than the corresponding ordinary shares. A conversion discount is the converse and measures how much cheaper it would be to buy the underlying shares. If a company held a convertible bond that was showing a conversion premium, clearly it would not convert into ordinary shares. If it was showing a conversion discount, conversion would be advantageous. Whether a convertible is standing at a premium or a discount to the underlying shares depends on the state of the market and many other economic and commercial factors.
(a) The conventional wisdom is that equities will show a higher return than government securities in the long term, but will be subject to wider fluctuations. This means that there is a danger that when an investor wishes to liquidate his holding, the prices could be at the bottom of the range. Hence, as one draws near the time when the funds are required for some specific purpose, the advice is to move into the less volatile securities. However, with the expansion still up to two years away, it is perhaps too early to be in such marketable securities as the government debt and 3-month bonds. Over the last 12 months, the return on the specific equities held by Z plc has been greater than that on their respective markets. On the surface this was beneficial, but those who believe that markets are efficient would suggest that this higher return must imply greater uncertainty, reinforcing the point made in the previous paragraph. If this is the case, was it deliberate policy on the part of the Z plc treasury? If the proposed expansion is in the US or countries whose currencies move in line with the dollar, then the investment in US equities could be said to provide something of a hedge against a fall in the dollar/sterling rate. Otherwise, it could be said to have opened up an exchange rate risk. (b) (i) At any point in time, the price of convertible bonds is likely to be different from the price of the corresponding ordinary shares – mainly on account of the fact that the latter could change significantly before conversion. If the price of the convertible is higher than that of the equivalent number of ordinary shares, it is said to be at a premium. Conversely, if the price of the convertible is lower than that of the equivalent number of ordinary shares, it is said to be at a discount. 2006.1
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Interest receivable 12 months hence: £3,000 1/1.07 Interest capital 24 months hence: £53,000 (1/1.07)2 Total
£ 2,804 46,292 49,096
If converted this year, 10,000 shares would be received, which at £5.40 is worth £54,000. However, as of today, the bond is at a discount, i.e. worth only £53,250. If these were the only choices, and transaction costs were negligible, one would convert now. There is one other possibility, that is, wait until 12 months hence, receive a dividend with a present value of £2,804 as above, and then convert. If the price of the ordinary shares at that time is more (in present value terms) than £5.69, the 9,000 shares received would be worth more than £51,196, which together with the dividend would exceed today’s £54,000 value. In conclusion, therefore: ● If you think the share price will be more (in present value terms) than £5.69 in a year’s time, wait and convert then. ● If you do not think that the share price will be more (in present value terms) than £5.69 in a year’s time, convert now.
Solution 5 This question examines the following syllabus area: ● ●
Types and features of domestic and international long-term finance; Criteria for selecting sources of finance.
(a) When choosing between alternative forms of finance, the directors of Denetter might consider the following: (i) Cost. If the market is efficient then the cost paid for any individual financing source will be the appropriate cost for that source, taking into account the relative risks of alternative sources. The fact that debt finance is normally cheaper than equity finance does not necessarily mean that debt finance should be chosen. Cost is important as it affects the entity’s overall cost of capital and therefore its market value per share. Assuming that financial structure influences the market value of a company, the entity should attempt to select the financing combination that minimises its overall cost of capital. (ii) Risk. The effect of financing upon risk can be measured in several ways, including financial gearing, interest cover, cash-flow cover, and the entity’s beta coefficient (systematic risk). (iii) Control. The ownership structure of the entity’s shares, and hence the control of the entity, will differ according to the financing method selected. (iv) Market conditions. If share prices are falling, an equity issue might not succeed or, if interest rates are expected to fall, a fixed-rate debt issue might be unwise. Market conditions can, therefore, influence the financing choice. (v) Speed of raising finance. Some forms of finance can be raised more quickly and easily than others. If the need for funds is urgent, speed of raising finance might outweigh some other considerations. 2006.1
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(ii) Using a 7 per cent p.a. discount rate, holding the bond until redemption is worth:
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(vi) Flexibility. Can the finance be redeemed easily and cheaply, or swapped into another form of commitment (e.g. an interest rate swap)? (b) Pre-emptive rights mean that entities wishing to make a further issue of equity shares for cash must first offer the shares to existing shareholders in proportion to their existing holdings. Their advantages might include: (i) they allow shareholders to maintain a certain percentage holding in an entity. This might be particularly important to entities that are controlled by a few large investors, and to institutional investors; (ii) alternative forms of share issue might have to be made at a lower price than a rights issue in order to attract new investors if pre-emptive rights did not exist. Disadvantages might include: (i) they are a form of restrictive practice that is not appropriate to modern stock markets; (ii) companies can raise finance more quickly and more cheaply when pre-emptive rights do not exist, for example, through placements. (c) In a semi-strong market the share price should accurately reflect new relevant information when it becomes publicly available. This would include the effect on Denetter of the expansion scheme and the redemption of the term loan. £m 60.8 1.1 15.0 (0.6)
The existing market value is 190 pence 32 million shares The new investment has an expected NPV of £1.1m, which will add to market value The proceeds of the issue will add to market value Issue costs of 4% would reduce market value
The early redemption of the bank loan will produce a benefit to the present value of cash flows associated with the loan. Expected present value of outflows before redemption is announced: £m Interest £750,000 per year (£5m 15%) 3.791 PV of repayment in year 5 £5m 0.621
2.843 3.105
Redemption cost now Penalty charge Present value benefit from early redemption Expected total market value
(5.000) (0.350)
5.948
70.598 76.898
(d) (i) Changes in factors affecting the value of the entity’s shares between the setting of the terms of issue and the issue date; (ii) existing shareholder reaction to the issue; (iii) the effect of the extra volume of shares on their marketability; (iv) whether forecast earnings from the new funds are considered realistic by the market.
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LEARNING OUTCOMES After completing this chapter you should be able to:
calculate the cost of equity using the divided growth model;
gear and ungear betas;
calculate, interpret and use the weighted average cost of capital;
appreciate the ideas of diversifiable risk and systematic risk.
4.1 Introduction The topics covered in this chapter are: ● ● ● ● ● ●
calculation of the cost of equity; impact of charging capital structures; weighted average cost of capital; adjusted present value; the capital asset pricing model; arbitrage pricing theory.
In this chapter we consider the advantages and disadvantages of using debt as a source of finance, and consider the impact of gearing on the cost of capital of an entity. The advantage to equity holders of using debt arises from the tax shield on debt, that is, the benefit to shareholders deriving from the treatment of debt for tax purposes as being deductible in arriving at an entity’s taxable profits. High gearing means that debt represents a high proportion of the financing of an entity’s assets, whereby in its capital structure of equity plus debt (E D), the element D is high in proportion to the element E; conversely, low gearing is where D is low in relation to E. The main disadvantage of increasing debt is that the additional interest payable reduces the earnings available to shareholders, thereby increasing the risk of their investment and consequently increasing the cost of capital, as new investors will require a higher return on equity to compensate for the increased financial risk. If you are still doubtful as to why increasing debt increases risk, you must appreciate that debt has priority over equity and also that coupon rates of debt must be met. Thus, if an entity hits bad times and profits fall significantly or losses ensue, there may be little if any 143
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return for shareholders. Clearly, therefore, the level of an entity’s gearing can affect both earnings per share and dividend policy decisions. You must take care to distinguish between operational gearing and financial gearing, noting that the former represents the ‘relationship of the fixed cost to the total cost of an operating unit’ (CIMA Official Terminology). It is evident, however, that operational and financial gearing have the common feature that an increase in either (i.e. higher fixed cost or higher debt) reduces the earnings available to shareholders and thereby increases their risk. Note also that high operational gearing exposes lenders to the risk that, if an entity makes losses or suffers a serious fall in profits, their loans may not be fully or even partially serviced.
4.2 Measuring gearing 4.2.1 Capital gearing Capital gearing is concerned with the level of debt in an entity’s capital structure. The gearing ratio expresses the relationship between fixed debt capital and shareholders’ funds. It is also known (especially in the US) as the leverage ratio. CIMA’s Official Terminology provides the following definition of gearing: the relationship between an entity’s borrowings, which includes both prior charge capital and long-term debt, and its shareholders’ funds (ordinary share capital plus reserves). Gearing can be calculated as: Total long term debt (D) Shareholder’s funds plus longterm debt (ED) The importance of the gearing ratio as a measure of the riskiness of the entity means that the classification of financial instruments as debt or equity is of great importance. Where an entity’s gearing ratio is already high, it will probably wish to avoid issuing new financial instruments that fall into the debt category. A straightforward way of doing this is to issue uncontroversial equity in the form of ordinary shares. However, there has been a tendency in recent years to issue complex financial instruments that technically meet the classification of equity but that are actually, in most essential respects, debt. Hence there is a need for an accounting standard in the area to ensure that debt and equity are correctly classified and disclosed. The table below illustrates some of the ways in which gearing can be manipulated: Improving the numerator: reducing debt Keep long-term liabilities off the balance sheet by using an ‘off-balance sheet’ scheme, or a special purpose entity (SPE) The use of operating leases instead of finance leases Repackaging debt, disguising it as a form of sale and repurchase agreement Splitting one overall transaction into a number of smaller transactions (e.g., sale and leaseback, debt factoring, consignment stock) in order to show different aspects of the transaction in different accounting periods, thus lessening the impact in the financial statements Window dressing: improving the appearance of the balance sheet 2006.1
Improving the denominator: increasing shareholders’ funds Revaluation of assets, thus increasing reserves
Including brands and other intangibles in the balance sheet Disguising debt as equity in the form of redeemable preference shares Capitalising development expenditure, rather than writing it off in the income statement
Showing items ‘net’ rather than ‘gross’, by netting off loans against the assets that they finance.
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●
When equity is valued using book values it must include any reserves and retained profits that are attributable to the ordinary shareholders: that is, the book value of equity ordinary share capital reserves.
●
When market values are used, reserves must be excluded since they are considered to be already incorporated into the market price of the shares: that is, the market value of equity number of shares share price.
High gearing exists when an entity has a large proportion of prior charge capital in relation to equity and low gearing exists when there is a small proportion of prior charge capital. High gearing increases the financial risk of the equity investor but the reward can be in the form of increased dividends when profits rise. If, however, profits falter, the equity investor can expect to be the first to feel the effect of the reduction in profits. Low gearing or no gearing may not necessarily be in the equity investor’s best interests because the entity might then be failing to exploit the benefits which borrowing can bring. Provided that the return generated from borrowed funds is greater than the cost of those funds, capital gearing could be increased. The extent to which it is prudent for an entity to increase its capital gearing will depend upon many variables such as the type of industry within which the entity operates, the cost of funds in the market, the availability of investment opportunities and the extent to which the company can continue to benefit from the ‘tax shield’. The ordinary share price of highly geared entities will tend to be depressed in times of rising interest rates.
4.2.2
Classification of debt and equity
Some of the basic characteristics of debt and equity are set out in the table below: Return Rights Effect on income statement
Interest on winding up of the entity Taxation implications
Equity Dividend Legal ownership of the entity Appropriation of profit after tax determined by the directors Residual Appropriation of post-tax profits
Debt Interest Repayment of capital Charge against profits before tax
Preferential, ranking before equity holders Interest payments are taxdeductible
These distinctions appear to be quite straightforward. However, in practice, determining the difference between debt and equity can be quite difficult because of the complexity of some of the financial instruments that have been issued in recent years. 2006.1
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The effect on the income statement and related ratios may have a bearing on whether an entity seeks to classify financial instruments as debt or equity. Where an instrument is classified as debt, there are related finance costs which will be recognised in the pre-tax section of the income statement and they will consequently affect interest cover adversely. Wherever possible, market values should be used in preference to book values for the capital gearing ratio. When using market values, care must be taken when calculating the market value of equity:
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IAS 32 IAS 32 requires that the issuer of a financial instrument shall classify it upon initial issue as either a liability or equity, according to the following classification principles: 1. The substance of a financial instrument, rather than its legal form, governs its classification. 2. Where there is a contractual obligation, potentially unfavourable to the issue of the instrument, to deliver either cash or another financial asset to the holder of the instrument, the instrument meets the definition of a financial liability. 3. Where a financial instrument does not give rise to a contractual obligation under potentially unfavourable conditions, then the instrument is classified as equity. 4. Where there is a requirement for mandatory redemption of the instrument by the issuer at a fixed or determinable future data, the instrument meets the definition of a financial liability. In recent years there has been a trend towards the issue of complex financial instruments whose classification is not immediately obvious. In the rest of this section we consider some examples. Warrants and options Warrants and options give the holder the right to subscribe for equity shares at a specified time at a specified price. IFRS 2 on accounting for share-based payment requires that a charge should be made in the income statement to reflect the benefit transferred to the holder of the option, with a credit to share capital. Such instruments therefore have an effect on equity, rather than debt capital. Perpetual debt Perpetual debt is an instrument that provides the holder with the right to receive payments in respect of interest at fixed rates, extending into the indefinite future. There is no redemption date for the debt, which makes it rather akin to equity which, similarly, is issued without a redemption date. Perpetual debt, nevertheless, is classified as debt. When such debt is issued, the issuer takes on a financial obligation to make a stream of future interest payments. The payments are regular and fixed in nature, and therefore the capital element is more akin to debt than equity, and should be classified as such. Redeemable preference shares Preference shares usually carry a fixed rate of return, and sometimes they are issued with redemption terms attached to them. Where the issuer is obliged to redeem the shares at a fixed or determinable future date, at a fixed or determinable amount, the instrument has the characteristics of a liability, and should be classified as such. However, a distinction can be drawn between the type of preference share described above, and a preference share that is redeemable solely at the option of the issuer (i.e., at the point of issue there is no fixed or determinable date of redemption attached to the instrument). In this case, the instrument is probably equity. Non-redeemable preference shares Non-redeemable shares may appear to be rather similar to the perpetual debt described earlier. However, the standard makes it clear that classification as debt or equity is determined by the rights attaching to the shares. If distributions are at the discretion of the issuer, then 2006.1
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Example 4.A On 1 January 2006 DP issues preference shares at $1 million par value. There is no redemption date attached to the shares. Under the terms of issue, DP has the option of determining the level of distribution to the holders of the preference shares, and the issue document refers to the possibility that in some years no distribution will be made. In this example, the financial instrument will be classified as equity.
Example 4.B On 1 January 2006 EQ issues 7% preferred shares at $1 million par value. There is no redemption date attached to the shares. The preferred shares are cumulative in nature, that is, if EQ cannot make the distribution of 7% of par value, the distribution liability is carried forward to a future year. In this example the distribution cannot be avoided (although it can be deferred). Therefore, the instrument is classified as debt.
Preference shares: conflict with national law One other relevant point about the classification of preference shares is that, in some jurisdictions, national laws require that preference shares are classified as equity. Adherence to the law is, obviously, a matter of some importance, and so compliance with IAS 32 in this respect may not be possible. This conflict exists in respect of the UK, for example. However, it is to be expected that national laws will, in time, be altered in this respect, so that international accounting standards can be adhered to. Convertible securities with options Sometimes, debt is issued with an option to convert the debt at some future date into equity shares. So, rather than repaying the debt with cash, the repayment would be with equity shares. Sometimes, such instruments contain an agreement (a put option) which allows holders of the debt to require redemption at a premium; often such securities will carry a low rate of interest to balance a high redemption premium. The put option requires buyback of the debt by the issuer at a premium price if conversion does not take place. Example 4.C C issues $1 million in convertible debt securities in 20X4. The debt carries an annual interest rate of 3%, and conversion is available in 20X9 at the option of the holder at a rate of 1 equity share for every $10 of debt. Alternatively, the holder can opt to exercise a put option in 20X9 to redeem the debt at a premium of 10%. At the time of issue, the market rate of interest for similar debt is 5.5%. In this case, the annual interest rate is low but is balanced by the availability of a high premium on redemption. If the price of 1 equity share in 20X9 is greater than $11 ($10 of debt plus 10% redemption premium) then the holders of the debt will choose that option. If, however, the price of a share is below $11, holders will choose to exercise the put option and will require redemption at par value 10%. In this case, the financial instrument should be classified as debt.
Financial instruments with contingent settlement Where shares are issued that give the holder the right to require redemption, in cash or another financial asset, upon the occurrence of an uncertain future event (e.g., if the entity fails to achieve a certain level of profits), the instrument should be classified as debt. 2006.1
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the non-redeemable shares are likely to be classified as equity. However, where distribution is mandatory, the instrument is much more akin to debt.
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Zero coupon bonds This is a financial instrument that requires no annual payment of interest. Instead, the issuer has a contractual obligation to repay the holders of the bonds a sum on redemption that reflects the fact that they have received no interest (i.e., it is higher than it would have been if annual interest had been paid). The redemption sum represents ‘rolled up’ finance charges. The obligation is clearly unfavourable to the issuer, it involves the delivery of a financial asset at a fixed or determinable point in the future, and it is therefore classified as debt. Convertible debt The view taken by IAS 32 is that this type of single financial instrument creates both debt and equity interests. The standard requires that the component parts of the instrument should be classified separately, and the following example demonstrates how this is done. Example 4.D An entity issues 5,000 convertible bonds at 1 January 20X0. The bonds have a five year term and are issued at par with a face value of $100 per bond. Total proceeds from the bond issue are therefore: 5,000 $100 $500,000. The interest rate on the bonds is 5%. Each bond is convertible at any time up to maturity into 100 ordinary shares. When the bonds are issued the prevailing market interest rate for similar debt without conversion options is 7%. At the issue date, the market price of one ordinary share is $2.50. The dividends expected over the five year term of the bonds amount to 10 cents per share at the end of each year. IAS 32 requires that the liability element is valued by reference, not to the actual interest rate on the convertible bond, but rather by reference to the prevailing market interest rate on similar debt without conversion right – in this case 7%. The calculations are as follows: $ Present value of the principal $500,000 at the 356,379 end of 5 years discounted to present value: 500,000/(1.07)5 Present value of the interest $25,000 payable annually in arrears for five years: $25,000 annuity factor for five years: $25,000 (1⁄1.07) (1⁄1.072) (1⁄1.073) (1⁄1.074) (1⁄1.075) 102,500 Total liability component 458,879 Equity component (balancing figure) 41,121 Total value of bond issue 500,000
Short-term borrowings Short-term borrowings are not usually included in the calculation of gearing. However, if the borrowings are short-term in maturity but the intention is to continually roll over these funds and use them as a semi-permanent form of finance, they should be included with long-term borrowings in the gearing calculation.
Exercise 4.1 The following is an extract from the balance sheet of Ashton plc at 30 September 2005: Ordinary shares of 25p each Reserves 7% preference shares of £1 each 15% unsecured bonds Total long-term funds 2006.1
£ 250,000 350,000 250,000 1,150,000 1,000,000
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Calculate the gearing ratio for Ashton plc using: (i) book values (ii) market values.
Solution Gearing
D ED
(i) Book values 150,000 15% 1,000,000 (ii) Market values Equity (Ve) Preference (Vp) Bonds (Vd)
1,000,000 125p 250,000 65p 150,000 85%
£ 1,250,000 162,500 1,127,500 1,540,000
127,500 8.3% 1,540,000
4.2.3 Interest cover An important ratio linking gearing with profitability is the interest cover, a measure of safety whereby the higher the rate, the greater the protection for shareholders and lenders, as the company is then less vulnerable in the event of a significant drop in profits. Interest cover
profit before interest payable and tax . interest payable
Example 4.E The profit and loss account of Ateyo plc for the year to 30 June 2005 shows the following figures:
Operating profit Interest payable Profit before tax Corporation tax Profit after tax Interest cover is calculated as
£000 100 140 160 118 142 £100,000 2.5. £40,000
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The ordinary shares are currently quoted at 125p each, the bonds are trading at £85 per £100 nominal and the non-redeemable preference shares at 65p each.
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4.2.4 Leverage The use of borrowings introduces financial risk to the balance sheet. This financial risk means that the earnings available to the ordinary shareholders become more volatile if the interest charges on borrowings are fixed. This effect on earnings is similar to the effect of leverage, which considers the relationship between fixed and variable charges and their effect on profits. Leverage may be calculated using the following two ratios: Operating leverage Financial leverage
contribution (sales less variable costs) profit before interest payable and tax profit before interest payable and tax profit before tax
Their use is best explained by means of an example:
Revenue Variable costs Fixed costs Operating profit Interest payments Profit before tax
For year 1: Operating leverage
Year 1 £000 1,000 (400) !!(200) 400 +$(50) 10350)
Year 2 £000 1,100 (440) +(200) 460 + (50) +410)
% Change 10
15 17.1
£600,000 1.5 £400,000
Operating leverage indicates by how much fixed costs could increase without the company making an operating loss. The figure of 1.5 also indicates that a 10 per cent increase in sales would result in a 15 per cent increase in operating profits (10 1.5). Financial leverage
£400,000 1.14 £350,000
Financial leverage indicates by how much interest payments could increase without the company making a pre-tax loss. By multiplying the two leverage measures together, it can be shown that a 10 per cent increase in sales would result in a 17.1 per cent increase in profit before tax, that is, total leverage (1.5 1.14) 1.71, giving an increase in profit before tax of 17.1 per cent (10 1.71). These projected increases are illustrated in the profit and loss figures for year 2 above, which assume an increase in sales of 10 per cent.
4.3 Cost of capital We call the cut-off rate, which separates viable from non-viable opportunities, the cost of capital and it is one of the fundamental disciplines of the capitalist market economy. Only those entities able to offer the prospect of a return in excess of the cost of capital will be able to attract the funds required to grow: those unable to do so will wither to extinction. This discipline is translated into a criterion for the allocation of resources within entities. The higher the cost of capital, for instance, the lower will be the investment in equipment, in innovation, in training and in working capital in anticipation of customers’ needs; the higher will be the selling price that optimises the return on a particular product, and so on. 2006.1
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4.3.1 Cost of equity Equity may be raised externally through a share issue, or internally through retained profits. Measuring the cost of equity is a very difficult task. The cost of equity must relate to the return that equity investors expect to reward them for the risk taken by investing in the company. However, this return is likely to vary from year to year. It is often thought that retained profits are a free source of finance. This is not true as there is an opportunity cost of the dividend forgone from retaining profits. There are a number of approaches to estimating the cost of equity that we shall now consider. Dividend valuation model We begin this section with the basic form of the dividend valuation model as a method of calculating cost of equity. This model makes the assumption that the market price of a share is related to the future dividend income stream from that share in such a way that the market price is assumed to be the present value of that future dividend income stream. This is known as the fundamental theory of share valuation. If a share pays a constant annual dividend in perpetuity, the ex-dividend share price may be calculated as: P0
d d d to infinity 2 (1 k) (1 k) (1 k)3
This simplifies to: P0 d ke which may be rearranged to give: ke d P0 where ke cost of equity d annual dividend P0 market value of equity (ex-dividend) This basic model assumes a constant rate of dividends to perpetuity and ignores taxation. Example 4.F Assume £1 shares quoted at £2.50, dividend just paid of 20p, then ke
20 0.08 or 8% 250 2006.1
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In order to understand fully the nature of cost of capital as discussed in this chapter, you will need to know how to calculate some of the basic financial models associated with the concept. It is important that you understand that the cost of capital must be equivalent to the return that investors expect to reward them for the risk taken by investing in a particular security, and effectively the market value in the calculations represents the NPV of the expected future cash flows to the investor discounted at this expected rate of return.
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STUDY MATERIAL P9 If a question quoted the share price as cum-div, or stated that the dividend proposed to be paid was 20p, then P0 needs adjustment to ex-dividend, thus: ke
20 0.087 or 8.7%. 250 20
Dividend growth model Equity investors will usually expect dividends to increase over time, rather than remain constant each year in perpetuity. This model still assumes the market price of a share is equal to the present value of the dividend income stream from that share. If we assume the dividend increases by a constant annual growth rate ( g), the market price of a share may be expressed as: d0(1 g) d0(1 g)2 d0(1 g)3 P0 to infinity (1 k) (1 k)2 (1 k)3 This simplifies to: P0
d0(1 g) ke g
which may be rearranged to give: d0(1 g) ke g P0 where ke cost of equity d0 current dividend P0 market value of equity (ex-dividend) g expected constant annual growth rate in dividends Note that the dividend growth model is sometimes shown as: ke
d1 g P0
where d1 d0(1 g), that is, next year’s dividend is equal to the current dividend uplifted by the growth rate.
Exercise 4.2 The current market price of a share is £2.50. A dividend of 20p has just been paid. Assuming the expected annual growth rate for the dividend is 5 per cent to perpetuity, calculate the cost of equity.
Solution d0(1 g) g P0 20(1.05) 0.05 250 0.084 0.05 0.134 ke 13.4%.
ke
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The current market price of a share is £2.00. A dividend of 20p per share has just been paid. Assuming the dividend is expected to decline by 2 per cent each year in perpetuity, calculate the cost of equity.
Solution d0(1 g) g P0 20(1 0.02) 0.02 200
ke
0.098 0.02 ke 7.8%.
Exercise 4.4 Thompson plc’s shares have gone ex-dividend having just declared a dividend of 20p per share. The market expects the dividend to grow by 5 per cent each year in perpetuity. The entity’s cost of equity capital is 13.4 per cent. What is the ex-dividend market price per share?
Solution d0(1 g) ke g 20(1.05) 0.134 0.05 21 0.084 P0 250p.
P0
Estimating the growth rate An examination question may require you to estimate the growth rate in dividends. There are two possible approaches with which you need to be familiar. You may need to extrapolate growth from historical data, assuming the historical average annual growth rate will continue in perpetuity. Example 4.G Year 2000 2001 2002 2003 2004
Dividend £ 15,000 15,500 17,200 18,100 19,000 2006.1
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Exercise 4.3
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STUDY MATERIAL P9 The historical average annual growth rate may be calculated using the compound interest formula: S X (1 r)n 19,000 15,000 (1 g)4 1g
15,000 1.06 4
19,000
g 1.06 1 g 0.06 or 6%.
Alternatively, Gordon’s growth model may be used to estimate the growth in dividends. This approach developed by economist Myron Gordon attempts to derive a future growth rate, rather than the previous approach of extrapolating the historical growth rate. Gordon argued that an increase in the level of investment by a company will give rise to an increase in future dividends. The two key elements in determining future dividend growth will be the rate of reinvestment by the company and the return generated by the investments. Gordon was able to demonstrate that the future dividend growth rate ( g) can be estimated as: g bR where b proportion of earnings retained each year Earnings dividend Earnings R average rate of return on investment Earnings Book value of capital employed There are a number of assumptions required to apply this model: ● ● ● ●
the entity must be all equity financed; retained profits are the only source of additional investment; a constant proportion of each year’s earnings is retained for reinvestment; projects financed from retained earnings earn a constant rate of return.
Exercise 4.5 An entity retains 60 per cent of its earnings for identified capital investment projects that are estimated to have an average post-tax return of 12 per cent. Estimate the future dividend growth rate for the entity.
Solution g bR 60% 12 7.2 g 7.2%. Capital asset pricing model (CAPM) The dividend valuation model as described above does not explicitly consider risk. Risk here is the risk that actual returns – that is, dividends – will not be the same as expected returns. 2006.1
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ke Rf [Rm Rf] where ke cost of equity Rf risk-free rate of return Rm expected return from the market portfolio equity beta Example 4.H Calculate the cost of equity using the CAPM, assuming an equity beta of 1.4, an expected market return of 16 per cent and a risk-free rate of 10 per cent.
Solution ke Rf [Rm Rf] ke 10 [16 10]1.4 10 8.4 18.4%.
4.3.2 Cost of debt Thus far we have considered dividend valuation models relating to an ungeared entity, so the next stage is to consider the effect of introducing debt into the calculation. In Chapter 3 we pointed out the need to distinguish between face value and market value of debt, and between coupon rate and rate of return. Any fixed interest debt, when issued will carry a coupon rate, that is, the rate of interest payable on the face or nominal value of the debt. Thus, £100 (face value) of 7 per cent bonds has a coupon rate of 7 per cent. When such debt is issued, the coupon rate will be fixed in accord with interest rates ruling in the market at that particular time for debt of similar nature and maturity. After issue of the debt, its market value will depend on the relationship of the coupon rate to the rate of return required by investors at any particular time. Thus, if the market value of £100 of 7 per cent debentures on a particular day is £90, the rate of return required at that time (gross of tax) is 7/90 100 ≈ 7.78 per cent. Irredeemable debt As the interest on debt is a tax-deductible expense, the relevant cost to an entity of using debt finance is the after-tax cost. For irredeemable debt, the cost of debt is given by an interest yield calculation: kd net
i(1 t ) P0 2006.1
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CAPM, as described later in this chapter, is a technique that enables risk to be incorporated into financial analysis. Using CAPM to calculate the cost of equity:
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where kd net cost of debt (after tax) i annual interest t rate of corporation tax (assumed immediately recoverable) P0 market value of debt (ex-interest, i.e. immediately after payment).
Exercise 4.6 Assume 7 per cent bonds quoted at £90 (ex-int), interest just paid, and corporation tax is 30 per cent, calculate the cost of debt:
Solution kd net
7(1 0.30) 0.054 or 5.4% 90
Notice that if £90 was the cumulative interest market price (i.e. the price includes the pending interest payment), then the cost of debt above would be: 7(1 0.30) kd net 0.059 or 5.9%. 90 7 Redeemable debt The cost of redeemable debt is calculated using an internal rate of return approach. The calculation takes the internal rate of return of the annual net of tax interest payments from year 1 to year n plus the redemption payment in year n minus the original market value of the debt in year zero. In other words, all of the cash flows associated with the debt from today’s market value through to the redemption value (Red) are discounted on a trial-anderror basis to find the internal rate of return.
Exercise 4.7 Calculate the cost of a 7 per cent bond currently quoted at £90. It will be redeemed at £101 in 5 years’ time. Interest and redemption payments are assumed to be payable at year end and tax of 30 per cent to be immediately recoverable.
Solution MV (ex-int) 1t
Year 0 1 to 5
Red
5
Cash flow 90 7 (0.70) 4.9 101
DF @ 5% 1.000 4.329 0.784
so by interpolation: kd net 5
(10 5) 10.39610.396 8.703
kd net 5 2.72 7.72%. 2006.1
DF @ 10% 1.000 3.791 0.621
PV @ 5% (90.000)
PV @ 10% (90.000)
21.212 79.184 10.396
18.576 62.721) |(8.703)
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Pn P0 (1 g)n Notice that this is the compound formula, previously seen as: S X(1 r)n If we assume dividend growth of 9.2 per cent per annum and P0 of 250p, then in four years’ time: P4 250 (1.092)4 ≈ 355p which we can use as the convertible value.
4.3.3 Cost of preference shares The cost of preference share capital is related to the amount of dividend payable on the share. The dividend is an appropriation from post-tax profits, which means that it is not allowable for tax. The cost can be represented by: kpref d P0 where kpref cost of preference shares d annual dividend P0 current ex-div market price Assuming a dividend of, say, 7p per £1 preference share and a market value of 60p (ex-div), the cost of the preferred share would be: 7 11.7%. 60
4.4 Weighted average cost of capital The weighted average cost of capital (WACC) assumes that when an entity raises finance, the cash raised is added into a pool of funds. When a potential investment project is identified, the project is assumed to be financed from the pool, rather than from any specific fund-raising operation. If the mix of equity, debt and preference shares within the pool of funds is assumed to remain constant over time, the discount rate to apply in appraising the project would be the cost of the pool of funds, that is, the weighted average cost of capital. The WACC can be found by calculating the cost of each long-term source of finance weighted by the proportions of finance used. In theory, market values of the securities should be used in the gearing calculations as these give a more accurate measure of the entity’s value, although book values are frequently used in practice. 2006.1
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Convertible debt In the case of convertible bonds, the redemption payment would become the market value at year n of the ordinary shares into which the debt is to be converted. We can calculate MV in n years’ time using the model:
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Using market values for a firm with equity, debt and preference shares in its capital structure, the WACC would be: k0
keVe kpVp kdVd Ve Vp Vd
where Ve, Vp and Vd denote the market value of equity, preference shares and debt, respectively. Note that in the formula sheet the formula for weighted average cost of capital is shown as:
V V V k V V V
k0 ke
d
e
e
d
d
e
d
This assumes that a firm has equity and debt in its capital structure, but no preference shares. Introducing preference shares into the formula would give:
k0 ke
Vp Vd Ve kd kpref Ve Vd Vp Ve Vd Vp Ve Vd Vp
This text will use the first formula quoted when illustrating the calculation of WACC.
Exercise 4.8 The following is an extract from the balance sheet of Gate plc at 30 September 2004: Ordinary shares of 25p each Reserves 7% preference shares of £1 each 15% unsecured bonds Total long-term funds
£ 250,000 350,000 250,000 1,150,000 1,000,000
The ordinary shares are currently quoted at 125p each, the bonds trading at £85 per £100 nominal and the preferred shares at 65p each. The ordinary dividend of 10p has just been paid, and the expected growth rate in the dividend is 10 per cent. Corporation tax is at the rate of 33 per cent. Calculate the weighted average cost of capital for Gate plc.
Solution Market values of the securities Equity (Ve) Preference (Vp) Bonds (Vd)
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1,000,000 125p 250,000 65p 150,000 85%
£ 1,250,000 162,500 1,127,500 1,540,000
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ke
CAPITAL STRUCTURE AND COST OF CAPITAL
Cost of equity (ke) d0(1 g) g P0 10(1.10) 0.10 125
0.088 0.10 18.8% Cost of preference shares (kp) kpref d P0 7 10.8% 65 Cost of bonds (kd net) i(1 t ) P0 15(1 0.30) 12.4% 85
kd net
Weighted average cost of capital (k0) k0
keVe kpVp kdVd Ve Vp Vd
(0.188 1,250,000) (0.108 162,500) (0.124 127,500) 1,540,000 235,000 17,550 15,810 k0 1,540,000 k0 0.174 17.4%. k0
4.4.1 Assumptions in the use of WACC WACC can be used as a cut-off or discounting rate for calculating the NPVs of projected cash flows for new investments, but the following criteria should be met: ●
●
●
●
159
the capital structure is reasonably constant; this assumption is necessary because if the capital structure changes, the weightings in the WACC calculation will change, which will lead to a change in k0; the new investment does not carry a significantly different risk profile from that of the existing entity; as k0 is the entity’s cost of capital, it will only be suitable for appraising a project if the project shows the same risk profile as the whole entity; the new investment is marginal to the entity; the calculations of ke, kp, and kd are based on small investments: in other words, they represent marginal costs of capital. Their use in the WACC calculation means that k0, by implication, is also a marginal cost; all cash flows are level perpetuities; the derivation of the formula for WACC would show that this must be the case, but it is not shown here as it is not a requirement of the syllabus for Management Accounting: Financial Strategy. 2006.1
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4.5 Marginal cost of capital As discussed above, the use of WACC assumes that the capital structure of an entity will remain unchanged and that any new investment will have a similar risk profile to existing investments. If a large project is under consideration, and it would fundamentally affect the capital structure of an entity, these assumptions would mean that WACC is no longer the appropriate technique for investment appraisal. Use of WACC could lead to the acceptance of projects that reduce the entity’s value. The relevant cost of capital is now arguably the incremental cost, i.e. the marginal cost reflecting the changes in the total cost of the capital structure before and after the introduction of the new capital. In theory, the marginal cost of capital is just the difference between the total cost with the existing capital structure and the total cost with the new capital structure once the investment has been undertaken. Consider an entity with the following cost of capital: Source Equity Preference Bonds
After-tax cost, % A 20 10 8
Market value, £m 1B 15 11 14 10
AB 1.00 0.10 0.32 1.42
Weighted average cost of capital 1.42/10 100 14.2% It has a large investment project under consideration, to be financed by a major issue of funds which will alter the capital structure. The estimated project cost is £1,000,000, to be financed in equal proportions by a new share issue and a new issue of bonds. The new capital structure will imply a new level of risk for holders of bonds and equity shares, causing the cost of capital for the company to change. The new cost of capital may be as follows: Source Equity Preference Bonds New Bonds
After-tax cost, % A 22 10 8 10
Market value, £m 1B 15.5 11.0 14.0 10.5 11.0
AB 1.21 0.10 0.32 0.05 1.68
Weighted average cost of capital 1.68/11 100 15.3% Marginal cost of capital 1.68 1.42 100% 26% 11 10 The total cost of capital has increased by £260,000 as a result of raising £1,000,000 of funds. The incremental cost of capital is therefore 26 per cent. It might be thought that by raising £500,000 of equity with a cost of 22 per cent, and £500,000 of bonds with a cost of 10 per cent, the marginal cost of capital would be: (0.5 22) (0.5 10) 16% but this would ignore the change in the cost of original capital. 2006.1
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4.6 The traditional theory of gearing The traditional theory of financial gearing considers the effect that a change in gearing has on the WACC and on the value of an entity. It is based on the following assumptions: ●
● ● ●
earnings remain constant in perpetuity and all investors have the same expectations about future earnings; taxation is ignored; risk remains constant, no matter how funds are invested; all earnings are paid out in dividends. From Figure 4.1 we note that:
●
●
●
●
Cost of equity increases as level of gearing increases; the introduction of debt brings financial risk. This financial risk will cause the earnings available to the ordinary shareholders to become more volatile. The ordinary shareholders will require higher returns to compensate for the increase in financial risk, which pushes the cost of equity up. Debt is assumed to be a cheaper source of finance than equity, as it ranks above equity for both distribution of earnings and on liquidation. Interest on debt is a tax-deductible expense and the issue costs of debt are normally lower than equity. As gearing level increases, cost of debt remains unchanged up to a certain point in the level of gearing, beyond which it will increase; interest cover will start to fall and there will be fewer assets available to offer as security for further loans. The risk to providers of debt increases, which pushes up the cost of debt. WACC forms a type of U-shape, at first falling as level of debt increases reflecting the low cost of debt, and then tending to increase as rising equity costs (and perhaps rising cost of debt) become more significant.
Figure 4.1
Traditional theory of gearing
Note: ke cost of equity; kd cost of debt; ked WACC. 2006.1
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The approach illustrated here is appropriate only if the investment project is large relative to the current size of the entity and undertaking the project causes an identifiable difference in the capital structure. In practice, entities rarely raise funds from a particular source for a particular purpose, which makes this approach difficult to use.
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Figure 4.2
Market value of a firm
The traditional view therefore is that WACC will be lowest at a level of gearing that represents an optimal capital structure (point OCS on the graph). This optimal level of gearing is likely to be different for each company within each industry. It can also be shown that the capital structure that minimises WACC will also be that which maximises the value of the entity, Figure 4.2 always provided that we assume earnings to be independent of the capital structure. This can be illustrated as follows.
Exercise 4.9 Mansel plc is expected to generate annual earnings of £600,000 for the foreseeable future. Ignoring taxation, calculate the total market value of Mansel plc, assuming that its cost of capital (WACC) is either (i) 10 per cent; or (ii) 20 per cent.
Solution Earnings where ked cost of capital (WACC) ked If ked 10 per cent: 600,000 MV £6,000,000 0.1 If ked = 20 per cent: 600,000 £3,000,000 MV 0.2 MV
4.7 Modigliani and Miller’s theories of gearing The background to Modigliani and Miller’s (MM’s) 1958 theory, which forms the basis for the ‘net operating income’ view of WACC, is set out as follows. Assuming that the conditions apply of a perfect capital market, two entities which yield identical earnings and have similar risk profiles and production capabilities will have the same value in terms of capitalisation whatever their capital structures may be. 2006.1
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Proposition I ‘The market value of any entity is independent of its capital structure and is given by capitalising its expected return at the rate appropriate to its class.’ This can also be expressed in terms of an entity’s ‘average cost of capital’, which is the ratio of the expected return to the market value of all its securities; thus, ‘the average cost of capital to any firm is completely independent of its capital structure, and is equal to the capitalisation rate of a pure equity stream of its class’.
Proposition II This relates to the rate of return on equity in entity whose capital structure includes some debt: ‘The expected yield of a share of stock is equal to the appropriate capitalisation rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-toequity ratio times the spread between [the capitalisation rate and the interest rate on debt]’. In simpler terms, these two propositions have the following effects: 1. The total market value of an entity is independent of the level of debt in its capital structure. This value can be calculated by capitalising the expected flow of operational earnings (before interest payments) at an appropriate discount rate depending on risk category. 2. As leverage (use of debt) increases, the equity cost of capital to a levered entity will also rise in order to exactly offset the advantages accruing from the lower cost of debt relative to equity. Note that debt is cheaper than equity, owing to its carrying a lower risk in that payment of interest on debt and usually repayment of principal (say in a breaking up of the company) takes precedence over equity dividends or repayment.
Proposition III This provides a rule for optimal investment policy by the entity: ‘The cut-off point for investment in the entity will in all cases be [the average cost of capital] and will be completely unaffected by the type of security used to finance the investment’. So, if the first two propositions hold, the cut-off rate used to evaluate investments will not be affected by the type of funding used to finance them, whatever may be the capital structure. The gain from using debt (at lower cost) is offset by the increased cost of equity (due to increased risk) and WACC therefore remains constant. 2006.1
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MM also assume that taxation and transaction costs can be ignored, and that their assumptions are supported by market intervention through the process of ‘arbitrage’ whereby the actions of investors would equate the values of the two entities in all respects except that of leverage (the use of debt, which is assumed to be risk-free and costs the same to individuals as to entities, to increase the expected return on equity). ‘Arbitraging’ here refers to the switching of funds by an investor as between investments in order to obtain a better return for the same risk level. In the perfect capital market assumed by MM, information is freely available to all investors, who in turn are assumed to act rationally, to have similar expectations as to returns and also to be in agreement as to the expected future streams of earning for each company, while all entities can be classified into equivalent risk groups. From this background, MM set out their three propositions.
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In order to maximise equity holders’ wealth, the company should therefore use its WACC as a cutoff rate. The equation for this theory (without tax) is: Proposition 1:
Vg Vug
Proposition 2:
keg keu (D/E )(keu kd)
Proposition 3: where
WACCg WACCug
Vg value of geared entity Vug value of ungeared entity keg cost of equity in geared entity keu cost of equity in ungeared entity kd cost of debt (gross of tax).
Example 4.I X plc is identical in all operating and risk characteristics to Y plc, except that X plc is all equity financed and Y plc is financed by equity valued at £2.1m and debt valued at £0.9m based on market values. The interest paid on Y plc’s debt is £72,000 per annum, and it pays a dividend to shareholders of £378,000 per annum. X plc pays an annual dividend of £450,000.
Requirements (i) (ii) (iii) (iv) (v)
Identify the value of X plc. Calculate the cost of capital for X plc. Calculate the cost of equity for Y plc. Calculate the cost of debt for Y plc. Calculate the weighted average cost of capital for Y plc.
Solution (i)
Vug Vg £2.1m £0.9m £3.0m (ii) keu
Dividend 450 0.15 15% E 3,000
(iii) keg keu (D/E)(keu kd) 15%
900 (15 8) 18% 2,100
Alternatively, keg
(iv) kd
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Dividend 378 0.18 18% E 2,100 .
Interest 72 0.08 8% D 900
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0.08
2,100 900 0.18 3,000 3,000
450 15% WACCug. 3,000
Note from Figure 4.3 that at the higher levels of gearing, there is the apparent paradox of cost of equity falling and cost of debt rising. This is explained by the selling of equity by existing shareholders who are relatively risk-averse to other investors who are prepared to take much higher risks for the possibility of a high return; the effect is to reduce the cost of equity while the cost of debt, now perceived by its holders as being increasingly risky, will rise. In 1963, MM accepted that corporate taxation could indeed have a distorting effect in that as a result of debt interest being deductible before computing taxation, WACC would continuously decrease as additional amounts of debt were incorporated into the entity’s capital structure. This is illustrated in Figure 4.4.
Figure 4.3
Figure 4.4
MM’s gearing propositions without tax
MM’s gearing propositions with tax 2006.1
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(v) WACCg kd
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The equation for this theory (with tax) is: Vg Vug TB
k eg keu (1 t) D (keu kd) E
WACCg WACCug 1
TB DE
or WACCg keg
E kd(1 t) D DE DE
where Vg value of geared entity Vug value of ungeared entity TB present value of tax shield Veg Vg D value of equity in a geared entity keg cost of equity in geared entity keu cost of equity in ungeared entity kd cost of debt (gross of tax) E market value of equity D market value of debt. For this proposition our assumptions change to allow for the inclusion of the debt tax relief at 33 per cent as follows. The value of Y plc now becomes:
Vg Vug TB 3,000,000 (900,000 0.33) £ 3,297,000 The value of equity for Y plc becomes Veg Vg D £3,297,000 £900,000 £2,397,000 2006.1
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CAPITAL STRUCTURE AND COST OF CAPITAL
The cost of equity for Y plc is now calculated as:
keg keu (1 t) D (keu kd) E
15% 0.67 900 (15% 8%) 2,397
15% 1.76% 16.76%. The weighted average cost of capital now becomes:
WACCg WACCug 1
TB 15% 1 900 0.33 13.65% 3,297 DE
or
WACCg keg
16.76%
4.7.1
E kd(1 t ) D DE DE
2,397 8% 0.67 900 13.65%. 3,297 3,297
Limitations of MM theory
Apart from MM’s own recognition of a flaw in their basic theory as examined above, other limitations can be briefly mentioned as follows: ● ●
●
●
cost of capital is not likely to remain constant in the real world; personal and corporate leverage are seldom equivalent, for entities even of medium size are likely to have a higher credit rating than most individual investors. (This was allowed for in Miller’s and MM’s later work, but knowledge of this is not required for the Financial Strateg y syllabus.); most investors would face less risk if they allow a entities with limited liability to borrow on their behalf; very high levels of gearing carry considerable dangers of corporate collapse.
4.8 Cost of capital and adjusted cost of capital You should clearly understand the two concepts of cost of capital: ●
●
167
Opportunity cost of capital, r, is ‘the expected rate of return offered in capital markets by equivalent-risk assets’, depending on the risk of project cash flows. Use r where there are no significant side-effects from financing. Adjusted cost of capital, r *, is an opportunity cost rate which also reflects the financing side-effects of an investment project. If these are significant, use r * and accept projects having positive APVs (adjusted present values).
4.8.1 Adjusted present value Cost of capital is the opportunity cost of capital and, as such, is frequently used as the discount rate in investment decisions. This is not entirely correct; the rate to be used in the 2006.1
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investment decisions should, in theory, be a specific risk-adjusted discount rate which reflects the business risk of the project. This adjusted rate is the basis of the concept of adjusted present value (APV) which suggests that the net present value (NPV) of a project can be increased or decreased by the side-effects of financing. You must be clear as to the difference between NPV and APV. Thus, in using APV you proceed by taking NPV as a first stage (‘base case NPV’), evaluating a project as if it was totally financed by equity, and then introduce APV as a second stage by making adjustments to the base case to allow for the side-effects of the intended method of financing. A simple example will serve to illustrate the basic idea. Example 4.J A project has a net present value of £50m (the ‘base case’ NPV). However, as the project is considered socially desirable it qualifies for an immediate tax-free government grant of £10m. This is a special financing arrangement and hence needs to be taken into account: APV NPV side- effect of financing £50m £10m £60m
More complicated examples could be found, for example to show how the tax benefits of debt interest might increase the base case NPV of a project. The issue costs would of course have the effect of decreasing base case NPV. Note that the calculation of APV usually takes the form of first calculating NPV as if the project financing was all by equity, and then incorporating adjustments to allow for the effects of the financing method to be actually used. Bear in mind that difficulties in using APV may arise either in determining the costs involved in the financing method to be used, or in finding a suitable cost of equity for the basic NPV calculation. Nevertheless, APV often has the advantage of being a more positive approach than making an arbitrary adjustment of the entity’s cut-off rate. The APV approach also suggests that an adjusted cost of capital can be calculated to use as a discount rate in specific circumstances. Example 4.K – APV and adjusted cost of capital calculations A project requires £1m capital investment. The project will save £220,000 per year after taxes. Assume the savings are in perpetuity. The business risk of the venture requires a 20 per cent discount rate. In this case the project’s base case NPV is just positive: Base case NPV 1,000,000
220,000 £100,000 0.2
However, assume this project has one financial side-effect, it expands the entity’s borrowing power by £400,000. The project lasts indefinitely so we treat it as supporting perpetual (i.e. undated) debt. If we assume the borrowing rate is 14 per cent and the net tax shield is 35 per cent, the project supports debt which generates an interest tax shield of: 0.35 0.14 £400,000 which is £19,600 per annum for ever. The PV of the tax shield is: 19,600 £140,000 0.14 2006.1
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APV Base case NPV TB £100,000 £140,000 £240,000 Adjusted discount rate The adjusted discount rate, or adjusted cost of capital, is the rate at which the APV 0; that is, the IRR. To calculate the adjusted discount rate we must first calculate the minimum acceptable annual income (i.e. the annual income that would result in an APV of zero). APV Base case NPV TB Initial investment Annual income/Base case discount rate TB £1m Annual income/0.2 £140,000 Assuming APV 0, we can rearrange the equation to give: Min. annual income 0.2 (£1m £140,000) £172,000 The minimum IRR is therefore: IRR Minimum annual income/initial investment (gross) £172,000/£1m 0.172 or 17.2% This is the adjusted cost of capital – denoted r*. To calculate r* we find the minimum acceptable rate of return – the IRR at which APV 0. The rule is, accept projects which have a positive NPV at the adjusted cost of capital.
The adjusted cost of capital is significant in that it separates out the financial side-effects of an investment project, while the marginal cut-off rate is useful in the case of projects whose financing may create significant variations in gearing, or create a markedly different risk profile from that of the existing entity.
4.8.2 Adjusted cost of capital – Modigliani and Miller Modigliani and Miller demonstrated that the adjusted cost of capital (r *) may be calculated from the formula: r * r(1 T *L) where r the opportunity cost of capital T * the rate of corporation tax L the project’s marginal contribution to the entity debt capacity as a proportion of the firm’s present value The formula may also be expressed as: kg keu(1 T *L) where kg the average cost of capital in a geared entity keu the cost of equity in an ungeared entity. 2006.1
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The project’s APV is therefore:
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Example 4.L A project requires £1m capital investment. The project will save £220,000 per year after taxes in perpetuity, and will expand the entity’s borrowing power by £400,000. The business risk of the venture requires a 20 per cent discount rate. The rate of corporation tax is 35 per cent. Calculate the adjusted cost of capital using Modigliani and Miller’s formula.
Solution r* r(1 T *L) where r 20% T * 35% L 400,000/1,000,000 40% r* 0.2(1 0.35 0.4) 0.2 0.86 0.172 17.2%. Notice that this is the same figure as calculated using the same raw data in Example 4.G. However, this was because the project was assumed to generate savings in perpetuity, and the level of gearing is assumed to remain the same.
4.9 Risk and reward Another major topic in finance theory concerns the relationship between risk and reward. The conventional wisdom is that investors (as distinct from gamblers who bet on football matches or horses, and customers of lotteries) are risk averse. Specifically, it is said that the higher the risk they associate with a particular investment, the higher the return they will demand. Figure 4.5 portrays the general relationship. For all practical purposes, ‘risk’ in the context of investment means uncertainty as to outcome. While it is legitimate to seek the truth about the past, any projections of the future need to recognise a margin of error. Although intuition may suggest that additional risk should be rewarded with additional return, we need to be able to define and measure return and risk in order to quantify the additional return required for each additional unit of risk.
Figure 4.5 2006.1
Risk and reward
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r
P1 P0 d P0
where r P1 P0 d
return from the share during the period value of the share at the end of the period value of the share at the beginning of the period dividend received in the period.
This equation can also be written as: P1 P0 d P0 P0 which shows that the return from a share is represented by a capital gain (or loss) plus the dividend (measured as dividend yield). The return from a share could be quoted either as a historical return based on actual data, or as an expected return based on subjective probabilities. Assuming that a dividend of 20p was paid during a period on a share whose price was 80p at the start of the period and 90p at the end, the historical return would be calculated as: r
r 90 80 20 90 80 20 0.125 0.25 0.375 or 37.5%. 80 80 80 The total return here comprised a capital gain of 12.5 per cent and a dividend yield of 25 per cent. Quantifying an expected return for the next period is more difficult as both the dividend and the share price at the end of the period will need to be estimated. It is usually assumed that any share will have a range of possible returns that are distributed symmetrically about the expected return. The risk of a share is usually expressed as a measure of the dispersion of the possible returns about the expected return. The measure of dispersion that tends to be used is the standard deviation, or the variance. As shown in Figure 4.6 if two shares X and Y offer the same expected return, risk-averse investors would prefer share X as the possible returns are less widely
Figure 4.6
Risk assessment of two shares 2006.1
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The measurement of return must be related to a time period. The return from a share over any given time period can be quantified as:
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dispersed about the expected return than with share Y. Share Y is a riskier investment than share X.
4.10 Portfolio theory As long ago as 1952, H M Markowitz explained how in an efficient market a rational riskaverse investor could achieve a more efficient investment by holding a combination (or portfolio) of shares. When shares are held together, the expected return on the portfolio is simply the weighted average of the individual expected returns. The risk of the portfolio, however, depends on the correlation between the expected returns of each pair of shares in the portfolio. The coefficient of correlation provides a measure of the strength of the relationship between the expected returns of two securities. The coefficient of correlation can vary between values of 1 and 1. If the expected returns of two securities are perfectly positively correlated (1), this would indicate that the expected returns will move in the same direction in the same proportion at all times. With perfect negative correlation (1), the expected returns on the two securities will move in the opposite direction in the same magnitude at all times. A portfolio of shares will not diversify risk if the returns on the shares within the portfolio are highly correlated. If correlation is low, the portfolio will be highly diversified and the risk much less, that is, if the return on a particular share is poor, this will be compensated by a good return from another share. Suppose, for example, that there was a perfect positive correlation between two securities (X and Y) that comprise the market. In other words, high and low returns always move in sympathy. It would pay the investor to place all funds in whichever security yields the higher return at the time. The straight line XY in Figure 4.7 represents the possible combinations of securities X and Y assuming the coefficient of correlation between the two securities is 1. Under this assumption there is a linear relationship between expected return and risk. If, however, there was perfect negative correlation (i.e. a high rate of return on X was always associated with a low return on Y and vice versa) or there was random (zero) correlation between the returns, then it can be shown statistically that overall risk reduction can be achieved by diversification. The triangle XYV in Figure 4.7 shows the full range of possible combinations of securities X and Y for all possible levels of correlation between the two securities. The diagram
Figure 4.7 2006.1
Risk–return profiles for differing correlation coefficients – the two-asset case
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Figure 4.8
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shows that as long as the correlation between the securities is less than perfect positive (1), then the risk of the portfolio as measured by standard deviation would be lower than the weighted average of its constituent elements. The greatest reduction of risk would be where the returns of securities X and Y show perfect negative correlation (1). The lines XV and VY contain all combinations of securities X and Y under this assumption, where at point V it is possible to construct a portfolio with zero risk. Portfolios will usually consist of more than two securities and the benefits of diversification are likely to increase as more securities are introduced to the portfolio. Most securities are likely to have a positive correlation with other securities. As long as this positive correlation between securities is less than perfect, the scope for risk reduction and the creation of more efficient portfolios increases. An efficient portfolio is one that satisfies two conditions relative to any other combination of financial assets, namely: (i) maximum expected return for its given risk; (ii) minimum risk for its given expected return; where the expected return and risk are measured by the arithmetic mean and standard deviation of the portfolio. At any point in time there will be a number of portfolios that satisfy the conditions as shown in Figure 4.8. Figure 4.8 represents all the securities and so all possible combinations of those securities for a particular market. The most desirable portfolios have been emphasised, lying on the curve XY which is referred to as the efficient frontier. These are the portfolios that offer the highest return for a given level of risk, or the lowest risk for a given level of return. The efficient frontier XY of risky portfolios reveals that to the right and below, alternative investments yield inferior results. To the left, no possibilities exist. Individual investors will have different preferences from this range of efficient portfolios, depending on their attitude to risk and expected return. This personal attitude to risk and expected return could be represented by an indifference curve. An optimum portfolio for an investor can be determined at the point where the individual’s utility indifference curve (calibrating an attitude towards risk and expected return) is tangential to the efficient frontier. The indifference curve for a particular investor is shown in Figure 4.9. The optimum portfolio for this investor is at the tangential point E to the efficient frontier. This investor is willing to take relatively high risks to earn high returns. Other investors may be more risk averse.
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Figure 4.9
Determination of an optimum portfolio
Introducing the possibility that investors can lend and borrow at a risk-free rate of interest leads to the conclusion that there would now be only one portfolio of risky securities that would be of interest to all investors, regardless of their individual attitudes to risk and return. As an alternative to the optimal wholly risky portfolio, investors may opt for: (i) a risk-free selection of short- to medium-term government securities; (ii) a mixed portfolio comprising any combination of risky and risk-free investments. These possibilities are portrayed in Figure 4.10, where M represents the optimal wholly risky portfolio, A denotes the risk-free portfolio and the line AB (which can be infinitely extended) represents the capital market line (CML) showing the boundary of efficient mixed portfolios. Since M denotes a wholly risky portfolio, the line AM represents increasing proportions of portfolio M combined with a reducing balance of lending at the risk-free rate. The line beyond M can only represent opportunities for borrowing at the risk-free rate in order to increase the size, but not the composition, of the optimal portfolio. By ‘leveraging’ (borrowing against) the investment, the investor’s risk would rise but so would the return. Thus, if all investors can borrow or lend at the same rate of interest, Tobin concluded that they all ought to choose the same optimal portfolio, irrespective of their attitude to risk, by first finding the point of tangency (M) and then borrowing or lending to adjust the balance between risk and return.
Figure 4.10 2006.1
The capital market line
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4.10.1 Systematic risk and unsystematic risk Other things being equal, if the standard deviation of an individual security is higher than that for a portfolio in which it is held, then part of the standard deviation must have been diversified away through correlation with other constituents, leaving only that portion of risk that is correlated with the economy as a whole. The latter portion of risk is inescapable (undiversifiable or systematic) and is the only risk that investors will pay a premium for. There emerged an academic consensus that the two elements of total risk associated with an investment were systematic or market risk (also known as beta, or non-specific risk) and unsystematic or non-market (alpha or specific) risk, which may or may not be correlated with other securities. Systematic risk affects the market as a whole and may be described as a portfolio’s inherent sensitivity to world political and economic events, a particularly good example being the collapse of the European Exchange Rate Mechanism (ERM) and the currency devaluations of 17 September 1992. Unsystematic risk relates to an individual security’s price and is independent of systematic risk. Specific to individual entities, it is caused by factors such as profitability, product innovation, management and, of increasing importance recently, law suits, consequential upon the paucity of published accounting data. Although neither element of risk can be observed directly, Figure 4.11 highlights the empirical fact that up to 95 per cent of unsystematic risk can be diversified away by randomly increasing the number of securities in a portfolio to about 30. When it approaches the composition of the market, virtually all the risk associated with holding that portfolio becomes systematic or market risk. It is not surprising, therefore, that practising fund managers requiring a far simpler model than that offered by Markowitz to enable them to diversify efficiently, as they invested across innumerable securities, sectors and countries, were quick to appreciate the utility of the relationship between the systematic risk of either a stock or a portfolio and their
Figure 4.11
Portfolio risk and diversification 2006.1
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By definition, portfolio M is the market portfolio of all risky securities available on the market, as it is the only wholly risky portfolio that is of interest to investors. The linear relationship between risk and expected returns shown in Figure 4.10 applies to all efficient portfolios. Unfortunately, it does not hold for individual risky investments, since securities with higher standard deviations may have lower returns and vice versa. An objective of portfolio diversification, therefore, is to achieve an overall standard deviation lower than that of its component parts.
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returns. But how to measure such risk and how to choose the efficient portfolio? This is the subject of the next section: the capital asset pricing model (CAPM).
4.11 The capital asset pricing model In the previous section we saw that risk could be reduced by investing in a portfolio of securities. The total risk involved in any one investment is the sum of the impact of all the risk that might affect the return on a specific investment. The CAPM would argue that investors do not need to suffer the total risk inherent with individual investments as this could be reduced by holding a diversity of investments within a portfolio. The return from a single investment in an ice-cream entity will be subject to changes in the weather – sunny weather producing good returns, cold weather poor returns. By itself the investment could be considered a high risk. If a second investment were made in an umbrella entity, which is also subject to weather changes, but in the opposite way, then the return from the portfolio of the two investments will have a much-reduced risk level. This process is known as diversification, and when continued can reduce portfolio risk to a minimum. The CAPM argues that total risk, as measured by standard deviation, can be split into two elements: the risk that can be reduced by diversification, known as specific risk, and the risk that will not be reduced by diversification, known as market risk. Market risk can be broken down further, as shown in Figure 4.12. The risk that can be removed through diversification – specific risk – is that risk that is specific to the individual investment. For example, if you had a single investment of ordinary shares in an entity that built houses, the specific risks would include particular planning applications, subsidence problems, non-payment by particular customers, etc. Market risk. Market risk is associated with the economic environment in which all entities operate, so changes in interest rates, exchange rates, prices, taxation, etc., affect all entities and their share prices to a greater or a lesser extent. Because investors can avoid specific risk through diversification, the CAPM would argue that the only risk worthy of consideration is market risk. This market risk is measured as a beta value. Business risk. Business risk is the risk associated with the particular activities undertaken by the entity. Financial risk. Financial risk is the risk resulting from the existence of debt in the financing structure of the entity. If individual investors wish to hold a single investment, such as the building entity ordinary shares, or a poorly diversified portfolio, then the market will not offer a compensation for suffering the specific risk associated with such a limited portfolio. As specific risk can be diversified away, (Figure 4.13), securities will be priced by reference to their market risk only. Securities with high market risk will have required returns above the market rate, while those with low market risk will have lower rates of return.
Figure 4.12 2006.1
Elements of total risk
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Figure 4.13
Risk reduction through diversification
In the following section we consider how the market risk, or beta, for a security may be measured.
4.11.1 Measuring beta values If the price of a selected security increases when the market rises, then statistical measurements are still needed to identify how much of the security price increase occurred because of systematic (market) and unsystematic (specific) risk respectively. In the UK, prior to the introduction of the FT-SE100 share price index, the obvious procedure was to compare movements in an individual share price with movements in the market using the FT All-Share Index. A scatter diagram was plotted over a period of time correlating percentage movements in: (i) market prices as measured by the index (on the horizontal axis); (ii) the selected share price (on the vertical axis). The line of ‘best fit’ for the observations could then be determined by regressing stock prices against the overall market over time using the method of least squares. This linear regression line is known as the share’s ‘characteristic line’. As Figure 4.14 reveals, the intercept of the line on the vertical axis measures the average percentage movement in the share price occurring if there is no movement in the market
Figure 4.14
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The relationship between security price and market movements – the characteristic line 2006.1
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and is called the alpha of the stock. A positive alpha over the period of observation indicates a share which has outperformed the market. The slope of the regression line in relation to the horizontal axis is the beta factor. It reveals the volatility of share price to market movements in terms of the ratio of expected change in the price of the stock to the market itself. Although alpha varies considerably over time, studies in the 1970s (e.g. Black, Jensen and Scholes, 1972) showed that beta values are more stable, displaying a near straight-line relationship with their returns. While this relationship is less than certain today, beta values are still valuable for portfolio selection. Fund managers can tailor a portfolio to their specific risk return (utility) requirements, aiming to hold securities with beta factors in excess of unity (one) while the market is rising, and less than unity when the market is falling. A beta of 1.15, for example, implies that if the underlying market with a beta factor of one were to rise by 10 per cent, then the stock may be expected to rise by 11.5 per cent. The market portfolio has a beta of one because the covariance of the market portfolio with itself is identical to the variance of the market portfolio. Needless to say, a risk-free investment has a beta of zero because its covariance with the market is zero. Whereas the linear relationship between portfolio risk and expected returns (the CML) does not hold for individual risky investments, all the characteristics of beta apply to portfolios, as well as to individual securities. The beta of a portfolio is simply the weighted average of the beta factors of its constituents. Using the seminal capital asset pricing model (CAPM) developed independently by Sharpe (1963), the attraction of this relationship becomes clear if the CML is, therefore, reconstructed to form what Sharpe termed the security market line (SML) by substituting systematic (market) risk for total risk on the horizontal axis. Since beta factors can be calculated, the CAPM provides a usable measure of risk. It also implies that the optimum portfolio is the market portfolio. Because the return on a share depends on whether it follows market prices as a whole, the closer the correlation between a share and the market index, the greater will be its expected return. Finally, the CAPM predicts that shares or portfolios with higher beta values will have higher returns.
4.11.2 The security market line As Figure 4.15 confirms, the expected risk-rate return of E (R m ) from a balanced market portfolio (M) will correspond to a beta value of one, since the portfolio cannot be more or less risky than the market as a whole. The expected return on risk-free investment (Rf) remains unchanged with a beta value of zero. Portfolio A (or anywhere on the line Rf M) is termed a ‘lending’ portfolio and consists of a mixture of risky and risk-free securities. Portfolio B is a ‘borrowing’ or leveraged portfolio, because beyond (M), additional securities are purchased by borrowing at the risk-free rate of interest. Proceeding one stage further, the Sharpe single index CAPM can now be utilised in order to establish whether individual securities are under- or overpriced (hence its name), since their expected rates of return and beta factors can be compared with the SML. For example, share (X) might have an expected return of 8 per cent and a beta coefficient of 0.5. Superimposed on Figure 4.15 (see Figure 4.16), this would reveal that the return was too low for the risk involved and that the share was overpriced, since (X) is located below the SML. Consequently, rational shareholders would sell their holdings, eliciting a fall in price, while potential investors would delay purchase until the price had fallen and the increased yield (A) impinged upon the SML. 2006.1
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Figure 4.16
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The security market line
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Figure 4.15
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The capital asset pricing model
Given a market return of 16 per cent from a balanced portfolio and a risk-free rate of 6 per cent, Figure 4.16 illustrates why the required rate of return with a beta value of 0.5 should be 11 per cent. This may be confirmed by Sharpe’s formula for the expected return of a portfolio or individual security. This comprises a risk-free return, plus a premium for accepting market risk and assumes all correctly priced securities will lie on the SML. Thus Expected return risk-free rate (beta (market rate risk-free rate)) As expressed in CIMA’s formula sheet: Expected return R f (R m R f) Example 4.M Assuming a market return of 16 per cent and a risk-free rate of return of 6 per cent, calculate the required rate of return for a share with a beta value of 0.5.
Solution Required return: r = Rf + (Rm Rf) 0.06 0.5(0.16 0.06) 0.11 11%
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It is also clear from Figure 4.16 why investment in security (Y) is beneficial. Stocks above the line will be in great demand; they will rise in price. Thus, it seems reasonable to conclude that in theoretical equilibrium, all securities or portfolios will lie on the SML and individual investors need not conform to the market portfolio. They need only determine how much systematic risk they wish to assume, leaving market forces to ensure that any security can be expected to yield the appropriate return for its beta.
4.12 Using the CAPM as an investment tool Beta () is a measure of responsiveness of the returns for a particular investment when compared to the average market return, as summarised in the Financial Times All-share Index. If the average market return moves up or down by (say) 10 per cent and the returns for a particular investment also move up and down by 10 per cent in parallel with market movements, then that investment is said to have a beta of 1.0 (10% 10%). Such an investment shadows market movements and has identical risk on the market as a whole. If the average market return moves up or down by (say) 20 per cent and the returns for a particular investment move up and down by 15 per cent, then that investment is said to have a beta of 0.75 (15% 20%). Such an investment is less risky than the market because it softens the impact of changes in market returns. The three key variables – Rf, Rm and – can be quantified from data available from the market. The beta for a particular investment is available from the London Business School Risk Analysis Service, which provides betas and other data on all quoted UK company shares. The risk-free rate of interest (Rf) is the expected rate for short-term government securities. The average return to the market (Rm) can be calculated from the Financial Times Actuaries All-share Index. If an investor was considering an investment in an entity whose quoted ordinary shares had a beta of 1.12 with the 3-month Treasury bill rate currently at 12 per cent and the average market return being 20 per cent, then the expected return from such an investment would be: Er Rf (Rm Rf) 12%+1.12 (20% 12%) 20.96% Just as returns for individual securities may be calculated using betas, then a similar approach can be adopted for a portfolio of investments.
Example 4.N A pension fund manager holds a highly diverse portfolio of investments on behalf of her members and is considering adding the following ordinary share investments to the portfolio: Investment BTR Tesco RTZ British Petroleum 2006.1
Quoted beta 1.14 0.83 1.15 0.83
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Investment BTR Tesco RTZ British Petroleum
Proportion (%) 20 25 20 35
then the risk associated with the new investments should be given by the weighted average beta, as follows: Investment (all ordinary shares) BTR Tesco RTZ British Petroleum
Percentage of portfolio 20 25 20 135 100
Beta of investment 1.14 0.83 1.15 0.83
Weighted average 0.228 0.208 0.230 0.291 Beta 0.957
The new investments with an average beta of 0.957 may be described as defensive, as they represent a mini-portfolio with less risk than the market. The portfolio manager may use this information to assess the wisdom of the new investments. For example, if the fund manager wished to hold a portfolio with an average beta of 1.0 and the existing portfolio already had an average beta greater than 1.0, then this selection may be suitable.
4.13 MM, CAPM and geared betas Students should note that CAPM to an extent follows Modigliani and Miller (MM) theory in that, based on the arbitrage process, two similar assets cannot sell at different prices. Earlier in this chapter it was shown that, by assuming a tax-free world, MM identified the relationship between the required return on the equity of a geared entity and that of an ungeared entity. This links with the relationship between the equity beta of a geared entity and the equity beta of an ungeared entity in the same systematic risk class. This relationship is given by:
G U (U D) D E where G equity beta of a geared entity; U equity beta of an ungeared entity; D beta of debt; E market value of equity in geared entity; D market value of debt in geared entity; it also assumes a tax-free environment. Although CAPM and MM theory are based on a number of similar assumptions, CAPM is strictly speaking a single-period model, while MM theory is a multi-period model which assumes that the cash flows to an enterprise are constant to perpetuity. Betas have an affinity with MM theory and provide one means of measuring rates of return, with responses to changes in gearing in the manner predicted by MM.
4.13.1
Ungearing beta
Let us now extend the model to show the relationships between entities, both geared ( G) and ungeared ( U), and the projects of which these entities consist ( A). We shall assume that ke, the expected return on projects, should be related to the return required by investors. 2006.1
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At first sight these investments seem to represent a broad spread of risk, with betas above and below the average market risk of 1.0. Before any realistic risk measure can be evaluated the proportions of new investment monies allocated to each investment must be considered. If the fund manager were to invest new moneys in the following proportions:
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We shall use a square balance sheet to illustrate the approach. The square balance sheet shows the financing of an entity or project on the left-hand side, while the right-hand side reflects how the financing has been applied by way of net assets. This is illustrated below for an all-equity-financed entity, investing in a single project (A):
where E market value of equity; U equity beta in ungeared entity; A beta of the activity (project beta). Note that, in many textbooks, A is called the asset beta. ‘Activity’ seems a more appropriate term, but A is used in exactly the same way as in other texts. The risk of the equity as measured by beta ( U) will relate to the risk of the activity as measured by beta ( A) so that:
U A
Equation 1
Using CAPM, the required rate of return on project (kA) is then calculated as: kA rf A(R m R f ) The beta of the activity is a measure of the activity’s systematic business risk. It can only be measured directly in a quoted all-equity-financed entity. For other entity we may have to estimate activity betas by using figures from similar quoted entities, or calculate the activity beta from the betas of the equity and debt. We shall begin by considering an entity that has invested in a number of projects. The assets on the right-hand side of our square balance sheet may be analysed into a number of identifiable projects. Each project will have its own beta, and the beta of the entity is determined by these projects.
If there is no debt, the entity’s equity beta will be the weighted average of the project betas (equals A):
A wi i U where wi weighting of individual project based on market values; i beta of individual project or activity. If there is debt, this will be modified by the financial risk inherent in raising debt. The left-hand side of our square balance sheet may now be analysed between equity and debt:
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A weighted average: A D
E D G DE DE
Equation 2
where G equity beta in geared entity; D market value of debt; E market value of equity. With tax, this becomes: D(1 t ) E A D G D(1 t ) E D(1 t ) E where t corporation tax rate. A can be used then to evaluate projects before considering the method of financing, that is, it is the business risk that is important. kA rf A(R m R f ) Remember from Equation 1 that u A, so that: D(1 t) E G u D D(1 t) E D(1 t) E and kuf u(RmRf)
4.13.2
Geared equity beta
We can now show the relationship between the equity beta in a geared entity and the equity beta of an ungeared entity in the same systematic-risk class:
A U D
E D G DE DE
(ignoring tax)
Rearranging:
U(D E ) D D G E G E UD U E D D Divide through by E:
U U D U D D E E ∴ G U ( U D) D Ungearing beta E Systematic business risk
Systematic financial risk (premium)
This links in with the Modigliani and Miller hypothesis on capital structure (see Section 4.7) where the cost of equity in a geared entity (keg ) was shown as: keg keu (keu kd) D. E 2006.1
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The activity beta will now be related to the equity beta and the debt beta, so that the activity beta becomes the weighted average of the equity and debt betas:
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The effect of the tax shield effect of debt can be introduced to give:
G U (U D)(1 t )D E
from: keg keu (1 t )(keu kd)D E
Example 4.O Ashton plc is identical in all operating and risk characteristics to Gate plc, except that Ashton plc is all-equity financed and Gate plc is financed by equity and debt in the proportion 75 : 25 at market valuation. The beta factor of Ashton plc is 0.9. Gate plc’s debt capital is virtually risk-free, and corporation tax is levied at the rate of 33 per cent.
Requirement Calculate the equity beta of Gate plc and the cost of equity for the entity.
Solution
G U (U D)(1 t)
D E
but debt is assumed risk-free so:
G U U(1 t)
D E
G 0.9 (0.9)(0.67)
25 75
G 0.9 0.201 1.101 Alternatively:
A D
D(1 t) E G D(1 t) E D(1 t) E
As D 0:
A G
E D(1 t) E
0.9 G
75 25(1 0.33) 75
G 1.101 The cost of equity may then be calculated as: keg rf G(Rm Rf) 6 1.101(12 6) 12.606%
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If we use CAPM as a means of project appraisal, we are in effect substituting an investment project for an investment in a share. The workings of the concept are similar, the purpose being to obtain an appropriate cost of capital for the project. We can proceed as follows: 1. Obtain the beta of an industry which relates as closely as possible to our own project, that is, with similar systematic risk characteristics, and use this beta to obtain the cost of capital using the CAPM formula. 2. A more exact method would be to obtain the betas of a few entities within that related industry and proceed as follows: (i) convert those betas to allow for our own entity’s gearing level, that is, its relationship of debt to equity, by first ungearing the betas and then converting them back to geared betas which reflect our own entity’s gearing ratio; (ii) average these new geared betas, possibly excluding any which seem unduly far from the mean, that is, where their standard deviation seems excessive; (iii) as a further step we could give weights to the new geared betas in relation to the closeness which we judge their entities to be in relation to our project, before averaging them; (iv) having obtained a new average geared beta, we obtain a cost of capital using the CAPM formula. These procedures could provide useful tools to employ, preferably in conjunction with other appropriate methods, in appraising an acquisition as well as a major project.
4.14.1 Limitations of CAPM The main limitations of using CAPM to obtain the cost of capital (discount rate) to a appraise an investment project are: ●
●
● ●
CAPM is a single-period model, so the discount rate calculated may not be appropriate for the whole life of the project. CAPM assumes only systematic risk needs to be captured as unsystematic risk has been diversified away. CAPM assumes that risk can be encapsulated in a single figure (beta). Close comparison with a proxy entity is difficult as it assumes close similarity of activities and business risk.
4.15 Arbitrage pricing model The CAPM provides a simple relationship between risk and return, such that the expected return of an asset is equal to the risk-free rate of return plus a risk premium. That risk premium is determined by beta ( ), which represents the asset’s systematic risk relative to the systematic risk of the market. Arbitrage pricing theory (APT ), developed in 1976 by S. Ross, attempts to explain the risk–return relationship using several independent factors rather than a single index. 2006.1
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4.14 Use of CAPM in investment appraisal
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APT may be expressed as: E(ke) rf 11 2 2 n n where E(Ke) required return on an asset rf risk-free rate of return the ‘market price’ for each risk factor, that is, the difference between the actual and expected value of each factor sensitivity of the asset’s returns to changes in the values of each factor Research undertaken to date suggests that there are a small number of factors, or economic forces, that systematically affect the returns on assets. These are: ● ● ● ● ● ●
inflation or deflation; long-run growth in profitability in the economy; industrial production; term structure of interest rates; default premium on bonds; price of oil.
Each factor must be independent of the other factors. APT assumes that the process of arbitrage would ensure that two assets offering identical returns and risks will sell for the same price. Intuitively, APT appears to improve on CAPM, as return is determined by a number of independent factors. The main practical difficulties are in determining what those factors are, as the model does not specify them, and forecasting their value. There have been few tests of APT, probably because of the difficulties in determining which variables to include in the model and how to weight them.
4.16 Summary In this chapter we have considered the implications of using debt in the capital structure. The main argument for gearing is that, by introducing debt, the interest payments attract tax relief. Against this, debt also introduces financial risk into a company. These factors call for the financial manager to formulate a policy that will effectively balance out their opposing effects. We examined methods of assessing the costs of equity, preference shares and debt finance and explored the impact that capital structure has on the overall cost of capital for an entity as measured by the weighted average cost of capital. We also saw that the marginal cost of capital is useful in the case of projects whose financing may create significant variations in gearing, or create a markedly different risk profile from that of the existing company. The impact of changing capital structures on the cost of capital was outlined before investigating the relationship between risk and reward. Portfolio theory helps towards a better understanding of the risk–reward relationship, especially as to the way it affects the investor in shares. Investors are assumed to evaluate portfolios from their expected return and standard deviation. The expected return of a portfolio is the weighted average of the expected returns of the individual securities, 2006.1
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whereas the risk or standard deviation is dependent on the correlation of returns between each pair of securities. A key aspect of portfolio theory is the concept derived from Markowitz that an efficient portfolio either offers the highest return for a given level of risk or has the lowest risk for a given level of return. From efficient frontiers and investor indifference curves emerged the capital market line (CML), with the conclusion that, with the opportunity to borrow and lend at the risk-free rate of interest, all investors will invest in a portfolio located on the CML. Portfolios on the CML will comprise the market portfolio of wholly risky securities with either lending or borrowing at the risk-free rate of interest. As the number of securities held in the portfolio is increased, the risk relating to individual securities (unsystematic or specific risk) can be eliminated but market (systematic) risk cannot be diversified away. The capital asset pricing model (CAPM) provides a useful decision-making framework for investors, by providing a measure for risk that can be quantified and operationalised by them. Like any economic model it is based on a series of assumptions, but empirical research suggests that the CAPM is both robust and durable for investment decisions in the real world, if investors hold diverse portfolios. You must make sure that you understand and can distinguish between the two key elements of CAPM share evaluation – specific risk and market risk. You must also be aware that significant controversy exists over the effectiveness of the concept, and the problems of using CAPM need to be clearly appreciated.
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4
Readings
In the following article, the author argues that CAPM provides a useful, simple and practically applicable approach to investment appraisal in risky environments.
The usefulness of beta in the investment appraisal process Alan Gregory, Management Accounting, January 1990. Reproduced with permission.
In a recent article, John Fielding argued that ‘most finance directors cannot be sure that the beta of their company is different from l’ and then went on to draw the conclusions that (a) the cost of equity for most companies was very close to 18 per cent, (b) the company accountant would find it difficult to explain to ‘a sceptical chairman that total risk is unimportant in assessing the riskiness of a project’ and (c) most treasurers or accountants should not spend too much time estimating their precise cost of equity, since ‘an estimate of 18 per cent won’t be too far out’. The purpose of this article is to examine these claims, and to explain why the beta measure potentially offers a very useful input to the investment appraisal process. Betas in the investment appraisal process
Fielding gives a useful description of the nature of systematic and specific risk. It must be emphasised, however, that studies have shown that investors are not rewarded for taking on specific risk but are rewarded for systematic risk. The theory (the capital asset pricing model or CAPM) predicts that this will be the case because investors can freely diversify away specific risk but must accept systematic (market) risk as the cost of investing in risky assets. It is this systematic risk that is measured by beta, which can be viewed as an index with a mean value of 1. Practical studies have suggested that there is, indeed, a linear relationship between systematic risk and return, although the relationship is a little flatter than the CAPM predicts (see Figure 1 (left)). We shall return to this point later. Provided that the risk borne per period is constant, it can be argued that the CAPM (a single period model) can be used in the appraisal of capital investment. Broadly, the approach is to estimate a beta for the project, and use this in the CAPM to give a discount rate for use in the calculation of net present value (NPV). In practice, most firms using this approach would calculate a beta (and hence a discount rate) for each division or principal business activity rather than for each individual project, unless that project represented a major new venture. 189
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Figure 1 (Left): Theoretical v empirical risk-return trade-off. (Right): Using the WACC rejects Project A (which has a positive NPV at the correct discount rate) and accepts B (which has a negative NPV at the correct rate)
The most common method of estimating beta in practice is to use companies operating in the same businesses as the division or project in question as proxies; in outline, the beta of a portfolio of proxy companies is calculated (the beta of the portfolio is simply a weighted average of the individual betas) and this is then adjusted for gearing effects. A case study of the practical aspects of this approach is covered in the CIMA course on Advanced Investment Appraisal. Note the contrast of all this with John Fielding’s recommendations. First, weighted average cost of capital (WACC) is not used; given that most businesses cover more than one business activity, each of which may support different levels of gearing, the use of WACC is totally inappropriate and may lead to non-optimal decision making within the firm (see Figure 1 (right)). Secondly, if we are not using WACC, it is not our company’s beta which is of concern but the betas of companies operating in the same business as the division or project being analysed. In general, WACC can only be used where: 1. the company has one main line of business; 2. project cash flows are of approximately the same systematic risk as the company’s existing line of business; 3. gearing is expected to remain constant. A possible example of this type of situation would have been the case of Jaguar (before recent events) appraising new production line investment of a scale not requiring major new finance. (Although given Fielding’s suggested 18 per cent cost of capital, it is worth noting that Jaguar’s beta was 1.34 as measured by London Business School Risk Measurement Service [LBSRMS] in September.) Contrast this with the not untypical case of brewing companies with interests in the hotel and catering trade, who wish to appraise new projects in both business areas. If we exclude those brewers which already have substantial hotel interests, from the LBSRMS data, we find that their typical beta factors are around 0.7. By contrast hoteliers average slightly over 1.0. How important is this difference? 2006.1
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Practical issues in using beta
Turning to Fielding’s point concerning the reliability of beta estimates, he notes that, for the majority of companies, beta is not statistically significantly different from 1.0. There are problems with his conclusion on this. For the reasons we discussed above, it is not the beta of our own company we are interested in but the beta of a portfolio of proxy companies. Fortunately, the standard error of a portfolio beta is always lower than the average of the standard errors of the individual betas. As an example, the beta of Blue Arrow plc is 1.36, with a standard error of 0.17, whereas the beta of the agencies sector in general is 1.39 with a standard error of 0.09. Thus we can be more confident in our estimated beta when we have a reasonable number of proxy companies in our portfolio. If we are particularly concerned about this point, we can estimate our betas by using a larger number of data points (for example, LBS tapes are available giving daily share and market returns) although, as Fielding correctly points out, there are a number of pitfalls here that can trap the unwary. Besides the empirical problem referred to above, these include mean reversion and ‘thin trading problems’, which are associated with smaller company shares (shares which are not frequently traded will appear to have betas which understate their ‘true’ systematic risk). The LBSRMS beta estimates do allow for such known problems. It is important that beta remains relatively stable over time if it is to be of any use in estimating a project discount rate. As we know that portfolio betas are more stable than individual company betas, we can again be more confident of our estimates if we are using a reasonable number of companies as proxies. However, we can check the beta to see if it is expected to change. For example, we would anticipate that a utility company like British Telecom would have a low beta; in fact it has a beta of 0.71, in line with expectations. 2006.1
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Let us assume that we are appraising a project with a ten-year life. As at November 1989, ten-year gilt yields are around 10.5 per cent and LBS estimates that the long-run historical market risk premium (i.e. return of the market less the risk-free return) is around 9 per cent for the UK. A perusal of various economic forecasts might lead us to the somewhat crude assumption that the average inflation rate over the ten-year period might be 5 per cent. Thus a suitable discount rate for hotel projects would be given by the CAPM (which predicts that return should be the risk-free rate plus beta times the market risk premium) as 10.5 (1.0 9) 19.5 per cent (this contrasts with an 18 per cent return assumed by Fielding), whereas for brewing projects this discount rate should be only 10.5 (0.7 9) 16.8 per cent. In real terms, using the relationship (1 real rate) (1 money rate)/(1 inflation rate), we obtain real discount rates of 13.8 and 11.2 per cent respectively. Imagine that projects costing £10 m are available in both brewing and hotels, that the projected annual benefits are £1.8 m p.a. for ten years, and that this amount will increase in line with inflation. At the CAPM real discount rate of 13.8 per cent, the hotel project NPV is £0.54 m negative, whereas the brewing project shows a positive NPV of £0.51 m at a real discount rate of 11.2 per cent. (Note that in the case of a real project we would need to be much more rigorous in our estimate of betas, and take account of the impact of gearing. Taxation has also been ignored for simplicity. Nonetheless, there is no reason to suppose that the scale of the difference will change by much.) Compared to the project cost of £10 m, the difference between these NPVs appears significant. Doubtless the news that a 2.6 per cent change in money cost of capital can have a considerable impact will come as no surprise to either the CBI or those of us with mortgages.
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If we knew that BT was about to take over BICC (which has a beta of 1.11) and was to finance this with a large increase in debt, we would expect BT’s beta to increase since (a) post takeover, BT would be a portfolio of the old BT and the old BICC and (b) highly geared companies should have higher betas than lowly geared companies, as their equity has a greater degree of systematic risk. It is also worth noting that in contrast to Fielding’s claims that modern portfolio theory ( MPT) is regarded with suspicion by many analysts and finance directors, in the USA ‘portfolio managers in almost any large American investment institution use modern risk measurement to analyse their portfolio … the investment community spends over $200 m per annum on MPT services alone’ (LBSRMS). Furthermore, the CAPM approach to investment appraisal is now virtually standard fare on any MBA programme in both the US and the UK, and the demand for courses on MPT in the UK would suggest that British practice may be about to follow the American experience. Alternative and supplementary approaches
This article should not be construed as unqualified support for the CAPM approach to the exclusion of all others. There are more sophisticated MPT-based approaches to risk analysis which may be of use in project appraisal. For example, one US study found four significant variables which drive security returns, which were an index of industrial production, changes in the default risk premium, twists in the yield curve and unanticipated inflation (this contrasts with the single parameter of ‘market risk premium’ in the CAPM). To use this in project appraisal would require estimates of all the parameters (including unanticipated inflation) and four beta estimates, each of which would need to remain relatively stable. There are no readily available data sources which provide such betas. In reality, companies will tend to look at total risk, although it is to be hoped that they will at least look at company-wide diversification effects; when doing so techniques such as sensitivity analysis and scenario modelling are useful inputs to the decision making process and can be recommended as supplementary to the CAPM approach. However, our ‘sceptical chairmen’ must be careful not to give too great an emphasis to total risk. It must be remembered that the market does not reward specific risk, and thus a company that attempts to ‘price’ this risk by building it into the appraisal process will tend to reject projects which ideally should have been accepted; such a company will tend to exhibit below average growth. ‘The market does have its own peculiar way of rewarding these companies;’ it’s known as a takeover bid. Of course, there is an exception to this rule of only pricing systematic risk, and that is where the shareholders are not fully diversified (thus contradicting one of the assumptions of the CAPM); the management of companies controlled by individuals or families would be concerned quite legitimately with total risk. Conclusion
As we have shown, management should be concerned with the systematic risk of each business activity. In effect, the aim is to value each project as though it is a ‘mini company’ in its own right. Although it is not a perfect method and can usefully be supplemented by other methodologies, the CAPM offers a useful, simple and practically applicable approach to investment appraisal in risky environments, which has theoretical foundations. It would be unfortunate to reject it too readily. 2006.1
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1. ‘Betas have a tendency over time to revert to 1, low betas increasing and high betas decreasing.’ Why might this be? 2. Bearing in mind the admitted difficulties of calculating betas, how widespread is their use likely to be in practice? Is this an instance where the enthusiasm of academics is not matched among practitioners? Outline solutions 1. Betas are not easy to estimate in the first place. They are generally calculated over a long period of time (typically 60 months), using a form of regression to obtain a line of best fit. This means observations are included from periods that may no longer be representative of the company’s (or country’s) current economic or financial potential. The variation around the characteristic line can be very great, which also reduces the confidence we can place in the accuracy of beta as a measure of risk. A company’s risk profile may change over time. Smaller companies are generally believed to be riskier than large ones. As they grow, their risk therefore reduces and their beta will move closer to 1. The reverse may also be true. Large companies stagnate unless they constantly develop new markets and products. This dynamism introduces risk into what may have been a relatively safe business. 2. There are three main groups of users of betas: financial analysts, academic researchers and companies themselves. We are not concerned here with the the academic examination of company performance using betas, although, even with this group, their use has been more readily accepted in the USA than elsewhere. ● Analysts. Investment analysts can use beta to design portfolios to match risk preferences of their clients. The method can also be used to monitor the performance of a company or portfolio – but bear in mind that performance is related to what was predicted by theory. Analysts generally have a stronger background in quantitative techniques than company managers and are better able to handle the complicated statistics involved. It would be useful here to review some of the surveys done by the financial press on the performance of fund managers and decide for yourselves whether the use of sophisticated techniques have helped them make improved returns for their clients. ● Companies. Company managers could use beta and the CAPM to establish a cost of equity and subsequently a weighted average cost of capital. The problem here is that beta measures only market risk. Many company managers would argue that they are more concerned with total risk, unless their company is so large and diversified that all specific risk of their projects has been eliminated. It might be useful here for you to recap on the meaning of total, specific and market risk and how all three types of risk are measured.
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Discussion questions
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Question 1 Crestlee plc is evaluating two projects. The first involves a £4.725 million expenditure on new machinery to expand the company’s existing operations in the textile industry. The second is a diversification into the packaging industry, and will cost £9.275 million. Crestlee’s summarised balance sheet, and those of Canall plc and Sealalot plc, two quoted companies in the packaging industry, are shown below:
Non-current assets Current assets Less current liabilities Financed by: Ordinary shares1 Reserves Medium and long-term loans2 Ordinary share price (pence) Debenture price (£) Equity beta
Crestlee plc £m 96 95 (70) 121)
Canall plc £m 42 82 (72) ,52)
Sealalot plc £m 76 65 (48) ,93)
15 50 156 121
10 27 115 ,52
30 50 113 ,93
380 104 1.2
180 112 1.3
230 – 1.2
Notes: 1. Crestlee and Sealalot 50 pence par value, Canall 25 pence par value. 2. Crestlee 12% debentures 1998–2000, Canall 14% debentures 2003, Sealalot medium-term bank loan.
Crestlee proposes to finance the expansion of textile operations with a £4.725 million 11 per cent loan stock issue, and the packaging investment with a £9.275 million rights issue at a discount of 10 per cent on the current market price. Issue costs may be ignored. Crestlee’s managers are proposing to use a discount rate of 15 per cent per year to evaluate each of these projects. The risk-free rate of interest is estimated to be 6 per cent per year and the market return 14 per cent per year. Corporate tax is at a rate of 33 per cent per year. 195
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Requirements (a) Determine whether 15 per cent per year is an appropriate discount rate to use for each of these projects. Explain your answer and state clearly any assumptions that you make. (19 marks) (b) Crestlee’s marketing director suggests that it is incorrect to use the same discount rate each year for the investment in packaging, as the early stages of the investment are more risky, and should be discounted at a higher rate. Another board member disagrees, saying that more distant cash flows are riskier and should be discounted at a higher rate. Discuss the validity of the views of each of the directors. (6 marks) (Total marks 25)
Question 2 PMS is a private limited company with intentions of obtaining a stock market listing in the near future. The company is wholly equity-financed at present, but the directors are considering a new capital structure prior to its becoming a listed company. PMS operates in an industry where the average asset beta is 1.2. The company’s business risk is estimated to be similar to that of the industry as a whole. The current level of earnings before interest and taxes is £400,000. This earnings level is expected to be maintained for the foreseeable future. The rate of return on riskless assets is at present 10 per cent and the return on the market portfolio is 15 per cent. These rates are post-tax and are expected to remain constant for the foreseeable future. PMS is considering introducing debt into its capital structure by one of the following methods: 1. £500,000 10 per cent debentures at par, secured on land and buildings of the company; 2. £1,000,000 12 per cent unsecured loan stock at par. The rate of corporation tax is expected to remain at 33 per cent, and interest on debt is tax-deductible. Requirements (a) Calculate, for each of the two options: (i) values of equity and total market values, (ii) debt/equity ratios, (iii) cost of equity. (9 marks) (b) List the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (6 marks) (c) ‘Capital structure can have no influence on the value of the firm.’ Discuss this statement and comment briefly on the practical factors which a company may take into account when determining capital structure. (10 marks) (Total marks 25)
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The following is an extract from the balance sheet of Leisure International plc at 30 June 19X2:
Ordinary shares of 50 p each Reserves 9% preference shares of £1 each 14% debentures Total long-term funds
£000 5,200 4,850 4,500 15,000 19,550
The ordinary shares are quoted at 80p. Assume that the market estimate of the next ordinary dividend is 4p, growing thereafter at 12 per cent per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72p and the debentures are quoted at par. Corporation tax is 35 per cent. (a) You are required to use the relevant data above to estimate the company’s weighted average cost of capital (WACC), i.e. the return required by the providers of the three types of capital, using the respective market values as weighting factors. (6 marks) (b) You are required to explain how the capital asset pricing model would be used as an alternative method of estimating the cost of equity, indicating what information would be required and how it would be obtained. (7 marks) (c) Assume that the debentures have recently been issued specifically to fund the company’s expansion programme under which a number of projects are being considered. It has been suggested at a project appraisal meeting that, because these projects are to be financed by the debentures, the cut-off rate for project acceptance should be the after-tax rate on the debentures rather than the WACC. You are required to comment on this suggestion. (6 marks) (d) Assume that instead of raising £5 million of 14 per cent debentures, the company had raised the equivalent amount in preference shares giving the same yield as the existing preference capital. You are required: (i) to demonstrate that the returns offered to investors in the two securities are consistent with investor risk aversion; and (ii) to calculate how Leisure International plc’s equity earnings would have been affected if the preference shares had been issued instead of the loan capital. (6 marks) (Total Marks 25)
Question 4 DEB plc is a listed company that sells fashion clothes over the Internet. Financial markets have criticised the company recently because of the high levels of debt that it has maintained in its balance sheet. The company’s debt consists of $150 million of 8% debentures that are due for repayment by 31 March 2005. Financial markets indicate it would not be possible to issue a new loan under the same conditions. The market value of the debentures is $90 per $100 nominal. 2006.1
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Question 3
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DEB plc’s draft balance sheet at 31 March 2002 was as follows: $ million 100 120 120 150 270
Ordinary shares of $1 Reserves 8% debentures (at nominal value) Non-current assets Net current assets
200 270 270
Fixed assets consist of $150 million of capitalised development costs and $50 million of land and buildings. The company’s share price has fallen consistently over the past 2 years as follows: 31 March 2000 31 March 2001 31 March 2002
Price per share $20 $8 $4
The company intends to make a 1-for-2 rights issue at an issue price of $2.50 on 30 June 2002. It is assuming that the cum rights price at the issue date will be $4. Immediately thereafter, all the proceeds will be used to redeem debt at its nominal value and thereby reduce its gearing. Requirements (a) Calculate the gearing (that is, debt/equity) of DEB plc at 31 March 2002 using both (i) book values; and (ii) market values. (3 marks) (b) Evaluate (i) the weaknesses; and (ii) the benefits of the two methods used to calculate gearing in requirement (a) above. (6 marks) (c) Calculate the gearing of DEB plc in market value terms, immediately after the rights issue and redemption of debt. (6 marks) (d) Briefly explain the advantages and disadvantages for DEB plc of redeeming part of its debt using an issue of equity shares. (5 marks) (Total marks 20)
Question 5 CAP plc is a listed company that owns and operates a large number of farms throughout the world. A variety of crops are grown. Financing structure The following is an extract from the balance sheet of CAP plc at 30 September 2002. Ordinary shares of £1 each Reserves 9% irredeemable £1 preference shares 8% loan stock 2003
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A new project Difficult trading conditions in European farming have caused CAP plc to decide to convert a number of its farms in Southern Europe into camping sites with effect from the 2003 holiday season. Providing the necessary facilities for campers will require major investment, and this will be financed by a new issue of loan stock. The returns on the new campsite business are likely to have a very low correlation with those of the existing farming business. Requirements (a) Using the capital asset pricing model, calculate the required rate of return on equity of CAP plc at 30 September 2002. Ignore any impact from the new campsite project. Briefly explain the implications of a beta of less than 1, such as that for CAP plc. (5 marks) (b) Calculate the weighted average cost of capital of CAP plc at 30 September 2002 (use your calculation in answer to requirement (a) above for the cost of equity). Ignore any impact from the new campsite project. (10 marks) (c) Without further calculations, identify and explain the factors that may change CAP plc’s equity beta during the year ending 30 September 2003. (5 marks) (Total marks 20)
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The ordinary shares were quoted at £3 per share ex div on 30 September 2002. The beta of CAP plc’s equity shares is 0.8; the annual yield on treasury bills is 5%, and financial markets expect an average annual return of 15% on the market index. The market price per preference share was £0.90 ex div on 30 September 2002. Loan stock interest is paid annually in arrears and is allowable for tax at a corporation tax rate of 30%. The loan stock was priced at £100.57 ex interest per £100 nominal on 30 September 2002. Loan stock is redeemable on 30 September 2003. Assume that taxation is payable at the end of the year in which taxable profits arise.
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Solution 1 (a) The discount rate should reflect the systematic risk of the individual project being undertaken. Unless the risk of the textile expansion and the diversification into the packaging industry are the same, their cash flows should not be discounted at the same rate. The discount rate to be used should not be the cost of the actual source of funds for a project, but a weighted average of the costs of debt and equity which is weighted by the market values of debt and equity. It is possible to estimate an existing weighted average cost of capital for Crestlee, but the rate cannot be applied to new projects unless the following assumptions are complied with. (i) The project is marginal, that is, it is small relative to the size of the company. Taken together, the two projects are not marginal, but this is not a crucial assumption as long as the costs of debt or equity do not alter because of the size of the financing required. (ii) All cash flows of the project are level perpetuities. This is unrealistic for ‘real world’ projects, but again makes little difference to the validity of the estimated weighted average cost of capital. The remaining two assumptions are of more importance: (iii) The project should be financed in a way that does not alter the company’s existing capital structure. The net present value investment appraisal method cannot handle a significant change in capital structure; if such a change occurs the adjusted present value (APV) method should be used. Crestlee’s existing capital structure using market values is: 30 million ordinary shares at 380 pence £56 million debentures at £104
£m 114 158.24 172.24
% 66 34
If the two investments are considered as a ‘package’: New finance being raised is £9.275m equity £4.725m debt 14.000m
% 66 34
The company’s capital structure does not change as a result of these two investments. 201
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(iv) The project should have the same level of systematic risk as the company’s existing operations. As the textile investment is an expansion of existing operations, it is reasonable to assume that it has the same systematic risk. The diversification into packaging could have very different risk characteristics. The company’s existing weighted average cost of capital should not be used as a discount rate for the diversification. Textile expansion. The discount rate may be based upon the company’s weighted average cost of capital (given that assumptions (iii) and (iv) are not violated): WACC ke
E k (1 T ) D d c ED ED
Using the capital asset pricing model, ke may be estimated by RF (RM RF)E ke 6% (14% 6%)1.2 15.6% kd is taken as the current cost of loan stock, 11 per cent (alternatively a rate could have been estimated using the redemption yield of the debenture): WACC 15.6% 66 11%(1 0.33) 34 12.8% 100 100 This is the suggested discounted rate for the expansion. Packaging diversification. The systematic risk of diversifying into the packaging industry may be estimated by referring to the systematic risk of companies within that industry. However, the equity beta is influenced by the level of financial risk (gearing). Unless the market-weighted gearing of Canall and Sealalot is the same as Crestlee, it is necessary to ‘ungear’ the equity of these companies (to remove the effect of financial risk) and regear to take account of Crestlee’s financial risk: Gearing Equity Debt
Canall (£m) 72.0 16.8 88.8
% 81 19
Sealalot (£m) 138 113 151
% 91 9
These are both significantly different from Crestlee. Ungearing Canall (assuming debt is risk-free and d 0):
a e
72 E 1.124 1.3 E D(1 t ) 72 16.8(1 0.33)
Ungearing Sealalot :
a e
138 E 1.2 1.129 138 13(1 0.33) E D(1 Tc)
These are very similar. The ungeared equity beta of the packaging industry will be assumed to be 1.125. Regearing for Crestlee’s capital structure:
e a 2006.1
114 58.24(1 0.33) E D(1 t ) 1.125 1.51 114 E
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6% (14% 6%)1.51 18.08% WACC 18.08% 66 11%(1 0.33) 34 14.4% 100 100 Fifteen per cent is not an appropriate discount rate for either of these projects. The less risky textile expansion has an estimated discount rate of 12.8 per cent, and the diversification 14.4 per cent. (b) The marketing director might be correct. If there is initially a high level of systematic risk in the packaging investment before it is certain whether the investment will succeed or fail, it is logical to discount cash flows for this high-risk period at a rate reflecting this risk. Once it has been determined whether the project will be successful, risk may return to a ‘more normal’ level, and the discount rate reduced commensurate with the lower risk. If the project fails there is no risk (the company has a certain failure!). The other board member is incorrect. If the same discount rate is used throughout a project’s life, the discount factor becomes smaller and effectively allows a greater deduction for risk for more distant cash flows. The total risk adjustment is greater the further into the future cash flows are considered. It is not necessary to discount more distant cash flows at a higher rate.
Solution 2 (a) If the rate of return on equities is perceived as comprising 10 per cent pure interest and 5 per cent risk premium, and the beta is put at 1.2, then the theoretical cost of capital (using the capital asset pricing model) is 10% 1.2 5%, i.e. 16%. The value of the entity, therefore, is £400,000/0.16, that is, £2.5m. Assuming totally equity funding, a 33 per cent tax rate and full distribution of profits (consistent with maintained earnings), £0.825m of this value would be attributable to the tax authorities, and £1.675m to the shareholders. This is illustrated in Figure 1.
Figure 1
All equity
ke Rf (Rm Rf)e 10 (15 10) 1.2 16% PBIT Tax PAT
400,000 132,000 268,000
MVfirm PAT/ke 268,000/0.16 £1,675,000 Of itself, capital structure cannot affect the overall cost of capital or value – only its attribution between the stakeholders. Take the first suggestion, that assets of the firm be secured against a loan of £500,000 (20 per cent of the total value) at 10 per cent, that is, 2006.1
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ke is estimated to be:
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£50,000 per annum. This leaves £350,000 p.a. for tax and dividends. This is worth £2.5 m £0.5 m, that is, £2 million, implying a cost of capital of 17.5 per cent per annum, higher than before because of the higher margin of error associated with the return. If tax takes 33 per cent, that is, £0.66 m, the value of the equity is £1.34 m. This is illustrated in Figure 2.
Figure 2
First option – 10% debentures
Vg Vug TB 1.675 (0.5 0.33) £1,840,000 Vg Vdebt Vequity
1,840,000 1,500,000 1,340,000
D/E 500/1,340 37.3% keg kug (kug kD)(1 t )D E 0.16 (0.06)(0.67)500 1,340 17.5%
Likewise, if £1m (40 per cent of the total value) was borrowed at 12 per cent p.a., £280,000 p.a. would be available for tax and dividends, with a value of £2.5 m £1 m, that is, £1.5 m, implying a cost of capital of 18.7 per cent p.a. Again assuming tax takes 33 per cent, that is, £0.495 m, the value of the equity is £1.005 m. This is illustrated in Figure 3.
Figure 3
Second option – unsecured loan stock
Vg Vug TB 1.675 0.33 £2,005,000 Vg Vdebt Vequity
2,005,000 1,000,000 1,005,000
D E 1,000 1,005 99.5% keg kug (kug kD)(1 t )D E 0.16 (0.04)(0.67)1,000 1,005 18.67%.
Summary (i) Value (£m) of: Equity Debt Total Entity (ii) Ratio: debt/equity (iii) Cost of equity (%, p.a.) 2006.1
Option 1
Option 2
1.340 0.500 1.840
1.005 1.000 2.005
37.3 17.5
99.5 18.7
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Solution 3 This question examines the following syllabus areas: Tips ● In answering part (a), some candidates made the (minor) error of treating the dividend given in the question as the current dividend instead of the next expected dividend. ● In part (b), saying that the return on the market portfolio ‘could be obtained from the financial press’ is rather an over-simplification. ● Not many candidates were aware of the exact external source of information on ‘beta’, or the practicalities of the company undertaking the calculations. 2006.1
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(b) There is an old saying that nothing stands still – what is not expanding is shrinking. Likewise, in many situations, either a vicious or virtuous circle is obtaining at any point in time: the gardens which have seen no rain are the ones which are not permitted to benefit from hosepipes. So it is with businesses, for when one gets into difficulty: ● suppliers are less keen to trade, demanding higher prices or faster payment; ● the best employees are the first to find jobs elsewhere; ● customers may go to other suppliers, out of fear (no doubt encouraged by competitors!) that continuity is uncertain, for example, spares will not be available; ● short-termist pressures (e.g. the need to keep up reported profits even if it means cutting back on intangibles like research, marketing and training) threaten long-term financial health; ● bankers are less willing to provide finance, other than at substantial premium rates of interest; ● there could be legal and professional costs of reconstruction, administration, etc., if things get that far. (c) Intuitively, the Modigliani and Miller theory that capital structure is irrelevant is valid: the value of a firm as an entity is independent of its capital structure. That does not mean, however, that it is irrelevant from a practical financial management point of view. For while the principal financial objective of a private-sector enterprise is to maximise the net present value of protected cash flows, there is a secondary objective which nevertheless has great importance: the maximisation of the proportion of entity value which is attributable to the shareholders. It is in pursuit of this objective that corporate treasurers consider a range of possible capital structures. The key factors which enter such considerations are: ● the variability and unpredictability of projected cash flows (the greater these are, the less likely that borrowings are appropriate); ● the variability and unpredictability of interest rates (as various ‘large ticket’ suppliers found in 1991/92, with high interest rates depressing demand and increasing outgoings); ● the bias introduced by the different taxation treatment of loans as distinct from profits; ● the anticipated rate of growth of the business, and the implication, therefore, in terms of retentions, and the growth in the proportion of cash flows earmarked for taxation; ● the concerns of incumbent management, e.g. degree of control, threat of being taken over; ● the transaction costs of issue and redemption (note greater popularity of companies buying back their own shares); ● the international aspects and hence currency risks: neutrality means matching currencies of capital to currencies of projected cash flows.
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●
●
In part (c), the basic point to be made was that debt always has an implicit as well as an explicit cost because it makes equity riskier and the net interest rate can never be the appropriate cut-off rate for risky projects. Many candidates correctly presented the ‘pool of funds’ argument without pointing out that the project might be in a different risk category from the company’s normal activities, thus invalidating the use of the current weighted average cost of capital. In part (d), not many candidates were able to work out that, allowing for the differing tax effects, debt resulted in higher expected equity earnings.
(a) Market value of securities Equity (Ve) Preference (Vp) Debentures (Vd) Total
10.4 million 80 p 4.5 million 72 p 5.0 million 100 p
£ million 8.32 3.24 15.00 16.56
Cost of equity (ke) d0(1 g) g P0 4 0.12 80 17%
ke
Cost of preference shares (kpref) kpref d P0 9 12.5% 72 Cost of loan stock (kd) i[1 t ] P0 14(1 0.35) 9.1% 100 keVe kpVp kdVd kd Ve Vp Vd (0.17 8,320,000) (0.125 3,240,000) (0.091 5,000,000) 16,560,000 1,414,000 405,000 455,000 16,560,000 k0 13.73%.
kd net
(b) The above calculations were based on explicit forecasts of dividends. In practice these are not available, and outsiders looking in have to resort to other approaches. The capital asset pricing model (CAPM) is one such approach and involves the following steps: (i) identification of the: so-called market-risk premium, that is, the excess of equity yields over bond yields for a particular period of time; 2006.1
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Solution 4 Requirement (a) (i) Book values Debt equity 150 125% 120 (ii) Market values Debt equity 135 33.75% 400 Requirement (b) (i) Weaknesses The market values based gearing of DEB plc will have increased as the share price has fallen over the past 2 years, reflecting industry and market changes. The book value will 2006.1
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beta of the share price over the same period, that is, its volatility relative to the market. There are consultants who will provide this information for a fee; (ii) presumption that, if investors had foreseen the particular volatility of the share, they would have expected a return that amounted to the bond rate plus the risk premium factored by the beta; (iii) presumption that this will be replicated in the future; (iv) calculation, therefore, of the cost of equity capital as the cost of debt, plus a premium based on the equity market average factored by the beta. The practical problems are associated with which of the past (and very different) time frames you are going to say is the model for the future. The market is often described in terms of random walks, that is, prices are discontinuous. As the financial services advertisements show, the return on investment depends more than anything on where you measure from. (c) The linking of particular branches of funds with particular parts of the business is frequently debated. The capital structure determines how the overall risk is shared as between investors. The evaluation of an individual project should concentrate on its projected cash flows and the perceived margin of error therein. Others point to particularly large projects, where it is only natural to consider the financing at the same time. So, it depends to an extent on the business. It also depends on how the margin of error in cash-flow forecasts is dealt with. If it is allowed for by depressing the forecast cash flows, then the cost of debentures is going to approximate to the pure cost of capital. It should be borne in mind, however, that the cost of capital appropriate to decision-making is the opportunity cost: were interest rates to rise, for instance, the historical cost of the debentures would be too low a figure. (d) (i) As shown in (a) above, the yield on the preference shares is 12.5 per cent. This is higher than the 9.1 per cent on the debentures, because the latter have a prior call on the assets of the business. (ii) The net payment on the debentures is 14 per cent of £5 million less 35 per cent, that is, £455,000. To give a 12.5 per cent yield, the company would have to issue the preference shares at a discount. The net payment would be 9.1 per cent of £5 million, that is, £625,000.
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have largely failed to recognise such changes and thus would be much the same as 2 years ago, other than changes in retained profit and any new capital. In general, book values tend to give poor measures of gearing as they include balance sheet values which may be inappropriate as: ● fixed assets may not have been revalued and thus represent historic costs rather than current market values; ● development costs may be subject to significant subjectivity as to the amount capitalised; ● debt appears to be stated at nominal value rather than market value; ● values are normally out of date reflecting only the position at the last balance sheet date. (ii) Benefits Notwithstanding these problems, restrictive covenants on debt are normally in terms of book values and thus the book gearing calculation may have relevance in this context. Market value measures of gearing have the following advantages: ● the reflect the going concern value of the business and thus its future earnings potential to repay debt; ● values reflect up-to-the-minute market movements; ● debt values reflect changes in corporate risk and industry risk since issue; ● comparison between companies is easier – with care!
Requirement (c) Proceeds raised $2.5 50 million $125 million Ex rights price
[$2.5 (2 $4)] $3.5 3
Value of equity after rights issue $3.5 150 million $525 million Value of debt after rights issue ($150 million $125 million) 0.90 $22.5 million Gearing 22.5 million 4.29%. 525 million Requirement (d) Advantages The issuing of new equity will reduce debt and thus partly address the concerns of financial markets. This may be important in developing relationships with the loan creditors for refinancing the remaining debt in 3 years, or for new finance. In the short term, it may also be important in helping prevent a breach of restrictive covenants based upon book gearing. Disadvantages The gearing was not particularly excessive at 33.75% in market value terms even prior to the repayment. The high book value measure of gearing may thus be misleading. 2006.1
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Solution 5 Requirement (a) Required return on equity 5% 0.8 (15% 5%) 13% The beta is a measure of the extent to which historic movements in CAP’s share price have correlated with average market returns (e.g. as summarised in the FT All Share Index). A beta of less than 1 means that the share price is less volatile than the market. Thus, at 0.8, it means that if the market index rises by 10% then on average the share price of CAP would be expected to increase by 8%. This argument does not however mean that the required rate of return on CAP’s shares also moves in direct proportion to the required return on the market as this is also affected by the risk free rate. Requirement (b) Cost of preference shares 9 10% 90 Cost of debt 20 (1 0.3) 250 250 1.0057 1 Kd Simplifying: 1 Kd
14 250 1.0057 250
Kd 5% Market values Equity (200 £3) Preference (50 0.9) Loan stock (250 1.0057) Total
Value £m 600.00 45.00 251.42 896.42
Proportion 0.669 0.050 0.281 1.000 2006.1
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The yield in the market on this type of debt is greater than the nominal rate paid to the debenture holders. In redeeming the loan, the company is thus paying off a cheap source of finance. If it needed further borrowing, this may be expensive. Paying off most of the debt ($125 million of the $150 million) appears excessive in appeasing the concerns of financial markets. The traditional model of gearing would leave the impact on the weighted average cost of capital (WACC) uncertain depending on whether the company was already beyond the minimum point on the WACC curve. If the redemption had the effect of lowering WACC, then the repayment may have been worthwhile. In terms of the timing of the issue, the efficient markets hypothesis would state that, in semi-strong form, it is irrelevant as we cannot predict future share prices. Historic share price falls are no guide to future prices.
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Cost of capital Equity Preference Loan stock Total
Cost % 13 10 5
Proportion 0.669 0.050 0.281 1.000
Average 8.697 0.500 11.405 10.602
Thus, the weighted average cost of capital is 10.602%. Requirement (c) There are three major factors occurring during 2003 which may impact upon the beta of CAP plc. ● ● ●
The opening of a new business venture in campsites; The financing of the new venture with a new issue of bonds; The refinancing of the existing debt which is redeemable in 2003.
The new business venture The new business venture is significantly different from the existing business. This is indicated by the low correlation of the returns of the two businesses. The low correlation may diversify the unsystematic risk of the business, but its impact on the beta of the company is uncertain. This will depend on the correlation of the returns on the campsite project with the market portfolio – not their correlation with existing company returns. Ignoring the impact of debt financing, this new equity beta will be the weighted average of the existing beta and the beta of the new project. Financing for the new project The new debt finance will increase financial gearing and thus increase the variability of equity returns on the project and for the company as a whole. If the equity returns become more variable in relation to the market index, then this will increase the equity beta, although the total risk to debt and equity will be unaffected. Refinancing existing debt The impact of refinancing on the beta will depend on the type of financing used to redeem the existing debt – if any. If there is like-for-like replacement with new debt, then there will be a minimal impact on the beta, although the terms of the replacement debt instruments may differ. If however, the debt is redeemed – totally or partially – with new equity then this will reduce gearing, reduce the volatility of equity returns and thus lower the beta. Other factors Betas are based on historic returns and may not be stable over time. Past betas are, thus, not necessarily a good guide to the future, as they are affected by random events in relation to the company and the market. Even without the significant operational and financial changes in CAP plc in 2003, the beta would thus be likely to change anyway through normal ongoing events in the farming industry. The direction of change would, however, be indeterminant. Summary The new beta will be the weighted average of the beta on the existing farming business and the beta of the new leisure business. Both of these may change over time. 2006.1
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5
LEARNING OUTCOMES After completing this chapter you should be able to:
calculate values of entities of different types;
identify and calculate the value of intangible assets.
5.1 Introduction The topics covered in this chapter are: ● ● ● ●
Valuation bases for assets, earnings, and cash flows; The strengths and weaknesses of each valuation method; Recognition of the interests of different stakeholder groups; Forms of intellectual property and methods of valuation.
Valuation models fall broadly into four variants based respectively on assets, earnings, dividends and discounted cash flows, typically using the capital asset pricing model to calculate a discount rate. Each method has its advantages and disadvantages and are not all appropriate in all circumstances. It is often unwise to depend on any one method and calculating a range of values using different appropriate types of valuation can provide valuable benchmarks for the project or entity valuation being considered. Frequently, the compulsory case study question in the Management Accounting: Financial Strategy examination will give information on an entity and request the candidate to calculate a range of values for that entity. Part of the test is not only to be able to use the various methods to calculate values but to understand the circumstances in which each is most appropriate. For example, asset based valuations have very limited relevance for entities which are going concerns especially if they have substantial intangible assets. In each of the following sections, the various valuation methods are explained together with the circumstances in which they might be most appropriate.
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5.2 Asset-based valuations Using an asset-based valuation, the value of an entity is equal to the net assets attributable to the equity shares. Intangible assets are only included if they have a realisable value. Net assets attributable to equity non-current assets current assets current liabilities non-current liabilities preference shares Example 5.A The summarised balance sheet of Owen at 31 December 2005 is as follows: Assets Non-current assets (net) Current assets
$ 23,600 08,400 32,000
Equity and Liabilities Capital and reserves $1 Ordinary shares Retained earnings
8,000 11,200 19,200
Non-current liabilities 6% Unsecured bond Current liabilities
8,000 04,800 32,000
What is the value of one ordinary share in Owen using the net assets basis of valuation?
Solution Assuming the balance sheet values are realistic, the valuation is: Non-current assets Current assets Less: 6% unsecured bond Current liabilities Net asset value
Value per share:
$ 23,600 8,400 (8,000) , (4,800) 19,200.
19,200 $2.40 8,000
Note that the net asset value of 19,200 is equal to the value of the ordinary share capital plus reserves.
5.2.1 Choice of valuation base The valuation can be used on various factors, for example: ●
●
Book value. This method suffers from being largely a function of depreciation policy, for example, some assets may be written down prematurely and others carried at values well above their real worth. Original costs may of little use if assets are very old, or if asset replacement has been irregular over time. Net present value. The real value of assets retained in an entity is the net present value of the future cash flows to be derived from them.
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●
Replacement value. This method recognises the additional store of worth to be derived from the future use of the asset. Break-up value. Individual assets are valued at the best price obtainable, which will depend partly on the second-hand market and partly on the urgency of realising the asset.
5.2.2 The strengths and weaknesses of asset-based valuations The main strengths of asset-based valuations are: ● ●
the valuations are fairly readily available; they provide a minimum value of the entity.
The main weaknesses of asset-based valuations are: ● ●
●
future profitability expectations are ignored; balance sheet valuations depend on accounting conventions, which may lead to valuations that are very different from market valuations; it is difficult to allow for the value of intangible assets such as intellectual property rights.
5.3 Earnings-based valuations 5.3.1
P/E ratio valuation
Earnings-based valuations assume that the value of an entity is equal to the present value of the future earnings that will be generated by the business. This method is based on two elements, the price/earnings (P/E) ratio and the post-tax earnings per share (EPS) of a business, which when combined give the market price per share (MPS). Thus: P/E ratio
Current market price per share Post-tax earnings per share
so that: MPS P/E EPS MPS is influenced by market or non-specific risk. When markets are at relatively low levels, MPS and P/E ratio are liable to considerably undervalue the real worth of an individual share. It is very useful in evaluating MPS to relate the figure for a particular entity to that for the nearest equivalent industry and to those for comparable entities within the industry sector. As a general guide, one might chart the relative movements in MPS for the last 3 or 5 years for the industry sector and comparable entities, taking care to note the effects of any significant events (e.g. mergers or acquisitions) occurring during the period. Another pointer is to check the P/E ratio on the basis of taking the median points of high and low values for the middle day of each quarter, comparing figures for the last one or two years, and taking care to note any significant trend or event over the period and endeavouring to weight the data accordingly. 2006.1
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●
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Example 5.B Molier is an unquoted entity with a recently reported after-tax earnings of $3,840,000. It has issued one million ordinary shares. A similar listed entity has a P/E ratio of 9. What is the value of one ordinary share in Molier using the P/E basis of valuation?
Solution Earnings per share
3,840,000 $3.84 1,000,000
Value per share P/E EPS 9 3.84 $34.56
5.3.2
Earnings yield valuation
Another important evaluation ratio is the earnings yield (EY), which can be expressed as: Earnings yield ( EY )
Earnings per share 100 Market price per share
Again, some deeper analysis is desirable, for example examining the trend of MPS over a number of quarters in the light of any events such as profits warnings and acquisitions (or rumours thereof ), and the likely effect that they have had on earnings. The stability of EY is often as important as its growth, bearing in mind that in a general way the market is absorbing new information to try to assess a sustainable level of EPS on which to base growth for the future. Clearly, effective growth is dependent on a stable base, and the trend of EY over time is to an extent a reflection of this factor. A prospective acquirer would, of course, be concerned to assess the worth of a prospective biddee on the basis of its becoming part of the acquiring entity, and the valuation will especially need to take into account the expectations of the biddee’s shareholders. A further point relates to the acquirer’s intentions regarding the biddee. If, for example, the latter entity is to be partially demerged, that is, certain parts disposed of to other entities in which they would provide a better fit, then the MPS valuation may well be greater than if the whole biddee entity was to be retained. Nevertheless, any such break-up considerations will need to take into account all the stakeholders, including employees, suppliers and customers of the biddee, as any serious demotivation will take away from the goodwill value of the acquisition and quite possibly damage that of the acquiring entity itself.
5.4 Dividend-based valuations In Chapter 1 you were introduced to the dividend decision as one of the key policy decisions many entities have to make. The announcement of dividends is widely believed to have ‘signalling’ properties; in other words, the entity is giving a signal to the market about its future prospects. How such signals are built into the share price depends on how they are interpreted by share purchasers. However, the dividend-valuation model provides a formula (or formulae – there can be variations on the basic model) that allows an estimate of cost of equity or share price to be calculated. 2006.1
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5.4.1 Dividend yield The dividend yield method of valuation assumes that the value of an entity is equal to the present value of the future dividends payable by the business. Dividend yield assumes that the amount of the dividend remains constant each year. Dividend per share Dividend yield 100 Market price per share Thus: Market price per share
Dividend per share 100 Dividend yield
5.4.2 Dividend growth model The dividend growth model assumes that the annual dividend payable by an entity will grow at a constant annual growth rate. The equation for obtaining a market value, based on a shareholder’s expected rate of return (ke), the projected growth rate (g) and the company’s dividend (d0) is given below: d0(1 g ) P0 (ke g ) So, for example, if the entity’s current dividend is 20 pence per share, its cost of equity is 18 per cent and it is expecting growth in earnings and dividends of 9 per cent per annum, we would estimate a share valuation of: 20 (1.09) P0 242 pence (0.18 0.09)
5.4.3
Problems of dividend-based valuations
Problems of using dividend models include: ● ●
●
●
●
the difficulties associated with MPS mentioned earlier; investors tend to have very different expectations from each other (Modigliani and Miller’s theories can hardly cope with the present-day wide difference in attitude between institutional and individual investors); most investors look for a return based on two components: dividend and capital appreciation leading to capital gain on sale of the shares; the mechanistic aspect of all such models. It should be noted that d0 is, of course, much dependent on EPS, and the factors mentioned above in regard to earnings-based valuations must be taken into account. dividend-based valuations are suitable for valuing small shareholdings rather than for valuing a controlling interest.
A profits warning will not of itself necessarily cause a reduction in d0, but is a strong pointer to the need for a possible negative weighting for g. Also, events such as a current or forthcoming acquisition will affect d1 (i.e. d0(1 g)) as well as g. Again, one is looking to 2006.1
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You should revisit Chapter 4 for examples of the use of dividend valuation models to calculate the cost of equity.
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measure d0 and g in terms of their stability as a base, which also means that movements in capital structure such as rights issues need also to be taken into account.
5.4.4 Capital asset pricing model The concept of the capital asset pricing model (CAPM) as described in Chapter 4 should be well understood. This is an important method of evaluating the standing in the market of a particular share or industry sector. To obtain a market value using CAPM, the formula combines with the dividend valuation model as follows: P0
d0 E(R1)
where d0 dividend to perpetuity; P0 share value at year 0; E(R1) expected return for share, noting that the CAPM formula is usually taken to relate to a period of one year. E(R1) Rf 1 (Rm Rf) Assume, for example: d0 30p; Rm 16%; Rf 8%; 1 1.1. Then: E(R1) 8% 1.1 (16% 8%) 16.8% and: P0
30p £1.79 0.168
5.5 Cash-based valuations Cash-based valuations assume that the value of an entity is equal to the present value of future cash flows to be generated by the business.
5.5.1 Discounted cash flow (DCF) Under this method, a value for the equity of the entity is derived by estimating the future annual after-tax cash flows of the entity, and discounting these cash flows at an appropriate cost of capital. Example 5.C The expected after-tax cash flows of Thomas will be as follows: Year 1 2 3 4 5 onwards A suitable cost of capital for evaluating Thomas is 12%. What is the value of Thomas using the DCF basis of valuation? 2006.1
£ 120,000 100,000 140,000 50,000 130,000
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Year 1 2 3 4 5
Cashflows £ 120,000 100,000 140,000 50,000 130,000
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Solution D.F. (12%) Present value £ £ 0.893 107,160 0.797 79,700 0.712 99,680 0.636 31,800 0.567 073,710 Value of Thomas 392,050
However, this ignores cashflows after year 5. Assuming the year 5 cashflow continues to infinity, this has a present value of: 130,000 £1,083,333 0.12 This has a present value today of: £1,083,333 0.567 £614,250 This gives a total present value of: £392,050 £614,250 £1,006,300
5.5.2 The strengths and weaknesses of DCF The strengths of this method of valuation are: ● ●
it can be used to place a maximum value on the entity; it considers the time value of money.
The weaknesses of this method are: ● ●
it is difficult to forecast cash flows accurately; it is difficult to determine an appropriate discount rate.
5.5.3 Shareholder value analysis Shareholder value analysis (SVA) is used to indicate the amount of economic value created in a period. It is based on the assumption that the value of an entity is equal to the present value of its future cash flows discounted at an appropriate cost of capital. SVA was covered in Chapter 1, and should be reviewed in relation to business valuation.
5.6 Business valuations and efficient markets Study of the efficient markets hypothesis (EMH) and share price volatility was covered in Chapter 2. However, it is necessary to review some of those issues in connection with business valuations. In particular, it is worth recalling the three forms of the EMH: ●
217
Weak form. This says that the current share price reflects all the information which could be gleaned from a study of past share prices. If this holds, then no investor can earn aboveaverage returns by developing trading rules based on historical price or return information. This form of the hypothesis can be related to the activities of chartists, analysts who believe future prices can be charted and a pattern identified which can be used to predict future prices. 2006.1
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Semi-strong form. This says that the current share price also reflects all other published information. If this holds, then no investor can be expected to earn above-average returns from trading rules based on any publicly available information. This form of the hypothesis can be related to fundamental analysis, in which estimated future prices are based on the analysis of all known information. Strong form. This says that the current share price incorporates all information, including unpublished information. This would include insider information and views held by the directors of the entity. If this holds, then no investor can earn above-average returns using any information whether publicly available or not. A useful summary of the hypothesis is as follows:
● ●
●
the weak form of efficiency is where share prices reflect all historical information; the semi-strong form of efficiency is where share prices reflect all publicly available information; the strong form of efficiency is where share prices reflect all information (public and internal) and is the perfect information environment.
The CAPM, which depends for its validity on markets being at least semi-strong form efficient, was covered in Chapter 4 of this Learning System, which dealt with cost of capital and capital structures. If we are to accept that the CAPM can be used to determine a cost of capital, then we must also accept some level of market efficiency. Generally, studies have shown the semi-strong form of the EMH to hold, although the presence of inside information cannot be ignored. A (contentious) point to consider is whether inside information, far from being a ‘bad thing’ (not to mention illegal in many countries), actually contributes to an informationally efficient market, and therefore should be encouraged. Of course, these topics are predominantly concerned with the valuation of large, listed profit-making entities. Although the underlying principles apply to a whole range of organisations, including those in the public sector, the absence of a market price removes a valuable benchmark.
5.7 Intellectual capital The following section is based mainly on IFAC’s Study 7, The Measurement and Management of Intellectual Capital: An Introduction (1998).
5.7.1 Forms of intellectual capital As it is applied today, the term intellectual capital has many complex connotations and is often used synonymously with intellectual property, intellectual assets and knowledge assets. Intellectual capital can be thought of as the total stock of capital or knowledgebased equity that the entity possesses. As such, intellectual capital can be both the end result of a knowledge transformation process or the knowledge itself that is transformed into intellectual property or intellectual assets of the firm. 2006.1
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• Human resources – The collective skills, experience and knowledge of employees; • Intellectual assets – Knowledge which is defined and codified such as drawing, computer program or collection of data; and • Intellectual property – Intellectual assets which can be legally protected such as patents and copyrights. Intellectual property is legally defined and assigns property rights to such things as patents, trademarks and copyrights. These assets are the only form of intellectual capital that is regularly recognised for accounting purposes. However, accounting conventions based upon historical costs often understate their value: ● ●
● ●
Patents are recorded at their registration cost but not their potential value in use. Trademarks, copyrights and other intellectual property rights are recorded at registration cost rather than their potential market value. Franchises are recorded at contract cost rather than the market value. Goodwill is recorded only when a business is sold (acquired). It is defined as the market price of the business as a whole, less fair market value of other assets acquired.
Definitions of intellectual assets and knowledge-based assets are typically less concrete and apply to a potentially broader range of intangible assets than those captured under the umbrella of intellectual property. The Society of Management Accountants of Canada defines intellectual assets as follows: In balance sheet terms, intellectual assets are those knowledge-based items, which the entity owns, which will produce a future stream of benefits for the entity. This can include technology, management and consulting processes, as well as extending to patented intellectual property. Within this knowledge view of the entity, the entity is seen as an institution for integrating knowledge, the critical input in production, and the primary source of value is knowledge; all human productivity is knowledge dependent, and machines are simply embodiments of knowledge. According to one expert on knowledge and intellectual capital management, this emerging view of the entity may require a fundamental shift in the way we think about entities: ‘Managers often have an unconscious and tacit mindset that is coloured by the values and the common sense of the industrial age. To see another world, they need to try to use a conscious mindset such as the knowledge perspective.’ Some of the major points of departure between an industrial management perspective and a knowledge management perspective are as follows: ●
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The knowledge view of the entity sees people as revenue generators whose primary task is to convert knowledge into intangible structures, whereas within the industrial paradigm, people at times are viewed more simply as costs or factors of production. The purpose of learning within the knowledge entity is to create new assets or processes instead of simply applying new tools or techniques. Within the knowledge entity, production flows are idea-driven and sometimes chaotic, as opposed to sequential and machine driven. 2006.1
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Intellectual capital: Knowledge which can be used to create value. Intellectual capital includes:
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The law of diminishing returns is replaced with increasing returns to knowledge, and economies of scale in the industrial paradigm are replaced with economies of scope in the knowledge paradigm. The power base of management rests with their relative level of knowledge as opposed to their hierarchical position within the entity. Information flows via collegial networks versus via the organisational hierarchy.
In his review of the emerging knowledge-based theory of the entity, Grant identified several characteristics of knowledge that have implication for the overall management of the organisation: ●
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First, he distinguishes between explicit knowledge – that which can be observed – and tacit knowledge – that which is subjective and revealed through its application. Explicit knowledge often has the characteristics of a public good that can be easily transferred, often at zero marginal cost. (An example of explicit knowledge is the information contained on a web page. The marginal cost of one more person accessing a web page is virtually zero.) Tacit knowledge, however, can be acquired only through practice. It is not easily transferred within the entity, and its transferral is slow, costly and uncertain. Second, transferring tacit knowledge within the entity will require certain organisational structures and cultures. Once entity are viewed as institutions for integrating knowledge, hierarchical structures and hierarchical coordination fails. The transfer or integration of tacit knowledge requires network lines of communication and team-based structures. When managers know only a fraction of what their subordinates know and tacit knowledge cannot be transferred upwards, then coordination by hierarchy is inefficient. Third, knowledge is a resource that is subject to unique and complex measurement problems resulting from the inability to define or identify ownership. Direct claims on the ownership of knowledge are often difficult to prove, except in the case of patents and copyrights where owners are protected by law. Fourth, Grant called into question the current shareholder structure of many entities based on the unique ownership characteristics of knowledge. He concluded: ‘If the primary resource of the entity is knowledge, if knowledge is owned by employees, if most of this knowledge can only be exercised by the individuals who possess it – then the theoretical foundations of the shareholder value approach are challenged.’ Finally, the knowledge-based view of the entity provides insights into the current trends in corporate management and design, such as delayering, empowerment, team building, the use of cross-functional teams in new product development, and building strategic allegiances. Each of these practices has been shown to facilitate the communication, integration and transformation of knowledge within the entity.
5.7.2 The components of intellectual capital One model of intellectual capital management – The Value Platform – separates intellectual capital into three main components that interrelate to form value: ● ● ●
human capital; customer (relational) capital; organisational (structural) capital.
Figure 5.1 shows the forms of intellectual capital falling into each of these categories. 2006.1
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Figure 5.1
Elements of intellectual capital
Within this system of classification, the intellectual capital of the entity has the following properties: ● ●
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It can be fixed, as in the case of a patent, or flexible, as in the case of human capabilities. It can be both the input and the output of a value-creation process. That is, intellectual capital is ‘knowledge that can be converted into value’ or the end product of a knowledge transformation process. It is created through the interplay of human, structural and customer capital – corporate value does not arise directly from any one of its intellectual capital factors, but only from the interaction between them all. Just as importantly, no matter how strong an entity is in one or two of these factors, if the third is weak (or worse, misdirected), that entity has no potential to turn its intellectual capital into corporate value.
While these characteristics imply that the management of intellectual capital will be unique in each entity, it is assumed that human capital acts as the building block for the organisational (structural) capital of the entity, and both human capital and organisational (structural) capital interact to create customer capital. At the centre of the three forms of intellectual capital lies the financial capital or value created by the interaction of the three components. As can be seen in Figure 5.2, it is at the intersection of the classes of intellectual capital that value is created. This interaction is dynamic, continuous and expansive. Indeed, the more the circles overlap, the greater the value produced. The intellectual capital management framework described here offers new ways of seeing the organisation and its core competences. However, many of the management concepts and methods it proposes parallel well-established management accounting practices. 2006.1
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Figure 5.2
Intellectual capital
Human capital Human capital refers to the know-how, capabilities, skills and expertise of the human members of the entity. It is the knowledge that each individual has and generates. Some of the key functions tied to human capital management are drawn from the traditional practices of human-resource management, and include: ● ●
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building an inventory of employee competences; scanning the environment and determining competences which need to be developed or acquired to meet strategic objectives; developing a system to deliver the needed knowledge, skill or intellectual upgrade as needed; developing an evaluation and reward system tied to the acquisition and application of competence that aligns with the organisation’s strategic objectives.
Organisational (structural) capital Organisational capital includes the organisational capabilities developed to meet market requirements, such as patents. Clearly, every patent, trademark, management tool, improvement technique, IT system and R&D effort that has been or will be implemented to improve the effectiveness and profitability of the entity can fall within the category of organisational (structural) capital. While it is impossible to prescribe an all-encompassing framework for managing this type of capital, value-chain analysis offers a systematic approach to the subject. The objective of value-chain analysis is to identify the elements of organisational processes and activities and link them to the creation of value by the entity. Processes are structured and measured sets of activities, designed to produce a specific output for a particular customer or market. Identifying the entity’s value-creating process – the way in which knowledge is created, integrated, transformed and utilised – will require a horizontal view of the entity and the cross-functional relationships that exist within it. A model is first established using process analysis and the activities within each process are subsequently 2006.1
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1. a patent, consulting process or trademark; 2. an improvement in organisational efficiency, measured by cost savings, profits, revenue growth, or return on investment; 3. improved innovative capabilities of the entity, measured by a variety of individual and team-based performance indicators. Customer capital Customer (relational) capital includes connections outside the organisation, such as customer loyalty, goodwill and supplier relations. It is the perception of value obtained by a customer from doing business with a supplier of goods and/or services. Various techniques and analysis tools have been developed to better understand the value of customers and their perceptions. Some of these are described below: ●
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Market-perceived quality profiles. These are developed through customer questionnaires for the purpose of: – identifying what quality really means to the consumer; – indicating which competitors are best on each aspect of quality; – developing overall quality-performance measures based on the definition of quality that customers actually use in making their purchasing decision. Market-perceived price profiles. These are derived in the same way as market-perceived quality profiles, but instead of asking customers to list factors affecting their perception of quality, the entity asks them to list factors affecting their perception of the product’s cost. Customers are then asked to weight these factors and rate their perception of competitors’ performance on each price attribute. Customer value maps. Entities use these to illustrate how customers decide among competing suppliers and products. They contain information on which companies might be expected to gain market share, and why. Won/lost analysis. This technique allows an entity to thoroughly analyse the reasons for either winning or losing a competitive bid. If it has won a bid, it can determine which product and service attributes were met, and what the relative price/quality conditions were. This approach also offers a method for examining the factors contributing to changes in market share, that is, what the quality–price relationships were, vis-à-vis the competitors. What/who matrix. These allow organisations to track responsibility for the actions that will ensure success in providing customer value. This matrix shows, for each quality attribute, those business processes that influence an entity’s performance and that of its competitors. It shows who owns the process that has the greatest impact on the entity’s performance vis-à-vis that of a specific competitor. The business process owner (in the entity) is then responsible for coordinating the processes and function required to improve customer value performance.
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analysed. In this way, management can begin to assess the flows of information, flows of knowledge and characteristics of knowledge transformation between functional departments, within divisions and throughout the entity. The end product of the knowledgemanagement process can then be identified and valued as:
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5.7.3 Valuing intellectual capital Intellectual capital can affect and be affected by the unique culture of the organisation and the distinct processes and relationships that evolve within it. This propensity for complexity suggests that a rigorous approach to managing, measuring and reporting on the intellectual capital within the entity would require a number of evaluation measures. Skandia AFS, a pioneer entity in the area of intellectual capital management and reporting, has developed an intellectual capital report on the basis of no fewer than 164 different indicators. These indicators can be consolidated into five main categories according to the primary focus that they take: financial focus, customer focus, process focus, renewal and development focus and human focus. Using this framework, 111 intellectual capital measures have been developed, forming the basis of the universal intellectual capital report. ●
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Financial focus. Indicators that take a financial focus are represented in money values or percentages. They are used to gain a picture of the profitability of the human resources and clientele of the entity. Examples of measures that take a financial focus include: – revenues per employee; – value added per customer; – profits per employee; – revenue from new customers/total revenues; – value added per employee; – value added per IT employee. Customer focus. The customer focus specifically assesses the value of the customer capital of the entity. It uses financial, percentage and numerical indicators to paint a picture of such things as composition of market share, customer service, demographic characteristics of various customer groups, and the overhead and other support costs required. Examples of customer capital indicators include: – market share; – customers per employee; – satisfied customer index; – annual revenues per customer; – customers lost; – average duration of customer relationship; – revenue-generating staff; – average time from customer contact to sales response; – IT investment per salesperson; – support expense per customer. Process focus. Measures that take a process focus emphasise the effective use of technology within the entity. Primarily they include ratios of administrative costs; information technology use and spending per employee; efficiency measures based on time, workload and error ratios; and effectiveness measures designed to monitor quality and quality-management systems. More specifically, process measures include: – administrative expense to total revenue; – cost of administrative error to management revenues; – processing time, outpayments; – contracts filed without error; – PCs and laptops per employee; – network capability per employee;
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What is evident from the diversity and extent of intellectual capital indicators is that each organisation must decide for itself which of these measures are most suited to their needs, budget constraints and available management resources.
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– IT expense per employee; – change in IT inventory; – IT capacity per employee; – corporate quality performance (e.g. ISO 9000). Renewal and development focus. The renewal and development focus utilises measurements that capture the innovative capabilities of the entity. These focus on the effectiveness of investment in training, research and development outcomes, and the return on technological infrastructure spending. The following indicators are seen to capture these elements: – training expense per employee; – training expense to administrative expense; – competence development expense per employee; – share of training hours; – business development expense to administrative expense; – R&D expense to administrative expense; – R&D invested in basic research; – R&D invested in product design; – R&D resources to total resources; – IT expense on training to total IT expense; – educational investment per customer; – value of electronic data interchange (EDI) system; – upgrades to EDI system. Human focus. Measurements that take a human focus are intended to reflect the human capital of the entity and the renewal and development of those resources. They include a number of calculated indices of employee competence and measures of the potential creativity of the workforce, as well as indicators of the rate at which the human resources of the firm must be replaced. The measures include: – IT literacy of staff; – leadership index; – motivation index; – number of employees; – number of managers; – average age of managers; – annual turnover of full-time permanent employees; – percentage of company managers with advanced degrees in business, science and engineering, and liberal arts; – time in training each year.
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5.7.4 Comparative indicators Three broad indicators have been developed to facilitate comparisons of intellectual capital stocks between firms: ● ● ●
market-to-book values; Tobin’s q; calculated intangible value.
Market-to-book values This is the most widely known indicator of intellectual capital. The contention is that the value of an entity’s intellectual capital will be represented by the difference between the book value of the entity and its market value. If an entity’s market value is £10bn and its book value £5bn, then the residual £5bn represents the value of the entity’s intangible (or intellectual) assets. The principal benefit of this method is its simplicity. However, as with most other measures, the more simple the calculation the less likely it is to capture the complexities of the real world. In this case, simply subtracting book value from market value tends to ignore exogenous factors that can influence market value, such as deregulation, supply conditions and general market nervousness, as well as the various other types of information that determine investors’ perception of the income-generating potential of the firm, such as industrial policies in foreign markets, media and political influences, rumour, etc. In addition, the current accounting model does not attempt to value an entity in its entirety. Instead it records each of its severable assets at an amount appropriate to the national or international accounting standard under which the accounts have been prepared (e.g. historical cost, modified historical cost, replacement value, etc.). The market, however, values a company in its entirety as a going concern with strategic intent. It may be argued that the differences between these two forms of valuation can be defined as the value of intellectual capital. This value will then be subject to variations arising from the book value of the severable assets, their current market price, and various imperfections that may exist in the market valuations. However, it must be recognised that, if we define intellectual capital this way, then we are talking about an aggregate, including the difference between severable assets and the market valuation of the firm. Calculations of intellectual capital that use the difference between market and book values can also suffer from inaccuracy because book values can be affected if firms choose, or are required, to adopt tax depreciation rates for accounting purposes, and the tax rates reflect factors other than an approximation of the diminution in value of an asset. Tobin’s q A way of getting around the depreciation rate problem when comparing the intellectual capital between entities is to use Tobin’s q. This was developed initially by James Tobin as a method of predicting investment behaviour. It uses the value of the replacement costs of an entity’s assets to predict the investment decisions of an entity, independent of interest rates. The q is the ratio of the market value of the entity (share price number of shares) to the replacement cost of its assets. If the replacement cost of an entity’s assets is lower than its market value, then an entity is getting monopoly rents, or higher-than-normal returns on its 2006.1
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Calculated intangible value A third measure, calculated intangible value (CIV) has been developed by NCI Research to calculate the fair market value of the intangible assets of the entity. The CIV involves taking the excess return on tangible assets and using this figure as a basis for determining the proportion of return attributable to intangible assets. Merck & Co., a pharmaceutical entity, can be used as an example in illustrating how the CIV works: 1. Calculate average pre-tax earnings for three years. For Merck: $3.694bn. 2. Go to the balance sheet and calculate the average year-end tangible assets over three years: US$12.952bn. 3. Divide earnings by assets to get the return on assets (ROA): 29 per cent. 4. For the same 3 years, find the industry’s return on assets. For pharmaceuticals, the number in this example was 10 per cent. If a company’s ROA is below average, then stop: NCI’s method will not work. 5. Calculate the ‘excess return’. Multiply the industry-average ROA by the company’s average tangible assets: this shows what the average drug entity would earn from that amount of tangible assets. Now subtract that from the entity’s pre-tax earnings. For Merck, excess earnings are: 3.694bn (0.10 12.952bn) $2.39bn This figure shows how much more Merck earns from its assets than the average drug-maker would! 6. Calculate the 3-year average income tax rate and multiply this by the excess return. Subtract the result from the excess return to show the after-tax premium attributable to intangible assets. For Merck (average tax rate 31 per cent) the figure was $1.65bn. 7. Calculate the net present value (NPV) of the premium. This is done by dividing the premium by an appropriate discount factor such as the entity’s cost of capital. Using an arbitrarily chosen 15 per cent yields, for Merck, $11bn. This is the CIV or Merck’s intangible assets – the one that does not appear on the balance sheet. 2006.1
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investments. A high value of q indicates that the entity will likely purchase more of those assets. Technology and human-capital assets are typically associated with high q-values. As a measure of intellectual capital, Tobin’s q identifies an entity’s ability to get unusually high profits because it has something that no one else has. However, Tobin’s q is subject to the same exogenous variables that influence market price as the market-to-book value. Both methods are best suited to making comparisons of the value of intangible assets of entities within the same industry, serving the same markets, and having similar types of tangible assets. In addition, these ratios are useful for comparing the changes in the value of intellectual capital over a number of years. When both the Tobin’s q and the market-to-book ratio of an entity are falling over time, it is a good indicator that the intangible assets of the entity are depreciating. This may provide a signal to investors that a particular entity is not managing its intangible assets effectively and may cause them to adjust their investment portfolios towards entities with climbing or stable values of q. By making intra-industry comparisons between an entity’s primary competitors, these indicators can act as performance benchmarks and can be used to improve the internal management or corporate strategy of the entity.
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While the CIV offers the potential to make inter- and intra-industry comparisons on the basis of audited financial results, two problems remain. First, the CIV uses average industry ROA as a basis for determining excess returns. By nature, average values suffer from ‘outlier’ problems and could result in excessively high or low ROA. Second, the entity’s cost of capital will dictate the NPV of intangible assets. However, in order for the CIV to be comparable within and between industries, the industry average cost of capital should be used as a proxy for the discount rate in the NPV calculation. Again, the problem of averages emerges, and one must be careful in choosing an average that has been adjusted for outliers, such as excessively high or low values.
5.8 The impact of changing capital structure The influence of capital structure on the value of the entity was introduced in Chapter 4. You will recall that, according to Modigliani and Miller, capital structure can have no influence on the value of the entity, other than by: ●
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the benefit of the tax shield on debt interest payments (which increases the value and is fairly easy to quantify); the probability of financial distress and bankruptcy (which decreases the value but is very difficult to quantify).
Although the Modigliani and Miller theories have been criticised for oversimplifying the issue and ignoring many market imperfections (that is, real-life complexities), there is some sound logic in their propositions. Assume, for example, that you buy a house next door to a friend. The house is identical in every way, but you have had to buy yours with a substantial bank mortgage, while your friend has bought his with a legacy from a grandparent. You both decide to work overseas and rent out your houses for 2 years. Will your method of financing your asset have any influence over the rental income you can expect, or on the capital value of your house in 2 years’ time? Of course not! This is obviously an oversimplified example, but it serves to demonstrate that the value of an asset depends on the cash flows that it can generate in the marketplace, not on how the asset is financed. What can influence the value, of course, are factors such as your marketing ability (do you know how to set up a website?) and your attitude to risk (would you take a tenant who would pay more but who has a poor credit record?). This is a different matter altogether.
5.9 Recognition of the interests of different stakeholder groups in company valuations There are three main sets of circumstances when an entity may need to recognise priorities of the various groups of shareholder in determining a valuation. These are liquidation, re-financing and merger or acquisition.
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The priorities of various stakeholders in the liquidation of an entity is, in the UK, determined by company law. This is beyond the scope of the Financial Strategy syllabus and candidates will have covered the topic elsewhere in their studies. However, subject to the legal constraints entities may be able to influence stakeholder priorities by negotiating with the various groups especially in a voluntary liquidation.
5.9.2 Re-financing There are occasions when entities need to obtain new financing or re-finance existing debt. The groups of stakeholder who may be most interested in these circumstances are the managers, shareholders or owners, and providers of finance. Lenders may also have an interest if there is any suggestion that they may not be paid out in full as part of the re-financing negotiations.
5.9.3 Mergers and acquisitions It is evident that numerous parties other than the bidder and biddee will be affected by an acquisition. A variety of stakeholders in the company will be involved in some way, for example: employees, suppliers, customers, environmental and health agencies, the government (through taxation and grants) and indeed, any person or institution whose activities may be directly affected by the entity’s operations. Failure to discuss takeover plans with some of these stakeholder groups, especially employee representatives and government, can lead to prolonged and expensive confrontations. The interests of the local community needs to be recognised also as localised protests can often lead to serious delay in proceedings with what might otherwise be a financially and commercially sound proposal.
5.10 Summary In this chapter, we have discussed various methods of valuing entities and determining share prices. The strengths and weaknesses of each method have also been explained. Particular emphasis has been given to valuing entities where traditional methods have little relevance, for example, those entities that own substantial intellectual capital and few, if any, tangible assets, or those which have a poor trading history but good future prospects. This is a topic of growing relevance, given the increasing volatility of share prices in general and stock-market valuation of internet entities. It is recognised that the intellectual capital of an entity plays a significant role in creating competitive advantage, and thus managers and other stakeholders in entities are asking, with increasing frequency, that its value be measured and reported for planning, control, reporting and evaluation purposes. However, at this point, there is still a great deal of room for experimentation in quantifying and reporting on the intellectual capital of the entity. Given the potential for both complexity and diversity, developing intellectual capital measures and
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5.9.1 Liquidation
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reporting practices that are comparable between entities remains one of the key challenges to the accounting profession.
References Grant, R. M. (1996), Toward a Knowledge-based Theory of the Firm, Strategic Management Journal, 17 (Winter special issue). International Federation of Accountants (1998), The Measurement and Management of Intellectual Capital: An Introduction.
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The launch of entities providing internet services provides a good example of the limitations of traditional valuation models. The ‘value’ of these entities, as measured by share price or market capitalisation, bears little relation to the value that would be placed on them using any of the methods described in this chapter. The following article explains some of the issues, and considers the use of shareholder value analysis as a method of valuation.
Shared visions Christine Parkinson and Patrick Barber, CIMA Insider, March 2001. Reproduced with permission.
Shareholder value analysis (SVA) emerged as a valuation technique in the 1980s largely from the work of Alfred Rappaport.1 It is not, however, particularly new, and the underlying principles and procedures have been around a long time. CIMA’s Official Terminology2 explains that shareholder value is: ‘Total return to shareholders in terms of both dividends and share price growth, calculated as the present value of future free cash flows of the business discounted at the weighted average cost of capital of the business less the market value of debt’. Put simply, SVA combines the notion that the key objective for a company is to maximise shareholder wealth, with the use of the net present value (NPV) approach to valuing cash flows. What is, perhaps, new is the creation of shareholder value as the explicit focus of corporate strategy. This was largely a phenomenon of the 1990s and was driven in part by the leadership of large institutional investors. Long term, the returns on a company’s shares are determined by its investment ‘fundamentals’ – earnings growth and dividend yields. In the short term, however, these fundamentals are often overwhelmed by speculation (which appears to have been the case in the past few years). This trend would not have surprised the economist John Maynard Keynes, who wrote in the 1930s that the powerful role of speculation in the markets was based on ‘the conventional valuation of stocks based on the mass psychology of a large number of ignorant individuals’.3 Many of the approaches to shareholder value analysis used or discussed today are based on the conceptual framework provided by Rappaport. He used a discounted cash flow (DCF)-based approach to determine shareholder value and identified seven key ‘drivers’ of value. These are: growth in turnover; operating margin; capital expenditure; change in working capital; the effective tax rate; cost of capital; and the competitive advantage period (CAP). At McKinsey and Co., Tom Copeland, Tim Koller and Jack Murrin4 follow a more theoretical approach and suggest three value drivers: return on invested capital; free cash 231
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flow; and economic profit. Free cash flow is the total after-tax cash flow generated by a company and available to all providers of the company’s capital – shareholders and creditors. Free cash flow is generally not affected by the company’s capital structure, even though this structure may affect the company’s weighted average cost of capital (WACC) and, therefore, its value. Economic profit, or economic value added (EVA) as it is sometimes referred to, is the net operating profit after tax less capital charges, where capital charges are the invested capital multiplied by the WACC. For example, assume a company has after-tax operating profits of £10m, capital employed of £50 million and a cost of capital of 12 per cent. Its economic profit is therefore: £10m (£50m 12 per cent) £4m. Richard Pike and Bill Neale5 claim that most companies find a high correlation between EVA and shareholder returns. Although Copeland, Koller and Mullin use different value drivers, the aim is similar – to emphasise the importance of shareholder value. They also recognise that their approach is not new, at least as far as their basic methodology is concerned: ‘Valuation is an age-old methodology in finance with its intellectual origins in the present value method of capital budgeting and on the valuation approach [of] Miller and Modigliani.’ Serious students may wish to read the seminal work by Miller and Modigliani,6 which forms the basis for many topics in the Financial Strategy syllabus. Copeland, Koller and Mullin’s book is a useful reference for many Financial Strategy topics, including the approach to international investment (or capital budgeting) and the problems surrounding the choice and calculation of the discount rate. It also looks at the different approaches to valuation used in the US, Germany and Japan. (The UK tends to follow the US approach.) The book attempts to demonstrate the link between maximising shareholder wealth – sometimes a disputed objective – and other economic and social goods, such as gross domestic product per capita. The authors make a claim that might be used as a justification for the whole topic: ‘Shareholder wealth creation does not come at the expense of other stakeholders … winning companies, when compared with their competitors, have greater productivity, greater increases in shareholder wealth and higher employment. Shareholder wealth maximisation may be an explicitly stated goal … or it may be implicitly the result of other correct decisions … either way, it cannot be ignored. Managers must measure and manage the value of their companies.’ Luis Serven7 recognises that what matters most to shareholders is what happens to the value of their shareholding, but criticises many of the short-term measures used to boost share price: dividend increases, share repurchases, and other headline-grabbing tactics. However, the impact of these measures will dissipate as investors digest the actual performance of a company over time. Serven proposes a value management system (VMS) as the number one management issue to ensure long-term value creation. He proposes five critical components of such a system: strategic assessment; long-term planning; operational planning; performance measurement and management; and incentive compensation. He also discusses three ‘value killers’: the fire-fighting trap; management that lacks incentive; and (somewhat predictably since he is recommending it) the absence of a value management system. A recent real-life example of a company attempting to create shareholder value from restructuring is that of Whitbread. The company announced in October 2000 that it had ‘completed a strategic review and has concluded that shareholder value will be enhanced by increased focus on growth sectors of the UK leisure markets, unlocking the full value in 2006.1
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Diagram 1 Shareholder value analysis framework © Pearson Reprinted with permission.
pubs and bars and returning a substantial part of that value directly to shareholders’. (Whitbread’s document to shareholders, 19 October 2000.) The company’s share price rose by 48p (11 per cent) to 479p after the news. At that date, published brokers’ estimates of the company’s pre-tax profits for the year to 28 February 2001 showed a large variation from £340m to £443.3m. Of these brokers, 25 per cent recommended that the shares should be bought, 60 per cent recommended they should be held and 15 per cent said they should be sold. The share price by 21 November 2000 was 533p. Whether this is long-term value creation or a quick fix remains to be seen. It might be useful to look up the share price of Whitbread now to see how it has moved and, perhaps, review brokers’ comments. (Share price movements and comments can be accessed on the Financial Times website: www.marketprices.ft.com) So how do we square the circle? Are the positive views of Rappaport and Copeland et al. incompatible with the rather less enthusiastic views of other writers? Not really – we are looking at two sides of the same coin. The theoretical arguments are conceptually sound and support the DCF approach to valuation. There is no serious support for the view that short-term fixes are relevant to the long-term valuation of a company. Diagram 1 illustrates how the variables that contribute to shareholder value are linked. The relationships are best explained by an example. Baxter plc is listed on the London International Stock Exchange. Its pre-tax operating cash flow for the last financial year was £76.5m. The company declared dividend payments of £26m. Its summary balance sheet as at 31 December 2000 was as follows: Fixed assets (NBV) Net current assets Financed by: Ordinary shares (25 pence par) Reserves 9 per cent bank loan
£m 57.50 144.50 102.00 25.00 32.00 145.00 102.00
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Other financial information is as follows: the current share price is 676p, debt is trading at par; equity beta is 0.9; the risk-free rate is 6 per cent per year, and the return on the market is 12 per cent per year (These figures are post-tax and are not expected to change in the foreseeable future.) The company pays tax at 30 per cent per year. The company’s directors have announced the following decisions together with the estimated effects on cash flow for the current financial year. ● ● ●
●
Sale of fixed assets: net receipts £3.4m. Purchase of new machinery and investment in working capital: £5.6m. Introduction of improved production methods: net improvement to operating cash flows of £4m per year before tax. Restructuring of regional offices: one-off redundancy payments of £1.75m before tax relief. Ignore the effect on tax of the changes in fixed and current assets. Assume the following for the next five years:
● ● ● ●
All figures are in real terms – so they exclude inflation. Post-tax operating cash flows will remain at year-1 levels. There will be no movement in fixed assets, other than as noted above. There will be no changes in dividend policy or capital structure.
Calculate the worth of Baxter plc based on the NPV of estimated future cash flows, using a fifteen-year time horizon, discounted at an appropriate cost of capital. There are four stages to the calculations: 1. Estimate post-tax cash flows for the coming year. 2. Estimate a discount rate, using the CAPM, as this is implied by the information given in the question. 3. Estimate cash flows for years 2 to 15. 4. Discount these cash flows and sum them to arrive at a NPV. Clearly these are oversimplifications, but they serve to demonstrate the principles involved in SVA. Stage 1 Present value of operating cash flows for year 1 Pre-tax OCFs for last year Less debt interest Plus annual productivity savings Recurrent pre-tax cash flows Tax at 30 per cent Recurrent post-tax cash flows Current year only effects: Sale of assets Investment in capital and working capital Redundancy payments after tax relief £1.75m 0.7 Total cash flows year 1
Stage 2 Cost of equity 6% 0.9(12% 6%) 11.4% Value of equity 100m shares 676p £676m Value of debt £45m 2006.1
£m 76.50 (4.05) (24.00 76.45 (22.94) 53.51 3.40 (5.60) (1.22) (1.22) 50.09)
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45 676 11.4% 0.9 (1 0.3) 676 45 676 45
BUSINESS VALUATIONS
WACC using market values
10.69% 0.39% 11.08% Stage 3 For simplicity assume a discount rate of 11 per cent. Recurrent cash flows £53.52 7.191 DCFs for year 1: (3.42) 0.901 Net present value Less debt Shareholder value
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£ 384.86 33(3.08) 381.78) 345.00) 336.78)
This would suggest a share price of 337 pence, significantly below the quoted price. The key things to note about these calculations are: 1. Although using present values of future cash flows is theoretically the correct technique, it relies heavily on estimates of both cash flow and the discount rate. The subjectivity involved in making these estimates is one reason why share prices might suggest a very different market value, or capitalisation, and why share prices may fluctuate regularly and substantially. 2. The time horizon is arbitrary. Fifteen years is a long time to assume no changes in policies, and more detailed forecasts would be used in practice. An estimate could be made of a terminal value based on the worth of the company at the end of fifteen years. 3. Dividend payments are not deducted from the cash flows. This is because we are looking at the total value of the cash flows to shareholders. If we were doing a cash budgeting exercise for the coming year, we would of course deduct dividend payments. 4. The difference between the quoted share price and the calculated share price could stem from one of two things, broadly speaking, and assuming the markets are at least semistrong efficient: (i) The market has information that is different from that of the directors and estimates higher cash flows and/or a lower discount rate and/or uses a different time horizon (note the Whitbread example, where the market did appear to concur with the directors). (ii) The price includes speculation about activities such as takeover. This approach is simply the application of DCF techniques to the valuation of a company’s shares. Of course, the value for small lots of shares will be different from the value for the entire share capital, as a bidder will almost inevitably have to pay a premium for acquiring the entire share capital. And the price of small lots might also be affected at times by market-wide movements or sentiment, or by speculation about, for example, a takeover bid. Few people can have failed to observe the recent volatility of internet shares and this has led to some seasoned analysts questioning whether the SVA approach is relevant to new economy companies. There appears to be a consensus that, as David Skyrme and Debra Amidon8 assert, ‘knowledge management is becoming a core competence that companies must develop in order to succeed in tomorrow’s dynamic global economy’. The movement away from traditional companies with their heavy investment in tangible fixed assets has meant, according to Thomas Stewart9 that ‘knowledge has become the most important factor in economic life. It is the chief ingredient of what we buy and sell, the raw material with which we work. Intellectual capital – not natural resources, machinery or even 2006.1
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financial capital – has become the one indispensable asset of corporations.’ The perceived difficulty of capturing the value of this intellectual capital (an intangible asset that is not shown on the balance sheet) has to be examined. It is difficult to state with certainty the cause and extent of any divergence between share price and the intrinsic value referred to by Keynes. Internet stocks highlight this difficulty. There may be an issue of thin trading, where a small change in the supply/demand equation for a share results in a relatively large movement in the share price, which is further compounded by the growing (and unregulated) use of bulletin boards on the internet where share tips and gossip encourages speculative behaviour. The emergence of strategies such as ‘pump and dump’ (the hyping of a share to encourage others to buy at inflated prices before realising your profit), and other momentum-based strategies, make it difficult to assess to what extent any short-term deviation between price and value is caused by uninformed traders, as opposed to an inherent weaknesses in SVA. Despite these sector specific problems, it can be argued that SVA is still a useful tool. But it needs to be supplemented by an awareness that knowledge-based companies have the potential to achieve high rates of growth by adapting and responding more speedily to the business environment than traditional businesses. This flexibility to determine the direction of their growth (referred to in the literature as ‘real options’) is measured through the valuation of future growth options.10 For example: market valuation of company value from existing business value of future growth opportunities. The ‘value from existing business’ element can be found using the SVA approach. It is likely that it is the second component which forms a large part of a new economy company’s value (as mentioned earlier, their scope for growth is high) and the difficulty of assessing this area is the subject of much current research. As Mills11 states: ‘Internet businesses are also often of the type where one opportunity leads to another, thereby making the projection of revenues and costs difficult. As a result, qualitative analysis may be as important as quantitative analysis in assessing the value of internet businesses, simply because investors in such businesses may be regarded as placing bets rather than making investments.’ Indeed, this may explain why analysts can justify such different valuations for the same company. Internet bookshop Amazon’s decision to develop the infrastructure to sell books over the internet allowed the company to move into the sale of CDs, toys, videos, electronic goods and an auction site. What else might the company move into? Unfortunately the decision points, probabilities and associated cash flows attached to the real options approach are extremely subjective. Some people have moved away from attempting to measure the value of the real options by reverting to a number of proxy measures designed to determine value, which may include number of visits to a website, the ‘stickiness’ (how long the user views the page) of the site, and its marketing spend. This view is countered by Maboussin and Hiler12 who argue that free cash-flow analysis is still relevant and that it is the lower investment in fixed assets which allows seemingly high valuations for internet businesses to be justified. As Boo.com and Clickmango demonstrated, cash is still king. The basic SVA approach, relying as it does on discounted cash flows, is really nothing new. By depending upon an accurate determination of the discount rate, it is possible that analysts are working with the same forecasts, but are choosing to discount them at different rates to arrive at company valuations. If companies are using SVA as a means of giving more information to the market, then we can only conclude that they do not have total confidence in the notion that the markets are semi-strong efficient. 2006.1
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References
1. A. Rappaport, Creating Shareholder Value: The New Standard for Business Performance, Macmillan, 1986. 2. CIMA, Management Accounting: Official Terminology, 2000 edn, CIMA Publishing. 3. J. Bogle, ‘Distortions in value creation’, Directors and Boards, winter 1999. 4. T. Copeland, T. Koller and J. Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd edn, John Wiley, 1994. 5. R. Pike and Bill Neale, Corporate Finance and Investment, 3rd edn, Prentice Hall, 2000. 6. M. Miller, and F. Modigliani, ‘Dividend policy, growth and the valuation of shares’, Journal of Business, October 1961. 7. L. Serven, ‘Shareholder value’, Executive Excellence, December 1999. 8. D. Skyrme and D. Amidon, ‘New measures of success’, The Journal of Business Strategy, 19(1), 1998. 9. T. Stewart, Intellectual Capital: the New Wealth of Organisations, London: Nicholas Brealy, 1997. 10. A. Jägle, ‘Shareholder value, real options, and innovation in technology-intensive companies’, R&D Management, Vol. 29 No. 3, 1999. 11. R. Mills, ‘Valuing internet businesses. What is the intrinsic value of a share?’, Henley Manager Update, Vol. 11 No. 3, spring 2000. 12. M. Maboussin, and R. Hiler, ‘Cash flow.com: cash economics in the new economy, frontiers of finance’, CSFB Equity Research, Vol. 9, 1999.
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Companies may believe that there is no other avenue for this information to be reflected in share prices, and that a formal analysis enables this ‘new’ information to improve the market perception of them. With the uncertainty surrounding the valuation of new economy shares, then SVA undoubtedly has its place – at least it is grounded in something tangible by highlighting the importance of cash to the business. It is when one moves into the valuation of real options that subjective assumptions can alter dramatically the view of what a company is worth. The valuation of real options is a complicated topic because it can involve using SVA as a starting block, and then incorporating both the possible choices that the company may face, and the benefits which might possibly follow. It warrants deeper exploration.
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Revision Questions
Question 1 PDQ plc is a medium-sized listed entity. The results to 31 December 1999 have just been announced. Earnings per share (EPS) and declared dividends per share (DPS) for the last 5 years are shown below: EPS (pence) DPS (pence)
1999 140 82
1998 136 81
1997 131 79
1996 127 78
1995 122 77
Dividends are paid on 31 December each year, and the dividend shown as declared in a particular year would have been or will be paid on 31 December the following year. lf the current dividend policy is maintained, the directors of PDQ plc estimate that annual growth in earnings and dividends will be no better than the average growth in earnings over the past four years. PDQ plc is reluctant to take on debt at the present time to finance growth. The entity is therefore considering a change in its dividend policy and total investment programme to allow 50 per cent of its earnings to be retained for identified capital investment projects, which are estimated to have an average post-tax return of 15 per cent. The market risk premium is expected to be 4 per cent over the risk-free rate of 6 per cent. The entity’s beta is currently quoted at 1.5 and is not expected to change for the foreseeable future. Requirements (a) Calculate the share price which might be expected by the market: (i) if the entity does not announce a change in dividend policy, (ii) if the entity does announce a change in dividend policy, using whatever model(s) you think appropriate. (8 marks) (b) (i) Comment on the limitations of the model(s) you have used in your answer to part (a); (ii) Discuss the reasons why the share price might react differently from the market’s expectations. (12 marks) Note: Dividend valuation model:
P0
D1 Ke g
Earnings growth model:
P0
E0(1 b) (1 br) Ke br
Capital asset pricing model:
Erj Rf Bj(Rm Rf)
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Question 2 The following financial data relate to RG plc: Year 1995 1996 1997 1998 1999
Earnings per share (pence) 42 46 51 55 62
Net dividend per share (pence) 17 18 20 22 25
Share price (pence) 252 184 255 275 372
An entity of market analysts which specialises in the industry in which RG plc operates has recently re-evaluated the entity’s future prospects. The analysts estimate that RG plc’s earnings and dividends will grow at 25 per cent for the next 2 years. Thereafter, earnings are likely to increase at a lower annual rate of 10 per cent. If this reduction in earnings growth occurs, the analysts consider that the dividend payout ratio will be increased to 50 per cent. RG plc is all equity-financed and has one million ordinary shares in issue. The tax rate of 33 per cent is not expected to change in the foreseeable future. Requirements (a) Calculate the estimated share price and P/E ratio which the analysts now expect for RG plc, using the dividend valuation model, and comment briefly on the method of valuation you have just used. Assume a constant post-tax cost of capital of 18 per cent. (10 marks) (b) Comment on whether the dividend policy being considered by the analysts would be appropriate for the entity in the following two sets of circumstances: (i) the entity’s shareholders are mainly financial institutions; and (ii) the entity’s shareholders are mainly small private investors. (8 marks) (c) Describe briefly three other dividend policies which RG plc could consider. (7 marks) (Total marks 25)
Question 3 One theoretical method of valuing an entity’s shares is to calculate the present value of future dividends using a discount rate that reflects the risk of the business. In respect of large, listed entities, current evidence suggests that this is far too simplistic a view of how entity values and share prices are determined. Requirement Comment on the reasons why share prices may be substantially different from the level suggested by theory. Include brief comments on the relevance of P/E ratios and net asset values in share price determination. (5 marks)
Question 4 XYZ plc is a software house. It has been trading for 10 years and has shown strong yearon-year improvement in revenue and profits. Revenue for the last financial year was 2006.1
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Requirement Calculate market capitalisation estimates for XYZ plc using two suitable evaluation methods, and comment briefly on your answer. (8 marks)
Question 5 MediCons plc provides a range of services to the medical and healthcare industry. These services include providing locum (temporary) cover for healthcare professionals (mainly doctors and nurses), emergency call-out and consultancy/advisory services to governmentfunded health entities. The company also operates a research division that has been successful in recent years in attracting funding from various sources. Some of the employees in this division are considered to be leading experts in their field and are very highly paid. A consortium of doctors and redundant health-service managers started the entity in 1989. It is still owned by the same people, but has since grown into an entity employing over 100 fulltime staff throughout the UK. In addition, the entity uses specialist staff employed in state-run organisations on a part-time contract basis. The owners of the entity are now interested in either obtaining a stock-market quotation, or selling the entity if the price adequately reflects what they believe to be the true worth of the entity. Summary financial statistics for MediCons plc and a competitor entity, which is listed on the UK Stock Exchange, are shown below. The competitor entity is broadly similar to MediCons plc but uses a higher proportion of part-time to full-time staff and has no research capability. Shares in issue (m) Earnings per share (pence) Dividend per share (pence) Net asset value (£m) Debt ratio (outstanding debt as % of total financing) Share price (pence) Beta coefficient Forecasts: Growth rate in earnings and dividends (% per annum) After-tax cash flow for 2000/2001 (£m)
MediCons plc Last year-end: 31.3.2000 10 75 55 60 10 n/a n/a
Competitor Last year-end: 31.3.2000 20 60 50 75 20 980 1.25
8 9.2
7 n/a
Notes 1. The expected post-tax return on the market for the next 12 months is 12 per cent and the post-tax risk-free rate is 5 per cent. 2006.1
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£48.5m and profits after tax were £9.4m. Growth in revenue and profits has averaged 15 and 12 per cent, respectively, over the 10-year trading period. Fifty-five per cent of XYZ plc is owned by the four founding shareholders, who are still directors and senior managers of the entity. Employees, friends and relatives of the founders own the remaining 45 per cent. The entity currently is all equity-financed, a tenyear loan of £1m, taken out when the entity was formed, having just been repaid. The controlling shareholders are now considering flotation to allow them and their employees to realise some of the gains their shareholdings have earned. The average P/E ratio for established listed entities in the computer industry is currently 18.4. This has ranged between 17.5 and 21.5 over the past 12 months. The average post-tax cost of capital for the industry, according to a recent study, is 14 per cent.
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2. The treasurer of the entity has provided the forecast growth rate for MediCons plc. The forecast for the competitor is based on published information. 3. The net assets of MediCons plc are the net book values of land, buildings, equipment and vehicles plus net working capital. 4. Sixty per cent of the shares in the competitor entity are owned by the directors and their relatives or associates. 5. MediCons plc uses a ‘rule-of-thumb’ discount rate of 15 per cent to evaluate its investments. 6. Assume that growth rates in earnings and dividends are constant per annum. 7. The post-tax cost of debt for MediCons plc and its competitor is 7 per cent. Requirement Assume that you are an independent consultant retained by MediCons plc to advise on the valuation of the entity and on the relative advantages of a public flotation versus outright sale. Prepare a report for the directors that provides a range of share prices at which shares in MediCons plc might be issued. Use whatever information is available and relevant and recommend a course of action. Explain the methods of valuation that you have used and comment on their suitability for providing an appropriate valuation of the entity. In the report you should also comment on the difficulties of valuing entities in a service industry and of incorporating a valuation for intellectual capital. (25 marks) Note: Approximately one-third of the marks are available for appropriate calculations, and two-thirds for discussion.
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5
Solution 1 (a) The required return on equity by PDQ’s shareholders using the CAPM is: 6% 1.5(10% 6%) 12% Average growth over the past four years is 3.5 per cent and the average payout ratio is 60 per cent. (i) Using the dividend valuation model and assuming constant growth, the share price would be: D1 82 1.035 998p Ke g 12 3.5 (ii) Using the earnings growth model and assuming the retention ratio is constant and the return on the investments perpetual: P0
E0(1 b)(1 br) Ke br
where b investment proportion (retentions ratio) and r expected return on investments.
140 50% [1 (50% 15%)] 1,672p 12 (50% 15%)
(b) (i) The assumptions underlying these models are fairly unrealistic: for example the DVM assumes dividends are the only determinant of share value; they ignore the possibility of outside finance and offer little guidance in determination of the cost of equity. In its commonest form it assumes constant growth. EGM, sometimes called free cash-flow model, allows for growth assuming permanent retention and a constant growth rate. Neither model can be used when growth is greater than the cost of equity, although the model can be adapted for temporary periods of supernormal growth. It is also not unreasonable to expect that the increased rate of return of 15 per cent will only apply to additional retention. (ii) The market will therefore make its own assessment of the company’s prospects. The increase in the retention ratio means that in the short term the dividend payment 243
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will fall. This may be interpreted by the market as a bad signal about the future, despite reassurances to the contrary by the directors. For example, when National Westminster Bank announced pre-tax profits in 1994 of £989 billion, up from £367 billion in 1993, the share price fell because the market did not like its small dividend increase. The announcement will be made in a dynamic market, and there are other influences on share price other than dividends and investment forecasts. For all these reasons the share price may not rise to anything like the level suggested by the calculations.
Solution 2 (a) The formula for the dividend valuation model is P0 D1/(Ke g), where Ke cost of equity, D1 dividend at end of year 1, that is, D0 growth, and g growth rate. In this question, however, we have two different growth rates. The appropriate course of action is to evaluate the first 2 years’ dividends, and apply the formula at the end of the period. On the basis of the information given, the following projections can be made: Year 2000 2001 2002
DPS (p) 31.3 39.1 53.3
Discount factors 0.847 0.718 0.609
Discounted DPS (p) 26.5 28.1 32.5 87.1
Thereafter, the perpetuity value, assuming 10 per cent constant annual growth, is: D1 53.3 110% 58.63 Therefore, P0 from the end of 2002 is: 58.63 733 pence 0.18 0.10 This must be discounted back to the present, using the 3-year discount factor for 18 per cent: Discounted value: 733 0.609 Plus: dividends for 2000–2002 Share price if market shares view of analysts
pence 446.40 587.10 533.50
This represents a P/E ratio of 533.5/62, that is, 8.6. (b) On the basis of the policy suggested by the analysts, the company’s dividends would be a function of reported profits, albeit a different ‘cover’ from 2002 onwards. This is consistent with the company law philosophy (dividends may only be paid out of profits) and the fundamental accounting concept (profit is what you could afford to distribute and still be as well off as you were), but is obviously backward-looking. In practice, of course, profits are likely to be volatile, and a conflict arises between the benefits of maintaining dividend cover, and maintaining dividend growth. Recent years have shown how some boards have gone for prudence, and reduced dividends; others have demonstrated confidence in the future by holding or even increasing dividends. Financial 2006.1
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Solution 3 Since the future is unknown, a valuation based on the discounting of future cash flows will vary according to the assumptions made by the valuer as regards the cash flows, the margin of error, risk aversion and the cost of capital. The theory referred to in the question is rooted in the presumption that the market is so efficient that share prices are fair as between buyers and sellers, that is, they equate with the present value of future cash flows. It is not possible to prove this, objectively, since: ● ●
no such valuations are ever published; the value of a company does not entirely manifest itself in the form of cash unless it ceases to exist; by the time any valuation could be verified, it would be too late. 2006.1
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management logic looks forwards, to make dividends an inverse function of opportunities to invest for a satisfactory return – providing a point of contact with the Modigliani and Miller theory that dividend policy is irrelevant to the value of the firm, provided that investment decisions are made in accordance with sound wealth-maximising principles. It is at this point, however, that differences emerge between the two categories of investor mentioned: (i) Financial institutions, for example pension funds, are in a favourable tax situation, in that they can reclaim the advance corporation tax imputed to their dividends. This makes a given stream of dividend income worth more to them than it is to a tax-paying individual shareholder, and explains the massive shift in the balance of ownership, despite privatisation. From a cash flow point of view, they also prefer dividends to capital gains, in that they avoid the transaction costs of obtaining the funds to meet their liabilities. It is likely, therefore, that institutions would press for a higher payout – as they did in 1991–92 when companies were reporting lower profits. (ii) Some individuals might be below the tax-paying threshold, or have invested in personal equity plans, and would therefore be in a similar position to the institutions. Most, however, will have to bear the imputed tax, or find themselves called upon to pay a further 15 percentage points of tax to bring the imputed amount up to their marginal rate. This category would, other things being equal, prefer capital gains, because of the relief available to compensate for inflation, and the annual exemption. They have been able to reinforce the shift mentioned above by moving into ISAs and National Savings. There is thus no dividend policy which satisfies all classes of shareholder. Understandably, therefore, there is growing support for tailoring it to a particular category, that is, seeking a homogeneous ‘clientele’. (c) There is a range of possible dividend policies, including: ● paying out all of its profits other than the amount needed to compensate for inflation (or, alternatively, the specific price increases associated with its assets) and accepting the need to make the case for attracting funds for real (or, respectively, operational) expansion; ● making a decision each year in accordance with current sentiment in the market, that is, based on what other companies are doing, what analysts are expecting; ● making a decision each year on the basis of perceived investment opportunities, judged against the contemporary perception of the cost of capital.
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Indeed, it is easily disproved by way of the null hypothesis, that is, were it to be valid: ●
●
it would be impossible for directors and managers to influence future cash flows, and strategic financial management would not exist – but it does; prices would only change significantly when cash flowed, but this is demonstrably untrue. It is not uncommon for the price of a particular share to rise or fall by 20 per cent or more in one day, usually as a consequence of a statement on current profitability.
Price/earnings ratios are the result of dividing last night’s share price by last year’s earnings per share, and therefore vary from day to day to exactly the same extent as share prices. They, not share prices, are the dependent variable. Many ‘start-up’ businesses, for example, are characterised by losses – but their share prices are never negative. The strongest observable correlation shown by share prices is with short-term accounting profit forecasts issued by the directors of the company. Net asset values have no direct connection with share values or prices. Where a company’s assets are primarily intangible, as with the drug companies (the pace of innovation, the reputation in the market place, etc.) the share prices are currently anything up to 50 times their net assets per share. Some companies – for example, those which have grown by acquisition – have net liabilities but, again, their share prices are never negative. The value to a buyer or holder of a share is the present value of its projected disposal price plus projected dividends in the interim. It is important to remember that the transfer of shares between shareholders has no effect on the cash flows of the company.
Solution 4 Last year’s earnings having been £9.4m, applying the industry average P/E ratio of 18.4 would suggest a market capitalisation of around £173m. The corresponding earnings yield of around 5.4 per cent per annum, if the cost of capital is really 14 per cent per annum, implies a compound growth rate of around 8 per cent per annum. In perpetuity, that seems a high figure, so we may choose to revisit our assumptions. That industry P/E ratio is around 15 per cent below its recent peak, so we might put an equivalent tolerance, that is, 15 per cent, producing a range of around £150m to £200m.
Solution 5 Report To: The directors of MediCons plc From: Independent consultant Date: Re: Valuation of company 1. Introduction and terms of reference Thank you for inviting me to provide advisory services in respect of estimating a valuation for your company. I have reviewed all the internal information made available to me and published information relevant to the exercise. I understand that you are considering two options: a flotation on a UK stock exchange or outright sale to another company. It is beyond the scope of this assignment to approach specific buyers for the company but I discuss later in this report the advantages and disadvantages of flotation at this time, as compared with an outright sale. 2006.1
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EPS (pence) Share price (pence) No. of shares (million) P/E ratio (share price EPS) Market value (£m) (no. of shares share price)
MediCons plc 75 n/a 10
Competitor 60 980 20
n/a n/a
16.3 196
P/E ratios are available only for listed companies. However, we can use the P/E of a competitor to provide a rough estimate of the growth rating the market might award to a new market entrant in the same industry. The P/E for your closest competitor is 16.3. This is above the overall average for commercial and industrial companies and reflects the higher than average growth prospects for the medical and health industry. It is, of course, always possible that a share price reflects takeover speculation but, given that directors and connected persons own 60 per cent of the competitor company, this is unlikely here. Your own estimate suggests that your company might be growing faster than your competitor (8 per cent per annum compared with 7 per cent). All forecasts are, of course, unreliable. However, listed companies may have more opportunities for growth. A range of 17–19 as the P/E ratio the market might award MediCons plc is probably not over-optimistic. This would imply a market valuation of approximately £135 million on last year’s earnings. 2.2 Dividend valuation The dividend valuation model suggests that a company can be valued by reference to its dividend payment. The value is the sum of the stream of future discounted dividend payments plus the value of the shares when they are sold. If the lifespan of the company is considered infinite then we can use a ‘shortcut’ formula: P0
D1 ke g
where P0 is the equity value of the company, D1 is the next year’s dividend, ke is the cost of equity and g is estimated growth (assumed here to be constant). This method requires an estimate of cost of capital. You say that you use a discount rate of 15 per cent to evaluate investments but that this is ‘rule of thumb’. I have, therefore, estimated a cost of equity using your competitor company’s weighted average cost of capital (WACC). A full explanation of the capital asset pricing model and beta is beyond the scope of this report. In summary it provides a useful benchmark for the calculation of a company’s cost of capital that reflects certain types of risk that the company might face. The formula for ke is: Rf (Rm Rf) 2006.1
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2. Estimated values Using the information available, three methods of valuation can be considered: P/E ratios, dividend valuation and net asset value. The first two of these methods require use of a competitor company as proxy for certain information. The third method, net asset value, is not relevant here but is discussed briefly in section 2.3 of the report. A fourth method, net cash flow or shareholder value analysis, may arguably be superior, but I do not at present have sufficient information and the method has its limitations for valuing an entire company. 2.1 P/E ratios
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The of the competitor is 1.25, giving a cost of equity of:
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ke 0.05 (0.12 0.05)1.25 0.1375, or 13.75% The competitor’s debt to equity ratio is 20:80. The WACC (or k0) is therefore: (13.75% 80%) (7% 20%) 12.4% Assuming that the risk levels of MediCons plc and the competitor are broadly the same, we can use the competitor’s WACC and MediCons plc’s debt ratio to calculate a cost of equity for MediCons plc, using the formula: ke k0 (k0 kd) D E
(
)
12.4% (12.4% 7%) 10 13% 90 All rates in the question are given post-tax. If this had not been the case, the formula would have had to be adjusted to allow for tax. The estimated valuation of MediCons plc using the dividend valuation model is therefore: £5.5m 1.08 £ 118.8m 0.13 0.08 This method has technical limitations and poses practical difficulties, but is a useful benchmark and as such is commonly used by security analysts. If we apply the same formula to your competitor company the value of that company would be: £10m 1.07 £158.5m 0.1375 0.07 2.3 Asset value This method of valuation has little relevance to any company, except in specific circumstances, such as a liquidation or disposal of parts of a business. In the case of a company which has a substantial amount of its value in human or intellectual capital, it has no relevance whatsoever, unless the company includes such capital in its accounts. This is not the case with MediCons plc. Within accounting guidelines, companies may include ‘brands’ and similar intangibles in the balance sheet, and thus net asset value. The argument for doing this is to make the market aware of the true value of a company that has substantial investments in such intangibles. Arguably, if markets are medium-strongform efficient, then the value of brands is already included in the market price (of quoted companies). If the market is less efficient, placing a value on ‘brands’ in the balance sheet might add to market efficiency and allow more accurate asset pricing. The problem, however, is to value the brands accurately for balance-sheet purposes. 2.4 Shareholder value analysis An alternative method of valuation is discounted net cash flows, or shareholder value analysis. This method involves identifying value drivers within the organisation, such as sales, working capital requirements and discount rate. It would be possible to do this 2006.1
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4.
I would also recommend a flotation as it allows you to continue to participate in future growth of the company, assuming you choose to retain a shareholding. Signed: Consultant 2006.1
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3.
for MediCons plc, but would require a much more detailed exercise than has been possible so far. To date you have provided a net cash flow forecast for only one year ahead. There is also a technical problem in the time horizon. The forecast would need to be made for a strategic planning period of between 5 and 10 years. Even then, there is a requirement to determine a terminal value at the end of the planning period. The costs and effort involved in determining all the necessary forecast figures may not justify the benefits. Advantages of flotation versus sale A major problem would be in finding a purchaser and agreeing a price, although establishing an issue price is also problematic, as noted above. Once listed, the market will provide a more accurate valuation of the company than had been previously possible. This clearly allows the realisation of paper profits. Outright sale would also have this advantage, but future gains arising from listed-company benefits would be lost to the original owners. This would also be true if you plan to sell your entire shareholding on flotation. I am assuming that you would not do this because of the adverse signals that this would send to the market and, as a consequence, the effect on the issue price and take-up of shares. A further advantage of a flotation would be that employee share schemes would be more accessible. This is also true of an outright sale, but the employees would not be guaranteed to keep their jobs if the buyer pursued a rationalisation programme. In the circumstances here – where many employees are highly qualified experts and probably in high demand – job security will not be an issue. Indeed, given that the company’s value might be so influenced by these employees, fear of losing them to a competitor might have an adverse effect on company valuation. A disadvantage of flotation is the relatively high cost involved, compared with a private sale, but this would still be a small proportion of the total proceeds. Also, control will be lost by the original owners but this is probably not an issue. Summary and recommendation We have two benchmark valuations that might be considered: £135 million using an estimated P/E ratio and £119 million using the dividend valuation model. The comparative figures for your competitor are £196 million and £158.5 million, respectively. The differences between the two figures for MediCons plc could arise from many factors, but it is the market valuation which is the most important, assuming that the market is informationally efficient. I would, therefore, suggest a minimum value of £135 million for MediCons plc, based on the following key factors: ● the market value of the competitor is unlikely to include any speculative element and is therefore unlikely to be ‘overpriced’; ● growth prospects for MediCons plc are forecast to be higher than those for the competitor; ● the value of the intellectual capital involved in MediCons plc is almost certainly higher than that for the competitor; ● MediCons plc has been valuing its investments using a discount rate of 15 per cent. This is probably too high and may have resulted in some worthwhile investments being rejected. If this is changed for the future it should have a positive effect on the company’s valuation.
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LEARNING OUTCOMES
Identify and evaluate the financial and strategic implications of proposals for mergers, acquisitions, demergers and divestments;
Compare and recommend alternative forms of consideration for, and terms of, acquisitions;
Calculate post-merger or post-acquisition values of entities;
Identify and evaluate post-merger or post-acquisition value enhancement strategies;
Evaluate exit strategies.
6.1 Introduction The topics covered in this chapter are: ● ● ● ● ●
the reasons for merger or acquisition; forms of consideration and terms for acquisitions; the post-merger or post-acquisition integration process; types of exit strategy and their implications; defences against takeover.
6.2 Terminology and types of merger 6.2.1 Terminology The term ‘merger’ is usually used to describe the fusing together of two or more entities, whether the fusion is voluntary or enforced. Strictly, if one entity acquires a majority shareholding in another, the second is said to have been ‘taken over’ by the first. If the two entities join together to submerge their separate identities into a new entity, the process is described as a merger. 251
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In fact, the term ‘merger’ is often used even when a takeover has actually occurred, because of the cultural impact on the acquired entity – no one likes to be ‘taken over’! The development of accounting standards tends nowadays to restrict business combinations mainly to acquisitions, and balance sheets are required to give much more information as to the effect of the new assets acquired.
6.2.2 Types of merger Acquisitions can be classified to reflect the nature of the enlarged group: (a) Horizontal integration results when two entities in the same line of business combine. The current trend in bank and building society mergers is a good example of this type of integration. (b) Vertical integration results from the acquisition of one entity by another which is at a different level in the ‘chain of supply’ – as an example, UK breweries have moved heavily into the distribution of their product via public houses. Note, however, that the Competition Commission acted to limit such activity when they felt the situation was not in the public interest. (c) A conglomerate results when two companies in unrelated businesses combine. (d) Synergy – where NPVAB NPVA NPVB (or 2 2 5!). Entities merge where the net present value of the combined enterprise is deemed to be greater than the net present value of the individual firms.
6.3 The reasons for merger or acquisition The main reason entities should merge is in order to maximise shareholder value. This suggests that a merger would take place only if the value of the combined entity is more than the value of the individual entities. If this were not the case, both entities would remain independent. The following reasons have been suggested as to why entities merge or acquire. ●
●
●
Increased market share – power. In a market with limited product differentiation price may be the main competitive weapon. In such a case, large market share may enable an entity to drive prices – for example, reducing prices in the short term to eliminate competition before increasing prices later. Economies of scale. These result when expansion of the scale of productive capacity of an entity (or industry) causes total production costs to increase less than proportionately with output. It is clear that a merger which resulted in horizontal or vertical integration could give such economies since, at the very least, duplication would be avoided. But how could a conglomerate merger give economies? Possibly through central facilities such as offices, accounting departments and computer departments being rationalised. (Indeed, both sets of management are unlikely to be needed in their entirety.) Combining complementary needs. Many small entities have a unique product but lack the engineering and sales organisations necessary to produce and market it on a large scale. A natural course of action would be to merge with a larger entity. Both entities gain something – the small firm gets ‘instant’ engineering and marketing departments, and the large entity gains the revenue and other benefits which a unique
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The following reasons are of questionable validity ●
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Diversification, to reduce risk. While acquiring an entity in a different line of activity may diversify away risk for the entities involved, this is surely irrelevant to the shareholders. They could have performed exactly the same diversification simply by holding shares in both entities. The only real diversification produced is in the risk attaching to the managers’ and employees’ jobs, and this is likely to make them more complacent than before – to the detriment of shareholders’ future returns. Shares of the target entity are undervalued. This may well be the case, although it would conflict with the efficient markets theory. However, the shareholders of the entity planning the takeover would derive as much benefit (at a lower administrative cost) from buying such undervalued shares themselves. This also presupposes that the acquiror entity’s management are better at valuing shares than professional investors in the market place.
6.4 Defences against takeover 6.4.1 Before the bid Any quoted entity needs to be aware of the possibility of a bid at all times. There are a number of ongoing points a board could follow to protect the entity: ●
Communicating effectively with shareholders. This includes having a public relations officer specialising in financial matters liaising constantly with the entity stockbrokers, keeping analysts fully informed, and speaking to journalists. 2006.1
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●
product can bring. Also if, as is likely, the resources which each entity requires are complementary, the merger may well produce further opportunities that neither would see in isolation. Improving efficiency. A classic takeover target would be an entity operating in a potentially lucrative market but which, owing to poor management or inefficient operations, does not fully exploit its opportunities. Of course, being taken over would not be the only way of improving such a poor performer, but such an entity’s managers may be unwilling to give themselves the sack! A lack of profitable investment opportunities – surplus cash. An entity may be generating a substantial volume of cash, but sees few profitable investment opportunities. If it does not wish to simply pay out the surplus cash as dividends (because of its long-term dividend policy, perhaps), it could use it to acquire other entities. A reason for doing so is that entities with excess cash are usually regarded as ideal targets for acquisition – a case of buy or be bought. Tax relief. An entity may be unable to claim tax relief because it does not generate sufficient profits. It may therefore wish to merge with another entity which does generate such profits. Reduced competition is often one benefit of merger activity – provided that it does not fall foul of the Competition Commission. Asset-stripping. Very popular in the early 1970s, this was the result of an entity’s accounts not showing the true value of properties so that a predator would acquire it and realise the easily separable assets, perhaps closing down or disposing of some of its operations.
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Poison pills. For example, shareholders are issued rights to buy bonds or preference shares which, in the event of a takeover, they have the right to convert into the acquiring entity’s equity shares or to enforce repurchase by the acquiror. Shark repellent – super-majority. The Articles of Association are changed to require a very high percentage of shares to approve an acquisition or merger – say 80 per cent. High asset values. Fixed assets are revalued to current values to ensure that shareholders are aware of true asset value per share. The right shareholders. Managing the shareholder base to ensure that the ‘right’ shareholders are on board. This would be difficult with a large, listed entity.
6.4.2 After the bid ●
●
●
●
●
Rejection letter. Having received the bidder’s offer document, the target must issue any reply to shareholders within fourteen days. Profit forecast. Poor past profit performance can be compensated for by promising high future profits. However, the board may lose credibility in the short term if the forecast is too optimistic and in the long term if they fail to achieve the forecast. Wellcome brought forward their financial results when under attack from Glaxo. They were presumably not good enough, however – they were eventually taken over. Note that profit forecasts have to be endorsed by the company’s financial advisers. Attacking the bidder. Typically concentrating on the bidder’s management style, overall strategy, methods of increasing earnings per share, dubious accounting policies and lack of capital investment. White knight. If another entity has already made a bid, then a new, more acceptable bidder could present itself as a ‘white knight’ to the board of the target. Competition Commission. The target company could seek government intervention by bringing in the CC. For this to be effective it would have to be proved that the takeover was against the public interest. The company could also appeal to the European Commission. The impact of regulation on takeover activity is discussed further in the following section.
In practice, directors do not operate purely on behalf of shareholders – they will, for example, take account of employees’ needs and, perhaps more importantly, their own.
6.5 Methods of payment for an acquisition There are two main methods of financing an acquisition: cash and share exchange.
6.5.1 Cash This method is likely to be suitable only for relatively small acquisitions, unless the bidding entity has an accumulation of cash from operations or disinvestments. There are two potential advantages of a cash bid: ●
●
the shareholders in the acquired entity are bought out completely, and have no further participation in the future profits of the combined entity – the shareholders in the acquirer retain control. the value of the bid is known and the process is simple – this might persuade the target entity’s shareholders to sell.
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6.5.2 Share exchange Large acquisitions almost always involve an exchange of shares, in whole or in part. The advantage of this method of financing is that the acquirer does not part with cash and does not increase financial risk by raising new debt. It is also possible that the acquirer can ‘bootstrap’ earnings per share if it has a higher P/E ratio than the acquired entity. The disadvantage of a share exchange is that the acquirer’s shareholders share future gains with the acquired entity. How the estimated gains are split between the two parties is a matter for negotiation. The following is a simple example of how post-merger gains might be divided. Example 6.A The cost of merger: cash Market price per share Number of shares Market value of company
Entity A 7,500p 100,000 £7,500,000
Entity B 1,500p 60,000 £900,000
If A intends to pay £1.2m cash for B, what is the cost premium if (a) the share price does not anticipate merger; (b) the share price includes a ‘speculation’ element of £2 per share? (a) The share price accurately reflects the true value of the entity (in theory). Therefore, the cost to the bidder is simply £1,200,000 £900,000, that is, £300,000. The entity is paying £300,000 for the identified benefits of merger. (b) The cost is £300,000 (60,000 £2), or £420,000. The entity is therefore really worth only £13 60,000, or £780,000.
The cost of merger: share exchange Suppose A offers 16,000 shares (£1.2m/7,500p) instead of £1.2m cash. The cost appears to be £300,000 as before, but because B’s shareholders will own part of A, they will benefit from any future gains of the merged entity. Their share will be (16,000/(16,000 100,000)), or 13.8 per cent. Further, suppose that the benefits of the merger have been identified by A to have a present value of £400,000 (i.e. A thinks that B is really worth £900,000 £400,000, or £1.3m). Therefore, the combined entity of A and B is worth £7.5m £1.3m, or £8.8m. What is the true cost of merger to the acquirer’s shareholders? Estimate of post-acquisition prices Proportion of ownership in merged entity Market value: £8.8m proportion of ownership Number of shares currently in issue Price per share
A 86.2% £7.586m 100,000 759p
B 13.8% £1.214m 60,000 202p
What we are attempting to do here is to value the shares in the entity before the merger is completed, based on estimates of what the entity will be worth after the merger. The valuation of each entity also recognises the split of the expected benefits which will accrue to the combined form once the merger has taken place. 2006.1
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A disadvantage from the acquired entity’s point of view is that there might be tax implications that might influence their decision. This is a fairly insignificant consideration these days.
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The true cost can now be calculated: 60,000 shares in B @ 202p Less current market value Benefits being paid to B’s shareholders
£ 1,212,000 2,900,000 2,312,000
6.5.3 Other types of finance Other types of finance could be used – for example, raising new debt. This would have the same advantages as a cash acquisition: the shareholders in the acquired entity are bought out. The disadvantage to the acquirer could be an increase in gearing (and therefore risk). This is a separate issue: sources of finance and the effect on capital structure were covered in Chapters 3 and 4. The disadvantage to the target entity’s shareholders is that debt might be infrequently traded, and this will affect the entity’s ability to liquidate the investment should they need to. Also, the lack of marketability might adversely affect the value of the security.
6.5.4 Earn-out arrangements The purchase consideration is sometimes structured so that there is an initial amount paid at the time of acquisition, and the balance deferred. Some of the deferred balance will usually only become payable if the target entity achieves specified performance targets. Earn-out arrangement: A procedure whereby owners/managers selling an entity receive a portion of their consideration linked to the financial performance of the business during a specified period after the sale. The arrangement gives a measure of security to the new owners, who pass some of the financial risk associated with the purchase of a new entity to the sellers. (Official Terminology, 2005)
6.6 The post-merger or post-acquisition integration process Mergers and acquisitions often fail to deliver the anticipated benefits as a result of failing to effectively integrate the newly acquired entity into the parent. Poor planning and a lack of information to guide the integration plans ahead of the acquisition will lead to post-acquisition integration problems.
6.6.1
Druker’s Golden Rules
PF Druker (1981) identified five Golden Rules to apply to post-acquisition integration. 1. Ensure a ‘common core of unity’ is shared by the acquired entity and acquirer. Shared technologies or markets are an essential element. 2. The acquirer should not just think ‘What is in it for us?’, but also ‘What can we offer them?’. 3. The acquirer must treat the products, markets and customers of the acquired company with respect. 4. Within one year, the acquirer should provide appropriately skilled top management for the acquired company. 5. Within one year, the acquirer should make several cross-entity promotions of staff. 2006.1
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The following are key points to consider when determining strategy for the combined entity: • The integration strategy must be in place before the acquisition is finalised. • Review each of the business units for potential cost cuttings/synergies or potential asset disposals. It is possible there are outlets more valuable to another company, but it is important they are in good shape before they are sold. However, more than this is needed for a full effective enhancement programme and a position audit could be carried out. • Consider the effect on the workforce and determine how many, if any redundancies are likely and what the cost will be. • Risk diversification may well lower the cost of capital and therefore increase the value of the entity. • The entity’s cost of capital should be re-evaluated. • Make a positive effort to communicate the post-acquisition intentions within the entity to prevent de-motivation and avoid adverse post-acquisition effects on staff morale. • There may be economies of scale to identify and evaluate. • Undertake a review of assets, or resource audit, and consider selling non-core elements or redundant assets. • There may well be a need to pursue a more aggressive marketing strategy. • The risks of the acquisition need to be evaluated. • There needs to be harmonisation of corporate objectives.
6.6.3 Impact on ratios or performance measures Following the completion of an acquisition the purchaser will need to examine thoroughly the financial and management accounting records of each business unit of the acquired entity. Thus, the directors of the acquirer will be particularly interested in the financial condition of those units which they might plan to dispose of. From a strategic point of view these are likely to be of more use to another entity with whom they would form a better fit. However, it is still essential that financially and operationally they should be in as good shape as possible to ensure that a good price can be obtained for them. Let us assume that one such acquired entity unit is their Wodgits subsidiary. The acquirer itself may not have a unit close enough to Wodgits’ business to make ready financial comparisons, so a search must be made for a competitor against which to measure some key financial ratios. A small plc called Bigwodge, whose core business is similar to Wodgits, would seem suitable, so by using all published and any other information reasonably available, the following analysis could be constructed: Wodgets Return on capital employed (ROCE) 14.9% Asset turnover (AT) 1.3 times Net profit as percentage of revenue (NP) 11.5% Current ratio (CR) 1.5 times Inventory turnover (based on revenue) (ST) 5.4 times Customer days (DD) 54 Supplier days (based on revenue) (CD) 49
Bigwodge plc 25.0% 1.8 times 13.9% 2.2 times 6.4 times 43 37
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6.6.2 Post-acquisition value enhancement strategies
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To refresh your memory concerning ratios, we will assume possible values of the ratio elements to support the calculations as follows:
Ratio ROCE
Formula Profit before interest and tax Capital employed (net assets)
Wodgits £000 860 0.149 5,770
Bigwodge plc £000 2,220 0.25 8,900
7,500 1.3 5,770
16,000 1.8 8,900
AT
Revenue Capital employed
NP
Profit before interest and tax Revenue
CR
Current assets Current liabilities
2,700 1.5 1,800
5,500 2.2 2,500
ST
Revenue Inventory
7,500 5.4 1,400
16,000 6.4 2,500
DD
Receivables 365 Revenue
1,100 365 54 7,500
1,900 365 43 16,000
CD
Payables 365 Revenue
1,000 365 49 7,500
1,600 365 37 16,000
860 0.115 7,500
2,220 0.139 16,000
As the acquirer’s management accountant, how would you advise the directors on the basis of the above comparisons? Your report could address return on capital employed and concern about liquidity. Return on capital employed (ROCE) Wodgits’ inadequate ROCE seems to be mainly due to a low rate of asset turnover, which we must carefully investigate. We know that land and buildings account for £2.5m of Wodgits’ fixed asset total of £4.87m and it is important to establish how much of this property value represents redundant assets. As to plant and machinery, it may be that this is substantially new or revalued, in which case the assets may be of good value and the faults may lie mainly in under-capacity working or production inefficiencies. Much more serious, however, would be a situation where the plant is old and requiring heavy maintenance, and would be hard put to cope with increased volume of throughput. If the first of these plant scenarios is correct, then Wodgits may well fetch a reasonable price, as a bidder, possible Bigwodge themselves, would be obtaining good assets to add to their own evidently successful performance in their sector. If the second scenario applies, then we might find it difficult to obtain net asset value for the assets remaining after sale of the redundant properties. Current ratio Wodgits’ current ratio and inventory turnover are fairly good but before we put the unit up for sale, we would improve our prospects for a reasonable price by taking early action in regard to both receivables and payables. Both are too high and we should aim to tighten up
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Conclusions Assuming that we can find that, say, £1.5m of land and buildings are redundant and can be separately sold, and that the plant scenario is favourable or can be made so, then it would not seem to be too difficult to make the remainder of Wodgits a saleable proposition. Thus if we can assume no debt interest, and taxation of 33 per cent, then after-tax profits could be £576,000 (£860,000 0.67), and as Bigwodge’s current P/E is 18, we might achieve for Wodgits a P/E of 9 or 10 which suggests a price of between £5.2 and £5.8m, which is comfortably above an asset value of £4.3m (£5.8m £1.5m assets sold).
6.6.4 Acquirer’s post-acquisition share price A very important aspect for an acquirer is the post-acquisition effect on its earnings per share (EPS), and the impact on the share price and P/E ratio arising from the market’s perceived views on the acquisition. Let us first consider EPS. Assume that the new entity starts with a prospective EPS of 13.1 pence based on combined profits of acquirer and acquired of £8.4m, and 64m shares in issue, and if these earnings could be maintained in year 1 (postacquisition) they would appear not to be diluted. However, if the acquirer is expected from its previous performances to attain 10 per cent per annum growth in normal (money) terms, then for year 1 EPS of 13.1 pence 1.1 would be 14.4 pence, and arguably if this is not attained then dilution will seem to have taken place. A serious threat to an acquirer’s EPS is the ‘getting to know you’ costs and also the ‘reverse synergy’ effects of 2 2 3, which sadly seems to be the fate of numerous acquisitions. A major question is whether the present value of the combined earnings, including assumed longer-term profit improvements, really takes into account all the downside costs of putting two different entities together, each with its own management style. We come back to the assessment made above of the key financial performance ratios of Wodgits, and would suggest that this analysis should be performed for each business unit. If the core business is similar to that of a business unit of the acquirer, then the ratios of that acquired entity unit should be compared with those of the relevant unit of the acquirer. As stated above, for those acquired entity units not comparable with the acquirer’s units, then comparison should be made with another company in the appropriate industry sector.
6.6.5 Example: Impact on stakeholders This example looks at aspects of share valuation and its effects on the acquirer and the acquired.
Example 6.B Oscar Wills is the chief executive of OW plc. The entity has been trading for 5 years and is quoted on the stock market. Oscar is ambitious and aims to make his entity market leader within 5 years.
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credit control and also bring payables down to the more acceptable level which Bigwodge indicates is appropriate for the industry sector.
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STUDY MATERIAL P9 He makes an offer to acquire Wilde plc, an older quoted entity of similar size to OW but with a profit record that has been erratic in recent years. Wills is of the opinion that Wilde lacks marketing strength and feels that he could make the entity much more profitable. A summary of the financial data before the bid is as follows: OW 40m £4m 20
Number of shares in issue Earnings available to ordinary shareholders P/E ratio
Wilde 44m £4.4m 10
Oscar Wills’ estimated financial data, post-acquisition Estimated market capitalisation Estimated share price Estimated EPS Estimated equivalent value of one old Wilde share
£167.7m 262p 13.1p 143p
The offer is six OW shares for eleven Wilde shares. The offer is not expected to result in any immediate savings or increases in operational cash flows.
Requirements (a) What reasoning did Oscar Wills use to calculate his estimate of post-acquisition values? Would you agree with his calculations? If not, give your own estimates of the post-acquisition share price, assuming the takeover goes ahead. (b) If Wilde’s shareholders rejected the bid, what is the maximum price OW would pay, without reducing its shareholders’ wealth, assuming Mr Wills’ estimates of post-bid market value is correct? (c) Give reasons why OW would wish to make the acquisition and comment on likely post-acquisition effects on the P/E ratio. (d) Discuss other post-acquisition impacts that the directors of OW plc should consider.
Solution (a) Pre-acquisition Earnings (£m) Number of shares (m) EPS (p) P/E ratio Share price (p) MV (£m) Post-acquisition Proportion of new entity owned by: Wills (40/64) Wilde (24/64) Market value (prop. £167.7m) Number of shares pre-acquisition (m) Post-acquisition price per existing share (p)
OW
Wilde
OW Wilde
4 40 10 20 200 80
4.4 44 10 10 100 44
8.4 64 13.1 20 262 167.7 (on Wills’ estimate)
62.5% 104.8
37.5% 62.9
40
44
262
143
Oscar Wills has applied his own pre-acquisition P/E ratio to the combined earnings of the new entity. The difference between the combined market values pre-acquisition (£124m) and the estimated market value post-acquisition (£167.7m) is £43.7m. This is Wilde’s pre-acquisition earnings multiplied by the difference between the entity’s pre-acquisition P/E and the combined post-acquisition P/E (20 10 10). EPS for Oscar Wills appears to have increased from 10p to 13.1p because of this ‘bootstrapping’ effect. 2006.1
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Wills: £124m 62.5% £77.5m or 194p per existing share compared with 200p per share now Wilde: £124m 37.5% £46.5m or 106p per existing share compared with 100p per share now There is a transfer of wealth from Wills’ shareholders to Wilde’s, because the terms of the offer are slightly more generous than the ratio of the old share prices. The pre-acquisition prices suggest 1-for-2, not 6-for-11. (b)
Estimated value of combined firm (per OW) Value of OW before merger Maximum price
£168m £80m £88m
This is £44m over the existing value of Wilde’s shares. It can be reconciled by multiplying the historic earnings by the difference between Wilde’s P/E and OW’s P/E – i.e. £4.4m (20 10). (c) OW plc may have had the following among their reasons for making a bid for Wilde plc: ● Expectation of growth. OW is an ambitious entity and it sees in Wilde a means of growing faster and more cheaply than by internal expansion, especially as Wilde seems to be a ‘slumbering heavyweight’ relative to OW. ● Management and technical staff. Wilde’s results may be erratic, but OW is aware that in terms of size and quality of main products Wilde is a significant player in its market sector. It is reasonable to assume therefore that Wilde may be suffering from poor administrative as well as marketing management, which could considerably undervalue the earning potential of its products. By means of more aggressive marketing and improved administration, OW believes that dramatic profit improvements are possible. Also Wilde may possess strong technical expertise which OW might find difficult and expensive to obtain by internal development. ● Market share. If Wilde is in the same industry sector as OW, this could well be a main reason for the bid, in which case OW’s shareholders might have less reason to be concerned over the price. Thus if the acquisition led to OW’s market share rising fairly quickly to make the new entity second or third in its sector, and not excessively far below the leader, it could begin to wield significantly greater influence in that sector. ● Synergy savings. Wilde may have a number of ‘dogs’ (Boston Consulting Group term for bad failure) among its business units, which OW may be much less prepared to pour resources into, even though some may be the Wilde chairman’s ‘pets’. However, if this aspect is known to the market, then the synergy savings may well attract a higher bidder. ● Risk reduction. From the comparative P/E ratios it seems evident that Wilde is regarded by the market as being much riskier than OW, and this could well be due to Wilde being an acquirer of struggling entities, bought at cheap prices, possibly even in sectors only remotely related to Wilde’s core business. Such entities often turn out to be disasters, taking up disproportionate amounts of the acquirer’s valuable management time. At OW, Mr Wills does not believe in keeping a ‘kennelful of dogs’! and the profit improvement suggested is likely to come not only from more aggressive marketing but from a concentration of resources on key products, thereby reducing risk in the new entity. Next, the acquirer needs to be concerned at the post-acquisition effects on its P/E ratio. On the basis of the preacquisition estimates, Mr Wills looked to maintain OW’s own P/E ratio of 20 (262p 13.1p), but on the more realistic basis of assuming a value of 194p per share – which assumes that OW inherits the greater risks of Wilde’s current operations – then, as shown above, for the new entity the market capitalisations should be simply added together, making £124m and the P/E ratio becomes 194p 13.1p 14.8. However, we must now consider the possibility of downside costs in year 1; thus even assuming that OW has taken several steps to improve Wilde’s operations and perhaps made some significant asset sales, an upset to earnings caused by ‘teething troubles’ could do more than offset the effect of the improvements. Thus, EPS of, say, 13.5p for year 1 (instead of 14.4p, showing 10 per cent expected growth), which one would expect to yield a P/E ratio of approximately 15.2 (13.5p 13.1p 14.8), might well fall back to about 13, or even 12. Downside factors often seem to the market to be more significant than improvements. Clearly then, at the time of making its bid, it would have been most unwise for OW to pay excessively for ‘synergy savings’ and not to give due regard to possible adverse post-acquisition impacts. (d) Further post-acquisition aspects ● Position audit. As an initial move, OW will need to do much more than analyse key financial factors of each of Wilde’s units. OW’s management will need to get a proper understanding of the main ‘stakeholders’ of each Wilde unit, for example, staff, customers and suppliers, and an appreciation of the products or services provided. In company planning, this wide-ranging survey is of the nature of a ‘position audit’, which should help considerably in speeding up the ‘getting to know you’ aspect which is so important if the full benefits of the acquisition are to be obtained. 2006.1
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In the absence of any immediate commercial benefits, or the disclosure of new information during the bid, there is no reason why the market value of the combined entity should be any different from the total of the two individual entitys’ market values – that is, £124m. This would suggest the following post-acquisition prices per existing share:
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Improving efficiency. It is better for OW to approach Wilde more as a management consultant rather than to demand immediate changes without adequate explanation. Administrative savings mainly involve people, and OW must try to ensure that the logic of its proposals is clearly explained to Wilde’s management and staff, and as far as possible their cooperation gained. Redundancies need to be worked out fairly but firmly with an emphasis on voluntary redundancy as far as possible; the main purpose must be to reduce the resentment of those who are losing their jobs and to provide as much help as possible by way of counselling or assistance in job-seeking. In these situations uncertainty should be avoided, as it tends to demotivate the entire workforce, and rumour is liable to feed greedily on rumour. Even if Mr Wills is convinced that Wilde’s marketing needs to be more aggressive, he should first of all make himself fully aware of the nature of Wilde’s marketing policies and of their customers and competitors. If Wilde is substantially in the same market sector as OW, there may be certain valuable niches occupied by Wilde which OW would do well to retain. Profit improvement. The financial analysis of Wilde’s units suggested above will help to pinpoint the areas where profit improvements can be obtained, but it is essential that a comprehensive action plan is then prepared, as far as possible in co-operation with Wilde’s management, and reasonable time allowed for the phasing-in of significant changes. It is not helpful to go ‘stomping around’ offices and factories, thereby emphasising the perceived incompetencies of Wilde personnel. It may be that many faults, especially of inadequate systems, may already be recognised by Wilde staff and, faced with the necessity of correcting them, they may be quite willing to join in making appropriate changes. Sadly, it is often the case that obstinate managers may be standing in the way of improvement, and in this situation OW is in a good position to take quick but fair and firm action, possibly by grasping the nettle of making major changes in Wilde’s organisation structure if this is seen to be necessary for a more profitable operation. Asset sales. Here it is often the reluctance of top management to dispose of redundant assets and ‘dog’ units, even though it is recognised that keeping them represents a serious waste of management time and scarce resources. OW will need to make it quite clear as to which activities are to be retained, which merged with OW units and which disposed of, but in all cases the logic of each move should be clearly explained to the Wilde management and staff affected. This assumes, of course, that OW has thought through what it intends to do, which again is a good reason for first carrying out a position audit before taking action on Wilde‘s operations. Effective communication. Finally, a qualitative factor of the utmost importance, as by effective communication we mean that OW must do all possible to ensure that Wilde is on the same ‘wavelength’ as itself. New reporting systems and procedures should only be introduced after proper consultation, in which OW will need to make clear their purposes and ensure that changes will not cause serious disruption to Wilde’s operations. This is especially true in seeking computer system compatibility, which will call not only for careful planning but an acceptance by OW that in this, as with other system changes, a sufficient period of parallel running may be an essential procedure. There should be reasonable opportunities for Wilde staff to have contact with those of OW and vice versa, especially through participation in training procedures and conferences; also Wilde staff should be encouraged to feel that promotional prospects throughout the new entity will be open to them. All the points made in this section concerning redundancies, changes and reorganisation created by the acquisition of Wilde apply equally to the need for OW to keep its own staff properly informed, otherwise demotivation may also affect OW with consequent damage to its own profitability whatever happens with Wilde. Perhaps, in the end, the most effective post-acquisition strategy that OW can apply to Wilde and itself is to provide an atmosphere in which both sides are able to talk freely with each other, seeking co-operation wherever possible, and even though some of OW’s actions – improving profitability and making asset sales – may be very hurtful to Wilde, at least things can probably be made somewhat more acceptable if the justification for them is properly explained to all concerned, and that includes any of OW’s own staff who may also be affected.
Example 6.C This example involves discussion of the significance of each of six different reasons for proceeding with the acquisition. You are required to evaluate net assets and price/earnings ratio as alternative methods of valuation, with discussion as to the most appropriate basis to be used in this case. The whole question has to be answered on the basis of given data in respect of the acquired entity, in which a firm of venture capitalists has a significant interest in terms of long-term loan capital. The prospective acquirer is a public entity. G Limited operates in the gaming and betting industry. The company was established 7 years ago, and the two founder directors still provide the necessary technical and marketing skills. They own 60 per cent of the issued share capital, the balance plus the long-term loan capital having been subscribed by a firm of venture capitalists. 2006.1
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Requirements (a) Discuss the extent to which each of the following six reasons might apply to the proposed acquisition of G Limited by H plc. Support your answers with appropriate analysis of the data provided. (i) Access to innovation (ii) Growth in earnings per share (iii) Achievement of operating economies (iv) Reduction of risk through diversification (v) Access to liquid funds (vi) Improved asset backing for borrowing.
Data relating to G Limited – extracts from annual reports Year ended 30 June
2000 £000
1999 £000
1998 £000
1997 £000
224 354 170
174 334 140
133 323 110
113 313 100
58 38 50
44 34 40
254 176 378
189 109 380
129 053 076
72 23 49
32 37 25
12 32 10
30 97 12 321 140
40 64 8 314 126
31 48 9 35 93
25 42 7 36 80
22 30 6 19 77
12 15 5 32 34
31 12 24 67
28 6 17 51
21 – 11 32
17 – 39 26
11 – 38 19
8 – 38 16
73
75
61
54
58
18
321 160 161
295 160 135
247 160 387
203 120 383
133 180 153
68 50 18
100 361 161
100 335 135
100 3(13) 3871
100 3(17) 3831
100 3(47) 3531
20 (2) 18 (
Revenue
860
684
5473
4213
281
175
Operating profit Loan interest Taxation Profit retained
55 (20) 3(9) 326
68 (14) 3(6) 348
16 (12) 1–1 334
38 (8) 1–1 330
(39) (6) 1–1 (45)
1 (3) 1–1 33(2)
Remuneration of founding directors
325
320
320
320
318
315
Tangible non-current assets At cost Less: depreciation Development costs At cost Less: written off Current assets Inventory Trade receivables Other receivables Cash Current liabilities Accounts payable Taxation Other Net current assets Total assets less current liabilities Long-term loans Net assets Share capital (shares of 25p each) Profit and loss account
1996 £000
1995 £000
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Extracts from the annual reports of G Limited are given opposite, together with supplementary information. You are acting as financial adviser to a public entity, H plc, in the hotel business. H plc is considering a takeover bid for the shares of G Limited.
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Supplementary information The directors now forecast that profits after tax for the next 4 years will be as follows: Year ended 30 June 2001 2002 2003 2004
£000 29 42 55 68
(b) Assuming that a bid is to be made, calculate alternative values for the total equity of G Limited, based on: (i) net assets; (ii) P/E ratio based on earnings; and discuss which basis should be used, having regard to the interests of the founder directors of G Limited and of the venture capitalist. For listed entities in the gaming and betting industry, the range of P/E ratios is currently between 10 and 15, which suggests that for an unlisted company, P/E ratios between 6 and 9 would be appropriate.
Solution (a) (i) Access to innovation. To comment upon this fully would require detailed income statement information. However, the development costs capitalised on the balance sheet give an indication of considerable increase in development as opposed to research expenditure which has been undertaken, assuming that this does not reflect changes in accounting policy. Against this, the high rate of write-off suggests that the life of developed products may well be short. As innovation depends on people, H plc should identify and take steps to retain key staff in the event of a takeover. (ii) Growth in earnings per share. The impact of the acquisition on the earnings per share of H plc will depend upon the price paid and whether the price included shares of H plc. The past profit performance of G Limited and forecast earnings are certainly erratic and lower in relation to revenue. This may be due to poor management, in which case the firm could be turned around and earnings improved or it could be uncontrollable factors in which case earnings might be low and volatile in the future. The counter-view would be to suggest that if the rapid growth of the past 3 years can be maintained, then there must be opportunities for boosting earnings even if the profit forecasts do not reflect this. (iii) Achievement of operating economies. The achievement of such economies depends upon integration of similar businesses. Given that hotels and gaming and betting are closely linked there may be scope for such economies if gambling operations already occur or are planned at the hotels of H plc. (iv) Reduction of risk through diversification. G Limited has volatile earnings and is more likely to increase the risk profile of H plc than reduce it. (v) Access to liquid funds. Although there is no ready cash in G Limited the entity has had a satisfactory liquidity position for several years with liquidity ratios of between 4.1 (1996) and 2.1 (2000). However, it should be noted that the position has worsened slightly over recent years. It is probable that since the hotel industry typically has fairly low liquidity, acquiring G Limited will improve the liquidity position of the combined entity as compared with H plc. (vi) Improved asset backing for borrowings. Tangible fixed assets at cost less depreciation have increased more than fourfold during the period 1995–2000. Obviously comments which can be made are limited due to a lack of categorisation of assets and detail of movements. However, the low depreciation charge suggests that there is land and buildings or long leasehold property among the assets. Such assets provide good security for borrowing, and as assets are at cost the borrowing capacity may well be higher as it will reflect market values. (b) (i) The net asset value per the books is £161,000. This is a historical cost valuation and includes £78,000 of an intangible asset. However, as non-current assets are fairly new there should be little need for adjustment. Inventory turnover is high and therefore this valuation is probably accurate. However, receivables have grown 52 per cent in the last year against a 26 per cent growth in sales and therefore their collectability should be investigated. A net asset valuation would also require an assessment of goodwill, which in a fast-growing company like this may well be significant. Valuations may therefore range from a conservative £83,000 (net assets less development costs) to an upper figure which depends on the value of goodwill. (ii) P/E ratios range from 6 to 9 (0.6 10 and 0.6 15) for unlisted entities such as G Limited. The entity has only been established 7 years and has demonstrated considerable earnings growth in the period despite difficulties in 1998. The appropriate earnings figure for a P/E ratio approach could be 2000 if the outlook was good or an average of 2000 and 1999 (to include earlier years with results affected by startup would probably be unreasonable). No adjustment has been made for directors’ remuneration as the amount
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£37,000 9 £333,000 and the worst: £26,000 6 £156,000 Given earnings volatility, an offer at the lower end of this range is justified. The founder directors’ interests would probably be best served by service contracts and a moderate payout for the shares. The venture capitalist will probably be a willing vendor given the erratic performance of the investment and therefore an offer at the lower end of the range (given by the net asset approach) may well be successful.
6.6.6 Reasons why mergers and acquisitions fail ●
●
●
●
●
●
The fit/lack of fit syndrome. There may be a good fit of products or services, but a serious lack of fit in terms of management styles or corporate structure. Lack of industrial or commercial fit. Failure can result from a horizontal or vertical takeover where the acquired entity turns out not to have the product range or industrial position that the acquirer anticipated. Usually in the case where a customer or supplier is acquired, the acquirer knows a lot about the acquired entity; even so, there may be aspects of the acquired entity’s operations which may cause unexpected problems for the acquirer, such that, even in these cases, a prospective acquisition should be planned very carefully and not be based solely on experience gained from a direct relationship with the acquired entity. Lack of goal congruence. This may apply not only to the acquired entity but, more dangerously, to the acquirer, whereby disputes over the treatment of the acquired entity might well take away the benefits of an otherwise excellent acquisition. ‘Cheap’ purchases. The ‘turn around’ costs of an acquisition purchased at what seems to be a bargain price may well turn out to be a high multiple of that price. In these situations, the amount of resources in terms of cash and management time could well also damage the acquirer’s core business. In preparing a bid, a would-be acquirer should always take into account the likely total cost of an acquisition, including the input of its own resources, before deciding on making an offer or setting an offer price. Paying too much. The fact that a high premium is paid for an acquisition does not necessarily mean that it will fail. Failure would result only if the price paid is beyond that which the acquirer considers acceptable to increase satisfactorily the long-term wealth of its shareholders. Failure to integrate effectively. An acquirer needs to have a workable and clear plan of the extent to which the acquired company is to be integrated, and the amount of autonomy to be granted. At best, the plan should be negotiated with the acquired entity’s management and staff, but its essential requirements should be fairly but firmly carried out. The plan must address such problems as differences in management styles, incompatibilities in data information systems, and continued opposition to the acquisition by some of the acquired entity’s staff. Failure to plan can – and often does – lead to failure of an acquisition, as it leads to drift and demotivation, not only within the acquired entity’s organisation but also within the acquirer itself. Every aspect of a prospective acquisition, as it will affect the would-be acquirer, should be weighed up before embarking on a bid. Problems of integration have a much better chance of being resolved before bidding action is taken than they do after the event, when many more complications can ensue. 2006.1
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seems reasonable or even low for active participation. This gives earnings of £26,000 or £37,000 respectively. On this basis the best value would be:
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●
Even if a product fit is satisfactory, the would-be acquirer should be satisfied that the aspects of its own operation affected by the bid will be properly adaptable to the new activities. Running the rule carefully over one’s own operations may yield vital information as to areas which may need adaptation before a bid can be contemplated, and provide vital clues to appropriate areas for search when a bid has actually been launched. One factor of special importance is a clear assessment of the flexibility of one’s own information systems. Inability to manage change. Several of the above points stress the need for an acquirer to plan effectively before and after an acquisition if failure is to be avoided. But this in itself calls for the ability to accept change – perhaps even radical change – from established routines and practices. Indeed, many acquisitions fail mainly because the acquirer is unable – or unwilling – reasonably to adjust its own activities to help ensure a smooth takeover. One such situation is where the acquired company has a demonstrably better data information system than the acquirer, which it might be greatly in the acquirer’s interest to adopt.
6.7 Exit strategies In the remaining sections of this chapter we consider the following methods of corporate and business restructuring: • • • •
sell-offs spin-offs management buy-outs reconstruction.
These will all change the ownership structure of the entity. Divestment: Disposal of part of its activities by an activity. (CIMA: Official Terminology, 2005). The reasons for divestment include: • • • •
the sum of the parts of the entity may be worth more than the whole; divesting unwanted or less profitable parts; to shift the strategic focus onto the core activities; a response to crisis.
6.7.1
Sell-off
A sell-off is the sale of part of an entity to a third party, usually in return for cash. The most common reasons for a sell-off are: • to divest of less profitable and/or non-core business units; • to offset cash shortages. Usually the business unit is sold-off as a going concern. However, at its extreme, the business unit or even the whole entity may be sold off in a liquidation. In this situation the owners volountarily dissolve the business, sell-off the assets piecemeal, and distribute the proceeds amongst themselves. 2006.1
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Spin-off
A new entity is created, where the shares of that new entity are owned by the shareholders of the entity that made the transfer of assets into the new entity. There are now two entities, each owning some of the assets of the original single entity. The ownership has not changed, and in theory the value of the two individual entities should be the same as the value of the original single entity. Spin-offs may be justified as follows • it allows investors to identify the true value of a business that was hidden within a large conglomerate; • it should lead to a clearer management structure; • it reduces the risk of a takeover bid for the core entity.
6.8 Management buyouts Management buyout : Purchase of a business from its existing owners by members of the management team, generally in association with a financing institution. (Official Terminology, 2005) There are a number of situations in which a management buyout (MBO) might be considered: ●
● ● ●
the management of the division may feel isolated from the main decision-making process of the entity; the entity may wish to dispose of a loss making subsidiary; the parent entity may need to raise cash to find on acquisition; the entity may want to focus on its designated core activities.
Members of the buyout team may possess detailed and confidential knowledge of other parts of the vendor’s business and the vendor will therefore require satisfactory warranties over such aspects which it will not be able to control. More seriously, key members of the MBO team may have skills vital to the vendor’s operation, especially in regard to information services and networking. A vendor may be reluctant to allow key players to end their contracts of service to take part in an MBO, because losing vital operational skills can hardly be compensated by forms of warranty.
6.8.1
Financing MBOs
Financiers tend to favour established businesses with reliable cash flows (to pay down the debt) and a clear exit route. They like definitive plans, but say they prefer them brief and to the point. The emphasis should be on the competences of the team, and the market opportunity to be exploited, with detailed financial numbers (majoring on cash flow) put into an appendix. How services previously supplied by group departments, or fellow subsidiaries, will be replaced is likely to be a key item. Managers will be required to invest some of their own money and this will take the form of shares with special features, for example, a high proportion of any disposal value. Capital structures are inevitably complex, with several levels of risk/reward: 2006.1
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6.7.2
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Secured loans are usually obtained from a bank, with a first charge on the assets taken over by the venture. The provider of senior debt will require a first-ranking security over all the assets involved in the MBO venture and, usually, over the capital of the MBO as evidenced by shares in the new entity. Security will also involve undertakings from the MBO team regarding the provision of financial information and the setting of restrictions on the MBO’s capacity to raise other debt finance and to dispose of assets. Junior debt is usually called mezzanine finance, which is an intermediate stage between senior debt and equity finance in relation to both risk and return. The return on mezzanine finance can comprise a mixture of debt interest and the ability to convert part of the debt into equity, perhaps by the conversion of warrants. By this means the lender can in time have a share in the premium resulting from eventual exit from the venture. The debt interest will carry a risk premium, as it is subordinate to the senior debt and with less security: it may even be unsecured. Venture capital is a form of equity provided mainly by institutional investors, whose reward will usually be in some form of dividends, probably preferential, combined with appreciation of their MBO equity holding which will build up a capital gain for when the investment is realised. The last link in the structural chain is the equity holding granted to the MBO team itself which, if their activities are successful, will provide a substantial capital gain when the venture is exited, either through flotation or by other means. Meanwhile, the MBO management will draw salaries or fees for their services.
6.8.2 Evaluation by investors and financiers Key points for investors – usually banks or other institutions – in deciding whether to support an MBO are as follows: ●
●
●
●
What is actually for sale, and why? It may be a division or subsidiary of an entity which no longer fits that company’s strategy, or it may be separable assets such as a factory or group of retail outlets. Whether the activities are profitable and enjoy a satisfactory cash flow. The prospective returns must justify the operational and financial risks involved. Profits must be sustainable and cash flow adequate to sustain the level of activities proposed. Whether the management is sufficiently strong. This point is particularly significant if the MBO relates to loss-making activities, although sufficient allowance must be made for the possibility that its existing owners may be burdening it with excessive overheads. Financial competence and marketing skills in the MBO’s sector are especially important. Whether the price is reasonable and a sufficient contribution is being made by the managers. The managers should have some financial involvement and the future prospects for the new company should be demonstrable, especially in a ‘turn-around’ situation.
Investors, probably institutions, backing the MBO will initially hold a majority of the equity, with a relatively small minority of shares held by the managers. Although the backers must be prepared to hold their investment for the long term, they and the managers will be looking to the entity growing successfully to the point where it can be launched on the stock exchange. At this stage, a market value can be obtained for the equity and, if desired, some portion of the investment can be realised. 2006.1
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6.9 Reconstruction If an entity is in financial trouble it may have no recourse but to accept liquidation as the final outcome. However, it may be in a position to survive and indeed flourish by taking up some future contract or opening in the market. The only hindrance to this may be that its future operations can only be carried out with an injection of cash into the entity. The problem facing the entity may be that to get out of its present situation it will require extra cash, which it cannot raise because the present structure and status of the entity will not be attractive to outside investors. This situation can sometimes only be resolved through some type of reorganising or reconstruction of the entity. A typical entity in this situation will have: ● ● ● ● ● ●
large accumulated losses, large debenture interest arrears, large cumulative preference dividend arrears, no ordinary dividend payments, a market price below the normal value of its shares, lack of market confidence in its future.
These features will hinder the chances of attracting new investment: Large losses will prevent the payment of ordinary dividends. This will make the entity unattractive to prospective equity investors. ● Debenture interest and preference dividend arrears will need to be paid before any future ordinary dividends are paid. In some countries, company law prevents shares from being issued at a price below the nominal value of the shares. ●
Reconstruction will involve some or all of the following: ● ● ●
Writing off accumulated losses; Writing of debenture interest and preference dividend arrears; Writing down the nominal value of the equity shares.
To do this the entity must ask all or some of its existing stakeholders to surrender existing rights and amounts owing and exchange these for new rights in a new or reconstructed entity. The main problem is to devise a scheme that will be acceptable to all parties: ●
●
Each party’s position must be better under the scheme than opting for liquidation. The first step is therefore to ascertain the amount each stakeholder could expect to receive without the scheme. This will require preparing a ‘break-up’ value balance sheet. The amount of additional risk to be carried by each party should be minimised. For example, debenture holders would be unlikely to accept ordinary shares in full 2006.1
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Where the backers desire a lower-risk element in their investment, they can require that some part of it will be in the form of redeemable convertible preference shares. This can give them priority in obtaining income through a preference dividend and preferential rights of repayment if the entity should fail. There is also the prospect of redemption if the entity does not develop satisfactorily, or conversely, the convertible aspect will allow backers eventually to increase their equity holding if the entity should prove successful.
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settlement if they could receive some or all of their capital in the form of cash through liquidation. There must be realistic long-term prospects for survival of the entity. There is no point in devising a scheme for an entity that is not going to survive anyway.
This exercise will inevitably throw up some very difficult problems, not least the need to throw out the product which the chairman has supported for years in the face of its descent into ever-increasing losses. Indeed, the entity may well face the need for a reconstruction simply because the top management, though well aware that certain activities were dragging the business down, kept on pushing more resources into them in the unrealistic hope that ‘they will come right again next year’. A management cannot be blamed for the entity’s industry going into deep recession, or for the market for a product collapsing through technological advances or the sheer weight of competition from bigger players; however it can be blamed for continuing to waste resources on products or services which are not adding value, or in fighting competitive battles without adequate weapons. Disposing of part of a business even at a relatively unattractive price is better than facing a forced reconstruction at a later date. Other important factors of a reconstruction are that time is short and speedy action essential; also that in terms of monitoring financial performance, cash flows are almost certainly more important than profit, at least in the short term.
6.9.1 Effect on the share price of a listed company If a listed entity is facing a reconstruction, it is almost certain that it will previously have issued profit warnings, unless of course it was itself taken by surprise by a sudden trading collapse. In the case of warnings being given, the share price will probably have fallen significantly, but sudden and possibly unsuspected disasters can cause even more dramatic falls. The stock market dislikes uncertainty, so that the sooner an entity in difficulties can make its proposals for reconstruction known, and can make clear the positive actions it is proposing to take to improve its position, the sooner it can look forward to an improvement in its share price. Clearly having announced its intentions, the entity should follow up by implementing actions as quickly as possible.
6.10 Summary In this chapter we have discussed various aspects of merger activity, including motives for merger, defence tactics, reasons for failure and the impact of regulation. We have also shown methods of valuing entities for takeover and explained the strengths and weaknesses of traditional approaches. How takeovers are financed and the relative advantages and disadvantages of each type of finance were also discussed. The chapter concluded with a discussion of reconstruction. MBOs and other forms of reconstruction involve the removal of some part of an entity from its present structure. However, a reconstruction is often a forced situation with limited choices of action, while MBOs are ususally well-considered strategic moves based on reasonable appraisal processes.
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Readings
The article below examines the management buy-out of Hamleys. The author explains how the business went private after a dismal decade on the stock market, and asks the finance director of the entity how the firm plans to be successful in the long-term.
Shop of little horrors Cathy Hayward, Financial Management, December/January 2003/04. Reproduced with permission.
Childhood haunts often seem much smaller and less impressive when you return to them as an adult. But if you walk through the doors of Hamleys on London’s Regent Street it won’t matter whether you’re 3ft or 6ft tall. You’ll still be overwhelmed by the atmosphere of pure excitement, the screams of delight and the sheer volume of kids’ stuff packing the world’s biggest toy shop. You can multiply that experience a hundred times if you visit the store just before Christmas. Thousands of starry-eyed children throng the floors, trampling over each other in their eagerness to grab as much as daddy can carry home. A well-padded Santa mingles with them, delving in his sack for little gifts, while harassed-looking adults fight their way through the hordes, searching for errant offspring or this year’s must-have present. It’s hardly less frantic behind the scenes. Christmas shopping accounts for 44 per cent of Hamleys’ annual takings, which means that the store spends most of the year getting ready for the festive flurry.
Toying with the figures 1760 500,000 44 5 million £7,995 £45.9 million Seven 6pm
the year that Cornishman William Hamley opened a toy shop in Holborn. the number of teddy bears that Hamleys sells over the Christmas period. the percentage of Hamleys’ annual sales taken over Christmas. the number of visitors to the Regent Street store in 2002 (28 per cent of whom were from abroad). the cost of Hamleys’ most expensive toy: the Outrage! Deluxe board game. Its cards are edged with gold leaf and the replicas of the crown jewels are 18-carat gold. Hamleys’ turnover in 2002. the number of sales floors at the Regent Street store. the time it closes on Christmas Eve.
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‘We started preparing by placing initial orders for our own-brand stock, such as the famous Hamleys teddy bears, at Easter time,’ explains Ian Parker ACMA, the company’s finance director. ‘Stocks change every year depending on what’s popular, but jigsaws, Monopoly and Cluedo are always big sellers.’ Keeping the store well stocked is a major challenge. Hamleys normally receives six deliveries a week, but in mid-December it will take six every day. Shift-workers spend the night replenishing the displays, ready for little hands to demolish them immediately the next morning. As Parker says: ‘It gets hairy in the run-up to Christmas.’ The festive period may be by far the busiest time of the year in the store, but Hamleys is also recovering from a frenetic summer in the boardroom, when the firm eventually went private after a long search for a backer. ‘After all the press interest and intense work on the management buy-out, it’s nice to get back to normal and focus on the business,’ Parker says. Since March, when it was announced that Parker and the chief operating officer, John Watkinson, were seeking finance for a management buy-out (MBO), the talk has been less about tricks and train sets and more about bid vehicles. In early June, Icelandic retail investment group Baugur agreed to finance the MBO and settled on a bid of 205p per share, valuing the business at £47.7 million. But later in the month it emerged that retail entrepreneur Tim Waterstone was also interested, so Baugur raised its bid to £52.2 million in order to fend him off. Waterstone’s eventual bid, which valued the business at £53.1 million, forced Baugur to up the ante again to £58.7 million, increasing Hamleys’ share price to a five-year high of 252p. Because Watkinson and Parker had been working with Baugur, the rival bids were considered by an independent committee of non-executive directors. But in the middle of July Waterstone bowed out and his bid vehicle, Children’s Stores, agreed to sell its shares to Soldier, the vehicle that Baugur had set up. The committee unanimously recommended that the shareholders accept the offer from Soldier, which represented a premium of more than 100 per cent on the share price before the bid talks were announced. Yet the media attention was not over: the deal came under the spotlight again when it was alleged that Jon Asgeir Johannesson, Baugur’s chief executive, had tried to use company funds to procure escort girls for a party on a yacht in Florida. Despite the furore, the sale went ahead on 4 August and Baugur took control of Soldier, with the Hamleys directors owning a minority interest. There was a collective sigh of relief at Hamleys, which had endured several years in the doldrums and had tried unsuccessfully twice before to go private. After floating on the stock market in 1994, the firm’s fortunes declined so far that it was forced to issue four profit warnings between 1998 and 2000. Parker attributes the company’s problems during that period to its decision to diversify ‘into a number of things it shouldn’t have touched’. For example, it acquired a firm called Toystack, opened franchise shops in Saudi Arabia, entered joint ventures in Singapore and opened department store concessions in Debenhams. ‘The business spread itself incredibly thinly and neglected its key asset: the Regent Street store,’ he says. In May 1999 Simon Burke became Hamleys’ third chief executive in two years and promptly set about revamping its image. He ordered the refurbishment of the Regent Street store and oversaw the modernisation of its product range. But in April 2000, before these changes could affect the balance sheet, the company had to disclose a decline in full-year profits from £6.3 million to £4.2 million. 2006.1
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As a result, the group began to consider going private and talks were under way in June 2000 when Parker joined as a business information manager, with responsibility for finance and information technology. ‘The day after I joined Hamleys I read in the newspaper that there was an MBO going on,’ he says. ‘That was the first I’d heard of it.’ But talks between Charterhouse Development Capital and Hamleys folded in July 2000 after a disagreement over the price. Hamleys’ then chairman, Howard Dyer, had demanded at least 200p a share, valuing the business at £42 million. The venture capital firm wasn’t prepared to pay more than 170p and Hamleys’ share price dived 26.5p to 141.5p as a result. Things began to change in October 2000 when Dyer left the firm. Burke immediately hired investment bank Close Brothers to review Hamleys’ options to see whether it should be seeking a private investor. A fruitless three-month search for a backer ensued, during which time the share price fell another 10 per cent. But Burke had plenty of other ideas. In 2001 he converted 12 Toystack stores into Bear Factory soft-toy shops. He also restructured the organisation, becoming executive chairman himself and appointing Parker to the board as FD in charge of merchandising, warehousing, finance, IT and legal matters. He made Watkinson chief operating officer, giving him responsibility for purchasing, operations, franchising and marketing. These changes proved so successful that 18 months later Hamleys was able to announce that group sales had risen 9.3 per cent, allowing it to open seven more Bear Factory shops. The firm is now completing its conversion into a private company, which is having a huge impact on boardroom discussions. ‘Everyone is focused on your next set of results in a listed company,’ Parker says. ‘The biggest change now that we’re a private company is that we can focus on the longer term.’ The MBO means that the firm is now highly geared, making cash extremely important. This in turn is putting more pressure on the finance function. ‘The role of my department now is to ensure that we use our cash effectively, and information is critical for the rest of the business,’ Parker says. ‘But it shouldn’t really make a huge difference, because at the end of the day only the goals are slightly different and the banks are different.’ Once Christmas is over and done with, the company plans to expand internationally. The global toy market is worth close to £50 billion and Hamleys currently has less than 0.05 per cent of that. Its three main brands – Hamleys, the Bear Factory and the English Teddy Bear Company (which was purchased almost 18 months ago) – will be extended abroad. Department stores in Sydney and Tokyo will stock some of Hamleys’ own-brand products, of which there are 500 different lines. The company may also open other stores around the world, but not in the UK. ‘The most important thing about the store at Regent Street is that it’s an experience. If you try to replicate it within the UK you will always compromise on that,’ Parker explains. This uniqueness was reflected in the attention that the MBO attracted. Before the deal, Hamleys was a small-cap company, but its every move was recorded religiously by the financial press. Parker attributes this to its successful recovery and also the nature of the business. ‘Everyone has a soft spot for it journalists and analysts can relate to Hamleys because they have all probably been there at some time in their lives and remember the first time they stepped through the doors.’ With the Christmas rush in full effect, the balance sheet is looking healthy. ‘The Regent Street store performs consistently, apart from the odd blip caused by events such as
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11 September, the Iraqi war and the Sars outbreak, but every time it bounces back within a couple of months,’ Parker says, but his measurement for how well the store is doing is surprisingly simple. ‘All I do is go out on to Regent Street and watch the number of people walking out of the store with Hamleys bags. At the moment there’s a sea of white-and-red bags all over the West End, so I know things are going well.’
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Revision Questions
Question 1 WT plc is a manufacturer of car-care products. It carries insignificant amounts of inventory. Revenue and profits after tax for last year are £145m and £40m, respectively. WT plc’s shares are currently quoted at 440 pence, the lowest price for five years. The directors believe that this is because the entity is not growing as fast as the market expects. They believe that the fastest way to grow, and as a result improve the share price performance, is to acquire another entity in a similar line of business with a lower P/E ratio. They are therefore evaluating SZ plc on the basis that its earnings can be ‘bootstrapped’, that is, on the assumption that, once the merger has been completed, the combined company’s P/E ratio will be the same as WT plc’s current ratio. SZ plc’s results for the past 3 years, and its directors’ own estimates for this year, are as follows: Year to 30 June 1997 actual 1998 actual 1999 actual 2000 estimate
Revenue £m 95 100 106 120
Profit after tax £m 12.1 12.5 13.5 14.0
SZ plc’s dividend payout ratio has been maintained at 50 per cent for the past 8 years. The company pays only one dividend per year at the end of December. Its shares are currently being traded at 126 pence. Summary balance sheets at 30 June 1999 for the two entities are as follows: Non-current assets (net of depreciation) Net current assets Total assets less current liabilities Capital and reserves Called-up share capital Reserves
WT plc £m 60.0 30.0 390.0 180.0
SZ plc £m 75.0 25.0 100.0 200.0
25.01 65.0 390.0 180.0
50.02 50.0 100.0 200.0
Notes: 1. 100m ordinary shares of 25p. 2. 100m ordinary shares of 50p. 275
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If the merger goes ahead, some fixed assets of SZ plc will not be needed following the merger, and will be sold at the end of the first year of operations. The estimated revenue receipts from these assets at the time of sale is £25m, which will also be the written-down book value at that time. No other savings or synergies have been identified by the directors of WT plc at this stage. WT plc’s financial advisers believe that its directors are overvaluing SZ plc’s future earnings post-tax. They advise that, in their opinion, the merged entity should be more prudently valued, and suggest that SZ plc’s growth for the foreseeable future is likely to be maintained at no more than the average of the last 4 years. The cost of capital for WT plc is 14 per cent, and for SZ plc is 12 per cent. Requirements (a) Estimate the maximum price, in total and per share, that WT plc might bid for the whole of the share capital in SZ plc, under each of the following assumptions: (i) the directors of WT plc are correct; (ii) the financial advisers are correct; and comment briefly on the weaknesses of the methods of valuation you have used. (10 marks) (b) Advise the directors of WT plc on an initial bid price and the maximum price they should offer for the shares of SZ plc. (6 marks) (c) Describe four possible defence tactics which the directors of SZ plc might use if they decide to resist the bid from WT plc. (6 marks) (d) The bid is eventually agreed at £176m. The directors of WT plc are now considering the most appropriate method of financing the bid, and two options have been suggested. The first is a share exchange; the second is an issue of £176m undated 12 per cent secured bonds at par. At present the return on the market is 12 per cent, the return on the risk-free asset is 8 per cent. Corporation tax is currently payable at 33 per cent and this is not expected to change in the foreseeable future. All figures given above are post-tax, with the exception of the coupon rate on the bond. You are required to calculate, on the basis of your answers to (a) and (b) above, the cost of equity and the weighted average cost of capital of the merged firm which might be expected under each of the two financing options, using any reasoned assumptions you might consider necessary. (8 marks) (Total marks 30)
Question 2 QWE plc is a medium-sized food manufacturing entity. It has recently sold a subsidiary that traded in what the entity considered to be non-core business. The sale raised £1.4m in cash. The entity’s long-term debt-to-equity ratio is relatively high compared with other entities in the industry and the directors have ruled out further borrowing at the present time. In fact, one of the directors thinks the cash raised from the sale of the subsidiary should be used to repay some of the entity’s outstanding debt. This is not a view shared by the other directors who are evaluating three small but potentially profitable acquisition opportunities. The directors believe that the shareholders of all three target entities would not be opposed to a bid at this time, especially to a cash offer. 2006.1
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Expected after-tax cash flows Company AB Ltd CD Ltd EF Ltd
Year 1 £000 (100) 125 200
Year 2 £000 750 275 325
Year 3 £000 1,100 380 450
Acquisition price £000 (1,100) (550) (650)
Note: The cash flows are in real terms, that is, they do not include inflation. QWE plc’s shareholders currently require a real return of 12 per cent on their investment in the entity. The entity uses this rate to evaluate all its investment decisions, including acquisitions.
Requirements Assume that you are a financial manager with QWE plc. Write a report to the directors evaluating the potential acquisitions. You should include the following information in your report: ●
● ●
●
The expected net present value and profitability indexes of the three projects. Based solely on these calculations comment on which company(ies) should be chosen for acquisition and comment on the use of 12 per cent as a discount rate in the circumstances here. Recommendation of uses for any cash that is left over after the acquisitions have been made. Comment on the directors’ decisions: (i) to invest rather than repay debt, and (ii) to limit their investment for the current year to cash purchases rather than raise new capital in the form of debt or equity. Comment on the advantages and disadvantages of growth by acquisition as compared with growth by internal (or organic) investment. (20 marks)
Question 3 PR plc is listed on the London Stock Exchange. The directors have made a bid for its main UK competitor, ST plc. ST plc’s directors have rejected the bid. If the bid eventually succeeds, the new entity will become the largest in its industry in Europe. However, it will still be smaller than some of its US competitors. The directors of PR plc are aware that the entity must continue to expand if it is to remain competitive in a global market, and avoid being taken over by a larger US entity. Relevant information is as follows: Share price as at today (21 May 2002) Shares in issue P/E ratios as at today Debt outstanding (market value)
PR plc 671 pence 820 million 14 £2.2 billion
ST plc 565 pence 513 million 16 £1.8 billion
Other information: ● ●
The average P/E for the industry is currently estimated as 13. The average debt ratio for the industry (long-term debt as proportion of total funding) is 30% based on market values. 2006.1
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However, to acquire all of them would require £2.3m. The share price is standing at an alltime high – a level considered unsustainable by the directors based on the entity’s projected earnings. The directors therefore intend to limit their expenditure to the £1.4m cash raised by the sale of the subsidiary.
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40% of PR plc’s debt is repayable in 2005; 30% of ST plc’s in 2006. PR plc’s cost of equity is 13% net of tax. PR plc has cash available of £460 million following the recent disposal of some subsidiary companies. ST plc’s cash balances at the last balance sheet date (31 December 2001) were £120 million.
Terms of the bid PR plc’s directors made an opening bid one week ago of 10 PR plc shares for 13 ST plc shares. They are aware that they might have to raise the bid in order to succeed and also may need to offer a cash alternative. Their advisers have told them that, typically, 50% of shareholders might be expected to accept the share exchange and 50% the cash alternative. Requirements Assume you work for PR plc’s financial advisers. You have been asked to write a report advising the directors of PR plc. Your report should cover the following issues: (i) A discussion of the implications that the current share prices of the two entities have for the bid. Recommend terms of a revised share exchange. (8 marks) (ii) The advantages and disadvantages of offering a cash alternative and how the cash alternative might be financed, based on your revised bid terms recommended in answer to (i) above. Your discussion should include an evaluation of the impact of the proposed finance on the merged entity’s financial standing. Assume a rights issue is not appropriate at the present time. (17 marks) (Total marks 25)
Question 4 AB plc is a firm of recruitment and selection consultants. It has been trading for 10 years and obtained a stock market listing 4 years ago. It has pursued a policy of aggressive growth and specialises in providing services to entities in high-technology and high-growth sectors. It is all-equity financed by ordinary share capital of £50 million in shares of £0.20 nominal (or par) value. The company’s results to the end of June 2002 have just been announced. Profits before tax were £126.6 million. The Chairman’s statement included a forecast that earnings might be expected to rise by 4%, which is a lower annual rate than in recent years. This is blamed on economic factors that have had a particularly adverse effect on hightechnology entities. YZ plc is in the same business but has been established much longer. It serves more traditional business sectors and its earnings record has been erratic. Press comment has frequently blamed this on poor management and the company’s shares have been out of favour with the stock market for some time. Its current earnings growth forecast is also 4% for the foreseeable future. YZ plc has an issued ordinary share capital of £180 million in £1 shares. Pre-tax profits for the year to 30 June 2002 were £112.5 million. AB plc has recently approached the shareholders of YZ plc with a bid of five new shares in AB plc for every six YZ plc shares. There is a cash alternative of 345 pence per share. Following the announcement of the bid, the market price of AB plc shares fell 10% while the price of YZ plc shares rose 14%. The P/E ratio and dividend yield for AB plc, 2006.1
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2002 High 425 350 187 230
Low 325 285 122 159
Company AB plc YZ plc CD plc WX plc
P/E 11 7 9 16
Dividend yield % 2.4 3.1 5.2 2.4
Both AB plc and YZ plc pay tax at 30%. AB plc’s post-tax cost of equity capital is estimated at 13% per annum and YZ plc’s at 11% per annum. Assume you are a shareholder in YZ plc. You have a large, but not controlling, shareholding and are a qualified management accountant. You bought the shares some years ago and have been very disappointed with their performance. Two years ago you formed a ‘protest group’ with fellow shareholders with the principal aim of replacing members of the Board. You call a meeting of this group to discuss the bid. Requirements In preparation for your meeting, write a briefing note for your group to discuss. Your note should: (i) evaluate whether the proposed share-for-share offer is likely to be beneficial to shareholders in both AB plc and YZ plc. You should use the information and merger terms available, plus appropriate assumptions, to forecast post-merger values. As a benchmark, you should then value the two entities using the constant growth form of the dividend valuation model. (13 marks) (ii) discuss the factors to consider when deciding whether to accept or reject the bid and the relative benefits/disadvantages of accepting shares or cash. (8 marks) (iii) advise your shareholder group on what its members should do with their investment in YZ plc, based on your calculations/considerations. (4 marks) (Total marks 25)
Question 5 DP plc is a family-owned entity in the motor trade and had a revenue in 1995 of £12m. It has two main services – car body repairs and breakdown recovery. A few years ago Alan, the managing director of DP plc, was considering a public flotation for the entity. However, in the past 2 years the rate of growth of both operations has slowed – particularly the car body repairs. This appears to be due to two main factors – increased competition for recovery services and a change of policy by insurance entities which has made car body repairs less profitable. Comments on the balance sheet A summary balance sheet for DP plc at 31 December 1995 is shown below. The ordinary and preference shares are all held by family members and their associates. The preference 2006.1
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YZ plc and two other listed entities in the same industry immediately prior to the bid announcement are shown below. All share prices are in pence.
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dividend had not been paid for 1995. The bank loan is secured by a charge on the company’s total non-current assets. DP plc – balance sheet at 31 December 1995 £000 Non-current assets (net book value) Inventory Receivables Cash Total current assets Unsecured loans EF plc (secured loan) Tax payable Bank loan Preferred dividend Total current liabilities Total assets less current liabilities Mortgage loan Bank loan due 31-3-1997 Net assets attributable to shareholders Financed by: Issued share capital Ordinary £1 shares Retained earnings/(loss) carried forward Preferred shares (undated) £1 shares 8 per cent
£000 4,350
825 2,150 2,155 2,980 (750) (300) (150) (300) z(100) (1,600) 5,730 (2,500) 2,(300) (2,800) (2,930
2,500 (820) (1,250 (2,930
Problems current at today’s date (19 November 1996) The book value of DP plc’s assets increased by £1m in 1995 over their book value at the end of 1994. This was primarily a consequence of: ●
● ●
an increase in receivables. Prior to 1995, receivables had represented about 40 days’ revenue. At the end of December 1995 they represented 65 days, and the situation is deteriorating; an increase in inventory; a failure to cancel an order for new recovery vehicles in 1995.
The supplier of the new recovery vehicles, EF plc, has not been paid. Payment had been due in April 1996. The supplier has, however, obtained a floating charge on DP plc’s current assets and has now, reluctantly, commenced court proceedings against DP plc to recover its money. Of the bank loan, 50 per cent (i.e. £300,000) was due to be repaid on 30 September 1996. The balance is due on 31 March 1997. The September payment was not made and, as a consequence, the senior loan officer of the bank called in the directors of DP plc to discuss the problem. At this meeting, the bank agreed to allow DP plc to repay the entire amount of the loan at the end of March 1997. Future prospects and problems Despite the current problems, the directors of DP plc are confident of an upturn in business. They are negotiating new contracts with two major insurance entities which will be worth approximately £1.5m per year in additional gross revenue. However, time is against 2006.1
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Possibilities of injection of new capital DP plc’s bank is not prepared to advance any more money, but it has put the company in touch with a merchant bank which may be prepared to buy into the entity. The merchant bank has now conducted an appraisal of DP plc and has concluded the following: ● ●
●
● ●
●
The non-current assets are estimated to be worth £1m less than the 1995 balance sheet value. Inventory would realise in the market place no more than 50 per cent of its book value at 31 December 1995. Bad debts are estimated at 10 per cent of the 31 December 1995 receivables value. Invoicing and collections are expected to be roughly equal throughout 1996. All other assets and liabilities are considered to be worth their 1995 book values. If the entity is liquidated, the administration costs are likely to be 20 per cent of the gross liquidation value. If the entity can be rescued, earnings after interest and taxes are likely to be £320,000 for 1997. A prospective P/E ratio of 12 is estimated, based on the average for entities in similar trades and on expected growth for DP plc after the reorganisation.
The merchant bank decides it is willing to invest in DP plc provided it gains control of 51 per cent of the voting share capital. However, the merchant bank makes three conditions: ● ● ●
the family would have to agree to retire the preference shares without compensation; the family would have to forego preference dividend arrears; some shares currently owned by the family would have to be cancelled and reissued to the merchant bank to provide it with the required 51 per cent ownership of DP plc. The merchant bank’s intention would be to hold DP plc’s shares as a medium-term investment, defined as 5–7 years, and then float the entity on the Alternative Investment Market (AIM).
Requirements (a) (i) Calculate the estimated market value of DP plc’s equity. Base your answer on the merchant bank’s estimate of future earnings, assuming the entity is rescued. (2 marks) (ii) Calculate the book value of net assets attributable to DP plc’s shareholders as at today’s date (19 November 1996), assuming the merchant bank’s conditions are met. In addition to the information provided in the case, you should assume that: ● all current liabilities are paid, with the exception of the portion of the bank loan not yet due; ● the values of non-current assets, inventory and receivables are as per the merchant bank’s estimates; ● the cash balance is cash on hand plus cash received from the merchant bank minus cash paid out; ● the merchant bank agrees to pay 140 pence per share for its shareholding. (7 marks) (iii) Comment briefly on the difference between the values you have found in answer to parts (i) and (ii) above. (3 marks) 2006.1
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them and they must now consider a capital reconstruction and pay off the main lenders – the bank, EF plc and a number of smaller suppliers to avoid liquidation.
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(b) Assume that you are employed by the merchant bank to advise on the rescue operation for DP plc and subsequently to assist the entity in improving its profitability. Write a report to the bank’s board, on the basis of the information provided in the case, which critically reviews the investment and exit strategies from the point of view of the bank. (13 marks) (Total marks 25)
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6
Solution 1 (a) (i) The directors are thinking, in effect, of applying WT plc’s price/earnings (P/E) ratio of 11 to SZ plc’s earnings of £14m. This indicates a value of £154m, to which must be added the value of the assets which can be sold: £25m, discounted at the cost of capital, say, for argument’s sake, a net present value of £22m. Thus, the directors’ ‘walk away’ price would be around £176m, that is, 176p per share. The greatest weakness of this approach is that it ‘puts the cart before the horse’, that is, it assumes that the value of a business is a fixed multiple of reported profits. The P/E ratio, not the price, is the dependent variable. It is dependent, in fact, on a traded price, which cannot safely be extrapolated to provide a value of the business as a whole. (ii) The advisers, meanwhile, have urged caution, and suggested valuing SZ plc, in effect, on a stand-alone basis, using recent history as a surrogate for future potential. Its cost of equity capital being assessed at 12 per cent p.a. and its growth at 5 per cent p.a. (both assumed to be constant compound), then the value of its net cash generating potential, as at the end of year 2000: Using the dividend valuation model: P0
£7,000,000 D1 , gives: £100m Ke g 12% 5%
To this should be added the disposal value of the assets, that is, £22m as above, bringing the total to £122m (122p per share) or slightly less than the existing ‘market capitalisation’. The greatest weakness of this approach is in the assumption that the future is a function of the past. Some of the most spectacular collapses of recent years have followed unbroken trends of increasing reported earnings. The presumption of a constant compound cost of capital is also a weakness. (b) If the advisers’ advice is valid, then a final offer should be at approximately the current market price. The fact that this is greater than the advisers’ stand-alone value suggests that ‘the market’ is using a lower cost of capital, is forecasting a higher rate of growth, or is anticipating a bid. Whatever the reason, it would provide very little room for manoeuvre. Most bids start off at a premium of, say, 10 per cent, which suggests an opening shot of around 1,140p per share. 283
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If the bid proceeds, it is because the directors have rejected the advisers’ advice, and their own calculations come to the fore. Their aim should be to offer a pound more than it is worth to anyone else, or a pound less than it is worth to WT plc, whichever is the lower. We have no information on other possible predators, but the value to WT plc was put by the directors at around £176m, that is, 176p per share. The final price needs to be less than this for the acquisition to benefit the bidder. (c) If the directors of SZ plc believe it to be against the best interests of their shareholders for the entity to be taken over by WT plc, then they need to help them quantify the value of the business for, in such a situation, they would be arguing that the market capitalisation of the entity fell short of its value to its equity investors – or persuade the bidder to increase the offer to the point that it was in the shareholders’ best interests. Possible defences include: ● issuing a forecast of profits and dividends, showing a greater potential than is implicit in the share price; ● (if it is a paper – as opposed to cash – bid) criticising the bidder’s management and prospects; ● accepting the industrial logic of the bid, but arguing that the terms are unrealistic, given the synergies, i.e. perhaps making a bid for the bidder; ● seeking intervention of government or regulatory agencies, for example, The Competition Commission; ● seeking a substantial investor big enough to block any effective merger or perhaps seeking a ‘white knight’, that is, a more acceptable bidder. In practice, it is clear that directors do not operate purely on behalf of shareholders. They take account, for example, of employees’ – and their own – interests. (d) Option 1: share issue The cost of equity capital of WT plc was put at 14 per cent, and that of SZ plc at 12 per cent, to reflect the differing risk/uncertainty associated with the forecast cash flows of the two businesses. Assuming that these margins of error are perfectly correlated (i.e. there are no favourable ‘portfolio effects’), the combined business will have a cost of equity capital somewhere between the two. The precise weighting is a moot point, but on any basis, WT plc is the bigger business. On the basis of pre-bid market capitalisation, for example, the ratios would be 440/126 for an average of 13.6 per cent. On the basis of the price paid for SZ plc, the ratios would be 440/176 for an average of 13.4 per cent. There being no borrowings, this would also be the weighted average of all capital. Option 2: bonds This is issued at 12 per cent gross, that is, 8 per cent net (in line with the ‘riskfree rate’). The value of the combined entity (net of tax) is £440m £176m £616m, to which an overall cost of 13.4 per cent is attached, implying a return of £82.5m. Capital structure will not affect this, but will affect its attribution as follows: Category Total Debt Equity
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Capital value £m 616 176 440
Return £m 82.5 14.1 68.4
% p.a. 13.4 8.0 15.5
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Solution 2 Calculations Year → 12% discount factors → Cash flows Company AB Absolute Discounted Cumulative Profitability index 192/1,100 17.5%
0 1.000 £000
1 0.893 £000
2 0.797 £000
3 0.712 £000
(1,100) (1,100) (1,100)
(100) (89) (1,189)
750) 598) (591)
1,100 783 192
Company CD Absolute Discounted Cumulative Profitability index 52/550 9.5%
(550) (550) (550)
125) 112) (438)
275) 219) (219)
380 271 52
Company EF Absolute Discounted Cumulative Profitability index 108/650 16.6%
(650) (650) (650)
200) 179) (471)
325) 259) (212)
450 320 108
Report To: The directors of QWE plc From: Financial manager Date: Subject: Potential acquisitions Thank you for the data regarding the three possible acquisitions. I have reviewed the situation and would like to comment as follows. Evaluation I have evaluated the three possibilities on the basis of a 12 per cent p.a. cost of capital (all figures in ‘real’ terms). The details are appended but, in summary, the figures are as follows:
Company AB Company CD Company EF
Outlay £000 1,100 550 650
Net present value £000 192 52 108
NPV/Initial outlay % 17.5 9.5 16.6
On this basis, if we wish to keep our total outlay below £1.4m, we should invest in AB and forget the others, since this will add the most value, compared with the base case, which is to return the money to the shareholders. That assumes that the cost of capital is a realistic one in the circumstances, notably as regards the uncertainty/risk aversion factors it comprises. I would welcome the opportunity to discuss this with you. Unspent receipts If we invest only £1.1m, that leaves £0.3m to deal with. I would suggest that consideration be given to: ●
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letting it reduce our borrowings, which are relatively high compared with other entities in our industry;
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●
using it to fund other opportunities, for example, carrying more stock or granting extra credit if this would increase demand: paying it out as a dividend.
Impact of past decisions Two of the tasks facing you as directors concern the capital structure of the entity, and the pace of expansion. In turn, these decisions depend on identifying the equilibrium point as regards gearing relative to your risk-aversion, and the company’s prospective growth rate relative to its return on investment. If you were worried that the entity’s gearing was too high relative to your risk-aversion, you would seek to reduce it either by repaying borrowings or by raising additional equity. Since you have chosen to do neither, the implication is that you are comfortable with the present ratio, and I have no grounds for questioning your decision. What is less clear to me is why you have chosen to limit your capital expenditure to £1.4m (a small amount for the average plc), and hence to forego opportunities which would add to the (net present) value of the business to its shareholders, discounted at your own assessment of the cost of capital. If this is valid, it means that equity could be raised at that cost (and borrowing at less). Alternatively, if you are firmly of the opinion that the share price is unsustainable, perhaps the answer is to think in terms of making paper offers for CD and EF. This would facilitate expansion without any cash absorption. Growth by acquisition The main benefits of growth by acquisition are that: ● ●
it speeds up the process, compared with starting afresh; it leaves capacity as it was, rather than increasing it (and hence increasing competition). On the other hand, the drawbacks are that:
●
●
acquisitions are made on the basis of public information only, whereas organic expansion can be based on inside knowledge and robust judgements; merging cultures takes a long time, and induces extra costs (including those related to redundancy).
All the evidence shows that the extra costs of mergers (e.g. higher head office coordination costs) are higher than acquirers expect, and many projected benefits do not arise, to the point that, in most cases, the only beneficiaries are the former shareholders in the acquired company. Signed: Financial manager
Solution 3 Report To: From: Subject: Date:
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Directors of PR plc Adviser Bid of ST plc 21 May 2002
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(i) The implications for the bid indicated by current share prices; (ii) The advantages and disadvantages of a cash alternative and how it might be financed. (i) Implications for the bid of current share prices The terms of the bid are 10 PR plc shares for 13 ST plc shares. On today’s share prices, the market appears to be expecting an increased bid; 10 PR plc shares are worth £67.10 whereas 13 ST plc shares are worth £73.45. This implies that you would need to raise the bid to at least 17 PR plc shares for 20 ST plc shares to gain acceptance (17 PR plc shares would be worth £114 and 20 ST plc shares £113). However, it must be recognised that the bid is taking place in a dynamic market and there are other, external influences that may affect share prices. The share prices of the two entities will also react to any revised bid based on market perceptions of the benefits to be gained by the shareholders of the two entities. Evidence has shown that in a hostile bid it is usually the target entity’s shareholders who obtain all the gains from a merger. Our advice is that you must make a realistic assessment of what ST plc is worth to you. ST plc’s earnings last year were £181.15 million [(565p/16 513 million)/100]. If you apply your own cost of equity to their earnings in perpetuity, this would give a value for the company of £1.393 billion. Its current market capitalisation is £2.9 billion. This suggests potential for growth is already discounted by the market, although there will be a bid premium in the current share price that is difficult to quantify. (ii) The advantages and disadvantages of offering a cash alternative and how it might be financed The main advantage of offering cash as an alternative to a share exchange is that the future gains from the merger are obtained by a proportionately larger number of the bidding entity’s shareholders. The disadvantages are, obviously, that cash has to be raised, most probably by the issue of a long-term debt instrument. There might also be taxation implications for individual shareholders, although as the offer is optional, this should not be a problem. If we assume a bid of 17 for 20 is accepted, this implies a price per ST plc share of 570 pence. If we assume 50% of ST plc’s shareholders are likely to accept a cash offer, then you need to raise approximately £1.46 billion. The combined cash at bank balances of £580 million could be used, leaving £880 million to be raised in new debt. The effect on gearing needs to be calculated based on the combined group’s debt: equity ratios. This is difficult to do without more information and it is almost impossible to forecast the value of the equity post-merger. If the combined entity increases the amount of debt in its capital structure, which is likely if a large proportion of ST plc’s shareholders opt for a cash alternative, then the gearing ratio will rise. However, this is unlikely to be an excessive increase, but any increase in the indebtedness of the company might have an adverse effect on cost of capital because of increased financial risk.
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Introduction You have asked us to provide you with advice on your recent bid for ST plc. This report aims to cover two key issues:
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Examiner’s Note Candidates who make attempts at gearing calculations using any sensible assumptions would gain credit. The effect on the cost of capital could also be estimated by making a number of assumptions, for example, the cost of new debt. It is likely that any new debt will carry a higher rate of interest because of this increased risk. It is also necessary to recognise that as some of both PR plc’s and ST plc’s existing debt matures within the next 3–4 years, refinancing needs to be considered. You will, of course, obtain ST plc’s cash balances post-merger, but the cost of the acquisition process is likely to be very high and will require a considerable amount of cash-generating capacity in the short term. The most likely form of finance is a long-term debt instrument as noted above. Secured debt with a maturity of 10–15 years would be the most obvious, but alternatives that could be considered and that have cost advantages are convertible debt or debt with warrants. A discussion of the features and benefits of these types of debt are outside the scope of this report, but the key feature is that they tend to offer lower rates of interest because of the opportunity of buying into the company’s equity ‘cheaply’ at some future date. Debt with warrants also has the advantage that additional money will be raised at some time in the future, subject of course to the holders exercising their warrants. Convertible debt does not raise additional money, but has the advantage of being self-liquidating if all holders convert into equity on or before the final maturity date. Signed: Adviser
Solution 4 (i) Evaluation Background calculations Profit before tax: £m Earnings after tax: £m Earnings per share: pence Pre-bid P/E ratio Pre-bid share price: pence MV of entity: £m No of new shares post bid (millions) % of combined entity owned by: Value to original shareholders (£m) assuming no ‘synergy’ Price per share/post bid announcement: pence
AB plc 126.60 88.62 35.45 11 390 974.80 250 62.50
YZ plc 112.50 78.75 43.75 7 306 551.30 150 37.50
953.80 382 (953.8/250)
572.30 318 (572.3/180)
Total 239.10 167.37 41.84
1,526.10 400 100 1,526.10
These figures assume that, in the absence of any synergy or commercial benefits resulting from the takeover, the market value of the combined entity of £1,526.1 million is equal to the total of the two individual entity’s market values. It suggests post-acquisition share prices of 382 pence for AB plc and 318 pence for YZ plc. There will be a transfer of wealth from AB’s shareholders to YZ’s based on the terms of this offer. AB’s share price has already fallen in anticipation of this. In reality, the price of YZ’s shares 2006.1
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Market value: Share price:
£167.37 11 £1,841.1 400
£1,841.1 460 pence
AB’s shareholders have exactly the same number of shares as they did before the merger. Their shares would therefore rise by 70p (460 390) or 18%. YZ’s shareholders have five-sixths the number of their old shares. Their share value might therefore be expected to rise from 306p to 383p (460p 5/6), a rise of 77 pence or 25%. As shareholders in YZ plc we are therefore taking more of the gains from the merger in a share exchange. The cash alternative is lower and unlikely to be accepted, although it is an assured amount. With the cash offer the premium is only 12.7%. (345 306) 100 306 An alternative method of valuing the shares is to use the dividend valuation model. Using Gordon’s model, we assume constant growth and all earnings are paid out as dividends. The value of AB plc would therefore be: AB Share price EPS1 0.354 1.04 409 pence 13% 4% Ke g Using the same assumptions, the value of YZ would be: YZ Share price EPS1 0.4375 1.04 650 pence 11% 4% Ke g On this basis the market slightly under values AB’s shares but YZ’s are substantially undervalued, possibly because the market is sceptical about the growth forecast given previous disappointments. However, if we believe AB’s forecast, then AB are getting YZ’s shares cheap, and especially so if any of YZ’s shareholders accept the cash offer of 345p. Examiner’s Note An alternative approach could use the dividend yield information given in the question to calculate a dividend per share and use this figure in the dividend growth model. (ii) Factors to consider when deciding whether to accept or reject the bid and the relative benefits/disadvantages of accepting shares or cash. ● If we reject the bid, will AB give even more of the gains away of YZ shareholders (us) by raising the offer? 2006.1
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is likely to be influenced by the value of the cash alternative and the price that will be observed in the market is unlikely to be below 345 pence. It is unlikely the directors of AB plc would launch a bid unless they expected they could improve the performance of YZ plc, and the value of the cash alternative implies they are expecting to do so. The post-bid share price of the new entity could be estimated by applying a P/E ratio to the combined earnings of the two old entities. The problem is – what P/E ratio? AB’s directors might expect their own pre-bid P/E ratio to be applied to the combined earnings. In which case, the market value and share price would be:
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The market appears to be taking a middle-of-the-road view. It does not appear to think AB management can apply its growth rates to YZ’s earnings. The growth rate forecast by YZ’s management does not appear to be believed by the market – hence the substantial difference between the P/E ratios of the two companies. ● Evidence has shown that target entities gain most from merger in the short term but in the longer term the gains are much reduced. ● Our shares are currently near their low for the year; this could mean AB is buying us at an opportunistic price because YZ’s business is currently unfashionable. ● There are problems of valuation of entities like this, for example a low asset base. The value is in intellectual capital/expertise. However, the market is getting better at evaluating such entities, which could be to our long-term advantage. ● A comparison of YZ’s share price performance/growth expectations with other entities in the industry shows that we are more poorly rated. WX in particular has a P/E more than twice YZ’s. We should raise this issue with YZ’s directors to find out why there is such a large differential. ● Accepting a cash bid might involve capital gains tax for some of us. ● The costs of the bid will ultimately be borne in part by us if we take the share offer. If we take cash we know what we are getting. We may not participate in future gains but neither do we share in the costs, which if it is a hostile bid will become enormous. ● What will be AB’s future dividend policy if we accept shares? Their dividend yield is below YZ’s and at least one of its major competitors. However, to be fair, our dividend yield has been raised by the fall in the share price, which is near the year’s low. (iii) Recommendation of what to do with the investment Making a single recommendation on whether to accept or reject the bid is difficult. To some extent it is ‘six of one, half a dozen of another’. The offer gives us a greater opportunity to sell out, or exchange shares, than we have seen for some time. However, given YZ’s poor performance over recent years this is not saying a lot. We should request a meeting with the directors to obtain their views. If shareholders wish to take a short term gain then holding out for a higher bid, perhaps a one for one share exchange and an increased cash alternative, is probably the better option: evidence shows that bidders rarely leave the stage after an initial bid. In respect of accepting cash or shares, each shareholder in our entity will have to determine their own objectives. However, if we take a longer term view based on my estimates of YZ’s value we might be better rejecting the bid and continuing our fight to replace the Board. ●
Examiner’s Note Shareholders could of course also choose to sell their shares now, or even buy more if they think the long-term prospects are good – there is no one right answer to this part of the question.
Solution 5 ●
This question involves a family-owned entity facing financial difficulties and the threat of liquidation. The aim of the case was to test for an ability to evaluate a situation from the point of view of the owners, managers and potential investors. It also tested for an
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(a) (i) Estimated market value £320,000 per annum EAIT at a P/E ratio of 12 £3,840,000 or 154 pence a share if 2,500,000 shares are in issue. (ii) Net assets attributable to shareholders if company rescued First calculate the cash paid out by the merchant bank: EF plc Other payables Bank overdraft Total
£000 300.0 900.0 1,300.0 1,500.0
Second, calculate cash balance after cash paid in less cash paid out: £ 1,785,000 1,500,000 1,285,000
Cash paid in: 1,275,000 shares at 140p Less cash paid out Balance
Third, calculate value of assets and liabilities: £000 Non-current assets Inventory Receivables Cash (£285,000 £5,000) Total assets Less: Mortgage loan Bank Total liabilities Net assets attributable to shareholders
£000 3,350.0 412.5 1,935.0 1,290.0 5,987.5
2,500.0 2,300.0 2,800.0 3,187.5
(iii) The estimated market value is based on future earnings capacity of the entity’s assets if the entity is rescued and the assets continue in productive use. The net asset value is based on estimated current realisable values, that is assuming the assets are disposed of. The net asset value is likely to be the most accurate because it is expected to be realised in the very near future. The market value, while higher than the asset value, is subject to all the recognised problems of forecasting into the future it is therefore almost certain to be wrong. Common errors in this type of question: – – – – –
omitting the opening cash balance; failing to remove the preference share dividend; double-counting the bank loan; incorrectly revaluing the non-current assets, inventory and receivables; misunderstanding the meaning of net assets.
In answer to sub-section (iii), many candidates could not understand the basis of the two methods and often suggested that the difference was simply a result of the P/E ratio being an estimate. The estimated market value is based on future earnings capacity of the entity’s assets if the entity is rescued and the assets continue in productive use. 2006.1
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ability to analyse a changing competitive business environment and to formulate a new financial and operational strategy.
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The net asset value is based on estimated current realisable values, that is assuming the assets are disposed of. (b) Report To: Board of merchant bank From: An accountant Date: Subject: Rescue of DP plc (i) Review of the investment and exit strategies ● Estimated current market value of the entity is £3.84m if rescued. P/E ratios are difficult to predict with accuracy, but if 12 is a reasonable forecast the bank is buying 51 per cent of £3.84m (£1.958m) at a cost of £1.785. This is a premium of approximately 20 per cent (precisely, 19.2 per cent) which suggests the investment should be acceptable. It is often claimed that venture capitalists require IRRs of between 35 and 50 per cent. If this is the case here, the merchant bank might not be satisfied. ● Bank should provide management expertise which would involve additional cost but might improve chances of rescue succeeding and even exceeding present estimates. This might give rise to issues of control. ● There may be strategic considerations if the investment fits with the merchant bank’s portfolio of products. ● Exit strategies: continued existence of AIM, possibility/preferability of full market quote, takeover, management buyback, asset sale and split, but note possible problems re the state of the economy/market when the bank wants to sell. ● The value of DP plc on a net asset basis is irrelevant to the bank and need not be considered further.
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Investment Appraisal Techniques
LEARNING OUTCOMES After completing this chapter you should be able to:
understand the purpose of investment appraisal;
analyse relevant costs and benefits of an investment project;
evaluate domestic investment projects;
recommend investment decisions when capital is rationed.
7.1 Introduction In this chapter we discuss various methods of evaluating investment projects. These methods are, in the main, concerned with quantitative aspects but first you need to be clear that methods of evaluation are by no means the only factors to be taken into account in investment appraisal. Thus, we might define investment appraisal as being concerned with maximising shareholder wealth, but we must be careful to qualify this concept by making it subject to constraints associated with issues of social responsibility, such as effective controls over pollution. So shareholders’ wealth in this context needs to be linked with the wider view of stakeholder theory, whereby many other interested parties apart from shareholders – for example, suppliers, lenders, employees, managers, as well as the general public – need to be taken into account in assessing a project’s viability. Incidentally, in the case of ‘notfor-profit’ entities, we should follow a similar path, but substituting maximising benefits in place of shareholders’ wealth. We must also be clear that maximising wealth is not the same thing as maximising profit from a project, by minimising costs regardless of the wider implications of so doing. Shareholders will best be served by action being taken to ensure that a project will meet an economic want while maintaining a good and respected image of the entity, and indeed
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projects which damage that image can negate the benefits of otherwise effective marketing and promotional activities. Clearly, then, qualitative aspects of a proposal are very important, and this leads us on to the data content needed to evaluate a project effectively. Bear in mind that the cash inflows and outflows involved are simply the standard means of translating into a common base of numbers all the underlying quantitative and qualitative assumptions which are the real determinants of projects viability. The management accountant needs to consider carefully the strengths and weaknesses of these assumptions before finally converting them to cash flows. As to the evaluation methods described below, it should be borne in mind that in the continuing debate as between NPV and IRR, the main contention centres on the respective reinvestment assumptions: in the case of IRR, inflows are assumed to be reinvested at the IRR solution rate for the project; inflows from NPV are assumed to be reinvested at the cost of capital applied to the project. You should also be aware that payback is actually more of a measure of liquidity than of project profitability, though it remains a popular method of evaluation in many entities. These various considerations lead one to suggest that it is not the choice of a particular measure which is so important as the recognition that it is usually more effective – especially in these days of computer spreadsheets – to use two, three or even more evaluation methods for a particular appraisal, rather than depending on a single yardstick. Thus, especially for a major project, assessing its NPV, IRR, payback period and accounting rate of return (ARR) may well throw valuable light on various and different aspects of a project’s value, provided that the limitations of each method, as set out below, are kept in mind.
7.2 Accounting rate of return Accounting rate of return (ARR) is calculated in basically the same way as ‘return on investment’ as: Profit Investment but whether ‘profit’ is before or after interest charges and whether ‘investment’ is the initial outlay or is averaged over the life of the project is unclear. This lack of clarity seems strange. The point of this technique is that it is based on the same principles as the published financial statements. Entities (and managers) are often evaluated by the ‘return on investment’ or ‘return on capital employed’ ratio derived from published income statement and balance sheet. ( The two ratios are identical, merely reflecting the two sides of the balance sheet; ‘capital employed’ reflects the financing of the business, ‘investment’ reflects the use of that finance.) It is therefore logical that it should be calculated in a way which makes it comparable with these ratios. As the balance sheet contains written-down asset values one would expect accounting rate of return to be calculated as: Profit Average (written-down) investment This accords with common sense, because if profit is after depreciation, then one would expect that depreciation to affect the value of the investment. Following the same principle
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Profit before interest and tax Average (total) capital employed but if we are measuring return to shareholders the ratio is: Profit after interest and tax Shareholders’ funds We must compare ‘return’ with the funds (or investment) which generate that return. Example 7.A The figures below will be used to illustrate accounting rate of return, and will subsequently be used to illustrate payback, discounted payback, net present value and internal rate of return. £000 (100)
Investment Cash inflows: Year 1 Year 2 Year 3 Year 4 Year 5
20 30 40 40 10
Straight-line depreciation of £20,000 per year over the 5-year life of the asset would mean reported profits of: £000 – 10 20 20 (10) (40)
Year 1 Year 2 Year 3 Year 4 Year 5 Total
Average profit would be £8,000 per year. Average investment would be £50,000 (as the investment declines in value over the five years due to the depreciation charge) and ARR would be: £8,000 16% £50,000 Note: Average profit
Average investment
Total profit Project life
£40,000 £8,000 5
Original cost residual value 2
£100,000 0 £50,000 2
The advantages of ARR are: ● ●
it is simple to calculate; it considers the total life of the project.
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(that the numerator and denominator must be comparable) allows other difficulties to be resolved. If we are measuring management’s performance the ratio would be:
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The disadvantages of ARR are: ● ● ●
it does not consider tax or capital allowances; it does not consider the timing of the cash flows; it uses profits rather than cash flows.
7.3 Payback Payback is a simple investment appraisal technique which involves determining how long will be needed before the initial investment is ‘paid back’. Unlike accounting rate of return, which is bound by accounting definitions of ‘profit’ and ‘investment’, payback concentrates on the specific cash flows which an investment will generate. (In this respect, payback is superior to accounting rate of return because the management accounting theory of decision-making is based on whether the wealth of the decision-maker will be increased if a particular decision is made. The definitions and conventions of financial accounting should not be allowed to muddy the waters of this essentially simple problem.) The well-documented drawbacks of the payback technique are based on the fact that future cash flows, in themselves, do not indicate increased wealth. This is because a money flow in the future is not worth as much as the same money flow now. (Cash available now can be invested and so is worth more than the same cash flow at a later date.) The disadvantages of payback are: ● ● ●
all cash flows within the payback period are given equal weight; cash flows outside the payback period are ignored; it is not easy to determine how long the payback period should be.
Although one might expect payback to be little used because of these disadvantages, in practice, it is used extensively! Its simplicity probably explains its popularity: ● ● ●
decision-makers understand information presented to them; calculations are straightforward and likely to be error-free; since data is itself unreliable (estimates of future cash flows) sophisticated analysis may not be justified.
Payback can also be recommended if the business requires liquid funds at some date in the future – a project which ‘pays back’ before this date would be preferable to one which needs to be funded for a longer period. A further advantage is the ‘risk aversion’ of payback and this will be discussed later. Example 7.B Using data from Example 7.A, the payback period would be calculated as follows: Investment Cash inflows: Year 1 Year 2 Year 3 Year 4
£000 (100) 20 30 40 010 (25% of 40) – ––
So the payback period would be 3.25 years. If the stipulated payback period is equal to or longer than this, then the investment would be accepted, but if the required period was less, say 2.5 years, then it would be rejected.
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7.3.1 Discounted payback One of the disadvantages of payback is its failure to take into account the time value of money, but this can be overcome by firstly discounting the cash flows to their present values and then using these discounted values to calculate the payback period. Taking the cash flow data from Example 7.B, and additionally requiring a discounted cash flow (DCF) rate of return of 10 per cent and a payback in DCF terms of 4 years, an example is as follows.
Example 7.C Year 0 1 2 3 4 5
Cash flow £000 (100) 20 30 40 40 10
Discount factor 10% 1.000 0.909 0.826 0.751 0.683 0.621
Present value £000 (100.0) 18.2 24.8 30.0 27.3 6.2
Cumulative NPV £000 (100.0) (81.8) (57.0) (27.0) 0.3
As the project payback in DCF terms in just under 4 years, it would be accepted, but if payback had been required in say 2.5 years it would be rejected. Although this is an improvement over basic payback, the technique is also not suitable as a sole method of investment appraisal because it does not take into account all project cash flows.
7.4 Discounting techniques 7.4.1 Net present value The theoretically correct approach is to calculate the net present value (NPV) of a proposed investment by discounting future cash flows to present value and summing (or netting) them together. The present value of a future cash flow is calculated by multiplying it by the factor 1 (1 r)n where r is the discount rate and n is the number of periods (usually years) in the future when the cash flow will take place. Discounting is the opposite of compounding and, remembering that a principal, X, will grow to an amount, V, after n years if invested at a rate of interest r, we have: V X (1 r)n and X
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It is seldom wise to use payback on its own for investment appraisal and it should be combined with at least one other technique, preferably based on discounted cash-flow procedures, to ensure that all project returns are taken into account.
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We can say that X grows to V in n years or, equivalently, that the future cash flow V is worth X in present value terms. By discounting future cash flows the problem of the time value of money is eliminated and, if the net present value is positive (inflows in present-value terms exceed outflows in present-value terms), the project can be recommended.
Example 7.D In practice, NPV calculations are easy because tables of discount factors are readily available. In our example, assuming a discount rate of 10 per cent per annum:
Year 0 1 2 3 4 5
Cash flow (£000) (100) 20 30 40 40 10
Factor 1.000 0.909 0.826 0.751 0.683 0.621
Present value (£000) (100.0) 18.2 24.8 30.0 27.3 06.2 06.5
If the cost of capital were 10 per cent this project could be recommended because it generates a positive NPV of £6,500. One interpretation of NPV is that, if the project were financed by a loan at 10 per cent per annum, the interest on the loan and the original capital could be repaid out of project cash flows and this would eventually leave a cash balance at the end of the project worth £6,500 in present value terms.
The NPV technique is the academic recommendation and it is theoretically sound. However, its use in practice implies that the decision-maker must judge a project by an absolute number and while it is easy to give the ‘rule’ – any project generating positive NPV is acceptable – a decision-maker will be interested not only in the final NPV ‘payoff ‘ but also in the size of the initial investment and the length of time before the project ‘matures’. Use of the NPV rule becomes problematic if capital is ‘rationed’ (see section 7.5), because not all projects can then be accepted. In this situation it becomes necessary to rank projects according to their ‘earning power’ – placing the project which generates the maximum NPV per pound invested at the top of the list. Conventionally the profitability index is calculated in order to rank projects, where: Profitability index NPV of cash inflows investment outflow In our example: Profitability index 106.5 1.065 100 This project would rank behind a project with profitability index of 1.1 but ahead of a project with profitability index of 1.05.
7.4.2 Internal rate of return An alternative approach, still based on discounting principles, is the calculation of internal rate of return (IRR) – that discount rate at which the net present value of the project is zero. The decision rule now becomes: accept the project if its internal rate of return is greater 2006.1
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Calculation is complex Example 7.E In our example the IRR might be calculated as follows – by trying a different discount rate – from 10 per cent to, say, 15 per cent: Year 0 1 2 3 4 5
Cash flow (£000) (100) 20 30 40 40 10
Discount factor @ 15% 1.000 0.870 0.756 0.658 0.572 0.497
Present value (£000) (100.0) 17.4 22.7 26.3 22.9 15.0 ( (5.7)
A linear approximation between 10 per cent and 15 per cent allows the discount rate where NPV is zero to be calculated: IRR 10%
( 6.56.5 5%) 12.7% 5.7
The calculation appears both messy and approximate. Nevertheless, neither of these criticisms is fair. The existence of powerful spreadsheets such as Lotus 1-2-3 and Excel allows IRR to be calculated instantly and accurately by using the relevant function. Multiple IRRs If project cash flows reverse during the life of the project – there may, for example, be an initial outflow followed by several inflows before another major outflow (as plant undergoes major refurbishment, for example) – there may be more than one IRR. A graph of discount rate versus NPV might appear as in Figure 7.1. In such an example, the IRR decision rule (accept if cost of capital is less than IRR) is misleading because the project should only be accepted if cost of capital is between IRR1 and IRR2. To explain this result it is necessary to understand the reinvestment assumptions implicit in the NPV and IRR calculations. All NPV calculations assume that incoming cash can be
Figure 7.1
Discount rate and NPV – more than one IRR 2006.1
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than the cost of capital, reject if the IRR is less than the cost of capital. If a decision has to be made about a single project with ‘conventional’ cash flows (i.e. a single outlay followed by a series of inflows) IRR will lead to the same decision as NPV. However, in more complex circumstances IRR and NPV can lead to different decisions and IRR generally receives a bad press for a number of reasons, highlighted below.
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reinvested at the rate which is used in the NPV calculation. This means that the calculation of IRR1 assumes reinvestment at IRR1 while the calculation of IRR2 assumes reinvestment at IRR2. Only at rates between IRR1 and IRR2 can the incoming cash be reinvested at a rate which is sufficient to offset both the initial cash outflow and the eventual second cash outflow. This analysis is perfectly sound and, arguably, the project is only acceptable if the cost of capital lies between IRR1 and IRR2. Unfortunately, however, it means that the IRR decision rule – accept if cost of capital is less than IRR – can be applied only to projects having conventional cash flows. The NPV approach avoids this problem quite simply. By using the cost of capital as the discount rate in the NPV formula a negative NPV is generated if cost of capital is less than IRR1, a positive NPV is obtained if cost of capital is between IRR1 and IRR2 and the NPV is negative again if cost of capital is greater than IRR2. The possibility of multiple IRRs is cited as a disadvantage of the IRR technique. However, the problem can be overcome. Multiple IRRs arise only when cash flows reverse more than once. In these circumstances it is only necessary to identify the (possibly) several IRRs (some calculators will draw the graph of NPV versus discount rate in a few seconds) and draw the correct conclusions. IRR and mutually exclusive projects The third problem concerns the selection of a favoured project from two or more projects which are ‘mutually exclusive’ (i.e. if one is chosen the others are automatically ruled out). Suppose that, instead of our project (A) being a simple accept/reject decision we have to choose between it and another project (B) which can be compared with project A as follows: Initial investment (£000) Net present value (£000) Internal rate of return (%)
Project A 100.0 6.5 12.7
Project B 50.0 5.0 18.0
The IRR approach would favour project B (18.0 per cent compared with 12.7 per cent). However, provided that funds are freely available project A would maximise wealth because, if chosen, it could generate £6,500 NPV compared with project B’s £5,000. In essence, IRR can mislead because it may select a lower investment with higher ‘earning potential’, when it may be preferable to invest a greater sum which generates a lower ‘return’ but (because of its scale) produces a greater sum in the end. The last objection does mean that IRR must be used with caution if a choice has to be made between mutually exclusive projects. And NPV is usually recommended in preference to IRR because of the three objections discussed above and a much more subtle point concerning the reinvestment assumptions implicit in the two methods. While the IRR technique assumes that cash flows can be reinvested at the IRR, the NPV technique assumes that cash flows can be reinvested at the cost of capital used in the discounting process. This difference has two repercussions: 1. Even if mutually exclusive projects have the same initial investment (so the third objection raised against IRR does not apply), NPV and IRR can give conflicting results. IRR may prefer a project with high early cash flows (assumed reinvestment at the IRR), while NPV may prefer a different project – with higher flows later. 2. If IRR is used to rank projects in a capital-rationing situation the ranking may be different from that obtained using the profitability index because IRR will favour early cash inflows (assuming reinvestment at the IRR), while the profitability index (being based on NPV) may produce a different ranking. 2006.1
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7.4.3 Modified internal rate of return To help overcome the problems of IRR, a recent innovation is the development of the modified internal rate of return (MIRR), which is described by F. Lefley in Management Accounting ( January 1997) as follows: The MIRR is, according to Lumby, ‘a cosmetic re-statement of an NPV analysis’. This is not, however, exactly the case as the MIRR does address some of the deficiencies of the conventional IRR. It eliminates multiple IRR rates; it addresses the reinvestment rate issue and reduces overoptimism; and produces a result which, when ranking projects, is consistent with the NPV rule. Using this method all cash flows after the initial investment are converted, by assuming that the cash flows can be reinvested at the cost of capital, to a single cash inflow at the end of the project’s life. The MIRR is obtained by assuming an outflow in year 0 and a single inflow at the end of the final year of the project. As the figure for the cash inflow in the final year of a project has been arrived at by assuming a reinvestment rate equal to the cost of capital and not at the project’s IRR (which will normally be in excess of the cost of capital) then the actual yield from a project will be more realistic when using the MIRR method. To illustrate the actual workings of the MIRR, a capital project (see Example 1) has first been evaluated using the conventional IRR method of investment appraisal. In this example, the IRR of the project is calculated at 14.7%. In theory this level of return would only be achieved if the funds generated from the project could be reinvested at 14.7% (the IRR of the project). As this is unlikely to be the case then the yield under the IRR method may be said to be overoptimistic. Example 1: Calculation of the IRR of a capital project Year 0 1
Cash flow £ (20,000) 6,500
—at 14%— factor £ (20,000) 0.8772 5,702
—at 15%— factor £ (20,000) 0.8696 5,652
Using the same cash-flow figures as used in Example 1, the MIRR of the same project is calculated at 11.3% (see Example 2). The MIRR is less than the conventional IRR because the funds generated from the project are assumed to have been reinvested (for the purpose of this evaluation) at 8%, being the cost of capital. This figure is significantly less than the original IRR. The 11.3% is, however, seen to be a more realistic return on the project under review and, if funds from the project were actually reinvested at 8%, would represent the actual return on the cash flows. Example 2: Calculating MIRR based on the cash flows from Example 1 Year 0
Cash flow £ (20,000)
The net cash flows from the project for years 1 to 5 are compounded at the same rate as the cost of capital (say, 8 per cent in this case) into a single figure for year 5.
Year 1 2 3 4 5
Cash flow £ 6,500 7,750 5,750 4,750 3,750
— at 8%— reinvestment rate factor £ 1.3605 8,843 1.2597 9,763 1.1664 6,707 1.0800 5,130 1.0000 33,750 34,193 2006.1
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It is usually assumed that NPV (and its derivative, the profitability index) provides the best guidance because the cost of capital reinvestment assumption is more conservative and likely to be more realistic.
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MIRR of the project (based on a cash outflow of £20,000 in year 0 and a single cash inflow in year 5 of £34,193) is 11.3%. The MIRR is calculated as follows: 20,000/34,193 0.5849 which, from the CIMA Mathematical Tables, suggests an MIRR between 11% and 12%. By interpolation: (0.5935 0.5849) 0.0086 1% 0.3% (0.5935 0.5674) 0.0261 which, added to 11.0%, gives 11.3%. If, as may well be the case in very exceptional circumstances, a reinvestment rate is greater than the company’s cost of capital, then the MIRR will underestimate a project’s true rate of return. The determination of the life of a project can also have a significant effect on the actual MIRR if the difference between the project’s IRR and the entity’s cost of capital is large. The MIRR, like the IRR, is still biased towards projects with short payback periods and those with large initial cash inflows, although possibly not to the same extent as the conventional IRR method. To what extent this method is being used in industry has yet to be reported in the academic literature; only time will tell its popularity amongst actual practitioners. Will it eventually replace the conventional IRR?
7.4.4 Discussion of techniques First, it is by no means certain that the NPV method is definitely better than the IRR approach. It is certainly conceivable that the IRR reinvestment assumption is as realistic as the NPV assumption – any business which could only invest its funds at the cost of capital would not be in business for long! And in a capital-rationing situation there may be other projects readily available which would generate returns well in excess of the cost of capital. The IRR reinvestment assumption could be more realistic in this situation and a technique which favours early inflows (as IRR does) could be preferable because it makes finance available with which to fund other projects. The point can also be made that the technique which favours early inflows is also more risk-averse – because earlier cash flows are more certain than later ones. Having defended IRR on theoretical grounds it can be pointed out that it is, arguably, more ‘meaningful’ than NPV. A manager presented with an NPV of £6,500 may well ask what this figure ‘means’ – What investment? How long? etc. – an absolute number cannot easily be assessed in isolation. The same manager presented with an IRR of 12.7 per cent immediately has a ‘feel’ for the project – if money can be borrowed at, say, 5 per cent, then the project is probably sound. If the cost of capital is 10 per cent, then there does not appear to be much margin for error. These considerations are borne out in practice. A survey by Pike revealed that 41 per cent of firms surveyed used IRR as their primary method of investment appraisal compared with only 17 per cent which used NPV as their primary method. To sum up, IRR is criticised because it is complex, there may be multiple IRRs, it can mislead where projects are mutually exclusive and its reinvestment assumption may be optimistic. Nevertheless, provided that the method is thoroughly understood, none of these objections is insuperable and there are reasons why IRR may be preferred to NPV. It is interesting to compare the result obtained using IRR with that produced by the accounting rate of return (ARR) method. Remember that the accounting rate of return was 2006.1
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1. If payback is used, reduce the required payback period; 2. If IRR is used, increase the required ‘cut-off ’ rate; 3. If NPV is used, increase the discount rate to take account of the ‘risk’ associated with the project. The capital asset pricing model provides a means of assessing the premium which ought to be added to the ‘risk-free’ discount rate; 4. Assign probabilities to ‘best’, ‘most likely’ and ‘worst’ values for each variable and calculate a range of possible outcomes together with their probabilities. (This approach can be refined by establishing distributions for the input variables and ‘simulating’ the project many times in order to build up a distribution of possible outcomes.) The relatively straightforward methods of handling risk if payback or IRR are used are cited as advantages of these techniques. However, none of the techniques described above deals with the important point that early cash flows are likely to be more certain than late ones. The discounting techniques take account of the time value of money but they assume that whatever cash flows are projected are certain. Only the payback technique clearly favours early inflows much more than later ones and this may partially account for its popularity. (The IRR approach favours early inflows when compared with the NPV approach because of its reinvestment assumption. However, this is a very fine point compared with payback which ignores late cash flows altogether.)
7.5 Capital rationing Capital rationing: A restriction on an entity’s ability to invest capital funds, caused by an internal budget ceiling being imposed on such expenditure by management (soft capital rationing), or by external limitations being applied to the entity, as when additional borrowed funds cannot be obtained (hard capital rationing). (Official Terminology, 2005) 2006.1
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16 per cent but the IRR was 12.7 per cent. This is typical. On the basis of ARR it may appear that the project is profitable if the cost of capital is, say, 14 per cent. However, this is erroneous; the project is viable only if the cost of capital is less than 12.7 per cent. Note that the IRR and the ARR are comparable but IRR is less than ARR. This is what one would expect because ARR treats all future inflows as equally valuable while IRR takes account of the time value of money. If ARR were calculated in other ways, for example based on initial investment rather than average (depreciated) investment, the comparison between IRR and ARR would not make sense. Given that ARR does not take account of the time value of money, one might assume that it should not be used. However, this does not necessarily follow. Remembering that analysts often use return on investment to evaluate business performance, a change in the ROI ratio could actually affect the company’s share price! If an investment were big enough to have repercussions on the published profit and loss account and balance sheet it would be foolish not to calculate the ARR! Having made a case for at least considering IRR and ARR we can consider the payback technique. As discussed earlier, payback is often used in practice, probably because of its simplicity. However, it may also be used because of its risk aversion – early cash flows are given full value, late cash flows are ignored. The usual textbook advice is to take account of risk in the following ways:
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The NPV assumes, implicitly, that funds will always be forthcoming for a project which offers the prospect of an adequate return on investment. This assumption needs some qualification, however: ●
●
●
●
Prospects are subjective judgements and, like beauty, are in the eye of the beholder. There may be problems perhaps on account of a poor track record in communicating that judgement to whoever controls the purse strings. The pace of growth may be limited by an unwillingness to seek capital from sources other than existing owners on the grounds that it would mean ceding control. Here, the usual response is to use a discount rate higher than the cost of capital, that is, trade off further back up the profit growth graph. An undue emphasis on short-term accounting numbers, for example, reported profits or return on assets ratios, so to avoid, perhaps, the accusation of jam tomorrow. Here, the response will be to evaluate in NPV terms, but then select those which have the most attractive accounting profile. A shortage of a particular resource, for example, engineering skills. Here, the appropriate response is an extension of the old marginal costing principle of maximising contribution or in this case NPV per unit of limiting factor.
Whatever the reason, however, turning away a viable project means weakening the longterm health of the enterprise. In practice, perhaps the biggest single problem is that opportunities do not surface at the same time, and choices are therefore made without all the information one would like. If capital is not rationed there is no problem; all projects which meet the cut-off criteria are accepted. When capital is rationed the ranking of projects becomes important. The various methods of investment appraisal – payback, IRR, NPV, etc. – often give conflicting rankings of investment priorities. Methods of determining how the investment decision should be made will depend on the type of capital rationing. Single-period capital rationing is a situation where capital is rationed at present (year 0), but will be freely available in the future. Multi-period capital rationing is a situation where capital is rationed over a number of periods. This syllabus concentrates on single-period capital rationing.
7.5.1 Single-period capital rationing In such situations, only a slight modification to the standard NPV rule is required. The overall return will be maximised by maximising the return per unit of limiting factor, where the limiting factor in this case is capital funding. Projects should be selected whose cash inflows have the highest NPV per £1 of capital invested. A profitability index can be calculated for each project to rank the projects. CIMA’s Management Accounting: Official Terminology defines the ‘profitability index’ as: Profitability index : Represents the net present value of each £1 invested in a project. Profitability index Present value of cash inflows Initial investment
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XYZ Ltd is planning its capital investment programme for next year, 200X. It has five projects, all of which give a positive NPV at the entity’s cost of capital of 15 per cent, the investment outflows and present values being as follows:
Project A B C D E
Investment £000 (50) (40) (25) (30) (35)
NPV @15% £000 15.4 18.7 10.1 11.2 19.3
The entity is limited to a capital spending of £120,000. Optimise the returns from a package of projects within the capital spending limit. The projects are independent of each other and are divisible (i.e. a part-project is possible).
Solution First ascertain the NPVs per £1 of investment and rank the projects on this basis as follows:
Project A B C D E
Investment £000 (50) (40) (25) (30) (35)
NPV @15% £000 15.4 18.7 10.1 11.2 19.3
Profitability index 1.31 1.47 1.40 1.37 1.55
Ranking 5 2 3 4 1
Next, build up a programme of projects based on their rankings as follows:
Project E B C D
Investment £000 (35) (40) (25) ( (20) (120)
NPV @15% £000 19.3 18.7 10.1 ( 7.5 (23 of project total) 55.6
Thus, project A should be rejected and only two-thirds of project D undertaken.
7.5.2 Single-period rationing with mutually exclusive projects The decision rule changes slightly if any of the projects are mutually exclusive. If we assume that either project C or project E could be accepted, but not both, the ranking process shown in Example 7.F will need to be undertaken twice. The first run would exclude Project C and the second run would exclude Project E. The optimal selection of projects would be given by the combination with the highest total NPV.
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Example 7.F
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Assuming that projects C and E are mutually exclusive: Project E B D A
Investment £000 (35) (40) (20) (25) (120)
NPV @15% £000 19.3 18.7 11.2 17.7 56.9
Project B C D A
Investment £000 (40) (25) (20) ((35) (120)
NPV @15% £000 18.7 10.1 11.2 10.8 50.8
( 12 of project total)
(70% of project total)
The optimum combination of projects is given by E B D 12 A.
7.5.3 Single-period rationing with indivisible projects When projects are not divisible, use of a profitability index may lead to an incorrect ranking. In these situations the investment selection decision has to be undertaken by examining the total NPV values of all the possible combinations of whole projects that do not exceed the amount of capital available. There may also be a small amount of unused capital with each combination of projects. Example 7.G Continuing with the data from Example 7.F, XYZ Ltd now discovers that the projects are not divisible. Surplus funds can be invested to earn 20 per cent per annum in perpetuity. Which combination of projects will maximise NPV?
Solution PV of interest earned for each £1 invested at 20% in perpetuity
£1 0.20 £1.33 0.15
NPV per £1 invested £1.33 £1 £0.33
Projects EBC EBD
Investment £000 100 105
NPV @ 15% £000 48.1 49.2
Surplus funds £000 20 15
NPV @ 15% £000 6.6 5.0
Total NPV £000 54.7 54.2
The highest NPV will be achieved by investing in projects E, B and C, and investing the surplus funds of £20,000 externally. Notice that if XYZ Ltd had been unable to invest surplus funds at a return higher than its cost of capital, a combination of E, B and D would have been preferable.
7.6 Annual equivalent cost This is basically a method of discounting especially for asset replacement decisions but it also has value when comparing the sensitivity of variables where projects have unequal lives. 2006.1
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So on an annualised basis, project B has the lowest cost and would be preferred even though on a non-annualised basis project A would have seemed more advantageous. Note that the 12 per cent discount rate must be a real rate rather than a nominal rate. See Chapter 8 for an explanation of the relationship between real and nominal rates. Unequal lives There are also means of comparing mutually exclusive projects with unequal lives. When two or more mutually exclusive investments with unequal lives are being compared, consideration must be given to the time period over which a comparison of the investments is to be made. Example 7.H Let us consider two such mutually exclusive investments, X and Y, with cash flows as shown below: Year Project X Project Y
0 £ (30,000) (30,000)
1 £ 20,000 37,500
2 £ 20,000
It is possible to compare X and Y on the cash flows as given. However, a comparison can also be made over an equal time span for both investments: the lives of X and Y can be equalised by assuming that the entity can reinvest in another project like Y at the end of year 1. The cash flows of two consecutive investments in Y would be as follows: Year Project Y Project Y repeated Total cash flow
0 £ (30,000) (30,000)
1 £ 37,500 (30,000) 7,500
2 £ 37,500 37,500
The NPVs and IRRs of X and Y under each of these alternatives are as follows:
1. Unadjusted cash flows (i.e. X over 2 years, Y over 1 year) 2. Cash flows adjusted to equalise project lives (i.e. X and Y both over 2 years)
NPV (r 10%) £ NPVX 4,711 NPVY 4,090 NPVX 4,711 NPVY 7,810
IRR 22% 25% 22% 25%
The ranking based on IRR makes project Y the superior choice, irrespective of the period over which the comparison is made. The IRR is a rate of return per pound invested, and it is obvious that this rate will be unchanged by subsequent repetitions of a project: if project Y were to be repeated on 50 consecutive occasions, its IRR would remain the same 25 per cent. However, this does not hold true for NPV, as it measures the absolute return on an investment. A comparison of the NPVs of X and Y under the two alternatives illustrates this point: X has the higher NPV when the lives are unequal, but Y has the higher NPV when the lives are equal. 2006.1
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When the present value (of a capital project) is expressed as an annual amount, this is called annual equivalent cost and is used to compare projects having different life cycles. As an example, suppose that the NPV of cash outflows for asset replacement project A is £64,300, with discounting at 12 per cent and an asset life of 4 years, while for project B, the NPV of outflows is £79,355, also after discounting at 12 per cent but with an asset life of 6 years. Annual equivalent costs are: £64,300 Project A: (12% cumulative over 4 years) £21,172 3.037 £79,355 Project B: (12% cumulative over 6 years) £19,303 4.111
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STUDY MATERIAL P9 As each case must be judged on its merits, it is not possible to stipulate that mutually exclusive investments should be considered over the same time period. The choice will be determined by the level of freedom of action enjoyed by the entity at the termination of the shorter-lived project. If it is forced to reinvest in similar assets at this point, the projects should be compared over equal time periods. However, comparison over differing lives may be perfectly valid if there is no presumption that the entity will be required, or even able, to act in this way. Some generalisations can be made. For example, if investments X and Y are alternative machines for a particular process, and it is known that the output from the process will be required for at least two years, then one investment in Y will not meet the entity’s requirements. At the end of the first year, the company will have to make an additional investment to provide the output required in the second year – X and Y must therefore be compared over an equal time period. However, the situation might be completely different if X and Y happen to be alternative marketing strategies for a novelty product. Let us assume that project X represents a low price and Y a high price strategy, and that, in charging the high price, the life of the product would be limited to 1 year. If this is the case, the product clearly cannot be relaunched at the end of that time. The options open to the entity at the end of year 1 are independent of the fact that it adopted strategy X in year 0, and an unadjusted comparison between X and Y will thus be perfectly valid.
Before making a comparison between mutually exclusive projects with differing lives, an explicit decision must be taken as to whether it is necessary to equalise the lives. A choice should be made on the basis of NPV, whether equalisation is required or not, although, as our earlier example showed, the process of equalisation may alter the ranking of the projects under consideration.
7.6.1 Asset replacement cycles The concept of annualised equivalents can be used in determining the optimum replacement cycle for an asset. This decision involves how long to continue operating the existing asset before it is replaced with an identical one. As the asset gets older, it may become less efficient, its operating costs may increase and the resale value will reduce. An example will demonstrate how annualised equivalents are used in this type of decision. Example 7.I Lita Ltd operates a delivery vehicle, which cost £20,000 and has a useful life of 3 years. Lita Ltd has a cost of capital of 5 per cent. The details of the vehicle’s cash operating costs for each year and the resale value at the end of each year are as follows.
Cash operating costs End of year resale value
Year 1 £ 9,000 14,000
Year 2 £ 10,500 11,500
Year 3 £ 11,900 8,400
Requirement Determine how frequently the vehicle should be replaced.
Solution The first step is to calculate the present value of the total costs incurred if the vehicle is kept for 1, 2 or 3 years, respectively.
5% discount Year factor 0 1.000 1 0.952 2 0.907 3 0.864 Total present value
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Keep for 1 year Cash Present flow value £ £ (20,000) (20,000) 5,000 4,760) 1 5,240 (15,240)
Keep for 2 years Cash Present flow value £ £ (20,000) (20,000) (9,000) (8,568) 1,000 907) 27,6 61 (27,661)
Keep for 3 years Cash Present flow value £ £ (20,000) (20,000) (9,000) (8,568) (10,500) (9,524) (3,500) 2(3,024) (41,116)
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Total present value of cost Cumulative 5% factor Annualised equivalent
Keep for 1 year £15,240 0.952 £16,008
Keep for 2 years £27,661 1.859 £14,880
Keep for 3 year £41,116 2.723 £15,100
The lowest annualised equivalent cost occurs if the vehicle is kept for 2 years. Therefore the optimum replacement cycle is to replace the vehicle every 2 years.
7.7 Summary In using discounting and other techniques of investment appraisal, you must always be aware that financial analysis is only a part of the decision-making process and that, often, social and other factors may also be of considerable importance. However, accepting this point and the need for a rounded, pragmatic approach to investment decisions, it is still essential that a management accountant should thoroughly understand the application of the ‘tools of his trade’. The arguments put forward here suggest that all the techniques of investment appraisal need to be well understood if they are to be wisely used. In summary: 1. NPV is the principal theoretical recommendation and should be used if the cost of capital is a realistic reinvestment assumption. 2. IRR, like NPV, incorporates discounting principles and, for some managers, may be more meaningful than the absolute NPV of the project. However, IRR needs to be thoroughly understood because of possible difficulties concerning multiple IRRs and its use if projects are mutually exclusive. MIRR is a recent innovation worthy of consideration. 3. Payback is much used in practice and, aside from its obvious simplicity, it can also be recommended if a risk-averse decision is needed (or if liquidity is a major problem). 4. ARR takes no account of the time value of money and could lead to an incorrect decision if compared with the cost of capital. However, because of the extensive use of the return on capital employed or return on investment ratio, in practice it could be foolish not to calculate it. The analysis suggests that there may be a place for all the techniques of investment appraisal in the management accountant’s armoury. However, a thorough understanding of their theoretical nuances is important, as is the background to appraisal techniques outlined in the introduction to this chapter. You should now be able to calculate annual equivalent cost, especially when faced with projects such as plant replacement decisions, where alternative projects have different lives, while it is also necessary for you to understand situations when capital rationing must be taken into account.
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These present value figures are not comparable because they relate to different time periods. To render them comparable they must be converted to average annual figures, or annualised equivalents, by dividing by the cumulative discount factors as before:
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Revision Questions
Question 1 Banden Ltd is a highly geared entity that wishes to expand its operations. Six possible capital investments have been identified, but the entity only has access to a total of £620,000. The projects are not divisible and may not be postponed until a future period. After the projects end it is unlikely that similar investment opportunities will occur. Expected net cash inflows (including salvage value) Project A B C D E F
Year 1 £ 70,000 75,000 48,000 62,000 40,000 35,000
2 £ 70,000 87,000 48,000 62,000 50,000 82,000
3 £ 70,000 64,000 63,000 62,000 60,000 82,000
4 £ 70,000
5 £ 70,000
73,000 62,000 70,000
40,000
Initial outlay £ 246,000 180,000 175,000 180,000 180,000 150,000
Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company’s existing capital investments. Any surplus funds may be invested in the money market to earn a return of 9 per cent per year. The money market may be assumed to be an efficient market. Banden’s cost of capital is 12 per cent per year. Requirements
(a) Calculate: (i) the expected net present value; (ii) the expected profitability index associated with each of the six projects, and rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ. (8 marks) (b) Give reasoned advice to Banden Ltd, recommending which projects should be selected. (6 marks) (c) A director of the entity has suggested that using the company’s normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director. (4 marks) (d) The director has also suggested the use of linear or integer programming to assist with the selection of projects. Discuss the advantages and disadvantages of these mathematical programming methods to Banden Ltd. (7 marks) (Total marks 25) 311
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Question 2 The board of directors of CP Ltd is considering two investments, each of which is expected to have a life of five years. The company does not have either the physical capacity or the funds to undertake both investments. Forecast profits and other financial data for the two investments are: Investment 1
Non-current assets Working capital Forecast revenue Forecast costs Finance charges Depreciation Profit before tax
Year 0 £000 (500) (50)
1 £000
2 £000
3 £000
4 £000
5 £000
370 300 15 (100 (45)
500 325 15 100 060
510 335 15 100 060
515 330 15 100 070
475 325 15 100 035
1 £000
2 £000
3 £000
4 £000
5 £000
420 310 15 380 015
510 385 15 380 030
575 420 15 380 060
550 400 15 380 055
510 350 15 380 065
Investment 2
Non-current assets Working capital Forecast revenue Forecast costs Finance charges Depreciation Profit before tax
0 £000 (450) (50)
Additional information ● The company pays tax at 33 per cent. Writing-down allowances are available on the initial investment in both projects at 25 per cent per year. Tax is payable/receivable 1 year in arrears. ● The data is in real terms, that is, it contains no increases for inflation. This has been ignored on the grounds that both revenue and costs are expected to increase by 5 per cent per year. ● The company’s nominal cost of capital is 12 per cent per year. Its target accounting rate of return (average profit before tax as a percentage of average investment) is 25 per cent. ● All cash flows may be assumed to occur at the end of the year except the initial capital cost and working capital. ● For each project the value of working capital expected to be released back to the project’s cash flows at the end of year 5 is £50,000 nominal. There will be no other terminal value of the investment. ● The £50,000 left over if investment 2 is chosen (i.e. the difference between the initial investment of £550,000 in investment 1 and £500,000 in investment 2) could be invested in the money market at between 6 per cent and 7 per cent. Requirement Assume that you are the financial manager with CP Ltd. Recommend to the board which investment, if either, should be selected using whatever methods of evaluation you think appropriate. Include in your report a discussion of the various methods of evaluation and any non-financial factors which might be relevant to the decision. Note: Your cash flows should be presented in nominal (as opposed to real) terms. (20 marks) 2006.1
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REM is a family-owned business. The family owns 80 per cent of the shares. The remaining 20 per cent is owned by four non-family shareholders. The Board of Directors is considering the purchase of two second-hand (that is, previously used) freight planes to deliver its goods within its key markets in the USA. The Managing Director, an ex-pilot and one of the non-family shareholders, commissioned an evaluation from the entity’s accountants and was advised that the entity would save money and be more efficient if it performed these delivery operations itself instead of ‘outsourcing’ them to established courier and postal services. The accountants built into their evaluation an assumption that the entity would be able to sell spare capacity on the planes to other entities in the locality. The Managing Director has decided that the accountants’ recommendation will be conducted as a ‘trial’ for 5 years when its success or otherwise will be evaluated. The net, posttax operating cash flows of this investment are estimated as: Year 0 Years 1 to 4 Year 5
$12.50 million (the initial capital investment) $3.15 million each year $5.85 million
Year 5 includes an estimate of the residual value of the planes. The company normally uses an estimated post-tax weighted average cost of capital of 12 per cent to evaluate investments. However, this investment is different from its usual business operations and the Finance Director suggests using the capital asset pricing model (CAPM) to determine a discount rate. REM, being unlisted, does not have a published beta so the Finance Director has obtained a beta of 1.3 for a courier entity that is listed. This entity has a debt ratio (debt to equity) of 1:2, compared with REM whose debt ratio is 1 :5. Other information: ●
● ●
The expected annual post-tax return on the market is 9 per cent and the risk-free rate is 5 per cent. Assume both entities’ debt is virtually risk-free. Both entities pay tax at 30 per cent.
Requirements (a) Using the CAPM, calculate: (i) an asset beta for REM; (ii) an equity beta for REM; (iii) an appropriate discount rate to be used in the evaluation of this project; (iv) the NPV of the project using the discount rate calculated in (iii); and comment briefly on you choice of discount rate in part (iii). (11 marks) (b) Evaluate the benefits and limitations of using a proxy entity’s beta to determine the rate to be used by REM in the circumstances here, and recommend alternative methods of adjusting for risk in the evaluation that could be considered by the entity. (9 marks) (c) Advise the Managing Director on the benefits of a post-completion audit. (5 marks) A report format is not required in answering this question.
(Total marks 25)
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Question 3
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7
Solution 1 (a) Calculations of expected net present value and profitability indices: Project A NPV £70,000 3.605 £246,000 £6,350 252,350 Profitability index Present value of cash inflows 1.026. 246,000 Initial investment Project B NPV £75,000 0.893 £87,000 0.797 £64,000 0.712 £180,000 £1,882 181,882 Profitability index 1.010. 180,000 Project C NPV £48,000 1.69 £63,000 0.712 £73,000 0.636 £175,000 (£2,596) 172,404 Profitability index 0.985. 175,000 Project D NPV £62,000 3.037 £180,000 £8,294 188,294 Profitability index 1.046. 180,000 Project E NPV £40,000 0.893 £50,000 0.797 £60,000 0.712 £70,000 0.636 £40,000 0.567 £180,000 £5,490 185,490 Profitability index 1.031. 180,000 315
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Project F NPV £35,000 0.893 £82,000 1.509 £150,000 £4,993 154,993 Profitability index 1.033. 150,000 Project Rankings 1 2 3 4 5 6
NPV D A E F B C
PI D F E A B C
The profitability index shows the present value per £ of incremental outlay, and is a relative measure. NPV is an absolute measure showing the expected benefit from a project. If projects differ in the amount of capital outlay, as they do in this case, NPV and PI may give different rankings. (b) The projects selected should be the combination of projects with the greatest total NPV, subject to the constraints that the total initial outlay must not exceed £620,000, and projects A and E are mutually exclusive. Possible combinations of three projects are: Projects A,B,D A,B,F A,D,F B,D,E B,D,F D,E,F
Expected NPV (£) 6,350 1,882 8,294 6,350 1,882 4,993 6,350 8,294 4,993 1,882 8,294 5,490 1,882 8,294 4,993 8,294 5,490 4,993
Total expected NPV (£) 16,526 13,225 19,637 15,666 15,169 18,777
Total outlay (£) 606,000 576,000 576,000 540,000 510,000 510,000
The recommended selection is projects A, D and F, which maximises expected total NPV subject to the constraints. Notes: 1. Project C is not considered, as it has a negative NPV. 2. Combinations of two projects are also possible, but none would have a higher expected total NPV. No combination of four or more projects is possible. 3. As the money market is efficient, any surplus funds invested in the money market will have zero NPV. Total NPV cannot be increased by investing surplus funds in the money market. (c) If a binding budget constraint exists in a capital rationing situation, the opportunity cost of the marginal pound will increase if profitable projects exist. The relevant discount rate is the higher of: (i) The yield forgone on the most profitable investment opportunity rejected because of the budget constraint (the marginal opportunity cost, which is represented by the shadow price in a linear programming solution). (ii) The company’s normal cost of capital. The director is correct in stating that the company’s cost of capital might not be appropriate. (d) Linear programming may be used in complex problems to choose an ‘optimum’ strategy involving the comparison of the value of various alternative uses of resources. The 2006.1
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(i) As it assumes projects are infinitely divisible – most capital investment projects are not. (If there are a large number of projects this might not be a serious problem.) (ii) The data used in the model are treated as being certain. Much of the data will actually represent uncertain forecasts. Additionally, the assumption of inflexible constraints may not be realistic; in practice a cash constraint will probably have some flexibility, but in the model it must be strictly adhered to. (iii) The relevant discount rate is unknown, and is given only after the linear programming problem is solved – yet it is required as an input for the linear programming problem. Integer programming produces an ‘optimal’ solution using only whole projects, which is more realistic for most capital budgeting situations and would be suitable for the needs of Banden Ltd. Except for project divisibility, it is subject to similar criticisms as linear programming. However, the small number of projects under consideration and the relatively simple nature of the capital rationing experienced by Banden allows the selection of projects to be made without formal use of mathematical programming techniques.
Solution 2 Calculations Investment 1 0 Inflation factors £000 Real terms revenue Real terms costs
1 1.05 £000 370 (300)
2 1.103 £000 500 (325)
Year 3 1.158 £000 510 (335)
4 1.216 £000 515 (330)
5 1.276 £000 475 (325)
41 389 (315)
23 591 (388) (64) 3 41 0162
17 626 (401) (67) 3 41 0175
13 606 (415) (74) 3 50 0180
(63) 3 41 0(23)
6 £000
Cash flows Plant Tax (25% p.a., 33%) Sales Costs Tax @ 33% Working capital Net
3(50) (550)
3 141 0 115
31 552 (359) (24) 3 41 0200
12% p.a. discount factors
1.000
0.893
0.797
0.712
0.636
0.567
0.507
Discounted cash flow, £000
(550)
0 103
0 159
0 115
0 111
0 102
0 (12)
NPV 5.1% of outlay
(500) 40
0 28)
Note: Total profit before tax £386,000. This amounts to 110 per cent of average assets of £350,000, an average of 22 per cent per annum.
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technique also provides information regarding the marginal value of resources through the dual values. It offers speed of calculation, can direct management’s attention to key areas (e.g. the main constraints on activity) and allows changes in variables, objectives or assumptions to be quickly incorporated. In capital rationing situations, linear programming may be criticised:
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Investment 2 0 Inflation factors £000 Real terms revenue Real terms costs Cash flows Plant Tax (25% p.a., 33) Sales Costs Tax @ 33% Working capital Net
1 1.05 £000 420 (310)
Year 2 1.103 £000 510 (385)
3 1.158 £000 575 (420)
4 1.216 £000 550 (400)
5 1.276 £000 510 (350)
21 666 (486) (46) 3 41 0 155
16 669 (486) (59) 3 41 0 140
11 651 (447) (60) 3 50 0 205
(67) 33 41 0 (31)
6 £000
(450) 37 441 (325) 3(50) (500)
3 41 0 153
28 564 (425) (38) 3 41 0 129
12% p.a. discount factors
1.000
0.893
0.797
0.712
0.636
0.567
0.507
Discounted cash flow, £000
(500)
00137
00103
00110
00089
00116
0 (16)
NPV 7.8% of outlay
36
0 390
Note: Total profit before tax £372,000. This amounts to 116 per cent of average assets of £320,000, an average of 23 per cent per annum.
Report To: The directors of CP Ltd From: Financial manager Date: Subject: Mutually exclusive investment opportunities Purely on the basis of the information provided, given that the two projects are mutually exclusive, the company should opt for investment 2: it shows a higher NPV in absolute terms and relative to the initial investment, and leaves £50,000 available for other opportunities – or for distribution to shareholders. The criterion should be the cost of capital which, one would expect, is higher than the rate which can be earned on deposit. A more important consideration, however, might be the opportunities contingent upon embarking on the alternative projects: what are referred to and evaluated, these days, as real options. Other methods of ‘evaluating’ investment proposals include: ● ● ●
the accounting rate of return – simple but ignores the value of time; payback period – simple but ignores cash flows after payback; internal rate of return – complex, and unrealistic (requiring constant cost of capital, uncertainty and risk aversion). Non-financial factors worthy of consideration include:
● ● ●
consistency with the company’s declared strategy; consistency with the company’s declared values, for example, environmental impact; consequences for other aspects of the business: – does it open up other opportunities (perhaps by bringing the company into contact with new customers)? – does it enable employees to develop additional skills? – the availability of suitable labour, spare parts, etc.; – technical difficulties in respect of installation/maintenance. Signed: Financial manager
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An equity beta is the beta that attaches to a company’s shares; it is this beta that is published. An asset beta reflects business risk assuming a company is ungeared. In the case here, the proxy company has a different debt ratio from REM, so it is necessary to ungear its beta and ‘regear’ it using REM’s debt ratio. (a) (i) Ungear proxy beta
V [1V [1 t] t ]V B V 2 B 0 1.3 2 1[1 0.3]
Bu Bd
D
D
g
E
VE E VD[1 t ]
u
Bu 0.96.
(ii) Regear using REM’s debt ratio
V VV [1 t ] 5 1[1 0.3] B 0.96 5 Bg Bu
E
D E
g
Bg 1.09.
(iii) The discount rate using the CAPM: DR R f (Rm R f ) DR 5% 0.96 (9% 5%) DR 8.84%. In theory, it is the asset beta that should be used to calculate a discount rate as it is the business risk of the project that the company wishes to reflect, not the financial risk also reflected in the proxy company’s equity beta. However, an argument could be made in the case here that it is total risk that is important and the equity beta should be used. This would give a discount rate of 9.36 per cent. (iv) The NPV of the project Year Cash flows (in $m) Discount rate @ 8.84% DCFs NPV ($m)
0 (12.50) 1 (12.50) $1.571
1 3.15 0.9188 2.894
2 3.15 0.8442 2.659
3 3.15 0.7756 2.443
4 3.15 0.7126 2.245
5 5.85 0.6547 3.830
Examiner’s Note Candidates who had correctly calculated NPVs using a rounded discount rate of 9 per cent, or used the discount rate using the equity beta and commented on this fact, would have received full marks. (b) Benefits: ● ●
If no other option, perhaps better than nothing. Gives some indication of risk of the project. 2006.1
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Solution 3
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Limitations: ●
●
●
●
No two companies exactly alike, the two operations may be quite different in terms of business risk. For example here the courier company will have a diversified range of external customers. REM will mainly have internal customers. Variance surrounding beta is large, using the CAPM at all can only provide a rough estimate. All the problems of CAPM: single period model, deals only with systematic risk, based on historical data, etc. Is the method appropriate anyway for a company owned by a small group of shareholders? The CAPM assumes a fully diversified portfolio, which may not be the case here. A discount rate reflecting total risk may be more appropriate. Alternative methods:
●
●
●
●
●
What Brealey and Myers call ‘fudge factors’. These are not theoretically acceptable but provide a good rule of thumb. Use the marginal rate of the new finance, not theoretically sound but has practical advantages. Use the company’s cost of equity. To calculate this using CAPM we would require to find a quoted company that is in a similar line of business to REM as a whole. The new project is likely to have a lower discount rate, but the project is dependent on REM’s business. There would therefore be some logic in arguing the discount rate should be REM’s cost of equity. Use REM’s WACC. Using an estimated WACC is a practical expedient for many companies and understood by many non-finance people. The argument against using the WACC would be (a) theory does not support using WACC for investment appraisal other than in very specific circumstances, and (b) here it is estimated – how is not explained but unlikely to be based on a theoretically correct formula (e.g. CAPM). Use certainty equivalents to calculate riskless cash flows, which would be discounted at the risk free rate of return although note the difficulty in determining appropriate probabilities. A recommendation might be to commission consultants/advisors to determine a rate/method, but note expense and distrust of consultants, especially by smaller companies.
(c) A post-completion audit (PCA) can be defined as ‘an objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project’. The main purposes may be summarised as: ● ● ●
project control; improving the investment system; assisting the assessment of performance of future projects. A major requirement of a PCA is that the objectives of the investment project must be clear and an adequate investment proposal should have been prepared. The objectives should also be stated, wherever possible, in terms, which are measurable. The main advantages are:
●
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It enables a check to be made on whether the actual results correspond with the expected results, for example if the proportions of own use to sale of spare capacity
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●
●
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●
are as expected. If this is not the case, the reason can be sought. This could form the basis for improvements in projects that are not functioning as expected or can cause projects to be abandoned. It generates information, which allows an appraisal to be made of the managers who took the investment decision. Managers will therefore tend to arrive at more realistic estimates of the advantages and disadvantages of their proposed investments. It can produce lessons for the decision-making process. If these lessons are actually learned, people will be able to make a better evaluation of the significance and the profitability of future periods. It can provide for better project planning. If, in the evaluation, it is found that the planning of the investment programme was poor, provision can be made to ensure that it is better for future investments.
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8
LEARNING OUTCOMES After completing this chapter, you should be able to:
analyse relevant costs, benefits and risks of an investment project;
evaluate domestic investment projects taking account of potential variations in business and economic factors;
evaluate procedures for the implementation and control of investment projects.
8.1 Introduction The topics covered in this chapter are: ● identification of a project’s relevant costs, benefits and risks; ● linking investments with customer requirements and product/service design; ● linking investment in IS/IT with strategic, operational and control needs; ● recognising risk using the certainty equivalent method; ● adjusted present value; ● capital investment real options; ● project implementation, control and audit.
8.2 Taxation Payments of tax or reductions of tax payments are cash flows and should be taken into account in discounted cash flow projections. Taxation rules may be simplified in an examination question, but the main tax implications are as follows: 1. Corporation tax. Project cash flows must be stated after tax and discounted at an after-tax discount rate, while you must take care over the timing of the tax cash flows. These usually slip 1 year in the projections, that is, tax related to profits in year 1 will usually be taken into the cash flows for year 2. Slippage does not always occur and, as with all aspects,
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you must read an examination question carefully to be clear as to what is actually required. 2. Tax depreciation allowances. These allowances take the place of income statement provisions for tax relief, except of course in those cases where tax allowances are used also for the income statement calculations. The effect of allowances is to reduce taxable profits and therefore they represent a cash saving or inflow in the DCF projections.
Example 8.A Pogle Ltd buys a machine costing £100,000 which is expected to have a resale value of £15,000 at the end of its 4-year life. The machine will attract capital allowances at 25 per cent per annum on a reducing-balance basis. Corporation tax is at the rate of 33 per cent. What are the tax depreciation allowances and their associated tax savings over the asset’s life?
Solution
Year 1 2 3 4 4 (end)
Asset (start of year) £ 100,000 75,000 56,250 42,187 31,640 (15,000)
Rate of allowance % 25 25 25 25
Value of allowance £ 25,000 18,750 14,063 10,547 16,640 85,000 85,000
Tax rate % 33 33 33 33 33
Tax saving £ 8,250 6,188 4,641 3,481 5,491
Year of tax saving 2 3 4 5 5
The total tax depreciation allowances claimed are £85,000. The amount of £16,640 at the end of year 4 is a balancing allowance which ensures that the total claimed equates with the asset cost less any sale or terminal values. If the amounts claimed exceed the asset cost adjusted for sale or terminal value, then a balancing charge will accrue.
8.2.1 Depreciation and tax depreciation allowances Depreciation is the recognition in accounting of the diminution in the value of fixed assets which occurs as a result of time or use. The calculated amount of depreciation for a period of time is credited to the asset account, thus reducing its ‘book value’ and debited to the income statement, thus showing the cost of using the asset as a charge against revenue. There are many different methods used for calculating depreciation, each based on a different concept. The Financial Strategy syllabus is not specifically concerned with the accounting treatment or methods of depreciation. Depreciation is not cash and the key point to remember is that if a question requiring a DCF calculation includes depreciation (or other non-cash items, including accruals and prepayments), these items have to be added back to profits or losses to arrive at operational cash flows. ‘Capital allowances’ is the term used in the UK for tax depreciation allowances. Most countries have similar schemes. The important point is that tax depreciation allowances themselves are not cash, but they affect the tax liability of a company, which in turn affects tax payable or refundable. Tax depreciation allowances do therefore have an effect on cash flow and their calculation needs to be understood. 2006.1
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8.3 Inflation A common source of confusion and misunderstanding in DCF calculations is the treatment of inflation. Typically, the discount rate is the money cost of capital (often referred to as the nominal cost of capital), that is, the rate payable on borrowed money (the source of funds may be a bank loan, bonds, equity or some combination of sources). Such a rate includes an allowance for inflation in the sense that the lender cannot expect any more than the interest rate. ( The lender may charge a 15 per cent rate assuming that inflation will be 8 per cent and so a 7 per cent ‘real return’ will be generated.) If a money cost of capital is employed, then the cash flows on which the analysis is performed should also include any inflation which is expected. (And, if different rates of inflation are expected on revenues and costs, then this should be reflected in the cash flows.) In practice, cash flows are often projected in so-called ‘real’ terms, that is, excluding inflation. Given the uncertain nature of estimated future cash flows this is not surprising – inflating ‘guestimated’ future cash flows may give even the most determined accountant pause for thought! And, since inflation might be expected to affect all entities equally, it can reasonably be assumed that, if there are unexpected inflationary pressures, they will be compensated by price adjustments. There are therefore arguable reasons for the use of cash flows in ‘real’ terms in DCF analysis. However, it therefore follows that the discount or ‘cut-off ’ rate should also be in ‘real’ terms. Any inflation element in the cost of capital should then be excluded from the discount rate before proceeding with the analysis. It would not be surprising if this important point were overlooked in practice and a survey by Carsberg and Hope showed that this was indeed the case. The relationship between real and nominal rates is embodied in the formula originally considered by Fisher: (1 nominal) (1 real) (1 inflation) or (1 N ) (1 R) (1 I) where N, R and I represent rates. Remember that nominal rates are often termed money rates. Example 8.B Mr Jordan invests £1,000 on 1 January 200X, for 1 year. The required rate of return is 20 per cent, and inflation is at the rate of 10 per cent per annum. If £1,200 is received on 31 December 200X, what is Mr Jordan’s real rate of return?
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Capital allowances are generally given in the form of first-year allowance followed by writing-down allowances. In the UK at present there is no difference in rate between first-year and subsequent writing-down allowances.
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Solution Owing to inflation, the purchasing power or real value of the pound has fallen in the period, and so restating £1,200 on 31 December in terms of its purchasing power on 1 January, we get: 1,200 1,200 £1,091 1r 1 0.1 where r is the rate of return. This gives a real rate of return of 9.1 per cent, that is: (1 0.20) ≈ (1 0.091) (1 0.10) (1 N) ≈ (1 R) (1 I) In deciding which rate to use in discounting, remember that for real cash flows you must use the real rate, and for actual (or nominal or money) cash flows you must use the nominal or money rate.
Example 8.C Brooker plc has under review a project involving the outlay of £55,000 and expected to yield the following net cash savings in current terms: Year 1 2 3 4
£ 10,000 20,000 30,000 5,000
The entity’s cost of capital, incorporating a requirement for growth in dividends to keep pace with cost inflation, is 20 per cent, and this is used for the purpose of investment appraisal. On the above basis, the divisional manager involved has recommended rejection of the proposal. Having regard to your own forecast that the rate of inflation is likely to be 15 per cent in year 1 and 10 per cent in each of the following years, you are asked to comment fully on his recommendation.
Solution Divisional manager’s appraisal
Year 0 1 2 3 4
Net cash flow £ (55,000) 10,000 20,000 30,000 15,000 10,000
DCF factor at 20% 1.000 0.833 0.694 0.579 0.482
Net present value £ (55,000) 8,330 13,880 17,370 1 2,410 (13,010)
Comment The anticipated inflation rate has been incorporated into the required rate of return and, on this basis, the project has produced a negative NPV. A better approach would be the adjustment of the forecast net cash flows to reflect the effect of the anticipated inflation rate. Revised appraisal
Year 0 1 2 3 4
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Net cash flow £ (55,000) 11,500 25,300 41,745 37,653 31,198
DCF factor at 20% 1.000 0.833 0.694 0.579 0.482
Net present value £ (55,000) 9,580 17,558 24,170 53,689 0 (3)
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Year Year Year Year
1: 2: 3: 4:
£10,000 1.15 £20,000 1.15 1.10 £30,000 1.15 1.102 £5,000 1.15 1.103
£ 11,500 25,300 41,745 7,653
Comments 1. It can be seen that the revised appraisal has produced a significantly different result from that which the divisional manager produced. 2. Because DCF factors to three decimal places have been used in the revised appraisal, a small negative NPV of £3 has been produced. In fact, the DCF yield on the project will be found to be identical to the cost of capital. 3. Before any final decision is made regarding the acceptance/rejection of the project, it is recommended that some form of probability or risk analysis is carried out.
Finally, there is the problem of using the real rate when there are taxation implications in an examination question. In general, we suggest that in using real rates, taxation will be adjusted to exclude inflation, so that it will appear in real terms for the year in which it falls in the DCF projections – that is, when the cash is saved or paid – but again we must emphasise that you should check carefully for any special requirement as to the treatment of tax cash flows given in the question. If there are any taxation implications in an investment appraisal, it would not usually be appropriate to leave the cash flows in terms of present-day prices and discount those cash flows at the real cost of capital. This would understate the overall tax liability as capital allowances are based on original, rather than replacement cost, and do not change in line with changing prices. The cash flows will have to be adjusted by the appropriate estimate of price change.
8.4 Working capital Next, we identify the correct approach, which may be called the incremental approach, for the incorporation of working capital into DCF analysis, particularly where inflation is involved. Example 8.D The cumulative working capital requirements for project A have been identified as follows: Year £(000)
0 200
1 300
2 350
3 350
4 400
These figures are based on present-day costs. Working capital requirements are expected to increase by 7 per cent per year. The project has an expected life of 4 years. What are the relevant working capital requirements for the appraisal of project A in nominal terms?
Solution
Year 1 2 3 4 4
Cumulative requirement in nominal terms £000 300 1.07 321 350 1.072 401 350 1.073 429 400 1.074 524
Increase/decrease £000 121 80 28 95 (524)*
*Cumulative working capital released (324 200)
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8.5 Identification of a project’s relevant costs and benefits A common difficulty experienced by students is how to choose which cash flows to include and which to exclude in the investment appraisal procedure. We have listed below a number of examples of the items that should be regarded as being of particular importance: ●
●
●
● ●
●
●
●
●
Accounting adjustments such as depreciation do not represent cash outflows, as no physical movement of cash takes place. However, tax allowances do represent inflows as they reduce the amount of tax actually to be paid in cash. Cash inflows should be after-tax, as we are concerned with the PV benefits to the shareholder, not to both the shareholder and the Inland Revenue. Cash flows represent dividends which would be paid if the project were financed entirely with equity. Financing decisions would be analysed separately from operational project decisions, which are based on investment appraisal evaluations. Incidental effects need to be included if they represent cash movements. Working capital needs to be included, but bear in mind that it will usually have a terminal value at the end of the project. Sunk costs should be excluded as they do not involve a new cash movement created by the project. For good or ill, they represent past cash flows, which cannot reasonably be recouped from a project which is not related to the purpose for which they were originally expended. Opportunity cost could be defined as ‘the value of a benefit sacrificed in favour of an alternative course of action’. Thus if a scarce resource used for a project A is greater than the amount required for a project B, for example 3 hours of limited machine time for a unit of A compared with 2 hours for a unit of B, then the cost of the extra hour per unit is an opportunity cost to be regarded as an outflow of A. Cash flows should as far as possible relate to directly distinguishable cost elements, otherwise it could be extremely difficult to successfully apply probabilities or sensitivity analysis in a meaningful way to the PVs ascertained. If you discount real cash flows at a nominal rate you are trying to mix oil and water!
Exercise 8.1 This exercise covers an NPV calculation including the aspects of taxation, capital allowances, terminal values and working capital. PQ Ltd, a motor components subsidiary of a conglomerate entity, has to decide near the end of year 0 whether to invest in a new production line. The project involves equipment costing £600,000 and working capital costing £180,000 at year 0, and the projected net cash inflows for the products are £200,000 per annum for 5 years at current price levels. At the end of 5 years it is projected that the equipment will have a terminal value of £50,000, and that the elimination of working capital will provide an inflow equal to its year 0 book value. PQ Ltd’s post-tax cost of capital is 14 per cent in nominal (money) terms and the inflation rate is projected to be 5 per cent per annum. Taxation data is as follows: (i) The equipment will be subject to writing-down allowances of 25 per cent per annum on a reducing-balance basis, which can be claimed against taxable profits as from the current year (year 0) which is shortly to end. A balancing charge or allowance will arise on disposal. (ii) The rate of corporation tax is 35 per cent payable 1 year in arrears. 2006.1
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Determine whether or not the net present value of the project will justify the investment.
Solution You should note that the figures required are in nominal (money) terms, but in this case, while it is possible to convert net cash flows back from nominal to real terms, it is not possible to ascertain a discount rate in real terms, from the data given, because of the mixture of inflated and non-inflated cash flows in the projections. If PQ Ltd’s planners wished the figures to be in real terms, then the company’s real discount rate would have to be separately determined. Care would also be required in adjusting the tax savings on tax depreciation allowances. Equipment Year £ 0 (600,000) 1 – 2 – 3 – 4 – 5 50,000 6 – Net present value
Working capital £ (180,000) – – – – 180,000 –
Net cash inflows £ – 210,000 220,500 231,525 243,101 255,256 –
Tax on cash inflows @35% £ – – (73,500) (77,175) (81,034) (85,085) (89,340)
Tax saved on capital all’nces £ – 52,500 39,375 29,531 22,148 16,611 32,335
Net cash flows £ (780,000) 262,500 186,375 183,881 184,215 416,782 (57,005)
Discount factor 14%
Present values £ (780,000) 230,213 143,322 124,120 109,055 216,310 2(25,994) 0 17,026
1.000 0.877 0.769 0.675 0.592 0.519 0.456
The net present value is positive and therefore the investment should be accepted. Workings Tax saved on capital allowances Year (A) 0 1 2 3 4 5 Sale proceeds Balancing all’nce
Investment (B) £ 600,000 450,000 337,500 253,125 189,844 142,383 (50,000) –
Allowance claimed @ 25% of (B) (C) £ 150,000 112,500 84,375 63,281 47,461 35,596 – 56,787
Written-down value (B)–(C) (D) £ 450,000 337,500 253,125 189,844 142,383 106,787 (50,000) –
Tax saved on allowances @ 35% of (C) (E) £ 52,500 39,375 29,531 22,148 16,611 32,335
Year of tax saving (F) 1 2 3 4 5 6
8.6 Linking investments with customer requirements and product/service design The capital budgeting decision faced by entities is to identify the range of projects, that within the capital funding available, will maximise shareholder wealth. The quantitative aspects of this process involves identifying the mix of projects that produces the highest net present value. In addition to the initial capital investment, working capital must also be made available throughout the life of the selected projects. 2006.1
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Requirement
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Investment in new products will result in cash outflows for the entity. Design and development of new products or services often demands significant cash investment, regardless of whether the product or service is ultimately accepted for manufacture or implementation. There will be a minimum size of entity that can afford certain types of research and development activity. This will be determined by the nature of the industry and the pace of technological change. Decisions will have to be made at a number of stages in the development of a product or service on whether the expected future benefits justify the commitment of further investment. This applies to all new products or services, regardless of the amount of design and development expenditure required. The investment decision for the new product or service requires the forecasting of expected cash inflows and outflows throughout the expected life of the product or service, and discounting to give a net present value.
8.6.1
Reasons for developing new products or services
There are a number of reasons why an entity will invest in developing new products and services. These include: • • • • • •
to meet changing customer demands; to take advantage of developing technology; to maintain or improve competitive position; to respond to emerging environmental or safety issues; to diversify the product range or geographical outreach; to attract new customers to the brand.
8.7 Linking investment in IS/IT with strategic, operational and control needs Until quite recently, most entities regarded their IT systems and their information systems as a resource that was necessary but not strategically significant. The IT department was treated like any other collection of overheads, and the information systems allowed to evolve rather than being formally planned. Many entities now realise that the information system is a strategic resource, and should be treated as such. This often includes having a formal strategy.
Exercise 8.2 Why should entities have a formal strategy for their information systems?
Solution The information system should have its own strategy, as part of the overall corporate strategy, for the following reasons: ● ● ●
the information system is an adaptive, open system; the entity exists in a dynamic environment; information needs are constantly changing;
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● ●
the entity relies upon the information system in order to construct its strategic plan; the information system requires significant investment over a long period; and the information system and information technology can help the entity achieve a competitive advantage.
8.7.1 Benefits of a formal strategy The major benefits of a formal information systems strategy are the following: ●
● ●
●
we can achieve goal congruence between the information systems objectives and the corporate objectives; the entity is more likely to be able to create and sustain a competitive advantage; the high level of expenditure on information systems will be more focused on supporting key aspects of the business; and developments in IT can be exploited at the most appropriate time (which is not always when they are first available).
8.7.2 IS, IT and IM strategy Some authors, including Earl, distinguish between three components (or levels) of strategy as follows: 1. IS strategy, which looks at the way in which the information systems in various parts of the entity are organised; 2. IT strategy, which looks at the technology infrastructure of the systems; and 3. IM strategy, which considers how the systems support management processes. In this chapter we use the term ‘information systems strategy’ to encompass all three of these components.
8.7.3 Content of information systems strategy It is unlikely that the information systems strategy will remain unchanged within an entity over any significant period of time. Strategies may need amending for various reasons including: ● ● ● ●
change in the overall objectives of the entity; development of new information technologies; update of existing hardware and software; change in the number of employees, resulting in existing systems not coping with new information requirements.
Whatever the reason for the change, it is important that some formal process is followed to ensure that the IS and business objectives remain in alignment. In the worst case scenario, the IT department may decide that some new technology is useful, and implement this. However, if it does not support the overall business objectives of the entity, then the business may not be able to operate successfully. A general strategy to follow when information systems require amendment is outlined below. Initially, the business strategy of the entity must be determined. Checking this strategy is essential, because the IT strategy must support this strategy and not drive it. Just because 2006.1
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new IT systems may be available does not mean that they have to be used in the entity. Also, new IT systems may not be compatible with other software or hardware used in the entity. Additional checks will be necessary to confirm compatibility. Within any entity, amending part of the information strategy may have an impact on other sections. For example, if information is suddenly provided in a different format, it may no longer be accessible by other divisions or branches. Amendments to the information strategy must be checked against the business plan and individual requirements of each part of the organisation. Having decided to amend the IS strategy in some way, a plan for developing and implementing the system will have to be developed. As well as setting out the plan in an appropriate manner alternative hardware and software as well as development methods may need to be considered. The choice will be between development in-house or outsourcing. A full cost–benefit analysis (CBA) may also be used now, or earlier in the change process, to check that the change will provide the necessary benefits to the organisation at an acceptable cost. Having determined the overall strategy for change, this can be implemented and systems amended. Checks may also be required to ensure that staff and customers are kept fully informed. Particularly where the change will result in some competitive advantage, advertising that the change has taken place will be essential. Finally, a review will be necessary to ensure that the initial objectives of the change have been met. If this is not the case, then further review may be required to determine why, and confirm what additional changes are actually required.
8.7.4 Cost-benefit analysis Traditional CBA tends to be focused on costs and benefits derived from the accounting system. With many of the costs and benefits of information being intangible, then this analysis may not form a suitable way of assessing the value of information. This section summarises the benefits and limitations of CBA, and these are given below: Which tangible costs to include in the CBA? The main issue is identifying which costs are actually attributable to producing the new information. Most entities have a network of some description, so distributing any additional information for a new system should not be a problem. However, increase in network traffic will result from the new information, along with growth in information transfer from other applications. When the network bandwidth needs upgrading, which specific project pays for this? How to measure intangible costs Many intangible costs arise from not having information available for a specific decision. For example, lack of information about competitors may result in incorrect decision making within the entity. The issue is how to measure the cost of not having all the information to make a decision. As the accounting system does not trap these costs, then they may be excluded from the CBA. Diminishing returns from benefits Some of the benefits of enhanced information systems can be seen in terms of the improvement in quality of information being provided. For example, if information is 2006.1
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How to measure intangible benefits Enhanced information may be provided by a new system, however, placing a value on how that information helps people make better decisions is more difficult. The benefits of having additional information may be measured in terms of improved customer service, competitive advantage gained, etc. Again, these items are not identified in the accounting system and it may be very difficult to place any value on them. The benefits from providing more or better information may also take a long time to accrue. Information systems have to be accepted by staff, and time will be taken for historical analysis to build up to any meaningful level. Traditional measures of CBA such as Payback or ROI may be inappropriate, because they provide too short a timeframe for assessing the benefits of information.
Exercise 8.3 List the main costs (one-off and continuing) of an information system implementation project, and the major benefits we might expect from it.
Solution One-off costs ● purchase of hardware and software; ● project team costs (feasibility, design, testing, etc.); ● production of documentation; ● training. Running costs ● staff salaries; ● overheads; ● training; ● maintenance; ● financing. Benefits ● better decision-making; ● fewer delays; ● better service to customers; ● competitive advantage; ● reduced staff levels. 2006.1
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provided in 2 seconds rather than 20 seconds, then the information is probably timelier. Placing some value on this benefit may be difficult, although it could be included in the CBA under a heading of ‘other benefits’ and a guess made as to the value. However, there will be significant diminishing returns to this provision, for example, providing information in 0.2 of a second rather than 2 seconds will attract a much smaller amount of benefit. Humans cannot necessarily react to information this quickly. There are limits to benefits from automation so the benefits of improving the quality of information should not be overstated.
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The most noticeable thing is that, with the exception of staff reductions (which hardly ever happen in real life), the benefits are difficult or impossible to quantify. This is the major problem that we must address if we are to provide a meaningful evaluation of information system performance.
8.7.5 Evaluating system performance Given the weaknesses of the decision-making techniques outlined above, how are we to assess the performance of an information system? There are three approaches we might take: 1. Ignore the benefits. If we choose to ignore those benefits or savings that are ‘too difficult’ to quantify, information systems will almost always appear to have negative cash-flow effects. This is obviously misleading, so this approach would be meaningless. 2. Quantify the benefits. We can attempt to take each of the benefits and turn it, by means of some educated guesswork and dubious assumptions, into a cash-flow stream. There are two problems with this approach: ● our colleagues will dispute our rationale and assumptions; ● it will be difficult, or impossible, to post-audit the system in order to prove that the claimed benefits have been realised. 3. Change the approach. Probably the best approach is to recognise and accept the qualitative nature of the benefits, and find some reasonable (but non-financial) way of assessing them. This might lead us to an evaluation such as the following given in Figure 8.1. The non-financial benefits could be assessed by means of an information audit. The issue then becomes determining appropriate ways to measure those benefits.
Figure 8.1
Systems performance evaluation
Exercise 8.4 Suggest measures for the following qualitative benefits of an information system: ● ●
customer service level; competitive advantage.
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●
●
Customer service level can be assessed by means of a questionnaire, asking customers to rate the service they receive on a scale, possibly with a set of specific criteria such as telephone responses, problem-solving, and flexibility. Competitive advantage could be assessed by measuring market share or cost reductions in production. The problem here is separating the effect of the information system from those of the other relevant factors.
8.8 Adjusting for risk A key aspect of investment appraisal is the determination of a discount rate, following consideration of project risk. Project risk arises when: ● ● ●
one of a range of outcomes may occur; each possible outcome has a known probability; probabilities are assessed by reference to past information about relative frequencies of outcome of repetitive phenomena (i.e. probabilities are objective). Uncertainty is a situation where:
● ● ●
range of outcomes is unknown, or probability of outcomes is unknown, or both.
In practice, the terms ‘risk’ and uncertainty are used interchangeably. Risk may be considered the case where the decision-maker is willing to act on probabilities, however determined. We set out below brief descriptions of procedures that can be used to help evaluate the role of projects.
8.8.1 Sensitivity analysis So far in this chapter it has been assumed that all the quantitative factors in the investment decision – the cash inflows and outflows, the discount rate and the life of the project – are known with certainty. In reality this is very rarely the case. Sensitivity analysis recognises this fact. The CIMA Official Terminology defines sensitivity analysis as: A modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome. Particular attention is thereafter paid to variables identified as being of special significance. As the definition indicates, sensitivity analysis can be applied to a variety of planning activities and not just to investment decisions. For example it can be used in conjunction with breakeven analysis to ascertain by how much a particular factor can change before the project ceases to make a profit. 2006.1
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Table 8.1
Variable
Adverse variation
Project life
– overestimated by 1 year 2 years – underestimated by 5% 10% – overestimated by 2% 5%
Cost of labour
Revenue volume
Revised NPV
% change in NPV
£50 (£550)
83% 192%
£300 (£150)
50% 125%
£150 (£650)
25% 208%
In sensitivity analysis a single input factor is changed at a time, while all other factors remain at their original estimates. There are two basic approaches: ●
●
An analysis can be made of all the key input factors to ascertain by how much each factor must change before the NPV reaches zero, the indifference point. Alternatively specific changes can be calculated, such as the sales decreasing by 5 per cent, in order to determine the effect on NPV. The latter approach might generate results such as those in Table 8.1, while the former approach is illustrated in the example that follows.
Exercise 8.5 The initial outlay for equipment is £100,000. It is estimated that this will generate sales of 10,000 units per annum for 4 years. The contribution per unit is expected to be £6 and the fixed costs are expected to be £26,000 per annum. The cost of capital is 5 per cent.
Requirements (i) Calculate the NPV. (ii) By how much can each factor change before the entity becomes indifferent to the project?
Solution (i) Contribution £6 10,000 Less: fixed costs Cash inflow per annum
Year 0 Years 1–4
Outlay Annual cash inflow
Cash flow £ (100,000) 34,000
£ 60,000 26,000 34,000 Discount rate 5% 1 3.546
(ii) NPV can fall by £20,564 before the indifference point is reached. 2006.1
NPV £ (100,000) 120,564 020,564
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X 3.546 £20,564 X £5,800 Therefore, the fixed costs can rise by £5,800 to £20,200 – this is a change of 22 per cent. The contribution can fall by £5,800 to £54,200 – this is a change of 9 per cent. This is the variation caused by price changes, volume changes and efficiency changes in costs. Without more detailed knowledge of the project, it can probably be safely assumed that the project is not sensitive to a change in fixed costs as a change of 22 per cent seems very unlikely. This project is not particularly sensitive to changes in any of the factors calculated. On the other hand, it is very difficult to predict future revenues of some projects and an error of 10 per cent may be expected. The contribution is made up of many factors (the individual variable costs and the selling price) and without more detailed knowledge it is not possible to comment further. Sensitivity analysis is very simple to carry out using a spreadsheet model and as a consequence has become very popular in recent years. Once the model has been built a single cell can be altered by trial and error to determine the change needed to make the NPV zero. As sensitivity analysis is carried out without the specification of the precise probability of a particular event occurring, it is easy to apply. Any outcome that appears critical as a result of the analysis can then be examined in more detail before a final decision is made. Its usefulness therefore lies in its role as an attention-directing technique as it directs attention to those factors that have the most significant impact on the outcome of the project. Armed with this knowledge management can take action to make sure that the events that are within their control stay within acceptable parameters. In the example in Table 8.1, wage rates may be critical. So management may seek to obtain a wage agreement that will limit rates of pay in the future so as to prevent the danger of even higher rates. In the example in Table 8.1, the life of the project and the revenue volume are likely to be outside the control of management. If, after sensitivity analysis, the decision-makers are still unsure about a particular factor, such as revenue volume, they may seek a full risk assessment based on a probability distribution for this particular factor and assess the resulting NPVs. It is important that the output from a sensitivity analysis is not misinterpreted. Sensitivity analysis looks at the change in one factor in isolation but in the real world it is likely that several factors would move together and so the actual outcome of the project might depend on the combined performance of several or all of the variables. Table 8.2 shows the probability of the occurrence of the ‘most likely’ figure for each of the factors given in Table 8.1. The figures in Table 8.2 indicate a high degree of confidence in the estimate of the project life while there is less confidence in the other two factors. If it is assumed that the outcomes Table 8.2
Variable Project life Cost of labour Revenue volume
Probability of ‘most likely’ outcome 0.9 0.7 0.5
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This means that the annual cash flows can change by
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of each of the variables are independent, the probability of all three most likely outcomes occurring together is obtained by the multiplication of the probabilities, that is: 0.9 0.7 0.5 0.315 This shows that there is a 32 per cent probability that the most likely NPV will occur.
8.8.2 Decision trees In appraisal situations where uncertainty can apply to more than one variable, and values of the variables can be interdependent, many different outcomes are possible. The decision tree is a useful tool for reviewing a multiplicity of choices and outcomes. Imagine the trunk of the tree as representing a project to be appraised, perhaps a new product to be added to a range, then the first branches (of which there may be two, three or more) may represent alternative predictions as to expected volume of revenue to each of which probabilities are assigned. Each revenue volume branch then creates secondary branches to represent contributions, to which again probabilities are assigned, and finally these branches create tertiary branches with allied probabilities to represent fixed costs. The probabilities of each branch sequence are then multiplied and the joint probabilities thus obtained are applied in turn to each sequential set of values to give a series of pay-offs or outcomes as shown in Figure 8.2. As can be seen from the diagram, we arrive at eight joint probabilities leading to eight outcomes arising from 2 2 2 branches, representing 2 sales volumes 2 contributions 2 fixed cost values. By relating the joint probabilities to the value figures we obtain the eight pay-offs which are added to give an overall predicted net contribution of £68,000. The pay-offs also show a range of net contributions from £24,000 positive to £18,000 negative, and by adding the joint probabilities, there is a 58 per cent chance of a positive outcome, 24 per cent of a breakeven and 18 per cent of a negative result.
8.8.3 Certainty equivalents Suppose that in testing the sensitivity assumptions regarding our variables we find that there is an evident risk of our cash inflows falling short of base case predictions, possibly
Figure 8.2
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Year 0 1 2 3
Base cash flow £ (10,000) 6,000 5,000 4,000
Discount factor 10% 1.000 0.909 0.826 0.751
Base PV £ (10,000) 5,454 4,130 1 3,004) 1 2,588.
Certainty equivalents % of base 80% 70% 60%
£ (10,000) 4,800 3,500 2,400
Present value £ (10,000) 4,363 2,891 1 1,802. 1 (944).
Clearly with the new inflows, what seems a satisfactory NPV for the project base case, has turned into a negative with certainty equivalents. A risk-averse management is likely to reject the project. The danger of using certainty equivalents lies in the high level of subjective judgement required from the decision-maker, while it could also be argued that risk-averse management might be better off using a high cut-off rate. Nevertheless certainty equivalents do represent a useful tool in the investment appraisal armoury, especially in assessing cases where an apparently small change in a key variable can interact with others to create significant falls in inflows, with a possible cumulative effect over the life of the project.
8.8.4 The discount rate In all the examples considered so far, a constant discount rate has been used, on the assumption that the cost of capital will remain the same over the life of the project. As the factors which influence the cost of capital, such as interest rates and inflation, can change considerably over a short period of time an organisation may wish to use different rates over the life of the project. NPV and discounted present value allow this but IRR and ARR present a uniform rate of return. Using NPV, for example, a different discount factor can be used for each year if so desired. Perhaps one of the major problems in using a discounted cash flow method is deciding on the correct discount rate to use. It is difficult enough in year 1 but deciding on the rate for, say, year 4 may be very difficult because of changes in the economy, etc. If a very low rate is chosen almost all projects will be accepted, whereas if a very high discount rate is chosen very few projects will be accepted. Looking back over the years it would appear that the majority of managers have probably used too high a discount rate and have, as a consequence, not invested in projects that would have helped their organisation to grow in relation to their competitors. There are no prizes for being too conservative; it is just as much a failing as being too optimistic. Porter (1992) and Baldwin and Clark (1994) have blamed this tendency on the perceived need for short-term share price appreciation. But it may be that Kaplan and Atkinson (1989) are closer to the mark when they suggest that it is because
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by, say, 20 per cent in the first year of a project. If we want a high degree of safety it seems prudent to assume that the following years, by being further in the future, will show still higher percentage falls from the base case. By applying safety factors of, say, 20, 30 and 40 per cent reductions of base net inflows we arrive at new figures called certainty equivalents for those years. Let us compare possible outcomes:
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discount rates are based on accounting rates and incorrectly include an inflationary element. If there is any doubt over the correct discount rate to use, sensitivity analysis can help.
8.8.5 Adjusted discount rate A further way of allowing for risk is to add a premium to the cut-off rate whereby more marginal projects would be less likely to have a positive NPV. A useful scheme is to have a risk category schedule providing say for four different risk gradings, ranging possibly from cut-off rate to cut-off plus 10 per cent, with cut-off itself probably being from 2 to 4 per cent above the risk-free rate (e.g. the rate obtainable on government securities). The difficulty with risk-adjusted rates lies mainly in the need for skilful management judgement as to the risk category, even though considerable product and market research may have been undertaken.
8.8.6 Capital asset pricing model The capital asset pricing model (CAPM) argues that total risk, as measured by standard deviation, can be split into two elements: the risk which can be reduced by diversification, known as specific risk, and the risk which will not be reduced by diversification, known as market risk. Market risk can be broken down further, as shown in Figure 8.3. The risk that can be removed through diversification – specific risk – is that risk which is specific to the individual investment. For example, if you had a single investment of ordinary shares in an entity which built houses, the specific risks would include particular planning applications, subsidence problems, non-payment by particular customers, etc. Market risk is associated with the economic environment in which all entities operate, so changes in interest rates, exchange rates, of prices, taxation, etc., affect all entities and their share prices to a greater or a lesser extent. Because investors can avoid specific risk through diversification, the CAPM would argue that the only risk worthy of consideration is market risk. This market risk is measured as beta. Business risk is the risk associated with the particular activities undertaken by the entity. Financial risk is the risk resulting from the existence of debt in the financing structure of the entity. Beta and the CAPM are covered in detail in Chapter 4 of this text, and you should revisit that chapter to be certain that you understand this important topic.
Figure 8.3 2006.1
Elements of total risk
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The following exercise brings together aspects from this and the previous chapter.
Exercise 8.6 You are required to report on investment opportunities, setting out necessary assumptions further to those stated in the question below and evaluating the two proposals. Part (b) of the question deals with the deeper analysis of factors other than the basic assumptions used for the calculations, including the opportunity cost of capital. The directors of ST Ltd are determined to increase the value of the entity’s equity. The entity has £250,000 available. It is also in a position to borrow a further £200,000 on a 5-year loan at an effective fixed rate of interest, after allowing for tax concessions, of 10 per cent per annum. Repayments of principal and interest will amount to £52,760 per annum. Investment opportunities available to the entity are as follows: (i) The assets of ZQ Limited might be acquired. These would generate cash flows, after allowing for the incidence of corporation tax, in addition to those which ST Ltd might gain otherwise. Details are given below. (ii) Shares in Q J plc could be purchased, when dividends would be received as franked investment income. The shares in Q J plc would be sold in 1996. ST Ltd does not trade with Q J plc nor would it be in a position to have direct influence on the policies of that entity. Cash flows would be as follows: Year
ZQ Limited £ (200,000) (50,000) 75,000 150,000 190,000 40,000
1991 1992 1993 1994 1995 1996 Year
Probability
1991
1.0 0.5 0.4 0.1 As 1992 As 1992 0.7 0.3 0.4 0.4 0.2
1992 1993 1994 1995 1996
Q J plc £ (190,000) 9,500 13,500 19,000
14,250 4,750 209,000 228,000 171,000
Requirements (a) Prepare a report advising the directors of ST Ltd whether the investment opportunities ought to be taken up. (b) Discuss what other factors should be taken into account. 2006.1
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Solution (a) Report To: The Board of ST Ltd From: Management accountant Date: Re: Investment opportunities You asked me to look at the ZQ and Q J projects, in the context of your determination to increase the value of the entity’s equity. In our subsequent telephone conversation, we agreed to make the following assumptions: ●
●
●
‘value’ in this context is the net present value of projected cash flows, discounted at the cost of capital; the cost of capital is assessed by the treasurer at the 10 per cent level in line with the cost of the incremental finance available; you see £450,000 as the maximum cash deficit which is sustainable without affecting the risk profile of the equity capital. Against that background, we should look at the proposals as follows: Year ZQ: 1991 1992 1993 1994 1995 1996
10% discount factor 0.909 0.826 0.751 0.683 0.621 0.564
Forecast cash flows £000 Absolute Discounted (200) (50) 75 150 190 40
(182) (41) 56 102 118 123 076
The positive net present value indicates that this is a viable project, and is within your cash limits. Year Q J: 1991 1992 1993 1994 1995 1996
10% discount factor 0.909 0.826 0.751 0.683 0.621 0.564
Forecast cash flows £000 Absolute Discounted (weighted average of expectations) (190) (173) 12 10 12 9 12 8 11 7 209 118 ((21)
The negative net present value indicates that this is not a viable project. (b) The assumptions attributed to the telephone conversation were necessary to be able to quantify the opportunities within the constraints of the information given. In practice, however, they would be the subject of considerable thought and elaboration. For instance: ● ● ●
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whether the financial objective should be expressed as a kind of cash limit; whether the marginal borrowing rate should be used as the cost of capital; there is a strong argument for saying that any amount of finance can be obtained if the project shows the prospect of an adequate return;
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●
●
increasing the apparently cheap source of finance will increase the risk associated with the equity, and thereby increase its cost. Gearing, according to many theorists, does not affect the cost of capital (other than via tax distortions), the primary factor being perceived risk; whether it is wise to assume that there will not be further projects becoming available, which are mutually exclusive with ones being considered. This may sound very judgemental, but then all decision-making is. It helps to think not in terms of the historical cost of capital, but the opportunity cost. Thus, without being specific as to the projects, the question is what rate of return is being forgone, which boils down to the market rate appropriate to the perceived risk; whether the management resources are available to manage the project. Often, this is the limiting factor, rather than finance as such.
8.10 Adjusted present value Adjusted present value is covered in detail in Chapter 4 and is revisited in Chapter 9. You should revisit Chapter 4 to be certain that you understand this important topic. The opportunity cost of capital is frequently used as the discount rate in investment decisions. This is not always entirely correct; the rate to be used in the investment decisions should, in theory, be a specific risk-adjusted discount rate which reflects the business risk of the project. This adjusted rate is the basis of the concept of adjusted present value (APV) which suggests that the net present value (NPV) of a project can be increased or decreased by the side-effects of financing. In using APV you proceed by taking NPV as a first stage (‘base case NPV’), evaluating a project as if it was totally financed by equity, and then introduce APV as a second stage by making adjustments to the base case to allow for the side-effects of the intended method of financing. A simple example will serve to illustrate the basic idea. Example 8.E A project has a net present value of £50m (the ‘base-case’ NPV). However, as the project is considered socially desirable it qualifies for an immediate tax-free government grant of £10m. This is a special financing arrangement and hence needs to be taken into account: APV NPV side effect of financing £50m £10m £30m More complicated examples could be found, for example, to show how the tax benefits of debt interest might increase the base case NPV of a project. The issue costs would of course have the effect of decreasing base case NPV.
Note that the calculation of APV usually takes the form of first calculating NPV as if the project financing was all by equity, and then incorporating adjustments to allow for the effects of the financing method to be actually used. Bear in mind that difficulties in using APV may arise either in determining the costs involved in the financing method to be used, or in finding a suitable cost of equity for the basic NPV calculation. Nevertheless, APV often has the advantage of being a more positive approach than making an arbitrary adjustment of the entity’s cut-off rate. The APV approach also suggests that an adjusted cost of capital can be calculated to use as a discount rate in specific circumstances. A further example of APV follows. 2006.1
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Example 8.F A project requires £1 million capital investment. The project will save £220,000 per year after taxes. Assume the savings are in perpetuity. The business risk of the venture requires a 20 per cent discount rate. In this case the project’s base case NPV is just positive: Base-case NPV (1,000,000)
220,000 £100,000 0.2
However, assume that this project has one financial side-effect: it expands the firm’s borrowing power by £400,000. The project lasts indefinitely so we treat it as supporting perpetual (i.e. undated) debt. If we assume that the borrowing rate is 14 per cent and the net tax shield is 35 per cent, the project supports debt which generates an interest tax shield of 0.35 0.14 £400,000, which is £19,600 per annum for ever. The PV of the tax shield is: £19,600 £140,000 0.14 The project’s APV is therefore: APV base case NPV PV shield £100,000 £140,000 £240,000.
Adjusted discount rate The adjusted discount rate, or adjusted cost of capital, is the rate at which APV 0, that is, the IRR. To calculate the adjusted discount rate we must first calculate the minimum acceptable annual income, that is, the income that would result in an APV of zero. APV Base case NPV PV tax shield Initial investment (Annual income/Base case discount rate) PV tax shield £1m (Annual income/0.2) £140,000 Assuming APV 0, we can rearrange the equation to give: Min. annual income 0.2 (£1m £140,000) £172,000 The minimum IRR is therefore: IRR Minimum annual income/Initial Investment (gross) £172,000/£1m 0.172 or 17.2% This is the adjusted cost of capital – denoted r *. To calculate r * we find the minimum acceptable rate of return – the IRR at which APV 0. The rule is, accept projects which have a positive NPV at the adjusted cost of capital. You should clearly understand the two concepts of cost of capital. Opportunity cost of capital, r, is ‘the expected rate of return offered in capital markets by equivalent-risk assets’, depending on the risk of project cash flows. Use r where there are no significant side-effects from financing. Adjusted cost of capital, r *, is an opportunity cost rate which also reflects the financing sideeffects of an investment project. If these are significant, use r * and accept projects having positive APVs (adjusted present values). 2006.1
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Option-pricing theory is not part of the syllabus, but it is useful to consider the option-like features found in investment decisions. When a project is slipping behind forecast managers can take action in an attempt to achieve the original NPV target. In other words, they can create options, or take action to mitigate losses or exploit new opportunities presented by capital investments. Before discussing investment decisions as options on future cash flows, it may be useful to identity the meaning of call and put options: ●
●
a call option is an option to buy a specified asset at a specified exercise price on or before a specified exercise date; a put option is an option to sell a specified asset at a specified exercise price on or before a specified exercise date.
The net present value approach to investment appraisal makes two assumptions that may be questioned: ● ●
a project is reversible; a project cannot be delayed.
The assumption that a project is reversible implies that if the project does not work out, the original investment can be recovered and applied to a new project. This is flawed, as in most significant projects the original investment will either be wholly or partly irreversible. In some instances it may not be possible to delay an investment decision, but in the majority of cases a delay is possible – although there may be costs associated with delay. If a project is irreversible to some degree, the ability to delay the investment decision in order to obtain new information is valuable. The additional costs associated with delay should be assessed against the benefits associated with that new information. Investment projects can be related to financial call options, in that the project provides the right, but not the obligation, to purchase an asset (or commit to a series of cash flows) in the future. When an irreversible investment decision is made, the call option becomes exercised. The opportunity to delay an investment and keep the option alive has a value, which is not normally reflected in a net present value calculation. The real options approach suggests that decisions that increase flexibility by creating and preserving options should be pursued. Decisions that reduce flexibility by exercising options and irreversibly committing resources should be valued at a lower figure than conventional net present value would suggest. In the context of investment decisions there are three options to be considered: 1. The abandonment option (financial put option). 2. Timing options (financial call option). 3. Strategic investment options (financial call option).
8.11.1 The abandonment option Major investment decisions involve heavy capital commitments and are largely irreversible: once the initial capital expenditure is incurred, management cannot turn the clock back and act differently. Because management is committing large sums of money in pursuit of higher, but uncertain, payoffs, the ability to abandon, or ‘bail out’, should things look grim, can be valuable. 2006.1
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8.11 Assessing investments as options on future cash flows
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Example 8.G Cardiff Components Ltd is considering building a new plant to produce components for the nuclear defence industry. Proposal A is to build a custom-designed plant using the latest technology, but applicable only to nuclear defence contracts. A less profitable scheme, B, is to build a plant using standard machine tools, giving greater flexibility in application. The outcome of a general election to be held one year hence has a major impact on the decision. If the current government is returned to office, their commitment to nuclear defence is likely to give rise to new orders, making proposal A the better choice. If, however, the current opposition party is elected, its commitment to run down the nuclear defence industry would make proposal B the better course of action. Proposal B has, in effect, a put option attached to it, giving the flexibility to abandon the proposed operation in favour of some other activity. (adapted from Pike and Neale)
Example 8.H Case I A project, P, has expected cash flows as shown in Table 8.3. Table 8.3 Year 0 1 2 3
Expected cash flow £ (3,500) 2,000 2,000 2,000
Discount rate 10% 1.000 0.909 0.826 0.751 Expected net present value
Discounted cash flow £ (3,500) 1,818 1,653 1,503 1,474
The initial investment of £3,500 in project P represents the purchase of a customised machine, the price of which is known with certainty. Because it is a customised machine its resale value is low; it can only be sold for £1,000 immediately after purchase. Once the machine is bought, therefore, the expected value of abandoning the project would be £1,000 (1.0 £1,000). This must be compared with the expected value of continuing with the project, which is £4,974 (£1,818 £1,653 £1,503). In this case the expected benefits of continuing with the project far outweigh the returns from abandoning it immediately. Case II The decision to abandon a project will usually be made as a result of revised expectations of future revenues and costs. These revisions may be consistent with the data on which the original investment decision was based, or represent an alteration to earlier expectations. If the decision is consistent with the original data, the possibility, but not the certainty, that the project might have to be abandoned would have been known when the project was accepted. In these circumstances, project abandonment is one of a known range of possible outcomes arising from accepting the project. The cash flows in Table 8.3 were the expected ones, based on the probabilities given in Table 8.4. Table 8.4 Year 0 £ (3,500)
Expected value
Year 1 p 0.33 0.33 0.33
£ 3,000 2,000 1,000 2,000
Year 2 p 0.33 0.33 0.33
£ 3,000 2,000 1,000 2,000
Year 3 p 0.33 0.33 0.33
£ 3,000 2,000 1,000 2,000
In Year 0, the expected net cash inflow in each year of project P’s 3-year life is £2,000. The actual outcome of any of the 3 years is unknown at this point, and each of the three possible outcomes is equally likely. The factors that will cause any one of these results to occur may differ each year, or they may be the same each year. In some instances, a particular outcome in the first year may determine the outcome of years 2 and 3 with certainty. For example, the outcome of £3,000 in year 1 may mean that this same outcome will follow with certainty in years 2 and 3. Similarly outcomes of £2,000 and £1,000 in year 1 may be certain to be repeated in years 2 and 3. In year 0, the investor can only calculate the expected net cash flow in years 2 and 3, but with perfect correlation of flows between years these future flows are known with certainty at the end of year 1. If the year 1 inflow is either £3,000 or £2,000, perfect correlation between years will ensure that the actual NPV of the project will be positive. But if the first year’s outcome is £1,000, the investment will have a negative NPV of £1,014, that is (£[3,500] £1,000 2.486). Should the project be abandoned? The information is now certain and so the decision on whether to abandon should be made using 2006.1
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Year 0 1 2
Cash flow £ (1,000) 1,000 1,000
Discount rate 5% 1.000 0.952 0.907
Discounted cash flow £ (1,000) 952 1,907 0 859
Clearly, the project should not be abandoned. Case III Suppose a buy-back clause had been part of the sale agreement for the machine, which requires the supplier to repurchase the machine on demand for £2,000 at any time up to and including the first anniversary of the sale. The abandonment value of the project at the end of year 1 will be £2,000. When this is compared with the £1,859 present value of continuation, it is clear that the entity should plan to terminate the project at the end of year 1, if the actual outcome of that year proves to be £1,000. When the buy-back option is included, the possible outcomes will change as shown in Table 8.5. Table 8.5 Year 0 £
Year 1 p
(3,500)
0.33 0.33 0.33
Expected value
Year 2 £
3,000 2,000 1,000 2,000 2,667
Year 3
p
£
p
£
0.33 0.33 0.33
3,000 2,000 0
0.33 0.33 0.33
3,000 2,000 0
1,667
1,667
Including abandonment in the plan increases the expected NPV of the project by £80: Year 0 1 2 3
Cash flow £ (3,500) 2,667 1,667 1,667
Discount rate 10% 1.000 0.909 0.826 0.751
Discounted cash flow £ (3,500) 2,424 1,378 1,252 1,554
This type of problem can be analysed using a decision tree. Figure 8.4 sets out the data in this format.
Figure 8.4 Decision tree for the cash flows in Table 8.5 2006.1
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a risk-free interest rate and not the company’s normal cost of capital. If we assume that the risk-free rate is 5 per cent, the present value of continuing at the end of year 1 will be:
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STUDY MATERIAL P9 The method outlined above can be utilised even where the correlation of cash flows between years is less than perfect. The correlation can range from perfectly positive (as in our example) to perfectly negative. Where the correlation is zero, that is total independence of cash flows between years, the method cannot be used. But in all other instances the knowledge gained in Year 1 will enable the forecast for later years to be refined to a greater or lesser extent. This in turn will allow the expected present value of continuing with the project to be compared with the present value of termination. Case IV During a project’s life, events that were unforeseen at the time of the original decision may occur and have an impact on the expected cash flows of the project. Such events will require a revision of future predictions. In the previous example, the announcement of a new tax charged on revenues during the course of year 1 would necessitate a review of the project’s profitability. If the effect of the new tax would be to reduce the project’s revenues after year 1 by 50 per cent, the position would be as shown in Table 8.6. Table 8.6 Year 0 £ (3,500)
Expected value
Year 1
Year 2
Year 3
p
£
p
£
p
£
0.33 0.33 0.33
3,000 2,000 1,000 2,000
0.33 0.33 0.33
1,500 1,000 500 1,000
0.33 0.33 0.33
1,500 1,000 500 1,000
The introduction of the new tax means that a cash flow of £2,000 in year 1 will now be followed by only £1,000 in years 2 and 3. This will mean that the project should be abandoned in year 1. At the time the project was being considered, this situation was not, and could not have been, foreseen by the decision-maker. Under these circumstances, it would be surprising if there was any resistance to the idea of terminating the project, as external events, for which no one could be held responsible, had made it necessary. But when a revision in future expectations arising from errors in the original forecasts, or due to problems in project implementation, indicate that abandonment is necessary, it can be much more difficult to acknowledge and accept. The post-completion audit team will play a significant role in identifying and highlighting the changed circumstances in such situations.
Example 8.I Project X had the following expected cash-flow pattern at the time of its approval: Year 1 2 3 4 Net present value
Discounted cash flow £m (8) (16) (24) 55 07
The entity experienced great difficulty in implementing the project in year 1, and the actual costs incurred during that year were £16m. The company must then ask itself whether the actual outcome in year 1 necessitates any revision in the expected outcomes of later years. If no revision is required, further costs of £40m (year 0 values) must be incurred to secure inflows of £55m (year 0 values). The expected net present value of continuing with project X beyond year 1 will thus be £15m (year 0 values). (Note that adjusting the figures to Year 1 values would increase the expected NPV slightly, strengthening the case for continuation.) The overall result of the investment would, of course, be negative by £1m, if years 2–4 costs and revenues are as forecast. The excess spend of £8m in year 1 is greater than the £7m net present value originally predicted. However, at the end of year 1 the £16m is a sunk cost and does not influence a decision on termination made at that time.
8.11.2 Timing options Example 8.G not only introduced the concept of abandonment, it also raises the possibility of a ‘wait and see’ policy. Management may have viewed the investment as a ‘now or never’ opportunity, arguing that in highly competitive markets there is no scope for delay: money is made by 2006.1
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8.11.3 Strategic investment options Certain investment decisions give rise to follow-on opportunities which are wealth-creating. New technology investment, involving large-scale research and development, is particularly difficult to evaluate. Managers refer to the high level of intangible benefits associated with such decisions. What they really mean is that these investments offer further investment opportunities (e.g. greater flexibility).
8.11.4 Valuing options The Black–Scholes option valuation model identifies five elements that together determine the premium payable on a call option for a share. These are: ● ● ● ● ●
the current market price of a share; the exercise price, or strike price, of the option; the time to expiry of the option; the variability of the share price over a period of time measured by the variance; the risk free rate of interest.
The five factors used in the Black–Scholes formula can be related to a call option on an investment appraisal to give the following elements: ● ● ●
● ●
present value of the future cash flows from the investment; initial outlay on the investment; time until the investment opportunity disappears, that is, the length of time that an investment decision can be deferred without losing the opportunity to invest; variability of project returns; risk-free rate of interest.
Pricing an option using values for these factors will arguably provide more information about the value of a project than using net present value. However, quantifying these factors objectively is not straightforward.
8.12 Project implementation and control 8.12.1 The investment cycle The financial evaluation of projects is only one part of the investment process. The full process is represented in Figure 8.5. This shows that the investment process is a cycle, rather than a single discrete event. 2006.1
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staying ahead of the competition. In effect, this amounts to viewing the decision as a call option which is about to expire on the new plant for the capital investment outlay. If a positive NPV is expected, the option will be exercised, otherwise the option lapses and no investment is made. The option to defer the decision by, say, 1 year until the outcome of the general election is known, makes obvious sense. An immediate investment would yield either a negative NPV – in which case it would not be taken up – or a positive NPV. Delaying the decision by a year to gain valuable new information is a more valuable option. This helps us to understand why management sometimes does not take up apparently wealth-creating opportunities: the option to wait and gather new information is sufficiently valuable to warrant such delay.
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Figure 8.5
The investment cycle
The cycle from concept through development, construction, manufacturing, operation and disposal can also be represented as follows: ●
●
●
●
●
●
Gather information – collect historical costs – gather external information – assess opportunity costs – consider strategic direction Make predictions – determine costs of project e.g. purchase and installation – evaluate the expected hard and soft benefits of the new system Accept project – compare predicted costs with benefits over a period of years, that is, investment appraisal – consider all other aspects of decision Implementation decision – prepare plan for implementation – carry out implementation Evaluate performance – monitor events by collecting regular statistics – carry out a post-completion appraisal Use knowledge gained – assess findings of post-completion appraisal – implement improvements to system
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8.12.2 Post-completion auditing A post-completion audit (PCA) can be defined as ‘an objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project’. The main purposes may be summarized as: ● ● ●
project control; improving the investment system; assisting the assessment of performance of future projects.
A project’s PCA provides the mechanism whereby experience of past projects can be fed into the entity’s decision-making processes as an aid to the improvement of future projects. Anecdotal evidence also suggests that the growing interest in PCA has arisen from a realisation that past investments have frequently failed to live up to expectations, and firms are keen to avoid repetition of the same mistakes.
8.12.3 Benefits of post-completion auditing Six potential benefits from the operation of a post-auditing system have been identified, and these are listed below in the order in which they appear in Management Accounting Guide 9: Post Completion Auditing (CIMA, 1993): 1. It improves the quality of decision-making, by providing a mechanism whereby past experience can be made readily available to decision-makers. 2. It encourages greater realism in project appraisal, by providing a mechanism whereby past inaccuracies in forecasts are made public. 3. It provides a means of improving control mechanisms, by formally highlighting areas where weaknesses have caused problems. 4. It enables speedy modification of under-performing/over-performing projects, by identifying the reasons for the under- or over-performance. 5. It increases the frequency of project termination for ‘bad projects’. 6. It highlights reasons for successful projects, which may be important in achieving greater benefits from future projects. Mills and Kennedy reclassified these benefits into three types: ●
● ●
Type (a) – those which relate to the performance of the current project, i.e. the project under review. Type (b) – those which relate to the investment system itself. Type (c) – those which relate to the choice and performance of future projects.
Using this subdivision, the benefits listed in the Guide are grouped under the three categories, as follows: Type (a) (b) (c)
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– publicise findings for future benefits – adjust or terminate project.
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The authors reported that all the surveyed entities that had an operational PCA system at the time of their research gained type (b) benefits from their system, and almost 40 per cent sought type (c) benefits. Only 20 per cent of the entities sought type (a) benefits, which may be considered surprising. However, it is pointed out that control of the current project during its life may be effectively gained through other procedures, such as routine project monitoring.
8.12.4 Organisation of PCA PCA does not adopt a narrow accounting focus. A good PCA report does not set out to identify the costs and benefits of a project in precise detail (as pointed out above, this particular task will normally have been carried out as part of a routine project-monitoring system), but rather seeks to identify general lessons to be learned from a project. It is not a policing exercise, and, if it is to be effective, should not be seen as such. PCA will nevertheless encourage honesty in facing problems at all levels of the organisation, as attempts to ignore or hide realities are unlikely to remain uncovered. The task is often carried out by small teams, typically consisting of an accountant and an engineer who have had some involvement in the project. Surprising though it may seem, it is not common to find PCA as the responsibility of the internal audit section. A post-audit reviews all aspects of a completed project, to assess whether it lived up to initial expectations in terms of revenues and costs, and analyses the causes of deviations from planned results. Its main purpose is to enable the experiences – good or bad – gained during the life of one project to be made available for the benefit of future projects. The role of post-audit is thus essentially a forward-looking one; it seeks to establish lessons from the past for the future benefit of the organisation. The formal mechanism for transmitting the information to management is the final post-audit report, which provides a history of the project from inception to completion. In the case of successful ventures, the reports will distinguish between projects which have a good outcome due to effective planning and management, and projects whose good outcome is the result of luck; in the case of unsuccessful ventures, the causes will be fully disclosed. It is at the planning stage that project control is most important and effective, and past experience provides an invaluable input into the process.
8.12.5 Role of post-appraisal in project abandonment Those intimately involved with a project may be reluctant to admit, even to themselves, that early problems with a project are likely to continue. When problems are being experienced in project implementation, those involved may be tempted to try to resolve the situation in one of two ways. They can make a change in the original plans and/or incur further expenditure in order to meet the original objective. Whether either of these responses is appropriate will depend on the particular circumstances of the project but any significant changes or deviations should not be undertaken without the formal approval of higher management. The control systems in place will normally require changes of scope to be documented and approved before they are undertaken. It is usually the responsibility of the engineers associated with the 2006.1
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8.13 Summary The discounting of cash flows is most relevant to the work of the financial manager. Specifically, it is how the imposed discipline of the capital market is translated into a criterion for the making and monitoring of decisions. Expansion opportunities, for instance, almost always involve an outlay now for a return in later periods. To see whether a particular proposal is viable, its projected cash flows can be discounted back to a present value. If the net result is positive, the proposal is seen to be financially worth while, that is, to augment the value of the enterprise. If, on the other hand, it is negative, it is seen as not being financially worthwhile, that is, as detracting from the value of the enterprise. Identifying the cost of capital is a vital component of financial management at the strategic level, and hence to the financial health of the entity. For its application, you must understand the interrelationship of cash flows, interest rates, growth and inflation, and the ways in which these come together in using discounted cash-flow techniques for investment appraisal. You must take particular care not to confuse real rates and nominal rates. The computer and spreadsheet are of great importance in using those measures of risk which involve the interaction of several variables, such as sensitivity analysis. Indeed, the asking of ‘what if ?’ questions in evaluating a project has been made enormously more effective by computer power. The decision tree represents a form of probability estimating which can often be of especial value in that it forces the decision-maker to think clearly through a sequence of events triggered by an initial action, e.g. initiating a capital expenditure project, before arriving at a final outcome (an overall NPV) built up from the separate outcomes of all the possible alternatives contained in the tree. You should be able to calculate certainty equivalents, especially where the high risk of a project makes it desirable to know how far net cash flows can change adversely before the project outcome becomes negative. 2006.1
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project to ensure that this is done. Expected project cost overruns should be highlighted by the routine monitoring of project expenditure by accounting staff, and formal approval should be obtained for the anticipated overspend. A prerequisite of approval by top management will often be the provision of the same level of detailed justification as was required when the initial funds were sanctioned. These controls ensure that significant changes to the character of a project cannot be made without top management’s approval. However, they do not, of themselves, ensure that the option to terminate a project is considered, although it would be unlikely that management would fail to consider this possibility. Some entities require an audit to be carried out on all projects that need additional funds. The request for further funding would then be considered alongside the audit report. Routine monitoring of projects tends to focus almost exclusively on costs. An audit will review both costs and revenues, and, most importantly, focuses on the future. By checking the continuing validity of both forecast costs and revenues, the postaudit team is in a position to prepare a report to advise management on the wisdom of continuing with the project.
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The approach to evaluating and reporting on investment opportunities is an important aspect of Financial Strategy. We also consider assessing investments as options on future cash flows, while the section on post-completion auditing makes clear the benefits of learning from the experience gained by keeping careful records of previous project implementations.
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Readings
Assessing investments as options on future cash flows
The two articles in this section consider approaches to investment decisions that use ideas developed for financial and commodity options. The use of real options allows managers to take into account intangible factors such as strategic issues. The method, therefore, provides a complementary approach to traditional DCF analysis, which is predominantly quantitative.
Keeping all options open The Economist, 14 August 1999 © The Economist Newspaper Limited, London 1999. Reprinted with permission.
‘Those who can, do; those who cannot, teach.’ Many a manager has at times been tempted to borrow this aphorism to put woolly professors in their place. Company bosses find it especially hard to resist grumbling about academic other-worldliness whenever they are deciding where to invest their shareholders’ money. To evaluate potential projects, they almost invariably have to resort to a theory of corporate finance called the ‘Capital Asset Pricing Model’ (CAPM). Yet real-life managers tend not to like this model, for the simple reason that it ignores the value of real-life managers. So they might welcome some recent academic work. In the ivory tower, they are talking about ditching the CAPM for a rival, called ‘real-options theory’, that places managers at its very core. To see why bosses are likely to prefer this new approach, consider what is wrong with the traditional model. The CAPM involves forecasting all the cash flows of an investment project and discounting them to their net present value (NPV). Getting the cash-flow projections right (or even close) is staggeringly difficult. But it is even trickier to choose the correct discount rate. Conceptually, that rate is the opportunity cost of not investing in another project of similar systematic risk (i.e. risk that, in a large portfolio, cannot be diversified away). So the higher a project’s risk, the higher its discount rate and the lower its NPV. But in practice, setting discount rates at the right level is almost impossible. The CAPM often spits out negative NPVs for many of the most exciting strategic opportunities. The main reason for this shortcoming is that the model can use only information that is already known. That is typically not much, and the resulting uncertainty tends to be reflected in an excessive discount rate. Combining an NPV calculation with decision trees (which assign numerical probabilities to various possible outcomes) may help, but not much. For each branch of the tree, the analyst still has to pick and apply an appropriate discount rate, and that of course was the problem in the first place. More fundamentally, the flaw in the CAPM is 355
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that it implicitly assumes that when firms buy new assets, they hold these passively for the life of the project. But they do not. Instead, they employ managers precisely in order to react to events as they unfold. Obviously, this managerial flexibility must be worth something. Getting real
To quantify exactly how much it is worth is the point of real-options analysis. It starts by recognising that most investment opportunities have embedded in them a series of managerial options. Take, for instance, an imaginary oil company. Its bosses believe that they have found an oil field, but they know neither how much oil it contains nor what the price of oil will be once they are ready to pump. So, as a first step they could simply put enough money down to buy or lease the land and explore. If they do not find oil, they can cap their outlays at the costs already sunk. If they do strike oil, however, they might invest a bit more and put the drilling gear in place. But suppose the oil price then plummets. Management could put the project on hold and let its field lie fallow. Perhaps it could also switch to producing gas instead of oil. Or it could drop the project and sell the land. If, on the other hand, the oil price goes up, the firm is ready to pump. Since oil prices and other factors are uncertain, in other words, the mere option to produce has value. The logic is similar in other industries. Pharmaceutical companies, for instance, are in the business of searching for new pills, but never know which ones will work. So they may start researching a number of drugs, in the hope of striking lucky with just a few. By contrast, if they stuck strictly to the CAPM in making their investment decisions, they would almost certainly turn down most of these projects, since the uncertainty surrounding them would require such high discount rates. Poker provides a good analogy. If players had to place their final bets right as the first hand is dealt (as the CAPM requires them to), most would (reasonably) opt out quickly. Instead, they merely put down a small initial stake to stay in the game. Depending on the next card, they then pass, match or raise, and so on. Options on ‘real’ assets (and indeed poker bets) behave rather like options on financial assets ( puts and calls on shares or currencies, say). The similarities are such that they can, at least in theory, be valued according to the same methodology. In the case of the oil company, for instance, the cost of land corresponds to the premium (or down-payment) on a call option, and the extra investment needed to start production to its strike price (at which the option is exercised). As with financial options, the longer the option lasts before it expires and the more volatile the price of the underlying asset – in this case, oil – the more the option is worth. This is in sharp contrast to the CAPM, which deals harshly with both long time horizons and uncertainty. There is a snag, of course: sheer complexity. Pricing financial options is daunting, but valuing real options is harder still. Their term, unlike that of financial options, is usually open-ended or undefinable. The volatility of the underlying asset can be difficult to measure or guess, especially since it is not always clear what it is – if, for example, it is yet to be invented. How can one define the appropriate benchmark asset-class in the case of a new drug for a rare disease? And there may be additional variables to consider, such as the strategic benefit of pre-empting a rival. So will real-options analysis replace the CAPM? Archie Pitts, a professor of finance at Warwick Business School, says that this would be likely only if all managers had doctorates in applied mathematics. He conducted a survey of Britain’s 100 largest companies and discovered that the finance directors of only four of them had heard of the term. They might do well to start paying attention, if only to keep the academics in their place. 2006.1
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Roger Peskett, Management Accounting, November 1999. Reprinted with permission.
Real options
J. S. Busby and C. G. C. Pitts (Assessing Flexibility in Capital Investment, CIMA Publishing, 1998) use the term ‘real options’ for ‘situations of flexibility in irreversible investments in real assets, such as factories and production lines’. The flexibility provided by real options in investments appears in many guises. Busby and Pitts identify the following types: ● ● ● ●
●
Timing : options to embark on an investment, to defer it or abandon it; Scale: options to expand or contract an investment; Staging: the option to undertake an investment in stages; Growth : options to make investments now that may lead to greater opportunities later, sometimes called ‘toe-in-the-door’ options; Switching: options to switch inputs or outputs in a production process.
Beyond DCF
Discounted cash flow (DCF) techniques see if a project is worth undertaking by calculating the net present value of the future cash flows generated. The DCF approach to a firm’s investment decisions could be likened to assessing projects as if they were investments held in a portfolio – if the Capital Asset Pricing Model (CAPM) was used to determine the discount rate (on the assumption that market risk has been diversified away). Investors’ decisions to buy, hold or sell financial assets are based on monitoring investment performance. If one of their investments is not performing, they would probably sell the asset. Similarly, managers could take action to help boost a project’s NPV if it falls behind forecast. They can create and take advantage of options in managing projects. Choosing to create choices
Conventional DCF analysis looks at whether a project is going to add value for shareholders. In practice, managers of a business are unlikely to consider net present values of projects alone. Investing in a particular project might lead to other investment opportunities that may have been ignored in a DCF analysis. If a manager ignores these and chooses between projects on grounds of NPV alone, the manager may be turning away from options to undertake ‘follow-on’ investments that have a value to the business. A follow-on investment could involve a change in the scale of operation (scale option). Case 1
Suppose that a brewing company with a mineral water source in its brewery is considering buying adjacent land on which to build a water-bottling plant. It prefers to buy more land and build a bigger factory than is needed for the plant it initially plans to install, in case future demand outstrips supply of the new product. It is investing in excess capacity because it sees value in the scale option. Planning a project so that it can be implemented in a number of phases over time may add costs, and scale economies may be less than if it were not phased. The benefit of phasing is that, as each phase is completed, there is the option of going no further (staging option). 2006.1
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Beyond DCF
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The added costs of phasing the project plus any forgone economies are the counterpart to the ‘premium’ paid for a financial or commodity option. We should choose to phase the project if the benefits of having the option to drop later stages exceed this premium. Case 2
For example, a new railway might be built in parts. Information on demand for earlier phases of the railway line, once they are operating, will help to establish whether the option to build later phases should be taken up. Undertaking a first loss-making project in a new area – for example, a new technology or a new market – can create an opportunity to undertake other projects later (growth option). Many Western companies set up operations in China during the 1990s. Although these operations have often made losses, they have provided the companies with entry into a potentially huge market in that country in the future. The loss made by the ‘toe-in-the-door’ project, or the negative NPV in DCF terms, can be seen as the option premium. Switching options can be illustrated by the choice of a plant that uses different fuels. Case 3
Even if gas is now relatively a much cheaper fuel than oil for a company’s production process, volatility in the relative prices of oil and gas may make dual-fuel oil/gas equipment an attractive investment even if it costs more than a single-fuel system. The company is buying the flexibility to switch between fuels as relative prices change. Options to delay and abandon
The option to ‘wait and see’ in the expectation of gaining further information before making a decision is common in investment decisions. Does this timing option provide the financial manager with a justification for indefinite procrastination? No, because only ‘wait and see’ options that have a positive value should be selected. It is unusual for investments to be ‘now-or-never’ opportunities. Often, there is a time period over which a project can be postponed corresponding to the period of time during which the option to invest can be exercised. Even if DCF analysis indicates a positive NPV, there may be a value in delaying before embarking on a project to allow time for new information to come to light. Weighing against the value of waiting (equivalent to a call option), we need to consider any cash inflows forgone during the period of postponement. Once a project has been started, having an option to abandon it (equivalent to a put option) can be of great value if the benefits of the project are highly uncertain. A break clause in a lease would be an example. Valuing real options
Valuing real options might seem like a tricky task. An approach cited by Busby and Pitts involves replicating the option by a combination of traded assets such as commodities, shares and government bonds whose value closely matches that of the option. This is rather like estimating the value of a house by looking at the prices at which similar houses have recently traded.
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●
● ● ●
the present value of the future benefit streams of the follow-on project (counterpart to the current value of the share); the initial cost of the follow-on project (counterpart to the exercise price); the time within which the option must be exercised; the variability of expected project returns (counterpart to variability of the share price).
Iterative methods, using a computer program to work by trial and error towards the answer, are used to value options. Will quantitative valuation methods actually be encountered in the exam or in practice? In an exam – no, such complex calculations are beyond the syllabus. In practice – financial decision-makers are currently unlikely to go very far down the road of putting figures to the value of real options. However, option-like decisions are often made in business, even if managers are only now beginning to talk of them as ‘real options’. A qualitative appreciation of the various aspects of option-like situations, supplemented by some broad-brush estimates of the quantitative value of options, could help to elucidate many investment decisions.
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The various factors contributing to the value of a real option can be compared with the determinants of the value of a share option. For a follow-on investment, for example, the factors will include:
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Revision Questions
Question 1 (a) Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal (or ‘money terms’) approach to the evaluation of an investment project under inflation. (4 marks) (b) Howden plc is contemplating investment in an additional production line to produce its range of compact discs. A market research study undertaken by consultants has revealed scope to sell an additional output of 400,000 units p.a. The study cost £0.1m, but the account has not yet been settled. The price and cost structure of a typical disc (net of royalties), is as follows: £ Price per unit Costs per unit of output Material cost per unit Direct labour cost per unit Variable overhead cost per unit Fixed overhead cost per unit
£ 12.00
1.50 0.50 0.50 1.50 (4.00) 08.00
Profit
The fixed overhead represents an apportionment of central administrative and marketing costs. These are expected to rise in total by £500,000 p.a. as a result of undertaking this project. The production line is expected to operate for five years and require a total cash outlay of £11m, including £0.5m of materials inventory. The equipment will have a residual value of £2m. Because the company is moving towards a JIT inventory management policy, it is expected to decline at about 3 per cent p.a. by volume. The production line will be accommodated in a presently empty building for which an offer of £2m has recently been received from another entity. If the building is retained, it is expected that property price inflation will increase its value to £3m after 5 years. While the precise rates of price and cost inflation are uncertain, economists in Howden’s corporate planning department make the following forecasts for the average annual rates of inflation relevant to the project: Retail Price Index Disc prices Material prices Direct labour wage rates Variable overhead costs Other overhead costs 361
6% p.a. 5% p.a. 3% p.a. 7% p.a. 7% p.a. 5% p.a. 2006.1
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Requirement Given that Howden’s shareholders require a real return of 8.5 per cent for projects of this degree of risk, assess the financial viability of this proposal. Note : You may ignore taxes and capital allowances in this question. (10 marks) (c) Briefly discuss how inflation may complicate the analysis of business financial decisions. (6 marks) (Total marks 20)
Question 2 The board of directors of Portland Ltd are considering two mutually exclusive investments, each of which is expected to have a life of 5 years. The entity does not have the physical capacity to undertake both investments. The first investment is relatively capital intensive while the second is relatively labour intensive. Forecast profits of the two investments are as follows: Investment 1 (requires four new workers) Year Initial cost Projected revenue Production costs Finance charges Depreciation1 Profit before tax Average profit before tax £30,600. Investment 2 (requires nine new workers) Year Initial cost Projected revenue Production costs Depreciation1 Profit before tax Average profit before tax £39,200.
0 (500)
0 (175)
1
£000 2
3
4
5
400 260 21 125 (6)
450 300 21 94 35
500 350 21 70 59
550 450 21 53 26
600 500 21 40 39
£000 1
2
3
4
5
500 460 44 (4)
600 520 33 47
640 550 25 65
640 590 18 32
700 630 14 56
Note: 1. Depreciation is a tax-allowable expense and is at 25 per cent per year on a reducingbalance basis. Both investments are of similar risk to the company’s existing operations.
Additional information (i) Tax and depreciation allowances are payable/receivable one year in arrears. Tax is at 25 per cent per year. (ii) Investment 2 would be financed from internal funds, which the managing director states have no cost to the entity. Investment 1 would be financed by internal funds plus a £150,000 14 per cent fixed-rate term loan. (iii) The data contains no adjustments for price changes. These have been ignored by the board of directors as both sales and production costs are expected to increase by 9 per cent per year, after 1 year. (iv) The entity’s real overall cost of capital is 7 per cent per year and the inflation rate is expected to be 8 per cent per year for the foreseeable future. (v) All cash flows may be assumed to occur at the end of the year unless otherwise stated. (vi) The entity currently receives interest of 10 per cent per year on short-term money market deposits of £350,000. (vii) Both investments are expected to have negligible scrap value at the end of 5 years. 2006.1
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Requirements (a) Discuss the validity of the arguments of each of Directors A, B and C with respect to the decision to select Investment 1, Investment 2 or neither. (7 marks) (b) Verify whether or not Director B is correct in stating that Investment 1 has the quicker discounted payback period. Evaluate which investment, if any, should be selected. All calculations must be shown. Marks will not be deducted for sensible rounding. State clearly any assumptions that you make. (14 marks) (c) Discuss briefly what non-financial factors might influence the choice of investment. (4 marks) (Total marks 25)
Question 3 The directors of XYZ plc wish to expand the entity’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the expansion programme. Three possible investment opportunities have been identified. Only £400,000 is available in cash, and the directors intend to limit their capital expenditure over the next 12 months to this amount. The projects are not divisible (i.e. cannot be scaled down) and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future. Expected net cash flows (including residual values): Project A B C
Initial investment £ (350,000) (105,000) (35,000)
year 1 £ 95,000 45,000 (40,000)
year 2 £ 110,000 45,000 (25,000)
year 3 £ 200,000 45,000 125,000
Company shareholders currently require a return of 15 per cent nominal on their investment. Ignore taxation. Requirements (a) (i) Calculate the expected net present value and profitability indexes of the three projects; and (ii) comment on which project(s) should be chosen for investment, assuming the entity can invest surplus cash in the money market at 10 per cent. Note: You should assume that the £400,000 expenditure limit is the absolute maximum the entity wishes to spend. (10 marks) 2006.1
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Director A favours Investment 2, as it has a larger average profit. Director B favours Investment 1, which she believes has a quicker discounted payback period, based upon cash flows. Director C argues that the entity can make £35,000 per year on its money market investments and that, when risk is taken into account, there is little point in investing in either project.
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(b) Discuss whether the entity’s decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders. (10 marks) (Total marks 20)
Question 4 Harry is financial manager of RP plc. He is nearing retirement. You have been appointed as his deputy with a view to taking over from him in twelve months’ time. The entity is considering an investment in a new product which will cost £1,200,000 in new machinery and will result in profit before depreciation and tax of £375,000 per annum in real terms for 5 years. At the end of the 5 years, the machinery can be sold for its written-down book value. The investment will require working capital at the beginning of each year as follows (figures in real terms): Year Amount (£)
1 100,000
2 200,000
3 300,000
4 400,000
5 500,000
Harry is proposing to evaluate the investment using the entity’s (nominal) weighted average cost of capital (WACC) of 16 per cent. The following notes are relevant: 1. At the end of year 5, the total working capital can be released in cash back to the entity. 2. Inflation is expected to be 4 per cent per annum on all operating cash flows and working capital for the period under review. 3. The entity pays tax at the rate of 33 per cent. There is a twelve-month time lag for tax payments or refunds. 4. Tax relief is available on capital expenditure at 25 per cent on a reducing balance. The entity also depreciates its plant and equipment on this basis. 5. Assume all cash flows occur at the end of the year except the purchase of non-current assets (that is, the new machinery) and working capital. Both these items of expenditure occur at the beginning of the year. Requirements (a) Evaluate the investment using the company’s WACC, as suggested by Harry. (12 marks) (b) Whatever your own answer to part (a), assume the results of your financial evaluation suggest the investment is not worthwhile (i.e. the NPV is negative). You think that some of Harry’s assumptions are unrealistic. In particular, you are concerned about the uncertainty surrounding each year’s cash flows and the use of the WACC as the discount rate. You are required to explain how the evaluation might be refined, or developed, to overcome your concerns. Note: You are not required to revise your calculations for part (a) of the question to answer part (b) of the question. (8 marks) (Total marks 20)
Question 5 ABC Limited is considering the purchase of a fleet of small delivery vehicles. The usage of the vehicles would be very heavy as they would be operated round the clock by teams of 2006.1
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Year 0 1 2 3
Initial investment and operating cash flow £ (10,000) 4,200 4,000 3,500
End of year ‘abandonment’ cash flow £ (10,000) 6,200 4,000 0
The company uses a cost of capital of 12 per cent to evaluate investments of this type. Requirements (a) Calculate: ● the NPV for each vehicle if it is operated for the full three years; ● the NPV for each vehicle if it is abandoned at the end of year 2 or year 1. (13 marks) (b) Comment on the economic life of this project and discuss, briefly, the advantages of including an abandonment option in the investment appraisal exercise. (7 marks) (Total marks 20)
Question 6 (a) Discuss the implications of the CAPM for senior managers involved in making major investment decisions, assuming that their aim is to maximise shareholder wealth. (12 marks) (b) Explain the main differences between the arbitrage pricing model (APM) and the CAPM, and the practical difficulties of using the APM. (8 marks) (Total marks 20)
Question 7 The shares of ZX plc are quoted on a stock market. Two of the directors are also major shareholders in the entity. They have been evaluating investment in a project which will require £3.9m capital expenditure on new machinery. The directors expect the capital investment to provide annual cash flows of £600,000 indefinitely. This figure is net of all tax adjustments. The entity is at present all equity financed. The discount rate, which it applies to investment decisions of this nature, is 14 per cent net. The directors believe that the current capital structure fails to take advantage of the tax benefits of debt, and propose to finance the new project with undated debt secured on the company’s assets. The current annual gross rate of interest required by the market on corporate undated debt of similar risk is 10 per cent. The after-tax costs of issue are expected to be £162,000. The entity intends to issue sufficient debt to cover the cost of capital expenditure and the after-tax costs of issue. The entity’s marginal tax rate is 30 per cent. You should use a sensible approach to rounding your answers throughout the question. 2006.1
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drivers working in shifts. The estimated maximum life of the vehicles is therefore only three years, after which they would be virtually worthless and scrapped. However, if they were taken out of service before the end of three years, they would have a positive ‘abandonment’ cash flow. The estimated post-tax cash flows for each vehicle are as follows:
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Requirements (a) Calculate the adjusted present value of the investment and the adjusted discount rate, and explain the circumstances in which this adjusted discount rate may be used to evaluate future investments. (10 marks) (b) The entity is considering three other investment opportunities. The initial capital investment required, the NPVs and duration of these three projects are as follows:
Project 1 Project 2 Project 3
Initial investment £m 3.85 4.25 2.95
NPV £m 0.85 0.90 0.68
Duration Years 3 4 2
However, resource constraints mean that the entity cannot invest in all three projects. It wishes to restrict investment to £7.5m. Notes: ● The projects are not divisible. ● The entity has used its cost of capital of 14 per cent to evaluate all three investments. ● Any surpl us cash could be invested in the money market at 6 per cent. ● Assume all rates in this part of the question are net of tax. You are required to discuss and recommend, with reasons, which project(s) should be undertaken. (15 marks) (Total marks 25)
Question 8 Explain: (i) the five input variables involved in the Black–Scholes pricing model; and (ii) how the five input variables can be adapted to value ‘real’ options, as opposed to traded share options. (10 marks)
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8
Solution 1 (a) Investors advance capital to companies expecting a reward for both the delay in waiting for their returns (time value of money) and also for the risks to which they expose their capital (risk premium). In addition, if prices in general are rising, shareholders require compensation for the erosion in the real value of their capital. If, for example, in the absence of inflation, shareholders require a company to offer a return of 10 per cent, the need to cover 5 per cent price inflation will raise the overall required return to about 15 per cent. If people in general expect a particular rate of inflation, the structure of interest rates in the capital market will adjust to incorporate these inflationary expectations. This is known as the ‘Fisher effect’. More precisely, the relationship between the real required return (r ) and the nominal rate (n), the rate which includes an allowance for inflation, is given by: (1 r ) (1 i ) (1 n) where i is the expected rate of inflation. It is essential when evaluating an investment project under inflation that future expected price level changes are treated in a consistent way. Companies may correctly allow for inflation in two ways, each of which computes the real value of an investment project: (i) inflate the future expected cash flows at the expected rate of inflation (allowing for inflation rates specific to the project) and discount at n, the fully inflated rate – the ‘money terms’ approach. (ii) Strip out the inflation element from the market-determined rate and apply the resulting real rate of return, r, to the stream of cash flows expressed in today’s or constant prices – the ‘real terms’ approach. (b) First, the relevant set-up cost needs identification. The offer of £2m for the building, if rejected, represents an opportunity cost, although this appears to be compensated for by its predicted eventual resale value of £3m. The cost of the market research study has to be met irrespective of the decision to proceed with the project or not, and is thus not relevant. Second, incremental costs and revenues are identified. All other items are avoidable except the element of apportioned overhead, leaving the incremental overhead alone to include in the evaluation. 367
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Third, all items of incremental cash flow, including this additional overhead, must be adjusted for their respective rates of inflation. Because (with the exception of labour and variable overhead) the inflation rates differ, a disaggregated approach is required. The appropriate discount rate is given by: (1 i ) (1 r ) 1 n (1.06) (1.085) 1 15% Assuming that the inflated costs and prices apply from and include the first year of operation, the cash flow profile is: Cash flow profile (£m): Year 0 Item Equipment Forgone sale of buildings Residual value of building Working capital Revenue Materials Labour and variable overhead Fixed overhead Net cash flows Present value at 15%
1
2
3
4
(10.50)
5 2.00
(2.00)
(13.00) (13.00)
5.04 (0.62) (0.43) (0.53) )3.46)
5.29 (0.64) (0.46) (0.55) )3.64)
5.56 (0.66) (0.49) (0.58) )3.83)
5.83 (0.68) (0.52) (0.61) )4.02)
3.00 0.50 6.13 (0.70) (0.56) (0.64) )9.73)
(13.00)
)3.01)
)2.75)
)2.52)
)2.30)
)4.84)
(0.50)
NPV £2.42m, therefore the project appears to be acceptable. However, the financial viability of the project depends quite heavily on the estimate of the residual value of the building and equipment. Note : The working capital cash recovery towards the end of the project is approximately equal to the initial investment in stocks because the rate of material cost inflation tends to cancel out the JIT-induced reduction in volume, leading to roughly constant stock-holding in value terms throughout most of the project life-span. (c) In addition to the problems offered for investment appraisal, such as forecasting the various rates of inflation relevant to the project, inflation poses a wider range of difficulties in a variety of business decision areas. Inflation may pose a problem for businesses if it distorts the signals transmitted by the market. In the absence of inflation, the price system should translate the shifting patterns of consumer demand into price signals to which producers respond in order to plan current and future output levels. If demand for a product rises, the higher price indicates the desirability of switching existing production capacity to producing the good or of laying down new capacity. Under inflation, however, the producer may lose confidence that the correct signals are being transmitted, especially if the prices of goods and services inflate at different rates. He may thus be inclined to delay undertaking new investment. This applies particularly if price rises are unexpected and erratic. Equally, it becomes more difficult to evaluate the performance of whole businesses and individual segments when prices are inflating. A poor operating performance may be masked by price inflation, especially if the price of the product sold is increasing at 2006.1
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Solution 2 (a) Director A. Average profit is a poor criterion to use in investment appraisal. Although readily understood by managers, it fails to take into account the time value of money or the incremental cash flows from the investments. A resource allocation decision should be based upon cash flows not profit, which is a reporting measure. The size of the initial outlay of the project is also ignored by this measure. Director B. Payback is frequently used as part of investment appraisal, often being argued by management to select less risky investments from among several alternatives. Its major weakness is that it ignores cash flows after the payback period is complete. Such cash flows might be substantial, and influence the investment decision where mutually exclusive investments are concerned. Discounted payback has the advantage of taking account of the time value of money, but still ignores cash flows after the discounted payback period. However, if the investment has a discounted payback period within its expected lifespan, it must have a zero or positive net present value, and be considered to be financially viable. If investments are not mutually exclusive, discounted payback will lead to the same decisions as NPV. If, as in this case, investments are mutually exclusive, an investment that does not maximise net present value could result from using discounted payback. A further problem is that working capital cash flows are difficult to incorporate within this technique. Director C. Director C is considering profit, not net present value. If the company’s cost of capital is in excess of the 10 per cent yield on money market deposits, then investing funds in deposits will result in a negative present value. If either project produces a zero or positive NPV, on financial grounds it should be selected, not the money market.
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a rate faster than prices in general or if operating costs are inflating more slowly. The rate of return on capital achieved by a business is most usefully expressed in real terms by removing the effect on profits of generally rising prices (or better still, the effect of company-specific inflation). The capital base of the company should also be expressed in meaningful terms. A poor profit result may translate into a high ROI if the capital base is measured in historic terms. Unless these sorts of adjustment are made, inflation hinders the attempt to measure company performance on a consistent basis, and thus can cloud the judgement of providers of capital in seeking out the most profitable areas for investment.
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(b) Payback is normally calculated using after-tax cash flows. Investment 1 Year Initial cost Revenue (9% increase) Production costs (9% increase) Taxable Tax Tax saved by depreciation Balancing allowance saving Net cash flows
11111. 1(500)
Discount factors1 Present values
1.000 1(500)
0 500
1 400 260 140
2
Cash flows (£000) 3 4
5
6
11111. 1 140
491 327 164 (35) 31 11111. 1 160
594 416 178 (41) 24 11111. 1 161
712 583 129 (45) 18 11111. 1 102
847 706 141 (32) 13 11111. 1 122
(35) 10 2 30 1 5
0.865 1 121
0.749 1 120
0.648 1 104
0.561 1 57
0.485 1 59
0.420 1 2
Payback period: None Expected NPV: ( £37,000)
Note: 1. Discount factor is 1.07 1.08 15.56 per cent. Money cash flows are being used and must be discounted by a money rate. (If a real discount rate is used, tax allowances must be deflated by the inflation rate, otherwise too high an NPV will result.) Investment 2 Year Initial cost Revenue (9% increase) Production costs: (9% increase) Taxable Tax Tax saved by depreciation Balancing allowance saving Net cash flows
1 . 0(175)
Discount factors Present values
1.000 1(175)
0 (175)
Cash flows (£000) 3 4
1
2
5
6
500
654
760
829
988
460 40
1 . 0 40
567 87 (10) 11 1 . 0 88
653 107 (22) 8 1 . 0 93
764 65 (27) 6 1 . 0 44
889 99 (16) 5 1 . 0 88
(25) 4 - 10 0(11)
0.865 0 35
0.749 0 66
0.648 0 60
0.561 0 25
0.485 0 43
0.420 0 (5)
Discount payback period: approximately 3 years 7 months (3 14/25 years) Expected NPV: £49,000
Investment 1 does not have the quicker discounted payback period, as it fails to pay back within its expected life. On financial grounds, Investment 2, with an expected NPV of £49,000, should be selected. Notes: (i) The financing costs of the investment are not included as cash flows as they are encompassed within the discount rate. Internal funds are not free; there is an opportunity cost of the cash flow that could have been earned from investing the funds elsewhere. (ii) It is assumed that the company has other investments generating profits against which the tax depreciation allowance can be set. (c) Relevant non-financial factors might include: (i) The availability of suitably skilled labour. (ii) Environmental factors; is one investment environmentally more acceptable? 2006.1
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Investment 2 creates more jobs and could be socially more acceptable. Speed of delivery and installation of capital equipment. Availability of spare parts and servicing (if required). Reliability of capital equipment.
Solution 3 (a) (i) 15% discount factors Project A:
absolute discounted absolute discounted absolute discounted
Project B: Project C:
Year 0 1.000
Year 1 0.870
Year 2 0.756
Year 3 0.658
Total
£000 (350.0) (350.0) (105.0) (105.0) (35.0) (35.0)
£000 104.5 90.9 49.5 43.1 (44.0) (38.3)
£000 133.1 100.6 54.5 41.2 (30.2) (22.8)
£000 266.2 175.2 59.9 39.4 166.4 109.5
£000
P/I*
16.1
1.05
18.7
1.18
13.4
1.38
* Defined as in Brealey and Myers, that is, NPV of later cash flows as ratio of initial flow.
(ii) Projects should first be ranked by NPV and P/I (all figures are in £000). Project B A C
NPV 18.7 16.7 13.4
Rank by NPV Cum NPV Capital exp 18.7 105.0 35.4 350.0 48.8 35.0
Cum cap exp 105.0 455.0 490.0
Project C B A
NPV 13.4 18.7 16.7
Rank by profitability index Cum NPV Capital exp 13.4 35.0 32.1 105.0 48.8 350.0
Cum cap exp 35.0 140.0 490.0
When capital is rationed, P/I may be the best decision method, as it shows the percentage return per pound invested and, all other things being equal, these investments should be chosen. However, NPV shows in absolute terms how much shareholder wealth is increased by an investment in each project. In the case here, using P/I would suggest C B, but only £140,000 would be invested for a cumulative NPV of £32,100. Although the surplus could be invested in the money market at 10 per cent, this is below the company’s cost of capital. It does not make sense, other than in the very short term, to invest surplus cash in the money market. Using NPV ranking, B and A would be chosen, giving a cumulative NPV of £35,400 for expenditure of £455,000. This is above the company’s limit, but by a relatively small amount ( just over 10 per cent) and it is unlikely it could not be raised. However, if this was indeed the case, only project B could be undertaken. (b) The higher the borrowings (and hence the extent to which cash flows are pre-empted for the payment of interest), the greater will be the volatility of returns to the shareholders. In turn, that volatility will inversely influence the value placed on prospective returns to the shareholder, thus partly offsetting the apparent benefit of the lower cost 2006.1
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(iii) (iv) (v) (vi)
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of borrowing. However, the fact that interest is tax deductible usually reduces the offset. Hence, what is an appropriate stance depends on a number of factors: ●
● ●
the volatility of prospective returns to the entity as a whole (the greater this is, the more attractive an ‘equity only’ stance is); interest rate expectations, relative to the perceived cost of equity capital; the tax position of the company, notably any unused allowances, and its dividend policy.
A company which has no borrowings is clearly going to be more flexible than one which has high borrowings, for example, better able to take advantage of unexpected opportunities.
Solution 4 (a) Calculation of NPV Year Tax calculations Profit before depreciation Inflated at 4% Tax depreciation Taxable Profit/–Loss Tax @ 33% Cash flows Cost of machine Working capital Second-hand value Profit before depreciation Tax payments Net cash flows DF @ 16% DCF NPV
0
1
2
3
4
5
375,000 390,000 300,000 390,000 29,700
375,000 405,600 225,000 180,600 ( 59,598
375,000 421,824 168,750 253,074 ( 83,514
375,000 438,697 126,563 312,134 103,004
375,000 456,245 94,922 361,323 119,237
1,200,000 100,000 108,000
116,480
125,466
134,984
390,000 282,000 282,000 0.862 243,084
405,600 229,700 259,420 0.743 192,749
421,824 3259,598 236,760 0.641 151,763
438,697 3283,514 220,199 0.552 121,550
584,929 284,766 456,245 103,004 3 119,237 1,222,936 119,237 0.476 0.410 582,117 348,887 357,623
282,000 1,300,000 1 1,300,000
6
The NPV is negative at £57,623 which suggests that the project should not be undertaken. (b) All projects have considerable uncertainty surrounding their cash flows when forecasting into the future. One way of adjusting/allowing for this uncertainty is by using techniques such as certainty equivalents and sensitivity analysis. ●
●
Certainty equivalents require detailed examination of probabilities, correlation of cash flows between years, variances, covariances, etc., which are difficult to forecast with accuracy. Sensitivity analysis is used to analyse the effect on project profitability of possible changes in input variables such as sales, direct costs, items of expenditure, etc. Sensitivity analysis expresses cash flows in terms of unknown variables and then calculates the consequences of under- or over-estimating the variables. It can help expose inaccurate or inappropriate forecasts. A major problem with sensitivity analysis is that underlying variables are likely to be interrelated.
Theory suggests adjusting the discount rate but in practice this has problems. Cost of capital would not be constant over such a long period of time: it would follow the yield curve of the market. 2006.1
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●
●
●
How realistic is it to use a proxy whose business may not match precisely that of the company undertaking the project? Is it realistic to ignore the method of financing in the discount rate? Theory has a persuasive argument for doing this but it is often ignored (or not understood) in practice. The CAPM has many limitations. For example, one-period model, use of risk-free asset, return on the market, difficulties of tax adjustments, etc., and betas are unstable variables with wide standard deviations.
Solution 5 (a)
Year 12% p.a. discount factors
0 1.000
1 0.893
2 0.797
3 0.712
£
£
£
£
If operated for 3 years Absolute cash flows Discounted cash flows Cumulative
(10,000) (10,000) (10,000)
4,200 3,751 (6,249)
4,000 3,188 (3,061)
3,500 2,492 (569)
NPV
If operated for 2 years Absolute cash flows Discounted cash flows Cumulative
(10,000) (10,000) (10,000)
4,200 3,751 (6,249)
8,000 6,376 127
127
NPV
If operated for 1 year Absolute cash flows Discounted cash flows Cumulative
(10,000) (10,000) (10,000)
10,400 9,287 (713)
(713)
(713)
NPV
(b) From the calculations, it can be seen that the 2-year life is preferable, and is worth more than it would appear above, because it could be repeated. If like is compared with like, for example three 2-year deals versus two 3-year deals, the former is even more positive, the latter more negative. Without allowing for the terminal value/abandonment possibilities, an incorrect assessment would be made. The possibility of abandonment adds to the flexibility of the project, thereby reducing the perceived risk.
Solution 6 (a) There are several practical limitations with the CAPM (expectations based on past returns, single period model, etc.) but it does provide a basis for understanding the nature of risk. The model is concerned only with market risk, on the assumption that specific risk is diversified away by rational investors (and managers). If managers act in the best interests of shareholders they should invest in all projects which yield above the rate of return required by investors on equivalent risk assets. If the beta is known 2006.1
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The WACC assumes the project has the same risk and is financed in the same way as the company. This is unlikely to be the case. In theory, Harry should use a specific risk-adjusted discount rate using the CAPM and a proxy company to evaluate the project. The rate should reflect the risk of the project, not that of the company. The problem noted above remains: would any discount rate remain constant over a period of time. In reality, the problems of using this method to derive a discount rate are as follows:
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and a view is taken about future returns on the market, then a cut-off point can be determined for new investments of similar risk. If the market is expecting higher returns overall than managers, then managers might invest in projects offering a return below that expected by shareholders. The subsequent fall in the share price is the mechanism whereby the market conveys to managers that the discount rate has been inappropriately determined. For the CAPM to be valid, however, it is essential that markets are at least semistrong form efficient. (b) The CAPM relies on expectations of returns on the market and past volatility of share prices to determine a discount rate to use on future projects. The APM assumes that the return on a share depends in part on macroeconomic factors and in part on issues specific to the company. As with the CAPM, the APM suggests that diversification eliminates specific risk. However, unlike the CAPM, the APM does not specify the explanatory factors, which could be the market index or many other economic variables (GDP, oil prices, etc.). Intuitively, the APM appears to be a better model because it includes many more variables. The main practical difficulties are determining what those variables might be (which the model does not specify) and forecasting their value. However, there have been few tests of the APM, probably because of the difficulties of determining which variables to include and how to weight them.
Solution 7 (a) All figures are in millions of pounds sterling. The base case NPV for ZX plc’s project is: £3.9 (£0.6/0.14) £3.90 £4.286 £0.386 The side effects of financing are: Issue costs Issue costs are £0.162. A total of £4.062 needs to be raised. Tax benefits Assuming perpetual debt, the annual tax relief on interest payments is: £4.062 10% 30% £0.122 in perpetuity. Assuming the discount rate is the interest rate, the value of this tax relief in perpetuity is: £0.122 £1.22 0.1 This also assumes continuation of unrelieved taxable profits. The APV is therefore: £0.386 £0.162 £1.22 £1.444 2006.1
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Adjusted discount rate First calculate the annual income/savings required to allow an NPV of zero:
APV £3.9 Annual income £0.162 £1.22 0.14 Assuming APV 0: £4.062 £1.22 Annual income/0.14 Annual income 0.14(£4.062 £1.22) £0.398 The minimum IRR is therefore: £0.398 0.098 or 9.8%. £4.062 Thus, the ADR is 9.8 per cent. This ADR may be used to evaluate future investments only if the business risk of the new venture is identical to the one being evaluated here, and the project is to be financed by the same method and on the same terms. This is unlikely, and the effect on the company’s cost of capital of introducing debt into the capital structure cannot be ignored. (b) The relevant calculations are as follows: Initial investment £m
NPV £m
Profitability index %
Project 1
3.85
0.85
22.08
Project 2
4.25
0.90
21.18
Project 3
2.95
0.68
23.05
EAA £m 0.85 2.322 0.90 0.309 2.914 0.68 0.413 1.647 0.366
Notes: ● The profitability index is the NPV expressed as a percentage of the initial investment (the ‘net’ method). The GPV method (the ‘gross’ method) would be equally acceptable. ● The equivalent annual annuity approach (EAA) seeks to determine the constant annual cash flow that offers the same present value as the project’s NPV. This is found by dividing the project’s NPV by the relevant annuity discount factor. As all three projects cannot be undertaken given the company’s capital expenditure limit of £7.5 million, it is necessary to look at combinations of any two projects:
Projects 1 2 Projects 2 3 Projects 3 1
Initial investment £m 8.10 7.20 6.80
NPV £m 1.75 1.58 1.53
375
Profitability index % 21.60 21.94 22.50
The combination of Projects 1 2 gives the highest NPV, but this would exceed the company’s investment limit. The combination of Projects 2 3 is the preferred option on the highest NPV criteria. The combination of Projects 3 1 is the preferred option 2006.1
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on the other two criteria. In theory, Projects 2 3 should be preferred unless other investment opportunities can be identified to utilise the unspent capital. Other factors to consider: ●
●
●
If the projects yield positive NPVs at 14 per cent, could the company consider borrowing to fund all three; in theory it should borrow. Investing in the money market is not a sensible option other than for very short-term deposits as the yield is below the shareholders’ required cost of capital. In the long run, this would result in a fall in the company’s share price. The company has used the same cost of capital for all three projects. Have the relative risks of the projects been considered? Taking PI as the criterion we would get:
Project 3 Project 1 Project 2
Investment £m 2.95 3.85 0.70 7.50
NPV £m 0.68 0.85 0.15 1.68
We should invest in Projects 3 and 1 with the balance in Project 2.
Solution 8 (i) The five variables are as follows: Share price or value. The current market price of a share. Exercise price. Also known as the ‘strike’ price – the price the holder of the option wishes to buy or sell the share at. Risk free rate. As with the CAPM, the rate typically paid on 3-month treasury bills. Time to expiry. The number of days/months to the expiry of the option. Share price volatility. This is the variability of the share price over a period of time measured by the variance. Author’s Note This part of the answer uses share options as required in part (ii) of the answer. The use of currency options in this part of the question would be equally valid. (ii) As applied to capital investments, the variable could relate as follows: Share price. Present value of expected cash flows. Exercise price. Initial outlay on the investment. Risk free interest rate. Risk free interest rate. Time to expiry. Time until the investment opportunity disappears (not the time to the end of the investment). Share price volatility. Project value uncertainty. 2006.1
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9
LEARNING OUTCOMES After completing this chapter, you should be able to:
identify and evaluate optimal strategies for the satisfaction of international longer-term financing requirements;
evaluate international investment projects taking account of potential variations in business and economic factors.
9.1 Introduction The topics covered in this chapter are: ● ● ● ● ● ●
methods of financing overseas operations; the euromarkets; international capital budgeting using NPV; international capital budgeting using APV; the effect of taxation, including differential tax rates and double tax relief; restrictions on remittances.
9.2 Financing overseas operations – a global strategy In times past a business would, in its early days, tend to be concentrated in one geographical area and in the regulated environment which used to obtain, even quite large entities would define themselves in national terms, and raise capital and invest in facilities where their market was. If asked about competition, they would naturally think of other enterprises based in the same country. 377
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But that was then. Now, it is feasible – and in some instances vital – for entities to raise capital in one country, invest it in another, and produce goods which are to be marketed in a third. Moreover, they need to think about competition on a worldwide basis. As a result of this, entities have developed global strategies, perhaps to exploit new markets or secure supplies of raw materials that are essential for its UK or other worldwide operations. The financing of these ventures is obviously of key importance if the risks outlined below are to be minimised. A number of different methods can be used to finance companies overseas. Retained earnings The subsidiary could rely upon its own internally generated funds. This would avoid many of the problems of financing overseas, but is unlikely to result in the necessary level of expansion to meet high growth objectives, and is obviously not suitable for new overseas ventures. Finance from the UK Funds can be raised by the parent entity within the UK and transferred overseas to subsidiary companies by way of a combination of equity and loans. The main advantage of this method is that the entity will probably be familiar with the UK capital markets and therefore be capable of raising finance quickly and cost effectively. However, if exchange controls exist this method can become difficult and expensive. Another disadvantage of using sterling-denominated finance for an overseas asset is that it will in no way reduce foreign-exchange risk through matching. The entity will also be more exposed to political risks. If the investment is lost, perhaps through a war or expropriation by a foreign government, the UK liability will still remain intact. Also, if the overseas investment is a subsidiary entity, failure of the subsidiary would leave the holding company with the liability in the same way. Finance in the overseas country The main advantage of this method is that it will result in reductions in risk. Foreignexchange risk will be reduced, since any losses in the value of the overseas asset will be offset by gains on the liability, and vice versa. The complete elimination of risk is, however, unlikely since it would require the exact matching of cash flows on the asset and liability. Political risk can also be reduced since, if the investment is lost, the liability will be eliminated as well. Difficulties may be experienced with this method of finance if the country concerned does not have a well-developed capital market. On the other hand, financing in the overseas country can make such investments more acceptable to that country since it is then seen that not all of the profits made are sent abroad. Alternatively, it could also be argued that financing overseas limits the methods by which profits from the overseas investment can be repatriated – heavy reliance being placed on the payment of dividends. When finance is raised in the UK it may be easier to get money out of the country as a combination of dividends, interest, management charges, etc. Most governments take steps to encourage overseas investors since they are beneficial to that country’s economy, creating employment and wealth. Such encouragement often takes the form of grants, subsidies and cheap or guaranteed finance. These incentives should be taken into account when considering overseas investments and their financing. Financing from other capital markets Finance can today be raised from a variety of capital markets. A multinational entity based in the UK could quite easily raise finance in Germany via a subsidiary in that country and 2006.1
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9.3 The effect of restrictions on remittances When a foreign subsidiary makes a profit, that profit will be included in the total profits generated by the multinational entity. Investors in the parent entity will be concerned to see not just how much profit is made, but how much cash is available for distribution as dividends. This will require the subsidiary entity remitting cash to the parent entity. There are various ways by which the parent may obtain a cash return from its foreign subsidiary: ●
● ●
capital flows comprising dividends and monies to servicing debt capital provided by the parent; payments for merchandise supplied, and management charges.
The ability to convert these cash flows from local currency into the parent’s currency will depend on local legislation. Some countries place restrictions on the remittance of profits overseas as part of a policy designed to protect the strength of their currency. Such restrictions work against the long-term interests of the country concerned as freedom to withdraw funds is a key determinant of investors’ willingness to commit in the first place. For dividends there may be a requirement to reinvest a certain proportion of the profit, which limits dividends. Loan servicing should be less restricted subject to the reasonableness of interest rates. Payments for merchandise will usually be permitted subject to transfer pricing restrictions, which will ensure that goods sold between the parent entity and a subsidiary are priced at ‘arm’s length’, and not so as to minimise the profits of the subsidiary to manipulate how the total profit of the entity is divided between the parent and subsidiaries. Management charges are usually restricted to avoid them being used as a way of avoiding dividend restrictions and it will often be necessary to justify them to the authorities. In all cases there is a risk that all foreign currency remittances will be placed under severe restriction and this possibility should be carefully considered before an investment decision is undertaken, as should the tax implications of various systems of remitting profits back to the parent entity.
9.4 The Euromarkets The ‘euro’ term is a catch-all tag used to refer to an investment in a currency held outside its country of origin. It does not imply that the investment is in Europe, or that the currency is European. For example, US dollars deposited in a Japanese bank would be referred to as eurodollars. 2006.1
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use the money to finance an investment in a different country, or even in the UK. One possible incentive in raising money in other countries is that interest rates may be substantially lower than in the UK or in the country where an investment is intended. However, if the interest cost is lower, then it is likely that the currency borrowed is strong, and will therefore appreciate with respect to sterling and other currencies. The expected exchange loss on the borrowings would therefore offset any benefit through a lower interest rate. Dealing with risk and individuals’ attitudes to risk is vital to any decision-making process, and when multinationals look to evaluate investments overseas they have to compare the risks with the rewards.
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9.4.1 Eurocurrency markets Eurodollars: US dollars deposited with, or borrowed from, a bank outside the USA. (CIMA, Official Terminology, 2005). The increase in international trade has meant that significant amounts of currencies such as US dollars, Japanese yen and UK sterling are held on deposit outside their home countries. These deposits are then loaned out by the banks. Eurocurrencies are effectively ‘stateless’ money, so any transactions are not subject to the domestic rules and regulations of any financial centre. London has become the main centre for eurocurrency transactions, although the eurocurrency market is not a domestic UK market and most eurocurrency transactions are carried out by overseas banks based there. Eurocurrencies can be deposited or borrowed for relatively short periods – typically 3 months – or for a number of years. The syndicated loan market developed from the short-term eurocurrency market. A syndicate of banks is brought together by a lead bank to provide medium- to long-term currency loans to large multinational companies. These loans may run to the equivalent of hundreds of millions of pounds. By arranging a syndicate of banks to provide the loan, the lead bank reduces its risk exposure.
9.4.2 Eurobonds Eurobond: Bond sold outside the jurisdiction of the country in whose currency the bond is denominated. (CIMA, Official Terminology, 2005) Eurobonds are bonds issued in a currency outside its country of origin. Large companies, banks and some governments raise money through issuing bonds in the eurobond market, in a similar way that companies and governments issue bonds in their domestic markets. The main difference is that borrowers are tapping the ‘euro’ pool of stateless money. This means that the eurobond market is not totally accountable to any particular government, which leads to fewer controls or regulation. Eurobonds are usually issued in bearer, rather than registered form, which means that the bondholder does not have to declare his identity. Possession of the bond is sufficient to prove ownership. Interest is paid gross, allowing investors to pay their own domestic tax, although the eurobond market has been criticised as being a haven for tax-shy investors.
9.5 The effect of taxation Tax planning for global organisations is complex, and beyond the scope of this study system. Most countries have a system of tax credits for taxes on income paid to the host country to avoid the same income being taxed twice.
9.5.1 Double taxation relief Double taxation occurs when income is taxed both by the taxpayer’s country of residence and in another country where the income crises. The purpose of double taxation relief is to remove or reduce the disincentive that this double taxation represents to outward investment. Another 2006.1
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(a) all income which arises in the UK, whether derived by a UK resident or not, and (b) income derived from abroad by a UK resident, is chargeable to UK tax. Many foreign countries have taxation systems based on similar principles so that income which arises in one country and flows to the other country is taxed twice, once in the country of its origin and again in the country in which the recipient resides. Double taxation of income could discourage residents of one country from investing and expanding their business activities in other countries. In order to ease the burdon of double taxation many countries provide for relief. This is achieved either by virtue of the provisions of a double taxation agreement or under the country’s own domestic legislation. There are two main methods: (a) exemption. Income or gains are exempted from tax in the country where the income or gains arise; exemption may also be given in the country of the recipient’s residence. (b) credit. Where the income or gains are taxed in both countries, the country in which the recipient is resident gives credit for the other country’s tax against its own tax. Where income remains taxable in both countries, the country in which it arises may agree, under a double taxation agreement, to tax it at a lower rate than its normal domestic rate. That is usually the case with dividends, interest, and royalties. The country in which the recipient is resident gives credit against its own tax for the reduced amount of tax paid in the other country.
9.6 International capital budgeting Evaluation of an international project should be similar to the evaluation of a domestic project. There are a few more complications, but the appraisal method that best deals with risk and uncertainty is net present value. For international project evaluation, net present value is often referred to as international capital budgeting. An international project will generate a stream of net cash flows in the currency of its host country. There are two possible approaches to evaluating overseas projects using an NPV analysis which should both lead to the same outcome, assuming that interest-rate parity theory holds (interest-rate parity theory is covered in Management Accounting: Risk and Control Strategy). Assuming a UK investing entity, these approaches are: (i) convert the currency cash flows from the project into sterling, then discount at a sterling discount rate to generate a sterling NPV; (ii) discount the currency cash flows from the project at a discount rate appropriate to that currency. Then convert the currency NPV into a sterling NPV by converting at the spot rate of exchange. Both approaches start with the currency net cash flows, and finish with a sterling NPV. The approach to be used will depend on what information is available and the reliability of forecasts for information that is not available. 2006.1
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important objective is to try to ensure that taxpayers do not exploit the terms of double taxation agreements and differing tax systems in each country for tax avoidance purposes. UK domestic legislation generally provides that
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Assuming a UK entity investing in the USA, the relationship between the sterling discount rate and the dollar discount rate can be found using the interest-rate parity theory: Exchange rate in 12 months’ time$/£ 1 annual discount rate$ Spot rate$/£ 1 annual discount rate£ Example 9.A Butler plc is considering undertaking a new project in Australia. The project would require immediate capital expenditure of A$10m, plus A$5m of working capital which would be recovered at the end of the project’s 4-year life. The net cash flows expected to be generated from the project are A$13m before tax. Straight-line depreciation over the life of the project is an allowable expense against corporate tax in Australia, which is charged at the rate of 50 per cent, payable at each year-end without delay. The project will have zero scrap value. Butler plc will not have to pay any UK tax on the project due to a double-taxation agreement. The A$/£ spot rate is 2.0 and the A$ is expected to depreciate against the £ by 10 per cent per year. A similar risk, UK-based project would be expected to generate a minimum return of 20 per cent after tax.
Solution Year 0 1 2 3 4
Investment A$m (15)
5
Cont’n A$m
Tax A$m
13 13 13 13
(5.25) (5.25) (5.25) (5.25)
Net cash flow A$m (15.00) 7.75 7.75 7.75 12.75
Net cash flow £m (7.50) 3.52 3.20 2.91 4.35
Ex rate 2.00 2.20 2.42 2.66 2.93
DF @ 20% 1.000 0.833 0.694 0.579 0.482
NPV £m (7.50) 2.93 2.22 1.68 2.10 1.43
Taxation workings A$m 13.0 ,,(2.5) 10.52
Contribution Depreciation (10/4)
@ 50% A$5.25m
The solution above converts the currency cash flows into sterling, and discounts the sterling cash flows at a sterling discount rate. An alternative method is as follows. Using interest rate parity: 1 annual discount rate$ 1 annual discount rate£ 1 annual discount rate$
Exchange rate in 12 months’ time$/£ Spot rate$/£
2.20 2.00 2.20 1.20 Annual discount rate$ 1 32% 2.00 1.20
Discounting the currency cash flows at this discount rate:
Year 0 1 2 3 4
Net cash flow A$m (15.00) 7.75 7.75 7.75 12.75
DF @ 32% 1.000 0.758 0.574 0.435 0.329
NPV A$m (15.00) 5.87 4.45 3.37 (14.19) (12.88)
A$2.88m 2 £1.44m, which shows that both approaches to appraising investments lead to the same outcome as long as interest-rate parity holds.
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Exercise 9.1 PG plc is considering investing in a new project in Canada which will have a life of 4 years. The initial investment is C$150,000, including working capital. The net after-tax cash flows which the project will generate are C$60,000 per annum for years 1, 2 and 3 and C$45,000 in year 4. The terminal value of the project is estimated at C$50,000, net of tax. The current spot rate for C$ against sterling is 1.7. Economic forecasters expect sterling to strengthen against the Canadian dollar by 5 per cent per annum over the next 4 years. The entity evaluates UK projects of similar risk at 14 per cent.
Requirements (a) Calculate the NPV of the Canadian project using the following two methods: (i) convert the currency cash flows into sterling and discount the sterling cash flows at a sterling discount rate; (ii) discount the cash flows in C$ using an adjusted discount rate which incorporates the 12-month forecast spot rate; and explain briefly the theories and/or assumptions which underlie the use of the adjusted discount rate approach in (ii). (12 marks) (b) The entity had originally planned to finance the project with internal funds generated in the UK. However, the finance director has suggested that there would be advantages in raising debt finance in Canada. You are required to discuss the advantages and disadvantages of matching investment and borrowing overseas as compared with UK-sourced debt or equity. Wherever possible, relate your answer to the details given in this question for PG plc. (8 marks) (Total marks 20)
Solution (a) Calculations Year (i) Method 1 C$ Initial investment Other cash flows Net cash flows
0
1
2
3
4
(150,000) (150,000) (150,000)
60,000 60,000
60,000 60,000
60,000 60,000
50,000 45,000 95,000
C$ per £ £ 14% p.a. discount factors Discounted £ Cumulative discount £
1.700 (88,235) 1.000 (88,235) 1(88,235)
1.785 33,613 0.877 29,479 (58,756)
1.874 32,017 0.769 24,621 (34,135)
1.968 30,488 0.675 20,579 (13,556)
2.066 45,983 0.592 27,222 13,666
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Taxation In Example 9.A, there was a double-taxation agreement between UK and Australia which meant that Butler plc did not have to pay any UK tax on the project. Many countries give a tax credit for any taxation paid to the host country, in order to prevent the same income being taxed twice.
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STUDY MATERIAL P9 (ii) Method 2 C$ net cash flows as above 19.7% p.a. discount factors Discounted C$ Discounted £ (@ C$ 1.700 per £ ) Cumulative discounted £
(150,000) 1.000 (150,000) (88,235) 1(88,235)
60,000 0.835 50,100 29,479 (58,756)
60,000 0.698 41,888 24,621 (34,135)
60,000 0.583 34,980 20,579 (13,556)
95,000 0.487 46,265 27,222 13,666
For the two approaches to yield the same net present value, the discount rate applied to the Canadian $ cash flows needs to be the combination of the sterling discount rate (14 per cent p.a.) and the projected strengthening of the pound (5 per cent p.a.), i.e. 19.7 per cent p.a. (1.14 1.05 being 1.197). A forecast of a 5 per cent per annum strengthening of the pound against the dollar will, generally, be associated with UK inflation rates/interest rates being 5 percentage points per annum below the corresponding Canadian figures. It is surprising, therefore, to see that the Canadian cash flows are expected to be constant. It would be worth checking that they are nominal, and not inadvertently real. (b) As the barriers to international trade come down, and globalisation becomes a reality, exchange rate risk management becomes a higher priority in financial management. This particular project looks viable given the assumptions as regards future exchange rates. However, they are only forecasts and the actuals could turn out to be significantly different. If the pound were to strengthen by more than forecast, the value of the project to PG plc’s shareholders would fall – and could even become negative. If PG plc’s managers are sufficiently risk averse, they may wish to protect the entity’s cash flows against that possibility. Borrowing Canadian dollars (as opposed to allowing UK borrowings to rise) would offer such protection in that, were sterling to strengthen, the number of pounds required to service/repay the loan would be fewer. Lower trading receipts, in other words, would be offset by lower financing payments. Covering the entire value of the project would mean borrowing its gross present value, that is, $177,222, but they could choose to hedge a proportion, for example, borrow $100,000 so as to offset more than half the risk. The interest rate is likely to be different in the two countries – in the particular situation described, it could afford to be up to 5 percentage points per annum higher in Canada than in the UK before it adds to PG plc’s costs. Interest payable is usually deductible in arriving at taxable profits, which could add further value. The other side of the coin, however, is that financing a project in the local currency could reduce its value if the currencies move in the opposite direction to that feared. In this case, for example, choosing not to borrow in Canada would be seen to have been the right move if sterling weakens against the dollar. It is most unlikely that additional UK equity would be raised for such a small (in the context of a plc) investment. It may, indirectly, affect the decision as to how much dividend to declare, but it is likely to be overwhelmed by other considerations.
9.6.1
Interest rate parity (IRP)
In Exercise 9.1 the first method of appraisal required the currency cashflows to be converted into sterling. In this exercise a simplistic approach to estimating forward exchange rates was adopted. 2006.1
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The relationship between interest rates and the spot and forward rates can be expressed as: Forward rate US$/£ Spot rate US$/£ 1 nominal US interest rate 1 nominal UK interest rate Example 9.B The spot exchange rate is US$1.50 £1. The UK interest rate is 4% The US interest rate is 3% Calculate the forward exchange rates for the next four years assuming the theory of interest rate parity applies.
Solution Forward rate US$/£ 1.50 1.4856
1.03 1.04
Year 0 1 2 3 4
Forward rate ($/£) 1.50 1.4856 1.4713 1.4571 1.4431
9.7 APV method The adjusted present value (APV) of investment appraisal may also be used to appraise an international project. While not being used as often as the net present value (NPV) approach, it may be used in situations where the financing of the project would move the parent entity to a new level of gearing, or where the risk characteristics of the project were different to existing projects.
Example 9.C Cheryl’s Shoes plc is considering establishing a subsidiary in the USA. The subsidiary would require immediate capital expenditure of $20m, plus $5m of working capital. The project has a planning horizon of four years, at the end of which the realisable value of the subsidiary’s fixed assets is estimated to be $8m. The working capital would be recovered at the end of the project’s 4-year life. 2006.1
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Forward exchange rates are normally calculated using IRP, and such an approach may be required in examination questions. If a country has a higher domestic rate of interest than its trading partner, it will find that this interest rate differential attracts foreign investors, and their desire to invest in that country will lead them to purchase the domestic currency, thus increasing that currency’s spot rate. However, assuming that the foreign investors will eventually wish to transfer their investment back into their own domestic currency, they will engage in a forward contract. This is done at the same time as buying the foreign currency spot: they engage in a forward contract to convert the currency back into their own domestic currency at some specified date in the future.
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STUDY MATERIAL P9 The estimated annual revenue from the project is $16m, with estimated annual operating costs of $6m. Straight-line depreciation over the life of the project is an allowable expense against corporate tax in the USA, which is charged at a rate of 35 per cent, payable 1 year in arrears. Cheryl’s Shoes plc plans to finance the project with a £6m 4-year eurosterling loan at 8 per cent, with the balance from retained earnings. Issue costs on the eurosterling loan will be 2 per cent and are tax-deductible. A suitable base-case discount rate for a similar UK-based project would be 17 per cent. Corporation tax in the UK is at 30 per cent and can be assumed to be payable one year in arrears. A double-taxation treaty exists between the UK and USA, so a liability for UK taxation is not expected to arise on the project. The current $/£ spot rate is 2.0 and the dollar is expected to depreciate against sterling at an annual rate of 5 per cent.
Requirement Calculate the adjusted present value of the project.
Solution Taxation workings Years 1–4 Revenue Operating costs Depreciation Taxable profit Taxation
$m 16.00 (6.00) (5.00) (5.00 (1.75
$ Project cash flows 0 $m (20.00)
Year Capital equipment Tax on sale Working capital Revenues Costs Taxation Net cash flow
1 $m
2 $m
3 $m
4 $m 8.00
5 $m (2.80)
(5.00)
25.00 (25.00)
16.00 (6.00) 10.00 10.00
16.00 (6.00) (1.75) 8.25
16.00 (6.00) (1.75) -8.25
5.00 16.00 (6.00) - (1.75) 21.25-
(1.75) (4.55)
£ Base-case present value Year 0 1 2 3 4 5
Net cash flow $m (25.00) 10.00 8.25 8.25 21.25 (4.55)
Ex. rate 2.00 2.10 2.21 2.32 2.43 2.55
Net cash flow £m (12.500) 4.762 3.733 3.556 8.745 (1.784)
DF @ 17% 1.000 0.855 0.731 0.624 0.534 0.456
NPV £m (12.500) 4.072 2.729 2.219 4.670 (0.814) )0.376)
Present value of financing side-effects ●
PV of tax shield: £6m 8% £480,000 30% £144,000 annual tax savings
These tax savings will be received in years 2–5, and discounted at the pre-tax cost of debt of 8 per cent they give a present value of: £144,000 3.067 £441,648
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MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY PV of issue costs: £6m 2% (1 0.30) £84,000 Adjusted present value Base-case PV PV tax shield PV issue costs Adjusted present value
£m 0.376 0.442 (0.084) )0.734) or £734,000 approx.
9.8 Summary As entities take a more global perspective to their trading activities, investing overseas and the financing of such operations will be given greater consideration. The ability to raise capital, and the cost of that capital, will remain important, but is is also important to be aware of the risks involved. In this chapter, we have identified the main types of foreign-exchange risk, which may have an impact on the method of financing overseas operations. Overseas projects can be appraised in two ways: the project’s currency cash flows can be converted into sterling and appraised using a sterling discount rate; or the cash flows in the overseas currency can be discounted at a discount rate appropriate to that currency. The NPV so produced can then be converted into a sterling NPV by converting at the spot rate of exchange. The APV method of investment appraisal also lends itself to international projects.
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Revision Questions
Question 1 A professional accountancy institute in the United Kingdom is evaluating an investment project overseas – in Eastasia, a politically stable country. The project involves the establishment of a training school to offer courses on international accounting and management topics. It will cost an initial 2.5 million Eastasian dollars (EA$) and it is expected to earn post-tax cash flows as follows: Year Cash flow (EA$000)
1 750
2 950
3 1,250
4 1,350
The following information is available: ● ●
● ● ●
The expected inflation rate in Eastasia is 3 per cent a year. Real interest rates in the two countries are the same. They are expected to remain the same for the period of the project. The current spot rate is EA$2 per £1 sterling. The risk-free rate of interest in Eastasia is 7 per cent and in the UK 9 per cent. The entity requires a sterling return from this project of 16 per cent.
Requirements (a) Calculate the sterling net present value of the project using both the following methods: (i) by discounting annual cash flows in sterling, (ii) by discounting annual cash flows in Eastasian dollars. (12 marks) (b) The chief finance officer of the institute has noted that borrowing rates in Scandinavia are below those in most other countries, and suggests that the institute should borrow Scandinavian currency to finance the project. Discuss the main methods of financing overseas operations and the issues the company should consider before making a decision about whether to borrow Scandinavian currency. (8 marks) (Total marks 20)
Question 2 (a) The financial press recently listed the following information about two currencies, the Westland dollar ($W) and the Eastland mark (Em). 389
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REVISION QUESTIONS P9 Spot rates: 90 day rate:
2.0725 Em/$W 0.4825 $W/Em 2.0687 Em/$W 0.4834 $W/Em
The Westland prime interest rate on the same day was 9.5 per cent. Note: Use a 365-day year. Requirements (i) Explain what is implied about the Eastland interest rate. (ii) Calculate and comment on the Eastland interest rate if the forward exchange rate was 0.4795 $W/Em. (iii) Calculate and comment on the 90-day forward rate on Em/$W if the Eastland interest rate was 8 per cent. (7 marks) ( b) In the late 1980s R plc, a manufacturing entity based in the United Kingdom, developed a substantial market for its products in Eastern Europe. The board decided to establish a subsidiary in Hungary. The assets needed for the new subsidiary were mainly buildings. Plant and equipment were provided from the UK. Most of the raw material for production was, and still is, sourced in the UK. Local labour is used, except for senior managers who are seconded from the UK parent for 2–3 years. Requirements Assuming the UK entity wished to minimise its exposure to exchange risk: (i) Discuss the options which were available to the parent entity management for financing the new subsidiary. Assume that the parent entity did not need to raise new long-term capital to finance this new venture. (ii) Explain how the UK parent could have minimised its exchange losses arising from either operating transactions or a decline in the value of Hungarian forints (HUF). (10 marks) (c) R plc went ahead with the overseas investment in June 1992 when the exchange rate was 150 HUF £1. In October 1992 the UK government was forced to devalue sterling and leave the European exchange-rate mechanism. The exchange rate of HUF to sterling at the end of 1992 was 125 £1. Requirement Discuss how the devaluation of sterling against the HUF might have affected the cash flows generated by the subsidiary and how the parent entity could have managed the situation. (8 marks) (Total marks 25)
Question 3 DaCosta plc is a manufacturer of expensive, built-to-order motor cars. The entity has been trading for 25 years and has seen year-on-year growth of sales and profits. Whereas most of the large, mass-production motor manufacturers have experienced over-capacity and falling profit margins in recent years, DaCosta plc has a waiting list of six months for a new car. All cars are manufactured in the UK, but there are sales outlets throughout Europe and the Far 2006.1
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Year Cash flow (US$million)
1 1.75
2 1.95
3 2.50
4 3.50
The following information is available: ● ●
● ●
●
●
the expected inflation rate in the USA is 2 per cent a year; real interest rates in the UK and USA are the same. They are expected to remain the same for the foreseeable future; the current spot rate is US$1.6 per £1 sterling; the risk-free rate of interest in the USA is 4 per cent per annum and in Britain 5 per cent per annum. These rates are not expected to change in the foreseeable future; the entity’s post-tax WACC is 14 per cent per annum, which it uses to evaluate all investment decisions; the entity is financed by £10 million shareholders’ funds (book values) and £2 million long-term debt which is due to be retired in two years’ time.
The entity can finance part of the investment from cash flow but, as it is also expanding operations in the UK, the chief executive would prefer external finance if this is available on acceptable terms. He has noted that borrowing rates in the euro-debt market appear very favourable at the present time. At 3 per cent they are below the rates in both the UK and the USA. Requirements (a) Calculate the sterling net present value of the project using both of the following methods: (i) by discounting annual cash flows in sterling; (ii) by discounting annual cash flows in US$. (10 marks) (b) Discuss: (i) the use of WACC as a discount rate in an international investment decision, in general terms and as it applies to DaCosta plc; (ii) the main risks to be faced by an entity such as DaCosta plc when it moves into a new international market, and how it might manage those risks; (iii) the main methods of financing overseas operations and the factors that the entity should consider before making a decision about borrowing in euro debt. (15 marks) (Total marks 25)
Question 4 GH plc is a UK-based retailing entity that operates in the USA and UK. The entity is evaluating the potential for expansion into Europe, starting in France. A detailed assessment of the costs and likely incremental revenues of opening stores in two major French cities 2006.1
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East. The chief executive of the entity, who is still the major shareholder, is considering extending the distributor network into the USA where there is a rising demand. At present, American customers have to order direct from the UK. A detailed assessment of the costs and likely incremental revenues of opening distributorships in two major US cities has been carried out. The initial cost of the investment is US$4.5 million. The cash flows, all positive and net of all taxes, are summarised below.
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has been carried out. The initial cost of the investment is FFr80m. The nominal cash flows, all positive and net of all taxes, are summarised below. Cash flow (FFr million)
Year 1 35.50
Year 2 42.50
Year 3 45.00
The entity’s treasurer provides the following information: ● The expected inflation rate in France is 4 per cent each year and in the UK 3 per cent each year. ● Real interest rates in the UK and France are the same. They are expected to remain the same for the foreseeable future. ● The current spot rate is FFr8.5 to £1 sterling. ● The risk-free annual rate of interest in France is 6 per cent and in the UK 5 per cent. These nominal rates are not expected to change in the foreseeable future. ● The entity’s post-tax weighted average cost of capital (WACC) is 15 per cent, which it uses to evaluate all investment decisions. The expansion will be financed by a combination of internal funds generated in the UK and long-term fixed interest rate debt raised in France. The entity plans to purchase in France the majority of its goods for resale. Requirements (a) Calculate the sterling net present value of the project, using both the following methods: (i) by discounting annual cash flows in sterling; (ii) by discounting annual cash flows in FFr, using an adjusted discount rate; and explain, briefly, the reasons why the two methods give almost identical answers. (9 marks) (b) Assume that the entity’s management is considering purchasing from outside France a substantial proportion of its goods to be sold in the French stores. Approximately 50 per cent of total goods for resale might be purchased in the Far East and a further 25 per cent in the UK. Discuss how a decision to change buying patterns might affect the evaluation and funding of the investment. (8 marks) (c) Assume that inflation in France turns out to be higher than forecast for the whole period of evaluation, with corresponding impact on the other economic factors. Inflation in the UK is slightly less than forecast. Discuss how the financial returns on the investment might be affected, and advise on a funding strategy that could minimise the impact of such inflationary effects. (8 marks) Note: Parts (b) and (c) are independent, that is, part (c) is not dependent upon the answer to part (b). (Total marks 25)
Question 5 Write a report on the pros and cons of using a Euro Commerical Paper programme as a major source of both short- and long-term funding. (6 marks)
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Solutions to Revision Questions
Solution 1 (a) Calculation of real rates and expected UK inflation 1 nominal interest rate 1 real rate 1 expected inflation rate 1.07 1.039 1.03 1.09 1.039 1.05
In Eastasian $ In £ sterling
Calculation of NPVs Method 1: Converting cash flows to sterling and discounting at sterling required rate of return Spot rates Current In 1 year’s time In 2 years’ time In 3 years’ time In 4 years’ time
2 (given) 2 (1.07 1.09) 2 (1.072 1.092) 2 (1.073 1.093) 2 (1.074 1.094)
2.0000 1.9633 1.9273 1.8919 1.8572
Discounting cash flows Cash flow (EA$000) Converted at spot rates as above Discounted at 16% NPV £270,000
Year 0 (2,500)
1 750
2 950
3 1,250
4 1,350
(1,250) (1,250)
382 329
493 366
1,661 1,423
1,727 1,401
Method 2: Discounting EA$s at risk-adjusted rate If required sterling return is 16 per cent and risk-free rate is 9 per cent, then risk premium is 1.16/1.09 per cent. The required return on EA$ cash flows is therefore 1.07 1.0642 13.87 per cent. Year 0 1 Discount factor at 13.87% 1.000 0.878 DCFs (2,500) 659 NPV EA$541,000 Converted at spot rate of 2.000: NPV £270,000.
2 0.771 733
3 0.677 847
4 0.595 803
(b) There are three main methods of financing overseas operations: 1. export capital from the home country; 2. borrow in the currency of the host country; 3. borrow internationally wherever interest rates are lowest. 393
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Each method has its own risks and costs. Risk mainly concerns the economic and political situation. If we take the question at its word and assume that Eastasia is politically stable, we are only concerned with economic risk. If Eastasia devalues its dollar, other things being equal, the Eastasian assets will be worth fewer pounds than before. The professional institute could protect itself against this risk by borrowing in Eastasian dollars. It would then have an Eastasian asset offset by an Eastasian liability. If the inflation rate in Eastasia is higher than expected, in theory this should be offset by a change in the exchange rate so the cash flows to the UK would be unaffected. However, if a rise in inflation coincides with a rise in the value of the Eastasian dollar, this indicates a rise in the real value of the Eastasian dollar and, other things being equal, a rise in the project’s cash flows when measured in sterling. Instead of focusing on the reduction of risk, the professional institute could use the CFO’s suggestion and finance the operation with Scandinavian currency. The question to be asked here is why Scandinavian interest rates are so low. Unless it is suspected that the Scandinavian government is deliberately holding down interest rates, there is no reason why the real rates of interest in Scandinavia are any different from anywhere else. The nominal rate is low only because investors expect low inflation and a strong currency. The advantage of Scandinavian currency is therefore likely to be offset by the fact that when the institute comes to repay the debt it will cost more in sterling than it would when the debt was taken out. There may also be other factors to take into account when deciding to issue bonds, such as the costs of raising the debt.
Solution 2 (a) (i) The forward rate for Westland dollars per Eastland mark is higher than the spot rate, which means that interest rates in Eastland are lower than in Westland: Day 1 Interest
8.7% p.a.
90 365
90
Em 1.0000
@ 0.4825
0.0215
9.5% p.a.
1.0215
@ 0.4834
$W 0.4825 90 365
0.0113 0.4938
(ii) On the other hand, if the forward rate was 0.4795, it would imply a higher rate of interest: Day 1 Interest
12.1% p.a.
90 365
90
Em 1.0000
@ 0.4825
0.0298
9.5% p.a.
1.0298
@ 0.4795
$W 0.4825 90 365
0.0113 0.4938
(iii) If the interest rate in Eastland was 8 per cent p.a., the implied forward rate would be 0.4842 $W per Em. Day 1 Interest: 90 2006.1
8% p.a.
90 365
Em 1.0000
@ 0.4825
0.0197
9.5% p.a.
1.0197
@ 0.4842
$W 0.4825 90 365
0.0113 0.4938
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Solution 3 (a) Calculation of NPVs (i) Method 1: Converting cash flows to sterling and discounting at sterling required rate of return Spot rates Current In 1 year’s time In 2 years’ time In 3 years’ time In 4 years’ time
1.6 (given) 1.6 (1.04 1.05) 1.6 (1.042 1.052) 1.6 (1.043 1.053) 1.6 (1.044 1.054)
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(b) (i) While it has been supplying the Hungarian market from the UK, R plc has been exposed to the risks consequent upon a weakening of the HUF, that is, it has effectively gone short of sterling to the extent of its investment, and long of HUF to the extent of its forecast remittances from Hungary. Had it wished to hedge this risk, it would have sought ways of (directly, or indirectly) borrowing HUF and depositing sterling. If the HUF weakened, it could pay off its borrowings with less than its total deposits, the balance being available to ‘subsidise’ prices to Hungary. On the assumption that the Hungarian market will continue to be supplied from somewhere, the principal currency risk which is opened up by a decision to produce locally is that of a strengthening of the HUF, that is, it reduces the exposure the company had when it was supplying from the UK. Thus, if it strengthened against sterling (assuming for simplicity that this is the only other country from which Hungary can be supplied), then local production will – other things being equal – look expensive. Hedging such a risk would involve (directly or indirectly) borrowing sterling and depositing in HUF. If the HUF strengthened, then sterling borrowings could be repaid with something less than the total HUF deposits – the balance being available to ‘subsidise’ prices in Hungary so as to match the international level. It will be seen that this is the opposite of that appropriate to supplying from the UK. The question does not say what cover was taken out while supplying from the UK, so we do not know what reduction in cover is required, but the result should be that the net present value of the cash flows expected to be remitted from Hungary (primarily purchases and dividends) should be matched by HUF denominated capital (shares or borrowings). (ii) As indicated above, given that a weakening remains the net risk, the required cover amounts to going short of HUF and long of sterling. Assuming the market had the appropriate liquidity, this could be achieved without actually borrowing/ depositing, for example, by selling HUF forward, or buying an option to sell HUF forward. (c) The cash flows within Hungary (sales, labour costs) would not be affected by a sterling devaluation, and the local company would – in terms of the spot rate – find its UK-sourced materials cheaper. Hence – other things being equal – the net cash flow of the Hungarian subsidiary would be improved. Moreover, the spot value of that net cash flow would amount to more pounds than it would have done without the devaluation. Tactically, therefore, the group would have been better off had it left the risk uncovered. Had it wished to protect itself against a weakening of the HUF, without eliminating the possibility of gaining from its strengthening, R plc could have investigated the costs of the option approach.
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Discounting cash flows: Year Cash flow ( US$M ) Converted at spot rates as above (£m) Discounted at 14% DCF (£m) NPV £1.541 million
0 4.500 2.813 1.000 2.813
1 1.750 1.104 0.877 0.968
2 1.950 1.242 0.769 0.955
3 2.500 1.608 0.675 1.085
4 3.500 2.273 0.592 1.346
(ii) Method 2: discounting US$ at risk-adjusted rate The required sterling return is 14 per cent and the risk-free rate is 5 per cent; the risk premium is 8.57 per cent (1.14/1.05). Required return on US$ cash flows is, therefore, 12.91 per cent, i.e. (1.04 1.0857) 1. Discount factors at 12.91% 1 0.886 DCFs (US$M) 4.500 1.550 NPV US$2.469 million Converted at spot rate of 1.6, NPV £1.543 million
0.784 1.529
0.695 1.737
0.615 2.153
Note: If candidates round the discount rate to 13 per cent they will arrive at an NPV of £1.534 million. This is acceptable. (b) (i) In theory, the WACC should be used to evaluate only those investments which are in the same risk class as the company average and which are financed in the same proportions of debt to equity and on the same terms. In domestic investments the discount rate should reflect the business risk of the project. The same principle applies to international investment decisions, although assessing the risk becomes more difficult, especially if proxy companies have to be found to determine the risk factor. In such circumstances, the WACC might be the ‘least-bad’ option. The effect on the WACC after the investment has been undertaken needs to be considered. The additional risks involved in investing overseas might be compensated by the diversification effect. (ii) The main factors to consider are: ● knowledge of the country’s operational environment; economic and financial, cultural and political; ● availability of local technical expertise. Probably not a problem here as training can easily be provided; ● travelling distances and difficulties between the overseas location and the home base; ● language problems – more of a problem in the USA than generally acknowledged; ● competition; ● alternative investment opportunities. The scenario mentions that DaCosta plc is considering UK expansion; what effect might the US operation have on the UK project in terms of financing and management? Risks fall into four main categories: transaction, translation, economic and political/ cultural. The main risks here would be transaction and, possibly, economic. Translation risk is an accounting issue and of little consequence to the investment decision, unless foreign borrowings are at a high level, and the providers of debt have imposed restrictions on gearing levels. This is unlikely to be the case here. Political risk is minimal, although some states’ tax rules might adversely affect the investment (it is not clear which states the two US cities are in). 2006.1
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Solution 4 (a) Calculation of NPVs Method (i): Converting cash flows to sterling and discounting at sterling required rate of return Spot rates Current In 1 year’s time In 2 years’ time In 3 years’ time
8.5 (given) 8.5 (1.04 1.03) 8.5 (1.042 1.032) 8.5 (1.043 1.033)
8.5 8.5825 8.6658 8.7500
Discounting cash flows Year Cash flow ( FFr M) Converted at spot rates as above Discounted at 15% DCF NPV £1.27 million
0 (80.00) (9.41) 1.000 (9.41)
1 35.50 4.14 0.870 3.60
2 42.50 4.90 0.756 3.70
3 45.00 5.14 0.658 3.38
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Transaction risk is the risk of adverse exchange-rate movements between the date of a transaction and the date of settlement. This can be managed by using internal or external hedging techniques, for example forward-rate contracts (external) or netting (internal). Economic risk is the risk of actions by governments and reactions of markets that have economy-wide implications. This type of risk might best be managed by raising finance in US dollars, as discussed below, or by manufacturing in the overseas country. (iii) There are three main methods of financing overseas operations: 1. export capital from the home country; 2. borrow in the currency of the host country; 3. borrow internationally wherever interest rates are lowest. Each method has its own risks and costs. Risk mainly concerns the economic and political situation. If we assume that the USA is politically stable, we are only concerned with economic risk. If the US dollar weakens against sterling, other things being equal, the US assets will be worth less, in sterling terms, than previously. DaCosta plc could protect itself against this risk by borrowing in US dollars. It would then have a US asset offset by a US liability. If the inflation rate in the US is higher than expected, in theory this should be offset by a change in the exchange rate, so the cash flows to the UK would be unaffected. However, if a rise in inflation coincides with a rise in the value of the dollar, this indicates a rise in the real value of the dollar and, other things being equal, a rise in the project’s cash flows when measured in sterling. Instead of focusing on the reduction of risk, the company could use the CE’s suggestion and finance the operation with euro debt. The nominal rate of this debt is low, presumably because investors expect low inflation and a strong currency. The advantage of euro debt is therefore likely to be offset by the fact that, when the company comes to repay the debt, it will cost more in sterling than it would when the debt was taken out. There may also be other factors to take into account when deciding to issue bonds, such as the costs of raising the debt.
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Method (ii): Discounting FFrs at risk-adjusted rate If the required sterling return is 15 per cent and the risk-free rate is 5 per cent, then the risk premium is: 1 9.52% 1.15 1.05 Required return on FFr cash flows is therefore: (1.06 1.0952) 1 16.09% Year 0 1 Discount factor at 16.09% 1.000 0.861 DCFs (FFr m) (80.00) 30.57 NPV FFr 10.87m Converted at spot rate of 8.5, NPV £1.28 million
2 0.742 31.54
3 0.639 28.76
If candidates round the discount rate to 16 per cent, they will arrive at an NPV of £1.297 million. This is acceptable. Two basic assumptions allow these calculations: ● Interest rate parity: Interest rates are determined in the market by supply and demand (although note political interference). There is a relationship between foreign exchange and money markets. Other things being equal the currency with the higher interest rate will sell at a discount in the forward market against the currency with the lower interest rate. ● Inflation also affects the relationship between exchange rates and interest rates. This is that the expected difference in inflation rates between two countries equals, in equilibrium, the expected movement in spot rates. (b) In theory, PPP suggests that there should be little effect, but there are practical considerations such as: ● Relative prices in the various countries, adjusted for transport costs and taxes. There is some level of harmonisation between France and the UK (although the UK is not in the common currency area), but the ‘Far East’ could encompass many different countries and associated tax regimes. ● Any legal restrictions on the purchase and movement of goods from countries in the Far East should be considered. ● As all sales will be made in France (presumably), the move to source goods for resale elsewhere removes the natural hedge of matching receipts and payments in the same currency. This means other forms of hedging mechanisms will need to be taken into account in the evaluation. ● Purchases in the UK will not be a problem because the parent company is in the UK, but purchases in the Far East could present difficulties, unless payment could be agreed in French francs/euros, sterling or a third currency such as US dollars. This transfers the risk to the supplier and whether this is acceptable will be influenced by the buying power of GH plc. ● The discount rate might need to be adjusted to accommodate the additional risks and uncertainties of dealing in different currencies. Movements in Far Eastern currencies tend to be related to each other and to the dollar. It would be useful to have forecasts of economic data for the US and relevant countries in the Far East. 2006.1
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The question does not say how the debt principal is to be repaid. Assuming it is paid at the end of the period, then it will be paid in depreciated currency.
Solution 5 (Note: a report format would be required in an examination). Pros Low interest rates Low regulation Flexibility in maturity/currency Widens investor base Deep, liquid market No onerous covenants
Cons Need good credit Liquidity/funding risk, both: ● whether it will be possible to refinance the loan at all, and ● at what rate (e.g. adverse effect of a fall in credit rating in the meantime) Time and cost to set up the programme
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As the FFr is forecast to depreciate against sterling, the benefits of buying in a depreciating currency might be lost (depending to some extent on any credit period allowed/taken). ● Funding the expansion in FFrs might still be advantageous for reasons noted in requirement (b) – debt will be repaid in depreciated currency. As all sales are in FFrs, the arguments for financing in that currency remain. (c) There is a strong connection between inflation, interest rates and exchange rates as discussed in requirement (a). This means that, if inflation rises in France, interest rates will also rise and, if interest rate parity and purchasing power parity hold, then the FFr will sell at a higher discount in the forward market against the £ than forecast. All other things being equal, the NPV of the investment in sterling terms will be lower. However, it will depend on factors such as: ● the scope the company has to raise prices in line with inflation; ● whether all costs in France will be affected by the same rate of inflation; ● the relative proportions of French-produced goods and imports, and where the imports are from. Issues to consider in respect of funding are: ● assuming interest is paid in francs in France, the method of financing is to the company’s advantage. In fact, it might have been advisable to have funded the whole of the expansion in francs. This would have provided additional benefits of matching currency inflows and outflows. ●
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This chapter is intended for use when you are ready to start revising for your examination. It contains: ● ● ●
●
a summary of useful revision techniques; details of the format of the examination; a bank of examination-standard revision questions and suggested solutions. These solutions are of a length and level of detail that a competent student might be expected to produce in an examination; a complete pilot paper. This should be attempted when you consider yourself to be ready for the examination, and you should emulate examination conditions when you sit it.
Revision technique Planning The first thing to say about revision is that it is an addition to your initial studies, not a substitute for them. In other words, do not coast along early in your course in the hope of catching up during the revision phase. On the contrary, you should be studying and revising concurrently from the outset. At the end of each week, and at the end of each month, get into the habit of summarising the material you have covered to refresh your memory of it. As with your initial studies, planning is important to maximise the value of your revision work. You need to balance the demands for study, professional work, family life and other commitments. To make this work, you will need to think carefully about how to make best use of your time. Begin as before by comparing the estimated hours you will need to devote to revision with the hours available to you in the weeks leading up to the examination. Prepare a written schedule setting out the areas you intend to cover during particular weeks, and break that down further into topics for each day’s revision. To help focus on the key areas try to establish: ●
●
which areas you are weakest on, so that you can concentrate on the topics where effort is particularly needed; which areas are especially significant for the examination – the topics that are tested frequently.
Do not forget the need for relaxation, and for family commitments. Sustained intellectual effort is only possible for limited periods, and must be broken up at intervals by lighter activities. And do not continue your revision timetable right up to the moment when you 401
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enter the exam hall: you should aim to stop work a day or even two days before the exam. Beyond this point the most you should attempt is an occasional brief look at your notes to refresh your memory.
Getting down to work By the time you begin your revision, you should already have settled into a fixed work pattern: a regular time of day for doing the work, a particular location where you sit, particular equipment that you assemble before you begin and so on. If this is not already a matter of routine for you, think carefully about it now in the last vital weeks before the exam. You should have notes summarising the main points of each topic you have covered. Begin each session by reading through the relevant notes and trying to commit the important points to memory. Usually this will be just your starting point. Unless the area is one where you already feel very confident, you will need to track back from your notes to the relevant chapter(s) in the Study System. This will refresh your memory on points not covered by your notes and fill in the detail that inevitably gets lost in the process of summarisation. When you think you have understood and memorised the main principles and techniques, attempt an exam-standard question. At this stage of your studies you should normally be expecting to complete such questions in something close to the actual time allocation allowed in the exam. After completing your effort, check the solution provided and add to your notes any extra points it reveals.
Tips for the final revision phase As the exam approaches, consider the following list of techniques and make use of those that work for you. ●
● ●
●
●
●
Summarise your notes into a more concise form, perhaps on index cards that you can carry with you for revision on the way into work. Go through your notes with a highlighter pen, marking key concepts and definitions. Summarise the main points in a key area by producing a wordlist, mind map or other mnemonic device. On areas that you find difficult, rework questions that you have already attempted, and compare your answers in detail with those provided in the Study System. Rework questions you attempted earlier in your studies with a view to producing more ‘polished’ answers (better layout and presentation earn marks in the exam) and to completing them within the time limits. Stay alert for practical examples, incidents, situations and events that illustrate the material you are studying. If you can refer in the exam to real-life topical illustrations you will impress the examiner and earn extra marks.
Format of the examination Structure of the paper There will be a written examination paper of three hours, with the following sections. Section A – 50 marks A maximum of four compulsory questions, totalling 50 marks, all relating to a single scenario. Section B – 50 marks 2006.1
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Types of question The compulsory case study-type question will usually be divided into two or three parts. If three parts, the first part may be a short discussion question that can be answered in general terms. This part of the question will typically carry 6–8 marks. The second and third parts of the compulsory question will involve calculations and discussion. The purpose of splitting the question in this way is to focus candidates’ attention on the need for, and type of, calculations required to support their discussion and to allow the report to focus on interpretation. The report section of the question may be further subdivided by bullet points. These are given to guide candidates’ answers. It may be useful for candidates to use these bullet points as headings in their report. The optional questions will, generally, be one of the following types: ●
●
●
of similar structure to the compulsory question. That is: part calculation, part discussion but of more limited scope; an essay-type question that requires discussion of theories and their practical application in the context of a short scenario provided. These questions may be subdivided by bullet points to guide candidates’ answers; a ‘split’ question, where parts (a) and (b) are independent of each other.
There will be a reasonable balance of different types of question in each paper but it must not be assumed that every paper will contain an example of each of the three types given above. The first two types are likely to be more common than the third. Two or three of the optional questions will contain some calculations. There will always be at least one question where no calculations are required. Overall, the paper will be weighted 30–40 percent calculations, 60–70 per cent discussion. It should be remembered that the report or discussion section of a question might allow for, or even require, additional calculations to fully demonstrate a point.
Allocation of time The time allowed for Financial Strategy is 3 hours. This is 1.8 minutes per mark although some allowance needs to be made for initial reading time and final checking/reading of the answers. Candidates should allocate the time according to the division of marks between each question and section of the question. As a rough guide, candidates could allocate their time as follows: Reading the paper Question 1 (50 marks) Optional questions (25 marks) Final check of script
10 minutes 85 minutes 40 minutes each 5 minutes
Time should be allocated to parts of questions in a similar way. So, for example, an optional question that is weighted 15 and 10 marks would require around 24 and 16 minutes, respectively on the answers. 2006.1
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Two questions, from a choice of four, each worth 25 marks. Short scenarios will be given, to which some or all questions relate. Any change in the structure of the examination or in the format of questions will be indicated well in advance in the appropriate CIMA journals.
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It is essential that candidates plan their answers. There is no hard and fast rule about how much time should be spent planning and how much spent writing but a rough guide might be 30 : 70. This means for question 1, for example, 25 minutes planning and doing rough calculations and 60 minutes writing the answer. Students should practise doing this with past exam papers.
Weighting of subjects The examination papers will reflect the syllabus weightings and learning outcomes. It may not be possible to test all learning outcomes on every paper and clearly all syllabus topics cannot be examined on every paper. However it can be expected that: ● ●
each examination paper will reflect the balance of the syllabus and learning outcomes; the balance of the questions in each paper will reflect the weighting given to different sections of the syllabus. In Financial Strategy, each section has equal weighting. Syllabus table
Learning outcome Formulation of Financial Strategy Identify an organisation’s objectives in financial terms and evaluate their attainment Discuss the interrelationships between decisions concerning investment, financing and dividends Identify and analyse the impact of internal and external constraints on financial strategy Evaluate current performance, taking account of potential variations in economic and business factors Recommend alternative financial strategies for an organisation Financial management Identify and evaluate optimal strategies for the management of working capital and satisfaction of longer-term financing requirements Identify and evaluate key success factors in the management of the finance function and its relationship with other parts of the organisation and, where necessary, with external parties Discuss the role and management of the treasury function Business valuations and acquisitions Calculate values of organisations of different types, e.g. service, capital intensive Identify and calculate the value of intangible assets (including intellectual property) 2006.1
Case-study question
Scenario question
4, 7, 8, 11, 12
1, 11, 14, 16, 17, 19, 41, 52, 55 9, 10, 19, 24, 40, 46
2, 9, 10, 14
2, 4, 27
7
1, 3, 27, 41, 49, 55
1, 5
10, 16, 17, 22, 33, 39
1, 3, 10, 13
6, 9, 13, 14, 15, 20, 21, 22, 23, 25, 26, 28, 29, 30, 33, 34, 35, 36, 37, 38, 39, 44, 47, 48, 50, 53, 54
1, 3, 4, 10
6, 16, 20, 21, 22, 23, 25, 26, 28, 29, 30, 33, 34, 35, 36, 37, 38, 52 15, 18, 19, 32, 38, 46, 52
3, 6, 7, 13, 14 3, 9, 13, 14
10, 14, 31, 39, 40, 42, 43, 45, 47, 53 42
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Learning outcome Identify and evaluate the financial and strategic implications of proposals for mergers, acquisitions, demergers and divestments Compare and recommend alternative forms of consideration for, and terms of, acquisitions Calculate post-merger value of companies Identify and evaluate post-acquisition value enhancement strategies Discuss and illustrate the impact of regulation on business combinations Evaluate exit strategies Investment decisions and project control Analyse relevant costs, benefits and risks of an investment project Evaluate investment projects (domestic and international) taking account of potential variations in business and economic factors Recommend methods of funding investments, taking account of basic tax considerations Evaluate procedures for the implementation and control of investment projects Recommend investment decisions when capital is rationed
Case-study question 6
Scenario question 31, 42, 45
31, 42, 45, 53 9 9, 13
42, 45, 53 42, 45
9 5, 6
43
1, 4, 8, 9, 10, 11, 12
4, 5, 7, 8, 12, 51
1, 2, 4, 8, 9, 10, 11, 12, 13, 14
2, 4, 5, 7, 8, 12, 51
1, 2
8
8, 13 8
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Syllabus table (continued)
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Case-study Questions
The case-study questions that follow cover a number of syllabus topic areas. A number of the questions are adapted from the case-study questions set under the ‘old’ syllabus for Management Accounting – Financial Strategy. In some cases, sections of questions have been removed if the topic covered is not relevant to the Management Accounting – Financial Strategy syllabus. Examiner’s notes, where they are still relevant, have been retained as part of the solutions.
Case study 1 Scenario Tutwiler plc manufactures musical instruments. It has been quoted on the Alternative Investment Market (AIM) in the UK for 12 months. The latest dealings have been in the region of 200p per share. The company exports around 60 per cent of its output. Customers are dispersed around the country and there is no concentration in one particular area. Tutwiler plc’s turnover has been growing at around 20 per cent per annum over the past 5 years, and it now needs to consider extending its premises or moving to a new location. The present premises are rented from the local government authority. The rental agreement is due for renewal on 1 January 1997. The company spent £500,000 on renovations to the property three years ago to provide a more suitable manufacturing environment for its products. The renovations are structural and could not be removed if Tutwiler plc decides to relocate. The company is considering three alternatives. 1. renegotiate the rental agreement and extend the existing premises with the approval of the landlords; or 2. buy a much larger property which is available a few miles from the current premises and which is around 20 years old; or 3. build a new factory and office premises in an ‘enterprise zone’ approximately 150 miles away. The information available on these three alternatives is as follows. Alternative 1: rent and extend The rental terms would be £500,000 per annum in real terms as at 1 January 1997. Rent will be payable at the end of each of the years 1997–2001. Rates are included with the rental payments. 407
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The agreement allows for an increase in the annual rental payments in line with inflation of 5 per cent per annum. Extensions to the premises would cost £950,000 (nominal), payable at the end of 1997. You should assume extension costs can be written off, for tax purposes, in the year in which they are incurred. The local authority (the landlord) has indicated it would be willing to purchase the extension from Tutwiler plc at the original nominal cost at the end of 2001. Alternative 2: buy larger, locally The purchase costs are £2.5m payable on 1 January 1997. Rates will be fixed at £250,000 per annum, payable at the end of each year from 1997 to 2006 inclusive. Renovations and removal costs payable at the end of the first year (1997) are estimated at £ 750,000 nominal. The company thinks these premises will be large enough until the end of 2006. After that, it may have to sell and move again, as there is no possibility of extending these premises. You should assume that writing-down allowances for tax purposes are available on the full purchase cost of the new premises at 4 per cent, straight line. The realisable value of the premises at the end of 10 years is estimated as £5m nominal. Note: Assume the application of indexation allowance at the time of sale will result in there being no balancing charge or balancing allowance. Alternative 3: build new The land will cost £1m which will be paid at the beginning of the evaluation period (1 January 1997). Building costs are estimated at £1.25m. They will be paid at the end of 1997. While building is in progress, the company will remain in its existing premises at an agreed annual rental of £500,000, payable on 1 January 1997. No rates will be payable on the new premises for the years 1997 to 1999 inclusive. From 2000 onwards they are expected to be £150,000 per annum indefinitely, payable at the end of each year. The company estimates that 50 per cent of the workforce will relocate. Removal and relocation costs at the end of 1997 will be £250,000. Recruitment and training costs of the new staff are estimated as £350,000, also payable at the end of 1997. Assume all costs in this alternative are in nominal terms. The cost of the land will not attract any tax allowances. The cost of the buildings, being in an enterprise zone, will attract 100 per cent first-year allowance. For purposes of evaluation, assume a 15-year life of the land and buildings from the commencement of the evaluation under this alternative. Notes 1. Assume that the starting date for the evaluation is 1 January 1997. 2. All costs other than those noted above are expected to be the same under all three alternatives. The choice of location is not expected to affect sales. 3. The company pays tax at 33 per cent. This rate is not expected to change. Tax relief is available on 100 per cent of all expenses and costs except land in alternative 3, and buildings in alternative 2, which attract writing-down allowances as indicated. You should assume that there is no time lag for tax payments or refunds. 4. The company currently has 5m shares in issue and £2m debt. The debt is a 15-year bank loan at 15 per cent fixed rate of interest, secured by personal guarantees of the directors. It was taken out in 1995. 5. If alternative 1 is chosen, Tutwiler plc can finance it out of operating cash flows. If alternative 2 or 3 is chosen, new finance must be raised. The most likely method would be a 2006.1
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Requirements (a) Calculate the company’s cost of capital using the CAPM (as per details in note 6 of the scenario). (4 marks) (b) Calculate the NPV and equivalent annual costs for each project, using the discount rate obtained in your answer to (a). Make whatever assumptions you think necessary but base them wherever possible on information provided in the scenario. Note: If you have been unable to answer part (a) you may assume a rate of 13 per cent after tax. (15 marks) (c) Assume you are the company’s management accountant. Write a report to the finance director, based on your calculations in answer to part (b) of the question, recommending which project should be chosen and why. You should include in your report an explanation of your method of ranking and choice of discount rates. You should also comment on the risks, financial and non-financial, involved in choosing between the three alternatives. (15 marks) (d) Explain the shortcomings of using the CAPM to arrive at risk-adjusted discount rates in the circumstances of the scenario presented here, and comment on an alternative method of evaluating uncertain cash flows. (8 marks) (e) The finance director later suggests that there is greater uncertainty attached to alternative 1 because of a cancellation clause in the contract, exercisable at the option of the landlord. He therefore suggests that a discount rate 2 percentage points higher than the one used in the original calculations is more appropriate to evaluate alternative 1. (i) Comment on the logic of adjusting the discount rate by a notional percentage to allow for uncertainty. (ii) Comment on the difference between risk and uncertainty. (8 marks) (f ) The decision is eventually taken to build new (alternative 3), but the company fails to get the required permission from its bankers to finance the investment by its preferred method of a 5-year debenture. The finance director suggests the company could consider raising the money via a venture capital company. Discuss the advantages and disadvantages of raising new capital by this method in the circumstances of the scenario compared with medium-term debt or a rights issue. (10 marks) (Total marks 60)
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5-year debenture secured on the building. The interest rate payable on debt of this maturity is 11.5 per cent. 6. The accountant advising Tutwiler plc suggests using the capital asset pricing model (CAPM) to estimate the company’s cost of capital, which can then be used as the discount rate. A competitor company, which is quoted on the London International Stock Exchange, and which has a debt : equity ratio (based on market values) of 1 : 3, has a published equity beta of 1.2. This is unlikely to change in the foreseeable future. You should assume a debt beta of 0.2. The expected return on 3-month Treasury Bills is 8 per cent. The expected return on the market is 13 per cent. Assume all these figures in note 6 are after adjusting for tax. 7. You should work in round £000s and, if necessary, round your calculated discount rate to the nearest percent and use the discount tables provided.
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Case study 2 (a) Zenobia is a developing country situated on the coast of Africa. Its government, now democratically elected, has produced a programme of economic reforms aimed at promoting investment in the country and reducing its dependence on foreign aid. A major feature of this programme is the privatisation of companies and corporations which are currently 100 per cent owned by the government, for example, hotels, breweries and coffee production. For the time being, the government is not considering privatising services such as post, railways or the provision of basic telecommunications (this is mainly the fixed line, voice telephony service). It does, however, wish to attract private capital to provide new services such as cellular (mobile) telephones and data communication. Global Telecommunications Inc (GTI) is a company registered in the USA but with global business interests. Its shares are not listed on a stock exchange, but industry sources estimate that it could command a market capitalisation of around US$200m. It has established itself as a specialist in the provision of mobile telephone (cellular) services. It is currently negotiating with the government of Zenobia (GoZ) for a licence to provide such services in the country and has already spent US$0.5 million in surveys and miscellaneous expenses. If GTI were successful in the negotiations, it would be the company’s first experience of working in a developing country. Based on a recent World Bank report, GTI estimates that there is a market for between 10,000 and 15,000 customers in a rectangular geographical area bounded by the capital city and three other main towns. The proposed cellular service will operate in this relatively prosperous ‘urban rectangle’ but the poorer, rural areas outside the rectangle will not be covered. The market for 10,000 lines is, apart from potential disasters, virtually guaranteed. GTI estimates that the initial investment for this number of lines will be US$25m. The company has asked the GoZ for a 5-year exclusivity period (a period when no other company will be allowed to enter the market to compete). Net operating cash flows, based on a network of 10,000 lines, are forecast to be: Year Net operating cash flows (US$m)
1 3.5
2 4.8
3 5.6
4 6.8
Cash flows are after interest and tax payments and are shown in US$ equivalents at today’s exchange rate. In year 6, competitors are likely to enter the market and cash flows are expected to fall to around US$6m per annum. For the purposes of evaluation, GTI assumes this annual net cash flow will be maintained indefinitely from year 6 onwards on a network of 10,000 lines. The GoZ is aware that there are other telecommunications companies which are considering investment in the country, although to date none has formally declared an interest. It is therefore not prepared to offer a licence based on GTI’s terms and has made two counter-proposals for GTI to consider. Option 1 GTI must provide at least 20 per cent of the 10,000 lines to rural areas and charge rural customers lower rental and call charges than urban customers. In return, the GoZ will allow a 10-year period of exclusivity to GTI. GTI estimates this option will involve US$30m in initial capital costs, and annual net operating cash flows are likely to fall US$0.5m below those forecast above. However, the 10-year period of exclusivity means 2006.1
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Number of additional lines 2,000 3,000 5,000
Probability 0.60 0.30 0.10
Note: You should assume that the additional lines will be connected simultaneously at the end of year 3. Option 2 GTI will be allowed a 5-year period of exclusivity, a tax holiday for that 5-year period and other cost concessions by the GoZ. In return for these concessions, the GoZ requires a 20 per cent shareholding in GTI’s Zenobia subsidiary. Dividends will not be payable on this 20 per cent, and GTI may remit all profits during this 5-year period free of tax. However, GTI will not be permitted to expand the network during the 5-year period, and at the end of 5 years GTI will be required to sell 100 per cent of its Zenobia interests on the Zenobia stock market, which is planned to be operational by that time. GTI estimates that this option will reduce the initial investment needed to US$20m, and increase annual net operating cash flows by 10 per cent over the company’s original forecasts. The terminal value of GTI’s Zenobia subsidiary is estimated as the capitalised value of year 5’s net operating cash flows. There is some dispute between GTI’s directors about the discount rate to be used for the evaluations of this project. The company’s cost of capital is 15 per cent per annum constant, and this is the rate which is being suggested. However, the managing director thinks this is a particularly risky project, not least because all calculations and negotiations with the GoZ are in US$, but also because much of the cash inflow will be in local currency. The technical director says that, as the project increases international diversification, it actually reduces the company’s risk, so a lower rate should be used. The finance director says that, as the three options being evaluated have different life spans, different discount rates should be used to evaluate the three options. He also notes that the cash flows for each year are highly correlated with those of the previous and subsequent years. Requirements (a) (i) Advise the board of GTI of the methods available for evaluating international investment decisions, and on how an appropriate discount rate should be determined for the evaluation of a project such as this. Your discussion should be based on, but not necessarily limited to, the comments of the three directors given in the last paragraph above. (10 marks) (ii) Provide the board of GTI with a report which evaluates the net present value of the company’s own proposal and the two options suggested by the GoZ. You should also provide in your report reasoned recommendations for which, if either, of the government of Zenobia’s offers should be accepted. You should assume that all cash flows occur at the end of each year, with the exception of the initial investment. 2006.1
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that further investment in the network might be advantageous. In considering this option, GTI estimates that an additional investment to provide between 2,000 and 5,000 additional lines at the end of year 3 may be worthwhile. The following information is relevant to GTI’s decision: The capital cost of each additional line is estimated at US$2,000. The average net operating cash flow for each additional line is estimated as US$600 from year 4 onwards. The probabilities for additional demand are:
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Assume also that the board of GTI has agreed on a discount rate of 20 per cent to evaluate all three options for the project. (25 marks) Note: You should ignore taxation in your calculations. (b) GTI is at present all equity financed. The company has sufficient cash flows from other projects to enable it to finance the Zenobia deal internally. However, the IFC (the World Bank’s sister company, which provides finance for investment in developing countries) is prepared to offer 10 per cent fixed interest rates on loans of up to US$20m for investments of this nature. Capital is repaid at the end of the loan period, which must be a minimum of 5 years. Interest is paid annually. No early repayment of the loan is permitted without severe financial penalties. If GTI were to raise a similar amount of debt in the capital markets, it would currently be obliged to pay 12.5 per cent interest. GTI will be eligible for tax relief at 40 per cent on loan interest payments. Requirement Discuss the advantages and disadvantages of financing the project with an IFC loan. (10 marks) (c) A regulatory body for the telecommunications industry in the country, the Zenobia Office of Telecommunications (Zoftel), is being established. Requirements (i) Explain the objectives and main activities of a regulatory authority. (10 marks) (ii) Comment on how Zoftel might influence negotiations between GTI and the GoZ. (5 marks) (Total marks 60)
Case study 3 Scenario Ibsen plc is a privately owned toy manufacturing company which has been trading for 12 years. It has fifteen shareholders who each own an equal number of shares. Two of the shareholders are full-time managers in the company. The shareholders have discussed the possibility of a public flotation of shares on a number of occasions over the past 5 years, but have each time decided against the idea because it would conflict with many of their personal objectives for the company. However, some of the shareholders would now like to liquidate a proportion of their investment and believe the time might be right for a quotation on the London International Stock Exchange. Recent financial information The company’s accounting year ends on 31 December. Summary financial information for the five years 1993–1997 and forecast for 1998 is shown below (all figures in £m). Income account (extracts)
Revenue Profit before tax and interest Interest 2006.1
1998 forecast 220.0 36.0 4.0
1997 215.0 25.0
1996 170.0 27.0
1995 150.0 26.0
1994 125.0 23.0
1993 115.0 21.0
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Dividend payable (net of ACT)
210.6 221.4
218.2 216.8
178.9 118.1
158.6 117.4
127.6 115.4
117.0 114.0
17.5
17.5
17.5
9.0
9.0
9.0
Balance sheet (extracts)
Assets Non-current Current (net of liabilities) Less: long-term borrowings Ten-year bank loan Financing Authorised and issued ord. share capital par value 50p Reserves
1998 forecast
1997
1996
1995
1994
1993
124.0 148.0 172.0
85.0 135.0 120.0
66.0 30.0 96.0
60.0 34.0 94.0
55.0 30.0 85.0
50.0 28.0 78.0
145.0 127.0
0–0 120.0
0– 0 96.0
0– 0 94.0
0– 0 85.0
0– 0 78.0
30.0 197.0 127.0
30.0 190.0 120.0
30.0 66.0 96.0
30.0 64.0 94.0
30.0 55.0 85.0
30.0 48.0 78.0
Notes ● The fixed assets were revalued in 1997. ● The average P/E ratio for companies in Ibsen plc’s industry is currently 11. ● The company’s marginal and average tax rate is 33 per cent. ● The bank loan was taken out on 1 January 1998. It is secured on the firm’s premises and carries a variable rate of interest. The interest rate on similar loans made to companies with the same risk characteristics as Ibsen plc averaged 10 per cent throughout 1997. ● The company’s weighted average cost of capital is currently 14 per cent after adjusting for tax. Developments 1998–2002 Note: The information in this section of the scenario relates only to requirement (b) of the question. The company is floated on the Stock Exchange during 1998 at 300 pence per share. Assume that it is now the year 2002 and the company wishes to raise £250m for the development and marketing of new products. The following information is relevant: ●
●
●
There has been no change in issued ordinary share capital during the 5 years and no new debt has been raised. Earnings after interest and taxes in the year to 31 December 2001 were £45m. The original shareholders now own 20 per cent of the issued shares; a further 20 per cent is owned by three large institutional investors and the remaining 60 per cent by a large number of small, private investors. P/E ratios have been as follows over the past 9 months: Present Three months ago Six months ago Nine months ago
Ibsen plc 18 15 14 16
Industry 16 16 15 15
The company is considering raising the £250m by means of either a rights issue at 15 per cent discount to the prevailing share price, or issuing convertible debt which would be convertible into ordinary shares in five years’ time. 2006.1
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Taxation Profit after interest and tax
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Requirements (a) Assume you are a financial adviser to Ibsen plc prior to flotation in 1998. Write a report to the board which: (i) recommends an issue price for the company if it decides to seek a stock market quotation. You should estimate the price using three methods: the dividend valuation model (using your own assessments about the growth rate), net asset value, and on a P/E basis, and explain the reasons for your formal recommendation. Assume no change in issued share capital before flotation and that the existing shareholders are each prepared to sell 49 per cent of their holding. (15 marks) (ii) discusses the difficulties of setting a new issue price and recommends what other information should be considered by the company before deciding whether to proceed with the flotation. (7 marks) (b) The company was floated in 1998 at an issue price of 300 pence per share. Assume it is now 2002 (i.e. 5 years after flotation) and you are advising the company on its need for new capital. Write a report to the board which: (i) advises a suitable rights issue price and calculates the theoretical ex-rights price. (6 marks) (ii) advises on the conversion terms for the issue of convertible debt. The return on unsecured debt is 10 per cent in 2002. (10 marks) (iii) explains, briefly, the main advantages and disadvantages to a company such as Ibsen plc of raising finance via either a rights issue or convertible debt. Using your assumptions and calculations in (i) and (ii) above, recommend which of the two methods of financing is to be preferred by Ibsen plc in the circumstances. (6 marks) (Total marks 44)
Case study 4 Scenario Spearhead plc, a company based in the UK, manufactures high-technology landing and airport control equipment which it sells worldwide, mainly to government departments. The company was owned by the government of the UK until 1988 and has demonstrated strong growth since privatisation, although it is not the market leader in the industry. In its last financial year, the company had earnings of £360m and earnings per share (EPS) of 60 pence. The current share price is 950 pence compared with 825 pence a year ago. The company’s equity beta is quoted at 1.5. Company objectives ● Financial objectives: (i) Investing in projects which yield a positive NPV when discounted at an appropriate discount rate. (ii) Maintaining an annual return on assets at 25 per cent. ● Other objectives. The company aims to be the leading UK supplier of airport control equipment within the next ten years and retains a large proportion of its earnings for future investment. It pays a relatively low annual cash dividend and aims to top this up with a scrip dividend each year. 2006.1
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The forecast cash flows, in nominal terms, are: Initial capital expenditure Estimated residual value at the end of the project Revenue Contract costs
●
£300m £50m DM500m per annum £ 75m per annum
The bidding for this contract is expected to be fiercely competitive. Despite the need for a fixed-price clause in the contract, the company classifies this investment as low risk. Contract 2. The customer is the government of a country in the Middle East. The contract is in two stages. The first stage is for the provision of a single delivery of a major piece of equipment worth US$2,000m. The terms are that a 50 per cent deposit is to be paid when contracts are signed: the balance will be paid on delivery at the end of year 2. Payment for stage 1 will be in US dollars. A penalty of 10 per cent of the contract value is payable if the contract overruns. The second stage of the contract, starting in year 3, involves the supply of a large number of smaller pieces of equipment over a 3-year period. No additional capital investment will be required for this work, which is estimated to be worth £600m. Payment for stage 2 will be in sterling. The second stage of the contract is relatively low risk, but there are high risks associated with the first stage. For example, the initial piece of equipment is state-of-the-art technology. This requires the full-time involvement of many of the company’s design staff, and will mean the loss of some other business currently being considered by Spearhead plc. The incremental cash flows (net of any saving in capital outlay) associated with this lost business are estimated at £175m in year 1 and £150m in year 2. The forecast cash flows, in nominal terms, are: Stage one of contract 2 Initial capital expenditure Revenue Contract costs
£500m. This can be used on the second stage of the contract if it is awarded but otherwise there is no residual value. As per contract details above. £350m in year 1 and £1 50m in year 2.
Stage two of contract 2 (starting in year 3) Revenue Contract costs
£200m per annum £100m per annum
Other information ● Estimated inflation rates per annum: UK 3 per cent; Germany 2 per cent; USA 4 per cent. ● Real interest rates in all countries are expected to remain the same. The risk-free rates are: UK 6 per cent; Germany 5 per cent; USA 7 per cent. ● The expected return on the market is 12 per cent per annum. 2006.1
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Information on major contracts Spearhead plc is examining two potential contracts which will each require substantial capital investment. The timing of the bids, the amount of capital investment required, and the need for highly specialised design staff mean that it can bid for only one of the two contracts. Details are as follows. ● Contract 1. The customer is a Western European government. The contract is for the supply of radar-controlled landing equipment over a period of 4 years to a value of DM2,000m. Spearhead plc must agree a fixed price in Deutschmarks for the duration of the contract.
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●
●
●
The current spot rates are DM3 to £1 and US$1.6 to £1. All cash flows occur at year end except where otherwise indicated. All raw materials and other costs associated with the supply of the equipment are sourced and paid for in the UK. The evaluation method used by Spearhead plc is to translate the foreign currency income into sterling and discount the cash flows at the appropriate sterling opportunity cost of capital. The company depreciates capital equipment on a straight-line basis over the life of the equipment, after adjusting for any estimated residual value. The company calculates its cost of equity using the CAPM and uses this to evaluate all sterling-denominated investments. However, because of the difficulties in determining discount rates for international investments, it uses a ‘rule of thumb’ approach and adjusts its cost of equity by a percentage for the estimated amount of risk involved, as follows: High-risk projects Medium risk Low risk
cost of equity plus 5% cost of equity plus 2% cost of equity
Requirements (a) Discuss the factors which need to be considered when determining discount rates for evaluating international investment decisions. Comment specifically on the difficulties which would be involved in using the CAPM to calculate international discount rates. (8 marks) (b) Calculate, using the information given in the case: (i) the cost of equity; (ii) the exchange rates to apply to the foreign currency cash flows of each of the contracts; (iii) the net present value and annual return on assets of each of the contracts. Make (and state in your answer) whatever assumptions you think necessary. Work to the nearest million units of currency (sterling, DM, US$). (22 marks) (c) Assume that you are a financial manager with Spearhead plc. Write a report to the board of Spearhead plc which recommends, with reasons, which contract, if either, should be chosen. You should include in your report comments on: (i) how each contract might contribute to the achievement of the company’s objectives; (ii) how the company has incorporated risk into its evaluation, and alternative methods of risk management which could be considered by the company; (iii) the difficulties involved in evaluating mutually exclusive projects of unequal risk and unequal lives; (iv) methods of hedging the risks associated with trading internationally. (30 marks) Note: If you have not been able to complete part (b) of this question, or think you have arrived at incorrect NPVs, answer part (c) in general terms but relate your answer to the company details in the case wherever possible. (Total marks 60)
Case study 5 Scenario VG plc is a manufacturer of electrical equipment. It is based in the south of England. The company trades with a large number of customers, mainly in Europe and Asia. Less 2006.1
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Extracts from VG plc’s balance sheet At 31 October 1998 9£000 £000 Non-current assets Freehold property Plant, equipment and vehicles (NBV) Current assets Inventories Receivables Total current assets Less current liabilities Overdraft1 Trade payables2 Tax payable3 Dividends payable 10% debenture 20004 Total current liabilities Net assets Financed by Ordinary shares (50 pence par value) Reserves
At 31 October 1999 (draft) 9£000 99£000
3,500 4,850 (95,250 (96,250
993,500 993,850 94,500 95,250
11,500 (1,900) (9,100) (9,(650) (9(9– (3,000)
999,750 (2,475) (9,500) (9(9– (9(9– (3,000)
(14,650) , 15,200)
(14,975) 1 2,125)
4,000 1,200 5,200
994,000 99(1,875) 99)2,125)
Notes 1. The overdraft at 31 October 1999 is the maximum agreed facility and is unsecured. Interest is payable at 6 per cent above base rates, which are currently 6 per cent. No change in rates is expected for the foreseeable future. 2. Eighty per cent of trade creditors at 31 October 1999 are seriously overdue. 3. The company’s marginal tax rate is 30 per cent. 4. The debenture is secured on the company’s fixed assets. It is due to be repaid at the end of June 2000.
Asset valuation The entity’s non-current assets are old and, in many cases, obsolete because of the fastchanging technology required in the industry. The realisable value of plant, equipment and vehicles is estimated at £2.25m. The value of its property has also fallen and the current expected realisable value is £2.5m. The valuation of current assets is also likely to be less than shown in the balance sheet. Twenty-five per cent of inventories is considered unsaleable. The balance could probably be sold at an average of 80 per cent of its book value. An estimated 10 per cent of debtors are expected to default. Market information The company is listed on the Alternative Investment Market (AIM). It was floated in 1992 at a price of 325 pence per share. The original owners of the firm retained, and still own, 60 per cent of the issued shares. One institutional investor owns 20 per cent of the shares and around 1,000 private investors own the remainder. 2006.1
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than 10 per cent of the company’s business is in the UK. Over the past 2-3 years, it has experienced difficulties in its chosen markets and has been forced to cut back some of its operations. Its revenue has fallen from £48m in 1998 to £33m in the year to 31 October 1999. Profits have also fallen steadily and in the year to 31 October 1999 the company sustained a loss, in part because of exchange rate losses. It is now in serious financial difficulties and may be forced into liquidation unless the directors can negotiate a refinancing package.
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The current share price (at 23 November 1999) is 28 pence compared with 68 pence at the same time last year. No dividend has been paid for the past two years. The debentures are trading at £95 per £100 nominal, ex interest. The return on the market is forecast at 12 per cent and the risk-free rate at 6 per cent. The company’s quoted equity beta is currently 1.4. However, the restructuring is likely to result in a fall in beta to 1.2. Profit improvement proposals The company has the opportunity to bid for a number of new contracts but would need to upgrade much of its plant and equipment. This would require £2.5m of capital expenditure and £0.5m of working capital. Some of its old equipment could be sold to raise an estimated £1m. If won, these contracts would improve the company’s pre-tax profits by an estimated £1.2m per annum. Restructuring proposal The board of VG plc has been approached by a venture capital organisation which is willing to provide £4m in new equity and £2m in new 12 per cent unsecured debt, repayable in 2005, if the company agrees to restructure its capital base. The conditions are as follows: (i) All existing shares are effectively cancelled and 8.6m new £1 shares are issued at par. The venture capitalist will take 4m of the shares. The existing shareholders will be given one new share for every five old ones currently held. (ii) The debenture is cancelled and the existing debenture holders are given 100 new ordinary shares in exchange for every £100 debenture. (iii) Warrants will be attached to the new shares issued to the debenture holders in exchange for their debt. These warrants will give the option to purchase in 3 years’ time, at par, one share for every two shares issued to them at the time of the reconstruction. The holders of the old ordinary shares and the venture capitalist will not be given these warrants. (iv) No dividends will be paid for the next 3 years. Shareholders will be given annually a scrip dividend of one share for every ten held. This policy will be reviewed in 3 years’ time. (v) The venture capitalist company will take two seats on the board of directors, including the position of chairman. (vi) The company’s bank will be asked to agree to convert the outstanding overdraft facility into a medium-term loan at 10 per cent interest secured on the company’s fixed assets. The bank will also be asked to provide an overdraft facility of £1m secured by a floating charge on the company’s current assets. (vii) The trade creditors will be paid 40 pence in the pound immediately the reconstruction is approved, and the remainder 6 months later. Requirements (a) Calculate and comment briefly on: (i) VG plc’s expected value if liquidated; (ii) the cash disbursements to the various creditors on liquidation; (iii) the effect on VG plc’s cash position if the venture capitalist provides refinancing. (10 marks) 2006.1
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Case study 6 Scenario ErOs Limited is an unquoted company that specialises in corporate design products, including web page designs. It has been trading for 4 years and has obtained a reputation for being one of the most innovative and technologically advanced operators in this particular field. The company was formed in 1997 by Eric Dee and Oscar George. The company borrowed £50,000 from the bank, secured on the two shareholders’ personal property. It is repayable in 2007. Interest is paid at 10 per cent each year. When the company was launched, it operated from rented premises and leased much of its computing equipment. It has subsequently bought additional and replacement equipment and other assets such as furniture and fittings. It has also moved premises and has taken out a 25-year lease on office premises that are large enough to allow for significant expansion. The company now employs 15 people and is planning to recruit additional designers and programmers to handle a large new contract it is hoping to obtain from a supermarket group. ErOs Limited ‘outsources’ most administrative and accounting functions. Future plans The company’s two owners/directors have been approached by the marketing department of an investment bank and asked whether they have considered using venture capital financing to expand the business. No detailed proposal has been made but the bank has implied that a venture capital company would require a substantial percentage of the equity in return for a large injection of capital. The venture capitalist would want to exit from the investment in four to five years’ time. 2006.1
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(b) Assume that you are a financial adviser to VG plc. Write a report to the directors of the company that assesses whether the proposals are likely to be acceptable to shareholders and other providers of finance. Your report should have two main sections: ● Section 1: the immediate effect on all providers of finance. (15 marks) ● Section 2 should include, but not necessarily be limited to, a discussion of the following matters: – the effects that the revised capital structure and dividend policy might have on the company’s share price and value of the company; – the medium-term effects of the proposals; – possible exit routes for the venture capitalist; – alternative actions in respect of financial or organisational issues that the company could consider to relieve the current financial difficulties. Note: You are not expected to restate the balance sheet or prepare an investment appraisal. (17 marks) (c) Many of VG plc’s problems have arisen as a result of difficulties in overseas markets, including poor management of debtors. (i) Explain the risks faced by an exporting company with a large number of overseas customers. (ii) Discuss ways in which VG plc could have managed these risks better than it appears to have done. (10 marks) (Total marks 52)
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Neither Eric nor Oscar is wholly convinced that such a large injection of capital is appropriate for the company at the present time. Their objective has been to obtain a stock market listing in 2–3 years’ time if their most optimistic expectations are realised. This would allow them to get some money back on their investment by selling some of their shares at the same time as raising additional funds for the company’s expansion. However, the two directors have little financial expertise and have decided to take some independent advice from their accountants before responding to the investment bank. Assume you are employed by ErOs Limited’s firm of accountants. You have been asked to advise Eric and Oscar about the company’s current financial situation and the various financing alternatives available to maximise ErOs Limited’s growth potential. You spend some time reviewing the company’s financial affairs and discussing future prospects with the directors and staff. You have managed to obtain the following information. Financial information Past data Revenue has grown from £50,000 in the first year of operations to £750,000 last year, the year to 31 March 2001. However, the company sustained losses in the first 3 years of operations and made only a small operating profit last year. The apparent poor results are primarily because of high research costs relative to sales. These were written off during the year. Expenditure on research and development will continue but not at such high levels. Other financial data for the year to 31 March 2001 is as follows: Shares in issue (ordinary £1 shares) Earnings per share Dividend per share Net asset value
10,000 125 pence 0 £385,000
Note: The net assets of ErOs Limited are the net book values of purchased and/or leased buildings, equipment and vehicles plus net working capital. The book valuations are considered to reflect current realisable values. Forecasts The company’s forecast revenue for the year to 31 March 2002 is heavily dependent on whether or not the company obtains the new contract from the supermarket group. If it does, forecast sales turnover is £1.8 million for the year. The company’s directors think they have a 50 per cent chance of getting this contract. Although this contract will be prestigious for ErOs Limited and should lead to a long-term business relationship, the terms will prevent ErOs Limited from undertaking work for the supermarket’s competitors, a number of whom have also shown interest in the company’s designs. If ErOs Limited does not get this contract, it will bid for other work which is likely to be less profitable. Revenue for the following year, to 31 March 2003, is dependent to some extent on the outcome of the year to 31 March 2002. Estimated revenue and probabilities are as follows: Estimates for year to 31 March 2002 Turnover Probability £000 0.5 1,800 (Outcome 1)
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0.3
1,200 (Outcome 2)
0.2
800 (Outcome 3)
Estimates for year to 31 March 2003 Turnover Probability £000 0.8 2,500 0.2 3,000 0.5 1,700 0.5 1,400 0.5 1,000 0.5 800
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Competitor/industry information This is a niche market and there are relatively few listed companies doing precisely what ErOs Limited does. However, if the definition of the industry is extended to include all companies involved in electronic design and associated products, the following figures are relevant. P/E ratios Industry average Range (individual companies)
27 12 to 82
Increase in market capitalisation over the past 24 months: Industry average Range (individual companies)
22% 10% to 2,000%
Cost of equity Industry average (net of tax) Individual companies
16% Not available
Share price movements of competitor companies are extremely volatile. Recently, two similar companies, one listed in 1999 and one unquoted, have gone into liquidation. These and other failures of internet-style companies have caused widespread concern. Calls for improved regulation of ‘new economy’ companies have been made, largely because of the huge potential debts involved in some cases and suspicions of trading irregularities. Tougher regulatory controls might address the composition of boards of directors and require more substantial trading history before flotation can be considered. Requirements (a) Write a report to the directors of ErOs Limited that explains the various methods by which the company might be valued and the alternative types of financing available for expansion. You should include in your report: (i) Calculation of a range of values for the company that could be used in negotiation with a venture capitalist, using whatever information is currently available and relevant. Make and state whatever assumptions you think are necessary. (15 marks) (ii) Discussion of the methods of valuation you have used. Explain, briefly, the relevance of each method to a company such as ErOs Limited. (9 marks) (iii) Discussion of the advantages and disadvantages of using either venture capital financing to assist with expansion or alternatively a flotation on the stock market in 2–3 years’ time. Include in your discussion likely exit routes for the venture capital company. (9 marks) (iv) Discussion of alternative types of financial support that could be used by ErOs Limited to assist the company to expand. Advise on the issues that the directors should consider before deciding on the most appropriate type of finance. (9 marks) (b) Advise the company’s directors on what actions/measures the company might take to protect itself against the risk of loss of key staff with technical expertise. (8 marks) (Total marks 50) 2006.1
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Operating costs, inclusive of depreciation, are expected to average 35 per cent of revenue in the year to 31 March 2002, reducing to 30 per cent in the year to 31 March 2003 as a result of economies of scale. Interest costs will remain at the present level for both years. Tax is expected to be payable at 30 per cent. Assume book depreciation equals capital allowances for tax purposes. Also assume that profit after interest and tax equals free cash flow. Growth in earnings in each of the years to 31 March 2004 and 2005 is expected to be 40 per cent, falling to 10 per cent each year after that. This assumes that no new long-term capital is raised. If the firm is to grow at a faster rate, then new financing will be needed.
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Case study 7 Scenario Almond Arts plc manufactures and distributes paint and related products to the building trade. It has traded for over 40 years and has been listed on the UK stock market since 1968. The shares are now widely held, with approximately 75 per cent in the hands of institutional investors. Draft, abbreviated financial statements for the year to 31 December 2000 are shown overleaf. The company’s directors are considering a rights issue to help finance an expansion programme. The first phase of the expansion will involve expenditure of £3 million on fixed assets and £1 million on stock in 2001. Additional capital expenditure of £2 million will be required in 2002. Assume you are assistant to the finance director. You have been asked to provide some key financial data and supporting evidence for discussion by the board. You have so far obtained the following information based on the assumption that the expansion will go ahead. Using the draft accounts for the year to 31 December 2000 as a base: ●
●
●
revenue is expected to grow by 5 per cent in the financial year ending 31 December 2001. This increased level of revenue is expected to be at least maintained in 2002 and beyond; the ratio of cost of sales excluding depreciation to revenue will improve in 2001 by 2.6 percentage points as a result of improved buying procedures; operating expenses in 2001 are expected to be held constant at the year-2000 level as a result of organisational restructuring and efficiency measures. However, this will involve a one-off charge of £125,000 during the year for redundancy payments.
Other relevant information is as follows: ●
●
●
●
●
●
●
the company’s tax accountant estimates that tax payable for 2001 will be £850,000. Assume tax is paid in the year in which the liability occurs; the ratios of receivables to revenue and trade payables to cost of sales less depreciation are expected to remain the same in 2001 as in 2000. Operating expenses are paid in the year in which they occur; no sales of non-current assets are planned for the next 2 years. Depreciation on existing and new assets will be £1.2 million in 2001; dividends are payable the year after they are declared. The company plans to maintain the 2000 payout ratio in 2001; the company’s cost of equity is 14 per cent per annum. It uses this rate to evaluate new investments but a full appraisal has not yet been carried out for the expansion proposals; assume interest charges for 2001 will relate only to payment on existing fixed-rate debt (i.e. no overdraft interest will be payable); inflation is anticipated at between 2 and 3 per cent per annum for 2001. Interest rates on long-term bonds suggest that inflation is likely to rise above 3 per cent in 2002.
Financial objectives The company’s financial objectives are stated as: ●
● ●
to earn an annual after-tax return on shareholders’ funds (as at the end of each financial year) of at least 25 per cent; to increase earnings per share and dividends per share by at least 10 per cent per year; to increase share price year on year without taking undue risks.
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Revenue Cost of sales (note 1) Operating expenses Operating profit Interest Corporation tax Net profit
£000 16,500 11,600 11,750 3,150 200 12,885 12,065
Dividends declared Retained profits
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Draft income account for the year to 31 December 2000
Draft balance sheet at 31 December 2000 Non-current assets (net book value) Current assets Inventory Receivables Cash and bank Equity and liabilities Capital and reserves Ordinary share capital (ordinary shares of £1) Accumulated profits Non-current liabilities 107 Debentures 2005 Current liabilities Trade creditors Other creditors (dividends)
£000 7,500 2,850 1,675 212,55 12,080
5,000 22,194 27,194 2,000 1,750 21,136 12,080
Notes 1. Including depreciation of £925,000 2. Share price information (pence) As at 31 December 1999: As at today (31 December 2000):
465p 525p
Range for year (1.1.99–31.12.99) Range for year (1.1.00–31.12.00)
425p–535p 515p–565p
3. Other financial information for 1999 EPS DPS After-tax return on shareholders’ funds
423
37.2p 20.5p 26.2%
Requirements Assume that today is 31 December 2000. Prepare: (a) (i) a forecast profit and loss account for the year to 31.12.2001; (ii) a forecast balance sheet as at 31.12.2001; (iii) a cash-flow forecast for 2001 (this is not an investment appraisal and you do not need to discount your cash flows); (iv) calculations of after-tax return on shareholders’ funds, earnings per share and dividends per share for the two years 2000 and 2001. Notes ● Work to the nearest £000 for parts (i) and (ii). ● Assume that the expansion is to be part-funded by a rights issue of 1 for 10 at 475 pence. Ignore issue costs. (20 marks) 2006.1
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(b) Write a report to the finance director of Almond Arts plc in which you: (i) discuss the key aspects and implications of the financial information you have obtained in your answer to part (a) of the question, in particular whether the company is likely to achieve its financial objectives in the years to 31 December 2000 and 2001. Include in your discussion comments on the suitability of the financial objectives for the company in its present circumstances and advise on alternative objectives which the directors could consider; (ii) explain the need for financing in 2001 and discuss alternative types of finance that might be suitable for the company at the present time. Use relevant data from the scenario and your answers to part (a) of the question, plus any additional calculations you think appropriate and relevant. Make whatever assumptions you think necessary. If you have been unable to complete your calculations for part (a), use your assumptions as the basis for discussion; (iii) discuss the difficulties of incorporating inflation into forecasts and comment on how a rate of inflation exceeding the 2–3 per cent anticipated for 2001 might affect the achievement of the objectives (you are not expected to rework your figures); (iv) recommend a course of action for the board to consider. (30 marks) (Total marks 50)
Case study 8 Background of company KL Group plc provides a range of products and services for sale in the UK and overseas. Its shares are listed on the London Stock Exchange and are widely held, although institutions hold the majority of shares. The company is structured as a group of wholly owned subsidiaries. Each subsidiary specialises in a particular product or service. Financial data Key data for the year to 31 December 2001 is as follows: Revenue Earnings Shares in issue Share price as at today (21 May 2002) Weighted Average Cost of Capital (WACC) for the Group
£850 million £105 million 250 million 331 pence 14% (nominal net of tax rate)
Company objectives The company has two stated objectives: ● ●
to increase operating cash flow and dividends per share year-on-year by at least 5%; to increase the wealth of our shareholders whilst respecting the interests of our employees, customers and other stakeholders and operating to the highest ethical standards.
Future plans The directors are considering establishing a new subsidiary company, KL15, to process industrial waste. The subsidiary will require a factory. The directors have identified that the 2006.1
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Alternative 1 This alternative will equip the factory to process waste to the highest environmental standards that the government regulations might impose. This would require the purchase of very expensive, specialised machinery from the USA. This machinery would have to be ordered and delivery time is approximately 6 months, which would coincide with completion of the factory conversion. The cost of this machinery is currently US$12 million but the price of the equipment is likely to rise by 5% over the next 6 months. If an order is placed immediately (year 0), together with a 50% deposit, the supplier will hold today’s price. The balance of the purchase price is payable 6 months after installation. The current exchange rate, US$ to £1 sterling, is 1.45. Inflation in the USA is forecast to be 4% over the next 12 months. In the UK it is forecast to be 2.5%. This equipment is not likely to need replacement for at least 8 years. Forecast revenues for KL15 under this equipment alternative are as follows. The probabilities are based on forecasts of the economy in the UK and the main overseas trading areas where the KL Group plc hopes to sell its services. Year 2 10.5 0.5
12.5 0.1
10.5 0.4
Year 3 13.5 0.5
16.0 0.1
1.8
8.5 0.4
Expected revenues (£m)
Revenues (£m) Probability
Year 1 (6 months of operating) 0.5 2.5 3.5 0.4 0.5 0.1
9.9
12.55
The probabilities of sales for year 2 or 3 and beyond are assumed to be independent of the achievement of the previous year’s sales. The costs are as follows: ●
●
●
Cash operating costs are expected to have a fixed element of £1.5 million each year starting as soon as the factory starts work, plus a variable element of 30% of sales revenue. A full year’s fixed costs will be charged to production in year 1. Redundancy payments of £1.2 million will be necessary for staff from the KL3 subsidiary. These would be payable immediately. The costs of the factory conversion will be incurred during the 6 months following the decision to proceed but, for simplicity, it can be assumed that these are paid at the end of year 1. 2006.1
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factory used by a long-established subsidiary, KL3, is currently operating at only 50% capacity. This factory could be converted for use by the new subsidiary at a cost of £1.3 million. KL3’s annual net (after-tax) earnings are £1.5 million. This subsidiary’s operations would cease immediately the decision to proceed with KL15 is taken as it will take some months to convert the factory. However, the company is aware that the government is reviewing the environmental controls currently in operation for waste processing and it is possible that tougher regulations will be introduced. Industry spokesmen are attempting to argue that current controls are adequate. Nevertheless, the directors of the KL Group plc wish to consider the situation should these tougher controls be introduced and two alternative methods of equipping the new subsidiary have been proposed by the company’s technical advisers. The company has sufficient cash available from a recent disposal to finance the capital costs of the new subsidiary under either alternative.
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SOLUTIONS TO CASE-STUDY QUESTIONS P9 ●
The availability of capital allowances and other tax reliefs mean that no tax is likely to be payable until year 4. For year 4 onwards, a rough estimate suggests 20% of annual net cash flows (revenue less cash operating costs) will be payable in tax.
Alternative 2 To plan for a continuation of, or modest improvement to, current regulations and produce accordingly. This alternative has greater flexibility as there is a much larger market, worldwide, for processing waste at a lower and therefore much cheaper specification. The capital cost to the KL Group plc would also be much lower at £2.5 million. Equipment for this alternative is readily available in the UK and can be bought when the factory conversion is completed. However, the equipment is likely to need to be replaced in 6 years’ time from the date of purchase. The revenues shown below are forecast using similar methods as used in Alternative 1. However, sales will be made to a wider range of customers, many in developing countries. Year 1 (6 months of operating) 3.5 4.5 5.5 0.2 0.6 0.2
Revenues (£m) Probability
4.5 0.2
Year 2 6.5 0.6
7.5 0.2
6.3
Year 3 9.5 0.6
11.5 0.2
4.5
Expected revenues (£m)
8.5 0.2
9.7
Costs are as follows: ●
●
● ●
Fixed cash operating costs will be £1.2 million each year; variable costs will be 15% of sales revenue. With this alternative, there will be fewer redundancies from KL3 and the associated costs will be only 20% of those for Alternative 1. Costs of factory conversion are as Alternative 1. Tax relief will be similar to Alternative 1, that is, no tax will be payable until year 4 when tax will become payable at 20% of annual net cash flow (revenue less cash operating costs).
Requirements (a) Calculate net present values for the new subsidiary (KL15) under the two alternatives, using whatever assumptions you think are appropriate. Include brief comments on your assumptions. (15 marks) (b) Assume you are the company’s financial manager. Write a report to the directors that: (i) discusses how the new subsidiary and the two alternatives might contribute to the attainment of the Group’s objectives. Refer to the figures you have calculated in answer to part (a) where appropriate. (10 marks) (ii) analyses and discusses the various types of risk and limitation involved in each alternative. (10 marks) (iii) recommends which, if either, of the alternatives should be chosen. Your recommendation should take into account all aspects of your evaluation as discussed in parts (b) (i) and (b) (ii) of this question. (5 marks) You should provide any additional calculations that you consider appropriate to support your discussion and analysis. (Total marks for part (b) 25) 2006.1
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Case study 9 Background Dobbs plc is an international publishing company based the UK. It has recently sold a subsidiary that publishes technical journals, a field the company considered to be noncore business. The sale raised £30m in cash. The directors are evaluating what they consider to be a very promising acquisition opportunity and the cash raised from the sale of the subsidiary would be used as part of the financing arrangement. Potential investment in a new subsidiary Alice Jain Inc is an American publisher that has two main divisions. One division publishes books, mainly ‘blockbuster’ type fiction, and the other publishes ‘lifestyle’ magazines. Both divisions have seen strong growth over the past five years as a result of changes in the public’s magasine-buying habits and also because of two high-selling authors whom the company contracted before they became popular. These contracts have between 3 and 5 years to run before they are re-negotiated. Many industry observers think Alice Jain Inc has been successful because of good luck rather than good judgment and that with stronger management the company could become a major international publisher. Alice Jain Inc is privately owned (i.e. it does not have a listing on a stock market). There are approximately 50 shareholders although 60 per cent of the shares are owned by the husband and wife partnership that started the business 25 years ago. Dobbs plc’s directors have already made an informal approach to Alice Jain Inc’s directors and believe they will be receptive to an offer if terms can be agreed. No announcement has yet been made to the press or to Dobbs plc’s shareholders about their intentions. On the basis of industry information and private sources, Dobbs plc’s directors forecast the following cash flows from Alice Jain Inc: Year Net cash flows ($ millions)
1 35.5
2 43.5
3 46.5
4 52.5
Notes (1) The spot $US/£ exchange rate is 1.45. Forecast economic data relevant to the USA and the UK is as follows: Risk-free rates for each year Inflaction rates for each year
USA 3.5% 2.5%
UK 4.5% 3.2%
Assume the theory of interest rate parity applies when forecasting exchange rates. (2) The cash flows are in real terms. Dobbs plc evaluates all its investment decisions at its domestic, post-tax cost of capital, which is a nominal 11 per cent. It evaluates international investments by converting the foreign currency cash flows to sterling and applying its domestic cost of capital of 11 per cent. The cost of capital for Alice Jain Inc is not 2006.1
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(c) Option pricing theory was originally developed to apply to share prices. The theory can also be applied to capital investment options, sometimes known as ‘real options’. Discuss the option features involved in the KL Group plc’s decision and explain, briefly, the benefits of including such options in the investment appraisal process. (10 marks) (Total marks 50)
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known. Dobbs plc’s Finance Director has used the capital asset pricing model to assist in the calculation of a discount rate based on the published information about a quoted British company with a similar commercial and financial profile to Alice Jain Inc. He has calculated that the proxy company’s nominal, post-tax cost of capital is 30 per cent. (3) When evaluating investments, Dobbs plc ignores cash flows beyond 4 years and terminal values. Financing of the acquisition Dobbs plc’s directors are considering offering Alice Jain Inc’s shareholders either shares in Dobbs plc or a cash alternative. The two majority shareholders are likely to take 50 per cent shares, 50 per cent cash as there are tax advantages to a share exchange. This will use up most of the cash from the sale of the subsidiary. The cash for the remaining shareholders will have to be raised by Dobbs plc increasing its borrowing. The ‘worst case’ scenario is that the remaining shareholders (that is, those except the two major shareholders) will all opt for cash. Finance Director’s concerns Dobbs plc’s long-term debt to equity ratio is relatively high compared with other publishing companies of similar size. The Finance Director thinks some of the cash raised from the sale of the subsidiary should be used to purchase a small British publishing company at an approximate cost of £15 million. The remaining cash should then be used to repay some of Dobbs plc’s outstanding debt. The other directors disagree and believe the financial risk of investing in Alice Jain Inc will be justified by substantial value enhancement strategies that can be put in place following the acquisition. Summary financial information on bidder and target companies Dobbs plc £m
Alice Jain Inc $m
Income account for 12 months to 31 December 2002 Revenue Operating profit Interest payable Profit before tax Taxation
251.5 65.6 12.0 53.6 15.0
75.8 20.9 2.0 18.9 7.0
Balance sheet at 31 December 2002 Non-current Net current assets Total assets less current liabilities Long-term debt Net assets
195.0 275.0 270.0 125.0 145.0
45.0 25.0 70.0 15.0 55.0
Ordinary share capital: Ordinary shares of £1 Common stock of $1 Total reserves Equity shareholders’ funds
45.0 100.0 145.0
15.0 40.0 55.0
Current share price for Dobbs plc is 885 pence. High and low share prices for the past 12 months were 925 and 755 pence, respectively. No share price is available for Alice Jain Inc. Assume you are a financial manager with Dobbs plc. 2006.1
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(b) Write a report to the directors of Dobbs plc, evaluating the potential acquisition. You should include in your report: (i) a recommendation, with reasons, of whether the investment should proceed and at what price; (ii) advice on strategies for enhancing the value of the combined company following the acquisition; (iii) discussion of the Finance Director’s recommendation to acquire a smaller company and repay some debt; (iv) advice on Dobbs plc’s directors’ responsibilities to ensure fair and equal treatment for all shareholders in accordance with current takeover regulation. Use additional calculations to support your arguments wherever relevant and appropriate. Note: Marks are distributed roughly equally between these four sections of the report. (34 marks) (Total marks 50)
Case study 10 C&C Airlines plc Background to company C&C Airlines plc operates a small fleet of aeroplanes from an airport in the UK. Its business is aimed at low-budget travellers on short-haul flights. The company was formed in 1990 by a group of private investors who continue to own the company. Two of these investors take an active role in the management of the company as executive directors. The shareholders’ objective is long-term capital growth. They have taken relative low dividends out of the company since its incorporation. The strategy has been to accept low, or no, profits, and build the brand name and market share in its niche market. Their ‘exit strategy’ is eventually to sell a majority holding in the company following either a stock market flotation or private sale of shares to another company. Assets and revenue C&C Airlines plc currently owns 12 planes, mainly Boeing 737s. It has bought all of them second-hand from the major airlines. The company’s total net assets are currently, and realistically, valued at £130m. It is allequity financed. The revenue in the last full financial year was £85m. The forecast revenue for the current year is £98m. Profits after tax are forecast as £18m. Proposed investment The company’s directors are examining a proposal for a strategic move into the long-haul market. The initial investment involves the purchase of a 5-year-old Boeing 757, which will 2006.1
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Requirements (a) (i) Calculate the present value of the investment/acquisition’s cash flows and explain your method of evaluation, including your choice of discount rate. (ii) Calculate the number of shares Dobbs plc might need to issue and the amount of debt that might need to be raised in the ‘worst case’ scenario. Include brief comments to explain your calculations. (16 marks)
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be used to fly to and from the Caribbean. Negotiations to buy this plane are already underway. C&C Airlines plc plans to operate the plane for 3 years and replace it at the end of this time with a newer model. When fully loaded, this type of plane will carry 220 passengers. The company estimates an average return fare of £300 per passenger on this route. All income will be received in £ sterling. The company’s estimates of average passenger loading are as follows: Load 100% (all seats taken) 80% full 50% full 40% full
Probability of load being achieved Year 1 Years 2–3 10% 15% 50% 60% 30% 20% 10% 5%
The plane is expected to make six return trips every week and be operational 48 weeks of the year. The capital costs of the purchase of the plane are US$ 30m. To date, C&C Airlines plc has spent £500,000 on market research and purchase negotiations. Other financial data associated with the venture are: ●
●
Capital allowances are available at 25 per cent on a reducing balance of the total capital cost. The estimated resale value of the plane 3 years after purchase, in norminal terms, is $16m.
Cash operating costs (per annum) Sterling-denominated costs such as maintenance, insurance, crew wages, salaries and training US$-denominated fuel costs Overheads and other costs (per annum) Administration and office space These costs include a £50,000 re-allocation of current head office costs. Advertising and promotion
£2.9m US$ 4.2m
£0.3m £0.35m
Estimates of increases in income and costs The figures given above are all in nominal terms as at today. Because this is an increasingly competitive market, the company is unlikely to be able to increase fares in line with inflation. The best estimate is an annual increase of 2 per cent. Operating costs (excluding fuel) are expected to increase by the annual UK rate of inflation (3 per cent). Forecasting fuel costs is very difficult but best estimates are that they will rise by 5 per cent each year over the next 3 years. Assume these inflationary increases commence in the first year of operations. Overheads and other costs are expected to be held constant in nominal terms. Currency and inflaction rates ● Current spot exchange rate is US$1.53/£1 ● Estimated per annum inflaction rates are as follows: UK USA
3% 4%
Inflation rates in the UK and USA are expected to remain at these levels. 2006.1
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Year 1 2 3
Certainty equivalent 0.90 0.85 0.80
The company’s new Finance Director would prefer to use a risk-adjusted discount rate. A competitor company to C&C Airlines plc has a quoted equity beta of 1.3 and a debt: equity ratio (based on market values) of 1: 4. This is unlikely to change in the foreseeable future. The post-tax return on the market is expected to be 12 per cent and the risk-free rate 5 per cent. Assume a debt beta of 0.15. Assumptions ● Capital costs are paid immediately but all other cash flows occur at year-end. ● Taxation at 30 per cent is paid or repaid at the end of the year in which the liability/ repayment arises (i.e. no time lag). ● The plane is acquired and becomes operational immediately. Requirements (a) Calculate the discount rate to be used in the investment decision using the CAPM and comment, briefly, on the limitations of using the CAPM in the circumstances here. (5 marks) (b) Calculate the £ sterling NPV of the proposed investment in the new plane using: (i) the discount rate calculated in (a) above, rounded to the nearest 1 per cent; and (ii) a discount rate of 9 per cent per annum nominal and adjusting for the company’s estimated certainty equivalents, and recommend, briefly, whether to proceed with the investment, based solely on your calculations above. NPV should be calculated in sterling, converting US$ cash flows to sterling. Assume the theory of purchasing power parity applies when calculating exchange rates. (Total marks for part (b) 20) (c) Assume you are the assistant to the Finance Director: On his behalf, draft a report to the board that critically evaluates the following: (i) the major economic forces that might impact on, or influence, the success of the investment; (ii) commercial aspects of the investment that involve the greatest uncertainty and risk; (iii) strategies for managing the risks discussed in parts (c)(i) and (c)(ii); The report should conclude with a recommendation of a course of action. (Total marks for part (c) 25) (Total marks 50)
Case study 11 Background RGB is a computer technology business based in the UK. It was listed until 4 years ago but following disagreements between the Board and major shareholders, the directors and 2006.1
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Allowing for risks The company evaluates investments by discounting cash flows at 9 per cent per annum nominal and applying certainty equivalents to net after-tax cash flows. The estimates for the proposed investment are shown below:
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senior managers bought out the external shareholders, effectively re-privatising the company. RGB sells its products and services worldwide, but its main market outside the UK is in North America. To date, all its manufacturing and administrative functions have been conducted from the UK. Summary
Financial statements for last financial year £m 840 76
Turnover Earnings (post-tax) Fixed assets Net current assets Less: Long term liabilities (8% Secured loan repayable 2010) Total net assets
650 90 (320) 420
Shareholders’ equity (120 million £1 shares in issue)
420
The average P/E ratio of listed companies in a similar industry is 10.53. Company objectives The company has three stated objectives. These are: ● ● ●
increase earnings per share by 5% per annum; post-tax accounting rate of return on shareholders’ funds of 20% per annum; maintain a leading global presence in its operating markets.
New capital investment The company is evaluating establishing a new manufacturing plant, marketing and administration facility in either the South of England or North America. Ideally, it would like to open the new UK facility as well as expanding into North America, but it does not believe it has the financial or management resources to do both at the same time. RGB has a policy of limiting capital investment in any one financial year to £50 million. Last year the company did not spend up to this limit, however capital investments have already been approved in the current year that require total capital expenditure of £17 million. None of these can be postponed without loss of money spent on set up costs such as feasibility studies. The estimated cost for the UK investment is £30 million. These initial investment costs will be written off over a period of 5 years. To establish operations in North America will cost an estimated US $75 million. This US investment, combined with capital expenditure already committed, would exceed the company’s capital investment limit if it were to be enforced. Forecast pre-tax operating nominal cash flows for the first three years of operations are as follows: Year North America Investment UK ●
US$m £m
1 22.25 6.30
2 24.25 9.00
3 26.25 10.50
All operating cash flows may be assumed to occur at the end of each year. The initial capital investment will be made at the beginning of year 1 (year 0).
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Estimated cash flows beyond year 3 are highly uncertain, but for purposes of evaluation, the company assumes 5% per year growth on year 3’s pre-tax operating sterling cash flows until the end of year 5. Cash flows beyond year 5 are ignored.
The investments this year will be financed by cash. The company has built up cash reserves of £50 million over the past 2 years and has also recently agreed the cash sale of some surplus assets. Exchange rate information USA UK
Forecast inflation rates per annum constant 1.5% 2.5%
The spot $/£ exchange rate as at today is 1.70. Taxation Corporate tax rates in the two countries are as follows: USA UK
25% 30%
Assume for the purposes of evaluation: ●
● ● ●
Both countries allow 100% first year allowance tax relief on capital investments of this type. There is a double taxation treaty in existence. Tax is payable (or refundable) at the end of the year in which the liability or refund arises. RGB pays tax at the national tax rates.
Cost of capital and adjustment for risk For domestic investments RGB uses a risk-adjusted discount rate using the CAPM where possible. The expected nominal, post-tax risk free rate in the UK is 5% and the return on the market is 9%. The quoted equity beta of a suitable proxy company with similar capital structure to RGB is 1.3. However, RGB’s Finance Director recognises that the risks involved in the overseas proposal are different. Determining an appropriate discount rate to reflect risk is difficult in the circumstances. She has therefore recommended that the post-tax cash flows for the North American venture be adjusted using estimates of probability applied to sterling cash flows, discounted at the risk free rate. These estimates of probability are as follows: Year Probability
1 0.9
2 0.87
3 0.82
Beyond year 3, a probability factor of 0.7 is estimated. Methods of investment appraisal RGB uses NPV analysis in the investment appraisal process, but the company also expects new investments to contribute to all the company’s objectives. 2006.1
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Requirements Assume you are the Capital Investment Analyst at RGB. (a) Estimate the discount rate to be used in the evaluation of the UK investment and comment briefly on the limitations of using this rate in the investment being proposed here for RGB. Assume RGB’s debt is trading at par and has a beta of zero. (5 marks) (b) Calculate the NPV, Profitability Index and estimated Accounting Rate of Return on Capital Employed (ROCE) for each investment. For the purposes of calculating the ROCE, assume that cumulative sterling post-tax cash flows at the end of year 5 equal cumulative post-tax profits before depreciation. (20 marks) (c) Write a report to the board evaluating the proposed investments. Include the following sections in your report: (i) An evaluation of how each of the two investments will contribute to the achievement of the company’s stated objectives. (10 marks) (ii) An analysis of the various types of risk involved in these investments and advice on a strategy for managing those risks. Include comments on the methods the Finance Director has recommended to adjust the cash flows for risk. (8 marks) (iii) A recommendation as to whether the company should invest in either or both projects. Include comments on the appropriateness of RGB limiting investment to £50 million in the current financial year. (7 marks) (Total for part (c) 25 marks) (Total 50 marks)
Case study 12 Background of company JHC Group manufactures and distributes a wide range of food products for sale throughout Europe. It also provides advisory services to retailers. Its shares are listed and are widely held, although institutions hold the majority. The company is structured as a group of wholly-owned subsidiaries. Each subsidiary specialises in a particular product or service. Financial data Key data for the year to 31 December 2003 is as follows: Revenue Earnings Shares in issue Share price as at today Weighted Average Cost of Capital (WACC) for the Group
€1,750 million €215 million 350 million €8.31 9% (nominal net of tax rate)
Company objectives The company has two stated objectives: ●
●
To increase operating cash flow and dividends per share year-on-year by at least 4%, which is 2.5% above the current rate of inflation. To increase the wealth of shareholders while respecting the interests of our employees, customers and other stakeholders and operating to the highest ethical standards.
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Alternative 1 This alternative will equip the factory to manufacture to the highest food safety standards that new regulations might impose. It would require the purchase of specialised machinery, which would have to be ordered. Delivery time is approximately 6 months, which would coincide with completion of the factory conversion. Capital costs The cost of this machinery is currently €8 million but its price is likely to rise by 5% over the next 6 months. If an order is placed immediately (year 0), together with a 40% deposit, the supplier will hold today’s price. The balance of the purchase price is payable 6 months after installation (i.e. 12 months after payment of the initial deposit). This machinery is not likely to need replacement for at least 8 years. Revenues Forecast revenues for SP for the first 3 years of operation have been provided by JHC Group’s planning department as follows. The probabilities are based on forecasts of the economies of JHC Group’s main trading areas.
Expected revenues (€m)
4.48
Year 2
7.5 0.3
12.5 0.5
Year 3
16.5 0.2
13.5 0.3
18.5 0.5
21.5 0.2
Revenues (€m) Probability
Year 1 (6 months of operating) 2.5 4.5 7.4 0.3 0.5 0.2
11.80
17.60
The probabilities of sales for year 2 or 3 and beyond are assumed to be independent of the achievement of the previous year’s sales revenues. Operating and other costs/reliefs ● Cash operating costs are expected to have a fixed element of €2.5 million each year, plus a variable element of 35% of sales revenues. A full year’s fixed costs will be charged to 2006.1
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Future plans The directors are considering establishing a new subsidiary company, SP, to manufacture and distribute health food products. The subsidiary will require a factory. The directors have identified that the factory used by a long-established subsidiary, CC, is currently operating at only 60% capacity. This factory could be converted for use by the new subsidiary at a cost of €2.8 million. CC’s annual net (after-tax) earnings are €2.2 million and are expected to remain at this level in nominal terms for the foreseeable future. This subsidiary’s operations would cease immediately the decision to proceed with SP is taken as it will take some months to convert the factory. However, the company is aware that the European parliament is discussing legislation that would introduce more stringent controls on the manufacture of health food products than are currently in operation. Industry spokesmen are attempting to argue that current controls are adequate. Nevertheless, the directors of the JHC Group wish to consider the situation should these tougher controls be introduced and two alternative methods of equipping the new subsidiary have been proposed by the company’s technical advisers. The company has sufficient cash available from a recent disposal to finance the capital costs of the new subsidiary under either alternative.
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●
●
●
production in year 1. Variable costs will be much higher under this alternative because the new regulations are likely to require more expensive ingredients in the products. Redundancy payments of €2.1 million will be necessary for staff from the CC subsidiary. These would be payable immediately. The costs of the factory conversion will be incurred during the 6 months following the decision to proceed but, for simplicity, it can be assumed that these are paid at the end of year 1. The availability of capital allowances and other tax reliefs mean that no tax is likely to be payable until year 4. For year 4 onwards, a rough estimate suggests 20% of annual net cash flows (revenues less cash operating costs) will be payable in tax.
Alternative 2 To plan for a continuation of, or modest improvement to, current controls and regulations. This alternative has greater flexibility, as there is a much larger market, worldwide, for cheaper products. Capital costs The capital cost to JHC Group would also be much lower at €4.5 million. Equipment for this alternative is readily available and can be bought when the factory conversion is completed. However, the equipment is likely to need to be replaced in 6 years’ time from the date of purchase. Revenues The revenues shown below are forecast using similar methods as used in Alternative 1. However, sales will be made to a wider range of customers, many in developing countries. Costs are as follows:
Revenues (€ m) Probability
4.5 0.1
Year 1 (6 months of operating) 7.5 0.6
Year 2
9.5 0.3
7.1 0.1
9.4 0.6
Year 3
11.1 0.3
Expected revenues (€ m)
●
●
● ●
9.5 0.1
12.5 0.6
15.6 0.3
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9.68
13.13
Fixed cash operating costs will be €1.5 million each year; variable costs will be 20% of sales revenue. With this alternative, there will be fewer redundancies from CC and the associated costs will be only 20% of those for Alternative 1. Costs of factory conversion are as Alternative 1. Tax relief will be similar to Alternative 1, that is, no tax will be payable until year 4 when tax will become payable at 20% of annual net cash flow (revenue less cash operating costs).
The revenues and costs for both alternatives are in nominal terms. Requirements Assume you are JHC Group’s financial manager. (a) (i) Calculate the net present value for the new subsidiary (SP) under each of the two alternatives. Make, and comment on, appropriate assumptions about cash flows beyond year 3, including terminal values, and the discount rate to use in the evaluation. (15 marks) 2006.1
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Case study 13 Scenario Business background – The Groots Group The Groots Group (Groots) is a retailer of clothing for women and children. The group started as a single store in France in the early 1900s. The business grew by acquisition of new premises and, occasionally, by buying out small competitors. Expansion outside France started in 1955 and the group now has stores in most European cities. The parent company obtained a listing in 1968, although at that time the founding family still owned the majority of the shares. It is no longer controlled by the family although the grandson of the founder is a board member and owns 2% of the share capital. The company’s other directors and senior managers own a further 8% between them. The style of clothing sold in the Group’s stores has changed over the years and its main theme now might be described as ‘ethnic’. Most of its goods are manufactured outside Europe, predominantly in India and other parts of Asia. Corporate objectives Groots has two financial objectives and one non-financial objective. These are: • to increase earnings and dividends per share year on year by 5% per annum; • to maintain an optimal debt/equity ratio within the range 25–30%; • to adhere to ethical trading policies and recognise the interests of our various stakeholder groups in all our business activities. Proposed acquisition The directors of Groots believe they have exhausted possibilities for further expansion in Europe unless they are to diversify into different products such as men’s clothing or household goods. They have, therefore, been reviewing opportunities for investment further afield for the past year. They have identified a small group of clothing stores trading in the East Caribbean and parts of South America, Cocomos Limited (Cocomos). 2006.1
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(ii) Explain, without doing any additional calculations, on the appropriateness and possible advantages of providing modified internal rates of return (MIRRs) for the evaluation of the two alternatives. (5 marks) (b) Write a report to the directors that discusses how the new subsidiary and the two alternatives might contribute to the attainment of the Group’s objectives and recommends which, if either, of the alternatives should be chosen. Refer to the figures you calculated in part (a) where appropriate. You should provide any additional calculations that you consider relevant to support your discussion and analysis. (22 marks) (c) Discuss the option features involved in the JHC Group’s decision and explain, briefly, the benefits of including such options in the investment appraisal process. (8 marks) (Total marks 50)
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Cocomos is a listed company whose shares trade on an East Caribbean Stock Exchange. It has 18 stores as outlets for its products. Twelve of them are operated by the company itself and six are operated by franchisees. The clothing is at the expensive end of the market and aimed mainly at tourists. Cocomos has followed a policy of buying locally-made clothing from within the Caribbean, Cuba or Puerto Rico, mainly from small co-operative-type manufacturers. The advantage of this policy is that the cost base is low, allowing for a substantial mark-up to retail. The disadvantage is that the quality is variable. If the acquisition proceeds, Groots would aim to review the product sources to improve the quality and expand the range. One alternative would be to supply the stores from sources in India, which already supply some of the European stores. The directors of Cocomos and their families own 51% of the shares. A further 15% of the shares are owned by a local pension fund. The remaining 34% are owned by a number of wealthy individual investors, including a few who live most of the time in Europe or Canada. Cocomos’ directors are believed to be interested in opening discussions about a bid from Groots, but the franchisees are likely to be hostile. Although the franchisees are not shareholders, they will use the ‘stealing our national assets’ argument to agitate the press, local politicians and, ultimately, the local population. On the basis of published accounts, industry information and discussions with Cocomos’ directors, the Groots’ directors have forecast the following post-tax cash flows for Cocomos: Year Net cash flows (C$millions)
1 31.5
2 37.5
3 41.5
4 47.2
Post-tax cash flows beyond year 4 are estimated to grow at 2% per annum. The cash flows are in real terms; that is they do not include inflation. Groots evaluates all its domestic investment decisions at a nominal, post-tax discount rate of 10%. Cocomos’ directors estimate their company’s cost of capital as 12%. However, Groots’ directors think this rate of 12% does not adequately reflect the risk of Cocomos’ cash flows. Summary of financial statements of bidder and target companies Income statement for the year ended 31 March 2005 Revenue Operating profit Finance costs (including overdraft interest) Profit before tax Taxation
Groots Group €millions
Cocomos Limited Caribbean $millions
1,051.5 241.5 48.0 193.5 46.9
215.8 63.6 15.0 48.6 11.5
895.0
245.0
275.0 1,245.0 1,215.0
88.0 012.0 345.0
Balance sheet as at 31 March 2005 Assets Non-current assets Property, plant and equipment Current assets Trade receivables and inventories Cash and cash equivalents Total assets
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245.0
55.0
290.0 535.0
100.0 155.0
Non-current liabilities Secured loan stock 7% repayable 2012 Secured loan stock 10% repayable 2008 Current liabilities Trade and other payables
1,205.0
055.0
Total liabilities
1,680.0
190.0
Total equity and liabilities
1,215.0
345.0
Other financial information Share price today Shares last traded on High-Low share prices in past 12 months Debt value (market) per €100 Debt last traded on
€ 6.85 19 May 2005 9.25–6.25 105.50 30 December 2004
C$ 6.95 31 January 2005 7.50–5.50 n/a n/a
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Equity and liabilities Equity Share capital (Nominal value of €1 and C$1 respectively) Retained earnings Total equity
475.0 135.0
Notes Exchange rate €/C$, interest and inflation rates The spot exchange rate is 0.30 (C$1 €0.30). Forecast economic data relevant to the Caribbean, the US and the European Common Currency Area (ECCA) are as follows:
Risk-free interest rate per annum Inflation rate per annum
ECCA
Caribbean
3.5% 2.5%
6.5% 4.5%
439
You should assume the theory of interest rate parity applies when forecasting exchange rates. Taxation Both companies will pay tax at an average of 25% from next year for the foreseeable future. Assume a double taxation treaty is in existence between France and the Caribbean country. Debt agreement There is a clause in Cocomos’ debt agreement that says the whole of the C$135 million debt is repayable immediately in the event of a successful takeover bid. Requirements (a) (i) Calculate the maximum price that Groots would be prepared to pay for Cocomos based on the present value in euros of the forecast cash flows. Using appropriate discount rates, you should calculate present value using both the recognised methods of evaluating international investments. (7 marks) (ii) Comment briefly on why, in theory, these two methods should give the same answer and why, in practice, the answers might be different. (3 marks) 2006.1
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(iii) Calculate the number of shares Groots might need to issue if it offers its own shares in exchange for Cocomos using the higher of the values for the company you have calculated in (i). Comment briefly on your calculations and/or assumptions. (4 marks) (Total for part (a) 14 marks) (b) Assume you are a financial manager with Groots. Write a report to the directors of Groots which should include the following: (i) A recommendation of the maximum price to be offered to Cocomos. You should base your recommendation on the figures you calculated in part (a) and other suitable methods of company valuation. (ii) Identify and discuss alternative methods of financing the acquisition and make a recommendation of the most appropriate method in the situation here. (iii) An analysis of strategies for enhancing the value of the combined company following the acquisition. (iv) Advice on the benefits and limitations of a post-completion audit and review in the context of the acquisition. Use additional calculations to support your arguments, wherever relevant and appropriate, for which up to 10 marks are available. Marks are distributed roughly equally between sections of the report. (Total for part (b) 36 marks) (Total for question one 50 marks)
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Solutions to Case-study Questions Solution to case study 1 ●
This case study involves an entity listed on the alternative investment market (AIM). The company wishes to expand and is considering three alternative locations. Net present value (NPV) and equivalent annual cost (EAC) techniques are examined.
(a) The beta of the proxy company being 1.2, the cost of its equity would be: (8% 5% 1.2) per annum 14% p.a. Assuming the cost of its debt to be 10 per cent p.a., and given a debt/equity ratio of 1 : 3, its weighted average cost of capital would be: (0.25 10% 0.75 14%) p.a. 12.75% (13% p.a. to nearest integer) Assuming its debt also cost 10 per cent p.a., the 12.75 per cent p.a. would be seen, in Tutwiler plc’s case, as:
16 10% 65 13.3% p.a. It would have been equally acceptable to approach this from the traditional textbook angle as follows. Calculate a of proxy:
a e
E D d DE DE
1.2 3 0.2 1 4 4 0.9 0.05 0.95 Ra using CAPM therefore: 8 0.95(13 8) 13%
e for Tutwiler plc (assuming market value of equity 5 million shares @ 200p and 2 million of debt at par, i.e. proportion of 5 : 1):
a D ( a d) E
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0.95 1 (0.95 0.2) 5 0.95 0.15 1.1
Tutwiler plc’s Re (or cost of capital) would therefore be 8 1.1 (13 8) or 13.5%. (b) Alternative 1: rent and extend 13% p.a. discount factors Cumulative Inflation index Rent Extension Combined Tax @ 33% Net
1997 0.885
1998 0.783
1999 0.693
2000 0.613
1.000
1.050
1.102
1.158
2001 0.543 3.974 1.216
£000 525 950 1,475 , (487) 1,988)
£000 551 (950) 551 (182) 11369)) )
£000 579
£000 608
£000 638
875 875
289 1,164
269 1,433
Discounted cash flow Cumulative DCF NPV Equivalent annual cost
579 (191) 1388))
608 (201) )11407)
(312) 103 (209)
249 1,682
(113) 1,569
1,569 3.517
1,446
Alternative 2: buy larger, locally Purchase price Capital allowances 100 0.33 5.426 Rates (250 33%) 167.5 for 10 years, i.e. 5.426 Renovations 750 33% 0.885 Sale 5,000 0.295 Net present value 1996–2006 inc: Aggregate discount factors 1997–2006 inc: Equivalent annual cost 2,200/5.426
£000 2,500 (179) 909 445 (1,475) 2,200 5.426 1,405
Alternative 3: build new £000 1996
Land Rent Tax
£000 1,000
£000
500 1,(165) 1,335 1,335
1997
Buildings Relocation/recruitment Tax
Rates (150 33%) Net present value, 1996–2012 Aggregate discount factors, 1996–2011 2000–2012
Equivalent annual cost 2,874/6.462
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1,250 1,600 1,850 1,(611) 1,239 0.885 100 4.423
1,097 2,442 2,874 6.462 1,440
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As requested, I have put together some calculations of the net present values, and equivalent actual costs, of the three alternatives identified for providing sufficient space for our expansion. The alternatives have different lives, which means that we need to put in a residual value at the end of each of the two shorter ones, before they can be compared. The equivalent annual costs appear to be comparable, but only because the differences beyond the end of the respective lives have been suppressed. The numbers are as follows: Alternative 1 2 3
NPV £000 1,569 2,000 2,874
EAC £000 446 405 440
On the surface, the second alternative looks the most attractive, since it shows the lowest ‘equivalent annual cost’. Whether it is indeed the best depends on the costs beyond the years for which information is provided in the question. If, for example, the follow-on cost of alternative 1 could be expected to be substantially lower than its initial cost, this could alter the ranking. You have asked me to comment on the choice of discount rate. Using the CAPM, we used the proxy company to determine the return required on assets (not equity: e includes financial risk and, in theory, we are concerned only with business risk). The method of financing should be ignored, as this is not the opportunity cost of the investment. However, if £2.5m is raised by debt, the company’s required return will rise from 13.5 to 14.5 per cent, as e will rise from 1.1 to 1.3 (i.e. 0.95 4.5/10 (0.95 0.20)). As regards the choice between the alternatives: ●
●
The ‘financial risk’ is that – in alternatives 2 and 3 – a greater proportion of the entity’s cash flows will be pre-empted for the payment of interest. Also, information is not available to calculate gearing based on book values. Assuming that £2.5m new debt is raised, gearing (debt : equity) in market-value terms would rise from 20 per cent to around 40–45 per cent, depending on how the equity value increased (or decreased) as a result of the announcement of the new project. Assuming no change in the value of equity, equity beta would increase from 1.1 to 1.3, as noted above. This might preclude raising new debt for investment in the near future. The main ‘non-financial risk’ (but one which would have considerable financial impact!), in each case, is concerned with what will be available at the end of the contractual period – notably how expensive it will be. This is obviously more significant in alternative 1 than 2, reinforcing the preference for the latter. It is also more significant in 2 than 3, but at such time horizons, this is unlikely to be seen as a major factor. In addition, there are various uncertainties, among them:
● ●
●
financial, for example, whether the finance will be forthcoming; the volume of throughput, for example, if it were to fall substantially short of expectations, a long-term commitment to premises could be embarrassing; the rental agreement is not reviewed in Alternative 1. Signed: Chartered management accountant 2006.1
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(c) From: Chartered management accountant To: Finance director Date:
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(d) Shortcomings of using the CAPM to arrive at a risk-adjusted discount rate include the following: ● The need to use a proxy company – which may not be entirely comparable with Tutwiler. ● Small companies quoted on secondary markets are usually more risky, so a higher beta would probably attach to Tutwiler. ● CAPM assumes past variability of return of stock with the market will continue (although the model can be adapted). ● CAPM is a one-period model, and forecasts of Rm and Rf beyond year 1 should be treated with caution. Alternative methods of evaluating cash flows could use certainty equivalents to attach to the cash flows, or an adjustment to the discount rates. The use of sensitivity analysis or similar methods could also be considered. (e) In summary: (i) ‘Fudge’ factors are not recommended to adjust for risk. In theory, the discount rate should be adjusted using a proxy company and adjusting discount rate. In practice, this is difficult to do. Adding a notional percentage is therefore a common practice. The use of certainty equivalents may be considered a more theoretically correct approach, although this still requires the probabilities to be estimated with some accuracy. (ii) Risk can be measured, uncertainty cannot. The differences can be summarised thus. Risk is a situation where: ● one of a range of outcomes may occur; ● each possible outcome has a known probability; ● probabilities are assessed by reference to past information about relative frequencies of outcome of repetitive phenomena (i.e. probabilities are objective). Uncertainty is a situation where: ● the range of outcomes is unknown; or ● the probability of outcomes is unknown; or ● both. Risk may be considered to apply where the decision-maker is willing to act on probabilities, however they are determined. (f ) Advantages ● A venture capital company may provide debt as well as equity, although gearing would be lower if finance is in equity. ● Input of management expertise (which may not be welcome, and could therefore be a disadvantage). Disadvantages ● A venture capital company will want a high rate of return (typically an accounting rate of return of between 35 and 50 per cent), and given the figures here, a substantial controlling interest. ● Finding a venture capital company which is interested in financing such a venture. It is not a high-risk venture and VC companies may not be interested, as the returns are unlikely to be acceptable. This is, effectively, a cost-reduction exercise. ● The company is already quoted, which may raise the issue of pre-emptive rights. ● The management time involved in preparing the business plan, etc. Medium-term debt would be the most obvious choice in raising finance for a project such as this, as it is usually cheaper than equity and the returns from a long-term cost-reduction exercise are likely to be lower than those from, say, new product 2006.1
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Solution to case study 2 ●
This question deals with a decision by a high-technology company to invest in a developing country. The question aims to test for an ability to apply conventional investment appraisal techniques, including the determination of the discount rate, to an investment decision. This case also examines for knowledge and understanding of how social benefits and costs, as perceived by a government, can influence investment decisions. Also covered by this case are the influence of external constraints on policy decisions, methods of financing the investment, and knowledge of regulatory bodies and their ability to affect financial transactions.
(a) (i) Two methods exist to calculate net present value of international investment decisions. One method converts the foreign currency into the domestic one and discounts the cash flows at the domestic opportunity cost of capital. This method requires a forecast of foreign exchange rates. The second method discounts foreign investments at the foreign country’s cost of capital and converts the result into the domestic currency. In the investment decision in a developing country, neither of these methods is ideal. Forecasting foreign exchange rates is extremely difficult in countries where exchange rates are highly volatile. It is also difficult to estimate the cost of capital in a developing country. The method chosen in the case is common in such circumstances. Implicit in the calculations is a suggestion that charges for telecommunication services will be increased in local currency terms to allow for inflation and devaluation. Technically this is quite acceptable, but there is a political risk that the government may not wish to see big increases in telecommunication charges. However, what is being offered here is a cellular service, where the market is likely to be with expatriates, diplomats and wealthy local businessmen. Tariffs are therefore unlikely to be subject to the same amount of political pressure. Option 2 is suspect because of the government’s requirement that a percentage of the lines are allocated to rural customers. These customers may be subject to pegged tariffs because of government pressure, and will involve greater initial capital costs. The volatility of exchange rates adds to project risk. Thus a project in a country whose currency has been highly volatile against the US dollar would carry more risk than a similar project in a country whose currency is pegged to the dollar. Expropriation risk, which can never be ignored in developing countries, is difficult to diversify and even more difficult to assess, and companies tend to stay out of countries where such risk is high. However, as with all high-risk projects, the rewards would be high enough to compensate. The technical director is, in principle, correct in that international diversification will reduce overall risk. However, for a US company to diversify internationally in, for example, Western Europe, is a very different proposition from diversifying into a developing country with a very short history of political and economic reforms. The life span of the project should not in principle affect the discount rate. The normal procedure for projects with different life spans is to calculate an equivalent annual rental and compare the projects on the basis of an annualised cost. This is not entirely appropriate here, as in two of the three cases we assume infinite project 2006.1
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developments. Similarly, shareholders may not want to advance additional money for a low-return venture.
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lives. Inter-temporal correlations affect the standard deviations of the net present value and internal rate of return and hence the project’s stand-alone risk. Generally, projects having cash flows with zero inter-temporal correlations have lower stand-alone risk than projects with high correlations. This is because low correlation means that a less than expected cash flow in one year can be offset by greater than expected cash flow in the next. Very few projects have zero inter-temporal correlations, and most of them are dependent to some extent on what has happened in a previous year. In theory, projects should be evaluated using a specific risk-adjusted discount rate which reflects the risk of that project. In order to determine a discount rate for a project we should use a proxy company’s beta and include this in the capital asset pricing model. In practice this is almost impossible to do, particularly in a developing country. Even if we assume that: (i) the government of Zenobia has agreed to allow GTI to increase prices in line with depreciation of the local currency, (ii) it can be trusted not to prevent expropriation of profits and dividends, and (iii) GTI accepts there will be no political interference in its operations, three risks remain.
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● ●
●
Risk 1: demand is at the level forecast by the World Bank. Risk 2: installation of the network does not meet geographical problems which were not foreseen. Risk 3: civil disturbances.
The board of directors of GTI can only take a view on this type of risk, and it is almost impossible to quantify a discount rate using any formal model such as CAPM. This part of the question required a discussion of discount rates from the perspective of GTI. For example, the volatility of exchange rates adds to project risk. Thus, a project in a country where the currency has been highly volatile against the US dollar would carry more risk than a similar project in a country where the currency is pegged to the dollar. Expropriation risk, which can never be ignored in developing countries, is difficult to diversify and even more difficult to assess, and companies tend to stay out of countries where such risk is high. However, as with all high-risk projects, the rewards should be high enough to compensate. In part (a)(ii), the report should provide calculations for the proposal and for the two options, and should then discuss the two options. The case stated that the government of Xenobia would not accept GTI’s proposal. It is therefore not sensible to suggest that the company’s proposal is the best option without qualifying the statement. The calculations should show that option 2 is preferable. (ii) Report To: Date: Subject:
Board of GTI Investment in Zenobia
This report evaluates the net present value of three options being considered for your investment in Zenobia and also suggests which option appears most acceptable. The financial evaluations are provided in Appendix 1. These are referenced throughout this report. 2006.1
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Government of Zenobia – option 1 This option has clearly been influenced by the GoZ’s need to provide a telecommunications service in the rural areas. This is not uncommon in developing countries. The evaluation, however, shows that this is not a profitable project even if the company invests in a further 2,600 lines at the end of year 3. The internal rate of return on this option is 19.5 per cent, which is still above the company’s cost of capital. However, there is a long payback period, and cumulative positive net cash flows do not start until well after year 5. This option, although apparently not worthwhile, should not be dismissed without further investigation. The evaluation has been done using World Bank estimates. A further study could be undertaken to determine whether there may be a market for more additional lines than the 2,600 proposed. Government of Zenobia – option 2 This is apparently the best option, financially. It shows a net present value of US$9.9m, an internal rate of return of approximately 33 per cent. However, this option could involve very high risk, depending on the terms of the licence. The calculation of the terminal value is approximate. The suggestion that the subsidiary could be floated on the Zenobia stock market at five times the capitalised net operational cash flows at the end of year 5 may be optimistic. The option also assumes that a stock market in Zenobia will be operational by year 5, which is highly optimistic. If the Zenobia government is implying that the company should be sold back to Zenobia nationals, this could restrict the market and have a downward influence on the price at which the company’s shares could be sold. Summary The key to the acceptability of any of these options is GTI’s attitude to risk. Telecommunications is a high-technology industry and accustomed to certain levels of risk, but developing a new network in a developing country, and in a country in which the company has no previous knowledge, is compounding the risk factors. As noted earlier, the main risks may be summarised as follows: ● Currency risk. Unless GTI has built into its licence a right to increase tariffs when the Zenobia currency depreciates. ● Political risk. That the government will honour its agreement in the licence and will allow the company to remit profits and dividends as promised. Appendix 1 Zenobia Telecommunications project
Discount factor @ 20%
$m 0 1.00
$m 1 0.83
$m 2 0.69
$m 3 0.58
$m 4 0.48
$m 5 0.40
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GTI proposal This proposal suggests that the project is just about viable using a discount rate for 20 per cent, the internal rate of return being around 23.5 per cent. The undiscounted payback period is just under five years. It is not possible to work out the discounted payback period without doing calculations on cash flows beyond year 6. This has not been provided at this stage. However, if this proposal is unacceptable to the GoZ it can only be used as a benchmark against which the government’s options may be compared.
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SOLUTIONS TO CASE-STUDY QUESTIONS P9 GTI PROPOSAL Initial investment Net operating cash flows (NOCF) Terminal value (6m/0.2)
(25.0) (25. 0) (25.0)
3.5 0.83 03.5
4.8 08 3 04.8
5.6 05.6 05.6
6.8 00.58 06.8
7.2 30.0 37.2
Discounted cash flows Cumulative DCFs
(25.0) (25.0)
2.9 (22.1)
3.3 (18.8)
3.2 (15.5)
3.3 (12.2)
14.9 12.7
GOZ OPTION 1 Initial investment NOCF (original 10,000 lines) NOCF (new lines) Terminal value (8.3 m/0.2)
0 (30.0)
1
2
4
5
3.0
4.3
3 (5.2) 5.1
(30.0) (30.0)
(22.1) 0 3.0
(18.8) 0 4.3
(15.5 ) 0(0.1)
6.3 1.6 (12.2 0 7.9
6.7 1.6 41.5 49.8
Discounted cash flows Cumulative DCFs
(30.0) (30.0)
2.5 (27.5)
3.0 (24.5)
(0.1) (24.6)
3.8 (20.8)
20.0 (0.8)
GOZ OPTION 2 Initial investment NOCF Terminal value (80%)
0 (20.0)
1
2
3
4
5
(20.0) (20.0)
3.9 (27.5) 0 3.9
5.3 (24.5) 0 5.3
6.2 (24.6) 0 6.2
7.5 (20.8) 0 7.5
7.9 31.6 39.5
Discounted cash flows Cumulative DCFs
(20.0) (20.0)
3.2 (16.8)
3.7 (13.1)
3.6 (9.6)
3.6 (6.0)
15.9 9.9
Summary
GT1 Proposal GoZ Option 1 GoZ Option 2
NPV (US$m) 2.7 (0.8) 9.9
IRR to nearest 0.5% 23.5% 19.5% 33.0%
Note: Initial investment is calculated as no. of expected lines probabilities cost per line: ((5,000 0.10) (2,000 0.3) (2,000 0.6)) US$2,000 US£5.2m NOCFs for new lines are calculated using the same number of lines and probabilities multiplied by US $600. (b) GTI is currently all equity financed and therefore has substantial debt capacity. Even though it is a service company, it will own a number of assets for the provision of telecommunications services. It will also own the right to future income generation on networks which it has installed, within the terms of its licences and agreements. On the face of it, GTI would be sensible to take the IFC offer of a loan fixed at 10 per cent, as this would release internally generated cash flows to earn money in other areas, which should earn a return of the 15 per cent cost of capital in projects of lower risk than that in Zenobia. The disadvantages could be as follows: 1. The interest rate is fixed. If interest rates are expected to fall GTI could be locked to a high interest loan for between 5 and 10 years. The capital is not repaid until the end of the loan period; therefore interest is payable on the full amount each year of the loan. 2. If GTI agree to GoZ’s option 1 the maximum amount of the loan of US$20m will not be sufficient to fund the project. The company will therefore have to provide a further $10m from internally generated funds at the beginning of the project and $5.2m at the end of year 3. 2006.1
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Other good points which could be included are the effect on the company’s beta if it becomes listed, the effect on WACC, and the ability to use the IFC’s knowledge and experience of developing countries to obtain advice and assistance when implementing the project. A discussion of debt versus equity is not required here, although an answer could introduce a summary of the main points. A good answer would note that many of the issues – for example, tax relief on interest payments – would be common to debt raised either from the IFC or from the capital markets. (c) (i) The starting point for establishing a regulatory regime is a clear set of government objectives. The regulatory rules should then be designed so that they both meet government objectives and can readily be understood by both regulator and the regulated industry. These objectives may be classified under three headings. ● the protection of customers from monopoly power; ● the promotion of social and macroeconomic objectives; ● the promotion of competition. Where participants in a regulated market are judged to possess significant market power, and where there is no other protection for customers, methods for protecting customers in a specific sector by controls on prices and controls on quality of service will need to be considered. A particular focus here will be on price or tariff controls. Social objectives cover a variety of possible government objectives, including the availability and affordability of services in particular areas and in particular groups, such as the disabled or customers in rural areas. It is often difficult to distinguish these objectives (which may be specific) from wider government macroeconomic objectives. These can include policy on employment, pricing (and inflation) and investment, and may be particularly important in developing countries. The first step in designing effective regulations to promote competition is to identify where potential barriers to entry might exist, and their relative importance. Once the market segments in which there is scope for competition have been identified, steps will need to be taken to assist its development. Other regulatory options may also be considered, including the following: ● Prohibiting cross-subsidy. To enforce this it will be necessary to require the company to make separate accounts for separate businesses available to the regulator. ● Removal of the right to compete in defined activities. An alternative to requiring separation or prohibiting cross-subsidy is to prohibit the regulated company from competing in the activity in which competition is to be promoted. 2006.1
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The main advantages and disadvantages of taking out a loan of this type may be in the small print. It is possible that the IFC will offer some inbuilt insurance that if Zenobia was subject to civil disturbance, the loan becomes non-repayable. A disadvantage might be that taking out this loan for Zenobia could preclude GTI’s borrowing money from the IFC for other projects in the future which may turn out to be less risky and more profitable. However, all three options being considered by GTI have internal rates of return in excess of both the company’s cost of capital and the interest rate being offered by the IFC. The advantages of borrowing from the IFC to finance this high-risk project would therefore seem to outweigh any of the disadvantages.
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Creation of regulation prohibiting discrimination. The established company can prevent the loss of its most valuable customers to a new competitor by offering special terms of service. A rule to prevent this may therefore be appropriate. Regulation may be enforced by a number of means: legislation, licences, industry codes of practice, government department versus independent regulator. The need for these, and the effectiveness of current controls, will depend very much upon the technical characteristics of the particular service offered. (ii) Telecommunications networks usually operate with already specified constraints and objectives and it is often sufficient to provide for these to continue. The financial or contractual terms of service for customers, however, often require reviewing when corporations are privatised and additional or modified controls may be desirable. A key aspect in the influence of Zoftel is its independence. If it is a quasi-government body, it will have little influence as it will be directed by the GoZ to do as it is told. If it is an independent body it may interfere in the following ways. 1. Disallow any period of exclusivity. 2. Force negotiation of tariffs, presumably downward to protect consumers, which will reduce the profitability of the project. 3. Introduce technical conditions which will make the initial investment more expensive. ●
Solution to case study 3 ●
This question involved a medium-sized, privately owned company taking the decision to float on the stock market. The question requires an understanding of the difficulties and problems facing the pricing of new issues and the effect on shareholders. It further examined how the company developed and the issues it needed to consider when raising finance five years after it has been floated. The alternatives were convertible debt or equity. The question also tested for an ability to make reasoned, logical assumptions leading to informed advice, based on information available, which was of course limited.
(a) Report To: Board of Ibsen From: Financial adviser Date: (i) Dividend valuation model The basic model is the constant growth model: P0
●
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There is no real basis for an estimate of growth but the reasons for assuming one are: a new issue would struggle to be accepted unless the company promised a change in dividend policy to allow for growth in dividends; growth in profit after interest and tax between 1997 and 1998 is expected to be around 27 per cent but 1997 could have been an unusual year because of the dip in profits and 1998 is the first year of the loan interest charge.
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PAIT EPS
Price/earnings basis 1997 1998 (forecast) £16.8m £21.4m 28.0p 35.7p
If the industry average P/E is used, then the value of the company would be: Using 1997 figures: Using 1998 forecast:
£16.80m 11 £184.8m or 308p per share £21.40m 11 £235.4m or 392p per share
Some discussion on the appropriateness of using the industry average could be made here. There is no other benchmark readily available although it could be argued that a new issue would have a lower or higher P/E (no consensus here). The share price might be lower than indicated because only 49 per cent of the shares are being offered. Net asset value This is a very common benchmark, and one which cannot be ignored when making comparisons even if it is only to provide a minimum. The net asset value is £120m or 200p per share if using 1997 figures. If using 1998 forecast it is £127m or 212p per share. The forecast figures are probably the most relevant. Recommendation There is a huge difference in price between the methods. Assumption (a) of the DVM uses past data and assumes no growth in dividends, which is highly unlikely. The P/E ratio incorporates growth estimates for the industry. The book value is likely to be the minimum price acceptable. Somewhere between 212 and 392p is the range to consider. However, if the company was floated at £127m (the value using the zero-growth version of the DVM – highly unrealistic), this would imply a P/E of just under 6, which would be well below the industry average and unlikely to appeal to the investing public. Given the company’s relatively poor performance over the past few years, a valid recommendation would be to wait until a more solid record of increasing profits can be demonstrated before the company is floated. (ii) Other information which would have been useful includes: ● current economic and market conditions; ● estimates of growth for the industry and the company; ● investment programme for the next 5 years; ● forecasts of economic indicators; ● market analysis, competition, etc. 2006.1
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Comment could be introduced here about the payout ratio. In 1996 and 1997 it was around 100 per cent (ignoring ACT) and in 1997 the company may have had to borrow to pay the maintained dividend. This could imply zero growth. If zero growth in dividends, then P0 17.5 0.14 £125m, or 208p per share. (It is unlikely that candidates will assume zero growth but if they do, and state why, they get full credit.) However, the question asks for an assumed growth rate. Anything between 2 and 10 per cent could be considered reasonable. Assuming 5 per cent growth would produce a price of (17.5 1.05)/(0.14 0.05) £204 m or 340p per share. An attempt to ungear the 14 per cent WACC to get to a precise cost of equity is acceptable but a number of assumptions then become necessary.
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Part (a)(i) was done satisfactorily if not well by many candidates. The most common shortcoming was to provide calculations but no comments/discussion of the problems with the three methods. Common errors were: making no assumptions about growth rates for the DVM. Zero was only acceptable if explained; There is no real basis for an estimate of growth but the reasons for assuming one are: – a new issue would struggle to be accepted unless the company promised a change in dividend policy to allow for growth in dividends; – growth in profit after interest and tax between 1997 and 1998 is expected to be around 27 per cent but 1997 could have been an unusual year because of the dip in profits; ● using 30m shares instead of 60m; ● lowering the P/E ratio by up to 50 per cent. A small discount is acceptable, and candidates who did this and gave reasons were awarded credit, but a large discount is unrealistic; ● using profit before tax instead of profit after tax for earnings; ● giving net assets of £172m for 1998; ● suggesting net asset value is the most appropriate valuation method for a going concern; ● using 49 per cent of the value of whatever is being considered as the valuation; ● very poor presentation which often resulted in silly mistakes because candidates had lost track of what they were doing. Part (a)(ii) was attempted reasonably well by many candidates but many failed to relate their answers to the case. ●
(b) Report To: Board of Ibsen From: Financial adviser Date: Calculation of terms Rights issue No assumptions are necessary here; the EPS can easily be calculated and the current P/E ratio is given. The share price is simply: £45m/60 m 18 = 1,350 pence A discussion is required as to what the rights issue price should be. The company’s P/E is higher than the industry’s, and is moving more erratically. This is probably to be expected as the industry P/E will have individual company’s volatilities smoothed out. The use of a P/E of 18 could give rise to discussion of whether the shares are ‘overpriced’, the effects on old/new shareholders, etc. Whether the shares are overpriced or not, the rights issue price cannot be set without reference to it. If the company sets the issue price at a discount of 15 per cent the price would be around 1,150p. This would mean issuing 21.74m shares to raise £250m (ignoring issue costs). The terms would be 1 for 2.76 – say 1 for 3. The theoretical ex-rights price is: (1,350 60m) (1,150 21.74m) 1,297 pence 2006.1
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Convertible bouds Quite a large number of assumptions are needed here and flexibility is required in marking, but there is a range of sensible options. It should be noted that companies in real life have these assumptions to make when setting conversion terms. Assume the convertible is issued at par at 10 per cent (a bit high at the moment, but a convenient figure). Assumptions have to be made about the ordinary share price in four years’ time to establish conversion terms. Assume no increase in issued share capital over the four years and that earnings grow at the same rate as in the years 1998–2002 (£21.4m in 1998 to £45m at the end of 2001). This is an average of approximately 20 per cent per annum. EPS at the end of 2005 would be 75 pence 1.204 156 pence. Assuming the P/E stays at 18, this implies a share price of 2,808p. The conversion terms at the end of 2005 would therefore be around 3.6 shares per £100 loan stock. Convertibles can usually be exercised over a number of years so terms for three to five years would be the norm. Also, if the share price gets as high as £28, it is likely there would have been a share split. An alternative approach as per the published solution would be to take the present price of 1,350 p, and a cost of equity of 14 per cent. Assume a dividend payout ratio of 50 per cent which would allow a rough increase in share price of 7 per cent per annum. This would result in a share price in five years’ time of around 1,890p, implying conversion terms of around 5.3 shares per £100 of debt. Discussion of financing issues The answer for this part of the question could be introduced by discussing Ibsen’s circumstances: original shareholders now own only 20 per cent of issued share capital, 60 per cent is owned by a large number of individual investors and 20 per cent by three large institutions. This shareholder profile could have an impact on the choice of method of financing and a good answer should consider this. A general discussion of rights versus convertible debt could note: ● Equity – rights issue. Will improve company’s gearing but will almost certainly dilute EPS in the short term. Control may also be diluted but it may no longer be an issue for the company (the original shareholders now owning only 20 per cent of the shares). Announcement of rights must be accompanied by strong signals to the market that the money is needed for profitable long-term investment. ● Convertible debt. This is debt which may be converted into equity (ordinary shares) on predetermined terms between specific dates. Interest payable is usually fixed and is tax deductible, which is an advantage. Convertibles can usually be issued at a lower interest rate than straight debt. It still has to be redeemed if holders do not convert. EPS may be diluted on conversion. Gearing is increased in the short term. EPS should be higher in the short term than with equity. A conclusion could summarise the main points. It is useful if candidates provide some gearing calculations and effects on cost of capital somewhere in their report (or at least note the possible effects) and credit should be given.
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If candidates manage to give any real life examples of how share prices move before and after a rights issue, credit should be given.
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No assumptions are necessary to calculate EPS as the current P/E ratio is given. The share price is simply: £45 million 60 million 18 1350 pence A discussion is required as to what the rights issue price should be. The company’s P/E is higher than the industry’s, and is moving more erratically. This is probably to be expected as the industry P/E will have individual companys’ volatilities smoothed out. The use of a P/E of 18 could give rise to discussion of whether the shares are ‘overpriced’, the effects on old/new shareholders, etc. Whether the shares are overpriced or not, the rights issue price cannot be set without reference to it. A discount rate of anything between 10 and 20 per cent was acceptable in calculating the rights price. If the company sets the issue price at a discount of 15 per cent the price would be around 1150p. This would mean issuing 21.74 million shares to raise £250 million (ignoring issue costs). The terms would be 1 for 2.76 – say 1 for 3. In part (b)(ii), quite a large number of assumptions are needed, but there is a range of acceptable options and it should be noted that companies in real life have these assumptions to make when setting conversion terms.
Solution to case study 4 ●
The case in this question concerns a large, publicly listed company which manufactures high-technology landing and airport control equipment and was once government owned. The company is evaluating two contracts, which are mutually exclusive. They both involve exchange risk and one also involves technical and political risk. The question aims to test candidates’ ability to evaluate foreign investment decisions and identify and assess the use of hedging methods to reduce such risk.
(a) Assuming that the financial objective of the enterprise is to maximise the net present value of projected cash flows to its shareholders, then the cost of capital in the currency in which dividends are declared will provide the criterion for the evaluation of feasible alternatives. On this basis, the cash flows to be discounted will be the remittances to that ‘home’ country, net of the relevant taxes. The basic cash flows will arise in a foreign currency, of course, and the forecast will need to be reduced to reflect the margin of error brought about by the uncertainties in that market, in the light of the decision makers’ risk aversion. The special factor is that they then need to be translated into the home currency, at the exchange rates forecast to be applicable at the time of the remittance. Assuming developed markets, these will normally be the corresponding forward rates, that is, the current spot rates are adjusted for the difference between the interest rates prevailing in the two countries. Otherwise, it calls for a specific forecast, again subject to a margin of error. Using the capital asset pricing model (CAPM) is not universally accepted as a means of calculating discount rates in domestic projects; in international projects the arguments against are even stronger. The main difficulties are in establishing appropriate betas and estimating expected returns for the market and the risk-free rate. In theory, projects should be evaluated using a specific risk-adjusted discount rate which reflects the risk of that project. In order to determine a discount rate for a project we should use a proxy company’s beta and include this in the CAPM. In practice this is almost impossible to do, particularly in a country with less-developed capital markets 2006.1
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The question asks specifically for comments on the difficulties that would be involved in using the CAPM to calculate international discount rates. What is not required is a lengthy discussion of the general shortcomings of the CAPM. The point, which could have been made about using the CAPM, is that it is not universally accepted as a means of calculating discount rates in domestic projects and that in international projects the arguments against are even stronger. The main difficulties are in establishing appropriate betas and estimating expected returns for the market and the risk-free rate. In theory, projects should be evaluated using a specific risk-adjusted discount rate that reflects the risk of that project. In order to determine a discount rate for a project we should use a proxy company’s beta and include this in the capital asset pricing model. In practice this is almost impossible to do, particularly in a country with less developed capital markets such as might be the case in contract 2. Other comments/points, which could have been included in a good answer, are: – the timing of the cash flows; – that the correlation of cash flows with domestic projects will affect total risk of the company; – inter-temporal correlation of cash flows for individual projects will affect the project’s standalone risk. This is a fairly technical point, and not one picked up by many candidates, although one or two had clearly taken note of past exam papers and solutions; – specific comment on country risk: economic risk concerns currency movements and exchange rates that in developed countries can be managed. In developing or politically volatile countries this is more difficult. (b) (i) The cost of equity capital would be calculated as follows: Risk-free rate the equity premium the beta of the company’s share price (6% (12% 6%) 1.5) % p.a. 15 % p.a. (ii) In the forward markets, sterling will be at a discount against the Deutschmark, equivalent to 1.05 1.06 (i.e. just under 1 per cent per annum) and a premium against the dollar, equivalent to 1.07 1.06 (i.e. just over 1 per cent per annum). On this basis, one pound sterling will be equivalent to: Deutschmarks at the end of : year 1 DM 3.0000 1.05/1.06 = DM 2.9717 year 2 DM 2.9717 1.05/1.06 = DM 2.9437 year 3 DM 2.9437 1.05/1.06 = DM 2.9159 year 4 DM 2.9519 1.05/1.06 = DM 2.8884 Dollars at the end of : year 1 year 2
$1.6000 1.07/1.06 = $1.6151 $1.6151 1.07/1.06 = $1.6303
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such as might be the case in contract 2. Those companies which use CAPM for domestic projects will probably use a rule-of-thumb approach to obtaining a discount rate. The adjustments needed must recognise that the risks noted above do not always increase the required rate of return. The diversification effect might reduce the rate although the political stability of the country might add to it.
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(iii) European opportunity Year 15% p.a. discount factors DM per £
0 1.000 3.0000
1 0.870 2.9717
Revenue
(300) (300) (300) (300) (300)
3 0.658 2.9159
4 0.572 2.8884
DMm 2.9500
DMm 2.9500
DMm 2.9500
DMm 2.8500
£m 168
£m 170
£m 171
1,(75) 22.93, 2281, (219) 62 300 31 10
1,(75) 2295, 2272, (147) 63 238 32 13
(75) 2.96, 263, (84) 62 175 34 19
£m 173 50 (75) 2148 285 221 63 113 35 31
£m Revenue (Investment)/residual value Contract costs Net cash flow Discounted cash flow Cumulative present value Depreciation Opening assets Profit % p.a. return on assets
2 0.756 2.9437
Middle Eastern opportunity Year 20% p.a. discount factors 15% p.a. discount factors $ per £ Revenue
0
1 0.833
2 0.694
1.6000 $m 1,000
1.6151
1.6303 $m 1,000
£m Revenue: dollar denominated sterling denominated Investment Contract costs Lost business Net cash flow Discounted cash flow Cumulative DCF Depreciation Opening assets Profit % p.a. return on assets
£m
625
£m
3
4
5
0.658
0.572
0.497
£m
£m
£m
200
200
200
(100) 100 100 166
(100) 100 100 157
(100) 100 100 150
613
(500)
125 125
(350) (175) (525) (437)
(150) (150) 313 217
125
(312)
(95)
(29)
128
178
100 500 (175) (35)
100 400 388 97
100 300 – –
100 200 – –
100 100 – –
Common errors in this type of question are: – using the interest or inflation rates the wrong way round to calculate forward exchange rates (i.e. showing the DM weakening and the dollar strengthening). The published solution uses interest rate parity to calculate forward exchange rates. The use of inflation figures, or purchasing power parity (PPP), was an equally acceptable approach; – mixing currencies in the cash flows; – inflating cash flows – the question stated (twice) that forecast cash flows were in nominal terms; – adjusting for tax – the question clearly instructed candidates to ignore tax, including the calculation of capital allowances; – ignoring the opportunity cost of lost income in contract 2, or showing it in years 3 and 4 instead of 1 and 2; 2006.1
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(c) Report To: From: Date: Subject:
Board of Spearhead plc Financial manager Potential contracts
You asked me to look at the financial aspects of two tenders currently under consideration. This I have done, and I have collected my thoughts under four headings: (i) How each contract might contribute to the achievement of the company’s objectives Contract 1 would do nothing to improve market capitalisation, which would contribute to shareholder value, at a discount rate of 15 per cent; the NPV is virtually zero. Contract 2 has an NPV of £78m, at discount rates of 20 per cent for stage 1 and 15 per cent for stage 2. This should improve share price by 13 pence, an increase of less than 2 per cent (600 million shares in issue, quoted at 950 pence at present). This of course assumes efficient markets. There could also be confounding factors which affect the share price and which have nothing to do with the contracts. The return on assets objectives is not achieved by either contract. This is not unusual with major capital investment projects of this nature and maintaining a RoA on an annual basis is not an entirely realistic objective in the circumstances. RoA is reduced for the next three years with contract 1 and for the first year for contract 2. However, with contract 2 there is a substantial improvement in year 2. The dividend policy objective should not be affected by obtaining either contract, although contract 2 would clearly offer opportunities for capital gain to shareholders who choose to sell their scrip dividends. No information is given on the size of the market leader in the industry, but obtaining contract 2 would increase the size of the company by most criteria so that it should be closing the gap at least between itself and the market leader, unless of course the market leader is bidding for even larger contracts. In summary, both contracts meet the NPV objective, but contract 1 by only a tiny margin. Neither contract fully meets the RoA objective (depending on assumptions). The dividend policy objective is largely unaffected by the decision and insufficient information is available to judge the effect on market leadership. Further investigation is required, including alternative uses of capital. (ii) How the risk of each project is reflected in the cash flows and alternative methods of risk management which could be considered by the company The main risks involved here are: ● Risk 1: Technical risk: the company can achieve what it promises the customer. ● Risk 2: Economic risk: the cash inflows are largely in foreign currency. ● Risk 3: Political risk of contract 2 and the possible knock-on effect to other customers (e.g. loss of permanent business; what if Israel is also a customer?). The board of directors of Spearhead can only take a view on risks 1 and 3, and it is almost impossible to quantify a discount rate using any formal model such as CAPM. The company’s cost of capital at 15 per cent per annum comprises a 6 per cent real rate 2006.1
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– failing to use two discount rates in contract 2 (20 per cent for years 1 and 2 and 15 per cent for subsequent years); – incorrect use of the CAPM and/or calculation of the discount rate; – inability to calculate return on assets.
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and an 8.5 per cent risk premium, the latter reflecting the implied uncertainty in the cash flows as well as risk. For the first 2 years of the Middle Eastern project, however, the discount rate has been increased to 20 per cent, implying a risk premium of 13.2 per cent p.a. Since risk aversion has not changed, the implied uncertainty associated with these cash flows is one and a half times as high as in the European project. An alternative approach to evaluation is to reduce the projected cash flows by a percentage calculated as the uncertainty multiplied by the risk aversion (both of which would vary from year to year, as would the pure cost of capital, in practice). This is sometimes referred to as the ‘certainty equivalent’ approach and would produce the same answer in this case but, by separating the uncertainty and risk aversion from the interest rate, would facilitate the identification of the most sensitive aspects (‘sensitivity analysis’) and provide a focal point for managing the consequent risk (e.g. modifying the phasing, or subcontracting some of the work). Other possibilities: ● use of sensitivity analysis, etc.; ● assessing the investments as options on future cash flows. (iii) The difficulties involved in evaluating mutually exclusive projects of unequal risk and unequal lives In theory, capital should be available for all projects if they return higher than the risk-adjusted rate required. However, in practice companies impose ‘soft’ capital rationing because they do not wish to overextend their non-financial resources. In contrast, ‘hard’ capital rationing is genuinely because of shortage of capital for investment and in reality this type of rationing no longer exists. The life span of the project should not in principle affect the discount rate. The normal procedure for projects with different life spans is to calculate an equivalent annual rental and compare the projects on the basis of an annualised cost. However, strictly speaking it is not possible to compare things when one has ceased to exist, and even the theoretically acceptable annualised cost approach implicity does this. Using terminal values at the end of equivalent lives is an acceptable alternative approach. Inter-temporal correlations affect the standard deviations of the net present value and internal rate of return and hence the project’s stand-alone risk. Generally, projects having cash flows with zero inter-temporal correlations have lower standalone risk than projects with high correlations. This is because low correlation means that a less than expected cash flow in one year can be offset by a greater than expected cash flow in the next. Very few projects have zero inter-temporal correlations and most of them are dependent to some extent on what has happened in a previous year. This is especially true in contract 2 where the cash flows from the second stage may be dependent on successful completion of the first stage. Linear programming methods can be used to accommodate projects of this nature, including contingent business. (iv) Methods of hedging the risks associated with trading internationally Technical and political risk cannot really be hedged although they can be managed – for example, by taking out patents in the case of the former and putting local staff on foreign subsidiary boards in the case of the latter. A number of similar actions could be discussed. Economic risk is brought about by currency volatility and there are two main timeframes to consider: between tendering and receiving the order, and between 2006.1
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Part c of the question could be answered in general terms if a candidate has failed to answer part (b) or arrived at figures he/she thinks incorrect. Main errors/weaknesses in this type of question are given below by section of the report. ●
●
● ●
● ●
How each contract might contribute to the achievement of the company’s overall objectives. – Not mentioning efficient markets and the effect of the contracts on share price. – Incorrect calculation of RoA. – Failure to comment on the dividend objective. – Some discussion could be provided about how market leadership might be measured. How the risk of each project is reflected in the flows and alternative methods of risk management which could be considered by the company. Failure to comment on payback, the use of certainty equivalents and/or probabilities. Some comment could be made in this section of the question about the use of the CAPM. Methods of hedging the risks associated with trading internationally. It is necessary to comment on both internal and external methods of hedging the risk, although for satisfactory marks it is necessary also to provide some discussion: for example, that invoicing in the home currency might avoid transaction risk but in a competitive market this might not be acceptable to the customer; or that manufacturing in the customer’s country is probably not an option because of the technical expertise necessary and the large items of capital equipment needed.
Solution to case study 5 ●
The scenario in this case concerns a manufacturer of electrical equipment in serious financial difficulty. The company may face liquidation unless the directors can negotiate a refinancing package, possibly with a venture capital company.
(a) (i) Break-up value Non-current assets Inventories Receivables Debentures
£m 4.750 2.700 4.725 (3.000) )9.175)
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receiving the order and being paid. The risk of not obtaining the contract is a complex matter and likely to be borne by the company. The second type of risk can be hedged using internal and external methods. The two contracts are in major currencies, so using the money or capital markets to hedge would be relatively simple and inexpensive (in relative terms). The company could use either fixed or option forward contracts or use the money markets. The company could, of course, bear the risk itself and not involve the expense of external hedging. Internal hedging techniques would most likely involve manufacturing in the customer’s country. This is probably not an option because of the technical expertise necessary and the large items of capital equipment needed. Other methods such as multilateral netting could be considered.
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(ii) Disbursements The bank and trade creditors would get £9.175/£11.975, that is, 76.6 pence in the pound; shareholders would get nothing. (iii) Quantifying the proposal If everyone concerned were to accept the proposals put forward by the venture capital organisation, the company would receive cash as follows: £m 4.000 2.000
4.000m £1 per share 12% p.a. debt 2005
£3.8m of this would be used to pay 40p in the £ to creditors, leaving £2.2m as ‘cash in hand’. The £3m of debentures would be converted into shares and, hence, the attributability of the operating assets would become: £m Lenders: 2.000 2.475 2.200 Taxers Shareholders Nominal: Original Debt-holder Venture capitalist Reserves
2.275 –
1.600 3.000 4.000 0.525 19.125 11.400
Total (7.6 3.8)
An alternative approach is as follows: £000 Cash inflow Equity Debt Sale of equipment Purchase of new equipment Working capital Trade creditors Net cash inflow
4,000 2,000 1.000 7,000 (2,500) (500) (3.800) 2,200))
This is a relatively small amount and is insufficient to allow any payment to the current debenture holders and the bank, should either of them refuse to consider the VC’s conditions. Also, the situation re the overdraft will have changed during the negotiating period, possibly for the worse. (b) Report To: From: Date: Subject:
The directors of VG plc Financial adviser An assessment of the venture capitalist’s proposals
As requested, l have looked at the implications of the above proposals, from the point of view of our financing stakeholders. 2006.1
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Lenders Taxers Shareholders
£m 5.475 – 2.125 7.600
If the company continues to lose money at a rate similar to that in 1998/99 (over £3m) it cannot continue in business for very long. The company will have increasing difficulty paying its trade creditors. This will induce a further contraction of the business, and/or one of them will commence an action to wind up the company. If not before, matters will come to a head in June, when the debenture is due to be redeemed. Since the holder has security over the fixed assets, a winding-up petition is again a strong possibility, unless avoiding action is taken. In response to your specific queries, my assessment is as follows: (i) Immediate impact on the providers of finance Existing Shareholders There are basically two ways of looking at this from the angle of the existing shareholders, as follows: ● The net present value of projected cash flows, as the company is presently constituted, is as near to zero as makes no difference. The injection of cash would improve that (the extent of the improvement being dependent on the use to which the cash is put) and is therefore to be welcomed. ● The company’s current market capitalisation is 8m 28p, that is, £2.24m. The issue of shares for cash, coupled with the conversion of the debentures, would – other things being equal – increase this to £9.24m, of which the existing shareholders would own 1.6/8.6 18.6 per cent, or £1.719m. In other words, they would be swapping five shares worth 140 pence for one share worth 107p. The reason for the difference is the fragility of the share price. If shares are trading at 28p each, buyers must be expecting some sort of rescue, but maybe they have overvalued it, and the share price has further to fall. On balance, I would suggest that existing shareholders would want to accept the arrangement, but then sell in the market sooner rather than later. Marks would also be awarded to candidates who distinguished between the interests of different categories of shareholder, for example, small versus institutional. Lenders From the debenture holders’ point of view, swapping secured loans for equity, effectively at par, amounts to taking on additional risk. The debenture holders could look forward to additional shares but the value of this depends on future profitability. If they were party to the ‘profit improvement’ proposals, they would see that the company would still be loss-making, which would not encourage them to want to participate. From the bank’s point of view, the trade-off is to gain additional security (worth 23.4 per cent of the facility, i.e. £584,000) in return for a 2 per cent lower interest 2006.1
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My starting point was with the recently completed balance sheet as at the end of October 1999. At that date, the company’s operating assets amounted to £7.6m, attributable as follows:
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rate, worth £50,000 p.a. This may be acceptable but, equally, the bank might prefer to cut its losses. Others The trade creditors would see the proposals in a very favourable light, since they could be more confident of receiving what they were owed. In effect, the proposal amounts to a transfer of value from lenders to trade creditors. Given their relative bargaining power, the chances of the proposal being ratified are slim. The question that is likely to be uppermost in your minds is why, given the bleak scenario painted, any venture capitalist would want to acquire a minority interest in the company. Clearly, they must be factoring in opportunities which are not allowed for in the above quantifications. These may be at the corporate level of strategy, for example, they may foresee a rationalisation of the industry, in which his stake in VG plc could be extremely valuable. (ii) Various other matters ● Effect on share price. There are currently 8 million shares in issue, and the latest price we are given is 28p, indicating a market capitalisation of £2.24m. An injection of cash of £4m, and the conversion of £3m of debentures at par would – assuming an efficient market – bring that up to £9.24m. There would then be 8.6 million of ordinary shares in issue, suggesting a price of 107 pence. In theory, a change in the dividend policy should not have a direct impact on the share price, since it is supposed to reflect the future value of the business, irrespective of whether it is realised by way of distributions or capital gains. In practice, however, the news of the reconstruction would have some impact on investors’ opinions of the company’s prospects, and hence on the balance of supply and demand for its shares, which determines the price at which they change hands. ● Medium-Term effects, assuming the proposals are approved by all concerned. Existing shareholders would receive an additional 480,000 shares by way of bonus issues over the next 3 years. The venture capitalist, likewise, would receive an additional 1,200,000 shares by way of a bonus issue over the next three years; The debenture holders (or those to whom they sell their shares/warrants) would receive an additional 900,000 shares by way of bonus issues over the next 3 years, and have an option to buy a further 1,500,000 shares in 3 years’ time, on payment of £1.5m. For them to do so, the financial health of the company would need to have improved significantly, compared with the present situation. If they did so, they would have 5,400/12,680, that is, 42.5 per cent of the total, compared with an initial 3,000/8,600, that is, 34.9 per cent. ● The venture capitalist’s exit routes. The venture capitalist will be free to sell shares in the market at any time. However, there is more likely to have some medium-term plans which they will want to see through. On fruition, they may want to: – buy all the other shares, and take the company private. This is a growing practice, to the point that venture capitalists are seen as ‘the new conglomerates’; – buy all the other shares and then arrange a disposal in some form, for example, trade sale; – place their shares with a small number of large investors; 2006.1
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I hope that the above meets your requirements but, if you would like me to elaborate, please let me know. Signed: Financial adviser (c) A company with a substantial proportion of overseas business is exposed to a number of risks. In particular, it faces various forms of currency risk, the adverse aspects of which are attributable to a strengthening of its own currency. In order of increasing significance: ● at the operational level, it faces the risk of that happening between invoice and remittance; ● at the tactical level, it faces the risk of it happening between the time of commitment to a particular market (e.g. by incurring costs and/or quoting prices) and selling; ● at the strategic level, it faces the risk of it happening between embarking on a particular course of action (e.g. building plant to service overseas markets) and its fulfilment (manufacturing the product only to find that local competitors can provide it much more cheaply). VG plc is not alone in its problems, but actions worth considering include: ● hedging of the operational risk by selling anticipated currency receipts forward; ● hedging of the tactical risk by buying options to sell forecast receipts at today’s forward price; ● hedging the strategic risk by borrowing in foreign currencies (lowering their value if the home currency strengthens). It also faces enhanced risks in other areas, for example, the failure of a far-away debtor to pay his/her account when due, an intervention as a result of political activity, and/or a depression in the overseas market generally. If its credit control is defective, as suggested in the question, the board could consider: ● insuring its debts; ● factoring its debts; ● investing in more professional credit control processes. An answer classifying currency risks under the headings ‘transaction’, ‘translation’ and ‘economic’ would have been equally acceptable. Part (a) of the question requires calculations of the liquidation value of the company, who would get what in liquidation, and how the cash flow might be improved 2006.1
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●
– sell their shares on to another venture capitalist. This is also a growing practice, to the point that an active ‘secondary market’ now exists, even in private company investments. Alternatives. The situation is quite desperate and, barring an unexpected change of fortunes, most alternative routes would only amount to delaying tactics, as follows: – The economics of the underlying business might be improved (lower costs, greater sales, improved asset velocity), etc., but these would only reduce the losses. – The danger of the debenture holder initiating a winding up might be averted by obtaining some alternative financing, for example, by discounting sales invoices or obtaining specific stock finance. Since these affect the real and perceived security of other stakeholders, however, they may be difficult to bring about. – It might be possible to deal directly with the debenture holder, along the lines of debt/equity swap. – Otherwise, seeking an acquirer is an option worth pursuing.
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by an injection of cash from the venture capitalist. In answer to part (a)(iii), assuming that the profit improvement proposals would be implemented is an acceptable approach. Part (b) requires a report structured along the lines indicated in the question. For higher marks, answers require some additional calculations of, for example: – – – –
the likely effect of the rescue on market capitalisation; the change in ownership and control, in total and by category of shareholder; the effect on shareholdings of the scrip issues and, ideally, the exercise of the warrants; gearing and liquidity ratios.
Part (c) requires more than a discussion of exchange rate risks. Political and cultural difficulties are also present and a discussion of the problems of effective credit control of overseas debtors is clearly a requirement. Common errors in this type of question are: Part (a) – Using market values as part of the liquidation proceeds and/or cash position following rescue. – Assuming the share exchange for current shareholders resulted in a cash inflow. – Calculating a negative liquidation value and saying the shareholders would be liable for the deficit. – Using 1998 rather than 1999 figures, in particular including tax in the cash disbursements. – Assuming the new overdraft facility involves a cash inflow. – Not appreciating the order of preference for disbursement, for example assuming the unsecured bank over-draft takes precedence over trade creditors or, worse, assuming shareholders ranked ahead of creditors. – Providing comment and no calculation, especially in part (iii). Part (b) The question specifically asks for a report containing two main sections and gives strong indications of the issues to be discussed in each section. Other errors/ weaknesses could be: – – – – –
Providing no additional calculations. Not recognising the full implications for each group of stakeholder. Confusing and/or comparing market values with nominal values. Repeating large chunks of the question rather than answering it. Providing discussions of theory, especially MM, although some reference to MM would be acceptable. – Not understanding the meaning of ‘exit route’. Part (c) – Limiting discussion to problems of currency/exchange rate risk.
Solution to case study 6 (a) Report To: From: Subject: Date: 2006.1
Directors of ErOs Limited An accountant Company valuation and financing for expansion 22 May 2001
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You have asked me to provide you with the following information: ● A range of values for the entity to be used as a basis for discussion with an investment bank and venture capitalist. ● An explanation of the methods of valuation and their relevance to your situation. ● Discussion of the advantages and disadvantages of using venture capital financing to expand compared with stock market flotation in 2–3 years’ time. ● Discussion of alternative types of financial support that are available to assist your company realise its growth potential and advice on the issues you should consider before deciding on the most appropriate type of finance. Range of values There are three basic methods that could be used to value an unquoted company such as ErOs Limited: asset value, P/E ratio basis and discounted cash flow basis. Each is discussed in turn. Asset value The book value of ErOs Limited’s net assets is a little under £400,000 at the last balance sheet date. This value has little relevance except in specific circumstances such as a liquidation or disposal of parts of a business. In your company’s situation it has even less relevance than in a company with a high level of tangible assets as much of your value is in your employees’ expertise, or intellectual capital. We need not therefore consider the book value of assets further. However, as the amount in the balance sheet does reflect realisable value, then this is a ‘floor’ level valuation. P/E ratio In a listed company, the P/E ratio is used to describe the relationship between the share price (or market capitalisation) and earnings per share (or total earnings). It is calculated by dividing the price per share by the earnings per share. Market capitalisation is the share price multiplied by the number of shares in issue. Market capitalisation is not necessarily the true value of a company as it can be affected by a variety of extraneous factors, but for a listed company it provides a benchmark that cannot be ignored in, say, a take-over situation. In the case of an unlisted company, a P/E ratio that is representative of similar quoted companies might be used as a starting point for arriving at an estimated market value. The potential market capitalisation would be the company’s latest earnings multiplied by the benchmark P/E ratio. The P/E ratio can be viewed as indicative of expected growth, which is why some companies in your industry have very high P/E ratios at the present time. A relatively high P/E would suggest that investors are prepared to pay a premium for the company’s shares, based upon present earnings, because they anticipate growth in future earnings beyond growth rates expected in comparable companies. I show below the potential value of your company using the average and range of P/Es for your industry: ErOs Limited’s earnings 2001: £12,500 (10,000 shares at 125p EPS) P/E ratio Estimated value (£000)
12 150
27 337
82 1,025
This valuation is very rough and ready and takes no real account of your own specific circumstances and potential. 2006.1
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Introduction and terms of reference
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It might be more appropriate to take the average P/E ratio and apply it to next year’s expected earnings of £643,000. This would give an estimated market capitalisation of £17.36 million. Any sensible combination of earnings and P/E ratio would have gained marks.
Discounted cash flow This method values your company using your own cash flow forecasts based on your expected sales growth and associated costs. The approach is as follows: 1. Estimate revenue using your forecasts and estimated probabilities for the years to 31 March 2002 and 2003. 2. Calculate earnings/cash flows for the years to 31 March 2002–2005 based on your estimates of growth. Assuming that earnings equal cash flows is a simplification for examination purposes. In reality, this would be affected by, for example: depreciation, movements in working capital, and sale and purchase of non-revenue items. 3. Calculate discounted cash flows using the industry average cost of capital of 16 per cent. 4. Estimate the present value of cash flows from 2006 to infinity using the dividend valuation model. This again is an oversimplification but provides a useful ‘short cut’. ErOs Limited has not in the past paid any dividends, but the earnings figure is equally acceptable: the basic form of the model assumes all earnings are paid as dividends. 5. Add the present value of all future estimated cash flows. Estimation of earnings and cash flows for 2002–2003
Probability
Year to 31 March 2002 Expected Revenue revenue £000 £000
50%
1,800
1,900
30%
1,200
1,360
20%
1,800
1,160 1,420 1,420
Total Operating costs (35% 30%) Interest Profit after interest Tax at 30% Earnings/cash flow
2006.1
(497) (5) 918 (275) 1(643,
Probability 50% 80% 50% 20% 30% 50% 30% 50% 20% 50% 20% 50%
Year to 31 March 2003 Expected Turnover revenue £000 £000 2,500 3,000 1,700 1,400 1,000 1,800
1,000 1,300 1,255 1,210 1,100 1,080 1,945 (584) (5) 1,356 1,(407) 1,949)
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Estimation of cash flows for 2004–2005 £000 1,329 1,861
2004: £949,000 1.40 2005: £1,329,000 1.40
Discounted cash flows for 2002–2005 Year 2002 2003 2004 2005
Cash flows £000 643 949 1,329 1,861
Disc. factor at 16% 0.862 0.743 0.641 0.552
DCF £000 554 705 852 1,027 3,138
Estimation of value of cash flows from 2006 to infinity Earnings in 2006 assuming 10% growth on 2005: £1,861 1.1 £2,047 In today’s money, D1 £2,047,000 0.552 £1,130 P0 = D1/ke-g = 1,130/0.16 0.10 = £18,833 Any sensible attempt to calculate the value of cash flows to infinity, and recognition that it is in fact necessary, would have gained credit. Present value of all future estimated cash flows 2002–2005 2006 onwards
£000 3,138 18,833 21,971
This method suggests a company valuation of almost £22 million. The P/E ratio basis could of course be used together with forecast earnings, but the unreliability of the method, noted above, would still apply. Summary of methods and values Asset value P/E based value: DCF value
£000 385 150–1,025 21,971
467
(or £17,361 if 2002 earnings used)
As discussed, the asset value is largely irrelevant, the P/E basis is highly unreliable because of difficulties in comparing one company with another, the DCF method is the most likely to be reliable, but the figures produced are very rough and ready. A more detailed exercise needs to be undertaken. Venture capital finance versus flotation If we accept a company valuation of around £22 million, this is still relatively small for a full listing. A listing on the Alternative Investment Market (AIM) might be an acceptable alternative and less expensive although the relative length of the ‘queues’ for listing (controlled by the Stock Exchange) needs to be considered. The main advantage of any sort of listing is that it provides a readily available benchmark valuation for the shares. However, the number of shares to be sold needs serious consideration. If a small percentage of the shares is sold, this may deter institutional investors as there may 2006.1
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not be a ready market in the shares if they want to sell. If a high percentage is issued, control is lost. However, if venture capital finance were to be sought, control would be surrendered anyway as these organisations typically require a large equity stake, high returns and an assured exit route. Normally, an exit route would be to sell the shares on the market either via a placing or offer for sale or to another venture capital company. The original owners of the company might be able to buy back their shares via an earn-out basis. This method allows the venture capitalist to sell shares back to the owners on the basis of the company achieving certain levels of return. No details of what investment would be required to allow the company to grow at a faster rate is given in the question. In a company such as this, the value is in the intellectual capital and this might be in short supply. Alternative types of finance At present you are considering only two alternatives: to use venture capital money to aid expansion beyond the present projects, with the implications for control, or to wait until you have built up your profits over the next year or so and then float the company. Alternatives you could consider are: ●
●
●
●
Increase your bank loan, secured on your assets or possibly in exchange for a stake in the equity of the company. Issue new shares and sell a non-controlling proportion to private investors. There are schemes available to encourage investment in small, growing companies. Conduct a review of your terms and conditions of sale – it could be that there are opportunities for substantial increases in revenue by entering into revenue-sharing agreements with internet providers. Bring forward your plans to float the company, perhaps on the AIM. Given the growth potential of companies in your sector, it is possible a much higher P/E ratio might be awarded to your company than suggested earlier in this report. If we combine the highest P/E with your most optimistic earnings forecast, the potential value is £815,500 82 approximately £67 million (based on sales of £1,800,000 for 2002).
Before deciding on a course of action, you must clarify your own short- and longterm objectives. If your aim is to maximise your own personal wealth in the shortest possible time, then an early flotation is probably the best alternative. If you would prefer to retain control of your company, then the other alternatives might be more appropriate. Other issues to consider are: ●
●
Timing and cost of a flotation, and how many other similar companies might be coming to market at the same time. The implications of the proposed changes in regulation, both on your existing business and potential market value.
Conclusion and recommendation This report has provided a range of values for ErOs Limited using three well-known methods of valuation. A very large range of values has been calculated: £150,000 to almost £22 million (or £67 million at the most optimistic and unrealistic valuation). A more detailed exercise is required including analysis of income and costs, competitive activity, and risks. 2006.1
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1. Key person insurance to provide cover if a key member of staff falls long-term sick or leaves. This could be expensive and the terms of insurance, if it is to be worthwhile, may be difficult to arrange. 2. Provide good working conditions and adequate remuneration to try and retain key staff. If the company plans to go public, share options are an ideal method of retaining staff loyalty, at least as long as the share options are valid and valuable. 3. Contracts that restrict what staff can do if they leave to join a competitor or set up on their own. These, however, are difficult to enforce. The first thing to recognise in this part (i) of this question is the need to calculate an expected value using the probabilities given in the question. Then attempt a valuation of the company using DCF/NPV techniques. In part (ii) it is necessary to demonstrate an ability to evaluate different methods of valuation – for example, that the asset valuation approach is inappropriate in the circumstances; that there are difficulties using the P/E approach; and that the most appropriate method would be DCF/NPV. In part (iii) a discussion of the advantages and disadvantages of using venture capital financing as opposed to a flotation on the stock market should recognise the issues of immediacy, cost, and impact on control. In part (iv) discussion of alternative sources of finance should recognise that the main need is for long-term finance, although better working capital management could have provided the temporary benefits that Eric and Oscar were looking for. Common errors were: Part (a) – ignoring probabilities and doing calculations on one outcome only; – not discounting the profit after tax to arrive at an NPV; – in the discussion of alternative sources of finance, repeating the discussion of the use of venture capital and/or stock-market flotation; – weak discussion of the key issues of alternative sources of finance. Part (b) – discussing only issues of remuneration.
Solution to case study 7 ●
This question concerns the evaluation of whether a company has met its financial objectives, and whether it will continue to do so given its current plans for expansion. 2006.1
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Venture capital financing would almost certainly involve loss of control of the business in the short–medium term, but would avoid the costs and delays involved in a stock market listing. Alternative methods of financing growth should be considered. Signed: An accountant (b) Protection against loss of technical expertise The risk is that the company’s employees might sell the company’s ideas to a competitor, which is a high risk for them as it is illegal, or move to another company taking their ideas and designs with them. The highest risk would be if a group of employees left to join a competitor or set up on their own. A number of actions could be taken:
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(a) (i) Forecast income account for the year to 31 December 2001 £000 17,325 10,760 1,200 1,750 3,615 200 3,125 3,290 2,850 2,440 1,342 1,098
Revenue Cost of sales Depreciation Operating expenses Profit from operations Interest Redundancy payment Profit before tax Tax liability Net profit Dividends declared Retained profits
(ii) Forecast balance sheet at 31 December 2001 £000 9,300
Non-current assets (net book value) Current assets Inventory Receivables Cash and bank
3,850 1,759 4,7864 15,773
Equity and liabilities Capital and reserves Ordinary shares Share pemium account Accumulated profits
5,500 1,875 73,292 10,667
Non-current liabilities 10% Debentures 2005
2,000
Current liabilites Trade creditors Dividends payable
1,764 71,342 15,773
Note: New capital raised is 500,000 shares at 475p £2,375,000: £500,000 ordinary share account and £1,875,000 share premium.
Preliminary calculations: Ratio of debtors to sales in 2000:
1,675 100 10.2% 16,500
Ratio of creditors to cost of sales less depreciation in 2000:
1,750 100 16.4% 10,675
(iii) Cash-flow forecast, 2001 £000 Net cash flows from operations Operating profit plus depreciation Increase in receivables Increase in creditors Total
2006.1
£000 4,815 (84) 4,714 4,745
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Less Non-current assets Inventories Interest Tax Dividends Redundancy Total Net cash flows before new capital Opening cash balance New capital Closing cash balance
3,000 1,000 200 850 1,136 1,125 (6,311) (1,566) 55 2,375 1,864
(iv) Return on shareholders’ funds is after-tax profits as a percentage of total shareholders’ funds at the end of each year. 2000:
2,065 100 28.7% 7,194
2001:
2,440 100 22.9% 10,667
Earnings per share 2000 2001
Pence 41.3 44.4
Inc. on previous year, % 11.0 7.5
Note: Accounting standards would require restatement of EPS for 2000 to reflect the rights issue made in 2001. Dividends per share 2000 2001
Pence 22.7 24.4
471
Inc. on previous year, % 10.7 7.5
(b) Report To: Finance director of Almond Arts plc From: Assistant Date: 1 January 2001 (i) Comments on forecast profit and loss account, balance sheet, cash-flow and financial objectives The forecast profit and loss account shows improving after-tax profits. The main reason for this is that sales are forecast to rise by a higher percentage than cost of sales or operating expenses. The justification for this approach is acknowledged, but it could be optimistic. The forecast net cash requirement is a fairly modest £1.5 million. The company is expecting its profit improvement to be maintained and the redundancy payment is a one-off expense. A ‘back-of-an-envelope’ cash-flow forecast for 2002, shown in section (ii) of this report, suggests that the company will generate substantial cash in 2002 and beyond, once the capital expenditure programme is out of the way. The need for new long-term finance is therefore questionable. This is addressed in a later section of this report. An investment appraisal is not available for this project and this should be prepared before the company decides to go ahead. The figures will also need to be 2006.1
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reworked when the method of financing the expansion is decided, as this will have an effect on profitability and cash flow. The financial objectives are discussed below. Return on shareholders’ funds The objective here is to achieve a ROSF of 25 per cent per annum. The company met this objective in 1999 and 2000 (draft) but is unlikely to meet it, on the basis of the forecast, in 2001. It is not uncommon for capital investment programmes to depress returns based on book values during the first year of operations. This highlights the paradox of using accounting-based measures against which to monitor performance; one way of raising return on capital and similar measures is to restrict investment. Growth in earnings per share The company achieved the objective of increasing EPS by at least 10 per cent per annum in 2000 (draft) but is not likely to do so in 2001. One reason is the one-off redundancy costs in 2001; another is that there will be new shares in issue before the full benefits of the new investment are seen in profits. Accounting standards require EPS shown in financial statements to be adjusted for comparability when the number of shares in issue has changed (for example, following a rights issue or a loanstock conversion), although there is still a ‘perceived’ problem with a drop in EPS. However, the use of this measure is widespread and an objective of increasing EPS year on year is common. However, it is based on accounting numbers, which can, of course, be manipulated and seriously distorted by a variety of factors.
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Growth in dividends per share As the company proposes to maintain the 2000 payout ratio in 2001, the growth figures for DPS will be the same as for EPS. As with earnings per share, the growth in DPS will be affected by the issue of new shares. In theory, it is total returns to shareholders that should matter, although shareholder preferences for dividends over capital gains is influenced by their tax situation, their need for regular cash flows and their attitude to risk. It is not clear whether the company’s policy is influenced by knowledge of its shareholder profile or whether it is simply using another popular objective. The dividend decision influences the way the company finances its operations. A stated objective of increasing dividends per share could prove problematic if the company wants to retain more of its earnings for future investment, as it does at present. However, dividends are seen as important ‘signals’ to the market and the company may not wish to reduce dividends, even if the alternative would be either to postpone investment or to raise new debt. Share price increase According to the theory of shareholder value analysis, the value of a company is the present value of future cash flows discounted at an appropriate rate. Forecast dividend streams can also be used as a basis on which to value companies. Both methods have practical limitations. Although in theory, as noted above, it is total returns to shareholders that should matter, an increasing share price is a sign of market confidence. A complication, however, is that share prices react to external influences outside the control of the company, for example speculation on takeover activity. The company appeared to achieve this objective in 2000 (share price having risen from 465 pence at the end of 1999 to 525 pence at the end of 2000) although we 2006.1
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Equity valuation, P0
£1,342,000 1.10 D1 £37m 14% 10% ke g
Note: Different assumptions about the amount and timing of the dividend payment would be acceptable. This compares with the current market capitalisation of £26.25 million at the end of 2000 (five million shares at 525p). An alternative would be to apply the current P/E ratio to the forecast EPS for 2001. This would give a valuation of £31 million (P/E of 12.7 EPS of 44.4 p 5.5m shares). However, the share price might rise when information on our expansion plans is known. If this were to happen, and all other things remained equal, the market capitalisation would move closer towards the figure produced by the dividend valuation model. Other suitable measures Financial objectives are normally related to a market measure of shareholder wealth, for example return on equity. The company is doing this to some extent by focusing on dividend growth and share-price increase. However, it is not clear how the company has derived its cost of capital of 14 per cent. If this has been set too high it would result in rejection of profitable projects and under-investment (and, conversely, if set too low, in accepting projects which should be rejected). (ii) Need for financing The company is planning to raise £2.375 million in 2001 by means of a rights issue. However, if sales and costs behave as forecast, the company needs finance for only around eighteen months (the £2.375 million raised by rights issue being ‘repaid’ roughly half way through 2003), as the following rough estimate shows:
Cash flow from operations (assuming min. 5% increase) Interest payments Dividends (previous year payment, assume 10% increase in 2003) Taxation (estimate) New non-current assets Net cash flow during year Opening balance Closing balance
2002 £000
2003 £000
4,982 (200)
5,231 (200)
(1,342) (1,000) (2,000) 440 1,864 1,304
(1,476) (1,050) (1,–0) 2,505 1,304 3,809
It must be emphasised that these figures are very approximate, and I have continued to assume that inflation can be absorbed in the forecasts, but the order of magnitude is probably realistic. The board needs to consider carefully whether longterm finance is appropriate at the present time. Unless we can identify profitable 2006.1
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really need to compare this increase with the increase in the general market index. A comparison with the market should be incorporated into our objectives. In respect of forecasting the effect on the market valuation of the company’s expansion programme (assuming the market is not yet aware of our plans), we could take the constant growth variant of the dividend valuation model and apply it to Almond Arts’ dividend forecasts. If we assume a constant growth in dividends of 10 per cent, we get a market capitalisation of approximately £37 million as follows:
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investments to use the surplus funds being generated, it would not be in the shareholders’ interests to raise long-term finance. Suggestions for alternatives could be: ● a 2-year bank loan or medium-term debt, for example a finance lease or a eurobond; ● hire purchase or operating lease for some of the assets, if available; ● phasing the expenditure to coincide with cash flows if possible; ● deferring dividend payments. This might not be acceptable to shareholders and clearly breaches one of the company’s objectives. (iii) Problems with inflation and effect on objectives The main problem is that inflation does not affect all companies and all variables at the same rate. Adjusting for inflation in financial statements such as profit and loss accounts and balance sheets is particularly difficult. Specific inflation rates need to be determined and applied. This is difficult to do with accuracy beyond the short term. It is also difficult for people to understand the true effects of inflation. Forecasting in real terms at least has the merit of accessibility. However, our forecasts for 2001 are in nominal terms. If inflation were to rise above 3 per cent the effect would much depend on which variables are affected, by how much, and whether the company will be able to increase prices to recover the higher-than-expected increase in costs. If this were to be the case, then, in nominal terms, ROSF, EPS and DPS would probably rise (ignoring any requirements of current cost accounting). Clearly the increase year on year would also rise unless we were to restate the figures in real terms. (iv) Summary and recommendation for a course of action The expansion proposals appear profitable and generate substantial cash flows. However, before a decision is taken, the following actions are recommended: ● a more thorough evaluation of the probabilities of achieving the forecast sales and containing costs should be made. Sensitivity analysis or simulation methods could be used to assist the exercise; ● a full investment appraisal exercise should then be undertaken using an appropriate discount rate; ● the discount rate the company uses should be reviewed. Using one rate to evaluate all investments may result in incorrect investment decisions; ● the company’s objectives should be reviewed, particularly those relating to dividend policy and share prices. Continuing to use a measure such as return on shareholders’ funds may be necessary, but its shortcomings should be recognised; ● short- or medium-term finance appears more appropriate than long-term capital. A review of alternative types of finance should be undertaken, including an evaluation of the effect on cash flows and risk, as measured by capital gearing. Signed: Assistant
Solution to case study 8 (a) Calculations of NPVs Alternative 1 Item Revenue Less: Costs Factory conversion Equipment Redundancy costs Operating costs 2006.1
Year
0 £m 0 4.14 1.20
1 £m 1.8
2 £m 9.9
1.30 4.08
(note 1)
2.04
4.47
3 £m 12.55
5.265
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5.43 0.769 4.18
7.29 0.675 4.92
Net present value of cash flows for first 3 years of operations £1.20 million One approach to the calculation of terminal value would be to assume, conservatively, that cash flows would only maintain for 8 years, that is until the first date the equipment may need to be replaced. The figures would be: NPV to end year 3 PV of after-tax cash flows from year 4 to year 8 Less: Opportunity cost of KL3 from year 1 to year 8 Total NPV
£m 1.18 13.52 6.96 005.39 million
(note 2) (note 4)
Notes 1. As the supplier is in the US and is quoting a price in US$, the payment due in 6 months’ time will be US$6 million/1.47 (the exchange rate that might be expected in 12 months’ time given the information on inflation rates given in the question) £4.08 million. 2. This is £7.29 million multiplied by 80% (year 3’s after-tax cash flow) multiplied by the appropriate year’s discount factor for each of the years’ 4–8. 3. This is £1.5 million multiplied by the 8-year 14% cumulative present value factor (4.639).
Examiner’s Note An alternative approach is to use the perpetuity formula to calculate values beyond year 3. The NPV would then become: £m 1.18
NPV to end year 3: PV of cash flows from year 4 onwards
80% 0.675 7.29 0.14
28.11
Less: Opportunity cost of lost revenue from K3
10.71
Total NPV (value to firm)
£16.22m
0.14 £1.5m
However, we really need estimates of the replacement costs of the equipment to obtain a more realistic figure. A value at the lower end of the range £5.39 million to £16.22 million is probably more appropriate given the finite life of the equipment. Alternative 2 Item Revenue (see workings) Less: Costs Factory conversion Equipment Redundancy costs Operating costs Net cash flows Discount rate @ 14% Discounted cash flows
Year
0 £m
2.50 2.74 2.74 1.000 2.74
1 £m 4.5
2 £m 6.3
3 £m 9.7
2.145 4.16 0.769 3.20
2.655 7.05 0.675 4.76
1.30 0.24 1.875 1.33 0.877 1.17
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5.34 1.000 5.34
Net cash flows Discount rate @ 14% Discounted cash flows
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Net present value of cash flows for first 3 years of operations £6.39 million As with Alternative 1, one approach to the calculation of terminal value would be to assume that cash flows would only maintain for 6 years, that is until the first date the equipment is likely to need to be replaced. The figures would be: £m 6.39 8.84 (note 1) 5.83 (note 2) 9.40m
NPV to end year 3 PV of after-tax cash flows from year 4 to year 6 Less: Opportunity cost of KL3 from year 1 to year 6 Total NPV
Notes 1. This is £7.05 million (year 3’s net cash flow) multiplied by the appropriate year’s discount factor for each of the years 4–6. 2. This is £1.5 million multiplied by the 6-year 14% cumulative present value factor (3.889).
Examiner’s Note An alternative approach here also is to use the perpetuity formula to calculate values beyond year 3. The NPV would then become: NPV for years 1–3
£m 6.39
PV of cash flows from year 4 onwards
27.20
Less: Opportunity cost of lost revenue from K3 Total NPV (value to firm)
10.71
80% 0.675 7.05 0.14 £1.5m 0.14
22.88
A value somewhere between £9.40 million and £22.88 million is suggested. As with Alternative 1, we really need estimates of the replacement costs of the equipment to obtain a more realistic figure. A value at the lower end of the range £9.40 million to £22.88 million is probably more appropriate given the finite life of the equipment.
Examiner’s Note Equivalent annual annuities (EAA) could also be calculated, assuming Alternative 1 ceases in year 8 and Alternative 2 in year 6: NPV £m
EAA £m
Alternative 1
5.39
1.162
Alternative 2
9.40
2.417
5.39 4.639 9.40 3.889
The equivalent annual annuity (EAA) approach seeks to determine the constant annual cash flow that offers the same present value as the project’s NPV. This is found by dividing the project’s NPV by the relevant annuity discount factor. The figures here support the choice of Alternative 2 that was already suggested by the NPV calculations.
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(b) Report To: From: Subject: Date:
Directors of KL Group plc Financial Manager New subsidiary – KL15 21 May 2002
Introduction You have asked me to prepare a report for discussion on the proposed establishment of a new subsidiary. This report addresses the following issues: ● Estimated net present value of KL15 under 2 alternatives; ● Contribution to attainment of group objectives; ● Analysis and discussion of risks and constraints involved in each alternative; ● Recommendation of a preferred alternative. Estimated value for KL15 Two alternatives have been proposed for equipping the factory. Alternative 1 assesses the revenues and costs assuming we purchase advanced equipment from the USA. Alternative 2 assumes we use ‘old’ technology with minor improvements. Workings for the revenues and costs for both alternatives are shown in appendix A (answer to requirement (a)). In summary, the NPV for Alternative 1 is between £5.39m and £16.18m and between £9.40m and £22.88m for Alternative 2, depending on method of calculating values beyond year 3. (i) Contribution to the attainment of the Group’s objectives The new subsidiary is small and will increase Group turnover by little more than 1 per cent in the first full year of operations under Alternative 1 and around 0.7 per cent under Alternative 2, assuming current group turnover remains constant or increases. In year 1, Alternative 2 will make a small contribution to cash flow, but Alternative 1 cash flows are negative. The loss of KL3’s earnings will not be compensated in the first year of operations and so, in the immediate future, the proposal will be detrimental to the Group’s objectives. The question must be asked whether the Group could not expend its resources, both financial and human, more effectively. There will be little impact on dividends under either alternative. In respect of the second objective, both alternatives would contribute to some extent. Using the estimated conservative figures in section 1, and shareholder value analysis, and assuming all other things are held constant, the effect on the company’s market capitalisation would be as follows. 2006.1
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Comments on assumptions 1. That the WACC is the appropriate discount rate to use in the evaluation. This may not be the case and is discussed further in requirement (b), the report. 2. For Alternative 1, we accept the supplier’s offer to pay a 50 per cent deposit to hold constant the purchase price in US$. This may not be to our advantage and is discussed further in requirement (b), the report. 3. K3 would continue to earn £1.5 million a year indefinitely. This may not be realistic, but provides an estimate that can be adjusted when we fine tune the evaluation. 4. Cash flows beyond the third year of operations are estimated assuming year 3’s cash flows. Again, this may not be realistic, but provides a basis for discussion.
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Current market value of the KL Group plc Value of KL 15 Total
Alternative 1 £m 827.50 835.39 832.89
Alternative 2 £m 827.50 839.40 836.90
Revised share price Current share price Increase
333 pence 331 pence 2 pence
335 pence 331 pence 4 pence
Both alternatives would add to shareholder wealth, but the increase is negligible. However, in theory, any increase would contribute to the first part of our second objective, and there is little to choose between them in respect of contribution to this objective. Alternative 2 would minimise the adverse effects on the workforce, but it is not as beneficial to the environment as Alternative 1. The two alternatives do, of course, have to be weighed against the continuation of KL3’s operations. However, as KL3 is operating at only 50 per cent capacity and has an NPV below both alternatives, then discontinuation of this subsidiary’s operation seems a logical decision. No information is given on whether any action could be taken to increase KL3’s productivity. It has to be assumed that this subsidiary is in decline, but it is worth asking the question. In the end, the decision must take into account other factors such as relative risks and future strategy of the group.
Examiner’s Note The effect on shareholder wealth does of course depend on the assumptions made. Any attempt using sensible assumptions would gain credit.
(ii) Risks and constraints involved in each alternative Risks fall into four broad categories: financial, commercial, political and operational/ technological. Financial In an investment appraisal, the choice of discount rate may be used to adjust for the risk of the investment. The use of the WACC might be inappropriate and not reflect the relative risks of the two alternatives. We could use the CAPM to determine the specific risk-adjusted discount rate. This would involve finding a proxy company in a similar industry whose beta is published, which may be difficult. Payback could also be used to judge risk. On the figures here, Alternative 1 would not pay back until early in year 4. Alternative 2 begins to pay back early in year 3. A second risk is the cost of the equipment under Alternative 1. If we take the supplier’s offer, we are insuring against the possibility of a price rise and also against the possibility that the US$ will rise in value against the £. However, inflation rate forecasts suggest that the US economy is likely to perform worse than the UK’s, which suggests that the $ will weaken. My calculations assume we do pay the deposit with the balance 12 months’ later (delivery time is 6 months and the remaining 50 per cent is payable 6 months after installation.) On my assumptions, this shows a windfall ‘profit’ of £38,000, ignoring discounting. This decision needs 2006.1
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further consideration and we need to decide whether paying 50 per cent of the purchase price 6 months earlier than necessary, but locking us into a guaranteed price in US$, is financially more advantageous than any alternative use of our money for those six months. There are exchange risks involved with revenue flows under Alternative 2 because the customers are more diverse and many are in developing countries. If this alternative is chosen, we need to address this issue and determine appropriate hedging strategies for dealing with less developed countries. It must also be recognised that the equipment for Alternative 2 needs replacing before the equipment for Alternative 1. In theory, this should be built into the evaluation, but we have insufficient information at this stage to make any accurate quantified assessment. There is also a technological risk aspect here as environmental issues are constantly evolving and it is possible that what is ‘state of the art’ now will be obsolete or inadequate in a relatively few years’ time. There are also different risk profiles in respect of estimates of revenues. Alternative 1 has the greater risk of achieving only the lower estimates, whereas that of Alternative 2 has greater probability of achieving the medium estimates. Alternative methods of risk assessment, such as the use of sensitivity analysis or simulation, could be considered to inform management decisions. Political There is a UK-based political uncertainty surrounding regulatory issues, as noted in the scenario, but there are further political risks with Alternative 2 because the customer base includes many customers in developing countries. Commercial The commercial risk with Alternative 1 is that there are fewer customers, which might leave us vulnerable and dependent. The risk with Alternative 2 is that many are in developing countries and may cause credit management problems. Operational/Technological The risk here is that the equipment under Alternative 2 becomes unusable because of changed regulation. Allowing for regulatory issues is, to some extent, frustrated by the political uncertainty. However, this is a fact of commercial life and one option is to plan for the ‘worst case’ scenario – in commercial terms. Pursuing Alternative 1 might be the least-risk option here, despite having the lowest NPV, and could be turned to the company’s advantage in terms of corporate image and PR. (iii) Recommendation On the basis of the increase in shareholder wealth, Alternative 2 is to be preferred. This also means fewer staff are made redundant. On these criteria, this alternative contributes most to the Group’s second objective. On environmental issues, Alternative 1 would contribute more. The risk issues make the decision ‘six of one and half a dozen of the other’, as discussed in the last section, but on balance Alternative 1 is probably less risky. Neither alternative will contribute much to the Group’s objective to increase both EPS and DPS by 5 per cent each year. The question has to be asked whether we should be pursuing the establishment of such a small subsidiary unless there are other issues of which I am unaware, for example the effect on another subsidiary.
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Appendix to Report Note 1 – Calculation of cost of new equipment under Alternative 1
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£million Assuming ordered and deposit paid now 50% (US$6 million) paid as deposit now at spot rate, 1.45 50% (US $6 million) paid in twelve months’ time at 1.47
1.04 1.451.025
4.14 4.08
Total
8.22
Assuming ordered now, but no deposit paid 50% (US$6.3 million 1.05) paid in 6 months’ time at 1.46 1.45 1.04/1.025
4.31
50% ( US$6.3 million 1.05) paid in 12 months’ time at 1.47
4.29 8.60
Examiner’s Note It could have been assumed here that the full US$12 million was payable on delivery in 6 month’s time, in which case the cost would have been £8.63 million (US$12.6/1.46)
(c) In the context of investment decisions, there are three options to be considered: 1. The abandonment option; 2. The timing option; 3. The strategic option. 1. Abandonment option Major investment decisions involve heavy capital commitments and are largely irreversible; once the initial capital expenditure is incurred, management cannot turn the clock back and act differently. Because management is committing large sums of money in pursuit of higher, but uncertain, payoffs, the option to abandon, or ‘bail out’, should things look grim can be valuable. Abandonment possibilities can reduce the riskiness of a project and increase the expected NPV of certain types of project which would otherwise produce large negative NPVs if they could not be abandoned in the event that things do not work out. Also, the investment could be repeated. In the case of KL15, the company could defer payment of the equipment for Alternative 1 and risk the 5 per cent increase in cost. This is a high price to pay for an abandonment option on an investment that will have already incurred some capital costs, redundancy payments and loss of earnings from the closure of KL3. In the case of Alternative 2, the equipment can be purchased any time. There will have been some expenditure made as soon as the decision is taken, but as the factory conversion will take six months, the company can choose to abandon the capital expenditure at any time within those six months. 2. Timing option The example here not only introduces an abandonment option, it also raises the option to ‘wait and see’. Management may have viewed the investment as a ‘now or never’ opportunity, arguing that in highly competitive markets there is no scope for 2006.1
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Solution to case study 9 (a) (i)
Calculations of present values of forecast cash for Alice Jain Inc Calculation of exchange rate: Spot rate 1 year forward 2 year forward 3 year forward 4 year forward
1.450 1.436 1.422 1.409 1.395
Calculation of DCFs/NPV Year 1 2 Cash flows in US$million 35.5 43.5 Inflated at 2.5% each year 36.4 45.7 Converted to £million using exchange rates above 25.3 32.1 Discount factor at 11% 0.901 0.812 DCFs in £ 22.8 26.1 Present value of discounted cash flows for years 1–4 @ 11% £102.3m Discount factor at 13% 0.885 0.783 DCFs in £ 22.4 25.1
3 46.5 50.1 35.5 0.731 26.0
4 52.5 58.0 41.6 0.659 27.4
0.693 24.6
0.613 25.5
Present value of discounted cash flows for years 1–4 @ 13% £97.6m
Note: Forward exchange rates can be calculated from the given information using either purchasing power parity or interest rate parity. Either approach is theoretically acceptable, but the question requests candidates to use interest rate parity. Discussion The present value (PV) of the cash flows for the four years represents what Dobbs plc might be prepared to pay as an initial investment for the acquisition of Alice Jain. PV analysis is theoretically sound and a sensible approach in the absence of a quoted share price to use as a benchmark. Asset values could have 2006.1
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delay: money is made by staying ahead of the competition. In effect, this amounts to viewing the decision as a call option which is about to expire on the new plant for the capital investment outlay. If a positive NPV is expected, the option will be exercised, otherwise the option lapses and no investment is made. The option to defer the decision by, say, one year until the outcome of the government’s deliberations on environmental issues becomes known, makes obvious sense. An immediate investment would yield either a negative NPV – in which case it would not be taken up – or a positive NPV. Delaying the decision by a year to gain valuable new information is a more valuable option. This helps us to understand why management sometimes does not take up apparently wealth-creating opportunities; the option to wait and gather new information is sufficiently valuable to warrant such delay. 3. Strategic investment options Certain investment decisions give rise to follow-on opportunities that are wealth creating. New technology investment is particularly difficult to evaluate. Managers refer to the high level of intangible benefits associated with such decisions. What they really mean is that these investments offer further investment opportunities (e.g. greater flexibility).
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been used, but these would ignore the value of intellectual capital (the authors’ earnings) in Alice Jain Inc. There are two basic approaches to evaluating international investments using present value analysis. One approach is to discount the local cash flows at the local cost of capital and then translate the present value analysis into the home currency. The other translates the local cash flows into the home currency using appropriate exchange rates and then discounts at the home cost of capital to give a present value (or a NPV, if an initial investment is part of the calculations) in the home currency. In theory, the answers should be identical but, in practice, minor inefficiencies and imperfections in the market will allow for differences. Many of the considerations to arrive at a discount rate for international investments are the same as for domestic projects, but there are additional risks to consider such as political, economic and transaction risks. The discount rate needs to be adjusted for the increased risk and international cash flows, but it may also be argued that international diversification reduces risks. Risk will also be affected by the correlation of the project’s cash flows with those of domestic projects, and by the inter-temporal correlation of cash flows. The choice of 11 per cent as a discount rate applied to home currency is therefore acceptable, but in the circumstances here may not fully incorporate the risk of the investment. Alice Jain Inc’s cost of capital is estimated as 13 per cent. However, alice Jain Inc has a lower gearing ratio (21.4 per cent debt to total assets less current liabilities compared with 46.3 per cent for Dobbs plc). Assuming the Finance Director has adjusted for this in his calculation of 13 per cent using the CAPM, the business risk inherent in Alice Jain Inc appears to be higher than Dobbs plc and the use of a higher discount rate might be advisable. The calculations also show the present value that would be expected if Dobbs plc applied a 13 per cent discount rate. (ii) Calculations of number of shares/debt required Assuming 13 per cent is an appropriate specific risk adjusted discount rate in the circumstances, then Dobbs plc will be prepared to pay a maximum of £97.6m for the acquisition of Alice Jain Inc. It is difficult to value shares in a private company and there is likely to be some difference between our valuation and that of Alice Jain Inc’s shareholders. Given the maximum price that we would wish to pay, an initial bid of perhaps £84.5m could be considered (using the P/E ratio valuation), emphasising the potential for future value that Alice Jain Inc’s shareholders would receive from a share exchange in preference to a cash offer. However, working on the maximum price Dobbs plc should consider paying would give the following bid terms: There are 15 million shares (common stock) in issue. The two major shareholders own 60 per cent, or 9 million shares. If they take cash for 50 per cent and the remaining shareholders all take cash, this is 10.5 million shares for cash and 4.5 million share exchange. If we assume a present value of £97.6 million is the maximum price Alice Jain Inc is worth to Dobbs plc, and 70% 10.5 100 opt for cash and 30 per cent 15 for a share exchange, this will require: £68.3 million cash (£97.6 million 70%) or its equivalent in US$ at the time of purchase. 2006.1
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The issue of 3.31 million shares
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The share issue will require the approval of Dobbs plc’s shareholders. The sale of the subsidiary raised £30 million. Assuming no other events have required use of this Examiner’s Notes Calculation using any sensible assumption about bid terms, based on present value, would be acceptable. money, Dobbs plc would need to raise a further £38.3 million in long-term debt to finance the cash part of the bid. (b) Report To: The Directors of Dobbs plc From: A Financial Manager Date: 20 May 2003 Evaluation of acquisition of Alice Jain Inc Introduction I have reviewed the relevant information relating to the proposed acquisition of the US-based publishing company, Alice Jain Inc. The terms of reference for this report are as follows: (i) To recommend whether the investment should proceed and at what price; (ii) To advice on strategies for enhancing the value of the combined company following the acquisition; (iii) To evaluate the Finance Director’s recommendation to acquire a smaller company and repay some debt; (iv) To advice on the company’s responsible to shareholders under the takeover code. These terms of reference form the basis of the four main sections of the report. (i) Recommendation of whether the investment should proceed The value of the company and per share using three methods of valuation are shown below: P/E ratio method Value of company £ million EPS 79.3 cents (54.7 pence at spot) by Dobbs P/E of 10.3 shares in issue
Present value of 13%
84.5
Per answer to requirement (a) (i)
97.6
Per accounts ($55 million/spot) Price per share
Asset value
37.9 563p
651p
253p
Based on the calculations for requirement (a) (i), the maximum price Dobbs plc should consider paying is £97.6m, give the assumptions about the discount rate. 2006.1
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However, the value based on Dobbs plc’s P/E provides a good benchmark, although Alice Jain Inc would probably command a higher P/E if it were to be floated as a listed company. This is because, if the Finance Director’s cost of capital calculation is correct, then the company may expect higher growth and, therefore a higher P/E. Also new and smaller companies tend to attract higher P/Es on flotation. The value of the company may be further enhanced if an estimate of cash flows beyond year 4 and terminal values were to be attempted. A time horizon of 4 years is very short for an investment such as this. The asset value is of limited usefulness in a company such as this, which earns its income largely from intellectual capital that generally does not feature in the balance sheet. There is clearly potential for value enhancement if only because the risk-diversifying aspects may well lower the cost of capital and therefore increase the value of the firm. An issue that needs to be considered is the effect on gearing and financial risk if the company has to borrow to finance this acquisition. This is discussed further in section (iii) of this report. (ii) Advice on strategies for enhancing the value of the combined company following the acquisition The following are key points we should consider when determining our strategy: ● The integration strategy must be in place before the acquisition is finalised. ● We should review each of the company’s business units for potential cost cuttings/synergies or potential asset disposals. It is possible there are units more valuable to another company than Dobbs plc, but it is important they are in good shape before they are sold. A straightforward ratio analysis could be considered to evaluate and compare the various component parts of Alice Jain Inc’s business. However, more than this is needed for a full effective enhancement programme and a position audit could be carried out. ● We should consider the effect on the workforce and determine how many, if any redundancies are likely and what the cost will be. ● We should review the authors’ contracts to ensure they do not lapse when the acquisition is completed. ● There is a need to pursue a more aggressive marketing strategy for the magazine division, in particular can some of the US magazines be marketed in the UK, and vice versa? ● The company’s cost of capital should be re-evaluated: the level of diversification obtained by merging two different income streams might reduce this and therefore increase the value of the company. ● We should make a positive effort to improve communication within the organisation to prevent demotivation and avoid ‘NIH’ (Not Invented Here) syndrome and other well-known, adverse post-acquisition effects on staff morale. ● This is basically, a horizontal merger and there may be economies of scale that we should aim to identify and evaluate. ● We should do a review of assets and consider selling non-core elements or redundant assets. Note: Valid comments about marketing strategy would be acceptable, although this is not the focus of the question. 2006.1
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(iii) Evaluation of the Finance Director’s recommendation to acquire a smaller company and repay some debt The decision to invest or divest hinges on the opportunity cost of capital. If we assume ● the return required by shareholders does take into account the financial risk of the company, and ● the interest rate of the debt in the company’s capital structure is less than 11 per cent after-tax, and ● the company can find positive NPV investment at 11 per cent or above, then, in theory, the company should continue to use debt financing. Repaying the debt would not be in the best interests of shareholders unless the debt is at a variable rate and the company expects rates to increase in the near future. Without comparable industry figures it is difficult to comment on whether the gearing ratio is excessively high (we are only told it is ‘relatively’ higher than other publishing companies of similar size.) However, the ratios does not appear to be excessive at around 46 per cent on book values at the last balance sheet date and interest cover is adequate. Also, the balance sheet as at 31 December 2002 does not reflect the £30m cash raised from the recent sale of a subsidiary. Assuming this amount is still a cash resource then one valid basis for calculating gearing would be to deduct this amount from long-term debt. More recent information is necessary before an accurate calculation can be made, but it is reasonable to assume the gearing percentage would decrease. In theory, market values should be used to calculate gearing. The current market value of Dobbs plc’s equity is £398m (45 million shares at 885 pence each). If we assume debt is valued at par then the gearing ratio (debt : debt equity) is only around 24 per cent. However, it is not clear how the Finance Director has identified the small British publisher to acquire or what other opportunities might exist for the use of the money. This potential investment would need to be evaluated in the same way as Alice Jain Inc. Purchasing a British publisher may reduce transaction, economic and possibly political risk, but there is no indication that it will provide any better strategic fit than Alice Jain Inc. The expected return to this company would need to be assessed. (iv) Advice on the implications of the company’s responsibilities to ensure fair and equal treatment for all shareholders in accordance with current take over regulation The UK Code does not have the force of law, but its main function is to ensure directors carry out their duties ‘without prejudice in a fiduciary manner’. That is, they must show trustworthy behaviour for the benefit of shareholder equally. The Code may not have the force of law, but the panel does have some powerful sanctions. These may take the form of public reprimands or the shunning of Codedefiers by the regulated City institutions. No regulated firm (such as a bank, a broker or an adviser) should act for client firms that seriously break the panel’s rules. The fundamental objectives of the Takeover Panel regulation are to ensure fair and equal treatment for all shareholders. The main areas of concern for the directors of Dobbs plc in the takeover of Alice Jain Inc are: ● Shareholders being treated differently – for example, the two large shareholders should not be seen to be getting a special deal; ● Insider dealing (control over this is assisted by statutory rules);
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●
● ●
●
●
Management action which is contrary to its shareholders’ best interest – for example, the advice to accept or reject a bid must be in the shareholders’ best interest, not that of the management; Lack of adequate and timely information released to shareholders; Artificial manipulation of share prices – for example, an acquirer offering shares cannot make the offer more attractive by getting friends to push up its share price; The bid process dragging on and thus distracting management from its proper tasks. It would also be necessary for Dobbs plc to recognise competition regulation in the US.
Summary This report has aimed to provide an evaluation of the proposed acquisition of the US company, Alice Jain Inc. In summary, it recommends that the acquisition should proceed although a review of alternative possibilities for acquisition should be considered. The recommended price is a maximum of £97.6m, financed by a combination of the issue of new shares, retained cash and new debt. An initial bid of around £84.5m could be suggested. This figure is based on the benchmark of Alice Jain Inc’s earnings multiplied by Dobbs plc’s P/E ratio.
Solution to case study 10 (a) Discount rate using the CAPM Required return Rf [Rm Rf ] Beta using proxy company is
u g
1.3
Vd[1 t] Ve d Ve Vd[1 t] Vd[1 t] Ve
4 1[14 0.3] 0.15 1[11[1 0.3]0.3] 4
1.106 0.022 1.13
Ra using CAPM therefore: 5% 1.13(12% 5%) approx. 13% Limitations of CAPM: single period model, which is being used to calculate a discount rate for 3 years; ● CAPM assumes only systematic risk needs to be captured as unsystematic risk has been diversified away; ● risk in airline industry difficult to encapsulate in one figure, and can the past be a useful guide to the future in the airline industry? ● close comparison with a proxy is difficult; assumes close similarity of activities and business risk. C&C is a small, private company with few shareholders whereas the proxy is a listed company with, presumably, a large number of unconnected shareholders; ● post-tax figures unreliable because of likely differences in taxation situation of the two companies. ●
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Year 1 Potential load 100% ( Full ) 80% 50% 40% Expected load
probability 10% 50% 30% 10%
10% 40% 15% 14% 69%
Expected number of passengers: 220 69%
151.8
Forward exchange rates: Year 0 1.530 Year 1 1.530 (1.04/1.03) Year 2 1.545 (1.04/1.03) Year 3 1.559 (1.04/1.03)
1.545 1.560 1.575
Fuel costs (figures in £000s) Year 1 $4,200 1.05 Year 2 $4,200 1.052 Year 3 $4,200 1.053
4,410/1.545 4,631/1.560 4,862/1.575
Years 2 and 3 probability 15% 60% 20% 5%
220 75%
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(b) Preliminary calculations Passenger loads
15% 48% 10% 72% 75% 165
2,855 2,969 3,087
Capital/balancing allowances (figures in £000s) Purchase costs 19,608 [US$30,000/1.530] Year 1 WDA at 25% 14,902 WDV end year 1 14,706 Year 2 WDA at 25% 13,676 WDA end year 2 11,030 Sale value 10,159 [US$16,000/1.575] Year 3 balancing allowance 10,871
Operational cash flows in 000s £ and $ Year 0
Year 1
Year 2
Year 3
13,378
14,832
15,129
(2,987)
(3,077)
(3,169)
Overhead and fixed costs
(600)
(600)
(600)
Fuels costs in £000 Inflated at 5% per annum Net operating cash flows Capital allowances
(2,855)
(2,969)
(3,087)
6,936 (4,902)
8,186 (3,676)
8,273 7,(871)
Taxable cash flows Tax payable
2,034 (610)
4,510 (1,353)
7,402 (2,221)
6,936 6,(610)
8,186 (1,353)
10,159 8,273 (2,221)
Sterling income and costs Income (Expected no of passengers 48 6 £300) inflated at 2% per annum Operating costs (Engineering, maintenance, insurance, wages) inflated at 3% per annum
(b) (i) Discounted cash flows (£000s) Capital cost of plane Resale value in £000 Net operating cash flows Taxation
487
(19,608)
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SOLUTIONS TO CASE-STUDY QUESTIONS P9 Net after tax cash flows Discount factor for 13% DCFs Cumulative DCFs/NPV
(19,608) 1 (19,608) (19,608)
6,326 0.885 5,598 (14,010)
6,833 0.783 5,351 (8,659)
16,211 0.693 11,234 2,575
Certainty equivalent NCFs certainty equivalent Discount factor for 9% DCFs Cumulative DCFs/NPV
1 (19,608) 1 (19,608) (19,608)
0.90 5,693 0.917 5,220 (14,388)
0.85 5,809 0.842 4,891 (9,497)
0.80 12,969 0.772 10,012 515
(b) (ii)
Based purely on the calculations shown in answer to requirement (b) (i), the investment shows a positive NPV using both methods of adjusting for risk and should therefore go ahead. Using the certainty equivalent method, the NPV is closer to zero and the outcome under both methods is heavily weighted by the resale value of the plane. However, the choice of one rate for all cash flows each year is a simplification. In reality, certainty equivalents would be different for each variable in the analysis, especially, for example, capital allowances. (c) Report To: From: Date: Subject:
Directors of C&C Airlines plc Assistant to Finance Director 18 November 2003 Appraisal of investment in new plane
(i) Introduction You have asked me to evaluate the financial viability of purchasing a second-hand Boeing 757 for use on a new route to the Caribbean. I have now completed this evaluation based on information available to me, using informed assumptions and estimates where necessary. There are three main sections to this report, plus a recommendation: ● the major economic forces that might impact on, or influence, the success of the investment; ● commercial aspects of the investment that involve the greatest uncertainty and risk; ● strategies for managing these risks. The report concludes with a recommendation of a course of action. (ii) The major economic forces that might impact on, or influence, the success of the investment: ● changes in interest rates, in absolute and relative terms – effect on future borrowing costs, exchange rates and consumer buying power – effect on airline business; ● increased inflation and connection to interest rates; increase in UK rates relative to US would impact on costs of fuel; ● increased interest rates would impact on tourist trade; ● relative rates of interest in UK and US; ● political influences on economy and airline industry. (iii) Commercial aspects of the investment that involve the greatest uncertainty and risk: ● capital cost – held for how long. Current surplus of second-hand planes available – could change and could affect resale value, an unpredictable market; 2006.1
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Examiner’s Notes 1. The presentation of the answer above has used a bullet point format for clarity and to assist student revision. In an examination, candidates are required to provide discussion of each point. However, using bullet points to highlight each separate point being discussed is a useful presentational format. 2. There is some overlap in requirement (c)(iii) with the FLBS syllabus. This is inevitable at the final stage and candidates are encouraged to consider all final stage subjects as complementary to each other. 2006.1
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high loading needed to make project viable; ● state of the tourist market, current volatility, timing of investment and expansion; ● competition – fierce at present with many airlines fighting for survival; ● the Caribbean is an expensive up-market destination dominated by the tour operators – is there a market for low-cost, no frills airline? And will it work on long-haul routes? ● company is aiming (apparently) at flight-only passengers – is there a sufficiently large market for such passengers? ● insurance/security costs likely to escalate. (iv) Strategies for managing these risks ● Take out an option on the purchase cost of the plane. ● Resale value allows for payback in 3 years, extend evaluation of the project to determine its impact. The application of a ‘real options’ approach could be used with advantage here. ● Aim for mixed passenger profile – business and tourist (although little business traffic to these destinations at present). Perhaps consider a joint venture or strategic alliance with a tour operator or national airline that does not yet fly these routes? This is probably not an option in the scenario circumstances at the present time but could be considered for longer-term strategy. ● Forward exchange rates – affect fuel costs in £ – hedge risk using capital markets and/or buy forward in the commodity market. Swaps a possibility. Internal methods of hedging not appropriate here. ● Determination of discount rate when using CEs seems high – revise calculations perhaps using sensitivity analysis? Comment on using sensitivity analysis in combination with CEs. ● Managing the security risk is more difficult - insurance is essential, could also use security guards on planes as many of the large airlines are doing but this is expensive. (v) Recommendation of a course of action ● Review discounting methods and check probabilities for loading and certainty equivalents. In particular, determine whether appropriate to use same CE for operational cash flows and capital resale value. ● Subject to determining the other information suggested, recommend plane is purchased as it has positive NPV using both methods of adjusting for risk and pays back in less then 3 years. ●
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Solution to case study 11 (a) Step 1 Calculate the asset beta, that is the beta of an ungeared firm, using the proxy company’s beta. The estimated market value of RGB, using industry average P/E ratio is £800.28 m (£76 million 10.53). u g 800/[800 (320 1 0.3)] 1.3 (800/1024) 1.016 Step 2 Calculate the discount rate using the CAPM DR Rf (Rm RF) 5% 1.016 (9% 5%) 9.06%, say 9% for evaluation purposes Note: The book value proportions could be used but, according to theory, it is market values that are correct. If book value used, Bu is 0.84 and the discount rate would be 8.4%. Limitations: ●
●
●
●
The discount rate assumes that unsystematic risk has been diversified away. This is a private company with a small number of shareholders, so may be inappropriate. Assumes risk of investment same as company as a whole; in the UK this is new manufacturing plant not a new product, so the risk may be lower than the average. CAPM is a single period model and the risk may change over the life of the project, which here is 5 years. It also assumes that past variability with the market will continue. Use of proxy company’s beta and industry P/E may be unreliable as businesses may not be the same and RGB may not be ‘average’. Also, the post tax figures may be unreliable because of likely differences in the taxation situation of the two companies.
(b) NPV calculations are below Profitability Index is calculated as (NPV Initial Investment)/Initial investment US Investment 48.65/44.12
1.103
UK Investment 34.02/30
1.134
Accounting rate of return is calculated as average profits as a percentage of average investment: Cum. Post-tax cash flows £m Less: Depreciation £M Profit Average over 5 years Average investment assuming straight line depreciation ARR
2006.1
US investment 67.78 44.12 23.66 4.73
UK investment 42.88 30.00 12.88 2.57
22.06 21.44 (4.73/22.06 100)
15.00 17.13 (2.57/15.00 100)
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1.015 1.025
1.683
1.667 (1.0152/1.0252) 1.651 (1.0153/1.0253)
Evaluation of US Investment Year US Investment Cash flow (US$) Converted to £ Tax @ 30% Payable After-tax cash flows Discount factor (DF) 5% Certainty equivalent (CE) Adj. DR (DF CE) DCF £million
0
1
2
3
4
5
75.00 44.12 13.24
22.25 13.22 3.97 9.27 22.49 0.952 0.900 0.857 19.27
24.25 14.55 4.36 4.36 10.19 0.907 0.870 0.789 8.04
26.25 15.90 4.77 4.77 11.13 0.864 0.820 0.708 7.88
27.56 16.70 5.01 5.01 11.69 0.823 0.700 0.576 6.73
28.94 17.53 5.26 5.26 12.27 0.784 0.700 0.548 6.73
30.00
1 6.30 1.89 7.11 13.41
2 9.00 2.70 2.70 6.30
3 10.50 3.15 3.15 7.35
4 11.03 3.31 3.31 7.72
5 11.58 3.47 3.47 8.10
30.00
12.30
5.30
5.68
5.47
5.27
44.12 1.000 1.000 1 44.12
NPV £million 4.53
Evaluation of UK Investment Year Cash flow (£million) Tax @30% Payable After tax cash flows Say 9% DCF
0 30.00 9.00
NPV £million 4.02
(b) Report To: From: Date: Subject:
Board of RGB Capital Investment Analyst 23 November 2004 Investment in new facilities in USA and UK
(i) Introduction You have asked me to evaluate the proposed investment in new manufacturing plant and associated facilities in either the USA or UK. There are three main sections to this report. ●
●
491
An evaluation of how the two investments will contribute to the achievement of the company’s stated objectives. An analysis of the various types of risk involved in these investments and advice on a strategy for managing those risks. The report concludes with a recommendation of a course of action.
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(ii) An evaluation of how the two investments will contribute to the achievement of the company’s stated objectives In summary, the results of the appraisal are as follows: Summary NPV (£million) Profitability Index RoCE (%) Increase in EPS (pence) (over 5 year period)
US Investment 4.53 1.103 21.44 19.7
UK Investment 4.02 1.134 17.17 10.7
Comments can be made broadly under the headings of the three company objectives, although there will be some overlap and common considerations. Increase in EPS/NPV Considerations (1st objective) ●
●
●
●
●
Using NPV analysis, the US investment would be selected as it increases shareholder wealth by the greatest amount. The UK investment together with investments already committed, do not use the full amount of capital available. If the UK investment is chosen then the surplus funds should be invested in another positive NPV project or returned to shareholders. Surplus cash could be invested short term in the money market, but this is not in the shareholders’ best interests in the long term. Investment in the US project together with other investments already committed would involve capital expenditure of approximately £61 million. If the company’s capital investment limit of £50 million is inflexible then this investment is ruled out without further consideration. In theory both investments should be undertaken, as they both have positive NPVs, with increased borrowings if necessary. Both investments will increase EPS over the five year period. Without information on the performance of existing operations it is difficult to calculate whether either investment will significantly affect the achievement of a 5% per annum increase. However, because of the 100% first year tax allowance on capital investment it is likely that both the US and UK investments will have an impact in the first year of operations. For example, if we assume no growth in existing operations, then the impact in years 1 and 2 will be: Current EPS
EPS from Investment Total Increase %
US investment Year 1 Year 2 63.3 74.7 11.4 1.1 74.7 75.8 18.0 1.5
UK investment Year 1 Year 2 63.3 69.5 6.2 0.3 69.5 69.8 9.8 0.4
Note: EPS from investment is cash flow for the year less annual depreciation (capital investment/5) divided by shares in issue (120 million). Accounting rate of return considerations (2nd objective) ●
●
An accounting rate of return (RoCE here) attempts to measure profit and capital cost on the same basis as adopted in preparing accounts. The method can be based on average investment or on initial investment method. Here, as a simplification, we have taken average annual profits as a percentage of average investment over the five-year period. It has the advantage of simplicity and is readily understood by non-finance managers, but it does not take into account timing or variations in cash flows, projects with different lives and risks and so on.
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●
It should not be used for resource allocation, which should use cash flows rather than profit. Here there is a RoCE, or accounting rate of return of over 20% for the US investment, but below 20% for the UK investment. The two measures, RoSF and RoCE are not identical, but assuming it is shareholders who require the highest return (compared with debt) and the investment is funded with equity, then RoCE is an acceptable proxy. Last year, the company failed to meet this objective and showed a RoSF of little over 18% (earnings of £76 miliion/shareholers’ funds of £420 million).
Maintaining a global presence (3rd objective) ●
●
If the company wishes to maintain a global presence in its operating markets, then it needs to maintain an adequate investment programme. Investment in the US would probably contribute more to ‘global’ presence, which may justify choosing this project, even though it means increased borrowing. However, meeting this objective implies the company should be looking to invest in projects outside the US and UK, so neither investment would contribute much.
Summary ●
As can be seen from the comparison of these two investments — NPV and RoCE and increase in EPS all suggest the US investment should be chosen. Only the PI criterion suggests the UK investment. When capital is rationed, as here, and a choice has to be made, then PI should be considered along with NPV, but managers may be rewarded on accounting measures such as RoCE and EPS.
(iii) An analysis of the various types of risk involved in these investments and advice on a strategy for managing those risks The four main areas of risk that can be discussed are: economic, commercial, political and technical. Economic risk ●
●
●
●
Inflation forecast suggests the US$ will strengthen against the £, but this could change. The risk could be hedged using external methods such as forward markets or possibly financing with a $ loan. Internal methods such as netting and matching may be better here as RGB has substantial operations in the US already. There is no interest rate risk as a direct consequence of these investments so hedging this type of risk not entirely relevant. The CAPM has been used to determine a discount rate for the UK investment using a proxy company’s beta. The company may not be so similar to RGB that this beta is appropriate. Sensitivity analysis could be used to help evaluate the investment’s sensitivity to the rate. The certainty equivalents used for the US investment are inevitably subjective. Again, sensitivity analysis could be used.
Commercial/technical risk ●
●
The investments appear to be in mainstream businesses and do not involve new product development so do not appear excessively risky. As much of the company’s business is in the USA there may be advantages in setting up a manufacturing base close to customers in the US. This would minimise some of the commercial risks associated with the US investment. 2006.1
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●
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Political risk ●
Political risk is not a major issue here other than potential changes to tax regime, for example, extension of unitary taxation system.
(iv) Recommendation and conclusion ●
●
●
●
Both investments would increase EPS over a five-year period, and both have positive NPVs at the chosen discount rate. The US investment would increase EPS and shareholder wealth by a greater amount than the UK investment. The discount rate in the US investment may be overly pessimistic; there is relatively low business risk, virtually no political risk and the foreign currency risk could be managed by a combination of external and internal hedging techniques, given RGB already has substantial investments in the US. The US investment meets the RoCE criteria whereas the UK investment does not, but this is not an appropriate measure on which to base investment decisions. The US investment would probably contribute to ‘global presence’ more than the UK investment, but an investment in a third country might be more appropriate for this objective. If the capital expenditure limit is absolute, then the UK investment must be chosen but my recommendations are: (i) If the choice is between only these two investments, then choose the US investment and break the capital expenditure limit, even if this means borrowing an extra £11 million. This extra borrowing would have a marginal effect on the company’s gearing and WACC; (ii) Consider alternative investments that might contribute more to the company’s third objective.
Solution to case study 12 (a) (i) Calculations of NPVs Alternative 1 Item
Year
Revenue Less costs Factory conversion Equipment Redundancy costs Operating costs Net cash flows Discount rate @ 9% Discounted cash flows
0 €m 0 3.20 2.10 5.30 5.30 1.000 5.30
1 €m 4.48
2 €m 11.80
3 €m 17.60
6.63 5.17 0.842 4.35
38.66 8.94 0.772 6.90
2.80 4.80 4.07 7.19 0.917 6.59
Net present value of cash flows for first 3 years of operations € 0.64 million One approach to the calculation of terminal value would be to assume, conservatively, that cash flows would only maintain for 8 years, that is until the first date the equipment may need to be replaced. The figures would be: NPV to end year 3 PV of after-tax cash flows from year 4 to year 8 Less opportunity cost of CC from year 1 to year 8 Total NPV
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€m 0.64 24.031 12.182 11.21 million
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Examiner’s Note An alternative approach would be to use the constant growth version of the dividend valuation model (substituting earnings for dividends) to calculate values beyond year 3. As JHC Group expects constant growth in earnings of 4% per annum, it might be reasonable to assume an annual 4% growth in earnings of a new venture. The NPV would then become: NPV to end year 3: PV of cash flows from year 4 onwards
€m 0.64 114.84 [(8.94 0.8 1.04 0.772)/(0.09 0.04)]
Less Opportunity cost of lost revenue from CC (Assuming no growth)
24.44 (2.2/.09)
Total NPV (value to firm)
€89.76
However, there are a lot of assumptions here and we really need estimates of the replacement costs of the equipment to obtain a more realistic figure. A value at the lower end of the range €11.21 million to €89.76 million is probably more appropriate given the finite life of the equipment. Alternative 2 Item
Year
0 €m
1 €m 7.80
Revenue Less: Costs Factory conversion Equipment Redundancy costs Operating costs Net cash flows Discount rate @ 9% Discounted cash flows
4.50 0.42 54.92 4.92 1.000 4.92
2 €m 9.68
3 €m 13.13
3.44 6.24 0.842 5.26
4.13 9.00 0.772 6.95
2.80 3.06 1.94 0.917 1.78
Net present value of cash flows for first 3 years of operations €9.07 million As with Alternative 1, one approach to the calculation of terminal value would be to assume that cash flows would only maintain for 6 years, that is until the first date the equipment is likely to need to be replaced. Note: The capital cost is payable when factory conversion is complete, so discounting at the half year rate, or even the 1 year rate, given the instruction on factory conversion costs in the question, would be acceptable. NPV to end year 3 PV of after-tax cash flows from year 4 to year 6 Less opportunity cost of CC – years 1–6
€m 9.07 15.201 9.872
Total NPV
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Notes 1. This is € 8.94 million multiplied by 80% (year 3’s after-tax cash flow) increased by 4% for growth and multiplied by the appropriate year’s discount factor for each of the years 4–8. 2. This is € 2.2 million multiplied by the 8-year 9% cumulative present value factor (5.535).
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Notes 1. This is €9.00 million multiplied by 0.8 (year 3’s after tax cash flow) increased by 4% growth multiplied by the appropriate year’s discount factor for each of the years 4–6. 2. This is €2.2 million multiplied by the 6-year 9% cumulative present value factor (4.486). Examiner’s Note An alternative approach here also is to use the perpetuity formula to calculate values beyond year 3. The NPV would then become: NPV for years 1–3 PV of cash flows from year 4 onwards Less Opportunity cost of lost revenue from CC Total NPV (value to firm)
€m 9.07 115.61 [(9.00 0.8 1.04 0.772)/(0.09 0.04)] 24.44 (2.2/0.09) 100.24
A value somewhere between €14 million and €100 million is suggested. As with Alternative 1, there are a lot of assumptions here and we really need estimates of the replacement costs of the equipment to obtain a more realistic figure. A value at the lower end of the range is probably more appropriate given the finite life of the equipment.
Examiner’s Note Equivalent annual annuities (EAA) could also be calculated, assuming Alternative 1 ceases in year 8 and Alternative 2 in year 6: Alternative 1 Alternative 2
NPV €m 11.21 14.40
EAA €m 2.025 (11.21/5.535) 3.210 (14.40/4.486)
The equivalent annual annuity (EAA) approach seeks to determine the constant annual cash flow that offers the same present value as the project’s NPV. This is found by dividing the project’s NPV by the relevant annuity discount factor. The figures here support the choice of Alternative 2 that was already suggested by the NPV calculations.
Assumptions ● That the WACC is the appropriate discount rate to use in the evaluation. This may not be the case and is discussed further in requirement (b), the report. ● For Alternative 1, we accept the supplier’s offer to pay a 50% deposit to hold constant the purchase price. This may not be to our advantage and is discussed further in requirement (b), the report. ● CC would continue to earn €2.2 million a year indefinitely. This may not be realistic, but provides an estimate that can be adjusted when we fine-tune the evaluation. ● Cash flows beyond the third year of operations are estimated based on year 3’s cash flows and assuming constant growth at 4%. Again, this may not be realistic, but provides a basis for discussion. 2006.1
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The process for calculating MIRR is: ● ●
●
An outflow in year 0 and a single inflow at the end of the project life is assumed. Cash flows after the initial investment are converted to a single cash inflow by assuming that the cash flows are reinvested at, usually, the cost of capital. MIRR is calculated by dividing the outflow by the single inflow, using PV tables and interpolation to arrive at the discount rate, or MIRR. MIRR is intended to address some of the deficiencies of IRR, for example:
● ● ●
It eliminates the possibility of multiple rates of return; It addresses the reinvestment issue; MIRR rankings are consistent with the NPV rule, which is not always the case with IRR. However, there are weaknesses:
●
●
● ● ●
If the reinvestment rate is greater than the cost of capital, then MIRR will under-estimate the project’s true return; The determination of the life of the project can have a significant effect on the actual MIRR if the difference between the project’s IRR and the company’s cost of capital is large; The MIRR, like IRR, is biased towards projects with short payback periods; It does not appear to be understood or used extensively in practice; In the case here, we are evaluating two mutually exclusive projects with different life spans. The argument for using MIRR is therefore weak.
(b) Report To: Directors of JHC Group From: Financial Manager Subject: New subsidiary – SP Introduction Contents of report (i) Estimated net present value of SP under two alternatives. (ii) Contribution to attainment of group objectives and likely impact of the new subsidiary on the Group’s share price and market value. (iii) Recommendation of a preferred alternative. (i) Estimated net present value for SP Two alternatives are proposed: Alternative 1 assesses the revenues and costs assuming we purchase advanced equipment. Alternative 2 assumes we use ‘old’ technology with minor improvements. Workings for the revenues and costs for both alternatives are shown in the answer to requirement (a). In summary the financial performance of the two alternatives is as follows (all figures in €millions): 2006.1
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(ii)
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NPV over 6 or 8 years NPV as a ‘perpetuity’ EAA
Alternative 1 11.21 89.76 2.025
Alternative 2 14.40 100.24 3.210
On the basis solely of the financial performance, alternative 2 is the better choice. (ii) Contribution to the Group’s objectives Objective 1 ● The new subsidiary is small and would increase Group revenue by less than 1% in the first full year of operations under both alternatives, assuming current group revenue remains constant or increases. Also, loss of sales revenues by CC would have to be made up before any overall increases in revenues occurred. ● In year 1, alternative 2 will make a small contribution to cash flow (but still negative on a cumulative basis), but alternative 1’s cash flows are negative until year 2 and the project only begins to pay back in the second half of year 3. ● The loss of CC’s earnings will not be compensated in the first year of operations and so, in the immediate future, the proposal will be detrimental to the Group’s objectives. ● The question must be asked whether the Group could not expend its resources, both financial and human, more effectively. There will be little impact on dividends under either alternative. Objective 2 ● Both alternatives would contribute to some extent. Using the estimated ‘bottom of the range’ figures in section 1 and shareholder value analysis, and assuming all other things are held constant, the effect on the company’s share price and market capitalisation would be as follows:
Current market value of the JHC Group Value of SP Total Revised share price Current share price Increase
●
●
Alternative 1 €m 2908.50 2911.21 2919.71
Alternative 2 €m 2908.50 2914.40 2922.90
8.34 8.31 3 cents
8.35 8.31 4 cents
Both alternatives would add to shareholder wealth, but the increase is negligible. However, in theory, any increase would contribute to the first part of our second objective, and there is little to choose between them in respect of contribution to this objective. Alternative 2 would minimise the adverse effects on the workforce, but may not be as beneficial to the other stakeholders if we assume the legislation is intended to benefit the health of the population at large as Alternative 1.
Examiner’s Note The effect on shareholder wealth does of course depend on the assumptions made. Any attempt using sensible assumptions would gain credit.
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●
●
●
●
●
The two alternatives have to be weighed against the continuation of CC’s operations. This is allowed for in the valuation, but some strategic evaluation is needed. If CC is operating at only 60% capacity and has an NPV below both alternatives, then discontinuation of this subsidiary’s operation seems a logical decision. No information is given on whether any action could be taken to increase CC’s productivity. It has to be assumed that this subsidiary is in decline, but it is worth asking the question. The decision must take into account other factors such as relative risks and future strategy of the group. On the basis of the increase in shareholder wealth, Alternative 2 is to be preferred. This also means fewer staff are made redundant. On these criteria, this alternative contributes most to the Group’s second objective. On general health and welfare issues, Alternative 1 would contribute more. Neither alternative will contribute much to the Group’s objective to increase both operational cash flows and dividends by 4% each year. In summary, the question has to be asked whether we should be putting so much effort into pursuing the establishment of such a small subsidiary unless there are other issues to consider, for example the effect on other subsidiaries. Signed: Financial Manager
(c) In the context of investment decisions, there are three options to be considered: ● ● ●
The abandonment option; The timing option; The strategic option.
The abandonment option ● Major investment decisions involve heavy capital commitments and are largely irreversible; once the initial capital expenditure is incurred, management cannot turn the clock back and act differently. ● Because management is committing large sums of money in pursuit of higher, but uncertain, payoffs, the option to abandon, or ‘bail out’, should things look grim can be valuable. ● Abandonment possibilities can reduce the riskiness of a project and increase the expected NPV of certain types of project which would otherwise produce large negative NPVs if they could not be abandoned in the event that things do not work out. Also, the investment could be repeated. ● In the case of SP, the company could defer payment of the equipment for Alternative 1 and risk the 5% increase in cost. This is a high price to pay for an abandonment option on an investment that will have already incurred some capital costs, redundancy payments and loss of earnings from the closure of CC. ● In the case of Alternative 2, the equipment can be purchased any time. There will have been some expenditure made as soon as the decision is taken, but as the factory conversion will take six months, the company can choose to abandon the capital expenditure at any time within those 6 months. 2006.1
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(iii) Recommendation Factors to consider:
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The timing option ● The example here not only introduces an abandonment option, it also raises the option to ‘wait and see’. Management may have viewed the investment as a ‘now or never’ opportunity, arguing that in highly competitive markets there is no scope for delay: money is made by staying ahead of the competition. In effect, this amounts to viewing the decision as a call option which is about to expire on the new plant for the capital investment outlay. If a positive NPV is expected, the option will be exercised, otherwise the option lapses and no investment is made. ● The option to defer the decision by, say, 1 year until the outcome of the government’s deliberations on health and safety issues becomes known, makes obvious sense. An immediate investment would yield either a negative NPV – in which case it would not be taken up – or a positive NPV. ● Delaying the decision by a year to gain valuable new information is a more valuable option. This helps to understand why management sometimes does not take up apparently wealth-creating opportunities; the option to wait and gather new information is sufficiently valuable to warrant such delay. The strategic investment option ●
Certain investment decisions give rise to follow-on opportunities that are wealth creating. New technology investment is particularly difficult to evaluate. Managers refer to the high level of intangible benefits associated with such decisions – meaning that these investments offer further investment opportunities (e.g. greater flexibility).
Solution to case study 13 Examiner’s Note The answer to this question is fuller than was expected from a well-prepared candidate. It has been provided for future candidates, and tutors, for study and revision purposes.
(a) (i) Calculations of present values of forecast cash flows for Cocomos Limited Calculation of exchange rates using interest rate parity
Spot rate 1 year forward 2 year forward 3 year forward 4 year forward
C$ €1 0.300 0.292 0.283 0.275 0.268
[0.300 (1.035/1.065) [0.292 (1.035/1.065)] [0.283 (1.035/1.065)] [0.275 (1.035/1.065)]
Calculation of DCFs/PVs for years 1 to 4 Year Cash flows in C$million Inflated at 4.5% each year 2006.1
1 31.50 32.92
2 37.50 40.95
3 41.50 47.36
4 47.20 56.29
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Converted to €million using exchange rates above Discount factor at 10% DCFs in €
9.61 0.909 8.74
11.59 0.826 9.57
13.02 0.751 9.78
15.09 0.683 10.31
Present value of discounted cash flows for years 1 to 4 @ 10% €38.4 million Method 2 If we take Groots’ directors’ suggestion that 12% is too low to reflect the risk, we could calculate a new rate using interest rate parity as follows: Exchange rate in 12 months' time C$/Euro 1 annual discount rate C$ Spot rate C$/Euro 1 annual discount rate Euro 1 annual discount rate C$ 3.425 (1/0.292) 1.10 3.333 (1/0.300) Annual discount rate C$ 1.10 3.425 1 3.333 Discount rate C$ 13% Note: Candidates who adjusted the discount rate using a sensible notional increase over 12% would have gained some credit. Cash flows inflated at 4.5% each year as above Discount factor at 13% DCFs in C$
32.92 0.885 29.13
40.95 0.783 32.06
47.36 0.693 32.82
56.29 0.613 34.51
Present value of discounted cash flows for years 1 to 4 @ 13% C$128.52 million Converted at spot (128.52 0.3) €38.56 million
Note: Credit is available for calculating method 2 using 12% discount rate. The NPV for years 1–4 using 12% would be C$131.55 or €39.47. Calculation of Cash flows for years 4 Method 1 (15.09 1.02 0.6837)/(0.10 0.02) €131.4 million Method 2 (15.09 1.02 0.613)/(0.13 0.02) €85.8 million Price to pay for equity (€million) PV years 1–4 Years 4 Secured loan stock at spot
Method 1 38.4 131.4 169.8 140.5 129.3
Method 2 38.6 185.8 124.4 140.5 173.9
Notes 1. Forward exchange rates can be calculated using either purchasing power parity or interest rate parity. Either approach is theoretically acceptable but the question requests the use of IRP. 2. The calculation for year 4 uses the constant growth version of the dividend valuation model, that is the year 4 cash flow under method 1 (15.09) multiplied 2006.1
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Method 1
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by 1 the estimated annual growth rate after year 4 multiplied by the year 4 discount rate divided by the cost of capital minus the growth rate. 3. Debt is deducted on the assumption Groots will take on the liability. There is an argument for not deducting debt as the cash flows are those attributable to equity. However, as the debt has to be repaid immediately, the €40.5 million could be considered a negative “x” factor, that is Groots would pay Cocomos’ shareholders €129.3 million and a bank/financier €40.5 million. (ii) Comments on why methods should give the same answer • Two basic approaches to evaluating international investments using present value analysis: Method 1 – discount the local cash flows at the local cost of capital and then translate the present value into the home currency. Method 2 – translate the local cash flows into the home currency using appropriate exchange rates and then discount at the home cost of capital to give a PV (or a NPV if an initial investment is part of the calculations) in the home currency. • In theory the answers should be identical but, in practice, minor inefficiencies and imperfections in the market will allow for differences. • Many of the considerations to arrive at a discount rate for international investments are the same as for domestic projects, but there are additional risks to consider such as political, economic and transaction risks. • The discount rate needs to be adjusted for the increased risk and international cash flows, but it may also be argued that international diversification reduces risks. Risk will also be affected by the correlation of the project’s cash flows with those of domestic projects, and by the inter-temporal correlation of cash flows. • If choosing Method 1: a choice of 10% as a discount rate applied to home currency is acceptable, but may not fully incorporate the risk of the investment. Groots’ cost of capital is estimated as 10%. • The calculations also show the present value that would be expected if Groots’ Group applied a 13% discount rate to cash flows in C$ and converted the total present value at spot. There is very little difference between the two figures, as would be expected. (iii) Calculations of number of shares Assuming 10% (Method 1) is an appropriate specific risk adjusted discount rate in the circumstances, then Groots will be prepared to pay up to €129.3 million for the acquisition of Cocomos. Suggested terms are calculated as follows: There are 55 million Cocomos shares in issue. If the value to be offered is €129.3, this is €2.35 per share, (C$7.83 per share in Cocomos’ local currency). Groots shares are currently quoted at €6.85 per share. This suggests an exchange ratio of 1 Groots for 2.9 Cocomos. Approximately 20 million new shares in Groots will therefore need to be issued. This will need Groots’ shareholders approval. (b) Report To: The Directors of Groots Group From: A Financial Manager Date: 25 May 2005 2006.1
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Introduction I have reviewed the relevant information relating to the proposed acquisition of the Caribbean-based company, Cocomos Limited. The terms of reference for this report are as follows: (i) To recommend whether the investment should proceed and at what price, including discussion of alternative methods of valuation. (ii) To identify and discuss alternative methods of financing the acquisition and make a recommendation of the most appropriate method in the situation here. (iii) To advise on strategies for enhancing the value of the combined company following the acquisition. (iv) To advise on the benefits and limitations of a post-completion audit in the context of the acquisition. These terms of reference form the basis of the four main sections of the report. (i) To recommend whether the investment should proceed and at what price, including discussion of alternative methods of valuation The value of the company in total and per share (in €, converted from C$ at spot) using four methods of valuation are shown below: Market value of equity (C$6.95 0.3 55 million) Net Asset value (C$155 million 0.3) Using Groots P/E to value Cocomos’ earnings (C$37.1 0.3 11.4) Forecast cash flows (per requirement (a))
Total company €million 114.68
Per share € 2.09
46.50
0.85
126.88
2.31
129.30
2.35
Notes 1. Cocomos’ earnings are C$48.6 11.5 C$37.1. 2. Groots EPS is (€193.5 46.9)/245 million €0.60. P/E is therefore 685/60 11.4 Based on the calculations for part (a)(i), the maximum price Groots’ Group should consider paying is €129 million, given the assumptions about the discount rate and debt repayment. This is around 12% above market value, which is not unreasonable even in an agreed bid, and given the illiquid nature of Cocomos’ shares (they were last traded in January). The value based on Groots’ Group’s P/E also provides a good benchmark. This is very close to the value based on cash flows and suggests a price of €129 million is not excessive. However, this value could provide the basis for an opening bid of €2.35 per share – C$7.83, a premium of just under 13% on current share price. A maximum price could be the NPV of cash flows before the debt repayment, around €170 million. This would be €3.09 or C$10.3 per share; a premium of C$3.35 per share on current market price, or almost 50%. This is excessive for an agreed bid. However, two caveats need to be made: 1. The value of Cocomos in € terms may change before the bid is completed, which introduces currency risk into the negotiations. 2006.1
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Evaluation of acquisition of Cocomos Limited
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2. If the franchisees object to the bid, as is currently being suggested they might, this could turn into a hostile bid, or at least one with difficult political implications. This could have a major impact on what we may ultimately need to pay for Cocomos. In the circumstances, it is recommended we look again at possibilities within Europe before finalising our bid plans. (ii) To identify and discuss alternative methods of financing the acquisition and make a recommendation of the most appropriate method in the situation here. There are basically two methods of financing a bid; a share exchange and cash. A combination of the two is also possible. If shares are offered, and we pay €129 million, there will be a need to issue up to 20 million additional Groots shares (55 million/2.9 as calculated in part (a)). This will need shareholder approval and will have a short-term dilution effect on EPS until the benefits of the Cocomos takeover are reflected in Groots’ earnings. If cash is offered we will need to raise the entire €129, as the €45 million cash and marketable securities in our balance sheet (assuming it is still available) will be used to repay the Cocomos debt. This will increase our gearing (debt: debt equity) from its current level of 23% (based on market values). Note: calculated as: Market value of equity 245 million shares €6.85 1,678.25 Market value of debt 475 million 105.5% 2,501.13 Total 2,179.38 501.1/2, 179.35 100 23% approx
If we assume we need to raise the whole of the €129 million and repay Cocomos’ debt out of our cash balances, gearing will rise to just under 26%, assuming the market value of equity post-acquisition is simply the market value of Groots plus the NPV of Cocomos (this is an over-simplification and any attempt at postmerger valuation would gain credit). Note: calculated as: Market value of Groots’ equity 245 million shares €6.85 1,678.25 Plus NPV of Cocomos 0,169.00 Market value of equity post-acquisition 1,847.25 Market value of debt 475 million 105.5% Plus debt raised to pay for Cocomos Total debt
Total capital
2,477
501.13 129.00 630.13
635/2,477 100 26% approx.
This is not excessive for a company such as ours and will not increase our risk profile by any significant amount. We may therefore be able to raise money at a lower interest rate than 7%; the current price of our debt is above par at €105.5 per €100, suggesting the market rate for debt of similar maturity and risk is 6.6%. This would lower our WACC. However, all other things being equal it should also raise our cost of equity capital, although there may be a lowering effect because of diversification of business risk, as discussed below in section iii of this report. 2006.1
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Individual Caribbean-based shareholders and pension fund May not want foreign-currency denominated shares. Groots could decide to retain Cocomos as a subsidiary listed on the East Caribbean stock exchange, but this is unlikely. Canadian/British-based shareholders Probably less opposed to a euro-denominated share, but they probably own Caribbean shares for a specific purpose, for example they have homes in the Caribbean and want C$ dividend payments. This group also may prefer cash. Cocomos’ directors and senior managers This is one group of shareholders who may elect for some Groots shares, although their intention is not clear at present. It is recommended that we offer a share exchange with a cash alternative. We should be prepared for up to 100% of Cocomos shareholders to opt for cash as shares in a European company may not be attractive to the majority of the shareholders. The following are key points we should consider when determining our strategy: (iii) To advise on strategies for enhancing the value of the combined company following the acquisition • The integration strategy must be in place before the acquisition is finalised • We should review each of the company’s outlets for potential cost cuttings/synergies or potential asset disposals. It is possible there are outlets more valuable to another company than Groots’ Group – perhaps the franchisees, but it is important they are in good shape before they are sold. However, more than this is needed for a full effective enhancement programme and a position audit could be carried out. • We should consider the effect on the workforce and determine how many, if any redundancies are likely and what the cost will be. This is likely to be a political issue and redundancies need to be avoided at all costs. • We should review the franchisees’ contracts to see if we wish to renew and on what terms. Alternatively, we might prefer to take over the stores ourselves. This aspect may be particularly difficult and may impact on the price to be paid for Cocomos. • There is clearly potential for value enhancement if only because the risk-diversifying aspects may well lower the cost of capital and therefore increase the value of the firm. The effect on gearing and financial risk if the company has to borrow to finance this acquisition was noted in section (ii) of this report. • The company’s cost of capital should therefore be re-evaluated. However, Cocomos’ revenue is currently only around 6% of ours so the effect will not be substantial. 2006.1
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Note: Candidates who adopted an MM approach to company valuation would have gained credit. It is likely in the circumstances here that cash or at least a cash alternative will need to be offered. The different groups of shareholders need to be considered; key points are:
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• We should make a positive effort to communicate our post-acquisition intentions within the organisation and within the region to prevent de-motivation and avoid adverse post-acquisition effects on staff morale. • This is, basically, a horizontal merger and there may be economies of scale that we should aim to identify and evaluate. • We should do a review of assets, or resource audit, and consider selling non-core elements or redundant assets. • There may well be a need to pursue a more aggressive marketing strategy. • The risks of the acquisition need to be evaluated. There are obvious currency and economic risks in any cross-border deal, but we are moving here into a different cultural environment as well. The East Caribbean is a stable region, so the political risks are minimal, but they are still greater than if we continued to operate within our own geo-political area. • There needs to be harmonisation of corporate objectives. (iv) To advise on the benefits and limitations of a post-completion audit in the context of the acquisition A post-completion audit (PCA) or review (PCR) can be defined as an objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project. The main purposes may be summarised as: • Project control • Improving the investment process • Assisting the assessment of performance of future projects. A major requirement of a PCA/PCR is that the objectives of the investment project must be clear and an adequate investment proposal should have been prepared. The objectives should also be stated, wherever possible, in terms that are measurable. An acquisition is basically an investment decision and the same processes can be applied. The main advantages of a PCA/PCR are: • It enables a check to be made on whether the actual results or post-acquisition performance correspond with the expected results. If this is not the case, the reasons should be sought. This could form the basis for improvements in aspects of the acquisition that are not functioning as expected. In the extreme, they could be used as an argument for abandoning or exiting from the acquisition. • It generates information, which allows an appraisal to be made of the managers who took the acquisition decision. Managers will therefore tend to arrive at more realistic estimates of the advantages and disadvantages of their proposed investments. • It can produce lessons for the decision-making in the acquisition process. If these lessons are actually learned, managers will be able to make a better evaluation of the significance and the profitability of future projects. • It can provide for better project planning. If, in the evaluation, it is found that the planning of the investment/acquisition programme was poor, provision can be made to ensure that it is better for future acquisitions. 2006.1
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• • • •
The process can be costly and time consuming; It requires good data collection systems to be in place; It is not a panacea for managerial judgement; It can be used to blame rather than learn from past mistakes.
Summary This report has aimed to provide an evaluation of the proposed acquisition of the Caribbean company, Cocomos. In summary, it recommends that the acquisition should proceed although given the potential for political difficulties; a review of alternative possibilities for acquisition within Europe should be considered. An initial bid of around €127 million (C$423 million) is suggested financed by an offer of new shares with a cash alternative. This figure is based on the benchmark of Cocomos’ earnings multiplied by Groots’ Group’s P/E ratio. The recommended maximum price to be paid is €134 million.
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The main limitations are that:
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Scenario Questions
Question 1 (a) Assume that you are finance director of a large multinational company, listed on a number of international stock markets. The company is reviewing its corporate plan. At present, the company focuses on maximising shareholder wealth as its major goal. The managing director thinks this single goal is inappropriate and asks his co-directors for their views on giving greater emphasis to the following: 1. cash-flow generation; 2. profitability as measured by profits after tax and return on investment; 3. risk-adjusted returns to shareholders; 4. performance improvement in a number of areas, such as concern for the environment, employees’ remuneration and quality of working conditions, and customer satisfaction. You are required to provide the managing director with a report for presentation at the next board meeting which: (i) critically evaluates the argument that maximisation of shareholder wealth should be the only objective of a company; and (ii) discusses the advantages and disadvantages of the MD’s suggestions about alternative goals. (15 marks) (b) The company is already considering improving the methods of remuneration for its senior employees. As a member of the executive board, you are asked to give your opinions on the following suggestions: 1. a high basic salary with usual ‘perks’ such as company car, pension scheme, etc., but no performance-related bonuses; 2. a lower basic salary with usual ‘perks’ plus a bonus related to their division’s profit before tax; 3. a lower basic salary with usual ‘perks’ plus a share option scheme which allows senior employees to buy a given number of shares in the company at a fixed price at the end of each financial year. You are required to discuss the arguments for and against each of the three options from the points of view of both the company and its employees. Detailed comments on the taxation implications are not required. (10 marks) (Total marks 25)
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Question 2 (a) Assume that you are the new financial manager for CBA Limited, a company which has always evaluated its investments using IRR as the selection criterion. The company’s managing director thinks that NPV may be a better method, and is aware that some companies use multiple methods, for example NPV in combination with a nondiscounting technique such as payback or accounting rate of return. He has asked for your opinion. You are required to write a report to the managing director which: ● explains the theoretical differences between IRR and NPV and comments on any practical aspects which might explain CBA Limited’s past preference for IRR; ● discusses the advantages and disadvantages of using multiple methods for the evaluation of investments. (10 marks) (b) Regulatory bodies are, typically, established to protect consumers and ensure that monopoly or near-monopoly suppliers do not abuse their position for financial gain. (Examples in the UK are Ofgas (gas industry) and Ofwat (water industry).) You are required to: ● explain the factors a regulator might take into account when discussing pricing policies with the management of a regulated industry; ● describe two other activities a regulator might perform (in addition to price controls) and explain why it might be necessary to retain a regulatory body even when competition enters an industry (e.g. in telecommunications in the UK). (10 marks) (Total marks 20)
Question 3 Hudson plc is an investment group which owns a number of subsidiary companies. Each subsidiary produces a particular product, product range or service. For the purposes of management control, the subsidiary companies are organised into three sectors: ●
●
●
Consulting and Services (CS): a consultancy practice which provides advice on product design, manufacturing technique and material usage both to Hudson group companies and to businesses outside the group. Salaries comprise about 95 per cent of costs in the CS sector. Heavy Engineering (HE): two subsidiary companies producing machinery, equipment and tools used in a variety of industrial applications. These companies require a major investment in the form of factory premises, plant and transport facilities. Light Engineering (LE): four subsidiaries which produce a range of small mechanical and electrical components, many of which are ‘designed’ into the products of HE sector companies. The production of these components is generally considered to be labourintensive.
At the start of 1992 Hudson plc’s management decides to prepare a 5-year strategic plan for the group. A team of Hudson executives is assembled to prepare this plan.
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CS £000
HE £000
Book value at 31 December 1991: Non-current assets Current assets Current liabilities Capital employed
80 90 1(20) 0150
4,970 820 5,(140) 05,650
Year to 31 December 1991: Sales Trading profit Group finance charge at 12% Residual income Return on capital employed
860 220 18 202 146%
6,320 1,073 678 395 19%
LE £000 810 180 1(65) 0925 1,918 240 111 129 26%
All the above figures are taken from the Hudson group’s main accounting system and are prepared on a historical cost basis. The ‘group finance charge’ is 12 per cent of the capital employed in each sector at the end of the year. This figure is Hudson plc’s cost of money and is also used as the discount rate for project evaluation. Inflation in 1990 and 1991 was about 10 per cent per year. After reviewing the above figures, a number of team members advocate expanding the CS sector because of its high return on capital employed (ROCE). It is suggested that this expansion could be achieved quickly by acquiring an established consultancy practice – the acquisition to be funded by selective divestments in the two other sectors. Other team members disagree with this proposal and advocate expanding the HE sector because of its high residual income (RI). Requirements (a) Explain the ways in which inflation might make it difficult to use the figures tabulated in the question in order to compare the performance of the three sectors. (10 marks) (b) Discuss the relative merits of ROCE and RI as performance indicators and explain which of the two you consider to be superior in the present context. (8 marks) (c) Discuss the relevance of the information given in the question, and state what additional information you would find helpful in advising Hudson plc on which of its three sectors should be expanded. (10 marks) (Total marks 28)
Question 4 COR Ltd owns a chemical works at Millfield, a small town in the north of England. The shares in COR Ltd are owned by a number of multinational chemical companies. The COR works converts crude oil into polyethylene. The COR works has the capacity to process 1 million barrels of crude oil per year and achieve an output of 0.95 million barrels of polyethylene per year. Crude oil costs US$20 per barrel, and polyethylene product is sold on the Amsterdam chemical market at a price of US$40 per barrel. These prices are current at January 1992 and are expected to remain stable if the effects of inflation are excluded. At January 1992 the US$/£ exchange rate is 2006.1
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At its first meeting, the team is provided with the following summary of the group’s performance in 1991:
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$1.90 and the £ is expected to depreciate against the US$ by 5 per cent per year over the next ten years. The COR works was opened in 1980 and has operated continuously at full capacity since that time. It is one of the major employers and payers of business rates (local authority taxes) in the Millfield area. Consequently, the local community has been reluctant to criticise any aspect of its operation. The works process involves the emission of a variety of noxious substances into the atmosphere. Since 1980 this has had the following effects in the Millfield area: 1. When it rains, the paintwork of cars left in the open is discoloured. 2. There is extensive damage to local vegetation and wildlife. 3. Local farms have been forced to discontinue the cultivation of certain crops because of soil contamination. 4. Many residents suffer from breathing difficulties. Hitherto, COR Ltd has dealt with these problems by paying compensation to residents and farmers at an average total of £100,000 per year. It costs £30,000 per year to administer this compensation. By 1991, environmental groups were taking an interest in the COR works. There have been a number of demonstrations at the site and the COR works featured prominently in a recent television documentary about industrial pollution. In January 1992 COR Ltd’s owners express concern about the situation and instruct COR Ltd’s management to submit a plan for dealing with it. A filter unit can be fitted to the process at the works which will completely eliminate the noxious emissions. Relevant details of the filter unit are as follows: 1. The supply, fitting and commissioning of the unit will cost £2,200,000. 2. The works will have to be shut down for 1 month to allow the fitting to take place; this closure will achieve no cost savings other than those arising from the reduced use of crude oil. 3. Once the filter is fitted, normal process losses will rise by an estimated 10 per cent. 4. The capital cost of the filter will qualify for low interest rate finance from the Association of European States (AES) Environmental Fund; the AES will make a loan to COR Ltd of 50 per cent of the filter’s cost at a 4 per cent interest rate; repayment of AES loans is on an annuity basis involving equal annual payments (interest and principal) over 8 years. As an alternative, it is considered possible to resolve the immediate problems in the following way: 1. Increase compensation paid to local residents and farmers from £100,000 to £250,000 per year. 2. Make annual donations of £100,000 per year to environmental charities. 3. Establish a wildlife sanctuary close to (but upwind of ) the COR works at a cost of £850,000. COR Ltd evaluates projects using a 12 per cent cost of money and a ten-year time horizon. Requirements (a) Write a report for presentation to COR Ltd’s owners evaluating the two options in the manner you consider to be most appropriate and advising which option should be adopted. (Note: You should ignore taxation.) (20 marks) 2006.1
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Question 5 Assume that you have been appointed finance director of Breckall plc. The company is considering investing in the production of an electronic security device, with an expected market life of 5 years. The previous finance director has undertaken an analysis of the proposed project; the main features of his analysis are shown below. He has recommended that the project should not be undertaken because the estimated annual accounting rate of return is only 12.3 per cent. Proposed Electronic Security Device Project £000 Year → 0 1 2 3 Investment in depreciable fixed assets 4,500 Cumulative investment in working capital 300 400 500 600 Revenue 3,500 4,900 5,320 Materials 535 750 900 Labour 1,070 1,500 1,800 Overhead 50 100 100 Interest 576 576 576 Depreciation 3,900 3,900 4,900 3,131 3,826 4,276
4
5
700 5,740 1,050 2,100 100 576 4,900 4,276
700 5,320 900 1,800 100 576 4,900 4,726
Taxable profit Taxation Profit after tax
1,014 4,355 0 659
1,044 4,365 0 679
369 3,129 0 240
1,074 3,376 0 698
1,044 4,365 0 679
Total initial investment is £4,800,000. Average annual after-tax profit is £591,000. All of the above cash-flow and profit estimates have been prepared in terms of presentday costs and prices, as the previous finance director assumed that the sales price could be increased to compensate for any increase in costs. You have available the following additional information: (a) Selling prices, working capital requirements and overhead expenses are expected to increase by 5 per cent per year. (b) Material costs and labour costs are expected to increase by 10 per cent per year. (c) Capital allowances (tax depreciation) are allowable for taxation purposes against profits at 25 per cent per year on a reducing balance basis. (d) Taxation on profits is at a rate of 35 per cent payable one year in arrears. (e) The fixed assets have no expected salvage value at the end of 5 years. (f ) The company’s real after-tax weighted average cost of capital is estimated to be 8 per cent per year, and nominal after-tax weighted average cost of capital 15 per cent per year. 2006.1
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(b) Explain what the environmental costs external to the COR works’ operation are and how you would express them in monetary terms. (15 marks) (c) Explain how environmental costs might be incorporated in COR Ltd’s investment appraisal procedure in order to evaluate the acceptance of projects on environmental grounds which are not viable on purely commercial grounds. (10 marks) (Total marks 45)
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Assume that all receipts and payments arise at the end of the year to which they relate, except those in year 0, which occur immediately.
Requirements (a) Estimate the net present value of the proposed project. State clearly any assumptions that you make. (13 marks) (b) Calculate by how much the discount rate would have to change to result in a net present value of approximately zero. (4 marks) (c) Describe how sensitivity analysis might be used to assist in assessing this project. What are the weaknesses of sensitivity analysis in capital investment appraisal? Briefly outline alternative techniques of incorporating risk into capital investment appraisal. (8 marks) (Total marks 25)
Question 6 DT plc is a quoted company. The directors have been evaluating a cost-saving project which will require £1.9m capital expenditure on new machinery. The directors expect the capital investment to provide cost savings of £300,000 per annum indefinitely. The company is at present all-equity financed. The discount rate which it applies to investment decisions of this nature is 16 per cent. The directors believe the current capital structure fails to take advantage of the tax benefits of debt and propose to finance the new project with undated debt secured on the company’s assets. The current rate of interest required by the market on corporate debt of this risk and maturity is 9 per cent. The costs of issue, which are not tax-deductible, are expected to be 5 per cent of the gross proceeds of issue. The company intends to issue sufficient debt to cover the cost of capital expenditure and the costs of issue. The company’s marginal tax rate is 33 per cent. Requirements (a) Using the information given for DT plc, calculate the adjusted present value of the investment and the adjusted discount rate, and explain the circumstances in which this adjusted discount rate may be used to evaluate future investments. (10 marks) (b) A finance lease is being considered as an alternative method of financing. DT plc has been told it could lease the machinery over 5 years. The terms would be five annual payments of £425,000 payable at the beginning of each year. Assume that the payments are net of tax. You are required: (i) to calculate the net present value of the lease, using whatever discount rate(s) you think appropriate, given the information in the scenario, and to comment briefly on your answer. (5 marks) (ii) to discuss the advantages and disadvantages of leasing as compared with long-term debt, and to comment on whether the choice of method should affect the investment decision. (5 marks) (Total marks 20) 2006.1
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The board of directors of CP Ltd is considering two investments, each of which is expected to have a life of five years. The company does not have either the physical capacity or the funds to undertake both investments. Forecast profits and other financial data for the two investments are as follows: INVESTMENT 1 Year → Non-current assets Working capital Forecast revenue Forecast costs Finance charges Depreciation Profit before tax INVESTMENT 2 Year → Non-current assets Working capital Forecast revenue Forecast costs Finance charges Depreciation Profit before tax
0 £000 (500) (50)
0 £000 (450) (50)
1 £000
2 £000
3 £000
4 £000
5 £000
370 300 15 100 (45)
500 325 15 100 060
510 335 15 100 060
515 330 15 100 070
475 325 15 100 035
1 £000
2 £000
3 £000
4 £000
5 £000
420 310 15 480 015
510 385 15 580 030
575 420 15 580 060
550 400 15 580 055
510 350 15 580 065
Additional information ● The entity pays tax at 33 per cent. Tax depreciation allowances are available on the initial investment in both projects at 25 per cent per year. Tax is payable/receivable one year in arrears. ● The data is in real terms, that is, it contains no increases for inflation. This has been ignored on the grounds that both sales and costs are expected to increase by 5 per cent per year. ● The company’s nominal cost of capital is 12 per cent per year. Its target accounting rate of return (average profit before tax as a percentage of average investment) is 25 per cent. ● All cash flows may be assumed to occur at the end of the year except the initial capital cost and working capital. ● For each project the value of working capital expected to be released back to the project’s cash flows at the end of year 5 is £50,000 nominal. There will be no other terminal value of the investment. ● The £50,000 left over if investment 2 is chosen (i.e. the difference between the initial investment of £550,000 in investment 1 and £500,000 in investment 2) could be invested in the money market at between 6 and 7 per cent. Requirements Assume that you are the financial manager with CP Ltd. Recommend to the board which investment, if either, should be selected using whatever methods of evaluation you think appropriate. Include in your report a discussion of the various methods of evaluation and any non-financial factors which might be relevant to the decision. Note. Your cash flows should be presented in nominal (as opposed to real) terms. (20 marks) 2006.1
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Question 7
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Question 8 OJ Limited is a supplier of leather goods to retailers in the UK and other western European countries. The entity is considering entering into a joint venture with a manufacturer in South America. The two entities will each own 50 per cent of the limited liability company JV (SA) and will share profits equally. £450,000 of the initial capital is being provided by OJ Limited, and the equivalent in South American dollars (SA$) is being provided by the foreign partner. The managers of the joint venture expect the following net operating cash flows which are in nominal terms:
Year 1 Year 2 Year 3
SA$ 000 4,250 6,500 8,350
Forward rates of exchange to the £ sterling 10 15 21
For tax reasons JV (SA), the company to be formed specifically for the joint venture, will be registered in South America. Ignore taxation in your calculations. Requirements (a) Assume you are a financial adviser retained by OJ Limited to advise on the proposed joint venture. (i) Calculate the NPV of the project under the two assumptions explained below. Use a discount rate of 16 per cent for both assumptions. ● Assumption 1. The South American country has exchange controls which prohibit the payment of dividends above 50 per cent of the annual cash flows for the first 3 years of the project. The accumulated balance can be repatriated at the end of the third year. ● Assumption 2. The government of the South American country is considering removing exchange controls and restrictions on repatriation of profits. If this happens all cash flows will be distributed as dividends to the partner companies at the end of each year. (ii) Comment briefly on whether or not the joint venture should proceed based solely on these calculations. (8 marks) (b) During a meeting to discuss the joint venture, the following questions are raised by the managers of OJ Limited. ● ‘In reality we will exchange our SA$ cash flows into sterling at the spot rate prevailing at the end of each year. How reliable are forward rates of exchange as predictors of spot rates?’ ● ‘If exchange controls exist we shall not get much of our cash for 3 years. Surely we should be using a higher discount rate for assumption 1?’ ● ‘Under either assumption we have to accept substantial exchange rate risk. Could we use a currency swap to help us minimise this risk?’ You are required to comment on the three questions raised by the managers of OJ Limited and advise them of any other practical issues which should be considered before they decide to proceed. (12 marks) (Total marks 20) 2006.1
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DIVS plc is a large international company with widespread interests in advertising, media and various consultancy activities associated with sales promotion and marketing. In recent years, the company’s earnings and dividend payments, in real terms, have grown on average by 15 per cent and 12 per cent per year respectively. The company is likely to have substantial cash surpluses in the coming year, but a number of investment opportunities are being considered for the subsequent two years. The senior managers of the company are reviewing their likely funding requirements for the next 2–3 years and the possible consequences for dividend policy. At present the company has a debt:equity ratio of 1 : 5, measured in market value terms. It does not want to increase this ratio at the present time but might need to borrow to pay a maintained dividend in the future. The senior managers of the company are discussing a range of issues concerning financial strategy in general and dividend policy in particular. Requirements Assume that you are an independent financial adviser to the board of DIVS plc. Write a report to the board which discusses the following issues: (a) The repurchase of some of the company’s shares in the coming year using the forecast surplus cash, the aim being to reduce the amount of cash needed to pay dividends in subsequent years. Other implications of share repurchase for the company’s financial strategy should also be considered. (9 marks) (b) The advisability of borrowing money to pay dividends in years 2 and 3. (7 marks) (c) The likely effect on the company’s cost of equity if the company decides on share repurchase and/or further borrowing. (4 marks) (Total marks 20)
Question 10 The table below shows earnings and dividends for XYZ plc over the past 5 years:
Year 1989 1990 1991 1992 1993
Net earnings per share £ 1.40 1.35 1.35 1.30 1.25
Net dividend per share £ 0.84 0.88 0.90 0.95 1.00
There are 10,000,000 shares issued and the majority of these shares are owned by private investors. There is no debt in the capital structure. It is clear from the table that the company has experienced difficult trading conditions over the past few years. In the current year, net earnings are likely to be £10 million, which will be just sufficient to pay a maintained dividend of £1 per share. Members of the board are considering a number of strategies for the company, some of which will have an impact on the company’s future dividend policy. The company’s shareholders require a return of 15 per cent on their investment. 2006.1
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Question 9
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Four options are being considered, as follows: 1. Pay out all earnings as dividends. 2. Pay a reduced dividend of 50 per cent of earnings and retain the remaining 50 per cent for future investment. 3. Pay a reduced dividend of 25 per cent of earnings and retain the remaining 75 per cent for future investment. 4. Retain all earnings for an aggressive expansion programme and pay no dividend at all. The directors cannot agree on any of the four options discussed so far. Some of them prefer option (1) because they believe to do anything else would have an adverse impact on the share price. Others favour either option (2) or option (3) because the company has identified some good investment opportunities and they believe one of these options would be in the best long-term interests of shareholders. An adventurous minority favours option (4) and thinks this will allow the company to take over a small competitor. Requirements (a) Comment on the company’s dividend policy between 1989 and 1993 and on its possible consequences for earnings. (5 marks) (b) Advise the directors of the share price for XYZ plc which might be expected immediately following the announcement of their decision if they pursued each of the four options, using an appropriate valuation model. You should also show what percentage of total return is provided by dividend and capital gain in each case. You should ignore taxation for this part of the question. Make (and indicate) any realistic assumptions you think necessary to answer this question. (8 marks) (c) Discuss the reliability you can place on the figures you have just produced and on the usefulness of this information to the company’s directors. (6 marks) (d) The directors are still unable to come to an agreement on dividend policy and decide to ask the consultancy division of their auditors for advice. The consultants suggest two alternatives: (i) Pay no cash dividend but give shareholders bonus shares in lieu (i.e. pay a scrip dividend). (ii) Offer shareholders an alternative: a cash dividend which will be 50 per cent of earnings or an issue of bonus shares to a value of 150 per cent of the value of the cash dividend. The directors are unfamiliar with the use of scrip dividends and are unsure about the advantages. You are required to advise the directors on the arguments for and against the use of bonus shares in lieu of cash dividends, and on the possible consequences for investors of offering alternative (ii). (6 marks) (Total marks 25)
Question 11 This question concerns two organisations, one in the private sector and one in the public sector. 2006.1
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● ●
‘To increase earnings per share year-on-year by 10 per cent per annum’; ‘To achieve a 25 per cent per annum return on capital employed’.
This company has an equity market capitalisation of £600 million. It also has a variety of debt instruments trading at a total value of £150 million. Organisation 2 This organisation is a newly established purchaser and provider of healthcare services in the public sector. The organisation has legal status as a Trust. Its total income for the current year will be almost £100 million. It is considering funding the building of a new healthcare centre via the Private Finance Initiative (PFI). The total debt will be £15 million. Capital and interest will be repaid over 15 years at a variable rate of interest, currently 9 per cent each year. The Trust’s sole financial objective states simply ‘to achieve financial balance during the year’. Its other objectives are concerned with qualitative factors such as ‘providing high quality healthcare’. Requirements (a) Discuss: (i) the reasons for the differences in the financial objectives of the two types of organisation given above; and (ii) the main differences in the business risks involved in the achievement of their financial objectives and how these risks might be managed. Use the scenario details given above to assist your answer wherever possible. (18 marks) (b) Explain how the financial risks introduced into the public sector organisation by the use of PFI might affect the achievement of its objectives and comment on how these risks might be managed. (7 marks) Note: Candidates from outside the UK may use examples of private financing of public sector schemes in their own country in answering part (b) of this question if they wish. (Total marks 25)
Question 12 KH is a large food and drink retailer based in the USA. To date, the company has operated only in the US but is planning to expand into South America by acquiring a group of stores similar to those operated in the US. Projected cash flows in the US and South America for the first 3 years of the project, in real terms, are estimated as follows: Cash flows in USA: In US$ 000 Cash flows in the South American country: In SA Currency 000
Year 0
Year 1
Year 2
Year 3
10,000
300
400
500
1,000,000
250,000
350,000
450,000
US$ cash flows are mainly incremental administration costs associated with the project. SA currency cash flows are cash receipts from sales less all related cash costs and expenses. 2006.1
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Organisation 1 This is a listed company in the electronics industry. Its stated financial objectives are:
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The exchange rate for the South American country’s currency is extremely volatile. Inflation is currently 40 per cent a year. Inflation in the US is 4 per cent a year. Best estimates by KH’s treasurer suggest these rates are likely to continue for the foreseeable future. The current exchange rate is SA currency 30 to US$1. The following information is relevant: ● ● ●
●
KH evaluates all investments using nominal cash flows and a nominal discount rate; SA currency cash flows are converted into US$ and discounted at a risk-adjusted US rate; All cash flows for this project will be discounted at 20 per cent, a nominal rate judged to reflect its high risk; For the purposes of evaluation, assume the year 3 nominal cash flows will continue to be earned each year indefinitely. Note: Ignore taxation.
Requirements Assume that you are the Financial Manager of KH. Prepare a report to the Finance Director that evaluates the proposed investment. Include in your report the following: (i) Calculation of the net present value of the proposed investment and a recommendation as to whether the company should proceed with the investment, supported by your reasons for the recommendation. (12 marks) (ii) Discussion of the main political risks that might be faced by the company and provision of advice on management strategies that could be implemented to counter those risks. (13 marks) (Total marks 25)
Question 13 AB plc manufactures products for children. The company’s turnover and earnings last year were £56 million and £3.5 million, respectively. Its shares are not listed but they occasionally change hands in private transactions. AB plc’s weighted average cost of capital (WACC) is 13 per cent net of tax. The directors believe that an appropriate gearing ratio (debt to debt equity) for a company such as AB plc is 30 per cent, which is the industry average. Currently, AB plc’s gearing ratio is slightly higher than this at 35 per cent. Its debt comprises two secured long-term bank loans and a permanent overdraft, secured by a floating charge on the company’s current assets. The current cost of debt to a company such as AB plc is 10 per cent before tax. The company is considering expansion outside the UK, in particular in an Eastern European (EE) country where its products have become popular. The EE government has offered AB plc a financing deal to establish a manufacturing operation. The financing would take the form of an EE marks 30 million 6-year loan at a subsidised rate of only 2.5 per cent each year interest. The current exchange rate is EE marks 20 to the £sterling. Interest would be payable at the end of each year and the principal repaid at the end of 6 years. The exchange rate of EE marks to the £ would be fixed at the current rate for the whole 6-year period of the loan. The marginal corporate tax rate in both countries is 25 per cent. Requirements (a) Calculate the company’s present cost of equity and the present value of the EE government subsidy implicit in the loan. Comment briefly on the method used and any assumptions you have made in your calculations. (7 marks) 2006.1
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Question 14 Assume you are the Management Accountant in PJH Limited. The company manufactures soft furnishings (such as curtains and drapes) for theatres, exhibitions and concert halls in the UK. It has been trading for 20 years. Fifty-five per cent of the shares are owned between 10 members of the founding family. There are also 25 other shareholders with holdings of various sizes. Two years ago, the company received an offer of £25m for its entire equity, which the Board of Directors rejected without conducting any serious evaluation. The company is forecasting pre-tax earnings of £4.5m on turnover of £32m for the current year. These sales and earnings levels are expected to continue unless new investment is undertaken. The Managing Director, Mrs Henry, who is also a major shareholder, is planning a major expansion programme that will require raising £5m of new finance for capital investment. This investment yields a positive net present value (NPV) of £1.2 million when evaluated at the company’s post-tax cost of capital of 9 per cent. The Board is considering two alternative methods of financing this expansion: (1) A rights issue to existing shareholders plus a new issue of shares to employees and trading partners. (2) Medium-term (5 years) debt, interest rate fixed at 7 per cent, secured on the company’s fixed assets, mainly land and buildings. The company at present has no long-term debt. It has an overdraft facility that is used for short-term financing needs. The company pays tax at 30 per cent. Mrs Henry is aware that the method of financing chosen might have an impact on the valuation of the company and also on the company’s long-term objectives. Requirements Write a report to Mrs Henry that advises on: (i) the factors that need to be considered by the Board when deciding to raise new equity (8 marks) (ii) the effect of each suggested method of financing on the valuation of the company. You only need provide some simple calculations here to support your arguments. You do not have enough information to do a detailed valuation. (10 marks) (iii) appropriate long-term financial objectives for a company such as PJH Limited. (7 marks) (Total marks 25) 2006.1
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(b) Discuss the relevance of both the cost of equity you have calculated in answer to (a) above and the WACC given in the scenario, to the company’s investment decision. Include comment on an alternative discount rate that could be used appropriately in the scenario’s circumstances. (6 marks) (c) (i) Discuss the advantages and disadvantages of using the EE government subsidy in AB plc’s international investment decision. (ii) Recommend alternative methods of financing that might be suitable for AB plc in the circumstances of the scenario. (12 marks) (Total marks 25)
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Question 15 Assume you are a financial manager with HH, a multinational company based in the USA with subsidiaries in Germany and the UK. One of your responsibilities is cash management for the group of companies. You have received the following forecasts of surplus funds for the next 30 days from the financial mangers in the two subsidiaries: Germany: UK:
Euros (€) 10.5 million £ sterling 5.5 million
The US operation is forecasting a cash deficit of US$ 10 million. You obtain the following exchange rate information from the financial press: Spot 30-day forward
€/US$ 1.131 1.126
£/US$ 0.695 0.700
Annual borrowing/deposit rates available to the group are: US$ 30-day £ Sterling 30-day € 30-day
1.7%/1.6% 4.1%/3.9% 3.1%/3.0%
You are considering introducing a system of cash pooling whereby all funds are converted into US$ and the net balance invested or borrowed in US$ in the USA. Ignore taxes and transaction costs. Requirements (a) Calculate the cash balance at the end of the 30-day period, in US$, for each company in the group (including the US parent) under each of the following two scenarios: (i) Each group company acts independently and invests/finances its own cash balances/deficits in its local currency. (ii) Cash balances are pooled immediately in the USA and the net $ balance invested/borrowed for the 30-day period. Based on your calculations, comment on which method is the most favourable in financial terms from the US parent’s point of view. You should assume simple interest rates based on a year of 360 days. (13 marks) (b) Discuss the benefits and possible drawbacks to the parent company and to each subsidiary if a system of pooling were to be introduced as a general policy for the group. (12 marks) A report format is not required in answering this question. (Total marks 25)
Question 16 (a) Explain the weak form of the efficient market hypothesis (EMH). (4 marks) (b) Outline and appraise the empirical research undertaken to test the validity of the weak form of EMH. (4 marks) (c) If the capital markets are efficient, this has implications for corporate finance. Discuss the implications for the financial manager of a large company that is trying to maximise the wealth of its shareholders. (12 marks) (Total marks 20) 2006.1
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Assume you are finance director of a large multinational company, listed on a number of international stock markets. The company is reviewing its corporate plan. At present, the company focuses on maximising shareholder wealth as its major goal. The managing director thinks this single goal is inappropriate and asks his co-directors for their views on giving greater emphasis to the following: 1. 2. 3. 4.
cash-flow generation; profitability as measured by profits after tax and return on investment; risk-adjusted returns to shareholders; performance improvement in a number of areas, such as concern for the environment, employees’ remuneration and quality of working conditions, and customer satisfaction.
Requirements Provide the managing director with a report for presentation at the next board meeting that: (a) critically evaluates the argument that maximisation of shareholder wealth should be the only objective of a company; and (b) discusses the advantages and disadvantages of the MD’s suggestions about alternative goals. (Total marks 15)
Question 18 ABC plc is a UK-based service company with a number of wholly owned subsidiaries and interests in associated companies throughout the world. In response to the rapid growth of the company, the managing director has ordered a review of the company’s organisation structure, particularly the finance function. The managing director holds the opinion that a separate treasury department should be established. At present, treasury functions are the responsibility of the chief accountant. Requirements (a) Describe the main responsibilities of a treasury department in a company such as ABC plc and explain the benefits that might accrue from the establishment of a separate treasury function. (12 marks) (b) Describe the advantages and disadvantages that might arise if the company established a separate treasury department as a profit centre rather than as a cost centre. (8 marks) (Total marks 20)
Question 19 TLC plc is a company that manufactures and sells a range of healthcare products. The company has expanded rapidly and markets the products worldwide. The board of directors has asked you to prepare a report to assist the managing director with the appointment of a financial manager to strengthen the management team. 2006.1
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Question 17
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(a) What tasks will be the main areas of responsibility of the financial manager? (6 marks) (b) Describe the more important techniques that will be used to tackle the tasks that were identified in (a). (8 marks) (c) Discuss the means available to control the treasury department if it is established as a profit centre rather than as a cost centre. (6 marks) (Total marks 20)
Question 20 A family-owned company needs to raise funds to enable a new project to be undertaken. The main shareholders are not willing to increase their stake in the company nor to dilute their holdings. Discuss the costs and benefits of the funding sources that could be used to obtain the funds. (Total marks 20)
Question 21 Carlham plc has short-term investments in the shares of four listed companies: Company Teval Undal Veral Wirtal
Teval Undal Veral Wirta
Holding 100,000 shares, 50 pence par value 155,000 shares, £1 par value 260,000 shares, 20 pence par value 430,000 shares, 10 pence par value
Beta equity coefficient 1.55 0.65 1.26 l1.14
Market price (pence) 280 340 150 95
Latest dividend yield (%) 6.8 3.6 6.4 7.2
Expected total return on investment per year (%) 21.0 12.5 18.0 18.5
The yield on Treasury bills is 6 per cent per year, and the market return is 16 per cent per year. Requirements (a) Estimate the risk of Carlham’s short-term investment portfolio relative to the market. (4 marks) (b) Recommend, giving your reasons, whether the composition of Carlham’s short-term investment portfolio should be changed. Relevant calculations must be shown. (10 marks) (c) Discuss the factors that a financial manager should take into account when investing in marketable securities. (6 marks) (d) Briefly describe five marketable securities that might form part of a company’s shortterm investment portfolio. (5 marks) (Total marks 25) 2006.1
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Once it has been decided to fund a new project by increasing the firm’s borrowings, there are further decisions. Should the funds be raised by means of short-term debt that is repayable within 1 year, medium-term debt, or loans that are repaid over periods of 10–25 years? Discuss the factors that should be taken into consideration in deciding on the most appropriate form of funding. (Total marks 20)
Question 23 ABC plc is classified as a small company for corporation tax purposes and is liable to tax at 25 per cent. The company is considering the purchase of a new computer system. The chief executive has been advised that it might be advantageous to lease the computer system rather than buy with a secured bank loan. The before-tax cost of a bank loan to ABC plc would be 12 per cent. Apart from the possible financial benefits that might arise, he has been told that leasing provides a hedge against obsolescence. The capital cost of the computer would be £50,000. The leasing company, which is not the supplier or manufacturer of the equipment, has offered what it considers to be very favourable terms for the lease of the computer. Payments would be £15,000 per annum for 5 years. The first payment would be made at the beginning of the lease contract. This would be followed by four further payments at the beginning of each of the next 4 years. Insurance and maintenance of the computer would be the responsibility of the lessee. At the end of year 5, the second-hand value of the computer is expected to be £5,000. The leasing company pays tax at the marginal rate of 33 per cent. Writing-down allowances are available on the computer at 25 per cent on a reducing balance basis. The company’s required rate of return on equity is 15 per cent and it considers this deal to be of about the average risk of its commercial ventures. The lessor will be able to finance the purchase of the computer from retained earnings. Requirements (a) Evaluate the financial decision concerning the lease from the point of view of both the lessee and the lessor. (8 marks) (b) Write a report to the chief executive of ABC plc explaining the purpose and conclusions of your evaluation. Include in your report an explanation of the claim that leasing provides a hedge against obsolescence. (9 marks) (c) The chief executive of ABC plc claims that the evaluation is basically a capital budgeting exercise and that the company’s weighted average cost of capital is a more appropriate rate to use as a discount rate. You are required to discuss the validity of the chief executive’s comments. (4 marks) (d) ABC plc decides to buy the computer system with a bank loan and notifies the leasing company of its decision. You are required to comment on what action the leasing company could take to try to persuade ABC plc to reconsider its position. (4 marks) (Total marks 25) 2006.1
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Question 22
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Question 24 AB and YZ both operate department stores in Europe. They operate in similar markets and are generally considered to be direct competitors. Both companies have had similar earnings records over the past ten years and have similar capital structures. The earnings and dividend record of the two companies over the past six years is as follows:
Year to 31 March
EPS cents
AB DPS cents
1999 2000 2001 2002 2003 2004
230 150 100 125 100 150
60 60 60 60 60 60
Average share price cents 2100 1500 1000 800 1000 1400
EPS cents
YZ DPS cents
240 160 90 110 90 145
96 64 36 0 36 58
Average share price cents 2200 1700 1400 908 1250 1700
Note: EPS Earnings per Share and DPS Dividends per Share
AB has had 25 million shares in issue for the past six years. YZ currently has 25 million shares in issue. At the beginning of 2003 YZ had a 1 for 4 rights issue. The EPS and DPS have been adjusted in the above table. The Chairman of AB is concerned that the share price of YZ is higher than his company’s, despite the fact that AB has recently earned more per share than YZ and frequently during the past six years has paid a higher dividend. Requirements (a) Discuss: (i) the apparent dividend policy followed by each company over the past 6 years and comment on the possible relationship of these policies to the companies’ market values and current share prices; and (ii) whether there is an optimal dividend policy for AB that might increase shareholder value. (12 marks) (b) Forecast earnings for AB for the year to 31 March 2005 are €40 million. At present, it has excess cash of €2.5 million and is considering a share repurchase in addition to maintaining last year’s dividend. The Chairman thinks this will have a number of benefits for the company, including a positive effect on the share price. Advise the Chairman of AB of ● ● ●
how a share repurchase may be arranged; the main reasons for a share repurchase; the potential problems of such an action, compared with a one-off extra dividend payment, and any possible effect on the share price of AB. (13 marks) (Total 25 marks)
A report format is not required for this question.
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RS Ltd is considering using a machine made by BC Ltd. The machine would cost £60,000 and at the end of a 4-year life is expected to have a resale value of £4,000, the money to be received in year 5. It would save £29,000 per year over the method that RS Ltd currently uses. RS Ltd expects to earn a DCF return of 20 per cent before tax on this type of investment. RS Ltd is currently earning good profits, but does not expect to have £60,000 available to spend on this machine over the next few years. It is subject to corporation tax at 35 per cent and receives capital allowances of 25 per cent on a reducing balance basis. You are required to: (a) recommend whether, from an economic viewpoint, RS Ltd should invest in the machine from BC Ltd; (5 marks) (b) calculate which of the following options RS Ltd would be financially better off to adopt: ● Option 1 – Buy the machine and borrow the £60,000 from the bank, repaying at the end of each year a standard annual amount that would comprise principal and interest at 20 per cent per annum; or Option 2 – Lease the machine for 4 years at an annual lease payment equal to the annual amount it would need to pay the bank under Option 1 above; (16 marks) (c) recommend, with explanations, which of the two options in (b) above RS Ltd should adopt, assuming that such a lease was available but that it would not give RS Ltd the right to acquire the machine at the end of the lease period. (4 marks) ●
Note: Assume that lease payments or loan repayments are made gross at the end of each year and that tax is paid and tax allowances received 1 year after those profits are earned. (Total marks 25)
Question 26 MRF is a charitable organisation and exempt from all taxes. It is about to acquire some new capital equipment for a special project. The president of the charity has been advised that it might be advantageous to acquire the equipment with a finance lease. The cost to the charity of the equipment, if it were purchased outright, would be £22.5 million. However, the leasing company would be able to negotiate a 20 per cent discount on this price because of its longterm commercial relationship with suppliers of the type of equipment being purchased. This discount would not be available to the charity if it purchased the equipment with a bank loan. The leasing company is nearing its year end and is keen to obtain the tax advantages denied to MRF because of its charitable status. It has therefore offered what it considers to be very favourable terms. Payments by MRF would be £7.5 million per annum for six years, payable at the end of each year of the lease contract. Writing-down allowances are available to the leasing company at 25 per cent on a reducing-balance basis. At the end of year 6, it is estimated that the second-hand value of the equipment would be £4 million. Insurance and maintenance would be the responsibility of the charity, whether it leases or purchases the equipment. The cost of a bank loan to the charity would be 12 per cent. The opportunity cost of capital for the leasing company would be 14 per cent. Assume no time lag in tax payments or refunds. You should work to two decimal places throughout. 2006.1
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Question 25
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Requirements (a) Assume you are MRF’s treasurer. Evaluate the financial aspects of the lease and recommend to the president whether the charity should purchase with a bank loan or use a finance lease. You should state the reasons for your recommendation and any assumptions you make in arriving at your decision. (8 marks) (b) Now assume that you are an account negotiator for the leasing company. You have been informed that MRF has decided to buy the equipment with a bank loan at 12 per cent interest. Your boss, Helen, has asked you to advise her whether the lease terms could be reduced so as to be competitive with the bank loan. The leasing company pays tax at the marginal rate of 33 per cent. Assume that the lease receipts from MRF are fully taxable. Requirement Write a short report advising Helen: ●
●
●
of the annual lease payments required for the charity to be indifferent between the bank and the leasing company; the effect on the leasing company’s evaluation if the lease payments were reduced to the amount calculated above (if you are unable to calculate a figure, assume £5m per annum); of other actions that the company could take to rescue the deal. Supporting calculations should be provided where appropriate. (12 marks) (Total marks 20)
Question 27 CBA Limited is a manufacturing company in the furniture trade. Its sales have risen sharply over the past 6 months as a result of an improvement in the economy and a strong housing market. The company is now showing signs of ‘overtrading’ and the financial manager, Ms Smith, is concerned about its liquidity. The company is 1 month from its year end. Estimated figures for the full 12 months of the current year and forecasts for next year, on present cash management policies, are shown below. Next year £000
Current year £000
Income account Revenue
5,200
4,200
Less : Cost of sales1 Operating expenses profit from operations Interest paid Profit before tax Tax payable Profit after tax Dividends declared
3,224 1,650 1,326 1,254 1,272 ,2305 0 967 387
2,520 1,500 1,180 1,148 1,132 ,1283 0 849 339
Current assets and liabilities as at the end of the year Inventory/work in progress Receivables Cash Trade creditors Other creditors (tax and dividends) Overdraft Net current assets/(liabilities)
625 750 0 464 692 ,2211 0 208
350 520 25 320 622 ,2620 0 (47)
225
175
Note: 1. Cost of sales includes depreciation of 2006.1
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Receivables Offer a 2 per cent discount to customers who pay within 10 days of despatch of invoices. It is estimated that 50 per cent of customers will take advantage of the new discount scheme. The other 50 per cent will continue to take the current average credit period. Trade creditors and inventory Reduce the number of suppliers currently being used and negotiate better terms with those that remain by introducing a ‘just-in-time’ policy. The aim will be to reduce the end-of-year forecast cost of sales (excluding depreciation) by 5 per cent and inventory/WIP levels by 10 per cent. However, the number of days’ credit taken by the company will have to fall to 30 days to help persuade suppliers to improve their prices. Other information ● All trade is on credit. Official terms of sale at present require payment within 30 days. Interest is not charged on late payments. ● All purchases are made on credit. ● Operating expenses will be £650,000 under either the existing or proposed policies. ● Interest payments would be £45,000 if the new policies are implemented. ● Capital expenditure of £550,000 is planned for next year. Requirements (a) Provide a cash-flow forecast for next year, assuming: (i) the company does not change its policies; (ii) the company’s proposals for managing debtors, creditors and stock are implemented. In both cases, assume a full 12-month period, that is the changes will be effective from day 1 of next year. (14 marks) (b) As assistant to Ms Smith, write a short report to her evaluating the proposed actions. Include comments on the factors, financial and non-financial, that the company should take into account before implementing the new policies. (6 marks) (Total marks 20)
Question 28 RH plc manufactures machine tools. It has 2 million ordinary £1 shares in issue, quoted at 168 pence each, and £1m 10 per cent secured debentures quoted at par. To finance expansion the directors of the company want to raise £1m for additional working capital. Cash flow from trading before interest and tax is currently £1m per annum. It is expected to rise to £1.3m per annum if the expansion programme goes ahead. To simplify placing a valuation on the company’s equity, you should assume that: ● ●
●
the forecast level of cash flow, and a tax rate of 33 per cent, will continue indefinitely; the required rate of return on the market value of equity, 18 per cent post-tax, will be unaffected by the new financing; there is no difference between taxable profits and cash flow.
The company’s directors are considering two forms of finance – equity via a rights issue at 15 per cent discount to current share price, or 12 per cent unsecured loan stock at par. 2006.1
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Ms Smith is considering methods of improving the cash position. A number of actions are being discussed:
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Requirements (a) Calculate for both financing options, the expected: (i) increase in the market value of equity; (ii) debt : debt equity ratio; (iii) weighted average cost of capital. (10 marks) (b) Assume you are the financial manager for RH plc. Write a report to the board advising which of the two types of financing is to be preferred. Include in your report brief comments on non-financial factors that should be considered by the directors before deciding how to raise the £1 million finance. (10 marks) (Total marks 20)
Question 29 Praktika plc has a capital structure consisting of 50 pence ordinary shares with a paid-up value of £45 million, and 14 per cent debentures to the face value of £40 million. The shares are currently trading at 400 pence, and the market price of the loan stock is £120 per £100 nominal. The company is concerned about the relatively high coupon rate it is committed to pay on the debentures, which still have several years to maturity. It is therefore proposed to make a 1- to-6 rights issue at a discount of 30 per cent to the current market price, and use the proceeds for part repayment of the debentures. Praktika’s annual after-tax earnings have regularly been in the region of £36 million for the last few years, and its P/E ratio is not expected to be materially affected by the change in gearing. The company pays corporation tax at the rate of 30%. Requirements (a) Using the information provided, numerically assess whether the rights issue would create value for Praktika’s shareholders, in the form of a share price that is higher than the theoretical ex-rights price. Comment upon your results. (8 marks) (b) Distinguish between a rights issue and a vendor consideration placing; to what extent does the latter encroach on shareholders’ pre-emptive rights? (5 marks) (c) Briefly describe the primary documentation necessary for a rights issue, and the nature of information that is required to be contained in it. (4 marks) (d) Briefly discuss the role of underwriting in rights issues. (3 marks) (Total marks 20)
Question 30 Perfect Design Ltd proposes to acquire a new piece of machinery costing £200,000. It would have a useful life of five years, at the end of which it could be sold for £30,000. The company is looking at the following financing alternatives that are available: (i) buy the machinery with a bank loan repayable over 5 years; (ii) lease it for 5 years at a lease rental of £45,000 payable at the end of each year; Perfect Design’s weighted average cost of capital is 18 per cent. The firm can borrow from its bank at 5.5 per cent over the base rate of 7.25 per cent per annum. Corporation 2006.1
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Requirements (a) Assess which of the two proposed methods of financing would be most beneficial for Perfect Design Ltd. (12 marks) (b) Explain the difference between a finance lease and a hire purchase contract, and describe how the financial evaluation of such a contract would be different from that of a finance lease. (4 marks) (Total marks 16)
Question 31 BST Motors plc (BST) is a long-established listed company. Its main business is the retailing of new and used motor cars and the provision of after-sales service. It has sales outlets in most of the major towns and cities in the UK. It also owns a substantial amount of land and property that it has acquired over the years, much of which it rents or leases on medium-long term agreements. Approximately 80% of its fixed asset value is land and buildings. The company has grown organically for the last few years but is now considering expanding by acquisition. The Chief Executive is not in favour of hostile bids as he believes the bidder always pays too much to acquire the target. Any acquisition that BST makes will therefore need to be an agreed bid. SM Limited (SM) owns a number of car showrooms in wealthy, semi-rural locations in the North of England. All of these showrooms operate the franchise of a well-known major motor manufacturer. SM is a long-established private company with the majority of shares owned by the founding family, many of whom still work for the company. The major shareholders are now considering selling the business if a suitable price can be agreed. The Managing Director of SM, who is a major shareholder, has approached BST to see if they would be interested in buying SM. He has implied that holders of up to 50% of SM’s shares might be willing to accept BST shares as part of the deal. The forecast earnings of BST for the next financial year are £35 million. According to the Managing Director of SM, his company’s earnings are expected to be £4 million for the next financial year. Financial statistics and other information on BST and SM are shown below: Shares in issue (millions) Earnings per share (pence) Dividend per share (pence) Share price (pence) Net asset value attributable to equity (£m) Debt ratio (outstanding debt as percentage of total market value of company) Forecast growth rate percentage (constant, annualised) Cost of equity
BST 25 112.5 50.6 1237 350 20
SM 1.5 153 100 n/a 45 0
4 9%
5 n/a
SM does not calculate a cost of equity, but the industry average for similar companies is 10% 2006.1
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tax is payable at the rate of 21 per cent, with a lag of 1 year. Capital allowances are available at 25 per cent on the written-down value of the machinery, and can be claimed from the year of purchase.
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Requirements Assume you are a financial manager working with BST. Advise the BST Board on the following issues in connection with a possible bid for SM: (i) Methods of valuation that might be appropriate and a range of valuations for SM within which BST should be prepared to negotiate. (10 marks) (ii) The financial factors relating to both companies that might affect the bid. (5 marks) (iii) The most appropriate form of funding the bid and the likely financial effects on BST. (5 marks) (iv) The advantages and disadvantages of growth by agreed acquisition as compared with growth by internal (or organic) investment. (5 marks) (Total 25 marks) A report format is not required for this question.
Question 32 The finance director of KM plc has recently reorganised the finance department following a number of years of growth within the business, which now includes a number of overseas operations. The company now has separate treasury and financial control departments. Requirements (a) Describe the main responsibilities of a treasury department, and comment on the advantages to KM plc of having separate treasury and financial control departments. (14 marks) (b) Identify the advantages and disadvantages of operating the treasury department as a profit centre rather than as a cost centre. (6 marks) (Total marks 20)
Question 33 The summarised balance sheet of D plc at 30 June 1999 was as follows: £000 Non-current assets Current assets Creditors falling due within 1 year Net current assets 9% debentures Ordinary share capital (25p shares) 7% preference shares (£1 shares) Share premium account Accumulated profits
£000 15,350
05,900 (2,600) 0 3,300 ((8,000) 10,650 2,000 1,000 01,100 ( 6,550 10,650
The current price of the ordinary shares is 135p ex-dividend. The dividend of 10p is payable during the next few days. The expected rate of growth of the dividend is 9 per cent per annum. The current price of the preference shares is 77p and the dividend has recently been paid. The debenture interest has also been paid recently and the debentures are currently trading at £80 per £100 nominal. Corporation tax is at the rate of 30 per cent. 2006.1
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Assume that D plc issued the debentures one year ago to finance a new investment. (c) Discuss the reasons why D plc may have issued debentures rather than preference shares to raise the required finance. (4 marks) (d) Explain what services a merchant bank may have provided to D plc in connection with the raising of this finance. (6 marks) (Total marks 20)
Question 34 (a) KB plc has a paid-up ordinary share capital of £1,500,000 represented by 6 million shares of 25p each. It has no loan capital. Earnings after tax in the most recent year were £1,200,000. The P/E ratio of the company is 12. The company is planning to make a large new investment which will cost £5,040,000, and is considering raising the necessary finance through a rights issue at 192p. Requirements (i) Calculate the current market price of KB plc’s ordinary shares. (2 marks) (ii) Calculate the theoretical ex-rights price, and state what factors in practice might invalidate your calculation. (6 marks) (iii) Briefly explain what is meant by a deep-discounted rights issue, identifying the main reasons why a company might raise finance by this method. (3 marks) (b) As an alternative to a rights issue KB plc might raise the £5,040,000 required by means of an issue of convertible loan stock at par, with a coupon rate of 6 per cent. The loan stock would be redeemable in 7 years’ time. Prior to redemption, the loan stock may be converted at a rate of 35 ordinary shares per £100 nominal loan stock. Requirements (i) Explain the term conversion premium and calculate the conversion premium at the date of issue implicit in the data given. (4 marks) (ii) Identify the advantages to KB plc of issuing convertible loan stock instead of the rights issue to raise the necessary finance. (5 marks) (Total marks 20)
Question 35 XYZ plc is a large company whose shares are listed on a major international stock exchange. It manufactures a variety of concrete and clay building materials. It has decided to replace 100 of its grinding machines with 100 of a new type of machine that has just been 2006.1
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Requirements (a) Calculate the gearing ratio for D plc using: (i) book values (ii) market values (4 marks) (b) Calculate the company’s weighted average cost of capital (WACC), using the respective market values as weighting factors. (6 marks)
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launched. The company is unable to issue any further equity and is therefore considering alternative methods of financing the new machines. The company’s accounting year end is 31 December. Option 1 – Issue debt to purchase the machines The machines are expected to cost $720,000 each on 31 December 2001 and on average are expected to have a useful economic life of 10 years. After this time, the company expects to scrap the machines, but it has no idea what proceeds would be generated from the sale. If XYZ plc issues debt, it would do so on 31 December 2001 for the full purchase price in order to finance the investment. The debt would be issued at a discount of 10 per cent on par value (that is, at $90 per $100 nominal) being redeemable at par on 31 December 2011 and carrying a coupon annual interest rate of 6 per cent. Debt interest is tax allowable and the corporation tax rate can be assumed to be 30 per cent (ignore any tax on the redemption). The debt would be secured by fixed and floating charges. Option 2 – Long-term lease The machines can be leased with equal annual rentals payable in arrears. The lease term would be 8 years, but this can be extended indefinitely at the option of the company at a nominal rent. The lease cannot be cancelled within the minimum lease term of 8 years. The company would need to pay its own maintenance costs. Option 3 – Short-term leases The machines can be leased using a series of separate annual contracts. Maintenance costs would be paid by the lessor under these contracts but, even so, the average lease rentals would be much higher than under Option 2. There is no obligation on either party to sign a new annual contract on the termination of the previous lease contract. Requirements (a) Calculate the after tax cost of debt at 31 December 2001 to be used in Option 1. (8 marks) (b) Explain whether the after tax cost of debt would be an appropriate discount rate for evaluating XYZ plc’s investment in grinding machines. (4 marks) Calculations are not required. (c) Write a memorandum to the directors of XYZ plc which discusses the factors that should be considered when deciding which of the three methods of financing the grinding machines is the most appropriate. (8 marks) (Total 20 marks)
Question 36 WEB plc operates a low-cost airline and is a listed company. By comparison to its major competitors it is relatively small, but it has expanded significantly in recent years. The shares are held mainly by large financial institutions. The following are extracts from WEB plc’s budgeted balance sheet at 31 May 2002: Ordinary shares of $1 Reserves 9% debentures 2005 (at nominal value)
2006.1
$ million 100 50 200 350
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New finance The company has now decided to purchase three additional aircraft at a cost of $10m each. The board has decided that the new aircraft will be financed in full by an 8 per cent bank loan on 1 June 2002. Requirements (a) Calculate the expected weighted average cost of capital of WEB plc at 31 May 2002. (8 marks) (b) Without further calculations, explain the impact of the new bank loan on WEB plc’s (i) cost of equity; (ii) cost of debt; (iii) weighted average cost of capital (using the traditional model). (8 marks) (c) Explain and distinguish (i) debentures; and (ii) a bank loan. In so doing, explain why, in the circumstances of WEB plc, the cost of debt may be different for the two types of security. (4 marks) (Total marks 20)
Question 37 COE plc is an all-equity financed, listed company in the pharmaceutical industry which produces a small, specialist range of drugs that treat heart disorders. The drugs are protected by international patent as soon as new research and development has progressed sufficiently. On 1 March 2002, following many years of testing, a new drug, kryothin, was given government approval in the UK. It was approved for use in most other countries during April and May 2002. Sales of kryothin will commence on 1 January 2003. The company’s accounting year end is 31 December. Including the earnings generated by sales of kryothin, the company could pay a total annual dividend of £32.2m in each of the years ending 31 December 2003 to 31 December 2007. Thereafter it is expected that competitors will develop similar drugs and most of the excess profits will disappear, in which case the company could pay a total annual dividend of £19m from 31 December 2008 onwards. (Assume for simplicity that dividends are declared and paid on 31 December each year.) In order to manufacture kryothin, it will be necessary to raise £80 million of new capital on 1 January 2003 to finance the purchase of equipment. 2006.1
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Dividends have grown in the past at 3 per cent a year, resulting in an expected dividend of $1 per share to be declared on 31 May 2002. (Assume for simplicity that the dividend will also be paid on this date.) Due to expansion, dividends are expected to grow at 4% a year from 1 June 2002 for the foreseeable future. The price per share is currently $10.40 ed div. and this is not expected to change before 31 May 2002. The existing debentures are due to be redeemed at par on 31 May 2005. The market value of these debentures at 1 June 2002 is expected to be $100.84 (ex interest) per $100 nominal. Interest is payable annually in arrears on 31 May and is allowable for tax purposes. The corporation tax rate for the foreseeable future is 30 per cent. Assume taxation is payable at the end of the year in which the taxable profits arise.
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The financing options being considered are: Option (1) An offer for sale at the market price per share on 1 January 2003. Option (2) An issue at par of 7 per cent irredeemable corporate bonds. In this case, the interest would reduce the amount otherwise available to pay dividends. The directors of COE plc assume that the annual cost of equity will remain at its current level of 10 per cent. The company currently has in issue a share capital of 20 million £1 ordinary shares. Requirements (a) Assuming a semi-strong efficient market, explain the nature and timing of the share price reaction to the new drug kryothin at each stage of its development. Calculations are not required. (7 marks) (b) Calculate COE plc’s price per share at 2 January 2003 under each of the following options for raising the £80 million of new finance: Option (1) an offer for sale Option (2) an issue at par of 7 per cent irredeemable corporate bonds Assume that the directors are correct in assuming that the annual cost of equity will remain at 10 per cent, and that financial markets believe the directors’ forecasts of future dividends. Ignore taxation. (13 marks) (Total marks 20)
Question 38 DDD plc runs a chain of twenty-six garden centres which sell plants, gardening implements and a range of other gardening products. It is listed on an international stock exchange and it has an accounting year end of 30 June. The company plans to open three new garden SuperCentres in 2004. Unlike existing stores, they will also sell garden furniture. Each of the three new stores will cost £6m to build and each will carry £3.5m of stocks. The following budgeted summary balance sheet at 30 June 2003 (which excludes the three new SuperCentres) was presented at a meeting of the board: Land and buildings Other non-current assets Inventory Receivables Cash Trade creditors Loans Share capital (£1 shares) Retained profits
£ million 26 13 16 1 1 (3) (24) 30 10 20 30
The balance sheet valuation for land and buildings reflects their current market values. Chief Executive ‘I believe that we should raise new equity to finance the new SuperCentres. Our share price has risen from £4 a year ago to £6 today. I believe that we should take advantage of this 2006.1
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Non-Executive Director ‘I am not keen on raising new external finance. We should use our retained profits of £20 million to finance most of the new land, buildings and stocks. To finance the remaining amount, we should sell the least profitable of our existing garden centres. This approach will save all the issue costs and all the uncertainty involved in raising new external finance.’ Finance Director ‘I am in favour of raising new debt to finance the expansion. The return on these new SuperCentres is bound to be greater than the cost of debt, so a profit is assured, and thus the risk is minimal.’ There are two alternatives: Alternative 1: Issue £30m of 7 per cent corporate bonds. These would be issued on 1 July 2003 at a 5 per cent discount and would be repayable on 30 June 2008 at their nominal value. Interest would be payable annually in arrears on 30 June each year. Alternative 2: Raise a bank loan of £28.5m on 1 July 2003. The interest rate would be 5 per cent per annum for the first 3 years and 10 per cent per annum for the following 3 years. The loan would be repayable on 30 June 2009. Interest would be payable annually in arrears on 30 June each year. Assume that interest paid can be relieved for tax at a rate of 30 per cent. Assume tax is payable at the end of the year in which the taxable profits arise and sufficient profits exist to set off all interest payments. Requirements (a) Calculate the after-tax cost of debt for each of the two alternatives. Briefly discuss any further factors that would need to be considered, other than the cost of debt, before choosing between these two alternatives. (11 marks) (b) Write a memorandum to the board, as a member of DDD plc’s treasury department, which discusses the financing options for expansion put forward at the board meeting. In so doing, evaluate the comments of the Directors. (14 marks) (Total marks 25)
Question 39 EQU plc is a listed company whose shares are mainly owned by large financial institutions. It currently owns and operates a theme park, called ‘Dragonland’, in the south west of England. It covers 5 square kilometres and contains various rides, gardens and attractions. Customers pay a single entrance fee. The company’s accounting year end is 31 July. The land is leased and the other fixed assets give poor security, so the company is all equity financed. The venture has been successful and although it was considered risky initially, it has now stabilised, with a constant stream of customers and steady turnover, profitability and cash flows. The Directors are now considering raising £8m new finance to be used in full to open a second theme park in Scotland, called ‘Phoenixworld’. 2006.1
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high share price and issue shares now in case the share price falls again. Moreover, our dividend yield is only 3 per cent – this is cheap finance at low risk.’
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The total dividend to be paid by the company on 31 July 2003 will be £1.2m. The company’s shares are already quoted ex dividend. The Board Meeting At a board meeting some concerns were expressed: The Chairman argued: ‘If we want to carry on growing, we need to expand to other sites. I admit that there may be some difficulties in the early years but, basically, Phoenixworld is the same type of business as we have now so the risk should be no different. Therefore the company’s cost of equity should not change from its current level, which I think should be about 12 per cent per annum. This seems appropriate for stable earnings such as ours. If we go ahead with Phoenixworld, I would expect us not to pay any more dividends after 31 July 2003 until 31 July 2006, at which time a total dividend of £2 million would be declared and this should then grow at 4 per cent per annum indefinitely.’ The Chief Executive disagreed: ‘Of course Phoenixworld would be more risky. This is a new venture with new capital investment and a different customer base. Earnings are therefore bound to be more volatile. This means that the cost of equity will be higher. I think the cost of equity for the company would rise to 15 per cent per annum if Phoenixworld goes ahead. Instead, we should stay at one site and invest £3m in new rides and facilities to expand and increase profitability and dividends. This will be a lower risk option and will therefore generate a more certain dividend stream. The company’s cost of equity should then stay at the current level of 12 per cent. If this option is taken, I would expect dividends to increase at 12 per cent per annum from the current level (at 31 July 2003) up to, and including, the dividend on 31 July 2007. I would expect dividends in all future years thereafter to be constant at this level as we will reach the capacity of our site by that time.’ Requirements (a) Using the dividend valuation model, calculate the total value of the share capital of EQU plc at 1 August 2003 if the Chairman’s proposal to open Phoenixworld is accepted. This calculation should be carried out for each of the following assumptions: (i) the Chairman’s assumption that the company’s annual cost of equity stays at 12 per cent; (ii) the Chief Executive’s assumption that the company’s annual cost of equity increases to 15 per cent. Comment on the differences in the two calculations. (10 marks) (b) Using the dividend valuation model, calculate the total value of the share capital of EQU plc at 1 August 2003 if the Chief Executive’s proposal to expand Dragonland is accepted. (4 marks) (c) Discuss the possible forms of financing the proposed new projects and assess which form of finance is likely to be most appropriate for EQU plc. Describe how each financing method, and each of the projects may affect the company’s cost of equity. (11 marks) 2006.1
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Question 40 CD Limited is a private company in a computer-related industry. It is based in India and has been trading for 6 years. It is managed by its main shareholders, who are the original founders of the company. Most of the employees are also shareholders, having been given shares as bonuses in 1999. None of the shareholders has attempted to sell shares in the company so the problem of placing a value on them has not arisen. Turnover last year, the 12 months to 31 December 2002, was 356 million Rupees. The table below shows earnings and dividends for CD Limited since its creation: Year 1997 1998 1999 2000 2001 2002
Earnings after tax Million Rupees Rupees per share 25 8.33 120 40.00 145 48.33 185 52.86 195 55.71 203 58.00
Dividend declared Rupees per share 0 20.0 24.2 26.4 27.8 26.3
Between 1997 and 1999 there were 3 million shares in issue. This was increased to 3.5 million by the issue of bonus shares at the end of 1999. The par value of the shares is 1 Rupee. The company is all-equity financed. The company pays tax at 30 per cent. Dividends declared in 1 year are paid the following year. In the current year (2003), earnings are likely to be slightly below 2002 at around 200 million Rupees. The company’s directors have decided to pay a maintained dividend for 2003. They are now evaluating investment opportunities that would require all the company’s free cash flow for 2003 plus borrowings of 150 million Rupees of undated debt. If the company does not borrow to invest, growth in earnings and dividends will be zero for the foreseeable future. If the company does borrow and invest, then it expects growth in earnings and dividends of 5 per cent in 2004 (from the 2003 base). The company’s expected post-tax cost of equity capital is estimated at 14 per cent per annum, assuming the borrowing takes place. Ignore the effects of inflation. Requirements (a) Discuss the relationship between dividend policy, investment policy and financing policy in the context of the scenario and recommend a course of action for the directors of CD Limited. (10 marks) (b) Calculate an estimated company value, share price and P/E ratio for CD Limited using Modigliani and Miller’s theory of capital structure, assuming the company does borrow and invest. (6 marks) (c) Discuss the relevance of the figures you have just calculated in answer to requirement (b) above in placing a value on (i) a small parcel of shares, for example the shareholding of one employee, and (ii) the entire company. (9 marks) Note: A report format is not required in answering this question.
(Total marks 25) 2006.1
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Ignore taxation. For simplicity, assume that dividends are declared and paid at each accounting year end. (Total marks 25)
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Question 41 (a) You are a newly appointed Finance Manager of an Educational Institution that is mainly government-funded, having moved from a similar post in a service company in the private sector. The objective, or mission statement, of this Institution is shown in its publicity material as: ‘To achieve recognized standards of excellence in the provision of teaching and research.’ The only financial performance measure evaluated by the government is that the Institution has to remain within cash limits. The cash allocation each year is determined by a range of non-financial measures such as the number of research publications the Institution’s staff have achieved and official ratings for teaching quality. However, almost 20 per cent of total cash generated by the Institution is now from the provision of courses and seminars to private sector companies, using either its own or its customers’ facilities. These customers are largely unconcerned about research ratings and teaching quality as they relate more to academic awards such as degrees. The Head of the Institution aims to increase the percentage of income coming from the private sector to 50 per cent over the next 5 years. She has asked you to advise on how the management team can evaluate progress towards achieving this aim as well as meeting the objective set by government for the activities it funds. Requirements Discuss the main issues that an institution such as this has to consider when setting objectives. Advise on ● whether a financial objective, or objectives, could or should be determined; and ● whether such objective(s) should be made public. (9 marks) (b) The following is a list of financial and non-financial performance measures that were in use in your previous company: Financial Value added Profitability Return on investment
Non-financial Customer satisfaction Competitive position Market share
Requirements Choose two of each type of measure, explain their purpose and advise on how they could be used by the Educational Institution over the next 5 years to assess how it is meeting the Head of the Institution’s aims. (16 marks) Note: A report format is not required in answering this question.
(Total marks 25)
Question 42 TDC Inc is a transport and distribution company listed on the New York Stock Exchange. On 14 November 2003, the directors made a bid for a competitor, UED plc that is based in the UK. UED plc’s directors are considering the bid but have indicated the terms are inadequate and would have to be improved if they were to feel able to recommend it to their shareholders. 2006.1
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TDC Inc
UED plc
Market data Common stock/share price as at today (18 November 2003) Common stock/share price on 18 October 2003 Common stock/shares in issue P/E ratio as at today
US$ 11.36 US$ 12.45 120 million 11
425 pence 305 pence 145 million 13.5
Accounting data Forecast profit after tax for the current financial year Net asset values at last balance sheet date (30 June 2003) Including cash balances of Debt outstanding (market value) [Repayable
US$ millions 98.5 825.2 125.5 250 2007
£ millions 45.5 230.5 65.2 75 2008]
Other information ● The average P/E for the industry is currently estimated as 10 in the UK and 13 in the USA. ● The average debt ratio for the industry internationally (long-term debt as proportion of total funding) is 15 per cent based on market values. ● TDC Inc’s cost of equity is 12 per cent net of tax. ● The US$/£ exchange rate is today 1.53. Terms of the bid TDC Inc’s directors have made an opening bid of one TDC Inc common stock for two UED plc shares. No cash alternative has been offered so far. Requirements Assume you are the Financial Manager with TDC Inc. Write an internal memorandum for the board that: (i) discusses how the recent price movements of the two companies’ shares might impact on the bid negotiations; (6 marks) (ii) recommends revised bid terms that might be acceptable to the directors and shareholders of UED plc and also to your own board. Your recommendation should be fully evaluated; (12 marks) (iii) evaluates the strategic implications of making a hostile bid compared with an aggressive investment programme of organic growth. (7 marks) (Total marks 25)
Question 43 PDQ plc is a software company and Internet provider that was established in the dot-com boom of the late 1990s. The three founding shareholders, who are still directors and managers of the company, own 30 per cent of PDQ plc. Employees, friends and relatives of the founders own a 2006.1
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The merger would create the fourth largest entity in the industry worldwide, but it would still be substantially smaller than the three largest entities. TDC Inc has suffered from slow growth over the past few years and has long been rumoured by market professionals to be a likely target of a hostile bid from one of the three larger entities, or even a reverse takeover by a smaller entity. The bid for UED plc is therefore being seen by the market as defensive.
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further 15 per cent. The majority 55 per cent shareholding is owned by a venture capital company that bought a stake in PDQ plc 4 years ago for £12m. The venture capital company now wishes to dispose of the holding. The 45 per cent minority shareholders and non-shareholding employees are considering a management buyout. PDQ plc has sustained losses for the past 3 years but believes it is now moving into profit. Because of these losses, no liability to tax will arise in 2004 but the company will begin to pay tax at 30 per cent per annum from 2005. It has not declared or paid a dividend since the company was formed. A summary of forecast key financial information for the current year and for 2004 is as follows: Profit and loss account for the year ended Turnover Direct costs and expenses Profit/(loss) before tax Balance sheet at Fixed assets (NBV) Current assets: Stock Debtors Cash and marketable securities
31 December 2004 £ million 15.25 12.50 ( 2.75
31 December 2003 £ million 14.52 16.97 ( 2.45)
0.50 1.25 4.25 0.50
0.50 1.25 3.25 0.00
6.00 Less Current liabilities: Trade creditors Bank overdraft
2.80 0.00
Total net assets Ordinary share capital (Ordinary shares of £1) Total reserves Equity shareholders’ funds
4.50 3.20 0.85
2.80 3.70
4.05 0.95
0.25 3.45 3.70
0.25 0.70 0.95
The directors expect growth of 20 per cent each year for the 3 years 2005–2007 inclusive, falling to 5 per cent each year after that. The average P/E ratio for established listed companies in the industry is currently 28.4 but there is a wide range of between 7.5 and 51.5. The average post-tax cost of equity capital for the industry, according to a recent study, is 15 per cent. Requirements Assume today is 31 December 2003. Advise the founders/employees on the following. (a) The price they might have to offer the venture capitalist to succeed with a management buyout. You should include in your discussion the various methods of share valuation that might be suitable in the circumstances. Make and state whatever assumptions you feel are necessary and appropriate. (18 marks) (b) The advantages and disadvantages of pursuing a management buyout at the present time compared with the possibility of a sale of the venture capitalist’s shareholding to another investor. (7 marks) Note: A report format is not required in answering this question.
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RZ is a privately owned textile manufacturer based in the UK with sales revenue in the last financial year of £68 million and earnings of £4.5 million. The directors of the company have been evaluating a cost saving project, which will require purchasing new machinery from the USA at a capital cost of $1.5 million. The directors expect the new machinery to have a life of at least 5 years and to provide cost savings (including capital allowances) of £240,000 after tax each year. Cash flows beyond 5 years are ignored by RZ in all its investment decisions. The discount rate that the company applies to investment decisions of this nature is its post-tax real cost of capital of 9% per annum. RZ at present has no debt in its capital structure. The directors, who are the major shareholders, would be prepared to finance the purchase of the new machinery via a rights issue but believe an all-equity capital structure fails to take advantage of the tax benefits of debt. They therefore propose to finance with one of the following methods: (i) Undated debt, raised in the UK and secured on the company’s assets. The current pre-tax rate of interest required by the market on corporate debt of this risk is 7% per annum. Interest payments would be made at the end of each year. (ii) A finance lease raised in the USA repayable over 5 years. The terms would be 5 annual payments of US$325,000 payable at the beginning of each year. The machinery could be bought by RZ from the finance company at the end of the five year lease contract for a nominal amount of $1. Assume the whole amount of each annual payment is tax deductible. (iii) An operating lease. No cost details are available at present.
Other information ● The company’s marginal tax rate is 30%. Tax is payable in the year in which the liability arises. ● Capital allowances are available at 25% reducing balance. ● If bought outright, the machinery is estimated to have a residual value in real cash flow terms, at the end of five years, of 10% of the original purchase price. ● The spot rate US$ to the £ is 1.58. ● Interest rates in the USA and UK are currently 2.5 and 3.5%, respectively. Requirements (a) Discuss the advisability of the investment and the advantages and disadvantages of financing with either (i) undated debt, (ii) a finance lease or (iii) an operating lease compared with new equity raised via a rights issue and comment on whether the choice of method of finance should affect the investment decision. Provide appropriate and relevant calculations and assumptions to support your discussion. (18 marks) (b) Discuss the benefits and potential problems of financing assets in the same currency as their purchase. (7 marks) (Total marks 25)
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Question 44
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Question 45 PCO plc operates in oil and related industries. Its shares are quoted on the London International Stock Exchange. In its retailing operations the company has concentrated on providing high quality service and facilities at its service stations rather than competing solely on the price of petrol. Approximately 75% of its Revenue and 60% of its profits are from petrol, the remainder coming from other services (car wash and retail sales from its convenience stores which are available at each service station). The company has been highly profitable in the past as a result of astute buying of petroleum products on the open market. The company does not enter into supplier agreements with the major oil companies except on very short-term deals. However, profit margins are now under increasing pressure as a result of intensifying competition and the cost of complying with environmental legislation. The managing director of the company is assessing a possible acquisition that would help the company increase the percentage of its non-petroleum revenue and profits. OT plc specialises in oil distribution from the depots owned by the major oil companies to their retail outlets. Its shares have been quoted on the UK Alternative Investment Market for the past 2 years. It operates a fleet of oil tankers, some owned and some leased. PCO plc has used its services in the past and knows it has an up to date and well-managed fleet. However, a bid for OT plc would almost certainly be hostile and, as the directors and their families own 40% of the shares, a successful bid is far from assured. Extracts from PCO plc’s Balance Sheet at 31 December 2003 Assets Employed Cash and marketable securities Accounts receivable and inventories
£m 105.00 95.00 3(75.00)
Less current liabilities Working capital Property, plant and equipment Less long term liabilities Secured loan stock 7% repayable 2009
125.00 160.00 3(80.00) 205.00
Shareholders’ equity Stated capital (Authorised £50 million) Issued Accumulated profits Net Assets Employed
40.00 165.00 205.00
PCO plc’s financial advisors have produced estimates of the expected NPV and the first full year post-acquisition earnings of PCO plc and OT plc:
PCO plc plus OT plc
Last year end Shares in issue (millions) Earnings per share (pence)
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Estimated post-acquisition earnings in first full year following acquisition £70 million
Estimated NPV of combined organisation £720 million
Summary financial statistics PCO plc OT plc 31 December 2003 31 December 2003 40 106
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Dividend per share (pence) Share price (pence) Book value of non-current assets and current assets less current liabilities (£ million) Debt ratio (outstanding debt as % of total market value) Forecast growth rate % (constant, annualised) Beta coefficient
Summary financial statistics PCO plc OT plc 32 21 967 1020
285
145
17.0
14.0
5 0.9
9 1.2
545
Requirements (a) Calculate, for PCO plc and OT plc before the acquisition: (i) The current market value and P/E ratio. (ii) The cost of equity using the CAPM, assuming the return on the market is 8% and the return on the risk free asset is 4%. (iii) The prospective share price and market value using the dividend valuation model. (6 marks) (b) Discuss and advise on the following issues: (i) The price to be offered to the target company’s shareholders. You should recommend a range of terms within which PCO plc should be prepared to negotiate. (ii) The most appropriate form of funding the bid and the financial effects (assume cash or share exchange are the options). (iii) The business implications (effect on existing operation, growth prospects, risk and so on). (19 marks) Marks are split roughly equally between sections of part (b) of the question. (Total marks 25)
Question 46 When determining the financial objectives of a company, it is necessary to take three types of policy decision into account: investment policy, financing policy and dividend policy. Requirements (a) Discuss the nature of these three types of decision, commenting on how they are inter-related and how they might affect the value of the firm (that is the present value of projected cash flows). (12 marks) (b) Describe the different functions of the treasury and financial control departments of an organisation and comment on the relative contributions of these two departments to policy determination and the setting and achievement of financial objectives. (13 marks) (Total marks 25) 2006.1
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Question 47 BiOs Limited (BiOs) is an unquoted company that provides consultancy services to the biotechnology industry. It has been trading for 4 years. It has an excellent reputation for providing innovative and technologically advanced solutions to clients’ problems. The company employs 18 consultants plus a number of self employed contract staff and is planning to recruit additional consultants to handle a large new contract. The company ‘outsources’ most administrative and accounting functions. A problem is recruiting well-qualified experienced consultants and BiOs has had to turn down work in the past because of lack of appropriate staff. The company’s two owners/directors have been approached by the marketing department of an investment bank and asked if they have considered using venture capital financing to expand the business. No detailed proposal has been made but the bank has implied that a venture capital company would require a substantial percentage of the equity in return for a large injection of capital. The venture capitalist would want to exit from the investment in 4–5 years’ time. The company is all-equity financed and neither of the directors is wholly convinced that such a large injection of capital is appropriate for the company at the present time. Financial information Revenue in year to 31 December 2003 Shares in issue (ordinary £1 shares) Earnings per share Dividend per share Net asset value
£3,600,000 100,000 756p 0 £395,0001
Note : 1. The net assets of BiOs are the net book values of purchased and/or leased buildings, equipment and vehicles plus net working capital. The book valuations are considered to reflect current realisable values. Forecast ● Sales revenue for the year to 31 December 2004 – £4,250,000. This is heavily dependent on whether or not the company obtains the new contract. ● Operating costs, inclusive of depreciation, are expected to average 50% of revenue in the year to 31 December 2004. ● Tax is expected to be payable at 30%. ● Assume book depreciation equals capital allowances for tax purposes. Also assume, for simplicity, that profit after tax equals cash flow. Growth in earnings in the years to 31 December 2005 and 2006 is expected to be 30% per annum, falling to 10% per annum after that. This assumes that no new long-term capital is raised. If the firm is to grow at a faster rate then new financing will be needed. This is a niche market and there are relatively few listed companies doing precisely what BiOs does. However, if the definition of the industry is broadened the following figures are relevant: P/E ratios Industry Average: Range (individual companies) Cost of equity Industry average Individual companies
BiOs does not know what its cost of equity is. 2006.1
18 12–90 12% Not available
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Question 48 XTA plc is the parent company of a transport and distribution group based in the United Kingdom (UK). The group owns and operates a network of distribution centres and a fleet of trucks (large delivery vehicles) in the UK. It is currently planning to expand into Continental Europe, operating through a new subsidiary company in Germany. The subsidiary will purchase distribution centres in Germany and invest in a new fleet of trucks to be based at those centres. The German subsidiary will be operationally independent of the UK parent. Alternative proposals have been put forward by Messrs A, B and C, Board members of XTA plc on how best to structure the financing of the new German operation as follows: Mr A: “I would feel much more comfortable if we were to borrow in our base currency, sterling, where we already have long-standing banking relationships and a good reputation in the capital markets. Surely it would be much more complicated for us to borrow in euros?” Mr B: “I am concerned about the exposure of our consolidated balance sheet and investor ratios to sterling/euro exchange rate movements. How will we be able to explain large fluctuations to our shareholders? If we were to raise long-term euro borrowings, wouldn’t this avoid exchange rate risk altogether? We would also benefit from euro interest rates which have been historically lower than sterling rates.” Mr C: “We know from our market research that we will be facing stiff competition in Germany from local distribution companies. This is a high-risk project with a lot of capital at stake and we should finance this new venture by XTA plc raising new equity finance to reflect this high risk.” Assume that today is Saturday 1 October 2005. A summary of the latest forecast consolidated balance sheet for the XTA Group at 31 December 2005 is given below. It has been prepared BEFORE taking into account the proposed German investment: £m Assets Total assets Equity and liabilities Equity Long-term borrowings (there were no other non-current liabilities) Current liabilities Total equity and liabilities
450 250 150 050 450
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Requirements (a) Calculate a range of values for the company that could be used in negotiation with a venture capitalist, using whatever information is currently available and relevant. Make and state whatever assumptions you think are necessary. Explain, briefly, the relevance of each method to a company such as BiOs. (15 marks) (b) Discuss the advantages and disadvantages of using either venture capital financing to assist with expansion or alternatively a flotation on the stock market in 2–3 years’ time. Include in your discussion likely exit routes for the venture capital company. (10 marks) (Total marks 25)
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The proposed investment in Germany is scheduled for the final quarter of 2005 at a cost of £60m for the distribution centres and £20m for the fleet of trucks when translated from euros at today’s exchange rate of £1 €1.50. There is a possibility that the euro could weaken against sterling to £1 €2.00 by 31 December 2005, but it can be assumed that this will not occur until after the investment has been made. The subsidiary’s balance sheet at 31 December 2005 will only contain the new distribution centres and fleet of trucks matched by an equal equity investment by XTA plc and will only become operationally active from 1 January 2006.
Requirements (a) Write a memorandum to the Board of XTA plc to explain the advantages and disadvantages of using each of the following sources of finance: • a rights issue versus a placing (assuming UK equity finance is chosen to fund the new German subsidiary); and • a euro bank loan versus a euro-denominated eurobond (assuming euro borrowings are chosen). (8 marks) (b) Evaluate EACH of the alternative proposals of Messrs A, B and C for financing the new German subsidiary and recommend the most appropriate form of financing for the group. Support your discussion of each proposal with • a summary forecast consolidated balance sheet for the XTA group at 31 December 2005 incorporating the new investment; and • calculations of gearing using book values using year end exchange rates of both £1 €1.50 and £1 €2.00. (17 marks) (Total for question two 25 marks)
Question 49 GSD Ltd is a private UK company owned by the two families that started the business in 2000. The company produces organic food products for distribution in the domestic UK market using food products from UK farms. The company is experiencing a period of rapid growth, with revenue expected to rise by 15% in each of the following five years. The company is hoping to retain a profit margin (profit before interest and taxes divided by revenue) of 30% throughout the next five years. The ratio of working capital to revenue is expected to remain constant, where working capital is inventories plus trade receivables less trade payables. Interest is paid on the overdraft and bank loan at 6% per annum. Interest on the bank loan and overdraft is calculated on the balance outstanding at the beginning of the year. Corporation tax is paid one year in arrears at a rate of 30%, with a 100% tax allowance for capital expenditure in the year in which it is incurred. In arriving at operating profit, depreciation is charged at 25% on a reducing balance basis based on year-end balances.
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Balance sheet as at 31 December 2004 Property, plant and equipment Working capital Share capital (50p ordinary) Retained earnings Long-term borrowings (bank loan) Short-term borrowings (overdraft) Current tax payable Income statement for the year ended 31 December 2004 Revenue Profit before interest and taxes Dividend paid in 2004
£m 15 009 24 10 4 8 1 01 24 45.0 13.5 50p a share
Capital expenditure plans are for expenditure on property, plant and equipment of £10m in 2005, £10m in 2006 and £7m in each of years 2007 to 2009. No disposals of property, plant and equipment are expected in this period. Shareholders expect a year-on-year increase in dividends of 5%. Any funds deficit in the year will be funded by overdraft and any surplus funds used to reduce the overdraft. However, with the increased demands on the funds of the business to finance growth, the directors are concerned that they may exceed the overdraft limit of £1.5m. They may, therefore, need to negotiate an increase in the bank loan, although the bank has indicated that it would not accept gearing higher than 70% based on book values where gearing is defined as long and short term borrowings (including overdraft) divided by equity. The shareholders have indicated that they do not wish to inject any additional capital into the business. Requirements (a) Construct the balance sheet, income statement and a cash flow analysis of the company for each of the years 2005 and 2006 and advise the company on the extent of any additional funding requirement in that period. In your answer, round figures to the nearest £100,000. (16 marks) (b) Discuss the interrelationships between financing, investment and dividend strategies with reference to the liquidity requirements of GSD Ltd. Include in your discussion how each could be adapted to meet the company’s liquidity requirements in the years 2005 and 2006 and provide a recommendation. (9 marks) (Total for question three 25 marks)
Question 50 FLG inc is an airline operator based in the United States, operating a wide network of both domestic and international flights. It has recently obtained a new licence to operate direct flights to a new European destination which will necessitate the acquisition of four identical second-hand aeroplanes at a total cost of $100 million. The aeroplanes are expected to be in service for five years and each one is expected to have a residual value of $12.5 million at the
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Extracts from the management accounts of GSD Ltd on 31 December 2004 are as follows:
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end of the five years. However, the residual value is highly dependent on the state of the airline industry at the end of the five-year period and there is a risk that the residual value could be much lower if there is a general reduction in air travel at that time. The company has been offered a lease contract with total lease payments of $15 million per annum for five years, payable in advance, with all maintenance costs being borne by the lessee. Alternatively, the aeroplanes could be purchased outright and the bank has offered the company a five-year loan with variable interest payments payable semi-annually six months in arrears at a margin of 1% per annum above a reference six-month $ inter-bank rate. The reference six-month $ inter-bank rate is forecast to be at a flat rate of 2.4% for each sixmonth period, for the duration of the loan. The company pays tax at 30% and expects to make taxable profits in excess of the lease payments, interest charges and tax depreciation allowances arising over the next five years. Tax depreciation on the purchase of the aeroplanes can be claimed at a rate of 20% at the end of each financial year on a written-down value basis, with a delay of one year between the tax depreciation allowance arising and the deduction from tax paid. Requirements (a) Calculate: (i) the compound annualised post-tax cost of debt; (ii) the NPV of the lease versus purchase decision at discount rates of both 4% and 5%; (iii) the breakeven post-tax cost of debt at which FLG Inc is indifferent between leasing and purchasing the aeroplanes. (10 marks) (b) Recommend, with reasons, whether FLG Inc should purchase with a loan or lease the aeroplanes. Your answer should include appropriate calculations of the sensitivity of the lease versus purchase decision to changes in EACH of the following: • the reference $ inter-bank rate for the duration of the loan; • the residual value of the aeroplanes. (15 marks) (Total for question four 25 marks)
Question 51 CTC Technology College (CTC) is a non-profit making institution located in Ireland, where the national currency is the euro. The college is funded by a combination of student fees and government grants. The number of students enrolled on the part-time Information Technology course at CTC has fallen over recent years due to competition from other colleges and the wide range of different courses available. The number of students enrolling on the current course, ITS (IT Skills) has stabilised at around 150 students per annum and there are currently 20 computers surplus to requirements which CTC plans to sell for an estimated €100 each; the current book value of each computer is €200. However, this sale will not occur if the college goes ahead with its plan to replace the current ITS course with an updated course, as it is expected that a new course would result in a significant increase in student numbers. CTC realises that the financial viability of switching courses is highly dependent on the number of students that the college can attract onto the new course and has commissioned some 2006.1
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Other relevant data is as follows: Fee for the course (per student, payable in advance) Directly attributable course costs (per annum, payable in arrears) Books and consumables per student, payable in advance Apportionment of college overheads (excluding staff costs) (per annum, charged at the end of the year) Staff training and course development (initial set-up cost)
ITS € 350 1,000 50
ITC € 360 2,000 60
20,000 0
25,000 30,000
The planning horizon for the college is four years and projects are evaluated using a discount rate of 8% and on the basis of a zero terminal value at the end of the four-year period. Each course is of one year duration and student enrolments should be assumed to remain constant throughout the four-year period, with ITS attracting 150 students each year. Taxation and inflation should be ignored. Requirements (a) Evaluate the number of student enrolments required on the ITC course in order for it to be financially beneficial, on a net present value of cash flow basis, for the college to replace the ITS course with the ITC course. (15 marks) (b) Advise the governing body of the college on the following issues: (i) How to monitor and control the costs and revenues of the project from the decision to introduce the new course to the start date of the course; (5 marks) (ii) Options available if only 150 students enrol on the new ITC course by the enrolment deadline two weeks before the beginning of the course by which time all other course preparations will have been completed. (5 marks) (Total for question five 25 marks) (Total for section B 50 marks)
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market research, at a cost of €10,000, into the best course content and likely increase in student numbers. The results of this research indicate that an ITC (IT Competence) course would be the most popular and lead to a significant increase in student enrolments at the college. It is also estimated that there could be an additional benefit to the college of average net revenues of €20 per additional student over and above 150 as a result of those students being attracted to the college and taking other courses at the college at the same time as the ITC course. The new ITC course would be run by existing staff currently working on the ITS course at a cost of €50,000 per annum. If, however, the numbers of students on ITC were to rise above 200 per annum, an additional part-time member of staff would be needed at a cost of €10,000 per annum, payable in advance. If ITC is adopted, several computers would need to be upgraded at a total one-off cost of €15,000.
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Solution 1 ●
This question deals with corporate objectives and planning. It tests for an ability to think beyond shareholder wealth maximisation and the difficulties in setting other objectives. It also tests for an understanding of the arguments for and against different remuneration policies for a company’s senior employees. Report To: From: Date: Subject:
Managing director Finance director Company objective(s) ahead of board meeting
(a) (i) Maximisation of shareholder wealth It has been argued that shareholders’ wealth, by which we mean the net present value of estimated future cash flows, is the only true objective of the firm. Jensen in particular has argued that the interests of shareholders, as owners of the firm, are paramount. However, this is an extreme view, and many companies now establish objectives which aim to maximise shareholder wealth while recognising the constraints, legally enforceable or voluntary, imposed by society. Other points that you might like to consider include the following: ● Separation of ownership and control, and the subsequent identification of the agency problem and the costs associated with it. ● Theories of objectives of the firm (e.g. Smith, Friedman, Jensen), and management behaviour (Baumol, Morris, Williamson, Cyert and March, Simon). ● The market for corporate control: the suggestion that the takeover mechanism now acts as proxy for shareholder control. ● Social responsibilities which act as constraints on unmitigated pursuit of wealth maximisation. (ii) Alternatives Cash-flow generation Economists, and many accountants, believe that cash flow is the main criterion to judge a company’s performance. Cash is a fact, whereas profit can be manipulated by accounting policies. Companies have in fact gone out of business because of lack of funds, even though they were profitable. In reality, shareholder wealth is 553
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based on the present value of future cash flows. A change in accounting policies should have no influence on share prices, other than possible ‘signalling’ effects.
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Profitability as measured by profits after tax and return on investment There are many problems with accounting ratios as measures of performance. For example: ● they are historical and backward-looking; ● they are subject to manipulation; ● a variety of policies are available, even within the rules – they do not reflect risk; ● tax can be affected by many factors outside control of management. Advantages include the fact that it is a concept well understood even by nonaccountants, and recognised guidelines are available in the form of accounting concepts and standards, etc. Also, profitability is expected by shareholders. Risk-adjusted returns The main disadvantage of risk-adjusted returns are: ● they are not well understood by small shareholders; ● they are subject to influences of general market factors; ● risk is often difficult to measure. The main advantages are that there is general agreement that returns and risk are related and, for listed companies at least, betas are published. Other measures These are really constraints on a company’s profitability, but they may be essential to stay in business, for example to obtain customer satisfaction. Also, they may have a favourable impact on getting business, especially with government or public sector customers. Some issues, for example protection of the environment, may be covered by legislation. Disadvantages are that cost : benefit may be difficult to quantify. Signed: Finance director (b) The appropriate remuneration policy is going to depend on the coping systems of the senior managers concerned. Some need frequent ‘fixes’, that is, short-term bonuses, to persuade them to do the job for which they are employed: others are irritated by such schemes, preferring predetermined arrangements. Specifically: ● the argument for a high basic salary is that of clarity of the contract between employer and employee: a fair day’s work for a fair day’s pay. The employee is clear as to what his take-home pay will be and the employer is clear as to his costs. Some employers, however, see a disadvantage in that the results are nevertheless uncertain, that is, the cost per unit of output, or as a percentage of sales, is unpredictable. ● A low basic salary plus a bonus based on profit is the antidote to the problem alluded to at the end of the previous paragraph: if profit is below expectations, then employment costs will also be below expectations (though not proportionately, of course). The disadvantage stems from the uncertainty thereby imposed on the employee – not knowing what his income will be (not least because profit is affected by many extraneous factors) – and this may well affect his performance. Depending on the individual, the effect may be favourable or adverse. It could be argued that a team bonus, such as this, encourages teamworking. 2006.1
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●
A low basic salary plus share options. The advantage to the employer is that there is no cost, in accounting terms, equivalent to the value derived by the employee. Shareholders bear the cost, in the sense that part of the cash flows which would otherwise be attributable to them is pre-empted to the beneficiaries of the scheme. It is often argued that the schemes harmonise the interests of the senior managers with those of the shareholders at large, but this is not so. Loyal shareholders are indifferent to the share price, and prospective buyers want it to be low; only those who intend to sell seek the highest price. This is bad corporate governance, especially when directors control the information supplied to the market, and can therefore influence the share price at a point in time. From the managers’ point of view, the reward is remote and subject to major influences outside their control. Institutional investors in the UK are agitating for more conditions to be attached to the granting of executive options (e.g. performance targets to be met before the options become exercisable), but this will not be easy. In all these cases, governments may load the dice, e.g. in the UK, profit-related pay and share option schemes enjoy tax benefits, which make them attractive beyond the underlying economics.
Solution 2 ●
This question combines an understanding of the theoretical and practical differences among the various methods of investment appraisal, with knowledge of regulatory activity.
(a) Report To: Managing director From: Financial manager Date: Subject: Investment criteria The IRR technique does not assume a ‘correct’ discount rate before the IRR can be calculated; it does assume that all cash flows are reinvested at the IRR. Its practical advantages are that: ●
●
the method and its interpretation are easier to explain to, and be understood by, nonfinancial managers; the ranking of different projects is on a single criterion – the IRR. It is not complicated by different risk characteristics, which might be the case with projects ranked on NPV using project-specific risk-adjusted discount rates.
It is, of course, also necessary in any discussion of investment appraisal techniques to consider the disadvantages of the various techniques. In the case of IRR, these are often expressed as the inability to consider the order of magnitude of competing projects and the possibility of multiple solutions. The first objection can be overcome by a commonsense approach and the second is a technical issue of little practical significance. Multiple methods usually combine a ‘theoretically’ sound method, such as NPV or IRR, with a ‘user-friendly’ one such as payback or ARR. The most common multiple method is probably NPV plus payback. The advantage of payback in isolation is that it 2006.1
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is simple to use and understand and may be used as an initial screening device and with other methods. The disadvantages with payback are that: ● it ignores timing of cash flows; ● it ignores cash flows after the payback cut-off point; ● the selection of payback period is often arbitrary; ● it is not a measure of profitability. The disadvantage of ARR is that it is biased against project acceptance because it uses accounting profit, not cash flows. It also ignores the timing of profit. Profit and capital employed can be manipulated and the selection of target rate of return may be arbitrary. The main reason for its popularity is its familiarity to managers. Signed: Financial manager (b) The regulator will be keen to ensure that the monopoly does not make excess profits earned as a result of its position. He/she will consider: ●
●
●
An appropriate rate of return on investment, usually using the accounting rate of return. This will take into account the nature of the industry and comparative statistics from non-monopoly suppliers in related areas. The possibility of cross-subsidy between activities of the business. To enforce this it will be necessary to require the company to make available to the regulator separate accounts for separate businesses. An appropriate formula for determining price increases. In the UK a much-used formula has been (RPI x), which means that the monopoly is allowed to increase prices by the rate of inflation as measured by RPI less x, which is an efficiency factor agreed between monopoly and regulator (or, as has been the case, imposed by the regulator).
An alterative method is to cap the accounting rate of return on capital employed. With this method the regulator will be especially concerned about the split between regulated and non-regulated businesses in the same company to prevent the crosssubsidies referred to above. Additional activities include: ●
●
●
The promotion of social and macroeconomic objectives. Social objectives cover a variety of possible government objectives, including the availability and affordability of services in particular areas and to particular groups such as the disabled or customers in rural areas. The promotion of competition. The first step in designing effective regulations to promote competition is to identify where potential barriers to entry might exist and their relative importance. Once the market segments in which there is scope for competition have been identified, steps will need to be taken to assist its development. Overseeing technical regulations to ensure the safety of the industry. This is not, strictly, the function of a regulator but it has implications for pricing and competition.
Some industries which were once monopolies are now competitive – for example, telecommunications in the UK. However, the former monopoly usually still has a substantial market share which can make it a monopoly in all but name. It may also have ownership of infrastructure to which new entrants have to buy access. The regulator will still be needed to ensure that new entrants are allowed to compete on fair terms. 2006.1
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(a) The most significant effect of inflation on the return on capital employed ( ROCE) figures relates to the use of book values for the fixed assets. A book value is the original cost of the fixed asset less a charge for depreciation, that is, the wearing out or other loss of value from use, effluxion of time or technological change. Where there is steady inflation, as given in the example of 10 per cent each year, the ROCE is distorted in two ways: ● the depreciated original cost may not represent a realistic current value of the asset in use, and ● the annual depreciation charge may not represent a realistic charge against the current year’s profit. So the ROCE may be distorted by the profit being overstated and the capital employed understated. Both ‘errors’ serve to give a higher ROCE. The older the fixed assets the larger will be the distortion. Sector HE has the major investment in fixed assets. Assuming that these are all some years old but have been maintained in good order, then HE would have a much lower charge for depreciation than competitors with newer equipment. They could then either charge lower prices or make higher profits. In addition, the resulting profit would be evaluated against a much lower asset base. Sector LE with fewer fixed assets will have the same favourable position, but on a reduced scale. Sector CS with possibly assets only of office accommodation and office furniture will be less affected. In fact some office space may be rented. Most current leases have regular rent revision clauses. So CS may have charges almost on a current basis. In addition, the current assets of HE and LE are likely to include stocks of raw materials and work-in-progress. Under the historical accounting convention these will be charged at a price based on cost at the time of purchase. The replacement cost will be at a higher rate – say at least 10 per cent increase. Similar problems occur in maintaining the monetary working capital – mainly comprising sundry debtors less sundry creditors – at the same comparative level. HE’s results are therefore distorted more than LE’s, while CS’s results are probably not distorted at all. Without major adjustment to the relevant figures it is not possible to compare the results of the three divisions with any degree of confidence. (b) ROCE is basically a measure of the profit generated as a percentage of sales and the productivity of the capital employed in terms of its usage in achieving the sales. It is calculated as: Profit 100 Capital employed and analysed to: Sales Profit Sales Capital employed On this basis: CS HE LE
25.6% 5.7 146% 17.0% 1.1 19% 12.5% 2.1 26% 2006.1
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Solution 3
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So the ROCE shows clearly that CS achieved much the best profit margin at 25.6 per cent – over twice that of LE. In the same way, the sales generated by CS were nearly six times the capital employed. However, HE sales and capital employed were very nearly the same. From this information it can be seen that CS was achieving both a high profit margin and making a more intensive use of the assets employed. It was doing this in a situation where most costs and sales were likely to be at a near current cost. In contrast, HE and LE appear to have some considerable advantages in using book values in a period of significant inflation, but produced poorer results. For residual income (RI) the trading profit, based on the same historical cost basis, is reduced by a group financing charge, in this case 12 per cent per annum of the capital employed. The RI calculation puts HE in the favourable position of producing a ‘surplus’ of £395,000 compared with CS £202,000 and LE £129,000. RI is intended to give an absolute measure of profit achieved after allowing for financing charges, whereas ROCE uses the basic profit as a relative measure. However, both measures suffer from a number of defects. Both are vulnerable to inflation and both will move throughout a firm’s plant replacement cycle. Both are subjective measures which are strongly influenced by the choice of accounting policies. Neither is a reliable performance indicator. In the present context both are of marginal use, although ROCE is probably more relevant since it is a relative measure which allows the performance of capital invested in different sectors to be compared. A consultancy practice will have a high ROCE since it has few ‘book’ assets. The price paid for a consultancy practice will be some multiple of earnings – and the relevant measure of its performance would be the ‘internal rate of return’ associated with the purchase price rather than some ROCE figure. To put it another way, the major assets of a consultancy practice are intangible ones such as ‘goodwill’. Such assets have to be paid for when a consultancy practice is purchased. In this case a ROCE which excludes intangibles from the sector’s asset base is meaningless. (c) The CS sector is advocated by the team as a priority for profitable expansion because of its high ROCE. However, future success would depend on the elasticity of demand for its services outside the group. A steady addition of new staff could be employed as work was obtained. Existing office facilities could possibly be used for an initial expansion. This would involve tendering for work in the same or similar fields of activity. The purchase of another established consultancy practice would need considerable investigation. If it is a profitable concern, then the purchase price is likely to be very high. It may be based on a number of years’ profits. It would not show much return in the early years unless investigation shows that there is substantial room for efficiency improvements by better methods, offering complementary services to the present work, combining both consultancies with cost savings in administration, etc. Whether the purchase should be done by divestment of existing assets in the other two sectors would need detailed study and a full investment appraisal. This would use discounted cash flow (DCF) methods and produce different results from those shown by the historical cost accounting records. As indicated in parts (a) and (b), HE and LE appear to receive advantage on a historical basis compared with a current cost approach. They might be ripe for divestment,
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Solution 4 (a) Report To: Shareholders of COR Ltd From: Management accountant Date: Subject: Solving the company’s pollution problems I have evaluated two options proposed to combat our company’s pollution problem. Option 1 involves fitting a filter unit to the process at the works, which will completely eliminate the noxious emissions. Over a 10-year time horizon this option has a present value cost of some £2.7m. Option 2 tries to resolve the immediate problems by increasing the compensation payments that we pay and by establishing a wildlife sanctuary near to the works. Over the same 10-year time horizon this option has a present value cost of £2.2m. However, I am unhappy in recommending option 2 on the simple grounds that it has a lower net present cost. Option 1 solves the problem, whereas option 2 tries to treat the symptoms while leaving the problem unsolved. It is possible that new European legislation may be brought in in the future, forcing us to reduce our noxious emissions, so option 1 would have to be introduced. It is also possible that the problem will get worse as the plant gets older, so that the pressure will increase on us to take root and branch action rather than to make appeasement payments. I recommend that we should adopt option 1 now and fit the filter unit. We can trumpet this as proof of our ‘green’ credentials as a company, which will raise the morale of the workforce as they know that their health and the health of their families is no longer at risk from the emissions. I would be pleased to discuss this matter with you further at your earliest convenience once you have thought the matter through. Signed: Management Accountant
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but in an appraisal, unforeseen complications may arise. For example, there is some inter-sector trading. How are the transfer prices for this work established? Can services of the same quality be bought from outsiders for the same price? Additional information I would find helpful in reviewing expansion plans would be, for each sector: ● future sales prospects with existing facilities; ● percentage of the market held by each product; ● chief competitors with their current financial results and any known expansion plans; ● value of assets at current prices and their disposal values; ● restated profits on a current cost basis; ● dependence on inter-sector trading; ● method of establishing inter-sector transfer prices; ● current cost returns on all separable existing business activities, listed in profitability order; ● advice on any new products visualised by current research and development; ● possibility of key personnel in an acquired consultancy transferring with the purchase.
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Working Option 1: Fitting of a filter unit Note 1 2 3 4 5 6
Cash flow £000 (2,200) 1,100) (789) (163) 130) (see note)
Time 0 0 0 1–8 1–10 1–10
Discount factor @ 12% 1.000 1.000 1.000 4.968 5.650 –
Present value £000 (2,200) 1,100) (789) (810) 735) 2,(761) (2,725)
The net present value of option 1 is £2.725m. Notes 1. Capital cost of the filter at time 0 £2.2m 2. Loan received from AES 50% £2.2m £1.1m 3. Loss of profit from one month’s closedown is as follows: Annual output 0.95m $40 $38m Annual input 1m $20 $20m Therefore annual contribution $18m One month’s loss of contribution in 1992 1/12 $18m 1.9 £789,000 4. Loan repayments will be made on an annuity basis to repay £1.1m over years 1–8 at a 4 per cent interest rate. From tables, the cumulative discount transfer for 8 years at 4 per cent is 6.73, so the annual repayment is £1.1m/6.73 £163,000. The cumulative discount factor for eight years at 12 per cent is 4.97, so these payments have a present value of £163,000 4.97 £810,000. 5. We no longer have to pay compensation to local residents and farmers, so there is a benefit of £130,000 pa for the 10-year time horizon. 6. There is an increased process loss each year which needs to be calculated. Year 1 2 3 4 5 6 7 8 9 10
Increased process loss $’000 0.05m $40 10% 200
Exchange rate 1.805 1.715 1.629 1.548 1.470 1.397 1.327 1.260 1.197 1.138
Discount factor (12%) 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322
Present value £’000 98.9 93.9 87.4 82.2 77.1 72.6 68.1 64.1 60.3 756.6 761.2
Option 2: Wildlife sanctuary
Note 1 2 3
Time 0 1–10 1–10
Cash flow £’000 (850) (150) (100)
The net present value of option 2 is £2.262m. 2006.1
Discount factor (12%) 1.000 5.650 5.650
Present value £’000 (850) (847) (565)
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Costs suffered by the individual The company may believe that it has a duty to compensate individuals for the loss that they suffer as a result of the company’s pollution. We know that a compensation scheme is already in operation to make payments to local residents and farmers, so the idea of such compensation already exists. But different costs would apply to different approaches to compensation. (i) The car discolouration could be dealt with by agreeing to pay for each car to be repainted regularly throughout its life. However, alternative approaches could be considered, for example, treating each car with a special anti-corrosion coating to stop the discolouration. Alternatively, car owners could be given plastic sheetings to cover their cars while they are parked in the open, or grants could be given towards building garages or providing other out-of-the-open parking facilities. (ii) Naturalists or specialist horticulturalists may be able to recommend strains of crops which could be grown by farmers without being damaged by the emissions. This would minimize the losses suffered by farmers as a result of the plant. However, where individuals have carried out remedial work to air-conditioning systems, the cost to the individual will be clearly evidenced by the invoice amount that has been paid, and the company should pay compensation of this amount. Note that the company would not be intending to compensate every individual who may suffer from the plant’s operations. For example, any driver might be driving their car close to the plant while it is mining, and the car could therefore be exposed to the acid rain, but compensation would only be offered to people living near the plant. Unless the company took the drastic step of buying up all the land for miles around the plant and prohibiting anyone from coming within an exclusion zone except employees and suppliers, some individuals are bound to suffer a loss without compensation being available for them. 2006.1
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Notes 1. Establishing the sanctuary costs £850,000. 2. The increase in compensation payable to farmers is £150,000 p.a. I assume that the administration cost for this payment is unaffected. 3. Donations to charity are £100,000 p.a. for 10 years. (b) Environmental costs external to the COR works operation The environmental costs external to the company’s operation refer to those costs incurred by third parties unconnected with the company as a result of the company’s impact on its environment, that is principally as a result of the current noxious emissions. The question gives the following examples of such environmental effects: (i) discolouration of cars from acid rain; (ii) damage to local vegetation and wildlife; (iii) soil contamination in local farms; (iv) breathing difficulties in local residents. Other examples could be the contribution to global warming or, less seriously, an inability to hang washing outside without it becoming stained. Giving a monetary value to these effects is somewhat subjective. Each cost could either be viewed as a cost suffered by the individual concerned, or the cost to the company remedying the problem. Let us consider each of these aspects of cost in turn.
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Cost to the company of rectifying the problem The simplest method of rectifying the problem is clearly to close down the plant and either to relocate it somewhere less environmentally sensitive or to buy in products from elsewhere. These are drastic options which could be examined using normal capital appraisal techniques, but are likely to prove prohibitively expensive. Less drastic possibilities might include: (i) inputting a higher-grade quality of crude oil; (ii) passing the noxious emissions through a further processing system to detoxify them before they are released; (iii) changing the production process to avoid creating the emissions; (iv) ensuring that computer-control processes have been introduced wherever possible so that the plant is sure to be running at its most optimum efficiency. Money values can be put to each of these possibilities so that they could be ranked in order of increasing net benefit or cost. (c) Each potential project should first be appraised using the company’s normal investment appraisal procedures to assess whether it is viable on purely commercial grounds, since management will wish to know this information before environmental factors are considered. For example, if a conventional NPV DCF approach is taken to investment appraisal, the prospective cash flows should be discounted at the appropriate interest rate to yield a forecast net present value from adopting the project. Next, the costs and benefits of the environmental factors should be incorporated into the appraisal process. Environmental consultants may be required to put monetary values to the perceived costs and benefits, but the general idea will usually be that avoiding pollution in one area will incur a cost (e.g. for new machinery, or training of the workforce, or additional computer controls). This cost will be offset by the benefits of reduced claims for compensation and higher quality of output. The balance of costs against benefits in the company’s appraisal procedure will show whether projects which are not viable on purely commercial grounds should be accepted on environmental grounds. The importance of a company’s effect on its environment should be stressed by senior management and appreciated through all levels of the workforce. Production methods which were accepted 20 years ago, say, are not tolerated today. Everyone employed in a business has a duty to ensure, as far as possible, that: (i) poisons are not emitted into the atmosphere; (ii) refrigeration processes do not use CFCs which endanger the ozone layer if released into the atmosphere; (iii) energy consumption is as low as possible; (iv) waste and scrap materials are recycled whenever possible; (v) waste and scrap which cannot be recycled is disposed of in a responsible fashion. Projects should be initiated only when their full impact upon the environment has been determined and found to be acceptable.
Solution 5 ●
This question is intended to test the candidate’s ability to recognise relevant cash flows in the appraisal of capital projects, and make appropriate adjustments for price level
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(a) It is not appropriate to leave the cash flows in terms of present-day prices and to discount such cash flows at the real cost of capital. This would understate the company’s tax liability, as capital allowances are based upon original rather than replacement cost, and do not change in line with changing prices. The cash flows should be adjusted by the appropriate estimate of price change. Revised estimates of Year Sales (5% rise per year) Less: Materials (10% rise per year) Labour (10% rise per year) Overheads (5% rise per year) Capital allowances Taxable income Taxation (35%)
revenue, expenses and tax liability (£000) 1 2 3 4 3,675 5,402 6,159 6,977
5 6,790
588 1,177 52 1,125 2,942 00733 00256
1,449 2,899 128 1,423* 5,899 00891 00312
907 1,815 110 3,844 3,676 1,726 00604
1,198 2,396 116 4,633 4,343 1,816 00636
1,537 3,075 122 5,475 5,209 1,768 00619
* This includes the balance of the written-down value of the fixed assets at the end of year 5, as there is no expected salvage value.
Interest is ignored, as the cost of finance is encompassed within the discount rate.
Year Inflows Revenue Outflows Materials Labour Overheads Fixed assets Working capital Taxation
Cash-flow estimates (£000) 2 3 4
0
1
5
6
4,80–
3,675
5,402
6,159
6,977
6,790
0.4–
588 1,177 52
907 1,815 110
Net cash flows
– – – 4,500) 300) 4,80– 4,800) (4,800)
1,198 2,396 116
1,537 3,075 122
1,449 2,899 128
– – –
120 1,93– 1,937 1,738
131 3,256 3,219 2,183
144 4,604 4,458 1,701
156 5,636 5,526 1,451
(851)* 4,619 4,244 2,546
– 0.312) 0.312) ((312)
Discount factors at 15%** Present values
1.000) (4,800)
0.870 1,512
0.756 1,650
0.658 1,119
0.572 830
0.497 1,265
0.432) ((135)
* Assuming that working capital is released at the end of the project. ** This discount rate, being the market rate, is assumed to incorporate ‘inflation effects’. Fifteen per cent will only be appropriate as a discount rate if the project’s systematic risk is similar to the systematic risk of the company as a whole.
Expected net present value is £1,441,000. On this basis it is recommended that the investment should be undertaken. (b) Calculating the internal rate of return (IRR) will produce a net present value of zero. This can be achieved by ‘trial and error’.
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changes in the calculation of an estimated net present value. Additionally, the candidate’s knowledge of sensitivity analysis and the treatment of risk is tested.
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Cash flow (4,800) 1,738 2,183 1,701 1,451 2,546 (312)
20% Discount .833 .694 .579 .482 .402 .335
PV (4,800) 1,448) 1,515) 985) 699) 1,023) 1,(105) )) 765)
27% Discount .787 .620 .488 .384 .303 .238
PV (4,800) 1,368 1,353 830 557 771 4,8(74) ) 5)
The discount rate would have to change from 15 per cent to approximately 27 per cent to produce a net present value of zero. This is a change of approximately 80 per cent. (c) Capital investment appraisal involves a large number of estimates of future cash flows. These estimates, and the estimate of an appropriate discount rate, are subject to varying margins of error. Sensitivity analysis is the process by which each individual element of cash flow (for example sales, labour costs, overheads), and the discount rate, are taken in turn to see the extent to which that element can vary, with all other elements held constant, before expected net present value becomes zero. This allows management to ascertain which elements the proposed investment is most sensitive to. These elements should be re-examined in order to see whether the cash-flow estimates can be improved in accuracy. The weaknesses of sensitivity analysis include: 1. In sensitivity analysis each element is varied individually. It is, however, likely that interrelationships exist between many of the elements, and two or more elements will, in reality, vary simultaneously. 2. Sensitivity analysis takes no account of the probabilities of events occurring. 3. No indication is given as to the correct reaction of the financial manager to a particular level of sensitivity, or whether decisions should be altered because of the level of sensitivity. Other traditional techniques of incorporating risk include using the probability distribution of a range of estimates to calculate expected net present value, finding the standard deviation of the probability distribution, decision trees, certainty equivalents, and simulation. These measures of risk normally apply to individual projects in isolation. Considering a project in its broader portfolio context will produce a more appropriate measure of risk. The direct measurement of systematic risk through the use of a risk-adjusted discount rate generated by the capital asset pricing model is often considered to be an appropriate way of incorporating risk into capital investment appraisal. (The certainty equivalent technique may be applied in conjunction with the CAPM.)
Solution 6 ●
This question concerned a company (quoted on the Alternative Investment Market) which was evaluating the purchase of a new machine to reduce costs and therefore improve profitability. The company was all-equity financed and was considering raising funds for the new equipment by issuing debt and obtaining the tax advantages of debt. The effect on the base case NPV and the cost of capital was considered.
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£1.9m (£300,000 0.16) £1.9m £1.875m £0.025m The side-effects of financing are: ●
●
Issue costs. A sum of £2m needs to be raised if issue costs are 5 per cent of gross finance raised. Issue costs are therefore £100,000. Tax benefits. Assuming perpetual debt, the annual tax relief on interest payments is: £2m 9% 33% £59,400
In perpetuity, and assuming that the discount rate is the interest rate, the value of this tax relief in perpetuity is: £59,400 0.09 £600,000 The APV is therefore: £25,000 £100,000 £660,000 £535,000 Adjusted discount rate First calculate the annual income/savings required to allow an NPV of zero: APV £1.9m Annual income £100,000 £660,000 0.16 Assuming APV 0: £2m £660,000 Annual income 0.16 Rearranging the equation: Annual income 0.16 (£2m £660,000) £214,000 £214,400 as percentage of £2m is 10.72 per cent. This is the ADR. (Proof: £1.9m less £100,000 plus (214,400 0.1072) 0.) This ADR may be used to evaluate future investments only if the business risk of the new venture is identical to the one being evaluated here and the project is to be financed by the same method and on the same terms. This is unlikely and the effect on the company’s cost of capital of introducing debt into the capital structure cannot be ignored. (b) (i) The NPV is the difference between the total outflows and total inflows. The cost of the lease over the five-year period, assuming the discount rate to use is 9 per cent, is £1,653,250. (Note: There is a case for using the after-tax cost of debt of approximately 6 per cent.) The present value of the savings is £1,875,000 as calculated in part (a) of the question. The difference is therefore £221,750. This is a worse outcome than the APV calculated above and suggests that long-term debt is the better alternative. There is, however, dispute about the appropriate discount rate to use in a leasing evaluation. It could be argued that 9 per cent is the rate to apply to both sets of cash flows (lease payments and cost savings). The use of 9 per cent is also contentious and some argue that it is the cost of capital that should be used. This suggests that the financing carries the same level of risk as the company’s business operations, which is not realistic. 2006.1
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(a) The base case NPV for DT plc is:
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(ii) The question requires a discussion of finance leases. Operating leases are not relevant in the situation here. The main advantages/disadvantages are as follows. Advantages of leasing Leasing may be considered a direct alternative to medium-term, rather than longterm, debt. The advantages here are that the lease is paid off in five years but the company has debt in its capital structure for much longer. Whether this is important or not is related more to the attitudes of management than to economic factors. Leasing is not ‘off-balance-sheet’ any more – if it ever was – so there should be no effect on ratios. One advantage shown by empirical studies is that leasing is often considered more convenient to arrange and involves lower issue costs. Disadvantages of leasing Leasing may be more expensive than debt and there may well be tax issues which would require more information than given in the scenario to evaluate properly. In theory, the method of financing is irrelevant to the investment decision, although the APV approach attempts to encapsulate the side-effects of financing into one calculation.
Solution 7 Calculations Investment 1 Year Inflation factors Real terms revenue, £000 Real terms costs, £000 Cash flows, £000 Plant Tax (25% p.a., 33%) Revenue Costs Tax @ 33% Working capital Net 12% p.a. discount factors Discounted cash flow, £000 NPV 5.1% of outlay
0
1 1.05 370 (300)
2 1.105 500 (325)
3 1.158 510 (335)
4 1.216 515 (330)
5 1.276 475 (325)
6
41 389 (315)
23 591 (388) (64) 0.0.0. 0.162
17 626 (401) (67) 0.0.0. 0.175
13 606 (415) (74) 0. 50 0.180
40
0.712 0.115
0.636 0.111
0.567 0.102
(500)
0(50) (550)
0.0.0. 0.115
31 552 (359) (24) 0.0.0. 0.200
1.000 (550)
0.893 0.103
0.797 0.159
(63) 0.0.0 . 0.(23) 0.507 0.(12) 0.0.28
Note: Total profit before tax £386,000. This amounts to 110 per cent of average assets of £350,000, an average of 22 per cent p.a.
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Year Inflation factors Real terms revenue, £000 Real terms costs, £000 Cash flows, £000 Plant Tax (25% p.a., 33%) Revenue Costs Tax @ 33% Working capital Net 12% p.a. discount factors Discounted cash flow £000 NPV 7.8% of outlay
0
1 1.05 420 (310)
2 1.103 510 (385)
3 1.158 575 (420)
4 1.216 550 (400)
5 1.276 510 (350)
37 441 (325)
21 666 (486) (46) 0.50.7 0.155
16 669 (486) (59) 0.50.6 0.140
11 651 (447) (60) 0.550 0.205
0.712 0.110
0.636 0.0.89
0.567 0.116
6
(450)
0(50) (500)
0.50.8 0.153
28 564 (425) (38) 0.50.7 0.129
1.000 (500)
0.893 0.137
0.797 0.103
36
(67) 0.50.5 0.(31) 0.507 0.(16) 0. 39
Note: Total profit before tax £372,000. This amounts to 116 per cent of average assets of £320,000, an average of 23 per cent p.a. Report To: The Directors of CP Ltd From: Financial Manager Date: Subject: Mutually exclusive investment opportunities Purely on the basis of the information provided, given that the two projects are mutually exclusive, the company should opt for investment 2: it shows a higher NPV in absolute terms and relative to the initial investment, and leaves £50,000 available for other opportunities – or for distribution to shareholders. The criterion should be the cost of capital which, one would expect, is higher than the rate which can be earned on deposit. A more important consideration, however, might be the opportunities contingent upon embarking on the alternative projects: what are referred to and evaluated, these days, as real options. Other methods of ‘evaluating’ investment proposals include: ● ● ●
the accounting rate of return – simple but ignores the value of time; payback period – simple but ignores cash flows after payback; internal rate of return – complex, and unrealistic (requiring constant cost of capital, uncertainty and risk aversion). Non-financial factors worthy of consideration include:
● ● ●
consistency with the company’s declared strategy; consistency with the company’s declared values, for example, environmental impact; consequences for other aspects of the business, for example, – does it open up other opportunities (perhaps by bringing the company into contact with new customers)? – does it enable employees to develop additional skills? – the availability of suitable labour, spare parts, etc.; – technical difficulties in respect of installation/maintenance. Signed: Financial manager 2006.1
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Investment 2
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Solution 8 ●
This question combined an ability to deal with foreign currency and to evaluate an overseas investment decision. It dealt in particular with an understanding of currency markets (forward and spot rates) and the choice of discount rate to use in an international investment.
(a) (i) 1. With exchange controls Year
0 1 2 3
Profit after tax SA$000
OJ share
50% div.
SA$000
SA$000
4,250 6,500 8,350
2,125 3,250 4,175
1,062 1,625 2,088 4,775
Disc. factor @ 16% £000 (450) 106 108 100 227
1.000 0.862 0.743 0.641 0.641
Net present value
Disc. cash flow £000 (450) 91 80 64 146 )(69)
2. Exchange controls removed and all earnings distributed as dividends Year
Profit after tax SA$000
0 1 4,250 2 6,500 3 8,350 Net present value
OJ share
OJ Share
SA$000
£000 (450) 212 217 199
2,125 3,250 4,175
Disc. factor @ 16% 1.000 0.862 0.743 0.641
Disc. cash flow £000 (450) 183 161 127 021
(ii) If exchange controls exist in the South American country the project has a negative NPV and should not be undertaken. Investing in countries with a history of high inflation and political volatility adds to the risk of the project and OJ Limited should proceed with caution. (b) Statement 1 Exchange of currency will be made at spot rates, and unless OJ Limited hedges its foreign exchange exposure the risk it accepts is that the exchange rates at the time the cash flows are received will be very different from those expected when the forecasts were made. In the absence of risk, the expectations theory indicates that the percentage difference today between the forward rate and the spot rate is the change expected in the spot rate. The forward rate of exchange for, say, 12 months is what the spot rate is expected to be in 12 months’ time. The use of forward rates as estimators of future spot rates can only be as reliable as the best predictions the market can make, based on the underlying technical information available at a point in time. These predictions will include assessments of difference between countries in purchasing power, inflation rate and interest rates for the period involved. Forward rates for up to three years hence for a currency from a country with a history of high inflation and a volatile economy is very much looking into a crystal ball. It is unlikely that OJ Limited could hedge its exchange risk so far ahead in a risky currency even if it wanted to. Statement 2 Discount rates already take account of the timing of cash flows. If the risk of this project is affected by the uneven nature of the forecast cash flows, the use of certainty 2006.1
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Statement 3 Currency swaps are usually used as a hedge against foreign exchange risk. Advantages are the ability to obtain finance, or cheaper finance, than by borrowing directly in the market if one company has a comparative advantage in terms of credit rating. This provides an arbitrage opportunity which can be shared by the participants in the swap. It is likely that the company in the scenario here will not have a high credit rating because it is expanding into new markets. However, there are disadvantages. Swaps are typically – but not necessarily – arranged through intermediaries which create opportunities for speculators. This is a high-risk business and should not be undertaken without extensive expertise. In the circumstances here, the company is experienced in foreign exchange in Europe but South America is very different. Capital markets are not as highly developed and are much more volatile. Also, the weakening of the SA$ implied by the forward rates would be reflected in any currency arrangement.
Solution 9 Common errors Two aspects of the question were frequently missed by candidates. The first is that share repurchase has strategic financial implications beyond dividend policy (and the question did ask for comments on ‘other implications’ of share repurchase). For example, additional benefits could be obtained if the following circumstances apply: ●
●
● ●
the business is being reprivatised (not relevant here, but some candidates noted the Virgin case); shares are made available for employee share option schemes (again, not mentioned in the question but this could be relevant); in a takeover defence (very possibly a consideration in the circumstances of the question); the capital structure is being modified (this was not explicit, but was implied by the scenario).
Another point which was rarely noted by candidates concerned the method of repurchase: the offer price may be difficult to determine unless the shares are bought in the open market (a point noted by very few candidates as most seemed to assume the shares could only be bought privately). Candidates who managed to give some real-life examples of share repurchase were given credit. However, Virgin was not the best example because Richard Branson reprivatised the entire company rather than effecting a share repurchase in the sense implied by the question. In respect of statement (a), most candidates noted that it is legal to borrow to pay a dividend in the UK provided that the dividend is covered by past or present realised profits. However, the commercial advantages of doing so are doubtful. If the company can invest at a higher rate of return than shareholders on their own behalf, then borrowing to pay a 2006.1
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equivalents might be a solution, although this would involve estimating probabilities for the next 3 years. The concept of inter-temporal correlations (ITCs) could be mentioned here, although we are not comparing projects, simply economic assumptions. However, 16 per cent may appear to be on the low side, given the interest rate differential implied by the forward rates.
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dividend makes no sense financially. However, the company’s gearing is at present relatively low and additional borrowings could bring tax advantages. This point was missed by many candidates. The signalling effect was also widely recognised. Many candidates mentioned signalling under both share repurchase and borrowing to pay a dividend. The difficulty is in deciding how the market will react to signals in each set of circumstances. There is no clearcut answer here. Report To: Board of DIVS plc From: Independent financial adviser Date: Subject: Dividend policy (a) Share repurchase If the company has no immediate positive NPV investments and distributes the shortterm surplus as a dividend, it could create the expectation of increased payment in the future. Buying back the shares might prevent this but might also signal to the market that the company has no good investment opportunities in the immediate future. There may be taxation advantages for the company if ACT on dividend payments cannot be offset, but also possible tax disadvantages for some shareholders. However, share repurchase has strategic financial implications beyond dividend policy. Additional benefits could be obtained if the following circumstances apply: ● the business is being reprivatised; ● shares are made available for employee share-option schemes; ● the repurchase is part of a takeover defence tactic; ● the capital structure is modified. One disadvantage concerns the method of repurchase, and the offer price (if not being bought in the open market) may be difficult to determine. (b) Borrowing to pay a dividend The problem to consider is how a firm should divide its earnings between payments to shareholders and retentions for future investments, if the overall aim is to increase the market value of the firm. The dividend decision is therefore a financing decision. In theory, a company should pay all cash from earnings as dividends if it has no positive NPV investment opportunities, and pay no dividends if it has sufficient investments. In practice, companies do not do this, mainly because of the signalling mechanism of dividend payments. In the UK it is perfectly legal to borrow to pay a dividend provided that the company has sufficient past or present profits from which the dividend can be allocated (dividends are allocated from profits, but paid in cash). A company has no legal obligation to make good past profits before paying a dividend and can also pay one out of capital profits if those profits are realised. Most companies try to maintain at least a stable dividend policy and to reduce the dividend only in extreme circumstances. Research in the USA has shown that dividend policy is important and that managers believe the payment of dividends affects the value of the firm. Findings have also shown that dividend payments depend on both current earnings and past dividends.
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Solution 10 (a) Though earnings have been falling the dividend has been rising, increasing from 60 per cent to 80 per cent. Conversely, the proportion retained to the extent that the pay-out ratio has been falling means that – in the absence of any capital injection – although capital employed has been increasing, its rate of growth has been falling, and the return on capital has been falling. (b) As we are not told what return is expected to be earned on the funds which are to be reinvested under the various scenarios, it is impossible to say what the share price should be. For simplicity, the following answers assume that, in each case, the return is equal to that ‘required’ by the shareholders, that is, 15 per cent p.a. ● If Option 1 were expected to provide a dividend of £1.00 per share in perpetuity, then the 15 per cent cost of capital would suggest a price of £1.00/15%, that is, £6.67, all of the return being in the form of a 15 per cent dividend yield. ● For Option 2 to suggest the same share price, people would need to believe that retained profits would be invested in projects, etc., which were expected to lead to growth of 7.5 per cent p.a., and that the share price would grow at this rate. Thus, half the return would be in the form of a 7.5 per cent dividend yield, and half as a 7.5 per cent capital appreciation. ● For Option 3 to yield the same share price, people would need to believe that retained profits would be invested in projects, etc., which were expected to lead to growth of 11.25 per cent p.a., and that the share price would grow at this rate. Thus, a quarter of the return would be in the form of a 3.75 per cent dividend yield, and threequarters as an 11.25 per cent capital appreciation.
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However, borrowing specifically to pay a dividend is rare, and the financial arguments in favour of such a move are questionable. If the company can invest at a higher rate of return than shareholders on their own behalf, then borrowing to pay a dividend makes no sense financially. However, the wishes of the shareholders should be considered. If the majority are institutions they may require regular cash flows to meet, say, pension commitments. Selling shares to raise cash – ‘homemade’ dividends – involves transaction costs. It could also be noted that the company’s gearing is at present relatively low and additional borrowings could bring tax advantages. (c) Effect on cost of equity There are two views here: ● The theoretical view says that if the company is ungeared, share repurchase would have little effect on the cost of equity unless it had an effect on the company’s business risk, which is unlikely. DIVS plc has a gearing ratio of 1 : 5, but there should still be no effect on the cost of equity as the total value of the firm should remain unchanged. ● There would be fewer shares in issue but, if the investment programme of the firm is unchanged, each share should be worth more. In practice share prices tend to fall, which has the effect of reducing the value of equity as a proportion of total value of the firm. Gearing, and therefore uncertainty about the returns to equity, is increased which, according to finance theory, would increase the required rate of return on equity.
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For Option 4 to yield the same share price, people would need to believe that retained profits would be invested in projects, etc., which were expected to lead to growth of 15 per cent p.a., and that the share price would grow at this rate. Thus, all of the return would be in the form of capital appreciation. If the expected rate of growth in each case were put at a figure higher than that mentioned, the suggested share price would be more than £6.67; if lower, less. (c) Share prices reflect the supply and demand for small lots of shares, and in that respect are not directly relevant to financial management. The directors should be looking at the other side of the coin, that is, the generation of the cash which will fund the dividends. Are the investments, with their specific uncertainties, viable against the criterion of the cost of capital? The question does not provide any guidance in this respect, but it ought to be the focal point for the directors. From an economic point of view, they should be looking to maximise the net present value of the projected cash flows of the enterprise. The fact that this might not maximise the short-run share price is not an argument for altering the objective of the enterprise (but will have predictable influence on directors with substantial share options about to mature!). (d) The issue of bonus shares is one of the most misunderstood aspects of the relationship between a company and its shareholders. Whether an individual has 600 shares at £5.67 each, or 1,000 shares at £4.00 of itself, matters not. Thus, if anyone wished to realise 25 per cent of their investment, selling 150 of the old shares would net the same as selling 250 of the new. Note, however, that the act of ‘capitalising’ reserves prevents them being distributed in the future, that is, provides the company with more permanent capital, and the shareholders less room for manoeuvre. Such a shift in the balance of power would need to be considered carefully by the shareholders. Providing shareholders with a choice between a dividend and a scrip, however, amounts to what has been described as a ‘disguised rights issue’. Does the company have opportunities to invest the funds for an adequate return? If so, why declare the dividend in the first place? If not, it should not seek to retain it. When the value of the alternatives is the same, few people opt for the scrip, but when it is biased (as in the question, and in the form which came to prominence in 1993) the situation is different. Those who do not prefer the cash choose the scrip; those who do, must accept the transaction costs of selling some shares, and hence a dilution of their holding. This discrimination between shareholders represents a major change in an important area of corporate governance – and is giving cause for concern. It is significant that most of the companies which have ‘loaded the dice’ in this way have said that it is a once and for all device. ●
Solution 11 Requirement (a) examines the differences between objectives of two organisations, one in the private sector and one in the public sector. Candidates are required to discuss these differences and identify the main risks involved. Requirement (b) tests for an understanding of the funding of public sector organisations with a specific reference to the use of the UK private finance initiative (PFI). (a) In recent years, the objectives of public and private sector organisations have moved closer together; the public sector recognising the need to be more accountable for
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EPS as an objective There is disagreement about the importance of EPS as a decision criterion but it is an important historic measure within the company. Comparison of EPS with other organisations is not useful although the growth in EPS can be directly compared. This growth is viewed as an important yardstick by which companies’ performance is assessed by the market and shareholders. This external scrutiny is largely missing in the public sector where public attention is focused on quality of services rather than financial rewards. Return on capital employed The directors of a private sector company have a fiduciary duty to shareholders as their priority. In the private sector, there is a requirement to offer the prospect of an adequate return on capital employed or investment. It has to produce a return comparable at least with similar risk investments to satisfy this group of stakeholders. In the public sector, it essentially means persuading a higher authority, and ultimately the Treasury, that the proposed activities represent value for taxpayers’ money. This is often politically driven, rather than being based on an assessment of long-term financial health. The scenario does not give a market-based objective, such as return on equity. Most listed plcs would use DCF and NPV approaches to investment decisions in order to take some account of risk of their investments. The basis might be rule-of-thumb or more formal CAPM-type approaches. Using the time value of money as a decision criterion is not particularly well developed in the public sector. The cost of capital, if used at all, is dictated by the Treasury and is likely to ignore aspects such as risk and realistic expectations of inflation. Tax is ignored, on the grounds that it is an internal transfer. Cash limits A feature of the public sector is the over-riding importance attached to the current fiscal year’s cash flows. ‘Borrowing’ is not generally available although short-term deficits can be ‘brokered’ either centrally or between institutions. Some public sector organisations attempted some years ago to finance using commercially priced debt instruments (not asset-backed PFI debt) and suffered severe losses. The reason for this might be that public sector finance managers are not experienced in borrowing commercially. A private sector company can borrow more freely subject to normal considerations of prudence and commercial probity. Management of risk A major difference between the two sectors is clearly one of risk. A public sector organisation, such as a health trust, has a more or less guaranteed number of ‘customers’ and associated income from the government. It does not therefore have to compete in the same way as private organisations. There is, however, a key difference between the public and private sectors’ definition of customer, which is the redistributive nature of the public sector organisation’s operations. There is an economic link between consumption and price, which the private sector can easily accommodate. In the UK public sector many services are free at the point of delivery. If an organisation’s
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taxpayers’ money and the private sector recognising there are stakeholders in the company other than the shareholders. However, private sector companies still have their key responsibilities to shareholders and are obliged to maximise their return on investment within the constraints imposed by social, legal and political interests and influences.
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income comes from a source other than paying customers, then demand will inevitably exceed supply. This is the risk faced by public sector organisations that they constantly struggle to manage, frequently by ‘robbing Peter to pay Paul’ or imposing some form of rationing of services. In summary then, the main risk to be faced by a private sector organisation is falling demand, whereas in the public sector it is rising demand and insufficient resources to meet it. The risk to the private sector organisation, failing to obtain the required level of earnings and return on investment, can be managed by normal commercial risk management techniques: ● undertaking analysis of customers and markets; ● providing product and service excellence; ● providing equitable treatment of all stakeholders in the organisation (paying creditors on time, fair remuneration for employees, respect for the environment and local community interests, etc); ● insuring where possible against risks, for example exchange and interest rate risks can be hedged, insurance can be taken out against loss, theft or damage. The list of stakeholders in a plc – for example, creditors, employees – could also apply to the public sector with taxpayers replacing shareholders. However, the main risk faced by this organisation is in many ways more complex. It has to be managed within the political constraints imposed by government as well as cash limits. Management techniques are: ● constant monitoring of value-for-money, of goods and services from internal and external suppliers; ● buying services for its clients based on evidence of effectiveness (especially in health services); ● using private sector funds within allowed limits, for example the PFI to fund major capital projects. (b) Note: The example used here is that of organisation 2 in the question. There are many variants of the PFI, and some carry more risk than others. The original purpose of the PFI was not to force public sector managers into operating as commercial enterprises but to supplement limited public sector funds. The cost to the borrower of PFI was generally below commercial rates, not necessarily because of the asset backing, which is relevant also to the private sector, but because of the much reduced risk of default. The main risks to the achievement of the trust’s financial objective arising from the PFI debt are as follows: ● Interest rates rise substantially and are not matched by increases in government payments, ● Income from government falls, for whatever reason, and capital and interest payments still have to be made. To be fair, the risks in this example are relatively small. Equal annual payments to service the loan would be £15m/8.061 £1,860,811, less than 2 per cent of total income, and the UK government has pledged increases in health-care funding considerably higher than inflation for some years to come. Income depends on patients treated and it is highly unlikely that patient numbers or treatment episodes will fall by any significant margin.
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Solution 12 Report To: Finance Director From: Financial Manager Subject: Evaluation of investment in South America Date: 20 November 2001 Introduction This report provides an evaluation of the proposed investment in South America. Section (i) contains the net present value calculations of the project, based on our estimated cash flows, and a recommendation. Section (ii) discusses the risk management strategies that could be used to minimise the political risk of the investment. Section (i) Calculations of NPV and recommendation Year Inflation factors US Inflation factors SA Exchange rate
0 (now) 1 1 30
1 1.04 1.4 40.3846
2 1.0816 1.96 54.3639
3 1.124864 2.744 73.1822
10,000 10,000
300 312
400 433
500 562
1,000,000 1,000,000
250,000 350,000
350,000 686,000
450,000 1,234,800
In US$000
33,333
8,667
12,619
16,873
Net cash flows in US$000 DF20% DCFs
43,333 1 43,333
8,355 0.833 6,959
12,186 0.694 8,457
16,311 0.579 9,444
NPV for years 1–3 NPV continuing operations Total US$000
18,473 47,220* 28,747
Cash flows in US$000 Real Nominal Cash flows in SA currency 000 Real Nominal
*
Calculated assuming US$ 16,311 will be received in perpetuity at 20%, that is: 0.579 16,311 0.2
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However, should this unlikely event take place, then the Trust could attempt one or more of the following strategies: ● Negotiate a longer repayment period – PFI for hospitals and health care centres is typically 20–30 years, so the 15-year term in the scenario here is much shorter than the norm. ● Negotiate lower treatment rates with the providers from whom it purchases healthcare. This would be difficult if the provider is in the public sector because it also will have similar financing considerations. Providers in the private sector may be willing to be more flexible. ● Improve their efficiency targets for the treatments they provide. The result of this might be to assist the achievement of the non-financial objectives rather than contributing to the achievement of the financial objective.
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On the basis of my calculations, I would recommend that we proceed with the investment. However, the following reservations should be noted: ● Positive cash flows are not evident in the first 3 years of operations. An estimated discounted payback period would be 5 years. ● The length of the payback, the volatility of the currency and the political risks, discussed in the next section of the report, make this a very high risk venture. Section (ii) Risk management strategies to counter potential political risks The main political risks we are likely to face investing in a politically volatile country, the implications for us and the strategies we could put in place to minimise these risks are briefly discussed below. ● Unlawful seizure of assets: the implications here are obvious as we stand to lose a substantial amount of money if these assets are seized permanently. ● Possibility the repatriation of profits and dividends will be prohibited: this will also involve us in severe losses and serious consequences for cash flow. Clearly, we would not wish to continue to operate if this became the case. ● Lack of developed currency and capital markets: the risks here mean it is difficult to hedge risks using forward or money markets. ‘Internal’ techniques such as matching assets and liabilities could be used.
Author’s Note The question did not state that there were undeveloped currency and capital markets, but many SA countries have experienced severe economic problems that have resulted in high levels of market volatility. In such cases, capital and currency markets do not operate as efficiently as in more stable market environments.
●
● ●
Weak or corrupt legal and financial infrastructure. This could adversely affect our public image if we are seen to be involved with corrupt regimes, especially if human rights issues are involved. Prohibitive rates of taxation and rules on transfer pricing. Social unrest, the result of poor living and working conditions.
The following strategies could be considered: ●
●
●
●
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Develop a risk management plan to identify and evaluate the extent of risk involved. This might include visits to the country concerned, discussions with aid organisations, researchers and journalists. Subscribe to publications that provide political risk scores. These are similar to credit rating agencies and allocate ‘scores’ to various risk factors, such as government stability, access to capital markets. Insure against extreme events such as war or riots. The main disadvantage here is that many insurers will not cover such risk, and if they do the premiums are very high. Purchase as many goods as possible in the host country, or manufacture in that country if possible.
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●
●
Involve local politicians in the development and management of the projects. This in itself is a risky approach. The company leaves itself open to accusations of bribery and other malpractice. Also, if the political party changes, the company could be wrong footed and in a worse situation than before. Obtain agreement from the incumbent government on the ability to repatriate profits and dividends. Governments in politically volatile countries may default on agreements but there might be some redress in law if the situation arises. Ensure our pricing strategy takes into account the possible risks and the return we expect from the project is adequate to compensate for these risks.
Summary and conclusion Political risk is not the only factor that should be considered. The investment should be viewed as part of the company’s overall strategy and evaluated accordingly. Signed: Financial Manager
Solution 13 (a) The cost of equity can be determined using the WACC formula: WACC
ke E D kd(1 ts) (D E) (D E)
13% ke 0.65 10% (0.75) 0.35 13% 0.65ke 2.62%; ke
(13.00% 2.62%) 16% 0.65
These calculations use AB plc’s current debt ratio. If the ratio were to fall to the company’s stated optimum, the cost of new debt might also fall and, as a consequence, the WACC. The value of the subsidy is the result of the difference between the interest payments that AB plc would have to make if the subsidized loan were not available and the interest it will have to pay with subsidy. The PV of the after-tax benefit over the 6-year period must be computed at the pre-tax (regular) rate of interest. The annual difference of interest payments is: (0.10 0.025) £1.5 million (30 million EE marks/20) £112,500 After tax, the annual amount is £112,500 0.75 £84,375 The PV of the benefits at 10% is £84,375 AF 6,10 (4.355) £367,453
The PV of the benefits has been calculated using the cost of debt as the discount rate. An argument could be made that the WACC is the more appropriate rate, representing as it does the opportunity cost of the benefits. This would have the effect of reducing the value, which seems perverse to common sense, but can be supported theoretically. It is also necessary to assume that AB plc will continue to be able to offset interest payments against tax. (b) Neither rate is entirely relevant to the investment decision. The rate calculated in (a) could only be used if the new investment was of the same risk as the company overall. The WACC could only be used if the investments was not only in the same risk class, but financed in the same way as the company. 2006.1
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●
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The rate that should be used is a risk-adjusted cost of capital that reflects the risk of the investment. The CAPM could be used by finding a proxy company’s published beta, adjusting for the differences in gearing and using the formula to calculate a discount rate. However, the idea that one constant discount rate can be used that compensates for uncertainty and risk over the entire life of the project is doubtful in today’s volatile market conditions. (c) (i) The advantage of using the EE government subsidy is obvious: that the company obtains cheap finance. Another advantage is that the company does not need to provide security for this loan. There may be other advantages such as having the government as a ‘partner’ might ease issues such as applications for planning permission. The potential problems are that: ● The domestic rates change downwards over the 6-year period, making the savings less attractive; ● The exchange rate EE marks/£ improves, making the interest payments more expensive; ● The EE government does not honour its commitments; ● The investment fails in less than 6 years and the company is tied into a 6-year loan agreement (this would also be true of any term loan agreement); ● Conditions attached to the loan might be commercially restrictive; ● Tax laws in both countries need to be examined for any hidden penalties. (ii) The requirements are for long-term finance and assume that AB plc wishes to continue operations in the EE country. The fact that the EE government loan is for 6 years raises the question of how the venture will be financed after that time. Alternative methods that might be considered are: Long-term bonds/bank loan. The company already has two loans and an overdraft. Its debt ratio is higher than it would like and higher than the industry average. Further debt might be considered too risky, especially for a relatively risky business venture into a new market in a region still developing economically. Supplier credit. The scenario does not give details of how AB plc sources its raw materials, but it is possible that suppliers would provide some funding if there were business opportunities for their products. Cash/disposal. AB plc clearly has no cash on hand as it is using overdraft facilities. It could review its assets to determine whether there is any surplus that could be disposed of. Leasing. Finance leases are the equivalent of secured medium-term bank loans and suffer the same disadvantages. Operating leases may be possible for some equipment, but this is an unlikely source in the circumstances. Equity. The amount required is too small for a new issue, but a rights issue might be a possibility. The scenario does not say how many shareholders there are, but it does say shares change hands occasionally which suggests there are more than just family members. This might be an expensive option because of the fees involved. Venture capital/joint venture. This is the type of venture that venture capitalists ought to be interested in. The disadvantage from AB plc’s point of view would be the return required by the investor if the finance is in the form of equity. The investor would almost certainly demand some level of control over the company’s entire 2006.1
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Recommendation. All the alternatives carry advantages and disadvantages. In these circumstances, there is no obvious preferred type of finance. The decision will rest with the directors’ attitudes to risk and control. Their future objectives for the entire company, not just their overseas expansion plans, should be established and evaluated. Subsequently, a financing, or possibly re-financing, plan should be discussed with the company’s bankers and, if appropriate, its shareholders.
Solution 14 Report To: Mrs Henry From: Management Accountant Date: 19 November 2002 Subject: Finance for expansion and company objectives Introduction You have asked me to comment on the proposed methods of financing the purchase of capital equipment for expansion, the possible effect on the value of our company and on appropriate objectives for a company such as ours. (i) Factors that need to be considered when raising new equity There is no market for the company’s shares so it is difficult to value the company. The nearest approximation would be the bid 2 years ago of £25m. This would have to be adjusted for movements in the company, the industry and the economy since it was made, plus allowing for factors surrounding the bid at that time, but it provides a benchmark. The number of shareholders is fairly small. If the shares were to be issued pro-rata then the family will need to find 55 per cent of £5m, which is £2.75m, or an average of £275,000 each. The remaining 45 per cent, or £2.25m, is owned by 25 shareholders, an average of £90,000 each. If we were to issue new shares to employees and trading partners, family control of the company could be lost. If the family does lose overall control and should the other shareholders – old and new – decide to accept a future bid, the company could be sold. This assumes all shareholders take up their rights in proportion to their holding. If the non-family existing members take up their rights but if all the family do not, then control could be lost even sooner. Employees might also expect to get their shares at a heavily discounted price. This would involve, in effect, a transfer of wealth from the old shareholders to (some of ) the new. Other aspects that require consideration are the costs and timing of the issue of any new permanent capital. If the capital raised is in the form of new equity, the issue price and future marketability of the shares also need to be considered. An assumed approach might be as follows: Assume that the £25m is still a valid valuation for the company, and that the company has 1 million shares in issue, making a value of £25 per share. Assume further a 2006.1
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operations. However, venture capitalists do provide debt finance and this might be an option.
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rights issue price of £20 and the Board decide to raise £3m of the required £5m from the existing shareholders, so issuing 150,000 shares, 82,500 to the family and 67,500 to the other shareholders. The balance of £2m is to be raised from employees and other interested parties. If the same £20 price is used this would require the issue of 100,000 shares. The logic of this approach must be questioned because of the wealth transfer, unless the existing shareholders accept that employees and others deserve such benefit to recognise their contribution to the business. This scheme would raise the full £5 million and leave the shareholdings as: Family Other existing shareholders New shareholders
550,000 82,500 450,000 67,500
632,500 517,500 1,100,000 1,250,000
50.60% 41.40% 00.8.00% 100.00%
Thus, family control is maintained, although each family member (on average) still has to find £165,000 and each other existing shareholder, £54,000. These sums may prove too much and since shareholdings will not be equally distributed, some shareholders would have to find even more. (ii) Effect of method of financing on company value Theory states that the value of a firm cannot be affected by the way in which it is financed, except by the value of the tax shield and the costs of bankruptcy and financial distress. We have to make some assumptions in order to arrive at a basic valuation of the ungeared firm. We could simply take the bid of 2 years ago and add the NPV of the new investment. This is £26.2m. Alternatively we could assume earnings after tax in perpetuity at the post-tax cost of capital (a simplified version of the DVM assuming no growth). £ million 4.50 (1.35) 3.15 £3.15m Value of earnings after tax in perpetuity: 0.09 Plus NPV of new investment Profit before tax Tax at 30% Earnings after tax
Assuming method 2, the value of the firm is increased by the value of the tax shield: Annual tax relief is £5m 7% 30% £105,000 PV for 5 years assuming a 7% discount rate: £105,000 4.1 Value of the firm
£35,000,000 £1,200,000
36,£430,500 £36,630,500
Factors to consider: 1. The above assumes no change in the risk of the firm, and hence the cost of capital. MM theory states that when debt is introduced into the firm the cost of equity rises to reflect the increased risk but the overall weighted average cost of capital stays the same. In reality this is unlikely to be the case. Debt does introduce some risk – so dividends (and jobs) might be at risk if the company does badly; equity is safer, but requires higher returns. However, debt is a relatively small proportion of total financing. 2. Equity would allow some participation in the profits of the company by employees and connected people but would dilute the control/EPS of the existing shareholders. 2006.1
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(iii) Appropriate long-term financial objectives Theory suggests that the main objective for a company is the maximisation of shareholder wealth, either by increased share price or increased dividends – or both. In practice, many companies, especially those privately owned, recognise that the unrestrained pursuit of wealth has to be constrained by the interests of the various other stakeholders. The company could consider objectives that recognise the interests of these other stakeholders, such as: ● Sales or profit per employee ● Market share/sales growth ● Employee remuneration as percentage of total costs (or other suitable comparison). ● Increased dividend payout. Dividends are likely to be important for at least some shareholders. ● Percentage of creditors paid within, say, 30 days. As the main shareholders are family members, their own objectives should be considered. For example, if many of them were looking to liquidate their holding in a few years’ time, this would influence the determination of objectives now.
Solution 15 (a) Note: All figures in 000s (i) Subsidiaries alone US$
Capital (10,000)
Interest for 30 days (14.17)
Germany
UK £
(10,500) 0.03 12 17.87
5,500 12 0.039 Total $ net receipts
10,526 1.126
9,348
5,518 0.70
7,883
26.25
5,500
US$ in 30 days (10,014)
(10,000) 0.017 12
10,500
Euro
Local currency in 30 days (10,014)
f
s
7,217
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Examiner’s Note There are a number of alternative approaches to estimating the value of the company. Any sensible attempt would gain credit.
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(ii) If pooled
US$ Germany Euro
US$ amount now (10,000) +9,284
UK £
+7,914
Total in US$ Interest on $ for 30 days Total $ net receipts
7,198 10,010 17,208
10.5m 1.131 5.5m 0.695
Not pooling, that is maintaining the existing system, is marginally preferable. It results in a gain of $9 million because of different interest rates; the US borrowing rate is well below investment rates in Germany and the UK. In reality, transaction costs might reduce any benefit. Also, the exchange rate data provided only shows mid-point exchange rates rather than buying and selling rates and this will account for some of the difference between the two approaches being considered. It is also a relatively small difference, as might be expected given the efficiency of the markets in these currencies, and the decision will need to take into account other factors and wider consideration of the group’s objectives. (b) The benefits are: ● Better interest rates might be obtained for larger amounts, especially if they are planned in advance. ● Possibly lower transaction costs, bank commissions, etc. ● More control for the parent, more visibility of cash resources. ● Possibly better management of cash resources. The disadvantages are: ● Costs of converting money back and forward. ● Risk of unexpected changes in exchange rates. ● Possibly higher transaction costs. ● Administrative complexities might make such a system difficult to operate effectively in practice, for example, obtaining cash transfers in a timely manner. ● A system would need to be in place to allow subsidiaries to obtain funds quickly should an unexpected, justifiable demand arise. From the parent’s point of view, the main benefit lies in control and reduced costs overall. From the subsidiaries perspective, they lose the flexibility of short-term investment and are constantly under the scrutiny of head office. The choice depends on the company’s objectives and strategy towards both cash management policies and management of its subsidiaries.
Solution 16 (a) The weak form of the efficient market hypothesis (EMH) states that the current share price reflects all the information contained in the record of past prices. Studies have shown that share prices usually display the features of a random walk and this means that future prices do not follow past trends. This has implications for people who chart the prices of shares in fundamental analysis. Even the weak form of the EMH would make ‘charting’ a waste of time. 2006.1
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Solution 17 Tips ●
There were some serious misunderstandings in candidates’ answers about the meaning of shareholder wealth, ‘increasing shareholder wealth may reduce profits’ being one variation of a common, and wrong, opinion.
Report To: Managing director From: Finance director Date: 24 November 2004 Subject: Company objective(s) ahead of board meeting (a) Maximisation of shareholder wealth It has been argued that shareholders’ wealth, by which we mean the net present value of estimated future cash flows, is the only true objective of the firm. Jensen, in particular, has argued that the interests of shareholders, as owners of the firm, are paramount. However, this is an extreme view, and many companies now establish objectives that aim to maximise shareholder wealth while recognising the constraints, legally enforceable or voluntary, imposed by society. 2006.1
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(b) The weak form of the efficient market hypothesis has been tested by subjecting a series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether following trading rules enables above-average returns to be earned. (c) It is generally acknowledged that the prime objective of a company is to maximise the wealth of shareholders. Can financing decisions contribute to the increase in wealth of the shareholders? If the capital markets are perfect, then financing decisions will not create value. If the capital markets are efficient, on the other hand, it is possible that shareholders’ wealth could be increased by the ‘right’ decisions being made by financial managers, though it is unlikely that the benefits will be generated consistently. So managers can make investment decisions that generate positive NPVs and create value through the disequilibriums that often exist in the real markets. However, the nature of the capital markets, especially the evidence of efficiency, means that it is less likely to occur in the area of finance. If capital markets are efficient, the main implications for corporate finance are as follows: ● It is not possible to generate a surplus by timing an issue of new securities at the ‘best’ time. ● A company can sell as many securities as it wishes without affecting the price. ● A company cannot mislead the markets by adopting ‘creative accounting’ techniques. Efficient market theory has provided valuable insights into the functioning of the markets for financial assets. It appears to be sensible for corporate financial managers to assume that the financial markets are highly efficient and it is, therefore, important that this is taken into consideration when they develop strategic plans to create value for shareholders.
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Other points that you might like to consider include the following: ● Separation of ownership and control, and the subsequent identification of the agency problem and the costs associated with it. ● Theories of objectives of the firm (e.g. Smith, Friedman, Jensen), and management behaviour (Baumol, Morris, Williamson, Cyert and March, Simon). ● The market for corporate control: the suggestion that the takeover mechanism now acts as proxy for shareholder control. ● Social responsibilities that act as constraints on unmitigated pursuit of wealth maximisation. (b) Alternatives Cash-flow generation. Economists, and many accountants, believe that cash flow is the main criterion to judge a company’s performance. Cash is a fact, whereas profit can be manipulated by accounting policies. Companies have in fact gone out of business because of lack of funds, even though they were profitable. In reality, shareholder wealth is based on the present value of future cash flows. A change in accounting policies should have no influence on share prices, other than possible ‘signalling’ effects. Profitability as measured by profits after tax and return on investment. There are many problems with accounting ratios as measures of performance. For example: ● they are historical and backward-looking; ● they are subject to manipulation; ● a variety of policies are available, even within the rules – they do not reflect risk; ● tax can be affected by many factors outside the control of management. Advantages include the fact that it is a concept well understood even by nonaccountants, and recognised guidelines are available in the form of accounting concepts and standards, etc. Also, profitability is expected by shareholders. Risk-adjusted returns. The main disadvantages of risk-adjusted returns are: ● they are not well understood by small shareholders; ● they are subject to the influences of general market factors; ● risk is often difficult to measure. The main advantages are that there is general agreement that returns and risk are related and, for listed companies at least, betas are published. Other measures. These are really constraints on a company’s profitability, but they may be essential to stay in business, for example to obtain customer satisfaction. Also, they may have a favourable impact on getting business, especially with government or public sector customers. Some issues, for example protection of the environment, may be covered by legislation. Disadvantages are that cost/benefit may be difficult to quantify. Signed: Financial director
Solution 18 Tips ● A significant minority of candidates were ignorant of the treasurer’s role and confused the job’s functions with those of the financial manager/controller. ● Another weakness was to confuse separation with decentralisation. The question did not require a discussion of decentralisation, or devolvement to overseas subsidiaries, although candidates were given credit for making good points.
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(a) CIMA Official Terminology describes the treasury function as the function concerned with the provision and use of finance. It includes provision of capital, short-term borrowing, foreign currency management, banking, collections and money-market investment. The main functions of such a department include: 1. Establishment of corporate financial objectives. 2. Managing the firm’s liquid assets: cash, marketable securities, etc. 3. Management of the company’s funding: determination of policies (e.g. on transfer pricing), identifying sources and types of funds. 4. Corporate finance and related issues such as taxation, pension fund investment, etc. 5. In a multinational such as ABC, it will also deal with currency management: dealing in foreign currencies, hedging currency risks, etc. 6. Cash management in a multinational such as ABC can involve centralised cash management and multilateral netting of foreign currency transactions between subsidiaries and associated companies. Treasury is usually a centralised function in that the relationships mentioned above are usually concentrated in head office, i.e. the parent company of a group. Financial control, meanwhile, is increasingly being devolved to individual business units, so as to be close to the customer, alert to competition, etc. Where this is the situation, a separation of treasury from control is inevitable. The skills required are also different, for example, given the liberalisation of financial markets and foreign exchanges, treasurers need to be aware of the expanding range of hybrid capital instruments (e.g. convertible preference shares issued in the name of a subsidiary registered in the Dutch Antilles) and financial instruments (forward markets and the various ‘derivatives’) and to be able to select from these the ones that are appropriate to the company’s needs in the prevailing circumstances. A separate treasury function is more likely to develop the appropriate skills: it is impossible for anyone to be expert in these matters and have time to be proactively involved in the management of individual business. It will also be easier to achieve economies of scale (e.g. better borrowing rates and the netting-off of balances). (b) As indicated in the answer to part (a), the case for a separation of treasury – not only from accounting but also from financial control – is a strong one. The question remains, however, as to how its performance/progress should be measured/assessed. Some people would argue for a ‘profit centre’ approach. This usually means that the treasury charges individual business units a market rate for the service it provides. If it writes currency options, for example, it charges the business unit a premium in line with that charged by the banks. It then has the task of managing that option (by buying and selling in the forward market, or by using derivatives) for a cost that laves it with a profit. The main argument for this is that the treasurer is then motivated to do what is best for the company as a whole, that is, to minimise the cost of the operation. Spot checks are obviously required (e.g. by internal audit) to ensure that charges are indeed at market rates, since there is an imbalance in the amount of information available to the two parties (weighted in favour of the treasures). There are obviously some administrative costs involved, but the main drawback in practice has been that some treasures have interpreted the profit concept as encouraging them to speculate. If it can make a profit writing options, why not write them for other companies? If it understands the foreign currency markets, why not speculate – for example, swap funds from currencies expected to depreciate into ones expected to
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appreciate? Often spectacular gains can be made, but the record shows that spectacular losses are at least as likely. A sound internal control system is a necessity in any treasury function, but especially so when speculation is encouraged. Consequently, there are many who advocate a ‘cost centre’ approach. This usually means that the costs of running the department are collected (and, no doubt, compared with budget) but that the substance of the transactions that they manage is reflected in the business unit’s books: for example, the ‘profit’ made on writing options is credited to the business for which it was written. Alternatively, the profits/losses are allowed to lie where they fall: for example, the business unit carries the profit or loss on an overseas sale (according to the spot rate when the cash is received) and the treasury carries the offsetting currency loss/gain respectively (the difference between the forward rate obtained and the eventual spot rate). This approach collects the total cost/benefit of hedging. It discourages speculation but may, by the same token, discourage initiative. Confrontation can occur when the business unit bears a loss, caused – as it sees it – by the treasury. The debate as to which method is appropriate mirrors that in various other aspects of business enterprise. Perhaps the most important observation is that the accounting model – whether it focuses on costs or profits – is insufficiently dynamic/long-termist to provide a platform for strategic control. What is required is a distinctive financial management approach.
Solution 19 (a) The main areas of responsibility of a financial manager are: ● providing information and advice to the management of the organisation, especially in respect of the financial aspects of both regular and ad hoc decisions. ● monitoring the liquidity position of the organisation to ensure that there are sufficient cash resources available at all times. In addition, it will be necessary to consider alternative forms of financing when new projects are initiated. This might involve the issue of additional equity or borrowing more funds, either short or long term. (b) A knowledge of both finance and accounting is essential to provide a background to both these broad functions. Decision-making will require an understanding of the factors that influence costs and also a detailed knowledge of the evaluation procedures, such as net present value. However, sensitivity analysis and techniques to deal with risk will be an important part of the financial manager’s task. Scenario analysis is often useful in considering the aspects of risk that are important in making long-term decisions. The financing decision requires a detailed knowledge of the capital markets and the issues affecting the cost of capital. Implications of the sources of finance will be important, as the financial manager will have to advise on the most appropriate capital structure. Knowledge of the capital asset pricing model, arbitrage pricing theory and the implications of different dividend policies will provide the basis on which advice will be given to the people who are responsible for making decisions on financing. At all times, a close watch will be needed on the cash position of the organisation, as this is fundamental to its survival. The management and control of working capital is
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Solution 20 At the present time, the family does not wish to invest any more money in the business and also does not wish to dilute its holdings by inviting ‘outsiders’ to acquire shares in the company. This is a situation that is often encountered in family businesses, as the principal shareholders do not want to lose control of the company. It is possible that the family currently owns more than 50 per cent of the total shares issued and this puts them in a dominant position that it does not wish to relinquish. These views mean that it is not possible to raise the additional funds by means of either an issue of shares or a rights issue. It may be possible to offer non-voting shares to potential investors. These could be preference shares that would provide the owners of these shares a specific rate of dividend, though if the company experienced a ‘lean period’, it would be possible to avoid paying the dividend. This would give the company greater flexibility, especially if the company profits fluctuate. The dividend offered on the preference shares might need to be higher than the rate of interest that would be payable on debt. This would mean that the issue of nonvoting preference shares would increase the cost of capital of the company. A family that wants to retain control of a company will usually prefer to obtain additional funds by means of increasing the company’s debt. The amount of capital that has already been raised by debt in relation to other companies in the same industry will usually affect
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another important task. Techniques such as the economic order quantity model and credit management procedures should be introduced to ensure that sound policies are used to control the capital invested in stocks and debtors. (c) Initially, the objectives of the treasury department must be set. It is likely that an aggressive approach to profit maximising would not be considered appropriate as this may expose the organisation to too much risk. Therefore, goals must be set that would define the limits of both return and risk. This is a fundamental issue in any finance situation. It is possible that at least a break-even position should be the goal of treasury management. By considering the alternatives in respect of treasury activities throughout the organisation, it will be possible to identify the best course of action for the whole business. Additional funding through short- or long-term loans will be negotiated and all foreign transactions will be routed through the department. In this way, treasury management will be aware of all the areas in which the organisation is exposed to interest and foreign currency risk and be able to plan the most appropriate strategy for the whole firm. By coordinating all the financing issues in the one department, it will be possible to obtain a broader picture of the extent of financial transactions relating to the whole organisation. In addition, it will be possible to use specialist knowledge to ensure that the most appropriate measures are taken to minimise both the organisation’s financial costs and its risks. Netting of transactions within the organisation and the combination of transactions are methods by which transaction costs can be reduced. At the same time, an overall view of the assets and liabilities and the extent of exposure will enable an overall strategy to be developed that will try to meet the objectives of minimising the costs and risks faced by the organisation.
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the debt ratio that is considered to be appropriate. The major benefit of debt is that it is an expense of the business and so interest is deductible from taxable profits. This reduces the cost of debt funding. Companies use large amounts of debt especially if they expect a steady stream of income from their operations. As the interest must be paid, debt increases the risk of the company and so would be inadvisable if the company is likely to experience difficulties in servicing its interest and also the repayment of the debt. The nature of the new project will determine if the company will use either long-term or short-term debt. For a major project, it is likely that long-term debt would be appropriate as it is unlikely that repayment of both the debt and the interest will be possible in the short term. This means that the company will issue either debentures or bonds. The conditions regarding the issue of debentures can vary but they are often secured against specific assets or as a floating charge against all the assets of the company. Long-term loans can be negotiated with a financial institution and the terms will vary according to the lender’s view of the company as a credit risk. Medium-term financing in the form of leasing may be another method of obtaining the funds. In general terms, the management of the company must consider the alternative forms of financing that could be used. The factors that they need to take into consideration are the availability of funds, the relative cost of funds, the tax implications of the different methods of funding and, finally, the impact of the new funding on the capital structure of the company.
Solution 21 (a) The risk of Carlham’s short-term investment portfolio may be measured by the weighted average beta equity coefficient of the four shares. The weighting is by the market value of the shares.
Teval Undal Veral Wirtal
Portfolio beta is
Market value £ 280,000 527,000 390,000 3,408,500 1,605,500
Beta 1.55 0.65 1.26 1.14
Beta equity £ 434,000 342,550 491,400 3,465,690 1,733,640
1,733,640 1.08 1,605,000
Carlham’s short-term investment portfolio is slightly more risky than the market. (b) The composition of the short-term investment portfolio may be considered from two viewpoints: (i) Is the expected performance of the individual investments within the portfolio satisfactory? (ii) Does the portfolio provide the most suitable form of short-term investments for Carlham plc? (i) The individual shares may be examined to establish if they are expected to provide a satisfactory return for the systematic risk they involve. The required return is: Rf [(Rm Rf ) ] 2006.1
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Required returns 6% ((16% 6%) 1.55) 21.5% 6% ((16% 6%) 0.65) 12.5% 6% ((16% 6%) 1.26) 18.6% 6% ((16% 6%) 1.14) 17.4%
Teval Undal Veral Wirtal
Teval Undal Veral Wirtal
17.4%
Required return 21.5% 12.5% 18.6% 18.5%
Expected return 21% 12.5% 18% 1.1%
Expected abnormal return 0.5% 0% Hold 0.6% Buy more shares
Recommendation Sell shares Sell shares
If the above data are accurate, the shares in Teval and Veral are not expected to give a satisfactory return relative to their systematic risk, and should be sold. The shares of Undal should be held and further shares should be purchased in Wirtal, which has an expected positive abnormal return. (However, none of the abnormal returns are large and any decision to buy or sell might be influenced by this, as well as by the existence of transaction costs.) This analysis considers only systematic risk. If Carlham does not have other investments and is not well diversified, systematic risk is likely to underestimate the risk to Carlham of these investments. (ii) The portfolio is unusual for a short-term investment portfolio. Short-term investments are usually made for a specific purpose, for example to ensure cash is available for purchase of assets, payment of dividends, taxes or creditors where a known amount of funds is required. Most companies are not willing to tolerate much risk of price movement in their short-term investments. This portfolio of investments in ordinary shares is exposed to substantial price movements as share prices change in response to the possibility that one or more of the companies could fail. Although the expected returns are relatively high, the risk of this portfolio is very high relative to most portfolios of marketable securities. Unless Carlham is happy to take such risks, it is recommended that short-term investments should concentrate upon fixed-interest marketable securities such as Treasury bills, certificates of deposit and bills of exchange (which are discussed further in part (d)). Such investments involve much less risk of price movement and default and, if held short term, possible inflation is not a concern. (c) The factors that a financial manager should take into account when investing in marketable securities include the following: (i) Default risk. The risk that interest and/or principal will not be paid on schedule on fixed-interest investments. Most short-term investment in marketable securities is confined to investments with negligible risk of default. (ii) Price risk. The risk of the value of the investment changing, for example when interest rates change. Financial managers normally wish to avoid substantial price risk. (iii) Marketability. Securities should normally be marketable at short notice at close to the quoted market price. (iv) Taxation. Are there any special tax effects of the selected marketable securities? (v) Yield. Managers will usually try to achieve the maximum yield possible, consistent with a satisfactory level of risk and marketability. (vi) Foreign exchange risk. If marketable securities are not denominated in the domestic currency of the investor, foreign exchange risk must be taken into account. 2006.1
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where Rf is the risk-free rate (assumed to be the yield on Treasury bills) and Rm is the market return.
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(vii) The amount of funds to be invested. Some types of investment require a minimum size of investment. (viii) The period for which the investment is to be made. The type of investment should be matched with the timing requirements of the future need for funds. (d) Possible marketable securities include the following: (i) Certificates of deposit (mostly sterling or US dollar for UK companies). A certificate of deposit is an acknowledgement of a deposit at a bank, the certificate being issued by the bank. CDs are negotiable and have maturities from 3 months up to 5 years. (ii) Treasury bills issued by the UK government for periods of approximately 3 months. Such bills are free from default risk. (iii) Local authority bonds. These bonds may be purchased with a remaining maturity of anything from a few days to several years. They have a lower level of liquidity than most marketable securities. (iv) Government bonds, especially ‘short dated’ with relatively short periods of maturity. (v) Eligible bills of exchange and trade bills. Such bills have short maturities (mostly 180 days or less) and are negotiable. (vi) Corporate equity or debt. Such investments do not usually form a large part of a short-term investment portfolio because of their relatively high level of risk.
Solution 22 Companies use debt to finance projects as it is usually less expensive than the other alternative funding sources. By borrowing, the company is committed to paying interest at regular intervals. In addition, the repayment of the original sum can be either spread over the period of the loan or repaid in full at the end of the loan period. The company’s decision whether to use short-, medium- or long-term debt will depend on a number of factors that include the following: Maturity structure. It is wise for a company to spread the repayments of its loans over a period of time. It may be difficult if the loans had to be repaid at the same time and so the maturity should be spread over a period of time to reduce this problem. Relative cost. It is usually cheaper to arrange short-term finance such as an overdraft, as the negotiations and legal procedures are relatively routine and most firms frequently enter into these arrangements. The relationship between short- and long-term interest rates is related to the yield curve. Although at a moment of time it may appear to be cheaper to borrow short term, it could change if interest rates move upwards. The future movements in the interest rates are difficult to predict and many managers prefer to take a cautious approach to this, although there are hedging techniques that can be used to reduce interest-rate risks. Matching. It is important that the financing is ‘matched’ to the projects in which the funds have been used. If the funds are used to purchase assets that will earn income over a long period of time, it is possible to spread the repayment of the loan over the same length of time. However, short-term financing would be possible if the additional finance was used to fund extra working capital for a limited period. The general rule is that long-term finance should be used to fund long-term assets and, conversely, short-term loans can be used to fund short-term financial needs. It is possible and prudent that some of short-term financing is funded by long-term capital as this means
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Solution 23 (a) As far as ABC plc is concerned, the cash-flow implications of the two methods of financing can be compared as follows: Year
0 1 2 3 4 5 6
9% * DCF
1.000 0.917 0.842 0.772 0.708 0.650 0.596
Purchase gross tax £ £ (50,000) 3,125 2,344 1,758 1,318 5,000 989 1,716
Lease gross £ (15,000) (15,000) (15,000) (15,000) (15,000)
tax £ 3,750 3,750 3,750 3,750 3,750
Difference absolute discounted £ £ (35,000) (35,000) 14,375 13,182 13,594 11,446 13,008 10,042 12,568 8,898 2,239 1,455 1,716 3,1,023 11,046
*12% less tax @ 25%, ignoring lag.
Hence, borrowing to finance the purchase is preferable to leasing, on the terms quoted, that is, the net present value of ‘lease versus buy’ is negative to the extent of over £11,000. From the point of view of the leasing company, the cash flows should be summarised as follows:
Year 0 1 2 3 4 5 6
15% * DCF 1.000 0.870 0.756 0.658 0.572 0.497 0.432
Purchase/Sale gross tax £ £ (50,000) 4,125 3,094 2,320 1,740 5,000 1,305 2,266
Lease gross £ 15,000 15,000 15,000 15,000 15,000
Net tax £ (4,950) (4,950) (4,950) (4,950) (4,950)
absolute £ (35,000) 14,175 13,144 12,370 11,790 1,355 2,266
discounted £ (35,000) 12,332 9,936 8,139 6,744 673 3,979 3,803 2006.1
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that the company has a greater degree of flexibility in its financing arrangements. For example, permanent working capital should be funded by means of long- or medium-term capital but it would be possible to finance seasonal fluctuations by means of short-term loans. Flexibility. If only long-term loans are used, there are likely to be times when the company will have surplus funds available. At these times, interest will still need to be paid on long-term loans. However, it would be possible for short-term loans to be repaid and this might result in less total interest expense for the company. It is possible for a company to invest the excess funds for short periods but it is usual to find that the difference between the interest paid and received favours the banks. It is, therefore, important that companies have a ‘package’ of loans of different lengths to balance the financing needs and cost of borrowing funds. Another factor that is important in making the decision regarding the nature of the loans is the uncertainty of getting future finance. This could be significant if the company is planning to undertake some risky (but potentially very profitable) projects or if it is possible that the lenders will change their attitudes to lending in the future as a result of changes in the economy.
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Hence, the leasing company shows a positive net present value, but significantly lower than the corresponding negative from the lessee’s point of view. (b) To: Chief Executive From: Management Accountant Date: I have summarised, on the enclosed schedule, the cash-flow implications of the borrowing/leasing means of financing our new computer, from our point of view and from the leasing company’s point of view. You will see that, assuming our borrowing costs remain at 12 per cent per annum, we are better off borrowing than leasing. If you share my concern that interest rates could increase, perhaps we can have a word about the possibility of hedging the risk, for example, by entering into an interest rate swap agreement. You mentioned obsolescence the other day, but having studied the draft lease, it is clear that the risk is ours. There was a company (Atlantic) that offered the facility to trade in or ‘walk away’ from the lease, but they went into liquidation. We could seek out organisations that offer an operating lease, or even facilities management. Either of these would provide a hedge against obsolescence, but the cost would be even greater than the quote evaluated here. Conversely, the leasing approach would be attractive from the point of view of the lessor. However, I would not advise devoting any energy or time to negotiating their quote downwards. Our relatively low tax rate, and our capacity to use the capital allowances, means that leasing is uneconomic. If there are any aspects you wish to probe further, we could discuss it ahead of the … meeting. Signed: Management accountant (c) It is important to distinguish between the two stages of an evaluation of this kind, summed up in the following questions: ● does the project add to the value of the entity? This involves discounting projected cash flows at the (weighted average) cost of capital to the entity; and ● (assuming a positive answer to the above), how should the initial investment be funded, so as to maximise the proportion of the value that is attributable to the equity? This involves comparing the after-tax interest costs associated with the alternatives – in this case, bank borrowing and leasing. In this particular example, the use of a higher figure would not have altered the conclusion, as it is largely the different tax situations that explain the mismatch of the evaluations. (d) The leasing company might offer to reduce the lease payments but, as indicated above, they could not match ABC plc’s needs without inducing a negative net present value. They may have more chance with a customer with unused tax allowances, but vis-à-vis ABC plc the only thing that would alter the conclusion would be to lower the cut-off rate. Beyond that, the company might consider seeking better terms from the manufacturer.
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Solution 24 Requirement (a) (i) Dividend policies and effect on market value Payout and P/E ratios for the two companies are as follows: AB 1999 2000 2001 2002 2003 2004
●
●
●
●
●
●
Payout 26 40 60 – 60 40
YZ P/E 9.1 10.0 10.0 – 10.0 9.3
Payout 40 40 40 – 40 40
593
P/E 9.2 10.6 15.6 – 13.9 11.7
Investors usually expect a constant dividend policy and a large rise or fall in any one year can have a significant effect on a company’s share price. Both companies have had constant policies, which act as a signal to investors: – AB has followed a policy of paying a fixed amount of 60 cents per share each year, including 2002 when the company sustained a loss. As earnings were actually declining, this meant a decreasing amount available for investment. The unwillingness of the company to restrict dividends when the company’s earnings were underperforming is likely to have led to continued low growth and a negative effect on share price and market value. – YZ has paid a fixed payout ratio of 40% of earnings each year, excluding 2002 when this company also sustained a loss. This meant that shareholders received widely varying dividends from 0 in 2002, 36 cents in years 2001 and 2003 and 96 cents in 1999. This may seem logical, but unless the market and shareholders are fully aware of this potential volatility it may result in sending negative signals to the market. However it increases share price volatility. In 2002, when the profits of both companies fell, AB’s shares fell by 20% whereas YZ’s fell by 35%. There is no definite relationship between the share price and dividend policy of these two companies. If AB continued to pay dividends when it was loss-making on the basis of sending signals to the market, this had little effect as the market value and P/E ratio were lower than YZ, which had similar losses. YZ had a rights issue in 2003 when shares were apparently at a low ebb following a year of losses. This might not have been a sensible time to launch a rights issue, but may have been necessary as a survival tactic. Compared to AB, it does not seem to have had too adverse an effect on share price. In 1999, the two companies had similar EPS and P/E ratios, but AB having more shares in issue had a higher market value. Since 1999 YZ has been given a higher growth rating by the market, as evidenced by the P/E ratio. This might suggest the market prefers a dividend policy of a constant payout ratio, but this is unlikely. The market is more likely to be reacting to YZ’s business strategy. In practice there is unlikely to be a single ‘optimal’ dividend policy for all investors as some will prefer dividends and some capital growth. Evidence is sparse that the ‘clientele’ effect has a strong influence on investor preferences in any given company.
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(ii) Optimal dividend policy In theory, according to Modigliani and Miller, dividend payments are irrelevant to the value of the firm. However, this theory makes three basic assumptions: 1. Perfect capital markets, no tax differentials and no transaction costs. 2. Rational investors, indifferent to return as capital gain or dividend. 3. Certainty about the future investment programme. These assumptions may be considered unrealistic, although probably not so unrealistic as to void the theory altogether. Capital markets are fairly efficient, at least for the larger companies’ shares, there are few tax differentials that really matter and transaction costs are relatively insignificant especially for the larger investors. It is unlikely there is an ‘optimal’ dividend policy for any firm as noted above. In theory, if a company has sufficient positive NPV investment, it should pay 0 in dividends; if it has no such investments it should return 100% of earnings to shareholders as dividends. Companies rarely do this. In a listed company, the ‘signalling’ mechanism of dividends is believed to have a strong influence on company directors who insist on paying maintained or even increased dividends when they should be reducing them, as evidenced by AB maintaining its dividend in the face of falling earnings and even losses. This policy does not seem to have translated into higher share price performance. Requirement (b) Methods of share repurchase Shares may be repurchased by one of the following methods: ● ● ●
purchase on the open market; individual arrangement with institutional investors; a tender offer to all shareholders.
An individual arrangement with institutional investors tends to be the most popular approach as it is the quickest, most efficient means of returning surplus cash. Often, therefore, only a small group of shareholders will participate in a share repurchase, whereas all shareholders will participate in a special dividend. A further consideration in the return of surplus cash concerns the possible tax implications for investors. A share repurchase may lead to a capital gains tax liability for participating investors, while a special dividend would normally attract an income tax liability. Reasons for share repurchase The repurchase of a company’s shares may be carried out for a number of reasons: ● ● ● ● ●
●
return of surplus cash to investors; to reduce the company’s cost of capital; to enhance earnings per share in the hope of also increasing market price per share; to prevent, or reduce the likelihood of, unwelcome takeover bids; to adjust the gearing of the company to a higher level, closer to the company’s optimal capital structure; to reduce the amount of cash needed to pay future dividends.
Potential problems of share repurchase are: ●
It may suggest a failure of management to identify projects that will generate returns above the company’s cost of capital. However, the logic is that returning capital to
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● ●
The majority of share repurchases, and special dividends are the result of companies having surplus cash in excess of their operational requirements, for example Vodafone in the UK. An example of dividend versus repurchase AB has excess cash of €2.5 million (or 10 cents per share) and is considering payment of this amount as an extra dividend. The Chairman has forecast that earnings will be €40 million next year, or €1.60 for each of the 25 million shares outstanding. The price earnings ratio is 9.3, so the shares of the firm should sell for €14.88. Alternatively, AB could use the excess cash to repurchase some of its own stock. Assume a tender offer of €15 a share is made. Here 166,667 shares will be repurchased so that the total number of shares remaining is 24.83 million. With fewer shares outstanding, the earnings per share will rise from 160 cents to 161.1 cents. The price-earning ratio remains at 9.3, since both the business and financial risks of the firm are the same in the repurchase case as they were for the dividend case. Thus the price of a share after the repurchase is €14.98. If commissions, taxes and other imperfections are ignored, the stockholders should be indifferent between a dividend and a repurchase. With dividends, each stockholder owns a share worth €14.88 and receives 10 cents in dividends, so that the total value is €14.98. This example illustrates that, in a perfect market, the firm is indifferent between a dividend payment and a share repurchase. This is similar to the indifference propositions established by MM. The calculations here make a number of assumptions and only a small number of shares are redeemed, so the effect is minimal. However, the principle is confirmed that share repurchase leads to an increase of 10 cents in share price, all other things being equal. However, the financial press may place undue emphasis on EPS figures in a repurchase agreement. Given the irrelevance propositions of MM, an increase in EPS need not be beneficial. When a repurchase is financed by excess cash, in a perfect capital market the total value to the stockholder should remain the same under the dividend payment strategy as under the repurchase agreement strategy.
Solution 25 (a) Project investment appraisal at 20 per cent before tax (13 per cent after tax)
Year 0 1 2 3 4 5
Investment £000 (60)
Income £000 29 29 29 29
4
Tax on income £000
(10.1) (10.2) (10.1) (10.2)
Tax all’nce on WDA £000
5.2 4.0 2.9 7.5
Net cash flow £000 (60.0) 29.0 24.1 22.8 21.8 1.3
13% DCF factor 1.00 0.88 0.78 0.69 0.61 0.54
Discounted net cash flow £000 (60.0) 25.5 18.8 15.7 13.3 20.7 14.0 2006.1
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●
shareholders gives the shareholders the opportunity to generate higher returns for themselves by investing elsewhere. If the arrangement is with institutional investors, subject to shareholder agreement, not all shareholders will be able to participate. Determining a price that is fair to all can be difficult. Tax disadvantages, for example shareholders may become liable for capital gains tax at an inconvenient time.
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Recommendation There is a positive discounted cash flow at 13 per cent so that, from an economic viewpoint, RS Ltd should invest in this machine. (b) Equal annual payments to service a bank loan at 20 per cent repaid over 4 years is: £60,000 £23,166 2.59* * Cumulative present value over 4 years.
Year 0 1 2 3 4
Split of investment and capital repayment Interest Annual Available to Balance at 20% payment repay principal outstanding £ £ £ £ 60,000 12,000 23,166 11,166 48,834 9,767 23,166 13,399 35,435 7,087 23,166 16,079 19,356* 3,871 23,166 19,295*
* Rounding difference
Option 1 Using a bank loan to purchase the machine:
Year 1 2 3 4 5
Annual payment £ (23,166) (23,166) (23,166) (23,166) 4,000
Tax all’ance on int’st £
Tax relief on WDA £
4,200 3,418 2,480 1,355
5,250 3,938 2,952 7,459
Net cash flow £ (23,166) (13,716) (15,810) (17,734) 12,814
DCF factor at 13% (20% at 35% tax rate) 0.88 0.78 0.69 0.61 0.54
Discounted net cash flow £ (20,386) (10,698) (10,909) (10,818) 2 6,920 (45,891)
Option 2 Lease for four years at £23,166 per year: Year 1 2 3 4 5
Annual payment £ (23,166) (23,166) (23,166) (23,166)
Tax allowance £ 8,108 8,108 8,108 8,108
Net cash flow £ (23,166) (15,058) (15,058) (15,058) 8,108
DCF factor at 13% 0.88 0.78 0.69 0.61 0.54
Discounted net cash flow £ (20,386) (11,745) (10,390) (9,185) 2 4,378 (47,328)
Therefore, the use of a bank loan to purchase the machine is the least-cost solution when compared with the lease arrangement. RS Ltd would be financially better off to use this method. (c) Recommendation RS Ltd is recommended to purchase the machine as it is a financially viable proposition. Because it does not have the cash available for purchase, it should borrow from the bank at 20 per cent. This is cheaper overall than a 4-year lease at a similar annual payment. 2006.1
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Solution 26 Tips ● The question tested for an understanding of the different types of lease available and for an ability to analyse and evaluate the decision from the point of view of both lessee and lessor. ● Common failings in candidates’ answers to this question were: – omitting scrap values – using incorrect discount rates – not appreciating that this was a comparison of cash outflows (not an investment appraisal) – little or no discussion – including capital allowances in the evaluation for the lessee – MRF is a charity and therefore tax exempt. (a) Calculations
Year 0 1 2 3 4 5 6 6 (disposal)
Forecast cash flow, £m Method of financing Bank loan Lease (22.50) (2.70) (7.50) (3.02) (8.40) (3.38) (9.41) (3.79) (10.54) (4.25) (11.80) (4.76) (13.22) 2 4.00 (60.87) (40.40) (60.87)
Difference (22.50) 4.80 5.38 6.03 6.75 7.55 8.46 04.00 20.47
Examiner’s Note The above layout might be more understandable for a non-accountant, and less prone to error. It would have been equally acceptable to use a discounted cash flow approach to arrive at a net present value of £10.37m (which is the product of the above terminal value of £20.47m and the year 6, 12 per cent per annum discount factor of 0.507) as follows: Year 0 1 2 3 4 5 6
12% disc. factors 1.000 0.893 0.797 0.712 0.636 0.567 0.507
Bank loan (22.50)
4.00
Cash flow, £m Lease Difference PV (22.50) (22.50) (7.50) 7.50 6.70 (7.50) 7.50 5.98 (7.50) 7.50 5.34 (7.50) 7.50 4.77 (7.50) 7.50 4.25 (7.50) 11.50 25.83 Net present value 10.37
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Outright purchase has the advantage of pride of ownership and a right to modify or adapt as necessary. Leasing might entail using specified service agents. There is also a chance that the machine’s life might exceed the expected 4 years.
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Assumptions Bank interest is an acceptable equivalent method of financing for the charity. The bank will lend to a charity and the charity’s regulations permit borrowing. Advice Better to buy with a bank loan as the cash outflows associated with the lease are higher than with the loan. Alternative to consider: public appeal for this specific project. The solution provided here is the published solution for this examination question. While covering the key points required by the question, it should not be considered an ideal solution, either in terms of its presentation or content. (b) Renegotiation of lease terms Report To: Helen From: Account negotiator Date: 26 November 20X1 Subject: Lease negotiations with MRF Calculations All values, £m 14% Year factor 0 1.000 1 0.877 2 0.769 3 0.675 4 0.592 5 0.519 6 0.456 Total 3.888
Capital (18.00)
24.00 (14.00)
Revenue 7.50 7.50 7.50 7.50 7.50 27.50 45.00
Capital all’nces 4.50 3.38 2.53 1.90 1.42 20.27 14.00
Profit 3.00 4.12 4.97 5.60 6.08 27.23 31.00
Tax (0.99) (1.36) (1.64) (1.85) (2.01) 2(2.38) (10.23)
Net (18.00) 6.51 6.14 5.86 5.65 5.49 29.12 20.77
PV (18.00) 5.71 4.72 3.96 3.34 2.85 4.16 6.74
Points to include The use of 14 per cent discount rate to evaluate the cash flows assumes that the risk of the project is the same as the average risk for the leasing company; if this is not true a lower rate could be applied. The evaluation also assumes that the leasing company can take advantage of capital allowances, that is, it has sufficient profits to absorb the relief. If the leasing company wishes to match the deal offered by the bank it will necessitate the charity being given a reduction in repayments of £10.37m over 6 years. This is £2.52m per year (£10.37/4.111). However, although MRF may now be indifferent, the leasing company has an almost zero NPV – only just acceptable. The leasing company may be willing to accept a lower discount rate, and therefore lower repayments, to gain the business. The leasing company could also borrow to finance the purchase which would provide tax relief, although if this increases their gearing too much it may have an effect on their cost of capital (doubtful; £18m for a finance company is a small amount of money). The breakeven point for repayments to the charity between the lease and the loan is £4.98m per annum. At this amount the charity is indifferent. This is also the break-even point for the leasing company at 14 per cent opportunity cost of capital. If the leasing 2006.1
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NPV @ 14 per cent Tax relief on £18m debt interest (assuming 6-year debt at 12 per cent) APV
£ 0.17 2.92 (Note 1 below) 3.09 3.09
Note 1 This is calculated as £18m 0.12 0.33 £0.71m per year. The present value of this for 6 years is £0.71m multiplied by the annuity factor for 6 years at 12 per cent (4.111), which is £2.92m. It assumes tax relief can be utilised by the leasing company and that the discount rate to apply to the tax refunds is the same as the coupon rate on the debt. It also assumes that the cost of debt to the leasing company is the same as for the charity; this is unlikely as the leasing company will almost certainly be able to raise debt more cheaply.
Solution 27 (a) All figures in £000s Profit from operations Add depreciation /change in debtors /change in creditors Cash flow from operations
No change in policy 1,326 225 230 144 1,465
Changes implemented 1,424 225 72 86 1,635
Interest paid Tax paid Dividends paid
54 283 339
45 283 339
Investing activities Non-current assets Inventory
550 275
550 212
36 25 11
206 25 231
Net cash flow Opening balance Closing balance Changes implemented 1. Profit from operations: Revenue Less discounts CoS (3,224 225) 95% 225 Operating expenses (unchanged)
5,200 52 3,074 650 1,424
2. Decrease in receivable: £520 [(£2,600/365 53) (£2,600/365 10)]
72
86
212
Decrease in trade creditors: [£320 (£2,849/365 30)] 3. Inventory: [£350 (625 90%)]
(b) Report To: Ms Smith From: Assistant Subject: Proposed working capital policy changes 2006.1
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company finances the lease with debt, the tax relief would allow this. An APV calculation shows this:
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The solution provided here is the published solution for this examination question. While covering the key points required by the question, it should not be considered an ideal solution, either in terms of its presentation or content. To include: ●
●
●
●
●
●
●
● ●
Comment that cash flow is improved by almost a quarter of a million pounds if the proposed changes are made. Problems appear to have arisen because credit and stock control have not been adequate for increased levels of turnover. Liquidity: current ratio was 0.95 : 1 (all current assets to trade and other creditors), will be around 1.2 : 1 under both options. Perversely, ratio looks to improve even if company takes no action and causes an overdraft. This is because of high debtors and stock levels. Moral: high current assets do not mean high cash. Cash ratio perhaps a better measure. Debtors’ days last year was 45, forecast to rise to 53 on current policies despite ‘official’ terms being 30. Company could perhaps look to improve its credit control before offering discounts. Creditors’ days were 46, forecast to rise to 52. Are discounts being ignored? Are relationships with suppliers being threatened?* Dramatic increase in stock levels forecast: 50 days last year, 71 days forecast this year. If change implemented, stock will still be 67 days.* Operating profit percentage forecast to fall to 25.5 per cent from 281.1 per cent if no changes made. Percentage will fall to 27.4 per cent if changes implemented; a fall probably acceptable if cash flow improved and overdraft interest saved. Non-financial factors include relationships with customers and suppliers. Other financial factors, is increase in turnover sustainable? *Using cost of sales figures including depreciation.
Solution 28 (a)
(i) The current market capitalisation is 2m £1.68, that is £3.36m. The after-tax present value of the investment is £0.2m 18%, that is, £1.111m. Thus, if the £1m is all equity, market capitalisation ought to increase to £4.471m (an enhancement, net of the investment, of £0.111m). If it is raised in the form of borrowings that accrue interest at 12 per cent p.a., the net cash flow will be (£0.3m £0.12m) less 33 per cent, that is, £0.12m p.a., which at 18 per cent p.a. has a value of £0.667m. On the assumptions provided, this would be a straight enhancement of the market capitalisation, bringing it to £4.027m. (ii) Assuming more equity is raised, the gearing will be £1m £5.471m, that is, 18.3 per cent. Assuming the money is borrowed, the gearing will be £2m £6.027m, that is, 33.2 per cent. (iii) Assuming more equity is raised, the cost of capital would be calculated as: £1.000m @ 6.7% £4.471m @ 18% £5.471m
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£ 67,000 804,000 871,000
i.e. a WACC of 15.9% p.a.
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£1.000m @ 6.7% £1.000m @ 8% £4.027m @ 18% £6.027m
£ 67,000 80,000 724,000 871,000
i.e. a WACC of 14.5% p.a.
(b) Report To: The board of RH plc From: Financial manager Date: Subject: Funding of the increased working capital requirement Market value of the firm is maximised under option 1 – financing with equity – and theory suggests that this is the main criterion. However, earnings per share (EPS) has a key position in company objectives and, in practice, the dilution effect of new equity cannot be ignored. This dilution is irrelevant if the new equity is raised via a rights issue and all shareholders take up their entitlement. However, the choice depends on the company objectives. If it aims to increase EPS, a common objective of companies, then option 2 is likely to be preferable. However, this option would increase financial risk, which has a knock-on effect on cost of capital. The calculations above assume no change in cost of equity. This would be unrealistic, and it is likely that the return required by shareholders would rise substantially. The required rate of return might not rise in strict proportion (as suggested by Modigliani and Miller) but clearly shareholders would require a greater return for higher levels of risk. The effect on dividend should also be considered. Earnings available for equity is lower if financing is with debt that could put dividend payments at risk if the return on the new investments failed to materialise either as early or as profitably as forecast. Other suitable types of finance to consider: medium-term debt, such as bank loans, or even an overdraft. The impact on EPS and dividend per share, and signals to the market, must be considered. Leasing is not suitable as financing for working capital, but factoring could be considered. Market and economic factors must also be considered. For example, the level of interest rates might affect the decision to finance with debt. The current price/earnings ratio is less than 6. This is very low for an industrial company, and casts doubts on the company’s ability to raise new equity if its growth prospects are so low.
Solution 29 (a) Current number of shares Market capitalisation Current EPS Current P/E ratio Rights issue price Number of rights shares at 1 : 6 Amount of rights issue
45m/0.50 90m 4 £36m/90m 400/40 400 0.7 15 million 15m £2.80
90m £360m 40p 10 280p
£42m
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Assuming the money is borrowed, the cost of capital would be calculated as:
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90 15 (360 42)/105
105 million 383 pence
Debentures redeemed Interest saved Tax saving forfeited Net saving New earnings figure New EPS New share price
£42m/1.20 35m 0.14 4.9 0.30 4.9 1.47 36 3.43 39.43/105 37.5 10
£35m £4.9m £1.47m £3.43m £39.43m 37.5 375 pence
As this is less than the theoretical ex-rights price, the proposal would have a negative impact on shareholder value. However, the expectation that the P/E ratio would be unaffected by the reduction in gearing does not seem realistic. If, as is more likely, the reduced gearing results in increasing the P/E ratio, the impact may be favourable. (b) A rights issue is an offering of new shares for subscription by existing shareholders in proportion to their existing shareholdings, in accordance with the principle of preemptive rights. Any new issue of shares in excess of 5 per cent of a company’s issued share capital (or 7.5 per cent maximum in a rolling 3-year period) would be subject to pre-emptive rights. Shareholders who do not wish to take up the rights can sell them on a nil-paid basis. A rights issue can be made at any time. A VCP, on the other hand, is made specifically in connection with acquisitions. It occurs when an acquiring company issues new equity in exchange for an acquired company’s assets, and places them with institutions for cash that is received by the owners of the acquired company. Thus, although the acquisition is effected by exchange of equity shares, the vendors still receive payment in cash. Pre-emption rights do not, therefore, apply. However, if the VCP relates to over 10 per cent of the issuing company’s share capital, or if the shares are offered at a discount to the market price greater than 5 per cent, existing shareholders are entitled to a 100 per cent clawback – that is, they are entitled to purchase shares at the placing price on a basis pro rata to their existing shareholding, to maintain their percentage holding and benefit from the discount offered (but these rights cannot be sold on a nil-paid basis, as in a conventional rights issue). (c) Listing particulars: Provide information about company, and state the purpose for which new funds are required. If for acquisition, information regarding the company to be acquired is to be furnished. Disclosure of material contracts entered into in the preceding year, and any legal or arbitration proceedings, etc., are required. Detailed regulations on what is to be contained in listing particulars are furnished in the Stock Exchange Yellow Book. Full listing particulars not required for issues of less than 10 per cent of existing issued equity. Provisional allotment letter: For rights issues, a provisional allotment letter (not a subscription form) is required. Each letter is to be addressed to an individual shareholder, specifying the exact number of shares that have been provisionally allotted. (d) In return for a fee, underwriters agree to subscribe for all shares not sold. The company effectively purchases a put option which guarantees take-up of all the issue, particularly if the equity market falls significantly between the time of setting the issue price and the closure of the offer. Underwriting is essential when the uncertainty costs of an undersubscribed issue are considerably greater than the costs of underwriting. It is possible to dispense with underwriting in respect of deeply discounted rights issues, which are unlikely to fail. However, it is relatively rare for underwriting to be dispensed with, as the presence of underwriters is a favourable signal to the market. 2006.1
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(a) Assessment of lease alternative The first step in tackling the problem is to correctly compute the tax shield on capital allowances:
Year
WDV of investment
Capital allowance
Tax shield on capital allowance
0 1 2 3 4 5 Less: Salvage value
200,000 150,000 112,500 84,375 63,281 47,461 30,000
50,000 37,500 28,125 21,094 15,820
10,500 7,875 5,906 4,430 3,322
17,461*
3,667
* Including balancing allowance
The next step is to do a DCF analysis of the cash flows arising as a result of choosing the leasing alternative. The discount rate to be used is the after-tax borrowing rate, that is, 12.75 (1 0.21) 10 per cent approximately. Tax shield Tax shield on purchase Lost on Salvage Lease lease cost capital value payment payments saved allowances lost
Year 0 1 2 3 4 5 6 NPV
200,000 45,000 45,000 45,000 45,000 45,000
9,450 9,450 9,450 9,450 9,450
10,500 7,875 5,906 4,430 3,322 3,667
Net cash flow
200,000 55,500 43,425 41,456 39,980 30,000 68,872 5,783
Discount factor @ Present 10% value (PV) 1 0.909 0.826 0.751 0.683 0.621 0.564
200,000 50,450 35,869 31,133 27,306 42,770 3,262 15,734
The NPV of the leasing alternative (when discounted at the after-tax borrowing rate of 10 per cent) is positive, hence it is better than the borrowing alternative. Note: If the alternative method of evaluation (i.e. PV of leasing costs versus PV of borrowing costs) is used, the correct answer should find that the PV of leasing costs is less than the PV of borrowing costs by £15,734. (b) A hire purchase transaction is similar to leasing in that immediate cash outflow for purchase of the asset is avoided, the cost of the asset being paid for in instalments over the period of hire purchase. But an important difference is that, under hire purchase, the contract envisages that the ownership will ultimately pass to the user of the asset. Consequently, the user of the asset gains the benefit of capital allowances and salvage value; in a leasing transaction, these benefits go to the lessor, not to the lessee. The other difference is that only the interest component of the hire purchase instalment is debited to the hirer’s profit and loss account (thereby creating a tax shield); in the case 2006.1
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Solution 30
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of leasing, the whole of the lease rental is charged to the lessee’s profit and loss account.
Solution 31 Requirement (i) The price to be offered Preliminary calculations Note: Valuations for BST are provided here as well as for SM as BST’s share values may be needed for the bid terms. Information in question (shown here in italics for convenience) EPS – pence DPS – pence Share price – pence No of shares (Million)
BST Motors
SM Limited
112.5 50.6 1237 25
153.0 100.0 n/a 1.5
Three types of valuation are attempted here: market value, asset value and value based on the dividend valuation model. Capitalisation of earnings would also be an acceptable method. Brief comments on the method of valuation accompany the calculations. Share price and market value using quoted share prices Assuming market capitalisation is assumed to represent market value, current market value is derived from a combination of historic earnings, the market’s expectations of future earnings and risk characteristics of the company. However, market prices may contain elements of speculative premium, particularly in a bid situation. The advantages are that, with a listed company, it is publicly available information and provides a benchmark for valuation. SM shares are not quoted, so the company does not have a market capitalisation, but clearly it has a value. We could use a ‘proxy’ P/E ratio if one were available, for example the industry average. If we use BST’s P/E – which may or may not be at all representative – and apply it to SM’s earnings, we get a value of £25.24 million (153 EPS 11 P/E 1 .5 million shares in issue). Using forecast future earnings of £4 million we get a potential value of £44 million. BST’s P/E could be adjusted to take account of SM being unlisted and a smaller company, but it is debateable whether the adjustment should be up or down. Share price and market value using dividend valuation model p0 d1 (ke g) 105/(0.10 0.05) 2100p Total equity value £million £21 1.5 million 31.50 This method of valuation requires knowledge of the cost of equity, dividend policy and the investment programme of the firm and assumes no external funding. In its simplest form it assumes constant growth although it can be adapted for other growth patterns. It assumes a share price is a function entirely of dividend policy and as such has serious limitations except as a benchmark. Here, we have assumed the dividend will be maintained at 100p plus 5% growth next year. Given that earnings are forecast to increase by 74% this may be too low. However, this forecast has been made by SM’s Managing Director who 2006.1
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Asset-based value Pence per share 45/1.5 3000 The expression ‘asset value’ is largely restricted to tangible assets and is usually based on costs not values. Frequently it has little relevance except in specific circumstances such as a liquidation or disposal of parts of a business. However, the circumstances here are unusual in that BST appears to be as much a property company as a motor trader (similar situation to Woolworths in the UK). SM also appears to have substantial property assets. It also has a valuable franchise, which will not be reflected in the balance sheet. Details of this franchise need to be known before a true valuation can be obtained. Price Range Market price DVM Asset value
£m 25/44 32 45
Per share (pence) 1667/2933 (current/forecast) 2100 3000
Requirement (ii) Financial factors that might affect the bid ●
●
●
●
●
●
As both P/E and DVM based valuations are below asset value, it is unlikely SM would consider an offer on these bases. Also, both use subjective estimates, which are unlikely to be anywhere near accurate. It is not clear how much cash BST has available. A share for share exchange will take longer to arrange and be more costly. The main business consideration is whether BST would want to be bothered with a deal of this relatively small size unless it was an entry vehicle into the prestige end of the motor distribution market. It is not clear from the question details that BST has any intention of diversifying into this ‘top end’ market of which it has no experience. This suggests that part of the deal might involve retaining some of SM’s management and employees. BST appears to be valued by the market at below asset value. This suggests either the assets are considered over valued in the balance sheet (unlikely) or the company, being relatively small, has avoided the scrutiny of the market. If BST does embark on a takeover, even an agreed one, it will arouse interest in the market and this discrepancy between asset value and market value would become subject to publicity. It could itself become a takeover target. SM is paying 65% of its earnings in dividends – not unusual for a small private company. If the dividend payout was reduced the valuation of the company might increase as funds could be retained for profitable investment (dividend irrelevancy theory notwithstanding). As SM has approached BST there is no reason why BST cannot get access to SM’s forecasts and business strategy to determine a more accurate price. 2006.1
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clearly has an interest in showing the company’s financial prospects in the most favourable light. An increase of 74% seems extremely high and warrants some scepticism. As this will be an agreed bid if it proceeds, BST should be able to verify the forecast. Clearly the difficulties faced by an outsider wishing to arrive at a valuation on the DVM basis are formidable. As in the question here, the difficulties are often suppressed by assuming that the future is a projection from the past. As BST is likely to gain access to SM’s projections, as noted above, using the DVM with estimated figures for growth is unlikely to be necessary.
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●
Will all SM’s shareholders be agreeable to the bid, or could a sizeable minority frustrate negotiations. Are there any other interested buyers that could lead to a price war? Has BST looked at other investment/takeover opportunities?
Requirement (iii) Funding the bid There are two methods to consider, cash and shares. The asset value would appear to be the starting price. £45 million is a relatively small sum of money and BST would almost certainly pay cash, even if this means increasing borrowings. Its borrowings at present are around £77 million, assuming its debt is quoted at par. Calculated as: Debt ratio Debt/Market value of company 20% Debt therefore 25% (12.37 25 million) £77.3 million If a further £45 million were to be raised, this would increase the debt ratio to 28% [122.3/(309.25 122.3)] which is not excessive for a company with substantial asset value. A share exchange would be more expensive and time consuming and would raise issues of dilution of EPS and control – how important this last issue might be is difficult to judge on the limited information available. However, it would have a favourable impact on the debt ratio, which would reduce to approximately 18% (£77 million/(£309 45 77). If 100% of SM’s shareholders were willing to accept shares, this would imply a minimum of 3.64 million new BST shares would have to be issued, assuming the current share price used as an exchange factor (£45 million/12.37). This is a ratio of 2.4 BST shares for each SM share. A combination of cash and shares is more likely to be the preferred option for most shareholders so BST needs to be prepared to negotiate. Requirement (iv) Organic growth versus acquisition Advantages of acquisition in general are often claimed as: ● ●
●
●
●
Buys out or reduces competition – not relevant here. Allows increase in market size and therefore influence on the market to be achieved more quickly – possibly a factor here given the franchise and location issues. Potential for economies of scale and synergies – although often these fail to materialise and unlikely to be of great significance here. Unless the two companies’ cash flows are perfectly positively correlated – unlikely – there will be some diversification of risk which might allow a lower cost of capital and hence increase in market value (all other things remaining equal). An advantage of an agreed bid is that there should be opportunities for sharing information to allow a realistic valuation and assessment of likely acquisition benefits. It is, therefore, likely to be faster than organic growth without the disadvantages of the unknown factors present in hostile bids.
Disadvantages are: ●
●
Integration of businesses and company cultures can take longer, be more costly and difficult than anticipated. The amount of information on the target in an acquisition may be limited and leads to post-acquisition surprises.
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This question deals with the role and management of the treasury function. Candidates are required to comment on the advantages of establishing a separate treasury function, and the advantages and disadvantages of operating this function as a profit centre. (a) The treasury function represents one of the two main aspects of financial management, the other being financial control. Treasury is concerned with the relationship between the entity and its financial stakeholders, which include shareholders, funds lenders and taxation authorities, while financial control provides the relationship with other stakeholders such as customers, suppliers and employees. In larger entities, treasury will usually be centralised at head office, providing a service to the various units of the entity and thereby achieving economies of scale. Financial control will frequently be delegated to individual business units, where it can more closely impact on customers and suppliers and relate more specifically to the competition that those units have to face. As a result, treasury and financial control may often be separated by location as well as by responsibilities. The key tasks of the treasury can be categorised according to the three levels of management: ● strategic – for example, matters concerning the capital structure of the business and distribution/retention policies, raising capital, including share issues, assessment of the likely return from each source and the appropriate proportions of funds from each source, the decision as to the level of dividends, and consideration of alternative forms of finance; ● tactical – for example, the management of cash/investments and decisions as to the hedging of currency or interest-rate risk; ● operational – for example, the transmission of cash, placing of surplus cash and other dealings with banks. Treasurers require specialist skills to be able to handle effectively an ever-growing range of capital instruments. They also need a knowledge of taxation in all areas in which the group operates, and the ability to advise on policies that have taxation implications. Both the treasurer and the financial controller will usually be responsible to the finance director. An example of how their roles may differ would be: the treasurer is best able to assess cost of capital and quantify the entity’s aversion to risk, while the financial controller relates these factors to group policy. Advantages to the company of a separate treasury function 1. Control of cash will be recognised as a separate and significant activity, concentrating on the most efficient use of this vital resource. 2. Cash-reporting packages will be receivable in a suitable form and in good time to help management in making effective cash decisions. 3. The function will be geared to the short response times required for cash transactions. 4. As a specialist user, treasury can ensure that information technology software is made available to meet the specific needs of cash/currency management. 5. Corporate planning staff will be aided by expert advice and quick feedback from specialists in such matters as interest rates and currency movements. 2006.1
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Solution 32
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6. Marketing management will be given a competitive edge by specialist expertise and speed of response in making important cash-based decisions, especially with regard to overseas projects and transactions. 7. Treasury could provide a training ground in finance for future line management, as its staff will need to be capable of making quick but sound decisions. 8. Treasury could operate as a profit centre. (b) The main advantages of operating treasury as a profit centre rather than as a cost centre are: ● individual business units of the entity can be charged a market rate for the service provided, thereby making their operating costs more realistic; ● the treasurer is motivated to provide services as effectively and economically as possible to ensure that a profit is made at the market rate, for example, in managing hedging activities for a subsidiary, thereby benefiting the group as a whole. ●
●
●
The main disadvantages are: the profit concept is a temptation to speculate, for example, by swapping funds from currencies expected to depreciate into ones expected to appreciate; management time is spent in arguments with business units over charges for services, even though market rates may have been impartially checked (say by the internal audit department); additional administrative costs may be excessive.
Solution 33 This question is aimed at testing gearing ratios, the cost of capital and the role of merchant banks in connection with an issue of new finance. It asks candidates to discuss why a particular form of financing might be preferred. Prior-charge capital Prior-charge capital equity 8,000,000 1,000,000 (i) Book values: 48.3% 9,000,000 9,650,000
(a) Gearing
Note: An acceptable alternative would be: Prior-charge capital 9,000,000 93.3% Equity 9,650,000 (ii) Market values: Equity (Ve): 8,000,000 135p Preference (Vp): 1,000,000 77p Debentures (Vd): 8,000,000 80%
6,400,000 770,000 39.9% 17,970,000 Note: An acceptable alternative would be: Prior-charge capital 7,170,000 66.4%. Equity 10,800,000 2006.1
£ 10,800,000 770,000 26,400,000 17,970,000
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(b) Cost of equity, ke: 10(1.09) d1 g 0.09 17.1% 135 P0 Cost of preference shares, kp: ke
kpref d 7 9.1% P0 77 Cost of debentures, kd:
609
(see formula sheet)
i[1 t] 9(1 0.30) 7.9% 80 P0 keVe kpVp kdVd k0 Ve Vp Vd
kd net
(0.171 10,800,000) (0.091 770,000) (0.079 6,400,000) 17,970,000 1,846,800 70,070 505,600 13.5%. 17,970,000
(c) The debentures are a cheaper source of finance than the preference shares. The interest is a tax-deductible expense, whereas the preference dividend is an appropriation from post-tax profits. The debentures will be secured on the company’s assets, which makes them more attractive to investors than preference shares. Preference shares cannot be secured. Both are treated as prior-charge capital in the gearing calculation, but debenture-holders will rank before preference shareholders in a liquidation. (d) A merchant bank may have provided the following services: ● advice on the type of capital to be issued, that is, debt, equity or preference shares; ● advice on the form of debt issued, that is, secured or unsecured, and on the use of sweeteners such as a conversion option or warrants; ● advising on the coupon rate, issue price and maturity of the debenture; ● marketing and administration of the issue; ● identifying potential investors; ● recommendations about any derivatives that may be available to hedge interest-rate exposure; ● ensuring that D plc complied with any statutory and regulatory requirements relating to the new issue.
Solution 34 This question tests knowledge of two potential long-term sources of finance. The question asks candidates to carry out relevant calculations for both sources, to discuss the advantages of issuing convertible loan stock rather than making a rights issue, and to briefly explain what is meant by a deep-discounted rights issue. 1,200,000 20p (a) (i) Earnings per share Profit after taxation 6,000,000 Number of shares Market price EPS P/E 20p 12 240p 2006.1
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(ii) Number of shares issued in rights issue Theoretical ex-rights price: 6,000,000 240p 2,625,000 192p 8,625,000 192p
TERP
£5,040,000 2,625,000 192p £ 14,400,000 25,040,000 19,440,000
£19,440,000 225.4p 8625,000
Factors that may invalidate this calculation in practice include: ● adverse factors affecting the value of KB plc’s shares between setting the terms of the rights issue and the issue date (e.g. a market crash); ● whether the market considers the forecast return from the new funds to be realistic; ● the increased number of shares in issue may affect their marketability, causing a further reduction in the ex-rights share price; ● if shareholders do not take up their rights, shares will be left with the underwriters, which will depress the share price; ● the new project may be seen by investors as more risky than existing projects, with no corresponding increase in return; ● investors’ expectations of future dividends per share may change as a consequence of the increase in the share capital. (iii) A deep-discounted rights issue is an issue where the issue price is set well below the current market price of the shares. In some cases, the discount has been as much as 40 per cent on the pre-issue price. The issue price must still, however, be above the nominal value to comply with company law. If share prices are volatile, there is a risk that the market price will fall below the rights issue price, which would lead to undersubscription. A deep-discounted rights issue should avoid this potential problem. The lower issue price does mean that more shares will need to be issued to raise the same level of finance, with a consequent impact on future dividends per share and earnings per share. (b) (i) At a point in time, the price of convertible loan stock is likely to be different from the price of the underlying ordinary shares. The conversion premium measures how much more expensive it would be to buy the convertible loan stock than the corresponding underlying ordinary shares. Conversion terms: £100 loan stock 35 ordinary shares i.e. £2.86 loan stock 1 ordinary share Cost of buying loan stock and converting to 1 ordinary share Cost of buying 1 ordinary share directly
£2.86 £2.40 £0.46
Premium 0.46 19% 2.40 (ii) 1. Convertible loan stock will usually be a cheaper source of finance than equity because its greater security and prospective convertibility into ordinary shares reduces the risk premium required by an investor. 2006.1
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Solution 35 Requirement (a) Year 0 1–10 10
Cash flow (90.00) 4.20 100.00
DF 5% 1.000 7.722 0.614
PV 5% (90.00) 32.43 61.40 23.83
DF 6% 1.000 7.360 0.558
PV 6% (90.000) 30.912 55.800 2(3.288)
By interpolation Kd 5
5.538% 3.83 3.83 3.288
Requirement (b) The use of the cost of debt is likely to be inappropriate, no matter which form of financing is used. If the project merely earned a sufficient return to cover the interest payments, it would fail to recognise the overall impact on existing providers of finance, and that they would be likely to demand a higher return in response to additional financial risk. This is because the borrowing of additional funds to finance the grinding machines will increase the gearing of the business, possibly significantly. In so doing, the equity shareholders, as the residual claimants on the company’s returns, are exposed to greater risk as the returns become more volatile. Also, in the event of corporate failure, they would rank behind a higher level of debt in a distribution from the receiver. Given that most investors are risk averse, then shareholders are likely to demand a higher return in response to this additional risk. The exception to this would be if the new project were lease financed, and there was no penalty arising from termination of the contract, other than the return of the asset. In this case, there is no additional exposure to existing shareholders. The lessor would, however, be taking most of the risk and would thus require a significant risk premium. The grinding machines project, financed by debt, may also change the operating risk of the business, thereby changing the required return on all existing forms of finance. As an alternative to the cost of debt, the weighted average cost of capital may be an appropriate discount rate. It would first be necessary, however, to calculate the cost of equity. 2006.1
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2. Interest on the loan stock is a tax-deductible expense, whereas dividends on ordinary shares are an appropriation of profits. 3. The issue of convertible securities will not immediately dilute existing shareholders’ control. 4. Convertible loan stock may be cheaper to issue than a rights issue. 5. Convertible loan stock may be more appropriate for high-risk companies, because it offers investors the opportunity to benefit from long-term growth in the company while providing short-term returns in the form of interest payments.
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Requirement (c) To: Subject:
Memorandum The Directors From: Financing New Grinding Machines Date:
Management Accountant 20 November 2001
Introduction The three methods of financing are likely to give similar conclusions in a competitive market, otherwise there would be little or no demand for such financing. It would be necessary, however, to carry out detailed calculations of the present values of the cash flows for each of the three options before a final decision was taken. Notwithstanding this, some of the broader issues that would need to be considered are as follows. Cash flow Given that the long-term lease is payable in arrears, a short-term cash flow advantage is given. The long-term lease is, however, payable equally over 8 years. In contrast, only the interest on the loan is payable over the next 10 years and the capital is not repayable until the end of this period. This gives a significant cash flow advantage to debt financing which may be relevant if capital is constrained. Risk The risk of the underlying operations is identical in each case, as the physical assets are the same. This can thus be ignored as a common factor. A purchase option, however, carries some residual risk in the net realisable value at the end of the machine’s life. Given this is some way into the future, it may be regarded as extremely uncertain, particularly if there is a thin market for this type of asset. Other aspects of risk include breakdown of the machine, which is covered in the shortterm lease, but not in the other forms of financing. Also, the payment terms of the purchase and long-term finance arrangements are fixed, but those of the short lease may vary. Lease rentals may rise with inflation or a change in market conditions. Alternatively, they may fall if the rate of technological change is greater than expected. In the extreme, it is possible that the lessor company may collapse and there may be other claims over the asset from creditors arising from this. The financial risk implications have already been discussed in requirement (b) above. Security Should the company be unable to repay the debt, then the debt holders’ claim would fall not just on the asset (which may have a low net realisable value) but also on other assets in the form of the floating charge. Depending on the terms of the lease contract, the lessor may only have the right to reclaim the asset, perhaps with a penalty. At best, the balance would be an unsecured creditor against XYZ. This relatively higher risk position of the lessor is likely to be reflected in the return demanded in the form of higher lease rentals. Maintenance The maintenance contract is included in the short-term lease, but not the other options, although the cost is clearly built into the short-term lease rentals. As already noted, this gives greater certainty, although perhaps less control, over the type and extent of maintenance than would be the case if it were subject to a separate contract. 2006.1
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Other forms of finance There may be other forms of finance which may be preferable to those specified. One example may be hire purchase, but also other forms of lease or debt contract may be available. Signed: Management Accountant.
Solution 36 Requirement (a) Cost of debt Year 2002 2003–2005 2005
Cash flow $ million 201.68 18(1 0.3) 200.00
DF 6% 1.000 2.673 0.840
DCF 6% $ million (201.68) 33.68 168.00 168nil
Thus, cost of debt equals approximately 6%. Cost of equity Ke
d1 g P0
Ke
1(1.04) 0.04 0.40
14% Weighted average cost of capital WACC
(6% $200 million 1.0084) (14% 100 million $10.40) ($200 million 1.0084) (100 million $10.40)
(12.1008 145.6) 1,241.68
WACC 12.7% 2006.1
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Financial reporting considerations For financial reporting purposes, the long-term lease is probably a finance lease, while the short-term lease is probably an operating lease. From a finance perspective, these definitions are not of themselves significant. Indirectly, however, the operating lease could probably be kept off balance sheet, while purchase and finance lease options are on balance sheet. This should not make any difference from an information perspective, as stock markets are reasonably efficient and are not normally deceived by changes in disclosed accounting procedures. However, there may be debt covenants (e.g. gearing ratios) or other accounting-based contracts which may be affected by putting significant assets and matching finance on balance sheet.
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Requirement (b) (i) Cost of equity The new bank loan will increase the level of gearing of the company; this will, in turn, increase the required return on equity as it becomes more risky. Investors, being riskaverse, thus demand a higher rate of return. The primary reason for the increased risk on equity is that interest costs must be paid before dividends. As the residual claimants, the returns to equity become more volatile and thus more risky. Additionally, debt also ranks in front of equity on liquidation. As a result, the possibility of equity holders gaining a share of the funds from liquidated assets is reduced as debt increases. Also, as interest must be paid, the probability of liquidation (and thus bankruptcy costs) increases as debt increases. (ii) Cost of debt The level of gearing is initially low in market value terms, but the issue of new debt will increase it. One concern, however, is that if the company is liquidated, then there may be insufficient assets to repay the debt. In the draft balance sheet, capital and reserves are $150m. As a result, book net assets are also $150m. This is lower than the initial nominal value of debt of $200m, and significantly below the new nominal value of debt of $230m. It may be that the balance sheet reflects the historic cost of assets, and their revalued amount may be greater. This is possible with land and buildings, but unlikely with aircraft. Moreover, the sale of assets under distress conditions of liquidation may yield proceeds below their historic cost. Thus, the new debt is likely to cause the overall cost of debt to rise as: ● the possibility of full payment on liquidation is reduced. ● the probability of liquidation is increased given the greater interest payments. (iii) Weighted averaged cost of capital There are two factors with opposite effects on WACC as the amount of debt increases. (1) Both the cost of equity and the cost of debt increase because of increased risk for the reasons noted above. (2) Debt is lower risk and, therefore, cheaper than equity. Increasing debt increases the proportion of this lower cost source of capital in the financing structure. It is uncertain as to which effect is greater, and thus whether WACC increases or decreases. The traditional theory argues that as debt increases from a zero level of gearing, WACC will initially fall as the perceived risk to equity is small. It continues to fall until it reaches its optimum point, then begins to increase as the perception of risk increases. The impact on WEB plc’s WACC will, therefore, depend on whether the existing level of gearing is below or above the optimal point. Requirement (c) (i) A debenture is a written acknowledgement of a debt by a company, usually given under seal and normally containing provisions as to repayment of interest and principal together with some conditions. Debentures can be offered to the public only if the offer is accompanied by a prospectus. In these circumstances, it may differ from a bank loan in that: ● the debenture may be held in trust on behalf of many different investors; ● it may be marketable and thus traded in a secondary market.
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Cost of debt differences The cost of debt may differ on the two types of debt as: ●
● ●
●
●
They cover different periods, thus market interest rates may have changed as might the perception of the company’s risk. Thus, the 9 per cent nominal rate on the existing debt may have been prevailing rate some time ago. The existing debt may also have been issued at a premium or a discount. The terms of the debt may differ. Thus, if one security has more covenants to protect the lender and reduce risk, then a lower rate of interest may be acceptable. The debentures are marketable, while the bank loan is unlikely to be. A lower rate of interest may, therefore, be available on debentures to compensate for lower liquidity risk. The yield, calculated in requirement (a), of 6 per cent is after tax, while the nominal rate on the bank loan of 8 per cent is before tax.
Solution 37 Requirement (a) A semi-strong efficient market is one that digests all publicly available information into the share price immediately. As such, the market may would attempt to anticipate the probability of the success of kryothin prior to its approval and commercial exploitation. This recognition is likely to be progressive as the probability of a successful new drug progresses towards profitable commercial exploitation. Patents must, by their nature, be in the public domain, and thus would be a further sign of a successful new drug about to be launched. This would cause share prices to rise as the probability of successful development increases. If patents are taken out early in the R&D process, the market price of shares is likely to fluctuate on the basis of publicly available information about the continued success of testing, costs of development, selling price, competitor products and so on. The response on 1 March 2002 to UK approval would depend on the market’s prior expectation of that decision. If the market was near certain that approval would be given (e.g. based upon information on testing results) then there may be a near zero response. At the opposite extreme, if the market had expected the UK regulators to reject the drug (or required further testing), then the share price would increase significantly with the news – assuming a significant level of profitable sales was expected in the UK. Similarly, the impact of the approval of other countries would depend partly on the prior expectation of the approval being given and partly on the expected levels of sales in those individual countries. The ultimate commencement of sales of the drug is unlikely to affect the share price unless they differ from expectations. In the long term, however, the share price will fall as excess profits cease to be earned, and thus are no longer discounted into the value of the company.
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(ii) In contrast, a bank loan is usually with a single bank and is not normally traded. However, large corporate loans can be made by a syndicate of banks or other institutions.
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Requirement (b) Offer for sale The issue is at the market price at 2 January 2003 thus: PV of dividend for 2003 to 2007
AF5yrs @ 10% £32.2 million 3.791 £32.2m £122 million
PV of dividends for 2008 onwards
Total value of equity
£122 £118 £240 million £ 240m 80m 160m £160m £8.00 20m
Value of existing shares Value of equity with kryothin New capital needed Value of existing shares Value per share Corporate bond issue Annual interest
£19m/0.1 1.15
£118 million
£80m 0.07 £5.6 million
The issue is at the market price at 2 January 2003 thus: PV of dividends for 2003 to 2007
AF 5 years @ 10% (32.2 5.6) 3.791 £26.6m £101 million £(19m 5.6m)/0.1
£83 million
PV of dividends for 2008 onwards
Total value of equity
£101 £83 £184 million
Value per share
1.15 £184m £9.20 20m
Solution 38 Requirement (a) Alternative 1 – Cost of debt The cost of debt is calculated after tax, which would mean it would be lower than the nominal cost of 7 per cent. The bonds are however issued at a discount, which would mean the cost of debt would be higher than the nominal cost of 7 per cent. As the discount is small relative to the tax effect try 6 per cent for the cost of debt. Examiner’s Note Linear interpolation is an acceptable alternative to trial and error. Year 30 June 2003 2004–2008 2008
Cash flow £ million (28.5) 2.1 (10.3) 30
Thus cost of debt equals approximately 6%. 2006.1
DF6% 1.0 4.212 0.747
DCF6% £ million (28.50) 6.19 22.41 20.10
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Examiner’s Note Linear interpolation is an acceptable alternative to trial and error. Year 30 June 2003 2004–2006 2007–2009 2009
Cash flow £ million (28.5) 1.425 (1 0.3) 2.85 (1 0.3) 28.5
DF5% 1.0 2.723 2.723 0.864 0.746
DCF5% £ million (28.5) 2.716 4.694 21.261 20.171
Thus, the cost of debt is approximately 5%. Other factors Other factors that may be considered in choosing between the two types of security are: ●
●
●
●
The amount of funds raised: In this instance, both methods raise the same amount of £28.5 million after the discount on issue of the bonds is considered. Cash flow: If DDD plc is facing difficulty in raising funds generally (that is it is capital constrained) then cash flow considerations may be important for liquidity. The bank loan has two cash flow advantages: (i) the interest rate is lower in the first 3 years than the bond issue; (ii) the repayment of capital is 1 year later. Issue costs: The bond issue is likely to have much higher issue costs than the bank loan. This could be built into the cost of debt, but given that these costs are not currently known, it represents an incremental cost on top of the cost of debt calculated above. Covenants: Typically, a bank loan will have more restrictive covenants than publicly issued debt and this may reduce financial flexibility.
Thus, while the bank loan is a whole percentage point cheaper than the publicly issued debt, a range of other factors will need to be considered before a final choice is made. Requirement (b) Memorandum To: From: Date: Subject:
The Board of DDD plc Treasury Department Accountant 20 May 2003 Financing the expansion programme
Introduction The expansion programme is of significant size compared to the existing operations of the company. Existing land and buildings and stocks amount to £42m, whereas the new venture amounts to £28.5m (i.e. it is 68 per cent of the existing level). 2006.1
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Alternative 2 – Cost of debt The average nominal before tax cost of debt is 7.5%, but this is subject to 30% tax relief, so try 5% as the later cash flows are discounted more heavily than the earlier flows.
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The estimate of new finance includes the funding of land and building and stock amounting to £28.5m, but no estimate is made of other additional financing need such as other fixed assets. There may thus be further finance needs, although it may be that these could be financed by: ●
● ●
Creditors exceeding debtors, as is usual in a retail business, where customers pay in cash or by credit card while suppliers tend to extend credit. Operating cash flows. Existing cash of £1 million.
Given this problem is common to all the finance methods being suggested, it will thus be assumed that £28.5 million is the total financing need in each case. Chief executive (new equity) The chief executive is suggesting that new equity is issued. If new equity is issued then gearing (debt/equity) will fall as follows: Previous** Revised**
Book values 24/30 80% 24/58.5 41%
Market values 24/60 40% 24/88.5* 27%
* Assumes no increase in share price arises from the announcement of the new projects. ** Assumes market value of debt equals its book value.
Thus, there will be lower financial risk arising from the use of new equity to finance the expansion. This may be appropriate as there is likely to be increased business risk in the new venture, which involves both a different retailing format in SuperCentres but also a new product market in garden furniture. Also, at 40 per cent, market value gearing (80 per cent in book terms, although this is less valid) may be regarded as relatively high. This is particularly the case as the value of existing land and buildings (£26m) is only just sufficient to provide security for loans (£24). The increase in assets financed by equity will thus give greater assurance to existing debt holders and added debt capacity for further expansion in future. While the suggestion of the chief executive to issue equity is credible, the reasoning for the decision is more questionable. I believe that we should take advantage of this high share price and issue shares now in case the share price falls again.
If share prices have risen, the semi-strong efficient markets hypothesis (EMH) would suggest that this is because the market is acting rationally and is valuing the company on the basis of publicly available information, including historic share price movement. As a result, even though the share price has risen substantially over the past year, it is no more likely to fall than it would be if the share price had been constant, or had fallen, over the past year. As such, there is no reason to ‘take advantage’ of the previous share price rise unless, on the basis of inside information, the chief executive believes that share prices will fall in future. This view is consistent with the strong form of the efficient markets hypothesis. Our dividend yield is only 3% – this is cheap finance at low risk.
The dividend yield of 3 per cent does not represent the required return on equity and may not be regarded as low risk. This is the case for a number of reasons: ●
The dividend yield is only the current dividend, divided by the share price. If the dividend valuation model is used this would also reflect anticipated future growth in dividends, which would not be included in the current dividend yield.
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●
An alternative approach is that the shareholder will require a capital gain and a dividend. The total required return on equity will reflect both of these elements, rather than just the dividend yield which thus understates the required return on equity. Market based models such as CAPM may best be used to determine the level of market risk associated with this security but, typically, equity shares will have more significant risk than debt finance. Any new equity finance will however reflect, not just the risk of the new project, but also the collective risk of all projects in the company.
Non-executive director (retained profit and divestment) ‘We should use our retained profits of £20 million to finance most of the new land, buildings and stocks.
Unfortunately, the use of retained profits to finance new ventures represents a fundamental misunderstanding of accounting. The retained profits of £20m in the balance sheet are not represented by cash assets, but by a variety of different assets. Indeed, it can be seen that the company only has cash of £1m. This is not, therefore, a feasible proposition. To finance the remaining amount we should sell the least profitable of our existing garden centres. This approach will save all the issue costs and all the uncertainty involved in raising external new finance.
It might be possible to combine a divestment policy with some other form of financing (for example raising only £20m in debt or equity rather than the full £28.5m). A number of factors need to be considered: ●
●
●
●
Issue costs and uncertainty in raising new finance will be replaced by transaction costs involved in selling existing sites, with the associated uncertainty in these transactions. The ‘least profitable’ of the existing centres may still be making reasonable profits thus the opportunity cost of raising funds by closures may represent an additional cost in financing the new venture. To the extent of divestment, the existing sites will be replaced by new sites, and thus there is no expansion in the overall asset base. Fewer assets thus exist for example to secure debt – although less debt would need to be raised. Where new sites are in a similar location to old sites, it may be appropriate to divest to avoid duplication.
Finance director (new debt) The finance director is in favour of issuing new debt to finance the expansion in the form of a bond issue or a bank loan. The choice between these two types of debt has already been considered (see (a)). This section thus considers debt as opposed to other types of finance to fund the new expansion. If new debt is raised then gearing (debt/equity) will increase as follows: Book values Market values Previous 24/30 80% 24/60 40% Revised** 52.5/30 175% 52.5/60* 88% * Assumes no change in the share price arises from the announcement of the new projects or their financing. ** Assumes market value of debt equals its book value.
Thus, there will be significantly increased financial risk arising from the use of new debt to finance the expansion. This may be inappropriate, as there is also likely to be increased business risk in the new venture. While there will be additional assets to secure the additional debt, the company remains near its debt capacity for using land and building to secure 2006.1
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●
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loans. Thus, the decision to use debt to finance expansion is questionable. Also, however, the reasoning of the finance director is questionable. The return on these new SuperCentres is bound to be greater than the cost of debt, so a profit is assured and thus the risk is minimal.
Even if the expected return on the new venture is greater than the cost of debt this does not make the venture viable. Consider also: ● ● ●
●
The operating risk of the new venture may be significant and thus requires a risk premium. The increase in debt adds financial risk and raises the cost of equity. Existing debt holders may be exposed to greater risk and thus their required rate of return may increase. Overall, the weighted average cost of capital may either increase or decrease depending (according to the traditional model) on whether the company is currently below or above the optimal level.
The overall change in the opportunity cost of capital is thus a more appropriate benchmark to judge the returns on the new project than the cost of debt.
Solution 39 Requirement (a) (i) Cost of equity is 12% Present value of dividends at 1 August 2003 is: 2m 2m(1.04)/(0.12 0.04) £19.93m (1.12)3 (ii) Cost of equity is 15% Present value of dividends at 1 August 2003 is: 2m 2m(1.04)/(0.15 0.04) £13.75m (1.15)3 The difference in the two calculations relates entirely to the cost of equity as the assumptions about cash flows and growth rates are consistent between the chairman and the chief executive. The major reason for the difference in the two estimates for cost of equity is the risk premium that has been built into the cost of equity. It should be noted, however, that the 15 per cent required return with the new project is an estimate of the total return required on the current activities plus the new project. It is not the marginal return on the new project. It is not clear from the information provided how much of the new dividend arises from the new and old projects, but if they were equal, it would then imply that the marginal return on the new project is 18 per cent. This is given that the return on the existing business is 12 per cent and the average is 15 per cent. More precise valuations of the two elements of the business will be needed to give more accurate weightings to determine the marginal returns. The difference of £6.18m is substantial, so careful consideration needs to be given to the most appropriate method of determining the cost of equity. 2006.1
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Requirement (c) Methods of finance Finance can take many different forms with different terms and conditions. The most basic distinction however is: (1) (2) (3) (4)
Corporate bond or debenture issue Bank loan Share issue Leasing
(1) Corporate bond or debenture issue A debenture is a written acknowledgement of a debt by a company, usually given under seal and normally containing provisions as to repayment of interest and principal together with other conditions. Debentures can be offered to the public only if the application is accompanied by a prospectus. In these circumstances it may differ from a bank loan in that: ● The debenture may be held in trust on behalf of many different investors. ● It may be marketable and thus traded in a secondary market. While the company has no gearing at the moment, the new projects are significant in relation to the size of the existing company. As a result, bond financing will generate a significant gearing level. Notwithstanding this, the introduction of some debt finance may be appropriate. Much will depend however upon the availability of security for any loan. If land is being purchased with the loan this may be appropriate, but the other fixed assets are likely to be similar to the existing site and these were deemed inappropriate security. Bond finance may include restrictive covenants and other contractual terms in addition to repayment requirements. These may limit the financial flexibility of the company to borrow further or engage in other actions prejudicial to the corporate bond holders. Agency costs may also arise from borrowing. The issuing of bonds may also incur significant issue costs, although not as great as with most types of share issue. Irredeemable bonds are unusual and thus consideration needs to be given to repayment. Long-term bonds would minimise this consideration, however, this may make their market value more sensitive to inflation and interest rate risk. This would, however, already be priced in the nominal interest rate. Impact on cost of equity If a corporate bond financing option is adopted, then the financial risk to which shareholders are exposed is higher than if a share issue takes place. 2006.1
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Requirement (b) The discount rate between 2003 and 2007 is equal to the growth rate thus, for discounting purposes, the real cash flows can merely be added. Thus, the present value is: 1.2m (1.12)4/0.12 (1.2m 4 years) (1.12)4 4.8m 10 m £14.8m
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Specifically, if bonds are issued, then gearing would rise and thus the cost of equity would rise rather than remain at 12 per cent due to increased financial risk. This would impact upon the total value of equity in the calculations, thereby reducing the price per share. This is in addition to any increase in operating risk. (2) Bank loan Unlike corporate bonds, a bank loan is usually with a single bank and is not normally traded. However, large corporate loans can be made by a syndicate of banks or other institutions. While bank loans may typically have slightly different terms than corporate bonds (e.g. on interest rates, covenants, repayment terms) in most respects they are very similar and the impact on the cost of equity is likely to be similar. Perhaps the most significant point, however, is the scale of the project. While significant to the company, the projects (particularly the £3m investment suggested by the chief executive) are relatively small for a public issue of debt. The issue costs are likely to be high if such an issue does take place and this might favour a bank loan which has low or zero set-up costs. (3) Share issue Shares may be issued in a number of different ways: for example offer for sale, rights issue, placing and public offer for subscription. While the ultimate effect may be similar, there are a number of factors to consider: ● Scale – both projects (but particularly the £3m investment suggested by the chief executive) are too small for an offer for sale or a public offer for subscription. ● Issues costs – are high for an offer for sale and a public offer for subscription. They are lower for a rights issue and a placing. However, all forms of equity issue are likely to have higher issue costs than raising debt. ● Control – unless there is a (fully subscribed) rights issue the relative control of individual shareholders would change with a share issue. Whereas with debt it would be unaffected. ● Return – The required return on the cost of equity is normally greater than the required return on the cost of debt. However, the overall impact on the WACC is uncertain according to the traditional model of gearing. Impact on cost of equity If equity is issued, the company would remain all-equity financed and so there would be no change in financial gearing. However, it could be argued that the existing lease on the land at Dragonland represents what is in effect a debt contract. In this case, the raising of equity would actually reduce financial gearing. This would lower financial risk and, in turn, lower the required return on equity. (4) Leasing The effects of a long-term lease on the new projects are likely to be similar to debt financing. This would clearly depend on the terms of the lease, however, and the nature of the assets being acquired. Leasing may, however, offer the following advantages: ● ● ●
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Impact on cost of equity If the lease is long term, it may be regarded as similar to debt in which case gearing would increase, financial risk would increase and cost of equity would, all other things being equal, also increase. Other considerations (a) Risk Irrespective of the method of finance, risk may increase if the new project is more operationally risky. However, from the perspective of the cost of equity, systematic risk (which is relevant to EQU plc’s institutional shareholders) may be unaltered as much of the variability is unlikely to be correlated to market returns. (b) Multiple sources of finance The above assessment of sources of finance considers each source individually. It is possible that more than one type of finance could be used. However, the transaction costs in raising finance are frequently fixed in nature, so it is likely that a single source of finance is most appropriate. A combination of a bank loan and leasing may, however, be possible because of their low transaction costs.
Solution 40 Requirement (a) The relationship between dividend, investment and financing policies Dividend policy is part of a company’s financing policy. The reason for this is that a company can only do one of two things with its profit after tax: pay it back to shareholders or invest it for the future. In theory, if a company has sufficient positive net present value projects, each discounted at a specific risk adjusted rate, then it should invest 100 per cent of its retained earnings for the future benefit of the shareholders. If it does not have any positive net present value projects, then it should return 100 per cent of its retained earnings to shareholders. Companies rarely operate at these two extremes unless they are either very unusual organisations, with a stated policy of not paying cash dividends, or they are in such serious financial difficulties that to pay a dividend would be considered against company law. In the circumstances here, the company has been paying out around 50 per cent of its earnings as dividends since the second year of operations. Although it has reduced the dividend payout ratio slightly last year to 45 per cent, this is still a high percentage payout for an organisation in the early stages of its development. The main shareholders are also the founders and managers of the company. The question does not say what proportion of the company they own, but it is reasonable to assume it is by far the majority of the shares. Also given that this company is not at present listed, it is reasonable to assume that the owners/managers are not too concerned with the signalling mechanism of dividends. The employees who have been given shares as bonuses clearly may be upset if they do not receive a dividend, but it is likely that most of them are holding the shares for future gain, when the organisation might be listed on a stock market. 2006.1
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Overall, much will depend on the terms of the lease and the implicit return required by the lessor.
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Financing policy does of course have an impact on a company’s cost of capital. This organisation is currently all-equity financed and it does not appear to be taking on a significant amount of debt into its capital structure. A rough calculation would suggest that, should it raise 150 million Rupees in debt financing, its gearing ratio would still only be around 20 per cent* (see overleaf ). This does not seem excessive, but the organisation should still consider whether it would be better off reducing the dividend payout ratio to a much lower percentage than it is proposing and borrowing less than the planned 150 million Rupees. In the circumstances here, the size of the new investment may place CD Limited at risk if the investment does not come up to expectations. The company should consider raising additional equity rather than debt. However, it is not clear whether shareholders would have sufficient resources to finance a rights issue. The dividend payout ratio, even reduced to 45 per cent, is probably still generous for a company such as this. There is therefore scope for expansion through internal funds if dividend policy were less generous. * Calculated as follows: Retentions 1997–2002 Retentions 2003 Share capital Total shareholders’ funds
458.2 (Earnings less dividends paid less bonus shares) 109.0 [200 (3.5 26)] 567.2 573.5 570.7
Borrowing
150.0
Total finance
720.7
150 100 20.8% 720.7 150 Debt: Equity 100 26.3% 570.7
Gearing
Recommendation A sensible course of action in the circumstances here, would seem to be for the owners/ managers to call a meeting of all the shareholders and put their proposals for future investments to the meeting. If those shareholders have the long-term interests of the company and, of course, of their employment at heart, they should be more than prepared to allow the money to be reinvested in the company for future gains. Requirement (b) Calculation of estimated value for CD Limited using MM Vu firm earnings before interest payments in perpetuity, assuming 5% growth over 2003: 210 1,500 million rupees 0.14 45 million rupees Plus Vts 150 million rupees 30% Total Vg 1,545 million rupees Less : Value of debt (assume par) 150 million rupees Value of equity 1,395 million rupees 1,395 million Value per share 399 rupees 3.5 million 399 P/E ratio 7 57.1 (estimated price per share/2003 earnings per share)
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1. 2. 3. 4.
External markets/environmental/economic factors; Different perceptions/information of the market about the company; Market imperfections such as transaction costs and irrational shareholder behaviour; Assumption that earnings are in ‘steady state’, that is no further growth. The model could be adapted by incorporating aspects of the dividend valuation model, assuming constant 5 per cent growth and all earnings are paid out as dividends. This would raise the value of the firm as follows: 210 0.14 0.05
2,333 million rupees
Plus Vts 150 million rupees 30% Total Vg Less: Value of debt (assume par) Value of equity 2,228 million Value per share 3.5 million
2,345 million rupees 2,378 million rupees 2,150 million rupees 2,228 million rupees
637 rupees
11.1
P/E ratio
637 57.1
This version seems to offer a more realistic set of figures based on the resulting P/E ratio, and 11.1 probably still seems low given the nature of the business. The influence of dividends on the value of a private company, such as CD Limited, is rather different from those that influence a public listed company. For a start, rather fewer people are scrutinising the actions and pronouncements of the organisation. Therefore, a theoretical model such as this may be of very limited value in the circumstances of this organisation, and the company would need to provide more detailed information on its investment plans before a more accurate valuation can be determined. In a large listed organisation, the value of the company is often quite different than the sum of the value of small parcels of shares that change hands on periodic bases. This is because the rationale for selling an entire company is often rather different from the rationale of individual shareholders selling small parcels of shares. This is likely to be the same in an unquoted company. If an individual shareholder wanted to sell their shares, then the basis of valuation may simply be taking the asset value plus a small amount for the type of intellectual capital that is obviously inherent in this company’s valuation and paying them out. However, if the owners/managers wish to sell the entire company they would have to put together a significant amount of additional information. For example, looking at the present value of the cash flows from their investments and also taking into account PE ratios of similar organisations that were listed, economic prospects for the industry, likely buyers, other companies that were on the market at the same time and so on. Therefore, as with a quoted company, the value of this company is unlikely to be simply the number of shares each individual shareholder holds multiplied by an estimated share price for that particular holding. 2006.1
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Requirement (c) Relevance of requirement (b) to valuation of shares/company Modigliani and Miller’s theory may be suitable for valuing the entire company, although it has serious flaws in a real world environment. Some of these may be as follows:
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Solution 41 Requirement (a) The main issues to consider are: ● ● ●
● ● ●
Who are the main stakeholders? Where is the financing coming from, and in what proportions? Are there other, higher level objectives that will supersede those set by the Institution, for example political aims/goals by the government? Does the objective need to be measurable? How can one objective meet all the competing aims of the stakeholders? Will information on the Educational Institution’s performance be publicly available?
Setting a financial objective has the main advantage of being measurable. If it is made public, it can also be compared with other, similar, institutions if they also set and make public their objective and their subsequent performance. One objective will probably be insufficient, especially as the Institution has two main markets with very different requirements, costs and revenue structures. The disadvantages of setting and making public an organisation’s objectives are: ●
●
●
The Educational Institution may not be allowed freedom to choose its own policies, for example on charging fees or selection of state-funded students. Political decisions may not affect all publicly funded institutions in the same way or to the same extent. Cost allocation between state funded business and private sector business may be difficult and politically sensitive.
Requirement (b)
Examiner’s Note The question asks for comments on two performance indicators from each list, four criteria in all. In this answer comments are provided for all six criteria. Candidates may only receive marks for a maximum of two indicators from each list (i.e. no compensation between the lists.)
Introduction Traditionally, financial measures have been the focus of management attention. Increasingly companies are using non-financial indicators to assess success across a range of criteria, which need to be chosen to help a company meet its objectives. However, an indicator, which is appropriate for one group of stakeholders in an organisation, may not be suitable for another group. Also, indicators that are suitable for short-term performance assessment may be unsuitable, or not optimum, for the long term. The objective, or mission statement, of this institution is entirely qualitative (and subjective) and makes no concession to financial considerations or constraints. 2006.1
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Profitability Profitability may be defined as the rate at which profits are generated. It is often expressed as profit per unit of input (e.g. investment). However, profitability limits an organisation’s focus to one output measure – profit. It overlooks quality and this limitation needs to be kept in mind when using it as a measure of success. Profitability as a measure of decisionmaking has been criticised because 1. it fails to provide a systematic explanation as to why one business sector has more favourable prospects than another; 2. it does not provide enough insight into the dynamics and balance of an enterprise’s individual business units and the balance between them; 3. it is remote from the actions that actually create value and cannot therefore be managed directly in all but the smallest of organisations; 4. the input to the measure may vary substantially between organisations. However, it is a well-known and accepted measure that, once the input has been defined, is readily understood. Provided the input is consistent across organisations and time periods it also provides a useful comparative measure. Although the concept of profit in its true sense is absent from most of the public sector, profitability may be used to relate inputs to outputs if a different measure of output is used, for example, surplus after all costs, to capital investment. In the case of the educational institution, a problem may be determining the value of the initial investment, which may have been purchased by the government many years ago and appear to have cost nothing. A notional value could be attached to these assets for the purpose. Profits would be fees and other income less costs of salaries and other expenses. Notional rents or depreciation would also have to be estimated. This measure would have little relevance to the Institution’s only stated objective and its calculation is fraught with uncertainties and unknowns. This would be a measure that the organisation might wish to introduce some time in the future, but first it needs to estimate the value of its assets and the true nature of its costs. 2006.1
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Financial performance measures Value added This is primarily a measure of performance. It is usually defined as sales value less the cost of purchased materials and services. It represents the value added to a company’s products by its own efforts. A problem here is comparability with other industries or even other companies in the same industry. It is less common in the public sector, although the situation is changing and many public sector organisations are now publishing information on their own value added, for example, in the health service. In respect of teaching, value added could be measured by the percentage of students that leave with a qualification. In post-graduate or executive education, it could be the increase in salary or improved jobs/job prospects obtained by graduates on obtaining their qualification. This may not precisely measure the qualitative aspects of the Institution’s objectives, but could provide a close approximation. In respect of research, the measure is much easier to apply and interpret. Research output can be measured by the number of staff publications in various categories of journal.
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Return on investment (ROI) This is an accounting measure, which is calculated by dividing annual profits by the average net book value of assets. It is, therefore, subject to the distortions inevitable when profit rather than cash flows are used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation policy, stock revaluations, write off of intangibles such as goodwill. A further defect is that ROI ignores the time value of money, although this may be of less concern when inflation rates, and therefore money discount rates, are very low. Return on assets may not adequately reflect how efficiently assets were utilised; in a commercial context taking account of profits, but not the assets used in their making, for whatever reason, would overstate a company’s performance. In the public sector, the concept of profit is absent, but it is still not unrealistic to expect organisations to use donated assets with maximum efficiency. If depreciation on such assets were to be charged against income, this would depress the amount of surplus income over expenditure. Other points which may affect interpretation of ROI in any public sector organisation, including educational institutions are: difficulty in determining value; assets may have no re-sale value; they are, or were originally intended, for use by the community at large and any charge for depreciation may have the effect of ‘double taxation’ on the taxpayer. As with profitability, the relevance of this measure at the present time and to the stated objective is limited. First of all, it needs to estimate the value of its assets and the true nature of its costs. Non-financial performance measures Customer satisfaction This measure can be linked to market share. If customers are not satisfied, they will take their business elsewhere and the company will lose market share or go into liquidation. Measuring customer satisfaction is difficult to do formally, as the inputs and outputs are not readily defined or measurable. Surveys and questionnaires may be used, but these methods have known flaws, mainly as a result of respondent bias. It can, of course, be measured indirectly by the level of sales and increase in market share. In the UK, the Citizens’ Charter was designed to help ‘customers’ of public services gain satisfaction and redress if they do not for example refunds on late trains. There are many criteria for determining customer satisfaction in an educational institution, if we assume the ‘customer’ is the student. For example: ●
● ●
Evaluations by students at the end of modules or entire programmes. There are problems of bias with this type of measure, but this is true of all surveys. Quality audits by government agencies and other regulatory bodies. Internal peer reviews.
However, the customer could also be the employer or sponsor of the graduating student. Surveys of satisfaction from this type of customer are less likely to be biased. This type of measure will already be in place and possibly to a greater extent than in many private sector institutions. If the Institution wishes to increase its proportion of private funding, then it needs to focus on developing its surveys of employers and likely providers of research funding.
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Market share Market share, a performance indicator that could conceivably be included under the financial heading as well as non-financial, is often seen as an objective for a company in its own right. However, it must be judged in the context of other measures such as profitability and shareholder value. Market share, unlike many other measures, can take quality into account as, it must be assumed, if customers do not get the quality they want or expect the company will lose market share. Gaining market share must be seen as a long-term goal of companies to ensure outlets for their products and services and to minimise competition. However, market share can only be acquired within limits if a monopoly situation is to be avoided. It is a measure that is becoming increasingly relevant to the public sector, for example, universities and the health service. In educational institutions, the market share within the home country can be measured quite easily by reference to student numbers, in total and by programme/course. It is more difficult to compare market share worldwide. However, this measure of market share is on volume not value. Some institutions have high value programmes, such as MBAs, that distort this simple volume measure. This institution needs to determine its mix of programmes and courses and set targets aimed at specific markets, for example to achieve x per cent of the market share of homebased MBA students by 2xxx. Such a target by itself will not be a guide to the quality of teaching and would need to be combined with other measures, such as customer satisfaction.
Solution 42 Internal Memorandum To: Directors of TDC Inc From: Financial Manager Date: 18 November 2003 Subject: Bid for UED plc
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Competitive position The performance of a business needs to be compared with that of its competitors to establish a strategic perspective. A number of models and frameworks have been suggested by organisational theorists as to how a competitive position may be determined and improved. A manager needing to make decisions must know by whom, by how much and why he is gaining ground or being beaten by competitors. Conventional measures such as accounting data are useful, but no one measure is sufficient. Instead, an array of measures is needed to establish competitive position. The most difficult problem to overcome in using competitive position as a success factor is in collecting and acquiring data from competitors. The public sector is increasingly in competition with other providers of a similar service both in the private and public sector. For example, universities must now compete for government funding on the basis of research output as well as meeting a range of targets for student recruitment. Their advantage is that it is easier to gain access to data from such competitors than is possible in the private sector as all this information is ultimately in the public domain. Less publicly available is data on the amount of privately funded teaching obtained by public-sector educational institutions. This measure will also be already extensively used by the Institution, certainly in respect of its competitive position for students worldwide. Where it might need to develop its measures and improve its measurement data is in respect of privately funded or sponsored students or courses.
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Introduction You have asked me to provide you with advice on our recent bid for UED plc. This memorandum aims to cover three key issues: (i) a discussion of how the recent share price movements of the two companies’ shares might impact on the bid negotiations; (ii) a recommendation of revised terms for a share exchange that might be acceptable to UED’s directors and shareholders and our own board; (iii) an evaluation of the strategic implications of making a hostile bid compared with an aggressive programme of organic growth. (i) Discuss how the recent share price movements of the two companies’ shares impact on the bid negotiations. The share price of UED plc has risen by almost 40 per cent in the last month from 305 to 425 pence, whereas the price of our common stock has fallen by almost 9 per cent from US$12.45 to $11.36 in the same period. This suggests the market has been anticipating a bid for UED plc. It is not unusual for the shares in companies that the market thinks are imminent take-over targets to rise substantially, or for the shares in the potential bidder to fall. The dramatic rise in the shares of the target further suggests the market thinks either our management will grow UED plc’s earnings at a faster rate than its current management, or in the knowledge that bidders typically pay in excess of a target company’s worth to acquire control. Although UED plc’s P/E ratio is currently higher than ours, this reflects the recent surge in its share price. A month ago its P/E would have been 9.7 (based on EPS of 31.5 pence forecast for the current year and a share price of 305 pence). The fall in our share price suggests the market believes we will raise our bid, and possibly pay more than the target is worth for the bid to succeed.
Examiner’s Note PE ratio is calculated as current share price divided by the EPS for the last financial year. Last year’s figures are not available so forecast can be used to give a rough approximation of PE.
A cash alternative has not been offered but it will almost certainly be necessary at some stage in the negotiations. This will involve us raising new finance, probably debt, as we currently have only US$125m available (at the last balance sheet date). We will, of course, acquire UED plc’s cash balances but these may have been depleted by the time the bid is finalised as a result of them fighting/negotiating the bid if nothing else. This issue is evaluated further in the next section of the report. (ii) A recommendation of revised terms for a share exchange that might be acceptable to UED plc’s directors and shareholders and our own board The terms of the bid are one TDC common stock for two UED shares. On today’s share prices, the market appears to be expecting an increased bid; one TDC common stock is worth $11.36 whereas two UED plc shares are worth $13 at today’s exchange rate. However, it must be recognised that the bid is taking place in a dynamic market and there are other, external influences that may affect share prices. Our own share price and that of the target 2006.1
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UED’s forecast earnings In US$ at 1.53 Current market value of equity Estimated market value using forecast earnings and P/E of 13.5
£45.5 million $69.6 million $942.9 million $939.6 million
The implication is the market is expecting a revised share exchange of at least four TDC common stock for seven UED shares (four TDC stock would be worth $45.44 and 7 UED shares $45.52). We could also estimate a value using the dividend valuation model. If we apply our own cost of equity to UED’s forecast earnings in perpetuity and assume zero growth, this would give a value for the company of approximately $580 million [(£45.5 1.53)/0.12]. Clearly we are hoping for growth. We can use the current market valuation and forecast earnings to estimate the growth rate incorporated by the market into the value of the company. d1 Value of company ke g If, for simplicity, we use earnings in the equation instead of dividends, we can solve for g: $942.9 g
69.6 (1 g)/[0.12 g] 0.043 or 4.3%
Examiner’s Note Any sensible attempt to estimate growth would gain credit. This suggests the market already discounts potential for growth of almost 5 per cent, although there is clearly a bid premium in the current share price that is difficult to quantify. If we believe we can obtain 5 per cent growth per annum on UED plc’s earnings, this implies a bid valued at just under $1 billion would ‘break even’, although all the gains will be going to the target shareholders. My recommendation would be to consider raising the bid to a maximum of 4-for-7 unless we can identify significant savings or growth prospects to justify a more generous offer. However, a note of caution is offered at the end of this memorandum. We should also consider offering a cash alternative to the share exchange. Many of the shareholders in UED plc will be UK-based and may not want shares quoted in US$ on a US stock exchange. The financial implications of this are beyond the scope of this report but we should consider the cost of additional debt, the effect on gearing and cost of capital. Our own gearing is currently 15.6 per cent, while UED’s is 11 per cent. For the combined group, this would be below the industry average of 15 per cent. However, in a worst-case scenario, we would have to pay out all UED’s shareholders in cash. Even assuming we still have cash balances as shown in the latest balance sheet, it would imply significant additional borrowing. 2006.1
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will, of course, react to any revised bid based on market perceptions of the benefits to be gained by the shareholders of the two companies. Evidence has shown that in a hostile bid it is usually the target company’s shareholders who obtain all the gains from a merger. My advice is that we must make a realistic assessment of what UED plc is worth to us. This is difficult to do without more information and it is almost impossible to forecast the value of the equity post-merger. Some ‘back of an envelope’ calculations can provide some approximate guidance:
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In this case, our gearing would be approximately as follows: Market value of equity (1,363 943) Market value of debt (250 75) Cost of acquisition (assuming 4 for 7) Less cash balances New borrowing Total financing
New group $ millions 2,306 325 941 (191) 3,750 3,381
Total debt as percentage of total financing therefore [(325 750)/3,381] 100 32% This level of gearing would have serious implications for our credit rating and cost of capital. Of course, the calculations are estimates and use current market values and exchange rates. If we were to use book values we might obtain a very different picture. UED’s assets value as a percentage of its total market value is 33 per cent (US$352m/1,058m 100) compared to 51 per cent for our company (US$825m/1,613m 100). An alternative could be assets to market equity: (352/943) 100 37%. This suggests that either UED’s assets are undervalued or in need of replacement. Revaluing the assets may appear ‘window dressing’ but we can justify this on the grounds of comparability. If the assets are in serious need of replacement we need to move with caution before we increase our bid. Examiner’s Note A variety of methods of gearing calculation are possible, including adjusting for cash balances. Any appropriate method would gain credit. (iii) An evaluation of the strategic implications of making a hostile bid compared with an aggressive programme of organic growth: Advantages of takeover compared with organic growth are usually that takeover: ● ●
●
●
buys out or reduces competition; allows increase in market size and therefore influence on the market to be achieved more quickly. However, the question here mentions an aggressive programme of organic growth, which to some extent would remove this advantage. provides potential for economies of scale and synergies – although often these fail to materialise and could also be provided by a programme of aggressive growth; allows some diversification of risk, unless the two companies cash flows are perfectly positively correlated (unlikely), which might allow a lower cost of capital and hence increase in market value (all other things remaining equal). Again, organic growth could also provide this diversification if planned appropriately.
Disadvantages of takeover are that: ●
●
the bid proceeds only on publicly available information and evidence shows that in hostile bids bidders over-pay; the integration of two companies is difficult at the best of times, when the bid has been hostile and therefore acrimonious the difficulties are exacerbated. Cultural changes in the way the company is managed could also be a concern with a programme of aggressive growth, as staff may have problems coping with rapid change. Signed: Financial Manager
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Requirement (a) Advice and recommendation of an offer price In the circumstances here we are valuing only part of the company. This means traditional methods of company valuation, such as asset values, P/E basis (using a proxy company or industry average for a non-quoted company) and cash flow need to be adjusted for a partsale. Any adjustment will inevitably be subjective, but in some ways it is no different from flotation where founding shareholders issue less than 50% in order to retain control. The first step is therefore to attempt a valuation of the whole company. (i) Asset value The book value of PDQ’s net assets is £950,000 in the 2003 forecast. It is forecast to rise to £3.7m this year, mainly due to an increase in debtors and a reduction in trade creditors. This value has little relevance except in specific circumstances such as a liquidation or disposal of parts (that is, functional parts, not part-shareholdings) of a business. In this company’s situation it has even less relevance than in a company with a high level of tangible assets as much of the value is in intellectual capital. We need not, therefore, consider the book value of assets further. However, assuming the amount in the balance sheet does reflect realisable value then this is a ‘floor’ level valuation. (ii) Dividend yield No dividend has been paid or declared since the company was formed so this method cannot be used for valuing the company. It is not usually an appropriate technique for valuing an entire company or a controlling stake. (iii) P/E ratio In a listed company, the P/E ratio is used to describe the relationship between the share price (or market capitalisation) and earnings per share (or total earnings). It is calculated by dividing the price per share by the earnings per share. Market capitalisation is the share price multiplied by the number of shares in issue. Market capitalisation is not necessarily the true value of a company as it can be affected by a variety of extraneous factors but for a listed company it provides a benchmark that cannot be ignored in, say, a take-over situation. In the case of an unlisted company, a P/E ratio that is representative of similar quoted companies might be used as a starting point for arriving at an estimated market value, based upon the present earnings of the unlisted company. The potential market capitalisation would be the company’s latest earnings multiplied by the benchmark P/E ratio. The P/E ratio can be viewed as indicative of expected growth, which is why some companies in your industry have very high P/E ratios at the present time. A relatively high P/E would suggest that investors are prepared to pay a premium for the company’s shares, based upon present earnings, because they anticipate growth in future earnings beyond growth rates expected in comparable companies. The potential value of your firm using the average and range of P/Es for your industry and the forecast earnings is as follows: PDQ plc’s forecast earnings for 2004 £2.75 million P/E ratio Estimated value (£ million)
Average 28.4 £78.1
Low 7.5 £20.6
High 51.5 £141.6
It is unlikely your company would be awarded a P/E as high as the industry average in current circumstances unless you can show significant growth potential and that you really 2006.1
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Solution 43
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are in a strong recovery situation. A P/E of 28.4 implies an earnings yield of 3.5 per cent. Assuming your cost of capital is similar to the industry average of 15 per cent, this would suggest an annual growth rate of 11.5 per cent. This seems unrealistically high in perpetuity although less so for a shorter period of time. You are currently benefiting from carried forward tax losses but these will end shortly. If we assume an increase in 2005 of 11.5 per cent over 2004 pre-tax profits, you pay tax at 30 per cent and we apply the industry average P/E of 28.4, this would give a value of just under £61m. However, this would be reduced because you are an unlisted company and your shares do not have a ready market. If we assume a reduction of 20%, this would give a P/E based value of just under £50m. Examiner’s Note Any sensible combination of earnings and P/E ratio would gain marks here.
(iv) Discounted cash flow This method values your company using your own cash flow forecasts and uses the dividend valuation model: d1 P0 ke g Assume: ● ● ● ●
earnings equals cash flow and equals dividends, you will pay tax at 30 per cent from year 2 (2005); your cost of equity is the same as the industry average; growth at 20 per cent for the next 3 years then 5 per cent after that.
We cannot use the constant growth form of the model if growth exceeds the cost of capital, which it does for the next 3 years. We therefore need to do a standard DCF for years 1–3 then apply the model for years 3. 2004 2005 2006 2007 Total 2004 to 2007 Year 2008 (3.33 1.05 0.572) In perpetuity 2.00/(0.15 0.05) Total
Post tax cash flow £ million 2.75 2.31 2.77 3.33
DF @ 15%
DCF
0.870 0.756 0.658 0.572 2.00
2.39 1.75 1.82 1.90 7.86 20.00 27.86
We now have a range of values: Asset value P/E using industry average NPV using DVM/cash flow
Approx. value – £ million Whole company Venture capitalist (55%) 1 0.6 50 27.5 28 15.4
These values assume the VC’s holding can be estimated strictly pro-rata. A more detailed evaluation needs to be done to determine a more accurate value of both the entire company and the VC’s 55 per cent. You should consider the following in your negotiations: 2006.1
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How are you going to finance the buy-out? What are the benefits to you? What is the lowest price the VC company will accept? What other options are available a) to you and b) to the venture capitalist?
Requirement (b) Advantages and disadvantages of an MBO If the VC is seeking a quick sale, it may be easier for him to sell to a ready buyer and he might be willing to accept a lower price for this speed and ease of disposal, although the sale may be delayed if you have to raise finance. Conversely, as founding shareholders you may value the business more highly than a third party investor. This is an advantage for the venture capitalist and your disadvantage and provides him with a good base to negotiate a higher price. An advantage to you of the VC selling to a third party is that new external investors may bring additional external skills and steer the business in a new direction to generate profitable returns. These new skills would not be obtained from reducing the shareholder base. However, there are two secondary issues to consider. The first is that new investors may introduce money but not management or other expertise. This may be viewed as an advantage by some and a disadvantage by others. The second is that if the new investor(s) did wish to take a ‘hands on’ approach to management, this could be to the detriment of job security for you and possibly other employees. A major disadvantage of buying the VC’s shares is that you may not have sufficient funds to acquire their shareholding, and would need to raise funds from a bank. This increases the risks from your point of view as you already have your personal capital and most of your financial capital invested in the company.
Examiner’s Note Question 43 does not lend itself easily to discussion under the headings ‘advantages’ and ‘disadvantages’ as many of the advantages have qualifications or the issue is not a clear cut advantage or disadvantage.
Solution 44 Requirement (a) NPV of investment The investment produces a negative NPV as follows: Capital cost $1,500,000 @ 1.58 Cost savings @ 9% for 5 years £240,000 3.89
949,367
NPV ●
●
0933,600 15,767
This suggests that, as an investment evaluated at the company’s post-tax cost of equity capital over 5 years, it is not financially sustainable. However, the tax advantages of debt might convert the investment into a positive NPV project. 2006.1
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1. 2. 3. 4.
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(i) Financing with undated debt If undated debt of, say, £950,000 is used to finance the investment there will be tax savings in perpetuity. However, as RZ evaluates investments over 5 years, it is (arguably) reasonable to take into account only 5 years’ worth of tax savings for this particular investment decision: £950,000 7% 30% PV £19,950 3.89 The adjusted NPV therefore becomes £15,767 £77,605 ●
●
£19,950 £77,605 £61,838
This assumes the discount rate to apply to the tax savings on the interest payments is the company’s cost of capital. There is a strong case for using the after tax cost of debt (7% [1 0.30] 4.9%, say 5%). In this case the adjusted NPV would increase by £8,759 to £70,597 (tax savings would be £19,950 @ 4.329 – the cumulative discount factor for 5 years @ 5% £86,364). A problem here is that long-term debt is being used to finance what the company views as a medium term investment. Consideration would have to be given to how the debt would be serviced at the end of the investment’s life.
Advantages ● Interest payments are tax deductible. ● Does not dilute share ownership or EPS, although in the case here this is probably not a concern. ● Probably cheaper and easier to administer. Disadvantages ● Risk of bankruptcy if interest payments not met. RZ has revenue of £68 million and earnings of £4.5 million. Interest payments are therefore comfortably covered. (ii) Financing with a finance lease ● Leasing may be considered a direct alternative to medium term debt rather than longterm debt. The advantages and disadvantages of a finance lease compared to equity are therefore similar to those for debt. ● The most appropriate method of evaluation is to compare the cash flows associated with debt with the cash flows associated with leasing. See attached table. This shows there is a net advantage of £29,343 of buying with debt. However, much of this advantage is based on the estimated residual value of the machinery. Other factors to consider are: ●
●
●
An advantage of leasing might be that it is paid off in 5 years but the company has debt in its capital structure for much longer. Whether this is important or not is related more to the attitudes of management than economic factors. Leasing is not ‘off balance’ sheet – if it ever was – so there should be no effect on ratios. An advantage of leasing shown by empirical studies is that leasing is often considered more convenient to arrange and involves lower issue costs than either debt or equity. The tax treatment needs more detailed consideration.
(iii) Financing with an operating lease The main difference between a finance lease and an operating lease is who bears the risk. With a finance lease it is the lessee, with an operating lease it is (usually) the lessor. An operating lease is more akin to rental or hire purchase than to new capital. 2006.1
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● ●
●
Usually it can be cancelled at break points in the lease. Although commitments of the lease should be disclosed in notes to the accounts, the machines would not appear as assets in the balance sheet, which may have a favourable effect on ratios. As this is a private company and the directors are major shareholders, this is probably not a concern. Associated costs such as insurance, maintenance and so on may be wrapped up in the lease charge – this may or may not be advantageous to the lessee. The main disadvantages are:
●
●
Cost – more expensive than other methods of finance, although there may well be tax issues, which would require more information than given in the scenario to evaluate properly. May not be available on this type of machinery.
Requirement (b) Benefits and potential problems of financing assets in the same currency as their purchase benefits ● Exposure to currency fluctuations is minimised as the value of the asset and the value of the liability are matched, assuming the loan is repaid in instalments broadly equal to depreciation. ● Interest payments would (presumably) be made in the foreign currency and paid overseas which would further aid the matching principle. ● There might be cheap finance available in the overseas country to give advantage to US exporters. ● Debt financing is cheaper than equity wherever raised as it has tax effects and is (usually) lower risk than equity. However, the tax situation is difficult to comment on without knowledge of detailed tax regimes and treaties between the two countries. ● The decision is a matter of judgement and depends, to some extent, on how risk averse the company is. However, hedging is an alternative option, which would minimize the risks. Potential problems ● Changes in exchange rates between decision to buy and finance, unless made simultaneously. ● Introduction of exchange controls during the life of the finance contract. ● Better finance deals may be available elsewhere, despite the currency risk.
Solution 45 Requirement (a) (i) P/E ratios and market values PCO plc Information in case (shown here for convenience) EPS – pence Share price – pence No of shares in issue (millions) P/E ratio (SP/EPS) Market Value (£M) ( No of shares * SP)
106 967 40
OT plc 92 1,020 24
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The main advantages are:
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(ii) Cost of equity using CAPM PCO plc
OT plc
0.04 0.08 0.9 7.6%
0.04 0.08 1.2 8.8%
K e Rf B(Rm Rf ) RF rate (given) Market return (given) Beta Cost of equity
(iii) Share price and market value using DVM P0 D1/(Ke g) Share price – pence Market value – £ million
1,292 [(32p 1.05)/(0.076 0.05)] 517
n/a [(21p 1.09)/(0.088 0.09)] n/a
Requirement (b) Advice on price and form of funding (i) Price to be offered ●
●
●
●
●
●
●
● ●
●
The market value of OT plc can be determined most easily by reference to the current share price. The constant growth version of the DVM will not work because estimated growth is greater than the cost of equity. It would be possible to use an adjusted version of the model but information on future cash flows would be necessary. Using current market values, PCO plc is worth £387 million and OT plc, £245 million, a total of £632 million before any acquisition gains. The financial advisors have estimated that the NPV of the combined companies is £720 million, a post-acquisition gain of £88 million. The price to be offered will depend on the negotiating abilities of the two companies. Clearly, PCO plc will not be able to retain all, or possibly even most, of the acquisition gains. A key factor may be that it is likely to be a hostile bid. This will inevitably raise the price to be paid and most research has shown that hostile bids result in a fall in wealth for the bidder’s shareholders. A realistic starting point may be to allocate the gains in the proportion of the relative current market values of the two companies. This would be £88 million in the proportions 61% and 39%. This would mean PCO plc would take £54 million of the gain and OT plc £34 million. The price to be offered would, therefore, be £279 million (£245 million market value £34 million share of merger gains) or 1,162 pence per share. PCO plc would also, presumably, take on OT plc’s outstanding debt of approximately £40 million, but the terms of the debt contract would need to be investigated.
(ii) Form of funding Cash ● PCO plc could not offer cash without raising additional debt funding. ● Assuming it was prepared to use all its cash reserves of £105 million (assuming the balance has not been used recently) this would mean an additional £174 million debt, or 2006.1
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Shares ● The opening bid would be based on current market prices, that is, 967 pence and 1,020 pence. ● Suggests an exchange ratio of 1.05 of a PCO plc share for every OT plc share, which would almost certainly be rejected as inadequate, as OT plc’s shareholders would have no incentive to accept the offer. ● If all the gains were to be given to OT plc’s shareholders the share price would be 1,387 pence for OT plc (£333 million/24 million). This would suggest a ratio of 1.43 PCO plc shares per OT plc share, and 34.32 million new shares would need to be issued to OT plc shareholders. ● If first year earnings are forecast as £70 million, this would be an EPS of 94.3 pence – a decline on current EPS for PCO plc, which might not satisfy shareholders. ● A strong statement from management would be needed. ● PCO plc has only 50 million shares authorised and 40 million are issued. A share offer would require increasing authorised share capital. This might give a signal to the market that PCO plc might be considering a bid for a large company, which would have an effect on the share price. Whether this is up or down would depend on market perceptions and sentiment towards PCO plc at the time. If the share price rose, then this is to PCO plc’s advantage in any share exchange. If it fell, then a share exchange might be considered unwise. Combination ● A combination offer could be considered; for example, shares plus cash or shares plus debt. (iii) Business implications ● It is likely to be a hostile bid, which will involve extensive advisors’ costs and PCO plc will probably eventually pay all acquisition gains (and possibly more) to OT plc’s shareholders. ● Advantages include the diversification aspects of the acquisition, which is after all why PCO plc wants to acquire another company. However, PCO plc has no experience of the industry. ● OT plc operates in an area in which PCO plc does not have any particular expertise, so it is difficult to see where any additional value can be created. Some synergies as a result of vertical integration might be claimed but these are likely to be small, and accompanied by a reduction in PCO plc’s flexibility to change suppliers. It is in the oil business so, again, it does not really look like a diversification move. ● The required investment is likely to be large by PCO plc’s standards. The company would be taking on a substantial amount of debt in the form of OT plc’s existing borrowings. A rights issue is possible, perhaps conditional upon the bid being successful. 2006.1
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●
£214 million if OT plc’s £40 million debt has to be repaid under the terms of the debt contract and PCO plc is required to re-finance it. PCO plc’s debt ratio (debt as a proportion of market value) would then increase substantially – much would depend on how the share price moved following the acquisition. If the market value of the combined group is worth £632 million, then the gearing in market value terms (assuming debt trading at par) would rise from 17 to 29%. This might be quite acceptable, although the effect on the cost of capital must be considered.
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SOLUTIONS TO SCENARIO QUESTIONS P9 ●
●
●
A share offer would need to be a bit above one-for-one, given the current market prices. This would require a prior increase in PCO plc’s authorised capital, since only 10 million shares remain unissued, and might give a signal that an acquisition was being considered. A possibility is a choice between shares in PCO plc or cash. Provided no more than half of OT plc’s shareholders opted for cash, this would leave a reasonable capital structure but, to be comfortable, the company would still need to increase authorised share capital. An evaluation of the acquisition should look in more detail at effect on business growth, risk of the company, effect on capital structure and cost of capital and so on. An exercise to identify other possible acquisitions targets could (should?) be launched.
Solution 46 Requirement (a) Three types of decision Investment decisions involve: ●
●
The analysis and appraisal of capital expenditure projects, acquisitions, mergers and divestments, together with the related committal of funds. Decisions relating to working capital and trade investments, with the aim of maintaining satisfactory returns for the organisation.
Financial controllers will assess the likely cash flows of the various alternatives and identify the one which shows the maximum NPV. Financing decisions relate to: ● ●
The obtaining of suitable and adequate funds with which to operate the business. The desired level of gearing represented by the most appropriate combination of short, medium and long-term debt together with equity, including internally generated funds.
If capital needs to be raised, managers will seek the mix of sources which minimises the weighted average cost of capital. Dividend decisions are: ●
●
Based in part on making payments to shareholders, which will currently satisfy their desired long-term rate of return on investment and thereby help to maintain the company’s share price. Based in part on retaining sufficient profits to sustain and advance the level of operations to secure the shareholders’ aspirations for the future.
The key decision is whether the shareholders would be better off having money now or allowing it to be reinvested in the business to produce a higher level of cash flow in the future. All three types of decisions are inter-related, thus the financing decision will affect the cost of capital, and as a consequence, the net benefits obtainable from a particular project, thereby influencing the investment decision, while the financing decision concerning gearing will affect both the other decisions. The dividend decision, in determining the level of retentions, will affect the cash available for investment, and the extent to which external sources of funds need to be sought in financing to optimise operations. 2006.1
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CIMA Official Terminology describes the treasury function as the function concerned with the provision and use of finance. The main functions of such a department include: ● ● ●
●
●
establishment of corporate financial objectives; managing the firm’s liquid assets; cash, marketable securities and so on; management of the company’s funding; determination of policies, identifying sources and types of funds; corporate finance and related issues such as taxation, pension fund investment and so on (although these functions are sometimes performed by the controller); in a multinational, dealing with currency management – dealing in foreign currencies, hedging currency risks and so on.
The financial control function is mainly concerned with the recording and reporting of financial information such as: ● ● ●
preparation of budgets and budgetary control; preparation of periodical financial statements such as monthly accounts, annual accounts; management and administration of activities such as paYearoll, internal audit (which in some cases may be a separate department responsible directly to the Finance Director).
It is therefore apparent that the Treasury Department has main responsibility for setting corporate objectives and policy and Financial Control has the responsibility for implementing policy and ensuring the achievement of corporate objectives. This distinction is probably far too simplistic and, in reality, both departments will make contributions to both determination and achievement of objectives. There is a circular relationship in that Treasurers quantify the cost of capital, which the Financial Controllers use as the criterion for the deployment of funds; Financial Controllers quantify projected cash flows which in turn trigger Treasurers’ decisions to employ capital. In smaller firms the functions of treasury and financial control may be combined and even in larger firms the two functions often include related activities, for example management of cash. Although the Financial Controller has the main reporting responsibilities, the Treasurer will, typically, report on cash flows and cash management. In some cases who has responsibility for certain activities is not clear cut. For example credit control, taxation, insurance or pensions are sometimes handled by the Treasury department and sometimes by the Financial Controller’s department.
Solution 47 Requirement (a) Range of values There are three basic methods we could use to value an unquoted company such as BiOs Limited (BiOs): asset value, P/E ratio basis and discounted cash flow basis. Each is discussed in turn. 2006.1
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Requirement (b) Treasury and financial control departments In summary, a Treasurer handles the acquisition and custody of funds whereas the Financial Controller has responsibility for accounting, reporting and control.
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Asset value ● The book value of BiOs’ net assets is a little under £400,000 at the last balance sheet date. ● This value has little relevance except in specific circumstances such as a liquidation or disposal of parts of a business. In BiOs’ situation it has even less relevance than in a company with a high level of tangible assets, as much of the value is in employees’ expertise, or intellectual capital. ● Assuming the amount in the balance sheet does reflect realizable value then this is a ‘floor’ level valuation, but of little real relevance in the circumstances here. P/E ratio ● In a listed company the P/E ratio is used to describe the relationship between the share price (or market capitalisation) and earnings per share (or total earnings). It is calculated by dividing the price per share by the earnings per share. ● Market capitalisation is the share price multiplied by the number of shares in issue. Market capitalisation is not necessarily the true value of a company as it can be affected by a variety of extraneous factors, but for a listed company it provides a benchmark that cannot be ignored. ● In the case of an unlisted company, a P/E ratio that is representative of similar quoted companies might be used as a starting point for arriving at an estimated market value, based upon the present earnings of the unlisted company. The potential market capitalisation would be the company’s latest earnings multiplied by the benchmark P/E ratio. ● The P/E ratio can be viewed as indicative of expected growth, which is why some companies in the industry have very high P/E ratios. A relatively high P/E would suggest that investors are prepared to pay a premium for the company’s shares, based upon present earnings, because they anticipate growth in future earnings beyond growth rates expected in comparable companies. ● The potential value of BiOs using the average and range of P/Es for the industry is as follows: BiOs’ earnings in 2003: £756,000 P/E Ratio Estimated value (£000) ●
●
●
(100,000 shares at 756p EPS) 12 18 90 9,072 13,608 68,040
This valuation is very rough and ready and takes no real account of BiOs’ specific circumstances and potential. It would be possible to estimate a more precise P/E ratio based on forecast growth rates, but this is complicated by 2 years of expected super-growth followed by a much lower rate after that. The average P/E ratio of the industry applied to next year’s expected earnings of £1,487,500 [Sales revenue of £4,250,000 50% (1 0.3)] might be more appropriate and would give an estimated market capitalisation of £26.775 million.
Note: Any sensible combination of earnings and P/E ratio would be acceptable here. Discounted Cash Flow This method values BiOs using the directors’ cash flow forecasts based on expected sales growth and associated costs. The approach is as follows: 1. Estimate sales income. 2. Calculate earnings/cash flows for the years 2004–2006 based on your estimates of growth. Assuming earnings equals cash flows is a simplification for examination 2006.1
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Estimation of earnings and cash flows for 2004–2006 (£000s) Year to: Revenue Operating costs Tax at 30%
31 December 2004 4,250 2,125 1,637
Earnings/cash flow
1,488
Estimation of cash flows for 2005–2006 (£000s) 2005 £1,488 1.30 1,934 2006 £1,934 1.30 2,514
Discounted cash flows for 2004–2006 Year 2004 2005 2006 Total
Discount factor at 12% 0.893 0.797 0.712
Cash flows 1,488 1,934 2,514
DCF £000 1,328 1,541 1,790 4,659
Estimation of value of cash flows from 2007 to infinity Earnings in 2007 assuming 10% growth on 2006: £2,514 1.1 £2,765 In today’s money, D1 £2,765 0.712 £1,969 P0 D1/ke g 1,969/(0.12 0.10) £98,450
[Note: Any sensible attempt to calculate the value of cash flows to infinity, and recognition that it is in fact necessary, will gain credit.] Present value of all future estimated cash flows 2004–2006 2007 onwards Total
4,659 98,450 103,109
This method suggests a company valuation of just over £100 million. Summary of methods and values Asset value P/E based value (industry average) DCF value
£000s 395 13,608 103,000
(or £26,775 if 2004 earnings used)
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purposes. In reality this would be affected by, for example: depreciation, movements in working capital, and sale and purchase of non-revenue items. 3. Calculate discounted cash flows using the industry average cost of capital of 12%. 4. Estimate the present value of cash flows from 2006 to infinity using the dividend valuation model. This again is an oversimplification but provides a useful ‘short cut’. BiOs has not in the past paid any dividends but the earnings figure is equally acceptable: the basic form of the model assumes all earnings are paid as dividends. 5. Add the present value of all future estimated cash flows.
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SOLUTIONS TO SCENARIO QUESTIONS P9 ●
●
As discussed, the asset value is largely irrelevant and the P/E basis is highly unreliable because of difficulties in comparing one company with another. The DCF method is the most likely to be reliable but the figures produced are very rough and ready and assume constant growth to infinity, which is fairly unrealistic. A more detailed exercise needs to be undertaken. Points to consider are: – How is revenue to grow by rates suggested when the limiting factor is qualified staff ? – What is the true cost of capital? – How will operating costs fall from 70% of revenue to 50% in 2004 and beyond? 70% is calculated as: EPS of 756p 100,000 shares Pre-tax this is 756,000/0.7 As a percentage of sales this is 1,080/3,600 100 Therefore, operating costs
£756,000 £1,080,000 30% 70%
Requirement (b) Venture capital finance versus flotation ● Even if a company valuation of around £100 million is accepted, this is still relatively small for a full listing. A listing on the AIM might be an acceptable alternative and less expensive although the relative length of the ‘queues’ for listing (controlled by the Stock Exchange) needs to be considered. ● The main advantage of any sort of listing is that it provides a readily available benchmark valuation for the shares. However, the number of shares to be sold needs serious consideration. If a small percentage of the shares is sold, this may deter institutional investors as there may not be a ready market in the shares if they want to sell. If a high percentage is issued, control is lost. ● If venture capital finance were to be sought, control would be surrendered anyway as these organisations require a large equity stake, high returns and an assured exit route. ● Typically, an exit route would be to sell the shares on the market either via a placing or offer for sale or to another venture capital company. The original owners of the firm might be able to buy back their shares via an earn-out basis. This method allows the venture capitalist to sell shares back to the owners on the basis of the company achieving certain levels of return. ● No details of what investment would be required to allow the company to grow at a faster rate is given in the question. In a company such as this, the value is in the intellectual capital and this is clearly in short supply. ● Before deciding on a course of action the directors must clarify their short and long-term objectives. If the aim is to maximise personal wealth in the shortest possible time, then an early flotation is probably the best alternative. If control is important then other alternatives might be more appropriate. Other issues to consider are: – timing and cost of a flotation, and how many other similar companies might be coming to market at the same time; – the implications of any likely changes in industry regulation. 2006.1
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(a) Memorandum to the Board of XTA plc From: An Accountant Date: 25 May 2005 Purpose: To explain the advantages and disadvantages of a rights issue versus a placing and a euro bank loan versus a euro-denominated Eurobond: Rights issue versus placing
Euro bank loan versus euro-denominated eurobond
Advantages of a rights issue • no dilution of ownership by current shareholders • reliable (can be underwritten)
Advantages of a euro bank loan • direct contact with lender • flexible terms • promotes good bank relationship • access to a wider source of funds via syndicated credit from a panel of banks • not dependent on a good rating • relatively quick and cheap to arrange
Disadvantages of a rights issue • limits potential investors to current shareholder base (placements can be marketed to a wider selection of institutional investors) • more complex and more expensive than a placement
Disadvantages of a euro bank loan • does not give access to large, deep international capital markets which may support larger issues • finer rates possible from eurobonds • longer maturities may be harder to obtain from a bank (for example 20 years)
• takes longer to arrange than a placement
Examiner’s Note The answer to (a) above has been given in list form as a study aid, but in an examination, candidates would be expected to provide a short paragraph (which could be in bullet point form) for each point.
(b) Revised balance sheets The balance sheet of the German subsidiary is translated at closing rate since the company is operationally independent of the UK parent. Table A: Mr A’s proposal: long-term borrowings in sterling
Total assets Equity Long-term borrowings Current liabilities Total equity and liabilities
At £1 €1.5 £m 530 250 230 050 530
(450 120/1.5) (balance)
At £1 €2.0 £m 510 230 230 050 510
(450 120/2) (balance)
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Solution 48
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SOLUTIONS TO SCENARIO QUESTIONS P9 Table B: Mr B’s proposal: long-term euro borrowings
Total assets Total equity Long-term borrowings Current liabilities Total equity and liabilities
At £1 €1.5 £m 530 250 230 050 530
( 450 120/1.5) ( balance) ( 150 120/1.5)
At £1 €2.0 £m 510 250 210 050 510
( 450 120/2) ( balance) ( 150 120/2)
Table C: Mr C’s proposal: UK equity funding
Total assets Total equity Long-term borrowings Current liabilities Total equity and liabilities
At £1 €1.5 £m 530 330 150 050 530
( 450 120/1.5) ( balance)
At £1 €2.0 £m 510 310 150 050 510
( 450 120/2) ( balance)
Impact on gearing Debt/Debt plus equity Current position Scenario Mr A: sterling borrowings Mr B: euro borrowings Mr C: UK equity
Table D 37.5% At £1 €1.5 48% 48% 31%
At £1 €2.0 50% 46% 33%
Evaluation of Board members’ comments Mr A: sterling-denominated borrowings • Reputation in the UK markets: Mr A’s comment on the advantage of sterling borrowings due to reputation in the sterling capital markets is not valid since banks providing sterling loans should be equally willing to provide euro loans and a good reputation in the capital markets will extend beyond the UK. • Foreign exchange risk: There is, however, a major exchange risk arising from funding eurobased assets with sterling borrowings, arising mainly from the retranslation of the net investment in the subsidiary at the year end and the effect this has on equity values and gearing levels. This is illustrated in Table A, where the value of equity has fallen from £250 million to £230 million as a result of the weakening of the euro against sterling from a rate of £1 €1.5 to £1 €2.0. The effect on gearing is seen in Table D where a fall in the value of the euro leads to deterioration in gearing levels from 48% to 50%. • Impact on gearing: The use of borrowings has a major impact on gearing level, with debt/equity deteriorating from 37.5% to 48% (at £1 €1.5). Euro-denominated borrowings have a similar impact at current exchange rates. • Other exchange risk: There is also an exchange risk on the sterling value of the repatriation of euro profits to the UK via dividends, interest and management charges. Mr B: euro-denominated borrowings • Lower euro interest rates: This is not a valid argument since, under interest rate parity, spot rates are expected to move to compensate for lower euro interest rates and so any gain on interest payments is likely to be offset by a loss on the capital value of the loan when it is repaid. 2006.1
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Examiner’s Note Although outside the scope of the Financial Strategy Syllabus, it could be noted that the hedge accounting provisions of IAS39 can be applied to avoid volatility in reported profit figures. Without hedge accounting, gains and losses on the loan would be recognised in profit for the year whereas gains and losses on the investment in the German subsidiary would be recognised as part of equity under IAS21. If hedge accounting is permitted, the hedge provided by the loan can be designated as such and exchange rate movements on both the investment and the loan recognised as changes in the value of equity.
• Exchange risk and gearing levels: The gearing ratio has again deteriorated markedly as a result of increased borrowing. In addition, gearing levels are exposed to exchange rate changes. In this case, gearing has improved from 48% to 46% as a result of a fall in the value of the euro, but a negative impact would have resulted from a strengthening of the euro against sterling. Mr C: UK equity • Risk profile: Mr C is correct in his assertion that equity finance is more suitable than long-term borrowings for a high risk project, since dividends can be cut or reduced if profits are lower than expected, whereas the interest on borrowings always has to be paid in full at each due date. • Exchange risk: However, with equity finance denominated in sterling and the investment being linked to the value of the euro, there is no natural hedge of exchange rate risk arising on the revaluation of the net investment in Germany. Table C shows that the value of equity would fall from £330million to £310million as a result of a fall in the value of the euro from £1 €1.5 to £1 €2.0 and there would be a deterioration in gearing from 31% to 33%. • Gearing levels: are at a much more acceptable level of around 31%. Indeed, additional long-term borrowings may not be practical if lenders are concerned about the already high gearing levels in the group and/or if the new venture has a high risk profile. In this case, the company may have no choice but to raise new equity finance. Recommendation The German distribution centre and transport fleet should be financed by long-term euro borrowings (which would be designated as a hedge under IAS 39 and hedge accounting provisions applied, as noted above) in order to match the currency and maturity of the assets to be funded and remove exposure of equity and reported profit to exchange rate gains and losses. 2006.1
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• Exchange risk and equity values: Euro borrowings provide a natural hedge by matching the currency of the assets with that of the funding used to finance those assets. At the balance sheet date, the exchange gain or loss on retranslating the net investement in the German subsidiary will be substantially matched by an equal and opposite gain or loss on retranslating the euro borrowings. This is illustrated in Table B where a weakening of the euro borrowings against sterling is seen to have no impact on the value of equity.
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It would be preferable for such euro borrowings to be raised by the German subsidiary so that the euro loan interest can be paid out of euro earnings. This also provides the opportunity for reducing the cost of funding by securing the loans on the euro assets. The proportion of new long-term borrowings may be restricted by the following:
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• German tax authority regulations on minimum capitalisation levels. • Value of assets in the German subsidiary that can be used for security. • Level of parent company loan guarantees offered (where additional security is required). • Debt capacity of the group (that is acceptable gearing level). To the extent that long-term borrowings are not possible, the group should consider a rights issue or placing to raise additional equity finance.
Solution 49 (a) Income statement Revenue Profit before interest and taxes Interest on bank loan Interest on overdraft Profit before taxes Taxation (at 30%) Profit after taxation Balance sheet Non-current assets Property, plant and equipment Current assets Working capital Equity Share capital Retained earnings Non-current liabilities Long-term borrowings (bank loan) Current liabilities Short-term borrowings (overdraft) Current tax payable Cashflow analysis Profit before interest and taxes Add: Depreciation Deduct increase in working capital Net cashflow from operations Interest paid Dividends paid Tax paid Capital expenditure Net cashflow Overdraft b/fwd Overdraft c/fwd
2006.1
2005 £m 51.8 15.5 (0.5) (0.1) 14.9 (3.4) 11.5
2006 £m 59.5 17.9 (0.5) (0.2) 17.2 (4.3) 12.9
Comments
18.7
21.5
See workings – (W2)
10.4 29.1
11.9 33.4
Revenue 20%
10.0 5.0
10.0 6.9
8.0
8.0
2.7
4.2
23.4 29.1
34.3 33.4
15.5 6.3 (1.4) 20.4 (0.6) (10.5) (1.0) (10.0) (1.7) (1.0) (2.7)
17.9 7.2 (1.5) 23.6 (0.7) (11.0) (3.4) (10.0) (1.5) (2.7) (4.2)
Increase by 15% each year 30% of the revenue £8 million loan 6% Opening balance 6% See workings – (W1)
See workings (W3)
Obtained from cashflow analysis See workings – (W1)
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(W1) – Calculation of taxes Deduct capital expenditure Add back depreciation Interest on bank loan Interest on overdraft Taxable profit Taxes (W2) – Non-current assets Property, plant and equipment Capital expenditure Net total Depreciation at 25% Property, plant and equipment c/fwd
15.5 (10.0) 6.3 (0.5) (0.1) 11.2 (3.4)
17.9 (10.0) 7.2 (0.5) (0.2) 14.4 (4.3)
30% revenue
£m
£m
Comments
15.0 10.0 25.0 (6.3) 18.7
18.7 10.0 28.7 (7.2) 21.5
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Workings From workings – (W2) 6% £8 million 6% opening balance 30% taxable profit
25% Net total
£m (W3 – Retained earnings) B/fwd Dividends Earnings for the year C/Fwd
4.0 (10.5) 11.5 5.0
Examiner’s Note Credit was available for approximate recognition of deferred tax.
Funding requirement in 2005 and 2006 Comparing 31 December 2004, 2005 and 2006, the maximum funding requirement in 2005 and 2006 appears to arise on 31 December 2006:
Maximum funding requirement Loan plus overdraft facility Funding shortfall
649
£m 12.2 19.5 12.7
However, it should be noted that we do not have any information about intra-year cashflows; these need to be examined to determine whether a greater funding shortfall arises at some other point during the period. (b) Finance, investment and dividend strategies are all inter- related and the £2.7 million funding shortfall at 31 December 2006 can be met by either withholding dividends, reducing or delaying capital expenditure (investment), by obtaining new finance or a combination of these methods. Increase the bank loan The additional funding requirement of £2.7 million would result in gearing levels marginally in excess of the bank’s maximum gearing level of 70%: Gearing levels: 2004: 64.3% (1.0 8.0)/(10.0 4.0) 2005: 71.3% (2.7 8.0)/(10.0 5.0) 2006: 72.2% (4.2 8.0)/(10.0 6.9) 2006.1
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However, the £2.7 million shortfall is only likely to be temporary and approximately 80% of the loan could be repaid by the end of 2007, so the bank would be more likely to provide the additional loan if it accepts the company’s forecasts for 2007 onwards. If the business achieves its target growth of 15% in 2007 and reduces capital expenditure to £7 million as planned, it can expect positive cashflows in 2007, as shown below: Profit before interest and taxes
£m 20.5
Add depreciation Deduct increase in working capital Net cashflow from operations Interest Dividend Tax paid Capital expenditure Estimated net cashflow in 2007
7.1 (1.8) 25.8 (0.7) (11.6) (4.3) (7.0) 2.2
Comments ( 2006 figure of 17.9 plus 15%) (25% (21.5 7)) ( (20% 68.4) 11.9) ( 6% (8.0 4.2))
Reduce or delay capital expenditure Reducing or delaying investment and thereby slowing down the growth of the company could jeopardise the success of the company. A decision would depend on the nature of the capital expenditure and what impact a delay or reduction would have on the performance and growth of the business. Alternative ways of funding the investment such as the use of leasing or sale and leaseback of non-current assets could also be considered. Reduce dividend Cutting dividend levels is more easily achieved in a private company such as GSD Ltd. This would create a potential problem if the company were preparing for flotation and needed to build up a good track record of dividend payments. However, this may not be acceptable to shareholders who may be dependent on dividend income. Recommendation A bank loan would enable dividend and investment strategies to remain unchanged and hence protect the future expansion plans of the business and meet shareholder payout expectations. If it is not possible to borrow the whole amount needed, it may be possible to borrow a substantial proportion of the amount required. Any remaining amount should be obtained by delaying capital expenditure plans or, if that is not feasible or would damage business prospects, by reducing dividend payouts in 2006.
Solution 50 (a) (i) Six-monthly interest payments are 2.9% ( 2.4% 0.5%) so post-tax interest for each six-month period is 2.03% (2.9 0.7) so annualised post-tax cost of debt is 4.10% (1.02032 1) Examiner’s Note An alternative, less accurate approach: Annual interest rate 1.0242 1 4.9% So post-tax interest (4.9% 1%) (1 0.3) 4.13%
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Item
Year(s)
Amount $m
d.f @ 4%
DCF @ 4%
d.f @ 5%
DCF @ 5%
Lease: Lease payment Tax relief
yr 0–4 yr 1–5
15 4.5
4.630 4.452
69.45 0020.03
4.546 4.329
68.19 0019.48
49.42
PV Buy: Purchase price Tax saving
Terminal value PV Net PV
Yr 0 1 2 3 4 5 6 5
100 6.0 4.8 3.8 3.1 (2.7) 50.0
1.000 0.962 0.925 0.889 0.855 0.822 0.790 0.822
100.00 0.00 5.55 4.27 3.25 2.55 2.13 0041.10 45.41 04.01
48.71 1.000 0.952 0.907 0.864 0.823 0.784 0.746 0.784
100.00 0.00 5.44 4.15 3.13 2.43 2.01 0039.20 47.66 01.05
The lease has been treated for tax purposes as an operating lease since the lessor retains significant risk of loss due to the high residual value of the aeroplanes. Workings: tax saving calculation Year 0 1 2 3 4
Opening value $m 100.0 80.0 64.0 51.2 41.0
Tax allowance at 20% $m 20.0 16.0 12.8 10.2 (9.0)
Closing value $m 80.0 64.0 51.2 41.0 50.0
Tax saving at 30% $m 6.0 4.8 3.8 3.1 (2.7)
It has been assumed that the asset is not in a tax pool and hence a tax balancing charge arises in year 4. Credit was available for calculations of tax savings in perpetuity based on a tax pool. (iii) The breakeven post-tax cost of debt can be calculated by extrapolation from the results in (ii) above as: 5% (1% 1.05/(4.01 1.05)) 5.35%. Conclusion The breakeven post-tax cost of debt in the NPV appraisal is 5.35% which is higher than the actual post-tax cost of borrowing of 4.1%. On the basis of these results, it would therefore be financially beneficial for FLG Inc to PURCHASE the aeroplanes with a loan rather than lease them. (b) The NPV calculation shows that it would be cheaper for FLG Inc to purchase the aeroplanes with a loan rather than lease them. However, there are several other factors that influence the decision on how best to proceed. Sensitivity of the NPV result to rises in interest rates The breakeven cost of debt of 5.35% is equivalent to: • a six-month post-tax cost of 2.640% • a six-month pre-tax cost of 3.771% • a six-month flat $ inter-bank rate of 3.27%
( 1.05351/2 1), equivalent to: ( 2.640/(1 0.3)), equivalent to: ( 3.77% 0.5%) 2006.1
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(ii) NPV of lease/buy decision:
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Examiner’s Note Alternative, less accurate approach: 5.35/0.7 7.64% 1.07641/2 1 3.75% 3.75% 0.5% 3.25% That is, the six-month flat $ inter-bank interest would only need to move up 87bp from 2.40% to 3.27% before it would become cheaper for FLG Inc to lease rather than purchase the aeroplanes. The lease/buy decision is, therefore, highly sensitive to a rise in interest rates. However, the uncertainty surrounding the final cost of the loan could easily be eliminated by arranging fixed, rather than floating, rate finance. If this can also be obtained at a flat rate of 2.4% per six-month period, this risk can be eliminated and the purchase approach adopted with more confidence. Sensitivity of the NPV result to a lower residual value of the aeroplanes At a discount factor of 4.10%, the net PV of the lease/buy decision can be estimated using interpolation: NPV $4.01 million at a DCF of 4% NPV $1.05 million at a DCF of 5% So the NPV at a DCF of 4.10% can be estimated as: (4.10 4.00) ($4.01 million $1.05 million)) $3.71 million ( $4.01 million (5.00 4.00) and the PV of the residual value of the aeroplanes can be calculated as: $40.90 million ( $50 million/1.0415) So the sensitivity of the lease/buy NPV computation to changes in the residual value is: 3.71 100% 9.07% 40.90 That is, the residual value of the aeroplanes only needs to be 9.07% lower, or less than $45.46 million ( $50 million (100 9.07%)) before it becomes cheaper for FLG Inc to lease rather than purchase the aeroplanes. Since both the price and demand for second-hand aeroplanes vary with economic and political conditions, it is not possible to make an accurate estimate of the residual value if, indeed, it is possible to find a buyer at all. Other factors Maintenance • Not relevant here as maintenance is FLG Inc’s responsibility in both cases. Quality of the aeroplanes • Check that the aeroplanes offered under the lease contract are of sufficiently high quality and match that of the aeroplanes that would be purchased. Upgrade terms • If FLG Inc wish to upgrade the aeroplanes (for example, introduce individual TV screens in seats), would this be possible under the lease contract and, if so, on what terms? 2006.1
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Plans at the end of the five years • Would FLG Inc actually want to sell the aeroplanes at the end of the five year period? If not, the purchase and loan approach may become more attractive and the residual value of the aeroplanes less important. Recommendation Assuming that the lease contract provides sufficient flexibility and upgrade terms to meet the company’s requirement and that it has no plans to use the aeroplanes after the end of the five year period, the company would be best advised to lease the aeroplanes rather than purchase with a loan. Although the lease is the more expensive method, it eliminates the large potential downside risk of a fall in residual value of the aeroplanes that is a key element of the purchase method.
Solution 51 (a) Firstly, assume that: N the number of students enrolled on the ITC course in excess of 150, and N is less than 50. Incremental cash flows of ITC versus ITS Project Year(s) Sale of computers (none now sold) Computer upgrade Staff training
0 (2,000) (15,000) (30,000)
Fees Knock-on benefit to other courses Direct costs Directly attributable costs (2K-1K) DF @ 8% PV Total:
0 to 3
1 to 4
360N 20N (60N) 000000 (47,000)
.320N
1 (47,000) 1,144.64N
3.577 1,144.64N 50,312
(1,000) (1,000) 3.312 (3,312)
Conclusion: If fewer than 200 students enrol on the ITC course, the breakeven minimum number of students required is N, where 1,144.6N 50,312 0 that is N 43.96 additional students above 150, or 194 in total Secondly, assume that: N the number of students enrolled on the ITC course in excess of 150, and N is more than 50. In this case, an additional part-time member of staff is required at an additional cost of €10,000 per annum in years 0 to 3. Relevant discount factor is 3.577, so the new PV breakeven equation is: 1,144.64N 50,312 35,770 0, so N 75.21 additional students above 150, or 226 overall 2006.1
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Flexibility • How certain is FLG Inc that it would need the aeroplanes for the five years? Can the lease be broken and, if so, on what terms? • If plans are uncertain, the purchase and loan approach may be more suitable because of the flexibility it offers.
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Overall conclusion It is financially beneficial to replace the ITS course with the ITC course for student numbers of between 194 and 199 (inclusive) and 226 and above. However, although it would be marginally beneficial to adopt the ITC course for student enrolments of between 194 and 199, it is highly unlikely that student numbers would remain within such a narrow band for the four-year duration and recommended that a minimum breakeven figure of 226 students should be adopted in any evaluation of the potential financial benefit of switching to the ITC course. (Note that this assumes that the course is not required to make any contribution towards college overheads.) (b) (i) Effective monitoring and controlling of costs and revenues can be achieved by: • Obtaining firm estimates/commitments on costs and realistic forecasts of revenues; • Establishing clear lines of responsibility; • Appointing a single, overall budget holder with responsibility for the project; • Holding regular review meetings with all relevant parties; • Maintaining regular, comprehensive reporting to monitor actual costs and revenues against budget; • Investigating any overruns without delay; • Requiring formal approval before any additional expenses are incurred. (ii) Alternative options: • Cancel the course; • Carry on for one year; • Continue indefinitely. Cancelling the course would not be possible if the college is committed to providing the course advertised. The reputation of the college may be damaged if the course were to be cancelled and it may be too late to make the necessary administrative arrangements to reintroduce the ITS course, even if students already enrolled on the ITC course were willing to switch across. It may also be possible to increase student numbers for the current year by: • Some last-minute advertising; • An extension of the registration deadline. Prospects for the 2nd to 4th years may be better if: • Current students recommend it to their peers; • Further advertising is carried out. The breakeven student numbers need to be recalculated to take account of the sunk costs of computer upgrade and the staff training and course development (£15,000 and £30,000 respectively) incurred by the enrolment deadline. The breakeven number for fewer than 200 students is N, where 1,144.6N 62,355 30,000 15,000 159,653 that is, N 154.65 That is, student numbers of 150 are now just about acceptable and so the course is sustainable over that four-year period if numbers can be maintained at this level or just above.
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November 2005 Examinations Strategic Level
Management Accounting – Financial Strategy (Paper P9)
Question Paper
656
Brief Guide
671
Examiner’s Answers
673
The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website (www.cimaglobal.com) from the end of February 2006 is a Post Examination Guide for this paper, which provides much valuable and complementary material including indicative mark information.
© 2005 The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher. 655
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Financial Management Pillar Strategic Level Paper
P9 – Management Accounting Financial Strategy 23 November 2005 – Wednesday Morning Session
Instructions to candidates You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, make annotations on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or sub-questions). The question requirements are highlighted in a dotted box. Answer the ONE compulsory question in Section A on pages 657 to 659. Answer TWO of the four questions in Section B on pages 660 to 665. Maths Tables and Formulae are provided on pages 666 and 670. Write your full examination number, paper number and the examination subject title in the spaces provided on the front of the examination answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close. Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.
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[the indicative time for answering this Section is 90 minutes]
READ THE SCENARIO AND ANSWER THE QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 5, WHICH IS DETACHABLE FOR EASE OF REFERENCE
Question One Scenario GAS plc Description of the business GAS plc is an international energy entity with a head office in the UK. Through its principal operating subsidiaries based in the UK and elsewhere in Europe, it generates electricity and supplies gas and electricity via energy supply networks across Europe. GAS plc’s strategy is to generate future growth through investment in new power stations, energy supply networks and gas storage assets. Its current focus for new investment is Bustan, a large Asian country that is in urgent need of major improvements in its electricity generation and supply systems to support the recent rapid increase in industrial production. Group profile On 31 December 2004, GAS plc had 1,200 million 50 pence ordinary shares in issue and a share price of 335 pence ex-dividend. Shareholders expect a return on equity of 9.4%. Dividends for GAS plc for the year ended 31 December 2004 were 14 pence a share, maintaining the 5% annual increase in dividends that has been achieved in recent years. For simplicity, dividends should be assumed to be declared and paid on 31 December each year. Investment project The new investment in Bustan has been at the planning stage since the beginning of 2004 when the government of Bustan first invited proposals for a large construction project from interested parties. The project was evaluated over a 10-year period beginning January 2005 and the project net operating cashflows in B$, the local currency of Bustan, were estimated to be as follows:
Year 1 Year 2 Year 3 Years 4–10
B$ million 20 150 250 300
All cash flows should be assumed to arise on 31 December of each year. It should also be assumed that annual cash flows, less tax, are paid across to the UK on the final day of each year. The cost of the initial investment in plant and other equipment at the beginning of January 2005 was B$700 million and this is subject to depreciation charged in the subsidiary accounts on a straight line basis at 5% per annum. An additional B$50 million was required to finance working capital at the beginning of January 2005. 2006.1
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SECTION A – 50 MARKS
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Tax Bustan charges entity tax at a preferential rate of 20% for the first 10 years of such investment projects, rather than the normal rate of 40%. In Bustan, tax depreciation allowances are calculated on the same basis as accounting depreciation allowances. The tax rate in the UK is 30%, but a double tax treaty allows taxes charged in Bustan to be deducted from UK taxes charged in the same period. Assume that Bustan taxes are payable in the year in which they are incurred and that UK taxes are payable one year in arrears. Exchange rates At 31 December 2004, the spot exchange rate was £1 B$0.7778. The B$ is expected to weaken against the British pound (sterling) in line with the differential in long term interest rates between the two countries over the life of the project. Long term interest rates are expected to remain stable at 4.8% per annum in the UK and 10% per annum in Bustan for the foreseeable future. Financing the project The total initial investment of B$750 million was funded by GAS plc at the beginning of 2005. The B$700 million investment in plant and equipment was funded by a rights issue and the B$50 million working capital requirement out of surplus cash. GAS plc evaluated the project on the basis of a realisable residual value of B$350 million for the plant and equipment and that 80% of the investment in working capital would be realised at the end of the project. Both these amounts are to be repaid in full to the UK without any taxes payable in either Bustan or the UK. Press statements In June 2004, GAS plc issued a press statement announcing its intention to submit a proposal for the project. On the same day, it announced its plans to use a 1 for 4 rights issue to fund the B$700 million capital investment in the event of the proposal being accepted. GAS plc’s proposal was accepted on 1 January 2005 and a press release issued to announce the acceptance of the proposal and GAS plc’s intention to proceed with the project without delay. The press statement also announced GAS plc’s intention to temporarily reduce dividend growth rates during the development stage of the project. Revised dividend plans are as follows: 2005–2007 2008 onwards
Dividend per share to be frozen at December 2004 levels 7% per annum growth
Investment criteria Criterion 1 GAS plc requires overseas projects to generate an accounting rate of return in the overseas country, which is Bustan in this instance, of at least 25% per annum. Accounting rate of return is defined as: average annual accounting profit before interest and taxes average annual (written down) investement Criterion 2 GAS plc also assesses investment projects based on the net present value of the cashflows and applies a risk-adjusted sterling discount rate of 10.5% to overseas projects of this nature. 2006.1
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(a) Show, by calculation, that the proposed investment project in Bustan met the two minimum investment criteria set by GAS plc. (18 marks) (b) Discuss the major risk issues that should have been considered by GAS plc when evaluating the project. (7 marks) (c) The board of GAS plc has been concerned about the unusually volatile movements in the entity’s share price in 2004 and 2005 and has asked you, an external management consultant, to draft a report to the board of GAS plc that critically addresses the issues detailed below. Assume a semi-strong efficient market applies. (i) Explain the possible reasons for the unusually volatile movements in GAS plc’s share price in the twelve months up to and including 1 January 2005. No calculations are required. (6 marks) (ii) Advise what would have been a fair market price for GAS plc’s shares in January 2005 following the announcement of the acceptance of the proposal and after adjusting for the proposed rights issue. As part of your answer, calculate GAS plc’s share price on each of the bases listed below and discuss the relevance of each result in determining a fair market price for the entity’s shares: • the theoretical ex-rights price before adjusting for the project cashflows; • the theoretical ex-rights price after adjusting for the project cashflows; • directors’ dividend forecast issued in January 2005. (14 marks) (iii) Advise on how and to what extent directors are able to influence their entity’s share price. (5 marks) (Total for requirement (c) 25 marks) Within the overall mark allocation, up to 4 marks are available for structure and presentation. (Total for Question One 50 marks) (Total for Section A 50 marks)
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Requirements
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SECTION B – 50 MARKS [the indicative time for answering this Section is 90 minutes]
ANSWER TWO ONLY OF THE FOUR QUESTIONS
Question Two HG is a privately-owned toy manufacturer based in a country in the European Union, but which is not in the European Common Currency Area (ECCA). It trades internationally both as a supplier and a customer. Although HG is privately owned, it has revenue and assets equivalent in amount to some public listed companies. It has a large number of shareholders, but has no intention of seeking a listing at the present time. In fact, the major shareholders have often expressed a wish to buy out some of the smaller investors. The entity has a long history of sound, if unspectacular, profitability. The directors and shareholders are reasonably happy with this situation and are averse to adopting strategies that they think might involve a substantial increase in risk, for example, acquisition or setting up manufacturing capability overseas, as some of HG’s European competitors have done. As a consequence, HG accepts its growth rate will be relatively low, compared with some of its competitors. The entity is financed 70% equity and 30% debt (based on book values). The debt is a mixture of secured and unsecured bonds carrying interest rates of between 7% and 8.5% and repayable in 5 to 10 years’ time. Inflation in HG’s country is near zero and interest rates are low and possibly falling. The Company Treasurer is investigating the opportunities for, and consequences of, refinancing. HG’s main financial objective is simply to increase dividends each year. It has one non-financial objective, which is to treat all stakeholders in the organisation with “fairness and equality”. The Board has decided to review these objectives. The new Finance Director believes maximisation of shareholder wealth should be the sole objective, but the other directors do not agree and think a range of objectives should be considered, for example profits after tax and return on investment and performance improvement across a number of operational areas.
Requirements (a) Evaluate the appropriateness of HG’s current objectives and the Finance Director’s suggestion, and discuss the issues that the HG Board should consider when determining the new corporate objectives. Conclude with a recommendation. (15 marks) (b) Discuss the factors that the treasury department should consider when determining financing, or re-financing strategies in the context of the economic environment described in the scenario and explain how these might impact on the determination of corporate objectives. (10 marks) (Total for Question Two 25 marks)
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FS provides industrial and commercial cleaning services to organisations throughout a country in the European Union. Its shares have been listed for 15 years and, until two years ago, the entity followed a policy of aggressive growth, mainly by acquisition. However, in the last two years, there have been few suitable takeover opportunities and, as a consequence, growth has slowed. The market has downgraded FS’s shares and they are currently trading at €3.57, the lowest price for five years. The market as a whole has declined in value, but not to the same extent as FS’s shares. FS’s bank has recently informed FS’s directors of a possible takeover opportunity of another of its clients, MT. This is a large private entity in the same industry as FS. MT’s directors have indicated to the bank that if the price is right they may be prepared to sell the entity. MT’s directors have made their financial forecasts and other strategic documentation available to the bank on a strictly confidential basis, requesting that this information only be released to a serious potential bidder. After much discussion between the bank and the two companies, MT agrees that FS should have the information. MT’s results for the past three years and the directors’ estimates for the current year are as follows: Year to 30 June 2003 2004 2005 2006 (forecast)
Revenue €million 925 1,020 1,150 1,350
Earnings €million 55.5 62.7 71.5 88.9
For 2007 onwards, growth in earnings and dividends is likely to fall to 4% per annum, according to MT’s directors. MT has paid a dividend of 50% of its earnings for the past 10 years. Summary balance sheets as at 30 June 2005 for both FS and MT are as follows:
TOTAL ASSETS Non-current assets Current assets* EQUITY AND LIABILITIES Equity Share capital (Shares of €1) (Shares of 50 cents) Retained earnings Non-current liabilities (Secured bonds, 6% 2015) (Unsecured bonds, 7% 2010) Current liabilities
* Includes cash of
FS €million
MT €million
1,944 1,796 2,740
1,040 1,375 1,415
420 1,080 1,500
220 1,680 1,900
750 1,490 1,240
300 1,215 1,515
2,740
1,415
250
65
FS’s revenues and earnings for the year ended 30 June 2005 were €2,250 million and €128.5 million respectively. 2006.1
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Question Three
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After thoroughly examining the information on MT, financial managers in FS have identified a number of savings and potential synergies that would arise if the takeover were to go ahead. These synergies are estimated to have a net present value of €200 million. However, the FS directors believe MT’s forecast earnings are over-optimistic and think earnings growth for 2006 onwards is likely to be in the range 2% to 4%. The bank advisers disagree, but they are in a delicate situation trying to balance the interests of two clients. FS’s cost of equity is 8.5%. MT has not provided information on its cost of capital, but the two entity’s asset betas are likely to be the same. FS’s equity beta is quoted as 1.1. The expected risk free rate of return is 3% and the expected return on the market is 8%. Assume that the debt beta for both companies is 0.2 and that FS’s debt is trading at par. Ignore tax in your calculations.
Requirements Assume you are a Financial Manager with FS. Advise the directors of FS on (i) the appropriate cost of capital to be used when valuing MT. Accompany your comments with a calculation of the cost of equity for MT. (6 Marks) (ii) a bidding strategy; that is the initial price to be offered and the maximum FS should be prepared to offer for the shares in MT. Use whatever methods of valuation you think appropriate and accompany each with brief comments on their suitability in the circumstances here. In calculations of value that require a discount rate, use the cost of equity you have calculated in (i) above. Your answer should consider the interests of both groups of shareholders. (13 marks) (iii) the most appropriate form of consideration to use in the circumstances. Assume the choice is either a share exchange or cash. Your answer should consider the interests of both groups of shareholders. (6 marks) (Total for Question Three 25 marks)
Question Four WZ is a manufacturer of specialist components for the motor trade. It is based in Zafran, a country in the Far East. The entity’s capital structure is as follows: • 5 million ordinary shares of Z$1 each, currently quoted at Z$12.5 per share. • 10 million preference shares of Z$1 each, currently quoted at Z$0.80 per share, paying a dividend of 7% per annum. • Z$20 million, 8% undated debt, secured on the entity’s non-current assets. This debt is currently trading at Z$90 per Z$100 nominal. 2006.1
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• That profit after interest and tax equals cash flow; • The required rate of return on equity will remain at the current rate of 12% per annum irrespective of type of finance raised; • There are no transaction costs. The directors of WZ are considering three forms of finance: 1 Equity via a rights issue at 15% discount to current market price; 2 9% bonds repayable in 2015 secured as a floating charge on the entity’s current assets. 3 Factoring the entity’s trade receivables. This is likely to provide a one-off release of funds of approximately Z$5 million.
Requirements (a) Calculate for the current situation and financing alternatives 1 and 2 the expected (i) earnings per share; (ii) market value of equity, using the capitalisation of earnings at the cost of equity; (iii) market value of the entity; (iv) gearing ratios (debt to total value of the entity), using market values; (v) weighted average cost of capital. State whatever assumptions you consider necessary. (12 marks) (b) Assume you are a Financial Manager with WZ. Advise directors of WZ of the issues to be considered before deciding on which form of finance to choose, including factoring, and make your own recommendation. (13 marks) (Total for Question Four 25 marks)
Question Five RJ plc is a supplier of surgical instruments and medical supplies (excluding drugs). Its shares are listed on the UK’s Alternative Investment Market and are currently quoted at 458 pence per £1 share. The majority of its customers are public sector organisations in the UK. RJ plc is doing well and now needs additional capital to expand operations.
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To finance expansion, the directors of WZ want to raise Z$5 million for additional working capital. Cash flow from trading, before interest and tax is currently Z$15 million per annum. If the expansion goes ahead, this is expected to rise to Z$17 million. The current rate of tax, which is expected to continue for the foreseeable future, is 30%. Assume for the purposes of simplicity:
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The forecast financial statements are given below. Extracts from the Income Statement for the year ended 31 December 2005 £000
Revenue Costs and expenses Operating profit Finance costs Profit before tax Tax
30,120 22,500 7,620 22,650 4,970 1,491
Note: Dividends declared for 2005 are £1,392,000 Balance Sheet as at 31 December 2005 £000 TOTAL ASSETS Non-current assets Current assets Inventories Trade receivables Cash
£000 14,425
4,510 3,700 3,198 28,408 22,833
EQUITY AND LIABILITIES Equity Share capital Retained earnings
8,350 4,750 13,100
Non-current liabilities (Secured bonds, 6% 2008) Current liabilities Trade payables Other payables (tax and dividends)
4,000 2,850 2,883 25,733 22,833
Additional information: 1 Revenue is expected to increase by 10% per annum in each of the financial years ending 31 December 2006 and 2007. Costs and expenses, excluding depreciation, are expected to increase by an average of 5% per annum. Finance costs are expected to remain unchanged. 2 RJ plc expects to continue to be liable for tax at the marginal rate of 30%. Assume tax is paid or refunded the year following that in which the liability or repayment arises. 3 The ratios of trade receivables to revenue and trade payables to costs and expenses will remain the same for the next two years. The value of inventories is likely to remain at 2005 levels. 4 The non-current assets are land and buildings, which are not depreciated in RJ plc’s books. Capital (tax) allowances on the buildings may be ignored. All other assets used by the entity (machinery, cars and so on) are either rented or leased on operating leases. 2006.1
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RJ plc’s main financial objectives for the years 2006–2007 are to earn a pre-tax return on the closing book value of equity of 35% per annum and a year-on-year increase in earnings of 10%.
Requirements Assume you are a consultant working for RJ plc. Evaluate the implications of the financial information you have obtained. You should: (i) Provide forecast income statements, dividends and retentions for the two years ending 31 December 2006 and 2007. (6 marks) (ii) Provide cash flow forecasts for the years 2006 and 2007. Comment briefly on how RJ plc might finance any cash deficit. (8 marks) Note: This is not an investment appraisal exercise; you may ignore the timing of cash flows within each year and you should not discount the cash flows. You should also ignore interest payable on any cash deficit. (iii) Discuss the key aspects and implications of the financial information you have obtained in your answer to parts (i) and (ii) of the question, in particular whether RJ plc is likely to meet its stated objectives. Provide whatever calculations you think are appropriate to support your discussion. Up to 4 marks are available for calculations in this section of the question. (11 marks) (Total for Question Five 25 marks) (Total for Section B 50 marks)
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5 Dividends will be increased by 5% each year. 6 RJ plc intends to purchase for cash new machinery to the value of £6,000,000 during 2006, although an investment appraisal exercise has not been carried out. It will be depreciated straight line over 10 years. RJ plc intends to charge a full year’s depreciation in the first year of purchase of its assets. Capital (tax) allowances are available at 25% reducing balance on this expenditure.
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Maths Tables and Formulae Present value table Present value of 1.00 unit of currency, that is (1 r)n where r interest rate; n number of periods until payment or receipt.
Periods
Interest rates (r)
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820
0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673
0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554
0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456
0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614 0.585 0.557 0.530 0.505 0.481 0.458 0.436 0.416 0.396 0.377
0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558 0.527 0.497 0.469 0.442 0.417 0.394 0.371 0.350 0.331 0.312
0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258
0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215
0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149
Periods
Interest rates (r)
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124
0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104
0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087
0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073
0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247 0.215 0.187 0.163 0.141 0.123 0.107 0.093 0.081 0.070 0.061
0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 0.195 0.168 0.145 0.125 0.108 0.093 0.080 0.069 0.060 0.051
0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043
0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037
0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031
0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026
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Receivable or Payable at the end of each year for n years
Periods (n)
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
1 (1 r)n r
Interest rates (r) 1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046
0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.679 16.351
0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.878
0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590
0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462
0.943 1.833 2.673 3.465 4.212 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470
0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594
0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818
0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129
0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514
Periods
Interest rates (r)
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963
0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469
0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025
0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623
0.870 1.626 2.283 2.855 3.352 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259
0.862 1.605 2.246 2.798 3.274 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929
0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628
0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 7.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353
0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101
0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870
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Cumulative present value of 1.00 unit of currency per annum
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FORMULAE Valuation models (i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d kpref (ii) Ordinary (equity) share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d ke (iii) Ordinary (equity) share, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value: P0
d1 ke g
or
P0
d0[1 g] ke g
(iv) Irredeemable (undated) debt, paying annual after-tax interest, i [1 t], in perpetuity, where P0 is the ex-interest value: P0
i [1 t] kdnet
or, without tax: P0 i kd (v) Total value of the geared firm, Vg (based on MM): Vg Vu TBc (vi) Future value of S, of a sum X, invested for n periods, compounded at r % interest: S X[1 r]n (vii) Present value of 1.00 payable or receivable in n years, discounted at r % per annum: 1 [1 r]n (viii) Present value of an annuity of 1.00 per annum, receivable or payable for n years, commencing in one year, discounted at r % per annum: PV
1 PV 1r 1 [1 r]n
(ix) Present value of 1.00 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r % per annum: PV 1r 2006.1
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1 PV r g
Cost of capital (i) Cost of irredeemable preference capital, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0: kpref d P0 (ii) Cost of irredeemable debt capital, paying annual net interest, i[1 t], and having a current ex-interest price P0: kd net
i [1 t ] P0
(iii) Cost of ordinary (equity) share capital, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0: ke d P0 (iv) Cost of ordinary (equity) share capital, having a current ex-div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g % per annum: ke
d1 g P0
or ke
d0[1 g] g P0
(v) Cost of ordinary (equity) share capital, using the CAPM: ke Rf [Rm Rf ]ß (vi) Cost of ordinary (equity) share capital in a geared firm (no tax): VD VE (vii) Cost of ordinary (equity) share capital in a geared firm (with tax): keg k0 [k 0 kd]
VD[1 t] VE (viii) Weighted average cost of capital, k0: keg keu [ko kd]
k0 keg
V V V k V V V E
E
D
d
D
E
D
(ix) Adjusted cost of capital (MM formula): kadj keu[1 tL]
or
r * r[1 T *L]
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(x) Present value of 1.00 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g % per annum, discounted at r % per annum:
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In the following formulae, ßu is used for an ungeared ß and ßg is used for a geared ß: (x) ßu from ßg, taking ßd as zero (no tax): ßu ßg
V V V E
E
D
(xi) If ßd is not zero: ßu ßg
V V V ß V V V E
E
D
D
d
D
E
(xii) ßu from ßg, taking ßd as zero (with tax): ßu ß g
VE VE VD[1 t]
(xiii) Adjusted discount rate to use in international capital budgeting using interest rate parity: Exchange rate in 12 months' time C$/Euro 1 annual discountrate C$ Spot rate C$/Euro 1 annual discount rate Euro
Other formulae (i) Interest rate parity (international Fisher effect): Forward rate US$/£ Spot US$/£ 1 nominal US interest rate 1 nominal UK interest rate (ii) Purchasing power parity (law of one price): Forward rate US$/£ Spot US$/£ 1 US inflation rate 1 UK inflation rate (iii) Link between nominal (money) and real interest rates: [1 nominal (money) rate] [1 real interest rate][1 inflation rate] (iv) Equivalent annual cost: Equivalent annual cost
PV of costs over n years n year annuity factor
(v) Theoretical ex-rights price: TERP
1 [(N cum rights price) issue price] N1
(vi) Value of a right: Value of a right or
Rights on price issue price N1
Theoretical ex rights price issue price N where N number of rights required to buy one share. 2006.1
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Section A – Compulsory Question One This question concerns an international energy entity. The organisation is based in the UK, but has operating subsidiaries throughout Europe. The organisation is looking to expand and has focused new investment in a large Asian country, which is in urgent need of major improvements in its energy generation and supply to support increases in industrial production there. The question involves investment appraisal and discussion of the major risks to the energy entity of this new investment. It also examines concerns made by the Board of the energy entity about the unusually volatile movements in its share price recently. The question requires candidates to explain the possible reasons for the movements, advise on a fair market share price following acceptance of the proposal by the country, after adjusting for the proposed share issue, and the extent to which the Board of the energy entity is able to influence this price. It further requires a calculation and discussion of the entity’s share price based upon three different bases. Marks are available for structure and presentation of the answer. It examines topics in all four sections of the syllabus. Section B – Choice of two from four questions Question Two Part (a) requires candidates to evaluate the appropriateness of the current and proposed objectives of the entity described in the question. It also requires discussion of the issues arising and asks candidates to make a recommendation to the Board about these. Part (b) requires discussion of the factors to be considered by the treasury department of the entity when determining financing, or re-financing, strategies in the context of the issues currently facing the entity. Question Three This question requires candidates to advise the directors of the entity described in the question on the appropriate cost of capital to be used when valuing a potential takeover of a current client. It also asks candidates to advise on a bidding strategy, using whatever methods of valuation the candidates think appropriate, supported by comments on their suitability in the circumstances described. Finally, candidates are asked to advise on the most appropriate form of consideration to use in the circumstances described, with particular consideration of the interests of both groups of shareholders. Question Four This question requires candidates to calculate various financial indicators, based upon three different bases, pertaining to the entity described in the question. It also requires candidates to advise the directors of the entity of the issues to be considered before deciding which form of financing to choose to fund its expansion and asks candidates to make a recommendation to the directors about these.
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The Examiner for Financial Strategy offer to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the questions included in this examination paper.
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Question Five This question requires candidates to evaluate the implications of the financial information by the provision of forecast income statements, dividends and retentions and cash flow forecasts for the next two years, based upon extracts of the income statement and balance sheet of the entity described in the question. It also requires discussion of the key aspects and implications obtained from the financial information provided and, in particular, whether the entity is likely to meet its stated objectives. Marks are available for calculations in part (iii) of this question.
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Strategic Level
P9 – Management Accounting Financial Strategy Examiner’s Answers
SECTION A Examiner’s Note The answers to Question One is fuller than was expected from a well-prepared candidate. It has been provided for future candidates, and tutors, for study and revision purposes. Question One (a) Investment criterion 1 Year Operating cash flows Loss on realisation of working capital Net profit before depreciation Deduct depreciation Annual accounting profit
1 B$ million 20
2 B$ million 150
3 B$ million 250
4–9 B$ million 300
20 35 15
150 35 0115
250 35 0215
300 35 0265
10 B$ million 300 10 290 35 0255
0
20
43
53
51
20
130
207
247
249
Tax at 20% (see note 1) Net cash flow repatriated to the UK ( operating cash flows tax)
Average annual profit
216
(15 115 215 (6 265) 255) 10
Average investment
570
(700 50 350 40) (see note 2) 2
Accounting rate of return
37.9% 216 570
673
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Note 1: Alternative assumptions regarding the offset of losses for tax purposes were also acceptable. Note 2: Average investment of (700 50 350 50)/2 was also acceptable. Workings: Loss on realisation of working capital: BS$ 10 million 20% B$50 million. Cash flow repatriated year 10: 249 300 51 (ignoring loss on realisation of working capital and depreciation) Conclusion: The project gives a pre-tax accounting rate of return of 37.9%, well in excess of the minimum requirement of 25%. Investment criterion 2 Year
Net cash flow repatriated to the UK UK tax paid at 30% paid one year in arrears less tax relief on Bustan tax Net UK taxes Post tax repatriated funds Initial investment & working capital
0 B$ million
1 B$ million
3 B$ million
4 B$ million
5–9 B$ million
10 B$ million
130
207
247
247
249
6 0
39 20
62.1 43
74.1 53
74.1 53
74.7 51
20
6 124
19 188
19.1 227.9
21.1 225.9
21.1 227.9 390
23.7 23.7
20
2 B$ million
750
11 B$ million
Net cash flow in $million Converted to £million at 0.7778 Discount factor at 16% (W1)
750 964.3
0,20 25.7
0.124 159.4
0.188 241.7
227.9 293.0
225.9 290.4
617.9 794.4
23.7 30.5
1
0.862
0.743
0.641
0.552
1.807 (W2)
0.227 (W3)
0.195
NPV Cumulative NPV
964.3 192.2
22.2
118.5
154.9
161.7
524.8
180.3
5.9
Workings: W1: (1 10.5%) (1 10%)/(1 4.8%) 1 15.983% so use 16% as an approximation W2: Either: AF5yrs@16% DF4yr@16% 3.274 0.552 1.807 Or: AF9yrs@16% AF4yrs@16% 4.607 2.798 1.809 W3: DF 10yrs@16% 0.227 Note: An alternative approach, using a discount factor of 10.5% is shown on the next page Conclusion: The project has a positive NPV of £192 million at a risk-adjusted cost of capital of 10.5% and therefore meets investment criterion 2.
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Alternative approach using a discount factor of 10.5%
750 750 0.7778 964.3 1 964.3 193.2
1 B$ million
2 B$ million
3 B$ million
4 B$ million
5 B$ million
6 B$ million
7 B$ million
8 B$ million
9 B$ million
10 B$ million
11 B$ million
20
130 6 0
207 39 20
247 62.1 43
247 74.1 53
247 74.1 53
247 74.1 53
247 74.1 53
247 74.1 53
249 74.1 53
74.7 51
20
6 124
19 188
19.1 227.9
21.1 225.9
21.1 225.9
21.1 225.9
21.1 225.9
21.1 225.9
20 0.8164 24.5 0.9050 22.2
124 0.8569 144.7 0.8190 118.5
188 0.8994 209.0 0.7412 154.9
227.9 0.9440 241.4 0.6707 161.9
225.9 0.9909 228.0 0.6070 138.4
225.9 1.0401 217.2 0.5493 119.3
225.9 1.0917 206.9 0.4971 102.8
225.9 1.1458 197.1 0.4499 88.7
225.9 1.2027 187.8 0.4071 76.5
21.1 227.9 390 617.9 1.2624 489.5 0.3684 180.3
23.7 23.7 23.7 1.3250 17.9 0.3334 6.0
Workings: W1: Exchange rate: 0.8164 0.778 1.10/1.048 and so on 0.8190 1/1.1052 and so on W2: Discount factor: 0.9050 1/1.105 Conclusion: The project has a positive NPV of £193 million at a risk-adjusted cost of capital of 10.5%. [Examiner’s Note: The slight difference in the NPV’s on pages 2 and 3 is due to roundings.]
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Net cashflow repatriated to the UK UK tax paid at 30% paid one year in arrears less tax relief on Bustan tax Net UK taxes Post tax repatriated profit Initial investment & working capital Net cashflow in $million Exchange rate (W1) £ Sterling equivalent Discount factor at 10.5% (W2) NPV Cumulative NPV
0 B$ million
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(b) The key risks that should be discussed include: • Costs and revenue estimates – Realisation of the plant and equipment – how reliable is this estimate? It may be totally unrealistic to assume that the investment in plant and equipment could be realised at all, let alone as early as the last day of the project. – Operating cash flows – how reliable are the forecasts here, for example, could capital expenditure on plant and equipment exceed budget? • Timings of cash flows – what is the risk that construction takes longer than planned and hence receipt of positive cash flows being delayed? • Regulator/political interference – Taxes – could these change, either in the UK or Bustan? – Repatriation of profits – might this be blocked? – What is the risk that the regulator might restrict the operation of the networks and generators in favour of local operators in future? • Exchange risk – will exchange rates mirror interest rate differentials? • Discount rate – does this adequately reflect the risk profile of the project?
(c) Report To: From: Date: Subject:
Board of GAS plc External Management Consultant 23 November 2005 Share price volatility
Introduction/terms of reference The purpose of this report is to address the following three issues relating to the entity’s share price: (i) Possible reasons for the unusually volatile movements in the entity’s share price. (ii) Fair market price for the entity’s shares. (iii) How and to what extent the share price can be influenced by the Board. (i) Possible reasons for the unusually volatile movements in the entity’s share price in the twelve months up to and including 1 January 2005 Introduction: the semi-strong efficient market In a semi-strong efficient market, the share price will reflect all publicly available information, including anticipated results or actions. Beginning of 2004: proposal invitation It is likely that the invitation to submit a proposal would be widely known and in the public domain. Any impact on the share price of GAS plc would depend on: • Expectations that the entity would submit a proposal (for example, has the entity been interested in similar projects in the past and does this fit its business strategy);
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June 2004: submit proposal Any impact on the share price in June 2004 will largely depend on the extent to which the project announcement has already been factored into the entity’s share price ahead of the formal announcement of the acceptance of the proposal. January 2005: proposal accepted The share price of GAS plc would be expected to rise on announcement of the acceptance of the proposal unless GAS plc had been singled out as the most likely contractor at an earlier stage and the market had already factored the effects of the proposal being accepted into the share price. The extent of a rise in share price in January 2005 will depend on market perceptions of: • the profitability of the project; • the risk profile of the cash flows; • the likelihood of obtaining further similar contracts in the future as a direct result of this proposal being accepted. General economic and business conditions The share price of GAS plc will also be affected by changes in general economic and business conditions such as: • energy prices • national disasters and other disruptions to supplies • world demand for energy (ii) Fair market price for the entity’s shares in January 2005 Theoretical ex-rights price before project cash flows Ignoring the new project and looking at the impact of the rights issue in isolation, the entity’s share price can be forecast as 328p after the rights issue. Workings: $700 million £900 million 0.7778 Number of shares to be issued at 1 for 4 300 Amount to be raised
So price rights at £3 each in order to raise £900 million (300 £3) T.E.R.P.
1,200 335p 300 300p 328 pence (1,200 300)
If the market is optimistic about the outcome of the proposed new investment and a semi-strong efficient market applies, the share price would be expected to respond positively to the announcement of the acceptance of the proposal and rise above the T.E.R.P.
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• Expectations that the entity would be successful in having its proposal accepted (for example, the number of projects available and the number of entities invited and/or intending to submit proposals); • Expectations of the profitability of the project.
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T.E.R.P. after adjusting for project cash flows A valuation based on the NPV of the project gives a predicted share price of 341 pence after the rights issue as follows: NPV of project cash flows Current value of shares Proceeds of rights issues New number of shares New share price
192.00 4,020.00 (1,200 shares 335 pence) 900.00 (300 shares £3) 5,112.00 1,500 5,112.00 341 pence 1,500
However, this assumes that: • The market has sufficient information to produce an accurate estimate of the NPV of the proposed project, which is unlikely to be the case; • The whole of the added value is reflected in the share price before commencement of the project. (£5,112.00) (30% 192 ) 337 1,500 Dividend growth model valuation The dividend growth model valuation gives a much higher share price valuation of 512 pence as follows: Workings:
2005 2006 2007
Pence 12.80 11.70 10.69
2008 on
476.70
Workings 14/1.094 14/1.0942 14/1.0943 14(1.07) (0.0.94 0.07)(1.0943)
511.89 pence
This would suggest that the intended dividends are unsustainable from the projected profits of the project. On the evidence of the earnings of this project alone, it is unreasonable to assume that the entity will be able to afford to increase dividend growth per share from 5% to 7% per annum and pay these dividends on a larger share base. The dividend forecast is also based on the unrealistic premise that the 7% dividend growth rate will continue indefinitely, even beyond the 10-year time horizon of the project before taking into account any growth in earnings in other parts of the business. Conclusion In practice, the share price is likely to be quite close to the T.E.R.P. of 328 pence plus some small premium to reflect the likely increase in shareholder value as a result of the new project.
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Workings: 14 pence dividend post rights issue 13.71 pence dividend pre-rights issue where 13.71 14 pence 328/335. The share price can be shown to be highly sensitive to the underlying dividend growth rate. At a growth rate of 6% from 2008, the current share price would be 369 pence: 2005 2006 2007
Pence 12.80 11.70 10.69
2008 on
333.35
Working 14/1.094 14/1.0942 14/1.0943 14(1.06) (0.094 0.06)(1.0943)
368.54 pence
At a growth rate of 5% from 2008, the current share price would be 290 pence 2005 2006 2007
Pence 12.80 11.70 10.69
2008 on
255.16
Working 14/1.094 14/1.0942 14/1.0943 14(1.05) (0.094 0.05)(1.0943)
290.35 pence
The project cash flows would therefore only appear to support a rise in dividends of between 5% and 6% rather than the 7% growth that was announced.
(iii) How and to what extent the share price can be influenced by the Board Informing the market It is important that the directors keep the market informed promptly of any changes affecting the performance or future business developments. The market will then factor this information into the share price of the entity and ensure that the share price is a fair reflection of the value of the entity and its future prospects. Releasing price sensitive information on a regular basis should reduce the volatility of the share price. This can be achieved by regular release of information to the market on current performance and business developments. Dividend predictions Dividend plans need to be achievable and sustainable out of forecast future earnings to give a fair indication to the market of the future prospects of the entity.
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Examiner’s Note The following calculations are included for tuition purposes and are beyond what would be expected from a good “pass” in the examination: Note the “freezing” dividends at 14 pence per share represents an increase in dividend per amount invested in shares of 2% due to the effect of the rights issue discount.
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A smooth dividend stream enables individual shareholders and institutions to plan their portfolio and income stream and should reduce share price volatility. Announcing a 7% increase in dividends that the market views as unsustainable would not lead to the large increase in share price that would be expected based on the dividend growth model. Regulatory issues: Consider potential conflicts of interest arising. For example, an over-optimistic projection of project returns could improve director bonuses if these are linked to the share price. Summary and conclusion The volatility of the share price in the last 12 months can largely be explained by the speculation surrounding the Bustan project. Note also that the dividend forecasts appear to be unrealistic in relation to the profits to be generated by the proposed project and may need to be revised. However, this could have a serious impact on the credibility of the management and on the entity’s rating and share price if the market has already factored the increased dividends into the share price. Assuming that the market has largely ignored the new dividend forecasts, the share price on 1 January 2005 is likely to be based on the T.E.R.P. of 328.08 pence. There may also be a small premium of no more than 10 pence a share to take into account the additional wealth generated by the new project.
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(a) Evaluation • Theory supports the Finance Director, suggesting that maximisation of shareholder wealth is the only true objective of the entity – now considered an extreme view – and one which may have contributed to some of the corporate scandals in recent years that have occasioned the increase in corporate governance requirements. • Many entities now establish objectives that aim to maximise shareholder wealth while recognising constraints, legally enforceable or voluntary, imposed by society. • A major problem with this objective in the circumstances of HG is that this is a private entity that does not have a quoted share price. Shareholder wealth, as traditionally valued, is difficult to determine. • Looking only at dividends as an objective has its limitations, for example dividends could increase while earnings fall. The dividend ratio therefore needs to be considered alongside dividend payout. Alternatives, such as those being considered by other directors, are therefore worth further consideration. • For example: profitability as measured by returns after tax and return on investment. The main advantages are: – Well understood measures and recognised guidelines are available in the form of International Accounting Standards. – Shareholders expect profitability – and indeed the current objective is to increase earnings. Disadvantages are: – – – –
Accounting ratios are historic and backward-looking; They are subject to manipulation; A variety of accounting policies are available – even within Accounting Standards; Tax can be affected by factors outside the control of managers.
Recommendation Maximisation of shareholder wealth, using the theoretical definition, is difficult to apply in the circumstances of HG. As a minimum it would be worth introducing an objective that incorporates earnings growth as well as dividend growth. A range of objectives could be considered, such as risk-related returns to investors, but again this is more difficult with a private entity than one with a share listing. The entity needs to consult its shareholders and, possibly, consider using a balanced scorecard approach to determine a range of objectives appropriate for an entity such as HG. (b) The scenario in this question concerns a large privately owned entity based in the EU, but outside the ECCA. It trades internationally, both as supplier and customer. Inflation is zero and interest rates are low and, possibly, falling. The treasury department needs to decide how to deal with the challenges and opportunities the specific set of circumstances provide and evaluate the impact on the entity’s capital structure.
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SECTION B
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• Finance theory suggests that entities should use a judicious amount of debt in their capital structure to lower cost of capital. Debt is cheaper than equity because interest payments attract tax relief and are (generally) cheaper than equity. This is because interest is (usually) secured and providers of debt do not participate in profits. Here we have a mixture of secured and unsecured debt, but the entity appears sound and of high credit worthiness so should be able to borrow at comparatively favourable rates. • This might even be an argument in favour of increasing gearing which will provide the ability to pay a special dividend or undertake a share buyback, as seems to be the desire of the major shareholders. • The opposite argument is that in a period of low and falling interest rates, fixed rate debt becomes a burden. Some of the reasons are as follows: 1. The real value of debt is not being eroded when there is low or no inflation, so one of the benefits of debt disappears. 2. The return on assets funded by debt will fall and lower taxable profits, meaning the tax benefit of debt is reduced. 3. If the growth is low, debt interest may have to be paid out of static (or even falling) profits, lowering return to shareholders. 4. Although interest rates may fall, they never become negative, so the real cost of borrowing increases. 5. The equity risk premium will tend to be less in inflationary times, so equity is relatively less expensive. 6. Raising equity is safer if profits really dive; dividends do not have to be paid and the shareholders do not get their money back in a liquidation. However, raising new equity in a private entity is more difficult than in a public entity, where shares are listed so there is a ready benchmark for the price of new shares. • Floating rate debt overcomes some of these concerns, but if markets are efficient then the interest rate obtainable should reflect expectations. • In theory (according to MM), the mix of debt and equity does not affect the value of the entity, other than the value of the tax shield, but it does have an effect on the attribution of profits to three groups of stakeholders: lenders, government (taxers) and owners (shareholders). • The main question is therefore what combination of dividend policy and capital structure is likely to maximise the present value of cash flows to shareholders. This is where the financing strategies adopted contribute to the achievement of the objectives of the entity. The treasury department needs to specifically look at • Terms of existing borrowing to see if refinancing at lower rates is feasible, recognising any possible penalties for early retirement of loans. • Discuss with the directors and major shareholders the possibility (or even probability) that returns are likely to be lower; the lower the rate of interest, the lower the cost of capital and therefore the return that can be expected – not least because the rate sought by competitors will be lower. • The different threats and opportunities that might be presented if HG’s country joins the ECCA. For example, there is a larger market for sourcing funds, which may mean increased competition and therefore access to cheaper finance. On the downside, 2006.1
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Question Three (i) In an investment appraisal, theory suggests that the rate to use should reflect the business risk only of the investment. This means using the asset beta in the CAPM, if this model is being used to calculate a discount rate. In a takeover where the target is a substantial size, relative to the bidder, there is a stronger argument for using the equity beta, especially if the bid is being financed by a combination of debt and equity. There are arguments for using the cost of equity of either the bidder or target. On the one hand, the rate should reflect the risk of the cash flows, which suggests using the target’s rate. However, how the assets are managed could also influence the risk of cash flows, which implies the bidder’s rate should be preferred. Unless the two entities are very dissimilar in terms of business risk and capital structure, the rates are likely to be similar. If there is a wide disparity, the question should be asked whether the takeover is in the interests of shareholders who, presumably, invest in the bidder because they are happy with the level of risk they are taking on. The cost of equity for FS is given in the question, but can be “proved” using the CAPM formula: Rf ß (Rm Rf) 3% 1.1 (8% 3%) 8.5%. To calculate the cost of equity for MT it is necessary to calculate the asset beta or return on assets of FS. This is most easily done by ungearing FS’s equity beta and re-gearing using MT’s debt ratio. Step 1 – Calculate market value for FS There are 420 million shares in issue and the market price is €3.57. The market value is therefore €1,499.4 million – say €1,500 million, which is the same as the book value. Step 2 – Degear the beta
ßu ßg VE VD ßd VD VE VE VD 1.1
1,500 0.2 750 1,500 (750 1,500) 750
0.73 0.07 0.8
Return on assets is therefore 3% 0.8(8% 3%) 7% Step 3 – Calculate ßg for MT
ßg ßu VD (ßu ßd) VE 0.8 300 (0.8 0.2) 900 0.8 0.2 1.0 2006.1
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ECCA rates might increase if this country joins the ECCA and/or if other countries join from less-developed parts of the continent.
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Strictly, it is market values that should be used, but these are not readily available. FS’s market and book values of equity are the same, therefore using MT’s book value of equity and debt seems an acceptable approximation. Step 4 – Calculate Re for MT If MT’s equity beta is 1, then the expected cost of equity for MT is the same as for the market, which is 8% (3% 1(8% 3%)). (ii) The first step is to attempt to place a value, or range of values, on MT. There are four methods that can be considered: asset value, earnings (or market) value based on an estimated P/E ratio, dividend-based value using the DVM and shareholder value using net present value of future cash flows. These last two methods could also be combined with a calculation of a discount rate using the CAPM. Each method is considered in turn, ignoring, in the first instance, the estimated €200 million synergy savings. Asset value There is €900 million (€1,415 €515) in net assets at book values as at 30 June 2005. This would rise to €944.45 million at 30 June 2006 (€900 retained earnings in 2005/06 of €44.45 [€88.9 50%]) taking the MT director’s earnings forecast), assuming current assets and liabilities do not change significantly. If the FS’s directors’ most cautious earnings estimate were taken (2% growth) then retained earnings would be €36.47 million (€71.5 1.02 50%) and the net asset value €936.47 million. Market value using estimated P/E We can calculate a range of values here by applying FS’s P/E ratio of 11.7 to MT’s 2005 earnings, forecast 2006 earnings of MT’s figures and FS’s more cautious estimate (to nearest €million): Using 2005 earnings Using MT’s 2006 forecast Using 2% growth on 2005
837 (71.5 11.7) 1,040 (88.9 11.7) 853 (71.5 1.02 11.7)
An adjustment could be made for the following factors: • MT is unlisted; there are arguments for both lowering and raising the P/E for this. • There will be aspects of MT that are different from FS, not least that FS has been “downgraded” by the market because of slower growth. On balance, there is insufficient information to make any reasoned adjustment. An industry P/E ratio could be sought and applied, but the two points above would still need to be considered. Examiner’s Note Any sensible adjustment by candidates would gain credit. Cash flows using CAPM We do not have enough information to calculate a NPV of the entity using forecast cash flows, but this is the theoretically correct method. An exercise should be carried out to forecast cash flows for the next 5–10 years and calculate a more accurate discount rate. 2006.1
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Dividend valuation model There are a number of possible valuations using this model, depending on which 2006 forecast is more acceptable. If we take MT’s 2006 forecast as accurate, then any calculation of g would make the model unworkable. The growth between 2005 and 2006 is 24%; the average growth over the last three years can be calculated as follows: Historic growth rate:
88.9 55.5 (l g)3 3 l g 1.6018 l g 1.17 g 17%
This exceeds the cost of equity, which would make the dividend valuation model unusable. Notes: 1. Using a simple average is also close to 17% and would gain credit. 2. The super-growth version of the DVM could be used, but this is time-consuming and not expected here. Also, earnings will be affected by any changes in the tax rate, but this is unlikely to have a significant effect on dividend growth percentage. Assuming FS’s more cautious forecast of between 2% and 4% growth over 2005 and using the constant growth version of the model (Po D1/ke – g) we would get: D0 (in 2005) is €71.5 million 50% €35.75 million Value assuming:
2% growth 35.75 1.02/0.08 0.02 €608 million
4% growth 35.75 1.04/0.08 0.04 €930 million
Using 2% growth provides a value less than the asset value and unlikely to be at all indicative of the market value of the entity. The range of values, to the nearest €million, excluding the estimated value of the synergies that would arise from the acquisition is therefore as follows: All figures in €millions Asset values Market values using FS P/E Dividend valuation model values
936–944 837–1,040 608–930
The relatively high value given by net assets, compared to the other methods of valuation, suggests MT would command a significantly higher P/E ratio than FS and that the MT directors’ earnings forecast may not be over-optimistic after all, especially when synergistic benefits are taken into account. 2006.1
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Examiner’s Note This method was not implied by the question, as sufficient information was not available, but credit would be given to candidates who provided sensible comments.
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Bidding strategy This is likely to be an agreed bid, so there is no reason why FS cannot ask for more information before making its initial offer. However, given that MT have already made available “financial forecasts and other strategic documentation”, they may not be prepared to supply anything more before an initial bid is received. FS should assume a two-stage bid; an initial offer that is not so low that MT will refuse further negotiations and a second “final” offer. The maximum FS should be prepared to pay depends on what it genuinely believes is the growth rate for MT and whether the estimated synergies are realistically achievable. A suggestion is therefore an initial bid of (say) around €950 million with a maximum bid of (say) €1,250 million. MT of course will not be aware of the estimated value of synergies, although they may have done their own sums and made an educated guess of what their entity is worth to FS. It is notable that this bid has been “engineered” by the entity’s bank. Clearly, the bank has a vested interest. FS should revisit its corporate objectives and strategies and look at the acquisition from first principles: does the operational and strategic fit make sense in the context of the entity’s objectives?
Examiner’s Note Any sensible figures used by candidates will gain credit, for example adding the estimated synergy value at each stage of the valuations rather than at the summary stage, or using MT’s forecasts, rather than FS’s in the DVM, but the test here is to understand the difficulties of valuation and the key role of non-symmetric information and negotiation in the bidding process.
(iii) Methods of financing Cash According to the latest balance sheet FS has cash at bank of €250 million, plus (possibly) the €65 million cash MT has in its balance sheet. Even assuming these cash balances are still available post-takeover €315 million is insufficient to purchase MT. FS therefore will need to raise new debt to finance the cash purchase (and will need short-term financing to cover the total payment in advance of acquiring MT and its cash balances). The main advantages of debt are the tax relief available on interest payments and the fact that the EPS of FS’s shareholders will not be diluted, as compared with an issue of shares or a rights issue. The tax benefit is a genuine one, but the EPS dilution argument is spurious. The dilution will be short-term provided the acquisition is financially sound and the investment is a positive NPV, the EPS effect is immaterial. However, this message needs to be fully explained and quantified to shareholders and the market. The potential disadvantages to consider about new debt are the effects on gearing and the implications for cost of capital and credit rating. In respect of MT’s shareholders, the benefits are that they know exactly what they are getting, but the disadvantage could be an immediate tax liability on the gain. Shares Assuming MT accepted a price of around 284 euro (maximum bid as above divided by number of shares in issue – 1,250/440) this would suggest a share exchange of 2006.1
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1. If large numbers of FS shares are offered for sale on the market, this would depress the share price unless there are many willing buyers. 2. If one or a group of MT shareholders sells to one large third party buyer, this could form the platform for a bid for FS. Other factors that could be considered are the administrative costs and difficulties of issuing new equity and control – although this is probably not an issue here. A choice of cash or shares might be popular with MT’s shareholders, but creates uncertainty for FS in terms of forecasting gearing and cash required after MT’s shareholders have decided what they will accept. Question Four (a) Calculations In summary: (i) EPS (cents) (ii) Market value of equity (Z$m) using 12% capitalisation rate (iii) Market value of the entity (iv) Gearing % (v) WACC
Existing 173.6
With equity 184.3
With debt 195.3
72.3 98.3 18.3 10.6
84.0 110.0 16.4 10.8
81.4 112.4 20.5 10.6
15,000 11,600 13,400 4,020 11,700 8,680 173.6 72,333 (8,680/0.12) 8,000 18,000
17,000 11,600 15,400 4,620 11,700 10,080 184.3 84,000 (10,080/0.12) 8,000 18,000
98,333
110,000
17,000 12,050 14,950 4,485 11,700 9,765 195.3 81,375 (9,769/0.12) 8,000 18,000 5,000 112,375
Supporting calculations Trading cash flow Interest on debt Earnings before tax and interest Less: Tax at 30% Preference dividends Earnings for equity EPS MV equity @ 12% Ke MV Preference shares MV debt MV new debt MV entity
Notes: 1. The calculations for the market value of the entity here use the value for equity calculated in (ii). If candidates had calculated market value for equity using number of shares in issue share price, this would have been accepted in parts (iii) to (v) for full credit. 2006.1
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approximately 1 FS for 1.25 MT. FS would need to issue approximately 350 million shares. The entity’s gearing, and probably cost of capital, would fall, but these are unlikely to be significant issues. It also implies that MT’s shareholders will own around 45% of the equity of the new entity. The key factor will be whether MT’s shareholders will accept FS shares and what they might do with them afterwards. The reason for the sale of the entity might be that the shareholders want to liquidate some of their investment. If they accept FS shares they might wish to sell them immediately (and accept a tax liability on the gain). This has two possible consequences for FS:
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2. The redemption date of the new debt was set 10 years ahead to simplify calculation of market value. Strictly, a NPV approach should have been used although the value is virtually identical.
No of shares New issue of shares calculated as: Z$5m/(1,250 cents 85%) 471,000 Gearing
Existing 5,000
With equity 5,471
With debt 5,000
18.3% 18,000 100 98,333
16.4% 18,000 100 110,000
20.5% 23,000 100 112,375
WACC calculations Calculations of percentage each method of finance bears to total finance
MV equity @ 12% Ke MV debt MV preferred MV new debt MV entity
Existing Z$000 72,333 18,000 98,000 98,333
% 73.6 18.3 8.1 100
With equity Z$000 84,000 18,000 118,000 110,000
% 76.3 16.4 7.3 100
With debt Z$000 81,375 18,000 8,000 115,000 112,375
% 72.4 16.0 7.1 4.5 100
Kp DPS/MPS 7/80 100 8.75% Kd1 [1(1 ts)/MPS 100] [8 (1 0.30)/90] 100 6.2% Kd2 [1(1 ts)/MPS 100] [9 (1 0.30)] 100 6.3%
Equity Preference Debt
Existing 8.8 (73.6% 12%) 0.7 (8.1% 8.75%) 1.1 (18.3% 6.2%)
With equity 9.2 (76.4% 12%) 0.6 (7.3% 8.75%) 1.0 (16.4% 6.2%)
10.6
10.8
Debt WACC
With debt 8.7 (72.4% 12%) 0.6 (7.1% 8.75%) 1.0 (16% 6.2%) 0.3 (4.5% 6.3%) 10.6
Examiner’s Note The gearing calculations above show debt as percentage of equity debt preference shares. However, the question does not say whether preference shares are redeemable or irredeemable. It was therefore equally acceptable to add preference shares to debt in the gearing calculations.
(b) The market value of equity is maximised with Alternative 1, financing with equity. The market value of the entity and EPS is maximised under Alternative 2 – financing with debt. However, this option would increase financial risk, which has a knock-on effect on cost of capital. The calculations above assume no change in cost of equity. This would be unrealistic and it is likely that the required return by shareholders 2006.1
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Factoring (Alternative 3) • There may be resistance from customers to dealing with a third party. Non-recourse factoring is unusual and will carry a higher cost than recourse factoring, but relieves the entity of the administrative work and reduces bad debts. • Factoring is a long-term policy option – entities do not factor one year and reverse to self-administration the next. • Factoring should have little or no effect on the market value of the entity, EPS or gearing. However, the effect on cost of capital is difficult to quantity. The market may consider the entity less risky, as it is outsourcing its debt collection, and therefore the cost of equity will be reduced. On the other hand, there is a cost involved, and factors are unlikely to take on bad or doubtful debts. No information is given on the costs involved, so calculations cannot be attempted. • Market and economic factors should also be considered, for example the level of interest rates may impact on the decision to finance with debt. The current P/E ratio is 7.2 (share price of $12.50 divided by EPS of 1.756), which might be considered low for a entity such as this and casts doubt on the entity’s ability to raise new equity if its growth prospects are so low. The fact that the market rates the entity’s growth prospects poorly is borne out by comparing the current market capitalisation of the entity (share price number of shares in issue) with the value of the entity using capitalisation of earnings and shareholders’ stated required rate of return of 12%. Using market capitalisation, the value is Z$62.5 million. Using capitalisation of earnings it is Z$72.33 million. Question Five (i) Extracts from the income statements for the years ended 31 December
Revenue Costs and expenses (including depreciation) Operating profit Less: Finance costs Profit before tax Tax* Profit after tax (earnings) Dividends declared Retained earnings for year
2005 £000 30,120 (22,500) 7,620 ,(2,650) 4,970 ,(1,491) 3,479 ,(1,392) 2,087
2006 £000 33,132 (24,225) 8,907 ,(2,650) 6,257 ,(1,607) 4,650 ,(1,462) 3,188
2007 £000 36,445 (25,406) 11,039 ,(2,650) 8,389 ,(2,359) 6,030 ,(1,535) 4,495
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would rise substantially. The required rate of return might not rise in strict proportion as suggested by MM, but clearly shareholders would require a greater return for higher levels of risk. The effect on dividend should also be considered. Earnings available for equity are lower if financing is with debt which could put dividend payments at risk if the return on the new investments failed to materialise either as early or as profitably as forecast. Information on dividends is not given, and the difference is small so in reality dividends are unlikely to be a major consideration. Other suitable types of finance could be considered, for example: medium-term debt such as bank loan or even overdraft.
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Examiner’s Note The question did not require candidates to show the figures for 2005; they are shown here in italics for convenience.
Capital allowances calculation:
Cost of machinery 2006 WDA @ 25% WDV 2007 WDA @ 25% WDV
6,000 1,500 4,500 1,125 3,375
*Tax is calculated on profit plus depreciation less capital allowances: 2006 (6,257 600 1,500) 30% 1,607 2007 (8,389 600 1,125) 30% 2,359
Examiner’s Note It was not intended that candidates should consider the impact of deferred taxation in their answer here. Credit was available for those who did so.
(ii) Cash flow forecasts for 2006 and 2007 Calculations of cash receivable and cash payable:
Revenue O/B trade receivables C/B trade receuvables at 12.3% (2005 3,700/30,120 100%) Cash receivable Costs and expenses O/B trade payables C/B trade payables at 12.67% (2005 2,850/22,500 100%) Cash payable
2006 33,132 3,700 ,(4,075)
2007 36,445 4,075 ,(4,483)
32,757 23,625 2,850 ,(2,993)
36,037 24,806 2,993 ,(3,143)
23,482
24,656
32,757
36,037
Cash flow forecasts Cash received from sales Costs and expenses Machinery Tax Dividends Finance costs Total outflows Net cash flow Opening balance Closing balance
2006.1
23,482 6,000 1,491 1,392 2,650
24,656 1,607 1,462 2,650 35,015
30,375
(2,258) ,(2,198 ,(2,060)
5,662 ,(2,060) ,,3,602
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2006 £000
2007 £000
Operations Operating profit Add back depreciation Change in receivables Change in payables
8,907 600 (375) 0,143
11,039 600 (407) 1,149
Sub total
9,275
11,381
Interest paid Taxation
(2,650) (1,491)
(2,650) (1,607)
Net cash flow from operations
7,519
7,124
Investments New Machinery
(6,000)
Financing Dividends paid
(1,392)
(1,462)
Total net cash flows
(2,258)
(5,662)
Opening cash balance Closing cash balance
198 (2,060)
(2,060) (3,602)
Examiner’s Note The question stated dividends of £1,392,000 were declared in 2005. It would be usual, but not inevitable that these would be paid in 2006. Candidates who assumed payment would be made in 2005 were not penalised.
There is need to finance a cash shortfall of just over £2 million by the end of 2006. Of course, if the machinery was bought early in 2006, there may well be a requirement to finance a much greater cash shortfall earlier in the year. There is insufficient information in the question to comment further on this. However, this would be a very short-term requirement as by the end of 2007 there is a healthy cash surplus of £3.6 million. As the shortfall is caused by the purchase of new machinery, there should be no problem in raising finance. Suitable methods include bank overdraft, supplier credit or short-term leasing. However, as this is a long-term asset, it could be argued it should be funded by long-term finance and the cash surplus used for additional investments or, alternatively, repaid to shareholders.
2006.1
NOVEMBER 2005 EXAMINATIONS
An alternative, equally acceptable, approach to presenting the cash flow forecasts is as follows. Note that IAS 7 allows for some discretion in the presentation format of cash flow statements. The question here required a forecast rather than a published statement and any sensible format gained credit. There is also the potential for different figures depending on rounding assumptions on accounts receivable and accounts payable.
691
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STUDY MATERIAL P9
(iii) Key aspects and implications Preliminary calculations: 2005
2006
2007
Total equity Share capital Retained earnings Total equity
8,350 4,750 13,100
8,350 7,938 16,288
8,350 12,433 20,783
Return on equity %
37.9 (4,970/13,100) 100 41.6
38.4 (6,257/16,288) 100 55.7 33.9
40.4 (8,389/20,783) 100 72.2 29.6
38,269 40% 16.7
51,160* 31.4% 17.5
66,316* 25.5% 18.4
EPS – pence % increase Market value of company if P/E 11 (Share price of 458/EPS) Dividend payout percentage DPS – pence
Examiner’s Note These figures would 51,150 and 66,330 respectively if calculations were total earnings 11.
Return on equity The entity easily meets its objectives of return on equity in all three years, even though a target of 35% is quite high for an entity such as this. Investment and financing No investment appraisal has been carried out for the purchase of the new machinery. This should be done before the investment is made, even though the entity appears more than capable of funding the purchase out of cash flow. Increase in earnings and dividends Earnings increase almost 34% in 2006 over 2005 and 30% in 2007 over 2006. Figures are not available for years before 2005, but an increase in two consecutive years of over 30% suggests either 2004 was an unusually poor year or there has been a substantial improvement in prospects. Effect of government/policy changes The entity’s main customer is the government which means RJ may be vulnerable to changes in government, government policy or regulation – or all three. Effect on market value/rating If the P/E ratio stays at 11, then the company can expect a significant increase in its market value in 2006, from £38 million to £51 million. However, the comment above about apparent lack of investment opportunities could have an adverse effect on its growth rating and the P/E ratio could actually fall despite the forecast increase in profits over the next two years.
2006.1
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Index
Abandonment option, 345–8, 480, 499 Absolute return, 307 Accounting rate of return (ARR), 294–6, 302–303 Accounts see Financial statements Acquisitions see Mergers and acquisitions Adjusted cost of capital, 167–70, 344 Adjusted discount, 340 Adjusted present value (APV), 167–9, 343–4, 385–6 Agency theory, definition, 3–4 Aggressive financing policies, 76 AIM see Alternative Investment Market (AIM) Alpha, 175, 178 Alternative Investment Market (AIM), 67, 95 Angels (business), 120 Annual equivalent cost, 306–308 Annual reports, forecast inclusion, 41 Appraisal see Investment appraisal APT see Arbitrage pricing model (APT) APV see Adjusted present value (APV) Arbitrage, 163, 185–6 Arbitrage pricing model (APT), 185–6 ARR see Accounting rate of return (ARR) Asset-based valuations, 212 mergers and acquisitions, 265 Asset-based valuations, merits, 212–13 Asset replacement cycles, 308–309 Asset-stripping, 253 Assets: definition, 42 depreciation, 212, 226, 324 infrastructure, 225 intellectual capital, 218–28 sales, 262 values, 28, 294, 465 Auditing, post-completion, 351 balance sheets, 279–80 Balanced scorecard, 62–3 Bank base rate, 26 Bank of England, 25–6 Bankruptcy see Liquidation Barber, P., 231 Base case NPV, 343 ‘Bear’ speculators, 95 Benchmarking, 63 Beta values, 176, 177–8 Betas: debts, 181, 210 investment appraisal, 185 user groups, 193 Bills of exchange, 66 Biological environments, 40
Board of directors, controls, 19 Bond market, 66 Bonds: deep-discounted, 103–104 yield, 104 Bonus issues, shares, 102–103 Book value: concepts, 94 depreciation effects, 212, 226 market-to-book values, 226 Book value per share, 74 Borrowings, repayment, 113–14 Boston Consulting Group, 261 Brands, 144 Break-up value, 215 Budgeting, international capital, 381–2 ‘Bull’ speculators, 95 Business angels, 120 Businesses: risk, 176 valuations, 211–30 see also Companies; Enterprises Buy-outs see Management buy-outs (MBOs) Cadbury Report, 19–20 Calculated intangible value (CIV), 227–8 Call option, 345 CAP see Competitive advantage period (CAP) Capital: allowances, 324 customers, 223 gearing, 144–5 human capital, 222 international budgeting, 381–2 marginal costs, 160–1 organisational capital, 222–3 rationing, 303–306 single-period rationing, 305–306 structure, 143–210 venture capital, 119–20, 268 see also Cost of capital; Intellectual…; Venture capital Capital Asset Pricing Model (CAPM): beta values, 177–8, 181–3 company valuations, 228–9 concepts, 154–5, 176–7, 179, 216, 340 limitations, 185, 373, 486 questions, 361–6 solutions, 367–376 Capital market line (CML), 174, 187 Capital markets, 70 CAPM see Capital Asset Pricing Model (CAPM)
693
2006.1
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MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
694
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Page 694
INDEX Cash: generation, 9 merger financing, 254–5 surplus, 253 Cash-based valuations, 216–17 Cash flows: decision trees, 338 discounting, 330 forecasting, 31–5 free cash flows, 5 future options, 345–9, 355–6 investment appraisal, 325 modelling, 31–5 overseas operations, 377–9 Cash value added (CVA), 48 CBA see Cost-benefit analysis (CBA) CDS see Certificates of deposit (CDS) Certainty equivalents, 338–9 Certificates of deposit (CDS), 66, 589 Change management, 266 CIMA Insider, 231–7 City Code on Takeovers and Mergers, 19 CIV see Calculated intangible value (CIV) CML see Capital market line (CML) Code of Best Practice, 20 Coggan, Phillip, 83–4 Commercial paper, 66 Communication, effectiveness, 262 Companies see Businesses; Enterprises Competition: dividend policies, 14–15 reduction, 261 Competition Commission, 23–5, 252, 254 Competitive advantage period (CAP), 231 Competitive position, 11, 629 Compliance, 36 Compliance, Code of Best Practice, 20 Conglomerates, 252 Conservative financing policies, 76 Controls: board of directors, 19 strategic/tactical controls, 7 Conversion values, 106 Convertible debt, 148 Convertibles, 106–107 Copyrights, 219, 220 Corporate governance, 19–20 The Corporate Report (1975), 40 Corporate social responsibility (CSR), 49 Corporation tax, 323–4 see also Taxation Correlation coefficients, portfolio theory, 172 Cost-benefit analysis (CBA), 332–3 Cost centres, 65 Cost of capital: adjusted, 167–70 debt, 145 equity, 145–9 marginal costs, 160–1 opportunity cost, 12, 167 weighted average, 157–8, 160, 183 Costs: debt, 155–7, 161 equity, 152 marginal costs, 160–1 mergers and acquisitions, 229 opportunity cost, 12, 167
2006.1
preference shares, 136 replacement costs, 226 Coupon rate, 105, 155 Covenants, restrictive, 13, 617 Creative accounting, 20 Creditworthiness assessment: reconstructions, 269–70 valuations, 212–13 Creditworthiness, lender’s assessment, 109 Cross-subsidy prohibitions, 23 CSR see Corporate social responsibility (CSR) Cum-dividend, 71 Currency see Foreign currency… Current-asset funding, divisions, 76 Current issues, financial reporting, 35–42 Customer capital indicators, 223 Customers: capital, 223 focus, 224 satisfaction, 3, 11, 628 value maps, 223 CVA see Cash value added (CVA) DCF see Discounted cash flow (DCF) Debentures: concepts, 103 distinctions, 94 yield, 99–100 Debt: betas, 181, 210 convertible debt, 148 cost, 155–7, 161 finance, 103–108 irredeemable debt, 155–6 redeemable debt, 156 repayment, 13 yields, 104 Decision trees: cash flows, 339 concepts, 338 Decisions: dividends, 12–13 financial management, 11–13 financing, 11–13 investment, 11–12, 480 Deep-discounted bonds, 103–104 Defences, takeovers, 253–4 Deferred equity, issues, 106 Deferred ordinary shares, 106 Depreciation: book value, 226 capital allowances, 324 Derivative markets, 68 Derivatives see Options Directors, controls, 21 Discount rates: appraisals, 339–40 selection, 98 Discounted cash flow (DCF), 216, 231, 466 Discounted payback, 297 Discounting: adjusted rate, 340, 343 cash flows, 216, 357–8 techniques, 297–8 Discrimination prohibition, 23 Disinvestment, 12 Diversification:
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INDEX
Earn-out arrangements, definition, 256 Earnings-based valuations, 213–14 Earnings per share (EPS), 71–2, 214, 259 Earnings yield (EY), 72, 214 EC Merger Regulation (ECMR), 23 EC see European Commission (EC) Economic profit (EP), 232 Economic value added (EVA), 47–8, 232 Economies of scale, 252 The Economist, 355–6 The economy, 7 Effectiveness, definition, 7 Efficiency: definition, 7 improvement, 253, 263 Efficient markets hypothesis (EMH): business valuation, 217 concepts, 69, 70 employees, 2 employment, reports, 40 financial manager implications, 70–1 human capital, 222 Enterprises: not-for-profit, 5–6 see also Businesses; Companies Environmental issues: reporting, 38–9 social accounting, 40 EP see Economic profit (EP) EPS see Earnings per share (EPS) Equity: beta, 183–4 capital gearing, 144–5 cost, 151–5 holding, 268 Eurobond market, 66 Eurobonds, 66, 380 Eurocurrencies, 380 Euromarkets, 379–80 European Commission (EC), merger regulations, 254 EVA see Economic value added (EVA) Evaluation: financiers, 268–9 investors, 268–9 systems performance, 334 Ex-dividend market price, 71 Ex-rights price, 98–100
The examination: format, 402–405 preparation, 401–405 questions, 407–40 solutions, 441–507 tips, 402 Exchange rates, 30 see also Foreign currency… Expectations theory, 27 Explicit knowledge, 220 Exposure, risk, 11 EY see Earnings yield (EY)
MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
CAPM, 176 portfolio theory, 172, 175 risk reduction, 177 Dividend-based valuations, 215–16 Dividend growth models, 152–4 Dividend valuation model, 151 Dividends: cover, 73–4 decisions, 12–13 ‘dogs’, Boston Consulting Group, 261 double taxation relief, 380–1 drawings, 12 irrelevancy theory, 15–18 MM theory, 15–16 payouts, 13, 72 policies, 14–15 scrip issues, 17 yield, 74, 215 Drucker, Peter, 45
695
Finance: decisions, 75–7 leases, 110–11 medium-term, 108–18 overseas operations, 377–99 small businesses, 118 term definition, 108 Financial control, 62 Financial controllers’ responsibilities, 641 Financial focus, 224 Financial gearing, 161–2 Financial leverage, 150 Financial management: concepts, 61–91 decisions, 11–13 definition, 61 evaluation, 62–3 see also Management Financial Management, 123–6 Financial managers, EMH implications, 70–1 Financial markets, 66–8 Financial objectives, 2–3 Financial performance measurement, 627–9 Financial reporting, current issues, 35–42 Financial risk, 176 Financial statements: forecasting, 31–5 modelling, 31–5 Financial statements: prices, 37 profit, 254 Financial Times, 83–4 Financing: MBOs, 267–9 mezzanine, 268 Financing policies, 76–7 Fit/lack of fit syndrome, 265 Flotations, 67 Forecasts, cash flows, 31–5 Foreign currency/exchange: hedging, 12 market, 30 risk, 379 see also Exchange rates Foreign exchange market, 67 Foreign investments, 30 see also Overseas operations Formulae, 668–71 Forward trading, 30 Franchises, 219 Free cash flows, 5 Fundamental analysis, 68, 70 Funding see Finance; Financing
2006.1
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MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
696
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Page 696
INDEX Funds, shareholders, 93–5 betas, 181–5 definition, 144 gearing, 161–2 goal congruence, 4, 265 goodwill, 214, 219 measuring, 144–50 MM theories, 162–7 risk, 165 traditional theory, 161–2 Gordon’s growth model, 154 Government assistance, 120–1 Greenbury Report, 20–1 Gregory, Alan, 189–93 Growth models, 152–5 Hampel report, 21 Hayward, Cathy, 271–4 Hedging, 12 Horizontal integration, 252 Human capital, 220, 225 indicators, 226–8 reporting, 42 IASB: current issues, 35 Framework. The Corporate Report, 40 technical agenda, 35 IFRS 1, 36 IFRS 2, Share-based payment, 36–8 Income see Dividends Inefficiency, markets, 17 Inflation, 29, 325–7 Information management strategy, 331 Information systems, IT linking, 330–2 Insolvency, 75 Intangible benefits measurement, 333 Intangible costs measurement, 332 Integration: failure, 265–6 types, 252 Intellectual capital, 218–28 comparative indicators, 226–30 components, 220–3 definitions, 219 indicators, 224–8 knowledge management, 219–20 management, 219 measurement, 218–23 reporting practices, 230 valuations, 224–5 Interest cover ratio, 149 Interest rates, 25–6 bank base rate, 25–9 effect of changes, 28–9 real, 28 term structure, 26–8 Interest yield, 104 Intermediate debt see Mezzanine finance Internal rate of return (IRR), 298–301 international capital budgeting, 381–5 introduction, shares, 93 modified, 301–303 multiple, 301–302
2006.1
Investment: betas, 181–4 decisions, 11–12, 75 foreign, 28 Investment appraisal, 293–309 beta usefulness, 189–2 CAPM, 154–6, 176–7, 185, 216, 340 cycles, 349–50 discounting techniques, 297–303 evaluation, 334 future cash flow options, 345–9, 355–9 investment trusts, venture capital, 119–20 investor ratios, 71–4 overseas operations, 377–87 post-completion audit, 351 risk, 335–40 IRR see Internal rate of return (IRR) Irredeemable debt, 155–6 Irrelevancy theory of dividends, 15–17 IS/IT systems, 330–5 Issues: deferred equity, 106 new, 96–7 quantity selection, 98 terms, 98 IT systems linking, 330–5 Knowledge management, 219–20 see also Intellectual capital Lease: definition, 109 kinds, 109 Lease-or-buy decisions, 112–16 Leasing, 109–11 finance, 110–11 sales, 111 Legislation, 19–20 Lessees, 114–16 Lessors, 114–16 Leverage, 144, 150 LIBOR see London Interbank Offered Rate (LIBOR) LIFFE see London International Financial Futures and Options Exchange (LIFFE) Liquidation, 229 Liquidity: concepts, 9, 13 preference theory, 27–8 Listed companies, share price, 259 Loan stocks, yield, 99 Loans, 108, 622 see also Debt London Interbank Offered Rate (LIBOR), 108 London International Financial Futures and Options Exchange (LIFFE), 68 London Stock Exchange agreements, 66, 83 see also Stock markets Long-term finance sources, 93–121 Main Market (Official List), 66 Management: intellectual capital, 218–28 knowledge management, 219–20 staff, 262 welfare, 3 working capital strategies, 76–9 see also Financial management
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INDEX dividend irrelevance, 15–17 gearing, 161–7 Money markets, 66 Monopolies and Mergers Commission (MMC) see Competition Commission MPS see Market price per share (MPS) Multinational working capital management, 80–1 Net present value (NPV): concepts, 212, 297–8, 381 discounting, 297–8 international capital budgeting, 381–5 New issues, 96–7 Nichols, P., 45–8 Nominal shares, 93–4 Non-executive directors, 21 Non-financial objectives, 3 Non-financial performance measurement, 628–9 Not-for-profit organisations, 5–7 NPV see Net present value (NPV) Objectives, 1–6, 12 Offer for sale, 96, 138, 139 Offer for sale by tender, 96 Office of Fair Trading (OFT), 23 Official List (Main Market), 66 OFT see Office of Fair Trading (OFT) Operating leases, 109 Operating leverage, 150 Operational controls, 7 Opportunity cost, 12, 113, 167, 316, 328 Options: future cash flows, 345–9 shareholders, 99 valuations, 349, 358–9 Ordinary shares, 93–4 Organisational capital, 222–3 Overseas operations, 377–87 cash flows, 369 financing, 377–87 investment appraisal, 385–7 remittances, 379 risks, 378–9, 381 taxation, 380–1 Own shares, 45, 51 P/E ratio see Price/earnings (P/E) ratio Parkinson, C., 231–7 Patents, 221, 223 Payback, 296–7 Payouts, 14 PCA see Post-completion audit (PCA) PCC see Prior charge capital (PCC) Peppercorn rents, 111 Performance, 9 indicators, 9–11 measurement, 55, 627 Peskett, R., 357–9 Physical environments, 40 Placing, 96–8 Poison pills defence, 254 Portfolio theory, 172–6 Position audit, 261 Post-acquisition impacts, 256–6 ROCE, 258, 511 share price, 69–70 share valuations, 239
2006.1
MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
Management Accounting, 45–8, 189–93, 357–9 Management buy-outs (MBOs), 267–9 definition, 267 evaluations, 268–9 finance, 267–8 Managers, EMH implications, 70–1 Marginal costs, capital, 160–1 Market-perceived price profiles, 223 Market-perceived quality profiles, 223 Market price per share (MPS), 71, 213 Market risk, 176 see also Betas Market segmentation, 28 Market share, 10–11, 252, 629 Market-to-book values, 226 Market value, 94 Markets: inefficiency, 17 volatility, 68–9, 83–4 Markowitz, H. M., 172 Mathematical tables, 302 Maximising benefits, 293 MBOs see Management buy-outs (MBOs) Measurement: financial performance, 9–10, 627 intangible benefits/costs, 333 intellectual capital, 218–28 non-financial performance, 628 performance, 9–10, 627 Medium-term financing, 108–18 Mergers and acquisitions: City Code, 19 defences, 253–4 definition, 229 examples, 252, 254 failure, 265–6 motivation, 257, 265 post-acquisition impacts, 256–66 post-merger impacts, 256–66 reasons, 265–8 regulation, 21–3 share valuation, 259–63 stakeholder interests, 228–9 synergy, 252, 261 types, 251–2 Meteorological environments, 40 Mezzanine finance, 268 Miller see Modigliani and Miller (MM) theory MIRR see Modified internal rate of return MM see Modigliani and Miller (MM) theory Modelling: cash flows, 31–5 financial statements, 31–5 Models: dividend growth, 152 dividend valuations, 151 pricing, 176–80 valuation, 211–30 see also Capital Asset Pricing Model (CAPM) Moderate financing policies, 77 Modified internal rate of return (MIRR), 301–302 Modigliani and Miller (MM) theory: adjusted cost of capital, 169–70 beta values, 177–8 capital structure irrelevance, 202 CAPM similarity, 185
697
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698
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Page 698
INDEX Post-completion audit (PCA), 351 Post-merger impacts, 256–66 Preference shares, 136 Preferred/ordinary shares, 93–5 Preparing for the examination, 401–405 Prevailing market price see Market price per share (MPS) Price volatility, shares, 68–9 Price/earnings (P/E) ratio, 72 Prices, future, 68 Prior charge capital (PCC), 144–5 Private sector: not-for-profit organisations, 109 see also Shareholders Private sector, 5–8 three Es, 7–8 Privatised industries, regulation, 22–6 Process focus, 224–5 Profit: forecasts, 254 improvement, 262, 418 objectives, 2–5 overseas remittances, 378 Profit centres, 65 Profit-making entities, objectives, 2–5 Profitability index, 10 Projects: control, 349–53 implementation, 349–53 risk, 176 Prospectus issue, 96 Public sector, 6–11 financial management, 5–9 not-for-profit organisations, 5–8, 109 Put option, 345 Random walk theory, 69 Rate of return: accounting, 10–11 internal, 298–302 see also Yield Ratios, 71–4 price/earnings, 72, 246 Re-financing, 120, 228 Real interest rates, 28 Reconstructions, 269–70 see also Management buy-outs (MBOs) Redeemable debt, 156–7 Redemption yield, 104 Regulation: mergers and acquisitions, 229 regulatory bodies, 21–3 Rejection letters, takeovers, 254 Relational capital see Customers Remittances, overseas operations, 379 Renewal and development focus, 225 Rents, peppercorn type, 111 Reorganisation see Reconstructions Repayment, borrowings, 13 Replacement cost, 226 Replacement value, 226 Reserves, 95 Residual dividend policies, 15 Restrictive covenants, 134 Retail Price Index (RPI), 361 Retained earnings, 9 Return on assets (ROA), 227 Return on capital employed (ROCE), 9, 47, 511
2006.1
Return on investment (ROI), 207, 223, 294 see also Accounting rate of return (ARR) Return on risks, 178, 196 Revision techniques, 401–402 Rights issues, 97–102 Rights, value, 97 Risk, 175 adjustments, 433 beta application, 177–8 diversification, 129, 172 elements, 126 exposure, 11 foreign currency/exchange, 30 gearing, 144–9 investment appraisal, 335–40 overseas operations, 377–87 portfolio theory, 187 reduction, 173 and reward, 170–2 see also Hedging ROA see Return on assets (ROA) ROCE see Return on capital employed (ROCE) ROI see Return on investment (ROI) RPI see Retail Price Index (RPI) Sale and leaseback arrangements, 111 Sales, lease finance, 109 Scenarios: questions, 509–51 solutions, 553–654 Scrip dividends, 17 Secretary of State for Trade and Industry (SOS), 23 Secured debentures, 529 Securities markets, 66–7 Security market line (SML), 178–9 Semi-strong form, EMH, 70 Sensitivity analysis, 35 Share-based payments, 36–8 Share capital, raising, 95–103 Share price, 68–9 company reconstructions, 270 post-acquisition, 256–66 see also Shares Shareholder value analysis (SVA), 4–5, 217, 233 Shareholders: communication, 262 funds, 93–5 options, 99 rights issues, 97–102 wealth maximisation, 232, 553 Shares: bonus issues, 102–103 characteristic line, 177 exchange, 255–6 own shares, 51 preference shares, 136 price volatility, 68–9, 376 repurchases, 18 risk and reward, 170–2 see also Share price Shark repellent defence, 254 Signalling effect, dividends, 13 Single-period capital rationing, 304–305 Small business financing, 118 SML see Security market line (SML) Social issues, reporting, 39–41 Sociological environments, 40
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INDEX
Tables, mathematical, 302 Tacit knowledge, 220 Tactical controls, 57 Takeovers: defences, 253–4 definition, 254 regulation, 254 see also Mergers and acquisitions Tangible costs, CBA, 332 Taxation: dividend irrelevance theory, 15–17 havens, 19 law, 19 overseas operations, 377–87 relief, 380–1 shield, 143, 145, 228 Technical agenda, IASB, 35 Technical analysis, 68, 69 Technical insolvency, 75 Tenders, offer for sale by tender, 96, 139, 594 Term loans, 108, 110 Term structure, interest rates, 141 Theoretical ex-rights price (TERP), 98 Three Es concept, 7–8 Timing options, 348–9, 480–1, 500–502 Tips for eff Tobin’s q, 226–7 Trademarks, 219 Transaction costs, 17 Treasurers: functions, 607 key tasks, 607 treasury function, 607
Ukaegbu, Ben, 123–6 Uncertainty see Risk Underwriting, 97 Unequal lives, 307–308 United Kingdom, overseas operation financing, 127, 378 Unsecured debentures, 103
MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
SOS see Secretary of State for Trade and Industry (SOS) Sources, long-term finance, 93–121 Specific risk, 175–6, 187, 193 Splits, 103 Splits, shares, 103 Spot trading, 30 Stakeholders: definition, 2 interests, 228–9 theory, 293 Starovic, Danka, 48–50 Stock Exchange, 18–21, 66–7 Stock markets, 95–103 see also London Stock Exchange agreements; Stock Exchange Strategic controls, 64, 607 Strategic financial management, definition, 1, 7 Strategic investment options, 349, 481, 500 Strategy, definition, 1 Strong form, EMH, 70 Structural capital, 222–3 Subordinate debt see Mezzanine finance Sustainable development, 48–50 SVA see Shareholder value analysis (SVA) Syllabus, 404–405 Syndicated loan market, 380 Synergy, mergers and acquisitions, 252, 261, 288 Systematic risk see Betas Systems performance evaluations, 334
699
Valuations: asset-based, 212 businesses, 211–29 cash-based, 216–17 choice of valuation base, 212–13 dividend-based, 214–16 earnings-based, 213–14 formulae, 668 intellectual capital, 218–28 options, 349 shares, 235–7 stakeholder interests, 228–9 Value added, 40 reports, 40 Value-chain analysis, 222 Value management systems (VMS), 232 Value of rights, 97 Venture capital: concept, 119–20 definition, 119 Vertical integration, 252 Virement, definition, 7 VMS see Value management systems (VMS) Volatility, 68 share prices, 68–9 WACC see Weighted average cost of capital (WACC) Warrants, 107–108 Watchdogs, 22 Weak form, EMH, 69 Wealth distribution, 29 Weighted average cost of capital (WACC), 46, 58, 157–8 Welfare management, 3 What/who matrix, 223 White knight defence strategy, 254, 284 Won/lost analysis, 223 Working capital: definition, 75 investment appraisal, 38 management strategies, 74–5 multinational management, 80–1 Yield: debentures, 103 debt, 104 dividend, 73 earnings, 71 Yield-adjusted ex-rights price, 99–100 Yield curve, interest rates, 26–8 Yield to maturity (YTM), 104 YTM see Yield to maturity Zero-coupon bonds, 104
2006.1
