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Adopting a rigorous receivables collection system

is essential to the ability of a company to pay its


suppliers and employees, and even survive. Even
where such a system is adopted and effective steps
are taken to chase late payers, a company may
still want to speed up the collection of cash from
its customers.
This article considers two methods a company
could adopt in order to speed up the collection
of cash from its customers. Additionally, worked
examples show how these methods can be
evaluated in order to decide whether or not they
should be adopted given the circumstances
particular to a specific company. This has been
a common exam requirement over the years
and, as there is no set approach or formula,
students very often lack the confidence to attempt
such questions.
Early settlement discount
An early settlement discount involves a company
offering a small percentage discount to customers
who pay within a defined short period. For instance
a 1% discount may be offered to those who pay
within 10 days.
The key advantage of offering such discounts is
that customers take the discount and pay earlier
than usual, so the company receives the cash
sooner. It has also been argued that by effectively
offering a choice of payment terms, the company
is likely to satisfy more customers, and that by
encouraging early payment, the risk of bad debts
is reduced.
However, such discounts suffer from a number
of key problems. First, it is difficult to decide on
suitable discount terms. If the discount is made
attractive to customers it is likely to be too costly
to the company, whereas if the discount is not too
costly to the company it is unlikely to be attractive
to many customers. Second, the introduction of
such a discount will make the management of the
sales ledger more complex and costly to run and
is likely to make the budgeting of receipts from
customers more difficult, as the company could
not be sure whether the discount will or will not
be taken. The final and in reality very often the
biggest problem is that all too often customers
will abuse the discount by taking it despite not
paying early. When this occurs, the company is
left to decide between spending time and effort
recovering what is often a small amount, or writing
the discount off and encouraging such behaviour.
Obviously, neither of these options is attractive.
Example 1
Melvin Co has a turnover of $900,000 (90% of
which is on credit) and receivable days are currently
42 despite the company only offering 30-days
credit. Melvin Co finances its receivables using its
overdraft which has an annual interest cost of 8%
and has a contribution margin of 30%.
Melvin Co is considering the introduction of
an early settlement discount at the same time as
extending their standard credit terms to 50 days. The
company would offer customers a 1% discount for
payment within 14 days. It is anticipated that 40% of
customers will take the discount, while those that do
not take the discount will keep to the new standard
credit terms. As a result of the extended credit terms,
credit sales are expected to rise by 10%. Due to
the extra administration involved it is thought that
administration costs will rise by $10,000 per year.
alternative
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rElEvant to papEr f9
collection
01 tEchnical
Studying Paper F9?
performance objectives 15 and 16 are linked
required
Evaluate whether or not Melvin Co should offer
the discount.
suggested approach
In some questions of this nature it may be worth
doing some preliminary calculations. In this case,
the calculation of credit sales and the anticipated
increase in sales would be worth evaluating:
Existing credit sales $900,000 90% = $810,000
Expected increase
in credit sales $810,000 10% = $81,000
Revised credit sales $810,000 + $81,000 =
$891,000
Having carried out any preliminary calculations, an
annual cost and benefit table should be constructed
and each cost or benefit should be evaluated and
put into the table.
The important annual benefit, and always the one
that is hardest to calculate, is the annual finance
saving on reduced receivables as the overdraft will
have been reduced and hence an interest saving
will arise. I suggest that you leave this calculation
to last as it is best to calculate the other costs and
benefits first to obtain the easy marks.
The second benefit to Melvin Co will be the
contribution earned on the extra sales. This can
be easily evaluated by multiplying the expected
increase in credit sales by the contribution margin:
$81,000 30% = $24,300
The costs to be evaluated are the additional
administration cost which is given as $10,000
per year, and the cost of the discount itself. The
discount cost is a function of the total credit sales,
the proportion of customers expected to take the
discount and the percentage discount offered:
$891,000 40% 1% = $3,564
The calculations carried out so far are relatively
straightforward and can be shown on the face of the
cost and benefit table. Hence, prior to calculating
the annual interest saving on the reduced
receivables, the cost and benefit table should be
as follows:
Annual benefits $
Finance saving on reduced receivables
see Working 1
Contribution on extra sales 81,000 30% 24,300

Annual costs
Extra administration costs (10,000)
Discount cost 891,000 40% 1% (3,564)

Net benefit/(cost) (3,564)
The annual finance saving on the reduced
receivables can now be calculated.
Working 1
Existing situation:
Receivable days Given as 42 days
Receivables $93,205 (810,000 42/365)
Note: remember to use the existing credit sales
Annual finance cost $7,456 (93,205 8%)
Note: receivables have not yet been received, so they
make the overdraft higher than it would otherwise
be, and so incur an interest cost.
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receivables
techniques
studEnt accountant 09/2009
02
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Revised situation
Receivable days
35.6 days ((14 40%) +
(50 60%))
Note: the new receivable days are simply an
average of the credit period taken by customers
taking the discount, and the credit period taken
by those refusing the discount weighted by the
proportion of customers taking and refusing the
discount respectively.
Receivables $86,903 (891,000
35.6/365)
Note: remember to use the revised credit sales.
It could be argued that the credit sales should be
reduced by the discount cost, otherwise you are
calculating a finance cost on an amount which will
never be collected. However, this adjustment makes
little difference so is often ignored.
Annual finance cost $6,952 (86,903 8%)
Annual finance saving $504 (7,456 - 6,952)
There are often quicker ways to calculate this
finance saving. For instance, in this example the
reduction in receivables could have been evaluated
and the finance saving could then have been
calculated from this figure:
Reduction in receivables $6,302 (93,205 -
86,903)
Annual finance saving $504 (6,302 8%)
However, the original approach shown should
always work whatever complications may exist in
the question.
Having calculated the annual finance saving, the
annual cost and benefit table can now be completed
and should be as follows:
Annual benefits $
Finance saving on reduced
receivables see Working 1 504
Contribution on extra sales (81,000 30%) 24,300

Annual costs
Extra administration costs (10,000)
Discount cost (891,000 40% 1%) (3,564)

Net benefit/(cost) 11,240
Note: In this example the finance saving on
reduced receivables is small, as although some
customers will be paying more quickly, others will
be paying more slowly and the amount of credit
sales has also increased. Indeed, an additional
finance cost could arise as occurs in Question 3 of
the Paper F9 Pilot Paper.
comment
Having calculated a net benefit, Melvin Co can be
advised that the proposed early settlement discount
appears worthwhile. Before a final decision is made,
consideration should also be given to the other
advantages and disadvantages of such a settlement
discount which have been discussed previously but
are not reflected in the above analysis.
factoring
The basic service offered by a factoring
company is the administration and collection of
receivables. As factors have significant expertise
in the management of receivables, a factor should
be able to collect cash from customers more
quickly than would a company operating its own
sales ledger. The factor will charge a fee which
is usually calculated as a percentage of credit
sales. Additionally, the factor will offer to protect
a company against bad debts and will also lend
money to the company against the security of
its outstanding receivables.
If the factor protects the company against all
bad debts then this is known as a non-recourse
factoring agreement. Obviously the factor will
charge a higher fee to cover the risk it is bearing
03 tEchnical
and will demand to credit check customers before
they are offered credit. If a factoring agreement
is with recourse, the factor provides no protection
against bad debts.
The amount a factor will lend to a company is
based on its experience of managing receivables
but may be up to 80% of the outstanding
receivables. The charge for this borrowing is likely
to be slightly in excess of the overdraft interest rate
that the company pays.
If a company uses a factor, then it has effectively
outsourced the administration and collection of
its receivables (the sales ledger function) which
should create significant savings. The need for
management control is reduced as there is no need
to hire new staff, develop new systems, train staff,
etc. However, an executive of the company will have
to manage the relationship with the factor. Factoring
is often considered useful where a company is
growing quickly, as management can attend to other
issues and does not have to worry about the need
to grow the sales ledger function. Additionally, as
the factor will lend a percentage of the outstanding
receivables, the amount the factor will lend grows
automatically as the business grows. This growing
source of finance can be very useful to a growing
company where additional finance is often required
and overtrading is a potential problem.
Criticisms of factoring include:
the factors charges may be high
once a company has started to use a factor it is
hard to rebuild its own sales ledger function
the factor will collect receivables in a vigorous
manner and this may damage the companys
relationship with its clients
the use of a factor may indicate that the company
has cash flow problems (this last criticism is less
relevant in the modern business environment
where outsourcing of support functions has
become very common).
Example 2
Velmin Co has a turnover of $700,000. Receivable
days are currently 48 despite the company only
offering 30-days credit and bad debts are currently
3% of turnover. Velmin Co finances its receivables
using its overdraft which has an annual interest cost
of 8%.
Velmin is considering the use of a factor.
The factor would charge 4% of turnover for a
non-recourse agreement and would expect to reduce
receivable days to 34 and bad debts to 2%. The
factor would lend Velmin 75% of the outstanding
receivables and would charge Velmin 1% above their
current overdraft interest cost. It is anticipated that
using the factor would reduce administration costs
by $6,000 per annum.
required
Evaluate whether or not Velmin Co should use
the factor.
solution
Annual benefits $
Finance saving on reduced receivables
see Working 1 1,659
Administration savings 6,000
Bad debts saved (700,000 3%) 21,000

Annual costs
Factors fee (700,000 4%) (28,000)
Net benefit/(cost) 659
Table 1 on the following page shows Working 1.
comment
Having calculated a net benefit, Velmin Co can be
advised that using the factor appears worthwhile.
However, the net benefit is very small, so before
a final decision is made the estimates used in the
evaluation should be checked and consideration
should be given to the other advantages and
disadvantages of using a factor which have not
been quantified.
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studEnt accountant 09/2009
04
Notes
1 As the agreement with the factor is a
non-recourse agreement the total bad debts will
be saved as far as Velmin Co is concerned. The
remaining 2% of bad debts will simply be a cost
to the factor.
2 The assumption used in questions of this nature
is that the company borrows the maximum
available from the factor. In reality, as the finance
provided by the factor is more costly, a company
will probably only use the finance offered by
the factor when they are at or close to their
overdraft limit.
summary
Working capital management, and in particular the
management of receivables and the evaluation of
proposed new methods of managing receivables,
has been a popular exam topic. When carrying out
these evaluations, a structured approach should
be adopted so that a marker can easily follow a
students thought process and give credit where
it is due even if the numbers have, at some stage,
gone awry.
The approach suggested in Example 1 looks
very long, because considerable explanation
has been included. Example 2 adopts the same
approach even though the scenario is different and
demonstrates that those confident with such an
approach can quickly and easily generate a concise,
logical and, I hope, accurate answer to any question
of this nature.
rEfErEncE
Corporate Finance Principles and Practice, Denzil
Watson and Antony Head
William Parrott is a lecturer at Kaplan Financial
tablE 1: working 1, ExamplE 2
Working 1
Existing situation
Receivable days 48 days given
Receivables $92,055 (700,000 48/365)
Annual finance cost $7,364 (92,055 8%)
Revised situation
Receivable days 34 days given
Receivables $65,205 (700,000 34/365)
Annual finance cost
on receivables financed by the factor $4,401 (65,205 75% (8% + 1%))
on receivables still financed by overdraft $1,304 (65,205 25% 8%)
Total $5,705 (4,401 + 1,304)
Annual finance saving $1,659 (7,364 - 5,705)
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05 tEchnical
42 student accountant March 2007
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This article explains the approach to
examining Paper F9, Financial Management,
and clarifies any uncertainty regarding the
content of the syllabus. For students planning
to take this paper, a good place to start
is the ACCA website, where the Paper F9
Syllabus and Study Guide, together with the
Pilot Paper and its Suggested Answers can
be found.
nancial
management
The aim of Paper F9 is to develop the
knowledge and skills expected of a finance
manager in relation to investment, financing,
and dividend decisions. The syllabus is
designed to equip candidates with the skills
that would be expected from a finance
manager responsible for the finance function of
a business.
From a relational point of view, Paper F9
builds on knowledge gained through studying
Paper F2, Management Accounting, and
also prepares candidates for further study of
financial management in Paper P4, Advanced
Financial Management. Students who are
exempt from Paper F2 should ensure that they
are familiar with its content by referring to its
Syllabus and Study Guide.
Syllabus and Study Guide
The first two sections of the syllabus consider
the role and purpose of the finance manager,
and the financial management environment.
As financial management decisions support
the achievement of business objectives, the
syllabus explores the link between objectives,
strategy, and stakeholders. Financial
management decisions are influenced by
factors external to the organisation, so
the syllabus also considers the impact of
government economic policy in key areas such
as interest rates and exchange rates, as well
as the nature and role of financial markets
and institutions.
The next three sections of the syllabus look
at working capital management, investment
appraisal, and sources of business finance.
Managing working capital is a key concern
of the finance manager, who must balance
the conflicting objectives of profitability and
liquidity. Investment decisions constitute
one of the three decision areas of financial
management, and the finance manager must
be able to identify relevant cash flows, and
evaluate a proposed investment and its effect
on the organisation. Financing decisions,
another of the three decision areas, are
examiners approach to Paper F9
44 student accountant March 2007
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considered in the business finance section of
the syllabus. A finance manager must be able
to identify and evaluate the most appropriate
sources of finance to meet organisational
financing needs.
One of the key relationships in financial
management is that between risk and return,
and the sixth section of the syllabus looks
at the cost of capital and the influence of
capital structure on the average cost of capital.
Candidates must be able to calculate the
cost of individual sources of finance and the
average cost of organisational finance, and
critically discuss whether financing choices
can reduce the average cost of capital and
thereby increase the value of the organisation
as a whole.
The next section of the syllabus looks at
business valuation. Candidates must be able
to value financial assets, such as ordinary
shares and bonds, and a business as a whole.
Evaluation of financial choices is a key theme
here and candidates are expected to be
able to discuss, as well as apply, a range of
valuation methods.
The final section of the syllabus looks
at risk management in relation to foreign
currency risk and interest rate risk. Candidates
should have an awareness of the different
types of foreign currency and interest rate risk,
and of the possible reasons why these arise.
Candidates will need to be able to
evaluate and apply both internal and external
risk management (hedging) methods, using
the methods identified in the syllabus. Note
that evaluation of derivative-based hedging
methods such as those using futures,
options, and swaps is not required.
Main capabilities
The main capabilities are described in the
Syllabus. Candidates who successfully pass
the Paper F9 exam will be able to:
discuss the role and purpose of the
financial management function
assess and discuss the impact of the
economic environment on financial
management
discuss and apply working capital
management techniques
carry out effective investment appraisal
identify and evaluate alternative sources of
business finance
explain and calculate cost of capital and
the factors that affect it
discuss and apply principles of business
and asset valuations
explain and apply risk management
techniques in business.
You will recognise that these eight capabilities
reflect the eight sections of the syllabus.
Format of the exam
The three-hour exam consists of four
questions, all of which are compulsory and
of equal length. Each question is worth
25 marks.
This format is commonly adopted by other
papers at this level and means that candidates
will not need to spend time choosing which
question to answer. An extra 15 minutes of
reading and preparation time is given at the
start of the exam.
Each question will have both discussion
and calculation elements. The balance
between discussion and calculation will be
similar to the balance in the Pilot Paper.
The topic areas covered by each question
are not fixed and all areas of the syllabus
are examinable.
No sections of the syllabus should be
neglected during study, since no one section is
more important than another.
Each exam paper will contain tables
of discount factors and annuity factors,
together with a formulae sheet, as in the Pilot
Paper. Candidates must ensure that they
are familiar with the formulae given in the
formulae sheet.
The Pilot Paper
The Pilot Paper illustrates the kind of
questions that will be set. A feel for my style
of writing can be gained by reviewing Paper
2.4, Financial Management and Control exam
questions from 2003 onwards.
Question 1 in the Pilot Paper requires
calculation of the weighted average cost of
capital (WACC) of a listed company, and
a discussion of whether, theoretically, a
minimum WACC can be found. It also requires
an evaluation of the effect of a loan note issue
on three key ratios.
Question 2 requires a discussion of
the types of foreign currency risk and an
explanation of how inflation rates can be used
to forecast exchange rates. It also requires a
comparative evaluation of a money-market
hedge and a forward market hedge, and an
explanation of how currency futures can be
used to hedge foreign exchange risk.
Question 3 requires an evaluation of a
proposed change in credit policy, application
of the MillerOrr model, and an explanation
of the key areas of accounts receivable
management. It also requires a discussion
of the key factors influencing working capital
funding policy.
Question 4 requires calculation of net
present value and return on capital employed,
as well as a discussion of the strengths and
weaknesses of the internal rate of return
method.
Conclusion
In order to pass this paper, candidates
should:
clearly understand the objectives of Paper
F9, as explained above, and in the Syllabus
and in the accompanying Study Guide
read and study thoroughly a suitable
financial management textbook
read relevant articles in student
accountant
practise exam-standard and exam-style
questions on a regular basis
be able to communicate their
understanding clearly in an exam
context.
Antony Head is examiner for Paper F9
For students planning to take this
paper, one place to start to clarify any
uncertainty regarding the content
of the syllabus is the ACCA website,
where the Paper F9 Syllabus and Study
Guide, together with the Pilot Paper
and Suggested Answers can be found.
46 student accountant April 2008
t
e
c
h
n
i
c
a
l

a=

e +

d
V
e
V
d
(1-T)
(V
e
+V
d
(1-T)) (V
e
+V
d
(1-T))
Section F of the Study Guide for Paper F9
contains several references to the capital
asset pricing model (CAPM). This article,
the second in a series of three, looks at
how to apply the CAPM when calculating
a project-specific discount rate to use in
investment appraisal. The first article in the
series published in the January 2008 issue
of student accountant introduced the CAPM
and its components, showed how the model
could be used to estimate the cost of equity,
and introduced the asset beta formula. The
third and final article will look at the theory,
advantages, and disadvantages of the CAPM.
As mentioned in the first article, the
CAPM is a method of calculating the return
required on an investment, based on an
assessment of its risk. When the business
risk of an investment project differs from
the business risk of the investing company,
the return required on the investment
project is different from the average return
required on the investing companys existing
business operations. This means that it is not
appropriate to use the investing companys
existing cost of capital as the discount rate for
the investment project. Instead, the CAPM can
be used to calculate a project-specific discount
rate that reflects the business risk of the
investment project.
PROXY COMPANIES AND PROXY BETAS
The first step in using the CAPM to calculate
a project-specific discount rate is to obtain
information on companies with business
operations similar to those of the proposed
investment project. For example, if a food
processing company was looking at an
investment in coal mining, it would need
to obtain information on some coal mining
companies; these companies are referred
to as proxy companies. Since their equity
betas represent the business risk of the
proxy companies business operations, they
are referred to as proxy equity betas or
proxy betas.
project-specifc discount rates
From a CAPM point of view, these proxy
betas can be used to represent the business
risk of the proposed investment project. For
example, the proxy betas from several coal
mining companies ought to represent the
business risk of an investment in coal mining.
BUSINESS RISK AND FINANCIAL RISK
If you were to look at the equity betas of
several coal mining companies, however,
it is very unlikely that they would all have
the same value. The reason for this is that
equity betas reflect not only the business
risk of a companys operations, but also the
financial risk of a company. The systematic
risk represented by equity betas, therefore,
includes both business risk and financial risk.
In the first article in this series, we
introduced the idea of the asset beta, which
is linked to the equity beta by the asset beta
formula. This formula is included in the Paper
F9 formulae sheet and is as follows:

a
= asset beta

e
= equity beta

d
= debt beta
V
e
= market value of companys shares
V
d
= market value of companys debt
((V
e
+ V
d
(1 - T)) = after tax market value of
company
T = company profit tax rate
To proceed further with calculating a
project-specific discount rate, it is necessary
to remove the effect of the financial risk or
gearing from each of the proxy equity betas in
order to find their asset betas, which are betas
that reflect business risk alone. If a company
has no gearing, and hence no financial risk, its
equity beta and its asset beta are identical.
UNGEARING EQUITY BETAS
The asset beta formula is somewhat unwieldy
and so it is common practice to make the
simplifying assumption that the debt beta (
d
)
is zero. This can be seen as a relatively minor
simplification if it is recognised that the debt
beta is usually very small in comparison to the
equity beta (
e
). In addition, the market value
of a companys debt (V
d
) is usually very small
in comparison to the market value of its equity
(V
e
), and the tax efficiency of debt reduces the
weighting of the debt beta even further.
Making the assumption that the debt beta is
zero means that the asset beta formula becomes:

a
= asset beta

e
= equity beta
V
e
= market value of companys shares
V
d
= market value of companys debt
((V
e
+ V
d
(1 - T)) = after tax market value of
company
T = company profit tax rate
If the equity beta, the gearing, and the tax rate
of the proxy company are known, this amended
asset beta formula can be used to calculate
the proxy companys asset beta. Since this
calculation removes the effect of the financial
risk or gearing of the proxy company from the
proxy beta, it is usually called ungearing the
equity beta. Similarly, the amended asset beta
formula is called the ungearing formula.
AVERAGING ASSET BETAS
After the equity betas of several proxy
companies have been ungeared, it is usually
found that the resulting asset betas have
slightly different values. This is not that
surprising, since it is very unlikely that two
proxy companies will have exactly the same
business risk from a systematic risk point of
view. Even two coal mining companies will not
be mining the same coal seam, or mining the
same kind of coal, or selling coal into the same
market. If one of the calculated asset betas
the capital asset pricing model part 2
relevant to ACCA Qualifcation Paper F9

a=

e +

d
V
e
V
d
(1-T)
(V
e
+V
d
(1-T)) (V
e
+V
d
(1-T))
48 student accountant April 2008
t
e
c
h
n
i
c
a
l
project-specific cost of equity. Once values
have been obtained for the risk-free rate of
return, and either the equity risk premium or
the return on the market, these can be inserted
into the CAPM formula along with the regeared
equity beta:
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
)
E(r
i
) = return required on financial asset i
R
f
= risk-free rate of return

i
= beta value for financial asset i
E(r
m
) = average return on the capital market
The project-specific cost of equity can be used
as the project-specific discount rate or
project-specific cost of capital. It is also
possible to go further and calculate a
project-specific weighted average cost of
capital, but this does not concern us in this
article and it is a step that is often omitted
when using the CAPM in investment appraisal.
SUMMARY OF STEPS IN THE CALCULATION
The steps in calculating a project-specific
discount rate using the CAPM can now be
summarised, as follows
1
:
1 Locate suitable proxy companies.
2 Determine the equity betas of the proxy
companies, their gearings and tax rates.
3 Ungear the proxy equity betas to obtain
asset betas.
4 Calculate an average asset beta.
5 Regear the asset beta.
6 Use the CAPM to calculate a
project-specific cost of equity.
The difficulties and practical problems
associated with using the CAPM to calculate
a project-specific discount rate to use in
investment appraisal will be discussed in the
next article in this series.
EXAMPLE 1
A company is planning to invest in a new
project that is significantly different from its
existing business operations. This company
is financed 30% by debt and 70% by equity.
It has located three companies with business
operations similar to the proposed investment,
and details of these companies are as follows:
is very different from the others, however,
it would be regarded with suspicion and
excluded from further consideration.
In order to remove the effect of the
slight differences in business operations and
business risk that are reflected in the asset
betas, these betas are averaged. A simple
arithmetic average is calculated by adding
up the asset betas and then dividing by the
number of asset betas being averaged.
REGEARING THE ASSET BETA
The average asset beta represents the business
risk of the proposed investment project.
Before a project-specific discount rate can
be calculated, however, the financial risk of
the investing company needs to be taken into
consideration. In other words, having ungeared
the proxy equity betas when calculating the
asset betas, it is now necessary to regear the
average proxy asset beta to reflect the gearing
and the financial risk of the investing company.
One way to approach regearing is to use
the ungearing formula, inserting the gearing
and the tax rate of the investing company, and
the average asset beta, and leaving the equity
beta as the only unknown variable. Another
approach is to rearrange the ungearing formula
in order to represent the equity beta in terms
of the asset beta, as follows:

e
=
a
((V
e
+ V
d
(1 - T))/V
e

=
a
((1 + (1 - T)V
d
/V
e
)

a
= asset beta

e
= equity beta
V
e
= market value of companys shares
V
d
= market value of companys debt
((V
e
+ V
d
(1 - T)) = after tax market value of
company
T = company profit tax rate
The gearing and the tax rate of the investing
company, and the average proxy asset beta,
are inserted into the right-hand side of the
regearing formula in order to calculate the
regeared equity beta.
CALCULATING THE PROJECT-SPECIFIC
DISCOUNT RATE
The CAPM can now be used to calculate a
Company A has an equity beta of 0.81
and is financed 25% by debt and 75% by
equity.
Company B has an equity beta of 0.98
and is financed 40% by debt and 60% by
equity.
Company C has an equity beta of 1.16
and is financed 50% by debt and 50% by
equity.
Assume that the risk-free rate of return is 4%
per year, and that the equity risk premium
is 6% per year. Assume also that all the
companies pay tax at a rate of 30% per year.
Calculate a project-specific discount rate for
the proposed investment.
Solution
Ungearing the proxy equity betas:
Asset beta for Company A
= 0.81 x 75//((75 + 25(1 - 0.30)) = 0.657
Asset beta for Company B
= 0.98 x 60//((60 + 40(1 - 0.30)) = 0.668
Asset beta for Company C
= 1.16 x 50//((50 + 50(1 - 0.30)) = 0.682
Averaging the asset betas:
(0.657 + 0.668 + 0.682)/3
= 2.007/3 = 0.669
Regearing the average asset beta:
0.669 =
e
x 70//((70 + 30(1 - 0.30))
=
e
x 0.769
Hence
e
= 0.669/0.769 = 0.870
If the regearing equation were used:

e
= 0.669 x ((1 + (1 - 0.30)30/70)
= 0.870
Calculating the project-specific discount rate:
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
) = 4 + (0.870 x 6)
= 4 + 5.22 = 9.2%
REFERENCE
1 Watson D and Head A, Corporate
Finance: Principles and Practice, 4th
edition, FT Prentice Hall, pp 250255,
2007.
Antony Head is examiner for Paper F9
This article, the second in a
series of three, looks at how
to apply the CAPM when
calculating a project-specifc
discount rate to use
in investment appraisal.

RELEVANT TO ACCA QUALIFICATION PAPER F9 AND
PERFORMANCE OBJECTIVES 15 AND 16
2012 ACCA
Business valuations
Businesses need to be valued for a number of reasons such as their purchase and
sale, obtaining a listing, inheritance tax and capital gains tax computations. Generally,
valuation difficulties are restricted to unlisted companies because listed companies
have a quoted share price. However, even listed companies can present valuation
challenges for example when one is trying to predict the effect of a takeover on the
share price.

Whenever a company is bought what the new owners have a right to depends on the
stake they hold:

Majority holders: have access to their share of earnings and, because they can opt for
a winding up, their share of net assets of the company.

Minority holders: have access to the dividends the majority decide to pay and a share
of the net assets if the majority decides to wind the company up.

Therefore, because minority holders have little power and no control, a 20% share of a
company should be less than 20% of its total value. Conversely, an 80% share should
be worth more than 80% of the full value of the company. Majority holders should be
prepared to pay a premium for control.

There are three broad approaches to share valuation:
1. Assets-based.
2. Income-based.
3. Cash flow-based.

ASSETS-BASED APPROACH
Here, the business is estimated as being worth the value of its net assets. However,
there are three common ways of valuing its net assets: book values, net realisable
values and replacement values.
The book value approach is practically useless. The book value of non-current
assets is based on historical (sunk) costs and relatively arbitrary depreciation.
These amounts are unlikely to be relevant to any purchaser (or seller). The
book values of net current assets (other than cash) might also not be relevant
as inventory and receivables might require adjustment.
Net realisable values of the assets less liabilities. This amount would represent
what should be left for shareholders if the assets were sold off and the
liabilities settled. However, if the business being sold is successful, then
shareholders would expect to receive more than the net realisable value of the
net assets because successful businesses are more than the sum of their net
tangible assets: they have intangible assets such as goodwill, knowhow, brands
and customer lists none of which is likely to be reflected in the net realisable
value of the assets less liabilities. Net realisable value therefore represents a
worst case scenario because, presumably, selling off the tangible assets
would always be available as an option. The selling shareholders should
therefore not accept less than the net realisable amount but should usually
hope for more.

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BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA
Replacement values. Once again, not of great practical benefit. The approach
tries to determine what it would cost to set up the business if it were being
started now. The value of a successful business using replacement values is
likely to be lower than its true value unless an estimate is made for the value of
goodwill and other intangible assets, such as brands. Furthermore, estimating
the replacement cost of a variety of assets of different ages can be difficult.

So, of the three approaches, net realisable value is likely to be the most useful
because it presents the sellers with the lowest value they should accept.

Figure 1
Non-current assets contain land and buildings that are valued $700,000 above their
book value, and plant and machinery, which would sell for $200,000 less than their
book value. Inventory would sell for $400,000 and only $250,000 would be realised
from receivables.
Closure costs would add $100,000 to liabilities.
Book values $000 Net realisable values $000

Non-current assets

1,000 +700 200

Non-current assets 1,500
Current assets Current assets
Inventory 500 -100

Inventory 400
Receivables 300 -50

Receivables 250
Cash 400 Cash 400
1,200 1,050
2,200 2,550

Share capital 400 Share capital 400
Reserves 900 Reserves (balance) 1,150
1,300 1,550
Bonds 400 Bonds 400
Current liabilities 500 +100

Current liabilities 600
2,200 2,550

The minimum amount that the shareholders should accept for this business is
$1,550,000, the amount of share capital plus reserves after revaluation (or
alternatively, $2,550,000 400,000 600,000).

INCOME-BASED APPROACH
There are two income-based approaches. One method uses P/E ratios and the other
uses dividend yields. The P/E ratio method is widely used in practice.


3
BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA
Both methods rely on finding listed companies in similar businesses to the company
being valued (the target company), and then looking at the relationship they show
between share price and earnings (or share price and dividends). Using that
relationship as a model, the share price of the target company can be estimated.

(1) P/E ratios
The P/E ratio is the price per share divided by the earnings per share and shows how
many years worth of earnings are paid for in the share price.

Lets say that the market value of a small chain of UK-based grocery shops has to be
estimated. The company has just has just enjoyed post tax earnings of $200,000, out
of which it paid a dividend of $50,000.

The first task is to identify three UK listed companies in the grocery business, then
look at their published characteristics. For this illustration, three large UK quoted
supermarket chains (Morrison (W), Sainsbury and Tesco) have been chosen. On
24 December 2011 their published characteristics were:

P/E ratio Dividend yield
Morrison (W) 10.8 3.8%
Sainsbury 9.9 5.8%
Tesco 10.0 4.3%

Here, all the P/E ratios are very similar. Sometimes they are not even in the same
sector because one or more has been distorted for whatever reason. For example, a
companys market price might be unusually high because of bid speculation, or its
earnings might be low because of once-off restructuring costs written off in the latest
financial statements. Usually, any P/E that seems adrift from the others is left out of
further calculations.

It is also important to look closely at listed companies range of activities as often
large listed companies have an element of diversification. For example, although
Tesco is regarded as a UK supermarket chain, approximately one third of its revenues
are earned overseas, and the importance to the company of selling clothing, electrical
goods and financial services is growing rapidly. Care is therefore needed to make sure
that there is not likely to be too much distortion in the P/E ratio or dividend yield
when using Tesco as a model for a chain of simple grocery stores. Here, for the sake
of this example, we will assume that any distortion is not material.

Then, usually for want of any better treatment, the average P/E of the selected listed
companies is calculated. Here it is 10.2, and this represents the relationship that
quoted companies, in the supermarket industry, are showing between their earnings
after tax and their market capitalisation (or between their earnings per share and their
price per share). Remember, 10.2 means that anyone who buys a share is buying it
for 10.2 times its last published earnings.

Therefore, as the target companys post tax earnings are $200,000, its market value
would be estimated at:
10.2 x $200,000 = $2,040,000.

4
BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA
However, just as the listed companies P/E ratios might be distorted, so might the
earnings of the company being valued. For example, if its owners had known for some
time that they wanted to sell the company, they could have planned to create inflated
earnings. Current earnings can be flattered by cutting back on discretionary costs
such as research and development, maintenance, training and recruitment. Although
this will make current earnings look good, it is likely to store up trouble and extra
costs for the future when the company has to catch up with neglected expenditure.
There is therefore a double trap for purchasers: paying a purchase price based on
unsustainable earnings and then finding themselves owners of a company that has
unexpected catch-up expenses.

Assuming that we are happy with a P/E ratio of 10.2 and earnings of $200,000, then
the calculated market value of $2,040,000 is the starting point for negotiations to
begin. Here are some points to consider:

When you buy a company, you are buying an entitlement to its future earnings,
not its past earnings. Even if the earnings of $200,000 were not deliberately
distorted, the buyer should still consider whether that figure is a fair
representation of future earnings. For example, the market sector in which the
company is operating could be in decline. Or, if the owner is retiring, will this
damage the earning ability of the company, or will earnings increase because
the owner no longer draws a large salary? It is worth noting that the sellers of a
company usually know more about it than the buyers. Just think about the
information asymmetry that there is if you are buying a second-hand car!
Are the risk, stability, and expertise present in large, highly professional quoted
companies comparable to those of a small company? Generally, large quoted
companies will have advantages and should be valued on a higher multiple of
their earnings than the small company.
Quoted share prices and, therefore, P/E ratios can be very volatile. Share
prices, particularly in turbulent economic times, can vary dramatically
day-to-day. Are the P/E ratios chosen fair?
How relevant is a valuation based on earnings to a buyer of a minority stake
who only ever receives dividends? The P/E ratio approach is therefore
particularly appropriate for purchases of majority stakes.
Quoted companies are more desirable investments because they are quoted.
Shares in quoted companies are easy to sell on the market, whereas unquoted
shares are much more difficult to sell because buyers have to be found and a
price negotiated. Minority shareholders in unquoted companies can have a
miserable time: they have little voting power and can be trapped in their
investment.

To account for these differences, particularly the move from a listed to a private
company, it is normal for the value of an unquoted company (as calculated above) to
be reduced by 1/3 1/2. There is no great theory behind these reductions but they
are common in practice and often accepted by the UK tax authorities. This would
result in the valuation of the target company (above) being reduced from $2,040,000
to around 1,020,000 to 1,360,000, before the other factors mentioned above are
negotiated and adjusted for. The valuation range is therefore from about $1m to
$1.4m.

5
BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA
(2) Dividend yields
The dividend yield is the relationship between the dividend and the share price. This
approach is more appropriate to purchasers of minority stakes in a company because
minorities receive dividends and have no access to earnings.

Once again, one would look at the dividend yields of listed companies and discard any
that were out of line. Here, perhaps, Sainsbury might be regarded as being
uncharacteristic of supermarkets generally. If that is omitted the average dividend
yield of this sector looks to be around 4%. Therefore:

Dividend x 100/Share value = 4%
50,000 x 100/Share value = 4%
Share value = 50,000 x 100/4 = $1,250,000 (approx).

Once again, this would be a starting position for negotiation, and thought would need
to be given to the reliability of future dividends.

The $1,250,000 would have to be reduced for two effects:

Minority holdings are less attractive than majority holdings (minorities cannot
even sack the directors).
Unquoted companies are less attractive to investors than quoted companies.


CASH FLOW-BASED APPROACH
The dividend valuation model (or growth model) suggests that the market value of a
share is supported by the present value of future dividends. The formula given in the
Paper F9 formula sheet is:

Figure 2

P
0
= D
0
(1 + g)
(r
e
g)

where:
P
0
= ex div share price at Time 0
g = future annual growth rate from time 1 onwards
D
0
= dividend at Time 0
r
e
= rate of return required by the equity shareholders.

Three amounts have to be estimated if this approach is to be used: D
0
, r
e
and g.

D
0
This is the dividend that has either just been paid or is just about to be paid: it is the
dividend of now. This amount is easy to identify.




6
BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA

r
e

This is the return required by ordinary shareholders. Just as with P/E ratios and
dividend yields, r
e
would be estimated using statistics from appropriate listed
companies.

r
e
depends on both business risk and gearing risk.

Both of these risks have to be appropriate to the unlisted company being valued.
Business risk derives from the type of business that the company is engaged in (such
as house building, supermarkets, air travel, car manufacturing). Gearing risk is related
to the amount of borrowing in the companys capital structure. The more borrowing
there is, the more risk that shareholders are exposed to and the higher will be their
required return.

There are two sets of listed company statistics that can be used to estimate r
e
:


1. By using the formula from Figure 2, rearranged as:

r
e
= D
0
(1 + g) + g
P
0


2. Alternatively, r
e
can be estimated using the capital asset pricing model:

Required rate of return, r
e
= R
f
+ (R
m
R
f
)

where:
R
f
= risk free rate
R
m
= return from the market
= the beta value for a listed company in the same type of business,
appropriately adjusted for gearing

g
g is the future dividend growth rate from Time 1 onwards. Often this is estimated by
looking directly at the historical dividend growth rate and assuming this will continue
in the future. Alternatively, the Gordons growth approximation can be used:

g = b x earnings rate of new investment in the company


where:
b = fraction of earnings retained in the company.

Figure 3

Valuation based on shareholders rate of return earned from a listed company.

Statistics of the company, Company A, to be valued:

Dividend/share just paid = 12c

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BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA
Historical dividend growth rate = 5%/year. This is expected to be maintained in the
future.

Statistics of a suitable listed company (same business and same gearing):
Share price = $2.40
Dividend just paid = 22c
Historical dividend growth rate = 10%/year. This is expected to be maintained in the
future.

To work out the share value of the unlisted company, first calculate what the
shareholders rate of return is in the listed company, and then apply that to the
unlisted company.

Step 1 (listed company)

r
e
= D
0
(1 + g) + g
P
0


r
e
= 0.22(1 + 0.1) + 0.1 = 0.2, or 20%
2.40

Step 2 (unlisted company, Company A)

P
0
= D
0
(1 + g)
(r
e
g)

P
0
= 0.12(1 + 0.05) = 0.84
(0.20 0.05)

So, the value of a share in Company A is $0.84.

Note that this is very much a theoretical value. It takes into account the lower dividend
per share and the lower growth rate in the unlisted company. However, as explained
above, shares in unquoted companies are normally regarded as less desirable and
riskier than shares in an equivalent listed company. The required rate of return is
therefore likely to be higher in the unlisted company. If r
e
in the unlisted company
were 30% (say) rather than 20%, the share price would fall to $0.50

Figure 4

Valuation based on the value of a listed company.

Statistics of the company, Company B, to be valued:

Dividend/share just paid = 12c
Historical dividend growth rate = 5%/year. This is expected to be maintained in the
future.


8
BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA
Company B is entirely equity financed.

Statistics of a listed company in the same business:

= 1.6
R
f
= risk free rate = 5%
R
m
= return from the market = 15%

This company is geared in the ratio Debt:Equity = 2:5
Tax rate = 25%

The shareholders required rate of return in the listed company is given by the capital
asset pricing model equation:

r
e
= R
f
+ (R
m
R
f
) = 5% + 1.6(15% 5%) = 21%

This is the return required by the shareholders of a company geared in the ratio
D:E = 2:5. However, Company B is ungeared, so 21% is inappropriate for the
shareholders of that company.

The F9 formula sheet provides a mechanism for adjusting values to take account of
gearing differences.



The value of the second set of brackets is nearly always assumed to be zero because

d
, the beta of debt, is assumed to be zero.




Therefore,



where:

a
= the asset beta, the beta relevant to the business risk in an ungeared company in
the appropriate line of business. It can be useful to think of this as the ungeared beta
value.

9
BUSINESS VALUATIONS
FEBRUARY 2012
2012 ACCA

e
= the equity beta, the beta relevant to the risk experienced by a holder of equity in
a geared company, in the appropriate line of business with a given level of gearing. It
can be useful to think of this as the geared beta value.

So, to convert the beta value of the geared listed company to the beta value if that
company were ungeared use:

a
= 5 x 1.6 = 1.23
5 + 2 (1 0.25)

Therefore, the cost of equity of an ungeared company in the same business as the
geared company is:

r
e
= R
f
+ (R
m
R
f
) = 5% + 1.23(15% 5%) = 17.3%, say 17%

Therefore, the value of a share in Company B, an unlisted, ungeared company, is:

P
0
= D
0
(1 + g)
(r
e
g)

P
0
= 0.12(1 + 0.05) = 1.05
(0.17 0.05)

Once again, remember that this calculation would be a starting point for negotiation.

Ken Garrett is a freelance lecturer and writer
January 2008 student accountant 69
t
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c
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Section F of the Study Guide for Paper F9
contains several references to the Capital
Asset Pricing Model (CAPM). This article
introduces the CAPM and its components,
shows how it can be used to estimate the
cost of equity, and introduces the asset beta
formula. Two further articles will look at
applying the CAPM in calculating a
project-specific discount rate, and will
review the theory, and the advantages and
disadvantages of the CAPM.
Whenever an investment is made, for
example in the shares of a company listed on
a stock market, there is a risk that the actual
return on the investment will be different
from the expected return. Investors take the
risk of an investment into account when
deciding on the return they wish to receive
for making the investment. The CAPM is a
method of calculating the return required on an
investment, based on an assessment of its risk.
SYSTEMATIC AND UNSYSTEMATIC RISK
If an investor has a portfolio of investments
in the shares of a number of different
companies, it might be thought that the
risk of the portfolio would be the average of
the risks of the individual investments. In
fact, it has been found that the risk of the
portfolio is less than the average of the risks
of the individual investments. By diversifying
investments in a portfolio, therefore, an
investor can reduce the overall level of
risk faced.
There is a limit to this risk reduction effect,
however, so that even a fully diversified
portfolio will not eliminate risk entirely. The
risk which cannot be eliminated by portfolio
diversification is called undiversifiable risk
or systematic risk, since it is the risk that
is associated with the financial system. The
the capital asset pricing model
relevant to ACCA Qualifcation Paper F9
risk which can be eliminated by portfolio
diversification is called diversifiable risk,
unsystematic risk, or specific risk, since it
is the risk that is associated with individual
companies and the shares they have issued.
The sum of systematic risk and unsystematic
risk is called total risk
1
.
THE CAPITAL ASSET PRICING MODEL
The CAPM assumes that investors hold fully
diversified portfolios. This means that investors
are assumed by the CAPM to want a return
on an investment based on its systematic
risk alone, rather than on its total risk. The
measure of risk used in the CAPM, which
is called beta, is therefore a measure of
systematic risk.
The minimum level of return required by
investors occurs when the actual return is the
same as the expected return, so that there is
no risk at all of the return on the investment
being different from the expected return. This
minimum level of return is called the risk-free
rate of return.
The formula for the CAPM, which is
included in the Paper F9 formulae sheet, is as
follows:
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
)
E(r
i
) = return required on financial asset i
R
f
= risk-free rate of return

i
= beta value for financial asset i
E(r
m
) = average return on the capital market
This formula expresses the required return on
a financial asset as the sum of the risk-free
rate of return and a risk premium
i
(E(r
m
) -
R
f
) which compensates the investor for the
systematic risk of the financial asset. If shares
are being considered, E(r
m
) is the required
the cost of equity
return of equity investors, usually referred to as
the cost of equity.
The formula is that of a straight line, y =
a + bx, with
i
as the independent variable,
R
f
as the intercept with the y axis, (E(r
m
) - R
f
)
as the slope of the line, and E(r
i
) as the values
being plotted on the straight line. The line
itself is called the security market line (SML),
as shown in Figure 1.
FIGURE 1: THE SECURITY MARKET LINE
In order to use the CAPM, investors need to have
values for the variables contained in the model.
THE RISK-FREE RATE OF RETURN
In the real world, there is no such thing as a
risk-free asset. Short-term government debt
is a relatively safe investment, however, and
in practice, it can be used as an acceptable
substitute for the risk-free asset.
In order to have consistency of data, the
yield on UK treasury bills is used as a substitute
for the risk-free rate of return when applying
the CAPM to shares that are traded on the
UK capital market. Note that it is the yield on
treasury bills which is used here, rather than
the interest rate. The yield on treasury bills
(sometimes called the yield to maturity) is the
cost of debt of the treasury bills.
Return
E(r
i
)
R
m
R
f
SML
1
70 student accountant January 2008
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l

a=

e +

d
Because the CAPM is applied within a
given financial system, the risk-free rate of
return (the yield on short-term government
debt) will change depending on which countrys
capital market is being considered. The risk-free
rate of return is also not fixed, but will change
with changing economic circumstances.
THE EQUITY RISK PREMIUM
Rather than finding the average return on
the capital market, E(r
m
), research has
concentrated on finding an appropriate value
for (E(r
m
) - R
f
), which is the difference between
the average return on the capital market and
the risk-free rate of return. This difference
is called the equity risk premium, since it
represents the extra return required for investing
in equity (shares on the capital market as a
whole) rather than investing in risk-free assets.
In the short term, share prices can fall
as well as increase, so the average return on
a capital market can be negative as well as
positive. To smooth out short-term changes
in the equity risk premium, a time-smoothed
moving average analysis can be carried out over
longer periods of time, often several decades. In
the UK, when applying the CAPM to shares that
are traded on the UK capital market, an equity
risk premium of between 3.5% and 5% appears
reasonable at the current time
2
.
BETA
Beta is an indirect measure which compares
the systematic risk associated with a companys
shares with the systematic risk of the capital
market as a whole. If the beta value of a
companys shares is 1, the systematic risk
associated with the shares is the same as the
systematic risk of the capital market as a whole.
Beta can also be described as an index of
responsiveness of the returns on a companys
shares compared to the returns on the market
as a whole. For example, if a share has a beta
value of 1, the return on the share will increase
by 10% if the return on the capital market as
a whole increases by 10%. If a share has a
beta value of 0.5, the return on the share will
increase by 5% if the return on the capital
market increases by 10%, and so on.
Beta values are found by using regression
analysis to compare the returns on a share
with the returns on the capital market. When
applying the CAPM to shares that are traded
on the UK capital market, the beta value for
UK companies can readily be found on the
Internet, on Datastream, and from the London
Business School Risk Management Service.
EXAMPLE 1
Calculating the cost of equity using the CAPM
Although the concepts of the CAPM can
appear complex, the application of the model
is straightforward. Consider the following
information:
Risk-free rate of return = 4%
Equity risk premium = 5%
Beta value of RD Co = 1.2
Using the CAPM:
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
) = 4 + (1.2 x 5)
= 10%
The CAPM predicts that the cost of equity of
RD Co is 10%. The same answer would have
been found if the information had given the
return on the market as 9%, rather than giving
the equity risk premium as 5%.
ASSET BETAS, EQUITY BETAS, AND DEBT
BETAS
If a company has no debt, it has no financial
risk and its beta value reflects business risk
alone. The beta value of a companys business
operations as a whole is called the asset beta.
As long as a companys business operations,
and hence its business risk, do not change, its
asset beta remains constant.
When a company takes on debt, its
gearing increases and financial risk is added
to its business risk. The ordinary shareholders
of the company face an increasing level
of risk as gearing increases and the return
they require from the company increases
to compensate for the increasing risk. This
means that the beta of the companys shares,
called the equity beta, increases as gearing
increases
3
.
However, if a company has no debt, its
equity beta is the same as its asset beta. As
a company gears up, the asset beta remains
constant, even though the equity beta is
increasing, because the asset beta is the
weighted average of the equity beta and the
beta of the companys debt. The asset beta
formula, which is included in the Paper F9
formulae sheet, is as follows:
V
e
V
d
(1-T)
(V
e
+V
d
(1-T)) (V
e
+V
d
(1-T))

a
= asset beta

e
= equity beta

d
= debt beta
V
e
= market value of companys shares
V
d
= market value of companys debt
((V
e
+ V
d
(1 - T)) = after tax market value of
company
T = company profit tax rate
Note from the formula that if V
d
is zero
because a company has no debt, then
a
=

e
, as stated earlier.
EXAMPLE 2
Calculating the asset beta of a company
You have the following information relating to
RD Co:
Equity beta of RD Co = 1.2
Debt beta of RD Co = 0.1
Market value of shares of RD Co = $6m
Market value of debt of RD Co = $1.5m
After tax market value of company = 6 + (1.5
x 0.75) = $7.125m
Company profit tax rate = 25% per year

a
= [(1.2 x 6)/7.125] +
[(0.1 x 1.5 x 0.75)/7.125] = 1.024
The next article will look at how the asset beta
formula allows the CAPM to be applied when
calculating a project-specific discount rate that
can be used in investment appraisal.
REFERENCES
1 Watson D and Head A, Corporate Finance:
Principles and Practice, Financial Times/
Prentice Hall, 2006, p213.
2 Ibid, p229.
3 Ibid, p250.
Antony Head is examiner for Paper F9
The CAPM is a method of calculating the return required on an investment,
based on an assessment of its risk. This article introduces the CAPM and its
components, shows how it can be used to estimate the cost of equity, and
introduces the asset beta formula.
technical
page 50
student accountant
JUNe/JULY 2008
CAPM: THEORY,
ADVANTAGES, AND
DISADVANTAGES
THE CAPITAL ASSET PRICING MODEL
RELEVANT TO ACCA QUALIFICATION PAPER F9
CAPM FORMULA
The linear relationship between the return
required on an investment (whether in stock
market securities or in business operations)
and its systematic risk is represented by the
CAPM formula, which is given in the Paper F9
Formulae Sheet:
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
)
E(r
i
) = return required on financial asset i
R
f
= risk-free rate of return

i
= beta value for financial asset i
E(r
m
) = average return on the capital market
The CAPM is an important area of financial
management. In fact, it has even been suggested
that finance only became a fully-fledged, scientific
discipline when William Sharpe published his
derivation of the CAPM in 1986
1
.
CAPM ASSUMPTIONS
The CAPM is often criticised as being unrealistic
because of the assumptions on which it is based,
so it is important to be aware of these assumptions
and the reasons why they are criticised. The
assumptions are as follows
2
:
Investors hold diversified portfolios
This assumption means that investors will only
require a return for the systematic risk of their
portfolios, since unsystematic risk has been
removed and can be ignored.
Single-period transaction horizon
A standardised holding period is assumed by the
CAPM in order to make comparable the returns on
different securities. A return over six months, for
example, cannot be compared to a return over 12
months. A holding period of one year is usually used.
Investors can borrow and lend at the risk-free rate
of return
This is an assumption made by portfolio theory,
from which the CAPM was developed, and provides
a minimum level of return required by investors.
The risk-free rate of return corresponds to the
intersection of the security market line (SML) and
the y-axis (see Figure 1). The SML is a graphical
representation of the CAPM formula.
Perfect capital market
This assumption means that all securities are
valued correctly and that their returns will plot on
to the SML. A perfect capital market requires the
following: that there are no taxes or transaction
costs; that perfect information is freely available
to all investors who, as a result, have the same
expectations; that all investors are risk averse,
rational and desire to maximise their own utility;
and that there are a large number of buyers and
sellers in the market.
FIGURE 1: THE SECURITY MARKET LINE

While the assumptions made by the CAPM allow
it to focus on the relationship between return
and systematic risk, the idealised world created
by the assumptions is not the same as the real
world in which investment decisions are made by
companies and individuals.
Section F of the Study Guide for Paper F9 contains several references to the capital asset pricing
model (CAPM). This article is the last in a series of three, and looks at the theory, advantages,
and disadvantages of the CAPM. The first article, published in the January 2008 issue of student
accountant introduced the CAPM and its components, showed how the model can be used to
estimate the cost of equity, and introduced the asset beta formula. The second article, published in
the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use
in investment appraisal.
Return
E(r
i
)
R
m
R
f
SML
1
technical
page 51
This investment decision is also incorrect,
however, since project B would be rejected if
using a CAPM-derived project-specific discount
rate, because the project IRR offers insufficient
compensation for its level of systematic risk
4
.
FIGURE 2: WACC OR CAPM?

ADVANTAGES OF THE CAPM
The CAPM has several advantages over other
methods of calculating required return, explaining
why it has remained popular for more than 40 years:
It considers only systematic risk, reflecting a
reality in which most investors have diversified
portfolios from which unsystematic risk has
been essentially eliminated.
For example, real-world capital markets are
clearly not perfect. Even though it can be argued
that well-developed stock markets do, in practice,
exhibit a high degree of efficiency, there is scope
for stock market securities to be priced incorrectly
and, as a result, for their returns not to plot on to
the SML.
The assumption of a single-period transaction
horizon appears reasonable from a real-world
perspective, because even though many investors
hold securities for much longer than one year,
returns on securities are usually quoted on an
annual basis.
The assumption that investors hold diversified
portfolios means that all investors want to hold a
portfolio that reflects the stock market as a whole.
Although it is not possible to own the market
portfolio itself, it is quite easy and inexpensive
for investors to diversify away specific or
unsystematic risk and to construct portfolios that
track the stock market. Assuming that investors
are concerned only with receiving financial
compensation for systematic risk seems therefore
to be quite reasonable.
A more serious problem is that, in reality,
it is not possible for investors to borrow at the
risk-free rate (for which the yield on short-dated
Government debt is taken as a proxy). The reason
for this is that the risk associated with individual
investors is much higher than that associated with
the Government. This inability to borrow at the
risk-free rate means that the slope of the SML is
shallower in practice than in theory.
Overall, it seems reasonable to conclude that
while the assumptions of the CAPM represent
an idealised rather than real-world view, there
is a strong possibility, in reality, of a linear
relationship existing between required return and
systematic risk.
WACC AND CAPM
The weighted average cost of capital (WACC)
can be used as the discount rate in investment
appraisal provided that a number of restrictive
assumptions are met. These assumptions
are that:
the investment project is small compared to
the investing organisation
the business activities of the investment
project are similar to the business activities
currently undertaken by the investing
organisation
the financing mix used to undertake the
investment project is similar to the current
financing mix (or capital structure) of the
investing company
existing finance providers of the investing
company do not change their required rates
of return as a result of the investment project
being undertaken.
These assumptions essentially state that WACC
can be used as the discount rate provided that
the investment project does not change either
the business risk or the financial risk of the
investing organisation.
If the business risk of the investment project is
different to that of the investing organisation, the
CAPM can be used to calculate a project-specific
discount rate. The procedure for this calculation
was covered in the second article in this series
3
.
The benefit of using a CAPM-derived
project-specific discount rate is illustrated in
Figure 2. Using the CAPM will lead to better
investment decisions than using the WACC in the
two shaded areas, which can be represented by
projects A and B.
Project A would be rejected if WACC was used
as the discount rate, because the internal rate
of return (IRR) of the project is less than that of
the WACC. This investment decision is incorrect,
however, since project A would be accepted if
a CAPM-derived project-specific discount rate
were used because the project IRR lies above the
SML. The project offers a return greater than that
needed to compensate for its level of systematic
risk, and accepting it will increase the wealth
of shareholders.
Project B would be accepted if WACC was
used as the discount rate because its IRR is
greater than the WACC.
C
R
f
0
SML
WACC

Company
A
x
B
x
R
e
q
u
i
r
e
d

r
a
t
e

o
f

r
e
t
u
r
n

%
D
linked performance objectives
performaNce obJectives 15 aNd 16 are reLevaNt to paper f9
technical
page 52
student accountant
JUNe/JULY 2008
It generates a theoretically-derived relationship
between required return and systematic risk
which has been subject to frequent empirical
research and testing.
It is generally seen as a much better method of
calculating the cost of equity than the dividend
growth model (DGM) in that it explicitly takes
into account a companys level of systematic
risk relative to the stock market as a whole.
It is clearly superior to the WACC in providing
discount rates for use in investment appraisal.
DISADVANTAGES OF THE CAPM
The CAPM suffers from a number of disadvantages
and limitations that should be noted in a balanced
discussion of this important theoretical model.
Assigning values to CAPM variables
In order to use the CAPM, values need to be
assigned to the risk-free rate of return, the return
on the market, or the equity risk premium (ERP),
and the equity beta.
The yield on short-term Government debt,
which is used as a substitute for the risk-free rate
of return, is not fixed but changes on a daily basis
according to economic circumstances. A short-term
average value can be used in order to smooth out
this volatility.
Finding a value for the ERP is more difficult.
The return on a stock market is the sum of the
average capital gain and the average dividend yield.
In the short term, a stock market can provide a
negative rather than a positive return if the effect of
falling share prices outweighs the dividend yield. It
is therefore usual to use a long-term average value
for the ERP, taken from empirical research, but it
has been found that the ERP is not stable over time.
In the UK, an ERP value of between 2% and 5% is
currently seen as reasonable. However, uncertainty
about the exact ERP value introduces uncertainty
into the calculated value for the required return.
Beta values are now calculated and published
regularly for all stock exchange-listed companies.
The problem here is that uncertainty arises in the
value of the expected return because the value of
beta is not constant, but changes over time.
Using the CAPM in investment appraisal
Problems can arise when using the CAPM to
calculate a project-specific discount rate. For
example, one common difficulty is finding suitable
proxy betas, since proxy companies very rarely
undertake only one business activity. The proxy
beta for a proposed investment project must be
disentangled from the companys equity beta. One
way to do this is to treat the equity beta as an
average of the betas of several different areas of
proxy company activity, weighted by the relative
share of the proxy company market value arising
from each activity. However, information about
relative shares of proxy company market value may
be quite difficult to obtain.
A similar difficulty is that the ungearing
of proxy company betas uses capital structure
information that may not be readily available.
Some companies have complex capital structures
with many different sources of finance. Other
companies may have debt that is not traded, or
use complex sources of finance such as convertible
bonds. The simplifying assumption that the
beta of debt is zero will also lead to inaccuracy
in the calculated value of the project-specific
discount rate.
One disadvantage in using the CAPM in
investment appraisal is that the assumption of
a single-period time horizon is at odds with the
multi-period nature of investment appraisal. While
CAPM variables can be assumed constant in
successive future periods, experience indicates that
this is not true in reality.
CONCLUSION
Research has shown the CAPM to stand up well
to criticism, although attacks against it have been
increasing in recent years. Until something better
presents itself, however, the CAPM remains a very
useful item in the financial management toolkit.
REFERENCES
1 Megginson W L, Corporate Finance Theory,
Addison-Wesley, p10, 1996.
2 Watson D and Head A, 2007, Corporate
Finance: Principles and Practice, 4th edition,
FT Prentice Hall, pp2223.
3 Project-specific discount rates, student
accountant, April 2008.
4 Watson and Head, pp2523.
Tony Head is examiner for Paper F9
Increasingly, many businesses have dealings in foreign
currencies and, unless exchange rates are fixed with respect
to one another, this introduces risk. There are three types
of currency risk as detailed below.
Economic risk. The source of economic risk is the change
in the competitive strength of imports and exports. For
example, if a company is exporting (lets say from the UK to
a eurozone country) and the euro weakens from say /1.1
to /1.3 (getting more euros per pound sterling implies that
the euro is less valuable, so weaker) any exports from the UK
will be more expensive when priced in euros. So goods where
the UK price is 100 will cost 130 instead of 110, making
those goods less competitive in the European market.
Similarly, goods imported from Europe will be cheaper in
sterling than they had been, so those goods will have become
more competitive in the UK market. Note that a company
can, therefore, experience economic risk even if it has no
overt dealings with overseas countries. If competing imports
could become cheaper you are suffering risk arising from
currency rate movements.
Doing something to mitigate economic risk can be difficult
especially for small companies with limited international
dealings. In general, the following approaches might provide
some help:
Trytoexportorimportfrommorethanonecurrencyzone
and hope that the zones dont all move together, or if they
do, at least to the same extent. For example, over the six
months 14 January 2010 to 14 June 2010 the
/US$ exchange rate moved from about /US$0.6867
to /US$ 0.8164. This meant that the had weakened
relative to the US$ (or the US$ strengthened relative
to the ) by 19%. This made it less competitive for US
manufacturers to export to a eurozone country. If, in the
same period, the /US$ exchange rate moved from
/US$0.6263 to /US$0.6783, a strengthening of the
US$ relative to of only about 8%. Trade from the US to
the UK would not have been so badly affected.
Make your goods in the country you sell them. Although
raw materials might still be imported and affected by
exchange rates, other expenses (such as wages) are
in the local currency and not subject to exchange rate
movements.
Translation risk. This affects companies with foreign
subsidiaries. If the subsidiary is in a country whose
currency weakens, the subsidiarys assets will be less
valuable in the consolidated accounts. Usually, this
effect is of little real importance to the holding company
because it does not affect its day-to-day cash flows.
However, it would be important if the holding company
wanted to sell the subsidiary and remit the proceeds. It
also becomes important if the subsidiary pays dividends.
However, the term translation risk is usually reserved for
consolidation effects.
It can be partially overcome by funding the foreign
subsidiary using a foreign loan. For example, take a US
subsidiary that has been set up by its holding company
providing equity finance. Its statement of financial position
would look something like this:
US$m
Non-current assets 1.5
Current assets 0.5
2.0
Equity 2.0
If the US$ weakens then all the US$2m total assets become
less valuable.
foreign
risk and its
relevant to acca qualification paper f9
01 technical
translation risk affects companies
with foreign subsidiaries. if the
subsidiary is in a country whose
currency weakens, the subsidiarys
assets will be less valuable in the
consolidated accounts.
However, if the subsidiary were set up using 50% equity and
50% US$ borrowings, its statement of financial position
would look like this:
US$m
Non-current assets 1.5
Current assets 0.5
2.0
$ Loan 1.0
Equity 1.0
2.0
The holding companys investment is only US$1m and the
companys net assets in US$ are only US$1m. If the US$
weakens, only the net US$1m becomes less valuable.
Transaction risk. This arises when a company is importing
or exporting. If the exchange rate moves between agreeing
the contract in a foreign currency and paying or receiving
the cash, the amount of home currency paid or received will
alter, making those future cash flows uncertain. For example,
in June a UK company agrees to sell an export to Australia
for 100,000 Australian $ (A$), payable in three months. The
exchange rate at the date of the contract is A$/1.80 so the
company is expecting to receive 100,000/1.8 = 55,556. If,
however, the A$ weakened over the three months to become
worth only A$/2.00, then the amount received would be
worth only 50,000.
Of course, if the A$ strengthened over the three months,
more than 55,556 would be received.
It is important to note that transaction risk management
is not mainly concerned with achieving the most favourable
cash flow: it is mainly aimed at achieving a definite cash flow.
Only then can proper planning be undertaken.
dealing with transaction risks
Assuming that the business does not want to tolerate
exchange rate risks (and that could be a reasonable choice
for small transactions), transaction risk can be treated in the
following ways:
1 Invoice. Arrange for the contract and the invoice to be
in your own currency. This will shift all exchange risk
from you onto the other party. Of course, who bears
the risk will be a matter of negotiation, along with price
and other payment terms. If you are very keen to get a
sale to a foreign customer you might have to invoice in
their currency.
2 Netting. If you owe your Japanese supplier 1m, and
another Japanese company owes your Japanese subsidiary
1.1m, then by netting off group currency flows your
net exposure is only for 0.1m. This will really only work
effectively when there are many sales and purchases
in the foreign currency. It would not be feasible if the
transactions were separated by many months. Bilateral
netting is where two companies in the same group
cooperate as explained above; multilateral netting is where
many companies in the group liaise with the groups
treasury department to achieve netting where possible.
3 Matching. If you have a sales transaction with one foreign
customer, and then a purchase transaction with another
(but both parties operate with the same foreign currency)
then this can be efficiently dealt with by opening a foreign
currency bank account. For example:
1 November: should receive US$2m from US customer
15 November: must pay US$1.9m to US supplier.
Studying Paper F9?
performance objectives 15 and 16 are relevant to this exam
currency
management
student accountant issue 15/2010
02
Deposit the US$2m in a US$ bank account and simply
pay the supplier from that. That leaves only US$0.1m of
exposure to currency fluctuations.
Usually, for matching to work well, either specific
matches are spotted (as above) or there have to be many
import and export transactions to give opportunities for
matching. Matching would not be feasible if you received
US$2m in November, but didnt have to pay US$1.9m until
the following May. There arent many businesses that can
simply keep money in a foreign currency bank account for
months on end.
4 Leading and lagging. Lets imagine you are planning to
go to Spain and you believe that the euro will strengthen
against your own currency. It might be wise for you to
change your spending money into euros now. That would
be leading because you are changing your money in
advance of when you really need to. Of course, the euro
might weaken and then youll want to kick yourself,
but remember: managing transaction risk is not about
maximising your income or minimising your expenditure, it
is about knowing for certain what the transaction will cost
in your own currency.
Lets say, however, that you believe that the euro is
going to weaken. Then you would not change your money
until the last possible moment. That would be lagging,
delaying the transaction. Note, however, that this does not
reduce your risk. The euro could suddenly strengthen and
your holiday would turn out to be unexpectedly expensive.
Lagging does not reduce risk because you still do not know
your costs. Lagging is simply taking a gamble that your
hunch about the weakening euro is correct.
5 Forward exchange contracts. A forward exchange contract
is a binding agreement to sell (deliver) or buy an agreed
amount of currency at a specified time in the future at an
agreed exchange rate (the forward rate).
In practice there are various ways in which the
relationship between a current exchange rate (spot rate)
and the forward rate can be described. Sometimes it
is given as an adjustment to be made to the spot rate;
in the Paper F9 exam, for example, the forward rates are
quoted directly.
However, for each spot and forward there is always a
pair of rates given. For example:
Spot / 1.2025 0.03 ie 1.2028
and 1.2022

Three-month forward rate / 1.2020 0.06 ie 1.2026
and 1.2014
One of each pair is used if you are going to change
sterling to euros. So 100 would be changed now for either
120.28 or 120.22. Guess which rate the bank will give
you! You will always be given the exchange rate which
leaves you less well off, so here you will be given a rate of
1.2022, if changing to euros now, or 1.2014 if using a
forward contract. Once you have decided which direction
one rate is for, the other rate is used when converting the
other way. So:
to to
Spot / 1.2028 - 1.2022

Three month forward rate / 1.2026 - 1.2014
So, lets assume you are a manufacturer in Italy, exporting
to the UK. You have agreed that the sale is worth
500,000, to be received in three months, and wish to
hedge (reduce your risk) against currency movements.
In three months you will want to change to and
you can enter a binding agreement with a bank that in
three months you will deliver 500,000 and that the bank
will give you 500,000 x 1.2014 = 600,700 in return.
That rate, and the number of euros you will receive, is
now guaranteed irrespective of what the spot rate is at
the time. Of course if the had strengthened against
the (say to / = 1.5) you might feel aggrieved as
you could have then received 750,000, but income
maximisation is not the point of hedging: its point is to
provide certainty and you can now put 600,700 into your
cash flow forecast with confidence.
03 technical
However, there remains here one lingering risk: what
happens if the sale falls through after arranging the
forward contract? We are not necessarily talking about a
bad debt here as you might not have sent the goods, but
you have still entered into a binding contract to deliver
500,000 to your bank in three months time. The bank will
expect you to fulfil that commitment, and so what you might
have to do is get enough to buy 500,000 using the spot
rate, use this to meet your forward contract, receiving
600,700 back. This process is known as closing out, and
you could win or lose on it depending on the spot rate at the
time.
6 Money market hedging. Lets say that you were a UK
manufacturer exporting to the US and in three months you
are due to receive US$2m. You would suffer no currency
risk if that US$2m could be used then to settle a US$2m
liability; that would be matching the currency inflow and
outflow. However, you dont have a US$2m liability to
settle then so create one that can soak up the US$. You
can create a US$ liability by borrowing US$ now and then
repaying that in three months with the US$ receipt. So
the plan is:
To work out how many US$ need to be borrowed now, you
need to know US$ interest rates. For example, the US$
three month interest rate might be quoted as:
0.54% 0.66%
It is important to understand that, although this might
be described as a three month rate it is always quoted
as an annualised rate. One rate is what you would earn in
interest if the money was on deposit, and the other is the
rate you would pay on a loan. Again, no prizes for guessing
which is which: you will always be charged more than you
earn. On the US$ loan we will be charged 0.66% pa for
three months and the loan has to grow to become US$2m
in that time. So, If X is borrowed now and three months
interest is added:
X(1 + 0.66%/4) = 2,000,000
X = $1,996,705
This can be changed now from US$ to at the current spot
rate, say US$/ 1.4701, to give 1,358,210.
This amount of sterling is certain: we have it now and
it does not matter what happens to the exchange rate in
the future. Ticking away in the background is the US$ loan
which will amount to US$2m in three months and which
can then be repaid by the US$2m we hope to receive
from our customer. That is the hedging process finished
because exchange rate risk has been eliminated
Why might this somewhat complicated process be
used instead of a simple forward contract? Well, one
advantage is that we have our money now rather than having
to wait three months for it. If we have the money now we
can use it now or at least place it in a sterling deposit
account for three months. This raises an important issue
when we come to compare amounts received under forward
contracts and money market hedges. If these amounts
are received at different times they cannot be directly
compared, because receiving money earlier is better than
receiving it later. To compare amounts under both methods
we should see what the amount received now would become
if deposited for three months. So, if the sterling three
month deposit rate were 1.2%, then placing 1,358,210 on
deposit for three months would result in:
1,358,210 (1 + 1.2%/4) = 1,362,285
It is this amount that should be compared to any proceeds
under a forward contract.
Interest on the US$ loan will accrue
for three months
US$2m
liability
Borrow
US$ now
US$2m
from
customer
available
now
Convert at
spot rate
student accountant issue 15/2010
04
The example above dealt with hedging the receipt of
an amount of foreign currency in the future. If foreign
currency has to be paid in the future, then what the
company can do is change money into sufficient foreign
currency now and place it on deposit so that it will grow to
become the required amount by the right time. Because
the money is changed now at the spot rate, the transaction
is immune from future changes in the exchange rate.
further methods of eXchange risk hedging
There are two other methods of exchange risk hedging which
you are required to know about, but you will not be required
solve numerical questions relating to these methods. They
involve the use of derivatives: financial instruments whose
value derives from the value of something else like an
exchange rate.
1 Currency futures. Simply think of these as items you
can buy and sell on the futures market and whose price
will closely follow the exchange rate. Lets say that a US
exporter is expecting to receive 5m in three months time
and that the current exchange rate is US$/1.24. Assume
that this rate is also the price of US$/ futures. The
US exporter will fear that the exchange rate will weaken
over the three months, say to US$/1.10 (that is fewer
dollars for a euro). If that happened, then the market
price of the future would decline too, to around 1.1. The
exporter could arrange to make a compensating profit
on buying and selling futures: sell now at 1.24 and buy
later at 1.10. Therefore, any loss made on the main the
currency transaction is offset by the profit made on the
futures contract.
This approach allows hedging to be carried
out using a market mechanism rather than entering
into the individually tailored contracts that the
forward contracts and money market hedges require.
However, this mechanism does not offer anything
fundamentally new.
2 Options. Options are radically different. They give the
holder the right, but not the obligation, to buy or sell a
given amount of currency at a fixed exchange rate (the
exercise price) in the future (if you remember, forward
contracts were binding). The right to sell a currency at
a set rate is a put option (think: you put something up
for sale); the right to buy the currency at a set rate is a
call option.
Suppose a UK exporter is expecting to be paid US$1m
for a piece of machinery to be delivered in 90 days. If
the strengthens against the US$ the UK firm will lose
money, as it will receive fewer for the US$1m. However,
if the weakens against the US$, then the UK company
will gain additional money. Say that the current rate is
US$/1.40 and that the exporter will get particularly
concerned if the rate moved beyond US$/1.50. The
company can buy call options at an exercise price of
US$/ = 1.50, giving it the right to buy at US$1.50/.
If the dollar weakens beyond US$/1.50, the company
can exercise the option thereby guaranteeing at
least 666,667. If the US$ stays stronger or even
strengthens to, say, US$/1.20, the company can let
the option lapse (ignore it) and convert at 1.20, to give
833,333.
This seems too good to be true as the exporter is
insulated from large losses but can still make gains. But
theres nothing for nothing in the world of finance and
to buy the options the exporter has to pay an up-front,
non-returnable premium. Options can be regarded just like
an insurance policy on your house. If your house doesnt
burn down you dont call on the insurance, but neither
do you get the premium back. If there is a disaster the
insurance should prevent massive losses.
Options are also useful if you are not sure about a
cash flow. For example, say you are bidding for a contract
with a foreign customer. You dont know if you will win or
not, so dont know if you will have foreign earnings, but
want to make sure that your bid price will not be eroded
by currency movements. In those circumstances, an
option can be taken out and used if necessary or ignored
if you do not win the contract or currency movements
are favourable.
Ken Garrett is a freelance author and lecturer
options give the holder the right,
but not the obligation, to buy or
sell a given amount of currency
at a fiXed eXchange rate (the
eXercise price) in the future.
05 technical

RELEVANT TO ACCA QUALIFICATION PAPER F9
2011 ACCA



Analysing the suitability of financing alternatives
The requirement to analyse suitable financing alternatives for a company has
been common in Paper F9 over the years. Indeed, it was examined again in
December 2010 and will, I am sure, be examined again in the future. This is a
key area in the Paper F9 syllabus and the requirement can be worth a
significant amount of marks for example, 15 marks in Question 2 of the
December 2010 exam.

Unfortunately, many students struggle with questions of this nature and do not
seem to know how to produce a good answer. This article will suggest an
approach that students could use and will then finish with a worked example
to demonstrate the technique discussed.

Financial performance and position
When considering the source of finance to be used by a company, the recent
financial performance, the current financial position and the expected future
financial performance of the company needs to be taken into account. Within
an exam question, the ability to do this will be restricted by the information
available. In some questions, details of recent performance and the current
situation may be provided, while in other questions the current situation and
forecasts may be provided.

Evaluating financial performance
Whether you are evaluating recent or forecast financial performance, key areas
to consider include the growth in turnover, the growth in operating profit, the
growth in profit after or before tax and the movement in profit margins. Return
on capital employed and return on equity could be calculated. A key point for
students to remember is that they only have limited time and it is better to
calculate a few key ratios and then move on and complete the question than it
is to calculate all possible ratios and fail to satisfy the requirement.

Evaluating the current financial position
The key consideration when evaluating the current financial position is to
establish the financial risk of the company. Hence, the key ratios to calculate
are the financial gearing, which shows the financial risk using data from the
statement of financial position and interest cover, which shows the financial
risk using data from the income statement. Equally, the split between short
and long-term financing, and the reliance of the company on overdraft finance,
should also be considered.

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ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011

When evaluating financial performance and financial position, due


consideration should be given to any comparative sector data provided.
Indeed, if no such data is provided, I would recommend that you state in your
answer that you would want to consider such comparative data. This is what
you would do in real life and stating it shows that you are aware of this. If the
examiner has not provided such data, it is simply because he is constrained by
the need to examine many topics in just three hours.

Recommendation of a suitable financing method
When recommending a financing method, consideration should be given to a
number of factors. These factors are key to justifying your choice of method
and the examiner has in the past asked students to discuss these factors in an
exam question. The factors include:

Cost Debt finance is cheaper than equity finance and so if the company has
the capacity to take on more debt, it could have a cost advantage.

Cash flows While debt finance is cheaper than equity finance, it places on
the company the obligation to pay out cash in the form of interest. Failure to
pay this interest can result in action being taken to wind up the company.
Hence, consideration should be given to the ability of the company to generate
cash. If the company is currently cash-generating, then it should be able to
pay its interest and debt finance could be a good choice. If the company is
currently using cash because it is investing heavily in research and
development for example, then the cash may not be available to service
interest payments and the company would be better to use equity finance. The
equity providers may be willing to accept little or no cash return in the short
term, but will instead hope to benefit from capital growth or enhanced
dividends once the investment currently taking place bears fruit. Also, equity
providers cannot take action to wind up a company if it fails to pay the
dividend expected.

Risk The directors of the company must control the total risk of the company
and keep it at a level where the shareholders and other key stakeholders are
content. Total risk is made up of the financial risk and the business risk.
Hence, if it is clear that the business risk is going to rise for example,
because the company is diversifying into riskier areas or because the operating
gearing is increasing then the company may seek to reduce its financial risk.
The reverse is also true if business risk is expected to fall, then the company
may be happy to accept more financial risk.

Security and covenants If debt is to be raised, security may be required.
From the data given it should be possible to establish whether suitable
3

ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011

security may be available. Covenants, such as those that impose an obligation


on the company to maintain a certain liquidity level, may be required by debt
providers and directors must consider if they will be willing to live with such
covenants prior to taking on the debt.

Availability The likely availability of finance must also be considered when
recommending a suitable finance source. For instance, a small or medium-
sized unlisted company will always find raising equity difficult and, if you
consider that the company requires more equity, you must be able to suggest
potential sources, such as venture capitalists or business angels, and be aware
of the drawbacks of such sources. Furthermore, if the recent or forecast
financial performance is poor, all providers are likely to be wary of investing.

Maturity The basic rule is that the term of the finance should match the term
of the need (the matching principle). Hence, a short-term project should be
financed with short-term finance. However, this basic rule can be flexed. For
instance, if the project is short term but other short-term opportunities are
expected to arise in the future the use of longer term finance could be
justified.

Students should always consider the maturity dates of debt finance in


questions of this nature as it is an area the Paper F9 examiner likes to explore.
For instance, in Question 2 of the December 2010 exam the company was
considering raising more finance but at the same time the existing long-term
borrowings were scheduled to mature in just two years and, hence,
consideration needed to be given to this issue. Equally, in previous questions,
a company had been considering raising finance for a period of perhaps eight
years and an examination of the companys statement of financial position
shows that the existing debt of the company would also mature in eight years.
Obviously it is unwise for a company to have all its debt maturing at once as
repayment would put a considerable cash strain on the company. If the debt
could not be repaid, but was to be refinanced, this could be problematic if the
economic conditions prevailing made refinancing difficult.

Control If debt is raised then there will be no change in control. However, if
equity is raised control may change. Students should also recognise that a
rights issue will only cause a change in control if shareholders sell their rights
to other investors.

Costs and ease of issue Debt finance is generally both cheaper and easier to
raise than equity and, hence, a company will often raise debt rather than
equity. Raising equity is often difficult, time-consuming and costly.

4

ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011

The yield curve Consideration should be given to the term structure of


interest rates. For instance, if the curve is becoming steeper this shows an
expectation that interest rates will rise in the future. In these circumstances, a
company may become more wary of borrowing additional debt or may prefer
to raise fixed rate debt, or may look to hedge the interest rate risk in some
way.

While this list is not meant to be exhaustive, it hopefully provides much for
students to think about. Students should not necessarily expect to use all the
factors in an answer.

Suitable financing sources
Students must ensure that they can suggest suitable financing sources. For
each source, students should know how and when it could be raised, the
nature of the finance and its potential advantages and disadvantages.
Combined with a consideration of the factors given above, this knowledge will
allow students to recommend and justify a source of finance for any particular
scenario. A discussion of each finance source is outside the scope of this
article, but students can read up on this area in any good study manual.

Worked example
The following forecast financial position statement as at 31 May 2012 refers to
Refgun Co, a stock exchange-listed company, which is seeking to spend $90m
in cash on a permanent expansion of its existing trade.



The forecast results for Refgun Co, assuming the expansion occurs from
1 June 2012, are as follows:
$m $m
Assets
Non-current assets 130
Current assets 104
Total assets 234
Equity and liabilities
Share capital 60
Retained earnings 86
Total equity 146
Non-current liabilities
Long-term borrowings 70
Current liabilities
Trade payables 18
Total liabilities 88
Total equity and liabilities 234
5

ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011


Year ending 31 May 2012 2013 2014 2015
$m $m $m $m
Revenue 71.7 79.2 91.3 98.6
Operating profit 24.4 28.5 33.7 37.1

Notes:
1. The long-term borrowings are 8% bonds that were issued in 1996 with a
20-year term
2. The current assets include $18m of cash, of which $15m is held on
deposit
3. Refgun Co has consistently grown its profits and dividends in real terms
4. No new finance has been raised in recent years
5. The sector average financial gearing (debt/equity on a book value basis)
is currently 85%
6. The sector average interest cover is currently 2.9 times
7. The company estimates that it could borrow at a pre-tax rate of 7.2%
per year
8. The company pays tax on its pre-tax profits at a rate of 28%

Required:
Recommend a suitable method of raising the finance required by Refgun Co,
supporting your evaluation with both analysis and critical discussion.
Prior to reading the suggested solution students should carry out their own
evaluation of the forecast financial performance and the current and forecast
financial position. A consideration of the factors discussed earlier should lead
students to a justified recommendation.

Suggested solution
Refgun Co is seeking to spend $90m on a permanent expansion of its existing
trade. It should be noted that the company has significant retained earnings,
$15m of which is held in cash on deposit. This could presumably be used to
help fund the expansion and, if this is the case, the need for additional finance
would be reduced to $75m. However, the company may have a reason for
holding cash for example, to meet budgeted cash payments in the near
future.

Forecast financial performance
The forecast financial performance of Refgun Co will be a key consideration to
potential finance providers. Analysis of the forecast performance of Refgun Co
gives the following information:
Geometric average growth in turnover = (98.6/71.7)
(1/3)
1 = 11.2%
Geometric average growth in operating profit = (37.1/24.4)
(1/3)
1 = 15.0%
6

ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011


Year ending 31 May 2012 2013 2014 2015
Operating profit margin 34.0% 36.0% 36.9% 37.6%

The forecast income statements for the years ending 31 May 2012 and 2015
are shown below. Two income statements have been prepared for 2015, one
assuming the expansion is funded by debt and the other assuming the
expansion is funded by equity:

Year ending 31 May 2012
$m
2015 debt
$m
2015 equity
$m
Operating profit 24.4 37.1 37.1
Interest (5.6) (11.0) (5.6)
Profit before tax 18.8 26.1 31.5
Tax 28% (5.3) (7.3) (8.8)
Profit after tax 13.5 18.8 22.7

The interest charge for 2012 is assumed to be (70 x 8%) = $5.6m
If debt finance is used the interest charge from 2013 onwards is assumed to
be (70 x 8%) + (75 x 7.2%) = $11.0m

Note: While it would be good to forecast the income statement for each year,
time pressure may mean this is not possible.

This analysis shows that the growth in revenue caused by the expansion is
exceeded by the growth in operating profit due to a steady rise in the operating
margin of the company. This may be a result of the company benefiting from
economies of scale as a result of the expansion. Whether debt finance or
equity finance is used, both the returns to all investors (operating profit) and
the return to the equity investors (profit after tax) both show considerable
growth.

Current and forecast financial position
The gearing (D/E) is currently 70/146 = 47.9% on a book value basis. If debt
finance is raised this would rise to (70+75)/146 = 99.3%, while if equity
finance was used it would fall to 70/(146+75) = 31.7%. Even if debt finance
was raised the gearing level would rapidly fall again as the company makes
and retains profits.

The interest cover is currently 24.4/5.6 = 4.4 times. If debt finance is used
then this would fall to 28.5/11.0 = 2.6 times in 2013. However, by 2015 it
would have recovered to 37.1/11.0 = 3.4 times. If equity finance were to be
used the interest cover would consistently improve.
7

ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011

Refgun Co currently has less financial risk than the sector average and the
financial risk would decline even further if equity finance was used. If debt
finance is used then the financial risk would initially rise slightly above the
sector average but would soon return to the sector average level or below.

Factors that Refgun Co should consider prior to choosing a financing method

Cost and cash flows Refgun Co would seem to have the capacity to raise
more debt as the non-current assets exceed the existing debt by $60m.
Furthermore, the company seems to be cash-generative in that it is currently
holding $15m on deposit, despite not having raised any finance for several
years. Hence, the company may be wise to take advantage of cheaper debt.

Risk As the company is expanding its existing trade there should be no
material change in business risk. If debt finance is chosen the directors should
ensure that the shareholders are happy with the extra financial risk. Given the
analysis above, this seems likely.

Security and covenants As long as the expansion involves investing in some
non-current assets there should be sufficient security available for potential
lenders. The company should check what potential covenants might be
imposed and ensure that they would be happy to live with them.

Availability and maturity Given the recent performance and the good
forecasts, the company is likely to have many finance sources available to it.
Debt providers should be willing to lend and shareholders would be likely to
support a rights issue. Equally, other investors may well wish to invest in the
equity of the company. As the finance is required to finance a permanent
expansion of the company, long-term finance should be raised. To the extent
that the expansion requires investment in additional working capital, some
short-term finance could be raised. Consideration should also be given to the
fact that the existing bonds of the company are due to be repaid in 2016.
Subject to early redemption penalties, it may be worth looking into refinancing
this debt at the same time as raising the new debt especially as the cost of
new debt appears lower.

Control If debt is issued, no change would occur to control. A rights issue
would also have little impact on control while the issue of shares to new
investors may cause control issues.

Costs and ease of issue A debt issue is likely to be cheaper and easier than
an equity issue and, hence, may well be favoured by the directors.

8

ANALYSING THE SUITABILITY OF FINANCING ALTERNATIVES

JUNE 2011

Yield curve The directors of Refgun Co should consider the yield curve if it is
decided to raise debt.

Recommendation of a suitable financing method
From the analysis and discussion above, it would seem that Refgun Co should
seek to finance the expansion by raising long-term debt secured on the
existing non-current assets of the company and the new non-current assets
acquired during the expansion. At the same time as raising the new debt, the
refinancing of the existing debt should also be considered. If shareholders and
other key stakeholders are concerned about the financial risk exceeding the
industry average, then Refgun Co could raise some short-term debt with the
aim of repaying it as soon as more cash is earned. The impact on gearing
could also be reduced by acquiring some assets on operating leases, or by the
sale and lease back of some existing assets. The directors should take action
to manage the interest rate risk that Refgun Co will suffer.

I hope that this article has provided students with an approach that they can
use when answering a question of this nature. All too often students have a feel
for the type of finance that may be suitable for a company, but cannot support
or justify what they are proposing and, hence, cannot earn the marks that are
available.

William Parrott is a lecturer at Kaplan Financial
Is it possible to increase shareholder wealth by
changing the capital structure?
The first question to address is what is meant
by capital structure. The capital structure of a
company refers to the mixture of equity and debt
finance used by the company to finance its assets.
Some companies could be all-equity-financed
and have no debt at all, whilst others could have
low levels of equity and high levels of debt. The
decision on what mixture of equity and debt capital
to have is called the financing decision.
The financing decision has a direct effect on
the weighted average cost of capital (WACC). The
WACC is the simple weighted average of the cost of
equity and the cost of debt. The weightings are in
proportion to the market values of equity and debt;
therefore, as the proportions of equity and debt
vary, so will the WACC. Therefore the first major
point to understand is that, as a company changes
its capital structure (ie varies the mixture of equity
and debt finance), it will automatically result in a
change in its WACC.
However, before we get into the detail of capital
structure theory, you may be thinking how the
financing decision (ie altering the capital structure)
has anything to do with the overall corporate
objective of maximising shareholder wealth. Given
the premise that wealth is the present value of
future cash flows discounted at the investors
required return, the market value of a company is
equal to the present value of its future cash flows
discounted by its WACC.
It is essential to note that the lower the WACC, the
higher the market value of the company as you
can see from the following simple example; when
the WACC is 15%, the market value of the company
is 667; and when the WACC falls to 10%, the
market value of the company increases to 1,000.
Market value of a company 100 = 667 100 = 1,000
0.15 0.10
Hence, if we can change the capital structure
to lower the WACC, we can then increase the
market value of the company and thus increase
shareholder wealth.
Therefore, the search for the optimal capital
structure becomes the search for the lowest WACC,
because when the WACC is minimised, the value
of the company/shareholder wealth is maximised.
Therefore, it is the duty of all finance managers to
find the optimal capital structure that will result in
the lowest WACC.
What mixture of equity and debt will result in the
lowest WACC?
As the WACC is a simple average between the cost
of equity and the cost of debt, ones instinctive
response is to ask which of the two components is
the cheaper, and then to have more of the cheap
one and less of expensive one, to reduce the
average of the two.
Well, the answer is that cost of debt is cheaper
than cost of equity. As debt is less risky than equity,
the required return needed to compensate the debt
investors is less than the required return needed to
compensate the equity investors. Debt is less risky
than equity, as the payment of interest is often a
fixed amount and compulsory in nature, and it is
paid in priority to the payment of dividends, which
are in fact discretionary in nature. Another reason
optimum
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releVAnT To ACCA quAlifiCATion pAper f9
Market value of a company = Future cash flows
(perpetuity formula) WACC
78 TeChniCAl
Studying Paper F9?
performance objectives 15 and 16 are linked
why debt is less risky than equity is in the event of a
liquidation, debt holders would receive their capital
repayment before shareholders as they are higher in
the creditor hierarchy (the order in which creditors
get repaid), as shareholders are paid out last.
Debt is also cheaper than equity from a
companys perspective is because of the different
corporate tax treatment of interest and dividends.
In the profit and loss account, interest is subtracted
before the tax is calculated; thus, companies get tax
relief on interest. However, dividends are subtracted
after the tax is calculated; therefore, companies do
not get any tax relief on dividends. Thus, if interest
payments are 10m and the tax rate is 30%, the
cost to the company is 7m. The fact that interest
is tax-deductible is a tremendous advantage.
Let us return to the question of what mixture
of equity and debt will result in the lowest WACC.
The instinctive and obvious response is to gear up
by replacing some of the more expensive equity
with the cheaper debt to reduce the average, the
WACC. However, issuing more debt (ie increasing
gearing), means that more interest is paid out
of profits before shareholders can get paid their
dividends. The increased interest payment increases
the volatility of dividend payments to shareholders,
because if the company has a poor year, the
increased interest payments must still be paid,
which may have an effect the companys ability
to pay dividends. This increase in the volatility of
dividend payment to shareholders is also called an
increase in the financial risk to shareholders. If the
financial risk to shareholders increases, they will
require a greater return to compensate them for this
increased risk, thus the cost of equity will increase
and this will lead to an increase in the WACC.
In summary, when trying to find the lowest
WACC, you:
Issue more debt to replace expensive equity; this
reduces the WACC
But more debt also increases the WACC as:
Gearing Financial risk Beta equity Keg
WACC
Remember that Keg is a function of beta equity
which includes both business and financial risk, so
as financial risk increases, beta equity increases,
Keg increases and WACC increases.
The key question is which has the greater effect,
the reduction in the WACC caused by having a
greater amount of cheaper debt or the increase in
the WACC caused by the increase in the financial
risk. To answer this we have to turn to the various
theories that have developed over time in relation to
this topic.

The Theories of Capital structure:
1. M + M (No Tax): Cheaper Debt = Increase in
Financial Risk / Keg
2. M + M (With Tax): Cheaper Debt > Increase in
Financial Risk / Keg C
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structure
Which has the greatest effect on the WACC?
The reduction in
WACC caused by
the cheaper debt
The increase
in WACC caused
by the increase
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and keg
sTudenT ACCounTAnT 06/2009
79
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3. Traditional Theory: The WACC is U shaped, ie
there is an optimum gearing ratio
4. The Pecking Order: No theorised process; simply
the line of least resistance first internally generated
funds, then debt and finally new issue of equity.
modigliani and millers no-tax model
In 1958, Modigliani and Miller stated that,
assuming a perfect capital market and ignoring
taxation, the WACC remains constant at all levels
of gearing. As a company gears up, the decrease
in the WACC caused by having a greater amount of
cheaper debt is exactly offset by the increase in the
WACC caused by the increase in the cost of equity
due to financial risk. The WACC remains constant
at all levels of gearing thus the market value of the
company is also constant. Therefore a company
can not reduce its WACC by altering its gearing
(Figure 1 on page 84).
The cost of equity is directly linked to the level of
gearing. As gearing increases, the financial risk to
shareholders increases, therefore Keg increases.
Summary: Benefits of cheaper debt = Increase in
Keg due to increasing financial risk.
The WACC, the total value of the company and
shareholder wealth are constant and unaffected by
gearing levels. No optimal capital structure exists.
modigliani and millers with-tax model
In 1963, when Modigliani and Miller admitted
corporate tax into their analysis, their conclusion
altered dramatically. As debt became even cheaper
(due to the tax relief on interest payments), cost
of debt falls significantly from Kd to Kd(1-t). Thus,
the decrease in the WACC (due to the even cheaper
debt) is now greater than the increase in the WACC
(due to the increase in the financial risk/Keg).
Thus, WACC falls as gearing increases. Therefore,
if a company wishes to reduce its WACC, it should
borrow as much as possible (Figure 2 on page 84).
Summary: Benefits of cheaper debt > Increase in
Keg due to increasing financial risk.
Companies should therefore borrow as much
as possible. Optimal capital structure is 99.99%
debt finance.
market imperfections
There is clearly a problem with Modigliani and
Millers with-tax model, because companies capital
structures are not almost entirely made up of debt.
Companies are discouraged from following this
recommended approach because of the existence
of factors like bankruptcy costs, agency costs and
tax exhaustion. All factors which Modigliani and
Miller failed to take in account.
bankruptcy costs
Modigliani and Miller assumed perfect capital
markets; therefore, a company would always
be able to raise funding and avoid bankruptcy.
In the real world, a major disadvantage of a
company taking on high levels of debt is that
there is a significant possibility of the company
defaulting on its increased interest payments and
hence being declared bankrupt. If shareholders
and debt-holders become concerned about the
possibility of bankruptcy risk, they will need to be
compensated for this additional risk. Therefore, the
cost of equity and the cost of debt will increase,
WACC will increase and the share price reduces.
It is interesting to note that shareholders suffer a
higher degree of bankruptcy risk as they come last
in the creditors hierarchy on liquidation.
If this with-tax model is modified to take into
account the existence of bankruptcy risks at high
levels of gearing, then an optimal capital structure
emerges which is considerably below the 99.99%
level of debt previously recommended.
80 TeChniCAl
Tax exhaustion
The fact that interest is tax-deductible means that
as a company gears up, it generally reduces its
tax bill. The tax relief on interest is called the tax
shield because as a company gears up, paying
more interest, it shields more of its profits from
corporate tax. The tax advantage enjoyed by debt
over equity means that a company can reduce its
WACC and increases its value by substituting debt
for equity, providing that interest payments remain
tax deductible.
However, as a company gears up, interest
payments rise, and reach a point that they are equal
to the profits from which they are to be deducted;
therefore, any additional interest payments beyond
this point will not receive any tax relief.
This is the point where companies become
tax-exhausted, ie interest payments are no
longer tax deductible, as additional interest
payments exceed profits and the cost of debt rises
significantly from Kd(1-t) to Kd. Once this point
is reached, debt loses its tax advantage and a
company may restrict its level of gearing.
The traditional view

Agency costs
Agency costs arise out of what is known as the
principal-agent problem. In most large companies,
the finance providers (principals) are not able to
actively manage the company. They employ agents
(managers) and it is possible for these agents to act
in ways which are not always in the best interest of
the equity or debt-holders.
Since we are currently concerned with the issue of
debt, we will assume there is no potential conflict of
interest between shareholders and the management
and that the managements primary objective is
the maximisation of shareholder wealth. Therefore,
the management may make decisions that benefit
the shareholders at the expense of the debt-holders.
Management may raise money from debt-holders
stating that the funds are to be invested in a low-risk
project, but once they receive the funds they decide
to invest in a high risk/high return project. This
action could potentially benefit shareholders as
they may benefit from the higher returns, but the
debt-holders would not get a share of the higher
returns since their returns are not dependent on
company performance. Thus, the debt-holders do
not receive a return which compensates them for
the level of risk.
To safeguard their investments, debt-holders
often impose restrictive covenants in the loan
agreements that constrain managements freedom
of action. These restrictive covenants may limit
how much further debt can be raised, set a target
gearing ratio, set a target current ratio, restrict
the payment of excessive dividends, restrict the
disposal of major assets or restrict the type of
activity the company may engage in.
As gearing increases, debt-holders would want
to impose more constrains on the management to
safeguard their increased investment. Extensive
covenants reduce the companys operating freedom,
investment flexibility (positive NPV projects may
have to be forgone) and may lead to a reduction in
share price. Management do not like restrictions
placed on their freedom of action. Thus, they
generally limit the level of gearing to limit the level
of restrictions imposed on them.
Cost of
capital
Kd
Ke
X Level of gearing
WACC
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sTudenT ACCounTAnT 06/2009
81
The WACC will initially fall, because the benefits of
having a greater amount of cheaper debt outweigh
the increase in cost of equity due to increasing
financial risk. The WACC will continue to fall until
it reaches its minimum value, ie the optimal
capital structure represented by the point X.
benefts of cheaper debt > increase in keg due to
increasing fnancial risk
If the company continues to gear up, the WACC
will then rise as the increase in financial risk/Keg
outweighs the benefit of the cheaper debt. At very
high levels of gearing, bankruptcy risk causes the
cost of equity curve to rise at a steeper rate and
also causes the cost of debt to start to rise.
increase in keg due to fnancial and bankruptcy risk >
benefts of cheaper debt
Shareholder wealth is affected by changing the
level of gearing. There is an optimal gearing level
at which WACC is minimised and the total value
of the company is maximised. Financial managers
have a duty to achieve and maintain this level of
gearing. While we accept that the WACC is probably
U-shaped for companies generally, we cannot
precisely calculate the best gearing level (ie there
is no analytical mechanism for finding the optimal
capital structure). The optimum level will differ from
one company to another and can only be found by
trial and error.
pecking order theory
The pecking order theory is in sharp contrast with
the theories that attempt to find an optimal capital
structure by studying the trade-off between the
advantages and disadvantages of debt finance. In
this approach, there is no search for an optimal
capital structure. Companies simply follow an
established pecking order which enables them to
raise finance in the simplest and most efficient
manner, the order is as follows:
1. Use all retained earnings available;
2. Then issue debt;
3. Then issue equity, as a last resort.
The justifications that underpin the pecking order
are threefold:
Companies will want to minimise issue costs.
Companies will want to minimise the time and
expense involved in persuading outside investors
of the merits of the project.
The existence of asymmetrical information and
the presumed information transfer that result
from management actions.
We shall now review each of these justifications in
more detail.
Minimise issue costs
1. Retained earnings have no issue costs as the
company already has the funds
2. Issuing debt will only incur moderate issue costs
3. Issuing equity will incur high levels of issue costs
Minimise the time and expense involved in persuading
outside investors
1. As the company already has the retained
earnings, it does not have to spend any time
persuading outside investors
2. The time and expense associated with issuing
debt is usually significantly less than that
associated with a share issue
The existence of asymmetrical information
This is a fancy term that tells us that managers
know more about their companies prospects
than the outside investors/the markets. Managers
know all the detailed inside information, whilst
the markets only have access to past and publicly
available information. This imbalance in information
(asymmetric information) means that the actions
of managers are closely scrutinised by the markets.
Their actions are often interpreted as the insiders
view on the future prospects of the company. A good
example of this is when managers unexpectedly
increase dividends, as the investors interpret this as
a sign of an increase in management confidence in
the future prospects of the company thus the share
price typically increases in value.
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82 TeChniCAl
Suppose that the managers are considering
how to finance a major new project which has
been disclosed to the market. However managers
have had to withhold the inside scoop on the new
technology associated with the project, due to the
competitive nature of their industry. Thus the market
is currently undervaluing the project and the shares
of the company. The management would not want
to issue shares, when they are undervalued, as this
would result in transferring wealth from existing
shareholders to new shareholders. They will want to
finance the project through retained earnings so that,
when the market finally sees the true value of the
project, existing shareholders will benefit. If additional
funds are required over and above the retained
earnings, then debt would be the next alternative.
When managers have favourable inside
information, they do not want to issue shares
because they are undervalued. Thus it would
be logical for outside investors to assume that
managers with unfavourable inside information would
want to issue share as they are overvalued. Therefore
an issue of equity by a company is interpreted as
a sign the management believe that the shares are
overvalued. As a result, investors may start to sell
the companys shares, causing the share price to fall.
Therefore the issue of equity is a last resort, hence
the pecking order; retained earnings, then debt, with
the issue of equity a definite last resort.
One implication of pecking order theory that we
would expect is that highly profitable companies
would borrow the least, because they have higher
levels of retained earnings to fund investment
projects. Baskin (1989) found a negative correlation
between high profit levels and high gearing levels.
This finding contradicts the idea of the existence of
an optimal capital structure and gives support to
the insights offered by pecking order theory.
Another implication is that companies should
hold cash for speculative reasons, they should
built up cash reserves, so that if at some point in
the future the company has insufficient retained
earnings to finance all positive NPV projects, they
use these cash reserves and therefore not need to
raise external finance.
ConClusion
As the primary financial objective is to maximise
shareholder wealth, then companies should seek
to minimise their weighted average cost of capital
(WACC). In practical terms, this can be achieved
by having some debt in the capital structure,
since debt is relatively cheaper than equity, while
avoiding the extremes of too little gearing (WACC
can be decreased further) or too much gearing (the
company suffers from bankruptcy costs, agency
costs and tax exhaustion). Companies should
pursue sensible levels of gearing.
Companies should be aware of the pecking order
theory which takes a totally different approach, and
ignores the search for an optimal capital structure.
It suggests that when a company wants to raise
finance it does so in the following pecking order:
first is retained earnings, then debt and finally
equity as a last resort.
Patrick Lynch is a lecturer at Dublin Business School
referenCes
Watson D and Head A, Corporate Finance:
Principles and Practice, 4th edition, FT
Prentice Hall
Head A, ACCA Past Papers for F9, Pilot Paper Q1
and June 08 Q2
Brealey and Myers, Principles of Corporate Finance,
6th edition, McGraw Hill
Glen Arnold, Corporate Financial Management, 2nd
edition, FT Prentice Hall
J.M. Samuels, F.M. Wilkes and R.E. Brayshaw,
Financial Management & Decision Making,
International Thomson Publishing Company
Power T, Walsh S & O Meara P, Financial
Management, Gill & Macmillan.
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sTudenT ACCounTAnT 06/2009
83
Value of
company
Cost %
Keg
WACC
Kd
Keu
10%
Level of gearing Level of gearing
Vu Vg
$
figure 1: modigliAni And miller no-TAx model
Value of
company
Cost %
Keg
WACC
Kd (1-t)
Keu
7%
Level of gearing Level of gearing
Vu
Vg
$
figure 2: modigliAni And miller WiTh-TAx model
key:
Keu = Cost of equity ungeared Vu = Value ungeared
Keg = Cost of equity geared Vg = Value geared
84 TeChniCAl
54 student accountant May 2004
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port folio theory
The risk-return relationship is explained in
two separate back-to-back articles in this
months issue. This approach has been taken
as the risk-return story is included in two
separate but interconnected parts of the
syllabus. We need to understand the
principles that underpin portfolio theory,
before we can appreciate the creation of the
Capital Asset Pricing Model (CAPM).
In this article on portfolio theory we will
review the reason why investors should
establish portfolios. This is neatly captured in
the old saying dont put all your eggs in one
basket. The logic is that an investor who puts
all of their funds into one investment risks
everything on the performance of that
individual investment. A wiser policy would
be to spread the funds over several
investments (establish a portfolio) so that the
unexpected losses from one investment may
be offset to some extent by the unexpected
gains from another. Thus the key motivation
in establishing a portfolio is the reduction of
risk. We shall see that it is possible to
maintain returns (the good) while reducing
risk (the bad).
LEARNING OBJECTIVES
By the end of this article you should be
able to:
understand an NPV calculation from an
investors perspective
calculate the expected return and
standard deviation of an individual
investment and for two asset portfolios
understand the significance of correlation
in risk reduction
prepare a summary table
understand and explain the nature of risk
as portfolios become larger
understand and be able to explain why
the market only gives a return for
systematic risk.
UNDERSTANDING AN NPV CALCULATION
FROM AN INVESTORS PERSPECTIVE
J oe currently has his savings safely deposited
in his local bank. He is considering buying
some shares in A plc. He is trying to
determine if the shares are going to be a
viable investment. He asks the following
questions: What is the future expected return
from the shares? What extra return would I
require to compensate for undertaking a risky
investment? Let us try and find the answers
to J oes questions. First we turn our attention
to the concept of expected return.
EXPECTED RETURN
Investors receive their returns from shares in
the form of dividends and capital gains/
losses. The formula for calculating the annual
return on a share is:
Annual return = D
1
+ (P
1
- P
0
)
P
0
where:
D
1
= dividend per share
P
1
= share price at the end of a year
P
0
= share price at the start of a year.
Suppose that a dividend of 5p per share was
paid during the year on a share whose value
was 100p at the start of the year and 117p
at the end of the year:
Annual return =
5 + (117 - 100) 100 = 22%
100
The total return is made up of a 5% dividend
yield and a 17% capital gain. We have just
calculated a historical return, on the basis
that the dividend income and the price at the
end of year one is known. However,
calculating the future expected return is a lot
more difficult because we will need to
estimate both next years dividend and the
share price in one years time. Analysts
normally consider the different possible
returns in alternate market conditions and try
and assign a probability to each. The table in
Example 1 shows the calculation of the
expected return for A plc. The current share
price of A plc is 100p and the estimated
returns for next year are shown. The
investment in A plc is risky. Risk refers to the
possibility of the actual return varying from
the expected return, ie the actual return may
be 30% or 10% as opposed to the expected
return of 20%.
REQUIRED RETURN
The required return consists of two elements,
which are:
Required return =
Risk-free return + Risk premium
Risk-free return
The risk-free return is the return required by
investors to compensate them for investing
in a risk-free investment. The risk-free return
compensates investors for inflation and
consumption preference, ie the fact that they
are deprived from using their funds while
tied up in the investment. The return on
treasury bills is often used as a surrogate for
the risk-free rate.
Risk premium
Risk simply means that the future actual
return may vary from the expected return. If
an investor undertakes a risky investment he
needs to receive a return greater than the
risk-free rate in order to compensate him. The
more risky the investment the greater the
compensation required. This is not surprising
and it is what we would expect from risk-
averse investors.
t he risk and ret urn relat ionship part 1
relevant t o ACCA Qualificat ion Papers F9 and P4
May 2004 student accountant 55
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Market Estimated Estimated Return % Probability Return %
conditions share price P
1
dividend D
1
probability
Boom 123p 7p 30 0.1 3
Normal 114p 6p 20 0.8 16
Recession 105p 5p 10 0.1 1
Expected return 20%
EXAMPLE 1
The Barclay Capital Equity Gilt Study 2003
The Barclay Capital Study calculated the
average return on treasury bills in the UK
from 1900 to 2002 as approximately 6%. It
also calculated that the average return on the
UK stock market over this period was 11%.
Thus if an investor had invested in shares
that had the same level of risk as the market,
he would have to receive an extra 5% of
return to compensate for the market risk.
Thus 5% is the historical average risk
premium in the UK.
Suppose that J oe believes that the shares in
A plc are twice as risky as the market and that
the use of long-term averages are valid. The
required return may be calculated as follows:
Required = Risk free + Risk
return of A plc return premium
16% = 6% + (5% 2)
Thus 16% is the return that J oe requires to
compensate for the perceived level of risk in A
plc, ie it is the discount rate that he will use
to appraise an investment in A plc.
THE NPV CALCULATION
Suppose that J oe is considering investing
100 in A plc with the intention of selling the
shares at the end of the first year. Assume
that the expected return will be 20% at the
end of the first year. Given that J oe requires a
return of 16% should he invest?
Decision criteria: accept if the NPV is zero or
positive. The NPV is positive, thus J oe should
invest. A positive NPV opportunity is where
the expected return more than compensates
the investor for the perceived level of risk, ie
the expected return of 20% is greater than
the required return of 16%. An NPV
calculation compares the expected and
required returns in absolute terms.
Calculation of the risk premium
Calculating the risk premium is the essential
component of the discount rate. This in turn
makes the NPV calculation possible. To
calculate the risk premium, we need to be
able to define and measure risk.
THE STUDY OF RISK
The definition of risk that is often used in
finance literature is based on the variability
of the actual return from the expected return.
Statistical measures of variability are the
variance and the standard deviation (the
square root of the variance). Returning to the
example of A plc, we will now calculate
the variance and standard deviation of
the returns.
The variance of return is the weighted sum of
squared deviations from the expected return.
The reason for squaring the deviations is to
ensure that both positive and negative
deviations contribute equally to the measure of
variability. Thus the variance represents rates
of return squared. As the standard deviation is
the square root of the variance, its units are in
rates of return. As it is easier to discuss risk as
a percentage rate of return, the standard
deviation is more commonly used to measure
risk. In the exam it is unlikely that you will be
asked to undertake these basic calculations.
The exam questions normally provide you with
the expected returns and standard deviations
of the returns.
Shares in Z plc have the following returns
and associated probabilities:
Probability Return %
0.1 35
0.8 20
0.1 5
Let us then assume that there is a choice of
investing in either A plc or Z plc, which one
should we choose? To compare A plc and Z
plc, the expected return and the standard
deviation of the returns for Z plc will have to
be calculated.
A plc
0 1
Cash flows (100) 120
Discount factor 16% 1 0.862
(100) 103
NPV 3
Market [Actual return Probability
conditions - expected
return]
2
Boom [30 - 20]
2
0.1 10
Normal [20 - 20]
2
0.8 0
Recession [10 - 20]
2
0.1 10
Variance
2
20
Standard deviation = 20 = 4.47
56 student accountant May 2004
The expected return is: (0.1) (35%) + (0.8)
(20%) + (0.1) (5%) = 20%
The variance is: =
2
z
= (0.1) (35% - 20%)
2
+ (0.8) (20% - 20%)
2
+ (0.1) (5% - 20%)
2
= 45%
The standard deviation is:
=
z
= 45 = 6.71%
Summary table
Investment Expected Standard
return deviation
A plc 20% 4.47%
Z plc 20% 6.71%
Given that the expected return is the same for
both companies, investors will opt for the one
that has the lowest risk, ie A plc. The
decision is equally clear where an investment
gives the highest expected return for a given
level of risk. However, these only relate to
specific instances where the investments
being compared either have the same expected
return or the same standard deviation. Where
investments have increasing levels of return
accompanied by increasing levels of standard
deviation, then the choice between
investments will be a subjective decision based
on the investors attitude to risk.
RISK AND RETURN ON TWO-ASSET
PORTFOLIOS
So far we have confined our choice to a single
investment. Let us now assume investments
can be combined into a two-asset portfolio.
The risk-return relationship will now be
measured in terms of the portfolios expected
return and the portfolios standard deviation.
The following table gives information
about four investments: A plc, B plc, C plc,
and D plc. Assume that our investor, J oe has
decided to construct a two-asset portfolio and
that he has already decided to invest 50% of
the funds in A plc. He is currently trying to
decide which one of the other three
investments into which he will invest the
remaining 50% of his funds. See Example 2.
The expected return of a two-asset portfolio
The expected return of a portfolio (Rport) is
simply a weighted average of the expected
returns of the individual investments.
Rport = x.RA + (1 - x).RB
x = the proportion of funds
invested in A
(1 - x) = the proportion of funds
invested in B
RA + B = 0.5 20 + 0.5 20 = 20
RA + C = 0.5 20 + 0.5 20 = 20
RA + D = 0.5 20 + 0.5 20 = 20
Given that the expected return is the same for
all the portfolios, J oe will opt for the portfolio
that has the lowest risk as measured by the
portfolios standard deviation.
The standard deviation of a two-asset portfolio
We can see that the standard deviation of all
the individual investments is 4.47%.
Intuitively, we probably feel that it does not
matter which portfolio J oe chooses, as the
standard deviation of the portfolios should be
the same (because the standard deviations of
the individual investments are all the same).
However, the above analysis is flawed, as
the standard deviation of a portfolio is not
simply the weighted average of the standard
deviation of returns of the individual
investments but is generally less than the
weighted average. So what causes this
reduction of risk? What is the missing factor?
The missing factor is how the returns of the two
investments co-relateor co-vary, ie move up or
down together. There are two ways to measure
Return on investments (%)
Market conditions Probability A plc B plc C plc D plc
Boom 0.1 30 30 10 10
Normal 0.8 20 20 20 22.5
Recession 0.1 10 10 30 10
Expected return 20 20 20 20
Standard deviation 4.47 4.47 4.47 4.47
covariability. The first method is called the
covariance and the second method is called the
correlation coefficient. Before we perform these
calculations let us review the basic logic behind
the idea that risk may be reduced depending on
how the returns on two investments co-vary.
Portfolio A+B perfect positive correlation
The returns of A and B move in perfect lock
step, (when the return on A goes up to 30%,
the return on B also goes up to 30%, when
the return on A goes down to 10%, the return
on B also goes down to 10%), ie they move
in the same direction and by the same
degree. See Example 3.
This is the most basic possible example
of perfect positive correlation, where the
forecast of the actual returns are the same in
all market conditions for both investments
and thus for the portfolio (as the portfolio
return is simply a weighted average). Hence
there is no reduction of risk. The portfolios
standard deviation under this theoretical
extreme of perfect positive correlation is a
simple weighted average of the standard
deviations of the individual investments:
port (A,B) = 4.47 0.5 + 4.47 0.5
= 4.47
Portfolio A+C perfect negative correlation
The returns of A and C move in equal but
opposite ways (when the return on A goes up
EXAMPLE 2
Return on investments (%)
Market Conditions A plc B plc Portfolio A + B
Boom 30 30 30
Normal 20 20 20
Recession 10 10 10
EXAMPLE 3
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to 30%, the return on C goes down to 10%,
when the return on A goes down to 10%, the
return on C goes up to 30%). See Example 4.
This is the utopian position, ie where the
unexpected returns cancel out against each
other resulting in the expected return. If the
forecast actual return is the same as the
expected return under all market conditions,
then the risk of the portfolio has been
reduced to zero. This is the only situation
where the portfolios standard deviation can
be calculated as follows:
port (A,C) = 4.47 0.5 - 4.47 0.5 = 0
Portfolio A+D no correlation
The returns of A and D are independent from
each other. Sometimes they move together,
sometimes they move in opposite directions
(when the return on A goes up to 30%, the
return on D goes down to 10%, when the
return on A goes down to 10%, the return on
D also goes down to 10%). See Example 5.
The forecast actual return is the same as
the expected return under normal market
conditions and almost the same under boom
market conditions (20 v21.25). Therefore,
we can say that the forecast actual and
expected returns are almost the same in two
out of the three conditions. This compares
with only one condition when there is perfect
positive correlation (no reduction of risk) and
all three conditions when there is perfect
Return on investments (%)
Market Conditions A plc C plc Portfolio A + C
Boom 30 10 20
Normal 20 20 20
Recession 10 30 20
EXAMPLE 4
negative correlation (where risk may be
eliminated). Therefore, when there is no
correlation between the returns on investments
this results in the partial reduction of risk.
Measuring covariability
Covariability can be measured in absolute
terms by the covariance or in relative terms
by the correlation coefficient.
The covariance
A positive covariance indicates that the
returns move in the same directions as in
A and B.
A negative covariance indicates that the
returns move in opposite directions as in
A and C.
A zero covariance indicates that the
returns are independent of each other as
in A and D.
For completeness, the calculations of the
covariances from raw data are included.
However, this approach is not required in the
exam, as the exam questions will generally
contain the covariances when required.
Return on investments (%)
Market Conditions A plc D plc Portfolio A + D
Boom 30 10 20
Normal 20 22.5 21.25
Recession 10 10 10
EXAMPLE 5
THE COVARIANCE OF A + B
Probability [Actual - [Actual -
Expected Expected
in A] in B]
0.1 [30 - 20] [30 - 20] 10
0.8 [20 - 20] [20 - 20] 0
0.1 [10 - 20] [10 - 20] 10
20
THE COVARIANCE OF A + C
Probability [Actual - [Actual -
Expected Expected
in A] in C]
0.1 [30 - 20] [10 - 20] -10
0.8 [20 - 20] [20 - 20] 0
0.1 [10 - 20] [30 - 20] -10
-20
THE COVARIANCE OF A + D
Probability [Actual - [Actual -
Expected Expected
in A] in D]
0.1 [30 - 20] [10 - 20] -10
0.8 [20 - 20] [22.5 - 20] 0
0.1 [10 - 20] [10 - 20] 10
0
However, knowledge of the covariance
formula is useful:
Cov
a,b
=
a,b

b
The covariance of returns in A and B is the
product of the correlation coefficient (
A,B
)
between the returns in A and B and the
standard deviation of returns for both A and B.
The correlation coefficient
Using the covariance formula, we can easily
determine the formula for the correlation
coefficient.

A,B
= Cov a,b

b
The correlation coefficient as a relative
measure of covariability expresses the strength
of the relationship between the returns on two
investments. It is strictly limited to a range
from -1 to +1. See Example 6.
58 student accountant May 2004
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In reality, the correlation coefficient between
returns on investments tends to lie between 0
and +1. It is the norm in a two-asset portfolio
to achieve a partial reduction of risk (the
standard deviation of a two-asset portfolio is
less than the weighted average of the standard
deviation of the individual investments).
Therefore, we will need a new formula to
calculate the risk (standard deviation of
returns) on a two-asset portfolio. The formula
will obviously take into account the risk
(standard deviation of returns) of both
investments but will also need to incorporate
a measure of covariability as this influences
the level of risk reduction.
The formulae for the standard deviation of
returns of a two-asset portfolio
Version 1
port (A,B) =
2
a
x
2
+
2
b
(1 - x)
2
+ 2x (1 - x)cov(R
A
,R
B
)
Version 2
port (A,B) =
2
a
x
2
+
2
b
(1 - x)
2
+ 2x (1 - x)
ab

b
(given on formula sheet in the exam)
The first two terms deal with the risk of the
individual investments. The third term is the
most interesting one as it considers the way in
which the returns on each pair of investments
co-vary. The covariance term is multiplied by
twice the proportions invested in each
investment, as it considers the covariance of A
and B and of B and A, which are of course the
same. Note the only difference between the
two versions is that the covariance in the
second version is broken down into its
constituent parts, ie cov
a,b
=
a,b

b
Based on the first version of the formula:
port (A,B) = 4.47
2
0.5
2
+ 4.47
2
0.5
2
+ 2 0.5 0.5 20
= 4.47
The second version of the formula is the one
that is nearly always used in exams and it is
the one that is given on the formula sheet.
port (A,B) = 4.47
2
0.5
2
+ 4.47
2
0.5
2
+ 2 0.5 0.5 +1
4.47 4.47
= 4.47
port (A,C) = 4.47
2
0.5
2
+ 4.47
2
0.5
2
+ 2 0.5 0.5 -1
4.47 4.47
= 0.00
port (A,D) = 4.47
2
0.5
2
+ 4.47
2
0.5
2
+ 2 0.5 0.5 0
4.47 4.47
= 3.16
Summary table
Investment Expected Standard
return (%) deviation (%)
Port A + B 20 4.47
Port A + C 20 0.00
Port A + D 20 3.16
A + C is the most efficient portfolio as it has
the lowest level of risk for a given level of return.
Perfect negative correlation does not occur
between the returns on two investments in the
real world, ie risk cannot be eliminated,
although it is useful to know the theoretical
extremes. However, as already stated, in reality
the correlation coefficients between returns on
investments tend to lie between 0 and +1.
Indeed, the returns on investments in the same
industry tend to have a high positive correlation
of approximately 0.9, while the returns on
investments in different industries tend to have
a low positive correlation of approximately 0.2.
Thus investors have a preference to invest in
different industries thus aiming to create a well-
diversified portfolio, ensuring that the maximum
risk reduction effect is obtained.
Based on our initial understanding of the
risk-return relationship, if investors wish to
reduce their risk they will have to accept a
reduced return. However, portfolio theory shows
us that it is possible to reduce risk without
havinga consequential reduction in return.
This can be proved quite easily, as a portfolios
expected return is equal to the weighted
average of the expected returns on the
individual investments, whereas a portfolios
risk is less than the weighted average of the risk
of the individual investments due to the risk
reduction effect of diversification caused by the
correlation coefficient being less than +1.
We can see from Portfolio A + D above
where the correlation coefficient was zero,
that by investing in just two investments we
can reduce the risk from 4.47% to just
3.16% (a reduction of 1.31 percentage
points). Imagine how much risk we could
have diversified away, had we created a large
portfolio of say 500 different investments or
indeed 5,000 different investments.
THE PROOF THAT LARGE PORTFOLIOS
INCREASE THE RISK REDUCTION EFFECT
As portfolios increase in size, the opportunity
for risk reduction also increases. We are
about to review the mathematical proof of
this statement. Remember that the SFM
paper is not a mathematics paper, so we do
not have to work through the derivation of any
formulae from first principles. We just need to
understand the conclusion of the analysis.
Suppose that we invest equal amounts in
a very large portfolio. Then the formula for
the variance of the portfolio becomes:

p
2
=1
2
+ N -1 cov (R
I
, R
J
)
N N
The first term is the average variance of the
individual investments and the second term is
the average covariance. As N becomes very
large the first term tends towards zero, while
the second term will approach the average
covariance.
In a large portfolio, the individual risk of
investments can be diversified away. The
individual risk of investments can also be
called the specific risk but is normally called
the unsystematic risk. However, the risk
contributed by the covariance will remain. We
already know that the covariance term reflects
the way in which returns on investments move
together. The returns on most investments will
tend to move in the same direction to a greater
or lesser degree because of common macro-
economic factors affecting all investments. The
risk contributed by the covariance is often
called the market or systematic risk. This risk
cannot be diversified away.

A,C
= -20 = -1
A,D
= 0 = 0
A,B
= 20 =+1
4.47.4.47 4.47.4.47 4.47.4.47
-1 0 +1
Perfect negative Zero Perfect positive
correlation correlation correlation
Maximum reduction Partial reduction No reduction
The greater the risk of diversification
EXAMPLE 6
May 2004 student accountant 59
The risk reduction is quite dramatic. We find
that two thirds of an investments total risk can
be diversified away, while the remaining one
third of risk cannot be diversified away. A
well-diversified portfolio is very easy to obtain,
all we have to do is buy a portion of a larger
fund that is already well-diversified, like buying
into a unit trust or a tracker fund.
Remember that the real joy of
diversification is the reduction of risk without
any consequential reduction in return. If we
assume that investors are rational and risk
averse, their portfolios should be
well-diversified, ie only suffer the type of risk
that they cannot diversify away (systematic
risk).
An investor who has a well-diversified
portfolio only requires compensation for the
risk suffered by their portfolio (systematic
risk). Therefore we need to re-define our
understanding of the required return:
Required return = Risk free return +
Systematic risk premium
Investors who have well-diversified portfolios
dominate the market. They only require a
return for systematic risk. Thus we can now
appreciate the statement that the market
only gives a return for systematic risk.
The next question will be how do we
measure an investments systematic risk? The
answer to this question will be given in the
following article on the Capital Asset Pricing
Model (CAPM).
10 KEY POINTS TO REMEMBER
1 The expected return on a share consists
of a dividend yield and a capital gain/loss
in percentage terms.
2 The required return on a risky investment
consists of the risk-free rate (which
includes inflation) and a risk premium.
3 Total risk is normally measured by the
standard deviation of returns ().
4 Portfolio theory demonstrates that it is
possible to reduce risk without having a
consequential reduction in return, ie the
portfolios expected return is equal to the
weighted average of the expected returns
on the individual investments, while the
portfolio risk is normally less than the
weighted average of the risk of the
individual investments.
5 The extent of the risk reduction is
influenced by the way the returns on the
investments co-vary. Covariability is
normally measured in the exams by the
correlation coefficient.
6 In reality, the correlation coefficient
between returns on investments tend to
lie between 0 and +1. Thus total risk can
only be partially reduced, not eliminated.
reality
-1 0 +1
Maximum Partial No
reduction reduction reduction
7 A portfolios total risk consists of
unsystematic and systematic risk.
However, a well-diversified portfolio only
suffers from systematic risk, as the
unsystematic risk has been diversified
away.
8 An investor who holds a well-diversified
portfolio will only require a return for
systematic risk. Thus their required return
consists of the risk-free rate plus a
systematic risk premium.
9 Investors who have well-diversified
portfolios dominate the market. Thus
the market only gives a return for
systematic risk.
10 The preparation of a summary table and
the identification of the most efficient
portfolio (if possible) is an essential exam
skill.
Patrick Lynch is a lecturer at FTC London
Total risk - standard deviation =
Unsystematic Systematic
risk risk
Company General
specific factors economic factors
Can be eliminated Cannot be eliminated
EXAMPLE 7
SYSTEMATIC AND UNSYSTEMATIC RISK
The total risk of a portfolio (as measured by
the standard deviation of returns) consists of
two types of risk: unsystematic risk and
systematic risk. If we have a large enough
portfolio it is possible to eliminate the
unsystematic risk. However, the systematic
risk will remain. See Example 7.
Unsystematic/Specific risk: refers to the
impact on a companys cash flows of largely
random events like industrial relations
problems, equipment failure, R&D
achievements, changes in the senior
management team etc. In a portfolio, such
random factors tend to cancel as the number
of investments in the portfolio increase.
Systematic/Market risk: general
economic factors are those macro-economic
factors that affect the cash flows of all
companies in the stock market in a consistent
manner, eg a countrys rate of economic
growth, corporate tax rates, unemployment
levels, and interest rates. Since these factors
cause returns to move in the same direction
they cannot cancel out. Therefore, systematic/
market risk remains present in all portfolios.
WHAT IS THE IDEAL NUMBER OF
INVESTMENTS IN A PORTFOLIO?
Ideally, the investor should be fully-diversified,
ie invest in every company quoted in the stock
market. They should hold the Market portfolio
in order to gain the maximum risk reduction
effect. The good news is that we can construct
a well-diversified portfolio, ie a portfolio that will
benefit from most of the risk reduction effects of
diversification by investing in just 15 different
companies in different sectors of the market.
t
e
c
h
n
i
c
a
l

RELEVANT TO ACCA QUALIFICATION PAPER F9
Studying Paper F9
Performance objectives 15 and 16 are relevant to this exam

2011 ACCA
Introduction to Islamic finance
The Paper F9 syllabus now contains a section on Islamic finance (Section E3). All
components of this section will be examined at intellectual level 1, knowledge and
comprehension.

Although the concept of Islamic finance can be traced back about 1,400 years, its
recent history can be dated to the 1970s when Islamic banks in Saudi Arabia and
the United Arab Emirates were launched. Bahrain and Malaysia emerged as
centres of excellence in the 1990s. It is now estimated that worldwide around US
$1 trillion of assets are managed under the rules of Islamic finance.

Islamic finance rests on the application of Islamic law, or Shariah, whose primary
sources are the Qur'an and the sayings of the Prophet Muhammad. Shariah, and
very much in the context of Islamic finance, emphasises justice and partnership.

The main principles of Islamic finance are that:
Wealth must be generated from legitimate trade and asset-based investment.
(The use of money for the purposes of making money is expressly forbidden.)
Investment should also have a social and an ethical benefit to wider society
beyond pure return.
Risk should be shared.
All harmful activities (haram) should be avoided.

The prohibitions
The following activities are prohibited:
Charging and receiving interest (riba). The idea of a lender making a straight
interest charge, irrespective of how the underlying assets fare, transgresses
the concepts of risk sharing, partnership and justice. It represents the money
itself being used to make money. It also prohibits investment in companies
that have too much borrowing (typically defined as having debt totalling more
than 33% of the firms stock market value over the last 12 months).
Investments in businesses dealing with alcohol, gambling, drugs, pork,
pornography or anything else that the Shariah considers unlawful or
undesirable (haram).
Uncertainty, where transactions involve speculation, or extreme risk. This is
seen as being akin to gambling. This prohibition, for example, would rule out
speculating on the futures and options markets. Mutual insurance (which
relates to uncertainty) is permitted if it is related to reasonable, unavoidable
business risk. It is based upon the principle of shared responsibility for
shared financial security, and that members contribute to a mutual fund, not
for profit, but in case one of the members suffers misfortune.
Uncertainty about the subject matter and terms of contracts this includes a
prohibition on selling something that one does not own. There are special
financial techniques available for contracting to manufacture a product for a
customer. This is necessary because the product does not exist, and
therefore cannot be owned, before it is made. A manufacturer can promise to
produce a specific product under certain agreed specifications at a
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determined price and on a fixed date. Specifically, in this case, the risk taken
is by a bank which would commission the manufacture and sell the goods on
to a customer at a reasonable profit for undertaking this risk. Once again the
bank is exposed to considerable risk. Avoiding contractual risk in this way,
means that transactions have to be explicitly defined from the outset.
Therefore, complex derivative instruments and conventional short sales or
sales on margin are prohibited under Islamic finance.

The permitted
As mentioned above, the receipt of interest is not allowed under Shariah.
Therefore, when Islamic banks provide finance they must earn their profits by other
means. This can be through a profit-share relating to the assets in which the
finance is invested, or can be via a fee earned by the bank for services provided.
The essential feature of Shariah is that when commercial loans are made, the
lender must share in the risk. If this is not so then any amount received over the
principal of the loan will be regarded as interest.

There are a number of Islamic financial instruments mentioned in the Paper F9
syllabus and which can provide Shariah-compliant finance:
Murabaha is a form of trade credit for asset acquisition that avoids the
payment of interest. Instead, the bank buys the item and then sells it on to
the customer on a deferred basis at a price that includes an agreed mark-up
for profit. The mark-up is fixed in advance and cannot be increased, even if
the client does not take the goods within the time agreed in the contract.
Payment can be made by instalments. The bank is thus exposed to business
risk because if its customer does not take the goods, no increase in the mark-
up is allowed and the goods, belonging to the bank, might fall in value.
Ijara is a lease finance agreement whereby the bank buys an item for a
customer and then leases it back over a specific period at an agreed amount.
Ownership of the asset remains with the lessor bank, which will seek to
recover the capital cost of the equipment plus a profit margin out of the
rentals payable.

Emirates Airlines regularly uses Ijara to finance its expansion

Another example of the Ijara structure is seen in Islamic mortgages. In 2003, HSBC
was the first UK clearing bank to offer mortgages in the UK designed to comply
with Shariah. Under HSBCs Islamic mortgage, the bank purchases a house then
leases or rents it back to the customer. The customer makes regular payments to
cover the rental for occupying or otherwise using the property, insurance
premiums to safeguard the property, and also amounts to pay back the sum
borrowed. At the end of the mortgage, title to the property can be transferred to
the customer. The demand for Islamic mortgages in the UK has shown
considerable growth.

Mudaraba is essentially like equity finance in which the bank and the
customer share any profits. The bank will provide the capital, and the
borrower, using their expertise and knowledge, will invest the capital. Profits
will be shared according to the finance agreement, but as with equity finance
there is no certainty that there will ever be any profits, nor is there certainty
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that the capital will ever be recovered. This exposes the bank to considerable
investment risk. In practice, most Islamic banks use this is as a form of
investment product on the liability side of their statement of financial
position, whereby the investor or customer (as provider of capital) deposits
funds with the bank, and it is the bank that acts as an investment manager
(managing the funds).
Musharaka is a joint venture or investment partnership between two parties.
Both parties provide capital towards the financing of projects and both
parties share the profits in agreed proportions. This allows both parties to be
rewarded for their supply of capital and managerial skills. Losses would
normally be shared on the basis of the equity originally contributed to the
venture. Because both parties are closely involved with the ongoing project
management, banks do not often use Musharaka transactions as they prefer to
be more hands off.
Sukuk is debt finance. A conventional, non-Islamic bond or debenture is a
simple debt, and the bondholders return for providing capital to the bond
issuer takes the form of interest. Islamic bonds, or sukuk, cannot bear
interest. So that the sukuk are Shariah-compliant, the sukuk holders must
have a proprietary interest in the assets which are being financed. The sukuk
holders return for providing finance is a share of the income generated by
the assets. Most sukuk, are asset-based, not asset-backed, giving investors
ownership of the cash flows but not of the assets themselves. Asset-based is
obviously more risky than asset backed in the event of a default.

There are a number of ways of structuring sukuk, the most common of which are
partnership (Musharaka) or lease (Ijara) structures. Typically, an issuer of the sukuk
would acquire property and the property will generally be leased to tenants to
generate income. The sukuk, or certificates, are issued by the issuer to the sukuk
holders, who thereby acquire a proprietary interest in the assets of the issuer. The
issuer collects the income and distributes it to the sukuk holders. This entitlement
to a share of the income generated by the assets can make the arrangement
Shariah compliant.

The cash flows under some of the approaches described above might be the same
as they would have been for the standard western practice paying of interest on
loan finance. However, the key difference is that the rate of return is based on the
asset transaction and not based on interest on money loaned. The difference is in
the approach and not necessarily on the financial impact. In Islamic finance the
intention is to avoid injustice, asymmetric risk and moral hazard (where the party
who causes a problem does not suffer its consequences), and unfair enrichment at
the expense of another party.

Advocates of Islamic finance claim that it avoided much of the recent financial
turmoil because of its prohibitions on speculation and uncertainty, and its
emphasis on risk sharing and justice. That does not mean, of course, that the
system is free from all risk (nothing is), but if you are more exposed to a risk you
are likely to behave more prudently.



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The Shariah board
The Shariah board is a key part of an Islamic financial institution. It has the
responsibility for ensuring that all products and services offered by that institution
are compliant with the principles of Shariah law. Boards are made up of a
committee of Islamic scholars and different institutions can have different boards.

An institutions Shariah board will review and oversee all new product offerings
before they are launched. It can also be asked to deliver judgments on individual
cases referred to it, such as whether a specific customers business proposals are
Shariah-compliant.

The demand for Shariah-compliant financial services is growing rapidly and the
Shariah board can also play an important role in helping to develop new financial
instruments and products to help the institution to adapt to new developments,
industry trends, and customers requirements. The ability of scholars to make
pronouncements using their own expertise and based on Shariah, highlights the
fact that Islamic finance remains innovative and able to evolve, while crucially
remaining within the bounds of core principles.

Developments
Perhaps the main current problem is the absence of a single, worldwide body to
set standards for Shariah compliance, meaning that there is no ultimate authority
for Shariah compliance. Each Islamic banks adherence to the principles of Shariah
law is governed by its own Shariah board. Some financial aspects of Shariah law,
and, therefore, the legitimacy of the financial instruments used can be open to
interpretation, with the result that some Islamic banks may agree transactions that
would be rejected by other banks. Therefore, a contract might unexpectedly be
declared incompatible with Shariah law and thus be invalid.

In Malaysia, the worlds biggest market for sukuk, the Shariah advisory council,
ensures consistency to help creating certainty across the market. Some industry
bodies, notably the Accounting and Auditing Organisation for Islamic Financial
Institutions (AAOIFI) in Bahrain, have also been working towards common
standards. To quote the AAOFI website: AAOIFI is supported by institutional
members (200 members from 45 countries, so far) including central banks,
Islamic financial institutions, and other participants from the international Islamic
banking and finance industry, worldwide. AAOIFI has gained assuring support for
the implementation of its standards, which are now adopted in the Kingdom of
Bahrain, Dubai International Financial Centre, Jordan, Lebanon, Qatar, Sudan and
Syria. The relevant authorities in Australia, Indonesia, Malaysia, Pakistan, Kingdom
of Saudi Arabia, and South Africa have issued guidelines that are based on
AAOIFIs standards and pronouncements.

However, despite these movements towards consistency, some differences between
national jurisdictions are likely to remain.

Ken Garrett is a freelance author and lecturer

RELEVANT TO ACCA QUALIFICATION PAPER F9
Studying Paper F9?
Performance objectives 15 and 16 are relevant to this exam

2011 ACCA
Business finance
Section E of the Paper F9, Financial Management syllabus deals with business
finance: What types of finance? What sources? What mix? Additionally, from June
2011 onwards, there is a section on Islamic finance (see the article in the 9 March
issue of Student Accountant which covers Islamic finance in detail available at:
www.accaglobal.com/students/student_accountant/archive/2011/117/3423853)

The article will first consider a businesss formation and initial growth, then a
company that is well-established and mature, and will look at the financing
choices and decisions that could face it at various stages.

Formation and initial growth.
Many businesses begin with finance contributed by their owners and owners
families. If they start as unincorporated businesses, the distinction between
owners capital and owners loans is almost irrelevant. If it starts as an
incorporated business, or turns into one, then there are important differences
between share capital and loans. Share capital is more or less permanent and can
give suppliers and lenders some confidence that the owners are being serious and
are willing to risk significant resources. If the owners friends and families do not
themselves want to invest (perhaps they have no money to invest) then the owners
will have to look for outside sources of capital. The main sources are:
bank loans and overdrafts
leasing/hire purchase
trade credit
government grants, loans and guarantees
venture capitalists and business angels
invoice discounting and factoring
retained profits.

Bank loans and overdrafts
In the current economic climate, start-up businesses are likely to find it difficult to
raise a bank loan, particularly if the business and its owners have no track record
at all. Banks will certainly require:
A business plan, including cash flow forecasts.
Personal guarantees and charges on personal assets.

The personal guarantees and charges on personal assets get round the companys
limited liability which would otherwise mean that if the company failed, the bank
might be left with nothing. This way the bank can ask the guarantors to pay back
the loans personally, or the bank can seize the charged assets that were used for
security.

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Note that overdrafts are repayable on demand and many banks have a reputation
of pre-emptively withdrawing overdraft facilities, not when a business is in trouble,
but when the bank fears more difficult times ahead.

On a more positive note, where it is known that the need for finance is temporary,
an overdraft might be very suitable because it can be repaid by the borrower at
any time.

Leasing and hire purchase
In financial terms, leasing is very like a bank loan. Instead of receiving cash from
the loan, spending it on buying an asset and then repaying the loan, the leasing
company buys the asset, makes it available to the lessee and charges the lessee a
monthly amount. Leasing can often be cheaper than borrowing because:
Large leasing companies have great bargaining power with suppliers so the
asset costs them less than it would cost the lessee. This can be partially
passed on to the leasee.
Leasing companies have effective ways of disposing of old assets, but lessees
normally do not.
If the lease payments are not made, the leasing company has a form of built-
in security insofar as it can reclaim its asset.
The cost of finance to a large, established leasing company is likely to be
lower than the cost to a start-up company.

It is important for businesses to try to decide whether loan finance or a lease
would be cheaper. (This is a separate topic in the Paper F9 syllabus, but it is not
covered in this article.)

Trade credit
This simply means taking credit from suppliers typically 30 days. That is
obviously a very short period, but it can be very helpful to new businesses.
Typically, credit suppliers to new businesses will want some sort of reference,
either from a bank or from other suppliers (trade references). However, some will
be prepared to offer modest credit initially without references, and as trust grows
this can be increased.

Government grants, loans and guarantees
Governments often encourage the formation of new businesses and, from time to
time and from region to region, help is offered. Government grants are usually
very small, and direct loans are rare because governments see loan provision as
the job of financial institutions.

Currently in the UK, the Government runs the Enterprise Finance Guarantee
Scheme (EFGS). This is a loan guarantee scheme intended to facilitate additional
bank lending to viable small and medium-sized entities (SMEs) with insufficient
security for a normal commercial loan. The borrower must be able to demonstrate
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to the lender that they should be able to repay the loan in full. The Government
provides the lender with a guarantee for which the borrower pays a premium.

The scheme is not a mechanism through which businesses or their owners can
choose to withhold the security a lender would normally lend against; nor is it
intended to facilitate lending to businesses which are not viable and that banks
have declined to lend to on that basis.

EFGS supports lending to viable businesses with an annual turnover of up to
25m seeking loans of between 1,000 and 1m.

Venture capitalists and business angels
These are either companies (usually known as venture capitalists) or wealthy
individuals (business angels) who are prepared to invest in new or young
businesses. They provide equity (private equity as opposed to public equity in
listed companies), not loans. The equity is not normally secured on any assets
and the private equity firm faces the risk of losses just like the other shareholders.
Because of the high risk associated with start-up equity, private equity suppliers
typically look for returns on their investment in the order of 30% pa. The overall
return takes into account capital redemptions (for example preference shares
being redeemed at a premium), possible capital gains on exiting their investment
(for example through sale of shares to a private buyer or after listing the company
on a stock exchange), and income through fees and dividends.

Typically, venture capitalists will require 25%49% of the equity and a seat on the
board so that their investment can be monitored and advice given. However, the
investors do not seek to take over management of their investment.

Invoice discounting and factoring
Before these methods can be used turnover usually has to be in the region of at
least $200,000. Amounts due from customers, as evidenced by invoices, are
advanced to the company. Typically 80% of an invoice will be paid within 24
hours. In addition to this service, factors also look after the administration of the
companys receivables ledger.

Fees are charged on advancing the cash (roughly at overdraft interest rates), and
also factors will charge about 1% of turnover for running the receivables ledger
(the exact amount depends on how many invoices and customers there are).
Credit insurance can be taken out for an additional fee. Unless that is taken out
the invoicing company remains liable for any bad debts.

Retained profits
Retained profits are no good for start-ups, and often no good for the first few
years of a businesss life when only losses or very modest profits are made.
However, assuming the business is successful, profits should be made and
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retaining those in the business can allow the company to repay debt capital and
to invest in expansion.

How much capital is needed?
Capital is needed:
for investment in non-current assets
to sustain the company through initial loss-making periods
for investment in current assets.

Cash-flow forecasts are an essential tool in planning capital needs. Typically,
suppliers of capital will want forecasts for three to five years. One of the biggest
dangers facing new successful businesses is overtrading, where they try to do too
much with too little capital. Most businesses know that capital will be needed to
finance non-current assets, but many overlook that finance is also needed for
current assets.

Look at this example:

Stage 1 Stage 2
$000 $000 $000 $000
Non-current
assets
1,000 1,000
Current assets
Inventory 50 100
Receivables 40 80
Cash 20 -

110
180
1,110 1,180

Current
liabilities

Payables 10 20
Overdraft - 60

Equity 1,100 1,100
1,110 1,180


This company starts with a healthy liquidity position (Stage 1). Business then
doubles, without investing in more non-current assets and without raising more
equity capital. It is a reasonable assumption that if turnover doubles then so will
inventory, receivables and payables (Stage 2). But here this forces the company to
rely on an overdraft (probably unexpected and unplanned) to finance its net
current assets. Relying permanently on overdraft finance is precarious and the
company would be advised to seek some more permanent form of capital.
x2
x2
x2
Balancing figuie
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When capital is raised, the company has to decide what to do with it, and there
are two main uses:
invest in non-current assets
invest in current assets, including leaving it as cash.

The more capital invested in non-current assets, the greater should be the profit-
earning potential of the business. However, leaving too little cash in current assets
increases the risk that the company will have liquidity problems. On the other
hand, leaving too much capital in current assets is wasteful: cash will earn modest
interest (but investors want higher returns from a company), and cash tied up in
inventory often causes costs (storage, damage, obsolescence). So, the company
has to decide on its working capital policy. An aggressive policy is one which
maintains relatively low working capital compared to another company; a
conservative policy is one which maintains relatively high working capital. Which
policy is appropriate partly depends on the nature of the business. If the business
is one where trading cash flows are very predictable then it should be able to
survive with an aggressive policy. If, however, cash flows are erratic and
unpredictable the company would be wise to build a margin of safety into its cash
management. Additionally, if the company foresees a period of losses, it will need
to keep cash available (probably earning interest in a deposit account) to see it
through its lean years.

Note that companies do not have to have actually raised capital to have it
available for emergency use. What they need is a pre-agreed right to borrow a
certain amount on demand. That is known as a line of credit. Many of us make
use of lines of credit in our personal lives, but there we call them credit cards. So
we dont have to have $1,000 sitting in the bank in case our car needs a major
repair, but its comforting to know that if repairs are necessary, we can pay for
them immediately. Of course, the credit card debt will have to be repaid at some
time, but repayments can be spread.

Long, medium and short-term capital
Capital can be short, medium or long-term. Definitions vary somewhat, but the
following are often seen:
Short term up to two years. For example, overdrafts, trade credit, factoring
and invoice discounting
Medium term two to five or six years. For example, term loans, lease
finance.
Long term over five years, or so, to permanent.

In general, it makes sense to match the length of the finance to the life of the
asset (the matching principle) and, again, we often apply this in our own lives,
where we would use a 25-year mortgage to buy an apartment, a 35-year loan to
buy a car, and a credit card to pay for a holiday.

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Within a business context:


Note that long-term capital (equity and bonds) can be used to fund all classes of
asset. Although each piece of inventory and each receivable are very short-life
assets, in total there will normally be fairly stable amounts of each that have to be
permanently funded. Therefore, it makes sense to fund most of those assets by
long-term capital and to use short-term capital to fund seasonal peaks. One of the
problems with short-term finance is that is comes to an end quickly and if finance
is still needed then more has to be renegotiated. Long-term capital is either
permanent or comes up for renewal relatively rarely.

Mature companies
Once a company has existed profitably for some time and grown in size,
additional sources of finance can become available, in particular:
public equity
public debt
bonds.

Public equity
Some stock exchanges provide different sorts of listings. For example:
London Stock Exchange: The Main Market and the Alternative Investment
Market (AIM). AIM focuses on helping smaller and growing companies raise
the capital they need for expansion.
NASDAQ: This is an electronic stock exchange in the US and has the
NASDAQ National Market for large, established companies (market value at
least $70m) and the NASDAQ Capital market for smaller companies.

On the London Stock Exchange the main differences are;


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An initial public offering is the first occasion on which shares are offered to the
public. A company seeking a listing has to issue a prospectus, which is a legal
document describing the shares being offered for sale, and including matters
such as a description of the company's business, recent financial statements,
details of the directors and their remuneration.

Shares can be listed via:
An offer for sale at fixed price: a company offers shares for sale at a fixed
price directly to the public, for example in newspaper advertisements. In
fact, the shares are usually first sold to an issuing house which sells them on
to the public.
An offer for sale by tender: investors are asked to bid, and all who bid more
than the minimum price that all shares can be sold at will be sold shares at
that minimum price.
A placing: shares are offered to a selection of institutional investors. Because
less publicity is needed, these are cheaper than offers for sale and are
therefore suited to smaller IPOs.
An introduction: this is rare and only happens when shares are already widely
held publically. No money is raised.

Subsequent issues of equity will be rights issues where existing shareholders are
offered new shares in proportion to existing holdings. The shares are offered at
below their current market value to make the offer look attractive, but in theory,
no matter at what price right issues are made and no matter whether
shareholders take up or dispose of their rights, shareholders will end up neither
better nor worse off. Wealth is neither created nor destroyed just by moving
money from a shareholders bank account to the companys.

Gaining a listing opens up a huge source of potential new capital. However, with
listing come increased scrutiny, comment and responsibility. Although this will
help the standing and respectability of the company the founders of the company,
having been used to running their own company in their own way, often resent
outside interference even though that is to be expected now that ownership of
their shares is more widespread.

Public debt
This refers to quoted bonds or loan notes: instruments paying a coupon rate of
interest and whose market value can fluctuate. Usually the bonds will be secured
either by fixed or floating charges and can be redeemable or irredeemable. Well-
secured bonds in companies that are not too highly geared are low risk
investments and bonks holders will therefore require relatively low returns. The
cost of the bonds to the borrower falls even more after tax relief on interest is
taken into account.



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Convertible bonds
Convertibles start life as loan capital and can later be converted, at the lenders
option, into shares. They are a clever and useful device, particularly for younger
companies, because:
In the very early days of the companys life, investors might not want to risk
investing in equity, but might be prepared to invest in the less risky
debentures. However, debentures never hold out the promise of massive
capital gains.
If the company does not do so well, the investors can stick with their safe
convertible loan stock.
If the company does well, the investors can opt to convert and to take part in
the capital growth of the shares.

Convertible bonds therefore offer a wait and see approach. Because they allow
later entry to what might turn out to be a growth stock, the initial interest rate
they have to offer is lower than with pure bonds and thats good for the
company that is borrowing.

Gearing
When deciding what sorts of finance to issue, companies must always bear in
mind the average cost of their finance. This article does not go into gearing
considerations in any detail except to point out that some borrowing can lower the
cost of capital.

If there is no borrowing, all finance will be equity and that is high cost to
compensate for the high risk attaching to it. Debt finance is cheap because it has
lower risk and enjoys tax relief on interest.

Therefore, introducing some debt into the finance mix begins to pull down the
average cost of capital. However, at very high levels of gearing the increased risk
of default pushes up both the cost of debt and the cost of equity, and the average
cost of finance starts to rise. Somewhere, there is an optimum gearing ratio with
the cheapest mix of finance.

The previous paragraph briefly described the traditional theory of gearing.
Modigliani and Miller suggested an alternative view, but the very precise
conditions and restrictions their theories require are not often found in practice.

Ken Garrett is a freelance lecturer and author
technical
page 57
RELEVANT TO ACCA QUALIFICATION PAPERS F9 AND P4
BUSINESS ANGEL INVESTMENTS
Business angels are normally interested in businesses with high-growth
potential and with owners who are committed to realising this potential.
This means that lifestyle businesses, where owners are not focused on
maximising returns, are unlikely to be of interest. In pursuit of high returns,
business angels are normally prepared to take high risks. They will usually
take an equity stake in a business but may also advance loans as part of a
total financing package. In some cases, they may even offer a loan as an
alternative to an equity stake, although this is less common.
Business angels are usually prepared to invest somewhere between
10,000 and 250,000 in a business, but larger sums may be made
available through a business angels syndicate. A UK study undertaken in
20002001 found that the majority of investments made by business angels
were below 50,000 (see reference 1). Most equity investments are for a
minority stake in a business but where a syndicate of business angels is
providing significant amounts of finance, a majority stake may be taken.
Business angels help to plug the equity gap that many small businesses
experience, which falls between the equity that the owners are able to raise
themselves and the minimum level of equity investment that private equity
firms are normally prepared to consider. Business angels tend to invest
in early-stage businesses but may also invest in more mature businesses,
such as those seeking finance for expansion, management buyouts, or
business turnarounds.
While business angels are recognised as a significant source of finance
for small, unquoted businesses, the exact scale of their investments is difficult
to determine. This is because they are under no obligation to disclose how
much they have invested. It has been estimated, however, that in the UK, the
investment made by business angels in start-up businesses is eight times that
made by private equity firms (see reference 2).
PROFILE OF A BUSINESS ANGEL
Business angels tend to be wealthy individuals who have already been
successful in business. The majority are entrepreneurs who have sold their
businesses, while the remainder are often former senior executives of major
organisations, or business professionals such as accountants, lawyers, or
management consultants.
Business angels invest with the primary motive of making a financial
return, but non-financial motives also play an important part. Research
suggests, for example, that business angels often enjoy being involved in
growing a business and may also harbour altruistic motives, such as wishing
to help budding entrepreneurs or wanting to make a contribution to the local
economy (see reference 3).
Business angels often seek an active role within the business, which is
usually welcomed, as the skills, knowledge, and experience that business
angels possess can often be put to good use. Involvement typically includes
providing advice and moral support, providing business contacts, and helping
strategic decision making. This active involvement may not simply be for the
satisfaction of helping a business to grow. By having a greater understanding
of what is going on, and by exerting some influence over decision making,
business angels may be better placed to increase their financial rewards
and/or reduce their level of investment risk.
Research suggests that business angels tend to invest in businesses
within their own locality. This may be because active involvement may only
be feasible if the business is within easy reach. Unsurprisingly, business
angels also tend to invest in business sectors in which they have personal
experience. One study, for example, revealed that around a third of business
angels invest solely in business sectors in which they have had prior work
experience. Around two-thirds of business angels, however, have made at
least one investment in a business sector with which they were unfamiliar
(see reference 3).
USING AN ANGEL
Business angels are an informal source of finance and are not encumbered
by bureaucracy. They can be flexible and decisions can often be made fairly
quickly, particularly if investment is made in a business sector with which
they are familiar. Although they will expect returns from their investment to
match the risks involved, they may be prepared to accept a slightly lower
return than would a private equity firm, in exchange for the opportunity to
become involved in helping the business grow.
Business angels are an important source of finance for smaller businesses. This article looks at
the role that business angels play in providing finance, the way in which they approach making an
investment, and the financial and non-financial returns that may be expected.
BEING AN ANGEL
studying papers f9 and p4?
PERFORMANCE OBJECTIVEs 15 AND 16 ARE lINkED
technical
page 58
student accountant
MaRCH 2009
Business angels vary considerably in the extent to which they wish to
become involved in the activities of a business. At one extreme, they may
simply want to become sleeping partners, while at the other, they may
want to become as involved as the business owner. It seems that the
majority of angels do seek a hands-on approach but do not seek a total
commitment. A survey of 48 business angels in Wales found that 63%
intended to take an active role in any business in which they invested, and
intended to spend a mean of 4.85 days per month with each business (see
reference 4).
However, the degree of involvement must suit both parties, and so must
be agreed before the investment is made. Failure to agree on an appropriate
post-investment role for the business angel is one of the most common
deal-killers (see reference 4).

THE INVESTMENT PROCESS
It was mentioned earlier that business angels can make decisions quickly.
This does not mean, however, that finance is always made available to a
business overnight. It has been suggested that four to six months may be
needed between the initial introduction and the provision of finance (see
reference 5). Various stages must normally be completed before the business
angel is satisfied that the investment is worthwhile.
Following the initial introduction between the business owners and
business angel, the business plan and financial forecasts will normally be
reviewed. This will involve close scrutiny of the validity of key assumptions
and of the quality of the information used. This is then likely to be followed
by a series of meetings to help the business angel gain a deeper insight into
the business and to deal with any concerns and issues that may arise. During
these meetings, the business angel will also be assessing the quality of the
management team as, ultimately, the success of the investment will rest on
their energy and skills.
Assuming the business angel is satisfied with the information gained
from the meetings, negotiations over the terms of the investment will then be
undertaken. This can be the trickiest part of the process, as agreement has
to be reached over key issues such as the value of the business, the precise
equity stake to be offered to the business angel, and the price to be paid. The
research evidence suggests that failure to reach
agreement with the
owners over a suitable
price, and over the
post-investment role to
be played by a business
angel, are the two most
common deal-killers.
One study has shown
that business angels
may make four offers
for every one offer that
is finally accepted (see
reference 6).
If a price can be
agreed between the
parties, due diligence
will then be carried
out. This will involve an
investigation of all material
information relating to
the financial, technical,
and legal aspects of
the business.
FINANCIAL RETURNS
Table 1 shows the results of
one study that examined the
internal rates of return (IRR) from 128 investments made by business angels
in the UK (see reference 7).
TABLE 1: RATE OF RETURN FOR BUSINESS ANGEL INVESTMENTS
Internal rate of return Percentage of investments
More than 100% 10%
50% to 99% 13%
25% to 49% 13%
0% to 24% 24%
Negative 40%
We can see in Table 1 that while some investments make very high returns,
by far the largest proportion produces a negative IRR.
A large study of 539 business angels in the US found that the average
IRR from investments was 27%. However, there was a wide range of
performance, with 52% of all investments returning less than the initial
capital invested. The study found that three factors had a positive effect on
investment returns. These were:
the time spent on due diligence
the business angels expertise in the business sector
the participation of the business angel in the investee business.
The study also found that where a business angel made follow-on
investments, there was a greater likelihood of lower returns. This is consistent
with additional investments being made to help a struggling business survive
(see reference 8).
These results raise some important points. First, business angels tend
to make relatively few investments and so they are unlikely to hold the
well-diversified portfolio of investments required to reduce risk. Such high
failure rates can therefore be a real problem for the business angel and can
hinder future investment flows. Some business angels, however, seek to
reduce their exposure to risk by becoming a member of a syndicate.
technical
page 59
screening investment proposals and advising owners of small businesses
on how to present their proposals to interested angels.
The British Business Angels Association (BBAA) is the trade association for UK
business angel networks. In addition to being a major source of information
about the business angel industry, it can help direct small businesses to their
local network.
The development of business angel networks has led to a more
efficient market for business angel finance. Greater visibility and greater
information flow has made the search for investment opportunities easier.
Various studies, however, have shown that these networks are not highly
regarded by business angels as a source of investment opportunities. They
have been criticised for the quality of the deals offered, the quality of staff
employed, and for poor matching of business angels interests to investment
opportunities. It is interesting to note that the Welsh study mentioned earlier
found that business associates and friends were business angels main
sources of suitable investment opportunities (see reference 4).
CONCLUSION
Business angels play an important role in filling the equity gap that
many small businesses experience. Although a business angels primary
motivation is to make a financial return, the evidence shows that their
investment performance is far from encouraging. While a few investments
may make exciting financial returns, most seem destined to fail. Such
a high failure rate can create difficulties for business angels as they are
unlikely to be well-diversified against risk. However, participating in a
syndicate can help.
The development of business angel networks has helped to improve the
efficiency of the market for this type of finance, but improvements in the
services offered are needed before business angels regard these networks
as a primary source of investment opportunities. It seems that business
angels regard business associates and friends as the best sources of
investment opportunities.
REFERENCES
1 Mason C M, Report on Business Angel Investment Activity 20002001,
quoted in Hurcombe R, Davies L, Marriot N, Business Angels in Wales:
Putting Some Boundaries on Our Ignorance www.bbaa.org.uk
pp1011, 2005.
2 Mason C M, Harrison R T, The Size of the Informal Venture Capital
Market in the United Kingdom, Small Business Economics, 15,
pp137148, 2000.
3 Macht S, The Post-Investment Period of Business Angels: Impact and
Involvement, pp 14-15 www.eban.org July 2007.
4 Hurcombe R, Davies L, Marriot N, Business Angels in Wales: Putting Some
Boundaries on Our Ignorance, pp1516 www.bbaa.org.uk 2005.
5 A Guide to Investing as a Business Angel, Envestors LLP www.bbaa.
org.uk 2005.
6 Mason C M, and Harrison R T, 2002, quoted in Carriere S, Best Practice
in Angel Groups and Angel Syndication www.eban.org p17,
January 2006.
7 Mason C M, Harrison R T, Is it Worth it? The Rates of Return from
Informal Venture Capital Investments, Journal of Business Venturing,
May 2002.
8 Wiltbank R, Boeker W, Returns to Angel Investors in Groups www.
eban.org November 2007.
9 Mason C M, Harrison R T, quoted in A Guide to Investing as a Business
Angel, Envestors LLP, p14 www.bbaa.org.uk
10 Mason C M, Harrison RT, Barriers to Investment in the Informal Venture
Capital Sector, Entrepreneurship and Regional Development 14,
pp 271287.
Peter Atrill is a freelance academic and writer
Second, it is not clear whether the high failure rates mentioned in the
studies are due to the high-risk nature of the investments or to
the poor investment skills of business angels. The fact that business angels
have enjoyed successful business careers does not necessarily mean
that they have the skills required to become successful investors. Many
might benefit by being mentored by more experienced business angels,
or by attending formal training programmes. However, there are few such
opportunities available.
FINDING AN EXIT ROUTE
Before making the initial investment, a business angel should consider
possible exit routes. Unless there is a clear way out at the end of the
investment period, usually three to five years, the proposal may be rejected
even though it is expected to be profitable. Table 2 shows the results of
research carried out by Mason and Harrison (see reference 9) into the ways in
which business angels exit from their investments.
TABLE 2: BUSINESS ANGEL EXIT ROUTES
Exit route Percentage of exits
Write investment off as a loss 40%
Trade sale to another business 26%
Sell to other shareholders,
including management buyouts 16%
Sell to a third party 10%
Float on the stock markets
(AIM, OFEX, LSE/Official list) 8%
Leaving aside the large percentage of investments that simply have to be
written off, we can see that a trade sale to another business is easily the most
popular exit route.
ANGEL SYNDICATES
As mentioned earlier, business angels may decide to become part of a
syndicate in order to diversify risk. Other advantages, however, can spring
from the pooling of expertise and capital. These include:
access to a larger number of investment opportunities and/or larger-scale
investment opportunities
an increased capacity to provide follow-up funding where
necessary
an ability to add greater value to an investee business
better scrutiny and monitoring of investments
shared search and transaction costs
access to knowledge and expertise of others within the syndicate.
Various studies have shown that business angels are generally enthusiastic
about syndication. There are, however, potential disadvantages, such as the
greater complexity of deal structures, the potential for disputes within the
syndicate, and the need to comply with group decisions.
BUSINESS ANGEL NETWORKS
Finding suitable investment opportunities can be a problem. Research
evidence suggests that a lack of investment opportunities is often an
important constraint on a business angels ability to invest (see reference
10). It has been pointed out that business angels are not always very visible,
and owners of small businesses may find them hard to find. There are,
however, an increasing number of networks available to help match business
angels with small businesses seeking finance. These networks offer various
services, including:
publishing investor bulletins and organising meetings to promote the
investment opportunities available
registering the investment interests of business angels and matching them
with emerging opportunities
exam paper resources
www.ACCAglOBAl.COM/sTuDENTs/sTuDy_ExAMs/quAlIFICATIONs
project appraisal 1 pure equity finance
So now we have two ways of estimating the cost of
equity (the return required by shareholders). Can
this measurement of a companys cost of equity
be used as the discount rate with which to appraise
capital investments? Yes it can, but only if certain
conditions are met:
1 A new investment can be appraised using the
cost of equity only if equity alone is being used
to fund the new investment. If a mix of funds is
being used to fund a new investment, then the
investment should be appraised using the cost of
the mix of funds, not just the cost of equity.
2 The gearing does not change. If the gearing
changes, the cost of equity will change and its
current value would no longer be applicable.
3 The nature of the business is unchanged. The
new project must be more of the same so
that the risk arising from business activities is
unchanged. If the business risk did change, once
again the old cost of equity would no longer
be applicable.
These conditions are very restrictive and would
apply only when an all-equity company issued
more equity to do more of the same type of
activity. Our approach needs to be developed if we
are going to be able to appraise projects in more
general environments.
In particular, we have to be able to deal with more
general sources of finance, not just pure equity, and
it would also be good if we could deal with projects
which have different risk characteristics from
existing activities.
project appraisal 2 saMe Business actiVities,
a MiX of funDs anD constant GearinG
Let us look at appraising a project which uses a
mix of funds, but where those funds are raised
so as to maintain the companys gearing ratio.
Remember, where there is a mix of funds, the funds
are regarded as going into a pool of finance and
a project is appraised with reference to the cost
of that pool of finance. That cost is the weighted
average cost of capital (WACC). As a preliminary
to this discussion, we need briefly to revise how
gearing can affect the various costs of capital,
particularly the WACC. The three possibilities are
set out in Example 1.
eXaMple 1
k
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part 2 releVant to acca qualification papers f9 anD p4
conventional
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Cost %
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k
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k
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WACC
01 tecHnical
All three versions show that the cost of debt (K
d
) is
lower than the cost of equity (K
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). This is because
debt is inherently less risky than equity (debt has
constant interest; interest is paid before dividends;
debt is often secured on assets; on liquidation
creditors are repaid before equity shareholders). In the
third version, cost of debt is further reduced because
in an environment with corporation tax, interest
payments enjoy tax relief.
Looking at the three cases in a little more detail:
Conventional theory
When there is only equity, the WACC starts at the
cost of equity. As the more expensive equity finance
is replaced by cheaper debt finance, the WACC
decreases. However, as gearing increases further,
both debt holders and equity shareholders will
perceive more risk, and their required returns both
increase. Inevitably, WACC must increase at some
point. This theory predicts that there is an optimum
gearing ratio at which WACC is minimised.
Modigliani and Miller (M&M) without tax
M&M were able to demonstrate that as gearing
increases, the increase in the cost of equity
precisely offsets the effect of more cheap debt so
that the WACC remains constant.
Modigliani and Miller (M&M) with tax
Debt, because of tax relief on interest, becomes
unassailably cheap as a source of finance. It
becomes so cheap that even though the cost of
equity increases, the balance of the effects is to
keep reducing the WACC.
(Note: the M&M diagrams shown in Example 1
hold only for moderate levels of gearing. At very
high levels of gearing, other costs come into play
and the WACC can be shown to increase again
looking rather like the conventional theory.)
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Studying Papers F9 or P4?
performance objectives 15 and 16 are linked
gearing and capm
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DownloaD part 1 Here pDf
stuDent accountant 11/2009
02
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Whichever theory you believe, whether there is
or isnt tax, provided the gearing ratio does not
change the WACC will not change. Therefore,
if a new project consisting of more business
activities of the same type is to be funded so as
to maintain the present gearing ratio, the current
WACC is the appropriate discount rate to use.
In the special case of M&M without tax, you can
do anything you like with the gearing ratio as the
WACC will remain constant and will be equal to
the ungeared cost of equity.
The condition that gearing is constant does not
have to mean that upon every issue of capital both
debt and equity also have to be issued. That would
be very expensive in terms of transaction costs.
What it means is that over the long term the gearing
ratio will not change. That would certainly be the
companys ambition if it believed it was already at
the optimum gearing ratio and minimum WACC.
Therefore, this year, it might issue equity, the next
debt and so on, so that the gearing and WACC hover
around a constant position.
project appraisal 3 Different
Business actiVities, a MiX of funDs anD
cHanGinG GearinG
Lets deal with different business activities
first. Different activities will have different risk
characteristics and hence any business carrying
on those activities will have a different beta factor.
The new funds being put into the new project are
subject to the risk inherent in that project, and so
should be discounted at a rate which reflects that
risk. The formula:
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
)
predicts the return that equity holders should
require from a project with a given risk, as
measured by the beta factor of that activity.
Note that we are doing something quite radical
here: CAPM is allowing us to calculate a risk
adjusted return on equity, tailor-made to fit the
characteristics of the project being funded. All
projects consist of capital being supplied, being
invested and therefore being subject to risk, but the
risk is determined by the nature of the project, not
the company undertaking the project. The existing
return on equity of the company that happens to be
the vehicle for the project has become irrelevant.
We can extend this argument as follows. If the
company doing the project is irrelevant theres no
reason why you cant view the project as being
undertaken by a new company specially set up for
that project. The way the project is funded is the
way the company is funded and, in particular, the
appropriate discount rate to apply to the project
is the WACC of the company/project, not its cost
of equity which would take into account only one
component of the funding.
03 tecHnical
So we can calculate the cost of equity component
which reflects project risk by using a beta value
appropriate to that risk. The final steps are to
adjust the cost of equity to reflect the gearing and
then to calculate the appropriate discount rate, the
WACC. The diagrams shown in Example 1 show
(qualitatively) how the rates might move. No matter
how reasonable the conventional theory seems,
its big drawback is that it makes no quantitative
predictions. However, the Modigliani and Miller
theory does make quantitative predictions, and
when combined with CAPM theory it allows the beta
factor to be adjusted so that it takes into account
not only business risk but also financial (gearing)
risk. The formula you need is provided in the
Paper F9 exam formula sheet:

a
= V
e

e
+ V
d
(1-T)
d

V
e
+ V
d
(1 - T) V
e
+ V
d
(1 - T)
Where:
V
e
= market value of equity
V
d
= market value of debt
T = corporation tax rate

a
= the asset beta

e
= the equity beta

d
= the debt beta

d
, the debt beta, is nearly always assumed to be
zero, so the formula simplifies to:

a
= V
e

e

V
e
+ V
d
(1 - T)
What is meant by
a
(the asset beta), and
e
(the
equity beta)?
The asset beta is the beta (a measure of risk)
which arises from the assets and the business the
company is engaged in. No heed is paid to the
gearing. An alternative name for the asset beta is
the ungeared beta.
The equity beta is the beta which is relevant to
the equity shareholders. It takes into account
the business risk and the financial (gearing) risk
because equity shareholders risk is affected by
both business risk and financial (gearing) risk.
An alternative name for the equity beta is the
geared beta.
Note that the formula shows that if V
d
= 0 (ie there
is no debt), then the two betas are the same. If
there is debt, the asset beta will always be less
than the equity beta because the latter contains an
additional component to account for gearing risk.
The formula is extremely useful as it allows us
to predict the beta, and hence the cost of equity,
for any level of gearing. Once you have the cost of
equity, it is a straightforward process to calculate
the WACC and hence discount the project.
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stuDent accountant 11/2009
04
To illustrate the use of CAPM in determining a
discount rate, we will work through the following
example, Example 2.
eXaMple 2
Emway Co is a company engaged in road building.
Its equity shares have a market value of $200
million and its 6% irredeemable bonds are valued at
par, $50m. The companys beta value is 1.3. Its cost
of equity is 21.1%. ( Note: this figure is quite high
in the current economic situation and is used for
illustration purposes. Currently, in a real situation,
the cost of equity would be lower.)
The company is worried about the recession and
is considering diversifying into supermarkets. It
has investigated listed supermarkets and found
one, Foodoo Co, which quite closely matches its
plans. Foodoo has a beta of 0.9 and the ratio of the
market value of its equity to its debt is 7:5. Emway
plans that its new venture would be financed with a
market value of equity to market value of debt ratio
of 1:1.
The corporation tax rate is 20%. The risk free rate
is 5.5%. The market return is 17.5%.
What discount rate should be used for the
evaluation of the new venture?
Solution:
1 We have information supplied about a company in
the right business but with the wrong gearing for
our purposes. To adjust for the gearing we plan
to have, we must always go through a theoretical
ungeared company in the same business.
Again the beta supplied to us will be the beta
measured in the market, so it will be an equity
(geared) beta. Were Foodoo to be ungeared, its
asset beta would be given by:

a
= V
e

e
= 7 x 0.9
V
e
+ V
d
(1 - T) 7 + 5 (1 - 0.2)
= 0.5727
This asset beta (ungeared beta) can now be
adjusted to reflect the gearing ratio planned in
the new venture:
0.5727 = 1
e
1 + 1(1 - 0.2)
So the planned
e
will be 0.5727 x 1.8 = 1.03
Check that this makes sense. Foodoo has a
gearing ratio of 7:5, equity to debt, a current beta
of 0.9, and a cost of equity of 16.30 (calculated
from CAPM as 5.5 + 0.9(17.5 - 5.5)). Were
Foodoo ungeared, its beta would be 0.5727, and
its cost of equity would be 12.37 (calculated
from CAPM as 5.5 + 0.5727(17.5 - 5.5)).
Emway is planning a supermarket with a gearing
ratio of 1:1. This is higher gearing, so the equity
beta must be higher than Foodoos 0.9.
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tecHnical 05
2 To calculate the return required by the suppliers
of equity to the new project:
Required return = Risk free rate + (Return from
market - Risk free rate)
= 5.5 + 1.03 (17.5 - 5.5) = 17.86%
3 17.86 is the return required by equity holders,
but the new venture is being financed by a mix
of debt and equity, and we need to calculate the
cost of capital of this pool of finance.
Note that while Paper F9 does not require students
to undertake calculations of a project-specific
WACC, they are required to understand it from a
theoretical perspective.
The appropriate rate at which to evaluate the
project is the WACC of the finance. Again, in the
Paper F9 and Paper P4 exam formula sheet you
will find a formula for WACC consisting of equity
and irredeemable debt.
K
e
= 17.86%
K
d
= 6% (from the cost of the debentures already
issued by Emway)
WACC = 1 x 17.86 + 1 x 6 (1 - 0.2) = 11.33%
1 + 1 1 + 1
In terms of the diagram used in Example 1, for
Modigliani and Miller with tax, what we have done
for Foodoos figures is set out below. We started
with information relating to a supermarket with a
gearing ratio of debt:equity of 5:7, and an implied
cost of equity of 16.30%. We strip out the gearing
effect to arrive at an ungeared cost of equity of
12.37, then we project this forward to whatever
level of gearing we want. In this example, this is
a gearing ratio of 1:1 and this implies a cost of
equity of 17.86%.
Finally, we take account of the cheap debt finance
that is mixed with this equity finance, by calculating
the WACC of 11.33%. This is the rate which should
be used to evaluate the new supermarket project,
funded by debt:equity of 1:1.
Cost %
Gearing = MV
d
/MV
e

k
e
K
d
(1-T)
WACC
17.86
16.30
12.37
11.33
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Ken Garrett is a freelance author and lecturer
stuDent accountant 11/2009
06
A fundamental part of financial management
is investment appraisal: into which long-term
projects should a company put money?
Discounted cash flow techniques (DCFs), and
in particular net present value (NPV), are generally
accepted as the best ways of appraising projects.
In DCF, future cash flows are discounted so that
allowance is made for the time value of money. Two
types of estimate are needed:
1 The future cash flows relevant to the project.
2 The discount rate to apply.
This article looks at how a suitable discount rate
can be calculated.
THE COST OF EQUITY
The cost of equity is the relationship between the
amount of equity capital that can be raised and the
rewards expected by shareholders in exchange for
their capital. The cost of equity can be estimated in
two ways:
1 The dividend growth model. Measure the
share price (capital that could be raised) and
the dividends (rewards to shareholders). The
dividend growth model can then be used to
estimate the cost of equity, and this model can
take into account the dividend growth rate. The
formula sheet for the Paper F9 exam will give the
following formula:
P
0
= D
0
(1 + g)
(r
e
g)
This formula predicts the current ex-dividend
market price of a share (P
0
) where:
D
0
= the current dividend (whether just paid or
just about to be paid)
g = the expected dividend future growth rate
r
e
= the cost of equity.
Note that the top line (D
0
(1 + g)) is the dividend
expected in one years time. The formula can be
rearranged as:
r
e
= D
0
(1 + g) + g
P
0
For a listed company, all the terms on the right
of the equation are known, or can be estimated.
In the absence of other data, the future dividend
growth rate is assumed to continue at the recent
historical growth rate. Example 1 sets out an
example of how to calculate r
e
.
EXAMPLE 1
The dividend just about to be paid by a company
is $0.24. The current market price of the share
is $2.76 cum div. The historical dividend growth
rate, which is expected to continue in the future,
is 5%.
What is the estimated cost of capital?
Solution
r
e
= D
0
(1 + g) + g = 0.24(1 + 0.05) + 0.05 = 15%
P
0
2.52
P
0
must be the ex-dividend market price, but we
have been supplied with the cum-dividend price.
The ex-dividend market price is calculated as the
cum-dividend market price less the impending
dividend. So here:
P
0
= 2.76 - 0.24 = 2.52
The cost of equity is, therefore, given by:
r
e
= D
0
(1 + g) + g
P
0
cost of capital,
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rELEvAnT TO PAPErS F9 And P4
01 TECHnICAL
Studying Papers F9 or P4?
Performance objectives 15 and 16 are linked
2 The capital asset pricing model (CAPM)
The capital asset pricing model (CAPM) equation
quoted in the Paper F9 exam formula sheet is:
E(r
i
) = R
f
+
i
(E(r
m
) R
f
)
Where:
E(r
i
) = the return from the investment
R
f
= the risk free rate of return

i
= the beta value of the investment, a measure
of the systematic risk of the investment
E(r
m
) = the return from the market
Essentially, the equation is saying that the
required return depends on the risk of an
investment. The starting point for the rate of
return is the risk free rate (R
f
), to which you need
to add a premium relating to the risk. The size
of that premium is determined by the answers to
the following:
What is the premium the market currently
gives over the risk free rate (E(r
m
) - R
f
)? This is
a reference point for risk: how much does the
stock market, as a whole, return in excess of
the risk free rate?
How risky is the specific investment compared
to the market as a whole? This is the beta of
the investment (
i
). If
i
is 1, the investment
has the same risk as the market overall. If
i

> 1, the investment is riskier (more volatile)
than the market and investors should demand
a higher return than the market return to
compensate for the additional risk. If
i
< 1,
the investment is less risky than the market
and investors would be satisfied with a lower
return than the market return.
EXAMPLE 2
Risk free rate = 5%
Market return = 14%
What returns should be required from investments
whose beta values are:
(i) 1
(ii) 2
(iii) 0.5
E(r
i
) = R
f
+
i
(E(r
m
) - R
f
)
(i) E(r
i
) = 5 + 1(14 - 5) = 14%
The return required from an investment with
the same risk as the market, which is simply
the market return.
(ii) E(r
i
) = 5 + 2(14 - 5) = 23%
The return required from an investment
with twice the risk as the market. A higher
return than that given by the market is
therefore required.
(iii) E(r
i
) = 5 + 0.5(14 - 5) = 9.5%
The return required from an investment with
half the risk as the market. A lower return than
that given by the market is therefore required.
COMPArIng THE dIvIdEnd grOwTH MOdEL
And CAPM
The dividend growth model allows the cost of
equity to be calculated using empirical values
readily available for listed companies. Measure the
dividends, estimate their growth (usually based on
historical growth), and measure the market value
of the share (though some care is needed as share
values are often very volatile). Put these amounts
into the formula and you have an estimate of the
cost of equity.
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gearing and capm
STUdEnT ACCOUnTAnT 10/2009
02
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However, the model gives no explanation as
to why different shares have different costs of
equity. Why might one share have a cost of equity
of 15% and another of 20%? The reason that
different shares have different rates of return is
that they have different risks, but this is not made
explicit by the dividend growth model. That model
simply measures whats there without offering
an explanation. Note particularly that a business
cannot alter its cost of equity by changing its
dividends. The equation:
r
e
= D
0
(1 + g) + g
P
0
might suggest that the rate of return would be
lowered if the company reduced its dividends or the
growth rate. That is not so. All that would happen
is that a cut in dividends or dividend growth rate
would cause the market value of the company to
fall to a level where investors obtain the return
they require.
The CAPM explains why different companies give
different returns. It states that the required return
is based on other returns available in the economy
(the risk free and the market returns) and the
systematic risk of the investment its beta value.
Not only does CAPM offer this explanation, it also
offers ways of measuring the data needed. The risk
free rate and market returns can be estimated from
economic data. So too can the beta values of listed
companies. It is, in fact, possible to buy books
giving beta values and many investment websites
quote investment betas.
When an investment and the market is in
equilibrium, prices should have been adjusted
and should have settled down so that the return
predicted by CAPM is the same as the return that is
measured by the dividend growth model.
Note also that both of these approaches give you
the cost of equity. They do not give you the weighted
average cost of capital other than in the very special
circumstances when a company has only equity in
its capital structure.
wHAT COnTrIbUTES TO THE rISk SUFFErEd bY
EQUITY SHArEHOLdErS, HEnCE COnTrIbUTIng TO
THE bETA vALUE?
There are two main components of the risk suffered
by equity shareholders:
1 The nature of the business. Businesses that
provide capital goods are expected to show
relatively risky behaviour because capital
expenditure can be deferred in a recession
and these companies returns will therefore
be volatile. You would expect
i
> 1 for such
companies. On the other hand, a supermarket
business might be expected to show less risk than
average because people have to eat, even during
recessions. You would expect
i
< 1 for such
companies as they offer relatively stable returns.
2 The level of gearing. In an ungeared company
(ie one without borrowing), there is a straight
relationship between profits from operations and
earnings available to shareholders. Once gearing,
and therefore interest, is introduced, the amounts
available to ordinary shareholders become more
volatile. Look at Example 3 on the opposite page.
03 TECHnICAL
This shows two companies, one ungeared, one
geared, which carry on exactly the same type of
business. Between State 1 and State 2, their profits
from operations double. The amounts available to
equity shareholders in the ungeared company also
double, so equity shareholders experience a risk or
volatility which arises purely from the companys
operations. However, in the geared company, while
amounts available from operations double, the
amounts available to equity shareholders increase
by a factor of 2.66. The risk faced by those
shareholders therefore arises from two sources:
risk inherent in the companys operations, plus risk
introduced by gearing.
Therefore, the rate of return required by
shareholders (the cost of equity) will also be
affected by two factors:
1 The nature of the companys operations.
2 The amount of gearing in the company.
When we talk about, or calculate, the cost of
equity we have to be clear what we mean. Is this
a cost which reflects only the business risk, or is
it a cost which reflects the business risk plus the
gearing risk?
When using the dividend growth model, you
measure what you measure. In other words, if
you use the dividends, dividend growth and share
price of a company which has no gearing, you will
inevitably measure the ungeared cost of equity.
Thats what shareholders are happy with in this
environment. If, however, these quantities are
derived from a geared company, you will inevitably
measure the geared companys cost of equity.
Similarly, published beta values are derived from
observing how specific equity returns vary as market
returns vary, to see if a shares return is more or less
volatile than the market. Once again, you measure
what you measure. If the company being observed
has no gearing in it, the beta value obtained depends
only on the type of business being carried on. If,
however, the company has gearing within it, the
beta value will reflect not only the risk arising from
the company, but also the risk arising from gearing.
Ken Garrett is a freelance writer and lecturer
Part 2 of this article on equity finance will
be published in the November 2009 issue of
Student Accountant
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EXAMPLE 3: LEvEL OF gEArIng
Ungeared Ungeared Geared Geared
company company company company
State 1 State 2 State 1 State 2

x 2 x 2

Profits from operations 1,000 2,000 1,000 2,000
Interest Nil Nil (400) (400)
Profit after interest 1,000 2,000 600 1,600
Tax at 20% (200) (400) (120) (320)
Available to equity
shareholders 800 1,600 480 1,280
x 2 x 2.66
STUdEnT ACCOUnTAnT 10/2009
04

RELEVANT TO ACCA QUALIFICATION PAPER F9
Studying Paper F9?
Performance objectives 15 and 16 are relevant to this exam

2010 ACCA

ADVANCED INVESTMENT APPRAISAL

Investment appraisal is one of the eight core topics within Paper F9,
Financial Management and it is a topic which has been well represented
in the F9 exam. The methods of investment appraisal are payback,
accounting rate of return and the discounted cash flow methods of net
present value (NPV) and internal rate of return (IRR). For each of these
methods students must ensure that they can define it, make the
necessary calculations and discuss both the advantages and
disadvantages.

The most important of these methods, both in the real world and in the
exam, is NPV. A key issue in the Paper F9 syllabus is that students start
their studies with no knowledge of discounting but are very rapidly
having to deal with relatively advanced NPV calculations which may
include problems such as inflation, taxation, working capital and
relevant/irrelevant cash flows. These advanced NPV or indeed IRR
calculations have formed the basis for very many past exam questions.

The aim of this article is to briefly discuss these potential problem areas
and then work a comprehensive example which builds them all in.
Technically the example is probably harder than any exam question is
likely to be. However, it demonstrates as many of the issues that
students might face as is possible. Exam questions, on the other hand,
will be in a scenario format and hence finding the information required
may be more difficult than in the example shown.

The problem areas
Inf l ati on
Students must be aware of the two different methods of dealing with
inflation and when they should be used. The money method is where
inflation is included in both the cash flow forecast and the discount rate
used while the real method is where inflation is ignored in both the cash
flow forecast and the discount rate. The money method should be used
as soon as a question has cash flows inflating at different rates or where
a question involves both tax and inflation. Because of this the money
method is commonly required. Students must ensure that they can use
the Fisher formula provided to calculate a money cost of capital or
indeed a real cost of capital for discounting purposes. They must also
be able to distinguish between a general inflation rate which will impact
on the money cost of capital and potentially some cash flows and a
specific inflation rate which only applies to particular cash flows.
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Taxati on
Building taxation into a discounted cash flow answer involves dealing
with the good the bad and the ugly! The good news with taxation is that
tax relief is often granted on the investment in assets which leads to tax
saving cash flows. The bad news is that where a project makes net
revenue cash inflows the tax authorities will want to take a share of
them. The ugly issue is the timing of these cash flows as this is an area
which often causes confusion.

Worki ng capi tal
The key issue that must be remembered here is that an increase in
working capital is a cash outflow. If a company needs to buy more
inventories, for example, there will be a cash cost. Equally a decrease in
working capital is a cash inflow. Hence at the end of a project when the
working capital invested in that project is no longer required a cash
inflow will arise. Students must recognise that it is the change in
working capital that is the cash flow. There is often concern amongst
students that the inventories purchased last year will have been sold
and hence must be replaced. However, to the extent the items have been
sold their cost will be reflected elsewhere in the cash flow table.

Rel evant/i rrel evant cash f l ows
This problem is rarely a big issue in Paper F9 as students have been
examined on this topic previously. However students should remember
the Golden Rule which states that to be included in a cash flow table
an item must be a future, incremental cash flow. Irrelevant items to look
out for are sunk costs such as amounts already spent on research and
apportioned or allocated fixed costs. Equally all financing costs should
be ignored as the cost of financing is accounted for in the discount rate
used.

Having reminded you of the potential problem areas let us now consider
a comprehensive example:

CBS Co
CBS Co is considering a new investment which would start immediately
and last four years. The company has gathered the following
information:
Asset cost $160,000
Annual sales are expected to be 30,000 units in Years 1 and 2 and will
then fall by 5,000 units per year in both Years 3 and 4.
The selling price in first-year terms is expected to be $4.40 per unit and
this is then expected to inflate by 3% per annum. The variable costs are
expected to be $0.70 per unit in current terms and the incremental fixed
costs in the first year are expected to be $0.30 per unit in current
terms. Both of these costs are expected to inflate at 5% per annum.
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The asset is expected to have a residual value (RV) of $40,000 in money
terms.
The project will require working capital investment equal to 10% of the
expected sales revenue. This investment must be in place at the start of
each year.
Corporation tax is 30% per annum and is paid one year in arrears. 25%
reducing balance writing-down allowances are available on the asset
cost.
General inflation is 4% and the real cost of capital is 7.7%
$12,000 has already been spent on initial research.

Required: Calculate the NPV of the proposed investment.

Solution and explanatory notes:
Many students fall into the trap of starting the cash flow table too
quickly. Initially there are a number of workings or thinkings that
should be carried out. These workings can generally be carried out in
any order. Once they are completed it will be possible to construct the
cash flow table quickly and accurately. Before going further students
must understand the difference between a T and a Year. A T is a point
in time and hence T0 is now and T1 is in one-years time. A Year is a
period of time and hence Year 1 is the period between T0 and T1 and
Year 2 is the period between T1 and T2. Please note T1 is both the end
of Year 1 and the start of Year 2.

Working 1 Inflation
As the question involves both tax and inflation and has different inflation
rates the money method must be used. Hence the cash flows in the cash
flow table must be inflated and the discounting should then be carried
out using a money cost of capital. As a money cost of capital is not
given it must be calculated using the Fisher formula:
(1 + i) = (1 + 0.077) x (1 + 0.04) = 1.12 Therefore, i the money
cost of capital is 0.12 or 12%

Note: The real rate (r) of 7.7% and the general inflation rate (h) of 4%
must be expressed as decimals when using the Fisher formula
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Working 2 Tax savings on the writing-down allowances (WDA)
Year TWDV - $000 Tax saving at 30% Timing
Asset cost 160.0
1 25% WDA (40.0) 12.0 T2
120.0
2 25% WDA (30.0) 9.0 T3
90.0
3 25% WDA (22.5) 6.8 T4
67.5
4 Balancing allowance (27.5) 8.3 T5
Residual value 40.0

Notes:
TWDV Tax written down value, WDA Writing-down allowance

The examiners normal assumption is that an asset is bought at the
start of the first year of the project and hence the first WDA is available
for Year 1.

The allowance and tax saving for Year 1 will be calculated at the end of
Year 1 which is T1 and as tax is paid one year in arrears the timing of
the cash flow will be one year later which is T2.

Rounding is a key technique in your exam as it saves time and by
keeping the numbers simple fewer mistakes will be made. Here it has
been decided to round in thousands and use one decimal place.

Students must ensure that they can calculate tax savings using different
tax regimes. For instance the next problem you face may have tax
allowances granted on a straight-line basis and the tax could be payable
immediately at each year end.

Working 3 Working capital (WC)
Sales
$000:
WC need at
10%:
WC cash
flow:
Timing:
Year 1 30 x $4.4 = 132.0 13.2 (13.2) T0
Year 2 30 x $4.4 x
1.03 =
136.0 13.6 (0.4) T1
Year 3 25 x $4.4 x
1.03
2
=
116.7 11.7 1.9 T2
Year 4 20 x $4.4 x
1.03
3
=
96.2 9.6 2.1 T3
9.6 T4



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Notes:
As the investment in working capital is based on the expected sales
revenue this has to be calculated first. Please note how the price per
unit was given in first-year terms and hence that figure has been used
for Year 1. In the following years the forecast inflation has been
included. You should note the cumulative nature of inflation.

The working capital need is simply calculated as the stated % of sales
revenue. When calculating the working capital cash flows it is the change
in the working capital need which is the cash flow. Hence for Year 1 the
need is 13.2 and as nothing has previously been invested the cash flow
is an outflow of 13.2. In Year 2 the need has risen to 13.6 but as 13.2
has already been invested the cash flow is just an outflow of 0.4 the
increase in the need. In Years 3 and 4 the need decreases and hence
cash inflows arise.

As the working capital is required at the start of each year the cash flow
for Year 1 will occur at T0 and the cash flow for Year 2 will occur at T1,
etc. Finally at the end of the project any remaining investment in
working capital is no longer required and generates a further cash inflow
at T4. The sum of the working capital cash flow column should total
zero as anything invested is finally released and turns back into cash.

Other potential workings:
A working could be shown for the variable and fixed costs. However,
this can be time consuming and enough detail can often be shown on
the face of the cash flow table to show your marker what your thought
process has been.

The $12,000 of initial research cost is ignored as it has already been
spent. Hence it is a sunk cost and is not relevant to the analysis of the
future project.
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The cash flow table
$000 Note: T0 T1 T2 T3 T4 T5
REVENUE 1
Sales revenue 2 132.0 136.0 116.7 96.2
Variable costs: 3
30 x $0.70 x 1.05 (22.1)
30 x $0.70 x 1.05
2
(23.2)
25 x $0.70 x 1.05
3
(20.3)
20 x $0.70 x 1.05
4
(17.0)
Fixed costs: 4
30 x $0.30 x 1.05 (9.5) (9.9) (10.4) (10.9)
Net revenue cash
flow
100.4 102.9 86.0 68.3
Tax at 30% 5 (30.1) (30.9) (25.8) (20.5)
CAPITAL
Asset cost (160.0)
Tax savings on the
WDA
6 12.0 9.0 6.8 8.3
Residual value 7 40.0
Working capital cash
flows
8 (13.2) (0.4) 1.9 2.1 9.6 ___
Total net money
cash flows
(173.2) 100.0 86.7 66.2 98.9 (12.2)
12% Discount
factors
9 1 0.893 0.797 0.712 0.636 0.567
Present Values 10 (173.2) 89.3 69.1 47.1 62.9 (6.9)
NPV 11 88.3

It is estimated that the project has a positive NPV of $88,300 and hence
it should be accepted as it will add to shareholder wealth.

Notes:
1 A cash flow table should always be started on a new page as it will
then hopefully fit on the one page. This avoids the need to transfer
data over a page break which inevitably leads to errors. As tax is
paid one year in arrears the cash flow table is taken to T5 even
though it is only a four-year project. A cash flow table should be
split into a Revenue section and a Capital section. In the
Revenue section all the taxable revenues and tax allowable costs
are shown. In the Capital section all the cash flows relating to the
asset purchase and other cash flows which have no impact on tax
are shown. Students should ensure that they put brackets around
negative cash flows as otherwise negative items may be treated as
if they are positive when the cash flows are totalled.
2 The annual sales revenue figures are brought forward from
Working 3. Note the normal assumption that the revenue for a year
arises at the end of the year hence the revenue for Year 1 is
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shown at T1. This assumption also applies to the variable and
fixed costs.
3 The variable costs for each year are based on the sales units for the
year, the price per unit and the inflation rate for costs. Note that as
the cost was given in current terms, which is as at T0 and the first
costs are recorded at T1, the inflation has to be accounted for
immediately. You should contrast this with the inflation of the sales
revenue in Working 3.
4 The fixed costs are relevant as they are said to be incremental. The
cost per unit for the first year has been given and this is multiplied
by the forecast sales in Year 1 to give the total incremental fixed
costs. Like the variable costs the cost per unit was given in current
terms and hence inflation must be accounted for immediately.
From Year 1 onwards the fixed costs have continued to be inflated
by the relevant inflation rate of 5%. You must remember that fixed
costs are fixed and do not change as the activity level changes. In
this way you will avoid the common error which is to treat the fixed
costs as though they were variable.
5 The tax is calculated at 30% of the net revenue cash flows. As tax is
paid one year in arrears the tax for Year 1 which is calculated at
the end of Year 1 (T1) will become a cash flow at T2. This pattern
continues in the following years.
6 The tax savings on the WDAs are brought forward from Working 2.
Please be careful to show them in the correct column given their
respective timings. Also please remember that these are the good
news of tax and so are cash inflows.
7 The residual value was given in money terms and hence already
reflects the impact of inflation. Had the value been given in current
terms and no specific inflation rate was indicated then the logical
approach would be to inflate at the general inflation rate. The
normal assumption is that the asset is disposed of on the last day
of the last year of the project and hence the cash inflow is shown
at T4.
8 The working capital cash flows are brought forward from
Working 3. They are shown in the Capital section as they do not
have any tax impact. If they were put in the Revenue section they
would change the net revenue cash flows and this would impact on
the tax calculated which would be incorrect.
9 The discount factors are found in the tables provided. The 12%
rate is the suitable money cost of capital calculated in Working 1.
10 The present values are found by multiplying the total net money
cash flows by the discount factors shown.
11 The NPV is simply the sum of the present values calculated. You
should always comment on what the NPV calculated is indicating
about the viability of the project.

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As indicated previously this is a very comprehensive example which
includes all the major potential problems you could face. I would not
expect any exam question to be as complex but all the problems shown
in this example have been examined in the past and will I am sure be
examined again in the future. Those most able to deal with these issues
will be those who are most successful in the exam.

William Parrott is a lecturer at Kaplan Financial
The risk and return relationship part 2 -CAPM
by Patrick Lynch
01 May 2004
In the article on portfolio theory, we saw that the motivation behind the establishment of a portfolio is that risk
(the bad) can be reduced without a consequential reduction in return (the good). This was mathematically
evident when the portfolios' expected return was equal to the weighted average of the expected returns on the
individual investments, while the portfolio risk was normally less than the weighted average of the risk of the
individual investments.
The portfolio's total risk (as measured by the standard deviation of returns) consists of unsystematic and
systematic risk. We saw the dramatic risk reduction effect of diversification (see Example 1). If an investor invests
in just 15 companies in different sectors (a well-diversified portfolio), it is possible to virtually eliminate
unsystematic risk. The only risk affecting a well-diversified portfolio is therefore systematic. As a result, an
investor who holds a well-diversified portfolio will only require a return for systematic risk. In this article, we
explain how to measure an investment's systematic risk.
Learning Objectives
By the end of this article you should be able to:
calculate beta from basic data using two different formulae
calculate the required return using the CAPM formula
understand the meaning of beta
prepare an alpha table and understand the nature of the alpha value
explain the problems with CAPM
briefly explain the arbitrage pricing model (APM)
calculatethe portfolio risk of a multi-asset portfolio when there is no correlation between the return of
the investments.
Example 1
The measurement of systematic risk
You may recall from the previous article on portfolio theory that the formula of the variance of a large portfolio
(where we invest equal amounts in each investment) is:
The first term is the average variance of the individual investments (unsystematic risk). As N becomes very large,
the first term tends towards zero. Thus, unsystematic risk can bediversified away.
The second term is the covariance term and it measures systematic risk. As N becomes large, the second term will
approach the average covariance. The risk contributed by the covariance (the systematic risk) cannot be
diversified away.
Systematic risk reflects market-wide factors such as the country's rate of economic growth, corporate tax rates,
interest rates etc. Since these market-wide factors generally cause returns to move in the same direction they
cannot cancel out.
Therefore, systematic risk remains present in all portfolios. Some investments will be more sensitive to market
factors than others and will therefore have a higher systematic risk.
Remember that investors who hold well-diversified portfolios will find that the risk affecting the portfolio is
wholly systematic. Unsystematic risk has been diversified away. These investors may want to measure the
systematic risk of each individual investment within their portfolio, or of a potential new investment to be added
to the portfolio. A single investment is affected by both systematic and unsystematic risk but if an investor owns a
well-diversified portfolio then only the systematic risk of that investment would be relevant. If a single
investment becomes part of a well-diversified portfolio the unsystematic risk can be ignored.
The systematic risk of an investment is measured by the covariance of an investment's return with the returns of
the market. Once the systematic risk of an investment is calculated, it is then divided by the market risk, to
calculate a relative measure of systematic risk. This relative measure of risk is called the beta' and is usually
represented by the symbol b. If an investment has twice as much systematic risk as the market, it would have a
beta of two. There are two different formulae for beta. The first is:
You must commit both formulae to memory, as they are not given on the exam formulae sheet. The formula that
you need to use in the exam will be determined by the information given in the question. If you are given the
covariance, use the first formula or if you are given the correlation coefficient, use the second formula.
Example 2
You are considering investing in Y plc. The covariance between the company's returns and the return on the
market is30%. The standard deviation of the returns on the market is 5%.
Calculate the beta value:
be =
30%=1.2
52%
Example 3
You are considering investing in Z plc. The correlation coefficient between the company's returns and the return
on the market is 0.7. The standard deviation of the returns for the company and the market are 8%and 5%
respectively.
Calculate the beta value:
be =
0.7 x 8%=1.12
5%
Investors make investment decisions about the future. Therefore, it is necessary to calculate the future beta.
Obviously, the future cannot be foreseen. As a result, it is difficult to obtain an estimate of the likely future co-
movements of the returns on a share and the market. However, in the real world the most popular method is to
observe the historical relationships between the returns and then assume that this covariance will continue into
the future. You will not be required to calculate the beta value using this approach in the exam.
The CAPM Formula
The capital asset pricing model (CAPM) provides the required return based on the perceived level of systematic
risk of an investment:
The calculation of the required return
The required return on a share will depend on the systematic risk of the share. What is the required return on the
following shares if the return on the market is 11%and the risk free rate is 6%?
The shares in B plc have a beta value of 0.5
Answer: 6%+(11%- 6%) 0.5 =8.5%
The shares in C plc have a beta value of 1.0
Answer: 6%+(11%- 6%) 1.0 =11%
The shares in D plc have a beta value of 2.0
Answer: 6%+(11%- 6%) 2.0 =16%.
Obviously, with hindsight there was no need to calculate the required return for C plc as it has a beta of one and
therefore the same level of risk as the market and will require the same level of return as the market, ie the RM
of 11%. The systematic risk-return relationship is graphically demonstrated by the security market line. See
Example 4.
Example 4
The CAPM contends that the systematic risk-return relationship is positive (the higher the risk the higher the
return) and linear.
If we use our common sense, we probably agree that the risk-return relationship should be positive. However, it
is hard to accept that in our complex and dynamic world that the relationship will neatly conform to a linear
pattern. Indeed, there have been doubts raised about the accuracy of the CAPM.
The meaning of beta
The CAPM contends that shares co-move with the market. If the market moves by 1%and a share has a beta of
two, then the return on the share would move by 2%. The beta indicates the sensitivity of the return on shares
with the return on the market. Some companies' activities are more sensitive to changes in the market - eg luxury
car manufacturers - have high betas, while those relating to goods and services likely to be in demand irrespective
of the economic cycle - eg food manufacturers - have lower betas. The beta value of 1.0 is the benchmark against
which all share betas are measured.
Beta >1- aggressive shares
These shares tend to go up faster then the market in a rising (bull) market and fall more than the market
in a declining (bear) market.
Beta <1- defensive shares
These shares will generally experience smaller than average gains in a rising market and smaller than
average falls in a declining market.
Beta =1- neutral shares
These shares are expected to follow the market.
The beta value of a share is normally between 0 and 2.5. A risk-free investment (a treasury bill) has a b =0 (no
risk). The most risky shares like some of the more questionable penny share investments would have a beta value
closer to 2.5. Therefore, if you are in the exam and you calculate a beta of 11 you know that you have made a
mistake.
Basic exam application of CAPM
1. Capital investment decisions
The calculation of Ke in the WACC calculation to enable an NPV calculation
A shareholder's required return on a project will depend on the project's perceived level of systematic risk.
Different projects generally have different levels of systematic risk and therefore shareholders have a different
required return for each project. A shareholder's required return is the minimum return the company must earn
on the project in order to compensate the shareholder. It therefore becomes the company's cost of equity.
Example 5
E plc is evaluating a project which has a beta value of 1.5. The return on the FTSE All-Share Index is 15%. The
return ontreasury bills is 5%.
Required:
What is the cost of equity?
Answer:
5%+(15%- 5%) 1.5 =20%
2. Stock market investment decisions
When we read the financial section of newspapers, it is commonplace to see analysts advising us that it is a good
time to buy, sell, or hold certain shares. The CAPM is one method that may employed by analysts to help them
reach their conclusions. An analyst would calculate the expected return and required return for each share. They
then subtract the required return from the expected return for each share, ie they calculate the alpha value (or
abnormal return) for each share. They would then construct an alpha table to present their findings.
Example 6
We are considering investing in F plc or G plc. Their beta values and expected returns are as follows:
Beta values Expected returns
F plc 1.5 18%
G plc 1.1 18%
The market return is 15%and the risk-free return is 5%.
Required:
What investment advice would you give us?
Answer:
Alpha table
Expected returns Requiredreturns Alpha values
F plc 18% 5%+(15%- 5%)
1.5 =20%
-2%
G plc 18% 5%+(15%- 5%)
1.1 =16%
+2%
Sell shares in F plc as the expected return does not compensate the investors for its perceived level of systematic
risk, it has a negative alpha. Buy shares in G plc as the expected return more than compensates the investors for
its perceived level of systematic risk, ie it has a positive alpha.
3. The preparation of an alpha table for a portfolio
The portfolio beta is a weighted average
A common exam-style question is a combined portfolio theory and CAPM question. A good example of this is the
Oriel plc question at the end of this article where you are asked to calculate the alpha table for a portfolio.
The expected return of the portfolio is calculated as normal (a weighted average) and goes in the first column in
the alpha table. We then have to calculate the required return of the portfolio. To do this we must first calculate
the portfolio beta, which is the weighted average of the individual betas. Then we can calculate the required
return of the portfolio using the CAPM formula.
Example 7
The expected return of the portfolio A +B is 20%. The return on the market is 15%and the risk-free rate is 6%.
80%of your funds are invested in A plc and the balance is invested in B plc. The beta of A is 1.6 and the beta of B
is 1.1.
Required:
Prepare the alpha table for the Portfolio
(A +B)
Answer:
b(A +B) =(1.6 .80) +(1.1 .20)
=1.5
R portfolio (A +B) =6%+(15%- 6%) 1.5 =19.50%
Alpha table
Expected return Requiredreturn Alpha value
Portfolio (A +B) 20% 19.50% 0.50%
The Alpha Value
If the CAPM is a realistic model (that is, it correctly reflects the risk-return relationship) and the stock market is
efficient (at least weak and semi-strong), then the alpha values reflect a temporary abnormal return. In an
efficient market, the expected and required returns are equal, ie a zero alpha. Investors are exactly compensated
for the level of perceived systematic risk in an investment, ie shares are fairly priced. Arbitrage profit taking would
ensure that any existing alpha values would be on ajourney towards zero.
Remember in Example 6 that the shares in G plc had a positive alpha of 2%. This would encourage investors to
buy these shares. As a result of the increased demand, the current share price would increase (which if you recall
from theportfolio theory article is the denominator in the expected return calculation) thus the expected return
would fall. The expected return would keep falling until it reaches 16%, the level of the required return and the
alpha becomes zero.
The opposite istrue for shares with a negative alpha. This would encourage investors to sell these shares. As a
result of the increased supply, the current share price would decrease thus the expected return would increase
until it reaches the level of the required return and the alpha value becomes zero.
It is worth noting that when the share price changes, the expected return changes and thus the alpha value
changes. Therefore, we can say that alpha values are as dynamic as the share price. Of course, alpha values may
exist because CAPM does not perfectly capture the risk-return relationship due to the various problems with the
model.
Problems with CAPM
Investors hold well-diversified portfolios
CAPM assumes that all the company's shareholders hold well-diversified portfolios and therefore need only
consider systematic risk. However, a considerable number of private investors in the UK do not hold well-
diversified portfolios.
One period model
CAPM is a one period model, while most investment projects tend to be over anumber of years.
Assumes the stock market is a perfect capital market
This is based on the following unrealistic assumptions:
no individual dominates the market
all investors are rational and risk-averse
investors have perfect information
all investors can borrow or lend at the risk-free rate
no transaction costs.
Evidence
CAPM does not correctly express the risk-return relationship in some circumstances. To cite a number of these
circumstances they are, for small companies, high and lowbeta companies, low PE companies, and certain days
of the week or months of the year.
Estimation of future b based on past b
A scatter diagram is prepared of the share's historical risk premium plotted against the historical market risk
premium usually over the last five years. The slope of the resulting line of best fit will be the b value. The difficulty
of using historic data is that it assumes that historic relationships will continue into the future. This is
questionable, as betas tend to be unstableover time.
Data input problems
Richard Roll (1977) criticised CAPM as untestable, because the FTSE All-Share Index is a poor substitute for the
true market, ie all the risky investments worldwide. How can the risk and return of the market be established as a
whole? What is the appropriate risk-free rate? However, despite the problems with CAPM, it provides a simple
and reasonably accurate way of expressing the risk-return relationship. Quite simply, CAPM is not perfect but it is
the best model that we haveat the moment.
Additionally, some critics believe that the relationship between risk and return is more complex than the simple
linear relationship defined by CAPM. Another model may possibly replace CAPM in the future. The most likely
potential successor to CAPM is the arbitrage pricing model (APM).
The Arbitrage Pricing Model -APM
The CAPM contends that the only reason the return of a share moves is because the return on the market moves.
The magnitude of a share's co-movement with the market is measured by its beta. If a share has a beta of two
and the market increases by 1%, we would expect the share's return to increase by 2%. If the market increases by
5%we would expect the share's return to increase by 10%. Remember that the market only gives a return for
systematic risk. Therefore, any changes in the market return are due to a large number of macro-economic
factors.
The model
The arbitrage pricing model, developed by Stephen Ross in 1976, attempts to identify all of the macro-economic
factors and then specifies how each factor would affect the return of a particular share. The APM is therefore
more sophisticated than CAPM in that it attempts to identify the specific macro-economic factors that influence
the return of a particular share. Commonly invoked factors are:
inflation
industrial production
market risk premiums
interest rates
oil prices.
Each share will have a different set of factors and a different degree of sensitivity (beta) to each of the factors. To
construct the APM for a share we require the risk premiums and the betas for each of the relevant factors.
Return on a share =RF +Risk premium F1.b1 +Risk premium F2.b2 +Risk premium F3.b3 +. . .
Example 8
beta 1 =the effect of changes in interest rates on the returns from a share
beta 2 =the effect of oil prices on the returns from a share
A share in a retail furniture company mayhave a high beta 1 and a low beta 2 whereas a share in a haulage
company may have a low beta 1 and a high beta 2. Under the APM, these differences can be taken into account.
However, despite its theoretical merits, APM scores poorly on practical application. The main problem is that it is
extremely difficult to identify the relevant individual factors and the appropriate sensitivities of such factors for
an individual share. This has meant that APM has not been widely adopted in the investment community asa
practical decision-making tool despite its intuitive appeal.
Before we conclude the articles on the risk-return relationship, it is essential that we see the practical application
of both portfolio theory and CAPM in an exam-style question. Indeed, it is quite common to have both topics
examined in the same question as demonstrated in Oriel plc below.
Exam Style Question (including the multi-asset portfolio exam trick)
Oriel plc
Oriel plc is considering investing in one of two short-term portfolios of four short-term financial investments. The
correlation between the returns of the individual investments is believed to be negligible (zero/independent/no
correlation). See Portfolio 1 and Portfolio 2. The market return is estimated to be 15%, and the riskfree rate 5%.
Portfolio 1
Investment Amounts invested
million
Expected return Total risk Beta
a 10 20% 8 0.7
b 40 22% 10 1.2
c 30 24% 11 1.3
d 20 26% 9 1.4
Portfolio 2
Investment Amounts invested
million
Expected return Total risk Beta
a 20 18% 7 0.8
b 40 20% 9 1.1
c 20 22% 12 1.2
d 20 16% 13 1.4
Required:
a. Estimate the risk and return of the two portfolios using the principles of both portfolio theory and CAPM
and decide which one should be selected.
b. How would you alter your calculations for the summary table if you were told: The correlation between
the returns of the individual investments is perfectly positively correlated'.
Solution to Oriel plc
Answer to part (a)
The CAPM calculations - the application of CAPM principles in the exam means the preparation of the alpha table
to find the portfolio with the largest positive alpha. See Portfolio 1 Solution and Portfolio 2 Solution.
Portfolio 1 Solution
Investment Investment weightings Expected return (%) Portfolio expected return (%) Beta Portfolio beta
a .1 20 2.00 0.7 .07
b .4 22 8.80 1.2 .48
c .3 24 7.20 1.3 .39
d .2 26 5.20 1.4 .28
23.20 1.22
The required return: 5 +(15 - 5) 1.22 =17.20%
Portfolio 2 Solution
Investment Investment weightings Expected return (%) Portfolio expected return (%) Beta Portfolio beta
a .2 18 3.60 0.8 .16
b .4 20 8.00 1.1 .44
c .2 22 4.40 1.2 .24
d .2 16 3.20 1.4 .28
19.20 1.12
The required return: 5 +(15 - 5) 1.12 =16.20%
Alpha table
Expected returns Required returns Alphavalues
Portfolio 1 23.20% 17.20% 6.00%
Portfolio 2 19.20% 16.20% 3.00%
Portfolio 1 is chosen because it has the largest positive alpha.
Portfolio theory calculations
The application of the portfolio theory principles in the exam requires the preparation of a summary table to help
identify the efficient portfolio. However, in this question we are dealing with more than a two-asset portfolio, in
fact there are four assets in each portfolio. This is known as the multi-asset portfolio exam trick. This was
examined in Rodfin (December 1995) and Maltec (June 2001). Both times you were told there is no correlation
between the returns of the individual investments. Therefore, the correlation coefficient is zero and the third
term disappears from the portfolio risk equation.
Therefore, the formula for a multi-asset portfolio with no correlation between the returns is:
Summary table
Expectedreturns Portfolio risk
Portfolio 1 23.20% 5.55%
Portfolio 2 19.20% 5.24%
The portfolio with the highest return also has the highest level of risk. Therefore, neither portfolio can be said to
be more efficient than the other. An objective answer cannot be reached. As the company is making decisions on
behalf of its shareholders the correct way to evaluate the investments is by looking at the effect they have on a
shareholders existing/enlarged portfolios.
Thus, the portfolio theory decision rule will probably break down if different shareholders experience different
levels of total risk or they may have different attitudes to risk. Therefore, some shareholders would prefer
portfolio 1 and other shareholders portfolio 2.
If the majority of Oriel's shareholders are institutional shareholders, I would recommend the use of CAPM to
make the decision, as they would hold well-diversified portfolios and only be subject to systematic risk. This
would be a reasonable assumption as institutional investors like pension companies and unit trust companies
hold approximately 75%of all the shares that are quoted on the London stock market.
Answer to part (b)
If the correlation coefficient identifies perfect positive correlation, there is no reduction in risk at all. Therefore,
the portfolio's total risk is simply a weighted average of the total risk (as measured by the standard deviation) of
the individual investments of the portfolio.
sport1 =8 0.1 +10 0.4 +11 0.3 +9 0.2 =9.9
sport2 =7 0.2 +9 0.4 +12 0.2 +13 0.2 =10
Summary table
Expectedreturns Portfolio risk
Portfolio 1 23.20% 9.9%
Portfolio 2 19.20% 10.0%
Portfolio 1 is the most efficient portfolio as it gives us the highest return for the lowest level of risk.
10 Key Points To Remember
1. The beta is a relative measure of systematic risk. It indicates the sensitivity of the return on a share with
the return on the market. If the market moves by 1%and a share has a beta of two, then the return on
the share would move by 2%.
2. We may have to calculate the beta from basic data using the following two different formulae:
3. The value of beta is normally between 0 and 2.5.
4. Ensure that you know how to calculate the required return using the CAPM formula:
RA =RF +(RM - RF) bA
as this is examined in every paper.
5. Be able to prepare an alpha table and to give investment advice based on alpha values:
Decision advice based on alpha values
Alpha Have shares Dont have shares
+ Hold Buy
- Sell Dont buy
6.
7. If CAPM is a realistic model and the market is efficient, an alpha value (a temporary abnormal return) is
on a journey towards zero.
8. Ensure that you are able to list the problems associated with CAPM.
9. APM suggests that a number of factors affect the risk-return relationship and in time, this model may
replace CAPM when more developments take place to improve its practical application.
10. Remember that the formula for a multi-asset portfolio with no correlation between the returns is:
11. The basic exam technique required for portfolio theory is the preparation of a summary table to aid
identification of the most efficient portfolio. Similarly, the key to applying CAPM is the preparation of an
alpha table to help identify the largest positive alpha value.
Patrick Lynch is a lecturer at FTC London
Market matters
by Anthony Head
21 Nov 2003
Capital markets, efficiency and fair prices
Investors in capital markets want to be sure that the prices they pay for securities, such as ordinary shares and
bonds, are fair prices. In order for security prices to be fair, the capital markets must be able to process relevant
information quickly and accurately. Relevant information is anything that could affect security prices e.g. previous
movements in security prices, newly-released company financial statements, changes in interest rates or details
of sales of their own companys shares by company directors. We say that a capital market is efficient when we
are confident that security prices are fair. A capital market can be efficient when share prices in general are falling
(a bear market) or rising (a bull market).
Types of efficiency
It is usual to identify four types of capital market efficiency1:
1. Operational efficiency requires that transaction costs are low and do not hinder investors in the sale or
purchase of securities.
2. Informational efficiency means that relevant information is widely available to all investors at low cost.
3. Pricing efficiency refers to the ability of capital markets to process information quickly and accurately,
and arises as a consequence of operational efficiency and informational efficiency.
4. Allocational efficiency means that capital markets are able to allocate available funds to their most
productive use and arises as a result of pricing efficiency.
Most of the research into market efficiency has been into pricing efficiency.
Forms of efficiency
In order to decide whether a capital market exhibits pricing efficiency, research must be undertaken into security
price movements and whether it is possible to make abnormal gains by acting on different kinds of information.
Most of this research has been based on ordinary share price movements and three forms of efficiency can be
described.
Weak form efficiency refers to a market where share prices fully and fairly reflect all past information. In such a
market, it is not possible to make abnormal gains by studying past share price movements. Research has shown
that capital markets are weak form efficient and that share prices appear to follow a random walk, the random
changes in share prices resulting from the unpredictable arrival of favourable and unfavourable information on
the market.
Semi-strong form efficiency refers to a market where share prices fully and fairly reflect all publicly available
information in addition to all past information. In such a market it is not possible to make abnormal gains by
studying publicly available information such as the financial press, company financial statements and records of
past share price movements. Research has shown that well-developed capital markets such as the London Stock
Exchange and the New York Stock Exchange are semi-strong form efficient.
Strong form efficiency refers to a market where share prices fully and fairly reflect not only all publicly available
information and all past information, but also all private information (insider information) as well. In such a
market, it is not possible to make abnormal gains by studying any kind of information. Since it is always possible
to make abnormal gains by using insider information (even if governments have made this illegal), even well-
developed capital markets cannot be described as strong form efficient. However, investors and analysts are
often accurate in their estimates of what is happening inside companies and financial management theory
considers well-developed capital markets to be highly efficient.
The consequences of market efficiency
What does it mean for companies if research has shown that capital markets are highly efficient? One
consequence is that theoretically at least, there is no right or wrong time to issue new shares since share prices
are always fair. Other considerations than share price must be used to decide on the best time to issue new
ordinary shares, such as the number of shares that will need to be issued to raise the required amount of finance,
the effect of the new share issue on earnings per share, any dilution of control that might arise, the effect on
gearing and financial risk, and so on.
Another consequence for companies is that it is pointless for company managers to try to manipulate information
given to the capital markets in order to present their companies in a more favourable light, since an efficient
capital market will see through this as it fully and fairly reflects all relevant information in the process of
providing fair prices.
A further consequence for both companies and investors, again from a theoretical point of view, is that there are
no bargains to be found in capital markets. There are no incorrectly priced shares from which to make a quick
profit and no undervalued companies to take over in order to produce an instant increase in market
capitalisation.
In fact, if capital markets are highly efficient, all that managers need to do (again theoretically) is to make good
financial management decisions (such as investing in all projects with a positive net present value). This is in order
to maximise the market values of their companies and hence to maximise shareholder wealth, which is the
primary financial management objective. It is easy to see, therefore, why financial management attaches so much
importance to capital market efficiency.
Product markets andthe problem of monopoly
Another market matter is regulation of business. One example is pricing restrictions. This can be illustrated by
looking at the problem of monopoly in product markets and how to respond to it.
One possible result of a company being successful in its chosen market is that it gains increasing market share.
This may be due to its competitors going out of business or as a result of taking over its competitors. If the trend
continues, a successful company may end up with no real competition at all. It is then in a position to earn
monopoly profits by selling at prices higher than would be found in a more competitive market.
The positive consequences of monopoly
There may be a circumstance in which a monopoly may be desirable, for examplewhen size is necessary for
efficient production of a particular product, i.e. through economies of scale2. This has been claimed to be true of
utilities such as water distribution and electricity production.
It is worth noting in this respect that successive UK governments have felt the need to artificially maintain
competition in the markets served by privatised UK utilities, implying that utilities naturally tend towards a
monopoly. It has also been suggested that monopoly may be the natural reward for entrepreneurial activity by
businesses, or the logical consequence of a focus on shareholder wealth maximisation.
The negative consequences of monopoly
The negative consequences of monopoly are usually felt to outweigh any positive outcomes. Society and the
public can suffer as a result of monopoly. Not only do consumers pay higher prices in order to support monopoly
profits, but they may be offered a reduced product range. Society can also suffer through the inefficient use of
economic resources in the production process, a decrease in innovation and product development, and a lack of
incentives for a monopoly to reduce managerial and other inefficiencies.
Government regulation of monopoly
Consumers cannot deal with monopolies and so this regulatory role isusually assumed by governments. Many
governments, including those of the UK, EU and USA, have long histories of regulatory intervention in product
and consumer markets. Their aims can be to stop monopolies arising, to prevent abuse of a dominant position in
a particular market, to prevent the creation of price-fixing cartels, and to preserve and maintain competition.
In the UK, these objectives are achieved through the actions of the Office of Fair Trading and the UK Competition
Commission, which are required to monitor, investigate and make binding recommendations in situations where
a potential monopoly may arise. The criteria used to initiate an investigation can be quite broad: UK legislation,
for example, considers that a monopoly position may arise when a company has a market share of 25 per cent or
more, of a particular market3.
Product markets and the problem of externalities
Excessive profits can be gained by companies which do not pay the full economic cost for their production
processes. For example, a company which causes environmental pollution does not bear the full cost of its
inefficient production process, but transfers the cost of cleaning up its waste products as an externality to society
as a whole. Externalities are social costs or benefits arising from economic decisions of individual economic
agents such as companies4.
Governments may need to intervene in product markets to require companies to bear more of the cost of the
externalities they produce. In other words, they may adopt greenpolicies, another example of regulation of
business suggested in Section 2 of the Paper 2.4 syllabus.
Green policies can result in increased production costs as companies are required by legislation to reduce the
environmental impact of their business operations. These increased costs will reduce company profits unless they
are passed on to customers through increased prices. If price increases occur, green policies can result in the
reduction of externalities and the transfer of their costs from society to consumer.
Green policies can therefore be seen as leading to fairer prices in particular product markets since these prices
reflect more completely the economic resources consumed in the production of the products offered for sale.
Money and capital markets and the cost of money
The syllabus also refers to rates of interest and yield curves. Both interest rate and yield can be seen as the cost of
money, ie the price of money set by the interaction of the supply of funds and the demand for funds in a
particular market.
It is important to recognise that interest rate and yield have different meanings. Interest rate is the percentage
return on the nominal (or money) amount of debt issued. Yield can either mean interest rate divided by market
price (often referred to as running yield), or it can mean the discount rate that makes the present value of future
interest payments and redemption value equal to the current market price (referred to as the redemption yield
or the cost of debt).
Consider a bond with a market value of 102.53 that pays 10 per cent per year for three years before being
redeemed at par. Its interest rate (or coupon) is 10 per cent. Its running yield is 100 x (10/102.53) =9.75 per cent.
Its redemption yield or cost of debt (found by linear interpolation) is 9 per cent.
The longer the period over which debt is offered, the greater is the risk to the lender that the borrower may be
unable to meet interest payments, or be unable to repay the principal amount borrowed. This means that as the
timeto redemption or repayment increases, the risk of default also increases, and we expect that lenders would
require a higher return to compensate for this increased risk. If we consider default risk alone, we would expect
long-term debt to be more expensive than short-term debt.
There are other factors to consider in discussing the relative risk and cost of long-term and short-term debt. The
important point to grasp, however, is that long-term debt is usually expected to be more expensive than short-
term debt (i.e. the yield curve slopes upwards), unless other factors arise which act to change the normal state of
affairs. Expectations theory, market segmentation theory and liquidity preference theory consider the different
costs of debt of differing maturities, and students should consider these as possible explanations of yield curves
which do not slope smoothly upwards5.
Selecting sources of finance for business
by Steve Jay
21 Sep 2003
This article considers the practical issues facing a business when selecting appropriate sources of finance. It does
not consider the theoretical aspects of such decisions (Modigliani and Miller), nor does it provide detailed
descriptions of various sources of finance. These are well covered in manuals and textbooks.
A business faces three major issues when selecting an appropriate source of finance for a new project:
1. Can the finance be raised from internal resources or will new finance have to be raised outside the
business?
2. If finance needs to be raised externally, should it be debt or equity?
3. If external debt or equity is to be used, where should it be raised from and in which form?
Can the necessary finance be provided from internal sources?
In answering this question the company needs to consider several issues:
How much cash is currently held? The company needs to consider the amount held in current cash
balances and short-term investments, and how much of this will be needed to support existing
operations. If spare cash exists, this is the most obvious source of finance for the new project.
If the required cash cannot be provided in this way then the company should consider its future cash
flow. A cash budget can be prepared, but it is probably too detailed at this stage. A cash flow statement
as shown in Example 1 would probably be more practical.
If the companys projected cash flow is not sufficient to fund the new project then it could consider
tightening its control of working capital to improve its cash position.
Pressurising debtors for early settlement, running down stock levels and lengthening the payment period to
creditors could increase cash resources. Note however, there are dangers in such tactics. For example, lost
customer / supplier goodwill and production stoppages due to running out of stock etc.
If the necessary finance cannot be provided internally then the company has to consider raising finance
externally.
The debt or equity decision
Here a company needs to consider how much it should borrow. This is a very important decision and several
British companies have experienced major problems with this decision in recent years, eg Marconi, British
Telecom and NTL. Issues to be considered include:
The cost of finance. Debt finance is usually cheaper than equity finance. This is because debt finance is
safer from a lenders point of view. Interest has to be paid before dividend. In the event of liquidation,
debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt
investors demand a lower rate of return than equity investors. Debt interest is also corporation tax
deductible (unlike equity dividends) making it even cheaper to a taxpaying company. Arrangement costs
are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs,
they are also tax deductible.
The current capital gearing of the business. Although debt is attractive due to its cheap cost, its
disadvantage is that interest has to be paid. If too much is borrowed then the company may not be able
to meet interest and principal payments and liquidation may follow. The level of a companys borrowings
is usually measured by the capital gearing ratio (the ratio of debt finance to equity finance) and
companies must ensure this does not become too high. Comparisons with other companies in the
industry or with the companys recent history are useful here.
Security available. Many lenders will require assets to be pledged as security against loans. Good quality
assets such as land and buildings provide security for borrowing- intangible assets such as capitalised
research and development expenditure usually do not. In the absence of good asset security, further
borrowing may not be an option.
Business risk. Business risk refers to the volatility of operating profit. Companies with highly volatile
operating profit should avoid high levels of borrowing as they may find themselves in a position where
operating profit falls and they cannot meet the interest bill. High-risk ventures are normally financed by
equity finance, as there is no legal obligation to pay equity dividend.
Operating gearing. Operating gearing refers to the proportion of a companys operating costs that are
fixed as opposed to variable. The higher the proportion of fixed costs, the higher the operating gearing.
Companies with high operating gearing tend to have volatile operating profits. This is because fixed costs
remain the same, no matter the volume of sales. Thus, if sales increase, operating profit increases by a
larger percentage. But if sales volume falls, operating profit falls by a larger percentage. Generally, it is a
high-risk policy to combine high financial gearing with high operating gearing. High operating gearing is
common in many service industries where many operating costs are fixed.
Dilution of earnings per share (EPS). Large issues of equity could lead to the dilution of EPS if profits from
new investments are not immediate. This may upset shareholders and lead to falling share prices.
Voting control. A large issue of shares to new investors could alter the voting control of a business. If the
founding owners hold over 50%of the equity they may be reluctant to sell new shares to outside
investors as their voting control at the AGM may be lost.
The current state of equity markets. In a period of falling share prices many companies will bereluctant
to sell new shares. They feel the price received will be too low. This will dilute the wealth of the existing
owners. Note this does not apply to rights issues where shares are sold to the existing owners of the
company. New issues of shares on the UK stock exchanges have been rare over the last few years due to
the bear market. At the time of writing there is some evidence that the bear market is coming to an end.
After consideration of the above points the company will be in a position to decide between the use of debt or
equity finance. The last major decision is what type of finance should be used and where should it be raised?
Equity Finance
A detailed consideration of the different sources of equity finance is beyond the scope of this article and students
are recommended to consult their textbooks or manuals for more detailed coverage. However, here are a few
general points on the subject:
For companies who already have shares in issue rights, issues are mandatory under company law. This
means that any new shares have to be offered to existing shareholders in proportion to their existing
holdings. This is to protect existing shareholders from the company selling shares to new investors at a
low price and diluting the wealth of existing shareholders. This requirement may be overcome if existing
shareholders are prepared to vote to waive their pre-emption rights.
The current status of the company is important. Companies listed on the London International Stock
Exchange or quoted on the Alternative Investment Market (AIM), can raise new equity finance by selling
new shares on these markets by way of rights issues, offers for sale or placing. Other companies who
lack access to the stock exchange find it more difficult to raise equity finance andmay need to turn to
venture capitalists if they require equity finance.
Debt Finance
Debt finance comes in many different forms. Students will find detailed descriptions in their textbooks and
manuals. The major considerations in raising new debt financeare detailed below.
The duration of the loan
Generally, short-term borrowing (loans for less than one year) is cheaper than longer-term borrowing (loans for
more than one year). This is because many lenders equate time with risk. The longer they lend for, the more risk
is involved as more things can go wrong. Hence they charge a higher interest rate on longer-term lending than on
short-term lending. However, short-term borrowing has a major disadvantage- renewal risk. Short-term loans
have to be regularly renewed and the company carries the risk that lenders may refuse to extend further credit.
This risk is at its highest on overdraft borrowing where the bank can call in the overdraft on demand. With long-
term borrowing, as long as the borrower does not breach the debt covenants involved, the finance is assured for
the duration of the loan.
In choosing between short-term and long-term borrowing, the firm should consider the textbook rule of thumb
for prudent financing: finance short-term investments with short-term funds and long-term investments with
long-term funds. Simply, this means use cheap short-term borrowing where it is safe to do so (investments that
are short-term in nature and hence renewal risk is not a problem) but use long-term finance for long-lived
investments.
Fixed v floating-rate borrowing
Many lenders offer the borrower the choice between a fixed rate of interest and one that floats (ie varies) with
the general level of interest rates. Fixed-rate borrowing has the attraction of certainty (you know what interest
rate you are going to pay) but on average is more expensive. This is because lenders see themselves as taking
more risk on fixed-rate lending as they may lose out if interest rates increase. Generally, floating (variable) rate
borrowing is cheaper, but it carries more risk to the borrower as interest payable may increase if interest rates
rise. If a firm is already highly geared it may consider the risks of floating-rate borrowing too high.
The status of the company
Some types of debt finance are only available to large listed companies. Small companies are usually restricted to
short-term borrowing. If long-term debt finance is available it is usually in the form of leasing, sale and leaseback,
hire purchase or mortgage loans on property.
Currency of borrowing
It is important to remember that if a company borrows in a foreign currency it has to repay the loan and the
interest in that currency. Currency fluctuations may add to the cost of the loan and increase the risk involved.
Debt Covenants
Borrowing money often entails certain obligations for the borrower over and above repaying the interest and
principal. These are referred to as covenants. These include restrictions on the use of assets financed by the loan,
restrictions on dividend payments and restrictions on further borrowing. Such covenants restrict the flexibility of
the borrower and should be carefully considered before borrowing money.
Conclusion
It is not possible to recommend an ideal source of finance for any project. What is important is that students
appreciate the advantages and disadvantages of different financing methods and can provide reasoned advice to
businesses.
Steve Jay is examiner for CAT Paper 7
Example 1
ABC plc needs $100m over the coming year to finance an expansion of the business. Accounting statements for
the last financial year are given below.
Income statementfor the year ended 30 June 20X3
$m
Turnover 300
Cost of sales* (180)
Operating profit 120
Interest charges (30)
Pre tax profit 90
Corporation tax (24)
Profit after tax 66
Proposed dividend (40)
Retained earnings 26
* This includes depreciation of $16m
Balance sheet as at 30 June 20X3
Non-current assets (net)
Land and buildings 100
Fixtures and fittings 100
Vehicles 400
600
Current assets
Inventory 120
Receivables 200
Cash 80
400
Liabilities falling due in less than one year:
Trade creditors (170)
Dividends payable (40)
Tax payable (24)
(234)
166
Total assets less current liabilities 766
15%debentures 2015 - 2018 (200)
Net assets 566
Issued share capital 200
Reserves 366
566
Without the expansion sales turnover, cost of sales (excluding depreciation), dividends and working capital
requirements are expected to grow by 10%in the coming year. The corporation tax bill is expected to be $120m.
Tax and dividends are paid nine months after the year end.
Required: Calculate ABCs expected net cash flow for the year ending 30 June 20X4 without the new investment.
Comment on the amount of external financing required for the proposed expansion. (Note: a statement in FRS 1
format is not required).
Solution
Net cash flow year ending 30 June 20X4
$m
Turnover (300m x 1.10) 330.0
Cost of sales (180m - 16m) x 1.10 (180.4)
149.6
Interest (30.0)
Tax paid (last years bill) (24.0)
Dividends paid (40.0)
55.6
Increase in stock (120m x 0.1) (12.0)
Increase in debtors (200m x 0.1) (20.0)
Increase in creditors (170m x 0.1) 17.0
Net cash flow 40.6
Comment
Cash flow from operations is expected to be $40.6m in the coming year. If the remaining $59.4m is financed from
the cash balance of $80m, then the firm will have no need to raise external finance to finance the proposed
expansion.
Business finance and the SME sector
by David Brookfield
21 Sep 2001
One of the most important problems accountants are likely to deal with in acting as advisors to a small or
medium-sized enterprise (SME) concerns the issue of financing. More succinctly, directors and owner managers in
SMEs often complain of the lack of finance for what are profitable investment opportunities. For candidates
preparing for professional examinations, the problem of learning about sources of finance for small businesses is
one of merely thinking of different ways of listing the available sources of finance. Of course, there is more to the
problem than that although, in my experience, when directors and owner managers talk about sources of finance
they do want to know what is available. Just as it is important for accountants to be able to advise on what
financing is available- and I will identify some below- is the need to be able to understand and explain why the
SME sector encounters difficulties in finding appropriate finance and what are the options in tackling the barriers
that exist to financing. As I will argue, dealing with such barriers are natural territory for accountants acting in an
advisory role and hence it is vital that aspiring professionals should understand the issues involved.
Background
There is no unequivocal definition of what is meant by an SME. McLaney (2000) identifies three characteristics:
1. firms are likely to be unquoted;
2. ownership of the business is restricted to few individuals, typically a family group; and
3. they are not micro businesses that are normally regarded as those very small businesses that act as a
medium for self-employment of the owners. However, this too is an important sub-group.
The characteristics of SMEs can change as the business develops. Thus, for growing businesses a floatation on a
market like AIM is a possibility in order to secure appropriate financing. In fact, venture capital support is usually
preconditioned on such an assumption.
The SME sector is important in terms of contribution to the economy and this is likely to be a characteristic of
SMEs across the world. According to the Bank of England (1998), SMEs accounted for 45%of UK employment
and 40%of sales turnover of all UK firms. This situation is similar across the EU.
Future developments mean that the importance of the SME sector will continue, if not develop. The growth in
small, new technology businesses servicing particular market segments and the shift from manufacturing to
service industries, at least in Western economies, means that economies of scale are no longer as important as
they once were and, hence, the necessity for scale in operations is no longer an imperative. We know, also, that
innovation flourishes in the smaller organisation and that this will be an important characteristic of the business
in the future.
The problem
The obvious point to state is that directors and owner managers of SMEs often describe a situation of shortage of
capital and consequential missed investment opportunities. At an economy wide level, if this is true, there is a
reductionin the nations wealth through investment opportunities lost. Lets see how this might be explained
more fully.
The market for finance
Money for investment comes from savings. Taking a broad perspective initially, as individuals we can save money
in the form of equity or debt. Equity is easy to understand and is represented in terms of stocks and shares. Debt
saving is broadly everything else and is usually characterised as interest bearing. A bank deposit account is an
example. As you will know, the form of business financing matches the methods of saving. Thus firms either have
equity or a mixture of equity and debt in their capital structure.
The total supply of savings is determined by disposable incomes and, in turn, tax policy. What is available to firms
as sources of finance on a macroeconomic scale is determined by:
the competition for savings from the government borrowing requirement (the higher the government
debt, the more government borrowing required, the less savings available to finance the corporate
sector);
overseas opportunities and the leakage of money from an economy that is invested abroad (the better
the overseas investment opportunities overseas the less capital available for domestic business);
corporate tax policy and the incentivescreated for investment such as capital allowances and large
disincentives on distributions (the more dividends are taxed the less income for investors).
interest rate policy (the higher interest rates are, the more likely savers are to delay consumption and
put money aside for future benefit).
This last point is important because, whilst businesses do not like high interest rates, it must be recognised that
without an interest rate no investment funds would be forthcoming. Just what might be the best interest rate to
have for the economy in terms of maintaining an appropriate balance between investing and saving involves
deeper issues than need be covered here.
In assessing why it is important to identify the factors that influence the supply of capital, accountants should
appreciate that savers can only save what they dont spend. This includes spending or paying taxes, and there
are many avenues that savers can use to invest their money. Thus, there is a competitive market for savers funds
and SMEsare not immune to its effects. For example, in high tax regimes and low levels of disposable income
there will be a shortage of funds made available by savers. Competitive pressure for the available funds may
therefore mean that the cost of capital (the return paid to savers) is high.
The broad capital flow representing the supply of finance being provided to those who demand it can be
represented in Diagram 1.
Intermediation is represented by the banking sector that brings together savers and investors in a cost effective
manner to allocate scarce funds.
Accessing scarce funds for SME investment
Thus we see that, even for the best firms, with the most effective management and the most original ideas there
is a shortage of funds inasmuch that there will always be a limited supply. The market for available funds is
competitive. Managers of SMEs who fail to recognise this do not understand an important part of their job which
is to secure proper financing: this is the point at which accounting advisors are most useful.
Beyond saying that there is a limited supply of funds there is a deeper issue. It is well recognised in the academic
literature on this issue that the problem of adequately financing SMEs is a problem of uncertainty. A defining
characteristic of SMEs is the uncertainty surrounding their activities. However much managers inform their banks
of what they are doing there is always an element of uncertainty remaining that is not a feature of larger
businesses. Larger businesses have grown from smaller businesses and have a track record- especially in terms of
a long term relationship with their bankers. Bankers can observe, over a period of time, that the business is well-
run, that managers can manage its affairs and can therefore be trusted with handling bank loans in a proper way.
New businesses, typically SMEs, obviously dont have this track record. The problem is even broader. Larger
businesses conduct more of their activities in public, or subject to external scrutiny, than do SMEs. Thus, if
information is public, there is less uncertainty. For example, a larger business might be quoted on an exchange
and therefore subject to press scrutiny, exchange rules regarding the provision of certain of its activities, and has
to publish accounts that have been audited. Many SMEs do not have to have audits, certainly dont publish their
accounts to a wide audience and the press are not really interested in them. The problem of SMEs is how do they
get over this barrier of conveying that they are a good business, can make profits if only they were provided with
appropriate finance, and can grow large if given half a chance.
Overcoming information barriers
This is the point at which financial intermediaries enter. There are basically two forms: banks, and accountants
acting in their role as activators. Thus, we see a vital role played by professionals in getting SMEs to grow. Lets
deal with banks first.
If SMEs wish to access bank finance then banks will wish to address the information problem in three phases.
First, by screening applicants to assess their product, the management team, the market they are to address and,
importantly, any collateral or security that can be offered. This first phase is likely to involve properly prepared
business plans, an audit of the firms assets, detailed explanation of any personal security offered by the directors
and owner managers, and the experience and relevance of the skills of the management team. The second phase
involves setting an appropriate contract for a loan. You should not forget basic finance at this point. Thus, in the
first phase, a bank would make an assessment of the risk of the business and any loan interest rate, set in the
second phase, will reflect that risk. A key feature for accessing bank finance is therefore in the assessment of risk
from the information gathered in the first phase. Contract details will specify interest rate, term, the level and
type of security offered, restrictive covenants, and repayment details. The third phase is the monitoring phase by
which banks monitor the performance of any loan according to the contract details set-out in phase 2.
Compliance comes to the fore at this point. It is also at this point that the key banking relationship can be
established.
There is still an important issue remaining. What about businesses that fail one of the screening or contracting
tests? What about businesses that have few tangible assets to offer as security, which is very typical of high
technology or Internet start-ups? These businesses are thus characterised by great uncertainty but still need that
start-up finance to develop. Accountants play a crucial role at this point. In order to understand how this might be
resolved it is important to see how the needs of SME financing change with their stage of growth.
Types of financing and growth in SMEs
A broad list of SME financing can be usefully provided at this point:
1. Initial owner financing
2. Business angel financing
3. Trade credit
4. Leasing
5. Factoring
6. Venture capital
7. Short-term bank loans
8. Medium term bank loans
9. Mezzanine finance
10. Private placements
11. Public equity
12. Public debt.
This list is loosely structured along growth lines. Thus, very small organisations start at point 1 and work through
to point 10. Not all of the financing is successive and a number will overlap. Further more, as businesses grow,
more information becomes known as they develop a track record. Thus the list is ordered as much in terms of
information availability as it is in terms of growth.
Diagrammatically, the relationship between type of finance and growth may be represented along a time line on
the assumption that growth is related to age of business as shown in Diagram 2.
It is important also that to realise that with age and growth comes greater information and larger firm size. There
is no significance to the vertical ordering. The horizontal ordering is flexible inasmuch that the exact timing of the
relevance of different types of finance will vary according to circumstances. Financing that appears on a single
line, such as business angel finance, venture capital and public equity is meant to represent a succession. Other
forms of finance may intervene in the line if appropriate to a particular business such as private placement or
mezzanine finance. The one curiosity is that often, with small businesses, longer-term loans are easier to obtain
than medium term loans because the longer loans are easily secured with mortgages against property. The fact
that medium term loans are hard to obtain is a well known feature of SMEs and is known as the maturity gap. Its
main problem arises in a mismatching of the maturity of assets and liabilities.
Initial owner finance is nearly always the first source of finance for a business, whether from the owner of from
family connections. At this stage many of the assets may be intangible and thus external financing is an unrealistic
prospect at this stage, or at least has been in the past. In fact, what the diagram illustrates is what is referred to
as the equity gap. With business angel finance unformalised in terms of a market and sometimes difficult to set-
up there are limited means by which SMEs can find equity investors. Trade credit finance is important at this
point too, although it is nearly always very expensive if viewed in terms of lost early payment discounts. Also, it is
inevitably very short term and very limited in duration (except that always taking 60 days to pay a creditor will
obviously roll-over and become medium term financing). Business angel financing is extremely important and is
represented by high net worth individuals or groups of individuals who invest directly in small businesses.
Candidates for the examination should make themselves aware of the principal features of all of the types of
finance identified. McLaney (2000), and tutor texts, with which you will be familiar, are a good source of
information. A chapter in a forthcoming set of readings by Jarvis (2000) provides an excellent assessment of the
importance of different sources of finance.
The role ofaccountants
Explaining and supporting businesses in identifying and accessing appropriate finance is a key role for accountants
throughout the development of an organisation. This is particularly important at the business angel financing
stage (one of theearliest stages at which external financing arises). Accountants, as professionals have a range of
contacts from individuals or businesses with surplus funds they wish to invest. Accountants are also in contact
with businesses that need finance. Matchmaking is therefore important and accountants can be crucial activators
in developing businesses in this way.
Also, it is important that businesses manage their finance, not just in terms of adequacy, but also with respect to
type. Financing can vary significantly in many ways. For example, the cost of financing will vary and it is well
known that debt is generally cheaper than equity, even for owner finance which will mostly be equity based.
Another example is with working capital. Besides highlighting the expensive nature of trade credit as a source of
finance when early settlement discounts are involved, accountants should realise that maturity matching of
working capital is important too. Thus, to the extent that current assets exceed current liabilities then, by
definition, the excess must be funded by longer term financing. I will leave you to think about that one.
Most importantly, accountants can assist in the provision of information for their clients looking to access
funding. If, as has been identifiedabove, information uncertainty is the biggest problem facing SMEs then
accountants should respond to that and aspiring accountants should be aware of the issues involved. Thus, for
example, a significant way in which accountants can assist is in the development of business plans.
Business finance and sources of finance are very important subjects andare becoming more so in the light of the
financing needs of new technology businesses with virtually no tangible assets. This particular problem is causing
headaches for the investment community too. For the time being, understanding the basics, as outlined above,
will be enough to begin with. What this article provides for examination candidates is a macroeconomic context
to understand the market for finance and a method of analysis in terms of information uncertainty, growth and
financing types that will enable candidates to address some of the important issues involved.