Copfin Module

Chapter 7 VALUATION OF LONG TERM SECURITIES
SOURCES OF FINANCE
Since every organisation needs finance to conduct its operations, the financial
manger must consider the broad categories of finance to be raised, the mix of
debt and equity and the cost of the finance. In addition, the financial
instruments to be issued to raise funds must appeal to investors for funds to
be forthcoming.
This part of Corporate Finance will loo at the marets and institutions through
which finance can be raised as well as types of finance available.
6.1 FINANCIAL MARKETS
Financial maret is a place where financial instruments are traded. These can
be classified as!
"oney and Capital "arets
#rimary and Secondary "arets
Call and Continuous "arets
$ealer and %roer "arets
"anual and &lectronic &xecution "arets
Formal and 'ver(the(Counter )'TC* "arets
Spot and $erivative "arets
6.1.1 Money and Capital Markets
"oney maret is the maret for short(term )less than one year to maturity*
government and corporate debt securities. It also includes securities originally
issued with maturities of more than one year but that now have one year or
less to maturity.
"ost money maret instruments are not traded in exchanges, trading is
largely by phone and they have minimum transaction si+es. %ecause of their
characteristics access to them is mainly through indirect investing )going
through an intermediary*, e.g. through finance houses, merchant and
commercial bans.
Capital maret on the other hand is a maret for long(term )with more than
one year term to maturity* instruments, lie bonds and stocs, and those with
1
no designated maturity at all. These instruments are traded in exchanges lie
the ,imbabwe stoc &xchange ),S&*
6.1. !ri"ary and Se#ondary Markets
#rimary marets are securities marets where new issues are traded. Issuing
of shares maybe direct to purchasers or could be through an intermediary,
e.g. Commercial bans. They provide a direct flow of cash to the issuing
entity-corporation.
Secondary maret is a mechanism of bringing buyers and sellers of second
hand securities together for trading purposes. It is maret where securities
initially issued in the primary maret are resold. Trades in this maret do not
provide a direct flow of cash to the issuer but to the investors themselves.
6.1.$ Call and Contin%o%s Markets
In Call marets trades tae place at specific time intervals and enough time is
allowed for each call so that a substantial number of buy or sale orders may
accumulate. &ach security is called and those interested in either buying or
selling will come together and transact. #rice can either be announced
verbally or shown on computer screens and traders will indicate the quantities
they wish to deal in at any particular price and price they wish for any
particular quantity.
In Continuous marets trading taes place on a continuous bases. To be
effective there should be enough intermediaries in the form of dealers,
broers and marets maers in this maret who will as buyers to those
investors who want to sell and as sellers to those who want to by at any time.
This saves investors time and cost of searching a prospective partner in the
deal. Intermediaries also ensure there is liquidity in the maret.
Liquidity is the ability to sale large volumes of securities at the price close to
the price of the previous trade without too much delay assuming no new
information has been received regarding the security since the previous trade.
6.1.& 'ealer and (roker Markets
. dealer acts for his own boo, i.e. he is a principal in all the deals he maes.
/e buys shares from investors using his own money and sells to other
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investors for his own gain, i.e. he does not act on anyone0s behalf but for
himself.
. broer, on the other hand, acts as an agent for somebody. /e buys and
sells shares on behalf of the investor and is paid a commission. /e uses the
investor0s funds and not his own and therefore is not a principal in the
transaction, and thus he has to follow instructions from the investor on whose
behalf he is acting.
6.1.) For"al and O*er t+e Co%nter ,OTC- Markets
.t one time in the 1S. securities where actually bought over the counter in
bans, which by then acted as primarily dealers for these securities. %ans
have since cessed to do this but the term 'TC still exists and it now refers to
the deals that are not executed on an organised exchange but which involve
the use of a dealer. The 'TC is highly automated and computers, telephone
and satellites lin participants. &xamples include 2ational .ssociation of
Securities $ealers .utomated 3uotation Service )2.S$.3S* in 1S..
Thus 'TC serves as part of the secondary maret for stocs and bonds not
listed on an exchange as well as some listed. $ealers and broers in this
maret stand ready to buy and sell securities at quoted prices.
'rganised exchanges on the other hand form the formal maret, e.g. ,S&,
4S& in South .frica, etc.
6.1.6 Spot and 'eri*ati*e Markets
'n the spot maret, instruments are traded at the agreed price immediately
whereas, in the case of derivative instruments, settlement is deferred. The
use of derivative instruments enables the creation of finance to suit the
particular need of lenders and borrowers.
$erivatives form side bets on interest rates, exchange rates, commodity
prices, and etcetera. Firms usually do not issue derivatives to raise money5
they buy or sell them to protect against adverse changes in various external
factors.
&xamples of derivatives are!
6. Traded Options 7 'ption to buy or sell an asset at a price agreed today.
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8. F%t%res 7 . standardised order to buy-sell or an order place in advance to
buy-sell an asset-commodity at a set price.
9. For.ards 7 . tailor made futures contract not traded on the stoc
exchange.
:. S.aps 7 These are exchanges of currency or-and interest rate debts.
N(/ The classifications of marets described above are not mutually
exclusive.
6. FINANCIAL INSTITUTIONS
These are intermediaries who bring together borrowers and lenders. Some
financial institutions specialise in certain types of finance, but the trend is
towards offering a global pacage of services so that the distinction between
types of institutions is becoming blurred.
Types of financial marets are!
6..1 'eposit0Takin1 instit%tions
Co""er#ial (ankin1
This includes a wide range of services mainly offering current account facility,
overdraft loans, etc.
The difference between commercial bans and building societies is now very
narrow.
Mer#+ant (ankin1
It offers a range of facilities and services which, inter(alias, include!
Corporate finance 7 e.g. provision of advice and assistance during
mergers, and debt and equity issues5
;ending 7 the actual provision of funds5
"oney maret 7 trading in money marets and foreign marets for
clients or on their behalf.
In*est"ent Instit%tions
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These include mutual funds, pension funds, and unit trust institutions. They
are significant participants in the financial marets because of the vast
amount of money under their control.
They form ma<or investors to an extend that a public issue of finance is
unliely to be successful unless if baced by one of them.
Spe#ial Instit%tions
These are institutions created either formally or informally for specific
purposes, e.g. ,$% )now Infrastructure $evelopment %an, I$%* and S&$C'.
They usually offer short( to medium(term loans for fixed assets and woring
capital, either through direct financing or indirect financing )guarantee a
percentage of loan offered from baning institution*.
2.$ E(T 3s E4UIT5 FINANCIN6
Sources of finance are broadly classified as debt or equity. The relationship
between the two is called capital structure. In determining the mix between
the two, ris and return have to be borne in mind. The following are features
of debt and equity discussed under return, ris and control.
2.$.1 Ret%rn
Fixed Interest: $ebt has a fixed interest charge whereas equity has no
such commitment. This is an advantage when the company is doing
well and earning more than interest charges.
Tax Deductibility: Interest charge on debt is usually tax(deductible. Its
effective cost to the company is therefore only about half of the nominal
rate. $ividends, on the other hand, are not tax deductible and so there
is no relief from the company0s point of view.
Cost of funds: the cost of debt is usually less than the cost of equity.
This allows the company to lever the return to shareholders higher than
the return on investment.

2.$. Risk
Commitment: Interest payment on debt must be met whether there
are profits or not, whilst with dividends this is not the case.
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Capital Repayment: $ebt requires capital repayment. This may put
strain on the company since it has to raise enough capital and interest
repayment and remain with more funds to run the company.
Capital Structure: There is a limit to the amount of debt that can be
raised before the maret reassesses the company0s ris profile, which
will be reflected in the cost of capital. Consequently, raising debt
reduces the company0s flexibility for raising future finance due to
restrictions imposed by debtors.
2.$.$ Control
Dilution of Control: =aising finance through the use of equity dilutes
the control of the existing shareholders, especially if the new equity is
being issued to new shareholders.
Levels of Control: Control over the affairs of a company is the ability
to arrange matters according to the preference of the body that can
exercise such control, and some of the more important points of control
are!
o >?@ of issued share capital 7 enables the passing of special
resolutions5
o ?A@ of issued share capital 7 enable the passing of ordinary
resolutions5
o 9A@ of issued share capital 7 control in terms of the Securities
=egulation Code on taeovers and "ergers5
o 8A@ to 9A@ of issued share capital 7 it is generally believed that
this is enough to effectively control a listed company depending on
how the other shares are held.
o Control of the board 7 it may be exercised not only through the
holding of shares, but also the ability to control or to have influence
over the board of directors.
o $efault 7 control may be lost through the company0s failure to
meet certain commitments, which transfer certain rights to other
parties.
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6.$ T5!ES OF MONE5 MARKET INSTRUMENTS
Treas%ry (ills ,T(s-
They are issued by the government0s treasury department for short(term loans
that it acquires from different investors
T%s are the most maretable and least risy of all the money maret
instruments. They are issued at a discount from face value and have no
explicit interest payment. The benefit to the investor is the difference between
the face value and the purchase price. They can also be traded on the
secondary maret.
Rep%r#+ase A1ree"ents7Repos
They are agreements between the borrower and the lender to sell and
repurchase the government securities. The borrower )issuer* will contract to
sell securities to the lender )buyer* at a given price and at the same time
contract to buy them bac at a future date at a given price. The return to the
lender is the difference between the two prices.
=epos usually range from overnight to two wees with long term repos being
called term repos.
(anker8s A##eptan#e ,(A-
They are contracts by the ban where they agree to pay a certain amount of
money on a particular date on or behalf of clients who owe someone money
arising from a business deal. The ban0s client issues a promissory note
stating when he will mae a payment available. The ban then assumes the
obligation by endorsing the note. 'n maturity the creditor )one owed* will
present the note to the ban and the ban will be obliged to pay.
Ne1otia9le Certi:i#ate o: 'eposit ,NC'-
They are time deposits with commercial bans. They are usually made in
specific units, e.g. a million each, have specific terms and they pay a higher
interest than demand deposit accounts. The rates are determined by the
credit rating of the ban that issues-bacs them.
2.C.$s can be traded in the secondary maret through negotiation before
maturity.
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Co""er#ial !aper
It represents unsecured promissory note of large financially sound
corporations. %ecause of their financial soundness such corporation paper
does not need to be baced by a ban or third parties as it is assumed to
have little ris of default if any.
=ates are determined by the creditworthiness of the company.
(ank O*erdra:ts ,O's-
It is a facility to mae payments beyond the amount of money in the ban
account. This helps in providing bridging finance to tide the company through
its woring capital cycle. '.$s are supposed to be paid up on monthly bases.

Forei1n C%rren#y 'eposits ,FC's-
They are deposits denominated in a currency other than that of the country in
which they are issued, e.g. 1SB deposits in ,imbabwe. Interest rate are
determined by the currency, si+e of deposits, etc.
6.& T5!ES OF CA!ITAL MARKET INSTRUMENTS
These instruments usually have a contractually mandated schedule of
payment from the issuer to the investor. Failure to meet any payments by the
issuer normally results in default and all remaining payments including arrears
and principal become due immediately.
They can either be equity(related )ownership* instruments or debt(related
)non(ownership* instruments.
6.&.1 E;%ity0related Instr%"ents
Ordinary s+ares
'rdinary shares, also nown as equity shares, are the most common form of
share. It represents a commitment on the part of the corporation to pay
periodically )or if necessary* a cash dividend to the holder as deemed by the
board of directors )%'$*.
From the investor0s side it represents ownership claim on the earnings on
assets of the company.
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. unique feature of equity-common stoc besides ownership claim )voting
rights* is that the shareholder has limited liability, i.e. should the company
become banrupt, the investor will only lose what he has originally invested in
the company, and not private property. /owever equity has residual claim
earnings of the business, i.e. the shareholder will only get a dividend after all
claim holders have been paid, and only so if the %'$ thins it appropriate.
$ue to this, equity is much risier that all types of fixed income securities.
/owever, as residual claimants, in good times they tend to benefit.
'e:inition o: Ter"s
The following terms are used in con<unction with ordinary shares!
NominalFace !alue: The value written on the share certificate that all
shareholders will be given by the company in which they own
shares.
"ar#et !alue: The amount at which a share is being sold in the stoc maret.
It may be radically different from the nominal value.
$ar !alue: Shares sold at their par value are sold by the issuing company in
the primary maret at the value equal to their nominal value.
$remium value: These are shares issued at par value plus an additional
premium.
Discount value: these are shares issued at a price less than the nominal
value.
The importance of share prices to a business, as reflected on the exchange,
is that it gives an indication of the value placed on the company by the
maret, e.g. if a company has 6A million shares and the current maret price
is B?AA each, then the value of the company )i.e. its maret capitalisation* is
B? billion. If share plummets to B8AA the company would only be worth B8
billion. In such cases the company becomes possible target for taeover.
!re:eren#e s+ares
#reference shares are of a hybrid nature, with characteristics of both
fixed-debt and equity nature.
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Typically preference shares promise a fixed dividend hence they are liened
to debt. 1nlie the interest paid on debt, the preference dividend is not
deductible for tax purposes. If dividend is not paid at one point it may be
cumulated )unless if it is non(cumulative* and will have to be paid at a future
date with other dividends. In this way it is liened to equity. %ecause
preference share dividend is not deductible for tax purposes it tends to be a
more expensive source of finance as compared to long(term debt.
The three ma<or differences between ordinary and preference shares are that!
6. #reference shares offer their owners preferences over ordinary shares
)i.e. they are paid dividends before ordinary shareholders*5
8. #reference shareholders are often entitled to a fixed dividend even
when ordinary shareholders are not5
9. #reference shareholders cannot normally vote at general meetings.
In the event of the preference shares being in arrears the preference
shareholders are granted voting rights and thus can exercise a measure of
control over the company.
#reference shares are available in different forms to suit a particular
requirement and the needs of investors. These are!
$articipatin% $reference S&ares: They have elements of both
preference and ordinary shares. They have a fixed dividend but in
addition they share in the remaining profit of the company in some
predetermined proportion to the ordinary shares.
Redeemable $reference S&ares: The company has the option to
redeem the shares at a specified price on a particular date or over a
given period of time. They are favourable to the company because it
can redeem them at a time when the situation is not favourable.
Investors are compensated for this uncertainty by a higher rate of
return.
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Convertible $reference S&ares: The holder of convertible preference
shares has the option, at some stage, of converting them into ordinary
shares or other securities according to prearranged terms.
6.&. 'e9t0related Instr%"ents
These instruments can either be long( or medium(term debt, fixed or variable
interest debt, secured or unsecured debt. The classifications are not mutually
exclusive.
Treas%ry 9onds and notes
These long(term government bonds have a maturity of between 6A to 8A
years, and are issued government0s treasury department. They have great
variability of return than treasury bills due to the fact that they have longer
maturity and thus their return is expected to be higher to compensate for the
extra ris.
Treasury notes are medium term treasury bonds with maturity of between 6 to
6A years.
%oth instruments pay interest t'ice a year with principal paid at maturity.
Treasury bonds can also be called before maturity. 2ormally the government
exercises this option if conditions are favourable to it )i.e. if the call price is
less than the maret price*. $ue to this embedded ris in callable treasury
bonds they pay a higher return as inducement to investors to buy them.
Corporate 9onds7de9ent%res
These are issued by business entities. They have similar payment a pattern to
treasury bonds, only that they have an element of ris should the company go
under. $ebentures are usually issued for a fixed interest rate and secured
over certain assets.
If the debenture is secured then, <ust lie a mortgage for a private house, the
debenture holder has a legal interest in the asset and the company cannot
dispose of it unless debenture holder agrees.
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Corporate bonds can be in the form of!
Secured bondsdebenture: /ave specific collateral security bacing
them in the event of the issuer defaulting.
(nsecured bondsdebenture: They do not have specific collateral
and are therefore risier than secured ones.
Subordinated bondsdebenture: They have no specific collateral and
also have a lower priority claim on assets in the event of default.
(nsubordinated bondsdebenture: /ave no specific collateral but
have priority over subordinated debentures in case of default.
N(/ $ebentures can also be callable )if interest rate is low*. $ebenture
holders have the right to receive their interest payments before any dividend
is payable to shareholders, and even if the company maes a loss5 it still has
to pay interest charges. $ebenture usually have restrictive covenant clauses
that restrict the way management runs the business so as to protect investors.
Mort1a1e 9onds
They are long term loans secured over the fixed property of the company, e.g.
land and buildings.
Leases
These are common sources of finance for movable assets. . leasing contract
is between the leasing company )the lessor* and the customer )the lessee*.
The lessor buys the asset and retains ownership whilst the lessee uses the
asset.
There are two types of leases!
Finance lease: =ental covers virtually all costs of the asset.
)peratin% lease: The lease does not run for a full life of the asset and
the lessee will not be liable for the full value. The lessor assumes
residual ris.
<ire p%r#+ase
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It is a method of acquiring assets without having to invest full amount in
buying them. . hire purchase agreement typically allows the hire purchaser
sole use of an asset for a period after which they have the right to buy them at
normally a small or nominal amount. The benefit is that the company gains
immediate use of the asset without having to pay a large amount for it or
without having to borrow a large amount.
6.) Ot+er So%r#es o: Finan#e
*rants: Can be issued by the government, local government or donor
community for specific pro<ects in a specific area.
!enture capital: It represents funds invested in a new enterprise. It
can be defined as capital contributed at an early stage in the
development of a new enterprise, which may have a significant chance
of failure but also a significant chance of providing above average
returns, and specifically where the provider of capital expects to have
some influence over the direction of the enterprise.
Factorin%: This involves the selling of receivables to a financial
institution )the factor*, usually without recourse )i.e. the selling firm
would not be liable for any receivables not collected by the factor*.
Thus once you mae a sale, you invoice your customer and send a
copy of the invoice to the factor and most factoring arrangements
require you to factor all the sales. The factor pays you a set proportion
of the invoice value, usually CA to C?@ of an invoice value within 8:
hours.
The ma<or advantage is that you receive most of the cash from debtors
within 8: hours rather than a wee, or even longer.
The other advantages of factoring are!
"aximisation of cash flow5
It reduces the time and money spent in debt collection since the
factor will run the sales ledger for you5
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It is a more efficient way of doing business especially with
overseas clients5 and
The factor0s credit control system can be used to assess the
credit worthiness of a new client.
The disadvantages are!
Since the factor taes control of the sales ledger, some clients
might not be willing to deal with the facto but the actual
company5
Factoring may impose constrains on the way to do your

business.
&nding a factoring arrangement can be difficult especially where
it involves repurchase of the sales ledger.
Lines of credit from creditors: This is a type of short(term credit. In
this case the supplier of, for example raw materials, will allow the
company to buy goods now and pay later.
$ersonal savin%s: These are amounts of money that a
businessperson, partner or shareholder has at their disposal to do as
they wish. If such money is used to invest in their own or other
business then it becomes a source of finance.
+or#in% capital: Doring capital is the money used to pay for the
everyday trading activities carried out by the business. It is defined as!
Working Capital = Current Assets Current Liabilities.
Dhere!
Current .ssets E Short(term sources of finance, e.g. stocs,
debtors and cash and cash equivalents.
Current ;iabilities E Short(term requirements for cash, e.g. trade
creditors, expense creditors, tax owing and dividends owing )Those
payable in a month or less*
Sale of ,ssets: This involves selling of surplus fixed or movable
assets.
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Retained profit: Since this profit is not distributed it is then at the
company0s own disposal to do as it sees fit. They can be retained for
suspected future rainy days.

3ALUATION OF LON6 TERM SECURITIES
2.13ALUE 'EFINE'
2.1.1 Li;%idation *al%e 3s 6oin10Con#ern *al%e
;iquidation value refers to the amount of money that could be raised if an
asset or group of assets )e.g. a firm* is sold seperately from its operating
organisation.
Foing(Concern value is the amount a firm could be sold for as a continuing
operating business.
2.1. (ook *al%e 3s "arket *al%e
%oo value, for an asset, it is the accounting value of an asset, i.e. the asset0s
cost less its accumulated depreciation.
For a firm it is the total assets less liabilities and preferred stoc as listed in
the balance sheet.
"aret value is the maret price at which the asset )or a similar asset* trades
in an open maret place. "aret value is usually higher than the liquidation or
going concern value.

2.1.$ Intrinsi# *al%e
This is the price a security ought to have if all valuation factors are taen into
account. Thus, intrinsic value is the economic value of the security. This value
is the present value of the cashflows provided an appropriate required rate of
return for the ris involved was used.
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2.(ON' 3ALUATION
. bond is a long(term debt instrument issued by a corporation or government.
It pays a stated amount of interest over a given period of time. The amount
that the investor gets at maturity of the bond is nown as the face value, whilst
coupon rate is the stated interest on bond paid annually until bond maturity.
%ond valuation involves discounting or capitalising the cashflow stream that
the security holder would receive over the life of the instrument. The
discounting rate is dependent on the ris associated with the bond.
2..1 !erpet%al (onds
It is a bond that never matures. Its present value is equal to the capitalised
value of an infinite stream of interest payments. It is calculated as!
I
V
k

Dhere! G E #resent value
I E .nnual payments
E =equired rate of return
2.. (onds .it+ a :inite "at%rity
i. Co%pon payin1 9onds
Instead of considering interest streams only the terminal-maturity-face value is
also considered. It is calculated as!
( ) ( ) 1 1 1
n
t n
t
I MV
V
k k
+
+ +
Dhere! "G E "aturity value

t E #eriod
n E 2umber of years to maturity
E=a"ple
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. bond has a par value of B6,AAA with 6A@ coupon paid over nine years. The
required rate of return is 68@. Calculate its value.

( ) ( )
1 2 9 9
100 100 100 1000
...........
1.12 1.12 1.12 1.12
$100 5.328 $1, 000 0.361
$532.80 $361.00
$893.80
V + + + +
+
+

.ssuming the required rate of return was C@ the value becomes B6,68:.>A.
The present value is greater than the par value because the required rate of
return is less than the coupon rate. In this case investors will be willing to pay
a premium to buy the bond. In the previous case, with the required rate of
return at 68@, investors would be willing to buy the bond only if it is sold at a
discount from par value.
Thus! If H coupon rate the bond will sell at a discount.
If I coupon rate the bond will sell at a premium.
If E coupon rate the bond will sell at par value.
i. >ero0#o%pon 9onds
It pays no interest but sells at a deep discount from its face value. Thus the
investor buys the bond at below face value and redeems it at face value on
maturity. The present value is!
( ) 1
n
MV
V
k
+
E=a"ple
.ssuming the bond with a face value of B6,AAA, with a 6A(year maturity and
required rate of return of 68@, calculate its value.
( )
10
1000
$322.00
1.12
V
ii. Se"i0ann%al Co"po%ndin1
17
1se the formula taing care of the time of compounding, e.g. for coupon
paying bond.
( ) ( )
2
2
1
2
1 1
2 2
n
t n
t
I
MV
V
k k
+
+ +

2.$!REFERRE' STOCK 3ALUATION
It pays a fixed dividend at regular intervals, but at the discretion of the board
of directors. It has preference over common stoc in the payment of dividends
and claims on assets. It has no stated maturity date. .ll preferred stocs have
a call feature. The present value formula is!
D
V
k
Dhere! $ E Stated annual dividend per share, and

E $iscount rate.
N(/ If the call feature is incorporated the formula becomes the same as that
of coupon paying bonds.
2.&COMMON STOCK 3ALUATION
The value of a share of common stoc can be viewed as the discounted value
of all expected cash dividends provided by the issuing firm until the end of
time. Its value is!
( ) ( ) ( )
( )
1 2
1 2
1
..........
1 1 1

1
t
t
t
D D D
V
k k k
D
k
+ + +
+ + +
_

+
,
Dhere! $ E Cash dividend at the end of time t, and

E $iscount rate.
For finite common stoc or those we intend to sell in the future the formula
becomes!
( ) ( ) ( ) ( )
1 2
1 2
..........
1 1 1 1
n n
n n
D P D D
V
k k k k
+ + + +
+ + + +
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Dhere! #
n
E the expected sales price at the end of period n.
In this case the foundation for the valuation of common stoc are dividends.
For those common stocs that do not pay dividends the valuation by investor
will be based on expected future selling price.
2.&.1 'i*idend 'is#o%nt Models
These models are designed to compute the intrinsic value of common stoc.
The valuation is dependent on the assumptions of the expected growth
pattern of stoc.
i. Constant 6ro.t+ Model
$ividends are expected to grow at a constant rate. The value can be
calculated as!
( )
( )
( )
( )
( )
( )
2
0 0 0
2
1 1 1
..........
1
1 1
D g D g D g
V
k
k k
+ + +
+ + +
+
+ +
Dhere! $
A
E #resent dividend per share, and
g E Frowth rate, which in this case is constant.
.ssuming is greater than g the equation can be summarised as!
( )
1
D
V
k g
Dhere! ( )
1 0
1 D D g +
, which is dividend in period 6.
Constant growth model is usually applicable to companies in their mature
stage.
ii. Earnin1s M%ltiplier Model
1
1

V b
Earnings Multiplier
E k g
Dhere! b E . constant proportion of earnings retained by the company

each year, and
&
6
E &xpected earnings per share in period 6.
E=a"ple
19
. company0s dividend per share at t
6
is B:, the dividend is expected to grow
at J@ forever and the discount rate is 6:@. Calculate the value of the stoc.
4
$50
0.14 0.06
V
.ssuming the same company has retention rate of :A@ and earnings per
share at t
6
of BJ.J>.
( )
( )
1
1 0.4
7.5
0.14 0.06
7.5*6.67 $50
V
times
E
V

iii. >ero 6ro.t+ Model
$ividends remain constant. The formula becomes!
1
D
V
k
i*. 6ro.t+ !+ases Model

&xpected dividends can grow at different percentages over the life of the
stoc. 1sually they start with high growth )even above * and then it reduces
later on.
E=a"ple
.ssuming the dividend is expected to grow at 6A@ for the first five years and
thereafter at J@. Galue can be calculated as!
( )
( )
( )
( )
( )
( ) ( )
( )
5
5
0 5
1 6
5
0
6
5
1
1.10 1.06

1 1
1.10
1
0.06
1 1
t t
t t
t t
t
t
t
D D
V
k k
D
D
V
k
k k
+
+ +
1
1
+ 1
1
+ + 1 1
]
]

2.)5IEL' TO MATURIT5 ,5TM- ON (ON'S

20
This is the expected rate of return on a bond if bought at its current maret
price and held to maturity. The rate, , which equates the discounted value of
the expected cash inflows to the security0s current maret price, is also
referred to as the security0s )maret* yield.
N(/ The investors0 required rate of return is equal to the security0s )maret*
yield only where the intrinsic value of the security to the investor is equal to
the security0s maret value )price*, i.e.!
( ) ( )
0
1 1 1
n
t n
t
I MV
P
k k
+
+ +
Fiven the value of "G, #

A
, and I one can calculate the value of using
interpolation.
E=a"ple
.ssuming a bond with a par value of B6,AAA5 current maret value of B>J65 68
years to maturity5 and C@ coupon rate. Fives a of 68@ )KT"*.
2.).1 (e+a*io%r o: (ond !ri#es
i. Dhen the maret required rate of return is greater than the coupon rate
the bond price will be less than its face value. Thus bond is selling at a
discount of face value. %ond discount is the amount by which face
value exceed current price.
ii. Dhen the maret required rate of return is less than coupon rate the
bond price will be greater than its face value. Thus the bond is selling
at a premium over face value. %ond premium is the amount by which
bond price exceeds face value.
iii. Dhen the maret required rate of return is equal to the coupon rate,
bond price is equal to the face value. The bond is said to be selling at
par.
iv. If interest increases leading to an increase in the maret required rate
of return the bond price will fall, and the reverse is true.
N(/ Interest rate ris )yield ris* is the variation in the maret price of a
security caused by changes in interest rates. .n investor incurs interest
21
rate ris only if the bond is sold before maturity and interest rate has
changed since the time of purchase.
v. For a given change in maret required rate of return, the price of a
bond will change by a greater amount, the longer is its maturity. Thus
the longer the maturity, the greater the riss of a price change to the
investor when changes occur in the overall level of interest rates.
vi. For a given change in maret required rate of return, the price of a
bond will change by proportionally more, the lower the coupon rate.
Thus the bond price volatility is inversely related to the coupon rate.
This is due to the fact that investors realise their returns later with a
low(coupon(rate bond than with a high(coupon(rate bond.
2.6 5IEL' ON !REFERRE' STOCK
It is derived from the formula for preferred stoc price. Thus!
0
0

D D
P k
k P

Dhere! $ E annual dividend per share of preferred stoc, and
E "aret required rate of return or yield on preferred stoc.
E=a"ple
.ssuming the current maret price of a company0s 6A@, B6AA par value
preferred stoc is BL6.8?. Calculate the yield.
$10
10.96%
91.25
k
2.2 5IEL' ON COMMON STOCK
This is the rate of return that sets the discounted value of the expected cash
dividends from a share of common stoc equal to the share0s current maret
price. .pplying the constant dividend growth model it implies that!
( )
1 1
0
0

D D
P k g
k g P
+
22
Thus common stoc yield comes from expected dividend yield
1
0
D
P
_

,
and
capital gains yield ( ) g
.
E=a"ple
Dhat maret yield is implied by a share of common stoc currently selling for
B?A whose dividends are expected to grow at a rate of 6A@ per year and
whose dividend is currently at B8.8A.
( )
1
: $2.20 1.1
$2.42
2.42
: 0.1
50
14.84%
First D
Then k
2.?(ON' 'URATION AN' 3OLATILIT5

This part, which acts as an appendix to this chapter, loos at the variability of
long(term and short(term bonds. The term duration describes the average
time to each payment. In other words, bond duration, is the weighted average
of the time to each cash flow.
Thus!
( ) ( ) ( )
1 2
1* 2* *
..........
n
PV C PV C n PV C
Duration
V V V
_ _ _
+ + +

, , ,
Dhere! G E Total value of the bond,
n E #eriod, and
#G)C
n
* E #resent value of cash flow n.
Golatility, on the other hand, is the percentage or degree by which the price of
a bond changes due to a change in the bond yield.
Thus!
( )
1
Duration
Volatility percentage
Yield
+
N(/ . bond0s volatility is directly related to its duration. It shows the liely
effect of a change in interest rates on the value of a bond.
23
E=a"ple
a. Calculate the duration and volatility of a J(year, B6,AAA par value bond
paying 69.68?@ coupon rate annually and a KT" of J.?@.
b. Calculate the duration and volatility of a J(year, B6,AAA par value bond
paying C@ coupon rate annually and KT" of J.?@.
c. Dhich bond is risierM

Ans.er
a. (ond A
5ear C
t
!3,C
t
- @
6.)A
!roportion o:
Total 3al%e
B!3,C
t
-73
t
C
!roportion o:
Total 3al%e =
Ti"e
6 696.8? 689.89L A.AL9 A.AL9
8 696.8? 66?.>6C A.ACC A.6>?
9 696.8? 6AC.J?? A.AC8 A.8:>
: 696.8? 6A8.A8: A.A>> A.9AL
? 696.8? L?.>L> A.A>9 A.9J9
J 696.8? >>?.8C: A.?C> 9.?88
3 D 1E$F.212 1.FFF &.2FG
T+%s '%ration D&.2FG 5ears
3olatility D &.2FG D &.&A
1.F6)
9. (ond (
5ear C
t
!3,C
t
- @
6.)A
!roportion o:
Total 3al%e
B!3,C
t
-73
t
C
!roportion o:
Total 3al%e =
Ti"e
24
6 CA.AA >?.66> A.A>A A.A>A
8 CA.AA >A.?99 A.AJJ A.698
9 CA.AA JJ.88C A.AJ8 A.6C?
: CA.AA J8.6CJ A.A?C A.898
? CA.AA ?C.9LA A.A?: A.8>8
J CA.AA >:A.6J6 A.JLA :.6:A
3 D 1EF2.61) 1.FFF ).F$1
T+%s '%ration D ).F$1 5ears
3olatility D ).F$1 D &.2A
1.F6)
#. . 6@ change in yield causes the price of a 69.68?@ bond to change by
:.:8@.as shown by its volatility. The volatility of an C@ bond is :.>8@.
Thus the C@ bond with a longer duration is more volatile and hence
more risier.

25
COST OF CA!ITAL
Cost of capital is the required rate of return on the various types of financing.
The overall cost of capital is the weighted average of the individual required
rates of return )costs*.
. company is a collection of pro<ects5 hence the use of an overall cost of
capital as the acceptance criterion )hurdle rate* for investment decisions is
appropriate only in situations where the current proposed pro<ects are of
similar ris and characteristics. If they differ then the cost of capital on its own
is not adequate for decision(maing.
The advantage of using the company0s overall cost of capital is for simplicity.
The overall cost of capital is a proportionate average of the cost of the various
components of the firm0s financing. These are cost of equity capital5 cost of
debt and cost of preferred stoc.

HEI6<TE' A3ERA6E COST OF CA!ITAL ,HACC-
This is the weighted average of individually calculated costs of the various
financing components of the firm. The components are common and preferred
stoc, along with debt. .ll these have a common feature, i.e. the investors
who provided the funds expect to receive a return on their investment.
The firm0s overall cost of capital )D.CC* can be expressed as!
Cost of capital E ( )
x x
n
x
W
1
Dhere! N
x
E .fter(tax cost of the x
th
method of financing.
D
x
E Deight given that method of financing as a percentage
of the firm0s total financing.
E=a"ple
!roportion o: Cost Hei1+ted Cost
26
Total Finan#in1
$ebt 9A@ J.J@ 6.LC@
#referred Stoc 6A@ 6A.8@ 6.A8@
Common Stoc JA@ 6:.A@ C.:A@
Total 6AA@ HACC D 11.&FA
The three securities have different required rates of return due to differences
in ris. The required rate of return of each capital component is called the
component cost.
The target percentages of financing sources differ from company to company.
In the example above the company has raised 9A@ of required capital from
debt, 6A@ from preferred stoc and JA@ from common stoc. This is called
the target capital structure and is determined by among others, maret
conditions and flotation costs.
"aret conditions loos at how strong the maret is for it to, for example,
issue common stoc. Flotation costs are costs associated with issuing
securities, e.g. underwriting, legal, listing and printing fees. They form part of
the initial cost outlay in the calculation of 2et #resent Galue )2#G*. $ue to
these factors the target capital structure tend to fluctuate from time to time.
CALCULATION OF COM!ONENT COSTS
1. Cost o: 'e9t ,K
i
-
The cost of debt is the required rate of return on investment of the lenders of a
firm. $ebt include fixed and floating rate debt, straight and convertible debt, or
debt with or without sining funds. The type of debt used depends on the
assets to be financed and the maret conditions.
The explicit cost of debt can be derived by solving for the discount rate )N
d
*
that equates the maret price of the debt issue with the present value of
interest plus principal payments. The discount rate )N
d
* nown as the yield to
maturity )KT"* is solved for using the following formula!
( )
1
]
1
+
+
t
d
t t
n
t
P I
P
1
1
0
27
Dhere! #
A
E Current maret price of the debt security5
I
t
E Interest payment in period t5
#
t
E #rincipal paid in period t.
%y solving for N
d
we obtain the required rate of return debt holders require.
This N
d
is the issuing company0s before(tax cost of debt.
Since the after tax cost of debt is the one that is required, the following
formula is used!
( ) T
d i
1
Dhere! N
i
E .fter(tax cost of debt5
T E Company0s marginal tax rate.
Since interest charges are tax deductible to the issuer, the after(tax cost of
debt is substantially less than the before(tax cost.
E=a"ple
Suppose the company borrow at an interest rate of 66@, and if it has a
marginal government tax rate of :A@, then its after(tax cost of debt is
calculated as!
( ) T
d i
1
E 66@)6 7 A.:*
E 66@)A.J*
E 6.6A
this calculation assumes that the firm has taxable income. Dithout the taxable
income N
i
E N
d
.
. Cost o: !re:erred Sto#k ,K
p
-
#referred dividends are not tax deductible, hence the company bears their full
cost. #referred stocs, generally, have no maturity date. They hold
precedence over common stoc in term of dividend payment and asset
distribution if the company is dissolved. Dith preferred stoc, it is not
mandatory that preferred dividends be paid, however, firms generally try to
pay since not doing so might mean!
They cannot pay dividends on common stoc5
They will find it difficult to raise additional funds in the capital maret5
28
#referred stoc holders can tae control of the firm.
N
p
is calculated using the following formula!
0
P
D
P
P

Dhere! $
p
E .nnual preferred stoc dividend5 and
#
A
E 2et issuing price or current maret price of the preferred stoc.
E=a"ple
If the company where to sell 6A@ preferred stoc issue )B6AA par value*. The
company has incurred flotation cost of 8.?@ per share. Calculate N
p
.
% 3 . 10
5 . 97 $
10 $

P
N(/ This cost is not ad<usted for taxes because the preferred stoc dividend
used is already an after(tax figure. Thus explicit cost of preferred stoc is
greater than that of debt.

$. Cost o: Co""on Sto#k ,E;%ity-0 K
e
Cost of equity is by far the most difficult cost to measure. &quity capital can be
raised in two ways!
I. Internally by retaining earnings5 or
II. &xternally by issuing of shares.
If the firm used either method it should earn more than
e
to provide this rate

of return to investors.
Dhere as debt and preferred stoc are contractual obligations, which have
easily determined costs, it is more difficult to estimate
e
. The three principles

employed to find
e
are!
i. The Capital .sset #ricing "odel )C.#"*5
ii. The %ond(Kield(#lus(=is(#remium .pproach5 and
iii. The $iscount cash Flow )$CF* method.
2%! These methods are not mutually exclusive.
29
-
st
,pproac&: T+e CA!M Approa#+
.s already covered.
To estimate the cost of equity using C.#" the following steps are followed!
Step -: &stimate the ris(free rate )=
f
* generally taen to be the yield of a long
or intermediate(term government bond.
Step .: &stimate the stoc0s beta coefficient ( )
i
, and use it as an index of

stoc0s ris.
Step /: &stimate the current expected rate of return of the maret, or on an
average stoc ( )
m
!
. =
m
estimates can be from stoc exchange
analysis, or consensus estimates of security analysts, economists
and others who regularly predict such returns.
Step 0: Substitute the preceding values into the C.#" equation to estimate
the required rate of return on the stoc in equation!
( )
e " i m "
! ! ! +
2%! The
; and
i " m
# ! !
values used should be the best possible estimates of
the future.
E=a"ple
.ssume! =f E C@5 =m E 6:@ and Oi E 6.6.
0.08 (0.14 0.08)
e
+
E 1&.6A
Thus 6:.J@ is the rate of return investors expect the company to earn on its
equity.
Heaknesses
i. If the firm0s stocholders are not well diversified, they may be concerned
with stand(alone ris in addition to maret ris. Thus in such a case the
firm0s ris should be measured by
i
alone as the C.#" procedure

would underestimate the cost of equity ( )
e
value.
ii. &ven if the C.#" method is valid it is hard to obtain correct estimates of
the inputs required since!
30
.* There is controversy as to whether one should use long(term or
short(term treasury yields )C.#" is a one period model*5
%* It is hard to estimate the beta that investors expect the company
to have in the future5 and
C* It is difficult to estimate the maret ris premium.

.
nd
,pproac&: (ond05ield0!l%s Risk0!re"i%"7(e:ore0Ta=0Cost0o:0'e9t0
!l%s0Risk0!re"i%" Approa#+
This method comes as an alternative to analysts who do not lie the
sophisticated approaches of C.#" and $CF. This approach is relatively
simple, fast and dirty )sub<ective and ad(hoc*. This approach can best be
illustrated using the following diagram of the security maret line )S";* with
debt and equity!
E=pe#ted Se#%rity Market Line ,SML-
Rate o:
Ret%rn
=
f

d
Syste"ati# Risk ,(eta-

.s illustrated, in addition to the ris premium on debt, the common stoc of a
company must provide a higher expected return than the debt of the same
company. The reason being that there is more systematic ris involved.
The historic ris premium in expected returns of stocs over bonds has been
around 9@ to ?@ points. The greater the ris of the firm, as shown by the
slope of the S";, the greater the premium.
1sing this approach the company0s approximate cost of equity ( )
e
would be!
Before-tax o!t of "e#t $ %&!' (re)&*) &n +x,e-ted %et*rn for .to-' /0er "e#t
e

)%ond Kield*
31
&.g. The Company0s bonds yield 6A@ in the maret.
10% 4% 14%
e
+
Thus the company0s before(tax cost of debt will form the basis for estimating
the firm0s cost of equity.
Heaknesses
i. Since the premium over debt is simply added, the method does not
give a precise cost of equity5
ii. It does not allow for changing ris premiums over time.
It however offers an alternative method of estimating the cost of equity )
e
*
that falls within the overall framewor of the C.#".
/
rd
,pproac&: 'i*idend 'is#o%nt Model7'i*idend yield !l%s 6ro.t+
Rate7'is#o%nted Cas+ Flo. ,'CF- Approa#+
.s outlined earlier the price of the expected rate of return on a share of
common stoc depends, ultimately, on the dividends expected on the stoc.
Thus the cost of equity )
e
* can be thought of as the discount rate that

equates the present value of all expected future dividends per share, as
perceived by investors at the margin, with the current maret price per share.
Thus!
( )
( ) ( )
( )
1 1
0 2
1
.....
1
1 1

1
e
e e
t
t
t
e
D D D
P
+ + +
+
+ +
Dhere!
0
P
E Current price of the stoc5
t
D
E $ividend expected to be paid at the end of year t5 and
e
E =equired rate of return.

Constant 6ro.t+
If dividends are expected to grow at a constant rate then the constant growth
model can be used, i.e.!
32
1
0
1
0
:
e
e
D
P
g
D
Thus g
P
+
Thus investors expect to receive a dividend yield,
1
0
D
P
_

,
plus a capital gain )
g
*
for a total expected return ( )
e
and in equilibrium this expected return is also

equal to the required return.
E=a"ple
$ividends are expected to grow at C@ per annum into the foreseeable future.
The dividend in the 6
st
year is expected to be B8 and the present maret price
is B8>. Calculate the cost of equity.

$2
8% 15.4%
$27
e
+
Dhilst it is easy to determine the dividend yield, it is difficult to establish the
proper growth rate.
Esti"atin1 6ro.t+ Rate ,1-
If past growth rates and dividends have been generally stable and if the trend
is expected to continue into the future, then historic growth rates can be used
to pro<ect into the future. /owever, if the past has been abnormal then historic
events cannot be used. Thus other means of estimating g have to be used.
Security analysts regularly mae growth pro<ections using things lie pro<ected
sales, profit margins, and competitive factors. Fetting an average g from
growth figures got from different analysts usually help in coming up with a
more accurate g.
Thus!
1
0
1ro2t3 rate a! ,ro4e-ted #5 ana65!t!
e
D
P
+
.nother method is the retention growth rate method. 1sing this method first
forecast the firm0s average future dividend payout ratio and its complement,
33
the retention rate, then multiply the retention rate by the company0s expected
future rate of return on equity )='&*, i.e.!
( ) ( )
( ) ( )
%e
1
g tention !ate !$E
Payout !ate !$E

6ro.t+ !+ases
If the growth rate changes from time to time then constant growth rate will not
apply in calculating cost of equity ( )
e
using the $iscounted Cash Flow )$CF*

approach.
E=a"ple
If dividends were expected to grow at a 8A@ for ?years, at 6?@ for the next
?years, and then grow at 6A@ into the foreseeable future, then!
( )
( )
( )
( )
( )
( )
5 10
5 10
0 5 10
0
1 6 11
1.20 1.15 1.10
1
1 1
t t t
t t
t t t
e
e e
D D D
P
t

+ +
+
+ +

%y solving for
e
the cost of equity is obtained. The last phase i.e.

( )
( )
10
10
11
1.10
1
t
t
t
e
D
turns into a constant growth model.

Co"pilation
.ccording to the calculations of
e
using C.#", =is #remium and $CF

methods the following were the results!
C.#" 6:.J@
=is #remium 6:.A@
$CF 6?.:@
Total &&.FA
Fetting the average
44%
14.7%
3
e

COM!OSIT7HEI6<TE' A3ERA6E COST OF CA!ITAL ,HACC-
'nce the cost of the individual components of the firm0s financing are
computed, weights are then assigned to each financing source according to
34
some standard, and then calculate D.CC. The standard used is the firm0s
optimal capital structure, nown as the mix of debt, preferred and common
equity that causes its stoc price to be maximised.
Thus!
( )
1
1

d d p p e e
n
x x
x
W%CC W T W W
W
+ +
N(/ i. D.CC is the weighted average cost of each new, or marginal, dollar of
capital 7 it is not the average cost of funds raised in the past. 'n
average each of the new dollar will consist partly of debt, preferred
stoc, and common stoc.
ii. Deights can be based either on!
a* .ccounting values as shown in the balance sheet )i.e. %oo values*
b* Current maret values of the components, or
c* "anagement0s target capital structure. The current weights are
those based on the firm0s target capital structure, since this is the
best estimate of how the firm will, on average, raise money in the
future.
Fa#tors T+at A::e#t HACC
Factors can either be economic factors beyond the company0s control, or can
be the company0s financing and investment policies.
A- E#ono"i# Fa#tors
a. Le*el o: Interest Rates
If interest rate increases the cost of debt increases. .lso the higher the
interest rates the higher the cost of common and preferred equity capital.
9. Ta= Rates
Tax rates are used in calculating the cost of debt5 hence it affects the cost of
debt. ;owering the capital gains tax relative to the rate on ordinary income
35
would mae stocs more attractive which reduces the cost of equity relative to
that of debt.
(- Finan#in1 and In*est"ent !oli#ies
These include!
a* Capital Structure #olicy5
b* $ividend #olicy5 and
c* Investment )Capital %udgeting* #olicy.
a- Capital Str%#t%re !oli#y
It is assumed that firm has a given target capital structure, and D.CC is
calculated based on those weights. . firm can effect a change in the capital
structure and such a change will affect the cost of capital. The cost of equity is
generally higher than the after(tax cost of debt. Thus if the firm decides to use
more debt this will tend to lower the D.CC. /owever, such a change will
increase the firm0s risness of both debt and the equity. Increases in
component costs will tend to offset the effects of the change in weights.
Fenerally the firm0s optimal capital structure is the one that minimises the cost
of capital.
9- 'i*idend !oli#y
The percentage of earnings paid out in dividends may affect a stoc0s
required rate of return ( )
e
. .lso, if a firm0s payout ratio is so high that it must

issue new stoc to fund its capital budget, it will be forced to incur floatation
costs, which will affect the cost of capital.
#- In*est"ent !oli#y
It is assumed that if the firm acquires a new capital it will invest it in the
existing line of business or assets. This is why estimation of the cost of capital
as a starting point is by use of the outstanding stoc and bonds. /owever, it
will be incorrect if the firm dramatically changed its investment policy. This will
36
drastically change the firm0s marginal cost of capital, so as to reflect the
risness of the new line of business.
Rationale For a Hei1+ted A*era1e
1. The rationale is that by financing in the proportions specified and
accepting pro<ects yielding more than the weighted average required
return, the firm is able to increase the maret price of its stoc. This
increase occurs because investment pro<ects are expected to return
more on their equity(financed portion than the required return on equity
( )
e
. 'nce these expectations are apparent to the maret place, the

maret price of firm0s stoc should increase because expected future
earnings per share and dividends per share are higher than those
expected before the pro<ects were accepted.
8. .nother rational is that the use of D.CC is based on the assumption
that investment proposals being considered do not differ in systematic
ris from that of the firm and that the unsystematic ris of the proposals
does not provide any diversification benefits to the firm. It is only under
these circumstances that the cost of capital figure obtained appropriate
as an acceptance criterion. Thus these assumptions imply that the
pro<ects of the firm are completely alie with respect to ris and that only
pro<ect only pro<ects of the same ris will be considered.
9. For a multi(product firm with investment proposals of varying ris, the
use of an overall required rate of return is inappropriate. . required rate
of return based on the ris characteristics of the specific proposal should
be used. Thus the ey to using the overall cost of capital as a pro<ect0s
required rate of return is the similarity of the pro<ect with respect to ris of
existing pro<ects and investment proposals under consideration.
AdI%stin1 t+e Cost o: Capital :or Risk
Investors require higher returns for risier investments. 'n the other hand a
company that is raising capital to tae on risy pro<ects will have a higher cost
of capital than a company that is financing safer pro<ects. This can be
illustrated using the following diagram..
37
Fi1. 2./ Trade )ff 1et'een Ris# and T&e Cost of Capital
=ate of .ccept
=eturn HACC
68.A
6A.? A =e<ect
6A.A
L.? '
>.A
N
F
=is
(
=is
A
=is
C
=is
Firm % is a low ris firm hence its hurdle rate is >@. Thus it will accept any
pro<ect with the expected return above >@. Firm C, on the other hand, is quite
ris and hence its hurdle rate is 68@.
.ssuming both firms, % and C, are considering investment in pro<ect . with a
composite D.CC of 6A.?@. .t first it would appear as if % should accept the
pro<ect since its 6A.?@ rate of return is above its >@, and C should re<ect the
pro<ect. This will be wrong since 6A.?@ is the hurdle rate for a typical pro<ect
in the firm, which is in line with the ris associated with the pro<ect. %oth firms
should accept the pro<ect since 6A.?@ is above the pro<ect0s hurdle rate of
6A@.
1sing the same reasoning pro<ect $ should be re<ected by both firms. If firm %
accepts the pro<ect basing on the fact that L.?@ is above >@ then this will
lead to a fall in the overall shareholder0s wealth, because the pro<ect0s return
is not high enough to <ustify its ris.
Thus, applying a specific hurdle rate to each pro<ect ensures that every
pro<ect will be evaluated properly.
38
1sing the same criterion of accept of re<ect stated above, one can apply it to a
company with different divisions or subsidiaries. .ssuming company K with
two subsidiaries, one a clothing shop and another a grocery shop. .ssuming
the clothing shop is low ris and has 6A@ cost of capital and grocery shop is
highly risy with 6:@ cost of capital. If these shops have equal weights then
the overall company0s cost of capital will be 68@.
E=a"ple
.ssume in 8AAJ the clothing manager has a pro<ect with an 66@ expected
return whilst the grocery manager has a pro<ect with a 69@ expected return.
Dhich pro<ect should be accepted or re<ectedM
The clothing manager0s pro<ect should be accepted and the grocery
manager0s pro<ect should be re<ected basing on each subsidiary0s specific
hurdle rate. /owever, had one considered the overall company K0s hurdle rate
of 68@ then the grocery manager0s pro<ect should have been accepted yet it
infact decreases the shareholders0 wealth.
Esti"atin1 !roIe#t Risk
=isier pro<ects have a higher cost of capital. /owever, how can pro<ect ris
be estimatedM There are three types of ris that can be identified.
i. Stand0Alone Risk
It is pro<ect0s ris disregarding the fact that it is but one asset within the firm0s
portfolio of assets and that the firm is but one stoc in a typical investor0s
portfolio of stocs. It is measured by the variability of the pro<ect0s expected
reruns.

ii. Co"parati*eE or Hit+in0Fir"E Risk
It is the pro<ect0s ris to the corporation, giving consideration to the fact that
the pro<ect represents only one of the firm0s portfolio of assets, hence that
some of its ris will be diversified away. It is measured by the pro<ect0s impact
on uncertainty about the firm0s future earnings.

iii. MarketE or (etaE Risk
39
It is the risness of the pro<ect as seen by a well diversified stocholder who
recognises that the pro<ect is only one of the firm0s assets and that the firm0s
stoc is but one part of the investor0s total portfolio. It is measured by the
pro<ect0s effect on the firm0s beta coefficient.
. pro<ect with a high degree of stand(alone or corporate ris will not necessarily
affect the firm0s beta. /owever, pro<ects with high uncertain returns that are
highly correlated with returns on the firm0s other assets and with most other
assets in the economy will have a high degree of all types of ris.
"aret ris is theoretically the most relevant ris because of its direct effect on
stoc prices. 1nfortunately, it is also the most difficult to measure. "ost
decision maers consider all three ris measures they classify pro<ects into low,
average, or high ris pro<ects. =is(ad<usted costs of capital are developed for
each category using composite D.CC.
=is(ad<usted cost of capital is the required return )discount rate* that is
increased relative to the firm0s overall cost of capital for pro<ects or group
showing greater than average ris and decreased for pro<ects or groups
showing less than average ris.
Dhile this approach is better than not ris ad<usting at all, these ris
ad<ustments are sub<ective and somewhat arbitrary.
Usin1 CA!M in !roIe#t8s Risk AdI%sted Cost o: Capital Esti"ation
"any firms use the C.#" to estimate the cost of capital foe specific pro<ects or
divisions. C.#" is based on the assumption that pro<ects will be finances
entirely by equity, that the firm considering pro<ects is entirely equity financed,
and that all beta information pertains to all(equity situations.
The required return for an equity(financed pro<ect, therefore would be!
( )
e " e m "
! ! ! ! +
Dhere
e
E the slope of the characteristic line that describes the relationship

between excess returns for pro<ect
e
and those of the maret portfolio.
E=a"ple
40
.ssuming
e
E 6.65
8% 12%
" m
! and !
8% 4%*1.1 12.4%
e
! +
If the firm intends to finance a pro<ect entirely with equity the acceptance
criterion would then be invest in a pro<ect if the expected rate of return met or
exceed the required rate of return ( )
e
!
, which in this case is 68.:@.
If the company uses only equity capital its cost of capital is also its corporate
cost of capital or D.CC.
E=a"ple
The firm currently has
12.4%; 8%; 12% 1.1
e " m e
! ! and
. It intends to
tae on a particular pro<ect which would cause its beta coefficient to change and
hence its cost of equity. The new weights and beta coefficients will be as
follows!

Old !roIe#t Ne. !roIe#t
Hei1+t A.C A.8
(eta 6.6 6.?
Calculate!
i. #ortfolio beta
ii. 'verall corporate cost of capital
iii. The cost of capital the new pro<ect should earn for the corporate to earn
the cost of capital calculated in ii above. Fist use weights and then use
beta coefficient.
Sol%tion
i. A.C)6.6* P A.8)6.?* E 1.1?
ii. N
p
E C@ P :@Q6.6C E 1.2A
iii. 1sing weights! A.CQ68.:@ P A.8QR E 68.>8@
R E 1&A
1sing beta!
8% 4%*1.5 14%
&
+
<o. to Meas%re (eta Risk
Two approaches have been used to estimate individual assets0 beta. These are
the pure play method and the accounting beta method.
41
i. T+e !%re !lay Met+od
In this case the company tries to find several single(product companies in the
same line of business as the pro<ect being evaluated, and it then averages
these companies0 betas to determine the cost of capital for its own pro<ect. The
riss of the companies should be the same as those of the pro<ect to be
undertaen.
This method can only be used for ma<or assets such as whole division and if
pure play proxies can be found.
ii. T+e A##o%ntin1 (eta Met+od
%etas are normally calculated by regressing the returns of a particular
company0s stoc against returns on a stoc maret index, i.e.!
&xcess =eturn on Stoc Characteristic ;ine
%eta E Slope )=ise over =un*
&xcess =eturn on
"aret #ortfolio
/owever, the company can run a regression of the company accounting
return on assets against the average return on assets for a large sample of
companies, such as those included on the Standard and #oor0s ?AA )SS#?AA*
or ,S&. %etas determined in this way )i.e. by use of accounting data rather
than stoc maret data* are called accounting betas.
.ccounting betas for a totally new pro<ect can be calculated only after the
pro<ect has been accepted, placed into operation, and begun to generate
output and accounting results. Thus it is not good for capital budgeting
decision.
42
/owever, if management thins that the accounting beta of a particular pro<ect
can be used as a proxy for a pro<ect in question then it can be used.
.ccounting betas are used for large pro<ects or divisions, and divisional betas
are then used for division pro<ects.
COST OF 'E!RECIATION ,INTERNALL5 6ENERATE' FUN'S-
$epreciation is the largest source of funds in many firms, and these
depreciation(generated funds are available to support the capital budget.
<andlin1 'epre#iation
. good approximation to the firm0s internally generated cash flow is found as!
Internal Cash Flow E 2et Income 7 Cash $ividends P $epreciation
E =etained &arnings P $epreciation
Internally generated cash can be used in whichever way management sees
fit, e.g. to retire debt, to pay more dividends, or to invest in operating assets.
'e*elopin1 'epre#iation Cost
If funds generated from depreciation are to be reinvested what then will be
their costM The following is a process used to develop the cost of depreciation
funds!
i. $epreciation means that fixed assets are wearing out and hence if the firm
is to continue operating some or all of the depreciation(generated funds
must be reinvested in fixed assets.
ii. The firm still has the opportunity to distribute the same funds to its
investors.
iii. If all the funds are paid to stocholders )preferred and ordinary* debt ratio
would increase and the reverse is true if all the funds are paid to retire
debt.
iv. Since an increase in debt ratio increases the risness of bonds hence
decreasing their value the effective result is that all depreciation cash
flows, if distributed, must be distributed on a pro(rata basis to common
stocholders, preferred stocholders, and bondholders.
43
v. Thus the cost of depreciation funds, if distributed, should reflect the
opportunity costs of all three groups of investors )i.e. N
e
5 N
p
and N
d
*
vi. The average opportunity cost should be based on the same capital
structure weights that would have been used in D.CC calculation.
Thus if the company!
6. 'btains its new common equity as retained earnings rather than by issuing
of new common stoc5
8. $oes not change its target capital structure5 and
9. Invests in assets that have about the same ris as its existing assets,
Then the D.CC can be used for capital budgeting purposes.
'RAH(ACKS IN COST OF CA!ITAL
. number of issues have been taen as given in the calculation of the cost of
capital not because they are this simple but because they are covered in
advanced finance courses. These include!
6. !ri*ately O.ned Fir"s
The decision on cost of capital assumed publicly owned companies. /owever,
the cost of capital for privately owned companies is not covered. Tax issues
become important in such a case. .lthough the same principles of obtaining
D.CC apply but obtaining input data differs.
8. Meas%re"ent !ro9le"s
$ifficulties are encountered in estimating the cost of equity. It is difficult to
obtain good input data for C.#", for growth )g* in
1
0
e
D
g
P
+
, and for ris
premium in N
e
E %ond Kield P =is #remium.
9. Cost o: Capital :or !roIe#ts .it+ 'i::erent Risk
It is difficult to measure ris of a pro<ect, thus maing it difficult to assign ris(
ad<usted discount rate to capital budgeting pro<ects of different degrees of
ris.

:. Capital Str%#t%re Hei1+ts
44
Deights are not simply given, hence stabilising the target capital structure is a
ma<or tas in itself.

?. S"all (%sinesses
Small businesses are generally privately owned maing it difficult to estimate
the cost of equity. .gain the three equity cost(estimating approaches
discussed have serious limitations when applied to small firms.
For example!
Frowth )g* in constant growth model is difficult to measure since the firm
might not pay dividends in the foreseeable future5
In the second method of adding the ris premium, this might be difficult if
the firm does not have publicly traded bond outstanding5
The third approach of C.#" is difficult to use because, if the firm0s stoc
is not publicly traded, then one cannot calculate beta. For privately owned
small firms the pure play C.#" can be used.
Small firms0 capital budgeting is also greatly affected by floatation costs
which tend to be very high. The higher the floatation cost the higher the
coat of external equity.
FOUR NOTA(LE T<IN6S
Dhen estimating the cost of capital always!
6. 1se the current cost of debt, i.e. the pre(tax cost of debt )or interest
rate* the firm would pay when issued the debt and not for existing debt.
8. Dhen using C.#" never use the historical return on stocs with the
current ris(free rate. 1se the estimate of the current expected rate of
return on common stocs and the current expected yield on Treasury
%onds.
9. 1se the target capital structure to determine the weight for the D.CC
and not basing on the boo values.
:. =emember that capital components are funds that come from
investors. If not from investors then it is not a capital component. These
include accounts payable and accruals that are due to operational
45
relations with suppliers and employees, they have to be deducted
when determining the investment required for the pro<ect.
'I3I'EN' !OLIC5
$ividend policy can be defined as a trade(off between retaining earnings on
one hand and paying out cash and issuing new shares on the other hand. It
forms the integral part of the firm0s financing decision.
The dividend payout(ratio determines the amount of earnings that can be
retained in the firm as a source of finance. The firm should therefore
determine the proper allocation of profits between dividend payments and the
retained earnings. The dividend policy is generally determined by legal
framewor, liquidity, control issues, stability of dividend, stoc dividend and
stoc splits, stoc repurchase and administration considerations.
N(/ $ividend(payout ratio E .nnual Cash $ividends
.nnual &arnings
'=
E $ividend per Share
&arnings per Share
The ratio indicates the percentage of a company0s earnings that is paid out to
shareholders in cash.
G.1 !ASSI3E 3s ACTI3E 'I3I'EN' !OLICIES
G.1.1 'i*idend as a !assi*e Resid%al
In this case one ass, T.ssuming the business ris is held constant, can the
payment of cash dividends affect shareholder0s wealth and if so, what
dividend(payout ratio will maximise shareholder wealthMU
To answer this question one needs to examine the firm0s dividend policy as
solely a financing decision involving the retention of earnings. If such a stands
is taen then the payment of dividends is a passive residual.
Some firms pay low or no dividends because management is optimistic about
the firm0s future and wishes to retain earnings for expansion. In this case the
dividend is a by(product of the firm0s capital budgeting decision. If the future
46
opportunities decrease the dividend(payout will also increase. Thus the
percentage of earnings paid out as dividends will fluctuate from time to time in
line with changes in investment opportunities available to the firm.
For situations between +ero dividend and a 6AA@ dividend payout the
dividend(payout ratio will be a fraction between +ero and one respectively.
The treatment of dividend policy as a passive residual implies that dividends
are irrelevant, that is, changes in dividend payout ratio do not affect
shareholder wealth.
/ow then do we separate the impact of the dividend increase from the impact
of investor0s disappointment at the lost growth opportunitiesM
G.1. 'i*idend Irrele*an#e
The argument for irrelevance of dividends on firm value was developed by
"iller and "odiglani )"S"* in 6LJ6 based on a perfect capital marets with
no transaction-floatation costs, taxes or other maret imperfections. "oreover,
the future profits of the firm are, assumed to be, nown with certainty.
"S" argues as follows!
Suppose the firm has settled on its investment program and has wored out
the amount of financing from borrowing and the rest from retained earnings,
what happens if the firm wants to increase the dividend payment without
changing the investment and borrowing policy.
If the borrowing is fixed then the only source should be through the issuing of
more shares.
To persuade new stocholders to part with their cash you should offer them
shares that are worth as much as they cost. The question is how can the firm
do this when its assets earnings, investment opportunities and maret value
are all unchanged. The answer is, Tthere must be a transfer of value from the
old to the new stocholdersU. 2ew stocholders get new shares, each worth
less than before the dividend change was announced, and the old ones suffer
a capital loss on their shares. The capital loss borne by the old shareholders
<ust offsets the extra cash dividend they receive.
47
Thus "S" suggest that the sum of the discounted value per share of
common stoc after financing plus current dividends paid is exactly equal to
the maret value per share of the common stoc before the payment of the
current dividend. In other words, the common stoc0s decline in maret price
is because of dilution caused by external equity financing and is exactly offset
by the payment of the dividend.
The shareholder is therefore, said to be indifferent between receiving
dividends and having earnings retained by the firm.
If corporate dividends are the only source of income for old stocholders then
receiving extra dividend payment plus an offsetting capital loss will mae a
difference to them. /owever, in a perfect capital maret, they can mae
homemade dividends through the selling of shares to new shareholders.
In either case there is a transfer of old to new shareholders, only that in the
former case it was through dilution and in the later it was through a reduction
in the number of shares held.
%ecause investors can manufacture homemade dividends they will not pay a
higher price for the shares of the firms with high payouts. Thus firms should
not worry about dividend policy, as in the eyes of the shareholder, they are all
the same. Thus firms should let dividends fluctuate as a by(product of their
investment and financing decisions.
The two ways of value transfer can be illustrated as follows!
'i*idend Finan#ed (y No 'i*idend No
Sto#k Iss%e ,'il%tion- Sto#k Iss%e
,<o"e"ade 'i*.-
Shares
Cash
Cash Shares
Cash
48
Firm
New Stockholder
Old Stockholder
New Stockholder
Old Stockholder
&ven under dilution the total value of the firm remains unchanged, what
changes is simply the value of each share )gets smaller*.
G. AR6UMENTS FOR 'I3I'EN' RELE3ANCE
The rightists argue that dividends are relevant under conditions of
uncertainty, that is, investors are not indifferent as to whether they
receive returns in the form of dividend income or share price
appreciation. Certain investors may have a preference for dividends
over capital gains. The receipt of an extra cash dividend forgoes an
equal capital gain since the dividend is safe and the capital gain is
risy. Dhilst management can stabilise dividends they cannot control
stoc price.
#ayment of dividends may resolve uncertainty in the shareholders0
minds concerning company profitability. $ividends are paid on a
current, ongoing basis, while the prospect of realising capital gains is in
the future )hence the bird(in(the(hand argument*. Thus investors prefer
to pay a higher price for a dividend paying stoc than for a non(
dividend paying stoc.
The second argument on dividend relevance in addition to preference
for dividends is taxes on the investor. The radical left(wing school
argues that whenever dividends are taxed more heavily than capital
gains, firms should pay the lowest cash dividend they can get away
with. .vailable cash should be retained or used to repurchase shares.
%y doing this corporations can transmute dividends into capital gains.
In addition to capital gains tax is deferred until the actual sale of stoc
)when any gain is then realised*. Since the effective tax on capital
gains )in present value terms* is less than that on dividend income, a
dividend(paying stoc will need to provide a higher expected before(tax
return than a non(dividend(paying stoc of the same ris. Thus, the
greater the dividend yield )i.e. anticipated annual dividend divided by
the maret price of the stoc* on a stoc, the higher the required
before(tax return, and all other things held constant.
49
The third argument is on floatation costs. The "S"0s conclusions
follow their assumption of perfect and efficient capital marets, which in
real world do not exist. The irrelevance of the dividend payout is based
on the idea that when favourable investment opportunities exist and yet
dividends are paid the funds paid out of the firm should be replaced by
funds acquired through external financing. Floatation costs favour the
retention of earnings in the firm. For each dollar paid out in dividends,
the firm nets less than the dollar after floatation costs per dollar of
external financing.
The fourth argument is on transactions costs and divisibility of
securities. Transaction costs mae it more expensive for old
shareholders to sell stoc to new shareholders, as they need to pay
broerage fees. Thus shareholders would prefer that the company pay
more dividends than sell stoc to compensate for corporate dividends.
Securities are no infinitely divisible as assumed under perfect as
assumed under perfect capital maret. The smallest equity security unit
is one share maing it a deterrent to the sale of stoc in lieu of
dividends. Transaction costs and security divisibility also act as a
deterrent to new investors as they do to old ones.
The fifth argument is on institutional restrictions. Certain institutional
investors are restricted on the types of common stoc they can buy or
in the portfolio percentages they can hold in various types of common
stoc. Certain institutions are not permitted to invest in firms that do not
pay dividends or have not paid dividends over a long period of time.
The sixth argument is on financial signalling. In this case dividends,
and not earnings per share, are said to be used by investors as
predictors of the firm0s future performance. If a firm increases its
dividend(payout ratio then it is a sign that management and board of
50
directors )%'$* truly believe that things are better that stoc price
reflects.
#ut in other words, a firm that reports good earnings and pays a
generous dividend is putting its money where its mouth is.
Firms, however, can cheat in the short run by overstating earnings and
scraping up cash to pay a generous dividend. This cannot be sustained
in the long run, and hence the firm will be revealed.
"S" on the other hand arguer that the <ump in stoc price that
accompanies an unexpected dividend increase would have happened
anyway as information about future earnings came out through other
channels.
G.$ EM!IRICAL E3I'ENCE ON 'I3I'EN'S AN' TAJES
The fact that most empirical testing has concentrated on tax effect and on
financial signalling does not mean to say other things as preference for
dividends, floatation costs, transaction costs, and institutional restrictions have
no effect. The fact is tax and financial signalling effects swamp results from
these other factors.
Dith tax effect, if dividends are taxed more heavily than are capital gains,
stoc prices and before(tax returns should reflect this differential taxation.
$ifferent researchers have come up with different conclusions on whether
high dividend stocs provide higher expected before(tax returns than low(
dividend stocs to offset the tax effect. Some evidence suggests a negative
)anti(dividend(paying* effect, but others are consistent with neutrality.
.ll in all a company should endeavour to establish a dividend policy that will
maximise shareholder wealth. It0s generally agreed that if the company has no
sufficiently profitable investment opportunities, it should distribute any excess
)in fact most of* funds to its shareholders.
G.& FACTORS INFLUENCIN6 'I3I'EN' !OLIC5
G.&.1 Le1al R%les
State laws vary from one state to another. "ost states prohibit the payment of
dividends if these dividends impair capital )legal capital*.
51
N(/ Capital generally consists of the par value of all outstanding shares,
where there is no par value it consists of all the receipts from the issue of
shares. Surplus, on the other hand, is what remains after legal capital is
subtracted from the boo net worth. Thus dividends can be paid from surplus
and not legal capital.
The purpose of capital impairment laws is to protect creditors of the
corporation. "ost states prohibit a company from paying dividends if doing so
would mae the company insolvent. Insolvency is defined in different ways as
either, in legal sense, deficiency of assets compared with all outstanding fixed
liabilities, or in a technical sense, as an inability to meet immediate
obligations.
Since firms0 ability to pay their obligations is dependent on their liquidity rather
that on capital, the technical insolvency restriction gives creditors a good deal
of protection.
.nother legal rule is the undue retention of earnings rule. This rule prohibits
the company from retention of earnings significantly in excess of the present
and future investment needs of the company. This is meant to prevent
companies from retaining earnings for the sae of avoiding tax.
G.&. F%ndin1 Needs o: t+e Fir".
The liely ability of the firm to sustain a dividend should be analysed relative
to the probability distribution of the possible future cash flows and cash
balances. %asing on this analysis, a company can determine its liely residual
future funds.
G.&.$ Li;%idity
The greater the cash position and overall liquidity of the company, the grater
is its ability to pay a dividend.
G.&.) A9ility to (orro.
52
The greater the ability of a firm to borrow on comparatively short notice, the
greater is its financial flexibility, and the greater is its ability to pay cash
dividends.
G.&.6 Restri#tions in 'e9t Contra#ts
These are restrictions employed by the lender to preserve the company0s
ability to service debt. 1sually it is expresse:d as a maximum percentage of
cumulative earnings retained )reinvested* in the firm.
G.&.2 Control
Shareholders may prefer that the company pay a low dividend payout and
retain some earnings to finance future investment shares instead of issuing
shares to new staeholders. Should old shareholders fail to tae(up new stoc
leading to new shareholders coming in, their control will be diluted.
From another angle companies in danger of being acquired may establish a
high dividend payout in order to please shareholders and hence avoid a
taeover.
G.) 'I3I'EN' STA(ILIT5
$ividend stability is one feature that attracts investors. Stability means
maintaining the position of the firm0s dividend payments in relation to a trend
line, normally one that is upward sloping.
Ceteris(paribus, a share of stoc may command a higher price if it pays a
stable dividend over time than if it pays a fixed percentage of earnings.
Compare the following two companies!
Co"pany A
A"o%nt
!er &
S+are
$ &arnings per
53
Share
$ividends per
Share
1
Ti"e

Co"pany (
A"o%nt
!er &
S+are
$ &arnings per
Share
$ividends per
Share
1
Ti"e
Company .0s dividend policy is a strict adherence to a constant ?A@ dividend
payout ratio. Company %0s dividend policy is a long run ?A@ dividend payout
ratio but dividend increase only when supported by growth in earnings.
In the long run the amount of dividends the companies would have paid is
equal. /owever the maret price of company % may be well above that of
company .. This is due to the fact that investors value dividend stability and
hence will place their trust in company %, and will be prepared to pay a
premium for the share due to the stability of its dividend. 'n the other hand,
investors prefer a stable dividend as compared to the one that fluctuates.
G.6 <OH COM!ANIES 'ECI'E ON 'I3I'EN' !A5MENT
4ohn ;inter, in mid 6L?As, conducted a survey on how companies determine
their dividend payments. /e came up with the following facts!
54
6. Firms have long(run target dividend payment ratios. "ature companies
generally pay a higher proportion of earnings, with young companies
paying low payouts.
8. "anagers focus more on dividend change that on absolute levels.
9. $ividend changes follow shifts in long(run sustainable earnings. Thus
managers smooth dividends.
:. "anagers are reluctant to mae dividend changes that might have to
be reversed.
/e then developed the following model!
.ssuming a firm always stuc to its target payout ratio, then the dividend
payment in the coming year )$
6
* would be equal a constant proportion of
earnings per share )&#S
6
*, where!
$
6
E Target dividend E Target payout ratio x &#S
6
.
$ividend change is!
$
6
7 $
A
E Target change E Target payout ratio x &#S
6
7 $
A
.
If a firm stics to its payout ratio then dividend should change each year,
however, managers are reluctant to do this hence they pay a constant
dividend.
Thus!
$
6
7 $
A
E .d<ustment rate x Target change
E .d<ustment rate x )Target ratio x &#S
6
7 $
A
*.
The more conservative the company, the more reluctant it is to move towards
its target and, therefore, the lower would be its ad<ustment rate.
G.2 FORMS OF 'I3I'EN'S
iii. Re1%lar Cas+ 'i*idend 7 It is the dividend that is expected to be paid
by the firm under normal circumstances. #aid quarterly, semi(annually,
or annually.
55
iv. E=tra 'i*idend 7 It is non(recurring dividend paid to shareholders in
addition to the regular dividend.
v. Spe#ial 'i*idend 7 It is usually reserved specifically for payments that
are unliely to be repeated. It is brought about by special
circumstances.
vi. Li;%idatin1 'i*idend 7 It is paid when all retained earnings are used
p and if funds are not needed for the protection of creditors.
vii. Sto#k 'i*idend 7 It is when the company gives out extra stoc to
investors instead of cash dividend.
viii.'i*idend Rein*est"ent !lan ,'RI!- ( Some companies offer
automated $=I#s. 2ew shares are issued at, say @ discount from the
maret price.
G.? STOCK 'I3I'EN'S
This involves a payment of additional shares of stoc to shareholders. It is
often used in place of or in addition to a cash dividend. It is simply a
booeeping shift of retained earnings to equity and additional paid in capital.
&ntries can be illustrated as follows, for example in the case of a ?@ stoc
dividend.
(EFORE AFTER
Current "aret #rice B:A B:A
#ar Galue B? B?
Common Stoc B8,AAA,AAA B8,6AA,AAA
.dditional #aid in Capital B6,AAA,AAA B6,>AA,AAA
=etained &arnings B>,AAA,AAA BJ,8AA,AAA
Total Shareholders0 &quity B6A,AAA,AAA B6A,AAA,AAA
2umber of Shares :AA,AAA :8A,AAA
N(/ ?@ .dditional Stoc E A.A? x :AA,AAA E 8A,AAA shares
"aret Galue E B:A x 8A,AAA E BCAA,AAA
;egal-#ar Galue E B? x 8A,AAA EB6AA,AAA
56
Thus B6AA,AAA contributes towards increase in common stoc account. The
remaining B>AA,AAA is additional paid in capital. The total of BCAA,AAA comes
from retained earnings.
Total shareholders0 equity remains the same at B6A,AAA,AAA.
'verally, shareholders have more shares of stoc but lower earnings per
share. /owever, proportionate claim against total earnings remains constant.
Dith a large percentage stoc dividend the full amount is transferred to
common stoc at par )a conservative approach*. This is due to the fact that
the increase in shares will affect the maret value. Thus the conservative way
will be as shown below.
Conser*ati*e Hay
#ar Galue B?
Common Stoc B:,AAA,AAA
.dditional #aid in Capital B6,AAA,AAA
=etained &arnings B?,AAA,AAA
Total Shareholders0 &quity B6A,AAA,AAA
2umber of Shares CAA,AAA
G.G STOCK S!LITS
This involves an increase in the number of shares outstanding by reducing the
par value of the stoc, e.g. a 8(for(6 stoc split where par value per share is
reduced by half.
N(/ . 8(for(6script issue )i.e. 8 new shares in addition to one old* is
equivalent to a 9(for(6 stoc split )i.e. replacing each outstanding share with 9
new shares*.
. 8(for(6 stoc split can be illustrated as follows!
(EFORE AFTER
#ar Galue B? B8.?A
Common Stoc B8,AAA,AAA B8,AAA,AAA
.dditional #aid in Capital B6,AAA,AAA B6,AAA,AAA
=etained &arnings B>,AAA,AAA B>,AAA,AAA
57
Total Shareholders0 &quity B6A,AAA,AAA B6A,AAA,AAA
2umber of Shares :AA,AAA CAA,AAA
&xcept in accounting treatment, then, the stoc dividend and split are very
similar. . stoc split, lie a large percentage stoc dividend, is usually
reserved for occasions where the company wishes to achieve a substantial
reduction in the maret price per share of common stoc, thereby at times
attracting more buyers. Dhilst the dividend per share falls the effective
dividend usually increases, e.g. if the dividend was B8 per share it will be
reduced to B6.8A per share.
G.1F EFFECT OF STOCK 'I3I'EN'7S!LIT TO IN3ESTOR
'wnership remains unchanged.
.s the number of shares increase their maret value falls
proportionally.
The number of shares available for disposal in exchange for cash
increases.
The total cash dividend increases if payment ratio is maintained.
#laces the stoc in a more popular trading range thus attracting more
individual buyers and less institutional investors.
Can be used to convey message about company0s future prospects.
G.11 RE3ERCE STOCK S!LIT
It is a stoc split in which the number of shares outstanding is decreased, e.g.
a 6(for(8 reverse split where each shareholder receives one new share in
exchange for two old shares held. It has the opposite effect to the stoc split.
=everse stoc splits are employed to increase the maret price per share
when the stoc is considered to be selling at too low a price. The informative
effect in this case is negative, as it might appear as if the company is in
financial difficulties. 'n the other hand, it might be driven by the need to move
the stoc price into a higher trading range where total trading costs and
servicing expenses are low.
G.1 STOCK RE!URC<ASE
58
It is the purchase )buybac* of stoc by the issuing firm, either in the open
)secondary* maret or by self(tender offer. Some of the reasons companies
buybac stoc are to have it available for management stoc option plans, to
have it available for the acquisition of other companies, to go private or even
to retire it.
G.1.1 Rep%r#+ase Met+ods
i. Sel:0tender o::er
In this case the company maes an offer to purchase a certain number of
shares, typically at a set price. 1sually the tender(offer period is between 8(9
wees. The investors have an option to accept the offer or to hold on to their
shares. If more than required shares are offered the company is under no
obligation to buy the extra shares.
Self(tender offer is, in general, less costly than open maret purchase.
ii. Open0"arket p%r#+ase
In this case the company buys its own stoc lie any other investor does, i.e.
through a broerage house. 1sually, the broerage fee is negotiated. This
process usually taes longer for the company to accumulate the required
amount of stoc, since most exchange houses restrict the manner in which a
company can bid for its own stoc. . self(tender offer is more suitable in this
case.
G.1$ RE!URC<ASIN6 AN' 'I3I'EN' !OLIC5
=epurchase is a way of distributing excess funds if the firm has no profitable
investment opportunities to <ustify the use of these funds. Firms can also
accomplish this distribution through increased dividend payout. In the
absence of personal income tax and transaction costs the two should yield the
same benefit. In case of repurchase, few shares remain in the maret and this
should lead to increased maret price and dividends per share.
59
E=a"ple
The company is considering distributing B6.? million either in cash dividend or
through share repurchase. The following are ey company figures <ust prior to
the B6.? million distribution!
&arnings .fter Tax B8,AAA,AAA
2umber of Common Stoc 'utstanding ?AA,AAA
&arnings per Share B:
Current "aret #rice per Share BJ9
&xpected $ividend B9
'ption 6! Cash dividend 7 Investors expect B9 per share cash dividend )i.e.
B6,?AA,AAA-?AA,AAA*. The BJ9 thus consists of B9 dividend and BJA maret
price of stoc expected to be earned after the cash dividend distribution.
'ption 8! =epurchase 7 The firm maes a self(tender offer to shareholders at
BJ9 per share. It can repurchase 89,C6A shares )i.e. B6,?AA,AAA-BJ9*. &#S
changes to B:.8? Vi.e. B8,AAA,AAA-)?AA,AAA(89,C6A*W.
Should the firm decide to pay a cash dividend, its price(earnings ratio after the
dividend would be 6? )i.e. BJA-B:*. If this ratio stays at 6? after a stoc
repurchase, total maret price per share will be BJ9 )i.e. B:.8A x 6?*. Thus the
two options bring the same benefits.
If personal tax rate on capital gains is less than that on dividend income, the
repurchase of stoc offers a tax advantage over the payment of dividend to
the taxable investor. .gain capital gains tax is postponed until the stoc is
sold, whereas with dividends the tax must be paid on a current basis.
G.1& STOCK RE!URC<ASE IN3ESTMENT OR FINANCIN6 'ECISION
Stoc repurchase is more of a financing decision since it leads to the altering
of the capital structure )i.e. debt to equity ratio* of the firm. It leads to more
debt than equity. .gain treasury stoc )i.e. common stoc that has been
repurchased and is held by the issuing company* does not provide an
expected return, as do other investments. 2o company can exist by investing
only in its own stoc.
60
G.1) STOCK RE!URC<ASE SI6NALIN6 EFFECT
Stoc repurchase tend to have a positive effect in situation where
management feels that the stoc is under valued and that they where
personally constrained in not responding to a self(tender offer on shares they
personally hold. The self(tender offer bid premium )amount by which offer
exceeds maret price* would reflect the degree of undervaluation.
Dhilst cash dividends provide regular information on the ability of the firm to
generate cash, stoc repurchase provides a once off extra bulletin on the
degree to which management feels the stoc is undervalued.
G.16 'I3I'EN' !OLIC5 A'MINISTRATI3E CONSI'ERATIONS
i. Re#ord 'ate
It is the date, set by the board of directors )%'$* when a dividend is decided,
on which an investor must be a shareholder of record to be entitled to the
upcoming dividend. .t the close of business on that date the company draws
up a list of shareholders from its stoc transfer boos.
For example a %'$ of 'ld "utual meets on "ay C, it decides a dividend of B6
per share payable 4une 6? to shareholders of record on "ay 96. Thus the
person who holds 'ld "utual stoc on "ay 96 is entitled to a dividend even
though he-she sales the shares prior to 4une 6?.
ii. E=0'i*ided 'ate
The first date on which a stoc purchaser is no longer entitled to the recently
declared dividend. This date helps in eliminating the problem of stoc sales in
days immediately prior to the record date when it taes time to settle the deal.
%roerage community has a rule whereby new shareholders are entitled to
dividends only if they purchase the stoc at least four business days prior to
the record date.
iii. 'e#laration 'ate
It is the date that the %'$ announces the amount and date of next dividend.
i*. !ay"ent 'ate
61
It is the date when the corporation actually pays the declared dividend.
The time line below indicates the abovestated dates.
"ay C "ay 8> "ay 96 4une6?
$eclaration &x($ividend =ecord #ayment
$ate $ate $ate $ate
. stoc that has gone ex(dividend is maret with an TRU in newspaper price
listing.
*. 'i*idend Rein*est"ent !lan ,'RI!-
It is an optional plan allowing shareholders to automatically reinvest dividend
payments in additional shares of the company0s stoc. There are two types of
$=I#s, i.e. where additional shares are from already existing common stoc
or newly issued stoc.
In case of old stoc all funds to be reinvested are transferred to a ban that
acts as a trustee. The ban then purchases shares of the company0s common
stoc in the open maret with either the company or investor bearing
broerage costs.
The other method is when the firm issues new stoc and this is when the firm
actually raises new capital. This method effectively reduces cash dividends.
The company does not pay broerage costs as the stoc is coming from itself.
2ormally investors buy the stoc at a discount of the maret price. &ven
though reinvested, the dividend is taxable to the shareholder as ordinary
income, and this posse as a ma<or disadvantage to taxable investors.
62
LEASE FINANCIN6
. lease is a contract under which one party, the lessor )owner* of an asset,
agrees to grant the use of an asset to another, the lessee )user*, in exchange
for periodic rental payments.
T5!ES OF LEASES
i. Operatin1 Lease
This is a short(term lease that is cancellable during the contract period at
the option of the lessee with proper notice. The term of operating lease is
shorter then the asset0s economic life. The lessor does not recover the full
investment during the first lease but through leasing the asset over and
over, either to the same lessee or different lessees. &xamples include
office space, copying machines, computers software or hardware and
automobile leases.
ii. Finan#ial Lease
This is a long(term lease that is not cancellable. It extends over most of
the estimated economic life of the asset. Should the lessee decide to
cancel the contract, then, the lessor should be reimbursed nay losses. The
total payments to the lessor include costs plus interest payments.
Financial lease is also called capital or full-payout lease. In the shipping
industry, a financial lease is called bareboat charter or demise hire.
iii. F%ll0Ser*i#e Lease
In this type of lease, the lessor promises to maintain and insure the
equipment and to pay any property taxes due on it. It is also referred to as
maintenance or rental lease.
i*. Net Lease
63
In this case the lessee agrees to maintain, Linsure and pay property tax for
the leased asset. Financial leases are usually net leases.
N(/ .t expiration of the lease the lessee has the option, according to
contract0s specification, either to return the leased asset to the lessor, to
renew the lease at the agreed rate or, to buy the asst at its fair maret value.
If the lessee fails to exercise the option, the lessor taes possession of the
asset and is entitled to any residual value associated with it.
FORMS OF LEASE FINANCIN6
.ll Financial lease arrangements fall into Sale and ;easebac, direct leasing
or ;everage leasing.
i=. Sale and Lease9a#k
This form of lease financing is common in real estate. It involves a situation
whereby the firm sells an asset it already owns and leases it bac from the
buyer. T.". stores, for instance, may wish to raise cash by selling the building
T.". /yper for cash to the leasing company and simultaneously signing a
long(term lease contract for the building. ;egal ownership of the building is
passed to the leasing company, but the right to use it stays with T.".
The lessor benefits in terms of lease rentals and residual value, whilst the
lessee benefits in terms of immediate cash and reduction in tax payments.
=. 'ire#t Leasin1
This usually involves a lease arrangement for brand new assets. The lessee
identifies the equipment, arranges for the leasing company to buy it from the
manufacturer, and signs a lease contract with the leasing company. "a<or
types of lessor in this case are manufacturers, finance companies, bans,
independent leasing companies and partnerships.
=i. Le*era1ed Leasin1
It is a lease arrangement in which the lessor provide part of the purchase
price )usually 8A(:A@* of the leased asset and borrows the rest from the third
part using the lease contract as security for the loan.
64
;everaged leasing is mainly used in financing large assets lie aircraft, oilrigs
and railway equipment.
RATIONAL FOR LEASIN6
a- Con*enien#e
Short(term leases are convenient, e.g. if one needs the use of a car for a
wee or if the company needs the use of an asset for 6 year or 8. /owever,
short(term leases tend to be very expensive for equipment that can easily be
damaged.
9- Maintenan#e and Ad*i#e
In a full service lease, the lessor provides expertise maintenance. ;ease
agencies also provide expertise advice to lessees on the best equipment to
lease.
#- Standardisin1 Leads to Lo. Ad"inistration and Transa#tion
Costs
;easing companies usually provide a simple standard lease contract. 1nlie
borrowing funds from bans, where a lot of administrative, legal and
transaction costs are involved in terms of investigations and collateral.
;easing provides financing on a flexible, piecemeal basis, with low transaction
costs, than in a private placement or public bond or stoc issue.
d- Ta= S+ields
The lessor deducts the asset0s depreciation from taxable income. If such
depreciation tax shields are put into a better use than an asst0s user can, the
benefit can be passed on to the lessee in the form of low lease payments.
e- A*oidin1 t+e Alternati*e Mini"%" Ta= ,AMT-
."T is an alternative, separate tax calculation based on the taxpayer0s
regular taxable income increased by certain tax benefits, collectively referred
to as Ttax preference itemsU. The taxpayer pays the large of the regularly
determined tax or the ."T.
65
Since finance managers want to earn lots of money for their shareholders but
report low profits to the tax authorities, firms may use straight(line
depreciation in its annual report but use accelerated depreciation for its tax
boos.
."T, therefore, trap companies that shield too much income5 hence ."T
must be paid whenever it is higher than their tax computed in the regular way.
1sing ."T, part of the benefits of accelerated depreciation and other tax
reducing items are added bac hence increasing total tax to be paid.
/owever, lease payments are not on the list of items added bac in
calculating ."T. Thus, if you lease rather than buy, tax depreciation is less
and the ."T is less.
:- Leasin1 !reser*es Capital
This is, however, a dubious reason for leasing. It is argued that leasing
companies provide T6AA@ financingU5 they advance the full cost of the leased
asset hence the company preserves cash for other things. /owever, the firm
can also Tpreserve capitalU by borrowing money. If, for example, a company
leases a B6billion dollar vehicle rather than buying it, it does conserve B6
billion cash. It could also buy the vehicle for cash and borrow B6 billion, using
the vehicle as security. Its ban balance ends up the same whichever way, it
has the vehicle and it incurs a B6billion debt in either case.
ACCOUNTIN6 AN' TAJ TREATMENT FOR LEASES
1ntil recently financial leases were treated as hidden or off balance sheet
financing. That is, the firm could acquire an asset, finance it through financial
lease, and show neither the asset nor the lease contract on it balance sheet.
.ll the firm was required to do was to add a brief footnote to its accounts
describing its lease obligation.
Today financing standards require that all capital )financial* leases be
capitalised, i.e. the present value of the lease payments must be calculated
and shown alongside debt on the right hand(side of the balance sheet. The
same amount must be shown as an asset on the left hand(side of the balance
sheet.
66
To distinguish between operating and financial leases the financial lease is
the one that meets any of the following requirements!
The lease agreement transfers ownership to the lessee before the
lease expires.
The lessee can purchase the asset for a bargain )fair maret value*
price when the lease expires.
The lease lasts for at least >?@ of the asset0s estimated economic life.
The present value of the lease payments is at least LA@ of the asset0s
value.
Thus all other leases are operating leases as far as the above is concerned.
E3ALUATIN6 LEASE FINANCIN6
To evaluate whether or not a proposal for lease financing maes an economic
sense, one should compare the proposal with financing the asset with debt.
The best financing method depends on the pattern of cash flows for each
financing method and on the opportunity cost of funds.
E=a"ple
The company has decided to acquire a piece of equipment valued at
B6:C,AAA to be used in the fabrication of microprocessors. If financed with
lease the manufacture will provide such financing over seven years. The
terms of the lease call for an annual payment of B8>,?AA. The annual
payments are made in advance, i.e. annuity due. The lease is a net lease.
=equired!
a. Calculate the before(tax return to the lessor.
b. Calculate the annual lease payment if required rate of return is 66@.
.nswer!
a. 1se the formula!
n
C
F
D BLCF
t
7,1Kk-
t
C
t!"
D LCF
F
K LCF
t
,!3IFA
kEn
-
67
Dhere!
C
F
is cost of the equipment
LCF
t
is lease cash flow at time t.
1sing interpolation solve for .
5r LCF
t
!3 @ )A !3 @ 1FA
A 8>,?AA.AA 8>,?AA.AA 8>,?AA.AA
6 8>,?AA.AA 8J,6LA.:C 8?,AAA.AA
8 8>,?AA.AA 8:,L:9.96 88,>8>.8>
9 8>,?AA.AA 89,>??.?9 8A,JJ6.6J
: 8>,?AA.AA 88,J8:.98 6C,>C8.C>
? 8>,?AA.AA 86,?:J.L> 6>,A>?.9:
J 8>,?AA.AA 8A,?8A.L8 6?,?89.A9
Total 162EF?1.)$ 1&2E6G.62
2#G at ?@ E B6L,AC6.?9
2#G at 6A@ E (B>9A.99
k D r
1
K BN!3
1
7,N!3
1
0N!3
-CLBr
0r
1
C
E A.A? P)6L,AC6.?9-6L,C66.CJ*Q)A.A?*
E G.?A
9. 6
M1&?EFFF DB,LCF
t
71.11-
t
C
tDF
D LCF
F
K LCF
t
,!3IFA
11AE6
-
E ;CF
A
P ;CF
t
):.896* E ;CF)?.896*
;CF E B6:C,AAA-?.896 E M?EG$
OR
5r LCF
t
!3 @ 11A
A R 6.AAAA
6 R A.LAAL
8 R A.C66J
9 R A.>968
: R A.J?C>
? R A.?L9?
J R A.?9:J
Total ).$F)
68
R E B6:C,AAA
?.896
E M?EG$.FF
!resent 3al%e o: a Lease Contra#t
Calculating the present value of lease contract help in determining whether to
lease or buy the asset. .s stated one need to compare the present values of
cash outflows for leasing and borrowing. The method to choose should be the
one with the lowest present value of cash outflows less inflows.
In the example above the company maes annual lease payments of B8>,?AA
for leased asset. These are tax deductible in the year in which they apply, i.e.
B8>,?AA paid in year A is only deductible for tax in year 6.
;easing is analogous to borrowing, thus an appropriate discount rate for
discounting the after(tax cash flows is the after(tax cost of borrowing.
.ssume the cost of borrowing is 68@ and the tax rate is :A@. Thus, the after(
tax cost of borrowing is 68@x)6(:A@* E >.8@.
Calculate the #resent value of cash flows of the lease.
Ans.er/
A ( D A=F.&F CD A0( ' D C7,1.F2-
t
End o: 5r
Lease
!ay"ent
Ta=0S+ield
(ene:its
Cas+ O%t:lo.
A:ter Ta=es
!resent 3al%e o:
Cas+ O%t:lo.s
A 8>,?AA.AA ( 8>,?AA.AA 8>,?AA.AA
6 8>,?AA.AA 66,AAA.AA 6J,?AA.AA 6?,9L6.>L
8 8>,?AA.AA 66,AAA.AA 6J,?AA.AA 6:,9?C.A6
9 8>,?AA.AA 66,AAA.AA 6J,?AA.AA 69,9L9.J>
: 8>,?AA.AA 66,AAA.AA 6J,?AA.AA 68,:L:.AL
? 8>,?AA.AA 66,AAA.AA 6J,?AA.AA 66,J?:.L:
J 8>,?AA.AA 66,AAA.AA 6J,?AA.AA 6A,C>8.6:
> 66,AAA.AA )66,AAA.AA* )J,>J6.8C*
Total !.3. D G?EGF$.$2
This #resent Galue figure should then be compared with the #resent Galue of
cash flows under the borrowing alternative. The alternative that gives a lower
#resent Galue is to be chosen.
3al%ation o: (orro.in1 Alternati*e
69
.s shown in the table below, since the #.G. of cash outflow for debt
alternative is less than that of lease financing the company should use debt.
Thus!
6. If the asset is purchased the company is assumed to finance it with a
68@ unsecured debt. ;oan payments are expected to be made at the
beginning of each year.
8. . loan of B6:C,AAA is taen up at time +ero payable over > years at
B8C,L?? a year.
9. #roportion of interest depends on annual unpaid capital. Thus, annual
interest for first year is B66L,A:? x A.68 E B6:,8C?
IM!ORTANCE OF T<E TAJ RATE
In general, as the effective tax rate declines, the relative advantage of debt
versus lease financing declines and may actually reverse depending on the
circumstances. Thus lease financing is attractive to those in the low to +ero
tax bracet that can en<oy the full tax benefits associated with owning an
asset.
70
5ear End
F 1 $ & ) 6 2 Total
AD Loan
!ay"ent 8C,L?? 8C,L?? 8C,L?? 8C,L?? 8C,L?? 8C,L?? 8C,L?? )6?,AAA*
( D (t01 0 AKC
!rin#ipal O.in1 66L,A:? 6A:,9>? C>,L:? JL,?:: :C,L9: 8?,C?6 (
C D (t01 = F.1
Ann%al Interest ( 6:,8C? 68,?8? 6A,??9 C,9:? ?,C>8 9,6A8 (
' D Ann%al
'epre#iation ( 8:,JJ> 8:,JJ> 8:,JJ> 8:,JJ> 8:,JJ> 8:,JJ> ( 1&?EFFF
E D ,CK'-LF.&F
Ta=0S+ield
(ene:it ( 6?,?C6 6:,C>> 6:,ACC 69,8A? 68,86J 66,6AC )J,AAA*
F D A 0 E Cas+
O%t:lo. A:ter
Ta= 8C,L?? 69,9>: 6:,A>C 6:,CJ> 6?,>?A 6J,>9L 6>,C:> )L,AAA*
6 D F7,1.F2-
t
!.3. Cas+
O%t:lo. 8C,L?? 68,:>J 68,8?6 68,AJC 66,L8J 66,C8: 66,>JA )?,?98* G)E2?
Chapter #$ %OR&ING CA'ITAL MANAGEMENT
HORKIN6 CA!ITAL MANA6EMENT
Doring capital can be viewed from two concepts, i.e. net woring capital and
gross woring capital.
.ccountants use the term woring capital to mean net woring capital, which
can be defined as current assets less current liabilities. Financial analysts, on
the other hand, mean current assets when they spea of woring capital.
Thus their focus is on gross woring capital, which is the firm0s investment in
current assets, e.g. cash, maretable securities, receivables, and inventory.
Doring capital is therefore all about the administration of the firm0s current
assets namely cash and maretable securities, receivables and inventory and
the financing )especially current liabilities* needed to support current assets.
O!TIMAL AMOUNT ,LE3EL- OF CURRENT ASSETS
To come up with the optimum level management must consider the trade off
between profitability and ris. For each level of output, the firm can have a
number of different levels of current assets. The greater the output level the
greater the need for investment in current assets to support that output. The
relationship is not linear5 current assets increase at a decreasing rate with
output as illustrated below!
!oli#y A
CURRENT
ASSETS !oli#y (
LE3EL ,M-
!oli#y C
OUT!UT ,UNITS-
72
.s shown in the diagram, it taes a greater proportional investment in the
current assets when only a few units of output are produced than it does later
on when the firm can use its current assets more efficiently. .ll other things
held constant, the greater the level of current assets the higher the firm0s
liquidity.
#olicy . is associated with high liquidity low profit and low ris, policy % is on
the medium side whilst policy C is associated with high liquidity and high
profitability and ris. This is due to the fact that looing at the relationship
between current assets and profitability one can use the return on investment
)='I* equation, i.e.!
='I E 2et #rofit
Total .ssets
E 2et #rofit
)Cash P =eceivables P Inventory* P Fixed .ssets
Thus, from the above equation, decreasing the amounts of current assets
held will increase the firm0s potential profitability, provided output and sales
remain constant or increase.
/owever, a decrease in current assets means a reduction in the firm0s ability
to meet obligations as they fall due, adopting stricter credit terms in order to
reduce accounts receivables, leading in loss of customers and lose of sales
as products run out of stoc. Thus, adopting an aggressive woring capital
policy leads to increased ris.
Garying woring capital levels leads to two most basic principles in finance,
i.e.!
#rofitability varies inversely with liquidity, and
#rofitability moves together with ris )i.e. there is a trade off between
ris and return*
The optimal level of current assets in the firm will be determined
management0s attitude to the trade(off between profitability and ris.
73
HORKIN6 CA!ITAL CLASSIFICATION
Doring capital can be classified either according to components )i.e.
maretable securities, receivables and inventory*, or time )i.e. permanent or
temporal*
#ermanent woring capital is the amount of current assts required to meet the
firm0s long(term minimum needs.
Temporal woring capital is the amount of current assets that varies with
seasonal requirements.
These two classifications are shown in the diagram below!
A"o%nt
Temporary Current assets
#ermanent Current .ssets
Ti"e
For a growing firm the level of permanent woring capital needed will increase
over time in the same manner as does fixed assets. /owever, unlie fixed
assets, permanent current assets are constantly changing.
FINANCIN6 CURRENT ASSETS
<ed1in1 Approa#+
This is a method of financing where each asset would be offset with a
financing instrument of the same approximate maturity.
1sing this approach, short(term or seasonal variations in current assets would
be financed with sort(term debt5 the permanent component of current assets
would be financed with long(term debt or with equity. This method can be
illustrated as follows!
74

A"o%nt Short(term
Financing

Current .ssets
;ong(term
Financing

Fixed .ssets
Ti"e
If total funds requirements behave in the manner shown above only the short(
term fluctuations shown at the top of the figure would be financed with short(
term debt. If such fluctuations are financed using long(term debt then the firm
will be paying interest for the use of funds during times when these funds are
not needed.
Thus, loans to support a seasonal need would be following a self 7liquidating
principle, e.g. loan taen to finance purchase of &aster eggs will be paid from
receivables from sale of eggs.
S+ort03s0Lon10Ter" Finan#in1
$ue to uncertainty the exact matching of the firm0s schedule of future net cash
flows and debt payment schedule is usually not appropriate. The question is,
what margin of safety should be built into the maturity schedule to allow for
adverse fluctuations in cash flowsM This depends on management0s attitude
to the trade(off between ris and profitability.
75
1. Relati*e risk in*ol*ed
In general, the shorter the maturity schedule of the firm0s debt obligations, the
greater the ris that the firm will be unable to meet principal and interest
obligations. .lso, when firm finances with long(term debt, it nows exactly its
interest costs over the period of time that it needs the funds. If it finances with
short(term debt, it is uncertain of its interest costs upon refinancing. Thus, the
uncertainty of interest costs represents ris to the borrower.
. Risk 3s #ost trade0o::
Fenerally, the expected cost of long(term financing is usually more than the
short(term financing. /owever, in periods of high interest rates, the rate on
short(term borrowings may exceed that of long(term borrowing. In addition to
being generally more expensive, firms borrowing on long(term basis might
end up paying interest on debt over periods of time when funds are not
needed.
Thus generally, short(term debt has greater ris then long(term debt but also
less costly.
The firm should therefore come up with the margin of safety, which can be
thought of as the lag between the firm0s expected net cashflow and the
contractual payments on its debt. The margin of safety will depend on the ris
preferences of management, as shown below!
76
Conser*ati*e Finan#in1 !oli#y

A"o%nt Short(term
Financing
Current .ssets
;ong(term
Financing
Fixed .ssets
Ti"e
A11ressi*e Finan#in1 !oli#y

A"o%nt Short(term
Financing
Current .ssets
;ong(term
Financing
Fixed .ssets
Ti"e
1nder conservative policy, the higher the long(term financing line, the more
conservative the financing policy of the firm, and the higher the cost. 1nder
the aggressive policy there is a negative margin of safety. The greater the
portion of the permanent asset needs financed with short(term debt, the more
aggressive the financing is said to be.
CAS< AN' MARKETA(LE SECURITIES MANA6EMENT
77
This section loos at how much of current assets should be carried in cash
and how much should be carried in maretable securities.
Moti*es For <oldin1 Cas+
These, according to 4ohn "aynard Neynes, are!
a* Transa#tion "oti*e/ to meet payments, )lie purchases, wages,
taxes, and dividends*, arising in the ordinary course of business.
b* Spe#%lati*e "oti*e/ to tae advantage of temporary opportunities, lie
the sudden decline in the price of raw materials.
c* !re#a%tionary "oti*e/ to maintain a safety cushion or buffer to meet
unexpected cash needs. The more predictable the cashflow of a firm
and easy access to credit facility the less cash that needs to be held for
precautionary needs.
The company0s treasury management department is responsible for cash or
maretable securities management, and it involves the efficient collection,
disbursement, and temporary investment in cash. . cash budget saves as a
foundation for cash forecasting and control. In addition to the budget, the firm
needs systematic information on cash as well as some ing of control system.
It is important to have daily reports on ban balances, anticipated daily
receipts and disbursements, as well as maretable securities position of the
firm.
. firm can employ four different ways of managing cash and maretable
securities and these are!
Speeding up cash receipts,
Slowing down cash payouts,
"aintaining cash balances, and
Investing in maretable securities.
78
Met+od I/ Speedin1 Up Cas+ Re#eipts
The firm wants to speed up the collection of accounts receivables so that it
can have the use of the money sooner. Today most firms use sophisticated
techniques to speed up collection and tightly control disbursement. These
methods include!
a- Colle#tions
This involves the acceleration of collections, it includes the steps taen by the
firm from the time a product or service is sold until the customers0 cheques
are collected and become usable funds for the firm. Collections can be
accelerated thorough!
&xpedite preparing and mailing the invoices,
.ccelerate the mailing of payments from customers to the firm, and
=educe the time during which the payments received by the firm
remain uncollected funds.
The second and third aspects above collectively represent collection float. It
represents the time it taes from the point when the cheque is mailed, )mail
float*, to the point when funds are available for use by the company )available
float*. The finance manager should therefore reduce collection float as much
as possible.
Collection float can be reduced thorough earlier billing. . computerised billing
system could used to achieve this. Some companies find it advantageous to
enclose invoices with bought merchandises, fax invoices, or even request
advance payment. %illing can be eliminated entirely through the use of
preauthorised )direct* debit.
Collection float can also be accelerated by use of loc(box system. In this
case the company rents a local post office box and authorises it ban to pic
up remittances in the box. Customers are billed with instructions to mail their
remittances to the loc(box. The remittances are piced up at several times
79
during the day and deposited into the ban account directly. .ll the company
receives are deposit slips and a list of payments.
The main advantage with this method is that cheques are deposited before
any processing or accounting wor is done )thus eliminating processing float*.
The main disadvantage is cost in the form of ban charges for additional
service.
9. Con#entration (ankin1
Firm that use loc 7box system and over(the(counter payment system find
themselves with numerous regional bans. Such firms find it more reasonable
to move part or all of these remote deposits to one central location
)concentration baning* usually at the head office.
The main advantages of such a move are that!
It improves control over inflow and outflow of corporate cash,
It reduces idle balances, and
It allows for more effective investments )through large investments*.
. compensating balance can be left in a remote account whilst any excess
funds would be moved to the concentration ban. 1sually three methods of
funds transfer are used in concentration baning. These are!
i. $epository Transfer Cheque )$TC*, which is a non(negotiable
cheque payable to a single company account at a concentration
ban. /owever because of the delays in cheque clearances most
companies now prefer a telegraphic transfer to a $TC.
ii. .utomated Clearing /ouse ).C/* &lectronic Transfer, which is an
electronic cheque image version of a $TC. Funds will be available
in the account one woring day late and can be used between
bans that a re members of the automated clearing house system.
iii. Dire Transfer, which is an electronic fund transfer system using a
two(way communication system. =TFS ha become a mandated
transfer system in ,imbabwe for large amounts of money.
80
Met+od II/ Slo.in1 'o.n Cas+ !ayo%ts
1sing this method, the firm wants to pay accounts payable as late as is
consistent with maintaining the firm0s credit standing with suppliers so that it
can mae the most use of the money it already has. The combination of fast
collections and slow disbursements will result in increased availability of cash.
'ne procedure for tightly controlling disbursements is to centralise payables
into a single or few account)s* presumably at the company0s headquarters.
If cash discounts are taen on accounts payable, the firm should send
payment at the end of the cash discount period, but if discount is not taen,
the firm should not pay until the final due date in order to have maximum use
of cash.
Companies can also draw cheques from remote ban )e.g. a /arare supplier
and a Nwewe ban* to try and increase the time within which the cheque will
be outstanding.
Met+od III/ Maintain Cas+ (alan#es
"ost firms establish a target level of cash balances to maintain in their
accounts. .ny excess balance is invested in maretable securities. The
greater the interest rate on maretable securities, the greater the opportunity
cost of holding idle cash balances.
'ptimal level should be the larger of!
The transactions balances required when cash management is
efficient5 or
The compensating balance requirement of commercial bans that the
firm has deposit accounts.
'ne cash management model developed to determine an optimal split
between cash and maretable securities is the Inventory "anagement "odel.
81
1sing this model, the &conomic 'rder 3uantity )&'3* formula used in
inventory management is used to determine the optimal amount of transaction
balances to maintain. &'3 is the quantity of an inventory item to order so that
total inventory costs are minimised over the firm0s planning period.
1sing this model, the carrying cost of holding cash 7 interest foregone on
maretable securities 7 is balanced against the fixed cost of transferring
maretable securities to cash or vice versa. It can be illustrated as follows!
Cas+
C
A*era1e
Cas+
(alan#e
,C7-

Ti"e
Key/ C D Total #as+
C7 D A*era1e #as+
The model assumes that the cash flows are constant. 'ne limitation to this
however is the fact that cash payments are seldom completely predictable.
The minimum average level of cash balances required is the point at which
the account is <ust profitable.
Met+od I3/ In*est"ent In Marketa9le Se#%rities
"aretable securities )and time deposits* are shown on the balance sheet as
Tcash equivalentsU, )because they are near(cash investments*, if their
remaining maturities are three months or less. Those with less than one year
but more than three months are shown as short(term investments. "aretable
securities are usually held for three purposes, which are!
82
6. =eady cash for unforeseeable excess cash outflows,
8. Controllable cash for nown future cash outflows lie salaries,
dividends, etc, or
9. Free cash set aside since the firm has no immediate use of the cash.
%efore investing in a maretable security the finance manager should
understand the important factors associated with the security, i.e. safety,
maretability, yield and maturity.
a- Sa:ety ,o: !rin#ipal-
This refers to the lielihood of getting bac the same number of dollars you
originally invested )principal*. Safety for securities, other than Treasury
issues, vary depending on the issuer and type of security issued.
9- Marketa9ility ,Li;%idity-
The ability to sell a significant volume of securities in a short period of time in
the secondary maret without significant price concession. That is the ability
of the owner to convert it into cash at short notice without suffering a great
lose. This requires a large active secondary maret.
#- 5ield ,Ret%rn-
This relates to interest and-or appreciation of principal provided by the
security. Treasury bills do not pay any interest but they are sold at a discount
and redeemed at face value. The portfolio manager needs to be aware of the
interest rate )yield* ris, i.e. variability in the maret price of a security caused
by changes in interest rates.
d- Mat%rity
It simply refers to the life of the security. 1sually, the longer the maturity the
greater the yield, but the more is the exposure to yield ris.
COMMON MONE5 MARKET INSTRUMENTS
They are generally short(term government securities and corporate
obligations. The instruments include Treasury %ills5 Treasury 2otes5 Treasury
%onds with less than one(year5 =epurchase .greements )=epos*5 %aners0
83
.cceptances )%.s*5 Commercial #aper and 2egotiable Certificate of $eposits
)2.C.$s*.
ACCOUNTS RECEI3A(LES AN' IN3ENTOR5 MANA6EMENT
1. A##o%nts Re#ei*a9les Mana1e"ent
This loos at the ey variables involved in effectively managing receivables
and how an optimum investment can be achieved.
&conomic conditions, product pricing, product quality and the firm0s credit
policies are the ey influences on the level of a firm0s accounts receivable. 'f
these, financial manager only influences credit policies.
;owering credit standards may stimulate demand, leading to higher sales and
profits, but at the same time increases cost of carrying the additional
receivables, as well as a greater ris of bad debt loses. Thus the trade(off
between profitability and ris should be managed. #olicy variables include the
quality of the trade accounts accepted, the length of the credit period, cash
discounts and the collection program of the firm. .ll these determine the
average collection period and the level of bad debts.
a- Credit Standards
In theory the firm should lower its quality standard for accounts accepted for
as long as profitability of sales generated exceeds the added cost of the
receivables.
.dded costs are in the form of additional wor due to increased receivables
and increased probability of bad debt loses. There is also the opportunity cost
of committing funds to the investment in additional receivables instead of
other investments.
=elaxing credit standards means customers who initially were not credit
worthy now qualify and collection from these clients is usually slower. Those
who qualified initially will also tend to relax.
84
E=a"ple
.ssume the firm0s product is selling at B6AA. Gariable cost per unit is BCA.
Contribution per unit is B8A )i.e. B6AA ( BCA*.
The firm plans to increase sales and this increase can be accommodated
without any increase in fixed costs since the company is currently operating
below capacity.
Current clients pay in 6 )one* month and are expected to continue doing so.
.nnual credit sales stand at B8: million.
Credit liberalisation will result in new credit clients paying in 8 )two* months0
time. The same relaxation will result in a 8?@ increase in credit sales )i.e. B8:
million x 6.8? E B9A million thus additional sales units is BJ million-B6AA E JA
AAA units*
The firm0s opportunity cost of carrying the additional receivables is 8A@
before tax.
Should the firm relax its credit standardsM
Ans.er
.dditional Sales #rofitability E 1nit Contribution x .dditional 1nits Sold
E B8A x JA AAA units
E M1 FF FFF
.dditional =eceivables E .dditional Sales =evenue
=eceivables Turnover for 2ew Clients
E )J AAA AAA*-J
E M1 FFF FFF
Investment in .dditional =eceivables E 1nit G-Cost x .dditional
#rice per 1nit =eceivables
85
E )BCA-B6AA* xB6 AAA AAA
D M?FF FFF
=equired %efore Tax =eturn on .dditional Investment
E 'pportunity x Investment in
Cost .dditional =eceivables
E A.8 x BCAA AAA
E M16F FFF
Since additional sales profitability )B6.8 million* far exceeds the required
before tax return on additional investment )B6JA AAA*, the firm should relax its
credit standards up to a point where the two are equal assuming all other
things remain constant.
9- Credit Ter"s
1. Credit period
This specifies the total length of time over which credit is extended to a
customer to pay a bill.
. firm0s credit term might be expressed as T8-6A net 9AU.
Dhere! T8-6AU means 8@ discount is given if the bill is paid within 6A days of
invoice date, and
Tnet 9AU means if discount is not taen full payment is due by the 9A
th
day from invoice date.
Thus credit period still remains 9A days.
E=a"ple
.ssume, using the above example, credit period has changed from net 9A to
net JA. This change also affects the old clients.
The credit policy has resulted in additional sales of B9,JAA,AAA and these new
clients also pay on average in two months.
Should the firm liberalise its credit period, ceteris(paribusM
86
Ans.er
.dditional Sales #rofitability E 1nit Contribution x .dditional 1nits Sold
E B8A x 9J AAA units
E M2F FFF
.dditional =eceivables .ssociated with 2ew Sales
E .dditional Sales =evenue
=eceivables Turnover for 2ew Clients
E )9 JAA AAA*-J
E M6FF FFF
Investment in .dditional =eceivables .ssociated with 2ew Sales
E 1nit G-Cost x .dditional
#rice per 1nit =eceivables
E )BCA-B6AA* xBJAA AAA
D M&?F FFF
;evel of =eceivables %efore Credit #eriod Change E .nnual Credit Sales
'ld =eceivables Turnover
E B8:,AAA,AAA-68
D MEFFFEFFF
2ew ;evel of =eceivables .ssociated with 'riginal Sales
E .nnual Credit Sales
2ew =eceivables Turnover
E B8:,AAA,AAA-J
E M&EFFFEFFF
Investment in .dditional =eceivables .ssociated with 'riginal Sales
E B: million ( B8 million
87
D MEFFFEFFF
Total Investment in .dditional =eceivables E B8 million P B:CA AAA
D ME&?FEFFF
=equired %efore Tax =eturn on .dditional Investment
E 'pportunity x Investment in
Cost .dditional =eceivables
E A.8 x B8,:CA AAA
E M&G6 FFF
Thus, since additional sales profitability )B>8A AAA* is greater then before(tax
return on additional investment )B:LJ AAA* the company should increase its
credit period from net 9A to net JA.
. Cas+ dis#o%nt period and #as+ dis#o%nt
Cash discount period is the period of time during which a cash discount can
be taen for early payment )e.g. 6A days of the invoice date*.
Cash discount is the percentage reduction in sales or purchase price allowed
for early payment of invoices. It acts as an incentive for credit customers to
pay quicly.
E=a"ple
.ssume a firm with annual credit sales of B9A million and an average
collection period of two months. Sales terms are Tnet :?U with no discounts.
Thus .verage =eceivables %alance E B9A million-J D M) "illion
.ssume by initiating terms of T8-6A, net :?U the average collection period can
be reduced to one month as JA@ of the customers )in money terms* tae
advantage of the 8@ discount.
Thus 'pportunity Cost of the $iscount E A.8 x A.J x B9A million D M$6F FFF,
annually.
88
Turnover of receivables has improved to 68 times a year.
.verage receivables are reduced from B? million to B8.? million )i.e.
B9Amillion-68*.
The firm therefore realises B8.? million )i.e. B? million ( B8.? million* from
accelerated collection.
The value of the funds received is the opportunity cost and assuming a 8A@
before(tax rate of return, the 'pportunity Savings E B8.? million x A.8 D M)FF
FFF.
Since opportunity savings )B?AA AAA* arising from a speed up in collections is
greater than the opportunity cost of the discount )B9JA AAA* the firm should
therefore adopt a 8@ discount.
$. Seasonal datin1s
In this case, during periods of slac sales, firms will at times sale to customers
without requiring payment for sometime to come )usually until after the pea
sales period*, e.g. in the sell of <erseys. .gain the firm should compare the
profitability of additional sales )due to this incentive* with the required return
on the additional investment in receivables to determine whether datings are
appropriate terms by which to stimulate demand.
$atings also help in reducing storage costs. If warehousing costs plus the
required return on investment in inventory exceeds the required return on the
additional receivables, datings are worthwhile.
#- 'e:a%lt Risk
It is important to note that the optimum credit standard policy will not
necessarily be the one that minimises bad debt loses. The optimal policy to
adopt should be the one that provides the greatest incremental benefit to the
firm.
The bad debt loses tend to decline as collection expenditure in the form of
letters, phone calls, personal visits and legal action increases. The same
applies to the average collection period.
IN3ENTOR5 MANA6EMENT AN' CONTROL
89
. manufacturing company must maintain a certain amount of inventory )Dor
in #rogress* during production.
Inventory(in(transit is inventory between various stages of production or
storage and it allows for the smooth flow of the production process.
=aw(materials inventory gives the firm flexibility in its purchasing.
Finished(goods inventory allows the firm flexibility in its production scheduling
and in its mareting.
;arge inventories allow efficient servicing of customer demand.
The main disadvantage of investing in inventory is the total cost of holding the
inventory including storage and handling costs and the opportunity cost.
There is also the danger of obsolescence.
;ie account receivables, inventories should be increased as long as the
resulting savings exceed the total cost of holding the added inventory.
MET<O'S OF IN3ENTOR5 CONTROL
1. A(C Met+od );oos at what to control*
This method controls expensive inventory items more closely than less
expensive items. Thus, most expensive inventory taes up the least
percentage of items in inventory whilst the cheapest tae the largest portion.
'ther factors, however, have to be taen into account, e.g. whether the item
is critical, or bottlenecs, or may soon become obsolete.
. E#ono"i# Order 4%antity );oos at how much to order*
&'3 is the quantity of an inventory item to order so that total inventory costs
are minimised over the firm0s planning period. For the optimal order quantity
of a particular type of inventory one must consider its forecast usage, ordering
cost, and carrying cost.
.ssume a nown, stead usage of 8,JAA items for six months period, 6AA
items are used each wee. 'rdering costs )'* are constant regardless of the
order si+e. Thus total ordering cost is the cost per order times the number of
orders for that period.
90
Carrying costs per unit )C* represent the cost of inventory storage, handling,
insurance and the required return on the investment in inventory, per period of
time. .gain they are assumed to be constant per period per unit. Total
carrying cost for that period is therefore equal to the carrying cost per unit
times the average number of units of inventory for that period. Its assumed
that inventory units are filled without delay when needed.
Dith a steady use of inventory over time and with no safety stoc, average
inventory can be expressed as!
3
8
Dhere 3 E 3uantity ordered.
This can be illustrated as follows!
In*entory
4

A*era1e
In*entory
,47-

Ti"e
.s shown, when a +ero level of inventory is reached, a new order of 3 items
arrives.
The carrying cost E C)3-8*
The total number of orders over a period of time E
Total usage )in units* for that period )S*
The quantity ordered )3*.
.t the same time total ordering cost E
91
'rdering cost per order x The number of orders Vi.e. ')S-3*W.
Thus, total inventory cost E Total carrying cost x Total ordering cost, i.e.
T E C)3-8* P ')S-3*.
It implies that the higher the order quantity )3* the higher the total carrying
costs, but the lower the total ordering costs. The firm therefore becomes
worried about the trade(off between the economies of increased order si+e
and the added cost of carrying additional inventory.
$. Opti"al Order 4%antity
This is the quantity )3
A
* that minimises total inventory costs over the planning
period. This is represented by the formula!
3
A
E 8)'*)S*
C
E=a"ple
.ssume inventory usage of 8,AAA during a 6AA day planning period costs are
B6AA per order, and carrying costs are B6A per unit per 6AA days. Calculate
the optimal order quantity.
Ans.er
3
A
E 8)B6AA*)8AAA* E FF %nits
B6A
Thus with an order quantity of 8AA the firm can order 6A times )i.e. 8,AAA-8AA*
during the 6AA days, i.e. every 6A days.
3
A
varies directly with usage )S* and order costs )'* and inversely with
carrying cost )C*. /owever, the relationship is not linear due to the square
root effect. Thus 3
A
changes at a lower proportionate rate in relation to others.
92
The relationship can be illustrated as follows!

Source! http!--en.wiipedia.org-wii-&conomicXorderXquantity
2%! 'rdering Costs E Total 'rdering Costs
Total Cost E Total Inventory Costs
/olding Costs E Total Carrying Costs
&conomic 'rder 3uantity E 3
A
.
:. Order !oint )Dhen to order*
This shows the quantity to which inventory must fall in order to signal a
reorder of the &'3 amount. This part taes into account the ;ead(Time, i.e.
the length of time between the placement of an order for an inventory item
and when the item is received in inventory.
In the previous example it was assumed that there is no lead(time, i.e. the
order is replenished as soon as request is made.
.ssuming a lead(time of ? days it follows that the firm needs to order every ?
days before it run out of stoc or at 6AA units of stoc on hand.
93
Thus, the 'rder #oint may be expressed as!
'# E ;ead(Time x $aily 1sage
E ? days x 8A units per day
D 1FF %nits.
.s illustrated below, when the new order is received ? days later, the firm will
<ust have exhausted its existing stoc.

In*entory
FF %nits

Order
!oint
,1FF %nits- 4
F

? 6A 6? 8A 8? 9A 'ays
Lead0Ti"e
). Sa:ety Sto#k
This is inventory stoc held in reserves as a cushion against uncertain
demand )or usage* and replenishment lead(time.
Thus, in this case, owing to fluctuations, it is not feasible to allow expected
inventory to fall to +ero before a new order is anticipated as illustrated below.
In this case 'rder #oint formula changes to!
'# E ).verage ;ead(Time x .verage $aily 1sage* P Safety Stoc
E )? x 8A* P 6AA
D FF %nits.
94
In*entory
$FF %nits
Order
!oint
,FF %nits-

1FF %nits
Sa:ety Sto#k

? 6A 6? 8A 8? 9A 'ays
Lead0Ti"e
In real life where demand and lead(time are not certain the diagram can be
shown as!
In*entory
$FF %nits
Order
!oint A ( C
,FF %nits-

1FF %nits

? 6A 6? 8A 8? 9A 'ays
95
.s shown in the diagram, the real life experience shows that at the first
segment the usage was less than expected hence the slope of the demand is
less than expected. The order point was only reached three days )shown by
.* before the next order is received hence it was received before the safety
stoc level was reached. In the next segment usage was as expected but it
too six days )represented by %* instead of five for the order to be received
hence the company was already utilising its safety stoc. In the third segment
the order is placed soon after receiving the other one due to low stoc levels
and delivery is also done immediately hence stocs are replenished.
.ll these issues point to the fact that the amount of safety stoc depends on
things lie demand uncertainty, lead(time uncertainty, wor stoppage costs
and the cost of carrying additional inventory.
"anagement will not wish to add safety stoc beyond the point at which
incremental carrying costs exceed the incremental benefits to be derived from
avoiding a stoc out.
6. N%st In Ti"e ,NIT-
This inventory management process developed in 4apan involves acquiring of
inventory and inserting it in the production at the exact times they are needed.
This requires a very accurate production and inventory information system,
highly efficient purchasing, very reliable supplies and an efficient inventory
handling system.
The goal of 4IT is not only to reduce inventories, but also to continuously
improve productivity, product quality, and manufacturing flexibility.
%y reducing the ordering related costs, the firm is able to flatten the total
ordering cost curve thereby shifting 3
A
to the left thereby approaching the 4IT
ideal of one unit.
96
MER6ERS AN' AC4UISITIONS
. merger or an acquisition involves the combining of two or more companies
in which only one firm survives as a legal entity.
.n acquisition lie any other investment should only be undertaen if it maes
a net contribution to shareholders0 wealth.
In most cases mergers are arranged amicably, but sometimes one firm will
mae a hostile taeover bid for another.
FORMS OF MER6ER
i. <oriOontal Mer1er
Involves the coming together of two firms in the same line of business.
Such mergers result in economies through the elimination of duplicate
facilities and offering a broader product line.
ii. 3erti#al Mer1er
Involves companies in related lines of business. The company acquires either
forward towards the ultimate consumer or bac ward towards the source of
raw materials. &conomies are en<oyed in the sense that the surviving
company will have more control over its distribution and-or purchasing.
iii. Con1lo"erate Mer1er
Two companies in unrelated lines of business merge. This can come about
due to the desire by the company for a strategic change of business line or
simply a diversify and reduce ris.
MOTI3ES FOR MER6ERS
a- E#ono"i# 6ains
.n economic gain occurs if the two firms are worth more together than apart,
i.e.
#G
.%
H #G
.
P #G
%
)or 6 P 6 E 9* where!
#G
.%
E #resent value of firm . and firm % combined,
#G
.
E #resent value of firm . held separately, and
#G% E #resent value of firm % held separately.
97
The gain to the acquiring company is calculated as!
Fain E #G
.%
7 )#G
.
P #G
%
*

If company . has acquired company % then the 2et #resent Galue )2#G* to .
of acquiring % will be given by!
2#G E Fain 7 Cost
E #G
.%
7 )#G
.
P #G
%
* 7 )Cash #aid 7 #G
%
*.
9- E#ono"ies o: S#ale
These occur when average cost declines with increase in quantity. Cost
declines come from things lie sharing central services lie office
management, accounting and mareting, financial control, executive
development and top(level management.
The surviving firm also gains the maret share and can even dominate the
maret.
Companies tend to gain through the combined use of facilities and gain
through synergy.
#- !ro*ision o: Co"ple"entary Reso%r#es
. small firm may have unique product or sill but lac the engineering or sales
organisation required to produce and maret it on a large scale. If each firm
has what the other needs then it may be more sensible to merge.
d- Eli"inatin1 Ine::i#ien#ies
Some firms are inefficiently managed, with the result that profitability is lower
than it might otherwise be.
e- Si1nallin1 E::e#t
Galue could occur if new information is conveyed as a result of the corporate
restructuring. This usually wors when there is information asymmetry
between management and common stocholders.
98
If management believes the share, to be undervalued then a positive signal
may occur via the restructuring announcement that causes share price to rise.
:- S%rpl%s F%nds
Firms with surplus cash and a shortage of good investment opportunities
often turn to mergers financed by cash as a way of redeploying their capital.
Firms with excess funds and not willing to redeploy it can also be targeted for
acquisition.
1- Ta= Reasons
. company coming out of banruptcy can have lots of money in unused tax(
loss carry(forwards. Such a company can buy of merge with another profit
maring company and hence be able to utilise the carry(forwards.
+- (orro. at Lo. Costs
. firm can merge with another so that it can improve its credit rating and
hence be able to access debt at low cost.
i- Mana1e"ent8s !ersonal A1enda
Some managers view growing from a small to a large company as more
prestigious or can have diversification as their ob<ective.
I- 'i*ersi:i#ation
%y merging with another firm and attaining more diversification, either through
product or maret diversification, help in reducing ris of loses to the
company. $iversification can be shown using the .nsoff )#roduct-"aret*
Frid below.
EJISTIN6 !RO'UCT NEH !RO'UCT
EJISTIN6
MARKET
"aret #enetration #roduct $evelopment
NEH MARKET "aret $evelopment $iversification
STRATE6IC 3s FINANCIAL AC4UISITIONS
99
Strategic acquisition occurs when one company acquires another as part of its
overall business strategy. The main motive in such cases is the cost
advantage.
Financial acquisition, on the other hand, occurs when the acquirer0s motive is
to sell off assets, cut costs, and operate whatever remains more efficiently
than before. This is done in the hope that the actions result in creating value
in excess of the purchase price.
Financial acquisition is not strategic in the sense that the acquired firm will
operate as an independent(stand(alone entity. . financial acquisition usually
involves cash payment to the selling shareholders financed largely by debt
)i.e. ;everaged %uyout(;%'*.
COMMON STOCK FINANCE' AC4UISITIONS
Dhen an acquisition is done for common stoc, a ratio of exchange, which
denotes the relative weightings of the two companies with regard to certain
ey variables, results. The two ratios to be considered are the per(share
earnings and the maret price ratio.
i. Earnin1s I"pa#t
In this case the acquiring firm considers the effect that the merger will have on
the earnings per share of the surviving corporation.
E=a"ple
Kou are given the following financial data in the case where company . is
considering the acquisition, by common stoc, of company %.
Co"pany A Co"pany (
#resent &arnings )AAA* B8A,AAA B?,AAA
Shares outstanding )AAA* ?,AAA 8,AAA
&arnings per share )&#S* B:.AA B8.?A
#rice per share BJ:.AA B9A.AA
#rice &arnings )#-&* ratio 6J 68
Company . has agreed to offer B9J )i.e. 8A@ premium above company %0s
stoc* a share to company %, to be paid in company .0s stoc.
100
a* Calculate the exchange ratio.
&.=. E 9J E F.)6)
J:
Thus company . will pay A.?J8? share for each of company %0s share.
In total company . will issue 6,68?,AAA )i.e. A.?J8? x 8,AAA,AAA shares*
shares to acquire 8,AAA,AAA shares in company % )hence acquiring company
%*.
b* .ssuming that the earnings of the component companies stay the
same, what will be the &#S of the surviving company after the
acquisitionM
Co"pany A
#resent &arnings )AAA* B8?,AAA
Shares outstanding )AAA* J,68?
&arnings per share )&#S* M&.F?
Thus the merger has lead to an immediate <ump in the earnings per share for
company . from B:.AA to B:.AC.
c* Calculate the post merger &#S related to each share of company %
previously held.
Thus! A.?J8? x B:.AC E M.$F.
Thus company0s shareholders have experienced a decline in &#S.
Suppose company . had offered a ?A@ premium its &#S would have
declined to B9.LA indicating an initial dilution due to the acquisition. 'n the
other hand company %0s shareholders would have en<oyed an increase in
&#S from B8.?A to B8.>:.
$ilution occurs whenever the price earnings )#-&* ratio paid for a company
exceeds the #-& ratio of the company doing the acquisition.
101
#-& ratio in the first instance was 6:.: )i.e. B9J-B8.?A* and in the second
instance it was 6C compared to 6J for company ..
In general, the higher the pre(merger #-& ratio and earnings of the acquiring
company in relation to the acquired company, the greater the increase in &#S
of the surviving company. Thus, avoid acquiring companies with high #-&
ratios and high earnings.
.n initial dilution of &#S can be accepted if future earnings are expected to
grow at a faster rate after the acquisition mainly due to synergistic effects.
Such growth can be illustrated as follows!
E=pe#ted
E!S ,M-
Frowth with merger
1
Frowth without merger
?
&
1 $ & ) 5ears
The greater the duration of the dilution, the less desirable the acquisition is
said to be from the standpoint of the acquiring company.
ii. Market 3al%e I"pa#t
$uring the acquisition bargaining process ma<or emphasis is placed on the
exchange ratio of maret price per share. "aret price reflects the earnings
102
potential of the company, as well as the dividends, bus ris, capital structure,
asset values, and other factors that bear upon valuation.
Market !ri#e E=#+an1e Ratio D
Market !ri#e !er S+are = N%"9er o: S+ares 9y A#;%irin1 Co"pany
o: t+e A#;%irin1 Co"pany :or Ea#+ S+are o: t+e A#;%ired Co"pany
Market !ri#e !er S+are o: t+e A#;%ired Co"pany
If the maret exchange ratio is 6 )one* it follows that the shares will be
exchanged on a 6!6 basis and the company being acquired finds little
enticement to accept such an exchange. The acquiring company should offer
a price in excess of the current maret price per share of the company it
wishes to acquire. Ceteris(paribus, shareholders of both companies will
benefit from such a merger, as shown below.
E=a"ple
Kou are given the following financial information of the acquiring and the
acquired company!

A#;%irin1 Co. A#;%ired Co.
#resent &arnings )AAA* B8A,AAA BJ,AAA
Shares outstanding )AAA* J,AAA 8,AAA
&arnings per share )&#S* B9.99 B9.AA
"aret #rice #er Share BJA.AA B9A.AA
#rice &arnings )#-&* ratio 6C 6A
The #-& ratio of the surviving company is expected to remain at its high level
of 6C after the acquisition.
The acquiring company has offered B:A for each of the shares in the acquired
company.
a* Calculate the "aret #rice &xchange =atio.
Thus! &.= E :A E F.662
103
JA
"aret #rice &xchange =atio E BJA x A.JJ> E 1.$$
B9A
The shareholders of the acquired company benefit in the sense that their
share, which is going for B9A.AA in the maret, has been bought for B:A.AA.
b* Ceteris(paribus what will be the maret value per share of the
acquiring company soon after the acquisitionM
It will stand at!
S%r*i*in1 Co.
Total &arnings )AAA* B8J,AAA
Shares outstanding )AAA* >,99:
&arnings per share )&#S* B9.??
#rice &arnings )#-&* ratio 6C
"aret #rice #er Share M6$.GF
N(/ >,99:,AAA E J,AAA,AAA P )A.JJ> x 8,AAA,AAA*
Thus the shareholders of the acquiring company also benefit through an
increase in the share price and &#S.
It follows that companies with high #-& ratios would be able to acquire
companies with low #-& ratios and obtain an immediate increase in &#S,
despite the fact that they have offered a premium, with respect to the maret
price exchange ratio, provided the #-& ratio after the merger remains
sufficiently high.
&mpirical evidence has shown that share prices of the target company start
increasing in days before the announcement date whilst those of the acquiring
company remain constant or fall. =eturns to shareholders of the acquiring
company tend to fall immediately after the merger whilst shareholders of the
acquired firm experience high and positive return.
104
The relative abnormal stoc returns around the announcement date of a
successful merger can be illustrated as follows!
C%"%lati*e
A*era1e
A9nor"al
Ret%rn
Selling company
K
" %uying company
(
Anno%n#e"ent 'ays
'ate
!URC<ASE OF ASSETS OR COMMON STOCK
. company may be acquired either by the purchase of its assets or its
common stoc. #ayment can be in the form of cash or by exchange of
common stoc.
.fter the purchase the selling company is but a corporate shell with its assets
composed entirely of cash or stoc of the buying company. The acquirer can
either hold the cash or stoc or distribute it to its shareholders as a liquidating
dividend, after which the company is dissolved.
/owever, if only part of the selling company0s assets are bought it can remain
in operation as a legal entity.
TAJA(LE AN' TAJ0FREE MER6ER
In a taxable acquisition, the selling stocholders are treated, for tax purposes,
as having sold their shares, and they must pay tax on any capital gains or
losses. Such is the case when an acquisition is made with cash or with a debt
instrument.
105
In a tax(free acquisition the selling shareholders are viewed as exchanging
their old shares for essentially similar new ones, hence no capital gains or
losses are recognised. This is the case when the transaction is by voting
preferred or common stoc.
In most cases the selling company and its shareholders because of the
postponable capital gains tax involved prefers a tax(free transaction.
ACCOUNTIN6 TREATMENT
.ccounting for mergers can be treated either as a purchase method or a
pooling of interests method.
. purchase method is an accounting treatment based on the maret price
paid for the acquired company.
#ooling of interests involves the treatment for a merger based on the net boo
value of the acquired company0s assets. The balance sheets of the two
companies are simply combined.
"ost acquiring companies prefer the pooling of interests method since
goodwill and-or asset write(ups )due to asset revaluation* are not reflected in
the new balance sheet hence no deduction is made to future income as
goodwill is amortised. /owever, the choice of accounting is usually governed
by the circumstances of the merger and the rules of the accounting
profession.
TAKEO3ER 'EFENCES
These are antitaeover amendments that a firm can employ to frustrate the
company intending to acquire it in a hostile taeover bid. Such a bid is when
the acquiring company maes a tender offer )an offer to buy current
shareholders0 stoc at a specified price* directly to the shareholders of the
company it wishes to acquire.
There are two hypothesises usually used as the motive to employ Tshar
repellentU devices, and these are!
106
i. "anagement entrancement hypothesis, which suggests that the
devices are employed to protect management <obs and that, such
actions wor to the detriment of shareholders.
ii. Shareholders0 interest hypothesis, which argues that contest for
corporate control are dysfunctional and tae management0s time
away from profit maing activities.
$evices usually used are!
a- Sta11ered 9oard P The board is classified into three equal groups and
only one group is elected each year. Thus at any given point in time there
is two(thirds board ma<ority that is unliely to vote in favour of the taeover.
9- S%per"aIority P . high percentage of shares is needed to approve a
merger, usually CA@.
#- Fair pri#e P The bidder must pay non(controlling shareholders a price at
least equal to a pre(specified fair price.
d- Restri#ted *otin1 ri1+ts P Shareholders who own more than a specified
proportion )usually 8A@* of the target have no voting rights unless
approved by the target0s board.
e- Haitin1 period ,:reeOe0o%t- P %idder must wait for a specified period
)usually 8(? years* before a merger can be completed.
:- Le*era1ed re0#apitalisation P Current management loads the balance
sheet with new debt, which it uses to pay a huge, one(time cash dividend
to shareholders.
1- !oison pill P &xisting shareholders are issued rights, which if there is a
significant purchase of shares )usually 8A@* by the bidder, can be used to
buy additional stoc in the company at a discount. Shareholders can also
be issued with convertible preference shares or convertible bonds.
+- !oison p%t P &xisting bondholders can demand immediate repayment if
there is a change of control as a result of a hostile taeover.
i- Asset restr%#t%rin1 P %uy assets that the bidder does not want or that
will create an antimonopoly problem.
I- Liti1ation P File suit against bidder for violating .ntimonopoly .ct.
107
k- Lia9ility restr%#t%rin1 P Issue shares to a friendly third party, increase
number of shareholders or buy shares from existing shareholders at a
premium.
'I3ESTITURE
This is the opposite of merger. It is the divestment of a portion of the
enterprise or the firm as a whole.
The following are the various methods of divestment.
i. 3ol%ntary Corporate Li;%idation
This comes about due to the fact that the firm0s assets may have a higher
value in liquidation than the present value of the expected cash(flow stream
emanating from them.
;iquidation allows the seller to sell assets to different parties hence realising a
higher value than in a merger.
ii. !artial Sell0O::
/is involves the selling of only part of the company, usually a division or
business unit. The value received should be greater then the present value of
the stream of expected cash flows.

iii. Corporate Spin0O::
It is a form of divestiture resulting in a subsidiary or division becoming an
independent company. 1nlie a sell(off, in a spin(off the business unit is not
sold for cash or securities.
Shares in the new company are distributed to the parent company0s
shareholders on a pro(rata basis, after which it operates as a completely
separate company.

i*. E;%ity C%r*e0O%t
It is a public sale of stoc in a subsidiary in which the parent company usually
retains the ma<ority control. The minority interest sold through a curve(out
represents a form of equity financing.
108
The subsidiary will have its value realised since it will have a separate stoc
price and trading publicly. This will encourage managers for that subsidiary to
perform well.
If the subsidiary is in leading(edge technology which cannot be realised whilst
it is financed from the parent, equity curve(out will the subsidiary0s maret to
be more complete hence accessing finance. .lso investors will be able to
obtain a pure play investment in technology.
N(/ #ure play is an investment concentrated in one line of business. It is the
opposite of investment in a conglomerate.
COM!AN5 OHNERS<I! RESTRUCTURIN6
The ownership restructuring methods to be looed at are going private and
leveraged buyouts.
i. 6oin1 !ri*ate
This is process of maing a public company private though the repurchase of
stoc buy current management and-or outside private investors.
The motive to go private could be to do away with the high costs of running a
public company, to do away with legislations governing public companies or
the need to realign and improve management incentives, hence increasing
efficiency.
/owever, going private involves high transaction costs, little liquidity to its
owners, large portion of owner0s wealth is tied up in the company, and the
company0s true value might not be realised unless it goes public.
ii. Le*era1ed (%yo%ts ,L(Os-
This is primarily debt(financed purchase of all the stoc or assets of a
company, subsidiary or division by an investor group.
The assets of the enterprise involved will secure the debt hence it is at times
called asset(based financing. %ecause of the fact that ;%'s are debt
financed most involve capital intensive as opposed to labour intensive
businesses.
"ost ;%'s are to the management of the company or division involved.
109
;%'s are done using cash and not common stoc and the division bought
becomes a private company. ;%'s are motivated by the following reasons!
The division might no longer fit in the company0s strategic ob<ectives.
The division en<oys a window of opportunity extending for several
years.
The company has gone through a program of heavy capital
expenditure and hence the plant is modern.
The company has assets that can be sold to finance its debts without
affecting its company business.
The division has proven historic performance and has an established
maret position.
.lso the availability of experienced and good quality senior
management is critical.
$ue to the leverage management will be forced to wor hard so that nothing
goes wrong.
110

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Chapter 7 VALUATION OF LONG TERM SECURITIES

Factoring may impose constrains on the way to do your

Dhere! "G E "aturity value

Dhere! $ E Stated annual dividend per share, and

Dhere! $ E Cash dividend at the end of time t, and

Dhere! b E . constant proportion of earnings retained by the company

i*. 6ro.t+ !+ases Model

2.)5IEL' TO MATURIT5 ,5TM- ON (ON'S

Fiven the value of "G, #

2.?(ON' 'URATION AN' 3OLATILIT5

to provide this rate

. The three principles

, and use it as an index of

alone as the C.#" procedure

Syste"ati# Risk ,(eta-

* can be thought of as the discount rate that

E =equired rate of return.

and in equilibrium this expected return is also

using the $iscounted Cash Flow )$CF*

the cost of equity is obtained. The last phase i.e.

turns into a constant growth model.

using C.#", =is #remium and $CF

. .lso, if a firm0s payout ratio is so high that it must

. 'nce these expectations are apparent to the maret place, the

E the slope of the characteristic line that describes the relationship

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