Corporate Finance

Chapter 7 VALUATION OF LONG TERM SECURITIES 1
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 look at the markets and institutions through
which finance can be raised as well as types of finance available.

6.1 FINANCIAL MARKETS
Financial market is a place where financial instruments are traded. These can
be classified as:
Money and Capital Markets
Primary and Secondary Markets
Call and Continuous Markets
Dealer and Broker Markets
Manual and Electronic Execution Markets
Formal and Over-the-Counter (OTC) Markets
Spot and Derivative Markets

6.1.1 Money and Capital Markets
Money market is the market 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.
Most money market instruments are not traded in exchanges, trading is
largely by phone and they have minimum transaction sizes. Because of their
characteristics access to them is mainly through indirect investing (going
through an intermediary), e.g. through finance houses, merchant and
commercial banks.
Capital market on the other hand is a market for long-term (with more than
one year term to maturity) instruments, like bonds and stocks, and those with
no designated maturity at all. These instruments are traded in exchanges like
the Zimbabwe stock Exchange (ZSE)
6.1.2 Primary and Secondary Markets
Primary markets are securities markets where new issues are traded. Issuing
of shares maybe direct to purchasers or could be through an intermediary,
e.g. Commercial banks. They provide a direct flow of cash to the issuing
entity/corporation.
Secondary market is a mechanism of bringing buyers and sellers of second
hand securities together for trading purposes. It is market where securities
initially issued in the primary market are resold. Trades in this market do not
provide a direct flow of cash to the issuer but to the investors themselves.

6.1.3 Call and Continuous Markets
In Call markets trades take 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. Each security is called and those interested in either buying or
selling will come together and transact. Price 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 markets trading takes place on a continuous bases. To be
effective there should be enough intermediaries in the form of dealers,
brokers and markets makers in this market 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 market.
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.

6.1.4 Dealer and Broker Markets
A dealer acts for his own book, i.e. he is a principal in all the deals he makes.
He buys shares from investors using his own money and sells to other
investors for his own gain, i.e. he does not act on anyones behalf but for
himself.
A broker, on the other hand, acts as an agent for somebody. He buys and
sells shares on behalf of the investor and is paid a commission. He uses the
investors 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.

6.1.5 Formal and Over the Counter (OTC) Markets
At one time in the USA securities where actually bought over the counter in
banks, which by then acted as primarily dealers for these securities. Banks
have since cessed to do this but the term OTC 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 OTC is highly automated and computers, telephone
and satellites link participants. Examples include National Association of
Securities Dealers Automated Quotation Service (NASDAQS) in USA.
Thus OTC serves as part of the secondary market for stocks and bonds not
listed on an exchange as well as some listed. Dealers and brokers in this
market stand ready to buy and sell securities at quoted prices.
Organised exchanges on the other hand form the formal market, e.g. ZSE,
JSE in South Africa, etc.

6.1.6 Spot and Derivative Markets
On the spot market, 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.
Derivatives form side bets on interest rates, exchange rates, commodity
prices, and etcetera. Firms usually do not issue derivatives to raise money;
they buy or sell them to protect against adverse changes in various external
factors.
Examples of derivatives are:
1. Traded Options Option to buy or sell an asset at a price agreed today.
2. Futures A standardised order to buy/sell or an order place in advance to
buy/sell an asset/commodity at a set price.
3. Forwards A tailor made futures contract not traded on the stock
exchange.
4. Swaps These are exchanges of currency or/and interest rate debts.

NB: The classifications of markets described above are not mutually
exclusive.

6.2 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 package of services so that the distinction between
types of institutions is becoming blurred.

Types of financial markets are:
6.2.1 Deposit-Taking institutions
Commercial Banking
This includes a wide range of services mainly offering current account facility,
overdraft loans, etc.
The difference between commercial banks and building societies is now very
narrow.

Merchant Banking
It offers a range of facilities and services which, inter-alias, include:
Corporate finance e.g. provision of advice and assistance during
mergers, and debt and equity issues;
Lending the actual provision of funds;
Money market trading in money markets and foreign markets for
clients or on their behalf.

Investment Institutions
These include mutual funds, pension funds, and unit trust institutions. They
are significant participants in the financial markets because of the vast
amount of money under their control.
They form major investors to an extend that a public issue of finance is
unlikely to be successful unless if backed by one of them.

Special Institutions
These are institutions created either formally or informally for specific
purposes, e.g. ZDB (now Infrastructure Development Bank, IDB) and SEDCO.
They usually offer short- to medium-term loans for fixed assets and working
capital, either through direct financing or indirect financing (guarantee a
percentage of loan offered from banking institution).

7.3 EBT Vs EQUITY FINANCING
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, risk and return have to be borne in mind. The following are features
of debt and equity discussed under return, risk and control.

7.3.1 Return
- Fixed Interest: Debt 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. Dividends, on the other hand, are not tax deductible and so there
is no relief from the companys 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.

7.3.2 Risk
- Commitment: Interest payment on debt must be met whether there
are profits or not, whilst with dividends this is not the case.
- Capital Repayment: Debt 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 market reassesses the companys risk profile, which
will be reflected in the cost of capital. Consequently, raising debt
reduces the companys flexibility for raising future finance due to
restrictions imposed by debtors.

7.3.3 Control
- Dilution of Control: Raising 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 75% of issued share capital enables the passing of special
resolutions;
o 50% of issued share capital enable the passing of ordinary
resolutions;
o 30% of issued share capital control in terms of the Securities
Regulation Code on takeovers and Mergers;
o 20% to 30% of issued share capital 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 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 Default control may be lost through the companys failure to
meet certain commitments, which transfer certain rights to other
parties.

6.3 TYPES OF MONEY MARKET INSTRUMENTS
Treasury Bills (TBs)
They are issued by the governments treasury department for short-term loans
that it acquires from different investors
TBs are the most marketable and least risky of all the money market
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 market.

Repurchase Agreements/Repos
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 back at a future date at a given price. The return to the
lender is the difference between the two prices.
Repos usually range from overnight to two weeks with long term repos being
called term repos.

Bankers Acceptance (BA)
They are contracts by the bank 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 banks client issues a promissory note
stating when he will make a payment available. The bank then assumes the
obligation by endorsing the note. On maturity the creditor (one owed) will
present the note to the bank and the bank will be obliged to pay.

Negotiable Certificate of Deposit (NCD)
They are time deposits with commercial banks. 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 bank that issues/backs them.
N.C.Ds can be traded in the secondary market through negotiation before
maturity.

Commercial Paper
It represents unsecured promissory note of large financially sound
corporations. Because of their financial soundness such corporation paper
does not need to be backed by a bank or third parties as it is assumed to
have little risk of default if any.
Rates are determined by the creditworthiness of the company.

Bank Overdrafts (ODs)
It is a facility to make payments beyond the amount of money in the bank
account. This helps in providing bridging finance to tide the company through
its working capital cycle. O.Ds are supposed to be paid up on monthly bases.

Foreign Currency Deposits (FCDs)
They are deposits denominated in a currency other than that of the country in
which they are issued, e.g. US$ deposits in Zimbabwe. Interest rate are
determined by the currency, size of deposits, etc.

6.4 TYPES OF CAPITAL 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.

6.4.1 Equity-related Instruments
Ordinary shares
Ordinary shares, also known 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 (BOD).
From the investors side it represents ownership claim on the earnings on
assets of the company.
A unique feature of equity/common stock besides ownership claim (voting
rights) is that the shareholder has limited liability, i.e. should the company
become bankrupt, the investor will only lose what he has originally invested in
the company, and not private property. However 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 BOD thinks it appropriate.
Due to this, equity is much riskier that all types of fixed income securities.
However, as residual claimants, in good times they tend to benefit.

Definition of Terms
The following terms are used in conjunction with ordinary shares:
Nominal/Face Value: The value written on the share certificate that all
shareholders will be given by the company in which they own
shares.
Market Value: The amount at which a share is being sold in the stock market.
It may be radically different from the nominal value.
Par Value: Shares sold at their par value are sold by the issuing company in
the primary market at the value equal to their nominal value.
Premium 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
market, e.g. if a company has 10 million shares and the current market price
is $500 each, then the value of the company (i.e. its market capitalisation) is
$5 billion. If share plummets to $200 the company would only be worth $2
billion. In such cases the company becomes possible target for takeover.

Preference shares
Preference shares are of a hybrid nature, with characteristics of both
fixed/debt and equity nature.
Typically preference shares promise a fixed dividend hence they are likened
to debt. Unlike 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 likened to equity. Because
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 major differences between ordinary and preference shares are that:
1. Preference shares offer their owners preferences over ordinary shares
(i.e. they are paid dividends before ordinary shareholders);
2. Preference shareholders are often entitled to a fixed dividend even
when ordinary shareholders are not;
3. Preference 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.

Preference shares are available in different forms to suit a particular
requirement and the needs of investors. These are:
Participating Preference Shares: 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 Preference Shares: 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.

Convertible Preference Shares: 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.

6.4.2 Debt-related Instruments
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.

Treasury bonds and notes
These long-term government bonds have a maturity of between 10 to 20
years, and are issued governments 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 risk.

Treasury notes are medium term treasury bonds with maturity of between 1 to
10 years.
Both instruments pay interest twice a year with principal paid at maturity.
Treasury bonds can also be called before maturity. Normally the government
exercises this option if conditions are favourable to it (i.e. if the call price is
less than the market price). Due to this embedded risk in callable treasury
bonds they pay a higher return as inducement to investors to buy them.

Corporate bonds/debentures
These are issued by business entities. They have similar payment a pattern to
treasury bonds, only that they have an element of risk should the company go
under. Debentures are usually issued for a fixed interest rate and secured
over certain assets.
If the debenture is secured then, just like 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.

Corporate bonds can be in the form of:
Secured bonds/debenture: Have specific collateral security backing
them in the event of the issuer defaulting.
Unsecured bonds/debenture: They do not have specific collateral
and are therefore riskier than secured ones.
Subordinated bonds/debenture: They have no specific collateral and
also have a lower priority claim on assets in the event of default.
Unsubordinated bonds/debenture: Have no specific collateral but
have priority over subordinated debentures in case of default.

NB: Debentures can also be callable (if interest rate is low). Debenture
holders have the right to receive their interest payments before any dividend
is payable to shareholders, and even if the company makes a loss; it still has
to pay interest charges. Debenture usually have restrictive covenant clauses
that restrict the way management runs the business so as to protect investors.

Mortgage bonds
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. A 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: Rental covers virtually all costs of the asset.
Operating 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 risk.

Hire purchase
It is a method of acquiring assets without having to invest full amount in
buying them. A 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.

6.5 Other Sources of Finance
Grants: Can be issued by the government, local government or donor
community for specific projects in a specific area.

Venture 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.

Factoring: 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 make 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 80 to 85% of an invoice value within 24
hours.
The major advantage is that you receive most of the cash from debtors
within 24 hours rather than a week, or even longer.
The other advantages of factoring are:
Maximisation of cash flow;
It reduces the time and money spent in debt collection since the
factor will run the sales ledger for you;
It is a more efficient way of doing business especially with
overseas clients; and
The factors credit control system can be used to assess the
credit worthiness of a new client.

The disadvantages are:
Since the factor takes control of the sales ledger, some clients
might not be willing to deal with the facto but the actual
company;

Factoring may impose constrains on the way to do your
business.
Ending 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.
Personal savings: 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.
Working capital: Working 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.
Where:
Current Assets = Short-term sources of finance, e.g. stocks,
debtors and cash and cash equivalents.
Current Liabilities = 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 Assets: This involves selling of surplus fixed or movable
assets.
Retained profit: Since this profit is not distributed it is then at the
companys own disposal to do as it sees fit. They can be retained for
suspected future rainy days.

VALUATION OF LONG TERM SECURITIES
7.1 VALUE DEFINED
7.1.1 Liquidation value Vs Going-Concern value
Liquidation 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.
Going-Concern value is the amount a firm could be sold for as a continuing
operating business.

7.1.2 Book value Vs market value
Book value, for an asset, it is the accounting value of an asset, i.e. the assets
cost less its accumulated depreciation.
For a firm it is the total assets less liabilities and preferred stock as listed in
the balance sheet.
Market value is the market price at which the asset (or a similar asset) trades
in an open market place. Market value is usually higher than the liquidation or
going concern value.

7.1.3 Intrinsic value
This is the price a security ought to have if all valuation factors are taken 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 risk involved was used.

7.2 BOND VALUATION
A 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 known as the face value, whilst
coupon rate is the stated interest on bond paid annually until bond maturity.
Bond 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 risk associated with the bond.

7.2.1 Perpetual Bonds
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
=

Where: V = Present value
I = Annual payments
k = Required rate of return

7.2.2 Bonds with a finite maturity
i. Coupon paying bonds
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 =
= +
+ +

Where: MV = Maturity value
t = Period
n = Number of years to maturity

Example
A bond has a par value of $1,000 with 10% coupon paid over nine years. The
required rate of return is 12%. 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 = + + + +
= +
= +
=

Assuming the required rate of return was 8% the value becomes $1,124.70.
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 12%, investors would be willing to buy the bond only if it is sold at a
discount from par value.
Thus: If k > coupon rate the bond will sell at a discount.
If k < coupon rate the bond will sell at a premium.
If k = coupon rate the bond will sell at par value.

i. Zero-coupon bonds
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
=
+

Example
Assuming the bond with a face value of $1,000, with a 10-year maturity and
required rate of return of 12%, calculate its value.

( )
10
1000
$322.00
1.12
V = =

ii. Semi-annual Compounding
Use the formula taking 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 =
= +
+ +

7.3 PREFERRED STOCK VALUATION
It pays a fixed dividend at regular intervals, but at the discretion of the board
of directors. It has preference over common stock in the payment of dividends
and claims on assets. It has no stated maturity date. All preferred stocks have
a call feature. The present value formula is:

D
V
k
=
Where: D = Stated annual dividend per share, and
k = Discount rate.
NB: If the call feature is incorporated the formula becomes the same as that
of coupon paying bonds.

7.4 COMMON STOCK VALUATION
The value of a share of common stock 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
=
= + + +
+ + +
| |
| =
|
+
\ .

Where: D = Cash dividend at the end of time t, and
k = Discount rate.

For finite common stock 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
= + + + +
+ + + +

Where: Pn = the expected sales price at the end of period n.
In this case the foundation for the valuation of common stock are dividends.
For those common stocks that do not pay dividends the valuation by investor
will be based on expected future selling price.

7.4.1 Dividend Discount Models
These models are designed to compute the intrinsic value of common stock.
The valuation is dependent on the assumptions of the expected growth
pattern of stock.

i. Constant Growth Model
Dividends 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
+ + +
= + + +
+
+ +

Where: D0 = Present dividend per share, and
g = Growth rate, which in this case is constant.
Assuming k is greater than g the equation can be summarised as:

( )
1
D
V
k g
=

Where: ( )
1 0
1 D D g = + , which is dividend in period 1.
Constant growth model is usually applicable to companies in their mature
stage.

ii. Earnings Multiplier Model

1
1

V b
Earnings Multiplier
E k g
= =

Where: b = A constant proportion of earnings retained by the company
each year, and
E1 = Expected earnings per share in period 1.

Example
A companys dividend per share at t1 is $4, the dividend is expected to grow
at 6% forever and the discount rate is 14%. Calculate the value of the stock.

4
$50
0.14 0.06
V = =

Assuming the same company has retention rate of 40% and earnings per
share at t1 of $6.67.

( )
( )
1
1 0.4
7.5
0.14 0.06
7.5*6.67 $50
V
times
E
V
= =
= =

iii. Zero Growth Model
Dividends remain constant. The formula becomes:

1
D
V
k
=

iv. Growth Phases Model
Expected dividends can grow at different percentages over the life of the
stock. Usually they start with high growth (even above k) and then it reduces
later on.

Example
Assuming the dividend is expected to grow at 10% for the first five years and
thereafter at 6%. Value 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
= =
=
= +
+ +
(
(
= + (
(
+ + ( (

7.5 YIELD TO MATURITY (YTM) ON BONDS
This is the expected rate of return on a bond if bought at its current market
price and held to maturity. The rate, k, which equates the discounted value of
the expected cash inflows to the securitys current market price, is also
referred to as the securitys (market) yield.
NB: The investors required rate of return is equal to the securitys (market)
yield only where the intrinsic value of the security to the investor is equal to
the securitys market value (price), i.e.:

( ) ( )
0
1 1 1
n
t n
t
I MV
P
k k =
= +
+ +

Given the value of MV, P0, and I one can calculate the value of k using
interpolation.

Example
Assuming a bond with a par value of $1,000; current market value of $761; 12
years to maturity; and 8% coupon rate. Gives a k of 12% (YTM).

7.5.1 Behaviour of Bond Prices
i. When the market 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. Bond discount is the amount by which face
value exceed current price.
ii. When the market 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. Bond premium is the amount by which
bond price exceeds face value.
iii. When the market 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 market required rate
of return the bond price will fall, and the reverse is true.
NB: Interest rate risk (yield risk) is the variation in the market price of a
security caused by changes in interest rates. An investor incurs interest
rate risk only if the bond is sold before maturity and interest rate has
changed since the time of purchase.
v. For a given change in market 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 risks of a price change to the
investor when changes occur in the overall level of interest rates.
vi. For a given change in market 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.

7.6 YIELD ON PREFERRED STOCK
It is derived from the formula for preferred stock price. Thus:

0
0

D D
P k
k P
= =
Where: D = annual dividend per share of preferred stock, and
k = Market required rate of return or yield on preferred stock.

Example
Assuming the current market price of a companys 10%, $100 par value
preferred stock is $91.25. Calculate the yield.

$10
10.96%
91.25
k = =

7.7 YIELD ON COMMON STOCK
This is the rate of return that sets the discounted value of the expected cash
dividends from a share of common stock equal to the shares current market
price. Applying the constant dividend growth model it implies that:

( )
1 1
0
0

D D
P k g
k g P
= = +

Thus common stock yield comes from expected dividend yield
1
0
D
P
| |
|
\ .
and
capital gains yield ( ) g .

Example
What market yield is implied by a share of common stock currently selling for
$50 whose dividends are expected to grow at a rate of 10% per year and
whose dividend is currently at $2.20.

( )
1
: $2.20 1.1
$2.42
2.42
: 0.1
50
14.84%
First D
Then k
=
=
= +
=

7.8 BOND DURATION AND VOLATILITY
This part, which acts as an appendix to this chapter, looks 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
| | | | | |
= + + +
| | |
\ . \ . \ .

Where: V = Total value of the bond,
n = Period, and
PV(Cn) = Present value of cash flow n.

Volatility, 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
=
+

NB: A bonds volatility is directly related to its duration. It shows the likely
effect of a change in interest rates on the value of a bond.

Example
a. Calculate the duration and volatility of a 6-year, $1,000 par value bond
paying 13.125% coupon rate annually and a YTM of 6.5%.
b. Calculate the duration and volatility of a 6-year, $1,000 par value bond
paying 8% coupon rate annually and YTM of 6.5%.
c. Which bond is riskier?

Answer
a. Bond A
Year Ct PV(Ct) @
6.5%
Proportion of
Total Value
[PV(Ct)/Vt]
Proportion of
Total Value x
Time
1 131.25 123.239 0.093 0.093
2 131.25 115.718 0.088 0.175
3 131.25 108.655 0.082 0.247
4 131.25 102.024 0.077 0.309
5 131.25 95.797 0.073 0.363
6 131.25 775.284 0.587 3.522
V = 1,320.717 1.000 4.709

Thus Duration =4.709 Years

Volatility = 4.709 = 4.42%
1.065

b. Bond B
Year Ct PV(Ct) @
6.5%
Proportion of
Total Value
[PV(Ct)/Vt]
Proportion of
Total Value x
Time
1 80.00 75.117 0.070 0.070
2 80.00 70.533 0.066 0.132
3 80.00 66.228 0.062 0.185
4 80.00 62.186 0.058 0.232
5 80.00 58.390 0.054 0.272
6 80.00 740.161 0.690 4.140
V = 1,072.615 1.000 5.031

Thus Duration = 5.031 Years
Volatility = 5.031 = 4.72%
1.065

c. A 1% change in yield causes the price of a 13.125% bond to change by
4.42%.as shown by its volatility. The volatility of an 8% bond is 4.72%.
Thus the 8% bond with a longer duration is more volatile and hence
more riskier.

Chapter 8 COST OF CAPITAL 26
COST OF CAPITAL
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).
A company is a collection of projects; 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 projects are of
similar risk and characteristics. If they differ then the cost of capital on its own
is not adequate for decision-making.
The advantage of using the companys 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 firms financing. These are cost of equity capital; cost of
debt and cost of preferred stock.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)
This is the weighted average of individually calculated costs of the various
financing components of the firm. The components are common and preferred
stock, along with debt. All these have a common feature, i.e. the investors
who provided the funds expect to receive a return on their investment.

The firms overall cost of capital (WACC) can be expressed as:
Cost of capital = ( )
x x
n
x
W K
1 =

Where: Kx = After-tax cost of the x
th
method of financing.
Wx = Weight given that method of financing as a percentage
of the firms total financing.
Example
Proportion of
Total Financing
Cost Weighted Cost
Debt 30% 6.6% 1.98%
Preferred Stock 10% 10.2% 1.02%
Common Stock 60% 14.0% 8.40%
Total 100% WACC = 11.40%
The three securities have different required rates of return due to differences
in risk. 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 30% of required capital from
debt, 10% from preferred stock and 60% from common stock. This is called
the target capital structure and is determined by among others, market
conditions and flotation costs.
Market conditions looks at how strong the market is for it to, for example,
issue common stock. 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 Net Present Value (NPV). Due to
these factors the target capital structure tend to fluctuate from time to time.

CALCULATION OF COMPONENT COSTS
1. Cost of Debt (Ki)
The cost of debt is the required rate of return on investment of the lenders of a
firm. Debt include fixed and floating rate debt, straight and convertible debt, or
debt with or without sinking funds. The type of debt used depends on the
assets to be financed and the market conditions.

The explicit cost of debt can be derived by solving for the discount rate (Kd)
that equates the market price of the debt issue with the present value of
interest plus principal payments. The discount rate (Kd) known as the yield to
maturity (YTM) is solved for using the following formula:

( )
(
+
+
=

=
t
d
t t
n
t
K
P I
P
1
1
0

Where: P0 = Current market price of the debt security;
It = Interest payment in period t;
Pt = Principal paid in period t.
By solving for Kd we obtain the required rate of return debt holders require.
This Kd is the issuing companys before-tax cost of debt.
Since the after tax cost of debt is the one that is required, the following
formula is used:
( ) T K K
d i
= 1
Where: Ki = After-tax cost of debt;
T = Companys 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.

Example
Suppose the company borrow at an interest rate of 11%, and if it has a
marginal government tax rate of 40%, then its after-tax cost of debt is
calculated as:
( ) T K K
d i
= 1 = 11%(1 0.4)
= 11%(0.6)
= 6.6%
this calculation assumes that the firm has taxable income. Without the taxable
income Ki = Kd.

2. Cost of Preferred Stock (Kp)
Preferred dividends are not tax deductible, hence the company bears their full
cost. Preferred stocks, generally, have no maturity date. They hold
precedence over common stock in term of dividend payment and asset
distribution if the company is dissolved. With preferred stock, 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 stock;
- They will find it difficult to raise additional funds in the capital market;
- Preferred stock holders can take control of the firm.

Kp is calculated using the following formula:

0
P
D
K
P
P
=
Where: Dp = Annual preferred stock dividend; and
P0 = Net issuing price or current market price of the preferred stock.

Example
If the company where to sell 10% preferred stock issue ($100 par value). The
company has incurred flotation cost of 2.5% per share. Calculate Kp.

% 3 . 10
5 . 97 $
10 $
= =
P
K
NB: This cost is not adjusted for taxes because the preferred stock dividend
used is already an after-tax figure. Thus explicit cost of preferred stock is
greater than that of debt.

3. Cost of Common Stock (Equity)- Ke
Cost of equity is by far the most difficult cost to measure. Equity capital can be
raised in two ways:
I. Internally by retaining earnings; or
II. Externally by issuing of shares.

If the firm used either method it should earn more than
e
K to provide this rate
of return to investors.
Where as debt and preferred stock are contractual obligations, which have
easily determined costs, it is more difficult to estimate
e
K . The three principles
employed to find
e
K are:
i. The Capital Asset Pricing Model (CAPM);
ii. The Bond-Yield-Plus-Risk-Premium Approach; and
iii. The Discount cash Flow (DCF) method.
NB: These methods are not mutually exclusive.

1
st
Approach: The CAPM Approach
As already covered.
To estimate the cost of equity using CAPM the following steps are followed:
Step 1: Estimate the risk-free rate (Rf) generally taken to be the yield of a long
or intermediate-term government bond.
Step 2: Estimate the stocks beta coefficient ( )
i
| , and use it as an index of
stocks risk.
Step 3: Estimate the current expected rate of return of the market, or on an
average stock ( )
m
R . Rm estimates can be from stock exchange
analysis, or consensus estimates of security analysts, economists
and others who regularly predict such returns.
Step 4: Substitute the preceding values into the CAPM equation to estimate
the required rate of return on the stock in equation:

( )
e f i m f
K R R R | = +
NB: The ; and
i f m
B R R values used should be the best possible estimates of
the future.

Example
Assume: Rf = 8%; Rm = 14% and i = 1.1.
0.08 (0.14 0.08)
e
K = +
= 14.6%
Thus 14.6% is the rate of return investors expect the company to earn on its
equity.

Weaknesses
i. If the firms stockholders are not well diversified, they may be concerned
with stand-alone risk in addition to market risk. Thus in such a case the
firms risk should be measured by
i
| alone as the CAPM procedure
would underestimate the cost of equity ( )
e
K value.
ii. Even if the CAPM method is valid it is hard to obtain correct estimates of
the inputs required since:
A) There is controversy as to whether one should use long-term or
short-term treasury yields (CAPM is a one period model);
B) It is hard to estimate the beta that investors expect the company
to have in the future; and
C) It is difficult to estimate the market risk premium.

2
nd
Approach: Bond-Yield-Plus Risk-Premium/Before-Tax-Cost-of-Debt-
Plus-Risk-Premium Approach
This method comes as an alternative to analysts who do not like the
sophisticated approaches of CAPM and DCF. This approach is relatively
simple, fast and dirty (subjective and ad-hock). This approach can best be
illustrated using the following diagram of the security market line (SML) with
debt and equity:

Expected Security Market Line (SML)
Rate of
Return

Rf

d
|
e
|
Systematic Risk (Beta)
As illustrated, in addition to the risk premium on debt, the common stock of a
company must provide a higher expected return than the debt of the same
company. The reason being that there is more systematic risk involved.
The historic risk premium in expected returns of stocks over bonds has been
around 3% to 5% points. The greater the risk of the firm, as shown by the
slope of the SML, the greater the premium.
Using this approach the companys approximate cost of equity ( )
e
K would be:

Before-tax Cost of Debt + Risk Premium in Expected Return for Stock Over Debt
e
K =
(Bond Yield)
E.g. The Companys bonds yield 10% in the market.
10% 4% 14%
e
K = + =
Thus the companys before-tax cost of debt will form the basis for estimating
the firms cost of equity.
Weaknesses
i. Since the premium over debt is simply added, the method does not
give a precise cost of equity;
ii. It does not allow for changing risk premiums over time.

It however offers an alternative method of estimating the cost of equity (
e
K )
that falls within the overall framework of the CAPM.

3
rd
Approach: Dividend Discount Model/Dividend yield Plus Growth
Rate/Discounted Cash Flow (DCF) Approach
As outlined earlier the price of the expected rate of return on a share of
common stock depends, ultimately, on the dividends expected on the stock.
Thus the cost of equity (
e
K ) 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 market price per share.
Thus:

( )
( ) ( )
( )
1 1
0 2
1
.....
1
1 1

1
e
e e
t
t
t
e
D D D
P
K
K K
D
K
=
= + + +
+
+ +
=
+

Where:
0
P = Current price of the stock;

t
D = Dividend expected to be paid at the end of year t; and

e
K = Required rate of return.

Constant Growth
If dividends are expected to grow at a constant rate then the constant growth
model can be used, i.e.:

1
0
1
0
:
e
e
D
P
K g
D
Thus K 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
K and in equilibrium this expected return is also
equal to the required return.

Example
Dividends are expected to grow at 8% per annum into the foreseeable future.
The dividend in the 1
st
year is expected to be $2 and the present market price
is $27. Calculate the cost of equity.

$2
8% 15.4%
$27
e
K = + =
Whilst it is easy to determine the dividend yield, it is difficult to establish the
proper growth rate.

Estimating Growth Rate (g)
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 project into the future. However, 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 make growth projections using things like projected
sales, profit margins, and competitive factors. Getting an average g from
growth figures got from different analysts usually help in coming up with a
more accurate g.
Thus:

1
0
Growth rate as projected by analysts
e
D
K
P
= +
Another method is the retention growth rate method. Using this method first
forecast the firms average future dividend payout ratio and its complement,
the retention rate, then multiply the retention rate by the companys expected
future rate of return on equity (ROE), i.e.:

( )( )
( )( )
Re
1
g tention Rate ROE
Payout Rate ROE
=
=

Growth Phases
If the growth rate changes from time to time then constant growth rate will not
apply in calculating cost of equity( )
e
K using the Discounted Cash Flow (DCF)
approach.

Example
If dividends were expected to grow at a 20% for 5years, at 15% for the next
5years, and then grow at 10% 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
K t
K K

= = =
= + +
+
+ +

By solving for
e
K the cost of equity is obtained. The last phase i.e.
( )
( )
10
10
11
1.10
1
t
t
t
e
D
K
= +
turns into a constant growth model.

Compilation
According to the calculations of
e
K using CAPM, Risk Premium and DCF
methods the following were the results:
CAPM 14.6%
Risk Premium 14.0%
DCF 15.4%
Total 44.0%
Getting the average
44%
14.7%
3
e
K = =

COMPOSIT/WEIGHTED AVERAGE COST OF CAPITAL (WACC)
Once the cost of the individual components of the firms financing are
computed, weights are then assigned to each financing source according to
some standard, and then calculate WACC. The standard used is the firms
optimal capital structure, known as the mix of debt, preferred and common
equity that causes its stock price to be maximised.

Thus:

( )
1
1

d d p p e e
n
x x
x
WACC W K T W K W K
W K
=
= + +
=

NB: i. WACC is the weighted average cost of each new, or marginal, dollar of
capital it is not the average cost of funds raised in the past. On
average each of the new dollar will consist partly of debt, preferred
stock, and common stock.
ii. Weights can be based either on:
a) Accounting values as shown in the balance sheet (i.e. Book values)
b) Current market values of the components, or
c) Managements target capital structure. The current weights are
those based on the firms target capital structure, since this is the
best estimate of how the firm will, on average, raise money in the
future.

Factors That Affect WACC
Factors can either be economic factors beyond the companys control, or can
be the companys financing and investment policies.

A) Economic Factors
a. Level of Interest Rates
If interest rate increases the cost of debt increases. Also the higher the
interest rates the higher the cost of common and preferred equity capital.

b. Tax Rates
Tax rates are used in calculating the cost of debt; hence it affects the cost of
debt. Lowering the capital gains tax relative to the rate on ordinary income
would make stocks more attractive which reduces the cost of equity relative to
that of debt.

B) Financing and Investment Policies
These include:
a) Capital Structure Policy;
b) Dividend Policy; and
c) Investment (Capital Budgeting) Policy.

a) Capital Structure Policy
It is assumed that firm has a given target capital structure, and WACC is
calculated based on those weights. A 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 WACC. However, such a change will
increase the firms riskness of both debt and the equity. Increases in
component costs will tend to offset the effects of the change in weights.
Generally the firms optimal capital structure is the one that minimises the cost
of capital.

b) Dividend Policy
The percentage of earnings paid out in dividends may affect a stocks
required rate of return ( )
e
K . Also, if a firms payout ratio is so high that it must
issue new stock to fund its capital budget, it will be forced to incur floatation
costs, which will affect the cost of capital.

c) Investment Policy
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 stock and bonds. However, it
will be incorrect if the firm dramatically changed its investment policy. This will
drastically change the firms marginal cost of capital, so as to reflect the
riskness of the new line of business.

Rationale For a Weighted Average
1. The rationale is that by financing in the proportions specified and
accepting projects yielding more than the weighted average required
return, the firm is able to increase the market price of its stock. This
increase occurs because investment projects are expected to return
more on their equity-financed portion than the required return on
equity( )
e
K . Once these expectations are apparent to the market place,
the market price of firms stock should increase because expected future
earnings per share and dividends per share are higher than those
expected before the projects were accepted.
2. Another rational is that the use of WACC is based on the assumption
that investment proposals being considered do not differ in systematic
risk from that of the firm and that the unsystematic risk 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
projects of the firm are completely alike with respect to risk and that only
project only projects of the same risk will be considered.
3. For a multi-product firm with investment proposals of varying risk, the
use of an overall required rate of return is inappropriate. A required rate
of return based on the risk characteristics of the specific proposal should
be used. Thus the key to using the overall cost of capital as a projects
required rate of return is the similarity of the project with respect to risk of
existing projects and investment proposals under consideration.

Adjusting the Cost of Capital for Risk
Investors require higher returns for riskier investments. On the other hand a
company that is raising capital to take on risky projects will have a higher cost
of capital than a company that is financing safer projects. This can be
illustrated using the following diagram..

Fig. 7.2: Trade Off Between Risk and The Cost of Capital
Rate of Accept
Return WACC
12.0
10.5 A Reject
10.0
9.5 D
7.0

KF

RiskB RiskA RiskC Risk
Firm B is a low risk firm hence its hurdle rate is 7%. Thus it will accept any
project with the expected return above 7%. Firm C, on the other hand, is quite
risk and hence its hurdle rate is 12%.
Assuming both firms, B and C, are considering investment in project A with a
composite WACC of 10.5%. At first it would appear as if B should accept the
project since its 10.5% rate of return is above its 7%, and C should reject the
project. This will be wrong since 10.5% is the hurdle rate for a typical project
in the firm, which is in line with the risk associated with the project. Both firms
should accept the project since 10.5% is above the projects hurdle rate of
10%.
Using the same reasoning project D should be rejected by both firms. If firm B
accepts the project basing on the fact that 9.5% is above 7% then this will
lead to a fall in the overall shareholders wealth, because the projects return
is not high enough to justify its risk.
Thus, applying a specific hurdle rate to each project ensures that every
project will be evaluated properly.

Using the same criterion of accept of reject stated above, one can apply it to a
company with different divisions or subsidiaries. Assuming company Y with
two subsidiaries, one a clothing shop and another a grocery shop. Assuming
the clothing shop is low risk and has 10% cost of capital and grocery shop is
highly risky with 14% cost of capital. If these shops have equal weights then
the overall companys cost of capital will be 12%.

Example
Assume in 2006 the clothing manager has a project with an 11% expected
return whilst the grocery manager has a project with a 13% expected return.
Which project should be accepted or rejected?
The clothing managers project should be accepted and the grocery
managers project should be rejected basing on each subsidiarys specific
hurdle rate. However, had one considered the overall company Ys hurdle rate
of 12% then the grocery managers project should have been accepted yet it
infact decreases the shareholders wealth.

Estimating Project Risk
Riskier projects have a higher cost of capital. However, how can project risk
be estimated? There are three types of risk that can be identified.

i. Stand-Alone Risk
It is projects risk disregarding the fact that it is but one asset within the firms
portfolio of assets and that the firm is but one stock in a typical investors
portfolio of stocks. It is measured by the variability of the projects expected
reruns.

ii. Comparative, or Within-Firm, Risk
It is the projects risk to the corporation, giving consideration to the fact that
the project represents only one of the firms portfolio of assets, hence that
some of its risk will be diversified away. It is measured by the projects impact
on uncertainty about the firms future earnings.

iii. Market, or Beta, Risk
It is the riskness of the project as seen by a well diversified stockholder who
recognises that the project is only one of the firms assets and that the firms
stock is but one part of the investors total portfolio. It is measured by the
projects effect on the firms beta coefficient.
A project with a high degree of stand-alone or corporate risk will not necessarily
affect the firms beta. However, projects with high uncertain returns that are
highly correlated with returns on the firms other assets and with most other
assets in the economy will have a high degree of all types of risk.

Market risk is theoretically the most relevant risk because of its direct effect on
stock prices. Unfortunately, it is also the most difficult to measure. Most
decision makers consider all three risk measures they classify projects into low,
average, or high risk projects. Risk-adjusted costs of capital are developed for
each category using composite WACC.
Risk-adjusted cost of capital is the required return (discount rate) that is
increased relative to the firms overall cost of capital for projects or group
showing greater than average risk and decreased for projects or groups
showing less than average risk.
While this approach is better than not risk adjusting at all, these risk
adjustments are subjective and somewhat arbitrary.

Using CAPM in Projects Risk Adjusted Cost of Capital Estimation
Many firms use the CAPM to estimate the cost of capital foe specific projects or
divisions. CAPM is based on the assumption that projects will be finances
entirely by equity, that the firm considering projects is entirely equity financed,
and that all beta information pertains to all-equity situations.

The required return for an equity-financed project, therefore would be:

( )
e f e m f
R R R R | = +
Where
e
| = the slope of the characteristic line that describes the relationship
between excess returns for project e and those of the market portfolio.

Example
Assuming
e
| = 1.1; 8% 12%
f m
R and R = =
8% 4%*1.1 12.4%
e
R = + =
If the firm intends to finance a project entirely with equity the acceptance
criterion would then be invest in a project if the expected rate of return met or
exceed the required rate of return ( )
e
R , which in this case is 12.4%.
If the company uses only equity capital its cost of capital is also its corporate
cost of capital or WACC.

Example
The firm currently has 12.4%; 8%; 12% 1.1
e f m e
K R R and | = = = = . It intends to
take on a particular project 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 Project New Project
Weight 0.8 0.2
Beta 1.1 1.5
Calculate:
i. Portfolio beta
ii. Overall corporate cost of capital
iii. The cost of capital the new project should earn for the corporate to earn
the cost of capital calculated in ii above. Fist use weights and then use
beta coefficient.
Solution
i. 0.8(1.1) + 0.2(1.5) = 1.18
ii. Kp = 8% + 4%*1.18 = 12.72%
iii. Using weights: 0.8*12.4% + 0.2*X = 12.72%
X = 14%
Using beta: 8% 4%*1.5 14%
N
K = + =

How to Measure Beta Risk
Two approaches have been used to estimate individual assets beta. These are
the pure play method and the accounting beta method.

i. The Pure Play Method
In this case the company tries to find several single-product companies in the
same line of business as the project being evaluated, and it then averages
these companies betas to determine the cost of capital for its own project. The
risks of the companies should be the same as those of the project to be
undertaken.
This method can only be used for major assets such as whole division and if
pure play proxies can be found.

ii. The Accounting Beta Method
Betas are normally calculated by regressing the returns of a particular
companys stock against returns on a stock market index, i.e.:

Excess Return on Stock Characteristic Line

Beta = Slope (Rise over Run)

Excess Return on
Market Portfolio

However, 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 Poors 500 (S&P500)
or ZSE. Betas determined in this way (i.e. by use of accounting data rather
than stock market data) are called accounting betas.
Accounting betas for a totally new project can be calculated only after the
project has been accepted, placed into operation, and begun to generate
output and accounting results. Thus it is not good for capital budgeting
decision.
However, if management thinks that the accounting beta of a particular project
can be used as a proxy for a project in question then it can be used.
Accounting betas are used for large projects or divisions, and divisional betas
are then used for division projects.

COST OF DEPRECIATION (INTERNALLY GENERATED FUNDS)
Depreciation is the largest source of funds in many firms, and these
depreciation-generated funds are available to support the capital budget.

Handling Depreciation
A good approximation to the firms internally generated cash flow is found as:

Internal Cash Flow = Net Income Cash Dividends + Depreciation
= Retained Earnings + Depreciation
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.

Developing Depreciation Cost
If funds generated from depreciation are to be reinvested what then will be
their cost? The following is a process used to develop the cost of depreciation
funds:
i. Depreciation 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 stockholders (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 riskness 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
stockholders, preferred stockholders, and bondholders.
v. Thus the cost of depreciation funds, if distributed, should reflect the
opportunity costs of all three groups of investors (i.e. Ke; Kp and Kd)
vi. The average opportunity cost should be based on the same capital
structure weights that would have been used in WACC calculation.
Thus if the company:
1. Obtains its new common equity as retained earnings rather than by issuing
of new common stock;
2. Does not change its target capital structure; and
3. Invests in assets that have about the same risk as its existing assets,
Then the WACC can be used for capital budgeting purposes.

DRAWBACKS IN COST OF CAPITAL
A number of issues have been taken 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:

1. Privately Owned Firms
The decision on cost of capital assumed publicly owned companies. However,
the cost of capital for privately owned companies is not covered. Tax issues
become important in such a case. Although the same principles of obtaining
WACC apply but obtaining input data differs.

2. Measurement Problems
Difficulties are encountered in estimating the cost of equity. It is difficult to
obtain good input data for CAPM, for growth (g) in
1
0
e
D
K g
P
= + , and for risk
premium in Ke = Bond Yield + Risk Premium.

3. Cost of Capital for Projects with Different Risk
It is difficult to measure risk of a project, thus making it difficult to assign risk-
adjusted discount rate to capital budgeting projects of different degrees of
risk.

4. Capital Structure Weights
Weights are not simply given, hence stabilising the target capital structure is a
major task in itself.

5. Small Businesses
Small businesses are generally privately owned making it difficult to estimate
the cost of equity. Again the three equity cost-estimating approaches
discussed have serious limitations when applied to small firms.
For example:
- Growth (g) in constant growth model is difficult to measure since the firm
might not pay dividends in the foreseeable future;
- In the second method of adding the risk premium, this might be difficult if
the firm does not have publicly traded bond outstanding;
- The third approach of CAPM is difficult to use because, if the firms stock
is not publicly traded, then one cannot calculate beta. For privately owned
small firms the pure play CAPM can be used.
- Small firms 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 NOTABLE THINGS
When estimating the cost of capital always:
1. Use 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.
2. When using CAPM never use the historical return on stocks with the
current risk-free rate. Use the estimate of the current expected rate of
return on common stocks and the current expected yield on Treasury
Bonds.
3. Use the target capital structure to determine the weight for the WACC
and not basing on the book values.
4. Remember 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
relations with suppliers and employees, they have to be deducted
when determining the investment required for the project.

Chapter 10 DIVIDEND POLICY 46
DIVIDEND POLICY
Dividend 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 firms 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
framework, liquidity, control issues, stability of dividend, stock dividend and
stock splits, stock repurchase and administration considerations.

NB: Dividend-payout ratio = Annual Cash Dividends
Annual Earnings
OR
= Dividend per Share
Earnings per Share
The ratio indicates the percentage of a companys earnings that is paid out to
shareholders in cash.

9.1 PASSIVE Vs ACTIVE DIVIDEND POLICIES
9.1.1 Dividend as a Passive Residual
In this case one asks, Assuming the business risk is held constant, can the
payment of cash dividends affect shareholders wealth and if so, what
dividend-payout ratio will maximise shareholder wealth?
To answer this question one needs to examine the firms dividend policy as
solely a financing decision involving the retention of earnings. If such a stands
is taken then the payment of dividends is a passive residual.
Some firms pay low or no dividends because management is optimistic about
the firms future and wishes to retain earnings for expansion. In this case the
dividend is a by-product of the firms capital budgeting decision. If the future
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 zero dividend and a 100% dividend payout the
dividend-payout ratio will be a fraction between zero 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.
How then do we separate the impact of the dividend increase from the impact
of investors disappointment at the lost growth opportunities?

9.1.2 Dividend Irrelevance
The argument for irrelevance of dividends on firm value was developed by
Miller and Modiglani (M&M) in 1961 based on a perfect capital markets with
no transaction/floatation costs, taxes or other market imperfections. Moreover,
the future profits of the firm are, assumed to be, known with certainty.

M&M argues as follows:
Suppose the firm has settled on its investment program and has worked 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 stockholders 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 market value
are all unchanged. The answer is, there must be a transfer of value from the
old to the new stockholders. New stockholders 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
just offsets the extra cash dividend they receive.

Thus M&M suggest that the sum of the discounted value per share of
common stock after financing plus current dividends paid is exactly equal to
the market value per share of the common stock before the payment of the
current dividend. In other words, the common stocks decline in market 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 stockholders then
receiving extra dividend payment plus an offsetting capital loss will make a
difference to them. However, in a perfect capital market, they can make
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.
Because 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:
Dividend Financed By No Dividend No
Stock Issue (Dilution) Stock Issue
(Homemade Div.)
Shares

Cash
Cash Shares
Cash

Firm
New Stockholders
Old Stockholders
New Stockholders
Old Stockholders
Even under dilution the total value of the firm remains unchanged, what
changes is simply the value of each share (gets smaller).

9.2 ARGUMENTS FOR DIVIDEND RELEVANCE
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
risky. Whilst management can stabilise dividends they cannot control
stock price.
Payment of dividends may resolve uncertainty in the shareholders
minds concerning company profitability. Dividends 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 stock than for a non-
dividend paying stock.
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. Available cash should be retained or used to repurchase shares.
By doing this corporations can transmute dividends into capital gains.
In addition to capital gains tax is deferred until the actual sale of stock
(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 stock will need to provide a higher expected before-tax
return than a non-dividend-paying stock of the same risk. Thus, the
greater the dividend yield (i.e. anticipated annual dividend divided by
the market price of the stock) on a stock, the higher the required
before-tax return, and all other things held constant.

The third argument is on floatation costs. The M&Ms conclusions
follow their assumption of perfect and efficient capital markets, 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 make it more expensive for old
shareholders to sell stock to new shareholders, as they need to pay
brokerage fees. Thus shareholders would prefer that the company pay
more dividends than sell stock to compensate for corporate dividends.
Securities are no infinitely divisible as assumed under perfect as
assumed under perfect capital market. The smallest equity security unit
is one share making it a deterrent to the sale of stock 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 stock they can buy or
in the portfolio percentages they can hold in various types of common
stock. 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 firms future performance. If a firm increases its
dividend-payout ratio then it is a sign that management and board of
directors (BOD) truly believe that things are better that stock price
reflects.
Put 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.
M&M on the other hand arguer that the jump in stock price that
accompanies an unexpected dividend increase would have happened
anyway as information about future earnings came out through other
channels.

9.3 EMPIRICAL EVIDENCE ON DIVIDENDS AND TAXES
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.
With tax effect, if dividends are taxed more heavily than are capital gains,
stock prices and before-tax returns should reflect this differential taxation.
Different researchers have come up with different conclusions on whether
high dividend stocks provide higher expected before-tax returns than low-
dividend stocks to offset the tax effect. Some evidence suggests a negative
(anti-dividend-paying) effect, but others are consistent with neutrality.
All in all a company should endeavour to establish a dividend policy that will
maximise shareholder wealth. Its 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.

9.4 FACTORS INFLUENCING DIVIDEND POLICY
9.4.1 Legal Rules
State laws vary from one state to another. Most states prohibit the payment of
dividends if these dividends impair capital (legal capital).
NB: 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 book 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. Most states prohibit a company from paying dividends if doing so
would make 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 firms 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.

Another 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 sake of avoiding tax.

9.4.2 Funding Needs of the Firm.
The likely 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. Basing on this analysis, a company can determine its likely residual
future funds.

9.4.3 Liquidity
The greater the cash position and overall liquidity of the company, the grater
is its ability to pay a dividend.

9.4.5 Ability to Borrow
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.

9.4.6 Restrictions in Debt Contracts
These are restrictions employed by the lender to preserve the companys
ability to service debt. Usually it is expresse4d as a maximum percentage of
cumulative earnings retained (reinvested) in the firm.

9.4.7 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 stakeholders. Should old shareholders fail to take-up new stock
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
takeover.

9.5 DIVIDEND STABILITY
Dividend stability is one feature that attracts investors. Stability means
maintaining the position of the firms dividend payments in relation to a trend
line, normally one that is upward sloping.
Ceteris-paribus, a share of stock 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:

Company A
Amount
Per 4
Share

3 Earnings per
Share

2
Dividends per
Share
1

Time

Company B
Amount
Per 4
Share

3 Earnings per
Share

2 Dividends per
Share

1

Time

Company As dividend policy is a strict adherence to a constant 50% dividend
payout ratio. Company Bs dividend policy is a long run 50% 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. However the market price of company B may be well above that of
company A. This is due to the fact that investors value dividend stability and
hence will place their trust in company B, and will be prepared to pay a
premium for the share due to the stability of its dividend. On the other hand,
investors prefer a stable dividend as compared to the one that fluctuates.

9.6 HOW COMPANIES DECIDE ON DIVIDEND PAYMENT
John Linter, in mid 1950s, conducted a survey on how companies determine
their dividend payments. He came up with the following facts:
1. Firms have long-run target dividend payment ratios. Mature companies
generally pay a higher proportion of earnings, with young companies
paying low payouts.
2. Managers focus more on dividend change that on absolute levels.
3. Dividend changes follow shifts in long-run sustainable earnings. Thus
managers smooth dividends.
4. Managers are reluctant to make dividend changes that might have to
be reversed.

He then developed the following model:
Assuming a firm always stuck to its target payout ratio, then the dividend
payment in the coming year (D1) would be equal a constant proportion of
earnings per share (EPS1), where:

D1 = Target dividend = Target payout ratio x EPS1.
Dividend change is:

D1 D0 = Target change = Target payout ratio x EPS1 D0.

If a firm sticks to its payout ratio then dividend should change each year,
however, managers are reluctant to do this hence they pay a constant
dividend.
Thus:
D1 D0 = Adjustment rate x Target change
= Adjustment rate x (Target ratio x EPS1 D0).

The more conservative the company, the more reluctant it is to move towards
its target and, therefore, the lower would be its adjustment rate.

9.7 FORMS OF DIVIDENDS
iii. Regular Cash Dividend It is the dividend that is expected to be paid
by the firm under normal circumstances. Paid quarterly, semi-annually,
or annually.
iv. Extra Dividend It is non-recurring dividend paid to shareholders in
addition to the regular dividend.
v. Special Dividend It is usually reserved specifically for payments that
are unlikely to be repeated. It is brought about by special
circumstances.
vi. Liquidating Dividend It is paid when all retained earnings are used
p and if funds are not needed for the protection of creditors.
vii. Stock Dividend It is when the company gives out extra stock to
investors instead of cash dividend.
viii. Dividend Reinvestment Plan (DRIP) - Some companies offer
automated DRIPs. New shares are issued at, say % discount from the
market price.

9.8 STOCK DIVIDENDS
This involves a payment of additional shares of stock to shareholders. It is
often used in place of or in addition to a cash dividend. It is simply a
bookkeeping shift of retained earnings to equity and additional paid in capital.

Entries can be illustrated as follows, for example in the case of a 5% stock
dividend.

BEFORE AFTER
Current Market Price $40 $40
Par Value $5 $5
Common Stock $2,000,000 $2,100,000
Additional Paid in Capital $1,000,000 $1,700,000
Retained Earnings $7,000,000 $6,200,000
Total Shareholders Equity $10,000,000 $10,000,000
Number of Shares 400,000 420,000

NB: 5% Additional Stock = 0.05 x 400,000 = 20,000 shares
Market Value = $40 x 20,000 = $800,000
Legal/Par Value = $5 x 20,000 =$100,000

Thus $100,000 contributes towards increase in common stock account. The
remaining $700,000 is additional paid in capital. The total of $800,000 comes
from retained earnings.
Total shareholders equity remains the same at $10,000,000.

Overally, shareholders have more shares of stock but lower earnings per
share. However, proportionate claim against total earnings remains constant.
With a large percentage stock dividend the full amount is transferred to
common stock at par (a conservative approach). This is due to the fact that
the increase in shares will affect the market value. Thus the conservative way
will be as shown below.

Conservative Way
Par Value $5
Common Stock $4,000,000
Additional Paid in Capital $1,000,000
Retained Earnings $5,000,000
Total Shareholders Equity $10,000,000
Number of Shares 800,000

9.9 STOCK SPLITS
This involves an increase in the number of shares outstanding by reducing the
par value of the stock, e.g. a 2-for-1 stock split where par value per share is
reduced by half.
NB: A 2-for-1script issue (i.e. 2 new shares in addition to one old) is
equivalent to a 3-for-1 stock split (i.e. replacing each outstanding share with 3
new shares).
A 2-for-1 stock split can be illustrated as follows:

BEFORE AFTER
Par Value $5 $2.50
Common Stock $2,000,000 $2,000,000
Additional Paid in Capital $1,000,000 $1,000,000
Retained Earnings $7,000,000 $7,000,000
Total Shareholders Equity $10,000,000 $10,000,000
Number of Shares 400,000 800,000

Except in accounting treatment, then, the stock dividend and split are very
similar. A stock split, like a large percentage stock dividend, is usually
reserved for occasions where the company wishes to achieve a substantial
reduction in the market price per share of common stock, thereby at times
attracting more buyers. Whilst the dividend per share falls the effective
dividend usually increases, e.g. if the dividend was $2 per share it will be
reduced to $1.20 per share.

9.10 EFFECT OF STOCK DIVIDEND/SPLIT TO INVESTOR
Ownership remains unchanged.
As the number of shares increase their market 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.
Places the stock in a more popular trading range thus attracting more
individual buyers and less institutional investors.
Can be used to convey message about companys future prospects.
9.11 REVERCE STOCK SPLIT
It is a stock split in which the number of shares outstanding is decreased, e.g.
a 1-for-2 reverse split where each shareholder receives one new share in
exchange for two old shares held. It has the opposite effect to the stock split.

Reverse stock splits are employed to increase the market price per share
when the stock 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. On the other hand, it might be driven by the need to move
the stock price into a higher trading range where total trading costs and
servicing expenses are low.

9.12 STOCK REPURCHASE
It is the purchase (buyback) of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer. Some of the reasons companies
buyback stock are to have it available for management stock option plans, to
have it available for the acquisition of other companies, to go private or even
to retire it.

9.12.1 Repurchase Methods
i. Self-tender offer
In this case the company makes an offer to purchase a certain number of
shares, typically at a set price. Usually the tender-offer period is between 2-3
weeks. 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 market purchase.

ii. Open-market purchase
In this case the company buys its own stock like any other investor does, i.e.
through a brokerage house. Usually, the brokerage fee is negotiated. This
process usually takes longer for the company to accumulate the required
amount of stock, since most exchange houses restrict the manner in which a
company can bid for its own stock. A self-tender offer is more suitable in this
case.

9.13 REPURCHASING AND DIVIDEND POLICY
Repurchase is a way of distributing excess funds if the firm has no profitable
investment opportunities to justify 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 market and this
should lead to increased market price and dividends per share.

Example
The company is considering distributing $1.5 million either in cash dividend or
through share repurchase. The following are key company figures just prior to
the $1.5 million distribution:
Earnings After Tax $2,000,000
Number of Common Stock Outstanding 500,000
Earnings per Share $4
Current Market Price per Share $63
Expected Dividend $3
Option 1: Cash dividend Investors expect $3 per share cash dividend (i.e.
$1,500,000/500,000). The $63 thus consists of $3 dividend and $60 market
price of stock expected to be earned after the cash dividend distribution.

Option 2: Repurchase The firm makes a self-tender offer to shareholders at
$63 per share. It can repurchase 23,810 shares (i.e. $1,500,000/$63). EPS
changes to $4.25 [i.e. $2,000,000/(500,000-23,810)].

Should the firm decide to pay a cash dividend, its price-earnings ratio after the
dividend would be 15 (i.e. $60/$4). If this ratio stays at 15 after a stock
repurchase, total market price per share will be $63 (i.e. $4.20 x 15). 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 stock offers a tax advantage over the payment of dividend to
the taxable investor. Again capital gains tax is postponed until the stock is
sold, whereas with dividends the tax must be paid on a current basis.

9.14 STOCK REPURCHASE INVESTMENT OR FINANCING DECISION
Stock 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. Again treasury stock (i.e. common stock that has been
repurchased and is held by the issuing company) does not provide an
expected return, as do other investments. No company can exist by investing
only in its own stock.

9.15 STOCK REPURCHASE SIGNALING EFFECT
Stock repurchase tend to have a positive effect in situation where
management feels that the stock 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 market price) would reflect the degree of undervaluation.
Whilst cash dividends provide regular information on the ability of the firm to
generate cash, stock repurchase provides a once off extra bulletin on the
degree to which management feels the stock is undervalued.

9.16 DIVIDEND POLICY ADMINISTRATIVE CONSIDERATIONS
i. Record Date
It is the date, set by the board of directors (BOD) when a dividend is decided,
on which an investor must be a shareholder of record to be entitled to the
upcoming dividend. At the close of business on that date the company draws
up a list of shareholders from its stock transfer books.
For example a BOD of Old Mutual meets on May 8, it decides a dividend of $1
per share payable June 15 to shareholders of record on May 31. Thus the
person who holds Old Mutual stock on May 31 is entitled to a dividend even
though he/she sales the shares prior to June 15.

ii. Ex-Divided Date
The first date on which a stock purchaser is no longer entitled to the recently
declared dividend. This date helps in eliminating the problem of stock sales in
days immediately prior to the record date when it takes time to settle the deal.
Brokerage community has a rule whereby new shareholders are entitled to
dividends only if they purchase the stock at least four business days prior to
the record date.

iii. Declaration Date
It is the date that the BOD announces the amount and date of next dividend.

iv. Payment Date
It is the date when the corporation actually pays the declared dividend.

The time line below indicates the abovestated dates.

May 8 May 27 May 31 June15

Declaration Ex-Dividend Record Payment
Date Date Date Date
A stock that has gone ex-dividend is market with an X in newspaper price
listing.

v. Dividend Reinvestment Plan (DRIP)
It is an optional plan allowing shareholders to automatically reinvest dividend
payments in additional shares of the companys stock. There are two types of
DRIPs, i.e. where additional shares are from already existing common stock
or newly issued stock.

In case of old stock all funds to be reinvested are transferred to a bank that
acts as a trustee. The bank then purchases shares of the companys common
stock in the open market with either the company or investor bearing
brokerage costs.
The other method is when the firm issues new stock and this is when the firm
actually raises new capital. This method effectively reduces cash dividends.
The company does not pay brokerage costs as the stock is coming from itself.
Normally investors buy the stock at a discount of the market price. Even
though reinvested, the dividend is taxable to the shareholder as ordinary
income, and this posse as a major disadvantage to taxable investors.

Chapter 11 LEASE FINANCING 63
LEASE FINANCING
A 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.

TYPES OF LEASES
i. Operating 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 assets 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. Examples include
office space, copying machines, computers software or hardware and
automobile leases.

ii. Financial 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. Full-Service 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.

iv. Net Lease
In this case the lessee agrees to maintain, 9insure and pay property tax for
the leased asset. Financial leases are usually net leases.

NB: At expiration of the lease the lessee has the option, according to
contracts 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 market value.
If the lessee fails to exercise the option, the lessor takes possession of the
asset and is entitled to any residual value associated with it.

FORMS OF LEASE FINANCING
All Financial lease arrangements fall into Sale and Leaseback, direct leasing
or Leverage leasing.

ix. Sale and Leaseback
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 back from the
buyer. T.M. stores, for instance, may wish to raise cash by selling the building
T.M. Hyper for cash to the leasing company and simultaneously signing a
long-term lease contract for the building. Legal ownership of the building is
passed to the leasing company, but the right to use it stays with T.M.
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.

x. Direct Leasing
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. Major
types of lessor in this case are manufacturers, finance companies, banks,
independent leasing companies and partnerships.

xi. Leveraged Leasing
It is a lease arrangement in which the lessor provide part of the purchase
price (usually 20-40%) of the leased asset and borrows the rest from the third
part using the lease contract as security for the loan.
Leveraged leasing is mainly used in financing large assets like aircraft, oilrigs
and railway equipment.

RATIONAL FOR LEASING
a) Convenience
Short-term leases are convenient, e.g. if one needs the use of a car for a
week or if the company needs the use of an asset for 1 year or 2. However,
short-term leases tend to be very expensive for equipment that can easily be
damaged.

b) Maintenance and Advice
In a full service lease, the lessor provides expertise maintenance. Lease
agencies also provide expertise advice to lessees on the best equipment to
lease.

c) Standardising Leads to Low Administration and Transaction
Costs
Leasing companies usually provide a simple standard lease contract. Unlike
borrowing funds from banks, where a lot of administrative, legal and
transaction costs are involved in terms of investigations and collateral.
Leasing provides financing on a flexible, piecemeal basis, with low transaction
costs, than in a private placement or public bond or stock issue.

d) Tax Shields
The lessor deducts the assets depreciation from taxable income. If such
depreciation tax shields are put into a better use than an assts user can, the
benefit can be passed on to the lessee in the form of low lease payments.

e) Avoiding the Alternative Minimum Tax (AMT)
AMT is an alternative, separate tax calculation based on the taxpayers
regular taxable income increased by certain tax benefits, collectively referred
to as tax preference items. The taxpayer pays the large of the regularly
determined tax or the AMT.
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
books.
AMT, therefore, trap companies that shield too much income; hence AMT
must be paid whenever it is higher than their tax computed in the regular way.
Using AMT, part of the benefits of accelerated depreciation and other tax
reducing items are added back hence increasing total tax to be paid.
However, lease payments are not on the list of items added back in
calculating AMT. Thus, if you lease rather than buy, tax depreciation is less
and the AMT is less.

f) Leasing Preserves Capital
This is, however, a dubious reason for leasing. It is argued that leasing
companies provide 100% financing; they advance the full cost of the leased
asset hence the company preserves cash for other things. However, the firm
can also preserve capital by borrowing money. If, for example, a company
leases a $1billion dollar vehicle rather than buying it, it does conserve $1
billion cash. It could also buy the vehicle for cash and borrow $1 billion, using
the vehicle as security. Its bank balance ends up the same whichever way, it
has the vehicle and it incurs a $1billion debt in either case.

ACCOUNTING AND TAX TREATMENT FOR LEASES
Until 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.
All 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.
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 market value)
price when the lease expires.
- The lease lasts for at least 75% of the assets estimated economic life.
- The present value of the lease payments is at least 90% of the assets
value.

Thus all other leases are operating leases as far as the above is concerned.

EVALUATING LEASE FINANCING
To evaluate whether or not a proposal for lease financing makes 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.

Example
The company has decided to acquire a piece of equipment valued at
$148,000 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 $27,500. The annual
payments are made in advance, i.e. annuity due. The lease is a net lease.
Required:
a. Calculate the before-tax return to the lessor.
b. Calculate the annual lease payment if required rate of return is 11%.
Answer:
a. Use the formula:
n
C0 = [LCFt/(1+k)
t
]
t=0
= LCF0 + LCFt(PVIFAk,n)
Where:
C0 is cost of the equipment
LCFt is lease cash flow at time t.
Using interpolation solve for k.
Yr LCFt PV @ 5% PV @ 10%
0 27,500.00 27,500.00 27,500.00
1 27,500.00 26,190.48 25,000.00
2 27,500.00 24,943.31 22,727.27
3 27,500.00 23,755.53 20,661.16
4 27,500.00 22,624.32 18,782.87
5 27,500.00 21,546.97 17,075.34
6 27,500.00 20,520.92 15,523.03
Total 167,081.53 147,269.67

NPV at 5% = $19,081.53
NPV at 10% = -$730.33
k = r1 + [NPV1/(NPV1-NPV2)]*[r2-r1]
= 0.05 +(19,081.53/19,811.86)*(0.05)
= 9.82%
b. 6
$148,000 =[(LCFt/1.11)
t
]
t=0

= LCF0 + LCFt(PVIFA11%,6)
= LCF0 + LCFt(4.231) = LCF(5.231)
LCF = $148,000/5.231 = $28,293
OR
Yr LCFt PV @ 11%
0 X 1.0000
1 X 0.9009
2 X 0.8116
3 X 0.7312
4 X 0.6587
5 X 0.5935
6 X 0.5346
Total 5.2305
X = $148,000
5.231

= $28,293.00
Present Value of a Lease Contract
Calculating the present value of lease contract help in determining whether to
lease or buy the asset. As 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 makes annual lease payments of $27,500
for leased asset. These are tax deductible in the year in which they apply, i.e.
$27,500 paid in year 0 is only deductible for tax in year 1.
Leasing is analogous to borrowing, thus an appropriate discount rate for
discounting the after-tax cash flows is the after-tax cost of borrowing.
Assume the cost of borrowing is 12% and the tax rate is 40%. Thus, the after-
tax cost of borrowing is 12%x(1-40%) = 7.2%.
Calculate the Present value of cash flows of the lease.
Answer:
A B = Ax0.40 C= A-B D = C/(1.072)
t

End of Yr
Lease
Payment
Tax-Shield
Benefits
Cash Outflow
After Taxes
Present Value of
Cash Outflows
0 27,500.00 - 27,500.00 27,500.00
1 27,500.00 11,000.00 16,500.00 15,391.79
2 27,500.00 11,000.00 16,500.00 14,358.01
3 27,500.00 11,000.00 16,500.00 13,393.67
4 27,500.00 11,000.00 16,500.00 12,494.09
5 27,500.00 11,000.00 16,500.00 11,654.94
6 27,500.00 11,000.00 16,500.00 10,872.14
7 11,000.00 (11,000.00) (6,761.28)
Total P.V. = 98,903.37
This Present Value figure should then be compared with the Present Value of
cash flows under the borrowing alternative. The alternative that gives a lower
Present Value is to be chosen.
Valuation of Borrowing Alternative
As shown in the table below, since the P.V. of cash outflow for debt
alternative is less than that of lease financing the company should use debt.
Thus:
1. If the asset is purchased the company is assumed to finance it with a
12% unsecured debt. Loan payments are expected to be made at the
beginning of each year.
2. A loan of $148,000 is taken up at time zero payable over 7 years at
$28,955 a year.
3. Proportion of interest depends on annual unpaid capital. Thus, annual
interest for first year is $119,045 x 0.12 = $14,285

IMPORTANCE OF THE TAX 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 zero
tax bracket that can enjoy the full tax benefits associated with owning an
asset.

Year End
0 1 2 3 4 5 6 7 Total
A= Loan
Payment 28,955 28,955 28,955 28,955 28,955 28,955 28,955 (15,000)
B = Bt-1 - A+C
Principal Owing 119,045 104,375 87,945 69,544 48,934 25,851 -
C = Bt-1 x 0.12
Annual Interest - 14,285 12,525 10,553 8,345 5,872 3,102 -
D = Annual
Depreciation - 24,667 24,667 24,667 24,667 24,667 24,667 - 148,000
E = (C+D)*0.40
Tax-Shield
Benefit - 15,581 14,877 14,088 13,205 12,216 11,108 (6,000)
F = A - E Cash
Outflow After
Tax 28,955 13,374 14,078 14,867 15,750 16,739 17,847 (9,000)
G = F/(1.072)
t

P.V. Cash
Outflow 28,955 12,476 12,251 12,068 11,926 11,824 11,760 (5,532) 95,728
Chapter 12 WORKING CAPITAL MANAGEMENT 72
WORKING CAPITAL MANAGEMENT

Working capital can be viewed from two concepts, i.e. net working capital and
gross working capital.
Accountants use the term working capital to mean net working capital, which
can be defined as current assets less current liabilities. Financial analysts, on
the other hand, mean current assets when they speak of working capital.
Thus their focus is on gross working capital, which is the firms investment in
current assets, e.g. cash, marketable securities, receivables, and inventory.

Working capital is therefore all about the administration of the firms current
assets namely cash and marketable securities, receivables and inventory and
the financing (especially current liabilities) needed to support current assets.

OPTIMAL AMOUNT (LEVEL) OF CURRENT ASSETS

To come up with the optimum level management must consider the trade off
between profitability and risk. 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 linear; current assets increase at a decreasing rate with
output as illustrated below:
Policy A
CURRENT
ASSETS Policy B
LEVEL ($)

Policy C

OUTPUT (UNITS)

As shown in the diagram, it takes 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. All other things
held constant, the greater the level of current assets the higher the firms
liquidity.

Policy A is associated with high liquidity low profit and low risk, policy B is on
the medium side whilst policy C is associated with high liquidity and high
profitability and risk. This is due to the fact that looking at the relationship
between current assets and profitability one can use the return on investment
(ROI) equation, i.e.:

ROI = Net Profit
Total Assets
= Net Profit
(Cash + Receivables + Inventory) + Fixed Assets

Thus, from the above equation, decreasing the amounts of current assets
held will increase the firms potential profitability, provided output and sales
remain constant or increase.
However, a decrease in current assets means a reduction in the firms 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 stock. Thus, adopting an aggressive working capital
policy leads to increased risk.

Varying working capital levels leads to two most basic principles in finance,
i.e.:
Profitability varies inversely with liquidity, and
Profitability moves together with risk (i.e. there is a trade off between
risk and return)
The optimal level of current assets in the firm will be determined
managements attitude to the trade-off between profitability and risk.

WORKING CAPITAL CLASSIFICATION
Working capital can be classified either according to components (i.e.
marketable securities, receivables and inventory), or time (i.e. permanent or
temporal)
Permanent working capital is the amount of current assts required to meet the
firms long-term minimum needs.
Temporal working capital is the amount of current assets that varies with
seasonal requirements.
These two classifications are shown in the diagram below:

Amount

Temporary Current assets

Permanent Current Assets

Time

For a growing firm the level of permanent working capital needed will increase
over time in the same manner as does fixed assets. However, unlike fixed
assets, permanent current assets are constantly changing.

FINANCING CURRENT ASSETS
Hedging Approach
This is a method of financing where each asset would be offset with a
financing instrument of the same approximate maturity.
Using this approach, short-term or seasonal variations in current assets would
be financed with sort-term debt; the permanent component of current assets
would be financed with long-term debt or with equity. This method can be
illustrated as follows:

Amount Short-term
Financing

Current Assets
Long-term
Financing

Fixed Assets

Time

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 liquidating
principle, e.g. loan taken to finance purchase of Easter eggs will be paid from
receivables from sale of eggs.

Short-Vs-Long-Term Financing

Due to uncertainty the exact matching of the firms 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 flows? This depends on managements attitude
to the trade-off between risk and profitability.


1. Relative risk involved
In general, the shorter the maturity schedule of the firms debt obligations, the
greater the risk that the firm will be unable to meet principal and interest
obligations. Also, when firm finances with long-term debt, it knows 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 risk to the borrower.

2. Risk Vs cost trade-off

Generally, the expected cost of long-term financing is usually more than the
short-term financing. However, 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 risk 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 firms expected net cashflow and the
contractual payments on its debt. The margin of safety will depend on the risk
preferences of management, as shown below:

Conservative Financing Policy

Amount Short-term
Financing

Current Assets

Long-term
Financing
Fixed Assets

Time

Aggressive Financing Policy

Amount Short-term
Financing

Current Assets

Long-term
Financing
Fixed Assets

Time

Under conservative policy, the higher the long-term financing line, the more
conservative the financing policy of the firm, and the higher the cost. Under
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.

CASH AND MARKETABLE SECURITIES MANAGEMENT
This section looks at how much of current assets should be carried in cash
and how much should be carried in marketable securities.

Motives For Holding Cash
These, according to John Maynard Keynes, are:
a) Transaction motive: to meet payments, (like purchases, wages,
taxes, and dividends), arising in the ordinary course of business.

b) Speculative motive: to take advantage of temporary opportunities, like
the sudden decline in the price of raw materials.

c) Precautionary motive: 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 companys treasury management department is responsible for cash or
marketable securities management, and it involves the efficient collection,
disbursement, and temporary investment in cash. A 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 king of control system.
It is important to have daily reports on bank balances, anticipated daily
receipts and disbursements, as well as marketable securities position of the
firm.

A firm can employ four different ways of managing cash and marketable
securities and these are:
Speeding up cash receipts,
Slowing down cash payouts,
Maintaining cash balances, and
Investing in marketable securities.

Method I: Speeding Up Cash Receipts
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) Collections
This involves the acceleration of collections, it includes the steps taken by the
firm from the time a product or service is sold until the customers cheques
are collected and become usable funds for the firm. Collections can be
accelerated thorough:

Expedite preparing and mailing the invoices,
Accelerate the mailing of payments from customers to the firm, and
Reduce 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 takes 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. A 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. Billing can be eliminated entirely through the use of
preauthorised (direct) debit.
Collection float can also be accelerated by use of lock-box system. In this
case the company rents a local post office box and authorises it bank to pick
up remittances in the box. Customers are billed with instructions to mail their
remittances to the lock-box. The remittances are picked up at several times
during the day and deposited into the bank account directly. All 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 work is done (thus eliminating processing float).
The main disadvantage is cost in the form of bank charges for additional
service.

b. Concentration Banking
Firm that use lock box system and over-the-counter payment system find
themselves with numerous regional banks. Such firms find it more reasonable
to move part or all of these remote deposits to one central location
(concentration banking) 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).

A compensating balance can be left in a remote account whilst any excess
funds would be moved to the concentration bank. Usually three methods of
funds transfer are used in concentration banking. These are:

i. Depository Transfer Cheque (DTC), which is a non-negotiable
cheque payable to a single company account at a concentration
bank. However because of the delays in cheque clearances most
companies now prefer a telegraphic transfer to a DTC.
ii. Automated Clearing House (ACH) Electronic Transfer, which is an
electronic cheque image version of a DTC. Funds will be available
in the account one working day late and can be used between
banks that a re members of the automated clearing house system.
iii. Wire Transfer, which is an electronic fund transfer system using a
two-way communication system. RTGS ha become a mandated
transfer system in Zimbabwe for large amounts of money.

Method II: Slowing Down Cash Payouts
Using this method, the firm wants to pay accounts payable as late as is
consistent with maintaining the firms credit standing with suppliers so that it
can make the most use of the money it already has. The combination of fast
collections and slow disbursements will result in increased availability of cash.
One procedure for tightly controlling disbursements is to centralise payables
into a single or few account(s) presumably at the companys headquarters.

If cash discounts are taken on accounts payable, the firm should send
payment at the end of the cash discount period, but if discount is not taken,
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 bank (e.g. a Harare supplier
and a Kwekwe bank) to try and increase the time within which the cheque will
be outstanding.

Method III: Maintain Cash Balances
Most firms establish a target level of cash balances to maintain in their
accounts. Any excess balance is invested in marketable securities. The
greater the interest rate on marketable securities, the greater the opportunity
cost of holding idle cash balances.

Optimal level should be the larger of:
The transactions balances required when cash management is
efficient; or
The compensating balance requirement of commercial banks that the
firm has deposit accounts.

One cash management model developed to determine an optimal split
between cash and marketable securities is the Inventory Management Model.
Using this model, the Economic Order Quantity (EOQ) formula used in
inventory management is used to determine the optimal amount of transaction
balances to maintain. EOQ is the quantity of an inventory item to order so that
total inventory costs are minimised over the firms planning period.
Using this model, the carrying cost of holding cash interest foregone on
marketable securities is balanced against the fixed cost of transferring
marketable securities to cash or vice versa. It can be illustrated as follows:

Cash
C

Average
Cash
Balance
(C/2)

Time
Key: C = Total cash
C/2 = Average cash

The model assumes that the cash flows are constant. One 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 just profitable.

Method IV: Investment In Marketable Securities
Marketable securities (and time deposits) are shown on the balance sheet as
cash equivalents, (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. Marketable
securities are usually held for three purposes, which are:
1. Ready cash for unforeseeable excess cash outflows,
2. Controllable cash for known future cash outflows like salaries,
dividends, etc, or
3. Free cash set aside since the firm has no immediate use of the cash.
Before investing in a marketable security the finance manager should
understand the important factors associated with the security, i.e. safety,
marketability, yield and maturity.

a) Safety (of Principal)
This refers to the likelihood of getting back 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.

b) Marketability (Liquidity)
The ability to sell a significant volume of securities in a short period of time in
the secondary market 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 market.

c) Yield (Return)
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) risk, i.e. variability in the market price of a security caused
by changes in interest rates.

d) Maturity
It simply refers to the life of the security. Usually, the longer the maturity the
greater the yield, but the more is the exposure to yield risk.

COMMON MONEY MARKET INSTRUMENTS
They are generally short-term government securities and corporate
obligations. The instruments include Treasury Bills; Treasury Notes; Treasury
Bonds with less than one-year; Repurchase Agreements (Repos); Bankers
Acceptances (BAs); Commercial Paper and Negotiable Certificate of Deposits
(N.C.Ds).

ACCOUNTS RECEIVABLES AND INVENTORY MANAGEMENT

1. Accounts Receivables Management
This looks at the key variables involved in effectively managing receivables
and how an optimum investment can be achieved.

Economic conditions, product pricing, product quality and the firms credit
policies are the key influences on the level of a firms accounts receivable. Of
these, financial manager only influences credit policies.

Lowering 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 risk of bad debt loses. Thus the trade-off
between profitability and risk should be managed. Policy variables include the
quality of the trade accounts accepted, the length of the credit period, cash
discounts and the collection program of the firm. All 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.
Added costs are in the form of additional work 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.
Relaxing 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.

Example
Assume the firms product is selling at $100. Variable cost per unit is $80.
Contribution per unit is $20 (i.e. $100 - $80).
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 1 (one) month and are expected to continue doing so.
Annual credit sales stand at $24 million.
Credit liberalisation will result in new credit clients paying in 2 (two) months
time. The same relaxation will result in a 25% increase in credit sales (i.e. $24
million x 1.25 = $30 million thus additional sales units is $6 million/$100 = 60
000 units)
The firms opportunity cost of carrying the additional receivables is 20%
before tax.

Should the firm relax its credit standards?

Answer
Additional Sales Profitability = Unit Contribution x Additional Units Sold
= $20 x 60 000 units
= $1 200 000

Additional Receivables = Additional Sales Revenue
Receivables Turnover for New Clients
= (6 000 000)/6
= $1 000 000

Investment in Additional Receivables = Unit V/Cost x Additional
Price per Unit Receivables

= ($80/$100) x$1 000 000
= $800 000

Required Before Tax Return on Additional Investment
= Opportunity x Investment in
Cost Additional Receivables

= 0.2 x $800 000
= $160 000

Since additional sales profitability ($1.2 million) far exceeds the required
before tax return on additional investment ($160 000), the firm should relax its
credit standards up to a point where the two are equal assuming all other
things remain constant.

b) Credit Terms
1. Credit period
This specifies the total length of time over which credit is extended to a
customer to pay a bill.
A firms credit term might be expressed as 2/10 net 30.
Where: 2/10 means 2% discount is given if the bill is paid within 10 days of
invoice date, and
net 30 means if discount is not taken full payment is due by the 30
th

day from invoice date.
Thus credit period still remains 30 days.

Example
Assume, using the above example, credit period has changed from net 30 to
net 60. This change also affects the old clients.
The credit policy has resulted in additional sales of $3,600,000 and these new
clients also pay on average in two months.

Should the firm liberalise its credit period, ceteris-paribus?

Answer
Additional Sales Profitability = Unit Contribution x Additional Units Sold
= $20 x 36 000 units
= $720 000

Additional Receivables Associated with New Sales
= Additional Sales Revenue
Receivables Turnover for New Clients
= (3 600 000)/6
= $600 000

Investment in Additional Receivables Associated with New Sales
= Unit V/Cost x Additional
Price per Unit Receivables

= ($80/$100) x$600 000
= $480 000

Level of Receivables Before Credit Period Change = Annual Credit Sales
Old Receivables Turnover
= $24,000,000/12
= $2,000,000

New Level of Receivables Associated with Original Sales
= Annual Credit Sales
New Receivables Turnover
= $24,000,000/6
= $4,000,000

Investment in Additional Receivables Associated with Original Sales
= $4 million - $2 million
= $2,000,000

Total Investment in Additional Receivables = $2 million + $480 000
= $2,480,000
Required Before Tax Return on Additional Investment
= Opportunity x Investment in
Cost Additional Receivables

= 0.2 x $2,480 000
= $496 000
Thus, since additional sales profitability ($720 000) is greater then before-tax
return on additional investment ($496 000) the company should increase its
credit period from net 30 to net 60.

2. Cash discount period and cash discount
Cash discount period is the period of time during which a cash discount can
be taken for early payment (e.g. 10 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 quickly.

Example
Assume a firm with annual credit sales of $30 million and an average
collection period of two months. Sales terms are net 45 with no discounts.

Thus Average Receivables Balance = $30 million/6 = $5 million

Assume by initiating terms of 2/10, net 45 the average collection period can
be reduced to one month as 60% of the customers (in money terms) take
advantage of the 2% discount.

Thus Opportunity Cost of the Discount = 0.2 x 0.6 x $30 million = $360 000,
annually.

Turnover of receivables has improved to 12 times a year.
Average receivables are reduced from $5 million to $2.5 million (i.e.
$30million/12).
The firm therefore realises $2.5 million (i.e. $5 million - $2.5 million) from
accelerated collection.
The value of the funds received is the opportunity cost and assuming a 20%
before-tax rate of return, the Opportunity Savings = $2.5 million x 0.2 = $500
000.

Since opportunity savings ($500 000) arising from a speed up in collections is
greater than the opportunity cost of the discount ($360 000) the firm should
therefore adopt a 2% discount.

3. Seasonal datings
In this case, during periods of slack sales, firms will at times sale to customers
without requiring payment for sometime to come (usually until after the peak
sales period), e.g. in the sell of jerseys. Again 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.
Datings 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.

c) Default 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.

INVENTORY MANAGEMENT AND CONTROL
A manufacturing company must maintain a certain amount of inventory (Work
in Progress) 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.
Raw-materials inventory gives the firm flexibility in its purchasing.
Finished-goods inventory allows the firm flexibility in its production scheduling
and in its marketing.
Large 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.

Like account receivables, inventories should be increased as long as the
resulting savings exceed the total cost of holding the added inventory.

METHODS OF INVENTORY CONTROL
1. ABC Method (Looks at what to control)
This method controls expensive inventory items more closely than less
expensive items. Thus, most expensive inventory takes up the least
percentage of items in inventory whilst the cheapest take the largest portion.
Other factors, however, have to be taken into account, e.g. whether the item
is critical, or bottlenecks, or may soon become obsolete.

2. Economic Order Quantity (Looks at how much to order)
EOQ is the quantity of an inventory item to order so that total inventory costs
are minimised over the firms planning period. For the optimal order quantity
of a particular type of inventory one must consider its forecast usage, ordering
cost, and carrying cost.

Assume a known, stead usage of 2,600 items for six months period, 100
items are used each week. Ordering costs (O) are constant regardless of the
order size. Thus total ordering cost is the cost per order times the number of
orders for that period.

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. Again 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.

With a steady use of inventory over time and with no safety stock, average
inventory can be expressed as:
Q
2
Where Q = Quantity ordered.
This can be illustrated as follows:

Inventory
Q

Average
Inventory
(Q/2)

Time
As shown, when a zero level of inventory is reached, a new order of Q items
arrives.

The carrying cost = C(Q/2)

The total number of orders over a period of time =
Total usage (in units) for that period (S)
The quantity ordered (Q).
At the same time total ordering cost =
Ordering cost per order x The number of orders [i.e. O(S/Q)].
Thus, total inventory cost = Total carrying cost x Total ordering cost, i.e.
T = C(Q/2) + O(S/Q).

It implies that the higher the order quantity (Q) 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 size
and the added cost of carrying additional inventory.

3. Optimal Order Quantity
This is the quantity (Q0) that minimises total inventory costs over the planning
period. This is represented by the formula:

Q0 = 2(O)(S)
C

Example
Assume inventory usage of 2,000 during a 100 day planning period costs are
$100 per order, and carrying costs are $10 per unit per 100 days. Calculate
the optimal order quantity.

Answer

Q0 = 2($100)(2000) = 200 units
$10

Thus with an order quantity of 200 the firm can order 10 times (i.e. 2,000/200)
during the 100 days, i.e. every 10 days.

Q0 varies directly with usage (S) and order costs (O) and inversely with
carrying cost (C). However, the relationship is not linear due to the square
root effect. Thus Q0 changes at a lower proportionate rate in relation to others.

The relationship can be illustrated as follows:

Source: http://en.wikipedia.org/wiki/Economic_order_quantity
NB: Ordering Costs = Total Ordering Costs
Total Cost = Total Inventory Costs
Holding Costs = Total Carrying Costs
Economic Order Quantity = Q0.

4. Order Point (When to order)
This shows the quantity to which inventory must fall in order to signal a
reorder of the EOQ amount. This part takes into account the Lead-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.
Assuming a lead-time of 5 days it follows that the firm needs to order every 5
days before it run out of stock or at 100 units of stock on hand.

Thus, the Order Point may be expressed as:

OP = Lead-Time x Daily Usage
= 5 days x 20 units per day
= 100 units.

As illustrated below, when the new order is received 5 days later, the firm will
just have exhausted its existing stock.

Inventory
200 units

Order
Point
(100 units) Q0

5 10 15 20 25 30 Days
Lead-Time

5. Safety Stock
This is inventory stock 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 zero before a new order is anticipated as illustrated below.

In this case Order Point formula changes to:

OP = (Average Lead-Time x Average Daily Usage) + Safety Stock
= (5 x 20) + 100
= 200 units.
Inventory
300 units

Order
Point
(200 units)

100 units

Safety Stock

5 10 15 20 25 30 Days
Lead-Time

In real life where demand and lead-time are not certain the diagram can be
shown as:
Inventory
300 units

Order
Point A B C
(200 units)

100 units

5 10 15 20 25 30 Days
As 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
A) before the next order is received hence it was received before the safety
stock level was reached. In the next segment usage was as expected but it
took six days (represented by B) instead of five for the order to be received
hence the company was already utilising its safety stock. In the third segment
the order is placed soon after receiving the other one due to low stock levels
and delivery is also done immediately hence stocks are replenished.

All these issues point to the fact that the amount of safety stock depends on
things like demand uncertainty, lead-time uncertainty, work stoppage costs
and the cost of carrying additional inventory.
Management will not wish to add safety stock beyond the point at which
incremental carrying costs exceed the incremental benefits to be derived from
avoiding a stock out.

6. Just In Time (JIT)
This inventory management process developed in Japan 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 JIT is not only to reduce inventories, but also to continuously
improve productivity, product quality, and manufacturing flexibility.

By reducing the ordering related costs, the firm is able to flatten the total
ordering cost curve thereby shifting Q0 to the left thereby approaching the JIT
ideal of one unit.

Chapter 13 MERGERS AND ACQUISITIONS 97
MERGERS AND ACQUISITIONS
A merger or an acquisition involves the combining of two or more companies
in which only one firm survives as a legal entity.
An acquisition like any other investment should only be undertaken if it makes
a net contribution to shareholders wealth.
In most cases mergers are arranged amicably, but sometimes one firm will
make a hostile takeover bid for another.

FORMS OF MERGER
i. Horizontal Merger
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. Vertical Merger
Involves companies in related lines of business. The company acquires either
forward towards the ultimate consumer or back ward towards the source of
raw materials. Economies are enjoyed in the sense that the surviving
company will have more control over its distribution and/or purchasing.

iii. Conglomerate Merger
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 risk.

MOTIVES FOR MERGERS
a) Economic Gains
An economic gain occurs if the two firms are worth more together than apart,
i.e.
PVAB > PVA + PVB (or 1 + 1 = 3) where:
PVAB = Present value of firm A and firm B combined,
PVA = Present value of firm A held separately, and
PVB = Present value of firm B held separately.
The gain to the acquiring company is calculated as:

Gain = PVAB (PVA + PVB)

If company A has acquired company B then the Net Present Value (NPV) to A
of acquiring B will be given by:

NPV = Gain Cost
= PVAB (PVA + PVB) (Cash Paid PVB).

b) Economies of Scale
These occur when average cost declines with increase in quantity. Cost
declines come from things like sharing central services like office
management, accounting and marketing, financial control, executive
development and top-level management.
The surviving firm also gains the market share and can even dominate the
market.
Companies tend to gain through the combined use of facilities and gain
through synergy.

c) Provision of Complementary Resources
A small firm may have unique product or skill but lack the engineering or sales
organisation required to produce and market it on a large scale. If each firm
has what the other needs then it may be more sensible to merge.

d) Eliminating Inefficiencies
Some firms are inefficiently managed, with the result that profitability is lower
than it might otherwise be.

e) Signalling Effect
Value could occur if new information is conveyed as a result of the corporate
restructuring. This usually works when there is information asymmetry
between management and common stockholders.
If management believes the share, to be undervalued then a positive signal
may occur via the restructuring announcement that causes share price to rise.

f) Surplus Funds
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.

g) Tax Reasons
A company coming out of bankruptcy can have lots of money in unused tax-
loss carry-forwards. Such a company can buy of merge with another profit
marking company and hence be able to utilise the carry-forwards.

h) Borrow at Low Costs
A firm can merge with another so that it can improve its credit rating and
hence be able to access debt at low cost.

i) Managements Personal Agenda
Some managers view growing from a small to a large company as more
prestigious or can have diversification as their objective.

j) Diversification
By merging with another firm and attaining more diversification, either through
product or market diversification, help in reducing risk of loses to the
company. Diversification can be shown using the Ansoff (Product/Market)
Grid below.

EXISTING PRODUCT NEW PRODUCT
EXISTING
MARKET
Market Penetration Product
Development
NEW MARKET Market Development Diversification

STRATEGIC Vs FINANCIAL ACQUISITIONS
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 acquirers 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. A financial acquisition usually
involves cash payment to the selling shareholders financed largely by debt
(i.e. Leveraged Buyout-LBO).

COMMON STOCK FINANCED ACQUISITIONS
When an acquisition is done for common stock, a ratio of exchange, which
denotes the relative weightings of the two companies with regard to certain
key variables, results. The two ratios to be considered are the per-share
earnings and the market price ratio.

i. Earnings Impact
In this case the acquiring firm considers the effect that the merger will have on
the earnings per share of the surviving corporation.

Example
You are given the following financial data in the case where company A is
considering the acquisition, by common stock, of company B.

Company A Company B
Present Earnings (000) $20,000 $5,000
Shares outstanding (000) 5,000 2,000
Earnings per share (EPS) $4.00 $2.50
Price per share $64.00 $30.00
Price Earnings (P/E) ratio 16 12

Company A has agreed to offer $36 (i.e. 20% premium above company Bs
stock) a share to company B, to be paid in company As stock.

a) Calculate the exchange ratio.

E.R. = 36 = 0.5625
64

Thus company A will pay 0.5625 share for each of company Bs share.

In total company A will issue 1,125,000 (i.e. 0.5625 x 2,000,000 shares)
shares to acquire 2,000,000 shares in company B (hence acquiring company
B).

b) Assuming that the earnings of the component companies stay the
same, what will be the EPS of the surviving company after the
acquisition?
Company A
Present Earnings (000) $25,000
Shares outstanding (000) 6,125
Earnings per share (EPS) $4.08

Thus the merger has lead to an immediate jump in the earnings per share for
company A from $4.00 to $4.08.

c) Calculate the post merger EPS related to each share of company B
previously held.

Thus: 0.5625 x $4.08 = $2.30.
Thus companys shareholders have experienced a decline in EPS.

Suppose company A had offered a 50% premium its EPS would have
declined to $3.90 indicating an initial dilution due to the acquisition. On the
other hand company Bs shareholders would have enjoyed an increase in
EPS from $2.50 to $2.74.
Dilution occurs whenever the price earnings (P/E) ratio paid for a company
exceeds the P/E ratio of the company doing the acquisition.

P/E ratio in the first instance was 14.4 (i.e. $36/$2.50) and in the second
instance it was 18 compared to 16 for company A.

In general, the higher the pre-merger P/E ratio and earnings of the acquiring
company in relation to the acquired company, the greater the increase in EPS
of the surviving company. Thus, avoid acquiring companies with high P/E
ratios and high earnings.

An initial dilution of EPS 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:

Expected
EPS ($)
Growth with merger
12

Growth without merger
8

4

1 2 3 4 5 Years

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 Value Impact
During the acquisition bargaining process major emphasis is placed on the
exchange ratio of market price per share. Market price reflects the earnings
potential of the company, as well as the dividends, bus risk, capital structure,
asset values, and other factors that bear upon valuation.

Market Price Exchange Ratio =
Market Price Per Share x Number of Shares by Acquiring Company
of the Acquiring Company for Each Share of the Acquired Company
Market Price Per Share of the Acquired Company

If the market exchange ratio is 1 (one) it follows that the shares will be
exchanged on a 1:1 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 market 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.

Example
You are given the following financial information of the acquiring and the
acquired company:

Acquiring Co. Acquired Co.
Present Earnings (000) $20,000 $6,000
Shares outstanding (000) 6,000 2,000
Earnings per share (EPS) $3.33 $3.00
Market Price Per Share $60.00 $30.00
Price Earnings (P/E) ratio 18 10

The P/E ratio of the surviving company is expected to remain at its high level
of 18 after the acquisition.
The acquiring company has offered $40 for each of the shares in the acquired
company.

a) Calculate the Market Price Exchange Ratio.

Thus: E.R = 40 = 0.667
60
Market Price Exchange Ratio = $60 x 0.667 = 1.33
$30

The shareholders of the acquired company benefit in the sense that their
share, which is going for $30.00 in the market, has been bought for $40.00.

b) Ceteris-paribus what will be the market value per share of the
acquiring company soon after the acquisition?

It will stand at:

Surviving Co.
Total Earnings (000) $26,000
Shares outstanding (000) 7,334
Earnings per share (EPS) $3.55
Price Earnings (P/E) ratio 18
Market Price Per Share $63.90

NB: 7,334,000 = 6,000,000 + (0.667 x 2,000,000)

Thus the shareholders of the acquiring company also benefit through an
increase in the share price and EPS.

It follows that companies with high P/E ratios would be able to acquire
companies with low P/E ratios and obtain an immediate increase in EPS,
despite the fact that they have offered a premium, with respect to the market
price exchange ratio, provided the P/E ratio after the merger remains
sufficiently high.

Empirical 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. Returns to shareholders of the acquiring
company tend to fall immediately after the merger whilst shareholders of the
acquired firm experience high and positive return.
The relative abnormal stock returns around the announcement date of a
successful merger can be illustrated as follows:

Cumulative
Average
Abnormal
Return
Selling company
+

0 Buying company

_

Announcement Days
Date

PURCHASE OF ASSETS OR COMMON STOCK
A company may be acquired either by the purchase of its assets or its
common stock. Payment can be in the form of cash or by exchange of
common stock.
After the purchase the selling company is but a corporate shell with its assets
composed entirely of cash or stock of the buying company. The acquirer can
either hold the cash or stock or distribute it to its shareholders as a liquidating
dividend, after which the company is dissolved.
However, if only part of the selling companys assets are bought it can remain
in operation as a legal entity.

TAXABLE AND TAX-FREE MERGER
In a taxable acquisition, the selling stockholders 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.

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 stock.
In most cases the selling company and its shareholders because of the
postponable capital gains tax involved prefers a tax-free transaction.

ACCOUNTING TREATMENT
Accounting for mergers can be treated either as a purchase method or a
pooling of interests method.

A purchase method is an accounting treatment based on the market price
paid for the acquired company.
Pooling of interests involves the treatment for a merger based on the net book
value of the acquired companys assets. The balance sheets of the two
companies are simply combined.

Most 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. However, the choice of accounting is usually governed
by the circumstances of the merger and the rules of the accounting
profession.

TAKEOVER DEFENCES
These are antitakeover amendments that a firm can employ to frustrate the
company intending to acquire it in a hostile takeover bid. Such a bid is when
the acquiring company makes a tender offer (an offer to buy current
shareholders stock 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 shark
repellent devices, and these are:
i. Management entrancement hypothesis, which suggests that the
devices are employed to protect management jobs and that, such
actions work to the detriment of shareholders.
ii. Shareholders interest hypothesis, which argues that contest for
corporate control are dysfunctional and take managements time
away from profit making activities.

Devices usually used are:
a) Staggered board 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 majority that is unlikely to vote in favour of the takeover.
b) Supermajority A high percentage of shares is needed to approve a
merger, usually 80%.
c) Fair price The bidder must pay non-controlling shareholders a price at
least equal to a pre-specified fair price.
d) Restricted voting rights Shareholders who own more than a specified
proportion (usually 20%) of the target have no voting rights unless
approved by the targets board.
e) Waiting period (freeze-out) Bidder must wait for a specified period
(usually 2-5 years) before a merger can be completed.
f) Leveraged re-capitalisation Current management loads the balance
sheet with new debt, which it uses to pay a huge, one-time cash dividend
to shareholders.
g) Poison pill Existing shareholders are issued rights, which if there is a
significant purchase of shares (usually 20%) by the bidder, can be used to
buy additional stock in the company at a discount. Shareholders can also
be issued with convertible preference shares or convertible bonds.
h) Poison put Existing bondholders can demand immediate repayment if
there is a change of control as a result of a hostile takeover.
i) Asset restructuring Buy assets that the bidder does not want or that
will create an antimonopoly problem.
j) Litigation File suit against bidder for violating Antimonopoly Act.
k) Liability restructuring Issue shares to a friendly third party, increase
number of shareholders or buy shares from existing shareholders at a
premium.

DIVESTITURE
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. Voluntary Corporate Liquidation
This comes about due to the fact that the firms assets may have a higher
value in liquidation than the present value of the expected cash-flow stream
emanating from them.
Liquidation allows the seller to sell assets to different parties hence realising a
higher value than in a merger.

ii. Partial Sell-Off
His 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 Spin-Off
It is a form of divestiture resulting in a subsidiary or division becoming an
independent company. Unlike 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 companys
shareholders on a pro-rata basis, after which it operates as a completely
separate company.

iv. Equity Curve-Out
It is a public sale of stock in a subsidiary in which the parent company usually
retains the majority control. The minority interest sold through a curve-out
represents a form of equity financing.
The subsidiary will have its value realised since it will have a separate stock
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 subsidiarys market to
be more complete hence accessing finance. Also investors will be able to
obtain a pure play investment in technology.
NB: Pure play is an investment concentrated in one line of business. It is the
opposite of investment in a conglomerate.

COMPANY OWNERSHIP RESTRUCTURING
The ownership restructuring methods to be looked at are going private and
leveraged buyouts.

i. Going Private
This is process of making a public company private though the repurchase of
stock 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.
However, going private involves high transaction costs, little liquidity to its
owners, large portion of owners wealth is tied up in the company, and the
companys true value might not be realised unless it goes public.

ii. Leveraged Buyouts (LBOs)
This is primarily debt-financed purchase of all the stock 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. Because of the fact that LBOs are debt
financed most involve capital intensive as opposed to labour intensive
businesses.
Most LBOs are to the management of the company or division involved.
LBOs are done using cash and not common stock and the division bought
becomes a private company. LBOs are motivated by the following reasons:
The division might no longer fit in the companys strategic objectives.
The division enjoys 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
market position.
Also the availability of experienced and good quality senior
management is critical.

Due to the leverage management will be forced to work hard so that nothing
goes wrong.

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Chapter 7 VALUATION OF LONG TERM SECURITIES 1

turns into a constant growth model.

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