ACCA

F9
FINANCIAL MANAGEMENT

Study System
Sample Session

ATC
INTERNATIONAL

ACCA

PAPER F9
FINANCIAL MANAGEMENT

STUDY SYSTEM

No responsibility for loss occasioned to any person acting or refraining from action as a result of any
material in this publication can be accepted by the author, editor or publisher.
This training material has been published and prepared by Accountancy Tuition Centre Limited
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Teddington
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United Kingdom.
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SESSION 00 CONTENTS

CONTENTS
Page
1

The Financial Management Function

0101

The Financial Management Environment

0201

Investment Decisions

0301

Discounted Cash Flow Techniques

0401

Relevant Cash Flows for DCF

0501

Applications of DCF

0601

Project Appraisal under Risk

0701

Equity Finance

0801

Debt Finance

0901

10 Security Valuation and Cost of Capital

1001

11 Weighted Average Cost of Capital and Gearing

1101

12 Capital Asset Pricing Model

1201

13 Working Capital Management

1301

14 Inventory Management

1401

15 Cash Management

1501

16 Management of Accounts Receivable and Payable

1601

17 Risk Management

1701

18 Business Valuation and Ratio Analysis

1801

19 Glossary

1901

Index

2001

(iii)

SESSION 00 CONTENTS

(iv)

SESSION 00 SYLLABUS

INTRODUCTION
This Study System has been specifically written for the Association of Chartered Certified
Accountants fundamentals level examination, Paper F9 Financial Management
It provides comprehensive coverage of the core syllabus areas and is designed to be used
both as a reference text and interactively with the ATC Learning System to provide you with
the knowledge, skill and confidence to succeed in your ACCA studies

SYLLABUS
AFM (P4)

FM (F9)

MA (F2)

Advanced Financial Management

Financial Management

Management Accounting

Aim
To develop the knowledge and skills expected of a finance manager, in relation to
investment, financing, and dividend policy decisions.

Main capabilities
On successful completion of this paper, candidates should be able to:
A

Discuss the role and purpose of the financial management function

Assess and discuss the impact of the economic environment on financial management

Discuss and apply working capital management techniques

Carry out effective investment appraisal

Identify and evaluate alternative sources of business finance

Explain and calculate the cost of capital and the factors which affect it

Discuss and apply principles of business and asset valuations

Explain and apply risk management techniques in business.

(v)

SESSION 00 SYLLABUS

Financial
management function
(A)

Financial management environment (B)

Working capital
management (C)
Investment appraisal
(D)
Business finance
(E)
Cost of capital
(F)

Business valuations
(G)

Risk management
(H)

RATIONALE
The syllabus for Paper F9, Financial Management, is designed to equip candidates with the
skills that would be expected from a finance manager responsible for the finance function of
a business. The paper, therefore, starts by introducing the role and purpose of the financial
management function within a business. Before looking at the three key financial
management decisions of investing, financing, and dividend policy, the syllabus explores
the economic environment in which such decisions are made.
The next section of the syllabus is the introduction of investing decisions. This is done in two
stages - investment in (and the management of) working capital and the appraisal of longterm investments.
The next area introduced is financing decisions. This section of the syllabus starts by
examining the various sources of business finance, including dividend policy and how much
finance can be raised from within the business. Cost of capital and other factors that
influence the choice of the type of capital a business will raise then follows. The principles
underlying the valuation of business and financial assets, including the impact of cost of
capital on the value of the business is covered next.
The syllabus finishes with an introduction to, and examination of, risk and the main
techniques employed in the management of such risk.

(vi)

SESSION 00 SYLLABUS

DETAILED SYLLABUS
A

Financial management function

1.

The nature and purpose of financial management

2.

Financial objectives and relationship with corporate strategy

3.

Stakeholders and impact on corporate objectives

4.

Financial and other objectives in not-for-profit organisations

Financial management environment

1.

The economic environment for business

2.

The nature and role of financial markets and institutions

Working capital management

1.

The nature, elements and importance of working capital

2.

Management of inventories, accounts receivable, accounts payable and cash

3.

Determining working capital needs and funding strategies

Investment appraisal

1.

The nature of investment decisions and the appraisal process

2.

Non-discounted cash flow techniques

3.

Discounted cash flow (DCF) techniques

4.

Allowing for inflation and taxation in DCF

5.

Adjusting for risk and uncertainty in investment appraisal

6.

Specific investment decisions (lease or buy, asset replacement, capital rationing)

(vii)

SESSION 00 SYLLABUS

Business finance

1.

Sources of, and raising short-term finance

2.

Sources of, and raising long-term finance

3.

Internal sources of finance and dividend policy

4.

Gearing and capital structure considerations

5.

Finance for Small and Medium-size Entities (SMEs)

Cost of capital

1.

Sources of finance and their relative costs

2.

Estimating the cost of equity

3.

Estimating the cost of debt and other capital instruments

4.

Estimating the overall cost of capital

5.

Capital structure theories and practical considerations

6.

Impact of cost of capital on investments

Business valuations

1.

Nature and purpose of the valuation of business and financial assets

2.

Models for the valuation of shares

3.

The valuation of debt and other financial assets

4.

Efficient Markets Hypothesis (EMH) and practical considerations in the valuation of

shares

Risk management

1.

The nature and types of risk and approaches to risk management

2.

Causes of exchange rate differences and interest rate fluctuations

3.

Hedging techniques for foreign currency risk

4.

Hedging techniques for interest rate risk

(viii)

SESSION 00 SYLLABUS

APPROACH TO EXAMINING THE SYLLABUS

The syllabus for Paper F9 aims to develop the skills expected of a finance manager who is
responsible for the finance function of a business.
The paper also prepares candidates for more advanced and specialist study in Paper P4,
Advanced Financial Management.
The syllabus is assessed by a three-hour paper-based examination consisting of four
compulsory 25-mark questions. All questions will have computational and discursive
elements. The balance between computational and discursive content will continue in line
with the pilot paper.
15 minutes for reading and planning is given at the start if the examination. During this time
candidates may make notes on the question paper but may not write in the answer booklet.
Candidates are provided with a formulae sheet and tables of discount and annuity factors.
Candidates should bring a scientific calculator to the examination.

(ix)

SESSION 00 TABLES AND FORMULAE

Formula sheet
Economic order quantity =

2C o D
Ch

Miller Orr Model

Return point = Lower limit + (1/3 spread)
1

3
3
4 transaction cost variance of cash flows
Spread = 3

interest rate

The Capital Asset Pricing Model

E(ri) = Rf + i(E(rm)Rf)

The asset beta formula

Vd (1 T )
Ve
a =
e +
d
(Ve + Vd (1 T ))
(Ve + Vd (1 T ))

The Growth Model

PO =

D O (1 + g )
(re g )

Gordons growth approximation

g = bre

The weighted average cost of capital

Ve
Vd
WACC =
k e +
k d (1 T )
Ve + Vd
Ve + Vd

The Fisher formula

(1+i) = (1+r) (1+h)

Purchasing power parity and interest rate parity

s1 = s 0 x

(x)

(1 + h c )
(1 + h b )

f0 = s0 x

(1 + i c )
(1 + i b )

SESSION 00 TABLES AND FORMULAE

Present value table

Present value of 1 i.e. (1 + r)n
where

r = discount rate
n = number of periods until payment
Discount rate (r)

Periods
(n)
1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0.990
0.980
0.971
0.961
0.951

0.980
0.961
0.942
0.924
0.906

0.971
0.943
0.915
0.888
0.863

0.962
0.925
0.889
0.855
0.822

0.952
0.907
0.864
0.823
0.784

0.943
0.890
0.840
0.792
0.747

0.935
0.873
0.816
0.763
0.713

0.926
0.857
0.794
0.735
0.681

0.917
0.842
0.772
0.708
0.650

0.909
0.826
0.751
0.683
0.621

1
2
3
4
5

6
7
8
9
10

0.942
0.933
0.923
0.914
0.905

0.888
0.871
0.853
0.837
0.820

0.837
0.813
0.789
0.766
0.744

0.790
0.760
0.731
0.703
0.676

0.746
0.711
0.667
0.645
0.614

0.705
0.665
0.627
0.592
0.558

0.666
0.623
0.582
0.544
0.508

0.630
0.583
0.540
0.500
0.463

0.596
0.547
0.502
0.460
0.422

0.564
0.513
0.467
0.424
0.386

6
7
8
9
10

11
12
13
14
15

0.896
0.887
0.879
0.870
0.861

0.804
0.788
0.773
0.758
0.743

0.722
0.701
0.681
0.661
0.642

0.650
0.625
0.601
0.577
0.555

0.585
0.557
0.530
0.505
0.481

0.527
0.497
0.469
0.442
0.417

0.475
0.444
0.415
0.388
0.362

0.429
0.397
0.368
0.340
0.315

0.388
0.356
0.326
0.299
0.275

0.350
0.319
0.290
0.263
0.239

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0.901
0.812
0.731
0.659
0.593

0.893
0.797
0.712
0.636
0.567

0.885
0.783
0.693
0.613
0.543

0.877
0.769
0.675
0.592
0.519

0.870
0.756
0.658
0.572
0.497

0.862
0.743
0.641
0.552
0.476

0.855
0.731
0.624
0.534
0.456

0.847
0.718
0.609
0.516
0.437

0.840
0.706
0.593
0.499
0.419

0.833
0.694
0.579
0.482
0.402

1
2
3
4
5

6
7
8
9
10

0.535
0.482
0.434
0.391
0.352

0.507
0.452
0.404
0.361
0.322

0.480
0.425
0.376
0.333
0.295

0.456
0.400
0.351
0.308
0.270

0.432
0.376
0.327
0.284
0.247

0.410
0.354
0.305
0.263
0.227

0.390
0.333
0.285
0.243
0.208

0.370
0.314
0.266
0.225
0.191

0.352
0.296
0.249
0.209
0.176

0.335
0.279
0.233
0.194
0.162

6
7
8
9
10

11
12
13
14
15

0.317
0.286
0.258
0.232
0.209

0.287
0.257
0.229
0.205
0.183

0.261
0.231
0.204
0.181
0.160

0.237
0.208
0.182
0.160
0.140

0.215
0.187
0.163
0.141
0.123

0.195
0.168
0.145
0.125
0.108

0.178
0.152
0.130
0.111
0.095

0.162
0.137
0.116
0.099
0.084

0.148
0.124
0.104
0.088
0.074

0.135
0.112
0.093
0.078
0.065

11
12
13
14
15

(xi)

SESSION 00 TABLES AND FORMULAE

Annuity table
Present value of an annuity of 1 i.e.

where

1 (1 + r ) n
r

r = discount rate
n = number of periods
Discount rate (r)

Periods
(n)
1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

1
2
3
4
5

0.990
1.970
2.941
3.902
4.853

0.980
1.942
2.884
3.808
4.713

0.971
1.913
2.829
3.717
4.580

0.962
1.886
2.775
3.630
4.452

0.952
1.859
2.723
3.546
4.329

0.943
1.833
2.673
3.465
4.212

0.935
1.808
2.624
3.387
4.100

0.926
1.783
2.577
3.312
3.993

0.917
1.759
2.531
3.240
3.890

0.909
1.736
2.487
3.170
3.791

1
2
3
4
5

6
7
8
9
10

5.795
6.728
7.652
8.566
9.471

5.601
6.472
7.325
8.162
8.983

5.417
6.230
7.020
7.786
8.530

5.242
6.002
6.733
7.435
8.111

5.076
5.786
6.463
7.108
7.722

4.917
5.582
6.210
6.802
7.360

4.767
5.389
5.971
6.515
7.024

4.623
5.206
5.747
6.247
6.710

4.486
5.033
5.535
5.995
6.418

4.355
4.868
5.335
5.759
6.145

6
7
8
9
10

11
12
13
14
15

10.37
11.26
12.13
13.00
13.87

9.787
10.58
11.35
12.11
12.85

9.253
9.954
10.63
11.30
11.94

8.760
9.385
9.986
10.56
11.12

8.306
8.863
9.394
9.899
10.38

7.887
8.384
8.853
9.295
9.712

7.499
7.943
8.358
8.745
9.108

7.139
7.536
7.904
8.244
8.559

6.805
7.161
7.487
7.786
8.061

6.495
6.814
7.103
7.367
7.606

11
12
13
14
15

(n)

11%

12%

13%

14%

15%

16%

17%

18%

19%

20%

1
2
3
4
5

0.901
1.713
2.444
3.102
3.696

0.893
1.690
2.402
3.037
3.605

0.885
1.668
2.361
2.974
3.517

0.877
1.647
2.322
2.914
3.433

0.870
1.626
2.283
2.855
3.352

0.862
1.605
2.246
2.798
3.274

0.855
1.585
2.210
2.743
3.199

0.847
1.566
2.174
2.690
3.127

0.840
1.547
2.140
2.639
3.058

0.833
1.528
2.106
2.589
2.991

1
2
3
4
5

6
7
8
9
10

4.231
4.712
5.146
5.537
5.889

4.111
4.564
4.968
5.328
5.650

3.998
4.423
4.799
5.132
5.426

3.889
4.288
4.639
4.946
5.216

3.784
4.160
4.487
4.772
5.019

3.685
4.039
4.344
4.607
4.833

3.589
3.922
4.207
4.451
4.659

3.498
3.812
4.078
4.303
4.494

3.410
3.706
3.954
4.163
4.339

3.326
3.605
3.837
4.031
4.192

6
7
8
9
10

11
12
13
14
15

6.207
6.492
6.750
6.982
7.191

5.938
6.194
6.424
6.628
6.811

5.687
5.918
6.122
6.302
6.462

5.453
5.660
5.842
6.002
6.142

5.234
5.421
5.583
5.724
5.847

5.029
5.197
5.342
5.468
5.575

4.836
4.988
5.118
5.229
5.324

4.656
4.793
4.910
5.008
5.092

4.586
4.611
4.715
4.802
4.876

4.327
4.439
4.533
4.611
4.675

11
12
13
14
15

(xii)

SESSION 00 EXAM TECHNIQUE

EXAM TECHNIQUE
Time allocation
To allocate your time multiply the marks for each question by 1.8 minutes.
i.e. each 25 mark question should take you 25 1.8 = 45 minutes.
You should also apportion your time carefully between the parts of each question.
Do not be tempted to go over the time allocation on each question - remember the law of
diminishing returns the longer you spend the lower your efficiency in gaining marks. It is
more effective to move onto the next question.

Numerical elements

Before starting a computation, picture your route. Do this by noting down the steps
you are going to take and imagining the layout of your answer.

Use a columnar layout if appropriate. This helps to avoid mistakes and is easier for the
marker to follow.

Use lots of space.

Include all your workings and cross-reference them to the face of your answer.

A clear approach and workings will help earn marks even if you make an arithmetic
mistake.

If you later notice a mistake in your answer, it is not worthwhile spending time
amending the consequent effects of it. The marker of your script will not punish you for
errors caused by an earlier mistake.

Dont ignore marks for written recommendations or comments based upon your
computation. These are easy marks to gain.

If you write good comments based upon calculations which contain errors, you can still
receive all the marks for the comments.

If you could not complete the calculations required for comment then assume an answer
to the calculations. As long as your comments are consistent with your assumed answer
you can still pick up all the marks for the comments.

(xiii)

SESSION 00 EXAM TECHNIQUE

Written elements
Planning

Read the requirements carefully at least twice to identify exactly how many points you
are being asked to address.

Note down relevant thoughts on your plan.

Give your plan a structure which you will follow when you write up the answer.

Presentation

Use headings and sub-headings to give your answer structure and to make it easier to
read for the marker.

Use short paragraphs for each point that you are making.

Use bullet points where this seems appropriate e.g. for a list of advantages/disadvantages

Separate paragraphs by leaving at least one line of space between each.

Style

Long philosophical debate does not impress markers.

Concise, easily understood language scores good marks and requires less writing.

Lots of points briefly explained tend to score higher marks than one or two points
elaborately explained.

(xiv)

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

OVERVIEW
Objective

To develop a model for the valuation of shares and bonds.

To use this model to estimate the cost of equity and the cost of debt.

To consider further practical influences on the valuation of securities.

SECURITY
VALUATION AND THE
COST OF CAPITAL

EQUITY
ANALYSIS

Dividend Valuation Model

Cost of equity

DEBT
ANALYSIS

Irredeemable debentures
Redeemable debentures
Semi-annual interest
Convertible debentures

1001

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

DIVIDEND VALUATION MODEL

1.1

The general model

The dividend valuation model states that:

the market value of a share or other security is equal to the present value of the
future expected cash flows from the security discounted at the investors required
rate of return.

A security is any traded investment e.g. shares and bonds.

1.2

Constant Dividend

The formula for share valuation can be developed as follows:

Ex-div market value at time 0

Present value of the future dividends

discounted at the shareholders
required rate of return

Ex-div market value is the market value assuming that a dividend has just been
paid.

Let:
Po
Dn
ke

=
=
=

Current ex-div market value

Dividend at time n
Shareholders required rate of return/companys cost of equity

The model then becomes:

Po

D1
+
(1 + ke)

D2
(1 + ke)

D3
(1 + ke)

.....

Dn
n

(1 + ke)

If the dividend is assumed to be constant to infinity this becomes the present

value of a perpetuity which simplifies to:
Po

D
ke

This version of the model can be used to determine the theoretical value of a share
which pays a constant dividend e.g. a preference share or an ordinary share in a zero
growth company.

1002

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

1.3

Constant growth in dividends

If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate
Po =
where

D0(1 + g)
ke g

D1
ke g

Do = most recent dividend

D1 = dividend in one year

The formula is published in the exam in the following format:

PO =

D O (1 + g )
(re g )

Where re = required return of equity investors = ke

1.4

Assumptions behind the dividend valuation model

rational investors

all investors have the same expectations and therefore the same required rate of return

perfect capital market assumptions, e.g.,

no transactions costs
large number of buyers and sellers of shares
no individual can affect the share price
all investors have all available information

dividends are paid just once a year and one year apart

dividends are either constant or are growing at a constant rate.

1.5

Uses of the dividend valuation model

The model can be used to estimate the theoretical fair value of shares in unlisted
companies where a quoted market price is not known. .

However if the company is listed, and the share price is therefore known, the model can
be used to estimate the required return of shareholders i.e. the companys cost of equity
finance.

1003

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Illustration 1
Suppose that a share has a current ex-div market value of 80 cents and
investors expect a dividend of 10 cents per share to be paid each year as has
been the case for the past few years.
Using the dividend valuation model the required return of the investors for
this share can be determined:
Po

D
ke

80c

10c
ke

ke

10c
80c

ke

12.5%

Investors will all require this return from the share as the model assumes they
all have the same information about the risk of this share and they are all
rational.
If investors think that the dividend is due to increase to 15 cents each year then
at a price of 80 cents the share is giving a higher return than 12.5%. Investors
will therefore buy the share and the price will increase until, according to the
model, the value will be:
Po

15c
0.125

120 cents

Alternatively suppose that the investors' perception is that the dividend will
remain at 10 cents per share but that the risk of the share has increased thereby
requiring a return of 15%. If the share only gives a return of 12.5% (on an 80
cents share price) then investors will sell and the price will fall. The fair value
of the share according to the model will be:
Po

1004

10c
0.15

66.7 cents

SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

1.6

Practical factors affecting share prices

The dividend valuation model gives a theoretical value, under the assumptions of the
model, for any security.

In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuation. These are likely to include:

interest rates
market sentiment
expectation of future events
inflation
press comment
speculation and rumour
currency movements
takeover and merger activity
political issues.

The dividend valuation model helps us to understand how a change in these

variables should affect the market value of the security.

Share prices change, often dramatically, on a daily basis. The dividend valuation model
will not predict this, but will give an estimate of the underlying fair value of the shares.

COST OF EQUITY

2.1

Shareholders required rate of return

The basic dividend valuation model is:

Po =

D
ke

This can be rearranged to find ke:

ke =

D
Po

If ke is the return required by the shareholders in order for the share value to remain
constant then ke is also the return that the company must pay to its shareholders.
Therefore ke also equates to the cost of equity of the company.

Therefore the cost of equity for a company with a constant annual dividend can be
estimated as the dividend divided into the ex-div share price i.e. the dividend yield.

The ex-div market value is the market value of the share assuming that the current
dividend has just been paid. A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value is given then this must be
adjusted to an ex div market value by taking out the current dividend.

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Example 1
A companys shares have a market value of $2.20 each. The company is just
about to pay a dividend of 20c per share as it has every year for the last ten
years.
What is the companys cost of equity?

Solution

2.2

Dividend with constant growth

The model can also deal with a dividend that is growing at a constant annual rate of g.

The formula for valuing the share is as seen earlier:

D 0 (1 + g)
ke g

Po

where

Do = most recent dividend

D1 = dividend in one year

D1
ke g

Rearranged this becomes

ke =

D0(1 + g)
+g
Po

where g = growth rate (assumed constant in perpetuity).

where Po = ex div market value

Therefore the cost of equity = dividend yield + estimated growth rate

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Illustration 2
Do = 12c, Po (ex div) = $1.75, g = 5%.
What is the value of ke?
ke

0.12 (1.05)
+ 0.05
1.75

= 12.2%

The growth rate of dividends can be estimated using either of two methods.
Two methods

Extrapolation of
past dividends

2.3

Gordons growth model

Growth from past dividends

Look at historical growth and use this to predict future growth. If you have specific
information about future growth, use that.

If dividends have grown at 5% in each of the last 20 years, predicted future growth
= 5%.

Uneven but steady growth take an average overall growth rate.

Discontinuity in growth rate take the most recent evidence.

New company with very high growth rates take care! It is unlikely to produce
such high growth in perpetuity.

No pattern do not use this method (i.e. dividends up one year, down the next).

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Example 2
A company has paid the following dividends over the last five years.
Cents per share
100
110
125
136
145

19X0
19X1
19X2
19X3
19X4

Estimate the growth rate and the cost of equity if the current (19X4) ex div
market value is $10.50 per share.

Solution

2.4

Gordons growth model

Gordons growth model states that growth is achieved by retention and reinvestment of
profits.
g = bre

proportion of profits retained

re

return on equity

Take an average of r and b over the preceding years to estimate future growth.
re

Profit after tax

Shareholders' funds

Retained profit
Profit after tax

Profit after tax

Net assets

These figures can be obtained from the statement of financial position and income
statement.

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Example 3
A company has 300,000 ordinary shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits
of $100,000.
Net assets at the year end were valued at $1.06m.
Estimate the cost of equity.

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

2.5

Cost of equity and project appraisal

Illustration 3
A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays
constant annual dividends of 30c per share.
It is considering adopting a project which will cost $500,000 and which is of the
same risk as its existing activities. The cost will be met by a rights issue. The
project will produce inflows of $90,000 pa in perpetuity. All inflows will be
distributed as dividends.
What is the new value of the equity in A plc and what is the gain to the
shareholders? Ignore tax.
0.30
= 15%
2.00

ke =

New dividend

Existing total dividend

Dividends from the project
New total dividend
Value of equity

$
300,000
90,000
390,000

390 ,000
0.15

= $2,600,000
Shareholders gain

= $(2,600,000 2,000,000) $500,000

= $100,000

Project NPV

= ($500,000) +

Therefore, new value of equity

90 ,000
0.15

= $100,000

= Existing value + Equity outlay + NPV

= Existing value + Present value of
additional dividends

Therefore the NPV of a project serves to increase the value of the companys shares i.e.
the NPV of a project shows the increase in shareholders wealth.

This proves that NPV is the correct method of project appraisal it is the only method
consistent with the assumed objective of maximising shareholders wealth.

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

2.6

Cost of preference shares

By definition preference shares have a constant dividend

Ke

where D = constant annual dividend

Preference dividends are normally quoted as a percentage, e.g. 10% preference shares.
This means that the annual dividend will be 10% of the nominal value, not the market
value.

D
Po

Example 4
A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
What is the cost of the preference shares?

Solution

COST OF DEBT

3.1

Terminology of debentures

A debenture is a written acknowledgement of a companys debt. A debenture usually pays a

fixed rate of interest and it may be secured or unsecured. It may be traded on the bond
market and will reach a market price. The terms debenture, bond and loan stock all basically
refer to the same thing i.e. traded corporate debt (unlike bank loans which are not traded).

The coupon rate is the interest rate printed on the debenture certificate.
Annual interest = coupon rate nominal value

Nominal value is also known as par or face value. In the exam the nominal value of one
debenture is usually $100.

Market value (MV) is normally quoted as the MV of a block of $100 nominal value.

e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual
interest is $10 per $100 block.

Market value (ex-int) is where interest has just been paid.

Market value (cum-int) includes the value of accrued interest which is just about to be
paid.

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

3.2

Irredeemable debentures

Irredeemable debentures are a type of debt finance where the company will never repay
the principal but will pay interest each year until infinity. They are also referred to as
undated debentures.

The market value of undated debt can be calculated using the same logic as the
Dividend Valuation Model:

MV (ex interest) = present value of future interest payments discounted at the debentureholders required rate of return

For irredeemable debentures the interest is a perpetuity.

MV (ex int) =
where

I
r

I = annual interest
r = return required by debenture holder

I
MV (ex int)

r =

The company gets tax relief on the debenture interest it pays, which reduces the cost of
debentures to the company known as the tax shield on debt.

Interest yield

Illustration 4
Consider two companies with the same earnings before interest and tax (EBIT).
The first company uses some debt finance, the second uses no debt.
$
100
(10)
___

$
100

Profits before tax

90

100

Tax @ 33%

29.70

EBIT
Debt interest

___

33

$3.30 difference
Therefore
Effective cost of debt
Debt interest
Less Tax shield

$
10.00
(3.30)
_____

Effective cost of debt

6.70
_____

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Because of tax relief, the cost to the company is not equal to the required return of the
debenture holders.
Unless told otherwise, we assume that tax relief is instant (in practice, there will be a
minimum time lag of nine months under the UK tax system).

Note that if debt is irredeemable then:

Cost of debt to the company (also
known as the post tax cost of debt)

Return required by the debenture

holders (1Tc)

Interest yield (1Tc)

Where Tc = corporate tax rate as a decimal

Kd can be used to denote the cost of debt but care is needed as to whether it is stated
pre-tax or post-tax.

Example 5
12% undated debentures with a nominal value of $100 are quoted at $92 cum
interest. The rate of corporation tax is 33%.
Find
(a) the return required by the debenture-holders
(b) the cost to the company.

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

3.3

Redeemable debentures/dated debentures

The cash flows are not a perpetuity because the principal will be repaid. However from
the dividend valuation model we can derive the following rule:

The cost of any source of funds is the IRR of the cash flows associated with that source.

If we are looking at the return from an investors point of view, interest payments are
included gross.

If we are looking at the cost to the company, we take the interest payments net of
corporation tax. Assume instant tax relief.

Assume that the final redemption payment does not have any tax effects.

To find the cost of debt for a company find the IRR of the following cash flows:
Time
0
1n
n

Market value (ex-interest)

Post-tax interest
Redemption value

$
x
(x)
(x)

The IRR is found as usual using linear interpolation.

Example 6
A company has in issue $200,000 7% debentures redeemable at a premium of
5% on 31 December 19X6. Interest is paid annually on the debentures on 31
December. It is currently 1 January 19X3 and the debentures are trading at $98
ex interest. Corporation tax is 33%.
What is the cost of debt for this company?

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Care should be taken not to confuse the required return of the debenture holders with
the cost of debt of the company.
Required return of the
redeemable debenture
holder

= IRR of pre-tax cash

flows from the
debenture

= Gross redemption
yield

Gross Redemption Yield is also referred to as the Yield To Maturity (YTM)

The cost of debt of the company is then determined by finding the IRR of the market
value, net of tax interest payments and redemption value.

MV (ex interest) = present value of future interest payments and redemption value
discounted at the debenture-holders required rate of return

Example 7
A company has 8% debentures redeemable at a 5% premium in ten years.
Debenture-holders require a return of 10%.
What is the cost to the company? Corporation tax is 33%.

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

3.4

Semi-annual interest payments

In practice debenture interest is usually paid every six months rather than annually.
This practical aspect can be built into our calculations for the cost of debt.

If interest payments are being made every 6 months then when the IRR of the debenture
cash flows is calculated it should be done on the basis of each time period being 6
months.

The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to
determine the annual cost of debt.

Effective annual cost = (1+semi annual cost)2 -1

Example 8
A company has in issue 6% debentures the interest on which is paid on 30 June
and 31 December each year. The debentures are redeemable at par on 31
December 19X9. It is now 1 January 19X7 and the debentures are quoted at
96% ex interest.
What is the effective annual cost of debt for the company? Ignore corporation
tax.

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

3.5

Convertible debentures

Convertible debentures allow the investor to choose between redeeming the debentures
at some future date or converting them into a pre-determined number of ordinary
shares in the company.

To estimate the market value it is first necessary to predict whether the investor will
choose redemption or conversion. The redemption value will be known with certainty
but the future share price can only be estimated.

MV (ex interest) = present value of future interest payments and the higher of (i)
redemption value (ii) forecast conversion value, discounted at the debenture-holders
required rate of return

You may also be required to calculate other data for convertibles:

Floor value = the value assuming redemption

Conversion premium = market value current conversion value

Example 9
A company has in issue 8% coupon bonds which are redeemable at their par value of $100 in
four years time. Alternatively, each bond may be converted on that date into 40 ordinary
shares. The current ordinary share price is $2.10 and this is expected to grow at a rate of 7%
per year for the foreseeable future. Bondholders required return is 9% per year.

Required:
Calculate the following values for each $100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

To find the post-tax cost of convertible debt for a company find the IRR of the following
cash flows:
Time
0
1n
n

Market value (ex-interest)

Post-tax interest
Higher of redemption value/forecast conversion value

$
x
(x)
(x)

Example 10
A company has in issue some 8% convertible loan stock currently quoted at $85
ex interest. The loan stock is redeemable at a 5% premium in five years time, or
can be converted into 40 ordinary shares at that date. The current ex-div
market value of the shares is $2 per share and dividend growth is expected at
7% per annum. Corporation tax is 33%.
What is the cost to the company of the convertible loan stock?

Solution

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SESSION 10 SECURITY VALUATION AND THE COST OF CAPITAL

Key points

If capital markets are perfect the sale/purchase of any security must be a

zero NPV transaction i.e. market price = present value of future cash flows
discounted at investors required return.

This general rule can be specifically applied to shares to develop the

dividend valuation model (DVM) and also to bond valuation.

If the market price of a security is already known then the model can be rearranged to find the required return of investors i.e. the companys cost of
equity/debt finance.

Care must be taken with the cost of debt as interest, unlike dividends, is a
tax allowable expense form the side of the company.

FOCUS
You should now be able to:

understand and use the dividend valuation model;

estimate the cost of equity and cost of debt for a company;

understand the practical factors that affect share prices.

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