Corporate Finance Notes2 PDF

Lecturer: Ms.
Nyathi
Corporate Finance Notes - CFI 2201
A. Mashiri
COURSE OBJECTIVES
To gain, understand and appreciation of the different sources of finance, their
management, their advantages and disadvantages and their effects on capital
structure. To comprehend the basics of security valuation, its applicability to other
areas of corporate finance, to gain appreciation of corporate activities and finally
restructuring.
COURSE OUTLINE
1. Sources of Finance
4.1. Overview of Financial Markets
4.2. Evaluation of Main Sources of Finance
4.3. Equity Issues, Rights Issues, Retained Issues
4.4. Bond Issues and other debt instruments
4.5. Venture Capital
2. Valuation of Securities
2.1. Bond Valuation
2.2. Bond Yields
2.3. Risks Associated in Investing in Bonds
2.4. Equity Valuation
2.5. Option Valuation
3. Corporate Valuation and Corporate Structure

3.1. The Total Cost of Capital
3.2. Theory of Capital Structure
3.3. Capital Structure Theory: Miller and Modigliani Model
3.4. The Trade Off Models
3.5. The Signaling Models
4. Dividends and Re-purchases

4.1. Dividend Policy
4.2. Dividend Stability
4.3. Establishing a Dividend Payout Policy
4.4. Forms of Dividend Payments
4.5. Factors Affecting Dividend Policy
4.6. Theories of Dividend Policies
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4.7. Theoretical Issues that Could Affect Dividend Policy

4.8. Dividend Payment Procedures
4.9. Dividend Reinvestment Plans
4.10. Stock Dividends and Stock Splits
4.11. Stock Repurchase
5. Leasing f Financing
5.1. Dividend Defined
5.2. Types of Leases
5.3. Forms of Lease Financing
5.4. Rational of Leasing
5.5. Accounting and Tax Treatment of Leasing
5.6. Evaluation of leases
5.7. Present value of Lease Contract
5.8. Valuation of Borrowing Alternative
5.9. Importance of the Tax Rate
5.10. Issues in Lease Analysis
5.11. Hire Purchase
6. Working Capital Management

6.1. Cash Management
6.2. Inventory Management
6.3. Short term financing i.e. accruals, accounts payable, bank loans, factoring.
7. Corporate Activity and Restructuring

7.1. Mergers and Acquisitions
7.2. Demergers
7.3. Company divestitures and spin offs
7.4. Leverage Buyouts / Management buyouts
7.5. Holding Companies.
Suggested Reading
Brealey, Richard and Meyers, Stewart, Principles of Corporate Finance; 4th ed.
Brigham, Eugine F and Ehrhardt Michael C (202), Financial Management:
Theory and Practice, 10th edition.
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Pike, Richard and Neale, Bill, (2006) Corporate Finance and Investment:
Decision and Strategies, 5th Edition, Prentice Hall
Van Horne, James, Financial Management and Policy, 4th edition, Prentice
Hall International Editions.
Weston Fred J and Copeland, Thomas Managerial Finance, 9th edition,
Dryden Press International
Weighting of Assessment
Examination -
70%
Coursework -
30%
1. SOURCES OF FINANCE
1.1. Overview of Financial Markets
This topic identifies the sources of finance namely Debt and Equity capital.
Source of debt and equity is the financial market.
Financial Market is a place through which securities are created and traded.
There are several different types of financial markets:(a). Physical Asset Markets.
These are the tangible assets e.g. maize, cars, real estate, and
computers e.t.c.
(b). Financial Asset Markets
These deal with stocks, bonds, mortgages and other financial
instruments which are merely claims on real estate.
(c). Continuous Markets & Call Markets
Some markets operate on a continuous basis during opening hours
whilst some markets trade at specific times during opening hours e.g.
the Zimbabwe Stock Exchange open at 0900 and 1200 hours these
are the call markets.
(d). Spot Markets & Future Markets
These are terms that refer to whether the assets are being bought or
sold on the spot delivery or future delivery e.g. Zimbabwe Stock
Exchange you buy shares today and get them 7 days later.
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When an asset is bought or sold for future delivery at some date then it
is traded in future market.
(e). Primary & Secondary Markets
Primary markets are markets in which companies raise new capital
either by a bond issue or issue of new stock.
Secondary markets are markets already in existence in which securities
are traded amongst investor.
NOTE: The issuer of the security does not receive any proceeds from
the sale of the security in a secondary market.
(f).
Private & Public Markets

In Private Markets transactions are negotiated directly between two
parties e.g. black market transactions.
Whereas in Public Markets standardised contracts are traded on
organised exchanges e.g. Zimbabwe Stock Exchange.
(g). Money & Capital Markets

Money markets deal with securities with maturities of 1 year or less.
Thats were we get treasury bills, call deposits, commercial paper,
bankers acceptance.
Capital markets are more concerned with instruments with maturity
greater than one year, e.g. bonds and equity.
NOTE: Capital Market is Stock Market
(h). Local & International Markets
Local Market is when you trade within Zimbabwe
International Market is when you trade beyond the borders of Zimbabwe
Secondary Markets
A secondary market is a market in which securities are traded. There are two
main markets to be considered:
Organised Exchanges
Over the counter markets
Organised Exchanges
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Stock markets are the most creative and most important secondary markets.
Stock exchanges operate as auction markets as buyers and sellers are

matched.
Examples of Stock Exchange

o Zimbabwe Stock Exchange
o New York Stock Exchange
o London Stock Exchange
o Botswana Stock Exchange
o Nairobi Stock Exchange
o Zambia Stock Exchange
NOTE: Stork Exchanges in developing countries are smaller compared to

developed countries.
Over the counter markets
-
The over the counter market is an interchangeable organisation that is

used to describe any buying or selling activities in securities that does not
take place on stock exchange
The over the counter is a dealer market in that business is conducted

across the country by brokers and dealers.
Importance of Secondary Markets

-
They provide an indication of value of a company for example. The price of

an issuers shares in the secondary market will indicate the value of the
company.
Secondary markets provide liquidity. They enable investors to sell their

shares i.e. buy shares in primary then sell in secondary market to enable
one to get in and out of market shares
Without a healthy secondary market for shares there will only be a limited
market for new share issues.
It provides a forum for exchange. A secondary market brings together

buyers and sellers of securities thus reducing search costs.
Listing of Stock Exchange

An exchange does not deal in securities of all companies. It has to select the
companies whose shares can be allowed to be bought and sold.
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The companies selected for those purpose as included in the official trading list.
Certain strict standards must be met and fees paid for initial and continued
listing.
Reasons for Listing
(a). Founder Diversification
The founders of the company have most of their wealth tied up in their
company; hence by selling some of their shares in a public offering they
can diversify their shareholding thereby reducing the risk in their
personal portfolios.
(b). It increases liquidity
- Shares in a privately owned company are in liquid as they do not
have a ready market.
- Search costs are incurred in trying to locate a willing buyer.
- Furthermore there are problems in valuing the stake in that market
- However by listing these problems are usually eliminated.
(c). It facilitates the raising of new cash
- It is difficult to raise new cash by selling new stock in a private
company, the reason being the existing owners might not have the
cash or they might reluctant to put in more money in the business.
- It is even more difficult to get outsiders to invest in a private company
as they will not have sufficient voting rights and might not get a return
in the form of dividends.
(d). To establish value of Company
You can easily establish value of a listed company.
(e). Prestige
- Companies seek listing for prestige reasons meaning you have met
requirements of listing such as fees e.t.c.
- Since the company will be known it becomes easy even to borrow
because you will be known.
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Disadvantages of Listing
(a). Cost of Reporting
- Listed companies are required to publish annual and semi-annual
results which are very costly.
- Accounts have to be audited and furthermore public has to be alerted
on any developments in that company that might affect the share
price.
(b). Disclosure Requirements

Disclosure of sensitive information in financial reports can give an urge to
competitors.
(c). Self Dealings
In privately owned companies there are opportunities for various types of
questionable but legal self dealings.
For example: - nepotism, payment of high salaries and perquisites (e.g.
company cars).
(d). Inactive Market or Low Price
If a company is small and shares are infrequently traded, this will result in
an under-valuation of shares.
(e). Control
Managers will not have control on the day to day running of the business
once the company is listed.
Dual Listing
-
A dual listing is whereby a company is listed on more than one stock

exchange.
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Generally such a companys primary listing is on a stock exchange in its

country of incorporation and its secondary listing is on an exchange in
another country.
Examples of Companies in Dual Listing

-
Old Mutual has primary listing in London Stock Exchange, secondary

listing on the Johannesburg Stock Exchange and Zimbabwe Stock
Exchange
Pretoria Portland Cement (PPC) - has primary listing on the

Johannesburg Stock Exchange and secondary listing on the Zimbabwe
Stock Exchange
Hwange Colliery - has primary listing on the Zimbabwe Stock Exchange

and secondary listing on the Luxembourg Stock Exchange
Reasons for Dual Listing

-
Improved accessibility to funds the Stock Exchange provides

companies with facility to raise capital.
To gain access to a larger investor base.
Improved visibility and profile
Disadvantages of Dual Listing

-
The company in question has to comply with listing requirements of

both markets.
Cost of reporting i.e. reporting required in more than one company. It

may be necessary to produce two different sets of accounts under
different standards.
Accessibility of Information ensure prices are same on both markets

and information availed on both markets.
De-Listing
It is the process of making a public company private.
De-listing can be volunteering or it can arise because a company has fallen
short of the listing regulations.
Reasons for de-listing
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(a). Under-valued Shares

Directors may believe that their shares are under-valued and may
decide to de-list their company.
(b). Financial Flexibility
If the company is now able to raise debt finance it makes sense for
them to de-list as there are no further advantages to being listed.
(c). Mergers and Acquisitions
Kingdom Financial Holdings was de-listed in 2007, its now part of
Kingdom Meikles African Limited.
Same applies to Tanganda Tea Company.
Capri was de-listed in 1998 through a reverse take-over by Inscor.
(d). Financial Problems of Entities / Viability Problems
Barbican Bank was de-listed due to liquidity problems as well as Trust
Bank, Zicco Holdings was de-listed is 1997.
(e). Control issue
The directors may wish to regain independence of action that they had
as executives of privately owned company. De-listing will then free them
from much regulations and public accountability.
(f).
Fear of Take-over
Companies may be liable to hostile takeovers by larger and more
established companies.
1.2. Evaluation Of Main Sources Of Finance

Two main sources of finance:
-
Debt Capital
Equity Capital
Debt capital
-
This can be long term e.g. bonds and debentures or can be short term
e.g. bank overdraft or commercial paper.
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Long term debt is sourced from banks and other lenders of capital such
as life assurance companies or pension funds e.g. PTC Pension Fund.
Where a company needs to fill in a short term funding gap it can use
short term debt, e.g. money market which has duration of less than a
year and is found under the current liabilities in Balance Sheet.
Advantages of using Debt Capital

-
A creditor does not have voting rights does not participate in the
management of the entity.
The use of debt is advantageous in that its interest expense is tax

deductable in calculating the taxable income.
Disadvantages of using Debt Capital

-
The interest payments are contractual and principal repayment must be

made i.e. paying back interest and principal
The lender may require security and in the event of a default the lender
has a right to repossess the asset.
The cash drain is large since interest repayments have to be made on a

regular basis thus putting pressure on the company cash flows.
High credits standards and a strong financial position are required for a
company to access debt capital.
1.3. Equity Issues, Rights Issues, Retained Issues

Equity Capital
-
It is the most common source of financing for most companies and is

normally the first source of capital.
Investors will inject cash or assets into a business in return for a

shareholding in that company.
Equity is the permanent source of capital meaning you do not have to

repay it back as long as the company is in existence.
It can be raised through rights issue or Private Placements.
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Rights Issue
It provides a way of raising new share capital by means of an offer to existing
shareholders inviting them to subscribe cash for new shares in proportion to
the existing holdings.
For example a right issue on a 1 for 4 basis, (1:4) at $2.80 per share would
mean that a company is inviting its existing shareholders to subscribe for one
new share for every 4 shares that they hold at a price of $2.80 per share.
Retained earnings
-
These are profits that are not paid out as dividends but are retained in
the company.
Retained profits are an attractive source of finance because investment

projects can be undertaken without involving the shareholders or any
outsiders.
Use of retained earnings as opposed to new shares or debentures

avoids issuing costs.
Advantages of using Equity Capital

-
Dividend payments are made at the discretion of the company. They

can choose whether to pay or not to pay the dividends.
There is no obligation to pay the principal amount under Equity Capital.
Disadvantages of using Equity Capital

-
On issuing shares voting rights are given to new shareholders leading

to the dilution of ownership and capital.
The cost of under-writing and distributing equity is higher than that of

debt.
Dividends are not deductable as an expense for calculating the

companys income, (because dividends are paid after tax on profit).
Financing Needs of Company and Product Life Cycle

Sources of financing that a company can utilise will ultimately differ
depending on its stage in the product life cycle.
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PRODUCT LIFE CYCLE
Start up Capital
Launch
Launch Stage
-
The pre-launch stage of a business a company will require seed capital.
If the product still appears financially viable after these initial investments
the additional expenditure can be made for operating facilities e.g.
operating equipment then start up capital will then be required.
Start-up Business
Note: The start-up stage for a company represents highest level of business
(Which is risk associated with business itself e.g. high fixed costs, price
controls e.t.c.
A start up business is likely to make accounting losses or very nominal

profits; for this reason start-up business should be financed by equity.
Moreover start-up companies have a large and growing demand for
cashflow, therefore taking on debts will put pressure on its cashflows.
In the launch stage the very high business risk implies that cost should be
kept variable and long term financial commitments should be avoided.
Financing start-up business should come from:

o Business Angels
o Venture Capitalist
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Business Angels
-
These are individuals that have made money in their own enterprises and
are seeking the excitement in the financial reward of investing in another
business.
The Angels usually receive stock / shares and a seat on the Board of
Directors.
As individuals are involved the deal is quicker to close and the

documentation much simpler.
They have a very flexible approach and their analysis less vigorous.
However they can only invest much lower amounts that Venture Capitalists.
Venture Capitalists
-
These are normally professional investors who specialise in a particular

industry.
They have a short term investment horizon.
Their focus is to invest during the high risk start up phase of business
which if it is successful they can realise capital gains.
They expect high rate of returns on their investment portfolio.
As the total risk of a company declines over its transition from launch to
growth stage, the returns on new capital will fall, and hence venture
capitalists will no longer be interested in financing further operations. They
want to exit at this point and invest the proceeds in further high risk
investments
NB: Example of Venture Capitalists is Takura Ventures
Corporate Ventures:
Corporate Venturing Companies invest in promising new ventures in order

to exploit their ideas to obtain the benefits of their new technology and gain
on urge on the market.
Growth Stage
In the growth stage sales start to increase significantly as the product

attains market acceptance.
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Although business risk is still high it has been reduced from that of the
launch stage.
There may be additional funding requirements. A new equity has to be

identified to replace original venture capital and provide continued capital.
Initial public offerings are common at this stage and provide an exit route
for venture capitalists.
Attracting equity investors is not a problem at this stage as prospects for

future growth are high.
The cash generated by the business is for re-investments and no dividend

is paid.
Investors look to capital gains as a major source of capital.

Maturity Stage
At this stage in the life cycle product demand and supply are now
synchronized.
Replacement demand becomes major source of total sales.
Cash flows are positive and there is a reduction in business risk.
There is reduction in business risk which enables financial risk to be

introduced through borrowing.
Because the cash flow are positive this enables the company to service
interest and principle repayment.
The company can also afford to pay dividends.

Decline Stage
At this stage demand for the product will eventually start to fall.
Business risk is low at this stage and using more debt can increase the
financial risk.
Re-investment into the business is no longer priority as the future growth

prospects are negative.
Companies can now instigate a high dividend pay off policy.
1.4. Bond Issues and other debt instruments

Evaluation:
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Evaluation is a process of arriving at the value for an asset expressed in

monetary terms.
The value of an asset is the present value of expected future benefits

usually represented by cash flows discounted at a required rate of return.
Bonds are the most basic type of fixed income security.
Fixed Income Security is a claim on a specified periodic stream of income.
Characteristics of Bonds:
1. Par Value / face value
-
It is the stated face value of the bond. This is the amount paid to the
bond holder on the maturity of the bond.
The par value represents the amount the issuer borrows and promises
to repay on the maturity date.
2. Coupon Rate
-
It is the annual and semi-annual or quarterly interest payment paid to

investors.
It may be fixed or floating. Some bonds do not pay coupons at all.
3. Yield
-
It is the required rate of return on the bond. It is the rate of interest

required by investors in order to entice them to invest in a bond.
They yield changes with changes in interest rates in the economy and
credit worthiness of the issuer.
4. Maturity
-
Bonds have specific maturity dates on which the par value must be
repaid.
The effective maturity of a bond declines each year after it has been
issued.
Bonds Classification
1. Coupon Payments
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(a).
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Straight Bonds / ballet Bonds / Vanilla Bonds
- It is the most common type of bond.

- The bond pays regular usually semi-annual fixed coupon over a fixed
period to maturity to return.
(b).
Zero Coupon Bonds
- They do not make coupon payments.

- The investors receive the par value at maturity date but receive no
interest payments.
- They are issued at a discount and the investors return comes from the
different from the issue price and payment of the par value at issue
e.g. bond issued at $700 yet its par value is $1, 000, on maturity the
investor gets the $1, 000.
(c).
Variable Rate / Floating Rate
- Floating rate bonds make payments that are tied to some measure of
current market rate.
- The payments can be linked to an index or from a current market rate
e.g. Treasury Bills rate or LOBOR.
(d).
Income Bonds.
- They provide coupon payments that must be paid only if the earnings
of the firm are sufficient to meet the interest obligations. The principal
however must be paid when due.
2. Redemption Dates / Maturity Dates
(a).
Double dated Bonds - Pricing.

-
These are bonds that can have a range of possible redemption

dates.
(b).
It eases flow of company cash flow.
Callable Bonds.
-
Callable bonds give the issuer the rights but not the obligation to
redeem the bond before maturity.
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The issuer however must pay the bond holders a premium.
Puttable Bonds.
These bonds give bond holders the right but not the obligations to
sell their bonds back to the issuer at predetermined price and date.
(d).
Irredeemable Bonds / Perpetuals.

These are bonds which do not have redemption dates. So interest
on them will be paid indefinitely.
(e).
Convertible Bonds
It is one that can be converted at the option of the holder into certain
number of shares in that company.
E.g. BAT issues bonds for $1000 to mature in December 2008. The
buyer will be given an option to convert the bond into shares worth
for example 20 shares and hence becomes a shareholder.
3. Issuer who is issuing them

(a).
Treasury Bonds / Government Bonds.

These are issued by the Government
(b).
Corporate Bonds / Debentures.

These are bonds issued by corporations / companies.
(c).
Municipal Bonds.
These are issued by the municipality and local government
(d).
Foreign Bonds.
These are issued by foreign government or foreign companies.
NOTE: - It is important to know the issuer so that one can asses the risk
involved under the bond being issued.
4. Priority
- The priority of the bond determines the probability that the issuer will
pay you back your money.
- The priority indicates your place in line should a company defaults in
payments.
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(b).
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Unsubordinated (senior) Security.

-
It ranks above other loans or security with regards to claims on

assets or earnings.
In the event a company defaults you will be 1st in line to receive

payments from liquidation of its assets.
(c).
Unsubordinated (junior) Security.

In the event a company defaults you will get paid only after the
senior debt holders have received their shares
5. Currency
(a).
Domestic Bonds.
These are bonds issued by the domestic borrower in their own
national markets denominated in the local currency that can be
purchased by anyone in possession of that currency.
(b).
Foreign Bonds.
These are bonds issued by the national markets by foreign
companies or government in the currency of that country in which
the market is based.
The issues are subjected to regulations and supervision of the
national market.
Examples:
* Bonds issued pound sterling in London by foreigners are called
Bulldog Bonds
* Similarly bonds issued in US$ denominations in New York by a
foreigner are called Yankee Bonds
* Bonds issued in Japan by foreigners in Yen denominations are
called Samurai Bonds
(c).
Euro Bonds.
-
These are bonds issued by government and companies outside

their own countries in currencies other than their own, e.g.
Swedish company issuing a bond in Zimbabwe in US$.
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They can be bought by anyone or organisation having the

currency available.
The bonds are not traded on any specific market.

Example: - A Eurobond denominated in Japanese Yen but
issued in the United States will be classified as a Euro yen
Bond.
(c) Price Yield Relationship
PRICE YIELD CURVE

Bond
Price
Yield
Interest rates are the primary determination of bond prices.
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However a change in the level of interest rates does not affect all
bonds in the same way.
In order to determine how sensitive a bond price is to change in

interest rates one has to know the price yield relationship.
The Price Yield Curve is a plot of the bonds required rate of return to
its corresponding price.
It is not a straight line, its a convex.
NOTE: - The price of a straight bond varies inversely with changes in

interest rates:
-
When interest rates increase bond prices fall.
When interest rates decrease bond prices rise.

(a) Long Term Bonds - These are more price sensitive to a given
change in yields than the short term bonds.
(b) High Coupon Bonds - These are less price sensitive to a given
change in yields as compared to lower coupon bonds.
-
The value of a bond in the market place is rarely constant over

life i.e. it fluctuates.
When you calculate the price of a bond you are calculating the
maximum price you would want to pay for the bond given the
bonds coupon rate in comparison to the average rate most
investors are currently receiving in the bond market.
Bonds can be priced at: o
Premium
Discount
Par
(c) Premium
If the bond price is higher than its par value the bond will sell at a
premium its coupon rate is higher than the required yield or
prevailing rates.
That is Coupon rate yield
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(d) Discount
If the bond price is lower than its par value the bond will sell at a
discount the reason being coupon rate will be lower than the yield.
(e) Par
This means the interest rate of the bond equals the prevailing rate.
If the coupon rate on the bond equals the prevailing interest rates
the bonds trades at par.
That is Coupon rate = yield
2.
VALUATION OF SECURITIES
2.1. Bond Valuation

(a). Pricing of Redeemable Bonds
Bond Price
C
C
C
M
+
+ ......
+
(1 + i ) (+1) 2
(1 + i ) n (1 + i ) n
1
n
(1 + i )
M
Cx
+
i
(1 + i ) n
Where:-
Coupon Payment
required yield / interest rate
number of payments
maturity value / par value / face value
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For Interest payment paid more than once a year we effect the formulae
below
Bond Price

1
1
(1 + i ) n f
f
C
x
i
f
f
M
i
(1 + ) n f
f
Where:-
frequency
If its semi-annually f will be 2

If its quarterly f will be 4
Example 1:
Calculate the price of a Bond with a par value of $1,000.00 to be paid in 10
years, a coupon rate of 10% and a required yield of 12%.
Assume that coupon payments are made semi-annual to bond holders and
that the next coupon payment is expected in 6 months.
Solution:
Bond Price

1
1
(1 + i ) n f
f
C
x
i
f
f
M
i
(1 + ) n f
f
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1
0
,
12
10
2
(1 +
)
100
1000
2
x
+
12 2
0,12
2
0,12
1
+
2
2
[0,688195 273] + 311,80472
50 x
573,50 + 311,80
885,30
0,06
Example 2:
25 years ago ZESA issued an annual coupon payment bond with a 10%
coupon rate and a $1,000 par value.
The bond has now 10 years remaining until maturity.
Due to the change in the interest rates and market conditions the required
rate of return on the Bond is 8%.
What is the intrinsic value of the Bond?
Solution:
Intrinsic Value
1
n
(1 + i )
M
C
+
i
(1 + i ) n
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1
10
(1 + 0,08)
1,000
100
+
0,08
(1 + 0,08)10
100
[1 0,463193488] + 463,193488
100
[0,536806512] + 463,193488
671,01 + 463,193488
$1,134.20
0,08
0,08
(b). Pricing of Zero Coupon Bonds
Bond Price
(1 + i )n
Where:-
maturity value / par value / face value
number of payments
Example:
Calculate maturity value of a zero coupon bond maturing in 5 years
that has a par value of $1, 000.00 and required yield of 6%.
Solution:
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Bond Price =
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Bond Price
(1 + i )n
i
1 +
f
1, 000
(1 + 0,06)5
n f
1, 000
0,06
1 +
1, 000
(1,06)5
$747,26
5 2
1, 000
(1,03)10
$744,09
Example:
Calculate maturity value of a zero coupon bond that matures in 15
years from now if par value is $1, 000.00 and the required yield is
9.4%.
Solution:
Bond Price
(1 + i )n
1, 000
(1 + 0,094)15
1, 000
(1,094)15
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$259.86
(c). Pricing of Irredeemable Bonds
C
i
Coupon Payment
Bond Price
Where:-
Example:
In 1990 a company issued a number of $100 par value 0, 80 irredeemable
debentures.
Calculate the amount investors will be willing to pay for such a debenture in
2004 if the prevailing interest rate is 11%.
Solution:
Bond Price
C
i
100 8%
100%
0,08
0,11
$72,73
2.2. Bond Yields

Bonds are traded on the basis of their prices but are compared in terms of
their yields.
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The three sources of return that may compromise a yield on a bond at:
Periodic Coupon Interest.
Capital gains resulting from buying at a different price then the one
received when the security is sold / matures.
Re-investment Income from investing periodic cashflows.
1. Current Yield
Current yield is the most basic measure of the yield.
It is the
Coupon payment
Current price of Bond
Coupon
Market price
Example:
Suppose that a 15 year $1,000 par value 7% semi-annual coupon bond is
currently trading at $1, 1000.
What is the current yield on this bond?
Solution:
Current Yield
Coupon
Market price
7% of 1,000
1,100
70
1,100
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6,36%
Current yield is used to estimate the cost of profit from holding a bond.
Example: - if other short term interest rates are higher than the current
yields, the bond is said to carry a running cost or negative carry.
Disadvantages of Current Yield
(a). The current yield does not take into account potential gains or losses
resulting from the difference between the current market price of a
bond and its value upon maturity.
(b). It does not take into account time value for money.
2. Yield to Maturity (YTM)

Yield to Maturity is the measure of a total return that will be earned on
a bond if it is bought now and held to maturity.
It takes into account:-
The pattern of coupon payments.
The bonds term to maturity and
The capital gains or losses arising over the remaining life of a

bond.
Formulae:
Bond Price
(1 + YTM )1
(1 + YTM ) 2
+ ......
(1 + YTM ) n
(1 + YTM ) n
Short Formulae:-
Year to maturity =
P PB
C+ v
n
1
(Pv + PB )
2
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Where:-
Coupon
Pv
Par Value
remaining years of maturity
PB
Price of the Bond
NB: Usually YTM is not given but bond price will be given.
The YTM is calculated by iteration. It is the discount rate that equates the
present value of all the bonds expected cashflows with the current market
price of a bond.
Example:
A bond is currently trading at a price of $96.50 with a coupon payment of
$8.75 paid semi-annually. I has exactly one year before maturity.
Calculate the YTM.
Solution:
Year to maturity
P PB
C+ v
n
1
(Pv + PB )
2
8,75 +
100 96.50
1
1
(100 + 96.50)
2
12,47%
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Advantages of Yield to Maturity

(a). It takes into account the potential gains or losses associated with
holding the bond to maturity.
(b). It takes into account that coupon receipts can be re-invested and
hence further interest rates.
Disadvantages of Yield to Maturity
(a). It assumes that a bond is held to maturity. Typical investors do not
hold bonds to maturity.
They are much more interested in holding periodic returns which
depends on the bonds price when it is sold in relation to the purchase
price.
(b). The YTM is a promised yield in that it assumes a bond regardless of
its credit rating will pay off the promised cash flows. Hence the YTM
will only be realised if the issuer does not default.
(c). The YTM assumes a flat yield curve meaning that it assumes all
interest rates will stay the same through out the period and that
coupons are re-invested at that constant rate.
3. Yield to Call
Callable bonds might not reach maturity for the very reason that they
may be called before maturity.
Hence that yield to call was developed to measure the return on a bond
if it where to be called on a particular call date.
Formulae
Yield to Call
PCB
P
C + Call
nc
1
(PCall + PCB )
2
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PCall
Call price of the bond
PCB
Price of callable bond (Price at which bond is

trading currently)
nc
Number of periods until the call ends.
Example:
What is the YTC of a 6% coupon, 5 year bond priced at $98 that is
callable in 3 years at $105?
Solution:
Yield to Call
PCB
P
C + Call
nc
1
(PCall + PCB )
2
6+
=
105 98
3
1
(105 + 98)
2
7
3
101,50
6+
8,21
Advantages of Call to Yield

It takes into consideration the coupon interest, capital gains and reimbursement of cash flow.
Disadvantages of Call to Yield
(a). It assumes that the interest will hold the bond until the next call date
and that the issuer will call the bond at that time.
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(b). It assumes that the interest received from the bond will be re-invested
at the yield to call rate.
3.2.
Risk Associated With Investing In Bonds

1. Interest Rate Risk
This is the risk that an increase in interest rates will cause the price of
the bonds to fluctuate.
2. Call Risk
This is the risk that a bond will be paid off before its maturity date.
3. Re-investment Risk
This is the risk that cashflows or income generated might have to be reinvested at lower yields if interest rate falls.
4. Default Risk
This is the risk that the issuer will fail to make interest for principal
payments when they fall due.
5. Down Grade Risk
This is the risk that the price of the bond might fall because the credit
rating agencies have reduced the credit rating of the bond issuer.
6. Liquidity Risk
This is the risk that the bond will not be sold so quickly because the
market is in liquid.
7. Re-structuring Risk
This is a risk that arises from the potential conflict of interest between
different claimants on firms assets when a company restructures.
8. Exchange rate Risk
If person is holding foreign bonds and currency of that bonds exchange
rate fluctuates it affects the value of the bond.
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9. Inflation Risk
When inflation increases value of the bonds decreases.
10. Event Risk
This is the risk that some unusual events will cause the price of bonds
to fall.
3.3.
Equity Valuation
Ordinary Shares / Common Stock
-
Common stock are equity securities that are issued by corporations
An investor who purchases ordinary shares in a company becomes part

owner of that company
The level of ownership will depend on the number of shares purchased

as compared to the total number of shares that has been issued by the
firm.
Characteristics of Ordinary Shares

(a). Control
-
Ordinary Shareholders are the owners of the company and as such

they have control of the company
This control is exercised through their voting powers on specific

issues at shareholders meetings
(b). Income
Ordinary Shareholders are entitled to a dividend but a company and its
directors are under no obligation to declare a dividend.
(c). Priority
In the event of a company being liquidated ordinary shareholders stand
last in the line to receive proceeds of liquidation as they are the residual
owners of the business. All other shareholders have to be paid before
they can receive their proceeds.
(d). Maturity
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Equity Capital is a permanent form of financing. It does not have a

maturity date and therefore the repayment of the initial amount is not
required.
(e). Tax Treatment
Dividends payments to common shareholders are not tax deductable,
i.e. they are taxed on dividends.
Valuation of Ordinary Shares
The value of an ordinary share is derived from the present value of all future
expected benefits it is expected to provide he expected future value comes in
two forms namely:-
Expected Cash Dividends
Capital Gains or losses due to change in price.
Models of Valuing Ordinary Shares

1. Zero Growth Model
This is the simplest approach to shares valuation which assumes a
constant non-growing dividends dream
P0
D1
Ks
Where:
P0
The value of Ordinary Share
D1
Amount of annual dividend
Ks
the required rate of return on common stock
Example
Edgars expects to pay a dividend of $3.60 at the end of each year
indefinitely into the future.
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If investors require 12% rate of return, what is the intrinsic value the
ordinary shares at Edgars.
Solution
P0
D1
Ks
3,60
0,12
$30.00
2. Constant Growth Model
P0
D0 (1 + g + )
Ks g
Where:
Growth Rate
D0
Dividends that has just been paid
Ks
Required rate of return
Example
Kingdom Bank has just paid a $2 dividend. Analysts expect the firms
dividend to grow at a constant rate of 6% per annum.
If investors require a 14% return on investment, what is the intrinsic
value the Kingdom common stock?
Solution
P0
D0 (1 + g + )
Ks g
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2(1 + 0,06)
0,14 0,06
26,5
3. Variable Growth or Supernormal

The zero and constant growth model do not allow for any shift in the
expected growth rate. However in reality the growth rate might shift up
and down or cease due to change on company expectations.
The variable growth model incorporates for change in the dividend
growth rate.
P0
D (1 + g1 )t
(1 + K s )t
Pn
(1 + K s )n
Where:
D0
Dividends that has just been paid in period zero
g1
Supernormal Growth Rate
g2
Normal Growth Rate
Dn + 1
1st Dividend at the resumption of normal growth
Pn
Terminal price of the stock
Pn
Length of the supermodel growth period
D (n + 1)
(K s g 2 )
Example:
Analysts expect dividend of Econet wireless to grow at a rate of 20% for
the next 4 years and at a rate of 5% there after.
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The company has just paid a dividend of $2 per share. If investors

require a 12% rate of return, what is the value of Econets common
stock today?
Solution:
Step 1:
Find the present value of the dividend during the supernormal growth
period.
=
D0 + (1 + g1 )t
(1 + K s )t
2 (1 + 0,20 )1
(1 + 0,12)1
2 (1 + 0,20)2
(1 + 0,12)2
2 (1 + 0,20 )3
(1 + 0,12)3
2 (1 + 0,20 )4
(1 + 0,12)4
2,142857143 + 2,295918367 + 2,459912536 + 2,63565300
9,534
Step 2:
Find the present value of the terminal price at the end of the
supernormal growth period.
Note:
Pn
Pn
P4
D (n + 1)
(K s g 2 )
4,15 (1 + 0,05)
0,12 0,05
P4
D (n + 1)
(K s g 2 )
= 62,25
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Pn
(1 + K s )n
62,25
(1 + 0,12)4
= 39,56
Step 3:
Sum the present value of both the dividend during the 4 year
supernormal growth period and the terminal price in year 4.
=
9,534 + 39,56
49,09
Example:
Cealsys is experiencing a period of rapid growth. Earnings and dividends
are expected to grow at a rate of 15% during the next two years at 13% in
the 3rd year and a constant growth rate of 6% there after.
The companys last dividend was $1.15 and the required rate of return on
stock is 12%.
Calculate the value of share today.
Solution:
P0
D (1 + g1 )t
(1 + K s )t
Pn
(1 + K s )n
Step 1:
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Find the present value of the dividend during the supernormal growth
period.
=
D0 + (1 + g1 )t
(1 + K s )t
1.15 (1 + 0,15)1
(1 + 0,12)1
1.15 (1,15)1
(1 + 0,12)1
1.15 (1 + 0,15)2
(1 + 0,12)2
1.15 (1,15)2
(1 + 0,12)2
1,1808 + 1,2124 + 1,2221
3,615
1.52 (1 + 0,13)1
(1 + 0,12)3
1.52 (1,13)1
(1 + 0,12)3
Step 2:
Find the present value of the terminal price at the end of the supernormal
growth period.
Note:
Pn
Pn
(1 + K s )n
D (n + 1)
(K s g 2 )
1,7176 (1 + 0,06 )
0,12 0,05
= 30.34
Pn
(1 + K s )n
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30,34
(1 + 0,12)3
= 21,59
Step 3:
Sum the present value of both the dividend during the 4 year supernormal
growth period and the terminal price in year 4.
=
21,59 + 3,62
25,21
Advantages of Dividend Discount Models

-
Simplicity is use
Disadvantages of Dividend Discount Models

-
Models are only applicable to dividends paying stocks
Model requires that the cost of equity is greater than the growth rate
otherwise the model will give nonsensical answers. Sometimes stocks
experience periods of supernormal growth were the growth rate will
exceed the cost of equity
The model assumes growth to be constant. However in reality growth

cannot be expected to continue indefinitely.
Preference Shares
-
These are hybrid securities in that they have some characteristics of

debt & equity.
Preference shares promise a fixed dividend and in this way they can
be likened to debt.
However unlike debt preferred dividends are not deductable for tax
purposes. Hence it has a higher cost of capital than debt.
Almost all preferred stocks have a cumulative feature providing for

unpaid dividends in any one year to be carried forward.
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A company has to pay its accumulated arrears on preferred stock

before it can pay a dividend on its common stock.
Preference shareholders are not given any voting rights in the

company because of their prior claim on assets and income.
Types of Preference Shares

(a). Participating Preference
These shares are entitled to the fixed dividends but in addition they
share in the remaining profits in some predetermined portion to the
ordinary shares.
(b). Redeemable Preference Shares
These are similar to normal preference shares except that the
company has the option to redeem them at a specified price on a
particular date or a given period of time.
(c). Convertible Preference Shares
These are similar to normal preference shares except that the holder
has right to exchange them for ordinary or other security according to
pre-arranged terms.
4. Valuation of Preferred Stock
Vp
Dp
Kp
Where:-
Vp
Valuation of Preferred Shares
Dp
Dividend
Kp
Required Rate of Return
Example:
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Suppose Delta Corporation has a $100 par value preferred stock that
pays an annual dividend of $7. If investors require an 8% return on this
stock, what will be the intrinsic value?
Solution:
Value of Preferred Stock
Dp
Kp
7
0,08
87,50
Example:
Assume the current market price of Schweppes preferred stock is $85 with
a dividend of $7.
What will be the expected rate of return if investors require rate of return of
8%. Should the investor consider buying the preferred stocks?
Solution:
Value of Preferred Stock
Dp
Kp
85
7
x
7
85
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Rate of Return
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0,0823
8,23%
The investor can consider buying the shares as the Rate of Return is
higher than what they expect.
Advantages of Preferred Stock
-
Flexibility
Dividends do not have to be paid in the year in which profits are
bad, while this is not the case on interest payments on long term
debt.
It avoids dilution of ownership. This is because preference shares

do not carry any voting rights. Hence they avoid diluting control of
existing shareholders. Which is what happens when ordinary
shares are issued?
Since preferred stock has no maturity this reduces cashflow drain

from repayments of principal that occurs with debt issues.
Preferred shares will lower the companys gearing ratios.
The issuing of preference shares does not restrict the companys

borrowing power.
Disadvantages of Financing Preferred Stock

-
The after cost shares of preferred stock is higher than the after tax
cost of debt. Furthermore because of the possibility that dividends
can be passed preferred stock shareholder often require a higher
return.
Fixed obligation of paying dividends. Although preferred dividends

can be passed the company is still under obligation to pay them in
subsequent years.
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Option Valuation
-
Options are derivatives
Derivatives are securities whose value is determined from the prices of

underline securities.
These assets are called contingent claims because their pay offs are
contingent on the prices of other securities.
Definition of Option
-
It is the contract that gives the holder the right but not the obligation to
buy or sell an asset at a pre-determined price known as the strike price
or exercise price on or before some expiration date.
Most options are American meaning that they can be exercised at any
time before or on the expiry date.
European Options allow only exercising on the expiry date.
Example Puttable Bonds
(a). Call Option

-
It gives its holder the right to buy an asset or security at a specified

date and at a specified price.
Happens when one anticipate price is going to shoot and one will
still be able to buy them cheaper
The holder of an option is not under any obligation to exercise it,

therefore call options are assets as the embody him the right to
buy and this right has value.
The Call Righter:

-
Sells all call options at said the right calls.
The righter of the call option receives the purchase price or

premium.
The premium is payment against a possibility that a righter may

have to deliver the asset in return for an exercise price lower than
that of the market value of the asset.
(b). Put Option

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If you think market will fall you buy put option.
A put option gives the holder the right not the obligation to sell an
asset at a specified price at a specified date.
The holder of a put option is not under any obligation to exercise it,
therefore the put option are assets as they embody him to sell and
this right has value
NOTE: These are used to limit ones risk / loss. The righter of the put
thinks the market will go down.
The Put Righter:
-
The righter of the put option will receive a premium for righting the put.
(c). Trading of Options

-
Options can be traded on the over the counter markets. This has
the advantage that the terms of the option contract can be tailor
made to meet the needs of the traders.
However the cost of establishing the over the counter option

contract are very high
Options Contract can also be traded on organised exchange e.g.

Chicago Board Options Exchange.
They are highly standardised contract specifications trading in

specific quantities of securities for delivery in specific months.
Valuation of Option Contracts

A value of an option can be broken down into two parts.
Intrinsic Value
Time premium
(a). Intrinsic Value

It depends on the price of the asset underlying the option in relation to
the call option exercised price.
Formulae:
Call Option:
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SK
KS
Put Option:
P
Where:-
Current Stock Price
Exercised Price
As long as the difference is positive the option has value.
Otherwise P = Zero or C = Zero .
This is because the options can not have a negative value.
(b). Terms describing option
In the Money
Describes the option where exercise would be profitable.
Out of the Money

Describes the option where exercise would not be profitable.
At the Money
Describes the situation where the asset price and exercise price are
equal.
(c). Time premium

This is a function of the probability that the option could change in
value by the time it expires.
The time premium depends upon four variables:
The amount of time before expiration
Volatility
Time Value of Money
Yield on the underlined asset
Example:
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In April 2004 maturity Call Option on a share of Motorola Stock was an

exercise price of $90 per share, sales on 16 December 2003 for $7.
The option is to expire on April 15 2004. Until the expiration day the
purchaser of the call is entitled to buy shares for Motorola for $90.
On December 16, 2003 the Motorola stock is trading / selling at $89, 25.
(a)
Calculate the intrinsic value on 16 December 2003?
(b)
Calculate the intrinsic value if Motorola trades for $100 on the

expiration date and the profits that will accumulate to the investor.
Solution for (a):

Call Option (C )
Therefore (C )
SK
89,25 90
0,75
Zero
(0)
Note: An option can not be trade negatively therefore call option

equal to zero.
Solution for (b):
Call Option (C )
SK
100 90
10
10
Therefore Intrinsic Value
Profit
Intrinsic Value Buying Value
10 7
$3
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Example:
In April 2004 maturity Put Option on Motorola with an exercise price of $90
per share, sales on 16 December 2003 for $7.
It entitles the owner to sell the shares of Motorola for $90 at any time until
15 April 2004.
If on December 16, 2003 the Motorola stock is trading / selling at $89, 25.
(a)
Calculate the pay off to the put holder.
(b)
Calculate the pay off on the expiration date if the Motorola Stock
trades at $80
Solution for (a):

Put Option ( P )
SK
90 89,25
0,75
There is no profit in this situation its out of the money

Note: An option can not be trade negatively therefore call option
equal to zero.
Solution for (b):
Call Option P
SK
90 80
10
10
Therefore Intrinsic Value
Pay-off
Intrinsic Value Buying Value
10 7,50
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$2.75
In this situation its in the money
3.
CORPORATE VALUATION AND CORPORATE STRUCTURE
3.3. The Cost of Capital

Debt, Preferred Stock and Common Equity are the capital components of
the firm. If a company decides to increase its total assets then that increase
will be financed by an increase in one or more of these capital components.
The cost of each of these components is called Component Cost of
Capital.
1. Cost of Debt ( K d
)
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Formulae:
Cost of debt ( K d
Kd (1 t )
Where t = Marginal Cost of Debt (marginal firms tax rate

-
It is the interest rate on the companys new debt.
This is the yield to maturity on existing debt,
It is also called the before tax component cost of debt
It is the current cost of debt or interest rate the firm would pay if it
issues debt today.
The yield to maturity is the rate of return the existing bond holders
expect to receive and it is also a good estimate of the return that
new bond holders would require.
The after tax cost of debt is used to calculate the weighted average
cost of interest
It is the interest rate on the new debt less the tax savings due to the
deductibility of interest.
Example:
Edgars is planning to issue new debt at an interest rate of 8%. Edgars is in
the 40% marginal tax rate.
What is the companys cost of debt capital.
Solution:
Cost of debt ( K d
Kd (1 t )
= 0,08 (1 0,4)
= 0,08 0,6
= 4.8%
2. Cost of Preferred Stock K ps
3. Cost of Retained Earnings ( K s )
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(a). Capital Pricing Model (CPM )
Ks
R f + Rm R f
Where:
Rf
Risk Free Rate of Return
Rm
Expected rate of return on the market
Beta Stocks risk measure
Risk Premium
(Rm R f )
(b). Bonds Yield + Risk Premium Approach ( K s )
Ks
= bond yield + risk premium approach
Example:
Suppose the Edgars interest rate on long term loan is 8% and the
risk premium is estimated to be 5%.
Calculate the companys estimated cost of the retained equity?
Solution:
Ks
= bond yield + risk premium approach
= 8% + 5%
= 13%
(c). Dividend Yield + Growth Rate Approach ( K s )

Formulae:
Po
D1
Ks g
Note that there is need to re-arrange the formulae and make K s

the subject of the formulae.
Ks
D1
+g
P0
Where:-
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D1
P0
Value of the share
Growth Rate
Formulae to find growth rate:
= return on equity ( ROE ) + retention rate
Example:
Suppose the Edgars Share sells for $21 and next year dividend is
expected to be $1.
Edgars has a return on equity (ROE) of 12% and they are
expected to pay out 40% of their earnings.
What is the cost of the retained equity?
Solution:
Po
D1
Ks g
or
Ks
D1
+g
P0
= return on equity ( ROE ) + retention rate
= 0,12 0,6
= 0,072
Ks
D1
+g
P0
1
+ 0,072
21
= 0,1196
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= 11,96%
(d). Cost of Newly Issued Equity ( K e )
Formulae:
Ke
D1
+g
P0 (1 f )
Where:-
Ke
Cost of Newly Issued Equity
D1
Floatation Cost
P0
Value of the share
Growth Rate
Example:
Suppose the Edgars Share sells for $21 and next year dividend is
expected to be $1.
Edgars has a return on equity (ROE) of 12% and they are expected
to pay out 40% of their earnings.
Assuming the previous growth rate of 7, 2% and that Edgars has a
floatation cost of 10%.
Calculate the new cost of Equity.
Solution:
Formulae:
Ke
D1
+g
P0 (1 f )
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1
+ 0,072
2 (1 0,1)
= 0,1249
= 12,5%
(e). Weighted Average Cost of Capital (WACC )
WACC
= W d K d (1 t ) + W ce K e + W ps K ps
Where:
Wd
Weight of Debt
Kd
Cost of Debt
K d (1 t ) =
Cost of Debt (after tax)
W ce
Weight of Common Stock (equity)
Ke
Cost of newly issued equity
W ps
Weight of Preferred Stock
K ps
Cost of Preferred Stock
WACC is used primarily for making long term capital investment

decision.
It reflects the firms average cost of long term financing.
The weights are based on the firms target capital structure.
The weights should be based on the market values of the firms

securities.
If the firms book value figures reasonably approximate the market

values then you can use the book value weights.
Example:
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Suppose Edgars target Capital Structure comprises 45% debt, 50%

equity and 5% Preferred Stock.
Calculate the companys weighted Average Cost of Capital (WACC).
Solution:
From previous example the following has been established:
K d (1 t ) =
4, 8%
Ke
12, 5%
K ps
8, 42%
Wd
45%
Kd
50%
W ps
5%
Next step is to substitute these figures into the formulae below and the
weights are established from the given example.
WACC
= W d K d (1 t ) + W ce K e + W ps K ps
= (0,45 0,048) + (0,50 0,125) + (0,05 0,0845)
= 0,0216 + 0,0625 + 0,00421
= 0,08831
= 8,83%
Factors that affect Firms Cost of Capital

A. Factors that a Firm Cannot Control.
1. Level of Interest Rates
If interests rates in the economy rise the cost of debt increases
because firms will have to pay bond holders a higher interest rate in
order to obtain debt capital.
2. Market Risk Premium
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This is the perceived risk market in stocks along with the investors
inversion to risk. Individual firms have no control over this factor but
it affects the cost of equity.
3. Tax Rates
Companies have no control over tax rates or tax bands.
4.
Dependent on the overall countrys economic conditions
When inflation rate is increasing, cost of doing business is more

expensive hence investors and lenders will demand a higher rate
of return which results in a higher cost of capital
When the economy is on its upbeat trend where demand for

funds increases and supply of funds are limited or not increasing
proportionately to demand then the lenders and financiers
increase their lending rate which will also increase a firms cost of
capital
B. Factors that a Firm Can Control.

1. Capital Structure Policy
The weights used to calculate the WACC are based on the
companys target capital structure.
Therefore a change in the companys capital structure can affect
its cost of capital.
2. Dividend Policy
The higher the pay-up ratio of a firm then the more it will have to
resort to expensive common stock financing similarly the more
a company retains the more it can rely on retained earnings.
Whatever Dividend Policy a firm will adopt this will have a
bearing on the cost of capital.
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3. Investment Policy
Dependent on the companys business risk

The higher a firms business risk, the higher the investors
required rate of return and the cost of capital will also
increased.
Dependent on the companys financial risk

Where a company is highly geared, the lending institutions will
consider the firms financial risk to be quite high hence would
require a higher rate of return from the firm hence increasing
the firms cost of capital
Dependent on the Size of Financing

Where the firms size namely its assets or sales turnover
cannot justify the size of financing needs, the lenders will be
more cautious and will impose a higher cost of fund which will
then increase the companys cost of capital
Example:
Hunyani has the following Capital Structure:Debt
25%
Preferred Stock
15%
Common Stock
60%
Hunyanis tax rate is 40% and investors expect earnings and dividends to
grow at a constant rate of 9% in the future.
Hunyani paid a dividend of $3.60 per share last year and its share price
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is currently $60. Treasury bonds yield 16%.

An average stock has a 14% expected rate of return. Company beta is
1.51.
The following terms apply to new security offerings:New preferred stock can be sold to the public at a price of $100 per share
with a dividend of $11.
Floatation cost of $5 will be incurred. Debt could be sold at an interest
rate of 12%.
Required:
Find the companys cost of debt, preferred stock and common stock.
Assume that Hunyani does not have to issue any additional shares of
common stock. What is the WACC?
3.5.
Theory of Capital Structure

-
Capital Structure relates to the mix of long-term finance.
When a company expands it needs capital to finance the additional

assets.
The capital can be derived from debt, equity or combination of both.
This topic of capital structure serves to see how the capital structure of
a company will affect the companys risk and how companies should
finance their operations.
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1. Target Capital Structure.

-
A firms target capital structure is a debt to equity ratio that a

company tries to maintain over a period of time.
If the companys current debt ratio should fall below the target
level, issuing new debt will satisfy the new capital.
If the firms current debt ratio increases above the target level, the
company will be required to raise new capital by retaining earnings
or issuing new equity.
2. Optimal Capital Structure.

-
When a company is setting its target capital structure it has to

consider the trade-off between risk and return associated with the
use of debt.
The use of debt increases risk to shareholders and the higher the
risk associated with the use of debt will depress share prices.
The firms optimum capital structure is the one that balance the
influence of risk and return and maximises the firm share prices.
Cost
K2
Lowest level
of WACC
WACC
Kd
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Leverage
Value
Share prices highest
Share Price
Optimal Capital
-
Leverage Debt Equity
Cost of equity increases with increasing debt but more rapidly than
the cost of debt, the increase is to compensate for the risk taking.
Cost of debt remains low due to the tax shield but slowly increases
as the company increases the gearing to compensate lenders for
the increasing risk
3.4.
Factors that influence Firms Capital Structure Decision

(a)
Business Risk
This is the risk that is inherent in the firms operations assuming zero
debt.
It is the risk that the company will not be able to cover its operating
costs.
The main features affecting business risk are:-
Demand variability
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The more variable a firms sales are the higher the business risk.
-
The sales price variability

Volatile market price will expose the firm more business risk than
that experienced by companies whose output prices are more
stable.
The input price variability

Companies with uncertain input costs are exposed to high
business risk.
Ability to adjust output prices for changes in input prices e.g. those
who sale controlled goods.
Operating Leverage
The higher the % of the firms costs that are fixed then the greater
the business risk.
Tax Position
-
The reason why companies use debt is because of the tax deductibility
of interest payments
The deductibility of interest lowers the effective cost of using debt.
However if a company is already in a low tax bracket because its

income is sheltered fro taxes by depreciation, interest on current debt
or a tax loss may carry forward, then the use of additional debt will not
be advantageous.
Financial Flexibility
Reasons why you require the capital for will determine whether you get long
term or short term debts.
Conservatism of Aggressiveness of Management
-
Aggressive Managers will tend to borrow more they do not hesitate to

take a risk.
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Conservative managers are not risk takers, they would not want to
increase risk, and they would rather opt to borrow shareholders.
3.5.
Theories of Capital Structure: Miller and Modigliani Theory

In the original paper of 1958 Franco Modigliani & Morton Miller (M & M)
assumed a world of no taxes and concluded that the value of the firm is not
affected by its capital structure.
They argued that in a world with no taxes companies can not benefit from
leverage or debt financing.
1. Assumption Made
(a) Perfect capital markets no taxes, all investors
(b) All companies are clustered or grouped into equivalent return
classes meaning that all firms within a class have the same degree
of business risk.
(c) Business risk can be measured by EBIT and firms within the same
degree of risk are said to be in a homogeneous risk class.
(d) All investors have homogeneous expectations about future earnings
and the riskness of those earnings.
(e) There are no personal or corporate taxes.
(f) There are no bankruptcy costs.
(g) The debt of companies and investors is risk free and so the interest
rate on all debt is the risk free rate of return.
(h) All cash flows are perpetuities meaning all companies have zero
growth.
2. Proposition of M & M in World with Taxes
This proposition says the value of any firm is found by capitalising its
expected net operating income of EBIT at a constant rate.
EBIT
K su
EBIT
WACC
Where:-
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K su
Vu
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Value of a Company / Firm

Required Rate of Return.
= Vl
Where:
Vu
Value of an ungeared / unlevered firm
Vl
Value of a geared / levered firm
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Assume that all the M & M assumptions hold, there is no corporate or
personal taxes. The EBIT is $12 million for each company.
What value will M & M estimate for each firm?
Solution:
EBIT
K su
12
0,3
= $40 million
Value of Leveraged company = Value of unleveraged company
Vl
-
= Vu
According to their proposition in the world of no taxes, the value of

a firm is independent of its leverage.
According to their proposition WACC for the firm is completely

independent of its Capital Structure. The WACC of the firm
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regardless of the amount of debt it uses is equal to the cost of

equity it would have if it uses no debt.
-
The market capitalizes the value of the firm as a whole. There is no

distinguision between debt and equity. The total value of the firm is
independent of its capital structure.
The total market value of the firm is given by capitalising earnings

at a discount rate appropriate for its risk class.
3. Proposition of M & M in World with no Taxes

The cost of equity of a levered firm is equal to the cost of equity of a
unlevered firm in the same risk class plus a risk premium whose size
depends on both the differential between the unlevered firms cost of
equity and the amount of debt being used.
K SL
K su + Risk premium
K su + ( K su K d ) D
Where:
K SL =
Cost of equity for levered firm
K su =
Cost of equity for unlevered firm
Market value of a firms debt
Market value of a firms equity (excluding debt)
Kd
Cost of debt
Example:
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Calculate cost of equity for Longman.

Solution:
Cost of equity for Longman
= K su + ( K su K d ) D
S
= 0,30 + (0,30 0,15)
15
(40 15)
= 0,39
= 39%
NOTE:
According to this proposition Number 2 the inclusion of debt in the
Capital Structure will not increase the value of the firm because
benefit of using cheaper debt will be exactly offset by an increase in
the riskness of the cost of equity.
Cost of Debt:
The cost of debt has two parts: -
It has the explicit cost thats represented by the interest rates.
The implicit or hidden cost which is represented by an increase in

the cost of equity which increases when the proportion of debt to
equity increases.
Example:
Calculate the value of Longman taking into account that it had debt in
its capital.
Solution:
Calculating value of Longman equity:
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VL
EBIT KdD
K SL
12 (0,15 x 15)
0,39
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= $25 million
4. Arbitrage Support of a Proposition
-
To support the above proposition M & M cited the presence of

arbitrage in the capital markets
Arbitrage merely prevents perfect substitutes from selling at

different prices in the same market.
In this instance, perfect substitutes are deemed to be two or more

similar firms operating in the same risk class but differ only in terms
of capital structure.
M & M argued that the total value of these firms has to be the same
otherwise arbitrage will enter the market and derives the values of these
two companies together.
Example:
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Calculate the WACC of Longman since Unilever one is 30%

(RememberV l
= Vu )
Solution:
EBIT
WACC
40
12
WACC
WACC =
12
40
0,30
30% -
Same as Unilever
5. Proposition of MM in World with Taxes

In 1963 M & M published a certain article which assumed the existence
of corporate taxes with the inclusion of taxes they argued that leverage
will increase the value of the firm.
This arises because interest is a tax deductable expense and therefore
in a leveraged company operating income flows through the investors.
(a) Proposition 1 of M & M

The value of a levered firm is equal to the value of the unlevered
firm in the same risk class plus the gains from using leverage which
is the value of the tax shield.
VL
V u + TD
Where: -
TD
Tax shield
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VL
Value of Levered Firm
Vu
Value of Unlevered Firm
TD
Corporate Tax Rate x Amount of Debt
Vu
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EBIT (1 T )
K su
Example:
Suppose both companies are now subject to a 40% tax in their
earnings but all the facts in the previous section still apply.
What value would M & M now estimate for each firm?
Solution:
Value of unlevered firm:-
Vu
EBIT (1 T )
K su
0,12 (1 0,40)
0,30
0,24
24%
Value of levered firm:-
VL
Vu + TD
24 + (0,4 15m )
24 + 6
30%
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According to this proposition the value of the firm is maximised when

the company uses 100% debt financing.
(b) Proposition 2 of M & M
The cost of equity of a levered firm is equal to the cost of equity of
an unlevered firm in the same risk class plus the risk premium
between the cost of equity and the cost of debt and the amount of
debt used (financial leverage) and amount of corporate tax rates.
K SL
K SU + ( K SU Kd )(1 t )
D
S
Example:
(i)
What is the cost of equity for Longman?
(ii)
Calculate the WACC for Longman.
Solution to (i):
Note that S = (30 15 (being cost of debt)
D
S
K SL
K SU + ( K SU Kd )(1 t )
K SL
0,30 + (0,30 0,15) (1 0.40)
0,30 + (0,15) (0,60 ) 1
0,39
39%
15
15
Cost of Equity.
Solution to (ii):
Calculating WACC for Longman
WACC
(Wd Kd ) + (Wke K e )
19
15
0,39 + 0,15 (1 0,40)

30
30
0,24
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24%
3.6. Trade-off Model

The trade off theory states that the company must trade off or balance the
tax advantages of using debt against the cost financial distress.
The theory states that there is an optimum debt ration that maximises the
market value off-setting the benefits of a tax shield against the increasing
cost of financial distress.
1. Definition
Financial distress occurs when a firm has debts. The greater the debts
financing the larger the fixed interest charges and the higher will be the
probability that the company will experience a decline in earnings
leading to financial distress.
2. Direct and indirect Cost of Financial Distress
(a) Direct Cost
It relates namely to costs of bankruptcy.
Bankruptcy Costs
It occurs as value of business declines
The financial conditions of a business deteriorate to the point when
bills are not paid for the value of equity is zero.
The direct bankruptcy costs are primarily legal and administrative
these are payments made to lawyers, accountants and consultants.
(b) Indirect Costs.
Destruction of Value
Arguments between claimants can often delay the liquidation
process.
Bankruptcy can take many years to settle and during this time
machinery rust and buildings may collapse.
Disruption & Management
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The collapse of a company in financial distress will result in the loss

of jobs to managers and other key employees of the company.
Customers & Suppliers
If customers and suppliers sense trouble they will evade the troubled
institution.
3.7.
Signaling Models
This theory recognises that management may have better information
than the investing public and postulate that there is a pecking order of
financing.
1. Pecking Order Hypothesis
It relaxes the assumptionthat perfect markets exists by assuming that
information is not symmetrical.
With the pecking order hypothesis companies will 1st use retained
earnings, than debt then lastly they will issue equity.
(a) Retained earnings / Internally Generated Funds
Companies use retained earnings 1st because they are cheaper than
issuing external debt or equity.
The implication or the signal is that most profitable firms borrow less
because they have sufficient internal funds.
(b) Externally Generated Funds

The debt will be used next because it sends a signal that management
is reluctant to share the success of the firm with new equity holders.
Equity will be used last because according to the signaling theory the
implications of issuing equity is that management perceives trouble for
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future debt payments or that management perceives company will do

well and they are happy to share performance with new shareholders.
PRACTICE QUESTIONS ON CAPITAL STRUCTURE

Example 1:
Mambo industries has six million ordinary shares outstanding with current market
value of $1 per share.
The company also has debt with current market value of $4 million and a current
interest rate of 12%.
The market has annual earnings before interest of $3 million.
The market believes that this performance can be maintained indefinitely.
The company has a policy of distributing all its after tax earnings as a dividend
and corporate tax is 33%
Required:
(a) Calculate the required rate of return of shareholders in Mambo PLC.
(b) Determine the companys Weighted Average Cost of Capital.
(c) Use your estimated WACC figure to verify that the total market value of
Mambo PLC is equal to $10 million.
Solution to Example 1:
World without Taxes
(a) Required rate of return.
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EBIT
KSU
KSU
EBIT
V
3
10
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6 ordinary shares + 4 Debt
= 30%
(b) Weighted Average Cost of Capital
WACC =
EBIT
WACC
EBIT
V
3
10
6 ordinary shares + 4 Debt
= 30%
(c) Verifying that the total market value of Mambo PLC is equal to $10 million.
EBIT
WACC
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KSU
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EBIT
V
3
0,30
10
10
= 10
Example 2
A company is planning a $50 million expansion. The expansion is to be financed
by selling $20 million in new debt and $30 million in new common stock.
The before Tax required return on debt is 9% and 14% on Equity. The company
has a target capital structure of 40% Debt and 60% Equity. The company also has
bonds in issue that pay a 10% semi-annual coupon maturing in 20 years and at
currently trading at $849.54.
Company Stock Beta is 1, 2
The Risk Free Rate is 10%
Market Risk Premium is 5%
The company has a constant growth firm that has just paid the dividend of $2 and
sales for $27 per share and has a growth rate of 890.
Calculate companys Weighted Average Cost of Capital (WACC).
Solution to Example 2
Cost of Debt
Kd (1 t )
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= 0,09 (1 0,40)
= 5,4%
Cost of newly issued Equity
Ke
D1
+g
P0 (1)
2
+ 0,08
27(1)
= 15,41%
Therefore:-
WACC
= W d Kd (1 t ) + Wk e K e
= 0,4 0,054 + 0,6 0,1541
= 0,0216 + 0,09246
= 0,1141
= 11,41%
4.
DIVIDENDS AND RE-PURCHASES
4.1. Dividend Policy

1. Introduction
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The firms dividend policy can be defined as the decision to either

distribute earnings to shareholders or retain them for further
reinvestment into the firm.
2. Types of Dividend Policies
(a) Low regular and extra dividend policy
This is a dividend policy based on paying a low regular dividend,
supplemented by an additional dividend when earnings allow it. The
extra dividend is paid by the firm if the earnings are higher than
anticipated.
(b) Constant payout ratio
With a constant payout ratio dividend policy, the firm establishes
that a certain percentage of earnings will be paid to owners in each
dividend period. The problem with this policy is that if the firms
earnings drop or if a loss occurs in a given period, the dividends
may be low or non existent.
(c) Regular Dividend Policy
This is a policy based on the payment of a fixed dollar dividend in
each period.
(d) Target dividend payout ratio
This is a policy under which the firm attempts to payout a certain
percentage of earnings as a stated dollar dividend, which it adjusts
toward a target payout as proven earnings increases occur.
4.2.
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.
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Compare the following two companies:
Company A
Amount
Per
Share
3
Earnings per
Share
2
Dividends per
Share
1
Time
Company B
Amount
Per
Share
3
Earnings per
Share
Dividend per
Share
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.
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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.
4.3.
Establishing a Dividend Payout Policy

John Linter, in mid 1950s, conducted a survey on how companies
determine their dividend payments. He came up with the following facts:
Firms have long-run target dividend payment ratios. Mature

companies generally pay a higher proportion of earnings, with young
companies paying low payouts;
Managers focus more on dividend change than on absolute levels;
Dividend changes follow shifts in long-run sustainable earnings. Thus

managers smooth dividends;
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).
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The more conservative the company, the more reluctant it is to move

towards its target and, therefore, the lower would be its adjustment rate.
4.4.
Forms of Dividend Payments

Dividend payments can be made out in the following ways.
(a) Cash dividend
This is a dividend paid in cash. A company cannot borrow to finance
dividend payment and neither can it pay dividends from the companys
share capital.
(b) Stock dividend
A stock dividend is the payment to existing shareholders of a dividend in
the form of common stock. Firms pay stock dividends as a replacement
or supplement to cash dividends.
(c) Dividends in specie
These are dividends that are paid out in kind in the form of other assets
in the form of products and services provided by the company or a
subsidiary company.
(d) Liquidating dividends
These are dividends paid in excess of the retained earnings shown on
the income statement.
4.5.
Factors Affecting Dividend Policy

(a) Legal Rules
Dividend payments cannot exceed the balance sheet item retained
earnings. This legal restriction known as the impairment of capital rule
is designed to protect creditors. Without this rule, companies in
distress would distribute most of its assets to shareholders thereby
leaving debt holders and other creditors not catered for.
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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.
(e) 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.
(f) Liquidity
The greater the cash position and overall liquidity of the company, the
greater is its ability to pay a dividend. Cash dividends can only be paid
with cash hence a shortage of cash in the bank can restrict dividend
payments.
(g) 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.
(h) Restrictions in Debt Contracts
These are restrictions employed by the lender to preserve the
companys ability to service debt.
Bond indentures in debt contracts limit dividend payments to

earnings generated after the loan was granted;
Preferred stock restrictions will state that common dividends

cannot be paid if the company has omitted its preferred dividend.
(i) 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
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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.
(j) Investment Opportunities
If a company expects a large number of profitable investment
opportunities, this will lower the target payout ratio and vice versa if
there are few profitable investment opportunities. Similarly the ability to
accelerate or postpone projects will allow a firm to adhere more closely
to a stable dividend policy.
(k) Cost of issuing new stock
If a company will incur high flotation costs by issuing new shares it will
make sense for it to maintain a low payout ratio and finance
investments through retained earnings.
4.6.
Theories of Dividend Policies

There are 3 main schools of thought that serve to explain investor
preferences for dividends.
(l) The Dividend Irrelevance Theory (Miller, Modigliani 1961)
Franco Modigliani and Merton Miller (MM) put the most prominent
argument concerning the irrelevance of dividends. These two
academics argue that the firms value is determined only by its basic
earning power and its business risk. The implication of thereof is that
the value of the firm depends only on the income produced by its assets
and not by how the income is split between dividends and retained
earnings. They were of the opinion that investors keen on dividends
could construct their own dividend policy by selling of a portion of their
shareholding. Hence investors could create their own dividend policy
without incurring costs. It should be noted that this theory was
developed under a strict set of assumptions, which assumed the
absence of taxes, brokerage costs and other market imperfections.
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(m) The Tax Preference Theories (Miller and Scholes, 1978)

This theory sites three tax related reasons as to why investors might
prefer a low dividend payout or none at all.
- The first being that capital gains are taxed at a lower rate as
opposed to the taxes on dividend income. This would imply that
investors should have a strong inclination for capital gains as
opposed to dividend income. According to this assertion it would
follow that tax paying investors are likely to prefer low or no dividend
payouts in order to reduce their annual taxable income. Whereas
shareholders in high tax brackets would opt for shares with low
payouts, leaving high payout stocks to investors subject to low or
zero tax rates.
- The second reason cited is that taxes are not paid on the capital
gains until a stock is sold whereas dividend income will result in an
annual tax liability. Hence this tax liability is deferred which is
advantageous to the investor in that a dollar of taxes paid in the
future has a lower effective cost than a dollar paid today.
- The third reason is that if a stock is held until someone dies; no
capital gains tax is due. These advantages are cited as being good
reasons as to why investors would be prefer companies to retain all
their earnings.
(n) The Bird in Hand Theory (Gordon, Lintner 1963)
This theory argues that investors place more value on dividends,
which are more certain as opposed to capital gains, which will be
received in the future and are more risky. It postulates that investors
would prefer to pay a higher price for a share that offers a greater
current dividend as opposed to receiving capital gains in the future,
which are distant and highly risky.
4.7.
Theoretical Issues that Could Affect Dividend Policy

(a) Information content or signalling hypothesis
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This is based on the notion of information asymmetry. This dispels the

assumption of perfect information and that all investors have free
access to information. It assumes that managers have superior
knowledge of the company and its future prospects as compared to
outsiders. As dividends are paid out from net profits, this theory says
dividends provide information to shareholders on the performance of a
company.
Dividend increases are a signal to investors that the company has
positive prospects in terms of higher future earnings and therefore
dividend increases are accompanied by an increase in share price.
While a dividend cut or no dividend is a bad signal implying poor
investment prospects, which generally leads to a fall in the share price.
(b) Clientele effect
There are companies that do not pay dividends at all. Until recently,
Microsoft and Econet did not pay dividends. However the shareholders
of these companies were assumed to be content with the no dividend
payout policy. One explanation for this is that investors tend to invest in
firms whose dividend policies match their preferences. Shareholders in
high tax brackets who do not need the cash flow from dividend
payments tend to invest in companies that pay low or no dividends.
Whereas those investors that are in low tax brackets, which need cash
from dividend payments tend to invest in companies that pay high
dividends. The clustering of shareholders in companies with dividend
policies that match their preferences is called the clientele effect.
The clientele effect segregates different investors into groups or
clienteles according to their preferences for different dividend payout
policies. It is said that pensioners, university and endowment funds
have a higher preference for cash income and so will prefer to invest in
companies with high dividend payout ratios. Moreover they are in low or
zero tax brackets hence taxes will be of no concern to them. Similarly,
shareholders in their peak earning years might prefer reinvestment as
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opposed to dividends. Those investors with strong needs for current

income would then own shares in high payout firms.
4.8.
Dividend Payment Procedures

(a) Declaration Date
This is the date the directors meet and declare the regular dividend,
issuing a statement similar to the following: On November 9, 2007 the
directors of Art Corporation met and declared the regular dividend of
50cents per share, payable to shareholders of record on December 7,
payment to be made on January 4, 2008.
(b) 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 at close of business on December 7, the company
closes its share transfer registers and makes a list of shareholders as of
that date. Thus the person who holds stock on December 7 is entitled to
a dividend even though he/she sells the after that.
(c) Ex Dividend Date
It is 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 two business days prior to the record date. In the above example,
the ex dividend date is December 5.
(d) Payment Date
This is the date when the company actually mails the cheques to the
holders of record on the payment date.
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4.9.
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Dividend Reinvestment Plans

It is an optional plan allowing shareholders to automatically reinvest
dividend payments in additional shares of the companys stock. There are
two types of Dividend Re-investment Plans, 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.
4.10. Stock Dividends and Stock Splits

(a) Stock Dividend
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
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Retained Earnings
Total Shareholders Equity
Number of Shares
NB:
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$7,000,000
$6,200,000
$10,000,000
$10,000,000
400,000
420,000
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.
(b) 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
Par Value
AFTER
$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
$10,000,000
$10,000,000
400,000
800,000
Total Shareholders Equity

Number of Shares
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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.
(c) 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.
(d) Reverse 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.
4.11. Stock Repurchase
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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 stocks 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.
(a) Advantages of Share repurchases
Repurchase announcements are viewed as positive signals by

investors
because
repurchase
is
often
motivated
by
managements belief that the firms shares are undervalued;
The shareholders can choose to sell or not when a firm distributes

its cash by repurchasing stock. With a cash dividend on the other
hand they must accept the cash dividend and pay the tax;
If a company views having excess cash as being temporary they

can choose to instigate a share repurchase as opposed to
declaring a cash dividend which they might not be able to maintain
in the future;
Repurchases can be used to produce large scale changes in

capital structures by using the funds to repurchase common stock;
Companies that use stock options as an important component of

employee compensation can repurchase shares and use them
when employees exercise their options. This avoids having to
issue new shares thereby diluting earnings.
(b) Disadvantages of Share repurchases
Cash dividends are generally more dependable whereas share

repurchases are not;
Selling shareholders may not be fully aware of all the implications

of a repurchase or they may not have all the information about the
companys present and future activities;
The company may pay too much for repurchased stock to the
disadvantage of the remaining shareholders.
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5.
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LEASING FINANCING
5.1. Lease Financing Defined

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.
5.2. Types of Leases

1. 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 than 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.
2. 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 any 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.
3. 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.
4. Net Lease
In this case the lessee agrees to maintain, insure and pay property tax
for the leased asset. Financial leases are usually net leases.
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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 asset 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.
5.3. Forms of Lease Financing

All Financial lease arrangements fall into Sale and Leaseback, direct
leasing or Leverage leasing.
1. 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.
2. 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.
3. 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.
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5.4. 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 for 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 assets
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
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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 aid 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.
5.5. 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:
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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.
5.6. 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:
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n
C0
t =0
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= LCFt / (1 + k )t
LCF0 + LCFt ( PVIFAkn )
Where:
C 0 is cost of the equipment

LCFt is lease cash flow at time t.
Using interpolation solve for k.
Yr
LCFt
27,500.00
27,500.00
27,500.00
27,500.00
26,190.48
25,000.00
27,500.00
24,943.31
22,727.27
27,500.00
23,755.53
20,661.16
27,500.00
22,624.32
18,782.87
27,500.00
21,546.97
17,075.34
27,500.00
20,520.92
15,523.03
167,081.53
147,269.67
Total
PV @ 5%
PV @ 10%
NPV @ 5% = $19,081.53
NPV @ 10% = $730.33
k = r1 + [NPV1 / ( NPV1 NPV2 )]* [r2 r1]
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= 0.15 + (19,081.53 / 19,811.86 ) * (0.05)

= 9.82%
b. Calculating the annual lease payment if required rate of return is 11%.
$148,000 = ( LCFt / 1.11)t

t =0
LCFt ( PVIFA11%,6)
LCF0 =
LCF0
LCFt (4.231) =
LCF
= $148,000 / 5.231
LCF (5.231)
= $28,293
= $28,293.00
OR
Yr
LCFt
0
1
2
3
4
5
6
X
X
X
X
X
X
X
Total
PV @ 11%
1.0000
0.9009
0.8116
0.7312
0.6587
0.5935
0.5346
5.2305
$148,000
5.231
= $28,293.00
5.7.
Present Value of a Lease Contract
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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
End of Yr
0
1
2
3
4
5
6
7
Lease
Payment
27,500.00
27,500.00
27,500.00
27,500.00
27,500.00
27,500.00
27,500.00
B = Ax0.40 C= A-B
D = C/(1.072)t
Tax-Shield Cash Outflow Present Value of
Benefits
After Taxes
Cash Outflows
27,500.00
27,500.00
11,000.00
16,500.00
15,391.79
11,000.00
16,500.00
14,358.01
11,000.00
16,500.00
13,393.67
11,000.00
16,500.00
12,494.09
11,000.00
16,500.00
11,654.94
11,000.00
16,500.00
10,872.14
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.
5.8.
Valuation of Borrowing Alternative

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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
5.9.
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.
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Year End
0
A= Loan Payment
28,955
28,955
28,955
28,955
28,955
28,955
B = Bt-1 - A+C
Principal Owing
119,045
104,375
87,945
69,544
48,934
25,851
28,955
Total
(15,000)
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
E = (C+D)*0.40 TaxShield 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)
148,000
95,728
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6.
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Working Capital Management
6.1. Cash management

6.2. Inventory Management
This introduction presents a foundation to facilitate the understanding of
inventory and its function.
Inventory management, or inventory control, is an attempt to balance
inventory needs and requirements with the need to minimize costs resulting
from obtaining and holding inventory. There are several schools of thought
that view inventory and its function differently.
Good inventory management is important to all organizations because:
Inventories represent a major commitment of monetary resources
Inventories affect virtually all aspects of a companys daily operations
Inventories are a major competitive weapon for many companies
Inventory control has two major objectives...
Maximize the level of customer service.
Promote production or purchasing efficiency by minimizing the cost of

providing an adequate level of customer service
Inventory Control Systems give answers to two questions:
When should an order be placed or a new lot be manufactured?
How much should be ordered or purchased?
Definitions:
Inventory Control
Inventory management, or inventory control, is an attempt to balance
inventory needs and requirements with the need to minimize costs resulting
from obtaining and holding inventory.
Inventory Control Systems
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Major goal of Inventory Control is to discover and maintain the optimum

level of inventory investment.
There are two danger points that management usually wants to avoid i.e.
inadequate inventories which disrupt production and loss of sales and
excessive inventories introduces unnecessary carrying and obsolescence
risks.
Inventory
Inventory is a quantity or store of goods that is held for some purpose or
use (the term may also be used as a verb, meaning to take inventory or to
count all goods held in inventory). Inventory may be kept "in-house,"
meaning on the premises or nearby for immediate use; or it may be held in
a distant warehouse or distribution center for future use.
6.3. Types of Inventory Control Systems

1. Control Classification Or The A-B-C Classification System
The ABC classification system groups items according to annual sales
volume, in an attempt to identify the small number of items that will
account for most of the sales volume, and that are the most important
ones to control for effective inventory management.
Advantages
The advantages of the ABC system are as follows:
(a). It ensures closer control on costly items in which a large amount of
capital has been invested.
(b). It helps in developing a scientific method of controlling inventories,
Clerical costs are reduced and stock is maintained at optimum level.
(c). It helps in achieving the main objective of inventory control at
minimum cost. The stock turnover rate can be maintained at
comparatively higher level through scientific control of inventories.
Disadvantages
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The system of ABC analysis suffers from a serious limitation.

(a). The system analyses the items according to their value and not
according to their importance in the production process.
(b). This sometimes creates problems e.g. an item of inventory may not
be very costly and hence it may have been put in category C but
however, the item may be very important to the production process
because of its scarcity, it requires the utmost attention of the
management.
Hence, the system of ABC analysis should not be followed blindly.
2. Continuous review systems / The visual Inventory Control System

The visual system is simply that, a visual inspection of what is on the
shelf. It may include a comparison with a listing of how many units
should be carried. When the stock falls below the level and order is
placed.
Each time a withdrawal is made from inventory, the remaining quantity
of the item is reviewed to determine whether an order should be placed
A common example of this system is the manual Cadex Inventory
Control System.
Advantages
(a). Lower Safety Stock
(b). Fixed lot sizes may make it easier to obtain quantity discounts
(c). Individual review of items is used and this may be very desirable for
expensive items
(d). the visual system is simple,

(e). inexpensive and
(f). Requires no special training.
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Disadvantages
(a). visual control systems are imprecise and
(b). tend to focus on impeding stock-outs rather than excess inventory.
(c). Furthermore, visual systems do not consider the monetary
investment in inventory.
3. Periodic review systems / The periodic Inventory Control System
In this system, stock on hand is counted at periodic intervals and
compared it the desired inventory levels. Items that fall below the
desired level are then orders. Because on evaluation of inventory levels
is made on a more formal basis, this system tends to be more precise
than the visual system.
The inventory of an item is reviewed at fixed time intervals, and an order
is placed for the appropriate amount
Advantages
Periodic Review System Advantages are:
Less time consuming and
Allows combining orders to the same supplier
Inventory record keeping costs can be reduced
improves the quality of the physical stocktaking as there are more

frequent physical counting;
It allows stock discrepancies to be more fully investigated;
Maintain a higher work standards as the warehouse personnel

know that they need to count the stock more frequently;
Unauthorized changes in procedures are detected and
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Disadvantages
Periodic Review System is expensive to maintain and it is therefore
sometimes reserved for "A" inventory items.
4. The perpetual Inventory Control System
The perpetual system is the most elaborate and more accurate method
of inventory control.
Advantages
Under the perpetual system, inventory is monitored at all times,

and it is possible to determine the number of units in stock of any
time at any time.
This system provides the best control of both number of units and
dollars.
Disadvantages
The most labor intensive and most expensive. The use of

computer systems makes the perpetual system available to most
managers.
time and manpower factor as it involves more frequent

stocktaking,
5. Client -Based Inventory Control Systems (ICS)

Client-based system can only be accessed by one user at a time and
there are widely used by companies who are on Local Area Network
(LAN) managing only one warehouse.
Advantages
Supports internal control of inventories
The key advantage to having inventory control system locally

managed is that personnel are aware of local factors and
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upcoming events. They are in a position to anticipate special

promotions that may be strictly local in nature. Additionally, they
may be aware of unique input regarding the plans of major
customers.
Finally, allowing the local management to control and manage

their inventory fosters a sense of ownership and control that can
be desirable.
Overriding of perfectly fine order levels on the basis of some

general "gut feel" that was frankly without merit by local
management.
Disadvantages
Client-based system can only be accessed by one user at a time.
Does not support integration of controls between head office and

branch inventory warehouse.
Does not allow delegation of inventory monitoring responsibilities

to other individuals in the company.
The biggest disadvantage to local control is that local personnel

may lack inventory management skills and operate on a highly
subjective basis, even when fairly sophisticated tools are
available.
There is a tendency to over react to events which are transient in

nature.
Finally, local management has a strong bias for high inventories

being visually present, that is, they fail to take advantage of the
inventory that is in the pipeline or which exists in the central
warehouse.
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6. Network-Based Inventory Control Systems (ICS)

Network-based inventory control systems are far more powerful than a
client-based ICS.
SAP is an example of the widely used inventory control system by most
governments departments, big corporate companies and also the
Zimbabwe Revenue Authority.
Advantages
Network-based ICS Inventory systems have the following advantages: (a). Enables you to integrate controls between the head office and
branch inventory warehouse.
(b). supports streamlining of business by delegating inventory
monitoring responsibilities to other individuals in firm
(c). can be accessed by many people at the same time.
(d). Centralized purchasing and ordering has the added benefit that the
company can invest in more highly trained purchasing and
inventory management people.
(e). It is also more economical to train people, plus the potential for
turnover is lower.
(f). Stronger, more professional inventory managers may be employed
who furthermore are removed from day-to-day events that cause
reactionary actions.
(g). Special buying opportunities can be more effectively explored since
all the information resides in one location and the individual is
taking a total company view.
Disadvantages
Network-based ICS Inventory systems have the following
disadvantages: (a). Inventory can not be accessed if network is down.
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(b). Expensive to manage as it supported by specialised:
software systems
IT experts for maintenance and upgrades
(c). Local management can feel disenfranchised by not having control

of their inventories.
(d). Problems can develop unless some mechanism is created to make
the central planners aware of local events.
7. Just-in-time (JIT)
JIT espouses that firms need only keep inventory in the right quantity at
the right time with the right quality.
An example of a Just-in-time system is the SkuFlow system, warehouse
inventory control software which allows coordination of inventory in
multiple warehouse systems via any Internet connection.
8. SkuFlow Inventory Control System
It is a true real-time warehouse system and inventory control software.
It combines e-commerce systems, warehousing, sales tracking,
inventory systems, customer management system, & product data
management.
Advantages
Just-in-time (JIT) is a philosophy that advocates the lowest

possible levels of inventory. The ideal lot size for Just-in-time is
one, even though one hears the term "zero inventory" used.
Can control rising warehouse inventory costs.
Disadvantages
Limited to specific firms. Not ideal to firms which use raw materials
with a longer lead time.
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9. PICS (Profitable Inventory Control Systems)

PICS (Profitable Inventory Control Systems) was incorporated in
January 1985 by companies whose primary purpose was and
continues to be the marketing, production and support of complete turn
key inventory control and data collection solutions.
Advantages
(a). Tracking of raw materials, finished goods, process flow and assets
(b). use barcode, RFID, and
(c). use wireless technology.
Disadvantages
(a). Need for ITC expertise which may be too expensive for small
companies.
10. WineSeller Pro (WSP) Inventory Control System
WineSeller Pro (WSP) is a unique, revolutionary inventory control
system which is currently controlling millions of dollars worth of
inventory at various restaurants and hotels.
Advantages
(a). WineSeller Pro interfaces with all existing Point-of-Sale systems:

MICROS, Squirrel, Aloha, POSitouch, Digital Dining, Flashpoint,
TEC, etc. Automated overnight transferring of the POS daily sales
directly into WSP keeps data processing simple.
(b). Support of wine, beverage and other inventory types.
(c). Periodic (user defined) accounting, processing, reporting, and
physical inventorying.
(d). Profit center tracking, including accounting, reporting and physical
inventorying by individual profit center with an unlimited number of
user defined profit centers.
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(e). Transfers (requisitions) and tracking of inventory movement

between profit centers.
(f). Multi-user access with an unlimited number of computers running
WSP simultaneously on a network.
(g). Support of a limitless number of remote barcode label printers and
scanners.
(h). Automated posting of inventory items (menu item descriptions)
from WSP to POS.
(i). Includes a proprietary database of wine, liquor and beer names
with over 60,000 domestic and international entries including
virtually all domestic releases thru 2005.
(j). Automated overnight running of the POS daily sales interface with
automatic generation of the sales exceptions and daily sales
reports.
(k). Tracking and accounting of purchases from vendors and suppliers
(l). Access security to each function in WSP controlled by the System
Administrator.
(m). Export to MS Word for any wine list using any font installed on the
computer.
(n). Export to MS Excel for all WSP reports.
(o). Reduced workload and increased due the time saving features
employed by this inventory control solution.
(p). The ability to count the physical inventory quickly and accurately
using the easy-to-use handheld barcode scanner.
(q). Eliminates tedious and continual data entry for wine list editing.
(r). Automatic printing of from WSP and/or exporting directly into a MS
Word document for further detailing.
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(s). Allows restaurant managers to obtain greater control of inventory

and staff activity.
Disadvantages
Like any other computerised inventory control system:(a). Inventory can not be accessed if network is down.
(b). Expensive to manage as it supported by specialised:
software systems
IT experts for maintenance and upgrades
Purpose of Inventory Control Systems

Inventory Control Systems contributes to the key success of various
companies world-wide as inventories are held for various reasons as
highlighted below.
To meet anticipated customer demand
To protect against stock-outs
To take advantage of economic order cycles
To maintain independence of operations
To allow for smooth and flexible production operations
To guard against price increases
The nature of business dictates the type of inventory control system to be

adopted by each company.
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CORPORATE ACTIVITY AND RESTRUCTURING
7.1. 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.
1.
FORMS OF MERGER
Horizontal Merger
It 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.
Vertical Merger
It 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.
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.
2.
MOTIVES FOR MERGERS

Economic Gains
An economic gain occurs if the two firms are worth more together than
apart, i.e.
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PVAB >
=
PVAB
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PVA + PVB or (1+1=3) where:Present Value of Firm A and Firm B combined,
PVA = Present Value of Firm A and held separately, and

PVB = Present Value of Firm B held separately.
The gain to the 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)

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.
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.
Eliminating Inefficiencies
Some firms are inefficiently managed, with the result that profitability is
lower than it might otherwise be.
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1. 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.
2. 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.
3. Tax Reasons
A company coming out of bankruptcy can have lots of money in unused
tax-loss carry-forwards. Such a company can buy or merge with another
profit marking company and hence be able to utilise the carry-forwards.
4. 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.
5. Managements Personal Agenda
Some managers view growing from a small to a large company as more
prestigious or can have diversification as their objective.
6. 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
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EXISTING MARKET
Market Penetration
Product Development
NEW MARKET
Market Development
Diversification
7.2. 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 motives 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.
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
B
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Present Earnings (000)

Shares outstanding (000)
Earnings per share (EPS)
Price per share
Price Earnings (P/E) ratio
$20,000
5,000
$4.00
$64.00
16
$5,000
2,000
$2.50
$30.00
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.
Exchange Ratio
= 36/64
= 0.5625
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
$25,000
6,125
$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
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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
1
4
2
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.
Market Value Impact
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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 Per Share

of the Acquiring
Company
Number of Shares by Acquiring Company for Each

Share of the Acquired Company
X
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.
$20,000
6,000
$3.33
$60.00
18
Acquired Co.
$6,000
2,000
$3.00
$30.00
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 = 40/60
= 0.667
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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
7,334
$3.55
18
$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
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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
+
Buying Company
_
Announcement
Days
Date
7.3. 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 is bought it can remain
in operation as a legal entity.
7.4. Taxable and Tax-Free Merger
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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.
7.5. Takeover Defenses

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 hypotheses 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%.
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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.
7.6.
COMPANY RESTRUCTURING
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.
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.
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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.
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.
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.
The ownership restructuring methods to be looked at are going private and
leveraged buyouts.
Going Private
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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.
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 assetbased 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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Lecturer: Ms.

Corporate Finance Notes - CFI 2201

3. Corporate Valuation and Corporate Structure

4. Dividends and Re-purchases

Corporate Finance Notes - CFI 2201

4.7. Theoretical Issues that Could Affect Dividend Policy

6. Working Capital Management

7. Corporate Activity and Restructuring

Corporate Finance Notes - CFI 2201

Corporate Finance Notes - CFI 2201

Private & Public Markets

(g). Money & Capital Markets

Over the counter markets

Corporate Finance Notes - CFI 2201

Stock exchanges operate as auction markets as buyers and sellers are

Examples of Stock Exchange

NOTE: Stork Exchanges in developing countries are smaller compared to

The over the counter market is an interchangeable organisation that is

The over the counter is a dealer market in that business is conducted

Importance of Secondary Markets

They provide an indication of value of a company for example. The price of

Secondary markets provide liquidity. They enable investors to sell their

It provides a forum for exchange. A secondary market brings together

Listing of Stock Exchange

Corporate Finance Notes - CFI 2201

Corporate Finance Notes - CFI 2201

(b). Disclosure Requirements

A dual listing is whereby a company is listed on more than one stock

Corporate Finance Notes - CFI 2201

Generally such a companys primary listing is on a stock exchange in its

Examples of Companies in Dual Listing

Old Mutual has primary listing in London Stock Exchange, secondary

Pretoria Portland Cement (PPC) - has primary listing on the

Hwange Colliery - has primary listing on the Zimbabwe Stock Exchange

Reasons for Dual Listing

Improved accessibility to funds the Stock Exchange provides

To gain access to a larger investor base.

Improved visibility and profile

Disadvantages of Dual Listing

The company in question has to comply with listing requirements of

Cost of reporting i.e. reporting required in more than one company. It

Accessibility of Information ensure prices are same on both markets

Corporate Finance Notes - CFI 2201

(a). Under-valued Shares

1.2. Evaluation Of Main Sources Of Finance

Corporate Finance Notes - CFI 2201

Advantages of using Debt Capital

The use of debt is advantageous in that its interest expense is tax

Disadvantages of using Debt Capital

The interest payments are contractual and principal repayment must be

The cash drain is large since interest repayments have to be made on a

1.3. Equity Issues, Rights Issues, Retained Issues

It is the most common source of financing for most companies and is

Investors will inject cash or assets into a business in return for a

Equity is the permanent source of capital meaning you do not have to

It can be raised through rights issue or Private Placements.

Corporate Finance Notes - CFI 2201

Retained profits are an attractive source of finance because investment

Use of retained earnings as opposed to new shares or debentures

Advantages of using Equity Capital

Dividend payments are made at the discretion of the company. They

There is no obligation to pay the principal amount under Equity Capital.