CIMA REVISION CARDS Financial Strategy John Ogilvie Strategic Level Paper P9
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OXFORD TOKYO
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TABLE OF CONTENTS 1. 2. 3. 4. 5. 6. 7. 8. 9.
Formulation of financial strategy ..................................................... 1 Financial management ................................................................. 23 Sources of long-term finance ......................................................... 35 Capital structure and cost of capital ................................................. 47 Business valuations .................................................................... 61 Mergers, acquisitions, and buyouts .................................................. 69 Investment appraisal techniques...................................................... 81 Advanced investment appraisal ....................................................... 91 International operations ................................................................ 101
Formulation of Financial Strategy Examining objectives, key decisions and external constraints
Topics
Key Study System questions CS14 9 11
. . . . . . .
Objectives Three key decisions of financial management Policies for the distribution of earnings Regulatory requirements Major economic influences Modelling forecast cash-flows and financial statements Emerging financial reporting issues 1
Formulation of Financial Strategy
Objectives
For a profit-making entity the main strategic objective is to optimise the wealth of the proprietors, i.e., to maximise shareholder wealth. Shareholder wealth may be measured by the return shareholders receive from their investment, represented by the dividend received each year, plus the capital gain from the increase in value of the shares over that period. In practice may have broader objectives, e.g., achieve satisfactory returns, or achieve a level of sales.
Stakeholders Groups or individuals having a legitimate interest in the activities of an organisation: KKKKKK
K
K
K
Financial objectives
Shareholders. Fund lenders. Customers. Suppliers. Employees. Government.
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Non-financial objectives
Goal congruence
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Objectives
The state which leads individuals or groups to take actions which are in their self-interest and also in the best interest of the entity.
Customer satisfaction. Welfare of employees. Welfare of management. Environmental welfare.
Agency theory The managers of an organisation are essentially agents for the shareholders, being tasked with running the organisation in the shareholders’ best interests.
Contracts within an organisation, whether formal or informal, can only be effective in helping to make the organisation successful, if there is general acceptance of them in practice, and a concerted effort by all concerned to strive in the same direction.
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Formulation of Financial Strategy
Financial performance indicators KKKK
Cash generation. Value added. Profitability. Return on assets.
Value for money
Non-financial performance indicators KKK
Objectives may be spelled out in a statute or vesting document. May be difficult to quantify. Stakeholder aspirations may be ignored.
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Not-for-profit organisations K
Objectives
Economy. Efficiency. Effectiveness.
Market share. Customer satisfaction. Competitive position.
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–––––––––––––––––––––––––––––––––––– Formulation of Financial Strategy
K
Those which determine how scarce resources are committed to projects, e.g., acquisition of new plant, takeovers, mergers. Disinvestment means the preparedness to withdraw from unsuccessful projects.
K
Dividend decisions
K
Investment decisions K
Financial management decisions
How much and how frequently to distribute profits of an entity as income for its proprietors? The level and regular growth of dividends represent a significant factor in determining the value of a company’s shares.
K
Financing decisions Acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed, e.g., sources and cost of funds, capital structure, risk evaluation.
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Formulation of Financial Strategy
Practical dividend policies KKK
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K
Factors to consider KK
Dividend policies
Liquidity; i.e., availability of cash. Debt repayment schedules, which may reduce cash availability. Covenants restricting payment or rates of growth in dividends. Rate of expansion. Stability of profits. Levels of gearing/control of company. Policy of competitors. Signalling, or informational content.
Constant payout ratio. Steady growth. Residual dividend.
Signalling The dividend decision is seen as a powerful signal to the market of the directors’ confidence in the company, and can drive share prices. In pure economic terms, companies should not pay dividends when they have positive NPV projects available to invest in.
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Dividend policies Dividend irrelevance
KK
K
KKK
Modigliani and Miller (1961) argued that: In a tax-free world, shareholders will not differentiate between dividends and capital gains. The value of a company will be based on the earnings capacity of its assets and investments. A company with a particular pattern and stability of dividends will attract shareholders with a preference for that profile (the clientele effect). If retentions are insufficient to allow a company to take up all its worthwhile investments, the shortfall caused by a dividend can be offset by obtaining further funds from other external sources. Information content of dividends causes shareholders to push up share price in expectation of future earnings. If a company does not have sufficient worthwhile projects to utilise retentions, the surplus funds should be distributed to shareholders.
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Formulation of Financial Strategy
Scrip dividends
Reasons for share repurchase
A dividend in the form of new shares rather than cash.
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Dividend policies
Share repurchases
K
KK
Shares may be repurchased by: Purchase on the open market. Individual arrangement with institutional shareholders. Tender offer to all shareholders.
Return of surplus cash to investors. Reduce the company’s cost of capital. Enhance earnings and market price. Prevent unwelcome takeover bids. Adjust company’s capital structure. Reduce the amount of cash needed for future dividends.
A share repurchase may suggest a failure of management to identify projects that will generate returns above the company’s cost of capital.
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Impact of regulation
KKK
KKK
K
The Hampel Report Primary duty of directors is to enhance shareholders’ investment. Non-executive directors constitute 1/3 of board. Separate roles of chairman and chief executive. Remuneration committee of independent non-executive directors. Audit committee of non-executive directors. Directors should report on internal control. Directors re-elected every three years.
Study tip Detailed knowledge of corporate governance issues is not required for this examination. Students are expected to have a general understanding of the key principles.
The Hampel Committee was set up to develop issues raised in the Cadbury and Greenbury reports.
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Formulation of Financial Strategy
Impact of regulation Regulatory bodies
Actions of regulatory bodies KKK
K
Objectives of regulatory bodies KK
Where a market is not competitive, or is in the early stages of becoming so, there is a need for regulators whose role is to try to balance the interests of the various stakeholders.
Protection of customers from monopoly power. Promotion of social and macro-economic objectives. Promotion of competition.
Prohibiting cross-subsidy. Removing right to compete in defined activities. Creation of a regulation prohibiting discrimination.
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Impact of regulation Competition Commission
Mergers can only be considered by the UK competition authorities, if:
If the Office of Fair Trading believe a merger may result in a substantial lessening of competition, it can be referred to the Competition Commission.
KK
Regulation of takeovers
Turnover in the UK firm being taken over > £70m. Merger creates or increases a 25% share in the UK market for goods or services.
Public interest cases are dealt with by SofS DTI.
Takeover Code Set of rules with no force of law, but which reflects best practice. Administered by Takeover Panel.
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Formulation of Financial Strategy
Major economic influences Interest rates
Term structure of interest rates
KKK
Interest rates will reflect: Time period of a loan. Risk and uncertainty. Amount of loan.
Real interest rates The real interest rate puts interest rates in the context of inflation. (1 þ nominal rate) ¼ (1 þ real rate) (1 þ inflation rate) Here the yield curve is upward sloping, i.e., long-term rates are higher than short-term rates.
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The effects of inflation K K
K
Exchange rates An increase in the exchange rate will lead to increased export prices and lower costs of imports.
K
Spending by consumers falls. Market value of financial assets drops. Foreign funds are attracted into the country. Export prices increase. Inflation falls.
K
Effects of interest rate increases KKKKK
Major economic influences
People bring forward purchases because they fear higher prices later. People on fixed incomes, or those lacking bargaining power, become worse off. Higher wage claims, which may precipitate a wage-price spiral. Exports are less attractive (assuming unchanged exchange rates). Borrowers gain at the expense of savers; the real value of savings is eroded.
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Formulation of Financial Strategy
Forecast financial statements You may be required to model profit and loss accounts, balance sheets and cash-flow forecasts, based on data for a base year. Remember that cash flows are not the same as profits. KKK
Consider the effects of: Additional asset purchases. Share issues. Increases in dividend and interest payments.
Sales Opening debtors Sales Closing debtors Cash received from debtors
X X (X) X
Purchases Opening creditors Purchases Closing creditors Cash paid to creditors
X X (X) X
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Forecast financial statements Cost of sales Opening stock Purchases Closing stock Cost of sales
Taxation X X (X) X
Dividends Payable at start of year Declared in the year Payable at end of year Paid in the year
Owing at start of year Tax charge for the year Owing at end of year Tax paid in year
X X (X) X
Balance sheet forecasts X X (X) X
Cash balance or overdraft may be used as a balancing figure. Share capital þ reserves > net assets ¼ cash balance
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Formulation of Financial Strategy
Forecast financial statements
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Balance sheet forecasts Intangible assets: Tangible assets: Stocks and debtors: Cash: Trade creditors: Bank overdraft: Taxation/dividends: Long-term loans: Share capital: Retained profits:
Consider any additions or write-downs to existing value. Adjust for purchases, disposals and depreciation. Possibly based on % of turnover or cost of sales. Balancing figure. Possibly based on % of cost of sales. Balancing figure. Amounts payable, often a % of profits. Existing balance less repayments. Assume no change, unless specific mention of share issue. Remember to add retained profits for year to balance brought forward.
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Forecast financial statements Sensitivity analysis
A modelling and risk assessment procedure, in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome. Particular attention is thereafter paid to variables identified as being of special significance.
Significant variables may include: KKKKK
Definition
Sales volumes. Levels of productivity. Costs of materials. Labour costs. Changes in capacity.
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Formulation of Financial Strategy
Emerging financial reporting issues Share-based payment (IFRS 2)
Recognition
Share option schemes are frequently used as a means of rewarding employees. They can also be used as a means of buying-in goods or services from parties outside the company. The issue of share options and grants of shares to employees creates a financial instrument which must be accounted for.
Charge to the profit and loss account when the goods or services are consumed. Where the payment is equity-settled the credit is to equity. Where the payment is cash-settled the credit is to liabilities.
Measurement The transaction should be measured at the fair-value of the shares or options issued.
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Disclosures in annual financial reports include:
K K
KK
Contingent liabilities relating to results of environmental audits, clean-up measures, environmental disasters, litigation due to noise or waste policies. Policies regarding environmental care. Comments on actions taken, e.g., product policies.
K
Problems
K
Environmental issues
K
Emerging financial reporting issues
Not all companies report environmental information. As disclosures are voluntary, there is a danger that information is incomplete or unreliable. Importance of disclosure of information varies according to particular industries. Disclosure is more of a public relations exercise than an obligation.
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Formulation of Financial Strategy
Social costs
Social reporting extends the reporting function to include:
K
K
K
Reporting of social issues
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Emerging financial reporting issues
The physical environment. The company will utilise physical resources but the social cost of this is not currently reported. The meteorological and biological environment. Changes caused by use of energy and production of goods. The social environment. The way in which a firm attracts human resources, and uses those resources, will affect local society.
Pollution: air, water, noise. Depletion and destruction of resources. Soil erosion and deforestation. Unemployment and idle resources.
Social reporting would include a social income statement, recording social costs and benefits; and a social balance sheet disclosing staff assets, organisational assets, the use of public goods, financial and physical assets.
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Valuation of human capital
Wages and salaries paid to employees are expensed in the year. However, if human resources were treated as an asset of the business, the costs would be capitalised in the balance sheet and depreciated to the income statement in line with the income they generate.
K
K
Reporting of human capital
K
Emerging financial reporting issues
Historic cost. All costs associated with recruiting, selecting, employing, training and developing an employee are capitalised and amortised over the expected useful life of the asset. Replacement cost. This method estimates the cost of replacing the existing human resources. Economic value. Discounted future wages are adjusted by an efficiency factor to measure the effectiveness of human capital of a company.
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Financial Management Examination of the acquisition and deployment of financial resources
Topics
Key Study System questions 16 18
. . . . . .
The treasury function Financial markets Share price volatility Efficient Market Hypothesis Investor ratios Working capital management strategies 23
Financial Management
The treasury function
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KK
Main functions Managing relationships with the banks. Ensuring the business has liquid funds and investing surplus funds. Identifying sources of funds and raising capital. Managing interest rate risks. Dealing in foreign exchange markets. Managing foreign exchange risks.
In larger companies and groups, treasury will usually be centralised at head office, providing a service to all the various units of the entity and thereby economies of scale. Treasurers require specialist skills to be able to handle effectively, e.g.: KKK
Treasury is concerned with the relationship between the entity and its financial stakeholders.
An ever growing range of capital instruments. Hedging of foreign exchange risk. Advising permissible ways of reducing overall tax liability.
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The treasury function Cost centre or profit centre
K K
Individual business units of the entity can be charged a market rate for services provided, making their operating costs more realistic. Treasurer is motivated to provide services effectively and economically, to ensure that a profit is made at the market rate, e.g., managing hedging activities.
K
Disadvantages of profit centre
K
Advantages of profit centre K
Treasury activities may be accounted for simply as a cost centre, but in some organisations it is treated as a business in its own right, seeking to make profit out of its activities.
Temptation to speculate, increasing exposure to risk. Management time is unduly spent in arguments with business units over charges for services. Additional administrative costs may be excessive.
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Financial Management
Financial markets Money markets
Capital markets
Markets for trading in relatively short-dated funds, usually less than one year. Dominated by banks and other financial institutions.
Markets for trading in longer-dated securities such as shares and loan stock. Examples of capital markets would be the Stock Exchange, the bond market, and the Eurobond market. Capital markets have two main functions: K
Inter-bank and inter-company loans. Local authority debt instruments. Bills of exchange. Certificates of deposit. Commercial paper. Eurocurrency.
K
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Encompasses:
They provide a primary market for raising new capital, usually in the form of equity. They also allow trading in existing securities – the secondary market.
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Financial markets Flotation
KK
Provides more accurate valuation of the company than previously possible. Realisation of paper profits. Raise profile of company. Raise capital for future investment. Employee share schemes more accessible.
KKK
Disadvantages of flotation
KKKK
Advantages of flotation K
The process of making shares available to investors by obtaining a quotation on the Stock Exchange.
Costly for a small company. Small companies perceived as risky, leading investors to require higher returns. Making enough shares available to market. Reporting requirements more stringent. Stock Exchange rules are stringent.
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Financial Management
Share price volatility Fundamental analysis
Technical analysis/Chartism
Analysis of external and internal influences upon the operations of a company, with a view to assisting in investment decisions.
The analysis of past movements in the prices of financial instruments.
Information accessed might include:
. . . .
Fiscal/monetary policy. Financial statements. Industry trends. Competitor analysis.
Chartists believe future prices can be charted and a pattern identified that can be used to predict future prices. On the available evidence, theorists have developed the idea that the progress of a particular share is a ‘random walk,’ rendering the achievement of consistently superior returns an impossibility.
The analysis will conclude that the share is overvalued or undervalued.
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Efficient market hypothesis
Weak form
Semi-strong form
Strong form
K
K
K
KKK
The hypothesis that, in an efficient market, prices fully and instantaneously reflect all available information. The main implications are: The timing of issues of debt or equity is not critical, as the prices quoted in the market are ‘fair’. A company cannot mislead the markets by adopting ‘creative accounting’ techniques. Share prices will reflect the net present value of the company’s future cash flows.
Current share price reflects all the information that could be gleaned from a study of past share prices.
Current share price reflects all historical information and all other published information.
Current share price incorporates all information, including non-published information.
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Financial Management
Investor ratios Market price per share (mps) The market price is the ex-dividend market price.
Earnings per share (eps) Net profit attributable to ordinary shareholders divided by the number of shares in issue.
Price earnings ratio (P/E) Market price per share (MPS) Earnings per share (EPS)
Earnings yield Reciprocal of the P/E ratio
Remember this!
Earnings per share (EPS) Market price per share (MPS)
The net profit must be after deduction of interest and tax.
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Investor ratios Dividend payout rate Dividend per share (DPS) Earnings per share (EPS)
Dividend yield Indicates the return on capital investment relative to price. Dividend per share (DPS) Market price per share (MPS)
Dividend cover Measures the ability of the company to maintain the existing level of dividend. Earnings per share (EPS) Dividend per share (DPS)
Book value per share Indicates the asset backing of the investment. Shareholders’ funds Number of equity shares in issue at balance sheet date
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Financial Management
Working capital management strategies
K
An aggressive policy involves holding low levels of stocks and cash. This minimises costs, but the company may not be able to respond rapidly to increased demand for sales. A conservative policy involves holding higher levels of stock and cash.
K
Financing decision
K
Investment decision K
KK
A company’s working capital policy is a function of two decisions: The appropriate level of investment in, and mix of current assets to be decided upon, for a set level of activity The methods of financing this investment.
An aggressive policy involves financing part of the permanent asset base with short-term debt. This provides the highest expected return but is very risky. A conservative policy has permanent financing (long-term debt plus equity) exceeding the permanent asset base.
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Working capital management strategies Conservative financing policy
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Sources of Long-term Finance Strategies for the satisfaction of long-term financing requirements
Topics
Key Study System questions 23 29
. . . . . . .
Shareholders’ funds Raising share capital Debt finance Lender’s assessment of creditworthiness Leasing Lease-or-buy decisions Financing of small businesses 35
Sources of Long-term Finance
Shareholders’ funds Ordinary shares
Preference shares
An equity interest in a company can be said to represent a share of the company’s assets and a share of any profits earned on those assets after other claims have been met.
Entitle their holder to a fixed rate of dividend from the company each year. This dividend ranks for payment ahead of ordinary dividends, and can only be paid if the company has distributable profits.
Remember this! The book value of equity is the sum of the ordinary share capital shown in the balance sheet, plus the value of shareholders’ reserves. The market value of equity is simply the share price, multiplied by the number of shares in issue.
Reserves Reserves include share premiums, revaluation reserves and retained profits.
Remember this! Reserves are a historical source of funds, and so are unlikely to be represented by an equal amount of cash on the balance sheet.
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Raising share capital Offer for sale
Prospectus issue
An issuing house, normally a merchant bank, acquires the shares from the company and then offers them to the public at a fixed price.
An issue whereby a company offers its shares direct to the public, rather than using an issuing house. The issue will not be underwritten.
The issue will usually be underwritten to ensure that the issue raises the desired amount of capital.
Placing
Offer for sale by tender Similar to above, but subscribers must tender for the shares at, or above, a minimum fixed price.
An issuing house arranges for the shares to be issued to institutional clients. Cheaper and quicker than other methods.
Introduction No shares are issued, and no new finance is raised.
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Sources of Long-term Finance
Rights issues Definition An offer by a company to its existing ordinary shareholders of the right to subscribe for new ordinary shares, or other convertible securities having an equity element, in direct proportion to their existing shareholding.
Normally issue price is set at a discount to mps.
K
Rights issues are normally underwritten. The underwriting costs could be avoided through a deep-discounted rights issue. Rights issues raise new funding, bonus issues do not.
Theoretical ex-rights price (TERP) Pp No Pn Nn þ N N Pp ¼ Pre-issue price
TERP ¼
Pn NO Nn N
¼ New issue price ¼ Number of ‘old’ shares ¼ Number of new shares ¼ Total number of shares
Value of a right The theoretical gain from taking up the rights, calculated as: TERP – issue price.
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Debt finance Debentures
Deep discounted bonds
A document issued by a company containing an acknowledgement of indebtedness. It usually gives a charge on the assets of the company.
Debt instruments issued at a price well below their nominal value.
Debentures can be secured or unsecured.
Zero-coupon bonds
Fixed charge – on the whole or a specified part of a company’s assets. These assets cannot be sold without debenture holders’ consent. Floating charge – general charge on a class of assets that company is not precluded from selling.
Issued at a very low price in relation to their nominal value. No interest is paid on the bond; all the investor’s return is wrapped up in a capital gain on redemption.
The company agrees to repay the principal to the lender by some future date and in each year up to repayment it will pay a stated rate of interest.
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Sources of Long-term Finance
Debt finance Interest yield gross interest 100% market value
Coupon rate The interest rate payable on the face, or nominal, value of the debt.
Convertibles Yield to maturity The effective yield on a redeemable security, calculated by adding the NPV of the interest payments to be made to the present value of the sum receivable on redemption.
Offer investors a fixed return, but also give the investor the right to convert into the underlying ordinary shares of the company at fixed terms. Conversion premium measures how much more expensive it is to buy the convertible than the underlying ordinary share. Cheaper than ordinary debt finance due to the option to convert into ordinary shares.
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Debt finance Warrants
Term loans
Options to buy shares in the company at a given price within a given period, usually issued with loan stock.
Are offered by the high street banks and are for a fixed amount with a fixed repayment schedule. Usually the interest applied is slightly less than for a bank overdraft.
Will enable the coupon rate to be reduced on the debt. The debt issued with warrants will run to maturity, maintaining the tax deduction. The timing of exercising the warrants is determined by investors.
The lender will require security to cover the amount borrowed, and an arrangement fee may be payable. Term loans have the following qualities: KKK
Can be bought and sold separately from the loan stock.
They are negotiated easily and quickly. Banks may offer flexible repayments. Variable interest rates.
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Sources of Long-term Finance
K
K
K
KK
Lender’s assessment of creditworthiness Bank references – these tend to be fairly standardised in the UK and so are not as helpful as they could be. Trade references – suppliers giving credit to the customer can give useful information about how good the customer is in paying its bills on time. Published information – the customer’s annual accounts and reports will give some idea of the general financial position of the company, and its liquidity. Credit agencies – agencies such as Dun & Bradstreet publish general financial details of many companies, together with a credit rating, and will produce a special report on a company, if requested. Company’s own sales record – for an existing customer, the sales ledger will show how prompt a payer the company is.
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Lender’s assessment of creditworthiness
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The factors that a bank will consider before extending finance will include: The purpose of the loan. The amount of the loan. The duration of the loan. The availability of assets that can be offered to give adequate security. The credit rating of the borrower. How the borrower is proposing to repay the loan. The level of borrowings currently outstanding. The perceived risk of the borrower. Previous track record of borrowing from the bank.
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Sources of Long-term Finance
Leasing Sale and leaseback K
A contract whereby one party (the lessee) obtains the use of an asset for a period of time, whereas the legal ownership of the asset remains with the party (the lessor).
Where a company sells assets to a financial intermediary and leases the assets back from the purchaser.
Finance leases
K
KKKK
K
KK
Operating leases Lessee bears most of the risks and rewards. Lease term normally extends over the full useful life of the asset. Shown in the lessee’s accounts as assets and liabilities. Lessee responsible for maintenance.
Lessor bears most of the risks and rewards. Not usually for the full life of the asset. Asset does not appear on lessee’s balance sheet. Lessor responsible for maintenance.
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Lease-or-buy decisions The traditional method requires a two-stage approach: 1.
2.
Acquisition decision – is the asset worth having? Discount the operational costs and benefits associated with using the asset, using the weighted average cost of capital. Financing decision – should the asset be purchased or leased? Discount the cash flows affected by the choice of financing, using the after-tax cost of borrowing. It is usually assumed funds would have to be borrowed to purchase the asset.
Study tip Most exam questions assume the acquisition decision has already been made. Many questions give no indication of how the loan is to be repaid, which simplifies the calculations.
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Sources of Long-term Finance
Financing of small businesses Venture capital
Business angels
Equity finance provided to young, unquoted businesses to help them to expand.
Private individuals with time and expertise, and cash, who invest directly in small businesses.
The finance is provided in exchange for an equity stake. Providers of capital sometimes require a seat on the board of directors.
Government assistance
Start-ups. Major expansion projects. Management buyouts. Rescues.
The UK government has introduced a number of schemes to help businesses, many of which are targeted at small and medium-sized enterprises, e.g.: KK
KKKK
Venture capital may be suitable for:
Enterprise Investment Scheme. Regional Selective Assistance.
Venture capitalists will require an exit point for the investment, which may be through a trade sale or flotation of the company.
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Capital Structure and Cost of Capital Examining use of debt and impact of gearing on cost of capital
Topics
Key Study System questions 33 35
Weighted average cost of capital Cost of capital
. . . . . . . .
Measuring gearing Cost of capital Weighted average cost of capital Traditional theory of gearing Modigliani and Miller’s theories of gearing Adjusted present value Capital asset pricing model Arbitrage pricing model 47
Capital Structure and Cost of Capital
Measuring gearing
K
K
Capital gearing is concerned with the level of debt in a company’s capital structure, and measures the relationship between: Equity (E) – the proportion of the company financed by the ordinary shareholders. Prior charge capital (PCC) – capital that has to be serviced prior to the equity capital receiving any return. PCC consists of preference share capital plus long-term interest bearing capital.
There are many alternative forms of the capital gearing ratio. The preferred form of calculation for the examination is: 100%
Prior charge capital (PCC) Equity (E) þ Prior charge capital (PCC)
Wherever possible, market values should be used in preference to book values for the capital gearing ratio.
Remember this! The book value of equity ¼ ordinary share capital þ reserves. The market value of equity ¼ number of shares share price.
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Cost of capital Cost of equity
Estimating the growth rate
The cost of equity must relate to the return that equity investors expect to reward them for investing. Retained profits are not a free source, as there is an opportunity cost of the dividend foregone from retaining profits.
There are two possible approaches: sffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi n dividend in year x 1 g¼ dividend in year 1
d Po ke ¼ cost of equity d ¼ annual dividend Po ¼ market value of equity (ex-dividend) ke ¼
Gordon’s growth model: g ¼ bR earnings dividend b¼ earnings earnings R¼ Book value of capital employed
49 —————————————————————————————————————————
Capital Structure and Cost of Capital
Cost of capital Cost of irredeemable debt
Cost of redeemable debt
As the interest on debt is a tax-deductible expense, the relevant cost to a company of using debt finance is the after-tax cost.
Calculated by taking the IRR of the annual net of tax interest payments to redemption, minus the original market value of the debt in Year 0.
ið1 tÞ Po kd net ¼ cost of debt (after tax) i ¼ annual interest kd net ¼
t ¼ rate of corporation tax Po ¼ market value of debt
Cost of preference shares d Po kpref ¼ cost of preference shares d ¼ annual dividend Po ¼ current ex-div market price kpref ¼
50 —————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Capital Structure and Cost of Capital
Cost of capital Weighted average cost of capital (WACC) ko ¼ ke
Ve Vd þ kd Ve þ Vd Ve þ Vd
ke ¼ cost of equity kd ¼ cost of debt Ve ¼ market value of equity Vd ¼ market value of debt
KKKK
Assumptions in the use of WACC: The capital structure of the company is reasonably constant. The project shows the same risk profile as the whole company. The new investment is marginal to the entity. All cash flows are level perpetuities.
51 —————————————————————————————————————————
Capital Structure and Cost of Capital
Cost of capital
KKK
The traditional theory of gearing Earnings and risk assumed to remain constant. Taxation is ignored. All earnings paid out in dividends.
Note: ke ¼ cost of equity; kd ¼ cost of debt; ked ¼ WACC. 52 —————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Capital Structure and Cost of Capital
Arbitrage The switching of funds by an investor as between investments in order to obtain a better return for the same risk level.
Limitations KK
Transaction costs can be ignored. Debt is assumed to be risk-free. Debt costs the same to individuals as to companies. Information is freely available to all investors. Investors act rationally and have similar expectations as to returns.
K
KK
Assumptions KKK
Modigliani and Miller’s theories of gearing
Cost of capital not constant in real world. Personal and corporate gearing seldom equivalent and investors would face less risk if company borrows on their behalf. High level of gearing carries risk of corporate collapse.
53 —————————————————————————————————————————
Capital Structure and Cost of Capital
Modigliani and Miller’s theories of gearing MM’s proposition without tax
MM’s proposition with tax
MM’s gearing propositions without tax
MM’s gearing propositions with tax
54 —————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Capital Structure and Cost of Capital
Modigliani and Miller’s theories of gearing Value of a geared company
Cost of equity in a geared company
Without tax:
Without tax:
Vg ¼ Vug
keg ¼ keu þ ðD=EÞðkeu kd Þ With tax:
With tax: Vg ¼ Vug þ TB Vg ¼ value of geared company Vug ¼ value of ungeared company TB ¼ present value of tax shield
keg ¼ keu þ ðð1 tÞ D=E ðkeu kd ÞÞ keg ¼ cost of equity in a geared company keu ¼ cost of equity in an ungeared company kd ¼ cost of debt (gross of tax) E ¼ market value of equity D ¼ market value of debt
55 —————————————————————————————————————————
Capital Structure and Cost of Capital
K
K
K
Adjusted present value (APV) Determine base case NPV, assuming project is all equity finance, discounting at appropriate cost of equity Calculate present value of side-effects of the intended method of financing, e.g., tax savings on loan interest, issues costs. APV ¼ base case NPV þ present value of financing side-effects.
Adjusted discount rate The adjusted discount rate, or adjusted cost of capital, is the rate at which the APV ¼ 0; i.e., the IRR.
Adjusted cost of capital – MM Modigliani and Miller demonstrated that the adjusted cost of capital (r*) may be calculated as: r ¼ rð1 T LÞ r ¼ opportunity cost of capital T ¼ the rate of corporation tax L ¼ the project’s marginal contribution to the firm’s debt capacity as a proportion of the firm’s present value
56 —————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Capital Structure and Cost of Capital
Capital asset pricing model (CAPM)
K
K
CAPM argues that total risk, as measured by standard deviation, can be split into two elements:
Risk reduction through diversification
The risk that can be reduced by diversification, known as specific risk or unsystematic risk. The risk that will not be reduced by diversification, known as market risk or systematic risk (measured as b).
Expected return ¼ risk-free rate þ (beta (market rate risk-free rate)) Expected return ¼ Rf þ (Rm Rf) b
57 —————————————————————————————————————————
Capital Structure and Cost of Capital
Capital asset pricing model (CAPM) Gearing and ungearing betas Consider a company that has invested in a number of projects: Dð1 tÞ E þ bG Dð1 tÞ þ E Dð1 tÞ þ E bD ¼ debt beta bG ¼ equity beta in geared company D ¼ market value of debt E ¼ market value of equity t ¼ rate of corporation tax bA ¼ bD
bA ¼ wi bi bA ¼ weighted average of the project betas ¼ asset beta wi ¼ weighting of individual project based on market values bi ¼ beta of individual project or activity
bA ¼ asset beta
βG βD
E
A1 A2
D
A3 58
—————————————————————————————————————————
–––––––––––––––––––––––––––––––––– Capital Structure and Cost of Capital
Capital asset pricing model (CAPM)
KKK
KKKK
Limitations of CAPM CAPM is a single-period model. CAPM ignores transaction costs. Difficult to determine the excess return (Rm Rf) or even the risk-free rate. CAPM depends on an efficient investment market. An imperfect market makes it more difficult for investors to eliminate specific risk from their portfolios. Close comparison with a proxy company is difficult; assumes close similarity of activities and business risk. The assumption that well-diversified portfolios are subject only to systematic risk. CAPM assumes all stocks in a portfolio relate to companies that are going concerns.
59 —————————————————————————————————————————
Capital Structure and Cost of Capital
Arbitrage pricing model
KKKKKK
Arbitrage pricing theory attempts to explain the risk-return relationship, using several independent factors rather than a single index. Research suggests there are a number of factors that systematically affect the return on assets: Inflation or deflation. Long-run growth in profitability in the economy. Industrial production. Term-structure of interest rates. Default premium on bonds. Price of oil.
The main practical difficulties are determining the relevant factors and forecasting their value.
60 —————————————————————————————————————————
Business Valuations Examination of methods of valuing organisations and intangible assets
Topics Key Study System questions CS5 CS6 42
Company valuations Company valuations Bid terms
. . . . .
Asset-based valuations Earnings-based valuations Dividend-based valuations Cash flow valuation Intellectual capital 61
Business Valuations
Value ¼ value of net assets financed by the ordinary shareholders. Net assets are defined as: fixed assets plus current assets less liabilities less preference share capital. Asset valuations can be based on:
Weaknesses of net assets valuation
K
Book values (balance sheet values). Market values. Break-up values.
KK
Strengths of net assets valuation
KKK
Net assets valuation
KK
Asset-based valuations
Valuations are fairly readily available. Should provide a minimum value of the company.
Ignores future profitability expectations. Balance sheet valuations depend on accounting conventions, which might be very different from market valuations. Difficult to allow for value of intangibles/ intellectual property.
62 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––––––– Business Valuations
Earnings-based valuations
K
Private company valuations can take a suitable P/E ratio from comparisons with similar listed companies, although a lower ratio is generally appropriate.
K
Current market price per share Post-tax earnings per share
Advantages of P/E valuation Bases value on future earnings.
Disadvantages of P/E valuation K
Price/Earnings ratio (P/E)
Selection of appropriate P/E and earnings subjective.
Earnings yield valuation Earnings per share 100% Market price per share
63 —————————————————————————————————————————
Business Valuations
Dividend-based valuations
Po ¼
do ð1 þ gÞ ðke gÞ
Po ¼ price at year 0 do ¼ dividend at year 0 g ¼ dividend growth rate
The cost of equity used in the dividend growth model can be calculated as: Ke ¼ Rf þ (Rm þ Rf) b
Problems of using dividend models
K
K
ke ¼ cost of equity
Capital asset pricing model
KK
Dividend growth model
Dividend policy likely to change on takeover. Investors’ return will be based on capital gain as well as dividends. Investors tend to have very different expectations from each other. Valuing companies that do not pay dividends.
64 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––––––– Business Valuations
Cash-based valuations Discounted cash flow (DCF) method
Shareholder value analysis (SVA)
A valuation for the company’s equity is derived by estimating the future annual cash flows over a specified period and discounting at an appropriate cost of capital.
SVA is used to indicate the amount of economic value created in a period. It does so by measuring and managing cash flows of the business that take account of risk and the true value of money.
K
K
Problems with DCF method The selection of a time period is fairly arbitrary. You may be required to assume cash flows in perpetuity in an examination question. Difficult to determine appropriate discount rate.
The cash flows used in SVA are the net profits after tax, plus non-cash items, less any investments in working capital and fixed assets. These are known as the ‘free cash flows’. Decisions depend on key value drivers such as: sales growth rate, profit margin, and working capital/sales.
65 —————————————————————————————————————————
Business Valuations
Intellectual capital can be thought of as the total stock of capital or knowledge-based equity that the company possesses. It can be separated into three elements:
Organisational capital
Human capital
KKKKK
Intellectual capital
KKK
The know-how, capabilities, skills and expertise of the human members of the organisation, e.g.: Education. Vocational qualifications. Work-related knowledge and competencies.
The organisational capabilities developed to meet market requirements, e.g.: Patents. Copyrights. Design rights. Management philosophy. Corporate culture.
Customer capital
KKKK
The perception of value obtained by a customer from doing business with a supplier of goods or services, e.g.: Brands. Customer loyalty. Backlog orders. Licensing agreements. 66 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––––––––––– Business Valuations
Intellectual capital
Human capital
Customer capital
KKKK
KKKKK
Measures for managing intellectual capital
Years of experience in the profession. Employee satisfaction. Value added per employee. Value added per unit of salary.
Growth in business volume. Proportion of sales by repeat customers. Customer satisfaction. Customer complaints. Product returns as a proportion of sales.
K
KKK
Organisational capital Number of patents. Income per R&D expense. Ratio of new ideas generated to new ideas implemented. Five-year trend of product life cycle.
67 —————————————————————————————————————————
Business Valuations
Intellectual capital Three broad indicators have been developed to facilitate comparisons of intellectual capital stocks between firms:
Market-to-book values The value of a firm’s intellectual capital ¼ market value of firm – book value of firm. The principal benefit of this method is its simplicity. However, it fails to capture the complexities of the real world.
Calculated intangible assets Takes the excess return on tangible assets (i.e., how much more the company earns from its assets than the industry average company would) as the basis for determining the proportion of return attributable to intangible assets.
Tobin’s q The q is the ratio of market value of the firm (share price number of shares) to the replacement cost of its assets.
68 —————————————————————————————————————————
Mergers, Acquisitions, and Buyouts Examination of financial and strategic implications
Topics
Key Study System questions CS8 CS11
. . . . . .
Mergers and acquisitions Defences against takeovers Methods of payment Post-acquisition impacts Management buyouts Exit strategies 69
Mergers, Acquisitions, and Buyouts
Mergers and acquisitions
KK
KK
Types of merger Horizontal integration results when two firms in the same line of business combine. Vertical integration results from the acquisition of one company by another that is at a different level in the supply chain. A conglomerate results when two companies in unrelated businesses combine. Synergy. Companies merge where the net present value of the combined enterprise is deemed to be greater than the net present value of the individual companies.
70 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––– Mergers, Acquisitions, and Buyouts
KKK
Increased market share. Economies of scale. Combining complementary needs. Improving efficiency. Using surplus cash, having found few profitable investment opportunities. Tax relief. Reduce competition.
KKKK
Factors in acquisition decision
KK
Reasons for acquisition KKKKK
Mergers and acquisitions
Cost of acquisition. Form of purchase consideration. Existence of service contracts for key personnel in target company. Reaction of the stock market. Reaction of target company shareholders. Effect on cost of capital. Potential to ‘bootstrap’ earnings of target company by assuming higher bidding company P/E can be applied to earnings of target company.
71 —————————————————————————————————————————
Mergers, Acquisitions, and Buyouts
After the bid KKK
Communicating effectively with shareholders. Poison pills. Super-majority clauses. Revalue assets to current values. Manage shareholder base to ensure the ‘right’ shareholders are on board.
KK
Before the bid KKKKK
Defences against takeover
Rejection letter. Revise profit forecasts. Attack the bidder; e.g., claim bid undervalues target, comment on dubious accounting policies. Seek a ‘white knight’. Counter-bid for the bidding company.
72 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––– Mergers, Acquisitions, and Buyouts
K
K
Buys out or reduces competition. Allows increase in market size and influence on the market to be achieved more quickly. Potential for economies of scale and synergies. Some diversification of risk leading to a lower cost of capital. Leaves capacity as it was, rather than increasing it.
K
Benefits of organic growth
KK
Benefits of growth by acquisition KK
Mergers and acquisitions
Acquisitions are made on the basis of public information only, whereas organic expansion can be based on inside knowledge and robust judgements. Avoids difficulties of integrating companies and cultures, which can take time and incur high costs.
73 —————————————————————————————————————————
Mergers, Acquisitions, and Buyouts
Advantages of cash
Disadvantage of shares
KK
K
Methods of payment
Disadvantage of cash
Advantages of loan stock KK
Future gains shared with target company shareholders.
K
Certainty about target company’s value Target company’s shareholders bought out.
Advantage of shares
Disadvantage of loan stock K
Interest payments are tax deductible. Target company’s shareholders bought out.
K
Tax liability on capital gain for target company’s shareholders.
Bidding company does not part with cash.
Increases gearing (and therefore risk).
74 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––– Mergers, Acquisitions, and Buyouts
K KKK
K
In the absence of any synergy benefits, the value of the enlarged group will equal the value of the individual companies prior to the acquisition. If target company P/E < bidder company P/E, bidder company’s eps will increase. If target company P/E > bidder company P/E, bidder company’s eps will decrease.
KKK
Reasons why acquisitions fail
K
If a company acquires another company by issuing shares: K
Post-acquisition impacts
Lack of fit in terms of management styles or corporate structure. Lack of industrial or commercial fit. Lack of goal congruence. Turn around costs of a ‘cheap’ purchase are higher than expected. Paying too much for an acquisition. Failure to integrate effectively. Inability to manage change.
75 —————————————————————————————————————————
Mergers, Acquisitions, and Buyouts
Post-acquisition impacts
KK
K
K
K
Post-acquisition integration Position audit to gain an understanding of the main stakeholders and an appreciation of the products or services provided. Efficiency improvements. Redundancies need to be worked out fairly but firmly, using voluntary redundancies as far as possible. Profit improvement. A financial analysis will help to pinpoint areas for improvement, which will need to be followed up by a comprehensive action plan. Asset sales. The logic of each disposal must be explained to the management and staff affected. Effective communication. New reporting systems and procedures should only be introduced after proper consultation.
76 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––– Mergers, Acquisitions, and Buyouts
Management buyouts (MBO)
KKK
There will always be three parties to an MBO: Management team. Vendors (owners or directors). Financial backers (venture capital).
KK K
A transaction in which the executive managers of a business join with financing institutions to buy the business from the entity which currently owns it.
Methods of funding MBOs
KK
Definition
Secured loans are usually obtained from a bank. Senior debt will have a first-ranking security over all the assets involved in the MBO. Junior debt is usually called mezzanine finance, which is an intermediate stage between senior debt and equity in relation to both risk and return. Venture capital. Equity investment provided by the MBO team.
77 —————————————————————————————————————————
Mergers, Acquisitions, and Buyouts
MBOs may benefit from:
K
Establish what is for sale and why? Are the activities profitable and enjoy a satisfactory cash flow? Is the MBO team sufficiently strong? Is the price reasonable? Is a sufficient financial contribution being made by the MBO team? What is the likely exit route?
KKK
Performance of MBOs
KKK
Evaluation by investors KK
Management buyouts (MBO)
Greater staff motivation. Faster decision-making. Reduced overheads.
Management buy-ins The purchase of all or part of a business from its owners by a group of external managers.
78 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––– Mergers, Acquisitions, and Buyouts
Exit strategies Reconstructions
The splitting up of a corporate body into a number of separate bodies to realise the true worth of the underlying operations.
Reconstruction involves:
Spin-off A new company is created whose shares are owned by the shareholders of the company making the distribution of assets.
KKKKKK
De-merger
Writing off accumulated losses. Writing off interest payment arrears. Writing off preference dividend arrears. Writing down asset values. Writing down nominal value of shares. Stakeholders surrendering existing rights, or amounts owing, for new rights. They must be persuaded; reconstruction potentially offers more than liquidation.
Sell-off The sale of a part of a company to a third party.
79 —————————————————————————————————————————
Investment Appraisal Techniques Examining the methods of evaluating investment projects
Topics
Key Study System questions 7
. . . . .
Accounting rate of return Payback Discounting techniques Capital rationing Annual equivalent cost 81
Investment Appraisal Techniques
Calculated in basically the same way as ‘return on investment’; i.e., profit/investment.
Advantages
There are a number of ways of expressing ARR. Two common approaches are:
KK
Accounting rate of return (ARR)
Average profit Initial investment
Disadvantages
Average profit Average investment
KKKKK
Simple to calculate. Considers the total life of the project.
Does not consider tax or capital allowances. Does not consider the timing of cash flows. Uses profits rather than cash flows. Relative measure rather than absolute measure. Ignores time value of money.
82 —————————————————————————————————————————
–––––––––––––––––––––––––––––––––––– Investment Appraisal Techniques
Payback
KKKK
Simple to calculate and understand. Considers timing of cash flows. Useful as an initial screening method. Calculations are straightforward and likely to be error free.
KK
Advantages
Disadvantages
K
The length of time required for the net cash returns from a project to equal the initial cash flows.
Ignores cash flows outside the payback period. Not easy to determine how long the payback period should be. Does not consider time value of money.
Discounted payback Payback fails to take into account the time value of money. This can be overcome by discounting the cash flows to their present values and then using these discounted values to calculate the payback period.
83 —————————————————————————————————————————
Investment Appraisal Techniques
Advantages
The value obtained by discounting all relevant cash inflows and outflows at a chosen target rate of return / cost of capital. A project with a positive NPV would normally be accepted. The present value of a future cash flow is calculated by multiplying it by the factor
Disadvantages
1 ð1 þ rÞn r ¼ discount rate n ¼ number of periods
KK
Net present value (NPV)
KKKK
Discounting techniques
Considers time value of money. Easy to understand. Considers total life of project. Produces an unambiguous result.
Relies heavily on quality of cash flow forecasts. Needs an accurate and realistic cost of capital.
84 —————————————————————————————————————————
–––––––––––––––––––––––––––––––––––– Investment Appraisal Techniques
Discounting techniques Net present value (NPV) example Year 0 1 2 3 4 5
Cashflow (£000) (100) 20 30 40 40 10
Discount factor (10%) 1.000 0.909 0.826 0.751 0.683 0.621
Present value (£000) (100.0) Year 0 is the first day of Year 1 18.2 24.8 30.0 27.3 6.2 6.5
Cash flows are assumed to occur at the year-end. This project generates a positive NPV of £ 6,500.
85 —————————————————————————————————————————
Investment Appraisal Techniques
Internal rate of return (IRR)
Advantages
The discount rate at which the net present value of the project is zero.
KKK
Discounting techniques
The IRR is usually found approximately by linear interpolation, after calculating the NPV of the project at two different discount rates.
Disadvantages KKK
The decision rule is: accept the project if its IRR is greater than the cost of capital, reject if the IRR is less than the cost of capital.
Easy to interpret. Considers the time value of money. Do not need to know company’s cost of capital.
Can have multiple IRRs. Assumes reinvestment at IRR. Ignores relative size of investment, so should not be used to choose between mutually exclusive projects.
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–––––––––––––––––––––––––––––––––––– Investment Appraisal Techniques
Discounting techniques Net terminal value (NTV)
Modified internal rate of return (MIRR)
The cash surplus remaining at the end of the project after taking account of interest and capital repayments, i.e., the sum you would end up with over and above the amount if you rejected the project.
MIRR addresses some of the deficiencies of IRR. It addresses the reinvestment rate issues and reduces over-optimism, and produces a result which, when ranking projects, is consistent with the NPV rule.
Calculate by compounding project cash flows forward to end of the project’s life at company’s cost of capital. NTV discounted at company’s cost of capital ¼ NPV of a project
All cash flows after the initial investment are converted, by assuming that the cash flows can be reinvested at the cost of capital, to a single cash inflow at the end of the project’s life. The MIRR is obtained by assuming an outflow in Year 0 and a single inflow at the end of the final year of the project.
87 —————————————————————————————————————————
Investment Appraisal Techniques
Capital rationing
A restriction on an organisation’s ability to invest capital funds, caused by an internal budget ceiling being imposed on such expenditure by management (soft capital rationing), or by external limitations being applied to the company, as when borrowed funds cannot be obtained (hard capital rationing).
Profitability index (PI) Present value of cash inflows Initial investment
Advantage of PI K
Definition
Usually gives same result as NPV of individual projects.
Disadvantages of PI K
Single period capital rationing Relative measure rather than absolute.
Projects should be selected whose cash inflows have the highest NPV per unit of capital invested.
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–––––––––––––––––––––––––––––––––––– Investment Appraisal Techniques
Capital rationing Single period rationing with mutually exclusive projects
Single period rationing with indivisible projects
In such cases the ranking process using PI will need to be undertaken twice.
When projects are not divisible, use of a profitability index may lead to an incorrect ranking.
The first run would exclude one of the mutually exclusive projects, and the second run would exclude the other. The optimal selection of projects would be given by the combination with the highest total NPV.
In these situations, the investment selection decision has to be undertaken by examining the total NPV values of all the possible combinations of whole projects that do not exceed the amount of capital available. There may be an amount of unused capital with each combination of projects.
89 —————————————————————————————————————————
Investment Appraisal Techniques
Annual equivalent cost When the present value of a project is expressed as an annual amount, this is called annual equivalent cost and is used to compare projects having different life cycles. PV of purchase cost þ PV operating cost PV disposal proceeds Annuity factor for number of years of project’s life The annuity factor is at the company’s cost of capital, expressed in real terms. The decision rule is to select the project with the lowest equivalent annual cost.
90 —————————————————————————————————————————
Advanced Investment Appraisal Further issues in evaluating investment projects
Topics Key Study System questions CS1 5 6
Discount rates and project appraisal NPV and sensitivity analysis Adjusted present value
. . . . . . .
Taxation Inflation Relevant costs and benefits Adjusting for risk Assessing investments as options Investment in IS/IT Project implementation and control 91
Advanced Investment Appraisal
Taxation Tax rules may be simplified in an examination question, but the main tax implications are:
Capital allowances Otherwise known as tax-allowable depreciation.
Study tip You must take care over the timing of the tax cash flows. Tax is usually paid in the year after the profit is made.
When asset is sold: K
Project cash flows must be stated after tax and discounted at an after-tax discount rate.
Capital allowances are not cash, but they affect the tax liability of a company, which in turn affects tax payable. Generally charged on a reducing balance basis. Usually assume first claimed in year 1.
K
K
Corporation tax
Balancing allowance if reduced balance > resale value. Balancing charge if resale value > reduced balance.
92 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––––– Advanced Investment Appraisal
Inflation Cash flows may be prepared in nominal (actual) terms or in real terms (in terms of price levels at Year 0).
Nominal cash flows must be discounted at a nominal rate.
Nominal (or money) terms include an allowance for inflation.
Real terms cash flows must be discounted at a real rate.
Real (constant price) terms exclude inflation. The relationship between real and nominal rates is given by:
Study tip
(1 þ nominal) ¼ (1 þ real) (1 þ inflation)
If there are any tax implications in a question, it is easier to up-rate cash flows into nominal terms (i.e., into projected actual cash flows) and discount at the nominal rate.
93 —————————————————————————————————————————
Advanced Investment Appraisal
Relevant costs and benefits
KKKKKKKKK
The following points need to be remembered when calculating the NPV of a project: Depreciation and capital allowances should not be included; tax on capital allowances should. Cash inflows and outflows should be incremental after-tax. Projected dividend or interest payments should be ignored, as they are encompassed within the discount rate. Incremental working capital requirements need to be included; the effect of inflation requires careful handling. Working capital is recovered at the end of the project. Sunk costs represent past cash flows that cannot be recouped from a project and must be excluded. Opportunity costs should be included. Allocated costs and overheads should be excluded. Nominal cash flows must be discounted at a nominal rate.
94 —————————————————————————————————————————
––––––––––––––––––––––––––––––––––––– Advanced Investment Appraisal
Relevant costs and benefits
Year
0
Receipts Payments
1
2
3
X (X)
X (X)
X (X)
X
X (X) X
X (X) X
4
Taxation Tax saved on CA Capital Opportunity costs Residual value Working capital
(X) X
(X) (X)
Net cash flows Discount factors
(X) X
X X
X X
X X
(X) X
Present values
(X)
X
X
X
(X)
(X) X
(X)
95 —————————————————————————————————————————
Advanced Investment Appraisal
Adjusting for risk
KKK
Project risk arises when: One of a range of outcomes may occur. Each possible outcome has a known probability. The probabilities are objective.
KKK
Uncertainty is a situation where: Range of outcomes is unknown, or Probability of outcomes is unknown, or Both.
Sensitivity analysis The aim of sensitivity analysis is to seek out which variables of a project could have the most adverse effect on the overall outcome of an appraisal, if they were to fall short of their own expected outcomes.
Decision trees The decision tree is a useful tool for reviewing a multiplicity of choices and outcomes.
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––––––––––––––––––––––––––––––––––––– Advanced Investment Appraisal
Certainty equivalents
Other methods of adjusting for risk
Involves converting the expected cash flows into equivalent risk-free amounts by applying a safety factor, or certainty equivalent.
KKKK
Adjusting for risk
The ‘risk-free’ cash flows are then discounted at the risk-free rate of return.
Monte Carlo simulation. Risk-adjusted discount rate, e.g., CAPM. Payback. Add premium to normal discount rate.
A high level of subjective judgement is required from the decision maker when determining the appropriate certainty equivalent factors.
97 —————————————————————————————————————————
Advanced Investment Appraisal
Assessing investments as options The abandonment option
Strategic investment options
Major investment decisions involve heavy capital commitments and are largely irreversible. The ability to abandon the project if it starts to go wrong can be valuable.
Certain investment decisions give rise to follow-on opportunities that are wealth creating. New technology investment is difficult to evaluate.
Valuing options The option to wait and gather new information before investing may be sufficiently valuable to warrant such a delay.
KKKKK
Timing options Present value of future cash flows. Initial outlay on the investment. Time until option disappears. Variability of project returns. Risk-free rate of interest.
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––––––––––––––––––––––––––––––––––––– Advanced Investment Appraisal
Benefits from IS implementation KKKKK
K
K
K
Benefits of formal IS strategy K
Investment in IS/IT
Goal congruence between the information systems objectives and the corporate objectives can be achieved. The organisation is more likely to be able to create and sustain a competitive advantage. The high level of expenditure on information systems will be more focussed on supporting key aspects of the business. Developments in IT can be exploited at the most appropriate time.
Better decision-making. Fewer delays. Better service to customers. Competitive advantage. Reduced staff levels.
It is important to note that the benefits are often difficult or impossible to quantify.
99 —————————————————————————————————————————
Advanced Investment Appraisal
Benefits of PCA
The cycle from concept through development, construction, manufacturing, operation, and disposal. It can also be represented as: gather information, make predictions, accept project, implement, evaluate performance, use knowledge gained.
Post-completion auditing (PCA)
K
An objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project.
K
K
The investment cycle
KKK
Project implementation and control
Improves the quality of decision-making. Encourages greater realism in project appraisal. Provides a means of improving control mechanisms. Enables speedy modification of under-performing/ over-performing projects. Increases frequency of termination for ‘bad projects’. Highlights reasons for successful projects.
100 —————————————————————————————————————————
International Operations Methods of financing and evaluating international operations
Topics Key Study System questions CS16 8
. . . .
Financing The Euromarkets Risks and risk management International capital budgeting 101
International Operations
Financing
K
K
Factors to consider
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Retained earnings. The subsidiary could rely on its own internally generated funds. Finance raised by the parent company in its home country and transferred to the subsidiary by a combination of equity and loans. Finance raised in the country of the subsidiary. Financing from other capital markets. A multinational company based in the UK could raise finance in Germany via a subsidiary in that country and use the money to finance an investment in a third country.
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A number of methods can be used:
Raising finance in the country of the subsidiary reduces foreign exchange risk through matching, and reduce political risk. Raising finance in the parent’s country may make it easier to use a combination of dividends, interest, and management charges to repatriate funds. Amount of investment required. Availability of government grants/subsidies to international investors. Parent may be able to raise finance quicker and more cost effectively in its own country.
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The Euromarkets Eurocurrencies
Eurobonds
An investment in a currency held outside its country of origin. Eurocurrencies can be deposited or borrowed for relatively short periods – typically three months. Transactions are not subject to domestic rules and regulations of any financial centre.
Bonds issued in a currency often differing to the currency of the country of origin.
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Large companies, banks and some governments, raise money through issuing bonds in the eurobond market.
A syndicate of banks is brought together by a lead bank to provide medium to long-term currency loans to large multinational companies.
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Syndicated loans
The market is not totally accountable to any particular government, leading to fewer controls or regulation. Eurobonds are issued in bearer form. Interest is paid gross, allowing investors to pay their own domestic tax.
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Risks and risk management
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The main factors to consider when moving into a new international market are: Knowledge of the country’s operational environment; economic and financial, cultural and political. Availability of local technical expertise. Travelling distances and difficulties between the international location and the home base. Language problems. Competition. Alternative investment opportunities.
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Risks and risk management Transaction risk
Economic risk
The risk of adverse exchange-rate movements between the date of a transaction and the date of settlement. This can be managed by using internal or external hedging techniques, e.g., forward rate contracts (external) or netting (internal).
The risk of actions by governments and the reactions of markets that have economy-wide implications. This type of risk might be managed by raising finance in the foreign country, or by manufacturing in that country.
Political risk Translation risk The susceptibility of the balance sheet and income statement to the effect of exchange rate changes. This can be reduced by borrowing in the foreign country, matching currency inflows and outflows.
The unwanted consequences of political activities that will have an effect on the value of a firm.
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Risks and risk management
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Discrimination against foreign businesses. Expropriation of assets. Nationalisation of local subsidiaries. Rules specifying use of local labour and materials. Price-setting constraints. Exchange controls. Tax regulations. Restrictions on access to local loans.
Methods of obtaining cash return from subsidiary
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Government actions
Capital flows comprising dividends and monies to service debt capital provided by the parent. Payments for merchandise supplied. Management charges.
Payments for merchandise will usually be permitted subject to transfer pricing restrictions, which will ensure that goods sold between the parent and subsidiary companies are priced at ‘arm’s length’.
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There are two possible approaches to evaluating overseas projects, using an NPV analysis that should both lead to the same outcome, assuming interest rate parity theory holds. Assuming a UK company investing in USA, these approaches are: 1
2
Convert the dollar cash flows from the project into sterling, then discount at a sterling discount rate to generate a sterling NPV. Discount the dollar cash flows from the project at a discount rate appropriate to that currency. Then convert the dollar NPV into a sterling NPV by converting at the spot rate of exchange.
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International capital budgeting The relationship between the sterling discount rate and the dollar discount rate is given by: 1 þ annual discount rate $ 1 þ annual discount rate £ Exchange rate in 12 month’s time $/t ¼ Spot rate $/£
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International capital budgeting Example The $/£ spot rate is 2.0 and the $ is expected to depreciate against the £ by 10 per cent per year. A similar risk, UK-based project, would be expected to generate a minimum of 20 per cent after tax. 1 þ annual discount rates 2:20 ¼ 1:20 2:00 2:20 1:20 1 annual discount rates ¼ 2:00 ¼ 32%
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Issues to consider
Double taxation occurs when income is taxed both by the taxpayer’s country of residence and in another country where the income arises. The purpose of double taxation relief is to remove or reduce the disincentive that this double taxation represents to outward investment. Another objective is to try to ensure that taxpayers do not exploit the terms of double taxation agreements and differing tax systems in each country for tax avoidance purposes.
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Double taxation relief
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International capital budgeting
future exchange rates will usually need to be calculated using interest rate parity. cash flows may be expressed in current prices and require up-rating to nominal terms. Terminal values may need to be calculated (perpetuity discounted back to the present). Adjustments for differential tax may be required.
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