Uploaded by tigerlillydoll

Corporate Finance - Principles and practice 6th Edition- Instructor's Manual

advertisement
Instructor’s Manual
Corporate Finance
Principles and Practice
Sixth edition
Denzil Watson
Antony Head
For further instructor material
please visit:
www.pearsoned.co.uk/watsonhead
ISBN: 978-0-273-76275-1
© Pearson Education Limited 2014
Lecturers adopting the main text are permitted to download and photocopy the manual as required.
PEARSON EDUCATION LIMITED
Edinburgh Gate
Harlow CM20 2JE
United Kingdom
Tel: +44 (0)1279 623623
Fax: +44 (0)1279 431059
Web: www.pearson.com/uk
First published 2007
This edition published 2014 (electronic)
© Pearson Education Limited 2014 (electronic)
The rights of Denzil Watson and Antony Head to be identified as authors of this work have been
asserted by them in accordance with the Copyright, Designs and Patents Act 1988.
ISBN 978-0-273-76275-1
All rights reserved. This ePublication is protected by copyright. Permission is hereby given for
the material in this publication to be reproduced for OHP transparencies and student handouts,
without express permission of the Publishers, for educational purposes only. In all other cases,
this ePublication must not be copied, reproduced, transferred, distributed, leased, licensed or
publicly performed or used in any way except as specifically permitted in writing by the
publishers (or, where applicable, a licence permitting restricted copying in the United Kingdom
should be obtained from the Copyright Licensing Agency Ltd, Saffron House, 6-10 Kirby
Street, London EC1N 8TS) as allowed under the terms and conditions under which it was
purchased, or as strictly permitted by applicable copyright law. Any unauthorised distribution or
use of this text may be a direct infringement of the author's and the publishers' rights and those
responsible may be liable in law accordingly.
All trademarks used herein are the property of their respective owners. The use of any
trademark in this text does not vest in the author or publisher any trademark ownership rights in
such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement
of this book by such owners.
Pearson Education is not responsible for the content of third-party internet sites.
The Financial Times. With a worldwide network of highly respected journalists, The Financial
Times provides global business news, insightful opinion and expert analysis of business, finance
and politics. With over 500 journalists reporting from 50 countries worldwide, our in-depth
coverage of international news is objectively reported and analysed from an independent, global
perspective. To find out more, visit www.ft.com/pearsonoffer.
2
Contents
Chapters
Chapter 1
Chapter 2
Chapter 3
Chapter 4
Chapter 5
Chapter 6
Chapter 7
Chapter 8
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Pages
The finance function
Capital markets, market efficiency and ratio analysis
Short-term finance and the management of working capital
Long-term finance: equity finance
Long-term finance: debt finance, hybrid finance and leasing
An overview of investment appraisal methods
Investment appraisal: applications and risk
Portfolio theory and the capital asset pricing model
The cost of capital and capital structure
Dividend policy
Mergers and takeovers
Risk management
3
© Pearson Education Limited 2014
6
10
15
21
24
30
37
45
48
52
56
62
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
4
© Pearson Education Limited 2014
GUIDELINE ANSWERS TO DISCUSSION
QUESTIONS
5
© Pearson Education Limited 2014
CHAPTER 1
THE FINANCE FUNCTION
Question 1
There are a number of ways of seeking to optimise managerial behaviour in order to encourage
goal congruence between shareholders and managers. One way is for shareholders to monitor
the actions of managers. There are several potential monitoring devices that could be used, but
they will all incur costs in terms of both time and money. These devices include:
•
Independently audited accounting statements
•
Government regulation
•
The legal system
•
Cash dividends
•
Reputation
•
Information disseminated as a result of new external financing.
The costs of monitoring must be weighed against the benefits accruing from a decrease in suboptimal managerial behaviour. One difficulty here is the existence of free riders; investors who
allow larger shareholders to incur monitoring costs while reaping the benefits of the corrected
management behaviour.
Alternatively, shareholders can try and incorporate clauses into managerial contracts which are
intended to reduce the agency problem and encourage goal congruence. Such clauses may
formalise constraints, incentives and punishments. In this way, agency costs are reduced. An
optimal contract is one which minimises agency costs, while reflecting the needs of individual
companies. For example, if monitoring is difficult or costly, the contract could include bonuses
for good performance.
It is also possible to discuss here the following points:
•
The right of shareholders to appoint and remove directors
•
Incentives (performance-related pay, share options, etc.)
•
The right of shareholders to sell their shares in the capital markets
•
Competition in the market for managerial control.
6
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 2
There is a difference between short- and long-term objectives. In the short-term, profits and cash
flow must be enough to ensure the survival of the company, but owners will want to receive
dividends. The need to strike a balance between short-term and long-term objectives could lead
to conflicts between objectives even within the objective of maximising shareholder wealth.
Although shareholder wealth maximisation is the primary financial objective, most companies
will usually have other objectives as well. In addition to responsibilities to shareholders,
companies will have responsibilities to employees, trade payables, suppliers, the government
and the general public. The diverse interests of these stakeholders will influence corporate
objectives and act as a restraint on the objective of shareholder wealth maximisation. Other
corporate objectives could include:
•
Providing for the welfare of managers
Managers may seek to improve their own personal wealth, status or working conditions. For
example, managers may pay themselves high salaries under generous employment contracts, or
they may resist a takeover bid because they wish to protect their jobs rather than recommending
an attractive bid to shareholders.
•
Providing for employee welfare
Employees must be paid attractive wages and work under good conditions of employment. In
the short-term, providing for employee welfare appears to conflict with the objective of
shareholder wealth maximisation, because paying higher wages means that profits will be lower.
In the long-term, however, employees who are well-paid and who are satisfied with their
working conditions may work more efficiently and effectively, contributing to increased profits.
In this case, there is no conflict between the objective of providing for employee welfare and the
objective of shareholder wealth maximisation.
•
Providing for the welfare of society as a whole
Companies have obligations to society as a whole. Many companies spend heavily on measures
promoting social welfare, even though this may reduce profitability. Such measures include
environmental protection measures, supporting community programmes, giving to charities and
so on. However, failure to take environmental protection measures may lead to their imposition
through legislation, and customer buying patterns may be negatively influenced if a company
acquires a reputation as uncaring and environmentally irresponsible. Undertaking measures
promoting social welfare may, therefore, not be inconsistent with shareholder wealth
maximisation.
Question 3
There have been many reports into corporate governance since the seminal Cadbury Committee
Report in 1992, including those by Greenbury (1995), Hampel (1997), Turnbull (1999), Higgs
(2003), Smith (2003) and Tyson (2003) and, more recently, several reviews by the Financial
Reporting Council. The recommendations of these reports and subsequent reviews have been
incorporated into the Combined Code on Corporate Governance, or the Corporate Governance
Code as it is now known.
7
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
The Cadbury Report put forward a number of proposals for increasing board accountability to
shareholders. It recommended a greater role for non-executive directors on remuneration
committees, a voluntary Code of Best Practice, an improved information flow to shareholders
and a strengthening of independence of auditors. The Code of Best Practice required that the
board have at least three non-executive directors: that directors’ service contracts be not more
than three years in duration; and that the chief executive officer and the chairman be different
post-holders.
Many commentators, in being critical of effectiveness of the Cadbury Report, focused on the
market-based nature of the proposed self-regulation system and the failure of this system to
involve shareholders in the governance process. Others argued that, while the Cadbury Report
concentrated on monitoring, checking and controlling board activities, it failed to address the
question of future company strategy.
Further measures to tackle corporate governance problems were introduced following the
subsequent reports by Greenbury, Hampel, Turnbull, Higgs, Smith and Tyson. The integration
of these recommendations into the Corporate Governance Code (overseen by the London Stock
Exchange and the UK Listing Authority) has certainly had a favourable effect on the
effectiveness of corporate governance in the UK. There is still some way to go before corporate
governance problems are a thing of the past, however, as shown by the failure of Enron in 2002.
The bankruptcy of Lehman Brothers in 2008, the resulting financial crisis and subsequent issues
surrounding the governance of some of the UK's major banking institutions ensure that
corporate governance and the problem of agency remain an important and topical issue.
Question 4
The failures of Enron and WorldCom had a dramatic effect on both UK and US corporate
governance, with both governments and investors taking corporate governance more seriously.
However, historically there have been and continue to be significant differences between the
approaches of the two countries to the governance problem. Traditionally, the UK system has
been based on a series of best practice guidelines that have been progressively developed over
time and integrated into the UK Corporate Governance Code. These guidelines are nonstatutory and are not enshrined in law, but require compliance (or an explanation, if otherwise)
from self-regulatory organisations such as the London Stock Exchange. The current version of
Corporate Governance Code, introduced in 2010, is now overseen by the Financial Reporting
Council (FRC). It stands alongside the Stewardship Code, also introduced in 2010 and
specifically directed towards institutional investors.
In contrast to this, the US system is far more legalistic in nature, with the Securities and
Exchange Commission (SEC) playing a principal role in the regulation process. The regulatory
framework was significantly bolstered after Enron (2002) with the introduction of the SarbanesOxley Act. This takes a regulatory and legislative approach to corporate governance and
disclosure of financial and other information, and contrasts with the UK best practice approach,
regarded by many as more flexible and effective. The Sarbanes-Oxley Act introduced sweeping
corporate governance reforms, requiring personal certifications of disclosure from both chief
executive and financial officers. Their written statements must certify that the report fully
complies with SEC requirements aim to ensure that a company fairly presents the results of both
the operational and financial condition of the company. Significant criminal penalties exist for
false certification.
8
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
The Act also effectively requires all companies listed in the US to have fully independent audit
committees. It prohibits auditors from providing an audit client with any non-audit services,
apart from a small number of exceptions. The compliance burden is far more onerous that faced
by UK companies and only time will tell if this more legalistic approach to corporate
governance is successful.
9
© Pearson Education Limited 2014
CHAPTER 2
CAPITAL MARKETS, MARKET EFFICIENCY AND
RATIO ANALYSIS
Question 1
(a) A good answer will discuss the various kinds of efficiency:
•
Operational efficiency, in terms of transaction costs and market access
•
Allocational efficiency, in terms of economic efficiency and optimum resource utilisation
•
Informational efficiency, where information is available to the majority at low cost
•
Pricing efficiency, in relation to market breadth and depth, liquidity, full reflection of
information and no individual dominating the market.
(b) The answer should build on points mentioned in the answer to (a). With respect to the
Alternative Investment Market:
•
It is used by young, dynamic companies or those not wanting a full listing
•
It is likely to have sufficient depth and breadth
•
The question of whether a market is efficient must be addressed by empirical
research rather than speculation.
(c) Following on from part (b), the answer should:
•
Distinguish between and discuss weak form, semi-strong form and strong form efficiency
•
Explain and discuss weak form tests (serial correlation, run tests and filter tests)
•
Explain and discuss semi-strong form tests (stock splits, response to Annual Reports and
so on)
•
Discuss tests for strong form efficiency.
Question 2
The efficient market hypothesis (EMH) describes an efficient market as one where the prices of
securities fully, fairly and quickly reflect all available information. The EMH is therefore,
concerned with information and pricing efficiency. Any new information that becomes available
is quickly and accurately absorbed by participants in the market and through their actions is
reflected in changes, if such are necessary, in the traded values of affected securities. The
efficiency of the market is a result of market participants actively competing against each other.
The three forms of market efficiency mentioned in the question refer to the types of information
shown to be reflected in security prices.
10
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
(a) Weak form efficiency
Security prices fully and fairly reflect all relevant past information. Future prices cannot
therefore, be predicted from historical data alone and trading rules based only on such price and
volume data (i.e. technical analysis or chartism) cannot consistently produce excess returns if
the weak form hypothesis holds true. The statement is therefore, false.
(b) Semi-strong form efficiency
Here, the prices of securities reflect all publicly available information. Reaction to public
announcements will not produce excess returns, as the information content of such
announcements is reflected in the prices of securities. If the semi-strong form of the EMH is
true, then fundamental analysis, which seeks to establish the intrinsic or fundamental value of a
share and compare it with its market value, cannot lead to abnormal gains. The statement is
therefore, false.
(c) Strong form efficiency
Here, the prices of securities reflect all information, whether publicly available or not. If this
form of efficiency were to hold, no investor could earn above average returns using such
information. It would rule out gains made by investors using inside information. The statement
is therefore true.
Question 3
(a) Shareholders concerned about the maximisation of their wealth
Because of the rather vague and intangible nature of shareholder wealth, the market price of a
company’s shares is taken as a surrogate measure. Whether the market price of a company’s
shares represents an accurate and appropriate measure of a shareholder’s wealth depends heavily
on the efficiency of the markets in which the shares are traded. Therefore, the efficient market
hypothesis has an important role to play with respect to shareholders and the maximisation of
their wealth. It provides the vital link between the overall value of a company and the market
price of its shares, which in turn is taken as a measure of shareholder wealth.
(b) Corporate financial managers making capital investment decisions
If the efficient market hypothesis is assumed to hold, it implies that good management decisions
with respect to investment and financing will be quickly and accurately reflected in a company’s
share price. It also implies that financial manipulation such as creative accounting is a waste of
time as the market will see through such actions. Another implication is that, as the market price
of an ordinary share always represents a fair price, the timing of new issues and rights issues is
not critical.
(c) Investors analysing the annual reports of listed companies
The implication of the efficient market hypothesis for investors is that studying company
accounts to try to make abnormal returns (fundamental analysis) is pointless. No bargains exist
on the stock exchange, as share prices change quickly and accurately to reflect new information
as it becomes available. The best strategy when managing a portfolio of shares is therefore, to
buy and hold, rather than to engage in a large amount of switching between shares.
11
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 4
(a) Shareholder wealth maximisation and shareholder return
Shareholders’ wealth increases through the receipt of dividends and increases in share prices.
Nominal dividend per share has increased every year by 7 per cent. This is less than the 10.9 per
cent average growth in revenue and less than the 8.0 per cent average growth in EPS.
Average share price growth of 24 per cent per year appears to be acceptable, but this will need
to be compared to the general trend of share prices within the business sector of Tor plc in order
to confirm historical performance. Share price growth in 20X9 at 37 per cent is higher than the
30.8 per cent growth (35% − 4.2%) of the sector overall. The share price has increased every
year and shareholders have therefore, experienced a capital gain every year.
Nominal dividend yield has declined every year, from 5.4 per cent in 20X6 to 3.5 per cent in
20X9, since growth in share prices has been much greater than growth in dividends per share.
The dividend yield of Tor plc needs to be compared with the average dividend yield for the
sector over the period for further insight into the historical trend in dividend yield. Dividend
yield in 20X9 at 3.5 per cent is less than the 4.2 per cent average for the sector.
Total shareholder return reflects both dividend and share price changes, and increasing share
price has more than compensated for the declining dividend yield. Total shareholder return was
a comparatively modest 14.0 per cent in 20X6, but rose to 36.6 per cent in 20X7, 35.3 per cent
in 20X8 and 40.5 per cent in 20X9. Total shareholder return in 20X9 is certainly higher than
the average return of 35 per cent for the sector, more than compensating for the shortfall in
dividend yield. The relative growth in the share price compared to the sector (and hence the
value of the price/earnings ratio relative to the sector) suggest that the market anticipates
increased dividends in the future.
Tor plc has achieved its stated target of a 15 per cent per year return to shareholders during the
period under review, apart from in the first year, 20X6. The average return is above the stated
target value.
Analysis of real dividends
Real dividend growth has declined each year during the period under review, from 4.3 per cent
in 20X6 to 3.8 per cent in 20X9. Real dividend growth in the last year has been less than the
declared growth target of 4 per cent per year.
Conclusion
As far as shareholder return is concerned, Tor plc has achieved its target of a 15 per cent per
year apart from in 20X6. As far as real dividend growth is concerned, Tor plc has achieved its
stated target of 4 per cent per year in 20X6 and 20X7, but not in 20X8 and 20X9. It is not
possible to say if shareholder wealth increase has been ‘maximised’, but shareholder return in
20X9 compared to the sector is certainly encouraging.
12
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Financial analysis
20X5
20X6
20X7
20X8
3.74
4.06
5.33
6.98
9.56
Capital gain
8.6%
31.3%
31.0%
37.0%
Dividend yield
5.4%
5.3%
4.3%
3.5%
14.0%
36.6%
35.3%
40.5%
Share price (£)
TSR
20X9
In nominal terms:
20X5
20X6
20X7
20X8
20X9
Revenue growth
2%
19%
5%
19%
EPS growth
8%
5%
1%
19%
DPS growth
7%
7%
7%
7%
Average revenue growth = (218/144)0.25 − 1 = 10.9%
Average EPS growth = (63.7/46.8)0.25 − 1 = 8.0%
In Real Terms:
Revenue (£m)
20X5
20X6
20X7
20X8
20X9
144
143
166
169
195
−1%
16%
2%
15%
19.5
20.3
21.1
21.9
4.3%
4.1%
3.9%
3.8%
39%
40%
43%
39%
Revenue growth
DPS (pence)
18.7
DPS growth
Payout ratio
40%
(b) The agency problem arises when managers, as agents of the shareholders, act in sub-optimal
ways so that shareholder wealth is not maximised. Students could discuss several ways of
reducing this problem.
•
Monitoring
•
Performance-related pay
•
Share option schemes
•
Optimal contracts.
Each way should be explained, and advantages and disadvantages of each way should be
discussed.
13
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
The information in the question has several features that can be used to illustrate mitigation of
the agency problem:
•
The CEO has 17 per cent of the issued share capital and 63 per cent of the share capital
owned by the board. He owns three times as many shares as the MD. He may be able to
exert a significant amount of power over company affairs.
•
UK institutional shareholders own 44 per cent of the issued share capital and so will
have considerable influence over the company’s direction and policies.
•
If foreign institutional investors join forces with UK institutional investors, they would
together own 54 per cent of the issued share capital.
•
Small shareholders are probably ineffective in mitigating agency problems within Tor plc,
due to their relatively small shareholding and the fragmented nature of individual
shareholdings.
14
© Pearson Education Limited 2014
CHAPTER 3
SHORT-TERM FINANCE AND THE MANAGEMENT
OF WORKING CAPITAL
Question 1
(a)
Option 1: Evaluation of early payment discount:
£
Current trade receivables = 20m × (60/365) =
New level of trade receivables:
Taking discount: = 20m × 35% × (30/365) =
Not taking discount: 20m × 65% × (60/365) =
£
3,287,671
575,342
2,136,986
2,712,329
575,342
Reduction in trade receivables
Finance saving on trade receivables at 8%
Decrease in bad debts:
Savings in administration costs:
46,027
60,000
20,000
126,027
70,000
56,027
Less cost of discount = 20m × 35% × 1% =
Net benefit
Option 2: Evaluation of factor’s offer:
£
Current trade receivables:
Trade receivables under factor = 20m × (30/365) =
£
3,287,671
1,643,836
1,643,836
Reduction in trade receivables
Reduction in financing cost: at 8%
131,507
Reduction in financing cost:
Reduction in bad debts = 0.2m × 80% =
Administration savings:
131,507
160,000
160,000
451,507
Increase in financing cost
Increased cost of 80% advance:
(£1,643,836 × 80% × (12% − 8%) =
Annual fee of factor:
(1.75% × £20) =
52,603
350,000
402,603
15
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Net benefit
48,904
The savings using the discount (£56,027) are marginally higher than the savings from using the
factor (£48,904) so the former’s offer is preferable on financial grounds.
(b) Working capital is concerned with the management of the liquid resources of the company
and as such needs to balance the need for liquidity against the need for profitability. Liquid
resources need to be managed so as to minimise the risk of insolvency while maximising the
return on assets. This is not a simple task and an optimum position is unlikely to be
achieved on a permanent basis. Rather, management of working capital is a dynamic
activity, seeking to anticipate company needs while responding to threats to the company’s
survival.
The risk of running out of funds can be reduced by matching financing with the life of the
assets being financed. Assets can be analysed into non-current assets, permanent current
assets and fluctuating current assets, with permanent or ‘core’ current assets being financed
from long-term sources. You should discuss the relative risk of long- and short-term
finance to the company. For example, an overdraft is repayable on demand, and so should
not be used to finance all working capital needs: in particular, it should not be used to
finance permanent current assets.
You could discuss taking steps to reduce the cash conversion period. The problem here is
that each component of the cycle needs to reflect the needs of the company in that area.
Inventory levels will reflect trading needs, for example, and the company will want to
maintain customer satisfaction. Trade receivable levels may be determined by the need to
remain competitive, rather than the need to reduce receivables to a minimum. Trade
payables may be unhappy if Stenigot defers payments to them, since they will be financing
the lower cash conversion cycle.
Beyond this, it also difficult to determine what an optimum level for working capital as a
whole should be. Not only will the overall level of working capital fluctuate with business
activity, being a dynamic concept, but the overall level will also be determined by the
company’s attitude to risk and return. An aggressive stance would call for lower levels of
working capital, but lead to increased risk as the price for higher profitability. Such a policy
could lead to overtrading and liquidity problems. A conservative policy would have the
opposite effect.
Question 2
(a) The main aim of credit management is the successful implementation and maintenance of
appropriate credit policies. These credit policies are not static, but will change over time in
response to the changing competitive structure of the construction industry. Successful
control of trade receivables will directly influence the liquidity of the firm. The policies will
cover a number of key areas:
•
Procedures to be followed in giving credit to customers (credit analysis system)
•
Setting credit limits for customer accounts (credit control system)
•
Determining the discount structure
•
Managing the collection of amounts due and overdue (trade receivables collection
system).
16
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Credit management is also concerned with minimising losses from bad debts and with
taking steps to ensure that as much as possible is recovered if a client goes into liquidation.
The credit controller should balance the benefits to be gained from offering credit to
customers against the costs of doing so.
Credit analysis system
The risk of bad debts can be minimised if the creditworthiness of new customers is assessed
and reviewed on a regular basis. Relevant information can be obtained from a variety of
sources including bank references, trade references, published information, credit agencies
and the company’s own experience.
Credit control system
•
Customer accounts should be kept within agreed credit limit.
•
Credit limits should be reviewed periodically.
•
Invoices should be despatched promptly.
•
Statements should be sent out regularly where appropriate.
Trade receivables collection system
•
Costs of debt collection should not exceed amounts recovered.
•
Aged trade receivables analysis must be regularly performed and late payers chased.
•
Company should establish procedure for pursuit of late payments.
•
Company could consider charging interest on overdue bills.
(b) Factors offer a range of services in the area of sales administration and the collection of
amounts due from trade receivables, including:
•
Administration of sales invoicing and accounting.
•
Collection of amounts due and chasing up slow payers.
•
Advance of cash against the security of accounts receivable.
•
Offering protection against non-payment through non-recourse factoring.
Invoice discounting, however, involves the sale of selected invoices to another company. It
is a service often provided by factoring companies; its value to the vendor lies in the
improvement in cash flow that results.
Among the advantages of factoring for a company are:
•
Prompt payment of suppliers, perhaps early payment discounts.
•
Reduction in amount of working capital tied up in trade receivables.
•
Financing growth through sales.
•
Savings on sales administration costs.
•
Gaining from factor’s experience in credit control.
(c) Companies like Saltfleet plc have a number of reasons why they may want to hold funds in
liquid or near-liquid form. Cash which is surplus to immediate needs should generate profit
for the company by being invested on a short-term basis without risk of capital loss. Large
companies will set limits on the amount that they will deposit with individual banks, since
17
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
credit risk should be taken into account by placing funds with a number of acceptable
institutions.
The factors to be considered when choosing appropriate short-term investments are:
•
The size of the surplus, since some instruments have minimum amounts.
•
The ease with which an investment can be realised.
•
The maturity of the investment.
•
The risk and the yield of the investment.
•
Any penalties which may be incurred for early liquidation.
Short-term instruments for use in the management of corporate liquidity include money
market deposits, sterling certificates of deposit, treasury bills, sterling commercial paper
and gilt-edged government securities nearing maturity. Ordinary shares listed on the London
Stock Exchange carry a significant risk of capital loss and are not suitable for the
investment of Saltfleet plc’s short-term cash surpluses.
Question 3
(a) The cash conversion cycle is the receivables’ conversion period (RCP) plus the inventory
conversion period (ICP), less the payables’ conversion period (PCP).
RCP = (1,538/12,000) × 365 =
47 days
ICP (Raw Materials) = (1,634/5,800) × 365 =
103 days
ICP (Finished Goods) = (2,018/8,860) × 365 =
83 days
PCP = (1,092/5,800) × 365 =
69 days
CCC = 47 + 103 + 83 − 69 =
164 days or 23.5 weeks
Investment in working capital must be financed: the longer the cash conversion cycle, the
more capital is tied up and the higher the cost to Rowett plc. The company could reduce the
cash tied up by optimising the components of the cash conversion cycle. So, for example,
shortening the inventory conversion period could reduce the working capital requirement
and increase profitability.
(b) See the answer to part (a) of the previous question.
(c)
€000
Current level of trade receivables =
Trade receivables under factor = 12,000 × (40/365) =
Reduction in trade receivables
1,538
1,315
223
€
Reduction in financing cost = 223,000 × 8% =
€
7,840
Cost of financing new trade receivables = 1,315,000 × 8% =
Cost of financing under factor:
1,315,000 × 8% × 25% =
26,300
18
© Pearson Education Limited 2014
105,200
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
1,315,000 × 10% × 75% =
98,625
Increased financing cost
124,925
19,725
€
Reduction in financing cost due to lower receivables
17,840
Reduction in bad debts = 12m × 0.5% =
60,000
Saving in administration costs =
€
160,000
Benefits
237,840
Increase in financing cost due to advance
19,725
Annual fee of factor = 12m × 2.0% =
240,000
Costs
259,725
Net cost
(21,885)
The finance provided by the factor is an accelerated cash flow derived from trade
receivables. It is therefore, not appropriate to use it for a long-term finance need, such as
the purchase of non- current assets. Rather, it should be used for a short-term need, such as
the payment of trade payables or meeting forecast cash needs. In general, the matching of
assets and liabilities is recommended. That said permanent current assets should be financed
from a long-term source.
Question 4
(a)
£
Current receivables = 15m × (45/365) =
New level of receivables:
15m × 0.4 × (30/365) =
15m × 0.6 × (45/365) =
£
1,849,315
493,151
1,109,589
1,602,740
Change in level of receivables:
246,575
Finance saving on receivables = 246,575 × 0.09 =
22,192
Decrease in bad debts:
60,000
Savings in administration costs:
15,000
97,192
Cost of discount = 15m × 0.4 × 0.015 =
Net benefit of proposal:
90,000
7,192
This benefit is so small that it is unlikely it can be justified. Further investigation of likely
costs and benefits is called for.
(b) Answer should discuss:
•
The matching of financing with life of assets
•
Analysis of assets into non-current assets, permanent current assets and fluctuating
current assets
19
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
The need to finance permanent or ‘core’ current assets from long-term source
•
The relative risk of long and short-term finance to the company
•
The need to balance liquidity against profitability
•
An overdraft is technically repayable on demand, and so should not be used to
finance all working capital needs: in particular, it should not be used to finance
permanent current assets.
(c) The components of the cash conversion cycle are inventory conversion period, receivables
conversion period and payables deferral period. The managing director is suggesting that
this cycle should be reduced to a minimum, and that this will optimise the overall level of
working capital. The meaning of ‘minimum’ is not specified.
The problem with reducing the cash conversion period to a minimum is that each
component of the cycle needs to reflect the needs of the company in that area. Inventory
levels will reflect trading needs, for example, and the company will want to maintain
customer satisfaction. Trade receivables levels may be determined by the need to remain
competitive, rather than the need to reduce trade receivables to a minimum.
Trade payables may be unhappy if Menendez defers payments to them, since they will
be financing the lower cash conversion cycle.
Beyond this, it is also difficult to determine what an optimum level for working capital as a
whole should be. Not only will the overall level of working capital fluctuate with business
activity, being a dynamic concept, but the overall level will also be determined by the
company’s attitude to risk and return. An aggressive stance would call for lower levels of
working capital, but lead to increased risk as the price for higher profitability. Such a policy
could lead to overtrading and liquidity problems. A conservative policy would have the
opposite effect.
The finance director should take a more informed approach to working capital management
than just following the suggestion offered by the managing director, which is not to say that
avoiding slack in working capital is to be ignored.
(d) The answer could discuss:
•
Factoring
•
Invoice discounting
•
Using trade receivables as security for a bank loan
•
Discounting bills of exchange.
20
© Pearson Education Limited 2014
CHAPTER 4
LONG-TERM FINANCE: EQUITY FINANCE
Question 1
(i) Rights issue price = 2.75 × 0.8 = €2.20 per share
Theoretical ex-rights price = ((2.75 × 4) + 2.20)/5
= €2.64 per share
(ii) New shares issued = 2,000,000/4 = 500,000 shares
Net cash raised = (500,000 × 2.20) − 50,000
= €1,050,000
(iii) Value of rights = (2.64 − 2.20)/4 = 11 cents per existing share
The meaning of the terms should be explained as well.
Question 2
(a) Students should define placing and public offer, and discuss their relative merits in terms
of ownership spread, issue costs, administrative costs and amount of funds required.
(b) Rights issues are priced at a discount to market price to make them attractive to existing
shareholders, and to guard against a fall in share price in the period between announcing
and making the issue.
(c) Rights issue price = 3.00 × 0.8 = £2.40 per share
Theoretical ex-rights price = ((6 × 3.00) + 2.40)/7 = £2.91 per share
Value of rights per share = (2.91 − 2.40)/6 = £0.085 or 8.5p per share
(d) The main factors determining the actual ex-rights share price are the expectations of
shareholders regarding the use of the funds raised and market sentiment regarding the future
prospects of the company. The actual ex-rights price and the theoretical ex-rights price are
the same only if the market view of the issuing company is unchanged and if the yield on
the new funds is identical to the average yield on the issuing company’s existing funds.
Question 3
(a) Current EPS = (10,000,000/20,000,000) × 100 = 50p
Current price/earnings ratio = 4.27/0.5 = 8.54
Rights issue price = €4.27 × 0.85 = €3.63
21
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Total cash raised = €3.63 × 4,000,000 = €14,520,000
Cash available after issue costs = 14,520,000 − 660,000 = €13,860,000
Redemption of bonds
Nominal value of bonds redeemed = 13,860,000/1.05 = €13,200,000
Interest saved = 13,200,000 × 13 per cent = €1,716,000
Increased tax = 1,716,000 × 30 per cent = €514,800
Net savings if bonds redeemed = 1,716,000 − 514,800 = €1,201,200
New level of earnings = 1,201,200 + 10,000,000 = €11,201,200
New number of shares = 20m + 4m = 24m
New EPS = (11,201,200/24,000,000) × 100 = 46.7p
Expected share price = 46.7 × 8.54 = 399p or €3.99
Investment in new project
Before tax return on new investment = 22 per cent
After tax return on new investment = 22 × 0.7 = 15.4 per cent
Earnings arising from new funds = 13,860,000 × 0.154 = €2,134,440
New level of earnings = 10,000,000 + 2,134,440 = €12,134,440
New EPS = (12,134,440/24,000,000) × 100 = 50.56p
Expected share price = 50.56 × 8.54 = 432p or €4.32
(b) We can compare the share prices derived in part (a) with the theoretical ex-rights share
price. This price represents a position where shareholder wealth is unaffected by the rights
issue, provided shareholders either take up all their rights or sell them. Since the rights issue
is a 1 for 5 issue, the theoretical ex-rights price = ((4.27 × 5) + 3.63)/6 = £4.16 per share.
The expected share price if bonds are redeemed is less than the theoretical ex-rights price. If
the funds raised are used in this way, a capital loss will be experienced by shareholders.
This proposal cannot be recommended.
The expected share price if the new project is undertaken is greater than the theoretical exrights price. If the funds raised are used in this way, a capital gain may be experienced by
shareholders. This proposal is acceptable.
The rights issue will be in the best interests of shareholders if the new project is undertaken.
Question 4
(a) If Mr Tundra subscribes to the rights issue he will buy 2,500 shares.
The rights issue price = £4.20 × 0.85 = £3.57.
£
Current value of 10,000 shares = 4.2 × 10,000 =
Cash subscribed for new shares = 3.57 × 2,500 =
Value of 12,500 shares
42,000
8,925
50,925
22
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Mr Tundra has suffered no change in his personal wealth, although part of it has been
transferred from cash to ordinary shares.
The theoretical ex-rights price is 50,925/12,500 = £4.074
The value of the rights on 4 shares = 4.074 − 3.57 = £0.504
If Mr Tundra sells his rights, he gets 0.504 × (10,000/4) = £1,260
He also suffers a capital loss of (4.2 − 4.074) × 10 000 = £1,260
Mr Tundra has suffered no change in his personal wealth, although part of it has been
transferred from ordinary shares to cash.
If Mr Tundra neither subscribes for shares nor sells his rights, his personal wealth will
diminish. In practice, Tundra plc is likely to sell his rights for him and remit part of the
proceeds.
(b) Students could discuss the following points.
(i)
•
The theoretical ex-rights price is a simple weighted average of the cum-rights price and
the rights issue price.
•
The theoretical ex-rights price represents the situation where the yield on new funds is
identical to the yield on existing funds.
•
The actual ex-rights price will reflect market expectations on the future of the company
and on the use to be made of new funds.
•
The theoretical ex-rights price has been found in practice to be a good guide to the
actual ex-rights price.
(ii)
•
Shareholders would need to waive their pre-emptive rights if equity finance were to be
raised other than by a rights issue.
•
Freeze plc could raise equity finance in the new issues market by means of a placing or
an offer for sale.
•
Freeze plc needs £3m. It is likely that a placing will be appropriate, as this has the
lowest cost and is used for smaller issues.
•
A rights issue will allow existing patterns of ownership and control to be maintained,
whereas a placing would bring in new investors.
23
© Pearson Education Limited 2014
CHAPTER 5
LONG-TERM FINANCE: DEBT FINANCE, HYBRID
FINANCE AND LEASING
Question 1
(a) The answer should focus on the following points:
•
The length of time to maturity
•
The level of interest paid on individual bonds
•
The general level of interest rates and the term structure of interest rates
•
The rate of return on other securities, especially ordinary equity
•
Expectations of likely movements in interest rates and inflation rates
•
The required return of investors in corporate bonds.
(b) (i) Equilibrium conversion value in three years:
= [90.01 − (9 × 2.361)]/0.693 = (90.01 − 21.249)/0.693 = £99.22
This corresponds to 99.22/25 = £3.97 per share.
Three years from now, the bond would have three years to maturity and would be worth
(9 × 2.361) + (100 × 0.693) = £90.55. Since this is less than £99.22, holders of the loan
stock will choose to convert.
£99.22 = 3.24 × 25 × (1 + g)3
Therefore, g = [99.22/(3.24 × 25)]0.3 − 1 = 1.06997 − 1 = 0.06997 ~ 7%
(ii) Current conversion value = 3.24 × 25 = £81.00
Implicit conversion premium = [(90.01 − 81.00)/25] = 36p per share or 11.1%
Question 2
(a) Note that different assumptions can be made about when tax benefits arise. A one-year lag
has been assumed for capital allowance tax benefits. The before-tax cost of borrowing is
11 per cent and the after-tax cost of borrowing is 7.77 per cent (i.e. 11% × (1 − 0.3)) or
approximately 8 per cent.
24
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
(i) Leasing (with taxable profits)
Year
Lease rentals (£)
Tax savings (£)
Net cash flow (£) 8% discount factor
PV (£)
0
(98,000)
(98,000)
1.000
(98,000)
1
(98,000)
(98,000)
0.926
(90,748)
2
(98,000)
29,400
(68,600)
0.857
(58,790)
3
(98,000)
29,400
(68,600)
0.794
(54,468)
4
(98,000)
29,400
(68,600)
0.735
(50,421)
5
29,400
29,400
0.681
20,021
6
29,400
29,400
0.630
18,522
(313,884)
Borrowing to buy (with taxable profits)
Year
0
Capital
CA tax
savings
Annual
maintenance
AM tax
savings
Net cash
flow
(£)
(£)
(£)
(£)
(£)
(480,000)
1
Discount
factor
PV
(£)
(480,000)
1.000
(480,000)
(14,500)
0.926
(13,427)
(14,500)
2
36,000
(14,500)
4,350
25,850
0.857
22,153
3
27,000
(14,500)
4,350
16,850
0.794
13,379
4
20,250
(14,500)
4,350
10,100
0.735
7,424
15,188
(14,500)
4,350
17,038
0.681
11,603
4,350
46,313
0.630
29,177
5
6
12,000
41,963
(409,692)
Capital allowances (CA) and tax savings
Year 2
Year 3
Year 4
Year 5
480,000 × 0.25 =
120,000 × 0.75 =
90,000 × 0.75 =
67,500 × 0.75 =
120,000 × 0.3 =
90,000 × 0.3 =
67,500 × 0.3 =
50,625 × 0.3 =
328,125
£36,000
£27,000
£20,250
£15,188
Year 6
(480,000 − 328,125 − 12,000) = 139,875 × 0.3 = £41,963
Net benefit of leasing with taxable profits is £95,808 (£409,692 − £313,884).
25
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
(ii) Leasing (with tax ignored)
Year
Lease payments (£)
Net cash flow (£)
Discount factor (11%)
PV (£)
0
(98,000)
(98,000)
1.000
(98,000)
1
(98,000)
(98,000)
0.901
(88,298)
2
(98,000)
(98,000)
0.812
(79,576)
3
(98,000)
(98,000)
0.731
(71,638)
4
(98,000)
(98,000)
0.659
(64,582)
(402,094)
Borrowing to buy (with tax ignored)
Year
0
Capital
Annual
maintenance
Net cash flow
(£)
(£)
(£)
(480,000)
Discount factor
PV
(£)
(480,000)
1.000
(480,000)
1
(14,500)
(14,500)
0.901
(13,065)
2
(14,500)
(14,500)
0.812
(11,774)
3
(14,500)
(14,500)
0.731
(10,600)
4
(14,500)
(14,500)
0.659
(9,556)
(14,500)
(2,500)
0.593
(1,483)
5
12,000
(526,478)
Net benefit of leasing with non-taxable profits is £124,382.
(b) A good answer would discuss the following points.
1. Source of finance to companies short of liquidity or profitability, such as Utterby.
2. Relative tax positions of lessor and lessee: here, Utterby may not be able to take full
advantage of the tax benefits of buying, although the savings in salaries look to increase
profitability (calculation of project NPV is not required).
3. Leasing will help to avoid obsolescence: the new machine could become out-of-date, so
an operating lease (such as the one being offered) would enable updating.
4. Year-end effects.
5. Borrowing advantage of lessor compared with lessee.
6. Leasing can be easier than borrowing: the bank loan would need security, whereas the
leased asset would be security for the lease contract.
7. Flexibility of lease contracts: here, the contract is renewable annually and includes
servicing of the leased asset.
8. Planning certainty with respect to lease payments may be seen as advantageous.
26
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 3
(a) Students could discuss the following points.
•
The bank could secure the loan on Cold plc assets, for example, on the new equipment.
•
The bank could agree a restrictive covenant with Cold plc. Terms could include a
maximum level of gearing, a minimum interest cover, etc.
•
Any terms in a restrictive covenant would need to be clearly specified so that breaches
could be clearly identified.
•
The bank could require repayment of the loan in instalments, rather than at the end of
the five-year period.
•
The bank could insist on a floating interest rate in order to protect itself against
unanticipated inflation.
(b) The after-tax cost of borrowing = 13 × 0.7 = 9%
If the first capital allowance is assumed to affect the first year’s profits, the first tax benefit
occurs in the second year.
Year
Capital (£)
0
(700,000)
Tax benefits (£)
PV factors
PV (£)
1.000
(700,000)
1
0.917
2
52,500
0.842
44,205
3
39,375
0.772
30,398
4
29,531
0.708
20,907
5
22,149
0.650
14,397
6
66,445
0.596
39,601
(550,492)
(c) The present cost of leasing is as follows:
Year
Cash flow
£
PV factors
PV (£)
0–4
Lease rentals
(180,000)
4.240
(763,200)
2–6
Tax benefits
54,000
3.569
192,726
(570,474)
The present cost of borrowing to buy is as follows:
Year
PV of buying (£)
0
(550,492)
Servicing (£)
Tax saved (£)
PV factors
PV (£)
1.000
(550,492)
1
(25,000)
0.917
(22,925)
2
(25,000)
7,500
0.842
(14,735)
3
(25,000)
7,500
0.772
(13,510)
4
(25,000)
7,500
0.708
(12,390)
5
(25,000)
7,500
0.650
(11,375)
7,500
0.596
6
4,470
(620,957)
27
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
The present cost of leasing is £50,483 (£620,957 − £570,474) cheaper than borrowing to
buy.
(d) See answer for Question 3 (b).
Question 4
(a) The expected market values will be equal to the present values of expected future cash
flows. The before-tax cost of debt is 10 per cent.
12 per cent Bond
PV of interest with 10 per cent cost of debt = 12 × 5.335 = £64.02
PV of redemption value = 100 × 0.467 = £46.70
Expected market value = 64.02 + 46.70 = £110.72
Zero Coupon Bond
PV of £100 received in eight years = 100 × 0.467 = £46.70
The bonds could be issued at a discount to par and the zero-coupon bonds at a deep discount
to par. Although no interest is payable on the zero-coupon bonds, Permafrost plc would
need a much larger sum to redeem them.
Zero coupon bond redemption cost = 800,000 × (100/46.7) = £1,713,062
Annual interest is payable on the bonds and the redemption cost is more than the initial
funds raised.
Redemption cost = 800,000/1.107 = £722,673
This redemption cost is increased by the annual interest payments. Interest paid = 800,000 ×
0.12 = £96,000
The interest payments on the bank loan, being at a floating rate, cannot be determined
without forecasting future interest rates. However, the total annual interest payments are
likely to decrease as the capital is repaid.
Both the bond issue and the bank loan require security and Permafrost needs to have
adequate assets to offer as security. Although no security is mentioned in connection with
the zero coupon bonds, these too are likely to need some security on issue.
The amount of funds to be raised seems small for a bond issue or an issue of zero coupon
bonds. The bank loan seems to be more appropriate in this respect.
The repayment terms of the loan may seem severe compared to interest on the bond (an
annual repayment of 800,000/5.335 = £149,953), but there will no redemption problem after
eight years.
All three debt financing methods match the expected life of the computer system, but in
order to choose between them Permafrost plc will need to consider its ability to meet their
respective annual cash demands.
(b) The after-tax cost of debt = 10 × 0.7 = 7%.
28
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Cost of leasing
Years
Cash flow
£
PV factors
PV (£)
0–7
Lease rentals
(150,000)
6.389
(958,350)
2–9
Tax benefits
45,000
5.580
251,100
(707,250)
If tax benefits are taken from year 1, the cost of leasing is £689,655.
Cost of borrowing to buy: tax benefits
Zero scrap value is assumed.
Year
WDA benefits (£)
Service benefits (£)
Net benefits (£)
Taken in year
1
60,000
3,000
63,000
2
2
45,000
3,000
48,000
3
3
33,750
3,000
36,750
4
4
25,312
3,000
28,312
5
5
18,984
3,000
21,984
6
6
14,238
3,000
17,238
7
7
10,679
3,000
13,679
8
8
32,037
3,000
35,037
9
Cost of borrowing to buy
Year
Cost
(£)
0
(800,000)
Servicing
(£)
Tax benefits
(£)
NCF
(£)
PVF
PV
(£)
(800,000)
1.000
(800,000)
(10,000)
0.935
(9,350)
1
(10,000)
2
(10,000)
63,000
53,000
0.873
46,269
3
(10,000)
48,000
38,000
0.816
31,008
4
(10,000)
36,750
26,750
0.763
20,410
5
(10,000)
28,312
18,312
0.713
13,056
6
(10,000)
21,984
11,984
0.666
7,981
7
(10,000)
17,238
7,238
0.623
4,509
8
(10,000)
13,679
3,679
0.582
2,141
35,037
35,037
0.544
9
19,060
(664,914)
The evaluation should discuss the following points:
•
There is a £42,336 difference between the cost of leasing and buying.
•
The life of the network seems excessive given the nature of the asset.
•
How can Permafrost plc avoid the obsolescence problem?
•
In-house servicing costs seem on the low side.
29
© Pearson Education Limited 2014
CHAPTER 6
AN OVERVIEW OF INVESTMENT APPRAISAL
METHODS
Question 1
(a) Calculation of NPV of Project A
Year
Cash flow (£)
10% Discount factor
Present value (£)
0
(110,000)
1.000
(110,000)
1
45,000
0.909
40,905
2
45,000
0.826
37,170
3
30,000
0.751
22,530
4
20,000
0.683
13,660
5
20,000
0.621
12,420
16,685
Calculation of NPV of Project B
Year
Cash flow (£)
10% Discount factor
Present value (£)
0
(200,000)
1.000
(200,000)
1
50,000
0.909
45,450
2
50,000
0.826
41,300
3
50,000
0.751
37,550
4
100,000
0.683
68,300
5
55,000
0.621
34,155
26,755
Calculation of IRR of Project A
Year
Cash flow (£)
20% Discount factor
Present value (£)
0
(110,000)
1.000
(110,000)
1
45,000
0.833
37,485
2
45,000
0.694
31,230
3
30,000
0.579
17,370
4
20,000
0.482
9,640
5
20,000
0.402
8,040
(6,235)
30
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Calculation of IRR of Project B
Year
Cash flow (£)
20% Discount factor
Present value (£)
0
(200,000)
1.000
(200,000)
1
50,000
0.833
41,650
2
50,000
0.694
34,700
3
50,000
0.579
28,950
4
100,000
0.482
48,200
5
55,000
0.402
22,110
(24,390)
IRRA = 10 + [(10 × 16,685)/(16,685 + 6,235)] = 17.3%
IRRB = 10 + [(10 × 26,755)/(26,755 + 24,390)] = 15.2%
Calculation of ROCE for Project A:
£
Total cash inflows:
Total depreciation:
Total accounting profit:
160,000
110,000
50,000
Average annual accounting profit = 50,000/5 = £10,000
Average investment = 110,000/2 = £55,000
Return on capital employed = 100 × 10,000/55,000 = 18.2%
Calculation of ROCE for Project B:
£
Total cash inflows:
Total depreciation:
Total accounting profit:
305,000
200,000
105,000
Average annual accounting profit = 105,000/5 = £21,000
Average investment = 200,000/2 = £100,000
Return on capital employed = 100 × 21,000/100,000 = 21.0%
NPV (£)
IRR (%)
ROCE
Project A
16,685
17.28
18.2%
Project B
26,755
15.23
21.0%
If the NPV method is used, Project B is preferred: if the IRR method is used, Project A is
better: if ROCE is used, Project B is preferred. However, as the projects are mutually
exclusive, the NPV method gives the correct investment advice.
31
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
(b) Students should discuss:
•
NPV assumption of perfect capital markets.
•
Investing in all positive NPV projects requires unrestricted availability of finance in the
capital market.
•
When capital is rationed, ranking by absolute NPV does not give the optimum
investment selection.
•
In single period capital rationing, divisible projects can be ranked by cost/benefit ratio
or profitability index.
•
In single period capital rationing, indivisible projects can be evaluated by finding the
NPV of combinations of projects.
•
In multi-period capital rationing, linear programming must be used to determine the
optimum investment schedule.
Question 2
(a) The NPV decision rule is to accept all projects which result in a positive net present value
when project cash flows are discounted at a company’s cost of capital. If capital available
for investment is restricted, a company is said to be in a capital-rationing situation and it
will not be able to accept all projects with a positive NPV.
Capital rationing may be described as either hard or soft. Soft capital rationing is due to
internal factors, hard capital rationing to external factors. Soft capital rationing may arise
due to:
•
managers choosing to adopt a policy of stable growth;
•
managers being reluctant to issue new equity for fear of diluting control;
•
managers being reluctant to issue new equity for fear of diluting EPS;
•
managers wishing to avoid raising new debt finance and a commitment to additional
fixed interest payments;
•
managers wishing to limit investment funds to retained earnings;
•
managers restricting available capital to encourage competition for funds.
Adopting a policy of restricting available investment funds can be sub-optimal, as the
organisation may reject projects with positive NPVs and hence forego projects that could
increase the market value of the company.
Hard capital rationing may arise because:
•
issuing equity share capital may be difficult if capital markets are depressed;
•
providers of debt finance may consider the company to be too risky;
•
the cost of raising small amounts of capital may be too high.
(b) The finance director should rank projects so that NPV can be maximised from available
funds. Ranking by absolute NPV will give incorrect results, since this will select large
projects with large NPVs, rather than a number of small projects with lower individual
NPVs but a higher total NPV. Ranking can be done by means of the profitability index or
32
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
benefit/cost ratio, if projects are divisible, to arrive at RM plc’s optimum investment
schedule for the limited resources available. If projects are indivisible, combinations of
projects must be evaluated to determine the best investment schedule.
Project
Outlay (£)
PV of benefits (£)
A
200,000
342,450
B
450,000
C
NPV (£)
Profitability index
Ranking
142,450
0.712
4
815,031
365,031
0.811
3
550,000
1,956,287
1,406,286
2.557
1
D
170,000
452,028
282,028
1.659
E
200,000
570,750
370,750
1.854
2
F
330,000
539,832
209,832
0.636
5
If projects are divisible:
Project
Profitability index
Outlay (£)
NPV (£)
C
2.557
550,000
1,406,286
E
1.854
200,000
370,750
B
0.811
250,000
202,795
1,000,000
1,979,831
The finance director should choose projects C, E and 55 per cent of B.
If projects are not divisible:
Projects
Outlay (£)
NPV (£)
B+C
1,000,000
1,771,317
A+C+E
950,000
1,919,486
B+E+F
980,000
945,613
The finance director should choose projects A, C and E.
(c) NPV is preferred by academics because:
1. It meets the assumed primary financial objective of financial management, the
maximisation of shareholder wealth, through maximisation of the company’s share
price. This is achieved by maximising investment net present value.
2. It takes account of the time value of money.
3. It discounts cash flows, which is what investors are concerned with, rather than
accounting profit.
4. Risk can be taken into account by adjustments to the discount rate.
5. Inflation can be incorporated into both cash flows and discount rate.
6. There is an easy decision rule: accept projects with a positive NPV.
Although NPV is theoretically superior to IRR, this does not make IRR redundant, since
IRR offers a different perspective on capital investment projects. It is common in practice
for companies to use more than one investment appraisal method and so NPV and IRR may
be combined with ROCE or even Payback.
33
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 3
(a) Evaluation of the Broad Project
Total accounting profit = £540,000 (see below)
Average annual accounting profit = 540,000/7 = £77,143
Average investment = 500,000/2 = £250,000
Return on capital employed = (77,143/250,000) × 100 = 30.9%
Year
Cash flow (£)
10% discount factor
0
(500,000)
1.000
(500,000)
1
60,000
0.909
54,540
2
90,000
0.826
74,340
3
140,000
0.751
105,140
4
210,000
0.683
143,430
5
300,000
0.621
186,300
6
140,000
0.564
78,960
7
100,000
0.513
51,300
540,000
Present value (£)
194,010
NPV = £194,010
Year
Cash flow (£)
20% discount factor
Present value (£)
0
(500,000)
1.000
(500,000)
1
60,000
0.833
49,980
2
90,000
0.694
62,460
3
140,000
0.579
81,060
4
210,000
0.482
101,220
5
300,000
0.402
120,600
6
140,000
0.335
46,900
7
100,000
0.279
27,900
(9,880)
IRR = 10 + ((10 × 194,010)/(194,010 + 9,880)) = 10 + 9.5 = 19.5%
Evaluation of the Keeling Project
Total accounting profit = £340,000 (see below)
Average annual accounting profit = 340,000/7 = £48,571
Average investment = 500,000/2 = £250,000
Return on capital employed = (48,571/250,000) × 100 = 19.4%
34
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Year
Cash flow (£)
10% discount factor
Present value (£)
0
(500,000)
1.000
(500,000)
1
220,000
0.909
199,980
2
220,000
0.826
181,720
3
50,000
0.751
37,550
4
50,000
0.683
34,150
5
50,000
0.621
31,050
6
50,000
0.564
28,200
7
200,000
0.513
102,600
340,000
115,250
NPV = £115,250
Year
Cash flow (£)
20% discount factor
Present value (£)
0
(500,000)
1.000
(500,000)
1
220,000
0.833
183,260
2
220,000
0.694
152,680
3
50,000
0.579
28,950
4
50,000
0.482
24,100
5
50,000
0.402
20,100
6
50,000
0.335
16,750
7
200,000
0.279
55,800
(18,360)
IRR = 10 + ((10 × 115,250)/(115,250 + 18,360)) = 10 + 8.6 = 18.6%
Summary
ROCE
NPV
IRR
Broad Project
30.9 per cent
£194,010
19.5 per cent
Keeling Project
19.4 per cent
£115,250
18.6 per cent
(b) Although the Broad Project has the higher ROCE, we should use a DCF method to evaluate
the projects since ROCE does not take account of the time value of money. If we consider
IRR, the Broad Project has the marginally higher value but, as the projects are mutually
exclusive, we should compare the NPV of the two projects. This is because NPV offers the
correct investment advice in these circumstances. As the Broad Project has the higher NPV,
it should therefore, be chosen.
(c) In the hierarchy of investment appraisal methods, ROCE is usually considered to be
superior to Payback but inferior to NPV and IRR. It is considered superior to Payback
because it considers the whole of the project, rather than only cash flows occurring during
the payback period. ROCE is a measure widely understood by managers, since it is
comparable with the ROCE accounting ratio used to evaluate company performance. It has
also been suggested that managers find a percentage to be useful since it can be compared
easily with other economic variables expressed as percentages, such as interest rates and
inflation rates.
35
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
One of the main disadvantages of ROCE as an investment appraisal method is that it uses
accounting profit rather than cash flow and corporate finance is primarily concerned with
cash flows. ROCE ignores the timing of profits, since it averages annual accounting profit.
ROCE ignores the time value of money, since distant profits are equally weighted with
profits in the near future in the averaging process. It produces a relative measure of return
rather than an absolute measure of return, so the immediate effect on the value of the
company is not apparent. NPV, on the other hand, gives an immediate indication of the
effect of an investment project on the market value of a company.
36
© Pearson Education Limited 2014
CHAPTER 7
INVESTMENT APPRAISAL: APPLICATIONS AND
RISK
Question 1
(a) In order to determine the net present value of the project, the cash flows must be adjusted to
take account of specific inflation, and the nominal cash flows produced must be discounted
by the nominal cost of capital.
Year
0
1
2
3
4
5
€000
€000
€000
€000
€000
€000
(600)
(400)
(18)
Working capital
(90)
90
Revenue
823
1,199
1,271
1,347
1,428
Packaging/labour
(185)
(267)
(280)
(294)
(309)
Frozen food
(407)
(593)
(629)
(667)
(707)
Freeze dryer
Net cash flow
(600)
(259)
339
362
386
484
Discount factors
1.000
0.877
0.769
0.675
0.592
0.519
Present values
(600)
(227)
261
244
229
251
NPV = 261 + 244 + 229 + 251 − 600 − 227 = +£158,000
Since the NPV is positive, DK should invest in the freeze dryer.
Workings:
Sales:
€
Year 1: 80,000 × 9.70 1.06 =
822,560
Year 2: 110,000 × 9.70 1.062 =
1,198,881
3
1,270,814
4
Year 4: 110,000 × 9.70 1.06 =
1,347,063
Year 5: 110,000 × 9.70 1.065 =
1,427,887
Year 3: 110,000 × 9.70 1.06 =
Packaging and labour:
€
Year 1: 80,000 × 2.20 × 1.05 =
184,800
Year 2: 110,000 × 2.20 × 1.052 =
266,805
3
280,145
4
Year 4: 110,000 × 2.20 × 1.05 =
294,152
Year 5: 110,000 × 2.20 × 1.055 =
308,860
Year 3: 110,000 × 2.20 × 1.05 =
37
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Frozen food and processing:
Year 1:
€
80,000 × 4.80 × 1.06 =
407,040
2
593,261
3
Year 3: 110,000 × 4.80 × 1.06 =
628,856
Year 4: 110,000 × 4.80 × 1.064 =
666,588
Year 2: 110,000 × 4.80 × 1.06 =
5
Year 5: 110,000 × 4.80 × 1.06 =
706,583
(b) You need to explain the difference between real and nominal discount rates, and then
explain the need to discount nominal cash flows with a nominal cost of capital and real cash
flows with a real cost of capital. You should also point out that in part (a) current price cash
flows were inflated by specific rates of inflation to obtain nominal or money terms cash
flows, which were then discounted with a nominal cost of capital.
Question 2
(a) Calculation of net operating cash flows (NOCF)
Year
Sales (£)
Quality (£)
Direct (£)
Adverts (£)
NOCF (£)
1
1,014,000
(30,420)
(525,000)
(70,000)
388,580
2
1,054,560
(31,637)
(551,250)
(70,000)
401,673
3
1,096,742
(32,902)
(578,813)
485,028
4
1,140,612
(34,218)
(607,753)
498,641
Calculation of tax liabilities
Year
NOCF (£)
WDA (£)
Taxable (£)
1
388,580
(250,000)
138,580
2
401,673
(187,500)
214,173
(41,574)
3
485,028
(140,625)
344,403
(64,252)
4
498,641
(371,875)
126,766
(103,321)
5
Tax (£)
(38,030)
Calculation of net cash flow
Year
Capital (£)
0
(1,000,000)
NOCF (£)
WC (£)
Tax (£)
NCF (£)
(80,000)
(1,080,000)
386,180
1
388,580
(2,400)
2
401,673
(2,472)
(41,574)
357,627
3
485,028
(2,546)
(64,252)
418,230
498,641
87,418
(103,321)
532,738
(38,030)
(38,030)
4
5
50,000
38
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Calculation of NPV
NCF (£)
12% DF
PV (£)
(1,080,000)
1.0000
(1,080,000)
386,180
0.893
344,859
357,627
0.797
285,029
418,230
0.712
297,779
532,738
0.636
338,821
(38,030)
0.467
(21,563)
164,926
(b) Sensitivity Analysis of Selling Price
Year
Sales (£)
Quality (£)
NCF (£)
1
1,014,000
30,420
983,580
2
1,054,560
31,637
1,022,923
3
1,096,742
32,902
4
1,140,612
34,218
After-tax CF (£)
PV (£)
983,580
878,337
(295,074)
727,849
580,096
1,063,840
(306,877)
756,963
538,958
1,106,394
(319,152)
787,242
500,686
(331,918)
(331,918)
(155,006)
5
Tax (£)
2,343,070
Sensitivity = NPV/PV of variable = 100 × 164,926/2,343,070 = 7.0%
(c) Students should discuss the following points:
•
Risk refers to a range of possible outcomes which are known and whose probabilities
can be predicted.
•
Uncertainty refers to outcomes whose likelihood cannot be predicted.
•
Risk increases with the variability of returns, while uncertainty increases with project
life.
•
Sensitivity analysis identifies the key or critical project variables to which project NPV
is most sensitive.
•
Sensitivity does not assess the probability of changes in the key variables and hence is
not a method of assessing project risk.
39
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 3
(a) NPV calculation using real discount rate of 7% applied to real cash flows:
Selling price = 11.00 × 150,000 × 3.387 =
5,588,550
Variable costs = 8.5 × 150,000 × 3.387 =
4,318,425
1,270,455
Fixed costs = 25,000 × 3.387 =
84,675
1,185,780
Working capital recovery = 80,000 × 0.763 =
61,040
1,246,820
PV of scrap value = 40,000 × 0.763
30,520
1,277,340
Initial investment (including working capital)
930,000
Net present value
347,340
Selling price sensitivity
100 × 347,340/5,588,550 = 6.2%
Variable cost sensitivity
100 × 347,340/4,318,425 = 8.0%
Sales volume sensitivity
100 × 347,340/1,270,455 = 27.3%
Comment
The key or critical variable is selling price, as the smallest percentage change in this
variable produces a negative NPV. Sensitivity analysis does not indicate how likely it is that
a change in project variables will occur. Sensitivity analysis focuses attention on areas of an
investment project where careful management may be needed to gain predicted NPV.
(b) To find the NPV of the project, inflated cash flows must be discounted by the nominal cost
of capital.
Year
0
1
2
3
4
€000
€000
€000
€000
€000
Purchase
(850)
Working capital
(80)
40
(3.2)
(3.3)
(3.5)
90.0
Contribution
374.4
389.4
405.0
421.1
Fixed costs
(26.3)
(27.6)
(28.9)
(30.4)
Net cash flow
(930)
344.9
358.5
372.6
520.7
10% DCF
1.000
0.909
0.826
0.751
0.683
Present values
(930)
313.5
296.1
279.8
355.6
NPV = €315,000 and so the investment is financially acceptable.
40
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Workings:
Working capital:
Year 0:
€
Incremental
= 80,000
Year 1:
80,000 × 1.041
= 83,200
3,200
Year 2:
80,000 × 1.042
= 86,528
3,328
Year 3:
80,000 × 1.043
= 89,989
3,461
Year 4:
Recovery
89,989
Contribution:
Per unit = 11.00 − 8.5 = £2.50
€
Year 1:
150,000 × 2.50 × 1.04
=
374,400
Year 2:
2
150,000 × 2.50 × 1.04
=
389,376
Year 3:
150,000 × 2.50 × 1.043
=
404,951
Year 4:
4
=
421,149
150,000 × 2.50 × 1.04
Fixed costs:
Year 1:
€
=
26,250
2
=
27,563
Year 3:
3
25,000 × 1.05
=
28,941
Year 4:
25,000 × 1.054
=
30,388
Year 2:
25,000 × 1.05
25,000 × 1.05
(c) Student could discuss a number of factors, as follows:
•
Constant sales volumes over the four-year period are unlikely.
•
A constant discount rate is assumed but economic environment and required returns will
change in practice.
•
It is assumed that production terminates after four years, when in practice machine
could be replaced.
•
Assumption of constant specific inflation rates over the period.
•
Assumption that cash flows occur at the end of each year.
•
Taxation has been ignored: this will affect the net present value.
41
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 4
(a) NPV Evaluation
Year
1
2
3
4
5
$000
$000
$000
$000
$000
$000
(3,400)
1,030
1,061
1,093
1,126
1,160
(50)
(50)
(50)
(50)
(50)
(850)
(638)
(478)
(359)
(269)
Taxable profit
130
373
565
717
841
Profit tax
(20)
(56)
(85)
(108)
(126)
110
317
480
609
715
850
638
478
359
269
(3,400)
960
955
958
968
984
(500)
(15)
(15)
(15)
(17)
(17)
Operating cash flows
0
Interest at 10%
Capital allowances
(3,400)
Add back CAs + interest
Working capital
Loan
500
Sale of factory
Project cash flow
Exchange rate ($/£)
Net cash for UK
5,000
(3,400)
945
940
943
951
5967
1.70
1.79
1.88
1.97
2.07
2.17
£000
£000
£000
£000
£000
£000
(2,000)
528
500
479
459
2,750
(11)
(30)
(43)
(52)
(58)
(2,000)
517
470
436
407
2,692
1.000
0.870
0.757
0.658
0.572
0.497
(2,000)
450
356
287
233
1,338
UK tax
After-tax cash flow
PV factors
PV of UK cash flows
Since NPV is a positive value of £664 000, the proposal is acceptable.
(b) The market value of $5m at the end of the five-year planning horizon should represent the
present value of expected future cash flows from subsequent years of operation. Assuming
the factory continues to sell and produce goods, the market value after five years represents
the present value of after-tax cash flows arising from these sales. The accuracy of any
estimate of the present value of these cash flows is diminished by the improbability of the
constant annual demand used in the evaluation above, as well as the improbability of no
change over time in project variable such as US inflation, discount rate, US and UK tax
rates, consumer tastes and capital allowances.
Using annual US inflation of 3 per cent as an expected growth rate and ignoring the fact that
the tax benefits on capital allowances will diminish over time, we can estimate the market
value after 5 years as follows.
MV = (1,026 × 1.03)/(0.15 − 0.03) = $8.8m
Ignoring capital allowance tax benefits gives a lower value:
MV = (1,160 × 0.85 × 1.03)/(0.15 − 0.03) = $8.5m
42
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Discarding the perpetuity approach and adopting a more conservative view by assuming 10
years of further operation gives a value similar to the $5m suggested above, since ignoring
capital allowance tax benefits gives a market value of $4.9m (1,160 × 0.85 × 5.019) and
including them a market value of $5.1m (1,026 × 5.019). It is possible therefore, that $5m
may be an acceptable estimate of the market value of the factory in five years’ time.
Question 5
(a) Evaluation of the proposal to increase production in the UK
Year
Cash flow
£
PV factors
PV (£)
0
Investment
(750,000)
1.000
(750,000)
1–7
Export sales
280,000
4.564
1,277,920
2–8
Tax on sales
(84,000)
4.075
(342,300)
NPV:
185,620
Evaluation of the proposal to increase production by FDI
Expected sales increase is (6 × 0.25) + (5 × 0.6) + (4 × 0.15) = 5.1%
Year
Capital
0
1
2
3
4
5
6
7
8
N$m
N$m
N$m
N$m
N$m
N$m
N$m
N$m
N$m
1.000
1.051
1.105
1.161
1.220
1.282
1.348
(2.70)
Sales
Tax
–
–
(0.300)
(0.315)
(0.331)
(0.348)
(0.366)
(0.385)
(0.404)
NCF
(2.70)
1.000
0.751
0.790
0.830
0.872
0.916
0.963
(0.40)
N$/£
3.60
3.74
3.89
4.05
4.21
4.34
4.55
4.74
4.92
£000
£000
£000
£000
£000
£000
£000
£000
£000
NCF
(750)
267
193
195
197
201
201
203
(82)
PVF
1.000
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
PV
(750)
238
154
139
125
114
102
92
(33)
ENPV = £181,000
The UK and Northland tax rates are identical and so no further tax is payable on remitted
cash flows. The domestic proposal is preferred because of its higher NPV, but the
difference is quite small. Good economic conditions in Northland might make the FDI
proposal more attractive, but the expected annual sales increase of 5.1 per cent is close to
the most likely annual increase of 5 per cent per year.
(b) The following points can be made about the evaluation process:
•
FDI may call for a project-specific discount rate or WACC that takes account of the
differing risks of such investment.
43
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
No account has been taken of inflation in the determination of the expected future cash
flows. The company could determine the nominal cash flows and discount these with a
nominal discount rate.
•
No terminal value has been determined for both proposal and the present value of cash
flows after the seven-year planning horizon have been ignored: the calculated NPV
values are therefore, incorrect.
•
The expected NPV of the FDI has been calculated but this is not an NPV that is
expected to occur in reality. It would be more accurate to compare the UK investment
with all three overseas scenarios.
•
Tax rates have been assumed constant in both countries over the seven-year planning
period.
•
The forecast sales increases in Northland assume economic conditions will be
unchanged over the seven-year period, which is unlikely.
Further information that could assist in the evaluation is as follows:
•
The exchange rates have been forecast based on a constant annual depreciation of 4 per
cent in the value of the foreign currency. A forecast of expected relative rates of
inflation would allow a more accurate prediction of exchange rates.
•
It would be useful to know the way in which either proposal is to be financed, as it will
influence the discount rate and expected cash flows.
•
A forecast of expected inflation in both countries would enable more accurate forecasts
of expected nominal cash flows to be made.
•
The relative sizes of the expansion projects compared to Ice plc are important as the
WACC of Ice plc can be used to evaluate investment projects, provided restrictive
assumptions on size, risk and financing are met. Insufficient information is given to
determine whether these restrictions are met.
•
Sales are expected to increase each year if manufacture takes place in Northland, but to
increase in the first year only if production is increased in the UK and sales to
Northland are exports. Why is advertising effective in one case but not the other?
•
Sales are expected to increase each year if manufacture takes place in Northland, but no
provision is made to expand overseas productive capacity. Is this an oversight in terms
of the forecasting of cash flows?
44
© Pearson Education Limited 2014
CHAPTER 8
PORTFOLIO THEORY AND THE CAPITAL ASSET
PRICING MODEL
Question 1
Portfolio
Expected return (%)
Standard deviation (%)
15
20.0
(b) 75% Z + 25% Y
(0.75 × 15) + (0.25 × 35) = 20
20.0
(c) 50% Z + 50% Y
(0.50 × 15) + (0.50 × 35) = 25
24.5
(d) 25% Z + 75% Y
(0.25 × 15) + (0.75 × 35) = 30
31.6
35
40.0
(a) 100% Z
(e) 100% Y
Workings:
Standard deviation of (75% Z + 25% Y)
= ((0.752 × 202) + (0.252 × 402) + (2 × 0.75 × 0.25 × 20 × 40 × 0.25))0.5
= (225 + 100 + 75)0.5 = 20.0 per cent
Standard deviation of (50% Z + 50% Y)
= ((0.502 × 202) + (0.502 × 402) + (2 × 0.50 × 0.50 × 20 × 40 × 0.25))0.5
= (100 + 400 + 100)0.5 = 24.5 per cent
Standard deviation of (25% Z + 75% Y)
= ((0.252 × 202) + (0.752 × 402) + (2 × 0.25 × 0.75 × 20 × 40 × 0.25))0.5
= (25 + 900 + 75)0.5 = 31.6 per cent
Question 2
Here you need to carry out the following steps:
•
Plot the efficient frontier using the data provided in the first table
•
Plot the risk-free rate on the Y axis
•
Draw the capital market line at a tangent to the efficient frontier and identify the
market portfolio
45
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
Plot the utility curve using the data in the second table
•
Extrapolate the utility curve identified until it intersects with the capital market line. This is
the optimal portfolio for the investor
•
Given the optimal portfolio identified, calculate the proportions of cash placed in risk-free
assets and the market portfolio. This should amount to two-thirds in the market portfolio
and one-third in risk-free assets.
Question 3
(a) The beta can be used to find the required return on equity:
Ke = 6 + 1.203 × (15 − 6) = 6 + 10.83 = 16.83%
The expected dividend growth rate can be determined from the pattern of dividends paid in
recent years. There is a problem in that no dividend was paid in 2006, and only a small
‘recovery’ dividend paid in 2007. Better financial health seems to have been restored in the
last two years, so the dividend growth rate will be based on the last two dividends paid.
Expected growth rate = (75/69) − 1 = 0.087 ~ 8.7%
The market price can be determined using the growth model:
P0 = (0.75 × 1.087)/(0.1683 − 0.087) = 0.815/0.0813 = £10.02
(b) Beta is an ‘index of responsiveness’ which indicates the sensitivity to changes in the overall
level of the market of the returns on a given security. It is therefore an index of risk,
indicating the expected volatility of returns on a given security relative to returns on the
market as a whole. The beta of a security can be calculated from the standard deviation of
its returns, the standard deviation of returns on the market as a whole, and the correlation
coefficient between the returns of the security and those of the market. The equity beta of a
public limited company can be determined by:
•
Regressing the returns of the security on those of the market as a whole
•
Consulting the beta tables published by the London Business School
•
Determining the slope of the line of best fit (the ‘characteristic line’) of the security’s
returns plotted against those of the market as a whole.
Most betas are between 0.5 and 1.6.
Question 4
The financial manager is concerned with questions such as, ‘how can I measure the risk of a
capital investment project?’ and ‘how can I identify the return that should be expected from it,
given its level of risk?’ Portfolio theory hints at how these questions should be answered, but no
more than that, since it focuses on the risk and expected return relationship of collections of
assets, not individual assets.
The CAPM is a share valuation model which focuses on individual assets, and arises directly
out of the ideas and conclusions of portfolio theory. It provides significant insights into the
46
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
major factors determining share prices and so is of direct interest to decision makers within
companies.
The suggestion that ‘the CAPM makes portfolio theory redundant’ ignores the fact that portfolio
theory deals with collections of assets while the CAPM can deal with individual assets. Portfolio
theory is likely to be of interest to the individual investor, while the CAPM is more likely to be
of interest to financial managers with investment appraisal needs.
Question 5
We need to determine σs and σm in order to calculate the beta of Super Lux.
Rs = (18 + 21 + 20 + 25 + 26)/5 = 22%
Rm = (10 + 11 + 8 + 12 + 14)/5 = 11%
σs2 = [(−4)2 + (−1)2 + (−2)2 + (+3)2 + (+4)2]/5 = 9.2
Hence σs = 3.03%
σ2m = [(−1)2 + (0)2 + (−3)2 + (+1)2 + (+3)2]/5 = 4
Hence σm = 2%
βs = (σs σm ρs, m)/ σ2m = (3.03 × 2 × 0.83)/4 = 1.26
E(Rs) = Rf + βs (Rm − Rf) = 8 + [1.26 × (11 − 8)] = 11.78%
The required rate of return on Super Lux plc’s shares is 11.78 per cent.
47
© Pearson Education Limited 2014
CHAPTER 9
THE COST OF CAPITAL AND CAPITAL
STRUCTURE
Question 1
For the cost of equity, Ke = 7 + (1.21 × 9.1) = 18.01%
For the cost of preference shares, Kp = DP/P0 = 7/66 = 10.61%
For the cost of debt, Kd using the Hawanini-Vora bond approximation model:
(9 + ((100 − 105)/8))/(100 + 0.6 × (105 − 100)) = 8.375/103 = 8.13%
Kd after tax = 8.13 × (1 − 0.3) = 5.69%
For the bank loans, Kbl = 9 × (1 − 0.3) = 6.30%
(Alternatively, the after-tax cost of debt of the bonds can be used)
Calculating market values:
£
Market value of equity, E = 400,000 × £2.35 =
940,000
Market value of preference shares, P = 300,000 × £0.66 =
198,000
Market value of bonds, D = 650,000 × £105/100 =
682,500
Book value of bank loans (no market value) BL =
560,000
Total weighting =
2,380,500
WACC = K0 = [(18.01 × 940) + (10.61 × 198) + (5.69 × 683) + (6.30 × 560)]/2,380.5
= (16,929 + 2,101 + 3,886 + 3,528)/2,380.5 = 11.1%
Question 2
(i) Ordinary bonds
After-tax interest payment = 12 × 0.7 = £8.40 per bond
Year
Cash flow
£
0
Market value
10% discount factor
PV (£)
5% discount factor
PV (£)
(114)
1.000
(114.00)
1.000
(114.00)
1–5
Interest
8.4
3.791
31.84
4.329
36.36
5
Principal
100
0.621
62.10
0.784
78.40
(20.06)
48
© Pearson Education Limited 2014
0.76
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Interpolating to find the required rate of return:
Kd after tax = 5 + ((5 × 0.76)/(0.76 + 20.06)) = 5.2%
(ii) Convertible bonds
Share price in three years = 3.14 × 1.073 = £3.85
Conversion value = 40 × 3.85 = £154.00
Since £154.00 > £125, conversion is preferred.
Share price in four years = 3.14 × 1.074 = £4.12
Conversion value = 35 × 4.12 = £144.20
Conversion in three years preferred
After-tax interest payment = 9 × 0.7 = £6.30 per bond
Year
Cash flow
£
10% discount factor
0
Market value
(119)
1.000
Interest
6.3
Conversion
154
1–3
3
PV (£)
15% discount factor
PV (£)
(119.00)
1.000
(119.00)
2.487
15.67
2.283
14.38
0.751
115.65
0.658
101.33
12.32
(3.29)
Interpolating to find the required rate of return:
Kd after tax = 10 + ((5 × 12.32)/(12.32 + 3.29)) = 14.0%
(iii) Ordinary shares
Ke = 0.07 + ((35 × 1.07)/314) = 18.9%
(iv) WACC
£
E = 225,000 × 3.14 =
706,500
Dd = 500,000 × 1.14 =
570,000
DC = 250,000 × 1.19 =
297,500
1,574,000
WACC = [(18.9 × 706,500) + (5.2 × 570,000) + (14.0 × 297,500)]/1,574,000)
= (13,352,850 + 2,964,000 + 4,165,000)/1,574,000 = 13.0%
Question 3
Many academic papers have addressed the optimal capital structure question. A good answer
would include the following points.
•
The traditional approach argued that an optimal capital structure did exist for companies.
49
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
Miller and Modigliani’s first paper argued that a company’s value was independent of its
financing policy, but based their model on a number of restrictive and unrealistic
assumptions.
•
Miller and Modigliani later modified their earlier model to take account of corporate taxes
and argued that companies should gear up in order take advantage of the tax shield of debt.
•
If this later model is modified to take into account the existence of bankruptcy and agency
costs at high levels of gearing, an optimal capital structure emerges.
•
Miller amended their earlier model to take into account the differences in the personal tax
treatment of equity and debt returns and concluded that all combinations of debt and equity
finance were optimal.
•
In practice it seems plausible that companies can reduce their cost of capital by integrating
sensible levels of debt finance into their balance sheet. Whether a company can accurately
locate its range of optimal capital structures is open to debate.
Question 4
(a) Equity (Ke):
Dividend growth rate g = (29/22)0.25 − 1 = 7.15%
Ke = 0.715 + ((29 × 1.0715)/265) = 18.88%
Preference Shares (Kp):
Kp = 100 × (7/75) = 9.33%
Bonds (Kd):
Kd =
I + ((P − D)/n)
10 + ((100 − 102)/7
=
= 9.60%
(P + 0.6 × (NPD − P)) (100 + 0.6 × (102 − 100))
After tax Kd = 9.60 × (1 − 0.3) = 6.72%
Market Values
£000
Equity
15,000 × 2.65 = 39,750
Preference
10,000 × 0.75 = 7,500
Bonds
15,000 × 1.02 = 15,300
Total
62,550
The WACC Calculation:
[(18.88 × 39,750) + (9.33 × 7,500) + (6.72 × 15,300)]/62,550 = 14.8%
(b) Equity (Ke):
Dividend growth rate g = 1.20 × 0.0715 = 8.58%
Ke = 0.0858 + ((29 × 1.0858)/278) + = 19.91%
Amount raised through bond issue = £15m × 105 = £15.75m
50
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Number of shares repurchased = £15.75m/£2.65 = 5,943,396
Shares remaining = 15,000,000 − 5,943,396 = 9,056,604
Preference Shares (Kp):
Kp = 100 × (7/68) = 10.29%
Bonds (Kd):
As before.
New Bonds:
Kd =
I + ((P − NPD)/n)
11 + ((100 − 105)/7
=
= 9.99%
(P + 0.6 × (NPD − P)) (100 + 0.6 × (105 − 100))
After tax Kd = 9.99 × (1 − 0.3) = 6.99%
Market Values
£000
Equity
9,057 × 2.78
=
25,177
Preference
10,000 × 0.68
=
6,800
Bonds
15,000 × 1.02
=
15,300
New bonds
15,000 × 1.05
=
15,750
Total
63,027
New WACC Calculation:
(19.91 × 25,177) + (10.29 × 6,800) + (6.72 × 15,300) + (6.99 × 15,750)
63,027
= 12.4%
(c) A good answer would include the following points.
•
It is difficult to estimate accurately the share price after purchasing the shares. This
will affect not only Ke but also the weighting applied to it.
•
There is no allowance in the calculation for purchasing the shares at a premium to
the market price. This may be needed to persuade such a large number of shareholders
to part with their shares.
•
The estimate makes no allowance for transaction costs, both in terms of repurchasing
shares and the issuing of new bonds.
•
It will be difficult to estimate accurately the increase in the shareholders’
required return, due to the increase in financial risk. The same is true for the
estimates for the cost of the preference shares.
•
Both Kd values are calculated after tax – will the increase in debt finance lead to the
company becoming tax-exhausted?
•
The cost of debt is different between two bonds of the same maturity, when we
would expect it to be the same.
51
© Pearson Education Limited 2014
CHAPTER 10
DIVIDEND POLICY
Question 1
We need to use the dividend growth model, with P0 = 80p, D0 = 15p and g = 0
Therefore, Ke = (15/80) × 100 = 18.75%
Once the new project has been accepted, the new dividend stream is:
10p (D1), 10p (D2), 18p (D3), 18p (D4) and so on.
Therefore:
P0 = (18/0.1875) − (8/1.1875) − (8/1.18752) = 83.6p
(Or, P0 = (10/1.1875) + (10/1.18752) + (18/(0.1875 × 1.18752)) = 83.6p)
Conclusion: a fair price for the shares would be 83.6p. As this is greater than the current
share price, the company increases its shareholders’ wealth by taking on the project.
Question 2
(a) Modigliani and Miller argued that share valuation is a function of corporate earnings, which
reflect a firm’s investment policy, and that the investment decisions responsible for a firm’s
future profitability are the only determinants of its market value. Share valuation, therefore,
is independent of the level of dividend. They argued that:
•
investors are indifferent between receiving capital gains or dividends on their shares;
•
the firm’s optimal investment policy is to invest in all projects yielding a positive
NPV, since in a perfect market there is no capital rationing and the firm can obtain
required funds at the market rate of interest;
•
the company may pay a dividend if it wishes to do so, since any shortfall of funds
can be made up by issuing new equity.
Under Modigliani and Miller, then, a firm’s choice of dividend policy, given its
investment policy, is really a choice of financing strategy. Shareholders who want
cash can make ‘home-made’ dividends by selling shares. Modigliani and Miller’s
argument clearly rests on a number of assumptions, as follows:
•
Capital markets are perfect, which means that:
1. investors are rational;
2. information is freely available and costless;
3. transactions are freely available and without cost;
4. no one investor is big enough to affect the market price;
52
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
The issue of securities is without cost;
•
No taxes exist.
In contrast to the dividend, irrelevance theory is one arguing for the relevance of dividend
policy to share valuation, which holds that dividends are preferred to capital gains due to
the certainty of dividends. A number of the assumptions made by Modigliani and Miller are
claimed to be unrealistic.
•
Transaction costs are not zero when shareholders sell their shares to create ‘homemade’ dividends, and so capital gains are not a perfect substitute for dividends in cash
flow terms.
•
Taxation does exist at both the corporate and personal level.
•
Securities are not without cost to float, but incur issue costs.
•
Information is not freely available.
These shortcomings undermine the Modigliani and Miller theory, but they do not invalidate
it. In fact, empirical research since Modigliani and Miller’s paper was published has tended
to support it.
(b) (i) Asymmetric information
In the context of dividends and dividend policy, this refers to the fact that shareholders
and managers have incomplete and different information in an imperfect market.
Managers do not know how shareholders will react to a dividend change and
shareholders are not party to the information available to managers. The result of this
information asymmetry is the information content of dividends, where dividends are
seen to have signalling properties.
(ii) Scrip dividends
Scrip dividends are an issue of ordinary shares to the shareholders as an alternative to a
cash dividend. One advantage to the company is in cash flow terms, because it does not
have to pay out a cash dividend. Scrip dividends may be attractive to shareholders who
want to increase their stake in a company while avoiding dealing costs.
(iii) Shareholder perks
Shareholders are offered a wide range of incentives by companies in addition to
dividends, such as vouchers that can be redeemed against goods and subsidised travel
on ferries. Such perks can be viewed as a way of increasing shareholder loyalty, as
well as rewarding shareholders.
(c) If a firm pays out zero dividends, then according to the dividend growth model it has no
value. However, the dividend growth model is only a guide to the value of a firm, and there
are many cases of companies which pay zero or negligible dividends, for example, young
companies who are reinvesting profits for growth. Such companies will attract investors
looking for capital growth, or who expect dividends in future periods, when the model
can be applied.
53
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 3
Here we need to analyse the data as follows:
Year
2009
2008
2007
2006
2005
3.3
3.1
2.7
2.6
2.5
2.0
Earnings per share (pence)
34.2
33.0
29.2
28.6
27.6
25.4
Dividend per share (pence)
11.4
11.1
9.9
9.6
9.2
8.5
Payout ratio (per cent)
33.3
33.6
33.9
33.6
33.3
33.5
Nominal dividend change (per cent)
2.7
12.1
3.1
4.3
8.2
Annual inflation (per cent)
3.1
3.4
3.1
2.4
3.4
2.5
Real dividend per share (pence)
9.8
9.8
9.1
9.1
8.9
8.5
Real dividend change (per cent)
nil
7.7
nil
2.2
4.7
Turnover (£m)
2004
Sample workings:
Payout ratio (2004) = 100 × (8.5/25.4) = 33.5%
Nominal dividend change (2004/2) = 100 × ((9.2/8.5) − 1) = 8.2%
Real dividend per share (2004) = nominal dividend per share (1994) = 8.5p Real dividend per
share (2005) = 9.2/(1 + inflation rate) = 9.2/1.034 = 8.9p Real dividend per share (2006) =
9.6/(1.034 × 1.024) = 9.1p
Real dividend per share (2007) = 9.9/(1.034 × 1.024 × 1.031) = 9.1p
Real dividend change (2004/2) = 100 × ((8.9/8.5) − 1) = 4.7%
Nominal annual growth rate (2004/6) = 100 × ((11.4/ 8.5)0.2 − 1) = 6.05%
Real annual growth rate (2004/6) = 100 × ((9.8/ 8.5)0.2 − 1) = 2.9%
Analysis indicates that LMT plc has a dividend policy of paying out a constant
proportion of its earnings, i.e. a constant payout ratio policy. This policy may be appropriate for
a large company with relatively stable earnings. However, the data indicates that the turnover of
LMT plc has grown consistently in nominal terms over the past six years.
Institutional investors are likely to prefer steady growth in dividend per share and while LMT
plc has achieved regular growth in nominal terms, it is erratic. The equivalent annual growth
rate is 6.05 per cent, but growth has been as low as 3.1 per cent and as high as 12.1 per cent.
Institutional investors are also likely to prefer a constant or increasing real dividend per
share and in this respect the performance of LMT plc is poor. The equivalent annual growth
rate in real terms is 2.9 per cent.
We cannot determine the acceptability of the dividend policy of the company solely in these
terms, however, since institutional investors will undertake investment on a portfolio basis. The
argument for dividend clienteles might be advanced here to suggest that the shareholders
of LMT plc are likely to find its dividend policy acceptable. This suggestion is also supported
54
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
by the fact that LMT plc has followed a constant payout ratio policy for at least six years and
perhaps more. It may have an established clientele.
Question 4
(a) If the company does not change its current dividend policy, the dividend growth model
can be applied.
Expected growth in dividends, g = (11.4/8.5)0.2 − 1 = 6%
Applying the model: P0 = (11.4 × 1.06)/(0.12 − 0.06) = 201.4p
Alternatively, the current payout ratio of 50 per cent may be maintained. As earnings for
2009 of 25 pence per share are expected, the 2009 dividend may be 12.5 pence per share.
Applying the model: P0 = 12.5/(0.12 − 0.06) = 208.3p
(b) If the company changes its dividend policy, the retention ratio increases from 50 per cent
to 70 per cent, and so the expected dividend for 2009 will be 25p × 0.3 = 7.5 pence per
share. Expected dividend growth rate = 8.75 per cent.
Applying the model: P0 = 7.5/(0.12 − 0.0875) = 230.8p
The implications of the calculations for Dilbert’s ordinary shareholders are that their wealth
will be increased if the current dividend policy is changed. However, the cut in dividend in
the medium term may be unwelcome.
55
© Pearson Education Limited 2014
CHAPTER 11
MERGERS AND TAKEOVERS
Question 1
(a) Effect of share exchange on shareholder wealth:
Number of shares to be issued in acquisition: 500,000 × 4/5 = 400,000
1. Net asset valuation based on book values
The problem with this method is that the book values of the assets are unlikely to reflect the
current value of the assets of Rattling Creek Ltd. They also ignore any goodwill associated
with the continuing business activities of Rattling Creek Ltd.
Hanging Valley
Rattling Creek
Both
£000
£000
£000
Net assets employed
Long-term liabilities
Balance sheet worth
Number of shares
Net assets per share
Increase in net assets per share =
2,100
1,100
3,200
0
200
200
2,100
900
3,000
1,500,000
500,000
1,900,000
£1.40
£1.80
£1.58
(158 − 1.40)
× 100 = + 12.9 per cent
1.40
2. Capitalisation of earnings valuation (earnings yield valuation)
This method considers the rate of return that will be required from Rattling Creek Ltd
after it has been acquired. It is assumed that the management of Hanging Valley plc is
more efficient than that of Rattling Creek and so can achieve a better return. The
target return on investment that has been used, therefore, is the reciprocal of Hanging
Valley’s P/E ratio. This valuation method can be used to indicate the maximum that
Hanging Valley would be prepared to pay for Rattling Creek, and therefore, the maximum
increase in value that Hanging Valley’s shareholders may expect from the acquisition.
Hanging Valley
Rattling Creek
Both
£
£
£
420,000
200,000
620,000
0
20,000
20,000
420,000
180,000
600,000
Tax (35 per cent)
147,000
63,000
210,000
Earnings after interest and tax
273,000
117,000
390,000
1,500,000
500,000
1,900,000
18.2
23.4
20.5
PBIT
Interest
Number of shares
Earnings per share (pence)
56
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
P/E ratio of Hanging Valley: 160/18.2 = 8.79
Hanging Valley earnings yield: 18.2/160 = 11.38%
Rattling Creek earnings, capitalised value =
Annual maintainable earnings
Required ROI
The required ROI can be taken as Hanging Valley plc’s earnings yield. Rattling Creek
earnings, capitalised value = 117,000/0.1138 = £1,028,119
Total combined value = (1.60 × 1,500,000) + 1,028,119 = £3,428,119
Hanging Valley share value after takeover = 3,428,119/1,900,000 = £1.80
Increase in value = 100 × ((1.80 − 1.60)/1.60) = +12.5% or 20p
3. Dividend yield method of share valuation
This method of share valuation is really only suitable for the valuation of small holdings of
shares in unquoted companies. It is based on the principle that small shareholders
are mainly interested in dividends, since they are unable to control decisions affecting
profits and dividends. However, if it is assumed that Hanging Valley is buying a company
which is not capable of increasing either profits or dividends, it can be used to value
Rattling Creek as a perpetual stream of dividends of constant value.
Using the dividend growth model, the required return on equity of Hanging Valley’s
existing shareholders, based on a current share price of £1.60 per share, a current
dividend of 6.9p per share and dividend growth of 15 per cent per annum, is calculated as
follows:
Ke = 0.15 + (0.069 × 1.15/1.60) = 20%
Market value of Rattling Creek = 500,000 × 0.14/0.2 = £350,000
Current market value of Hanging Valley = 1,500,000 × 1.60 = £2,400,000
Market value after takeover = 2,400,000 + 350,000 = £2,750,000
Hanging Valley share price after takeover = 2,750,000/1,900,000 = £1.45
Decrease in share price = 100 × (1.60 − 1.45)/1.60 = −9.4% or 15p
It may be concluded that, since Hanging Valley is paying 400,000 × 1.60 = £640,000 for
Rattling Creek, the management of Hanging Valley expects to achieve some growth in
earnings and dividends from the acquired company.
(b) You could discuss the following economic reasons for takeovers:
•
Synergy (both operating and financial synergy)
•
Economies of scale
•
Elimination of inefficient management
•
Entering new markets
•
Providing critical mass
•
Growth
•
Increasing market power
57
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
Risk reduction
•
Acquisition of managerial expertise.
Question 2
(a) The original EPS of Blur = £1.8m/3m = 60p
Number of shares of Blur to be issued = 6m/3 = 2m
Post-merger earnings of the new company = 1.8 + 0.5 + 0.2 = £2.5m
Merged company’s EPS = (£1.8m + £0.5m + £0.2m)/5m = 50p
The expected EPS dilution from Blur’s shareholders’ point of view is 10p.
(b) Here assume P = the number of new shares in Blur to be issued and Q = the amount of
debt finance in the new company to be issued. The distributable earnings of the new
company of £2.5m will be reduced by the after-tax cost of the interest on the 6.5 per cent
loan stock. The EPS of the new company must remain at 60p, however, and so:
2,500,000 − (0.70 × 6.5% × Q)
= 60p
(3,000,000 + P)
Rearranging this equation:
(1) 0.0455Q + 0.6P = 700,000
Also, we know that:
(2) 10,500,000 = Q + 7.2P
Rearranging (2):
Q = (10,500,000 − 7.2P)
Inserting this into (1):
0.0455 ×(10,500,000 − 7.2P) + 0.6P = 700,000
Solving for P:
P = 222,250/0.2724 = 815,896
From (2), substituting for P we have:
Q = 10,500,000 − (7.2 × 815,896) = £4,625,549
Hence, Oasis shareholders receive 815, 896 shares in Blur and £4, 625, 549 of 6.5 per
cent loan stock.
Question 3
(a) (i) Calculating Trollope’s value using the P/E ratio method:
Wrack’s P/E ratio = £4.21/29p =
14.52
Trollope’s earnings per share = £47.4m/156m =
30.4p
Share price of Trollope = 14.52 × 30.4p =
£4.41
We are assuming here that the market expects Wrack to achieve a return on
Trollope’s assets comparable to that on its own assets. Therefore:
Total market value = 156m × £4.41p = £688.0m
58
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
(ii) The dividend valuation method requires values for g and r.
Here g is given by (16/13)0.25 − 1 = 5.3%
The cost of equity for Trollope (Ke) can be calculated using the CAPM: Ke = 5 + 1.15 ×
(12 − 5) = 13.1%
Therefore P0 = [(16 × 1.053)/(0.131 − 0.053)] = £2.16 per share
Total market value = 156m × £2.16 = £337.0m
(iii) We can discount future cash flows using Wrack’s WACC:
Present value of earnings = [(£47.4m × 1.02)/(0.12 − 0.02)] = £483.5m
Present value of asset sale = (25/1.12) = £22.3m
Present value of synergy = (5/0.12) = £41.7m
Total present value of Trollope = 483.5 + 22.3 + 41.7 = £547.5m
(b) Using the P/E ratio method to value firms is a rule of thumb to be used with caution.
EPS is an accounting figure that can be manipulated through creative accounting. In
addition, earnings will vary over time and not remain at their current level, and the
EPS figure used in calculations needs to be ‘normalised’ to reflect this. Problems associated
with the P/E ratio method include selecting an appropriate P/E ratio to apply to the EPS
and the fact that the ratio combines a current value (i.e. a share price) with an historic value
(i.e. EPS).
The accuracy of the dividend valuation model relies heavily on the ability of users
to forecast future dividend payments and to calculate shareholders’ required rate of
return. Both of these figures are difficult to estimate with any real accuracy. Another
problem of the model is that it considers the dividends that flow to individual investors,
rather than the company’s ability to generate cash flows from its assets.
The discounted cash flow valuation is considered the most academically appropriate way to
value a company. Practical difficulties with this method include, estimating future
cash flows and choosing a suitable discount rate. Cash flows are difficult to predict
accurately over long periods of time. The acquiring company will also have to decide on the
time period over which to predict cash flows and will need to accurately forecast any
economies of scale or synergies that may result from the acquisition. The appropriate rate at
which to discount future cash flows is the acquiring company’s cost of capital. Companies
may have a reasonable idea of their current cost of capital, but are less likely to know
what their future cost of capital will be. Also, the acquirer’s cost of capital will not be the
best discount rate if the risk of the acquired company is different to the risk of existing
activities. In such a case, appropriate adjustments will have to be made. Such adjustments
tend to be subjective.
In the case of Trollope, the P/E valuation assumes that the market applies Wrack’s P/E ratio
to Trollope’s EPS – which it may or may not do, so a valuation of £688.0m can be
considered to be too high. The dividend valuation (£337.0m) appears unrealistic as it is not
significantly above the net asset value of the company (£231m). The third valuation, the
discounted cash flow valuation is the academically most sound of the three valuation
methods. It’s valuation of £547.5m is above the dividend valuation model’s figure and
below the P/E valuation. This appears of sensible magnitude and hence should be used by
Wrack.
59
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
(c) A good answer would include the following points:
•
The tax position of the target company’s shareholders. If they are tax exempt they
may prefer a cash offer, as they will not incur capital gains tax. If they are liable for
capital gains, they may prefer a share-for-share offer. If there is a range of investors in
different tax paying positions, a mixed bid may be more appropriate.
•
The bidding company’s level of liquidity and its ability to borrow more funds
will determine whether it will be able to find sufficient funds in order to make a cash
offer. If it is short of liquidity and is already highly geared, a cash offer may be out of
the question.
•
The bidding company’s share price will also be a major factor. If it is relatively
high compared to the target company’s share price, the bidding company will be able to
make a share-for-share offer with fewer shares, therefore, reducing any potential
dilution of EPS and control for the existing shareholders.
•
The combined preferences of both bidding company and target company
shareholders are also very important. The shareholders of the bidding company many
not want it to borrow in order to make a cash offer because this may increase the
financial risk beyond a level they are prepared to tolerate. A cash offer may be
unattractive to target company shareholders because they no longer have a participating
interest in the company that they originally bought shares in.
Question 4
(a) Given that Membrane’s shares are currently trading at £2.03, Goldblade will have to buy
them at 2.03 × 1.20 = £2.44.
Assuming its shares remain stable at £3.65, Goldblade will exchange one of its shares
for 1.5 of Membrane’s shares (£3.65/£2.44). Alternatively, it could exchange two of its
shares for three in Membrane. The new number of shares will be 160m + (92m × 2/3) =
160m + 61.3m = 221.3m.
(b) Cash offers:
Cash required by Goldblade plc will be £2.44 × 92m = £224m
As the company has only £59m on its balance sheet, it will have to raise the
purchase consideration by borrowing.
The company’s gearing may become an issue:
Current: (353m)/((160m × 3.65) + 353m) = 38%
Proposed: (353m + 224m + 121m)/((221.3m × 3.65) + 698m) = 46%
This takes gearing above the industrial average and may be a problem.
Interest cover currently stands at (122/49) = 2.5
This will become (170/(49 + 18 + 22.4)) = 1.9 which is on the low side.
Share-for-share offers:
The firm’s share price is currently at the top end of the low/high range, so it may want
to cash in on the relative buoyancy via a share-for-share offer.
60
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Goldblade has a bootstrapping opportunity, as its current PER is 11.4 (365/(51m/160m))
compared with Membrane’s 8.9 (203/(£21m/92m). If the market applies Goldblade’s PER
to the post-acquisition EPS of (£72m/221.3m) = 33p, a new share price of (33p × 11.4) =
£3.76 would result (compared to £3.65p).
However, the issue of shares will have control implications, as 28 per cent of the firm’s
shares will be owned by a new set of investors who may, in the future, sell their holding to a
potential bidder.
You could also mention the following points:
•
The effect on the capital structure of Goldblade
•
Share-for-share issues are often more expensive than cash offers
•
The payment preferences of the target company’s shareholders.
Question 5
The viability of the financing proposal depends on whether there will be sufficient cash after
paying salaries to pay the interest on the mezzanine debt, and whether there will be enough free
cash flow to meet the reinvestment in 2012. The venture capitalists will be heartened by the fact
that the four members of the MBO team are putting in a significant equity stake (£1.25m each).
The appropriate calculations are as follows.
2010
2011
2012
2013
2014
Predicted sales
6.78
6.82
7.23
7.51
8.02
Costs of sales
3.39
3.34
3.47
3.53
3.84
Salaries
0.6
0.6
0.6
0.6
0.6
Profit before interest and tax
2.8
2.9
3.2
3.4
3.6
Interest at 11%
2.2
2.2
2.2
2.2
2.2
Profit before tax
0.59
0.68
0.96
1.18
1.38
Tax at 20%
0.12
0.14
0.19
0.24
0.28
After tax at 20%
0.47
0.54
0.77
0.94
1.10
Cumulative surplus
0.47
1.01
1.78
2.72
3.82
The proposition appears to be viable from a cash flow perspective, since the MBO can cover:
•
Salaries and interest payments on the basis of predicted sales and costs
•
The re-investment due at the end of 2012 of £1.5m.
The venture capitalist’s exit from the deal is unresolved, however.
61
© Pearson Education Limited 2014
CHAPTER 12
RISK MANAGEMENT
Question 1
(a) Answers should discuss four of the following techniques:
Matching
Here, a company selling goods denominated in a foreign currency should try to use a
raw materials importer that invoices in the same foreign currency.
Leading and lagging
This method involves companies settling accounts in foreign currencies either at the
beginning or at the end of their allowed credit period, according to their expectations of future
exchange rate movements.
Forward exchange contracts
These allow companies to fix future exchange rates in advance on agreed quantities of foreign
currency, for delivery or purchase on agreed dates. They are generally set up via banking
institutions and are legally binding, non-negotiable contracts.
Money market hedges
Here, companies use appropriate money market transactions at the current spot rate to lock
into a specific exchange rate.
Various derivatives
The most commonly used derivatives to hedge transaction risk include options (both traded
and over-the-counter) and futures contracts.
(b) (i) Hedging the three-month $197,000 receipt via the forward rate gives:
$197,000/1.7063 = £115,454
This means that in three months’ time Goran has to make a net payment of
£116,000 − £115,454 = £546
(ii) Hedging using the money market requires borrowing dollars:
($197,000/(1 + 0.09/4)) = $192,665
This is then converted into sterling at the spot rate:
62
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
$192,665/1.7140 = £112,407
This is then invested on the sterling money markets for three months giving:
£112,407 × (1 + 0.095/4) = £115,076
This means that in three months’ time Goran has to make a net payment of:
£116,000 − £115,076 = £924
For the six-month $447,000 payment, hedging using the forward rate gives:
$447,000/1.6967 = £263,453
Hedging using the money market requires lending dollars:
$447,000/(1 + 0.06/2) = $433,980
This amount of dollars is acquired at the current spot rate:
$433,980/1.7106 = £253,700
The sterling amount has to be borrowed for six months so the overall cost is:
£253,700 × (1 + 0.125/2) = £269,556
Question 2
1. Options
Using options to hedge interest rate risk is discussed in section 12.5.3.
Advantages
•
The holder has the right but not the obligation to exercise the contract, giving the chance
to benefit from favourable changes in interest rates.
•
Options are tradable due to their standardisation and can therefore be sold on to a
third party.
Disadvantages
•
Contracts are standardised in terms of both duration and value, so it may be difficult to
find a perfect hedge.
•
Options are also seen as an expensive form of hedging, due to the premiums payable
on them.
2. Swaps
The use of swaps to hedge interest rates is discussed in section 12.6.1.
Advantages
•
Swaps allow companies to hedge interest rate exposures for relatively long periods of
time compared to other derivatives.
63
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
•
Arrangement fees are likely to be much less than the premiums paid on options.
•
Swaps are more flexible as regards both principal and duration compared to
standardised derivatives.
Disadvantages
•
Servicing payments must still be paid by the party that originally took out the loan if the
counterparty defaults. This is ‘counterparty risk’.
•
Market risk exists, since a suitable replacement for a defaulting counterparty may not
be found if interest rate movements are adverse.
•
Once locked into a swap, a company can no longer take advantage of favourable
interest rate movements.
Question 3
In order to hedge interest rate risk, companies will buy futures contracts to hedge
against interest rate falls and sell futures to hedge against interest rate rises. These
contracts run in three-month cycles and have nominal values of £500,000. The two most
appropriate contracts for hedging sterling interest rate risk are the three-month sterling and long
gilt contracts. Contracts are priced in nominal terms by subtracting the value of the specified
interest rate from 100 (i.e. pricing is on a discount basis). Profits or losses made on futures
contracts are given in terms of ticks, where one tick is defined as 0.01 per cent per year of the
contract or £12.50 (i.e. 0.0001 × £500,000/4).
Advantages
•
Unlike options, there is no ‘up front’ premium to be paid.
•
The contracts are tradable (can be bought and sold on a secondary market).
•
Contracts are marked to market, so if interest rates move in a company’s favour, benefits
are immediately credited to its margin account.
Disadvantages
•
Unlike options, futures do not allow a company to take advantage of favourable
movements in interest rates.
•
The contracts are standardised, so it is often difficult to find a perfect hedge with respect
to the principal to be hedged and its maturity.
•
Basis risk may exist, whereby a perfectly negative correlation between changes in
interest rates and the price of futures contracts does not exist.
64
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Question 4
HYK can currently borrow at LIBOR + 0.75 or 7.25 per cent. Using a futures hedge, the firm
will seek a futures gain in order to offset a possible cash market loss if interest rates rise.
As the primary concern is an interest rate rise, the company will sell futures contracts. The
current four-month borrowing cost is £18,000,000 × 0.0725 × 4/12 = £435,000.
(i) Interest rates increase by 150 basis points (1.5 per cent)
Cash market
The new borrowing cost will be £18,000,000 × 0.875 × 4/12 = £525,000
This is a cash market loss of £90,000
Futures market
Sell March futures contracts as March is the nearest expiry date after borrowing
commences. Number of contracts needed to hedge four-month risk:
£18,000,000/£500,000 × (4/3) = 48 contracts
Basis risk is the interest rate implicit in the March futures price less the current LIBOR rate,
i.e. (100 − 93.10 − 6.5) = 0.40%
When the future contracts mature at the end of March, the basis risk will be zero. Assuming
basis risk falls at a constant rate, the expected basis risk when the loan is taken out at the start of
February will be 0.20 per cent (the contract matures in four months, the loan is taken out in two
months). The expected futures price in two months is (93.1 − 1.50 + 0.20) = 91.80
The expected futures gain if the 48 contracts are closed out in two months is 48 × £12.50
× (93.10 − 91.80) × 100 = £78,000
Net borrowing cost = 525,000 − 78,000 = £447,000 or 7.45%
Hedge efficiency = 100 × (78,000/90,000) = 87%
If basis risk is assumed constant, the gain will be £90,000 and the net borrowing cost will
be 525,000 − 90,000 = £435,000 or 7.25%
Hedge efficiency = 100 × (90,000/90,000) = 100%
Options market
Using the 93.00 exercise price, 48 March put options are needed at a cost of £18,000,000 ×
0.002 × 4/12 = £12,000
If interest rates increase by 1.5 per cent, the options will be exercised and 48 futures contracts
sold at the exercise price of 93.00. (It might be possible to sell the options at a better rate as they
still have some time value.)
Expected futures price in two months = 91.80
65
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
Expected gain = 48 × 12.50 × (93.00 − 91.80) × 100 = £72,000
Overall cost of loan = 525,000 − 72,000 + 12,000 = £465,000 (7.75%)
If basis risk is assumed constant, expected gain = £84,000 and overall cost of loan = 525,000 −
84,000 + 12,000 = £453,000 (7.55%)
Using the 93.50 exercise price, 48 March put options are needed at a cost of £18,000,000 ×
0.006 × 4/12 = £36,000
Expected futures price in two months = 91.80
Expected gain = 48 × 12.50 × (93.50 − 91.80) × 100 = £102,000
Overall loan cost = 525,000 − 102,000 + 36,000 = £459,000 (7.65%)
If basis risk is assumed constant, expected gain = £114,000 and overall cost of loan = 525,000 −
114,000 + 36,000 = £447,000 (7.45%)
Using the 94.00 exercise price, 48 March put options are needed at a cost of £18,000,000 ×
0.0135 × 4/12 = £81,000
Expected futures price in two months = 91.80
Expected gain = 48 × 12.50 × (94.00 − 91.80) × 100 = £132,000
Overall loan cost = 525,000 − 132,000 + 81,000 = £474,000 (7.90%)
If basis risk is assumed constant, expected gain = £114 000 and overall cost of loan = 525 000 −
114,000 + 81 000 = £492,000 (7.70%)
(ii) If interest rates fall by 50 basis points (0.5%)
Cash market
The new borrowing cost will be £18,000,000 × 0.675 × 4/12 = £405,000
This is a cash market gain of £30,000
Futures market
The same futures contract will have been used and the expected basis risk at the start
of February will still be 0.20%.
The expected futures price in two months is (93.1 + 0.50 + 0.20) = 93.80
The expected futures loss if the futures contracts are closed out in two months is 48 × £12.50
× (93.10 − 93.80) × 100 = £42,000
Net borrowing cost = 405,000 + 42,000 = £447,000 or 7.45%
Hedge efficiency = 100 × (30,000/42,000) = 71%
66
© Pearson Education Limited 2014
Watson and Head, Corporate Finance: Principles and Practice, 6th edition, Instructor’s Manual on the Web
If basis risk is assumed constant, the loss will be £30,000 and the net borrowing cost will be
405,000 + 30,000 = £435,000 or 7.25%
Hedge efficiency = 100 × (30,000/30,000) = 100%
No matter how interest rates move, the futures hedge should keep the cost of borrowing below
the desired 7.50 per cent maximum. Note that in reality any gains or losses on futures would
occur on a daily basis, not at the end of the period, and basis risk may not fall at a constant rate.
Options:
The expected futures price is 93.80. The 93.00 and 93.50 options will not be exercised and
the overall cost will be:
93.00 exercise price:
£405,000 + £12,000 = £417,000 or 6.95%
93.50 exercise price:
£405,000 + £36,000 = £441,000 or 7.35%
94.00 exercise price:
Expected gain = 48 × £12.50 × (94.00 − 93.80) × 100 = £12,000
Overall loan cost = 405,000 − 12,000 + 81,000 = £474,000 (7.9%)
If basis risk is assumed constant, expected gain = £24,000 and overall cost of loan = 405,000 −
24,000 + 81,000 = £462,000 (7.70%)
Conclusion
If basis risk is expected to fall to 0.20, none of the option contracts has a maximum expected
interest rate (including option premium) of 7.5 per cent, although the 93.50 exercise price is
close to it. If basis risk is assumed constant, the 93.50 option has a rate of 7.45 per cent. If the
finance director does not wish to pay more than 7.5 per cent, hedging with futures should be
selected. An option collar might also be possible in this situation, if HYK is prepared to limit the
benefit from any fall in interest rates.
67
© Pearson Education Limited 2014
Download
Random flashcards
State Flags

50 Cards Education

Countries of Europe

44 Cards Education

Art History

20 Cards StudyJedi

Sign language alphabet

26 Cards StudyJedi

Create flashcards