BMCF5103
Corporate Finance
Copyright © Open University Malaysia (OUM)
BMCF5103
CORPORATE FINANCE
Dr Noryati Ahmad
Dr Fahmi Rahim
Dr Balkis Harris
Copyright © Open University Malaysia (OUM)
Project Director:
Prof Dato’ Dr Mansor Fadzil
Open University Malaysia
Module Writers:
Dr Noryati Ahmad
Dr Fahmi Rahim
Dr Balkis Harris
Universiti Teknologi MARA
Moderator:
Dr Mohamed Hisham Dato’ Haji Yahya
Universiti Putra Malaysia
Developed by:
Centre for Instructional Design and Technology
Open University Malaysia
First Edition, April 2017
Copyright © Open University Malaysia, April 2017, BMCF5103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).
Copyright © Open University Malaysia (OUM)
Table of Contents
Course Guide
Topic 1
Topic 2
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Introduction to Corporate Finance
1.1 Corporate Finance
1.1.1 Financial Management Decisions
1.2 The Corporate Firm
1.3 The Importance of Cash Flows
1.3.1 Identification of Cash Flows
1.3.2 Timing of Cash Flows
1.3.3 Risk of Cash Flows
1.4 The Goal of Financial Management
1.4.1 Profit Maximisation Goal versus ShareholdersÊ
Wealth Maximisation Goal
1.5 The Agency Problem and Control of the Corporation
Summary
Key Terms
References
Advanced Capital Budgeting
2.1 Net Present Value (NPV)
2.1.1 NPV Problem Solving Using Formula
2.1.2 NPV Problem Solving Using Financial Table
(Interest Factor Table)
2.1.3 NPV Problem Solving Using Financial Calculator
2.2 Internal Rate of Return (IRR)
2.2.1 IRR Problem Solving Using Formula
2.2.2 IRR Problem Solving Using Financial Table
(Interest Factor Table)
2.2.3 IRR Problem Solving Using Financial Calculator
2.3 Discounted Payback Period (DPP)
2.4 Profitability Index (PI)
2.5 Incremental Cash Flows
2.6 Inflation and Capital Budgeting
Summary
Key Terms
References
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Topic 3
Topic 4
TABLE OF CONTENTS
Efficient Capital Market and Behavioural Challenges
3.1 Can Financing Decision Create Value?
3.2 A Description of Efficient Capital Markets
3.2.1 Assumption of Efficient Capital Market
3.3 The Different Types of Information and Efficient Market
Hypothesis
3.4 The Evidence of Efficient Market Hypothesis (EMH)
3.4.1 Weak-form Tests of the EMH
3.4.2 Semi-strong-form Test of EMH
3.4.3 Strong-form Test of EMH
3.5 The Behavioural Challenge to Market Efficiency
Summary
Key Terms
References
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Capital Structure
4.1 Maximising Firm Value Versus Maximising Shareholders
Interest
4.2 The Effect of Financial Leverage
4.2.1 Analysing the Break-even EBIT
4.2.2 Corporate Borrowing and Homemade Leverage
4.3 Capital Structure and the Cost of Equity Capital (M&M
Proposition Without Tax)
4.3.1 M&M Proposition I: The Pie Model
4.3.2 M&M Proposition II: The Cost of Equity and
Financial Leverage
4.4 M&M Proposition I and II with Corporate Tax
4.4.1 The Interest Tax Shield
4.4.2 Taxes and M&M Proposition I
4.4.3 Taxes and M&M Proposition II
4.5 The Pecking Order Theory
4.5.1 Implications of the Pecking Order
Summary
Key Terms
Reference
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Topic 5
Dividend Policy
5.1 Different Types of Dividend Payouts
5.1.1 Cash Dividend
5.1.2 Stock Dividend
5.1.3 Stock Split
5.2 Standard Method of Cash Dividend Payment
5.3 Repurchase of Stocks
5.4 Personal Taxes, Dividends and Stock Repurchases
Summary
Key Terms
References
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Topic 6
Options and Corporate Finance
6.1 Options
6.1.1 Option Contract Specifications and Quotation
6.2 Types of Options
6.2.1 Features of Option Contract
6.2.2 Value and Options
6.3 Options Pricing
6.3.1 Intrinsic Value
6.3.2 Time Value
6.3.3 Factors Affecting Option Prices
6.3.4 Options Pricing Formula
6.4 Stocks and Bonds Options
Summary
Key Terms
References
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Topic 7
Warrants and Convertible Bonds
7.1 Warrants
7.2 Differences between Warrants and Call Options
7.3 Warrant Pricing
7.4 Convertible Bonds
7.5 Value of Convertible Bonds
7.6 Reasons for Issuing of Warrants and Convertible Bonds
Summary
Key Terms
References
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TABLE OF CONTENTS
Topic 8
Leasing
8.1 Types of Leases
8.1.1 Operating Leases
8.1.2 Financial Leases
8.1.3 Rationale for Leasing
8.2 Accounting and Leasing
8.3 Taxes and Leases
8.4 NPV Analysis: Lease versus Buy Decision
Summary
Key Terms
References
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Topic 9
Merger and Acquisition
9.1 Basic Forms of Acqusitions
9.1.1 Motives for Acquisition
9.1.2 Friendly versus Hostile Takeovers
9.2 Synergy
9.3 The Net Present Value of a Merger
9.4 Dubious Reasons for Mergers and Acquisitions
Summary
Key Terms
References
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Topic 10
International Corporate Finance
10.1 Foreign Exchange Markets and Rates
10.1.1 FOREX Market Participants
10.1.2 Spot Foreign Exchange Market
10.1.3 Forward Market
10.2 Theories Related to Foreign Exchange Rates
10.2.1 Purchasing Power Parity Theory
10.2.2 Interest Rate Parity Theory
10.2.3 Unbiased Forward Rate
10.2.4 International Fisher Effect Theory
Summary
Key Terms
References
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Copyright © Open University Malaysia (OUM)
COURSE GUIDE
Copyright © Open University Malaysia (OUM)
Copyright © Open University Malaysia (OUM)
COURSE GUIDE
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COURSE GUIDE DESCRIPTION
You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend to
complete the course successfully. Please keep on referring to the Course Guide as
you go through the course material as it will help you to clarify important study
components or points that you might miss or overlook.
INTRODUCTION
BMCF5013 Corporate Finance is one of the courses offered at Open University
Malaysia (OUM). This course is worth 3 credit hours and should be covered over
8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all learners taking the Master in Business Administration
programme. This module aims to impart the essence of corporate finance and
form a good understanding of the concepts and applications of corporate finance
in organisations.
As an open and distance learner, you should be acquainted with learning
independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course material,
the course requirements and how the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
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COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours
Study Activities
Study
Hours
Briefly go through the course content and participate in initial discussions
5
Study the module
60
Attend 4 tutorial sessions
8
Online Participation
12
Revision
15
Assignment(s), Test(s) and Examination(s)
20
TOTAL STUDY HOURS ACCUMULATED
120
COURSE OUTCOMES
By the end of this course, you should be able to:
1.
Describe the problems that are revealed by a principal-agent framework in
the contractual model of a company;
2.
Apply alternative methods for capital budgeting with leverage and market
imperfections;
3.
Evaluate the implications of the evidence for market efficiency for investors
and corporate management;
4.
Describe the process involved in issuing securities and their potential
impacts on company valuation;
5.
Explain the way in which option pricing theory can be used in real
investment decisions;
6.
Apply hedging strategies using some of the derivative instruments that are
commonly used by financial managers to hedge risk;
7.
Discuss all aspects of mergers and acquisitions including methods, gains
and losses as well as defensive tactics;
8.
Discuss some useful indicators of impending corporate financial distress;
and
9.
Evaluate the impact of foreign exchange risk on international financial and
investment decisions.
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COURSE GUIDE
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COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic can be listed as
follows:
Topic 1 begins with an explanation on the nature of corporate finance. This is
followed by highlighting the importance of cash flow and the goal of financial
management. Next, the issue of the agency problems and costs as well as the
mechanism used to mitigate agency problems will also be discussed.
Topic 2 examines the capital budgeting techniques applied in evaluating
investment projects. Among them are net present values, internal rate of return,
discounted payback and profitability index. This is followed by identifying and
illustrating how incremental cash flows are determined. Last but not least, this
topic also explains the implication of inflation on capital budgeting decisions.
Topic 3 discusses the concept of efficient capital markets and the different forms
of efficient capital markets. The subsequent subtopic explains the emergence of
behavioural finance and its challenges to the market efficiency hypothesis.
Topic 4 begins by explaining the meaning of capital structure and its relationship
with firm value maximisation and shareholders wealth maximisation. It also
discusses further on how financial leverage has an impact on firm value.
ModiglianiÊs and MillerÊs propositions are also examined in relation to the capital
structure of a company. Lastly, the implication of taxes, cost of financial distress,
signalling theory and pecking order theory on the capital structure are discussed
in detail.
Topic 5 starts with a discussion on the dividend policy of a company and
different types of dividend payouts given by a company. An illustration of how
cash dividend payment is made and how repurchase of stocks affect companyÊs
balance sheet are discussed next. The impact of personal taxes, dividends and
stock repurchases on dividend policy are also explained in this topic.
Topic 6 explains the meaning of options and different types of options traded.
This topic also discusses how option is priced and explains the use of stocks and
bonds as options.
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Topic 7 examines warrants and convertibles bonds as another form of hybrid
security. It starts with identifying the difference between warrants and call
options and then illustrates how a warrant is priced. This topic also explains the
meaning of convertible bonds. The valuation of convertible bonds is also
demonstrated and then explanations are provided as to the reasons companies
issue warrants and convertible bonds.
Topic 8 looks at the meaning of leases and types of leases offered. This is
followed by an in depth discussion on the reasons for leasing. The subsequent
subtopic provides the calculation and evaluation decision related to either lease
or bought assets.
Topic 9 starts with the basic forms of acquisition and how synergy is derived
from the merger and acquisition exercise. It further elaborates on the dubious
reason for companies to acquire other companies. Next, a calculation of net
present value of a merger is illustrated. This topic closes with the nature of
takeovers and explains whether mergers enhance company values.
Topic 10 explains the terminology related to foreign exchange markets. It also
discusses how exchange rates between the two currencies are determined.
Exchange rate theories such as purchasing power parity theory, interest rate
parity theory, unbiased forward rate theory and the International Fisher effect
theory are also discussed in this topic.
TEXT ARRANGEMENT GUIDE
Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations
throughout the module. It may be inserted after one sub-section or a few subsections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
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COURSE GUIDE
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Activity: Like Self-Check, the Activity component is also placed at various
locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful
textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Before starting with this course, it is important that you have taken a course on
Financial Management.
ASSESSMENT METHOD
Please refer to myINSPIRE.
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COURSE GUIDE
REFERENCES
Ali, R., Ahmad, N., & Ho, S. F. (2012). Introduction to Malaysian derivatives
(4th ed.). Shah Alam, Malaysia: UiTM Press.
Damodaran, A. (2001). Corporate finance: Theory and practice (2nd ed.). New
York, NY: John Wiley & Sons.
Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2013). Multinational business
finance (13th ed.). Boston, MA: Pearson.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
Madura, J. (2000). International financial management (6th ed.). Cincinnati, OH:
South-Western.
Parrino, R., & Kidwell, M. (2011). Fundamentals of corporate finance (2nd ed.).
Hoboken, NJ: John Wiley & Sons.
Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2011). Core principles
and applications of corporate finance (3rd ed.). New York, NY: McGraw-Hill
Irwin.
Ross, S. A., Westerfield, R. W., Jaffe, J. F., Lim, J., & Tan, R. (2016). Fundamentals
of corporate finance (Asian Global Edition, 2nd ed.). New York, NY:
McGraw-Hill Irwin.
Shapiro, A. C. (2005). Foundations of multinational financial management (5th
ed.). Hoboken, NJ: John Wiley & Sons.
TAN SRI DR ABDULLAH SANUSI (TSDAS)
DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books247, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.
Copyright © Open University Malaysia (OUM)
Topic  Introduction to
1
Corporate
Finance
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Define corporate finance;
2.
Discuss the importance of cash flow;
3.
State the drawbacks of setting profit maximisation as a goal for a
company;
4.
Explain the issues of the agency problem and agency costs; and
5.
Explain the mechanism used to mitigate agency costs.
 INTRODUCTION
The moment we start flipping through the business section of the New Straits
Times or other newspapers, we may come across headline news such as these:
„Sarawak Oil Palms Bhd (SOP) to buy 47,000ha oil palm estate from Shin Yang
Holdings‰
(Ooi, 2016)
„MRT Corp awards three works packages for MRT Sungai Buloh-SerdangPutrajaya project‰
(Kaur, 2016)
„Malaysia Airports received shareholders approval for acquisition of
remaining 40% equity stake in Istanbul Sabiha Gokcen International Airport‰
(Malaysia Airports, 2014)
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TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
These headline news provide information about the respective companyÊs
decision making that has pertinent financial implications related to this subject,
that is, Corporate Finance.
For a start, in this topic, you will be exposed to the meaning of corporate finance;
the fundamental decisions made by corporate firms and explanations as to why
cash flows matter to a company. Then, we will discuss the goal that financial
managers need to set and explain how agency problems will lead to agency costs.
Last but not least, we will discuss measures taken by the company to mitigate
agency problems.
ACTIVITY 1.1
Go through the business section found in any newspaper and discuss
with your coursemates on any news or announcements that have
financial implications to the specific company.
1.1
CORPORATE FINANCE
Corporate finance is not specific to large companies but also to small companies.
Damodaran (2015) explained that „every decision that a business makes has
financial implications, and any decision which affects the finances of a business is
a corporate finance decision.‰
A better way of understanding corporate finance is to examine the balance sheet
components of a company (Ross, Westerfield, Jaffe & Jordan, 2011). A balance
sheet provides information on a companyÊs current assets, fixed assets, current
liabilities, long-term liabilities and shareholdersÊ equity at a specific period of
time (see Figure 1.1).
Current assets and fixed assets found in the balance sheet of a company relate to
the investment decision while current liabilities, long-term liabilities and
shareholdersÊ equity represent the financing decision that a company makes to
pay for its investments. Current assets and current liabilities components reflect
the companyÊs working capital management decision.
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TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
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Figure 1.1: Balance sheet components of a company
1.1.1
Financial Management Decisions
Every financial manager in either a small or a large company carry out three
important activities. These corporate finance activities are important to ensure
that the company is able to survive, compete and be sustainable in the industry.
Figure 1.2 displays the three activities involved: financing decisions, investment
decisions and working capital management decisions. A detailed discussion on
these decisions will follow.
Figure 1.2: Three important decisions made by financial manager
(a)
Financing Decisions
When we want to start a company or perhaps intend to further expand our
well-established business, the most pertinent question that we will need to
address is: where should we get the financing to support our investments?
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TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
As a financial manager, we have a choice to raise those funds either by
issuing shares (equity) or by issuing bonds (debt) or both. The proportion
between equity and debt financing that the company prefers to maintain is
known as a companyÊs capital structure.
Figure 1.3: Financing decision using equity or debt
Figure 1.3 illustrates the types of capital structures that a company may
choose. The financial manager has to weigh the advantages and
disadvantages of using either type of financing. This decision depends
mostly on the costs involved in sourcing the funds through equity or debt
financing as well as the amount needed to borrow. Financing your
investments with debt provides low costs but may put your company at
high risk of default and eventually lead towards financial distress. In short,
we want an optimal capital structure that minimises the costs and
maximises the companyÊs value. Topic 4 will provide an in-depth
discussion on this topic.
(b)
Investing Decisions
Once the financing decision has been identified, the next important
question that a financial manager needs to ask is: what long term
investments should the company consider? Investing or the capital
budgeting decision process requires you to evaluate if those projects under
consideration generate more positive cash flows relative to the cost of the
asset. In other words, when making capital budgeting decisions, you need
to analyse the size, timing and risk of the future cash flows expected from
those projects.
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TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
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For example when Malaysia Airports Holdings Berhad (MAHB) decided to
invest in KLIA2, its chief financial officer and his financial team had to
carefully analyse the expected benefits generated against the cost incurred
before embarking on this project. In corporate finance, generating positive
cash flows are pertinent as it affects the value of the company.
(c)
Working Capital Management Decisions
Financing and investing decisions are usually long term in nature. In the
short run, company must also ensure proper management of its day-to-day
operations of current assets and current liabilities. This is known as
working capital management. Working capital management decisions
involve determining the level of cash and inventory to be kept, whether
sales made are paid in cash or on credit, where excess cash is invested and
how short-term liabilities are being paid.
Poor working capital management decisions will result in the trade-off
between profitability and risk. For example, if your company has a high
level of current assets and assuming that current liabilities remain constant,
then your company may have lower profitability as most of its cash is tied
in the current assets instead of investing elsewhere that will generate higher
returns. In contrast, when your company has a high level of current assets,
your company has lower default risk on its short-term liabilities and is less
likely to be in financial distress.
ACTIVITY 1.2
Based on Activity 1.1, categorise the type of decision made by the
company and explain why.
SELF-CHECK 1.1
1.
What is corporate finance?
2.
Explain the important decisions that a financial manager needs to
make for the company.
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1.2
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
THE CORPORATE FIRM
How a business is formed affects its capability to raise funds, being taxed and the
liability condition of the owners. Generally a business can be formed as follows:
(a)
Sole Proprietorship
This is a business owned by an individual using his name or trade name.
It is the easiest and cheapest way of owning a business as no formal charter
is required. There is no legal separation between the owner and the
business and the owner pays only personal income tax.
The capability of the owner to raise funds is restricted to the ownerÊs
personal wealth. In case of bankruptcy, the owner has unlimited liability
and therefore all his assets (both personal and business-related) can be used
to settle the debt obligations. The life of the business ends when the owner
dies.
(b)
Partnership
The business is owned by two or more persons using a trade name. The
partnerships can be a general partnership or limited partnership:
(i)
Unlike general partnership, limited partnership allows limited
liability on some partners based on the amount of cash provided to
the business.
(ii)
For limited partnership, at least one partner is a general partner and is
allowed to participate in the running of the business.
(iii) The life of the general partnership ends when one partner dies or
withdraws, while partners in a limited partnership can sell their
interests in a business.
Similar to sole proprietorship form of business, it is less costly to establish.
Partnerships have a higher capability to raise funds relative to sole
proprietorship due to the number of persons involved in the business.
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TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
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Income of a partnership is reported as personal income tax and similar to
sole proprietorship, each partnerÊs personal and business assets can be used
to pay any outstanding debt obligation.
(c)
Corporation
As a business starts to grow rapidly, a sole proprietorship or partnership
may consider forming a corporation. Unlike these two forms of business, a
corporation is a separate entity that has the right to buy and sell assets.
Corporations can sue and be sued and liabilities of the corporation are not
the liabilities of the corporationÊs owners, that is, the shareholders. The
corporation is made up of a board of directors, top management and
shareholders. Corporations can raise funds by issuing shares or bonds.
Since a corporation is a separate legal entity, it has to pay corporate tax
instead of personal income tax. However, employees employed by the
corporation have to pay personal income tax on income earned. The
continuity of the corporation does not end when the owners die or
withdraw from the company.
ACTIVITY 1.3
When forming a business, you will be subjected to the rules and
regulations of different countries. Surf the Internet and discuss these
different rules and regulations that are being practised in Malaysia,
Dubai and Australia when forming a business.
1.3
THE IMPORTANCE OF CASH FLOWS
In corporate finance, creating cash flows is important as it enhances the firmÊs
value. Thus, it is essential for management to make operating, investment and
financing decisions that generate more cash from the assets then the cost. You
need to have clear understanding between cash flows and profits that is
indicated in the income statements. Profits as stated in the income statement do
not indicate actual money in hand, while cash flows do.
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1.3.1
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
Identification of Cash Flows
For example, let us assume that you are running a small bakery shop in Shah
Alam. The raw materials needed to run the business cost you RM2,000 and you
have paid for them in cash. At the same time, you have secured sales amounting
to RM10,000 and received RM1,000 in cash and the rest is sold on credit. Table 1.1
shows the profit realised from the accounting and cash flow perspective. Since
profit from the accounting perspective is based on accrual basis, you can see that
you are making a profit of RM8,000. However, from the cash flow basis, you are
actually incurring a loss of RM1,000.
Table 1.1: Profit from Accrual and Cash Flow Basis
Accrual Basis
Cash Flow Basis
Sales
10,000
1,000
Less: Cost of Goods Sold
(2,000)
(2,000)
Profit or Loss
8,000
1,000
As discussed earlier, cash flow basis indicates the actual cash inflow and cash
outflow activities of your business. In terms of the cash inflow activities,
although you have made sales worth RM 10,000, only RM1,000 is received in
actual cash while the remaining RM9,000 is yet to be paid by your customers.
Since you have made 100% cash payments to your suppliers for the raw
materials bought, the cash outflow amounting to RM2,000 is reported.
Thus, in corporate finance, financial managers are more concerned about creating
more cash flows as opposed to profits. Cash flows of a company are created from
its financing, investing and operation activities.
How are these cash flows generated? We will begin by looking at the financing
activities of the company:
(a)
Cash flows from financing activities start when a company issues shares or
debts to investors in the financial market in order to raise funds to operate
and expand its businesses.
(b)
These cash flows are then invested in the investment and operating
activities to generate higher returns which mean creating more cash flows.
(c)
Then, certain portion of cash flows received from the investment and
operating activities are then paid to debt holders or shareholders who have
invested in the company while the other portion is kept in the company as
retained earnings or paid as taxes.
Copyright © Open University Malaysia (OUM)
TOPIC 1
(d)
INTRODUCTION TO CORPORATE FINANCE

9
Value of the company is created when cash flows paid to investors
(shareholders and debt holders) are higher than the cash flows received
from those investors.
1.3.2
Timing of Cash Flows
When and how you receive cash flows are important considerations. We will use
Example 1 to explain the importance of timing associated with cash flows.
Example 1:
Let us assume that you have inherited RM10 million from your late uncle and
desire to start up a business. After consulting with several friends, you have
narrowed down to two projects, X and Y. The cash outflows and cash inflows are
presented in Table 1.2.
Table 1.2: Cash Outflows and Inflows of Projects X and Y
Project
Year
X
Y
Initial Outlay
î(20,000)
î(20,000)
Cash Inflows
1
0
8,000
2
0
8,000
3
0
8,000
4
0
8,000
5
60,000
8,000
RM60,000
RM40,000
Total
Initially, it seems that project X is preferred to project Y since it has higher cash
flows. However, if we are to consider the timing of cash flows associated with
both projects, project Y is preferred since its cash flows are received earlier than
those of project X. This brings us back to the concept of the time value of money
(TVM) which emphasises that a dollar that you received today is worth more
than a dollar received later. Hence the cash flows worth RM60,000 received in
year 5 for project X is worth less than the cash flows received from project Y.
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
1.3.3
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
Risk of Cash Flows
Apart from the timing of cash flows, financial managers must also consider risks
related to the cash flows received. Going back to Example 1, you might not
consider investing in project X since the expected cash flows received is only in
year 5. The question that you may want to ask is: how certain are you in getting
that RM60,000 in 5 yearsÊ time? Unlike project Y, the risk or uncertainty of
receiving the cash flows is lesser since your first cash flow worth RM8,000 is paid
in year 1. Besides, since project YÊs cash flows are received earlier, you can
reinvest those cash flows to get higher returns.
ACTIVITY 1.4
Based on the following table, explain which project is preferred based
on the timing and risk associated with the cash flows.
Cash Flow Stream
Year
M
N
O
1
0
1,000
5,000
2
0
2,000
3,000
3
10,000
7,000
2,000
Total
10,000
10,000
10,000
SELF-CHECK 1.2
1.
Discuss why financial managers are more interested in cash flows
rather than profits.
2.
Explain why the timing and risk associated with cash flows are
important factors to be considered in corporate finance.
Copyright © Open University Malaysia (OUM)
TOPIC 1
1.4
INTRODUCTION TO CORPORATE FINANCE

11
THE GOAL OF FINANCIAL MANAGEMENT
Can you list down the reasons for the formation of a company? Yes, there are
many reasons why a company is formed and you may by now have given at least
five reasons for its existence. Surprisingly, the most popular answer given would
be to make profit.
Do you think setting profit maximisation as a goal is appropriate for a company?
Gitman and Zutter (2015) stated that the ultimate goal of a company is to
maximise shareholdersÊ wealth. At this juncture you might wonder whether
there are differences between these two goals. Indeed there are differences and
we will now proceed to explain the difference between the two goals.
1.4.1
Profit Maximisation Goal versus Shareholders’
Wealth Maximisation Goal
When the companyÊs goal is to maximise profit, the focus is on the efficient
utilisation of capital resources and it ignores the elements of risk, size and timing
of the cash flow.
(a)
Risk Associated with Cash Flows
If you have taken the Financial Management course, you would recall that
there is a trade-off between risk and return. In a situation where you are
faced with two investments that have the same returns but different levels
of risk, naturally you will pick the investment with lower risk.
Unfortunately, profit maximisation goal does not consider risk related to
the cash flows. When a chief executive officer (CEO) is consistently being
pressured to make profit for the company, this could drive him to make
investment decisions without weighing the level of risk associated with the
cash flows.
On the other hand, shareholdersÊ wealth maximisation goal focuses on
maximising the companyÊs stock price. In achieving this goal, the CEO of a
company will incorporate risk in the investment evaluation and make sure
that the total value of cash inflows is above the total value of cash outflows
when making investment decisions (Parrino, Kidwell & Bates, 2011).
Engaging in investments that bring in less risky cash flows will lead to cash
flows being worth more and eventually increases the companyÊs stock
price.
Copyright © Open University Malaysia (OUM)
12

(b)
Size of the Cash Flows
Profit maximisation goal tends to focus on making as much profit as
possible for the company. You need to understand that profits of a
company are not the same thing as its cash flows. A company can make lots
of profits, yet face insufficient cash flows. In short, a company with high
profit does not necessarily have high cash flows. Why do you think this is
so?
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
Well, there are many ways that a company can generate profits. One way is
to cut or reduce its operating costs. Let us assume that the company has
decided to cut off its operating costs by downsizing its quality control
department that has contributed to 10% of its operating costs. Although the
company is able to reduce costs and increase profit in the short run, the
effect of downsizing has resulted in an increased number of customer
complaints and defect products. In the long run, the company loses out to
its competitors and share prices spiral down as investors anticipate the
companyÊs cash flows to decrease.
Since shareholdersÊ wealth maximisation goal aim is to increase the share
price of the company, increasing its cash flows become the main motive.
You must remember when you have cash you are able to invest to make
more cash. For a company to increase its cash flows, the financial manager
must accept projects or investments where the cash inflows exceed its cash
outflows. Remember larger cash flows increase the value of the share price
of the company.
(c)
Timing Associated with Cash Flows
A CEO of a company who is interested in making profits is usually not
concerned about when those profits are made. As discussed earlier in
subtopic 1.3, the concept of the time value of money (TVM) states that a
dollar that you received today is worth more than a dollar received later.
Thus, if the company is able to generate higher profits in later years, then
that profits are worth less than if it has been generated earlier due to factors
like inflation.
In contrast, if your goal is to maximise shareholdersÊ wealth then you are
concerned about the timing of cash flows that are expected to be received.
You would prefer that most of those cash flows are received in the earlier
periods since those cash flows can be used to reinvest and therefore
generate more returns.
Copyright © Open University Malaysia (OUM)
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE

13
Table 1.3 summarises the difference between profit maximisation goal and
shareholdersÊ wealth maximisation goal.
Table 1.3: Difference between Profit Maximisation Goal and ShareholdersÊ Wealth
Maximisation Goal
Elements
Profit Maximisation
ShareholdersÊ Wealth
Maximisation
Risk
Ignores risk related to the cash
flows involved. Riskier cash flows
are worth less.
Considers the risk associated with
cash flows.
Size of
cash flow
High profit does not lead to high
cash flows.
Value of the firm increases when
cash flows are larger.
Timing
Ignores timing of the cash flows
received as long as the company
makes profit.
Considers the timing of the cash
flows
received.
Cash
flows
received earlier are preferred than
later so that those cash flows can be
reinvested to earn more return.
SELF-CHECK 1.3
1.
Discuss why maximising shareholdersÊ wealth is an appropriate
goal for a company.
2.
What are the drawbacks of setting profit maximisation as a
companyÊs goal?
1.5
THE AGENCY PROBLEM AND CONTROL OF
THE CORPORATION
If you recall in subtopic 1.2, we did say that the owners of a corporation are the
shareholders who have invested their money in the company. These
shareholders hire top management to make decisions that benefit them (the
owners). In other words, there is a separation between the ownership and control
of the corporation.
Copyright © Open University Malaysia (OUM)
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
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
A company faces agency problems when the management puts self-interest
above the shareholdersÊ interest. As a consequence, the company will incur
agency costs in an attempt to mitigate agency problems. The costs are usually
borne by shareholders. Corporate governance are rules, regulations and
processes that are put in place to reduce the agency problems.
The following section discusses in depth the agency problem, agency costs and
corporate governance.
(a)
Agency Problem
You should realise that the management in control of the corporation acts
as an agent to shareholders who are principals. Agency problems exist
when sometimes the management is tempted to pursue goals that are in
conflict with the interests of the shareholdersÊ goal. The problem could
ultimately cause corporations to go out of business.
(b)
Agency Costs
In an attempt to prevent or reduce agency problems, shareholders have to
bear agency costs so that management and shareholder interests are
aligned. Examples of agency costs are costs incurred to monitor the
activities of top management, costs of management failure to make good
investment decisions and costs of issuing employee stock options. Agency
costs are said to be a loss to shareholdersÊ wealth and, therefore, affect the
value of the company.
Can you cite examples of large corporationsÊ failures due to agency
problems? Yes, the most famous large corporations involved are the
Lehman Brothers Holdings Incorporation, Enron Corporation and Barings
Bank which are good examples related to agency problems.
(c)
Corporate Governance
The downfall of large multinational corporations like Lehman Brothers and
Enron, as a result of agency problems, has made corporations put in place
good corporate governance practices. Corporate governance is basically the
rules, regulations and processes that regulate and control the corporationÊs
operation to mitigate agency problems.
In Malaysia, the Securities Commission (SC) has imposed the Malaysian
Code on Corporate Governance 2007 which was later revised to Malaysian
Code on Corporate Governance 2012 (MCCG 2012). MCCG 2012 provides
standards for those companies listed in Bursa Malaysia to apply in their
corporate governance process. For detailed information on MCCG 2012,
you can go to this website: http://www.sc.com.my/home/faqs/otherfrequently-asked-questions/
Copyright © Open University Malaysia (OUM)
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE

15
ACTIVITY 1.5
Surf the Internet and read the cases related to Enron Corporation and
Lehman Brothers Holdings. Discuss the agency problems and costs
related to the companies.
SELF-CHECK 1.4
1.
Explain the agency relationships between shareholders and
management.
2.
Discuss the reasons for agency problems to occur.
3.
What are the sources of agency costs and how does a company
reduce these costs?

Corporate finance involves making financing, investing and working capital
management decisions.

A business can be established as a sole proprietorship, a partnership and a
corporation.

Financial managers should focus on creating more cash flows instead of
profits.

The ultimate goal of the financial manager is to maximise shareholdersÊ
wealth rather than profit maximisation.

Agency problems exist when there is significant degree of separation between
owners and management.

Good corporate governance practices can mitigate agency problems and
costs.
Copyright © Open University Malaysia (OUM)
16

TOPIC 1
INTRODUCTION TO CORPORATE FINANCE
Agency conflicts
Partnership
Agency costs
Profits
Cash flows
Size of cash flows
Corporate finance
Sole proprietorship
Corporation
Timing of cash flows
Financing decision
Working capital management
decision
Investment decision
Damodaran, A. (2001). Corporate finance: Theory and practice (2nd ed.).
New York, NY: John Wiley & Sons.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
Kaur, S. (2016, July 4). MRT Corp awards three works packages for MRT Sungai
Buloh-Serdang-Putrajaya project. New Straits Times Online. Retrieved from
http://www.nst.com.my/news/2016/07/156694/mrt-corp-awards-threeworks-packages-mrt-sungai-buloh-serdang-putrajaya-project
Malaysia Airports. (2014, December 23). Malaysia Airports received shareholders
approval for acquisition of remaining 40% equity stake in Istanbul Sabiha
Gokcen International Airport. Retrieved from
http://www.malaysiaairports.com.my/?m=media_centre&c=news&id=452
Ooi, T. C. (2016, July 4). SOP to buy 47,000ha oil palm estate from Shin Yang
Holdings. New Straits Times Online. Retrieved from
http://www.nst.com.my/news/2016/07/156696/sop-buy-47000ha-oilpalm-estate-shin-yang-holdings
Parrino, R., Kidwell, D., Bates, T. (2011). Fundamental of corporate finance
(2nd ed.). Hoboken, NJ: John Wiley & Sons.
Copyright © Open University Malaysia (OUM)
TOPIC 1
INTRODUCTION TO CORPORATE FINANCE

17
Ross, S. A., Westerfield, R., Jaffe, J. F., & Jordan, B. D. (2011). Core principles and
applications of corporate finance (3rd ed.). New York, NY: McGraw-Hill
Irwin.
Commission Malaysia. (2007). Malaysian code on corporate
governance 2007. Retrieved from
http://www.ecgi.org/codes/documents/cg_code_malaysia_2007_en.pdf
Securities
Commission Malaysia. (2012). Malaysian code on corporate
governance 2012. Retrieved from
https://www.sc.com.my/wp-content/uploads/eng/html/cg/cg2012.pdf
Securities
Copyright © Open University Malaysia (OUM)
Topic  Advanced
2
Capital
Budgeting
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Discuss the fundamentals of the capital budgeting concept;
2.
Calculate the net present value (NPV), internal rate of return (IRR),
discounted payback period (PP) and profitability index (PI) of a
project;
3.
Explain the incremental cash flow; and
4.
Discuss inflation and capital budgeting.
 INTRODUCTION
Capital budgeting, also known as investment appraisal, deals with important
financial decisions. It is the process of evaluating and ranking potential
investments or expenses that are significant in amount and normally involve a
long-term investment. Decisions on investment that depend on time to maturity
will be based on the returns of the investment.
Copyright © Open University Malaysia (OUM)
TOPIC 2
ADVANCED CAPITAL BUDGETING

19
„TNB to invest more in renewable energy‰
(Bernama, 2014)
„Telekom Malaysia invests RM2.3bil for better high-speed broadband‰
(Aruna, 2015)
„UMW Holdings: Confirms MYR2b new Klang plant‰
(Yap, 2016)
The abovementioned headlines are examples of long-term investments made by
the companies after taking into consideration the cost of capital, return on the
investment and the risk involved. The company might have several investment
alternatives to consider as part of their investment. The selection of the best
investments that will increase the value of the firm is one of the factors in
selecting the best investment.
The companyÊs capital budgeting decision is important for future strategic
direction such as setting up new branches, introducing new products, upgrading
current production line and enhancing the new corporate image, etc. These
results must be preceded by capital budgeting (Brigham & Ehrhardt, 2014). Also,
it is important because capital budgeting decisions involve long-term
investments, hence, it reduces the companyÊs capital flexibility. Once the
company has invested large capital in the chosen project, it has to make sure that
the project generates expected returns.
Poor capital budgeting can lead to serious financial consequences. For example, if
the company invests too much in certain projects, it will incur unnecessarily high
depreciation and other expenses. However, if it does not invest enough, the fixed
assets might not be up-to date and modern enough to enable it to compete with
other companies. This can lead to losing market share to the rivals, losing
customers (which requires heavy selling expenses), price reductions or product
improvement, all of which, are costly.
Copyright © Open University Malaysia (OUM)
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
TOPIC 2
ADVANCED CAPITAL BUDGETING
ACTIVITY 2.1
Do you know what capital budgeting is? Discuss with your coursemates.
2.1
NET PRESENT VALUE (NPV)
The net present value (NPV) is the difference between the present value of the
inflows and the present value of the outflows. The NPV is a measure of how
much value is created or added today by undertaking an investment. As stated in
subtopic 1.4., the ultimate goal of a company is to maximise shareholdersÊ wealth
which means creating value for the shareholders. Therefore, in the capital
budgeting process, value creation exists when the investment has a positive NPV.
Let us say we have two projects to consider for an investment, project A and
project B. Project A has RM95,000 cash outlay and RM30,000 cash inflows for five
years. Project B has RM100,000 cash outlay and RM40,000 cash inflows for the
first two years and RM15000 for the last two years. Both projects have an
expected return (r) of 10%. Calculate the NPV for both projects. Based on the
calculation, which project should we choose?
Figures 2.1 and 2.2 show the timeline for Projects A and B respectively.
Figure 2.1: The timeline for Project A
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TOPIC 2
ADVANCED CAPITAL BUDGETING

21
Figure 2.2: The timeline for Project B
The formula for net present value (NPV) is:
n
NPV  

CFt
t 1 1  r
t
 CF0
Where,
CF = Cash inflow
n
= Number of period
r
= Rate of return
t
= Time period
In selecting the best investment, we need to apply the NPV rule.
NPV Rule:
An investment should be accepted if the NPV is positive and rejected if it is
negative.
If the NPV is greater than RM0, the firm will earn a return greater than its cost
of capital. This will increase the market value of the firm, hence, the wealth of
its owners will increase by an amount equal to NPV (Gitman & Zutter, 2015).
Copyright © Open University Malaysia (OUM)
22

TOPIC 2
ADVANCED CAPITAL BUDGETING
SELF-CHECK 2.1
Identify the importance of capital budgeting decisions.
2.1.1
NPV Problem Solving Using Formula
The NPV formula is actually the present value of all the future cash inflows
minus the cash outlay.
n
NPV  

CFt
t 1 1  r
t
 Cash outlay
Project A
 30,000
30,000
30,000
30, 000
30, 000 
  95, 000




NPV  
  1  0.11  1  0.12  1  0.13  1  0.1 4  1  0.15 


 18,724
Project B
 40, 000
40, 000
40, 000
15,000
15, 000 
  100, 000




NPV  
  1  0.11  1  0.12  1  0.13  1  0.1 4  1  0.15 


 19, 034
Project AÊs answer is 18,724 while Project BÊs is 19,034. Based on these two
answers, we will select the project that gives the highest NPV, which is Project B.
Any project that gives a positive NPV will actually increase the value of the firm.
Copyright © Open University Malaysia (OUM)
TOPIC 2
2.1.2
ADVANCED CAPITAL BUDGETING

23
NPV Problem Solving Using Financial Table
(Interest Factor Table)
Using the same example, through Projects A and BÊs cash inflows and cash
outlay, we calculate the NPV using the interest factor table. In this case, since we
need to find the present value of all the future cash inflows, we use the present
value annuity table for Project A and present value single factor for Project B
with 10% expected return (refer to Table 2.1).
Table 2.1: Calculation of NPVs for Project A and B
Cash Flow
Project A (RM)
10%
0
ă95000
PVIFA
1
30000
2
30000
3
30000
4
30000
5
30000
ă95000
3.7908
113724
r = 10%
NPV = RM18724
Cash Flow
Project B (RM)
10%
0
ă100000
PVIF
1
40000
0.9091
36364
2
40000
0.8264
33056
3
40000
0.7513
30052
4
15000
0.6830
10245
5
15000
0.6209
9314
ă100000
119031
r = 10%
NPV
Copyright © Open University Malaysia (OUM)
19031
24

TOPIC 2
ADVANCED CAPITAL BUDGETING
Decision: Since both Projects A and B give a positive NPV, both projects are
acceptable, because the NPV of each is greater than RM0. However, if both
projects were being ranked, Project B would be considered superior to A. NPV
for A and B are RM18,724 and RM19,033 respectively.
2.1.3
NPV Problem Solving Using Financial Calculator
The example (in Table 2.1) for Project A and B can be solved using a financial
calculator. In this example, we use the BA II Plus Texas Instruments calculator
(refer to Tables 2.2 and 2.3).
Table 2.2: Details of Project A
Input
Function
ă95000
CF0
30000
CO1
5
FO1
10
I
18724
NPV
Table 2.3: Details of Project B
Input
Function
ă100000
CF0
40000
CO1
3
FO1
15000
CO2
2
FO2
10
I
19033
NPV
Copyright © Open University Malaysia (OUM)
TOPIC 2
ADVANCED CAPITAL BUDGETING

25
If we use the calculator to solve the NPV problem for project A and B, we need to
use the cash flow (CF) button. Project AÊs cash inflows are an equal cash flow
except the cash outlay or the cost. Hence, the cash flows for project A is an
annuity. That is why the frequency of the cash flow, n or FO1 = 5. The calculated
NPV for project A is RM18,794 which is the same with the NPV that was
calculated before.
Project B has unequal cash flows where the first three years is RM40,000 while
the fourth and fifth years are RM15,000. This is called the mixed stream. The first
three cash inflows are the same which is 40,000, hence we input FO1 = 3 (which
means we input its frequency, n = 3). Also, the last two cash inflows are of the
same values, hence, we input FO2 = 2. The calculated NPV for project B is
RM19,033. The NPV using the financial calculator is not the same with values
using the PVIF table. This is due to the fact that PV tables use factors that are
rounded off to fewer decimal places. The NPV using the financial calculator is
more accurate than the PV table.
ACTIVITY 2.2
1.
Discuss the NPV decision criterion.
2.
How does the NPV create value to the shareholders?
SELF-CHECK 2.2
1.
What is net present value (NPV)? How is it calculated?
2.
What are the NPV accept-reject decisions?
3.
What are equal and unequal cash flows? Define these two types of
cash flows.
Copyright © Open University Malaysia (OUM)
26
TOPIC 2

2.2
ADVANCED CAPITAL BUDGETING
INTERNAL RATE OF RETURN (IRR)
Internal rate of return is the most widely used capital budgeting technique
(Gitman & Zutter, 2015). The IRR is the discount rate that equates the NPV of an
investment opportunity with RM0. This is because the present value of cash
inflows equals the initial investment at the internal rate of return. The IRR is the
discount rate that makes NPV = 0 (Brealey, Myers, & Allen, 2014).
The equation for calculating the IRR is:
n
RM0  

CFt
t 1 1  IRR
t
 CF0
IRR Rule:
An investment should be accepted if the IRR is greater than the cost of capital
and rejected if it is less.
If the NPV is greater than RM0, the firm will earn a return greater than its cost
of capital. This will increase the market value of the firm, hence, the wealth of
its owners will increase by an amount equal to NPV (Gitman & Zutter, 2015).
2.2.1
IRR Problem Solving Using Formula
Let us use the same example as in NPV, that is, Project AÊs and Project BÊs (see
Figures 2.1 and 2.2) cash inflows and outlays with 10% expected return.
Project A has equal cash flows, hence we can use the formula and interpolation to
find the IRR. The following is the IRR calculation for Project A.
Step 1
n
CF0  

CFt
t 1 1  IRR
t
 CF0
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TOPIC 2
ADVANCED CAPITAL BUDGETING

27


1
1
1
1
1
  95, 000
95,000  30, 000 




  1  IRR 1  1  IRR 2  1  IRR 3  1  IRR  4  1  IRR 5 



95, 000 
1
1
1
1
1






30, 000   1  IRR 1  1  IRR 2  1  IRR 3  1  IRR  4  1  IRR 5 




1
1
1
1
1





31, 667  
  1  IRR 1  1  IRR 2  1  IRR 3  1  IRR  4  1  IRR 5 


Step 2:
Use interpolation to find the IRR.
16%
3.2743
IRR
3.1667
18%
3.1272
IRR  16% 3.1677  3.2743

18%  16% 3.1272  3.2743
IRR  16% 0.1076

0.1471
2%
IRR  16%
 0.7315
2%
IRR   0.7315  2%   16%
IRR  0.17463 or 17.463%
The IRR for Project A is 17.463%. We need to compare IRR for Projects A and B,
and choose the project that gives the highest IRR.
For Project B, we could try finding the IRR by trial and error, that is, by
experimenting the different discount rates to find the one that satisfies the
definition of NPV = 0. It is easier to find IRR for project A than B, since Project A
has an equal cash flow. However, this can be very time consuming. Hence, we
suggest using the financial calculator in finding the IRR.
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2.2.2
TOPIC 2
ADVANCED CAPITAL BUDGETING
IRR Problem Solving Using Financial Table
(Interest Factor Table)
Project A has equal cash flows, hence, we can use the financial table and then use
interpolation to find the IRR. However, for project B it is quite tedious to use
interpolation and trial and error since it has uneven cash flows. Hence, it is
advisable to use financial calculator for uneven cash flows.
Here is the calculation for even cash flows.
Project A
Step 1
Cash flow (PVIFA IRR, 5)  Initial outlay
30,000 (PVIFA IRR, 5)  95, 000
(PVIFA IRR, 5) 
95, 000
30, 000
 3.1667
Find 3.1667 from the PVIFA table (n = 5 years); it falls between 16% and 18%.
Step 2
Do interpolation to get the exact rate.
16%
3.2743
IRR
3.1667
18%
3.1272
IRR  16% 3.1677  3.2743

18%  16% 3.1272  3.2743
IRR  16% 0.1076

2%
0.1471
IRR  16%
 0.7315
2%
IRR   0.7315  2%   16%
IRR  0.17463 or 17.463%
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ADVANCED CAPITAL BUDGETING
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29
The IRR for Project A is 17.463%. We need to compare IRR for Projects A and B
and choose the project that gives the highest IRR.
2.2.3
IRR Problem Solving Using Financial Calculator
The best way to find IRR is to use the financial calculator to solve for the IRR
problem for Project A and Project B (refer to Tables 2.4 and 2.5).
Table 2.4: Details of Project A
Input
Function
ă95000
CF0
30000
CO1
5
FO1
17.45
IRR
Table 2.5: Details of Project B
Input
Function
ă100000
CF0
40000
CO1
3
FO1
15000
CO2
2
FO2
18.66
IRR
We need to use the cash flow (CF) button as we did in finding the NPV.
Regardless whether the cash inflows are an equal cash flow or otherwise, it is
always easy to use the calculator in finding the IRR. If not, we have to use the
trial and error and interpolation methods in finding the IRR, which is quite
cumbersome if the project cash inflows are very numerous.
We enter the data as we did in the NPV calculation. Once we finish entering all
the cash inflows and outflows, we need to press IRR, and then press CPT to get
the answer.
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ADVANCED CAPITAL BUDGETING
The calculated IRR for Project A is 17.45% and B is 18.66, respectively. Both
projects have higher IRR than the cost of capital (or required rate of return) at
10%, hence, we can choose both projects if we have sufficient capital. However, if
we rank both IRRs, we should choose the project with the highest IRR, which is,
Project B.
ACTIVITY 2.3
1.
Discuss the IRR decision criterion.
2.
How does the IRR create value to the shareholders?
SELF-CHECK 2.3
What is internal rate of return? How is it calculated?
2.3
DISCOUNTED PAYBACK PERIOD (DPP)
Discounted payback period (DPP) uses the same concept like NPV and IRR.
Firstly, all the cash inflows have to be discounted to the current period, and
secondly, we calculate the payback period for the project. The concept of DPP is
very simple. Basically the main question we ask in DPP is, how many years it
takes to cover all the cash outlays. The number of years taken to cover the cost of
the investment is called the payback period, and it is called discounted payback
period (DPP) because we need to find the present value for each of the cash
inflow. In other words, it is the length of time for the project to reach NPV= 0.
Let us use the same example as we used before, that is Project A and Project B
(Figures 2.1 and 2.2).
The steps that we need to take in finding the DPP are as follows:
(a)
Find the present value for all the future cash inflows to the current year.
(b)
Then, accumulate each of the present value of future cash inflows until the
total accumulation is just enough to cover the cash outlays, which is known
as DPP.
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(c)
ADVANCED CAPITAL BUDGETING
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31
B
Apply the formula DPP  A   
C
Where,
(i)
A = Last period with a negative discounted cumulative cash flow;
(ii)
B = Absolute value of discounted cumulative cash flow at the end of
the period A; and
(iii) C = Discounted cash flow during the period after A.
DPP Rule:
An investment should be accepted if the DPP is less than some pre-specified
number of years.
Discounted payback period (DPP) rule requires the use of an arbitrary cut-off
period in summing the discounted cash flows.
The cash flow and DPP for Project A is shown in Table 2.6.
Table 2.6: Cash Flow and DPP for Project A
Cash Flow
Project A
(RM)
PVIF
10%
Discounted
Discounted
Cumulative
0
ă95000
1
ă95000
ă95000
1
30000
0.909
27273
ă67727
2
30000
0.826
24792
ă42935
3
30000
0.751
22539
ă20396
4
30000
0.683
20490
94
5
30000
0.621
18627
DPP
3.99 years
The discounted cumulative cash flow at t = 0 is just the initial cost of RMă95,000.
At year 1, the discounted cumulative is the previous discounted cumulative of
RMă95,000 plus the year 1 discounted cash flow of RM27,273: where, RM95,000 +
RM27,273 = RMă67,727.
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ADVANCED CAPITAL BUDGETING
Similarly, the year 2 discounted cumulative cash flow is the previous discounted
cumulative of RMă67,727 plus the year 2 discounted cash flow of RM24,792,
resulting in RMă42,935. Then, the discounted cumulative cash flow for year 3 is
the previous discounted cumulative cash flow of RMă67,727 plus the year 3
discounted cash flow of RM22,539, resulting in RMă20,396.
We can see that, by the end of year 4 the discounted cumulative cash flow has
more than recovered the initial outflow. Thus, the discounted payback period
occurs during the fourth year.
The exact calculation of discounted payback period for Project A is:
(a)
Last period with a negative discounted cumulative cash flow (A) = 3
(b)
Absolute value of discounted cumulative cash flow at the end of the period
(B) = 20,396
(c)
Discounted cash flow during the period after (C) = 20,490
(d)
 120, 396 
B
Discounted Payback Period = A     3  
  3.99 years
C
 20, 490 
Applying the same procedure for Project B, we find the discounted payback
period as shown in Table 2.7.
Table 2.7: Cash Flow and DPP for Project B
Year
Cash Inflows
0
ă100000
1
40000
2
PVIF
10%
1
Discounted
Discounted
Cumulative
ă100000
ă100000
0.9091
36364
ă63636
40000
0.8264
33056
ă30580
3
40000
0.7513
30052
ă528
4
40000
0.683
10245
9717
5
40000
0.6209
9313.5
DPP
3.05 years
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ADVANCED CAPITAL BUDGETING
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33
The exact calculation of discounted payback period for Project B is:
(a)
Last period with a negative discounted cumulative cash flow (A) = 3
(b)
Absolute value of discounted cumulative cash flow at the end of the period
(B) = 528
(c)
Discounted cash flow during the period after (C) = 10,245
(d)
B
 1528 
Discounted Payback Period = A     3  
  3.05 years
C
 10245 
Decision:
If the pre-specified number of years is 3 years, both projects are rejected.
If the pre-specified number of years is 4 years, both projects are accepted.
ACTIVITY 2.4
1.
Discuss the DPP decision criterion.
2.
How does the DPP create value to the shareholders?
SELF-CHECK 2.4
1.
What is discounted payback period (DPP)? How is it calculated?
2.
Discuss why DPP decision might not be the same as NPV and
IRR.
3.
Explain why DPP is not the best capital budgeting method even
though this method is the most widely used by companies.
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2.4
TOPIC 2
ADVANCED CAPITAL BUDGETING
PROFITABILITY INDEX (PI)
The last method in this topic of project evaluation is called the profitability index
(PI) or cost-benefit ratio. This PI is defined as the present value of the future cash
inflows divided by the initial cash outlay (Titman, Keown & Martin, 2014).
Profitability index (PI) =
 Present value of future cash flows 
 Initial cash outlay 
n
PI 
CF
 1 r t
t 1


CF0
PI Rule:
An investment should be accepted if the PI is higher than 1.0.
When PI is more than 1.0, it is the equivalent of having an NPV that is greater
than zero. For this reason, NPV and PI will always give the same conclusion
regarding the investment decision.
We are still using the same example, as in the NPV method, to calculate the PI.
Using the formula, the PIs for Project A and B are:
Project A
5
 30, 000
30, 000
30, 000
30, 000
t 1
  1  0.1
1  0.1
1  0.1
 1  0.1
 PV5  

1

2

3

4
30, 000 

 1  0.15 
5
 PV5  113,724
t 1
Hence, PI 
113,724
 1.1971
95, 000
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ADVANCED CAPITAL BUDGETING
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35
Project B
5
 40, 000
40, 000
40, 000
15, 000
t 1
  1  0.1
 1  0.1
 1  0.1
1  0.1
 PV5  

1

2

3

4
15, 000 

1  0.15 
5
 PV5  119, 034
t 1
Hence, PI 
119, 034
 1.1903
100, 000
Decision:
Since both Projects A and B have PIs of more than 1.0, we select both projects.
However, if we ranked the PI, from highest to the lowest, we should select
Project A.
ACTIVITY 2.5
Discuss the decision criterion to accept-reject an investment using PI.
SELF-CHECK 2.5
1.
Define PI.
2.
State the differences between PI and other capital budgeting
techniques, that is, NPV, IRR and discounted payback period.
2.5
INCREMENTAL CASH FLOWS
In subtopic 1.3, you have read the importance of the cash flows, inflows and
outflows. Cash flows of a company are created from its financing, investing and
operational activities. Financial managers are more concerned about creating
more cash flows as opposed to profits that are realised from the accounting
perspective. As noted in Topic 1, cash flows rather than accounting figures are
used because cash flows directly affect the firmÊs ability to pay bills and purchase
assets. In our previous examples in this topic, when we calculated the NPV, IRR,
DPP and PI, the after-tax cash flows were given. Estimating the cash flows is the
most important part of the capital budgeting process.
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The incremental cash flows represent the additional cash flows, outflows or
inflows that the company is expected to generate from a proposed new project. A
positive incremental cash flow means that the project will create more money
and should be accepted. A negative incremental cash flow indicates that the
project is probably a bad investment. The incremental cash flows can be
calculated by using the following formula:
Incremental Cash Flow = Cash flow with project ă Cash flow without project
Generally, there are two basic types of projects, expansion and replacement. In
either of these two, we are concerned with the incremental cash flows that will be
provided. For the expansion project, this calculation of incremental cash flow is
straightforward. For the replacement type project, the incremental cash flows are
those that occur as a result of the new project.
In both types of projects, we will have three categories of incremental cash flows:
(a)
The initial outlay or investment;
(b)
The annual after-tax operating cash flows (AATOCF); and
(c)
The terminal cash flows.
Now, let us explore further on the different types of incremental cash flows:
(a)
The Initial Outlay
For expansion projects, this will consist of the cash flows resulting from
acquiring the new asset and will consist of:
(i)
The purchase price of the new asset;
(ii)
Installation costs of the new asset, for example, transportation,
shipping and handling;
(iii) Increases in working capital requirements, for example, inventory
such as raw materials and finished goods;
(iv) After-tax non-capital expenditures, for example, costs to train
employees to operate assets; and
(v)
Investment tax credit (ITC) given by government due to the nature of
the company's business (this ITC could be given at any time during
the project's life).
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ADVANCED CAPITAL BUDGETING
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37
Note: The sum of the cash flows at (i) and (ii) above is equal to the recorded
value of the new asset in the company's books (that is, the value at which
the asset will be depreciated).
The initial outlay (IO) calculation can be done as follows:
IO = (Cost of proposed machine + Installation and shipping cost +
Training) ă (Proceeds sale of old machine ă Tax on sale of old
machine) + (Change in net working capital)
(b)
The Annual After-Tax Operating Cash Flows (AATOCF)
AATOCF must be measured incrementally. First, we need to calculate
the EBIT. Then, subtract corporate taxes from EBIT. Third, add back
depreciation. Depreciation had to be added back into the equation because
it is a non-cash expense but influences the cash flows through impact on
taxes.
AATOCF = EBIT ă Corporate taxes + Depreciation
or,
AATOCF = (Sales ă Expenses ă Depreciation) ă Corporate taxes +
Depreciation
Where,
EBIT = Sales ă Expenses ă Depreciation
Corporate tax rate = Tax rate  EBIT
(c)
Terminal Cash Flows
For both the expansion and replacement projects, this will comprise cash
flows that occur as a result of termination of the new project. These may
include:
(i)
The after-tax cash flows resulting from the sale of the new asset
(calculation is similar to above, see initial outlay);
(ii)
Recovery of working capital, that is, the working capital cash outflows
experienced in the initial outlay will be recovered; and
(iii) Any other after-tax clean-up costs.
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ADVANCED CAPITAL BUDGETING
Terminal Cash Flow =
(d)
(Proceeds from sale of new assets ă Tax on sale
of new assets) ă (Proceeds from sale of old
asset ă Tax on sale of old assets) + Change in
net working capital
Other Types of Cash Flows
The other types of cash flows are sunk costs, opportunity costs and
externalities:
(i)
Sunk Costs
These are cash outflows that have already occurred and, therefore, do
not affect the capital budgeting decision. Sunk costs cannot be
removed and should not be considered in investment decision, for
example, consulting fees (Ross, Westerfield, & Jordan, 2015).
(ii)
Opportunity Costs
In economics, this is referred to as benefits foregone. In other words,
opportunity costs are benefits that are not going to be achieved due to
a particular action or decision. These must be accounted for in the
capital budgeting decision as cash outflows, on an after-tax basis.
For example, in a replacement project analysis, we assume that the
existing asset will be sold and the new asset bought. However if that
„old‰ asset was kept in operation until the end of its useful life, the
company may have been able to receive some cash by selling it
afterwards. If such a salvage value existed, then the company would
not be able to fetch this amount if they went ahead and replaced the
old asset with the new one.
Therefore, the after-tax effects of this opportunity cost would have to
be incorporated in the analysis. Using this example of the asset's
foregone salvage value, the procedure for determining the after-tax
effect would be identical to that mentioned earlier (see initial outlay),
except that the result would be an after-tax cash outflow.
(iii) Externalities
In economics, this refers to the effects of a project on other parts of the
firm or company. If the increased revenues or the cost savings derived
by a new project result in decreased revenues for other existing
projects or products in a company, this effect must be factored into the
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ADVANCED CAPITAL BUDGETING
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39
capital budgeting process. To account for this, the decreased revenues
of the existing project or products must be applied to offset or reduce
the increased revenues of the new project (or be treated as increased
costs of the new project).
Alternatively, the increased revenues or the cost savings derived by
the new project could result increased revenues for other existing
projects or products in a company. In this case, the increased revenues
of the other existing projects or products would be treated as
additional increased revenues for the new project.
The following is an example of the incremental cash flow calculation (adapted
from Vernimmen, Quiry, Dallocchio, Le Fur & Salvi, 2009).
ArtGlobal is planning to replace a machine with a new, better-performing one.
The figures for the investment are as follows:
Purchases of New Machine
Cost RM2m
Useful life 5 years, residual value nil
Linear depreciation over 5 years
Savings on charges RM0.8m per year
Sale of Second Hand Machine
Purchase cost RM1.5m (machine bought the previous year)
Linear depreciation over 5 years (residual value is nil)
Net book value today RM1.2m
Potential sale price RM1.0m
If the tax rate on profits and capital gains or losses is 40%, what is the „value‰ for
the company of the new machine that the company is planning to buy (this
companyÊs required rate of return is 12%)? Calculate the net present value and
internal rate of return of the planned investment. The solution is as shown in
Table 2.8.
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TOPIC 2
ADVANCED CAPITAL BUDGETING
Table 2.8: Solution
Year
0
1
2
3
4
5
ăîPurchase of new machine
ă2
+ Sale of old machine
1
+ Cost savings after tax
0.8  60%
0.48
0.48
0.48
0.48
+ Tax savings on
incremental depreciation
and amortisation
0.1  40%
0.04
0.04
0.04
0.04
0.52
0.52
0.52
0.52
0.64
+ Tax credit on capital loss
ă0.2  40%
= Cash flows to be
discounted
ă0.92
NPV
1.0
IRR
50%
SELF-CHECK 2.6
Explain the three categories of incremental cash flows.
2.6
INFLATION AND CAPITAL BUDGETING
In economics, we know that inflation affects interest rates. Increase in inflation
will increase the interest rates and vice-versa. The interest rate is related to the
cost of borrowing or investment (also known as cost of capital), hence, affecting
the expected rate of return in capital budgeting. Since increase in interest rates
causes the expected rate of return to upwardly rise, inflation creates a downward
bias on present value of the cash flows.
Inflation affects two factors in capital budgeting, that is, discount rates and cash
flows. When we analyse the project, both factors should use either all nominal or
real (that is, inflation-adjusted) cash flows. However, consistency is important
(that is, real and nominal cannot be mixed).
Variable elements in calculating the cash flows are likely to change with the
changes in inflation. However, fixed charges such as depreciation remains
constant with inflation.
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ADVANCED CAPITAL BUDGETING
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41
Every investment needs capital. A company engages in borrowings when it is
necessary especially when the company wants to expand into new businesses or
buy new machines. Every borrowing has a cost called cost of capital. Due to the
limitation of the capital, a company can only select one investment at a time. This
type of selection is based on whether the project is mutually exclusive or nonmutually exclusive project.
Mutually versus Non-mutually (Independent) Exclusive Projects
Mutually exclusive projects refer to several sets of projects that the company has
to choose, out of which only one project can be selected at a time due to several
limitations, that is, capital or labour. For example, if the company has two
projects and both projects give positive NPV and IRR is greater than the expected
return, the company can only choose the project that gives the highest NPV and
IRR.
For the non-mutually (independent) exclusive projects, the decision of
investment is not limited to any resource, however, it depends on the value of the
NPV or IRR, either positive or negative. If the company has two potential
projects to choose, and each project gives positive NPV and IRR greater than the
expected rate of return, the company can choose both projects at the same time.
Example: Mutually versus Non-mutually Exclusive Projects
Let us say LovInvest Corporation has three projects to invest (refer to Table 2.9).
Cost of capital for all the projects is 10%. What would be the best decision if the
projects are (a) mutually exclusive or (b) independent?
Table 2.9: Investment Projects for LovInvest Corporation
Project X
Project Y
Project Z
Initial Investment
RM100,000
RM150,000
RM150,000
NPV
RM200,000
RM150,000
RM210,000
IRR
26%
16%
21%
Dependent (mutually exclusive) companies can only select one project at a time.
It cannot invest simultaneously in all the three projects. Hence, the company
should select the project that gives the higher NPV, which in this case is Project
Z. Even though Project A has the highest IRR, in the case of a mutually exclusive
project, a decision is made based on NPV is theoretically sounder.
An independent (non-mutually exclusive) company can invest in all these three
projects since all projects have positive NPVs and IRRs are higher than the cost of
capital (in this case is 10%).
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ADVANCED CAPITAL BUDGETING
SELF-CHECK 2.7
1.
Discuss the relationship between inflation and capital budgeting.
2.
What are the capital budgeting factors that can be affected by
inflation?
ACTIVITY 2.6
1.
You are the financial officer for Integrated Bhd. Your manager has
asked you to evaluate the two proposed capital investments;
Projects S and L. Each project has a cost of RM80,000, and the cost
of capital for each project is 12%. The projectÊs expected net cash
flows are as follows:
Table 2.10: Expected Net Cash Flows
Year
Project S
Project L
0
ăRM80,000
ăRM80,000
1
52,000
28,000
2
24,000
28,000
3
24,000
28,000
4
8,000
28,000
(a)
Calculate each projectÊs net present value, internal rate of
return, discounted payback period and profitability index.
(b)
Which project or projects should be accepted if they are
independent?
(c)
Which project should be accepted if they are mutually
exclusive?
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2.
ADVANCED CAPITAL BUDGETING

Your department is considering expanding the business in two
regions. Region AÊs cash outlay is RM85,500 and Region BÊs is
RM112,150. The cost of capital is 14%. After-tax cash flows,
including depreciation, are as follows:
Table 2.11: Expected Net Cash Flows Including Depreciation
3.
Year
Region A
Region B
0
ăRM85,500
ăRM112,150
1
25,500
37,500
2
25,500
37,500
3
25,500
37,500
4
25,500
37,500
5
25,500
37,500
(a)
Calculate each projectÊs net present value, internal rate of
return, discounted payback period and profitability index.
(b)
Indicate the correct accept or reject decision for each, if they
are independent.
(c)
Indicate the correct accept or reject decision for each, if they
are mutually exclusive.
In order to increase the production, Solar Premium Sdn Bhd
must decide whether to invest in a new solar technology. The two
possible technologies available to them are POWERSOLAR and
TURBOSOLAR. The after-tax cash flows for both technologies are
as follows:
Table 2.12: Expected Net Cash Flows Including Depreciation
Year
Powersolar
Turbosolar
0
îRM30,000,000
ăRM30,000,000
1
10,000,000
40,000,000
2
20,000,000
20,000,000
3
40,000,000
12,000,000
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ADVANCED CAPITAL BUDGETING
(a)
Calculate each projectÊs net present value, internal rate of
return, discounted payback period and profitability index if
the cost of capital is 10%, 5% and 15%.
(b)
Indicate the correct accept or reject decision for each, if they
are independent.
(c)
Indicate the correct accept or reject decision for each, if they
are mutually exclusive.

Capital budgeting techniques include net present value, internal rate of
return, discounted payback period and profitability index.

Net present value, internal rate of return, discounted payback period and
profitability index use present value techniques.

Net present value and internal rate of return techniques give the same
investment decisions.

Discounted payback period only uses an arbitrary cut-off period in summing
the discounted cash flows.

Profitability index only measures whether the discounted cash flow is greater
than cash outlay or otherwise.

Incremental cash flows are important cash flows as it helps the company to
make an investment decision.

Inflation is an important element in capital budgeting as inflation will
affect the cost of capital and the required rate of return, especially, if the
investments involve a long term investment due to uncertainty.
Copyright © Open University Malaysia (OUM)
TOPIC 2
ADVANCED CAPITAL BUDGETING
Capital budgeting
Initial outlay
Cash flows
Internal rate of return (IRR)
Cash outlay
Net present value (NPV)
Cost of capital
Profitability index (PI)
Discounted payback period (DPP)
Required rate of return
Equal cash flows
ShareholdersÊ wealth
Incremental cash flows
Unequal cash flows
Inflation
Value of the firm

45
Aruna, P. (2015, December 18). Telekom Malaysia invests RM2.3bil for better
high-speed broadband. The Star Online. Retrieved from
http://www.thestar.com.my/business/business-news/2015/12/18/tm-toinvest-rm23bil/
Bernama. (2014, December 18). TNB to invest more in renewable energy. The Star
Online. Retrieved from http://www.thestar.com.my/business/businessnews/2014/12/18/tnb-to-invest-more-in-renewable-energy/
Brealey, R. A., Myers, S. C., & Allen, F. (2014). Principles of corporate finance
(11th ed.). New York, NY: McGraw-Hill Irwin.
Brigham, E. F., & Ehrhardt, M. C. (2014). Financial management: Theory and
practice (14th ed.). Mason, OH: South-Western, Cengage Learning.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
Copyright © Open University Malaysia (OUM)
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
TOPIC 2
ADVANCED CAPITAL BUDGETING
Ross, S. A., Westerfield, R., & Jordan, B. D. (2015). Fundamentals of corporate
finance (11th ed.). New York, NY: McGraw-Hill.
Titman, S., Keown, A. J. & Martin, J. D. (2014). Financial management: Principles
and applications (12th ed.). Upper Saddle River, NJ: Pearson.
Yap, I. (2016, May 25). UMW Holdings: Confirms MYR2b new Klang plant. Bursa
Market Place. Retrieved from
http://www.bursamarketplace.com/index.php?ch=48&pg=186&ac=27414
&bb=research_article_pdf
Vernimmen, P., Quiry, P., Dallocchio, M., Le Fur, Y., & Salvi, A. (2009). Corporate
finance: Theory and practice (2nd ed.). New York, NY: Wiley.
Copyright © Open University Malaysia (OUM)
Topic  Efficient
3
Capital Market
and
Behavioural
Challenges
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Discuss the importance of capital market efficiency in corporate
finance;
2.
Describe the efficient market hypothesis theory;
3.
Discuss the types of efficient capital markets;
4.
Interpret the evidence of efficient market hypothesis; and
5.
Explain the behavioural challenges in efficient market hypothesis.
 INTRODUCTION
In this topic, we will discuss the importance of understanding efficient capital
markets in corporate finance. In Topic 2, we focused on creating values of the
firm through investment decisions. It discussed the left-hand side of the balance
sheet which is the firmÊs capital expenditure decision. Now we move to the right
hand side and to the problems that are involved in financing the capital
expenditures. To start the discussion of financing decisions, this topic explains
the theory used as the base in financing decisions of the firms, which is, the
efficient market hypothesis theory.
Copyright © Open University Malaysia (OUM)
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
3.1
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
CAN FINANCING DECISION CREATE
VALUE?
The main objective of managerial decision making is to maximise wealth of
shareholders through maximising the value of the firms. Managers can increase
the value of the firm by using valuable financing opportunities in three ways:
(a)
Deceive the Investors
A firm can issue complex and sophisticated financing instruments to
receive more than the actual market value. Investors without strong
knowledge in securities valuation will buy the securities at a price higher
than the fair value of the securities.
(b)
Reduce Costs or Increase Subsidies
A firm can package securities to reduce taxes. Such a security will increase
the value of the firm. In addition, financing techniques involve many costs,
such as accountants, lawyers and investment bankers. Companies will try
to package securities in a way to reduce these costs and at the same time
increase the value of the firm.
(c)
Create a New Security
A previously unsatisfied investor may be willing to pay an extra price for a
specialised security that fits his needs. Corporations gain from developing
unique securities by issuing these securities at premium prices.
In the short run, the three methods mentioned can increase the value of the firms
because the strategies can reduce financing cost and create good perception
about the financing strategies. However, in the long run, the effect of value
creation is relatively small because investors have the information and react
accordingly to the information arriving in the markets. The reactions of market
participants towards the information available in the market are discussed in the
efficient market hypothesis theory.
ACTIVITY 3.1
Discuss the types of financing decisions involved in your workplace.
Copyright © Open University Malaysia (OUM)
TOPIC 3
3.2
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

49
A DESCRIPTION OF EFFICIENT CAPITAL
MARKETS
An efficient capital market is a market in which all current securitiesÊ prices
adjust rapidly to the arrival of new information about the securities including
risk. We can define an informationally efficient capital market as a market where
the prices of securities reflect all information about the security (Reilly & Brown,
2003).
Figures 3.1 and 3.2 show how efficient and inefficient markets react to the good
and bad news. The solid-line shows the efficient marketÊs reaction towards news
while the dot-line and dash-line represent the inefficient marketÊs reaction
towards information. From the figures, we can see that the price in efficient
markets absorbs, adjusts and reacts accordingly and correctly to the information
that arrives. On the other hand, inefficient markets might have delayed
overreaction responses as information arrives. The inefficient market needs time
to adjust the price correctly to the information that arrives and this provides
opportunity for the market participants to make abnormal profit.
Figure 3.1: Reaction of stock price to new good information in
efficient and inefficient markets
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TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
Figure 3.2: Reaction of stock price to new bad information in efficient
and inefficient markets
3.2.1
Assumption of Efficient Capital Market
According to Reilly and Brown (2003), the efficient capital market is based on the
following assumptions:
(a)
There must be large and enough number of participants with profit
maximising goals in the market. In addition, the market participants should
analyse and value the securities independently of each other.
(b)
The new information that arrives to the market is in random fashion. The
news announcement is independent of each other with regards to timing.
The new information should also need to be disseminated effectively to all
market participants.
(c)
Investors adjust their prediction of security prices rapidly to reflect their
interpretation of the new information received. Market efficiency does not
assume that the market participants correctly adjust prices accordingly to
price. Market efficiency needs investors to adjust their price without bias
such that some investors will overreact and some will underreact.
(d)
Expected return that is set by all market participants should implicitly
include risk in the price of the security.
Copyright © Open University Malaysia (OUM)
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

51
Under these four assumptions, the competitive behaviour of this large group of
market participants should cause rapid price adjustments in response to any new
released information to the market. The new price will reflect the investorÊs new
prediction of the investmentÊs value and riskiness. Should these assumptions not
hold, for example, in most emerging markets around the world, investors may
generate excess returns from the capital markets (Reilly & Brown, 2003).
SELF-CHECK 3.1
1.
In your own words, explain what efficient capital market is.
2.
Explain the four assumptions of efficient capital market.
3.3
THE DIFFRENT TYPES OF INFORMATION
AND EFFICIENT MARKET HYPOTHESIS
Before we start a discussion on types the efficient market hypothesis, it is
important for us to understand the type of information set in the market.
Basically types of information available in the market can be divided into three
main categories, which are:
(a)
Information Set of Past Historical Data
This type of information is related to the historical data and past reports
regarding the securities such as historical sequence of price, rate of returns,
trading volume data and transactions by specialist. Most of the data under
this category is used by technical analysts in analysing the stock price.
(b)
Information Set of Publicly Available Source
Information in this category includes the information set of past historical
data and all non-market public information such as earnings and dividend
announcements, price-to-earnings ratios, dividend yield ratios, price to
book value ratios, stock splits, news about the economy and politics,
company's financial statements (annual reports, income statements, filings
for the Security and Exchange Commission), announced merger plans, the
financial situation of company's competitors and expectations regarding
macroeconomic factors (such as inflation, unemployment). The data must
be available publicly to the markets.
Copyright © Open University Malaysia (OUM)
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
(c)
Information Set of Private and Publicly Available Sources
Information in this category includes the information set of past historical
data, public available source and all private or internal information related
to the securities, which is, not published yet to the market. Examples of
private or non-published internal information are internal investment
reports, internal minutes of meetings, strategic investment strategies
presented in the board of directorÊs meetings and unpublished annual
reports.
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
Reilly and Brown (2003), Brealey and Myers (2003) and Berk and DeMarzo (2011)
mentioned that the efficient market hypothesis (EMH) classifies market forms
into three categories which are:
(a)
Weak-form Efficient Markets
The weak-form of the EMH assumes that current stock prices fully reflect
all currently available security market information. The weak-form assumes
that the current price of a security already reflects all the currently available
(historical) market information. Thus, past price and volume information
will have no relationship with the future direction of security prices, that is,
nobody can detect mispriced securities and "beat" the market by analysing
past prices. In conclusion, in a weak-form efficient market, an investor
cannot achieve excess returns by using technical analysis.
(b)
Semi-strong-form Efficient Markets
The semi-strong-form of the EMH holds that security prices instantly adjust
to the arrival of all new public information. As such, current security prices
fully reflect all publicly available information. The semi-strong-form says
security prices include all security market and non-market public
information available to the public. The conclusion is that an investor
cannot achieve excess returns using fundamental analysis in a semi-strongform efficient market.
(c)
Strong-form Efficient Markets
The strong-form of the EMH states that stock prices fully reflect all
information from public and private sources. The strong-form includes all
types of information: market, nonmarket public and private (inside)
information. This means that no one has monopolistic access to information
relevant to the formation of prices. The conclusion is that no group of
investors should be able to consistently achieve excess returns.
Copyright © Open University Malaysia (OUM)
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

53
In other words, the strong-form of EMH states that a company's
management (insiders) are not be able to systematically gain from inside
information by buying company's shares 10 minutes after they decided (but
did not publicly announce) to pursue what they perceive to be a very
profitable acquisition. Similarly, the members of the company's research
department are not able to profit from the information about the new
revolutionary discovery they completed half an hour ago. The strong-form
assumes perfect markets in which all information is cost free and available
to everyone at the same time.
ACTIVITY 3.2
In Table 3.1, you are required to tick () in the box that shows the
correct type of information that can generate profit in three different
form of efficient markets.
Table 3.1: Ability to Generate Profit in Different Efficient Capital Market
Ability to Generate Abnormal Profit
Market Forms
Past Historical
Data
Public Available
Source
Private Available
Sources
Weak-form
Efficient
Markets
Semi-strongform Efficient
Markets
Strong-form
Efficient
Markets
SELF-CHECK 3.2
1.
Differentiate types of information available in the market.
2.
Discuss the three forms of efficient market hypothesis.
Copyright © Open University Malaysia (OUM)
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
3.4
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
THE EVIDENCE OF EFFICIENT MARKET
HYPOTHESIS (EMH)
The study of existing efficient market hypothesis (EMH) in capital markets has
been a major area in finance literature. Most of the previous researches in this
area have tried to investigate whether there is an evidence of EMH in capital
markets. The evidence of EMH can be divided into three forms which are:
(a)
Weak-form tests of the EMH;
(b)
Semi-strong-form test of the EMH; and
(c)
Strong-form test of the EMH.
3.4.1
Weak-Form Tests of the EMH
The weak-form EMH assumes that current stock prices fully absorb all past
security market information such as historical price and volume. There are two
types of tests of the weak-form of the EMH which are:
(a)
Statistical Tests of Independence
As mentioned before, the EMH states that the security returns over time
should be independent of one another because all new information that
arrives is already absorbed by the current price (Schweser, 2004). To verify
this, previous studies used two major tests which are:
(i)
Autocorrelation Test
According to Reilly and Brown (2003), this test measures the
significant positive or negative correlation in return over time. To
conduct this test, we investigate the correlation between current
return of securities with the previous return. For example, we try to
find the correlation between todayÊs return with yesterdayÊs return.
Significant correlation between current return and previous return
means that the market is not in a weak-form EMH and investors can
make abnormal profit by trading using past market information. If the
result shows that there is insignificant correlation, it proves that the
market is a weak-form EMH and investors are unable to generate
abnormal profit by using past information as a base for their
investment decision.
Copyright © Open University Malaysia (OUM)
TOPIC 3
(ii)
(b)
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

55
Run Test
Run test is conducted based on series of price changes data. To
conduct this test, we need to calculate the price changes. If the price is
increased, we put it as „+‰ (positive sign). On the other hand, if the
price is decreased, we put it as „ă„ (negative sign). A run occurs in the
series of data when two consecutive changes are the same. For
example ++ or ă is considered as 1 run. If the price changes are
different, for example + followed by ă, the run is considered end and a
new run may begin. To test for independence, you would compare the
number of runs for a given series to the number in a table of expected
values for the number of runs that should occur in a random series. If
the number of runs is within the range expected for random series, the
market is considered in the weak-form EMH (Reilly & Brown, 2003).
Trading Rule Test
Reilly and Brown (2003) said that the test of trading rule is used because
some researchers found that the methods used in the statistical test of
independence were too rigid to examine the price pattern used by technical
analysts. Technical analysts are a group of analysts who believe that the
future market movement can be predicted by using historical market data.
In order to run the trading rule test, we simulate the alternated technical
trading rule based on the hypothesis that market participants are unable to
make any abnormal profit above a buy-and-hold policy using any trading
rule that depended solely on past information. The study compares the
result from trading rule simulation including all the transaction costs with
the results from a simple buy-and-hold strategy.
If the return from simulation of trading rules outperform the return from
buy-and-hold policy, it shows evidence that the market is not following the
weak-form EMH. On the other hand, if the return from simulation of
trading rules underperform the return from buy-and-hold strategy, it can
be concluded that the market supports the weak-form EMH.
SELF-CHECK 3.3
1.
Explain two set of studies used in testing weak-form EMH.
2.
In your own words, discuss how to conduct an autocorrelation
test and run test.
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
3.4.2
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
Semi-strong-form Test of EMH
The semi-strong-form of EMH states that current stock prices fully absorb all past
security market information and public information. There are two types of
studies that analyse the semi-strong EMH which are:
(a)
Return Prediction Study
The return prediction study tries to predict the time series of future rate of
return for individual stocks by using public information. For instance, it is
possible to predict abnormal rates of return for a stock by using public
information such as dividend yield, price earnings ratio and growth rate
ratio. Insignificant relationship between public information with stock
return provides evidence that the markets follow semi-strong-form of
EMH.
(b)
Event Study
Event studies examine the abnormal return for a period immediately after
an announcement of event such as dividend announcement, stock splits,
exchange listing, political news as well as economic events and mergers.
Based on the semi-strong EMH, the event studies would expect returns to
adjust quickly and accordingly to the announcement of new information.
Therefore, market participants cannot generate abnormal return by acting
after the announcement.
Both types of study on the evidence of semi-strong-form EMH discussed
previously used abnormal returns to measure the adjusted securities rates of
return for the rate of return of the overall market during the period considered.
There are two types of calculation for abnormal return which are (Schweser,
2004):
(a)
Unadjusted Abnormal Return
In this method, we calculate abnormal return simply by subtracting the
market return from the return of individual securities. The calculation of
unadjusted abnormal returns is:
Arit  rit  rmt
Where:
Arit = Abnormal rate of return on security i at time t
rit
= Rate of return rate of return on security i at time t
rmt
= Rate of return rate of return on market at time t
Copyright © Open University Malaysia (OUM)
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

57
Example:
The current return for ABC shares is at 8% and current market returns is at
6%. Calculate the unadjusted abnormal return for ABC shares.
Solution:
Arit  rit  rmt
 8%  6%
 2%
(b)
Adjusted Abnormal Return
In this method, we calculate abnormal returns by subtracting the expected
rate of return from the return of individual securities. The calculation of
unadjusted abnormal returns is:
Arit  rit  Erit
Where:
Arit = Abnormal rate of return on security i at time t
rit
= Rate of return on security i at time t
Erit = Expected rate of return on security i at time t
Example:
The current return for ABC shares is at 8% and the expected rate of return
for ABC shares is at 5%. Calculate the adjusted abnormal return for ABC
shares.
Solution:
Arit  rit  rmt
 8%  5%
 3%
The element of risk and volatility are considered in the calculation of
adjusted abnormal return. This method uses assumption under capital asset
pricing model (CAPM) where the theory states that the reaction of each
individual stock is based on the volatility of the stock (beta) and might be
different from market return.
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
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
The formula for CAPM is as follows:
Erit  rfrt   i  rmt  rfrt 
Where:
Erit = Expected rate of return on security i at time t
rfrt
= Risk free rate at time t
i
= Beta on security i
rmt
= Market return at time t
Therefore, the formula for adjusted abnormal return can be written as
follows:
Arit  rit  rfrt  i  rmt  rfrt  
Where:
Arit = Abnormal rate of return on security i at time t
rit
= Rate of return on security i at time t
i
= Beta on security i
rmt
= Market return at time t
rfrt
= Risk free rate at time t
Example:
The current return for ABC shares is at 8%. Based on the market reports, the
current market returns and returns from risk free instrument are at 6% and
4% respectively. Calculate the adjusted abnormal return if beta for ABC
shares is at 0.50.
Solution:
Arit  rit  rfrt  i  rmt  rfrt  
 8%   4%  0.5%  6%  4%  
 5%
Copyright © Open University Malaysia (OUM)
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

59
ACTIVITY 3.3
Calculate the adjusted abnormal return and unadjusted abnormal
return for Company Harrd based on the following information.
3.4.3
Rate of return HarrdÊs share
13%
Market return
8%
Risk free rate of return
4.5%
Beta on HarrdÊs shares
1.3
Strong-form Test of EMH
The strong-form EMH implies that current price of securities fully reflects all
information available in the market. The hypothesis states that there is no group
of investors who can consistently experience above average profits if they trade
using past, public and private information. Previous studies have analysed the
rate of returns over time for different identifiable investment groups to
determine whether any group consistently received above average return.
Most of these studies have analysed the following four major groups of investors
who have access to private information in order to test the strong-form of EMH
(Reilly & Brown, 2003):
(a)
Corporate Insider Trading
A corporate insider can be anybody who is a member, director or senior
officer of a company, as well as any person or entity that beneficially owns
more than 10% of a company's voting shares.
(b)
Stock Exchange Specialist
A specialist is a representative or member of a stock exchange who acts as
the market maker and intermediaries to assist the trading of a given stock.
The stock exchange specialist posts the bid and asks prices, holds an
inventory of the stock, executes trades and manages limit orders.
(c)
Security Analyst
The security analyst is a full time market expert who analyses the market
and may have information that the rest of market does not have.
Copyright © Open University Malaysia (OUM)
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
(d)
Professional Money Manager
A professional money manager is a business or bank or company
responsible for managing the securities portfolio of an individual or
institutional investor. Typically, a money manager company employs
people with various expertise ranging from research and selection of
investment opportunities to monitoring the assets and deciding when to
make investment decision.
3.5
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
THE BEHAVIOURAL CHALLENGE TO
MARKET EFFICIENCY
Up to this level, we have discussed the efficient market hypothesis theory which
explains how capital markets function in responding to the information. In more
recent times, researchers have started to analyse why some market conditions
deviate from the common rule of efficient market hypothesis.
Brealey and Myers (2003) explain that one of the explanations for this scenario is
the behaviour of participant of capital markets. The study on behavioural finance
is concerned with the analysis of various psychological traits of individuals and
how these traits affect how they act as market participants. The behaviour of
markets participants cause the information to be volatile.
Some of the areas in behavioural finance that have been discussed in previous
literature are attitude towards risk, beliefs about probabilities and rationality of
investors.
(a)
Attitude towards Risk
Brealey and Myers (2003) explain that psychologists have observed the
behaviour of investors in making risky investment decisions. They found
that people always think about loss when dealing with risky investment
decisions even though the loss is actually very small compared to the
return. The investor becomes more averse to risk if they have suffered loss
in the previous transaction dealing with capital markets. The attitude
towards risk can cause the investor to try to avoid this unpleasant
possibility by staying away from those actions that may result in loss.
(b)
Beliefs about Probabilities
Most market participants do not possess good knowledge in probability
theory. Most of them make wrong investments decisions because they
assume what happened in the past can be repeated in the future. They lack
knowledge in analysing the probability of uncertain possible future
outcomes. This causes the market participant to try to project recent
Copyright © Open University Malaysia (OUM)
TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES

61
experiences into the future outcomes and to forget the lessons learned from
the past. For example, investors who do not consider probability might
assume that the glamorous growth of the company is very likely to
continue even though very high rates of growth cannot persist indefinitely
(Brealey & Myers, 2003).
(c)
Rationality of Investors
Do investors in the market act rationally when dealing with uncertainty
investment decisions? This question has been debated in the literature on
behavioural finance. Most of the previous findings show that investors are
not always rational in making investment decisions. They tend to act
irrationally or emotionally when faced with difficult and sophisticated
investment decisions.
SELF-CHECK 3.4
1.
Discuss the four types of market participants that have access to
private information.
2.
What is behavioural finance?

Under efficient capital markets, financing decisions can only create value in
the short run.

An efficient capital market is a market in which all current securitiesÊ prices
are adjusted rapidly to the arrival of new information available about the
securities including risk.

There are three forms of EMH which are weak-form, semi-strong-form and
strong-form.

The studies on weak-form of EMH can be divided into two types: statistical
test of independence and trading rule tests.

Return prediction study and event study are type of studies use in analysing
semi-strong-form EMH.

Strong-form EMH has been tested by analysing whether groups of investors
that have access to the private information can continuously generate
abnormal profit by using the private information.
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

TOPIC 3
EFFICIENT CAPITAL MARKET AND BEHAVIOURAL CHALLENGES
The deviation of markets from EMH could be due to the behavioural of
market participants in capital markets.
Abnormal return
Publicly available sources
Autocorrelation test
Return prediction study
Behavioural finance
Run test
Capital asset pricing model (CAPM)
Security analyst
Corporate insider trading
Semi-strong-form efficient markets
Efficient market hypothesis (EMH)
Stock exchange specialist
Event study
Strong-form efficient markets
Past historical data
Trading rule test
Private information
Weak-form efficient market
Professional money manager
Berk, J., & DeMarzo, P. (2011). Corporate finance (2nd ed.). Boston, MA: Pearson.
Brealey, R. A., & Myers, S. C. (2003). Principles of corporate finance (7th ed.).
Boston, MA: McGraw-Hill.
Reilly, F. K., & Brown, K. C. (2003). Investment analysis and portfolio
management (7th ed.). Mason, OH: Thomson South-Western.
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2010). Fundamentals of corporate
finance (9th ed.). Boston, MA: McGraw-Hill.
Schweser, C. (2004). Schweser notes for the CFA Exam Level 1. Book 4: Corporate
finance, portfolio management, and equity investments. New York, NY:
Kaplan.
Adjusted Abnormal ReturnWhere:
The element of risk and volatility are considered in the calculation of adjusted abnormal return. This method uses assumption under Where:
Where:
Copyright © Open University Malaysia (OUM)
Calculate the adjusted abnormal return and unadjusted abnormal return for Company Harrd based on the following information.
Rate of return HarrdÊs share
13%
Market return
8%
Risk free rate of return
4.5%
Beta on HarrdÊs shares
1.3
Topic  Capital
4
Structure
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
State the effect of financial leverage to the value of firm;
2.
Discuss the concept of M&M Proposition;
3.
Describe the impact of homemade borrowing;
4.
Explain the interest tax shield;
5.
Interpret the effect of tax on capital structure; and
6.
Discuss the pecking order theory.
 INTRODUCTION
The decision of capital structure is very important in corporate finance. In this
topic, we will discuss all the theories and concepts used in making decisions on
the capital structure of the firm.
4.1
MAXIMISING FIRM VALUE VERSUS
MAXIMISING SHAREHOLDERS INTEREST
The main objective of a managerial decision is to maximise the wealth of its
shareholders by maximising the value of the firm. In corporate finance, the
decision on capital structure has significant impact on the firmÊs value.
According to Ross, Westerfield and Jordan (2010) the change in the value of the
firm is the same as the net effect on the stockholders. Financial managers,
therefore, try to find the capital structure that maximises the value of the firm.
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The following example can show how the decision on capital structure can affect
the value of the firm.
BALANCE SHEET OF ABC COMPANY (in RM)
Asset
Fixed Asset
Debt and Equity
10,000
Equity (1,000 units at price
RM10)
Debt
Value of firm
10,000
Value of firm
10,000
0
10,000
The balance sheet shows that the firmÊs value of ABC Company is at RM10,000.
The formula for the firmÊs value is:
Value of Firm = Total Assets = Total Debt + Total Equity
Currently, the capital structure of the firm consists of 100% equity. Therefore, the
value of ABC Company is:
Value of Firm = Total Assets = Total Debt + Total Equity
= RM10,000 = 0 + RM10,000
The management of ABC Company decides to issue bonds worth RM5,000. Let
us say, the company has two alternatives in deciding the new capital structure of
the firms:
(a)
Alternative 1: 60% Equity and 40% Debt
BALANCE SHEET OF ABC COMPANY (in RM)
Asset
Debt and Equity
Fixed Asset
10,000
Equity (750 units at price
RM10)
7,500
Cash
2,500
Debt
5000
Value of firm
12,500
Value of firm
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The above balance sheet shows the firmÊs value of ABC Company if the
company decides to use 60% equity and 40% debt as the capital structure.
The company uses RM2,500 from the proceeds of issuing bonds to buy back
their 250 unit of equity at price RM10 and keep the remaining RM2,500 as
cash in the company. Therefore, the total equity of ABC Company is
reduced from RM10,000 to RM7,500 (750 unit of equity at the price of
RM10). By using 60% equity and 40% debt as their capital structure, ABC
Company can increase the value of the firm from RM10,000 to RM12,500.
(b)
Alternative 2: 50% Equity and 50% Debt
BALANCE SHEET OF ABC COMPANY (in RM)
Asset
Fixed Asset
Value of firm
Debt and Equity
10,000
10,000
Equity (500 units at price
RM10)
5,000
Debt
5000
Value of firm
10,000
The above balance sheet shows the firmÊs value of ABC Company if the
company decides to use 50% equity and 50% debt as the capital structure.
The company then uses RM5,000 from the proceeds of issuing bonds to buy
back their 500 unit of equity at price. Therefore, the total equity of ABC
Company is reduced from RM10,000 to RM5,000 (500 unit of equity at price
RM10). There is no change in the value of the firm if ABC Company uses
50% equity and 50% debt as their capital structure. We can see from the
balance sheet that value of the ABC Company is maintained at RM10,000.
This example shows that the small changes in the capital structure can
affect the value of the firm. Therefore, it is very crucial for the management
to decide on the best capital structure that can maximise the value of the
firm.
ACTIVITY 4.1
Discuss how capital structure can affect the value of the firm.
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4.2
TOPIC 4
CAPITAL STRUCTURE
THE EFFECT OF FINANCIAL LEVERAGE
As mentioned in the previous subtopic, the capital structure that can produce the
highest firm value or has the lowest weighted average cost of capital (WACC) is
the best to the stockholders. In this subtopic, we examine the impact of financial
leverage on the payoffs to stockholders. Financial leverage refers to the extent to
which a firm relies on debt. The more debt financing a firm uses in their capital
structure, the more financial leverage it employs.
To explain the effect of financial leverage to the payoff of stockholders we use
earnings per share (EPS) and return on equity (ROE) as the measurement tools.
For ease of discussion, we also ignore the impact of taxes on the calculation of
EPS and ROE.
To begin the discussion on the effect of financial leverage to the payoff of
stockholders, we assume the company is currently using 100% of equity. Let us
use the following example in our discussion (refer to Table 4.1).
Table 4.1: Current Capital Structure of Scavilo Company
Capital Structure
Total
Assets
RM8 million
Debt
0
Equity
RM8 million
Debt to equity ratio
Share price
Number of share
Interest rate
0
RM20
400,000 unit
10%
Table 4.1 shows the current capital structure of Scavilo Company. Currently, the
company uses 100% of equity. The company has 400,000 units of share at market
price RM20. Total value of equity for Scavilo Company is at RM8 million. The
company has no debt in their capital structure. Therefore, the debt to equity ratio
for Scavilo Company is 0.
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CAPITAL STRUCTURE
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The management of Scavilo Company is considering changing the capital
structure of the firm from 100% equity to 50% equity and 50% debt. To exercise
the new proposed capital structure, the company plans to borrow RM4 million at
an interest rate of 10% and uses the proceeds from the borrowing to buy back
200,000 units of shares at price RM20. The following Table 4.2 presents the new
capital structure of Scavilo Company.
Table 4.2: New Capital Structure of Scavilo Company
Capital Structure
Total
Assets
RM8 million
Debt
RM4 million
Equity
RM4 million
Debt to equity ratio
Share price
1
RM20
Number of share
Interest rate
200,000 unit
10%
Interest expenses
RM400,000
Table 4.2 shows that the total asset is maintained at RM8 million. Total equity is
reduced to RM4 million (200,000 unit of share at price RM20) in Table 4.2
compared to RM8 million of equity (400,000 units of share at price RM20) in
Table 4.1. As mentioned before, Scavilo Company issues debt worth RM4 million
and uses the proceeds to buy back 200,000 unit of shares at price RM20. The new
debt to equity ratio is increased to 1 and the company needs to pay interest
expenses worth RM400,000 for using debt value at RM4 million.
To analyse the impact of financial leverage on the ROE and EPS of Scavilo
Company, we need to estimate the earnings before interest and tax (EBIT) for the
company. Let us say we predict that there will be three market outcomes for the
company. If the economy is in worst market condition, the company predicts to
produce EBIT worth RM500,000. If market is in normal condition the company
projects to produce RM1 million of EBIT. In addition, the company also predicts
that the company can generate RM1.5 million in the best market condition. Now
we can analyse the effect of financial leverage to the payoffs to stockholders in
three different market conditions.
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Table 4.3: Worst Market Condition of Scavilo Company
Current Capital Structure
(No Debt)
New Capital Structure
(With Debt)
Total debt
0
RM4 million
Total equity
RM8 million
RM4 million
Number of share
400,000 unit
200,000 unit
EBIT
RM400,000
RM400,000
Interest
0
RM400,000
RM400,000
RM0
5%
0%
RM1.00
RM0.00
Details
Net income (NI)
ROE (NI/Total equity)
EPS (NI/Number of share)
Table 4.3 shows the value of ROE and EPS for Scavilo Company for the current
capital structure and new proposed capital structure in the worst market
condition. It is clearly shown in the table that if the company generates only
RM500,000 of EBIT, the ROE and EPS of the firm is higher if the company uses
100% equity as their capital structure.
Why are ROE and EPS for the no-debt capital structure higher compared to ROE
and EPS for capital structure with debt? The reason is that capital structure with
debt needs to service interest expenses on the debt. As we can see from the table
the net income of capital structure with debt is lessened by the amount of interest
(RM400,000) compared to net income of no-debt capital structure.
Table 4.4: Normal Market Condition: Scavilo Company
Current Capital Structure
(No Debt)
New Capital Structure
(With Debt)
Total debt
0
RM4 million
Total equity
RM8 million
RM4 million
Number of share
400,000 unit
200,000 unit
EBIT
RM800,000
RM800,000
Interest
0
RM400,000
RM800,000
RM400,000
ROE (NI/Equity)
10.00%
10.00%
EPS (NI/Number of share)
RM2.00
RM2.00
Details
Net income
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Table 4.4 shows the value of ROE and EPS for Scavilo Company for its current
capital structure and the new proposed capital structure in normal market
condition. Under normal market conditions, the table shows that there is no
difference for the value of ROE and EPS if the company uses 100% equity or
mixed of 50% equity and 50% debt as their capital structure.
Even though the net income of capital structure with-debt is lesser than net
income of no-debt capital structure by amount of interest expenses worth
RM400,000, the ROE and EPS is not affected because the amount of equity and
number of share is also reduced by a significant amount. Therefore, we can
conclude that in normal market conditions, there is no significant difference in
Scavilo Company stockholdersÊ payoff measured by ROE and EPS.
Table 4.5: Best Market Condition: Scavilo Company
Current Capital Structure
(No Debt)
New Capital Structure
(With Debt)
Total debt
0
RM4 million
Total equity
RM8 million
RM4 million
Number of share
400,000 unit
200,000 unit
EBIT
RM1,200,000
RM1,200,000
Interest
0
RM400,000
RM1,200,000
RM800,000
15%
20%
RM3.00
RM4.00
Details
Net income
ROE (NI/Equity)
EPS (NI/Number of share)
Table 4.5 shows the value of ROE and EPS of Scavilo Company for current capital
structure and new proposed capital structure in the best market conditions.
Under the best market conditions, the table shows that the ROE and EPS for new
capital structure is higher compared to current capital structure. Even though the
net income of new capital structure is less than the net income of the current
capital structure, the ROE and EPS of the new capital structure is higher because
of the benefit of financial leverage.
There is a question of the best capital structure that the company should use
referring to the example of Scavilo Company, in three different market
conditions. To answer this question, the management of the company needs to
analyse the break even EBIT of the firm.
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4.2.1
CAPITAL STRUCTURE
Analysing the Break-even EBIT
Break-even EBIT is a situation where the company records an equal EPS value
even though the company uses different types of capital structure. To calculate
the break-even EBIT, we must recall back the basic formula for EPS without tax:
EPS 
EBIT  Interest
Number of Share
Now we assume the company has two types of capital structure, namely, capital
structure without debt and capital structure with debt. Therefore, the formula of
break-even EBIT can be written as follows:
EPS Capital Structure without Debt = EPS Capital Structure with Debt
To illustrate the calculation of break-even EBIT, we refer back to the example of
Scavilo Company (refer to Table 4.6).
Table 4.6: Scavilo Company Capital Structure
Capital Structure without
Debt
Capital Structure with
Debt
Total debt
0
RM4 million
Total equity
RM8 million
RM4 million
Number of share
400,000 unit
200,000 unit
EBIT
RM500,000
RM500,000
Interest
0
RM400,000
Details
EPS
(NI/Number of share)
EPS 

EBIT  Interest
Number of Share
EBIT  0
400, 000
EPS 

EBIT  Interest
Number of Share
EBIT  400, 000
200, 000
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Break-even EBIT =
EPS Capital Structure without Debt = EPS Capital Structure with Debt
 EBIT  0   EBIT  400, 000 
400, 000

200, 000
EBIT  2   EBIT  400, 000 
 RM800,000
The previous calculation for Scavilo Company shows that the break-even EBIT is
at RM800,000. This means that if the expected EBIT of Scavilo Company is less
than the break-even EBIT which is RM800,000, the company should use capital
structure without debt because it can generate higher EPS.
If the expected EBIT is higher than RM800,000, Scavilo Company should use
capital structure with debt because it can generate higher EPS for the firm.
Table 4.7 can help you to understand the analysis.
Table 4.7: Analysing the Break-even EBIT on EPS for Scavilo Company
Earnings before
Interest and Tax
(EBIT)
RM0
EPS Current Capital Structure
Without Debt
(100% Equity)
No. of Share = 400,000 Unit
Interest = RM0
EPS 
EBIT  Interest
Number of Share
EPS 

RM0.00  RM0.00
400, 000 unit

 RM0.00
RM400,000
EPS New Capital Structure
With Debt
(50% Equity, 50% Debt)
No. of Share = 200,000 Unit
Interest = RM400,000
EPS 

EBIT  Interest
Number of Share
RM400,000  RM0.00
400, 000 unit
 RM1.00
EBIT  Interest
Number of Share
RM0.00  RM400, 000
200, 000 unit
 RM2.00
EPS 

EBIT  Interest
Number of Share
RM400,000  RM400, 000
200, 000 unit
 RM0.00
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RM800,00
(Break-even EBIT)
CAPITAL STRUCTURE
EPS 

EBIT  Interest
Number of Share
RM800,000  RM0.00
400, 000 unit
EPS 

EBIT  Interest
Number of Share
RM1,200,000  RM0.00
400, 000 unit
 RM3.00

EBIT  Interest
Number of Share
RM800,000  RM400, 000
200, 000 unit
 RM2.00
 RM2.00
RM1,200,00
EPS 
EPS 

EBIT  Interest
Number of Share
RM1,200,000  RM400, 000
200, 000 unit
 RM4.00
Table 4.7 shows the amount of earnings per share of different capital structures
for Scavilo Company. We can see that if Scavilo Company uses a capital structure
without debt, they can generate EPS worth at RM0.00, RM1.00, RM2.00 and
RM3.00 for EBIT amount at RM0, RM400,000, RM800,00 and RM1,200,000
respectively. The table also indicates that if Scavilo Company uses capital
structure with debt, they can generate EPS worth at RMî2.00, RM0.00, RM2.00
and RM4.00 for EBIT amount at RM0, RM400,000, RM800,00 and RM1,200,000
respectively.
The information presented in Table 4.7 can be illustrated in a graph as shown in
Figure 4.1 where we plot the EPS against the EBIT for both types of capital
structure. The horizontal axis in the graph represents EBIT while the vertical axis
represents the EPS. The solid line represents capital structure with debt. On the
other hand, the dotted line represents capital structure without debt. The breakeven point is when the solid line intersects with the dotted line (EPS = RM2.00
and EBIT = RM800,000). The graph shows that if the expected EBIT of Scavilo
Company is less than break-even EBIT which is RM800,000, the company should
use capital structure without debt because it can generate higher EPS. If the
expected EBIT is higher than RM800,000, Scavilo Company should use capital
structure with debt because it can generate higher EPS for the firm.
Figure 4.1 also presents evidence of the effect of financial leverage to the
sensitivity of EPS towards the changes in EBIT. We can see that the slope of the
solid line representing capital structure with debt is steeper compared to the
slope of dotted line representing capital structure without debt. It means that EPS
of capital structure with debt is more sensitive towards changes of EBITS
compared to the sensitivity of EPS of capital structure without debt. The steeper
slope of the line representing capital structure with debt shows that the risk of
firms using financial leverage is higher compared to if the firm uses 100% of
equity.
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Figure 4.1: Financial leverage: EPS and EBIT
Up to this point, we have discussed the effect of financial leverage on the value of
the firm and payoff of shareholders. Ross et al. (2010) conclude that:
(a)
The effect of financial leverage depends on the company's earnings before
interest and tax. Financial leverage has more positive impact if the earnings
before interest and tax (EBIT) of the firm is high.
(b)
Financial leverage can increase the return on equity (ROE) and earnings per
share (EPS) for shareholders.
(c)
The changes of return on equity and earnings per share becomes more
sensitive to the changes of earnings before interest and tax (EBIT) if the
company uses financial leverage.
(d)
Capital structure is an important consideration in corporate finance because
of the impact that financial leverage has on both the expected return to
stockholders and the riskiness of the stock.
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CAPITAL STRUCTURE
Based on our discussion on Scavilo Company, all three of the conclusions are
clearly correct. However, Ross et al. (2010) argue on the conclusion point (d)
where capital structure is an important consideration in corporate finance
because of the impact that financial leverage has on both the expected return to
stockholders and the riskiness of the stock. They maintain that the decision on
capital structure has no significant impact to the expected returns of the
stockholder because of the use of homemade leverage.
ACTIVITY 4.2
Calculate the break-even EBIT for Fresh Care Company.
Fresh Care Company Capital Structure
4.2.2
Capital Structure
Without Debt
Capital Structure
With Debt
Total Debt
0
RM4 million
Total Equity
RM8 million
RM4 million
Number of share
400,000 unit
200,000 unit
EBIT
RM500,000
RM500,000
Interest
0
RM400,000
Corporate Borrowing and Homemade Leverage
Ross et al. (2010) define homemade leverage as the use of personal borrowing
to change the overall amount of financial leverage to which an individual is
exposed. Homemade leverage has no effect on financial leverage through
corporate borrowings to the expected return of shareholders.
To illustrate how homemade leverage removes the effect of financial leverage to
the return of stockholders, we will use the same example on Scavilo Company.
We assume Mr Khairul is a current shareholder who buys 200 unit of Scavilo
Company at current market price, which is, RM20. The total investment of
Mr Khairul in Scavilo Company is RM4,000 and he uses his own cash to invest in
the company. The following discussion is based on the capital structure of the
Scavilo Company as discussed in the previous subtopic.
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(a)
CAPITAL STRUCTURE
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75
Scavilo Company issues debt and uses the proceeds to buy back shares
(refer to Table 4.2)
Table 4.2 showed that Scavilo Company issues debt worth RM4,000,000 and
uses the proceeds to buy 50% of existing shares. By issuing the debt, Scavilo
Company changes their capital structure to 50% of equity and 50% of debt.
The debt equity ratio for Scavilo Company also changes from 0 to 1. In this
case, we can say that Scavilo Company uses corporate borrowing. Table 4.9
shows the effect of share repurchase to the KhairulÊs investment in Scavilo
Company.
Table 4.9: KhairulÊs Investment on Scavilo Company
Details
Total
Number of share
100 unit
Price of share
RM20.00
Value of investment
RM2,000
Investment using own cash
RM2,000
Loan amount
0
Debt to equity (Khairul)
0
Debt to equity (Company)
1
Interest rate
10%
Interest expenses
0
Table 4.9 shows that the number of shares held by Mr Khairul decreased to
100 units from the original number of 200 units. The value of investment
also decreased from RM4,000 to RM2,000. Now, let us analyse the amount
of return received by Mr Khairul after the company uses financial leverage
in their capital structure.
Table 4.10: KhairulÊs Investment on Scavilo Company
Details
Worst Market
Normal Market
Best Market
Number of share
100 unit
100 unit
100 unit
EPS
RM0.00
RM2.00
RM4.00
Total earnings
RM0.00
RM200
RM400
Interest expenses
RM0.00
RM0.00
RM0.00
Net earnings
RM0.00
RM200
RM400
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The amount of EPS stated in Table 4.10 is calculated based on information
reported in Table 4.3, Table 4.4 and Table 4.5. We can see when Scavilo
Company uses financial leverage, the total net earnings for Mr Khairul is
RM0, RM200 and RM400 for worst market condition, normal market
condition and best market condition respectively. There is no interest
expense for Mr Khairul because he does not have any debt in buying the
shares from Scavilo Company.
(b)
Scavilo Company uses 100% equity as the capital structure of the firm (refer
to Table 4.1)
Table 4.1 showed that Scavilo Company uses 100% equity as their capital
structure. Let us assume, when the company uses 100% equity, Mr Khairul
will use homemade leverage based on the proposed debt to equity ratio for
the company in Table 4.2, which is, 1. If Mr Khairul decides to use
homemade leverage as stated in Table 4.2, he needs to borrow 50% of his
investment value so that the source of his investment is 50% own cash
(equity) and 50% debt. Table 4.11 shows the effect homemade leverage to
Mr KhairulÊs investment position in Scavilo Company.
Table 4.11: KhairulÊs Investment on Scavilo Company (Homemade Leverage)
Details
Total
Number of Share
200 unit
Price of Share
RM20.00
Value of Investment
RM4,000
Investment using own cash
RM2,000
Loan Amount
RM2,000
Debt to Equity (Khairul)
1
Debt to Equity (Company)
0
Interest rate
10%
Interest Expenses
RM200
Table 4.11 shows that the number of shares held by Mr Khairul is
maintained at 200 units at price RM20. The value of investment is also
maintained at RM4,000. However, after using homemade leverage,
Mr KhairulÊs loan increases from RM0 to RM2,000. Mr KhairulÊs debt to
equity ratio also increased from 0 to 1. By using debt to finance his
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investment in Scavilo Company, Mr Khairul needs to pay interest expenses
worth RM200. Now let us analyse the total amount of return received by
Mr Khairul if he decides to use homemade leverage.
Table 4.12: KhairulÊs Investment on Scovila Company (Homemade Leverage)
Details
Worst market
Normal Market
Best Market
Number of Share
200 units
200 units
200 units
EPS
RM1.00
RM2.00
RM3.00
Total Earnings
RM200
RM400
RM600
Interest expenses
RM200
RM200
RM200
Net Earnings
RM0.00
RM200
RM400
The amount of EPS stated in Table 4.12 is calculated based on information
reported in Table 4.3, Table 4.4 and Table 4.5. We can see when Mr Khairul
uses homemade leverage, the total net earnings for Mr Khairul is RM0,
RM200 and RM400 for worst market condition, normal market condition
and best market condition respectively.
The example from Mr KhairulÊs investment in Scavilo Company supports
the argument that decisions on capital structures have no impact on total
return received by shareholders (Ross et al., 2010).
SELF-CHECK 4.1
1.
What is the effect of financial leverage on the firmÊs value and to
the return on equity?
2.
Is there any change on earnings per share if the company uses
financial leverage? Why?
3.
What is break-even EBIT?
4.
Should the company use financial leverage if the EBIT is higher
than break-even EBIT? Explain.
5.
Should the company use financial leverage if the EBIT is less than
break-even EBIT? Explain.
6.
What is homemade leverage?
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4.3
TOPIC 4
CAPITAL STRUCTURE
CAPITAL STRUCTURE AND THE COST OF
EQUITY CAPITAL (M&M PROPOSITION
WITHOUT TAX)
Up to this point, the discussion has shown that there is nothing special about
corporate borrowing or financial leverage because investors can borrow or lend
on their own or use homemade leverage. The examples discussed in following
subtopics are based on the Modigliani and Miller (M&M) Proposition I by Franco
Modigliani and Merton Miller.
4.3.1
M&M Proposition I: The Pie Model
M&M Proposition I states that the value of the firm is independent of the firmÊs
capital structure (Ross et al., 2010). Figure 4.2 shows the M&M Proposition I: The
Pie Model.
Figure 4.2: Value of Firm under M&M Proposition I: The Pie Model
Figure 4.2 shows the two different capital structures of Company A. Let us
assume the value of Company A is RM100. Under M&M Proposition I, the value
of company A is not affected by changes in the capital structure of the firm. The
value of the firm is maintained at RM100 even though Company A changes its
capital structure from 30% equity, 70% debt to 70% equity, 30% debt.
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4.3.2
CAPITAL STRUCTURE
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79
M&M Proposition II: The Cost of Equity and
Financial Leverage
In M&M Proposition I, it is clearly stated that the changes of capital structure has
no impact on the value of the firms and cost of capital. However, we must
remember that the change of capital structure has an impact on the cost of equity
of the firms. The formula for WACC by ignoring tax is:
E 
D 
  RE     RD
V
 
V 
RA  
V E D
Where:
E
= Total equity
D
= Total debt
V
= Total value of the firm
R A = Return on asset or WACC
R E = Return on equity
R D = Return on debt
Now, let us rearrange the formula for WACC to find the return on equity:
D 

E 
R E  R A   R A  RD   
Where:
E
= Total equity
D
= Total debt
R A = Return on asset or WACC
R E = Return on equity
R D = Return on debt
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Example:
The Scavilo Company has a WACC (ignoring tax) of 15%. The company cost of
debt is 10%.
(a)
Calculate the return on equity of Scavilo Company if the capital structure of
the company consists of 30% debt and 70% equity.
Solution:
D 

E 
RE  R A   R A  RD   
 0.3 
 0.15   0.15  0.10   

 0.7 
 17.14%
(b)
Calculate the return on equity for Scavilo Company if the company uses
50% of equity and 50% of debt.
Solution:
D 

E 
R E  R A   R A  RD   
 0.5 
 0.15   0.15  0.10   

 0.5 
 20%
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(c)
CAPITAL STRUCTURE
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81
Calculate the WACC of the company if the capital structure of the company
consists of 30% debt and 70% equity.
E 
D 
  R E     RD
V
 
V 
RA  
 0.7 
 0.3 

  0.1714  
  0.10
 1 
 1 
 15%
(d)
Calculate the WACC of the company if the capital structure of the company
consists of 50% of debt and 50% of equity.
E 
D 
  R E     RD
V 
V 
RA  
 0.5 
 0.5 

  0.20  
  0.10
 1 
 1 
 15%
Table 4.13: Summary of Cost of Capital for Scavilo Company
Details
Capital Structure
70% Equity + 30% Debt
50% Equity + 50% Debt
Debt-to-equity ratio
0.43
1
RE
17.14%
20%
RD
10%
10%
R A or WACC
15%
15%
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The following Figure 4.3 illustrates the cost of capital under M&M Proposition II
with no taxes:
Figure 4.3: The cost of capital under M&M Proposition II with no taxes
Table 4.13 and Figure 4.3 show evidence to support the M&M Proposition II
where it states that the changes in capital structure do not affect the cost of
capital (WACC). In addition, it also shows that the firmÊs cost of equity capital is
a positive linear function of the firmÊs capital structure. The M&M Proposition II
states that the return on equity (RD) is dependent on:
(a)
Return on asset or cost of capital (RA = WACC);
(b)
Return on debt (RD); and
(c)
Debt-to-equity ratio.
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CAPITAL STRUCTURE
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83
Figure 4.3 shows that the return on asset (RA) or weighted average cost of capital
(WACC) and return on debt (RD) are not affected by changes in debt to equity
ratio. The figure also illustrates that return on equity (RE) is a positive linear
function of debt to equity ratio. Ross et al. (2010) explain that as the firm raises its
debt-equity ratio, the increase in leverage raises the risk of the equity and
therefore the required return or cost of equity.
ACTIVITY 4.3
The Skilfull Scavilo Company has a WACC (ignoring tax) of 17.5%. The
company cost of debt is 9%.
(a)
Calculate the return on equity if the capital structure of the
company consists of 40% debt and 60% equity.
(b)
Calculate the return on equity for Scavilo Company if the
company uses 50% equity and 50% debt.
(c)
Calculate the WACC of the company if the capital structure of the
company consists of 40% debt and 60% equity.
(d)
Calculate the WACC of the company if the capital structure of the
company consists of 50% debt and 50% equity.
SELF-CHECK 4.2
1.
Explain the M&M Proposition I (Without Tax).
2.
Interpret the Pie Model.
3.
Describe the M&M Proposition II (Without Tax)
4.
Discuss the relationship between return on equity with debt to
equity ratio.
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4.4
TOPIC 4
CAPITAL STRUCTURE
M&M PROPOSITION I AND II WITH
CORPORATE TAX
Up to this point, our discussion has excluded the effect of tax on the capital
structure of the firm. The interest paid on debt is tax deductible. This is the
advantage of having debt in the capital structure since interest expenses can
reduce the amount of tax payment. Table 4.14 shows how interest can reduce the
amount of tax payment.
Table 4.14: Financial Information on Scavilo Company
Details
Without Debt
With Debt
Total assets
RM8,000,000
RM8,000,000
Total equity
RM8,000,000
RM4,000,000
Total debt
RM0
RM4,000,000
Market price of equity
RM20
RM20
400,000 unit
200,000 unit
Interest rate
10%
10%
Tax rate
30%
30%
Interest expenses
RM0
RM400,000
RM2,000,000
RM2,000,000
Interest expenses
RM0
RM400,000
Earning before tax
RM2,000,000
RM1,600,000
Tax payment
RM600,000
RM480,000
Net income after tax
RM1,400,000
RM1,120,000
Earnings per share
RM3.50
RM5.60
Return on equity
17.50%
28%
Number of equity
Earnings before interest and tax
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CAPITAL STRUCTURE
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Table 4.14 shows the benefit of having debt in the capital structure of the firm. If
Scavilo Company chooses to have no debt in its capital structure, the company
needs to pay high amount of tax worth RM600,000. High payment of tax is
caused by the higher net income of the company at RM1,400,000. As a result, the
EPS and ROE of the firm is just at RM3.50 and 17.50% respectively. If Scavilo
Company chooses to have debt in its capital structure, the amount of interest
expenses can reduce the amount of earning before tax and this leads to the
reduction in amount of tax payment. Even though the net income after tax for
capital structure with debt is lower compared to without debt, the EPS and ROE
for capital structure with debt is higher which is at RM5.60 and 28% respectively.
4.4.1
The Interest Tax Shield
Interest tax shield is the amount of tax savings attained by a company from the
interest expenses. To simplify the explanation on interest tax saving, first we
need to assume a few things:
(a)
The depreciation expenses of the company is zero;
(b)
There is no new capital spending; and
(c)
There are no changes on net working capital.
Table 4.15: Financial Information on Scavilo Company
Details
Without Debt
With Debt
Interest rate
10%
10%
Tax rate
30%
30%
Interest expenses
RM0
RM400,000
RM2,000,000
RM2,000,000
Interest expenses
RM0
RM400,000
Earning before tax
RM2,000,000
RM1,600,000
Tax payment
RM600,000
RM480,000
Net income after tax
RM1,400,000
RM1,120,000
Earnings before interest and tax (EBIT)
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Referring to the previous example on two types of capital structure for Scavilo
Company as shown in Table 4.15, we can see that the amount of tax is different
because of the interest payment. If we simplify the calculation in Table 4.15 based
on the three assumptions mentioned above, we can generate the basic asset cash
flow for Scavilo Company as shown in Table 4.16.
Table 4.16: Basics Cash Flow from Asset for Scavilo Company
Details
Without Debt
With Debt
Earnings before interest and tax
(EBIT)
RM2,000,000
RM2,000,000
Tax payment
RM600,000
RM480,000
Net income after tax
RM1,400,000
RM1,520,000
Difference of net income
= Net income with debt ă Net income without debt
= RM1,520,000 ă RM1,400,000
= RM120,000
Table 4.16 shows the basic cash flow generated from the assets of Scavilo
Company. The amount of earnings before interest and tax for both types of
capital structure is at RM2,000,000. If the company uses capital structure without
debt, the tax payment amount is RM600,000 and the net income of the company
is RM1,400,000. The table also states that if Scavilo Company uses debt in its
capital structure, the amount of tax is only RM480,000 and the net income of the
company is higher at RM1,520,000. From this example, we can see the cash flow
generated from the same amount of asset is unequal for different types of capital
structures. The capital structure with debt generates higher net income by
amount of RM120,000.
To investigate how the net income of the firm is unequal for both types of capital
structures, we can compute the cash flow paid to the stockholder and bond
holders as presented in Table 4.17.
Table 4.17: Cash Flow for Stockholder and Bondholder of Scavilo Company
Details
Without Debt
With Debt
To Stockholder
RM1,400,000
RM1,120,000
To Bondholder
RM0
RM400,000
Total Cash Flow
RM1,400,000
RM1,520,000
Difference of Cash Flow = Total Cash Flow with debt ă Total Cash Flow without debt
= RM1,520,000 ă RM1,400,000
= RM120,000
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CAPITAL STRUCTURE
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Table 4.17 shows that the total payment to stockholder and bondholder for
capital structure with debt is higher compared to capital structure without debt.
The extra payment is RM120,000 and it is equivalent to amount of reduction on
tax payment which is also at RM120,000 (Tax payment for capital structure
without debt is RM600,000 while tax payment for capital structure with debt is
RM480,000). The amount of RM120,000 from the tax savings is also called interest
tax shield. The formula of interest tax shield is as follows:
Interest Tax Shield = Tax Rate  Interest Expenses
If we use the information from Scavilo Company, the interest tax shield can be
calculated as follows:
Interest Tax Shield = Tax Rate  Interest Expenses
= 30%  RM400,000
= RM1,200,000
4.4.2
Taxes and M&M Proposition I
As discussed in the previous subtopic, M&M Proposition I without considering
tax states that the capital structure of the firm is not affected the value of the firm.
The formula for firmÊs value is:
VU VL
Where:
VU = Value of firm without debt (unlevered firm)
VL = Value of firm with debt (levered firm)
However, if we refer to the discussion on interest tax shields, there is a reduction
on tax payment generated by company that uses debt in their capital structure
(interest tax shield). Assuming that the debt is perpetual, then, the interest tax
shield will be generated every year forever. The M&M Proposition I with taxes
states that the value of the firm increases as total debt increases because of the
interest tax shield. Therefore, the formula for firm value under M&M Proposition
I with tax consideration is:
VL VU  TC  D
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Where:
VU = Value of firm without debt (unlevered firm)
VL = Value of firm with debt (levered firm)
TC = Tax rate
D
= Amount of debt
Based on this formula, the new value of Scavilo Company are as follows:
VL VU  TC  D
 RM8,000,000  30%  RM4,000,000
 RM9,200,000
4.4.3
Taxes and M&M Proposition II
Under M&M Proposition II with tax, the formula for weighted average cost of
capital and return on equity is as follows:
E 
D 
  R E     R D   1  TC 
V
 
V 
RL  
V E D
Where:
E
= Total equity
D
= Total debt
V
= Total value of the firm
R L = Return on asset or WACC of levered firm
R E = Return on equity
R D = Return on debt
TC = Tax rate
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CAPITAL STRUCTURE

D 
   1 TC 
E 
R E  RU   RU  RD   
Where:
E
= Total equity
D
= Total debt
RU = Return on asset or WACC of unlevered firm
R E = Return on equity
R D = Return on debt
TC = Tax rate
RDaT  RD   1 TC 
Where:
R DaT = Return on equity
RD
= Return on debt
TC
= Tax rate
Table 4.18: Summary of Financial Information on Scavilo Company
(Levered: 50% equity + 50% Debt)
Capital Structure
Details
Unlevered
(100% Equity)
Levered
(50% Equity + 50% Debt)
Interest tax shield
(Debt  Tax rate)
RM0
RM1,200,000
Value of debt
RM0
RM4,000,000
Value of equity
RM8,000,000
RM5,200,000
Value of firm
RM8,000,000
RM9,200,000
Debt-to-equity ratio
0
1
R D before tax
10%
10%
WACC
15%
Tax rate
30%
30%
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Based on the information in Table 4.18, return on equity and weighted average
cost of capital for levered capital structure of Scavilo Company are as follows:
Return on equity:
D 
   1  TC 
E 
R E  RU   RU  R D   
 RM4,000,000 
 0.15   0.15  0.10   
   1  0.30 
 RM5,200,000 
 17.69%
WACC for levered capital structure
E 
D 
  R E     R D   1 TC 
V
 
V 
RL  
 RM5,200,000 
 RM4,000,000 

 0.1769  

  0.10   1  0.30 
 RM9,200,000 
 RM9,200,000 
 13.04%
Return on debt after tax
RDaT  R D   1 TC 
 0.10   1  0.30 
 7%
Table 4.19: Summary of Financial Information on Scavilo Company
(Levered: 30% Equity + 70% Debt)
Capital Structure
Details
Unlevered
(100% Equity)
Levered
(30% Equity + 70% Debt)
Interest tax shield
(Debt  Tax rate)
RM0
RM1,680,000
Value of debt
RM0
RM5,600,000
Value of equity
RM8,000,000
RM4,080,000
Value of firm
RM8,000,000
RM9,680,000
Debt-to-equity ratio
0
1
R D before tax
10%
10%
WACC
15%
(to be calculated)
Tax rate
30%
30%
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CAPITAL STRUCTURE
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91
Based on the information in Table 4.19, return on equity and weighted average
cost of capital for levered capital structure of Scavilo Company are as follows:
Return on equity:
D 
   1  TC 
E 
R E  RU   RU  R D   
 RM5,600,000 
 0.15   0.15  0.10   
   1  0.30 
 RM4,080,000 
 19.80%
WACC for levered capital structure:
E 
D 
  R E     R D   1  TC 
V
 
V 
RL  
 RM4,080,000 
 RM5,600,000 

  0.1980   RM9,680,000   0.10   1  0.30 
RM9,680,000




 12.40%
Return on debt after tax:
RDaT  RD   1 TC 
 0.10   1  0.30 
 7%
Table 4.20: Summary of Cost of Capital for Scavilo Company
Capital Structure
Details
Levered
(50% Equity + 50% Debt)
Levered
(30% Equity + 70% Debt)
Debt-to-equity ratio
1
2.33
17.69%
20%
R D after tax
7%
7%
WACC unlevered
15%
15%
WACC levered
13.04%
12.40
RE
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The following Figure 4.4 illustrates the cost of capital under M&M Proposition II
with taxes:
Figure 4.4: The Cost of Capital under M&M Proposition II with Taxes
Table 4.20 and Figure 4.4 summarise the cost of capital of Scavilo Company by
using M&M Proposition II with taxes. From the table and figure, we can
conclude that by using the M&M Proposition II with taxes:
(a)
There is negative relationship between weighted average cost of capital and
debt to equity ratio. If the company increases the amount of debt, it can
reduce the weighted average cost of capital.
(b)
There is a positive relationship between return on equity with debt to
equity ratio. If the company increases the amount of debt, it causes the
increase in return on equity.
SELF-CHECK 4.3
1.
What is interest tax shield?
2.
Explain M&M Proposition I with tax.
3.
Explain M&M Proposition II with tax.
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4.5
CAPITAL STRUCTURE
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93
THE PECKING ORDER THEORY
The pecking order theory is one of the theories in the decision of capital
structure. A key element in the pecking order theory is that firms prefer to use
internal financing whenever possible. A simple reason is that selling securities to
raise cash can be expensive, so it makes sense to avoid doing so if possible. If a
firm is very profitable, it might never need external financing; so it would end up
with little or no debt.
There is a better reason companies may prefer internal financing. Suppose you
are the manager of a firm, and you need to raise external capital to fund a new
venture. As an insider, you are privy to a lot of information that is not known
to the public. Based on your knowledge, the firm's future prospects are
considerably brighter than outside investors realise. As a result, you think your
stock is currently undervalued. Should you issue debt or equity to finance the
new venture?
If you think about it, you definitely do not want to issue equity in this case. The
reason is that your stock is undervalued, and you do not want to sell it too
cheaply. So, you issue debt instead. Would you ever want to issue equity?
Suppose you thought your firm's stock was overvalued. It makes sense to raise
money at inflated prices, but a problem crops up.
If you try to sell equity, investors will realise that the shares are probably
overvalued, and your stock price will take a hit. In other words, if you try to
raise money by selling equity, you run the risk of signalling to investors that the
price is too high. In fact, in the real world, companies rarely sell new equity, and
the market reacts negatively to such sales when they occur. So, we have a
pecking order. Companies will use internal financing first. Then, they will issue
debt if necessary. Equity will be sold pretty much as a last resort.
4.5.1
Implications of the Pecking Order
The pecking order theory has several significant implications, a couple of which
are at odds with our static trade-off theory:
(a)
No target capital structure: Under the pecking order theory, there is no
target or optimal debt-equity ratio. Instead, a firm's capital structure is
determined by its need for external financing, which dictates the amount
of debt the firm will have.
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(b)
Profitable firms use less debt: Because profitable firms have greater
internal cash flow, they will need less external financing and will
therefore have less debt. As we mentioned earlier, this is a pattern that
we seem to observe, at least for some companies.
(c)
Companies will want financial slack: To avoid selling new equity,
companies will want to stockpile internally generated cash. Such a cash
reserve is known as financial slack. It gives management the ability to
finance projects as they appear and to move quickly if necessary.

Decisions on capital structures have significant impacts on firm value.

A companyÊs objective is to have a capital structure that can produce the
highest firm value or the lowest weighed average cost of capital.

Break-even EBIT is the amount of EBIT where there is no difference in the
value of EPS between different types of capital structures.

The effect of financial leverage depends on the company's earnings before
interest and tax. Financial leverage has more positive impact if the earnings
before interest and tax of the firm is high.

Financial leverage can increase the return on equity (ROE) and earnings per
share (EPS) for shareholders.

The changes of return on equity and earnings per share become more
sensitive to the changes of earnings before interest and tax if the company
use financial leverage.

Capital structure is an important consideration in corporate finance because
of the impact that financial leverage has on both the expected return to
stockholders and the riskiness of the stock.

Homemade leverage such as the use of personal borrowing changes the
overall amount of financial leverage to which the individual is exposed.

The homemade leverage causes the decision on capital structure to have no
impact on total return received by shareholders
TOPIC 4
CAPITAL STRUCTURE
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CAPITAL STRUCTURE
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
M&M Proposition I (no tax): The value of the levered firm is equal to the
value of the unlevered firm. Therefore, a firm's capital structure is not
affected by the value of firm and the WACC is the same no matter what
mixture of debt and equity is used to finance the firm.

M&M Proposition II (no tax) states that the cost of equity rises as the firm
increases its use of debt financing.

The interest tax shield is the amount of tax savings attained by a company
from the interest expenses.

M&M Proposition I (with tax): The value of the firm levered is equal to the
value of the firm unlevered plus the present value of the interest tax shield.

M&M Proposition II (with tax): There is a negative relationship between
weighted average cost of capital and debt to equity ratio. If the company
increases amount of debt, it can reduce the weighted average cost of capital

M&M Proposition II (with tax): There is a positive relationship between
return on equity with debt to equity ratio. If the company increases the
amount of debt, it causes the increment in return on equity.

The pecking order theory states that firms prefer to use internal financing
whenever possible.
Break-even EBIT
Levered firm
Capital structure
M&M Proposition I
Corporate borrowing
M&M Proposition II
Cost of capital
Return on debt
Earnings before interest and tax (EBIT)
Return on equity
Earnings per share (EPS)
The pecking order theory
Financial leverage
The pie model
Homemade leverage
Unlevered firm
Interest tax shield
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CAPITAL STRUCTURE
Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2010). Fundamentals of corporate
finance (9th ed.). Boston, MA: McGraw-Hill.
= Return on debt after tax
= Return on debt before tax = Tax rate
before taxReturn on debt after taxReturn on debt after tax:Table 4.20 after tax
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Topic  Dividend
5
Policy
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Define dividend payouts;
2.
Discuss the standard method of cash dividend payments;
3.
Explain why and how companies repurchase stocks; and
4.
Discuss the impact of personal taxes and issuance costs on
dividends.
 INTRODUCTION
InvestorsÊ motives of investing in common stock of a particular company is to
earn incomes through capital gains and dividend paid by the company. This
topic discusses the different types of dividends paid by company and the
important dates related to dividend payment. In addition we will also explore
the reasons for company to repurchase its stock and the impact of personal taxes
as well as issuance costs on dividends.
The following are some examples of news headlines that you will come across
associated with dividend payment by companies either at the end or middle of
its accounting year. The first headline was reported by the Edge Weekly on
25 July, 2016, stating that Malaysia companies paid lower dividends in first
quarter of 2016. The second headline reported that in 2014, Maxis declared
16 cent dividends due to the decline in fourth quarter net profit amounted to
RM290 million.
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DIVIDEND POLICY
„Corporate Malaysia paid lower dividends in 1Q2016‰
(Murugiah, 2016)
„Maxis Q4 net profit 23.3% fall to RM290m‰
(„Maxis Q4‰, 2014)
ACTIVITY 5.1
Go through the business section found in any newspaper and discuss
with your coursemates on any dividend announcements that would
have financial implications to the specific company.
5.1
DIFFERENT TYPES OF DIVIDEND PAYOUTS
Dividend is a payment made from the net income of a company to its
stockholders. Table 5.1 shows the top eight best dividend stocks paid by the
respective companies. British American Tobacco (BAT) Malaysia paid the highest
dividend, that is, 312 cents.
Table 5.1: Top Eight Best Dividend Stocks Paid in 2015
Company Name
Total Dividend (Cents)
British American Tobacco Malaysia
312
Nestle
260
Dutch Lady
220
Panasonic Manufacturing Malaysia
142
Tasek Corporation Bhd
110
United Plantation Berhad
100
Puncak Niaga Holdings Bhd
100
Time Dotcom Berhad
80.2
Source: MalaysiaStock.Biz (2015)
There are several types of dividends. The basic types of dividends are as shown
in Figure 5.1. These different types of dividends will be further discussed in the
following subtopics.
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DIVIDEND POLICY
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Figure 5.1: Common types of dividends
5.1.1
Cash Dividend
Dividends can be paid in the form of cash or stock. Cash dividends are dividends
paid out from the current or accumulated retained earnings. There are several
forms of cash dividends. They are:
(a)
Regular cash dividends ă the normal cash dividend paid by company in its
normal course of business. In countries like the US, companies pay regular
cash dividend four times a year (Ross, Westerfield, Jordan, Lim, & Tan,
2016).
(b)
Extra cash dividends ă this dividend paid on top of the regular cash
dividends.
(c)
Special dividends ă the dividend under unusual circumstances and is a
one-off dividend payment.
(d)
Liquidating dividends ă this form of dividend is paid when the company
sells off some of its business. Liquidating dividends may reduce the
companyÊs paid-in capital.
Copyright © Open University Malaysia (OUM)
100  TOPIC 5 DIVIDEND POLICY
CompanyÊs profits and retained earnings are reduced when cash dividends are
distributed. How does the distribution of dividend either in the form of cash or
stock affect the equityÊs account of the company? Let us use the following
examples to demonstrate the effect.
Example 5.1:
TimeLine Incorporation recorded a net income of $200 million during the year.
The Board of Directors decided to declare a cash dividend of $3.50 per share. The
companyÊs balance sheet before cash dividend payment is:
TimeLine Inc. Balance Sheet Before Cash Dividend Payment
Common stock:
Par (50 million outstanding shares @ $1 per share)
$50,000,000
Paid-in capital
200,000,000
Retained Earnings
300,000,000
Total
$550,000,000
Total cash dividend paid for that year is:
= 50,000,000 shares  $3.50/share
= $175,000,000
This implies that the company has to pay $175 million in the form of cash
dividends during that year. Hence the retained earnings of TimeLine Inc. after
cash dividends are distributed:
Retained earnings before dividend payment
$300,000,000
Add: Net Income
200,000,000
Less: Dividend Paid
(175,000,000)
Retained earnings after dividend payment
$325,000,000
TimeLine Inc.Ês Balance Sheet after Cash Dividend
Common stock:
Par (50 million outstanding shares @ $1 per share)
$50,000,000
Paid-in capital
200,000,000
Retained Earnings
325,000,000
Total
$575,000,000
Copyright © Open University Malaysia (OUM)
TOPIC 5
5.1.2
DIVIDEND POLICY

101
Stock Dividend
Alternatively, companies may decide to pay dividends in the form of stocks. This
involves issuing new shares as a bonus to the existing stockholders and,
therefore, is also called the bonus issue. For stock dividends, the profits or
retained earnings of the company are not affected but rather it involves
increasing the number of outstanding shares. A stock dividend can be expressed
in percentages, for example, 12% stock dividends. Retained earnings, paid-in
capital and number of outstanding shares are adjusted in the balance sheet when
company declares stock dividends (Benninga, Ahmad, Rahman, & Syed Alwi,
2016).
Example 5.2:
Now let us assume that instead of cash dividends being paid, TimeLine
Incorporation declares a 5% stock dividend.
(a)
A 5% stock dividend declared will lead to an increase in the number of
outstanding shares by:
= 50,000,000 shares  5% = 2,500,000 shares
Thus, the total numbers of outstanding shares are:
= 50,000,000 shares + 2,500,000 shares = 52,500,000 shares
(b)
Now if the current market price of TimeLine Inc., is $10 per share, the total
market value of the new shares is:
Market Value of New Shares = $10 per share  2,500,000 shares
= $25,000,000
(c)
Additional Paid-in Capital = ($10 per share ă $1 per share)  2,500,000 shares
= $22,500,000
TimeLine Inc. Balance Sheet After 5% Stock Dividend
Common stock:
Par (52.5 million outstanding shares @ $1 per share)
$52,500,000
Paid-in capital ($200 million + $22.5 million)
222,500,000
Retained Earnings ($300 million ă $25 million)
275,000,000
Total
$550,000,000
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102  TOPIC 5 DIVIDEND POLICY
Notice that TimeLine Inc.Ês outstanding shares and paid-in capital have increased
to 52.5 million shares and $222.5 million respectively. Simultaneously, its
retained earnings have been reduced by $25 million as a result of the market
value of the new shares issued.
5.1.3
Stock Split
Stock split is when a company announces stock dividends that are more than
25% of the number of outstanding shares. In this situation, only the par value of
the share and the number of outstanding shares are adjusted.
Example 5.3:
Now let us look at what happens to the balance sheet of the company when a
stock split is declared. Assume that TimeLine Inc. decides to declare a 2 to 1 stock
split during that year. This means that the stockholders will receive 2 new shares
for every 1 share that they have. Hence the adjustments needed to be made in the
balance sheet are the number of outstanding shares and the par value.
(a)
Number of new outstanding shares =
(b)
Adjusted Par Value =
2
 50,000,000 shares = 100,000,000
1
1
 $1.00 per share = $0.50 per share
2
TimeLine Inc. Balance Sheet After Stock Split
Common stock:
Par (100 million outstanding shares @ $0.50 per share)
$50,000,000
Paid-in capital
200,000,000
Retained Earnings
300,000,000
Total
$550,000,000
Copyright © Open University Malaysia (OUM)
TOPIC 5
DIVIDEND POLICY

103
ACTIVITY 5.2
The ownersÊ equity accounts of DNAIS International Inc. are provided
as follows:
Equity Accounts of DNAIS International Inc.
Par (20 million outstanding shares @ $2 per share)
$40,000,000
Paid-in capital
100,000,000
Retained Earnings
200,000,000
Total
$340,000,000
(a)
Illustrate how the company accounts would change if a 10% stock
dividend is announced. The DNAIS share is currently sold for $20
per share.
(b)
If the company decides to declare a five-for-one stock split, show
how the companyÊs equity accounts would change.
SELF-CHECK 5.1
1.
What are the different types of dividends?
2.
Explain the difference between stock dividends and stock splits.
3.
What are the effects on companyÊs paid-up capital, retained
earnings and outstanding shares when cash dividends, stock
dividends and stock splits are declared?
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104  TOPIC 5 DIVIDEND POLICY
5.2
STANDARD METHOD OF CASH DIVIDEND
PAYMENT
If you have bought shares from a company, there are four important dates that
you have to observe when the company declares dividend payment.
(a)
Declaration date ă This refers to the date when the board of directors of the
company makes announcements to the stockholders and the market that
the company is paying dividend in that financial year.
(b)
Ex-date or Ex-dividend date ă It is a date that will set apart who is eligible
to receive the dividend. If as an investor, you buy the company share on or
after the ex-dividend date, then you are not qualified to receive dividend
declare in that year. However, if you have bought the stock prior to the exdividend date then you will be entitled to the dividend. Normally the exdividend date is the second business day before the date of record (Ross,
Westerfield, Jaffe & Jordan, 2011).
(c)
Record date ă When the stock transfer book is closed, the investors who
own stocks on this date will receive the dividend declared.
(d)
Date of Payment ă It is the date when the company pays the eligible
stockholder the dividend. Usually the identified stockholders will receive
the dividend via mail in about a week or more.
Figure 5.2 illustrates the interim dividend payment procedures of SAM
Engineering and Equipment Company. The Board of Directors made an
announcement on 22 June 2015 that the company will pay an interim dividend
amounting to 0.1194 cents per share to its outstanding stockholders. SAM has set
the ex-dividend date to be on 30 July 2015. So if you intend to receive the interim
dividend, then you should buy SAM stock before 30th July.
If you have already owned the shares, then you should sell the stock on (or after)
this ex-dividend date. The dividend is payable to holders of record as of 3
August 2015. This means that only shareholders listed with SAM on this date got
the dividend. The dividend payment date was 28 August 2015. This is the date
on which the dividend would actually be paid out to the SAM stockholders (see
Figure 5.3).
Copyright © Open University Malaysia (OUM)
TOPIC 5
DIVIDEND POLICY
Figure 5.2: SAM first interim dividend
Source: Bursa Malaysia Dividend News (2015)
Figure 5.3: Timeline of the payment procedures of
SAM Engineering and Equipment Company
Copyright © Open University Malaysia (OUM)

105
106  TOPIC 5 DIVIDEND POLICY
ACTIVITY 5.3
1.
What are the chronological dates related to dividend payment?
2.
In April 20, 2016, MaybankÊs BOD declared final dividend of
24 cents for the financial year 31 December 2015. The record date
is May 06, 2016 and the payment date is on June 03, 2016. What is
the ex-dividend date? If Mr Remy Lee buys Maybank shares
before that date, will he gets the dividends on those shares? Why
or why not?
5.3
REPURCHASE OF STOCKS
From time to time, a company may decide to buy back their outstanding stocks.
There are several reasons for company to take such an action:
(a)
To provide internal investment opportunity;
(b)
To improve earnings per share of the company;
(c)
To avoid hostile takeover;
(d)
To minimise costs related to servicing minority stockholders;
(e)
To obtain shares to enable mergers and acquisition programme; and
(f)
To obtain shares for employee compensation programme.
A company can repurchase its own stock either through tender offers or open
markets. A tender offer is when company states a purchase price and a desired
number of shares (Ross et al., 2016). The company can also have the choice of
buying back its shares in the open market. Under the share repurchase
programme, stockholders who decide to sell their shares will receive cash
distribution from the company and also have potential tax advantage.
What is the implication to the investors when company repurchases its own
stock? Well, when this happens the price of the share will increase.
Copyright © Open University Malaysia (OUM)
TOPIC 5
DIVIDEND POLICY

107
Irrelevance and Relevancy of Dividend on CompanyÊs Value
Is dividend policy relevant or irrelevant to value of the company? Actually there
are two schools of thoughts related to this issue.
Miller and Modigliani or better known as M&M, argued that dividends have no
implication on the value of the company. When a company distributes dividends,
this does not affect shareholdersÊ wealth but rather the earnings and investment
policy will influence the value of the company (Ross et al., 2011).
Example 5.4:
Assume that AXX Company is currently selling at $20 per share with 2,000,000
shares outstanding. Its current income is $4 million, with EPS equal to $2 per
share. Its earnings are earmarked for capital investment. If AXX declares a
dividend of $1 per share, then the company has only $2 million for capital
investment. Since the company needs $4 million, it will have to issue $2 million
worth of shares through issuing of new shares.
(a)
Value of AXX Company before New Issue
No. of Shares  Current Price per Share = 2,000,000  $20/share
= $40,000,000
(b)
Price of New Shares Issued after Ex-dividend Announcement
Ex-dividend Price of Share = Current Price per Share ă Dividend per Share
= $20 ă $1 = $19
(c)
Number of New Shares to be Issued
Note value of new share is equal to the value of dividend paid, that is:
Dividend per Share  No. of Shares  $1  2, 000, 000  $2, 000, 000
No. of New Shares Issued 

Value of New Share
Ex-dividend per Share
$2, 000, 000
$19 per share
 105, 263 shares
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108  TOPIC 5 DIVIDEND POLICY
Total Number of Shares after the New Issue
Number of Old Shares + Number of New Shares = 2,000,000 + 105,263
= 2,105,263
(d)
Value of the AXX Company after New Issue
Number of New Shares  Ex-dividend Price of Share
= 2,105,263  $19 per share = $4,000,000
In conclusion, the value of company AXX remains the same irrespective of the
dividend policy.
On the other hand, there are advocates that support the relevancy of dividend
policy on the companyÊs value. Depending on the nature of investment
opportunities, if the returns on that investment are higher than the shareholdersÊ
expectations, then, the company should consider retaining the net income
available to shareholders rather than distributing dividends (Gitman & Zutter,
2015). In contrast, if the returns on that investment are lower, then, distributing
dividends to shareholders is advisable. You should refer to other corporate
finance textbooks for a detailed illustration on this perspective.
5.4
PERSONAL TAXES, DIVIDENDS AND
STOCK REPURCHASES
Up till now, we have assumed that there is no tax being imposed on dividends.
Now if we were to incorporate taxes, let us see what happens to the dividends
received by shareholders. Different countries practice different tax systems when
it is related to dividends. In the US, both cash dividends and capital gains
received by shareholders are taxed while in Malaysia and Singapore dividends
received by shareholders are tax exempt since these countries apply the one-tier
tax system. Example 5.5 illustrates the effect of tax on the dividend.
Copyright © Open University Malaysia (OUM)
TOPIC 5
DIVIDEND POLICY

109
Example 5.5:
Let us assume that TR Company has declared a $5.60 per share dividend. If
dividends are taxed at 15%, what is the after tax dividend?
After tax dividend = $5.60 (1 ă 0.15) = $4.76 per share
Thus, you could see that the shareholder will receive $4.76 per share after tax
dividend instead of $5.60 per share dividend.
Sometime shareholders prefer stock repurchases relative to cash dividends since
shareholders pay less tax when stock is repurchased.
Assume Mr Y receives a dividend of $2 on each of 100 shares he owned. He has
initially bought the shares at $60 per share. A 15% tax is imposed on the
dividend. Therefore, the amount tax paid on the dividend is:
Tax paid on dividend = ($2  100)  0.15 = $30
Now let us assume further that the company that issued the shares decided to
repurchase the stock at $100 per share. Here Mr Y has capital gain:
Capital gain = $100 ă $80 = $20
Tax paid on capital gain = $20  0.15 = $3
This shows that the tax paid on repurchase of stock is lower than on dividend
although a 15% tax rate is imposed.
ACTIVITY 5.4
1. What is the rational for some companies to repurchase their stocks?
2. Ross et al. (2016) discussed that certain countries practise three
types of corporate tax systems: classical, imputation and the one-tier
tax system. Discuss these three types of tax systems and explain
how each of the tax systems affect the company upon distribution of
cash dividends.
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110  TOPIC 5 DIVIDEND POLICY
SELF-CHECK 5.2
1.
Discuss the argument for the relevancy and irrelevancy of
dividend policy on the firmÊs value.
2.
Green Company has declared a $8.00 per share dividend. If
dividends are taxed at 17%, what is the after tax dividend?
3.
Mr Suchi owned 100 shares of DNA shares. He initially bought
the shares at $30 per share. If DNA company declares dividend of
$1.80 per share and a 15% tax is imposed on the dividend, what is
the after-tax value of the share? Assume that the company decides
to repurchase the share at $70 per share. Should Mr Suchi go for
the dividend or sell the share back to the company? Why?
•
Dividend policy is the proportion of net income that the company pays to
shareholders.
•
Dividends can be distributed in many forms.
•
Shareholders should be aware of the different dates related to dividend
payments.
•
There are two perspectives on the relevancy of dividend policy on the firmÊs
value.
•
Cash dividends, stock dividends and stock splits have different impacts on
the equityÊs account of a company.
•
Personal taxes and stock repurchase have implications on dividend
payments.
Copyright © Open University Malaysia (OUM)
TOPIC 5
DIVIDEND POLICY
Cash dividend
Record date
Declaration date
Stock dividend
Dividend payment date
Stock repurchase
Dividend payments
Stock split
Ex-dividend date
Tax system

111
Benninga, S., Ahmad, N., Rahman, H. A., & Syed Alwi, S. F. (2016).
Fundamentals of finance with Microsoft Excel (2nd ed., Asian ed.). Shah
Alam, Malaysia: Oxford University Press.
Bursa Malaysia Dividend News. (2015). SAM: First Interim Dividend (0.1194).
Retrieved from http://bursa-dividend.blogspot.com/
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
MalaysiaStock.Biz. (2015). Top 50 best Bursa Malaysia dividend stocks of the year
2015. Retrieved from
http://www.malaysiastock.biz/Report-Analysis/Top-KLSE-DividendStock.aspx
Maxis Q4 net profit 23.3% fall to RM290m. (2014, February 12). The Sun Daily.
Retrieved from http://www.thesundaily.my/node/240797
Murugiah, S. (2016, July 25). Corporate Malaysia paid lower dividends in
1Q2016. The Edge Markets. Retrieved from
http://www.theedgemarkets.com/my/article/corporate-malaysia-paidlower-dividends-1q2016
Copyright © Open University Malaysia (OUM)
112  TOPIC 5 DIVIDEND POLICY
Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2011). Core principles
and applications of corporate finance (3rd ed.). New York, NY: McGrawHill Irwin.
Ross, S. A., Westerfield, R. W., Jordan, B. D., Lim, J., & Tan, R. (2016).
Fundamentals of corporate finance (Asia Global Edition, 2nd ed.).
New York, NY: McGraw-Hill Irwin.
Currently, the capital structure of the firm consists of 100% equity. Therefore, the value
of ABC Company is:The management of ABC Company decides to issue bonds
worth RM5,000. Let us say, the company has two alternatives in deciding the new
capital structure of the firms:Now we assume the company has two types of capital
structure, namely, Break-even EBIT = The previous calculation for Scavilo
Company shows that the break-even EBIT is at RM800,000. This means that if the
expected EBIT of Scavilo Company is less than the break-even EBIT which is
RM800,000, the company should use capital structure without debt because it can
generate higher EPS. Table 4.7 shows the amount of earnings per share of different
capital structures for Scavilo Company. We can see that if Scavilo Company uses a
capital structure without debt, they can generate EPS worth at RM0.00, RM1.00,
RM2.00 and RM3.00 for EBIT amount at RM0, RM400,000, RM800,00 and
RM1,200,000 respectively. The table also indicates that if Scavilo Company uses
capital structure with debt, they can generate EPS worth at RM−2.00, RM0.00,
RM2.00 and RM4.00 for EBIT amount at RM0, RM400,000, RM800,00 and
RM1,200,000 respectively.Now, let us rearrange the formula for WACC to find the
return on equity:Calculate the return on equity for Scavilo Company if the company
uses 50% of equity and 50% of debt.Calculate the WACC of the company if the
capital structure of the company consists of 30% debt and 70% equity.Calculate the
WACC of the company if the capital structure of the company consists of 50% of
debt and 50% of equity.Table 4.13is dependent on: = WACC);; and) or weighted
average cost of capital (WACC) and return on debt () are not affected by changes in
debt to equity ratio. The figure also illustrates that return on equity (is a positive
linear function of debt to equity ratio. Ross et al. (2010) explain that as the firm
raises its debt-equity ratio, the increase in leverage raises the risk of the equity and
therefore the required return or cost of equity.If we use the information from
Scavilo Company, the interest tax shield can be calculated as follows:4.However, if
we refer to the discussion on interest tax shields, there is a reduction on tax
payment generated by company that uses debt in their capital structure (interest tax
shield). Assuming that the debt is perpetual, then, the interest tax shield will be
generated every year forever. The M&M Proposition I with taxes states that the
value of the firm increases as total debt increases because of the interest tax shield.
Therefore, the formula for firm value under M&M Proposition I with tax
consideration is:Based on this formula, the new value of Scavilo Company are as
follows:4. = Return on debt after tax
= Return on debt before tax
= Tax
ratebefore tax before tax after tax
Copyright © Open University Malaysia (OUM)
Topic  Options and
6
Corporate
Finance
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Define options in the context of corporate finance;
2.
Differentiate between call and put options;
3.
Calculate the value of a call option using the option pricing models;
4.
Explain the components related to an option premium;
5.
Explain why the minimum intrinsic value for both call and put
options is zero.
 INTRODUCTION
Risks are inherent in any form of investments taken by investors. Price risk is the
risk associated with the fluctuation of financial instrumentÊs prices. Investors
require a mechanism to mitigate price risk. Derivatives are introduced for this
purpose. Among the derivatives that are available are futures, options, forwards
and swaps. Figure 6.1 displays the different types of derivatives instruments.
Figure 6.1: Different types of derivatives instruments
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114  TOPIC 6 OPTIONS AND CORPORATE FINANCE
In this topic, we will focus on options. Option is another type of hybrid financial
instrument created to manage risk. It is categorised as a derivative instrument,
where the value of the assets is derived from the spot market. To date, there are
many types of option contracts traded globally. Options are traded either on an
organised exchange market or over-the-counter (OTC) market. The Chicago
Board of Options Exchange (CBOE) is an example of an organised exchange
market. It is the oldest exchange in the US that offers various options contracts to
market participants who are interested in managing risk and/or earning profit.
Stock, stock index, bond, currency, interest rates and commodity options are
examples of the options contracts that are traded around the world (see Figure 6.2).
Exchange-traded option or listed options are standardised contracts with
predetermined exercise prices, size of contract (that is, RM25 per metric tonnes,
AUD100,000 per contract) and fixed maturities contract month (that is, March,
Jun, September and December).
Figure 6.2: Different options contracts
Copyright © Open University Malaysia (OUM)
TOPIC 6
OPTIONS AND CORPORATE FINANCE

115
ACTIVITY 6.1
Go to the Bursa Malaysia website and answer the following questions:
(a)
Identify the name of exchange where derivatives are traded.
(b)
What are the various derivatives instruments offered by this
exchange?
(c)
What are the options contracts offered at this exchange?
6.1
OPTIONS
What exactly is an option? Let us explain the meaning of options with this simple
example. Suppose your friend puts up an antique painting for sale. You verbally
agree to buy the painting from him at a specific price since you are very
interested in the painting. However, you have informed your friend that you will
need some time to raise the money to pay him. Your friend now either faces
he risk of you not fulfilling the contract or to cancel the agreement. Due to
this uncertainty, your friend requires you to pay a non-refundable deposit of
US$5,000. If you fail to honour the agreement, your deposit will be forfeited.
What we have read just now can be said conceptually to be an option contract
because you have bought an option from the seller (your friend) of $5,000 giving
you the right to buy the antique painting at an agreed price within the certain
period of time. Note, your friend needs to understand that you do not have any
obligation to do so and, in turn, will lose your $5,000. He has no recourse on you.
In contrast, your friend as the seller of the option contract has an obligation to sell
the painting should you choose to exercise your right. This is fair as your friend
has already received the non-refundable money today from you. Therefore, by
definition, a buyer has to pay a deposit in order to acquire a „right‰ while a seller
will receive a deposit in order to place him with an „obligation‰.
In short, an option is a contract that allows the buyer of the contract the right, but
not the obligation, to sell (put) or buy (call) the contracted assets at a
predetermined price and date from the seller of the contract. This means that if
the market is favourable to the buyer of the option contract; he has the right to
exercise the contract. On the other hand, if the market is not favourable, then the
buyer has no obligation to exercise the contract. Does the seller of the option
contract have the same right as the buyer of the option contract? Unfortunately,
he does not! The seller of the option contract has only the obligation but no right
to fulfil the contract if the buyer decides to exercise the contract.
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116  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Generally, the strategy of using options is the same whether the option is traded
in Malaysia or other countries like Japan, the UK and US. The only difference is
that each option contract has its own contract specification.
Contract specification means the standard and the characteristics specific to
the particular option contract offered. This can be easily accessible from the
derivative exchanges offered in the respective countries.
6.1.1
Option Contract Specifications and Quotation
Table 6.1 provides the contract specification of FBM KLCI Option (OKLI). This
information is available on the Bursa Malaysia Derivative Berhad website.
Table 6.1: Contract Specifications of FBM KLCI Options (OKLI)
Underlying
Instrument
FBM KLCI Futures (FKLI)
Type
European Style
Contract Size
One FKLI contract
Tick Size
0.1 index point valued at RM 5.00
Contract Month
Spot month, the next month and the next two calendar quarterly
months. The calendar quarterly months are March, June,
September and December.
Daily Price Limits
There shall be no price limits for the spot month contract.
Matched trades which exceed the price limits are not valid.
Trading Hours
First trading session: Malaysian 8.45am to 12.45pm.
Second trading session: Malaysian 2.30pm to 5.15pm
Last Trading Day
The last market day of the contract month.
Settlement of
Option Exercise
In the absence of contrary instructions delivered to the Clearing
House, an option that is in-the money at expiration shall be
automatically exercised. Exercise results in a long FKLI position,
which corresponds with the optionÊs contract month for a call
buyer or a put seller, and a short FKLI position for a put buyer or
a call seller. The resultant positions in FKLI shall then be cashsettled based on the final settlement value of FKLI.
Exercise Price
Intervals
At least 13 exercise prices in the money at the money (6 are in-themoney, 1 is at-the-and 6 are out-of-the-money) shall be set at
interval of 10 index points for the spot and next month contracts.
At least 7 exercise prices (3 are in the-money, 1 is at-the-money
and 3 are out-of-the-money) shall be set at interval of 20 index
points for the next 2 quarterly month contracts.
Copyright © Open University Malaysia (OUM)
TOPIC 6
Speculative
Position Limit
OPTIONS AND CORPORATE FINANCE

117
10,000 FKLI-equivalent contracts (a combination of OKLI and
FKLI contract) net on the same side of the market in all contract
months combined.
Source: Bursa Malaysia (2012)
As stated in Table 6.1, OKLI contract size is one FBM KLCI Futures (FKLI)
contract, which is, the index points multiplied with RM50. Hence, if you long one
call option and if the FBM KLCI futures price at that time is say 1800.05 points,
then the value of one contract is 1800.05  RM50 = RM90,002.50. The contract
months for OKLI are March, June, September and December. The minimum
fluctuation for OKLI futures option is RM5 (0.1 index point  RM50).
OKLI is a European style option since the option is allowed to be exercised only
at the maturity date. At expiry date, if the option is in-the-money (ITM), the
exchange (BMDB) will automatically exercise the option. This option is a cashsettled against the final settlement value of FKLI futures price. BMDB offers
different exercise prices with interval of 10 points for the current and next month
contracts.
If you surf the BMDB website, you will also find the market price quotation of
the OKLI. Table 6.2 is a summary of the market price quotation of OKLI quoted
on 19 August 2016.
Table 6.2: Summary of the OKLI Market Price Quotation (as of 19 August 2016)
Strike Price
Month Open High Low
Bid
Ask
Last
Done
Settlement
Price
Change
OI
Vol
OKLI C 1650 Aug-16
ă
ă
ă
ă
ă
ă
36.4
ă
ă
ă
OKLI P 1650 Aug-16
ă
ă
ă
ă
ă
ă
0.4
ă
ă
ă
OKLI C 1660 Aug-16
ă
ă
ă
ă
ă
ă
27.1
ă
93
ă
OKLI P 1660 Aug-16
ă
ă
ă
ă
ă
ă
1.2
ă
77
ă
OKLI C 1670 Aug-16
22.5
22.5
22.5
ă
ă
22.5
22.5
ă2.2
32
2
OKLI P 1670 Aug-16
ă
ă
ă
ă
ă
ă
2.8
ă
41
ă
OKLI C 1680 Aug-16
15
15
15
ă
ă
15
15
îă1.6
îă31
ă
OKLI P 1680 Aug-16
ă
ă
ă
ă
ă
ă
5.9
ă
25
19
Source:
http://www.bursamalaysia.com/market/derivatives/prices/#/?page=1&contract_code
=OKLI
Copyright © Open University Malaysia (OUM)
118  TOPIC 6 OPTIONS AND CORPORATE FINANCE
How do you interpret the quotation in Table 6.2? Notice with the exception of the
contract being traded, the quotation format for options offered in any organised
exchanges in the world is similar. Now let us interpret the previous quotation.
(a)
OKLI: It is the type of futures options transacted that is the FBM KLCI
futures options.
(b)
Strike Price: Refers to the different series of strike price or exercise price
available.
(c)
Contract Month: The contract month that OKLI contracts expire. In this case
the OKLI contract expires in August 2016.
(d)
C1670 August 2016: Indicates OKLI Call option with a strike price of 1670
index points and will expire in August 2016.
(e)
P1670 August 2016: Indicates OKLI Put option with a strike price of 1670
index points and will expire in August 2016
(f)
Open/High/Low: Refers to the opening, highest and lowest prices of
options by their classes and series.
(g)
Bid/Ask: It is the buying price (bid) and offer price (ask) of the option
price.
(h)
Last: Refers to the last closing price of options by the classes and series of
options.
(i)
Sett.: Refers to the settlement or closing prices of option.
(j)
Change: Refers to a change in option prices as compared to previous
closing price.
(k)
O.I.: Means open interest which indicates the number of outstanding
options contract.
(l)
Volume: Refers to the number of options contract transacted on that day.
Congratulations!!!You have successful interpreted the OKLI market quotation.
Now, go to other organised exchanges that traded different types of options and
try to interpret the market quotation of the contract.
Copyright © Open University Malaysia (OUM)
TOPIC 6
OPTIONS AND CORPORATE FINANCE

119
ACTIVITY 6.2
1.
Surf the derivatives exchanges in Malaysia and the US websites
and find out what are the contract specifications for OCPO,
Australian Dollar Currency Option and British Pound Currency
Option.
2.
Why do think there is a need for the option to be standardised?
3.
Can you create option contracts on any product? Describe how
you can do it.
6.2
TYPES OF OPTIONS
There are two types of options traded in the exchange:
(a)
Call Option
Call option is an option contract that allows the buyer of the contract the
right to buy a specified asset for a premium at certain period of time. The
option is usually refer to as long call. On the other hand, the seller (writer)
of the call option has an obligation but not the right to sell a specified asset
for a premium at certain period of time. This is usually referred to as a short
call. Figure 6.3 shows that call option is a combination of long call and short
call.
Figure 6.3: Call option
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120  TOPIC 6 OPTIONS AND CORPORATE FINANCE
(b)
Put Option
As for the put option, it is also an option contract that allows the buyer of
the contract the right to sell a specified asset for a premium at certain
period of time. The option is usually referred to as long put. On the other
hand, the seller (writer) of the call option has an obligation but not the right
to buy a specified asset for a premium at certain period of time. This is
usually referred to as a short call. Figure 6.4 shows that put option is a
combination of long call and short call.
Figure 6.4: Put option
Remember: whether it is a call or a put option, buyer of either option contract is
the holder of the contract and therefore will always has the right but no
obligation to buy or sell the asset.
ACTIVITY 6.3
1.
Alan Chong Wei, an option trader enters into an option that gives
him an obligation and not the right to sell the asset at specified
period of time for a premium. What is the type of option that he
has entered into?
2.
Pauline Abdullah enters into a long put option and would like to
exercise her right since the market is favourable. However the
seller of the put option refuses to buy the asset from her. Explain if
the seller can do so.
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TOPIC 6
6.2.1
OPTIONS AND CORPORATE FINANCE

121
Features of Option Contract
There are several option features that you should be familiar with. We will
explain these features using the following example.
Example 1:
Let us assume that a trader is long one OKLI 1680 September call options at
22.50 points.
What are the option features that are found in Example 1? Figure 6.5 shows the
features of option contracts.
Figure 6.5: Features of option contracts
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122  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Let us now explore further the features of option contracts:
(a)
Underlying Asset
Underlying asset refers to the physical or financial asset in which the option
contract is created. By now you should know that Bursa Malaysia
Derivatives Berhad (BMDB) traded two types of options which are FTSE
Bursa Malaysia KLCI options (OKLI) and Options on Crude Palm Oil
Futures (OCPO). OKLIÊs underlying asset is the FBM KLCI Futures (FKLI),
while OCPOÊs is the Crude Palm Oil Futures. Both of these contracts are
known as options on futures.
An option on spot underlying market is where its underlying asset is the
physical product. Example are the foreign currencies options traded at the
Philadelphia Stock Exchange (PHLX) or Nasdaq PHLX (now part of
NASDAQ) where the underlying assets for options are the spot foreign
currencies like Australian Dollar, British Pound, Canadian Dollar, Swiss
Franc etc. Hence if we refer to Example 1, the option is the FBM KLCI
option (OKLI) of which if you refer to the contract specification and its
underlying asset is the FBM KLCI futures.
(b)
Exercise Price
Exercise price also known as strike price is the price that the buyer (holder)
has the right to sell or buy the underlying assets from or to the seller
(writer). The term „strike‰ is used to indicate that the holder will exercise
his right whenever his option strikes the price. In Example 1, the exercise
price is 1680 index points and since it is long call, therefore this is a call
option. We will use the term „exercise‰ or „strike‰ price interchangeably.
(c)
Current Market Price
This is the price of the underlying asset that is displayed in the spot market.
Thus, to see what is the current market price for the „OKLI 1680 September
call options‰, you will need to see what is the price traded in the spot
market. As of August 2016, the current market price for FBM KLCI futures
was 1,812.72 points. This price will change daily to reflect the demand and
supply of the KLCI futures market.
Copyright © Open University Malaysia (OUM)
TOPIC 6
(d)
OPTIONS AND CORPORATE FINANCE

123
Premium
Premium is the price of option and is determined by the bid and ask price
in the market. In other words, the premium may go up, down or remain
unchanged throughout the life of option contracts. As mentioned earlier, an
investor who buys an option will pay premium while a seller will receive it.
Therefore, like stock prices or indices, premiums of options will fluctuate
over time. Continuing with Example 1, can you guess what the premium of
the OKLI is? Yes, the premium is the 22.50 points that the buyer of the
option has to pay to the seller of the option. Now since the minimum index
point is RM5 for 0.1 index point (refer to the contract specifications),
therefore in terms of the value is:
Premium value = 22.50 points  RM5  1 contract = RM112.50
(e)
Expiry Date
All options will have expiry dates. It is the last date that the options can be
exercised. In Example 1, the „one OKLI 1680 September call option‰
indicates that the contract will expire in the month of September. Options
that are not exercised at or before the expiry will become worthless and the
buyer of the call or put option can do nothing about it. With regards to the
expiry date, an option that can be exercised at any time up to the expiration
date is called an American option, while an option that can be exercised
only at expiration date is referred to as a European option.
6.2.2
Value and Options
Since the exercise price is the agreed price that remains fixed throughout the life
of the contract, the value of options will be determined by the current market
prices. For ease of discussion, let us once again refer to Example 1 and add
another example where the trade also buys a put option.
Example 2:
A trader has long one OKLI 1680 September call options at 22.50 points and
also is long one OKLI 1680 September put options at 15.00 points.
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124  TOPIC 6 OPTIONS AND CORPORATE FINANCE
In Example 2, the OKLI call option has an exercise price of 1680 points per
contract. Due to the volatility of the underlying assets, the exercise price may be
above, at par or below the current market price of the underlying assets bought
or sold. Therefore, the options may fall under one of the three possible situations
for the buyer to decide whether to exercise or not to exercise:
(a)
(b)
In-the-Money (ITM)
In-the-money refers to an option that has an exercise price that is profitable
if exercised.
(i)
For Call Option
Since the buyer has the right to buy he expects the current price to be
more or above the exercise price. In Example 2, if the FKLI futures
settlement price is 1720, then the OLKI call option is said to be ITM. In
other words, this call option is profitable for the buyer to exercise
because the FKLI futures settlement price is above the OKLI exercise
price (1720 > 1680).
(ii)
For Put Option
On the other hand, if current settlement price of FKLI futures drops to
1650 points, a put option is in-the-money when the current market
price is below the exercise price. This put option is also ITM because a
buyer has the right to sell, and hence, is very bearish about FKLI
futures. In other words, it is profitable for the buyer to exercise
because his option „strikes‰ the price as the current price has fallen as
what he expects to happen (1650 < 1680).
Out-of-the-Money (OTM)
Out of the money options are, as the name suggests, the opposite of in-the
money options, which means the options would not be profitable to
exercise.
(i)
For Call Option
Let us assume that instead of going up, the current price settlement of
FKLI futures is below the exercise price, which is 1650 points. Under
this situation, it is unprofitable for the buyer to exercise his right
because the current settlement price of the underlying FKLI futures is
unfavourable to him (1650 < 1680).
Copyright © Open University Malaysia (OUM)
TOPIC 6
(ii)
(c)
OPTIONS AND CORPORATE FINANCE

125
For Put Option
As for the put option, out-of-the money exists when the OKLI exercise
price stands at 1680 and the current settlement FKLI futures price is
1720 points. This means that put option is OTM if the current
settlement FKLI futures price is above the OKL exercise price (1720 >
1680). Hence, the higher the current settlement FKI futures price, the
more OTM is the put option.
At-the-Money (ATM)
At-the-money option refers to an option where the buyer neither makes
losses nor gains from the option contract.
(i)
For Call Option
The ATM call option occurs when the current settlement FKLI futures
price is trading at the fixed exercise price. In other words, the two
prices are the same. Now let us assume that the current settlement
FKLI futures price stands at 1680 which is similar to the OKLI call
exercise price (1680 = 1680). Here the trader will not exercise his call
option since he does not make any profit or loss from it.
(ii)
For Put Option
Similarly for put option, if the current settlement FKLI futures price is
the same as the OKLI put exercise price, then this put option is said to
be ATM and once again the trader will not exercise his right since he
neither makes profit or loss from exercising the put option.
Table 6.3 summarises the relationship between an options exercise price and the
market price of the underlying asset.
Table 6.3: Relationship between Current Market Price and Exercise Price
Relationship
Call Options
Put Options
Current market price > Exercise price
In-the-money
Out-of-the-money
Current market price = Exercise price
At-the-money
At-the-money
Current market price < Exercise price
Out-of-the-money
In-the-money
If you observe from Table 6.3, the relationship between current market price and
the exercise price of the call options and put options are opposite of each other.
For holder (buyer) of the call option, when the market price is greater than the
exercise price, the option is ITM while put option holder is OTM. Likewise, if
when market price is less than the exercise price, the call option is OTM but put
option is ITM.
Copyright © Open University Malaysia (OUM)
126  TOPIC 6 OPTIONS AND CORPORATE FINANCE
ACTIVITY 6.4
A trader has short two OKLI 1700 put option at 12.00 points. Currently
the FKLI futures price at the time the option is exercised is 1730 points.
(a)
What do you think the trader should do?
(b)
How much profit or loss does the trade make?
(c)
What is the underlying asset for OCPO options and what is the
contract size of the option?
SELF-CHECK 6.1
1.
Discuss the different features of options.
2.
Explain what an option is and who is given the right to exercise
the option.
3.
Differentiate between call and put options.
6.3
OPTIONS PRICING
If you remember, the option price is the premium that the buyer (holder) of the
option pays to the seller (writer) of the option. There are two components of
option pricing which are: intrinsic value and time value (see Figure 6.6).
Figure 6.6: Two components of option pricing
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TOPIC 6
6.3.1
OPTIONS AND CORPORATE FINANCE

127
Intrinsic Value
An option has an intrinsic value (IV) when it is profitable, that is, in-the-money
(ITM). The intrinsic value is the difference between the exercise price and the
current market price. It can be expressed as given:
Intrinsic value of call option = Current market price ă Exercise price
Continuing with this equation, if the current settlement FKLI futures price is
1720, then the intrinsic value of that call option is:
Intrinsic Value of OKLI Call Option = (1720 ă 1680)  RM5.00 per point
= RM200
The RM5.00 per point is from the contract specification of the OKLI contract.
However if the FKLI settlement price is 1650 then the intrinsic value of OKLI call
option is zero, since the intrinsic value can never be negative.
In essence, the intrinsic value of the call option is:
Call IV = (Max S ă X, 0)
Where S is the current market price, X is the exercise price.
Would the intrinsic value for the put option be the same as the call option?
Definitely not, since what is ITM for the call option will be OTM for the put
option. So applying once again the equation given for OKLI put option, if the
settlement FKLI futures price is at 1720, then the intrinsic value for the put option
is going to be zero. However, if the settlement FKLI futures price is 1650, then the
intrinsic value of put option is:
Intrinsic Value of OKLI Put Option = (1680 ă 1650)  RM5.00 per point
= RM150
Thus, the intrinsic value of put option is:
Put IV = (Max X ă S, 0)
By now if you observe the intrinsic value of call and put option is market price
less (or minus) strike price (call option) or strike price less market price (put
option) respectively. Intrinsic value of both options will never be negative since
the holder of the option will never exercise the option if it is out-of-the-money
(OTM). Table 6.4 summarises the intrinsic value of call and put options.
Copyright © Open University Malaysia (OUM)
128  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Table 6.4: Intrinsic Value of Call and Put Option
Call Option
Put Option
In-the-money (ITM)
Current Market price less
Exercise price
Exercise price less Current
Market price
At-the-money (ATM)
Zero
Zero
Out-of-the-money (OTM)
Zero
Zero
6.3.2
Time Value
The other component of the option price is the time value. It is derived by
subtracting the intrinsic value from the option premium. As long as the option
has not expired, then the time value of the option is positive.
Plugging in the figures from our example, the time value for OKLI call option is:
Time value = Intrinsic Value ă Option Premium
= RM200 ă 22.50 (RM5)
= RM200 ă RM112.50
= RM87.50
On the other hand, the time value for OKLI put option is:
Time value = Intrinsic Value ă Option Premium
= RM150.00 ă 15.00 (RM5)
= RM150 ă RM75
= RM75.00
Take note, for an American option, since you can exercise any time before expiry
date for the option that are out-of-the-money or at-the-money, even though the
intrinsic value of this call option or put option is zero, the option does have the
time value. Why is that so?
This is because as long as there is time remaining until an option matures, it is
worth its time value. This does make sense since any unexpired options still have
time to be in-the-money (ITM) and hence, can be exercised for profits.
Copyright © Open University Malaysia (OUM)
TOPIC 6
6.3.3
OPTIONS AND CORPORATE FINANCE

129
Factors Affecting Option Prices
Several factors affect the option price of an option. Among them are the price of
the underlying assets, the exercise price, expiry date, interest rates, market
volatility and dividend.
(a)
Underlying Asset Price
The fluctuation of the underlying asset affects the option price. For a call
option, if the price of the underlying assets exceeds the strike price and is
deeper in-the-money, the call option becomes more valuable. In contrast, if
the underlying assets are less than the strike price, then the call option price
is less valuable. This is opposite for the put option. The put option prices
become more expensive when its underlying asset price falls below the
strike price but are less valuable if the underlying asset price is greater than
the strike price.
For Call Option: Higher option price if CMP if higher than X
For Put Option: Lower option price if CMP if higher than X
(b)
Strike Price
A higher strike price call option will have a lower option price relative to a
call option with a lower strike. This is because the call option with a higher
strike has lower intrinsic value. For the put option, the premium is higher
for those with higher strike price since it has higher intrinsic value.
If X1 = 1680 and X2 = 1700 and CMP = 1800, then:
Call option  Higher option price for call option with X1, since CMP ăîX1 >
CMP ăîX2
If X1 = 1680 and X2 = 1700 and CMP = 1500, then:
Put option  Higher option price for put option with X2, since X2 ăîCMP >
X1îă CMP
(c)
Expiration Time
Whether it is a call option or a put option, both will have higher premiums
if their time to expiration is longer. This is because options with longer life
to expiration have more opportunity to gain in their intrinsic value as
compared to those options with short time duration. An option is said to be
a wasting or depleting asset as the time to expiry approaches. However the
rates of decline in time value are smaller for deep in-the-money and out-ofthe-money options as opposed to that of at-the-money options.
Copyright © Open University Malaysia (OUM)
130  TOPIC 6 OPTIONS AND CORPORATE FINANCE
(d)
Interest Rate
The premium of the option is also influenced by interest rates. Higher
interest rates result in borrowing money to buy underlying assets which
becomes expensive, and vice versa. For put option, rising interest rates lead
to the option price to decline. Alternatively for call options, rising interest
rates increase the price of the option as it is cheaper to buy a call option
than buy stock in the market.
(e)
Volatility of Market Prices
As the price of the underlying assets become more volatile, the probability
of the price of the underlying asset to fluctuate in either direction also
increases. This will enhance the tradersÊ opportunity to make large gains.
Hence, call and put option prices are more valuable when the volatility of
the underlying asset increases.
(f)
Dividends Paid
Usually dividends have a different impact on the stock option price of call
and put. Once dividends are paid, the stock price will decrease for
adjustment purposes and this leads to the asset becoming cheaper. Thus,
the price of the call option becomes less valuable. Alternatively, this causes
a higher put option price since the option becomes more valuable.
As for the European style option, the relationship between the above factors
(with exception to the expiry date) and the option prices are also similar.
When large dividend is expected to be distributed in the near period
of time, the short-life option is more valuable than the long-life option.
Table 6.5 summarises the relationship between all the factors and the option
prices of the American and European styles.
Table 6.5: Factors Affecting Put and Call Option Prices
American Style
European Style
Call
Put
Call
Put
Price of underlying assets
Increase
Decrease
Increase
Decrease
Strike price
Decrease
Increase
Decrease
Increase
Expiry time
Uncertain
Uncertain
Increase
Increase
Interest rate
Increase
Decrease
Increase
Decrease
Volatility
Increase
Increase
Increase
Increase
Dividends
Decrease
Increase
Decrease
Increase
Variables
Copyright © Open University Malaysia (OUM)
TOPIC 6
OPTIONS AND CORPORATE FINANCE

131
ACTIVITY 6.5
1.
Your friend argues that there is no difference between a European
option and an American option. Discuss.
2.
If you have a put option of OKLI with a strike price of 1620 and a
premium of 21.0 points, while FKLI futures settlement price at
expiry is 1600, what is the intrinsic and time value of the put
option?
3.
Based on question (2), what is the intrinsic and time value of the
put option, if the FKLI futures settlement price at expiry is 1680?
SELF-CHECK 6.2
1.
What is an option premium? Explain the components related to
the premium.
2.
Discuss the intrinsic value of call option and put option.
3.
Explain why the minimum intrinsic value for both call and put
options is zero.
4.
Why exercise price and market volatility among others will affect
the price of option? How do these two factors influence the option
price of call and put option?
5.
Fill up the blank based on the relationship between the factors and
option prices.
Variables
American Style
European Style
Call
Call
Put
Price of underlying assets
Strike price
Expiry time
Interest rate
Volatility
Dividends
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Put
132  TOPIC 6 OPTIONS AND CORPORATE FINANCE
6.3.4
Options Pricing Formula
This subtopic will expose you to the option pricing models used to evaluate the
theoretical value of an option. Determining the fair value of the option price is
more complex than determining the fair value of a futures contract. Put-call
Parity Theorem, Binomial Option Pricing Model and Black Scholes Pricing
Models are used to evaluate the price of the option. Reasons for determining the
option price are:
(a)
To determine whether the price of option is fairly priced; and
(b)
To identify whether arbitrage opportunities exist when the price of the
option is overpriced or underpriced.
The three option pricing models can be described as follows:
(a)
Put-call Parity Theorem
This theory states that there is a relationship between the price of the call
option and the price of the put option on the same underlying asset with
the same strike prices and same expiration dates. Mathematically, it can be
expressed as:
C
E
 1  r t
 S0  P
Where,
C = Price of the call option
P = Price of the put option
S 0 = Current market price
E = Exercise price
r
= Risk-free interest rate
t
= Time to maturity
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OPTIONS AND CORPORATE FINANCE

133
If the relationship is violated, then arbitrage opportunity arises. To
illustrate this relationship, consider the following situation:
C = RM1.70
P = RM0.50
S 0 = RM11.00
E = RM10.50
r
= 5% for 6 month
t
= 6 month
Then:
RM1.70  RM10.50
 RM1.10  RM0.50
1.05 
RM11.70  RM11.50
Therefore, mispricing has occurred. To take advantage of this arbitrage
opportunity, the trader could buy the cheaper portfolio (RM11.50) and sell
the higher-priced one (RM11.70) or borrow RM10 (10.50/1.05) now and
then write the call option at RM1.70, then long put option (RM0.50) and
buy the share (RM11.00).
The Put-call Parity assumes the following:
(b)
(i)
No dividends are paid before maturity; and
(ii)
Option is a European style option.
Binomial Option Pricing Model (BOPM) or Two Stage Model
Binomial Option Pricing Model can be used to estimate the theoretical
value of either a call or put option. The model is based on the assumption
that asset prices can move to only two values over any given time period.
Consider the following strategy:
Illustration:
Assume that the price of MLM share today (t = 0) is RM100.00 and that
after one year (t = 1) its share will be selling for either RM120 or RM90. In
addition, the annual risk free rate is 8% compounded continuously. Traders
are assumed to be able to either borrow or lend at this rate.
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134  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Now, consider a call option on MLM that has an exercise price of RM100.00
and an expiration date of one year from now. This means that at maturity,
the call option will have a value of either RM20 (if MLM is at RM120) or
zero (if MLM is at RM90).
Figure 6.7 shows the situation using a „price tree‰ known as a binomial
model. As indicated from this tree, there are only two branches that
represent prices at the expiration date:
Figure 6.7: Binomial model
If we bought one call and invested the present value of the exercise at t = 0
in a riskless asset, then at t = 1, the value of the investment will be:
92.59  (1.08) = 100
Hence the total investment value will either be RM100 or RM120 (value of
the investment plus option worth which can either be zero or RM20). But
this strategy does not have the same value of MLMÊs share a year later
which is RM120.
Copyright © Open University Malaysia (OUM)
TOPIC 6
OPTIONS AND CORPORATE FINANCE

135
Instead of investing in the present value of the exercise price (RM100/1.08),
the company should invest in the present value of the lower share price at
t = 1 (RM90/1.08). At maturity date, if MLMÊs share price is RM90, then the
payoff will be RM90 even though the option is worthless. On the other
hand, if the share price is RM120, then our investment will worth RM90
which is RM30 short (RM120 ă RM90). Since our option is worth RM20, we
need to find out what is the hedge ratio that results in the strategy having
the same value in the future, that is RM120, or otherwise arbitrage will
exist. Hedge ratio is calculated as:

 S u  S d    120  90   1.5
C u  C d   20  0 
To find out the option price today, we can apply this formula:
S 0  C 0 
X
 1  r t
Where,
S 0 = Current price of MLM
 = Hedge ratio
C 0 = Call option price
X = Exercise price
r
= Risk free rate
t
= Time to maturity
Plugging the above information in previous formula, the theoretical value
of the option at time 0 is as follows:
S 0  C 0 
X
 1  r t
100  1.5C 0 
90
1  8% 1
1.5C 0  100  83.33
C 0  RM11.11
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136  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Thus, the current value of the call option with an exercise price of RM100.00
is RM11.11 This is a simple example of the Binomial Option Pricing Model
since the change in the share price occurs only once during the one year.
The model above assumed that the MLM share does not pay any dividend
and the option can only be exercised at expiration (European style).
Nevertheless, this model can be modified to derive the price of the option
that pays dividend as well as those options that can be exercised before or
at maturity (American style).
(c)
Black and Scholes Option Pricing Model
Black and Scholes (1973) introduced an option pricing model famously
known as Black Scholes (BS) Model to calculate the theoretical value of
European option for a share that does not pay any dividend during the life
span of the option. There are five variables used in the valuation of the call
option of the non-dividend paying share. They are:
(i)
The price of the underlying share ( S 0 );
(ii)
Exercise price of the option (E );
(iii) The time remaining to the expiration of the call option (t);
(iv) Risk-free interest rate (r); and
(v)
Volatility of the underlying share (s).
The BS model is mathematically expressed as follows:
CP  S 0 N d 1  
E
 N d 2 
e rt
S 
ln     r  0.5s 2  t
E
d1   
s t
d 2  d1  s t
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TOPIC 6
OPTIONS AND CORPORATE FINANCE

137
Where,
CP = Price of call option
S 0 = Current share price
N d 1  & N d 2  = Values of cumulative standard normal distribution
functions
E
= Exercise price of the call option
e rt = Exponential function of continuously compounded risk-free rate of
interest
Illustration:
To illustrate the BS option pricing formula, assume the following
information is given:
UV share price
= RM47
Exercise price
= RM45
Time left before maturity
= 183 days
Standard deviation (expected volatility) = 25
Risk-free rate
= 10%
Substituting the values above into the formula, we get:
2
 47 
ln    0.10  0.5  0.25   0.5


45
d1   
 0.6172
0.25 0.5
d 2  0.6172  0.25 0.5  0.4404
Values of d 1 and d 2 are interpolated using the Normal Distribution table
that you can get from any investment books.
N (0.6172) = 0.7315
N (0.4404) = 0.6702
(Note: Learners need to refer to the normal distribution table.)
Copyright © Open University Malaysia (OUM)
138  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Thus the fair value of the call option is:
C  47  0.7315  
45
e  0.10  0.5 
  0.6702   RM5.69
If the call option is currently selling for RM8.00, then the trader should
consider writing them. This is because the option is overpriced. The writer
would make a profit from the difference between the premium received
and the premium paid when he closed out the position later.
On the other hand, if the call option is selling for RM2.00, then he should
consider buying them. In this way, he can pay a premium of RM2.00 and
when the price increase in value in the future, he could sell them at a higher
price, making a profit on the difference.
ACTIVITY 6.6
1.
A put option expires in 6 months with an exercise price of $65
selling for $2.03. The stock is currently priced at $67, and the riskfree rate is 4.9% per year, compounded continuously. Calculate
the price of a call option with the same exercise price.
2.
A put option and a call option with an exercise price of $7.20 have
3 months expiration date. They are selling for $0.29 and $0.62
respectively. What is current price of the stock if the risk-free rate
is 4.2% per year compounded continuously?
3.
Use the BS model to find the value of a call option on the
following share:
Time to maturity
= 6 months
Standard deviation = 50% per year
Exercise price
= RM5.00
Share price
= RM5.30
Interest rate
= 10%
Copyright © Open University Malaysia (OUM)
TOPIC 6
6.4
OPTIONS AND CORPORATE FINANCE

139
STOCKS AND BONDS OPTIONS
In this subtopic, we will examine how stocks and bonds can be treated as options
of a company. We will begin by discussing the firm (or company) value as a call
option and then later explain how it can be viewed as a put option.
(a)
Firm Value from the Call Option Perspective
(i)
Stockholders
A levered equity can be classified as a call option. The assets of the
firm are the underlying asset and the exercise price is the amount
invested (buy) which is the payoff of the bond. In this situation, we
consider the bondholders as the owner of the firm and the
stockholders have a call option on the firm with an exercise price.
We will use the following scenario to have clearer explanation.
Assume that the value of the firm is $750 and that when the bond
matures, the firm value exceeds the bond value, say $1000. To the
shareholders, the option is ITM and therefore they will exercise the
option, that is, they will buy the firm and payoff the bondholders.
Thus, their net cash flows are:
Net Cash Flows
= FirmÊs Cash Flow ă Exercise Price
= 1000 ă 750
= 250
Then again, if the firmÊs cash flows are below the exercise price, then
stockholders will not exercise the option and the bondholders would
get the entire cash flow, that is, $750.
(ii)
Bondholders
As for the bondholders, we can view them as the owner of the firm
and the writer of the call option with the exercise of $750 (principal
and interest amount). If the value of the firm (firmÊs cash flows) is
below the exercise price ($750), the bondholders get $750 and keep the
firm. Conversely, if the option is ITM, that is the value of the firm is
greater than the exercise price, the bondholders have to sell the firm
and receive $750.
Let us now illustrate how the value of equity, value of debt and interest rate
on debt are calculated if the equity is viewed as call option.
Copyright © Open University Malaysia (OUM)
140  TOPIC 6 OPTIONS AND CORPORATE FINANCE
Example 3:
Company XYZÊs assets are currently worth $1,020. In a yearÊs time, the
assets will be worth either $1,000 or $1,250. The company has an
outstanding debt with a face value of $1,000. It can invest at a risk-free rate
of 5%.
Remember when treating equity as call option, the value of debt is the
exercise price (X), while the current value of the asset is S 0 and C 0 and
represents the value of the equity. Using the formula, the value of the
equity is:
S 0  C 0 
X
1020  1C 0 
1000
1  r t
 S  S d   1250  1000   1
 u
 250  0 
C u  C d 
1  5% 1
C 0  1020  952.38  $67.62
Hence the value of the equity is $67.62. Since the value of the assets is the
same as value of debt and value of equity, to solve for the value of debt:
Value of Debt = Value of Assets ăîValue of Equity
Value of Debt = $1020 ăî$67.62 = $952.38
Now since the value of the debt is $952.38 and its face value is $1000,
therefore the interest rate is:
 Face Value  
  1
 Value of Debt  
R  
 $1000 

1
 $952.38 
 5.0%
The interest rate is similar to the risk-free rate indicating that the debt has
the same risk as those of risk-free rate instruments.
Copyright © Open University Malaysia (OUM)
TOPIC 6
(b)
OPTIONS AND CORPORATE FINANCE

141
Firm Value from the Put Option Perspective
Can we also view the value of the firm as the put option? Yes, we can.
(i)
Stockholders
As a put option, stockholders are considered as owners of the firm
and they owe the bondholders both the principal and interest amount.
In addition, they also own a put option on the firm with an exercise
price. If the cash flows of a firm are less than $750, then the put option
is ITM. Hence the stockholders sell the firm to the bondholders and
since they owe the bondholders an amount of $750, therefore the debt
is cancelled out. In sum, the stockholders have nothing if the cash
flow is less than the exercise price.
What happens if the cash flow is more than the value of the firm
($750)? Since we know that X > firm value, the put option is now outof-the money (OTM). Stockholders are not going to exercise their
option and therefore will get to retain the firm. But in this case, the
stockholders will need to pay the bondholders $750 for the amount
owed to them.
(ii)
Bondholders
Based on the put option perspective, the bondholders will write a put
option on the firm to the stockholders who owe the bondholders the
principal and interest amount. Thus, using the earlier, if the firm
value is less than $750, the stockholders will find the option to be ITM
and exercise their option rights. Bondholders are obligated to pay
$750 for the firm. Since stockholders owe the bondholders the same
amount, the two obligations are offset against each other.
In contrast if the value of the firm is more than the exercise price of
$750, the stockholders will do nothing and bondholders will receive
$750 due to them. This relationship can simply be expressed as
follows:
Value of Risky Bond = Value of Riskless Bond ă Value of Put Option
In sum, when viewing the stock and bond as options, we can equate
this relationship with the relationship of the Put-call Parity as
explained in the option pricing section, which is:
C0  S0  P 
X
 1  rf t
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142  TOPIC 6 OPTIONS AND CORPORATE FINANCE

Option is a contract that allows the buyer of the contract (holder) the right,
but not the obligation, to sell (put) or buy (call) from the seller of the contract
the contracted assets at a predetermined price.

Buyer or holder of the option contract exercises the contract if it is in-the
money (ITM).

Buyer of the optionÊs profit is unlimited while seller of the option has limited
profit.

Buyer and the seller of the option enter into the contract based on their
expectation of the market direction.

Put-call Parity Theorem, Binomial Model and Black Scholes Model are used
to price option premium.
At-the-money (ATM)
Organised exchange
Call options
Out-of-the money (OTM)
Contract size
Over-the-counter (OTC) market
Derivatives
Put options
Exercise price
Settlement price
In-the-money (ITM)
Standardised contract
Intrinsic value
Time value
Options
Copyright © Open University Malaysia (OUM)
TOPIC 6
OPTIONS AND CORPORATE FINANCE

143
Ali, R., Ahmad, N., & Ho, S. F. (2012). Introduction to Malaysian derivatives
market (4th ed.). Shah Alam, Malaysia: UiTM Press.
Black, F., & Scholes, Myron. (1973). The pricing of options and corporate
liabilities. Journal of Political Economy, 81(3), 637ă654.
Bursa Malaysia. (2012). FTSE Bursa Malaysia KLCI options (OKLI) contract
specification. Retrieved from
http://bursa.listedcompany.com/newsroom/Media_Release_20120522.pdf
Damodaran, A. (2001). Corporate finance: Theory and practice (2nd ed.).
New York, NY: John Wiley & Sons.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance
(14th ed.).Boston, MA: Pearson.
Parrino, R., & Kidwell, M. (2011). Fundamental of corporate finance (2nd ed.).
Hoboken, NJ: John Wiley & Sons.
Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2011). Core principles
and applications of corporate finance (3rd ed.). New York, NY: McGrawHill Irwin.
Ross, S. A., Westerfield, R. W., Jordan, B. D., Lim, J., & Tan, R. (2016).
Fundamentals of corporate finance (Asia Global Edition, 2nd ed.).
New York, NY: McGraw-Hill Irwin.
Copyright © Open University Malaysia (OUM)
Topic  Warrants and
7
Convertible
Bonds
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Define warrants;
2.
Distinguish between warrants and call options;
3.
Discuss the valuation of warrants;
4.
Describe convertible bonds and its valuation; and
5.
Explain the reasons for the issuing of warrants and convertible
bonds.
 INTRODUCTION
This topic discusses warrants and convertible bonds, which are, varieties of
hybrid securities. We will examine the difference between warrants and call
options and how warrants are priced. Next, we will look at convertible bonds
and explain how convertible bonds are valued. Last, but not least, we will
explain why warrants and convertible bonds are issued.
Copyright © Open University Malaysia (OUM)
TOPIC 7
7.1
WARRANTS AND CONVERTIBLE BONDS

145
WARRANTS
A warrant is a derivative instrument that provides the buyer an option to buy a
specific number of shares of a company for a given period of time at a certain
price (Fabozzi, 1999). A warrant is similar to taking a long call position.
Normally, companies issue warrants as a package deal which are attached to the
debt issuance. In Malaysia, a warrant is also referred to as Transferable
Subscription Rights (TSRs). Warrants are detachable from the security instrument
that it is attached to and, therefore, the holder can sell the warrant separately
(Jones, 2000).
Features of a Warrant
A warrant has several features. These features will be explained using the
following example:
Example 1:
Sparkling Diamond Company has warrants that allow the purchase of 5 shares of
its outstanding common stock at $50 per share. The common stock price per
share and the market value of the warrants, related to the stock price, are $58 and
$48 respectively. The warrant will expire in 3 monthsÊ time.
(a)
Exercise Price
This is the price at which the buyer of the warrant can purchase the new
shares from the company. The exercise price of the warrant is usually
higher than the market price of the common stock when it is issued, that is,
10 to 20% higher (Gitman & Zutter, 2015). The holder of the warrant will
exercise the rights if the current market price of the shares is above the
exercise price. For the above example the exercise price is $50 per share.
(b)
Conversion Ratio
It is the number of warrants needed to purchase one new share at a specific
exercise price. As for Sparkling Diamond CompanyÊs warrants, the
conversion ratio is 5 shares of common stock for each warrant.
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146  TOPIC 7 WARRANTS AND CONVERTIBLE BONDS
(c)
Maturity Period
All warrants have expiry dates. If the holder of the warrant fails to exercise
the warrant within the stipulated time period, then the warrants will expire.
The maturity period of Sparkling Diamond Company is 3 monthsÊ time
from the date when the warrants were issued.
ACTIVITY 7.1
AAA CompanyÊs common stock is selling for $45 per share. Its warrants
to buy three shares of common stock at $40 per share are selling for $20.
Determine the conversion ratio of the warrant. What is the exercise
price of the warrant?
SELF-CHECK 7.1
Explain the features of the warrant.
7.2
DIFFERENCES BETWEEN WARRANTS AND
CALL OPTIONS
As mentioned earlier, warrants and call options are similar because they allow
the holder the right to exercise when the warrants or call options are ITM
(Gitman & Zutter, 2015). Both have exercise prices and maturity dates.
Although warrants are similar to call options, there are differences between these
two types of hybrid securities. Table 7.1 displays the differences between
warrants and call options.
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WARRANTS AND CONVERTIBLE BONDS
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147
Table 7.1: Differences between Warrants and Call Options
Features
Warrants
Call Options
Time to
Maturity
Longer maturity date, usually
between 3 months and 15 years.
Shorter maturity date.
Type
Only call warrant, that allows
the holder to buy certain number
of shares.
Two types of options: call and put.
So, trader can both buy and write
the options.
Issuer
Issued by the company of the
underlying stock.
Usually issued by exchange.
Capital
Structure
Capital structure of the company
changes when warrants are
exercised.
No effect on the capital structure
of the company when it is exercise
since it is not the company that
issues options.
Standardised
Contract
Contracts are customised and
not standardised.
Option contracts are standardised.
ACTIVITY 7.2
Determine the types of warrants being traded in Bursa Malaysia.
SELF-CHECK 7.2
Discuss the similarities and differences between warrants and options.
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148  TOPIC 7 WARRANTS AND CONVERTIBLE BONDS
7.3
WARRANT PRICING
A warrant has market and theoretical value. The market value of a warrant is the
current price of the warrant currently being traded in the market. Usually this
value exceeds the theoretical value of the warrant. The theoretical value of a
warrant refers to the value of the warrant that would be sold in the market
(Jones, 2000). The theoretical value of a warrant can be mathematically expressed
as:
WTV   S 0  X   NS
Where,
WTV = Theoretical value of the warrant
S0
= Current market price of a share
X
= Exercise price of the warrant
NS
= Conversion ratio
When the market value of warrants (WMV) exceed the theoretical value of the
warrants (WTV), then this is known as a warrant premium (Jones, 2000). This
usually occurs because of the positive expectation that the investor has on the
warrants as well as the leverage provided when trading in warrants relative to
buying the common stock.
Warrant Premium = WMV ă WTV
Continuing with Example 1, the theoretical value of a warrant is therefore:
WTV = (S 0 ă X)  NS = ($58 ă $50)  5 = $40
Therefore the warrant premium is:
Warrant Premium = WMV ă WTV = $48 ă $40 = $8
Notice warrantsÊ prices fluctuate between a minimum and maximum value.
What is the minimum value of a warrant? Just like a call option, if the current
market price of the common stock is below the exercise price of a warrant, then
the minimum value of a warrant is zero.
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TOPIC 7
WARRANTS AND CONVERTIBLE BONDS

149
If Minimum Value of a Warrant = S 0 < X, then, Minimum value of a warrant is
equal to 0
However, if the current market price of the common stock is above the exercise
price of a warrant, the maximum value of the warrant will be the difference
between the current market price and the exercise price times the conversion
ratio (Gitman & Zutter, 2015).
If Maximum Value of a Warrant = S 0 > X, then, (S 0 ă X )  NS
Based on Example 1, what would be the value of the warrant? Here, we will have
to compare the current market price of the share and the exercise price of the
warrant. Since the current market price of Sparkling Diamond ($58) exceeds the
warrant exercise price ($50), therefore:
Maximum value of a warrant = ($58 ă $50) ï5 = $40
This is the actual theoretical value of the warrant.
What happens if the current market price is $45? In this case, the warrant has a
minimum value of zero since the current market price is lower than the warrant
exercise price ($45 < $50).
ACTIVITY 7.3
1.
LLM issued a warrant with an exercise price of $20.00 and
received a share of stock. Currently the price of the common share
is $25.50 and the price of the warrant is $8.30. What is the value of
the warrant? Calculate the warrant premium.
2.
AAA companyÊs common stock is currently selling for $45 per
share. Its warrants to buy three shares of common stock at $40 per
share are selling for $20. Determine the warrant theoretical value.
Is the warrant selling at premium? What happens if the AAAÊs
share is selling for $30 per share and the price of the warrant is
$5.00?
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150  TOPIC 7 WARRANTS AND CONVERTIBLE BONDS
SELF-CHECK 7.3
1.
Explain the minimum and maximum value of a warrant.
2.
What is the relationship between theoretical and market values of
a warrant?
3.
Discuss why warrant premiums exist.
7.4
CONVERTIBLE BONDS
Convertible bonds are a type of equity-derivative security that gives an option to
the investor to convert the bond into certain number of shares of common stock
(Jones, 2000). Generally, convertible bonds are cheaper relative to straight bonds.
It is categorised as a hybrid security since it has both the features of bonds and
common stock (Gitman & Zutter, 2015).
Convertible bonds have several features:
(a)
Conversion Ratio
This refers to the ratio that enables the convertible bonds to be changed for
certain number of shares. For example, let us assume that an investor has
an outstanding $1,000 par value bond that is convertible into 20 shares of
common stock, then, the conversion ratio is 20.
(b)
Conversion Price
This is the par value of the convertible bond divided by the conversion
ratio.
Conversion Price 
Par Value
Conversion Ratio
Continuing the previous example, the conversion price is:
Conversion Price 
$1000
 $50 per share
20
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TOPIC 7
(c)
WARRANTS AND CONVERTIBLE BONDS

151
Conversion Value
It is the value of the convertible bond based on the current market price of
the common stock. It can be expressed as:
Conversion Value = Conversion Ratio ïCurrent Market Price
Assuming further that the current market price for the common stock is $55
per share, the conversion value is:
Conversion Value = 20  $55 = $1100
Notice that since the conversion value ($1100) is higher than the par value
of the convertible bonds ($1000), therefore the investor should consider
converting the bonds into common stock.
(d)
Conversion Premium
This is the point where the market value exceeds the conversion value of
the convertible bonds. This is derived by subtracting the market price of the
convertible bond from the conversion value.
Conversion Premium = Market Price of Convertible ăîConversion Value
Using our example earlier and assuming further that the market value of
the bond is $990, the conversion premium is:
Conversion Premium = $990 ăî$1100 = $110
ACTIVITY 7.4
Based on the following table, calculate the conversion price and value of
the following convertible bonds.
Par Value
Conversion
Ratio
Conversion
Price
Market Price of
Stock per Share
1000
30
$50
800
20
$38
1000
40
$12
1000
100
$30
Conversion
Value
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152  TOPIC 7 WARRANTS AND CONVERTIBLE BONDS
7.5
VALUE OF CONVERTIBLE BONDS
Every convertible bond has a minimum (floor) value (Fabozzi, 1999). This
minimum value is either the value of the straight bond or its conversion value.
The value of the straight bond will be used as the minimum value of the
convertible bond if the current market price of the common stock is lower than
the conversion price (Gitman & Zutter, 2015).
To illustrate how the value of the convertible bond is determined via the straight
bond, the following example is used:
Example 2:
RJW Incorporated has an outstanding issue of convertible bonds with a $1,000
par value. The bonds are convertible into 40 shares of common stock. The bonds
have a 11% annual coupon interest rate and a 20 year maturity. The interest rate
on a straight bond of similar risk is 12%. The current market price of the common
stock is $20 per share.
To calculate the value of the convertible bond, you will need to use the discount
rate of the straight bond of similar risk, that is, 12%. Therefore the value of
convertible bond is:
Value of Convertible Bond = Coupon Payment (PVIFA12%,20) + PV (PVIF12%,20)
= (1000 ï11%) (7.4694) + 1000 (0.1037)
= 821.64 + 103.67 = $925.31
Next, we need to determine the conversion value, this would be:
Conversion Value = Conversion Ratio ïCurrent Market Price
= 40 ï$20 = $800
Now since the conversion value is less than the value of the convertible bond
($800 < $925.31), with the current market price of $20 per share, the convertible
bond would be sold for its straight value, that is, $925.31.
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TOPIC 7
WARRANTS AND CONVERTIBLE BONDS
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153
Now what would happen, if the current market price of the share is $30? In this
situation, the conversion value would be:
Conversion Value = 40  $30 = $1200
This means that the convertible bond is at a premium and, therefore, it is
expected to be sold at its conversion value, that is, $1200.
ACTIVITY 7.5
1.
Calculate the straight bond value for each convertible bond as
follows:
Convertible
Bond
Par
Value
Annual
Coupon
Interest Rate
Interest rate on
similar risk straight
bond
Years to
Maturity
K
1000
8%
10%
20
L
800
10%
12%
25
M
1000
12%
14%
15
N
1000
14%
16%
30
O
600
15%
17%
20
2.
XYZ Company has an outstanding issue of 20 year convertible
bonds with a $1,000 par value. These bonds are convertible into
50 shares of common stock. The bonds pay 11% annual coupon
interest rate. The interest rate on straight bonds with similar risk is
15%.
(a)
Calculate the straight bond value of the convertible bond.
(b)
What are the conversion ratio and conversion price of the
bond?
(c)
What is conversion value of the bond when the market price
is $15, $18, $20, $25 and $30 per share?
(d)
Based on the answer in part (c), what would be the expected
selling price of the convertible bonds?
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154  TOPIC 7 WARRANTS AND CONVERTIBLE BONDS
7.6
REASONS FOR ISSUING OF WARRANTS
AND CONVERTIBLE BONDS
Why do you think a company issues warrants and convertible bonds? Table 7.2
provides several reasons for warrants and convertible bonds to be issued.
Table 7.2: Reasons for Issuing Warrants and Convertible Bonds
Warrants
Convertible Bonds
It provides investor the cheapest way of
buying common shares.
It has a unique feature, that is, investor
can earn fixed income and an
opportunity to exchange for common
share when the price increases
It gives leverage opportunity where
investor can earn large gains (of course
large losses too) but small capital
investment.
It provides downside protection because
even though the share price declines, the
convertible bond price will not decline
below its straight bond value
Price of the warrant appreciates more
than common stock
It enables investor to benefit from the
increase in share price and the value of
the convertible bond is worth the
conversion price or more.
Like a convertible bond, it provides
downside protection where if the share
price declines then the investor does not
have to exercise the warrants and let the
warrant expire.
The yield of the convertible bond is
worth more than the common share.
It provides deferred equity financing.
Similarly, convertible bond is a form of
deferred equity financing.
SELF-CHECK 7.4
1.
How do you determine the value of convertible bond based on the
straight bond?
2.
The value of convertible bond can either be the value of the
straight bond or the conversion value. Discuss this statement.
3.
Explain the reasons for issuing of warrants and convertible bonds.
Copyright © Open University Malaysia (OUM)
TOPIC 7
WARRANTS AND CONVERTIBLE BONDS
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155

Warrants and convertible bonds are forms of hybrid securities.

Warrants are similar to stock rights.

The exercise price of a warrant is the price at which the buyer can buy a
certain number of common stocks.

The minimum value of a warrant is the difference between the market price
of common stock and exercise price of a warrant, or zero.

Convertible bonds are a type of equity-derivative security that gives an
option to the investor to convert the bond into certain number of shares of
common stock.

Minimum value of convertible bond is the conversion value or the value of
the straight bond.
Common shares
Market value of warrants
Conversion premium
Minimum value of a convertible bond
Conversion price
Minimum value of a warrant
Conversion ratio
Options
Conversion value
Straight bond
Convertible bonds
Theoretical value of warrants
Exercise price
Warrant premium
Hybrid securities
Warrants
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156  TOPIC 7 WARRANTS AND CONVERTIBLE BONDS
Fabozzi, F. J. (1999). Investment management (2nd ed.). Englewood Cliffs, NJ:
Prentice Hall.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
Jones, C. P. (2000). Investments: Analysis and management (7th ed.). New York,
NY: John Wiley & Sons.
Copyright © Open University Malaysia (OUM)
Topic  Leasing
8
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Describe the different types of leases;
2.
Differentiate between leveraged, sale-leaseback and tax-oriented
leases;
3.
Discuss the reasons for leasing;
4.
State the criteria for lease payments to be considered as tax shields;
and
5.
Evaluate the decision to lease or buy assets.
 INTRODUCTION
Leasing is another form of hybrid security, similar to convertible securities and
warrants. Under certain circumstances, companies prefer to lease instead of buy
assets. Lease involves a contract between a lessor and a lessee to let the lessee use
the asset at a stipulated period of time (lease period) in exchange for certain
series of payments (lease rentals) (Srivastava & Misra, 2008). The following is an
example of a leasing company in Japan venturing its business abroad.
Mitsubishi UFJ Lease and Finance Company Limited started its business in
April 1971 and is involved in the lease, instalment sales and financing
business. It was reported in Nikkei Asian Review on August 3, 2016 that the
company will join venture with Hitachi Capital to set up a leasing business in
Mexico in 2017. The business venture attempts to seize opportunity to
capitalise on MexicoÊs growing automotive industry.
Adapted from: Nikkei Asian Review (2016)
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158  TOPIC 8 LEASING
Figure 8.1: Relationship between lessor and lessee
Notice the distinct difference between leasing versus buying. As displayed in
Figure 8.1, leasing isolates the ownership of the asset from the usage of the assets.
The lessor owns but does not use the assets, while the lessee has no ownership on
the assets but uses the assets. In contrast, when we buy the assets, both the
ownership and usage of the assets belong to the buyer of the assets.
Before discussing the rationale for companies to lease instead of buy assets, we
will first explain in the next subtopic the types of leases available.
ACTIVITY 8.1
Can you identify companies in Malaysia that are into the leasing
business? Discuss the rationale for companies to lease from those
identified companies instead purchasing the assets.
8.1
TYPES OF LEASES
Generally, leases can be classified as operating leases and financial leases (see
Figure 8.2). These two types of leases will be further explained in the following
subtopics.
Figure 8.2: Types of leases
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TOPIC 8
8.1.1
LEASING

159
Operating Leases
An operating lease is a contractual agreement between lessor and lessee to allow
the lessee to use the assets for certain years in return for periodic payments to the
lessor. Typically the total payments over the lease term are below the initial cost
of the leased asset. Examples of industries that use operating leases are the
technology industry (computers), airline industry and transportation industry
(monorails).
The characteristics of operating leases include the following:
(a)
The lessee can cancel the contract but at a certain penalty price.
(b)
Assets under this type of leases have longer usable life than the term of the
lease.
(c)
Duration is shorter than the financial leases.
(d)
Once the leasing contract expires, the lessee has the choice either to
purchase the assets or renew the leasing contract with the lessor.
(e)
Assets price being sold to the lessee is usually less than the initial purchase
price paid by the lessor.
(f)
Insurance, taxes and maintenance are borne by the lessor.
8.1.2
Financial Leases
Financial leases or also known as capital leases have a longer duration relative to
operating leases. It involves the leasing of land, large pieces of equipment used in
the construction of offices, mining and buildings. This type of leasing is recorded
in the balance sheet of the company and assets value is depreciated over the
duration of the assets. Similar to debt financing, default in the periodic payments
can lead to the lessee being bankrupt.
The characteristics of financial leases are as follows:
(a)
The lessee cannot cancel the contract unless with a penalty.
(b)
Assets under this type of leases have longer usable life than the term of the
lease, that is, must be 75% or more of the economic life of the asset.
(c)
Duration is longer than the operating leases and the assets are fullyamortised.
(d)
Lessee can take ownership of the assets when the contract matures.
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160  TOPIC 8 LEASING
(e)
Lessee can buy the assets below the market price.
(f)
Insurance, taxes and maintenance are borne by the lessee.
There are several forms of financial leases. The most common forms of financial
leases are as shown in Figure 8.3.
Figure 8.3: Forms of financial leases
Table 8.1 explains further about the three common forms of financial leases.
Table 8.1: Descriptions of the Three Forms of Financial Leases
Forms
Leveraged Leases
Descriptions
• It involves one or more third-party lenders.
• Lessor buys the assets through borrowing on the non-recourse
basis.
• Usually lender has 80% equity on the cost of assets, while
lessor has the remaining balance.
• If lessor defaults payments, lender recovers the amount from
the lessee not the lessor.
• Leverage leases are tax-oriented.
Tax-oriented
Leases
• Lessee enters into this contractual agreement when he is not
able to have tax savings if he owns the assets.
• Lessor is the owner for the tax-purposes.
• Through the lessor, lessee can have lower lease payments
when lessor enjoys tax savings from owning the assets.
Sale-leaseback
• Here, the lessee sells the assets to the lessor and then leases it
back.
• In this situation lessee receives payment for selling the assets
and also proceed to use the assets for a fixed periodic
payments made to lessor.
• The reason for such arrangement is because lessee needs
capital to operate the business.
Copyright © Open University Malaysia (OUM)
TOPIC 8
8.1.3
LEASING
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161
Rationale for Leasing
By now, you may have guessed the reasons for company to lease instead of buy
the assets. We are going to list some of the reasons and let us see if those reasons
are similar with what you have:
(a)
Lessee is not tied with the assets that are only used for certain period of
time.
(b)
Leasing provides tax shields.
(c)
Leasing is cheaper than buying the asset.
(d)
Lessee faces less restriction when leasing relative to financing through debt.
ACTIVITY 8.2
Based on Activity 8.1, explain the types of leases that these companies
are involved in.
SELF-CHECK 8.1
1.
Explain what is leasing and why do companies prefer to lease.
2.
Explain the different types of leases and discuss how they are
different from each other?
3.
Distinguish between leveraged, sale-leaseback and tax-oriented
leases.
8.2
ACCOUNTING AND LEASING
Prior to November 1976, leasing activities were considered as off-balance-sheet
financing (Ross, Westerfield, Jordan, Lim & Tan, 2016). However, after the
introduction of Financial Accounting Standards No. 13 (FASB 13) in November
1976 and later the International Accounting Standard 17 (IAS 17) in 1982,
financial leases are required to be disclosed in the balance sheet.
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162  TOPIC 8 LEASING
Table 8.2 demonstrates how the buying, operating lease and financial lease of a
company will appear in the balance sheet statement.
Table 8.2: Treatment of Leasing on the Balance Sheet
A. Company Buys The Assets Through Debt
Tower cranes
250,000
Other assets
300,000
Total assets
$550000
Debt
250,000
Equity
300,000
Total debt and equity
$550,000
B. Company Uses Operating Lease
Tower cranes
0
Other assets
300,000
Total assets
$300000
Debt
0
Equity
300,000
Total debt and equity
$300,000
C. Company Uses Financing Lease
Tower cranes
250,000
Assets under financial lease
300,000
Total assets
550000
Debt
250,000
Equity
300,000
Total debt and equity
550,000
Copyright © Open University Malaysia (OUM)
TOPIC 8
LEASING
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163
As illustrated in Table 8.1, in case A, the company purchases the tower cranes
amounting to $250,000 through debt financing. In this situation, both the
borrowing and the assets bought are reported in the balance sheet.
As for case B, the company decided to finance the tower cranes using an
operating lease. Under the FASB 13 and IAS 17, the company does not have to
disclose the operating lease on the balance sheet but rather to footnote the
transaction. Thus, in case B, the balance sheet will not report the transaction
related to the tower cranes as well as the present value of the lease payments for
the tower cranes or the cost of the cranes (the liability).
However, in case C, since the company uses financial leasing for the tower
cranes, the accounting procedure is to report the tower cranes as assets and the
present value of the leases payments or the cost of the cranes as a liability on the
balance sheet statement. This is because financial leases must be „capitalised‰
(Ross et al., 2016). The present value payments of the lease are usually 90% of the
market value of the asset when the lease commences.
ACTIVITY 8.3
As a financial manager of Bigg Biz Corporation, you are asked by the
CEO to explain with examples how to report balance sheet transactions
of the equipment that the company intends to finance by:
(a)
Debt;
(b)
Operating lease; and
(c)
Financial lease.
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164  TOPIC 8 LEASING
8.3
TAXES AND LEASES
Lease payments are tax-deductible. As mentioned earlier, one of the reasons for
using a tax-oriented lease is to enjoy the tax benefits gained from leasing.
Nevertheless, the company will have this benefit if the assets being leased are for
business purposes.
For the tax authority, several criteria must be met before the lease payments are
considered to be tax shields:
(a)
Lease schedule payments must not be very high at the beginning of the
lease term and then lower payment towards the end of the lease term.
(b)
Lessor must be able to make profits before income taxes.
(c)
In the contract, the selling price of the asset at the end of the lease term
must not be lower than the market price at the end of the lease term to
avoid lessee having equity interest on the assets.
(d)
The lease term must be 80% of the economic life of the asset.
(e)
If the lessee decides to renew the contract, the lease payments must reflect
the market value when it is renewed.
SELF-CHECK 8.2
1.
Discuss why tax authorities are interested to know whether the
lease is either for business or non-business purposes.
2.
Explain the criteria to be met before the lease payments have tax
shields.
8.4
NPV ANALYSIS: LEASE VERSUS BUY
DECISION
How does a company make a decision either to buy or lease an asset? Well,
usually this decision requires the use of the capital budgeting method which we
have discussed in Topic 2. To begin with, we will use Example 1 to show step-bystep how the decision either to lease or buy the asset is made.
Copyright © Open University Malaysia (OUM)
TOPIC 8
LEASING
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165
Example 1:
Let us assume that Xcel Medical Laboratory Corporation is evaluating two
options:
Option 1: The 5-year life medical care health X-ray machine costs $150,000. The
machine is depreciated using MACRS method. The annual interest payment is
$39,570. The firm will pay $10,000 per year for the maintenance costs.
Option 2: The company can lease the medical care health X-ray machine under a
5 year payments of $38,000. Lessor will bear the maintenance costs of $10,000,
while the insurance and other costs are paid by the lessee. When the contract
matures lessee has the option to buy the machine at $30,000.
The tax rate is 35% and interest cost is 10%. Hence what would be the best
decision for the company? Should it take option 1 or option 2?
Now, let us look into the steps on how the decision either to lease or buy the
asset is made:
(a)
Step 1: Determine the after-tax cash outflows (CFO) and present value cash
outflows for each year under the lease option.
In this step, the annual lease payments will be adjusted for tax and also the
cost of buying the machine when lease term ended is included. Table 8.3
provides the calculation of the after-tax cash outflows for lease option.
Table 8.3: After-tax Cash Outflows for Lease Payment
A
B
C
D
E
F
End of the
Year
Lease
Payment
Tax @ 0.35
(B  0.35)
After-tax
CFO
(B ă C)
PVIF @ 7%
PV after-Tax
CFO
(D  E)
1
38,000.00
13,300.00
24,700.00
0.9390
23,192.49
2
38,000.00
13,300.00
24,700.00
0.8817
21,776.98
3
38,000.00
13,300.00
24,700.00
0.8278
20,447.87
4
38,000.00
13,300.00
24,700.00
0.7773
19,199.88
5
38,000.00
13,300.00
24,700.00
0.7299
18,028.06
30,000.00*
30,000.00
0.7299
21,896.43
Total PV CF
$124,541.71
5
*Cost of buying the machine at end of lease term
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166  TOPIC 8 LEASING
Once you have calculated the after-tax cash outflows of lease payment, the
next step is to discount the cash out flows using the after-tax cost of debt of
6.5%. The rate is obtained by multiplying the interest rate with (1 ă tax rate),
which is 10%  (1 ă 0.35%). Based on this calculation, the total present value
after-tax cash outflows for lease option is $124,541.71.
(b)
Step 2: Determine the after-tax cash outflows (CFO) and present value cash
outflows for each year under the buying option.
Under this buying option, company makes a loan to purchase the machine.
Before deriving the after-tax outflows of loan payment, the loan payment of
$39,570 must be adjusted for maintenance costs, depreciation and interest
costs and the tax shields. Table 8.4 provides the calculation for the principal
and interest payments of the loan.
Table 8.4: Calculation for Principal and Interest Payments for Loan
A
B
C
D
E
F
End of
the Year
Loan
Payments
Beginning of
Year Principal
(F)
Interest
(C  10%)
Principal
(B ă D)
End of Year
Principal
(C ă E)
0
0
0
0
0
150,000.00
1
39,570.00
150,000.00
15,000.00
24,570.00
125,430.00
2
39,570.00
125,430.00
12,543.00
27,027.00
98,403.00
3
39,570.00
98,403.00
9,840.30
29,729.70
68,673.30
4
39,570.00
68,673.30
6,867.33
32,702.67
35,970.63
5
39,570.00
35,970.63
3,597.06
35,972.94
ă2.31
Next we need to calculate the costs and tax shields involved for us to derive
the adjusted after-tax cash outflows for loan payments.
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TOPIC 8
LEASING
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
167
168  TOPIC 8 LEASING
Once the adjusted after-tax cash outflows are computed (refer to Table 8.5),
we can now discount the cash outflows to get the present value after tax
cash outflows of loan payments as shown in Table 8.6.
Table 8.6: Present Value after Tax Cash Outflows for Loan Payments
A
B
C
D
End of Year
After-tax CFO
PVIF @ 9%
PV after Tax CFO
(B ïC)
1
30,320.00
0.9390
28,469.48
2
24,879.95
0.8817
21,935.64
3
32,650.90
0.8278
27,030.01
4
37,366.43
0.7773
29,045.79
5
38,511.03
0.7299
28,108.46
TOTAL PV CFO
134,589.39
As presented in Table 8.6, the total present value cash outflows for loan
payments are $134.589.39. Since we have already calculated the present
value cash outflows for both lease and loan payments, we will proceed to
Step 3 to make the decision.
(c)
Step 3: Compare the present value of cash flows for lease payments and
loan payments and choose the lowest cost of financing
Since the present value of cash outflows for leasing ($124,541.71) is less than
the cost of buying ($134,589.39) the machine, therefore the lease option is
preferable (refer to Table 8.7). In fact, the lease option has resulted in the
company having incremental savings of $10,047.68.
Table 8.7: Comparison between PV Cash Outflows of Lease and Loan Payments
PV CFO
Difference
Lease Payments
Loan Payments
124,541.71
134,589.39
($10,047.68)
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TOPIC 8
LEASING

169
ACTIVITY 8.4
1.
Answer the following questions based on Example 1:
(a)
Calculate the after-tax cash outflows associated with each
option.
(b)
What are the present values of each cash outflows, using the
after-tax-cost of debt?
(c)
Is your decision similar with the decision made for Example
1? Why?
2.
Explain the difference between calculating the after-tax cash
outflows for leasing versus buying an asset.
3.
The following table presents the lease payments and terms of
three companies. Each company is in the 28% tax bracket and all
payments are made at the end of the year. Calculate the yearly
after-tax cash outflows for each company.
4.
Company
Annual Lease Payment
Term of Lease
D
100,000
15
N
72,000
12
A
65,000
10
ID Sonar Corporation needs to expand its business. To do so, the
company must buy a new research equipment costing $80,000.
The machine can be leased or bought. The after-tax cost of debt is
8%. The terms of the purchase and lease plan are:
Lease: The end of the year lease payments are $19,000 over the
5 years. All maintenance costs will be paid by the lessor; insurance
and other costs will be borne by the lessee. The lessee will exercise
its option to buy the equipment for $20,000 when the terms ended.
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170  TOPIC 8 LEASING
Purchase: The company will have to pay $80,000 if it decides to
buy the equipment. The purchase of the equipment will be finance
with a 5 year, 12% loan and the equal instalment payments are
$22,192.78. The equipment is depreciated using MACRS 5-year
recovery period. The company is required to pay $2,000 per year
for a service contract that includes all maintenance costs. The
equipment will be used by the company after its 5 year recovery
period.
Which alternative (lease or purchase) would you propose to the
company? Justify your answer.
•
Leasing is another form of hybrid security, besides convertible securities and
warrants.
•
There are two types of leasing: operating and financial leasing.
•
There are three types of financial leases; leveraged, sale-leaseback and taxoriented leases.
•
FASB 13 provides guidelines as to how financial leases are being treated in
the balance sheet.
•
Company can benefit from tax saving if the lease is meant for business
purposes.
•
The advantages and disadvantages of leasing versus buying should be
considered when making decision
•
A company can evaluate whether to lease or buy the asset by calculating the
after-tax cash outflows of both options.
Copyright © Open University Malaysia (OUM)
TOPIC 8
After-tax cash outflows
Leasing
FASB Statement No. 13
Loan payments
Financial leasing
Operating leasing
LEASING

171
Lease payments
(FASB). Statement of Financial
Accounting Standards No. 13 (FASB 13). Retrieved from
http://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=12182
20124481&acceptedDisclaimer=true
Financial
Accounting
Standards
Board
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
International Accounting Standards Committee. (1982). International Accounting
Standard 17 (IAS 17: Leases). Retrieved from
http://www.iasplus.com/en/standards/ias/ias17
Nikkei Asian Review. (2016, August 3). MUFG, Hitachi units plan leasing service
in Mexico. Retrieved from http://asia.nikkei.com/Japan-Update/MUFGHitachi-units-plan-leasing-service-in-Mexico
Ross, S. A., Westerfield, R. W., Jordan, B. D., Lim, J., & Tan, R. (2016).
Fundamentals of corporate finance (Asia Global Edition, 2nd ed.). New
York, NY: McGraw-Hill Irwin.
Srivastava, R., & Misra, A. (2008). Financial management. New Delhi, India:
Oxford University Press.
Continuing the previous example, the conversion price is:Next, we need to
determine the conversion value, this would be:
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Topic  Merger and
9
Acquisition
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Define mergers and acquisitions;
2.
Describe the different types of mergers and acquisitions;
3.
Differentiate between mergers and acquisitions; and
4.
Evaluate the benefits of a merger.
 INTRODUCTION
How many of you have come across such headlines either on the Internet or
newspaper related to Figures 9.1 and 9.2? Merger and acquisition exercises are
nothing new in the business world. In fact, mergers and acquisitions happen
globally.
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TOPIC 9
MERGER AND ACQUISITION

173
Figure 9.1: News headline related to mergers and acquisitions
Source: http://www.thestar.com.my/business/business-news/2016/01/23/mergersand-acquisitions/
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174  TOPIC 9 MERGER AND ACQUISITION
Figure 9.2: Headlines related to mergers and acquisitions on Financial Post
Source: http://business.financialpost.com/tag/mergers-and-acquisitions
Graham, Smart and Megginson (2010) defined a merger as a transaction where
two or more companies combine into a single entity. Acquisition is referred to as
the buying of additional resources by a company. This buying transaction can be
in the form of buying new assets, some of another companyÊs assets or perhaps
even the whole company. Note that acquisitions can also occur through buying
of shares of the target company. Normally companies have their own motives for
going through the merger and acquisition process. This topic examines the basic
forms of acquisitions, discusses whether acquisitions create synergy and where
this synergy can be obtained. In addition, the net present value (NPV) of a
merger is also explained. Table 9.1 explains the merger and acquisition methods.
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TOPIC 9
MERGER AND ACQUISITION

175
Table 9.1: Merger and Acquisition Methods
Merger
Acquisition via Stock
Acquisition via Assets
There must be
approval from at least
two-thirds of
shareholders for
merger to happen
There is no requirement for
shareholders to vote for or
against acquisition
It involves formal voting
from shareholders of the
selling firm
Merger results in full
acquisition of the
other company.
This involves only partial
overtake initial and perhaps
eventually complete merging
exercise
Acquisition through assets
may lead to transfer of titles
individual assets.
For merger to happen,
the acquired company
must have consent
from the target
company.
Sometimes the consent of the
target company is not
required.
This method does not result
in the target company to be
out of the „picture‰ and will
not exist if shareholders
decide to sell their shares.
In most instances, it is
a friendly merger.
Acquisition is usually hostile
where the acquired company
faced resistance by target
company.
Source: Ross, Westerfield, Jordan, Lim & Tan (2016)
Can you now see the differences between mergers and acquisitions? Good, now
we will move on to discuss the different forms of acquisitions.
ACTIVITY 9.1
Browse through the Internet and identify companies in Malaysia that
have gone through the merging and acquisition process for the past five
years.
(a)
Explain if it is a merger or acquisition through assets or cash.
(b)
Discuss whether those companies have emerged to be more
successful financially and strategically or otherwise.
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176  TOPIC 9 MERGER AND ACQUISITION
9.1
BASIC FORMS OF ACQUSITIONS
How does acquisition take place? There are three different forms of acquisitions
(see Figure 9.3).
Figure 9.3: Three forms of acquisitions
The three forms of acquisitions can be described as follows:
(a)
Horizontal Acquisition
Horizontal acquisition occurs within the same industry, for example, it
occurs when an automobile company X buys assets from another
automobile company Y.
(b)
Vertical Acquisition
This is when an acquiring company buys the target company which either
is the supplier for the company or the distributor for the company. For
instance KFC Holdings may acquire a poultry company that formerly
supply chickens for its fast food business.
(c)
Conglomerate Acquisition
This is an acquisition where the bidder company takeover the target
company that are not related to the business that the bidder company is
involved in.
In other situations, companies may decide to enter into a strategic alliance
without going through mergers or acquisitions. These companies simply work
together to benefit from each other competencies. Examples would be Fuji and
Xerox as well as Proton and Mitsubishi. However such alliances may end up
being either acquired or merged.
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TOPIC 9
9.1.1
MERGER AND ACQUISITION

177
Motives for Acquisition
A company engages in acquisition exercises for several reasons. These reasons
are:
(a)
To Gain Higher Revenue
When two companies merge as one entity, the revenues generated are more
than if both companies were independent companies. Greater revenue can
be realised through:
(i)
Strategic Advantage
Sometimes a company acquires another company because the target
company has valuable assets like trademarks, distribution systems,
brand loyalty and the like. Through acquisition, the bidder company
do not have to start from scratch.
(ii)
Market Power
Certain companies have market power advantage over its
competitors. When a company merges or acquires another company,
it is able to expand its market shares. This will improve its profit and
at the same time reduce competition.
(iii) Marketing Benefits
In this situation, acquisition occurs because the bidder finds that it is
weak in its marketing segment and has been losing sales due to this
weakness. Acquiring a target company that has those marketing
expertise could save the acquired company money and time.
(b)
Minimise Costs
A company may find it worthwhile to acquire another company, if the
acquisition exercise is able it to attain cost efficiency. Cost minimisation can
be achieved through:
(i)
Economies of Scale
For instance, a manufacturing company acquires a target company
that has well equipped warehouses. By sharing the facility, the
company is able to spread its overhead costs.
(ii)
Complementary Resources
Ross, Westerfield, Jaffe and Jordan (2011) pointed out that a company
can gain through acquisition when the target company can
complement the resource or capability that the acquired company
may be lacking.
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178  TOPIC 9 MERGER AND ACQUISITION
(c)
Lower Taxes
Another motive for company to acquire another company is due to tax
gains. This can be possible through the use of tax losses, unused debt
capacity, surplus funds and through assets depreciation (Ross et al., 2016).
9.1.2
Friendly versus Hostile Takeovers
Sometime mergers and acquisitions take place without the consent of the target
companies. This is known as hostile takeovers (Ross et al., 2011). This usually
gets messy with the management of the target company resisting the takeover
and trying to influence the shareholders not to accept the takeover exercise.
In other cases, it could result in prolonged court cases. The various techniques
used by resisting target company is to amend the corporate charters and make it
difficult for the acquiring company to takeover. Another way is for the
management of target company to try to force the acquiring company to enter
into an agreement that limits its control in the target company. This is referred to
as standstill agreement (Gitman & Zutter, 2015).
ACTIVITY 9.2
1.
Based on Activity 9.1, explain the forms of acquisitions that are
involved by those identified companies and discuss the motives
for going through such methods.
2.
Your friend argued that the term merger and acquisition can be
used interchangeably. Do you agree with him? Why or why not?
SELF-CHECK 9.1
1.
Discuss the different form of acquisitions.
2.
Explain why companies decide to go for mergers and acquisitions.
3.
What are some techniques used by management of a target
company to avoid being acquired?
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TOPIC 9
9.2
MERGER AND ACQUISITION
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179
SYNERGY
How does a merger create synergy? For us to determine if a particular merger
creates synergy, we need to find out the relevant incremental cash flows (Ross
et al., 2011). We will use Example 1 to illustrate how synergy is generated from
acquisition.
Example 1:
Assume that X Inc. is considering acquiring Y Company.
Let us say the value of X Inc. is VX, while the value of Y Company is VY. Now,
the merger is worthwhile if the value of the merging company is greater than the
value of each company, that is:
VXY > VX + VY
Thus, the incremental value is:
V = VXY ă (VX + VY)
A positive V leads to the creation of synergy as a result of merger. In short, if
the merger takes place, Opal Inc. will receive the value of Emerald Company
worth (WVY):
WVY = V + VY
Now, using Example 1, let us compute the value of synergy attained through the
merger.
We further assume that both these companies are all-equity companies with after
tax cash flows of $300 per year. After the merger, the merged firm has an after tax
cash flow of $675 per year. Both have an overall cost of capital of 15%.
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Now, let us analyse Example 1 further by answering the following questions:
(a)
Does the Merger Generate Synergy?
Plugging the figures given before:
V XY V X VY
 $300   $300 


 0.15   0.15 
V X VY  
 $2, 000  $2, 000  $4, 000
V XY 
$675
 $4, 500
0.15
Hence, this merger has created synergy, since VXY > VX + VY.
(b)
What is the Incremental Net Gain?
V = VXY ă (VX + VY)
Putting the figures,
V = $4,500 ă ($4,000) = $500
Based on the above calculation, the incremental net gain from the merger is
$500.
(c)
What is the Value of Y Company to X Inc.?
WVY = V + VY
= $500 + $2000 = $2500
The value of Y Company to X Inc. is $2,500.
The sources of synergy gain from acquisitions are operational, managerial and
financial synergy. Operational synergy arises from the economies of scale and
resource complementaries. On the other hand, managerial synergy is the result of
capitalising on the strengths and expertise of management teams (Graham et al.,
2010.
SELF-CHECK 9.2
Explain how synergy is created through mergers.
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MERGER AND ACQUISITION
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ACTIVITY 9.3
Opal Inc. wishes to acquire Diamond Inc. The after cash flow of the
respective company is $100 per year for Opal and $120 per year
Diamond. The cash flow is for infinity. Both have cost of capital of 10%.
The value of merger is $320 per year.
(a)
What is the value of each company?
(b)
What is the incremental net gain?
(c)
Is synergy generated from the merger? Why?
(d)
What is the value of Diamond to Opal Inc.?
9.3
THE NET PRESENT VALUE OF A MERGER
It is found that mergers and acquisitions happen mostly during financial and
economic downturns since the target companies are usually in financial distress
and have lower market value (Gitman & Zutter, 2015). As a consequence,
acquiring companies have higher net present values (NPVs). To clearly
demonstrate how this could happen, let us use Example 2.
Example 2:
Consider that an acquiring firm, G is about to acquire a target firm, K. Table
below provides the premerger information of both companies. For now, we will
assume that these firms are all equity based.
Table 9.2: Premerger Information of Companies G and K
Firm
G
(Acquiring Firm)
K
(Target Firm)
Shares outstanding
350 shares
150 shares
$30
$20
Price per share
Acquisition via cash
Synergy value
$22 per share
$6000
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Calculating the Net Present Value (NPV) of Merger
Now, the NPV of the merger is the difference between the synergy of the merger
and the premium paid to the target firm (Ross et al., 2016), that is:
NPV = V ă Premium
Where, premium is derived as the sum paid to the target firm over and above
before the merger, that is:
Premium = Amount paid to target firm Value of target firm
Putting the formula together, the NPV of the merger is:
NPV = V ă Premium
= VGK ă (VG + VK) ă (Amount paid to G ă VK)
= îVGK ă VG ă Amount paid to G
Earlier, we did mention that acquisitions can be done through cash or stock. First,
we will learn how to calculate the NPV of the merger if it is a cash acquisition,
than if it is a stock acquisition.
(a)
Cash Acquisition
(i)
NPV of the Merger
NPV = V ă Premium
= $6000 ă [($(22 ă 10) ï(150)]
= $6000 ă $1800 = $4,200
Thus, the acquisition is considered to be profitable.
(ii)
Price Per Share of the Merger = VGK/No of Shares
VGK = VG ă NPV of Merger
= $30(350) ăî$4,200 = $6,300
Price per share =
$6, 300
= $18 per share
350
Note that cash acquisition will result in target firm, K receiving cash
for its stock and has no part in the company G.
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TOPIC 9
(b)
MERGER AND ACQUISITION
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183
Stock Acquisition
When it involves stock acquisition, the target firmÊs shareholders will be the
new shareholders of the merged firm. Thus, the value of the merged firm is:
(i)
What is the Value of the Merged Firm?
VXY = VX + VY + V
= 350($30) + 150($10) + 6,000
= $10,500 + $1,500 + $6,000 = $18,000
(ii)
What then would be the Shares Given to the Target Firm and the
Total Share Price of the Merged Firm?
The following formula can be used to calculate it:
Shares given to Target Firm 

V
Price per Share of Acquiring Firm
$6, 000
$30
 200 shares
Total Post Merger Shares = 350 + 200 = 550 shares
Post-merger share price 

V XY
Total Post Merger Shares
$18, 000
$50
 $33.00
(iii) How much does Acquiring Firm have to Pay to the Target Firm?
Amount Paid to Target Firm 

New Shares
V XY
Total Post Merger Shares
200
 $18, 000  $6, 545.45
550
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184  TOPIC 9 MERGER AND ACQUISITION
(iv) What is the Merger Premium?
Merger Premium = Amount Paid to Target Firm ăîVY
= $6,545.45 ă (150  $10) = $5,045
(v)
What is the NPV of the Merger?
NPV = Vîă Premium = $6,000 ăî$5,045 = $955
Notice, firm X has initially 350 shares worth $30 per share. With the merger,
the NPV is $955. This indicates that the value of each share has increased by
approximately $3 ($955/350 shares). This has been shown through the
calculation of the post-merger share price.
Does it matters if it is a cash acquisition or a stock acquisition? Ross et al.
(2016) argued that there is a difference between the two. Table 9.3 explains
how sharing gains, control and taxes are affected if it is a cash acquisition or
a stock acquisition.
Table 9.3: Differences between Cash Acquisition and Stock Acquisition
Features
Cash Acquisition
Stock Acquisition
Sharing the
benefits of
acquisition
gains
Shareholders of the acquiring
company do not have to
share acquisition gains since no
exchange of shares are involved.
Cost is higher since
shareholders of the acquiring
company must share the gains
benefitted from acquisition with
the target company.
Control
No control issue arises on the
acquiring company
Involves control of the merged
company since the shareholders
of the target company hold the
shares of the merger company
and has the voting rights
Taxes
Since acquisition is paid using
cash, therefore the transaction is
taxable.
On the other hand, acquisition
using stocks is tax-free.
SELF-CHECK 9.3
Discuss how the calculation of NPV of a merger would differ if it is cash
acquisition and stock acquisition.
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ACTIVITY 9.4
Company K is acquiring company M. The information for all-equity
companies are given in the following table.
Firm
K
M
Shares outstanding
3000
1500
Price per share
$30
$20
Acquisition via cash
$22.00
Synergy value
$8,000
(a)
If company K decides to acquire company M using cash, do you
think that the acquisition is worthwhile? Why?
(b)
What is the NPV of the merged company if the acquisition is
through stock?
9.4
DUBIOUS REASONS FOR MERGERS AND
ACQUISITIONS
There are instances where you may realise that the mergers and acquisitions that
occur among companies appear to be dubious. Some of the dubious reasons for
mergers and acquisitions are:
(a)
Earnings per Share (EPS)
Earnings per share (EPS) of a merged firm can appear to grow once
acquisition exercise has taken place. However, in actual fact, this is not
necessarily true. Whether the EPS grows, or not, will largely depend on the
ratio of exchange and the EPS before merger of respective companies.
Gitman and Zutter (2015) summarise the effect of price earnings ratio (PER)
with EPS after merger takes place (refer to Table 9.4).
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186  TOPIC 9 MERGER AND ACQUISITION
Table 9.4: Effects of PER with EPS after Merger
Relationship between PER paid and
PER of Acquiring Company
Effect on EPS
Acquiring
Company
Target Company
If PER paid greater than PER of
acquiring company
Decreases
Increases
If PER paid is equals to PER of
acquiring company
No changes
No changes
If PER paid less than PER of acquiring
company
Increases
Decreases
Source: Gitman & Zutter (2015)
(b)
Diversification
In other situations, the company may decide to acquire other company
simply because it wants to diversify. But diversification, as argued by Ross
et al. (2016), does not enhance the value of the merged firm. For example, if
company A decides to merge with company B, then the shareholders who
own stocks of both companies have already diversified their investment
portfolio. Furthermore, apart from investing in these two stocks, investors
can also buy other stocks of different companies to diversify their risks and
therefore the merging of two companies has no effect.
SELF-CHECK 9.4
Explain the reasons why some merger or acquisition exercises are
considered to be dubious.
ACTIVITY 9.5
Your friend explains that there are no differences if acquisition is via
cash or stock. Do you agree with your friend? Explain.
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TOPIC 9
MERGER AND ACQUISITION
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187
•
From time to time, a company may merge with or acquire another company.
•
Mergers and acquisitions can either be horizontal, vertical or conglomerate.
•
Company can acquire another company using cash or stocks acquisition.
•
A decision to go ahead with the merger will depend on whether it creates
positive synergy, or not.

There are differences between acquisitions using cash and stock in terms of
sharing gains, control and taxes.
Acquisition
Net present value (NPV)
Cash acquisition
Stock acquisition
Conglomerate acquisition
Synergy
Horizontal acquisition
Vertical acquisition
Mergers
Graham, J., Smart, S., & Megginson, B. (2010). Corporate finance: Linking theory to
what companies do (3rd ed.). Mason, OH: South-Western Cengage Learning.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
Ross, S. A., Westerfield, R. W., Jordan, B. D., Lim, J., & Tan, R. (2016).
Fundamentals of corporate finance (Asia Global Edition, 2nd ed.). New York,
NY: McGraw-Hill Irwin.
Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2011). Core principles
and applications of corporate finance (3rd ed.). New York, NY: McGraw-Hill
Irwin.
Copyright © Open University Malaysia (OUM)
Topic  International
10
Corporate
Finance
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Define the terms foreign exchange markets and rates;
2.
Calculate the exchange rates between two currencies;
3.
Identify the different currencies with forward rates;
4.
Describe the purchasing power parity theory;
5.
Discuss the relationship between spot rates, interest rates, inflation
rates, forward rates and future spot rates; and
6.
Explain the covered interest arbitrage.
 INTRODUCTION
Corporate finance becomes more intricate when companies expand their
businesses abroad. These companies are not only subjected to the local business
rules and regulations but also foreign business rules and regulation, the volatility
of foreign exchange rates, different tax structure, political risk and culture
differences that could influence their corporate finance decision at international
level.
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INTERNATIONAL CORPORATE FINANCE
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The following are stories of foreign business deals that went sour due to
problems encountered when doing business abroad due factors mentioned
previously.
Stories of Multinational Companies Business Deals
Abroad that have Financial Implications
In 2008, MaxisÊs joint-venture with Indonesia counterpart, Lippo Group into a
pay-TV business failed and was caught in a bitter legal battle.
In 2016, Ford Motor Company announced that it has to cease business
operations in Indonesia and Japan due to intense competition with other
automotive companies and saw their market share shrinking.
An Iranian razor manufacturer faced huge sales losses in Qatar when the
company did not realise that the brand name „Tiz‰ which in Persian language
means „sharp‰ has different meaning in Arabic language. „Tiz‰ was an Arabic
slang for „buttocks‰ and when the Iranian company aggressively launched the
products, it offended the Arabic speaking Qatarians.
In mid-2015, due to surpluses of oil supply, oil and gas companies globally
were badly affected when the oil prices plummeted from USD109.45 per barrel
in 2012 to the lowest of USD49.49 per barrel in 2015. As a result oil producing
countries like Venezuela, Kuwait faced sharp depreciation of their currencies
relative to the other foreign currencies and affected the countriesÊ economy.
Figure 10.1 presents the currency trend of the Malaysian ringgit against the US
dollar from 2006 to 2016. As at 30 August 2016, the Malaysian ringgit was 4.08765
against the US dollar. The Malaysian ringgit depreciated to an all-time low of
MYR4.71 in January of 1998 when it was badly hit by the currency crisis in 1997.
This led the Malaysian government to take the initiative to peg the Malaysian
ringgit to MYR3.800 against the US dollar. Although not as severe as the 1997
crisis, the country once again faced another currency crisis when the crude oil
prices declined sharply in 2015 which led to the depreciation of Malaysian ringgit
of MYR4.40 per USD.
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190  TOPIC 10 INTERNATIONAL CORPORATE FINANCE
Figure 10.1: Malaysian ringgit against USD from 2006 until 2016
Source: http://www.tradingeconomics.com/malaysia/currency
What are the implications to corporations when they encounter such business
events abroad especially when it relates to foreign currency? In this topic, we will
examine the use of foreign exchange markets as a platform for doing business
internationally as well as how the foreign exchange rates are quoted and affect
business transaction. In addition, this topic discusses the theories used to
determine exchange rate.
ACTIVITY 10.1
Form a group of five and discuss the severity of the 1997 Currency
Crisis, 2008 World Economic Crisis and 2015 Oil Crisis and how these
crises affect the foreign exchange markets.
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TOPIC 10
10.1
INTERNATIONAL CORPORATE FINANCE
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191
FOREIGN EXCHANGE MARKETS AND
RATES
Did you know that the foreign exchange market (FOREX) is the largest financial
market in the world that operates 24 hours a day, 365 days a year? In January,
2015, the daily foreign exchange volumes were USD5.3 trillion. The foreign
exchange market (FOREX) enables market participants to transfer purchasing
power denominated in one currency to another, that is, to exchange one specific
currency for another specific currency.
Foreign exchange transactions are done over-the-counter (OTC) and do not have
designated exchange market where buyers and sellers of foreign currency meet
(Eiteman, Stonehill & Moffett, 2013). Rather, the FOREX market is a worldwide
linkage of bank currency traders, non-bank dealers and FOREX market brokers
who assist in trades connected with one another via a network of telephones,
telex machines, computer terminals and automated dealing systems. The largest
vendors for quote screen monitors used in trading currencies are Reuters,
Telerate and Bloomberg.
10.1.1
FOREX Market Participants
The FOREX market is a two-tier market made up of wholesale or interbank
market and the retail or client market. FOREX market participants fall under five
categories as shown in Figure 10.2.
Figure 10.2: Five categories of FOREX market participants
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192  TOPIC 10 INTERNATIONAL CORPORATE FINANCE
Now, let us read more about these categories of FOREX market participants:
(a)
International banks are the major participants of the FOREX market.
Approximately, more than 700 banks worldwide are actively involved in
foreign exchange transactions, willingly buying or selling foreign currency
for their own accounts. These international banks serve their retail clients,
the bank customers.
(b)
Bank customers namely multinational companies (MNCs), money market
managers and private speculators or arbitrageurs trade in this market for
their normal international business transaction or international investment
in financial assets.
(c)
Non-bank dealers are employees of large non-bank financial institutions
who trade directly in the interbank market for their foreign exchange needs
in their own dealing rooms at the firmÊs premise.
(d)
FOREX brokers or dealers are involved in the FOREX market on behalf of
their customers for a fee.
(e)
Central banks are also major players in the FOREX market by selling or
buying currencies in an attempt to influence the price of currencies.
Basically the foreign exchange markets are divided into spot market and forward
market. Let us now discuss these two markets.
10.1.2
Spot Foreign Exchange Market
The spot market is where foreign currencies are traded for immediate delivery.
Usually, it takes two business days for the transaction to complete. Spot bid rates
or spot ask rates are quoted between the customer and the bank when trading
takes place in the spot foreign exchange market (Parrino & Kidwell, 2011). If you
buy foreign currency from the bank or money changer, then the spot ask rate is
quoted. On the other hand, if you sell foreign currency then the bank will quote
you the spot bid rate.
Bid-Ask Spread
Banks normally give currency quotations in pairs because a dealer usually does
not know whether a prospective customer is in the market to buy or sell a foreign
currency. The first rate is the buy or bid price and the second is the sell or ask or
offer price. Bid price is the price that banks are willing to buy and the ask price is
the price that banks are willing to sell (Gitman & Zutter, 2015).
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193
Now assume that you are given the following spot market quotation. How do
you interpret the quotation?
Spot Price: MYR4.0835 / 4.0885
Spot Price: 35 ă 85
The quotation above is an outright quotation where the bid and ask price of
Malaysian ringgit (MYR) against US dollar (USD) are stated in full. The quotation
amount, MYR4.0835 is the bid price (per USD) while MYR4.0885 is the ask price.
In reality, currency dealers do not quote the full rate to each other. Instead, they
quote only the last two digits of the decimal which is known as the small figure.
Thus in our example, the US dollar would be quoted at 35 ăî85 as shown in the
second row of the table above. The „4.08‰ is known as the big figure and
currency dealers are expected to know what the „big figure‰ is on that particular
trading day (Shapiro, 2005). Remember, banks will always buy low and sell high.
Banks do not normally charge a commission on their currency transactions. They
make profit from the spread between the buying and selling price that is known
as the bid-ask spread. This spread is usually stated as a percentage cost of
transacting in the FOREX market and is computed as follows:
Percentage Spread 
Ask Price  Bid Price
 100
Ask Price
Continuing with the same example given, the bid-ask spread for the spot market
quotation for USD to MYR is:
Percentage Spread 
MYR4.0885  MYR4.0835
 100  0.12%
MYR4.0885
Direct and Indirect Quotation
Spot foreign currency prices are quoted via the direct or indirect basis. Direct
quotation basis is where the exchange rate is quoted in home currency of one unit
or 100 units of foreign currency (Eiteman et al., 2013). Normally, when you visit a
particular country, for example, Singapore or the UK, you will find that the
exchange rate of foreign currencies quoted at the money changers or the banks
are displayed in its home currency against the foreign currencies. To the
residents of that country, that is a direct quotation. Banks in most countries use a
system of direct basis quotation when dealings with non-bank customers.
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However to the non-residents of that country, the quotation is on an indirect
basis. Banks in the UK, Australia, New Zealand and Ireland use a system of
indirect basis quotation. An indirect basis quotation is a quotation that quotes
foreign currency price of one unit or 100 units of home currency. Table 10.1 lists
some of the countries that quote foreign currencies.
Table 10.1: Countries that Quote Foreign Currencies
Malaysia
Singapore
UK
US
MYR4.03 per USD
SGD1.81 per GBP
GBP0.73 per USD
USD0.24 per MYR
MYR5.45 per GBP
SGD1.36 per USD
GBP0.18 per MYR
USD1.12 per EUR
MYR3.01 per SGD
SGD0.33 per MYR
GBP0.55 per SGD
USD0.73 per SGD
American and European Terms
When interbank trade involves the US dollars, these rates will be expressed in
either American terms (number of US dollar per unit of foreign currency) or
European terms (number of foreign currency units per US dollar) (Parrino &
Kidwell, 2011). For example, for the quotation of US dollar and EUR: the
American term would be EUR1 = USD1.12 and the European term would be
USD1 = EUR0.8929.
Taking an example from the Malaysian perspective, the direct quotation for
the US dollar and Malaysian ringgit is USD1 = MYR4.03, while the indirect
quotation is MYR1 = USD0.24.
It should be noted that both the American and European term quotes and direct
and indirect basis quotes are reciprocals of one another, that is:
(a)
1/American quote = European quote; and
1/European quote = American quote.
(b)
1/Direct quote
1/Indirect quote
= Indirect quote; and
= Direct quote.
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Note that when American terms are converted into European terms (that is,
direct basis is converted into indirect basis), bid and ask quotes are reversed. The
reciprocal of the American (direct) bid becomes the European (indirect) ask and
the reciprocal of the American (direct) ask becomes the European (indirect) bid
(refer to Table 10.2).
Table 10.2: Direct and Indirect Currency Quotation
Spot Price
Direct/European Basis
Indirect/American Basis
MYR4.0835 (Bid)
1
 USD0.24489 (Ask)
4.0835
MYR4.0885 (Ask)
1
 USD0.24459 (Bid)
4.0885
Spot Price
35 ăî85
59 ăî89
ACTIVITY 10.2
If you are holidaying in Australia and you come across the following
quotation AUD0.3245/MYR, what is the basis of that quotation? How
much would be its reciprocal?
Cross Rates
The cross rate is the exchange rate between two currencies when they are quoted
against one common currency (Ross, Westerfield, Jaffe & Jordan, 2011). For
example, if USD to MYR is MYR4.0500 and GBP to MYR is 5.4500, therefore the
cross rate of GBP to USD is:
Cross Rate 
GBP1
MYR4.0500

 GBP0.74312/USD
MYR5.4500
USD1
You can also calculate the cross rate in terms of USD to GBP. However, the
common practice among currency traders is to calculate the cross rate in the
manner of stronger value currency against the weaker value currency.
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Appreciation and Depreciation of Currency Value
From time to time due to several factors, a particular countryÊs currency can
depreciate or appreciate relative to another countryÊs currency. Depreciation is
when there is a decline in a particular currencyÊs value against another
currencyÊs value and appreciation is when there is an increase in a particular
currencyÊs value against another currencyÊs value (Shapiro, 2005). For instance,
when the US dollar depreciates against the Malaysian ringgit, this means that
Malaysian ringgit is strengthening relative to the US dollar.
How do you calculate the percentage change in the value of a foreign currency?
This is done using the following formula:
Percentage  
Current Spot Rate  Old Spot Rate
 100
Old Spot Rate
Let us assume that on 1 January 2016, the Malaysian ringgit against US dollar
is MYR4.00/USD and that on 31 December 2016, the new spot rate is
MYR4.08/USD.
Hence the percentage change in US dollar is:
Percentage  
MYR4.08 / USD  MYR4.00 / USD
 100 = 2%
MYR4.00 / USD
This implies that the foreign currency (USD) has appreciated relative to the
Malaysian ringgit by 2%. Note if it is a negative percentage change, then this
indicates that the foreign currency has depreciated relative to the local currency.
If you remember, we were discussing about how the appreciation or depreciation
of foreign currency. When the spot rates fluctuate, the traders (buyers and
sellers) of the foreign currency face a foreign exchange risk (exposure). The buyer
of the foreign currency will make a foreign exchange profit when the foreign
currency depreciates and will suffer a foreign exchange loss when it appreciates
in value.
Alternatively, the seller of the foreign currency will make a foreign exchange
profit when the foreign currency appreciates, and will suffer a foreign exchange
loss when it depreciates in value. The following example will illustrate what we
mean:
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Example 1
Suppose Mr Green, an exporter of medical gloves wants to buy the raw materials
needs to manufacture his gloves from an importer in the US worth USD100,000.
When he called the foreign exchange dealer last week, the rate quoted is
MYR3.9000/USD. However, today he finds out that the exchange rate is
MYR4.050.
From the BuyerÊs Perspective
Table 10.3 shows that if Mr Green bought USD100,000 last week, he has to
pay MYR390,000 for the same amount. However, he has decided to wait and
buy it today, during which, the USD has appreciated. As such, he has to
pay MYR405,000 for buying USD100,000. In short, he has to pay additional
MYR15,000 today and this is considered as a foreign exchange loss.
Table 10.3: Foreign Exchange from the BuyerÊs (Mr GreenÊs) Perspective
Time
Exchange Rate
Amount in MYR
Last week
MYR3.900/USD
USD100,000 ïMYR3.9000/USD = MYR390,000
Today
MYR4.050/USD
USD100,000 ïMYR4.050/USD = MYR405,000
Difference
MYR15,000
Now let us look from the perspective of the seller.
From the SellerÊs Perspective
If the seller is paid last week, then he will receive MYR390,000 for selling the
USD100,000 worth of raw materials. On the other hand, if he is paid today, then
he will receive MYR405,000 for selling the same amount of raw materials. This
means that the seller receives more today in MYR (MYR 405,000 ăîMYR390,000 =
MYR15,000) for selling the USD100,000. This is considered as a foreign exchange
profit. Notice the situation is the opposite for the seller when USD depreciates in
value.
We will now proceed to discuss the other type of foreign exchange market, which
is the forward market.
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10.1.3
Forward Market
A forward market is a contract made by the buyer and seller of foreign currency
for future delivery (Ross, Westerfield, Jaffe, Lim & Tan, 2016). The contract is
entered today and the rates used would be the forward rates quoted today
depending on the forward period of the contract. The most common forward
contracts are 30-day (1 month), 90-day (3 months) and 180-day (6 months).
If a trader enters into a forward contract, the exchange rates used to settle his
contract at maturity date will be the forward rate that he has entered earlier
regardless of what the spot rate is on the maturity date. Thus, the trader will
know in advance the amount that he has to pay or receive in his home currency
when he buys or sells foreign currency. Therefore, forward contracts can be used
as a hedge against foreign exchange risk.
Referring to our earlier discussion on the spot market, the buyer of the foreign
currency will face foreign exchange loss if foreign currency appreciates in value.
As for the seller, he will suffer foreign exchange loss when the foreign currency
depreciates in value.
However, in the case of the forward contracts, since the forward rates entered
will be the rates used in the settlement of the contract in the future, regardless of
whether the spot foreign currency appreciates or depreciates in the future, the
trader is not affected by the foreign exchange loss. We will demonstrate how this
is possible using Example 2.
Example 2
Assume today is 9 September 2016 and CIMB Bank quoted the USD to Malaysian
ringgit as follows:
(a)
Spot rate
= USD/MYR4.0835/85
(b)
1 month forward = USD/MYR4.0900/05
Forward Buying ă Foreign Currency Appreciates
A trader would enter into a forward buying position, if he expects to receive
foreign currencies in the coming future. In this case, he is said to be the buyer of
the foreign currency. Let us examine what happen to the buyerÊs position when
the foreign currency appreciates.
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A buyer who wants to buy the USD one month forward will enter the contract at
MYR4.0905 today.
Now assume the USD appreciates in one monthÊs time to USD/MYR 4.1010/15
on 9 October 2016 from USD/MYR 4.0835/85. One month later, when the buyer
settles his forward buying contract and assuming that he needs to buy USD =
100,000, he will therefore pay:
USD100, 000  MYR4.0905/USD = MYR409, 050
If the buyer had not entered into the forward contract, then on 9 October 2016 he
has to pay:
USD100, 000  MYR4.1015/USD = MYR410, 150
By entering into forward buying contract, the buyer saves MYR1,100
(MYR410,150 ă MYR409,050). This means that when foreign currency
appreciates, taking a forward buying position will be an advantage to the buyer
of the foreign currency.
Forward Buying ă Foreign Currency Depreciates
What happens if instead of USD appreciating in value it actually depreciates to
USD/MYR 4.0820/30?
In this situation, the buyer will have to settle his forward buying contract at the
forward rate that he has agreed on, that is USD/MYR4.0905 and the amount he
has to pay is MYR410,150 irrespective of whether the foreign currency has
depreciated at USD/MYR4.0820/30 or not.
Obviously, when foreign currency depreciates, taking a forward buying position
does not benefit the buyer since he is obligated to fulfil the forward contract.
You have seen how forward contract works for the buyer of the foreign currency,
let us now examine it from the perspective of the seller of the foreign currency.
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Forward Selling ă Foreign Currency Appreciates
A trader who wants to sell foreign currency usually enters into a forward selling
position when he anticipates that the foreign currency is going to depreciate in
the future. But let us see what happens to the traderÊs position if the foreign
currency appreciates (notice the trader is the seller of the foreign currency). As
for the seller of the foreign currency (USD) who wants to sell the USD one-month
forward, will enter the contract at MYR4.090 today. If the USD appreciates to
USD/MYR 4.1010/15, then in one month time, the seller will receive:
USD100, 000 ïMYR4.0900/USD = MYR409, 000
However, if he has not entered into the forward contract but instead sells
USD100,000 a month later, he would have received:
USD100,000 ïMYR4.1010/USD = MYR410,100
Thus, for the seller of foreign currency, when foreign currency appreciates the
seller will incur a loss if he has entered into a forward market.
Forward Selling ă Foreign Currency Depreciates
Now let us assume that the foreign currency depreciates to USD/MYR 4.0820/30.
Since the seller has entered a forward selling at USD/MYR4.090, then he will
receive MYR409,000 for the USD100,000 that he sold.
If he had not entered a forward selling on 8 September 2016, then on 9 September
2016, he will receive:
USD100,000 ïMYR4.0820/USD = MYR408,200
This amount is less the amount that he would have received through forward
selling (MYR1,900).
In essence, based on the previous example, when the USD depreciates in value,
the buyer (seller) will make a profit and the seller (buyer) will incur a loss. So,
when foreign currency (USD) appreciates in value, the buyer of forward contract
will benefit and avoid foreign exchange (Eiteman et al., 2013). As for the seller of
foreign currency, he will benefit and avoid foreign exchange loss by entering into
forward contract when the foreign currency appreciates.
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ACTIVITY 10.3
1.
Explain what would the trader do in the forward market if he
needs to buy foreign currency and to sell foreign currency.
2.
Today, Public Bank quoted the USD to Malaysian ringgit as
follows:
Spot rate
= USD/RM4.5000/15
3-month forward rate = USD/RM4.5030/80
If you anticipate to pay USD10,000 in 3 monthsÊ time, should you
enter into the forward contract? How much Malaysian ringgit
would you need to pay?
3.
Jackie Chan, a SME trader, is expected to receive EUR150,000 in
3 monthsÊ time. The EUR currency is expected to be very volatile
in the coming months.
(a)
What should Jackie Chan do to protect from being exposed
to exchange rate fluctuation?
(b)
In which direction should the EUR currency go for Jackie
Chan to start thinking of hedging his position?
(c)
If the spot rate today is EUR/RM4.56 and forward rate is
EUR/RM4.60, should he enter into a forward contract if the
EUR is expected to depreciate? Why or Why not?
(d)
Assuming that Jackie Chan decides to enter into the forward
contract today and 3 months later the future spot rate
is EUR/RM4.50, calculate and comment on his hedging
strategy.
(e)
If Jackie Chan needs to pay EUR150,000 to his supplier in
Germany, answer questions (a) to (d).
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Forward Rate Quotation
Forward rates are expressed either as outright rate quotations or swap (point)
rate quotations.
(a)
Outright rate refers to the forward rates that are quoted in the actual price.
Example: 1-month forward USD/MYR is 4.0835.
(b)
Swap (point) rate means the forward rates are quoted in so many points
discount from (or a premium on) the spot rate. Example: 1-month forward
USD/MYR is 30 points.
Banks will always quote the outright rates when trading with their commercial
customers but will use the swap rates when it involves interbank transactions.
Forward rates are always expressed either at a forward discount or forward
premium. A foreign currency is at a forward discount if the forward rate is below
the spot rate. The foreign currency is at a forward premium if the forward rate is
above the spot rate (Madura, 2000).
The forward discount or premium on the foreign currency from the spot rate can
be calculated as:
Forward Premium or Discount = Forward Rate ă Spot Rate
Alternatively, the forward premium or discount can also be expressed as an
annualised percentage. The formula is:
Forward Premium (Discount) Annualised:

Forward Rate  Spot Rate
360

Spot Rate
Forward Contract No. of Days
To demonstrate how the annualised forward premium (discount) is calculated,
we will use Example 3.
Example 3:
Assume that Maybank in Kuala Lumpur quotes the spot rate, 30-day forward
rate and 90-day forward rate for Malaysian ringgit against USD as shown in
Table 10.4.
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Table 10.4: Assumptions of the Rates of Malaysian Ringgit against USD
Rate
KL Quotation of USD/MYR
Spot rate
4.0220
30-day forward rate
4.0293
90-day forward rate
4.0175
Now, let us analyse Example 3 further by answering the following questions:
(a)
What is the 30 day and 90 day annualised forward premium or discount?
The 30 day forward is at a premium of 73 points (4.0293 ă 4.0220) from the
spot rate. To calculate the 30 day annualised forward premium, just plug in
the figures from Example 10.3 into the formula:
30-day Forward Premium Annualised:

(b)
MYR4.0293  MYR4.0220 360

 100  2.9%
MYR4.0220
30
What about the 90 day forward rate? Is it at a premium or a discount?
The 90 day forward is at a discount of 45 points (4.0175 ă 4.0220) from the
spot rate and annualised discount of 0.47%:
90-day Forward Discount Annualised:

MYR4.0175  MYR4.0220 360

 100  0.47%
MYR4.0220
30
Converting Forward Swap Rate Into an Outright Rate
You can convert the forward swap rate into an outright rate. Before you do that,
you need to determine if the forward rate is at a discount or premium. This can
be done by following these simple rules:
Rule 1
To determine if the forward bid point is smaller or larger than the forward ask
point. If forward bid point is smaller than the forward ask point (B < A), then the
forward rate is at a premium and you must add the points to the spot rate to
derive the outright rate.
Rule 2
If the forward bid point is larger than the forward ask point (B > A), then the
forward rate is at a discount and you must deduct the points to the spot rate to
derive the outright rate.
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To clearly illustrate how the forward outright rate is derived from the swap point
rate, we will use Example 4.
Example 4:
Assume that the quotes of the spot rate, 30 day forward swap point and 90 day
forward swap point for USD/MYR are as shown in Table 10.5.
Table 10.5: Forward Swap Point Rates for KL Quotation of USD/MYR
Rate
KL Quotation of USD/MYR
Spot rate
MYR4.0546/78
30-day forward swap point
32/51
90-day forward swap point
94/83
We will begin by determining the 30 day forward outright rate based on the
30 day forward swap point rate. Following the previous rule, we will identify if
the forward bid swap basis point is either smaller or larger than the forward ask
swap basis point.
30 Day Forward Outright Rate
The forward bid swap basis point is smaller than the forward ask swap basis
point (that is ă 32 < 51).This means that the 30 day forward is at a premium and
therefore you will need to add the basis point to the spot rate.
30 day forward bid outright rate = 4.0578 = (4.0546 + 0.0032)
30 day forward ask outright rate = 4.0629 = (4.0578 + 0.0051)
90 Day Forward Outright Rate
The forward bid swap basis point for 90 day forward is larger than its ask swap
basis point (that is, 94 > 83). This indicates that the 90 day forward is at a
discount and, therefore, the basis points will be deducted from the spot rate.
90 day forward bid outright rate = 4.0452 (4.0546 ă 0.0094)
90 day forward ask outright rate = 4.0459 (4.0578 ă 0.0083)
The forward premium or discount point is closely related to the interest
differentials on the two currencies. Once the points are computed, to get the
forward rates, they will be added to the spot rate (if premium) or subtracted from
the spot rate (if discount).
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ACTIVITY 10.4
1.
Go to the Wall Street Journal website and look for the following
information:
(a)
Find out which currencies have forward rates. Why do you
think they have forward rates?
(b)
Determine if the forward rates for those currencies are at
premium or discount.
2.
The EUR/MYR exchange rate is 4.5600 and the USD/MYR
exchange rate is 4.0900. What is the USD/EUR exchange rate?
3.
Suppose you have the following quotations:
Rate
Spot rate
4.
GBP/USD
1.3268/70
One-month forward
25/20
Three-month forward
30/35
(a)
Calculate the spot, 1 month forward and 3 month forward
rate for USD against GBP.
(b)
If you need USD500,000 today, how much British pounds
would you exchange with it?
(c)
How many British pounds would you receive if you sell
USD1 million in one month and have 3 months forward
contracts?
(d)
If the GBP/USD is at 1.3350/60, would you benefit from the
entering the forward contract in (c)?
BNM quoted the spot rate of Australian dollar to Malaysian
ringgit at 3.100/10 and the spot rate of US dollar to Malaysian
ringgit at 4.0910/18.
(a)
What is the spot rate for Australian dollar in Singapore?
(b)
Compute the percentage bid-ask spreads on AUD/SGD.
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10.2
THEORIES RELATED TO FOREIGN
EXCHANGE RATES
Parity conditions exist when the same or equivalent things can be transacted at
the same price across different places and, therefore, deprive arbitrageurs from
making any riskless profits. This condition is known as the law of one price
(Eiteman et al., 2013). Understanding these international parity relationships
such as international Fisher effect, interest rate parity and purchasing power
parity enables an international financial manager to examine how foreign
exchange rates are determined and forecasted.
This topic will discuss five key international parity relationships as well as the
techniques used in forecasting. The four theories that can be used to explain the
relationships are:
(a)
Purchasing Power Parity Theory (PPP);
(b)
Interest Rate Parity Theory (IRP);
(c)
International Fisher Effect Theory (IFE); and
(d)
Forward rates as an unbiased predictor of future spot rate (UFR).
10.2.1
Purchasing Power Parity Theory
The purchasing power parity (PPP) theory explains that currencies with high
inflation rates should depreciate relative to currencies with lower inflation rates
(Shapiro, 2005). In short, the theory links inflation rates with the future changes
in the spot rate.
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To explain this relationship, let us use the following example:
Example 5:
Assume that the spot rate of Malaysian ringgit against USD is MYR4.05 per USD.
It is expected that the USÊs inflation rate to be 4% higher than the Malaysian
ringgit. Therefore, according to the purchasing power parity theory, the USD will
depreciate by 4% relative to Malaysian ringgit for the law of one price to prevail.
What is the effect on the future spot exchange rate as a result of different inflation
rates in two countries? The PPP states that the future exchange rates between two
countries should change in accordance with the changes in price levels of these
two countries (Eiteman et al., 2013). Mathematically, this relationship can be
written as:
1  infhc t X t

1  inffc  X 0
Where infhc and inffc are the inflation rate of home currency (in this case,
Malaysia) and the inflation rate of foreign currency (in this case, the US),
respectively. X0 and Xt are the spot exchange rate and future spot exchange rates.
If we rearrange this equation, then the future spot exchange rate will be:
Xt 
 1  infhc t
X0
1  inffc 
Or, in percentage form:
PPP 
 infhc  inffc t
 100
1  inffc 
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Hence, if the US and Malaysian inflation rates stood at 13% and 9% respectively,
the future spot rate of USD will be:
X1 
1.09 t
 MYR4.05
1.13 
 MYR3.9066/USD or  4%
If PPP holds: Since the US inflation is 4% higher than that of Malaysia, the US
future exchange rate will depreciate by 4% to reflect changes in the price level.
ACTIVITY 10.5
1.
If the inflation is 8% in the US and 3% in Germany, how much
should the dollar value of EUR change in order to equalise the
USD price of goods in the two countries?
2.
Calculate the PPP rate for the EUR if inflation rate in the US and
France are expected to be 4% p.a. and 8% p.a. respectively. If
current spot rate is USD1.11/EUR, what is the expected spot rate
in 3 years?
10.2.2
Interest Rate Parity Theory
Interest Rate Parity (IRP) theory examines the relationship between spot rate
and forward exchange rate (Madura, 2000). The theory states that the forward
discount or premium on a currency (percentage difference between spot rate and
forward rate) should be equal to the differences in the interest rates of two
countries, that is:
Forward discount/premium  rhc  rfc
ft  X 0 360

 100  rhc  rfc
X0
n
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Continuing with Example 10.4, let us further assume that the interest rate for
Malaysian ringgit is 12% and interest rate for US dollar is 16%. If we are to plug
those figures in the equation as follows, then:
ft  X 0 360

 100  12%  16%
X0
n
3.9066  4.05 360

 100  4%
4.05
360
4%  4%
Note if disequilibrium occurs between the two, the covered interest arbitrage
opportunity arises. Moving away from the assumption, let us see how covered
interest arbitrage can occur.
Example 6:
Let us assume the following data is provided:
Spot rate (X0)
= USD1.30/GBP
1 year forward rate (f1) = USD1.50/GBP
Interest rate in the US
= 30% p.a.
Interest rate in the UK
= 10% p.a.
With this information given, we will now show, step by step, how to identify if
covered interest arbitrage exists and then determine where we should invest and
borrow simultaneously.
Step 1: To determine whether there is covered interest arbitrage, we will compare
the percentage difference between spot rate and forward rate with the differences
in the interest rates of two countries, that is:
ft  X 0 360

 100  rhc  rfc
X0
n
1.40  1.30 360

 100  25%  10%
1.30
360
7.69%  15%
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The result above clearly shows that there is disequilibrium between forward
premium on GBP and difference of interest rates of the two currencies. This is
known as covered interest rate arbitrage (Madura, 2000). So what will
arbitrageurs do to make riskless profit? First, arbitrageurs will need to decide
whether to invest at home or abroad by determining the following. Step 2
demonstrates how arbitrageur can decide to invest at home or abroad.
Step 2: Making decision to invest at home or abroad.
 1  rhc  
t
1  rhc  
t
1  rfc t
X0
 1  rfc t
X0
 ft
 ft , then arbitrageur will invest at home and borrow
abroad.
1  rhc  
t
1  rfc t
X0
 ft , then arbitrageur will invest abroad and borrow at
home.
Thus, plugging the figures from Example 10.6 into the previous equation:
 1  rhc  
t
1.30 1 
1  rfc t
X0
1.10 1
1.30
 ft
 1.50
1.30  1.27
The above result indicates that it is better to invest in the US and borrow from the
UK since the return will be greater after taking into account the exchange rates.
Step 3: Calculating the outcome of the arbitrage strategy taken.
Let us go further by looking at how such a decision can bring riskless profit to
the arbitrageur due to the disparity condition (assume that the arbitrageur can
borrow GBP 1,000,000 and he borrows GBP1,000,000).
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Table 10.6: Arbitrage in the UK and US
T=0
GBP
USD
Borrows GBP1,000,000 at interest rate of 10%
1,000,000.00
ă
Sells GBP1 million for USD spot @ USD1.30/GBP
(1,000,000.00)
1,300,000.00
Invests USD1.3 million at interest rate of 30%
ă
ă
Enters into a forward selling for USD1.3 mil plus
return
ă
ă
0
0
ă
1,690,000.00
Delivers USD1.69 million @ 1 year forward rate
USD1.50/GBP
1,126,666.67
(1,,690,000.00)
Pays borrowed amount GBP1 million plus interest
expense
1,100,000.00
ă
GBP26,666.67
USD0
T = 1 year
Receives USD1.3 mil plus return
As shown in Table 10.6, the consequence of taking this arbitrage opportunity is
that the trader is able to make riskless profit amounting to GBP26,666.67.
10.2.3
Unbiased Forward Rate
This theory relates the relationship between forward rate and future spot rate,
where it is stated that forward rates can be used as an unbiased predictor of
future spot rates (Shapiro, 2005). However, for this to occur, there are several
current expectations of future events.
For instance, if a player in the market expects the US dollar to depreciate, then
the following events may take place:
(a)
Those who expect to receive the US dollar will begin selling it forward;
(b)
Malaysian ringgit earners will slow down their sale of the ringgit in
forward market and this will, in turn, push the price of forward US dollar;
(c)
Banks will even out their long position in the forward US dollar by selling
US dollar spots; and
(d)
Those earning US dollars will speed up the collection and conversion of the
US dollar.
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Those events lead to the future spot exchange rate of the US dollar to be the same
as the forward rate. Mathematically this can be explained as follows:
Difference in forward rate = Expected change in exchange rate
X t  X 0 ft  X 0

X0
X0
ft  X 0
Where ft is the forward rate, plugging in those figures from the assumption
given:
MYR3.9066  MYR4.0500 ft  MYR4.0500

MYR4.0500
MYR4.0500
ft  MYR3.9066/USD
Thus the future spot rate of the US dollar will be the same as the forward rate. If
this parity condition does not hold, then speculation can take place.
10.2.4
International Fisher Effect Theory
This is an extension of the Fisher Effect theory named after the founder, that is,
Fisher Irving. This theory relates the relationship between interest rate and future
spot rate (X1), where the differences of interest rate between two countriesÊ
currencies can be an unbiased predictor of the future change in the spot rate
(Eiteman et al., 2013).
Mathematically, this can be expressed as follows:
1  rhc t X t

 1  rfc t X 0
Where,
rhc = Interest rate of home country
rfc = Interest rate of foreign country
Xt = Future spot rate of foreign currencies in home currencies at time, t
X0 = Spot rate of foreign currencies in home currencies
t
= Period of time
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Thus, the expected return from investing at home should be equal to the
expected return from investing abroad, that is:
 1  rhc t 
Xt
1  rfc t
X0
Substituting the figures in the assumptions, we can use the formula mentioned
previously to predict the future change in the spot rate, that is:
1  9% 1 
Xt
4.05
 1  13% 1
1
 1.09 
 4.05
 1.13 
X1  
 MYR3.9066/USD
This implies that since the Malaysian ringgit (MYR) has a lower interest rate
(9%), then MYR is expected to appreciate relative to the US dollar with a higher
interest rate (13%) in the future that is MYR3.9066/USD.
How much would the interest rate of Malaysia be if the future spot rate is
USD/MYR4.1000? Using the formula, the result is:
1  rhc t X t

1  rfc t X 0
1  rhc 1 RM4.1000

1  0.13 1 RM4.05
 1.0123  1.13    1  rhc 
rhc  1.1400  1  0.1400 or 14%
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214  TOPIC 10 INTERNATIONAL CORPORATE FINANCE
ACTIVITY 10.6
1.
Suppose the following data are given.
Rate
2.
USD
CAN
Interest rate
2%
5%
Inflation rate
5%
8%
Spot rate
CAN1.3010/USD
One-year forward rate
CAN1.3018/USD
(a)
Use the forward rate to forecast the percentage change in the
Canadian dollar over the next year.
(b)
Use the PPP theory to forecast the percentage change in the
Canadian dollar over the next year.
(c)
Use the IRP theory to forecast the exchange rate over the
next year.
(d)
Use the spot rate to forecast the percentage change of
Canadian dollar over the next year.
An investor will invest his funds in any market to maximise his
profit. The one-year Singapore interest rate is 6% and the US
interest rate is 10%. The spot rate USD/SGD is SGD3.0500 and the
one year forward rate is SGD3.0540.
(a)
Are there any covered interest arbitrage opportunities?
(b)
Explain how the investor can profit from the situation
(assume the initial investment by Malaysian investors is
USD1,000,000 and by the US investors is USD1,000,000).
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TOPIC 10
INTERNATIONAL CORPORATE FINANCE

215
SELF-CHECK 10.1
1.
What is the difference between the retail or client market and the
wholesale or interbank market for foreign exchange?
2.
Describe the parity conditions and how they are achieved through
the theories related to foreign exchange rates.
3.
Discuss the relationship between spot rates, interest rates,
inflation rates, forward rates and future spot rates.
4.
Describe covered interest arbitrage.
5.
Explain why the International Fisher effect theory may not hold.

Corporate financial decisions become more complex when companies expand
abroad.
Ć
Many factors influence corporationsÊ financial decisions and one of them is
foreign exchange rate.
Ć
The foreign exchange market is the largest financial market and operates 24
hours a day.
Ć
Foreign exchange market is made up of spot and forward exchange markets.

Both spot rate and forward rate are expressed in terms of either outright rate
or swap basis points.

Purchasing power parity, interest rate parity, forward as unbiased predictor
of spot future rate and International Fisher effect theories are theories related
to how exchange rates are determined.
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216  TOPIC 10 INTERNATIONAL CORPORATE FINANCE
Arbitrageur
Outright rate
Foreign exchange market (FOREX)
Over the counter (OTC)
Forward discount
Purchasing power parity (PPP)
theory
Forward market
Spot market
Forward premium
Swap basis points
Interest rate parity (IRP) theory
International Fisher effect (IFE) theory
Unbiased forward rate
Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2013). Multinational business
finance (13th ed.). Boston, MA: Pearson.
Gitman, L. J., & Zutter, C. J. (2015). Principles of managerial finance (14th ed.).
Boston, MA: Pearson.
Madura, J. (2000). International financial management (6th ed.). Cincinnati, OH:
South-Western.
Parrino, R., & Kidwell, M. (2011). Fundamental of corporate finance (2nd ed.).
Hoboken, NJ: John Wiley & Sons.
Ross, S. A., Westerfield, R. W., Jaffe, J. F., & Jordan, B. D. (2011). Core principles
and applications of corporate finance (3rd ed.). New York, NY: McGrawHill Irwin.
Ross, S. A., Westerfield, R. W., Jaffe, J. F., Lim, J., & Tan, R. (2016). Fundamentals
of corporate finance (Asia Global Edition, 2nd ed.). New York, NY:
McGraw-Hill Irwin.
Shapiro, A. C. (2005). Foundations of multinational financial management
(5th ed.). Hoboken, NJ: John Wiley & Sons.
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