MODULE OUTLINE

CHAPTER 1
Investment Risks, Returns and Portfolio Theory
- Nature of Risk
- Analysing investment Risk
- Expected returns and risk
- CAPM and Portfolio Theory
- Security Market Line and the Capital Market Line

CHAPTER 2
The Cost of Capital and Capital Structure Decisions
- Gearing and the Cost of Capital
- Cost of equity and Cost of Debt
- Weighted Average cost of capital
- The Modiglani and Miller Propositions
- The MM propositions with market imperfections

CHAPTER 3
The Dividend Decision
- The Theory of Dividend Policy
- Are Dividends irrelevant?
- Taxation and the Bird in the hand theory
- Clientele and signalling effects

CHAPTER 4
Corporate mergers, Acquisitions and takeovers
- Motives for take over and mergers
- Assessing and the success of take-over and mergers
- Valuation of target firms

CHAPTER 5
Working Capital management
- The need for working capital and The cost of working capital
- Control of Debtors
- Control of stock and W-I-P
- The Control of Cash and bank balances

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CHAPTER I PORTFOLIO THEORY, RISK AND RETURN

Portfolio Theory
Financial decisions are made in uncertain environment. The firm therefore has to
take risk in making any financing decisions. Financial decisions by their very
nature are never risk – free.

Risk is having uncertainty and we can only have uncertainty when dealing with
future events. If we are making a decision whose outcome we are not certain we
are risk taking. In a business the firm might base the decision on past
performance. The most important concept is the attitude of people to risk and
the sub – total of individual’s attitude to risk will be the organisation’s attitude to
risk.
There are 3 classes of risk attitude.
I. Risk – takers
II. People indifferent to risk
III. Risk averse – people

Risk takers choose between 2 project with the same rate on investment but
different return on investment for managers to deal with risk they must be able to
calculate the return on expected decision the distribution of the income and their
corresponding probability.
Example
Weather Probability Income
Severe drought 0.1 10 000
Drought 0.2 50 000
Right weather 0.6 250 000
Too much rain 0.1 100 000

Expected return (Probability x Income)

0.1 * 10 000 = $1 000

0.2 * 50 000 = $10 000
0.6 * 250 000 = $150 000
0.1 * 100 000 = $10 000
171 000

Expected Return
The expected return for an asset is the weighted average rate of return using the
probability of each rate of return using the weight. It is denoted as (r)
An expected return is calculated by summary the products of the rate of return
and their respective probabilities.

T
t=1(Pr ) (Return)

2
Laws of Probability
a) Probabilities sum to I
b) There is no negative probability
c) An outcome that is certain to occur has a probability of I
d) Impossible outcomes have zero probability

Examples 2 consider the following information.

Outcome Possible Return Prob E( r)

1 50% 0.1 0.0//5
2 30% 0.2 0.06
3 10% 0.4 0.04
4 -10% 0.2 -0.02
5 -30% 0.1 -0.03
1 0.1 .

Measuring Risk
Measuring of risk is just as important as calculating it. Minimising risk and
maximising the rate of return are interrelated objectives of in investment
management. Risk is the chance of achieving less than expected returns –
therefore it is measured by the dispersion of possible returns around the mean
(r). We use the Variance And The Standard Deviation to measure risk.

The variance
It is the weighted sum of the squire deviation from the expected return.
Squaring deviations ensures that deviations that are above and below the
expected value contribute equally to the measure of variability regardless of the
sign.

Variance 2 =  Pr { (R – Er)2} where P = probability

R = return
Er = expected return

Standard Deviation =  2

Return E(r) R-Er (R-Er) x Pr

50% 0.1 0.4² 0.16 x 0.1 0.016
30% 0.1 0.2² 0.04 x 0.2 0.008
10% 0.1 0.0² 0.00 x 0.2 0
-10% 0.1 -0.2² 0.4 x 0.2 0.008
-30% 0.1 -0.4² 0.16 x 0.1 0.016
Total 0.048

2 = 0.048
 = 0.219 or 21.9%

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Example

State of economy Prob Project A project B

Strong 0.2 700 550
Normal 0.5 400 400
Weak 0.3 200 300
1
Required
a) Calculate the expected values of projects A and B
b) Calculate the variance and the standard deviation if A and B
c) What conclusion can draw from the answer A and B

(1) (r) = Prob x Return

Project A Project B
0.2 * 700 = 140 0.2 * 500 = 110
0.5 * 400 = 200 0.5 * 400 = 200
0.3 * 200 = 60 0.3 * 300 = 90
400 400

Project A
Return (r) R – E(r) ]² [* Prob
700 400 (700 – 400) ² * 0.2 = 18 000
400 400 (400 – 400) ² * 0.5 =0
200 400 (200 – 400) ² * 0.3 = 12 000
30 000
2 = 30 000
 = 30 000
= 173.21

Project B
Return (r) R – E(r) ]² [* Prob
550 400 (500 – 400) ² * 0.2 = 4500
400 400 (400 – 400) ² * 0.5 =0
300 400 (300 – 400) ² * 0.3 = 3000
7500
2 = 7500
 = 7 500
= 86.60

a) If the decision maker is neutral to risk he can take any of the 2 projects
b) If he is risk averse he will take project B which has a lower standard
deviation. Project be A is more risk hence less attractive therefore reject.

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Therefore expected values do not tell us more about risk.
NB- the standard deviation and the variance are conceptually equivalent
measures of total risk (market or systematic risk + unique risk)

RISK AND RETURN IN PORTFOLIOS

Before calculating risk for a portfolio we need to understand the concept of
diversification, covariance and coefficient of correlation.

Diversification
It is buying or holding different securities in one portfolio for the purposes of
spreading risk. For this to be effective, the securities in question should have
different risks, return trade-off characteristics. Thus different classes of securities
should be included in the portfolio in order for it to be well diversified.

Specific Risk
It is that part of total risk that can be directly identified with a particular project or
firm. It is the variability in return due to factors unique to the individual project or
firm. Specific factors that affect the company’s return like demand, management
deficiency equipment failure, and Research and Development achievements.
This specific risk can be reduced through diversification.

30

25

20
Specific risk
15
Market risk
10

0
1 2 3 4 5 6 7 8 9 10

Because specific risks for projects are independent of other bad events by stock
will be off set by good events effects on the other.

Systematic Risk / Market Risk

It is that part of risk which cannot be diversified in any way because it is caused
by factors common to all activities. It is also known as market risk e.g. the
general level of demand in the economy, interest rates, labour costs, exchange
rates etc. It therefore refers to macro economic factors that cause reactions on
stock market etc.
There is no insulation against such factors by an individual firm.

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Co-variance
The above example assumes a single asset or project. In reality investors hold
portfolio of different assets. For diversification or risk reduction will work if the
returns in creating a portfolio behave or move differently over the same period of
time. The term given to such movement is called covariance. The co-variance of
returns of assets that make up a portfolio is a measure of the extend to which the
returns of each one vary with another in different conditions.

If an increase in the rate of return of Asset A is associated with an increase in the

rate of return of B then there is a positive covariance.

25
20
15 A
10 B

5
0
1 2 3 4 5 6 7

If an increase in asset A is associated which a decrease in Asset B then there is

a negative covariance.

25
20
15 A
10 B

5
0
1 2 3 4 5 6 7

A covariance of zero implies that independence of the 2 returns’ movements of

securities. Thus for the purpose of diversification assets that negatively
correlated are better suited than positively correlated.

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Portfolio Return – Expected Return Of More Than 1 Asset.
It is simply the value weighted average of the expected return of individual
securities. The weight applied to each return will be equal to the fraction of the
portfolio invested in that security.

Er(p) = W 1 (Er)

Steps
o Calculate the expected values of each of the assets that make up the
portfolio.
o Find the weighted average for the expected value of each of the assets in
the portfolio.
o The weights are not the probabilities but the contribution of each of the
assets to the total portfolio.
Example
Suppose portfolio I has a total value of $200000 and of this total, asset A
contributes $70 000 and B the remainder. Assuming the expected income for A
and B are $10 000 and $60 000 respectively.
Calculate the expected portfolio income.
70 000 * 100 000 + 130 000 * 60 000 = $42 500
200 000 200 000

Example 2
Security Weight Expected Return
A 40% 20
B 50% 15
C 10% 10

E(Rp) = (0.2* 0.4) + (0.5*0.15) +(0.1*0.1)

= 16.5%

Co-Efficient Of Variation
It is a measure of the relative rather than the absolute dispersion. It shows the
risk / unit of returns and provides a meaningful basis for comparison when two
alternatives have different expected rate of returns. The co-efficient of variation
can be interpreted as a risk measure or in certain circumstances as an overall
criterion for acceptability.

Co-efficient of variation (CV = 

x
Where x = expected values of net cash flows.

The lower the Co-efficient of variation the lower the relative degree of risk.

Example
Consider the following

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Investment A E(r) $20 000 Standard deviation of 3000
Investment B E(r) $50 000 Standard deviation of 6000

Which investment should be chosen?

A = 3000 B = 6000
20 000 50 000
= 0.15 = 0.12

Investment B should be chosen lower CV of 12%.

In the above example investment B has higher level of risk than investment. A.
B has a lower co-efficient of variation in absolute terms. Its standard deviation of
is greater than that of A and B would be selected by a risk averse – manager.
Therefore for two investments with different risk returns profiles – the Standard
deviation and the variance are not good enough measures of risk and cannot
provide a good decision for investment.

Covariance / Interactive Risk

It is calculated as follows

1) Where probabilities are equal

Covariance xy = 1/n{Rx – E(Rx)} {Ry – E(Ry)}

Where n = number of outcomes or observations

Rx = rate of return of x at any point
E(Rx)} = expected return on RxY
{Ry = rate of return of y at any point
E(Ry)} = expected return on Ry

2) 1) Where probabilities are different

Covariance xy =  Pi {Rx – E(Rx)} {Ry – E(Ry)}

Example
You are given the following data for security A and B
Event Return (A) Event B Return (B)
A 20 A 5
B 15 B 10
C 10 C 15
Each event is likely to occur
Calculate the expected return, variance and standard deviation for each security
and determine the Covariance.

A Expected return E(RA) = (1/3 *20) + (1/3*15) +(1/3 *10)

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 = 15
B Expected return E(RB) = (1/3 *5) + (1/3*10) +(1/3 *15)
= 10

Covariance = 1/n{Rx – E(Rx)} {Ry – E(Ry)}

= 1/3 {(20-15)(5-10) +(15-10)(10-10) +(10-15)(5-10)}
= -16.66667

These results tell us that these securities are negatively correlated – they move
in different directions. This is however an absolute measure and makes the
interpretation difficult especially where other relevant information is absent. To
overcome this difficulty, the correlation coefficient is used.

Correlation Coefficient
It overcomes the problems by the covariance by realising that the movements of
returns of securities should be affected by variance or variability of these
securities. It is a standard or adjusted covariance. It is a relative measure as
compared to variance or standard deviation which are absolute measures and
this makes it more useful than the covariance.

Correlation coefficient rxy = Covariance xy / (xy)

rxy = Correlation coefficient
x = standard deviation of x
y = standard deviation of y

In our example = -16.667/(4.08*4.08)

= -1

Interpretation of Correlation Coefficient

A correlation coefficient of –1 implies perfect negative correlation or inverse
relation between movements of returns of 2 securities that is if one increase by
x% at any time the other will decrease by the same magnitude. A correlation
coefficient of 1 implies perfect positive correlation between movements of returns
of 2 securities that is if one increase by x% at any time the other will increase by
the same magnitude.
A correlation coefficient of 0 implies independence between movements of
returns of 2 securities.

PORTFOLIO RISK – THE STANDARD DEVIATION OF A PORTFOLIO

As opposed to the calculation of expected return which is simply the weighted
average expected return of individual sum in the portfolio, calculation of the
standard deviation/risk is different. It takes into account not only the weights,
variances, and standard deviation of each security but also the covariance or
correlation coefficient between pairs individual securities in the portfolio.

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General Formula For the Portfolio Variance
²AB = W 2A2A + W 2B2B+ 2 WA WB CovAB

Since Correlation coefficient rab = Covariance ab / (AB) it implies that

Covariance ab = Correlation coefficient rab x AB
Cov ab = rab x AB
Therefore
²AB = W2A2A + W 2B2B+ 2 WA WBAB rAB

 = √[ W 2A2A + W 2B2B+ 2 W A WBAB rAB]

The assumption of this model is that the attitude of investors in creating portfolios
is entirely depended on risk and return and the quantification of risk.

Example
Form our previous example, suppose that an investor holds the following 40% of
A and 60% of B calculate the portfolio risk.

 = √[ W 2A2A + W 2B2B+ 2 W AWBAB rAB

 = √[ (0.42*4.082)+(0.62*4.082)+(2*0.4*0.6*-1*4.08*4.08)
=
=

The Importance of Correlation Coefficient

Effect of Changing Correlation Coefficient on Portfolio Risk with weights

constant and where securities being combined have different returns and
different standard deviations.

Stock Expected return Weight Standard Deviation

1 0.1 0.5 0.0049
2 0.2 0.5 0.0100

From the above details create a portfolio of stock 1 and 2 given that the
correlation coefficient is
a) 1 b) 0.5 c) 0 d) –0.5 e) –1

Conclusion
As the correlation coefficient decrease the portfolio risk (standard deviation) also
decreases, where the weight of the individual securities are kept constant and
the individual securities have different returns and standard deviations. Therefore
negatively correlated assets are the most ideal for inclusion in a portfolio
especially where there is perfect negative correlation.

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Effect of changing weights on Portfolio standard deviation where the
correlation coefficient is constant.
Stock Expected return Standard Deviation
1 0.1 0.0049
2 0.2 0.0100
The correlation of coefficient is 0.5.
The weights are as follows Stock 1 Stock 2
a) 0.2 0.8
b) 0.4 0.6
c) 0.5 0.5
d) 0.6 0.4
e) 0.8 0.2
From the above results varying the weights where the correlation is kept constant
for assets with different returns and standard deviations results in different risk
levels for the portfolio being formed decreasing the weight of the riskier asset and
increasing that of the less risky asset results in reduced risk of the portfolio so
formed while on the other hand increasing the weight of the riskier asset results
in higher risk for the portfolio so formed.

However the reduction is still less that where the weights are constant and
correlation coefficient allowed to vary,. This underscores the fact that the
correlation coefficient is the most important factor in risk reduction for portfolio
formed out of individual securities with different returns and standard deviations.

Draw a graph in Expected return and standard deviations of the above portfolio

Effect of changing correlation coefficient on standard deviation where the

securities combined have the same risk, return and weight
Stock Return Risk Weight
1 10 5 0.5
2 10 5 0.5
Form a portfolio given the following correlation coefficient.
a) 1 b) 0.5 c) 0 d) –0.5 e) –1

From the above results there are two important subjects to note
a) In a case where the 2 securities are perfectly positively correlated the
standard deviation for the portfolio is equal to the weighted average of the
standard deviations forming the portfolio. The reason is that both
securities have the same standard deviations and also constitute equal
weights in the portfolio.
b) In a case where the 2 securities are negatively perfectly correlated and
have the same risk and weight, combining them will have a risk of zero.

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A case where the standard deviation of a portfolio simply equals the
weighted average of standard deviations of individual assets in that
portfolio.
Although the standard deviation of a portfolio is not the weighted average of each
security in the portfolio there is an exception to this and this occurs where there
correlation of the pairs is 1 e.g.
Stock Return Risk
1 15 12
2 13 18
The correlation coefficient is 1
You are required to prove that the standard deviation of made of weight
Stock 1 Stock 2
a) 0.8 0.2
b) 0.6 0.4
c) 0.4 0.6
d) 0.2 0.8
Are in each case equal to the weighted average of the standard of individual
assets.

A Three Asset Portfolio

E(Rp3) = ∑Pi(Ri)

 = √[ W 2A2A + W 2B2B+ W2c2c +2 WA W BAB rAB+2 W A WcAC rAC+

2 WB W CBC rBC

Calculate the expected return and the risk for a portfolio made up of
0.25A, 0.5B and 0.25C
Cov AB = 5, Cov AC = 9 Cov BC = -1.3
Stock Return Risk
A 6 4
B 8 5
C 10 6

The Efficient Frontier and Optimal Folios

The efficient frontier is a curve in expected return (ER) – standard deviation

space which traces or joins all the portfolio all the for a given level of risk or the
minimum risk for a given level of expected return. In other words it is the locus of
all attainable portfolio that have the best results for a given situation.

These investments are mean –variant efficient because

12
 - no other portfolio or investment has a higher expected return and a lower
level of risk and
- no other portfolio investment with the same level of risk has a higher rate
of return and
- no other portfolio or investment with the same level of return has a lower
level of risk.
The investment that are mean variant efficient make up the efficient frontier.
Given that investors are risk averse they would want to invest on the efficient
frontier because they obtain the best risk –return relationship.

ERp
Ay

x x
x x
c x B
x
Qp
In the above diagram curve xy is the efficiency frontier i.e. on it lies all those
securities that have the best risk return trade-offs i.e. have either a lower risk for
equal expected return or a higher expected return for equal than portfolio lying
below the curve/ frontier. Thus since portfolios. AC lie on the frontier they are
better than B for example which lies in the curve. This is because even though
both A&B have the same risk (Qp) but A has a higher return on the other hand
portfolio B&C have the same expected return but C has a lower standard or risk.
Thus portfolio A&B are called efficient portfolios

It would not be rational to hold a portfolio below and to the right of the efficiency
frontier since such a portfolio can be improved upon by obtaining the same
expected return at lower risk or a higher expected return at the same risk. Points
above and to the left of the efficiency frontier are not attainable and hence are
not feasible. Points in ABC are feasible but not efficient since all such points are
dominated by points on the efficiency frontier. When a portfolio either yields a
lower expected return for the same risk or a higher risk for the same expected
return, as an alternative portfolio then it is said to be dominated by that
alternative portfolio.

Such an approach to portfolio diversification-pioneered by Markowits-suffers from

the practical problem of enormous amount of information. It requires knowledge
of the expected returns on each asset, the standards deviations of those
expected returns and the correlation of expected returns between every pair of
assets. When the available assets are numbered in thousands, the data
requirements become vast.

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Optimal Portfolios
Different investors have different risk preferences- some are said to be risk-
takers they enjoy high levels whereas some are said to be risk averse i.e. they
prefer lower risk or no risk at all. Because of this investors will have different
utility functions or indifference curves which in portfolio they specify the trade-offs
between risk and return that an investor is willing to make. This optimal portfolio
is the efficient portfolio that has the highest utility for a particular investor or one
with the highest return for an investor’s risk preference. It is found by point’s
tangents between efficient frontier and the indifference curve with the highest
utility for a given investor.

Ii Iii
Erp Iiii
Ay

x x
x x
c x B
x
Qp

In the diagram indifference curves have also been drawn to show the possible
investment choices by different investors depending on where their indifference
curve are tangent to the efficient frontier. One of the objectives of the analysis is
to be able to determine the required rate of return of an investment given a
certain level of risk. The assumption is that all investors would like to invest on
the efficient frontier since it provides the best risk-return relationship. The efficient
frontier is however a curve that is difficult to describe and use in calculating the
required rate of return. The problem can be solved by adding a risk free asset.

Capital allocation between the risky asset and the risk free asset of a
portfolio
A risk free asset is one with a known return for a given holding period e.g. TB
with this security or asset there is no the variability of return in about it and
expected return ER and therefore no risk. It has no both liquidity and default rsik.
In addition the return of the risk free asset has no correlation with the return on a
risky asset i.e. its return is not directly affected by returns on risky assets.
If the riskless asset is combined with an individual asset or market portfolio, the
efficiency frontier will form a linear relationship.

Portfolio of a risk and riskless asset

Because of the properties of the risk free asset both risk and return of a portfolio
formed out of a risk free asset and a risky asset would imply by weighed average
of the return and risk of each in the portfolio.

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 Asset Return Risk
A 10 0
B 20 20
Correlation Coefficient A.B = 0

Calculate risk and return of a portfolio made up as follows:

A% (weight) B%(weight) E(Rp) 

a 100 0 10 0
b 75 25 12.5 5
c 50 50 15 15
d 25 75 17.5 15
e 0 100 20 20

THE CAPITAL MARKET LINE

Given an assumption that there is risk free lending and borrowing, risk averse
investors will hold portfolios that are made up of a market portfolio (a risky asset)
and a risk free asset. The market portfolio is held because it is mean variance
efficient. The relationship obtained is illustrated below.

The inclusion of the risk free asset results in a linear relationship. This is called
the Capital Market Line. All efficient portfolios will plot on the RfMZ line or the
capital market line. An investor can employ the following strategies:-
- lend all money at the risky free rate. Investor will be at Rf on the capital
market line.
- Lend part of the money at risky free rate Rf and invest the remainder in
the market portfolio. The investor will be between point Rf and M on the
capital market line.
- Invest all money in the market portfolio – Investor will be at point M
- Borrow money at the risk free rate and together with own funds invest in
the market. The investor will fall on the M to Z line which represent
borrowing at the risk free rate and investing in the market portfolio.

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The Capital Market Line is described by the following :-

CML(Rp) = Rf +[ E(Rm) – Rf] x p

m
where CML(Rp) – return on the portfolio
Rf – rsik free rate
Rm – expected return on the market portfolio
p –standard deviation of the portfolio
m - standard deviation of the market
Example
The Rf is 10%, the market return is 20%, and the rsik of the market is measured
by the standard deviation of 5% . investor A wants to invest 80% of his proceeds
in the market portfolio and the remaim\nder in risk free assets. What is the
required rate of return on the portfolio

(Rp) = Rf +[ E(Rm) – Rf] x p or sp

m or sm

sp – standard deviation of the portflio

sp = sm x wm where wm is the proportion of wealth invested in the market
portfolio and sm is the standard deviation of the market
sp = 0.05 *.08 = 0.04

Rp = 0.1+ [0.2 – 0.1]*0.04 =

0.05

THE STANDARD CAPITAL ASSET PRICING MODEL

The CAPM is an equilibrium model for risk and return trade off in portfolio
Theory. It is derived from other portfolio theory models like Markowitz selection
model which spells how securities should be combined in order to create efficient
and optimum portfolios. The CAPM is a technique for predicting expected return
on risky assets. It has a number of assumptions some of which are unrealistic but
nevertheless help in giving insight to more relevant issues in portfolio analysis in
the real world.

Assumptions of the CAPM

a) No transactions costs i.e. there is no cost of trading or looking for

information and put differently this way also mean transactions costs are
irrelevant in decision making by investors.

16
 b) Investors make their decisions based only on risk and return only of a
period horizon i.e. investors are expected to liquidated their position within
or at the end of one period.
c) Individual financial assets are initially divisible that is investors could take
any position in a security regardless of wealthy- e.g. holding a fraction of
stock.
d) No taxes- i.e. investors are not taxed for their gains are therefore one
indifferent between receiving dividends or capital gains
e) There is unlimited lending and borrowing of funds by all investors at the
same risk free rate which is represented by return on a Treasury Bill
f) Short selling is allowed
g) There is perfect competition
h) Investors have homogenous expectations regarding return risk and
covariance of securities
i) All assets are marketable- can be converted into cash without significant
loss
j) Relevant information is instantly available to all investors.

The capital market line and the CAPM

Since the CAPM is partly derived from the Markowitz model it also states that the
optimal and or efficient portfolio should line on the capital market line which
represents the market portfolio. It also states that to determine the effect of an
individual security or the risk of diversified portfolio, it is not appropriate to
consider the total riskless of that individual asset if held on its own, but such total
risk should be divided into 2 points which are market risk and non-market risk.

Market risk

This measures the sensitivity of the individual security’s return to movements in

the market portfolio. This sensitivity measure is called Beta B and can be said to
measure the marginal contribution of a stock to the risk of a market portfolio
Beta coefficiency can be anything from zero upwards. A beta of zero means
insensitivity to the movements in the market portfolio. This Treasury Bills have a
Beta of zero as they are said to be riskless and have no correlation with the
market portfolio.
A Beta of 1 means the individual security moves in tandem or in line with market
portfolio if the market or average increases or decreases by 10%, the return on
that security will also be expected to decrease or increase by the same margin.
Because of this the market portfolio has a Beta of 1 and stocks with a Beta of 1
will therefore have expected return equal to the market return.
In general terms the CAPM implies that the expected return of a security is
related to its Beta or market risk and not total risk. Market risk comes about due
to economy wide factors which affect all businesses and therefore can’t be
avoided or eliminated by diversifying. Because of this market risk is also called
non-diversifiable risk or systematic risk.

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Non-market risk

It is the risk that is unique to a given security i.e. it is not common to all securities
e.g. shares have risk which may not affect bonds and with careful security
selection in creating a portfolio, such risk can be eliminated. Because of this non-
market risk is also called diversifiable risk, or unique risk or unsystematic risk.

Given the division of total risk into market and non-market risk the CAPM implies
that the risk of a well-diversified portfolio will only depend on the market risk on
non-diversifiable risk of its constituent security as non-market risk would have
been eliminated three diversification.

Total Risk = Systematic Risk +Non-systematic Risk

Determination of the Beta

The level of systematic risk of asset x = x * Pxm

Where x = standard deviation of asset x
Pxm= correlation of returns of x to those of the market portfolio
In financial models the systematic risk is measured by an index of the systematic
risk of the asset. This index is calculated by dividing the systematic risk of an
asset by that of the market portfolio. The market portfolio is made up of all risky
assets in the economy and therefore only systematic risk since it is fully
diversified.
The index of the systematic risk is called Beta coefficient

Beta B = x*Pxm / m

The Beta coeffiecent is the tendency of the returns of a stock to move with
market returns. The beta is therefore the sensitivity of asset returns to changes in
the returns of the market portfolio. The market portfolio will therefore have a beta
that is equal to 1

THE CAPM EQUATION

Ri = Rf + B (Rm – Rf)

Where Ri – expected return on asset I for an holding period

Rf- return on risk free asset (TBs).
B – beta
Rm – rtm on market portfolio for on holding print

This equation defines the equilibrium relations between the expected return of a
security and its market risk.

18
Such an equilibrium relationship is represented by the capital market line.

The Security Market Line (SML) The Capital Market Line And CAPM

If the risk is measured by using the beta coffiecient a linear relationship- can be
derived is called the Secuirty Market line.

The SML is a line on which all securities whether efficient or not will plot at
equilibrium.
Why All Securities Plot on the SML
- according to the CAPM , if a security is correctly priced the required rate
of return (RRR) should equal the expected rate of return (ERR). The
difference between the RRR and the ERR called alpha is zero. If an asset
has a non-zero alpha there is some mispricing of the asset.
- When the alpha is positive an investor’s RRR is higher that the ERR This
means that the security is overpriced and the expected rate of return will
plot below the SML. Since security returns are expected to eventually
return to equilibrium the recommendation is to sell this security since it is
overpriced.
- When the alpha is negative an investor’s RRR is lower than the ERR
This means that the security is underpriced and the expected rate of
return will plot above the SML. Since security returns are expected to
eventually return to equilibrium the recommendation is to buy this security
since it is underpriced.

The security market line is a linear relationship between market covariance and
expected between of the efficient portfolios. The capital market line also
represents the linear efficient set of the CAPM. The CAPM almost always uses
above the security market line and they are only equal if the market covariance
and market standard deviation are equal.

Expected Risk Premiums

- This can be derived by rearranging the CAPS equation

19
 ri = Rf + B (Rm – Rf)
Ri – RF + B (Rm – Rf)

NB The expression on the left side of the equation is called the expected risk
premium on the individual security.
The expression in brackets is called the expected risk premium on the market
(RM – RF)
As can be seen the expected risk premium is equal to Beta multiplied by the
expected risk premium.

Example
For the following stocks calculate the expect return

Stock beta
TB rate = 10% A 0.8
Rm = 15% B 1
C 1.25
D 2.1

a) 10 + 0.8 (15 – 10) = 14% c) 10 + 1.25 (15 – 10) = 16.25%

b) 10 = 0.1 (15 – 10) = 15% d) 10 + 2.1 (15- 10) =20.5%

ALTERNATIVES TO THE STANDARD CAPM = NON STANDARD CAPM

Alternatives to the standard CAPM realise that most assumptions improved in the
standard. CAPM are implausible – do not hold in reality. The alternative seek to
incorporate realistic factors or implies in the pricing model with will help provide
a way of studying their impact or input on the capital market equilibrium. This
such factors as taxes, transaction costs etc. with the standard CAPM assume
away are captured by the non-standard forms of the CAPM.

Types of non – standards CAPM

a) The multi-beta CAPM
b) The multi-period CAPM
c) Consumption oriented CAPM.
d) Arbitrage pricing theory (APT)

a) The Multi – beta CAPM

It states that the expected return of a security is a function of the security +
sensitivity to a number of influences which should be represented by different
betas and not one beta.
It also says that these influences are distributed with a multi period horizon.

Ri = Rt + Br (Rm, - Rf) = B (Rm1 – Rf) + B2 (Rm2 – Rf) + Bi (Rm2 – Rf)

20
 + Bi (Rij – Rf) +…
Where Ri = expected return
Rf = risk free return
Rm = market return
Bn = sensitivity of the securities to market’s return
Bi = sensitivity of the securities return to expected on the set of
portfolios that the investor can use to hedge a given risk.

The other betas besides the market beta did represents such risks as term
structure risk, default risk, deflation or inflation risk, profit risk etc.

2) The Multi – period CAPM

It realises that investors are not confined to a one period horizon in making an
investment decision it therefore seeks to find a model which will be able to define
an equilibrium condition even for those investors’ multi-period investment
horizons. Multi beta CAPM is an example of a multi-period CAPM.

3) The Consumption Oriented CAPM

Among other assumptions it states that three only are consumption good and
that the capital market allows the investors to attain a consumption such that they
cannot after that level, jointly benefit from additional trades, i.e. after that level if
one consence benefits another will be equally losing.

4) The Arbitrage pricing Theory

Whereas the CAPM states that the beta coefficient is enough to measure a
security systematic risk the APT says that they are many systematic factors
which affect risk and that they cannot be adequately catered for by a sing beta
coefficient. It is therefore a multifactor model for security pricing.

Empirically, it has been observed and established that expected returns

calculated by a standard CAPM are in most cases very different from the actual
returns realised after the Holdings period. Because of this the APT and other
non- standards forms of CAPM have been used in calculating returns more than
the standard CAPM as they are deemed to be more representative that is they
have measures of sensitivity (betas) for the type of systematic factor.
Examples of such systematic factors are labour mounts productivity fluctuation,
management skills availability, unforeseen inflation, and unanticipated changes
in interest rates. However the problem is this method is in identifying with factors
are important factors and reporting the unforeseen and foreseen.
- the formula suggested for the APT is as follows

Ri = ai + bifi + b2f2 + b3f3 + … + bifi + ei

Where ai = expected return if all the systematic factors – the bs have a value
of zero.
Bi = sensitivity of the stocks’ return to the I factor.

21
 fi = value of the 1st factor that affects the stock’s return.
ei - the residual error

NB researchers advice that even through APT may seem to be a superior

measure of that the CAPM, nothing to that effect has been concluded because of
its infancy and the fact that not much research and empirical evidence/
observations have been made. Thus they say at the moment APT is just another
model of pricing securities and is not necessary superior to CAPM.
However in Japan’s Tokyo stock Exchange APT has been tested and results
show that it is superior to CAPM in selecting securities for portfolio and about for
explaining past returns.
Because of this it has replaced the CAPM in that market.

22
CHAPTER 2 CAPITAL STRUCTURE THEORIES AND POLICY
A. THE COST OF CAPITAL
The cost of capital is minimum required return by the providers of long-term
funds. Long-term funds can be raised in the form of debt capital and equity
capital.

Equity Capital
Equity capital-shareholders who receive dividends which vary according to
amongst other things how well the firm is doing. No dividends can be paid to the
shareholders until the firm has paid all its obligations to the providers of debt
capital. Amount of dividend paid does not have any limit but depends on whether
the firm has enough reserves. The principal amount invested is not repaid unless
the company is liquidated.

Debt Capital
The returns paid to debt capital (interest) should be paid so that the company is
not dragged into liquidation. Much debt capital is redeemable that is a date is
specified by which it must be paid. Debt becomes irredeemable if there is no
provision for repayment. Failure to pay interest or repay capital due results in the
control of the firm being passed to debt holders. Since debt and equity capital
carry different risks relating to both interest and dividends are different.
Debt capital holders generally require a lower return than the equity holders
because the interest paid to the and repayment of capital are contractual and
both take preference in distribution.

To calculate the cost of capital which incorporates both equity and debt it is
necessary to:-
- First calculate the cost debt and equity ( individual costs of different sources )
-Combine the individual costs into weighted average cost of capital. (WACC)

WACC = kd(1-tax) x Market value of debt + ke x Market value of Equity

Total market value of Total market value of
debt + equity debt + equity

WACC = kd(1-tax) x D . + E
(D+E) (D+E)
Cost of Equity it is the rate which investors discount the expected dividend of the
firm to determine it its share value. It is the minimum return required by
shareholders.
NB 2 forms of common stock financing – retained earnings and new issues.
There are 3 most widely advocated models
1. The Dividend growth model
2. Capital Asset pricing Model
3. The Earnings Model

23
1. The Dividend Valuation Model
It defines the value of equity capital as the PV of the future dividend stream. It
rest on the premise that the value of a share is equal to the PV of all future
dividends.

a) The No growth Model

Key assumptions
- the dividend remain the same forever – they don’t grow
- the dividend is like a perpetuity

Po = D1
ke

b) The Constant Growth Model

Po = D1
ke -g
Where D1 = the next dividend to be paid or (or Do (1+g)
ke = the required rate of return
g = the forecast growth rate

What if g exceeds ke
The model shows that if g is greater than ke the denominator becomes negative
and the value infinite.

Problems with the Dividend growth model

- the growth rate might not be constant as it assumes a constant rate.
- What if the firm paid no dividend it implies no it implies no value to the
company but this is not so
- It assumes the availability of profitable projects in the long run which is not
true.
- What if g >ke

2. CAPITAL ASSET PRICING MODEL

Under the CAPM, the calculation of the cost of equity is very different from the
dividend growth model. The cost equity under CAPM is calculated with reference
to return in a single horizon /period by the company’s investors. This return
comprise 2 elements a risk free element Rf and this represent a fixed minimum
rate of return and an element of premium which depends on the relative risk
associated with the performance of the company’s shares. It is called risk free
because of the Government’s investment which are not expected to default. The

24
split of return into riskless and risk element is a very useful way of understanding
why different investment offer different returns.

The CAPM is dependant on the beta of a stock. The greater the level of risk the
higher the return. The relative risk of a company’s shares is determined by

a) The average return available from all listed shares limit from the market
portfolio. All market shares n the ZSE form a portfolio
b) The relative risk of a company’s shares compared to the average return of
all listed shares

ke under CAPM = Rf + ß (Rm – Rf)

Where ß = beta
Example
Suppose the return on treasury bills is 10%. All under is R/m = 19% and the
variability on return as determined by a series of observations in 8% that of the
market (i.e. if the index terms all index is to increased by 10% this particular
company will increase by 10%. Calculate the cost of equity for the company or
the minimum return required by all shareholders.
Ke = 0.1 + 0.08 (0.19 – 0.1)
= 0.1072

NB if the capital market is in equilibrium the dividend valuation under and the
CAPM should give similar result but since they use different the horizons i.e. the
CAPM is a single period model and dividend growth model covers period longer
than 1 year the outcome will therefore be different.

Example
Z PLC is an all equity financial company whose shares are listed on the ZSE. It
has paid dividend per share of the past 5 years.
Year 1 2 3 4 5
Dividend 7.5p 8.5p 8.7p 10.4 12p
If the current market price per share is 2.40. The company financial analyst has
collected own the returns of ZPLC’s shares and those of the financial times all
the share of the past 5 years. An estimated company’s beta factor 70% (0.7). this
analyst has also estimated the average return on all index to be 15% of the
return of the treasury bills to be 8%. Given the above in for calculator Z’s cost of
capital with CAPM.

% = n-1 latest dividend – 1 = 5-1  12 - 1= 0.125

earliest dividend 7.5

CAPM = 0.08 + 0.7 (.15 – 0.08)

= 0.129 = 12.9%
Dividend Model
D1 = 0.12 (1 + g) = 0.135

25
 Ke = 0.135 + 0.125 = 0.18 = 18%
2.40
Growth model vs. CAPM

- CAPM is a single period model and therefore the rate obtained is the
returned expected our the next time period and ke I dividend growth model
is the average return on perpetuity.
- When dividend growth model is used in calculating cost of capital or equity
it can be adjusted for floatation costs i.e.
Ke = D1
Po - F
- The CAPM doesn’t allow for such adjustment. This is so because the
CAPM doesn’t include a variable that is needed to take such adjustment.
- The beta estimate is based on historic data and for decision making
purposes the beta values should be based on what is going to happen and
not on what has happened.
- CAPM consider the firm’s risk as reflected by beta which dividend growth
model doesn’t look at. It uses Po as a reflection of the expected risk
preference of investors in market place.

Cost of retained earnings (Kr)

It is the rate of return shareholders require on the firm’s common stock. Kr
represents cost of retained earnings. If earnings are not retained they should be
paid out as dividend to common stock holds. Retained earnings increase the
stockholders’ equity in the same way so the new issue and Kr = Ke in principle.
The difference is that Kr doesn’t involve any issue costs.
With issue of costs the scenario will be Kr < Ke

Cost of preferred stock (Preference shares)

It refers to annual stock dividend d divided by the amount preferred stock price
Po Growth (g) do not apply because preferred stock have fixed rate interest e.g.
Assure perpetual preferred stock is to be issued at $100 far value, annual
dividend to be 9% Floatation costs are 2,5% of pa value. Calculate the cost of
preferred stock.
Kp = .. 9 = 9.2%
100 – 2.5

3. Earning model

ke = EPS + g
Po

The value you get under the Earnings method is greater than that of dividend
EPS = $ 10 Price $100 = 5%
Div = $5

26
 10 + 0.05 = 15%
100
Since dividends one paid out of earnings and earning can be split into retained
earnings and dividend then it follows that the earning method will result in a
greater cost of equity.

Weighted Average Cost of capital

 Having computed the costs of specific sources of capital it is then
necessary to weight these according to value of the sources of capital.
 Market value and not book values should be used because they are
current and observable. It represents the amount sacrificed by investors
as a result of their continuing to own debt which could sold at its market
value.
 They indicate opportunity cost of being masters in that company.
Weighting arise because the aim of cost of capital calculation is to provide
a minimum acceptable return for all project undertaken by the firm
regardless of the source of finance.

Question
The finance director of your company has approached for advice on the
computation of company’s cost of capital. Given the following information
Current share price of 50 cents which exclude divided of 25c paid recently.
The dividend is expected to increase by 10% for the foreseable future.
EPS of 50cents are expected to increase by 10%. The company has a beta of
1.2. current rate of return is estimated at 15% on the market. the T/B are offering
a return of 5%. The company has ordinary shares in issue and 2 million undated
debentures and the current rate of interest on debentures of this quality is 12%

Required
1. Explain the methods available for the calculation of cost of equity capital
based on, dividends, earnings and Beta factor
2. Calculate the cost of equity capital for the three which one do you think is
the most appropriate
3. Calculate the WACC using of the costing equity capital calculated in 2
assuming no taxation
4. Why has the market value of debentures gone below par value.

Cost of Debt
- The relevant cost of Debt is after tax cost of debt
- The after tax component cost of debt is the interest rate of the new debt
kd (1 – T)
where T = marginal tax rate

27
After tax component cost of debt is equal to
Kd1 = Kd (1 – T)
Par value – Market value of asset
Cost of debt (Kd) = C + No of years
Par value + Market value
2
This is suitable for redemption bond.
Since tax is deductible expense the get in effect pay part of the interest charges
e.g. assume a 30-year straight bond of 10% corporate offered to the public at
$1000 par value. What is the cost of debt 40% tax is charged by the state.
Assume that the current rate of interest is equal to the coupon rate.
1000 - 1000
Kd = 10% + 30
1000 + 1000
in this case par value is assumed equal market value

The after tax rate is = i ( 1 – T) = 10% *(1 –0.4) =0.06 or 6%.

Example
Kbc PLC has a capital structure as follows 4 million ordinary shares (equity) of $1
ea (Par value $4 000 000). 7% debt redeemable at par in 7 years time =
$1.5million. the ordinary shares have a current value of $4 ea excluding dividend.
An annual dividend of $1 million has been paid. Dividends have grown yearly at
6% per annum over the past years and are expected to grow in the future at the
same rate. The debt has a current market value of 77.177% ($77.177).
Required
2. Using the formula for each specific source of capital calculate the WACC
assuming NO1 taxation at all.
3. Why is the return on equity on a geared firm ke is higher than them the
return on an ungeared free key.
Ke = D1/Po +g
= 1 000 000(1.06) +0.06
16 000 000
= 12.63

Par value – Market value of asset

Cost of debt (Kd) = C + No of years
Par value + Market value
2
= 7+(100-77.177)
7
(100+77.177)
2
= 10.68%
kd = 10.68%

28
ke = 12.63%
Po = 16 000 000
Vd = 1 157 655 ($1.5m x 77.177%)

WACC = 10.68%(1157655)/17157655 +12.63(16000000/17157655)

= 12.50%

Example 1
An irredeemable 9% loan stock is currently quoted at $75 par $100 normal value
of stock.
Market rate of interest = Normal rate of interest x Old interest rate
Market value
= $100 x 9%
$75
= 12%

Question
ABC is a listed company has an equity beat of 1.50 It is wholly financed by
equity. The total risk as measured by the variance of expected returns of the
company is 24% and the risk of the market as a whole is 9%.
a) Decompose ABC’s risk into systematic and non-systematic risk components
b) If the risk free rate of return is 15% and the market premium is 10% what is the
company’ cost of capital.

The Marginal Cost Of Capital

The use of WACC assumes that the capital structure of an entity will remain
unchanged and that any new investment will have a similar risk profile to existing
investments. If a large project is under consideration it will fundamentally affect
the capital structure of an entity , this assumption would mean that WACC is no
longer the appropriate technique for investment appraisal. Use of WACC could
lead to the acceptance of projects that reduce the entity’s value.
The relevant cost of capital is now arguably the incremental cost i.e the marginal
cost reflecting the changes in the total cost of the capital structure before and
after the introduction of the new capital.
In theory the marginal cost of capital is just the difference between the total cost
with the existing capital structure and the total cost with the new capital structure
once the investment is undertaken.
Consider the company with the following cost of capital

Source After tax cost % Market Value AxB

A B ($m)
Equity 20% 5 1
Preference shares 10% 1 .0.1
Debt 8% 4 0.32
10 1.42

29
WACC = 1.42/10*100% =14.2%

This firm is considering a large investment project to be financed by a major

issue of funds which will alter the capital structure. The estimate project cost is
$1m to be financed by equal proportion of debt and equity. The new capital
structure will imply a new level of risk to both debt and equity holders causing the
cost of capital of the company to increase.

The new cost of capital may be as follows

Source After tax cost % Market Value AxB
A B ($m)
Equity 22% 5.5 1.21
Preference shares 10% 1 .0.1
Debt 8% 4 0.32
New debt 10% 0.5 0.05
11 1.68

WACC = 1.68/11*100% =15.3%

The marginal cost of capital = (1.68 –1.42) / (11 – 10) *100%

= 26%
The total cost of capital has increased by 260 000 as a result of raising 1 000 000
of funds. The incremental cost of capital is therefore 26%.
It might be thought that by raising 500 000 of equity with a cost 22% and of debt
with a cost of 10%, the marginal cost would be =
(0.5*22%) + (0.5*10%) = 16%, but this would ignore the change in the original
capital.
This approach illustrated here is appropriate only if the investment project is large
relative to the current size of the entity and undertaking the project causes an
identifiable difference in the capital structure. In practice companies rarely raise
funds from a particular source for a particular purpose which makes this
approach difficult to use.

30
B. CAPITAL STRUCTURE THEORIES
An ungeared firm is financed by equity – the company has no debt – Eu
A geared company is financed by debt and equity that is E .g. and the value of
debt dg
Does Debt really matter?
Say you have $ 10 000 to invest and intend to start up a company. Your plan is
have a company buy a property renovate it and sell it at – a profit.
A suitable property presents itself with requires $ 100 000 as an initial
measurement.
How do you finance this venture?
Conceptually 2, courses present themselves
a. A – company geared with your $10 000 and have to borrow $90
000 at say 10% p.a.- you have a combination of ($90 000) debt +
$10 000 equity.
a) Company ungeared with your $10 000 and persuade friends to
become partners in the company with a right of to ownership pro-
rata to the amount contributed by each partners.

NB- both companies- ungeared and geared- have the same physical assets.
Your choice is of investing your $10 000 in either of the 2.
Does it make any difference?
Suppose the outcome of the 1st year is that the cay property is worth $135 000
what will be the total return that you will get from either of the debt.

Geared = 135 000 - 100 000 = 35 000 – 10% x 90 000 (debt)

10 000 equity
= 260%

Ungeared = 35 000 – 0
100 000
= 35%

Support the prices fall and the outcome is $105 000 –

= (105 000 – 100 000)
= 5000

Ungeared = 5 000 x 100%

100 000
= 5%
Geared = 5 000 – 9000
10 000
= - 40%

Geared is more risky and this is the first lesson of gearing

31
THEORIES OF CAPITAL STRUCTURE

Firms’ attempts to find a combination of debt and equity that maximises it overall
market value.
Advantages of debt capital
It is cheaper than equity because
i) The administrative costs and issuing costs are normally lower –
underwriting is usually not required.
ii) Debt interest is allowable against profits for tax purposes
iii) The pre-tax rate of interest is invariably lower than ke the return
required by shareholders because lenders have prior charge claims.

However it introduces the default risk – inability to service loan may lead to
liquidation.
Generally debt is relatively cheap but there may be limits to the prudent use of
debt financing because it may be lower risk to the lenders but highly risk to the
borrower. Corporate problem are associated with and are compounded by high
borrowings.
 Is there a correct level of Debt?
 How much should a firm borrow)

THE CONCEPT OF AN OPTIMAL CAPITAL STRUCTURE.

[I] NET INCOME MODEL

- Value of firm increases as gearing or debt increase
- The cost of capital and debt remains constant as gearing increases.
- WACC decreases as gearing increases.
- The reason why the model is often referred to as naïve is because it is
considered to be oversimplified approach e.g. it is not sensible to assume
that ke and kd remain constant as gearing increases when evidence
suggest that at some point additional debt will result in significantly
increasing the finance risk of the firm.

[II] THE TRADITIONAL MODEL

- A range of traditional views which basically show the following
characteristics.
a) Initially cost of debt is constant but will rise as the level of gearing
increases reflecting the higher probability that the firm may default on its
debt.
b) Ke rises as gearing increases reflecting the added financial risk the
shareholders are subjected to.
c) WACC does not remain constant may fall initially as the composition of its
debt increases but then begin to rise as both ke & kd both increase
d) There is an optimum gearing level where the WACC is at its lowest and
where the value of the firm is maximised.

32
[III] THE NET OPERATING INCOME MODEL (NOI) associated is (M & M)

- Firm value is a function of its expected averaged NOI in perpetuity

- The value of the firm does not change with gearing. Rational changes in
income can only be affected by changes in investment of the firm and thus
it is not affected by the way in which these investment projects are
financed.
- Ke is a linear function of the level of gearing and is explained as
keg = keu + a premium for risk
- WACC reflects with average return by investors in a geared firm. The level
of return required by investors(in a geared firm) is dependant upon their
perception of the business risk of the firm as reflected through level and
variances of the firm’s NOI. There is no reason way the firm’s gearing will
affect the business risk of income generated by the firm’s investment
projects. Therefore the level of gearing will not affect either the WACC or
the total value of the firm
The conclusion t be drawn from all this are as follows:
- There probably does exist an optimal capital structure or at least an
optimal range of structures for every firm
- However the financial theory is not powerful enough at this point to enable
us to locate the optimal structure with any degree of precision.
- Still financial theory can help identify the key factors and assumptions
which influence the value maximising structure.

The Valuation Equations

Theories of the effects of leverage on value of the firm and its cost of capital
addresses to basic questions:-
i) Can a firm increase firm the earnings of its shareholders by
replacing its equity with debt and
ii) If so exactly how much debt should it use?

Key Terms
Vs – Market value of the firm’s equity (price/share x No of shares)
VB – Market value of debt (one of debt with perfectly I used)
VO – Total market value of firm (Vs + VB)
NOI – Net operating income (EBIT) – assumed constant
Ke – required rate of return by shareholders
Kd – rate of return required by lenders
WACC – weighted average cost of capital given firm’s risk class
T – corporate taxes
I – interest rate on the firm’s single class debt
NB – if VB is equal to our value of debt than interest payment will be equal to i.
(VB for simplicity we assume that the market value of debt will be equal to the
book value of debt
If the debt is risk free this implies that interest will be equal to the cost of equity or
required rate of return by shareholders.

33
Assume that a firm is in a zero growth situation i.e. NOI is expected to remain
constant. All earnings are to be paid out as dividends, then the total market value
will be equal to market value of a perpetuity.

Ungeared firm
The Vs is a perpetuity whose value is as follows:

Vs = NOI (1 – T)
Ke

= D
Ke

Geared firm Vs = [NOI – KdVB (1 – T)]

Ke

The numerator gives the net income that is available to common stockholders
and which we assume is all paid out, as dividend while the denominator is the
cost of equity.
NB MM’s 1961 paper shows that dividend and retained earnings are perfect
substitute.
Equation I will be used to show how changes in the amount of debt financing
would affect the value of the firm’s equity under different capital structure
theories.

Equation 1 Vs = (NOI – KdB) ( 1 – T)

Ke

Equation II
WACC= (1 – T) (Kd) B + Vs x Ke
Vo Vo

We will use Equation II to examine how changes in the debt ratio will affect the
firm’s WACC.

Equation III – the total market value of the firm.

Vo = VS + VB

Stage I Vo = (VB) (Kd) ( 1 – T) + (Vs) (Ke) from Equation II

WACC

Stage II = substitute for Vs: Vo = (VB) (Kd) (1 – T) + (NOI– KdVb) )1– T)ke
Ke

34
 WACC

Vo = (VB) (Kd) ( - T) + NOI (1 –T) kdVB (1 – T)

WACC

Vo = (VB) (Kd) ( - T) + NOI (1 –T) kdVB (1 – T)

WACC

Vo = NOI (1 – T)
WACC
Equation 3 shows that Vo can be found as value of perpetuity with capitalise
the constant after that operating income NO1 (1 –T) at the firm’s WACC.

Assumption of MM 1958

1) A firm’s bus risk can be measured by the standard deviation of NOI and
firms with some degree of bus risk are said to be in a homogeneous
business risk class.
2) All present and prospective investors have identical estimates of each
firm’s NOI- that is investors have homogeneous expectations about the
expected future corporate earnings and the riskness of these earnings.
3) Stocks, shares and bonds are traded in perfect capital market no
brokerage fees and investors (individuals and institutions) can borrow at
the same rate as corporations (by implications)
4) Debt of firms and individuals is riskless, therefore interest is at Rf rate i.e.
regardless of how much a debt a firm of individual issue
5) All cases firm are perpetuities – zero growth firms an exceptionally
constant NOI and its bonds are perpetuities.

Example

Company L has a policy of distributing all its cash surplus after interest and taxes
as a dividend paid annually. An annual dividend has just been made. It has 6
000000 shares with a market value of $ 1.50 each. It also has a debt with a
market value of $ 2 500 000 and the market rate of interest is 8%. Company
maintains annual earnings of $ 2000 0000 after all other payments but before
interest and taxes. The tax rate 40% and is paid when need arises. The market
believes that this performance can be maintained indefinitely.
Required
1. Determine with market value of Brinken L debt and equity – by discounting
the firm company’s earnings before interest and tax appropriately by the
WACC.

2. Comment on your answer.

35
 Vs = 6 000 000 x 1.5
= $9 million

VB = $2.5 00000 at 8%

First find Ke Ke = (NOI – KdB) (1 – T)

Vs

= (2 000 000 – 0.08 x 2 500 000) (1 – 0.4)

9 000 000
= 1080 000
9 000 000
= 12%

2nd find WACC = (1 – T) (Kd (VB) + Vs x Ke

Vo Vo

= (1 – 0.4) (0.08) (2 500000) + 9 000 000 (0.12)

11 500 000 11 5000 00
= 0.0104 + 0.090
= 0,104347
Vo = NOI (1 – T)
WACC

= 2 000 000 (1 – 04)

0.104347

= 11.505.273

Proposition I

Vo = NOI
WACC
= NOI
Ke (ungeared)

The value of a firm is by capitalising NOI by the rate appropriate for the firm’s
asset risk class. The value of a firm is independent of its leverage.
It also implies that the average cost of capital to any firm is completely
independent of its capital structure and the equal to the capitalisation rate of an
unmeasured firm the same risk class.

Consider the following -

Firm L has $4 000 000 7.5% debt
Firm U is all equity financed
Both L.&U have NOI of $900 000

36
In the initial situation before any arbitrage we assume that both have an equity
capitalise of 10% keu = keg = 10%
The following situations could exist

Vo = NOI = 900 000 = $9 million

Keu 0.1

L Vo = NO1 – KdB + B
Keg
= 900 000 – 0.075 x 4 000 000 + 4 000 000
0.1
= $10 000 000

Thus before arbitrage L’s value exceed that of U. M&M argue that this
disequilibrium is temporary. Suppose you own 10% of L’s equity with a
market value of $600 000. According to M&M you can increase your total
investment without increasing your financial risk.
i) Sell your 10% holding at 600 000
ii) Borrow an amount equal to 10% of L’s debt at 7,5%
iii) Buy 10% of U’s equity at 900 000
In selling + borrowing you would receive (600+400) 000 = 1 000 000 – 900 000 –
10 0000  must this risk debt of L at 7,5% = 7,500 annually.
Old income position = (900 000 x 0.1 – 0.075 x 4 00000 x 0.1)
= 60 000
New income position = 10% 90 0000 = + $ 90 000
0.1 x 0.075 x 40 000 = - $ 30 000
+ 0.075 x 100 000 $ 7 500
= $ 67 500

Example II (Arbitrage Process)

Assume 2 company A is ungeared and cay B is geared
Capital structure is as follows:
A B
$1 5000 000 4000 000
Debt 10% - - 1000 000
5 000 000 5 000 000
The required rate of return for A is ke is 20%
Net operating income is $ 1 000 000
Imagine that market value of A = $4million B = $ 6 million

Value of A’s equity = $4 million = 0.80c

$5 million

B’s equity = (6-1) million = $1,25

4 million

37
A should have a value of $ (NOI) = $1 million
Ke 0.2
= $5 million

Assume you hold 1% of equity in B how could you make more income through
the concept of homemade leverage.
Initial earnings = 1 000 000 (NO1) – 0.1 x 0.01 x $ 100 000)
= $9 000

i) Sell 1% of you holding in B = 50 000

ii) Borrow 1% of the 1 million debt = 10 000
60 000

Invest all in A = 60 000 x = 1.5%

4 000 000

1.5% x 1 000 000 = 15 000

- 1% x 10% interest 10 000 = 1 000
14 000
or

Invest on 1% of A (4 000 000) = 40 000

Lend the 20 000 to B at 10%
Income 1% x 1 000000 = 10 000
Interest owing from B = 2 000
Interest due to B = - 1 000
11 000
M&M use arbitrage proof to support their proposition to show that under their
proposition if 2 companies differ only
i) in the way they are financed.
ii) total market value then investors will sell shares of the overvalued
firm and buy those of the undervalued firm and continue the
process until the companies have exactly the same market value.

Proposition II

Keg = Keu + Risk Premium

= Keu + (Keu – Kd) (B/B+S)

- The ke of a levered firm is equal to the cost of equity an unlevered firm

plus risk premium which depend on the way on it degree of firm leverage
the firm uses.
- If a firm’s leverage increase its cost of equity rises and in an exactly
specified manner. Taken together the first 2 of M&M proposition imply the
inclusion of debt in the capital structure will not increase the value of the

38
 firm because the value of cheaper debt will exactly be offset by on
increase in the cost of equity.
- The basic M&M theory in a world without both firm value and its cost of
capital are completely unaffected by the capital structure.

Proposition III
If a firm is acts in the best interest of its shareholders, it will only invest in those
projects with rate of the return greater or equal to WACC or keg. This proposition
is well accepted in finance.

M and M with corporate taxes

M and M were criticised for not including corporate Taxes. They revised their
analysis to incorporate taxes. They revised analysis can be using prop I and prop
II.

Proposition with Taxes

When M&M incorporated taxes they found that the value of the firm increased
because of the debt tax shield arises because debt interest is a tax-deductible
expenditure.
Interest on debt paid by the company is a tax-deductible expense. If an item is
tax deductible it reduces the amount of taxable income and therefore the amount
of tax paid by the firm. A reduction in tax is an inflow or positive cash flow.

Vg = Ve + Tax shield
Vg = Ve + TTs
Ve = [NOI (1 – T)]
Ke
Vg = NOI (1 – T) + Tax shield
Keu

Vg = NOI (1 – T) + (I.B.T)
Keu Kd

Value of the geared firm is therefore the value of ungeared firm + a debt tax
shield. Tax shield depend only the corporate tax rate and on the ability of the
levered/ geared firm to earn example to cover the interest payment.

Present value shield = Corporate tax rate x interest payments

Expected return on the debt

= T x rD D
rD
= TD
MM - the value of a pie does not depend on how it is sliced.

39
Gearing increases the value of the firm solely because of the existence of the tax
shield. The higher the level of debt the greater the tax shield. The
recommendations is for the firm to be 99% +++ debt financed.
- Is this realistic

M and M proposition II
No taxes keg = keu + ( keu – kdB/VS)
With Taxes keg = keu + ( keu – kd) (I-T) B/VS

The cost of equity will increase with gearing and as the Weighted Average Cost
Of Capital will remain the same at whatever debt/equity ratio.
But an increase in key will be slightly less than the increase where there are no
taxes.

Criticisms of the M and M approaches

A major criticism of M&M approval is the restrictive assumption hat they make to
reach their conclusion.
- The analysis does not take into account financial distress (bankruptcy)
agency costs, debt capacity, debt exhaustation.

Cost of financial distress

M&M analysis does not take into account for distress. Costs of having financial
problems because of the firm is over borrowed. These are associated with
inability to service its debts or debts are honoured with difficulty. Loss of
customers, loss of discounts, legal costs - It may lead to bankruptcy. Financial
distress worries investors.

Veg (value of firm) = Value of all equity finance + PV of Tax shield - Pv of

financial distress
Veg = Ve + PV of tax shield – Pv of financial distress

The potential costs of firm’s distress increase as the firm increase earning and
reduce tax shield.
Cost of financial distress depends on the probability of distress and the
magnitude of costs encountered when distress occurs.

Pv of fin distress

Pv of tax shield

Value of all equity financed

40
 Debt ratio
Optimal date ratio

Present Value of Tax shield initially increases as the firm borrow more. At
moderate debt levels of the present value of financial distress is trivial and so
the Pv cost of financial distress is small and tax advantages dominate. But at
some point the probability of financial distress increase rapidly with additional
borrowing, the cost of distress begin to take substantial bite on the firm’s
value.

If the firm cannot be sure of profiting from he corporate tax shield, the tax
advantage is likely to dwindle and eventually disappear.

Bankruptcy costs
Corporate bankruptcy occurs when shareholders exercise their right to
default- when a firm gets into trouble, limited ability allows the stockholder
simply to move away from it and its trouble to its creditors
In the USA Continental Airlines legal fees were US$2 million / month
In times of fin distress the security holders are likely many political parties- united
on generalities but threatened by squabbling to any specific issue.
Financial distress is costly when these conflicts of interest get in the way of
proper operating investment and financing decisions. Stockholders are tempted
to forsake their usual objective of maximising market value of the firm and pursue
natural self-interest instead.
They are tempted to play games at the expense of their creditors.

Debt capacity
Most corporate borrowing has to be secured by assets owned by the firm.
Lenders usually require the asset pledged by the firm to have higher value than
the borrowings because of liquidity risk on most corporate assets.

Agency costs
Because managers might not act in the best interest of the debt holders debt
holders will usually covenants into debenture agreement that safeguard their
interest.
It might be clause on dividends and issue of new debts. This results in restricted
decision making by the manager. The costs are ultimately borne by the
shareholders as the constraints to the maximising shareholders’ wealth.

Agency cost will cause a reduction in the tax shield

Veg = Veu + Tax shield – Pv of Agency costs

Tax Exhaustion
Where the firm does not have adequate taxable income to avoid the benefit. The
assumption so far is that the earnings of the firm will always be adequate to avail
the tax shield. In some cases earnings of the company are not adequate to avail

41
the debt tax shield. This results in the falling away on any benefit that can be
derived from additional debt firm.

Making capital standard decisions

In the real world firms have to make financing decisions. Financial theory has not
been able to come up with conclusive evidence on irrelevance or relevance of
capital structure decision-making. No theoretical methodology has been optimal
capital structure of a company. What highlights the issue involved in making up
structure decision: - corporate value, debt, Tax shield, financial distress, Tax
exhuastation debt capacity and agency costs important when making capital
structure decision.
There is need for company to determine the best source of financing. A practical
method that is useful in reaching capital structure is Financial Break Even
Analysis. Earnings per share is calculated for each financial alternative, the EPS
are compared with the highest EPS chosen.

A firm would like to finance new project worth $400 000 with the following
financing alternative.

i. Issue $125 000 shares at $ 160 each and issue of $ 200 000
worth of debt at 20%
i) Issue of $100 000 worth of debt at 18%, $150 000 preference
shares a yield of 25% $1.60 of $750 shares
The firm has an expected earning before interest annual tax of $100 000 tax rate
is 40%. Use $100 000 and $40 000.
EBIT
EPS
BEP for the 2 = (EBIT – 1B} (1-T) – Dps
N
(I) = (100 000-0.18x100 000) (1-0.4)-0.25*15000
93750
= 11 700
93 750
= 0.124

(II) = (100 000-0.2x200 000) 1-0.4)

125 000
= 0.48
T = tax rate
RB = interest on debt
Dps – Pref share div
N = no of shares

42
CHAPTER 3 DIVIDEND THEORY AND POLICIES
Dividend policy involves the decision to pay out earning vs. retaining them for
reinvestment in the firm. An important issue for both investors and corporate
managers is whether a firm’s dividend policy has any impact on its value.

GORDON’S CONSTANT GROWTH MODEL

Vo = D1
ke-g where g is assumed constant
The model shows that a policy of paying out more cash dividends will tend to
raise Vo. However, if dividends are raised and consequently less money is
available for reinvestment, the expected growth rate of will be lowered which in
turn will reduce the value of the firm Vo. Thus dividend policy has 2 opposing
effects. Some academics have argued that dividends are irrelevant e.g. MM
argue that under perfect market conditions i.e. no taxes, brokerage costs,
floatation costs or signalling and or clientele effects- the value of the firm is
determined by its investment policy not by its dividend but investment structure
policies.
The so called residual theory of dividends also suggests that a firm’s cash
dividend is a mere detail that has no impact on the value of the firm provided the
firm uses its funds to make value maximising investments and then just pays out
as dividends any residual left over.

Actual dividend policies take place in less than perfect markets. Dividend policies
which we see in practice reflect manager’s belief that clientele effects and the
signalling are important and that capital markets view reduction in dividends as
particularly bad ones (i.e. signal) regarding the firm’s prospects.
In practice managers believe that an optimal dividend policy strikes exactly the
balance that investors in the aggregate want between current dividend and future
growth and this will thereby maximise the value of the firm.

DIVIDEND POLICY THEORIES

Factors influencing dividend policy- include among others
- The differential tax rates on dividends and capital gains.
- The number of good investment opportunities available for the firm.
- Availability and cost of alternative sources of capital.
- Shareholders preference for current vs. future consumption.

DIVIDEND IRRELEVANCE THEORY

- Associated with MM’s 1961 paper in the Journal of Business.
- MM asserted that dividend policy has no effect on either the price of a
firm’s equity or its cost of capital i.e. dividend policy is irrelevant
- The value of a firm is determined by its Basic Earning Power and its risk
class.

43
 - The value of a firm depends on its investment policy and not how the
firm’s earnings are split dividends and retained earnings.
- The so called Residual Theory Of Dividends which recognises that new
share issues are more costly than retained earnings comes to very similar
conclusions to MM’s analysis
- Provided the firm re-invests internally generated funds in investment
opportunities which are at least as good as those facing the investors, the
residual it pays out as dividends will be irrelevant as regards its effect
upon firm value.

Assumptions on MM propositions
- No personal/ corporate taxes
- No share floatation cots
- Financial leverage has every little effect on the cost of capital (refer MM
proposition II on capital structure )
- The dividend policy has no effect on the firm’s cost of capital
- A firm’s investment policy I independent of its dividend policy.

On both their single period and multi-period irrelevant models, MM found the
same results (with their assumptions) that dividends are irrelevant.

MM’s assumptions are very strong and they don’t hold precisely. Firms and
investors do pay taxes, incur floatation, transaction costs and both taxes and
transaction costs c/d cause the ke to be affected by dividend policy. Thus the MM
conclusion on dividend irrelevance may not be valid with real world conditions
NB: MM conclusions still hold with corporate but not with personal taxes

The Bird In The Hand Theory

It will be recalled that the Gordon Growth Model gives the value of an all equity
firm which grows at a constant rate forever. The Constant Growth Model is
derived by assuming that a constant fraction b of earnings [NOI] is retained for
investment and that the average rate of return R is the same fat all projects we
have.
Vo = NOI(1-b) = D1
[Ke-bR] Ke-g

Because the product of the investment rate and the average rate of return bR is
the same as the Growth Rate of cash flows. Since all NOI with is not reinvested
is paid out as dividends then [NOI (1-b] = D1

One of the most critical assumptions of MM dividend irrelevance theory is that

dividend policy doesn’t affect investor’s required return on equity Ke . The
question of whether or not dividend policy affect cost of equity has been hotly
debated in academic circles

44
Myron J Gordon and John Linter argue that Ke increases as dividend payout is
reduced because investors are more sure of receiving dividend payments than
income from the capital gains with the should result from retained earnings.
They say in effect that investors value a $ of expected dividends than the $ of
expected capital gains because of the dividend yield.

D1/Po or D1/Vo is less risky than the g component in the total expected return
equation D1/Vo + g
Gordon says investors prefer what he calls an “Early resolution of
uncertainty”

On the other hand MM argue that Ke is independent of dividend policy which

implies, if we ignore tax effects, that investors are indifferent between D1/Vo
and g and hence between dividends and capital gains.

MM call the Gordon Linter argument “The bird in the hand fallacy” because in
MM’s view many if not most investors are going to reinvest their dividend in
the same or similar firms anyway. In any event, the riskness of the firm’s cash
flows to investors in the long run is determined only by the riskness of it asset
cash flows not by its dividend policy.

The tax differential theory

The 2 models discussed above assume a world of corporate taxes but no
personal taxes. What happens when personal taxes are considered?
A lot will depend on the relative tax rates to dividend income (subject to personal
tax rates) and capital gains arising from share price changes (subject to capital
gains tax)
In most developed economies, the taxes relating to capital gains are generally
significantly less than personal income tax rates
Also capital gains taxes do not normally need to be paid until the asset is realised
that is sold and hence the payment can be put off for long periods which further
reduces the effective tax rate.

Consider the information

Capital gains tax = 40%

Personal income tax = 60%

Share G Y
Expected totals before tax return 15% 15%
Expected dividend yield 5% (1/3) 10% (2/3)
Expected capital gains yield 10% (2/3) 5% (1/3)

What is the expected after tax return to investor in G.

45
 G (Ke) (after tax) = (1 – 0,6) x .05 + (1 – 0.4) x 0.10
0.02 + 0.06
= 0.08 or 8%
Expected return of Y
Y(Ke) (after tax) = (1- o.6) x 0.1 + (1 – 0.4) x 0.05
= 0.04 + 0.03
= 7% or 0.07

What before tax return is required to provide investor with the same after tax
return on Y as that offered on G or 8%.

If we let x = total before tax return for share Y, then X must be equal 17.1%
G (Ke after tax) = 8% = (1-6)2/3) (X)+(1-0.4)(1/3)x
8% = 0.2667x + .2x
= .4657x

x = 8/0.4667

x = 17.14%

Therefore the investor would need a 17.1% return on the high dividend payout
share of he/she is to receive the some after tax return as that provided by a 15%
low dividend, high growth share. This 17.1% pre-tax return consists of a (2/3)
17.1%= 11.4% dividend and (1/3): 17.1% = 5.7%
capital gains yield.

It therefore follows that because of differential personal taxes on dividends and

capital gains investors should require higher rates if returns on high dividend
yield shares than they do on low dividend yield shares ceteris paribus

46
CHAPTER 4 WORKING CAPITAL MANAGEMENT
Working capital (WC) is made up of current assets and current abilities include
cash money market securities and investors, or stock.

Cash management policy

An effective cash management policy requires that the treasurer knows why the
firm needs cash.

The major reasons why firms hold cash are

a) Transaction motive- day to day operations
b) Precautionary motive- cover uncertainties
c) Speculative motive – if a firm wants to speculate in areas such as real
estate or securities it will require ready cash to make the investments.

Bank requirements
Banks usually require a positive cash balance in order to ensure that the able
will be able to meet the short-term obligation e.g. loan repayments.
- Future obligations e.g. payment of dividends.

Cash operating cycle / working capital cycles

This is the period from where the firm pays cash for raw materials to when cash
is actually received from debts. The cash operating cycle COC is made up of the
following conversion period.
Cash
Raw Materials
Debtors

Finished goods W.I.P

Raw material conversion time- (RCT)

Average time from purchase of raw material to conversion such raw materials
into W/P or the average time from purchase of raw materials to the time they
enter into production cycle.
Formula RCT = Value of raw materials in stock
Raw materials consumed/ day

Work In Progress (WCT)

47
Work in progress conversion time - time taken to converse the W/P into finished
products the shorter the better.

WCT = Value of WIP

Cost of goods manufactured/ day
Creditors Conversion Time (CCT)
It is the time from the purchase of raw materials to the time when the firm makes
actual cash payments for raw materials (the longer the better- you can must and
earn interest)
CCT = Value of creditors
Purchase of raw materials/ day

Finished goods conversion time (FCT)

Average time taken to sell goods that have come out of the production line- the
less the better)
FCT = Value of finished goods
Costs of goods sold/ day

Debtors conversion time average conversion time)

The period from when goods are sold to the period when the firm receives
payment from debtors
DCT = Value of trade debtors
Value of sales/ day

Formula = RCT + WCT + FCT DCI –CCT

The CCT is deducted in calculating the cash operating cycle because the firm
has not ye paid for raw materials

Example
The introduction of ESAP has had an effect om the working capital management
of the firm. The Treasurer of P ltd is interested in finding out whether there have
been any changes in the COC. The information has been obtained for the
calculation operating cycle.
Item 1995 1996
Sales 3 240 000 3 600 000
Purchase R/M 1 125 000 1 687 000
Raw Materials consumed 1 080 000 1 440 000
Cost of goods manufactured 2 160 000 2 880 000
Debtors 540 000 800 000
Creditors 156 250 375 000
Inventory: RM 90 000 60 000
W/P 60 000 120 000
Finished Goods 25 000 75 000
Cost of Goods sold 1 800 000 2 700 000

48
 Assume a 360-day year
Solution

RCT 90 000 x 360 = 30 60 000 x 360 =15

10 80 000 1 440 000
CCT 360 x 156 250 = 50 375000 x 360=80
1125 000 1 687 000
WCP 360 x 60 000 = 10 120000 x 360 =15
2160000 2880000
FCT 25000 x 360 = 5 75000 x 360 = 10
1800000 2700000
DCT 360 X 540 000 =60 800 000 x 360 =80
324 000 3 600 000
30 + 10 + 5 + 60 – 50 15 – 80 + 15 + 10 + 80
=55 = 40
NB: The cash operating cycle has dropped from 55 days to 40 days mainly
because of the increase in the firm’s creditors conversion. Time and a
decrease in the RCT.

Banking Policy
A company’s banking policy requires clear decision on optimal banking and float
management- management of cheque deposit and receipts.

Optimal Banking frequency

- The policy must result in minimisation of banking costs and the
maximisation of the funds or reduction in overdraft.
- The higher the frequency the more interest will receive on ea deposits
- A high banking frequency results in high banking costs such as
transportation labour security, stationery costs.

Other considerations
- possibility of theft
- cost of security arrangements within the cay and insurance arrangements
on bulks of cash that should be kept in the firm.

Float management
- use of cheques in cash receipts and disbursement results in a float
periods
- float s the period from posting of cheque to when the cheque proceeds are
released by the payee.

Float can be dividend into 3

The mail float –the period from posting a cheque to when it is received by the
firm
The process float- it is from receipt.

49
The Clearing float- time it take to clean the cheque

Total float = Mail + Process float + Cleaning float (the lower the better)

BAUMOL MODEL

The model calculates the current of marketable securities that should be

liquidated whenever cash is required. It is equivalent of the Economic Order
Quantity Model used in inventory management of stock. It determines the
amount of marketable securities that should be liquidated to achieve the lowest
carrying costs for the firm and overriding costs for the firm.

The EOQ can be calculated as

= 2 x Annual cash require x cost of sale of securities

Interest rate (carrying costs)

The Boumal model assumes investors’ replacement and gradual use of cash.

Example
A firm has an average cash disbursement of $1.2 million. The cays hold its
monetary resources as cash or marketable securities. The marketable securities
carry on interest rate of 20%. It costs the cay $15 to sell any of its securities.
Determine the optimum out of securities that have to be solid at any given point
in times.

= 2 x 1.2 x 15
0.2

= 13416.41

Where cash is required the firm has to sell 13416.41 dollars worth of securities.

Miller model

This is stochastic model i.e. based on the real life assumption that cash
movements are random. The basic aim of the model is to determine the amount
of marketable securities that the firm should sell and purchase. The firm sells
marketable securities when It reaches the lower limit of its cash balance and
requires additional cash. It purchases marketable securities that it reaches its
upper limits and needs to reduce the cash balance.

Million begins with a predetermined lower limit. The lower limit.

50
 - The upper limit will be determined by the ff factors.
- The variances of the firm’s cash flow
- The opportunity of cost of holding marketable securities.

CREDIT MANAGEMENT

- Effective credit management policy

- a) Credit standards b) credit terms c) collection d) control policy

a) Credit standard

- looks at who to offer credit to how much credit should be advanced, what
not to offer credit to.
- The basic evaluation the 5 c analysis
i) Character – person’s payment record, any banking records
ii) Capital – net worth and financial position of the customer
iii) Collateral – asset by the customer as securities for borrowing
look at the value and liquidity of the asset pledged by the
customer
iv) Capacity – customer’s ability to pay back income p capacity
v) Condition – general macro-economic conditions that can have
on impact on the honouring credit by customer
- it analysis must be made on whether conditions such as ESAP have any
effect

Sources of information

- Prospective customer, bank reference

- The account information credit reporting agencies
- Internal sources, historical sales records and reports from sales reps can
provide 1st hand knowledge of the operations of the credit applicant.

Credit Terms

- looks at the credit period i.e. most firms have a 30 day credit period
- cash discounts
- they are usually quoted as 2/10 net 30 there is 2% discount for setting
debt in 10 days
- the effective rate or cost of discount is calculate as

Discount rate x 365

100 – Discount rate credit period-discount period

= Annual cost of Discount

51
If the figure that you get is low than the annual return that the cays achieves the
discount should not be granted and vice versa.

Collection policy – looks with what to do with late payers how much to spent on
collection the procedures to ff in collection.

Stock management
- stocks are kept because firm has to meet the customer demands.
- To hedge against prospective price increase firms need to increase stock
holding in order to reduce the cost of insurance wastage pilferage
handling costs, storage costs etc.

The Economic Order Quantity

- it is the equivalent of Bormol model used in cash management. It is
determined by the number of items to be purchased per order and the
number of orders to be made in ea individual year.
- It is an optimal stock ordinary quantity model which will minimise both
holding and handling costs.

Its assumptions
b) demand is certain, constant continuous
c) assumes number stock outs
d) assume that all prices are constant and certain.

Example

A company that sells items that are used by other manufacturing would like to
reduce inventory by determining the optimal no of units to order.

Annual demand 100 000 units

Ordering costs $ 50/ order
Average carrying cost $ 10/unit

EOQ = 2 x 100 000 x 56 = 1000 units

10

Total ordering costs = 1000 x 50

= 50 000

Total carry costs = 1000 x 10

= 100 000

Total inventory costs = 50 000 10 000

= $ 60 000

52
CHAPTER 5 MERGERS AND ACQUISITIONS
Mergers and Acquisitions are a common and popular ways/vehicles that
management often use the achieve growth and shareholder value maximisation
goals. They therefore represent long-term investment decisions that should be
critically evaluated.

Motives of Mergers and Acquisitions

- these may include among others
o To expand market share.
o To diversify business operations
o To improve on cost and operational efficiency.
o Economies of scale
o Reduced competition
o Combining complementary needs
o To use surplus cash more profitably when there are no new
avenues for investment.
o To preserve business assets through tax loss shields e.g. buying a
loss making company in order to have a tax advantage.

Types Of Mergers
Horizontal – 2 or more firms in the same industry and same line of business
combine to form one large company doing the same business.

Vertical – when 2 firms in related industries combine might be that the firms are
at different levels of production cycle or they are at different levels of distribution
channels.

Conglomerate Merger – when 2 firms in unrelated industries combine to create a

conglomerate company.

Factors influencing the terms of a merger

- the earnings factor – how a proposed merger is likely to affect EPS and
MPS
- Merger synergy – economic gain or value added.

Financial Analysis – A merger synergy

Synergy contribute to value added gain to a firm. Value added is an economic
gain that comes when 2 firms are worth more together when combined that if
they are separately. (1+1=3)

The following steps should be taken in a merger synergy. Assume firm A is in the
process of acquiring firm B

Step 1
Calculate the implied merger economic gain

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 Gain = PV(AB) - [PVA+PVB]
Where PVAB is the present value of combined A and B
PVA is the present value of A alone
PVB is the present value of B alone

Step 2
Determine the cost of acquiring firm B by A as the difference between the cash
purchase bid and the PV of firm B.
Acquisition Cost = Cash Bid – PVB

Step 3
Calculate the NPV of the merger as the difference between value added and the
cost of acquisition.
NPV = Value added/gain –Acquisition cost

{V(AB) -[PVA+PVB]} – {Cash Bid – PVB}

Thus if there is a positive NPV then there is a net merger gain to the
shareholders of the acquiring firm.

Valuation the Target firm

How much should we pay for the target firm. We have to determine the
value of the target firm. This valuation is important because it provides a
basis for negotiating the price to be paid for the acquisition.

1) Current Market price Valuation

This is for companies tat are listed on the Stock Exchange

Value of target firm =MPS x no of shares issued

Example
XYZ targets LMN which has 30 000 000 shares outstanding which are
currently trading at $1,50 in the market.

Value of target firm = 30 000 000 x $1.50

= 45 000 000

The net Asset Value Approach

The net asset value is the net of the firm’s total assets and liabilities

The Earnings or Dividend Income stream

If the firm is going to have a majority holding in the target firm then the
dividend/earnings can be used as the income stream since the firm will

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have control over how much will be paid out as dividends by he acquired
firm.

Example 1
Company A with a required rate of return of 25% intends to purchase
company D. Company D has 1 000 000shares issued and ahs just paid a
dividend of $100 000, presently retains 20% of its earnings and reinvests
the funds at 28%. How much should company A pay for company B if the
firm will
a) Continue paying 80% of income as dividends
b) Will pay out 100% of income as dividends

Solution
Earnings for this year = Div/ Payout ratio
= 100000/(0.8)
= 125 000

Growth rate for company D = 0.2 * 0.28

= 0.056

Expected earnings = Current earnings * (1+g)

= 1250000*(1.056)
= 132 000
Dividend in year 1 = Earnings in Year 1 * payout ratio
= 132 000* 0.8
= 105 600

Company A’s share of the div = 105 600 * 0.9

= 95 040
Market Value of dividend/share = 95 040/(0.25 – 0.056)
= 489 896.91

ii) If the company will change the dividend policy to 100%, then there will
be no growth.

Annual dividend for A = 125 000 *0.9

= 112 500
Value of 90% ownership = Div/RRR
= 112 500/(0.25)
= 450 000

Take Overs
Acquisitions or takeovers can be friendly or hostile.

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In a friendly takeover the directors of the target firm will be supportive of
the take over. After the 2 parties agree a price, what will be left is to
convince the shareholders that they should support the idea.

In a hostile take over the directors of the target firm will be opposed to the
idea. If a firm is faced with a hostile takeover it has to appeal to the target
firm’s shareholders and persuade the to agree to the takeover.
Persuasion can be through a tender offer or a proxy fight.

Defensive Strategies
1) Discouraging shareholders
A firm fighting a hostile takeover can discourage the shareholders from
accepting the hostile offer. This can be through:-
 Purchasing space in the media or writing to shareholders –telling the
shareholders that their welfare is better off if they do not accept the
offer.
 Increasing they payout ratio- more dividends are more attractive.

2. Raising legal issues

A target firm can approach regulatory authorities that the proposed merger
will break some regulatory instruments e.g. Anti monopolies or unfair
competition.

3.Internal changes
 Change in articles – a firm can change the articles by including a
clause that the a e of say 80% of the shareholders.
 Issuing more shares –the greater the number of shareholders the
more difficult it is to gain control of the company. If the firm issues
more shares to the public there will be greater number of
shareholders making it difficult to acquire the shares.

4. Poison Pill
A poison pill is a suicide move that makes the firm unattractive. Examples
of poison pills:-
 Borrow at terms that require immediate repayment of debt should a
firm be involved in a merger.
 Sell off some of its prized assets or crown jewels that made the firm
attractive.
 The firm can grant lucrative golden parachutes to the executive in
case of a take over. The golden parachute will be a large cash drain
if the firm is to be involved in a merger.

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