SECURITY VALUATION AND THE COST OF CAPITAL

Financing Decisions
Part C

2 Estimating Cost of Capital

Evaluate and apply:
a) Cost of equity, using dividend growth model and capital asset pricing model (CAPM)
b) Cost of fixed interest capital
c) Weighted average cost of capital

B. Business Analysis
3 Bond Valuation and Analysis
a) Evaluate and advise on the worth of a bond using value of bond or yield to maturity

Asset can be real or financial, securities e.g. shares and bond are called financial assets while
physical assets are called real assets. The concept of risk and return as the determinant of
value is as fundamental and valid to the valuation of securities as to that physical asset.
There are three schools of thought which brought into focus the values expected to be placed
on securities. These three schools of thought are:
Fundamental Theory: the essence of this theory is that every business has an intrinsic long-
term value quite apart from any transitory value that is placed on it currently by the market.
The worth is as much an inherent part of the company as is a person’s intelligence or an
engine’s horse power. It is further believed that this intrinsic value can be discovered by an
assembly and analysis of financial information about specific company derived from its annual
accounts. Where intrinsic value obtained is higher than the current share price, the security
is considered undervalued and should be bought. If the intrinsic value is lower than the actual
share price, the security is overvalued and it should be sold.
This theory states that there is one intrinsic value for all types of securities which is determined
by the present value of the future amount expected to be received from the security. It has
an implicit assumption that all relevant information about a company will be available to the
investors who will act rationally upon the information. The fundamentalist uses the dividend
valuation model to value securities. Note at this juncture that all discussion and computation
on the value of securities are based on this theory.

Summary of the Theory

o You expect an asset (securities) to provide a stream of cash flows while you own it.
o The security has one intrinsic value.
o The value of an asset (security) is the present value of its expected cash flows.

Assumptions of Fundamental Analysis

o That a business has an intrinsic value
o That is can be determined by analysis of company’s generated data
o That this value may not be recognised by the market in the short term

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 o That it will eventually be recognised by the market in the long run.

Random walk theory

Like the fundamental theory, the proponents of this theory state that the value of securities
can be determined by the present value of future cash receipt on those securities but they
disagree that there is one intrinsic value. The theory argues that since the expectation of
future cash receipt is bound to alter so also will the values of share alter, therefore the theory
believes that there will be many values as information available permit and these values will
take random walk around the fundament theory intrinsic value i.e. the behaviour of investors
is such that the actual share price will fluctuate at random around the intrinsic value.

Technical or Chartist theory

The proponents of this theory use the information about past share price to predict the trend
of the future share price. That is, technicians’ values security by reference to historical trend
of the price of those securities. It is believed that the past pattern may also be repeated. This
is done by examining the trend in the past years, (Primary trend) or in the past months
(Secondary trend) or past weeks (tertiary trend). The proponents of this theory make use of
charts and graphs of share price information and mechanical trading rules. They have no
evidence to justify the theory, it is therefore not often used.
Technical analysts believe that security prices particularly share prices are fairly valuable and
anyone who can successfully predict the direction of interest rates (and therefore bond
prices) and share prices can correctly time investment to beat the market. The objective is to
obtain an above average return.

Dividend valuation model

The dividend valuation model states that:
“The market value of a share or other security is equal to the present value of the future
expected cash flows from the security discounted at the investor’s required rate of return”.
A security is any traded investment e.g. shares and bonds.

Assumptions behind the dividend valuation model

i. Rational investors
ii. All investors have the same expectations and therefore the same required rate of
return
iii. Perfect capital market assumptions, e.g.
o No transaction costs
o Large number of buyers and sellers of shares
o No individual can affect the share price
o All investors have all available information
iv. Dividends are paid just once a year and one year apart
v. Dividends are either constant or are growing at a constant rate.

Uses of the dividend valuation model

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 i. The model can be used to estimate the theoretical fair value of securities in unlisted
companies where a quoted market price is not known.
ii. However, if the company is listed, and the share price is therefore known, the model
can be used to estimate the required rate of return of shareholders i.e. the company’s
cost of equity finance.

Constant Dividend
The formula for share valuation can be developed as follows:
Ex-dividend value at time Zero (0) = Present value of the future dividends
discounted at the shareholders’ required
rate of return

Ex-dividend market value is the market value assuming that a dividend has just been paid.
If the dividend is assumed to be constant to infinity this is the present value of a perpetuity
which is as follows:
Po = d/ke
This version of the model can be used to determine the theoretical value of a share which pays
a constant dividend e.g. a preference share or an ordinary share in a zero growth company.

Constant growth in dividends

If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate:
Po = do(1 + g)/(ke – g) or d1/(ke – g)
Where do = most recent dividend or current dividend or dividend now
d1 = dividend in one year
The dividend valuation model gives a theoretical value under the assumptions of the model
for any security.

Class Illustration 1 - DIDI plc (DVM Model)

i. DIDI plc expects to pay a constant annual dividend of 45k per share and the market
expects a rate of return of 15%.
ii. DIDI plc expects to pay dividend of 30k next year and dividend growth rate is 5% whilst
earnings growth rate is 10%. Ungeared cost of equity is 10%.
iii. DIDI plc expects to pay dividend of 30k next year and dividend growth rate is 5% and
the market expects a rate of return of 15% and what is the cum dividend value of share?
iv. Current dividend of DIDI plc is 30k and dividend growth rate is 5%. Risk free rate is 5%
and market rate of return is 10% and beta is 1.3.
v. DIDI plc expects to pay dividend of 30k next year. Ungeared cost of equity is 10%.
Dividend in 4 years ago was 20k per share and now is 25k per share.
vi. DIDI plc expects to pay dividend of 30k next year. Ungeared cost of equity is 10%. DIDI
plc has an accounting rate of return of 11% and pays out 35% of its profit after tax as
dividend each year.

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vii. DIDI plc has a DPS of 30k and has just paid out whilst dividend growth is expected to
be 10% in the next 2 years and 5% in year 3. DIDI plc estimates a 3% growth of dividend
till perpetuity after year 3. Ungeared cost of equity is 5%.
Required:
Using DVM calculate share value of DIDI plc.

Home Study Question

Wright plc has just paid a dividend of 15k per share. The market is in general agreement with
directors’ forecasts of 30% growth in earnings and dividends for the next 2 years. Thereafter,
a reasonable estimate is 15% growth in year 3 followed by 6% growth to perpetuity. The
market’s required return on investments of this risk level is 25% per annum.
Estimate the share value.

Exam Type Question

You are the Finance Manager of Prime Holding (Nig.) Plc and have just received two copies of
placement memorandum from two reputable private companies – Dagbolu (Nig) Ltd and
Jamal (Nig) Ltd asking your company to subscribe to their shares.
Your board has agreed that the company should subscribe to 5% of the shares of either
company but not both; investable capital is not a constraint. Dagbolu intends a pay dividend
in the next one year at the rate of 30k per share. The company’s dividends are expected to
grow into an indefinite future time at a compound rate of 10% per annum.
The asking price from the company is N3.50 per share. Jamal plans to pay a dividend in the
next one year at the rate of 10k per share. Its dividends are expected to display an above-
average performance in the near future and therefore expected to grow at an annual
compound rate of 25% in the first five years after which it reverts to the normalized industry
growth of a perpetual annual compound rate of 8%. Jamal on its part is asking for N2.50 per
share.
Both companies belong to the same risk class. The expected rate of return for the shares to
which each company’s shares belong is 18%.
Required:
Advise your Board which particular investment should be purchased.

In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuations. These are likely to include:
o Interest rates
o Market sentiment
o Expectation of future events
o Inflation
o Press comment
o Speculation and rumor
o Currency movements
o Takeover and merger activity
o Political issues

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Points to note:
o Dividend valuation model helps us to understand how a change in these variables
should affect the market value of the security.
o Share prices change often dramatically, on a daily basis. The dividend valuation model
will not predict this, but will give an estimate of the underlying fair value of the shares.

Cost of equity with zero growth in dividend

The basic dividend valuation model is: Po = d/ke
This can be rearranged to find ke: Ke = d/Po
If Ke is the required rate of return by the shareholders in order for the share value to remain
constant, then Ke is also the return that the company must pay to its shareholders. Therefore,
Ke also equals to the cost of equity of the company.
Therefore, the cost of equity for a company with a constant annual dividend can be estimated
as the dividend divided by the ex-div share price i.e. the dividend yield.

Class Illustration 1
S plc has in issue N1 shares with a market value of N2.40 per share. A constant dividend of 30k
per share has just been paid.
What is the shareholders’ required return (ke), (and therefore the cost of equity to the
company)?

Class Illustration 2
Cygnus has a dividend cover ratio of 4.0 times and expects zero growth in dividends. The
company has one million N1 ordinary shares in issue and the market capitalisation (value) of
the company is N50 million. After-tax profits for next year are expected to be N20 million.
What is the cost of equity capital?
The problem with this example is that it assumes that shareholders are expecting a constant
dividend. In practice, as we discussed before, it is more likely that they are expecting growth
in dividends.

The formula with constant growth rate to perpetuity

Ke = d0(1+g)+ g
P0
Where:
Ke = the shareholders required rate of return (=cost of equity)
d0 = the current dividend
P0 = the current market value per share (ex div) 0
g = the rate of dividend growth p.a.
Class Illustration 3
T plc has in issue 50k shares with a market value of N4.20 per share. A dividend of 40k per
share has just been paid. Dividends are growing at 6% p.a.
What is the cost of equity?

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Class Illustration 4
U plc has in issue N1 shares with a market value of N3.60 per share. A dividend of 30k per share
has just been paid.
Dividends are growing at 8% p.a. What is the cost of equity?

Estimating the rate of growth in dividends

When using the formula for the cost of equity, we need to know the rate of dividend growth
that shareholders expect in the future. If this figure is given us in the examination, then there
is obviously no problem.
However, you may be expected to estimate the dividend growth rate using one of two
approaches:
o using the rate of growth in the past
o using the ‘rb’ model

Past dividend growth

Class Illustration 5
It is now the year 2001, and X plc has paid out the following total dividends in past years:
1996 N28,000
1997 N29,000
1998 N32,000
1999 N31,000
2000 N33,000
Estimate the average rate of growth of dividends p.a.

‘rb’ growth
This approach considers the reason for growth in dividends. In order to have long-term
growth in dividends, the company needs to achieve long-term growth in earnings.
In order to achieve long-term earnings growth, the company needs to expand, which will
require additional investment. The only long-term, continual source of finance that
shareholders will be in a position to expect is the retention of earnings. If all earnings are
distributed as dividends, then shareholders will not be in a position to expect growth.
However, the more of the earnings that are retained for expansion then the more growth
shareholders will be expecting.
The growth can be estimated using the following formula: g = r b
Where:
b = the proportion of earnings retained in the company
r = the rate of return that the company can earn on re-investment

Class Illustration 6
A company has 300,000 ordinary shares in issue with an ex-div market value of N2.70 per
share. A dividend of N40,000 has just been paid out of post-tax profits of N100,000. Net
assets at the year-end were valued at N1.06m.

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Required:
Estimate the cost of equity capital.

BOND VALUATION AND YIELD (COST OF DEBT)

Bond is a long-term debt instrument issued by a corporation or government. It is a security
that pays a stated amount of interest to the investor, period after period, until it is finally
retired by the issuing company.
Face value: The stated value of an asset. In the case of a bond, the face value is usually N1,000
in the United States of America while the face value is quoted as N100 in Nigeria.
Coupon rate: The stated rate of interest on a bond; the annual interest payment divided by
the bond’s face value.
Market Value: This is the quoted value of Bonds/Debt. This can be quoted in % or as a value,
eg 97% or N97. Both mean that N100 nominal value of debt is worth N97 market value.

Valuation of Bonds
In valuing a bond, or any security for that matter, we are primarily concerned with
discounting, or capitalizing, the cash-flow stream that the security holder would receive over
the life of the instrument. The terms of a bond establish a legally binding payment pattern at
the time the bond is originally issued. This pattern consists of the payment of a stated amount
of interest over a given number of years coupled with a final payment, when the bond
matures, equal to the bond’s face value. The discount, or capitalization, rate applied to the
cash-flow stream will differ among bonds depending on the risk structure of the bond issue.
In general, however, this rate can be thought of as being composed of the risk-free rate plus
a premium for risk.

Irredeemable Bonds (Perpetual Bond):

The first (and easiest) place to start determining the value of bonds is with a unique class of
bonds that never matures. These are indeed rare, but they help illustrate the valuation
technique in its simplest form.
The present value of a perpetual bond would simply be equal to the capitalized value of an
infinite stream of interest payments. If a bond promises a fixed annual payment of interest
forever, its present (intrinsic) valueat the investor’s required rate of return for this debt issue
is:
B0 = i
Kd
Where B0 = the market price of the bond ex-interest
i = the annual interest payment on the bond
Kd = the return required by the bond investors

Illustration
An investor intends to purchase a N1,000 debenture issued at par. The coupon rate is 15% with
promise of a fixed interest payment for an indefinite period. If the required rate of return of
the investor is 20%, determine the value of the debenture.

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Redeemable Bonds/Debt
These are bonds with specified maturity dates. The value of these bonds will be determined
not only by the interest payment; the capital repayment at maturity (redemption value) will
be considered, and these will be discounted by bondholders required rate of return (yield to
maturity).
This is depicted in the table below:
Years Cash flows DCF @ x % Present Value
Yield to Maturity
1 Interest xx xx
2 Interest xx xx
3 Interest xx xx
4 interest + Redemption Value xx xx
Value of Redeemable Bond xx

Class Illustration 1
An investor intends to purchase a N1,000 debentures in Platinum Plc. The debenture was
originally issued at par in 1 January 2009 and is due for redemption in 1 January 2017. If the
coupon rate is 16% and lenders in general consider 20% as required rate of return, given the
risk of the debenture, determine the value of the debenture.

Class Illustration 2
A company has issued some 9% bonds, which are now redeemable at par in three years’ time.
Investors now require a redemption yield of 10%. What will be the current market value of
each N100 of bond?

Behaviour of Debenture Values

Debenture value fluctuates in response to changes in market interest rates relative to coupon
rates. The lower the market interest rate (yield to maturity) compared with the coupon rate,
the higher the value of the debenture and vice versa.

Class Illustration
i. N20m 7% Bond will be redeemed in 3 years at par (N100). Yield to maturity is 5.25%.
Compute value of the bond.
ii. Recalculate the Value of the bond if the YTM increases to 6% and explain the directional
change in the value of Bond and state the reason.

Zero-coupon Bonds
These are bonds that pay no interest. Instead, they are sold at high discount to the par value
with the return solely in steady capital appreciation over its original low price value toward
the redemption date when the bond will be redeemed at its nominal value.
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Class Illustration
Prince plc issues a zero-coupon bond having a 12-year pull to maturity and par value of N1,000.
If an investor’s required rate of return is 15%, compute the value of the debenture.

Bond Value with Semi-annual Interest

Most of the bonds pay interest semi-annually, to value such bonds; we have to work with a
unit period of 6 months, and not one year. This means that the bond valuation equation has
to be modified along the following lines.
o The annual interest payment must be divided by two (2) to obtain the semi-annual
interest payment.
o The annual discount rate has to be divided by two (2) to get the discount rate
applicable to half-yearly period.
o The number of years to maturity must be multiplied by two (2) to get the number of
half-year periods.
Class Illustration 1
Happiness plc bond stock bears a coupon rate of 14% and matures after five years. Interest is
payable semi-annually. Compute the value of the bond if the required rate of return is 16%.

Class Illustration 2
Furry has in issue 12% bonds with par value N100,000 and redemption value N110,000, with
interest payable quarterly. The redemption yield on the bonds is 8% annually and 2% quarterly.
The bonds are redeemable on 30 June 2023 and it is now 31 December 2019.
Required:
Calculate the market value of the bonds.

Convertible Bonds/Debts
A convertible bond is a hybrid security. It is a loan stock but with the right to convert to
ordinary shares in future.

Definition
Convertible bonds are bonds that give their holder the right, but not the obligation, at a
specified future date to convert their bonds into a specific quantity of new equity shares.
o If the bondholders choose to exercise the right, they will become shareholders in the
company, but will surrender their bonds.
o If the bondholders decide not to exercise their right to convert, the bonds will be
redeemed at maturity.

Example
A company might issue N100 million of 3% convertible bonds. The bonds might be convertible
into equity shares after five years, at the rate of 20 shares for each N100 of bonds. If the shares

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are not converted, the company will have the right to redeem them at par immediately.
Alternatively, the bonds will be redeemed after ten years.
For the first five years, the company will pay interest on the convertible bonds. After five
years, the bondholders must decide whether or not to convert the bonds into shares.
o If the market value of 20 shares is higher than the market value of N100 of the
convertibles, the bondholders will exercise their right and convert the bonds into
shares. They will make an immediate capital gain on their investment. For example, if
the share price is N6, the bondholders will exchange N100 of bonds for 20 shares, and
the value of their investment will rise to N120.
o If the market value of 20 shares is lower than the market value of N100 of the
convertibles, the bondholders will not exercise their right to convert, and will hold
their bonds until they are redeemed by the company (which will be either immediately
or at the end of the tenth year).

The value of a convertible bond will therefore be discussed from two points of view.
o Its value as a straight loan; and
o Its value when it is converted
Whatever value a convertible bond takes on is influenced by the movement in the price of the
share of issuing company. If the price of the share in the market moves up, the value of the
convertible will be determined mainly by its conversion value. If the price falls, the value of
the convertible will be the value of a straight bond issued by the same company. In this case
the value of the convertible bond will not fall below the value of the straight bond; the
convertible is said to have a downside protection against risk.

When convertible bonds are traded on a stock market, its minimum market price will be the
price of straight bonds with the same coupon rate of interest. If the market value falls to this
minimum, it follows that the market attaches no value to the conversion rights.
The actual market price of convertible bonds will depend on:
o The price of straight debt
o The current conversion value
o The length of time before conversion may take place
o The market’s expectation as to future equity returns and the associated risk
Note: Price or value of a straight bond is the value of redeemable bond.

Where the conversion will occur, the conversion value is calculated as follows:
Conversion value = Po (1 + g) n x R
Where Po is the current ex-dividend ordinary share price
g is the expected annual growth of the ordinary share price
n is the number of years to conversion
R is the number of shares received on conversion

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The current market value of a convertible bond where conversion is expected is the sum of
the present values of the future interest payments and the present value of the bond’s
conversion value.
Years Cash flows DCF @ x % Present Value
1 Interest xx xx
2 Interest xx xx
3 Interest xx xx
4 interest + Bonds Conversion Value xx xx
Value of Convertible Bond xx

Class Illustration 1
What is the value of a 9% convertible bond if it can be converted in five years’ time into 35
ordinary shares or redeemed at par on the same date? An investor’s required return is 10% and
the current market price of the underlying share is N2.50 which is expected to grow by 4% per
annum.

Class Illustration 2
Assume that bond investors require a return of 9% per year on their investments.
Required
Estimate the market value of the following bonds:
(a) Irredeemable 7.5% bonds that pay interest annually.
(b) Bonds paying coupon interest of 6% per year annually, which are redeemable at par in four
years’ time.
(c) Bonds paying coupon interest of 10%, redeemable at par after three years, where interest
is payable every six months.
Notes:
An annual cost of capital of 9% is equal to a six-monthly cost of capital of
(d) A convertible bond with a coupon of 5% and interest payable annually: these bonds are
convertible after three years into equity shares at the rate of 20 shares for every N100 nominal
value of bonds. The expected share price in three years’ time is N7.

Class Illustration 3
(a) Calculate the value of the following bonds:
(i) a zero coupon bond redeemable at par in ten years’ time
(ii) a bond with an 8% coupon, with interest payable half-yearly, and redeemable at par after
ten years.
Assume that the yield required by investors is 5%, and that this is 2.5% each half year for the
purpose of valuing the 8% coupon bond.
(b) Calculate the value of both bonds in part (a) of the question if the yield required by
investors goes up by 1%, to 6% for the zero coupon bond and 3% each half year for the 8%
coupon bond.

Conversion premium

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When convertible bonds are first issued, the market value of the shares into which the bonds
will be convertible is always less than the market value of the convertibles.
This is because convertibles are issued in the expectation that the share price will rise before
the date for conversion. Investors will hope that the market value of the shares will rise by
enough to make the market value of the shares into which the bonds will be convertible
higher than the value of the convertible as a ‘straight bond’.
The amount by which the market value of the convertible exceeds the market value of the
shares into which the bonds will be convertible is called the conversionpremium.

Example
A company issues 4% convertibles bonds at a price of N101.50. The bonds will be convertible
after six years into equity shares at the rate of 30 shares for every N100 of bonds. The current
market price of the company’s shares is N2.50.
The market price of the bonds is N101.50 for every N100 face value of bonds.
The conversion premium is therefore N101.50 – (30 × N2.50) = N26 for every N100 of
convertibles.

Class Illustration 4
A company has in issue 8% coupon bonds which are redeemable at their par value of N100 in
four years’ time. Alternatively, each bond may be converted on that date into 40 ordinary
shares. The current ordinary share price is N2.10 and this is expected to grow at a rate of 7%
per year for the foreseeable future. Bondholders’ required return is 9% per year.
Required:
Calculate the following value for each N100 convertible bond:
(i) Market value
(ii) Floor value;
(iii) Conversion premium

Class Illustration 5
Kiely plc has 11% convertible loan notes on issue. Each N100 unit may be converted at any time
up to the date of expiry (in seven years’ time) into 15 fully paid ordinary shares in Kiely plc. Any
loan notes which remain outstanding at the end of the seven-year period are to be redeemed
at N120 per cent.
Loan note holders normally require a yield of 9% p.a. on seven-year debt.
Recommend whether investors should convert, if the current share price is:
(a) N7.00, or
(b) N8.00, or
(c) N9.00.

Advantages of convertibles
The advantages of convertibles for companies are as follows:
o The company can issue bonds now, and receive tax relief on the interest charges, but
hope to convert the debt capital into equity in the future.

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 o The interest rate on convertibles is lower than the interest rate on similar straight
bonds. This is because investors in the convertibles are expected to accept a lower
interest rate in return for the option to convert the bonds into equities in the future.
o Occasionally, there is strong demand from investors for convertibles, and companies
can respond to investors’ demand by issuing convertibles in order to raise new capital.

The advantages of convertibles for investors are as follows:

o Investors receive a minimum annual income up to the conversion date, in the form of
fixed interest.
o In addition, investors in convertibles will be able to benefit from a rise in the company’s
share price, and hope to make an immediate capital gain on conversion.
o Convertibles therefore combine some fixed annual income and the opportunity to
benefit from a rising share price.
The risk for investors in convertibles is that the share price will not rise sufficiently to make
conversion worthwhile. When this happens, it would have been better to invest in straight
bonds, which would have paid higher interest.

Preference shares
Preference shares pay a fixed rate dividend which is not tax-deductible for the company.
The current ex-dividend value P0, paying a constant annual dividend d and having a cost of
capital kp:
P0 = d
kp

Weighted Average Cost of Capital

The weighted average cost of capital is the average cost of the company’s finance (equity,
debentures, bank loan) weighted according to the proportion each element bears to the total
pool of capital.

Book Value versus Market Value

The weighted average cost of capital (WACC) can be computed using the book values or
market value weights. If there is difference between the two, the weighted average cost of
capital will differ according to the weights used. The WACC computed using the book value
weights will be understated if the market value weight of the securities is higher than the
book value weight and vice versa.

Advantages of Book Value Weights

o Simplicity
o Easily derived from the published sources
o Firms set their capital structure targets in terms of book values.

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 o The book value debt equity ratios are used are analysed by investors to evaluate the
riskiness of the firms in practice.
Note:
The use of book value weight can be seriously questioned on theoretical grounds.
Superiority of the market value weight
Market value weights are theoretically superior to the book value weights. They presumably
reflect the economic value and are not influenced by accounting policies. They are also
consistent with the market-determined component costs.
Note:
The difficulty in using market value weights is that the market prices of securities fluctuate
widely and frequently.

Procedures for Calculating the Combined Cost of Capital

i. Estimate cost of each source of capital
ii. Calculate weight for each source of capital
iii. Multiply proportion of total of each source of capital by cost of that source of capital
iv. Sum up the results of step 3 to give the weighted average cost of capital.

General formula for the WACC

A general formula for the weighted average cost of capital (WACC) k0 is as follows.

Class Illustration 1: Weighted average cost of capital

An entity has the following information in its statement of financial position.
N'000
Ordinary shares of 50k 2,500
12% unsecured bonds 1,000
The ordinary shares are currently quoted at 130k each and the bonds are trading at N72 per
N100 nominal. The ordinary dividend of 15k has just been paid with an expected growth rate
of 10%. Corporation tax is currently 30%.
Calculate the weighted average cost of capital for this entity.

When to Use the Weighted Average Cost of Capital

In using the weighted average cost of capital to appraise the project, the following implicit
assumptions are made.
i. The historic proportions of debts and equity are not changed. The cost of equity and
debt based on current market information reflects the firm’s current gearing ratio. If
the firm substantially changes the long run proportions in which funds are raised, then
the cost of equity and debt are likely to change with a resultant change in the
combined cost of capital.

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 ii. The operating risk of the firm will not change. The firm’s current cost of equity and
debt also reflect its current are of operations. For example, high risk electronics
companies are likely to have higher costs of funds than, say, low risk food
manufacturers. If a food manufacturing company were to diversify into electronics, its
costs of finance will change. Current estimates of the cost of capital are therefore only
suitable for appraising investments of similar operating risk.
iii. The finance is not project specific. In some circumstances it is unwise to use the
average cost of a pool of funds. Suppose a government offered a multinational
company an interest free loan to encourage it to invest in a particular country. In this
situation it would be unwise to put the cheap loan into the pool of funds and spread
its benefits over all projects as it is associated with only one specific project.
iv. The project is small relative to the overall size of the company.

Other Problems with the Weighted Average Cost of Capital

i. Which sources of finance to include: Firms also raise finance from short term sources
e.g. overdrafts, short- term loan, trade credit, etc. It is possible to calculate a cost for
short-term finance and we need to decide whether it should be included in our
calculations. The usual argument is that short-term weighted average cost of capital
is a tool for appraising long term investments and as these should only be financed by
long term funds then the costs of short term funds should be excluded. However, if it
is clear that short-term finance is being used to fund long term projects then it should
be included.
ii. Loan without market values: Bank loan do not have market values in the same way as
debentures. All we can do in this case is to take the book value of loans as an
approximation of market value.
iii. Unlisted companies and public sector: There are particular problems in trying to
calculate the cost of capital for unlisted companies and public sector. For unlisted
companies no external market price exists, so no cost of equity or beta can be directly
calculated. A further problem arises in that the level of dividend each year is likely to
be manipulated depending on the shareholders’ personal tax positions, so the annual
growth in dividends may be erratic. The best method of estimating the cost of capital
of an unlisted company is probably to take the cost of a similar listed company and add
a risk premium. The lack of an external share price presents similar difficulties when
trying to estimate the cost of capital of a public sector organisation.

Home Study Questions

Benton
i. A is equity financed by 500,000, 50k ordinary shares. Current market value is 30k and
the annual dividend of N12,000 is about to be paid. Calculate A’s cost of capital.

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 ii. B is financed by equity shares having a market value of N3. A dividend of 25k has just
been paid and this compares favourably with the dividend of 15k paid four years ago.
Calculate B’s cost of capital.

iii. C is financed by 400,000 N1 ordinary shares and N600,000 12% debentures. The market
values are N1.40 ex div and N90% respectively. A dividend of 14k has just been paid and
dividends have been growing at 6% per annum. Interest is shortly to be paid on the
debentures which are redeemable at a 5% premium in 6 years’ time. Ignoring taxation,
calculate C’s cost of capital.

iv. D is financed by 1 million 50k ordinary shares, market value N1.30 and N500,000 5%
debentures valued at N95%. A dividend of 15k is about to be paid and dividends have
always been constant. Interest on the debentures is soon to be paid and redemption
is at par in 5 years’ time. If corporation tax is at 35%, calculate D’s cost of capital.
Claris
i. A is financed by 100,000 50k ordinary shares with an ex div market value of N1.30 and
N80,000 of 9% irredeemable loan stock with an ex interest market value of 95%. The
dividend which has just been paid is the constant annual dividend of 15k per share.
Corporation tax is at 35%. Find Ke, Kd, E and D and hence the WACC.

ii. B limited is partly financed by 9% redeemable debentures currently valued at N75,

interest having been paid. The debentures are redeemable in 5 years’ time at a
premium of 10%. Calculate the cost of these debentures to the company if tax is 35%.

iii. C has N1m 8% redeemable debentures in issue. Interest is paid half yearly on June 30
and December 31 and the current ex-interest market price on July 1 1995 is N97.
Redemption is at par on December 31 1999. Calculate the annual cost the debentures.
Tax is at 35%.

Exam Type Questions

Question 1
The following statement of financial position information relates to Tufa Co, a company listed
on a large stock market which pays corporation tax at a rate of 30%.
Nm Nm
Equity and liabilities
Share capital 17
Retained earnings 15
Total equity 32
Non-current liabilities
Long-term borrowings 13
Current liabilities 21
Total liabilities 34
Total equity and liabilities 66
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The share capital of Tufa Co consists of N12m of ordinary shares and N5m of irredeemable
preference shares.
The ordinary shares of Tufa Co have a nominal value of N0·50 per share, an ex-dividend market
price of N7·07 per share and a cum dividend market price of N7·52 per share. The dividend for
20X7 will be paid in the near future.
Dividends paid in recent years have been as follows:
Year 20X6 20X5 20X4 20X3
Dividend (N/share) 0·43 0·41 0·39 0·37
The 5% preference shares of Tufa Co have a nominal value of N0·50 per share and an ex
dividend market price of N0·31 per share.
The long-term borrowings of Tufa Co consist of N10m of loan notes and a N3m bank loan. The
bank loan has a variable interest rate.
The 7% loan notes have a nominal value of N100 per loan note and a market price of N102·34
per loan note. Annual interest has just been paid and the loan notes are redeemable in four
years’ time at a 5% premium to nominal value.
Required:
(a) Calculate the after-tax weighted average cost of capital of Tufa Co on a market value
basis. (11 marks)
(b) Discuss the circumstances under which it is appropriate to use the current WACC of Tufa
Co in appraising an investment project. (3 marks)
(c) Discuss THREE advantages to Tufa Co of using convertible loan notes as a source of long-
term finance. (6 marks)
(20 marks)

Question 2
The following information has been taken from the statement of financial position of Corfe
Co, a listed company:
Nm Nm
Non-current assets 50
Current assets
Cash and cash equivalents 4
Other current assets 16 20
Total assets 70
Equity and reserves
Ordinary shares 15
Reserves 29 44
Non-current liabilities
6% preference shares 6
8% loan notes 8
Bank loan 5 19
Current liabilities 7
Total equity and liabilities 70
The ordinary shares of Corfe Co have a nominal value of N1 per share and a current ex-dividend
market price of N6·10 per share. A dividend of N0·90 per share has just been paid.

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The 6% preference shares of Corfe Co have a nominal value of N0·75 per share and an ex-
dividend market price of N0·64 per share.
The 8% loan notes of Corfe Co have a nominal value of N100 per loan note and a market price
of N103·50 per loan note. Annual interest has just been paid and the loan notes are
redeemable in five years’ time at a 10% premium to nominal value.
The bank loan has a variable interest rate.
The risk-free rate of return is 3·5% per year and the equity risk premium is 6·8% per year. Corfe
Co has an equity beta of 1·25.
Corfe Co pays corporation tax at a rate of 20%.
Investment in facilities
Corfe Co’s board is looking to finance investments in facilities over the next three years,
forecast to cost up to N25m.
The board does not wish to obtain further long-term debt finance and is also unwilling to make
an equity issue. This means that investments have to be financed from cash which can be
made available internally. Board members have made a number of suggestions about how
this can be done:
Director A has suggested that the company does not have a problem with funding new
investments, as it has cash available in the reserves of N29m. If extra cash is required soon,
Corfe Co could reduce its investment in working capital.
Director B has suggested selling the building which contains the company’s headquarters in
the capital city for N20m.
This will raise a large one-off sum and also save on ongoing property management costs. Head
office support functions would be moved to a number of different locations rented outside
the capital city.
Director C has commented that although a high dividend has just been paid, dividends could
be reduced over the next three years, allowing spare cash for investment.
Required:
(a) Calculate the after-tax weighted average cost of capital of Corfe Co on a market value
basis. (11 marks)
(b) Discuss the views expressed by the three directors on how the investment should be
financed. (9 marks)
(20 marks)

Question 3
The summarised Statement of Financial Position of Golden Co at 30 June 20X9 was as follows.
N'000 N'000
Non-current assets 15,350
Current assets 5,900
Creditors falling due within one year (2,600)
Net current assets 3,300
9% loan notes (8,000)
10,650
Ordinary share capital (25k shares) 2,000
7% preference shares (N1 shares) 1,000

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Share premium account 1,100
Retained earnings 6,550
10,650
The current price of the ordinary shares is 135k ex dividend. The dividend of 10k is payable
during the next few days. The expected rate of growth of the dividend is 9% per annum. The
current price of the preference shares is 77k and the dividend has recently been paid. The loan
notes interest has also been paid recently and the loan notes are currently trading at N80 per
N100 nominal. Assume that Golden Co issued the loan notes one year ago to finance a new
investment. Company income tax is at the rate of 30%.
Required
(a) Calculate the gearing ratio for Golden Co using:
(i) Book values
(ii) Market values (5 marks)
(b) Calculate the company's weighted average cost of capital (WACC), using the respective
market values as weighting factors. (7 marks)
(c) Explain how the capital asset pricing model would be used as an alternative method of
estimating the cost of equity, indicating what information would be required and how it
would be obtained. (8 marks)
(d) Discuss the reasons why Golden Co may have issued loan notes rather than preference
shares to raise the required finance. (5 marks)

Question 4
JELLY Co is an all equity financed listed company. It develops customised software for clients
which are mainly large civil engineering companies. Nearly all its shares are held by financial
institutions.
JELLY Co's chairman has been dissatisfied with the company's performance for some time.
Some directors were also concerned about the way in which the company is perceived by
financial markets. In response, the company recently appointed a new finance director who
advocated using the capital asset pricing model as a means of evaluating risk and interpreting
the stock market's reaction to the company.
The following initial information was put forward by the finance director for two rival
companies operating in the same industry:
Beta
Tilley Co 0.7
Razor Co 1.4
The finance director notes that the risk-free rate is 5% each year and the expected rate of return
on the market portfolio is 15% each year.
The chairman set out his concerns at a meeting of the board of directors: 'I fail to understand
these calculations.
Tilley cooperates largely in overseas markets with all the risk which that involves, yet you seem
to be arguing that it is a lower risk company than Razor Co, whose income is mainly derived
from long-term contracts in our domestic building industry. I am very concerned that we can
take too much notice of the stock market. Take last year for instance, we had to announce a
loss and the share price went up.'

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Required:
(a) Calculate, using the capital asset pricing model, the required rate of return on equity of:
(i) Tilley Co
(ii) Razor Co (4 marks)
(b) Calculate the beta of JELLY Co, assuming its required annual rate of return on equity is 17%
and the stock market uses the capital asset pricing model to calculate the beta, and explain
the significance of the beta factor. (6 marks)
(c) As the new finance director, write a memorandum to the chairman which explains, in
language understandable to a non-financial manager, the following:
(i) The assumptions and limitations of the capital asset pricing model; and
(ii) An explanation of why JELLY Co's share price could rise following the announcement of a
loss. In so doing, discuss the observations and concerns expressed by the chairman. You may
refer, where appropriate, to your calculations in (a) and (b) above. (15 marks)

Question 5
Crystal Co-operates a low-cost airline and is a listed company. By comparison to its major
competitors it is relatively small, but it has expanded significantly in recent years. The shares
are held mainly by large financial institutions.
The following are extracts from Crystal Co's budgeted Statement of Financial Position at 31
May 20X2.
N’m
Ordinary shares of N1 100
Reserves 50
9% loan notes 20X5 (at nominal value) 200
350
Dividends have grown in the past at 3% a year, resulting in an expected dividend of N1 per
share to be declared on 31 May 20X2. (Assume for simplicity that the dividend will also be paid
on this date.) Due to expansion, dividends are expected to grow at 4% a year from 1 June 20X2
for the foreseeable future. The price per share is currently N10.40 ex div, and this is not
expected to change before 31 May 20X2.
The existing loan notes are due to be redeemed at par on 31 May 20X5. The market value of
these loan notes at 1 June 20X2 is expected to be N100.84 (ex-interest) per N100 nominal.
Interest is payable annually in arrears on 31 May and is allowable for tax purposes. Tax is
payable on profits at a rate for of 30%. Assume taxation is payable at the end of the year in
which the taxable profits arise.
New finance
The company has now decided to purchase three additional aircraft at a cost of N10 million
each. The board has decided that the new aircraft will be financed in full by an 8% bank loan
on 1 June 20X2.
Required
(a) Calculate the expected weighted average cost of capital of Crystal Co at 31 May 20X2. (8
marks)
(b) Without further calculations, explain the impact of the new bank loan on Crystal Co's
(i) Cost of equity

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(ii) Cost of debt
(iii) Weighted average cost of capital (using the traditional model). (8 marks)
(c) Explain and distinguish
(i) A bank loan
(ii) Loan notes
In so doing, explain why, in the circumstances of Crystal Co, the cost of debt may be different
for the two types of security. (4 marks)
(d) Explain why Crystal might decide to raise capital in the form of a convertible debt issue
rather than straight equity or debt. (5 marks)

Question 6
Bubble Co wishes to calculate its weighted average cost of capital and the following
information relates to the company at the current time:
Number of ordinary shares 20 million
Book value of 7% convertible debt N29 million
Book value of 8% bank loan N2 million
Market price of ordinary shares N5·50 per share
Market value of convertible debt N107·11 per N100 bond
Equity beta of Bubble Co 1·2
Risk-free rate of return 4·7%
Equity risk premium 6·5%
Rate of taxation 30%
Bubble Co expects share prices to rise in the future at an average rate of 6% per year. The
convertible debt can be redeemed at par in eight years’ time, or converted in six years’ time
into 15 shares of Bubble Co per N100 bond.
Required:
(a) Calculate the market value weighted average cost of capital of Bubble Co. State clearly any
assumptions that you make. (12 marks)
(b) Discuss the circumstances under which the weighted average cost of capital can be used
in investment appraisal. (6 marks)
(c) Discuss whether the dividend growth model or the capital asset pricing model offers the
better estimate of the cost of equity of a company. (7 marks)

Question 7
Modular Co is a listed company that owns and operates a large number of farms throughout
the world. A variety of crops are grown.
Financing structure
The following is an extract from the Statement of Financial Position of Modular Co at 30
September 20X2.
N million
Ordinary shares of N1 each 200
Reserves 100
9% irredeemable N1 preference shares 50
8% loan notes 20X3 250

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 600
The ordinary shares were quoted at N3 per share ex div on 30 September 20X2. The beta of
Modular Co's equity shares is 0.8, the annual yield on treasury bills is 5%, and financial markets
expect an average annual return of 15% on the market index.
The market price per preference share was N0.90 ex div on 30 September 20X2.
Loan notes interest is paid annually in arrears and is allowable for tax at a rate of 30%. The loan
notes were priced at N100.57 ex interest per N100 nominal on 30 September 20X2. Loan notes
are redeemable on 30 September 20X3.
Assume that taxation is payable at the end of the year in which taxable profits arise.
A new project
Difficult trading conditions in European farming have caused Modular Co to decide to convert
a number of its farms in Southern Europe into camping sites with effect from the 20X3 holiday
season. Providing the necessary facilities for campers will require major investment, and this
will be financed by a new issue of loan notes. The returns on the new campsite business are
likely to have a very low correlation with those of the existing farming business.
Required:
(a) Using the capital asset pricing model, calculate the required rate of return on equity of
Modular Co at 30 September 20X2. Ignore any impact from the new campsite project. Briefly
explain the implications of a Beta of less than 1, such as that for Modular Co. (5 marks)
(b) Calculate the weighted average cost of capital of Modular Co at 30 September 20X2 (use
your calculation in answer to requirement (a) above for the cost of equity). Ignore any impact
from the new campsite project. (10 marks)
(c) Without further calculations, identify and explain the factors that may change Modular
Co's equity beta during the year ending 30 September 20X3. (5 marks)
(d) Explain the limitations of the capital asset pricing model. (5 marks)

Question 8
Silogar Limited and Lowood Limited are two companies in the same chemical industry. While
Silogar has automated its operations, Lowood is just in the process of doing so. Both however
use good quality materials in their production process and their products are well accepted in
the market. For the year ended 31 December, 2011 each company had net turnover of
N4,800,000. The actual kegs of chemical sold were Silogar 320,000 and Lowood 300,000.
Other operating statistics for the companies for 2011 are as follows:
SILOGAR LOWOOD
N N
Cost of materials consumed 1,800,000 1,950,000
Direct labour cost 1,200,000 450,000
Production overhead 400,000 1,000,000
Administrative and selling expenses 420,000 120,000
Interest on debentures 100,000 180,000
Tax rate 30% 30%
Ordinary shares dividend payout ratio 50% 50%
Current market price of each ordinary share N3.45 N0.70

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The two companies summarized statements of financial position as at 31 December 2011 are
as follows:
SILOGAR LOWOOD
N N
Capital N1.00 ordinary shares 1,000,000 -
25k ordinary shares - 1,000,000
400,000 10% preference shares 400,000 -
General reserves 1,500,000 1,600,000
Debentures 800,000 1,200,000
Accounts payable and accruals 1,300,000 1,200,000
5,000,000 5,000,000
Non-current assets 2,000,000 3,200,000
Current assets 5,000,000 5,000,000
Required:
Assuming the market values of preferences shares and debentures are the same as their book
values, you are to advise the management of the two companies on the appropriate cost of
capital for purposes of project evaluation.
(Note: Use earnings method for equity cost of capital) (15 Marks)

Question 9
The directors of Jaleyemi plc. (JP), an Abuja-based entertainment company, are currently
considering the appropriate cost of capital to use in appraising capital investments. It is the
policy of the company to assess the financial viability of all capital projects using net present
value criterion.
You have been provided with the following financial information of the company.
Most recent statement of financial position
N’m N’m
Equity finance
Ordinary shares (N1 nominal value) 200
Reserves 120 320
Non-current liabilities
7% Convertible bonds (N100 nominal value) 160
5% Preference shares (N1 nominal value) 80 240
Current liabilities
Trade payables 80
Overdraft 120 200
Total liabilities 760
JP has an equity beta of 1.2 and the ex-dividend market value of the company’s equity is N1
billion. The ex-interest market value of the convertible bonds is N168 million and the ex-
dividend market value of the preference shares is N50 million.
The convertible bonds of JP have a conversion ratio of 19 ordinary shares per bond. The
conversion date and redemption date are both on the same date in five years’ time. The

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current ordinary share price of JP is expected to increase by 4% per year for the foreseeable
future.
The equity risk premium is 5% per year and the risk-free rate of return is 4% per year. JP pays
profit tax at an annual rate of 30% per year.
Required:
a. Calculate the market value after-tax weighted average cost of capital of JP, explaining
clearly any assumptions you made. (10 marks)
b. Discuss why market value weighted average cost of capital is preferred to book value
weighted average cost of capital when making investment decisions. (4 marks)
c. Discuss how the capital asset pricing model can be used to calculate a project – specific
cost of capital for JP, referring in your discussion to the key concepts of systematic
risk, business risk and financial risk. (6 marks)

Financing Decisions
Part C
1. Sources of finance
a) Assess the range of long-term sources of finance available to businesses, including
equity, debt and venture capital.
b) Evaluate and discuss methods of raising equity finance including:
(i) Right issue
(ii) Placement
(iii) Public offer
(iv) Stock exchange listing; and
(v) Financial market dealers’ quotation over the counter

Sources of finance
Sourcing money may be done for a variety of reasons. Traditional areas of need may be for
capital asset acquisition - new machinery or the construction of a new building or depot. The
development of new products can be enormously costly and here again capital may be
required. Normally, such developments are financed internally, whereas capital for the
acquisition of machinery may come from external sources. In this day and age of tight liquidity,
many organisations have to look for short term capital in the way of overdraft or loans in order
to provide a cash flow cushion. Interest rates can vary from organisation to organisation and
also according to purpose.
There are many more sources available to companies who do not wish to become "public" by
means of share issues. These alternatives include bank borrowing, government assistance,
venture capital and franchising. All have their own advantages and disadvantages and degrees
of risk attached.
Financing Decisions
Part C
2. Sources of finance

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 c) Assess the range of long-term sources of finance available to businesses, including
equity, debt and venture capital.
d) Evaluate and discuss methods of raising equity finance including:
(vi) Right issue
(vii) Placement
(viii) Public offer
(ix) Stock exchange listing; and
(x) Financial market dealers’ quotation over the counter

Sources of finance
Sourcing money may be done for a variety of reasons. Traditional areas of need may be for
capital asset acquisition - new machinery or the construction of a new building or depot. The
development of new products can be enormously costly and here again capital may be
required. Normally, such developments are financed internally, whereas capital for the
acquisition of machinery may come from external sources. In this day and age of tight liquidity,
many organisations have to look for short term capital in the way of overdraft or loans in order
to provide a cash flow cushion. Interest rates can vary from organisation to organisation and
also according to purpose.

There are many more sources available to companies who do not wish to become "public" by
means of share issues. These alternatives include bank borrowing, government assistance,
venture capital and franchising. All have their own advantages and disadvantages and degrees
of risk attached.

We can classify the sources of finance into three, thus:

i. Short term sources-those repayable within one year

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 ii. Medium term sources those repayable within one to three years or sometimes 1-5
years
iii. Long term sources available for 5 or more years.
Kindly consult chapters 11, 12 and 13 of ICAN Study Text on Strategic Financial Management
for further reading on:
(i) Range of long term sources of finance
(ii) Short and medium term sources of finance
Note: Venture capital is in chapter 13 of the Study Text.

Methods of raising equity finance

The main methods of issuing new shares for cash are as follows:

(i) Offer for subscription

(ii) Offer for sale
(iii) Private placement
(iv) Offer by tender
(v) Stock Exchange quotation
(vi) Rights Offer

Offer for Subscription

These are issues of shares or debentures made directly by the company to the public. The
proceeds of issue go directly to the company to finance its non-current assets, other
expansion programmes and working capital as stated in the prospectus. The company
normally goes through an issuing house which advices on such things as pricing and timing of
issue. This method may be used by companies coming to the market for the first time or
already quoted companies. Underwriting is usually necessary under this method.

Offer for Sale

This is an offer of existing securities to the public. These are two known forms this type of
offer may take. Firstly, it might occur where the issuing company initially sells the shares to
an issuing house which in turn sell the shares to the investing public at a slightly higher price.
Secondly, it might occur where the shares were already owned by government and it decides
to privatize these holdings. In both cases, the proceeds go to the vendor and not the
company. Most of the Federal Government parastatals that were sold under the privatization
programme fall into the second category. Underwriting is usually, not necessary in this case.

Private placement
A placing involves the sale of a relatively small number of new shares, usually to selected
investment institutions. A placing raises cash for the company when the company does not
need a large amount of new capital. A placing might be made by companies whose shares are
already traded on the stock exchange, but which now wishes to issue a fairly small amount of
new shares.

Offer for sale by tender

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This is a variation of an existing method offer for subscription. Under this method shares are
offered to the public and prospective buyers are required to quote price they are willing to
pay. The company would have a reserved price; the price below which the company will not
sell. Offers can only be made at prices above this price. The price at which the issues are
eventually made will be the highest price which will absorb all the shares. This price is called
the striking price. Prospective buyers who quoted higher than the striking price would be
required to pay the striking price. This is the price at which all shares would be sold. This
method of issue is suitable for companies going to the market for the first time, that is, making
initial public offer (IPO). This is because pricing may be difficult and it is, therefore, necessary
to allow the public to fix the price.

Stock exchange Introduction

In a stock exchange introduction, a company brings its existing shares to the stock exchange
market for the first time, without issuing new shares and without raising any cash. The
company simply obtains stock market status, so that its existing shares can be traded on the
stock market.
The rule of stock exchange might require that a minimum percentage of the shares of the
company should be held by the general investing public. If so, a stock exchange introduction
is only possible for a company that has already issued shares to the public but without having
those shares traded on the stock exchange market.
A stock market introduction is rare, but it might be used by a well-established company
(formerly a private company) whose shares are now held by a wide number of individuals and
institutions.
When a company makes a stock market introduction, it is able at some time in the future to
issue new shares for cash, should it wish to do so, through a placing or right issue.

An offer for sale is a means of selling the shares of a company to the public.
a) An unquoted company may issue shares, and then sell them on the Stock Exchange, to raise
cash for the company. All the shares in the company, not just the new ones, would then
become marketable.

b) Shareholders in an unquoted company may sell some of their existing shares to the general
public. When this occurs, the company is not raising any new funds, but just providing a wider
market for its existing shares (all of which would become marketable), and giving existing
shareholders the chance to cash in some or all of their investment in their company.

When companies 'go public' for the first time, a 'large' issue will probably take the form of
offer for sale. A smaller issue is more likely to be a placing, since the amount to be raised can
be obtained more cheaply if the issuing house or other sponsoring firm approaches selected
institutional investors privately.

Rights Issue

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A rights issue also known as a “privileged subscription” provides a way of raising new share
capital by means of an offer to existing shareholders, inviting them to subscribe cash for new
shares in proportion to their existing holdings.
For example, a rights issue on a one-for-four basis at 280k per share would mean that a
company is inviting its existing shareholders to subscribe for one new share for every four
shares they hold, at a price of 280k per new share.
A company making a rights issue must set a price which is low enough to secure the
acceptance of shareholders, who are being asked to provide extra funds, but not too low, so
as to avoid excessive dilution of the earnings per share.
In addition, the shareholders have option to exercise the right and take up the shares in full
or sell all the rights to someone else or sell enough rights that will give him enough cash to
subscribe for the balance or lastly to do nothing.

The theoretical ex-rights price

When a company announces a rights issue, the market price of the existing shares just before
the new issue takes place is called the “cum rights price”.
The theoretical ex-rights price is what the price ought to be, in theory, after the rights issue
has taken place.

o All the shares will have the same market price after the issue.
o In theory, since the new shares will be issued at a price below the cum-rights price, the
theoretical price after the issue will be lower than the cum rights price.

The theoretical ex-rights price is simply the weighted average price of the current shares cum
rights price and the issue price for the new shares in the rights issue.

Class Illustration 1
A company presently has in issue one million N1 equity shares. It plans to make a 1 for 4 rights
issue at a subscription price of N3.60. Assume that the shares just before the right issue were
selling on the stock market at N4.
Required:
(i) Calculate the theoretical ex-rights price and the value of the rights
(ii) Advise a shareholder who has 2000 shares in the company on what to do on receipt of
a right circular and on the effect of his action on his wealth.

Class Illustration 2
Wiseman plc, has 25,000,000 is issue with a current share price of N10.50. The company
requires N100m to finance an expansion project. The board of the company has decided to
issue rights to raise fund. The issue price has been fixed at N8.00. Hope limited holds 10% of
the ordinary shares of the company and is considering the following reactions to the rights
offer.
i. To take up the right
ii. To sell all the right
iii. To sell 40% and take up 60% of the right

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 iv. Sell enough to provide cash for subscription
v. To ignore the right offer
Required:
i. Calculate the number of right required to purchase a new share
ii. What is the theoretical ex-right price?
iii. What is the value of a right?
iv. Evaluate the options Hope limited is considering and advise the company on the best
course of action.

Exam Type Questions

Question 1
Sagitta is a large fashion retailer that opened stores in India and China three years ago. This
has proved to be less successful than expected and so the directors of the company have
decided to withdraw from the overseas market and to concentrate on the home market. To
raise the finance necessary to close the overseas stores, the directors have also decided to
make a one-for-five rights issue at a discount of 30% on the current market value. The most
recent income statement of the business is as follows.
Income statement for the year ended 31 May 20X4
Nm
Sales 1,400.00
Net profit before interest and taxation 52.0
Interest payable 24.0
Net profit before taxation 28.0
Company tax 7.0
Net profit after taxation 21.0
Ordinary dividends payable 14.0
Accumulated profit 7.0
The capital and reserves of the business as at 31 May 20X4 are as follows.
Nm
N0.25 ordinary shares 60.0
Revaluation reserve 140.0
Accumulated profits 320.0
520.0
The shares of the business are currently traded on the Stock Exchange at a P/E ratio of 16
times. An investor owning 10,000 ordinary shares in the business has received information of
the forthcoming rights issue but cannot decide whether to take up the rights issue, sell the
rights or allow the rights offer to lapse.
Required
(a) Calculate the theoretical ex-rights price of an ordinary share in Sagitta. (3 marks)
(b) Calculate the price at which the rights in Sagitta are likely to be traded. (3 marks)
(c) Evaluate options available to the investor with 10,000 ordinary shares. (4 marks)
(d) Discuss, from the viewpoint of the business, how critical the pricing of a rights issue is likely
to be. (5 marks)

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Question 2
Smeaton Furniture wishes to increase its production capacity by purchasing additional plant
and equipment at a cost of N3.8 million. The abridged profit and loss account for the year
ended 30th November 20X6 is as follows:
Nm
Sales turnover 140.6
Profit before interest and taxation 8.4
Interest 6.8
Profit before tax 1.6
Tax 0.4
Profit after taxation 1.2
Earnings per share 15 kobo
In order to finance the purchase of the new plant and equipment, the directors of the
company have decided to make a rights issue equal to the cost of the equipment.
The shares are currently quoted on the Stock Exchange at N2.70 per share and the new shares
will be offered to shareholders at N1.90 per share.
Required
(a) Calculate:
(i) the theoretical ex-rights price per share
(ii) the value of the rights on each existing share
(iii) assuming the increase in production capacity will lead to an increase in profit after tax of
N600,000 per annum and the P/E ratio of the company will remain unchanged after the rights
issue, calculate the market value per share after the rights issue.
(b) What are the options available to a shareholder who receives a rights offer from a
company?

Question 3
Omosola Co is a medium-sized manufacturing company which is considering a 1 for 5 rights
issue at a 15% discount to the current market price of N4.00 per share. Issue costs are expected
to be N220,000 and these costs will be paid out of the funds raised. It is proposed that the
rights issue funds raised will be used to redeem some of the existing loan stock at par.
Financial information relating to Omosola Co is as follows:
Current statement of financial position
N'000 N'000
Non-current assets 6,550
Current assets
Inventory 2,000
Receivables 1,500
Cash 300
3,800
10,350
Ordinary shares (par value 50 kobo) 2,000
Reserves 1,500
12% loan notes 2X12 4,500

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Current liabilities
Trade payables 1,100
Overdraft 1,250
2,350
10,350
Other information:
Price/earnings ratio of Omosola Co: 15.24
Overdraft interest rate: 7%
Tax rate: 30%
Sector averages: debt/equity ratio (book value): 100%
Interest cover: 6 times
Required
(a) Ignoring issue costs and any use that may be made of the funds raised by the rights issue,
calculate:
(i) the theoretical ex rights price per share;
(ii) the value of rights per existing share. (3 marks)
(b) What alternative actions are open to the owner of 1,000 shares in Omosola Co as regards
the rights issue? Determine the effect of each of these actions on the wealth of the investor.
(6 marks)
(c) Calculate the current earnings per share and the revised earnings per share if the rights
issue funds are used to redeem some of the existing loan notes. (6 marks)
(d) Evaluate whether the proposal to redeem some of the loan notes would increase the
wealth of the shareholders of Omosola Co. Assume that the price/earnings ratio of Omosola
Co remains constant. (3 marks)
(e) Discuss the reasons why a rights issue could be an attractive source of finance for Omosola
Co. Your discussion should include an evaluation of the effect of the rights issue on the
debt/equity ratio and interest cover. (7 marks)
(Total = 25 marks)

Ex-rights price and Actual market price

So far, it has been assumed that the actual ex-rights price will be equal to the theoretical ex-
rights price. However, this may not be so for the following reasons:
(i) General factors affecting the market as a whole may cause actual market price to fall
short or below the theoretical ex-right price.
(ii) Many shareholders off-loading their rights thereby creating excess supply on the
market. This possible outcome leads to the actual price falling below the theoretical
ex-rights price.
(iii) Investors may not have faith in the management’s ability to utilize the rights’ funds
efficiently and therefore maintain the same level of dividend rates on the enlarged
capital based. This will also cause the actual price falling below the expected market
price.

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 (iv) Investors may on the other hand, have maximum confidence that the use of which the
rights funds are put will add value to the business. In this case, the actual price may
rise above the theoretical ex-rights price.

Pricing of rights issue

Pricing of rights issue is not critical as pricing of new issues of shares to the investing public as
a whole. From the point of view of investors, it would have been seen, from the above that
as long as a shareholder takes up his rights, or sell them, his wealth would not be affected by
the issue of rights by the company. Based on this reasoning, which was confirmed by various
calculations, it can be said that a shareholder’s wealth will not be equally affected by the
subscription price of a rights issue.
However, from the standpoint of companies, two points stand out;
(i) A subscription price at a discount to the current market price exerts pressure on a
shareholder to take up his rights or sell them. This has the effect of making the issue
a success as the shares will be fully taken up and amount required by the company fully
recovered.
(ii) A subscription price at an acceptable discount below the current market price will
ensure that a fall in actual market price, following the date of announcement but
before the date of the rights issue, does not cause the actual market price to fall below
the subscription price. if his happens, investors would prefer buying she shares in the
open market than subscribing for the rights. The natural result is the failure of the
rights issue.

Capital structure theories

In finance, capital structure refers to the way a corporation finances its assets through some
combination of equity, debt, or hybrid securities. A firm's capital structure is then the
composition or 'structure' of its liabilities. For example, a firm that sells N20 billion in equity
and N80 billion in debts is said to be 20% equity-financed and 80% debt-financed. The firm's
ratio of debt to total financing, 80% in this example is referred to as the firm's leverage. In
reality, capital structure may be highly complex and include tens of sources. Gearing Ratio is
the proportion of the capital employed of the firm which come from outside of the business
finance, e.g. by taking a short term loan etc.

The Traditional View

The traditional view claims that there is an optimal capital structure where WACC is at a
minimum and at this point the combined market value of the firm’s debt and equity will be at
maximum. Managers therefore should identify this optimum level of gearing and ensure that
their company maintains its capital structure.
The bases of the traditional theory are:
o The cost of equity increases as the level of gearing increases. The introduction of debt
brings financial risk. This financial risk will make the earning available to equity
shareholders to become more volatile. The equity shareholders will therefore require

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 additional return to compensate for the increase in financial risk, and will push the cost
of equity up.
o Debts finance is cheaper than equity as it is ranked before equity in terms of
distribution of earnings and on liquidation, and also interest on debt is a tax allowable
expense. The issue cost on debt is also cheaper than issuing cost of equity.
o Cost of debt remain constant, as the level of gearing increase, up to some point of
gearing level and beyond which it will increase. The reason being that risk to providers
of debt finance increases because interest cover will be falling and there may be few
assets available to offer as security against nonpayment. This will push the cost of debt
up.
o WACC will then form a type of U-shape. At first falling as level of debt increases as
reflecting the low cost of debt, and then tending to increase as rising equity cost and
rising cost of debt become more significant. The optimum capital structure is where
the WACC is at its minimum.

The Modigliani-Miller view: ignoring corporate taxation

The traditional view of gearing and WACC was challenged by Modigliani and Miller (MM) in
the 1950s. Initially, their arguments were based on the assumption that corporate taxation,
and the tax relief on interest, could be ignored.
All companies with the same earnings in the same risk class have the same future income
stream and should therefore have the same value, independent of capital structure.

Assumptions
MM made several assumptions in making their propositions.
Assumptions
o Investors are rational
o Investors have the same view of the future
o Personal and corporate gearing are perfect substitutes
o Information is freely available
o No transaction costs
o No tax
o Firms can be grouped into similar risk classes.
It is not possible to explain properly the relevance of the assumptions about risk free debt, its
availability and the absence of transaction costs in buying and selling shares. These
assumptions were used by MM to justify their views and explain how investors were
indifferent to the gearing of companies because they are able to adjust their own personal
gearing by borrowing and buying or selling shares.

Modigliani and Miller’s propositions: ignoring taxation

MM argued that if corporate taxation is ignored, an increase in financial gearing will have the
following effect:
o As the level of gearing increases, there is a greater proportion of cheaper debt capital
in the capital structure of the firm.
o However, the cost of equity rises as gearing increases.

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 o As gearing increases, the net effect of the greater proportion of cheaper debt and the
higher cost of equity is that the WACC remains unchanged. The effect of the higher
cost of equity is exactly equal to the offsetting effect of having a larger proportion of
debt capital in the capital structure.

The WACC is the same at all levels of financial gearing.

The total value of the company (equity + debt capital) is therefore the same at all levels of
financial gearing.
Modigliani and Miller therefore reached the conclusion that the level of gearing is irrelevant
for the value of a company. There is no optimum level of gearing that a company should be
trying to achieve.

Modigliani-Miller view of gearing and the WACC: no taxation

MM’s theory is sometimes called the ‘net operating income’ approach because MM argued
that, in the absence of taxation, the total market value of a company is determined by just
two factors:
o The total earnings of the company (profit after interest, if tax is ignored).
o The business risk of the company, which determines the WACC. WACC is not affected
by financial gearing, but it is affected by the perceived business risk of investing in the
company. WACC is higher for companies with higher business risk.

Modigliani-Miller formulae: no taxation

There are three formulae for the Modigliani and Miller theory, ignoring corporate taxation.
These are shown below. The letter ‘u’ refers to an ungeared company (all equity company)
and the letter ‘g’ refers to a geared company.

Proposition 1: value of company

Vg = Vu

Proposition 2: cost of equity

Keg = Keu+(Keu−Kd) Vd/Ve

Proposition 3: WACC
WACCg = WACCu (Keu)

Example
An all-equity company has a market value of N60 million and a cost of equity of 8%. It borrows
N20 million of debt finance, costing 5%, and uses this to buy back and cancel N20 million of
equity. Tax relief on debt interest is ignored.
Required
According to Modigliani and Miller, if taxation is ignored, what would be the effect of the
higher gearing on (a) the WACC (b) the total market value of the company and (c) the cost of
equity in the company?

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Example
A company has N500 million of equity capital and N100 million of debt capital, all at current
market value. The cost of equity is 14% and the cost of the debt capital is 8%.
The company is planning to raise N100 million by issuing new shares. It will use the money to
redeem all the debt capital.
Required
According to Modigliani and Miller, if the company issues new equity and redeems all its debt
capital, what will be the cost of equity of the company after the debt has been redeemed?
Assume that there is no corporate taxation.

Exercise 2
A company has N80 million of equity capital, which costs 10% and N20 million of debt capital
that costs 5%. The company borrows N20 million of debt finance, costing 5%, and uses this to
buy back and cancel N20 million of equity.
According to Modigliani and Miller, ignoring corporate taxation, what will be:
(a) the WACC of the company after the increase in gearing
(b) the market value of equity in the company after the increase in gearing, and the cost of
equity in the company after the increase in gearing.
(Hint: To calculate the new cost of equity, calculate the cost of equity in an all-equity company
first, and then calculate the cost of equity for the company at its new level of gearing.)

MODIGLIANI AND MILLER – INCLUDING CORPORATION TAX (1963)

Modigliani and Miller revised their arguments to allow for corporate taxation and the fact that
there is tax relief on interest.
The values of companies with the same earnings in the same risk class are no longer
independent. Companies with a higher gearing ratio have a greater net future income stream
(purely due to corporation tax relief on interest payments) and therefore a higher value.

Modigliani and Miller argued that allowing for corporate taxation and tax relief on interest,
an increase in gearing will have the following effect:
o As the level of gearing increases, there is a greater proportion of cheaper debt capital
in the capital structure of the firm. However, the cost of equity rises as gearing
increases.
o As gearing increases, the net effect of the greater proportion of cheaper debt and the
higher cost of equity is that the WACC becomes lower. Increases in gearing therefore
result in a reduction in the WACC.
o The WACC is at its lowest at the highest practicable level of gearing.
o There are practical limitations on gearing that stop it from reaching very high levels.
For example, lenders will not provide more debt capital except at a much higher cost,
due to the high credit risk or insolvency risk.

The conclusions that MM reached were that:

o The total value of the company is higher for a geared company than for an identical all-
equity company.

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 o The value of a company will rise, for a given level of annual cash profits before interest
and tax, as its gearing increases.
o There is an optimum level of gearing that a company should be trying to achieve. A
company should be trying to make its gearing as high as possible, to the maximum
practicable level, in order to maximise its value.
A graph showing the relationship between WACC and gearing, according to MM’s theory with
taxation, is as follows:

Modigliani-Miller formulae: allowing for taxation

Proposition 1: value of company
Vg = Vu + Dt

Proposition 2: cost of equity

Ke = Keu + (1-T) x (Keu - Kd) x Vd/Ve
Ke = cost of equity of a geared company,
Keu = cost of equity in an ungeared company
Kd = cost of debt (pre-tax)
VdVe = market value of debt & equity

Proposition 3: WACC
WACCg = Keu (1 − (Vdt/( Ve + Vd))
Lecture Example 1
An all-equity company has a market value of N60 million and a cost of equity of 8%. It borrows
N20 million of debt finance, costing 5%, and uses this to buy back and cancel N20 million of
equity. The rate of taxation on company profits is 25%.

Lecture Example 2
Grant plc (an all equity company) has on issue 6,000,000 N1 ordinary shares at market value
of N2.50 each.
Bell plc (a geared company) has on issue: 17,000,000 25p ordinary shares; and N8,000,000 15%
debentures (quoted at 125)
Taking corporation tax at 35%, and assuming that:
1. The companies are in all other respects identical; and
2. The market value of Grant’s equity and the market value of Bell’s debt are “in equilibrium”.
Calculate the equilibrium price per share of Bell’s equity.

Why do companies not attempt a 99.9% debt structure?

1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the associated “COSTS
OF FINANCIAL DISTRESS”.
Vg = Vu + Dt − Present value of costs of financial distress
2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high levels of gearing.
3. Tax exhaustion

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The value of the company will be reduced if advantage cannot be taken of the tax relief
associated with debt interest.
4. Debt capacity
Generally, loans must be secured against a company’s assets and clearly some assets (e.g.
property) provide better security for loans than other assets (e.g. high-tech equipment which
may become obsolescent overnight). The depth of the asset’s second hand market and its
rate of depreciation are important characteristics.
5. Personal taxes (MILLER’S CRITIQUE 1977)
Investors will be concerned with returns net of all taxes.
o If a firm’s income is paid out as debt interest, corporation tax savings are made (see M
& M 1963) but investors will have to pay income tax on debt interest.
o If a firm’s income is paid out as an equity return, corporation tax has to be paid but
personal tax can be saved (e.g. by avoidance of capital gains tax using exemptions).
o In deciding its gearing level, a firm should consider its corporation tax position and the
personal tax position of its investors if it wishes to maximise their wealth.
o In his 1977 article, Miller argues that firms will gear up until marginal investors face a
personal tax cost of holding debt equal to the corporation tax saving. At this point
there is no further advantage of gearing.

PECKING ORDER THEORY

The Pecking Order Theory is that a company’s capital structure decision is not determined by
the costs and benefits of using a combination of debt and equity finance to minimize the cost
of capital.
The theory suggests that a company has a well-defined order of preference in relation to
available sources of finance i.e.
(a) The first preference is the use of retained earnings, since internal finance is readily
accessible, has no issue costs and does not involve negotiating with third parties, such as
banks.
(b) If external finance has to be used (because the company has identified more positive NPV
projects than can be financed by retentions alone), bank borrowings, loan stock and
debentures are the initial preferred source of external finance. The cost of issuing new debt
is normally much smaller than the cost of equity issues. Furthermore, it is possible to raise
smaller amounts of debt than of equity.
When raising debt, initially it is advisable to issue low risk secured debt, and when there are
no more assets available as security, then to issue unsecured debt with a consequent higher
risk and higher cost.
(c) If, after the company’s level of debt capacity is reached, there remain further positive NPV
projects that remain to be financed, the final and least preferred source of finance is the issue
of new equity capital.
Accordingly, there appears to exist a financing pecking order i.e. first use retained profits,
then secured debt, then unsecured debt and finally equity.
A more sophisticated explanation of the Pecking Order Theory was developed in 1984, when
it was suggested that the order of preference stemmed from the existence of “asymmetry of

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information” between the company and the capital markets. This term refers to the fact that
company management are likely to have a much better idea of the true worth of the
company’s shares than do outside investors.
Accordingly, if a company wishes to raise new project finance and the capital market has
underestimated the benefits of the project, company management (with their inside
information) will be aware that the market has undervalued the company.
They would therefore choose to finance the project through retentions, so that when the
market discovers the true value of the project, existing shareholders will benefit. If retained
earnings are inadequate, the company would choose to raise debt finance in preference to a
new equity issue (since they would not wish to issue new equity shares which are undervalued
by the market).
However, if the company’s management believes that investors are overvaluing the benefits
of the new project and therefore placing too high value on the company’s shares, they would
prefer to issue new equity at that overvalued price.

STATIC TRADE-OFF THEORY

This variation on the 1963 with corporate tax theory of Modigliani and Miller arrives at a
conclusion, which is similar to that of the traditional theory of gearing i.e. there exists an
optimum level of leverage that companies should attempt to attain.
Provided a company is in a static position i.e. not in a period of extreme growth, it is likely to
have a gearing policy that is stable over time. This is achieved by striking a balance between
the benefits and the costs of raising debt.
The benefits of debt relate to the tax relief that is enjoyed when interest payments are made
– the cheaper debt finance will reduce the weighted average cost of capital and increase
corporate value.
The costs of debt relate to the increases in the costs of financial distress (e.g. bankruptcy
costs) and increases in agency costs that arise when the company exceeds its optimum
gearing levels. The resultant increase in required returns demanded by investors cause the
weighted average cost of capital of the company to increase and hence corporate value to
fall. There is accordingly, in theory, a trade-off between these two effects and hence the cost
of capital and the value of the company will be optimized. However, subsequent research
suggests that there is little evidence of the static trade-off theory operating in the real world.

Question 1
Berlan plc has annual earnings before interest and tax of N15m. These earnings are expected
to remain constant. The market price of the company’s ordinary shares is 86 kobo per share
cum div and of debentures N105.50 per debenture ex-interest. An interim dividend of 6 kobo
per share has been declared. Corporate tax is at the rate of 35% and all available earnings are
distributed as dividends.
Berlan’s long-term capital structure is shown below:
N’000
Ordinary shares (25 kobo par value) 12,500
Reserves 24,300
36,800

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16% debentures 31.12.2007 (N100 par value) 23,697
60,497
Required:
Calculate the cost of capital of Berlan plc according to the traditional theory of capital
structure. Assume that it is now 31 December 2004.

Question 2
Canalot plc is an all-equity company with an equilibrium market value of N32.5 million and a
cost of capital of 18% per year.
The company proposes to repurchase N5 million of equity and to replace it with 13%
irredeemable loan stock.
Canalot’s earnings before interest and tax are expected to be constant for the foreseeable
future. Corporate tax is at the rate of 35%. All profits are paid out as dividends.
Required:
(a) Using the assumptions of Modigliani and Miller, explain and demonstrate how this change
in capital structure will affect:
(i) the market value
(ii) the cost of equity
(iii) the cost of capital of Canalot plc.
(b) Explain any weakness of both the traditional and Modigliani and Miller theories and discuss
how useful they might be in the determination of the capital structure for a company.

Financing Decision
5. Portfolio Theory and Asset Pricing Models
(a) Portfolio Theory
Assess and apply:
Risk and return relationship in investments;
Risk (standard deviation) of 2-asset portfolio; and
Risk reduction through diversification.
(b) Capital assets pricing model (CAPM)
Discuss:
Systematic and unsystematic risks;
Capital market line (CML) and the security market line (SML); and
Alpha value and its use
Calculate Beta factor and explain its uses
Evaluate return on assets using multifactor model (MFM).

Portfolio Theory
It is axiomatic that an investor will spread his funds over a number of available investments
and will not put “all his eggs in one basket”. If asked why he does this? He will simply reply
that it reduces the risk of loss. If he invests in one security and this fails, he will lose money.
It is unlikely that he will lose everything if he holds a number of investments. Investment in

39 | P a g e
different types of securities is termed Diversification (spreading the risk). It should be noted
that blind adherence to random diversification is not sensible and analytical framework needs
to be set up within which to devise a suitable policy.
The branch of strategic financial management which deals with this is known as portfolio
theory. The term portfolio in this context can simply be simply described as diversification of
investment in order to reduce risks or alternatively it can be simply put to mean collection of
different investments that make up an investor’s total holding. For an investor through the
stock exchange, the portfolio will be a collection of shareholdings in different companies. For
a property investor, his portfolio will be a collection of real capital projects.
Portfolio theory was developed by Harry Markowitz and Markowitz model is the name given
to the approach for portfolio selection. Portfolio selection is concerned with the problem of
determining the best group of investments to hold taking into consideration both the
expected return from the individual investment and the risk attached to it. Markowitz was
credited for being the first writer to apply statistical techniques to the assessment of risk and
the consequent buy or sell decision. He introduced the use of standard deviation or variance
of the return of an investment as a measure of risk and in general introduced the whole
concept of statistical measure of dispersion as measure of risk in the selection situation.

Separability theorem and interior decorator

The separability theorem states that all investors ranging from the risk averse to the cavalier
(that is, the risk to living) should have the same mix of risky securities in their portfolio. This
contradicts the interior decorator school of thought which stipulated that a skilled analyst is
expected to furnish information on the securities that suit his client’s psychology. For
example, a skilled analyst is not expected to introduce a hypertensive client to transport
business as this in most unsuitable to his wellbeing.

Traditional Investment Appraisal and Portfolio Theory

Traditional investment appraisal considers only factors relating to an individual project. The
main factor is the predicted cash flow and if the project is risky, this may also be taken into
account by the use of expected value for cash flows.
Portfolio theory takes the above analysis a step further. According to the theory:
(i) A financial manager is concerned with the overall risk of the business and not the risk
attaching to individual segment of it.
(ii) Diversification of activities is capable of reducing overall risk below that of individual
segment taking separately.
(iii) Individual project should, therefore, be evaluated not only by reference to their
expected returns but also with regard to their contribution to overall risk (i.e. their
portfolio effect).
(iv) For diversification to be successful in reducing risk, the portfolio effect of a proposed
project must be favourable.

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The portfolio effect is favourable where the individual risk attaching to a project is
uncorrelated or (better) inversely correlated with the risk attaching to the existing portfolio
to which it is to be added.

Portfolio Expected Return and Risk

Return
When an investor has a portfolio of securities, he will expect the portfolio to provide certain
return on his investment; this expected return from the portfolio will be a weighted average
return of all the investments that make up the portfolio, with weight equal to the portfolio of
investment in each security.

Portfolio Weight
There are many equivalent ways of describing a portfolio. The most convenient approach is
to list the percentages of the total portfolio’s value that are invested in each portfolio asset.
We call these percentages the portfolio weights. For example, if we have N5 Million in one
asset and N15 Million in another, then our total portfolio is N20 Million. The percentage of our
portfolio in the first asset is 25%. The percentage of our portfolio in the second asset is 75%.
Our portfolio can be simply put as .25 and .75. Notice that the weights have to add up to
“one” since all our money is invested somewhere.

Risks
The risk in an investment or in a portfolio of investment is that the actual return will not be
the same as the expected return. The actual return may be higher or lower. A prudent
investor will want to avoid too much risk and will hope that the actual returns from his
portfolio are much the same as what he expected them to be. The risk in a security or in a
portfolio can be measured as the standard deviation of expected returns, given estimated
probabilities of actual return.

Class Illustration 1
The following are the likely returns from Z plc, and the associated probability of each of the
returns:

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 Return Probability
10% 0.2
15% 0.5
20% 0.3
Calculate the average return, and the total risk.

Note that the square of the standard deviation is also called the variance. On occasions you
have been given the variance and been expected to calculate the standard deviation from it.

Class Illustration 2
Rosita Ramirez invests the following sums of money in common stocks having expected
returns as follows:
Security Amount Invested Expected Return
N %
Morck Drug 6,000 14
Kota Chemical 11,000 16
Fazio Electronics 9,000 17
Northern California Utility 7,000 13
Grizzle Restaurants 5,000 20
Pharlap Oil 13,000 15
Excel Corporation 9,000 18
a) What is the expected return (percentage) on her portfolio?
b) What would be her expected return if she quadrupled her investment in
GrizzleRestaurants while leaving everything else the same?

Formula for Portfolio Risk:

Measuring Co-variability

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Co-variability can be measured in absolute terms by the covariance or in relative terms by the
correlation coefficient.

Correlation
The measure of how closely two investments move with each other is known as the
coefficient of correlation (ρ). If two investments move in exactly the same way, then the
coefficient of correlation will be +1 (perfect positive correlation), whereas if they move in
exactly opposite directions then the coefficient of correlation will be -1 (perfect negative
correlation). These are the two extremes – in any situation the coefficient of correlation will
lie between +1 and -1.
If we know the coefficient of correlation between two investments, and the risk of the two
investments, then we are able (using a formula) to calculate the risk of any combination of
the two investments. Zero coefficient of variation indicates that the returns are independent
of each other. The above relationship is measured by the correlation coefficient (r).
If r = +1 Perfect positive correlation
r = -1 Perfect negative correlation
r=0 Neutral correlation (no correlation)
The formula for the correlation coefficient is as follows:
Covariance between X and Y
Std. deviation of X and std. deviation of Y

The covariance
o A positive covariance indicates that the returns move in same direction.
o A negative covariance indicates that the returns move in opposite direction.
o A zero covariance indicates that the returns are independent of each other.
The formula for the covariance is as follows:
Covariance = ∑ P (x – x) (y – y)
Where P = probability of the outcome
X = return from security X at that outcome
X = expected return from security X
Y = return from security Y at that outcome
Y = expected return from security Y

Essence of Portfolio Theory

Using this theory, it is possible to:
i. Measure the expected size of the return from the investment portfolio.
ii. Measure the risk associated with the portfolio i.e. standard deviation of the expected
return.
iii. Select desirable portfolio.

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Factors Influencing the Choice of an Investment
There are five major factors to be considered when an investor chooses an investment, no
matter whether the investor is an internal investor or not (a private company or an individual
investor). They are:
i. Security: the most important is the security of the capital invested. The investment
should at least maintain his capital value.
ii. Liquidity: where the investments are made with short term funds, they should be
convertible back into cash at short notice.
iii. Return: the funds are invested to make money. The highest return compatible with
safety should be sought.
iv. Spreading risks: The investor who puts all his funds into one type of security risks
everything on the fortunes of that security. If it performs badly, entire investment will
make a loss. A better (and more secured) policy is to spread over several types of
security, so that a possible loss in some may be offset by gains in other. A planned
spread of investments is known as a portfolio.
v. Growth prospects: the most profitable investments are likely to be in securities of
companies with good growth prospects.

Assumptions of Portfolio Theory

The preceding analysis of portfolio theory has been conducted with several simplifications
and assumption in mind. The more important ones are listed and commented below.
(i) Investors are rational and risk averse: the assumption that investors do not like risk is
one of the foundation of portfolio theory, without which the whole idea of
diversification becomes meaningless. The implication of the risk adverse attitude is
that he will prefer the portfolio with the highest expected return for a given level of
risk or prefer the portfolio with the lowest level of risk for a given level of expected
returns. This is known as the principle of dominance in the portfolio theory.
(ii) Investors seek to maximize utility: Which is a function of risk and expected returns.
This is quite a reasonable assumption. Although, investors may consider other factors
in determining the utility of investment (consider, for example investing in a football
club you support). This will have only a small effect compared with risks and returns.
(iii) Risk is measured by standard deviation of returns: the assessment of risk may be more
than a straight forward standard deviation but this measure is convenient and easy to
manage.
(iv) There are no transaction costs: This is obviously not true in practice where brokers
fess, stamp duties etc., will cause significant transaction costs to arise. It
effectively makes the attainment of market portfolio (portfolio of all risky assets)
impossible.
By holding only, a limited number of well selected shares, however, it should be possible to
obtain a fairly close approximation to the market portfolio. The use of unit trust and
investment trust companies would be a good way of obtaining diversification whilst

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minimizing transaction costs especially if an investor has only a relatively small amount to
invest.
It is assumed that an investor or a decision maker will act rationally in the following pattern.

(i) If two portfolios of investment have the same risk but different expected returns the
portfolio with higher returns will be selected.
(ii) If two portfolios of investment have the same return but different degree of risk,
portfolio with the lower risk will be selected.
(iii) A portfolio with a larger expected returns and lower degree of risk will be preferred to
the one with a lower expected return and higher risk.

Class Illustration 1
An investment analyst has provided the following data in respect of securities A and B.
Expected Return Risk
N N
A 2,150 381
B 2,250 637
A prospective investor believes that by combining securities A and B in the proportion 60%
and 40% respectively, he could improve his position.
Required:
Calculate the portfolio return and risk where the correlation co-efficient is +1, -1, and 0.

Class Illustration 2
A risky portfolio has an expected return of 0.33 and a standard deviation of 0.4. The return
on the Treasury bill is 12%. Your portfolio has 40% investment in the Treasury bill and the
balance of the fund in the risky portfolio. What is the expected return and standard deviation
of your portfolio?

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Class Illustration 3
You are considering investment in one or both of two securities X and Y and you are given the
following information:
Security Possible rates of returns Probability of occurrence
%
X 30 0.3
25 0.4
20 0.3
Y 50 0.6
40 0.4
You are required to:
a) Calculate the expected return for each security separately and for a portfolio
comprising 60% X and 40% Y, assuming positive correlation between rates of return from
the shares comprising the portfolio.
b) Calculate the expected risk of each security separately and of the portfolio as defined
above.
c) Outline the objectives of portfolio diversification, and explain in general why the risk on
individual securities may differ from that of portfolio as a whole.

Choosing between share investments

When an investor is choosing between different shares to invest in, they take into account
both the return from the shares and the level of risk associated with these returns.
If two shares were to have the same level of risk, then they would select the share giving the
highest expected return. On the other hand, if two shares were to give the same expected
return then they would choose the one with the lowest risk.
If one share had more risk than the other, but at the same time were giving a higher return,
then it would be up to the individual shareholder to decide whether or not the higher risk was
compensated for by the higher return. This would depend on the individual shareholders
attitude to risk.
It is however important to appreciate that investors will accept higher risks provided that
there is sufficient extra return to compensate for that higher risk.

Example 1
An investor has the choice of the following share investments:
Share Expected
return Risk (σ)
A 20% 8%
B 25% 6%
C 23% 4%
D 20% 2%
E 22% 2%

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Which share (or shares) will the investor definitely not choose?

Note that although we can reject A and D, we are not in a position to decide which is better
of the remaining three. It depends on the attitude to risk of the individual involved and as to
whether he regards the additional return as being sufficient or not for the extra risk. (We
could perhaps base a decision on the ratio of the risk to the return, but this would at best only
be a guide – it is the attitude of the investor that matters, and we are not in a position to know
this.)

Combining share investments

In the previous section we were looking at the criteria for choosing between investments, and
we said that we want higher returns, but only if the level of risk is acceptable.
It is potentially possible, however, to reduce the risk without suffering a reduction in the
return, by investing in a combination of 2 or more investments. If we are able to reduce risk
without a reduction in return, then this must be worthwhile.

Class Illustration 2
The following are the likely returns from investments in ice-cream and in umbrellas, together
with the associated probabilities:
Weather Return from ice-cream Return from umbrellas Probability
Sun 20% 10% ⅓
Cloud 15% 15% ⅓
Rain 10% 20% ⅓
a) What is the average return and the total risk for each investment separately?
b) What is the average return and the total risk if an equal amount were to be invested in
each?

Class Illustration 3
Juris currently has a portfolio of shares giving a return of 20% with a risk of 10%. He is
considering a new investment which gives a return of 20% with a risk of 12%. The coefficient of
correlation of the new investment with his existing portfolio is +0.2. The new investment will
comprise 40% of his enlarged portfolio.
Should he invest in the new investment?

Class Illustration 4
Janis currently has a portfolio of shares giving a return of 18% with a risk of 10%. He is
considering investing in one of the following additional investments.
A B
Return 8% 8%
Risk 5% 3%
Coefficient of correlation with existing portfolio -0.7 +0.4
The new investment will comprise 20% of his enlarged portfolio.
Which of the two investments should he choose?

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Well-diversified portfolios
As the number of shares in a portfolio increases, one would expect the level of risk to fall. For
the risk to fall to zero would require negative correlation and this does not occur in practice
with share investments. What will happen is that provided shares are chosen sensibly, the
level of risk will fall to a minimum.
The reason for this effect is that there are two types of risk in a share investment
Systematic risk (or market risk):
This is the risk due to general economic factors (such as the level of inflation in the country).
It exists in all shares, but different business sectors have different levels of systematic risk. All
shares in a particular business sector will have the same level of systematic risk.

Unsystematic risk (or company specific risk):

This is the extra risk in each individual company due to factors specific to that company such
as the quality of management or labour relations.
It is the unsystematic risk that can be diversified away within in portfolio. What cannot be
diversified away is the systematic risk. The level of systematic risk depends on the business
sector, and the level of systematic risk remaining in a portfolio will depends on the sector or
sectors invested in.
A well-diversified investor is one who has created a portfolio where the unsystematic risk has
been fully diversified away. The only risk remaining will be systematic risk and it is the level of
systematic risk that will determine the return required by the investor. It is this statement that
forms the basis of the Capital Asset Pricing Model.

CAPITAL ASSETS PRICING MODEL

This method also calculates the cost of equity (like dividend valuation model) but looks more
closely at the shareholder’s rate of return, in terms of risk. The more risk a shareholder takes,
the more return he will want, so the cost of equity will increase.
For example, a shareholder looking at a new investment in a different business area may have
a different risk.
The model assumes a well-diversified investor.
It suggests that any investor would at least want the same return that they could get from a
“risk free” investment such as government bonds. This is called the “risk free” return
On top of the risk free return, they would also want a return to reflect the extra risk they are
taking by investing in a market share. This is called the “risk premium”.
They may want a return higher or lower than the average market returns depending on
whether the share they are investing in has a higher or lower risk than the average market
risk.
The average market premium is Market return - Risk free return.

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How risky is the specific investment compared to the market as a whole?
(i) This is the ‘beta’ of the investment If beta is 1, the investment has the same risk as the
market overall.
(ii) If beta > 1, the investment is riskier (more volatile) than the market and investors
should demand a higher return than the market return to compensate for the
additional risk.
(iii) If beta < 1, the investment is less risky than the market and investors would be satisfied
with a lower return than the market return.
(iv) If beta = 0, the investment if risk free e.g. government securities.

Class Illustration
Risk free rate = 5%
Market return + 14%
What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.5

Class Illustration

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The risk-free rate of return is 4% and the return on the market portfolio is 8.5%.
What is the expected return from shares in companies’ X and Y if:
i. the beta factor for company X shares is 1.25
ii. the beta factor for company Y shares is 0.90?

CAPM Assumptions
The CAPM is based on the following assumptions:
(i) Individuals are risk averse.
(ii) Individuals seek to maximize the expected utility of their portfolio over a single period
planning horizon.
(iii) Individuals have homogeneous expectations – they have identical subjective estimates
of the means, variances, and co-variances among returns.
(iv) Individuals can borrow and lend freely at a riskless rate of interest.
(v) The market is perfect: there are no taxes, there are no transaction costs; securities are
completely divisible, the market is competitive.
(vi) The quantity of risky securities in the market is given.
CAPM which brings together aspect of portfolio, share valuation, cost of capital and gearing
was developed as an aid to optimal portfolio selection, whereby according to attitude to risk
of the investor, “a capital market line” will be established such that all efficient portfolios
(preferred tradeoff between risk and return) lie on the capital market line.

Systematic and unsystematic risk

Under portfolio theory, we explained what is meant by systematic and unsystematic risk and
the fact that the total risk in a share is a combination of the two. The total risk of an investment
as measured by the standard deviation of its return can be written as:
σ total 2 = σ sys2 + σ unsys2

Class Illustration
Shares in X plc have a total risk of 18%.
The unsystematic risk in the company has been identified as being 5%.
Calculate the systematic risk.

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Note: Investors should not expect markets to reward them for taking on risks that can be
diversified away. They should expect compensation only for bearing systematic risk.

The return from quoted shares

Shareholders (as a whole) can get whatever return they require from a quoted share because
they determine the market value of the share. The market value is determined by the
expected future dividends and the investors’ required rate of return.
We assume that the shareholders in a large quoted company are overall well-diversified
(partly because there are many shareholders, but also because many of the shareholders will
be pension funds and unit trusts that will have large portfolios).
If the shareholders are well-diversified, then they will have diversified away all the
unsystematic risk (portfolio theory) and will therefore only be concerned with the level of
systematic risk. It is therefore the level of systematic risk that will determine the return that
they require (and hence the return actually given) from the share.
Instead of measuring the systematic risk in isolation as a %, we normally measure it relative to
the risk of the market as a whole (i.e. the stock exchange as whole). We call this the β of the
share.
β = σ syt
σmkt

Class Illustration
Y plc has systematic risk of 8% and the market has risk of 10%.
What is the β of Y plc?

Class Illustration
Z has total risk of 15%, which includes unsystematic risk of 4%.
The variance of the market is 30. What is the β of Z plc?

Class Illustration
T plc is giving a return of 20%.
The stock exchange as a whole is giving a return of 25% with a risk of 8%, and the return on
government securities is 8%.
What is the β of T plc, and what is the systematic risk of T plc?

Class Illustration
Share Capital (50k) N2 million
Dividend per share (just paid) 24k
Dividend paid four years ago 15.25k
Current market returns = 15%
Risk free rate = 8%
Equity beta 0.8

Class Illustration

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T plc is all equity financed. It wishes to invest in a project with an estimated β of 1.4, which is
significantly different from the business risk characteristics of T’s current operations.
The project requires an outlay of N100,000 and is expected to generate returns of N15,000
p.a. in perpetuity.
The market return is 11% and the risk free rate is 6%.
Estimate the minimum return that T will require from the project and assess whether or not
the project is worthwhile.

Calculating Beta Co-efficient (β)

Beta factor can be computed using any of the following formula depending on the available
information.
β =Rs – Rf
Rm – Rf

β= n∑ xy - ∑x∑y
n∑x2 - (∑x) 2

β = Covariance between X and Y

Variance of X

β = Corr. Coefficient between X and Y

Standard Dev. Of X

Class Illustration 1
The risk free rate of return is 6%. The standard deviation of returns for the market as a whole
is 40%. The covariance of returns for the market with return for the shares of Sage plc is 19.2%.
The market rate of returns is 11%.
Calculate the beta factor of Sage plc. And what it’s cost of capital?

Capital Market Line and Security Market Line

CML stands for Capital Market Line, and SML stands for Security Market Line.
The CML is a line that is used to show the rates of return, which depends on risk-free rates of
return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line,
is a graphical representation of the market’s risk and return at a given time.
One of the differences between CML and SML, is how the risk factors are measured. While
standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors
of the SML.
The CML measures the risk through standard deviation, or through a total risk factor. On the
other hand, the SML measures the risk through beta, which helps to find the security’s risk
contribution for the portfolio.

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 While the Capital Market Line graphs define efficient portfolios, the Security Market Line
graphs define both efficient and non-efficient portfolios.
While calculating the returns, the expected return of the portfolio for CML is shown along the
Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis. The
standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of
security is shown along the X-axis for SML.
Where the market portfolio and risk free assets are determined by the CML, all security factors
are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected returns of
individual assets. The CML determines the risk or return for efficient portfolios, and the SML
demonstrates the risk or return for individual stocks.
Well, the Capital Market Line is considered to be superior when measuring the risk factors.

Summary:
1. The CML is a line that is used to show the rates of return, which depends on risk-free rates
of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic
Line, is a graphical representation of the market’s risk and return of a security at a given time.
2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk
factors of the SML.
3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line
graphs define both efficient and non-efficient portfolios.
4. The Capital Market Line is considered to be superior when measuring the risk factors.
5. Where the market portfolio and risk free assets are determined by the CML, all security
factors are determined by the SML.

The differences between the capital market line and the security market line:
Capital market line:
▪ CML shows the tradeoff between expected return and total risk.
▪ CML considers both systematic and unsystematic risk.
▪ CML is the graphical presentation of the equilibrium relationship between expected
return and total risk for efficiency diversified portfolios.
▪ The slope of the CML shows the market price of risk for efficient portfolios.
▪ The CML is a line that is used to show the rates of return, which depends on risk-free
rates of return and levels of risk for a specific portfolio.
▪ Slope of the CML = (Rm – Rf) / σm

Security market line:

▪ SML shows the tradeoff between the required rate of return and systematic risk.
▪ SML considers only systematic risk.
▪ SML is the graphical presentation of CAPM.
▪ The slope of the SML shows the differences between the required rate of return on
the market index and the risk-free rate.
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▪ SML is a graphical representation of the market’s risk and returns at a given time.
▪ The slope of the SML = (Rm – Rf).

CAPM and the Systematic Risk

The CAPM is mainly concerned with:
i. How systematic risk is measured, and
ii. How systematic risk affects required returns and share price.

CAPM theory includes the following propositions:

i. Investors in shares require a return in excess of the risk free to compensate them for
systematic risk.
ii. Investors should not require a premium for unsystematic risk because this can be
diversified away by holding a wide portfolio of investments.
iii. Because systematic risk varies between companies, investors will require a higher
return from shares in those companies where the systematic risk is bigger.

Alpha Values
A share’s alpha value is a measure of its abnormal return, which is the amount by which the
share’s returns are currently above or below the required return, given its systematic risk.
Alpha value can be seen as a measure of how wrong the CAPM is. It can be shown that in an
efficient market, the expected value of the alpha coefficient is zero. Therefore, the alpha
coefficient indicates how an investment has performed after accounting for the risk it
involved. It is a measure of selection risk (also known as residual risk) of a mutual fund in
relation to themarket.
Alpha values are:
i. Only temporary abnormal values.
ii. Can be positive or negative
iii. Overtime, will tend towards zero for any individual share, and for a well-diversified
portfolio taken as a whole, will be zero.
iv. May exist due to the inaccuracies and limitations of the CAPM.
α value = actual return – expected return
Alpha value can be positive or negative as stated above. It is positive when the actual return
is greater than the expected return and this means that the security is undervalued. It is
negative when the actual return is less than the expected return and this means that the
security is overvalued.
Note:
o If Alpha value is less than Zero, it means that the investment has earned too little for
its risk (or it is too risky for its return).
o If Alpha value equals Zero, it means that the investment has earned a return adequate
for its risk.

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 o If Alpha value is greater than Zero, it means that the investment has a return in excess
of the reward for the assumed risk.

Class Illustration 1
ABC plc’s shares have a beta value of 1.2 and alpha value of 12%. The market return is 10% and
the risk free rate of return is 6%.
Calculate the expected return and current return.

Class Illustration 2
The return on shares of company A is 11%, but its normal beta factor is 1.10. The risk-free rate
of return is 5% and the market rate of return is 8%. Compute the alpha value and explain the
implication of this.

Class illustration 3
A security has a beta of 1.2, the expected return of treasury bill is 10% and the expected return
on the Nigeria Stock Exchange is 22%. At the end of the period, the actual return of the security
is 25%. What is the alpha value of the security?

Question
Currently, the rate of return on the federal government bond redeemable at par in the year
2005 is 5%. The securities of four company, Apex Limited, Simplex Limited, Bindex Limited and
Harbix Company, have expected returns of 13%, 10%, 10.5% and 14% respectively. The average
return on the market portfolio is 10% subject to a 6% risk. Other relevant information relating
to the four companies securities are:
Standard Deviation Correlation Coefficient
Apex 8% 0.975
Simplex 7.5% 0.64
Bindex 9% 0.74
Harbix 16% 0.675
You are required to show which of the companies is overvalued.
If the risk free return were for rational economic reasons to be raised to 7% while the expected
average return on market portfolio is 11% (assuming all other parameters remain constant)
which of the securities will be overvalued?

Question
The following is available on several investment
Expected Returns Std Deviation Corr. Coefficient
Treasury Bills 10% 0 0
ABC stock 12% 10.8% 0.6
DEF stock 13.8 12.95% 0.75
PQR stock 15.5% 16.2% 1.0
JKT stock 17.3% 45.36% 0.5

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XYZ stock 18.9% 30.45% 0.8
Required:
Assuming expected return on the market is 15%, variance of the market is 2.6244% and the beta
of the market is 1. Which instruments are over/under priced?

Question
The following is availbale on several investments:
Expected Returns Std Deviation Covariance with market
Dele stock 16% 14% 2.94
Bolaji stock 17.98% 15.2% 3.3
Kola stock 16.68% 16.7% 1.09
Dayo stock 15.97% 18.4% 1.03
Uche stock 20.67% 18.9% 1.84
A treasury bill rate is currently 12% and the market rate of return is 19%, the variance of the
return on the market is 2.25.
Required:
Which investments are over/undervalued?

Question
The expected return on the market portfolio (estimated from past data) is 12% p.a. with a
standard deviation of 15% and the risk-free rate of 4%. The actual prices, last year dividends
and the covariances from three securities (A,B,C) with the market are given in the table
below.
Security Actual Price Last Year Dividend Covariance with market
N N
A 107 1.30 0.025650
B 618 18.00 0.018675
C 1,350 22.00 0.029025
Required:
i. Calculate the betas and required rates of returns of securities A, B and C (3 marks)
In the table below you have market consensus forecast of 12-month price targets, ex-div and
the expected dividend growth rate of the securities.
Security 12-month price target Dividend growth rate
N %
A 122.50 12
B 740.00 10
C 1,500.00 11
ii. Assuming the dividends are paid in 12 months exactly, compute the required stock price for
the 3 stocks and state your conclusion. (4 marks)
iii. Considering the results in (ii) above, explain briefly what will be your strategy. (1 mark)

Question
An investor tries to buy shares or bonds for his portfolio that provide a positive abnormal
return. He is considering two shares and two bonds for adding to his portfolio.
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The required return on shares is measured by the Capital Asset Pricing Model (CAPM). The
required return for bonds is measured using a model similar to the CAPM, except that the
‘beta’ for a bond is measured as the ratio of the duration of the bond in years to the duration
of the bond market as a whole.
The following information is available:
Shares Expected Standard deviation Correlation coefficient
of
actual return (%) of returns returns with the market
Equity market 11.0 12 1.00
Company X 9.5 14 0.92
Company Y 12.0 17 0.83
Bonds Duration Coupon (%) Redemption
(years) yield(%)
Bond market 6.0 ‐ 6.2
Bond P 5.0 7 6.4
Bond Q 8.5 6 6.5
The risk-free rate of return is 5%.
Required:
Identify which of these investments currently offers a positive abnormal return.

Aggressive and Defensive Shares

The expected returns on the market portfolio will change in relation to changed economic
expectations. This in turn, will cause a change in the expected return of shares which depends
on their beta factors. Thus, beta is a measure of the responsiveness of the expected share
returns to changes in the returns of the market. Shares with high betas are termed aggressive
(bearing high risk) and those with betas less than one are termed defensive.

Practical Implications of the CAPM for an Investor

i. He should decide what beta factor he would like to have from his portfolio. He might
prefer a portfolio beta factor of greater than 1, in other to expect above-average
returns when market returns exceed the risk-free rate, but he would then expect to
lose heavily if market returns fall. On the other hand, he might prefer a portfolio beta
factor of 1 or even less.
ii. He should seek to invest in shares with low beta factors in a bear market, when average
market returns are falling. He should also sell shares with high beta factors.
iii. He should seek to invest in shares with high beta factors in a bull market, when average
market returns are rising.
As far as stock market investment tactics are concerned, an investor should buy high beta
shares if the market is expected to rise because they can be expected to rise faster than the
market. If the market is expected to fall, low beta shares are more attractive.

Class Illustration 1

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Company P and company Q pay a cash return to shareholders of 34.048 kobo per share per
annum. The risk free rate of return is 8% and the current average market portfolio rate of
return is 12%. Company P’s β factor is 1.8 and that of company Q is 0.8.
Required:
What is the expected return from companies P and Q respectively, and what wouldbe the
predicted market value of each company’s share. Comment on your result.

Class Illustration 2
The risk free rate of return is 10%. The expected return on the market index has been revised
upwards from 16% to 17% as a result of favourable tax legislation just announced. How will this
affect the expected return of a share with a beta factor of (a) 1.4, (b) 0.7?

CAPM and Portfolio Management

Just as an individual security has a beta factor, so too does a portfolio of securities. If an
investment is made in a combination of several shares with different levels of systematic risk,
then the overall β will be the weighted average of the individual share β’s.
(i) A portfolio consisting of all the securities on the stock market (in the same proportion
as market as a whole), and so will have a beta factor of 1.
(ii) A portfolio consisting entirely of risk-free securities will have a beta factor of 0.

Class Illustration 1
Matiss decides to invest his money as follows:
(i) 20% in A plc which has a β of 1.2
(ii) 40% in B plc which has a β of 1.8
(iii) 30% in C plc which has the same risk as the market
(iv) 10% in government securities
The market return is 20% and the risk free rate is 8%.
(a) what will be the overall β of his investments?
(b) what overall return will he be receiving?

Class Illustration 2
You own a stock portfolio invested 20% in Stock Q, 20% in Stock R, 10% in Stock S, and 50% in
Stock T. The betas for these four stocks are 1.4, 0.6, 1.5 and 1.8 respectively.
What is the portfolio beta?

Class Illustration 3
You own a portfolio equally invested in a risk free asset and two stocks. If one of the stocks
has a beta of 1.4 and the total portfolio is equally as risky as the market.
What must be the beta for the other stock in your portfolio?

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Class Illustration 4
A portfolio contains five securities. The proportions of each security in the portfolio and the
beta factor of each security are as follows:
Security Proportion of the portfolio Beta factor of the security
1 10% 1.20
2 25% 0.90
3 15% 0.96
4 30% 1.15
5 20% 1.06
What is the portfolio beta?

Ungearing β’s
Until now, we have been ignoring gearing and assuming that the companies in our examples
have been all equity financed. In this case the risk of a share is determined solely by the risk of
the actual business. If, however, a company is geared, then a share in that company becomes
riskier due to the gearing effect.
If, therefore, we are given the β of a share in a geared company, then the gearing in that
company will have made the β higher than it would have been had there been no gearing. The
β of a share measures not simply the riskiness of the actual business but also includes the
gearing effect.
We therefore need to be careful when comparing the β’s of shares in different companies. A
higher β certainly means that the share is riskier, but it may be due to the fact that the
company is more highly geared, or due to the fact that the business is inherently riskier, or a
combination of the two!

Using the geared and ungeared beta formula to estimate a beta factor for a company
Another way of estimating a beta factor for a company’s equity is to use data about the
returns of other quoted companies which have similar operating characteristics that is, to use
the beta values of other companies’ equity to estimate a beta value for the company under
consideration.
The beta values estimated for the firm under consideration must be adjusted to allow for
differences in gearing from the firms whose equity beta values are known. The formula for
geared and ungeared beta values can be applied.
If a company plans to invest in a project which involves diversification into a new business, the
investment will involve a different level of systematic risk from that applying to the company's
existing business. A discount rate should be calculated which is specific to the project, and
which takes account of both the project's systematic risk and the company's gearing level.
The discount rate can be found using the CAPM. The mathematical relationship between the
'ungeared' (or asset) and 'geared' betas is as follows:

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Debt is often assumed to be risk-free and its beta (βd) is then taken as zero, in which case the
formula above reduces to the following form.

Class Illustration 1
The management of Crispy plc wish to estimate their company’s equity beta value. The
company which, is an all equity company, has only recently goes public and insufficient data
is available at the moment about its own equity performance to calculate the company’s
equity beta. Instead, it is thought possible to estimate Crispy’s equity beta for the beta values
of quoted companies operating in the same industry and with the same operating
characteristics as Crispy.
Details of three similar companies are as follows:
(i) Snapp plc has an observed equity beta of 1.15. Its capital structure at market value is
70% equity and 30% debt. Snapp plc is very similar to Crispy plc except for its gearing.
(ii) Crackle plc is an all-equity company. Its observed equity beta is 1.25. It has been
estimated that 40% of the current market value of Crackle is caused by investment in
projects which offer a high growth, but which are more risky than normal operations
and which therefore have a higher beta value. These investments have an estimated
beta of 1.8, and are reflected in the company’s overall beta value. Crackle’s normal
operations are identical to those of Crispy.
(iii) Popper plc has an observed equity beta of 1.35. Its capital structure at market values
is 60% equity and 40% debt. Popper has two divisions, X and Y. The operating
characteristics of X are identical to those of Crispy but those of Y are thought to be 50%
more risky than those of X. It is assumed that X accounts for 75% of the total value of
Popper, and Y 25%.
The tax rate is 33%.
a) Assuming that all debt is virtually risk-free, calculate three estimates of the equity beta
of Crispy, from the data available about Snapp, Crackle and Popper respectively.
b) Now assume that Crispy plc is an all-equity company, but instead is a geared company
with a debt equity ratio of 2:3 (based on market values). Estimate the equity beta of
Crispy from the data available about Snapp.

Advantages of CAPM
(i) The relationship between risk and return is market based
(ii) Correctly looks at systematic risk only
(iii) Good for appraising specific projects and works well in practice

The limitations of CAPM are as follows:

(i) It is difficult to estimate the β of a project accurately. Generally we use the β of a
company operating in the same type of business as the project, which restricts it to
large projects
(ii) The theory of CAPM was developed as just a single period model, whereas in practice
most investment projects will be expected to continue for more than one year.

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 (iii) It presumes a well-diversified investor. Others, including managers and employees
may well want to know about the unsystematic risk also.
(iv) Generally, CAPM overstates the required return for high beta shares and vice versa.

Class Illustration 1
The following information is available about the performance of an individual company’s
shares and stock market as a whole.
Individual company stock market
Price at start of period 105k 480k
Price at end of period 110k 490k
Dividend during the period 7.6k 89.2k
Required: Calculate returns on the company’s share (Rs) and the returns on the
marketportfolio of shares (Rm).

Exam Type Question

Bread and Butter Plc is fully financed by equity. It is in the process of embarking on any of the
two mutually exclusive projects with the following cash flows.
Project A: (Production of canned tomatoes)
Project B: (Production of plantain chips)
The associated cash flows with the projects are:
Project A Project B
Initial outlay N5 million N12 million
Cash flow per annum years 1 – 3 N2.4 million N4.9 million
Cash flow per annum years 4 – 5 N2.8 million N4.45 million
Residual value N500,000 -
Relevant data about the companies cost of capital for evaluating projects are given below:
Current market price per share N1.20
Current annual gross dividend per share 10 k
Expected average annual growth rate in dividend 7%
Beta – coefficient for company’s shares 0.5
Expected rate of return on risk free securities 8%
Expected rate of return on the market portfolio 12%
Required:
a) Using the dividend growth model as well as capital asset pricing model, determine the
viability of each project separately.
b) Which project will you prefer and why?

Class Illustration 2

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The average stock market return on equity 15%
The risk free rate of return (pre-tax) 8%
Company X dividend yield 4%
Company X share price (capital gain) 12%
standard deviation of total stock market return on equity 9%
standard deviation of total return on equity of Company X 10.8%
corr. Co-eff. between company X return and average stock market 0.75
What is the beta factor for Company X shares, and what does this information imply for
theactual return and actual market value of company X shares?

APPROPRIATE COST OF CAPITAL (Project Specific Cost of Capital)

What discount rate to apply?
The relevant discount rate depends on the business risk in the company being acquired and in
the way in which the acquisition is to be financed (the gearing). The effect of changes in either
or both of the business risk and the gearing risk has aresummarised as follows:

1. If the business risk of the company being acquired is the same as that of the acquiring
company, and there is little or no change in the existing gearing of the acquiring company
after the acquisition:
In this (unlikely) situation, then we discount at the current WACC of the acquiring company.

2. If the business risk of the company being acquired is different from that of the acquiring
company, but there is little or no change in the existing gearing of the acquiring company
after the acquisition:
o Calculate the asset beta for the company being acquired. This will probably mean
ungearing the equity beta of a company having a similar type of business, using the
gearing of the similar company (proxy or Benchmark Company).
o calculate an equity beta by gearing up the asset beta just calculated, using the gearing
of the acquiring company
o calculate a cost of equity using the equity beta just calculated
o calculate WACC (using this cost of equity and the gearing of the acquiring company)
and use this to discount the free cash flows

Class Illustration 1
A plc is company with a gearing ratio (debt to equity) of 0.4. Shares in A plc have a β of 1.48.
They are considering acquiring another company - B plc. Shares in B plc have a β of 1.8 and B
plc has a gearing ratio (debt to equity) of 0.2. A plc is raising more debt in order to partly
finance the acquisition of B plc, but their overall gearing ratio is not expected to change
substantially. A plc has a cost of debt of 7%. The market return is 15% and the risk free rate is
8%. Corporation tax is 25%
Calculate the discount rate that should be applied to the free cash flows of B plc in order to
arrive at a value of B plc.

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3. If the business risk of the company being acquired is different from that of the acquiring
company, and there is a substantial change in the existing gearing of the acquiring company
after the acquisition (i.e. a leveraged buyout where substantial debt is being issued to help
finance the acquisition)
Take an adjusted present value approach (APV).
o Calculate the ungeared equity beta for the company being acquired (which will be the
same as the asset beta for the company)
o Calculate a cost of equity using this beta
o Discount the free cash flows at this cost of equity
o Add the tax benefit on the debt raised to arrive at the APV

Class Illustration 2
XYZ plc, a food retailing company, has an equity beta of 0.5 and a gearing level, measured as
the market value of debt to equity, of 1:5. It is trying to decide whether or not to invest in a
construction project. It has identified a quoted company that undertakes similar operations
to the project in Class Illustration. The construction company has an equity beta of 1.2 and a
gearing level of 1:3. Corporation tax is 35 per cent. The equity beta of the quoted construction
company is appropriate for establishing a risk-adjusted discount rate for project appraisal, but
must first be modified to reflect XYZ plc’s gearing level.

Class Illustration 3
A company's debt: equity ratio, by market values, is 2:5. The corporate debt, which is assumed
to be risk-free, yields 11% before tax. The beta value of the company's equity is currently 1.1.
The average returns on stock market equity are 16%.
The company is now proposing to invest in a project which would involve diversification into
a new industry, and the following information is available about this industry.
(a) Average beta coefficient of equity capital = 1.59
(b) Average debt: equity ratio in the industry = 1:2 (by market value).
The rate of corporation tax is 30%. What would be a suitable cost of capital to apply to the
project?
What beta should be used?

Class Illustration 4
Hubbard, an all equity food manufacturing company is about to embark upon a major
diversification in the consumer electronics industry. Its current equity beta is 1.2, whilst the
average equity beta of electronics firms is 1.6. Gearing in the electronics industry averages
30% debt and 70% equity. Corporate debt is considered to be risk free. Rm = 25%, Rf = 10%,
Corporation tax rate = 30%.
Required:
What would be a suitable discount rate for the new investment if Hubbard were to finance
the new project in ea bch of the following ways?
i. Entirely by equity
ii. By 30% debt and 70% equity
iii. By 40% debt and 60% equity?

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Class Illustration 5
A company is considering whether to invest in a new capital project where the business risk
will be significantly different from its normal business operations. The company is financed
80% by equity capital and 20% by debt capital.
It has identified three companies in the same industry as the proposed capital investment and
has obtained the following information about them:
(1) Company 1 has an equity beta of 1.05 and is financed 30% by debt capital and 70% by equity.
(2) Company 2 has an equity beta of 1.24 and is financed 50% by debt capital and 50% by equity.
(3) Company 3 has an equity beta of 1.15 and is financed 40% by debt capital and 60% by equity.
The risk-free rate of return is 5% and the market rate of return is 8%. Tax on company profits is
at the rate of 30%. Assume that the debt capital in each company is risk-free.
Required:
Calculate a project-specific discount rate for the project, assuming that this is:
(a) the project-specific cost of equity for the project, or
(b) the weighted average of the project-specific equity cost and the company’s cost of debt
capital.

Home Study Question

Question 1
X plc is an oil company with a gearing ratio (debt to equity) of 0.4. Shares in X plc have a β of
1.48. They are considering investing in a new operation to build ships, and have found a
quoted shipbuilding company – Y plc. Y plc has a gearing ratio (debt to equity) of 0.2, and
shares in Y plc have a β of 1.8. The market return is 18% and the risk free rate is 8%. Corporation
tax is 25%
At what discount rate should X plc appraise the new project, if it is to be financed
i. Entirely from equity?
ii. By equity and debt in the ratio 50%/50%
iii. By debt and equity in the same ratio as that currently existing in X plc?

Exam Type Question

Question 1
Tisa Co is considering an opportunity to produce an innovative component.
This is an entirely new line of business for Tisa Co. (New business risk)
Tisa Co has 10 million 50k shares trading at 180k each. Its loans have a current value of N3.6
million and an average after-tax cost of debt of 4.50%.
Tisa Co’s capital structure is unlikely to change significantly following the investment. (No
change in Financial risk)
Elfu Co manufactures electronic parts for cars including the production of a component similar
to the one being considered by Tisa Co.
Elfu Co’s equity beta is 1.40, and it is estimated that the equivalent equity beta for its other
activities, excluding the component production, is 1.25.
Elfu Co has 400 million 25k shares in issue trading at 120k each.
The loans have a current value of N96 million.

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It can be assumed that 80% of ElfuCo’s debt finance and 75% of ElfuCo’s equity finance can be
attributed to other activities excluding the component production.
i. Tax 25%.
ii. Risk free rate 3.5%
iii. Market risk premium 5.8%.
Required
Calculate the cost of capital that Tisa Co should use to calculate the net present value of the
project.

Question 2
Backwoods is a major international company with its head office in Nigeria, wanting to raise
N150 million to establish a new production plant in the eastern region of Germany. Backwoods
evaluates its investments using NPV, but is not sure what cost of capital to use in the
discounting process for this project evaluation.
The company is also proposing to increase its equity finance in the near future for NIGERIA
expansion, resulting overall in little change in the company's market-weighted capital gearing.
The summarised financial data for the company before the expansion are shown below.
Income statement for the year ended 31 December 20X1
N’m
Revenue 1,984
Gross profit 432
Profit after tax 81
Dividends 37
Retained earnings 44
Statement of financial position as at 31 December 20X1
N’m
Non-current assets 846
Working capital 350
1,196
Medium term and long term loans (see note below) 210
986
Shareholders' funds
Issued ordinary shares of N0.50 each nominal value 225
Reserves 761
986
Note on borrowings
These include N75m 14% fixed rate bonds due to mature in five years time and redeemable at
par. The current market price of these bonds is N120.00 and they have an after-tax cost of
debt of 9%. Other medium and long-term loans are floating rate NIGERIA bank loans at LIBOR
plus 1%, with an after-tax cost of debt of 7%.
Company rate of tax may be assumed to be at the rate of 30%. The company's ordinary shares
are currently trading at 376 pence.

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The equity beta of Backwoods is estimated to be 1.18. The systematic risk of debt may be
assumed to be zero. The risk free rate is 7.75% and market return 14.5%.
The estimated equity beta of the main German competitor in the same industry as the new
proposed plant in the eastern region of Germany is 1.5, and the competitor's capital gearing
is 35% equity and 65% debt by book values, and 60% equity and 40% debt by market values.
Required
Estimate the cost of capital that the company should use as the discount rate for its proposed
investment in eastern Germany. State clearly any assumptions that you make.

Question 3
MERIT is a profitable, listed manufacturing company, which is considering a project to
diversify into the manufacture of computer equipment. This would involve spending N220
million on a new production plant.
It is expected that MERIT will continue to be financed by 60% debt and 40% equity. The debt
consists of 10% loan notes, redeemable at par after 10 years with a current market value of
N90. Any new debt is expected to have the same cost of capital.
MERIT pays tax at a rate of 30% and its ordinary shares are currently trading at 453 kobo. The
equity beta of MERIT is estimated to be 1.21. The systematic risk of debt may be assumed to
be zero. The risk free rate is 6.75% and market return 12.5%.
The estimated equity beta of the main competitor in the same industry as the new proposed
plant is 1.4, and the competitor's capital gearing is 35% equity and 65% debt by book values.
Required:
(a) Calculate the after-tax cost of debt of MERIT’s loan notes. (3 marks)
(b) Calculate a project-specific discount rate for the proposed investment. (9 marks)
(c) Discuss the problems that may be encountered in applying this discount rate to the
proposed investment. (8 marks)
(d) Explain briefly what is meant by pecking order theory. (5 marks)

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We can classify the sources of finance into three, thus:
iv. Short term sources-those repayable within one year
v. Medium term sources those repayable within one to three years or sometimes 1-5
years
vi. Long term sources available for 5 or more years.
Kindly consult chapters 11, 12and 13 of ICAN Study Text on Strategic Financial Management for
further reading on:
(iii) Range of long term sources of finance
(iv) Short and medium term sources of finance
Note: Venture capital is in chapter 13 of the Study Text.
Methods of raising equity finance
The main methods of issuing new shares for cash are as follows:

(vii) Offer for subscription

(viii) Offer for sale
(ix) Private placement
(x) Offer by tender
(xi) Stock Exchange quotation
(xii) Rights Offer

Offer for Subscription

These are issues of shares or debentures made directly by the company to the public. The
proceeds of issue go directly to the company to finance its non-current assets, other
expansion programmes and working capital as stated in the prospectus. The company

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normally goes through an issuing house which advices on such things as pricing and timing
of

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