The Catholic University in

Zimbabwe

Faculty of Commerce
Department of Business Management and
Information Technology
Financial Management for Accounting II
[BM206]
STUDY PACK
[1] Bachelor of Business Management & Information Technology Honours Degree

[2] Bachelor of Business Management Finance Honours Degree

[3] Bachelor of Accounting Honours Degree

Lecturer : F. Kufakunesu
ACMA[UK];CGMA[UK];BComm(Hons)Acc[GZU];BSc(Hons)Econ[UZ];MBA[UZ];MAcc[UZ]

Contacts : +263 786 935 295 / +263 772 676 275

Email : [email protected]; [email protected]

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ARRANGEMENT OF THE STUDY PACK’S CONTENTS
The Study Pack is organised as follows:
Course Outline
1.0 Advanced Financial Mathematics
2.0 Risk and Return
3.0 Sources and Cost of Capital
4.0 Valuation of Securities
5.0 Valuation of Companies
6.0 Market Efficiency
7.0 Dividend Policy
8.0 Capital Structure Theories
9.0 Advanced Working Capital Management
10.0 Advanced Investment Appraisal
11.0 Risk Management
12.0 Mergers, Acquisitions and Corporate Restructuring
Typical Examination Questions
List of Formulae Financial (Present Value) Tables References

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 DEPARTMENT OF BUSINESS MANAGEMENT & INFORMATION TECHNOLOGY

COURSE OUTLINE

Lecturer: Forward Kufakunesu

Contacts: 0786 935 295 / 0772 676 275
Email: [email protected] / [email protected]

1.0 Course Name: FINANCIAL MANAGEMENT FOR ACCOUNTING II 1.1

Course Code : BM 206
1.2 Course Level: YEAR 2: SEMESTER 2

2.0 Pre-requisite(s)
Corporate Finance 1A/Financial Management for Accounting I and all accounting first year
courses are a pre-requisite. This course is an integration of all the concepts learnt in the first year
and second year first semester and how they can be used to solve real world problems. Students
are required to read expected literature as well as passionately take part in lecture attendance,
class exercises, assignments and projects.

3.0 Course Overview

Corporate Finance 1B/Financial Management for Accounting II is a second year second semester
course designed to consolidate the key areas of the financial management knowledge acquired in
Corporate Finance 1A/Financial Management I and to introduce students to the advanced
concepts in the financial management of organizations today in order to make key financial
decisions.

4.0 Course Aims

The aim of the course is to equip students with the advanced skills in the financial management
of an entity by providing them with the following knowledge:
∙ Capital investment appraisal
∙ Capital structure theory
∙ Risk & working capital management
∙ Valuation of businesses and corporate restructuring
∙ Dividend policy and market efficiency

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5.0 Course Objectives

At the end of the course, students are expected to:

1. Understand advanced financial mathematics and demonstrate formula derivation.

2. Understand and evaluate the application of advanced capital investment appraisal
techniques.
3. Demonstrate the application of capital structure theory in the finance of an entity 4.
Understand the management of working capital, calculate and assess risk in working
 capital management.
5. Value securities and businesses and explain the purpose of valuation.
6. Formulate dividend policy and assess the efficiency of financial markets.

6.0 Learning and Teaching Activities (Course Delivery)

Course delivery will include lectures, tutorials, seminars, case studies and discussion. Lectures
are designed to bring about the competence and skills required of a professional accountant.

6.1 Attendance at Lectures and Tutorials

Attendance of tutorials, lectures, discussions and seminars is compulsory, as these are central to
the intended learning outcome of the course. Individual progress as a learner will be assessed
through participation of discussions and presentations.

7.0 Schedule of Teaching Activities

Week Lecture (Hrs) ∙ Recap of the Time Value of Money Concept
1 1(2) 2(2) ∙ Annual, non-annual and continuous
compounding and discounting
Topic and Content ∙ Present Value of Ordinary Annuity, Annuity
Due and Perpetuity
Advanced Financial Mathematics
(8) Self-directed learning
Study groups, Library

∙ Present Value of a single cashflow

2 3(2) 4(2) Due and Perpetuity ∙ Use of the Financial
Calculator and Spreadsheet-aided
computations
∙ Future Value of a single cashflow ∙ Derivation of Corporate Finance Formulae
∙ Future Value of Ordinary Annuity, Annuity

(6) Self-directed learning

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capital rationing
∙ Advanced investment appraisal techniques
3 5(2) 6(2) involving inflation, taxation, real and nominal
cash flows and discount rate ∙ Asset
Replacement Decisions
Study groups, Library ∙ Lease or buy decisions
∙ Risk and uncertainty : probability, expected
Advanced Investment Appraisal Techniques values, certainty equivalence
∙ Advanced Aspects of NPV and IRR
(reinvestment assumptions) ∙ The concept of
(6) Self-directed learning Study
groups, Library
4 7(2) 8(2) Valuation of shares ∙
Valuation of bonds

Valuation of securities ∙

(6) Self-directed learning Study

groups, Library
5 9(2) 10(2) valuation ∙ Dividend based
share valuation ∙ Cash flow
based share valuation ∙ Net
Valuation of businesses Operating Income (NOI)
∙ Asset-based valuations
∙ Earnings based share

(6) Self-directed learning Study

groups, Library
6
Corporate restructuring
11(2) 12(2 ∙ Spin-offs
∙ Hostile and friendly takeovers
∙ Pre-offer and post-offer defence
∙ Mergers mechanisms against takeovers
∙ Acquisitions

(6) Self-directed learning

Study groups, Library

7
Working Capital Management
13(2) 14(2) receivables and payables ∙
Cash operating cycle
∙ Recap of inventory and cash
management ∙ Management of

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(6) Self-directed learning Study
groups, Library
8
Risk Management
15(2) 16(2) hedge ∙ Money market
hedge
∙ Foreign exchange

(6) Self-directed learning

Study groups, Library
9
Capital Structure Theory
 17(2) 18 (2) ∙ Empirical tests of capital structure on
∙ Debt, equity, debt beta, equity beta and corporate performance ∙ WACC and
cost of capital ∙ Theories of capital MWACC
structure
(8) Self-directed learning
Study groups, Library
10
Dividend Policy and market efficiency
19(2) 20(2) ∙ Weak form, semi-strong form
∙ Dividend policy and financing and strong form ∙ Implications of
decision ∙ Dividend Theories Market Efficiency
∙ Dividend policies ∙ Practical considerations of EMH
∙ Empirical studies to test stock
Market Efficiency market efficiency
∙ Random Walk Hypothesis
∙ Efficient Market Hypothesis
learning Study
groups, Library
11 Capital Restructuring
(8) Self-directed
21(2) 22(2) (sell-off and spin-off)
∙ Mergers and acquisitions ∙ Management buyouts
∙ Post-merger or post-acquisition ∙ Reconstruction
integration process ∙ Exit strategies

(8) Self-directed learning

Study groups, Library
12
Financial Markets and Derivatives
23(2) 24(2) ∙ Swaps and options and
∙ Introduction to Derivatives swaptions ∙ Put and call
∙ Derivative markets (OTC and options
Exchanges) ∙ Futures and ∙ Black and Scholes Option
forward contracts Pricing Model
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(8) Self-directed learning
Study groups, Library
(16) Revision and preparation for semester examinations
13 (7) Revision and preparation for
(3) semester examinations Semester
(150 Hrs) examination

7.1 Summary of Student Workload and Total Study Time (TST)

7.1.1 Contact Time (CT)
 Activity Time Commitment (hours) Lectures 48

Presentations 4 Tutorials 2

Google Classroom 2
7.1.2 Independent Study Time (IST)

Activity Time Commitment (hours) Reading Course

related material 14

Writing Assignments 12
Library 26 Study Groups 22 Revision & prep of
exams 13

7.1.3 Assessment Time (AT)

Activity Time Commitment (hours) Assignments 4

Examination 3
Sub-Total 7
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Total study time= CT+IST+AT
=56+87+7=150
Number of credits= TST/10
=150/10=15
NB: Activities under CT, IST and AT are only indicative and do not necessarily apply to all
modules/courses in a University.
8.0 Scheme of Assessment
Course Work and Final examination will be used to assess students
8.1 Weighting
The course will be assessed by course work (30 percent) and a three-hour closed book
examination (70percent).The coursework will comprise two written assignments, one test and
one presentation and/or two projects.

8.2 Formative Assessment

The test, assignments and projects will be marked interactively and the students are expected to
learn and further deepen their understanding of the subject matter from the marked tests,
assignments and projects.

8.3 Student Feedback

The faculty will administer feedback instruments during the first half of the semester. The course
outline will be the standard against which delivery will be assessed. Your honest and precise
feedback will help improve service delivery. A second instrument will be administered at the end
of the semester and your feedback will help further improve service delivery

8.4 Summative Assessment

A three-hour closed book examination will be administered at the end of the semester. You are
advised to refer to the course objectives and learning outcomes during your preparation for the
examination.
9.0 Recommended Literature
9.1 Textbooks
1. Megginson W, Smart B and Lucy B (2008): Introduction to Corporate Finance, South
Western Cengage Learning
2. Van Horne J.C. (2006), Financial Management & Policy (International Edition), Prentice
Hall
3. Weston F and Brigham E.F. (2002): Essentials of Managerial Finance, Harcourt Brace
Publishers

9.2 E-Resources
∙ www.ebscosearch.com
https://books.google.co.zw

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COURSE CONTENT

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1.0
ADVANCED.FINANCIAL
MATHEMATICS
In order to consolidate knowledge on all the potential scenarios in which advanced financial
mathematics can be moulded, the following five different scenarios will be covered under this
topic:
SCENARIO 1 – PV followed by FV, with no instalments (PMTs) in-between
SCENARIO 2 – PV followed by a series of PMTs, with no FV at the end
SCENARIO 3 - PV followed by an infinite series of PMTs into perpetuity
SCENARIO 4 - A series of PMTs followed by FV at the end
SCENARIO 5 – PV followed by PMTs and an FV at the end

1.1 SCENARIO 1
PV followed by FV, with no instalments (PMTs) in-between

Lecture Objectives
∙ To understand the Time Value of Money Concept
∙ To understand appreciate how Financial Tables are generated
∙ To understand annuities and to differentiate between them
∙ To compute and interpret the following Time Value of Money Concepts: ∙
Time Line
∙ Compounding
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding

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Time Value of Money
Cash has a time value. A $1 received today is worth more than a $1 received in the future. The
difference emanates from the potential interest forgone between today (Period 0) and the future
period concerned (Period n). The following is an illustration of a simple time line:

Cash Flow PV FV

Period 0 n
Scenario 1 is described by the following relationship between PV and FV as mapped by r and
n: FV = PV(1+r)n ……………… Equation 1

Where:
FV = Future Value
PV = Present Value
r = interest rate per period
n = number of periods

Please note that the word period not only represents a year, but it can represent a year, a half year,
a quarter, a month, a week, a day, an hour, a minute or a second. The following constitutes a
derivation of Equation 1 for a given set of PV, FV, r and n.

End of Period 1;
FV = PV + rPV = PV(1 + r)
End of Period 2;
FV = PV(1+r)(1+r) = PV(1+r)2
End of Period 3;
FV = PV(1+r)2(1+r) = PV(1+r)3
End of Period n;
FV = PV(1+r)n

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Compounding and Discounting
It is important to realize that Equation 1 defines both compounding and discounting as reverse
processes to each other.

Compounding involves finding FV given PV, r and n: FV = PV(�� + ��)

Discounting involves finding PV given FV, r and n: PV = (�� ��)

Whilst Compounding makes FV the subject of formula, Discounting makes PV the subject of the
formula.

Worked Example
An investor invests $2000 in a fund that pays 24% per annum. Calculate the value of the fund at
the end of 1 year in each of the following compounding frequencies:
 ∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding

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Class Exercise With Answers
An investor invests $2000 in a fund that pays 15% per annum. Calculate the value of the fund at
the end of 3 years in each of the following compounding frequencies:
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding

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∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding
FURTHER ASPECTS OF FINANCIAL MATHEMATICS
∙ Continuous Compounding
∙ Discounting as the opposite of Compounding
∙ Use of Microsoft Excel to compute PV, FV, r and n at the click of a button

Derivation of Continuous Compounding Formula

FV = PV(1+r)n

FV = PV(1+r)1/r * r * n

FV = PV(1+0.0001%)1/0.0001% * r * n

FV = PV(1.000001)1/0.000001 * r * n

FV = PV(2.718281828) r n

FV = PVe r n or FV = PVe r t
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Another Class Exercise With Answers
An investor invests $2000 in a fund that pays 24% per annum. Calculate the value of the fund at
the end of 1 year in each of the following compounding frequencies:
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding
∙ Continuous compounding

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Another Class Exercise With Answers
An investor invests $2000 in a fund that pays 15% per annum. Calculate the value of the fund at
the end of 3 years in each of the following compounding frequencies:
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding
∙ Continuous compounding

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Example of Discounting as the opposite of Compounding

Recall that Compounding‟s formula: FV = PV(�� + ��)

Also recall that Discounting‟s formula: PV = (�� ��)

Example
A man wishes his investment to grow to $10,000 at the end of the next 2 years in a fund that pays
21% interest per annum. How much should he invest today in each of the following
compounding frequencies?
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Continuous compounding

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THE USE OF MICROSOFT SPREADSHEET FOR SCENARIO 1
FUTURE VALUE (FV)
Monthly compounding
PV= -2000; rate = 1.25% per month; nper = 36 months; pmt = 0
• =fv(rate,nper, pmt,[pv],[type])
• =fv(1.25%,36,0,-2000,0)
• Click Enter
• You get $3,127.89

PRESENT VALUE (PV)

Monthly compounding
FV=3127.89; rate = 1.25% per month; nper = 36 months; pmt = 0
• =pv(rate,nper, pmt,[fv],[type])
• =pv(1.25%,36,0,3127.87,0)
• Click Enter
• You get -$2,000.00

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NUMBER OF PERIODS (NPER)
Monthly compounding
PV = -2000; FV=3127.89; rate = 1.25% per month; pmt = 0
• =nper(rate, pmt,pv,[fv],[type])
• =nper(1.25%,0,-2000,3127.89,0)
• Click Enter
• You get 36

INTEREST RATE PER PERIOD (RATE)

Monthly compounding
PV = -2000; FV=3127.89; pmt = 0
• =rate(nper, pmt,pv,[fv],[type])
• =rate(36,0,-2000,3127.89,0)
• Click Enter
• You get 1.25%

Worked Example
An investor invests $1000 in a fund that pays 24% per annum. Calculate the value of the fund at
the end of 1 year in each of the following compounding frequencies using both Manual and
Excel Formulae:
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding

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Class Exercise with Answers
An investor invests $2000 in a fund that pays 15% per annum. Calculate the value of the fund at
the end of 3 years in each of the following compounding frequencies using both Manual and MS
Excel Formulae:
∙ Annual compounding
∙ Semi-annual compounding
∙ Quarterly compounding
∙ Monthly compounding
∙ Weekly compounding
∙ Daily compounding
∙ Hourly compounding
∙ Minutely compounding
∙ Secondly compounding

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PRESENT VALUE TABLES OR FINANCIAL TABLES
They are made up of:

PV of $1 Cashflow at the end of Period n

∙ This is made up of one FV of $1 in period n
∙ It shows the PV of $1 for each combination of n and r from n =1 and from r = 1%

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PV

PV of ordinary annuity of $1
They are made up of:
∙ PV of a uniform cashflow (Annuity) of $1 occuring at the end of each period from period 1
up to period n
∙ It shows the PV of $1 for each combination of n and r from n =1 and from r = 1%

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1.2 SCENARIO 2 – PV followed by a series of PMTs
∙ Ordinary Annuity
∙ Annuity Due
∙ Solving investments/savings/borrowings word problems as a Financial Advisor ∙ Use
of Microsoft Excel to compute PV, FV, PMT, r and n at the click of a button ∙ It is a
series of uniform cashflows occuring either at the end of each period or at the
beginning of each period
∙ If the cashflows occur at the end of each period, it is called an Ordinary Annuity ∙
If the cashflows occur at the beginning of each period, it is called an Annuity Due

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PRESENT VALUE OF ORDINARY ANNUITIES [PVOA] FORMULA DERIVATION

Study the timeline below:

PMT PMT PMT PMT PMT ……………………………………………….. PMT

0 1 2 3 4 5 ……………………………………………….. n
The above timeline depicts a series of uniform cashflows (an annuity), PMT, receivable or
payable at the end of each period (ordinary annuity), from end of period 1 to end of period
n. The interest rate per period is r.

The Present Value of the ordinary annuity (PVOA) is the sum of all the PMT equal instalments
discounted to Period 0 terms. See diagram below:

PMT/
(1+r)n

PMT/
(1+r)6

PMT/
(1+r)5

PMT/
(1+r)4

PMT/
(1+r)3

PMT/
(1+r)2

PMT/
(1+r)

PMT PMT PMT PMT PMT PMT . . . . . . . . PMT

0123456........n

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PVOA = ( )+ ( ) + ( ) + ( ) + ( ) +………+ ( ) …………..[1] Multiply both sides

by ( )

( )= ( ) + ( ) + ( ) + ( ) +………+ ( ) + ( )( ) ………..[2]

Subtract Equation [2] from Equation [1]

PVOA - ( )= ( )-

( )( )

()
( )) =

PVOA(1 -

( )( )

()
PVOA( ( )) = ( )( )

()
PVOA( ( )) = ( )( )
()
( ))(

PVOA( PVOA = ( )
()
( )( ) *
)= ()

()
( )( ) *

PVOA = ()
*
()

PVOA = ()
*
()

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)
PVOA = PMT* (
 *
()

PVOA = PMT*[1 -
*
()

PVOA = *[1 -
()

PVOA = *[1 - ( + )

NB

Present Value of Ordinary Annuity Factor (PVAIF) is found using the same formula but with a
PMT of $1 = PVOA OF $1

= *[1 -
()

= *[1 - ( + )

= ()

LOAN AMORTISATION SCHEDULE

∙ It is a schedule that shows all the repayments of the interest and principal portions on a
loan
∙ It adheres to the frequency of compounding specified on the loan contract itself ∙ The
(PMT) is uniform in each period and is made up of both the interest component and the
principal component
∙ Interest component is initially low and as the loan is progressively amortised, it decreases
while the principal component increases by the same amount, thereby keeping the
instalment constant
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EITHER
Use the PVOA formula to make PMT the subject of formula

OR
Use Financial Tables
Instalment =

=
= $357.0516

Class Exercise
Find IPMT and PPMT for each of the 6 months in the above Loan Amortisation Example, add
them and comment on your results.

1.3 SCENARIO 3 – PV followed by a series of PMTs forever ∙ It is a series of

uniform or non-uniform cashflows occuring either at the end of each period or at the
beginning of each period forever or to infinity or in perpetuity. ∙ If the cashflows are
uniform and occur at the end of each period, it is called an Ordinary Pepertuity
∙ If the cashflows are uniform and occur at the beginning of each period, it is called an
 Pepertuity Due

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∙ If the cashflows are non-uniform but grow at a constant growth rate, g, and occur at the end of
each period, it is called a Growing Ordinary Pepertuity
∙ If the cashflows are non-uniform but grow at a constant growth rate, g, and occur at the
beginning of each period, it is called a Growing Pepertuity Due

• PVOP = ��

• PVPD = (�� ��)

��

• PVGOP = (�� )
��

• PVGPD = (�� ��)(�� )

��

1.4 SCENARIO 4 – A series of PMTs followed by FV

This scenario is concerned with determining the future value of an ardinary annuity and the
future value of an annuity due as follows:

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1.5 SCENARIO 5 – PV followed by PMTs and eventually FV This scenario
combines any of the four scenarios considered above. To that extent, it does not introduce any
new formula. Thus, Scenario 5 is a matter of applying the knowledge of the first four scenario in
a combined/complex manner at once. The following class exercise illustrates this point. All
students must attempt this question using all the four methods specified below, and make sure
that their answers are all $28,967.22. The hint is to treat the $5000 deposit separately, $800
annuity separately and adding the two future values together for the first two methods. However,
the last two methods combine the entire process at once because of their computational
superiority.

Class Exercise
A woman invests an initial deposit of $5 000 at the beginning of January 2018. She then makes
24 monthly deposits of $800 at the end of every month starting at the end of January 2018. The
investment fund pays interest at the rate of 15% per annum compounded monthly. Calculate the
total amount that would accumulate in the fund soon after the last deposit.

31 | P a g e
Method 1 – Using first principles $28,967.22

Method 2 – Manual Formula $28,967.22

Method 3 – Financial Calculator $28,967.22

Method 3 – MS Excel FV Function $28,967.22

1.5 RULE OF 72
The Rule of 72 states that 72 is divided by 100*r where r is the compound interest rate per period
if we wish to determine the approximate number of periods required to double an investment in a
situation in which there are no instalments in-between as depicted in Scenario 1 above.

Derivation of the Formula approximated by Rule of 72

FV = PV(1+r)n
For PV to double, it implies that FV = 2PV
2PV = PV(1+r)n
(1+r)n= 2
Applying Log to both sides:
Log[(1+r)n] = Log2
nLog(1+r) = Log2

n=
()

Example
At an interest rate of 10%; 15%; 20% and 25% per annum, how many years will it take for an
investment to double?
Solution
r Using the formula n =
(�� ��)Using the Rule of 72 10% n = Log2/Log1.1 =

7.27 years n = 72/10 = 7.2 years 15% n = Log2/Log1.15 = 4.96 years n = 72/15 =
4.8 years 20% n = Log2/Log1.2 = 3.8 years n = 72/20 = 3.6 years 25% n =
Log2/Log1.25 = 3.11 years n = 72/25 = 2.88 years

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1.6 GEOMETRIC MEAN
There are certain situations in which the traditional arithmetic mean is unsuitable ie situations in
which we need to determine the average of a set of percentage observations that embody a
compounding effect. Examples include:
∙ Percentage salary increases overtime
∙ GDP or economic growth rate overtime
∙ Inflation or price increases overtime
∙ Tariff increases overtime

Example
The following salary increases have been observed at the beginning of each year over the past 5
years at a certain organization.
Year % increase
2011 7%
2012 9%
2013 15%
2014 -4%
2015 3%

Required
(a) Calculate the arithmetic mean
(b) Calculate the geometric mean
(c) Explain why the latter is preferable to the former.
Solution
(a) Arithmetic mean = [∑Xi]/n = [7%+9%+15%-4%+3%]/5 = 30%/5 = 6%

]-1
(b) Geometric Mean = √( + )( + )( + ) ( + )

]-1
= √( + )( + )( + )( )( + )

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]-1
= √( )( )( )( )( )
= [√ ] – 1
 Mean %
Grows to
= 1.0580917173 – 1

= 0.05809

= 5.809% per year

To demonstrate that your answer is correct,

to perform the following exercise: Assume a
base figure of 100 in 2010

Year % observed Grows to Geometric

2010 - 100.00000000 - 100.00000000 2011 7% 107.00000000 5.80917173%

105.80917173 2012 9% 116.63000000 5.80917173% 111.95580822 2013 15%
134.12450000 5.80917173% 118.45951338 2014 -4% 128.75952000 5.80917173%
125.34102994 2015 3% 132.6223056 5.80917173% 132.6223056
34 | P a g e

2.0 RISK AND RETURN

∙ Return is the reward for the commitment of resources in an investment
∙ Measures of RETURN to be considered in the next lecture : Required Rate of Return;
Holding Period Return.
∙ Risk is the potential departure of actual outcomes from the expected outcome. ∙ Measures of
RISK to be considered : Variance; Standard Deviation; Covariance; Beta
Worked Example
The following historical returns have been observed for two assets, X and Y.
Year Asset X Asset Y
1 18% 30%
2 10% 25%
3 16% 21%
4 25% 10%
5 15% 15%

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Calculate
[a] the expected return of each asset
[b] the variance of each asset
[c] the standard deviation of each asset
[d] the covariance between the two assets.

How to Use the Financial Calculator

∙ Select the Stock Calculator
∙ Then select the Expected Return Calculator
∙ Repeat Class Exercise 1 and compare the answers
∙ Please take note on the Financial Calculator, type an equally spread probability since it is
historical data
∙ Take note that some returns can be negative or 0%, they are not always positive.

Class Exercise Without Answers

The following returns and their probabilities are expected to arise in the forthcoming year:
State of the Economy Probability Asset X Asset Y
Very good 12% 37% 42%
Good 10% 29% 31%
Fair 48% 22% 18%
Comatose 30% -12% -6%
Calculate
[a] the expected return of each asset
[b] the variance of each asset
[c] the standard deviation of each asset
[d] the covariance between the two assets.
36 | P a g e

Class Exercise

Go back to Class Exercise 1 and assume that the two assets constitute a portfolio with the
following weights:
Asset Weight in the portfolio
X 60%
Y 40%
Calculate
[a] the expected return of the portfolio
[b] the variance of the portfolio
[c] the standard deviation of the portfolio

Class Exercise
Go back to Class Exercise 2 and assume that the two assets constitute a portfolio with the
following weights:
Asset Weight in the portfolio
X 28%
Y 72%

37 | P a g e
Calculate
[a] the expected return of the portfolio
[b] the variance of the portfolio
[c] the standard deviation of the portfolio

How to Use Microsoft Excel

+average(
+var.p(
+stdev.p(
+covariance.p(

Geared and Ungeared Beta

Lecture Objectives
∙ Risk vs Return and CAPM
∙ Differentiate between Beta [β] and Standard Deviation [σ]
∙ Risk-Adjusted Rates of Return
∙ Understand the meaning and application of Beta, both Geared and Ungeared ∙
Calculation of both Geared and Ungeared Beta
∙ Calculation of both Geared and Ungeared Beta
∙ Ability to Ungear Beta and Regear Beta
∙ Business Risk vs Financial Risk

The Relationship Between Risk and Return

“High-risk high-return” is an old adage that represents the CAPM formula E(R) = Rf + [Rm –
Rf]β. The CAPM Equation is a linear relationship between required return and risk and is called
the Security Market Line (SML)
∙ If beta = 1.0, the security is just as risky as the overall stock market.
∙ If beta > 1.0, the security is riskier than the average stock market.
∙ If beta < 1.0, the security is less risky than the average stock market.
Most stocks have betas in the range of 0.5 to 1.5. Betas are often calculated by regressions on
historical data Ri = αi + βi*Rm.

38 | P a g e

Limitations of CAPM
∙ Investors seem to be concerned with both market risk and total risk.
∙ CAPM assumes that unsystematic risk is diversified away, yet this may not apply to
entities controlled by individuals or FOBs
∙ Therefore, the SML may not produce a correct estimate of Ri.
Ri= Rf + [Rm – Rf]βi+ ???

∙ CAPM/SML concepts are based upon expectations, but betas are calculated using
historical data. Thus, a company‟s historical data may not reflect investors‟ expectations
about future riskiness.
∙ CAPM is a single-period model such that the discount rate it computes may not be
appropriate to evaluate long-term projects, unless β remains relatively stable over time
39 | P a g e

Risk-Adjusted Measures of Return

[1] Sharpe‟s Ratio =

[2] Treynor‟s Ratio =

Geared and Ungeared Beta – Their Relationship

∙β
= [ ()
]β
() +[
]β
()

∙ Take note that β ≡ β and that β ≡ β

 ∙β
= [ ()
]β
() +[
]β
() ……Ungear β

∙β + E = [D(1 - t)]β + [E]β

[D( t)

∙ β = β + [β - β
][1 - t][ ] ……Regear β

∙β
= [ ()
]β
() +[
]β
() …Ungear β

∙ �� = R + β [R R
]
∙ β = β + [β - β
][1 - t][ ] …Regear β

40 | P a g e
∙ �� = R + β [R R
]

The above constitutes the relationship between equity beta of a geared entity and the equity
beta of an ungeared entity within the same systematic risk class.

Worked Example
A Ltd is identical in all operating and risk characteristics to G Ltd, except that A Ltd is all-equity
financed and G is financed by equity and debt in the ratio 75:25 at market valuation. The beta
factor of A Ltd is 0.9. G Ltd‟s debt capital is virtually risk-free, and corporation tax is levied at
the rate of 33%. The expected return on the market is 12% and the risk-free rate is 6%.
Calculate the equity beta of G Ltd and the cost of equity for the entity. ∙ Identify an
all-equity proxy company with a beta factor (observable for listed entities only). It is an
ungeared beta factor

∙ Gear the proxy entity‟s ungeared beta using the capital structure of the geared entity to
get the geared beta of the geared entity

∙ Substitute the geared beta into the CAPM formula to get the cost of equity for the geared
entity.

∙β
= [ ()
]β
() +[
 ]β
() = 0.9

∙ β = β + [β - β
][1 - t][ ] …Regear β

= 0.9 + [0.9 – 0][1-0.33][ ]

= 1.101

∙ �� = R + β [R R
]

= 6% + 1.101[12% - 6%]

= 12.606%

Alternatively;
β
= [ ()
]β
() +[
]β
()

0.9 = [ (�� )
(�� ) ]0 +[
]�� ; therefore ��
(�� ) = 1.101

41 | P a g e
DETAILED EXAMPLE – RISK AND RETURN

1. The following historical returns have been observed for the past 10 years for the overall
stock market index (ZSE Returns), Delta Holdings (Delta Share Returns), Dairibord
Zimbabwe Limited (DZL Share Returns) and the risk-free asset (Treasury Bill).
Year ZSE Returns Delta DZL Share Returns
Share Returns Treasury Bill Returns
1 27% 22% 18% 10% 2 31% 17% 13% 10% 3 24% 19% 12% 10% 4 18%
23% 15% 10% 5 17% 14% 16% 10% 6 19% 9% 10% 10% 7 22% 13% 11%
10% 8 30% 16% 14% 10% 9 25% 24% -6% 10% 10 15% 12% -5% 10%

(a) Calculate the following:

Delta DZL Treasury
Share Share Bill
Year ZSE Returns Returns Returns
Returns
 1 27% 22% 18% 10% 2 31% 17% 13% 10% 3
24% 19% 12% 10% 4 18% 23% 15% 10% 5
17% 14% 16% 10% 6 19% 9% 10% 10% 7
22% 13% 11% 10% 8 30% 16% 14% 10% 9
25% 24% -6% 10% 10 15% 12% -5% 10%

∑Xi 228% 169% 98% 100%

ER =
∑
22.8% 16.9% 9.8% 10.0%

42 | P a g e
(i) The Expected Return on the overall stock market E(RZSE)
= ∑ = = 22.8%

(ii) The Expected Return on the Delta Share E(RDELTA)

= ∑ = = 16.9%

(iii) The Expected Return on the Dairibord Share E(RDZL)

= ∑ = = 9.8%

(iv) The Expected Return on the Treasury Bill E(RTBILL)

= ∑ = = 10.0%

(v) The Variance of returns on the overall stock market = 0.2756% = 0.002756

Year ZSE
Returns
1 27% 22.8% 0.1764000%
2 31% 22.8% 0.6724000%
3 24% 22.8% 0.0144000%
4 18% 22.8% 0.2304000%
5 17% 22.8% 0.3364000%
6 19% 22.8% 0.1444000%
7 22% 22.8% 0.0064000%
8 30% 22.8% 0.5184000%
9 25% 22.8% 0.0484000%
10 15% 22.8% 0.6084000%
 228% 2.756000%

ER 22.8% VAR 0.2756000%

SD 0.052497619

43 | P a g e
(vi) The Variance of returns on the Delta Share = 0.2289% = 0.002289

Year Delta Share

Returns

1 22% 16.9% 0.2601000%

2 17% 16.9% 0.0001000%
3 19% 16.9% 0.0441000%
4 23% 16.9% 0.3721000%
5 14% 16.9% 0.0841000%
6 9% 16.9% 0.6241000%
7 13% 16.9% 0.1521000%
8 16% 16.9% 0.0081000%
9 24% 16.9% 0.5041000%
10 12% 16.9% 0.2401000%

169% 2.289000%

ER 16.9% VAR 0.2289000%

SD 0.047843495

(vii) The variance of returns on the Dairibord Share = 0.6356%

DZL

Year Returns
Share 1 18% 9.8%
 0.6724000% 2 13% 0.0144000% 8 14%
9.8% 0.1024000% 3 9.8% 0.1764000% 9
12% 9.8% 0.0484000% -6% 9.8% 2.4964000%
4 15% 9.8% 10 -5% 9.8%
0.2704000% 5 16% 2.1904000%
9.8% 0.3844000% 6
10% 9.8% 0.0004000% 98% 6.356000%
7 11% 9.8%

44 | P a g e
ER 9.8% VAR 0.6356000% SD 0.079724526

(viii) The variance of returns on the Treasury Bill = 0%

Treasury
Year 0.0000000% 6 10%
Bill 10.0% 0.0000000% 7
Returns 10% 10.0%
1 10% 10.0% 0.0000000% 8 10%
0.0000000% 2 10% 10.0% 0.0000000% 9
10.0% 0.0000000% 3 10% 10.0%
10% 10.0% 0.0000000% 10 10%
0.0000000% 4 10% 10.0% 0.0000000%
10.0% 0.0000000% 5
10% 10.0% 100% 0.000000%

ER 10.0% VAR 0.0000000%

SD 0.00000000

(ix) The standard deviation of returns on the overall stock market

SD = √ = √ = 0.0524976

(x) The standard deviation of returns on the Delta Share SD

= √ = √ = 0.047843495

(xi) The standard deviation of returns on the Dairibord Share

SD = √ = √ = 0.079724526

(xii) The standard deviation of returns on the Treasury Bill

SD = √ = √ = 0
45 | P a g e
(xiii) The co-variance of returns between the market and Delta = 0.0928%`=0.000928
Delta Share Returns
Year ZSE Returns
1 27% 22.8% 22% 16.9% 4.2% 5.100% 0.2142000% 2 31% 22.8% 17% 16.9% 8.2% 0.100%
0.0082000% 3 24% 22.8% 19% 16.9% 1.2% 2.100% 0.0252000% 4 18% 22.8% 23% 16.9%

-4.8% 6.100% -0.2928000% 5 17% 22.8% 14% 16.9% -5.8% -

2.900% 0.1682000%
6 19% 22.8% 9% 16.9% -3.8% -
7.900% 0.3002000%

7 22% 22.8% 13% 16.9% -0.8% -

3.900% 0.0312000%
8 30% 22.8% 16% 16.9% 7.2% -
0.900% -0.0648000%
9 25% 22.8% 24% 16.9% 2.2% 7.100% 0.1562000% 10 15% 22.8% 12% 16.9% -7.8% -

4.900% 0.3822000%

228% 169% 0.928000% 22.8% 16.9% 0.0928000% (xiv) The co-variance between the market

and Dairibord = 0.1116% = 0.001116

DZL Share Returns

Year ZSE Returns

1 27% 22.8% 18% 9.8% 4.2% 8.200% 0.3444000% 2 31% 22.8% 13% 9.8% 8.2% 3.200%
0.2624000% 3 24% 22.8% 12% 9.8% 1.2% 2.200% 0.0264000% 4 18% 22.8% 15% 9.8% -4.8%
5.200% -0.2496000% 5 17% 22.8% 16% 9.8% -5.8% 6.200% -0.3596000% 6 19% 22.8% 10%
9.8% -3.8% 0.200% -0.0076000% 7 22% 22.8% 11% 9.8% -0.8% 1.200% -0.0096000% 8 30%

22.8% 14% 9.8% 7.2% 4.200% 0.3024000% 9 25% 22.8% -6% 9.8% 2.2% -

15.800% -0.3476000%
10 15% 22.8% -5% 9.8% -7.8% - 14.800% 1.1544000%

46 | P a g e
228% 98% 1.116000% 22.8% 9.8% 0.1116000% (xv) The co-variance between the market
 and the Treasury Bill = 0%

Returns
Year ZSE Returns
Treasury Bill
1 27% 22.8% 10% 10.0% 4.2% 0.0% 0.0000000% 2 31% 22.8% 10% 10.0% 8.2% 0.0%
0.0000000% 3 24% 22.8% 10% 10.0% 1.2% 0.0% 0.0000000% 4 18% 22.8% 10% 10.0% -4.8%
0.0% 0.0000000% 5 17% 22.8% 10% 10.0% -5.8% 0.0% 0.0000000% 6 19% 22.8% 10% 10.0%
-3.8% 0.0% 0.0000000% 7 22% 22.8% 10% 10.0% -0.8% 0.0% 0.0000000% 8 30% 22.8% 10%
10.0% 7.2% 0.0% 0.0000000% 9 25% 22.8% 10% 10.0% 2.2% 0.0% 0.0000000% 10 15% 22.8%
10% 10.0% -7.8% 0.0% 0.0000000%

228% 100% 0.000000% 22.8% 10.0% 0.0000000%

(xvi) The co-variance between Delta and Dairibord = 0.0108% = 0.000108

Returns
Year Delta Share DZL Share Returns

1 22% 16.9% 18% 9.8% 5.1% 8.200% 0.4182000% 2 17% 16.9% 13% 9.8% 0.1% 3.200%
0.0032000% 3 19% 16.9% 12% 9.8% 2.1% 2.200% 0.0462000% 4 23% 16.9% 15% 9.8% 6.1%
5.200% 0.3172000% 5 14% 16.9% 16% 9.8% -2.9% 6.200% -0.1798000% 6 9% 16.9% 10% 9.8%
-7.9% 0.200% -0.0158000% 7 13% 16.9% 11% 9.8% -3.9% 1.200% -0.0468000% 8 16% 16.9%

14% 9.8% -0.9% 4.200% -0.0378000% 9 24% 16.9% -6% 9.8% 7.1% -

15.800% -1.1218000%
10 12% 16.9% -5% 9.8% -4.9% - 14.800% 0.7252000%

47 | P a g e
169% 98% 0.108000% 16.9% 9.8% 0.0108000%

Students to calculate the following from (xvii) to (xxxii) individually:

(xvii) The co-variance between Delta and the Treasury Bill

(xviii) The co-variance between Dairibord and the Treasury Bill
(xix) The Beta of returns on the overall stock market
(xx) The Beta of returns on the Delta Share
(xxi) The Beta of returns on the Dairibord Share
(xxii) The Beta of returns on the Treasury Bill
(xxiii) The Alpha of returns on the overall stock market
(xxiv) The Alpha of returns on the Delta Share
(xxv) The Alpha of returns on the Dairibord Share
(xxvi) The Alpha of returns on the Treasury Bill
 (xxvii) The coefficient of correlation between the market and Delta
(xxviii)The coefficient of correlation between the market and Dairibord
(xxix) The coefficient of correlation between Delta and Dairibord
(xxx) The coefficient of determination between the market and Delta
(xxxi) The coefficient of determination between the market and Dairibord
(xxxii) The coefficient of determination between Delta and Dairibord

[48 marks]

(b) Using the procedure of inserting a scatter plot and fitting the regression line of best
fit, displaying the regression equation and the R2on the chart, generate the
following graphs in Microsoft Excel Spreadsheet and copy and paste it onto your
Word document:
(i) Stock market returns (horizontal axis) against Delta Share Returns (vertical axis).
State Alpha, Beta and R2and briefly comment on them.

48 | P a g e
30% 25% 20% 15% 10% 5% 30% 35% ZSE Returns
0%
Delta's
s

n
Characteristic
r
R² = 0.1365
u

t
Line
e

Series1
a

l Linear (Series1)
e

D
y = 0.3367x + 0.0922
0% 5% 10% 15% 20% 25%

α = 0.0922 [intercept]

A positive alpha indicates that the Delta share can outperform the overall ZSE stock market
during periods in which the ZSE returns are 0%.
β = 0.3367 [slope]

Being less than 1, the beta of DZL shares indicates a security which is less volatile than the
overall stock market ZSE.\

R2= 13.65% [coefficient of determination]

13.65% of the variability in Delta share returns is explained by the variability in the ZSE Stock
Market returns, while the other 86.35% is explained by other factors apart from ZSE returns.

(ii) Stock market returns (horizontal axis) against Dairibord Share Returns (vertical
axis). State Alpha, Beta and R2and briefly comment on them.

49 | P a g e
Characteris
tic Line

s
y = 0.4049x +
n

r
0.0057
u

t
Series1
e

R
Linear (Series1)
s

'

20% 15% 10% 5% R² = 0.0711

ZSE Returns
0%

-5% α = 0.0057
[intercept]
-10% 0% 10% 20% 30%
40%
DZL's
A positive alpha indicates that the DZL share can outperform the overall ZSE stock market
during periods in which the ZSE returns are 0%.

β = 0.4049 [slope]

Being less than 1, the beta of DZL shares indicates a security which is less volatile than the
overall stock market ZSE.

R2= 7.11% [coefficient of determination]

7.11% of the variability in Dairibord share returns are explained by the variability in the ZSE
Stock Market returns, while the other 92.89% is explained by other factors apart from ZSE
returns. This low value of R2depicts a very weak explanatory power between DZL and ZSE
returns

[8 marks]

(c) Assuming that an investor would like to construct a portfolio of Delta (with ¾
weighting) and DZL (with ¼ weighting), calculate:
(i) The Portfolio Expected Return
(ii) The Portfolio Variance
(iii) The Portfolio Standard Deviation [10 marks]

(d) Use the Capital Asset Pricing Model to deduce the required rate of return and
comment on the differences with the respective Expected Returns computed in 1(a)
above, for each of the following:

50 | P a g e
(i) Delta Share
RRR = Rf + β[Rm – Rf]
= 10% + [0.3367][22.8% - 10%]
= 10% + [0.3367][12.8%]
= 10% + 4.30976%
= 14.30976%
This is lower than the 16.9% expected return based on the past 10 years’ historical returns.
The Delta Stock is generating a much higher average return than the one otherwise
required to compensate the investor of the riskiness involved.
 (ii) Dairibord Share

RRR = Rf + β[Rm – Rf]

= 10% + [0.4049][22.8% - 10%]
= 10% + [0.4049][12.8%]
= 10% + 5.18272%
= 15.18272%
This is higher than the 9.8% expected return based on the past 10 years’ historical returns.
The DZL Stock is therefore generating a pittance, lacklustre investment performance,
which is substantially lower than the rate of return that would otherwise be commensurate
with the stock’s volatility or riskiness. [12 marks]

2(a) Using a diagram to illustrate your answer, show that the relationship between βA, βD and βE
)(1 - t)
reduces to βG = βU + (βU – βD . [10 marks] • βA is the weighted average of βD and βE

•β
= [ ()
]β
() +[
]β
()

• Since β ≡ β and β ≡ β

•β
= [ ()
]β
() +[
]β
() ……Ungear β

•β + E = [D(1 - t)]β + [E]β

[D( t)

• β = β + [β - β
][1 - t][ ] ……Regear β

51 | P a g e
(b) AZ plc is identical in all operating and risk characteristics to GP plc, except that AZ plc is
all-equity-financed and GP plc is financed by equity and debt in the proportion 3:2 respectively,
at market valuation. The beta factor of AZ plc is 0.85. GP plc‟s debt capital is virtually risk-free,
and corporate tax is levied at the rate of 25.75%. The expected return on the market is 12% and
the risk-free rate is 6%.
You are required to show that GP plc’s equity beta = 1.27075 and its geared cost of equity
= 13.6245%. [12 marks]

β = β + [β - β
][1 - t][ ]

= 0.85 + [0.85 – 0][1-0.2575][

= 0.85 + [0.85][0.7425][
= 0.85 + 0.42075

= 1.27075

Keg = Rf + [Rm – Rf]βg

= 6% + [12% - 6%][1.27075]

= 6% + [6%][1.27075]

= 6% + 7.6245%

= 13.6245%

52 | P a g e

3.0 SOURCES AND COST

OF CAPITAL
Lecture Objectives
 ∙ Ability to calculate value of equity and cost of equity
∙ Ability to calculate value of debt and cost of debt
∙ Ability to calculate WACC (weighted average cost of capital) in the following stages :
Current WACC; Revised WACC and Marginal WACC
∙ Identify circumstances that require the use of MWACC rather than WACC

Source of Capital Cost of Capital

[1] Equity

[2] Debt (1-t)

[3] Preferred Share Capital

[4] Bank Loans (1-t)

The cost of Debt and Bank Loans are reduced by factor (1-t) because interest cost is an allowable
deduction for tax purposes whilst equity dividends and preference dividends are not. This is
called tax-deductibility of debt interest or tax shield or tax savings arising from debt rather than
equity or preferred share capital.

The WACC Formula

WACC =
[]+
[ ][1-t]

+
[]+
[ ][1-t]

EQUITY
Equity is raised through issuing shares. The issuer issues shares and receives cash whilst the
holder pays cash in exchange of shares. In a publicly listed entity, shares exchange hands through
buying and selling existing shares via the secondary market [eg ZSE].

Share Valuation Methods

∙ Dividend Valuation Model
∙ Dividend growth model
53 | P a g e
– Constant growth stocks
– Non-constant growth stocks
Share price cum-div includes the dividend just declared and usually to be paid in the next few
days. Share price ex-div excludes the dividend just declared. It is share price ex-div that we use
in financial analysis
Example
The current price of the ordinary shares is 135 cents cum-div. A dividend of 10 cents is payable
in the next few days. Thus, the current price ex-div = 135c – 10c = 125c per share or $1.25 per
share.

54 | P a g e
The Importance of Intrinsic Value of Shares
We can spot mispriced shares, that is undervalued shares and overvalued shares
If Intrinsic value < Market Price →overvalued
If Intrinsic value > Market Price →undervalued
If Intrinsic value = Market Price →correctly valued

55 | P a g e
Cost of Equity

We can determine cost of equity using either of two methods as demonstrated below:

First [GCDGM]:

ke = ��

+g= (�� )

+g

NB

If there are issue costs use Po(1-F) in place of Po.

Second [CAPM]:

ke = rf + β[rm – rf]

It all depends on which information is available to enable you to calculate ke.

56 | P a g e
Debt
It is raised through issuing debt instruments such as debentures or bonds. The issuer issues debt
and receives cash. The holder pays cash in exchange of debt instruments.

Pre-tax Cost of Irredeemable Debt

Kd =

Post-tax Cost of Irredeemable Debt

Kdnet = [1-t]
NB If there are any issue costs use Po(1-F) in place of Po.

Pre-tax Cost of Redeemable Debt

YTM = YTR = Kd = ( )
Post-tax Cost of Redeemable Debt

Kdnet = [ ( )
[1-t]

Cost of Irredeemable Preference Shares

Kp =
[without issue costs]

Kp =
(�� ) [with issue costs]

Cost of Redeemable Preference Shares

Kp =

57 | P a g e
Pre-tax Cost of Bank Loan

KbL = interest rate on loan

Post-tax Cost of Bank Loan

KbL = [interest rate on loan]*[1-t]

A WORKED EXAMPLE

FK (Pvt) Ltd has asked you to help management to determine the cost of financing the company.
Relevant extracts from the most recent Statement of Financial Position as at 30th November 2019
are as follows:

Equity $[millions] Ordinary Shares of $0.50 each 2.0

Retained Earnings 1.5

Non-Current Liabilities

7.5% Redeemable Debentures of $1000 each 2.2

6% Irredeemable Preference Shares of $100 each 1.4

7.1

The following additional information is relevant:

FK (Pvt) Ltd‟s ordinary shares are currently trading at $2.60 cum-div per share and $2.00 ex-div
per share. The most recent dividend just declared will be paid in the next 5 working days. Since
the company‟s product lines are now predominantly in their decline stage in accordance with the
Product Life Cycle (PLC) Model, the Board of Directors has seen it fit to reduce the annual
dividend per share by 5% per annum forever, starting with the forthcoming financial year ended
30th November 2020. Debentures are presently valued at 10% below their par value and will be

58 | P a g e
redeemed on the 30th November 2026. Preference shares are trading at 20% above their par value.
The prevailing corporate tax rate is 25.75%.

REQUIRED

(a) Calculate FK (Pvt) Ltd‟s Weighted Average Cost of Capital (WACC) using the following
weighting bases:
(i) Book values [7]
(ii) Market values [10]
(b) Which weighting base is superior and why? [4]
(c) Explain any four factors that influence a company‟s weighted average cost of capital
(WACC). [4]

Source of capital Book values Market Values Cost of Capital

= 2m+1.5m = $3.5m = $8m
VE = Po*number of ordinary Using Constant Dividend
Equity Pick from SOFP [Ordinary shares = 2*2m/0.5 Growth Ke = Do(1+g)/Po + g =
Share Capital =2*4m 0.60(1-0.05)/2.00 – 0.05
+ All Reserves]
 = .57/2 -0.05 =23.5%
Preference Share VP = Po*number of =$1.68m = 5%
Capital preference shares Irredeemable Kp =
Pick from SOFP =120*1.4m/100 d/Po
=$1.4m =120*14000 = 6/120
=900*2.2m/1000 =900*2200 [(1000+1800)/3]
=$1.98m =89.285714286/933.33 =
Debentures Pick from SOFP Redeemable 9.56632653%
=$2.2m Kd =
VD = Po*number of debt units [75 + [1000-900]/7]

59 | P a g e
Using Book Values

WACC

= [ [Ke] +[
[Kd(1-t)] +
[Kp]

=[ [0.235] +[
[0.0956632653(1-0.2575)] + [0.05] = = 0.4929577465*0.235 +

0.3098591549*0.095663*0.7425 + 0.1971830986*0.05 = 0.1158450704 +

0.0220092879 + 0.0098591549

= 14.771%

Using Market Values

WACC

= [ [Ke] +[
[Kd(1-t)] +
[Kp]

=[ [0.235] +[
[0.0956632653(1-0.2575)] + [0.05] = 0.6861063465*0.235 +

0.1698113208*0.095663*0.7425 + 0.1440823328*0.05 = 0.1612349914 +

0.0120616938 + 0.0072041166

= 18.05%

CLASS EXERCISE

A client company Sun (Pvt) Ltd has asked you to help management better understand the cost of
financing the company. Relevant extracts from the Statement of Financial Position as at 30 April
2017 are as follows:

60 | P a g e
Equity $000 Ordinary shares of $2 each 500 Accumulated Profits 400 900

Non-Current Liabilities

10% Debentures Redeemable 30 April 2021 500 12% Irredeemable Preference

Shares $100 each 200 1600

Your investigations have revealed the following relevant information:

The most recent dividend declared was 50 cents per share. This dividend will be paid in the next
2 weeks. The average compound rate of growth in dividends over the last five years has been
20% and is expected to continue in the foreseeable future. Sun (Pvt) Ltd‟s ordinary shares
presently trade at $5 ex-div. Debentures are presently valued at 90% of their par value and
preference shares are trading at $120 each. The prevailing corporation tax rate is 40%.

REQUIRED

(d) Calculate Sun (Pvt) Ltd ’s Weighted Average Cost of Capital (WACC) using market
values as weighting factors.
[19]
(e) Explain why market values are preferred as weighting factors as compared to book
values in the calculation of WACC. [6]

WACC and MWACC

Appropriateness of WACC as a discount rate in investment appraisal To use WACC as the

discount rate to evaluate a project, three conditions must be met as follows: [1] The project being

appraised must be small relative to the size of the company [2] The project has the same business
risk as the company

[3] The existing capital structure must be maintained such that the financial risk remains
the same

61 | P a g e
Once these three conditions are violated, WACC ceases to be appropriate in evaluating a
particular project

We use MWACC instead (ie Marginal Weighted Average Cost of Capital)

In other words, the following conditions require the use of MWACC in evaluating a
project:

[1] The project must be large relative to the size of the company

[2] A major issue of capital is required to fund the project, such that the capital structure
(and hence financial risk) will be significantly altered

[3] The project has different business risk characteristics from the company‟s existing
operations.

Steps involved in Calculating MWACC

[1] Calculate current WACC (Scenario prior to raising of new capital)

[2] Calculate Revised WACC (Scenario after raising of new capital)
[3] Calculate Marginal WACC (Depicting the additional cost of capital vis-a-vis the additional
capital).

Step 1
Current WACC = ∑ ∑ where Kc is the % cost of current components of capital and Vc is the
market value of current components of capital.

Step 2
Revised WACC = ∑ ∑ where KR is the % cost of revised components of capital and VR is the
market value of revised components of capital.

Step 3
Marginal WACC = ∑ ∑
∑∑
62 | P a g e

4.0 VALUATION OF
SECURITIES
The basic underlying principle that defines the valuation of securities if the fact that a security‟s
intrinsic value or intrinsic price is the present value of the security‟s future cashflows discounted
to present value terms using the investor‟s required rate of return as the discount rate.

4.1 VALUATION OF EQUITY

Equity shares are always considered as having a perpetual or infinite stream of dividends since
they are a financial instrument without a predetermined redemption date. The future cashflows
are therefore dividends from Year 1 up to infinity, with no face value being taken into
consideration as equity shares are irredeemable by their very nature. Share valuation is therefore
based on either a dividend-growth share or a dividend non-growth share. These two scenarios are
examined in the following two sections namely 4.1.1 and 4.1.2.

4.1.1 Gordon’s Constant Dividend Growth Model

The diagrammatic representation below shows dividend cashflows that grow by factor g annually
from Year 1 into perpetuity. The same cashflows are each discounted to present value terms (Year
0) using the equity-holders‟ required rate of return denoted by Ke.

Do(1+g)5/(1+ke)5

Do(1+g)4/(1+ke)4

Do(1+g)3/(1+ke)3

Do(1+g)2/(1+ke)2
 Do(1+g)/(1+ke))

Do(1+g) Do(1+g)2Do(1+g)3Do(1+g)4Do(1+g)5. . . . . . . . . . 0 12345.....∞

63 | P a g e

( )+ ( )

()+ ()

()+ ()

Po = () ()+ ()

()+ ()

()+ ……….. to infinity ………..[2]

Multiply both sides by ( ) ( )

( )= ( )

()+ ()

()+ ()

()+ ……….. to infinity ……….[1]

()

Equation[1] Less Equation [2] yields the following:

P0 - ( )

( )= ( )
()
P0 [1 -( )
( )] = ()
()

P0 [ ( )
( )] = ()
()

P0 [ )
( )] = ()
()

P0 [ )
( )] = ()
()

P0 [ )
( )] /[)
( )] = ()
( )/ [)
( )]

64 | P a g e
P0 = ()

( )* [)
( )]

P0 = ()

()=
()
4.1.2 Non-Growth Shares
Shares with no growth can be valued by substituting g with 0 thereby giving the following
expression of share valuation:

P0 = ()

()= ()

( )=

4.2 VALUATION OF DEBT

Debt instruments such as bonds or debentures are either redeemable or irredeemable. Their
valuation thus differ because of different cashflow streams associated with these two scenarios.
Irredeemable debt instruments have a perpetual or infinite stream of debt interest whilst their
redeemable counterparts have a predetermined redemption date. The future cashflows of
redeemable bonds or debentures are therefore interest from Year 1 up to the time of maturity and
the face or par value of the security is also discounted, taking great care as to whether the
compounding frequency is annual or semi-annual. The debtholder‟s required rate of return is also
known as the Yield To Maturity (YTM) or Yield To Redemption (YTR) or effective cost of debt
or annual yield. The yield to maturity is also identical to the security‟s internal rate of return
(IRR).

Worked Example

(a) For each of the four $1000 bond instruments tabulated below, calculate, amortise and
interpret the value of each bond using the following formula:

VB = [ ∑ ( )
] + [ ( ) ] in each of the following two circumstances:

65 | P a g e
(i) if the interest is compounded on an annual basis. [10] (ii) if the

interest is compounded on a semi-annual basis. [10]

 Yield to Maturity Time to Maturity

Bond Coupon Rate Per Annum

1 12% 9% 5 years
2 8% 8% 7 years
3 0% 10% 8 years
4 10% 14% 6 years
(b) Explain how each of your answers above can be verified using both an Excel Spreadsheet and
the Financial Calculator. [5]

BOND 1 – VALUATION
ANNUAL COMPOUNDING
VB = [ ∑ ( )
] + [ ()]

=[∑
] + [ ()]
()

= [1 -
() + [ ()]

= $1,116.6895

BOND 1 – VALUATION
SEMI-ANNUAL COMPOUNDING
VB = [ ∑ ( )
] + [ ()]

=[∑
] + [ ()]
()

= $1,118.6908
66 | P a g e
BOND 1 - ANNUAL COMPOUNDING

SUB
YEAR OPENING INTEREST TOTAL INSTALMENT CLOSING

BALANCE CHARGES BALANCE 1 $1,116.6895 $100.5021 $1,217.1916 ($120.0000)

$1,097.1916 2 $1,097.1916 $98.7472 $1,195.9388 ($120.0000) $1,075.9388 3 $1,075.9388
$96.8345 $1,172.7733 ($120.0000) $1,052.7733 4 $1,052.7733 $94.7496 $1,147.5229
($120.0000) $1,027.5229 5 $1,027.5229 $92.4771 $1,120.0000 ($120.0000) $1,000.0000

BOND 1 - SEMI-ANNUAL
COMPOUNDING

SUB
HALFYEAR OPENING INTEREST TOTAL INSTALMENT CLOSING
BALANCE CHARGES BALANCE 1 $1,118.6908 $50.3411 $1,169.0319 ($60.0000)
$1,109.0319 2 $1,109.0319 $49.9064 $1,158.9383 ($60.0000) $1,098.9383 3 $1,098.9383
$49.4522 $1,148.3905 ($60.0000) $1,088.3905 4 $1,088.3905 $48.9776 $1,137.3681
($60.0000) $1,077.3681 5 $1,077.3681 $48.4816 $1,125.8497 ($60.0000) $1,065.8497 6
$1,065.8497 $47.9632 $1,113.8129 ($60.0000) $1,053.8129 7 $1,053.8129 $47.4216
$1,101.2345 ($60.0000) $1,041.2345 8 $1,041.2345 $46.8556 $1,088.0900 ($60.0000)
$1,028.0900 9 $1,028.0900 $46.2641 $1,074.3541 ($60.0000) $1,014.3541 10 $1,014.3541
$45.6459 $1,060.0000 ($60.0000) $1,000.0000

BOND 2 – VALUATION
ANNUAL COMPOUNDING
VB = [ ∑ ( )
]+

[ ()]

=[∑
] + [ ()]
()

= $1,000
67 | P a g e
BOND 2 – VALUATION
SEMI-ANNUAL
COMPOUNDING VB = [ ∑ ( )
]+[
()]

=[∑
] + [ ()]
()

= $1,000 SUB
TOTAL INSTALMENT CLOSING
BOND 2 - ANNUAL COMPOUNDING

YEAR OPENING INTEREST

BALANCE CHARGES BALANCE 1 $1,000.0000 $80.0000 $1,080.0000 ($80.0000)

$1,000.0000 2 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000 3 $1,000.0000
$80.0000 $1,080.0000 ($80.0000) $1,000.0000 4 $1,000.0000 $80.0000 $1,080.0000
($80.0000) $1,000.0000 5 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000 6
$1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000 7 $1,000.0000 $80.0000
$1,080.0000 ($80.0000) $1,000.0000

BOND 2 - SEMI-ANNUAL
COMPOUNDING
SUB
HALFYEAR OPENING INTEREST TOTAL INSTALMENT CLOSING
BALANCE CHARGES BALANCE 1 $1,000.0000 $40.0000 $1,040.0000 ($40.0000)
$1,000.0000 2 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000 3 $1,000.0000
$40.0000 $1,040.0000 ($40.0000) $1,000.0000 4 $1,000.0000 $40.0000 $1,040.0000
($40.0000) $1,000.0000 5 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000 6
$1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000 7 $1,000.0000 $40.0000
$1,040.0000 ($40.0000) $1,000.0000 8 $1,000.0000 $40.0000 $1,040.0000 ($40.0000)
$1,000.0000 9 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000 10 $1,000.0000
$40.0000 $1,040.0000 ($40.0000) $1,000.0000 11 $1,000.0000 $40.0000 $1,040.0000
($40.0000) $1,000.0000 12 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000 13
$1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000 14 $1,000.0000 $40.0000
$1,040.0000 ($40.0000) $1,000.0000

68 | P a g e
BOND 3 – VALUATION
ANNUAL COMPOUNDING
VB = [ ∑ ( )
]+

[ ()]

=[∑
] + [ ()]
()

= $466.5074

BOND 3 – VALUATION
SEMI-ANNUAL COMPOUNDING
VB = [ ∑ ( )
]+[
()]

=[∑
] + [ ()]
()

= $458.1115 SUB
TOTAL INSTALMENT CLOSING
BOND 3 - ANNUAL COMPOUNDING

YEAR OPENING INTEREST

BALANCE CHARGES BALANCE 1 $466.5074 $46.6507 $513.1581 $0.0000

$513.1581 2 $513.1581 $51.3158 $564.4739 $0.0000 $564.4739 3 $564.4739 $56.4474
$620.9213 $0.0000 $620.9213 4 $620.9213 $62.0921 $683.0135 $0.0000 $683.0135 5
$683.0135 $68.3013 $751.3148 $0.0000 $751.3148 6 $751.3148 $75.1315 $826.4463
$0.0000 $826.4463 7 $826.4463 $82.6446 $909.0909 $0.0000 $909.0909 8 $909.0909
$90.9091 $1,000.0000 $0.0000 $1,000.0000
69 | P a g e
BOND 3 - SEMI-ANNUAL
COMPOUNDING

SUB
HALFYEAR OPENING INTEREST TOTAL INSTALMENT CLOSING
BALANCE CHARGES BALANCE 1 $458.1115 $22.9056 $481.0171 $0.0000 $481.0171
2 $481.0171 $24.0509 $505.0680 $0.0000 $505.0680 3 $505.0680 $25.2534 $530.3214
$0.0000 $530.3214 4 $530.3214 $26.5161 $556.8374 $0.0000 $556.8374 5 $556.8374
$27.8419 $584.6793 $0.0000 $584.6793 6 $584.6793 $29.2340 $613.9133 $0.0000
$613.9133 7 $613.9133 $30.6957 $644.6089 $0.0000 $644.6089 8 $644.6089 $32.2304
$676.8394 $0.0000 $676.8394 9 $676.8394 $33.8420 $710.6813 $0.0000 $710.6813 10
$710.6813 $35.5341 $746.2154 $0.0000 $746.2154 11 $746.2154 $37.3108 $783.5262
$0.0000 $783.5262 12 $783.5262 $39.1763 $822.7025 $0.0000 $822.7025 13 $822.7025
$41.1351 $863.8376 $0.0000 $863.8376 14 $863.8376 $43.1919 $907.0295 $0.0000
$907.0295 15 $907.0295 $45.3515 $952.3810 $0.0000 $952.3810 16 $952.3810 $47.6190
$1,000.0000 $0.0000 $1,000.0000

BOND 4 – VALUATION
ANNUAL COMPOUNDING
VB = [ ∑ ( )
]+

[ ()]

=[∑
] + [ ()]
()

= $844.4533

BOND 4 – VALUATION
SEMI-ANNUAL COMPOUNDING
VB = [ ∑ ( )
] + [ ()]

=[∑
] + [ ()]
()

= $841.1463

70 | P a g e
BOND 4 - ANNUAL COMPOUNDING

SUB
YEAR OPENING INTEREST TOTAL INSTALMENT CLOSING

BALANCE CHARGES BALANCE 1 $844.4533 $118.2235 $962.6768 ($100.0000)

$862.6768 2 $862.6768 $120.7747 $983.4515 ($100.0000) $883.4515 3 $883.4515
$123.6832 $1,007.1347 ($100.0000) $907.1347 4 $907.1347 $126.9989 $1,034.1336
($100.0000) $934.1336 5 $934.1336 $130.7787 $1,064.9123 ($100.0000) $964.9123 6
$964.9123 $135.0877 $1,100.0000 ($100.0000) $1,000.0000

BOND 4 - SEMI-ANNUAL
COMPOUNDING

SUB
HALFYEAR OPENING INTEREST TOTAL INSTALMENT CLOSING
BALANCE CHARGES BALANCE 1 $841.1463 $58.88 $900.0265 ($50.0000) $850.0265
2 $850.0265 $59.50 $909.5284 ($50.0000) $859.5284 3 $859.5284 $60.17 $919.6954
($50.0000) $869.6954 4 $869.6954 $60.88 $930.5740 ($50.0000) $880.5740 5 $880.5740
$61.64 $942.2142 ($50.0000) $892.2142 6 $892.2142 $62.45 $954.6692 ($50.0000)
$904.6692 7 $904.6692 $63.33 $967.9961 ($50.0000) $917.9961 8 $917.9961 $64.26
$982.2558 ($50.0000) $932.2558 9 $932.2558 $65.26 $997.5137 ($50.0000) $947.5137 10
$947.5137 $66.33 $1,013.8396 ($50.0000) $963.8396 11 $963.8396 $67.47 $1,031.3084
($50.0000) $981.3084 12 $981.3084 $68.69 $1,050.0000 ($50.0000) $1,000.0000
71 | P a g e

5.0 VALUATION OF
COMPANIES
5.1 Introduction

The valuation of companies is based on either the MM Proposition 1 (without taxes), MM

Proposition 2 (with taxes), both of which are known as the Net Operating Income (NOI)
Approach, or based on the Net Income (NI) Approach. NOI = EBIT(1-T) whilst NI = PAT.

In general;

[1] The value of an ungeared company (Vu) is the present value of an entity‟s future post-tax
earnings discounted at the entity‟s ungeared cost of equity (Keu).

Vu = ()

[2] The value of a geared company (Vg) is the present value of an entity‟s future post-tax
earnings discounted at the entity‟s ungeared cost of equity (Keu) plus the present value of future
tax shields discounted at the entity‟s cost of debt (Kd)

Vg = ()

+
Where;
Vg is the value of a geared entity

NOI is the Net Operating Income = Post-tax Profit before interest = EBIT(1-T)

Keu is the ungeared cost of equity

rDT is the annual tax shield of which Rd is the annual interest amount

Kd is the cost of debt

Please Take Note of The Following Relationship Between Keu and Keg

[1] Without Taxes

Keg = Keu + (Keu – Kd) …………………….[i]

72 | P a g e
[2] With Taxes

Keg = Keu + (Keu – Kd)(1-T) ………………….[ii]***

Recall the following from Risk and Return (Section 2.0)

Geared and Ungeared Beta – Their Relationship
∙β
= [ ()
]β
() +[
]β
()

∙ Take note that β ≡ β and that β ≡ β

∙β
= [ ()
]β
() +[
]β
()

∙β + E = [D(1 - t)]β + [E]β

[D( t)

∙ �� = �� + [�� - ��
][1 - t][ ] ……………………..[iii]***

***TAKE NOTE OF THE STRIKING SIMILARITY BETWEEN EXPRESSION [ii] AND

[iii] ABOVE.
5.2 Earnings Based Valuation Bases

In the first two formulae below, [1] and [2], you make Market Price Per Share (MPS) the subject
of the formula if you are given EY & EPS or P/E & EPS respectively.

[1] Earnings Yield =

[2] Price Earnings (P/E) Ratio =

[3] Market Value of a Company (Earnings with growth) = ( )

73 | P a g e
Worked Example

A company currently has the following financial information:

Earnings Before Interest and Tax $16.8m

Interest $ 3.2m

Tax (40%) $ 5.44m

Earnings After Tax $8.16m

The cost of equity of an equivalent ungeared firm in the same risk class is 24% and debt capital
has a yield of 16%.

(a) Calculate the value of the firm according to MM Proposition 1

(b) (i) Determine the value of the geared firm according to MM Proposition 2 (ii)
Determine the cost of equity of the geared firm according to MM Proposition 2

Solution

Rearrange the financial information as follows:

 $

EBIT 16,800,000

Interest ( 3,200,000)

EBT 13,600,000

Tax (40%) (5,400,000)

EAT 8,160,000

(a) Vg = (�� )

+ �� but T = 0 under MM Proposition 1 (without taxes)

= ()

+0

= $70,000,000

74 | P a g e
(b) (i) Value of geared firm = Value of ungeared firm + Value of Tax Shield

Value of ungeared firm = EBIT(1-T)/Keu = 16,800,000*0.6/0.24 = 10,080,000/0.24 =

42,000,000

Value of Tax Shield = Value of Debt * Tax Rate

Value of debt = 3,200,000/0.16 = 20,000,000

Value of Tax shield = 20,000,000*0.4 = 8,000,000

Value of the firm under MM Proposition 2 = 42,000,000 + 8,000,000 = 50,000,000

(b)(ii) Cost of equity of geared entity with taxes is:

Keg = Keu + (Keu – Kd)(1-T)

= 24% + (24%-16%)(1-40%)*
= 27.2%
75 | P a g e

6.0 MARKET EFFICIENCY

6.1 Introduction
Market efficiency can be thought of as either:
• Informational efficiency (the flow of information among market participants and
market‟s reaction to news)

• Allocative efficiency (the allocation of capital to most productive uses) •

Operational efficiency (in terms of low transaction costs)

We are concerned with Informational Efficiency only.

It is important to take note that the notion of market efficiency was popularised by Eugine Fama
(1965). In an efficient stock market, investors are assured that they can recover a fair value if they
are to dispose of their investments. EMH provides a theoretical underpinning of how share prices
react to new information about an entity. Share price reaction to news is dependent upon the
stock market‟s level of informational efficiency. In an efficient market it is not possible to earn a
profit based on past share price information. The more efficient a stock market is, the more
random and unpredictable the share prices and market returns would be. In the most efficient
market the future prices will be totally random and the price formation can be assumed to be a
stochastic process with mean in price change equal to zero. The objective of this section is to
investigate whether share prices on the Zimbabwe Stock Exchange follow a random-walk
process as required by stock market efficiency. The presence or absence of random walk in the
price generation process in a stock market is evaluated using stock market indices.

EMH has three levels or forms of efficiency:

• Weak form efficiency
• Semi-strong form efficiency
• Strong form efficiency

Definition of Terms
Random walk is the notion that future share prices or returns cannot be predicted by using
historical share prices or returns.

76 | P a g e
Efficient market is a financial market which fully reflects all information and is free from
mispricing tendencies by market participants.

6.2 Efficient Market Hypothesis

The efficient market hypothesis (EMH) is concerned with informational and pricing efficiency. In
an efficient market, prices fully and instantaneously reflect all available information. There are
three forms of efficiency associated with the EMH hypothesis and these levels depend on the
amount of information available to market participants. They are namely weak form efficiency,
semi-strong form efficiency and strong form efficiency.

6.2.1 Weak Form Efficiency

The weak form states that the current share price reflects all the historical information. This form
of efficiency implies that no investor is able to consistently beat or outperform the market by
consistently earning above-average returns by following trading rules developed by technical
analysis. The weak form of EMH can be tested by subjecting a series of share prices or stock
market indices to statistical tests so as to determine whether any correlation exists between past
and present share prices or indices. Sunde (2008) postulates that the weak-form efficiency is
represented mathematically as:
Pt = Pt-1+Expected return+Random error (1) and this expression says that the price today is equal
to the sum of the last observed price plus the expected return on the stock plus a random
component occurring over the interval. Sunde (2008) further asserts that the last observed price
could have occurred yesterday, last week, or last month, depending on one's sampling interval.
The expected return is a fraction of a security‟s risk. The random component is due to new
information on the stock. It could be either positive or negative and has an expectation of zero.
The random component in any one period is unrelated to the random component in any past
period. Hence, this component is not predictable from past prices. If the stock prices follow
Equation 1 above, Sunde (2008) argues that they are said to follow a random walk. Weak-form
efficiency constitutes the weakest type of efficiency that we would expect to be exhibited by a
financial market because historical price information is the easiest kind of information about a
stock to acquire. Had it been possible to make extraordinary profits simply by finding the

77 | P a g e
patterns in the stock price movements, everyone would jostle thereby leading to an instant
disappearance of abnormal gains.

6.2.2 Semi-Strong Form Efficiency

The semi-strong variant of EMH states that the current share price will not only reflect historical
information, but will also reflect all published current information also. This form of EMH can
be related to fundamental analysis. Fundamental analysis attempts to identify mispriced entities
through studying publicly available information. The speed at which the market captures news is
so rapid that public information is instantaneously reflected into share prices the moment such
news is released, thereby explaining why it is not possible to outperform a semi-strong efficient
market by acting on publicly available current information. Those market participants with
insider information are the only ones who can profit from possessing such privileged
information. A market is semi-strong efficient if prices incorporates all publicly available
information, including information such as published accounting statements, wire news,
announcements as well as historical price information (Sunde, 2008). Sunde (2008) further
asserts that fundamentalists use the above information when buying or selling stocks. If
fundamental analysis works, the efficient market hypothesis (semi-strong form) is wrong. The
distinction between semi-strong efficiency and weak-form efficiency is that semi-strong
efficiency implies weak-form efficiency in that semi-strong efficiency requires not only that the
market be efficient with respect to historical price information, but all the information available
to the public be reflected in price.

6.2.3 Strong Form Efficiency

The strong form of EMH states that the current share price incorporates all information, both
past, present and private non-published insider information. This would include views and
opinions being held by directors about their companies‟ prospects. If this form of stock market
efficiency holds, it follows that no investor can be able to generate above-average returns using
any information whatsoever since all market participants have access to all information, both past
and present and both public and private. Ogilvie (2009) posits that it is difficult to test the strong
form of EMH since insider trading is illegal in most jurisdictions throughout the world. This
form says that anything that is pertinent to the value of the stock and that is known to at

78 | P a g e
least one investor is in fact, fully incorporated into the stock value. In other words, security prices
reflect all available information that is public and private data. A precondition for this strong
version of the hypothesis is that information and trading costs, the costs of getting prices to
reflect information, are always zero. Its advantage, however, is that it is a clean benchmark that
allows to sidestep the problem of deciding what are reasonable information and trading costs.
Since there are surely positive information and trading costs, the extreme version of the market
efficiency is unattainable. If one can make money by inside trading (assuming that you don‟t get
caught), the strong EMH is wrong, but may be weak or semi-strong EMH is still correct.

6.3 Random Walk Hypothesis

The random walk model was first developed by Bachelier (1900) in which he asserts that
successive price changes between two periods is independent with zero mean and its variance is
proportional to the interval between the two time periods. Accordingly, the variance of weekly
changes should be five times the variance of the daily changes (assuming the market remains
closed on weekends). This concept is exploited in the variance ratio tests, which has been widely
used to test the random walk hypothesis in various markets.
The more efficient a stock market is, the less will be the opportunity to generate speculative profit
from trading market instruments. The concept of stock market efficiency has generated a lot of
debate ever since Eugene Fama first introduced it a couple of decades ago. Random walk of
share prices is considered to be a sufficient condition for market efficiency to occur. However,
rejection of random walk model does not necessarily imply the inefficiency of stock-price
formation, so a dose of caution is required to avoid misinterpretation in this regard. Random
walk is the path of a variable over time that exhibits no predictable patterns pertaining to the next
successive step. The random walk hypothesis (RWH) states that the present market price is the
best indicator of the future market prices with an error term that is stochastic in nature. Hence the
next time period price is anybody‟s guess.

Random Walk Hypothesis refers to the notion that stock prices are so unpredictable that
historical stock prices cannot be utilised in charting the future trajectory (Fama, 1995). The study
of rejection of random walk in the share prices due to mean reverting tendency which is a

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consequence of persistence of one sided volley in share prices was first presented by De Bondt &
Thaler (1985). The presence of mean reverting tendency and absence of random walk in US
stocks was confirmed by the studies of De Bondt & Thaler (1989) and Poterba & Summers
(1988). The variance ratio test was proposed by Lo and MacKinlay in 1988 to test the random
walk hypothesis. The study compared variance estimators derived from data at various levels of
frequencies for weekly stock market returns in the New York Stock Exchange and American
Stock Exchange for a period of over 32 years. They improved the variance ratio statistic by
taking overlapping period and corrected the variances used in estimating the statistic for bias.
They also proposed a test statistic Z*, which is robust under the heteroscedastic random walk
hypothesis, hence can be used for a longer time series analysis.

An extensive Monte Carlo simulation was conducted by Lo & MacKinlay (1989) to find out the
size and power of these tests in infinite samples. They identified that the variance of random walk
increments was linear in all sampling intervals. Their findings provided evidence to reject the
random walk model for the entire sample period of 1962-1985 and for all sub-periods for a
variety of aggregate returns indexes and size-sorted portfolios. Their results also indicated
positive autocorrelation for weekly holding-period returns not only for the entire sample but also
for all sub-periods.
The rejection of the random walk model by Lo & MacKinlay (1988) was mainly due to the
behaviour of small stocks. But this could not be attributed entirely to the effects of infrequent
trading or time-varying volatilities. They used simple specification test based on variance
estimators to prove that stock prices did not follow a random walk. The Lo & MacKinlay finding
of positive autocorrelation was inconsistent with the negative serial correlation found by Fama &
French (1988). Fama & French discovered that for the U.S. stock market, 40 percent of the
variations of longer holding-period returns were predictable from the information on past returns.
Campbell in 1991 used variance decomposition method for stock returns and concluded that the
expected stock return changes through time in a fairly persistent fashion. Parameswaran (2000)
performed variance ratio tests corrected for bid-ask spread and nonsynchronous trading on the
weekly returns derived from CRSP daily returns file for a period of 23 years. His results show
that eight out of ten size sorted portfolios do not follow a random walk. He observed that

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