FM Summary Lynchpin Part 1

CHAPTER 1
OBJECTIVES OF ORGANISATIONS
1 WHAT IS MEANT BY FINANCIAL STRATEGY
Remember the usual distinction between strategy, tactics and
operational control.
Strategy is a course of action, including the specification of
resources required, to achieve a specific objective.
Tactics are the most efficient deployment of resources in an
agreed strategy.
perational control is the management of daily activities in
accordance with strategic and tactical plans.
Senior management select the strategy
!iddle managers decide the tactics
"ine managers carry out the operational control.
2 THE IMPORTANCE OF FINANCIAL STRATEGY TO THE
ORGANISATION
#inancial strategy is that area of a companys overall strategy
within the scope of the financial managers, including$
#rom which sources should funds be raised%
Should proposed investments be underta&en%
'ow large a dividend should be paid%
'ow should wor&ing capital be controlled e.g. should
discounts be offered to debtors for prompt payment%
Should hedging strategies be adopted to avoid currency or
interest rate ris&%
FTC FOULKS LYNCH 1
CHAPTER 1 OBJECTIVES OF ORGANISATIONS
3 FINANCIAL STRATEGY AND OVERALL CORPORATE
STRATEGY
( companys overall corporate strategy will be a portfolio of
different strategies designed to carry out a long)term plan of
action to attain specified objectives. *t is therefore of critical
importance to consider the possible objectives of organisations.
4 AIMS AND OBJECTIVES OF ORGANISATIONS
*n most e+am questions a companys primary objective will be
assumed to be the ma+imisation of shareholders wealth.
,ut one may need to discuss alternative concepts.
!a+imising and satisficing
!a+imising means see&ing the best possible outcome.
Satisficing means see&ing only an adequate outcome.
*n practice often the shareholders wealth will be ma+imised
subject to satisficing other objectives such as paying the
wor&force high wages, respecting health and safety issues and
minimising environmental damage. Sta&eholder views are
assuming increased prominence.
5 THE GOALS OF DIFFERENT INTEREST GROUPS
-hose returns are we ma+imising$
community%
employees%
management%
ordinary shareholders%
"ast option is normally assumed, but often rela+ed in the
decision)ma&ing process.
2 FTC FOULKS LYNCH
OBJECTIVES OF ORGANISATIONS CHAPTER 1
.ach of the interest groups is li&ely to have different objectives.
/ommunity may want low pollution and high involvement
in local issues e.g. supporting local charities.
.mployees want high wages and continuity of their
employment.
!anagement want high wages and may want the company
to be as large as possible so that they can empire)build.
rdinary shareholders want high dividends and growth in
the share price.
ther interest groups which might be considered are trade
suppliers, trade customers, debt providers, government, etc.
FOCAL POINT
The sta&eholder approach to business is currently a fashionable idea in
01 academic circles, with all the sta&eholders wor&ing together as a
team. 2o not overemphasise the role of shareholders in your e+am
answers. *f the other sta&eholders are not happy, then there will be
fewer profits generated for distribution to the shareholders.
6 CALCULATION OF RATES OF RETURN ON ORDINARY
SHARES
3ossible measures of returns on shares would be$
profits
earnings per share
dividends
dividends plus capital growth.
The best measure of returns to equity investors is generally
agreed to be dividend yield plus capital growth.
FTC FOULKS LYNCH 3
Example
ver the last year the share price of 4 plc has increased from
567p to 587p, while a dividend of 59p has just been paid. -hat
percentage return has been earned by the equity investors over the
year% *gnore ta+.
Solution %
2ividend yield
59
567
58
/apital growth
587 567
567
68
Total return :7
7 RISK AND RETURN
*ndifference curves show the relationship between return and
ris& for a particular investor.
increasing
benefit
indifference
curves
Return
Ris&
4 FTC FOULKS LYNCH
OBJECTIVES OF ORGANISATIONS CHAPTER 1
Return is the anticipated dividend yield plus capital growth
from the investment.
Ris& is the probability that the actual return will be different
from that forecast.
!ost investors are ris& averse, so demand higher returns to
compensate for higher ris&s, thus their indifference curves tend
to be of the shape above.
PROBLEMS WITH THE ASSUMED OBJECTIVE OF
MA!IMISATION OF WEALTH
bjectives of other parties ;employees, management< may
conflict with the assumed objective of ma+imising shareholder
wealth in such areas as$
ta&eovers ;management and employees may be &een for
the company not to be ta&en over<
time hori=on ;management may concentrate on short)term
profits<
ris& ;management may avoid ris& since their job depends
on the future of the company<
gearing ;again, management may see& the low ris& of low
gearing<.
The conflict between managers objectives and shareholders
objectives may partially be overcome by designing a
remuneration pac&age which ta&es shareholder wealth into
account e.g. share options.
" CHANGING SHARE OWNERSHIP PATTERNS
2espite the former /onservative governments privatisation
programme, individual direct shareholdings have fallen while
institutional shareholdings have increased.
FTC FOULKS LYNCH 5
The reasons for this trend can be summarised as$
ta+ advantages of institutional investment
growth in occupational pension schemes
growth in unit trusts
individuals have concentrated their savings in their houses
stoc&bro&ers have mar&eted to institutions rather than
cultivating private investors.
*S(s ;*ndividual Saving (ccounts< have not reversed the trend
described above$ the percentage of shares held by institutions
continues to grow, while the percentage of shares held directly
by individuals continues to fall.
6 FTC FOULKS LYNCH
CHAPTER 2
CONFLICTS OF INTEREST
1 DIRECTORS# POWERS AND BEHAVIOUR
Shareholders entrust the day)to)day management of their
company to directors. The directors will generally set their own
agenda to run the business> shareholders are entitled to attend
(?!s and challenge the directors but in practice this seldom
occurs.
2irectors may be remunerated by a bonus system based on the
companys profitability. They will therefore be motivated to
report high short)term profits, perhaps at the e+pense of long)
term profitability. Similar arguments apply if their company is
vulnerable to ta&e)over. Reporting high short)term profits
should drive up the value of the business and discourage
predators.
'owever in the 5@97s several managements too& this process
too far and flattered their reported profits by indulging in
creative accounting e.g. the use of leased assets rather than
purchased assets, or the use of quasi)subsidiaries. The
continuing wor& of the (S, should discourage these practices
e.g. the virtual abolition of e+traordinary items in #RS A and
the requirement to consolidate quasi)subsidiaries in #RS 8.
2 AGENCY THEORY AND GOVERNANCE
The shareholders have appointed the directors as their agents to
run the company. There is an agency relationship in law
between the two parties. (gency theory e+amines this
relationship and postulates that the company can be viewed as a
set of contracts between each of the various interest groups.
(lthough each member of each group might act in his own self)
interest, the groups as a whole ;i.e. the company< will not thrive
FTC FOULKS LYNCH 7
CHAPTER 2 CONFLICTS OF INTEREST
unless all the groups comprising the company are performing
well.
#or e+ample, managers must see it to be in their interests for
the company to prosper in the long)term, so they should not just
see& to boost short)term profits.
3 CONFLICT BETWEEN INTEREST GROUPS
This has already been e+amined in /hapter 5.
4 GOAL CONGRUENCE
?oal congruence e+ists where each of the units within a
business ;i.e. individual employees, managers, directors,
departments, etc< is see&ing to achieve personal objectives
which are also in the best interests of the business as a whole.
To persuade managers that a companys long)term strength
should be pursued, remuneration schemes may be based on
growth in a companys share price.
#or options granted under an approved scheme, there is no ta+
charge when the option is granted ;at the current mar&et value<
and also no ta+ charge when the option is e+ercised, providing
that options are e+ercised between three and ten years after they
are granted, and not more frequently than once in three years.
FOCAL POINT
The remuneration of senior managers is a topical issue, with public
disquiet centred on directors receiving large pay rises in newly
privatised utilities for doing much the same job. (s e+plained earlier,
the /ombined /ode requires listed companies to include a report from
the remuneration committee in the companys annual report, setting
out the companys policy for remunerating its e+ecutive directors.
8 FTC FOULKS LYNCH
CONFLICTS OF INTEREST CHAPTER 2
5 NON$FINANCIAL OBJECTIVES
The influence of the various parties with interests in the firm
results in firms adopting many non)financial objectives, such
as$
growth
diversification
survival
contented wor&force
quality service
environment issues.
Some of these objectives may be viewed as specific to
individual parties, whereas others may be seen as straight
surrogates for profit, and thus shareholder wealth ;e.g. quality
service<. #inally areas such as respect for the environment may
be societal constraints rather than objectives.
6 NON$E!ECUTIVE DIRECTORS
The role of non)e+ecutive directors has been covered in the
/adbury Report. The organisation 3R B.2 e+ists to promote
the role of non)e+ecutive directors in 01 business. 'istorically
non)e+ecutive directors have often been chosen by the
chairman from amongst his golfing friends> this is no longer
acceptable.
7 CORPORATE OBJECTIVES
#or the purposes of studying financial strategy you are
recommended to initially accept the theoretical objective of the
ma+imisation of shareholder wealth. This can be rela+ed when
evaluating and criticising the theories.
FTC FOULKS LYNCH 9
CHAPTER 2 CONFLICTS OF INTEREST
Small firm objectives will be similar to those of listed
companies above e+cept$
agency problems are often avoided due to owner)managers
ma+imisation of owners wealth is more li&ely than that of
shareholders wealth as the shares are not listed.
bjectives of public corporations will depend upon in whose
interests they are run. 3resumably such organisations are run in
the interests of society as a whole and therefore many of the
benefits they provide to society will be intangible.
10 FTC FOULKS LYNCH
CHAPTER 3
CORPORATE GOVERNANCE
1 INTRODUCTION TO CORPORATE GOVERNANCE
The /ommittee on the #inancial (spects of /orporate
?overnance ;the /adbury committee< defines corporate
governance as the system by which companies are directed and
controlled.
2evelopment in corporate governance in the 01 was slow until
the establishment of the /adbury committee in !ay 5@@5 and
the publication of the /adbury Report in 2ecember 5@@6
bounced the topic into the forefront of 01 debate.
!ain issues that have emerged in corporate governance$
trying to ensure a suitable balance of power on the board of
directors
trying to ensure that directors are remunerated fairly
ensuring that the e+ternal auditors remain independent
ma&ing the board of directors responsible for monitoring
and managing ris&
other related issues include business ethics and corporate
social responsibility.
01 practice in corporate governance can be compared to other
systems internationally. 2ifferences arise from the different
traditions under which financial statements are prepared.
0S( practice
S./ imposes quarterly reporting requirements.
(ll listed companies are required to have an audit
committee.
FTC FOULKS LYNCH 11
CHAPTER 3 CORPORATE GOVERNANCE
?erman practice
"arge companies generally have a two)tier board system,
with separate management board and supervisory board.
,an&s providing credit to a company will often hold a
long)term equity sta&e in the company.
Capanese practice
Traditionally companies wishing to do business with each
other will buy shares in each other to symbolise their long)
term relationship. !any companies were therefore
sheltered from the attentions of e+ternal shareholders
requiring dividends and interested in day)to)day matters.
'owever the system of cross)holdings is now reducing.
2 THE DEBATE ON CORPORATE GOVERNANCE IN THE UK
The /adbury Report was published in 2ecember 5@@6,
containing a /ode of ,est 3ractice.
The ?reenbury Report was published in Culy 5@@8. *t builds on
the wor& of the /adbury committee in setting out best practice
in disclosing details of directors remuneration in a companys
annual report.
The 'ampel Report in 5@@9 brought together the previous
recommendations of /adbury and ?reenbury, and submitted a
proposed /ode to the Stoc& .+change which listed companies
should comply with.
The Stoc& .+change published its 3rinciples of good
governance and code of best practice ;&nown as the /ombined
/ode< in Cune 5@@9. (ll listed companies must now disclose in
their annual report and accounts how they have applied the
principles and complied with the /ode.
12 FTC FOULKS LYNCH
CORPORATE GOVERNANCE CHAPTER 3
The /ombined /ode is in two sections.
Section 5 is a code for listed companies and has four parts
dealing with$
directors, including board meetings, roles and balance
directorsD remuneration
the relations of the company with its shareholders
accountability and audit.
Section 6 is a code for institutional shareholders investing
in listed company shares.
The Turnbull Report was published in 5@@@ to publish
guidelines to listed companied on how to apply the 3rinciples
of the /ode.
The 'iggs Report and the Smith Report were published in
677A.
FOCAL POINT
The debate over corporate governance issues is of great importance to
the future of the accounting profession. 1eep up to date with this issue
by reading articles on this topic in the professional press.
FTC FOULKS LYNCH 13
CHAPTER 3 CORPORATE GOVERNANCE
14 FTC FOULKS LYNCH
CHAPTER 4
STRATEGY FORULATION
1 THE THREE LEVELS OF CONTROL
Strategic control E R/., R*, gearing levels.
Tactical control E pricing decisions, cash flow forecasts.
perational control E budgets, variance analysis.
FOCAL POINT
Bote that the strategic level of control relates to the long term whilst
operational control relates to the shorter term. Remember this when
considering the information requirements for each level of control.
2 INFORMATION RE%UIREMENTS FOR FINANCIAL CONTROL&
FORECASTS& DECISION SUPPORT AND MONITORING
2efinition of control.
,udget variances.
Sales variances.
Fariance analysis.
Gou will have met the control process in your earlier studies
and will appreciate the three aspects of$
setting standards as performance guidelines
measuring actual performance
comparing the two and ta&ing corrective action if required.
FTC FOULKS LYNCH 15
CHAPTER 4 STRATEGY FORULATION
3 INFORMATION NEEDS OF SHORT$TERM FINANCIAL
PLANNING
3rojected profit and loss account.
3rojected cash flow statement.
3rojected balance sheet.
Statement of relevant assumptions.
Statement of contingency plans.
#inancing implications.
!ethods of control.
( short)term plan would generally be prepared for the
forthcoming one year period, bro&en down if required into
months or quarters. The cash flow statement, in particular,
would normally be prepared on a month)by)month basis.
4 THE FINANCING OF WORKING CAPITAL
-ithin a business, funds are required to finance both fi+ed and
current assets. The level of current assets fluctuates, although
there tends to be an underlying current asset requirement.
16 FTC FOULKS LYNCH
STRATEGY FORULATION CHAPTER 4

Bet
assets
H
#luctuating
current assets
3ermanent net current
assets
#i+ed assets
Time
The tas& of financial forecasting includes estimating the total
permanent assets over time, and also the li&ely range of
fluctuating assets.
5 MEETING SHORT$ AND MEDIUM$TERM FINANCIAL
OBJECTIVES
The control of cash flows is of &ey interest to the financial
manager, because the forecast financing requirement must be
satisfied. The manager can ta&e early steps to research potential
sources of new finance before a crisis emerges.
6 BUSINESS PLANS
,usiness plans set out how to achieve specific financial
objectives. The plan covers a number of years ;three to five
typically, but could be longer< and is part of the companys
overall strategic plan.
The plan is developed from forecasts$
environmental forecasts
industry forecasts
forecasts for the company itself.
FTC FOULKS LYNCH 17
7 ANALYSING PERFORMANCE THROUGH RATIOS AND OTHER
TECHNI%UES
Ratios are of particular relevance when the performance of the
profit centre and its constituent parts is measured by
comparison with other organisations or parts of the profit
centre.
FOCAL POINT
-hen analysing performance through the use of ratios it is important
to use comparisons. ( single ratio holds little information and is only
of use when compared with other ratios, competitors, and over time.
.valuation of the organisation as a wholeE ratios can be
calculated from data produced by the accounting information
system. Ratios can be used$
to compare results over a period of time
to measure performance against other organisations
to compare results with a target.
1ey ratio used in practice is return on capital employed
;R/.<$
R/. may be termed return on investment ;R*<.
.valuation of parts of the organisation
*f the accounting information system can brea& down parts
of the organisation as investment centres all the ratios used
for evaluation of the performance of the organisation can
be computed and can be used in the same ways.
ther ratios are required for non)investment centres.
18 FTC FOULKS LYNCH
Structure of operating ratios E the pyramid
R/.
perating profit
Sales
perating profit
perating assets
perating assets
Sales perating assets
Sales
Farious cost elements
Sales
or
eg,
3roduction costs
Sales
#i+ed assets
Sales
/urrent assets
Sales
Stoc&
Sales
2ebtors
Sales
/ash
Sales
FOCAL POINT
-hen answering e+am questions it is important not to calculate ratios
at random, nor to calculate too many ratios. Start at the top of the
pyramid and then by using the comparisons mentioned previously,
further analyse the problem areas.
R/. I
577
assets perating
profit perating
J
#i+ed assets may be included in capital employed at various
values.
?ross value ;original cost<$
comparison is facilitated
FTC FOULKS LYNCH 19
if net values are used, R/. increases as an asset ages
because of the reducing capital employed figure in the
denominator
all assets are included, even those that have been fully
depreciated.
Bet value ;net boo& value<$
values after deduction of depreciation are shown in the
balance sheet
profit is ta&en after deductions for depreciation. Therefore,
net asset values should be used for consistency.
?ross profit percentage I
J 577
Turnover
profit ?ross
Should be constant. Fariations due to$

selling prices
sales mi+
items included in purchases ;e.g. trade discounts, carriage<
items included in production cost
stoc& ;obsolescence, shortages<.
(ffected by errors in stoc& valuation.
Stoc& turnover I
stoc& (verage
sales of /ost
(verage stoc& holding period I
days AK8
sales of /ost
stoc& (verage
-here stoc& turnover is high$

20 FTC FOULKS LYNCH
indication of efficiency
danger of stoc&outs.
"ow stoc& turnover indicates funds tied up unnecessarily
/hanges in ratio due to$
improvingLdeteriorating efficiency
changes in management policy e.g. bul& purchases to get
trade discounts.
"imitations$
inclusion of obsolete stoc&
different stoc& valuation policies
average calculation based on beginning and year)end stoc&
may not represent actual average in year.
2ebtor days I AK8
sales /redit
debtors trade end Gear
/hanges due to$

improvingLworsening credit control
major new customer pays fastLslow
change in credit terms
early settlement discounts.
Borm I stated credit terms, e.g. A7 days.
"imitation E are year)end debtors typical of level%
/reditor days I
AK8
purchases /redit
creditors trade end Gear
FTC FOULKS LYNCH 21

'igh or increasing period$
may be good as credit from suppliers represents free credit
if e+cessive, suppliers will not e+tend credit
if e+cessive, may indicate insolvency.
"imitation E are year)end creditors typical of level%
/urrentLwor&ing capital ratio
s liabilitie /urrent
assets /urrent
Borm 6$5 but industry variation.
"ow ratio may indicate insolvency.
'igh ratio may indicate not ma+imising return on wor&ing
capital.
/an be manipulated by window dressing.
"iquidity, acid test or quic& ratio
creditors Short term

cash s investment asset current 2ebtors +
!easures more immediate position ;i.e. e+cludes stoc&<.
Borm 5$5 but industry specific.
/an be manipulated by window dressing.
?earing
capital return #i+ed M reserves and capital .quity

capital return #i+ed
22 FTC FOULKS LYNCH
2enominator could be computed on the assets side of the
balance sheet$
total assets less current liabilities
!ar&et values or boo& values could be used.
'ighly geared company
Substantial proportion of capital is preference shares,
debentures or loan stoc&.
Share price often more volatile.
!ust have stable profits and suitable assets for security e.g.
property investment, hotel industry.
"imitations
2istorted by different accounting policies e.g. treatment of
goodwill, revaluing assets.
Bon)recording of assets e.g. operating leases.
CONTROLLING CASH FLOWS
!ost cash control is carried out by drawing up traditional cash
flow forecasts for future periods.
#orecast surpluses can then be invested until they are required.
#orecast deficits can be managed by changing the timing of
receipts and payments$
offer prompt payment discounts to debtors
delay payments to creditors
defer discretionary purchases
raise new funds e+ternally.
FTC FOULKS LYNCH 23
" STOCK E!CHANGE RATIOS
Such ratios are significant to investors in reaching their
decision of whether or not to increase or reduce their
shareholding in a company$
dividend yield
earnings per share
price earnings ratio.
2ividend yields are generally calculated net of ta+.
1' COMPARING ACTUAL AND E!PECTED PERFORMANCE
'ori=ontal analysis E line by line analysis of current year with
previous year;s<. .+tending the hori=ontal analysis over a
number of years provides trends.
Example
20X3 20X4 % change
Hm Hm
Turnover @85.@ 5,58K.8 M 65.8
/ost of sales K5N .5 NA@ .7 M 5@.9
Fertical analysis
.ach balance sheet item is e+pressed as a percentage of the
balance sheet total.
.ach profit and loss account item is e+pressed as a
percentage of sales ;or earnings<.
Example
Common size statements
20X3 20X4 20X3 20X4
Hm Hm % %
#i+ed assets
"and and buildings 58K.@ 5K@.7 A6.6 A7.:
3lant and machinery 676 .9 6A@ .8 :5 .K :A .6
A8@.N :79.8 NA.9 NA.K
24 FTC FOULKS LYNCH
/urrent assets
Stoc&s, debtors A78.7 A::.7 K6.8 K6.7
/reditors
;due within 5 year< ;5KA.8< ;595.K< ;AA.8< ;A6.N<
/reditors ;due over
5 year< ;5A .8< ;5K .7< ;6 .9< ;6 .@<
:9N .N 88: .@ 577 .7 577 .7
ther techniques$
standard variance analysis
product life cycle analysis
learning curve analysis.
FTC FOULKS LYNCH 25
CHAPTER 5
E!PANSION AN" ARKET AINTENANCE STRATEGIES
1 SHORT$TERM AND LONG$TERM FINANCIAL PLANNING
"ong)term financial planning depends on$
corporate philosophy and mission statement
meeting the shareholders required rate of return
what if analysis on spreadsheets
gap analysis.
FOCAL POINT
-hen answering an e+am question it is important to consider the
firms mission when analysing its performance. *f required, clues as
to the firms mission will be found in the question.
?ap analysis e+amines the difference between a companys
estimated future performance and the managements desired
position.
-ays of closing the gap$
improved internal efficiency
e+pansion within the present industry
diversification into new fields.
The planning e+ercise continues via$
strategic plans
tactical plans
operational plans
FTC FOULKS LYNCH 26
E!PANSION AN" ARKET AINTENANCE CHAPTER 5
STRATEGIES
monitoring deviations of actuals from operational plans.
/ompanies are often accused of favouring short)term
profitability at the e+pense of long)term prosperity. Some of the
reasons are$
reward systems
fear of disappointing the mar&ets
fear of ta&e)over
dominance of accountants ;perhaps< in 01 industry.
2 TOP DOWN AND BOTTOM UP PLANNING SYSTEMS
Top downE senior management announce instructions which
filter their way down through the organisation structure.
,ottom upE information is gathered from lower levels, which is
consolidated until a summary is produced for the board.
"ong)term strategic decisions are ultimately the responsibility
of senior management. They cannot shir& this role.
3 USING BUDGETS TO INFLUENCE THE SUCCESS OF
FINANCIAL PLANNING
"ong)term plans are implemented by developing them into a
series of shorter term plans or budgets.
2efinition of budgets$ a plan e+pressed in money
Gou will have studied budgetary control in previous
e+aminations.
FTC FOULKS LYNCH 27
CHAPTER 5 E!PANSION AN" ARKET AINTENANCE
STRATEGIES
4 THE RELATIONSHIP OF INVESTMENT DECISIONS TO
LONG$TERM PLANNING
Types of investment decision$
internal investments
e+ternal investments
divestments.
*f the long)term planning objective is to ma+imise the wealth of
shareholders, then conventional 2/# analysis can be applied to
investment decisions.
5 ALTERNATIVE STRATEGIES FOR LONG$TERM GROWTH
"ong)term strategies
Survival ?rowth
,y acquisition *nternal
/onservative growth or high growthE high growth is achieved
by rapid diversification into similar mar&ets as well as
completely new mar&ets.
(cquisition diversification.
'ori=ontal diversification.
Fertical diversification ;bac&wards and forwards<.
28 FTC FOULKS LYNCH
E!PANSION AN" ARKET AINTENANCE CHAPTER 5
STRATEGIES
/oncentric diversification.
/onglomerate diversification.
The search for synergy ;6 M 6 I 8<.
FTC FOULKS LYNCH 29
CHAPTER 6
THE VALUATION OF SECURITIES
1 MODELS FOR THE VALUATION OF SHARES AND BONDS
(ll formulae use the fundamental relationship that the value of
a security equals the present value of the e+pected cash inflows
arising from owning the security.
/onstant dividends
3
7
I
&
d
/onstant dividend growth
3
7
I
g k
g) (1 d
0
+
I
g - k
d
1
.stimating g
.+trapolation of past dividends i.e. dividend growth model
e.g.
g I 5
:
ago years : 2ividend d
7

.arnings growth model
g I br> b I
.(*T
d ) .(*T
7
r I
cost historical O equity of value pening
.(*T
FTC FOULKS LYNCH 30
THE VALUATION OF SECURITIES CHAPTER 6
Symbols
& I the shareholders cost of capital
3
7
I e+ dividend mar&et value of equity
d I total annual dividend payment
d
7
I total current dividend
d
5
I total dividend in one years time
g I dividend growth rate
b I retention rate
r I return on reinvested funds
.(*T I earnings after interest and ta+
I .3S number of shares
Botes
Remember that 3
7
is the e+ div mar&et value
.+ div !F I /um div !FE d
7
FOCAL POINT
Throughout the Strategic #inancial !anagement paper the formulae
relating to the valuation of securities and calculation of costs of capital
are based on e+ div security prices. This is because the equations are
formed using discounting theory ta&ing into account flows starting in
one years time.
#or determining g from past dividends, loo& out for the
relevant period e.g. dividend growth over a four year
period will give five dividend figures.
3. ratio I
.(*T
3
7
FTC FOULKS LYNCH 31
CHAPTER 6 THE VALUATION OF SECURITIES
2ividend cover I
d
.(*T
Similar formulae apply for irredeemable bonds as they do
for shares.
32 FTC FOULKS LYNCH
Example
3odge plc has just paid a dividend of 5:p per share. Two years
previously the dividend was 56p per share. The companys
shareholders have a cost of capital of 5KJ. .stimate the fair value
of the share price.
Solution
56 ;5 M g<
6
I 5:
g I 9J
3
7
I
79 . 7 5K . 7
< 79 . 5 ; 5:
I 59@p
Example
The ordinary shares of P plc are quoted at HA e+ div. The dividend
just paid was A7p per share> four years ago the dividend was 68p
per share. .stimate the cost of equity.
Solution
5 M g I
:
68
A7
I 5.7:KK g I :.KKJ
&
e
I
( )
7
7
3
g 5 d +

M g I

A H
7:KK . 5 A7 . 7 H
M
7.7:KK I 58.56KJ
2 LIMITATIONS OF SUCH MODELS
(ssumption of constant future growth rate could be wrong.
*nvestors are assumed to be rational and ris&)averse.
FTC FOULKS LYNCH 33
*gnores asset values.
*gnores earnings values.
*gnores investors different ta+ positions.
FOCAL POINT
(lthough theoretically the correct value of a share is the B3F of its
future income stream, be careful not to ignore other simpler methods
of valuing shares such as calculating a net asset value or using a 3.
ratio ;as e+plained below<. /alculating the values of shares by
different methods may give different valuations, but this e+tra
information is a good thing, not a problem.
3 ACCOUNTING INFORMATION AND SHARE VALUATION
Shares can be valued using
net assets basis
price per share I .3S agreed 3. ratio.
'owever, accounting information is based on the past, whereas
in buying a share one is buying a series of future cash flows.
4 VALUE$BASED MEASURES
.conomic Falue (dded ;.F(< focuses on the concept of
economic income.
!ar&et Falued (dded ;!F(< is the value added to the business
by management since it was formed.
Shareholder Falue (dded ;SF(< represents the discounted
future free cash flows less the value of the companyDs debt.
34 FTC FOULKS LYNCH
5 PRACTICAL INFLUENCES ON SHARE PRICES& INCLUDING
REASONS WHY SHARE PRICES DIFFER FROM THEIR
THEORETICAL VALUES
?ood asset bac&ing i.e. high net asset value per share.
"evel of earnings.
Technical factors e.g. a larger number of sellers than buyers one
day will tend to drive the price down.
/hanges in forecasts ta&ing time to disseminate through the
mar&et.
2istrust of particular management figures e.g. some fund
managers always refused to own shares in companies involved
with Robert !a+well.
6 THE TERM STRUCTURE OF INTEREST RATES (YIELD CURVE)
The term structure of interest rates refers to the way in which
the yield of a debt security varies according to the term of the
security i.e. to the length of time before the borrowing will be
repaid.
Bormally, the longer the term of a security, the higher will be
its gross redemption yield ;i.e. interest yield plus capital gain or
loss to maturity<.
/hec& that this is the case by loo&ing at the 01 ?ilts 3rices
section of the #inancial Times. The redemption yield on shorts
will normally be less than the redemption yield of mediums and
longs.
The yield curve at any time shows the graph of gilts
redemption yields plotted against the term of each gilt.
FTC FOULKS LYNCH 35
7 8 57 58 67 68
8
K
N
9
?ross
redemption
yield ;J<
Gears to maturity
#or e+ample a gilt with five years before redemption could be
e+pected to yield just over 8J pa until redemption, while a 67
year gilt would yield nearly KQJ.
The normal form of yield curve is upwards sloping as shown
in the graph. This can be e+plained by investors liquidity
preference i.e. the fact that investors need to be compensated
with a higher yield for being deprived of their cash for a longer
period of time.
0nusually, the yield curve might become inverted i.e.
downwards sloping. This arises when the e+pectations of
investors generally are that interest rates are going to fall, so
that short)term rates are higher than long)term rates.
( further factor affecting the shape of the yield curve is mar&et
segmentation theory. This suggests that different categories of
investors are interested in different segments of the curve ;e.g.
building societies in the short end and pension funds in the long
end<. The two ends of the curve might therefore react
differently to the same set of economic news.
36 FTC FOULKS LYNCH
#inancial managers should inspect yield curves
primarily to assess the mar&ets e+pectations of future
movements in interest rates.
7 MODELS FOR THE VALUATION OF DEBT AND OTHER
SECURITIES
The principles of valuing debt as the present value of the cash
flows arising are e+actly the same as for shares.
*rredeemable debt
3
7
I
k
I
where 3
7
I e+ int mar&et value of debt
* I interest payments ;net of ta+ if appropriate<
& I the required return ;net or gross of ta+<
Note: *f * is net of ta+, & must be net of ta+.
Redeemable debt
3
7
I present value of interest payments M present value of
redemption amount
/onvertible loan stoc&
*f the option to convert into ordinary shares at tn is e+ercised,
the cost is the *RR of the following cash flows
t
7
;.+ interest mar&et value of debt<
t
5
n *nterest ;5 T<
t
n
!ar&et value of ordinary shares into which the debt is
to be converted
,an& loans and overdrafts
/ost I interest rate ;5 T<
FTC FOULKS LYNCH 37
1ey to symbols above
&
d
I cost of debt
3
7
I e+ interest mar&et value of debt
* I total annual interest payment
T I rate of corporation ta+
Botes
The cashflows for the determination of the cost of
redeemable ;and irredeemable< debt would need to be
adapted if there were a lag in the ta+ relief.
3reference dividends are payable from post)ta+ profits and
therefore should not be reduced by ta+ in the formula.
*f no conversion ratio is given for convertible loan stoc&, it
must be assumed that it will remain as debt.
Falue convertible loan stoc& at the higher of entry value
into equity and value as a straight loan stoc&.
-arrants
Falue at the e+cess of entry value into equity over the current
equity price.
Example
3odge plc has irredeemable 57J debentures. Ta+ is
payable at AAJ and investors continue to require 5KJ
;gross< on their investments. .stimate the fair value of a
H577 debenture.
#air value I
capital of /ost
*nterest
I
5K . 7
57 H
38 FTC FOULKS LYNCH
I HK6.87
Example
The 9J debentures of G plc are quoted at H@8 e+ int and are
redeemable at par in two years time. /orporation ta+ is paid at
AAJ. -hat is the net of ta+ cost of debt%
Solution
The cost of debt is the *RR of the following cash flows.
Time Cash flow Discount factor PV Discount factor PV
H at 0% H at !% H
7 ;@8< 5 ;@8< 5 ;@8<
5 9 7.KN I 8.AK 7.@7@ :.9N 7.@6K :.@K
6 578.AK 7.96K 9N .7A 7.98N @7 .6@
;A .57< 7 .68
The net of ta+ cost of debt to the company is slightly over 9J.
FTC FOULKS LYNCH 39
40 FTC FOULKS LYNCH
CHAPTER 7
INVESTENT "ECISIONS
1 WHAT IS MEANT BY ADE%UATE FINANCIAL RETURN*
*n practice shareholders will have a satisficing objective i.e.
they will see& a satisfactory return from an investment.
Similarly companies will see& a satisfactory return from
projects that they underta&e.
There are several ways in which an adequate financial return
could be measured$
profits
profits per share
R/.
dividends
dividend M capital growth.
This last item is the accepted measure of shareholders wealth.
Since profits can be distorted by the selection of different
accounting policies and by inflation, measures of return based
on cash flows are preferred.
2 THE BENEFITS OF USING NET PRESENT VALUE
The assumed primary corporate objective is generally the
ma+imisation of shareholder wealth. #undamental analysis
implies that shareholder wealth equals the net present value of
cash flows arising. B3F analysis can therefore unite
shareholders and management in a common objective.
FTC FOULKS LYNCH 41
CHAPTER 7 INVESTENT "ECISIONS
FOCAL POINT
The concept that shareholder wealth equals the net present value of
cash flows arising provides the basis for the dividend valuation model.
This concept is fundamental to financial strategy and the valuation of
securities.
ther measures of project return are possible$
"#$antages Disa#$antages
E 3aybac&
3roject investment
(nnual cash flow
.asy to understand *gnores the time
value of money
The number of
years it ta&es to
recoup the initial
investment
0ses earlier cash
flows which are
more certain
0ses cash flows not
profits
0seful measure if
short of cash
*gnores cash
flows after
paybac& period
2ifficulty in
finding a target
period
E (ccounting rate of
return
(verage annual profit 577
3roject investment
J return on
investment in
terms of
accounting profit
.asy to understand
3ercentage result
more acceptable to
management
,usiness is judged
by R* by financial
mar&ets
!anagement often
judged on R*
*gnores the time
value of money
2oes not use
cash flows
(mbiguity over
definitions in
formula
2ifficulty in
finding a target
(RR
42 FTC FOULKS LYNCH
INVESTENT "ECISIONS CHAPTER 7
E Bet present value
/alculate using
formula or tables
(ccept only
projects with
positive B3F or
ran& mutually
e+clusive projects
in order of B3F
0ses the time value
of money
0nambiguous
criteria for
acceptLreject
decision
2irect lin& with
assumed objective
of investment
appraisal
Bot easily
understood by
management
Requires cost of
capital
3 NPV ANALYSIS
B3F is based on cash flows, not profits.
.+clude non)cash flow credits and charges e.g. depreciation.
*gnore sun& costs.
Relevant costs are opportunity costs and incremental cash
flows.
2eal with inflation by either discounting money flows at the
money rate, or real flows at the real rate. 2o not mi+ them up.
FOCAL POINT
*f inflation is affecting different costs at different rates ;as is normally
the case<, then it is much easier to deal with inflation in a 2/#
question by discounting money cashflows at money discount rates.
This is the usual approach in e+am questions.
4 THE MEANING OF THE TIME VALUE OF MONEY
There is a time preference for receiving the same sum of money
sooner rather than later.
FTC FOULKS LYNCH 43
5 REASONS FOR TIME PREFERENCE
/onsumption preference money received now can be spent on
consumption.
Ris& preference ris& disappears on receipt of money.
*nvestment preference money received can be invested
internally or e+ternally.
6 SIMPLE AND COMPOUND INTEREST
Simple interest interest is paid when due and not added to the
capital balance on which subsequent interest will be calculated.
/ompound interest interest is added to the capital outstanding
and it is on this revised balance that interest will be calculated.
/ompounding formula$
S I 3 ;5 M r<
n
where S I final amount
3 I initial investment
r I interest rate for the time period ;usually rate for a
year<
n I number of time periods ;usually number of years<
7 THE MEANING OF PRESENT VALUE
2efinition$ the present value of an amount S receivable in n
years is that sum of money which, invested at the current
annual rate of interest, r, will amount after compounding to S
after the e+piry of n years.
3 I
n
r) + (1
S
44 FTC FOULKS LYNCH
Example
-hat is the present value of H877 in three years when r I 67J%
Solution
3 I
A
< 67 . 7 5 ;
877 H
+
I
N69 . 5
877 H
I H69@
(//( tables show values for
5
5 ; + r<
n for different values of r
and n
r I column headings
n I row headings
Steps to use the tables$
select the appropriate r column
select the appropriate n row
read off the value of the intersection I the present value
factor
multiply the factor by the cash flow I the present value.
Example
0se the (//( present value table to estimate the present value of
H877 in three years at a discount rate of 67J p.a.
Solution
#rom tables, present value factor I 7.8N@ for r I 67J, n I A
3resent value I H877 7.8N@ I H69@ ;as before<
FTC FOULKS LYNCH 45
ESTIMATION OF IRR AND NPV OF A PROJECT AND
RECOMMENDATION OF PROJECT ACCEPTANCE OR
REJECTION
Bet present value$ the net amount of all cash flows associated
with the project discounted bac& to the beginning of the project.
*nternal rate of return ;*RR<$ that discount rate which gives a
net present value of =ero to a projects cashflows.
*nvestment decisions$
*RR E if the *RR on the project is greater than the cost of
capital E accept
B3F E if the present value of cash inflows less cash
outflows is positive when discounted at the cost of capital E
accept.
Example
( project requires an initial investment of H5,777 and generates
cash inflows of HA77, H:77 and H877 respectively during Gears 5,
6 and A of its life. The cost of capital is currently 57J p.a. Show
whether the project should be accepted$
;i< by calculating the B3F of the project
;ii< by estimating the *RR of the project.
Solution
;i< Time Cash flow Discount factor Present $alue
H at 0% H
7 ;5,777< 5 ;5,777<
5 A77 7.@7@ 6NA
6 :77 7.96K AA7
A 877 7.N85 AN8
;66<
The project has a negative B3F so should be rejected.
46 FTC FOULKS LYNCH
;ii< 57J is too high a discount rate. Try a smaller one, say 8J.
;iii< Time Cash flow Discount factor Present $alue
H at %% H
7 ;5,777< 5 ;5,777<
5 A77 7.@86 69K
6 :77 7.@7N AKA
A 877 7.9K: :A6
95
*nterpolating between the two,
*RR 8J + ( )

+
J 8 57
66 95
95
I 9.@J
Since the *RR is less than the cost of capital, the project should be
rejected.
" THE MEANING OF AN ANNUITY
(nnuity$ 2efinition E a cash receipt, received each year,
starting at Gear 5, for a series of years.
Falued according to the (//( cumulative present value tables.
3erpetuity$ 2efinition E an annuity to be received indefinitely.
3resent value of a perpetuity I
r
a
where a I annual amount receivable
r I discount rate
*RR of a perpetuity I
3
a
where a I annual amount receivable
3 I initial investment at time 7
FTC FOULKS LYNCH 47
Example
( project requires an initial investment of H5,777 and generates
an annual cash inflow of H587 for the ten years of its life. The
cost of capital is currently 57J p.a.
;i< Recommend whether the project should be accepted by
calculating its B3F.
;ii< *f the project generated H587 p.a. in perpetuity rather than
only for ten years, would this change your recommendation%
Solution
;i< B3F I H5,777 + ;H587 K.5:8<
I HN9
Since the projects B3F is negative, it should be rejected.
;ii< Revised B3F I H5,777 +
5 . 7
587 H
I H877
Since the projects B3F is now positive, it should be
accepted.
1' THE EFFICIENT MARKETS HYPOTHESIS
-ea& form E share prices reflect all the information contained
in the record of past prices. (s a result it is not possible to
predict future share price movements by reference to past
trends. Share prices follow a random wal&.
Semi)strong form E share prices also reflect all current publicly
available information. Therefore prices will change only when
new information is published. (s a result it would only be
possible to predict share price movements if unpublished
information were &nown ;insider dealing<.
48 FTC FOULKS LYNCH
Strong form E share prices reflect all information that is
relevant to the company.
*f this is the case then share price movements can never be
predicted.
?ains through insider dealing are not possible because
shares are priced absolutely fairly.
FOCAL POINT
*t is generally believed that the 01 stoc& mar&et is at least semi)
strongly efficient, although the sudden corrections of ctober 5@9N
and 5@@N offered a serious challenge to this belief.
11 THE MEANING OF MARKET EFFICIENCY
2efinition
(n efficient mar&et is one in which the mar&et price of all
securities traded on it reflects all the available information.
*f this is correct, a companys real financial position, with
respect to both current and future profitability, will be
reflected in its share price.
*mplications of .!'
!ar&ets have no memory E the pattern of past price
changes contains no information about future changes.
Trust mar&et prices E in an efficient mar&et they reflect all
available information and are fairly valued.
There are no financial illusions E investors are concerned
only with the companys cash flows i.e. changes in
accounting or dividend policies are irrelevant.
The do)it)yourself alternative E mergers are often
justified on the basis that they result in a more diversified
FTC FOULKS LYNCH 49
and more stable firm, but investors can achieve their own
diversification by holding different securities.
Seen one share, seen them all E investors buy a share
because it offers a fair return for its ris&, not for any
specific qualities. Therefore shares should be close to
perfect substitutes for each other such that if the return on
one is too low relative to its ris&, nobody will want to hold
that share, and vice versa if the return is too high.
Reading the entrails E since mar&et prices reflect all
available information, a study of their detailed build up
may be used to ma&e predictions about the future.
FOCAL POINT
The efficient mar&ets hypothesis should be thought of as a scale of
mar&et efficiency. .fficiency is measured in relation to the degree of
relevant information reflected in the share price. (s with many
measurement scales, the e+tremes may not be observed in the real
world.
50 FTC FOULKS LYNCH
CHAPTER
PORTFOLIO THEORY
1 INTRODUCTION TO PORTFOLIO THEORY
3ortfolio diversification reduces ris&. *nvestors are assumed to
be ris& averse, so diversification pleases investors by offering
e+pected returns at lower ris& than individual securities.
The better the negative correlation between the investments, the
better the diversification ;e.g. umbrellas and ice cream<.
2 RISK AND RETURN OF PORTFOLIOS
Two security portfolios$
return I weighted average of individual security returns
ris& is not equal to weighted average of individual security
standard deviations ;unless perfectly positively correlated<
;anything less than perfect positive correlation results in
ris& reduction<.
#ormulae
Fariance, Far I p;+ ) +<
6
Standard deviation, I
var
.+pected value,
+
I
p+
/ovariance, /ov
+y
I
) y - )(y x - p(x
or I
n
y x n. - xy
FTC FOULKS LYNCH 51
CHAPTER 8 PORTFOLIO THEORY
/orrelation, /or
+y
I
y x
y x,
Covariance

or I
)
y
)(
x
n(
y x n - xy

Return on a two asset portfolio,

, ( ( ( p
r < + ) ;5 M r + I r
Ris& of a two asset portfolio,
B A AB A A
2
B
2
A
2
A
2
A
Cor ) x 1 ( x 2 ) x 1 ( x = + +
p
where +
(
is the proportion of investment ( in the portfolio
5+
(
is the proportion of investment , in the portfolio
r
p
is the e+pected return from the portfolio
(
r
is the e+pected return of investment (
,
r
is the e+pected return of investment ,
p
is the standard deviation of the returns from the

portfolio
(

investment (
,

investment ,
/or
(,
is the correlation between the returns of investments
( and ,
Example
52 FTC FOULKS LYNCH
PORTFOLIO THEORY CHAPTER 8
*nvestment ( has an e+pected return of 58J and variance of
5AJ, while investment , has an e+pected return of 56J and
variance of 56J. Their covariance is A.
FTC FOULKS LYNCH 53
/ompute the return and ris& of portfolios of investments (
and , when the proportions of the total amount invested are
as follows$
*nvestment$ ( ,
;a< 3roportion$ 7.6 7.9
;b< 3roportion$ 7.N 7.A
Solution
;a< +
(
I 7.6
r
p
I ;7.6 58J< M ;7.9 56J<
I 56.KJ
Far
p
I ;7.6
6
5A< M ;7.9
6
56< M ;6 7.6 7.9
A<
I @.5K
p
I
I A.7AJ
;b< +
(
I 7.N
r
p
I ;7.N 58J< M ;7.A 56J<
I 5:.5J
Far
p
I ;7.N
6
5A< M ;7.A
6
56< M ;6 7.N 7.A
A<
I 9.N5
p
I
I 6.@8J
FOCAL POINT
Bote the following important results$
-hen /or
(,
I M5, the ris& of the two asset portfolio becomes the
weighted average of the ris&s of each asset.
-hen /or
(,
I 7, the final term in the
p equation is eliminated.
54 FTC FOULKS LYNCH
/or
(,
affects the ris& of the two asset portfolio and not the return.
(s +
(

in the above e+ample varies from 7 to 5, we can prepare a
graph of the possible ris&)return combinations available from
holding a portfolio comprising proportions of ( and ,.
6 A :
+
+
+
+
pportunity set of all
portfolios possible from
combining investments ( and ,
all (
all ,
Return
;J<
58
5A
55
+ I 7.N
(
+ I 7.6
(
Ris& ;standard deviation J<
3 MEAN$VARIANCE EFFICIENCY& EFFICIENT PORTFOLIOS AND
THE EFFICIENT FRONTIER
.+pected
return
*ncreasing
utility
.fficient frontier
pportunity
set
Standard deviation
FTC FOULKS LYNCH 55
( portfolio is mean)variance efficient if it offers the ma+imum
return for a given level of ris&, or the minimum ris& for a given
level of return.
(ll efficient portfolios lie on the efficient frontier.
4 UTILITY AND ITS IMPORTANCE TO PORTFOLIO SELECTION
*nvestors are each assumed to be trying to ma+imise their own
personal utility. *ndifference curves can be drawn for a
particular investor showing combinations of ris&s and returns
that offer that investor equal satisfaction i.e. equal utility. (n
investor will therefore choose the portfolio on the efficient
frontier which cuts the highest indifference curve on the graph
to ma+imise his utility.
.+pected
return
*ncreasing
utility
.fficient
ptimal portfolio
Ris& ;standard deviation<
frontier
*ndifference
curves
5 PORTFOLIO SELECTION WHEN BOTH RISKY AND RISK FREE
ASSETS ARE AVAILABLE
/ombining a ris& free asset with a single ris&y asset is a special
case of the two asset portfolio considered earlier, where one of
the assets has a certain return and =ero standard deviation. The
efficient frontier is then the straight line joining the ris& free
asset and the ris&y asset i.e. there is a straight)line trade)off
between return and ris&.
56 FTC FOULKS LYNCH
-hen a ris&)free asset is combined with many ris&y assets, the
conclusion emerges that there is only ris&y portfolio worth
considering, comprising the whole mar&et portfolio !. The
portfolio selection therefore simplifies to selecting the optimal
point along the capital mar&et line.
!
#
R
f
R
m
m
Standard deviation
.+pected
return
/!"
/apital mar&et line I

new efficient frontier I
mar&et price of ris&
R
f I
ris& free rate
R
m
I return on
mar&et portfolio
m
I on mar&et
portfolio
(ppro+imations in practice
R
f

could be estimated as the return available from Treasury
,ills.
R
m
could be estimated as the return available from a world
inde+ such as the #TLSR3 -orld *nde+.

m

could be estimated as the standard deviation observed
on a world inde+ such as the #TLSR3 -orld *nde+.
.quation of /!"$
R
j
I R
f
M
;R R < m f j
m

Slope I The mar&et price of ris& and

R
j I required return for portfolio f which lies on the /!".
FOCAL POINT
FTC FOULKS LYNCH 57
The introduction of ris& free securities results in all portfolios inside
the original opportunity set becoming relatively inefficient. 'igher
returns for each level of ris& can be achieved by investing in a
combination of ris& free securities and the mar&et portfolio and hence
moving on to the /!".
*nvestors can choose a combination of ris& free securities ;e.g.
government)bac&ed Treasury ,ills< and ris&y securities ;the
whole stoc& mar&et<. The straight line #! and beyond is their
efficient frontier.
Example
(n investor has H577 to invest. The following information is
available$
R
!
I 58J ;Return on portfolio !<
!
I 57J ;Ris& of portfolio !<
R
f
I KJ ;Ris&)free rate of return<.
You are required to plot the capital mar&et line and show that a
lending portfolio ;of H87 invested at the ris&)free rate and H87
invested in portfolio !< and a borrowing portfolio ;of H87
borrowed at ris&)free rate and H587 invested in portfolio !< lie on
this line.
Solution
To calculate portfolio returns we can treat the two investment
opportunities as a two)asset portfolio, hence$
r I + r M ;5) + <r
p ( ( ( ,

p
I + + + + /or
( ( ( , ( ( (, ( ,
6 6 6 6
5 6 5 + + ; < ; <
58 FTC FOULKS LYNCH
Lending portfolio
R
p
I 7.8 58J M 7.8 KJ
I 57.8J
p
I
0) 0.5 0.5 (2 + 0) (0.5 + ) 10 (0.5
2 2 2

I
2 2
10 0.5
I 8J
Borrowing portfolio
Bote: 587J of original sta&e is invested in !, 87J is borrowed.
R
p
I ;5.8 58J<;7.8 KJ<
I 5@.8J
p
I
5.8 57
6 6
I 58J
;This shows that gearing up equity portfolios is a profitable but
ris&y business.<
( graph can then be drawn showing that the returns and ris&s
calculated for the portfolios above lie on the /!".
6 THE NATURE AND SIGNIFICANCE OF THE CAPITAL MARKET
LINE
The line joining the ris& free rate ;point #< to a portfolio of all
quoted shares ;point !< and beyond is called the /apital
!ar&et "ine. *t is the efficient frontier comprising efficient
combinations of ris& free and ris&y investments. *ndividual
investors should select the point along this line at which their
utility is ma+imised.
FTC FOULKS LYNCH 59
7 PORTFOLIO THEORY AND PRACTICAL FINANCIAL
MANAGEMENT
3roblems
Beed to assess the ris&Lreturn preferences of shareholders.
3ortfolio theory is only a single time period model.
#orecasting returns and the correlations between returns is
difficult.
'owever it is valuable for managers to appreciate the benefits
of diversification, especially in unquoted companies where the
shares might comprise a large proportion of the shareholders
wealth. "arger companies should not be so &een on
diversification, since their shareholders can become diversified
by buying a selection of shares in different companies rather
than relying on the companies themselves being diversified.
+IMITATIONS OF PORTFOLIO THEORY
3roblems mentioned above.
!easuring ris& as the standard deviation of e+pected returns is
not the whole story> there are other costs ;e.g. the ris& of
ban&ruptcy< associated with high ris& investment strategies.
60 FTC FOULKS LYNCH
FTC FOULKS LYNCH 61
CHAPTER "
THE CAPITAL ASSET PRICING O"EL
1 SYSTEMATIC AND UNSYSTEMATIC RISK
Total
3ortfolio
Ris&
0nsystematic ris&
;unique ris&<
Systematic ris&
;mar&et ris&<
58)67
random securities
securities
Bumber of random
5 security
Systematic ris& depends on the mar&et as a whole.
0nsystematic ris& is unique to each companys shares.
0nsystematic ris& can be eliminated by holding a diversified
portfolio.
FOCAL POINT
This distinction between systematic and unsystematic ris& is vital to
the /apital (sset 3ricing !odel ;/(3!<. The assumption that return
is only required to compensate for systematic ris& is fundamental to
the model. /ontrast this with portfolio theory which considers only
total ris&.
FTC FOULKS LYNCH 62
THE CAPITAL ASSET PRICING O"EL CHAPTER 9
2 THE SECURITY MARKET LINE
nly systematic ris& commands returns in an efficient mar&et.
*n /(3! systematic ris& is measured by an inde+ called .
Ris&)free assets have a of =ero. The mar&et as a whole has a
of one. The systematic ris& of all other securities is measured
by reference to these values.
R
f
R
m
Systematic ris&,
.+pected
return
I 5
Security mar&et
line ;S!"<

.quation of S!"
R
j
I R
f
M ;R
m
R
f
<
3 ESTABLISHING BETA FACTORS FOR INDIVIDUAL SECURITIES
-e need to determine future factors for each individual
company ;in order to appraise future investments<. *n practical
terms we will content ourselves with establishing past s and
use these to appraise required returns on fresh investment
projects.
The normal way of measuring s is to use regression analysis.
The following diagram gives a graphical representation of this
analysis.
FTC FOULKS LYNCH 63
CHAPTER 9 THE CAPITAL ASSET PRICING O"EL
!ar&et returns
R
m
Security
returns R
y
3ast relationship between returns on the mar&et
portfolio and returns on security y
Slope I

The slope of the line gives the securitys factor. 'ere the line
is very steep and the factor will be greater than 5.7.
*f we performed similar analysis for another security we might
obtain the following results.
R
m
3ast relationship between returns on security =
and returns on the mar&et portfolio
Security
returns
!ar&et returns
R
=
64 FTC FOULKS LYNCH
*n this case security = is of a low degree of systematic ris& as it
is far less volatile than the mar&et portfolio. *ts beta factor will
be less than 5.7.
4 ALPHA FACTORS AND BETA FACTORS
*ntercept I
;R
j

R
f
<
Security characteristic line
Slope I
the steeper the characteristic line,
the more volatile the return, the
higher the systematic ris&
should equal =ero. *f not it will be
quic&ly competed away
Spread of
observations
I non
systematic
ris&
:
;R
m

R
f
<
FOCAL POINT
Bote the differences between the a+es of the security mar&et line
graph and the security characteristic line graph. This is a common
cause of confusion.
By regression
Slope of line I
j
I
cov
Far
jm
m
I
/or
jm

j m
m
6
FTC FOULKS LYNCH 65
I
/or
jm
j
m
I the abnormal return i.e. the return observed greater than
that forecast by /(3!. Sometimes also called the rate of price
appreciation.
I a measurement of the systematic ris&.
5 PROBLEMS OF USING HISTORIC DATA, STABILITY OF BETA
OVER TIME
,eta is calculated statistically from past observed returns.
The longer the period inspected, the better.
The more data inspected, the better, so perhaps use a sector
average rather than just one companys .
,eta will only be stable if the companys systematic ris&
remains stable i.e. the company carries on the same areas of
business E research indicates that betas are more or less
constant over time.
6 THE ASSUMPTIONS OF CAPM
Total ris& can be split between systematic ris& and unsystematic
ris&.
0nsystematic ris& can be completely diversified away.
( ris& free security e+ists.
,eta values remain constant throughout time.
FOCAL POINT
66 FTC FOULKS LYNCH
/onsiderable research has been underta&en into the movement of
company beta values over time. The assumption of constant beta
values has been found to be fairly realistic as betas, although not
absolutely constant, have been shown to move only slowly.
7 THE USES OF THE MODEL IN FINANCIAL MANAGEMENT
/(3! enables a required discount rate to be calculated for
capital investment projects on the basis of the projects
systematic ris&.
/(3! can be used to tailor ma&e discount rates to the
systematic ris& of projects which differ from the current
business ris& of the firm.
R
m
/onstruction industry
Return
S!"
Tobacco industry
7.9 5.6
5

,etas for project appraisal can be obtained by$
using s of companies operating in similar areas to the
proposed project.
forecasting project returns and mar&et returns, and
calculating a project from first principles.
-arning E when using betas from other firms, care must be
e+ercised to ensure they are as similar as possible to the project.
-atch out for differences in si=e, operating gearing and
financial gearing.
FTC FOULKS LYNCH 67
Bote that differences in financial gearing can be adjusted for by
using ! R ! equations ;see later<.
/(3! enables a companys cost of equity to be estimated from
the equation
&
e
I r
f
M
equity
;r
m
E r
f
<
where
equity
is the observed beta of the shares in question.
/(3! enables the performance of fund managers to be
assessed to see if their actual return e+ceeded the return
e+pected from the model.
Example
Tussac plc is an all equity company with a cost of capital of 58J
p.a.
*t wishes to invest in a project with an estimated beta of 5.6. *f r
f
I
57J and r
m
I 59J, what is the minimum required return of the
project%
Solution
The firms cost of capital is probably irrelevant because the new
project almost certainly has ris& characteristics different from the
firms e+isting operations.
0sing the project beta, its minimum required return is 57J M ;9J
5.6< I 5@.KJ.
THE LIMITATIONS OF THE CAPM MODEL
Fiews income and capital returns as equally attractive.
FOCAL POINT
The differences between the impact of ta+ation on income and capital
returns have lessened in the 01. 'owever, differences still remain and
will affect the requirements of the investor.
68 FTC FOULKS LYNCH
*gnores unsystematic ris&, which may be of interest to investors
who do not hold a diversified portfolio.
*s a single period model.
-hat rate to choose for r
f
%
-hat to choose%
*n practice the basic /(3! appears not to wor& accurately for
investments with very high or very low betas, overstating the
required return for high beta securities and understating the
required return for low beta securities. 'owever this problem
mostly disappears when the effects of ta+ation are introduced to
develop the basic model.
Similarly, /(3! does not seem to generate accurate forecasts
for returns for companies with low 3.s, and ignores seasonal
effects. #or e+ample, !ay is usually a bad month for the stoc&
mar&et ;sell in !ay and go away< while Canuary is a good
month. Such anomalies cannot be justified by /(3!.
" ALTERNATIVES TO THE CAPITAL ASSET PRICING MODEL
/(3! suffers from a number of problems, theoretical as well
as practical, so researchers have sought other relations for the
e+pected return on a share.
/(3! is a single inde+ model
r
s
I r
f
M ;r
m
E r
f
<
where a securitys e+pected return is a function of only one factor,
the beta value.
FTC FOULKS LYNCH 69
(rbitrage pricing theory ;(3T< is a multi)inde+ model
r
s
I a M b
5
f
5
M b
6
f
6
M ...
a, b
5
, b
6
, .. are constants
f
5
, f
6
, .. are the various factors which influence share returns
#or e+ample f
5
could be the return on the mar&et ;as in /(3!<, f
6
could be an industry inde+, f
A
an interest rate inde+ etc.
(rbitrage profits e+ist when profits can be made at no ris& at all
e.g. better returns are available from a different portfolio at the
same level of ris&.
(3T states that when no further arbitrage profits are possible,
the e+pected return from a security is given by$
r
s
I r
f
M
5
;r
5
E r
f
< M
6
;r
6
E r
f
< M ...
where r
f
I the ris& free rate
i
I constants e+pressing the securitys sensitivity to
each factor
r
i
I the e+pected return on a portfolio with unit
sensitivity to factor i and =ero sensitivity to any
other factor
The model was proposed by Ross in 5@NK but has not yet been
developed into anything of practical use. #urther wor& is
continuing to identify$
the factors affecting security prices
methods of estimating r
f
and the
i
.
70 FTC FOULKS LYNCH
FTC FOULKS LYNCH 71
CHAPTER 1'
THE COST OF CAPITAL
1 THE COST OF E%UITY USING THE CAPM AND DIVIDEND
VALUATION MODELS
The formulae use the same fundamental analysis as in the
valuation of securities above.
/ost of equity
/onstant dividends
&
e
I
d
3
7
/onstant dividend growth
&
e
I
d 5 g<
3
7
7
; +
M g I
d
3
g
5
7
+
where &
e
I the cost of equity
3
7
I e+ div mar&et value of equity
d I total annual dividend payment
d
7
I total current dividend
d
5
I dividend in one years time
g I dividend annual growth rate, estimated either
by e+trapolating the previous observed growth
rate, or by the earnings growth model g I rb.
FOCAL POINT
The above equations are provided in the e+am although the notation
used may differ slightly. Bote that d
7
;5 M g< reflects the dividend to be
paid in one years time and that therefore 3
7
is the ex div mar&et value
of equity.
FTC FOULKS LYNCH 72
THE COST OF CAPITAL CHAPTER 10
Bote also that it does not matter whether d and 3
7
are &er share or
total figuresE so long as you are matching li&e with li&e. /apital
asset pricing model
&
e
I r
f
M
equity
;r
m
E r
f
<
where r
f
I ris& free rate
r
m
I e+pected return on mar&et portfolio
equity
I company ;equity<
2 THE COST OF REDEEMABLE AND IRREDEEMABLE DEBT
*rredeemable debt
&
d
I
0
!) - I(1
where * I annual interest
3
7
I mar&et value of debt ;e+ interest<
Redeemable debt
&
d
of loan stoc& redeemable at t
n
is the internal rate of return of
the following cash flows ;assuming ta+ relief is immediate<
t
7
;.+ *nterest !ar&et 3rice<
t
5
n
*nterest ;5)T<
t
n
Redemption price
FOCAL POINT
Bote that as with the formula for the cost of equity above the first
return is received at t
5
. Therefore as for equity, the security price is e+
interest.
3reference share capital
FTC FOULKS LYNCH 73
CHAPTER 10 THE COST OF CAPITAL
#i+ed dividend ;cf irredeemable debt<
/ost of preference share capital I
"# dividend $x
dividend Ann%a&
/onvertible loan stoc&
*f the option to convert into ordinary shares at t
n
is e+ercised, the
cost is the *RR of the following cash flows
t
7
;.+ interest mar&et value of debt<
t
5
n
*nterest ;5 T<
t
n
!ar&et value of ordinary shares into which the debt is to
be converted.
,an& loans and overdrafts
/ost I interest rate ;5 T<
Symbols
&
d
I cost of debt
3
7

I e+ interest mar&et value of debt
* I total annual interest payment
T I rate of corporation ta+
Botes
The cash flows for the determination of the cost of
redeemable ;and irredeemable< debt would need to be
adapted if there were a lag in the ta+ relief.
3reference dividends are payable from post)ta+ profits and
therefore should not be reduced by ta+ in the formula.
*f no conversion ratio is given for convertible loan stoc&, it
must be assumed that it will remain as debt.
74 FTC FOULKS LYNCH
3 WEIGHTED AVERAGE COST OF CAPITAL
#ormula for -(//
& I &
e
' + $
$
M &
d

' + $
'
Botes
*n this formula &
d
is the after)ta+ cost of debt. *f &
d
were
to represent the before)ta+ cost of debt, the -(// formula
would be rewritten$
& I &
e

2 .
.
+
M &
d ;5E T<
2 .
2
+
The -(// formula may be e+panded to incorporate other
forms of financing, based on the respective mar&et values.
FOCAL POINT
Bote that in the -(// formula the costs of capital are weighted
using their respective mar&et values and not their nominal values. This
is because, as can be seen from the formulae for each category of
security, costs of capital are lin&ed to mar&et values.
Example
4 plc has 8m ordinary H5 shares quoted at H5.67, 6m preference
shares quoted at K7p and H5m debenture stoc& quoted at H97. The
cost of capital of each of these securities has been calculated as
67J, 57J and 9J respectively. /alculate the weighted average
cost of capital, ignoring ta+.
Solution
Total mar&et value I ;8m H5.67< + ;6m H7.K7< + ;5m H7.97<
I H9m
FTC FOULKS LYNCH 75
-(// I
( )
)
) . 0
( 10
)
2 . 1
( 20
)
*
I 5N.AJ
-hen should -(// be used%
/ompanys funds can be viewed as a pool of resources.
Bew project is financed from this pool.
-hen not applicable%
3rojects with different business ris& to company.
3rojects with different finance ris& i.e. financed in a
different way from the company.
3roject specific finance e.g. government subsidy or grant.
/alculation difficulties are discussed below.
/alculating the cost of equityE dividend valuation model
Falidity of share price I discounted value of future
dividends.
/urrent share price must be in equilibrium.
Falidity of constant dividends or constant growth of
dividends.
2etermination of g.
FOCAL POINT
Bote that g is either calculated using e+trapolation of past dividend
payments or the rb model. ,oth techniques are based on historic
figures. The resultant growth rate is then used as an estimate for the
future and therefore may be inaccurate.
76 FTC FOULKS LYNCH
/alculating the cost of equity E capital asset pricing model
See /(3! section above.
/alculating the cost of debt
Falidity of mar&et value I discounted future cash flows.
/urrent mar&et value must be in equilibrium.
/alculating the cost of convertible loan stoc&
-ill it be converted into shares%
2etermination of mar&et value of shares at conversion date.
/alculating the cost of ban& loansLoverdrafts
Fariable interest rates.
( general difficulty is the distinction between short)term and
permanent finance e.g. overdraft E if only for wor&ing capital,
do not include in -(//.
4 THEORIES OF GEARING
perating gearing I
+a&e+ in c,ange (
$BI! in c,ange (
higher fi+ed costs, higher operating gearing
Example
( firm has fi+ed costs of H5m p.a. and variable costs equal to
97J of sales values. *f sales increase from H57m to H55m,
calculate the operating gearing.
Solution 'ales of (0m 'ales of (m
Hm Hm
Sales 57 55
FTC FOULKS LYNCH 77
Fariable costs ;9< ;9.9<
#i+ed costs ;5< ;5<
.,*T 5 5 .6
perating gearing I 2
( 10
( 20
=
#inancial gearing
/apital$
' + $
'
or
$
'
could also be based on boo& values
*ncome$
e+- 'e.- in-er
$BI!
;I *nterest cover<
The traditional view of gearing
ptimal
capital
structure
/ost of
capital J
?earing
2
.
&
e
&
d
-(//
FOCAL POINT
78 FTC FOULKS LYNCH
Bote that the cost of debt will rise at very high levels of gearing. This
is because although interest payments are contractual, and therefore
certain, at high levels of borrowing the firms ability to meet its
obligations becomes uncertain.
The traditional view of gearing states that there is an optimal
gearing level at which the overall -(// is a minimum, and the
overall mar&et value of the firm is ma+imised.
ptimal
capital
structure
Falue
of firm
?earing
2
.
!ar&et value
of debt and
equity
!odigliani and !iller 3roposition * ;5@89<
(ll companies with the same earnings in the same ris&
class have the same future income stream and should
therefore have the same value, independent of capital
structure.
This first proposition assumes =ero ta+ation. Such an
assumption is rela+ed in the later propositions.
'owever, 3roposition * leads to the following graph
and formulae.
FTC FOULKS LYNCH 79
;i<
/ost of
capital J
?earing
2ebt
.quity
&
e
&
d
-(//
;ii< 3roposition *
-ithout ta+
F
g
I F
u
&
eg
I&
eu
M
2
.
;&
eu
)&
d
<
-(//
g
I-(//
u
where F I Falue of firm ;F
g
I value of geared firm, F
u
I
value of ungeared firm<
&
e
I /ost of equity ;&
eg
I cost of equity in geared
firm, &
eu
I cost of equity in ungeared firm<
&
d
I /ost of debt ;must be gross of ta+<
2 I !F of debt
. I !F of equity
(ssumptions
*nvestors are rational.
80 FTC FOULKS LYNCH
*nvestors have the same view of the future.
3ersonal and corporate gearing are perfect substitutes.
FOCAL POINT
!odigliani and !illers theory assumes that individuals are able to
borrow funds at the same interest rate as that offered to companies.
This can be observed in their arbitrage proof.
*nformation is freely available.
Bo transaction costs.
Bo ta+.
#irms can be grouped into similar ris& classes.
The arbitrage proof, which incorporates these assumptions,
can be used to support the !R! 3roposition *.
!odigliani and !iller 3roposition ** ;5@KA<
The values of companies with the same earnings in the
same ris& class are no longer independent. /ompanies with
a higher gearing ratio have a greater net future income
stream and therefore a higher value.
FTC FOULKS LYNCH 81
;i<
/ost of
capital J
?earing
2ebt
.quity
&
e
&
d
; <
-(//
;ii< 3roposition ** -ith ta+
F
g
I F
u
M 2t
&
eg
I &
eu
M;5)t<
2
.
;&
eu
E&
d
<
-(//
g
I -(//
u
;5E
2t
2M .
<
FOCAL POINT
This final equation ;for -(//
g
< is included in the formula sheet
provided in the e+amination.
(s gearing increases, the -(// steadily decreases.
Bote that the without ta+ formulae are simply a special
case of the with ta+ formulae with t I 7.
82 FTC FOULKS LYNCH
FOCAL POINT
ccasionally the hori=ontal a+is of the !odigliani and !iller graphs
use
.quity M 2ebt
2ebt
as a measure of gearing.
(lthough this alters the gradients of the lines it does not alter their
theory.
Theory E (rbitrage proof in a world with
corporation ta+es
(ssume two companies, identical in every aspect e+cept ?
is financed by H5,777 of 57J irredeemable debt. The ! R
! assumptions listed above still hold apart from
corporation ta+ is now A8J.
The traditional view of the two companies could be$
) *
H H
.,*T 877 877
*nterest ) ;577<
877 :77
Ta+ ;A8J< ;5N8< ;5:7<
2ividends A68 6K7
/ost of equity &
e
67J 6KJ
H H
Falue of equity ;.< 5,K68 5,777
Falue of debt ;2< ) 5,777
Falue of firm ;F< 5,K68 6,777
-(// 67J 5K.68J
Suppose that an investor owns 57J of ?s equity ;income H6K<.
'e should arbitrage i.e.
sell his sta&e in ? for H577
FTC FOULKS LYNCH 83
adopt the same financial ris& as ? by borrowing a
proportional amount at 57J I H5,777 57J ;5E7.A8< I
HK8.
FOCAL POINT
!odigliani and !illers theories assume that investors are both
rational and ris& averse. Therefore once the investor has sold his
original sta&e in the geared firm, he would wish to maintain the
gearing ris& by obtaining ;or substituting< personal borrowing prior to
investing in the ungeared firm.
,uy 57J of 0s equity for H5K6.87 to give the same
income as before i.e.
H
2ividends from 0 A6.87
*nterest on loan ;K .87<
*ncome 6K .77
,ut$ investor has spare funds ;H577 M HK8E H5K6.87 I H6.87<
which can be invested elsewhere to increase his income for
the same level of ris&
Result E mar&et pressure will quic&ly compete away this
money machine. ;?s equity will fall in price, 0s equity
will rise.< (ssuming ;for convenience< all the price
changes are concentrated on ? this will give an equilibrium
value of equity of H@N8 ;5K6.87E K8 I H@N.8 for 57J< and
a value of the firm of H5,@N8 for ?.
84 FTC FOULKS LYNCH
5 RELEVANCE OF THE COST OF CAPITAL FOR UNLISTED
COMPANIES AND PUBLIC SECTOR ORGANISATIONS
0nlisted companies
Bo e+ternal share price e+ists, so no cost of capital can be
directly calculated or beta estimated.
2ividends are li&ely to be manipulated each year
depending on shareholders personal ta+ positions.
,est method to estimate the cost of capital is to ta&e the
cost of a similar listed company and add a ris& premium.
3ublic sector organisations
The government sets a discount rate in real terms against
which all large public sector projects are appraised.
'owever there are significant non)financial costs and
benefits from most public sector projects which must also
be ta&en into account. This is usually done as part of a
formal cost benefit analysis e+ercise.
6 PRACTICAL PROBLEMS IN ESTIMATING AN APPROPRIATE
DISCOUNT RATE
The practical problems have been introduced above. The ne+t
chapter will develop the idea that a companys -(// can only
be used directly to appraise new projects if$
the gearing ratio is unchanged by the project
the project is of the same ris& class as the whole company.
,oth of these assumptions are li&ely to be at least
appro+imately valid in the majority of cases.
FTC FOULKS LYNCH 85
CHAPTER 11
FURTHER ASPECTS OF THE COST OF CAPITAL
1 CAPITAL STRUCTURE AND HIGH GEARING
3roblems associated with high levels of gearing
The !R! proposition ** suggests that companies should
aim to ma+imise their gearing in order to ma+imise the
value of the business. 'owever in practice problems arise
as gearing levels increase. #our new e+pected costs can be
identified.
F
g
I F
u
M 2t ) ,an&ruptcy
costs
;5<
) (gency
costs
;6<
) Ta+
e+haustion
;A<
) 3ersonal
ta+es
;:<
FOCAL POINT
The impact of these four costs at high levels of gearing serves to
increase the weighted average cost of capital. This in some ways
returns us to the traditional view of gearing.
,an&ruptcy costs E the higher the level of gearing the
greater the ris& of ban&ruptcy with the associated costs of
financial distress.
F
g
I F
u
M 2t E .+pected present value of the costs of
financial distress
(gency costs E costs of restrictive covenants to protect the
interests of debt holders at high levels of gearing.
Ta+ation e+haustion E the value of the company will be
reduced if advantage cannot be ta&en of the ta+ relief
associated with debt interest.
3ersonal ta+es ;!illers critique 5@NN< ;see following<.
FTC FOULKS LYNCH 86
FURTHER ASPECTS OF THE COST OF CAPITAL CHAPTER 11
*nvestors will be concerned with returns net of all ta+es.
*f a firms income is paid out as debt interest, corporation
ta+ savings are made ;see !R! 5@KA< but investors will
have to pay income ta+ on debt interest.
*f a firms income is paid out as equity return, corporation
ta+ has to be paid but personal ta+ is saved ;via the
imputation system as dividends or by avoidance of capital
gains ta+ by delaying sale or using e+emptions<.
*n deciding its gearing level, a firm should consider its
corporation ta+ position and the personal ta+ position of its
investors if it wishes to ma+imise their wealth.
#irms should gear up until marginal investors face a
personal ta+ cost of holding debt equal to the corporation
ta+ saving. (t this point there is no further advantage to
gearing. 0nder current 01 ta+ legislation this situation
appears unli&ely.
3ractical constraints on level of gearing
rganisations perception of its debt capacity, based on its
potential ability to repay such debt.
Fiew of providers of capital as to acceptable level of
gearing. ;This can dramatically change.<
Suality of asset bac&ing to the debt.
.+pected cash flows and ris& attached.
Ta+ position of organisation.
Si=e of organisation.
/ountries in which funds are invested and borrowed.
FOCAL POINT
FTC FOULKS LYNCH 87
CHAPTER 11 FURTHER ASPECTS OF THE COST OF CAPITAL
-hen answering e+am questions it is important to consider practical
aspects of gearing in addition to the theoretical aspects if so required.
2 CAPM AND THE COST OF CAPITAL
,etas are a way of measuring required rates of return and
should respond to changes in gearing in the way predicted by
!R!.

asset
=
+
+

+
e d
.
. 2 t
2 t
. 2 t ; <
; <
; < 5
5
5
FOCAL POINT
Bote that this formula is provided in the e+am. The ungeared equity
;the asset < is lower than the geared equity as it purely reflects the
business ris& associated with the equity. *n many cases d is assumed
to be =ero, so the second term of the equation will disappear.
(s this approach is based on the theories of !R!, it is
subject to the limitations of their theory.
3 PECKING ORDER THEORY OF CAPITAL STRUCTURE
3ec&ing order theory suggests a reason for the observed
inconsistency in practice between the static trade)off model and
what companies actually appear to do.
#irms have a preferred hierarchy for financing decisions$
main preference to obtain finance from retained profits
before raising funds e+ternally
if funds raised e+ternally, the preferred financing
method is debt followed by convertible securities followed
by preference shares followed by equity.
88 FTC FOULKS LYNCH
4 BEHAVIOURAL THEORY OF CAPITAL STRUCTURE
'erd migration theory E following what other firms were doing.
#ollow my leader theory E following the leading firm.
5 PROJECT$RELATED DISCOUNT RATES AND GEARING
/(3! can be used to find a suitable discount rate for an
individual investmentLdivision, estimating the beta value of the
investment by using the beta of a company in a similar area of
business. 'owever different companies can have different debt
structures which affect their betas. !R! show how this
problem can be solved by ungearing and then regearing the beta
using the equation$
a
I
e

.
. 2 t + ; < 5
M
d

< t 5 ; 2 .
< t 5 ; 2
+
where
a
I beta asset I beta equity for the ungeared company
e
I beta equity for the geared company
d
I beta of debt
2 I mar&et value of debt
. I mar&et value of equity
t I corporation ta+ rate
FOCAL POINT
Bote that
e
is the that reflects the impact of gearing on equity and
not on total capital. This is a common misconception.
*f
d
is assumed to be =ero ;a common assumption<, then the
equation simplifies to$
FTC FOULKS LYNCH 89
a

I
e

.
. 2 t + ; < 5
Example
4 plc manufactures TF sets. *t is considering a more ris&y
new project selling video games. 4 is currently ungeared
and has an equity beta of 7.@. The average beta amongst
video games sellers is 5.9, while their average gearing is
67J debt $ 97J equity. Ris& free investments yield KJ, the
mar&et return is 67J and corporation ta+ is AAJ.
-hat required rate of return should 4 plc loo& for in its new
project if it remains financed purely by equity%
Solution
-e must first ungear the quoted beta for video games sellers.
(ssuming that debt is ris&)free$
a
I 5.9
< KN . 7 67 ; 97
97
+
I 5.9
: . @A
97
I 5.8:
This beta represents the pure systematic ris& of the video
games industry, e+cluding any financial ris& arising from
gearing.
R
s
I R
f
M ;R
m
E R
f
<
I K M 5.8: ;67E K<
I 6N.KJ
4 plc requires a return of 6N.KJ from the new project.
Bote that if 4 plc too& on debt itself, a new geared beta for
the company could be estimated from the geared beta
equation used above.
90 FTC FOULKS LYNCH
FOCAL POINT
The necessity to first ungear the remains. 'owever if 4 plc ta&es on
debt, the can then be regeared to reflect this. Bote that if an industry
is provided, it is already ungeared.
6 THE ADJUSTED PRESENT VALUE TECHNI%UE
The procedure
Step 5.stimate the base case B3F assuming that the
project is financed entirely by equity.
Step 6.stimate the financial effect of the actual method of
financing ;e.g. ta+, issue costs, etc<.
Step A(dd the values from steps 5 and 6 to give the (3F.
*f the (3F is positive, accept the project.
The (3F method has the advantage of brea&ing down a
comple+ problem into its constituent parts rather than trying to
encapsulate the whole problem into determining a single
discount rate.
Example
3am plc is considering a new project that would cost H67m. 'alf
the necessary finance would be provided from retained profits,
the other half coming from a five year subsidised development
loan at 9J pa, compared to a normal mar&et rate of 57J. (
residual value of H57m is e+pected at the end of the 8 years.
The project would generate after ta+ ;but before -2(s< net cash
flows of H8m pa during the 8 year planning period. (ll capital
e+penditure attracts a 68J -2( on a reducing balance basis> ta+
is charged at a rate of A7J and is paid 56 months in arrears.
FTC FOULKS LYNCH 91
/ompanies in the new industry have an average gearing of K7J
equity, :7J debt by mar&et values, and a beta of 5.6. The return
on the whole mar&et is e+pected to be 5KJ pa.
0se the (3F method to recommend whether this proposed
investment should be underta&en.
Solution
#irst the base case B3F is calculated, assuming that the project is
financed entirely by equity.
asset I

e

) 1 ( t D E
E
+
I 5.6
) / . 0 1 ( 00 *0
*0
+
I 7.96
,ase case discount rate I r
f
M ;r
m
E r
f
<
I 57 M 7.96 ;5K 57<
I 58J appro+.
Calculation of W!s
Hm Hm Hm
Gear 5 67.7 68J I 8.7 A7J I 5.8
;8 .7<
Gear 6 58.7 68J I A.N8 A7J I 5.5A
;A .N8<
Gear A 55.68 68J I 6.95 A7J I 7.9:
;6 .95<
Gear : 9.:: 68J I 6 .55 A7J I 7.KA
Gear 8 57.7 5A.KN I ;A .KN< A7J I ;5.57<
Calculation of base case present value "#m$
Time 0 2 3 4 % +
utlay ;67<
(fter)ta+ inflows 8 8 8 8 8
Residual value 57
92 FTC FOULKS LYNCH
-2(s TTT TTT 5 .8 5 .5A 7 .9: 7 .KA
;5.57<
;67< 8 K.8 K.5A 8.9: 58.KA
;5.57<
2iscount factor at 58J 5 .9N7 .N8K .K89 .8N6 .:@N
.:A6
3F ;67< :.A8 :.@5 :.7A A.A: N.NN
;7.:9<
,ase case B3F I HA.@6m
Calculation of t%e &' of t%e financing side(effects
;i< *nterest paid I 9J H57m I H7.9m pa.
This attracts A7J H7.9m I H7.6:m ta+ relief p.a.
FTC FOULKS LYNCH 93
These payments are certain, so are discounted at 57J
3F I H7.6:m A.N@5 7.@7@
I H7.9Am
;ii< *nterest saved on cheap loan I 6J H57m I H7.6m p.a.
3F I H7.6m A.N@5 I H7.NKm
;iii< Ta+ relief lost by having a cheap loan
3F I H7.6m A7J A.N@5 7.@7@
I H7.65m
(3F calculation
Hm
,ase case B3F A.@6
3F of ta+ shield on loan 7.9A
3F of cheap loan 7.NK
3F of ta+ relief lost on cheap loan ;7 .65<
8 .A7
Conclusion
The project has a positive (3F and therefore should be
underta&en.
7 PRACTICAL PROBLEMS OF USING THE APV TECHNI%UE
Relies on the !R! 3roposition ** formulae to be valid so
requires the !R! assumptions to hold true.
2ifferent discount rates should be applied to the different side
effects, which can become complicated.
The danger of getting bogged down in the detail, and not being
able to see the wood from the tree.
94 FTC FOULKS LYNCH
CHAPTER 12
ERGERS AN" AC#UISITIONS
1 ARGUMENTS FOR AND AGAINST MERGERS AND
AC%UISITIONS
Types of merger$
hori=ontal mergers
vertical mergers ;bac&wards or forwards<
conglomerate mergers.
( merger is rational if synergy is created.
(n e+pansion policy based on merger or ta&e)over can be
justified on the basis of synergy i.e.
Falue of ( plc
and , plc
combined
U
Falue of ( plc
operating
independently
M
Falue of , plc
operating
independently
;sometimes stated as 6 M 6 I 8<
3ossible sources of synergy I sensible argument
+ I silly argument
perating economies
.conomies of scale
.conomies of vertical integration
/omplementary resources
.limination of inefficiency
Surplus managerial talent
Surplus cash.
FTC FOULKS LYNCH 95
CHAPTER 12 ERGERS AN" AC#UISITIONS
!ar&et power
The desire to earn monopoly profits ;good for
shareholders but not for public interest<.
#inancial effects
+ 2iversification reduces ris& ;it only reduces total ris&
not systematic ris& for well diversified shareholders<.
2iversification reduces the variance of operating cash
flows giving less ban&ruptcy ris& and therefore
cheaper borrowing.
+ 'igh 3. ratio companies can impose their multiples on
low 3. ratio companies ;bootstrapping<.
/onclusion of synergy
Synergy is not automatic.
-hen bid premiums are considered, the only consistent
winners in mergers and ta&e)overs are victim company
shareholders.
2 MERGER AND AC%UISITION ACTIVITY INTERNATIONALLY
!erger activity is much higher in the 01 and 0S( than in
?ermany or Capan. This is principally because ban&s dominate
the financial systems of ?ermany and Capan, and develop long)
term relationships with the companies they serve, ta&ing
significant equity sta&es. They would not sell these sta&es to a
predator.
*n the 01 and 0S( institutional shareholders are willing to sell
if offered a significant premium.
The previous 01 accounting standard SS(3 66 permitted
goodwill to be offset directly against reserves, which was often
stated as encouraging 01 ta&e)overs. 'owever #RS 57 now
96 FTC FOULKS LYNCH
ERGERS AN" AC#UISITIONS CHAPTER 12
requires 01 companies to capitalise their purchased goodwill
on the balance sheet and amortise it over its useful life. This
brought 01 practice in line with international practice and has
ended the perceived advantage enjoyed by 01 companies.
FOCAL POINT
Bote that the regular reading of the financial sections of broadsheet
newspapers is recommended for this section of the syllabus. (lthough
it is unli&ely that specific activities would be e+amined, an awareness
of actual merger and acquisition activities can only enhance answers.
3 ALTERNATIVE STRATEGIES AND TACTICS OF MERGERS AND
AC%UISITIONS
Strategy
*dentify a li&ely acquisition target.
(pproach the board in confidence to gauge their reaction.
2ecide on a price to offer.
2ecide on the terms of the offer.
Tactics
2awn raid.
!a&e a general offer.
4 HOW POSSIBLE AC%UISITION TARGETS MAY BE IDENTIFIED
USING FINANCIAL OR OTHER INFORMATION
Research targets turnover and mar&et share.
3oor cost control.
See&ing dynamic management.
FTC FOULKS LYNCH 97
.+isting spread of shareholdings.
Trade maga=ines.
3ublished accountsL.+tel cards.
Specialist internet sources.
5 ESTIMATING THE VALUE OF POTENTIAL TARGET
COMPANIES
.arnings based valuation methods
3resent value
of future cash
flows
) Theoretically
sound
) .stimation of future
cash flows and suitable
discount rate
) nly suitable for
controlling interest
3. ratio ) Simple
) #ew data
requirements
) /an be used for
non)controlling
interest
) .stimation of
maintainable earnings
) .stimation of suitable
3. ratio ;si=e, industry,
systematic ris&<
) (djustments for non
mar&etability
2ividend
valuation
) Simple
) /an be used for
non)controlling
interest
) .stimating future
dividends
) .stimation of suitable
cost of equity interest
) (djustments for non
mar&etability
FOCAL POINT
Bote that an estimation of maintainable earnings is required if the 3.
ratio is being used to capitalise future earnings. *n effect the purchaser
is buying future results.
98 FTC FOULKS LYNCH
(sset)based valuation methods
'istorical cost
"#$antages
) Readily
available
Disa#$antages
) ?ives une+pired
cost not value
Replacement
cost
) ?ives cost of
setting up an
equivalent
business
) .+cludes
goodwill
) Faluation
problems
) nly suitable
for controlling
interest
Bet realisable
value
) ?ives disposal
value to
e+isting
owners, often
seen as a
minimum
figure
) .+cludes
goodwill
) Faluation
problems
*f the mar&et value of a company is available this should be
seen as a minimum value.
6 METHODS OF FINANCING MERGERS AND AC%UISITIONS
/ash ) Simple
) 3rice certain
) "iquidity
problems
) /apital gains
ta+
Shares ) Saves cash
) !aintains ownership
state
) (voids capital gains ta+
) Falue uncertain
) 2ilution of .3S
FTC FOULKS LYNCH 99
"oan stoc& ) Saves cash
) ?earing
problems
) /hanges
character of
investment
/onvertible
loan stoc&
) Saves cash
) Target shareholders can
continue an equity
interest
) ?earing
problems
) /hanges
character of
investment
7 DEFENCES AGAINST TAKE$OVERS
3re)offer defences
3oison pills.
1eep dividends high.
Regular revaluation of assets.
Special terms in managers service contracts.
3ost)offer defences
(rgue that victim shares are undervalued, bidders shares
are overvalued ;contrary to .!' but you may have inside
information<.
2isclose favourable information.
!erge with a more friendly party ;white &night defence<.
(ppeal to /ompetition /ommission.
Reverse ta&e)over.
/riticise the rationale claimed for the merger.
(ll defence strategies must comply with the /ity /ode.
100 FTC FOULKS LYNCH
KEY ISSUES THAT INFLUENCE THE SUCCESS OF
AC%UISITIONS
3rice paid.
-hether synergistic hopes turn out as e+pected.
!otivation of employees.
#uture resource needs.
" POST$AUDIT AND MONITORING OF POST$AC%UISITION
SUCCESS
Too often managements attention turns to planning the ne+t
acquisition.
2ruc&ers five rules for easing the process of post)acquisition
integration.
The human factor is particularly important.
FTC FOULKS LYNCH 101
CHAPTER 13
CORPORATE REORGANISATION AN" CAPITAL
RECONSTRUCTION SCHEES
1 DIVESTMENTS
2efinition E divestment is the withdrawal of investment in an
activity.
Eit%er the business is sold as a going concern or the assets
associated with the activity are sold piecemeal.
FOCAL POINT
(s for /hapter 56, the regular reading of the financial sections of
broadsheet newspapers is recommended for this section of the
syllabus.
3ossible reasons for divestment$
earning inadequate return
not a core activity
ris& too high
need for cash.
2 -UNBUNDLING# AND -DEMERGING# OF %UOTED COMPANIES
(fter a period of acquisition activity, a company may find that
it has bought several large groups of businesses, some related to
its chosen core activities but some connected with non)core
activities. 0nbundling is the process of selling off incidental
businesses to release funds, reduce gearing and allow
management to concentrate on their chosen core businesses.
CHAPTER 13 CORPORATE REORGANISATION AN" CAPITAL
( demerger is the opposite of a merger. ( group is split into two
or more separate parts of roughly comparable si=e which are
large enough to carry on independently after the split e.g. */*
and Peneca.
3 THE ADVANTAGES OF MANAGEMENT BUY$OUTS
2istinguishing features
?roup of managers acquire effective control and
substantial ownership of an operation and form an
independent business.
(lso employee buyouts, buyins, spinouts.
!otivations for sale
3arent company wishes to sell due to losses, lac& of fit, or
si=e.
3rivate business owners wishing to sell out.
!otivations for purchase
3otential high returns.
Relatively low ris& as compared to greenfield starts.
.limination of managerial slac&.
3rotects their jobs.
*ssues to be addressed
2o the current owners wish to sell%
-ill management top other bidders%
,usiness plan.
"oss of group services.
/lear management structure.
CORPORATE REORGANISATION AN" CAPITAL CHAPTER 13
!ethod of financing the deal.
4 SITUATIONS IN WHICH A MANAGEMENT BUY$OUT IS LIKELY
TO OFFER THE BEST VALUE FOR A DISPOSER
There are few other potential purchasers.
The management have a plan to realise the companys potential.
The disposer could continue to offer central support services for
a price.
The management have put together a financing pac&age which
does not need help from the disposer.
5 ALTERNATIVE SOURCES OF FINANCE FOR BUY$OUTS
/ommonly highly geared to leave managers with a controlling
interest in equity.
Support from institutions is normally required.
.+amples include clearing ban&s, Ai group, .*S funds, etc.
Syndication is common.
*nstitutions normally require business plans, details of e+it
routes, sometimes board representation.
/ommon instruments include debt, preference shares,
equity ;limited<, me==anine finance.
ther sources of finance$
leasing and hire purchase
government grants e.g. from area development agencies
employees pension scheme.
6 THE VIABILITY OF BUY$OUTS
-hy do current owners wish to sell%
2oes the proposed management team cover all &ey functions%
*f not, new appointments should be made.
,usiness plan, particularly cash flow projections.
3roposed sale price.
#inancing method.
7 ADVANTAGES AND DISADVANTAGES OF MANAGEMENT BUY$
INS
2efinition E a management buy)in is when a group
of outside managers buys a controlling sta&e in a business.
,est when current management are not up to the job.
.mployee resistance can be e+perienced when the new
management try to impose new ways of doing things.
WHEN A CAPITAL RECONSTRUCTION MAY BE RE%UIRED OR
APPROPRIATE
S5A8 /(98$ restructuring scheme.
S:68 /(98$ scheme of arrangement.
" INTERESTS OF THE VARIOUS SUPPLIERS OF CAPITAL IN A
RECONSTRUCTION SCHEME
rdinary shareholders have the prospect of future dividends.
3reference shareholders may have to forgo arrears of their
dividends, so offer them a higher coupon in future.
CORPORATE REORGANISATION AN" CAPITAL CHAPTER 13
Secured creditors could be offered free equity to persuade them
not to apply for the company to be wound up.
0nsecured creditors have the prospect of being paid in full.
*t is possible to devise a scheme such that every supplier of
capital is better off after the scheme than before it. *f this is not
the case, then that class of capital provider will vote against the
scheme and the court may not approve it.
1' FORMULATING A FEASIBLE RECONSTRUCTION
!ethod of scheme
-rite off 3R" debit balance.
-rite off fictitious assets, formation e+penses, deferred
e+penditure.
Revalue other assets.
Reorganise capital structure.
(llow new capital to be raised.
?uidelines for devising a scheme
/apital reductionLreconstruction account allows write offs
of assets to be matched by write offs of share capital.
rdinary shareholders must bear most of the write offs.
11 REASONS FOR SHARE REPURCHASE
To return surplus cash to shareholders.
To increase the share price.
To support the share price during a period of temporary
wea&ness.
To adjust the gearing ratio towards an optimum capital
structure.
To remove dissentient shareholders from the share register and
thus, for e+ample, retain family control of the business.
12 REASONS FOR GOING PRIVATE
The ownership of the company might change.
The e+pectations in going public might not occur.
The costs and regulatory bodies of a stoc& mar&et quotation.

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CHAPTER 1

Should be constant. Fariations due to$

-here stoc& turnover is high$

/hanges due to$

FTC FOULKS LYNCH 21

creditors Short term

capital return #i+ed M reserves and capital .quity

Return on a two asset portfolio,

is the standard deviation of the returns from the

is the standard deviation of the returns from the

is the standard deviation of the returns from the

/apital mar&et line I

Slope I The mar&et price of ris& and

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