LEVEL 6 CORPORATE FINANCE

Y o u r r o a d t o s u c c e s s

LEVEL 6 CORPORATE FINANCE

Your road to success

• ABE • OF

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ISBN: 978-1-911550-28-0

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Author: Stuart Green MSc, MPhil, PGCE, PGCE (HE), FHEA, CPFAReviewer: Colin Linton MRes MBA PGCHE DipM DipFS FCIB FCIM FCIPS FCIEA FHEA FInstLM

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Contents

Using your study guide iv

Chapter 1 The Importance of Capital Structure 2

1.1 Corporate finance and capital structure 3

1.2 The roles played by stakeholders, different types of risk and business strategy in capital structure 7

1.3 Alternative frameworks for the development of a capital structure 13

Chapter 2 Sources of Finance 18

2.1 Alternative approaches to sources of equity and debt 19

2.2 Sources of finance and how they relate to strategic objectives and strategic environment 24

2.3 Decision-making frameworks that could be applied to ensure that the business utilises sources of finance that are appropriate to its needs and strategic circumstances 39

Chapter 3 The Cost of Capital 44

3.1 Alternative approaches to the valuation of equity 45

3.2 Methods for the calculation of the cost of capital to provide a basis on which strategic financing and investment decisions can be made 52

3.3 The effects of risk on the cost of capital 59

Chapter 4 Advanced Investment Appraisal 68

4.1 Select and justify appropriate investment appraisal techniques 69

4.2 Application of investment appraisal techniques 73

4.3 A critical evaluation of investment appraisal techniques 86

Chapter 5 Contemporary Issues in Corporate Finance 94

5.1 Alternative perspectives on the role of ethics in corporate finance 95

5.2 Appraise approaches to corporate governance in the context of legal, regulatory and professional requirements 98

5.3 Critically evaluate the role of corporate finance in mergers and acquisitions 104

Glossary 109

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Using your study guideWelcome to the study guide for Level 6 Corporate Finance, designed to support those completing their ABE Level 6 Diploma.

Below is an overview of the elements of learning and related key capabilities (taken from the published syllabus).

Element of learning Key capabilities

Element 1: The importance of capital structure

• Ability to develop an approach to formulating the capital structure for a business based on sound conceptual and theoretical underpinning

• Ability to manage stakeholders and risks as part of selecting a financing structure, ensuring that the choice reflects the strategic objectives and existing and potential strategic pressures

Financial management, application of theoretical frameworks, appreciation of impact of strategic objectives of financial decision-making, communication, influence, stakeholder management, approaches to business strategy

Element 2: Equity and debt financing

• Ability to critically evaluate alternative sources of finance in order to ensure that financing decisions reflect the strategic objectives and strategic circumstances of the business

• Ability to apply criteria and decision-making frameworks in the context of equity and debt financing

Critical thinking, analysis, business acumen, commercial awareness, decision-making

Element 3: The cost of capital • Ability to critically evaluate different approaches to the calculation of the cost of capital in line with a business’s strategic direction

• Ability to apply techniques to calculate the cost of capital that take account of alternative approaches to the valuation of equity and different types of risk

Critical thinking, analysis, calculations, decision-making, risk assessment

Element 4: Advanced investment appraisal

• Ability to select and apply appropriate investment appraisal techniques that reflect the strategic objectives and environment in which the business operates

• Ability to apply investment appraisal techniques that take account of cash flows, taxation and inflation

Analysis, decision-making, influence and persuasion, investment appraisal techniques

Element 5: Contemporary issues in corporate finance

• Appreciation of contemporary issues in corporate finance and their impact on businesses

• Recognition of the importance of ethics, corporate governance and the role of corporate finance in ownership and control in a globalised economy

Critical thinking, contemporary issues, ownership and control, ethical issues

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This study guide follows the order of the syllabus, which is the basis for your studies. Each chapter starts by listing the syllabus learning outcomes covered and the assessment criteria.

L6 descriptor

Knowledge descriptor (the holder…) Skills descriptor (the holder can…)

• Has advanced practical, conceptual or technological knowledge and understanding of a subject or field of work to create ways forward in contexts where there are many interacting factors

• Understands different perspectives, approaches or schools of thought and the theories that underpin them.

• Can critically analyse, interpret and evaluate complex information, concepts and ideas.

• Determine, refine, adapt and use appropriate methods and advanced cognitive and practical skills to address problems that have limited definition and involve many interacting factors.

• Use and, where appropriate, design relevant research and development to inform actions.

• Evaluate actions, methods and results and their implications

The study guide includes a number of features to enhance your studies:

’Over to you’: activities for you to complete, using the space provided.

Case studies: realistic business scenarios to reinforce and test your understanding of what you have read.

’Revision on the go’: use your phone camera to capture these key pieces of learning, then save them on your phone to use as revision notes.

’Need to know’: key pieces of information that are highlighted in the text.

Examples: illustrating points made in the text to show how it works in practice.

Tables, graphs and charts: to bring data to life.

Reading list: identifying resources for further study, including Emerald articles (which will be available in your online student resources).

Source/quotation information to cast further light on the subject from industry sources.

Highlighted words throughout denoting glossary terms located at the end of the study guide.

Note

Website addresses current as at August 2017.

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Introduction

In this chapter, you will consider the strategic role and purpose of corporate finance in a business. Capital structure, or the mix of long-term finance in a business that minimises the cost of capital, is a key aspect of corporate finance; decisions on capital structure can be critical to the success of a business.

You will examine how to formulate a capital structure that reflects the strategic objectives and strategic environment of the business. For businesses to survive and prosper, capital structure must be developed and maintained in a way that reflects both the existing and potential strategic pressures to which the business is exposed. You will also consider the key conceptual and contemporary ideas that underpin capital structures in modern business. While Modigliani and Miller (1958) argue that capital structure is unimportant, in practice it appears that decisions on the use of different methods of financing do have considerable consequences for many businesses.

Learning outcomes

On completing the chapter, you will be able to:

1 Critically analyse the factors that influence capital structure decisions and strategy

Assessment criteria

1 Critically analyse the factors that influence capital structure decisions and strategy

1.1 Appraise the alternative role and purpose of corporate finance in order to decide how best to formulate a capital structure for the business

1.2 Critically analyse the roles played by different stakeholders, different types of risk and alternative approaches to business strategy in order to select a capital structure that reflects the strategic objectives and strategic environment of the business

1.3 Critically evaluate the alternative frameworks for the development of a capital structure to ensure that it is based on a sound conceptual underpinning

The Importance of Capital Structure

Chapter 1

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1.1 Corporate finance and capital structure

The role and purpose of corporate finance

Corporate finance is concerned with the efficient and effective management of business finances in order to achieve business objectives (Watson and Head, 2016). Financial resources must be acquired (also known as “raised”). These financial resources must then be allocated (also known as “invested”) and their use must be controlled (or “managed”). Atrill (2014) suggests that the overarching aim of corporate finance is the optimal allocation of scarce resources in a business, the scarcest resource of which is money (or “finance”).

Capital structure is concerned with the particular mix of long-term finance that is used by a business. The cost of capital is the rate of return required by investors to supply finance to a business (and therefore the rate of return that is required of prospective investors). An optimal capital structure is one that minimises the cost of capital (Ogier, Rugman and Spicer, 2004). You will return to the cost of capital later in the module.

Capital structure is concerned with the mix of long-term finance that is used by a business. An optimal capital structure is one that minimises the cost of capital.

NEED TO KNOW

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In this module, we will view businesses as investment agencies: the role of business is to raise and invest finance in a way that generates profit. This profit could then be reinvested in the business in order to generate more profit. Some or all of the profit could be returned to shareholders in the form of dividends.

Businesses can be seen as investment agencies. Their role is to raise and invest finance in a way that generates profit. Profit can be reinvested in the business or returned to shareholders in the form of dividends.

NEED TO KNOW

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Level 6 Corporate Finance

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Chapter 1 The Importance of Capital Structure

In a capitalist system, shareholders are considered to be of paramount importance. They provide funds to businesses in return for ownership rights. Shareholders invest in the expectation that they will receive the maximum possible increase in wealth in return for their investment. This key idea underpins modern corporate finance: the primary objective of a business is to maximise the wealth of its shareholders. Since shareholders receive their wealth through dividends and capital gains, shareholder wealth will therefore be maximised by optimising the value of the dividends and capital gains that shareholders receive over time.

The primary objective of a business is to maximise the wealth of its shareholders. Shareholders provide funds to businesses in the expectation that they will receive the maximum possible increase in wealth in return for their investment.

NEED TO KNOW

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Activity 1: Shareholder wealth maximisation

If we accept that the primary objective of a business is to maximise the wealth of its shareholders, then how will a business know that is has achieved this primary objective? Explain the problems that might exist when trying to determine if this objective has been achieved.

OvEr TO yOu

The Importance of Capital Structure Chapter 1

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Watson and Head (2016) identify three key problems with the concept of shareholder wealth maximisation. These problems are summarised in Table 1.

Problem Description

Measurement Maximisation of shareholder wealth requires that wealth is defined and measured accurately, and that all factors contributing to it are known and can be taken into account.

This is often problematic. Measures of wealth can vary markedly. The factors that contribute to wealth creation are not always observable.

Timescale Should wealth be maximised in the short term or the long term? Is short-term wealth maximisation consistent with long-term wealth maximisation?

Risk The processes of wealth generation and measurement do not always take account of risk. Wealth generation may be foregone in order to secure lower levels of risk.

Source: Watson and Head (2016, p. 11/12).

Table 1: Problems in the measurement of shareholder wealth on the goREVISION

The concept of shareholder wealth maximisation can be problematic. These problems include measurement, timescale and risk.

NEED TO KNOW

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Atrill (2014) suggests that the concepts of a business as an investment agency and the primary objective of wealth maximisation are probably a little simplistic. Businesses do not exist in isolation from the environments in which they operate. Attempts to maximise the wealth of shareholders need to take account of a range of factors. As you will see later in this chapter, other stakeholders can have an effect on corporate finance decisions in a business. The strategic environment in which finance is raised and invested is of critical importance to a business. What “works” for one firm may be entirely inappropriate for another one.

Activity 2: Strategic environment and corporate finance

Search online for ‘’Indian companies facing wave of shareholder activism’’ and read the FT newspaper article featuring Diageo.

Consider the strategic environment in which businesses like Diageo operate in India. Identify the factors in the strategic environment that might have an effect on the corporate finance decisions that are made by these businesses.

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The relationship between corporate finance and the formulation of a capital structure

As we have seen, businesses do not exist in isolation from the strategic environments in which they operate. While wealth maximisation remains the primary objective of business, it is also important to take account of a range of other factors, including risk, legal form and corporate governance. The aim of corporate finance includes the need to balance the primary objective of wealth maximisation with these factors.

Factor Context

Risk and return Decisions of any type relate to the future. An appropriate balance needs to be maintained between risk and return. In financial management, risk is considered to relate to circumstances in which all possible outcomes can be identified and quantified.

Legal form Many businesses operate under the legal form of a company, whether this is private limited or public limited. A key feature of a company is limited liability: shareholders cannot be held personally responsible for the company’s liabilities.

Corporate governance Corporate governance relates to the practice of board leadership and to effectiveness, remuneration, accountability and relations with shareholders. A business’ approach to corporate governance and the regulatory regime to which it is subjected will have a major effect on financial decision-making.

Table 2: Other factors that might affect capital structure on the goRevision


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Risk and return, legal form and corporate governance must also be considered when formulating the capital structure of the business. Remember that capital structure is concerned with the particular mix of long-term finance that is used by a business; an optimal capital structure is one that minimises the cost of capital. It may be that wealth maximisation (and the minimum cost of capital) could be achieved through the use of a particular capital structure. However, the need to consider factors other than wealth maximisation means that an alternative capital structure (and a higher cost of capital) might be necessary. We will return to this idea later in the module.

Capital structure is concerned with the particular mix of long-term finance that is used by a business. Wealth maximisation could be achieved through the use of a particular capital structure. However, the need to consider factors such as risk and return, legal form and corporate governance might mean that an alternative capital structure is required.

NEED TO KNOW

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1.2 The roles played by stakeholders, different types of risk and business strategy in capital structure

The stakeholder approach

Freeman and Reed (1983) define stakeholders as persons, groups or organisations that have an interest in a business, that can affect a business or that are affected by a business. The stakeholder theory of corporate finance reflects the idea that investment and financing decisions should be guided by the need to create and maintain positive working relationships with key stakeholders.

Stakeholders are persons, groups or organisations that have an interest in a business that can affect a business or that are affected by a business (Freeman and Reed, 1983). The stakeholder theory of corporate finance reflects the idea that investment and financing decisions should be guided by the need to create and maintain positive working relationships with key stakeholders.

NEED TO KNOW

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Stakeholders can be internal or external to the business. Examples of internal stakeholders include shareholders and employees. External stakeholders include suppliers and lenders. Some stakeholders are also more important than others, these key stakeholders will include shareholders, but other stakeholders might also be important due to the extent of their power to affect the business.

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Stakeholder analysis techniques: Mendelow’s (1991) Power–Interest Matrix

Mendelow’s (1991) power–interest matrix is a technique that can be used to analyse stakeholders in a way that reflects the emphasis that must be applied to their needs. This emphasis is determined using the extent of the impact (or “power”) and interest that the stakeholder may have on the activities of the business. If done correctly, this should allow the key stakeholders to be identified and managed appropriately. The four categories of stakeholders are shown in Figure 1 below, followed by a brief explanation of each.

Low level of interestLow level of power

High level of interestLow level of power

Low level of interestHigh level of power

High level of interestHigh level of power

Figure 1: Mendelow’s (1991) Power–Interest Matrixon the goRevision

Low level of interest and low level of power: This group will usually follow instructions and accept the plan.

High level of interest, low level of power: These stakeholders are interested in the organisation but have no power. If not convinced about plans for the organisation, they may join with those with high power.

Low level of interest, high level of power: By keeping this group satisfied and not involved, they will not affect or influence the business.

High level of interest, high level of power: This group needs to be fully communicated with and listened to as they have the power to alter the course of the organisation if it is not in line with their view.

Activity 3: Stakeholder mapping and the power–interest matrix

Develop a power–interest matrix for the stakeholders of Diageo. Focus your analysis on the business’ operations in India.

Identify each of the stakeholders then rank each in terms of their power (think about the influence that they might have on Diageo’s business) and the extent of their interest.

For tips on how to prepare a power–interest matrix, use the following link: http://www.brighthubpm.com/resource-management/80523-what-is-the-powerinterest-grid/

[Accessed on: 27 February 2017]

OvEr TO yOu


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Stakeholders and corporate finance

For most businesses (particularly companies), three groups of stakeholders are often key (Watson and Head, 2016): ordinary shareholders, lenders and managers. Shareholders provide equity finance to companies and expect a return in the form of dividends and in growth in the market price of the shares that they own. Lenders provide debt finance and expect this finance to be repaid on maturity. Returns are expected in the form of interest payments. Managers direct and control the business and are responsible for its financial performance.

Interactions between these three groups of stakeholders have to be managed effectively. Careful consideration needs to be given to the strategic objectives, the strategic environment in which it operates and the power/interest of key stakeholders. Shareholders, particularly large institutional investors, will often try to influence strategy. In addition to this, they may try to influence operational management structure and executive pay. Lenders may also try to influence strategy and operations by making loans contingent on covenants relating to financial structure and financial performance. Managers will have their own personal objectives that, sometimes, may conflict with those of shareholders and lenders.

Shareholders will often try to influence strategy. They may also try to influence operational management structure and executive pay. Lenders may try to influence strategy and operations by making loans contingent on covenants. Managers will have their own personal objectives that may conflict with those of shareholders and lenders.

NEED TO KNOW

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Aviva plc

Aviva plc is a multinational financial services company that provides insurance, savings and investment products. It has 31 million customers worldwide and is the UK’s largest insurer.

In May 2012 Aviva lost a vote on executive pay at its annual general meeting (AGM) when 54% of ordinary shareholders (excluding abstentions) voted against Aviva’s proposed policy for executive remuneration. This was seen as a major embarrassment for the directors of the company. Shareholders were angry about poor financial results and the amount that the new UK chief executive, Trevor Matthews, was paid when he joined the company. Following the vote, company chairman Colin Sharman apologised to investors for ignoring their views on executive pay.

CASE STuDy

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This shareholder revolt at Aviva was set in the context of a falling share price and reduced dividends. Within days of the vote, Aviva’s group chief executive, Andrew Moss, had left the company.

Source: Adapted from BBC (2012)

Activity 4: Analyse the impact of the conflicts between stakeholders in Aviva plc

Identify the stakeholders in the Aviva plc case. Consider the potential conflicts between each stakeholder. Explain how these conflicts might be reflected in terms of Aviva plc’s approach to corporate finance.

OvEr TO yOu

Conflicts between key stakeholders are reflected in different aspects of corporate finance. Examples are summarised in Table 3.

Conflict Corporate financial strategy

Governance The roles of chairperson and chief executive should be separate.

Executive remuneration Pay and other financial rewards should be set by remuneration committees. These committees should comprise independent non-executive directors. Recommendations on executive pay should be subject to a vote by ordinary shareholders at the business AGM.

Dividend policy Management needs to be mindful of the expectations of ordinary shareholders and of other key stakeholders such as lenders.

Capital structure Management must comply with loan covenants.

Table 3: Conflicts between key stakeholders and their effects on a business’s approach to corporate finance

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Conflicts between key stakeholders can often be reflected in aspects of corporate finance such as governance, executive remuneration, dividend policy and capital structure.

NEED TO KNOW

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The international context and capital structure

Arrangements of capital structure vary greatly around the world (Brealey, Myers and Allen, 2014). For example, the United States is said to have a market-based financial system: capital structures are reflective of a large equity market and a large market in corporate bonds (a type of debt financing). In parts of Europe and in Japan, bank-based financial systems apply; bank loans are a more common form of debt financing than corporate bonds and equity markets are relatively small. Differences in financial systems have important implications for capital structure, particularly for businesses that operate on a multinational basis. An understanding of these differences can be crucial when formulating a capital structure.

Different systems of ownership and control also apply in different countries. A summary is provided in Table 4. Again, these differences will have an impact on capital structure. They also have important management implications for businesses that operate on a multinational basis.

Country Ownership and control

UK and USA Managers have a legal responsibility to act in the best interests of shareholders. Ownership is often dispersed and shares are actively traded, although ownership of many large businesses is often concentrated in financial institutions.

Japan Banks form a central “hub” for large, co-operative groups of businesses. Significant cross-ownership exists between the main bank in the group, other banks and the businesses within the group.

Germany and much of Europe Banks traditionally have long-standing relationships with businesses. Larger businesses have two boards of directors. Management boards are responsible for business operations, but report to supervisory boards. These supervisory boards represent all employees as well as shareholders. Business decisions are made in the interests of the business “as a whole” rather than shareholders.

Source: Brealey, Myers and Allen (2014, p. 851)

Table 4: Ownership and control in an international context on the goRevision

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The international context and capital structure

Let’s return to a case study that we considered earlier in the chapter. Aviva plc is a multinational financial services company that provides insurance, savings and investment products. It has 31 million customers worldwide and is the UK’s largest insurer.

Aviva plc has its origins in the UK. The original business was established almost 300 years ago. Aviva plc’s capital structure and system of ownership and control reflect that of a traditional UK company.

CASE STUDY

Activity 5: The international context and capital structure

Imagine that Aviva plc is thinking of setting up a subsidiary company in Japan. The new Japanese subsidiary will have a capital structure and system of ownership and control that reflects those of a “typical” Japanese business. Explain how the capital structure and system of ownership and control will differ from that of a “typical” UK company.

OvEr TO YOU

Irrespective of differences in capital structure, ownership and control, remember that the key principles of corporate finance still apply; businesses in all countries would recognise the concepts of capital structure and the cost of capital. All would be familiar with the idea of the maximisation of shareholder wealth as the primary objective of business.

Differences in financial systems, patterns of ownership and governance arrangements will have an effect on capital structure. Businesses that operate on a multinational basis must be aware of these differences when formulating their capital structure.

NEED TO KNOW

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1.3 Alternative frameworks for the development of a capital structure The advantages and disadvantages of different types of capital structure

Sources of finance can be grouped into two broad categories: equity and debt. A range of potential sources of each of these two broad types of finance is available. The mix of these two broad types can be referred to as capital structure (also known as financing structure). Capital structure must be developed and maintained in a way that reflects both the existing and potential strategic pressures to which the business is exposed. As you have seen so far in this chapter, the formulation of a capital structure that reflects the strategic objectives and strategic environment of the business is not an easy task.

There is a need to take account of a range of factors: shareholders are considered to be of paramount importance, but the concept of maximising shareholder wealth is not clear. Risk and return, legal form and corporate governance all need to be considered when formulating capital structure. Conflicts between key stakeholders can also have an effect and, sometimes, can be difficult to reconcile. International differences in financial systems and systems of ownership and control can further complicate these problems.

So, how can businesses develop a capital structure that takes account of all of these issues? Thankfully, a number of frameworks exist that can be of help. You will return to these decision-making frameworks later in the module. For now, consider their key features, advantages and disadvantages of each. These are summarised in Table 5.

Framework Key features Advantages Disadvantages

Pecking order theory (Myers, 1984)

An “order of priority” for the financing of investments. Retained profit, debt and, finally, share capital should be used to finance investments.

Reflects asymmetries of information between businesses and capital markets

Some empirical support, e.g. Baskin (1999)

Does not take account of existing capital structure

Some empirical criticism, e.g. Frank and Goyal (2003)

Contradicts aspects of dividend theory

Matching principle of finance

Maturity of financing should be matched with the maturity of asset types

Reflects desired levels of risk and return

Can lead to reduced flexibility and higher costs

Table 5: Frameworks for the development of capital structureon the goRevision

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Pecking order theory suggests that there is an “order of priority” for the financing of investments. Retained profit, debt and, finally, share capital should be used to finance investments.

NEED TO KNOW

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Conceptual underpinning for capital structure

For Modigliani and Miller (1958) any capital structure is as good as another: the relative mix of debt and equity finance in a business’s capital structure is unimportant. Provided that markets are perfect, financing decisions and their effects on financial gearing do not matter. Modigliani and Miller (1958) suggest that this is because a business’s value is determined by its real assets, not by financing decisions.

Perfect markets are those that are perfectly competitive. In such markets, there are no barriers or even temporary delays to the formation of perfectly fair prices. Prices should instantaneously and universally reflect all available and relevant information. Certain conditions are needed to produce perfect markets. These conditions are summarised in Table 6.

Condition Description

Large number of buyers and sellers

A sufficiently large number of participants must exist such that no individual participant or group of participants can manipulate prices.

No barriers to entry or exit Entry to and exit from the market is free. For example, registration or listing fees do not exist.

Information All participants can gain all of the information that they need on which to base their decisions. This information is free and is available instantaneously.

No transaction costs There are no transaction costs such as stamp duties or brokers’ commissions. Tax regulations and accounting practices do not affect the relative attractiveness of different investment opportunities. Regulatory constraints do not prevent investors from participating in markets.

No effects on market prices Decisions by prominent investors do not have an impact on market prices.

Table 6: Conditions that need to be met in order for a perfect market to exist on the goRevision

Many of these conditions are unrealistic. Most empirical research suggests that it is unlikely that perfect markets do exist (Megginson, 1997). However, businesses do not need markets to be perfect. What they need is for markets to be efficient and to offer fair prices so that they can make sound financing and investment decisions (Watson and Head, 2016). A business should be able to make decisions on, for example, the use of debt finance, and understand the practical effects of changes in capital structure.


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In perfect markets, prices should instantaneously and universally reflect all available and relevant information. However, the conditions that are needed to produce perfect markets are unrealistic.

NEED TO KNOW

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Contemporary issues in the formulation of capital structure

Capital structure has been an issue of considerable importance for many businesses in recent years. In particular, the “Great Recession” that followed the financial crisis of 2008 meant that the use of debt relative to equity financing has been questioned in some businesses. The risks associated with debt financing in times of economic stress have meant that some businesses have had to change their capital structure.

You will return to this and other contemporary issues later in the module.

Brealey, Myers and Allen (2014) suggest that the mix of debt and equity finance in a business can be used as a “starting point” with which to evaluate potential investment opportunities via the calculation of a cost of capital. Investment opportunities that are funded using unusually risky financing methods can be reflected in adjustments to the cost of capital.

The cost of capital is the rate of return that is required by investors who supply financing to a business. Hence, it is also the minimum rate of return that is required on prospective investment projects. While Modigliani and Miller (1958) argue that the relative mix of debt and equity in a business’s financing structure is unimportant, in practice it appears that decisions on the use of different methods of financing do have considerable consequences for many businesses.

NEED TO KNOW

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Activity 6: Financing structure, financial gearing and entrepreneurs

Research online for the paper by Milana (2010) at http://onlinelibrary.wiley.com/doi/10.1002/jsc.860/abstract. If you don’t have access to this article, perform your own online research to answer the question that follows.

This article provides an account of an interview with an entrepreneur and offers a perspective on the relative balance of debt and equity finance in a business.

Identify and explain the key factors that might need to be considered in the achievement of an appropriate balance of debt and equity finance in a business. Outline the additional factors that might influence this choice for an entrepreneur.

OvEr TO yOu

http://onlinelibrary.wiley.com/doi/10.1002/jsc.860/abstract

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• Atrill, P. (2014) Financial management for decision makers, 7th edition, Harlow: Pearson.

• Baskin, J.B. (1989) “An empirical investigation of the pecking order hypothesis”, Financial Management, 18, pp. 26–35.

• BBC (2012) “Aviva loses vote on executive pay at its AGM”, Retrieved from: http://www.bbc.co.uk/news/business-17938865 [Accessed on: 30 December 2012].

• Brealey, R. A., Myers, S. C. & Allen, F. (2014) Principles of corporate finance, 11th edition, Maidenhead: McGraw-Hill.

• Financial Times (2014) “Indian companies facing a wave of shareholder activism”, Financial Times, December 2014.

• Frank, M. and Goyal, V. (2003) “Testing the pecking order theory of capital structure”, Journal of Financial Economics, 67, pp. 217–48.

• Freeman, R. and Reed, D. (1983) “Stockholders and stakeholders: a new perspective on corporate governance”, California Management Review, 59 (1), pp. 88–106.

• Kaptein, M. and Van Tulder, R. (2003) “Toward effective stakeholder dialogue”, Business and Society Review, 108 (2), pp. 203–224.

• Megginson, W. (1997) Corporate finance theory, Reading: Addison-Wesley.

• Modigliani, F. and Miller, M.H. (1958) “The Cost of Capital, Corporation Finance and the Theory of Investment”, The American Economic Review, 48(3), pp. 261–297.

• Myers, S. (1984) “The capital structure puzzle”, Journal of Finance, 39, pp. 575–592.

• Ogier T., Rugman, J. and Spicer, L. (2004) The real cost of capital: a business field guide to better financial decisions. Harlow: Pearson.

• Watson, A. and Head, A. (2016) Corporate finance: principles and practice. 7th edition, Harlow: Pearson.

rEADiNg LiST


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For tips on how to prepare a power–interest matrix, use the following link: http://www.brighthubpm.com/resource-management/80523-what-is-the-powerinterest-grid/

[Accessed on: 27 February 2017]

Milana, C. (2010) “Rebalancing the optimal financial structure: the entrepreneurs’ point of view”, Strategic Change, 19 (1), pp. 91–95. Retrieved from: http://onlinelibrary.wiley.com/doi/10.1002/jsc.860/abstract.

[Accessed on: 31 August 2017]

rESOurCES

http://onlinelibrary.wiley.com/doi/10.1002/jsc.860/abstract

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Introduction

Sources of finance can be grouped into two broad categories: equity and debt. In this chapter, you will consider the key features of different types of equity and debt financing. You will examine how to measure the market value of a business’s share capital and the different ways in which share capital can be issued. You will also consider how different types of finance relate to the strategic objectives of a business and its environment.

A key feature of this chapter is a critical evaluation of alternative sources of both equity and debt finance. Businesses must take care to select sources of finance that are appropriate. Failure to do so may result in an inefficient use of resources and a failure to take full advantage of investment opportunities. At worse, it could result in the destruction of value in the business. You will consider criteria and decision-making frameworks, including models of financial distress that could be applied to ensure that sources of finance are appropriate to the strategic objectives and environment of the business.

Learning outcomes


2 Critically evaluate alternative sources of finance to ensure that financing decisions reflect the strategic objectives and strategic circumstances of the business

Assessment criteria

2 Critically evaluate alternative sources of finance to ensure that financing decisions reflect the strategic objectives and strategic circumstances of the business

2.1 Compare alternative approaches to sources of equity and debt in relation to the strategic objectives and strategic environment of the business

2.2 Critically evaluate the impact of the use of a range of equity and debt financing on business’s financing structure

2.3 Apply criteria and decision-making frameworks in equity and debt financing

Sources of Finance

Chapter 2

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2.1 Alternative approaches to sources of equity and debtThe matching principle of finance and its importance in the selection of source of equity or debt

The matching principle of finance states that short-term investment needs should be financed with short-term sources of finance. Long-term investment needs should be financed with long-term sources of finance. Atrill (2014) asserts that this concept of “matching” can be seen as, perhaps, a very simple idea but is, in fact, at the heart of corporate finance.

The matching principle of finance means that short-term investment needs should be financed with short-term sources of finance. Long-term investment needs should be financed with long-term sources of finance.

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So, there is a need to consider the purpose to which finance is to be applied: this should then be matched with a source of finance that “matches” with the duration of the investment. The investment of a business in non-current assets (e.g. property, machinery, vehicles) should be financed by long-term sources of finance. Current assets that fluctuate (e.g. inventories, trade receivables) should be financed using short-term sources of finance.

You will consider the distinctions between long-term and short-term sources of finance and between internal and external sources of finance later in the chapter. For now, firstly reflect on the two broad categories of finance: equity and debt. You have already considered the nature of equity and debt finance earlier in the chapter. Secondly, reflect on the distinction between internal and external sources of finance. The latter require the agreement of one or more third parties before they can be used. In contrast, internal sources of finance can be used without the agreement of third parties.


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Chapter 2 Sources of Finance

External sources of finance require the agreement of one or more third parties before they can be used by a business.

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As discussed in Chapter 1, a business can be viewed as an investment agency. Its role is to acquire (or “raise”) finance and then to spend (or “invest”) that finance to generate a profit. This profit could then be reinvested in the business in order to generate more profit. Some or all of the profit could be returned to shareholders in the form of dividends.

The way in which finance is raised can have huge implications for a business. Essentially, a business has two options: finance can be raised in the form of equity or in the form of debt. Definitions and examples of each are provided in Table 1.

Type of finance Description Examples

Equity The “ownership interest” in a business

Ordinary shares and some other types of shares, retained earnings, revaluation reserves, and other reserves

Debt Sometimes referred to as “borrowing”. A common feature of this type of finance is the finance charge or “interest” that is applied to each

Loans, debentures, lease arrangements and preference shares

Table 1: Types of financeon the goRevision

Essentially, a business can raise up two different types of finance: equity and debt.

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Activity 1: Equity and debt

The distinction between equity and debt as types of finance is usually clear. However, there are some sources of finance that have characteristics that make the distinction difficult.

OvEr TO yOu

Sources of Finance Chapter 2

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Consider the following sources of finance and classify each as either equity or debt:

1 Loans

2 Ordinary shares

3 Retained earnings

4 Debentures

5 Share premium reserve

6 Bank overdraft

7 Loan notes

8 Finance leases

9 Preference shares

The mix of equity and debt financing together represents a business’s financial structure. Any imbalance will lead to inefficiency; remember that the aim of the business is to raise and invest finance in order to make a profit. If a business’s financial structure is not “correct”, profits will be lower than they would be otherwise.

Hence, the cost to a business of raising finance is referred to as the cost of capital. Brealey, Myers and Allen (2014, p. 28) define the cost of capital as:

The expected return on a portfolio of all the company’s existing securities. It is the opportunity cost of capital for investment in the

business’s assets, and therefore the appropriate discount rate for the business’s average-risk projects.

You will examine the cost of capital and its calculation in the next chapter.

The mix of equity and debt financing in a business comprises its financial structure. Any imbalance in this financial structure will cause profits to be lower than they would be otherwise. The cost to a business of raising finance is referred to as its cost of capital.

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Equity and debt finance

Edmonton plc is a multinational petrochemicals company that manufactures plastic drinks containers. The company’s net assets have a balance sheet value of $300 million: $250 million of these assets are financed by debt, with the rest financed by equity. Edmonton plc has revenues of $80 million, but has experienced a prolonged period of poor financial performance. Recently, the company has experienced a severe shortage of cash.

The company relies heavily on materials purchased from a number of key suppliers. Significant trade credit is in danger of becoming overdue to these key suppliers.

The company finance director has concerns. Finance charges (also known as interest payments) are due on the debt next month and the company will be unable to pay these charges. The company finance director also believes that Edmonton plc will not be able to refinance $100 million of its debt when it reaches maturity in six months’ time.

The board of directors have agreed that a restructuring of the company’s financial structure is required.

CASE STuDy

Activity 2: Equity and debt finance

Consider the actions that the board of directors of Edmonton plc might need to take in each of the short-term, the medium-term and the longer-term situations. Explain how the company’s finances might be restructured as a basis for longer-term stability.

OvEr TO yOu


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Other factors: legal, regulatory and market requirements

The matching principle is an important idea in financial management. Other factors that need to be considered when selecting a source of finance are outlined in Table 2.

Factor Description

Cost Different sources of finance have different cost implications for a business.

Flexibility Short-term sources of finance can offer greater flexibility than long-term sources.

Refinancing risk Short-term sources of finance have to be renewed more frequently than long-term sources. This can be problematic for businesses that are in financial difficulties or if there is a shortage of finance overall in the market.

Interest rates Fluctuating interest rates can cause problems when a business uses debt as a source of finance. This can be a particular problem when combined with the need to re-finance debt.

Table 2: Elements in the cost of debt financingon the goRevision

Activity 3: How best to meet the financing needs of the business

Read the paper by Dolar and Yang (2013) at https://aabri.com/manuscripts/121305.pdf.

This paper provides evidence that the consolidation of the banking sector has had a negative impact on the level of lending to small businesses.

Critically evaluate the effect of the financial crisis on the availability of debt finance to small businesses.

OvEr TO yOu

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2.2 Sources of finance and how they relate to strategic objectives and strategic environment Internal and external sources of finance

You have already considered the nature of equity and debt finance earlier in the chapter. Share capital is a form of equity and is an external source of finance: it requires the agreement of potential shareholders (who agree to purchase the shares) in order to raise finance. Debt is also an external source of finance: again, it requires the agreement of parties outside the business (one or more lenders) before it can be used. Internal sources of finance, in contrast, arise from decisions that do not require agreement from other parties beyond the directors of the business (Atrill, 2014).

External sources of finance require the agreement of parties outside of the business in order to raise the finance. Internal sources of finance arise from decisions that do not require agreement from other parties beyond the directors of the business.

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Internal: Retained profit

Retained profit is a type of equity finance. The retention of profit (rather than distribution in the form of dividends) is, in effect, a way to raise finance (Atrill and McLaney, 2014). Unlike share capital, retained profit is an internal source of finance, its use does not depend on agreement from parties other than the directors of the business. Typically, it is long term in nature.

Atrill and McLaney (2014) report that retained profit has represented about half of all the long-term finance raised by UK businesses in recent years. Despite the popularity of the use of retained profit, a number of important factors need to be considered before it is used. These issues are summarised in Table 3.

Factor Description

Dividend policy The retention of profit and the subsequent use as a source of equity finance will have an effect on the dividends paid. Some suggest that this will reduce the net wealth of investors.

Issue costs Other approaches to the raising of equity finance, such as Initial Public Offerings, have issue costs. Retained profit can be attractive for this reason.

Risk There is no guarantee that additional retained profits will be generated in the future.

Dilution of control The use of retained profits does not affect the voting strength of investors.

Table 3: Factors to consider in the use of retained profit as financeon the goRevision


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Activity 4: Retained profit

Are retained profits a “free” source of finance? How might shareholders feel if a business consistently uses retained profit as a source of finance, rather than distributing it to shareholders in the form of a dividend?

Source: Atrill, (2014, p. 254)

OvEr TO yOu

Internal: Working capital

This is another internal source of finance. Four principal elements comprise working capital: inventories, trade receivables, cash and trade payables. Effective management and control of these elements can provide opportunities to generate and “drive out” sources of finance that can be used to support a business’s activities.

Atrill and McLaney (2014) note that the effective management of working capital is linked to longer term financing decisions. The amount of working capital that needs to be held across time, the timing of cash flows and the level of risk involved all need to be considered when reflecting on the importance of working capital and financing.

Activity 5: Working capital

In some industries, current assets such as inventories, receivables and cash can constitute a significant proportion of the total asset base. The appropriate management of payables can also be critical, particularly for a business that purchases goods and services on a credit basis.

In which industries might working capital represent a significant proportion of a business’s asset base?

OvEr TO yOu

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Working capital comprises inventories, account receivables, cash and accounts payable. Effective management of working capital is linked to longer term financing decisions. Timing of cash flows and levels of risk are important when considering the amount of working capital that might be available as a source of finance.

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The level of inventories held by a business will vary according to a number of factors, including the industry in which the business operates. Businesses are not obliged to hold inventories. The level of inventories held will be informed by a number of factors. These factors are summarised in Table 4.

Factor Description

Trade-off Optimal inventory levels involve a trade-off between carrying costs and order costs.

Carrying costs Carrying costs include the cost of storing goods as well as the cost of capital tied up in inventor.

Frequency of orders A business can manage its inventories by waiting until they reach some minimum level and then replenish them by ordering a predetermined quantity. When carrying costs are high and order costs are low, it makes sense to place more frequent orders and maintain higher levels of inventory.

Non-linearity Inventory levels do not rise in direct proportion to sales. As sales increase, the optimal inventory level rises, but less than proportionately.

Table 4: Factors in the determination of inventory levels on the goRevision

Cash is another important element of working capital. The amount of cash held by a business needs to be considered with great care: the marginal value of holding such a liquid asset as a cash balance declines as the amount of cash held increases.


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Activity 6: Cash

Identify and discuss the costs of holding:

1 too little cash

2 too much cash.

OvEr TO yOu

The marginal value of holding cash declines as the amount of cash held increases. The costs of holding too little cash include a failure to meet payables and other obligations when they fall due. The costs of holding too much cash include the opportunity cost of failing to use cash to finance profitable investment opportunities.

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External: Share capital

You have seen that equity represents the “ownership interest” in a business. For businesses that are limited companies, examples of equity finance include share capital. This share capital comprises all of the funds raised by a business in exchange for shares in that business (Brealey, Myers and Allen, 2014). Usually, share capital is issued in exchange for cash although sometimes forms of non-cash consideration can be used.

There are a number of different methods by which share capital can be issued.

Initial public offering

The process of selling shares to the public for the first time is called an initial public offering (IPO). IPOs can take a number of different forms, including:

• primary offerings: new shares are sold to raise additional cash for the business;

• secondary offerings: often confined to small, less-established types of business.

IPOs offer both advantages and disadvantages. A summary of each is provided in Table 5.

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Advantages Disadvantages

Access: IPOs provide access to a much greater amount of equity finance

Dilution of control: shareholders of a business become more widely dispersed

Performance: provide a “yardstick” measure with which to evaluate performance

Agency (problem): direct monitoring and supervision of managers becomes more difficult

Diversification: greater diversification of sources of finance

Administrative costs: additional regulatory and administrative costs

Reduced costs: potentially reduces the cost of borrowing

Table 5: Advantages and disadvantages of initial public offerings on the goRevision

In some cultures, IPOs are very rare. For example, Italy has only 10% listed companies compared to those in the UK (Brealey, Myers and Allen 2014).

Initial public offerings (IPOs) offer both advantages and disadvantages. Advantages include access, performance, diversification and reduced costs. Disadvantages include dilution of control, agency problems and administrative costs.

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Investment banks and professional advisors are the key to the IPO process. The latter are referred to by Brealey, Myers and Allen (2014) as the “financial midwives” or underwriters for an IPO. They buy the shares and then sell them to the public.

The IPO process typically involves some or all of the following stages that are outlined in Table 6.

Stage Description

Investment bank Select an investment bank as a professional advisor and underwriter.

Due diligence An investigation by the investment bank and the business that produces the information required to satisfy appropriate regulatory authorities.

Pre-marketing Distribution of briefing documents to institutional investors in order to introduce the company.

Underwriting An underwriting syndicate is formed by the investment bank to underwrite the issue.

Initial prospectus An initial prospectus includes an initial price range based on the investment bank’s analysis and the feedback from pre-marketing. Note that some techniques for taking the business public fix the price in the due diligence phase, so there is no initial prospectus.

Pricing/allocation If the price has already been fixed, only the allocation remains to be done.


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Activity 7: Initial public offerings

Read the paper by Smith (2013) You can access it at https://aabri.com/manuscripts/ 121367.pdf

This paper examines alternative methods of abnormal performance detection and applies the most powerful method to examine the price performance of IPOs. This application is used to determine if IPOs generate abnormal performance.

Critically evaluate the evidence that IPOs generate abnormal performance.

OvEr TO yOu

Seasoned equity offerings

A business’s need for equity rarely ends at the IPO. Profitable investment opportunities occur throughout the life of the business. In some cases, it will not be feasible for these investment opportunities to be financed using other sources of finance. As a result, businesses return to equity markets and offer new shares for sale; this is a type of offering called a seasoned equity offering (SEO), also known as a security sale.

There are two kinds of SEOs:

• cash offers: the business offers new shares to investors at large;

• rights offers: the business offers new shares only to existing shareholders.

When a business issues shares using an SEO, it follows many of the same steps as for an IPO. The main difference is that a market price for the shares already exists. This means that the price-setting process is not necessary.

A seasoned equity offering (SEO) can be used to raise additional equity finance following an initial public offering (IPO). The key difference between an SEO and an IPO is that, in an SEO, a market price for the shares already exists.

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Research has shown that, on average, the equity markets greet the news of an SEO with a decline in the market price of a business’s shares. Often, the value destroyed by the price decline can be a significant fraction of the new finance raised. A business that is concerned with protecting its existing shareholders will tend to sell new shares at a price that correctly values or overvalues the business, investors infer from the decision to sell that the company is likely to be overvalued, therefore, the market price drops with the SEO announcement.

https://aabri.com/manuscripts/121367.pdf

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Seasoned equity offerings (SEOs) often lead to a reduction in the market price of a business’s shares. Equity markets tend to interpret SEOs as a sign that a business’s shares are overvalued and so the market price of those shares falls with the announcement of an SEO.

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Rights issues

This form of SEO involves the offer of new shares, for cash, to existing investors. To encourage existing investors to take up a rights offer, a price is set that is usually below the current market price. The number of shares that an existing investor has the “right” to take up will depend on the number of shares owned by that investor prior to the SEO.

Activity 8: Rights issues

Baker Holdings plc has 20 million ordinary shares of £0.50 in issue. These shares are currently valued on the London Stock Exchange at £1.60 per share. The directors of Baker Holdings plc believe that the business requires additional long-term capital and have decided to make a one-for-four rights issue (that is, one new share for every four shares held) at £1.30 per share. What is the value of the rights per new share?

OvEr TO yOu

Market forces will usually ensure that the actual price of rights and the theoretical price will be fairly close. Rights issues are a popular approach to the raising of equity finance. Atrill and McLaney (2014) report that, between 2001 and 2010, rights issues averaged 45% of total SEOs.

External: Debt

There are many other sources of debt finance. In this part of the chapter, we will consider some of the most popular types of debt financing.

Loans

Loans are a major source of debt finance for many businesses. This form of debt financing is an external source of finance. Loans can be both short-term and long-term in nature.


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Lenders invest in businesses via a contract that will typically specify interest rates, dates of interest payments, capital repayments and the security for the amount lent to the business. To protect themselves against the non-repayment of interest and capital amounts, lenders seek some form of security for their investment (Atrill, 2014).

The cost of this type of debt financing will typically be made up of the elements that are outlined in Table 7.

Element Description

Finance costs (interest charges) The cost of borrowing and a reflection of the level of risk that the lender perceives to arise as a result of their investment in the business

Security charges The means by which lenders establish some form of security on their investment. The charge may be fixed on particular assets of the business or “floating” on the whole asset base of the business

Fees Arrangement and administrative fees may also be incurred as a result of borrowing


There are many types of debt finance. The cost of debt includes finance costs (interest charges, security charges and fees).

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Long-term loans are available from banks and other financial institutions. Fixed and floating (also known as variable) rates of interest can be applied to these loans. These finance costs (interest charges) reflect the perceived risk of the borrowing business. The greater the risk that is perceived by a bank or financial institution, the higher the interest rate.

Payments on long-term loans will include both principal (also known as capital) and interest elements. The annual repayment amount on a loan can be found by dividing the amount of the loan by the cumulative present value (also known as the annuity) factor at the relevant rate of interest.

Annual repayment amounts on a long-term loan

Liqui manages a highly successful hairdressing business in Hong Kong. She started the business 10 years ago with her business partner, Meifing. Liqui and Meifing opened their first salon in Kowloon.

CASE STuDy

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The business now comprises five salons in various areas of Hong Kong. Each salon has approximately 3,000 customers per year, although the salon in Kowloon attracts 7,000 customers per year. Most of the supplies that are used by the business are purchased from a single supplier.

Liqui and Meifing’s business is a limited company. A local businessman owns 45% of the shares in the company. The rest of the shares are owned by 30 other investors, who include Liqui and Meifing.

Liqui plans to expand operations into mainland China. Liqui intends to finance this expansion using a loan from a local bank.

Consider that Liqui plans to use a $100,000 bank loan at an interest rate of 10% per year. The loan is repayable in equal annual instalments over five years.

Activity 9: Annual repayment amounts on a long-term loan

Carefully read through the information in the case study above and calculate the annual repayment amount on the loan.

Remember that this can be found by dividing the amount of the loan by the cumulative present value (also known as the annuity) factor at the relevant rate of interest.

Source: Watson and Head (2016, p. 147)

OvEr TO yOu

The annual repayment amount on a long-term loan can be found by dividing the amount of the loan by the cumulative present value (also known as the annuity) factor at the relevant rate of interest.

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For many businesses, loans are a major source of debt finance. Loans are an external source of finance and can be both short-term and long-term in nature.

Providers of loan finance use contracts that will typically specify interest rates, dates of interest payments, capital repayments and the security for the amount lent to the business. To protect themselves against the non-repayment of interest and capital amounts, lenders seek some form of security for their investment.

Source: Atrill (2014) on the goRevision

Bonds

Many firms raise finance via issuing securities that bear a fixed interest rate that is payable on the face value of those securities (Atrill and McLaney, 2014). These securities include loan notes, debentures and bonds.

A bond is an evidence of debt issued by a business or a government body (government bonds are sometimes referred to as “gilts”). A bond represents a loan made by investors to the issuer. In return for this investment, the investor receives a legal claim on future cash flows of the borrower. The issuer promises to:

• make regular coupon payments (interest payments) every period until the bond matures

• pay the face/par/maturity value of the bond when it matures (i.e. when the bond becomes due for repayment.

The nominal yield or coupon rate is the rate of interest on the face value of the bond. This is not necessarily the same as the market rate of interest. The current yield is the nominal interest payment divided by the current market price.

Bonds are a form of debt finance and represent a loan made by investors to the issuer. The nominal rate of interest is the rate of interest on the face value of the bond. This is not necessarily the same as the market rate of interest. The current yield is the nominal interest payment divided by the current market price.

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Redeemable bonds (i.e. bonds for which the principal amount needs to be repaid when the bond matures) can be valued by discounting the future interest payments and the future redemption value by the debt holders’ required rate of return. Interest payments are usually made on an annual or semi-annual basis. The formula for the valuation of a redeemable bond is:

PO = I(1 + Kd ) + I

(1 + Kd )2 + I(1 + Kd )3 + … + I + RV

(1 + Kd )n

Where:

PO = ex-market rate of interest

I = interest paid ($)

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Kd = rate of return required by debt investors (%)

RV = redemption value ($)

n = time to maturity (years)

The formula for the calculation of the value of a redeemable bond is:

PO = I(1 + Kd ) + I

(1 + Kd )2 + I(1 + Kd )3 + … + I + RV

(1 + Kd )n

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Activity 10: Bond valuation

Consider a bond that pays an annual interest of 10% and that is redeemable at a nominal value of £100 in four years’ time. Assume that investors in this bond require an annual rate of return of 12%.

Calculate the value on the bond.

Source: Watson and Head (2016, p. 155)

OvEr TO yOu

The world’s debt markets provide the basis for the issue and trading of many types of bonds. Typically, these bonds have terms (also known as “maturities”) of up to 10 years but can have much shorter or longer terms.

The need to meet these finance costs can present a number of risks to a business. Assuming that the level of profit remains constant, then the need to meet these finance costs means that there will be less profit to distribute to shareholders in the form of dividends. Alternatively, if the debt finance is used to generate additional profit that exceeds the finance costs, then this will increase the amount of profit that is available to distribute to shareholders in the form of a dividend.


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Advantages and disadvantages of different sources of equity and debt financing

Equity: advantages and disadvantages

The use of equity can offer advantages to a business, not least the avoidance of the disadvantages that are associated with the use of debt. You will consider some of the theoretical underpinnings for the use of equity finance later in the chapter.

However, the use of equity can lead to problems. Brealey, Myers and Allen (2014) suggest that these problems arise most commonly due to conflict between shareholders and managers. Shareholders will often try to influence strategy. Conflicts of interest can exist between shareholders and managers, while the latter have a theoretical responsibility to act in the best interests of the former, this might not always be the case in reality.

Shareholders will often try to influence strategy. They may also try to influence operational management structure and executive pay. Lenders may try to influence strategy and operations by making loans contingent on covenants. Managers will have their own personal objectives that may conflict with those of shareholders and lenders.

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Activity 11: Shareholders and corporate finance

Re-read the case study on page 9 in Chapter 1, Section 1.2: Aviva plc.

Consider the potential conflicts between shareholders and management in Aviva plc. Explain how these conflicts might be reflected in terms of Aviva plc’s approach to corporate finance.

OvEr TO yOu

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Conflicts between key stakeholders can often be seen to be reflected in aspects of corporate finance such as governance, executive remuneration, dividend policy and capital structure.

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Debt: advantages and disadvantages

One of the key advantages of debt finance is the creation of a “tax shield”. These tax shields protect profits from corporate tax. You will consider tax shields and their effects later in the chapter. For now, consider the key features, advantages and disadvantages of the main types of debt finance which are summarised in Tables 8 and 9.

Type Key features Advantages Disadvantages

Subordinated loan

Ranked below other types of borrowing: interest payments and capital repayments on other borrowing are paid in priority to subordinated loans. Sometimes referred to as “junior debt”

Loan covenants on other types of loan often ignore subordinated loans, as they pose no threat to their claims: so, subordinated loans can be a source of borrowing when other sources are not available

Normally incur higher interest charges due to higher risks to lenders

Term loans Tailored to meet the specific needs of borrowers

Terms are open to negotiation and agreement. Flexible and often cheap

Restricted availability

Loan notes Divided into units and offered for sale to investors. Often traded on a stock exchange

Can be attractive to investors

Market value may fluctuate

Mortgages Secured on an asset Often long term Lack of flexibility

Source: Adapted from Atrill (2014)

Table 8: The key advantages and disadvantages of the main types of debton the goRevision

A commonly cited disadvantage of debt finance is the existence of loan covenants (Brealey, Myers and Allen, 2014). Many of the types of debt finance that are outlined in Table 8 will include these restrictions. Loan covenants are assurances or “promises” made by businesses that certain activities will or will not be carried out. Typically, loan covenants will be included in a contract between a borrower and a lender.


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Loan covenants offer protection to lenders against the risk of default (i.e. a failure to meet finance charges or repayment obligations) by borrowers. Table 9 provides an outline of the typical types of loan covenant:

Type Key features

Merger restrictions Restrict the business’s ability to develop mergers and other types of partnerships with other businesses.

Dividend or other payment restrictions

Restrict the ability of a business to pay dividends or other payments. Approval may be required by the lender.

Debt covenants Restrict the amount of additional borrowing by the business.

Default-related events Trigger specific actions as a result of the default on debt obligations.

Changes in control Restrict the business’s ability to make changes to its management team.

Source: Adapted from Brealey, Myers and Allen (2014)

Table 9: Types of loan covenanton the goRevision

Atrill and McLaney (2014) note that all lenders will worry, to some extent, about the risk of default. Loan covenants result in some providers of debt finance having greater security than others.

The effect of corporate taxes in the selection of different sources of finance

Debt, corporate taxes and tax shields

As we saw in the previous chapter, the use of debt as a source of finance is not without its risks. Nevertheless, if debt finance is used to generate additional profit that exceeds the cost of debt, then this will increase the amount of profit that is available to distribute to shareholders in the form of a dividend. Research by, for example, Dimson, Marsh and Staunton (2011) suggests that debt finance is cheaper than equity finance, at least in the short-term.

Debt is a very popular source of finance for many businesses. Research suggests that this is because it is cheaper than equity finance, at least in the short-term.

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Finance costs (also known as interest charges) create “tax shields”. These tax shields protect profits from corporate tax. This is one of the reasons why debt finance is often cheaper than equity finance. Tax shields are calculated as the present value of future tax savings arising from the use of debt finance (Watson and Head, 2016).

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Tax shields

Let’s return again to the case study about Liqui and Meifing’s business.

Remember that Liqui plans to expand operations into mainland China. Liqui intends to finance this expansion using a loan from a local bank.


Now consider that, instead of the bank loan, Liqui plans to raise $100,000 by issuing new share capital in the form of a rights issue.

Assume that the annual earnings before interest and tax of Liqui’s business are expected to be $200,000.

CASE STuDy

Activity 12: Tax shields

Calculate the tax shield that will be created if Liqui decides to finance the investment in expanding the business operations using the bank loan, rather than the rights issue.

Source: Brealey, Myers and Allen (2014, p. 441)

OvEr TO yOu


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2.3 Decision-making frameworks that could be applied to ensure that the business utilises sources of finance that are appropriate to its needs and strategic circumstancesPecking order theory, the matching principle of finance and models of financial distress

Pecking order theory starts with the principle of asymmetric information (Brealey, Myers and Allen, 2014): managers have greater knowledge and information about the business’s prospects, risks and values than shareholders and lenders do.

This asymmetry of information has an effect on the choice between internal and external financing and between the use of equity and debt finance. Pecking order theory suggests that:

• investment should be financed with internal funds;

• of these internal funds, retained earnings should always be used first;

• if internal funds are not available, then debt finance should be used;

• new equity should be used as a last resort.

You have considered the matching principle of finance earlier in the chapter. Remember: short-term investment needs should be financed with short-term sources of finance. Long-term investment needs should be financed with long-term sources of finance.

Pecking order theory suggests that there is an “order of priority” for the financing of investments. Retained profit, debt and, finally, share capital should be used to finance investments.

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Models of financial distress

Predictions of financial failure are estimates of the likelihood that a business will experience financial distress. Typically, this will result in negative consequences for investors.

The use of financial ratios in the prediction of financial failure is concerned with creditworthiness: lenders and other providers of finance will only invest in a business if the rewards of investment exceed any risk.

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Activity 13: Models of financial distress

List the types of providers of finance that might seek to predict the likelihood of financial distress or the financial failure of a business.

OvEr TO yOu

The relevance of particular ratios in the prediction of financial distress has been the subject of considerable research. For example, Beaver (1966) examined the use of ratios such as Total debt / Total assets and Working capital / Total assets for failed and non-failed businesses. Beaver’s (1966) research indicated that there was evidence that financial distress and failure could be predicted by the use of key ratios.

Other research has sought to consider the use of a single index, rather than the examination of a number of single ratios. A key model of this type is the Z-score model that was provided by Altman in 1968. This model was developed using paired samples of failed and non-failed businesses; evidence indicated that the model was able to predict financial failure up to two years before it occurred. Such failed businesses had a Z score of less than 1.81.

Altman’s initial Z-score model sought to develop a single index based on the calculation and weighting of the following ratios:

Ratio Weighting

Working capital / Total assets 1.2

Retained profit / Total assets 1.4

Profit before interest and taxation / Total assets 3.3

Market value of ordinary and preference shares / Total liabilities at book value 0.6

Sales revenue / Total assets 1.0

Table 10: Ratio and weightings to predict financial failureon the goRevision

Via the use and weighting of these ratios, Altman’s Z-score model considers liquidity, long-term profitability, current profitability, financial leverage on a market value basis and revenue generation capacity.


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While Altman’s model has proved to be useful, particularly when compared with the use of a number of single rations, it is not perfect: there are missing categorisations between firms that are predicted to fail and those that are not.

More recently, industry and culture specific models have been developed.

Activity 14: Models of financial distress

Read the paper by Grice and Ingram (2001) at https://www.researchgate.net/publication/4966730_Test_of_the_Generalizability_of_Altman’s_Bankruptcy_Prediction_Model

This paper provides evidence on the usefulness of Altman’s model in the prediction of bankruptcy. Critically evaluate the usefulness of Altman’s model as a predictor of financial distress.

OvEr TO yOu

A summary of the sources of finance that have been considered in this chapter is provided in Table 11.

Type Key features

Retained profit Accumulated profit earned by the business; an internal source of finance.

Working capital Management of inventories, receivables, cash and payables to generate sources of finance.

Initial public offering

Sale of shares to the public for the first time.

Cash offer Offer of new shares, for cash, to investors at large.

Rights issue Offer of new shares, for cash, to existing investors.

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Type Key features

Loans Can be both short-term and long term, typically underpinned by a contract that specifies interest rates, dates of interest payments, capital repayments and the security for the amount lent to the business.

Bonds Debt issued by a business or a government body; the investor receives a legal claim on future cash flows of the borrower.

Subordinated loan Ranked below other types of borrowing: interest payments and capital repayments on other borrowing are paid in priority to subordinated loans, sometimes referred to as “junior debt”.

Term loans Tailored to meet the specific needs of borrowers.

Loan notes Divided into units and offered for sale to investors, often traded on a stock exchange.

Mortgages Secured on an asset.

Source: Adapted from Atrill (2014)

Table 11: Sources of finance: summaryon the goRevision


• Atrill, P. and McLaney, E. (2014) Accounting and Finance for Non-Specialists, 9th edition, Harlow: Pearson.

• Beaver, W.H. (1966) “Financial ratios as predictors of failure”, Empirical Research in Accounting: Selected Studies, pp. 71–111.

• BBC (2012) “Aviva loses vote on executive pay at its AGM”, Retrieved from: http://www.bbc.co.uk/news/business-17938865 [Accessed on: 30 December 2012].


• Dolar, B. and Yang, F. (2013) “The 2007–2008 financial crisis and the availability of small business credit”, Journal of Finance and Accountancy, 12, pp. 1–12.

• Dimson, E., Marsh, P. and Staunton, M. (2011) “Equity premiums around the world”, CFA Institute Publications, 11 (4), pp. 18–26.

• Grice, J. & Ingram, R. (2001) “Tests of generalizability of Altman’s bankruptcy prediction model”, Journal of Business Research, 54, pp. 53–61.

• Smith, Z. (2013) “An empirical analysis of initial public offering (IPO) price performance in the United States”, Journal of Finance and Accountancy, 12, pp. 1–12.

• Watson, A. and Head, A. (2016) Corporate finance: principles and practice, 7th edition, Harlow, Pearson.

rEADiNg LiST


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• Grice, J. & Ingram, R. (2001) “Tests of generalizability of Altman’s bankruptcy prediction model”, Journal of Business Research, 54, pp. 53–61.

• https://www.researchgate.net/publication/4966730_Test_of_the_Generalizability_of_Altman’s_Bankruptcy_Prediction_Model [Accessed on: 27 February 2017]

rESOurCES

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Introduction

The mix of equity and debt financing in a business comprises its financial structure. Any imbalance in this financial structure will cause profits to be lower than they would otherwise be. The cost to a business of raising finance is referred to as its cost of capital.

A business must understand its cost of capital in order to make decisions that will generate wealth: a failure to do so will mean that the business makes a decision that does not add value or, even worse, destroys existing value. If managers can understand and are able to calculate the cost of capital of the business, then they should have a key tool with which to make decisions that secure increases in value for the business and its owners.

A key feature of this chapter is the application of calculations in a number of case studies and activities. You will also be given an opportunity to critically evaluate alternative approaches to the calculation of the cost of capital.

Learning outcomes


3 Critically evaluate approaches to the calculation of the cost of capital that take account of techniques for the valuation of equity and different types of risk

Assessment criteria

3 Critically evaluate approaches to the calculation of the cost of capital that take account of techniques for the valuation of equity and different types of risk

3.1 Critically evaluate the alternative approaches to the valuation of equity

3.2 Apply appropriate methods for the calculation of the cost of capital in order to provide a basis on which strategic financing and investment decisions can be made

3.3 Critically evaluate the effects of different types of risk on the cost of capital by applying techniques that reflect the strategic environment in which the business operates

The Cost of Capital

Chapter 3

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3.1 Alternative approaches to the valuation of equity The cost of capital

The mix of equity and debt financing together represents a business’s financial structure. Any imbalance will lead to inefficiency; remember that the aim of the business is to raise and invest finance in order to make a profit. If the financial structure of a business is not right, profits will be lower than they would otherwise be.

The cost to a business of raising finance is referred to as the cost of capital. Brealey, Myers and Allen (2014, p. 28) define the cost of capital as:

The expected return on a portfolio of all the company’s existing securities. It is the opportunity cost of capital for investment in the

business’s assets, and therefore the appropriate discount rate for the business’s average-risk projects.

Put simply, the cost of capital provides a “test” against which prospective investment opportunities can be evaluated (McLaney, 2014). It is therefore crucial that the cost of capital is calculated and applied as the basis for investment decisions.

Later in this chapter, you will be given the opportunity to apply alternative techniques in order to calculate the weighted average cost of capital. First, you will consider two of the main approaches to the calculation of the cost of a key element in a business’s financing structure: equity.

The mix of equity and debt financing in a business comprises its financial structure. Any imbalance in this financial structure will cause profits to be lower than they would otherwise be. The cost to a business of raising finance is referred to as its cost of capital.

NEED TO KNOW

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ABE Level 6 Corporate Finance

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Chapter 3 The Cost of Capital

Alternative approaches to the valuation of equity: the capital asset pricing model

The capital asset pricing model (CAPM) provides a precise prediction of the relationship between the risk of an asset and its expected return. CAPM allows us to identify an efficient portfolio of assets without prior knowledge of the expected return of each security. Brealey, Myers and Allen (2014) note that this model is the most widely used approach in the context of the determination of the cost of equity.

At least in theory, the CAPM tells us that expectations of returns will be enhanced by the extent of the covariance of expected returns from the particular security with those of the market portfolio (McLaney, 2014).

At heart, the CAPM’s message is “startling and simple” (Brealey, Myers and Allen 2014, p. 193): in a competitive market, an expected risk premium will vary in direct proportion to a measure of risk known as “beta” (ß). Beta is a measure of the level of “systematic risk” that relates to a particular asset/investment. A ß =1 indicates that a 1% rise in the stock index would be expected to be associated with an equivalent (1%) rise in the stock price.

The capital asset pricing model provides a prediction of the relationship between the risk of an asset and its expected return. It tells us that expectations of returns will be enhanced by the extent of the covariance of expected returns from a particular security with those of the market portfolio.

Beta is a measure of the level of systematic risk that relates to a particular asset or investment.

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The CAPM equation for the expected return is then:

E [R t] = rf + ß (E [RMkt] − rf )

Where:

E [R t] = the expected return on the capital asset

rf = the risk-free rate of interest (such as interest on government bonds)

E [RMkt] – r f ) = the market premium (the difference between the expected market rate of return and

the risk-free rate of return.

Activity 1: The capital asset pricing model (1)

The expected risk-free return of a market is 5% and the market return is expected to vary between 10% and 20%.

Calculate the return that can be expected from an asset having a beta coefficient of

a. 0.5

b. 1.0

c. 1.5

OvEr TO yOu

The Cost of Capital Chapter 3

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Applying the formula stated above, the CAPM can be calculated as follows:

a) If ß = 0.5, the return expected from the security is as follows:

Rm Rs

10% 5 + (10 − 5) 0.5 = 7.5%

15% 5 + (15 − 5) 0.5 = 10%

20% 5 + (20 − 5) 0.5 = 12.5%

From this, we can conclude that if ß is less than 1, the return expected from the security is less than the market return, and any change in the security return is less than the change in the market return.

b) If ß = 1, the return expected from the security is as follows:

Rm Rs

10% 5 + (10 − 5) 1 = 10%

15% 5 + (15 − 5) 1 = 15%

20% 5 + (20 − 5) 1 = 20%

From this, we can conclude that if ß is equal to 1, the return expected from the security is equal to the market return, and any change in the security return is equal to the change in the market return.

c) If ß = 1.5, the return expected from the security is as follows:

Rm Rs

10% 5 + (10 − 5) 1.5 = 12.5%

15% 5 + (15 − 5) 1.5 = 20%

20% 5 + (20 − 5) 1.5 = 27.5%

From this, we can conclude that if ß is greater than 1, the return expected from the security is greater than the market return, and any change in the security return is greater than the change in the market return.

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Capital asset pricing model: evaluation

As with all of the approaches and models that we have considered so far, the CAPM is founded on a number of assumptions. These include the following.

• Investors can buy and sell all securities at competitive market prices (without incurring taxes and transaction costs).

• Investors can borrow and lend at the risk-free rate.

• Investors hold only efficient portfolios of traded securities that yield the maximum expected return for a given level of volatility.

• Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities.

Many of the assumptions provide the basis for criticism of the CAPM. Both McLaney (2014) and Brealey, Myers and Allen (2014) note that testing of the CAPM has been less than conclusive in providing support for its practical usefulness. The reasons why the assumptions appear to be problematic are summarised in Table 1.

Factor Description

Investor concerns Investors are only concerned with a security’s expected value and standard deviation: it has been suggested that investors are concerned with other factors and that, therefore, beta cannot be a true measure of risk.

“True” market portfolios A representative stock market index is a reasonable surrogate for the market portfolio: a “true” market portfolio contains more than just the securities that are listed on a stock market.

“True” risk-free rates Returns from short-term government securities are a reasonable surrogate for the risk-free rate: it is not possible to view a “true” risk-free rate because no investment can ever be completely free of risk.

Expectations The output of the CAPM is a projection of what is expected to occur. Tests of the model are undertaken on the basis of what has actually happened.

Table 1: Criticisms of the CAPMon the goRevision

Criticisms of the CAPM include investor concerns, the lack of a “true” market portfolio, the lack of a “true” risk-free rate and difficulties in making predictions and projections.

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Alternative approaches to the valuation of equity: the dividend valuation model

What are dividends?

Dividends are payments made by businesses (specifically limited companies) to their equity investors. They could be considered to be one means by which businesses return wealth, in the form of distributed profits, to their equity investors. McLaney (2014) suggests that they seem to be viewed by both businesses and equity investors as the equivalent of finance charges (interest) that would be paid to a lender on debt finance.

Shares are traded “with dividends” (also known as cum dividend) until shortly before the date on which a dividend is distributed. After dividends are distributed, shares are traded ex-dividend.

A share, just like any other economic asset, is valued on the basis of future cash flows that are expected to arise from it (McLaney, 2014). This gives rise to an opportunity in the context of the cost of capital: models based on dividends can be used to calculate the cost of equity.

The dividend valuation model

The dividend valuation model (DVM) is an approach to the calculation of the equity risk premium that seeks to estimate the implied equity rate of return that is embedded in the current market price of a security, based on the forecast dividends to be paid in shares.

Simply put, the DVM defines the price of a share to be the present value of all future dividends discounted by the required rate of return for that particular share (McLaney, 2014).

Pi =∑ Dn

(1 + E (Ri ))n

Where:

Pi = current price of share i

Dn = dividend expected in year n on share i

E (Ri ) = expected return on share i, given its risk.

Gordon’s growth model

Gordon’s growth model (1959) assumes, for simplicity, that dividends will grow at a constant rate. Although this assumption is, in itself, unrealistic, it does help to address the fundamental weakness of the DVM. Also, it results in a dramatic simplification of the formula for the DVM, to:

Pi = D1

E (Ri ) − g

Where:

Pi = current price of share I

D1 = dividend expected in year 1 on share I

E (Ri ) = expected return on share i, given its risk

g = expected constant annual growth rate of share i’s dividend.

Rearranging this equation allows the expression that the required rate on a share is the sum of the dividend yield. So, using Gordon’s growth model, the cost of equity capital for a share can be

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estimated by inputting the expected dividend for next year and dividing by the current share price. Finally, the expected constant growth rate for dividends beyond next year is applied. These stages are reflected in the following formula:

E (Ri ) = D1

Pi

+ g

Activity 2: Gordon’s growth model (1)

The expected risk-free return of a market is 5% and the market return is expected to vary between 10% and 20%.

Calculate the cost of equity capital using Gordon’s growth model.

Source: McLaney (2014)

Over tO yOu

Applying the formula stated above, the cost of equity capital can be calculated as follows.

The cost of equity capital can be estimated as:

E (Ri ) = D1

Pi

+ g = 3

100 + 8%

= 3% + 8%

= 11%

if it is assumed that dividend growth in the future will be the same as in the past.

Alternatively, suppose the long-term inflation forecast is 5% annually and the company is expected to grow in line with the economy, which is expected to grow 2.5% in real terms every year. Using the Fisher equation to establish the relationship between nominal and real growth for interest rates:

1 + nominal growth rate = (1 + real growth rate)(1 + expected inflation)

The nominal growth rate can therefore be expressed as:

nominal growth rate = ((1 + real growth rate) (1 + expected inflation)) − 1

= ((1.025) (1.05)) − 1

= 1.07625 − 1

= 7.625%


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Substituting into the Gordon growth model, the cost of equity capital for this company can be estimated as:

E (Ri ) = D1

Pi

+ g

= 3% + 7.625%

= 10.6%, rounded to one decimal place

Activity 3: Gordon’s growth model (2)

The ordinary shares of a business are currently trading at $2.00 (ex-dividend) each in the capital market. Next year’s dividend is expected to be 14 cents per share, and subsequent dividends are expected to grow at an annual rate of 5% of the previous year’s dividend.

Calculate the cost of equity capital using Gordon’s growth model.

Source: McLaney (2014)

Over tO yOu

Applying the formula stated above, the cost of equity capital can be calculated as follows:

E (Ri ) = D1

Pi

+ g

E (Ri ) = 0.14

2.00 + 0.05

= 12%

Dividend valuation model: evaluation

Research by McLaney et al. (2004) revealed that 28% of listed UK companies used a dividend approach to the estimation of the cost of equity. Other studies have indicated that a slightly lower proportion of businesses use this method to determine their cost of equity; this is a reflection, perhaps, of the relative popularity of the CAPM in this context.

This does not necessarily suggest that dividend-based approaches are without utility.

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However, perhaps the key weakness of such models is, once again, due to the assumptions on which they are based. The difficulties that are inherent in any forecast of dividend payment may result in a questionable basis for dividend-based approaches. As noted by McLaney (2014), dividends tend to vary over time.

Even Gordon’s (1959) growth model, while helping to simplify much of what preceded it, is recognised to be somewhat overly simplistic (e.g. by McLaney, 2014) in the context of the cost of capital.

Criticisms of the dividend valuation model include the difficulties in the forecasting of dividend payments and the tendency for dividend payments to vary over time.

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3.2 Methods for the calculation of the cost of capital to provide a basis on which strategic financing and investment decisions can be made Application of alternative methods for the calculation of the cost of capital: the weighted average cost of capital

Remember that the cost of capital is the opportunity cost of capital for investment in the business’s assets (Brealey, Myers and Allen, 2014, p. 28). The weighted average cost of capital (WACC) is the average rate of return required by all sources of finance used by a business (Watson and Head, 2016). The WACC takes account of the relative weights of each component of a business’s financing structure.

The WACC calculation for a company financed only by debt and equity finance is represented by:

WACC (R) = EE + D Ke+ D

E + D Kd (1 − Tc)

Where:

Ke = Cost of equity

Kd = Cost of debt (after tax)

E = Market value of equity

E = Market value of debt

Tc = Corporate tax rate.

Where a business is financed using only equity and debt, the weighted average cost of capital can be calculated using the following formula:

WACC = DD + E Kd + E

D + E Ke

Where:

D = total debt

E = total equity


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Kd = cost of debt

Ke = cost of equity.

The market values of debt and equity should be used to compute the weights for use in the WACC formula.

The weighted average cost of capital (1)

Consider a business that has a cost of debt that is estimated to be 5.0%, a cost of equity of 11.1% and an actual tax rate of 28%. The actual market debt/equity ratio was 21.77%.

CASE STuDy

Activity 4: The weighted average cost of capital (1)

Using the data in the case study above, calculate the business’s weighted average cost of capital.

OvEr TO yOu

Applying the formula stated above, the WACC can be calculated as follows:

WACC = 21.77% × 5.0% × (1 − 0.28) + 78.23% × 11.1%

= 9.4673%

= 9.5%

To allow for the effects of corporate taxation (look back to the previous chapter) in the calculation of the WACC, the following formula should be applied:

WACC = Ke E

D + E + Kd (1Tc) EE

Where:

Tc = the corporation tax rate.

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Consider that Derby plc is financed by a combination of debt and equity. The book value of equity is $3.5 million and it has 1.5 million shares outstanding. The shares are traded at $4 each. The rate of return demanded by its shareholders on equity is 12%. The value of Derby plc’s outstanding debt is $2 million and the cost of debt is 8%. Assume there is no corporate tax.

CASE STuDy


Estimate the value and the WACC of Derby plc (assuming no corporate tax).

OvEr TO yOu


The total value of equity is $6 million (1.5 million × $4). The value of debt is $2 million.

Therefore:

WACC = 0.12 6 million8 million + 0.08 2 million

8 million = 0.12 (0.75) + 0.08 (0.25)

= 0.11 or 11%

In the presence of corporate taxation, interest payments on corporate debt are deductible for the purposes of arriving at taxable income.

Two businesses with identical pre-tax operating cash flows, but which differ in their capital structure, will pay different amounts of tax because debt offers a tax shield. For this reason, the levered company will be valued more highly than the unlevered company.


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Miller (1977) contends that the tax benefits of leverage will depend on the tax positions of both lenders and investors. Therefore, businesses will tend to attract investors that are “suited” to the financing structure of a particular business: this is known as the “clientele” effect. This suggests that businesses should avoid making changes to their financing structure: investors, be they equity or debt investors, might then choose to disinvest in a business that no longer meets their investment preferences.

The weighted average cost of capital and its relationship with strategic financing and investment decisions

McLaney (2014) states that the use of WACC as the discount rate in an investment appraisal is based on four important assumptions.

• There is a known target ratio for the financing elements, which will continue for the duration of the investment project under consideration.

• The costs of the various elements will not alter in the future from the costs calculated.

• The investment under consideration is of similar risk to the average of the other projects undertaken by the business.

• The investment under consideration supports the same fraction of debt to equity as in the business’s overall capital structure.

The use of the WACC as the discount rate is based on four important assumptions: there is a known and stable target ratio for the financing elements; the costs of the various elements will not alter; the investment under consideration is of similar risk to the average of the other projects undertaken by the business; and the investment under consideration supports the same fraction of debt to equity as in the business’s overall capital structure.

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The use of the WACC also rests on two important prerequisites:

• the need to calculate the cost of equity (look back earlier in the chapter to remind yourself of how this might be done);

• corporate tax: the WACC should be calculated after tax because interest on debt is a tax deductible expense.


Consider that Derby plc is financed by a combination of debt and equity. The book value of equity is $3.5 million and it has 1.5 million shares outstanding. The shares are traded at $4 each. The rate of return demanded by its shareholders on equity is 12%. The value of Derby plc’s outstanding debt is $2 million and the cost of debt is 8%.

CASE STUDY

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Estimate the WACC of Derby plc assuming corporate tax at 30%.

OvEr TO yOu

Applying the formula stated above, the WACC can be calculated as follows.

The total value of equity is $6 million (1.5 million × $4). The value of debt is $2 million.

WACC = 0.12 6 million8 million + 0.08 (10.3) 2 million

8 million

= 0.12(0.75) + 0.056(0.25) = 0.104 or 10.4%


Hazlewood plc is financed by:

a. One million ordinary shares (nominal value $1 each.These are expected to yield a dividend of $0.10 per share in one year’s time. Dividends are expected to grow by 10 per cent of the previous year’s dividend each year. The current market price of the shares is $1.80 each;

CASE STuDy


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b. $800,000 (nominal) loan notes. These will pay interest at the end of each year of 11% (of nominal) for three years. After this, the loan notes will be redeemed at their nominal value. Currently, the loan notes are quoted in the capital market of $95 (per $100 nominal).

Assume that the corporate tax rate is 30%.


Calculate the WACC for Hazlewood plc.

Source: McLaney, E. (2014) Business Finance: Theory and Practice, 10th edition, Harlow: Pearson.

OvEr TO yOu


a. Cost of equity

Cost of equity Ke = $0.01$1.80 + 10%

= 15.6%, say 16%

b. Loan notes

We must use IRR type “trial and error” to determine the discount rate on the loan notes. The discount rate that gives an NPV of 0 lies close to 9 per cent, based on calculations in Table 2.

Year Cash flow ($) Discount factor Present value

0 (95.00) 1.000 (95.0)

1 7.70 0.917 7.1

2 7.70 0.842 6.5

3 107.70 0.772 83.1

1.7

Table 2: Internal rate of returnon the goRevision

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Ke ED + E + Kd (1Tc) E

E

There is little point in seeking more accuracy than the nearest whole percentage (9%). This is because:

• the cost of the other element in the financing (ordinary shares) has been calculated making some fairly sweeping assumptions about future dividends;

• the cash flows that will be discounted by the resulting WACC cannot be predicted with any great accuracy.

We say, then, that the cost of the loan notes, Kd = 9%. Next, we need to value the two elements:

a. Ordinary shares. The total value of the ordinary shares:

Ke = 1 million × $1.80 = $1.80 million

b. Loan notes. The total value of the loan notes:

Kd = 800,000 × 95100

= $0.76 million

Now that we have the costs and values of the two financing elements, we can go on to calculate WACC.

WACC (R) = EE + D Ke + E

E + D Kd (1 − Tc)

R = 1.801.80 + 0.76

× 16 + 0.76 1.80 + 0.76

× 9

R = 11.25 + 2.67

R = 13.92%, say 14%

The WACC is a popular approach to the calculation of the cost of capital. However, the assumptions on which it is based have been subject to criticism. These criticisms are summarised in Table 3.

Factor Description

Cheap debt Although debt is always a cheaper source of financing than equity, higher proportions of debt will lead to increasingly expensive equity: as equity investors seek greater protection from the increased risks that arise from high levels of debt.

Cost of equity Estimation of the cost of equity is inherently difficult.

Future characteristics The WACC is based on a business’s current characteristics: an investment decision is based on future cash flows.

There is no “true” cost of capital

The “true” cost of capital depends on the purpose to which finance is applied: strict reliance on the WACC could lead to the acceptance of too many high-risk projects and reject too many low-risk projects (Brealey, Myers and Allen 2014).

Table 3: Criticisms of the WACCon the goRevision


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Key criticisms of the use of the WACC include the assumption that debt is cheaper than equity; the inherent difficulty in estimating the cost of equity; the fact that investment decisions are based on future cash flows; and strict reliance on the WACC could lead to the acceptance of too many high risk projects.

NEED TO KNOW

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3.3 The effects of risk on the cost of capital

Risk and the cost of capital: sensitivity analysis, scenario analysis, expected values and simulations

Risk refers to the probability that the actual outcome of a decision will differ from the expected outcome. Risk is a key issue in many aspects of corporate finance: it is particularly important in the context of the cost of capital. Businesses need to understand the risks that they face and how these risks might affect their cost of capital. The range and complexity of the different types of risk and the impact that they could have in this context can seem overwhelming. As Watson and Head (2016) note, financial decision-making and the management of risk is a complicated and dynamic process.

Risk refers to the probability that the actual outcome of a decision will differ from the expected outcome. Risk is particularly important in the context of the cost of capital. Businesses need to understand the risks that they face and the potential effects of these risks on the cost of capital. If possible and necessary, businesses must attempt to manage and control these risks.

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Thankfully, there are models and techniques that can be used to help with financial decision-making regarding the cost of capital. Techniques are also available to support the management of risk once a decision has been made. A summary of these models and techniques is provided in Table 4.

Technique Description

Sensitivity analysis Models the effects of a chosen variable. A number of variables may be modelled consecutively. In simple terms, sensitivity analysis can be seen as “what if?” analysis.

Scenario analysis Allows the effects of a number of variables to be modelled simultaneously.

Expected values A weighted average of a range of possible values, with probabilities used as weights.

Simulations A computer based form of sensitivity analysis.

Table 4: Techniques that could be used to evaluate financial risks on the goRevision

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Sensitivity analysis

This technique examines key variables that affect a financial decision to determine how changes in each variable might influence the outcome. Key input values can be varied to pose a series of “what if?” questions. By considering these “what if?” questions, managers will have a range of possible outcomes to consider (Atrill, 2014). It is possible to use sensitivity analysis to determine the extent to which a key factor can be changed before a financial decision would change for that reason alone.

Weighted average cost of capital and sensitivity analysis

Consider the data in the table in respect of United Transport Limited.

Number of shares 3,000,000

Market price per share ($) 10

Market value of equity (E) ($) 30,000,000

Market value of debt (D) ($) 10,000,000

Ke (%) 20

Kd (%) 8

Tc (%) 40

Recent political developments suggest that Tc may increase to 50%.

CASE STuDy

Activity 8: Weighted average cost of capital and sensitivity analysis

Use the data shown in the case study above to calculate the WACC.

Use the data on the variability in Tc to recalculate the WACC. Calculate the sensitivity of the WACC to changes in Tc.

Note: The solution to this activity is provided at the end of the chapter, but you are strongly encouraged to attempt it yourself before referring to the solution.

OvEr TO yOu


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Sensitivity analysis offers certain advantages in helping to reduce exposure to financial risk. Atrill (2014) suggests that these advantages include the following:

• Margin of safety: the calculation of a margin of safety for each key factor can help to identify highly sensitive factors that require more detailed information. The collection, reporting and evaluation of information can be costly and time-consuming. The more managers can focus on the critical aspects of a financial decision, the better;

• Planning: financial managers can use sensitivity analysis to formulate plans to deal with factors that are highly sensitive.

Disadvantages of sensitivity analysis include:

• clarity: sensitivity analysis does not provide clear decision rules. To some extent, financial managers must still rely on their judgement;

• static: only one factor can be considered at a time while the rest of the variables are held constant.

Sensitivity analysis offers certain advantages in helping to evaluate the effects of financial risk. These advantages include the calculation of a margin of safety and in corporate finance decision-making. The disadvantages of sensitivity analysis include a lack of clarity in decision rules and the static nature of the technique: only one factor can be considered at a time while the rest of the variables are held constant.

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Scenario analysis

Unlike sensitivity analysis, scenario analysis allows the effects of a number of variables to be modelled simultaneously. A number of scenarios can be developed; typically, “best case” and “worst case” scenarios are modelled. Scenario analysis does not identify the likelihood of each occurrence of each of the cases.

Expected values

Statistical probabilities can be assigned to a range of values. Using this information, an expected value can be calculated and represents a weighted average of the possible outcomes with the probabilities used as weights.

Objective probabilities can be determined based on past experience. Historical data can be a reliable basis for the assigning of a probability to a value. However, past experience may not always be a reliable guide to the future (Atrill, 2014). Subjective probabilities are based on opinion and can be useful where historic data is unavailable.

Expected values can be a useful risk management technique. They rely on the assignment of probabilities to values in order to calculate a weighted average of the possible outcomes with the probabilities used as weights. Objective probabilities or subjective probabilities can be used in the calculation of expected values.

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Simulations

Simulations are a form of computer-based sensitivity analysis. A range of possible values for key variables are identified and a probability of occurrence is assigned to each. One of these possible values is selected on a random basis and outcomes are then calculated. This process is repeated using other values for each variable until all the possible combinations of values for key variables have been considered. In practice, thousands of calculations will be carried out (Atrill, 2014).

The use of simulations offers two key advantages.

• Understanding: the process of modelling can help managers to understand its nature and the key issues in the decision.

• Risk measurement: the distribution of outcomes can help to assess the risk of a decision.

Disadvantages of simulations include:

• complexity: designing and producing a simulation model can be time consuming. The greater the complexity of a decision, the greater the complexity of identifying key variables and probabilities;

• mechanical approach: simulations can lead to an over-reliance on a quantitative approach to financial decision-making.

Simulations are a form of computer-based sensitivity analysis. Understanding and risk measurement are the key benefits of the use of this approach to the evaluation of risk. Complexity and a mechanical approach to decision-making are the key disadvantages of simulations.

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Activity 9: Risk taking and its effects

Read the paper: Impact of risk taking on bank financial performance during 2008 financial crisis, Journal of Finance and Accountancy, 13, pp. 1 – 18, by Tarraf and Majeske (2013) at https://aabri.com/manuscripts/131544.pdf

This paper studies the relationship between risk taking and other factors and the financial performance of bank holding companies during the 2008 financial crisis.

Critically discuss the relationship between risk taking and financial performance. Explain the effects that risk taking appears to have on the financial performance of banks and, more generally, in the financial crisis.

OvEr TO yOu


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Alternative approaches to the calculation of the cost of capital

Adjusted present value

The idea behind adjusted present value (APV) is to “divide and conquer” (Brealey, Myers and Allen 2014). Whereas a WACC calculation seeks to reflect the effects of financing and other factors such as corporate taxation, APV rests instead on a series of present value calculations.

The APV method involves the calculation of an unlevered cost of capital (VU) and then a levered (VL) cost of capital. The VU is the base value of the investment without any leverage, it reflects the base assumption that all of the investment will be equity financed. The VL is then calculated to reflect the financing effect of debt.

The following formula can be used to calculate the unlevered cost of capital:

Ru = EE + D Ke + D

E + D Kd = Pretax WACC

The following formula is used to calculate the levered cost of capital ( V L ):

V L (or APV) = V u + PV (interest tax shield)

Effectively, the business’s unlevered cost of capital equals its pre-tax WACC. This is happening because WACC represents investors’ required return for holding the business. As long as the business’s leverage choice does not change the overall risk of the business, the pre-tax WACC must be the same (levered or not).

In order to calculate the levered investment with the APV method, we should:

• determine the investment’s value without leverage, by discounting its free cash flows at the unlevered cost of capital;

• determine the present value of the interest tax shield;

• add the unlevered value to the present value of the interest tax shield in order to determine the value of the investment with leverage.

Adjusted present value

Expected free cash flow from Avco’s project, data in respect of which is provided below.

Year 0 1 2 3 4

Incremental earnings forecast ($ million)

Sales 60.00 60.00 60.00 60.00

Cost of goods sold (25.00) (25.00) (25.00) (25.00)

Gross profit 35.00 35.00 35.00 35.00

Operating expenses (6.67) (9.00) (9.00) (9.00) (9.00)

Depreciation (6.00) (6.00) (6.00) (6.00)

EBIT (6.67) 20.00 20.00 20.00 20.00

Tax @ 40% 2.67 (8.00) (8.00) (8.00) (8.00)

CASE STuDy

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Unlevered net income

Free cash flow ($ million)

(4.00) 12.00 12.00 12.00 12.00

ADD: Depreciation 6.00 6.00 6.00 6.00

LESS: Capital expenditure

(24.00)

LESS: Increases in NWC

Free cash flow (28.00) 18.00 18.00 18.00 18.00

Debt to value ratio d 50%

Equity cost of capital Ke 10%

Debt cost of capital Kd 6%

Corporate tax rate Tc 40%

Source: Adapted from Berk, J. and DeMarzo, P. (2009) Corporate Finance. Harlow: Pearson.

Activity 10: Adjusted present value

Using the information in the case study above, calculate the unlevered cost of capital. Estimate the project’s value without leverage.

OvEr TO yOu

Adjusted present value: evaluation

If we would like to calculate the unlevered cost of capital, it should be:

Ru = 0.50 × (0.10 + 0.50) × 0.06 = 8%

Similarly, if we wanted to estimate the project’s value without leverage, it should be:

V L = 181.08

+ 18(1.08)2

+ 18(1.08)3

+ 18(1.08)4

= 59.62 million


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The flow to equity method

WACC and APV methods consider a project’s free cash flow (without interest and debt payments). However, these methods do not determine the cash flows that the shareholders will receive. The flow to equity (FTE) method fills this gap as it calculates the cash flow that is available to shareholders after taking into consideration all the payments from/to debt holders.

In order to estimate the FTE, we should adopt a two-step approach:

• calculate the free cash flow to equity;

• value the equity cash flows.

The free cash flow to equity is the remaining free cash flow after adjusting for interest and debt payments. Consider Avco’s project from the previous case study. In order to calculate FTE, we must first calculate free cash flow. We have to adjust for every potential expense. Then we have to consider any potential proceeds from the business’s investments.

Flow to equity method

Expected free cash flow from Avco’s project:

Year 0 1 2 3 4

Incremental earnings forecast ($ million)

Sales 60.00 60.00 60.00 60.00

Cost of goods sold (25.00) (25.00) (25.00) (25.00)

Gross profit 35.00 35.00 35.00 35.00

Operating expenses (6.67) (9.00) (9.00) (9.00) (9.00)

Depreciation (6.00) (6.00) (6.00) (6.00)

EBIT (6.67) 20.00 20.00 20.00 20.00

Interest expense (1.84) (1.42) (0.98) (0.51)

Pre-tax income (6.67) (18.16) 18.58 19.02 (19.49)

Tax @ 40% 2.67 (7.27) (7.43) (7.61) (7.80)

Unlevered net income

Free cash flow ($ million)

(4.00) 10.89 11.15 11.41 11.69

ADD: Depreciation 6.00 6.00 6.00 6.00

LESS: Capital expenditure

(24.00)

LESS: Increases in NWC

ADD: Net borrowing

30.62 (6.92) (7.39) (7.89) (8.43)

Free cash flow (28.00) 18.00 18.00 18.00 18.00

Source: Adapted from Berk, J. and DeMarzo, P. (2009) Corporate Finance. Harlow: Pearson.

CASE STuDy

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Activity 11: Adjusted present value

Using the information in the case study above, calculate the flow to equity for the project.

OvEr TO yOu

The project’s free cash flow shows the potential additional amount that the company will have available to pay dividends. These cash flows represent gain to shareholders, so they should be discounted at the project’s cost of capital. If in the Avco example the equity cost of capital is 10%, then it will be:

NPV (FTE) = 2.62 + 9.981.10

+ 9.761.102

+ 9.521.103

+ 9.271.104

= 33.25 million.

Remember that the value of the FTE represents the gain to shareholders.

Solution to Activity 8

Applying the formula stated, the WACC can be calculated as follows:

WACC (where Tc is 40%) = 20% × (1 − 0.40) + 8%

= 20%

WACC (where Tc is 50%) = 20% × (1 − 0.50) + 8%

= 18%

WACC decreases by 2% for every 10% change in Tc.



• Gordon, M. J. (1959) “Dividends, earnings and stock prices”, Review of Economics and Statistics, 41(2), pp. 99–105.

• McLaney, E. (2014) Business finance: theory and practice, 10th edition, Harlow: Pearson.

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• McLaney, E., Pointon, J., Thomas, M. & Tucker, J. (2004) “Practitioners’ perspectives on the UK cost of capital”, European Journal of Finance, 10(2), pp. 123–138.

• Miller, M. (1977) “Debt and taxes”, Journal of Finance, 32 (2), pp. 261–275.

• Modigliani, F. and Miller, M.H. (1958). “The cost of capital, corporation finance and the theory of investment”, The American Economic Review, 48(3), pp. 261–297.

• Tarraf, H. and Majeske, K. (2013) “Impact of risk taking on bank financial performance during 2008 financial crisis”, Journal of Finance and Accountancy, 13, pp. 1–18.


• Additional resources of the calculation of the cost of capital, cost of debt and similar terms can be found via the following link:

https://www.business-case-analysis.com/cost-of-capital.html [Accessed on: 27 February 2017]

• Additional resources of the dividend valuation model can be found via the following link:

http://educ.jmu.edu/~drakepp/FIN362/resources/dvm.pdf [Accessed on: 27 February 2017]

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Introduction

The focus of this chapter is on how quantitative techniques can be used to make investment decisions. You will consider how to select and utilise advanced investment appraisal techniques in order to ensure that investment decisions reflect the strategic environment in which the business operates. You will also address how to apply these advanced investment appraisal techniques in a way that takes account of cash flows, taxation and inflation.

An important feature of this chapter is the development of a critical understanding of advanced investment appraisal techniques: a technique that is appropriate for one business may well be entirely inappropriate for another. The nature of the industry in which the business operates, the size of the business, its maturity and the availability of different sources of finance will all need to be considered in the selection of a strategically appropriate investment appraisal technique.

Learning outcomes


4 Critically evaluate the strategic objectives and environment in which the business operates in order to decide on appropriate advanced investment appraisal techniques

Assessment criteria

4 Critically evaluate the strategic objectives and environment in which the business operates in order to decide on appropriate advanced investment appraisal techniques

4.1 Apply appropriate investment appraisal techniques

4.2 Apply advanced investment appraisal techniques that take account of cash flows, taxation and inflation in ways that reflect the strategic environment in which the business operates

4.3 Critically evaluate a range of investment appraisal techniques in order to ensure that their use by the business reflects a critical understanding of how decisions might be affected by the features of different techniques

Advanced Investment Appraisal

Chapter 4

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4.1 Select and justify appropriate investment appraisal techniques

The nature and characteristics of different investment appraisal techniques

Investments can involve substantial cash flows (both outflows and inflows). Often, the initial investment required to finance the acquisition of an asset that is needed to undertake a project can be significant. Inappropriate investments can lead to disaster for the business.

Decision-making in this area of financial management can be complex. These decisions are made relatively infrequently and as such managers in the organisation may have limited experience of them. The effects and consequences of investments can last for many years: many investment opportunities give rise to cash outflows and cash inflows over many years.

In this chapter, you will have an opportunity to apply investment appraisal techniques that take account of the time value of money, inflation and risk. For now, you will start by considering the nature and characteristics of different investment appraisal techniques.

The nature and characteristics of different investment appraisal techniques


Liqui plans to expand operations into mainland China and intends to finance this expansion using a loan from a local bank.


Now, assume that the loan is secured on the property that is owned by the business. If Liqui does not meet the repayment of finance charges and the principal amount of the loan, the bank has the right to seize the property owned by the business.

CASE STUDY


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Chapter 4 Advanced Investment Appraisal

As we saw in Chapter 3, the use of debt financing will increase financial gearing in the business. If the expansion into mainland China generates the level of additional profit that has been forecast by Liqui, then the returns from the use of the debt finance will exceed the finance costs of the borrowing.

If insufficient profit is generated by the business, then the repayments of finance charges and principal cannot be made.

Activity 1: The nature and characteristics of different investment appraisal techniques

Think about the nature and characteristics of the investment opportunity for Liqui’s business. Why does this type of scenario mean that investment appraisal techniques might need to be applied in order to help Liqui (and both the bank and the other investors in the business) to evaluate this opportunity?

Over tO yOu

A summary of four common investment appraisal techniques is provided in Table 1. You will be given an opportunity to apply and evaluate these different investment appraisal techniques later in the chapter. For now, reflect on the nature and characteristics of each of the techniques.

Technique Description Formula

Payback Time taken for an initial investment to be recovered out of net cash flows from the project

Net cash flows – initial investment

Expressed in time (years and/or months)

Accounting rate of return (ARR)

Relies on identifying the profitability of the investment over its life. A profit-based, rather than cash-based, technique

An acceptable project is a project which has an ARR above a pre-determined target

Average annual profit / (Average investment) x 100/1

Where:

Average investment = (Initial investment + residual value) / 2

Advanced Investment Appraisal Chapter 4

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Technique Description Formula

Net present value (NPV)

NPV considers all the costs and the revenues of a project and it gives a simple decision rule: if the NPV of a potential investment is positive then accept the project, if it is negative then reject the project

Present value of net cash flows – initial investment

Internal rate of return (IRR)

IRR is the true interest rate that is earned on an investment over its economic life. It is also the discount rate (r) that if applied to future cash flows, will give an NPV that is equal to zero. IRR seeks to identify the rate of return that an investment will yield.

R1 + (R2 – R1) × NPV2(NPV2 – NPV1)

Where:

R1: discount rate 1

R2: discount rate 2

NPV1: NPV at discount rate 1

NPV2: NPV at discount rate 2

Table 1: Types of investment appraisal techniqueon the goRevision

For the NPV technique, the present value of net cash flows is calculated as follows:

PV of year n = actual cash flow of year n(1 + r)n

Where:

n = the year of the cash flow

r = discount rate (representing the cost of capital)

If an investment generates a positive NPV, then it should be pursued, at least in theory.

For the NPV technique, the present value of net cash flows is calculated as follows:



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Investment appraisal techniques and the time value of money

The time value of money is a key concept in modern financial management (look back to Chapter 1 for a reminder of this concept). Given that the effects and consequences of many investment opportunities can be long-lasting, some investment appraisal techniques seek to reflect the time value of money.

In the previous chapter, we calculated the weighted average cost of capital (WACC). Remember that the cost of capital provides a benchmark against which investment opportunities can be appraised. Look back at investment appraisal techniques that seek to reflect the time value of money (such as NPV), the WACC can be used as the discount rate.

Some investment appraisal techniques seek to reflect the time value of money. The WACC can be used to determine the cost of capital. The WACC can be used as the discount rate.

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Stages in the investment decision-making process

Irrespective of the investment appraisal technique that might be used to support an investment decision, Atrill (2014) suggests that there are a number of stages that are common to the investment process. These stages are outlined in Table 2.

Stage Description

Determine availability of finance The amount of finance that can be raised may be limited, managers may also place internal limits on investment activities.

Identify profitable investment opportunities

Methodical and systematic searches for investment opportunities should be a normal part of the planning process.

Refine and classify proposed projects Develop and classify investment opportunities, categories include new product development, cost reduction exercises or replacement of non-current assets.

Evaluate the proposed projects Apply investment appraisal techniques, consider non-financial factors.

Approve the projects Formal approval by senior managers in the business.

Monitor and control the projects Information gathering, progress reporting and post-completion audit.

Source: Atrill (2014, p. 158)

Table 2: Stages in the investment decision-making processon the goRevision


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A number of stages are common to most investment opportunities. These stages are: determine availability of finance; identify profitable opportunities; refine and classify proposed projects; evaluate; approve; and monitor and control.

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4.2 Application of investment appraisal techniques

The application of payback period, accounting rate of return, net present value and internal rate of return

Earlier in this chapter, you considered the nature and characteristics of the payback, ARR and NPV investment appraisal techniques. It is now time to apply these techniques. A case study provides an opportunity to practise this application.

Application of investment appraisal techniques

Remember that the WACC can be used as the discount rate for investment appraisal techniques such as net present value (NPV).

Road Toll Ltd has been offered the chance to bid to operate a new toll road that connects mainland India to a nearby island. You will return to this case study later in the module. Some of the terms in the case study may be unfamiliar at this stage. For now, consider the data in the context of sensitivity analysis.

The company has undertaken significant analysis of the likely level of demand over the next three years. The company has asked you as the finance manager to undertake further investment appraisal of the project to help it create the right kind of bid proposal. The following information is available.

The company has debt which costs 11% and its estimated equity cost of capital is 15%, it is geared 50:50.

The cost of the toll for using the road has been extensively researched and the marketing department has arrived at a fee of $10 per vehicle, per journey, as acceptable to motorists.

The finance team has estimated that running the toll service will cost $1,200,000 per annum.

The contract is for three years and the likely acceptable bid price for exclusive rights to operate the toll road is $1,000,000. All fixtures and fittings required to operate the toll road are included in this price, as is ongoing maintenance of the road and the toll facilities.

CASE STUDY

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The analysis so far has predicted the following demand levels:

Estimated demand

Year 1 2 3

Number of journeys 150,000 185,000 350,000

These could vary by as much as 10%, i.e. they could be 10% higher or 10% lower than this estimate.

The company has a hurdle payback period (PP) of two years, a companywide average return on investment of 25%.

So far the company has invested $100,000 in research and administration.

Activity 2: Application of investment appraisal techniques

Using the information in the case study above, calculate the payback, accounting rate of return and net present value for the project.

OvEr TO YOU

The cost of capital also provides a “benchmark” or “threshold” against which investment opportunities (that will use the finance raised in order to generate profit) can be appraised.

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Payback

The payback period (PP) represents the time it takes for an initial investment to be repaid out of cash flows from the project. As noted by McLaney (2014), payback is a measure of how long it takes for an investment to pay for itself.


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Payback period

Consider the cash flows from the following project:

Year Cash flows ($000)

Initial investment (100)

1 20

2 40

3 60

4 60

5 20

Proceeds from disposal 20

CASE STUDY

Activity 3: Payback period

Calculate the payback period for the investment described in the case study above.

OvEr TO YOU

Applying the formula stated above, the payback period can be calculated. Assuming that the cash flows are happening at the year-end we need to calculate the cumulative cash flows. Then we can see that it will take three years to recover the initial investment.

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Year Cash flows ($000) Cumulative cash flows ($000)

Initial investment (100) (100)

1 20 (80)

2 40 (40)

3 60 20

4 60 80

5 20 100

Proceeds from disposal 20 120

Table 3: Calculating the payback periodon the goRevision

In order to accept a project on the basis of the PP appraisal, it should have a PP shorter than a pre-specified target (from the business). If there are more than one alternative projects with acceptable PP then the decision maker should select the one with the shortest PP.

Accounting rate of return

Accounting rate of return (ARR) relies on identifying the profitability of the investment over its life. This technique is based on a comparison of average annual profit generated (after taking account of the initial investment) with the amount of the initial investment. Unlike payback and net present value, ARR is a profit-based rather than cash-based technique. The result of an ARR is typically expressed as a percentage.

An acceptable project is the project which has an ARR above a pre-determined target. This target is set by the business. If there are many alternative projects which have ARRs above the company’s target value, then the one with the highest ARR may be preferable.


An investment involves an initial outlay of $100,000 in an asset. Profits before depreciation are estimated as follows:

Year Profit ($000)

1 20

2 40

3 60

4 60

5 20

At the end of the period, disposal proceeds of $20,000 will be raised upon the sale of the asset.

CASE STUDY


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Activity 4: Accounting rate of return

Calculate the accounting rate of return for the investment described in the case study above.

OvEr TO YOU

Applying the formula stated above, the accounting rate of return can be calculated as follows:

For the numerator:

Average profits before depreciation: 20,000 + 40,000 + 60,000 + 60,000 + 20,0005

= 40,000

Assuming straight line depreciation: 100,000 – 20,0005

= 16,000

Average annual profit after depreciation: 40,00016,000

= 24,000

For the denominator:

The average investment is calculated from:

Initial investment + Residual value2

Thus: 100,000 + 20,0002

= 60,000

Finally ARR = 24,00060,000

× 100%

ARR = 40%

Net present value

As you saw earlier in the chapter, the present value of net cash flows is calculated as follows:


Where:


r = discount rate (representing the cost of capital)


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This investment appraisal technique rests on the time value of money. Remember that the effects and consequences of many investment opportunities can be long-lasting. Remember also that the cost of capital (which could be calculated using the WACC) provides a benchmark against which investment opportunities can be appraised.

Net present value

Again, if we consider the cash flows from the project that was considered in the “payback” case study:



1 20

2 40

3 60

4 60

5 20


CASE STUDY

Activity 5: Net present value

Calculate the net present value for the investment described in the case study above (assume a cost of capital of 20%).

OvEr TO YOU

Applying the formula stated above, the net present value can be calculated. In order to calculate what these future inflows mean in current values we should estimate the present value (PV):

PV of year n = actual cash flow of year n

(1 + r)n


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Where:


r = rate (representing the opportunity cost of alternative investments).

Assuming that 20% is the required rate then the present value for year one should be:

PV = $20,000(1.20)1

PV = $16,667

So = $16,667 today is equivalent to $20,000 in one year’s time.

For the project in the case study, see Table 4.

Year Cash flows ($000) PV ($000)

Initial investment (100) (100)

1 20 16.67

2 40 27.78

3 60 34.72

4 60 28.94

5 20 8.04

Proceeds from disposal 20 8.04

Net present value (NPV) 24.19

Table 4: Calculating the net present valueon the goRevision

There are three points that can be made in relation to the significance of the NPV.

• First, a positive NPV indicates that an investment is worthwhile, all other things being equal. A negative NPV indicates that the investment is not worthwhile.

• Second, the NPV is not a percentage return, relating the return from the investment to the original amount invested. It is an absolute amount of money, representing a gain or loss. If it is positive it may be thought of as a surplus after all expenses, including interest, have been met.

• A negative NPV may be viewed as a deficit. This is best illustrated by calculating the terminal value of the investment after all expenses, including interest, have been paid.

Internal rate of return

Internal rate of return (IRR) is another investment appraisal method that involves discounting of future cash flows. The IRR is the true rate of interest earned on an investment over its economic life. The IRR is also the discount rate (r) which, if applied to the future cash flows, will give an NPV equal to zero.

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IRR seeks to identify the rate of return that an investment will yield on the basis of the amount of the original investment that remains outstanding during any period, compounding the interest annually (McLaney, 2014). It is for this reason that IRR is sometimes referred to as DCF yield.

Where IRR is used, the decision rule is that only those investments that yield an IRR that is in excess of a predetermined hurdle rate should be accepted. Where mutually exclusive investments are under consideration, the one with the highest IRR should be pursued.


Again, if we consider the cash flows from the project that was considered in the “payback” case study:



1 20

2 40

3 60

4 60

5 20


CASE STUDY

Activity 6: Internal rate of return

Calculate the internal rate of return for the investment described in the case study above (assume an interest rate of 30%).

Year Cash flows ($000) Discount factor PV ($000)

Initial investment (100) 1.000 (100)

1 20 0.769 15.38

2 40 0.592 23.68

3 60 0.455 27.30

4 60 0.350 21.00

5 20 0.269 5.38

Proceeds from disposal 20 0.269 5.38

Net present value (NPV) (1.88)

Table 5: Calculating the net present value with discount factor

OvEr TO YOU


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With a discount rate of 20% we had a NPV of $24,190, while with a discount factor of 30% we have an NPV of $1,880.

From this manual exercise we can conclude that the IRR in the above example is slightly below 30%.

Cash flows, taxation and inflation

Cash flows, accounting flows and depreciation

Some investment appraisal techniques rely on cash flows: others are based on accounting flows. So, it is important to be able to identify, calculate and (if necessary) apply the correct discount rate to each.

Sometimes, accounting flows need to be converted to cash flows. Two typical examples of accounting-based balances that need to be converted for use in cash-based methods of investment appraisal are working capital movements and depreciation.

Working capital is comprised of inventories, receivables, and payables; the accruals basis for financial accounting means that movements on these balances can have an effect on the profit. For cash-based approaches to investment appraisal, adjustments for these effects need to be made in order to calculate cash-based, rather than accounting-based (i.e. accruals), balances.

Simply, any depreciation charged in the calculation of accounting flows needs to be eliminated, because it is not a cash flow, it is an accounting-based adjustment.

In order to apply investment appraisal techniques such as payback, net present value and internal rate of return, it is sometimes necessary to convert accounting flows into cash flows. This includes depreciation, since this is not a cash flow.

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Do cash flows really occur at year ends?

Cash-based approaches to investment appraisal are based on the assumption that cash flows occur at exact points in time; typically the end of each year that is included in the appraisal. This is somewhat unrealistic in practice: cash flows could occur at any time during a period. Strictly speaking, the precise day on which a cash flow occurs should be identified and a discount factor (based on days, rather than years) should be calculated and applied to each cash flow.

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For reasons of practicality in investment appraisal, it is often assumed that cash flows occur at the end of a year (McLaney, 2014). Strictly speaking, this does introduce an element of inaccuracy into the calculation.

Cash-based approaches to investment appraisal are based on the assumption that cash flows occur at exact points in time, typically at the end of each year that is included in the appraisal. This is somewhat unrealistic in practice.

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Inflation

Inflation may be considered as the increase in the price of goods over time, or alternatively as the loss in the purchasing power of money. Inflation may have a major impact in defining the failure or success of a project. Inflation may affect the cash flows of the project and the discount rate that is applied. One way to calculate the present value by incorporating the effects of inflation is the money terms approach. The aim is to forecast cash flows in money terms and discount at the nominal cost of capital (including inflation).

Money terms are the actual price levels that are forecasted to exist at the date of each cash flow.

Activity 7: Cash flows, inflation and net present value

A machine costs $18,000 and it is expected to produce the following cash flows. The cost of capital is 16.6% and the inflation rate is 6%.

Calculate the net present value for the investment described in the case study above. Adjust for inflation as part of your calculation.

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Applying the formula stated above, and adjusting for the effects of inflation, the net present value can be calculated as follows:

Year Cash flow ($) Actual prices ($)Discount factor

@ 16.6%Present value

($)

0 (18,000) (18,000) 1 (18,000)

1 6,000 6,360 1/(1.166) 5,454

2 10,000 11,236 1/(1.166)2 8,264

3 7,000 8,337 1/(1.166)3 5,259

NPV 977

Table 6: Calculating the net present value using the money terms approach on the goRevision

In the above example the original cash flows are converted in actual money prices by taking into consideration the 6% inflation effect (for example in Year 1 we have: 6,000(1 + 0.06) = 6,360). These cash flows are then discounted at a 16.6% rate in order to give the present value (PV) for each year and the net present value (NPV) at the end.

Investment appraisal and taxation

Investments are usually carried out with a view to increasing the profits of the business. If this is the case the corporate tax liability of the company will also be higher. It is therefore important to identify the additional tax payments resulting from the additional profits, and include them in our investment appraisal. Taxation clearly affects cash flows from investments and there are also various incentives from the authorities to help business investments.

Some tax incentives may reduce the tax bill in the early years of investment, differing it to later years.

Tax allowances may be available for the investment and these will tend to reduce the company’s future corporation tax payments. These tax savings from capital allowances must also be included in the investment appraisal.

Cash flows and taxation

A company is investing in machinery which costs $40,000 in January 2017. The machinery has a four-year life and zero scrap value. The expected net cash flows are $10,000 for the first year and $20,000 for each of the following three years. The discount rate is 15% and the corporate tax rate is 30%.

CASE STUDY

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Activity 8: Cash flows and taxation

Calculate the net present value for the investment described in the case study above. Adjust for taxation as part of your calculation.

Year Cash flows ($) Tax 30%Cash flow

after tax ($)Discount

factor @ 15%Present value after tax ($)

0 (40,000) – (40,000) 1 (40,000)

1 10,000 (3,000) 7,000 0.869 6,083

2 20,000 (6,000) 14,000 0.756 10,584

3 20,000 (6,000) 14,000 0.657 9,198

4 20,000 (6,000) 14,000 0.572 8,008

NPV (6,127)

Table 7: Calculating the net present value adjusting for taxation

This project is not acceptable if we take corporate tax into consideration!

OvEr TO YOU

Investment appraisal and taxation: the effect of “tax shields”

In many countries a tax relief is given for certain capital expenditure in the form of annual writing down allowances (WDA); this allowance is a form of standardised depreciation for tax purposes. These capital allowances will, ultimately, reduce a business’s corporate tax liability.


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In the UK, the current rate of WDA for most capital expenditure is 18%.

First, we have to calculate the WDA. WDA attracts an 18% allowance, so it begins with 40,000 × 25% = $7,200.

End of accounting year

Tax written down value ($)

WDA @ 18% ($) 21% relief (main rate corporate tax)

Initial outlay

WDA @ 18%

40,000

(7,200)

32,800

(7,200) (1,512)

WDA @ 18% (5,904) (5,904) (1,240)

WDA @ 18%

26,896

(4,841)

22,055

(4,841) (1,017)

WDA @ 18% (3,970)

18,085

(3,970) (834)

Table 8: Calculating the WDA on the goRevision

Once we have calculated the WDA and the relevant tax relief, we can take into consideration the 30% corporate tax and calculate the PV.

Year Pre-tax cash flows

($)

Tax at 21% ($)

Tax relief on WDA

($)

Net cash flows ($)

Discount factor @

15%

Present value ($)

0 (40,000) – 1.000 (40,000)

1 10,000 (2,100) 1,512 9,412 0.869 8,179

2 20,000 (4,200) 1,240 17,040 0.756 12,882

3 20,000 (4,200) 1,017 16,817 0.657 11,049

4 20,000 (4.200) 834 16,634 0.572 9,515

NPV 1,625

Table 9: Calculating the PV after tax relief and the WDA on the goRevision

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4.3 A critical evaluation of investment appraisal techniques

The advantages and disadvantages of different investment appraisal techniques

Businesses tend to use more than one investment appraisal technique (Alkaraan and Northcott, 2006). The NPV technique appears to be most common. The payback method is popular in smaller businesses and for fairly straightforward and non-strategic projects (Cohen and Yagli, 2007). Consider the advantages and disadvantages of each technique, there is no “best” technique. The selection of an investment appraisal technique needs to reflect the needs of the business.

Remember: you will be given an opportunity to apply these different investment appraisal techniques later in the chapter. For now, consider the advantages and disadvantages of each in Table 10.

Technique Advantages Disadvantages

Payback • Simple and quick

• Will tend to identify and lead to the acceptance of low-risk projects

• Does not accurately allow for the timing of cash flows within the payback period

• Does not relate to wealth maximisation

• Ignores the cash flows outside the payback period

• Target payback period is arbitrary and difficult to establish


• Simple and quick

• Profit-based and is therefore easy for managers to understand

• Profit based: profit can be distorted by accounting adjustments

• Does not seek to adjust for the effects of the time value of money

• Target ARR is necessarily arbitrary and difficult to establish

• Does not relate directly to the concepts of wealth creation or wealth maximisation

Net present value

• Relates directly to wealth creation and wealth maximisation

• Reflects and adjusts for the effects of the time value of money

• Takes full account of the timing of the initial investment and of the cash inflows and outflows that arise during the project

• Difficult to use and to understand

• Does not necessarily lead to the identification and acceptance of the least risky investment


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Technique Advantages Disadvantages


• Takes account of the time value of money

• Provides a “hurdle rate” against which potential investments can be tested

• Complicated and can be difficult to understand

• Expression as a percentage can lead to a failure to maximise shareholder wealth

• Unrealistic assumption that cash flows can be reinvested immediately

• Unsuitable when projects have unconventional cash flows

Table 10: The key advantages and disadvantages of the payback, accounting rate of return, net present value techniques and internal rate of return

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The advantages and disadvantages of different investment appraisal techniques

Let’s return to the case study on Liqui and Meifing’s business. Consider the circumstances of the business and the nature of the investment opportunity.





CASE STUDY

Activity 9: The advantages and disadvantages of different investment appraisal techniques

Reflect on the circumstances of the business and the nature of the assessment opportunity outlined in the case study above. Consider the nature of the investment appraisal techniques and their respective advantages and disadvantages. Explain which of the investment appraisal techniques would be most appropriate for use by Liqui.

OvEr TO YOU

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Activity 10: Which investment appraisal technique is “best”?

There have been many attempts to answer this question. Some have sought to combine and synthesise the advantages of different approaches to investment appraisal, to maximise the combination of advantages and minimise the disadvantages of each.

Research online for the paper by Osborne detailed in the reading list at the end of this chapter: Osborne, M. (2010) “A resolution to the NPV-IRR debate”, Quarterly Review of Economics and Finance, 50(2), pp. 234–239. If you are unable to access this paper, perform your own research online to answer the question that follows.

This paper provides an overview of an attempt to resolve the debate on the superiority of two common investment appraisal techniques.

Critically evaluate the attempt to resolve the debate and to integrate the best elements of each of these techniques.

Over tO yOu


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There is no “best” investment appraisal technique. Every technique has both advantages and disadvantages. The selection of an investment appraisal technique needs to reflect the needs of the business.

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Modifications to the net present value technique

The NPV technique of investment appraisal that has been introduced in this chapter was based on cash flows. Sometimes, the identification and calculation of cash flows is not straightforward. Financial accounting is based on accounting flows (also known as the accruals basis). Data taken from a business’s accounting records might, therefore, need to be adjusted from an accruals basis to a cash basis.

Other factors that might need to be considered when applying the NPV technique are identified by Watson and Head (2016) and are summarised in Table 11.

Factor Description

Mutually exclusive projects

Sometimes, only one investment opportunity can be pursued as the interaction between two or more projects can cause a conflict of preferences to arise.

Capital rationing Limits on finance mean that competing projects need to be ranked.

Discount rate A business’s discount rate can fluctuate over time.

Indivisible, non-deferrable projects

When one or more projects are either indivisible or non-deferrable, rankings may have to be adjusted.

Source: Adapted from Watson and Head (2016)


Sometimes, the net present value technique needs to be adjusted to take account of factors other than the present value of future cash flows. These factors include: the need to forecast cash flows with accuracy; mutually exclusive projects; capital rationing; variable discount rates; and indivisible and non-deferrable projects.

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Modifications to the net present value technique

Let’s return to a case study that we considered earlier. Our concern now is with factors that might lead to a need to modify the net present value technique.

Road Toll Ltd has been offered the chance to bid to operate a new toll road that connects mainland India to a nearby island.

The company has undertaken significant analysis of the likely level of demand over the next three years. The company has asked you as the finance manager to undertake further investment appraisal of the project to help it create the right kind of bid proposal. The following information is available.

The company has debt which costs 11% and its estimated equity cost of capital is 15%, it is geared 50:50.

The cost of the toll for using the road has been extensively researched and the marketing department has arrived at a fee of $10 per vehicle, per journey, as acceptable to motorists.

The finance team has estimated that running the toll service will cost $1,200,000 per annum.

The contract is for three years and the likely acceptable bid price for exclusive rights to operate the toll road is $1,000,000. All fixtures and fittings required to operate the toll road are included in this price, as is ongoing maintenance of the road and the toll facilities.

The analysis so far has predicted the following demand levels:

Estimated demand

Year 1 2 3

Number of journeys 150,000 185,000 350,000

These could vary by as much as 10%, i.e. they could be 10% higher or 10% lower than this estimate.

The company has a hurdle payback period of two years, a companywide average return on investment of 25%.

So far the company has invested $100,000 in research and administration.

CASE STUDY

Activity 11: Modifications to the net present value technique

Reflect on the circumstances of the case study above and the nature of the NPV technique. Consider if any of the factors that might lead to a need for modification apply. Remember that these factors include: the need to forecast cash flows with accuracy; mutually exclusive projects; capital rationing; variable discount rates; and indivisible and non-deferrable projects.

OvEr TO YOU


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Non-financial factors and their importance in investment decision-making

Investment appraisal techniques can be very useful. However, they are only part of the process of investment decision-making in business. Look back to Chapter 1, and remember that much of financial management assumes that the objective of the business is to maximise the wealth of its shareholder. Investment appraisal techniques, particularly NPV, can help to guide some investment decision-making to achieve this objective.

However, there are a number of other factors that might need to be considered in investment decision-making. Atrill (2014) summarises these factors as follows:

• Strategy: the overall strategy of the business needs to be considered. An investment opportunity that might seem to be suitable following an investment appraisal might not be appropriate in terms of wider strategy.

• Flexibility: some investment decisions are non-reversible. A business that seeks to retain flexibility might avoid otherwise profitable investment opportunities.

• Creditworthiness: the provider of the source of finance for an investment opportunity needs to be assessed for creditworthiness.

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Non-financial factors and their importance in investment decision-making

Let’s return for the final time to Liqui and Meifing’s business. Consider the circumstances of the business and the nature of the investment opportunity.





CASE STUDY

Activity 12: Non-financial factors and their importance in investment decision-making

Reflect on the circumstances of the business and the nature of the assessment opportunity described in the case study above. Identify and explain the non-financial factors that might be important in this investment decision. Use the categories of strategy, flexibility and creditworthiness to guide your answer.

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• Alkaraan, F. and Northcott, D. (2006) “Strategic capital investment decision-making: a role for emergent analysis tools? A study of practice in large UK manufacturing companies”, The British Accounting Review 38(2).


• Cohen, G. and Yagli, J. (2007) “A multinational survey of corporate financial policies”, Working Paper, Haifa University.

• McLaney, E. (2014) Business finance: theory and practice, 10th edition, Harlow: Pearson.

• Osborne, M. (2010) “A resolution to the NPV-IRR debate”, Quarterly Review of Economics and Finance, 50(2), pp. 234–239.


rEADiNg LiST

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Introduction

Corporate finance does not exist in a vacuum. It needs to reflect the strategic environment in which businesses operate. Corporate finance is concerned with the efficient and effective management of business finances in order to achieve business objectives: this has been the case for some time and will continue to be so. However, the environment in which businesses operate and the precise influences and techniques in corporate finance have evolved and will continue to evolve over time.

In this chapter, you will consider the importance of ethics and corporate governance in corporate finance. You will appraise approaches to corporate governance in the context of legal, regulatory and professional requirements. You will also critically evaluate the role of corporate finance in mergers and acquisitions and the international market for ownership and control.

Learning outcomes


5 Critically evaluate contemporary issues in corporate finance, including the importance of ethics and corporate governance, and the role of corporate finance in the market for ownership and control

Assessment criteria

5 Critically evaluate contemporary issues in corporate finance, including the importance of ethics and corporate governance, and the role of corporate finance in the market for ownership and control

5.1 Critically evaluate alternative perspectives on the role of ethics in corporate finance

5.2 Appraise the business’s approach to corporate governance in the context of legal, regulatory and professional requirements

5.3 Critically evaluate the role of corporate finance in mergers and acquisitions, and the market for ownership and control in a globalised environment

Contemporary Issues in Corporate Finance

Chapter 5

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5.1 Alternative perspectives on the role of ethics in corporate financeThe role and purpose of corporate finance

In this module, we have viewed businesses as investment agencies. In this context, the primary role of business is to raise and invest finance in a way that generates profit. This profit could then be reinvested to generate more profit. Some or all of the profit could be returned to shareholders in the form of dividends.

Businesses can be seen as investment agencies. Their role is to raise and invest finance in a way that generates profit. Profit can be reinvested in the business or returned to shareholders in the form of dividends.

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Remember, in a capitalist system, shareholders are considered to be of paramount importance. The primary objective of a business is to maximise the wealth of its shareholders. These shareholders receive ownership rights in return for providing finance to businesses. They invest in the expectation that they will receive the maximum possible increase in wealth in return for their investment. Since shareholders receive their wealth through dividends and capital gains, shareholder wealth will therefore be maximised by maximising the value of the dividends and capital gains that shareholders receive over time.

The primary objective of a business is to maximise the wealth of its shareholders. Shareholders provide funds to business in the expectation that they will receive the maximum possible increase in wealth in return for their investment.

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Chapter 5 Contemporary Issues in Corporate Finance

Activity 1: The role and purpose of corporate finance

Given the following corporate objectives, explain which of them should be the main goal of a financial manager:

1 Profit maximisation

2 Sales maximisation

3 Maximisation of benefit to employees and the local community

4 Maximisation of shareholder wealth

OvEr TO yOu

Corporate social responsibility and corporate finance

Some businesses adopt an altruistic social purpose as a corporate objective. Corporate social responsibility (CSR) as this is sometimes known, can take various forms. Examples include improving working conditions for employees, providing a health product for customers or donating goods and services to beneficiaries in society.

Watson and Head (2016) suggest that CSR should play a supporting role within the framework of corporate objectives rather than act as a business’s primary goal. Remember, businesses do not exist primarily to please employees or to, say, maintain the happiness of local residents. However, adverse publicity can have a negative effect on corporate image and can, ultimately, affect the corporate finance activities of the business.

Contemporary Issues in Corporate Finance Chapter 5

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Corporate finance, ethics and corporate social responsibility

In 2010, an explosion on the Deep Water Horizon drilling rig in the Gulf of Mexico had a serious adverse impact on the corporate image of its owner, British Petroleum (BP).

Eleven people were killed as a result of the explosion. The Deep Water Horizon incident is considered to be the largest marine oil spill in history. The US government estimated that a total discharge of 4.9 million barrels was released into the Gulf of Mexico. BP were fined a total of $18.7 billion as a result of the incident. More than half of the company’s market value was destroyed in just two months.

CASE STuDy

Activity 2: Corporate finance, ethics and corporate social responsibility

Reflect on the potential effects of the Deep Water Horizon incident on the corporate finance activities of BP. Remember that more than half of the company’s market value was destroyed in just two months.

Consider the corporate financing effects of this incident. Write your thoughts here.

OvEr TO yOu

Corporate social responsibility should play a supporting role within the framework of corporate objectives rather than act as a business’s primary goal.

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5.2 Appraise approaches to corporate governance in the context of legal, regulatory and professional requirements Codes of ethical standards and corporate finance

The need to maximise the wealth of shareholders and the difficulties that can be involved in the creation and maintenance of positive working relationships with key stakeholders have increased the risk that managers use methods that are regarded as unethical. Some managers may feel that unethical behaviour can be justified if it contributes to maximisation of shareholder wealth.

Atrill (2014) suggests that integrity and high standards of ethical behaviour are particularly important in financial management, where many opportunities for inappropriate and “sharp” practice often exist. Some businesses have produced codes of ethical standards and behaviour for staff that are involved in financial management. Such codes seek to promote high standards of integrity and ethical behaviour in financial management.

Shell plc’s ethical code for executive directors and senior financial managers

Shell plc, a large firm in the oil and energy business, has a code of ethics for its executive directors and senior financial managers. The key elements of this code are that these individuals should:

• adhere to the highest standards of honesty, integrity and fairness, while maintaining a work climate that fosters these standards;

• comply with any codes of conduct or rules concerning dealing in securities;

• avoid involvement in any decisions that could involve a conflict of interest;

• avoid any financial interest in contracts awarded by the company;

• not seek or accept favours from third parties;

• not hold positions in outside businesses that might adversely affect their performance;

• avoid any relationship with contractors or suppliers that might compromise their ability to act impartially;

• ensure full, fair, timely, accurate and understandable disclosure of information that the business communicates to the public or publicly files.

Source: Atrill (2014, p. 16)

CASE STuDy

Activity 3: Codes of ethical standards and behaviour for financial management

Find out about codes of ethical standards and behaviour for a business in your country. Explain how such codes might promote high standards of ethics and integrity in financial management.

OvEr TO yOu


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Codes of ethical standards and behaviour for directors and managers may contribute to high standards of integrity in financial management, but they are unlikely to provide a complete solution. Atrill (2014) suggests that those involved in financial management must appreciate the importance of fair play in building long-term relationships with stakeholders. As we saw earlier in the chapter, this is not contradictory to the primary objective of a business: shareholder wealth should still be maximised by avoiding problems that can arise due to poor standards of ethical behaviour in financial management.

Some businesses incorporate ethical considerations in a wider context. While our concern is with integrity and high standards of ethical behaviour in financial management, it is important to consider this wider context. Corporate social responsibility (CSR) has been adopted as an objective by some businesses. Firms in the UK, such as AstraZeneca and GlaxoSmithKline, invest billions of pounds in CSR activities annually. It is important to recognise that shareholder wealth should remain the key concern of managers in these businesses. Social responsibility should play a supporting role within a firm’s corporate objectives (Watson and Head, 2016).

High standards of ethical behaviour in financial management are not contradictory to the primary objective of shareholder wealth maximisation. While opportunities for short-term profit may be foregone, the avoidance of problems that can arise due to poor integrity should help to promote wealth maximisation in the long term.

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Approaches to ethics and their importance in corporate finance

As you saw earlier in the chapter, corporate finance does not exist in a vacuum. Approaches to corporate governance and attempts to regulate the ethical behaviour of financial managers originated in key approaches to ethics. We will not consider these approaches in detail in this subject but, rather, reflect on the outline of the key approaches as provided below. Consider the current approaches to corporate governance and ethics in the context of these approaches.

• Deontology: duty-based ethics that seek to ensure that people “do the right thing”. Under this approach, an action can be justified by demonstrating that duties have been fulfilled.

• Virtue ethics: this approach is based on the idea that certain actions are “virtuous”. “Good” ethics are therefore those that reflect moral actions and behaviours.

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• Utilitarianism: utilitarian ethics are based on the idea that the “best” action is one that maximises utility (also known as benefit) in society.

• Social contract theory: this approach is based on the idea that there is a contract or “deal” between businesses and their stakeholders. Each party cedes some of its rights in return for the ceding of rights by other parties. The overall result is of benefit to all parties.

The agency problem that may exist between shareholders and directors

For larger businesses, there is often a separation between the owners or shareholders (the principals) and the managers (the agents). Managers control the business on behalf of shareholders and should make decisions that maximise shareholder wealth. While this relationship offers considerable benefits to investors, the separation of ownership and control can be problematic. An agency problem can occur when the managers of a business make decisions that are not consistent with the primary objective. For example, managers may be more concerned about maximising their own income or job security rather than the wealth of shareholders.

Watson and Head (2016) suggest that three important factors contribute to the existence of the agency problem.

• Ownership and control: those who own the company (shareholders) appoint agents (managers) to run the company on their behalf.

• Goals: managers are likely to seek to maximise their own wealth rather than the wealth of shareholders.

• Asymmetry of information: managers have access to detailed financial data, whereas shareholders only receive summary reports (that may have been subject to manipulation by managers).

Activity 4: Agency theory

Read the paper by Mitrick (2006) at http://www.pitt.edu/~mitnick/agencytheory/agencytheoryoriginrev11806r.htm

Consider the differences between the economic and institutional theories of agency.

Imagine that you an advisor to a group of shareholders. You have been asked to provide advice on how the system of compensation for managers should be designed to try to deal with the agency problem. Explain the mechanisms that might be used to encourage managers to act in the best interests of shareholders.

OvEr TO yOu

http://www.pitt.edu/~mitnick/agencytheory/agencytheoryoriginrev11806r.htm



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The agency problem can occur when the managers of a business make decisions that are not consistent with the objective of the maximisation of shareholder wealth. The agency problem arises due to three important factors: the divergence of ownership and control; differences in the objectives of managers and those of shareholders; and information asymmetry.

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Critics of shareholder wealth maximisation argue that the pursuit of this objective has led many businesses to take financial decisions that cause conflict with other groups.

Activity 5: Stakeholder dialogue and wealth maximisation

Research online for the article by Kaptein and Van Tulder detailed in the reading list at the end of this chapter: Kaptein, M. and Van Tulder, R. (2003) “Toward effective stakeholder dialogue”, Business and Society Review, 108 (2), pp. 203–224. If you are unable to access this paper, perform your own research online to answer the question that follows.

Consider the importance of stakeholders and how a dialogue with stakeholders has been used by businesses to improve approaches to reporting and, ultimately, to help to maximise wealth for shareholders.

OvEr TO yOu

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Stakeholders can be important contributors to the success of the business. In the short term, some financial decisions may appear to contribute to the maximisation of shareholder wealth. Examples include aggressive cost cutting, employee redundancies and forcing suppliers to reduce prices. Longer term, cost cutting may lead to a failure to comply with legal requirements; discontented staff may lead to low productivity; disgruntled suppliers may result in poorer quality resources and delayed deliveries. The failure to create positive working relationships and to align the needs of shareholders with those of other key stakeholders may, in fact, lead to the destruction of shareholder wealth.

Activity 6: Other factors in financial decision-making

Identify and explain three examples of financial decisions that might be taken to maximise shareholder wealth, but which might be considered to be unacceptable in terms of risk and return, legal form and corporation governance.

Over tO yOu

At the very least, there is a need for businesses to recognise the needs and demands of groups other than shareholders. The maximisation of shareholder wealth should be balanced with the risks associated with investment and financing decisions, the need to comply with legal requirements and a commitment to sound corporate governance. This approach is not contradictory to the primary objective of a business: in the longer term, shareholder wealth should still be maximised by avoiding the problems that often accompany the relentless and direct pursuit of short-term wealth maximisation.

Activity 7: Shareholder activism

Re-read the article about shareholder activism in India from Activity 2, Chapter 1 (page 5).

Now, find out about shareholder activism in your country. Explain the effects of shareholder activism on financial management decisions.

Over tO yOu

https://www.ft.com/content/3f0aa396-7ba7-11e4-b6ab-00144feabdc0


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Corporate governance

Corporate governance relates to the practice of board leadership and to effectiveness, remuneration, accountability and relations with shareholders (Financial Reporting Council, 2016). Put simply, the aim of corporate governance is to ensure that “shareholders’ pockets are close to the managers’ hearts” (Brealey, Myers and Allen, 2014, p. 14). A firm’s approach to corporate governance and the regulatory regime to which it is subjected will have a major effect on financial management activities in the business.

The need for corporate governance is often rationalised in terms of agency theory. Corporate governance can also be seen as part of the attempt to secure high standards of integrity and ethical behaviour. It is important that you consider these issues together and that you understand the links between these three issues.

Corporate governance in the UK

In the UK, the UK Corporate Governance Code (Financial Reporting Council, 2016) provides the framework for corporate governance. This code addresses issues such as the role of executive and non-executive directors, the remuneration of directors, and arrangements in respect of functions such as audit committees. The code is maintained by the Financial Reporting Council (FRC). The FRC is the independent regulator of corporate reporting, auditing and actuarial practice in the UK.

Different systems exist in other jurisdictions. For example, in Germany, a system of co-determination applies: larger firms have two boards of directors, one of which includes representatives elected from a firm’s staff and trade unions. In contrast to the “comply or explain” approaches that are used in many countries, the corporate governance in the USA is “rules based” and underpinned by legislation in the form of the Sarbanes–Oxley Act 2002.

Activity 8: Corporate governance codes

The UK Corporate Governance Code (Financial Reporting Council, 2016) provides a framework for corporate governance for firms that are registered on the London Stock Exchange (LSE). All firms that are listed on the LSE must report on how they have applied the Code in the annual report and financial statements.

For an international perspective on corporate governance, take a look at the website of the International Corporate Governance Network: http://www.icgn.org

Find out about codes of corporate governance in your country. Explain how such codes might help to ensure that “shareholders’ pockets are close to the managers’ hearts”.

OvEr TO yOu

http://www.icgn.org

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You may have found some differences between the approach to corporate governance in your country and that in the UK. Irrespective of the jurisdiction in which a firm operates and the corporate governance regime to which it is subjected, McLaney (2014) identifies three broad guiding principles of any approach to the regulation of corporate governance:

• disclosure: adequate and timely reporting of corporate financial performance and position;

• accountability: definitions of the roles and duties of directors. UK company law requires directors to act in the best interests of the investors in a firm;

• fairness: “insider trading” is illegal. Directors should not seek to gain from their privileged knowledge of the firm for which they work. Many stock exchanges place restrictions on the ability of directors to trade in the shares of the firms for which they work.

Most approaches to corporate governance seek to regulate three aspects of corporate behaviour: disclosure, accountability and fairness.

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5.3 Critically evaluate the role of corporate finance in mergers and acquisitions What are mergers and acquisitions?

The terms “merger” and “acquisition” have come to be used synonymously. It is important to note that they are, in fact, different types of transactions. It is for this reason that some commentators, such as Mishkin and Eakins (2012) and Watson and Head (2016), make a distinction between mergers and takeovers (rather than mergers and acquisitions). Mergers are a “friendly reorganisation of assets into a new organisation” (Watson and Head 2016, p. 360).

In contrast, acquisitions are the takeover of one business’s share capital by another business. Resisted acquisitions are often referred to as hostile takeovers (Mishkin and Eakins, 2012). As noted by Brealey, Myers and Allen (2014, p. 792), acquisitions (and some mergers) almost always involve “one firm [that] is the protagonist and the other [that] is the target”.

The terms mergers and acquisitions have come to be used synonymously. These are, in fact, different types of transactions. Mergers are friendly reorganisations; takeovers are the acquisition of one business’s share capital by another.

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At this point, it is useful to summarise the terminology that is often used in mergers and acquisitions.

Term Meaning

Conglomerate takeover Firms in the takeover operate in different industries.

Horizontal takeover Firms in the takeover operate in the same industry and at a similar stage of the production cycle.

Merger A “friendly” reorganisation of the assets of two firms (that are often of a similar size).

Takeover Acquisition of one firm’s equity share capital by another firm, the bidding company is usually larger than the target firm.

Vertical takeover Firms in the takeover operate in the same industry but at different stages of the production cycle.

Table 1: Key terms in mergers and acquisitionson the goRevision

The role of corporate finance in mergers and acquisitions

Equity and debt markets

In some parts of the world, equity and debt markets are relatively small. For example, in the UK, most households (i.e. investors) invest their wealth in insurance and pension funds; ownership of equities is generally indirect through these funds. In contrast, in the USA, the largest proportion of household investment portfolios are held directly in equities (Brealey, Myers and Allen 2014). The USA also has a large corporate bond market: as such, both the UK and the USA are considered to have market-based financial systems.

Contrast both the UK and the USA with most parts of Europe, where households tend to hold relatively less of their wealth in financial assets. In Europe and parts of Asia, banks tend to provide debt financing (rather than corporate bond markets). In Japan, there is also a relatively large inter-company loans market. European countries and Japan tend to be considered to operate bank-based (rather than market-based) financial systems.

The nature of the financial system in a particular country has an effect on the approach to financing that is used by a business, particularly when this finance is needed for a merger or acquisition.

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Ownership, control and governance

These differences have important implications for businesses and their corporate finance activities, not least in the financing of mergers and acquisitions transactions. In countries that operate market-based financial systems, investors tend to be afforded greater protections than those in bank-based financial systems. In the UK and the USA, firms have a duty to act in the financial interests of their shareholders.

Investors in market-based financial systems tend to be afforded greater protection than those in bank-based financial systems.

NEED TO KNOW

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In countries that operate bank-based financial systems, banks tend to make significant investments (either directly or indirectly) in firms. Brealey, Myers and Allen (2014) point to the keiretsu system in Japan as an example of the role of banks in corporate finance in bank-based financial systems. A keiretsu is a network of companies that have a long-established relationship with a bank. The bank owns shares in the network of companies; the network of companies typically owns shares in the bank. This means that the number of shares available for purchase by outside investors is lower than would otherwise be the case (Brealey, Myers and Allen 2014).

Activity 9: Ownership, governance and control

Identify the financial system that applies in your home country, or a country with which you are familiar. Consider the implications of this financial system for corporate finance.

OvEr TO yOu

Corporate finance and mergers and acquisitions: a critical evaluation

Positive effects

Developments in corporate finance have had positive effects in this context (Mishkin, 2004). High-risk debt securities, such as junk bonds, have allowed businesses to raise large amounts of finance in order to engage in mergers and acquisitions transactions.

Heffernan (2004) suggests that many mergers and acquisitions have realised economies of scale and synergies. Some evidence points to the achievement of these benefits and the improved returns for shareholders that have followed mergers and acquisitions transactions (Rhoades, 1994).


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Many mergers and acquisitions have realised economies of scale and synergies. Some evidence points to the achievement of these benefits and of improved returns for investors following mergers and acquisitions.

NEED TO KNOW

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Negative effects

The use of junk bonds to finance mergers and acquisitions transactions ultimately contributed to the near collapse of some banks during the financial crisis. Indeed, the corporate financier credited with the invention of junk bonds was ultimately sent to prison as a result of the collapse of the investment bank for which he worked.

Many businesses suffered during the financial crisis; some banks had purchased and held other types of bonds that were issued to finance mergers and acquisitions activity in their own investment portfolios. Mishkin and Eakins (2012) note that as the market realised that the quality of these securities did not support their price, the investment banks found that they could not sell the bonds.

Banks and other businesses also encountered liquidity problems during the financial crisis; large debt portfolios needed to be refinanced, but there was no ready source of new funds. Much of these debt portfolios, again, were attributed to mergers and acquisitions activities. Investment banks, such as Lehman Brothers were declared bankrupt. Ultimately, aggressive action by national government was needed to prevent the collapse of many investment banks.

Bank failures and corporate finance

Bank failures and government intervention to try to prevent such failures are not new (Heffernan, 2004). Overend Gurney (1866) in the UK, the Bank of the USA (1933) and Bankhaus Herstatt (1974) in West Germany are just some examples of bank failures. What is new is the impact of involvement in mergers and acquisitions in this context.

CASE STuDy

Activity 10: Bank failures and corporate finance

Select a bank that has failed in your home country, or a bank with which you are familiar that has failed. Explain the role of corporate finance in the failure of this bank.

OvEr TO yOu

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Heffernan (2004) also questions the assertions made by some corporate financiers regarding the benefits of mergers and acquisitions. A lack of “hard evidence” on the realisation of economies of scale and synergies (Heffernan, 2004, p. 517) is seen to pervade the claims by many corporate financiers.

Mergers and acquisitions have been associated with wider problems in the financial system, including the use of junks bonds and a lack of liquidity.

NEED TO KNOW

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• Brealey, R.A., Myers, S.C. and Allen, F. (2014) Principles of corporate finance, 11th edition, Maidenhead: McGraw-Hill.

• Heffernan, S. (2004) Modern bank, West Sussex: John Wiley & Sons.

• Kaptein, M. and Van Tulder, R. (2003) “Toward effective stakeholder dialogue”, Business and Society Review, 108 (2), pp. 203–224.

• Mishkin, F.S. (2004) The economics of money, banking and financial markets, New Jersey: John Wiley & Sons.

• Mishkin, F.S. and Eakins, S.G. (2012) Financial markets and institutions, Harlow: Pearson.

• Mitrick, B. (2006) Origin of the theory of agency. University of Pittsburgh, Retrieved from: http://www.pitt.edu/~mitnick/agencytheory/agencytheoryoriginrev11806r.htm. [Accessed on: 27 February 2017]

• Rhoades, S. (1994) “A summary of merger performance in banking, 1980–92 and an assessment of ‘operating performance’ and ‘event study’ methodologies”, Federal Reserve Bulletin, July.


READING LIST

• ”International Corporate Governance Network” (2017), Retrieved from: http://www.icgn.org. [Accessed on: 27 February, 2017]

• Mitrick, B. (2006) Origin of the theory of agency, University of Pittsburgh, Retrieved from: http://www.pitt.edu/~mitnick/agencytheory/agencytheoryoriginrev11806r.htm. [Accessed on: 27 February 2017]

RESOURCES


http://www.icgn.org


Glossary

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Glossary

Accounting rate of return The average profit from an investment, expressed as a percentage of the average investment made.

Agency (problem) The theoretical relationship between the owners and managers of a firm.

Asymmetry of information Situations in which one party has access to privileged information that puts it in an advantageous position compared to another party.

Beta A measure of the level of systematic risk that relates to a particular asset/investment.

Bonds (corporate bonds) Medium or long-term debt securities, in bearer form, that commit the issuer to a specific repayment date and to interest payments at a fixed or variable rate.

Capital asset pricing model (CAPM) A model that can be used to determine an appropriate rate of return on an asset. It can also be used to assess the extent to which an investment portfolio should be diversified.

Capital markets Financial markets for long-term loan finance and shares.

Corporate governance The way in which firms are directed and controlled by their owners and managers.

Corporate social responsibility (CSR) A form of corporate self-regulation whereby businesses seek to comply with ethical standards, national and international norms and the “spirit” of laws and regulations, particularly those related to ethics and environmental requirements.

Cost of capital The rate of return that is required by investors who supply finance to a firm. The minimum rate of return that is required on an investment.

Debentures Fixed interest redeemable bonds that are normally secured on the non-current assets of the issuing company.

Dividends A transfer of assets, usually in the form of cash, from the business to its shareholders.

Due diligence An investigation of all material information relating to the financial, technical and legal aspects of a business prior to making an investment.

Equity finance The “ownership interest” in a business.

Expected values A technique that assigns probabilities to possible outcomes.

External stakeholders Persons, groups of organisations who are impacted by the business.

Financial gearing (leverage) The relationship between the debt and equity finance that is used in a firm.

Initial public offering (IPO) Issuing shares for the first time in order to obtain a stock market listing.

Insider trading Using “inside” information to buy and sell securities in order to obtain abnormal returns.

Internal rate of return (IRR) The true interest rate that is earned over the economic life on an investment.

Internal stakeholders Persons, groups or organisations who participate in and serve the needs of the business.

Junk bonds High risk debt securities.

Loan (debt) covenants Assurances made by businesses that certain activities will or will not be carried out.

Loan notes Long-term borrowings usually made by limited companies.

Matching principle of finance (matching principle) The principle that a source of finance and the purpose to which it is put should be mutually compatible.

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Glossary

Maximise the wealth (wealth maximisation) The concept that the primary objective of a business is to maximise the wealth of its shareholders. This idea underpins modern financial management.

Mergers Combination of two or more businesses to form a single business.

Mortgage A loan secured on property.

Net present value (NPV) The net cash flows from an investment that have been adjusted to take account of the time value of money. Net present value is used to evaluate investment projects.

Payback period (PP) The time taken for the initial investment in a project to be repaid from the net cash inflows of the project.

Redeemable bonds Bonds for which the principal amount needs to be repaid when the bond matures.

Retained profit Cash retained by a business for reinvestment purposes.

Rights offer An issue of shares to existing shareholders, pro rata to their existing shareholdings, in exchange for cash.

Scenario analysis A method of dealing with risk that involves changing a number of variables simultaneously so as to provide a particular scenario for managers to consider.

Sensitivity analysis The technique of analysing how changes in an individual project variable affect a project’s overall net present value.

Separation of ownership and control The tendency for shareholders to appoint managers to run businesses on their behalf.

Simulation A method of dealing with risk that involves calculation probability distributions from a range of possible outcomes.

Stakeholder theory The view that each stakeholder group should have its interests reflected in the financial management objectives and activities of the business.

Subordinated loan A loan that is ranked below other loan capital in the order of interest payment and capital repayment.

Takeover A situation in which one business acquires control of another business.

Tax shield The benefit of shielding profits from corporate tax, calculated as the present value of the future tax savings arising from debt finance.

Term loan A loan, usually from a bank, that is tailored specifically to the needs of the borrower. The loan contract usually specifies the repayment date, interest rate and so on.

Time value of money The value of money (cash) changes over time. The concept that $1 received in the future is not equivalent to $1 received today due to factors such as risk and opportunity cost.

Trade payables (accounts payable) Money owed by a business to suppliers of goods and services.

Trade receivables (accounts receivable) Money owed to a business by the customers to whom it has supplied goods and services

UK Corporate Governance Code A code of practice for companies listed on the London Stock Exchange that deals with corporate governance matters.

Uncertainty A position in which all possible outcomes cannot necessarily be identified and/or quantified.

Weighted average cost of capital The average rate of return that is required on all the sources of finance that are used by a firm. It can be used as the discount rate in investment appraisal.

Working capital The difference between a business’s current assets and current liabilities.

LEVEL 6 CORPORATE FINANCE

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