ACCA F9 FINANCIAL MANAGEMENT. Study System Sample Session

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ACCA

F9

FINANCIAL MANAGEMENT

Study System

Sample Session

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ATC

INTERNATIONAL

ACCA

PAPER F9

FINANCIAL MANAGEMENT

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No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, editor or publisher.

This training material has been published and prepared by Accountancy Tuition Centre Limited 16 Elmtree Road

Teddington TW11 8ST United Kingdom.

Editorial material Copyright  Accountancy Tuition Centre (International Holdings) Limited, 2009. All rights reserved. No part of this training material may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including photocopying and recording, or in any information storage and retrieval system, without permission in writing from the Accountancy Tuition Centre Limited.

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SESSION 00 – CONTENTS

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INTRODUCTION

This Study System has been specifically written for the Association of Chartered Certified Accountants fundamentals level examination, Paper F9 Financial Management

It provides comprehensive coverage of the core syllabus areas and is designed to be used both as a reference text and interactively with the ATC Learning System to provide you with the knowledge, skill and confidence to succeed in your ACCA studies

SYLLABUS

Advanced Financial Management

Financial Management

Management Accounting

Aim

To develop the knowledge and skills expected of a finance manager, in relation to investment, financing, and dividend policy decisions.

Main capabilities

On successful completion of this paper, candidates should be able to: A Discuss the role and purpose of the financial management function

B Assess and discuss the impact of the economic environment on financial management C Discuss and apply working capital management techniques

D Carry out effective investment appraisal

E Identify and evaluate alternative sources of business finance

F Explain and calculate the cost of capital and the factors which affect it G Discuss and apply principles of business and asset valuations

H Explain and apply risk management techniques in business. AFM (P4)

FM (F9)

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Financial management environment (B)

Working capital management (C) Investment appraisal

(D) Business finance

(E) Cost of capital

(F)

Risk management (H)

Business valuations (G)

Financial management function

(A)

RATIONALE

The syllabus for Paper F9, Financial Management, is designed to equip candidates with the skills that would be expected from a finance manager responsible for the finance function of a business. The paper, therefore, starts by introducing the role and purpose of the financial management function within a business. Before looking at the three key financial

management decisions of investing, financing, and dividend policy, the syllabus explores the economic environment in which such decisions are made.

The next section of the syllabus is the introduction of investing decisions. This is done in two stages - investment in (and the management of) working capital and the appraisal of long-term investments.

The next area introduced is financing decisions. This section of the syllabus starts by

examining the various sources of business finance, including dividend policy and how much finance can be raised from within the business. Cost of capital and other factors that

influence the choice of the type of capital a business will raise then follows. The principles underlying the valuation of business and financial assets, including the impact of cost of capital on the value of the business is covered next.

The syllabus finishes with an introduction to, and examination of, risk and the main techniques employed in the management of such risk.

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DETAILED SYLLABUS

A

Financial management function

1. The nature and purpose of financial management

2. Financial objectives and relationship with corporate strategy 3. Stakeholders and impact on corporate objectives

4. Financial and other objectives in not-for-profit organisations

B

Financial management environment

1. The economic environment for business

2. The nature and role of financial markets and institutions

C

Working capital management

1. The nature, elements and importance of working capital

2. Management of inventories, accounts receivable, accounts payable and cash 3. Determining working capital needs and funding strategies

D

Investment appraisal

1. The nature of investment decisions and the appraisal process 2. Non-discounted cash flow techniques

3. Discounted cash flow (DCF) techniques 4. Allowing for inflation and taxation in DCF

5. Adjusting for risk and uncertainty in investment appraisal

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E

Business finance

1. Sources of, and raising short-term finance 2. Sources of, and raising long-term finance 3. Internal sources of finance and dividend policy 4. Gearing and capital structure considerations 5. Finance for Small and Medium-size Entities (SMEs)

F

Cost of capital

1. Sources of finance and their relative costs 2. Estimating the cost of equity

3. Estimating the cost of debt and other capital instruments 4. Estimating the overall cost of capital

5. Capital structure theories and practical considerations 6. Impact of cost of capital on investments

G

Business valuations

1. Nature and purpose of the valuation of business and financial assets 2. Models for the valuation of shares

3. The valuation of debt and other financial assets

4. Efficient Markets Hypothesis (EMH) and practical considerations in the valuation of shares

H

Risk management

1. The nature and types of risk and approaches to risk management 2. Causes of exchange rate differences and interest rate fluctuations 3. Hedging techniques for foreign currency risk

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APPROACH TO EXAMINING THE SYLLABUS

The syllabus for Paper F9 aims to develop the skills expected of a finance manager who is responsible for the finance function of a business.

The paper also prepares candidates for more advanced and specialist study in Paper P4,

Advanced Financial Management.

The syllabus is assessed by a three-hour paper-based examination consisting of four compulsory 25-mark questions. All questions will have computational and discursive elements. The balance between computational and discursive content will continue in line with the pilot paper.

15 minutes for reading and planning is given at the start if the examination. During this time candidates may make notes on the question paper but may not write in the answer booklet. Candidates are provided with a formulae sheet and tables of discount and annuity factors. Candidates should bring a scientific calculator to the examination.

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SESSION 00 – TABLES AND FORMULAE

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Formula sheet

Economic order quantity =

h o

C D 2C

Miller — Orr Model

Return point = Lower limit + (1_/₃_{× spread)}

Spread

=

3 1 rate interest flows cash of variance cost n transactio 3 4 3             _× _×

The Capital Asset Pricing Model

E(ri) = Rf + βi(E(rm)–Rf)

The asset beta formula

βa =

₍

₎



     − + e d e e _β T 1 V V V +

₍

(

₍

)

₎

_      − + − d d e d _β T 1 V V T 1 V

The Growth Model

PO =

₍

(

₎

)

g g − + e O r 1 D

Gordon’s growth approximation

g = bre

The weighted average cost of capital

WACC = _e

d e e _k V V V      

+ + V V k

(

1 T

)

V d d e d ₋       +

The Fisher formula

(1+i) = (1+r) (1+h)

Purchasing power parity and interest rate parity

s1 = s0 x

₍

(

)

₎

b c h 1 h 1 + +

f0 = s0 x

₍

(

)

₎

b c i 1 i 1 + +

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Present value table

Present value of 1 i.e. (1 + r)–n

where r = discount rate

n = number of periods until payment

Discount rate (r) Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7 8 0.923 0.853 0.789 0.731 0.667 0.627 0.582 0.540 0.502 0.467 8 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15 (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15

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Annuity table

Present value of an annuity of 1 i.e. 1−(1+r)−

r

n

where r = discount rate n = number of periods

Discount rate (r) Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10 11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11 12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12 13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13 14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14 15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15 (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.586 4.327 11 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15

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SESSION 00 – EXAM TECHNIQUE

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EXAM TECHNIQUE

Time allocation

To allocate your time multiply the marks for each question by 1.8 minutes. i.e. each 25 mark question should take you 25 × 1.8 = 45 minutes.

You should also apportion your time carefully between the parts of each question.

Do not be tempted to go over the time allocation on each question - remember the “law of diminishing returns” the longer you spend the lower your efficiency in gaining marks. It is more effective to move onto the next question.

Numerical elements

¾

Before starting a computation, picture your route. Do this by noting down the steps you are going to take and imagining the layout of your answer.

¾

Use a columnar layout if appropriate. This helps to avoid mistakes and is easier for the marker to follow.

¾

Use lots of space.

¾

Include all your workings and cross-reference them to the face of your answer.

¾

A clear approach and workings will help earn marks even if you make an arithmetic

mistake.

¾

If you later notice a mistake in your answer, it is not worthwhile spending time

amending the consequent effects of it. The marker of your script will not punish you for errors caused by an earlier mistake.

¾

Don’t ignore marks for written recommendations or comments based upon your computation. These are easy marks to gain.

¾

If you write good comments based upon calculations which contain errors, you can still receive all the marks for the comments.

¾

If you could not complete the calculations required for comment then assume an answer to the calculations. As long as your comments are consistent with your assumed answer you can still pick up all the marks for the comments.

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SESSION 00 – EXAM TECHNIQUE

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Written elements

Planning

¾

Read the requirements carefully at least twice to identify exactly how many points you are being asked to address.

¾

Note down relevant thoughts on your plan.

¾

Give your plan a structure which you will follow when you write up the answer.

Presentation

¾

Use headings and sub-headings to give your answer structure and to make it easier to read for the marker.

¾

Use short paragraphs for each point that you are making.

¾

Use bullet points where this seems appropriate e.g. for a list of advantages/disadvantages

¾

Separate paragraphs by leaving at least one line of space between each.

Style

¾

Long philosophical debate does not impress markers.

¾

Concise, easily understood language scores good marks and requires less writing.

¾

Lots of points briefly explained tend to score higher marks than one or two points

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SESSION 10 – SECURITY VALUATION AND THE COST OF CAPITAL

1001

OVERVIEW

Objective

¾

To develop a model for the valuation of shares and bonds.

¾

To use this model to estimate the cost of equity and the cost of debt.

¾

To consider further practical influences on the valuation of securities.

EQUITY ANALYSIS

SECURITY

VALUATION AND THE COST OF CAPITAL

DEBT ANALYSIS

¾ Dividend Valuation Model

¾ Cost of equity

¾ Irredeemable debentures

¾ Redeemable debentures

¾ Semi-annual interest

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1002

1 DIVIDEND VALUATION MODEL

1.1 The general model

¾

The dividend valuation model states that:

“the market value of a share or other security is equal to the present value of the future expected cash flows from the security discounted at the investor’s required rate of return”.

¾

A security is any traded investment e.g. shares and bonds.

1.2 Constant Dividend

¾

The formula for share valuation can be developed as follows:

Ex-div market value at time 0 = Present value of the future dividends discounted at the shareholders’ required rate of return

¾

Ex-div market value is the market value assuming that a dividend has just been paid.

¾

Let:

Po = Current ex-div market value

Dn = Dividend at time n

ke = Shareholders’ required rate of return/company’s cost of equity

¾

The model then becomes:

Po =

ke) (1 D ke) (1 D ke) (1 D 3 3 2 2 1 + + + +

+ ... ₍₁ _ke)

Dn n

+

¾

If the dividend is assumed to be constant to infinity this becomes the present value of a perpetuity which simplifies to:

Po =

ke D

¾

This version of the model can be used to determine the theoretical value of a share which pays a constant dividend e.g. a preference share or an ordinary share in a zero growth company.

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1003

1.3 Constant growth in dividends

¾

If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate

Po =

g ke g) (1 D0 − + = g ke D1 −

where _{Do = most recent dividend}

D₁ = dividend in one year

The formula is published in the exam in the following format:

PO =

₍

(

₎

)

g g − + re 1 D_O

Where re= required return of equity investors = ke

1.4 Assumptions behind the dividend valuation model

¾

rational investors

¾

all investors have the same expectations and therefore the same required rate of return

¾

perfect capital market assumptions, e.g.,

no transactions costs

large number of buyers and sellers of shares

no individual can affect the share price

all investors have all available information

¾

dividends are paid just once a year and one year apart

¾

dividends are either constant or are growing at a constant rate.

1.5 Uses of the dividend valuation model

¾

The model can be used to estimate the theoretical fair value of shares in unlisted companies where a quoted market price is not known. .

¾

However if the company is listed, and the share price is therefore known, the model can be used to estimate the required return of shareholders i.e. the company’s cost of equity finance.

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1004

Illustration 1

Suppose that a share has a current ex-div market value of 80 cents and investors expect a dividend of 10 cents per share to be paid each year as has been the case for the past few years.

Using the dividend valuation model the required return of the investors for this share can be determined:

Po =

ke D

80c =

ke 10c

ke =

80c 10c

ke = 12.5%

Investors will all require this return from the share as the model assumes they all have the same information about the risk of this share and they are all rational.

If investors think that the dividend is due to increase to 15 cents each year then at a price of 80 cents the share is giving a higher return than 12.5%. Investors will therefore buy the share and the price will increase until, according to the model, the value will be:

Po =

0.125 15c

= 120 cents

Alternatively suppose that the investors' perception is that the dividend will remain at 10 cents per share but that the risk of the share has increased thereby requiring a return of 15%. If the share only gives a return of 12.5% (on an 80 cents share price) then investors will sell and the price will fall. The fair value of the share according to the model will be:

Po =

0.15

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1005

1.6 Practical factors affecting share prices

¾

The dividend valuation model gives a theoretical value, under the assumptions of the model, for any security.

¾

In practice there will be many factors other than the present value of cash flows from a security that play a part in its valuation. These are likely to include:

interest rates

market sentiment

expectation of future events

inflation

press comment

speculation and rumour

currency movements

takeover and merger activity

political issues.

The dividend valuation model helps us to understand how a change in these variables should affect the market value of the security.

¾

Share prices change, often dramatically, on a daily basis. The dividend valuation model will not predict this, but will give an estimate of the underlying fair value of the shares.

2 COST OF EQUITY

2.1 Shareholders required rate of return

¾

The basic dividend valuation model is:

Po =

ke D

¾

This can be rearranged to find ke:

ke =

Po D

¾

If ke is the return required by the shareholders in order for the share value to remain constant then ke is also the return that the company must pay to its shareholders. Therefore ke also equates to the cost of equity of the company.

¾

Therefore the cost of equity for a company with a constant annual dividend can be estimated as the dividend divided into the ex-div share price i.e. the dividend yield.

¾

The ex-div market value is the market value of the share assuming that the current dividend has just been paid. A cum-div market value is one which includes the value of the dividend just about to be paid. If a cum-div market value is given then this must be adjusted to an ex div market value by taking out the current dividend.

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1006

Example 1

A company’s shares have a market value of $2.20 each. The company is just about to pay a dividend of 20c per share as it has every year for the last ten years.

What is the company’s cost of equity?

Solution

2.2 Dividend with constant growth

¾

The model can also deal with a dividend that is growing at a constant annual rate of g.

¾

The formula for valuing the share is as seen earlier:

Po =

g ke

g) (1 D0

− +

=

g ke

D₁

−

where _{Do = most recent dividend}

D₁ = dividend in one year

¾

Rearranged this becomes

ke = g

Po g) (1 D0

+ +

where g = growth rate (assumed constant in perpetuity). where Po = ex div market value

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1007

Illustration 2

Do = 12c, Po (ex div) = $1.75, g = 5%. What is the value of ke?

ke =

75 . 1

) 05 . 1 ( 12 . 0

+ 0.05 = 12.2%

¾

The growth rate of dividends can be estimated using either of two methods.

Two methods

Extrapolation of past dividends

Gordon’s growth model

2.3 Growth from past dividends

¾

Look at historical growth and use this to predict future growth. If you have specific information about future growth, use that.

If dividends have grown at 5% in each of the last 20 years, predicted future growth = 5%.

Uneven but steady growth – take an average overall growth rate.

Discontinuity in growth rate – take the most recent evidence.

New company with very high growth rates – take care! It is unlikely to produce such high growth in perpetuity.

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1008

Example 2

A company has paid the following dividends over the last five years.

Cents per share

19X0 100

19X1 110

19X2 125

19X3 136

19X4 145

Estimate the growth rate and the cost of equity if the current (19X4) ex div market value is $10.50 per share.

Solution

2.4 Gordon’s growth model

¾

Gordon’s growth model states that growth is achieved by retention and reinvestment of profits.

g = bre

b = proportion of profits retained re = return on equity

¾

Take an average of r and b over the preceding years to estimate future growth.

re =

funds rs' Shareholde

tax after Profit

=

assets Net

tax after Profit

b =

tax after Profit

profit Retained

¾

These figures can be obtained from the statement of financial position and income statement.

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1009

Example 3

A company has 300,000 ordinary shares in issue with an ex-div market value of $2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits of $100,000.

Net assets at the year end were valued at $1.06m. Estimate the cost of equity.

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1010

2.5 Cost of equity and project appraisal

Illustration 3

A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays constant annual dividends of 30c per share.

It is considering adopting a project which will cost $500,000 and which is of the same risk as its existing activities. The cost will be met by a rights issue. The project will produce inflows of $90,000 pa in perpetuity. All inflows will be distributed as dividends.

What is the new value of the equity in A plc and what is the gain to the shareholders? Ignore tax.

¾

_{ke =}

00 . 2 30 . 0

= 15%

¾

New dividend

$

Existing total dividend 300,000

Dividends from the project 90,000

New total dividend 390,000

Value of equity =

15 . 0 000 , 390 = $2,600,000

Shareholders’ gain = $(2,600,000 – 2,000,000) – $500,000 = $100,000

Project NPV = ($500,000) +

15 . 0

000 ,

90 _{= $100,000}

Therefore, new value of equity = Existing value + Equity outlay + NPV = Existing value + Present value of additional dividends

¾

Therefore the NPV of a project serves to increase the value of the company’s shares i.e. the NPV of a project shows the increase in shareholders’ wealth.

¾

This proves that NPV is the correct method of project appraisal – it is the only method consistent with the assumed objective of maximising shareholders’ wealth.

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1011

2.6 Cost of preference shares

¾

By definition preference shares have a constant dividend

¾

Ke =

Po D

¾

where D = constant annual dividend

¾

Preference dividends are normally quoted as a percentage, e.g. 10% preference shares. This means that the annual dividend will be 10% of the nominal value, not the market value.

Example 4

A company has 100,000 12% preference shares in issue (nominal value $1). The current ex-div market value is $1.15 per share.

What is the cost of the preference shares?

Solution

3 COST OF DEBT

3.1 Terminology of debentures

A debenture is a written acknowledgement of a company’s debt. A debenture usually pays a fixed rate of interest and it may be secured or unsecured. It may be traded on the bond market and will reach a market price. The terms debenture, bond and loan stock all basically refer to the same thing i.e. traded corporate debt (unlike bank loans which are not traded).

¾

The coupon rate is the interest rate printed on the debenture certificate. Annual interest = coupon rate × nominal value

¾

Nominal value is also known as par or face value. In the exam the nominal value of one debenture is usually $100.

¾

Market value (MV) is normally quoted as the MV of a block of $100 nominal value. e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual interest is $10 per $100 block.

¾

Market value (ex-int) is where interest has just been paid.

¾

Market value (cum-int) includes the value of accrued interest which is just about to be paid.

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1012

3.2 Irredeemable debentures

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Irredeemable debentures are a type of debt finance where the company will never repay the principal but will pay interest each year until infinity. They are also referred to as undated debentures.

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The market value of undated debt can be calculated using the same logic as the Dividend Valuation Model:

MV (ex interest) = present value of future interest payments discounted at the debenture-holder’s required rate of return

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For irredeemable debentures the interest is a perpetuity.

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MV (ex int) = r I

where I = annual interest

r = return required by debenture holder

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r =

int) (ex MV

I

= Interest yield

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The company gets tax relief on the debenture interest it pays, which reduces the cost of debentures to the company – known as the “tax shield” on debt.

Illustration 4

Consider two companies with the same earnings before interest and tax (EBIT). The first company uses some debt finance, the second uses no debt.

$ $

EBIT 100 100

Debt interest (10)

___ ___

Profits before tax 90 100

Tax @ 33% 29.70 33

$3.30 difference Therefore

Effective cost of debt

$

Debt interest 10.00

Less Tax shield (3.30)

_____

Effective cost of debt 6.70

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Because of tax relief, the cost to the company is not equal to the required return of the debenture holders.

Unless told otherwise, we assume that tax relief is instant (in practice, there will be a minimum time lag of nine months under the UK tax system).

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Note that if debt is irredeemable then: Cost of debt to the company (also

known as the post tax cost of debt) = =

Return required by the debenture holders × (1–Tc)

Interest yield × (1–Tc) Where Tc = corporate tax rate as a decimal

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Kd can be used to denote the cost of debt – but care is needed as to whether it is stated pre-tax or post-tax.

Example 5

12% undated debentures with a nominal value of $100 are quoted at $92 cum interest. The rate of corporation tax is 33%.

Find

(a) the return required by the debenture-holders (b) the cost to the company.

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3.3 Redeemable debentures/dated debentures

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The cash flows are not a perpetuity because the principal will be repaid. However from the dividend valuation model we can derive the following rule:

The cost of any source of funds is the IRR of the cash flows associated with that source.

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If we are looking at the return from an investor’s point of view, interest payments are included gross.

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If we are looking at the cost to the company, we take the interest payments net of corporation tax. Assume instant tax relief.

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Assume that the final redemption payment does not have any tax effects.

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To find the cost of debt for a company find the IRR of the following cash flows:

Time $

0 Market value (ex-interest) x

1 − n Post-tax interest (x)

n Redemption value (x)

The IRR is found as usual using linear interpolation.

Example 6

A company has in issue $200,000 7% debentures redeemable at a premium of 5% on 31 December 19X6. Interest is paid annually on the debentures on 31 December. It is currently 1 January 19X3 and the debentures are trading at $98 ex interest. Corporation tax is 33%.

What is the cost of debt for this company?

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Care should be taken not to confuse the required return of the debenture holders with the cost of debt of the company.

Required return of the redeemable debenture holder

= IRR of pre-tax cash flows from the debenture

= Gross redemption yield

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Gross Redemption Yield is also referred to as the Yield To Maturity (YTM)

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The cost of debt of the company is then determined by finding the IRR of the market value, net of tax interest payments and redemption value.

MV (ex interest) = present value of future interest payments and redemption value discounted at the debenture-holder’s required rate of return

Example 7

A company has 8% debentures redeemable at a 5% premium in ten years. Debenture-holders require a return of 10%.

What is the cost to the company? Corporation tax is 33%.

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3.4 Semi-annual interest payments

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In practice debenture interest is usually paid every six months rather than annually. This practical aspect can be built into our calculations for the cost of debt.

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If interest payments are being made every 6 months then when the IRR of the debenture cash flows is calculated it should be done on the basis of each time period being 6 months.

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The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to determine the annual cost of debt.

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Effective annual cost = (1+semi annual cost)2_-1

Example 8

A company has in issue 6% debentures the interest on which is paid on 30 June and 31 December each year. The debentures are redeemable at par on 31 December 19X9. It is now 1 January 19X7 and the debentures are quoted at 96% ex interest.

What is the effective annual cost of debt for the company? Ignore corporation tax.

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3.5 Convertible debentures

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Convertible debentures allow the investor to choose between redeeming the debentures at some future date or converting them into a pre-determined number of ordinary shares in the company.

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To estimate the market value it is first necessary to predict whether the investor will choose redemption or conversion. The redemption value will be known with certainty but the future share price can only be estimated.

MV (ex interest) = present value of future interest payments and the higher of (i) redemption value (ii) forecast conversion value, discounted at the debenture-holder’s required rate of return

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You may also be required to calculate other data for convertibles:

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Floor value = the value assuming redemption

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Conversion premium = market value – current conversion value

Example 9

A company has in issue 8% coupon bonds which are redeemable at their par value of $100 in four years’ time. Alternatively, each bond may be converted on that date into 40 ordinary shares. The current ordinary share price is $2.10 and this is expected to grow at a rate of 7% per year for the foreseeable future. Bondholders’ required return is 9% per year.

Required:

Calculate the following values for each $100 convertible bond: (i) market value;

(ii) floor value;

(iii) conversion premium

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To find the post-tax cost of convertible debt for a company find the IRR of the following cash flows:

Time $

0 Market value (ex-interest) x

1 − n Post-tax interest (x)

n Higher of redemption value/forecast conversion value (x)

Example 10

A company has in issue some 8% convertible loan stock currently quoted at $85 ex interest. The loan stock is redeemable at a 5% premium in five years time, or can be converted into 40 ordinary shares at that date. The current ex-div

market value of the shares is $2 per share and dividend growth is expected at 7% per annum. Corporation tax is 33%.

What is the cost to the company of the convertible loan stock?

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Key points

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If capital markets are perfect the sale/purchase of any security must be a zero NPV transaction i.e. market price = present value of future cash flows discounted at investors’ required return.

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This general rule can be specifically applied to shares to develop the dividend valuation model (DVM) and also to bond valuation.

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If the market price of a security is already known then the model can be re-arranged to find the required return of investors’ i.e. the company’s cost of equity/debt finance.

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Care must be taken with the cost of debt as interest, unlike dividends, is a tax allowable expense form the side of the company.

FOCUS

You should now be able to:

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understand and use the dividend valuation model;

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estimate the cost of equity and cost of debt for a company;

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