Documenti di Didattica
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Documenti di Cultura
LECTURE NOTES
TABLE OF CONTENTS
TABLE OF CONTENTS.......................................................................................ii
TOPIC 1: INTRODUCTION TO FINANCIAL MANAGEMENT....................................1
Definition of Financial Management................................................................................1
Finance Functions..................................................................................................................1
Objectives of a Business Entity.........................................................................................2
Agency Theory........................................................................................................................5
TOPIC 2: SOURCES OF FINANCE.....................................................................10
Internal Sources...................................................................................................................10
External Sources..................................................................................................................12
Factors to Consider In Choice of source of finance................................................20
TOPIC 3: KENYAN FINANCIAL SYSTEM............................................................21
Financial intermediaries....................................................................................................21
Functions of Financial Markets/Institutions in the Economy...............................22
Capital Market......................................................................................................................22
Money/discount markets..................................................................................................23
Financial Instruments in Money market include:....................................................23
Primary Markets...................................................................................................................24
Economic Advantage/Role of Secondary Markets in the Economy..................24
Types of Stock Markets.....................................................................................................24
Financial intermediaries....................................................................................................25
The Stock Exchange Market............................................................................................26
Rules for floatation of new shares on NSE.................................................................38
Capital Market Authority (Cma).....................................................................................40
Central Depository System (C.D.S)..............................................................................41
Development Banks and Specialized Financial Institutions................................43
Banking Institutions............................................................................................................45
Central Banks...................................................................................................................46
Commercial Banks..........................................................................................................47
TOPIC 4: CAPITAL BUDGETING DECISIONS.....................................................51
Investment Evaluation Criteria......................................................................................52
Capital Budgeting Techniques........................................................................................52
Discounted Cashflow Methods........................................................................................53
Non-Discounted Cashflow Methods...............................................................................55
Projects Selection under Capital Rationing.................................................................62
Risk Analysis in Capital Budgeting.................................................................................64
Actual Measurement of Risk.............................................................................................66
Incorporating Risk in Capital Budgeting.......................................................................69
Sensitivity Analysis..............................................................................................................75
Break-Even Analysis............................................................................................................78
Utility Theory.........................................................................................................................84
TOPIC 5: COST OF CAPITAL............................................................................90
Importance of cost of finance.........................................................................................90
Factors that will influence the Cost of Finance........................................................91
Cost of Different Types of Funds....................................................................................93
ii
iv
The
Financing decisions
financing as well as the financial risk. This will further be discussed under the
risk return trade-off.
(c)
The finance manager must decide whether the firm should distribute all profits
to the shareholder, retain them, or distribute a portion and retain a portion.
The earnings must also be distributed to other providers of funds such as
preference shareholder, and debt providers of funds such as preference
shareholders and debt providers. The firm's divided policy may influence the
determination of the value of the firm and therefore the finance manager
must decide the optimum dividend - payout ratio so as to maximize the value
of the firm.
(d)
Liquidity decision
The firm's liquidity refers to its ability to meet its current obligations as and
when they fall due. It can also be referred as current assets management.
Investment in current assets affects the firm's liquidity, profitability and risk.
The more current assets a firm has, the more liquid it is. This implies that the
firm has a lower risk of becoming insolvent but since current assets are nonearning assets the profitability of the firm will be low. The converse will hold
true.The finance manager should develop sound techniques of managing
current assets to ensure that neither insufficient nor unnecessary funds are
invested in current assets.
Routine functions
For the effective execution of the managerial finance functions, routine
functions have to be performed.
Some of the
(b)
(c)
(d)
The finance manager will be involved with the managerial functions while the
routine functions will be carried out by junior staff in the firm.
however, supervise the activities of these junior staff.
2
He must
Profit maximization
Social responsibility
Business Ethics
Growth
Profit
maximization refers to achieving the highest possible profits during the year.
This could be achieved by either increasing sales revenue or by reducing
expenses. Note that: Profit =
It
should be noted however, that maximizing sales revenue may at the same
time result to increasing the firm's expenses.
however, help the firm to determine which goods and services to provide so
as to maximize profits of the firm.
Objections to Profit Maximization
Profit maximization objective has however been criticized in recent years. It
fails to serve as an operational criterion for maximizing owners economic
welfare. It suffers from the following limitations:
o It is vague.
-The precise meaning of profit maximization objective is unclear.
-The definition of the term profit is ambiguous:
- Does it mean short or long term profit?
- Does it refer to profit after taxes?
- Does it refer to total profits or profit per share?
- Does it mean operating profit or profit accruing to shareholders?
o It ignores the timing of returns
Profit maximization does not make distinction between returns
received in different time periods. It gives no consideration to the
3
(c)
Social responsibility
The firm must decide whether to operate strictly in their shareholders' best
interests or be responsible to their employers, their customers, and the
community in which they operate.
which do not directly benefit the shareholders, but which will improve the
business environment.
Business Ethics
ii.
iii.
iv.
This
They therefore
ii.
The lender may threaten the firm with non-provision of funds in case
their interests are not made.
in
activities
which
would
be
in
conflict
with
societal
expectations. In this case the government will act as the principal and the
shareholder will act as the agency who expected to consider the interests of
the government in making relevant decisions.
The following problems may arise:1. The owner may engage in activities which are non-governmental.
2. The shareholders may not practice good consumerism e.g. changing
high prices
3. The shareholders may evade or avoid tax
4. The shareholders may engage in activities leading to environmental
pollution.
The following may assist in solving agency related problems
1. Establishment of legal and regulatory framework
2. Establishment of regulatory agencies e.g. use of audit firm for tax
purposes
3. Imposition of heavy penalties for the offenders e.g. penalties on nonremittance of tax or under-declaration of tax.
Resolution
of
the
Agency
problem
between
owners
and
the
ii)
1.
iii)
iv)
v)
The
This
people.
2.
replaced.
Threat of Hostile take-over
Is a situation in which a firm is taken over by another and at the same
time the management of the taken over firm is opposed to the
takeover. This most likely occurs when a firms stock is undervalued
relative to its potential.
This implies that in the event of take over the management of the
taken-over firm will be sacked. Even if they managed to hold on to
their jobs they will not be as powerful as they used to be. Therefore
managers of the firm should to keep the stock price of the firm high so
as to avoid a hostile take-over.
Counter-actions of the threatened management by Hostile take-over
i)Poison Pill
This is action that management of a firm takes that practically
kills the firm and therefore makes it unattractive to potential
acquirers. For example:a)
To sell large blocks/units of shares at low prices to friendly
b)
parties.
To make old debts of the firm immediately payable. The
c)
is taken over
ii)Divestiture/spin-of
A business sells or spins-off some of its business so as to reduce
the attractiveness of the company.
iii) Green Mail (Black Mail)
stock holders.
White Knight
The management of the target company offer to be acquired by
a friendly company so as to avoid a hostile takeover.
3.
4.
Proxy Fight
This is the process of getting stockholders to vote out the management
in the AGM.
Compensation
How to motivate the management to act on the
How to remunerate the management so as to motivate their act in the
interest of shareholders.
a) To remunerate management on the basis of achieving
specific certain financial targets.
remuneration.
Disadvantages
i)
Management may be compelled to make sub-optimal
decisions e.g. buying cheapest items thus losing customers
ii)
at the end.
In the short run research and development could be
discontinued. In the short run it may get a very high profit.
In the long run, it has adverse effects.
11
i)
Higher charge for the lease is available expense for the purpose
ii)
iii)
iv)
Mostly lessor & lessee know each other so it does not entail any
restrictions
on the part of the lessee.
ii)
iii)
iv)
The finance is Ltd to the value of the asset leased so it may not
be enough for the company to expand its operations.
4. Trade credit
- The use of credit from suppliers. Important to small growing firms
- Cheap source of finance, easy to obtain, flexible source of financing, but a
company should avoid overtrading.
Has double edge significance for a firm.
- A source of credit for financing purchase
- Firm finances credit sales to customers
The difference between credit purchase and credit sales is known as net
credit. It is convenient
Main disadvantage:
- Loss of cash discount If lost cash discount is lower than interest paid on
other sources of finance, then trade credit will be beneficial and vice versa.
13
An organization will find it convenient to use trade credit under the following
circumstances
i.
ii.
iii.
iv.
Trade credit can be obtained more easily as compared to bank credit due to
the following reasons.
i.
ii.
iii.
iv.
More flexible and can be used by small firms as well as large firms
v.
FACTORING
Factoring Means selling debts for immediate cash to a factor who charges
commission. When the factor receives each batch of invoices from his client,
he pays 80% of its value in cash immediately. Factoring can result in savings
to management in forms of savings in bad debt loses, salary cost, phone,
postage etc. The factor must bear loss if the person/firm that bought the
goods does not pay.
INVOICE DISCOUNTING
Almost similar to factoring
Definition:
Assignment of debts whereas factoring is selling of debts
Characterized by the fact that lender not only has lien on the debts but also
has recourse to the borrower (seller) if the firm of person that bought the
goods does not pay. In this case the loss is borne by the selling firm.
It acts as the agents of the seller.
14
ii)
Main disadvantages
i)
relatively
ii)
small in value.
The firm uses high liquid asset as security
to the
investors. .
Can raise large amounts of capital if the company is quoted on the
stock
exchange.
15
Disadvantage
Cumulative
Non-cumulative
Participating
Redeemable
Non-convertible
Convertible
3. DEBENTURES
A debenture is a long-term promissory note for raising capital.
The firm promises to pay interest and principal as stipulated.
Purchasers of debentures are called debenture holders.
Advantages
Disadvantages
4. COMMERCIAL PAPER
This is a form of unsecured promissory note issued by firms to raise short
term funds. Buyers of commercial papers include - banks, insurance
companies, unit trusts, and firms with surplus funds to invest for short period
with minimum risk.
Its maturity ranges from 1 to 270 days.
Cost
17
Discount
Rating charges
Stamp duty.
Agent charges.
Days of maturity
Example
A company issues a 90 - day commercial paper (CP) of a face value Sh. 1000
at Sh. 985. The credit rating expenses are 0.5% of the size of the issue,
issuing charge are 0.35% and stamp duty is 0.5%. What is the cost of CP.?
The discount is Sh; (1000 - 985) = Sh. 5
Issuing and stamp duty charges are 0.5% + 0.35% + 0.5% = 1.35 percent =
1.35%.
Thus the cost is 1.35 x 1000 = 13.5
Cost of CP = 15 x 13.5 x 360 = 0.1157 or 11.6%
985 90
Advantages of CP
From issuing firm's point of view
funds using
commercial paper.
maturity
5. LOAN FINANCE
Is a direct business loan with a maturity of more than 1 year but less than 15
years. They have a provision for a specific amortization during the right time
of the loan. They are mainly obtained from commercial banks and issuance
companies.
Advantages
Disadvantages .
19
The interest rate may be higher than that of short term loans.
is not
The companys future cash flows (inflows and their stability) must be
assured.
interest.
The names of major shareholders 51% plus i.e. owner who must
give consent.
Long-term
forecasts
are
not
only
difficult
but
also
vague
as
Cost of finance in the long term, the cost of finance may increase
and yet they cannot pass such a cost to borrowers since the interest
rate is fixed.
Usually security market favours short term loans because there are
very few long term securities and as such commercial banks prefer to
lend short term due to security problems.
6. LEASE FINANCE
Is a contract between owner (Lessor) and the users (Lessee) of the asset.
Under this gives right to lessee to use specific asset for a prescribed period
against the payment of the lease rental.
Lessee pays the lease rental on monthly, quarterly, 2yearly or yearly.
Lease agreement is for a specific period e.g. 5yrs, 10yrs etc.
On long-term lease contracts, lease period or renew the lease lessee is
entitled to claim wear & tear allowance for the leased asset.
21
TYPES:
1. Operating lease
Are those contracts which are for short-term and can be cancelled at a shortnotice e.g. lease contract for computers, office equipment, renting a car by a
tourist etc. Under this, rental charges are written off as an expense on a
straight line basis over lease period.
22
This source is very suitable if the assets become Obsolete very fast
e.g. computers, aircraft etc
Disadvantages
Rental charges may be too high and lessee may pay money in rental
charges than
the cost of the asset.
Lease finance is available for fixed assets only thus not useful for all
financial requirements of the company.
Reserves/Retained Earnings
These are undistributed profits. It is the cheapest and painless method of
raising more capital.
Advantages
If the firm is unable to raise long term loans due to insufficient assets
for security, these are the only source
Disadvantages
23
High retained earnings are possible only when dividends are declared
at a low rate.
- A business enterprise will prefer that mode of finance which allows the
repayments of the principal and interest in easy and convenient installments.
Others
and
mutual funds. Their role is to assist in the transfer of savings from savings
surplus
units
to savings deficit units so that savings can be re-distributed into their most
productive
uses. These intermediaries come between ultimate borrowers and lenders by
transforming
direct claims into indirect claims. Financial intermediaries purchase direct (or
primary)
securities and, in turn, issue their own indirect (or secondary) securities to
the
public.
For
25
example, the direct security that a savings and loans association purchases
is
mortgage,
given
degree of risk and lower costs of borrowing than would be possible with
direct
finance.
Higher
savings
rate
encourage
savings
permit
and
lower
borrowing
costs
greater
investments. Savings and investments are equated more rapidly thus there
is
faster
economic growth.
Functions of Financial Markets/Institutions in the Economy
1.
2.
3.
investment.
4.
Enable companies to make short term and long term investments and
increase liquidity of shares.
5.
6.
7.
in share prices.
8.
Primary market
Secondary market
Capital Market
These are markets for long term funds with maturity period of more than one
year. E.g of Financial instruments used here are debentures, terms, loans,
bonds, warrants, preference shares, ordinary shares etc.The capital market
serves as a way of allocating the available capital to the most efficient users.
Capital market financial institution includes:
Stock exchange
Development bank
Hire purchase companies
Building societies
Leasing firms
shareholders is facilitated.
Facilitates the international capital inflow.
Facilitating the liquidation and marketing of a long term
Acting as a channel through which foreign investments find their way
into the market.
Money/discount markets
This is a market for S.T funds maturing in one year. Money market works
through financial institutions.
The transfer can be direct (from saver to investor) and indirectly through
an intermediary).
The money market or discount market is the market for short term loans.
Commercial paper
Treasury bills
Bills of exchange
Promissory notes
Bank overdrafts
28
Primary Markets
These are markets that deal with securities that have been issued for the
first time.
economy.
Enable investors
securities.
Increases diversification of investments
Improves corporate governance through separation of ownership and
realize
their
investments
through
disposal
of
2.
This
only to the members at a very low interest rate e.g. SACCOS charge p.m
interest on outstanding balance of loan.
4. Pension Funds
These are retirement schemes or plans funded by firms or government
agencies for their workers.
They are, in
outside Hong Kong and Macao which have special status, and Taiwan which
is also claimed by China).
The need for this kind of market came about as a result of two major
characteristics of joint stock company (Public Limited Company), shares.
1.
First of all, these shares are irredeemable, meaning that once it has
sold them, the company can never be compelled by the shareholder to take
back its shares and give back a cash refund, unless and until the company is
winding up and liquidates.
2.
continuous auction market for securities, with the laws of supply and
demand determining the prices.
Functions of the Nairobi Stock Exchange
The check against flight of capital which takes place because of local
inflation and currency depreciation.
Encouragement
of
higher
standards
of
accounting,
resource
Debt
There are many other less general benefits which stock exchanges
afford
to.
government.
Individuals,
corporate
organizations
and
even
the
When the
Therefore their
trading in shares even though he may not be having the technical expertise
relevant to the stock market.
6. Participating in Company Decisions
By buying shares and therefore becoming a part-owner in an enterprise, a
shareholder gets the right to participate in making decisions about how the
company is managed.
Annual.
General meetings, whereby the voting power is determined by the number of
shares an investor holds since the general rules is that one share is equal to
one vote.
STOCK MARKET TERMINOLOGY
1. BROKER
A dealer at the market who buys and sells securities on behalf of the public
investors.
He is an agent of investors
He is the only authorized person to deal with the quoted securities. He is
authorized by CMA and NSE
He obtains the suitable deal for his clients/investors, gives financial advice
and charges commission for his services.
He doesnt buy or sell shares in his own right hence he cannot be a market
marker.
He must maintain standards set by the stock exchange.
36
2. JOBBERS/SPECULATORS
This is a dealer who trades in securities in his own right as a principal.
He can set prices and activate the market through his own buying and selling
hence he is a market maker.
He engages in speculation and earns profit called Jobbers turn (selling price
buying price).
He does not deal with members of the public unlike brokers.
However,
Bulls
A jobber buy shares when prices are low and hold them in anticipation that
the price will rise and sell them at gain.
When a market is dominated by bulls (buyers predominate sellers), it is said
to be bullish. The share prices are generally rising.
Therefore the market is characterized by an upward trend in security prices.
It signifies investors confidence/optimism in the future of economy.
b)
Bears
It signifies
Stags
He believes the price will rise and sell them at a gain to the ultimate
investors
Stags are vital because they ensure full subscription of the share issue.
3,
Underwriting
Blue Chips
Are first class securities of firms which have sound share capital and are
internationally reputable.They have very good dividend record and are highly
demanded in the markets. Individuals holding such securities are reluctant
to sell them because of their high value.
5.
This is the process of selling (going short) or buying (going long) on a share
that one does not have/own. The aim is to make gain from assumed change
in the market value of shares. This practice is not allowed in Kenya. It is
aided by brokers in countries where it is practiced. Investors going short or
long are required to pay a premium called margin on the transaction.
TRADING MECHANISM
1.
AT NSE
floor.
38
2.
At the trading floor, the buying and selling brokers meet and seal the
deal.
3.
investors.
The note contains details such as:
Number of shares bought or sold
Buying/selling price
Charges/commission payable etc.
4.
5.
Old share certificate is cancelled (for selling investor) and a new one is
State of management of the company e.g are the B.O.D. and key
management personnel of repute? They should be trusted and run the
company honestly and successfully.
Nature of the product dealt in and its market share e.g is the product
vulnerable to weather conditions? Is it subject to restrictions?
Marketability of the shares how fast or slowly can the shares of the
firm be sold?
The recent profit record of the company especially the recent dividend
paid to shareholders and the prospects of their growth and stability.
The general economic conditions situations e.g boom and recession e.g
during boom, firms would have high profits hence rise in prices.
If the
trade.
Announcement of good news eg that a major oil field has been struck
or a major new investment has been undertaken.
The value of assets and the earnings from utilization of such assets will
also influence share prices.
Shs.25 M
Year 2001 sales are 120% of year 2000 sales, year 2000 is called Base year.
A stock index therefore measures relative changes in prices or values of
shares. The NSE has its base year as 1966. 20 companies constitute the
index.
The stock index is computed using Geometric mean (G.M) as follows:
41
Where G.M =
N = number of companies
When stock prices are rising, stock market index will rise and vice
versa.
Illustration
The following 6 companies constitute the index of democratic republic of
Kusadikika.
Company
Todays share price
A
20
B
52
C
83
D
12
E
78
F
10
25
53
83
10
75
0
96
index
the
construction/computation
of
stock
following
considered:
1. Choice of base year on which to base the price changes
42
should
be
benchmark.
43
The 20 companies sample whose share prices are used to compute the
index are not true representatives.
New companies are not included in the index yet other firms have been
suspended/deregistered e.g. ATH, KFB etc.
Dormant firms Some of the 20 firms used are dormant or have very
small price changes.
The weights used and the method of computation of index may not
give a truly representative index.
If the price is not consistent with the activities of the firm e.g a decline
in share price of a firm with very good growth prospects.
Price is not compatible with the price of other similar shares of firms in
the same industry
M.P.S). The greatest problem however is that no one can be sure when the
market is at its bottom or at its top (prices are lowest and highest).
Systems have been developed to indicate when shares should be purchased
and when they should be sold. These systems are Dow theory and Hatch
system.
1. Dow Theory
This theory depends on profiting of secondary movement of prices of a chart.
The principal objective is to discover when there is a change in the primary
movement.
This is determined by the behaviour of secondary movement but tertiary
movements are ignored. Eg in a bull market, the rise of prices is greater
than the fall of prices.
In a bear market the opposite is the case ie the fall is greater than the rise
In a bear market, the volume of the business being done at a certain stage
can also be used to interpret the state of the market.
Basically, it is maintained that if the volume increases along with rising
prices, the signs are bullish and if the volume increases with falling prices,
they are bearish.
2. Hatch System
This is an automatic system based on the assumption that when investors
sell at a certain % age below the top of the market and buys at a certain
percent above the market bottom, they are doing as well as can reasonably
be expected. This system can be applied to an index of a group of shares or
shares of dividends companies eg Dow Jones and Nasdaq index of America.
Illustration 1
45
An investor uses the hatch system to determine when to buy and sell his
shares. He sells the shares when prices are 15% less of the top price and
buy the shares when prices are 15% less of the top price and buy the shares
when prices are 15% more of the bottom price. At the beginning of January,
the share price was 200/=.
Shs.320.
i)
ii)
iii)
The investor had D.P.S of 3.00 at the end of the year. Compute his
shilling return in %.
The company must have made profits during the last 3 years.
The firm must issue a prospectus which will give more information to
investors to enable them to make informed judgement
4. Financial statements of the firm showing EPS and DPS for the last 5
years
5. Action report etc.
6. Action may be taken against the directors if the prospectus is
fraudulent.
The Advantages and Disadvantages of a Listing
Advantages
Less of a commitment is
necessary on the part of shareholders. For this reason the shares are
likely to be perceived as a less risky investment and hence will have a
higher value.
The greater marketability and hence lower risk attached to a market
listing will lead to a lower cost of equity and also to a weighted
backward looking.
The shares of a quoted company can be used more readily as
Disadvantages
This is because
substantial costs are fixed and hence are relatively greater for small
companies. Also, the annual cost of maintaining the quotation may be
high due to such things as increased disclosure, maintaining a larger
management.
The market-determined price and the greater accountability to
shareholders
that
comes
with
its
concerning
be
the
disliked
by
companys
The ownership of
are 2 shareholders of XYZ Ltd. XYZ Ltd. does not need to deliver the share
certificate to A or B but a ledger account for both shareholders would be
maintained at the CDS. Their accounts will be credited with the number of
shares. If A want to sell shares to B the CDS will debit As account and credit
Bs account.
Advantages of CDS
1.
2.
3.
4.
Its faster and less risky settlement of securities which make the market
more attractive for investors e.g instances of fraud will be reduced
since there is no physical share certificate which may be forged.
5.
6.
Functions of CDS
1.
securities.
2.
3.
50
This can be done without delay if CDS is linked to the central payment
clearing system e.g CBK.
4.
5.
issues.
6.
private
investors
and
market
professionals.
For
faster
b)
c)
unattractive/low return
d)
e)
Tourism
Rural housing
Agriculture
Rural enterprise
Such sector e.g agriculture and tourism are essential for a balanced
economic growth and development.
The government
has thus
to cater
They
include:
development in Kenya.
Development Finance Company of Kenya (DFCK) To finance
various project will spur economic development and create
employment.
52
development
cooperation
(ICDC)
dealing
with
industrial development.
Agriculture Finance Co-operation (AFC)
Post Bank To mobilize rural savings
National Housing Cooperation for development of houses to
sectors.
They were only useful during periods of foreign exchange
restriction
They are risk capital providers in areas which are not attractive to
Banking Institutions
The Central Bank
53
Central Banks
Functions of Central Bank
1. Banker to the government
2. Lender to the government
54
Commercial Banks
These are financial are financial institutions that accept deposits of money
from the general public, safeguard the deposits and make them available to
their owners when need arises.
customers accounts
Transferring of money from individual to another person s accounts
interest
Facilitate international trade by issuing letter of credit and undertake
foreign exchange transactions on behalf of their customers
55
etc
Making decision affecting development. Before advancing loans to
prospective
customer, commercial banks are very careful and strict so as to give
loans
to
through
lending;
which
commercial
form
part
banks
create
additional
of
the
total
By
and
is similarly enhanced.
Intermediaries: commercial banks connect savers of surplus funds to
borrowers. They (banks) play the role of middlemen in the lendingborrowing
cycle.
By
so
doing, commercial banks relieve savers of the risk of loss, which may
result
when
to
and
borrowers,
they
would
56
have
to
carry
the
risk
of
possible
loss
personally.
Economies of scale:
Commercial
banks
economies
provide
of
scale.
the
By
necessary
aggregating
savings
into
were
play
to
and
economic development.
Safety: Commercial banks are also used as strong boxes for keeping
valuable assets in
documents
people deposit
jewellery,
for
no
other
objective
Mortgages
An arrangement where the property being purchased provides the
security for funding. Other assets may be used as security for funding
of another asset.
Features
57
1. Mortgagor
and
mortgagee
agree
on
long
term
financing
arrangement
2. Financing relates to acquisition of specific asset
3. Mortgagor provides a contribution which is paid up-front.
4. Repayment is over a specified long term period.
5. Interest
rate
is
stated
with
provision
for
variations
of
the
It implements the
a)
development
58
It
6.
Merchant Banks
Merchant Banks begun life as merchants and begun to operate in
financial firms, within the 19th Century.
The merchant banks act as a principal when they buy share from the
company before the issue is made.
60
62
ii.
iii.
Profitability index
ii.
Payback period
Ct
t Io
t=1 (1 + K )
NPV =
Where
Ct is the cashflow
K is the opportunity cost of capital
63
Ct
- =0
t Io
t=1 (1+ r )
NPV =
3.
Profitability Index
This is a relative measure of projects profitability. It is given by the
following formula.
(1+CK )
t
PI =
t=1
Io
Decision Rule
If
1.
65
Payback Period
This is defined as the time taken by the project to recoup the initial
cash outlay.
The decision rule depends on the firms target payback period (i.e.
the maximum period beyond which the project should not be
accepted.
ILLUSTRATION
A company is considering two mutually exclusive projects requiring an initial
cash outlay of Sh 10,000 each and with a useful life of 5 years. The company
required rate of return is 10% and the appropriate corporate tax rate is 50%.
The projects will be depreciated on a straight line basis.
The before
4,000
4,000
4,000
4,000
3,000
2,000
5,000
5,000
Required:
66
ii.
iii.
iv.
Profitability index
v.
10,000 - 0
Sh 2,000
5
Project A
Annual Cashflow
4,000
2,000
2,000
1,000
1,000
2,000
3,000
Project B
Year
3
1
4
Less depreciation
4,000 1,000
0 3,000 3,000
2,000
500
0 1,500 1,500
2,000
500
0 1,500 1,500
i.
Project A =
10,000
3 1/3 years
3,000
Project B
Sh 4,000 + Sh 2,500 + Sh 2,000 = Sh 8,500 is recovered in three years. The
remaining amount of Sh 10,000 - 8,500 = 1,500 is to be recovered in the
fourth year.
Thus PB =
3 years +
1,500
3 3/7 years
3,500
According to PB Project A is better.
ii.
Project A
Average income
5 x 1,000=
Shs 1,000
5
Average investment
= 10,000/2
68
Shs 5,000
ARR =
1,000
0.20 or 20%
5,000
Project B
Average income = 2,000 + 500 + 0 + 1,500 + 1,500
5
=
5,500
Shs 1,100
5
ARR
1,100
0.22 or 22%
5,000
According to ARR Project B is better.
iii. Net Present Value Method
Project A
NPV =
10%, 5 years
Project B
NPV can be computed using the following table:
69
Year
CashflowsPV.F
10%
4,000
0.9093,636
2,500
0.8262,065
2,000
0.7511,502
3,500
0.6832,390.5
3,500
0.621 2,173.5
PV
Total PV 11,767
Less initial cost 10,000
NPV 1,767
Project B is better because it has a higher NPV.
iv.
Project A
PI
11,373
1.1373
1.1767
10,000
Project B
PI
11,767
10,000
Project A
NPV =
3,000
PVIFA
r%, 5years
- 10,000 = 0
70
PVIFA
r%, 5years
10,000
3.333
3,000
From the table r lies between 15% and 16%. We use linear interpolation to
compute the exact rate.
PVIFA
15%
3.352
PVIFA
15%
3.352
PVIFA required =
3.333
PVIFA
Difference
0.019
Difference
IRR =
16%
(0.019) =
3.274
0.078
15.24%
0.078
Project B
We use trial and error method since the cashflow are uneven:
NPV at 16% =
10,186 - 10,000
NPV at 17% =
186
9,960.5 - 10,000
71
(39.5)
17 - IRR
186
39.5
3.794
16.8%
72
If a firm rations capital its value is not being maximised. A value maximizing
firm would invest in all projects with positive NPV. The firm may however want
to maximize value subject to the constraint that the capital ceiling is not to be
exceeded.A linear programming method can be used to solve constrained
maximization problems. The objective should be to select projects subject to
the capital rationing constraint such that the sum of the projects NPVs is
maximized.
Illustration
Management is faced with eight projects to invest in.
The capital
expenditures during the year has been rationed to Sh 500,000 and the
projects have equal risk and therefore should be discounted at the firm's cost
of capital of 10%.
Project
Cost
Project
t = 0(Shs) Life
CashflowNPV at the
per year
10% cost
400,000
20
58,600
98,895
250,000
10
55,000
87,951
100,000
24,000
28,038
75,000
15
12,000
16,273
75,000
18,000
3,395
50,000
14,000
3,071
250,000
10
41,000
1,927
250,000
99,000
(3,802)
Required:
Determine the optimal investment sets.
73
St 1 =
500,000
2 =
NPV
250,000
87,951
100,000
28,038
75,000
16,273
75,000
3,395
500,000
135,657
ABANDONMENT VALUE
It has been assumed so far that the firm will operate a project over its full
physical life. However, this may not be the best option - it may be better to
abandon a project prior to the end of potential life. Any project should be
abandoned when the net abandonment value is greater than the present
value of all cash flows beyond the abandonment year, discounted to the
abandonment decision point. Consider the following example:
Project A has the following cashflows over its useful life of 3 years.
market value (Abandonment value) has also been given.
Year
Cash Abandonment
flow
value
Sh`000'
Sh`000'
74
The
(4,800)
4,800
2,000
3,000
1,875
1,900
1,750
Required:
Determine when to abandon the project assuming a discount rate of 10%.
Suggested Solution:
If the project is used over its life, the NPV is negative as shown below:
NPV =
2,000 x PVIF
10%, 1year
+ 1,875 X PVIF
10%, 2years
+ 1,750 X PVIF
10%, 2 yrs
4,800
=
Shs -119
Sh 136
75
The NPV is positive if the project is abandoned after 2 years and therefore this
is the optimal decision.
Note that abandonment value should be considered in the capital budgeting
process because, as our example illustrates, there are cases in which
recognition of abandonment can make an otherwise unacceptable project
acceptable. This type of analysis is required to determine projects economic
life.
Risk Analysis in Capital Budgeting
The Risk associated with a project may be defined as the variability that is
likely to occur in the future returns from the project. Risk arises in investment
evaluation because we cannot anticipate the occurrence of the possible future
events with certainty and consequently, cannot make any correct prediction
about the cashflow sequence.
Attitudes towards Risk
Three possible attitudes towards Risk can be identified. These are:
(a) Risk aversion
(b) Desire for Risk
(c)
Indifference to Risk
A Risk averter is an individual who prefers less risky investment. The basic
assumption in financial theory is that most investors and managers are risk
averse.Risk seekers on the other hand are individuals who prefer risk. Given a
choice between more and less risky investments with identical expected
monetary returns, they would prefer the riskier investment.
76
The person who is indifferent to risk would not care which investment he or
she received.
To illustrate the attitudes towards risk assume two projects are available. The
cashflows are not certain but we can assign probabilities to likely cashflows as
shown below.
States of nature
cashflow
Sh 900,000
600,000
0.2
Moderate prediction
600,000
600,000
0.6
Pessimistic prediction
300,000
600,000
0.2
Optimistic prediction
Sh 600,000
Project B
Expected cashflow =
=
Sh 600,000
Therefore, the two projects have the same expected cashflows (Sh
600,000). However, Project A is a riskier project since there is a chance
that the cashflow will be Sh 300,000. Project B on the other hand is a
less risky project since we are sure that Sh 600,000 will be received.
77
A risk seeker would choose Project A while a risk averter would choose
Project B. A risk neutral decision maker would be indifferent between the
two projects since the expected cashflows are equal.
The Beta () can also be used and is dealt with under Portfolio
Analysis
To illustrate the first two methods, let us assume that we are examining
an investment with the possible outcomes and probability of outcomes as
shown below:
Note: the outcome could either be cashflow or NPV.
Assumptions (states of nature)
Outcome Sh`000'
Probability
Pessimistic
300
0.2
Moderately successful
600
0.6
Optimistic
900
0.2
The expected value which is a weighted average of the outcomes times their
probabilities can be computed as follows:
78
DP
DP
300
0.2
60
600
0.6
360
900
0.2
180
DP 600
Standard Deviation ( ) =
(D - D ) P
(D - D )
(D - D )2
(D - D )2 x P
300
0.2
-300
90,000
18,000
600
0.6
900
0.2
300
90,000
18,000
36,000
79
Standard Deviation ( ) =
(D - D ) P
36,000=SH 190,000
Expected value
Standard deviation
Sh 6,000
600
Sh 600
190
80
600
0.100
6,000
Project B
CV =
190 =
0.317
600
Generally, the larger the coefficient of variation, the greater the risk.
Therefore, Project B carries a greater risk than Project A.
Another risk measure, the beta () is widely used with portfolios of
common stock. Beta measures the volatility of returns, on an individual
stock relative to a stock market index of returns.
(Note: Beta will be discussed under portfolio analysis).
Incorporating Risk in Capital Budgeting
(c)
Certainty equivalents
Payback
Payback period is an attempt to allow for risk in capital budgeting.
As discussed earlier, firms using Payback period usually prefer short
payback to longer ones, and often establish guidelines such that the
firm accepts only investments with some maximum payback period,
say three or five years.
limitations:
(a) It ignores the time value of cashflows
(b) It does not make any allowance for the time pattern of the
initial capital recovered
(c)
2.
This approach uses different discount rates for proposals with different risk
levels. A project that carries a normal amount of risk and does not change the
overall risk composure of the firm should be discounted at the cost of capital.
Investments carrying greater than normal risk will be discounted at a higher
discount rate.The NPV of the project will be given by the following formula.
82
Ct
t Io
t=1 (1+ K )
NPV =
The following diagram shows a possible risk-discount rate trade off scheme.
Risk is assumed to be measured by the coefficient of variation, C.V)
83
The normal risk for the firm is represented by a coefficient of variation of 0.30.
An investment with this risk will be discounted at the firm's normal cost of
capital of 10%. As the firm selects riskier projects with, for example, a C.V. of
0.90, a risk premium of 5% is added for an increase in C.V. of 0.60 (0.90 0.30). If the firm selects a project with a C.V. of 1.20, it will now add another
5% risk premium for this additional C.V. of 0.30 (1.20 - 0.90). Notice that the
same risk premium was added for a smaller increase in risk.
This is an
example of being increasingly risk averse at higher levels of risk and potential
return.
Advantages of Risk-adjusted discount rate
(a) It is simple and can be easily understood.
(b) It has
a great
deal
of
intuitive
appeal
for
risk-averse
businessmen.
(c)
Disadvantages
(a) There is no easy way of deriving a risk-adjusted discount rate.
(b) It does not make any risk adjustments in the numerate - for the
cashflows that are forecast over the future years.
(c)
3.
Certainty Equivalent
Using this method the NPV will be given by the following formula:
t Ct t Io
(1
+
Kf
)
t=0
NPV =
Where Ct
t
coefficient
Io
Kf
85
80,000 =
0.8
100,000
Illustration:
Assume a project costs Sh 30,000 and yields the following uncertain
cashflows:
Year
Cashflow
12,000
14,000
10,000
6,000
Assume also that the certainty equivalent coefficients have been estimated as
follows:
0
1.00
0.90
0.70
0.50
0.30
t Ct t Io
t=0 (1+ Kf )
NPV =
=
-
0.9 (12,000)
0.7 (14,000)
0.5 (10,000)
0.3 (6,000)
30,000
1 + 0.1
(1 + 0.1)3
(1 + 0.1)
(1 + 0.1)4
(30,000)
PV
1.00
(30,000)
0.9 (12,000)
0.909
9,817.2
0.7 (14,000)
0.826
8,094.8
0.5 (10,000)
0.751
3,755.0
0.3 (6,000)
0.683
1,229.4
NPV (7,103.6)
The project has a negative NPV and therefore should not be undertaken.
Note that if risk was ignored the NPV would have been Sh 4,080 and the
project would have been accepted.
Merits of certainty equivalent approach
87
1.
2.
It recognises that cashflows further away into the future are less
certain (therefore a lower t)
Demerits
1.
2.
3.
Sensitivity Analysis
Sensitivity Analysis is a way of analysing change in the project's NPV for a
given change in one of the variables affecting the NPV. It indicates how
sensitive the NPV is to changes in particular variables.
The more
2.
3.
Sensitivity Analysis allows the decision maker to ask "what if" questions.
88
375,000
30,000
Depreciation
15,000
345,000
30,000
Tax (50%)
15,000
15,000
15,000
30,000
30,000 x PVIFA
10%, 10 yrs
- 150,000
Sh 34,350
The NPV is positive and therefore the project is acceptable. However, the
investor should consider how confident he is about the forecast and what
would happen if the forecast goes wrong. A sensitivity can be conducted
with regard to volume, price, cost etc. In order to do so we must obtain
pessimistic and optimistic estimates of the underlying variables.
89
Assume that in the above example, the variables used in the forecasts
are:
(a) Volume of sale ( = market size x market share)
(b) Unit price
(c)
Pessimistic
Expected
Optimistic
Market Size
9,000
10,000
11,000
Market Share
0.004
0.01
0.016
3,500
3,750
3,800
3,000
2,750
30,000
20,000
40,000
Expected
Optimistic
Market size
11,306.25
34,350
57,393.75
Market share
-103,912.5
34,350
172,612.5
Unit price
-42,462.5
34,350
49,712.5
-150,000
34,350
11,162.5
3,625
34,350
65,075
Fixed costs
90
Sh
67,500
45,000
22,500
11,250
Less tax
11,250
15,000
Net cashflows
26,250
NPV =
=
91
Break-Even Analysis
In sensitivity
10%, 10 yrs
- 150,000
But
Annual cashflows = Revenue - variable costs - Fixed costs - depreciation Tax + depreciation.
Let variable cost per unit be V
Annual cashflows = (375,000 - 100 (V) - 45,000)0.5 + 15,000
Therefore NPV = [(330,000 - 100 V) 0.5 + 15,000] x 6.145 - 150,000
At Break even point NPV = 0
Therefore (165,000 - 50 V + 15,000) 6.145 = 150,000
1,106,100 - 307.25v
= 150,000
307.25 V = 956,100
V
= 3,111.8
92
Therefore the point above which the variable cost per unit will cause the
NPV to be negative is about Sh 3,112.
To prove if variable unit cost is Sh 3,112 the NPV will be computed as
follows:
Sh
Revenue
375,000
30,000
Depreciation
15,000
356,200
18,800
Tax
9,400
9,400
15,000
Net cashflows
24,400
93
2.
3.
Disadvantages
1.
Market size
Once the probability distributions are determined, the average rate of return
resulting from a random combination of the above nine factors is determined.
A computer can be used to carry out simulation trials for each of the above
factors. A simulation model relies on repetition of the same random process
as many times as possible. One of the benefits of simulation is its ability to
test various possible combination of events. This sensitivity testing allows the
planner to ask "what if" questions.
DECISION TREE FOR SEQUENTIAL DECISIONS
Illustration:
A project has the following cashflows
Year 1
Year 2
Cashflow Probability
60,000
80,000
100,000
0.3
0.4
0.3
Cashflow
Probability
50,000
0.3
60,000
0.5
70,000
0.2
60,000
0.3
80,000
0.5
100,000
0.2
80,000
0.3
100,000
0.5
120,000
0.2
95
96
NPV =
It clearly brings out the implicit assumptions and calculations for all
to see, so that they may be questioned and revised.
2.
Demerits
1.
The decision tree can become more and more complicated as more
alternatives are included.
2.
Utility Theory
When discussing the expected value and the standard deviation we noted that
decision makers can either be risk seekers, risk averse or risk neutral.
Therefore, we cannot be able to tell with certainty whether a decision maker
will choose a project with a high expected return and a high standard
deviation, or a project with comparatively low expected return and low
standard deviation.Utility theory aims at incorporating the decision maker's
preference explicitly into the decision procedure. We assume that a rational
decision maker maximises his utility and therefore would accept the
investment project which yields maximum utility to him.
We can graphically demonstrate the three attitudes towards risk as follows:
97
98
risk
seeker, the marginal utility is positive and increasing. For a risk neutral
decision maker, the marginal utility is positive but constant. To derive the
utility function of an individual, we let him consider a group of lotteries
within boundary limits.
Illustration: Derivation of utility functions
99
willing to pay Sh 21,000 for this lottery. The utile value for Sh 21,000 can
be computed as follows.
U (Sh 21,000) = (0.3 U(Sh 0) + 0.7 U(Sh 33,000)
= 0.3 x (0) + 0.7(0.5)
= 0.35
Note that other lotteries can be provided to the decision maker until we
have enough points to construct his utility function.
12.2
100
Prob.
Cashflows
0.10
Sh -25,000
0.10
60,000
0.60
0.60
80,000
0.80
0.50
-0.20
Project B
Utiles
-0.25
Prob.
0.10
0.20
50,000
0.50
0.50
100,000
1.00
0.20
101
Project A
Utile
Project B
Prob.Weighted
Utile
Utility
-0.20
0.10
Prob.Weighted
Utility
-0.02
-0.25
0.10
-0.025
0.10
0.20
0.60
0.60
0.36
0.50
0.50
0.25
0.80
0.20
0.16
1.00
0.20
0.20
0.54
0.425
2.
Limitations
1.
2.
3.
102
103
capital structure and whether this is optimum capital at which the cost
of finance is lowest or optimum.
3. APPRAISING
THE
FINANCIAL
PERFORMANCE
OF
THE
TOP
MANAGEMENT
This will involve a comparison of actual profit abilities of the
investment projects undertaken by the firm with the projected overall
cost of capital and the appraisal of the actual costs incurred by
management in raising the required funds. OR It is used to assess the
ability of the companys management to utilize the financial resources
at its disposal to generate profits.
4. DETERMINING A COMPANYS SHARE PRICES
The cost of finance in particular dividends on share capital will have a
lot of influence on the companys share prices which will be high if the
dividends are high and this will affect the companys ability to raise
extra finance be it in form of debt or equity finance
5. GAUGING THE AVAILABILITY OF FINANCE
The average cost of finance is used to gauge the availability of finance.
This means that if the cost is quite high, this will make it difficult to
raise the necessary finance needed for the companys operations. This
situation will affect the companys investments and thus its growth.
7. Nature of security
This will affect the implicit costs. Usually if the security is a depreciable
asset like buildings, these will have to insured comprehensively and
this will increase the implicit cost of such finance. On the other hand if
the security was land, such implicit cost will not be warranted.
8. Growth stage of the company
Growing company will pay fewer dividends and will retain more so as
to plough back retained profit to acquire fixed assets. On the other
hand, mature companies will pay high dividends as they will have
reached their highest level of growth and thus profitability.
Irredeemable debt
i
r
MV
OR
i
Kd
Therefore :
Kd
i
MV
irredeemable
Kd
i
MV
i
MV
Kd
Interest, i
10
x 100 = 10
100
10
x 100
90
= 11.1%
(ii) Redeemable Debt
Here the interest will be received in the year of redemption plus the
amount payable
On redemption.
MV
i MVn
i
i
1 +
2 +..+
(1 K d )
(1 K d )
(1 K d ) n
Using example 1 above, calculate the cost of this capital, if the debenture is
redeemable after 10years.
90
10
10
10 100
..................................
(1 K d ) (1 K d )2
(1 K d )10
Here, we get the Kd using trial and error, like getting the IRR.
YEAR
Discount factor.
0
Cash Flow
Try 12%
PV ()
Market Value
(90)
1.000
10
5.650
100
0.322
(90.00)
1- 10
Interest
56.50
10
Capital Repayment
32.00
107
(1.30)
Try 11%
Discount factor
PVs ()
(90)
1.000
(90.00)
10
5.889
58.89
100
0.352
35.20
4.09
4.09
1
1
( FV MV ) 10 (100 90)
11
n
10
X 100 11.56%
1
1
95
( FV MV )
(100 90)
2
2
i (1 T )
MV
108
0.08125 8.125%
=
80,000
8
MV
The higher the corporation tax the greater the tax benefits having debt
finance compared with equity finance.
N.B
In the case of redeemable debenture, capital repayment is not allowable for
tax.
Example
Assume the same facts as example 1 for Owen PLC except that the market
price is 95% and the debentures are redeemable at per after 3yrs. Calculate
the Kd assuming corporation tax 35%.
Yr
MV ()
Interest ()
Tax Relief ()
Flow ()
0
(95)
(95)
10
10
(3.5)
6.5
10
(3.5)
106.5
(3.5)
(3.5)
100
10
Kp
PDiv
Po
Net
Cash
D
r
And r
Div
Kp
(ii)
D
MV
10
x 100 10
100
10
0.1053
95
Therefore,
or 10.53%
This is a preference share with finite maturity. A formula similar to the one
for calculation of the market value of redeemable debt is used:
n
MV Po
t 1
DIVt
Pn
t
(1 K p )
(1 K p ) n
The cost of preference share is not adjusted for taxes are because preference
dividend is paid after the corporate taxes have been paid.
COST OF EQUITY CAPITAL.
New funds from equity shareholders are obtained in one of two ways;
(a)
(b)
(c)
(i)
110
The dividend valuation model for a firm whose dividends are expected to
grow at a constant rate g , is as follows,
MV
Do (1 g )
Ke g
DIV1
Ke g
NB: D1 = Do (1+g)1
D2 = Do (1+g)
Dn
Do
(1+g)n
Thus,
Ke
DIV1
g
MV
Ke
DIV1
MV
(ii)
Sh.100
Ke = DIV1
+g
MV
NB:
+g
MV-f
Ke = DIV1
+g
Io
Example
In the example above calculate the cost of external equity;
Ke= 4.75 + 0.06
95
= 0.05 + 0.06
= 0.11 or 11%
Estimating growth rate
Recall that, Ke = DIV1 + g
Ke = Do(1+g) + g
MV
Thus,
MV
DIV1 = Do (1+g)1
112
Therefore
DIV2= Do (1+g)2
DIVn = Do (1+g)n
Example:
The dividend earnings of HL Ltd over the last 5 years is as follows;
Year
Dividend (E)
Earnings (t)
1991
150,000
400,000
1992
192,000
510,000
1993
206,000
550,000
1994
245,000
650,000
1995
262,350
700,000
The company is financed entirely by equity and there are 1 million shares is
issued cash with a market value of 3.35 ex-div
(i)
Solution
Ke = DIV1
+g
MV
DIV in 1991 x (1+g)4 = DIV in 1995
150,000 (1+g)4 = 262,350
113
= 1+g = 1.14999
g = 1.14999 1
g = 0.14999
= 14.999% or 15%
Ke
DO (1 g )
g
MV
.0.26235(1 0.15)
0.15
3.35
262350
1000 000
= 0.24 or 24%
114
ii)
iii)
WACC = K1 W1 + K2 W2 + K3 W3 + ---------------------------
Where k1 and K2 are component costs and W1 and W2 are the weights of
various types of capital employed by the company.
EXAMPLE 1
Prudence Co. is financed partly by equity and partly by debentures.
The
equity proportion is always kept at 2/3 of the total. The cost of Equity is
18% and that of debt is 12%. Calculate the WACC.
Source of capital
Proportion
Cost
Weighted
Cost
WACC
Equity
Debt
2/3
1/3
18%
12%
2/3 x 18
1/3 x 12
WACC=
Or
WACC=
12%
4%
16%
Wd Kd + WeKe
=
1/3 x 12 + 2/3 x 18
4 + 12
16%
EXAMPLE 3
The following is the capital structure of a firm:
Source
Amount (sh)
450,000
45%
Retained earnings
150,000
15%
100,000
10%
115
Proportion (%)
Debt
300,000
30%
1,000,000
Revision Questions
Company XYZ, a geared company has financed its activities as follows;Ordinary shares- 100 000 shares @ Shs 10
40 000 8% debentures (par value Shs. 10/)
50 000 10% preference share of Shs. 10
Also the following information is provided;Ordinary shares are currently quoted at Shs. 25 and dividend of
Shs. 2 per share is expected by shareholders. These dividends have been
growing at 3% p.a.
Preference Shares currently sell at Shs. 15. Tax=40%
REQUIRED
Compute the weighted average cost of capital using the two methods (i.e
weighting approach and percentage approach)
Answer
Weighting Approach
The companys capital structure is as follows (currently) ;Ordinary shares- 100 000 @ Shs. 25
Shs 3,650,000
15
Cost of debentures = Cd = bcd (1-t) x 100
Kd
Bcd
8 x10
80cts
100
0.8(1 0.4)
X 100
100
(0.8 X 0.6) X 100
Kd
0.048 OR 4.8%
Source
amount
proportion
after tax
Weighted
Cost
Ordinary
2,500,000
68.49%
11%
7.5339%
Preference
750,000
20.55%
6.67%
1.3707%
Debentures
400, 000
10.96%
4.8%
0.5261%
3,650,000
100%
9.4307
Percentage approach
Cost of equity = 2, 500, 000 x 11%
= 275, 000
= 50, 025
19, 200
344 245
TCCE
TCE
WACC=
To get g =
X 100 =
344225
X 100 = 9.4308%
3650000
x 100
(d) Cost of retained earning has no explicit cost but opportunity cost which is
that dividend the shareholders have forgone to allow retention - thus the
cost of retained earnings will be the same as the cost of equity:
Cr
Do
X 100 g
Po
Po - f
Loan finance = Kd = I (1-t) =% cost
(a) Cost of preference share capital. This is the dividends due to preference
shareholders, but these are fixed. Thus the cost of preference of shares:
= Kp
Pdiv
X 100
Pp
pp f
Cost of debt (before tax)
= bcd = I x debt finance used where tax is ignored giving allowance for
tax
= Cd = bcd I t
x 100
pd t
Pd f
I = interest rate
This formula is used to determine the cost of debenture finance
Cost of loan finance = cd = I(I-t)=%
Where I = interest rate,
t = tax
NOTE
In case computing the cost of ordinary share capital and reserve, using
the market approach, it is advisable to combine them into equity.
Example 3
Information obtained from the books of Havabley and Edwin Ltd indicated
that;
1. This company sold 10,000 ordinary shares at shs. 100 with a
floating cost of shs. 20 each
2. It sold 5,000 preferences shares of shs. 100 at shs. 150 which carry
a dividend of 16%
3. It sold 5,000 shs. 100 10% debentures at shs. 80
4. It sold 10,000 shs. 50, 12% debentures with issue cost of shs. 15
This company hopes to earn a return on the above finances of 18%.
Required:
be
40%
Answer
Cost of preference share capital
DP= 16% of 100 = Shs. 16
PP= 150
= Cp = Dp x 100 = Cp = 16 x 100 = 10.667%
Pp
150
Cost of debentures
= Cd = bcd (1-t) x 100 = Cd = 10(1-0.4) x 100
Pd
80
retention.
Tax
Pd=80
Cd= bcd (1-t) x 100
Pd-f
bcd = 12% of 50= 6
pd = 50
f = 15
cd= 6(1-0.4) x 100
50.15
Source
Amount
proportion
Weighted
After tax
Shs.
Cost
Cost
Ordinary
1,000, 000
37.74%
x%
0.377x%
Preference
750,000
28.30%
10.667%
3.0189%
10% Debentures
400,000
15.09%
7.5%
500, 000
18.86%
10.2857%
1.131%
12 debentures
1.9399%
2,650,000
6.0906%
+ 0.377%
6.090% + 0.3774 x = 18%
0.3774x= 18% -6.090%
0.3774x = 11.9094 %
X = 11.9094% =31.556%
0.3774%
Proof
120
99.99%
Source
Amount
proportion
Weighted
After tax
Shs.
cost
cost
Ordinary
1,000, 000
37.74%
31.556%
28.30%
10.667%
11.9092%
Preference
750, 000
3.0189%
10% debentures
400,000
15.09%
7.5%
1.1318%
12 debentures
500, 000
18.86%
10.2587%
1.9399%
2, 650,000
99, 99%
17.9998%
=18%
Using Percentage Approach
Shs
Cost of ordinary shares
315, 560
= 31.556% of 1,000,000
Cost of preference shares
= 10.67 %
80,025
of 750, 000
Cost of debt
= 7.5 % of 400,000
30,000
Cost of debt
= 10.2857% of 500,000
51, 428.5
477, 0135
(TCCE)
The Weighted Average Cost of Capital (WACC) =
Total Cost of Capital Employed x 100
Total Capital Employed
121
18.001%
2,650,000
a)
i)
ii)
b)
c)
Investments appreciate in the stock market and as such the cost must
be adjusted to reflect such a movement in the value of an investment.
1.
MCE =
D1
x100
Po f
Ke =
D1
Po f
Where:
P0 = current MPS
f = floation costs
g = growth rate in equity
2.
Kp =
Dp
x100
Po f
Where:
Kp = Cost of preference
Cost of debenture
Kd
Int(1 T)
Vd f
Where:
Kd = Cost of debt
Int = interest
Po = Market price for debenture (at discount)
f = flotation costs
t = Tax rate
4.
computed using:
i)
ii)
Percentage method
123
Example
XYZ Ltd wants to raise new capital to finance a new project. The firm will
issue 200,000 ordinary shares (Sh.10 par value) at Sh.16 with Sh.1 floatation
costs per share, 75,000 12% preference shares (Sh.20 par value) at Sh.18
with sh.150,000 total floatation costs, 50,000 18% debentures (sh.100 par)
at Sh.80 and raised a Sh.5,000,000 18% loan paying total floatation costs of
Sh.200,000.
b)
Solution
a)
Ordinary
Sh.000
shares
200,000 3,200,000
shares @ Sh.16
200,000
3,000
shares
shares @ Sh.18
(150,000
75,000 )
3,000,000
3,000
-____
50,000 5,000,000
debentures @ Sh.80
Floatation costs
1,200
4,800
(200,000 12,000
)
Loan
Less floatation costs
Total capital raised
124
b)
Ke
d 0 (1 g )
g
P0 f
d0
4%
Sh.1.00
P0
Sh.16
Therefore marginal
Ke
Sh.2.80
2.80(1.04)
0.04
16 1
= 0.234 = 23.4%
dp
P0-f
dp
Sh.2.40
P0
Sh.18
Sh.150,000 = Sh.2.00
75,000 shares
Kp
2.40 =
0.15 =
18 2
Marginal cost of debenture Kd:
Kd
Int (1-t)
Vd-f
0
125
15%
Vd
Sh.80
Int
30%
Kd
18(1-0.3)
Sh.18
0.1575
15.75%
80
Marginal cost of loan Kd
Kd
Int (1-t)
Vd-f
30%
Vd
Sh.5 million
Sh.0.2 million
Int
Kd
0.9 (1-0.3)
0.13125
5 0.2
Source
Amount to %
Maturity
raise
cost
before
marginal
f. cost
costs
Sh.000
Sh.000
3,200
23.4%
748.8
shares
1,350
15.0%
203.5
Preference
3,000
15.75%
472.5
shares
5,000
13.13%
656.5
Ordinary
Debenture
12,550
2,080.3
Loan
126
13.13%
2,080.3 x 100
16.58%
12,550
Users of Ratios
This analysis is important to various parties with a financial stake in the
company. These include:
1.
short and long term survival. For this reason they will use ratios such as:
a)
b)
dividends. The common ratios include earning yield (E/Y), Dividend pay out
ratio (DPO), dividend yield, Price earning ratio, all of which will measure
return to owner.
127
2.
meet their short-term obligations as and when they fall due. For this reason
they will use ratios such as:
a)
and debenture holders. These have both short and long term interest in the
company and its ability to pay not only interest on debt but also principal as
and when it falls due. These parties are interested in the following:
a)
current obligations.
b)
investment.
d)
interest in:
a)
b)
The companys viability from the investors point of view and the
the company.
128
5.
both on short and long term basis in particular the companys ability to
generate acceptable return on their money.
Therefore, they will use:
6.
a)
Dividend ratios
b)
Return ratios
c)
Gearing ratios
Government
The
Government
is
interested
mostly
in
utility
companies (e.g. KPLC, KPTC) and those that will provide public services in
this case the government will be interested in their survival and thus ability
to provide those services.
7.
a)
Profitability ratios
b)
Return ratios
the market share point of view and will use the ratios that enable them to
ascertain companys competitive strength e.g. profitability ratios, sales and
returns ratio etc.
8.
interested in the ability of the company to provide good services both in the
short and long run. To gauge the companys ability to provide goods and
services on short and long term basis. We have:
a) Returns ratio
129
b) Sales ratio
130
Classification of Ratios
Ratios are broadly classified into 5 categories:
1.
Liquidity ratios
2.
Turnover ratios
3.
Gearing ratios
4.
Profitability ratios
5.
BALANCE SHEET
RATIOS
DEBT RATIOS
LIQUIDITY RATIOS
(a)
3. COVERAGE RATIOS
4. ACTIVITY RATIOS
5. PROFITABILITY RATIOS
Liquidity Ratios:
Measure a firms ability to meet short-term/current obligations. They
asses the liquidity position of a firm i.e. does the firm suffer from
lack of liquidity/or insolvency? Or does the firm hold excess
liquidity?
NB: Short term obligations are the current liabilities
1. Current Ratio =
131
3. Cash Ratio =
(b)
NWC
Net Assets
TotalDebt
2.
Debt Ratio =
TotalDebt
TD
TotalDebt (TD)
CapitalEmp
loyed
NA
TotalDebt Networth
3.
132
CapitalEmployed
Networth
(c)
Coverage Ratios
These are ratios that indicate a firms ability to service or cover
interest and other fixed charges.
1. Interest Coverage Ratio =
= x times
Shows the number of times the interest charges are covered
by funds that are ordinarily available for their payment.
EBDIT
Loan
Re payment
2. Fixed Charges Coverage Ratio =
Interest (
)
1 tax rate
(d)
2.
3.
Credit Sales
Average Debtors =
133
4.
Average Debtors
x 365 x days
Credit Sales
Sales
x times
Total Assets NFS CA
This shows the firms ability in generating sales from all financial
resources committed to total assets.
6.
Sales
xtimes
Net Assets
7.
8.
Sales
xtimes
Current Assets
Average
Creditors
payment
period
Average Creditors
x363 xdays
Credit Purchase
e.
Profitability Ratios:
These are calculated to show the operating efficiency of a company.
The major types of profitability ratios are calculated:
I.
Gross Profit
x 100
Net Sales
134
x100 x%
Net Sales
Sales
3. Contribution Ratio =
Sales
Sales
It indicates how well the firm has used the resources owned. It
tells
of
the
earning
power
of
shareholders
book
value
investments.
3. Return on Assets =
4. Return
on
Shareholders
135
funds
1.
2.
Dividend
per
share(DPS)=
3.
NB: 1 -
DPS
Retention Ratio
EPS Retention Earning - Dividends
DPS
4.
5.
EPS
6.
Price-Earnings Ratio =
7.
MV
Torbins q -> this is the ratio of the market value of a firms asset
or
(equity and debt) to its assets replacement costs.
Market value of assets
QUESTION One
a) KAMWERETHO Ltd. A medium sized company has just released its
financial results for the ending financial year alongside the results for
the previous financial year.
KAMWERETHO Ltd.
2007
Sh. 000
Sh. 000
Cash
15,250
24,400
Accounts receivable
80,320
77,800
Inventory
98,600
158,800
194,170 261,000
25,230
27,600
Machinery
33,800
26,400
14,920
28,200
Total assets
268,120 343,200
138
34,220
73,760
Accruals
15,700
34,000
49,920
107,760
60,850
60,858
115,000 115,000
Retained earnings
42,350
59,582
268,120 343,200
KAMWERETHO
October
2006
Shs. 000
2007
Shs. 000
827,000
858,000
Cost of sales
(661,600)
(710,000)
Gross profit
165,400
148,000
(63,600)
(47,264)
(25,400)
(31,800)
76,400
68,936
Interest expenses
(12,800)
(26,800)
63,600
42,136
Taxes
(25,400)
(16,854)
Net income
38,200
25,282
4,600,000
4,600,000
Shs.8.30
Shs. 5.50
Shs.1.75
Shs.48.90 Shs.13.25
Shs.1.75
Required:
Calculate for each year:
i.
ii.
iii.
iv.
v.
vi.
Quick ratio
Inventory turnover ratio
Average collection period
Fixed assets turnover
Price earnings ratio
Debt/Equity ratio
QUESTION
(2marks)
(2marks)
(2marks)
(2marks)
(2marks)
(2marks)
Two
140
Kshs. 000
Sales
300
Cash
,000
-
600
Credit
,000
210,000
660,000
900
,000
870,000
opening sock
150,000
13,100
Less expenses
15,000
Depriciation
20,900
Directors emoluments
4,000
720
,000
180,
000
General expenses
Interest on loan
Net profit before tax
Corporation tax at 30%
4,800
10,000
(53,000)
Preference dividend
127
Ordinary dividend
,000
(38,100)
88
,900
14
,800
74
,100
141
Aminata limited
Balance sheet as at 31st December 2008
Kshs.000
000
Kshs.
Kshs. 000
Fixed
assets
213,000
Current assets
Stocks
150,000
Debtors
35,900
Cash
20,000
205,900
Current Liabilities
Trade Creditors
60,000
Corporation tax
63,500
Proposed Dividend
14,800
67,600
281,500
Financed by:
142
138,300
100,000
60,000
Revenue reserves
81,500
40,000
281,500
Additional Information
1.
2.
Required
a) Determine the following ratios
i)
(2 Marks)
ii)
Operating ratio
(2 Marks)
iii)
(2 Marks)
iv)
(2 Marks)
v)
(2 Marks)
vi)
(2 Marks)
vii)
(2 Marks)
143
b) Outline any six limitations of using ratios as a basis for financial analysis
(6 Marks)
144
dividend policies.
Constant Amount Of Dividend Per Share
Constant Payout Ratio
Fixed Dividend Plus Extra
Residual Dividend Policy
ii)
iii)
payment of high dividends means less retained earnings and the firm may
have to go to the market to borrow for investment purposes.
increase its gearing level.
145
This will
policy which will maximize the wealth of the shareholders (value of shares).
Does the change in dividend policy affect the value of the firm?
Some
Constant return and cost of capital: The firms rate of return, r and its
cost of capita, k, are constant
Constant EPS and DPS (Dividend per Share): Any given values of EPS
and DPS are assumed to remain constant forever.
146
k
k
Where
The equation above reveals that the market price per share is the sum of the
present value of two sources of income
(i) The PV of the infinite stream of constant dividends. DPS/k
(ii) PV of infinite streams of capital gains {r (EPS-DPS)/k}
Thus, the value of a share is the PV of all dividends plus the PV of all capital
gains as shown above.
This can be simplified to:
firms will maximise the value per share if they follow a policy of retaining all
earnings for investment.
Therefore, the market value per share of such a firm is maximum when it
retains all the earnings. The optimum POR for a growth firm is zero. Market
Price per Share (MPS) increase as POR (Payout Ratio) declines.
Illustration:
The EPS of a company are Sh 8. It has an internal rate of return of 17% and a
capitalization rate of its risk class is 16%. If Walters model is used;
What should be the optimum payout ratio?
What will be the price of the share at this payout?
How shall the price of the share be affected if a different payout were
employed?
148
However, in a more
Firms cost of capital or discount rate, k, does not remain constant since
it changes directly with the firms risk.
+.. + DIV
(1+K)
(1+K)2
149
=
t 1
DIV (1 g ) t
(1 k ) t
b=retention ratio
r= rate or return
Thus;
PO
t 1
DIV (1 g )1 DIV (1 g ) 2
+
(1 k )1
(1 k ) 2
DIV (1 g ) 3
(1 k ) 3
++
DIV (1 g )
(1 k )
DIV (1 g ) t
(1 k ) t
PO
DIV1
(k g )
or
EPS (1 b)
k br
b for
150
This is where the firm will pay a fixed dividend rate e.g. 40% of earnings.
The DPS would therefore fluctuate as the earnings per share changes.
Dividends are directly dependent on the firms earnings ability and if no
profits are made no dividend is paid.
This policy creates uncertainty to ordinary shareholders especially who rely
on dividend income and they might demand a higher required rate of return.
151
applied by the firms whose earnings are highly volatile e.g agricultural
sector.
d) Residual dividend policy
Under this policy dividend is paid out of earnings left over after investment
decisions have been financed.
When to Pay
Firms pay interim or final dividends. Interim dividends are paid at the middle
of the year and are paid in cash. Final dividends are paid at year end and
can be in cash or bonus issue.
152
It will not
decision is a mere detail without any effect on the value of the firm.
153
Dividends
payments are more certain than capital gains which rely on demand and
supply forces to determine share prices.
Therefore, one bird in hand (certain dividends) is better than two birds in the
bush (uncertain capital gains).
Therefore, a firm paying high dividends (certain) will have higher value
since shareholders will require to use lower discounting rate.
MM argued against the above proposition.
154
Note
In Kenya, dividends attract a withholding tax of 5% which is final and capital
gains are tax exempt.
vi) Clientele effect theory
Advance by Richardson Petit in 1977
It stated that different groups of shareholders (clientele) have different
preferences for dividends depending on their level of income from other
sources.
Low income earners prefer high dividends to meet their daily consumption
while high income earners prefer low dividends to avoid payment of more
tax. Therefore, when a firm sets a dividend policy, therell be shifting of
investors into and out of the firm until an equilibrium is achieved. Low,
income shareholders will shift to firms paying high dividends and high
income shareholders to firms paying low dividends.
At
equilibrium,
dividend
policy
will
be
consistent
with
clientele
of
This is because they know the firm will be exposed to external parties
through external borrowing.
2.
3.
Stock repurchase
4.
NB:
Dr.
Cr.
A firm can also make a script issue where bonus shares are directly
158
ABC Company has 1000 ordinary shares of Sh.20 par value and a split of 1:4
i.e one stock is split into 4. The par value is divided by 4.
1000 stocks x 4 = 4000 shares
par value = 40 = Sh.5
5
Ordinary share capital = 4000 x 5 = Shs.20,000
A reverse split is the opposite of stock split and involves consolidation of
shares into bigger units thereby increasing the par value of the shares. It is
meant to attract high income clientele shareholders. E.g incase of 20,000
shares @ Shs.20 par, they can be consolidated into 10,000 shares of Shs.40
par. I.e. (20,000 x ) = 10,000 and Sh.20 = x 2 = 40/=
3. Stock Repurchase
The company can also buy back some of its outstanding shares instead of
paying cash dividends.
This is true in
mature firms to continue with investment plan even when E (K) is lower than
cost of capital.
3. Enhanced dividends and E.P.S.
Following a stock repurchase, the number of shares issued would decrease
and therefore in normal circumstances both D.P.S. and E.P.S. would increase
in future.
earnings having less and/or market signal effect that shares are under value.
5. Capital structure
A companys managers may use a share buy back or requirements, as a
means of correcting what they perceive to be an unbalanced capital
structure.
If shares are repurchased from cash reserves, equity would be reduced and
gearing increased (assuming debt exists in the capital structure).
160
Factors
to
consider
in
paying
dividends
(factors
influencing
dividend)
1. Legal rules
a)
States that dividend may be paid from companys profit either past or
present.
b)
insolvent. Insolvent company is one where assets are less than liabilities.
Insolvent company is one where assets are less than liabilities. In such a
case all earnings and assets of company belong to debt holders and no
dividends is paid.
2. Profitability and liquidity
A companys capacity to pay dividend will be determined primarily by its
ability to generate adequate and stable profits and cash flow.
If the company has liquidity problem, it may be unable to pay cash dividend
and result to paying stock dividend.
3. Taxation position of shareholders
Dividend payment is influenced by tax regime of a country e.g in Kenya cash
dividend are taxable at source, while capital are tax exempt.
The effect of tax differential is to discourage shareholders from wanting high
dividends. (This is explained by tax differential theory).
4. Investment opportunity
162
163
9. Shareholders expectation
Shareholder clientele that have become accustomed to receiving stable and
increasing div. Will expect a similar pattern to continue in the future.
Any sudden reduction or reversal of such a policy is likely to dissatisfy the
shareholders and may result in a fail in share prices.
10. Access to capital markets
Large, well established firms have access to capital markets hence can get
funds easily
They pay high dividends thus, unlike small firms which pay low dividends
(high retention) due to limited borrowing capacity.
11. Contractual obligations on debt covenants
They limit the flexibility and amount of dividends to pay e.g. no payment of
dividends from retained earnings.
Dividend ratios
1.
DPS
MPS
Dividend cover
DPS
DPS
164
Shows the proportion of Earnings which was paid out as dividends and how
much was retained.
165
By coming to the
The basic
elements of the financial plan are the cash budget and the projected income
statement and the balance sheet. The building blocks for these three are
myriad detailed operating budgets (including personnel budget, production
budget, purchasing budget) representing time-phased schedule of the
expenditures, people, material and activities required to accomplish the
objectives set forth in the overall financial plan. Without co-ordination such
meshing could be a daunting task.
Control
Management control systems are based on comparisons of actual data
versus plans. By comparing actual versus plan data at frequent intervals,
deviations can be detected as events unfold, and timely corrective action
can
In sum, cash
167
range plans.
Short range financial planning: covers time periods of one year or
less. They focus on day to day activities and provide a concrete
base
for
evaluating
progress
towards
the
achievement
of
168
2.
3.
4.
Figure 11.1
Short term financial planning process
169
Current
period
balance
sheet
Sales
projection
Production
plans
Pro-forma
income
statement
Pro-forma
balance
sheet
Cash
budget
Other
supportive
budgets
170
The beginning step in financial planning is goal setting. If the goals set are
unrealistic either they are unattainable or too low. This will hinder effective
financial planning.
(c) Resistance to Change
By its very nature, financial planning involves change. Fear of the unknown,
preferences for status quo and economic insecurity causes organizational
members including managers to resist change and as such resist financial
planning that might cause such change.
(d) Time and Expense
Lack of time or financial resources can limit financial planning. Financial
planning takes time and the managers face many pressures and these
pressures may cause them to resist financial planning.
(e) Other Constraints
Various situational constraints such as labour contracts, government
regulations, scarce resources, natural factors and disasters may all affect
financial planning.
Avoiding the Barriers
Certain guidelines if followed by managers can help them deal with the
roadblocks to financial planning. These include:
(a) Financial planning should start at the top
Top managers should set the goals and strategies that lower level managers
will follow. Top management committed is crucial for any plan to actualise.
(b) Planners should recognize the limits
Managers must recognize that no financial planning system is perfect.
Financial planning has limits and cannot be done with absolute precision.
(c) Communication
Vertical communication within the organization hierarchy can facilitate
financial planning. People should be let to know what is expected of them at
all times.
171
(d) Participation
Managers who are involved in financial planning are more likely to know
what is going on and therefore be motivated to contribute.
(e) Integration
As much as possible the long term, intermediate and short range plans must
be properly integrated and the better they are integrated, the more effective
the organizations overall financial planning system.
(f) Contingency financial planning
Managers should develop alternative actions that a company might follow if
conditions change.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
NB: Managers should remove obstacles to financial planning and try and
establish a climate in which subordinates must plan. The following guidelines
could help managers to establish a climate conducive to financial planning
172
i.
ii.
iii.
iv.
v.
clearly
vi.
vii.
change
cash budgeting
(ii)
JANUARY
XXX
cash XXA
FEBRUARY
XXG
XXH
disbursements
173
XXB
cash XXC
XXI
XXD
balance
Ending cash balance
XXD
Less
minimum XXE
XXJ
XXK
balance
Required
XXL
total
financing
Excess cash balance
XXF
Lets now examine the two main components of the cash budget.
Cash Receipts
Cash receipts include all of a firms cash inflows during the period. The most
common sources of cash are cash sales, collections from debtors, other
operating receipts and capital receipts from sales of fixed assets, borrowings
and issue of shares. Depending on the credit terms offered to customers, and
their payment habits, a schedule for collections from debtors could be
necessary working for the preparation of the budget..
Cash Disbursement
The most common cash disbursements are cash purchases of stock,
payment to creditors, payment of expenses like rent, wages, and utilities,
purchase
of
fixed
assets,
interest
payments,
dividend
distributions,
repayment of loans and payment of taxes. Depreciation and other non cash
charges are not included in the cash budget.
Example
The actual sales and purchases for Sirikwa Importers Ltd. for September and
October 2005, along with its forecast sales and purchases for the period
November, 2005 through April, 2006, follows:174
MONTH
SALES
PURCHASES
September
Sh.000
210,000
Sh.000
120.000
(actual)
October
250,000
150.000
(actual)
November
December
January
February
March
April
170.000
160.000
140.000
180.000
200.000
250.000
140.000
100.000
80.000
110.000
100.000
90.0000
The firm makes 20% of all sales for cash and collects on 40% of its sales in
each of the 2 months following the sale. Other cash inflows are expected to
be Sh. 12 million in September and April, Sh. 15 million, in January and March
and Sh. 27 million in February. The firm pays cash for 10% of its purchases.
It pays for 50% of its purchases in the following month and for 40% of its
purchases 2 months later.
Wages and salaries amount to 20% of the preceding months sales. Rent of
Sh.20 million per month must be paid. Interest payments of Sh.10 million
are due in January and April. A principal payment of Sh.30 million is also
one in April.
175
(b)
If the firm were requesting a line of credit to cover needed financing for
the period November to April, how large would this line of credit have
to be? Explain.
Solution (a)
SIRIKWA IMPORTERS LTD
CASH BUDGET FOR NOVEMBER TO APRIL
Novemb
Decemb
Januar
Februar March
April
er
er
Sh
Sh 000
Sh 000
Sh 000
Sh
Sh 000
000
156,000
168,00
202,000
27,000
0
15,000
12,000
175,00 183,00
183,0
214,00
00
140,000
114,00
91,000
97,000
103,000
34,000
20,000
0
32,000
20,000
10,000
28,000
20,000
30,000
20,000
40,000
20,000
10,000
30,000
20,000
80,000
000
Cash
Receipts
Receipt from 218,000
sales
Other
200,000
160,00
0
15,000
cash
inflows
218,000
200,000
Cash
Disburseme
nts
Payment
for 137,000
purchases
Wages
50,000
Rent
20,000
Interest
Principal
Dividend
Taxes
Purchase of
20,000
25,000
Fixed assets
207,000
Net cash flow
11,000
219,000
196,00 139,00
153,0
303,00
(19,000)
0
0
(21,000 44,000
00
30,000
0
(89,000)
)
176
Add
22,000
33,000
14,000
(7,000)
37,000
67,000
balance
Ending cash
33,000
14,000
(7,000
37,000
67,00
(22,000
Less
15,000
15,000
)
15,000
15,000
0
15,000
)
15,000
1,000
22,000
beginning
minimum
balance
Required
37,000
total
financing
Excess cash 18,000
22,000
balance
(b)
52,00
0
The company should ask for a line of credit of Sh.37 million to cater for
the biggest cash requirement of Sh.37 million in the month of April,
2006.
WORKINGS
Collection
from
debtors
Cash
Novemb
Decemb
Januar
Februar March
April
er
er
Sh.00
Sh.00
Sh.000
Sh.000 Sh.00
Sh.000
32,000
0
28,000
36,000
40,000
50,000
68,000
64,000
56,000
72,000
80,000
100,000
68,000
64,000
56,000
72,000
sales 34,000
(20%)
First
month 100,000
after
sales
(40%)
Second
month
84,000
after
sales (40%)
177
218,000
Payment
200,000
160,00
156,00
168,00
202,00
to
creditors
Novemb
Decemb
Januar
Februar March
April
er
er
Sh.00
Sh.00
Sh.000
Sh.000 Sh.00
Sh.000
14,000
10,000
0
8,000
11,000
10,000
9,000
(10%)
One
month 75,000
70,000
50,000
40,000
55,000
50,000
60,000
56,000
40,000
32,000
44,000
140,000
114,00
91,000
97,000
103,00
Cash
purchase
after
purchase
(50%)
Two
months 48,000
after
purchase
(40%)
137,000
178
flow for each period. The amount of financing necessary during the
period can then be determined.
Exercise
The following information related to the proposed budget for K.K Ltd for the
months ending 31 December 1996.
Material
Production
Administrati
Sales
Purchas
Wage
Overheads
on
Overheads
Sh.
es
Sh.
s
Sh.
Sh. 000
Sh. 000
000
000
000
July
August
Septemb
72000
97000
86000
25000
31000
25500
10000
12100
10600
6000
6300
6000
5500
6700
7500
er
October
Novemb
88600
102500
30600
37000
25000
22000
6500
8000
8900
11000
er
Decemb
108700
38800
23000
18200
11500
Month
er
Additional Information
1. Depreciation expenses are expected to be 0.5%of sales.
2. Expected cash balance in hand on 1 July 1996 is Sh. 72,500,000
3. 50% of total sales are cash sales
4. Assets are to be acquired in the months of August and October at Shs.
8,000,000 and Shs. 25,000,000 respectively
179
5. An application has been made to the bank for the grant of a loan of Shs.
30,000,00 and it is hoped that it will be received in the month of
November
6. It is anticipated that a dividend of Shs. 35,000,000 will be paid in
December
7. Debtors are allowed one months credit
8. Sales commission at 3% on sales is paid to the salesmen each month
Required
A cash budget for the six months ending 31 December 1996.
benefits/advantages:
It ensures that sufficient cash is available when required.
It shows whether capital expenditure projects can be financed internally.
It indicates the cash needed for current operating activities.
180
Profit planning relies in accrual concepts to project the firms profit and
financial position.
account balances for revenues, expenses, assets and equities using a variety
of procedures as shown in Figure 11.1. Pro-forma statements represent the
goals and objectives of a firm for a planning period. They are a guide to
action and are used in controlling operations.
Figure 11.2
Development process of the pro-forma income statement
Sales Proforma
Production
plan
Production
income
statement
Figure 11.3
Development of a pro-forma balance sheet
181
Current
Balance
Sheet
Pro-forma
balance
sheet
Pro-forma
income
statement
analysis
Cash
budget
analysis
The
three
basic
inputs
necessary
for
preparing
pro-forma
financial
statements are:
1) Financial statement information for the proceeding year.
2) The sales forecast for the coming year
3) The assumption that financial relationships reflected in the firms
financial statements will remain unchanged in the coming year
Example
Loitokitok Manufacturing Company Limited (LMCL) makes retread tires which
it sells for Sh.1,550. Mr.Lopos is the majority owner and manages the
inventory and finances of the company. He has collected the following
information to help him project the financial needs and position of the
company for the first quarter of the year just started
.
182
1,700 tires
February
1,200 tires
March
1,400 tires
April
2,000 tires
May
2,500 tires
basis.
following month. The average tax rate is 40 per cent, and the companys
dividend pay-out ratio is 50 per cent. Dividends are paid at the end of each
quarter. Marketable securities are sold before funds are borrowed at the
beginning of the month, when a cash shortage is faced.
As of year just ended, LCMLs balance was as follows:
Sh.
5,878,000
8,000,000
13,878,000
Sh.
cent
Ordinary share capital
Retained earnings
Total liabilities and
936,000
4,000,000
5,042,000,
3,900,000
13,878,000
owners equity
Required
(a)
(b)
(c)
Solution
(c)
Loitokitok Manufacturing Company Limited
Pro-forma balance sheet
As at 31 March 2007
ASSETS
Current Assets
Cash
Sh. 250,000
Accounts receivable
3,100,000
Inventory
4,500,000
Total current assets
Fixed Assets
Plant and equipment
10,000,000
Less: Accumulated
2,000,000
depn
Total assets
LIABILITIES AND OWNERS EQUITY
Accounts payable
Notes payable
Lon-term debt: 9 per
Sh.
7,850,000
8,000,000
15,850,000
Sh.
cent
Ordinary share capital
Retained earnings
Total liabilities and
1,200,000
425,000
4,000,000
5,042,000,
4,378,200
15,045,200
owners equity
185
They will be
assumed to be unchanged.
(d)Retained earnings will rise so long as the company is profitable and
the overall dividend payout ratio is less than 100%.
2.
approaches:
i) Prepare a pro-forma balance sheet, or
ii) Use an equation
Equation
As sales increase the external funds needed to support sales level will be
determined as follows:-
186
Additional
outside
financing
required
Funds
from
Additional
= assets
required
Re tained
profits
for
period
SL
= Spontaneous liabilities
S0
S1
- bc(1 + g)/g
(11.2)
Example
The balance sheet of Mars Ltd. as at 31 December 2004 is given below:
Assets
Liabiliti
es
Cash
Sh
5,000,000
b\debto 40,000,000
Accounts
Sh
40,000,000
payable
Accrued
10,000,000
187
r
Invento
ry
Fixed
25,000,000
expenses
Notes
15,000,000
50,000,000
payable
Share
10,000,000
--------------
capital
Retained
45,000,000
assets
earnings
120,000,0
120,000,0
00
00
Solution
(a)
5/200
Debtor
=
40/20
2.5%
Accounts
40/200 =
20%
20%
payable
Accrued
10/200 =
5%
188
s
Invento
0=
25/20
12.5
expenses
Total
ry
0=
spontane
25%
ous
Total
35.0
curren
t
assets
Fixed
50/20
assets
0=
25
Retained
0.06 x0.6
10,800,0
earnings
00
300millio
n=
Total
60%
assets
ii)
Mars Ltd
Pro-forma balance Sheet as at 31 December 2005
Assets
Liabilities
Sh.
Cash (2.5%
7,580,000
Accounts
x 300)
payable
Debtors
x 300)
Accrued
(20%
60,000,000
x
300)
Inventory
(12.5%
300)
Fixed
expenses
Sh
60,000,000
(20%
15,000,000
(5%
37,500,000
x 300)
Notes payable
15,000,000
75,000,000
Share capital
10,000,000
189
assets
(25%
300)
Retained (45 + 55,800,000
10.8)
155,800,0
--------------
External
00
24,200,00
financing
required
(Balancing)
b)
180,000,0
180,000,0
00
00
Equation
External Financing Required (EFR)
= A/S0*(S1 S0) - SL/S0*(S1 S0) - bcs1
= 120/200*(300 200) - 50/200*(300 200) - 0.6 x 0.06 x 300
= 0.6 x 100 - 0.25 x 100 - 10,800,000
= Sh.24,200,000
190
Fixed Cost. Total fixed costs remain constant as volume varies in the
relevant range of production. Fixed cost per unit decreases as the cost
is spread over an increasing number of units. Examples include: Fire
insurance, depreciation, facility rent, and property taxes.
Variable Cost. Variable cost per unit remains constant no matter how
many units are made in the relevant range of production. Total variable
cost increases as the number of units increases. Examples include:
Production material and labor. If no units are made, neither cost is
necessary
or
incurred.
However,
each
unit
produced
requires
The relationship holds only within the relevant range. The relevant range is
a band of activity within which a given cost behaviour is defined.
The behaviour of total cost and total revenue has reliably been determined
and is lineal within the relevant range.
192
All costs can be divided into fixed and variable such that mixed costs are
decomposed into their fixed and their variable components.
Efficiency and productivity remain the same so that we therefore ignore the
learning curve effect.
V = Vu (Q)
Where:
VU = Variable cost per unit
Q = Quantity (volume) produced
Substituting this variable cost information into the basic total cost equation,
we have the equation used in cost-volume analysis:
C = F + VU (Q)
Illustration 2.1
If you know that fixed costs are Sh.500, variable cost per unit is Sh.10, and
the volume produced is 1,000 units, you can calculate the total cost of
production.
C = F + Vu (Q)
= 500 + 10 (1000)
= Sh.10500
Given total cost and volume for two different levels of production, and using
the straight-line assumption, you can calculate variable cost per unit.
Remember that:
Variable cost per unit does NOT change in the relevant range of
production.
As a result, we can calculate variable cost per unit (V U) using the following
equation:
VU = Change in Total Cost
Change in Volume
194
= C2 C1
Q2 Q1
Where:
C1 = Total cost for Quantity 1
C2 = Total cost for Quantity 2
Q1 = Quantity 1
Q2 = Quantity 2
Illustration
You are analyzing an offeror's cost proposal. As part of the proposal the
offeror shows that a supplier offered 5,000 units of a key part for Sh.60,000.
The same quote offered 4,000 units for Sh.50,000. What is the apparent
variable cost per unit?
Vu = C2 C1
Q2 Q1
= 60000 - 50000
5000 4000
= Sh. 10
If you know total cost and variable cost per unit for any quantity, you can
calculate fixed cost using the basic total cost equation.
GRAPHIC ANALYSIS
Introduction to Graphic Analysis
When you only have two data points, you must generally assume a linear
relationship. When you get more data, you can examine the data to
determine if there is truly a linear relationship.
You should always graph the data before performing an algebraic analysis.
195
Graphic analysis is the best way of developing an overall view of costvolume relationship.
In this section of text, all data points will fall on a straight line. All that you
have to do to fit a straight line is connect the data points. Most analysts use
regression analysis to fit a straight line when all points do not fall on the line.
Step 4. Estimate the cost for a given volume.
Draw an imaginary vertical line from the given volume to the point where it
intersects the straight line that you fit to the data points. Then move
horizontally until you intersect the vertical axis. That point is the graphic
estimate of the cost for the given volume of the item.
Example of Graphic Analysis. The four steps of cost-volume-profit analysis
can be used to graph and analyze any cost-volume relationship. Assume that
you have been asked to estimate the cost of 400 units given the following
data:
Units
Cost
200
$100,000
500
$175,000
600
Solution
$200,000
197
198
(in units)
= F
S- Vu
Illustration
Assume that you are planning to sell badges at the forthcoming Nairobi
Show at Sh.9 each. The badges cost Sh.5 to produce and you incur Sh.2000
to rent a booth in the Show ground.
Required:
a) Compute the breakeven point
b) Compute the margin of safety
c) Compute the number of units that must be sold to earn a before tax profit
of 20%
d) Compute the number of units that must be sold to earn an after tax profit of
Sh.1640, assuming that the tax rate is 30%.
Solution
a) Break even point
BEP units = 2000/(9-5) = 500 units
BEP Sh. = 500 x 9 = 4500/b) Margin of safety
199
The margin of safety is the amount by which actual output or sales may fall
short of the budget without the company incurring losses. It is a measure of
the risk that the company might make a loss if it fails to achieve the target.
A high margin of safety means high profit expectation even if the budget is
not achieved. Margin of safety (MOS) can be computed as follows:
MOS = Expected sales - Break even sales
Expected sales
=
600-500
= 16.7%
600
c) Target before tax profit (Y)
Y = Z__
It
Therefore
X = F + z/1-t
S Vu
=
2000 + 1640
1-0.3
9-5
X = 1085.71
Approximately 1086 units.
C-V-P Analysis Multiple Products
The simple product CVP analysis can be extended to handle the more realistic
situations where the firm produces more than one product. The objective in such
a case is to produce a mix that maximises total contribution.
Total BEP
units
Average CM=
(S
t 1
Vt ) t
BEP
tsh.
= BEPt(units) xSt
Illustration
Assume that ABC Ltd produces two products, product A and B and the following
budget has been prepared.
Sales in units
Sales @5/-, 10/Variable cost @ 4/-, 3/Contribution @ 1/- 7/Total fixed cost
Profit
A
120,000
Sh.
B
40,000
Sh.
Total
160,000
Sh.
600,000
480,000
120,000
400,000
120,000
280,000
100,000
600,000
400,000
300,000
100,000
Required:
a) Compute the break-even point in total and for each of the products.
b) The company proposes to change the sales mix in units to 1:1 for products A
and B.
Advice the Co. on whether this change is desirable.
Solution
A
Sales mix
(units)
0.75
0.25
Sales mix
(Shs)
0.60
0.40
Average CM=
(S
t 1
Vt ) t
= 2.5
Total BEP
units
300000
Average CM
2.5
= 120,000 units
BEP (units)
120000 x 0.75 = 90,000
120000 x 0.25 = 30,000
120,000
A
B
BEP(sh)
(90000x5) = 450,000
(30000 x 10)
= 300,000
750,000
The above question can be solved by computing the BEP Sh first and the using the
Sales Mix in Shs.
Total BEP
Sh.
C/S ratio
= 400,000 = 0.4
1000,000
Total BEP(sh)
= 300000 =
750,000
0.4
Sh.
Units
750000 x 0.6
450000
450000/5 = 90000
750000 x 0.4
300000
300000/10= 30000
750000
b) Changing sales mix in units to 1:1 ratio
203
120000
Sales in units
80000
Total
80000
sh
160000
sh
sh
400000
800000
1200000
320000
240000
560000
Contribution
80,000
560,000
640,000
300,000
Net Profit
340,000
BEP
units
sh.
A (0.5 x 75000)
37500
187,500
B (0.5 x 75000)
37500
375,000
75000
562,500
For manager of product line A, the change is good because he now breaks even at
sh.187500 than on sh.450000. But for manager of product B, the change is not
good because BEP has risen from sh.300000 to sh.375000.
A major limitation of the basic C.V.P analysis is the assumption that the unit
variable cost, selling price and the fixed costs are constant and can be predicted
with certainty.
Sensitivity analysis
Simulation analysis
Margin of safety
price
Unit
205
variable
Sh.10
Sales demand
Condition
Unit
Worst possible
45000
Most likely 50000
Best possible55000
cost
Condition
Prob.
0.3
0.6
0.1
Cost
Best possible3.5
Most likely 4.0
Worst possible
5.5
Sh.
0.30
0.55
0.15
b.
Compute the prob. that the company will fail to break even
c.
Solution
a)
E(Demand) = (45000 x 0.3) + (50000 x 0.6) + (55000 x 0.1) = 49000
E(variable cost) = (3.5 x 0.3) x (4 x 0.55) + (55 x 0.15) = Sh.4.075
E(Profit) = (10-4.075) 49000 240000 = Sh.50325
This can be worked out differently as shown below:
Demand
Prob.
D
Unit VC
Prob.
Contr
(FxG)
Profit
Joint weighted
Prob.
45000
Profit
0.3
3.5
0.30 292500
4725
206
52500
0.09
50000
4.0
0.55 270000
5.5
0.15 202500
0.6
3.5
0.3
325000
30000
0.165 4950
0.18
15300
55000
4.0
0.55 300000
60000
0.33 19800
5.5
0.15 225000
(15000)
0.09 (1350)
0.1
3.5
0.3
357500
117500
0.33
3525
4.0
0.55 330000
90000
5.5
0.15 247500
7500
Expected profit
b)
0.055 4950
0.015 112.5
50325
c)
Worked example
Thunder manufacturing company produces a toxic product, coros that must
be sold in the month produced or else discarded. Thunder can manufacture
coros itself at a variable cost of Sh40 per unit or they can purchase it from
an outside supplier at a cost of Sh70 per unit. Thunder can sell coros at
Sh80 per unit. Production levels must be set at the start of the period and
cannot be changed during the period. The production process is such that at
least 9,000 units must be produced during the period. Thunder management
207
Probability
(units)
4,000
0.4
7,000
0.5
11,000
0.1
Required:
a) Expected demand
b) Expected profit from purchasing coros from an outside supplier and
selling it
c) Expected profit from manufacturing and selling
d) Standard deviation of profits from purchasing and selling.
e) Standard deviation of profits from manufacturing and selling.
f) Coefficient of variation for each alternative
Solution
a) Expected demand is computed as follows:
Demand (units)
Probability Expected
demand(units)
4000
0.4
1600
7000
0.5
3500
11,000
0.1
1100
Expected demand
6200
b) The expected profit from purchasing and selling would be equal to the
208
Units
produced in excess of 9,000 could carry the variable cost of Sh40 each.
The expected profit from manufacturing is:
Demand (units) Probability Manufacturing costProfit
Expected profit
(Shs)
(Shs)
4000
0.4
360,000(40,000)(16,000)
7000
0.5
360,000200,000100,000
11,000
440,000
0.1
440,000 44,000
128,000
(I ) P (million)
(4,000
6200)
Sh10
6200)
Sh10
193.6
(7,000
32.0
(11,000
6200)Sh10
230.4
456.0
209
Standard
456m
e)
deviation
= Sh21,354
(I )P (million)
-40,000
128,000
128,000
11,289.6
200,000
2,592.0
440,000
128,000
9,734.4
Total 23,616.0
Sh 21,354 = 0.344
Sh 62,000
210
assets.
b)
c)
d)
maximize average net profit, with the amount invested treated as its
equivalent annual cost. The management of working capital boils down to
balancing the risks and benefits of holding excessive, to those of holding too
little, working capital.
(3)
Turn-over periods.
Symptoms of over-trading
Accounting indicators of overtrading include:
(1)Rapid increases in turn-over ratios (over-heating)
(2)Stock
turnover
and
debtors
turnover
might
slow
down
with
expected life of assets with the expected life of the source of funds raised to
finance assets.
The firm, therefore, uses long term funds to finance permanent assets and
short-term funds to finance temporary assets.
Permanent assets refer to fixed assets and permanent current assets. This
approach can be shown by the following diagram.
b) Conservative Approach
An exact matching of asset life with the life of the funds used to finance the
asset may not be possible. A firm that follows the conservative approach
depends more on long-term funds for financing needs. The firm, therefore,
finances its permanent assets and a part of its temporary assets with longterm funds. This approach is illustrated by the following diagram.
Risk-Return trade-off of the three approaches:
It should be noted that short-term funds are cheaper than long-term funds.
(Some sources of short-term funds such as accruals are cost-free). However,
short-term funds must be repaid within the year and therefore they are
214
highly risky. With this in mind, we can consider the risk-return trade off of
the three approaches.
The conservative approach is a low return-low risk approach. This is because
the approach uses more of long-term funds which are now more expensive
than short-term funds. These funds however, are not to be repaid within the
year and are therefore less risky.
The aggressive approach on the other hand is a highly risky approach.
However it is also a high return approach the reason being that it relies more
on short-term funds that are less costly but riskier.
The matching approach is in between because it matches the life of the
asset and the life of the funds financing the assets.
Determinants Of Working Capital Needs
There are several factors which determine the firms working capital needs.
These factors are comprehensively covered by A Textbook of Business
Finance by Manasseh (Pages 403 406). They however include:
a)
b)
c)
Business fluctuations
d)
Production policy
e)
f)
Availability of credit
g)
215
216
Cash refers to cash in hand and cash on demand deposits (or current
accounts).
accumulated more cash than needed, it often puts the excess cash into an
interest-earning instrument. The firm can invest the excess cash in any (or a
combination) of the following marketable securities.
a)
b)
securities
c)
d)
e)
Repurchase agreements
f)
g)
Eurocurrencies etc.
requires payment within thirty days of a purchase while the firm currently
requires its customers to pay within sixty days of a sale. However, the firm
on average takes 35 days to pay its accounts payable and the average
217
Receivable collection
Period (70 days)
Payable
deferral
Purchase
of raw
Payment for
the raw
materials
Sale of
Finished
70
Collection
of
Cycle
period
period
period
85 + 70 35 = 120 days
360
360
120
3 times
Note also that cash conversion cycle can be given by the following formulae:
NB:
inventory receivable
s
Payables
Accruals
costofsale
s
sales
Cashoperat
ingexpense
s
360
219
The Cash Budget shows the firms projected cash inflows and outflows over
some specified period.
earlier courses. The student should however revise the cash budget.
b) Baumols Model
The Baumols model is an application of the EOQ inventory model to cash
management. Its assumptions are:
1. The firm uses cash at a steady predictable rate
2. The cash outflows from operations also occurs at a steady rate
3. The cash net outflows also occur at a steady rate.
Under these assumptions the following model can be stated:
C* 2bT
i
Where:
TC 1 Ci T b
2
C
Illustration
220
ABC Ltd. makes cash payments of Shs.10,000 per week. The interest rate on
marketable securities is 12% and every time the company sells marketable
securities, it incurs a cost of Shs.20.
Required
a)
b)
Determine the total cost of maintaining the cash balance per year.
d)
Solution
a)
C*
2bT
i
Where:
b = Shs.20
T = 52 x 20,000 = Shs.520,000
i = 12%
C*
2 x 20 x 520,000
Sh.13,166
0.12
b)
T
C*
221
520,000
13,166
c)
TC
39.5
40 times
1
T
Ci b
2
C
2
13,166
13,166
2
Shs.6,583
c) Miller-Orr Model
Unlike the Baumols Model, Miller-Orr Model is a stochastic (probabilistic)
model which makes the more realistic assumption of uncertainty in cash
flows.
Merton Miller and Daniel Orr assumed that the distribution of daily net cash
flows is approximately normal.
2
Z 3B
4
i
3Z - 2L
Where:
4Z L
3
H = Upper Limit
L = Lower Limit
b = Fixed transaction costs
i = Opportunity cost on daily basis
= variance of net daily cash flows
223
Illustration
XYZs management has set the minimum cash balance to be equal to
Sh.10,000.
Solution
a)
3b
4i
1/ 3
224
c)
3x 20 x ( 2,500)
10,000
9%
4x
360
b)
3Z 2L
3 x 17,211 2(10,000)
Shs.31,633
d)
The spread
4Z L
3
4 x17,211 10,000
3
HL
31,633 10,000
Shs.21,633
Note: If the cash balance rises to 31,633, the firm should invest Shs.14,422
(31,633 17,211) in marketable securities and if the balance falls to
Shs.10,000, the firm should sell Shs.7,211(17,211 10,000) of marketable
securities.
Other Methods
Other methods used to set the target cash balance are The Stone Model and
Monte Carlo simulation. However, these models are beyond the scope of this
manual.
225
ii)
iii)
This
a)
a)
Concentration Banking
b)
Lock-box system.
Concentration Banking
Firms with regional sales outlets can designate certain of these as
regional collection centre. Customers within these areas are required
to remit their payments to these sales offices, which deposit these
receipts in local banks. Funds in the local bank account in excess of a
specified limit are then transferred (by wire) to the firms major or
concentration bank.
226
Lock-box system.
In a lock-box system, the customer sends the payments to a post office
box. The post office box is emptied by the firms bank at least once or
twice each business day.
deposits the cheques in the firms account and sends a deposit slip
indicating the payment received to the firm. This system reduces the
customers mailing time and the time it takes to process the cheques
received.
MANAGEMENT OF INVENTORIES
Manufacturing firms have three major types of inventories:
1. Raw materials
2. Work-in-progress
3. Finished goods inventory
The firm must determine the optimal level of inventory to be held so as to
minimize the inventory relevant cost.
227
2DCo
Cn
Where:
TC = QCn + Q C o
Where:
228
Under this model, the firm is assumed to place an order of Q quantity and
use this quantity until it reaches the reorder level (the level at which an order
should be placed). The reorder level is given by the following formulae:
D
L
360
Where:
EOQ ASSUMPTIONS
The basic EOQ model makes the following assumptions:
i)
ii)
iii)
iv)
v)
Illustration
ABC Ltd requires 2,000 units of a component in its manufacturing process in
the coming year which costs Sh.50 each. The items are available locally and
the leadtime in one week. Each order costs Sh.50 to prepare and process
while the holding cost is Shs.15 per unit per year for storage plus 10%
opportunity cost of capital.
Required
229
a)
b)
c)
d)
Suggested Solution:
a)
2DCo
Cn
Where:
D = 2,000 units
Co = Sh.50
Cn = Sh.15 + 10% x 50 = Sh.20
L = 7 days
b)
c)
2 x 2,000 x 50
100units
20
DL
360
2,000 x 7
360
39 units
No. of orders
D
Q
2,000
100
230
d)
TC
20 orders
D
QCn + Q C o
(100)(20) +
1,000 + 1,000
Sh.2,000
2,000
(50)
100
Under the basic EOQ Model the inventory is allowed to fall to zero just before
another order is received.
EXISTENCE OF QUANTITY DISCOUNTS
Frequently, the firm is able to take advantage of quantity discounts. Because
these discounts affect the price per unit, they also influence the Economic
Order Quantity.
If discounts exists, then usually the minimum amount at which discount is
given may be greater than the Economic Order Quantity.
If the minimum
discount quantity is ordered, then the total holding cost will increase because
the average inventory held increases while the total ordering costs will
decrease since the number of orders decrease. However, the total purchases
cost will decrease.
Illustration
Consider illustration one and assume that a quantity discount of 5% is given
if a minimum of 200 units is ordered.
231
Required
Determine whether the discount should be taken and the quantity to be
ordered.
Suggested Solution
We need to consider the saving in purchase costs; savings in ordering costs
and increase in holding costs.
Savings in purchase price:
New purchase price
50 47.50
Sh.2.50
2,000
Total savings
5,000
500
Total savings
5,500
Qd
2DCo
Cn
Qd
2 x 2,000 x 50
19.75
975
4,525
To
= 100.6 units
Decision rule:
If Qd < minimum discount quantity, then order the minimum discount
quantity.
If Qd < minimum discount quantity, then order Qd.
UNCERTAINTY AND SAFETY STOCKS
Usually demand requirements may not be certain and therefore the firm
holds safety stock to safeguard stock out cases.
However,
carrying a safety stock has costs (it increases the average stock).
Illustration
Consider illustration one and assume that management desires to hold a
minimum stock of 10 units (this stock is in hand at the beginning of the
year).
Required
a)
b)
Suggested solution
a)
DL
S
360
Where:
=
b)
2,000
x 7 10
360
49 units
Q + S
(Q + S)Cn + D/QCo
[(100) + 10]20 +
1,200 + 1,000
Shs.2,200
2,000
(50)
100
b)
235
Accounts receivables
Length
of
collection period
The average collection period depends on:
a)
accounts
b)
Credit period which is the length of time for which credit is granted
c)
d)
a) CREDIT STANDARDS
A firm may follow a lenient or a stringent credit policy. The firm following a
lenient credit policy tends to sell on credit to customers on a very liberal
terms and credit is granted for a longer period.
A firm following a stringent credit policy on the other hand, sell on credit on a
highly selective basis only to those customers who have proven credit
worthiness and who are financially strong.
A lenient credit policy will result in increased sales and therefore increased
contribution margin. However, these will also result in increased costs such
as:
1. Increased bad debt losses
2. Opportunity cost of tied up capital in receivables
3. Increased cost of carrying out credit analysis
4. Increased collection cost
5. Increased discount costs to encourage early payments
236
The goal of the firms credit policy is to maximise the value of the firm. To
achieve this goal, the evaluation of investment in receivables should involve
the following steps:
1. Estimation of incremental operating profits from increased sales
2. Estimation of incremental investment in account receivable
3. Estimation of incremental costs
4. Comparison of incremental profits with incremental costs
b) CREDIT TERMS
Credit terms involve both the length of the credit period and the discount
given. The terms 2/10, n/30 means that a 2% discount is given if the bill is
paid before the tenth day after the date of invoice otherwise the net amount
should be paid by the 30th day.
In considering the credit terms to offer the firm should look at the profitability
caused by longer credit and discount period or a higher rate of discount
against increased cost.
c) DISCOUNTS
Varying the discount involves an attempt to speed up the payment of
receivables. It can also result in reduced bad debt losses.
d) COLLECTION POLICY
The firms collection policy may also affect our analysis. The higher the cost
of collecting account receivables the lower the bad debt losses.
The firm
must therefore consider whether the reduction in bad debt is more than the
increase in collection costs.
237
credit terms is net 30 but the average debtors collection period is 45 days.
Current annual credit sales amounts to Sh.6,000,000.
extend credit period net 60. Sales are expected to increase by 20%. Bad
debts will increase from 2% to 2.5% of annual credit sales. Credit analysis
and debt collection costs will increase by Sh.4,000 p.a.
The return on
Sh.6,000,000 x 1.20
Contribution margin
Sh.6,000,000
Sh.7,200,000
Sh.100 Sh.75
Sh.25
x100
Sh.100
Sh.25
=
25%
25% x 7,200,000
25% x 6,000,000
1,800
=
1,500 =
300
(84)
2.5% x 7,200,000 =
2% x 6,000,000
180
=
120
(60)
Debtors
New debtors
Current debtors
Cr.period
360days
60
x 7,200,000
360
45
x 6,000,000
360
1,200
750
450
12% x 450
(54)
102
a)
b)
c)
Banks
d)
Other firms
e)
239
Where:
a1(X1) + a2(X2)
X1 is quick ratio
Szz dx Sxzdz
Sxx Sxx Sxz
a2
Szz dx Sxzdz
Szz Sxx Sxz
Where:
QUESTION
Wema Ltd has estimated that the standard deviation of its daily net cash
flows is Sh.2,500. The firm pays Sh.50 in transaction costs to transfer funds
into and out of this money market. The rate of interest in the money market
is 7.465% p.a.
balances.
Required
a)
b)
c)
d)
242
advantage
within
the
marketplace.
For
example,
large
industries with poor prospects for growth will seek to diversify their businesses
through mergers and acquisitions.
Reasons For Mergers
a. Synergy
Every merger has its own unique reasons why the combining of two companies
is a good business decision. The underlying principle behind mergers and
acquisitions ( M & A ) is simple: 2 + 2 = 5. The value of Company A is Sh. 2
billion and the value of Company B is Sh. 2 billion, but when we merge the two
companies together, we have a total value of Sh. 5 billion. The joining or
merging of the two companies creates additional value which we call "synergy"
value.
Synergy value can take three forms:
1. Revenues: By combining the two companies, we will realize higher revenues
than if the two companies operate separately.
2. Expenses: By combining the two companies, we will realize lower expenses
than if the two companies operate separately.
3. Cost of Capital: By combining the two companies, we will experience a
lower overall cost of capital.
For the most part, the biggest source of synergy value is lower expenses. Many
mergers are driven by the need to cut costs. Cost savings often come from the
elimination of redundant services, such as Human Resources, Accounting,
Information Technology, etc. However, the best mergers seem to have strategic
reasons for the business combination. These strategic reasons include:
Positioning - Taking advantage of future opportunities that can be exploited
when the two companies are combined. For example, a telecommunications
company might improve its position for the future if it were to own a broad band
244
e. Undervalued Target
The Target Company may be undervalued and thus, it represents a good
investment. Some mergers are executed for "financial" reasons and not
strategic reasons. A compay may, for example, acquire poor performing
companies and replace the management team in the hope of increasing
depressed values.
The Overall Merger Process
The Merger & Acquisition Process can be broken down into five phases:
Phase 1 - Pre Acquisition Review:
The first step is to assess your own situation and determine if a merger and
acquisition strategy should be implemented. If a company expects difficulty in
the future when it comes to maintaining core competencies, market share,
return on capital, or other key performance drivers, then a merger and
acquisition (M & A) program may be necessary.
It is also useful to ascertain if the company is undervalued. If a company fails to
protect its valuation, it may find itself the target of a merger. Therefore, the preacquisition phase will often include a valuation of the company - Are we
undervalued? Would an M & A Program improve our valuations?
The primary focus within the Pre Acquisition Review is to determine if growth
targets (such as 10% market growth over the next 3 years) can be achieved
internally. If not, an M & A Team should be formed to establish a set of criteria
whereby the company can grow through acquisition. A complete rough plan
should be developed on how growth will occur through M & A, including
responsibilities within the company, how information will be gathered, etc.
Phase 2 - Search & Screen Targets:
246
The second phase within the M & A Process is to search for possible takeover
candidates. Target companies must fulfill a set of criteria so that the Target
Company is a good strategic fit with the acquiring company. For example, the
target's drivers of performance should compliment the acquiring company.
Compatibility and fit should be assessed across a range of criteria - relative size,
type of business, capital structure, organizational strengths, core competencies,
market channels, etc.
It is worth noting that the search and screening process is performed in-house
by the Acquiring Company. Reliance on outside investment firms is kept to a
minimum since the preliminary stages of M & A must be highly guarded and
independent.
Phase 3 - Investigate & Value the Target:
The third phase of M & A is to perform a more detail analysis of the target
company. You want to confirm that the Target Company is truly a good fit with
the acquiring company. This will require a more thorough review of operations,
strategies, financials, and other aspects of the Target Company. This detail
review is called "due diligence." Specifically, Phase I Due Diligence is initiated
once a target company has been selected. The main objective is to identify
various synergy values that can be realized through an M & A of the Target
Company. Investment Bankers now enter into the M & A process to assist with
this evaluation.
A key part of due diligence is the valuation of the target company. In the
preliminary phases of M & A, we will calculate a total value for the combined
company. We have already calculated a value for our company (acquiring
company). We now want to calculate a value for the target as well as all other
costs associated with the M & A.
Phase 4 - Acquire through Negotiation:
247
Now that we have selected our target company, it's time to start the process of
negotiating a M & A. We need to develop a negotiation plan based on several
key questions:
- How much resistance will we encounter from the Target Company?
- What are the benefits of the M & A for the Target Company?
- What will be our bidding strategy?
- How much do we offer in the first round of bidding?
The most common approach to acquiring another company is for both
companies to reach agreement concerning the M & A; i.e. a negotiated merger
will take place. This negotiated arrangement is sometimes called a "bear hug."
The negotiated merger or bear hug is the preferred approach to a M & A since
having both sides agree to the deal will go a long way to making the M & A
work. In cases where resistance is expected from the target, the acquiring firm
will acquire a partial interest in the target; sometimes referred to as a "toehold
position." This toehold position puts pressure on the target to negotiate without
sending the target into panic mode.
In cases where the target is expected to strongly fight a takeover attempt, the
acquiring company will make a tender offer directly to the shareholders of the
target, bypassing the target's management. Tender offers are characterized by
the following:
- The price offered is above the target's prevailing market price.
- The offer applies to a substantial, if not all, outstanding shares of stock.
- The offer is open for a limited period of time.
- The offer is made to the public shareholders of the target.
A few important points worth noting:
248
- Generally, tender offers are more expensive than negotiated M & A's due to
the resistance of target management and the fact that the target is now "in
play" and may attract other bidders.
- Partial offers as well as toehold positions are not as effective as a 100%
acquisition of "any and all" outstanding shares. When an acquiring firm makes
a 100% offer for the outstanding stock of the target, it is very difficult to turn
this type of offer down.
Another important element when two companies merge is Phase II Due
Diligence. As you may recall, Phase I Due Diligence started when we selected
our target company. Once we start the negotiation process with the target
company, a much more intense level of due diligence (Phase II) will begin. Both
companies, assuming we have a negotiated merger, will launch a very detailed
review to determine if the proposed merger will work. This requires a very detail
review of the target company - financials, operations, corporate culture,
strategic issues, etc.
Phase 5 - Post Merger Integration:
If all goes well, the two companies will announce an agreement to merge the
two companies. The deal is finalized in a formal merger and acquisition
agreement. This leads us to the fifth and final phase within the M & A Process,
the integration of the two companies.
Every company is different - differences in culture, differences in information
systems, differences in strategies, etc. As a result, the Post Merger Integration
Phase is the most difficult phase within the M & A Process. Now all of a sudden
we have to bring these two companies together and make the whole thing work.
This requires extensive planning and design throughout the entire organization.
The integration process can take place at three levels:
249
Full: All functional areas (operations, marketing, finance, human resources, etc.)
will be merged into one new company. The new company will use the "best
practices" between the two companies.
Moderate: Certain key functions or processes (such as production) will be
merged together. Strategic decisions will be centralized within one company,
but day to day operating decisions will remain autonomous.
Minimal: Only selected personnel will be merged together in order to reduce
redundancies. Both strategic and operating decisions will remain decentralized
and autonomous.
If post merger integration is successful, then we should generate synergy
values. However, before we embark on a formal merger and acquisition
program, perhaps we need to understand the realities of mergers and
acquisitions.
Reasons Behind Failed Mergers
Mergers and acquisitions are extremely difficult. Expected synergy values may
not be realized and therefore, the merger is considered a failure. Some of the
reasons behind failed mergers are:
Poor strategic fit - The two companies have strategies and objectives that are
too different and they conflict with one another.
Cultural and Social Differences - It has been said that most problems can be
traced to "people problems." If the two companies have wide differences in
cultures, then synergy values can be very elusive.
Incomplete and Inadequate Due Diligence - Due diligence is the
"watchdog" within the M & A Process. If you fail to let the watchdog do his job,
you are in for some serious problems within the M & A Process.
Poorly Managed Integration - The integration of two companies requires a
very high level of quality management. In the words of one CEO, "give me some
people who know the drill." Integration is often poorly managed with little
planning and design. As a result, implementation fails.
250
Paying too Much - In today's merger frenzy world, it is not unusual for the
acquiring company to pay a premium for the Target Company. Premiums are
paid based on expectations of synergies. However, if synergies are not realized,
then the premium paid to acquire the target is never recouped.
Overly Optimistic - If the acquiring company is too optimistic in its projections
about the Target Company, then bad decisions will be made within the M & A
Process. An overly optimistic forecast or conclusion about a critical issue can
lead to a failed merger.
We should also recognize some cold hard facts about mergers and acquisitions.
In the book The Complete Guide to Mergers and Acquisitions, the authors
Timothy J. Galpin and Mark Herndon point out the following:
- Synergies projected for M & A's are not achieved in 70% of cases.
- Just 23% of all M & A's will earn their cost of capital.
- In the first six months of a merger, productivity may fall by as much as 50%.
- The average financial performance of a newly merged company is graded as C
- by the respective Managers.
In acquired companies, 47% of the executives will leave the first year and 75%
will leave within the first three years of the merger.
Due Diligence
There is a common thread that runs throughout much of the M & A Process. It is
called Due Diligence. Due diligence is a very detailed and extensive evaluation
of the proposed merger. In
An over-riding question is - Will this merger work? In order to answer this
question, we must determine what kind of "fit" exists between the two
companies. This includes: Investment Fit - What financial resources will be
required, what level of risk fits with the new organization, etc.?
251
Strategic Fit - What management strengths are brought together through this
M & A? Both sides must bring something unique to the table to create synergies.
Marketing Fit - How will products and services compliment one another
between the two companies? How well do various components of marketing fit
together - promotion programs, brand names, distribution channels, customer
mix, etc?
Operating Fit - How well do the different business units and production
facilities fit together? How do operating elements fit together - labor force,
technologies, production capacities, etc.?
Management Fit - What expertise and talents do both companies bring to the
merger? How well do these elements fit together - leadership styles, strategic
thinking, ability to change, etc.?
Financial Fit - How well do financial elements fit together - sales, profitability,
return on capital, cash flow, etc.?
Due diligence is also very broad and deep, extending well beyond the functional
areas (finance, production, human resources, etc.). This is extremely important
since due diligence must expose all of the major risk associated with the
proposed merger. Some of the risk areas that need to be investigated are:
- Market - How large is the target's market? Is it growing? What are the major
threats? Can we improve it through a merger?
- Customer - Who are the customers? Does our business compliment the
target's customers? Can we furnish these customers new services or products?
- Competition - Who competes with the target company? What are the barriers
to competition? How will a merger change the competitive environment?
- Legal - What legal issues can we expect due to an M & A? What liabilities,
lawsuits, and other claims are outstanding against the Target Company?
Another reason why due diligence must be broad and deep is because
management is relying on the creation of synergy values. Much of Phase I Due
Diligence is focused on trying to identify and confirm the existence of synergies
252
between the two companies. Management must know if their expectation over
synergies is real or false and about how much synergy can we expect? The total
value assigned to the synergies gives management some idea of how much of a
premium they should pay above the valuation of the Target Company. In some
cases, the merger may be called off because due diligence has uncovered
substantially less synergies then what management expected.
MAKING DUE DILIGENCE WORK
Since due diligence is a very difficult undertaking, you will need to enlist your
best people, including outside experts, such as investment bankers, auditors,
valuation specialist, etc. Goals and objectives should be established, making
sure everyone understands what must be done. Everyone should have clearly
defined roles since there is a tight time frame for completing due diligence.
Communication channels should be updated continuously so that people can
update their work as new information becomes available; i.e. due diligence must
be an iterative process. Throughout due diligence, it will be necessary to provide
summary reports to senior level management.
Due diligence must be aggressive, collecting as much information as possible
about the target company. This may even require some undercover work, such
as sending out people with false identities to confirm critical issues. A lot of
information must be collected in order for due diligence to work. This
information includes:
Corporate Records: Articles of incorporation, by laws, minutes of meetings,
shareholder list, etc.
Financial Records: Financial statements for at least the past 5 years, legal
council letters, budgets, asset schedules, etc.
Tax Records: Federal, state, and local tax returns for at least the past 5 years,
working papers, schedules, correspondence, etc.Regulatory Records: Filings with
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the NSE, reports filed with various governmental agencies, licenses, permits,
decrees, etc.
Debt Records: Loan agreements, mortgages, lease contracts, etc.
Employment Records: Labor contracts, employee listing with salaries, pension
records, bonus plans, personnel policies, etc.
Property Records: Title insurance policies, legal descriptions, site evaluations,
appraisals, trademarks, etc.
Miscellaneous Agreements: Joint venture agreements, marketing contracts,
purchase contracts, agreements with Directors, agreements with consultants,
contract forms, etc.
Good due diligence is well structured and very pro-active; trying to anticipate
how customers, employees, suppliers, owners, and others will react once the
merger is announced. When one analyst was asked about the three most
important things in due diligence, his response was "detail, detail, and detail."
Due diligence must very in-depth if you expect to uncover the various issues
that must be addressed for making the merger work.
FINANCIAL TERMS OF EXCHANGE
When two companies are combined, a ratio of exchange occurs, denoting the
relative weighting of the firms. The ratio of exchange can be considered in
respect to earnings, market prices and the book values of the two companies
involved.
a.
Earnings
In evaluating possible acquisition, the acquiring firm must at least
consider the effect the merger will have on the earnings per share of the
surviving company. We can discuss this through an illustration:
Illustration (4.1)
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Present earnings
Company A
Company B
Shs 20,000,000
Shs 5,000,000
5,000,000
2,000,000
Shares
Earnings per share
Shs 4
Price/earning ratio
Price of shares
Shs 2.50
16
12
Sh 64
Sh 30
35/64
0.546875 shares
Earnings of A + Earnings of B
Total No. of shares
20,000,000 + 5,000,000
5,000,000 + 1,093,750
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25,000,000
6,093,750
Shs 4.10
Therefore the earnings for share of the combined firm is Shs 4.10.
There is therefore an immediate improvement in earnings per share for
Company A as a result of the merger.
However, Company B's former shareholders experience a reduction in
earnings per share. These EPS will be given by
0.546875 X 4.10
b.
Shs 2.50
Future Earnings
If the decision to acquire another company were based solely on the
initial impact on earnings per share, an initial dilution in earnings per
share would stop any company from merging with another.
However,
Market Value
The major emphasis in the bargaining process is on the ratio of exchange
of market price per share.
of exchange
company
Considering the previous example (example 4.1)
Market price ratio =
64 X 0.546875
1.167.
30
Therefore, Company B receive more than its market price per share. It is
common for the company being acquired to receive a little more than the
market price per share.
therefore benefit from the acquisition because their shares were originally
worth Shs 30 but they receive Shs 35.
Illustration (4.2)
The following information relates to Company X and Y.
Present earnings
Company X
Company Y
Shs 20,000,000
Shs 6,000,000
6,000,000,000
2,000,000
No. of shares
Earnings per share
Market price per share
Shs 3.33
Shs 3.00
Shs 60.00
Shs 30.00
18
10
Price/earning ratio
257
60 X 0.667
1.33
Combined Effect
Total earnings
Shs 26,000,000
No. of shares
7,333,333
Shs 3.55
Price/earning ratio
18
Shs 63.90
Note:
Both companies tend to benefit due to the merger. This can be seen by
the increased market price per share for both company. This is due to the
assumption that the price earnings ratio of the combined company will
remain 18. If this is the case, companies with high price/earning ratios
can be able to acquire companies with lower price/earnings ratio to
obtain an immediate increase in earnings per share (even if they pay a
premium for the share.)
d.
Book value
Book value per share is not a useful basis for valuation in most mergers.
However, it may be important if the purpose of an acquisition is to obtain
the liquidity of another company. The ratio of exchange of book value per
share of the two companies are calculated in the same manner as is the
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ratio for market values computed above. The application of this ratio in
bargaining is usually restricted to situations in which a company is
acquired for its liquidity and asset values rather than for its earning
power.
4.9 VALUING THE TARGET FIRM
To determine the value of the target firm, two key items are needed:
a.
set
of
proforma
financial
statements
which
develop
the
relates to ABC Ltd. for the next five years. The projected financial data
are for the post-merger period. The corporate tax rate is 40% for both
companies.
Amounts are in Shs `000'
Net sales
1994
1995
1996
1997
1998
1,050
1,260
1,510
1,740
1,910
259
Cost of sales
735
882
1,057
1,218
1,337
120
130
150
160
50
70
90
110
Interest expenses
40
Other information
a.
After the fifth year the cashflows available to XYZ from ABC is
expected to grow by 10% per annum in perpetuity.
b.
ABC will retain Shs 40,000 for internal expansion every year.
c.
REQUIRED:
i.
ii.
SOLUTION:
XYZ LTD
260
1995
1996
1997
1998
1,050
1,260
1,510
1,740
1,910
735
882
1,057
1,218
1,337
315
378
453
522
573
120
130
150
160
EBIT
215
258
323
372
413
40
50
70
90
110
175
208
253
282
303
Net sales
Less cost of sales
Less interest
EBT
Less tax 40%
70
83.2
101.2
112.8
121.2
105
124.8
151.8
169.2
181.8
40
40.0
40.0
40.0
40.0
65
84.8
91.8
129.2
Net income
65
84.8
.
91.8
141.75
1,949.75
129.2 2,091.55
141.8 (1 + 0.1)
Shs 1,949.75
0.18 - 0.10
ii.
Assuming the discount rate of 18%, the maximum price of ABC can be
determined by computing the PV of the projected cashflows.
Year
Cashflow
PVIF18%
PV
65
0.847
55.055
84.8
0.718
60.886
91.8
0.607
55.723
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129.2
0.516
2,091.55
0.437
66.667
914.24
1,152.57
2.
They
help
target
companies
develop
and
implement
defensive techniques
Target firms that do not want to be acquired generally enlist the help
of an investment banking firm, along with a law firm that specializes
in helping to block mergers. Defensive techniques include:
3.
4.
Anti-Takeover Defenses
Throughout this entire lesson we have focused our attention on making the
merger and acquisition process work. In this final part, we will do just the
opposite; we will look at ways of discouraging the merger and acquisition
process. If a company is concerned about being acquired by another company,
several anti-takeover defenses can be implemented. As a minimum, most
companies concerned about takeovers will closely monitor the trading of their
stock for large volume changes.
a. Poison pill
One of the most popular anti-takeover defenses is the poison pill. Poison pills
represent rights or options issued to shareholders and bondholders. These
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rights trade in conjunction with other securities and they usually have an
expiration date. When a merger occurs, the rights are detached from the
security and exercised, giving the holder an opportunity to buy more securities
at a deep discount. For example, stock rights are issued to shareholders, giving
them an opportunity to buy stock in the acquiring company at an extremely
low price. The rights cannot be exercised unless a tender offer of 20% or more
is made by another company. This type of issue is designed to reduce the
value of the Target Company. Flip-over rights provide for purchase of the
Acquiring Company while flip-in rights give the shareholder the right to acquire
more stock in the Target Company. Put options are used with bondholders,
allowing them to sell-off bonds in the event that an unfriendly takeover occurs.
By selling off the bonds, large principal payments come due and this lowers
the value of the Target Company.
b. Golden Parachutes
Another popular anti-takeover defense is the Golden Parachute. Golden
parachutes are large compensation payments to executive management,
payable if they depart unexpectedly. Lump sum payments are made upon
termination of employment. The amount of compensation is usually based on
annual compensation and years of service. Golden parachutes are narrowly
applied to only the most elite executives and thus, they are sometimes viewed
negatively by shareholders and others. In relation to other types of takeover
defenses, golden parachutes are not very effective.
c. Changes to the Corporate Charter
If management can obtain shareholder approval, several changes can be
made to the Corporate Charter for discouraging mergers. These changes
include:
Staggered Terms for Board Members: Only a few board members are
elected each year. When an acquiring firm gains control of the Target
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Company, important decisions are more difficult since the acquirer lacks
full board membership. A staggered board usually provides that one-third
are elected each year for a 3 year term. Since acquiring firms often gain
control directly from shareholders, staggered boards are not a major antitakeover defense.
Super-majority Requirement: Typically, simple majorities of shareholders
are required for various actions. However, the corporate charter can be
amended, requiring that a super-majority (such as 80%) is required for
approval of a merger. Usually an "escape clause" is added to the charter,
not requiring a super-majority for mergers that have been approved by
the Board of Directors. In cases where a partial tender offer has been
made, the super-majority requirement can discourage the merger.
Fair Pricing Provision: In the event that a partial tender offer is made, the
charter can require that minority shareholders receive a fair price for their
stock. Since many countries have adopted fair pricing laws, inclusion of a
fair pricing provision in the corporate charter may be a moot point.
However, in the case of a two-tiered offer where there is no fair pricing
law, the acquiring firm will be forced to pay a "blended" price for the
stock.
Dual Capitalization: Instead of having one class of equity stock, the
company has a dual equity structure. One class of stock, held by
management, will have much stronger voting rights than the other
publicly traded stock. Since management holds superior voting power,
management has increased control over the company.
d. Re-capitalization
One way for a company to avoid a merger is to make a major change in its
capital structure. For example, the company can issue large volumes of debt
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and initiate a self-offer or buy back of its own stock. If the company seeks to
buy-back all of its stock, it can go private through a leveraged buy out (LBO).
However, leveraged re-capitalization require stable earnings and cash flows
for servicing the high debt loads. And the company should not have plans for
major capital investments in the near future. Therefore, leveraged recaps
should stand on their own merits and offer additional values to shareholders.
Maintaining high debt levels can make it more difficult for the acquiring
company since a low debt level allows the acquiring company to borrow
easily against the assets of the Target Company.
Instead of issuing more debt, the Target Company can issue more stock. In
many cases, the Target Company will have a friendly investor known as a
"white squire" which seeks a quality investment and does not seek control of
the Target Company. Once the additional shares have been issued to the
white squire, it now takes more shares to obtain control over the Target
Company.
Finally, the Target Company can do things to boost valuations, such as stock
buy-backs and spinning off parts of the company. In some cases, the target
company may want to consider liquidation, selling-off assets and paying out
a liquidating dividend to shareholders. It is important to emphasize that all
restructuring should be directed at increasing shareholder value and not at
trying to stop a merger.
e. Other Anti Takeover Defenses
Finally, if an unfriendly takeover does occur, the company does have some
defenses to discourage the proposed merger:
1. Stand Still Agreement:
The acquiring company and the target company can reach agreement
whereby the acquiring company ceases to acquire stock in the target for a
specified period of time. This stand still period gives the Target Company
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time to explore its options. However, most stand still agreements will
require compensation to the acquiring firm since the acquirer is running
the risk of losing synergy values.
2. Green Mail: If the acquirer is an investor or group of investors, it might
be possible to buy back their stock at a special offering price. The two
parties hold private negotiations and settle for a price. However, this type
of targeted repurchase of stock runs contrary to fair and equal treatment
for all shareholders. Therefore, green mail is not a widely accepted antitakeover defense.
3. White Knight: If the target company wants to avoid a hostile merger,
one option is to seek out another company for a more suitable merger.
Usually, the Target Company will enlist the services of an investment
banker to locate a "white knight." The White Knight Company comes in
and rescues the Target Company from the hostile takeover attempt. In
order to stop the hostile merger, the White Knight will pay a price more
favorable than the price offered by the hostile bidder.
4. Litigation: One of the more common approaches to stopping a merger is
to legally challenge the merger. The Target Company will seek an
injunction to stop the takeover from proceeding. This gives the target
company time to mount a defense. For example, the Target Company will
routinely challenge the acquiring company as failing to give proper notice
of the merger and failing to disclose all relevant information to
shareholders.
5. Pac Man Defense: As a last resort, the target company can make a
tender offer to acquire the stock of the hostile bidder. This is a very
extreme type of anti-takeover defense and usually signals desperation.
One very important issue about anti-takeover defenses is valuations.
Many anti-takeover defenses (such as poison pills, golden parachutes,
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Consequently,
companies
with
anti-takeover
defenses
Such deals are called corporate alliances and they take many
268