financial management - lse

8/12/2019 Financial Management - LSE

1/60

Financial management

L. Fung

AC3059, 2790059

2012

Undergraduate study in

Economics, Management,

Finance and the Social Sciences

This is an extract from a subject guide for an undergraduate course offered as part of the

University of London International Programm es in Economics, M anagement, Finance and

the Social Sciences. M aterials for these programmes are developed by academics at the

London School of Economics and Political Science ( LSE) .

For more information, see: www.londoninternational.ac.uk


2/60

The 20 12 edi t ion of t his guide was prepared for th e Universi ty of London Internat ionalProgrammes by:

Dr L. Fung , Lecturer in A ccountin g an d Finance, Birkbeck, School of Bu siness, Econom ics andInformat ics

It is a revised edit ion o f previou s edit ions of the g uide p repared b y J. Dahya and R.E.V. Groves,and draws on the w ork of those authors.

This is one of a series of subject gu ides published by t he University. We regret that due t opressure of wo rk the author is unable to enter into any correspondence relat ing to, or arisingfrom, the guide. If you have any comments on this subject guide, favourable or unfavourable,please use the form at the back of this guide.

Universi ty of London Internat ional Programm esPublications OfficeStewart House32 Russell SquareLondon WC1B 5DNUnited Kingdom

www.londoninternat ional .ac.uk

Published by: University of London

Un iver sit y o f London 2 012

The University of London asserts copyright over all material in this subject guide except where

otherw ise indicated. Al l r ights reserved. No part of th is work may be reprodu ced in any form ,or by any means, wi thout permission in w ri t ing f rom the pub l isher.

We m ake every ef fort to contact copyright holders. I f you think w e have inadvertent ly usedyour copyright material, please let us know.


3/60

Contents

i

Contents

Introduction ............................................................................................................ 1

Aims and objectives ....................................................................................................... 1

Syllabu s ............................ ................................. ................................ ............................ 2

How to use the subject guid e ..... . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. 4

Online study resources ................................................................................................... 5

M aking use of the Online Library ................................................................................... 6

Examination advice........................................................................................................ 6

Summary ....................................................................................................................... 7

Abbreviations ................................................................................................................ 7

Chapter 1: Financial manage ment function and environment ............................... 9

Essential reading ........................................................................................................... 9

Further reading.............................................................................................................. 9

Works cited ................................................................................................................... 9

Aims ............................................................................................................................. 9

Learning outcomes ........................................................................................................ 9

Tw o key con cepts in f inancial man agem ent .... . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. 9

The n ature and purp ose of f inancial man agem ent .... . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . 11

Corporate objectives .................................................................................................... 14

The agency problem .................................................................................................... 15

A reminder of your learning outcom es.......................................................................... 15

Practice questions ........................................................................................................ 16

Sample examination questions ..................................................................................... 16Chapter 2: Investment appraisals ......................................................................... 17

Essential reading ......................................................................................................... 17

Further reading............................................................................................................ 17

Works cited ................................................................................................................. 17

Aims ........................................................................................................................... 17

Learning outcomes ...................................................................................................... 17

Overview ..................................................................................................................... 17

Basic investment appraisal techniques ......................................................................... 18

Pros and cons o f investment appraisal techniqu es ..... . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . 21

Non -convent ional cash f low s ..... . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . 22Advanced investment appraisals .................................................................................. 23

Practical consideration ................................................................................................. 33

A reminder of your learning outcom es.......................................................................... 34


Sample examination questions ..................................................................................... 34

Chapter 3 : Risk and return ................................................................................... 37


Further reading............................................................................................................ 37

Works cited ................................................................................................................. 37

Aims ........................................................................................................................... 37Learning outcomes ...................................................................................................... 38

Overview ..................................................................................................................... 38

Introd uction of risk measurem ent .... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . . 38


4/60

59 Financial management

ii

Diversif ication of risk and port fol io theo ry .... . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . 40

App lications of the capital market l ine (CM L) ..... . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . . 45

Derivation of capital asset pricing mo del (CAPM ) .... . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . 46

Alt erna tive asset pricing mo dels .............................. ................................. .................... 51

Practical consideration of CAPM .................................................................................. 51

A remind er of your learning out comes ..... . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. 52

Practice questions ........................................................................................................ 52Samp le examinat ion question s ..... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . 53

Chapte r 4 : Capita l m arket efficiency .................................................................... 55


Further reading ............................................................................................................ 55

Aims ........................................................................................................................... 55


Capital markets ........................................................................................................... 55

Types of efficiency ....................................................................................................... 56

Efficient market hypothesis (EM H) ................................................................................ 56

A remind er of your learning out comes ..... . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. 60Practice questions ........................................................................................................ 60

Samp le examinat ion question s ..... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . 61

Chapte r 5: Sources of f inance .............................................................................. 63


Further reading ............................................................................................................ 63

Aims ........................................................................................................................... 63


Introduction ................................................................................................................ 63

Internal funds .............................................................................................................. 63

External funds ............................................................................................................. 64Flotation ..................................................................................................................... 64

Share issues ................................................................................................................ 65

Rights issues ............................................................................................................... 67

Private issues............................................................................................................... 68

The role of stock markets ............................................................................................. 68

Debt finance ................................................................................................................ 68

The issue of loan capital .............................................................................................. 69

A remind er of your learning out comes ..... . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. 70


Samp le examinat ion question s ..... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . 70

Chapte r 6: Capital structure ................................................................................. 71


Further reading ............................................................................................................ 71

Works cited ................................................................................................................. 71

Aims ........................................................................................................................... 71


Introduction ................................................................................................................ 72

M odigliani and M illers theory ...................................................................................... 72

M odigliani and M illers argum ent w ith corporat e t axes ..... . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . 74

Personal taxes ............................................................................................................. 75

Oth er tax shield subst itu tes ............................... ................................ ........................... 76

Financial distress ......................................................................................................... 76

Trade-off theory ........................................................................................................... 77


5/60

Contents

iii

Signalling effect ........................................................................................................... 78

Agen cy costs on debt and equity .... . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . . 79

Pecking order theory .................................................................................................... 81

Conclusion .................................................................................................................. 81

A reminder of your learning out comes.......................................................................... 82


Samp le examinat ion question s ..... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . 82Chapter 7: Dividend policy ................................................................................... 83


Further reading ............................................................................................................ 83

Works cited ................................................................................................................. 83

Aims ........................................................................................................................... 83


Introduction ................................................................................................................ 84

Types of dividend ........................................................................................................ 84

Dividend controversy ................................................................................................... 85

M od iglia ni an d M illers argum ent ............................. ................................. ................... 85Clientele effect ............................................................................................................ 86

Inform ation conten t of dividend and signall ing effect ... . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . 87

Ag ency costs and di viden d ............................ ................................. .............................. 88

Empirical evidence ....................................................................................................... 89

Conclusion .................................................................................................................. 90



Samp le examinat ion question s ..... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . 91

Chapter 8: Cost o f capital and capital investment s ............................................. 93

Essential reading ......................................................................................................... 93Further reading ............................................................................................................ 93

Aims ........................................................................................................................... 93


Introduction ................................................................................................................ 93

Cost of capital and equity f inance ..... . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . 93

Cost of capital and capital structure .... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . 94



Samp le examinat ion question ..... . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . 98

Chapter 9: Valuation of business .......................................................................... 99


Further reading ............................................................................................................ 99

Works cited ................................................................................................................. 99

Aims ........................................................................................................................... 99


Introduction ................................................................................................................ 99

App roaches to business valuation ..... . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . 9 9

Valuation of debt /bon ds ..... . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . 10 2

Valuation of equity .................................................................................................... 103

Conclusion ................................................................................................................ 106

A reminder of your learning out comes........................................................................ 106

Practice questions ...................................................................................................... 106

Samp le examinat ion question ..... . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . 10 6


6/60


iv

Chapte r 10: M ergers ........................................................................................... 109

Essential reading ....................................................................................................... 109

Further reading .......................................................................................................... 109

Aims ......................................................................................................................... 109

Learning outcomes .................................................................................................... 109

Introduction .............................................................................................................. 109

M otives for mergers ................................................................................................... 110Conclusion ................................................................................................................ 118

A remind er of your learning out comes ..... . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . 118


Samp le examinat ion question ..... . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . 11 9

Chapte r 11: Financial planning and working capital manageme nt ................... 121

Essential reading ....................................................................................................... 121

Aims ......................................................................................................................... 121


Introduction .............................................................................................................. 121

Financial analysis ....................................................................................................... 121Cash based ratios ...................................................................................................... 123

Financial planning ..................................................................................................... 128

Short -term versus lon g-term financing ..... . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . 131

Wo rking capital man agem ent .... . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . 1 32

Trade receivables management .................................................................................. 133

Wo rking capital an d t he pro blem of o vertrading ..... . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . 13 6



Samp le examinat ion question s ..... . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . 13 9

Chapte r 12 : Risk ma nagement ........................................................................... 141Essential reading ....................................................................................................... 141

Further reading .......................................................................................................... 141

Works cited ............................................................................................................... 141

Aims ........................................................................................................................ 141


Introduction .............................................................................................................. 141

Reasons for managing risk ......................................................................................... 142

Instrumen ts for hedg ing risk .... . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . 1 43

Some simple uses of options ...................................................................................... 144

Put-call parity ............................................................................................................ 145

Corporate uses of options .......................................................................................... 145

Option pricing ........................................................................................................... 146

Futures and forw ard contracts .... . . . . . .. . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . . 1 47

Risk management ...................................................................................................... 148

Conclusion ................................................................................................................ 150



Samp le examinat ion question s ..... . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . 15 1

Appendix 1: Sample examinat ion paper ............................................................ 153

Examp le o f 8-colu mn accountin g paper..... . . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . .. . . . . . .. . . . . . .. . . . . . . 157


7/60

Introduct ion

1

Introduction

59 Financial managementis a 300 course offered on the degrees and

diplomas in Economics, Management, Finance and the Social Sciences(EMFSS) suite of programmes awarded by the University of London

International Progra mmes.

Financial management is part of the decision-making, planning and

control subsystems of an enterprise. It incorporates the:

treasury function, which includes the mana gement of w orking capital

and the implications arising from exchange rate mechanisms due to

international competition

evaluation, selection, mana gement and control of new capita l

investment opportunities

raising and management of the long-term financing of an entity

need to understa nd the scope and effects of the capital markets for a

company, and

need to understand the strategic planning processes necessary to

mana ge the long a nd short-term financial activities of a firm.

The management of risk in the different aspects of the financial activities

undertaken is also addressed.

Studying this course should provide you with an overview of the problems

facing a financial mana ger in the commercial w orld. It w ill introduce

you to the concepts and theories of corporate finance that underlie the

techniques that a re offered as a ids for the understanding, evaluation and

resolution of financial managers problems.

This subject guide is w ritten t o supplement the Essential a nd Further

reading listed for this course, not to replace them. It makes no

assumptions about prior knowledge other than that you ha ve completed

25 Principles of accounting. The a im of t he course is to provide

an understand ing and a w areness of both the underlying concepts and

practical application of the basics of financial management. The subject

guide and the readings should also help to build in your mind the ability

to make critical judgments of the strengths and weaknesses of the theories,

just as it should be helping to build a critical appreciation of the uses and

limitations of the same theories and their possible applications.

Aims and object ives

This course aims to cover the ba sic building b locks of fina ncial

mana gement that a re of primary concern to corporate mana gers, and all

the considerations needed to make financial decisions both inside and

outside firms.

This course also builds on the concept of net present value a nd a ddresses

capita l budgeting a spects of investment d ecisions. Time value of mon ey

is then applied to value financial assets, before extensively considering

the relat ionship between risk and return. This course also introduces the

theory and practice of financing and dividend d ecisions, cash and w orkingcapital mana gement and risk mana gement. Business valuation and

mergers and acquisitions will also be discussed.


8/60


2

By the end of this course and having completed the Essential reading a nd

activities, you should be able to:

Subject-specific objectives

describe how different financial markets function

estimate the value of different financial instruments (including stocks

and bonds)

make capital budgeting decisions under both certainty and uncertainty

apply the capital assets pricing model in practical scenarios

discuss the capital structure theory and dividend policy of a firm

estimate the value of derivatives and ad vise mana gement how to use

derivat ives in risk mana gement and capital budgeting

describe and assess how companies mana ge w orking capital and short-

term financing

discuss the main motives and implications of mergers and acquisitions.

Intellectual objectives

integrate subject matt er studied on relat ed modules and to demonstrate

the multi-disciplinary aspect of practical financial management

problems

use aca demic theory and research to question established financial

theories.

Practical objectives

be more proficient in researching materials on the internet and Online

Library

be able to use Excel for statistical ana lysis.

Syllabus

The subject g uide examines t he key theoretical a nd practica l issues

relating to financial management. The topics to be covered in this subject

guide are organised into the following 12 chapters:

Chapter 1: Financial management function and environment

This chapter outlines the funda menta l concepts in finan cial mana gement

and deals w ith the problems of shareholders wealth ma ximisation and

agency conflicts.

Chapter 2: Investment appraisals

In this chapter we begin with a revision of investment appraisaltechniques. The main focus of this chapter is to examine the advantages of

using the discounted cash flow technique and its application in complex

investment scenarios: capital rationing, replacement decision, project

deferment and sensitivity analysis.

Chapter 3: Risk and return

We forma lly examine the concept an d mea surement of risk an d return

in this chapter. We a lso look at t he necessary cond itions for risk

diversification, portfolio theory a nd t he tw o fund separa tion theorem.

Asset pricing models a re discussed a nd pra ctical considerat ions in

estimating beta will be covered. Empirical evidence for and against the

asset pricing models will also be illustrated.


9/60

Introduct ion

3

Chapter 4: Ca pital market efficiency

This chapter discusses the concepts a nd implicat ions of m arket efficiency

and the mechanism of equity a nd debt issuance.

Chapter 5: Sources of finance

In this chapter we focus on how companies raise funds from both the stock

and bond markets and discuss the advantages and disadvantages of each

type of financing method.

Chapter 6: Capital structure

This chapter critically reviews t he existing leading t heories of capita l

structure. Specifically, the t rad e-off theory, signa lling effect, ag ency cost of

equity a nd debt an d the pecking order theory w ill be examined. We will

also evaluate the practical considerations of capital structure decisions

made by corporate mana gers.

Chapter 7: Dividend policy

This chapter aims to explore how the a mount of d ividend paid by

corporations would affect their market values. The tax, signalling and

agency effects of dividend will be discussed.

Chapter 8: Cost of capital and capital investments

In this chapter w e discuss how the cost of capital can be a djusted w hen

firms are financed w ith a mixture of debt a nd equity.

Chapter 9: Valuation o f business

We introduce the valua tion of equity, debt, convertibles an d w arra nts in

this chapter.

Chapter 10: Mergers

This chapter focuses on the theory and motives of mergers and

acquisitions. The determination of merger value and the defensive tacticsagainst merger threats will also be covered. The empirical evidence of

using financial ratios to predict mergers and acquisitions will be discussed.

Chapter 11: Financial planning and working capital

management

The importance of ma naging cash a nd short-term fina ncing w ill be

discussed in this cha pter.

Chapter 12: Risk m anagement

This chapter provides an introduction to risk management including:

hedging, futures, options and derivatives and their uses in both long-term

and short-term situations.

Reading

Essential reading

Brea ley, R.A., S. C. Myers and F. Allen Prin ciples of corpor ate finance. (New York:

McGraw -Hill, 2010) t enth edition [ISBN 9780071314268]. Herea fter ca lled

BMA, this textbook d eals w ith most of the to pics covered in this subject

guide.

Detailed reading references in this subject guide refer to the edition of the

set textbook listed above. New editions of this textbook may have been

published by the time you study t his course. You can use a more recent

edition of this book or of any of the books listed below; use the detailedchapter and section headings a nd t he index to identify relevant rea dings.

Also check the VLE regularly for upda ted guida nce on rea dings.


10/60


4

Further reading

Please note that as long a s you read t he Essential read ing you are then free

to read a round the subject area in a ny text, pa per or online resource. You

w ill need to support your learning by reading a s w idely a s possible and by

thinking abo ut how these principles apply in the real w orld. To help you

read extensively, you have free access to the virtual learning environment

(VLE) and t he University of London Online Library (see below) .

Other useful texts for t his course include:

Arnold, G. Corporate financial management. (Ha rlow : Fina ncial Times/Prent ice

Hall, 2008) fourth edition [ISBN 9780273719069]. Hereafter called ARD,

this textbook a lso covers most of the topics in this subject guide. It is less

technical tha n BMA.

Copeland, T.E., J .F. Weston an d K.S. S hastri Financial theory and corporat e

policy. (Ha rlow : Pearson-Add ison Wesley, 2004) fourth ed ition [ISB N

9780321127211].This is a cla ssic finance t extbook pitched at an ad vanced

level. You ma y use this t extbook for reference as it contains some useful

updat es of empirical studies in the field of corporate finan ce.

Wat son, D. a nd A. Head Corporate finance passnotes. (Harlow: Pearson

Education, 2010) first edition [ISBN 9780273725268].This concise version

of a passnote neatly summarises the key concepts in financial management.

You might f ind it useful as a revision to ol.

Apart from the a bove textbooks, this subject guide a lso refers to some of

the original articles from w hich the financial ma nagement theories are

developing. You should refer to t he w orks cited in ea ch chapt er for the full

reference of these a rticles.

How to use t he subject guide

This subject guide is mean t to supplement but not t o replace the ma in

textbook. You should use it a s a guide to d evise a plan for your ow n studyof this subject. Suggested here is one approach in how to use this subject

guide.

Approach financial management in the same order as the chapters in

this subject guide. It is specifically designed t o help you build up your

understanding of the subject.

1. For each chapter (a part from this Introduction) you should fam ilia rise

yourself w ith the a im and outcomes before reading the ma terials.

2. Read the introductory section of each chapter to identify the area s you

need to focus on.

3. Carefully read the suggested chapters in BMA, w ith the a im of ga iningan initial understanding of the topics.

4. Read t he remainder of the chapter in the subject guide. You may then

approach the Further reading suggested in the subject guide and BMA.

5. The subject guide is designed to set the scope of your studies of this

topic as well as attempting to reinforce the basic messages set out

in BMA. Therefore you should pa y ca reful att ention to the examples

in both the texts and the subject guide to ensure you achieve that

basic understanding. By taking notes from BMA, and then from other

books you should ha ve obta ined the necessary ma terial for your

understanding, a pplicat ion and later revision.

6. Pay particular attention to the practice questions and the examplesgiven in the subject guide. The ma terial covered in th e examples and

in the activity exercises complements the textbook and is important in

your prepara tion for the examinat ion.


11/60

Introduct ion

5

7. Ensure you have achieved the listed learning outcomes.

8. Attempt the Sample examina tion questions a t the end of each chapter

and the quizzes on the virtual learning environment (VLE).

9. Check you have mastered each topic before moving on to the next.

10. At the end of your prepara tions, att empt the questions in the Sa mple

examination paper at the end of the subject guide. Then compare

your answ ers with the suggested solutions, but do remember that they

may w ell include more information tha n the Examiner would expect

in an examina tion pa per, since the guide is trying t o cover a ll possible

angles in the answ er, a luxury you do not usually ha ve time for in a n

examination.

Online study resources

In addition to the subject guide and the Essential reading, it is crucial that

you ta ke advanta ge of the study resources that a re available online for this

course, including the VLE and the Online Library.

You ca n a ccess the VLE, the Online Libra ry a nd your University of Londonemail account via t he Student Portal at:

http://my.londoninternational.ac.uk

You should have received your login details for the Student Port al w ith

your official offer, w hich wa s emailed to the ad dress that you ga ve

on your application form. You have probab ly alread y logged in to the

Student Portal in order to register! As soon as you registered, you will

automatically have been granted access to the VLE, Online Library and

your fully functional University of London email account.

If you forget your login details at any point, please email uolia.support@

london.ac.uk quoting your student number.

The VLE

The VLE, w hich complements this subject g uide, ha s been d esigned to

enhance your learning experience, providing additional support and a

sense of community. It forms an important part of your study experience

with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

Self-testing activities: Allow you to test your ow n understand ing of

subject material.

Electronic study mat erials: The printed materials that you receive from

the University of London are a vailable to dow nload, including updat edreading lists and references.

Past examination papers and Examiners commentar ies: These provide

ad vice on how each examination question might best be answered.

A student discussion forum: This is an open space for you to discuss

interests an d experiences, seek support from your peers, w ork

collaboratively to solve problems and discuss subject material.

Videos: There are recorded aca demic introductions to the subject,

interviews and debates and, for some courses, audio-visual tutorials

and conclusions.

Recorded lectures: For some courses, w here appropriat e, the sessionsfrom previous years Study Weekends have been recorded and ma de

available.


12/60


6

Study skills: Expert advice on preparing for examinations and

developing your d igital litera cy skills.

Feedback forms.

Some of these resources are available for certain courses only, but we

are expa nding our provision a ll the time and you should check the VLE

regularly for updates.

M aking use of the Online Library

The Online Library contains a huge array of journal articles and other

resources to help you read widely and extensively.

To a ccess the ma jority o f resources via the Online Library you w ill either

need to use your University of London Student Portal login details, or you

will be required to register and use an Athens login:

http://tinyurl.com/ollathens

The easiest wa y to locate relevant cont ent an d journal art icles in the

Online Library is to use the Summon search engine.

If you a re having trouble finding a n a rticle listed in a reading list, t ry

removing a ny punctuation from the title, such as single quotat ion marks,

question marks and colons.

For further advice, please see the online help pages: www.external.shl.lon.

ac.uk/summon/about.php

Unless otherwise stated, all websites in this subject guide were accessed in

June 2012. We cannot guara ntee, how ever, tha t t hey w ill stay connected

and you may need to perform a n internet search to find t he relevant

pages.

Examinat ion adviceImportant: the information and advice given here are based on the

examination structure used a t the time this guide wa s written. Please

note that subject guides may be used for several years. Because of this

w e strongly advise you to alw ays check both the current Regulationsfor

relevant information a bout the examina tion, and the VLE where you

should be ad vised of a ny forthcom ing chang es. You should a lso carefully

check the rubric/instructions on the paper you actually sit and follow

those instructions.

Remember, it is important to check the VLE for:

up-to-da te informat ion on examination and assessment arra ngementsfor th is course

w here available, past examination papers and Examiners commentar ies

for the course which give advice on how each question might best be

answered.

The examination paper consists of eight questions of which you must

answer four questions. Each question carries equal marks and is divided

into several parts. The style of question varies but each question aims to

test the mixture of concepts, numerical techniques and application of each

topic. Since topics in financial management are often interlinked, it is

inevitable that some questions might examine overlapping topics.

Remember when sitting the examination to maximise the time spenton each q uestion and although, throughout, the subject guide will give


13/60

Introduct ion

7

you a dvice on ta ckling your examinations, remember tha t t he numerical

type questions on this paper ta ke some time to read through and digest.

Therefore try to remember and practise the following approach. Always

read t he requirement(s) of a question first before read ing the body of the

question. This is appropriate whether you are making your selection of

questions to a nswer, or w hen you are read ing the question in prepara tion

for your answer.

In the question selection process at the start of the examination, by

reading only the requirements, w hich are a lwa ys placed a t the end of a

question, you only read material relevant to your choice, you do not w aste

time reading ma terial you are not going to a nswer. Secondly, by reading

the requirements first, your mind is focused on the sort of information you

should be looking for in order to answer the question, therefore speeding

up the ana lysis and saving time.

Remember, it is important to check the VLE for:

up-to-da te information on examination and assessment arra ngements

for th is course

where available, past examination papers and Examiners commentar iesfor the course which give advice on how each question might best be

answered.

Summary

Remember this introduction is only a complementary study tool to help

you use this subject guide. Its aim is to give you a clear understanding of

what is in the subject guide and how to study successfully. Systematically

study the next 12 chapters along with the listed texts for your desired

success.

Good luck and enjoy the subject!

Abbreviations

AEV Annua l equiva lent va lue

AIM Alterna tive investmen t ma rket

APM Arbitra ge pricing mod el

ARD Arnold, 2008

ARR Account ing ra te of return

BMA Brea ley, Myers and Allen

CAPM Capita l asset pricing model

CFs Cash flow s

CME Capita l market efficiency

CML Capita l market line

CPI Consumer price index

DFs Discount factors

DPP Discounted payb ack period

DPS Dividend per share

EMH Efficient market hypothesis

EPS Earnings per share

EVA Economic va lue add ed


14/60


8

IPO Initial public offer

IRR Interna l rat e of return

LSE London Stock Exchange

MM Modigliani and Miller

MVA Market va lue add ed

NCF net cash flow

NPV Net present va lue

NYSE New York Sto ck Exchange

PE Price earning s rat io

PI Profita bility index

PP Payba ck period

ROA Return on assets

ROC Return on capita l

ROE Return on equity

S&P Sta nda rd and Poors

Std dev Stand ard deviation

VLE Virtua l learning environment

WACC Weighted average cost of capita l


15/60


9

Chapt er 1: Financial management

funct ion and environment

Essent ial readingBrea ley, R.A., S.C. Myers a nd F. Allen Pr inciples of corpor ate finance. (New York:

McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 1 and 2.

Further reading


Hall; 2008) fourth edition [ISBN 9780273719069].Chapter 1.

Works cited

Fisher, I. The theory of i nterest. (New York: MacMillan, 1930).

Aims

This chapter paves the founda tion for you to understand w hat financial

mana gement is about. In pa rticular, w e w ill examine the roles of financial

mana gement, the environment in w hich businesses are operated, and

agency theory. More importantly we explain the two key concepts which

underpin much of the t heory and practice of financial ma nagement.

Learning outcomes

By the end of this chapter, and having completed the Essential reading andactivities, you should be able to:

outline the nature and purpose of financial mana gement

describe the general environment in which businesses operat e

explain the relationship between financial objectives and corporate

strategies

assess the impact of stakeholders on corporat e strategies

discuss the time value for money concept and the risk and return

relationship.

Tw o key concept s in financial managementBefore we look at w hat financial mana gement is about, it is essential for us

to understand tw o key concepts which lay t he foundation of this subject.

The tw o key concepts are:

i. Risk an d return.

ii. Time value of money.

Risk and ret urn

Financial markets seem to reward investors of riskier investments1with a

higher return.2The follow ing gra ph indicat es this relationship.3

1 Risk is oft en measured

as a dispersion of the

possible return outcomes

from the expected mean.

In Chapter 3 of this

subject guide, we will

more formally define

the concept of risk in

financial management

and discuss the different

methods to quant ify risk.

2 Return refers to the

financial reward gained

as a result of making

an investment. It is

often defined as the

percentage of value gain

plus period cash flow

received to the initial

investment value.

3The graph has been

rescaled in log to fit thepage. You should note

the vast differences of

the cash returns from

each investment type.


16/60


10

T Bill (14)

(Approximate values)

Corp. Bonds (55)

Long Bonds (39)

S&P (1800)

Small Cap. (5500)

1997

0.1

1925

Index

10

1

1000

Year

end

Figure 1.1: The cash return from five different investments.

Source: BMA.

Suppose we invested $1 in 1925 in each of th e following five portfolios:

i. the la rgest quot ed companies in the US, Sta nda rd &Poors (S&P)

ii. the smallest quot ed companies measured by market capita lisa tion in

the US, Sma ll Capita lisation (Sma ll Cap)

iii. corporate bonds

iv. long-term US government bond s, Long Bond s

v. short -term US govern ment bond s, T Bill.

These portfolios have different levels of perceived risk. Arguably, smaller

companies have higher varying returns than larger companies. Bonds,on the other hand, are a safer investment to investors. Over time, these

portfolios generate cash returns which seem to follow the same order

as their respective perceived risk. This leads us to one of the a xioms in

financial management:

The higher t he risk, the higher the expected return.

Companies and investors should therefore only consider undertaking

a riskier investment provided that they are suitably and sufficiently

compensated by a higher return.

Activit y 1.1

What are the m ain reasons for smal ler companies having higher p erceived risk? What are

the specif ic risks we are referring to?

See VLE for discussion.

Time value of money4

Money (i.e. cash) has different values over time. Holders of money can

either spend a sum of money now or delay their consumption by investing

the money in different investment opportunities until it is required.

Suppose an investor can deposit a sum of money in a ba nk and ea rn an

an nua l interest of 5%. The value of mo ney to this investor w ould then be

5% per ann um. If the sa me investor can invest t he same sum of money in

a fina ncial a sset which gives a return o f 10% an nua lly, then t he value of

money t o this investor w ould be 10% per annum . The future return fro m

4BMA, Chapter 2 deals

with t he concept of time

value for money and

covers in detail how to

calculate present and

futu re values.


17/60


11

the money invested now is based on the duration of time, the risk of the

investment a nd inflat ion.

For exam ple, $100 invested t oda y w ill ea rn 10% per annum of return ( i.e.

$110 in one yea rs time and $121 in tw o yea rs time). An investor w ho

assumes a 10% return w ill be indifferent bet w een receiving $100 tod ay

and $110 in one years time as the tw o cash flows ha ve identical value to

the investor. In the t ime value of mon ey terminology, thepresent valueof $110 received in one yea rs time is exactly $100. Similarly, t he present

value of $121 received in tw o yea rs time is exactly $100, too.

This concept ca n be a pplied to convert future ca sh flow s into their present

values. Denote the present va lue of a cash flow as PVand future (t-period)

value of a cash flow as FVt.The genera l relationship betw een the present

and future value is:

FVt= PV(1+r)twhere ris the time value of money measured as a

percentage

Re-arra nging the above equa tion, w e have:

PV =

FVt

1+ r( )t =FVt

1

1+ r( )t

where1

1+r( )tis the t-period discount factor

The nature and purpose of f inancial management

Having discussed the t w o key concepts in financial ma nagement, w e

can now turn our attention to the function of financial ma nagement.

In general, there are three ma in tasks that financial ma nagers need to

undertake:

i. Investing decisions this is how finan cial mana gers select the rightinvestments. This can b e examined in tw o stag es. First we look at how

financial mana gers invest in a nd ma nage short-term w orking capital

(this is covered in Chapter 11 of this subject guide) and then we

examine how financial mana gers may appraise long-term investment

projects.

ii. Financing decisions this involves the choice of particular sources of

funds w hich provide cash for investments. The key issues that financia l

mana gers should address are how:

these sources of funds can be raised (covered in Chapter 5)

the value of the business may be affected through the combination

of different sources of funds (covered in Chapter 6)

the sources of funds may affect the relationship between different

stakeholders (covered in Chapter 6).

iii. Dividend policy this concerns the return to shareholders (covered in

Chapter 7).

So in theory and in practice, how are these decisions being considered by

financial manag ers?

Link bet w een investing, financing and dividend decisions

In a perfect a nd complete capital ma rket w here there are no tra nsaction

costs and information is widely available to everyone, it is argued tha t afirms investing, finan cing and dividend d ecisions are not interlinked. This

is known as Fishers separation theorem (Fisher, 1930). This is illustrated

in the following diagra m.


18/60


12

C1

C0

C1, a

Y1

C*1

CF1

C1, b

X

a

b

C*0, a

C*0

Y0

C0, b W0

Individual 2

Individual 1

I1

Figure 1.2: Fishers Separation Theorem

Suppose a firm is operating in a two-period environment (period 0 now

and period 1 in one years time) with a n initial cash flow of Y0. It has

the opportunity to invest in tw o types of investments. The first type of

project relates to investments which require an initial investment outlay

(Ii) a nd d eliver CF

iin the next period for each investment ( i). For example,

investing Iiin period 0 w ill produce CF

iin period 1. Hereafter these types

of projects are referred t o a s production investment projects. The second

type of investment is essentially financial, which allows the firm to borrow

and lend an unlimited amount at an interest rat e of r. In this case, if a firm

borrows (or lends) W0in period 0, it will pay back with interest (or receivew ith interest) W1= W

0(1+ r).

Investing decision

What should t he firm do in t erms of its investments? A firm w ill logically

rank and invest in investment projects in descending order of their

profitability (Rifor each i). A production opportunity frontier can be

obtained (such as the curve Y0Y

1). A firm will invest up to the point where

the ma rginal investment i*yields a return that equals the return from

the capital market (i.e. interest rat e r). The tota l investment outlays - the

amount represented by C0Y

0- is the sum I

ifor all i( i= 1 to i*). Once the

investment plan is fixed, the firm will have C*0in period 0 remaining and

a ca sh return of C*1in period 1.


19/60


13

Dividend po licy

In this setting, how much should the firm give out as dividend to its

shareholders in ea ch period? The an sw er is simple. It should give out

C*0and C*

1in period 0 an d 1 respectively. How ever, w ould sha reholders

be satisfied w ith these amounts in each period? Suppose we ha ve two

individual shareholders 1 and 2. Each of them has their unique utility

function of consumption in ea ch period. This can be represented by the

indifference curves in Figure 1.2 abo ve. Individua l 1 prefers to consume

less in period 0 and more in period 1 (the combination at a). Given the

current firms dividend policy, how would he be satisfied? There are two

w ays to a chieve it:

i. The firm w ill pay C0,a

and invest any excess cash flow (i.e. C*0 C

0,a)

a t rin period 0 and give out C*1+ (C*

0 C

0,a)(1 + r). Mathematically,

it can be proved tha t it is equa l to C1,a

. Therefore the firm w ill pay the

exact dividend in each period to individual 1 as he prefers.

ii. Alternat ively, the firm pays C*0to individual 1 a nd he can invest a ny

excess cash flow after his consumption in period 0 in the financial

investment earning a return of rand receive the same combined cashflow of C

1,ain period 1.

This reasoning applies to a ny individua l shareholders with a ny unique

utility functions. Take Individua l 2 a s an example. Her consumption

pattern does not match t he firms dividend pa yout. Similarly there a re tw o

w ays w e can satisfy her consumption pattern:

i. The firm w ill borrow C0,b

C*0a t rin period 0 and pa y out C

0,bto

Individual 2. In period 1, the firm will pay out C*1 (C

0,b C*

0)

(1 + r). Mathema tically, it ca n be proved tha t it is equa l to C1,b

.

Therefore the firm will pay the exact dividend in each period to

Individual 2.

ii. Alterna tively, the firm pay s C*0to Individual 2 and she borrows any

shortfall to make up to her consumption C0,b

in period 0. In period 1,

she will receive C*1less the loan and interest she takes out in period

0. This will leave her with a net am ount exact ly equa l to C1,a

.

The above a rgument indicates that financial mana gers do not need to

consider shareholders consumption patterns when fixing the investment

plan or the d ividend policy. The easiest w ay is to ma ximise the firms

cash flows a nd d istribute the spare cash flows a s dividends. Shareholders

will use the capital markets to facilitate their consumption patterns

accordingly.

Financing decisionIn the beginning, w e assume that the firm has an initial cash flow of

Y0and requires a tota l investment outlay of C

0Y

0. If any part of Y

0is

not contributed by shareholders, the firms dividend in period 1 will

be reduced by t he funds raised from borrow ing (at a cost of r) and the

interest. However, shareholders can offset this shortfall of dividend in

period 1 by investing the fund not contributed in the firm to the capital

market and earn a return exactly equal to r.

The above argument illustrates the Fisher separation in which investing,

financing and dividend decisions are all unrelated. However, if the capital

market is imperfect in such a way that external funding is restricted, the

Fisher separat ion might n ot a pply. The follow ing scenarios highlight th epractical considerat ions that financial ma nagers w ould need to ta ke.


20/60


14

Investment

A company w ould l ike to

undertake a large number

of prof i table investment

projects.

Financing

I t w i l l need to raise funds

in order to take up these

projects.

Dividends

I f the company fails to

raise suff icient funds from

outside the company,

i t would need to cut

dividends in order t o

increase internal fund ing.Dividends

A company wants to

pay a large dividend to

shareholders

Financing

A lower level of avai lable

internal cash f low s might

force the company to seek

extra funds via external

f inancing.

Investment

I f external f inancing is

restr icted throu gh part ial ly

f inancing the dividend,

the company might need

to postpone some of the

investment projects.

Financing

A comp any has been using

a higher level of external

funding.

Investment

Due to the high cost of

f inancing, the number

of at t ract ive investmentprojects might be reduced.

Dividends

The companys abil i ty to

pay dividends in th e future

may be ad versely affected.

Activit y 1.2

i . Why wo uld a f i rm invest up to the point where the return of the marginal

investment equals the return f rom the capi tal market?

i i . What w ould happen to the Fishers separat ion theorem i f the borrow ing rate di f fers

from th e lending rate?

See VLE for solutions.

Corporate objectives

BMA, Cha pter 1, pp.3740 discuss the goa ls of corpora tion. The genera l

assumption in financial mana gement is that corporate mana gers will

try their best to maximise the value of the shareholders investment

in the corporation (i.e. shareholders wealth maximisation (SHWM)).

Maximisation of a companys ordinary share price is often used as a

surrogate objective to tha t of ma ximisation of shareholder w ealth. In

order to achieve this objective, it is argued that corporate managers will

maximise the va lue of all investments und ertaken by the firm. This can be

illustrated in the follow ing diagra m:

Corporate net present value(sum of individual Projects NPVs)

NPV 1

NPV ANPV 3

NPV 2

NPV 4

Share price SHWM

(1)

(2)(3) (4)

Figure 1.3: Shareholders wealth maximisation

Source: BMA.

How ever, in practice, corpora te o bjectives vary. For exa mple, HP, a US-based computer corporation, has the following objectives listed on its

website:5

5 (http://welcome.hp.com/country/uk/en/

companyinfo/corpobj.

html)


21/60


15

customer loyalty

profi t

g ro w th

market leadership

leadership capability

employee commitment

global citizenship.

While profit maximisation, social responsibility and growth represent

important supporting objectives, the overriding objective of a company

must be tha t of shareholders w ealth ma ximisation. The financial w ealth of

a shareholder can be a ffected by a companys financial ma nagers action.

Arguably, when good investment, financing and dividend decisions are

made, a company s market value w ill increase. The rest of this subject

guide will explore how financial managers decisions can increase a firms

value.

Activit y 1.3

Althoug h shareholders w eal th maximisat ion seems to be t he overriding object ive,

corporate managers st i ll face a num ber of constraints to imp lement m ul t iple object ives

simultaneously.

Ident i fy the types of constraint that corporate managers face w hen assessing long -term

financial plans.

See VLE for discussion .

The agency problem

The agency problem occurs when financial managers make decisions

which are not consistent with the objectives of the companys stakeholders.

It a rises because:

1. There is a separa tion of ownership an d control: ag ents (financial

mana gers) are given the pow er to mana ge and control the company by

the principals (stakeholders: shareholders, creditors and customers).

2. The goals of agent s are different from those of the principals.6

3. Principals do not get full information about t heir company from the

agent or the ma rket (a symmetric information).

Activit y 1.4

What are the signs of an agency problem? What possible act ions can be taken t o m it igatesuch a p roblem?

See VLE for discussion .

A reminder of your learning outcomes

Having completed this chapter, as well as the Essential reading and


outline the nature and purpose of financial mana gement

describe the general environment in which businesses operat e

explain the relationship between financial objectives and corporatestrategies

assess the impact of stakeholders on corporat e strategies

6For example,

agents may want to

increase the size of

the company (empire

building), strengthen

their managerial

pow er, secure theirjob s, im pro ve t hei r

remuneration and

pursue other personal

objectives. These

objectives may not

necessarily be enhan cing

the value of the

company.


22/60


16

discuss the time value for money concept and the risk and return

relationship.

Pract ice quest ions

1. Compute the future value of $1,000 compounded a nnua lly for:

a. 10 years at 5%

b. 20 years at 5%

How w ould your answ er to the above question be different if interest is

paid semi-annually?

2. Compare each of the follow ing examples to a receipt of $100,000

today:

a . Receive $125,000 in two yea rs time.

b. Receive $55,000 in one yea rs time and $65,000 in two yea rs time

c. Receive $31,555.7 for the next 4 years, receivable at t he end of each

year.

d. Receive $10,000 for each yea r for an infinite period.

Assume the interest rate is 10% per year for the foreseeable future.

Sample examination questions

1. We need to ma ximise our profit in order for us to ma ximise the

shareholders w ealth Executive at OverHill Plc.

Critically comment on the statement above.

2. Explain, with the aid of a d iagram, how a firms dividend policy is

independent from its investment policy in a perfect and complete

world.3. Identify five different stakeholder groups of a public company and

discuss their financial and other objectives.


23/60

Chapter 2 : Investment appraisals

17

Chapt er 2: Investment appraisals

Essent ial reading

Brea ley, R.A., S. C. Myers and F. Allen Prin ciples of corpor ate finance. (New York:

McGraw -Hill, 2010) t enth edition [ISBN 9780071314268] Cha pters 5

and 6.

Further reading


Hall, 2008) fourth edition [ ISBN 9780273719069]Chapters 26.

Works cited

Gra ham, J .R. and C.R. Harvey The theory and pra ctice of corporate finance:

evidence from the field, Journal of Financial Economics, 60, 2001, pp.187

243.

Aims

This chapter focuses on t he techniques commo nly used for investment

appraisals in practice. In particular, we concentrate on the pros and cons of

the following techniques:

Accounting rat e of return (ARR)

Payback period (PP)

Discounted payba ck period (DPB)

Internal rate of return (IRR)

Net present value (NPV).

Learning outcomes

By the end of this chapter, and having completed the Essential reading and


describe the commonly used investment appraisal techniques

apply the discounted cash flow technique in complex scenarios

evaluate the investment decision process.

OverviewAs mentioned in Chapter 1, financial managers make decisions about

which investment they should invest in to maximise their shareholders

value. In order to do so, they need to understand how to measure the

value of investments they undertake and how these investments help to

improve the value of the firm. First, we will examine the basic techniques

an d evalua te their pros and cons in investment a ppraisals. We will then

compare the relative merits of using NPV over IRR. Thirdly, we consider

some of the scenarios when NPV can be applied to deal with the selection

of investments. Finally, w e discuss the problems relating to th e application

of these investment appraisal techniques.


24/60


18

Basic investment appraisal t echniques

BMA, Chapter 5 reviews the appraisal techniques and explains them at

grea t length. You should read the relevant sections of the chapter before

you carry on w ith the rest of the material covered here.

Here we summarise these commonly used techniques.

Accounting rat e of return (ARR)

The method is also know n a s return on capital employed (ROCE)

or return on investment (ROI). It relates accounting profit to the capital

invested. One widely used definition is:

ARR=Average annual profit

Average investment outlays 100 %

Average investment takes into consideration any scrap value. It can be

expressed as follows:

Average Investment = Investment - Scrap value2

It measures the average net investment outlay of the project.1Accounting

profit is defined as before-tax operating cash flows after adjustment for

depreciation. The decision rule is to accept investments w ith ARR higher

than a predetermined ta rget rate of return.

Payback period (PP)

Payback period measures the shortest time to recover the initial investment

outlay from the cash flows generated from the investment. A company will

accept an investment if the PP is less than or equal to a target period.

Discounted payback pe riod (DPP)

This is similar to PP except that the cash flows from the investment are

first discounted to time 0 and the shortest time to recover the initial

investment outlay will then be measured.

Internal rat e of return (IRR)

The internal rate of return on an investment or project is the annualised

effective compounded return rate or d iscount rate t hat makes the net

present value (NPV) of all cash flows (both positive and negative)

generated from a particular investment equal to zero. The decision rule

is to accept a project or investment if its IRR is higher tha n the cost o fcapital.

Net present value (NPV)

NPV combines the present values of all future cash flows and compares

the to ta l to th e initial investment. If th e NPV of a project is positive, it

indicat es that it earns a positive return over the cost of capital a nd w ill

therefore increase th e sharehold ers value. A firm should invest in all

positive NPV projects, so t he ma rket value of t he firm w ill increase by the

total of the NPVs, once they are announced to the market.

To illustra te how these techniques a re applied in investment a ppraisal, lets

look at the following example.

1Some textbooks prefer

to calculate ARR by

referring to the average

level of investment.

Consequently, the

average investment will

be defined as (initial

investment + scrap

value)/2.


25/60


19

Example 2 .1

Suppose we ha ve tw o mutua lly exclusive projects, A an d B. Ea ch project

requires an initial investment in a machine, payable at the beginning of year 0.

There is no scrap value for these ma chines at t he end of the project. Suppose

the cost of capita l (discount rate) is 20%per a nnum. The following b efore-ta x

operating cash flows a re also known:

Before-tax operating

cash flows ($)Year

Project 0 1 2 3 4

A (25 ,00 0 ) 5 ,00 0 1 0 ,0 00 15 ,000 20 ,00 0

B (2 ,50 0 ) 2 ,00 0 1 ,5 00 250

Accounting rate of return

Suppose the profit before depreciation for each year is identical to the annual

cash flow. The ARR can be d etermined a s follows:

Project Initialinvestment

Averageinvestment

Total profit afterdepreciation

Averageprofit

ARR

A 25 ,0 00 12 ,500 25 ,000 6 ,25 0 5 0%

B 2 ,5 00 1 ,250 1 ,250 417 3 3%

Payback per iod

We can look at the cumulative cash flow at t he end of each yea r to determine

the PP.

Cumulative cash flow s

Project 0 1 2 3 4 PP

A (2 5,0 00 ) (2 0,0 00 ) (1 0,0 00 ) 5 ,0 00 2 5 ,0 0 0 2 .6 7 yea rs

B (2 ,500 ) (500 ) 1 ,0 00 1 ,250 1 .33 years

Discounted payback period

Year

Project A 0 1 2 3 4

Cash f low s ($ ) (25 ,00 0 ) 5 ,0 00 10 ,0 00 15 ,000 20 ,00 0

Discount factor (DF) (20% ) 1 0 .833 0 .694 0 .578 0 .48 2

Present value (25 ,00 0 ) 4 ,165 6 ,9 40 8 ,670 9 ,64 0

Cu mu lat ive cash f lo w s (2 5,0 00 ) (2 0,8 35 ) (1 3,8 95 ) (5 ,2 25 ) 4 ,4 15

Year

Project B 0 1 2 3 4

Cash f low s ($ ) (2 ,50 0 ) 2 ,0 00 1 ,5 00 250

Discount factor (DF) (20% ) 1 0 .833 0 .694 0 .578 0 .48 2

Present value (2 ,50 0 ) 1 ,666 1 ,0 41 14 4 .5

Cum ulat ive cash f low s (2 ,50 0 ) (83 4 ) 2 07

For Project A, the payba ck period occurs in Year 4. If w e a ssume that cash flow s

arrive evenly throughout the year, we can determine the approximated paybackperiod at 5,225/9,640 = 0.54 year (i.e. PP at 3.54 years). Similarly, for Project

B, the PP occurs in 1.8 years.


26/60


20

Net presen t value

The NPV can be determined as:

Year

Project A 0 1 2 3 4

Cash flow s ($ ) (25 ,00 0 ) 5 ,00 0 10 ,000 1 5 ,0 00 20 ,00 0

Discount factor (DF) (20 % ) 1 0 .83 3 0 .694 0 .5 78 0 .48 2

Present value (25 ,00 0 ) 4 ,16 5 6 ,940 8 ,6 70 9 ,64 0

NPV 4 ,4 15

Year

Project B 0 1 2 3 4

Cash flow s ($ ) (2 ,50 0 ) 2 ,00 0 1 ,500 2 50

Discount factor (DF) (20 % ) 1 0 .83 3 0 .694 0 .5 78 0 .48 2

Present value (2 ,50 0 ) 1 ,66 6 1 ,041 144 .5

NPV 35 1 .5

Internal rate of return

To find the IRRs of these tw o projects, we ca n use the extrapolat ion method.

First, we recalculate the NPV of each of the two projects with a higher discount

rate. For example, we choose 30%and 35%as the discount rate for Project A

and B respectively. This gives, in both cases, negative NPVs.

Year

Project A 0 1 2 3 4

Cash flow s ($ ) (25 ,000 ) 5 ,000 1 0 ,0 00 15 ,000 2 0 ,00 0

Discount factor (DF) (30 % ) 1 0 .769 0 .5 92 0 .455 0 .3 5

Present value (25 ,000 ) 3 ,845 5 ,9 20 6 ,825 7 ,00 0

NPV (1 ,410 )

Year

Project B 0 1 2 3

Cash flow s ($ ) (2 ,500 ) 2 ,000 1 ,5 00 250

Discount factor (DF) (35 % ) 1 0 .741 0 .5 49 0 .407

Present value (2 ,500 ) 1 ,482 8 24 102

NPV (93 )

We then substitute the relevant figures into the follow ing equa tion:

IRR =R+ + NPV

R +

NPVR +

NPVR

R R+( )

R+ is the discoun t ra te w hich gives a positive NPV, NPVR+

Ris the d iscount rat e w hich gives a neg at ive NPV, NPVR

Consequently, the IRRs for Project A and B a re 27.6%a nd 31.9%respectively.

Activit y 2.1

Attem pt Quest ion 1, BM A Chapter 5 .

See VLE for solution .


27/60


21

Pros and cons of investment appraisal t echniques

Example 2.1 highlights the potentia l problems of using some of t hese

techniques in investment a ppraisals. Recall the results for Projects A an d B

respectively:

Pro jects NPV IRR PP A RR

A 4 ,41 5* 27 .6% 2 .67 years 50% *

B 3 51 .5 31 .9% * 1 .33 years* 33%

* Indicates the project that w ill be chosen under the specific appraisal method.

Suppose the main o bjective is to ma ximise shareholders value. Financial

managers w ould prefer Project A as it provides a higher NPV, a nd hence

it gives the greatest increase to the shareholders value. However, if we

choose projects based on a higher va lue of IRR or PP, Project B w ill be

selected. But this project clearly does not produce the greatest value to the

company. So why are these techniques still being used in practice?

ARR

Advantages:

It gives a value in percenta ge terms which is a fa miliar measure of

return.

It is relatively easy to calculate compared to NPV or IRR.

It considers the cash flows (but only after adjustment for depreciation

in profit) a rising from the lifetime of the project (unlike PP).

It can be used in selecting mutua lly exclusive projects.

Disadvantages:

It is very much based on the accounting profits and hence technically it

does not deal w ith the actua l cash flows a rising from the project.

It ignores the timing of the cash flows and hence it does not take into

consideration the time value of money.

It is expressed in percentage terms and t herefore it does not measure

the absolute value of the project. It does not indicate how much wea lth

the project creates.

PP

Advantages:

It is computationally straightforwa rd.

It considers the actual cash flows, not profits, arising from a project.

Disadvantages:

It ignores cash flow s beyond the PP and hence it does not provide a full

picture of a project.

It does not consider the time value of money (even though the

discounted payba ck period t akes care of tha t).

The target payba ck period is somehow a rbitrary.

IRR

Advantages:

It uses all relevant cash flows, not accounting profits, arising from a

project.

It takes into account the time value of money.


28/60


22

The difference betw een the IRR and t he cost of capital can be seen as a

margin of safety.

Disadvantages:

The main limitations of using IRR in investment appraisals are that it may

not give the correct decision in the following scenarios:

w hen comparing mutually excusive projects

w hen projects have non-conventional cash flows

w hen the cost of capital varies over time

It discounts all flow s at the IRR rate not the cost of capital rate.

Mutually exclusive projects

Referring to Example 2.1, Project Bs IRR is higher tha n tha t of Project A.

One w ould ra nk Project B a s more desirab le tha n Project A. How ever, if

w e consider the NPV of these projects, there is no d oubt t ha t Pro ject A is,

by far, more valuable than Project B.

Non-convent ional cash f low sA typical investment project has an initial cash outflow followed by

positive cash flows in subsequent years. However, in some cases, a project

(such as oil drilling or mining) may have negative cash flows during its

lifetime. Mathematically, each time the cash flow stream of a project

chang es sign, t here is a possibility tha t multiple IRRs might a rise.

Example 2 .2

Suppose a project requires $100 as a n initial investment. Its Year 1 and Year 2

cash flow s are $260 and $165 respectively. Ba sed on this projects cashflow s, it

produ ces tw o possible IRRs (10% or 50%):

DF PV DF PV

Year Cash f low s 50% 10%

0 100 1 10 0 1 100

1 260 0 .66 7 17 3 0 .90 9 23 6

2 165 0 .44 5 73 0 .82 6 136

Net Present Value 0 0

Suppose th e cost of ca pita l for this project is 20%. According to the IRR rule,

the project should be accepted (as the cost of capital is less than the higher IRR

of 50%). How ever, it should a lso be rejected a s the cost of ca pital is higher tha nthe low er IRR of 10%. So fo r a project w ith non-conventiona l cash flow s, the

IRR decision is sensitive to the cost o f capita l. Therefore it is arg ued th at IRR

does not give an unambiguous decision when dealing with non-conventional

projects.

To furth er illustrat e this problem , lets look at t he NPV profile of the pro ject.

This depicts the relationship of t he NPV of the project a nd its discount ra te. In

the above example, we know that the NPV of the project is zero at both 10%

and 50%.

Suppose t he cost of ca pita l is 5%, 25% or 70%. The NPV of the pro ject w ill

become $2, $2 and $4 respectively. The following diagram shows the NPV

profile of the project. We can see th at , due t o the non -conventional ca sh flow

patt ern, the projects NPV varies at different discount ra tes. It only provides apositive NPV if the d iscount ra te for t he projects cash flow s is betw een 10%

and 50%.


29/60


30/60


24

sensitivity ana lysis.

BMA, Chapter 5, pp.14347 deals with capital rationing and Chapter 6

deals w ith the remaining ad vanced topics. Before you proceed w ith the

following section, it would be advisable to skim through those sections in

the textbook.

Capital rationing

A company may ha ve insufficient funds t o undert ake a ll positive NPV

projects. Due to the shortage of funds, this restriction is more commonly

known a s capital rat ioning. There are tw o types of capital ra tioning.

Hard capital rationing

This is where t he shorta ge of fun ds is imposed by externa l fa ctors. This

might happen in three different w ays:

1. Capita l markets are depressed.

2. Investors are too risk adverse.

3. Tran saction costs a re too high.

Soft capital rat ioning

This may arise when financial managers impose internal restrictions on:

issuing equity to avoid dilution of original shareholders value

issuing debt to avoid fixed interest obligat ion and tra nsaction cost

investing activities in order to maintain a consta nt growth.

In any case, ranking projects by absolute NPV in these situations may

not necessarily give the optimal strategy. Some combinations of smaller

projects ma y g ive a higher NPV.

For each type of capital rationing we can further sub-divide it into twocategories.

Single period capital rationing

If the shortage of funds is only restricted in the first year, the ranking of

projects can be done by using the profitability index. Profita

financial management - lse

Documents