My dissertation is based on two important areas of financial management (i) investment decisions (ii) sources of business finance. Decision on both areas has got critical importance for the business. The importance of investment decision can be checked from these words” for long term survival of the company capital budgeting decisions are very critical” Klammer et al. (1991, p. 113). “Capital investment decisions are very important for the society. These decisions utilize resources of the economy and form a base of business activities for the coming generations. The success of these decisions are very important for a good future of the country” Butler et al. (1993 p49). PBP is the time taken by cash inflows from a capital investment project to equal cash outflows, usually expressed in years (Anon. et al. BPP3.7, 2003 pg 88).ARR is related to annual post tax accounting profits (net of depreciation) to the cost of an investment, profitability being determined by historical accrual methods of financial accounting (Hill et al, 1998 pg 17). NPV is the value obtained by discounting all cash out flows and inflows of a capital investment project by a chosen target rate of return or cost of capital (BPP, paper8 et al, 2003 pg 471). IRR is that discounting rate which gives NPV of zero (ATFL 2.4, 2003 pg 172). The area of capital budgeting is of great interest for the researchers. Since 1960, many studies are made on this topic such as Pike (1983b, 1988b), Sangster (1993), Cowton et al (1995) and Duny et al (1996). While academic prefer NPV but the research made said PBP is vastly used. Further more in sophisticated techniques, preference of IRR is found by researchers that might be due to easy interpretation of it (Klammer, Thomas et al 1984, Ryan 2002). Financing decision is a very important area of corporate financing. Investment needs finance, and there are many sources available. Financing decision is basically a decision that what is the optimal capital structure. The question of whether firms can have an optimal level of capital structure has been far from easy to answer. Hill, A. (1998). These are two basic sources for finance (i) Equity: equity finance is the investment in a company by the ordinary shareholders, represented by the issued ordinary share capital plus reserves and equity finance raised through internally generated funds and rights issues will principally be provided by existing shareholders; new issues will result in a wider shareholder base (ATFL2.4 et al, (2005); Levy, H. and Sarnat, M. (1994) (ii) Debt, long term non equity finance includes preference shares, bonds and debentures, and hybrid securities such as warrants and convertibles; medium term forms are bank loans, leasing and HP; short term debt finance includes overdrafts and trade credit; the government can also be a source of a form of funds, particularly to smaller enterprises. Hill, A. (1998) ;( ATFL2.4 et al, 2005 pg142). The main objective of my dissertation is that what sources of finance are available and how these effects the investment decisions and what capital mix Co should use to appraise its investment? All these questions are answered in my dissertation. Chapter 2 of my dissertation is based the theory of investment appraisal and sources of business finance. I have discussed the complete literature of both investment appraisal and business finance in this chapter (including the merits and demerits of each technique of investment and sources of finance). Chapter 3 of my dissertation describes how the research was made and how the data for the analysis of the effect of the different sources of capital on investment appraisal was collected and how much research I have made for collecting data. I have made my dissertation on the basis of secondary data which is a case study on KNOC plc. In chapter 4 the major findings of my dissertation are calculated i.e. NPV of a project of my selected Company (KNOC PLC) at a particular WACC. Firstly I have calculated WACC (using Ke and Kd) and then I have used this risk adjusted WACC rate to find out NPV and IRR of the project. I have also calculated the PBP of this project. Chapter 5 is based on the discussion and arguments on the statement that what sources of finance effect investment decisions. It basically means that what kind of capital structure is required for investment decision. Here I have presented all the different factors which will affect the investment decision. Finally, I have proved that the project appraised by KNOC was fine. The appraisal which was made on NPV basis was correct. For my own satisfaction I have also calculated the IRR and PBP of the project to be totally confident about the appraisal of the project. The report ends with a conclusion in chapter 6.
This chapter illustrates the theory of investment appraisal and sources of business finance. I will discuss the complete literature of both investment appraisal and business finance in this chapter.
According to Walther et al. (2002) there are two different types of investment decisions (i) Fortune i.e. fixed capital long term oriented decisions and (ii) Payment i.e. cash flow oriented investment decisions. Investment decisions are long term i.e. for more than one year and include decisions such as product range, market positioning and industry, (Pinches 1996); Carsberg, B. (1974) Investment decisions can also be classified as according to (Walther et al 2002). 1. Real investment (i.e. buildings, fleet and machinery)
(i) Expansion (ii) Risk reduction (iii) Cost reduction
(i) One investment project raises the benefit of the project (ii) One investment project disqualifies another project (iii) One investment project removes the benefit from the other project
(i) Initial cash outflow over number of years (ii) Initial cash outflow followed by positive cash inflows
Capital investment involves expenditure on fixed assets for use in a project which is intended to provide a return by way of interest, dividends or capital appreciation. (ATFL, Paper 2.4 et al. p161, 2001)For project to be viable, company must consider all its implications. Any investment can affect the following areas; (ATFL, Paper 2.4 et al. p161, 2001); Richard Pike and Bill Neale et al. (2003); Alan Hill et al. (1998).Capital investments will have an impact on the following areas; 1) It will affect the liquidity position. 2) It will have an affect on the profits and earnings. 3) It will have an affect on the cash flows. 2.4 Investment Appraisal Techniques There are four common techniques of investment appraisal. Gitman et al (2000)
PBP (pay back period) ARR (accounting rate of return) Modern/Sophisticated Methods; NPV (Net present value) IRR (Internal rate of return) For explaining these techniques, an example of PBP can be seen in illustration 2.2 (BPP paper 8 (2000).
Pay back may be defined as the time it takes the cash inflows from a capital investment project to equal the cash outflows, and usually expressed in years. (BPP paper 8 (2000); Mclaney (2003).When deciding between two or more competing projects, normally decision is to accept the one with the shortest payback. Payback is often used as a ‘first screening method’. The organization might have a target payback, and so it would reject a capital project unless its payback period was less than a certain numbers of years. (Levy et al. 1994), (BPP paper 8 p.461 (2000), Gitman (2000). PBP can be explained by the following example. Payback period = Initial payment Annual cash inflow Formula 2.1 Payback Period (PBP) Project A £ Cumulative Cash flows £ Project B £ Cumulative Cash flows £ Capital asset (60,000) (60,000) (60,000) (60,000) Profits before depreciation Year 1 20,000 (40,000) 50,000 (10,000) Year 2 30,000 (10,000) 20,000 10,000 Year 3 40,000 30,000 5,000 15,000 Year 4 50,000 80,000 5,000 20,000 Year 5 60,000 140,000 5,000 25,000
Projects A pays back in year 3 (about one quarter of the way through year 3). Project B pays back half way through year 2. If we use payback alone to judge capital investments, project B would be preferred. But the returns from project A over its life are much higher than the returns from project B. Project A will earn total profits before depreciation of £140,000 on an investment of £60,000. Project B will earn total profits before depreciation of only £25,000 on an investment of £60,000. (BPP paper 8 p.461 (2000).
(a) It is simple to calculate and simple to understand and this may be important when management resources are limited. (b)It can be used as a screening device as a first stage in eliminating obviously inappropriate projects prior to more detailed evaluation. (c) The fact that it tends to bias in favor of short term projects means that it tends to minimize both financial and business risk. (d) It can be used when there is a capital rationing situation to identify those projects which generate additional cash for investment quickly.
Disadvantages of payback period methods which are by BPP paper 8 (2000) (Pinches 1996; Gitman 2000; Boardman et al. 1982)
(a) It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return. (b) It ignores the time value of money. (c) The method is unable to distinguish between projects with the same payback period. (d) It may lead to excessive investment in short term projects.
The accounting rate of return is used in assessing the average accounting profits as a percentage of investment. BPP paper 8, p462. (2000); Levy et al. (1991) If it exceeds a target rate of return, the project will be undertaken. There are several different definitions of ‘return on investment’. BPP paper 8, p462. (2000); Mclaney et al. (2003); Richard Pike and Bill Neale et al. (2003). One of the most popular is as follows. ARR = Estimated average profits × 100% Estimated initial investment (Or) ARR = Estimated average profits × 100% Estimated average investment (Or) ARR = Estimated total profits × 100% Estimated initial investment Formula 2.2 Accounting Rate of Return (ARR)
“A project involves the immediate purchase of an item of plant costing £ 110,000. It would generate annual cash flows of £24,400 for five years, starting in year 1. The plan purchased would have a scrap value of £10,000 in five years, when the project terminates. Depreciation is on a straight line basis. Targeted rate of return (Assuming 6%) Calculate the ARR (ROCE) using; (i) Estimated initial investment (ii) Estimated average investment Solution:
Annual cash flows are taken to be profit before depreciation. Average annual depreciation = (£110,000 – £10,000) ÷ 5 = £20,000 Average annual profit = £24,400 – £20,000 = £4,400 ROCE = Average annual profit × 100 Initial capital cost = £4,400 × 100 £110,000 = 4% Using estimated average investment Average annual profits (as before) = £4,400 Average investment = Initial capital cost + Final scrap value 2 = £110,000 + £10,000 = £60,000 2 ARR (ROCE) = £4,400 × 100 = 7 1/3 % £60,000
According to the calculation if company uses initial investment to find out ARR (ROCE) the project is not viable because 4% is less than the targeted rate of return. But if the revised calculations are checked (which are based upon average investment) then project is viable because 7.333% is more than the company targeted rate of return is 6%. Richard Pike and Bill Neale et al. (2003); (ATFL, Paper 2.4 et al. p164, 2001) The calculation of the ARR is fast, easy and clearly understandable whilst it has some advantages (ATFL, Paper 2.4 et al. p164, 2001); Neale et al. (2004); Proctor et al. (2002). (a) Simplicity; being based on widely reported measures of return (profits) and asset (balance sheet values). (b) It is widely used and sounds familiar to managers and accountants mostly. Whilst the ROCE is a simple and familiar measure, it has various drawbacks that result in it being an unreliable basis for project evaluation; it also has some disadvantages like; BPP paper 8, (2000); (ATFL, Paper 2.4 et al. p164, 2001). (a) ROCE ignores either the project life or the timing of cash flows within the life. (b) ROCE ignores working capital requirements. (c) There is no proper investment signal. The decision to investment or not remain subjective. (d) It does not measure absolute gain in wealth for the business owners. (e) ROCE will change with specific accounting policies and the extent to which project costs are capitalized.
Before discussing NPV we will discuss about the present value .It is the cash equivalent now of a sum of money receivable or payable at a started future date, discounted at a specified rate of return. BPP paper 8, (2000); Arnold, Glen (2002). Net present value is the value obtained by discounting all cash flows and inflows of a capital investment project by a chosen target rate of return or cost of capital. BPP paper 8, (2000); Mclaney (2003) Gitman et al. (2000). NPV= Co + C1 1+r Where, C0 = Cash flow in year 0 C1 = Cash flow after 1 year r = Interest Rate Formula 2.3 Net Present Value (NPV) Illustration 2.3 BPP paper 8 p473, (2000) shows the NPV calculation of the example. “A project involves an immediate purchase of a machine for £90,000 and it will generate an annual cash flow of £30,000 for the 1st 3years and £40,000 in the 4th and final year. The company expects to earn at least 12% p.a. from its investment. (Check the project viability through NPV method). Year Cash flow £ PV factor 12% PV of cash flow £ 0 (90,000) 1.000 (90,000) 1 30,000 0.893 26,970 2 30,000 0.797 23,910 3 30,000 0.712 21,360 4 40,000 0.636 25,440 NPV +7,500
The NPV is positive and so the project is expected to earn more than 12% per annum and is therefore acceptable. BPP paper8, p473, (2000); Mclaney et al. (2003); Arnold, Glen (2002); We can also use annuity formula to calculate NPV for the 1st 3years. So firstly, we must know what annuity is?
It is a fixed periodic payment which continues for a specified time. BPP paper 8, (2000); Mclaney et al. (2003); PV of annuity = FV (1-(1+r)-n ) r Formula 2.4 (Annuity) We can calculate the above NPV example through annuity factor also, it is as follows. PV for 1st 3years = 30,000 (1-(1.12)-3) 0.12 = 30,000 (2.402) 72060 PV of 4th year = 40,000 (1.12)-4 25440 Total PV cash inflows 97500 Total PV of cash out flow (90000) NPV 7500 Illustration 2.4. (Calculation of Annuity) So it is clear from the solution that NPV is the same, as before, by using annuity facto. Mclaney et al. (2003); BPP paper 8, (2000; Richard Pike and Bill Neale et al. (2003);
Another important concept is that of perpetuity. It means “an annuity continuing for a limit less time periods”. BPP paper 8, (2000; Mclaney et al. (2003); ATFL, Paper 2.4 et al. (2001) PV of Perpetuity = (Annual cash inflow) = (A) Discount rate R Formula 2.5 (Perpetuity) For example PV of £6,000 receivable annually in arrears at a discount rate of 7% is; (£6,000/0.07) = £85714(approx). BPP paper 8, (2000). Illustration 2.5. (Calculation of Perpetuity)
Relevant cash flows Relevant cash flows are the future incremental cash flows of the organization as a whole which arise as a result of the project’s acceptance. ATFL, Paper 2.4, P179, et al. (2001) Levy et al. (1994) Relevant cash flows = cash flow if projected accepted – cash flow if projected rejected. Examples of the costs that are irrelevant to DCF appraisals are depreciation, apportioned overheads, book value of assets, sunk costs, interest and dividends. Dury, C. (2000); ATFL, Paper 2.4, P179, et al. When deciding between the two projects that which one is to be accepted, normally, two approaches are used; 1) Discount the cash flows of each project separately and compare NPV’s. 2) Find differential/incremental cash flows year by year and then by using discounted value of that differential cash flow to set up the preference. Either approach will give the conclusion. ATFL, Paper 2.4, et al. (2001); Pike, R and Neale, B. 2003
DCF and inflation
Inflation is said to be a general price increase leading to a general decline in the real value of money. BPP paper 8, (2000); Artill, P. and McLaney, E. 2002 There are 2 impacts of inflation on DCF project appraisal 1) The discount rate given may include an allowance for a general rate of inflation. BPP paper 8, (2000); Hill, A. (1998). 2) The cash flows may be subject to inflation, possibly at different rates for different flows. Hill, A. (1998). The discount rate shows the investor’s required rate of return. In times of inflation investor needs return made up of two things. BPP paper 8, (2000); Carsberg, B. 1974. 1) A return to compensate for inflation. 2) A real return on top of this for the use of their funds. The required rate which is made up of both of these elements is called money return. ATFL, Paper 2.4, et al. (2001).
Money discount rates and cash flows include the effect of inflation. Real discount rates and cash flows exclude the effect of inflation. ATFL, Paper 2.4, et al. (2001). Hirst, I. (1998).
DCF and taxation
Taxation has two major effects on DCF project appraisal. 1) Project cash flows will give rise to taxation which itself has an impact on project appraisal. 2) Tax relief on interest payments will reduce the effective rate of interest which a firm pays on its borrowings, and hence the opportunity cost of capital. Pike, R and Neale, B. 2003. The effects of taxation are complex, and are influenced by a number of factors including the following. Taxable profits and tax rate. Co’s accounting period and tax payments dates. Capital allowances. Losses available for set-off. When ever tax is relevant to investment appraisal careful checking of tax rates, timings and capital allowances are necessary. ATFL, Paper 2.4, et al. (2001). Levy, H. and Sarnat, M. 1994.
The internal rate of return (IRR) is that discount rate which gives a net present value of zero. ATFL, Paper 2.4, et al. (2001); Mclaney et al. (2003) BPP paper 8, p475 (2000); Hill, A. (1998). For IRR, first step is to calculate 2 NPV’s. Ideally 1’+’ and 1′ – ‘. For the rate which we have to calculate first NPV is, roughly we can say, 2/3 of ROI/ARR. BPP paper 8, p475 (2000); Illustration 2.6(i) BPP paper 8 p476, (2000) shows the IRR calculation of the example. Cost of an asset = £80,000 Cost saving = £20,000(for 5 yrs) Scrap value = £10,000 DCF return = 10% Depreciation = Straight line method
Annual depreciation would be £ (80,000 – 10,000)/5 = £14,000. The return on investment would be: 20,000 – Depreciation of 14,000 = 6,000 = 13.3% ½ of (80,000 + 10,000) 45,000 Two third of this is 8.9% and so we can start by trying 9%. The IRR is the rate for the cost of capital at which the NPV = 0. BPP paper 8 p476, (2000) Try 9%; Year Cash flow £ PV factor 9% PV of cash flow £ 0 (80,000) 1.000 (80,000) 1-5 20,000 3.890 77,800 5 10,000 0.650 6,500 NPV 4,300
Illustration 2.6(i). Example of calculating IRR
It is fairly close to zero. It is also positive, which means that the real rate of return is more than 9%. BPP paper 8 p476, (2000); Gitman et al. (2000) We can use 9% as one of our two NPVs close to zero, although for the greater accuracy, we should try 12%. Hirst, I. (1998); BPP paper 8 p476, (2000); Procter et al. (2002). Try 12%; Year Cash flow £ PV factor 12% PV of cash flow £ 0 (80,000) 1.000 (80,000) 1-5 20,000 3.605 72,100 5 10,000 0.567 5,670 NPV (2,230)
Illustration 2.6(ii) Example of Investment Calculation with IRR
This is fairly close to zero and negative. The real rate of return is therefore greater than 9% (positive NPV of £4,300) but less than 12% (negative NPV of £2,230). BPP paper 8 p476, (2000); Walther et al. (2002); Rosenblatt et al. (1979). We shall now use the two NPV values calculated earlier to estimate the IRR. The interpolation method assumes that the NPV rises in linear fashion between NPVs close to 0. The real rate of return is therefore assumed to be on a straight line between NPV = £ 4,300 at 9% and NPV = -£2,230 at 12%. The formula for IRR is; IRR= A + [ P × (B – A)] % P-N Formula 2.6 Internal Rate of Return (IRR) Where; A is the (lower) rate of return with positive NPV B is the (higher) rate of return with a negative NPV P is the amount of the positive NPV N is the absolute amount of the negative NPV IRR= 9 + [ 4,300 × (12 – 9)] % = 11% (approx) 4,300 + 2,230 We can undertake this project because IRR is greater than DCF return. BPP paper 8 p476, (2000); Proctor et al. (2002); Dury, C. (2000); Walther et al. (2002). Y 5000 4000 A 3000 (NPV) 2000 1000 IRR 11% (approx) 0 X 1000 3 6 9 12 COC (1) 2000 3000 B Y1 Graph 2.1 Internal Rate of Return (IRR)
Investment decisions using NPV and IRR criteria may appear to conflict. ATFL, Paper 2.4, et al. (2001); Walther et al. (2002); Dury, C. (2000) The conflict may arise; Single investment decision Mutually exclusive investments Projects with multiple yield
There is no conflict between NPV and IRR in single investment decision. If the NPV is positive it means that IRR is greater than the required rate of return. So there is no problem in accepting the project. BPP paper 8, (2000); ATFL, Paper 2.4, et al. (2001); Hirst, I. (1998)
We can explain the conflict in mutually exclusive investments by the help of following illustration 2.8(i) Time 0 1 Project A (£’000) (200) 240 Project B (£’000) (100) 125 Company has a cost of capital of 10%. Find the NPVs and IRRs of the two projects. NPV £’000 IRR % Project A (240 ÷ 1.10) – 200 18.18 20 Project B (125 ÷ 1.10) – 100 13.64 25
IRR is calculated through trial and error. NPV of project A is more than the NPV of Project B and IRR of B is greater than IRR of A. Graphical and Theoretical Explanation of the problem NPV versus Discount rate for mutually exclusive projects Graph 2.2 (NPV versus IRR Conflict) In the above given diagram, discount is taken along x- axis and NPV is taken along y- axis. IRR of project A is 20% and B 25%. Both the line intersect at 15%.project B has more IRR, where as at the coast of capital at 10% Project A has more NPV. ATFL, Paper 2.4, et al. (2001); Hirst, I. (1998); Pinches (1996) The golden rule is to accept the project with higher NPV and this is because; to maximize shareholders wealth (that is the NPV). Project B shows higher relative return, it is on a smaller investment providing lower absolute benefits. (It is assumed that B can not be done twice) ATFL, Paper 2.4, et al. (2001); Project B gives more NPV for all discount rates above 15%. But this is irrelevant to the investor as the cost of capital is just 10%. The higher IRR of project B shows that project b will have a +NPV over a wider range of discount rate( 0 to 25%) than A (0 to 20%) and this is useful for sensitivity analysis where the discount rate is not certain. ATFL, Paper 2.4, et al. (2001); Gitman (2000); Mclaney (2003).
It can be explained by the following illustration2.7 (ii); Time Project A £ Project B £ Project C £ 0 (5,000) (10,000) (100,000) 1 2,000 23,000 360,000 2 2,000 (13,200) (431,000) 3 2,000 (1,000) 171,600
These cash flows can be plotted in graphic form; Project A Graph 2.3(i) (IRR of Multiple Yield Project) Project B Clearly it is difficult to use the IRR method in these circumstances. Graph 2.3(ii) (IRR of Multiple Yield Project) Project C Graph 2.3(iii) (IRR of Multiple Yield Project) Project A is a conventional project, with one outflow followed by several net inflows and has an IRR of 10%. Project B is an unconventional project with outflows of significant size appearing at the start and at the end of the project and has no IRR. Project C has got 3 IRR at 10%, 20% and 30%. ATFL, Paper 2.4, et al. (2001); Dury, C. (2000)
Project A had an outflow followed by inflows, where as project B had outflows then inflows, but then further inflows. There may be as many IRRs as there are changes in sign in the patterns of cash flows. Clearly project C has three changes in sign and has three IRRs; although project B has two changes in sign but no IRRs. ATFL, Paper 2.4, et al. (2001); Pike, R and Neale, B. (2003); Levy, H. and Sarnat, M. (1994) Yields provide further evidence that the NPV method is superior to IRR. (Walther el at.2002); ATFL, Paper 2.4, et al. (2001); Mclaney et al. (2003).
NPV is worked out by using opportunity cost of capital There is not logic in assuming that cash generated by various projects in any single period will be reinvest at various rates of return, simply because the projects have different rates of return. There is no logic in assuming that cash generated from project will be re invested at its IRR rate. IRR does not deal adequately with different sized projects IRR is relatively in sensitive to interest rate changes.
It is easy to communicate, since users are familiar with percentages. IRR can be used to give a crude indication of crucial errors in the project appraisal. IRR does not require knowledge of discounting factors before proposals are evaluated and therefore helps in formulating immediate ranking of the projects. IRR allows the managers to incorporate certain qualitative judgments within the frame work of a formal analysis. Such as pride, image, risk etc. associated with the project by looking at difference in margin of safety indicated by such projects. Pike, R and Neale, B. (2003); Walther et al. (2002); Evans et al. (1993); Pinches et al. (1996).
Survey made by RH Pike (1992) produced the following results of 100 large UK firms. Total Always Mostly Often Rarely Firms using % % % % % Payback 94 62 14 12 6 Accounting rate of return 50 21 5 13 17 Internal rate of return 81 54 7 13 7 Net present value 74 33 14 16 11 (Source: Pike & Neale, Corporate finance and investment)
Almost two thirds of the firms surveyed by Pike used there or more appraisal techniques, indicating that DCF techniques complement rather than replace more traditional approaches, Hirst, I. (1998). PBP is used by 94% of the companies. But it is a traditional method with some limitations as described above. Its wide spread use is done due to its simple calculation. ARR is used by half of the companies because of its importance in practice i.e. the rate of return on capital as a financial goal. Data shows that IRR is preferred over NPV (in spite of theoretical superiority of NPV) because it is a convenient way of ranking projects in % terms BPP paper 8, (2000).
Kin et al. (1982) said that companies using DCF’s shows better performance. Klammer (1973) said that investment appraisal techniques are only tools of measuring a project’s viability and qualitative factors are more important than these tools; Farragher (2001); Kim (1982). “Managerial sophistication, as reflected by the adoption of selected analytical practices and positively affects the likelihood of better than average firm performance” Moore et al p86. (1989); Haka et al. (1985)
As described in investment appraisal techniques and companies’ performance, qualitative factors (such as employees, image, legal etc) risk and uncertainty considerations are very important for investment decisions, Proctor et al. (2002). Different methods are used to consider risk in project appraisal such as sensitivity analysis, Klammer et al. (1991); (Rosenblatt et al.1979) Risk appraisal techniques can be divided into two groups’ i.e., (Ho et al. 1991) (i) Simple risk adjusted (ii) Probabilistic risk Because of change in economic environmental uncertainty companies mostly use simple risk adjusted and increase the use of probabilistic method, (Ho et al. 1991); Hirst, I. (1998); ATFL, Paper 2.4, et al. (2001). The application of these risk and qualitative factors is not so easy. More time is consumed in estimation and qualitative factors may change over time, (Bates et al. 2003); Pike, R and Neale, B. (2003); Hirst, I. (1998). (ii) Financing Decisions
Finance is required to (i) Fulfill the gap between paying for production of finished goods and receiving money from customers (working capital). (ii) Purchase of fixed assets (i.e. fixed capital) Major sources of finance are retained profit but some times it is insufficient. So short, medium and long term finance are used to finance any project. Stevenson, A and Jennings, E. (1981); Hirst, I. (1998)
Capital Market Money Market Sources of long term finance Sources of medium and short term finance
Short- -term up to one year Medium-term 1 year to 7 years Long-term 7 years or more ATFL, Paper 2.4, et al. (2001)
If the cost of funding is high then company’s profit will be less. Debt is cheaper than equity. Debt provider has less risk as compare to equity provider and so he also earns less return. Interest on debt finance is corporation tax deductible while equity returns are not. Radcliffe, R. (1994); Hill, A. (1998)
Long term finance is more expensive than short term. This is because long term finance has more risk as compare to short term. Long term finance though, has an advantage of security (not short term finance). Thumb rule says; “Long term assets should be financed by long term funds and short term assets by short term funds”. Dury, C. (2000); ATFL, Paper 2.4, et al. (2001)
Gearing is the ratio of debt to equity. High gearing means use of more cheap debt finance as compare to equity. But then the owner has to pay regular interest payments plus the capital portion of the loan. On the other hand, too little debt might results in earning dilution. Levy, H. and Sarnat, M. (1994);
Small companies normally have accessibility problem for finance sources (not large companies). Carsberg, B. (1974) Quoted Companies; a quoted company is one whose shares are dealt in a recognized stock market, so shares in such a company represent a highly liquid asset. This, in turn, makes it mush easier to attract new investors to buy new shares issued by the company. Carsberg, B. (1974) Unquoted Companies; investment in shares of unquoted companies represents the acquisition of highly illiquid investment. For this reason it is much more difficult for such a company to raise finance by new shares issues. Hirst, I. (1998)
Issued ordinary share capital plus reserves make equity finance. Hirst, I. et al. (1998)
Ordinary Preference Shares Shares Cumulative Non Cumulative Preference Shares Preference Shares Type of Share Capital Security or Voting Rights Income Amount of Capital
Usually have voting rights in general meetings of the company. Rank after all creditors and preference shares in rights to assets on liquidation. Dividends payable at the discretion of the directors (subject to sanction by share holders) out of undistributed profits remaining after senior claims have been met. Amounts available for dividends but not paid out are retained in the company on behalf of the ordinary shareholders The rights to all surplus funds after prior claims have been met.
Right to vote at a general meeting only when dividend is in arrears or when it is proposed to change the legal rights of the shares. Rank after all creditors but usually before ordinary shareholders in liquidation. A fixed amount per year at the discretion of the directors subject to sanction of shareholders and in accordance with rules regarding dividend payments; arrears accumulate and must be paid before a dividend on ordinary shares may be paid. Note that unlike other firms of debt, the dividend paid on preference shares is not corporation tax deductible.
Non- cumulative preference shares Likely to have some voting rights at all times rather than in specified circumstances as in the case of cumulative. Rank as cumulative in liquidation. A fixed amount per year, as above; arrears do not accumulate. A fixed amount per share. Radcliffe, R. (1994); ATFL, Paper 2.4, et al. (2001)
There are three main sources of equity finance are; Pike, R and Neale, B. (2003) 1. Internally generated funds – retained earnings 2. New external share issues – placings, offers for sale etc 3. Rights issues
Internally generated funds comprise retained earnings (i.e. undistributed profits attributable to ordinary shareholders) plus non cash charges against profits (e.g. depreciation) Internally generated funds are a cheap and immediate source of finance; however, the company’s dividend policy must be taken into account when determining the level of usage. Artill, P. and McLaney, E. (2002);
New shares can be issued by private negotiation, placing, or offer for sale, or by a right issue. Levy, H. and Sarnat, M. (1994); Type of Company Company requirement Method of issue Type of investor Unquoted Finance without an immediate stock market quotation. Private negotiation or placing; enterprise investment scheme (EIS) Individuals, merchant banks, finance corporations. Unquoted quoted Finance with an immediate quotation. Finance with a new issue. Stock exchange or small firm market placing; offer for sale; offer for sale by tender. The investing public, pension funds, insurance companies and other institutions. Quoted or Unquoted Limited finance without offering shares to non shareholders. Rights issue. Holders of existing shares. Table 2.5(New external share issues) New issues for Unquoted Companies In the modern business environment, it can be difficult for small unquoted companies to raise equity finance from outside shareholders. Due to the following reasons; Dury, C. (2000); The shares are not easily realizable. Costs can be kept down by investing in large parcels of shares rather than spreading investment over many small companies. Small firms are regarded as more risky (for example they may lack proper financial control system). Becoming quoted (listed) The possible methods of obtaining a stock exchange listing in the UK are an offer for sale by prospectus, an offer for sale by tender, a placing or an introduction. Hill, A. (1998);
Offer for Sale by Prospectus
An offer for sale is an invitation to apply for shares in a company based upon information contained in a prospectus. Hill, A. (1998);
Offer for Sale by Tender
Shares are offered to the general public (including institutions) but no fixed price is specified. Potential investors bid for shares at a price of their choosing. The ‘striking price’ at which the shares are sold is determined by the demand for shares. Stevenson, A and Jennings, E. (1981); Levy, H. and Sarnat, M. (1994);
A placing may be used for smaller issues of shares (up to £ 15m in value). The bank advising the company selects institutional investors to whom the shares are ‘placed’ or sold. Carsberg, B. (1974);
An introduction is used where there is no new issue of shares and the public already holds at least 25% of the shares in the company (the minimum requirement for a stock exchange listing). Hirst, I. (1998);
A right issue is an offer to the existing shareholders to subscribe for more shares, in proportion to their existing holding, usually at a relatively cheap price. Radcliffe, R. (1994);
Pricing of rights issues
Rights issues are usually priced at below the current market price to give the shareholders an incentive to take up their rights. The new share price after the issue is known as the theoretical ex – rights price and is calculated as follows;
Market value of old shares
Theoretical ex-rights price = before rights issue + (Proceeds of rights) Number of shares ex-rights Formula 2.7 (Theoretical ex-rights price) Illustration 2.8 (ATFL, Paper 2.4 et al. p111, 2001) shows the calculation of the pricing of rights issues example. “Alpha PLC, which has an issued capital of 1,000,000 shares with a current market value of £1 each, makes a rights issue of one new share for two existing shares at a price of 40p, raising £200,000. The ex-rights price is 80p each, calculated as follows”; (Market value of old shares) + (proceeds of rights issue) = 1000000 + 200000 Number of shares ex-rights 1500000 = 80p Illustration 2.8 Example of the Pricing of Rights Issues The shareholder’s options The shareholders’ options with a rights issue are to do one of the following; Pike, R and Neale, B. (2003); ATFL, Paper 2.4 et al. (2001) 1. Take up their rights by buying the specified proportion at the price offered. 2. Renounce their rights and sell them in the market. 3. Renounce part of their rights and take up the remainder. 4. Do nothing. Shareholders must take some action on a rights issue if they are not to lose out as a result.
The dividend valuation model states that; the value of a security = the future expected returns from that security discounted at the security holder’s required rate of return. ATFL, Paper 2.4, et al. (2001)
Extra Polation Past Dividend Current Dividend = Past Dividend (1 + g) n Formula 2.16 (Extra polation of past dividend) RB Model g = RB Formula 2.17 (RB Model) Where R = rate of return on investments B = proportion of retained profits for investment R = PAT or PAT SH, fund Net operating Assets B = Retained Profit PAT
It is the policy that company uses to decide how much it will pay out to the shareholders in dividends. A company’s dividend policy can be used as a signal by investors on management’s view of the company’s future prospects. Companies are generally severely punished in the marketplace for dividend decreases. Therefore, dividend increases usually occur only when management is confident of the earnings and cash flow prospects of the company. https://bwnt.businessweek.com/Glossary/definition.asp?DEFCode=D35
The term clientele effect describes the tendency of companies to attract particular types of shareholders because of their management organisation and policies, particularly dividend policies. BPP paper3.7, p 519 (2004)
Invest in any project with positive NPV Only when these investment opportunity are not their should dividends to be paid or not? BPP paper3.7, (2004)
Focus is on the effect of share price The share price depends upon the mix of dividends given share holders required rate of return and growth
According to MM in tax free economy, the value of the company is determined by the earning power of its assets and investment. M said that if company decides to pay dividend and it there is a shortage of retain earnings to make investment then additional funds are obtained from outside so; MM said that company should follow a consistent dividend policy which would attract and encourage all the existing and potential shareholders. (This was MM answer to the critics about dividend preference).there is strong arguments against MM views that dividend policy is irrelevant to share holder’s wealth. 1. Differing rates of taxation on dividends and capital gains can create a preference for a high dividend or one for high earnings retention. 2. Dividend retention should be preferred by companies in a period of capital rationing. 3. Due to imperfect markets and the possible difficulties of selling shares easily at a fair price, shareholders might need high dividends in order to have funds to invest in opportunities out side the company. 4. Markets are not perfect. Because of transaction costs on the sale of shares, investors who want some cash from their investments should prefer to receive dividends rather than to sell some of their shares. 5. Shareholders will tend to prefer a current dividend to future capital gains (or deferred dividends) because the future is more uncertain.
High flotation costs on new equity cause the difference between the cost of new equity and the cost of retained earnings to be greater.
Firms are likely to increase dividends if their managements think that profits will increase in the future. Investors, thus, perceive dividend increases as positive signals. Firms may want to increase dividends in order to give a positive signal to shareholders.
Firms with good investment opportunities to invest in capital projects are likely to pay low dividends so, they can use retained earnings rather than new equity capital to finance capital projects.
Actual vs. Target Capital Structure
Firms that have actual debt ratios those are higher than their target debt ratios maybe likely to pay lower dividends in order to move closer to their target capital structures. Firms that have actual debt ratios that are lower than their target debt ratios may be likely to pay higher dividends in order to move closer to their target capital structures.
Firms generally would be more generous in paying dividends, the higher their earnings are. Firms sometimes stop paying dividends when they have losses. https://www.ssc.uwo.ca/bacs/courses/310/peters/DIVIDEND%20POLICY.pdf#search=’factors%20affecting%20dividend%20policy‘; McLaney E. 2005
2.18. Debt and Other Sources of Finance
BPP paper3.7, (2004)
My dissertation focus is on long term finance so; I shall be discussing debentures in detail.
2.18 1. Corporate Bonds / Debentures
A debenture is a written acknowledgment of a debt by a company, normally containing provisions as to payment of interest and the terms or repayment of principal. It may also be referred to as a corporate bond or loan stock. ATFL, Paper 2.4, et al. (2001); BPP paper3.7, (2004)
2.18.2. Secured Debt
Secured debt will carry a charge over; BPP paper3.7, (2004) ATFL, Paper 2.4, et al. (2001); One or more specific assets, usually lands and buildings, which are mortgaged in a fixed charge All assets – a floating charge
2.18.3. Irredeemable and Redeemable Debt
Irredeemable debt is not repayable at any specified time in the future; interest is payable ad infinitum. As well as some debentures, preference shares are often irredeemable. If the debt is redeemable the principal will be repayable at a future date. ATFL, Paper 2.4, et al. (2001); Irredeemable Debt MVo (ex int) = i/r (without tax effect) Formula 2.18 (MV Irredeemable Debt without tax effect) MVo (ex int) = i (1 – t)/r (with tax effect) Formula 2.19 (MV Irredeemable Debt with tax effect) Where i = PV of future int; payment r = debt providers t = corp. tax rate But we know that Debt providers required rate of return = min cost of debt (for Co.) Dury, C. (2000); i.e. r = Kd So r = Kd = i/MVo (ex int) (without tax effect) Formula 2.20 (Kd without tax effect) r = Kd = I (1 – t)/ MVo (ex int) (with tax effect) Formula 2.21 (Kd with tax effect) Redeemable Debt We use IRR formula for this (hit and trial method) A + NA/NA – NB (B – A) Where A = lower discount rate B = higher discount rate NA = NPV of lower discount rate NB = NPV of high discount rate
Formula 2.22 (Redeemable Debt Calculation using IRR)
We can calculate the cost of redeemable and irredeemable debt by the following examples. ATFL, Paper 2.4, et al. (2001); 10% debentures = £100(nominal value) MVo = £90 (ex int) Find cost of capital if debt is (i) irredeemable (ii) redeemable at par (after 10 yrs) Irredeemable Kd = i/MVo (ex-int) = 10/90 = 11.1% (ii) Redeemable (Calculation of Discount Rate) Interest = 100 – 90 = 10 £ 10 will be earned in 10 yrs So, int 1 yr = 10/10 = +1 So 1/90 = 1.11% So 11.1% + 1.11% = 12.21% or 12% (approx) Years CF’s NPV (12%) 0 Current MVo (ex int) (90) (90) 1 – 10 Int (100 * 10%) 10 56.5 10 Redemption at par 100 32.2 (1.30) ATFL, Paper 2.4, et al. (2001); Calculate NPV at 11% Years CF’s NPV (11%) 0 (90) (90) 1 – 10 10 58.89 10 100 35.2 4.09
A + NA/ NA – NB (B – A) 11 + 4.09/ 4.09 + 1.30 (12 – 11) = 11.76% Kd calculated above represents * Cost of continuing to use finance rather than to redeem it * Shows cost of raising additional fixed interest capital (assume current int cost = future int cost here in point (ii)) ATFL, Paper 2.4, et al. (2001); Illustration 2.11(Calculation of Kd redeemable and Irredeemable without tax) We can calculate the cost of redeemable and irredeemable debt with tax by the following examples. ATFL, Paper 2.4, et al. (2001);
Irredeemable with Tax
(A) Issues 12% irredeemable debt (nominal value £100) quoted at £92 (cum int). Corp Tax is 33%; ATFL, Paper 2.4, et al. (2001); Find Kd Kd = i (1 – t)/ MVo (ex int) = 12(0.67)/ 80= 10.05% Redeemable with Tax; ATFL, Paper 2.4, et al. (2001); 8% deb = £100 (nominal value) MVo = £103 (cum interest) Debt is redeemable after 3 years at par Corporation tax rate = 30% Tax is paid each year on 31st December on profits earned in the year ended on previous 31st December; Item Date year Cash flow Ex int £ PV 5% £ PV 8% £ Market Value 0 (95.00) (95.00) (95.00) Interest 31.12.x3 1 8.00 7.62 7.41 Tax Saved 31.12.x4 2 (2.40) (2.18) (2.06) Interest 31.12.x4 2 8.00 7.26 6.86 Tax Saved 31.12.x5 3 (2.40) (2.07) (1.91) Interest 31.12.x5 3 8.00 6.91 6.35 Tax Saved 31.12.x6 4 (2.40) (1.98) (1.76) Redemption 1.1.x6 3 100.00 86.40 79.40 NPV 6.96 (0.71) BPP paper3.7, (2004) The estimated cost of capital is; 5% + ( 6.96 * 3%) = 7.7%) (6.96 – -0.71) Illustration 2.12(Calculation of Kd redeemable and Irredeemable with tax)
2.19. Weighted Average Cost of Capital (WACC)
It is used to calculate the cost of new funds raised for new investments. BPP paper3.7, (2004); WACC Ke (E/ E + D) + Kd (D/ E + D) Formula 2.23 Weighted Average Cost of Capital (WACC) WACC can be explained by the help of following example. Suppose Ke =18%, Kd 12 % debt to equity 1:2. Find WACC = (Ke E ) + (Kd D ) E + D E + D = (18 2 ) + (12 1 ) 3 3 = 16% Illustration 2.13(Calculation of WACC)
Assumptions of WACC
(a) The company pays out all its earnings as dividends. (b) The gearing of the company can be changed immediately by issuing debt to repurchase shares, or by issuing shares to repurchase debt. There are no transaction costs for issues. (c) The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these futures earnings. expectations about these future earnings. d) Business risk is also constant, regardless of how the company invests its funds. (c) Taxation, for the time being, is ignored. BPP paper3.7, (2004); ATFL, paper 2.4, et al. (2001)
Arguments against WACC
The business risks faced by the company and that of project may be different. It is assumed that WACC shows long term capital structure and capital cost of company. But the finance raised for new project might change the capital structure which might affect the financial risk. If floating debt is used to fiancé the project. It is not easy to incorporate floating debt rate into WACC computations. Ignores impact of personal taxations. Assumes a constant tax rate which is not possible always. ATFL, Paper 2.4, et al. (2001); Hill, A. (1998)
2.20. Theories for Gearing/ Debt Financing
Theories for Gearing/ Debt Financing Traditional view Net operating income Approach/ MM Approach
2.20.1. MM approach
Assumptions 1. Investors are rational 2. Information is freely available 3. No transaction cost 4. Debt is risk free 5. Investors are indifferent between corporate and personal borrowings 6. Debt is irredeemable 7. No tax (corporate or personal) Hill, A. (1998); BPP paper3.7, (2004)
Think WACC as overall return on Co’s assets (thus WACC is just like ROCE). So as ROCE reflects the risky nature of business in which the Co is engaged (i.e. business risk ) and the BR is unaffected that how the Co is financed and so WACC will be unaffected by gearing level. BPP paper3.7, (2004); Pike, R and Neale, B. (2003) Y Cost of Capital WACC 0 X (Gearing)
Assuming Kd remains constant and WACC is also constant (as explained above). So if gearing increases Ke (linear in proportion) BPP paper3.7, (2004) Y Ke Cost of Capital WACC Kd 0 X (Gearing)
Gearing (given that) has no impact on WACC then it will have no impact on the overall value of the company. BPP paper3.7, (2004) Y Cost of Capital V 0 X (Gearing)
MM justified its approach through arbitrage. It means trading in shares and debt to get profit by different prices in different companies (or) buying and selling of securities to profit from different market prices. In the end MM concluded that capital structure of Co has no effect on the overall value of WACC. BPP paper3.7, (2004); Levy, H. and Sarnat, M. (1994)
The response to MM (no tax analysis) by the world is called the traditional view. BPP paper3.7, (2004); Advantages of Debt Finance Disadvantages of Debt Finance (a) Kd < Ke (a) As gearing Ke (b) Tax relief on interest (b) As gearing the different classes of debt also feels their own financial risk and so Kd Traditional view argues that; At low level of gearing; Advantages of debt > disadvantages of debt And so the company’s overall cost of capital is lowered but at high gearing level; Advantages of debt < disadvantages of debt, so company’s overall cost of capital rises. These results in U shaped WACC and the optimal structure at gearing ratio that minimises WACC and at this point value of company is maximised. BPP paper3.7, (2004) Y Ke Cost of WACC Capital Kd 0 X Y (Gearing) Value of Company V 0 X (Gearing)
In no tax analysis it made no difference whether equity or debt financing is used. But difference comes in with tax analysis. Government subsidises one form of finance i.e. debt (by giving tax relief on interest). But don’t subsidises equity (because no tax relief on dividends is given).Other reason for cheap debt finance is that debt holders required rate of return is less. So companies should be using more debt as compare to equity finance because it’s cheap. So when more and more of debt finance are used WACC falls. BPP paper3.7, (2004); McLaney E. (2005) Y Cost of Ke Capital Increase financial risk pushes up Ke Tax relief on interest pushes down WACC WACC Kd 0 X (Gearing)
Graph 2.6(i) (MM with Tax Analysis)
As more debt is used it gets more tax relief which reduces tax liability. This falling function will give rise to value of company. McLaney E. (2005); Dury, C. (2000) Y V Value of Company 0 X (Gearing)
Graph 2.6(ii) (MM with Tax Analysis)
M&M conclusion now changes; capital structure is now important and companies should use more and more of debt finance if they want to maximise the value of firm. Dury, C. (2000); BPP paper3.7, (2004) Formulas of MM theory Without Tax With Tax (1) WACC (g) = WACC (ug) (1) WACC (g) = WACC (ug) * 1 – (Dt/ D + E Formula 2.24 MM without Tax Formula 2.27 MM with Tax But WACC = value of business where Dt = tax savings caused by debt So, So, (2) MV (g) = MV (ug) + Dt Formula 2.28 MM with Tax (2) MV (g) = MV (ug) (3) Ke (g) = Ke (ug) + (Ke (ug) – Kd (g) (1 – t)) * D/ E Formula 2.25 MM without Tax Formula 2.29 MM with Tax Since Ke is present in both ‘g’ and ‘ug’ Co’s So, (3) Ke (g) = Ke (ug) + (Ke-(ug) Kd (g)) * D/E Formula 2.26 MM without Tax ATFL, Paper 2.4, et al. (2001)
Example of MM (Without Tax)
Loesch plc is an all equity company and its cost of equity is 12%. Berelco plc is similar in all respects to Loesch plc, except that it is a geared company, financed by £1,000,000 of 3% debentures (current market price £50 percent and 1,000,000) ordinary shares (current market price £1.50ex div). What is Berelco’s cost of equity and weighted average cost of capital? ATFL, Paper 2.4, et al. (2001); BPP paper3.7, (2004)
We know that without tax WACC (g) = WACC (ug) alternatively WACC (g) = (Ke (g) * E/E+ D) + (Kd (g) * D/ E +D) Kd (g) = i/MVo (ex int) = 1000000 * 3%/ 1000000 * 50% = 6% Ke (g) = Ke (ug) + (Ke (ug) + Kd (g)) * D/E = 12 + (12 – 6) * 1/3 = 14% So, WACC = (14 * 3/4) + (6 * 1/4) = 12%
Example with Tax Effect
“Find cost of equity and WACC for Berelco plc with same information as in last example. The corporation tax rate is 30%”. BPP paper3.7, (2004); ATFL, Paper 2.4, et al. (2001)
WACC (g) = (WACC (ug) 1 – Dt/D+E) WACC (g) = (12 – 1 * 30%/1 +3) = 11.1%
WACC (g) = (Ke (g) * E/E + D) + (Kd (g) * D/E+D) Kd (g) = i (1 – t)/MVo (ex int) = 30/500 = 4.2% Ke (g) = Ke (ug) + (Ke (ug) – Kd (g)) (1 – t) * D/E Ke (g) = 12 + (12 – 6) (0.7) * 1/3 Ke (g) = 13.4% WACC = (13.4 * 3/4) + (4.2 * 1/4) = 11.1%
WACC (g) < WACC (ug) 11.1 < 12 Due to cheap debt (as Gearing WACC Illustration 2.15. MM (With Tax)
Now I will explain important share holders and debt holder’s ratios. But firstly I will explain the most important ratio of gearing. Gearing; Debt/total finance (debt+ equity) Formula 2.30 (Gearing) Debt Holder Ratios (i) Interest Cover PBIT/Interest Charges for the year Formula 2.31 (Interest Cover) (ii) Interest Yield Interest on debenture/MV of debenture Formula 2.32 (Interest Yield) Shareholder Ratios (i) Dividend per Share Ordinary Dividend/Ordinary Share Capital Formula 2.33 (Dividend per Share) (ii) Dividend Cover PAT – Preference Dividend/Ordinary Dividend Formula 2.34 (Dividend Cover) (iii) Dividend Yield DPS/MV of ordinary shares Formula 2.35 (Dividend Yield) (iv) Return on Equity (ROE) PAT – preference dividends/ordinary share capital * 100% Formula 2.36 (Return on Equity) (v) Earning per Share (EPS) PAT – preference dividend /Ordinary Share Capital
(vi) Price Earnings Ratio (PE ratio) MV of Ordinary Shares /EPS Formula 2.38 (Price Earnings Ratio) ATFL, Paper 2.4, et al. (2001); BPP paper3.7, (2004); Dury, C. (2000); Hill, A. (1998)
As we have already discussed in MM (tax effect) theory that debt finance is cheap as compare to equity finance. So it must be included in capital structure to reduce overall WACC. However, we have not discussed the impact of gearing which will be more influential by the increase in debt finance (for shareholders). ATFL, Paper 2.4, et al. (2001); Stevenson, A and Jennings, E. (1981) There are two main risks faced by equity investors; (i) Business/operating risk (ii) Financial/gearing risk
(i) Business/operating risk
The basic earnings (before interest) of the company can fluctuate, caused by factors such as changes in market demand, actions of competitors, size of the company, quality of management decisions, the state of the economy etc. for example, an oil prospecting venture will carry more business or operating risk than a property company. Carsberg, B. (1974); Hirst, I. (1998)
(ii) Financial/gearing risk
If a company has a financial gearing, (debt in its capital structure), then a fixed interest charge must be deducted from the fluctuating earnings before the payment of dividends. As we have seen, this has the effect of “amplifying” fluctuations in the company’s earnings, so that dividends face an additional risk, known as the finance or gearing risk. So, as gearing increases, financial risk increases for shareholders and so their required rate if return will also be increased (i.e. Ke). But point to be remembered here is that increased amount of cheaper debt don’t necessarily leads to in WACC. Hirst, I. (1998); Radcliffe, R. (1994)
2.23 Capital Gearing, Portfolio Theory and CAPM
Here we are considering the matters that relates to modern portfolio theory in general and CAPM in particular. Earlier we saw that the introduction of gearing brings business risk and financial risk for the shareholders. Now question is how these two are related to systematic and unsystematic risk. BPP paper3.7, (2004); Levy, H. and Sarnat, M. (1994); McLaney E. (2005)
2.23.1 Total Risk
Total Risk Systematic Unsystematic Undiversifiable Diversifiable Business Risk Financial Risk Both business risk and financial risk are Partly diversifiable and partly undivesifiable Hill, A. (1998); ATFL, Paper 2.4, et al. (2001); BPP paper3.7, (2004)
Table 2.10(Total Risk)
We know that business risk shows the variance of assets and the nature of industry concerned (i.e. investment policy) where as financial risk arises from either change in the amount of debt and equity in capital structure or the amount of dividend paid in relation to retained earnings (i.e. financial policy). Both of these risks can be partly diversified and partly undiversified. Market systematic risk arises due to general economic factors (such as corporation tax rates, unemployment level, interest rates etc)these risks are undivesifiable. On the other hand unsystematic/specific/unique risk can be diversified because it arises from inside the company (Such as equipment failure, industrial relations, change management etc). ATFL, Paper 2.4, et al. (2001); BPP paper3.7, (2004); It means that equity shares in geared businesses are more volatile (?) than those in all-equity ones. The ? for a portfolio is the average (weighted by the market value) of the ?s of the constituents of the portfolio. Therefore while ignoring (tax); McLaney E. (2005); ?EE = ?EG SG + ?LG LG SG + LG SG + LG Formula 2.39 (Beta without Tax) Where ?EE is the beta of the equities of the all-equity business; ?EG is the beta of the equities of the geared business; ?LG is the beta of the loan stock of the geared business. Now by considering “tax shield” of debt, the relationship between the ? is; McLaney E. (2005); ATFL, Paper 2.4, et al. (2001) ?EE = ?EG SG + ?LG LG (1 – T) SG + LG (1 – T) SG + LG (1 – T) Where T is the corporation tax rate. Assuming that the loan stock is without risk (?LG = 0), then ?EE = ?EG SG (ignoring tax) SG + LG Rearranging gives; ?EG = ?EE [1 + LG] SG ?EG = ?EE + ?EE LG SG Or ?EG = ?EE + ?EE LG (1 – T) (taking account of tax) SG
Formula 2.40 (Beta with Tax)
So we may say that, ATFL, Paper 2.4, et al. (2001); McLaney E. (2005) Total systematic risk (of equities in a geared business) = systematic business risk + systematic financial risk, As we know, business risk can be measured by ?, and financial risk is simply an accentuation of that same risk. This is entirely consistent with MM’s assertions. McLaney E. (2005); ATFL, Paper 2.4, et al. (2001)
From the above given literature review I may conclude that there are four main methods to appraise an investment. PBP and ARR (the traditional method) NPV and IRR (the modern techniques).All have got some merits and demerits but in my opinion the project should be appraised by looking at the NPV and IRR of the project because both of them consider time value of money. But in practical life we cannot ignore the importance of PBP. It is always checked before appraising an investment. In this chapter I have discussed two major sources of finance (i.e. debt and equity). It is shown from the explanation that a proper mix of both of them is needed in an investment. Only equity based or debt based investment is not fine. In this chapter I also conclude that how a capital structure is formulated (by the help of Ke, Kd) and we have checked the role of dividend policy in formulating a capital structure. We have also discussed about the share holders and debt holders ratios in our discussion. In the next chapter I will describe the complete research methodology which I have applied for this dissertation.
This chapter describes how the research was carried out and how the data for the analysis of the effect of the different sources of capital on investment appraisal was collected and how much research I have made for collecting data. In this chapter the technique of collecting data is described which is followed by the explanation about research material and reason for their use.
A broad range of industries were available for this type of analysis but I have just considered manufacturing /production process, not leisure, entertainment; sports organization and trading organization.
3.3. Data collection problems
With respect to primary data; basically, my research topic required primary data to make my analysis more interesting and realistic but due to some problems I was not able to collect it. I myself went to more than three companies to collect primary data but unfortunately they did not entertain me properly. That’s why I made my mind to rely on secondary data. The problems were not only in collecting primary data but also for secondary data too. Investment decisions and financing decisions not only rely upon the quantitative calculation but also on the qualitative factors and risk. Because of the importance of this, I personally went to get that data but was not successful. Then relying on secondary data I searched many different web sites of different companies. At the end I got case study based data of KNOC plc which was at least required to do analysis more realistically. My chosen company KNOC plc is engaged in the business of crude petroleum/natural gas production. It was founded in 1979 with a purpose to secure stable supplies of petroleum, a critical resource for the development and maintenance of both companies and households. Its major activities are exploration and production, strategic storage and domestic distribution of petroleum. KNOC’s mission is to be a global company, leading the nation’s drive for energy self-sufficiency. KNOC is engaged in many projects which are related0 to construction, oil stock piling, and oil department technology; drilling ship etc. Many projects of KNOC are overseas.
3.4. Organization (KNOC plc) Chart
https://www.knoc.co.kr/eng/index.php Table 2.11 (Organization Chart)
3.5. Technique used
For collecting the secondary data, the first criterion was used to find a data of manufacturing /Production Company. The second criterion was used to find data of that company which is using NPV, IRR, PBP and WACC for appraising their projects. From more than twenty companies the case study of KNOC plc was chosen randomly for analysis because the access and availability of data of this company was easy than other companies. A further selection criterion for data was an existing websites registered in the database which was also not very much easy for collecting the secondary data of a company.
In using questionnaire, it was possible to reach a broader range of participants than the instrument of interview could do. Although, the use of questionnaire are criticised due to their response bias by the several authors such as; Wallace (1988); Rappaport (1979); Klammer et al. (1978); Aggarwal (1980) for the research this method was recognised the best to use. As it has been explained that there were so many restrictions to get access for primary data that is why the most effort for collecting data was put on secondary data which was accessed through different web sites of the companies.
The target group contain twenty different companies. Significant research criterion was the company category and an existing manufacturing/production process of the companies. The research was carried out by searching different companies websites registered in the database which were using NPV, PBP, IRR and WACC for appraising their investment projects. From twenty companies which were searched just one company KNOC plc’s data was available in the shape of case study on internet which was used for the analysis. The search rate for collecting and recording data was 5% which represents a limited conclusion to a broad range of companies. In the following chapters I will discuss the findings and discussion on those findings relating to the investment appraisal project.
In this chapter I will discuss about the investment appraisal project of KNOC plc which is related to the acquisition of an oil field in South Africa. There are so many limitations to get access of relevant data to do analysis more interesting. Data which is given on web site is also very scattered but I will try my best to get at least that level of information which can make me able to do analysis more realistic. Data of NPV calculation is available on site but not more than this. But I will calculate IRR and PBP from the raw data which is available in the case study. I will do all these calculations on the basis of my theoretical knowledge which I have gained through my studies. I will calculate the NPV of the project on which my decision will be based. I will also be calculating WACC, IRR and PBP of the project to analyze the project viability thoroughly. The WACC theory assumes that the business risk of any new investment project is the same as that for the firm as a whole Carsberg, B. (1974). In reality risk adjusted discount rates will be better than WACC ATFL, Paper 2.4, et al. (2001). KNOC has used the WACC which was risk adjusted. In the end I have given the conclusion to the findings. https://www.ccop.or.th/projects/PPM/Case_Study_Phillipines_files https://www.knoc.co.kr/eng/about/KNOC2006AR(Eng).pdf
4.2. Oil Field Acquisition Project
As noted in Chapter 3, there was a problem in gathering the data regarding my dissertation, which meant that it was difficult to gather primary and secondary data. As an alternative, I found the data presented in this section from a case study of KNOC plc. This is basically a presentation of an assumed situation given as part of a workshop hosted by The Coordinating Committee for Geosciences Programmes in East and Southeast Asia (CCOP) in the Philippines. Most of my work and explanation in this section will be carried out on the basis of that case study. Only the adjusted NPV calculation and some basic facts regarding to debt, equity, working capital and WACC are presented in the case study. I have used my theoretical knowledge to attempt to confirm these results and to extend the analysis to include other relevant calculations (such as IRR and PBP and basic NPV and WACC). This project is acceptable because it shows positive NPV and more IRR as compare to WACC. So I can say that this project will certainly increase the value of the Company. The link of the web site and annual report is given in bibliography. https://www.ccop.or.th/projects/PPM/Case_Study_Phillipines_files https://www.knoc.co.kr/eng/about/KNOC2006AR(Eng).pdf KNOC has invested $7,000m in the acquisition of oil field in South Africa ($5,000 as acquisition investment and $2,000 as working capital). KNOC wants internal capital 60% and external 40%. So, I need to calculate the Kd and Ke for this purpose (for the project) to find out WACC. https://188.8.131.52/search/cache?ei=UTF-8&fr=slv8-msgr&p
4.3. Cost of Debt (Kd)
KNOC has taken a debt of $3160 (cum interest) for this project, (nominal value $3,000). The coupon interest rate is 12% where as the income tax rate is 30%. (No information was given in case study that when the debt will be redeemed. So I am assuming debt as irredeemable). i Kd = MVo (ex interest) i = 3000 × 12% = $360 MVo (ex int) = 3160 – 360 = 2800 So, 360/ 2800 = 12.86% Since interest payments are tax deductible, meaning for each $ of debt of the firm, the tax is reduced; So after tax Kd, Kd = Kd (before tax) (1 – Tc) = 12.86 (1 – 0.3) = 9% (approx)
4.4. Cost of Equity (Ke)
KNOC could go for investment through retained earnings or new issue of shares. Retained earnings is mostly preferred by the companies because of competitive less cost as compare to new issue of shares (which has a high flotation cost always)BPP paper3.7, (2004). In addition, three different ways to know Ke are DVM, CAPM model and Bond- Yield- Plus- Premium ATFL, Paper 2.4, et al. (2001). The first two methods are more common and are used mostly by the companies. Hill, A. (1998). So I will also include the effect on only first two in my analysis, ignoring the third one. DVM is based on the PV of future dividend where as CAPM model considers risk as reflected in ? (beta). DVM don’t explicitly consider risk. These models use (MVo) as a reflection of the expected risk – return preference of investor in market. DVM CAPM Ke = D (1 + g) + g Ke = rf (rm – rf) ? MVo (ex div) Although, both are theoretically equal, but DVM is preferred because data required is more easily available. So, I will also use the Ke calculated through DVM (but I will also prove that Ke through CAPM is near to that calculated through DVM). The MV of the shares at the time of project appraisal were $4430m (cum div) which includes dividend of $230m and the dividend growth rate which was estimated at that time is 5% p.a. (expected growth rate was given in case study calculated through extrapolation of past dividend method). Ke = D (1 + g) + g MVo = 230 (1.05) + 0.05 4200 = 10.75% If the same Ke is calculated through issues of new shares that would include an extra flotation cost of $200m (case study). So, Ke = 230(1.05) + 0.05 4200 – 200 = 11.04% If the same is calculated through CAPM model, ? is 2(in case study). Treasury bill rate is currently found to be 7% and similar oil developed companies are reported to have gotten 9 as the market average return of capital. https://www.ccop.or.th/projects/PPM/Case_Study_Phillipines_files So, Ke = 7+ (9 – 7) × 2 = 11% So, from above given calculations it is clear that Ke calculated through DVM is slightly less than the Ke through new issue of shares. But when we compare Ke through DVM and CAPM, DVM provides slightly less required return from share holders. So, I shall be using the figure of Ke calculated through DVM.
I have calculated Ke through new issue of shares and CAPM on my own because I want to make it sure that the Company has selected the least Ke for WACC calculation. Company has only calculated the Ke of retained earnings through DVM. Only raw data was given in the case study from where I have calculated Ke through new issue of shares and CAPM on my own from my theoretical knowledge.
4.5. WACC Calculation of the Project
WACC = (Ke ( E ) + Kd ( D )) E+D E+D = 10.75 ( 4200 ) + 9 (2800) 7000 7000 WACC = 10.05% So, 10 %( approx) So, this shows that NPV of the project should be calculated at 10%. https://www.ccop.or.th/projects/PPM/Case_Study_Phillipines_files
Yr 2004 2005 – 2010 2011 – 2015 2016 – 2018 2019 Acquisition (5000) W/C (2000) CASH INFLOW (Net Revenue) 930 1100 450 450 Recover W/C 2000 TAX SHIELD (D/P) 60 NCF (7000) 990 1100 450 2450 https://www.ccop.or.th/projects/PPM/Case_Study_Phillipines_files So, I will calculate NPV from the net cash flows of the project. Years Workings ($)m 2004 (5000+2000) (7000) 2005-2010 4.355×990 4311 2011-2015 (6.495-4.355) ×1100 2354 2016-2018 (7.367-6.495) ×450 392 2019 2450(1.10)-15 587 NPV 644 So, the NPV is $644m for this project of the oil field acquisition. But the company has calculated the NPV (which is shown below) as $383m. It looks there is a mistake in calculation but not in formula and method. I did calculation twice but the answer is same or KNOC plc might have taken some practical assumptions to calculate the NPV of $383m. This project is a long term project for 15 years. So, KNOC plc has to consider all the economic and political factors before appraising the project. KNOC plc also has to check the element of risk and uncertainty which will appear in the coming years. So, I might say that KNOC plc has taken an optimistic view by considering the elements of risk, uncertainty, political and economic factors. The factors which have contributed to this downfall of NPV from $644m to $383m are as follows. 1. KNOC plc has considered the probability of occurrence of each cash flow in NPV calculation which will certainly reduce the NPV (the risk and uncertainty factor). 2. The interest rate in the economy might change in 15 years which will certainly have an effect on WACC and then on NPV. 3. Dividend growth in the future might change and affect Ke, WACC and net cash flows of the project. 4. The political factors do have an effect on the project. 5. The net cash flows are calculated in US dollars. So, the foreign exchange rate in the future might have an effect on the net cash flows because the US dollar foreign exchange rate will not remain same for 15 years. 6. If the market value of the company (KNOC plc) change in future this might have an effect on the net cash flow and the NPV. 7. The income tax rate may change in the future. (Cannot be 30% all the time). This will have an effect on the NPV of the project in the coming 15 years. All these factors are also discussed in detail in the next chapter. But in this chapter I can say that these factors may be the basic cause of the NPV to be $383m (not $644m). The calculation of $383m is now shown below. These calculations are made by KNOC Plc.
NPV = (7000) + PVIFA10%, 6X990 + (PVIFA10%, 11 – PVIFA10%, 6) X 1100 + (PVIFA10%, 14 – PVIFA10%, 11) X 450 + 2450/1.115 = $383M. https://www.ccop.or.th/projects/PPM/Case_Study_Phillipines_files The positive cash flows of $383m show that the project can be undertaken in long term and this investment is beneficial for KNOC plc. The net cash flows of the project can also be presented in form of a bar chart.
4.7. Internal Rate of Return (IRR) Calculation
To calculate IRR I have to choose a hypothetical discount rate. Suppose WACC is 15%. Type Yr 2004 2005 – 2010 2011 – 2015 2016 – 2018 2019 Acquisition (5000) W/C (2000) CASH INFLOW (Net Revenue) 930 1100 450 450 Recover W/C 2000 TAX SHIELD (D/P) 60 NCF (7000) 990 1100 450 2450 NPV (at 15%) (7000) 3746 1595 221 301 YEARS WORKINGS NET CASH FLOWS ($ in m) 2004 5000+2000 = (7000) 2005 – 2010 (3.784 × 990) = 3746 2010 – 2015 (5.234 – 3.784) × 1100 =1595 2015 – 2018 (5.724 – 5.234) × 450 = 221 2019 2450(1.15)-15 = 301 NPV = (1137) So, IRR now; A + P × (B-A) P-N = 10+ 383 (15-10) 383+1137 = 11.26% (approx) Y 600 300 IRR 11.26% (approx) (NPV) X 5 10 15 (Discount Rate) 300 600 900 1200 Y Graph 2.8 Internal Rate Return (IRR)
4.8. Payback Period (PBP) Calculation
In traditional measures I can also check the PBP of the project (to check the project viability and cash flow recovery period). At WACC the net cash flows are follows. YEARS NCF’s 2004 (7000) 2005-2010 990 2011-2015 1100 2016-2018 450 2019 2450 (6years) 2005-2010 = 990×6 = 5940 (6 full years + 1060/1100) = 6.96 years (7years approx) The above given calculation shows that the PBP of the project is around 7 years (approx). By looking at the length of the project i.e. years, PBP of 7 years is quite ok. The cash flows are consistent. There is no negative cash flows are coming in the project due to its long term nature. The project cannot be dropped. Pay back period can be presented in form of a diagram.
Graph 2.9 Payback Period (PBP)
The box on the left shows initial investment of $7000m and the boxes on right side shows NCF’s of the project. It can be seen that the inflows will be equal to outflows at same point near the 7th year.
I have calculated IRR, value of company and PBP on my own because I want to make it sure that the company was right in appraising this project. KNOC has only calculated NPV. But I have calculated IRR and PBP from the raw data which was available in the case study. I have calculated IRR and PBP on the basis of my theoretical knowledge which I have gained through my studies.
In this chapter, I have calculated the WACC firstly. The answer of WACC 10% and then I have calculated the NPV of the project of KNOC. After calculating NPV I have calculated the IRR of the project and I have proved that IRR of the project is more than shareholders required rate of return. To satisfy the people who believe in traditional measures also I have calculated PBP which shows that after how much time project will recover its investment. In the following chapter, I will be giving a detailed discussion on findings.
In this chapter I will discuss on the findings which I have gathered in the previous chapter. I will discuss the effects of sources of finance (i.e. equity and debt) on investment decision. I will also discuss that if the capital structure was changed by KNOC what affect that would have caused on investment. Finally this chapter would end with the limitation, implications and recommendation with respect findings followed by a conclusion. There are many factors related to debt and equity which can affect the investment decision of KNOC plc which I will discuss now. But firstly we should know that the effects of sources of finance on investment decision; means the effect of Kd and Ke, (i.e. WACC) on investing decisions.
5.2. Capital Structure
Firstly I would like to comment upon the capital structure used by KNOC plc (i.e. 60% equity and 40% debt). Let’s see the pie chart. 40% 60%
Graph 2.10 Debt/Equity
This Capital structure is quite acceptable which KNOC has chosen. Normally, for an investment, mixture of both debt and equity is good Levy, H. and Sarnat, M. (1994); Company has used both in good proportion which is ideal. The debt /equity ratio is 66% which is quite good and acceptable for the project where as the gearing ratio for the project is 40% (2800/7000). Both debt and equity have got some merits and demerits for investment purposes Radcliffe, R. (1994). So, KNOC cannot go for either debt or equity for the project otherwise the company will be losing on the merits of debt or equity. If we change capital structure, investment decision might change.
5.3. Interest Rate
I would like to discuss about interest rate which I have used in the calculation of Kd. The coupon interest rate was 12% and interest was calculated as $360. If this rate would have been more than 12% then surely Kd would have been more and WACC would have increased. That might have lowered down the NPV of the project might have affected the investment decision. Interest yield for the project is 360/2800 = 12.86 %( on MV basis). But this factor was not in the control of KNOC plc.
5.4. Tax Rate
The tax rate for income tax is 30% in the economy for the project. The company has calculated the Kd and value of the company (after tax). If this tax rate was to be less than 30% then Kd would have been high leading to a high WACC and low NPV. This might have affected the financing and investing decision of KNOC plc.
5.5. Dividend Policy
Dividend policy of the company might also have an effect on the investment decision. KNOC has used retained earnings for the appraisal of the project. If company has made new issue of shares and had not used the retained earnings then certainly Ke would have been different. Ke calculated through new issue of shares was more than retained earnings because of the floatation cost majority. If KNOC wants to give out more dividends to the shareholders then it might have used new issue of shares which might have increased the WACC and might have affected the investment decision. Dividend as a % age of equity (ex div) is 230/4200 = 5.48% which is acceptable that the company is paying 5% as dividend from the project.
5.6. Dividend Growth Rates
Growth rate of dividend calculated through extrapolation of past dividend was 5%. If the growth rate has been more than 5% (means that shareholders are demanding more dividends and company is growing at a faster rate) then the Ke might have been increased, influencing WACC and the investment decision of KNOC plc.
5.7. Investment Policy
Risk is also a basic factor considered for the purpose of investment. If the company is already engaged in projects with high business and financial risks then company will think in nay project which is having high business risk and financial risk. But this project was not that risky, though it was for 15 years, but it does not have negative inflows coming. So, that is why company went for this project. If there had been negative inflows, then company might have considered other options.
5.8. Discussion on NPV, IRR and PBP
Positive NPV of $383m shows that the project is a worthwhile investment for KNOC plc. There are also negative inflows during the project life. So, that is why company appraised this project. Similarly, the IRR was calculated as 11.26% which was more than overall WACC which further proves that there is no problem in investment. The PBP of the project is around 7years. The total length of the project is 15years. So, it means that near half way approx, it is covering its cost which seems quite acceptable KNOC has not calculated IRR and PBP in their calculation but they must have considered them before appraising this oil field project.
Finally, I would like to conclude that in this chapter I have shown the effects of Ke and Kd (i.e. sources of finance) on investment decisions. Such factors are; like interest rate, tax rate, dividend policy and capital structure etc, and ii have proved how these might have affected the investment decision of KNOC.I have also discussed the answers of NPV,IRR and PBP in this chapter. In the last chapter, I will be giving a detailed conclusion to my dissertation.
The most preferred method for an investment decision is NPV. In my opinion, it should be used because it considers time value of money and gives you the PV of the project is real monetary terms. It is argued by the academics that the NPV method is theoretically the preferred method of investment appraisal. ATFL, Paper 2.4, et al. (2001). However, the practice is often diverse to the theory, as found in the studies Hirst, I. (1998). In practice, a high preference of the PBP method is found and in comparing the sophisticated methods IRR and NPV, the IRR method has a higher use than the NPV. ATFL, Paper 2.4, et al. (2001). Ryan et al. (2002) found in their study, focusing on the fortune 1000, an increase in the use of NPV method and the preference for this method within the sophisticated techniques compare to the IRR. My dissertation was actually based on the investment decision taken by KNOC and the financing methods used by it. This dissertation explains fully the effects of sources of finance on investment decision (of KNOC plc). The aim which I have fulfilled in my dissertation is the full explanations and calculations of investment appraisal techniques such as PBP, ARR, NPV and IRR (including their merits and demerits). The effect of inflation and tax on investment decision are also presented. Full explanation of investment appraisal techniques and qualitative factors affecting investment decision is also processed. I have also explained fully that if there is a conflict between NPV and IRR decision then what company should do. The other important part of my dissertation was the financing decision. In this part I have explained fully about the debt and equity and their components. I have fully explained the DVM and CAPM as well. I have given a detailed explanation for the calculation of Ke, Kd and WACC. Full length explanation of dividend policy, MM views and capital structure ratios is also presented in the essay. I have also explained about my chosen company KNOC plc and its history. What problems I have faced in gathering data are all explained. My dissertation is completely based on secondary data due to lack of availability of primary data. All the sources from where I have gained the data are given in bibliography. I have shown the full detailed workings of the oil field project’s NPV, IRR, WACC and the value it contributes to the company. I have used all my theoretical knowledge gained during my MBA study, in these calculations. I have proved not only on NPV basis but also on IRR basis that why KNOC has appraised this 15years oil field acquisition project. I have also explained fully that how the sources of finance (debt or equity) has an effect on the investment decision that if any of the factor related to debt or equity is changed, investment decision may change. These factors include dividend policy, capital structure, tax and interest rates etc. My topic is a never ending topic and more research is still required in this field to explore fully that why and how sources of finance (WACC) affect the investment decision. I think my work is a small contribution to this very big field and it will help somewhat to the managers, potential investors, shareholders and the students of finance in future.
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