Corporate Finance & Decision Making

Corporate finance
Theory and practice
In memory of Glynne Jones
For Vanessa and her friend Tommy
Steve Lumby and Chris Jones
Corporate finance
Theory & practice
seventh edition
Australia Canada Mexico Singapore Spain United Kingdom United States
Corporate Finance:Theory and Practice

Copyright 1981, 1984, 1991, 1994, 1999,
2003 The Lumby Family Partnership
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British Library Cataloguing-in-Publication Data
A catalogue record for this book is available
from the British Library
First edition published by Chapman & Hall
1981
Sixth edition published by International
Thomson Business Press 1999
Reprinted 2000 and 2001 by
Thomson Learning
Seventh edition published as Corporate
Finance: Theory and Practice 2003
Typeset by Saxon Graphics Ltd, Derby
Printed in Croatia by ZRINSKI d.d.
ISBN 1861529260
Thomson
High Holborn House
50/51 Bedford Row
London
WC1R 4LR
http://www.thomsonlearning.co.uk
Brief contents
Preface
Book plan
PART 1
PART 2
PART 3
PART 4
xvii
xx
INTRODUCTION
Financial decision making
Decision objectives
14
INVESTMENT DECISIONS
31
Traditional methods of investment appraisal
33
Investmentconsumption decision model
50
The discounted cash flow approach
67
Net present value and internal rate of return
94
Project cash flows
125
Capital rationing
148
RISK ANALYSIS
177
179
Simple risk techniques
10 Risk and return
204
11 Portfolio theory
226
12 The capital asset pricing model
255
13 Option valuation
291
14 Interest rate risk
325
FINANCING DECISIONS
353
15 Financial markets
355
16 The cost of capital
379
17 Weighted average cost of capital
420
18 Capital structure in a simple world
442
vi
PART 5
PART 6
BRIEF CONTENTS
19 Capital structure in a complex world
462
20 Capital structure in practice
488
21 Investment and financing interactions
506
22 The dividend decision
534
MERGERS AND ACQUISITIONS
551
23 Acquisition decisions
553
24 Company valuation
577
INTERNATIONAL ISSUES
593
25 Foreign exchange
595
26 Foreign exchange hedging
615
27 Foreign direct investment
642
Tables
667
Answers to quickie questions
673
Answers to problems
699
Index
783
Detailed contents
xvii
Preface
xx
Book plan
PART 1
PART 2
INTRODUCTION
Chapter 1
The nature of financial decisions

The decision process
Technology and financial decision making
Summary
Notes
Quickie questions
3
4
6
11
12
12
13
Chapter 2
14
Decision objectives
Wealth maximization and the company

Ownership and control
Regulation of the relationship between directors and shareholders
Incentive scheme criteria
When incentive schemes and regulation are ineffective
Conclusion
Summary
Notes
Further reading
Quickie questions
Problems
14
15
16
23
26
27
28
29
29
30
30
INVESTMENT DECISIONS
31
Chapter 3
33
Introduction
The payback method
Return on capital employed
Conclusions
Summary
Notes
Further reading
Quickie questions
Problems
33
34
41
44
44
45
47
47
48
viii
DETAILED CONTENTS
Chapter 4
50
Introduction to the model

The time value of money
The basic graphical analysis
Introduction of capital markets
The separation theorem
The conclusions of the basic model
Payback and ROCE
Summary
Notes
Further reading
Quickie questions
Problem
50
51
53
55
57
61
62
62
63
65
65
66
Chapter 5
67
Net present value

Alternative interpretations of NPV
Internal rate of return
Discounted payback
Truncated NPV
Summary
Appendix: compounding and discounting
Notes
Further reading
Quickie questions
Problems
67
73
78
83
84
85
85
89
90
90
91
Chapter 6
94
Net present value and internal rate of return
NPV and project interdependence

IRR rule and interdependent projects
Extending the time horizon
Multiple IRRs
Other problems with the IRR rule
The modified IRR
NPV versus IRR: Conclusion
The replacement cycle problem
Summary
Notes
Further reading
Quickie questions
Problems
94
99
108
109
113
114
115
116
119
120
121
121
122
Chapter 7
125
Project cash flows
Investment appraisal and inflation

Inflation and the IRR rule
Investment appraisal and taxation
125
130
131
ix
DETAILED CONTENTS
PART 3
Financing cash flows

Investment appraisal and the relevant cash flow
Summary
Appendix: the UK corporate tax system
Notes
Further reading
Quickie questions
Problems
132
136
141
141
142
143
143
144
Chapter 8
148
Capital rationing
Introduction
Hard and soft capital rationing
Single-period capital rationing
Multi-period capital rationing
Summary
Appendix: linear programming
Notes
Further reading
Quickie questions
Problems
148
150
152
158
168
169
171
171
172
173
RISK ANALYSIS
177
Chapter 9
179
Risk and return

Expected net present value
The abandonment decision
Sensitivity analysis
The risk-adjusted discount rate
Summary
Notes
Further reading
Quickie questions
Problems
179
180
186
191
194
196
197
197
198
199
Chapter 10 Risk and return
204
Introduction to uncertainty
The expected utility model
Risk, return and the investment decision
Summary
Notes
Further reading
Quickie questions
Problem
204
206
213
222
223
223
224
224
DETAILED CONTENTS
Chapter 11 Portfolio theory
226
Two-asset portfolios
Multi-asset portfolios
Introduction of a risk-free investment
The capital market line
Diversification within companies
Summary
Notes
Further reading
Quickie questions
Problems
226
234
237
243
248
249
251
251
252
252
Chapter 12 The capital asset pricing model
255
The security market line

The CAPM expression
The beta value
The validity of the CAPM
Arbitrage pricing theory
Betas and project investment appraisal
Summary
Appendix: The security market line
Notes
Further reading
Quickie questions
Problems
255
259
262
271
276
278
281
282
285
285
286
287
Chapter 13 Option valuation
291
Introduction
The basic characteristics of options
Option terminology
The valuation of options
The Black and Scholes model
The building blocks of investment
Putcall parity theorem
Using share options
The option Greeks
The binomial model
Summary
Appendix: the area under the normal curve
Notes
Further reading
Quickie questions
Problems
291
291
293
293
298
302
307
310
314
318
320
321
323
323
323
323
DETAILED CONTENTS
PART 4
xi
Chapter 14 Interest rate risk
325
Introduction
The money markets
Forward forward loans
Forward rate agreements
Interest rate guarantees
Option contract markets
Interest rate futures
Caps, collars and floors
Interest rate swaps
Summary
Notes
Further reading
Quickie questions
Problems
325
325
327
328
331
333
334
343
344
348
348
349
349
350
FINANCING DECISIONS
353
Chapter 15 Financial markets
355
Introduction
Market efficiency
Market efficiency and share dealing
The empirical evidence of EMH
The term structure of interest rates
Pure expectations hypothesis
Summary
Notes
Further reading
Quickie questions
Problems
355
355
358
360
365
369
375
376
377
378
378
Chapter 16 The cost of capital
379
The financing decision

The cost of equity capital
Expected return, dividends and market price
Applying the dividend valuation model
CAPM and the cost of equity capital
CAPM versus the DVM
The cost of debt capital
Cost of preference shares
Convertible debt
Summary
Notes
Further reading
Quickie questions
Problems
379
380
383
385
393
395
397
409
410
414
414
416
416
417
xii
DETAILED CONTENTS
Chapter 17 Weighted average cost of capital
420
The project discount rate

The calculation of K0
The WACC and project risk
Summary
Appendix: Differing corporate and private costs of debt
Notes
Further reading
Quickie questions
Problems
420
423
427
430
431
437
437
438
438
Chapter 18
442
Capital structure in a simple world
Introduction
An optimal capital structure
Business and financial risk
The arbitrage proof
Summary
Notes
Further reading
Quickie questions
Problems
442
442
446
450
457
458
458
459
459
Chapter 19 Capital structure in a complex world
462
Taxation and capital structure

Using the M and M equations
M and M in the real world
Further views on capital structure
Conclusion
Summary
Notes
Further reading
Quickie questions
Problems
462
467
472
477
482
482
483
484
484
485
Chapter 20 Capital structure in practice
488
The pecking order theory

Real-world considerations
Earnings per share and gearing
Degree of operating gearing
Summary
Notes
Further reading
Quickie questions
Problems
488
491
493
496
500
501
501
501
502
DETAILED CONTENTS
PART 5
xiii
Chapter 21 Investment and financing interactions
506
Company valuation and investment appraisal

The dividend and interest valuation model
Adjusted present value model
The M and M valuation model
The traditional valuation model
Approaches to investment appraisal
Asset betas and gearing
Risk-adjusted WACC
Lease or purchase decision
Summary
Notes
Further reading
Quickie questions
Problems
506
507
507
508
508
509
514
521
524
529
529
529
530
531
Chapter 22 The dividend decision
534
Dividend policy in perfect capital markets

Traditional view of the dividend decision
Dividend policy in an imperfect market
The empirical evidence
Conclusion
Summary
Notes
Further reading
Quickie questions
Problems
534
538
542
544
545
546
547
547
548
548
MERGERS AND ACQUISITIONS
551
Chapter 23 Acquisition decisions
553
Introduction
Synergy
Valuing synergy
Acquisition premiums
Organic growth versus growth via acquisition
The coinsurance effect
Bootstrapping EPS
Diversification
Takeover defence
Financing acquisitions
Summary
Notes
Further reading
Quickie questions
Problems
553
554
557
558
560
562
564
567
568
571
572
574
574
574
575
xiv
PART 6
DETAILED CONTENTS
Chapter 24 Company valuation
577
Introduction
Asset basis
Earnings basis
Dividend basis
Free cash flow basis
Intellectual capital
Summary
Further reading
Quickie questions
Problems
577
577
579
582
582
584
586
587
587
588
INTERNATIONAL ISSUES
593
Chapter 25 Foreign exchange
595
Introduction
Exchange rates
Foreign exchange markets
Exchange rate systems
Determinants of FX rates
Summary
Notes
Further reading
Quickie questions
Problems
595
595
600
605
608
612
613
613
613
614
Chapter 26 Foreign exchange hedging
615
Definitions
Transaction risk hedging
FX futures contracts
Forward versus futures
FX options contracts
Setting up an option hedge
Early exercise
Contingent exposure to FX risk
Traded options versus OTC options
Summary
Notes
Further reading
Quickie questions
Problems
615
616
621
626
627
629
634
635
635
636
637
637
637
639
Chapter 27 Foreign direct investment
642
Introduction
Project cash flows
Project discount rate
642
644
648
DETAILED CONTENTS
xv
Translation risk
Economic risk
Country/political risk
Management charges and transfer pricing
Summary
Notes
Further reading
Quickie questions
Problems
653
656
659
660
661
662
662
663
663
Tables
667
673
Answers to problems
699
Index
783
xvii
Preface
There is a popular feeling that theory is opposed to practice and the merits lie with
practice. This is a false conclusion, based on a false supposition. If practice has long been
successful and does not conform to theory, the theory is bad and in need of revision... The
distinction should not be between theory and practice; it should be between good theory
and bad theory, between good practice and bad practice... Practice is brick; theory is
mortar. Both are essential and both must be good if we are to erect a worthy structure.
d. paarlberg, great myths of economics
The description in plain language will be a criterion of the degree of understanding that
has been reached.
w. heisenberg, physics and philosophy
This book takes these two quotations as its starting point. Its subject matter
covers some of the major financial decisions that face companies: investment,
financing, the dividend decision, acquisitions and the management of risk. These
are areas of vital importance to companies because they represent the main ways
by which firms can enhance the worth of the owners. This importance is
reflected in the fact that corporate finance is a standard element of most degree
courses that are concerned with industrial or commercial decision-making, as
well as being a prominent element in professional accountancy examinations.
It is with all these groups of people in mind that this book has been written.
However, we hope that practising financial decision-makers will also find its
contents of interest, in that it may help to provoke thoughtful reflection on how
financial decisions are actually made.
The books origins lie in the courses we have taught at various universities at
both undergraduate and postgraduate level and in the courses taught to students studying for professional accountancy qualifications. In reality, this is the
seventh edition of Investment Appraisal and Financial Decisions, but we have taken
the opportunity of a new edition to change the title to Corporate Finance, in
order to reflect better its scope and contents.
In many ways this is not our book, but our students book. Their searching
questions have often prompted us to think through the subject matter in greater
xviii
PREFACE
depth and to seek out alternative ways of providing clear and full explanations
of the subject matter.
In this new edition we have made a number of substantial additions, as well as
several more minor amendments, revisions and rearrangements. The main
extension has been to include the area of mergers and acquisitions, with a new
chapter on the valuation of companies for purposes of acquisition and a chapter
that covers a number of aspects of acquisition activity. Mergers and acquisitions
are amongst the most important events that occur in the life of a company and
this is an area that takes a central role in the preoccupations of corporate treasurers and other finance professionals.
In addition to these new chapters, the chapter on option valuation theory has
been rewritten to improve the clarity with which this complex subject matter is
developed. We have also extended the chapter on the capital structure decision
in the real world to include a discussion of the so-called pecking order theory
and have revised and updated several other areas within the book, including the
ever-developing issue of corporate governance and the potential conflicts of
interest between shareholders and managers.
Finally, the layout of the book has been entirely redesigned to help enhance
its ease of use. It is all too easy for authors to lose sight of just how difficult
some topics can be to the new reader. Familiarity, if not exactly breeding contempt, can sometimes lead to an over-concise exposition of the subject being
discussed. Hopefully we have managed to avoid this pitfall, and we are confident that the books new design further enhances the clarity of presentation of
the subject matter.
What has been retained from previous editions are the end-of-chapter summaries, together with suggestions on selected further reading, sets of Quickie
questions (and answers) and full-length exam-style questions.
The summaries are designed to give a general overview of the topics covered
in each chapter and to give just a quick snapshot picture of the main points. The
suggested further reading has been compiled with particular emphasis on providing articles that are, in the main, accessible to those readers who do not
posses a higher degree in mathematics! The Quickie questions are designed to
test both recall and understanding and to give the reader essential feedback
the Quickie answers are tucked away at the back of the book, in order to reduce
the temptation to cheat! Finally, the exam-style questions - all 60 of them have been selected to try and cover the major elements of each chapters subject
matter. These questions are either of our own design, or have been culled from
the examination papers of various professional accountancy bodies. Collectively
these examiners have set some splendid questions in the past, and we are
grateful to the accountancy bodies concerned for their kind permission to use
them. One other change to this new edition - and this is in response to reader
demands - is that many of the answers to these questions are now included at
the end of the book!
The books website: www.thomsonlearning.co.uk/accountingandfinance/
lumbyandjones/, contains an extensive multiple-choice question bank to
provide further opportunities for testing and feedback. Although solutions to
most of the exam-style questions are given at the end of the book, the solutions
to certain questions have been placed in a lecturers only area of the website.
PREFACE
xix
As before, we should make it clear that this is not a how-to-do-it book of
corporate financial management. Such a book is not really a possibility in the
complex, practical and ever-changing area of corporate finance. Instead, it is an
attempt at a fairly detailed, reasoned discussion of the normative theory of corporate finance. Examples that have used real-world data are there for the purposes of exposition, rather than to encourage unthinking application of the
theory to practical decision-making. It is not our aim to put forward theoretical
solutions to practical problems, but to promote thought and reflection on how
decisions are actually made and, perhaps, how they can be improved.
As far as possible, the presentation has been argued in descriptive and graphical terms rather than using a strict mathematical analysis. The reasons for this
are two-fold. First, a mathematical treatment often excludes a great many
potential enquirers and reduces the subject matter to a degree of terseness that
makes unrealistic demands upon the concentration of the reader. Second, a
mathematical treatment, although often rather elegant, can sometimes fail to
make clear the full significance of important conclusions. However, it has been
impossible to exclude mathematics completely - indeed it would have been
counterproductive to do so in some areas - but its complexity has been kept to
an absolute minimum. We have resisted the temptation to derive formulas and
relationships just for the sake of it and have only done so where the mathematical derivation leads to a greater understanding for the reader.
All that remains is to thank the people at Thomson Learning, in particular
Pat Bond as editor, Fiona Freel as production manager and Katie Thorn, who is
concerned with the marketing, for all their help, understanding and general
prodding to get the book written and onto the bookshelves. Most of all our
thanks go to our students who make writing and teaching so enjoyable!
Book plan
Part 1
1
Financial
decision
making
Part 2
3
Traditional
methods of
investment
appraisal
Part 3
9
Simple risk
technique
Part 4
15
Financial
markets
Part 5
23
Acquisition
decisions
Part 6
25
Foreign
exchange
Introduction
2
Decision
objectives
Investment decisions
4
Investment
consumption
decision
model
5
The
discounted
cash flow
approach
6
Net present
value and
internal rate
of return
7
Project
cash flows
8
Capital
rationing
12
The capital
asset pricing
model
13
Option
valuation
14
Interest rate
risk
18
Capital
structure in
a simple
world
19
Capital
stucture in
a complex
world
20
Capital
structure in
practice
Risk analysis
10
Risk and
return
11
Portfolio
theory
Financing decisions
16
The cost of
capital
17
Weighted
average cost
of capital
Mergers and acquisitions

24
Company
valuation
International issues
26
Foreign
exchange
hedging
27
Foreign
direct
investment
21
Investment
and
financing
interactions
22
The
dividend
decision
Part 1
Introduction
The nature of financial decisions

An overview
This book covers a particular area of managerial economics: the theory of
financial decision making by business corporations. It is concerned with how
management within companies1 should make2 financial decisions,3 and so it can
be said to adopt a normative approach because it sets out to establish a standard,
or norm. But such a theory cannot hope to succeed in its task if it is developed
in isolation from what actually does happen in practice, and so we shall also
examine how financial decisions are made in order to guide and enrich the
development of our normative approach.
The value base

Financial decisions are no different in their fundamental aspects from other
decisions of a non-financial nature, be they in industry or commerce (such as
marketing decisions) or elsewhere (such as decisions to transfer footballers, or
even international diplomacy decisions). In essence, all decisions are based on
the concept of the comparison of alternatives, and it is in this sense that the
theory of financial decisions really has its roots in valuation theory, because all
the alternatives in any decision-making situation have to be valued in order to
be compared. Therefore, although we can say that all types of decisions involve
the same fundamental process, each is given its own unique characteristics by
the valuation base that it employs.
The financial decision theory developed in this book is founded on the valuation bases that come from capitalism4 and the idea of the free market economy.
It is important that this is specified from the outset, because a different valuation base would be likely to produce a different overall theory of financial decisions. However, many parts of our financial theory will be applicable to other
types of economic organization, and you may wish to consider and reflect upon
the implications of our theory for more social value bases, such as those that
might be appropriate to the public sector and, in particular, state-owned public
enterprises. This is especially interesting because the past 20 years have seen an
FINANCIAL DECISION MAKING
apparent change in value bases in those particular areas and a transfer of many
public sector enterprises into the private sector.
The model approach and the structure of the text

We have structured this text in six parts:
1.
2.
3.
4.
5.
Introduction to the context of financial decisions Chapters 1 and 2.

The capital investment decision Chapters 3 to 8.
The impact of uncertainty on financial decisions Chapters 9 to 14.
Financing decisions Chapters 15 to 22.
Decisions by one company to purchase another company Chapters 23
and 24.
6. Financial decisions in an international context Chapters 25 to 27.
In the course of our development of a normative approach to financial decisions, a considerable number of abstractions from and simplifications of the
real world will be made, in order to distil the difficulties and focus attention on
areas of major importance.
Adopting this type of modelling approach is normal in the study of economics and related areas. However it brings with it a danger that it is seen as
fully describing a real world and providing simple solutions to real-world
problems. It is important to remember that we are developing a normative
theory and are therefore attempting to give advice on how financial decisions
should be taken. In general we will work with simplified models and if the theory
were to be followed in practice, without recognizing the full range of possible
complicating factors, the quality of financial decisions made in business might
deteriorate rather than improve.
The difficulties caused by taxation, inflation and capital scarcity will all be
taken into account, as will the concept of risk and the fact that the future is
uncertain.5 All these real-world complexities will be added layer by layer to the
simplified model with which we start. Even though that model might be a poor
reflection of the real world, it provides a logically sound framework upon which
to build.
A warning
As a final point, the reader should be constantly aware that the theory of financial decisions presented here is neither in a state of general detailed agreement,
nor does it yet provide complete solutions to many of the important problems
of financial decision making. In order to reflect this state of affairs, we shall
examine the causes and evidence of these controversies and point out the irrationalities, ambiguities and inconsistencies that necessarily accompany the
development of any theory that aspires to real-world application.
The decision process

In order to examine the decision process and to answer the question, How do
we make a decision?, we have first to discuss the circumstances in which a
THE DECISION PROCESS
decision needs to be made. We can specify two necessary conditions for a decision situation: the existence of alternatives and the existence of an objective or
goal.
The first necessary condition

The existence of alternatives is necessary because, if there are no alternatives
from which to choose, then there is no need for a decision. This condition can be
specified further in that not only must alternatives exist, but they must be seen to
exist by the potential decision maker. There are two points of interest here.
First, notice that we talk of a decision situation and of a potential decision
maker. This is because the mere existence of perceived alternatives does not
necessarily mean that a decision will be made. For instance, the potential decision maker may well procrastinate, and therefore the passage of time takes him
(or her) out of a decision situation and into a situation where there is only one
possible course of action and no alternatives are available. (Death is the ultimate
example of the passage of time removing a decision situation from an
individual.)
The second point of interest is that we are not specifying that all possible
alternatives are perceived; if they were, we could call this an optimal decision
situation. We are, rather, examining how decisions are made, given that a particular decision situation exists. Whether the decision is truly optimal or
non-optimal is of no concern at present.
The second necessary condition

The second necessary condition for a decision situation arises from the fact that
the actual process of making a decision is liable to cause the decision maker to
expend both time and effort. Rationally decision makers will be unwilling to do
so unless they expect that some of the perceived alternatives will be preferred to
others in relation to attaining the desired objective. Thus the existence of an
objective is the second necessary condition: without it, there will be no purpose
in making a decision.6
Valuation of alternatives
Together, these two necessary conditions provide the rationale for making
decisions: if the decision maker does not perceive alternatives, or sees no reason
to choose between the alternatives if they are perceived, then no decision will
be made (except one of a totally arbitrary kind, as in note six). But once these
conditions do exist, a decision cannot actually be made until values are placed
upon the alternatives. In fact, we can assert that the only reason why any alternative course of action is ever evaluated is in order to make a decision about it;
therefore, the valuation method used must be related to the objective involved
in making the decision and the way in which that objective is expressed.
For example, if our objective were to drive from A to B in the shortest possible time, then we should value the alternative routes from A to B by a
common value criterion that was related to our objective of time, and choose
whichever route took the shortest time. Suppose there were three alternative
routes and one we valued by time, one by distance and one by scenic beauty.
We obviously could not make a decision because the alternatives have different
measures or yardsticks of value and so cannot be compared. Alternatively, if all
three routes were measured in terms of scenic beauty, we should again be
unable to make a decision, even though we could compare the routes, because
the basis of the comparison is not the one that gives the rationale for the deci7
sion: the value base of the objective, which in this example is time.
Therefore, any decision-making process consists of these three components:
a series of perceived alternatives, an expectation that these alternatives are not
all equally desirable in terms of attaining an objective held by the decision
maker, and a common value base related to the decision objective. So it is with
all financial decisions made in business.

This book focuses attention on only two of the three components that we have
identified in the decision process and examines how they relate to the making of
financial decisions: the expectation that the perceived alternatives are not all
equally desirable in terms of attaining a specific objective, and the common
value base that is related to this objective and is used to compare the
alternatives.
The remaining component of the decision process is the series of perceived
alternatives. We shall not be examining it in the main body of the text as it is
primarily a condition for the decision situation, and we are concentrating on the
actual decision making, assuming that the decision situation already exists.
However, this omission does not mean that the search process (as it is called)
for alternatives is unimportant. It is in fact extremely important. If this search
process is not efficient in seeking out alternatives, then there is a grave danger
that the decision itself will not be optimal because the most preferred alternative may go unperceived.
The decision objective

Turning to the two decision process components that we shall examine in
detail, we immediately become involved in value judgements, because the
objective we use for financial decision making, and the consequent value base,
will determine the decision reached as to which alternative is selected. Therefore, what objective are we going to use and what valuation base are we going to
set up for our theory of financial decisions?
We stated earlier that the fundamental value judgement upon which our
approach is based is capitalism. The approach is thus most appropriate in
largely unregulated, competitive economies. In such economies, it is reasonable to assume that companies exist for one overriding purpose: in order to
benefit their owners.8 While companies provide income for their employees
and the wider local community, supply the needs of a particular market, and
provide other benefits such as technological advance, the fact remains that the
fundamental rationale for their existence must be to bring benefit to their
owners.
This rationale for existence undoubtedly holds true for the great majority of
privately owned9 companies (and also, to some extent, for state-owned indus10
tries although their rationale for existence can be more complex ). Therefore,
managements objective in making financial decisions should be to further the
very reason for the companys existence, of benefiting the owners, i.e. the
shareholders. We shall see that there might be other managerial objectives but,
in essence, we will treat those as deviating from what they should be (this is
consistent with the idea of adopting a normative approach). So if the decision
objective is to benefit the owners, what is the value base to be used for the comparison of alternatives?
To answer this question, we have to examine the decision objective more
closely. It is obvious from what we have already said that not only should
company managements make financial decisions so as to benefit the shareholders but they should also strive to maximize that benefit, otherwise shareholders will be interested in replacing them with a set of decision makers who
will do this. Therefore, what is meant by the term maximizing owners or
shareholders benefit?
Maximizing shareholder wealth

We are going to assume that maximizing benefit means maximizing wealth.
Although there is nothing surprising about this, we have to be careful here
because we are going to assume that maximizing the increase in the owners
wealth is the only way in which management decisions can benefit owners.
This is a slight simplification of the real world, because it is quite possible for
shareholders to gain benefit from a company other than by increases in wealth. For
example, shareholders of a company such as Body Shop may gain benefit from
ownership in terms of pride in the fact that the company has a proactive stance
towards protecting the environment, and this is also reflected in various investment
vehicles such as ethical unit trusts. However, this is a comparatively minor point
and we shall proceed on the relatively sound assumption that increase in wealth is
the main, if not the sole source of benefit from company ownership.
What about firms selling military arms to countries that have repugnant policies, or firms causing pollution to land, air or water resources? Do these types
of activity enter into consideration of our decision objective? On the basis of
our underlying assumption about the nature of the economy, our answer must
be that they should not, because if these activities were thought to be truly
undesirable, governments would legislate to constrain companies decision-choice alternatives so as to exclude them (as in many cases they do).
Company decision makers should only need to perceive and analyse the decision alternatives in terms of maximizing the owners wealth. From this viewpoint we can treat financial decisions as not being anything to do with morality.
Morality, the law and other things might act as constraints on what a company
does but they are entirely different issues and are generally assessed using different criteria.
In market economies, we can develop a theory of financial decisions for privately owned firms in this way because of the workings of the market system for
company capital. Ordinary share capital, the substance of ownership, is
normally provided through supply and demand markets (e.g. stock exchanges),
which means that potential shareholders can buy shares in companies that they
expect will provide them with the greatest possible increase in wealth
(i.e. shareholders have to make financial decisions in much the same way as
management, choosing between alternative ownership opportunities), and
existing shareholders can sell their shares if they see other companies providing
greater increases to their owners wealth than they are receiving. (An important
concept here, and one we have yet to deal with, is that the future is uncertain
and so any decision amongst alternatives usually has a risk attached to
it: the risk that the alternative chosen may not turn out as expected. Some alternatives are riskier than others and so shareholders will really want to own
companies that they expect will give them the greatest possible increase in
wealth, for a given level of risk. This concept will be considered much more
fully later.)
Therefore, if a company were to make its decisions on bases other than that
of maximizing shareholder wealth, the whole rationale for the companys existence so far as shareholders are concerned would be in doubt and they
would be likely to take their investment funds elsewhere. In the extreme case,
company law provides the opportunity for shareholders to replace a companys
decision makers if enough of them believe that decisions are not being taken in
their best interests.
Defining wealth
However, we still cannot determine the value base for financial decision making
until we have defined wealth, because the purpose of the value base is to act as a
common denominator with which to make the alternative courses of action
directly comparable and to see which one leads furthest towards the decision
objective. As the objective of financial decisions is assumed to be to maximize
the increase in owners wealth, let us define wealth and so determine the value
base.
Wealth can be defined as the capacity to consume, or, to put it in more
straightforward terms, money or cash.11 Thus the objective of management
becomes the maximization of shareholders purchasing power, which can be
achieved by maximizing the amount of cash paid out to shareholders in the
form of dividends. But which dividends should a companys management try to
maximize: this years, next years or what?
The point here is that it would be a relatively easy task for a company to maximize a single years dividend, simply by selling up all the assets and paying a
final liquidation dividend! (We are ignoring the niceties of company law here,
but the point still remains.) Obviously this is not what is meant by our decision
objective of maximizing dividends, and the trouble arises through the omission
of the time dimension. When fully defined, including the time dimension, the
objective of a companys financial decision makers becomes the maximizing of
the flow of dividends to shareholders over or through time.
The role of accounting profit

There are two points of fundamental importance that arise from the development of this decision objective. First, the word profit has not been mentioned
and the emphasis has been laid on wealth defined as cash. Secondly, the introduction of time means that decisions must be analysed not only in terms of
immediate cash gains and losses, but also in terms of future gains and losses.
These two points are interlinked. Profit, when used in a business sense, is a
concept developed by financial accountants in order to assist them with their
auditing and reporting functions, performed on behalf of shareholders.
Accounting has developed over hundreds of years from a base called stewardship. It was really designed to provide evidence that people holding responsibility for other peoples assets could account for them (i.e. demonstrate where
the resources went). In many ways this still lies at the heart of financial
accounting. Although financial reports are produced each year and contain the
figure profit it should not be interpreted as being the same thing as the
increase in the value of the company during the year. Annual reports are produced using a number of conventions and rules, the most important of which is
that the figures are expressed in terms of historic cost (with one or two possible
exceptions). There is also a certain amount of judgement exercised in the production of the statement and it has been said that profit is the invention rather
than the discovery of the accountant. The Accounting Standards Board (the
UK body that defines many of the rules used by accountants) has expressed the
view that accounting should not be seen as being concerned with value or
worth. As we will see, wealth, worth and value are all concepts related to the
future (and cash flows in the future) but profit is related to the past.
Financial decisions are basically economic or resource allocation decisions.
Management have to decide whether they should allocate the firms scarce
resources (land, labour, machinery, etc.) to a particular project. The economic
unit of account is cash, not accounting profit, because it is cash which gives
power to command resources (i.e. resources are purchased with cash, not
profit). Thus to use the accounting profit concept in financial decision making
would be to use an entirely inappropriate concept a concept specially developed for reporting the outcome of decisions and not developed for helping to
take the actual decision itself.
However, we cannot discard the accounting profit concept completely. To
do so would be rather like a sports team whose policy is that they do not mind
whether they win or lose, so long as in playing they give maximum entertainment to their supporters. This is fine, and it is probably the correct attitude; but
often it is on the winning or losing that the success of the team is ultimately
judged and therefore that part of the game cannot be ignored. So it is with
accounting profit. The companys financial decision makers should have as
their major concern the maximization of the flow of cash through time to the
shareholders, but they should always do so with an eye to reported profit. Profitability, as expressed in annual published accounts, forms a major criterion by
which shareholders and prospective shareholders judge a companys success
and, as we shall see later, it is important that people do form correct judgements about a companys performance.
10
A further reason why the effects of financial decisions on reported profits

cannot be completely ignored is provided by the fact that the level of retained
profit, in company law, can form a very substantial maximum barrier to an
annual dividend payment. Thus a company that wishes to maximize its dividend
flow must ensure that its dividend payout intentions are legally within the confines of company law.
Therefore, with the exception of these two provisos, we can say that the
financial decision theory developed here is built on an analytical framework
that is largely devoid of the accounting profit concept, although it would be
correct to assume that, in the longer run, good company cash flows will result
in good reported profits.
The time dimension

Turning to the second point of importance in our decision objective, the introduction of the time dimension, we have already noted that the arbitrary time segmentation of a continuous flow process has been the cause of major problems for
the accounting profit concept, but to see the true significance of the introduction
of this factor we have to return to our discussion on value.
An asset (such as a machine or a share in a company) is valued on the basis of
the gains, or losses, that the owner receives. Furthermore, these gains and losses
do not refer to just a single time period, but to the whole period of future time
for which the asset will exist. (This concept is sometimes referred to as the
assets earning power.)
Let us consider an asset of company ownership: an ordinary share. Ordinary
shares are traded (i.e. bought and sold) in supply and demand markets and so a
shares market valuation represents an equilibrium value, a value at which
demand for the share by people who wish to buy it equates with the supply of
the share by people who wish to sell it. But what process actually gives a share
its equilibrium price, what makes prospective purchasers wish to buy it at that
price and what makes prospective sellers willing to sell it at that price? Let us
examine the prospective purchasers reasons.
Suppose an ordinary share of XYZ plc has a stock market price of 150p.12
Prospective owners of that share would only be willing to buy it if they thought
it was worth 150p. In other words, they would expect that the gains to be
received from ownership would have a value of at least 150p.
These gains of ownership consist of two elements: the stream of dividends
received for as long as the share is owned, and the selling price received when
the share is sold (and so ownership relinquished) at some future point in time.
However, it is important to note that this future selling price of the XYZ share
is itself based on the value the succeeding owner in turn puts on the benefits
expected to be received from ownership the dividend flow received and the
selling price that will be received upon selling the share at some future point in
time. So the process goes on ad infinitum. Therefore, although there are two
benefits of ownership, the dividends received and the future selling price, this
latter benefit is itself determined by the flow of dividends expected to be generated by the share subsequent to its sale. (We can treat the cash flow received if
the company were to be wound up or liquidated as a final dividend.)
TECHNOLOGY AND FINANCIAL DECISION MAKING
11
Given this argument, our theory will assume that shares derive their (equilibrium) stock market price on the basis of the sum of the dividend flow that they
will produce through time. (As the future is uncertain, it is more correct to talk
of valuation based on the expected dividend flow, but we shall return to this
later.) Thus the greater the future dividend flow, the more highly are the shares
valued. Therefore if our financial decision makers are taking decisions so as to
maximize dividend flow through time, then via the direct link between dividend
flow and a shares market price, this action will result in the maximization of the
market value of the companys shares. It is this that we shall take as being the operational objective of financial management decision making.13
The objective hierarchy

So let us summarize our assumed hierarchy of decision objectives:
1. Decisions are taken by companies so as to maximize owners wealth.
2. Owners wealth can be maximized through maximizing owners purchasing power.
3. Purchasing power can be maximized through maximizing the amount of
cash the company pays out to shareholders in the form of dividends.
4. With the introduction of the time dimension the objective becomes the
maximizing of the value of the dividend flow through time to the
shareholders.
5. The maximization of the value of the dividend flow through time maximizes the stock markets valuation of the companys ordinary share capital.
However, it is important to realize that although it is this fifth level of objective we shall use in developing the theory of financial decision making, it is
really only a surrogate objective for the fundamental, underlying objective of
maximizing shareholders wealth.
A fundamental assumption
As a final point, let us state the assumptions about the shareholder that have
been implied in the analysis. It was earlier argued that the maximization of
shareholders wealth had to be the fundamental decision objective, because of
the nature of the capital markets. However, the validity of this assertion
depends entirely upon the assumption that shareholders perceive wealth in the
way we have postulated and that in this perception they are rational. In essence
this means that we have assumed that shareholders see wealth as the receipt of
cash flows through time and that they will always prefer a greater to a lesser
cash flow. These appear reasonably safe assumptions, but we shall consider situations where they may not hold when we look later at dividend policies.
Technology and financial decision making

The past 20 years have seen what amounts to a technological revolution. This
has been described as an information revolution on a par with the industrial
12
revolution of the 18th and 19th centuries. It is now most unlikely that decision
makers will not have access to computer facilities and the power of the typical
desktop machine is now such that sophisticated software can be used to aid their
decisions. In most cases the type of software used will be based on spreadsheets
such as Microsoft Excel and you are encouraged to use the software available to
you when answering the problems set throughout the text. However, it is
important that you understand the underlying principles so it is not advisable to
rely solely on the financial functions embedded in the software. It is also worth
mentioning that some of the functions can be somewhat problematical as we
will see.
Summary
Notes
The decision process consists of three elements:

1. a series of perceived alternatives;
2. an expectation that these alternatives are not all equally desirable in terms
of attaining an objective held by the decision maker;
3. a common value base, related to the objective, by which the alternatives
may be compared.
As far as financial management is concerned, it is assumed that the
objective of financial management decision making is the maximization of
shareholder wealth. This is normally translated to mean maximizing the
current worth of the companys shares.
Given that shareholder wealth is seen in terms of an ability to consume
goods and services and that it is cash that provides consumption power, so
share value can be maximized by maximizing the sum of the expected
stream of dividends through time generated by the share.
Accounting profit is essentially an inappropriate concept within the
context of financial management decision making because it is a reporting
device, not a decision-making device. Finance decisions are economic or
resource allocation decisions and the economic unit of account is cash;
hence decisions are evaluated in terms of their cash flow impact. However,
the reported profit impact of financial decisions remains an important
consideration in terms of the correct communication of managements
actions to shareholders and others.
1. Be these large stock exchange quoted companies such as BP or Unilever, or small

unquoted companies such as a local printing company or car rental company.
2. The terms decision making and decision taking can be used synonymously.
However, the term decision making will be used in this book because of its more
positive emphasis on deliberate creative action.
3. We will carefully define just what financial decisions are, but for now this covers
such things as a decision to invest in a new machine, to borrow money from the bank or
a decision to pass (i.e. not pay) an annual dividend that shareholders may have been
expecting.
4. There are many variants of capitalism (which in itself is just one type of economic
system; for example, alternatives could include socialist, feudal and primitive communal
economies) but its two general features are the private ownership of property and the
QUICKIE QUESTIONS
13
allocation of the economys resources (land, labour and machinery) through a supply
and demand price mechanism.
5. Indeed, we shall also occasionally allude to the psychological processes behind firms
financial decisions where conflicts of interest arise.
6. In a way, in specifying this second necessary condition, we are ignoring the situation
where a decision has to be made, even though this second condition does not exist. For
instance, if you are out for a walk with no particular destination in mind and you come
to a crossroads, a decision has to be taken on which direction to take, even though the
second necessary condition is really unfulfilled. Such situations are of little interest as
far as the decision process is concerned; we could call them indifference decisions.
7. For the present, we shall ignore the possibility of multiple objectives, although we
shall touch upon it later. However we may observe that where multiple objectives exist
in real life, one objective is often regarded (either implicitly or explicitly) as being of
overriding importance, with the other objectives acting as constraining factors or
considerations.
8. In abstract terms we can define a company as a collection of assets. The owners of
the company have therefore pooled their funds to assemble such a collection and are
logically only likely to do so in order to bring benefit (either directly or indirectly) to
themselves.
9. The term privately owned companies can be a source of confusion. It refers to all
companies that are owned by individuals, either singly or collectively, whether or not
they are publicly quoted (plc) on a stock exchange or otherwise. Thus both public and
private companies (in financial nomenclature) are privately owned companies.
10. See, for instance, Ivy Papps, Government and Enterprise, Hobart Paper No. 61,
Institute of Economic Affairs, 1975.
11. We shall be ignoring the effects of inflation until later.
12. This is obviously a simplification, as in practice each share has two equilibrium
prices, a buying price and a selling price. The former will be the higher of the two, and
the difference constitutes the market-makers turn. However, for simplicity, we will
ignore this complication and use a middle value.
13. Of course, if the companys shares are not quoted on a stock exchange, then the
objective simply reduces to the maximization of the value of the companys shares.
This, however, still leaves the problem of how the shares are to be valued. In fact they
should be valued on exactly the same basis as quoted shares: the future expected
dividend flow. It is one of the great advantages of a stock market quotation that this
value is automatically and continuously provided for use both by management and by
investors.
Quickie
questions
1.
2.
3.
4.
5.
What are the three major areas of financial decisions?

What is the search process?
What is the fundamental objective of financial management decision
making?
Why is accounting profit an inappropriate criterion for financial
decision making?
How are shares valued?
(See the Answers to quickie questions section at the back of the book.)
667
Tables
Compounding and discounting tables

TABLE A
Compound
interest factor
(1 + i)N
TABLE B
Present value
factor
(1 + i)N
i
N
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
i
N
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
1.0400
1.0816
1.1249
1.1699
1.2167
1.2653
1.3159
1.3686
1.4233
1.4802
1.5395
1.6010
1.6651
1.7317
1.8009
1.0600
1.1236
1.1910
1.2625
1.3382
1.4185
1.5036
1.5939
1.6895
1.7909
1.8983
2.0122
2.1329
2.2609
2.3966
1.0800
1.1664
1.2597
1.3605
1.4693
1.5869
1.7138
1.8509
1.9990
2.1589
2.3316
2.5182
2.7196
2.9372
3.1722
1.1000
1.2100
1.3310
1.4641
1.6105
1.7716
1.9487
2.1436
2.3580
2.5937
2.8531
3.1384
3.4523
3.7975
4.1773
1.1200
1.2544
1.4049
1.5735
1.7623
1.9738
2.2107
2.4760
2.7731
3.1058
3.4785
3.8960
4.3635
4.8871
5.4736
1.1400
1.2996
1.4815
1.6890
1.9254
2.1950
2.5023
2.8526
3.2519
3.7072
4.2262
4.8179
5.4924
6.2613
7.1379
1.1600 1.1800 1.2000

1.3456 1.3924 1.4400
1.5609 1.6430 1.7280
1.8106 1.9338 2.0736
2.1003 2.2878 2.4883
2.4364 2.6996 2.9860
2.8262 3.1855 3.5832
3.2784 3.7589 4.2998
3.8030 4.4335 5.1598
4.4114 5.2338 6.1917
5.1173 6.1759 7.4301
5.9360 7.2876 8.9161
6.8858 8.5994 10.6993
7.9875 10.1472 12.8392
9.2655 11.9737 15.4070
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
0.9615
0.9246
0.8890
0.8548
0.8219
0.7903
0.7599
0.7307
0.7026
0.6756
0.6496
0.6246
0.6006
0.5775
0.5553
0.9434
0.8900
0.8396
0.7921
0.7473
0.7050
0.6651
0.6274
0.5919
0.5584
0.5268
0.4970
0.4686
0.4423
0.4173
0.9259
0.8573
0.7938
0.7350
0.6806
0.6302
0.5835
0.5403
0.5002
0.4632
0.4289
0.3971
0.3677
0.3405
0.3152
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
0.4241
0.3855
0.3505
0.3186
0.2897
0.2633
0.2394
0.8929
0.7972
0.7118
0.6355
0.5674
0.5066
0.4532
0.4039
0.3606
0.3220
0.2875
0.2567
0.2292
0.2046
0.1827
0.8772
0.7695
0.6750
0.5921
0.5194
0.4556
0.3996
0.3506
0.3075
0.2697
0.2366
0.2076
0.1821
0.1597
0.1401
0.8621
0.7432
0.6407
0.5523
0.4761
0.4014
0.3538
0.3050
0.2630
0.2267
0.1954
0.1685
0.1452
0.1252
0.1079
0.8475
0.7182
0.6086
0.5158
0.4371
0.3704
0.3139
0.2660
0.2255
0.1911
0.1619
0.1372
0.1163
0.0985
0.0835
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
0.1346
0.1122
0.0935
0.0779
0.0649
668
TABLE C
Present value of
an annuity AN i
TABLES
i
N
TABLE D
Terminal value of
an annuity SN i
0.04
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
i
N
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
0.9434
1.8334
2.6730
3.,4651
4.2124
4.9173
5.5824
6.2098
6.8017
7.3601
7.8869
8.3838
8.8527
9.2950
9.7122
0.9259
1.7833
2.5771
3.3121
3.9927
4.6229
5.2064
5.7466
6.2469
6.7101
7.1390
7.5361
7.9038
8.2442
8.5595
0.9091
1.7355
2.4869
3.1699
3.7908
4.3553
4.8684
5.3349
5.7590
6.1446
6.4951
6.8137
7.1034
7.3667
7.6061
0.8929
1.6901
2.4018
3.0373
3.6048
4.1114
4.5638
4.9676
5.3282
5.6502
5.9377
6.1944
6.4235
6.6282
6.8109
0.8772
1.6467
2.3216
2.9137
3.4331
3.8887
4.2883
4.6389
4.9464
5.2161
5.4527
5.6603
5.8424
6.0021
6.1422
0.8621
1.6052
2.2459
2.7982
3.2743
3.6847
4.0386
4.3436
4.6065
4.8332
5.0286
5.1971
5.3423
5.4675
5.5755
0.8475
1.5656
2.1743
2.6901
3.1272
3.4976
3.8115
4.0776
4.3030
4.4941
4.6560
4.7932
4.9095
5.0081
5.0916
0.8333
1.5278
2.1065
2.5887
2.9906
3.3255
3.6046
3.8372
4.0310
4.1925
4.3271
4.4392
4.5327
4.6106
4.6755
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
1.0000
2.0400
3.1216
4.2465
5.4163
6.6330
7.8983
9.2142
10.5828
12.0061
13.4864
15.0258
16.6268
18.2919
20.0236
1.0000
2.0600
3.1836
4.3746
5.6371
6.9753
8.3938
9.8975
11.4913
13.1808
14.9716
16.8699
18.8821
21.0151
23.2760
1.0000
2.0800
3.2464
4.5061
5.8666
7.3359
8.9228
10.6366
12.4876
14.4866
16.6455
18.9771
21.4953
24.2149
27.1521
1.0000
2.1000
3.3100
4.6410
6.1051
7.7156
9.4872
11.4359
13.5795
15.9374
18.5312
21.3843
24.5227
27.9750
31.7725
1.0000
2.1200
3.3744
4.7793
6.3528
8.1152
10.0890
12.2997
14.7757
17.5487
20.6546
24.1331
28.0291
32.3926
37.2797
1.0000
2.1400
3.4396
4.9211
6.6101
8.5355
10.7305
13.2328
16.0853
19.3373
23.0445
27.2707
32.0887
37.5811
43.8424
1.0000
2.1600
3.5056
5.0665
6.8771
8.9775
11.4139
14.2401
17.5185
21.3215
25.7329
30.8502
36.7862
43.6720
51.6595
1.0000
2.1800
3.5724
5.2154
7.1542
9.4420
12.1415
15.3270
19.0859
23.5213
28.7551
34.9311
42.2187
50.8180
60.9653
1.0000
2.2000
3.6400
5.3680
7.4416
9.9299
12.9159
16.4991
20.7989
25.9587
32.1504
39.5805
48.4966
59.1959
72.0351
0.9615
1.8861
2.7751
3.6299
4.4518
5.2421
6.0021
6.7327
7.4353
8.1109
8.7605
9.3851
9.9856
10.5631
11.1184
669
COMPOUNDING AND DISCOUNTING TABLES
TABLE E
Annual equivalent
1
factor A N i
i
N
TABLE F
Sinking fund factor
1
S N i
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
i
N
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
1.0400
0.5302
0.3603
0.2755
0.2446
0.1908
0.1666
0.1485
0.1345
0.1233
0.1141
0.1066
0.1001
0.0947
0.0899
1.0600
0.5454
0.3741
0.2886
0.2374
0.2034
0.1791
0.1610
0.1470
0.1359
0.1268
0.1193
0.1130
0.1076
0.1030
1.0800
0.5608
0.3880
0.3019
0.2505
0.2163
0.1921
0.1740
0.1601
0.1490
0.1401
0.1327
0.1265
0.1213
0.1168
1.1000
0.5762
0.4021
0.3155
0.2638
0.2296
0.2054
0.1874
0.1736
0.1627
0.1540
0.1468
0.1408
0.1357
0.1315
1.1200
0.5917
0.4163
0.3292
0.2774
0.2432
0.2191
0.2013
0.1877
0.1770
0.1684
0.1614
0.1557
0.1509
0.1468
1.1400
0.6073
0.4307
0.3432
0.2913
0.2572
0.2332
0.2156
0.2022
0.1917
0.1834
0.1767
0.1712
0.1666
0.1628
1.1600
0.6230
0.4453
0.3574
0.3054
0.2714
0.2476
0.2302
0.2171
0.2069
0.1989
0.1924
0.1872
0.1829
0.1794
1.1800
0.6387
0.4599
0.3717
0.3198
0.2859
0.2624
0.2452
0.2324
0.2225
0.2148
0.2086
0.2037
0.1997
0.1964
1.2000
0.6545
0.4747
0.3863
0.3344
0.3007
0.2774
0.2606
0.2481
0.2385
0.2311
0.2253
0.2206
0.2169
0.2139
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
1.0000
0.4902
0.3203
0.2355
0.1846
0.1508
0.1266
0.1085
0.0945
0.0833
0.0741
0.0666
0.0601
0.0547
0.0499
1.0000
0.4854
0.3141
0.2286
0.1774
0.1343
0.1191
0.1010
0.0870
0.0759
0.0668
0.0593
0.0530
0.0476
0.0430
1.0000
0.4808
0.3080
0.2219
0.1705
0.1363
0.1121
0.0940
0.0801
0.0690
0.0601
0.0527
0.0465
0.0413
0.0368
1.0000
0.4762
0.3021
0.2155
0.1638
0.1296
0.1054
0.0874
0.0736
0.0627
0.0540
0.0468
0.0408
0.0357
0.0315
1.0000
0.4717
0.2963
0.2092
0.1574
0.1232
0.0991
0.0813
0.0677
0.0570
0.0484
0.0414
0.0357
0.0309
0.0268
1.0000
0.4673
0.2907
0.2032
0.1513
0.1172
0.0932
0.0756
0.0622
0.0517
0.0434
0.0367
0.0312
0.0266
0.0228
1.0000
0.4630
0.2853
0.1974
0.1454
0.1114
0.0876
0.0702
0.0571
0.0469
0.0389
0.0324
0.0272
0.0229
0.0194
1.0000
0.4587
0.2799
0.1917
0.1398
0.1059
0.0824
0.0652
0.0524
0.0425
0.0348
0.0286
0.0237
0.0197
0.0164
1.0000
0.4545
0.2747
0.1863
0.1344
0.1007
0.0774
0.0606
0.0481
0.0385
0.0311
0.0253
0.0206
0.0169
0.0139
670
TABLE G
Compound interest
N0.5
factor (1 + i)
Present value of 1
received evenly
through year
TABLES
i
N
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.04
0.06
0.08
0.10
0.12
0.14
0.16
0.18
0.20
0.9806
0.9429
0.9066
0.8717
0.8382
0.8060
0.7750
0.7452
0.7165
0.6889
0.6624
0.6370
0.6125
0.5889
0.5663
0.9713
0.9163
0.8644
0.8155
0.7693
0.7258
0.6847
0.6460
0.6094
0.5749
0.5424
0.5117
0.4827
0.4554
0.4296
0.9623
0.8910
0.8250
0.7639
0.7073
0.6549
0.6064
0.5615
0.5199
0.4814
0.4457
0.4127
0.3821
0.3538
0.3276
0.9535
0.8668
0.7880
0.7164
0.6512
0.5920
0.5382
0.4893
0.4448
0.4044
0.3676
0.3342
0.3038
0.2762
0.2511
0.9449
0.8437
0.7533
0.6726
0.6005
0.5362
0.4787
0.4274
0.3816
0.3407
0.3042
0.2716
0.2425
0.2165
0.1933
0.9366
0.8216
0.7207
0.6322
0.5545
0.4864
0.4267
0.3743
0.3283
0.2880
0.2526
0.2216
0.1944
0.1705
0.1496
0.9285
0.8004
0.6900
0.5948
0.5128
0.4421
0.3811
0.3285
0.2832
0.2441
0.2105
0.1814
0.1564
0.1348
0.1162
0.9206
0.7801
0.6611
0.5603
0.4748
0.4024
0.3410
0.2890
0.2449
0.2075
0.1759
0.1491
0.1263
0.1071
0.0907
0.9129
0.7607
0.6339
0.5283
0.4402
0.3669
0.3057
0.2548
0.2123
0.1769
0.1474
0.1229
0.1024
0.0853
0.0711
Using this discount factor actually assumes that the cash flows take place in the middle of the
year. However this is a very good approximation for cash flows that are spread evenly during
the year.
TABLE H
Present value of an
annuity AN05i
Present value of 1
received each year
evenly throughout
the year
i
N
2%
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
0.9901
1.9609
2.9126
3.8456
4.7604
5.6572
6.5364
7.3984
8.2435
9.0720
9.8842
10.6806
11.4613
12.2267
12.9771
4%
0.9806
1.9234
2.8300
3.7018
4.5400
5.3460
6.1209
6.8661
7.5826
8.2715
8.9340
9.5709
10.1834
10.7723
11.3386
6%
8%
10%
12%
14%
16%
18%
20%
0.9713
1.8876
2.7520
3.5675
4.3369
5.0627
5.7474
6.3934
7.0028
7.5777
8.1200
8.6317
9.1144
9.5698
9.9994
0.9623
1.8532
2.6782
3.4421
4.1493
4.8042
5.4106
5.9721
6.4920
6.9733
7.4190
7.8317
8.2138
8.5677
8.8953
0.9535
1.8202
2.6082
3.3246
3.9758
4.5678
5.1060
5.5953
6.0401
6.4445
6.8121
7.1463
7.4501
7.7262
7.9773
0.9449
1.7886
2.5419
3.2144
3.8149
4.3511
4.8298
5.2573
5.6389
5.9796
6.2839
6.5555
6.7980
7.0146
7.2079
0.9366
1.7582
2.4788
3.1110
3.6655
4.1520
4.5787
4.9530
5.2813
5.5693
5.8219
6.0435
6.2379
6.4085
6.5580
0.9285
1.7289
2.4189
3.0137
3.5265
3.9686
4.3497
4.6782
4.9614
5.2055
5.4160
5.5975
5.7539
5.8887
6.0050
0.9206
1.7007
2.3619
2.9222
3.3970
3.7994
4.1404
4.4294
4.6743
4.8818
5.0577
5.2068
5.3331
5.4401
5.5309
0.9129
1.6736
2.3075
2.8358
3.2761
3.6429
3.9486
4.2034
4.4157
4.5926
4.7401
4.8629
4.9653
5.0506
5.1217
Using this discount factor actually assumes that the cash flows take place in the middle of
each year. However this is a very good approximation for cash flows that are spread evenly
during each year. It will be noticed that at 10% over 10 years, the annuity factor is 6.4445
whilst using the year-end cash flow assumption (Table C) produces a factor of 6.1446. It is a
matter of judgement as to whether or not this difference (of 5%) is seen as being significant.
671
AREA UNDER THE NORMAL CURVE
Area under the normal curve
TABLE I
Areas under the
normal distribution
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
3.0
.0000
.0398
.0793
.1179
.1554
.1915
.2257
.2580
.2881
.3159
.3413
.3643
.3849
.4032
.4192
.4332
.4452
.4554
.4641
.4713
.4773
.4821
.4861
.4893
.4918
.4938
.4953
.4965
.4974
.4981
.4987
.0040
.0438
.0832
.1217
.1591
.1950
.2291
.2611
.2910
.3186
.3438
.3665
.3869
.4049
.4207
.4345
.4463
.4564
.4649
.4719
.4778
.4826
.4864
.4896
.4920
.4940
.4955
.4966
.4975
.4982
.4987
.0080
.0478
.0871
.1255
.1628
.1985
.2324
.2642
.2939
.3212
.3461
.3686
.3888
.4066
.4222
.4357
.4474
.4573
.4656
.4726
.4783
.4830
.4868
.4898
.4922
.4941
.4956
.4967
.4976
.4982
.4987
.0120
.0517
.0910
.1293
.1664
.2019
.2357
.2673
.2967
.3238
.3485
.3708
.3907
.4082
.4236
.4370
.4484
.4582
.4664
.4732
.4788
.4834
.4871
.4901
.4925
.4943
.4957
.4968
.4977
.4982
.4988
.0160
.0557
.0948
.1331
.1700
.2054
.2389
.2704
.2995
.3264
.3508
.3729
.3925
.4099
.4251
.4382
.4495
.4591
.4671
.4738
.4793
.4838
.4875
.4904
.4927
.4945
.4959
.4969
.4977
.4984
.4988
.0199
.0596
.0987
.1368
.1736
.2088
.2422
.2734
.3023
.3289
.3531
.3749
.3944
.4115
.4265
.4394
.4505
.4599
.4678
.4744
.4798
.4842
.4878
.4906
.4929
.4946
.4960
.4970
.4978
.4984
.4989
.0239
.0636
.1026
.1406
.1772
.2123
.2454
.2764
.3051
.3315
.3554
.3770
.3962
.4131
.4279
.4406
.4515
.4608
.4686
.4750
.4803
.4846
.4881
.4909
.4931
.4948
.4961
.4971
.4979
.4985
.4989
.0279
.0675
.1064
.1443
.1808
.2157
.2486
.2794
.3078
.3340
.3577
.3790
.3980
.4147
.4292
.4418
.4525
.4616
.4693
.4756
.4808
.4850
.4884
.4911
.4932
.4949
.4962
.4972
.4979
.4985
.4989
.0319
.0714
.1103
.1480
.1844
.2190
.2517
.2823
.3106
.3365
.3599
.3810
.3997
.4162
.4306
.4429
.4535
.4625
.4699
.4761
.4812
.4854
.4887
.4913
.4934
.4951
.4963
.4973
.4980
.4986
.4990
.0359
.0753
.1141
.1517
.1879
.2224
.2549
.2852
.3133
.3389
.3621
.3830
.4015
.4177
.4319
.4441
.4545
.4633
.4706
.4767
.4817
.4857
.4890
.4916
.4936
.4952
.4964
.4974
.4981
.4986
.4990
672
Natural logarithms
TABLE J
N
1.0
.1
.2
.3
.4
.5
.6
.7
.8
.9
2.0
.1
.2
.3
.4
.5
.6
.7
.8
.9
3.0
.1
.2
.3
.4
.5
.6
.7
.8
.9
4.0
.1
.2
.3
.4
.5
.6
.7
.8
.9
0.0000
.0953
.1823
.2623
.3364
.4054
.4700
.5306
.5877
.6418
0.6931
.7419
.7884
.8329
.8754
.9162
.9555
.9932
1.0296
.0647
1.0986
.1314
.1631
.1939
.2237
.2527
.2809
.3083
.3350
.3609
1.3862
.4109
.4350
.4586
.4816
.5040
.5260
.5475
.5686
.5892
.0099
.1043
.1906
.2700
.3435
.4121
.4762
.5364
.5933
.6471
.6981
.7466
.7929
.8372
.8796
.9202
.9593
.9969
a
.0331
.0681
.1019
.1346
.1662
.1969
.2267
.2556
.2837
.3110
.3376
.3635
.3887
.4134
.4374
.4609
.4838
.5063
.5282
.5496
.5707
.5912
.0198
.1133
.1988
.2776
.3506
.4187
.4824
.5423
.5988
.6523
.7031
.7514
.7975
.8415
.8837
.9242
.9631
a
.0006
.0367
.0715
.1052
.1378
.1693
.1999
.2296
.2584
.2864
.3137
.3402
.3660
.3912
.4158
.4398
.4632
.4861
.5085
.5303
.5518
.5727
.5933
.0295
.1222
.2070
.2851
.3576
.4252
.4885
.5481
.6043
.6575
.7080
.7561
.8020
.8458
.8878
.9282
.9669
a
.0043
.0402
.0750
.1085
.1410
.1724
.2029
.2325
.2613
.2892
.3164
.3428
.3686
.3937
.4182
.4422
.4655
.4884
.5107
.5325
.5539
.5748
.5953
.0392
.1310
.2151
.2926
.3646
.4317
.4947
.5538
.6097
.6626
.7129
.7608
.8064
.8501
.8920
.9321
.9707
a
.0079
.0438
.0784
.1118
.1442
.1755
.2059
.2354
.2641
.2919
.3190
.3454
.3711
.3962
.4207
.4445
.4678
.4906
.5129
.5347
.5560
.5769
.5973
.0487
.1397
.2231
.3001
.3715
.4382
.5007
.5596
.6151
.6678
.7178
.7654
.8109
.8542
.8960
.9360
.9745
a
.0116
.0473
.0818
.1151
.1474
.1786
.2089
.2383
.2669
.2947
.3217
.3480
.3737
.3987
.4231
.4469
.4701
.4929
.5151
.5368
.5581
.5789
.5993
.0582
.1484
.2311
.3074
.3784
.4446
.5068
.5653
.6205
.6729
.7227
.7701
.8153
.8586
.9001
.9400
.9783
a
.0152
.0508
.0851
.1184
.1505
.1817
.2119
.2412
.2697
.2974
.3244
.3506
.3762
.4011
.4255
.4492
.4724
.4951
.5173
.5390
.5602
.5810
.6014
.0676
.1570
.2390
.3148
.3852
.4510
.5128
.5709
.6259
.6780
.7275
.7747
.8197
.8628
.9042
.0439
.9820
a
.0188
.0543
.0885
.1216
.1537
.1847
.2149
.2441
.2725
.3001
.3270
.3532
.3787
.4036
.4279
.4516
.4747
.4973
.5195
.5411
.5623
.5830
.6034
.0769
.1655
.2468
.3220
.3920
.4574
.5187
.5766
.6312
.6831
.7323
.7793
.8241
.8671
.9082
.9477
.9858
a
.0224
.0577
.0919
.1249
.1568
.1878
.2178
.2470
.2753
.3029
.3297
.3558
.3812
.4061
.4303
.4539
.4770
.4996
.5217
.5433
.5644
.5851
.6054
.0861
.1739
.2546
.3293
.3987
.4637
.5247
.5822
.6365
.6881
.7371
.7839
.8285
.8712
.9122
.9516
.9895
a
.0260
.0612
.0952
.1281
.1600
.1908
.2208
.2499
.2781
.3056
.3323
.3584
.3837
.4085
.4327
.4562
.4793
.5018
.5238
.5454
.5665
.5871
.6074
a. Add 1.0 to indicated figure.
673

Chapter 1
1. (a) The capital investment decision.
2.
3.
4.
5.
(b) The financing and capital structure decision.

(c) The dividend decision.
The process by which the company seeks out alternative courses of action,
alternative projects, etc.
The assumed objective of financial decision making is maximization of shareholder
wealth. While recognizing that this is a simplification of the real world, it is
reasonable to accept that this should be the main objective, other things being
equal.
It is a reporting concept, not a decision-making concept. Its purpose is to report on
the success or failure of decisions taken. It has only a secondary role in the
decision-making process itself. Accounting profit is also based on historic cost
whereas financial management is concerned with value. The two things are very
different. Finally, profit as reported is subject to the judgement of the accountant
and cannot be regarded as entirely reliable.
On the basis of the expected flow of dividends they will generate in the future.
Chapter 2
1. The problem is one of control. How does the principal control the agent to ensure
that the agent acts in the principals best interests?
2. Fiduciary responsibilities; independent external audit; London Stock Exchange
Yellow Book listing rules and Model Code for directors share dealings;
Companies Act regulations on directors transactions; and the Combined Code
best corporate governance practice.
3. Reward managerial ability, not luck; rewards should have a significant impact on
managerial remuneration; reward system should work two ways; concept of risk
should be taken into account; the shareholders time horizon should be taken into
account; scheme should be simple, inexpensive and difficult to manipulate.
Chapter 3
1. Stage one: The best of the alternative projects has the shortest payback.
Stage two: Accept the best project as long as its payback period satisfies the
decision criterion.
2. Working capital is excluded from the analysis. Net cash flow:
0
1
2
3
4
5
11 000
+ 4 000
+ 4 000
+ 4 000
+ 3 000
+ 3 000
Payback = 2.75 years
3. (a) Quick and simple to calculate.

(b) Thought to automatically select less risky projects in mutually exclusive
decision situations.
674
ANSWERS TO QUICKIE QUESTIONS
4.
5.
6.
7.
8.
9.
(c) Saves management the trouble of having to estimate project cash flows beyond
the maximum payback time period.
(d) Convenient method to use in capital rationing.
The payback criterion is reduced until total capital expenditure equates with the
amount of finance available.
(a) Managements experience of successful projects within the firm.
(b) Industry practice.
(c) Reflects the limit of managements forecasting skills.
However, none of these can be seen as being really objective.
The payback decision rule, adjusted to take account of the time value of money.
Ignores cash flows outside the payback time period. (The fact that normal
payback ignores the time value of money is equally important but this criticism
can, of course, be easily overcome through the use of discounted payback.)
Money has a time value because it can earn a rate of interest/a rate of return. This
has nothing to do with inflation although that might have an effect on the levels of
return expected.
The question does not specify which ARR/ROCE to calculate, so both are given:
Annual depreciation: (11 000 1 000) 5 = 2 000.
Profit:
4 000
4 000
4 000
3 000
2 000
Total profit
2 000
2 000
2 000
2 000
2 000
=
=
=
=
=
=
=
2 000
Yr 1
2 000
Yr 2
2 000
Yr 3
1 000
Yr 4
0
Yr 5
7 000 5 = 1 400
Av. ann. profit
Average capital employed:

11 000 1 000
+ 1 000 + 4 000 = 10 000
2
Return on initial capital employed = 1 400 15 000 = 9 13%
Return on average capital employed = 1 400 10 000 = 14%
10. (a) Evaluates via a percentage rate of return.
(b) Evaluates on the basis of profitability.
(c) Appears logical to evaluate projects on the same basis as management have
their own performance evaluated by shareholders.
11. (a) Ignores the time value of money.
(b) Evaluates on the basis of profit, not cash flow.
Chapter 4
1. This is an example of the economic concept of diminishing marginal utility. Each

additional 1 of t0 consumption forgone, through investment, is likely to be of
increasing value in terms of consumption benefits forgone. Each additional 1 of
future consumption gained is likely to be of decreasing value. Hence, the time
value of money rises.
2. The complete range of maximum consumption combinations that the firm owner
can obtain at t0 and t1.
3. The marginal return on the investment opportunity at any particular point.
4. A curve of constant utility. All combinations of consumption at t0 and t1 that lie
along a single indifference curve would provide the same level of utility or
satisfaction.
675
CHAPTER 5
5. It invests until the return on the marginal investment equates with the owners
marginal time value of money.
6. Lending at t0 would reduce the amount of money available for consumption at t0
and increase the amount available at t1, hence the move would be up the financial
investment line.
7. The firm should continue to invest in projects as long as the marginal rate of return
is not less than the market rate of interest. This rule is, of course, obvious. There
would be little point in investing money in a project that gave a lower return than
could be obtained by lending the money on the capital market.
The cash (dividend) distribution to shareholders in t0 and t1 that arises out of the
firms investment decision can then be redistributed by shareholders, using the
capital markets, to suit their own set of indifference curves.
8. A risky investment is one where the outcome is uncertain.
9. Ensure that any project earns at least the capital market rate of return that is
available for investments of equivalent risk to the project.
10. (a) single time horizon;
(b) infinitely divisible projects;
(c) all independent projects;
(d) rational investors.
11. Investors dislike risk: they are said to be risk-averse. Hence they require a reward
for taking on a risk, which is the expectation (but, of course, not the certainty) of a
higher return.
12. In these circumstances, the market rate of return offers you greater compensation than
you require to forgo current consumption. Therefore you would want to lend money.
Chapter 5
1. 0
1 000
1
2
3
+ 500
+ 600
+ 400

0.8772=
0.7695=
0.6750=
1 000
+
+
+
+
438.60
461.70
270
170.30 NPV
2. There are several interpretations:

(a) It produces a return > 10%.
(b) It produces 120 more (in t0 terms) than a 1000 capital market investment of
similar risk.
(c) The project would produce a sufficient cash flow to repay its outlay, pay its
financing charges and provide an additional 120 in t0 terms.
(d) If accepted, shareholder wealth would increase by 120.
3. At 4% discount rate: NPV = +147.48
At 20% discount rate: NPV = 9.28
147.48
Therefore IRR = 4% +
(20% 4%) = 19.05% approx.
147.48 (9.28)
With any problem like this it is a good idea to use a computer to arrive at an
answer. In this case the solution, using the IRR function of a spreadsheet, is
18.825%.
4. Year Cash flow.
Discount factor
0
500

1
=
500
1
+200

0.9091
=
+181.82
2
+300

0.8264
=
+247.92
3
+200

0.7513
=
+150.26
676
500 181.82 247.92 = 70.26 150.26 = 0.47.

Therefore payback is 2.47 years approx.
5. The return available elsewhere on the capital market on a similar risk investment.
6. For the same project they should be identical. In both cases they are the
opportunity cost return referred to in the answer to question five.
7. +350 A40.10 = 350 3.1699 = +1109.47.
8. (a) annuity due;
(b) immediate annuity;
(c) deferred annuity.
9. Given that the PV of a perpetuity is:
Annual amount
, then:
Discount rate
IRR =
100
= 0.10 or 10%
1 000
because: 1 000 +
10.
Chapter 6
100
= 0 NPV
0.10
1 000 + 200 A20.16 + 500 A30.16 (1 + 0.16)2 = NPV

1 000 + (200 1.6052) + (500 2.2459 0.7432) = +155.62
1. The NPV rule is to accept whichever project has the largest positive NPV.
Differences in magnitude, duration and risk can be ignored. Hence Project A
should be accepted.
2. The assumptions made are:
(a) There is a perfect capital market so that the firm can finance the large project
just as easily as it can finance the small project.
(b) The projects represent independent decisions in that they are not part of a
continuous replacement chain.
(c) The discount rates used do correctly reflect the risk of each project.
3. NPV and IRR both make assumptions about the rate of return at which
project-generated cash flows are reinvested. NPV assumes that the rate is the
market discount rate, while IRR assumes that it is equal to the IRR of the project
generating those cash flows. Given a perfect capital market, the NPV method is
making the correct assumption.
4. Non-conventional cash flows, where there is more than one change in sign. The
problem can be avoided by using the extended yield technique or the modified
IRR.
5. Using the extended yield technique:
Year 3: 20 (1 + 0.10)3 = 15.02 at Year 0
Therefore the revised cash flow is:
0 115.02
1 + 60
2 + 80
At a 4% discount rate: +16.64 NPV
At a 20% discount rate: 9.46 NPV
16.64
IRR = 4%
(20% 4%) = 14.2%
16.64
(9.46)
677
CHAPTER 7
+ NPV
NPV: B
NPV: B
IRR: A
0 NPV
Discount rate
Discount
rate
IRR: B
IRR of differential
cash flow
NPV profile A
NPV profile B
NPV
7. If IRR diff. c/f > hurdle rate: accept project smallest IRR.
If IRR diff. c/f < hurdle rate: accept project largest IRR.
8.
1 +40 (1.10)2
=
2 +80 (1.10)1
=
3 3 0
=
Year 3 Terminal value
()
+60.5
+88
30
+118.50
Modified cash flow of the project:
Year
0
3
()
80
+118.50
Estimating the IRR using linear interpolation:

NPV at 5% = +22.36
NPV at 20% = 11.42
22.36
IRR = 5% +
(20% 5%) = 14.9%.
22.36 (11.42)
Chapter 7
1.
(1.13)
1 = 0.086 or 8.6%
(1.04)
2. Either: (a) Project money cash flows discounted at the market discount rate to
NPV; or (b) project money cash flows discounted at the general rate of inflation
and then at the real discount rate to NPV.
3. The money cash flow, deflated (discounted) by the general rate of inflation.
1.155
4.
1 = 0.10 = real discount rate
1.05
(a) 10 000 (1.05)2 = 11 025
(b) 10 000
(a) 11 025 (1.155)2 = 11 025 (1.10)2 (1.05)2 = 8263.73
(b) 10 000 (1.155)2 = 10 000 (1.10)2 (1.05)2 = 7495.45
678
5.
500
125
375
93.75
281.25
0.25
WDA
+125
0.35
Tax relief
+43.75
Timing
Year 2
0.25
+ 93.75 0.35
+32.81
Year 3
+281.25 0.35
+98.44
Year 4
6. Historic cost: 60 000, irrelevant, sunk cost.

Written-down book value: 10 000, irrelevant non-economic figure.
Scrap now: 3000.
Rent and then scrap: 2500 + 800 = 3300.
Therefore, if the machine is used to undertake the project, the best opportunity
forgone is the rent and then scrap alternative. So this is the opportunity cost of
using the machine on the project: 3300.
7. Discount the after-tax cash flows by the after-tax discount rate.
8. They are non-incremental.
9. Market price of factory space: 2 per m2 (external opportunity cost).
Contribution 15 per m2 (internal opportunity cost).
Cost to project: 150 (15 + 2) = 2550.
Chapter 8
1. Hard and soft capital rationing.

2. The firm cannot necessarily accept a project just because it has a positive NPV, nor
can it necessarily reject a project just because it has a negative NPV. Hence the
standard NPV decision rule breaks down. In theory capital rationing should not
exist because we assume that cash will be available for investments at an
appropriate rate of return. In another sense it causes no problem for NPV because
we could assume that the appropriate discount rate is the return on the alternative
investments (i.e. opportunity cost of capital).
3. The benefitcost ratios are:
A:
B:
C:
D:
200
100
100
40
60
60
+60
+90
+20
10
100
200
40
100
=
=
=
=
+0.60
+0.45
+0.50
0.10
(1)
(3)
(2)
()
available
invest in A, producing
+ 60 NPV
invest in C, producing
+ 20 NPV
invest in 30% B, producing
+ 27 NPV
+107 Total NPV
4. The benefitcost ratios are:

A:
B:
C:
D:
240
50
190
190
0
+60
+90
+20
10
50
200
150
=
=
=
=
+1.200
+0.450
+0.133
available
(1)
(2)
(3)
invest in 95% of B, producing :
+ 60 NPV
+ 85.5 NPV
+145.5 Total NPV
679
CHAPTER 8
As D has a costbenefit ratio of: 10 20 = 0.50 and B, the marginal project, has a
benefitcost ratio of 0.45, further investment is not worthwhile.
5. Benefitcost ratios:
A:
*B:
*C:
D:
E:
40
30
50
10
4
300
100
200
100
100
100
0
100
100
200
100
50
=
=
=
=
=
0.40
0.30
0.25
0.10
0.08
(1)
(2)
(3)
(4)
(5)
available
+40 NPV
invest in B, producing
+30 NPV
invest in D, producing
+10 NPV
+80 Total NPV
available
+40 NPV
invest in C, producing
+50 NPV
+90 Total NPV
alternatively:
300
100
200
200
0
Therefore, the best alternative is to undertake projects A and C.

6.
40a
100a
200a
30c
20b
+ 150b
+ 120c
+ 50c
+ 200c
a, b, c
a, b, c
7.
Dual values
1.86
0.73
0.64
1.21
+
+
+
+
+
10% discount factor

1.0000
0.9091
0.8264
0.7513
Max.
190
110 + 70b
50a + 70b
1
0
=
=
=
=
=
Total opportunity cost of cash

2.8600
t0
1.6391
t1
1.4664
t2
1.9613
t3
Gain from an extra 1 at t1:

1 1.6391 = 1.6391
Loss from repayment of 1, plus interest (i) at t2
(1 + i) 1.4664 = 1.4664 + 1.4664i
The maximum interest rate would occur at the point where the gain equals the
loss:
1.6391 = 1.4664 + 1.4664i
1.6391 1.4664 = 1.4664i
1.6391 1.4664
= i = 0.118 or 11.8% max.
1.4664
680
8. NPV:
100
+ 40
+ 90
1
0.9091
0.8264
=
=
=
100.00
+ 36.36
+ 74.38
+ 10.74 NPV
Internal opportunity cost:

100
1.86
=
+ 40
0.73
=
+ 90
0.64
=
186.00
+ 29.20
+ 57.60
99.20
Total opportunity cost:

+10.74 NPV
99.20 Internal opportunity cost
88.46 Net total opportunity cost
As this net figure is negative, the additional project will not be a worthwhile
investment, so reject.
Chapter 9
1 000 + 500 A30.10 = + 243 NPV

1 000 + 350 A30.10 = 130 NPV
1. Success:
Failure:
State
I
II
Prob.
0.45
0.55
2. Survey indicates
State I
State II

NPV
+243
130
Action
Accept
Reject
Prob.
0.45
0.55
ENPV with survey

ENPV without survey
Max. worth of survey
3. Survey indicates
State I correctly
State I incorrectly
State II correctly
State II incorrectly
State
A
B
C
D
Action
Accept
Accept
Reject
Reject
:
:
:
Probability
0.45 0.75
0.45 0.25
0.55 0.75
0.55 0.25
Prob.
0.3375
0.1125
0.4125
0.1375
ENPV with survey

ENPV without survey
=
=
Outcome
+243 NPV =
0 NPV =

+109
+ 37
+ 72
=
=
=
=
:
:
:
+41
+37
+ 4
State
A
B
C
D
0.3375
0.1125
0.4125
0.1375
Outcome
+243 NPV
72 NPV
0 NPV
243 NPV
ENPV

+109
72
+ 37 ENPV
=
=
=
=
+82
8
0
33
+41
+109
0
+109 ENPV
681
CHAPTER 9
4.
State
I
II
III
Prob.
0.3
0.5
0.2
NPV
+100
+ 50
300
ENPV

=
=
=
+30
+25
60
5
Therefore, without the survey we would not accept the project and so incur a zero
NPV.
Survey indicates
State I
State II
State III
Action
Accept
Accept
Reject
Prob.
0.3
0.5
0.2
ENPV with survey

ENPV without survey

:
:
:
Outcome
+100
+ 50
+ 0
ENPV
=
=
=
+30
+25
0
+55
+55
0
+55
5. If the machine is bought and, at the end of Yr 1, the decision is taken not to
abandon the project, then the outcome will be:
State
I
II
III
Yr 1
60
60
60
Yr 2
+100
+ 60
+ 40
NPV
+23.43
6.81
21.93
Decision
Dont abandon
Abandon
Abandon
The investment decision is therefore:

State
I
II
Yr 0
140
140
III
140
Yr 1
+100
+ 60
+ 60
+ 40
+ 60
Yr 2
+100
NPV
+22.57
35.65

Prob.
0.70 = +15.80
0.10 = 3.56
53.04
0.20 = 10.61
ENPV
+ 1.63
The complete decision is that the company should purchase the machine but, if
either states II or III occur, then the machine should be sold off at the end of the
first year.
6. 1 000 + 280 A50.10 = +61.42 NPV
Life = x
At 5 year life: +61.42 NPV

At 4 year life:
1000 + 280 A40.10 = 112.40 NPV
Using linear interpolation:

112.40
x = 4+
(5 4 ) = 4.65 yrs.
61.42+112.40
Thus the life of the project can be reduced by up to 0.35 of a year (approx 4
months) before the original decision advice is incorrect. This represents a
maximum change of 0.35 5 = 7%.
Net cash flow = x
1000 + x A50.10 = 0 NPV
x = 1000 A50.10 = 264
682
Thus the annual net cash flow can fall by up to 16 per year, or 16 280 = 5.7%
before the original decision advice is incorrect.
Chapter 10
1. (a) How to measure the projects risk.

(b) How to find the return available on the capital market for that level of risk.
2. Transitivity means that choice between alternatives is consistent: if X is preferred
to Y and Y is preferred to Z then X must be preferred to Z if the choice is to
exhibit transitivity.
3. It is the guaranteed outcome that is regarded as being of equal value to the
expected value of an uncertain investment. The guaranteed outcome will be
smaller in cash terms than the equivalent uncertain outcome with the same
perceived value so long as the investor is risk-averse.
4. U (+10 000) = 1
U (5 000) = 0
U (C E) = pU (+10 000) + (1 p) U (5 000)
U (3 500) = (0.60 1) + (0.40 0) = 0.60
5. Risk aversion.
6. Linear. However, it is likely that any individual will be risk-averse.
7. Certainty-equivalent < expected outcome.
8.
9.
(Selling price Purchase price) + Dividends received

= Return
Purchase price
State of world
I
II
III
(Return)2
(40%)2
(15%)2
(10%)2
2
Prob.
0.20
0.60
0.20

Return
+40%
+15%
10%

Prob.
0.20
0.60
0.20
=
=
=
=
=
=
+ 8%
+ 9%
2%
+15% = E(r)
320
135
20
475 = E(r2)
2
= E(r ) E(r) = 475 (15%) = 475 225 = 250

2
= = 250 = 15.81%
Solution: Expected return: 15%
Risk (std. dev.): 15.81%
10. Downside risk is concerned with the possibility that an investment might do worse
than expected.
11. In this situation the variance or standard deviation of the returns are not adequate
descriptors of risk. An investment with a lower variance might also be the
investment that bears the greater chance of a loss.
Chapter 11
1.
2.
The correlation coefficient. The further away it is from +1, the greater the degree
of risk-reduction effect.
p = [x22A + (1 x)2 2B + 2x(1 x)Cov(rA, rB)],
or
p = [x22A + (1 x)2 2B + 2x(1 x)A B A, B].
683
CHAPTER 11
3.
A: 0.3
0.4
0.3

=
=
=
=
28%
18%
6%
E(rA)

(28% 17.4%)
(18% 17.4%)
(6% 17.4%)
A: 0.3
0.4
0.3
(28%)2
(18%)2
(6%)2
E(r2A)
=
=
=
=
B:
0.3
0.4
0.3
(35% 22.5%)
(15% 22.5%)
(20% 22.5%)
235.2
129.6
10.8
375.6
B:
0.3
0.4
0.3

35%
15%
20%
E(rB)

0.3 =
0.4 =
0.3 =
Cov(rA, rB)
(35%)2
(15%)2
(20%)2
E(r2B)
A = [ E ( rA2 ) E ( rA )2 ]
B = [ E ( rB2 ) E ( rB )2 ]
A = ( 375.6 17.4 2 ) = 8.5%
B = (577.5 22.5 2 ) = 8.4%
A, B =
4.

8.4%
7.2%
1.8%
17.4%
=
=
=
=
=
=
=
=
10.5%
6%
6%
22.5%
+39.75
1.80
+ 8.55
+46.50
367.5
90.0
120.0
577.5
Cov.( rA , rB )
46.50
=
= 0.65
A B
8.5 8.4
E(rp) = xE(rA) + (1 x) E(rB)

20%
=
x 17.4% + (1 x) 22.5%
20
=
17.4x + 22.5 22.5x
20 22.5
=
17.4x 22.5x
2.5
=
5.1x
2.5
=
x = 0.49.
5.1
Therefore invest 49% of the funds in investment A, and the remaining 51% in B.
20% = (0.49 17.4%) + (0.51 22.5%).
5.
N
E ( ri ) = x i i .
i=1
p =
6.
x x
i=1 j=1
i j ij
A portfolio which lies along the capital market line (CML). It provides either (a)
the maximum level of expected return for a given level of risk; or (b) the minimum
level of risk for a given level of return.
7.
E ( r j ) = rF + j or E ( r j ) = rF +
8.
E ( rM ) rF
j.
M
An efficient portfolio consists of investing in the market portfolio and government

stock (or borrowing at the risk-free interest rate).
Thus, using:
E(rp)
=
xE(rM) + (1 x)rF
15%
=
x 16% + (1 x) 10%
15
=
16x + 10 10x
15 10
=
16x 10x
5
=
x
6
684
Therefore 83 % of the funds should be placed in the market portfolio and the
balance, 16 %, should be invested in government stock. The resulting portfolios
risk can be calculated from:
E ( rp ) = rF +
E ( rM ) rF
p
M
15% = 10% =
16% 10%
p
3%
15% 10%
= p = 2.5%.
2%
9.
20%
20
20 10
10
10
6
=
=
=
=
=
x 16% + (1 x) 10%
16x + 10 10x
16x 10x
6x
x = 1.66.
Therefore borrow 66 % of own personal funds at the risk-free interest rate of
10%:
Borrow 1000 0.66 = 666.67.
Invest your own funds (1000) plus the borrowed funds (666.67) in the market
portfolio.
Risk of the portfolio would be:
20% = 10% +
16% 10%
p
3%
20% 10%
= p = 5%
2%
10. The market portfolio is the ultimate diversified portfolio and so contains only
non-diversifiable risk. It consists of shares in all companies quoted on the stock
exchange, held in proportion to the companies total market values.
Chapter 12
1. rA = rF + [E(rM) rF] A.
2.
3.
4.
5.
The market portfolio has a beta of 1 so a portfolio with a beta of 0.5 would only be
half as risky as the market portfolio.
The systematic risk of an investment, relative to the risk of the market portfolio.
Unsystematic risk is that part of an investments total risk that can be diversified
away. Its sources are those factors that are specific to the investment, such as its
managements ability and the quality of its research and development activities.
There are three principal factors:
(a) the sensitivity of the firms revenues to the level of economic activity in the
economy;
(b) the proportion of fixed to variable costs;
(c) the amount of debt finance (gearing).
20% 0.6 = 12% = systematic risk
8% = unsystematic risk
20% = total risk
B =
20% 0.6 12%

=
= 1.20.
10%
10%
685
CHAPTER 14
6. C = Cov (rC, rM) 2M = 73.5 [7% 7%] = 73.5 49 = 1.5.

7. company + project = (1.20 0.90) + (1.70 0.10) = 1.25.
8. If a share is overvalued, it is giving an expected return of less than it should. Hence,
it would lie below the CAPM.
9. The CAPM is a single-factor model: expected return is determined by a single
factor systematic risk or beta. The arbitrage pricing model is a multi-factor
model: expected return is determined by more than a single factor.
10. E(rproject) = 8% + (12% 8%) 1.75 = 15%
100 (1.15)0
+ 60(1.15)1
+ 50(1.15)2
=
=
=
100.00
+ 52.18
+ 37.80
10.02 NPV
The project has a negative NPV when discounted at 15%. Thus it produces a return of
less than 15%. As the CAPM indicates that the minimum return from an investment
with this level of systematic risk (estimated by the beta value of the industry group into
which the project can be classified) is 15%, the project should be rejected.
Chapter 13
1. An option to sell shares that can only be exercised on the expiry date.
2. An option to buy shares that can be exercised at any time up to the expiry date.
3. At expiry.
4. Use a straddle. Simultaneously buy both call options and put options at the same
exercise price and expiry date.
5. The effect is the same as if the underlying shares had been bought: if the share
price goes up, you gain; if the share price falls you make a loss. However, buying a
call and selling a put is significantly cheaper than buying the underlying shares
instead.
6. The intrinsic value of the option and the time value of the option.
7. The Black and Scholes model is a function of:
(a) the current share price;
(b) the future exercise price;
(c) the risk-free rate of interest;
(d) the time to expiry;
(e) the volatility of the market price of the underlying shares.
8. Shares, risk-free bonds, call options on the shares and put options on the shares.
The fundamental equality relationship is:
S + P = B + C.
T
9. S X (1 + rF) = C P or S Xe rF. T = C P.
10. Delta risk is the hedge ratio of the option. It measures the sensitivity in the value of
the option to changes in the value of the shares. It is given by N(d1). The greater
the delta risk, the greater the sensitivity of the options value to changes in the
underlying share price, and vice versa.
Chapter 14
1. 8% 4 = 2% per three months. 1 million 0.02 = 20 000.

2. Borrow 5 million now for five months and place the money on deposit for the
next two months until it is required.
3. You would receive compensation equal to:
10mn 6/12 (0.07 0.065) = 25 000.
686
4. FRAs provide a hedge against adverse and favourable interest rate movements.
IRGs provide a hedge against adverse movements, but allow advantage to be taken
of a favourable movement in interest rates.
5. You require a short hedge: you would sell futures.
6. Futures are priced on an indexed basis and so this implies: 100 92.75 = 7.25%.
7. $1 million 3/12 0.0001 = $25.
8. It is the risk that the futures price will not move precisely in line with interest rate
movements.
9. Because of basis risk and because only whole contracts can be traded.
10. No. For there to be an advantage to an interest rate swap there must be a quality
spread differential. Here, the QSD is zero. Fixed interest: 12.75% 11% = 1.75%;
LIBOR: 2.75% 1% = 1.75%; QSD = 1.75% 1.75% = 0.
Chapter 15
1. (a) Weak efficiency.
2.
3.
4.
5.
6.
7.
8.
9.
10.
(b) Semi-strong efficiency.

(c) Strong efficiency.
(a) Share prices will reflect management decisions as long as they are
communicated to the stock market.
(b) Shares are never overvalued or undervalued from the point of view of the
timing of capital raising.
(c) A takeover of a quoted company is unlikely to represent a positive NPV
investment.
With weak efficiency, technical analysis is worthless; with semi-strong efficiency,
so too is fundamental analysis; and with strong efficiency investors cannot even
expect to gain from inside information.
Share prices react to the disclosure of new, relevant information. New information
arises at random intervals of time and can be randomly either good or bad. Hence
share price movements themselves occur at random.
A technical analyst tries to identify patterns that recur in past share price
movements. Then if one of those patterns is observed starting to develop, the
technical analyst hopes that this will provide an ability to predict the future share
price movement as the pattern develops more fully.
Upward sloping. See Fig. 15.4 in the text.
This states that the shape of the yield curve is determined by expected future
interest rates.
This states that the normal yield curve is upward sloping because investors prefer
short-term bonds they have a preference for liquidity. Thus they are willing to
accept a low interest rate on short-term bonds, but have to be offered a higher
interest rate to attract them to the less-preferred long-term bonds.
According to the Fisher Effect, market interest rates are determined by inflation
rates. Thus if the market expects future interest rates to be lower based on the
pure expectations hypothesis and a falling yield curve this implies that inflation
rates are also expected to fall in future.
Suppose you invest 100 in a two-year bond. At the end of two years you will have:
100 (1.07)2 = 114.49. If you invest 100 in a one-year bond, at the end of one
year you will have: 100(1.06)1 = 106. This implies that the market expects the
yield on one-year bonds next year to be: (114.49 106) 1 = 0.08 or 8%, so that
106(1.08)1 = 114.49 (approx.).
687
CHAPTER 16
Chapter 16
1. PE = 147 13 = 134p ex div

11(1 + g)3 = 13
1
g = (1311 41 ) 3 1 = 0.049
KE =
13(1 + 0.049)
+ 0.049 = 0.154 or 15.4%.
130
2. (a) Both r and b remain constant values.

(b) All-equity financed company.
(c) All projects financed out of retained earnings.
3. PB = 128 15 = 113 ex int.
4
+ 113 15(1 0.35) A4K DAT + 110 (1 + K DAT ) = 0 NPV

At 5%, NPV = 12.07
At 15%, NPV = +22.28
12.07
KD = 5% +
(15% 5%) = 8.5%
22.28 +12.07
VB = 12m 1.13 = 13.56mn.

4. 12(1 0.35) A30.085 + 100(1.085)3
= 92.08 = PB
(7.8 2.5540) + (100 0.7216)
10mn 0.9208 = 9.208mn = VB.

5. Given note 19 and the fact that:
PB = 118 18 = 100 ex int.
and the debt is redeemable at par then the coupon rate equals KD and so
K DAT = 18% (1 0.35) = 11.7%.
6. 87 = 100 (1 + KD)3
87
= (1 + KD)3 = 0.87
100
1
=1.149
(1 + KD)3 =
0.87
KD = 1.149 1 = 0.0475 or 4.75%.
7. (a) The bonds are issued at par and are redeemable at par and carry a coupon rate
reflecting the market interest rate at the time of issue.
(b) The bonds are issued at a substantial discount on par but are redeemed at par
value. They pay zero interest. Thus the investor receives a return purely in the
form of a capital gain.
(c) The conversion ratio is the number of shares into which each unit of
convertible debt can be converted.
(d) The conversion price is effectively the exercise price of the call options on the
companys shares which is contained in an issue of convertible debt.
(e) The conversion premium is the percentage by which the conversion price
exceeds the current share price (normally, at the time of issue).
8. Convertibles have advantages from both the investors and the companys
viewpoint. From the investors viewpoint they offer the security of a fixed rate of
interest, plus the possibility of making a significant capital gain on conversion,
together with the security of being able to have the debt redeemed if they so wish.
From the companys viewpoint convertibles have the twin advantages of paying a
688
lower coupon than straight debt and, with luck, never having to repay the loan (as
investors will convert).
9. In four years time, the share price is likely to be: 165p (1.08)4 = 224.5p. Thus 50
shares will be worth: 50 224.5p = 112.25. Therefore we would expect investors
to convert. The coupon rate is 5% and so the after-tax interest payments payable
by the company are: 5 (1 0.33) = 3.35. The after-tax cost of the convertible
debt is given by the internal rate of return on the following cash flow:
Year:
0
88
(3.35)
4
(112.25)
NPV at 4% = 20.11
NPV at 12% = +6.49.
20.11
K D AT = 4%
(12% 4%) = 10%.
20.11 6.49
10. The minimum value of a convertible is the greater of its value as straight debt and
its conversion value.
Chapter 17
1.
KE =
K DQ =
5(1.07)
+ 0.07 = 13.4%
83
15(1 0.35)
= 8.9%
110
VE = 24 mn 83p = 19.92mn
V B Q = 25 mn 1.10 = 27.5mn
K D UQ = K DQ = 8.9% (assuming similar risk).

PBUQ
12(1 0.35)
=
= 87.64
VB UQ = 10 mn 0.8764 = 8.76
0.089
KL = 14%(10.35) = 9.1% VL = 3mn
V0 = 19.92mn + 27.5mn + 3mn = 59.18mn
19.92
27.5
8.75
+ 8.9%
+ 8.9%
K 0 = 13.4%
59.18
59.18
59.18
3
= 10.4%.
+ 9.1%
59.18
2. In the medium to long term the company will maintain a fixed capital structure
and it is the overall return on this mix of capital that projects must be able to
generate to allow the company to continue in existence.
3. (a) Project is small relative to the size of the company.
(b) Project will be financed in such a way as not to change the capital structure.
(c) Project has the same degree of systematic risk as that of the companys
existing cash flows.
(d) All level-perpetuity cash flows.
4. Its WACC will reflect its average level of systematic risk, and not the particular
level of systematic risk of any one of its individual business activities. Thus the
WACC is an unsuitable NPVdiscount rate with which to evaluate projects in any
one of the companys areas of activity.
5. The CAPM produces an NPVdiscount rate which is tailor-made to the level of
systematic risk of the individual project. The WACC only reflects the companys
existing, average systematic risk level.
6. Because companies, but not individual investors, can get tax relief on debt interest.
689
CHAPTER 18
7. Companies should finance themselves almost entirely with debt capital.

8. The gearing or leverage ratio is usually measured as VB VE, although it is
sometimes measured, as a percentage, as: VB V0.
Chapter 18
1. Given
K E g = K E ug + ( K E ug KD )
VB
then
VE
20% = K E ug = ( K E ug 10%)
1
4
20% = K E ug + 0.25 K E ug 2.5%

20% + 2.5% = 1.25 K E ug
22.5%
= K E ug = 18%.
1.25
2. Again using the M and M equation:
K E g = 18% + (18% 10%)
3
= 22.8%.
5
In a no-tax world, the gearing ratio does not affect the WACC. So the change in
capital structure will leave K0 unchanged:
K 0 = 20%
4
1
+ 10% = 18%.
5
5
K 0 = 22.8%
5
3
+ 10% = 18%.
8
8
3. Sell your shares in company A for 100 cash and buy 25 of debt in company B
and 75 of company Bs equity.
4. In arbitrage it is necessary to show the pure gain that can be made with no change
in either business or financial risk. Business risk does not cause problems as the two
companies involved in the arbitrage would be in the same business risk class (same
asset betas). However, if a shareholder in a geared company wished to arbitrage
into another company, care must be taken in order to preserve the existing degree
of financial risk held. This is maintained by substituting home-made for corporate
gearing.
5. Financial risk is borne by the shareholders in a geared company. It arises out of the
fact that, because debt interest has to be paid in full before equity dividends can be
paid, then shareholders are at risk that the company may have insufficient cash
flow to pay dividends because it has all gone out in interest payments. This is
financial risk.
6. As KD = rF = 10%, then we can assume debt = 0
Using CAPM, 20% = 10% + (15% 10%) equity
therefore
20% 10%
= equity = 2.0
(15% 10%)
assets = 2.0
7.
assets = assets
2
1
+ 0 = 1.33
3
3
7
V0
= 1.33 = 1.87.
5
VE
690
8. For two companies to be in the same business risk class, they should have the same
asset betas and in a no-tax world the same WACC. As the WACCs of the two
companies are not the same, we can conclude that they are not in the same
business risk class:
K 0 = 20%
2
1
+ 10% = 16.67%.
3
3
K 0 = 20%
5
2
+ 10% = 17.14%.
7
7
Alternatively, the asset beta of the question 6 company is 1.33.

The asset beta of the question 8 company is:
2.0 5 + 0 2 =
assets = 1.43.
7
7
Chapter 19
1.
Using: K E g = K E ug + ( K E ug + K D )
VB (1 TC )
VE
then:
1(1 0.35)
3
2.17%
25% = K E ug + ( K E ug 10%)
25% = K E ug + 0.217 K E ug
25% = 2.17 = 1.217 K E ug
27.17% 1.217 = K E ug = 22.32%.

2.
VT
K 0 g = K E ug 1 B C , therefore:
V0
1 0.35
K 0 g = 22.32%1
1+ 2
K 0 = 22.32% 0.8833 = 19.7%.
3. V0 g = VE ug + VBTC, therefore
V0 g = 40mn + (10 0.35) = 43.5mn.
Shareholder wealth would have increased by the value of the tax shield:
VBTC = 10mn 0.35 = 3.5mn.
4.
VT
K 0 g = K 0 ug 1 B C .
V0
5. The tax shield represents the present value of the tax relief on debt interest. It is
the source of the increase in shareholders wealth that arises from increasing the
level of gearing.
6. Debt capacity describes an assets ability to act as security for a loan. Specifically,
an assets percentage debt capacity indicates the size of loan it would act as security
for, expressed as a percentage of the assets worth.
7. Using:
V0 g = VE ug + VBTC E(b/c)
then:
40mn = VE ug + (10mn 0.35) (0.05 1mn)
40mn 3.5mn + 0.05mn = VE ug = 36.55mn.
691
CHAPTER 21
8.
(1 TC )(1 TE )
V0 g = V0 ug + VB 1
.
1 TD
Chapter 20
1.
Long-term debt and short-term debt Cash balances.

Shareholders funds
However, the definitions of debt, etc. are not entirely unproblematical and thought
needs to be given to items such as the capitalized value of leases.
2.
Earnings available for shareholders (after tax and interest).

Number of shares in issue
3. Gearing ratios cannot be viewed as being high or low in absolute terms (within
reason), but only in relative terms. Thus whether, at 50%, a company could be
considered to have a high or low level of gearing would depend on the gearing
ratio of other companies in its industry group.
This is likely to be related to the business risk of the particular industry, cost
structures, etc.
4. Financial risk is all systematic. It is not unsystematic.
5. There are two main factors:
(a) the revenue sensitivity of the company;
(b) the proportion of fixed to variable operating costs.
6.
Revenues Variable operating costs.

Earnings before interest and tax
7. DOG gives the percentage change in EBIT for every 1% change in revenues.
8. The greater the DOG value, the greater the systematic business risk of a company
in comparison with similar companies. Thus the company with a DOG of 2.50 has
a greater degree of systematic business risk than a similar company whose DOG
value is only 1.50.
Chapter 21
1. Because the projects NPV will add to the market value of the equity.
2. The return required from the project which purely reflects its systematic business
risk (i.e. it assumes the project is all-equity financed).
3. What the NPV of the project would be, if it was all-equity financed.
4. An operating lease is essentially a marketing device to encourage sales and can be
viewed as an operating cash flow. A financial lease is a particular method of project
financing.
5.
5
2(1 0.35)
assets 1.45
+ 0.25
= 1.20.
5 + 2(1 0.35)
5 + 2(1 0.35)
6. The equity beta reflects both the business and financial systematic risk. The asset
beta purely reflects the business systematic risk. Therefore the financial systematic
risk is reflected in a beta value of: 1.45 1.20 = 0.25.
7. Debt capacity concerns an assets ability to act as security for a loan.
8. The PV of the tax shield is based on debt capacity. Therefore the PV of the tax
shield can be calculated as:
2500 0.10 = 250 0.35 = 87.50 = Annual tax relief
PV of tax relief: 87.50 A50.10 (1.10)1 = 301.54.
692
Chapter 22
1. The dividend decision could be said to be irrelevant because it does not affect the
overall return on the shares, but simply determines how that return is split up
between dividend and capital gain.
2. Given the irrelevancy argument of the dividend decision, a company should invest
as much of its retained earnings as possible in positive NPV projects. If all earnings
cannot be utilized in this way, then the residual should be paid out as a dividend. In
this way, shareholder wealth will be maximized.
3. If dividends are to be truly irrelevant, then companies must be indifferent between
financing projects with retained earnings and financing via cash raised externally.
For this to be the case, the companys capital structure must also be an irrelevant
consideration.
4. The bird-in-the-hand argument is that dividends, because they represent a certain
current cash flow, are worth more than retained earnings which represent an
uncertain future cash flow. Hence dividends are preferred to capital gains.
5. Investors with high marginal rates of personal tax are likely to prefer capital gains
to dividends. There are two reasons. The first is that the marginal rate of capital
gains tax is likely to be less than the marginal rate of tax on dividends. Secondly,
the investor can control the time at which he takes his capital gains to give the
greatest degree of tax efficiency. In contrast dividends must be taken when the
company decides to pay them.
6. The clientele effect implies that companies should follow a consistent dividend
policy to attract a specific clientele of investors.
7. There are two main classes of evidence. One is that companies seem reluctant to
face a situation where they have to reduce dividends from one year to the next.
Thus dividend growth lags behind earnings growth. The other evidence suggests
that share prices react significantly to unexpected changes in dividends.
8. Given the evidence on signalling, to retain an expected dividend for capital
investment purposes might be thought of as unwise. The market might interpret
the decision as a signal about an unfavourable financial position.
There is, however, evidence that so long as shareholders are properly prepared by
the company, the withholding of a dividend for investment purposes can be seen as
a good thing.
Chapter 23
1. Increased revenues, reduced operating costs, tax savings and financing savings.
2. By generating economies of scale and so lowering unit costs of production,
increased efficiency through coordination of activities, use of complementary
resources and the elimination of weak management teams.
3. No, unless it helps to reduce the volatility of the companys cash flow and so lower
its risk of debt default, resulting in increased debt capacity and a lower cost of debt
capital.
4. Offer: One A share for four B shares.
One A share is worth
480p 4 B shares = 120p bid value.
Acquisition premium
120p 100p = 20p per share or 20p/110p = 20%.
5. Post-acquisition As share price is likely to fall as a result of payment of the
acquisition premium. However, synergy benefits might offset this effect.
6. The key advantages of an acquisition-led growth strategy are: speed, achievement
of critical mass, use of companys own shares to finance the strategy; allows the
acquisition of the intellectual assets as well as the tangible assets of the business.
7. Because of the coinsurance effect.
8. It will harm the position of shareholders as it will result in a transfer of wealth from
shareholders to debt holders.
693
CHAPTER 25
9. Two factors. One is the variability of the companys cash flows the greater the
variability, the greater the potential for a reduction in variability, and so the greater
the potential gain to shareholders. The other factor is the correlation coefficient of
the two companies cash flows. The further away it is from +1, the greater will be
the coinsurance effect and the greater the consequent gain to debt holders.
10. When A bids for B through a share-for-share exchange and B is valued on a lower
PER than A.
11. The post-acquisition PER of the predator company will be an average of the
pre-acquisition PERs of the two companies, weighted by their earnings.
12. They will try to: (a) argue that the value of the bid undervalues the company and
(b) question the desirability of the terms of the offer.
13. If the post-acquisition market share is in excess of 25% and there are significant
barriers to new entrants to the industry.
14. The value of the cash alternative will typically be around 10% below the value of
the share-for-share exchange. The main reason for this is to account for the fact
that the value of the cash offer is certain, whilst the value of the share-for-share
exchange varies as the predators share price changes.
Chapter 24
1. The technique ignores the companys intellectual capital.

2. The replacement cost of the assets of 9 million would be the most appropriate
valuation on a going concern basis.
3. You would look to adjust it for differences in gearing, earnings growth and
company size.
4. As the company being valued is much smaller, it would be perceived as being more
risky and so a lower PER should be used.
5. Its weighted average cost of capital: Ko.
6. Data identification: actually identifying the free cash flow.
7. Human capital, relationship capital and organizational capital.
8. It is trying to predict which companies are most likely to want to invest for future
growth.
Chapter 25
1. Spot:
2.
3.
4.
5.
6.
7.
187.50 192.40
less premium:
1.20 1.10
Forward:
186.30 191.30
As the forward rate is at a premium, the first currency () is appreciating against
the second currency (). Therefore, it follows that the must be depreciating
against the .
350 000 187.50 = 65.625mn cost.
3.5mn 191.30 = 18 296 receipt.
$/:
1.5280
E/: 1.6240
1.6240
E/$:
1.5280
E/$
1.0628
187.50 [1 0.03]4 [1 + 0.10]2 = 200.85: Year 6 forward.
Using the IRPT:
1.5815
US bills yield = 1.05
19.18%.
1.5210
8. Using the PPPT:
694
Future $/ spot:
9.
0.05 0.06
= 0.0094
1.06
1.5835(1 0.0094) = 1.5686
0.07 0.07
=0
1.07
1.5686(1 + 0) = 1.5686
0.09 0.05
= +0.038
1.05
1.5686(1 + 0.038) = 1.6282
Current $/ spot
Year 1 forecast
Year 2 forecast
Year 3 forecast
Chapter 26
1.
1.05
1.4550 = 1.4832.
1.03
Year 1
Year 2
Year 3
:
:
:
:
1.5835
1.5686
1.5686
1.6282
Spot:
1.1020 1.1050
less Premium:
Forward
180
165
1.0840 1.0885
$150 000 1.0885 = E163 275 payable in one months time.

2. (a) Forces of supply and demand for currencies from
(i) hot money;
(ii) international trade and investment.
(b) Differences in interest rates between countries (IRPT). Movements in FXrates
will take up differences in interest rates.Thus the currency of the country with
high interest rates can be expected to depreciate.
(c) Differences in inflation rates between countries (PPPT). Movements in FX
rates will take up differences in inflation rates. Thus the currency of the
country with higher inflation can be expected to depreciate.
3. (a) Sell E100 000, one month forward:
E100 000 1.0885 = $91 869 received in one months time.
0.10
(b) Borrow Ex. 1 +
= E100 000
12
Ex = 99 173
Sell E99 173 at spot to give:
E99 173 1.1050 = $89 750 received now.
0.11
= 90 573
(c) $89 750. 1 +
12
As the forward market hedge produces $91 869 in one months time, the
forward market hedge is best.
4. $ / =
9.8040
= 1.9216.
5.1020
5. Exercise of put option will generate $100 000 1.80 = 55 555.56.

(a) (i) A spot sale of $100 000 at 1.95 will produce only 51 282.05. Therefore,
exercise option.
695
CHAPTER 26
(ii) A spot sale of $100 000 at 1.70 will yield: 58 823.53 therefore allow
option to lapse and sell currency in spot market.
(b) (i) A spot purchase of $100 000 at 1.95 will only cost 51 282.05. Therefore
spot purchase $100 000 and then sell them through exercising the option
to yield a profit of: 55 555.56 51 282.05 = 4273.51.
(ii) A spot purchase of $100 000 at 1.70 would cost 58 823.53, therefore it is
not worth exercising the option allow it to lapse.
6. The deal will be done at the worst rate to forward sell the dollar: 1.7650.
7. (a) OTC options available in large numbers of currencies, traded currency
options available only in major currencies.
(b) OTC options available in cross currencies, traded currency options are only
available against dollars.
(c) OTC options are available for any reasonable exercise date; traded currency
options only 3/6/9 months forward.
(d) OTC option prices determined by bank. Thus a big company can use its
financial strength to strike a better deal.
(e) A very large transaction may be difficult to arrange on a traded currency
option exchange (LIFFE).
(f) OTC currency options are not dependent on the option exchange being open
to deal or exercise.
(g) OTC currency options are available for any amount of currency; traded
currency options come in standardized amounts (i.e. 25 000 is the unit in
sterling options).
8. (a) Target receipt:
$526 000 1.1050 = E476 081
Number of contracts:
$526 000 1.1060 =
E 475 587
= 9.51 10 contracts.
E50 000
Buy or sell?
contract size currency: E (E50 000 per contract);
cash market: sell 526 000 and buy E;
therefore: buy futures.
Hedge: buy 10 $/E futures for September at $1.1060.
(b) In August, the company receives $526 000 which it sells at spot:
$526 000 1.0580 =
Target receipt:
Profit on target:
E497 164
E476 018
E 21 146
Close out the futures position: sell 10 $/E September futures at $1.0595.
Loss on futures:
Bought: 10 E50 000 1.1060 =
Sold:
10 E50 000 1.0550 =
Loss:
$553 000 cost.

$529 750 receipt
$ 23 250
Buying these $ at spot (to pay off the loss) costs:

$23 250 1.0550 = E22 038.
Hedge efficiency:
E21146
= 95.9%.
E22 038
9. (a) Buy $297 500 forward to October at a rate of $1.7000.

Cost: $297 500 1.7000 = 175 000.
696
(b) Number of futures:
175 000
= 14 contracts.
12 500
Hedge position: sell 14 sterling December futures at $1.70 each. In October,

close out the futures position by buying 14 December sterling futures
contracts at the going price. At same time buy $297 500 on spot market to pay
supplier.
(c) Cost of paying invoice:
$297 500 1.7800 = 167 135.
Outcome of futures market deals:
Bought
14 12 500 1.78
Sold
14 12 500 1.70
=
=
$311 500 Cost

$297 500 Received
$ 14 000 Loss
These dollars would then have to be bought at spot to pay off the loss: $14 000
1.3800 = 7865 cost. Therefore the net cost of invoice: 167 135 + 7865 =
175 000, which is the same as the outcome of the forward market hedge.
Chapter 27
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
1 + inflation $ Forward rate

$ inflation inflation
=
or
1+ inflation $
Spot rate
1+ inflation
1.8420 1.25
1 = 0.209 or 20.9% approx.
1.9050
1.9280(1 0.07)3 = 1.5508.
$1.7940
less 150
$1.7790 = two-month forward rate
(a) Projects dollar cash flows are discounted by dollar discount rate to give a
dollar NPV which is then converted at spot to a sterling NPV; or
(b) projects dollar cash flows are converted into sterling cash flows and then
discounted at the sterling discount rate to give a sterling NPV.
Because they may well affect the cash flow available to be remitted back to the
parent.
Property fixed assets and working capital finance in the overseas currency.
Non-property fixed assets finance via the export of sterling.
(a) Dividends;
(b) interest;
(c) management charges;
(d) royalty payments;
(e) transfer prices.
The risk that the host government might adversely change the rules of the game
after the company have undertaken the investment.
Economic risk describes the risk that a company is exposed to from unexpected FX
rate movements and their resulting impact on the sterling worth of a foreign
projects cash flows.
697
Answers to Problems
Chapter 2
Decision objectives
problem 1
If shareholders want to ensure that their managers act in the best interests of shareholders, then it is vital that an attempt is made to bring managers own personal objectives into line with their shareholders objectives. This can be done through a
variety of schemes designed to give the management an incentive to be wealth maximizers rather than just satisficers.
One obvious approach would be to link management pay to profitability. This could be
done either in absolute terms or in relative terms via earnings per share. However, this
raises two problems. The first concerns the undoubted conflict that can occur between
short-term and long-term profitability. It is difficult to devise an incentive scheme based
on long-term profitability managers are often in their positions for a relatively short
time and want to be rewarded via an incentive scheme on a yearly basis and therefore
there is always the temptation to sacrifice long-term profitability for short-term profitability. (An example would be where the use of lower quality raw materials increases
product contribution, but damages the longer-term reputation of the product.)
The second difficulty with incentive schemes based on profit is that the level of profitability is not solely a function of managerial ability and effort. A large number of
external macroeconomic factors that are outside the control of management such as
the rate of national economic growth affect the profitability of the firm. A fundamental
principle of any incentive scheme is that it should be related directly to effort and should
not be affected by other factors. Thus, to reward management for a rise in profitability
that is unconnected with their efforts or to penalize them for a fall in profitability that
has been caused by external economic influences outside their control would mean that
the incentive scheme was not performing its intended task.
To avoid both these problems, it would be better to link the incentive scheme to the
share price of the company (or, in the case of a company not quoted on a stock market,
link the incentive scheme to a periodic private valuation of the shares). In so doing, this
gets over the problem of a possible conflict between the long and short term (to some
extent) as the share price should reflect all the implications of managements actions.
In addition, if the incentive scheme was linked to relative share price performance,
this would then ensure that only the superior or inferior actions of the managements
performance would be rewarded or penalized. What is meant by linking the incentive
scheme to relative share price performance is that the link should be between the performance (i.e. increase or decrease) in the companys share price relative to the share price
of its competitors. In this way macroeconomic influences on the companys share price
(which are largely beyond the control of the management) can be screened out of the
incentive reward system.
In essence, a perfect incentive scheme would be almost impossible to devise in that it
should try to take the following factors into account.
1. It should reward ability, not luck.

2. It should potentially form a significant part of the managers overall renumeration if
it is to modify behaviour.
698
ANSWERS TO PROBLEMS
3. It should work both ways: rewarding good performance and penalizing poor.
4. It should take into account the maximum level of risk to which shareholders are
willing to expose themselves. This is to avoid a potential problem (particularly with a
one-way scheme) where managers take very high risks in the hope that they will
pay off and so they generate a large bonus, with the knowledge that if a risky venture
fails, managers can always leave and find a job elsewhere (leaving the mess for the
shareholders to clean up).
5. The incentive scheme should operate over the same time horizon as that used by
shareholders for decision making, so as to avoid the problem (referred to above) of
short term versus long term.
6. The scheme should be simple in structure and easy to understand by all parties and it
should be cheap to monitor.
7. Management should not be able to artificially manipulate the schemes criteria.
problem 2
Strictly speaking, risk means measurable uncertainty. In other words, we

cannot be sure what the outcome of a decision will be, but we have some estimate of
likely outcomes derived from past experience. More generally, risk means that a decision
in this context, an investment decision can result in a range of outcomes. We tend to
concentrate on the risk of loss (downside risk) because it is this that hurts.
Some investments are more risky than others because of the nature of the business
involved. For example, an investment in a supermarket chain such as Sainsburys is less
risky than an investment in a heavy engineering company such as Sheffield Forgemasters
because the demand for the goods sold by the supermarket is less volatile. We will see
later in the text that there are other things that determine total risk.
problem 3
We have seen that the assumed objective for commercial companies is

the maximization of shareholder wealth. This, in turn, can be translated into meaning
the maximization of the value of the companys shares. When we turn to the situation of
a state-owned company we could argue that this objective remains unchanged, but now
we need to consider the shareholders as meaning society at large.
In such circumstances, the financial manager may be faced with the complication that
financial decision making is not something that can be seen simply in terms of cash flow
(or profits), but that the wider impacts of a decision have to be taken into account.
An example might help to clarify this point. A commercial company would evaluate a
decision to relocate its factory from a rural area to an urban area on the basis of the decisions cash flow impact on the company. It may be that the urban location would be
nearer to the raw material source and so produce a significant transportation cost saving.
However from the viewpoint of a state-owned company, such a decision would be much
more complex in that many more factors would have to be taken into consideration.
These might include such things as the impact of the loss of jobs on the rural community
and the increased congestion and pollution that might result from locating in the urban
area.
In conclusion therefore, although we might be able to say that financial managers in a
state-owned company can be seen to have the same objective as their counterparts in a
commercial organization, the efficient achievement of that objective is likely to require
a much more complex and wide-ranging analysis.
Chapter 3

problem 1
Given that the total outlay for the electronics project is 2 million, the
project pays back a total of 1.6 million at Year 3 and 2.4 million at Year 4. Therefore,
breakeven is achieved at approximately Year 3.5. The decision advice here is ambiguous.
CHAPTER 3
TRADITIONAL METHODS OF INVESTMENT APPRAISAL
699
On the one hand the project does not pay back within three years of the projects
starting date, while on the other hand it does pay back within three years (actually 2.5
years) of the completion of the capital expenditure.
Property project
The property project has a straight three-year payback and so just meets the decision
criterion.
Mining project
Again, the decision advice is ambiguous. The project pays back its outlay in two years
and so, on that criterion, is acceptable. However, a further outlay is required at Year 4.
(b) The best choice here is not clear. One interpretation would be to accept the Electronics project as it pays back in 2.5 years as opposed to three years for the Property
project.
An alternative interpretation would be that the Property project pays back by Year 3
while the Electronics project pays back by Year 3.5. Therefore, the former should be
accepted.
A further factor to consider is the post-payback cash flows. Post-payback, the Electronics project generates a further 1.2 million. The Property project only generates a
further 400 000 post-payback. Quite simply, there is no clearly correct decision using
payback.
(c) The Mining project, on one basis, has a payback of two years against a payback of
three years for the Property project. However, the Mining project requires an extra
0.75 million outlay and only generates a net 0.05 million post-payback. In contrast,
the Property project does not require any further capital expenditure and generates 0.4
million post-payback. Again the correct decision advice is unclear.
(d) The payback decision criterion should really take the project risk into account. The
more risky the project (that is, the more uncertain its expected future cash flows) the
shorter should be the maximum permitted payback.
Almost certainly, these three projects are of unequal risk. Clearly the property project,
with its rent-paying tenant already installed, has much less uncertain cash flows than the
other two projects. Thus the companys use of the same decision criterion for all three
divisions does not appear sensible.
problem 2
(a) Payback calculation (excluding working capital)
Year
0
1
2
3
4
Net cash flow

(200 000)
50 000
60 000
110 000
20 000
80 000
Scrap value
Therefore the project has less than a three-year payback and is acceptable. However, it is
debatable whether, in this example, working capital should be excluded from the analysis
as it is not fully recovered. If it were to be included, then the analysis would be:
700
ANSWERS TO PROBLEMS
Year
0
Net cash flow

(200 000)
(50 000)
50 000
60 000
110 000
20 000
80 000
40 000
1
2
3
4
Scrap value
Working capital recovery
The project now takes longer than three years to pay back and should not be accepted.
ROCE calculation
Annual depreciation: (200 000 80 000) 4 = 30 000
Year
1
2
3
4
Net cash flow

50 000
60 000
110 000
20 000
Depreciation
30 000
30 000
30 000
30 000
=
=
=
=
=
Profit
20 000
30 000
80 000
(10 000)
Total profit
120 000
Average annual profit = 120 000 4 = 30 000

Return on initial capital employed:
30000
= 0.12
250000
As the project only has a ROCE of 12%, against a decision criterion of 13%, it is
unacceptable.
Advice
The project does not meet the firms ROCE criterion and, on one interpretation, nor
does it satisfy the payback criterion. Therefore, on balance, the advice would be to
reject.
(b) Normally, working capital (WC) is excluded from the payback analysis on the basis
that it is automatically paid back whenever the project is terminated: the stocks are eliminated and the debtors pay up. However, in the project currently under consideration,
working capital is not fully recovered. In such circumstances there is a strong argument
for including working capital expenditure (i.e. expenditure on current assets) along with
expenditure on fixed assets (capital expenditure) in the payback calculation.
(c) In many ways, the return on average capital employed is a more sensible measure of
profitability than the return on initial capital employed. Average annual profits are compared to the average capital employed in generating those profits. The average annual
profit is 30 000. The average capital employed is given by
Capital expenditure Scrap value
+
+
WC expenditure WC recovered
=
2
(200 000 + 50 000 ) + (80 000 + 40 000 )
= 185000
2
CHAPTER 4
701
INVESTMENTCONSUMPTION DECISION MODEL
Therefore the return on average capital employed is

30 000
= 0.162 or 16.2%
185 000
On this basis, given the firms decision criterion, the project should be accepted. I hope
that I get that promotion!
(d) There are two major drawbacks with the ROCE/ARR as an investment appraisal
decision rule. One is that it ignores the time value of money. The other is that it tries to
use a reporting concept accounting profit in a decision-making context.
In contrast, the payback technique does use a cash flow analysis of the decision, which
is correct. A capital investment decision is an economic, resource allocation decision and
the economic unit of account in such circumstances is cash or cash flow. Thus, between
the two appraisal techniques, payback is to be preferred, even though it too ignores the
concept of the time value of money. However, this criticism can easily be overcome by
using a variation on payback: discounted payback see Chapter 5.
Chapter 4

problem 1
(a) Fig. P4.1 shows the physical investment line facing the firm.
(b) From the graph in (a) it can be seen that the point of tangency between the physical
investment line (PIL) and the financial investment line (FIL) indicates the firms investment decision.
At t0, the firm will undertake project I and II only, and reject project III. This will
result in a cash flow of 200 at t0 and a cash flow of 420 at t1.
(c) The graphical decision in (b) is such because projects I and II both give a return in
excess of the market return of 8%, while project III gives a return that is less than the
market return:
FIG. P4.1
t1
630
III
420
I
300
FIL
II
PIL
200
300
(1.08)
500
t0
702
ANSWERS TO PROBLEMS
Market return = 0.08

Project I: (120/100) 1 = 0.20
Project II: (300/200) 1 = 0.50
Project III: (210/200) 1 = 0.05
(i)
If the market interest rate moved to 4%, then all three projects would be
accepted.
(ii) If the market interest rate moved to 25% then only Project II would be
accepted.
(iii) If the market interest rate moved to 20% then Project II would be accepted and
Project III would be rejected. However, the firm would be indifferent between
accepting or rejecting Project I as it gives the same return as the market.
(d) The new project produces a return of 32% (330/250) 1 = 0.32. Thus the firm
would now undertake Projects I, II and IV. However this would require a total investment of 550 at t0. As the firm only has 500 available at t0, it should borrow the additional 50 required at the market interest rate of 8%.
If the firm cannot borrow additional resources, or does not wish to do so, then the
optimal investment decision is to accept Projects II and IV and 50% of Project I, as Fig.
P4.2 shows.
FIG. P4.2
t1
960
III
750
I
660
IV
300
II
250
50
50
300
500
t0
CHAPTER 5
Chapter 5
703
THE DISCOUNTED CASH FLOW APPROACH

problem 1
(a) NPV calculation (mn)
Capital
expenditure
1.8
Year
0
1
.
.
.
.
6
7
.
.
.
10
Net revenue
+ 0.5
.
.
.
.
.
+ 0.5
+ 0.3
.
.
.
+ 0.3
+ 0.5
6
10
1.8 + 0.5A 6 0 .18 + 0.3A 4 0 .18 (1.18) + 0.5 (1.18)
1.8 + (0.5 3.4976) + (0.3 2.6901 0.3704) + (0.5 0.1911)

1.8 + 1.7488 + 0.2989 + 0.0955= + 343 200 NPV.
(b) ROCE calculation (mn)
Depreciation:
Annual profit:
(1.8 0.5)
10 = 0.13mn/year
0.5 0.13 =
0.37 mn/year, Years 1 to 6
0.3 0.13 =
0.17mn/year, Years 7 to 10
Average annual profit: [(0.37 6) + (0.17 4)] 10 = 0.29 million
1.8 + 0.5
= 1.15 million
2
0.29
= 0.252 or 25.2 %
Return on average capital employed =
1.15
0.29
Return on initial capital employed =
= 0.161 or 16.1%
1.8
Average capital employed:
(c) The project pays back its outlay on capital expenditure after 3.6 years.
(d) Report to the chairman
Trionym PLC
Subject: Chocolate-coating machine decision
It is advised that the capital expenditure proposal should be evaluated on the basis of the
net present value (NPV) decision rule. This decision rule, given certain assumptions
outlined below, will ensure that projects are selected only if they lead to an increase in
the market value of the companys shares.
On this basis, the chocolate-coating machine currently under consideration should be
undertaken as it has a positive NPV of 343 200. This indicates that, as a result of acceptance, the total market value of Trionyms equity should rise by this amount (and so
increase shareholders wealth).
The NPV investment appraisal decision rule can be justified on the basis of a number
of interconnected reasons. First, it evaluates investment proposals on the basis of cash
704
ANSWERS TO PROBLEMS
flow, rather than profitability. This is important because a capital investment decision is
an economic (or resource allocation) decision and the economic unit of account is cash,
not accounting profit. This is because it is cash, not profit, which gives power to
command resources. Accounting profit is not, in fact, a decision-making concept at all. It
is a reporting concept, used to report on the outcome of investment (and other)
decisions.
The second reason to justify the use of NPV is that it takes account of the time value
or opportunity cost of cash through the discounting process. Money has a time value in
the sense that a rate of interest or rate of return can be earned by investing money (the
return expected from such an investment being determined by the risk involved). Therefore, when money is invested in a particular project, the opportunity cost or the rate of
return available elsewhere from a similar risk investment that is forgone must be taken
into account.
This is achieved through the discounting process used by the NPV technique. As a
result, the magnitude of the NPV indicates how much extra return that particular
project produces (in current terms) over and above the return available elsewhere from a
similar risk investment. Therefore, by having a 343 200 positive NPV, when discounted at 18%, the chocolate-coating machine can be said to produce an extra return of
that amount, over and above the 18% return available elsewhere.
This leads directly on to the third justification for the use of the NPV decision rule.
The magnitude of the NPV indicates the increase in the companys total equity market
value or the increase in shareholder wealth that will arise from the project. Thus the
decision rule can be seen to link in directly with the companys overall objective.
However, there are two important reservations that should be mentioned about the
advice given above. The first is that it is assumed that the company is not facing any
form of effective capital expenditure constraint (either internally or externally imposed).
The second is that an 18% discount rate does correctly reflect the projects risk and so
represents the return available elsewhere on the capital market from an investment with
a similar degree of risk.
(e) Discounted payback (mn)
Year
0
1
2
3
4
5
6
7
.
.
Capital
Net
expenditure cash flow
1.8
+ 0.5
+ 0.5
+ 0.5
+ 0.5
+ 0.5
+ 0.5
+ 0.3
.
.
18% Present value

discount
cash flow
1.0
=
0.8475
=
0.7182
=
0.6086
=
0.5158
=
0.4371
=
0.3704
=
0.3139
=
1.8
+ 0.4237
+ 0.3591
+ 0.3043
+ 0.2579
+ 0.2185
+ 0.1852
+ 0.0942.
.
.
Discounted payback: 6.5 years (approx.)

Memo to the chairman: Discounted payback
(i) Discounted payback is a truncated version of NPV. In other words, instead of
calculating a projects NPV over the whole of its expected life, an artificial time
horizon (or cut-off point) is applied: the maximum acceptable payback time period.
Under these circumstances, the project is undertaken only if it manages to produce
at least a zero NPV by the cut-off point.
CHAPTER 5
705
THE DISCOUNTED CASH FLOW APPROACH
(ii) In the case of the chocolate-coating machine, given a five-year payback criterion, the project will not produce a positive NPV at the end of five years: only after
6.5 years will it reach the zero NPV breakeven point.
(iii) Discounted payback has all the advantages of the normal NPV technique, but
with one important addition. Many companies feel that they only have a limited ability
to forecast accurately future project cash flows and so are uncomfortable at making a
decision on a project based on forecasted cash flows over the whole of its life, when
some of the estimated cash flows in later years may be more like guesses rather than
estimates. Discounted payback can be used to acknowledge this reality by placing on
the projects evaluation an artificial time horizon, which may be used to indicate the
perceived limits of the managements forecasting ability.
(iv) However, this additional advantage of discounted payback is also a disadvantage. The technique does not take into account project cash flows that arise outside
the maximum acceptable payback criterion. Thus the decision-making process may
be seriously biased towards shorter-term rather than longer-term projects.
(f) Decision criteria
The main problem with the current investment appraisal procedures of Trionym plc is
that the decision rules can give conflicting advice. Under these circumstances, it is not at
all clear how the company would resolve such conflicts nor is it clear whether such a resolution would necessarily lead to optimal decisions being taken.
problem 2
(a) Calculations
Project 1
000
Project 2
000
(a) (i) Accounting rate of return

Cash flow
Depreciation (see below)
200
100
500
263
= Average accounting profit
100
237
Initial investment
Scrap value
556
56
1 616
301
Total depreciation
500
1 315
5
= Annual depreciation
100
263
Average book value of investment

556 + 56
2
306
1616 + 301
2
(ii)
Accounting rate of return

Net present value
Year Initial outlay
15
200 3.4331
500 3.4331
5
Residual value
56 0.5194
301 0.5194
958.5
32.7%
(556)
687
24.7%
(1 616)
1 717
29
156
706
ANSWERS TO PROBLEMS
Net present value
+ 160
+ 257
(iii) Internal rate of return

Project 1
At 14%
NPV = + 160
At 20%
NPV = + 64
IRR =
Project 2
At 14%
At 20%
IRR =
160
14% +
(20% 14%) = 24%
160 64
NPV = + 257
NPV = + 0
20%
(iv) Payback period

Annual cash flows
Initial investment
Payback period in years
Project
(i) Accounting rate of return
(ii) Net present value (000s)
(iii) Internal rate of return
(iv) Payback period (years)
Rankings
(i)
(ii)
(iii)
(iv)
Accounting rate of return

Net present value
Internal rate of return
Payback period
200
556
2.8
Project 1
32.7%
+ 160
24%
2.8
500
1 616
3.2
Project 2
24.7%
+ 257
20%
3.2
Best project
1
2
1
1
(b) On the basis of the calculations made in answer to part (a), Congo Ltd should undertake Project 2. In doing so they would be following the advice given by the NPV decision rule and would be rejecting the advice given by the other three decision criteria.
The NPV decision advice should be accepted because it provides the correct decision
advice, given a perfect capital market. Project 2 will lead to the greatest increase in
shareholder wealth as it has the largest positive NPV.
All three of the other investment appraisal techniques can be faulted and so give unreliable decision advice.
(i) The ARR evaluates the projects in percentage terms and so ignores differences
in outlay. It does not use any discounting process and so ignores the time value of
money. It evaluates the projects on the basis of their profitability, which is incorrect.
Accounting profit is a reporting concept, not a decision-making concept.
(ii) The IRR method cannot be relied upon to give the correct decision advice in a
situation such as this which involves mutually exclusive projects. This is for two
reasons. One is because, like the ARR, it evaluates on the basis of a percentage and
so ignores differences in project outlay. The other is that it employs an incorrect
assumption about the rate at which project-generated cash flows are reinvested.
(iii) The payback method can be criticized on two grounds. First, as discounted
payback has not been used, the time value of money has been ignored. Secondly, the
approach does not evaluate project cash flows that lie beyond the project payback
time period.
CHAPTER 6
NET PRESENT VALUE AND INTERNAL RATE OF RETURN
707
Chapter
Chapter66 Net
Netpresent
presentvalue
valueand
andinternal
internalrate
rateofofreturn
return
problem
problem11
(a)
Type A
At 4% NPV = +558 (approx.)
At 20% NPV = + 47 (approx.)
558
IRR = 4% +
(20% 4%)= 21.5%
558 47
Type B
At 4% NPV = +849 (approx.)
At 20% NPV = 86 (approx.)
849
IRR = 4% +
(20% 4%)= 18.5%
849 86
Differential cash flow (A B)

+1 000 290 A
5 i = O NPV
At 4% NPV = 291
At 20% NPV = +133
291
IRR = 4% +
(20% 4%)= 15.0%
291 + 133
The decision rule is that:

If the IRR of the differential cash flow is less than the hurdle rate, accept the project
with the greatest IRR; and if the IRR of the differential cash flow is greater than the
hurdle rate, accept the project with the smallest IRR.
In this case, Saucy Steamboats hurdle rate is 10%. As the IRR of the differential cash
flow is 15.0% then the project with the smallest IRR the Type B boat should be
accepted.
(b) There are a number of problems concerning the use of the internal rate of return
decision rule for investment appraisal purposes. A problem that is common to both decisions involving single independent projects and decisions involving mutually exclusive
projects is that of multiple internal rates of return. Any investment projects cash flow is
likely to have multiple internal rates of return if the cash flow is of a non-standard form,
i.e. where the cash flow contains more than one change of sign. As a rule of thumb, a
cash flow will have as many IRRs as it has changes in sign. One particular non-standard
cash flow is extremely common because of the fact that tax is chargeable 12 months in
arrears; after-tax project cash flows will then typically exhibit the signs:
+ + + + + +
+ + + + + +
In this cash flow there are two changes in sign and so two IRRs can be expected. The
problem is that in such circumstances, the IRR decisions rules break down absolutely
and cannot be operated reliably.
Another serious problem with the IRR is confined to decisions concerning mutually
exclusive projects. Under these circumstances the normal IRR decision rule i.e. accept
whichever alternative project produces the largest IRR (given that it exceeds the cut-off
rate) cannot be relied upon to give the correct investment decision advice. The problem
is caused by the fact that the IRR calculation for a project implicitly assumes that the
project cash flows possess an opportunity cost equal to the IRR of the generating project.
708
ANSWERS TO PROBLEMS
Thus, when comparing mutually exclusive projects with different IRRs, the implicit
assumption becomes inconsistent and, as a result, the decision rule fails. A modified decision rule can be used (as in (a) above) but the rule is really no more than a rule of thumb
with very little underlying logic to sustain it.
In contrast, given the circumstances surrounding Saucy Steamboats Ltd, the net
present value decision rule evades these difficulties and can be relied upon to produce
correct investment decision advice, given the assumption that the discount rate used
reflects the projects risk level correctly.
problem
problem22
(a) 000s
Project A
Discount rate
4%
8%
12%
18%
NPV
+21
+14
+ 7
2
Project B
Discount rate
4%
8%
12%
18%
NPV
+26
+14
+ 3
10
(b) From the graph shown in Fig. P6.1, the internal rate of return of Project A is
approximately 17% and the internal rate of return of Project B is approximately 13%.
(c) Based on the information given and the graph, the following advice should be given
to Mr Cowdrey:
(i) if his discount rate is 6%, Project B should be undertaken, because at a 6% discount rate the NPV of Project B is higher than for Project A;
(ii) if his discount rate is 12%, Project A should be chosen, because the NPV of
Project A is higher than the NPV for Project B.
(d) The following additional information would be useful to Mr Cowdrey in making the
decision:
(i) The degree of accuracy of the cash flow estimates.
(ii) Tax implications and how these might affect the projects cash flows.
(iii) Riskness of each project.
(iv) Effects, if any, of each projects acceptance on the overall business risk.
(v) Existence of other projects not included in the current appraisal.
(vi) More general social effects that acceptance of the project would impose on the
firm, its employees and its surrounding environment.
(vii) Cut-off rate required by Mr Cowdrey.
(e) The decision rule under the NPV method is to accept all projects that yield positive
NPVs when discounted at the specified discount rate. Under the IRR method, all projects with IRRs that exceed the required rate should be accepted. Both methods give the
same decision advice in simple accept/reject situations. However, we have argued that,
theoretically, the NPV method should be preferred.
The NPV approach is more consistent with the assumed objective of maximization of
shareholders wealth than the IRR method. In a simple accept/reject situation, knowledge of the projects NPV is sufficient to ensure that the shareholders wealth will be
maximized when the present value of the future stream of cash flows received by the
shareholders is maximized. However, knowledge of a projects IRR is not in itself sufficient for optimal investment decisions, nor is it necessary; the IRR method makes economic sense only because in simple accept/reject situations it gives the same decision as
the NPV method.
CHAPTER 6
FIG. P6.1
709
+NPV
(000)
28
26
24
22
20
18
16
14
12
10
8
6
13%
17%
2
0
2
4
12
18
Discount rate %
Project A
6
10
14
Project B
NPV
(000)
The two methods may give different decision advice when choosing between two
mutually exclusive investments. This difference stems from the different assumptions
made regarding the reinvestment rates of intermediate cash flows. The NPV approach
assumes that intermediate cash flows can be reinvested at a rate of interest equivalent to
that used as the discount rate. The IRR method assumes that these can be reinvested and
earn a return equal to the projects IRR. Of the two, it appears that the NPV assumption
is more realistic, given a perfect capital market.
When viewed in a ranking situation, the NPV approach assumes that the discount rate
reflects the opportunity cost of capital. The opportunity cost concept under the IRR
method is less valid because of the IRR reinvestment assumption. In fact, the actual
opportunity cost of funds does not even enter into the IRR method when the method is
used for ranking.
The NPV method gives an absolute measure that may be more meaningful than the
average concept used in the IRR method. Also, the NPV method is generally more flexible. It can be easily adjusted to include multiple discount rates over time.
Multiple rates of return are possible under the IRR method. The presence of multiple
rates of return makes interpretation difficult, and, for some patterns of cash flows, under
the IRR method it may not be possible to derive a meaningful IRR at all.
All that said, however, it is often argued that the theoretical difficulties of the IRR
method are outweighed by its practical advantages. For instance, being based on a rate of
return concept, the method is more easily understood and accepted by managers. It is also
argued that the method obviates the decision maker from having to work out the firms
710
ANSWERS TO PROBLEMS
discount rate, which in itself poses a number of problems. The NPV method, on the other
hand, requires the decision maker to determine the discount rate to be used from the start.
problem 3
(a) As funds are readily available at the market interest rate of 10%, you should accept
all projects having a positive net present value (NPV) when discounted at 10%. Justification for the NPV rule is based on two main assumptions:
(i) that the companys objective is to maximize the wealth of its shareholders, as
measured by the current market value of its ordinary shares;
(ii) that the discount rate used (the companys cost of capital) reflects the return
available elsewhere on similar-risk investments.
If these assumptions hold, the net present value of a project measures the amount by
which the wealth of a companys shareholders will change if the project is accepted (an
increase if the NPV is positive and vice versa).
The NPVs of the four projects under consideration are
NPV
Project 1
Project 2
Project 3
Project 4
2 500 + 1 000 A3 0 .10

2 500 + (1 000 2.4869)
1
1 000 + 100 (1 + 0.1)
1 000 + (100 0.9091)
1
1 000 + 800 (1 + 0.1)
1 000 + (800 0.9091)
3
4 000 + 5 000 (1 + 0.1)
4 000 + (5 000 0.7513)
= 13
2
+ 1 400 (1 + 0.1)
+ (1 400 0.8264) = + 248
2
+ 600 (1 + 0.1)
+ (600 0.8264)
= + 223
= 243
(Reject)
(Accept)
(Accept)
(Reject)
(b) The decision rule would then be: accept whichever project has the largest positive
NPV. This is Project 2.
The decision rule does not have to take account of (i) differing project lives or (ii) differing capital outlays because it is assumed that (i) all considerations of risk are allowed
for in the discount rate and (ii) there is a perfect capital market.
(c) Project 2
10% discount rate NPV +248
20% discount rate NPV + 55
248
IRR = 10% +
(20% 10%)=23%
248 55
Project 3
10% discount rate NPV +223
20% discount rate NPV + 83
223
IRR = 10% +
(20% 10%)=26%
223 83
It would not be valid to use the normal IRR decision rule for mutually exclusive projects:
accept whichever project has the largest IRR, given that it is greater than the cut-off
rate. This is because the IRR decision rule makes an incorrect assumption concerning
the opportunity cost of project-generated cash flows which makes its decision advice
unreliable when faced with mutually exclusive projects.
The alternative decision rule, making use of the IRR of the differential cash flow is:
(i) If IRR (differential cash flow) > cut-off rate, accept the project with the smallest
IRR.
CHAPTER 6
711
(ii)
If IRR (differential cash flow) < cut-off rate, accept the project with the largest
IRR.
Therefore:
Project 2
1 000
+ 100
+1 400
+ 500
23 %
+ 248
Net undiscounted cash flow

IRR
NPV10%
Project 3
1 000
+ 800
+ 600
+ 400
26%
+ 223
2 minus 3
0
700
+ 800
14 1%
3
(The IRR of the incremental cash flow is found by solving:

700
800
+
= 0 NPV
1 + i (1 + i )2
Multiplying each side by (1 +i):
800
=0
1+ i
800 = 700 (1 + i)
800 700 = 700i
700 +
100
= i = 0143
. , or14 13 %)
700
As the IRR (2 minus 3) > 10%, accept the project with the smallest IRR (Project 2)
which is, of course, the project with the largest positive NPV. The result is shown
graphically in Fig. P6.2.
(d) The principal reasons for the managerial preference for IRR over NPV are as
follows.
(i) Management are familiar with a decision rule that uses a percentage rate of
return.
FIG. P6.2
+NPV
+500
+400
+248
+223
10 141/3
23
26
NPV
Discount rate %
3
712
ANSWERS TO PROBLEMS
(ii)
With IRR, the discount/cut-off rate does not have to be specified in the calculations, but only at the time of the final decision. Even then, an exact cut-off
rate does not need to be specified. The decision can be made in reply to the
question: Is this projects IRR sufficiently high to make it acceptable?
(iii) Many managements (incorrectly) see a link between a projects IRR, current
market interest rates and accounting rates of return.
(iv) Many managements believe (incorrectly) that the capital rationing problem can
more easily be overcome by using IRR instead of NPV (see Chapter 8).
Using IRR instead of NPV may well lead to the wrong project being selected when a
mutually exclusive choice has to be made among alternatives, but it should not lead to a
project being accepted that has a negative NPV (i.e. the IRR decision rule will help
select investments that will increase shareholder wealth, but not necessarily maximize it).
Of course, this ignores the problem of multiple IRRs where such a choice is possible, but
probably unlikely. Furthermore, both DCF methods only evaluate a project in terms of
their quantifiable financial effects. Most managements have a high level of qualitative
factor inputs into a decision, such as strategic reasons or competitiveness.
Chapter 7
Project cash flows

problem 1
In assembling the projects cash flows the following should be ignored.
(i)
(ii)
depreciation this is a non-cash cost and so is irrelevant to the analysis;

allocated fixed overheads on the assumption that these represent non-incremental
cash flows;
(iii) interest payments (plus their associated tax relief) financing charges are never
included in project cash flows, but instead they are implicitly reflected in the
required after-tax rate of return/discount rate, which in this example is 10%;
(iv) dividend payments these too are part of the financing charges and are never
explicitly included as part of a projects cash flows.
Writing-down allowances
1 200 000
300 000
900 000
225 000
675 000
168 750
506 250
126 562
379 688
94 922
284 766
200 000
84 766
0.25 =
300 000
0.4
Tax credit Year

120 000
1
0.25 =
225 000
0.4
90 000
0.25 =
168 750
0.4
67 500
0.25 =
126 562
0.4
50 625
0.25 =
94 922
0.4
37 969
=
=
Sale proceeds
Balancing allowance 0.4 = 33 906
Tax on trading profits/year

Sales
1 400 000
Materials
(300 000)
Labour
(500 000)
Taxed profit 600 000
Tax at 40% 240 000
Net trading cash flow
CHAPTER 7
713
PROJECT CASH FLOWS
Project cash flow (000s)

Year
Machine
Machine Trading
Tax on
Working
cost
tax
c/f
trading
capital
relief
0
(1200)
(150)
1
120
600
2
90
600
(240)
3
67.5
600
(240)
4
50.625 600
(240)
5
200
37.969 600
(240)
150
6
33.906
(240)
NPV calculation
Year
Net cash flow
10% Discount factor =

0
(1 350 000)
1
=
1
720 000
0.9091
=
2
450 000
0.8264
=
3
427 500
0.7513
=
4
410 625
0.6830
=
5
747 969
0.6209
=
6
(206 094)
0.5645
=
Net project
cash flow
=
=
=
=
=
=
=
Net present value +
(1 350)
720
450
427.5
410.625
747.969
(206.094)
PV cash flow
(1 350 000)
654 552
371 880
321 181
280 457
464 414
(116 340)
626 144
problem 2
Contract 1: PV costs (000s)
Special materials
Other materials
Skilled labour
Unskilled labour
0
30
Total direct costs

Variable overheads (6% direct costs)
Total net cash flows
Discount factors
30
1
100
42
58.8
110
46.2
64.7
200.8
220.9
12.05
13.25
212.85
234.15
0.9091
0.9091 0.8621
30
193.50
183.51
1
120
42
66.15
2
132
46.2
72.75
Direct costs
Variable overheads (6% direct costs)
228.15
13.7
250.95
15.05
Total net cash flows

Discount factors
241.85
0.9091
266.0
0.9091 0.8621
PV cash flows
219.87
208.47
PV: 407.01
Contract 2: PV costs (000s)
Other materials
Skilled labour
Unskilled labour
PV: 428.34
714
ANSWERS TO PROBLEMS
NPV of Contract 1 produced in-house

+700 000 407 010 = +292 990 NPV
NPV of Contract 2 produced in-house
+680 000 428 340 = +251 660 NPV
NPV of Contract 1 when subcontracted
1
PV cost: 245 000 + 245 000(1.10)
Revenue
=
=
467 730
+700 000
+232 270 NPV
NPV of Contract 2 when subcontracted

1
PV cost: 265 000 + 265 000(1.10)
Revenue
=
=
505 911
+680 000
+174 089 NPV
The possible combinations open to Sparrow Ltd are:

Produce Contract 1
+ 292 990 NPV
Subcontract Contract 2
+ 174 089 NPV
+467 079 Total NPV
Produce Contract 2
Subcontract Contract 1
+ 251 660 NPV

+ 232 270 NPV
+483 930 Total NPV
Therefore the best option, given the constraints, is to produce Contract 2 in-house and
subcontract Contract 1. This results in the greatest amount of aggregate NPV.
Chapter 8
Capital rationing
problem 1
(a) The conflict arises from the differing assumptions that the NPV and IRR methods
make about the opportunity cost (or reinvestment rate) of generated cash flows. Given a
perfect capital market, the NPVs assumption that their opportunity cost is equal to the
market interest rate (for that level of risk) is correct. The IRRs assumption that their opportunity cost is equal to the IRR of the project which generates the cash flows is incorrect.
Therefore the company should accept the alternative with the largest positive NPV:
the electrically powered vans. This selection will provide the greatest increase to shareholder wealth.
(b) Given that the situation is one of single-period capital rationing, the capital allocation problem can be solved using benefitcost ratios:
Project
A
B
C
D
Petrol fleet (P-F)
Electrical fleet (E-F)
Benefitcost ratio
60/50
= 1.2
40/80
= 0.5
84/140
= 0.6
32/80
= 0.4
80/100
= 0.8
110.5/170
= 0.65
Ranking
1
5
4
6
2
3
CHAPTER 8
715
CAPITAL RATIONING
As projects P-F and E-F are mutually exclusive (the two van fleets) two alternative
combinations of projects have to be evaluated, each containing one of the mutually
exclusive alternatives:
Project
A
P-F
C
Outlay at t0
50
100
140
290
Project
A
E-F
0.5C
Outlay at t0
50
170
70
290
NPV:
60 + 80 + 84 = +224 000
NPV:
60 + 110.5 + 42 = 212 500
Therefore, projects A, C and the petrol-powered van fleet should be accepted as this
will provide the largest total of positive NPV, given the capital constraint.
(c) If the delivery fleet project were delayed by one year, their NPVs become:
P-F
E-F
80/1.15
110.5/1.15
=
=
69 565
96 087
Clearly, the electrically powered van fleet is the best alternative. Therefore, excluding
the above from the capital rationing problem:
Project
A
C
B
1D
4
Outlay at t0
50
140
80
20
290
NPV:
60 + 84 + 40 + 8 = 192 000
Hence, the total NPV would be: 192 000 + 96 087 = +288 087, which represents a
gain of 64 087 over the original solution. This is the additional gain in shareholder
wealth.
problem 2
(a) Accept all projects with NPV 0.
Project
A
B
C
D
E
NPV (000s)
+58.5
+39.3
20.7
+109.1
+38.8
(b) Using benefitcost ratios:
Therefore, accept A, B, D and E.
NPV
Rationed investment
716
ANSWERS TO PROBLEMS
000s
A
+ 58.5/100
=
0.585
3
B
+ 39.3/50
=
0.786
2
C
20.7/100
=
0.207
5
D
+ 109.1/100 =
1.091
1
E
+ 38.8/200
=
0.194
4
225 000 available, therefore accept D, B, 75% of A.
Ranking
(c) The two alternative project combinations are:

D, B, 37 12% of E
000s
109.1 + 39.3 + 14.55
D, A, 12 12% of E
109.1 + 58.5 + 4.85
000s
162.95 NPV
172.45 NPV
1
2
Therefore the best combination is D, A and 12 % of E.

(d) Examining all the different whole project combinations shows that A and D
produce the maximum amount of total NPV.
(e) Recalculating the benefitcost ratios, now using t1 outlays:
A
B
C
D
E
+58.5/100
+39.3/100
20.7/
+109.1/50
+38.8/50
=
=
=
=
=
0.585
0.393
2.182
0.776
3
4
1
2
Ranking
If project C is accepted, this makes an extra 100 000 of investment finance available
at t1; however, in doing so, a negative NPV (20 700) is incurred. Thus we will have to
examine whether the extra +NPV generated by the additional investment finance outweighs this cost.
150 000 of capital: accept D, E and 50% of A. Total NPV = 177 150.
150 000 + 100 000 of capital: accept D, E, A, 50% of B and C. Total NPV =
205 350. This is the optimal combination.
(f) Let a equal the proportion of Project A undertaken,
b be the proportion of Project B undertaken,
c be the proportion of Project C undertaken,
d be the proportion of Project D undertaken, and
e be the proportion of Project E undertaken.
Objective function
58.5a + 39.3b 20.7c + 109.1d + 38.8e Max
Constraints
100a + 50b + 200c + 100d + 200e
100a + 100b + 50d + 50e
a, b, c, d, e
225
150 + 100c
1
Non-negativity conditions
a, b, c, d, e 0
1a, b, c, d, e
CHAPTER 9
717
SIMPLE RISK TECHNIQUES
(g)
Year 0
Year 1
Year 2
DV of
cash
10% Discount
factor
Total opportunity
cost
0.92
0.84
0
+
+
+
1.0
0.9091
0.8264
=
=
=
1.9200
1.7491
0.8264
The circumstances when a deposit account facility would be worthwhile would be

when 1 1.9200 < (1 + i) 1.7491.
(h)
1 1.7491
= 1(1 + i) 0.8264
1.7491
= 0.8264 + 0.8264i
1.7491 0.8264
= 0.8264i
1 7491 0.8264
0.8264
= i = 1.17 or 117% approximately.
Therefore, the company would have to be offered a minimum rate of interest of 117%
before they would be willing to transfer money from t1 to t2.
Chapter 9

problem 1
(a) The first task with this type of complex ENPV question is to identify the different
states of the world and their associated probabilities. Once this is done, the projects
NPV in each state of the world can be calculated. These state of the world NPVs are
then each multiplied by their associated probabilities and added together to give the
overall expected NPV or ENPV of the project.
The states of the world
There are three stages involved with this project.
Stage 1
Stage 2
Stage 3
The seismic survey. There is a 50% chance that this will reveal that the geology indicates the possibility of oil. If it does, we proceed to the next stage.
But there is also a 50% chance (i.e. 1.0 0.50 = 0.50) that the geology indicates that there will be no oil. Under these circumstances, the company
goes no further and abandons the project.
The exploration wells. If the seismic survey indicates the possibility of oil then
the company will proceed to drill exploration wells to see if oil does actually
occur. There is a 30% chance that the exploration well will discover oil, in
which case we proceed to stage 3. However, there is a 70% chance (i.e. 1.0
0.30 = 0.70) that the exploration well will indicate no oil is present. Under the
circumstances, the company will go no further and abandon the project.
The appraisal wells. If the exploration wells indicate oil then we will proceed to
drill appraisal wells to identify just what quantity of oil is there. There is a 60%
chance that the oil will be in negligible quantities (what the question refers to
as type I). In those circumstances, the project is then obviously abandoned.
However, there is a 32% chance that the appraisal wells will indicate the presence of 42 million barrels of oil (type II) and an 8% chance that 2250 million
barrels of oil will be indicated (type III). Under each of these last two circumstances the company will then proceed to extract the oil.
As a result, there are five possible outcome combinations, or states of the world.
State A
Seismic survey indicates no oil and the project is abandoned.
718
ANSWERS TO PROBLEMS
State B
State C
State D
State E
Seismic survey indicates that there may be oil, an exploration well is drilled
and finds no oil. The project is then abandoned.
Seismic survey indicates that there may be oil, an exploration well is drilled
and also indicates oil. Therefore an appraisal well is drilled, but a negligible
amount of oil is found. The project is abandoned.
This is the same as for State C, except the appraisal well discovers 42 million
barrels of oil which the company then extracts.
Again, the same as for State C, except the appraisal well discovers 2250 million
barrels of oil which the company then extracts.
The probability of occurence of each of these five states can be found from the product
of the probability of each event in each state.
State A
0.50 or 50%
State B
0.50 0.70 = 0.35 or 35%
State C
0.50 0.30 0.60 = 0.09 or 9%
State D
0.50 0.30 0.32 = 0.048 or 4.8%
State E
0.50 0.30 0.08 = 0.012 or 1.2%.
The required information

Having identified the separate states of the world and their associated probabilities, the
next stage is to work out the projects NPV under each state. However, before doing
that, we need to assemble the required information.
(i) The first item of information is to identify the annual oil production pattern in the
two states (D and E) where oil is actually produced. From the information in the question, the following can be derived.
State D
State E
14 million barrels per year output for the first two years of the oilfields life
and 7 million barrels per year for the second two years: 14 million +
14 million + 7 million + 7 million = 42 million
300 million barrels per year output for the first five years of the oilfields life
and then 150 million barrels per year for each of the remaining five years:
(5 300 million) + (5 150 million) = 2250 million.
(ii) As all the other financial figures are provided in terms, we need to express the oil
revenues similarly. At $26.40 a barrel and an exchange rate of $1.20 = 1, the revenue
from a barrel is $26.40 1.20 = 22.
(iii) The operating net cash flow (pre-tax) per barrel is: 22 0.45 = 9.90.
(iv) The annual revenues (pre-tax) will be:
7 million barrels = 69.3 million
14 million barrels = 138.6 million
140 million barrels = 1 485 million
300 million barrels = 2 970 million
(v) The annual tax cash flow on these net revenues are as follows:
69.3 million 0.77 = 53.361 million
138.6 million 0.77 = 106.722 million
1 485.0 million 0.77 = 1 143.45 million
2 970.0 million 0.77 = 2 286.9 million
(vi) Finally, there is the timing of cash flows and the discount rate. The licence fee of
20 million and the seismic survey cost of 2 million both occur at Year 0. The appraisal
wells cost of 100 million and the exploration well cost of 10 million both occur at Year
CHAPTER 9
719
1. All exploration costs receive tax relief at 50%. The first oil production revenues occur
at Year 2 and the first tax charge occurs at Year 3. The discount rate is 16%.
The NPV calculations ( millions)
In these calculations (which really test your discounting ability), use can be made of the
fact that a lot of the cash flows are annuities.
State A
Year 0
Year 1
20
2
+10
=22
1
=+11(1.16)
+1
=22.00
=+ 9.48
NPV
State B
Year 0
Year 1
Year 2
20
2
+10
+1
10
+5
=22
1
=+(1.16)
2
=+5(1.16)
=22.00
=+ 0.86
=+ 3.72
NPV
State C
Year 0
Year 1
Year 2
Year 0
Year 1
Year 2
20
2
+10
+1
10
+5
100
+50
22
= 22.00
1
99(1.16) = 85.35
2
+55(1.16) =+40.88
NPV = 66.47
State D
1
2
1
22
99(1.16)
+55(1.16)
+138.6A
2 0 .16 (1.16)
2
3
106.722 A
+ 69.3 A
2 0 .16 (1.16)
2 0 .16 (1.16)
4
53.361 A
2 0 .16 (1.16)
22 85.35 + 40.88 + 191.80
137.32 + 71.27
47.31 = +11.97 NPV
State E
1
2
1
22 99(1.16) + 55(1.16) + 2 970 A
5 0 .16 (1.16)
2
6
2 286.9 A
+ 1 485 A
5 0 .16 (1.16)
5 0 .16 (1.16)
7
1 143 A
5 0 .16 (1.16)
22 85.35 + 40.88 + 8 383.64
5 565.08 + 1 964.37
1 324.10 = +3 892.86 NPV
Expected NPV
mn NPV
12.52
17.42
66.47
+11.97
+3 892.86
Probability
0.50
=
0.35
=
0.09
=
0.048
=
0.012
=
6.26
6.10
5.98
+ 0.57
+ 46.71
+28.94mn ENPV
=12.52
=17.42
=22
=99
=+55
720
ANSWERS TO PROBLEMS
FIG.P 9.1
Probability
0.6
9%
0.32
4.8%
0.08
1.2%
15%
70%
I
II
: oil
lore
Exp
0.50
Exp
lore
: no
oil
0.50
il
y: o
rve
u
S
0
0.3
Su
rve
y: n
0.7 o oil
0
III
(b) Revised probability tree

The revised probability tree is shown in Fig. P9.1. The survey only changes the probabilities of States A and B. Therefore its worth should be determined by the difference
the change in probabilities makes to the ENPV of these two outcomes, plus the cost of
the existing survey:
State
A
B
NPV
mn
12.52
17.42
Existing
probability
0.50
0.35
State
=6.26
=6.10
ENPV
12.36
A
B
NPV
mn
12.52
17.42
Revised
probability
0.70 =8.76
0.15 =2.61
ENPV 11.37
The difference between is:

mn
12.36
11.37
0.99
2.00
(0.86) =
Plus cost of existing survey:

Less PV of tax relief:
2.13mn =
2.0mn 0.50 (1.16)
Max after-tax value of new survey
Let = gross cost of the new survey, then:

1
0.50 (1.16) =
0.569 =
=
2.13
2.13
2.13/0.569 = 3.74mn (approx.)
problem 2
(a) The market research cost has already been incurred and so can be ignored for decision purposes.
NPV analysis
Outlay: 200 000
Revenue: 250 000 per year
Variable costs: 150 000 per year
Fixed costs: 25 000 per year
Scrap value: 2 000
Life: 4 years
Discount rate: 10%
CHAPTER 9
721
200 + (250 150 25 ) A 4 0 .10 + 2(110

. )4 + 39 108 NPV
= accept
200 + (75 31699
.
) + (2 0.6830 )
Sensitivity analysis
Let outlay =
4
+75 A
= 0 NPV
4 0 .10 + 2(1.10)
4
= 75 A
= 239 108
4 0 .10 2(1.10)
% change:
239 108 200 000

= 0.196
200 000
Let revenue =
4
200 + A
=0
4 0 .10 175 A
4 0 .10 + 2(1.10)
=
200 + 175 A
2(110
. )4
4 0 .10
A
4 0 .10
% change:
= 237662
250000 237662
= 0.049
250 000
Let variable costs =

4
=0
200 + 250 A
4 0 .10 A
4 0 .10 25 A
4 0 .10 + 2(1.10)
=
200 250 A
. )4
4 0 .10 + 25 A
4 0 .10 2(110
= 162 337
4 0 .10
A
% change:
162 337 150 000

= 0.082
150 000
Let fixed costs =

4
200 + 250 A
=0
4 0 .10 150 A
4 0 .10 A
4 0 .10 + 2(1.10)
=
. )4
200 250 A
4 0 .10 + 150 A
4 0 .10 2(110
= 37 337
A
4 0 .10
% change:
37 337 25000
= 0.494
25000
Let life = years
200 + 75 A
=0
X 0 .10 + 2(1.10)
When = 4 NPV = +39 108
When = 2 NPV = 200 + (75 1.7355) + (2 0.8264) = 68 185
68 185
= 2+
( 4 2) = 3.27 years
68 185 39 108
% change:
4 327
.
= 0.182
4
Let sales price =

4
200 + 50 A
=0
4 0 .10 175 A
4 0 .10 + 2(1.10)
=
200 + 175 A
4 0 .10
50A
2(1.10 )4
4 0 .10
= 4.75
722
ANSWERS TO PROBLEMS
5 4.75
= 0.05
5
% change:
Let sales volume =
=0
200 + (5 3) A
4 0 .10 25 A
4 0 .10 + 2(1.10)
=
. )
200 + 25 A
4 0 .10 2(110
(5 3) A
4 0 .10
% change:
= 43 831 bottles
50 000 43 831
= 0.123
43 831
Let variable cost/bottle =

4
=0
200 + 250 A
4 0 .10 50 A
4 0 .10 25 A
4 0 .10 + 2(1.10)
=
4
200 250 A
4 0 .10 + 25 A
4 0 .10 + 2(1.10 )
= 3.25
50 A
4 0 .10
% change:
3.25 3
= 0.083
3
(b) Sensitivity table

Forecast
Outlay
Revenue
Variable cost
Fixed cost
Life
Sales price
Sales volume
Variable cost/unit
Max. % change
19.6% rise
4.9% fall
8.2% rise
49.4% rise
18.2% fall
5.0% fall
12.3% fall
8.3% rise
The sensitivity table indicates that the accept advice given by the NPV analysis is most
sensitive to changes in the estimates of the annual revenue and the sales price. Management should go back and ensure that they cannot significantly improve their confidence
in the reliability of both estimates.
(c) Expected Year 6 sales:
Successful:
28 000 0.5 =
9 000 0.5 =
14 000
4 500
18 500
Unsuccessful:
12 000 0.5 =
5 000 0.5 =
6 000
2 500
8 500
Contribution/sale: 5 3 = 2
ENPV of contribution (000s):
5
6
5
6
+70(1.10)
+37(1.10)
5
6
+14(1.10)
+17(1.10)
=
=
PV
64 350
18 289
Probability
0.6 = 38 610
0.4 = 7 316
+45 926
PV of fixed costs (000s):

5
25(1.10) 25(1.10) = 29 635
CHAPTER 9
723
Therefore the PV of the life extension would be:

45 926 29 635 = +16 291
PV cost of trade advertising (000s):
5
10(1.10) 10(1.10) = 11 854

PV cost of price reduction (000s):
5
35 0.40(1.10) 18.5 0.40(1.10) = 12 870 0.6 = 7 722

5
6
7 0.40(1.10) 8.5 0.40(1.10) = 3 658 0.4 = 1 463
9 185
NPV of life extension with trade advertising:
16 291 11 854 = +4 437
NPV of life extension with price reduction:
16 291 9 185 = +7 106
Therefore, although either alternative would be worthwhile, the price reduction alternative leads to the largest additional amount of positive NPV.
problem 3
(a) Report
Assuming that the investment in Goer is undertaken, is it better to continue with the
project at the end of the first year, or to abandon it?
If it is decided not to abandon the project at Year 1, there is an opportunity cost of
141 000 the payment from Goer that is forgone.
In Year 2, there are four possible outcomes: a cash flow of 80 000, 90 000, 100 000
or 110 000, plus 81 000 final payment.
The NPV of deciding not to abandon at Year 1 is as follows:
Year 1 cash flow: 80 000
Year 1
(141 000)
Year 2
80 000
81 000
NPV at 18%
(3 867)
Prob.
0.6
(2 320)
(141 000)
90 000
81 000
3 314
0.4
1 326
ENPV
(994)
Year 1 cash flow: 100 000

Year 1
Year 2
(141 000) 100 000
81 000
(141 000) 110 000
81 000
NPV at 18%
Prob.
10 497
0.6
6 298
17 679
0.4
7 072
ENPV
13 370
Therefore if, at the end of Year 1, the company receives a cash flow of 80 000, the best
course of action is then to abandon the project (for to continue incurs a negative ENPV
of 994). However, if at the end of Year 1, the company receives a cash flow of 100 000,
the best course of action is to continue the project (for continuing generates a positive
ENPV of 13 370).
724
ANSWERS TO PROBLEMS
Now that the optimal action at Year 1 is known, the overall investment decision can
be evaluated.
There are three possible states of the world. State 1 is where the company receives an
80 000 cash inflow at Year 1 and so abandons the project. The probability of this state
is 0.60.
State II is where the company receives a 100 000 cash inflow at Year 1, continues
with the project and receives another 100 000 cash inflow at Year 2. The probability of
this state is: 0.40 0.60 = 0.24.
State III is where the company receives a 100 000 cash inflow at Year 1, continues
with the project and receives a 110 000 cash inflow at Year 2. The probability of this
state is: 0.40 0.40 = 0.16.
NPV analysis
State
Year 0
Year 1
(201 000)
80 000
141 000
II
(201 000)
100 000
III (201 000)
100 000
Year 2
NPV at
18%
(13 702)
Probability
0.6
(8 221)
100 000 13 744
81 000
0 .24
3 299
110 000 20 926
81 000
0.16
3 348
ENPV (1 574)
Therefore, despite the abandonment option at Year 1, the overall project is not worthwhile. The company would do better to invest its 20 000 in the money market, which
represents a zero NPV investment.
(b) The practical problems of abandonment analysis relate primarily to the estimation
of the relevant cash flows. It is difficult, if not impossible, to accurately estimate:
(i) annual net cash flows cash flows are usually estimated to be single figures, e.g.
80 000 or 100 000, whereas in reality they might take various alternative
values;
(ii) the conditional probabilities associated with the cash flows;
(iii) the actual abandonment value unless contractual agreements exist, the abandonment value estimated may be subject to substantial error.
Estimates of NPV are likely to be less accurate as the number of years that an abandonment opportunity exists increases.
Abandonment is normally advocated in the first year that the present value of abandonment exceeds the present value of expected cash flows from continued operation.
However, abandonment at a later date might produce an even greater expected present
value. The normal abandonment rule might lead, therefore, to a sub-optimal decision.
Abandonment part-way through the expected economic life might occur for many
reasons, which results in the present value of abandonment exceeding the expected
present value of continuing. Important factors might include unexpected unfavourable
changes in inflation, exchange rates, taxation, labour, material and other costs, the development of new technology, labour disputes and increased competition.
CHAPTER 10
Chapter 10
725
RISK AND RETURN
Risk and return

problem 1
(a) The utility function can be derived by arbitrarily defining the utility of two levels of
income and then using the relationships the investor has provided to calculate the utilities of the remaining levels of income.
Define U(500) = 0 and U(4500) = 1. Then using the expected utility hypothesis it
is possible to calculate the utility of 2500 which must equal the expected utility of 500
with probability 0.4 and 4500 with probability 0.6. Thus:
(i)
U(2 500) = 0.4 U(500) + 0.6 U(4 500)

U(2 500) = 0.4 0 + 0.6 1 = 0.6
Similarly:
(ii)
U(2 500) = 0.75 U(1 600) + 0.25 U(4 500)

0.6 = 0.75 U(1 600) + 0.25 1
U(1 600) = 0.35/0.75 = 0.467
(iii) U(2 500) = 0.55 U(1 600) + 0.45 U(3 500)

0.6 = 0.55 0.467 + 0.45 U(3 500)
U(3 500) = (0.6 0.55 0.467)/0.45 = 0.763
(iv) U(2 500) = 0.75 U(2 000) + 0.25 U(3 500)
0.6 = 0.75 U(2 000) + 0.25 0.763
U(2 000) = (0.6 0.25 0.763)/0.75 = 0.546
(v)
U(2 500) = 0.5 U(2 000) + 0.5 U(3 000)

0.6 = 0.5 0.546 + 0.5 U(3 000)
U(3 000) = (0.6 0.5 0.546)/0.5 = 0.654
(vi) U(2 500) = 0.85 U(2 000) + 0.15 U(4 000)

0.6 = 0.85 0.546 + 0.15 U(4 000)
U(4 000) = (0.6 0.85 0.546)/0.15 = 0.906
FIG. P10.1
Ut
1.0
0.8
0.6
0.4
0.2
1 000
2 000
3 000
4 000
Total income
726
ANSWERS TO PROBLEMS
Therefore we have the following data:

U(500) = 0
U(1 600) = 0.467
U(2 000) = 0.546
U(2 500) = 0.6
U(3 000) = 0.654
U(3 500) = 0.763
U(4 000) = 0.906
U(4 500) = 1.0
Figure P10.1 illustrates this utility function. As can be seen from the graph, for a total
income level of between (approximately) 0 and 2500 the utility function is concave to
the origin, indicating risk-aversion. However, for income levels of between 2500 and
4000 the utility function is convex to the origin, suggesting that the investor becomes a
risk-seeker/risk-lover.
(b) Note that the alternative activities are additional. As the utility function was drawn
up using total income it can be used to compare the total incomes given by different
alternatives.
Thus with (i) the total incomes will be 2500 (1500 + 1000 already received), probability of 0.5, and 3000 (2000 + 1000), probability of 0.5. The expected utility of (i) is
thus:
0.5 U(2 500) + 0.5 U(3 000) = 0.5 (0.6 + 0.654) = 0.627
Similarly the total incomes from (ii) are 2000 and 3500 each with a probability of
0.5.
The expected utility of (ii) is thus:
0.5 U(2 000) + 0.5 U(3 500) = 0.5 (0.546 + 0.763) = 0.655
Thus (ii) is preferred by the investor as it has a higher utility.
(c) Expected values
(i)
2 500 0.5 =
3 000 0.5 =
Expected
value
(ii)
2 000 0.5 =
3 500 0.5 =
1 250
1 500
2 750
1 000
1 750
2 750
Variances
(i)
2
(2 500 2 750) 0.50
2
(3 000 2 750) 0.50
= 31 250
= 31 250
(ii)
2
(2 000 2 750) 0.5
2
(3 500 2 750) 0.5
= 281 250
= 281 250
Variance
= 62 500
Variance
= 562 500
(d) (ii) is preferred by the investor even though it has a greater variance than (i) and the
same expected value. Variance is a successful measure of risk where individuals are
risk-averse. The investor is not risk-averse over the range of utilities of (i) and (ii).
CHAPTER 11
Chapter 11
727
PORTFOLIO THEORY
Portfolio theory
problem 1
(a) In Fig. P11.1 AB, BC and AC are joined by straight lines since they are perfectly
positively correlated.
The shaded area represents possible risky portfolios. CML represents the capital
market line. The market portfolio is risky Security B.
(b) The market price of risk is represented by the slope of CML:
015
. 0.08 0.07
=
= 175
.
0.04
0.04
Therefore, investors will receive an expected return of 1.75% (in addition to the
risk-free return) for every 1% increase in risk (standard deviation of return) that they
accept, if they hold an efficient portfolio.
(c) Investors would only be willing to hold risky Security B in possible combination
with the risk-free security, assuming that all investors were risk-averse. This is because
Security B gives the best price for risk, i.e. the maximum slope for the capital market
line. Since A and C do not give as good a price for risk there must be a temporary disequilibrium; they are both giving a return that is too low for the risk involved.
(d)
E(rp)
E(rM)
rF
E(rp)
0.10
0.10
0.02
0.02
=
=
=
=
=
=
=
x E(rM) + (1 x)rF
0.15
0.08
0.10
0.15x + (1 x) 0.08
0.15x + 0.08 0.08x
0.07x
0.07
=
x = 0.286
Thus the investor would place 28.6% of his investment capital in Security B and the
remainder (71.4%) in the risk-free security.
The risk of the resulting portfolio can either be calculated via the market price of risk:
0.10 0.08
= 0.011
1.75
or via:
2
p = x 2 2 = (0.286 0.04 ) = 0.011

(e) As the market portfolio yields an expected return of only 15% per period, to gain a
20% return, the investor will have to borrow additional funds at an interest cost of 8%
per period:
E(rp)
=
x E(rM) + (1 x)rF
E(rp)
=
0.20
E(rM)
=
0.15
rF
=
0.08 (borrowing cash)
0.20
=
0.15x + (1 x) 0.08
0.20
=
0.15x + 0.08 0.08x
0.12
=
0.07x
0.12
0.07
x = 1.714
728
ANSWERS TO PROBLEMS
FIG. P11.1
E(rp )
%
CML
20
15
10
8
Therefore an investor will borrow an amount equivalent to 71.4% of his own funds.
These borrowings, together with his own investment funds, will be placed in Security B.
The risk attached to this portfolio yielding a 20% expected period return is as follows:
via the market price of risk
p =
0.20 0.08
= 0.0686
1.75
or:
2
p = x
= (1.714 0.04 ) = 0.0686
The main assumptions are:

(f) (i) The investors objective is to maximize the utility of wealth.
(ii) Investors make choices on the basis of risk and return. Return is measured by
the arithmetic mean return from a portfolio of assets, and risk is measured by
the standard deviation or variance of those returns.
(iii) All investors can lend and borrow unlimited amounts of cash at the risk-free
interest rate.
(iv) No taxation, transaction costs or other market imperfections.
(v) All investors have the same knowledge and expectations about the future and
have access to the complete range of investment opportunities. Investors are all
price-takers and have free access to all relevant information.
(vi) All investors have the same decision-making time horizon, i.e. the expected
return on investments arises from expectations over the same time period.
Portfolio theory is important to companies as far as investment decision making is
concerned because it illuminates the risk reduction effect of diversification and, more
importantly, it indicates that the reward for risk-taking is only linked to systematic risk,
rather than total risk.
problem 3
(a)
E[rp] = x E[rA] + (1 x) E[rB]

E[rp] = (0.8 12) + (0.2 20) = 13.6%
CHAPTER 12
THE CAPITAL ASSET PRICING MODEL

2 2
(b) p = x
2 2
A
2
+ (1 x)
2
729
+ 2x(1 x)ABAB
p = (0.8 3 ) + (0.2 7 ) + (2 0.8 0.2 3 7 0.1)

p = 2.9%
(c) The weighted average risk of the portfolio is:
(0.8 3%) + (0.2 7%) = 3.8%
The actual risk of the portfolio, as calculated in part (b) above, is 2.9%. Thus a significant amount of risk reduction has been achieved through portfolio diversification. The
reason for such a significant degree of risk reduction (0.9% as a percentage of 3.8% represents 23.7% risk reduction) is that the correlation coefficient, at a value of +0.1, is well
away from +1.
(d) It is possible to construct a zero-risk two-asset portfolio, if the correlation coefficient
is perfectly negative: 1.
In such circumstances, the equation for portfolio risk reduces to:
p = xA (1 x)B
Therefore, solving for x:
0
0
7%
7%
=
=
=
x 3% (1 x) 7%
3%x 7% + 7%x
10%x
10%
= x = 0.70
Therefore 70% of the funds should be placed in Project A and the other 30% in Project B.
Chapter 12
The capital asset pricing model

problem 1
(a) Given:
SHARES =
Systematic risk of shares

Risk of market portfolio
then:
Systematic risk of shares = SHARES Risk of market portfolio
Also given:
x + y = x
x
y
+y
x+ y
x+ y
Therefore:
62
4
V + A = 0.67 + 0.67 = 0.67

66
66
62
4
V + B = 0.67 + 1.14 = 0.698

66
66
62
4
V + C = 0.67 + 0.88 = 0.683

66
66
730
ANSWERS TO PROBLEMS
And so:
Systematic
M
risk
V+A
=
0.67
16%
V+B
=
0.698
16%
V+C
=
0.683
16%
In all three cases, the new market value of the
62 million + 4 million = 66 million.
=
10.72%
=
11.17%
=
10.93%
company would be expected to be:
(b) Portfolio theory shows that when assets are combined, the total risk of the combination (measured as standard deviation of returns) is less than a weighted average of the
risks of the individual assets, as long as the assets are less than perfectly positively correlated with each other. The further away the correlation coefficient is from being perfectly positive (i.e. +1), the greater will be the amount of risk reduction.
The simplest type of portfolio is a two-asset portfolio. Vanhal, plus an acquired
company, could be viewed as such a portfolio. For example, if Vanhal were to acquire
company A, then the total risk of the enlarged company would be given by:
2 2
V+A = x
+ 2x(1 x)VAV,A
where x and (1 x) represent the proportions of Vanhal and A represented in the

enlarged company. As long as the correlation coefficient (V,A) is less than + 1, then V+A
will be less than (V x) + A (1 x). In other words, Vanhal will have been able to
reduce its total risk (in the sense that the resulting total risk will be less than a weighted
average of the total risk of the components) through the diversification process.
(c) There could be a large number of possible reasons why the directors of Vanhal
might wish to diversify, but the question indicates that the primary reason is to broaden
the companys activities. In this respect, the desire of the directors to diversify arises
from their wish to reduce the total risk of the company. How this may be done in relation to the companys stock exchange return has been shown in the answer to part (b).
However, from the directors viewpoint, risk reduction through diversification would
manifest itself in a reduction in the variability of the companys operating cash flow and
therefore resulting (in stock market parlance) in an increase in the perceived quality of
the companys earnings.
The directors would be interested in trying to bring about such an effect for two
reasons. One would be to hope for an enhancement of the stock market price of the
companys shares through the increased earnings quality leading to a higher
priceearnings ratio multiple being applied to the companys earnings per share.
However, such an effect would only come about if the market valued total risk, rather
than just systematic risk.
The second reason for the directors interest in such a policy would be the benefits
that a more stable corporate cash flow would bring to the job of management. For
example, there would be a reduced probability of insolvency (and the consequential costs
for directors); there may be opportunities for increasing the companys gearing; a stable
dividend policy might be able to be maintained with greater ease; and generally the task
of managing the overall company would become less demanding.
To suggest which of the three companies under consideration best meets the directors requirements is difficult, given the information available. As all three are in the
same area of industry, any one of the three would presumably provide the required
broadening of the companys activities. However, assuming that the directors are interested in such a move in order to reduce total corporate risk, then they may not be indifferent between the three companies. Given that all three companies have the same value,
CHAPTER 12
THE CAPITAL ASSET PRICING MODEL
731
and assuming that they all have the same correlation coefficient with Vanhal (which is
not unrealistic, given the circumstances), then company A is likely to be preferable as it
has the smallest amount of total risk and specific risk. (Non-specific or systematic risk
cannot be diversified away.) If the assumption about the correlation coefficient is unsafe,
then the company best suiting the directors requirements would be that whose combination of total risk and correlation coefficient used in the expression given in answer to
part (b) above would result in the lowest level of total risk for the enlarged company.
(d) Portfolio theory and the capital asset pricing model suggest that investors should
only be interested in systematic risk. As systematic risk cannot be diversified away, there
would be no risk reduction benefits accruing to shareholders as a result of the merger,
assuming that they already hold well diversified investment portfolios.
In fact such a move as that contemplated by Vanhal may be unwelcome to shareholders if it were to significantly change the total market value and beta of the company.
In such circumstances, a shareholder holding a diversified portfolio with a desired beta
value would have to adjust his/her portfolio (and so incur transaction costs) in the light
of the change to Vanhal.
Despite the foregoing, shareholders might still welcome the takeover, even given the
assumption in part (a) of the question that there are no synergy benefits. For example,
shareholders holding non-fully diversified portfolios would gain some risk reduction
effect. Alternatively, if the company taken over was worth more than the 4 million purchase price, then Vanhals shareholders wealth would increase. Again if, as a result of the
takeover, Vanhal were able to increase their debt capacity, then the tax shield benefits (if
they exist) would also accrue to the shareholders (see Chapter 19).
However, given a reasonably efficient capital market with shareholders holding well
diversified investment portfolios, the value to shareholders of such a takeover as that
proposed is likely to be minimal. In fact, the costs (both internally and externally to
Vanhal) associated with the takeover may result in shareholders suffering an actual
reduction in their wealth.
problem 2
(a) Given that Mr Swift has a well diversified portfolio, it will be safe to assume that
most of the unsystematic risk that is attached to the individual securities in the portfolio
will have been diversified away. Thus his portfolio risk will largely consist of systematic
risk and so the variance of returns on his portfolio will essentially measure systematic
risk.
If he wishes to include shares that will reduce his portfolio variance, then he will be
concerned with the covariance of returns between any new share and his existing portfolio. In other words, he is interested in selecting the shares of that company which
would help to bring the greatest reduction in portfolio risk. This would be indicated by
looking at the product of the standard deviation of returns and the correlation with Mr
Swifts existing portfolio:
Dove:
Jay:
D D,S = 35% 0.16 = 5.6%

J J,S = 30% 0.21 = 6.3%
Under these circumstances, the optimal course of action for Mr Swift given his
objective would be to invest in the shares of Dove plc.
(b) The CAPM shows that there is a positive relationship between the expected return
on a security and its degree of systematic risk which is normally measured by its beta
value. Thus, the greater the amount of systematic risk the greater will be the expected
return demanded by investors in an equilibrium stock market. The systematic risk of
732
ANSWERS TO PROBLEMS
individual securities can be measured as the product of their standard deviation of return
and their correlation coefficient with the market portfolio. In the case of Dove and Jay,
this gives values for systematic risk of:
Dove:
Jay:
D D,M = 35% 0.3 = 10.5%

J J,M = 30% 0.25 = 7.5%
As Dove plc has the higher level of systematic risk, it would follow that Dove should
have the higher expected return, as indeed it does: 9% as against only 7% for Jay plc.
(c) If Mr Swifts portfolio contained shares in a few companies only, then he would be
holding a largely undiversified portfolio. Hence, the variance of returns of the portfolio
would reflect both the systematic and unsystematic risk components as there would be
insufficient diversification to wash out the unsystematic risk.
Without passing comment on whether such a portfolio is wise (although it would
appear sensible for Mr Swift to diversify further), in order to meet his objective on portfolio variance Mr Swift would be most interested in selecting that company which would
help to bring the greatest reduction to the total risk of his existing portfolio.
However, in these particular circumstances a problem arises from the fact that with
small portfolios a securitys contribution to portfolio risk can arise out of its own variance, as well as from its covariance with the existing portfolio. Thus, although Dove plc,
as was seen in the answer to (a), has the smaller covariance with the existing portfolio, it
has a higher variance (or standard deviation) than Jay:
2
D
= 0.1225
J = 0.09
Therefore the final choice between the two companies will depend upon the existing
components of Mr Swifts portfolio and their weights and the resulting changes brought
about through the introduction of the new security.
(d) Shareholders, assuming that they hold well diversified efficient portfolios, will be
interested in the effect on the risk of their portfolio of the addition to it of any particular
security. However, because the portfolio is fully diversified, when a new share is added
(again, assuming that only a marginal investment is made), then that new shares unsystematic risk is eliminated, or is washed out, and it is only the systematic risk that is added
to the portfolio. It is therefore for this reason that the relevant measure of risk for a companys shareholders is the amount of systematic risk. This is most conveniently measured in relative terms via the beta value.
Debt holders are also interested in the systematic risk of their investment which,
again, could be measured by beta. However, as most debt is unquoted, beta does not
provide a convenient measure of risk. Hence debt holders attempt to measure the risk of
a companys debt through a series of alternative measures including the degree of capital
gearing, the interest cover ratio, the amount of tangible assets held by the company and
the stability, or otherwise, of the companys annual net cash flow. Just which of these
factors contribute to systematic risk and which to unsystematic risk is somewhat unclear.
What evidence there is available suggests that all four factors with the possible exception of the amount of tangible assets held are likely to contribute to systematic risk.
Finally, managers, as far as their labour is concerned, hold undiversified portfolios.
Therefore, unlike outside investors, they are interested in the total risk of a company
and in particular the likelihood that it will fall. Thus, managers are likely to measure
risk by the variability of net annual cash flows (i.e. by the variance of corporate net cash
flows), the skew of those cash flows and by the degree of capital gearing. All three factors
will have a bearing on the riskiness of the company as seen from managements
viewpoint.
CHAPTER 13
733
OPTION VALUATION
problem 3
(a) (i) Expected return on Cemenco equity
Average % annual capital gain:
1
[16.42 9.50] 1= 20%

3
Average % dividend yield:

[10% + 12% + 8% + 10%] 4 = 10%
Therefore, expected return on Cemenco shares = 20% + 10% = 30%
(ii) Expected return on TSE Index
Average % annual capital gain:
1
[1983 1490] 1 = 0%
3
Average % dividend yield:

[16% + 15% + 10% + 18%] 4 = 15%
Therefore, expected return on the TSE Index = 10% + 15% = 25%
(iii) Return on government stocks
15% + 16% + 14% + 15% 4 = 15%
Therefore, risk-free return = rf = 15%
(iv) Beta value of Cemenco equity
E[rc] = rf + (E[rm] rf) . c
Therefore:
E [ rc ] rf
E [ rm ] rf
= c
30% 15% 15
=
1.50
25% 15% 10
(b) It is difficult to predict with any accuracy whether the governments action will make
Cemenco Ltd more or less systematically risky. Although in total risk terms the risk of
the company will be reduced, it is difficult to be certain what will be the effect on systematic risk. The companys revenues will, as always, be fairly sensitive to the level of
Trinkas economic activity and this is unlikely to change by being given a monopoly.
However, there will be price control and this may therefore result in increasing the companys systematic risk exposure.
Chapter 13
Option valuation
problem 1
(i) In order to answer this question, we need to use the Black and Scholes model to
value the Pear call options, where:
S = 415p
X = 400p;
T = 0.25 years
Rf = 0.05
= 0.22.
734
ANSWERS TO PROBLEMS
and the Black and Scholes model is:

Rf T
C = S N (d1) [X e
] N (d2)
where:
( d1 ) =
S
log e + ( Rf T )
X
T
+ (0.5 T
and
(d2) = (d1) T
We will do the calculations, item by item:
log e S/X = log e 415/400 = log e 1.0375 = 0.0368
Rf T = 0.05 0.25 = 0.0125
T = 0.22 0.25 = 0.22 0.50 = 0.11
0.5 T = 0.5 0.11 = 0.055
0.0368 + 0.0125
(d1) =
+ 0.055 = 0.5032
0.11
(d2) = 0.5032 0.11 = 0.3932
Using the area under the normal curve tables:
N (d1) = N (0.50) = 0.5 + 0.1915 = 0.6915
N (d2) = N (0.39) = 0.5 + 0.1517 = 0.6517
and so finally:
0.25 0.05
C = 415p 0.6915 (400p e

) 0.6517
C = 286.97p (400p 0.9876) 0.6517
C = 286.97p (395.03p 0.6517)
C = 286.97p 257.44p = 29.5p
The Black and Scholes model suggests that the Pear calls should have a value of 29.5p.
(ii) We can use the putcall parity equation to value the pear put options:
P = C + [X e
Rf T
]S
where:
C = 29.5p
X = 400p
S = 415p
e
Rf T
0.05 0.25
=e
= 0.9876
Therefore:
P = 29.5p + [400p 0.9876] 415p = 9.5p
(iii) The delta or hedge ratio for the Pear calls is given by the value of N (d1) = 0.6915.
Therefore, in order to construct a delta neutral hedge on the holding of 50 000 Pear
shares, the investor would need to sell/write:
50 000 shares 0.6915 = 72 307 call options.
As a result, any gains or losses on the shareholding should be exactly matched by offsetting losses or gains on the written call options.
CHAPTER 14
735
INTEREST RATE RISK
problem 2
e
T.
Rf.T
In S/X
One plc
0.988
0.15
0.0125
0.0513
Two plc
0.951
0.177
0.05
0
Three plc
0.963
0.173
0.0375
0.0954
d1
d2
0.5003
0.3503
0.3710
0.1940
0.2482
0.4212
N(d1)
N(d2)
0.6915
0.6368
0.6443
0.5753
0.4013
0.3372
C
P
9.4p
3.3p
9.7p
4.8p
Rf.T
Chapter 14
4.4p
10.3p
Interest rate risk

problem 1
(a) Manling loan interest rate:
12%
Swap: Manling pays:
LIBOR + 11 2%
Manling receives:
115 8%
Net interest rate paid by Manling after the swap: LIBOR + 1 12% + 12%
115 8% = LIBOR + 17 8%
(i) LIBOR remains at 10%
Without swap: interest rate paid = 12%
With swap: interest rate paid = 10% + 17 8% = 117 8%
Interest saving from swap:
1
8% on 14mn loan
Less Bank fee
= 17 500
= (20 000)
Net cost
= ( 2 500)
Net cost of swap after tax relief:

(2 500) (1 0.35) = (1 625)
Therefore in this LIBOR scenario, the swap would not be worthwhile.
(ii) LIBOR falls to 9% after six months
Without swap: interest rate paid = 12%
With swap: interest rate paid = 10% + 1 7 8 % 0.5
= 11 3 8 %
9% + 1 7 8 % 0.5
Interest saving from swap:
5
8% on 14mn loan
Less Bank fee
Net saving
= 87 500
= (20 000)
= 67 500
Net saving from swap after tax relief:

67 500 (1 0.35) = 43 875
736
ANSWERS TO PROBLEMS
Therefore, in this LIBOR scenario, the swap is worthwhile.

(b)
Manling
Swap partner
Fixed interest
loan
12%
11 3 4 %
1
Interest differentials
Floating rate
loan
LIBOR + 2%
LIBOR + 11 8%
As the interest differentials between the two types of loan are not the same, there is a
benefit to be gained from a swap agreement equal, in total, to the difference between the
two interest differentials:
7
% = 5 8% interest saving
Given that this benefit is to be equally shared, each company will gain an interest saving
of 5 8% 2 = 5 16 %.
The swap arrangement is put together as follows:
1. Greatest interest differential: floating rate loan.
2. The swap partner can raise this type of loan most cheaply: LIBOR + 11 8%.
3. Therefore the swap partner borrows 14mn at LIBOR + 11 8% and Manling keeps its
existing loan at a fixed interest rate of 12%.
4. Manling wants a floating rate loan and we know that through a swap, such a loan can
be arranged at a 5 16 % interest saving on the normal interest rate that Manling would pay
for that type of loan: LIBOR + 2% 5 16 % = LIBOR + 111 16 %.
5. Manling therefore pays LIBOR + 111 16 % interest to the swap partner and, in
exchange, receives a fixed 12% interest rate from the swap partner (which can then be
used to pay the interest on their fixed rate loan).
6. The swap partner therefore:
(i) Pays interest on its own loan :
LIBOR + 11 8%
(ii) Receives from Manling
:
LIBOR + 111 16 %
Gain from swap
(iii) Pays Manling
Net interest cost
16 %
12%
117 16 %
:
:
:
Therefore, like Manling, the swap partner ends up with a loan at a

on the normal interest rate paid:
Swap partner:
Normal fixed interest loan rate
Effective swap interest rate
Interest saving
:
:
:
16
% interest saving
11 3 4 %
117 16 %
5
16 %
Now, if LIBOR remains at 10%:

Manling
With swap:
14mn (10% = 111 16 %)
Without swap:
14mn 12%
Interest saving
Less bank fee
Net interest saving
Net interest saving after tax: 23 750 0.65 = 15 438
=
=
Interest
1 636 250
1 680 000
43 750
(20 000)
23 750
CHAPTER 14
737
INTEREST RATE RISK
Swap partner
With swap:
Without swap:
14mn 117 16 %
14mn (10% = 11 8%)
=
=
Interest
1 601 250
1 557 500
Interest cost
Plus bank fee
(43 750)
(20 000)
Total cost
(63 750)
Net interest cost after tax relief: (63 750) 0.65 = (41 438)
Therefore, with the benefit of hindsight, although the swap deal results in a gain for
Manling, it results in a loss for the swap partner.
problem 2
(a) Omniown faces interest rate risk: the risk of an adverse movement in interest rates
over the next three months. All three techniques will help hedge their exposure, but in
different ways.
A forward rate agreement can be used to lock the company into a specific rate of
interest, say 14%, so that whatever happens to interest rates over the next three months,
Omniown will not be affected.
An FRA agreement works on the basis that the company pays the market rate of
interest on its loan but, if that rate is above the agreed 14%, then they receive compensation to bring their net effective interest rate down to the agreed 14%. Conversely, if
market interest rates fall then they will have to pay compensation to bring their interest
costs up to an effective 14%.
Interest rate futures have the same hedging effect as an FRA in that they hedge the
company against both a rise and a fall in interest rates. However, unlike an FRA, futures
are not tailor-made to the companys precise requirements but are standardized contracts and so may not provide a perfect hedge effect.
A futures hedge works by ensuring that whatever happens to interest rates, there will
be an offsetting effect from the futures contracts. Thus, for example, if interest rates rise
over the next three months, Omniown will make an offsetting profit on their futures
market contracts and vice versa.
In contrast to the first two hedging techniques, interest rate guarantees only hedge the
company against a rise in interest rates, but allow the company to take advantage of a fall
in rates. In other words, interest rate guarantees work as an option which the company
exercises if rates rise, to enable the company to borrow at 14%. On the other hand, if
rates fall, the company allows its option to lapse as it can borrow more cheaply at the
open market rate. The only problem with interest rate guarantees is that this advantage
that they have over forward rate agreements and futures means that they are a significantly more expensive hedging device.
(b) Value of a tick: 500 000 3 12 0.0001 = 12.50
Target interest charge: 5mn 6 12 0.14 = 350 000
Hedge:
As the company wishes to hedge against the risk of a rise in interest rates, it needs to sell
futures and then, in March, to close out its futures position it will reverse the effects of
this initial deal by buying futures.
Number of contracts involved:
5mn
= 10 contracts
500 000
738
ANSWERS TO PROBLEMS
But to allow for the maturity mismatch three month futures used to hedge a
six-month loan the number of contracts involved will have to be doubled: 10 2 = 20
contracts.
Therefore Omniown will sell 20 futures contracts at 86.25.
(i) Interest rates rise to 16% and, it is assumed, the futures price falls by 2% to
84.25
Interest on loan: 5mn 6 12 0.16
= 400 000
Target interest
= 350 000
Loss on target
= 50 000
Profit on futures:
Bought at
Sold at
84.25
86.25
Profit
2.00 = 200 ticks/contract
Total profit: 20 200 12.50 = 50 000

Interest on loan
Less profit on futures
=
=
400 000
(50 000)
Net interest cost
350 000
Hedge efficiency:
Profit 50 000
=
= 100%
Loss 50 000
(ii) Interest rates rise to 16% and, it is assumed, the futures price falls by 1.5% to
84.75
Interest on loan: 5mn 6 12 0.16 = 400 000
Target interest
= 350 000
Loss on target
= 50 000
Profit on futures:
Bought at
Sold at
84.75
86.25
Profit
1.50 = 150 ticks/contract
Total profit: 20 150 12.50 = 37 500
Interest on loan
Less profit on futures
= 400 000
= (37 500)
Net interest cost
= 362 500
Hedge efficiency:
Profit 37 500
=
= 75%
Loss
50 000
(iii) Interest rates fall to 13% and futures price rises by 0.75% to 87.00.
Interest on loan: 5mn 6 12 0.13
Target interest
= 325 000
= 350 000
Profit on target
= 25 000
CHAPTER 15
739
FINANCIAL MARKETS
Loss on futures:
Bought at
Sold at
87.00
86.25
Loss
0.75 = 75 ticks/contracts
Total loss: 20 75 12.50 = 18 750

Interest on loan
Plus loss on futures
= 325 000
= 18 750
Total interest costs
= 343 750
Hedge efficiency:
Profit 25 000
=
= 133.3%
Loss
18 750
(c) Cost of the guarantee: 5mn 0.002 = 10 000

(i)
Interest rate:
Guarantee rate:
Exercise the guarantee:
16%
14%
Interest cost: 5mn 6 12 0.14

Plus guarantee cost
= 350 000
= 10 000
Total interest cost
= 360 000
Interest cost with futures

(ii)
(iii)
Interest rate:
Guarantee rate:
Exercise the guarantee:
= 350 000
16%
14%

Plus guarantee cost
= 350 000
= 10 000
Total interest cost
= 360 000
= 362 500
Interest rate:
Guarantee rate:
Allow the guarantee to lapse:
13%
14%

Plus guarantee cost
= 325 000
= 10 000
Total interest cost
= 335 000
= 343 750
The outcome of this analysis shows that, with the benefit of hindsight, the interest rate
guarantee would provide the best outcome in scenarios (ii) and (iii), but in scenario (i)
futures provide the best outcome.
Chapter 15
Financial markets
problem 1
The statement can be divided into five separate sentences. However,

before we discuss these we need to consider the meaning of the word correct. All it
means is that, given all the available information, the price set for shares is the best estimate available. It does not mean that the price will turn out to have been correct with
the benefit of hindsight.
740
ANSWERS TO PROBLEMS
1. The efficient market hypothesis demonstrates how different levels of information

efficiency have different implications. In the strong form, it would not be possible to
identify a mispriced investment even if one had access to information about the company
that was not publicly available. If this were true then prices of shares would be correct
(given our definition of the word). However, it is difficult to imagine a situation where
privileged information would consistently have no value.
2. The second sentence is also not true. Share prices should respond to new information in an appropriate manner. In other words, the market should adjust the share prices
in a way that values the new information appropriately. It is the information that arises
in a random manner and not the valuation of the information.
3. The third sentence is also incorrect. In an efficient market, share prices should move
in response to the disclosure of all relevant information, and not just accounting
information.
4. Whilst there is no evidence that technical analysts contribute to market efficiency,
there is every reason to suppose that fundamental analysts do. They invest a great deal of
time, effort and resources in acquiring an information network and the ability to interpret that information. They cannot predict share prices but they do help to ensure that
new information is correctly interpreted.
5. If we return to point one, corporate managers will often be aware of information
that has not yet been made public and they will thus be in a position to predict share
price movements.
problem 2
(a) The spot interest rates can be estimated on the basis that the return on a two-year
bond should be the same as the yield on two consecutive one-year bonds. Therefore:
Year 2 spot rate estimate:
2
100 (1 + 0.0575) = 111.83

1
100 (1 + 0.06) (1 + S2) = 111.83
1
S2 = [111.83/100 (1 + 0.06) ] 1 = 5.5%
3
100 (1 + 0.055) = 117.42

100(1.06)(1.055)(1 + S3) = 117.42
S3=[117.42/100(1.06)(1.055)] 1 = 5%
4
100(1 + 0.05) = 121.55

100(1.06)(1.055)(1.05)(1 + S4) = 121.55
S4=[121.55/100(1.06)(1.055)(1.05)] 1 = 3.5%
5
100(1 + 0.045) = 124.62

100(1.06)(1.055)(1.05)(1.035)(1 + S5) = 124.62
S5=[124.62/100(1.06)(1.055)(1.05)(1.035)] 1 = 2.5%
Estimated spot rates:
Year
1
2
3
4
Rate
6%
5.5%
5%
3.5%
CHAPTER 15
741
FINANCIAL MARKET
FIG. P15.1
Yield
Falling yield curve
6%
5%
4%
1
2.5%
(b) The yield curve is plotted in Fig. P15.1.

(c) Given the relationship:
(1 + Real).(1 + Inflation) = (1 + Market)
1+ Market
then: Inflation =
1
1+ Real
Therefore:
Year 1:
106
.
1
102
.
3.92%
Year 2:
1055
.
1
102
.
3.43%
Year 3:
105
.
1
102
.
2.94%
Year 4:
1035
.
1
102
.
1.47%
Year 5:
1025
.
1
102
.
0.49%
Year
1
2
3
4
5
Inflation
forecast
3.92%
3.43%
2.94%
1.47%
0.49%
(d) Return from a 100 two-year bond:
Years to
redemption
742
ANSWERS TO PROBLEMS
2
100(1 + 0.0575) = 111.83

Return from two consecutive one-year bonds as specified:
100(1 + 0.06)(1 + 0.07) = 113.42.
This is equivalent to a compound annual rate of return of:
113.42
100
= 6.5%
whereas the compound annual rate of return on a two-year bond is only 5.75%.
Chapter 16
The cost of capital

problem 1
(a) (i)
Price/share = 35.8p 28 = 1 002.4p

1
Dividend growth rate = (11 4.86)

Cost of equity capital =
(ii)
1 = 22.7%
11(1 + 0.227 )
+ 0.227 = 24%
1002.4
Proportion of retained earnings:

Return on capital employed:
35.8 11
= 0.693
35.8
35.8
= 0.188
190
Dividend growth rate = 0.693 0.188 = 13%

Cost of equity capital =
11(1 + 0.13)
+ 0.13 = 14.2%
1 002.4
(iii) Cost of equity capital = 10% + [9% 0.80] = 17.2%

(b) The dividend growth model used contains three principal assumptions:
(i) shares are valued on the basis of the present value sum of future expected
dividends;
(ii) the share price used is in equilibrium;
(iii) the estimated dividend growth rate will continue indefinitely.
The first of these assumptions could be assumed to be reasonably realistic. The
second assumption is, however, open to some doubt, as the companys P/E multiple is
substantially different from the average of what is a reasonably homogeneous industry
group. Nevertheless, the most serious doubts concern the third assumption. Forecasting
the future on the basis of what has occurred in the past is never satisfactory unless there
are positive reasons to believe that the past will replicate itself in the future. In this case
this may be particularly unrealistic, given that the company has achieved a very high rate
of dividend growth in the recent past. It is doubtful whether such a trend would be
maintained indefinitely.
The Gordon model also makes three specific assumptions:
(i)
the proportion of retained earnings and the companys ROCE remain constant
in the future;
(ii) the company is all-equity financed;
(iii) projects are only financed out of retained earnings.
In the example in question, although the retention rate has remained reasonably constant over the recent past, the firms ROCE has changed significantly, growing steadily
from 15.6% to 18.8%. Thus doubt must be cast on the realism of the assumption that
this will remain constant in the future.
CHAPTER 16
THE COST OF CAPITAL
743
As far as the second assumption is concerned, Thamos is indeed all-equity financed at

present but it may not necessarily remain so in the future. The third assumption also
holds at present, but again it may be unrealistic to assume that the firm will not wish to
raise additional equity finance at some future point in time.
It is because of the questionable nature of some of the assumptions that lie behind
these models that it is not surprising that the two estimates of future dividend growth,
approximately 23% and 13%, are so different. This, in turn, then feeds through into the
estimate of the cost of equity capital.
Finally, the CAPM-based estimate of the companys cost of equity capital is also
founded on a number of assumptions, the realism of which might be open to question.
Principal amongst these would be:
(i) beta is the sole determinant of return;
(ii) tax has been correctly taken into account;
(iii) the risk-free return and the market risk premium have been correctly
identified;
(iv) investors have homogeneous expectations and a one-period time horizon;
(v) betas are stable over time.
These, and many other assumptions behind the CAPM, are of questionable
real-world validity. However, the real question concerning the applicability of CAPM to
generate a firms cost of equity capital is: is it empirically valid and does it work in practice? Although this evidence has come in for recent criticism, the best-known study of
this question is by Black, Jensen and Scholes (1972) which does tend to suggest that the
CAPM is, at least approximately, correct in relation to reality although it may be that
the model is just too simplistic and a model using multi-factor determinants of return
may be more applicable to the real world.
In many ways the three models used are not competitors, but just take different views
of the same problem. However, given the data input difficulties that are associated with
all the models, it is not surprising that the diversity of results obtained in part (a) has
actually occurred.
(c) In pure finance theory, it is highly debatable whether managers do need to know
their firms cost of equity capital and, in practice, many managers may well believe that
cost of capital numbers produced as in part (a) owe more to fiction than reality.
It is conceivable that a company operating in a single area of business and wishing to
evaluate an investment project that is in the same area may require knowledge of the cost
of equity capital as an input into the weighted average cost of capital (WACC) computation, in order to obtain a discount rate. Additionally, a manager might also want to identify the companys cost of equity capital as an input into a WACC calculation in an
attempt to observe the effect on the WACC (and on the cost of equity) of a change in
the companys capital structure (see Chapter 17).
However, perhaps the most useful information imparted to managers by a companys
cost of equity capital is its opportunity cost implications. The cost of equity capital represents the return available to shareholders, elsewhere on the capital markets, from an
investment of a similar level of risk to that of investing in the companys shares. Thus it
could be interpreted as being the minimum return that management should earn on
investing shareholders funds. As an investment criterion, this has only a restricted
validity because the risk level has to be held constant. However, it does have the advantage of clearly bringing home to management the fact that retained earnings forming
as they do part of shareholders funds cannot be considered costless or free capital,
but have a very significant opportunity cost.
744
ANSWERS TO PROBLEMS
problem 2
(a) (i)
The dividend valuation model is:

KE =
d 0 (1 + g )
+g
PE
The total dividend payout is given as 2.14mn and the number of shares in issue is
10mn. Thus the dividend per share, d0, is: 2.14mn 10mn = 21.4p.
The market price per share, PE, is given as 321p (assumed to be ex div) and the
dividend growth rate, g, is given as 11%. Therefore:
KE =
21.4 (1 + 0.11)
+ 0.11 = 0.184 or 18.4%
321
The companys cost of equity capital is 18.4%.

(ii) The CAPM is:
Rcompany = Rf + (Rm Rf) company
The companys beta for its equity is not given and so has to be calculated from first
principles using the beta equation:
company = company company, market
market
The question gives:
company
market portfolio
company, market
Therefore company =
=
=
=
20%
10%
+0.7
20% 0.7 14%

=
= 1.40
10%
10%
Also, given that the risk-free return (Rf) is 12% and the return on the market portfolio
(Rm) is 16%, then the CAPM can be used to find the companys cost of equity capital
(Rcompany):
Rcompany = 12% + (16% 12%) 1.40 = 17.6%
Assumptions made:
1. The quoted share price is ex div.
2. The share price represents an equilibrium value in an efficient market.
3. The dividend growth rate is expected to remain constant in perpetuity.
(b) Under normal circumstances, we would not expect the dividend valuation model
(DVM) and the CAPM to give the same estimates for the KE of a company. The reasons
for this are as follows:
1. CAPM is a normative model. It indicates what should be the companys cost of
equity capital, given the systematic risk involved. In contrast, the DVM is a positive
model. It indicates what is the companys cost of equity capital.
2. CAPM is a single time period model. It looks at the return on equity over a
single time period. In contrast, the DVM is a multitime period model as it involves a
discounting process and looks at the expected dividend flow over each future time
period.
3. The CAPM, being a normative or predictive model, may be incomplete. That
is to say, the model is a single-factor model in that it assumes that there is only one
factor which determines the return on equity: beta or systematic risk. It may well be
that other factors, such as company size and dividend policy, also determine the
CHAPTER 17
745
WEIGHTED AVERAGE COST OF CAPITAL
return. If this is so, then the estimate of KE given by CAPM would not be correct.
(Notice that this problem of possibly being an incomplete model does not apply to
the DVM as it is a positive or deterministic model. Only predictive models run the
risk of being incomplete.)
4. Finally, both models require data which has to be estimated. Obviously if any
of these estimates are incorrect, the values produced for the cost of equity capital
would not be correct. Thus despite points 1 to 3, only if all the estimated variables
were correct: (g, Rf, Rm and ) would the two models produce the same value for the
cost of equity capital.
Chapter 17
Weighted average cost of capital

problem 1
(a) Cost of equity capital
KE
d 0 (1 + g )
+g
PE
where PE = 135 p
1
g = (13.6 / 10 ) 4 1 = 0.08
d 0 = 13.6 p
KE =
13.6(1 + 0.08)
+ 0.08 = 0.189
135
Cost of debentures
VB = 800 000 0.825 = 660 000
KD is found by solving:
+ 82.50 8 [ A4 K D
100(1 + K D )
=0
Using linear interpolation:

At 10%: + 82.50 8 A4 0 .10100(1 + 010
. )4 = 11.16
At 16%: + 82.50 8 A4 0 .16 100(1 + 016
. )4 = + 4.88
11.16
K D10% +
6% = 0.142
11.16 4.88
Cost of bank loan
As the interest rate is variable with market rate movements:
VL = 900 000
KL = 0.165
Weighted average cost of capital (K0)
K0 =
VE K E + VB K D + VL K L
VE + VB + VL
where:
VE = 1.35 3mn = 4.05mn
VD = 0.66mn
VL = 0.9mn
K0 =
KE =18.9%
KD =14.2%
KL =16.5%
(4.05 18.9%) + (0.66 + 14.2%) + (0.9 + 16.5%)

= 18%
4.05 + 0.66 + 0.9
(b) Apart from the obvious assumptions that the market values and the costs of capital
used in the calculation of the WACC are correct, there are three major assumptions that
746
ANSWERS TO PROBLEMS
have to be made if the WACC is to be a reliable discount rate for project appraisal. They
are:
(i) the project is marginal;
(ii) the company will maintain its existing gearing ratio;
(iii) the project has the same degree of (systematic) risk as the companys existing
cash flows.
The project should be marginal (i.e. small relative to the size of the firm) because the
WACC is a marginal cost of capital figure. It is so because each of the individual costs of
capital that go up to make the WACC are themselves marginal costs of capital. For
example, the cost of equity capital of (approximately) 19% represents the return that the
market would require from a marginal (i.e. relatively small) investment in the companys
equity. Thus the WACC is an appropriate discount rate or minimum required rate of
return for a relatively small capital investment project.
As can be seen in the calculation of the WACC in part (a) above, it is based on the
companys existing capital structure (gearing ratio). If the company were to change its
gearing, then the WACC could be expected to change also, for two reasons.
First, changing the gearing would change the weights applied to the individual costs
of capital, and second, changing the gearing would also change the degree of financial
risk held by ordinary shareholders and would thus, in turn, change the cost of equity
capital. [Only in a Modigliani and Miller world of no taxes and perfect markets would
this assumption prove unnecessary (see next chapter)].
Finally, the companys WACC relates to the degree of risk surrounding the companys existing cash flows. Therefore it would be appropriate to use this as an investment
appraisal discount rate only if the investment project has a similar level of risk.
(c) A number of practical problems are likely to be encountered in the calculation of
real world WACCs. However, there are three principal problems.
The first is that capital structures are often far more complex in practice than in textbook examples/calculations, with some securities causing really difficult valuation problems. Examples would include convertible debentures, loan stocks in foreign currencies
(Eurobonds, etc.) and unquoted, fixed interest capital.
The second problem specifically concerns the calculation of the cost of equity capital.
To obtain this number, estimates are normally required of the market value of the equity
and of the future dividend growth rate. With the market value of the equity there is a
problem in deciding what value to take if the share price is relatively volatile, but the real
problem concerns the dividend growth rate estimate. The past dividend growth rate may
be highly erratic, or it might have been depressed because of legal restraints on dividends, or it may be non-existent in the sense that no dividends have been paid in recent
years. In all cases, estimating the future dividend growth rate becomes highly problematical. The Gordon approach (where the growth rate g = b r) may be of some help in
such circumstances, but again it is hedged around by a number of assumptions such as
constant earnings retention percentages and constant rates of return on reinvested earnings which severely limit its usefulness. One other approach to calculating the cost of
equity capital would be to use the capital asset pricing model rather than the dividend
valuation model, but that too has its operational difficulties, in particular the specification of the risk-free interest rate and the rate of return on the overall market.
The final major problem with the real-world calculation of WACC is caused by taxation. In a taxed world what is required is an after-tax WACC, but the corporate tax
regime is now so complex and specific in terms of how it affects individual companies
that major problems are posed in trying to arrive at a reliable after-tax WACC estimate.
CHAPTER 17
747
WEIGHTED AVERAGE COST OF CAPITAL
problem 2
(a) (i)
Equity capital
KE = 18% (given)
VE = 8mn 1.10 = 8.8mn
(ii)
Irredeemable debentures
KIRR =
Annual Int. (1 Tc ) 3(1 0.35) 1.95

=
= 0.068
=
Mkt. value, ex. int. 31.60 3 28.6
VIRR = 1.4mn 0.286 = 0.4004mn
(iii) Redeemable debentures

KRED is found by solving the internal rate of return of the following cash flow:
10
=0
(10326
. 9 ) 9(1 0.35 )A
10K RED100(1 + K RED )
At 10% discount rate: NPV = +19.76

Interpolating:
20.75
KRED 4% +
(10% 4%) = 7.07%
20.75 19.76
VRED = 1.5mn 0.9426 = 1.4139mn
(iv) Loan stock
Current value of each 100 unit of loan stock:
6 A
. )10 = 75.42
10 0 .10 + 100(1 + 010
VL = 2mn 0.7542 = 1.5084mn
KL is found by solving the IRR of the following cash flow:
10
+75.42 6(1 0.35)A10 KL 100(1 + KL)
=0

At 10% discount rate: NPV = +13.74
Interpolating:
2377
.
K L 4% +
(10% 4%) = 7.8%
. 1374
.
2377
(v) Bank loans
KB = 13%(1 0.35) = 8.45%
VB = 1.54mn
(vi) Weighted average cost of capital (WACC)
K0 =
{(18% 8.8) + (6.8% 0.4004) + (7.07% 1.4139)

+ (7.8% 1.5084) + (8.45% 1.54)}/
{(8.8+ 0.4004 + 1.4139 + 1.5084 + 1.54)}
K0 =
195.9
= 14.3%
1366
.
(b) In order to estimate a companys weighted average cost of capital it is necessary to

estimate the after-tax market return and market capitalization (or equivalent) of each
type of long-term capital. Thus in judging the difficulty encountered with any one particular type of capital, both aspects should be taken into account.
748
ANSWERS TO PROBLEMS
The presence of bank overdrafts in the capital structure do not cause much difficulty
as long as the amount of the overdraft remains reasonably stable. The interest rate
charged on the overdraft can be expected to vary with changes in market interest rates
and so the current market value of the overdraft will remain equal to its nominal
amount. Furthermore, given that the overdraft is repaid at par, the after-tax market
return will simply be the current actual overdraft interest rate, adjusted for the tax relief
on the interest payments.
Convertible loan stock causes greater difficulties. Such stock may well have a market
quotation, and in such circumstances finding its capitalized market value causes no problems. However, if it is unquoted an equivalent valuation must be estimated. The valuation of this type of security can be approached by splitting it into two elements, the loan
stock itself and the convertible option, which is a call option on the companys equity.
Thus its market value can be estimated as whichever is the greater between its value as a
simple loan stock and its value if converted immediately, plus the value of the call option.
Apart from these difficulties, whether or not a market value exists, there is still the
problem of estimating the market return on the security, which requires the determination of the point in time at which conversion is expected to take place, and the expected
gain that the stockholders can be expected to make upon conversion.
(c) There are four fundamental assumptions that are made when a companys weighted
average cost of capital (WACC) is used as an NPV discount rate. These are:
(i) the project under evaluation is marginal;
(ii) the project, if accepted, is financed in such a way as not to change the companys existing capital structure;
(iii) level-perpetuity cash flows;
(iv) the project has the same degree of systematic risk as the companys existing
projects.
The assumption that the project should be marginal, i.e. that it is small relative to the
size of the company is necessary because the WACC itself is a marginal rate of return.
The WACC is made up of the cost of each individual source of the companys capital,
and each of these costs represents the required return on a marginal investment in that
security. For example, the companys cost of equity capital represents the required
market return from a marginal investment in the companys equity. Hence the WACC
should only be applied to evaluating relatively small capital investment projects.
The second assumption is required (except in a Modigliani and Miller world with no
taxation) because a change in the companys capital structure can be expected to change
its WACC. There are two reasons for this. First, changing the gearing ratio will change
the amount of financial risk borne by ordinary shareholders and hence will change the
cost of equity capital value in the WACC calculation, and secondly, changing the
gearing will in turn change the weights (assuming market value weights) used in the
WACC calculation.
The third fundamental assumption arises from the fact that, strictly speaking, the
WACC calculation is a level-perpetuity model. Hence the different types of company
capital should involve only level-perpetuity cash flows, as so too should the cash flows of
the project being evaluated.
Finally, and perhaps most important, is the assumption about a constant level of systematic risk. A companys WACC represents the overall return that the company earns,
given the systematic risk of the existing collection of assets. It therefore follows that its
WACC is applicable only to the evaluation of new investment opportunities that have a
similar level of systematic risk.
It is this last requirement in particular that makes the WACC of Redskins especially
unsuitable for investment appraisal purposes, as it is a holding company consisting of a
number of different subsidiaries in (presumably) different industries, and with the
CHAPTER 18
749
CAPITAL STRUCTURE IN A SIMPLE WORLD
likelihood of different levels of systematic risk. Thus the WACC represents the required
return on the average of these risks, but it cannot be thought to reflect the systematic
risk of any one particular subsidiary.
Chapter 18
Capital structure in a simple world

problem 1
(a)
Earnings
Interest
Alpha
5.0mn
0.72mn
Beta
5.0mn
Dividends
PE
PB
VE
VB
KE
KD
K0
4.28mn
100p
50
17.2mn
4mn
0.249
0.18
0.236
5.0mn
50p
23.2mn
0.216
0.216
Beta shareholding: 464 000 shares = 1%

Annual divs. = 50 000
Arbitrage to Alpha: Sell Beta for 232 000, and either:
Alpha geared 4:17.2
Buy 43 774 debt 0.18
and 188 226 equity 0.249
=
=
7 879 interest
46 838 dividends
54 717 income
4 717/year better off

Buy 1% Alpha debt, plus the balance in equity:
40 000 debt 0.18
= 7 200 interest
192 000 equity 0.249
= 47 808 dividends
55 008 income
5 008/year better off
As a shareholder in Beta, Ms Gamma holds no financial risk as Beta is an all-equity
company. In order to be able to compare like with like it is necessary for her to maintain
this zero exposure to financial risk when she moves into Alpha. Thus she wishes to buy
into the earnings probability distribution of Alpha (which, by definition, has the same
degree of business risk as Betas dividend distribution). The simplest way would be to
buy debt and equity in Alpha in proportion to the companys existing gearing ratio.
However, this is not a perfect answer as Alphas equity and hence the gearing ratio is
in disequilibrium. Therefore the alternative arbitraging mechanism that is shown above
may be preferred, as it effectively has Ms Gamma buying into Alpha in proportion to the
equilibrium gearing ratio.
(b) In equilibrium, given that the earnings of the two companies have the same
magnitude:
V0 = V0 = VE
23.2mn
750
ANSWERS TO PROBLEMS
VB
4.0mn
VE
19.2mn
PE = 19.2mn/17.2mn
1.12/share
problem 2
(a) If two companies are in the same business risk class then their asset betas will be the
same. Given that these two companies are in the same business risk class, this condition
should hold. Furthermore, as Chardonnay is all-equity, its equity beta will equal its asset
beta. Hence its equity beta can be estimated as Cabernets asset beta:
Cabernet assets = 1.6
= 1.2 = Chardonnay equity
(b) Cabernet:
KE = 10% + (6% 1.6) = 19.6%
KD = 10%
K0 = (19.6% 0.75) + (10% 0.25) = 17.2%
Chardonnay:
KE = 10% + (6% 1.2) = 17.2% = K0
This is just the result that the Modigliani and Miller no-tax capital structure hypothesis
would expect: companies in the same business risk class have the same weighted average
costs of capital.
(c) Given the information in (b) above, a regular 150 per year dividend should have a
value of 150/0.172 = 872.09. Thus the shareholder is, in effect, being offered a disequilibrium price for his shares. This price implies a WACC of: 150/1 000 = 15%.
Hence there would be a gain to be made by arbitraging into Cabernet. This can be
achieved as follows.
(i) Sell shares in Chardonnay for 1 000 cash.
(ii) Use the money to buy both the debt and equity of Cabernet in the same proportion as Cabernets own debt: equity ratio (1:3). Thus the investor should purchase 250 of Cabernet debt and 750 of Cabernet equity. This would have the
effect of maintaining a zero financial risk level (as at present) and would produce an
annual income of:
250 0.10
750 0.196
=
=
25
147
172/year
Thus the investor is 172 150 = 22/year better off, with no change in risk.
(d) In these circumstances, Cabernets WACC value of 17.2% is an equilibrium value.
Hence Chardonnays WACC (and hence KE also, as it is an all-equity company) should
equal 17.2%. Thus the equilibrium value of the investors shareholding in Chardonnay
is 150/0.172 = 872.09.
Chapter 19
Capital structure in a complex world

problem 1
(a) Mandina plc
Using the asset beta, the CAPM can be used to calculate what would be the companys
cost of capital, if it were all-equity financed:
CHAPTER 19
CAPITAL STRUCTURE IN A COMPLEX WORLD
751
7% + (15% 7%) 0.50 = 11%

Hence Mandina, if it were all-equity financed, would have a value of:
500 000(1 0.35)
= 2.954mn
0.11
Using the Modigiani and Miller (M and M) expression for the total market value of a
geared company in a taxed world, the actual total market value of Mandina can be
estimated:
Total market value: 2.954mn + (1mn 0.35) = 3.304mn
As Mandinas debt is worth 1mn, its equity will be worth: 3.304mn 1mn =
2.304mn. As there is an 8% chance of bankruptcy and a cost of bankruptcy of 0.5mn,
the expected cost of bankruptcy will be: 0.5mn 0.08 = 40 000, and so the total
market value of the equity will be reduced to 2.264mn.
Therefore:
Total market value of equity
= 2.364mn
Total market value of debt
= 1mn
Total market value of company
= 3.264mn
Debt:equity ratio
= 1:2.264
Clarice plc
Companys cost of capital, assuming all-equity financing:
7% + (15% 7%) 1.50 = 19%
Value of company if all-equity financed:
1.2mn(1 0.35)
= 4.105mn
0.19
Total market value of company: 4.105mn + 1mn 0.35 = 4.455mn
Total market value of company:
Less: total market value debt:
4.455mn
1.000mn
Total market value equity:
3.455mn
Less expected cost of bankruptcy: 10% 0.5mn = 50 000

Total market value of equity:
3.405mn
Total market value of debt:
1mn
Total market value of company:
4.405mn
Debt:equity ratio
= 1:3.405
(b) There are, perhaps, four principal determinants behind the capital structure decision
in practice:
(i) bankruptcy costs;
(ii) agency costs;
(iii) debt capacity;
(iv) tax exhaustion.
Each of these will be discussed in turn to examine how they affect the capital structure
decision.
Debt finance involves firms in a contractual agreement to pay interest and repay the
capital sum. If the firm defaults on the agreement, debt holders can appoint receivers
and effectively bankrupt the firm. Except in the case of fraud, firms are only going to
752
ANSWERS TO PROBLEMS
default on loan agreements when there is insufficient cash flow. Thus, the more highly
geared the company, the greater the chance of a shortfall in cash flow and hence the
greater the chance of bankruptcy.
Although shareholders (and others, such as employees) no doubt bear a cost in such
circumstances as the question illustrates the actual cost of bankruptcy is likely to represent only a very small loss in the wealth of a shareholder who has a well-diversified
portfolio. However, in contrast, a very substantial loss would be suffered by the company
directors in such circumstances loss of office and loss of confidence in their professional abilities and this would particularly be the case for the finance director whose
responsibility it is for the companys gearing level.
Thus directors are going to be cautious about the level of corporate gearing so as to
keep the probability of bankruptcy and the associated costs that they would bear at an
acceptably low level. Whether this results in low gearing or higher gearing depends not
only upon the risk attitudes of the directors concerned, but also on the volatility of the
companys pre-interest cash flow. Thus the directors of a property company, with its
very stable (rental income) cash flow, may well be willing to gear the company up to high
levels because even then the probability of loan default and consequent bankruptcy is
relatively low. On the other hand, an engineering companys directors may only indulge
in a low level of gearing because of that type of companys much more volatile cash flow.
The second factor is agency costs. When a company raises debt capital, the loan is
made under a trust deed which has attached to it a series of restrictive conditions. These
conditions represent part of the lenders efforts to control the actions of the management to ensure that they act responsibly with the money lent. In essence, these conditions represent agency costs.
Generally speaking, the more highly geared the company, the more restrictive become
these conditions. (Restrictions may be placed on such things as dividend growth, asset
sales, diversification and further increases in gearing.) Thus once again management may
wish to restrict the level of gearing simply to avoid the more onerous of these agency costs
being imposed.
The third factor is concerned with the fact that most corporate lending is secured
against the assets of the firm. However, different assets have different levels of ability to
act as security for a loan. This is referred to as an assets debt capacity. The main determinants of debt capacity are, first, the efficiency/quality of the second-hand market and,
secondly, the rate of depreciation. The greater the former and the slower the latter, the
better will be an assets ability to act as security. Thus, property assets will have a high
debt capacity and industrial machinery will have a low debt capacity.
Therefore the directors choice as to the companys gearing level may well be dictated
by the debt capacity of the firms assets and hence the capital markets willingness to
supply debt capital. Returning to the example used earlier, even if an engineering companys directors were willing to ignore bankruptcy costs, it is likely that they would be
prevented from gearing the firm up to high levels by the low debt capacity. However,
the capital markets would be willing to gear up the property companys capital structure
more highly because of its high debt capacity.
The final determinant of the gearing ratio arises from the fact that the main attraction
of debt capital is the tax-deductibility of the interest payments. Tax exhaustion refers to
the situation where the firm has insufficient tax liability to take the tax relief available. In
such circumstances, much of the attractiveness of debt, relative to equity, disappears.
Thus companies may well restrict their level of gearing to avoid the possibility of
moving into a situation of tax exhaustion.
Finally, no mention has been made in this discussion of the weighted average cost of
capital (WACC). The reason for this is that first most companies are unable to measure
their WACC with any confidence (principally because of valuation difficulties), and even
CHAPTER 19
CAPITAL STRUCTURE IN A COMPLEX WORLD
753
when they do, the WACC is such a volatile figure that company directors cannot realistically indulge in the static analysis of the traditional view of capital structure, seeking
to identify the minimum point on the WACC function. Certainly companies might try
to identify some optimal capital structure, but its optimality is more likely to be based
on managerial judgement arising out of the four factors discussed earlier, rather than on
an estimate of the WACC function.
Also, mention should also be made of the M and M analysis. M and M suggested that,
in a taxed world, companies should gear up as high as possible in order to take advantage
of debt interest tax relief. Implicit in the foregoing discussion is the assumption that this
is the policy that directors would wish to pursue, but they are prevented from always following this advice because of the factors discussed.
In addition, the later Miller analysis (1977) throws all this analysis into some confusion. Miller argued that in a world of corporate and personal taxes and a perfect market
for corporate debt capital, the capital structure decision (from an M and M viewpoint) is
irrelevant. However, such circumstances if they hold good in the real world still do
not negate the impact of the four factors discussed on the capital structure decision.
problem 3
Modigliani and Miller show that companies that have the same earnings
stream and the same level of business risk will have the same total market values (V0) in
the absence of taxation, whatever their individual capital structures. Dora and Bella are
two such companies and so it is not surprising that in t3, when there was no taxation in
Despina, their total market values were identical:
Dora: VE = V0 = $1mn
Bella: VE + VB = V0 = $0.8m + $0.2mn = $1mn
In the following year taxation was introduced on company profits and therefore
company market values could be expected to fall. However, under the t2 regime there
was no difference between the tax treatment of equity dividends and debt interest.
Therefore the tax charge was unaffected by a companys capital structure. Consequently,
the total market values of the two companies should remain the same, despite their different gearing ratios. This was the case:
Dora: VE = V0 = $0.51mn
Bella: VE + VB = V0 = $0.51mn
In t1 the tax regime was changed so that debt interest was treated differently from
equity dividends. Specifically, debt interest was now allowable against taxation. Thus a
geared company would have a lower tax charge than a similar ungeared company and, as
a result, the geared company would have a higher total market value.
Again Modigliani and Miller showed that under such a tax regime with two identical
companies, except that one was geared while the other was ungeared, then the total
market value of the geared company would be:
V0 (geared) = V0 (ungeared) + VB Tc
where Tc is the rate of corporation tax. Therefore it would be expected that Bella (the
geared company) would have a greater market value than Dora:
Dora: VE = V0 = $0.52mn
Bella: VE + VB = V0 + $0.60mn
and this value for Bella can be shown to fit in with the M and M expression:
V0 (Bella) = V0 (Dora) + (VB (Bella) Tc)
$0.6mn = $0.52mn + ($0.16mn 0.50)
754
ANSWERS TO PROBLEMS
Finally, in t0, although the tax regime remained unchanged from t1, there is effectively
no corporation tax as tax allowances shield operating earnings fully.
Therefore, once again, the total market values of the two companies would be
expected to equate, as they do:
Dora: VE = V0 = $0.98mn
Bella: VE + VB = V0 = $0.98mn
Chapter 20 Capital structure in practice

problem 1
Calculations
Current EPS:
5.778mn
= 57.78p
10mn
Current gearing (debt:equity using book values):
12m+ 6mn
= 817
. %
22.02mn
Impact on EPS and gearing of the three different sources of finance
This question gives no indication as to the impact on earnings of the extra 10 million of
investment. Thus it will be assumed that it will generate the same return on investment
as at present.
Operating profit:
Capital employed:
11.17mn
= 32.8%
34.02mn
Thus the extra 10 million of capital will generate extra operating profits of:
10mn 0.328 = 3.28mn
(i) Ordinary share financing
It is assumed that the new shares will be issued at a 10% discount on the current share
price of 350p: 315p.
Thus, the number of new shares issued will be:
10mn/315p = 3 175 00 approx.
Also, it is assumed that the company will maintain its current dividend per share payout
of:
3.467mn
= 34.67p / share
10mn
Operating profit
Interest
11.17 + 3.28 =
Pre-tax profit
Tax at 35%
Earnings
Dividends
Retained earnings
mn
14.45
(2.28)
12.17
(4.26)
(10mn + 3.175mn) 34.67p =
7.91
(4.57)
3.34
CHAPTER 20
755
CAPITAL STRUCTURE IN PRACTICE
7.91mn
= 60 p
13175
. mn
Revised EPS:
Revised gearing:
12mn + 6mn
= 50.9%
22.02mn + 10mn + 3.34mn
(ii) Preference share financing

Operating profit
Interest
mn
14.45
(2.28)
Pre-tax profit
Tax at 35%
12.17
(4.26)
Earnings
Preference dividends
7.91
(1.40)
Earnings available for shareholders

Dividends
6.51
(3.467)
Retained earnings
3.043
6.51mn
= 65.1p
10mn
Revised EPS:
12mn + 6mn + 10mn

= 1117
. %
22.02mn + 3.043mn
Revised gearing:
(iii) Loan stock financing
Operating profit
Interest
mn
14.45
2.28 + 1.2 = (3.48)
Pre-tax profit
Tax at 35%
10.97
(3.84)
Earnings
Dividend
7.13
(3.467)
Retained earnings
3.663
7.13mn
= 71.3p
10mn
Revised EPS:
Revised gearing:
12mn + 6mn + 10mn

= 109%
22.02mn + 3.663mn
Report to the Directors of Latost plc

Dear Sirs
We have analysed the probable impact of the three proposed financing packages of the
companys EPS and gearing levels. The results are shown below:
Current situation
Equity financing
Preference financing
Loan stock financing
EPS
57.78p
60p
65.1p
71.3p
Gearing
81.7%
50.9%
111.7%
109%
All three financing packages will result in an increase in EPS. Financing via preference
shares or loan stock will increase the level of gearing, while financing with equity will
reduce the gearing.
756
ANSWERS TO PROBLEMS
The decision as to which financing package should be chosen is not clear-cut.

However, the analysis would appear to suggest that loan stock financing is a better alternative to preference share financing as the loan stock alternative provides a significantly
higher EPS and a marginally lower level of gearing.
This then narrows the choice between equity financing and loan stock financing. It is
here that the directors must judge the trade-off that their shareholders will find acceptable between risk and return.
Equity financing results in a small increase in EPS from 57.78p to 60p, but does
provide a substantial reduction in gearing (and hence, a reduction in the riskiness of
ordinary shares) from 81.7% to 50.9%.
In contrast, loan stock financing results in a substantial increase in EPS from 57.78p
to 71.3p, but it also increases the level of gearing from an already high 81.7% up to
109%.
We would suggest that the final choice be made after investigating the gearing levels
of Latosts competitors. If the competitors have gearing levels of around 100%, then it
would be reasonable to assume that such a high level of gearing is acceptable and, on
balance, the loan stock option should be selected.
However, if Latosts competitors generally have a much lower level of gearing, then
the equity financing alternative may represent the more acceptable course of action.
Yours faithfully
B.E.R. Tie
Accountants
problem 2
(a) Business risk arises out of the risky nature of the companys business, which manifests itself in the variability of the companys earnings stream (before interest and tax).
Quite simply, some companies have very stable earnings streams because of the steady,
low-risk nature of their businesses. A supermarket company might be one such example.
In contrast, some other companies have highly volatile earnings, again because of the
very variable high-risk nature of their businesses. A small oil-exploration company might
serve as a suitable example of a company with a high degree of business risk.
Portfolio theory shows that risks can be divided up into systematic risk and unsystematic risk. Systematic risk is that part of total risk that cannot be diversified away,
while unsystematic risk is the risk that can be diversified away. Therefore business risk is
partially systematic and partially unsystematic.
The systematic element of business risk is largely (but not completely) out of the
control of the individual company management. The unsystematic element of business
risk arises out of factors which are specific to the individual company and are directly
under the control of management.
The two main determinants of a companys exposure to systematic business risk
would be the sensitivity of the companys revenues to the level of economic activity in
the economy (and its sensitivity to macroeconomic events in general), and its proportion
of fixed-to-variable operating costs, i.e. the costs incurred in generating those revenues
principally material, labour and energy costs. The greater its revenue sensitivity and
the greater its proportion of fixed costs, the greater its exposure to systematic business
risk.
Such factors as revenue sensitivity and fixed-to-variable operating costs are largely
out of managements control, and arise out of the nature of the market and the production technology. Thus a carpet manufacturing business can do very little about the
highly revenue-sensitive nature of the business (people buy new carpets when the
CHAPTER 20
CAPITAL STRUCTURE IN PRACTICE
757
economy booms and not otherwise). Nor can the manufacturer do much about the high
proportion of fixed costs involved in carpet production technology.
However, it should be noted that these factors are not entirely out of managements
control. For example, the carpet manufacturer may try to lock his customers into
long-term deals to bring greater stability to the revenues. Similarly they may try to subcontract out as much of the manufacturing process as they can, on short-term contracts,
to keep as many of their costs variable as possible.
The unsystematic aspects of business risk arise from such factors as the skill of the
top management team, the training of the workforce, the state of labour relations and
the ability of the marketing department. Obviously, such factors are largely under the
direct control of the management.
(b) An investor with a well diversified share portfolio will have eliminated all unsystematic risk. Therefore such an investor is only going to be interested in the systematic
element of business risk which, together with financial risk, goes to make up the beta
value of the shares.
(c) (1) Degree of operating gearing (DOG)
DOG at a given level of turnover is:
Turnover Variables costs
Profit before interest and tax
At the start of the current financial year:
DOG =
3381 2193
= 2.57
462
Assume that variable costs comprise wages and salaries, raw materials and direct selling
expenses. (In reality these are not all likely to vary directly with turnover.)
One interpretation of a 2.57 DOG may be that a 1% change in sales will lead to a
2.57% change in profit before interest and tax (in the same direction).
At the end of the financial year, the expected profit and loss account, assuming no
price changes except those stated, is:
(000s)
(000s)
Turnover (15% increase)
3 888
Operating expenses:
Wages and salaries (1 220 0.80 1.15)
1 122
Raw materials (15% increase)
1 004
Direct selling prices (15% increase)
115
General administration (no increase)
346
Other fixed costs (85 000 increase)
465
3 052
836
Therefore expected DOG at the end of the year is:

3888 2241
= 1.97
836
The degree of operating gearing is expected to fall.
If a high percentage of a companys total costs are fixed, that company will have a high
degree of operating gearing. If other factors are held constant the higher the operating
gearing the higher will be the business risk of a company. In this case other factors have
not been held constant; the unit variable cost of wages and salaries and also the level of
fixed costs are expected to change. The overall result is a lower DOG at the sales level of
3 888 000.
758
ANSWERS TO PROBLEMS
Financial gearing
As an accounting-based analysis of the company is being undertaken, an
accounting-based measure of financial gearing will be used:
Balance sheet value of debt
Shareholders' funds
At the start of the year financial gearing is
570
= 37.7%
1510
At the end of the year profit before interest and tax has been estimated to be 836 000.
(000s)
836
Interest
(207)
Profit before tax
Tax
629
(252)
Profit available to ordinary shareholders

Estimated dividend
377
(189)
Retained earnings
188
Estimated financial gearing
570 + 820
= 81.8%.
1510 + 188
The expected financial gearing more than doubles by the end of the year. The higher
the level of financial gearing, the higher the financial risk placed on the ordinary
shareholders.
(c) (2) (i) If turnover increases by 15%, the expected profit available to ordinary
shareholders is 377 000. There are 3 200 000 issued ordinary shares resulting in an
expected earnings per share of 11.78 pence.
The earnings per share at the start of the year is
227 000
= 7.09 pence per share.
3 200 000
Because of the financial and operating gearing effects, earnings per share are expected
to increase by 66%.
(c) (2) (ii) If turnover falls by 10%
(000s)
(000s)
Turnover
3 043
Operating expenses:
Wages and salaries (1 220 0.90 0.80)
878
Raw materials (10% fall)
786
Direct selling expenses (10% fall)
90
General administration (no change)
346
Other fixed costs (85 000 increase)
465
2 565
Interest
478
(207)
Profit before tax

Tax
271
(108)
Profit available to ordinary shareholders
163
CHAPTER 21
759
INVESTMENT AND FINANCING INTERACTIONS
The estimated earnings per share is
163 000
= 5.09 pence.
3 200 000
This is 28% lower than the current earnings per share.

The changes in the operating and financial gearing have increased the risks for the
shareholders.
Chapter 21 Investment and financing interactions

problem 1
(a) Base-case discount rate
1(1 0.35)
3

+ 0.10
= 1.26
3
+ 1(1 0.35 )
3
+
1(1
0.35)

Asset
= 1 036 + 0.018 = 1.054
Asset
project
project
E[rProject] = 7% + [15.5% 7%] 1.054 = 16% approx.

Base-case present value
10 000 + 6 700 (1 0.35) A
3 0 .16
= 219 PV
Financing side-effects
PV tax shield
3 000 0.14 0.35 + A
3 0 .14
= 341 PV
Issue costs
3 000 0.01 (1 0.35) =
19.5
4 000 0.02 (1 0.35) =
52
71.5PV
Note that the project gains the tax shield and incurs the issue costs based on how the
project would be financed as a free-standing entity. Hence, assuming that 3000 of
retained earnings would be used and its 30% debt capacity would allow 3000 of debt
financing, this means that, under normal circumstances, 4000 of equity finance (via a
rights issue) would be raised.
Adjusted present value:
219 + 341 71.5 = +50.5 APV Accept
(b) Effect of cheap loan
Interest saved: 10 000 0.14 A3 0 .14
Less lost tax shield: 10 000 0.14 0.35A3 0 .14
Net saving
+3 250
1 138
+2 112
Revised APV: 219 + 2 112 71.5 = +1 821.5 APV.

Note, as the cheap loan is specifically attached to this project, all of its net benefits are
taken into account.
760
ANSWERS TO PROBLEMS
problem 2
(a) Calculation of an asset beta for project
VE
VB(1 TC )
+ Debt
VE + VB(1 TC )
VE + VB(1 TC )
3
2(1 0.35 )
= 2.29
+ 0.15
3 + 2(1 0.35 )
3 + 2(1 0.35 )
Asset = Equity
Asset
. + 0.04 = 164
.
Asset = 160
Calculation of base-case discount rate for project
Base-case discount rate = rF + [E(rM) rF] Asset
8.5% + [15.5% 8.5%] 1.64 = 20% approx.
Calculation of base-case present value for project
Data
Capital expenditure: 1mn
Scrap value: 0.6mn
Working capital requirement: 0.3mn
Revenues: 1.1mn/year for 5 years
Operating expenses:
Materials: 0.25mn/year
Labour: 0.165mn/year
Supervisory labour: 0.056mn/year
Training: 0.270mn at Year 1
Variable overheads: 0.076mn/year
Rent: 0.012mn/year
Var. selling expenses: 0.095mn/year
(Note: Labour has been costed on an incremental basis. Depreciation has been excluded
as it is a non-cash item. Financing cash flows interest have been excluded. All other
non-incremental/allocated expenses have been excluded.)
Total operating expenses 0.654mn/year
Net revenues 1.1mn 0.654mn = 0.446mn/year pre-tax
Capital allowance tax relief
Capital allowances
1mn
Tax relief
Year
0.25
0.25mn
0.40
0.1mn
0.25
0.1875mn
0.40
0.075mn
0.25
0.1406mn
0.35
0.0492mn
0.25
0.1055mn
0.35
0.0369mn
0.25
0.0791mn
0.35
0.0277mn
(0.3627mn)
0.35
(0.1269mn)
0.25mn
0.75mn
0.1875mn
0.5625mn
0.1406mn
0.4219mn
0.1055mn
0.3164mn
0.0791mn
0.2373
0.6m =
CHAPTER 21
761
INVESTMENT AND FINANCING INTERACTIONS
Cash flow analysis (mn)

Machinery
Scrap
CA tax relief
WC
Training
Tax relief
Net revenues
Tax
0
(1)
0.1
0.075
0.0492
0.0369
0.6
0.0277
0.3
(0.3)
(0.1269)
(0.270)
0.108
0.446
0.446
0.446
0.446
(0.1784) (0.1561) (0.1561) (0.1561) (0.1561)
0.446
Net cash flow

20% discount
rate
(1.3)
0.276
0.4506
0.3391
0.3268
1.2176
(0.283)
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
PV cash flow
(1.3)
0.23
0.3129
0.1962
0.1576
0.4893
(0.1061)
Base-case present value: (20 100)

Calculation of present value of financing side-effects
The debt capacity of the project is:
Capital expenditure:
WC expenditure:
1mn 0.50 =
0.3mn 0.10 =
0.5mn
0.03mn
Total
0.53mn
Therefore the tax shield will only be calculated as a total of 530 000 of debt financing at
10% interest.
PV tax shield
530 000 0.10 = 53 000/year interest for 5 years.
53 000 0.40 = 21 200 tax relief in Year 1.
53 000 0.35 = 18 550 tax relief/year thereafter
PV: 21 200 (1 + 0.10)
18 550 A
4 0.10
(1+ 0.10)2
= 17 520
= 48 594
66 114
Adjusted present value

Base-case present value
PV of tax shield
(20 100)
66 114
APV + 46 014
As the APV is positive, the project should be accepted.

(b) The evaluation carried out in part (a) differs in two fundamental ways from the analysis carried out by the production director. First, the project was evaluated on the basis
of incremental cash flows. Therefore, a number of irrelevant items were excluded from
the analysis. Secondly, the project was evaluated on the basis of APV and not NPV, to
capture better the impact of the finance package proposed for the project.
(c) Net present value is a capital expenditure evaluation technique. In contrast, adjusted
present value is able to evaluate not only the capital expenditure decisions, but also the
financing package with which it is proposed to undertake the project. In this way, therefore, APV is a more powerful form of analysis than the rather limited NPV analysis.
762
ANSWERS TO PROBLEMS
Chapter 22 The dividend decision

problem 1
(a) (i) Cum dividend price after declaration of 150 000 dividend = 140p. The total
value of Pulini plc will be 1.4 million.
(ii) The current price reflects the expected dividend of 150 000. The share price
should increase by the NPV of the contract.
Dividend
15
=
= 12%
Ex div value 125
80 000 22400
= +560 000
NPV = 80 000 +
0.12
012
.
KE =
Share price should increase by 560 000 1mn = 56p;

Revised cum dividend price = 196p;
Revised total value = 1.96mn.
(iii) By using the 80 000 revenue from the project Pulini can increase its current
dividend from 15p to 23p per share. The way in which the market responds to this
will depend upon whether it is efficient in the semi-strong or strong form.
(1) Semi-strong. The revised price will depend upon whether the market supposes that the increased dividend is a one-off payment for this year only, or, based
on Pulinis past record of constant dividends, anticipates the increased dividend to
continue indefinitely:
One-off:
Cum-div price = 140p + 8p = 148p

Total value 1.48mn.
Continuing:
23p +
23p
= 215 p
0.12
Total value 2.15mn.

(2) Strong form. If the market is efficient in the strong form it will learn of the
project and the share price will adjust to 196p as calculated in part (ii) above.
(b) In theory, dividends are a passive residual in the context of financial decision making.
As the positive net present value of investment projects accrues to shareholders it must
necessarily be the companys aim to undertake all projects giving a positive net present
value even if this entails reductions in dividends below previously existing levels. Funds
not required for investment will be paid out as dividends. For these ideas to be valid
there must be perfect information about company activities available to shareholders,
who must understand and believe the information. They will then accept any reduction
in dividend as being in their own interest and the share price will in fact rise to reflect
this improvement in the value of the company.
In the short term at least, the reduction of dividends to finance beneficial investment
would in theory substitute a capital gain for dividends. Shareholders must be prepared to
accept this distribution. They will do so only if they can borrow at the same rate as the
company (and repay later out of a future enhanced dividend) or if they can realize the
capital gain to obtain cash in substitution for the dividend. These will only be adequate
substitutes if there are no transaction costs or distorting taxes.
If the conditions necessary to uphold the dividend irrelevancy theory were met in
practice then dividends would truly be a residual and not a determining factor in the
CHAPTER 22
THE DIVIDEND DECISION
763
valuation of a company. However, in reality, they do not hold well and it is necessary to
examine those aspects of dividend policy which may in practice affect a companys
market value.
It is information which determines share price and one of the principal pieces of objective information available to investors to assist them in pricing shares is the level of dividend. Whilst published accounts and reported earnings are extremely useful, they are both
historical, indicating what the company has done rather than what it is doing or will do.
Dividends are, by contrast, an indicator of the current state of the company and its future
prospects. The amount of, and trends in, dividends are thus strongly reacted to by the
market. This is strikingly illustrated by the different reactions to reduced dividends in
theory and practice. In theory this could well herald further beneficial investment and
increased company value whereas in practice it is likely to be seen as evidence of severe
difficulties and the share price is likely to drop. Even if the management set out clearly
their intentions for the use of funds, it is possible that the message will not be fully understood, or may be treated with scepticism. In view of these practical realities, company
management are likely to pursue a policy of dividend stability and, where possible, steady
growth at a prudent rate. Above all shareholders require a consistent policy. Where this is
possible, uncertainty, and hence risk, is reduced. The rate of return required by investors
may therefore be adjusted downwards leading to higher market capitalization.
In summary, investors are not indifferent between current dividends and the retention
of earnings with the prospect of future dividends, capital gains, or both. They prefer the
resolution of uncertainty and are willing to pay a higher price or a share that pays a greater
current dividend, all other things being equal.
(c) The factors that will influence company managements dividend policy relate essentially to prudence, company funding requirements and regard for individual shareholders requirements.
With regard to prudence, it might well be that whilst a company makes good profits, a
significant proportion of these may not be realized in cash terms and it is therefore not
possible to pay substantial dividends without placing strains on the companys liquidity.
Dividends must be budgeted for as an integral part of the cash flow forecast and where
necessary further funds obtained for the purpose of dividend payments. The alternative
to this is a more restrained payout policy.
Company management will also have regard to future funding requirements. Use of
retained earnings is one of the simplest and cheapest ways of obtaining finance for expansion, and it is therefore quite attractive to management to pursue a relatively low payout
policy in order to retain funds for expansion. The companys access to capital markets will
also play a large part in the decision on retention policy. A company with ready access to
capital markets may in practice prefer a higher payout policy coupled with regular rights
issues rather than keep dividends deliberately low to provide a large pool of retained earnings. Smaller companies cannot count on this advantage and therefore in practice will seek
funding largely from retained earnings.
In financial management it is generally assumed that the objective of company management is to follow a policy of maximizing the wealth of shareholders. To this end dividend policy is of vital importance. Clearly a high retentions policy is commensurate with
high capital growth in share value whilst high payouts will benefit shareholders who
require high income. Whilst in a perfect capital market with no taxes this differentiation
of policy would be irrelevant, in actuality the tax position of shareholders will significantly influence their accumulation of wealth through shareholdings. Whilst in large
companies researching shareholders preferences and setting policy accordingly might
be impracticable, this will not necessarily be so in small companies where tax considerations may well play an extremely important part in setting dividend policy.
764
ANSWERS TO PROBLEMS
It should not be forgotten that dividends can only be paid regularly where the
company is inherently profitable and hence management must examine profitability in
setting dividend policy, and in particular the stability of earnings. Where earnings are
very stable the company will be less at risk in following a high percentage payout policy
than if earnings are extremely volatile. Dividend cuts are usually anathema to company
management as the market is likely to consider that this presages bad news, with consequent disastrous effects on share price. Hence companies with volatile earnings are
unlikely to risk dividend cuts by pursuing a high payout policy. Indeed good dividend
policy is to pursue the ideals of stability and consistency. Variable dividends are uncertain dividends, giving rise to an increased risk perception in shareholders. This feeds
through into a higher required return and hence lower market capitalization, defeating
the company aim of shareholder wealth maximization.
While the conventional models assume the objective of maximization of shareholder
wealth this may not be the objective being pursued by particular companies. It may be
that corporate managers are pursuing alternative objectives such as sales maximization,
market share maximization or the maximization of managerial discretion subject to the
constraint of providing an acceptable return to investors. Alternatively managers may
not be maximizing at all but may be satisficing, i.e. pursuing a battery of parallel objectives. In such circumstances they will need to modify their dividend policies to suit the
objectives they are pursuing. In any event they will need to know what constitutes an
acceptable return to their investors and this in turn requires a knowledge of what can be
earned on similar risk investments elsewhere, i.e. the opportunity cost of capital.
Finally it cannot be forgotten that there are legal requirements governing dividend
payments and company management must have regard to the legal definitions of distributable profits.
problem 3
(a) Net present value to Charles Pooter (Contractors) Ltd:
2
NPV = 3 000 + 800(1.04) + 1 000(1.04) + 1 700(1.04)

NPV = 3 000 + 769 + 925 + 1 511 = +205
(b) (i) Lupin is satisfied (as stated in the question). Charles can borrow one half of the
present value of the cash inflows from the project (i.e. he can borrow the present
value of the dividends he expects to receive):
Charles can borrow ( 12 3 205) 1 602 at 4% (and go on the cruise)
Interest Year 1 at 4%
64
Repay end Year 1 ( 12 800)
1 666
400
1 266
51
Repay end Year 2 ( 12 1 000)
1 317
500
817
33
Repay end Year 3 ( 12 1 700)
850
850
By borrowing, and using his dividends to repay the loan, Charles is 102 better off if
the project is accepted than if it is rejected. So the company is acting in the best interests
of both shareholders by accepting the project.
CHAPTER 23
765
ACQUISITION DECISIONS
(ii) Lupin is still satisfied (as stated in the question). The present value of Charless
dividends at a 10% discount rate is:
1
400(1.10) + 500(1.10) + 850(1.10)

= 400(0.9091) + 500(0.8264) + 850(0.7513) = 1 415
which is the maximum amount he could borrow and repay out of his share of the project
dividends. He would be better off with an immediate dividend of 1500. So the company
is not acting in the best interests of both shareholders.
(c) The above analysis suggests that the net present value rule results in correct investment decisions provided that all shareholders have the same cost of capital as the
company, even if their consumption preferences vary. Any shareholder can adjust his
dividend receipts to fit his desired consumption pattern by lending or borrowing. (b)(ii)
suggests that the net present value rule needs to be applied cautiously where shareholders costs of capital differ from the companys (e.g. where capital markets are imperfect).
In this case it may not be possible for shareholders to adjust their consumption patterns
by lending or borrowing without incurring an interest cost different from the
companys.
Chapter 23 Acquisition decisions

problem 1
After a merger of Peden and Tulen
Value of debt (45 + 10)

Value of equity (bal fig)
Total value
Recession
(p = 0.15)
(mn)
55
50
105
Slow growth
(p = 0.65)
(mn)
55
80
135
Rapid growth
( p = 0.2)
(mn)
55
140
195
Expected
value
(mn)
55
87.5
142.5
42
42
45
10
55
45
30
75
44.55
12.5
57.05
10
53
63
10
70
80
10
110
120
10
75.45
85.45
Without a merger of the two companies:

Peden
Value of debt
Value of equity
Total value
Tulen
Value of debt
Value of equity
Total value
Since no operational synergy has occurred on the merger, the total value of the
merged company is equal to the sum of the values of the individual companies:
57.05mn + 85.45mn = 142.5mn
However, there has been a transfer in total value from the shareholders to the debt
holders. The total of the individual companies debt is 44.55 + 10 = 54.55 million, while
the value of the merged companys debt is 55 million. Conversely, the total of the individual companies equity is 12.5 + 75.45 = 87.95 million, while the value of the merged
companys equity is 87.5 million.
This transfer arises from the position of Pedens debt in a time of recession. Peden
would have total net assets to be financed of 42 million, but 45 million of debt. In such
766
ANSWERS TO PROBLEMS
a situation the equity is worthless and 3 million of debt is unable to be repaid. There is
a 0.15 probability that debt holders will lose 3 million, i.e. an expected loss of 450 000.
In the merged company there is no longer any risk that the debt will be unable to be
repaid in full. Therefore the debt holders can expect to be 450 000 better off, as the
above calculations show.
In practice the merged company is likely to have cash flows that are less risky than
each of the individual companies, so both the cost of equity and cost of debt may reduce
after the merger. This would offer a gain to both the equity holders and the debt
holders, even in the absence of any operational synergy.
problem 2
The bid will be viewed favourably by the shareholders of Savealot if it

offers a premium above the current share price. It will be viewed favourably by the
shareholders of Minprice if it will increase the value of their shares.
Consider the shareholders of Savealot first. The current share price of Savealot is
4
295p. At its current share price Minprice is offering shares worth 3 232p = 309p. This is
only 14p or 4.7% above the current share price of Savealot, which is probably not
enough to entice a majority of the Savealot shareholders to accept the offer.
Factors likely to influence the decision include:
(i) Recent annual growth trends. Savealot is currently growing faster than
Minprice in both dividends and EPS, indicating that Savealot has good prospects.
This is confirmed by the companies PE ratios:
PE ratio
Minprice
2.32
= 13.9
50mn / 300mn
Savealot
2.95
= 14.75.
8mn / 40mn
The shareholders of Savealot will be unwilling to swap into the shares of a company
with worse prospects, unless they are given a proper incentive.
(ii) The intrinsic value of Savealots shares. Using the dividend valuation model,
the shares of Savealot have an intrinsic value of:
P=
D1
12.5p 1.08
= 270p.
=
ke g
13% 8%
This suggests that Savealots shares are currently overvalued at their current price
of 295p, and would be a reason encouraging the Savealot shareholders to get out for
this value while they can.
(iii) The different financial profiles of the two companies. Minprice has much
higher gearing than Savealot, e.g. at book values:
Minprice
314
= 141%
222
Loans
Gearing =
Shareholders' funds
Savealot
17.5
= 32%.
54.7
Minprice has a higher dividend cover than Savealot (2.1 times rather than 1.6 times),
and a lower dividend yield (3.4% rather than 4.2%). If a shareholder was worried about
financial gearing, he would be happier owning Savealot than Minprice. If a shareholder
was most interested in the dividend stream from his investment he would take account of
the dividend statistics calculated above.
Consider now the shareholders of Minprice. Using PE ratios we can estimate the
share price of the combined company. If we first ignore the effects of the rationalization:
Combined earnings
Combined number of shares
Expected combined EPS
=
=
=
50 + 8 = 58mn
300mn + (4 3 40mn) = 353.3mn
16.4p
CHAPTER 24
767
COMPANY VALUATION
Expected combined PE ratio
Current market value of Minprice

Current market value of Savealot
=
=
Combined PE ratio
Combined share price
Weighted average of the PERs of the two

companies
300mn 2.32 = 696mn
40mn 2.95 = 118mn
696
118
13.9 +
14.75 = 14.0
814
814
14.0 16.4p = 230p
This is marginally below the current share price of 232p, so would not be attractive.
However, the effects on the value of the combined company would be:
Sale of warehouse
Redundancy
Wage savings 2.7 Annuity (12%, 5 years) = 2.7 3.605
The effect on the combined share price will be
mn
6.8
(9.0)
9.7
7.5
7.5mn
= 2.1p
353.3mn
This takes the expected share price after the combination to 232p, i.e. the same as
before the combination. There is no financial reason for the shareholders of Minprice to
want the scheme to go ahead.
However, if the wage savings could last longer than the five years used in the calculation, or if there are other possible synergies from the combination, then Minprices
shareholders would look favourably at the scheme.
Chapter 24 Company valuation

problem 1
Bid 7 September by BZO: 2 for 3 share exchange
The value of this bid equates to 5.20 per Demast share (Working 6). The true value per
Demast share is likely to be in the region of 4.43 (Working 5). Thus it appears that
BZO are paying approximately 5.20 4.43 = 77p too much.
This is largely borne out by the reaction of BZOs shareholders to the bid as its share
price falls 70p from 7.80 to 7.10 once the bid is announced. It appears that BZOs
shareholders value Demast at around the 4.50 mark so the bid is not financially prudent
from their perspective.
BZO is a conglomerate so no great synergies would be expected as a result of the
acquisition and a purchase price of 5.20 per share would not appear an undervaluation.
Bid 2 October by Nadion: 170p plus 100 convertible per 6.25 nominal value of
shares
The value of the bid equates to 5.70 per share ignoring the value of the option
(Working 6). The true value of the share is likely to be around 4.43. It appears that
Nadion is offering a premium of approximately 5.70 4.43 = 1.27 per share.
Upon announcement the Nadion share price increases 15p from 3.20 to 3.35. It is
surprising that the Nadion share price did not go higher because a combination of two
companies in the same industry often results in considerable synergies.
Bid 19 October by BZO: 600p per share
The value of the bid is 6 per share. The value of the share is approximately 4.43.
After announcement of the bid the BZO share price falls by 100p from its original
value of 7.80 to 6.80. This is a substantial fall. It appears that BZOs shareholders
768
ANSWERS TO PROBLEMS
think the bid is considerably higher than the true value of the shares. The bid is not
therefore prudent from the point of view of the companys shareholders. This is probably exacerbated by two further problems.
BZOs gearing will increase substantially as a result of taking a loan to finance the
cash purchase.
Directorships will be given to Demasts current directors. As BZO is a conglomerate
they may not have the relevant experience to run other subsidiaries effectively.
Working 1: Book value of net assets acquired
From the balance sheet this is 6 500 000. Reservations are as follows:
The predators are likely to run Demast as a going concern so are more likely to be
concerned with its income than with its assets.
A historical cost balance sheet is not a valuation device.
Working 2: Net realisable value of net assets acquired
Book value of net assets
Less stock devaluation (5 500 000 10%)
Net realizable value
6 500 000
(550 000)
5 950 000
Working 3: Valuation by priceearnings multiple

This is a practical and common method of valuing a target in a takeover situation. Companies in the same industry tend to have similar PERs because a PER partly reflects
growth prospects and the perceived risk of the company.
In the absence of Demasts own PER (it is not a listed company), Nadions will be
used instead as it is also a games manufacturer.
PER ratio of Nadion
=
Value of Demast shares
=
Total value of equity acquired =
320 58 = 5.5
80.5p 5.5 = 442.75p
442.75 100 1 000 000 4 (25p nominal)
= 17.71mn
Comments and reservations include:

An income-based valuation is presumably more consistent with the purchasers intentions (i.e. to run Demast as a going concern).
Nadions PER may not be representative of the industry. Further information on
similar companies is required.
The calculation assumes that Demasts current earnings would be unchanged after a
change of ownership. The true value to the predator is the value of the earnings under
their control. The following specific comments can be made:
The directors own 25% of Demast. Thus they may be paying themselves inflated
management salaries which would not continue after a change of ownership.
The earnings may change after a change of ownership because of synergistic benefits. These are unlikely to be major in the case of BZO as its operations are dissimilar
to those of Demast. However Demast and Nadion are in the same industry so considerable synergies could result from cost savings, sharing of know-how and reduced
competition.
Working 4: Dividend valuation approach
The intrinsic value of a share is thought to be the present value of the future dividend
stream. Therefore by estimating a value of the future dividends of Demast and discounting at an appropriate discount rate a share price can be obtained.
CHAPTER 24
769
COMPANY VALUATION
PV of dividends
do/Ke g
do
G
Ke
=
=
=
=
=
Value of shares
Value of shares
1 500 000
9% per annum
16% per annum
Value of shares =
1 500 000 [1+ 0.09]

= 23.3mn
0.16 0.09
Comments and reservations include:

An income-based method is more consistent with the predators intentions.
The dividend valuation approach is theoretical and subject to a number of criticisms.
Working 5: Summary of valuations
In total
Book value of net assets (Working 1)
NRV of net assets (Working 2)
PER basis (Working 3)
Discounted dividend approach (Working 4)
6.5mn
5.95mn
17.71mn
23.3mn
Per share
1.63
1.49
4.43
5.83
In practice the PER multiple is probably the most common valuation method so the
main body of this answer assumes this to be the most accurate valuation. This gives a
price for one Demast share (17.7mn 4mn) = 4.43.
Reservations include:
As stated above the predators are more likely to value Demast on an earnings basis.
Insufficient information is available to value Demast properly. The current market
value, for example, of land and buildings is required.
Working 6: Value of bids
Bid 7 September by BZO
Value of bid per share = 2 7.80 3 = 5.20.
Bid 2 October by Nadion
Value of bid per share = 1.70 +
100
= 5.70.
6.25 4
The value of the option cannot be quantified.

Bid 19 October by BZO
Value of bid per share = 6.00.
problem 2
The current market price of 410 pence per share, or a total market value
of 123 million, is likely to be the lowest that shareholders of Omnigen would accept,
and a premium over the current market price will normally be payable.
If industry PERs are used to value Omnigen, the range of values would be 182
million to 210 million. (Omnigens total earnings after tax of 14 million, multiplied by
the PERs of 13:1 and 15:1.)
The realizable value of assets, 82 million, is substantially below the estimates based
upon PERs. This shortfall in value is likely to be caused by the fact that the value of
Omnigens intellectual capital is being ignored.
A better method of estimating the value of Omnigen is to use the cash flow projections to find the present value of Omnigen to Laceto. This will be based upon the free
770
ANSWERS TO PROBLEMS
cash flow after replacement expenditure and expenditure required to achieve the forecast
growth levels.
Financial year
Net sales
Cost of goods sold (50%)
Selling and administrative
expenses
Capital allowances
Taxable
Taxation (30%)
Year 1
(mn)
Year 2 Year 3
Year 4
230
115
261
131
281
141
298
149
32
40
187
43
12.9
30.1
40
34
42
207
54
16.2
37.8
42
36
42
219
62
18.6
43.4
42
38
42
229
69
20.7
48.3
42
Year 5
onwards
Add back capital allowances

Less cash flow needed for asset
Replacement and forecast
growth
(50)
(52)
(55)
(58)
Net cash flow
20.1
27.8
30.4
32.3
1
Discount factors (14%)
0.877
0.769
0.675
0.592
Present values
17.6
21.4
20.5
19.1
19.1(1.03)
= 178.8
.14.03
Total present value is 257.4 million (the sum of the present values for each year).
This value is the value of the entire entity, i.e. equity plus debt. The value of debt will
depend upon the final gearing, and will vary between approximately 45 million and 58
million (18%23% gearing), giving a value of equity between 19.4 million and 212.4
million. If growth is 5% the present value of the entity would be 297.2 million, and the
value of equity between 228.8 million and 243.7 million.
Assuming these cash flow projections are reasonably accurate (which itself must be
subject to serious doubt e.g. can the imbalance after Year 5 between capital allowances
and replacement capital expenditure continue indefinitely), it is clearly worth Laceto
offering a premium over the current market price for the shares of Omnigen. In theory,
using present values to infinity, it could afford to offer a premium of more than 50%
above the current market price, but in order to increase its own value it would offer the
lowest price that would attract more than 50% of the shareholders of Omnigen. It is not
possible to know what this price would be. An initial bid might offer a 2530% premium
above the current price, or between 154 million and 160 million. If that bid was
refused then there is scope for increasing it up to a maximum of the estimated equity
present values discussed above.
It must be stressed that all of the above estimates are subject to significant margins of
error, and that valuation for takeover is not a precise science.
1
Discount rate:
Using the capital asset pricing model
Ke = 6% + (14% 6%) 1.3 = 16.4%
Omnigens cost of equity after the acquisition is used as this is likely to reflect the systematic risk of the activities of Omnigen within Laceto. As the range of expected gearing
levels is quite small (1823%), and gearing is relatively low, it is assumed that the cost of
equity will not significantly change over this range of gearing, other than the change
already reflected in the increase in the equity beta by 0.1.
The cost of debt is not given but may be estimated from the data regarding Lacetos
debenture. As Omnigen currently has a lower gearing than Laceto, it is assumed
CHAPTER 25
771
FOREIGN EXCHANGE
increasing Omnigens gearing should not have a significant effect on Lacetos cost of
debt, even if the overall gearing increases to 23%.
The cost of debt, using linear interpolation is:
At 6% interest
12(1 0.3) 2.673
100 0.840
=
=
22.45
84.00
106.45
At 5% interest
12(1 0.3) 2.723
100 0.864
=
=
22.87
86.40
109.27
By interpolation:
5% +
0.47
1% = 5.17%.
0.47 + 2.35
The weighted average cost of capital may be estimated for the full range of expected
gearing:
At 18% gearing:
The weighted average cost of capital is 16.4 0.82 + 5.17% 0.18 = 14.38%
At 23% gearing:
The weighted average cost of capital is 16.4 0.77 + 5.17% 0.23 = 13.82%
The estimated WACC does not change dramatically over the possible range in
gearing. 14% will be used as the discount rate.
Chapter 25 Foreign exchange

problem 1
There are three basic causes of movements in FX rates:
1. forces of supply and demand;

2. interest rate differentials;
3. inflation rate differentials.
Exchange rates represent the price of one currency in terms of another currency, and the
price of currencies responds to the forces of supply and demand in exactly the same way as
the price of anything else. Thus if lots of people want to buy the Japanese yen, the yen FX
rate appreciates relative to other currencies. If people are selling the US$, then the $ FX rate
depreciates. These supply and demand market forces arise out of the needs of international
trade (a UK importer receives an invoice in US$ and therefore has to buy $ in order to pay
the invoice) and investment (a US company wants to build a factory in Germany and therefore has to buy euros in order to pay for the investment). However, it is thought that the
most important source of supply and demand market forces arises out of speculation.
The second cause of FX movements is interest rate differentials between different
countries. This idea is represented by the interest rate parity theorem which states that
exchange rates should move to effectively bring about interest rate parity. Thus if the
loan interest rate in US$ is 6% and in is 10% then IRPT states that the US$ should
appreciate against by approximately the interest differential of 4%.
The reasoning that lies behind IRPT is that international financial markets are efficient and, in such markets, there is no such thing as cheap finance. Thus a UK company
772
ANSWERS TO PROBLEMS
wishing to borrow money might be tempted to borrow $ rather than . But IRPT holds
that what they gain from a more favourable rate of interest they are likely to lose in an
adverse movement in exchange rates: over time it would cost more and more in terms
to pay the 6% $ interest and repay the $ loan.
The third cause of FX movements is inflation rate differentials between countries.
This is the purchasing power parity theorem which states that the currency of the
country with the lower rate of inflation will appreciate against the currency of the
country with the higher rate of inflation by an amount approximately equal to the difference between the two inflation rates.
What lies behind the PPPT is the law of one price which states that the price of a good
in one particular currency, times the exchange rate, should equal the price of that same
good in another currency. If not, there is an opportunity for arbitrage gain. Therefore as
inflation affects the price of the good in each country, the differences in inflation rates
cause the exchange rate to move in compensation so as to maintain the law of one price.
problem 2
The two extreme types of exchange rate system are a system of fixed
exchange rates and a system of freely floating exchange rates. Between these two
extremes are a whole series of semi-fixed/semi-floating type systems.
In a fixed rate system, exchange rates between different currencies are fixed by agreement between the countries concerned. Such a system makes importing and exporting
much more straightforward as there is no foreign exchange risk. An importer invoiced in
the overseas currency knows exactly how much that import deal will cost in his own currency because the exchange rate between the two currencies is fixed and unchanging.
Exporters invoicing in the foreign currency would be equally certain about the outcome
of that export deal in their own currency.
The problem with fixed exchange rate systems is that they try to deny the forces of
supply and demand by attempting to have a fixed price for one currency in terms of
another. Such a system, almost by definition, is going to be unstable unless the economic
conditions are such equality of interest and inflation rates and a balance between
imports and exports to enable currency price stability to be maintained.
A freely floating exchange rate system does not try to deny these supply and demand
market forces as the exchange rate is allowed to float to wherever these forces push it.
Therefore the system is stable in as much as it is a sustainable system, but it has two main
problems.
The first is that, in such a system, international trade is not encouraged because
importers and exporters are exposed to the risk of adverse movements in exchange rates:
foreign exchange risk. The second problem is that the exchange rate plays an important
role in the macroeconomic affairs of an economy. As a result, most governments are not
willing to allow their currencys exchange rate to be determined solely by supply and
demand market forces (as in a freely floating or clean floating system).
Because all of these extremes have both advantages and disadvantages, there are many
examples, throughout the world, of semi-fixed exchange rate systems that try to capture
the advantages of each extreme whilst avoiding their disadvantages. One such system was
the Exchange Rate Mechanism (ERM) of the European Union which was set up in 1979.
In such a system the exchange rates between the member country currencies are fixed,
but those rates then are allowed to appreciate or depreciate, in response to supply and
demand market forces, to a very limited (and specified) extent.
Such a system is designed to encourage international trade between member countries
by having (approximately) fixed exchange rates. The problem is that market forces in
foreign exchange markets can be enormous. With such potentially large market forces it
is very difficult to maintain only a limited movement in exchange rates unless economic
CHAPTER 26
FOREIGN EXCHANGE HEDGING
773
conditions (convergence of interest and inflation rates between member countries) can
control them.
Chapter 26 Foreign exchange hedging

problem 1
(a) As the question gives only the S$/US$ and US$/FX rates, we first have to calculate
the S$/ cross rate:
Two months forward:
S$/US$
US$/
= 2.0964
= 1.5047
/US$
= 1/1.5047 = 0.6646
20964
.
= 3.1544
=
0.6646
S$/
Three months forward:

S$/US$
US$/
= 2.0915
= 1.5105
/US$
= 1/1.5105 = 0.6620
20915
.
=
= 3.1592
0.6620
S$/
There are basically two ways an exporter can hedge against FX risk if they have to
invoice customers in the overseas currency. One is to use the forward market and the
other is to use the money market.
Singapore sale
With Oxlake, as far as the Singapore sale is concerned, they could investigate either
approach. However, due to the uncertainty as to when the customer will pay and the fact
that the company wishes to hedge without taking any risks, this means that only the
forward market approach is possible.
The reason for this is that, with a money market hedge, the company would be open
to risk in that it doesnt know whether to take out a two- or three-month loan. If they
just take out a two-month loan, there is the risk that the customer will not pay until
three months have elapsed. Thus the loan would have to be extended for a month (subjecting the company to interest rate risk) and the increased level of interest payable
(three months rather than two) would also expose the firm to a small FX risk on the
difference.
In order for Oxlake to hedge the Singapore contract without any risk they will need to
take out an option forward contract as the timing of the S$ receipts is uncertain and
could arise at any time between two and three months. Option forward contract rates are
always set at the least favourable rate to the company. A two-month forward contract has
an exchange rate of 3.1544, whilst the three-month contract is at a rate of 3.1592. As it is
the latter which is the least favourable to Oxlake, this will be the rate they are charged on
their option forward contract. Hence the company will take out an option forward contract to sell S$715 500 at some time between two and three months in the future, at an
exchange rate of 3.1592. Thus the expected cash flow will be:
S$715 500 3.1592 = 226 481
774
ANSWERS TO PROBLEMS
Indonesian sale
As there is no forward market in Indonesian rupiahs against , and no rupiah loans are
available, Oxlake must accept their customers offer of US$125 000 in three months if
they wish to be able to hedge the FX risk.
The US$ could be sold three months forward as a FX hedge to yield:
US$125 000 1.5105 = 82 754 received in three months.
The alternative is to use the money market to hedge by taking out a three-month US$
loan for US$x: such that:
US$x (1 + 0.03) = US$125 000.
Therefore they should take out a loan for:
US$x = 125 000 1.03 = US$121 359.
This loan will be repaid (capital, plus interest, will amount to US$125 000) with the
money received from the customer in three months time.
The US$ loan can be converted into at spot:
US$121 359 1.4875 = 81 586 available now.
In order to compare this alternative with the forward market deal, we need to be able
to compare like with like (i.e. 82 754 in three months time as against 81 586 now).
Therefore, assuming that the 81 586 is placed on three-month deposit then this will
yield in three months time:
81 586 (1 + 0.01625) = 82 912.
As this amounts to marginally more than Oxlake could obtain from the forward market
transaction, the company should hedge the Indonesian sale through the use of the
money market.
Summary
Singapore sale: Expected revenues in three months time = 226 481.
Indonesian sale: revenues immediately = 81 586 (or 82 912 in three months time)
The Singapore hedge is achieved through a two-to-three month option forward sale
contract. The Indonesian hedge is achieved through a three-month US$ loan (a
so-called currency overdraft).
(b) Standard sale price:
100 000 2 246 = 224.6mn rupiahs.
Discount price: 224.6mn 0.95 = 213.37mn rupiahs.
The R/US$ spot rate is the cross rate of the R/ and the US$/ spot rates:
2481
= 1 668 = R / US$ spot rate.
1.4875
Therefore the Indonesian customer will pay immediately:
US$ = 213.37mn 1 668 = 127 920
which Oxlake can sell at spot for:
US$127 920 1.4875 = 85 996.
CHAPTER 26
775
As this is more than the 81 586 available immediately from use of the money market,
the offer made by the Indonesian importer is likely to be accepted by Oxlake.
(c) There are three main reasons why it may be advantageous for a company to invoice an
export sale in a foreign currency. First, the foreign currency might be expected to appreciate (i.e. the forward rates would be at a premium) and therefore the company could
expect a favourable FX movement.
The second reason is that the exporter may have an existing liability in that overseas
currency. Therefore, by invoicing the customer in that currency, some hedging of the
FX risk can be gained through the matching principle.
Finally, it may be advantageous to agree to invoice in the foreign currency in order to
gain a competitive advantage over your rival suppliers. Export markets are often very
competitive and offering to invoice in the customers currency may be an effective marketing device.
The main disadvantage of invoicing in a foreign currency is the exposure it creates to
foreign exchange risk. This exposure may be difficult to hedge (because no forward
market exists and there is no convenient proxy currency to invoice in instead) or, if
hedging is possible, then the company has to incur the transaction costs involved, which
can be significant.
problem 2
(a) Four FX hedging techniques are:
1.
2.
3.
4.
forward market hedge;

money market or financial hedge;
futures market hedge;
options market hedge.
With a forward market hedge an exporter who is due to receive payment in a foreign
currency arranges with a bank to sell that currency at a specific rate of exchange for
delivery on a specific future date (or, sometimes, between two specific future dates)
which coincides with the expected payment of the invoice.
With a money market hedge the exporter would borrow an amount of money in the
foreign currency for the period of the credit granted to the customer, such that the principal sum plus the accumulated interest at the end of the loans term would exactly equal
the amount of foreign currency due from the customer on payment of the invoiced
amount. The amount borrowed is sold at spot for and represents the outcome of the
export deal. The principal plus interest is then repaid using the money received from the
customer at the end of the credit period.
If the company were to use a futures market hedge, the exporter would open up a
position on the futures market such that any profit or loss made on the futures when the
position is subsequently closed out approximately offsets the loss or gain made on the
invoiced amount arising out of a movement on exchange rates over the credit period.
Finally an options market hedge guarantees the company a minimum rate of exchange
for its future foreign currency receipt, known as the option exercise or strike price.
Thus, when the foreign currency is received from the export customer, if a better rate of
exchange is available on the spot market, then the option is allowed to lapse and the currency is sold spot. On the other hand, if the spot market provides a less favourable rate of
exchange, then the option is exercised to take advantage of its guaranteed minimum rate
of exchange.
Each of the first three of these hedging techniques hedges the company against both
an adverse and a favourable movement in exchange rates over the credit period granted
to the customer. In contrast, the FX options hedge the exporter against an adverse
776
ANSWERS TO PROBLEMS
movement in exchange rates, but allows him to take advantage of any favourable
movement.
(b) The $/ rates are:
Spot:
3 months forward:
6 months forward:
1.7106 1.7140
1.7024 1.7063
1.6967 1.7006
(i) Fidden has the following transactions due:

Due to pay
Due to receive
Due to pay
Due to receive
Net payment due
:
:
:
:
:
116 000
$197 000
$447 000
$154 000
$293 000
No FX risk
Requires hedge
Net out for a natural hedge,
leaving the balance
Requires hedge
[a]
[b]
(1) Forward market hedge

[a] Sell $197 000 at 1.7063 = 115 454 receivable in 3 months.
[b] Buy $293 000 at 1.6967 = 172 688 payable in 6 months.
(2) Money market hedge
[a] Borrow
$x for 3 months at 9% 4 = 2[1/4]% so that:
$x(1 + 0.0225) = $197 000
$x = $197 000 1.0225 = $192 665
Sell the $192 665 spot, at 1.7140, to give 112 407 received immediately. Use the
$197 000 received in three months time to repay loan, plus accumulated interest.
[b] Deposit
$x for 6 months at 6% 2 = 3% so that:

$x(1 + 0.03) = $293 000
$x = $293 000 1.03 = $284 466
Purchase the $284 466 spot, at 1.7106, to give 166 296 payable now. The net payment
of $293 000 due in six months time can be made with the contents (capital plus interest)
of the $ deposit account.
Therefore the net position from the forward markets will be:
(i) Three months time:
Pay:
Receive:
116 000
115 454
Net pay:
546
(ii) Six months time:

Pay:
172 688
The net position for the money markets will be:

(i) Immediately:
Receive:
Pay:
112 407
166 296
Net pay:
53 889
(ii) Three months time:

Pay:
116 000
CHAPTER 26
777
(ii) As the question only gives details of the spot rate in six months time, it is assumed
that the question only refers to the net payment of $293 000, payable in six months
time.
To hedge this FX risk in the option market we will need to buy June put options.
June options are involved because the payment is due in June (although September
options could possibly be used). Put options are involved because in the cash market we
will need to buy $293 000 to pay the invoice by selling . Therefore we need to buy
options to sell : puts.
With June puts, there is a choice of two exercise prices. (Notice that the more
favourable the exercise price is to the company $1.80 the more expensive will be the
option cost.)
However, we can see that in this case we would not select the $1.70 exercise price, the
reason being that the cost of paying the invoice at this exercise price would be: $293 000
$1.70 = 172 353. This is only marginally cheaper than the cost of paying the invoice
through a forward market hedge: 172 688. The cost of the July options will certainly
be in excess of this saving of 335, therefore we can ignore the $1.70 exercise price in
this case.
Therefore, we would hedge with June puts at an exercise price of $1.80. Paying the
invoice at this rate of exchange would have a cost of:
$293 000 $1.80 = 162 778.
Given the size of option contracts, to hedge the FX risk we would need: 162 778
12 500 = 13.02 contracts.
We are now faced with a choice of two alternatives:
1. hedge with just 13 option contracts and leave a very small amount unhedged;
2. over-hedge by using 14 option contracts.
Assuming that the company wants no FX risk, it will go for the over-hedge. Therefore
we will hedge by buying 14 June puts at an exercise price of $1.80 and a cost of:
14 12 500 9.32 = $16 310
In June, we also have a choice. We either allow the option to lapse and buy $293 000
on the spot market in order to pay the amount due or, alternatively, buy $ through the
exercise of the option contracts.
As the June $/ spot rate is 1.69671.7006, it is obviously better to buy $ by exercising
the option as they can be bought at a more favourable rate of exchange $1.80 than
the 1.6967 rate on the spot market.
Exercising the option contracts:
Buy: 14
12 500 $1.80 = $315 000 at a cost of:

$315 000 $1.80 = 175 000.
The invoice of $293 000 can then be paid out of these purchased $, leaving a surplus of:
$315 000 $293 000 = $22 000. The surplus can then be used to pay the option cost of
$16 310. This leaves a residual of: $22 000 $16 310 = $5690 which can be sold spot at
1.7006 to yield: $5690 1.7006 = 3346.
Therefore, overall:
cost of exercising option contracts
Less the proceeds from sale of surplus $
:
:
175 000
3 346
Net cost
+171 654
778
ANSWERS TO PROBLEMS
As this net cost, payable in six months time, is less than the forward market hedge cost
of 172 688, the option hedge is preferred.
(However, note you can only tell with the benefit of hindsight whether the option
hedge is more or less favourable than the forward market hedge. In this question the
option turns out to be the better alternative, but this will not always be the case.)
(iii) A forward market hedge locks the company into a specific future exchange rate (as
does a futures hedge). Therefore the company is hedged against a favourable move in
FX rates, as well as hedged against an adverse movement.
With options, the company has additional flexibility. The option allows the company
to hedge against an adverse move in FX rates (by exercising the option), but at the same
time the company can take advantage of a favourable movement in FX rates (by allowing
the option to lapse).
This extra flexibility means that options are more expensive than forward contracts,
but they are particularly useful where a company has a contingent exposure to FX risk.
Chapter 27 Foreign direct investment

problem 1
(a) Discount rate
Given:
A =
A A, M
M
then:
Subsidiary
Subsidiary Subsidiary, Market

Market
Subsidiary
0.65 0.885
= 1.198
0.48
Using CAPM:
E [ rSubsidiary ] = rf + ( E [ rMarket ] rf ) Subsidiary
E [ rSubsidiary ] = 8% + [13% 8%] 1.198 = 14%
Writing-down allowances
Assuming that the capital expenditure is incurred on the first day of the companys
accounting year:
mn
15
3.75
11.25
2.81
8.44
2.11
6.33
1.58
4.75
mn
WDA
0.25
3.75
0.35
1.312
Year 2
0.25
2.81
0.35
0.984
Year 3
0.25
2.11
0.35
0.739
Year 4
0.25
1.58
0.35
0.553
Year 5
10
(5.25)
0.35
(1.837)
Year 6
Writing-down
allowance
tax relief
Balancing charge
CHAPTER 27
779
FOREIGN DIRECT INVESTMENT
Contribution/gallon
300 140
160(1.04)
166.4(1.03)
171.39(1.03)
176.53(1.04)
= 160/gal.
= 166.4/gal.
= 171.39/gal.
= 176.53/gal.
= 183.59/gal.
Annual contribution
Year
Contrib/gal.
1
160
2
166.4
3
171.39
4
176.53
5
183.59
Annual fixed costs
Year
1
2
3
4
5
2
2(1.04)
2.08(1.03)
2.142(1.03)
2.206(1.04)
Sales
20 000
50 000
50 000
50 000
50 000
1.4725 (1 0.05)
1.3989 (1 0.05)
1.3289 (1 0.05)
1.2625 (1 0.05)
Royalty payments
Year
Sales
1
20 000 $50 =
2
50 000 $50 =
3
50 000 $50 =
4
50 000 $50 =
5
50 000 $50 =
$mn
1.0
2.5
2.5
2.5
2.5
Tax charges (mn)

Year Contrib. Fixed
costs
1
3.2
2
2
8.32
2.08
3
8.57
2.142
4
8.827
2.206
5
9.18
2.294
=
=
=
=
=
m
3.2
8.32
8.57
8.827
9.18
mn
2
2.08
2.142
2.206
2.294
=
=
=
=
=
=
Exchange rate
1.4725
1.3989
1.3289
1.2625
1.1994
Royalties
0.679
1.787
1.881
1.980
2.084
=
=
=
=
=
=
=
=
=
=
=
Exchange rates forecast

Spot
Year 1
Year 2:
Year 3:
Year 4:
Year 5:
Year 1
Year 2
Year 3
Year 4
Year 5
Taxable
c/f
0.521
4.453
4.547
4.641
4.802
1.5500
1.4725
1.3989
1.3289
1.2625
1.1994
mn
0.679
1.787
1.881
1.980
2.084
=
=
=
=
=
Tax
rate
0.35
0.35
0.35
0.35
0.35
= Tax
Tax
charge timing
= 0.182
2
= 1.558
3
= 1.591
4
= 1.624
5
= 1.681
6
780
ANSWERS TO PROBLEMS
Project cash flows ( mn)

0
1
Outlay
15
Grant
+3
Scrap
WDA T/R
Contribution
+3.2
Fixed costs
2
Tax charge
+1.312
+8.32
2.08
0.182
+0.984
+8.57
2.142
1.558
+0.739
+8.827
2.206
1.591
+10
+0.553
+9.18
2.294
1.624
1.837
1.681
Net cash flow

Discount factor
12
1
+1.2
+7.37
0.8772 0.7695
+5.854 +5.769 +15.815 3.518

0.6750 0.5921
0.5194 0.4556
PV c/f
12
+1.053
+3.951
+5.671
+3.416
+8.214
1.603
NPV of proposed UK subsidiary: +8.702 million.

The royalty cash flow has been excluded from this calculation (but not the impact of the
royalty payments on the corporate tax charge) because it is a cash flow which is internal
to the company.
In US dollar terms, the project could be expected to have a positive NPV of:
8.702 million 1.55 = $13.488 million.
In addition, there is a further opportunity benefit arising out of the project. At present
the UK market is supplied from the US where there is no spare production capacity.
The UK project will make some spare production capacity become available in the US,
which will allow the company to exploit the Scandinavian market and so generate an
after-tax net cash flow of 1.5mn.
On the assumption that the Scandinavian market project has the same risk as the UK
project, then the interest rate parity theorem could be used to estimate a suitable discount rate to apply to these incremental after-tax US$ cash flows:
1+ $ discount rate 12 month forward $ /
=
1+ discount rate
Spot $ /
1+ $ discount rate 1.4725
=
1+ 0.14
1.5500
1.14 1.4725
$ discount rate =
1 = 0.083 or 8.3%.
1.5500
Thus the present value of the Scandinavian market could be estimated as:
$15
. mn
= $18.07 mn PV.
0.083
Note: As an alternative, the present value of this opportunity benefit could be calculated
over just five years, the projects planning horizon, giving $5.94million.
(b) Investment in any overseas project is likely to expose the parent company to FX
translation risk. In this particular case Blue Grass Distillery Inc would have sterling
assets and, if it finances the project by exporting dollars, dollar liabilities.
The easiest way to avoid this risk is to match the overseas currency assets with a liability in that same currency. However, such a perfect hedge may not be legally possible
(the projects host country might insist that at least some of the finance should be
exported by the parent) or may not be seen to be advisable from a public relations
viewpoint.
In such circumstances, the standard advice is that a projects non-property fixed assets
should be financed with sterling, while the property fixed assets, together with the
working capital, should be financed in the currency of the host country. The reasoning
CHAPTER 27
781
FOREIGN DIRECT INVESTMENT
behind this advice is that the company can hedge part of its foreign exchange risk through
matching assets and liabilities in the same currency, while at the same time it gets some
protection from foreign exchange risk on its unmatched assets through the workings of
the law of one price. The reason why the non-property fixed assets are left unmatched is
that they are the most likely assets to react to the law of one price. Therefore if sterling
depreciates against the US dollar (as it is expected to do) it might be reasonable to assume
that the sterling worth of the non-property fixed assets may rise in order to counteract the
reduced worth of sterling, assuming that those assets are capable of being traded
internationally.
problem 2
(a) Base-case present value
Base-case discount rate ( terms)
assets = 1.40
4
= 1.20
4 + 1(1 0.35 )
Base-case discount rate = 7.1% + (17.85% 7.1%) 1.20 = 20%

A$ project tax charge (A$mn)
Years
Revenue
Operation costs
Depreciation
=
14
18
(5)
(3.75)
Taxable profit
Tax charge
9.25
4.625
A$ project cash flows (A$mn)

Year
0
Capital equipment
(15)
Working capital
(5)
Revenues
Costs
Taxation
Net cash flow
(20)
(20)
8.375
8.375
8.375
13.375
2
1
2(1.10)
2
2(1.10)
3
2(1.10)
4
2(1.10)
18
(5)
(4.625)
18
(5)
(4.625)
18
(5)
(4.625)
5
18
(5)
(4.625)
8.375
8.375
8.375
13.375
m base-case present value calculation

Year
A$mn
Exchange =
n
rate
0
1
2
3
4
=
=
=
=
=
mn
(10)
3.807
3.461
3.146
4.568
20%
disount
rate
1
0.833
0.694
0.579
0.482
Base case PV
=
=
=
=
=
m
PV
cash flows
(10)
3.171
2.402
1.821
2.202
(0.404mn)
PV of financing side-effects
PV of tax shield
5mn 0.10
500 000 0.35
=
=
PV of tax relief: 175 000 A
4 0 .10
500 000
175 000
=
554 750
=
=
Annual interest
Annual tax relief
782
ANSWERS TO PROBLEMS
PV of issue costs
5mn 0.025 (1 0.35) = (81 250)
Base-case PV
PV tax shield
PV issue costs
mn
(0.404)
0.555
(0.081)
0.07mn or + 70 000 approx.
Therefore, the project should be accepted.

(b) The companys proposed financing plans for the Australian project can be criticized
on the basis that they have not taken the opportunity to arrange them so as to help limit
exposure to foreign exchange risk.
By having a long-lived Australian dollar (A$) asset the company is exposing itself to
both foreign exchange translation and transaction risk. This risk can be reduced by
matching the A$ assets as closely as possible to an A$ liability.
The standard advice given on the assumption that the company will have to finance
some part of its overseas project by exporting sterling is that the projects non-property fixed assets should be financed with sterling, while the property fixed assets,
together with the working capital, should be financed in the currency of the host
country. The reasoning behind this advice is that the company can hedge part of its
foreign exchange risk through matching assets and liabilities in the same currency, while
at the same time it gets some protection from foreign exchange risk on its unmatched
assets through the workings of the law of one price. The reason why the non-property
fixed assets are left unmatched is that they are the most likely assets to react to the law of
one price. Therefore if the A$ depreciates against sterling (as it is expected to do) it
might be reasonable to assume that the A$ worth of the non-property fixed assets may
rise in order to counteract the reduced worth of the A$, assuming that those assets are
capable of being traded internationally.
783
Index
abandonment decision, ENPV 18691
accounting role, profit 910
acquisition decisions 55376
acquisition premiums 55860
all-equity situation 5623
anti-competitive defence 5701
bootstrapping EPS 5647
City Code 19
coinsurance effect 5624
cost synergy 5556
defence document 56970
diversification 5678
EPS 5647
financial synergy 557
financing acquisitions 5712
geared situation 5634
organic growth vs. acquisition growth
5602
revenue synergy 5545
synergy 5548
takeover defence 56871
tax synergy 5567
valuing synergy 5578
White Knight defence 571
adjusted present value (APV)
applying 51621
company valuation 5078
investment and financing interactions
5078, 513
maintaining gearing ratio 51011
agency costs
bankruptcy costs 4735
debt capital 4723
all-equity financed companies, WACC
4201
all-equity situation, acquisition decisions
5623
alpha coefficient, beta value 2678
alternatives valuation, decision making 56
American options, option valuation 293,
2967
annual equivalent factors
compounding and discounting 88
table 669
annual reports, decision objectives 17

annuities
defined 87
present value 878
tables 668
terminal value 88
answers, problems 699786
answers, quickie questions 67398
anti-competitive defence, acquisition
decisions 5701
appraisal, investment see investment
appraisal
appreciation, foreign exchange 6023
APT see arbitrage pricing theory
APV see adjusted present value
arbitrage
capital structure 4504, 4712
criticism 53940
reverse arbitrage 4534
taxation 4712
arbitrage pricing theory (APT), CAPM
2767
area under the normal curve
option valuation 3212
tables 671
Arthur Andersen 267
asset basis, company valuation 5779
asset betas
capital structure 4478
gearing 4478, 51421
51421
taxation 51516
assumptions, decision making, financial 11
at-the-money (ATM), option valuation
296
audits, decision objectives 17
bankruptcy costs, capital structure 4735
base-case discount rate, investment and
financing interactions 51314
benefit-cost ratios, capital rationing
1527
784
INDEX
beta value
adjusting beta 27980
alpha coefficient 2678
beta stability 26970
CAPM 26271
information sources 276
interpreting 2624
investment appraisal 27881
measuring 2656
portfolio betas 2645
project beta 2789
project discount rate 27881
bid prices, cost of capital 386
binomial model, option valuation 31820
Black and Scholes model
assumptions 301
dividends 302
option valuation 298302, 3212
bonds
discount 4034
low coupon 4045
plain vanilla bonds 3989
pricing 399
zero coupon 4034
bootstrapping EPS, acquisition decisions
5647
borrowing possibility, portfolio theory
2402
business risk, capital structure 44650,
4969
buying rates, exchange rates 5958
Cadbury Code 1921
calculated intangible value (CIV),
intellectual capital 585
call options
Black and Scholes model 298302
combining puts 31213
foreign exchange hedging 629
gamma 316
option valuation 293, 294, 304
speculating with calls 310
vega 317
capital asset pricing model (CAPM)
25590
APT 2767
assumptions 2713
beta value 26271
CAPM expression 25971
DVM 3937
empirical evidence 2735
KE 3937
M and M 4978
NPV 278
PER 275
Rolls critique 2734
SML 2559
systematic risk 25962
unsystematic risk 25962
validity 2716
capital, cost of see cost of capital
capital market borrowing, capital
rationing 14850
capital market line (CML)
portfolio theory 2438
SML 2559
capital markets, investment-consumption
decision model 556
capital rationing 14875
benefit-cost ratios 1527
capital market borrowing 14850
divisibility assumption 157
hard 1501
LP 1608
multi-period 15868
mutually exclusive investments 157
opportunity costs 15960
single-period 1528
soft 1501, 1589
capital structure
arbitrage 4712
arbitrage proof 4504
asset betas 4478
assumptions 4556
bankruptcy costs 4735
business risk 44650
complex world 46287
corporate taxes 47982
debt capacity 4756
debt, consideration 490
DOG 496500
EPS 4936
financial risk 44650
financing dilemma 490
gearing 4445
interest cover ratio 496
judgement 4956
M and M 443, 4557, 47782
market signals 48990
optimal 4426
pecking order theory 48891
in practice 488505
principal-agent problem 4723
785
INDEX
real-world considerations 4913

rising cost of debt 4567
risk 44650
risk and return 4935
simple world 44261
tax exhaustion 476
taxation 4627
timing 489
total market value model 4436
traditional view 4779
views, further 47782
CAPM see capital asset pricing model
caps, interest rate risk 3434
cash alternative, acquisition decisions 572
cash flows
FCF basis 5824
incremental 99103
timing 712
see also discounted cash flow; project
cash flows
cash offers, acquisition decisions 571, 572
CGPP see current general purchasing
power
City Code
takeover defence 569
CIV see calculated intangible value
clean floats, foreign exchange 606
clientele effect, dividend decision 5423
CML see capital market line
coinsurance effect, acquisition decisions
5624
collars, interest rate risk 3434
combined borrowing and lending,
Combined Code 213
combining calls/puts 31213
combining risk-free and risky investment,
Company Securities (Insider Dealing) Act
1985; 18
company valuation 5068, 57791
APV 5078
asset basis 5779
current EAIT 5802
dividend basis 582
DVM 507
earnings basis 57982
FCF basis 5824
intellectual capital 5846
M and M see Modigliani and Miller
capital structure hypothesis
owner-managers 580
PER 5801
suitable multiple 5801
traditional valuation model 508
see also investment and financing
interactions; investment appraisal
compound interest factors
table 667, 670
compounding and discounting
annual equivalent factors 88
annuities 878
compound interest factors 856
perpetuities 867
present value factors 86
sinking fund factors 89
tables 66770
constant capital structure, WACC 4223
contingent exposure, foreign exchange
hedging 635
control and ownership, decision objectives
1516
convertible debt
advantages 411
cost of capital 41013
corporate debt costs 4317
corporate taxes, capital structure 47982
corporation tax see taxation
convertible debt 41013
cum dividend 3867
dividend growth model 3889
dividend growth rate 38992
dividend valuation model 38593
dividends 3835
ex dividend 3867
expected return 3835
financing decision 37980
graphical relationship 4667
interest valuation model 398
M and M 46676
market price 3835
plain vanilla bonds 3989
preference shares 40910
retained earnings 3923
share price-return relationship 3845
see also weighted average cost of capital
cost of debt capital 397409
vs. equity capital 3978
cost of equity capital (KE) 3802
CAPM 3937
gearing 449, 466
786
INDEX
cost synergy, acquisition decisions 5556

country/political risk, foreign direct
investment 642, 65960
covariance, portfolio theory 2279
cross rates, exchange rates 598600
cum dividend, shares 3867
currency finance, overseas, foreign direct
investment 6467
current EAIT, company valuation
5802
current general purchasing power
(CGPP) 12730
DCF see discounted cash flow
debt capacity, capital structure 4756
debt capital
agency costs 4723
explicit costs 409
extreme use 4356
financing via 431
imperfect markets 4335
implicit costs 409
irredeemable 401
opportunity costs 399400
perfect markets 4323
taxation 4312
debt costs
corporate 4317
private 4317
decision making, financial 313
accounting profit 910
alternatives valuation 56
assumptions 11
maximizing shareholder wealth 78
process 46
technology 1112
time dimension 1011
value base 34
wealth 78
decision objectives 67, 11, 1430
annual reports 17
audits 17
directors transactions 18
fiduciary responsibilities 1617
incentive scheme criteria 236
ownership and control 1516
relationship, directors/shareholders
1415, 1623
stock exchange rules 1723
wealth maximization 1415
decision pivot point, sensitivity analysis
1913
defence document, acquisition decisions

56970
degree of operating gearing (DOG)
defined 498
meaning 499500
delta, option valuation 314
depreciation
foreign exchange 6023
non-cash flow 137
directors
good governance 22
shareholder relationship 1415, 1623
see also management
directors transactions, decision objectives
18
dirty floats, foreign exchange 606
discount bonds 4034
discount rate
base-case 51314
beta value 27881
foreign direct investment 64853
risk-adjusted 1946
WACC 4203
discounted cash flow (DCF) 67124
assumptions 956
IRR 7885, 94124
NPV 6777, 94124
discounted payback, IRR 834
discounting and compounding see
compounding and discounting
discounts, foreign exchange 6012
diversification, acquisition decisions
5678
diversification within companies, portfolio
theory 2489
dividend basis, company valuation 582
dividend decision 53450
clientele effect 5423
dividend patterns 5378
external finance 5401
policy, imperfect markets 5424
policy, perfect capital markets 5348
taxation 544
traditional view 53841
valuation model 5378
dividend flow approach, maintaining
gearing ratio 510
dividend growth model, cost of capital
3889
787
INDEX
dividend growth rate

changing 3912
dividend irrelevancy hypothesis 536
dividend valuation model (DVM)
CAPM 3937
dividends
Black and Scholes model 302
probability distribution 4467
as a residual 5357
signalling effect 543
DOG see degree of operating gearing
domestic vs. foreign projects, foreign
direct investment 642
dominance, portfolio theory 233
downside risk
dual values, LP 1628
DVM see dividend valuation model
EAIT, company valuation 5802
early exercise, foreign exchange hedging
6345
earnings basis, company valuation 57982
earnings per share (EPS)
gearing 4936
economic risk
foreign exchange hedging 615, 616
efficient markets hypothesis (EMH)
35565
see also market efficiency
EMU see European Monetary Union
ENPV see expected net present value
Enron 267
EPS see earnings per share
equity capital
cost 3802, 3937, 4646
vs. cost of debt capital 3978
ERM see Exchange Rate Mechanism
European Monetary Union (EMU) 6067
European options, option valuation 293,
2967
ex dividend, shares 3867
exchange/delivery of currencies, foreign
exchange 6035
Exchange Rate Mechanism (ERM) 6067

exchange rate systems, foreign exchange
6057
exchange rates
buying rates 5958
cross rates 598600
forecasting 612
inverting 598
selling rates 5958
see also foreign exchange
exchange-traded options, option valuation
293
exercise price, foreign exchange hedging
629
expected net present value (ENPV)
abandonment decision 18691
additional information 1846
limitations 1834
risk techniques 18091
see also net present value
expected returns
expected utility model, risk and return
20612, 21920
explicit costs, debt capital 409
extended yield, IRR 112
external finance, dividend decision 5401
FCF basis see free cash flow basis
fiduciary responsibilities, decision
objectives 1617
finance, external, dividend decision 5401
financial investments, cf. physical
investments 380
financial leases 5249
financial market line,
investment-consumption decision
model 56
financial markets 35578
market efficiency 35565
pure expectations hypothesis 36975
term structure, interest rates 3659
yield to maturity 366
financial risk, capital structure 44650,
4969
financial synergy, acquisition decisions
557
financing acquisitions 5712
financing and investment interactions see
financing decision, cost of capital 37980
788
INDEX
financing via debt capital 431

Fisher Effect 12630
interest rates 3712
fixed forward contracts, foreign exchange
6035
floating rate debt 4079
floors, interest rate risk 3434
forecasting exchange rates 612
basic approach 6434
country/political risk 642, 65960
domestic vs. foreign projects 642
economic risk 6569
management charges 6601
overseas currency finance 6467
project cash flows 6447
taxation 64953
transfer pricing 6601
translation risk 6536
appreciation 6023
clean floats 606
depreciation 6023
determinants, FX rates 60812
dirty floats 606
discounts 6012
EMU 6067
ERM 6067
exchange/delivery of currencies 6035
exchange rate systems 6057
exchange rates 595614
fixed forward contracts 6035
forward contracts 6035
inflation 61012
interest rates 60910
markets 6005
option forward contracts 6035
premiums 6012
time option forward contracts 6035
see also exchange rates
comparing hedges 61920
contingent exposure 635
definitions 61516
early exercise 6345
economic risk 615, 616
exercise price 629
forward market hedging 618
forward vs. futures 6267
futures contracts 6216
importer case 6312
leading hedge 6201

LIFFE 626
margin 626
money market hedging 61819, 621
netting 617
option hedging, setting up 62934
options contracts 6279
OTC options 628, 6356
risk, contingent exposure 635
risk types 615
swaps 61718
techniques 61621
traded currency options 6289, 6356
transaction risk hedging 615, 61621
translation risk 61516
variation 6334
forward contracts, foreign exchange
6035
forward forward loans, interest rate risk
3278
forward interest rates 3701
forward market hedging, foreign exchange
hedging 618
forward rate agreements (FRAs)
interest rate risk 32831
vs. IRGs 333
market in 331
forward vs. futures, foreign exchange
hedging 6267
FRAs see forward rate agreements
free cash flow (FCF) basis, company
valuation 5824
futures contracts
vs. forward market hedging 6267
ticks 3356
FX see foreign exchange
gamma, option valuation 316
geared situation, acquisition decisions
5634
gearing
asset betas 4478, 51421
assumptions 445
defined 443
DOG 496500
EPS 4936
KE 449, 4646
no-tax world 4445
see also capital structure
789
INDEX
Gordons approach, dividend growth rate

38991
governance, corporate 1527
graphical analysis,
model 535
graphical derivation, decision rule,
model 579
graphical interpretation, NPV 757
Greeks, option 314
Greenbury Code 21
growth, organic vs. acquisition 5602
Hampel Report 21
hard capital rationing 1501
hedge efficiency, interest rate risk 33840
hedge ratio, option valuation 31416
Hirshliefer single-period
investment-consumption model see
model
imperfect markets
debt capital 4335
implicit costs, debt capital 409
importer case, foreign exchange hedging
6312
in-the-money (ITM), option valuation
296
incentive schemes
criteria 236
decision objectives 237
ineffective 267
types 256
incremental cash flows, IRR 99103
indifference curves,
model 545
individual choice, risk and return 21112
inflation
IRR 1301
insider dealing, Company Securities
(Insider Dealing) Act 1985; 18
intellectual capital
CIV 585
defined 584
market to book 585

Tobins q quotient 585
value 5845
interdependent projects
IRR 99108
NPV 949
interest cover ratio, capital structure 496
interest rate futures, interest rate risk
33443
interest rate guarantees (IRGs)
vs. FRAs 333
interest rate options (IROs) see interest
rate guarantees
caps 3434
collars 3434
defined 325
floors 3434
forward forward loans 3278
FRAs 32831
hedge efficiency 33840
interest rate futures 33443
interest rate swaps 3447
IRGs 3313
margin 3423
maturity mis-match 3401
money markets 3257
option contract markets 3334
strip hedge 342
interest rates
Fisher Effect 3712
forward 3701
liquidity preference 3734
market 12630
real 12630
segmented markets 3745
spot rates 3679
taxation 3723
term structure 3659
transaction costs 3723
yield curve 3667
yield to maturity 366
interest valuation model
cost of capital 398
507
internal rate of return (IRR) 7885
decision rule 82
discounted payback 834
estimating 7982
790
INDEX
extended yield 112

incremental cash flows 99103
inflation 1301
interdependent projects 99108
model 823
linear interpolation 7982
model 789
modified 11415
multiple 10912
mutually exclusive projects 94124
and NPV 94124
vs. NPV 11516
opportunity cost of cash assumption
1058
problems 11314
rates of return, average/marginal 109
single-period capital rationing 1578
time horizon extension 1089
truncated NPV 845
use of 101
intrinsic value, option valuation 295, 297
inverting, exchange rates 598
investing in
call options in the shares 304
put options in the shares 305
risk-free bonds 3034
shares 303
50633
adjusted present value model 5078
asset betas 51421
base-case discount rate 51314
capital structure, changing 51113
DVM 507
investment appraisal approaches
50914
lease or purchase decision 5249
risk-adjusted WACC 5214
traditional valuation model 508
investment appraisal
approaches 50914
beta value 27881
CAPM 27881
inflation 12530
model 5066
IRR 7890
NPV 6777
payback method 3441

relevant cash flow 13641
ROCE 414
taxation 1312
traditional methods 3349
investment building blocks, option
valuation 3027
investment-consumption decision model
5066
assumptions 501
capital markets 556
financial market line 56
graphical analysis 535
graphical derivation, decision rule 579
indifference curves 545
IRR 823
multi-owner firms 5961
NPV 745
separation theorem 5761
single-owner firms 534
TVM 515
uncertainty 612
investment decision, risk and return
21222
investors behaviour axioms, risk and
return 2067
IRGs see interest rate guarantees
IROs see interest rate guarantees
IRR see internal rate of return
irredeemable debt capital, cost 401
ITM see in-the-money
judgement, capital structure 4956
K0 calculation, WACC 4236
KE see cost of equity capital
leading hedge, foreign exchange hedging
620
lease or purchase decision, investment and
leases
financial 5249
operating 5245
legal issues
Company Securities (Insider Dealing)
Act 1985; 18
governance, corporate 1527
lending and borrowing combined,
leverage see gearing
LIFFE, foreign exchange hedging 626
791
INDEX
linear programming (LP) 16970

assumptions 162
dual values 1628
liquidity preference, interest rates 3734
logarithms, natural, tables 672
London Stock Exchange
Model Code 1723
rules 1723
long-term finance
types 380
see also cost of capital
low coupon bonds 4045
LP see linear programming
M and M see Modigliani and Miller capital
structure hypothesis
M and M valuation model, investment
and financing interactions 508
management
incentive schemes 237
shareholder relationship 1415, 1623
see also directors
management charges, foreign direct
investment 6601
margin
market efficiency
defined 3556
financial markets 35565
importance 3567
levels 3578
semi-strong efficiency 3613
share dealing 35860
strong efficiency 364
weak efficiency 3601
market interest rates 12630
market portfolio, portfolio theory 2446
market portfolio risk, portfolio theory 248
market price, cost of capital 3835
market price of risk, portfolio theory
2478
market to book, intellectual capital 585
market value, option valuation 2967, 298
markets
financial see financial markets
maturity mis-match, interest rate risk
3401
maximizing shareholder wealth 78,

1415
mergers see acquisition decisions
mixed capital structure companies,
WACC 4212
Model Code, London Stock Exchange
1723
Modigliani and Miller (M and M) capital
structure hypothesis 443, 4557,
47782
CAPM 4978
dividend irrelevancy hypothesis 536
M and M valuation model 508
real world 4726
money market hedging, foreign exchange
hedging 61819, 621
money markets, interest rate risk 3257
multi-asset portfolios, portfolio theory
2347
multi-period capital rationing 15868
mutually exclusive investments, capital
rationing 157
mutually exclusive projects, IRR 94124
natural logarithms, tables 672
net present value (NPV) 6777
alternative interpretations 737
CAPM 278
decision rule 723
discounting example 6970
discounting process 689
graphical interpretation 757
model 745
and IRR 94124
vs. IRR 11516
mutually exclusive projects 94124
present values, calculating 71
project interdependence 949
rates of return, average/marginal 109
repair vs. replace 118
replacement cycle problem 11619
time horizon extension 1089
timing, cash flows 712
truncated 845
see also expected net present value
netting, foreign exchange hedging 617
NPV see net present value
792
INDEX
objectives, decision making 67, 11,

1430
offer prices, cost of capital 386
Office of Fair Trading (OFT), acquisition
decisions 570
operating leases 5245
opportunity cost of cash assumption,
internal rate of return (IRR) 1058
opportunity costs
debt capital 399400
optimal capital structure 4426
option contract markets
OTC options 3334
option forward contracts, foreign
exchange 6035
option Greeks, option valuation 314
option hedging, setting up, foreign
exchange hedging 62934
American options 293, 2967
area under the normal curve 3212
ATM 296
binomial model 31820
Black and Scholes model 298302,
3212
building blocks, investment 3027
call options 293, 294
characteristics, options 2912
delta 314
downside risk 31011
European options 293, 2967
exchange-traded options 293
fundamental relationship 3056
gamma 316
hedge ratio 31416
intrinsic value 295, 297
ITM 296
market value 2967, 298
option Greeks 314
OTC options 293
put-call parity theorem 30710
put options 293, 2945, 302
rho (phi) 317
risk-free investment portfolio 3067
share options 31014
speculating with calls 310
speculating with puts 31112
terminology 293
theta 31617
time value 296, 2978
types, options 292

vega 317
writing (selling) options 31314
options contracts, foreign exchange
hedging 6279
organic growth vs. acquisition growth
5602
over-the-counter (OTC) options
foreign exchange hedging 628, 6356
option contract markets 3334
overseas currency finance, foreign direct
investment 6467
owner-managers, company valuation 580
ownership and control, decision objectives
1516
payback method, investment appraisal
3441
advantages 367
decision criterion 38
disadvantages 389
ROCE 62
TVM 3940
pecking order theory, capital structure
48891
PER see price-earnings ratio
perfect markets
debt capital 4323
perpetuities, compounding and
discounting 867
personal taxation 47982
phi (rho), option valuation 317
physical investment line (PIL),
model 535
physical investments, cost of capital 380
PIL see physical investment line
plain vanilla bonds, cost of capital 3989
political/country risk, foreign direct
investment 642, 65960
pool of funds, WACC 423
portfolio betas, beta value 2645
portfolio, risk-free investment 3067
assumptions 2467
borrowing possibility 2402
CML 2438
combined borrowing and lending 242
combining risk-free and risky
investment 23940
793
INDEX
covariance 2279
diversification within companies 2489
dominance 233
graphical representation 2356
market portfolio 2446
market portfolio risk 248
market price of risk 2478
multi-asset portfolios 2347
practicality considerations 2367
risk and return 227
risk-free investment 23742
risk-reduction effect 22932
riskless asset plus risky portfolio 23940
risky-riskless boundary 2379
separation theorem 2434
three-asset portfolios 2345
two-asset portfolios 226, 237
PPPT see purchasing power parity
theorem
preference shares, cost of capital 40910
premiums, foreign exchange 6012
present value factors
tables 6678, 670
price-earnings ratio (PER)
CAPM 275
principal-agent problem, capital structure
4723
private debt costs 4317
problems, answers to 699786
profit, accounting role 910
financing cash flows 1326
inflation 12531
profit tax charge 1346
relevant cash flow 13641
taxation 1312
WDAs 1334
project discount rate
beta value 27881
WACC 4203
project interdependence
IRR 99108
NPV 949
project investment appraisal, CAPM
27881
project risk, WACC 4279
purchase or lease decision, investment and

purchasing power parity theorem (PPPT)
61011
pure expectations hypothesis, financial
markets 36975
put-call parity theorem
put-call parity equation 30910
put options
combining calls 31213
option valuation 293, 2945, 302, 305
speculating with puts 31112
quickie questions, answers to 67398
rates of return, average/marginal,
IRR/NPV 109
real interest rates 12630
real-world considerations, capital
structure 4726, 4913
redeemable debt, cost 402
regulation 1527
ineffective 267
repair vs. replace 118
replacement cycle problem, NPV 11619
required return on equity capital 3802,
3834
retained earnings, cost of capital 3923
return on capital employed (ROCE)
advantages 413
disadvantages 434
62
return on equity capital 3802
return on investment, risk and return
21216
revenue synergy, acquisition decisions
5545
reverse arbitrage 4534
see also arbitrage
rho (phi), option valuation 317
risk
business 44650, 4969
country/political risk 642, 65960
financial 44650, 4969
interest rate see interest rate risk
systematic/unsystematic 25962
see also uncertainty
794
INDEX
risk-adjusted discount rate 1946

risk-adjusted WACC, investment and
assumptions 2201
downside risk 21819
expected returns 21416
expected utility model 20612, 21920
individual choice 21112
investment decision 21222
investors behaviour axioms 2067
limitations 2212
return on investment 21216
risk techniques 17980, 1945
uncertainty 2045
upside potential 21819
utility function 20710
risk-free investment
portfolio 3067
risk-free bonds 3034
risk, interest rate see interest rate risk
risk, project, WACC 4279
risk-reduction effect, portfolio theory
22932
certainty-equivalents 1956
ENPV 18091
risk-adjusted discount rate 1946
risk and return 17980, 1945
sensitivity analysis 1914
risk types, foreign exchange hedging 615
riskless asset plus risky portfolio, portfolio
theory 23940
risky-riskless boundary, portfolio theory
2379
ROCE see return on capital employed
Rolls critique, CAPM 2734
satisficing shareholder wealth 1415
security market line (SML) 2825
CAPM 2559
CML 2559
derivation 2567
segmented markets, interest rates 3745
selling rates, exchange rates 5958
selling (writing) options, option valuation
31314
semi-annual interest payments 403
sensitivity analysis
decision pivot point 1913

limitations 1934
separation theorem
model 5761
share dealing, market efficiency 35860
share-for-share exchange, acquisition
decisions 5712
share options, option valuation 31014
shareholders
management relationship 1415, 1623
markets 385
maximizing shareholder wealth 78,
1415
shares
cum dividend 3867
ex dividend 3867
single-owner firms,
model 534
single-period capital rationing 1528
IRR 1578
sinking fund factors
table 669
SML see security market line
soft capital rationing 1501, 1589
speculating with calls, option valuation
310
speculating with puts, option valuation
31112
spot rates, interest rates 3679
Stiglitz, J 267
stock exchange rules, decision objectives
1723
stock market, workings 383
strip hedge, interest rate risk 342
structure, this books 4
suitable multiple, company valuation
5801
swaps, interest rate 3447
advantages/disadvantages 347
quality spread 3457
swaptions 345
synergy, acquisition decisions 5548
systematic risk, CAPM 25962
tables 66772
area under the normal curve 671
795
INDEX
natural logarithms 672

takeover defence
City Code 569
early warning system 5689
three-stage strategy 56971
takeovers see acquisition decisions
tax exhaustion, capital structure 476
tax synergy, acquisition decisions 5567
taxation
arbitrage 4712
asset betas 51516
corporate taxes 47982
corporation tax 1312, 1412, 4057
debt capital 4312
foreign projects 64953
gearing 4445
interest rates 3723
personal 47982
project cash flows 1312, 1346
V0 4647
WACC 429, 4647
technology, decision making, financial
1112
term structure, interest rates 3659
terminal value, annuities 88
table 668
theta, option valuation 31617
three-asset portfolios, portfolio theory
2345
ticks, futures contracts 3356
time dimension, decision making,
financial 1011
time horizon extension, IRR/NPV 1089
time option forward contracts, foreign
exchange 6035
time value of money (TVM)
model 515
3940
time value, option valuation 296, 2978
timing
cash flows 712
Tobins q quotient, intellectual capital
585
total market value model (V0)
assumptions 445
no-tax world 4445
traded currency options, foreign exchange
hedging 6289, 6356
traditional valuation model, investment
and financing interactions 508
transaction costs
interest rates 3723
transaction risk hedging
defined 615
transfer pricing, foreign direct investment
6601
translation risk
transmission vehicle, company as 1415
TVM see time value of money
two-asset portfolios, portfolio theory 226,
237
uncertainty
model 612
see also risk
unquoted debt 4078
unsystematic risk, CAPM 25962
upside potential, risk and return 21819
utility function
construction 2078
shape 20911
utility model, expected, risk and return
20612
V0 see total market value model
valuation, company see company
valuation
valuing synergy, acquisition decisions
5578
vega, option valuation 317
WACC see weighted average cost of
capital
WDAs (writing-down allowances) 1334
wealth
defining 8
maximization, decision objectives 1415
maximizing shareholder 78
796
INDEX
weighted average cost of capital (WACC)

42041
all-equity financed companies 4201
assumptions 421, 4256
constant capital structure 4223
formal derivation 424
5214
K0 calculation 4236
mixed capital structure companies
4212
pool of funds 423
project risk 4279
risk-adjusted 5214
role 4367
taxation 429, 4647

see also cost of capital
White Knight defence, acquisition
decisions 571
working capital, payback method,
WorldCom 267
writing-down allowances (WDAs) 1334
writing (selling) options, option valuation
31314
Yellow Book 1819
yield curve, interest rates 3667
yield to maturity, interest rates 366
zero coupon bonds 4034

Corporate Finance &amp; Decision Making

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Corporate Finance &amp; Decision Making

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Corporate finance

Theory and practice

In memory of Glynne Jones

For Vanessa and her friend Tommy

Steve Lumby and Chris Jones

Australia Canada Mexico Singapore Spain United Kingdom United States

Corporate Finance:Theory and Practice

Financial decision making

Traditional methods of investment appraisal

Investmentconsumption decision model

The discounted cash flow approach

Net present value and internal rate of return

Project cash flows

Simple risk techniques

10 Risk and return

12 The capital asset pricing model

14 Interest rate risk

16 The cost of capital

17 Weighted average cost of capital

18 Capital structure in a simple world

19 Capital structure in a complex world

20 Capital structure in practice

21 Investment and financing interactions

22 The dividend decision

MERGERS AND ACQUISITIONS

26 Foreign exchange hedging

27 Foreign direct investment

Answers to quickie questions

Financial decision making

The nature of financial decisions

Wealth maximization and the company

Traditional methods of investment appraisal

Investmentconsumption decision model

Introduction to the model

The discounted cash flow approach

Net present value

Net present value and internal rate of return

NPV and project interdependence

Project cash flows

Investment appraisal and inflation

Financing cash flows

Simple risk techniques

Risk and return

Chapter 10 Risk and return

Chapter 11 Portfolio theory

Chapter 12 The capital asset pricing model

The security market line

Chapter 13 Option valuation

Chapter 14 Interest rate risk

Chapter 15 Financial markets

Chapter 16 The cost of capital

The financing decision

Chapter 17 Weighted average cost of capital

The project discount rate

Capital structure in a simple world

Chapter 19 Capital structure in a complex world

Taxation and capital structure

Chapter 20 Capital structure in practice

The pecking order theory

Chapter 21 Investment and financing interactions

Company valuation and investment appraisal

Chapter 22 The dividend decision

Dividend policy in perfect capital markets

MERGERS AND ACQUISITIONS

Corporate Finance & Decision Making

Corporate Finance & Decision Making