Aklan State University

School of Management Sciences

Banga, Aklan
Lecture in Finance 2 No. 10
Financial Risk Management
Risk Management is the process of measuring or assessing risk and developing strategies to manage it.
Risk management is systematic approach in identifying, analyzing and controlling areas or events with a
potential for causing unwanted change.
As defined in the International Organization of Standardization (ISO 31000), risk management is the
identification, assessment and prioritization of risks followed by coordinated and economical application of
resources to minimize, monitor and control probability and/or impact of unfortunate events and to
maximize the realization of opportunities.
Basic Principles of Risk Management
The International Organization of Standardization (ISO) identifies the basic principles of risk management.
Risk management should:
1.
Create Value resources to spent to mitigate risk should be less than the consequence of inaction,
i.e., the benefits should exceed the cost
2.
Address uncertainty and assumptions
3.
By an integral part of the organizational processes and decision making
4.
Be dynamic, iterative, transparent, tailorable and responsive to change
5.
Create capability of continual improvement and enhancement considering the best available
information and human factors
6.
Be systematic, structured and continually or periodically reassessed
Elements of Risk Management
1.
Identification, characterization and assessment of threats
2.
Assessment of vulnerability of critical assets to specific threats
3.
Determination of the risk
4.
Identification of ways to reduce those risks
5.
Prioritization of risk reduction measures based on a strategy
Potential Risk Treatments
1.
Risk Avoidance This includes performing an activity that could carry risk. Avoiding risks,
however, also means losing out on the potential gain that accepting the risk may have allowed.
2.
Risk Reduction involves reducing the severity of the loss or the likelihood of the loss from
occurring.
3.
Risk Sharing means sharing with another party the burden of loss or the benefit of gain, from a
risk and the measures to reduce a risk.
4.
Risk Retention involves accepting the loss or benefit of gain, from a risk when it occurs.
Estimating Risk and Return on Assets
Risk is the variability of an assets future returns. Risk refers also to the chance that some unfavourable
event will occur.
Capital Asset Pricing Model (CAPM) is a model based on the proposition that any stocks required rate of
return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining
diversification.
Assessing Long-term Debt, Equity and Capital Structure
Introduction:
Capital refers to the investor supplied funds, debt, preferred shares, ordinary equity and retained
earnings.
Capital structure refers to the mix of debt, preferred stock and ordinary equity that the firm uses to
finance the firms assets.
Why Capital Structure Changes Over Time
1.
Deliberate management actions
2.
Market actions
Factors Influencing Optimal Capital Structure
1.
Control
6. Tax Consideration
11. Sales Stability
2.
Risk
7. Timing
12. Growth Rate
3.
Income
8. Profitability
13. Operating Leverage
4.
Cost of Capital
9. Marketability
14. Management Attitudes
5.
Financial Leverage
10. Company size
6.
7.
Business Risk and Financial Risk
1.
Business Risk, which is the riskiness of the firms assets if no debt is used. Business risk is the
most important determinant of capital structure and it represents the amount of risk that is inherent
in the firms operations even it uses no debt financing. It is the equity risk that comes from the
nature of the firms operating activities. The most commonly used measure of business risk is the
standard deviation of the firms return on invested capital or ROIC.

8.
9.

ROIC =

EBIT (1T )
Investor Supplied Capital

ROIC measures the after tax return that the firm provides for all of its investors. Since ROIC
does not vary the changes in the capital structure, the standard deviation of ROIC measures the
underlying risk of the firm considering the effects of debt financing, thereby providing a good
measure of business risk.
10.
Factors that Affect Business Risk
1. Variability of demand for the firms product
5. Variability of production cost
2. Competition
6. Foreign risk exposure
3. Variability of sales price
7. Legal exposure and regulatory risk
4. Product Obsolescence
8. Degree of Operating Leverage
2.
Financial Risk, which is the additional risk, placed on the ordinary equity shareholders as a result
of using debt.
11.
Capital structure policy involves a choice between risk and expected returns associated with
the firms financing mix.
12.
13.
Sources of Long-Term Financing
14.
Sources of Capital for Business Firms
a. Suppliers of debt financing which include capital funds borrowed from personal savings of friends or
relatives, financial institutions such as commercial bank loans or venture capitalists.
b. Suppliers of equity financing, which include capital funds invested by venture capitalists.
15.
16.
Advantages and Disadvantages of Debt Financing
17.
Advantages:
1.
Interest payments are tax deductible.
2.
The financial obligation is clearly specified and of fixed nature (with the exception of floating rate
bonds)
3.
In an inflationary economy, debt may be paid back with cheaper pesos.
4.
The use of debt, up to a prudent point, may lower the cost of capital to the firm. To the extent that
debt does not strain the risk position of the firm, its low after-tax cost may aid in reducing the
weighted overall cost of financing to the firms.
18.
Disadvantages:
1.
Interest and principal payment obligations are set by contact and must be met, regardless of the
economic position of the firm.
2.
Indenture agreements may place burdensome restrictions on the firm, such as maintenance of
working capital at a given level, limits on future debt offerings and guidelines for dividend policy.
Although bondholders generally do not have the right to vote, they may take virtual control of the
firm if important indenture provisions are not met.
3.
Utilized beyond a given point, debt may depress outstanding common stock values.
19.
20.
Classification of Debt Financing
1.
Term loans are always backed by some form of collateral. It should be noted that restricted
covenants are subject to negotiation. Term bonds are generally repaid with periodic instalments
which include both an interest and a principal component.
21.
Example: A firm borrows P1,500,000 which is to be repaid in five equal annual instalments. The loan
will carry an 8% rate of interest and payments will be made at the end of each of the next five
years.
a. Determine the annual amortization.
b. Prepare an amortization schedule that will show that the loan will be fully paid at the end of
five years?
2.
Bonds is any long-term promissory note issued by the firm. A bond certificate is the tangible
evidence of debt issued by a corporation or a governmental body and represents a loan made by
investors to the issuer
22.
Advantages:
1. The long-term debt is generally less expensive than other forms of financing because (a)
investors view debt as a relatively safe investment alternative and demand a lower rate of
return and (b) interest expenses are tax deductible.
2. Bondholders do not participate in extraordinary profits; the payments are limited to interest.
3. Bondholders do not have voting rights.
4. Floatation costs of bonds are generally lower than those of ordinary equity shares.
23.
Disadvantages:
1. Debt (other than income bonds) results in interest payments that, if not met, can force the
firm into bankruptcy.
2. Debt (other than income bonds) produces fixed charges, increasing the firms financial
leverage. Although this may not be a disadvantage to all firms, it certainly is for some firms
with unstable earnings streams.
3. Debt must be repaid at maturity and thus at some point involves a major cash outflow.
4. The typically restrictive in nature of indenture covenants may limit the firms future financial
flexibility

24.

Credit Quality Risk is the chance that the bond issuer will not be able to make timely
payments.
25.
Bond Ratings involve a judgment about a future risk potential of the bond provided by
rating agencies such as Moodys Standard and Poors and Fitch IBCA, Inc. Dominion Bond Rating
Services. Bond ratings are favourably affected by:
1. A low utilization of financial leverage
2. Profitable operations;
3. A low variability of past earnings;
4. Large firm size
5. Little use of subordinated debt
26.
Methods of Retiring Debt
1. Serial Payments
3. Call provision
2. Conversion
4. Bond Refunding
27.
28.
Preferred Shares is a class of equity shares which has preference over ordinary equity shares in
the payment of dividends and in the distribution of corporation assets in the event of liquidation
29.
Advantages:
1. Financing Flexibility
4. No maturity
2. Favorable financial leverage
5. Asset preservation
3. No dilution of control
6. No equal participation in earnings
30.
Disadvantages:
1. High Cost
2. Seniority of the holders claim
31.
32.
Ordinary Equity Share is a form of long-term equity that represents ownership interest of the
firm. Ordinary equity shareholders are called residual owners because their claims to earnings and
assets is what remains after satisfying the prior claims of various creditors and preferred
stockholders.
33.
Advantages:
1. No mandatory fixed charges
4. Increase creditworthiness
2. No definite maturity date
5. Avoidance of restrictive provisions
3. Potentially greater ease of sale
6. From a social viewpoint
34.
Disadvantages:
1. Dilution of control and earnings
2. Higher issue cost
3. Causes increase in component cost of capital
35.
36.
Leasing as a Form of Debt
37.
Advantages:
1. The lease may lack sufficient funds or the credit capability to purchase the asset from the
manufacturer, who is willing, however to accept a lease agreement or to arrange a lease obligation
with a third party.
2. The provisions of the lease obligation may be substantially less restrictive than those of a bond
indenture.
3. There may be no down payment requirement, as would generally be the case in the purchase of an
asset.
4. The lessor may possess particular expertise in a given industry allowing for expert product
selection, maintenance and eventual resale. Through this process, the negative effects of
obsolescence may be reduced.
5. Creditor claims on a certain types of leases, such as real estate are restricted in bankruptcy and
reorganization proceedings. Leases on chattels have no such limitation.
6. It is an easy method of financing capital asset having a heavy cost involved.
7. It permits the lessee for alternative use of funds without incurring huge capital investment on an
asset.
8. It spreads the capital cost over a period of the lease, so that sufficient flexibility is available by just
making payment of periodical lease rentals.
9. The lease rentals can be structured according to the needs of the lessee.
10. It helps to conserve the funds which can be used to improve the liquidity and can be used for some
other urgent purposes.
11. The lessee can avoid the risk of obsolescence by taking the asset on lease basis.
12. Leasing is free from restrictive covenants such as debt equity ratio, dividend declaration, etc.
13. Generally, lease or rent payments under operating lease are tax deductible.
14. Finally, a firm may wish to engaged in a sale-leaseback arrangement, in which assets already
owned by the lessee are sold to the lessor and then leased back.
38.
39.
Disadvantage:
1. The main criticism of leased method of financing is that the accounting procedure adopted for
recording lease method of financing is quite complicated.
2. Lease financing compared to other methods is generally more costly for the lease.
3. The financial lease has all the rigidities of other methods of financing
4. As the lease is not the owner of the asset, technically he cannot enforce the warranties or
guarantees enforceable against the vendor.

40.
41.
42.
43.
44.

Sharing Firm Wealth: Dividends, Share Repurchases and other Payouts

Introduction:
Dividend policy is an important subject in corporate finance and dividends are a major cash
outlay for many corporations.
Advantages of Paying Dividends:
1. Cash dividends can underscore good results and provide support to the equity share price.
2. Dividends may attract institutional investors who prefer some return in the form of dividends. A mix
of institutional and individual investors may allow a firm to raise capital at lower cost because of the
ability of the firm to reach a wider market.
3. Equity share price usually increases with the announcement of a new or increased dividend.
4. Dividends absorb excess cash flow and may reduce agency costs that arise from conflicts between
management and shareholders.

45.
46.

Disadvantages of Paying Dividends:

1. Dividends are taxed to recipients.
2. Dividends can reduce internal sources of financing. Dividends may force the firm to forgo positive
NPV projects or to rely on costly external equity financing.
3. Once established, dividend cuts are hard to make without adversely affecting the firms equity
share price.
47.
Dividend Policy Theories:
1. Dividend Policy Irrelevance Theory. It has been agreed that dividend policy has no effect on
either the price of a firms stock or its cost of capital that is that dividend policy is irrelevant. Thus,
the shareholder is indifferent to a choice between dividends today or to a claim on future earnings.
The proponents of the dividend policy irrelevant theory are Merton Miller and Franco Modigliani.
2. Dividend Policy Relevance Theory. The dividend relevance viewpoint states that in a world with
market imperfections such as taxes, floatation cost and transaction costs, a companys dividend
policy affects its market value.
3. Residual Theory of Dividend Policy. It views that dividends are paid out of the residual or
leftover earnings remaining after profitable investment opportunities are exhausted. In practice,
dividend policy is very much influenced by investment opportunities and by the availability of funds
with which to finance new investments.
48.
Factors Influencing Dividend Policy
1. Restrictions on dividend payments
a. Contractual Constraints
b. Legal Constraints
2. Investment Opportunities
3. Availability and cost of alternative sources of capital
a. Dividend Policy
b. Cost of selling new stock
c. Ability to substitute debt for equity
d. Control
4. Effects of dividend policy on the cost retained earnings
49.
Types of Dividend Policy
1. Stable Dividend Policy is characterized by the tendency to keep a stable peso amount of
dividends per share from period to period.
2. Constant Dividend Payout Ratio Policy is one in which a firm pays out a constant percentage of
earnings as dividends.
3. Regular Dividends Plus Extras Policy is one in which a firm maintains a low regular dividend
plus an extra dividend, if unwarranted by the firms earnings performance.
50.
Types of Dividends
1. Cash Dividends
a. Regular cash dividends
b. Extra dividends
c. Special Dividends
d. Liquidating Dividends
2. Stock Dividends
51.
Basics of Capital Budgeting
52.
Introduction:
53.
Strategies asset allocation process is usually more involved than just deciding whether to buy
F
a particular fixed asset.
54.
Capital Budgeting Process is a system of interrelated steps for making long-term investment
E
decisions.
55.
E
Goals
Business Strategy
Environment
56.
D
57.
58.

CAPITAL BUDGETING PROCESS

B

59.

Generating Project Proposals

Collecting Relevant Information About Opportunities

Implementing
and
Reviewing
Selecting
Projects
Estimating
Cash
FlowsProjects
Evaluating
Project
Proposals

60.

4
3
6
5

A
C

Information
Requireme
nts

61.
62.
63.
64.
65.
66.
67.
68.

Capital Budgeting Decisions

1. Replacement decisions to continuous current operations
6. Safety and/or environmental
projects
2. Replacement to effect cost reduction
7. Mergers
3. Expansion to new products or markets
8. Other projects
4. Expansion of existing products or markets
5. Equipment selection decisions
69.
Cash Flow the Project Falls into Three Categories
1. Net Initial Investment is the net initial cash outlay needed to acquire a specific investment
project
70.
Formula:
71.
Purchase Price of New Asset
72.
+
Installation and transportation cost
73.
+
Additional net working capital
Proceeds from sale of old asset
74.
+/Tax effects on disposal of old asset
75.
And/or the purchase of new one
76.
Net Investment
77.
Example:
78.
Kendra Enterprises plans to add a new machine to increase product capacity. The machine cost
P18,000 plus P20,000 for installation and transportation costs and requires P40,000 additional
working capital. The net investment is:
79.
Purchase price of new machine
P180,000
Purchase Price of machine
P180,000
80.
+
Installation & transportation
20,000
+Installation & Transportation cost
20,000
81.
+
Additional Working Capital
40,000
Depreciable Basis
P200,000
82.
Net Investment
P240,000
2. Net Operating Cash Flows or Returns are the incremental changes in the firms cash flows that
result from investing in a project
83.
Formula:
84.
Annual incremental revenue from the project
Pxxx
85.
Less: Incremental cash operating costs
xxx
86.
Annual Cash inflow before taxes
Pxxx
87.
Less: Taxes
88.
[Tax rate (Annual cash inflow before taxes-Depreciation)]
xxx
89.
Annual Net cash inflow after Taxes
Pxxx
90.
Or
91.
Annual incremental revenue from the project
Pxxx
92.
Less: Incremental cash operating costs
xxx
93.
Annual cash inflow before taxes
Pxxx
94.
Less: Incremental depreciation
xxx
95.
Net income before taxes
P xxx
96.
Less: Income Taxes
xxx
97.
Net Income After Taxes
Pxxx
98.
Add: Incremental Depreciation
xxx
99.
Annual Net cash inflow after taxes
Pxxx
100.
101.
Annual cash operating costs (if the old asset or method is used)
Pxxx
102.
Less: Annual cash operating costs (if the new asset or method is used)
xxx
103.
Annual cash savings before taxes
xxx
104.
Less: Taxes
105.
[Tax rate (Annual cash inflow before taxes Incremental Depreciation)] xxx
106.
Annual cash savings after taxes
Pxxx
107.
Or
108.
Cash operating costs (if the old asset or method is used)
Pxxx
109.
Less: Annual Cash Operating Costs (if the new asset or method is used)
xxx
110.
Cash Savings before Taxes
Pxxx
111.
Less: Incremental Depreciation
xxx
112.
Increase in Income before Taxes
Pxxx

113.
114.
115.
116.
117.

118.
119.
120.
121.
122.
123.
124.
125.
126.
127.
128.
129.
130.
131.
132.
133.

Less: Income Taxes

xxx
Increase in Income After Taxes
Pxxx
Add: Incremental Depreciation
xxx
Net Cash Savings after Taxes
Pxxx
Illustrative Example: The Visayan Division of Marlow Supply Company has been considering a
new production method that can reduce materials costs by an estimated amount of P52,000 a year.
The new method is also expected to result in annual savings of labor and overhead method is
estimated at P40,000 a year over a period of 10 years. Income taxes are estimated at 30% of
income before income taxes. What are the annual net returns (or savings) expected from new
production method?
Solution:
Annual savings in direct material costs
P52,000
Annual savings in direct material labor and overhead costs
64,000
Total Savings before depreciation
P116,000
Less: Depreciation
40,000
Savings after Depreciation
P56,000
Less: Incremental income taxes (30%)
16,800
Net Increase in Income
P39,200
Add: Depreciation
40,000
Net cash returns (Savings)
P79,200
Capital Budgeting Risk
Forecasting risk or estimation risk is the possibility that a bad decision will be made because of
errors in the projected cash flows. Because of forecasting risk, there is a danger that we will
conclude a project has a positive NPV when it really does not.
Screening and Selecting Capital Investment Proposals
Capital Budgeting Techniques
A. Net Present Value Method
1. Net Present Value Method
134.
Net present value is the excess of present value of the projects cash inflows over the
amount of the initial investment. The advantages of using NPV are that it considers the
magnitude and timing of cash flows, provides an objection criterion for decision making
which maximizes shareholders wealth and is the most conceptually correct capital budgeting
approach. The disadvantages of using NPV are that it is more difficult to compute an
unsophisticated methods and its meaning is difficult to interpret because the NPV does not
provide a measure of the projects actual rate of return.
135.
Formula:
136.
Present Value of Cash Inflow computed based on minimum desired discount
rate
Pxxx
137.
Less: Present Value of Investment
Pxxx
138.
Net Present Value
Pxxx
139.
140.
Decision Rule: Accept the project if the NPV is equal or greater than zero; otherwise
the project is rejected.
141.
142.
Illustrative Example: NPV Application: Uniform Cash Inflows
143.
Project A has a net investment of P120,000 and annual net cash inflows of P50,000
for five years. Management wants to calculate Project As net present value using 16%
discount.
144.
Solution:
145.
Present Value of cash inflows (P50,000 x 3.274)
P163,700
146.
Less: Net Investment
120,000
147.
Net Present Value
P 43,700
148.
Illustrative Example: NPV Application: Uneven Cash Inflows
149.
Detdet Corp. plans to invest in a four-year project that will cost P750,000. Detdets
cost of capital is 8%. Additional information on the project is as follows:
150.
Year
Cash Flow from Operations, net of taxes
PV of P1 at 8%
151.
1
P200,000
0.926
152.
2
220,000
0.857
153.
3
240,000
0.794
154.
4
260,000
0.735
155.
Required: Using the net present value method, determine whether the project is
acceptable or not.
156.
Solution:
Year
Amount
(A)
PV of P1 at 8% (B) PV
(AxB)
157.
1
P200,000
0.926
P185,200
158.
2
220,000
0.857
188,540
159.
3
240,000
0.794
190,560
160.
4
260,000
0.735
191,100

161.
162.

Total
Less: Present Value of Investment

P755,400

750,000
163.
Net Present Value
P
5,400
164.
2. Internal Rate of Return
165.
IRR is also known as a discount rate of return and time adjusted rate of return is the
rate which equates the present value of the future cash inflows with the cost of investment
which produces them.
166.
Decision Rule:
167.
Accept Project if IRR > Cost of Capital
168.
Reject Project if IRR < Cost of Capital
169.
3. Profitability Index
170.
The profitability index is the ratio of the total present value of the future cash flows
divided by its investment.
171.
Formula:

172.

PV Index

PV of Cash Inflows
PV OF Net Investment

173.

Decision Rule: The higher the PV Index the more desirable the project. Projects with
index of 1 or greater than one should be accepted; otherwise the project is rejected.
174.
Advantages:
a. It considers the magnitude and timing of cash flows;
b. It provides an objective criterion for decision making which maximizes shareholders
wealth;
c. It provides a relative measure of return per peso of net investment
175.
The disadvantage of using PV Index is that conflict may arise with the NPV when
dealing with mutually exclusive investment.
176.
Illustrative Example:
177.
XYZ Company has a P200,000 funds available for investment. It is considering the
following projects:
178.
A
B
C
179.
180.
181.
182.
183.
a.
b.
c.
184.
a.

Present Value of Annual

Cash Inflow
P244,000
P130,000
Less: Investment required
200,000
100,000
Net Present Value
P44,000
P30,000
Required:
Compute the profitability index of each project.
Rank each project on the basis of PV index
Which project should be undertaken?
Solution:
Computation of Profitability or PV index

185.

P30,000

P 244,000
P 200,000

= 1.22

Project B

P 130,000
P 100,000

= 1.30

Project C

P 130,000
P 100,000

= 1.30

188.
189.

100,000

Project A

186.
187.

P130,000

b. Ranking of Projects
190.
Rank
Project
191.
1
B and C
192.
2
A
c. The company should invest in Projects B and C for the following reasons:
a) The PV indexes of Projects B and C are higher than A
b) The combined Net Present Value of the Projects B and C is higher than that of
Project A.
c) The company can afford to invest in both A and B.
4. Discounted Payback Period
193.
Discounted Payback Period is a capital budgeting method that determines the length
of time required for the investment cash flows, discounted at the investments cost of capital,
to cover its cost.
194.
Decision Rule:

195.
Accept Project if Calculated DBP Maximum Allowable Discounted Payback
196.
Reject Project if Calculated DBP > Maximum Allowable Discounted Payback
B. Non-Discounted Cash Flow Approach
1. Payback Period
197.
Payback Period is the length of time required for projects cumulative net cash inflows to
equal its net investment. It measures the time required for a project to break-even.
198.
Formula:

199.

Payback Period with Equal Cash Flows

Net Investment
Annual Net Cash Inflows

200.
201.

Payback Period

Number of Years Prior Full Recovery+

Unrecovered Cost at the Start of Year

Cash Flow During Full Recovered

202.

Decision Rule: The desirability of the project is determined by comparing the projects
payback period against the maximum acceptable payback period as predetermined by
management. The project with shorter payback period than the maximum will be accepted.
In short:
203.
If: PB period Maximum allowed PB period; Accept
204.
If: PB period > Maximum allowed PB period; Reject
205.
Advantages:
a. It is easy to compute and understand.
b. It is used to measure the degree of risk associated with a project.
c. Generally, the longer the payback period, the higher the risk.
d. It is used to select projects which provide a quick return of invested funds.
206.
Disadvantages:
a. It does not recognize the time value of money.
b. It ignores the impact of cash inflows after payback period.
c. It does not distinguish between alternatives having different economic lives.
d. The conventional payback computation fails to consider salvage value, if any.
e. It does not measure profitability only the relative liquidity of the investment.
f. There is no necessary relationship between a given payback and investor wealth
maximization so an investor would not know what an acceptable payback is.
2. Bail-out Period
207.
In conventional payback computations, investment salvage value is usually ignored. An
approach which incorporates the salvage value in payback computations is the Bail-out
Period. This is reached when the cumulative cash earnings plus the salvage value at the end of
particular year equals the original investment.
208.
3. Payback Reciprocal
209.
Payback reciprocal measures the rate of recovery of investment during the payback period.
For projects with even cash flows, the payback reciprocal is computed as follows:

210.

Payback Reciprocal

1
Payback Period

211.

For projects with uneven cash flows, the payback reciprocal can be computed on an annual
basis by dividing the Cash Inflows for the year by the net investment.
212.
Alternative Way:

213.
214.
215.
216.

Payback Period Reciprocal

1
100
Payback Period

Thus, if a project has a payback period of 2.5 years, then the payback period reciprocal
would be:

1
100
2.5

40%

The higher the payback period reciprocal, (and hence the lower the payback period) the
more worthwhile the project becomes. The only relevance of this calculation is that laymen may
be more at ease in discussing percentage measures.
4. Accounting Rate of Return
217.
Accounting rate of return (ARR) or simple rate of return is a measure of a projects
profitability from a conventional accounting standpoint by relating the required investment to
the future annual net income.
218.
There are numerous ways to compute the ARR, but the most use way is to divide the
projects average annual net income by its initial investment or average net investments.
Average annual net income is determined by summing the expected net incomes over the
projects life and dividing by the total number of periods in the life of the project. Average net
investment is assumed to be one-half of the net investment.
219.
Formula:

220.

ARR

221.
222.

ARR

224.
225.
if

229.

230.
231.
232.
233.
234.
235.
236.
237.

Average Annual Net Income

Initial Investment Average Investment

Or, if a cost reduction project is involved, the formula becomes:

223.

226.
227.
228.

Cost SavingsDepreciation on New Equipment

Initial Investment Average Investment

Decision Rule:
Under the ARR method, choose the project with the highest rate of return. Accept the project
the ARR is greater than the cost of capital, Thus:
If: ARR Required rate of return; Accept
If: ARR < Required rate of return; Reject
Advantages:
a. It is easily understood by investors acquainted with financial statements.
b. It is used as a rough preliminary screening device of investment proposals.
Disadvantages:
a. It ignores the time value of money by failing to discount the future cash inflows and
outflows.
b. It does not consider the timing component of cash inflows.
c. Different averaging techniques may yield inaccurate answers.
d. It utilizes the concepts of capital and income primarily designed for the purposes of
financial statements preparation and which may not be relevant to the evaluation of
investment proposals.

Mergers and Acquisitions; Divestitures

Nature and Types of Mergers and Acquisitions
Merger is a transaction in which two firms combine to form a single firm.
Acquisition is the purchase of one firm by another.
Consolidation another type of merger in which an entirely new firm is created. A consolidation
absorbs both the bidder and target firms to this new firm and the old firms cease to exist as
separate entities.

Classification of Merger:
1. Horizontal merger is one that combines two companies in the same industry.
2. Vertical merger combines a firm with a supplier or distributor.
3. Conglomerate merger combines two companies that have no related products or market.
238.
Product Extension Merger is a combination of firms that sell different, but somewhat related
products.
239.
240.
Motives for Business Combinations
241.
Financial Motives
1. Maintenance of the firms rate of return
5. Lowering Cost of Capital
2. Revenue enhancement
6. Exhaust unused debt potential
3. Cost reduction
7. Reduction in bankruptcy costs
4. Tax considerations
242.
243.
Non-Financial Motives
1. Managers personal incentives
2. Possible synergistic effect
244.
245.
Valuing a Merger
246.
The Net Present Value (NPV) or the discounted cash flow (DCF) method is the most practical and
reliable tool used to evaluate whether a merger will be a profitable one. The NPV method allows the
bidder and target firm managers to predict pro forma cash flows of the merged firm.
247.
248.
Methods of Payment in Merger Transactions
1. Cash Purchase
249.
The purchase of another company can be viewed within the context of a capital budgeting decision.
Instead of purchasing new plant or machinery, the purchaser has opted to acquire a going concern.
2. Stock-for-Stock Exchange
250.
The shareholders of the acquired firm are concerned mainly about the initial price they are paid for
their shares and about the outlook for the requiring firm.
3. Debt and Preferred Stock Financing
251.
Since some investors prefer growth stocks, while others seek substantial dividend or interest
income, an acquiring company must at times offer a combination of securities in settlement with
the new stockholders. In an attempt to tailor a security for such investors, convertible debentures
and convertible preferred stock have frequently been used.
252.
Advantages:
a. Potential earnings dilution may be partially minimized by issuing a convertible security.
b. A convertible issue may allow the acquiring company to comply with the sellers income
objectives without changing its own dividend policy.

c. Convertible preferred stock also represents a possible way of lowering the voting power of
the acquired company.
4. Deferred Payment Plan
253.
The deferred payment plan, which has come to be called an earn-out, represents a relatively recent
approach to merger financing. The acquiring firm agrees to make a specified initial payment of cash
or stock and, if it can maintained or increase earnings, to pay additional compensation.
254.
Tender Offer
255.
A tender offer involves a bid by an interested party for controlling interest in another corporation.
The prospective purchaser approaches the stockholders of the firm, rather than the management,
to encourage them to sell their shares, typically at a premium over current market price.
256.
Tactics to Resist Unfriendly Mergers (Defense Tactics)
1.
White Knight
257.
A white knight is a company that comes to the rescue of a corporation that is being targeted for a
takeover.
2.
PacMan
258.
Pacman, the name taken from the video game, is another defensive tactic to tender offers, where
the firm under attack becomes the attacker.
3.
Shark Repellents
259.
Shark repellents are often used to discouraged unfriendly takeovers. As an example, a firm may
revise its by-laws to stagger the terms of directors so that only a few come up for election in any
one year.
4.
Poison Pill
260.
Another tactic is the poison pill, an action initiated automatically, if an unfriendly party tries to
acquire the firm. For instance, management might devise a plan whereby all the firms debt
becomes due, if the management is removed.
5.
Golden Parachute
261.
Still another tactic is the golden parachute, which stipulates that the acquiring company must pay
the executives of the acquired firm a substantial sum of money to let them down easy as new
management is brought into the company.
6.
Greenmail
262.
Greenmail or targeted repurchase is a defensive tactic used to protect against takeover after a
bidder buys a large number of shares on the open market and makes a tender offer.
7.
Staggered election of directors
263.
Staggered election of directors requires new shareholders to wait several years before being able to
place their own people on the board.
8.
Fair price provisions
264.
Warrants issued to shareholders that permit purchase of equity share at a small percentage (often
half) of market price in the event of a takeover attempt.
9.
Flip-over rights
265.
The charter of a target corporation may provide for its shareholders to acquire in exchange for their
equity share (in the target) a relatively greater interest in an acquiring entity.
10.
Flip-in rights
266.
Acquisition of more than a specified ownership interest in the target corporation by a raider is a
contingency, the occurrence of which triggers additional rights in the equity share other than the
equity shares acquired by the raider.
11.
Issuing Equity share
267.
The target corporation significantly increases the amount of outstanding equity share.
12.
Reverse Tender
268.
The target corporation may respond with a tender offer to acquire control of the tender offeror.
13.
Crown jewel transfer
269.
The target corporation sells or otherwise disposes of one or more assets that made it a desirable
target.
270.
14.
Legal action
271.
The target corporation may challenge one or more aspects of a tender offer. Delays increase costs
to the raider and enable defensive action.
272.
Divestitures
273.
A divestiture represents a variety of ways to divest a portion of the firms assets. It has become an
important vehicle in restructuring the corporation into a more efficient operation.
274.
Types:
1.
Sell-off - is the sale of a subsidiary, division or product line by one company to another.
2.
Spin-off Involves the separation of a subsidiary from its parent, with no change in the equity
ownership.
3.
Liquidation the asset sold to another company and the proceeds are distributed to the
stockholders.
4.
Going Private results when a company whose stock is traded publicly is purchased by a small
group of investors and the stock is no longer bought and sold on a public exchange.
5.
Leverage buyout is a special case of going private. The existing shareholders sell their shares to
a small group of investors.
275.
276.
International Aspects of Corporate Finance
277.
Why do companies, foreign and domestic go international?

1.
2.
3.
4.
5.
6.
7.
278.
1.
2.
3.
4.
5.
6.
7.

To seek new markets

To seek raw materials
To seek new technology
To seek production efficiency and cheaper costs
To take advantage of increasing capital flow between countries for international financial
investment purposes
To avoid political and regulatory constraints
To diversify
Problems Facing Multinational Companies
Trading in wider range currencies
Differing legal, taxation and political environments
Differing economic and capital markets
Wider range of products and factor markets each with differing levels of competition and efficiency.
Difficulty in organizing, evaluating and controlling divisions of a company when they are separated
geographically and when they operate in different environments.
Language and cultural differences
Political risk arises when a nation exercises sovereignty over the people and property in its
territory.

279.
280.
281.
282.
283.
284.
285.
286.
287.
288.

289.