Académique Documents
Professionnel Documents
Culture Documents
Nyathi
A. Mashiri
COURSE OBJECTIVES
To gain, understand and appreciation of the different sources of finance, their
management, their advantages and disadvantages and their effects on capital
structure. To comprehend the basics of security valuation, its applicability to other
areas of corporate finance, to gain appreciation of corporate activities and finally
restructuring.
COURSE OUTLINE
1. Sources of Finance
4.1. Overview of Financial Markets
4.2. Evaluation of Main Sources of Finance
4.3. Equity Issues, Rights Issues, Retained Issues
4.4. Bond Issues and other debt instruments
4.5. Venture Capital
2. Valuation of Securities
2.1. Bond Valuation
2.2. Bond Yields
2.3. Risks Associated in Investing in Bonds
2.4. Equity Valuation
2.5. Option Valuation
2 of 123
A. Mashiri
5. Leasing f Financing
5.1. Dividend Defined
5.2. Types of Leases
5.3. Forms of Lease Financing
5.4. Rational of Leasing
5.5. Accounting and Tax Treatment of Leasing
5.6. Evaluation of leases
5.7. Present value of Lease Contract
5.8. Valuation of Borrowing Alternative
5.9. Importance of the Tax Rate
5.10. Issues in Lease Analysis
5.11. Hire Purchase
Suggested Reading
Brealey, Richard and Meyers, Stewart, Principles of Corporate Finance; 4th ed.
Brigham, Eugine F and Ehrhardt Michael C (202), Financial Management:
Theory and Practice, 10th edition.
3 of 123
A. Mashiri
Pike, Richard and Neale, Bill, (2006) Corporate Finance and Investment:
Decision and Strategies, 5th Edition, Prentice Hall
Van Horne, James, Financial Management and Policy, 4th edition, Prentice
Hall International Editions.
Weston Fred J and Copeland, Thomas Managerial Finance, 9th edition,
Dryden Press International
Weighting of Assessment
Examination -
70%
Coursework -
30%
1. SOURCES OF FINANCE
1.1. Overview of Financial Markets
This topic identifies the sources of finance namely Debt and Equity capital.
Source of debt and equity is the financial market.
Financial Market is a place through which securities are created and traded.
There are several different types of financial markets:(a). Physical Asset Markets.
These are the tangible assets e.g. maize, cars, real estate, and
computers e.t.c.
(b). Financial Asset Markets
These deal with stocks, bonds, mortgages and other financial
instruments which are merely claims on real estate.
(c). Continuous Markets & Call Markets
Some markets operate on a continuous basis during opening hours
whilst some markets trade at specific times during opening hours e.g.
the Zimbabwe Stock Exchange open at 0900 and 1200 hours these
are the call markets.
(d). Spot Markets & Future Markets
These are terms that refer to whether the assets are being bought or
sold on the spot delivery or future delivery e.g. Zimbabwe Stock
Exchange you buy shares today and get them 7 days later.
4 of 123
A. Mashiri
When an asset is bought or sold for future delivery at some date then it
is traded in future market.
(e). Primary & Secondary Markets
Primary markets are markets in which companies raise new capital
either by a bond issue or issue of new stock.
Secondary markets are markets already in existence in which securities
are traded amongst investor.
NOTE: The issuer of the security does not receive any proceeds from
the sale of the security in a secondary market.
(f).
Secondary Markets
A secondary market is a market in which securities are traded. There are two
main markets to be considered:
Organised Exchanges
Organised Exchanges
5 of 123
A. Mashiri
Stock markets are the most creative and most important secondary markets.
Without a healthy secondary market for shares there will only be a limited
market for new share issues.
A. Mashiri
The companies selected for those purpose as included in the official trading list.
Certain strict standards must be met and fees paid for initial and continued
listing.
Reasons for Listing
(a). Founder Diversification
The founders of the company have most of their wealth tied up in their
company; hence by selling some of their shares in a public offering they
can diversify their shareholding thereby reducing the risk in their
personal portfolios.
(b). It increases liquidity
- Shares in a privately owned company are in liquid as they do not
have a ready market.
- Search costs are incurred in trying to locate a willing buyer.
- Furthermore there are problems in valuing the stake in that market
- However by listing these problems are usually eliminated.
(c). It facilitates the raising of new cash
- It is difficult to raise new cash by selling new stock in a private
company, the reason being the existing owners might not have the
cash or they might reluctant to put in more money in the business.
- It is even more difficult to get outsiders to invest in a private company
as they will not have sufficient voting rights and might not get a return
in the form of dividends.
(d). To establish value of Company
You can easily establish value of a listed company.
(e). Prestige
- Companies seek listing for prestige reasons meaning you have met
requirements of listing such as fees e.t.c.
- Since the company will be known it becomes easy even to borrow
because you will be known.
7 of 123
A. Mashiri
Disadvantages of Listing
(a). Cost of Reporting
- Listed companies are required to publish annual and semi-annual
results which are very costly.
- Accounts have to be audited and furthermore public has to be alerted
on any developments in that company that might affect the share
price.
8 of 123
A. Mashiri
De-Listing
It is the process of making a public company private.
De-listing can be volunteering or it can arise because a company has fallen
short of the listing regulations.
Reasons for de-listing
9 of 123
A. Mashiri
Fear of Take-over
Companies may be liable to hostile takeovers by larger and more
established companies.
Debt Capital
Equity Capital
Debt capital
-
This can be long term e.g. bonds and debentures or can be short term
e.g. bank overdraft or commercial paper.
10 of 123
A. Mashiri
Long term debt is sourced from banks and other lenders of capital such
as life assurance companies or pension funds e.g. PTC Pension Fund.
Where a company needs to fill in a short term funding gap it can use
short term debt, e.g. money market which has duration of less than a
year and is found under the current liabilities in Balance Sheet.
A creditor does not have voting rights does not participate in the
management of the entity.
The lender may require security and in the event of a default the lender
has a right to repossess the asset.
High credits standards and a strong financial position are required for a
company to access debt capital.
11 of 123
A. Mashiri
Rights Issue
It provides a way of raising new share capital by means of an offer to existing
shareholders inviting them to subscribe cash for new shares in proportion to
the existing holdings.
For example a right issue on a 1 for 4 basis, (1:4) at $2.80 per share would
mean that a company is inviting its existing shareholders to subscribe for one
new share for every 4 shares that they hold at a price of $2.80 per share.
Retained earnings
-
These are profits that are not paid out as dividends but are retained in
the company.
A. Mashiri
Start up Capital
Launch
Launch Stage
-
If the product still appears financially viable after these initial investments
the additional expenditure can be made for operating facilities e.g.
operating equipment then start up capital will then be required.
Start-up Business
Note: The start-up stage for a company represents highest level of business
(Which is risk associated with business itself e.g. high fixed costs, price
controls e.t.c.
In the launch stage the very high business risk implies that cost should be
kept variable and long term financial commitments should be avoided.
13 of 123
A. Mashiri
Business Angels
-
These are individuals that have made money in their own enterprises and
are seeking the excitement in the financial reward of investing in another
business.
The Angels usually receive stock / shares and a seat on the Board of
Directors.
They have a very flexible approach and their analysis less vigorous.
However they can only invest much lower amounts that Venture Capitalists.
Venture Capitalists
-
Their focus is to invest during the high risk start up phase of business
which if it is successful they can realise capital gains.
As the total risk of a company declines over its transition from launch to
growth stage, the returns on new capital will fall, and hence venture
capitalists will no longer be interested in financing further operations. They
want to exit at this point and invest the proceeds in further high risk
investments
NB: Example of Venture Capitalists is Takura Ventures
Corporate Ventures:
14 of 123
A. Mashiri
Although business risk is still high it has been reduced from that of the
launch stage.
Initial public offerings are common at this stage and provide an exit route
for venture capitalists.
At this stage in the life cycle product demand and supply are now
synchronized.
Because the cash flow are positive this enables the company to service
interest and principle repayment.
At this stage demand for the product will eventually start to fall.
Business risk is low at this stage and using more debt can increase the
financial risk.
15 of 123
A. Mashiri
Characteristics of Bonds:
1. Par Value / face value
-
It is the stated face value of the bond. This is the amount paid to the
bond holder on the maturity of the bond.
The par value represents the amount the issuer borrows and promises
to repay on the maturity date.
2. Coupon Rate
-
3. Yield
-
They yield changes with changes in interest rates in the economy and
credit worthiness of the issuer.
4. Maturity
-
Bonds have specific maturity dates on which the par value must be
repaid.
The effective maturity of a bond declines each year after it has been
issued.
Bonds Classification
1. Coupon Payments
16 of 123
(a).
A. Mashiri
- Floating rate bonds make payments that are tied to some measure of
current market rate.
- The payments can be linked to an index or from a current market rate
e.g. Treasury Bills rate or LOBOR.
(d).
Income Bonds.
- They provide coupon payments that must be paid only if the earnings
of the firm are sufficient to meet the interest obligations. The principal
however must be paid when due.
2. Redemption Dates / Maturity Dates
(a).
(b).
Callable Bonds.
-
Callable bonds give the issuer the rights but not the obligation to
redeem the bond before maturity.
17 of 123
(c).
A. Mashiri
Puttable Bonds.
These bonds give bond holders the right but not the obligations to
sell their bonds back to the issuer at predetermined price and date.
(d).
(e).
Convertible Bonds
It is one that can be converted at the option of the holder into certain
number of shares in that company.
E.g. BAT issues bonds for $1000 to mature in December 2008. The
buyer will be given an option to convert the bond into shares worth
for example 20 shares and hence becomes a shareholder.
(b).
(c).
Municipal Bonds.
These are issued by the municipality and local government
(d).
Foreign Bonds.
These are issued by foreign government or foreign companies.
NOTE: - It is important to know the issuer so that one can asses the risk
involved under the bond being issued.
4. Priority
- The priority of the bond determines the probability that the issuer will
pay you back your money.
- The priority indicates your place in line should a company defaults in
payments.
18 of 123
(b).
A. Mashiri
(c).
5. Currency
(a).
Domestic Bonds.
These are bonds issued by the domestic borrower in their own
national markets denominated in the local currency that can be
purchased by anyone in possession of that currency.
(b).
Foreign Bonds.
These are bonds issued by the national markets by foreign
companies or government in the currency of that country in which
the market is based.
The issues are subjected to regulations and supervision of the
national market.
Examples:
* Bonds issued pound sterling in London by foreigners are called
Bulldog Bonds
* Similarly bonds issued in US$ denominations in New York by a
foreigner are called Yankee Bonds
* Bonds issued in Japan by foreigners in Yen denominations are
called Samurai Bonds
(c).
Euro Bonds.
-
A. Mashiri
Yield
20 of 123
A. Mashiri
However a change in the level of interest rates does not affect all
bonds in the same way.
The Price Yield Curve is a plot of the bonds required rate of return to
its corresponding price.
When you calculate the price of a bond you are calculating the
maximum price you would want to pay for the bond given the
bonds coupon rate in comparison to the average rate most
investors are currently receiving in the bond market.
Premium
Discount
Par
(c) Premium
If the bond price is higher than its par value the bond will sell at a
premium its coupon rate is higher than the required yield or
prevailing rates.
That is Coupon rate yield
21 of 123
A. Mashiri
(d) Discount
If the bond price is lower than its par value the bond will sell at a
discount the reason being coupon rate will be lower than the yield.
(e) Par
This means the interest rate of the bond equals the prevailing rate.
If the coupon rate on the bond equals the prevailing interest rates
the bonds trades at par.
That is Coupon rate = yield
2.
VALUATION OF SECURITIES
C
C
C
M
+
+ ......
+
(1 + i ) (+1) 2
(1 + i ) n (1 + i ) n
1
n
(1 + i )
M
Cx
+
i
(1 + i ) n
Where:-
Coupon Payment
number of payments
22 of 123
A. Mashiri
For Interest payment paid more than once a year we effect the formulae
below
Bond Price
1
1
(1 + i ) n f
f
C
x
i
f
f
M
i
(1 + ) n f
f
Where:-
frequency
Bond Price
1
1
(1 + i ) n f
f
C
x
i
f
f
M
i
(1 + ) n f
f
23 of 123
A. Mashiri
1
0
,
12
10
2
(1 +
)
100
1000
2
x
+
12 2
0,12
2
0,12
1
+
2
2
50 x
573,50 + 311,80
885,30
0,06
Example 2:
25 years ago ZESA issued an annual coupon payment bond with a 10%
coupon rate and a $1,000 par value.
The bond has now 10 years remaining until maturity.
Due to the change in the interest rates and market conditions the required
rate of return on the Bond is 8%.
What is the intrinsic value of the Bond?
Solution:
Intrinsic Value
1
n
(1 + i )
M
C
+
i
(1 + i ) n
24 of 123
A. Mashiri
1
10
(1 + 0,08)
1,000
100
+
0,08
(1 + 0,08)10
100
[1 0,463193488] + 463,193488
100
[0,536806512] + 463,193488
671,01 + 463,193488
$1,134.20
0,08
0,08
Bond Price
(1 + i )n
Where:-
number of payments
Example:
Calculate maturity value of a zero coupon bond maturing in 5 years
that has a par value of $1, 000.00 and required yield of 6%.
Solution:
25 of 123
Bond Price =
A. Mashiri
Bond Price
(1 + i )n
i
1 +
f
1, 000
(1 + 0,06)5
n f
1, 000
0,06
1 +
1, 000
(1,06)5
$747,26
5 2
1, 000
(1,03)10
$744,09
Example:
Calculate maturity value of a zero coupon bond that matures in 15
years from now if par value is $1, 000.00 and the required yield is
9.4%.
Solution:
Bond Price
(1 + i )n
1, 000
(1 + 0,094)15
1, 000
(1,094)15
26 of 123
A. Mashiri
$259.86
C
i
Coupon Payment
Bond Price
Where:-
Example:
In 1990 a company issued a number of $100 par value 0, 80 irredeemable
debentures.
Calculate the amount investors will be willing to pay for such a debenture in
2004 if the prevailing interest rate is 11%.
Solution:
Bond Price
C
i
100 8%
100%
0,08
0,11
$72,73
27 of 123
A. Mashiri
The three sources of return that may compromise a yield on a bond at:
Capital gains resulting from buying at a different price then the one
received when the security is sold / matures.
1. Current Yield
Current yield is the most basic measure of the yield.
It is the
Coupon payment
Current price of Bond
Coupon
Market price
Example:
Suppose that a 15 year $1,000 par value 7% semi-annual coupon bond is
currently trading at $1, 1000.
What is the current yield on this bond?
Solution:
Current Yield
Coupon
Market price
7% of 1,000
1,100
70
1,100
28 of 123
A. Mashiri
6,36%
Current yield is used to estimate the cost of profit from holding a bond.
Example: - if other short term interest rates are higher than the current
yields, the bond is said to carry a running cost or negative carry.
Disadvantages of Current Yield
(a). The current yield does not take into account potential gains or losses
resulting from the difference between the current market price of a
bond and its value upon maturity.
(b). It does not take into account time value for money.
Formulae:
Bond Price
(1 + YTM )1
(1 + YTM ) 2
+ ......
(1 + YTM ) n
(1 + YTM ) n
Short Formulae:-
Year to maturity =
P PB
C+ v
n
1
(Pv + PB )
2
29 of 123
A. Mashiri
Where:-
Coupon
Pv
Par Value
PB
NB: Usually YTM is not given but bond price will be given.
The YTM is calculated by iteration. It is the discount rate that equates the
present value of all the bonds expected cashflows with the current market
price of a bond.
Example:
A bond is currently trading at a price of $96.50 with a coupon payment of
$8.75 paid semi-annually. I has exactly one year before maturity.
Calculate the YTM.
Solution:
Year to maturity
P PB
C+ v
n
1
(Pv + PB )
2
8,75 +
100 96.50
1
1
(100 + 96.50)
2
12,47%
30 of 123
A. Mashiri
3. Yield to Call
Callable bonds might not reach maturity for the very reason that they
may be called before maturity.
Hence that yield to call was developed to measure the return on a bond
if it where to be called on a particular call date.
Formulae
Yield to Call
PCB
P
C + Call
nc
1
(PCall + PCB )
2
Where:31 of 123
A. Mashiri
PCall
PCB
nc
Example:
What is the YTC of a 6% coupon, 5 year bond priced at $98 that is
callable in 3 years at $105?
Solution:
Yield to Call
PCB
P
C + Call
nc
1
(PCall + PCB )
2
6+
=
105 98
3
1
(105 + 98)
2
7
3
101,50
6+
8,21
32 of 123
A. Mashiri
(b). It assumes that the interest received from the bond will be re-invested
at the yield to call rate.
3.2.
4. Default Risk
This is the risk that the issuer will fail to make interest for principal
payments when they fall due.
5. Down Grade Risk
This is the risk that the price of the bond might fall because the credit
rating agencies have reduced the credit rating of the bond issuer.
6. Liquidity Risk
This is the risk that the bond will not be sold so quickly because the
market is in liquid.
7. Re-structuring Risk
This is a risk that arises from the potential conflict of interest between
different claimants on firms assets when a company restructures.
8. Exchange rate Risk
If person is holding foreign bonds and currency of that bonds exchange
rate fluctuates it affects the value of the bond.
33 of 123
A. Mashiri
9. Inflation Risk
When inflation increases value of the bonds decreases.
10. Event Risk
This is the risk that some unusual events will cause the price of bonds
to fall.
3.3.
Equity Valuation
Ordinary Shares / Common Stock
-
(b). Income
Ordinary Shareholders are entitled to a dividend but a company and its
directors are under no obligation to declare a dividend.
(c). Priority
In the event of a company being liquidated ordinary shareholders stand
last in the line to receive proceeds of liquidation as they are the residual
owners of the business. All other shareholders have to be paid before
they can receive their proceeds.
(d). Maturity
34 of 123
A. Mashiri
P0
D1
Ks
Where:
P0
D1
Ks
Example
Edgars expects to pay a dividend of $3.60 at the end of each year
indefinitely into the future.
35 of 123
A. Mashiri
If investors require 12% rate of return, what is the intrinsic value the
ordinary shares at Edgars.
Solution
P0
D1
Ks
3,60
0,12
$30.00
P0
D0 (1 + g + )
Ks g
Where:
Growth Rate
D0
Ks
Example
Kingdom Bank has just paid a $2 dividend. Analysts expect the firms
dividend to grow at a constant rate of 6% per annum.
If investors require a 14% return on investment, what is the intrinsic
value the Kingdom common stock?
Solution
P0
D0 (1 + g + )
Ks g
36 of 123
A. Mashiri
2(1 + 0,06)
0,14 0,06
26,5
P0
D (1 + g1 )t
(1 + K s )t
Pn
(1 + K s )n
Where:
D0
g1
g2
Dn + 1
Pn
Pn
D (n + 1)
(K s g 2 )
Example:
Analysts expect dividend of Econet wireless to grow at a rate of 20% for
the next 4 years and at a rate of 5% there after.
37 of 123
A. Mashiri
D0 + (1 + g1 )t
(1 + K s )t
2 (1 + 0,20 )1
(1 + 0,12)1
2 (1 + 0,20)2
(1 + 0,12)2
2 (1 + 0,20 )3
(1 + 0,12)3
2 (1 + 0,20 )4
(1 + 0,12)4
9,534
Step 2:
Find the present value of the terminal price at the end of the
supernormal growth period.
Note:
Pn
Pn
P4
D (n + 1)
(K s g 2 )
4,15 (1 + 0,05)
0,12 0,05
P4
D (n + 1)
(K s g 2 )
= 62,25
38 of 123
A. Mashiri
Pn
(1 + K s )n
62,25
(1 + 0,12)4
= 39,56
Step 3:
Sum the present value of both the dividend during the 4 year
supernormal growth period and the terminal price in year 4.
=
9,534 + 39,56
49,09
Example:
Cealsys is experiencing a period of rapid growth. Earnings and dividends
are expected to grow at a rate of 15% during the next two years at 13% in
the 3rd year and a constant growth rate of 6% there after.
The companys last dividend was $1.15 and the required rate of return on
stock is 12%.
Calculate the value of share today.
Solution:
P0
D (1 + g1 )t
(1 + K s )t
Pn
(1 + K s )n
Step 1:
39 of 123
A. Mashiri
Find the present value of the dividend during the supernormal growth
period.
=
D0 + (1 + g1 )t
(1 + K s )t
1.15 (1 + 0,15)1
(1 + 0,12)1
1.15 (1,15)1
(1 + 0,12)1
1.15 (1 + 0,15)2
(1 + 0,12)2
1.15 (1,15)2
(1 + 0,12)2
3,615
1.52 (1 + 0,13)1
(1 + 0,12)3
1.52 (1,13)1
(1 + 0,12)3
Step 2:
Find the present value of the terminal price at the end of the supernormal
growth period.
Note:
Pn
Pn
(1 + K s )n
D (n + 1)
(K s g 2 )
1,7176 (1 + 0,06 )
0,12 0,05
= 30.34
Pn
(1 + K s )n
40 of 123
A. Mashiri
30,34
(1 + 0,12)3
= 21,59
Step 3:
Sum the present value of both the dividend during the 4 year supernormal
growth period and the terminal price in year 4.
=
21,59 + 3,62
25,21
Simplicity is use
Model requires that the cost of equity is greater than the growth rate
otherwise the model will give nonsensical answers. Sometimes stocks
experience periods of supernormal growth were the growth rate will
exceed the cost of equity
Preference Shares
-
Preference shares promise a fixed dividend and in this way they can
be likened to debt.
However unlike debt preferred dividends are not deductable for tax
purposes. Hence it has a higher cost of capital than debt.
41 of 123
A. Mashiri
Vp
Dp
Kp
Where:-
Vp
Dp
Dividend
Kp
Example:
42 of 123
A. Mashiri
Suppose Delta Corporation has a $100 par value preferred stock that
pays an annual dividend of $7. If investors require an 8% return on this
stock, what will be the intrinsic value?
Solution:
Value of Preferred Stock
Dp
Kp
7
0,08
87,50
Example:
Assume the current market price of Schweppes preferred stock is $85 with
a dividend of $7.
What will be the expected rate of return if investors require rate of return of
8%. Should the investor consider buying the preferred stocks?
Solution:
Dp
Kp
85
7
x
7
85
43 of 123
Rate of Return
A. Mashiri
0,0823
8,23%
The investor can consider buying the shares as the Rate of Return is
higher than what they expect.
Advantages of Preferred Stock
-
Flexibility
Dividends do not have to be paid in the year in which profits are
bad, while this is not the case on interest payments on long term
debt.
The after cost shares of preferred stock is higher than the after tax
cost of debt. Furthermore because of the possibility that dividends
can be passed preferred stock shareholder often require a higher
return.
3.4.
A. Mashiri
Option Valuation
-
These assets are called contingent claims because their pay offs are
contingent on the prices of other securities.
Definition of Option
-
It is the contract that gives the holder the right but not the obligation to
buy or sell an asset at a pre-determined price known as the strike price
or exercise price on or before some expiration date.
Most options are American meaning that they can be exercised at any
time before or on the expiry date.
Happens when one anticipate price is going to shoot and one will
still be able to buy them cheaper
A. Mashiri
A put option gives the holder the right not the obligation to sell an
asset at a specified price at a specified date.
The holder of a put option is not under any obligation to exercise it,
therefore the put option are assets as they embody him to sell and
this right has value
NOTE: These are used to limit ones risk / loss. The righter of the put
thinks the market will go down.
The Put Righter:
-
The righter of the put option will receive a premium for righting the put.
Options can be traded on the over the counter markets. This has
the advantage that the terms of the option contract can be tailor
made to meet the needs of the traders.
Intrinsic Value
Time premium
46 of 123
A. Mashiri
SK
KS
Put Option:
P
Where:-
Exercised Price
In the Money
Describes the option where exercise would be profitable.
At the Money
Describes the situation where the asset price and exercise price are
equal.
Volatility
Example:
47 of 123
A. Mashiri
(b)
Therefore (C )
SK
89,25 90
0,75
Zero
(0)
SK
100 90
10
10
Profit
10 7
$3
48 of 123
A. Mashiri
Example:
In April 2004 maturity Put Option on Motorola with an exercise price of $90
per share, sales on 16 December 2003 for $7.
It entitles the owner to sell the shares of Motorola for $90 at any time until
15 April 2004.
If on December 16, 2003 the Motorola stock is trading / selling at $89, 25.
(a)
(b)
Calculate the pay off on the expiration date if the Motorola Stock
trades at $80
SK
90 89,25
0,75
SK
90 80
10
10
Pay-off
10 7,50
49 of 123
Profit
A. Mashiri
$2.75
3.
)
50 of 123
A. Mashiri
Formulae:
Cost of debt ( K d
Kd (1 t )
It is the current cost of debt or interest rate the firm would pay if it
issues debt today.
The yield to maturity is the rate of return the existing bond holders
expect to receive and it is also a good estimate of the return that
new bond holders would require.
The after tax cost of debt is used to calculate the weighted average
cost of interest
It is the interest rate on the new debt less the tax savings due to the
deductibility of interest.
Example:
Edgars is planning to issue new debt at an interest rate of 8%. Edgars is in
the 40% marginal tax rate.
What is the companys cost of debt capital.
Solution:
Cost of debt ( K d
Kd (1 t )
= 0,08 (1 0,4)
= 0,08 0,6
= 4.8%
51 of 123
A. Mashiri
Ks
R f + Rm R f
Where:
Rf
Rm
Risk Premium
(Rm R f )
Ks
Example:
Suppose the Edgars interest rate on long term loan is 8% and the
risk premium is estimated to be 5%.
Calculate the companys estimated cost of the retained equity?
Solution:
Ks
= 8% + 5%
= 13%
Po
D1
Ks g
Ks
D1
+g
P0
Where:-
52 of 123
A. Mashiri
D1
P0
Growth Rate
Example:
Suppose the Edgars Share sells for $21 and next year dividend is
expected to be $1.
Edgars has a return on equity (ROE) of 12% and they are
expected to pay out 40% of their earnings.
What is the cost of the retained equity?
Solution:
Po
D1
Ks g
or
Ks
D1
+g
P0
= 0,12 0,6
= 0,072
Ks
D1
+g
P0
1
+ 0,072
21
= 0,1196
53 of 123
A. Mashiri
= 11,96%
(d). Cost of Newly Issued Equity ( K e )
Formulae:
Ke
D1
+g
P0 (1 f )
Where:-
Ke
D1
Floatation Cost
P0
Growth Rate
Example:
Suppose the Edgars Share sells for $21 and next year dividend is
expected to be $1.
Edgars has a return on equity (ROE) of 12% and they are expected
to pay out 40% of their earnings.
Assuming the previous growth rate of 7, 2% and that Edgars has a
floatation cost of 10%.
Calculate the new cost of Equity.
Solution:
Formulae:
Ke
D1
+g
P0 (1 f )
54 of 123
A. Mashiri
1
+ 0,072
2 (1 0,1)
= 0,1249
= 12,5%
WACC
= W d K d (1 t ) + W ce K e + W ps K ps
Where:
Wd
Weight of Debt
Kd
Cost of Debt
K d (1 t ) =
W ce
Ke
W ps
K ps
Example:
55 of 123
A. Mashiri
K d (1 t ) =
4, 8%
Ke
12, 5%
K ps
8, 42%
Wd
45%
Kd
50%
W ps
5%
Next step is to substitute these figures into the formulae below and the
weights are established from the given example.
WACC
= W d K d (1 t ) + W ce K e + W ps K ps
= (0,45 0,048) + (0,50 0,125) + (0,05 0,0845)
= 0,0216 + 0,0625 + 0,00421
= 0,08831
= 8,83%
A. Mashiri
This is the perceived risk market in stocks along with the investors
inversion to risk. Individual firms have no control over this factor but
it affects the cost of equity.
3. Tax Rates
Companies have no control over tax rates or tax bands.
4.
57 of 123
A. Mashiri
3. Investment Policy
Example:
Hunyani has the following Capital Structure:Debt
25%
Preferred Stock
15%
Common Stock
60%
Hunyanis tax rate is 40% and investors expect earnings and dividends to
grow at a constant rate of 9% in the future.
Hunyani paid a dividend of $3.60 per share last year and its share price
58 of 123
A. Mashiri
3.5.
This topic of capital structure serves to see how the capital structure of
a company will affect the companys risk and how companies should
finance their operations.
59 of 123
A. Mashiri
If the companys current debt ratio should fall below the target
level, issuing new debt will satisfy the new capital.
If the firms current debt ratio increases above the target level, the
company will be required to raise new capital by retaining earnings
or issuing new equity.
The use of debt increases risk to shareholders and the higher the
risk associated with the use of debt will depress share prices.
The firms optimum capital structure is the one that balance the
influence of risk and return and maximises the firm share prices.
Cost
K2
Lowest level
of WACC
WACC
Kd
60 of 123
A. Mashiri
Leverage
Value
Share Price
Optimal Capital
-
Cost of equity increases with increasing debt but more rapidly than
the cost of debt, the increase is to compensate for the risk taking.
Cost of debt remains low due to the tax shield but slowly increases
as the company increases the gearing to compensate lenders for
the increasing risk
3.4.
Business Risk
This is the risk that is inherent in the firms operations assuming zero
debt.
It is the risk that the company will not be able to cover its operating
costs.
The main features affecting business risk are:-
Demand variability
61 of 123
A. Mashiri
The more variable a firms sales are the higher the business risk.
-
Ability to adjust output prices for changes in input prices e.g. those
who sale controlled goods.
Operating Leverage
The higher the % of the firms costs that are fixed then the greater
the business risk.
Tax Position
-
The reason why companies use debt is because of the tax deductibility
of interest payments
Financial Flexibility
Reasons why you require the capital for will determine whether you get long
term or short term debts.
Conservatism of Aggressiveness of Management
-
62 of 123
A. Mashiri
Conservative managers are not risk takers, they would not want to
increase risk, and they would rather opt to borrow shareholders.
3.5.
EBIT
K su
EBIT
WACC
Where:-
63 of 123
K su
Vu
A. Mashiri
= Vl
Where:
Vu
Vl
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Assume that all the M & M assumptions hold, there is no corporate or
personal taxes. The EBIT is $12 million for each company.
What value will M & M estimate for each firm?
Solution:
EBIT
K su
12
0,3
= $40 million
Vl
-
= Vu
A. Mashiri
K SL
K su + Risk premium
K su + ( K su K d ) D
Where:
K SL =
K su =
Kd
Cost of debt
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Assume that all the M & M assumptions hold, there is no corporate or
personal taxes. The EBIT is $12 million for each company.
65 of 123
A. Mashiri
= K su + ( K su K d ) D
S
= 0,30 + (0,30 0,15)
15
(40 15)
= 0,39
= 39%
NOTE:
According to this proposition Number 2 the inclusion of debt in the
Capital Structure will not increase the value of the firm because
benefit of using cheaper debt will be exactly offset by an increase in
the riskness of the cost of equity.
Cost of Debt:
The cost of debt has two parts: -
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Assume that all the M & M assumptions hold, there is no corporate or
personal taxes. The EBIT is $12 million for each company.
Calculate the value of Longman taking into account that it had debt in
its capital.
Solution:
Calculating value of Longman equity:
66 of 123
VL
EBIT KdD
K SL
12 (0,15 x 15)
0,39
A. Mashiri
= $25 million
4. Arbitrage Support of a Proposition
-
M & M argued that the total value of these firms has to be the same
otherwise arbitrage will enter the market and derives the values of these
two companies together.
Example:
Two companies Unilever & Longman are identical in every respect
except that Unilever is unlevered whilst Longman has $15 million of
15% debt outstanding.
Assume that all the M & M assumptions hold, there is no corporate or
personal taxes. The EBIT is $12 million for each company.
67 of 123
A. Mashiri
= Vu )
Solution:
EBIT
WACC
40
12
WACC
WACC =
12
40
0,30
30% -
Same as Unilever
VL
V u + TD
Where: -
TD
Tax shield
68 of 123
VL
Vu
TD
Vu
A. Mashiri
EBIT (1 T )
K su
Example:
Suppose both companies are now subject to a 40% tax in their
earnings but all the facts in the previous section still apply.
What value would M & M now estimate for each firm?
Solution:
Value of unlevered firm:-
Vu
EBIT (1 T )
K su
0,12 (1 0,40)
0,30
0,24
24%
VL
Vu + TD
24 + (0,4 15m )
24 + 6
30%
69 of 123
A. Mashiri
K SL
K SU + ( K SU Kd )(1 t )
D
S
Example:
(i)
(ii)
Solution to (i):
Note that S = (30 15 (being cost of debt)
D
S
K SL
K SU + ( K SU Kd )(1 t )
K SL
0,39
39%
15
15
Cost of Equity.
Solution to (ii):
Calculating WACC for Longman
WACC
(Wd Kd ) + (Wke K e )
19
15
0,24
70 of 123
A. Mashiri
24%
71 of 123
A. Mashiri
Signaling Models
This theory recognises that management may have better information
than the investing public and postulate that there is a pecking order of
financing.
1. Pecking Order Hypothesis
It relaxes the assumptionthat perfect markets exists by assuming that
information is not symmetrical.
With the pecking order hypothesis companies will 1st use retained
earnings, than debt then lastly they will issue equity.
(a) Retained earnings / Internally Generated Funds
Companies use retained earnings 1st because they are cheaper than
issuing external debt or equity.
The implication or the signal is that most profitable firms borrow less
because they have sufficient internal funds.
72 of 123
A. Mashiri
Solution to Example 1:
World without Taxes
(a) Required rate of return.
73 of 123
EBIT
KSU
KSU
EBIT
V
3
10
A. Mashiri
= 30%
(b) Weighted Average Cost of Capital
WACC =
EBIT
WACC
EBIT
V
3
10
= 30%
(c) Verifying that the total market value of Mambo PLC is equal to $10 million.
EBIT
WACC
74 of 123
KSU
A. Mashiri
EBIT
V
3
0,30
10
10
= 10
Example 2
A company is planning a $50 million expansion. The expansion is to be financed
by selling $20 million in new debt and $30 million in new common stock.
The before Tax required return on debt is 9% and 14% on Equity. The company
has a target capital structure of 40% Debt and 60% Equity. The company also has
bonds in issue that pay a 10% semi-annual coupon maturing in 20 years and at
currently trading at $849.54.
Company Stock Beta is 1, 2
The Risk Free Rate is 10%
Market Risk Premium is 5%
The company has a constant growth firm that has just paid the dividend of $2 and
sales for $27 per share and has a growth rate of 890.
Calculate companys Weighted Average Cost of Capital (WACC).
Solution to Example 2
Cost of Debt
Kd (1 t )
75 of 123
A. Mashiri
= 0,09 (1 0,40)
= 5,4%
Cost of newly issued Equity
Ke
D1
+g
P0 (1)
2
+ 0,08
27(1)
= 15,41%
Therefore:-
WACC
= W d Kd (1 t ) + Wk e K e
= 0,4 0,054 + 0,6 0,1541
= 0,0216 + 0,09246
= 0,1141
= 11,41%
4.
A. Mashiri
Dividend Stability
Dividend stability is one feature that attracts investors. Stability means
maintaining the position of the firms dividend payments in relation to a trend
line, normally one that is upward sloping. Ceteris-paribus, a share of stock
may command a higher price if it pays a stable dividend over time than if it
pays a fixed percentage of earnings.
77 of 123
A. Mashiri
Company A
Amount
Per
Share
3
Earnings per
Share
2
Dividends per
Share
1
Time
Company B
Amount
Per
Share
3
Earnings per
Share
Dividend per
Share
Time
A. Mashiri
In the long run the amount of dividends the companies would have paid
is equal. However the market price of company B may be well above
that of company A. This is due to the fact that investors value dividend
stability and hence will place their trust in company B, and will be
prepared to pay a premium for the share due to the stability of its
dividend. On the other hand, investors prefer a stable dividend as
compared to the one that fluctuates.
4.3.
A. Mashiri
4.5.
80 of 123
A. Mashiri
Another legal rule is the undue retention of earnings rule. This rule
prohibits the company from retention of earnings significantly in excess
of the present and future investment needs of the company.
This is meant to prevent companies from retaining earnings for the
sake of avoiding tax.
(e) Funding Needs of the Firm
The likely ability of the firm to sustain a dividend should be analysed
relative to the probability distribution of the possible future cash flows
and cash balances. Basing on this analysis, a company can determine
its likely residual future funds.
(f) Liquidity
The greater the cash position and overall liquidity of the company, the
greater is its ability to pay a dividend. Cash dividends can only be paid
with cash hence a shortage of cash in the bank can restrict dividend
payments.
(g) Ability to Borrow
The greater the ability of a firm to borrow on comparatively short notice,
the greater is its financial flexibility, and the greater is its ability to pay
cash dividends.
(h) Restrictions in Debt Contracts
These are restrictions employed by the lender to preserve the
companys ability to service debt.
(i) Control
Shareholders may prefer that the company pay a low dividend payout
and retain some earnings to finance future investment shares instead of
issuing shares to new stakeholders. Should old shareholders fail to
81 of 123
A. Mashiri
take-up new stock leading to new shareholders coming in, their control
will be diluted. From another angle companies in danger of being
acquired may establish a high dividend payout in order to please
shareholders and hence avoid a takeover.
(j) Investment Opportunities
If a company expects a large number of profitable investment
opportunities, this will lower the target payout ratio and vice versa if
there are few profitable investment opportunities. Similarly the ability to
accelerate or postpone projects will allow a firm to adhere more closely
to a stable dividend policy.
(k) Cost of issuing new stock
If a company will incur high flotation costs by issuing new shares it will
make sense for it to maintain a low payout ratio and finance
investments through retained earnings.
4.6.
82 of 123
A. Mashiri
83 of 123
A. Mashiri
84 of 123
A. Mashiri
85 of 123
4.9.
A. Mashiri
BEFORE
AFTER
$40
$40
Par Value
$5
$5
Common Stock
$2,000,000
$2,100,000
$1,000,000
$1,700,000
86 of 123
Retained Earnings
Total Shareholders Equity
Number of Shares
NB:
A. Mashiri
$7,000,000
$6,200,000
$10,000,000
$10,000,000
400,000
420,000
5% Additional Stock
= 0.05 x 400,000
= 20,000 shares
Market Value
= $40 x 20,000
= $800,000
Legal/Par Value
= $5 x 20,000
=$100,000
BEFORE
Par Value
AFTER
$5
$2.50
Common Stock
$2,000,000
$2,000,000
$1,000,000
$1,000,000
Retained Earnings
$7,000,000
$7,000,000
$10,000,000
$10,000,000
400,000
800,000
87 of 123
A. Mashiri
Except in accounting treatment, then, the stock dividend and split are
very similar. A stock split, like a large percentage stock dividend, is
usually reserved for occasions where the company wishes to achieve a
substantial reduction in the market price per share of common stock,
thereby at times attracting more buyers. Whilst the dividend per share
falls the effective dividend usually increases, e.g. if the dividend was $2
per share it will be reduced to $1.20 per share.
(c) Effect Of Stock Dividend/Split To Investor
A. Mashiri
It is the purchase (buyback) of stock by the issuing firm, either in the open
(secondary) market or by self-tender offer. Some of the reasons companies
buyback stocks are to have it available for management stock option plans,
to have it available for the acquisition of other companies, to go private or
even to retire it.
(a) Advantages of Share repurchases
because
repurchase
is
often
motivated
by
The company may pay too much for repurchased stock to the
disadvantage of the remaining shareholders.
89 of 123
5.
A. Mashiri
LEASING FINANCING
90 of 123
A. Mashiri
NB: At expiration of the lease the lessee has the option, according to
contracts specification, either to return the leased asset to the lessor, to
renew the lease at the agreed rate or, to buy the asset at its fair market
value. If the lessee fails to exercise the option, the lessor takes
possession of the asset and is entitled to any residual value associated
with it.
91 of 123
A. Mashiri
92 of 123
A. Mashiri
93 of 123
A. Mashiri
The lease agreement transfers ownership to the lessee before the lease
expires.
The lessee can purchase the asset for a bargain (fair market value)
price when the lease expires.
The lease lasts for at least 75% of the assets estimated economic life.
The present value of the lease payments is at least 90% of the assets
value.
Thus all other leases are operating leases as far as the above is
concerned.
Answer:
a. Use the formula:
94 of 123
n
C0
t =0
A. Mashiri
= LCFt / (1 + k )t
Where:
LCFt
27,500.00
27,500.00
27,500.00
27,500.00
26,190.48
25,000.00
27,500.00
24,943.31
22,727.27
27,500.00
23,755.53
20,661.16
27,500.00
22,624.32
18,782.87
27,500.00
21,546.97
17,075.34
27,500.00
20,520.92
15,523.03
167,081.53
147,269.67
Total
PV @ 5%
PV @ 10%
NPV @ 5% = $19,081.53
NPV @ 10% = $730.33
95 of 123
A. Mashiri
LCFt ( PVIFA11%,6)
LCF0 =
LCF0
LCFt (4.231) =
LCF
= $148,000 / 5.231
LCF (5.231)
= $28,293
= $28,293.00
OR
Yr
LCFt
0
1
2
3
4
5
6
X
X
X
X
X
X
X
Total
PV @ 11%
1.0000
0.9009
0.8116
0.7312
0.6587
0.5935
0.5346
5.2305
$148,000
5.231
= $28,293.00
5.7.
96 of 123
A. Mashiri
Lease
Payment
27,500.00
27,500.00
27,500.00
27,500.00
27,500.00
27,500.00
27,500.00
B = Ax0.40 C= A-B
D = C/(1.072)t
Tax-Shield Cash Outflow Present Value of
Benefits
After Taxes
Cash Outflows
27,500.00
27,500.00
11,000.00
16,500.00
15,391.79
11,000.00
16,500.00
14,358.01
11,000.00
16,500.00
13,393.67
11,000.00
16,500.00
12,494.09
11,000.00
16,500.00
11,654.94
11,000.00
16,500.00
10,872.14
11,000.00
(11,000.00)
(6,761.28)
Total P.V. =
98,903.37
This Present Value figure should then be compared with the Present Value
of cash flows under the borrowing alternative. The alternative that gives a
lower Present Value is to be chosen.
5.8.
A. Mashiri
As shown in the table below, since the P.V. of cash outflow for debt
alternative is less than that of lease financing the company should use
debt.
Thus:
1. If the asset is purchased the company is assumed to finance it with a
12% unsecured debt. Loan payments are expected to be made at the
beginning of each year.
2. A loan of $148,000 is taken up at time zero payable over 7 years at
$28,955 a year.
3. Proportion of interest depends on annual unpaid capital. Thus, annual
interest for first year is $119,045 x 0.12 = $14,285
5.9.
98 of 123
A. Mashiri
Year End
0
A= Loan Payment
28,955
28,955
28,955
28,955
28,955
28,955
B = Bt-1 - A+C
Principal Owing
119,045
104,375
87,945
69,544
48,934
25,851
28,955
Total
(15,000)
14,285
12,525
10,553
8,345
5,872
3,102
D = Annual
Depreciation
24,667
24,667
24,667
24,667
24,667
24,667
15,581
14,877
14,088
13,205
12,216
11,108
(6,000)
F = A - E Cash
Outflow After Tax
28,955
13,374
14,078
14,867
15,750
16,739
17,847
(9,000)
G = F/(1.072)t P.V.
Cash Outflow
28,955
12,476
12,251
12,068
11,926
11,824
11,760
(5,532)
148,000
95,728
99 of 123
6.
A. Mashiri
Definitions:
Inventory Control
Inventory management, or inventory control, is an attempt to balance
inventory needs and requirements with the need to minimize costs resulting
from obtaining and holding inventory.
Inventory Control Systems
100 of 123
A. Mashiri
A. Mashiri
(c). Individual review of items is used and this may be very desirable for
expensive items
A. Mashiri
Disadvantages
(a). visual control systems are imprecise and
(b). tend to focus on impeding stock-outs rather than excess inventory.
(c). Furthermore, visual systems do not consider the monetary
investment in inventory.
3. Periodic review systems / The periodic Inventory Control System
In this system, stock on hand is counted at periodic intervals and
compared it the desired inventory levels. Items that fall below the
desired level are then orders. Because on evaluation of inventory levels
is made on a more formal basis, this system tends to be more precise
than the visual system.
The inventory of an item is reviewed at fixed time intervals, and an order
is placed for the appropriate amount
Advantages
Periodic Review System Advantages are:
103 of 123
A. Mashiri
Disadvantages
Periodic Review System is expensive to maintain and it is therefore
sometimes reserved for "A" inventory items.
4. The perpetual Inventory Control System
The perpetual system is the most elaborate and more accurate method
of inventory control.
Advantages
This system provides the best control of both number of units and
dollars.
Disadvantages
104 of 123
A. Mashiri
Disadvantages
105 of 123
A. Mashiri
A. Mashiri
software systems
IT experts for maintenance and upgrades
7. Just-in-time (JIT)
JIT espouses that firms need only keep inventory in the right quantity at
the right time with the right quality.
An example of a Just-in-time system is the SkuFlow system, warehouse
inventory control software which allows coordination of inventory in
multiple warehouse systems via any Internet connection.
8. SkuFlow Inventory Control System
It is a true real-time warehouse system and inventory control software.
It combines e-commerce systems, warehousing, sales tracking,
inventory systems, customer management system, & product data
management.
Advantages
Disadvantages
Limited to specific firms. Not ideal to firms which use raw materials
with a longer lead time.
107 of 123
A. Mashiri
108 of 123
A. Mashiri
109 of 123
A. Mashiri
software systems
IT experts for maintenance and upgrades
110 of 123
7.
A. Mashiri
FORMS OF MERGER
Horizontal Merger
It involves the coming together of two firms in the same line of business.
Such mergers result in economies through the elimination of duplicate
facilities and offering a broader product line.
Vertical Merger
It involves companies in related lines of business. The company
acquires either forward towards the ultimate consumer or back ward
towards the source of raw materials. Economies are enjoyed in the
sense that the surviving company will have more control over its
distribution and/or purchasing.
Conglomerate Merger
Two companies in unrelated lines of business merge. This can come
about due to the desire by the company for a strategic change of
business line or simply a diversify and reduce risk.
2.
111 of 123
PVAB >
=
PVAB
A. Mashiri
Gain =
NPV
= Gain Cost
Eliminating Inefficiencies
Some firms are inefficiently managed, with the result that profitability is
lower than it might otherwise be.
112 of 123
A. Mashiri
1. Signalling Effect
Value could occur if new information is conveyed as a result of the
corporate restructuring. This usually works when there is information
asymmetry between management and common stockholders.
If management believes the share, to be undervalued then a positive
signal may occur via the restructuring announcement that causes share
price to rise.
2. Surplus Funds
Firms with surplus cash and a shortage of good investment
opportunities often turn to mergers financed by cash as a way of
redeploying their capital. Firms with excess funds and not willing to
redeploy it can also be targeted for acquisition.
3. Tax Reasons
A company coming out of bankruptcy can have lots of money in unused
tax-loss carry-forwards. Such a company can buy or merge with another
profit marking company and hence be able to utilise the carry-forwards.
4. Borrow at Low Costs
A firm can merge with another so that it can improve its credit rating and
hence be able to access debt at low cost.
5. Managements Personal Agenda
Some managers view growing from a small to a large company as more
prestigious or can have diversification as their objective.
6. Diversification
By merging with another firm and attaining more diversification, either
through product or market diversification, help in reducing risk of loses
to the company. Diversification can be shown using the Ansoff
(Product/Market) Grid below.
EXISTING PRODUCT
NEW PRODUCT
113 of 123
A. Mashiri
EXISTING MARKET
Market Penetration
Product Development
NEW MARKET
Market Development
Diversification
Example
You are given the following financial data in the case where company A is
considering the acquisition, by common stock, of company B.
Company
B
114 of 123
A. Mashiri
$20,000
5,000
$4.00
$64.00
16
$5,000
2,000
$2.50
$30.00
12
Company A has agreed to offer $36 (i.e. 20% premium above company Bs
stock) a share to company B, to be paid in company As stock.
a) Calculate the exchange ratio.
Exchange Ratio
= 36/64
= 0.5625
Thus company A will pay 0.5625 share for each of company Bs share.
In total company A will issue 1,125,000 (i.e. 0.5625 x 2,000,000
shares) shares to acquire 2,000,000 shares in company B (hence
acquiring company B).
b) Assuming that the earnings of the component companies stay the
same, what will be the EPS of the surviving company after the
acquisition?
Company A
Present Earnings (000)
Shares outstanding (000)
Earnings per share (EPS)
$25,000
6,125
$4.08
Thus the merger has lead to an immediate jump in the earnings per
share for company A from $4.00 to $4.08.
c) Calculate the post merger EPS related to each share of company B
previously held.
Thus: 0.5625 x $4.08 = $2.30.
Thus companys shareholders have experienced a decline in EPS.
Suppose company A had offered a 50% premium its EPS would have
declined to $3.90 indicating an initial dilution due to the acquisition. On
115 of 123
A. Mashiri
Expected
EPS ($)
Growth with merger
12
Growth without merger
8
1
4
2
5
Years
The greater the duration of the dilution, the less desirable the acquisition is
said to be from the standpoint of the acquiring company.
Market Value Impact
116 of 123
A. Mashiri
If the market exchange ratio is 1 (one) it follows that the shares will be
exchanged on a 1:1 basis and the company being acquired finds little
enticement to accept such an exchange. The acquiring company should
offer a price in excess of the current market price per share of the company
it wishes to acquire. Ceteris-paribus, shareholders of both companies will
benefit from such a merger, as shown below.
Example
You are given the following financial information of the acquiring and the
acquired company:
Acquiring Co.
Present Earnings (000)
Shares outstanding (000)
Earnings per share (EPS)
Market Price Per Share
Price Earnings (P/E) ratio
$20,000
6,000
$3.33
$60.00
18
Acquired Co.
$6,000
2,000
$3.00
$30.00
10
The P/E ratio of the surviving company is expected to remain at its high
level of 18 after the acquisition.
The acquiring company has offered $40 for each of the shares in the
acquired company.
a) Calculate the Market Price Exchange Ratio.
Thus: E.R = 40/60
= 0.667
117 of 123
A. Mashiri
= 1.33
$30
The shareholders of the acquired company benefit in the sense that
their share, which is going for $30.00 in the market, has been bought for
$40.00.
b) Ceteris-paribus what will be the market value per share of the acquiring
company soon after the acquisition?
It will stand at:
Surviving Co.
Total Earnings (000)
Shares outstanding (000)
Earnings per share (EPS)
Price Earnings (P/E) ratio
Market Price Per Share
$26,000
7,334
$3.55
18
$63.90
118 of 123
A. Mashiri
Cumulative
Average
Abnormal
Return
Selling Company
+
Buying Company
_
Announcement
Days
Date
119 of 123
A. Mashiri
120 of 123
A. Mashiri
Asset restructuring Buy assets that the bidder does not want or that
will create an antimonopoly problem.
j)
COMPANY RESTRUCTURING
Divestiture
This is the opposite of merger. It is the divestment of a portion of the
enterprise or the firm as a whole. The following are the various methods of
divestment.
Voluntary Corporate Liquidation
This comes about due to the fact that the firms assets may have a higher
value in liquidation than the present value of the expected cash-flow stream
emanating from them. Liquidation allows the seller to sell assets to different
parties hence realising a higher value than in a merger.
121 of 123
A. Mashiri
Going Private
122 of 123
A. Mashiri
The company has assets that can be sold to finance its debts without
affecting its company business.
Also
the
availability
of
experienced
and
good
quality
senior
management is critical.
Due to the leverage management will be forced to work hard so that nothing goes
wrong.
123 of 123