Business Finance Book - Open

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C o p y r i g h t : O p e n U n i v e r s i t y o f M a u r i t i u s , 2 0 1 3 A l l r i g h t s r e s e r v e d . N o p a r t o f t h i s c o u r s e m a y b e r e p r o d u c e d i n a n y f o r m b y a n y m e a n s w i t h o u t p r i o r p e r m i s s i o n i n w r i t i n g f r o m : O p e n U n i v e r s i t y o f M a u r i t i u s R é d u i t , R e p u b l i c o f M a u r i t i u s F a x : ( 2 3 0 ) 4 6 4 8 8 5 4 T e l : ( 2 3 0 ) 4 0 3 8 2 0 0 E m a i l : o p e n u n i v e r s i t y @ o p e n . a c . m u

BUSINESS FINANCEOUbs002223

January 2014

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OUbs002223 Business Finance

Table of Contents  

Unit 1 Agency Issue between shareholders and managers

Unit 2 Investment appraisal methods

Unit 3 Risks and Return

Unit 4 Asset Pricing Models, CAPM & APT

Unit 5 Capital Market Efficiency and Stock Market Anomalies

Unit 6 Cost of Capital, Shareholder’s wealth, Gearing & Leasing

Unit 7 The dividend decision

Unit 8 Corporate Restructuring

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Aim of the Module 

To provide learners with knowledge of the principles and practice of the financing decisions of enterprises. Learners will learn about the decisions which firms make about financing their investments in productive capital.

Teaching and learning strategy 

The teaching and learning strategy is designed to develop in students an ability to understand the mechanisms of financial markets and the issues pertaining to investment decision in those markets. Students should be able to understand and apply the time value concepts with regards to investment decision. They should also be able to evaluate the risks and returns of financial instruments.

Assessment Strategy 

GUIDELINES FOR SELF­STUDY 

This manual aims at fulfilling the preciously identified learning objectives. Despite the fact that

this manual is self-contained, you are expected to do some additional research in books and

academic articles to deepen your understanding of quantitative techniques and research

methodology.

Manual:

Open University of Mauritius OUbs002223: Business Finance

  Unit(s) of Assessment  Weighting Towards Module Mark (%)   Assignment    30   WrittenExamination    70 

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References 

Brealey, R. and S. Myers Principles of Corporate Finance. (Boston, Mass.; London: McGraw-

Hill, 2003) [ISBN 0071151451] Chapter 33.

Copeland, T. and J. Weston Financial Theory and Corporate Policy. (Reading, Mass.;

Wokingham: Addison-Wesley, 1988) third edition [ISBN 0201106485] Chapters 15 and 16.

943-963.

Pandey I M, Financial Management, 9th Edition, Vikas Publishing House Pvt Ltd, 2009

Other Indicative Reading 

Students will need to thoroughly search the numerous journals that are most appropriate for their

chosen research topic. Articles in reputable journals (Journal of Finance and Journal to

Corporate Finance among others) often deal with a topic in much more detailed than textbooks.

Moreover, because articles are generally peer reviewed, they are likely to have more credibility.

Video resources: 

https://www.coursera.org/;

https://www.futurelearn.com;

https://www.udacity.com/

HOW TO USE THE MANUAL  

• Read the overview and learning objectives of each Unit. This will help you in

identifying the knowledge and skills that is required to successfully complete the

study of the Unit.

HOW TO STUDY

• Plan your study time carefully

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• Read the Unit thoroughly. Prepare a list of questions that you may ask your tutor.

Note that the questions should be relevant to the Unit studied.

• Be a critical thinker

• Work your activities. It is important for you to attempt all activities as this will

give you an idea of concepts that you have not understood.

• Re-work your corrected activities later.

You are expected to study regularly as there is no ‘easy’ way to pass the examination.

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UNIT 1 AGENCY PROBLEM BETWEEN SHAREHOLDERS AND MANAGERS

Unit Structure

1.0 Overview

1.1 Learning Objectives

1.2 Shareholder Wealth Maximization Principle

1.3 The Agency Relationship

1.4 Managers as Agents

1.5 Activities

1.6 Suggested Readings

1.0 OVERVIEW

Ownership and Control are most commonly separate as shareholders of a Company entrust the

day to day running of the organisation to managers, referred to as ‘agents’.In the pages that

follow, we shall explore the relationship between managers and shareholders and the possible

conflicts of interest.

1.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to:

1. Demonstrate understanding of the basic notion of principal and agent;

2. Demonstrate understanding of the possible conflict of interest;

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1.2 Shareholder Wealth Maximization Principle

In general, the main aim of any firm is the maximization of shareholders’ wealth. Put in simple terms, it implies making shareholders as rich as possible. The wealth of shareholders is maximized when a given decision generates a net present value-which is the basically, the difference between present value of the benefits of a project and present value of its costs. A project that yields a positive net present value creates wealth for shareholderswhile onethat generates a negative net present value reduces wealth of shareholders. It therefore follows that only those projects which have positive net present value should be accepted.

1.3 The Agency Relationship

The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his/her interests. In all such relationships, there is a possibility of a conflict of interest between the principal and the agent. Such a conflict is called an agency problem .

Managers are usually appointed by the shareholders to run the firm in their best interests. Whether the former holds true depends on two factors, the first being alignment of management and shareholder goaland may often partly relate to the way managers are compensated. In reality, there can often be goal divergence. The second factor pertains to control and the possibility of the manager being replaced.

For instance, managers may be more interested in short term payback which favours their promotional prospects rather than investing in projects with positive net present values which optimizes shareholder wealth.

Furthermore, shareholders may wish todiversify their risk by investing in a number of firms whilst the managers may be averse to investing in risky investments.It is also believed that managers will generally be more inclined to maximize the amount of resources over which they have control in a view to gain more corporate power. This can lead to an overemphasis on corporate size or growth. Instances where managers are ready to overpay to buy another company with the sole aim of growing the size of the business or to exhibit corporate power are not uncommon.

All the above indicate that managers may be likely to overemphasize organizational survival to protect job security.

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Therefore the agency relationship between shareholders and managers has agency conflicts which can have implications for corporate governance and business ethics.

1.4 How to Motivate Managers to Act in Shareholder's Best Interest

• Managerial compensation • Direct intervention by stockholders • Threat of firing • Threat of takeovers

1. Managerial Compensation It is a known fact that employees are motivated by rewards, tangible and intangible. Since managers are mere agents of shareholders, the lattershould find means to induce them to act in their best interests. By securing their commitment and make them feel that they are part of the ‘family’ in the organization, there will be a natural tendency that their goals get aligned with those of the shareholders. Incentives can be linked directly to better job prospects, promotion possibilities and more attractive packages, be it higher salaries or perks such as company car. Thus, by upon successful achievement of set shareholder goals, the managers can reap enormous rewards

Other forms of rewards can be performance bonuses and company shares.

Company shares can be distributed to managers either as:

o Performance shares, where managers will receive a certain number shares based on the company's performance. o Executive stock options, allowing managers to buy shares at a future date and price. With this option, managers will join the line of shareholders and a greater possibility of alignment with shareholder goals exist.

2. Direct Intervention by Stockholders

It can be argued here that control of the firm ultimately rests with stockholders. The latter elect the board of directors, who, in turn, control management.

Another option can be by having the majority of the firm’s stock be owned by large institutional investors, such as pensions and mutual funds. As such, these large institutional stockholders have the ability to exert influence on managers and, hence, the firm’s operations.

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3. Threat of Firing In case shareholders are still not satisfied with the performance of existing managers, they may request to review the composition of current managers. Shareholders even have the powerto re-elect a new board of directors that will accomplish the task. 4. Threat of Takeovers In extreme cases whereby stock price deteriorates because of management’s inability to run the company effectively, competitors or stockholders can take a controlling interest in the company and bring in their own managers.

1.5 ACTIVITIES

Activity 1: “Managers always act in the best interests of shareholders”. Discuss. Activity 2: “Shareholder Wealth Maximization Principle-A utopia or reality?” Discuss 1.6 SUGGESTED READINGS

Thomas E. Copeland, J. Fred Weston “Financial Theory and Corporate Policy (3rd or Latest

Edition)” by Addison Wesley

Brealey and Meyers, Principle of Corporate Finance, McGraw-Hill, 5th or Latest edition

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UNIT 2 Investment Appraisal Techniques

Unit Structure

2.0 Overview

2.1 Learning Objectives

2.2 The Capital Budgeting & Investment AppraisalProcess

2.3 Identifying Cash flows

2.4 Discounting

2.5 Methods of Investment Appraisal

2.5.1 Payback Method &Discounted Payback Method

2.5.2 Net Present Value

2.5.3 Internal Rate of Return

2.5.4 Accounting Rate of Return

2.5.3 Activities

2.7 Suggested Readings

2.0 OVERVIEW

Financial managers and investors are faced with various investment opportunities.

However, the financial manager needs to ensure that the investment decisions are in line with the

objectives of the particular firm and depending on the firm’s strategy and budget constraints, the

manager may have to select the best alternative or rank them in order of preference, as well as

gauge the alternatives foregone. This is why a proper screening of investment proposals is very

important.

The process of evaluating long-term investment decision is known as Investment Appraisal. The

decision whether or not to select a project will usually depend on the stream of cash flows which

are generated over a given time period. Investment appraisal methods can be categorised into

discounted cash flows techniques based on time value of money and non-discounting techniques

ignoring the time value of money.

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2.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to:

3. Understand the different concepts and importance of investment decisions

4. Calculate the NPV, IRR, payback and profitability Index.

5. Analyse the results obtained in line with whether to invest in a particular project or not.

6. Evaluate the pros and cons of each technique

2.2 THE CAPITAL BUDGETING &INVESTMENT APPRAISAL PROCESS

Further to Unit One, whereby you have learned that shareholders entrusting their money to

managers in a given Company and expect that their money is invested in the most optimal way.

To this effect, capital budgeting is the process of making long-term investment decisions that

support the shareholders’ wealth maximization principle.

To assess capital budgeting projects ,the followingare required:

• Gauge the project's relevant cash flows

• Decidewhether or not a project should be undertaken based on a particular decision rule.

2.3 IDENTIFYING THE PROJECT’S CASH FLOWS

The following points should be taken into account when identifying relevant cash flows:

• Accounting profits are irrelevant and only cash flows should be taken into account

Accounting profit takes into account not only cash sales but also credit sales. However, credit

sales are not cash flows as they have not yet been converted into cash. Therefore, you need to

disregard all non-cash flows for investment appraisal purposes.

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• Incremental cash flows are the relevant cash flows

All sunk costs, committed future costs, non-incremental fixed costs and overheads should not be

taken into account In effect, only incremental cash flows (i.e those cash flows that will change

as a direct result of undertaking the project) are relevant.

• All financing cash flows should be disregarded The present value of the financing cash flows is represented by the project's initial outlay.

Interest and principal repayments over and above the initial capital outlay do not need to be taken

into consideration so as to avoid double counting.

Illustration:

A company desires to purchase a machine which costs Rs120, 000 and has a three year life. The

company decides to finance the purchase of this machine by taking a loan from the bank. The

bank charges an interest rate of 10% per annum with the principal being paid at the end of the

third year.

Cash flows:

Year 0 1 2 3

Item

Machine (120,000)

Interest (12000) (12000) (12000)

Principal (120,000)

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However, the above is wrong since the present value of the loan’s cash flows is the machine

initial outlay. The interest and principal are financing cash flows and should be ignored.

In fact, the following calculation shows:

PV of loan cash flows: 1.13

000,12012000 1.12

12000 1.11

12000 +++

• Working capital adjustment needs to be taken into account

Changes in the level of working capital represent changes in cash flows. Basically, cash outflows are represented by increases in the working capital requirement such as increase in debtors or stocks. In fact, the increase in debtors represents an investment in working capital as payment of sales is not made immediately. Also, increases in stock are due to lower stock turnover. On the other hand, cash inflows are represented by decreases in the working capital requirement. For instance, reduction in stocks may be due to greater stock turnover or reduction in debtors may be to earlier payment by debtors

• Take into account all opportunity costs from undertaking the project

The opportunity cost of any can be defined in terms of the next best alternative to that action,i.e

"What you would have done if you did not make the choice that you did". For, instance a firm

that uses a particular machinery for production purpose also has the choice to sell that

machinery. The opportunity cost of using the machinery is the value of its forgone alternative

use.

• Taxation

In the appraisal of an investment project, focus is on the cash flows that will be generated by the

project and that which are available for shareholders. As such, we want to assess the after tax

cash flows of the project.

It is important to note that the taxation charge is levied on the taxable profits of the business and

not on the net cash flows.

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The investment appraisal process is a very important business decision as:

- They influence the business’ growth in the future

- They affect the risk of the firm

- They involve the commitment of large amount of funds

The capital budgeting process involves three basic steps:

(i) Generating long term investment proposals

(ii) Reviewing, analysing and selecting proposals that have been granted

(iii) Implementing and monitoring the proposals that have been selected.

Prior to selecting any investment proposal, it is important to take the following into

consideration:

(i) If the projects are Mutually exclusive – i.e,either one or the other can be selected

(ii) If they are Independent Projects – i.e, cash flows of one project are not affected

by accepting or rejecting other projects

(iii) Whether the company has Unlimited funds or is thereCapital Rationing- i.e, will

the company be able to finance any profitable projects or not.

(iv) Does the company need to either Accept a particular proposal and Rejectothers

or can it rank the alternatives based on available funds.

2.4 DISCOUNTING

To discount means to calculate the present value of a future cash flow.

Discounting into today’s rupees helps us to compare a sum that will not be produced until later.

Technically speaking, to discount is to ‘depreciate’ the future. It is to be more rigorous with

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future cash flows than present cash flows, because future cash flows cannot be spent or

invested immediately.

First, take tomorrow’s cash flow and then apply to it a multiplier coefficient below 1, which is

called a discounting factor. The discounting factor is used to express a future value as a present

value, thus reflecting the depreciation brought on by time.

Consider an offer whereby someone will you Rs1,000 in 5 years. As you will not receive this sum

for another 5 years, you can apply a discounting factor to it, for example, 0.6. The present, or

today’s value of this future sum is then 600. Having discounted the future value to a present value,

we can then compare it to other values. For example, it is preferable to receive 650 today than 1000

in 5 years, as the present value of 1000 5 years from now is 600, and that is below 650.

Discounting make is possible to compare sums received or paid out at different dates.

Discounting is based on the time value of money. After all, ‘time is money’. Any sum received

later is worth less than the same sum received today. Remember that investors discount they

demand a certain rate of return. If a stock pays you Rs110 in one year and you wish to see a

return of 10% on your investment, the most you would pay today for the security (i.e. the present

value) is 100.

Discounting is calculated with the required return of the investor. If the investment does not meet

or exceed the investor’s expectations, he will forego it and seek a better opportunity elsewhere.

2.5 METHODS OF INVESTMENT APPRAISAL

The investment appraisal techniques can be classified into two main categories, discounting and

non-discounting techniques.

Discounted Cash Flow Techniques: Takes into account the time value of money

• Net present value

• Internal Rate of Return.

• Discounted payback

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Non-Discounting Techniques : Ignores the time value of money

• Payback period

• Accounting rate of return

2.5.1 PAYBACK PERIOD

The payback method is one of the most popular and widely used methods of evaluating

investment proposals. The payback period is the amount of time required for the firm to recover

its initial investment. That is, the payback period can be calculated by dividing the cash outlay or

initial investment by the annual cash inflow.

Payback = Initial Investment = C0 Annual Cash flow C

llustration 1 Mr John decides to invest in 2 projects (Project A and Project B) with the following cash flows:

Project A ($) Project B ($)

Initial Investment (1,200) (1,200)

Year 1 500 200

2 400 200

3 300 700

4 100 900

Payback Project A = 3 years

Payback Project B = 3.11 years{200+200 + 700+ (1200-1100)/900}

Based on above, the company will choose Project A since it will take less years as compared to

Project B.

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The advantages of the payback period method include the following:

Easy to understand and simple to compute

When capital is scarce or in short supply, it could be argued that projects that returned

the expenditure rapidly are the best ones.

It is useful in certain situations (rapidly changing technology and improving investment

conditions)

It favours quick return, which in turn help company growth, minimizes risk and

maximizes liquidity

It uses cash flows, not accounting profits

The drawbacks of this method are:

Ignore the time value of money.

It does not assess the impact of cash inflows arising after the payback period, which

could greatly affect the project’s profitability.

It is subjective – no definitive investment signal

It ignores project profitability

The Discounted Payback Period method

The Discounted payback period method has been introduced to cater for the time value

disadvantage borne by the payback period. By discounting the future cash flows arising from the

project, the time value of money is taken into consideration. Consider the following example:

Year Cash Flow Discounted Cash Flow

(at 7%)

Cumulative Cash Flow

Payback Period

0 (250,000) (250,000) (250,000) 0

1 80,000 74,766 (175,234) 1

2 90,000 78,609 (96,625) 2

3 100,000 81,629 (14,996) 3

4 110,000 83,918 68,922 14,996/83,918 x 12 Months

= 3 years and 3 Months

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Hence, using the discounted payback period, as opposed to the normal payback period, the

payback period has increased from 2 years and 10 months to 3 years and 3 months. This new

method has taken into consideration the riskiness of the cash flows and has accounted for the risk

by applying the time value of money to it.

2.5.2 THE NET PRESENT VALUE (NPV)

When calculating the NPV of a project, follow the two steps hereunder:

1. Write down the net cash flows that the investment will generate over its life

2. Discount these cash flows at an interest rate that reflects the degree of risk inherent in the

project

The resulting sum of discounted cash flows equals the project’s net present value. The NPV

Decision Rule says to invest in projects when the net present value is positive (greater than

zero):

NPV > 0 Invest

NPV < 0 Do Not Invest

The NPV Rule implies that firms should invest when the present value of future cash inflow

exceeds the initial cost of the project. The firm’s primary goal is to maximize shareholder

wealth. The discount rate r represents the highest rate of return (opportunity cost) that investors

could obtain in the marketplace in an investment with equal risk. When the NPV of cash flow

equals zero, the rate of return provided by the investment is exactly equal to investors’ required

return. Therefore, when a firm finds a project with a positive NPV, that project will offer a return

exceeding investors’ expectations

Consider the following example:

Greys Plc, a company engaged in the manufacture of deep-sea diving suits. The firm is

considering whether to invest in one of two automated machine processes, Machine A and

Machine B, in view of savings on operations. The following information is provided:

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Greys Plc

Machine A

(MUR)

Machine B

(MUR)

Investment outlay (payable immediately) 150,000 185,000

Annual cost saving:

Year 1 30,000 60,000

Year 2 40,000 61,000

Year 3 50,000 62,000

Year 4 60,000 63,000

The rate of return that is expected on projects with similar risk is 6%.

Note: The annual cost savings imply that the company will ‘receive’ these

cash flows and as such are relevant cash flows for the company

NPV of Machine A project

328.408,3 06.1 4

60,000 06.1 3

50,000 06.1 2

40,000 06.1

30,000 000,150 =++++−

NPV of Machine B project

06.1 4

63,000 06.1 3

62,000 06.1 2

61,000 06.1

60,000 000,185 ++++− = 27,851.85

NPV shows how much more or less in money terms the project is earning in comparison with an

alternative project with similar risk levels. A positive NPV of 3,408.328indicates that the

shareholders' wealth will increase by this amount should they decide to go forward with the

project. Hence, this implies that the project has a higher return than the others of same risk

levels.

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Basically, if the same amount was invested on a similar risk level project, a return of 6% will be

obtained.

Advantages of NPV:

• Takes into account the risk levels of the projects- Basically, the risk is reflected in the

discount rate as it is the return that is obtained on projects having similar risks.

• Decision to reject or accept a project is a relative one not an absolute one- in fact, it is

relative to what the foregone alternative will earn.

• Considers the time value of money concept

• Take into consideration all cash flows arising

• It is an absolute measure of return

• Leads to maximization of shareholder wealth

Disadvantages of NPV

• It is difficult to explain to managers. To understand the meaning of the NPV calculated

requires an understanding of discounting.

• It requires the knowledge of the cost of capital

• It is relatively complex

2.5.3 THE INTERNAL RATE OF RETURN (IRR)

If net present value (NPV) is inversely proportional to the discounting rate, then there must exist

a discounting rate that makes NPV equal to zero. The discounting rate that makes NPV equal to

zero is called the ‘internal rate of return’ or IRR. The IRR is the actual rate of return of the

project.

The decision making rule is very simple: if an investment’s internal rate of return is higher than

the investor’s required return, he will make the investment. Otherwise, he will abandon the

investment.

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The IRR of Machine A project is calculated as follows:

0 )1( 4

60,000 )1( 3

50,000 )1 2(

40,000 )1(

30,000 000,150 =+

++

++

++

+−IRRIRRIRRIRR

A variety of computer software can be used to solve the above equation. Alternatively, linear

interpolation, a mathematical technique can be used to estimate the IRR

By linear interpolation, we apply the following formula to estimate IRR:

IRR= NPV NPV - NPVLDR - HDR LDR LDR

HDRLDR

×+

Where:

HDR = Higher discount rate

LDR = Lower discount rate

NPVLDR = NPV corresponding to the LDR

NPVHDR = NPV corresponding to the HDR

IRRs and NPVs

The IRR only compares the project yield with that of the capital market. In other words, it

answers the question “can the project produce a higher return than the capital market. However,

it does not give an indication to judge between alternative projects like the NPV i.e how much

more or less the project is earning relative to the risk equivalent capital investment alternative.

Another problem arising with the IRR is that this method gives rise to multiple IRRs when

uneven cash flows are considered. Out of these two investment appraisal techniques, NPV

always prevail over IRR.

Advantages of IRR

• Considers the time value of money

• Is a percentage and is readily understood

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• Uses cash flows and not profits

• Consider the whole life of the project

• Means a firm selecting projects where the IRR exceeds the cost of capital, should

increase shareholders’ wealth

Disadvantages

• It is not a measure of absolute profitability

• Interpolation only provides an estimate and an accurate estimate requires the use of

spreadsheet program

• It is fairly complicated to calculate

• Non-conventional cash flows may give rise to multiple IRRs which means the

interpolation method cannot be used.

2.5.4 THE ACCOUNTING RATE OF RETURN (ARR)

The ARR measure the project’s profitability over the entire asset life. It compares the average

accounting profit of the project with the initial or average amount of capital invested. The ARR

can be calculated as follows:

ARR = 100 invested capital ) average(or Initial

profit annual ×

Average

We assume that straight line depreciation method is used in each case.

The average accounting profit and the ARR (based on initial capital invested) for Machine A can

be calculated as follows:

Machine Project A Year 1 Rs

Year 2 Rs

Year 3 Rs

Year 4 Rs

Cash flow 80,000 90,000 100,000 110,000

Depreciation (62,500) (62,500) (62,500) (62,500)

Profit 17,500 27,500 37,500 47,500

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The average profit over the years is: (17,500 + 27,500 + 37,500 + 47,500) / 4 = Rs 32,500

Hence, the accounting rate of return for Machine project A is given by:

(32,500/250,000) x 100 = 13%

The advantages of this method are:

• easy to understand and simple to compute

• It takes into account the importance of profitability.

The drawbacks of this method are that:

• It ignore the time value of money

• It makes use of accounting data instead of cash flow data

2.6 ACTIVITIES

Activity 1

ABC Company is considering investment in either project A or project B. The management

of the company has entrusted you the responsibility to determine the feasibility of the

project. Each project has an initial investment of Rs 300m and the Weighted Average Cost

of Capital (or discount rate or opportunity cost of capital) is 12%. Using both discounting

and non-discounting investment appraisal techniques, determine which project should be

selected.

Year Expected Future Cash Flows

Project A Project B

1 90M 75M

2 85M 70M

3 80M 65M

4 80M 65M

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Activity 2

As a financial manager in Apple BLimited , you are considering whether to invest in projects A or B. The expected cash flows for projects A& B over the next 4 years are given. Each project has an initial investment of £ 150m and the Weighted Average Cost of Capital is 13%.

Year Expected Net Cash flows Project A Project B

1 68M 74M

2 63M 78M

3 61M 73M

4 60M 72M

Required:

Calculate for each project:

(i) Payback; (ii) NPV; (iii) IRR; (iv) ARR

Activity 3

As financial analyst for Stone Ltd, you are asked to analyze the following investment

proposals. Each project has an initial investment of $10,000 and the WACC is 12 percent.

Expected Net Cash Flows Year Project X($) Project Y($)

0 (42,000) (45,000) 1 14,000 28,000 2 14,000 12,000 3 14,000 10,000 4 14,000 10,000 5 14,000 10,000

1. Calculate the payback period, NPV and IRR for these two projects.

2. Which project(s) would you select if the projects are mutually exclusive? What if they

are independent?

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Activity 4

Assess the following project given that each project has an initial investment of £200m and

the Weighted Average Cost of Capital is 22%.

Year Expected Net Cash flows Project A Project B

1 85M 81M

2 82M 48M

3 80M 43M

4 80M 42M

5 80M 42M

Using the discounting and non-discounting, assess which projects you would select

assuming that project A and B are mutually exclusive.

4.7 SUGGESTED READINGS

Thomas E. Copeland, J. Fred Weston “Financial Theory and Corporate Policy (3rd or Latest

Edition)” by Addison Wesley

Brealey and Meyers, Principle of Corporate Finance, McGraw-Hill, 5th or Latest edition

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UNIT 3: RISK, RETURN AND DIVERSIFICATION

Unit Structure

3.0 Overview

3.1 Learning Objectives

3.2 Introduction

3.3 Measures of Risk and Return

3.4 Portfolio of Assets

3.5 The Concept of Minimum Variance Frontier

3.6 Activities

3.7 Suggested Readings

3.0 OVERVIEW

As an investor or financial manager or be it as a lay man, undertaking any project or investment

or decision involves an analysis of the risks and return trade-off.

In the sections that follow, you will have the opportunity to grasp understanding of the concepts

of risk and return and its computations for a single asset and for a portfolio made up of two assets.

3.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to do the following:

1. Demonstrate understanding of the concepts of risk and return;

2. Calculate expected return and standard deviation for individual assets.

3. Compute expected returns and standard deviation for a portfolio of 2 assets.

4. Determine the covariance and correlation between assets and an understanding of its effect

on a portfolio of assets.

5. Appreciate the difference between systematic and unsystematic risk

6. Show understanding of the minimum variance opportunity set and its implications

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3.2 INTRODUCTION

It is believed that the riskier an investment, the higher the return. It therefore follows that the

main aim of an investor is to earn the highest return possible. However, in practice this depends

on the risk profile of the investor, i.e whether he is risk-lover or risk-averse or risk-neutral. In

general, investors are risk averse and seek compensation for the risk they take.

This possibly explains why the US Treasury Bills, which provide investors a lower return than

Microsoft have always been one of the most traded assets across the globe.

3.3 MEASURES OF RISK AND RETURN

A simplistic definition ofReturn is the percentage increase in value of an investment per amount invested in the security initially.

Different return outcomes exist for a risky security and these return outcomes have different probabilities. This information can be summarized in terms of a probability distribution. As a result of this distribution, the expected return is the weighted average of all the returns, where the weights are the probabilities.

Consider the following on stock A, a non-dividend payingstock.

Current Share Price

(Rs)

Probability, p (%) Expected Share

Price in one year

(Rs)

Expected Return, R

(%)

100

25% 140 40%

50% 110 10%

25% 80 -20%

From its current market price of Rs100, the share can either move up or down since the future

outcome remains uncertain. Therefore, a probability of the expected future outcome (price) is

27  

attached to it. Hence, the share has a 25% probability that it will increase to Rs140, a 50%

probability that it will move to Rs110 and a 25% probability that it will decrease to Rs80.

The expected return is calculated as follows:

Expected Return = (0.25*40% + 0.5*10% + -0.2*25%) = 10%

The risk of a given investment can be determined from the standard deviation, often referred to as volatility, which is the square root of the variance, as per formulas below:

Applying the above formula to calculate the variance of the stock A:

Variance = 25%*(-0.2-0.1)2 + 50% * (0.1-0.1)2 + 25% * (0.4-0.1)2 = 0.045 = 4.5%

Standard deviation = √Variance = √4.5% = 2.12%

The total risk of a stock comprises of two elements of risk: a diversifiable and a non-diversifiable

risk component.

• Diversifiablerisk/Unsystematic Risk/ Unique Risk (or specific risk) Firm-

specific/Idiosyncraticis the variability in return due to factors unique to the individual

firm. Examples include management team, workforce, equipment used. It is also known

as diversifiable risk as the unsystematic risks can be diversified away by holding a fully

diversified portfolio of assets. Harry Markowitz (1952) stipulated that investors are able

to do so by holding a portfolio of stocks that do not move exactly together. Same shall be

covered in more detail shortly.

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• Non-diversifiable risk/Market Risk/ Systematic Risk is the variability in return due to

market-wide or macroeconomic factors that affect all firms in the economy to a more or

less same extent. It is also known as non-diversifiable risk as it cannot be diversified

away. Hence, a risk premium is paid on market risk.

3.4 PORTFOLIO OF ASSETS

Assume 2 risky assets X and Y in a portfolio with weights W a% and W b% respectively.

The expected return of the portfolio Rpis:

)()()( BBAAp REWREWRE +=

The total risk of the portfolio/stock is given by the sum of the unique and systematic risks and is

measured by the variance/standard deviation.

Portfolio variance will be:

ABBABBAAp CovWWWW 222222 ++= σσσ

= ABWWBWW BABABAA Γ++ 12222 2 σσσσ

The amount of firm-specific risk that can be diversified away depends on the covariance between

the pairs of stocks.Now, what is covariance?

Covariance is the expected product of the deviations of 2 returns from the mean. It is given by

the following formula.

Cov (Rx,Ry) = E[(Rx – E[Rx]) (Ry – E[Ry])]

It follows that if 2 stocks move together, their returns will tend to be above or below average at

the same time and the covariance will be positive and vice versa.As long as security returns are

not perfectly correlated, diversification benefits can be achieved.

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A correlation of 0 (uncorrelated variable) implies absence of any linear (straight-line)

relationship between the variables. Increasing positive correlation indicates an increasingly

strong positive linear relationship (up to 1, which indicates a perfect linear relationship).

Increasing negative correlation indicates an increasingly strong negative (inverse) linear

relationship (down to -1, which indicates a perfect inverse linear relationship).

3.5 THE CONCEPT OF MINIMUM VARIANCE FRONTIER

The minimum variance frontier/ minimum variance opportunity set is defined as the set of all portfolios of risky assets that yield the minimum variance for a given rate of expected return.

From the example above for portfolio of stocks X and Y, it was seen that when the weight invested in each stock was 50%, the volatility reduced from 13.4% to 11.7%. Now, for these same 2 assets, there can be a combination of weights that gives the investor a better return for each unit of risk borne.

For the purpose of illustration, consider the following two stocks with their respective characteristics:

Stock ABC:

Expected Return:26%

Volatility: 50%

Stock XZY:

Expected Return: 6%

Volatility: 25%

Correlation of 0.

If we invest 40% in A and 60% in B, the expected return of the portfolio is 14% and the variance is given by:

Expected Return = 0.40*0.26 + 0.60*0.06

Variance= 0.42*0.52 + 0.62*0.252 + 2(0.4)(0.6)(0)(0.5)(0.25) = 0.0625

The volatility is 25%.

If the same procedure is repeated by varying the weights in the portfolio, we will obtain pairs

of expected return and volatility and the result is tabulated below.

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Portfolio Weights Portfolio Expected Return

(%) Portfolio

Volatility (%) Alpha Beta

100% 0% 26.0 50.0

80% 20% 22.0 40.3

60% 40% 18.0 31.6

40% 60% 14.0 25.0

20% 80% 10.0 22.3

0% 100% 6.0 25.0

The part of the line below the 20% Alpha and 80% Beta weight consists of inefficient portfolios the reason being that for the same volatility, a better portfolio closer to the (0.4,0.6) weight allocation can be found to give investors higher returns for the same risk.

The portfolio lying on the efficient set and that is tangential to the line drawn from the risk free asset (lying on the vertical axis with coordinates (0,1%) is called the efficient portfolio.

Given the 2 assets, this portfolio is the best among all other combinations from a risk-retun perspective.

For different levels of correlation, the frontier will change as shown in the graph below.

Minimum Variance FrontierExpected Returns

Std.Deviation

(1,0)

(0.8,0.2)

(0.6,0.4)

(0.4,0.6)

(0.2,0.8)

(0,1)

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For a given asset allocation, correlation has no impact on the expected return as the correlation is not used in calculating the expected return of the portfolio. However, the volatility will change.

When assets are perfectly positively correlated (correlation of +1), the set of portfolios will be along a straight line and there is no diversification benefit.

When the correlation is less than 1, volatility of the portfolio is reduced due to diversification and the minimum variance frontier curve bends to the left. This reduction in volatility is greater as the correlation decreases.

In case of uncorrelation between assets, i.e. correlation of -1, an optimal weight combination would enable a return above the riskless rate (e.g. US T-Bill) at no risk as illustrated above.

In the previous sections, we have considered a portfolio consisting of risky assets only. However, investors can also hold a combination of risky and risk-free assets. A risk-free asset is one which pays a risk-free rate and has zero standard deviation.

The earlier figure can be combined to show the different possible portfolios consisting of a risk-free security and risky securities. The Capital Allocation Line (CAL) displays how capital can be allocated between the risk-free and risky securities.

Assuming that the investors have three feasible combinations of risky portfolios (P, B and M) on the efficient frontier, we draw three CALs from the risk-free rate to these three portfolios of risky assets.

32  

(Source: Financial Management by Pandey)

The CAL which is tangential to the efficient set of risky assets is the best. It shows the risk-return trade off when the market is in equilibrium. The Capital Market Line (CML) shows this efficient set of risk-free and risky securities in market equilibrium.

3.6 ACTIVITIES

Activity 1.

Calculate the risk and return for each assets of the two assets, A and B, under different economic conditions as given below:

Economic climate Probability Return of asset A Return of asset B Recession 0.2 11% 7%

Stable 0.5 15% 16% Growth 0.3 20% 12%

Risk,

Return

B

M

Q

N

O

L

R

Capital Market Line (CML)

Capital Allocation Lines (CALs)

P

33  

Activity 2

Consider the following probability distribution of fund returnsfor investment purposes:

Expected Return Standard Deviation

ABC 30% 20%

XZY 13% 18%

Correlation coefficient between ABC & XYZ =0.6

Required:

Calculate the expected return and standard deviation of the following three portfolios:

Portfolio Proportions (%)

Portfolio ABC XYZ

1 45 55

2 60 40

3 100 0

Activity 3

The following information is given for two risky assets (an Equity Fund and a Debt Fund):

Securities Expected Return Standard Deviation

Equity Fund (E) 0.4 0.25

Debt Fund (D) 0.10 0.13

The correlation between the fund returns is -0.10.

34  

a) Given that an individual decides to invest 55% of his wealth in Equity Fund and 45% in

Debt Fund, calculate the expected return and standard deviation of the individual’s

portfolio.

b) What are the investment proportions in the minimum-variance portfolio of the two risky

funds?

c) Calculate the expected return and risk of the minimum variance portfolio?

Activity 4

The following information is given for three risky assets:

Securities Expected Return Standard Deviation

X 0.25 0.15

Y 0.35 0.23

Z 0.15 0.20

The correlation between X and Y is -0.10.

The correlation between X and Z is -0.33.

The correlation between Z and Y is +0.15.

Given that an individual decides to invest 25% in X, 20% in Y and the remaining in Z,

calculate the expected return and standard deviation of the individual’s portfolio.

3.8 SUGGESTED READING

Brealey, Richard A.; Myers, Stewart C., Principles of Corporate Finance, Latest Edition

Pike, Richard; Neale, Bill, Corporate and Finance Investment – Decisions and Strategies, Second

Edition

Bodie, Zvi; Kane, Alex; Marcus, Alan J., Investments, Eight Edition

35  

UNIT 4: ASSET PRICING MODELS

Unit Structure

4.0 Overview

4.1 Learning Objectives

4.2 Introduction

4.3 The Capital Asset Pricing Model (‘CAPM’)

4.4 The Arbitrage Pricing Theory

4.5 Other Models

4.6 Activities

4.7 Suggested Readings

4.0 OVERVIEW

Asset pricing models are a way of mapping from abstract states of the world into the prices of financial assets like stocks and bonds. The prices are always conceived of as endogenous; that is, the states of the world cause them, not the other way around, in an asset pricing model. Several general types are discussed in the research literature. The CAPM is one, distinguished from three that Fama (1991) identifies: (a) the Sharpe-Lintner-Black class of models; (b) the multifactor models like the Arbitrage Pricing Theory and (c) the consumption based models.

36  

4.1 LEARNING OBJECTIVES

After completion of this chapter, you are expected to:

• Demonstrate understanding of the asset pricing models to find the required rate of return

of a security;

• Be able to explain how, in large diversified portfolios, an individual asset's contribution

to the

risk of the portfolio is its covariance with the returns of the existing portfolio and that

individual variances are irrelevant.

• Explain why, when a riskless asset is introduced, all investors will hold themarket

portfolio and the riskless asset in some proportion.

• Understand why the return/risk tradeoff has to be the same for all assets in equilibrium.

• Understand and use the Security Market Line or CAPM where appropriate.

•. Appreciate the use of the CAPM in a capital budgeting exercise;

• Identify the limitations of the CAPM and the alternative solutions; • Demonstrate understanding the APT and its relevance

4.2 INTRODUCTION

Portfolio theory has taught us how to determine the price of market risk if we combine a risk-free

asset with the market portfolio. The expected return on such a portfolio will be the risk-free

return plus a premium for the amount of systematic risk carried by the portfolio.

However, the investor may not be interested in investing in a portfolio of assets. He may only be

interested in investing in one asset. Therefore, the required rate of return which the investor

should expect if he invests in a particular asset ‘i’ needs to be determined. This can be done by

extending portfolio theory to derive a framework for valuing risky assets, which is referred to as

the Capital Asset Pricing Model (‘CAPM’). An alternative model for the valuation of risky

assets is the Arbitrage Pricing Model (APT). The following pages will provide a deeper insight

into the aforementioned models.

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4.3 THE CAPITAL ASSET PRICING MODEL (‘CAPM’)

The CAPM provides a framework to determine the required rate of return on an asset and indicate the relationship between risk and return of the asset.

The required rate of return on the specific asset can be compared with the expected rate of return on the asset to estimate if the asset has been fairly priced.

The Security Market Line illustrates the relationship between an asset’s risk and its required rate of return.

4.3.1 The Security Market Line (SML)

The SML gives the required rate of return, E[˜ri], on an asset, which consists of the risk-freerate and a risk premium. The premium is calculated by multiplying the expected excess returnof the market portfolio, E[˜rM] − rf, with the “quantity of risk”, which is measured by theasset’s beta:

βi =σi,M/σ2M

The risk-return relationship as

predicted by the CAPM can be shown graphically as follows.

From the graph above, the following can be depicted:

• The linear relation between risk and return is the primary result of the CAPM. • If the model is correct, then all assets should have expected returns that can be found by

calculating β and finding the corresponding E(r) on the security market line. • The SML graphs the risk premium of individual assets as a function of asset risk. • The relevant measure of risk for well-diversified investors is not the standard deviation

of an asset’s returns, but rather how it contributes to the risk of the portfolio as measured by β.

38  

The required rate of return on an asset is given as a function of its beta. In practice, this relation

can be used as a benchmark to determine the “fair” expected return of a risky asset. Fairly priced

assets lie exactly on the SML. Underpriced assets lie exactly above the SML and the required

rate of return are higher than implied by the CAPM.

4.3.2 Distinction between CML and SML

The Capital Market Line (CML) shows the expected rates of return for efficient portfolios as a

function of the standard deviation of returns.

The Security Market Line (SML) depicts individual security risk premium as a function of

security risk. The individual security risk is measured by the security’s beta. Beta reflects the

contribution of the security to portfolio risk.

Under the CAPM framework, the risk of an individual asset is defined as the volatility of the

asset’s return with respect to the market portfolio. The risk of an individual risky asset is its

systematicrisk, which is the covariance between a single asset or portfolio and the market

portfolio itself. The market portfolio is defined as the portfolio of all risky assets, where the

weight on each asset is simply the market value of that asset divided by the market value of all

risky assets.

To analyse the contribution of a given asset’s contribution to the risk of a given portfolio, the

covariance between the asset and the the portfolio is divided by the overall variance of the

portfolio, given by mδ 2

The contribution of a specific asset to the risk of the market portfolio is measured by Beta, β ,

which is actually a measure of its volatility in terms of market risk. The beta of the market as a

whole is 1.0. Market risk makes market returns volatile and the beta can simply be used as a

basis against which the risk of other investments can be measured.

For a specific Asset i, 2)(),(

m

im

m

mii RVar

RRCovδδβ ==

39  

It is worth noting here that:

• Where β >1, it implies that the shares have more systematic risk than the stock market average

• Where β <1, it implies that the shares have less systematic risk than the stock market average

• Where β = 0, it implies that the shares have no systematic risk. Thus, the CAPM equation will be as follows:

E(Ri) = rf + (E(Rm) – rf) * 2m

im

δδ

E(Ri) = rf + (E(Rm) – rf) * Bi

Where E(Ri) = expected return on asset i E(Rm) = expected return on the market portfolio Bi = Beta of stock i rf = risk free rate The CAPM equation shows that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.

4.3.3 ASSUMPTIONS OF THE CAPM

The premises on which the CPAM Model is based are as follows: 1. Security markets are perfectly competitive.

a) Many small investors b) Investors are price takers

2. Markets are frictionless a) There are no taxes or transaction costs.

3. All investors have only one and the same holding period

4. Investments are limited to publicly traded assets with unlimited borrowing and lending at the risk-free rate.

5. All investors are rational mean-variance optimizers

6. Perfect Information a) All investors have access to the same information. b) All investors analyze information in the same manner.

7. All investors have homogenous beliefs concerning the distribution of security returns.

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4.3.4 LIMITATIONS OF THE CAPM

• The model is based on a number of unrealistic assumptions; • It is difficult to test the validity of the model; • Betas do not remain stable over time; • There can be other factors in additional to systematic risk that might influence expected

return

4.3.5 USES OF THE CAPM

CAPM helps to:

(a) Identify overvalued or undervalued assets;

(b) Estimate a Risk-Adjusted Discount Rate

4.4 THE ARBITRAGE PRICING THEORY (‘APT’)

The Arbitrage Pricing Theory (‘APT’) was developed by Ross as an alternative approach to the CAPM further to its limitations.

The APT is a multiple-index model, unlike the CAPM-which is a single index model. According to the APT, there are many factors which influence asset returns and not just one, as per the CAPM. From a conceptual point of view, this seems more plausible.

As per the APT, expected return is a function of several factors, each with their own beta, measuring the sensitivity of an asset or portfolio to that particular factor.

E(R) =Rf+(β1F1 + β 2F2+ β 3F3+…. β nFn)

The APT Pricing Equation is:

E(Ri) =λ1F1 + λ 2F2+ λ 3F3+…. λ nFn

This equation specifies that the relation between the expectedreturn of a security and its factor loadings (bs) is linear.

The λ or factor risk premia tells us how much extra return we can obtain for each extra unit of risk our portfolio has.

From the equation, it can be seen that there is one λ for each factor in the economy, plus one extra λ0.( where that λ0= rf)

41  

4.4.1 MERITS OF THE APT MODEL

• It is a multi-index model, i.e risk is multi-dimensional; there are many risk factors influencing returns);

• It does not require asset returns to follow a joint normal distribution; • There is no central role for the market portfolio; • The model can be tested.

4.4.2 LIMITATIONS OF THE APT MODEL

• It does not convey what are the factors affecting returns; • The factors need to be determined by factor analysis or using an economic theory; • The factors are time-varying, i.e one set of factors found relevant at one point in time

may no longer be relevant five years down the lane; • The factors may also be country-specific or sector-specific or company-specific.

4.5 ACTIVITIES

Activity 1

Discuss the assumptions of the CAPM Model and usefulness of same.

Activity 2

What are the limitations of the CAPM and what alternative models can be used.

4.6 SUGGESTED READINGS

ZviBodie, Alan Marcus and Alex Kane “Investments”, 6th or Latest Edition by McGraw-Hill

Higher Ed.

Thomas E. Copeland, J. Fred Weston “Financial Theory and Corporate Policy (3rd or Latest

Edition)” by Addison Wesley

Sharpe, Alexander and Bailey, Investments, Prentice-Hall, 6th or Latest Edition

42  

UNIT 5 MARKET EFFICIENCY

Unit Structure

5.0 Overview

5.1 Learning Objectives

5.2The Efficient Market Hypothesis& the different Forms of Efficiency

5.3Testing Market Efficiency: Fundamental & Technical Analysis

5.3.1 Testing Weak Form Efficiency

5.3.2 Testing Semi-Strong Form Efficiency

5.3.3 Testing Strong Form Efficiency

5.4 Stock Market Anomalies

5.4.1 Size Effects 5.4.2 Day of the Week Effects 5.4.3 The January Effect 5.4.4 The Diwali Effect 5.4.5 The Ramadan Effect

5.4.6 The Chinese New Year Effect

5.5 Activities

5.6 Suggested Readings

5.0 OVERVIEW

Efficient Market Hypothesis was first heard of in the mid 60’s. At that time, in general people

had only a vague notion of a well-functioning stock market and it was Samuelson in1965 who

stated that in a competitive market, price fluctuations are random. Fama (1970) made a

comprehensive overview of the relevant theoretical and empirical literature and was the first who

gave the name of Efficient Market, while also presenting empirical evidence. According to the

efficient market hypothesis, at any point in time stock prices fully reflect all available

information about individual stocks and about stock market as a whole. Following this stance,

excess return cannot be earned on the market since prices immediately adjust to any information

before any individual investor manages to make use of this information.

43  

According to Efficient market hypothesis:

a) previous prices give no indication for future prices,

b) prices immediately and fully integrate all information.

In short, markets are assumed to be efficient where prices of financial assets are fair, thus making

it impossible to outperform or beat the market. In the pages that follow, we shall explore the

notion of market efficiency and whether it holds true in reality or is merely utopian.

5.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to do the following:

1. Demonstrate understanding of the three forms of Markets Efficiency;

2. Appreciate the usefulness of fundamental and technical analysis;

4. Assess the validity of the market efficiency notion;

5. Realise the implication of stock market anomalies on the market efficiency concept

5.2 MARKET EFFICIENCY AND ITS DIFFERENT FORMS

Efficiency can be viewed from two angles, namely operational efficiency and pricing efficiency.

Whilst operational efficiency relates to the infrastructural efficiency in terms of administrative

mechanism or institutional settings to improve trading, pricing efficiency relates to the extent to

which current share prices are fair on a specific day. Efficient Market hypothesis, commonly

denoted as ‘EMH’ mostly relates to price efficiency. According to Fama (1970), an efficient

market is “a market in which prices fully reflect all available information”.

Following the above, since the shares at all times trade at their fair values, it is not possible for

investors to purchase undervalued shares or sell overvalued stocks and beat the market as current

share prices at all times include and reflect all significant information.

44  

The efficient market hypothesis is generally stated in three forms as follows:

• Weak Form Efficiency

In weak-form efficiency, security prices reflect all past information about price movements.

Excess return cannot be earned using investment strategies based on past prices or other

historical information. Share prices do not display any pattern, implying that prices follow a

random walk. In the weak form efficient market, current share prices represents the best,

unbiased, estimate of the value of the security.

• Semi-Strong Form Efficiency

In a semi-strong form market, share prices reflect all public information such that no excess

return cannot be earned by relying solely on all publicly available information. Under semi-

strong-form efficiency, neither fundamental analysis nor technical analysis techniques will be

able to consistently produce surplus returns.

• Strong Form Efficiency

Under strong-form efficiency, share prices reflect all information- both public and private, and

the market cannot be beaten. The prices incorporate private information and insider information,

such that it is impossible for insider trading to earn excess returns.

5.3 TESTING FOR MARKET EFFICIENCY

Even though EMH constitutes one of the vital tenants of current financial theory, it is highly

contentious and often dubious.If investors imbibe the notion of the Efficient Market Hypothesis,

then no profits can be reaped on the stock market. How can the success of Warren Buffet and the

existence of so many investment firms out there whose aims are to beat the market and reap

benefits for investors be explained then. On one hand, supporters of EMH claim that it will be

useless to undertake any forecasting exercise since the market will automatically update any

news on the market. On the other hand, there are otherswho believe that the market is inefficient

and abnormal returns can be reaped through either fundamental or technical analysis.

45  

Fundamental Analysis

Fundamental analysis basically relates to the scrutiny of underlying factors affecting the welfare

of the economy, industry groups, and companies. Fundamental analysis comprises of

examination of financial data, management, business concept and competition at the company-

level. At the industry level, supply and demand forces for the products offered is usually

examined. At the national economy level, fundamental analysis uses economic data to assess the

present and future growth of the economy. Fundamental analysis is based on fundamental

information derived from company analysis, industry analysis, macro-economic analysis to

forecast the movement of security prices. In cases where the current stock prices do not tally

with the fair value, fundamental analysts believe that the stock is either over or under valued.

Since prices do not accurately reflect all available information, fundamental analysts aim at

exploiting the perceived price discrepancies until the market prices gravitate towards the fair

value eventually. Fundamental analysts believe that markets are weak-form efficient.

Technical Analysis

Technical analysis, also known as chartism, basically relates to forecasting of future financial

price movements by examining past price movements, using a variety of charts to depict any

existing trend or pattern.

5.3.1 TESTING WEAK FORM EFFICIENCY

Weak-form market efficiency is tested using past trading data. Most studies generally formulate

a trading rule based on past security prices which they then test to see whether its application can

earn risk-adjusted profits in excess of the market return. One commonly used trading strategy is

the filter rule which involves purchasing stocks following a price increase of at least x% and

selling stocks and going short after prices have fallen by at least y% from a subsequent high. The

investor stays in the short position until prices again increase again, after which the short position

is covered and the stock bought again. If the market is inefficient and stock prices exhibit

positive serial correlation, such a strategy could allow investors to reap abnormal profits.

Other tests of the weak form include trading rules, relatives’ strength as well as technical

analysis indicators. Most research on the subject support the validity of the hypothesis in that

technical analysis does not allow abnormal returns to be achieved.

46  

5.3.2 TESTING SEMI-STRONG FORM EFFICIENCY

Event analysis or event study is the most common method employed to test semi-strong form

efficiency. The test is usually conducted by studying an event window of three or five days

around news announcements about certain stocks. If the news announcements convey new

information to the market or if they dispel any doubt on rumoursdoing the rounds prior to the

announcement, shares of the company which are affected by the news will show abnormal

returns. Also, by computing the abnormal returns on the stocks following news announcements,

the speed of price adjustment can be analysed and it can be evaluated whether information has

been leaked prior to announcements. For instance, if dividends have been announced on date d1

and abnormal gains have been made on d1, same should not recur the next day, i.e on d2. In case

there are statistically significant abnormal gains on dates other than d1, it implies that

information about the dividend could have been leaked prior to the announcement day or that the

market is not efficient asprices take more than one day to incorporate new information.

Most empirical research on the semi-strong form seem to suggest that the market is informational

efficient in the semi-strong form.

5.3.3 TESTING STRONG FORM EFFICIENCY

According to the efficient market hypothesis, based on technical, and fundamental analysis

above-average profits cannot be earned in the long run. The strong form efficiency is the most

difficult to verify, as it requires the use of non-public information. Strong form efficiency can be

tested by company insiders, who have access to information not accessible to investors to inspect

stock price movements after trade or looking for abnormal returns just before news

announcements.

5.4 STOCK MARKET ANOMALIES

Counter arguments to the Efficient Market Hypothesis claim that reliable patterns are present on

the market which can be exploited to make gains. Such patterns which have repeated themselves

over time are referred to as anomalies and include the following:

47  

5.4.1 Size Effects The ‘size effect’, also known the ‘small firm effect’ claims that abnormal gains may be reaped

by holding stocks of low capitalisation companies.

Banz (1981) saw that the smallest stocks tend to outperform the largest stocks on the New York

Stock Exchange. Further toBanz(1981) study, there were other studies such as Dimson and

Marsh (1989) which provided evidence of a “Size effect” in different markets. In particular, it

was observed that small firms indeed seem to earn higher average return than larger firms.

The major explanations for the size effect are that differences in performance may be related to

superior risks and institutional neglect as very often, financial institutions tend to pay relatively

less attention to smaller companies due to their rather small investments.

5.4.2 Day of the Week Effects

Further to a number of research conducted, such as Fran Cross (1973), Gibbon & Hess (1981),

Fortune (1991) amongst others, it has been observed that the return of share prices are dependent

on the day of the week. It is particularly believed that companies and governments make public

good news on weekdays when market are open and the news can be readily absorbed. However,

bad news are announced mainly after the close of business on Friday as investors cannot react

until the Monday opening. As such, Gibbons and Hess (1981) assert that there may be possible

biases on Friday prices such that errors for low Monday returns could be offset by upward biases

in Friday. Essentially, prices will tend to fall on Mondays and rise on Fridays leading to a

“Monday Effect”. However, there are some emerging markets where research has proved that

returns have been higher in other days of the week. All the above are in sharp contradiction with

the EMH as prices should follow a random walk.

5.4.3 The January Effect According to a number of studies, such as Rozeff and Kiney (1976); Keim (1983); Reinganum

(1983); Gulketin and Gulketin (1983); Ariel (1987) amongst others),it has been observed that

returns are abnormally higher in January relative to other months, which is referred to as the

‘January effect’.

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This may be so due to the following reasons:

(i) Minimisation of tax liability, also known as ‘Tax-Loss Selling Hypothesis;

(ii) The belief that news released on specific dates or months influences the trading behaviour

of investors- referred to as ‘Information release hypothesis’; 

(iii)Window-dressing, whereby managers sell loser stocks at the end of the year so that their

portfolios appear more decent at the end of the year to their clients

Seasonality effect which exists on stock market is contrary to the Efficient Market Hypothesis

proposed by Fama (1970). One of the reasons for presence of calendar effect is festivals

celebrated by the people of a nation which can have their impact of economic conditions of the

country. The following section highlights some of the most prominent festivals and their effect

on the stock market as per empirical research.

5.4.4 The Diwali Effect

For instance, in India, Diwali is one of the most celebrated festival andSrikanth et al. (2013) has

attempted to analyze the impact of Diwali festivals on the Indian stock market. However, the

study revealed that Diwali effect is not statistically significant on the stock market in India and

results of run tests conducted showed that average abnormal returns are random during the study

period.

5.4.5 The Ramadan Effect

Ramadan is another of the most celebrated religious traditions in the world. A study by Jedrzej et

al. (2011) investigates stock returns during Ramadan for 14 predominantly Muslim countries

over the years 1989–2007. The results show that stock returns during Ramadan are significantly

higher and less volatile than during the rest of the year. As per the research, since Ramadan

promotes feelings of solidarity and social identity among Muslims world-wide, Ramadan may

positively affect investor psychology, promoting optimistic beliefs that influence investment

decisions.

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5.4.6 The Chinese New Year Effect

Research carried out byAbidin et al. (2012) with respect to the Chinese New Year Effect

demonstrate significant evidence supporting the Chinese New Year Effect. Significant positive

returns have been observed a few days before the Chinese New Year period in stock markets of

Hong Kong, Japan, Singapore, Malaysia, and Taiwan.

5.5 ACTIVITIES

Activity One “Efficient Market Hypothesis holds true at all times”. Discuss

Activity Two Discuss the 3 forms of market efficiency and how each form may be tested.

Activity Three “Fundamental Analysis is superior to Technical Analysis as the former is based on a rational

approach whereas the latter relies simply on charts”. Discuss.

5.6 SUGGESTED READINGS

ZviBodie, Alan Marcus and Alex Kane “Investments”, 6th or Latest Edition by McGraw-Hill

Higher Ed.

Sharpe, Alexander and Bailey, Investments, Prentice-Hall, 6th or Latest Edition

50  

UNIT 6 COST OF CAPITAL,GEARING & SHAREHOLDER’S WEALTH

Unit Structure

6.0 Overview

6.1 Learning Objectives

6.2 The Cost of Capital& its importance

6.3 The Concept of Opportunity Costof Capital

6.4 Components of Cost of Capital

6.5 How to determine the Cost of Capital;

6.6 The Weighted Average Cost of Capital;

6.7 Gearing, Cost of Capital and the shareholders' wealth

6.8 Activities

6.9 Suggested Readings

6.0 OVERVIEW

In the previous chapters, it was seen that 2 main inputs were required for evaluating investment proposals using discounted cash flow techniques, which are:

(i) Identification of the project’s relevant cash flows; (ii) The Discount Rate

In all problems tackled earlier, the discount rate was already given. We shall now proceed with the process of identifying and coming up with the discount rate.

6.1 LEARNING OBJECTIVES

Upon successful completion of this chapter, you are expected to:

• demonstrate full understanding of the concept of ‘Cost of Capital’; • be able to determine the various components of the Cost of Capital; • appreciate the constitution of the Weighted Average Cost of Capital; • be able to determine the cost of capital • assess the effect of capital gearing on WACC, the value of the business and the

shareholders' wealth

• the traditional view of this effect

• the Modigliani and Miller view

• the empirical evidence of the effects of gearing and CAPM

• financial gearing and operating gearing

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• a conjectural conclusion on gearing – trade-off theory

• pecking order theory.

6.2 THE COST OF CAPITAL

The ‘Cost of Capital’, also referred to as the ‘opportunity cost of capital’ is simply the discount rate used for discounting a specific project’s cash flows.

The project’s cost of capital is the minimum required rate of return on the project, which is directly related to the risk inherent in the cash flows. A company’s cost of capital is the total or averagerequired rate of return on the total investment proposals. Hence, a company’s cost of capital is not the same as a project’s cost of capital. However, the company’s cost of capital can be used to discount those investment proposals which have similar risks to the average risk of the company.

The most common method used for computing the risk-adjusted cost of capital of projects is the Capital Asset Pricing Model (which was covered in the earlier chapters)

6.3 IMPORTANCE OF THE COST OF CAPITAL

The Cost of Capital is a useful benchmark for:

(i) assessing the financial performance of top management; (ii) evaluating investment decisions; (iii) planning a company’s debt policy

6.4 CONCEPT OF THE OPPORTUNITY COST OF CAPITAL

The opportunity cost of capital can be defined as the expected rate of return forgone on the next best alternative investment opportunity of similar risk.

6.5 COMPONENT COST OF CAPITAL

Capital of a company is obtained from different sources and the cost of capital for each source of capital is not the same due to the differences in risk and the contractual agreements between the company and investors.

The cost of capital for each source of capital is referred to as the ‘component’ or ‘specific’ cost of capital.

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6.6 WEIGHTED AVERAGE COST OF CAPITAL

As stated above, different sources of capital have altering costs of capital.As a company obtains capital from various sources, the cost of all sources of capital is combined together to give the overall or average cost of capital. Now the question is how are these pooled together?

The component costs are added in accordance with the weight of each specific component capital, which gives the average costs of capital. Therefore, the overall/ average cost of capital is also denoted as the ‘weighted average cost of capital’.

6.7 HOW TO DETERMINE OPPORTUNITY COST OF CAPITAL & COMPONENT COSTS OF CAPITAL

Required rate of returns for investors are determined by the market. The market price of securities is a function of the return expected by investors on same. Equilibrium rates of return for different securities are established by the forces of demand and supply in the market. The opportunity cost of capital can be obtained as follows:

11

21 2 1

Where I = Capital supplied by investors in period 0, representing a net cash inflow to the company;

C1= Expected returns by investors, representing cash outflows;

k = Required rate of return/ Cost of Capital

The component cost of a particular source of capital is usually equivalent to the rate of return required by investors and can be found using the above equation. However, this needs to be adjusted for tax in current practice.

Once the component costs are calculated, they are multiplied by the respective sources of capital to obtain the WACC. The steps involved in the computation of a company’s WACC are as follows:

1. Calculate the cost of specific sources of funds; 2. Multiply the cost of each source by its proportion in the capital structure; 3. Add the weighted component costs to get the WACC.

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6.8 GEARING &COST OF CAPITAL

As the primary financial objective is to maximise shareholder wealth, then companies should seek to minimise their weighted average cost of capital (WACC). In practical terms, this can be achieved by having some debt in the capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from bankruptcy costs, agency costs and tax exhaustion). Companies should pursue sensible levels of gearing.

6.9 ACTIVITIES

Activity One What do you understand by the term ‘Cost of Capital of a Company’? Explain its significance.

Activity Two How can the cost of capital be determined in theory?

6.10 SUGGESTED READINGS

ZviBodie, Alan Marcus and Alex Kane “Investments”, 6th or Latest Edition by McGraw-Hill

Higher Ed.

Sharpe, Alexander and Bailey, Investments, Prentice-Hall, 6th or Latest Edition

54  

UNIT 7 THE DIVIDEND DECISION-THEORY AND EMPIRICAL EVIDENCE

Unit Structure

7.0 Overview

7.1 Learning Objectives

7.2 Types of Dividend

7.3 Issues involved in Dividend Policy

7.4 Dividend Theories

7.4.1 Dividend Irrelevancy Theory

7.4.2 The Bird-In-The-Hand Theory

7.4.3 Tax-Preference Theory 7.4.4 Dividend Signaling Theory

7.4.5 Clientele Effect 7.4.6 Dividend as a Residual

7.5 Activities

7.6 Suggested Readings

7.0 OVERVIEW

The main decisions a financial manager has to face are the Financing Decision, the Investment Decision and the Investment decision. While the capital budgeting decision is concerned with what long-term assets the firm should acquire, the financing decision is concerned with how these assets should be financed. The dividend decision occurs when the firm begins to generate profits. The main concern of managers lies in whether to distribute all or a proportion of earned profits in the form of dividends to the shareholders, or should the profits be ploughed back into the business altogether and trying to find the optimum dividend policy.

‘Dividend policy’ refers to “the practice that management follows in making dividend payout decisions or, in other words, the size and pattern of cash distributions over time to shareholders”.

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Dividend policy and its possible implications of firm value has always captured the attention of finance scholars, who have tried to solve several issues pertaining to dividends and formulate theories and models to explain corporate dividend behaviour. However, the dividend enigma has not only been an enduring issue in finance, it also remains unresolved.

7.1 LEARNING OBJECTIVES

By the end of this Unit, you should be able to:

• Appreciate the fact that the dividend question remains an important decision for financial managers;

• Demonstrate understanding of the various types of dividends available; • Explain the different theories of dividend policy and their implications

7.2 TYPES OF DIVIDENDS

Dividend refers to cash distributions of earnings.

The various types of dividends are as follows:

1. Cash dividends

These are the most common and are usually paid four times a year.

2. Stock dividends

Stock dividends are not deemed to be true dividends in that a distribution of stock does not affect the value of the firm or the wealth of the shareholder. These dividends are paid out of Treasury stock.

3. Stock split

Similar to a stock dividend. The NYSE requires share distributions of less than 25% to be treated as stock dividends.

4. Share repurchases

° The company repurchases the stock. Shareholders pay tax only on the capital gains portion.

° Same effect as a regular dividend as cash leaves the corporation.

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7.3 ISSUES INVOLVED IN DIVIDEND POLICY

Managers need to exercise a high degree of judgment when establishing a sound dividend pattern since the latter to a large extent affects the financial structure, the flow of funds, liquidity, stock prices and shareholders' satisfaction.

Some of the main factors to take into consideration when determining a sound dividend policy are:

1.Cost of Capital

Prior to distribution of dividend, cost of capital needs to be taken into consideration. As a decision making tool, the Board calculates the ratio of profits that the business expects to earn to the profits that the shareholders can expect to earn outside. If the ratio is less than one, it is a signal to distribute dividend and if it is more than one, the distribution of dividend will be discontinued.

2. Realisation of Objectives

The dividend policy needs to be aligned with the main objectives of the firm and the shareholder wealth maximization principle.

3. Shareholders' Group

The prevailing dividend policy of a firm affects the ‘shareholders group’. A company with low pay-out and heavy reinvestment attracts shareholders interested in capital gains rather than in current income whereas a firm having high dividend pay-out attracts those who are interested in current income.

4. Release of Corporate earnings

Dividend distribution can be viewed as a means of distributing unused funds, whereby the financial manager needs to decide whether to release corporate earnings or not, thereby affecting the shareholders wealth by varying the dividend pay-out ratio.

7.4 DIVIDEND POLICIES

The three main theories of dividend policy are : high dividends increase share value theory (or

the so-called ‘bird- in-the- hand’ argument), low dividends increase share value theory (the tax-

preference argument), and the dividend irrelevance hypothesis. The dividend debate is not

limited to these three approaches. Several other theories of dividend policy include the

information content of dividends (signalling), the clientele effects, and the agency cost

hypotheses.

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7.4.1 Dividend Irrelevancy Theory

Modigliani and Miller (usually referred to as M&M), the proponents of the dividend irrelevancy

theory ,advance that a firm's dividend policy has no effect on its market value or its cost of

capital. It is argued that dividend policy is a "passive residual" which is determined by a firm's

need for investment funds. Following this argument, it therefore does not matter how a firm

divides its earnings between dividend payments to shareholders and internal retentions and trying

to find the optimal dividend policy since an optimal dividend policy simply does not exist.

The assumptions on which M&M built their dividend irrelevancy are as follows

1. Capital markets are perfect whereby investors are rational, information is freely available,

there are no transaction costs, securities are divisible and no investor can influence the market

price of the share.

2. There are no taxes.

3. The firm has a fixed investment policy which will not change. Hence,if the retained earnings

are reinvested, there will not be any change in the risk of the firm.

4. Floatation cost does not exist.

7.4.2 The Bird-In-The-Hand Theory

The main premise of the bird-in-the-hand theory of dividend policy, which was put forward by

John Litner and Myron Gordon is that shareholders are risk-averse and prefer to receive dividend

payments rather than future capital gains. Since shareholders believe that dividend payments are

more certain that future capital gains, therefore a "bird in the hand is worth more than two in the

bush".

It is argued that because of the less risky nature dividends, shareholders and investors will

discount the firm's dividend stream at a lower rate of return, "r", thereby increasing the value of

the firm's shares.

According to the constant growth dividend valuation, commonly referred to as Gordon's

growthmodel, the value of an ordinary share, SV0 is given by:

SV0 = D1/(r-g)

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Where g represents the constant dividend growth rate, r is the investor's required rate of return,

and D1 represents the next dividend payments. From the formula above, it is clear that the share

value is directly proportional to the value of the dividend payment and inversely proportional to

rate of return. Hence, the lower r is in relation to the value of the dividend payment D1, the

greater the share's value. According to Linter and Gordon, r, the return from the dividend, is less

risky than the future growth rate g from the investor’s perspective.

M&M debated against the aforementioned view, which they referred as the‘bird-in-the-hand

fallacy’. M&M state that the required rate of return or cost or capital, r, is independent of

dividend policy and that a company's risk, which influences the investor's required rate of return,

r, is a function of its investment and financing decisions, and not its dividend policy. As stated in

the paragraphs above, investors are indifferent between dividends and capital gains, i.e between r

and g of the dividend valuation model.

7.4.3 Tax-Preference Theory

According to this theory, taxes are important considerations for investors and since capital gains

are taxed at a lower rate than dividends, investors may prefer capital gains to dividends.

7.4.4 Dividend Signaling Theory

The ‘Dividend Signaling Theory" purports that a change in a firm's dividend hasan effect on its

share price, whereby an increase in dividend produces an increase in share price and vice-versa.

Now, the change in dividend payment is to be deemed to be a signal to shareholders and

investors about the future earnings prospects of the firm. Usually, an increase in dividend

payment is viewed as apositive signal since it conveys positive information about a firm's future

earning prospects thereby resulting in an increase in share price. The converse also holds true.

7.4.5 Clientele Effect

Different groups of investors, or clienteles, prefer different dividend policies. It is believed that a company’s past dividend policy largely determines its current clientele of investors.

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7.4.6 Dividend as a Residual

Supporters of this school of thought believe that the dividend pay-out is a function of its financing decision. The investment opportunities should be financed by retained earnings. It basically consists of the following steps:

• Find the retained earnings needed for the capital budget. • Pay out any leftover earnings (the residual) as dividends.

This policy minimizes flotation and equity signaling costs, hence minimizes the WACC.

Thus internal accrual forms the first line of financing growth and investment. If any surplus balance is left after meeting the financing needs, such amount may be distributed to the shareholders in the form of dividends. Thus, dividend policy is in the nature of passive residual. In case the firm has noinvestment opportunities during a particular time period, the dividend pay-out should be 100%.

A firm may smooth out the fluctuations in the payment of dividends over a period of time. The firm can establish dividend payments at a level at which the cumulative distribution over a period of time corresponds to cumulative residual funds over the same period. This policy smoothens out the fluctuations of dividend pay-out due to fluctuations in investment opportunities.

7.5 ACTIVITIES

Activity 1.

Discuss the theories of Dividend Policy and the possible implications on managers of a firm.

Activity 2.

What are the issues that can be faced when deciding on the dividend policy.

7.6SUGGESTED READINGS

• Sharpe, Alexander and Bailey, Investments, Prentice-Hall, 1999, 6th edition

• Brealey and Meyers, Principle of Corporate Finance, McGraw-Hill,1996, 5th or Latest

edition

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UNIT 8 CORPORATE RESTRUCTURING-MERGERS AND ACQUISITIONS

Unit Structure

8.0 Overview

8.1 Learning Objectives

8.2Motived for Formation of Mergers & Acquisitions

8.3 Mergers

8.3.1Types of Mergers

8.4 Acquisitions

8.5Benefits & Limitations of Mergers and Acquisitions

8.6Activities

8.7Suggested Readings

8.0 OVERVIEW

Corporate Restructuring is said to occur when there are changes in ownership, business mix, assets mix and alliances with a view to optimise shareholder value. Various ways in which this can be achieved are as follows: Mergers and acquisitions, leveraged buy-outs, share buyback, spin-offs, joint ventures and strategic alliances.

This unit explores the concepts underlying merger/takeover/acquisition activity and provides a better picture of same.The basis of undertaking any such decision lies in the value creation possibility. It is argued that mergers should be undertaken if they generate positive NPV and where the value of the merged firm created from firms X and Y (VXY) exceeds the sum of pre- merger values of X and Y (i.e VX + VY). This can be achieved through the exploitation of scale economies or elimination of inefficiencies. The pages that follow shall provide a deeper insight into same.

8.1 LEARNING OBJECTIVES

Upon completion of this unit, you should be able to:

1. Appreciate the underlying dynamics of corporate restructuring ;

2. Differentiate between mergers and acquisitions;

3. Assess the benefits and limitations of mergers and acquisitions ;

4. Discuss the challenges faced to implement the corporate restructuring processes.

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8.2 WHY M&A ARE FORMED

The motives for forming M& A can be analysed from two different standpoints, namely from the

seller side and the buyer side.

Seller’s reasons for merging

• The sale of the agency provides a good return onthe investment;

• Inability of the current agents to make the company successful;

• Growing age and wishing to transfer ownership and retire from the operations;

• Demise of a principal and passage of ownership interest to wife/children/family who do not

want any active involvement in the agency.

• Boredom, fatigue, frustration, leading to simply evade the ownership responsibility.

Buyer’s reasons for merging

• Efficiency explanations

It is believed that if firm X is managed more efficiently than Firm Y, then it is likely that the

merger of X with Y, will increase the level of efficiency of Y to that of X, thereby bringing

private gains as well as social gains. The rationale is that the predator firm generally consists of

superior management having much experience in a particular line of business. Therefore, under

efficiency theories, the basic motive for companiesX and Y to merge is the value creation

rationale, that is, the expectation that once put together, the two firms would be worth more than

individually. The value of the combined firm, Vxy, exceeds the sum of the values of the

individual firms, Vx + Vy, brought together. This added value is termed synergy.

In cases where synergy is absent, other reasons for M&A believed to have potential synergistic

are:

• Economies of scale

Larger firm size is usually associated with economies of scale-which are advantages that accrue

to the firm, in terms of lower average cost when the size of the firm increases. Economies come

from sharing central services such as office management.

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• Cost of external growth

Acquisition of another company can sometimes be cheaper than growing internally for big firms.

Moreover, the two merging firms may have complementary distinctions that each had been

unable to obtain until now due to barriers such as availability of finance. Hence, M&A can offer

a cheap as well as quick shortcut to growth and success.

• Information Theories

When a potential merger is officially announced, the Information Signalling hypothesis involves

the revaluation of a firm’s shares as a response to the new information available. Basically,

information theories stipulate that a merger shall occur when firm X believes that the market

value of firm Y is much below its true worth and acquiring firm Y will be a gain. In short, it is

believed that an undervalued company is more susceptible to be taken over.

8.3MERGERS

Mergers refer to the pooling together of two or more companies to form one company.

The features of a true merger are as follows:

• The parties aremore or less similar in size; • Management of the two entities is combined or unified after the combination. • The shareholders of the two combining businesses are still shareholders after the

combination.

8.3.1 TYPES OF MERGERS:

There are five most common types of business combinations known as mergers: conglomerate merger, horizontal merger, market extension merger, vertical merger and product extension merger. The term chosen to describe the merger depends on the economic function, purpose of the business transaction and relationship between the merging companies.

Conglomerate This type of merger is between firms that are engaged in unrelated business activities. This is broken down further into pure and mixed conglomerate mergers. The former involves firms with nothing in common, while the latter relates to companies looking for product extensions or market extensions.

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Horizontal Merger

Horizontal merger basically involves firms in the same industry. It often happens between competitors offering the same good or service and is common in industries with fewer firms, as there tends to be higher competition and the synergies and potential gains in market share are much larger for merging firms in such industries.

Vertical Merger

This type of merger is between two firms operating at different levels within the same industry's supply chain. The main aim of the vertical merger is to increase synergies created by merging companies that would be more efficient operating as one. It is referred to as vertical in the sense that the combination is a movement up or down the production ladder, which runs from production to distribution. Therefore, vertical integration can be either:

• Backward integration: this shows the movement of a firm, back down the supply chain. For example, acquiring an existing supplier of raw materials.

• Forward integration: is the reverse of backward integration. A company moves forward to the next stage in the market, which can be, for instance, buying an existing customer.

Market Extension Mergers

A market extension merger is said to occur when two firms dealing in the same products but in different markets merge together. The ultimate objective behind this type of merger is to provide the merging companies with access to a larger market that also safeguards a larger client base.

Product Extension Mergers

Another type of merger is the product extension merger which occurs between two companies dealing with related products and operating in the same market. This allows the merging companies to group their products together and get access to a larger pool of customers, thereby giving the possibility of earning higher profits.

8.4 ACQUISITIONS

Acquisitions or takeovers basically refer to the acquisition of the share capital of a company by another in exchange of cash, ordinary shares, loan stock or some mixture of these. During this process, the identity of the ‘acquiree’gets absorbed into that of the acquirer.

Contrary to a merger, an acquisition generally involves a larger company (predator) acquiring a smaller company (prey or target). The predator incorporates the target into its structure.

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It is worth noting that in the terms mergers and acquisitions are commonly used interchangeably and it is not uncommon for an acquisition or takeover to be referred to as a merger. This is because:

• Customers can have the wrong perception that an acquired company is weak and that there can be considerable upheaval post the acquisition. On the other hand, a merger portrays a better message to the customers.

• Employees of the target company may be feeling insecure and so to ensure that the predator company continues to get their commitment, it may be more appropriate to treat the combination as a merger and graduallymake the employees integrate into the system and culture of the new holding company.

8.5 BENEFITS AND LIMITATIONS OF MERGERS & ACQUISITIONS

The advantages of mergers and acquisitions include the following:

1.Economies of scale occur when a bigger firm with increased output can minimize average costs. Lower average costs enable lower prices for consumer.

2.International Competition-mergers can help companies deal with the threat of multinationals and compete on an international scale.

3.Mergerscan provide forlarger investment in R&D, which is due to more profits being made.

4.With greater efficiency, employees can be more productive and hence, redundancies can be avoided.

5. Mergers may be valuable in a declining industry where businesses are struggling to stay afloatand they can serve to protect an industry from closing.

6. In conglomerate mergers where two companies from different industries merge, there can be diversification of activities as there is increased sharing of knowledge and know-how.

Costs of mergers and acquisitions

Some of the costs incurred are as follows:

1. Legal expenses

Mergers and acquisitions can be expensive due to the high legal expenses and the cost for the acquisition of a new company may not be profitable in the short term

2. Short-term opportunity cost

M&A activity can be impaired by the short-term opportunity cost. This refers to the cost borne if the same amount of investment could be placed elsewhere for a higher financial return. At times

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this cost does not inhibit or dissuade the merger or acquisition because the anticipated long-term financial benefits outweigh the short-term costs.

3. Cost of takeover

The costs involved in the takeover of the target company may be very high.

4. Potential devaluation of equity

5. Intangible costs

6. Consumer and shareholder drawbacks

In certain instances, mergers and acquisitions may be to the detriment of shareholders, as well as consumers. This happens when the newly formed entity becomes a large oligopoly or monopoly. Moreover, if due to reduced competition, higher pricing power emerges, consumers may be left worse off financially. Some of the potential drawbacks to consumers with respectto mergers are:

• Increase in cost to consumers

• Decreased corporate performance and/or services

• Potentially lowered industry innovation

• Suppression of competing businesses

• Decline in equity pricing and investment value

At times, if the new managers become too complacent with its market positioning, shareholders may not stand to benefit. In other words, when a powerful and influential corporate entity is produced from the merger/takeoveractivity, this lessens industry competition and the company may be faced with non-competitive stimulus and lowered share prices.

8.6 ACTIVITIES

Activity 1.

Discuss the benefits and limitations of M & A.

Activity 2.

What are the various motives to merge?

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8. 7 SUGGESTED READINGS

Bradley, M., A. Desai and E. Kim 'Synergistic Gains from Corporate Acquisitions and Their Division Between the Stockholders of Target and Acquiring Firms', Journal of Financial Economics (1988) 21: 3-40.

Supporting Materials 

References  • Fabozzi,  F.J.,  Modigliani,  F.,  Jones,  F.J.,  and  Ferri, M.J.,  Foundations  of Financial Markets and Institutions. Third or Latest Edition 

• Thomas  E.  Copeland,  J.  Fred  Weston  “Financial  Theory  and  Corporate Policy (3rd or Latest Edition)” by Addison Wesley  

• ZviBodie, Alan Marcus and Alex Kane “Investments”, 6th or Latest Edition by McGraw‐Hill Higher Ed.  

• V.  K  Bhalla  (Author)  “Investment  management:  Securities  analysis  and portfolio management”  

• Bailey,  Jeffery  V,  and  Alexander,  Gordon  J,  and  Sharpe,  William  “Fundamentals of Investments”,3rd ed., Prentice Hall, 2000  

• Baye,  Jansen. 1996. Money, Banking &  Financial Markets, An  Economics Approach 

• Cheol, S. Eun. And Bruce, G. Resnick. International Financial Management, McGraw‐Hill. Third or Latest Edition 

• David Goacher. 1999. The Monetary and Financial System, Fourth Edition   • J.  Rutterford  ,1996,  “Introduction  to  Stock  Exchange  Investment”  Latest 

Edition • Ian, H., Giddy, 1997. Global Financial Markets. Latest Edition • Hull,  J.,  Introduction to Futures Options Markets, Prentice‐Hall, 1998, 3rd 

edition • Tavella, D.A., Quantitative Methods in Derivatives Pricing. An Introduction 

to Computational Finance, Wiley Finance Series, John Wiley & Sons, 2002.  • Wilmott, P., Paul Wilmott on Quantitative Finance, Vol 1 & 2, John Wiley & 

Sons, Reprinted, 2003.  • Robert Steiner,1997, “Mastering Financial Calculations.” By Pearson Ed. • Sharpe, Alexander and Bailey, Investments, Prentice‐Hall, 1999, 6th edition • Brealey and Meyers, Principle of Corporate Finance, McGraw‐Hill,1996, 5th 

or Latest edition • Keith Pilbeam “Finance and Financial Markets: Second Edition” by Palgrave • Elton,  E.  and  Gruber,  M.,  Modern  Portfolio  Theory  and  Investment 

Analysis, New York, John Wiley & Sons Inc. 1991 • Fabozzi  Frank,  J.,  Bond  Markets,  Analysis  and  Strategies,  Prentice‐Hall, 

1996, 3rd edition • Fixed  Income  Analysis  for  the  Chartered  Financial  Analyst  Program  by 

Frank J. Fabozzi (Paperback ‐ 2005)